Laurian Lungu: A significant and rapid reduction of excessive tax evasion is necessary in Romania

Interview with a Romanian economic expert on fiscal policy and issues related to the budget deficit, public debt, labour taxation and foreign investment in Romania

Ancuța-Carolina Stanciu, Financial Intelligence (Romania), 28 February 2024

Laurian Lungu is co-founder of the think-tank Consilium Policy Advisors Group. Previously, Laurian Lungu worked in academia, doing extensive economic research and teaching courses in macroeconomics and mathematical methods in the UK at Cardiff University’s economics department. Mr Lungu is the author of several articles and analyses published in internationally renowned journals and books in areas related to macroeconomic modelling and forecasting, economic policy, international finance and energy. Laurian Lungu holds a PhD in economics from Cardiff University, an MA in economics from the University of Liverpool and an MBA from the Canadian MBA program in Bucharest.

Cross-border Talks team decided to republish this article due to important data and statements on Romanian economy, including on tax evasion and budget resources in the electoral year. We may not agree necessarily with all the suggestions advanced in the talk, though.

Highlights from the interview with him:

  • “Turnover tax has no economic basis in the current tax philosophy. It belongs to the category of anti-economic tax innovations, like one of its forerunners, the famous “pole tax”. The simultaneous increase of the tax level for the whole business environment, i.e. large companies, SMEs, micro, i.e. everything that means productive capacity, is a mistake, which will influence the market conditions in the Romanian economy”.
  • “Tax evasion has become a national security issue; efforts by the authorities to control it have limited results since evasion is on an upward trend, especially uncollected VAT” .
  • “It is likely that some of the smaller firms have closed down, many affected by the new tax regulations and the legislative uncertainty surrounding them.”
  • “Public debt, as a ratio to GDP, has been increasing for almost two decades, even though we have had significant economic growth during this period”
  •  “The biggest shock to budget spending is the pension increase; it will be difficult to implement that 40% pension increase in September 2024 under current conditions because we are talking about huge costs.”
  •  “I don’t think we will have a nationalisation of private pension funds. If that were to happen, it would be a tragedy for the economy.”
  •  “In extreme situations I expect a VAT increase – it’s the most handy solution.”
  • “In 2007, we had public debt to GDP at 12.7%, now we are at 59%.”

How do you see the economic situation in this election year?

Electoral influence no longer has as great an economic impact as it did 15-20 years ago. Back then it was a different time, our budget responded to the election cycle much more strongly, there was spending to win elections in the territory.

Now the space is more limited because we are also in an excessive deficit procedure. The European Commission is looking at the budget deficit and then the possibility of having discretionary spending for elections is also much smaller.

Overall, I see Romania’s economic situation as positive, compared to other countries in Europe. I always think we have to make this comparison, even if our economy is expected to grow by more than 2% this year.
It may seem like a relatively small figure, but if we look at what is happening in the region, we see that we basically have one of the fastest growing economies in Europe, including Eastern Europe, where countries usually grow faster than the EU average. From this perspective, I would still remain relatively optimistic that we have growth potential that we need to exploit, which comes mainly from European funds.

Minister Boloș recently told Bloomberg that we are in for seven years of poverty and that there is no way he can cut spending in an election year, even though he has increased taxes for business.

Indeed, we have a budget deficit problem. It’s been a problem for years and it’s practically become endemic. Some corrections should have been made on the expenditure side if we want to reach the budget deficit target.

We know well that the budget deficit in 2023 was the same as in 2022 as a percentage of GDP, i.e. about -5.7%. The government sees for this year a deficit of minus 5% of GDP equivalent.

In my opinion, it will be quite difficult to achieve, because, as the Finance Minister said, it is difficult to cut spending in an election year. In my opinion, in this case, he also has the understanding, perhaps not even the full understanding, of the European Commission. The European authorities are insisting on a downward trajectory for the budget deficit, and getting the budget deficit to minus 3% of GDP by 2026 at the latest will be very difficult. On the other hand, given these successive crises that have hit Europe, politicians are certainly also thinking about the electorate, they are also weighing up the extremist side. If you go ahead and cut budget spending, you can end up with certain extremist parties winning more seats in the European Parliament. These calculations are made in Europe in many countries, not only in ours.

Hence this situation – we have a high budget deficit, it will remain high and probably for the next one to two years.

This year there will be no increase in taxes – at least compared to what they already increased on 1 January. And then, if you don’t cut spending and increase taxes or make other adjustments, it’s clear that the budget deficit will remain very high.

