ROMANIA: NEW GOVERNMENT INAUGERATES FISCAL

UNCLAS SECTION 01 OF 03 BUCHAREST 000130

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SENSITIVE

E.O. 12958: N/A
TAGS: ECON ETRD EIND EFIN RO
SUBJECT: ROMANIA: NEW GOVERNMENT INAUGERATES FISCAL
REVOLUTION WITH ADOPTION OF FLAT TAX

RE: Bucharest 01873

THIS MESSAGE IS SENSITIVE BUT UNCLASSIFIED - PLEASE PROTECT
ACCORDINGLY


1. (SBU) SUMMARY: Just before New Year's eve, and the day
after receiving Parliament's vote of confidence, the new
center-right government of PM Calin Popescu-Tariceanu
carried out its campaign pledge to amend the Fiscal Code and
introduce a 16% flat tax on personal income and corporate
profits. The new tax rate was effective January 1, 2005.
The IMF is concerned that the measure may result in the
GOR's not meeting this year's programmed budget deficit
target of 1.5% of GDP. The Government is counting on new
revenues from both the hitherto untaxed gray economy and
from economic growth. Measures to increase tax compliance
must still be enacted, but legal actions just taken against
some of the most dubious objects of economic largesse of the
last Government may have a salutary impact on revenue
collections. END SUMMARY.

ROMANIA JOINS THE FLAT TAX CLUB
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2. (U) One of the main pledges of the center-right Liberal-
Democratic (PNL-PD) alliance throughout the autumn
parliamentary and presidential campaign was to introduce a
flat tax of 16% on personal income and corporate profits.
On December 29, in the first cabinet meeting after receiving
a Parliamentary vote of confidence, the first major act of
the new PNL-PD led government was to enact the measure
through an emergency ordinance effective January 1, 2005.
Prime Minister Calin Popescu-Tariceanu and the new Finance
Minister Ionut Popescu declared that the purpose was to put
more money in Romanian taxpayers' pockets, create more jobs
and stimulate foreign direct investment (FDI). Through the
"multiplier" effect generated by increased employment and
greater disposable incomes, the Romanian government expects
to collect more tax revenue over time. In addition, the GOR
hopes to reduce tax evasion and bring more money into
national coffers through "surfacing" the underground (gray)
economy, in which many workers receive unreported, untaxed
wages. (Note: The last Government estimated a full quarter
of the economy was represented by the informal or gray
economy in 2004.


3. (U) Romania is not the first country in Eastern Europe
with a flat tax. According to information available to
post, Estonia, Latvia, Serbia, Ukraine, Slovakia, Russia,
and most recently Georgia have adopted flat tax rates
ranging from 12 to 26%. Romania's 16% corporate tax is the
region's second lowest (Georgia's is 12%),while only Russia
(13%) and Georgia (12%) have lower flat tax rates on
personal income.

GOVERNMENT MESSAGE: EVERYONE WINS, NO ONE LOSES
-------------- --

4. (U) The Government promises that no employee will lose
through replacement of the former personal tax brackets
(which ranged from 18-40%) with the new 16% flat tax. Under
the flat tax, the main deduction an employee receives are
the personal and dependent deductions. For employees
earning up to a gross monthly wage of ROL 10 million ($345),
the deductions range between ROL 2.5 million ($86),for
those with no dependents to ROL 6.5 million ($225),for a
wage-earner with four or more dependents. Deductions are
gradually lowered for employees with gross monthly wages
between ROL 10 and ROL 30 million ($1,037),with no personal
deductions for those with gross monthly wages exceeding ROL
30 million. Other deductions preserved include private
health insurance (up to euro 200 per year per person),
social security contributions, optional contributions to
occupational pension schemes (life insurance, up to euro 200
per year) and expenditures for employees carrying out
independent activities (commerce or professions such as
lawyers, medical doctors).

BUSINESS HAPPY, LABOR COMPLAINS
--------------

5. (U) The business community's reaction was predictably
enthusiastic. Both the American Chamber of Commerce in
Romania and the Foreign Investor's Council hailed the
measure as a step forward toward creating a stable and
predictable tax environment for investors. Trade union
leaders, however, denounced the flat tax as "socially
unfair," disproportion ally benefiting wealthy taxpayers.
The former governing Social Democratic Party (PSD) similarly
characterized the flat tax as a "political measure,"
claiming the flat tax will lead to major medium and long
term problems for the budget and will have to be compensated
by either raising excise taxes or by drastic budget cuts.

