Prospective tax cuts raise risk of new taxes

The government has proposed tax reductions in critical sectors including labor and retail in the next two years, as it tries to clamp down on tax evasion running at around EUR 30 billion. Experts, however, warn that the cuts should not pave the way for new taxes, as authorities may then face a lower overall tax take.

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The updated political strategy of the third cabinet of Prime Minister Victor Ponta was adopted last week in Parliament by Ponta, following the break-up of the center-left coalition, the USL. The program proposes a 5 percentage points cut in VAT and social contributions along with a progressive income tax and a 22 percent hike in the minimum wage.

The International Monetary Fund (IMF) has repeatedly urged the government to clearly outline new streams of revenue if it moves to cut taxes so as to prevent any widening in the budget deficit. The country currently has a EUR 4 billion stand-by agreement with the IMF and the European Commission, the executive arm of the EU. A new review mission of the international lenders is due in Bucharest next month.

The government said that these measures could be implemented in the next two years, provided that there is “room” in the fiscal-budgetary framework.

Ioana Petrescu, the finance minister, said last week in a broadcast appearance that her main priority as minister would be to put in place a more efficient tax collection system. Easing the burden on taxpayers has been cited as one the main drivers in achieving this goal.

Hopes for a CAS reduction from July

“I am a big supporter of a reduction in CAS (e.n. social security contribution). I hope that the reduction (…) will be made this year. If not, we could include it directly in the Fiscal Code at the beginning of next year. I hope we can do it from July,” said Petrescu, a Harvard alumnus and former adviser on taxation matters to PM Ponta.

Members of the business community have been calling for a reduction in CAS in recent years, arguing that it could help create more jobs and shrink the black labor market.

Mihaela Mitroi, tax and legal services leader at PwC Romania, the professional services firm, said the Romania’s labor taxation of 45 percent is among the highest in Europe, while the caps on social contributions are also big, accounting for five medium average wages. Meanwhile, the EU average of social contributions in the EU stands at 35.6 percent, while in neighboring Bulgaria is 30.3 percent.

According to statistics from the Fiscal Council, an independent think tank specializing in budgetary matters, Romania’s informal labor market was made up of around 1.4 million workers in 2012, accounting for 23.2 percent of the total employees in the economy.

Overall, local tax evasion reached around EUR 30 billion in 2012, which is equivalent to 24.5 percent of GDP, according to data from the National Statistics Institute (INS).

“In the current macroeconomic context, as is the case with other fiscal ‘easing’ measures, the target of reducing CAS for employers by 5 percentage points would both support consumption and investments, and be an attempt to attract additional resources to the budget by reducing employers’ incentives to make ‘informal payments’,” Ionut Bohalteanu, partner at law firm Musat & Asociatii, told BR.

“It is well known that Romania has one of the highest labor taxation rates in Europe, which is still unattractive for investors. In addition, this labor taxation level forces numerous people to seek alternative income sources, which are not necessarily legitimate, in an effort to avoid the system.”

According to Romulus Badea, tax partner at Soter & Partners, a tax consultancy, the government should pursue voluntary tax compliance by easing the fiscal burden on companies. He commented that controls by the tax collection agency ANAF and labor inspection body ITM cannot cope with the sheer size of the black market.

Claudia Sofianu, human capital country practice leader at EY Romania, said the professional services firm, the five percent in reduction in CAS would lower total wage costs by four percent (around RON 100), if we taken into account the average gross medium wage of RON 2,298 (EUR 510). However, for unskilled labor or seasonal jobs, such as in the construction sector, the minimum wage is declared.

“As a result, we do not think this reduction would in any way reduce the black labor market, and even less stimulate the creation of new jobs,” Sofianu told BR.

Government wants progressive taxation on income

Another measure included in the political strategy is the enforcement of a three-tier taxation system for individuals, depending on their wage.

A progressive taxation of wages with fiscal deductibility of 8, 12 and 16 percent will be applied depending on income scales to be established.

Bohalteanu of Musat & Asociatii said this measure should in principle help increase domestic consumption and the disposable income of low earners. However, he added that it would create an additional burden for companies, which would have to make differentiated reporting on income statements and change their IT systems, as well as for ANAF, which would oversee the implementation of the measure.

