BULGARIA WOOS INVESTORS WITH 10 PERCENT CORPORATE

UNCLAS SECTION 01 OF 02 SOFIA 001495 SIPDIS SIPDIS E.O. 12958: N/A TAGS: EFIN ECON PGOV EINV BU SUBJECT: BULGARIA WOOS INVESTORS WITH 10 PERCENT CORPORATE TAX; CONTINUED STRONG GROWTH ¶1. SUMMARY: The Bulgarian government's recent decision to lower the corporate tax rate to 10 percent was a bold act to put the country in the lowest bracket in Europe, attract foreign investors and encourage domestic growth. During its recent mission visit, the IMF commended continued strong economic growth and the government's prudent fiscal policies. The widening current account gap of 14.2 percent, however, remains a point of concern for the Fund. Inflation of 5.6 percent, well above the Maastricht criteria for eventual eurozone entry, is also a potential problem. The IMF argued against a corporate tax reduction because of its affect on next year's budget, which currently enjoys a more than three percent surplus. END SUMMARY BUSINESS PRAISES CORPORATE TAX CUT, WHILE IMF OPPOSES ¶2. In proposing to cut the tax rate, Bulgaria seeks to win "the race to the bottom" and establish itself in Europe as a tax champion. Through the lower rates, officials hope to attract more investments, encourage further business development and reduce the level of the gray economy. However, the IMF sees potential risks to the budget due to the expected 10 percent growth in public sector wages and the payment of 624 million BGN (USD 405 M) in EU membership fees in 2007, and called on authorities to abolish as "groundless" the introduction of the new rate. The decision for the tax abatement was agreed to by the three-party coalition, and must now go to parliament where it is likely to pass without significant opposition. Parliamentary budget committee chairman Petar Dimitrov said the decision is final and is part of the draft budget for 2007. IMF PRAISES GOOD MACROECONOMIC INDICATORS ¶3. During its October 18-25 mission, part of the fourth and final performance review under the precautionary standby agreement expiring in March 2007, the IMF commended Bulgaria's strong economic performance so far in 2006. The Fund projected 6 percent growth for this year, higher than the previous estimate of 5.5-5.6 percent. The Fund pointed to buoyant domestic demand, especially in the investment sector, and praised the government's tight fiscal policies, with an expected budget surplus for 2006 at around 3.3 percent of GDP. CURRENT ACCOUNT DEFICIT GROWS EVER LARGER ¶4. Despite tight fiscal policies, the risk from the rising current account deficit remains high, according to the IMF and others. The Fund estimates that the current account deficit is likely to grow to over 14 percent of GDP this year, versus 11.8 percent in 2005, and this expansion is expected to continue in 2007. The Fund attributes the current account deficit to strong private domestic demand -- particularly in the import sector -- fueled by a substantial resurgence of bank credit growth. Foreign Direct Investment (FDI) covers around 90 percent of the current account deficit, which when combined with strict bank regulation gives most observers confidence that this will not become a serious problem in the short term. After a complete standstill of privatization in 2005, this year the process has regained momentum, which should bring more FDI to Bulgaria. The IMF remained critical of progress in implementing structural reforms, calling it "uneven." INFLATION TO FALL FROM LAST YEAR, BUT STILL HIGH ¶5. Conservative fiscal policies will help bring the expected end-year inflation down to 4.8 percent from last year's 6.5 percent, according to the Fund. Although this projection seems rather optimistic, especially compared to official estimates of 6.6 percent for 2006, it follows the recent deflationary trend. Inflation remains the only macroeconomic parameter under the Maastricht criteria for eurozone entry that the GOB has failed to achieve at this point. EU membership may provoke some upside pushes on domestic prices in early 2007, but the GOB argues that there are no economic reasons for a price boom after 2007. The Finance Ministry is optimistic that Bulgaria will be fit to enter the eurozone in 2010. Prime Minister Stanishev called on business to be cautious about raising prices. IMF DRAFTS THREE POLICY RECOMMENDATIONS ¶6. The IMF encouraged authorities to maintain the deflationary trend of the past quarter while sustaining strong growth and containing the current account risks. To this end, the IMF drafted three policy recommendations: --Maintain a minimum budget surplus of two percent of GDP in 2007 based on realistic budget projections and without SOFIA 00001495 002 OF 002 relying on within-year conditional caps on discretionary spending; --Moderate wage increases in the public sector to secure an affordable wage bill; --Intensified efforts in the implementation of structural measures in the remainder of this year. ¶7. COMMENT: Bulgaria faces tough decisions over the next few months on its fiscal outlook. Budget hawks will push to maintain a substantial surplus in order to reduce inflation, cut the current account deficit, and qualify for early eurozone entry. Threats to the strong fiscal picture will come chiefly from the new tax cut, political pressure to raise social spending, additional payments to the EU for membership and to finance Bulgaria's share of EU-sponsored projects, and increased price expectations due to EU entry. In our view, the coalition government understands the competing needs and will do what is needed to keep it all in balance. As Finance Minister Oresharski told the Ambassador recently, "we've worked too long to rebuild our fiscal reputation internationally" to allow populist or political pressures to weaken macro discipline." END COMMENT BEYRLE