So I think that this year we have some agreement from the international institutions, provided that the budget deficit does not get out of control, i.e. that it continues to decline. I don’t know where this decrease will come from, probably from the reduction in investment, which is always the case, from year to year.

But the biggest shock to budget spending is the increase in pensions. All sorts of estimates have been made. This year, pensions are expected to double, they went up in January by 13.8% and we have another 40% increase in September. Cumulatively, this effect of the pension increase has an impact of 30 billion lei (6,04 billion euro) on the budget in 2024 alone, so it is in addition to what pensions cost, which is the equivalent of almost 2% of GDP.

Putting this into perspective, it is hard for any economist to see how the state will bring in an extra 2% of GDP in revenue to pay pensions and keep the budget deficit around 5%. It’s a question we may find the answer to later.

Laurian Lungu (source: YouTube)

How do you see 2025? Are we likely to see drastic measures such as VAT increases or the nationalisation of pension funds?

In 2025, the problem is even more complicated because the impact will be stronger. If this year we have a 40% increase in pensions from September 2024, in 2025 we will have this increase for the whole year. And then we are talking about an effect of 3.2% of GDP equivalent. That’s how much pension reform costs the budget.

I for one do not see how to implement the pension increase under the current conditions, because we are talking about enormous costs. Perhaps this pension increase will be phased in over several years. It is very difficult to have such a high cost and to find a way to recover it, especially as we have a very high budget deficit.

In extreme situations I expect an increase in VAT – it is the most handy solution.

We already have some very high taxes – we are in the top third of Europe in labour taxation. I’m not just talking about income tax, but social security contributions, health contributions, etc. Together, all of these put Romania in the top third of Europe in terms of taxation.

So what’s left to tax?

If you tax the workforce that high, you go on consumption. And then I certainly see the option of raising VAT temporarily, for a year or two, if the budget deficit gets very deep, although it will be to the detriment of the economy.

I don’t think we will have a nationalisation of private pension funds. If that were to happen, it would be a tragedy for the economy, for economic principles, for what we as a country have committed ourselves to, for the direction we want to take. This would be a turning point for economic policies in Romania and let’s hope we don’t end up there.

Last year, foreign direct investment (FDI) plummeted to around €6 billion from €10 billion the year before. How do you see FDI evolving, given the tax increases and lack of predictability for business?

2021 and 2022 were special years. If you look at an average of foreign investment as a percentage of GDP, between 2012 and 2019, the average was 2.2% of GDP. Last year, it was 2.1%. Basically, we are back to the average of the last decade.

In 2020, FDI fell because it was the year of the pandemic, then there was a rebound in 2021-2022 and it was somewhere between 3.5 and 3.8%, and now we’re back towards 2.1%.

In principle, I would not see the situation as catastrophic, just a return to the normal trend of the last decade. But it is clear that we need foreign investment, especially for climate transition.

Taxes for business have been increased. Will this increase bring more money to the budget? Or will we see the growth of the underground economy?

This is, indeed, the great puzzlement. We are all waiting for the results of the first quarter of 2024.

From an economic point of view, I notice that many small companies have closed down, many of them affected by the new regulations which are unclear and leave room for interpretation.

People say that the uncertainty is far too great, that their margin of gain was relatively small anyway. And then obviously if you have this very high uncertainty hitting you and basically you’re working on a low margin, you choose to close your company.
It remains to be seen what will happen in the future, and what the effect will be on the economy. In addition, it’s not only small firms that have been hit.

On the other hand, the cap on microenterprises had to be lowered, even the current one is high. The concept of a micro-enterprise is a help when you start a business, you have some tax advantages when you are relatively small. You can’t have very high turnover ceilings and remain micro. This was a problem that was corrected and even so the micro cap is high today.

I understand that there is a further lowering of the ceiling for micro-enterprises in the National Recovery and Resilience Programme to €60,000 turnover.

I think 60,000 euros is an ok ceiling. I would average it out to 40% of total turnover.

Regarding the turnover tax on companies with more than 50 million euros, plus the additional turnover tax on companies operating in the oil and gas sector, these are aberrations because they have no economic basis and will create big problems for large companies in Romania. We are talking about different sectors that have different profit margins and cannot be treated in a lump sum. There is no such thing in the whole of Europe. This is a banana policy and basically it affects your production capacity very strongly.

The authorities were wrong to take measures that affected both the SME, micro sector, but also strongly influenced large firms at the same time. Of course, many of the measures for SMEs and micro should have been taken long ago, but the key word here is concomitant. Through the policies that have been taken, they are simultaneously, significantly, affecting production margins for companies at all levels in the country. This is a big mistake.