The reduction of CAS and the progressive taxation rate should create enough room for the government to gradually increase the minimum wage to RON 1,100 (EUR 243), according to Badea of Soter & Partners. The government has reduced the minimum wage target for 2016 by RON 100 (EUR 22), a move that was included in the political program approved in 2012.

Sofianu of EY said any growth in the minimum wage has to be sustained by an organic growth of the economy.

“Any other option is not feasible, given the persistency of a significant budget deficit,” s said Sofianu. She commented that the current fiscal framework does not allow any reduction in the level of the black labor market.

“This is due to the fact that those employing people on the minimum wage and paying the rest of the money “under the table” will make part time labor contracts and thus, pay officially less than the minimum wage,” she added.

Sofianu expects the flat tax rate to be kept at least by the end of this year. She said the reduction of the taxes for low earners is not the solution, but the increase of the tax deductions, which would reduce the taxable base and help them obtain a higher net income.

She commented that scrapping that flat tax rate may pave the way for a further increase of the maximum tax rate, which would hit the economic activity and push higher wages in the area of tax evasion.

Mitroi of PwC added that once progressive taxation is rolled out, authorities may be tempted to increase the rates, which would impact the economy and consumption, and in the same time discourage labor, saving and local capital formation.

Lower VAT needs higher tax take

PM Ponta said last week that the return of VAT to 19 percent would be sustainable if the economy continued to grow at over 3 percent annually, according to Mediafax newswire. VAT was hiked from 19 to 24 percent in 2010. Official estimates show the local economy is set to grow by up to 3 percent this year.

“Discussions regarding the reduction of VAT from 24 percent to 19 percent are premature. The government should realistically assess the impact of these measures and estimate if there is room for it, fiscally. Such a reduction would be beneficial only if it were supported by a significant improvement of collection and not through the introduction of new taxes to cover the gap. At present, tax evasion on VAT is very high and you cannot achieve miracles in the short term,” said Badea of Soter & Partners.

He suggested the government make targeted cuts in VAT for food products, following the reduction of VAT on bread to 9 percent last year.

“Even this measure has to be sustained by a better tax collection and not by new taxes, such as the increase in excises last summer. If this is not possible, the economic value of this fiscal measure disappears and only the electoral one remains,” added Badea.

VAT currently accounts for 26 percent of revenues to the state budget, amounting to around RON 51.8 billion (EUR 11.5 billion), according to Mitroi of PwC.

“Assuming the reduction would be partially offset by the decrease in tax evasion, which is significant on VAT, it would still create a gap of a couple billions of RON to the state budget. As a result, we do not expect a reduction in VAT on the short term, but some differentiated rates for other food products (oil, milk, sugar, cooking oil), which would have a positive social benefit, but would also contribute to the decrease of tax evasion,” Mitroi told BR.

PM Ponta has said that lower VAT should be applied in areas where tax evasion is rampant.

“From my point of view, we have to focus, as much as possible, on targeted areas (…) I would like this in fruit and vegetables, because there we also have huge fiscal evasion and unfair competition between local producers and the fruit and vegetables that are brought from outside the EU and within the EU, where we have evasion on intra-community taxes,” said Ponta in a TV appearance.

He hinted that VAT on meat could also be slashed to 9 percent, in addition to fruit and vegetables, “if possible”.

According to agriculture minister Daniel Constantin, tax evasion on meat imports dropped from 50 percent in 2012 to 30-40 percent this year, a level he said “is still very high”. However, he acknowledged that control institutions were doing their job.

Bohalteanu of Musat & Asociatii warned that the proposed 5 percentage points reduction in VAT would eat into budget revenues, given that VAT collection currently has the second biggest share in the budget, after contributions. He said the government should focus on collecting more taxes to make this measure work.

The partner added that the reduction of VAT on bread and the reverse taxation on cereals trading had reduced evasion and fraud in this sector, which is barely taxed. Bohalteanu said this had happened because the potential “gains” of those involved in such activities had been diminished.

Florina Paring, tax senior consultant at EY Romania, said: “On the backdrop of the low collection of budget revenues, the VAT ensures a fast collection (until the 25th of the next month versus the one in which the delivery was made) to the state budget when transactions are carried out by fair tax payer.”

She said that any discussion regarding the punctual reduction of VAT in other food products could be made after the impact of VAT reduction in bakery products on the budget revenues is assessed.

Ovidiu Posirca

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