FISCAL IMPLICATIONS SUBSTANTIAL...
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6. (U) According to Finance Minister Popescu's estimate, the
budget revenue losses could amount to $242 million from the
profit tax cut and $830 million from the 16% flat income
tax. While conceding a transition period of budget revenue
losses, the Finance Minister is optimistic that budget
revenues will ultimately increase, as has happened in other
countries that have adopted a flat tax.

...SOME TAXES SET TO RISE
--------------

7. (U) To compensate for these projected losses, the new
Government introduced a series of tax hikes. The micro-
enterprise tax, applicable to firms with nine employees or
less, was doubled from 1.5% to 3.0% of total turnover.
According to the Finance Minister, the doubling of the tax
paid by mico-enterprises is an attempt to uncover personal
incomes disguised as micro-enterprise revenues. A
significant number of these enterprises are organized to
circumvent payment of employee-employer payroll taxes
through "spinning off" operations into micro-enterprises for
favorable tax treatment.


8. (U) Other tax increases include:
Dividends obtained by individuals will be taxed at 10%,
level with the corporate dividend tax;
- Agricultural income tax is increased from 15% to 16%;
- Gambling tax is increased from 10% to 16%.


9. (U) Despite the fact that the former PSD government
approved a 2% cut in payroll taxes for 2005, the new
government annulled this measure, maintaining social
insurance contributions at 49.5%. The downside to this is
with social contributions remaining high, a strong incentive
remains for employees to continue working in the untaxed
"gray" economy.

IMF'S CAUTIOUS REACTION
--------------

10. (U) The IMF initially expressed concern regarding the
GOR's recent fiscal step. The IMF resident representative
met with Finance Minister Popescu prior to the cabinet
meeting of December 29, 2004. He conveyed the message that
the 1.5% of GDP deficit for 2005 is the maximum Romania can
afford and perhaps should be decreased in order to ensure
Romania meets inflation and current account deficit targets.
He also advised the GOR to refrain from taking any step
prior to the visit of the IMF's technical team scheduled for
January 25. Nevertheless, he conceded the new Cabinet's
move to introduce the 16% flat tax was in line with regional
trends to reduce taxation. He subsequently softened his
position, noting that the IMF visitors would examine
budgetary implications.

REFORM BY DECREE - THE MECHANISM
--------------

11. (U) The government introduced the flat tax on December
30, 2004, through Emergency Ordinance 138 to Law 571/2003 of
the Fiscal Code. In the preface to the ordinance the
Government stated it was necessary for the measure to take
effect at the beginning of the year (2005),because waiting
until later would result in fiscal confusion and uncertainty
for taxpayers and complicate tax collection.


12. (U) Two issues cloud the issuance of the emergency
ordinance. Formal consultations with the Social and
Economic Council (CES),required before passage of emergency
ordinances, did not occur as the CES was on vacation.
However, the new Government stated it had received the CES's
approval "in principle." Secondly, as with all emergency
ordinances, the flat tax measure will ultimately have to be
ratified by the Parliament at a later date. Parliament
could ultimately reject the flat tax, although this is
unlikely given the current majority held by the Government.

COMMENT
--------------

13. (U) The new GOR's ordinance has positive and negative
implications for the new government. On the positive side,
it demonstrates the Tariceanu government's commitment to
keep its election promises to cut taxes to improve living
standards and build a more business friendly environment.
Further, the new government's tax philosophy makes sense as
long as the 2005 tight budget deficit (1.5% of the GDP) and
disinflation process are not endangered. The flat tax
simplifies fiscal legislation, cuts fiscal administration
and collection costs, and renders the economy more
transparent. On the negative side, however, there is a risk
of macroeconomic disequilibria, with government revenues
initially expected to decline.


14. (SBU) Changing the mentality of Romanians is another
major obstacle. A high payroll tax (49.5% of wages) is
still the main obstacle to bringing the wages actually
earned, but not reported, out in the open. It will keep
substantial numbers of Romanians in the "gray" economy.
What is likely to be more openly reported is the incomes of
self-employed persons (architects, accountants, lawyers,
physicians),who might elect to pay the 16% flat income tax
rather than risk being charged with tax evasion. It is
significant that anti-tax dodging measures have not been put
into place. Nevertheless, the average taxpayer and
corporation can hardly fail to absorb lessons carried in the
daily press in recent days about new indictments issued
against some of the country's corrupt "big fish" who had
taken advantage of favorable tax debt for shares swaps or
tax holidays.


15. (SBU) Post does not perceive that a major problem has
arisen between the IMF and the GOR regarding the flat tax or
that the IMF doubts the GOR's commitment to continuing
prudent fiscal policies. Nonetheless, post plans to speak
with the local IMF representative to gauge IMF flexibility
with the new government and report Septel.
DELARE