When you do a tax reform or introduce a tax package, you think about it in such a way that it balances certain things. That has not happened here. Here it has hit everything that means production margins in Romania with high intensity. A mistake for Romania that is not economically based.

Turnover tax we had in the 1920s in Europe and it turned out to be a system that didn’t work eventually. Basically, this is a measure that I can’t support as an economist in the current context of tax philosophy, and I think it hurts the economy.

What is your opinion about state loans in recent years?

In 2007, we had a public debt to GDP ratio of 12.7%, now we are at 59%.

We had two big jumps, one after 2008, when the financial crisis hit, and we reached somewhere around 40% in 2011. We stayed there at 40% until 2019 when we had the pandemic crisis and costs went up. We borrowed and public debt as a percentage of GDP jumped to 56%. And now we’re at 59% of GDP.

The basic problem is that in 2007, almost two decades ago, we had an increasing public debt as a percentage of GDP, while we had economic growth.

In the economy you can accumulate debt, but when you have economic growth, you reduce public debt as a percentage of GDP. But we have borrowed continuously. This is a major structural problem.

We practically cannot reduce the public debt and now we are talking about increasing pensions and other reforms, big investments that the state is going to make in the economy – where is all this money coming from? What are you doing? Do you borrow more?

If we compare ourselves with other countries, we can say that we are fine at 60% debt to GDP, because there are others with 80-90-100% debt to GDP. But that is not an explanation. Romania’s economy cannot sustain public debt at the level of other countries because it does not have the productive capacity. This really is a fundamental problem.

I look back 18 years and see that we have not decreased public debt in GDP at all, even though we have had economic growth. And that to me raises a big question mark. We have had economic policies calibrated for that. In 2018 we couldn’t create a budget deficit and we borrowed for various things.

I wouldn’t count the pandemic because we’re talking about a global shock there, everyone has borrowed. But on top of these global shocks, we have domestic shocks, which have created these problems.

Much more should have been done to reduce public debt to GDP, not increase it.

We seem to have the highest inflation in the EU. How do you see inflation in the future? What will interest rates be like? What about the euro-leu exchange rate?

The leu-euro exchange rate has been relatively stable for years. If you look at it, the variations are very small over the course of a year. I expect it to stay there, unless something dramatic happens, some big financial crisis in the markets. So, in the absence of an external factor that is disruptive, I think it will stay there, especially as the foreign reserves of the National Bank of Romania have increased a lot.

On inflation, we still have high inflation at the end of January compared to January 2023 because we had the fiscal impact with the tax increases. But if you look at the 12-month average – because that’s a fairer figure – we’re not that bad, we’re still somewhere up, but the trend is down.

Inflation has generally been caused by external factors and now the influence of those external factors has diminished, I am referring to the price of energy, commodities, etc.

The forecast is for inflation towards 5% towards the end of the year, which is possible.

On interest rates, the question is what the National Bank of Romania will do.
We are somewhere close to having positive real interest rates, but probably the National Bank of Romania will not make a decision to cut interest rates yet until inflation has been down for a while. This is the view of other central banks and it matters a lot what the European Central Bank does, what the banks in the region do.

US investors look to the Fed as God…

There was quite a lot of media pressure on the Fed to lower interest rates, including on the ECB, but they resisted because, basically, until inflation comes down and stays down for a while, you can’t cut interest rates.

The authorities insist on this, because they learned from the 1970s and early 1980s, when we had the oil price shock, inflation rose, central banks, after a while, cut interest rates and then we had the second big inflationary spike.

Lesson learned – don’t cut interest rates until inflation is low and stay there for a while.

What are the biggest risks to the Romanian economy, in your opinion? Is an agreement with the IMF possible?

The biggest risks are on the part of not accessing European funds through the National Plan for Recovery and Resilience and the other European funds, because there is a lot of money, which Romania’s economy badly needs.

This I think would be the biggest risk – failure to meet the targets, the milestones in the National Plan for Recovery and Resilience, so that these tranches are not collected.
There are two tranches this year that we could theoretically collect and they represent significant percentages of GDP. Let’s not forget that we have an election year, the guard changes, documents get messed up, the process is delayed and the risk is quite high that we will not collect the money.

Another risk I mentioned above is pensions. I don’t know what will be decided in their case.

Regarding an agreement with the IMF, the way things are at the moment, I see a low risk of turning to the IMF. As I was saying, the international reserves of the National Bank of Romania are very high, the budget deficit is certainly high, but the current account deficit has declined as a ratio to GDP – we are still very high, we are now 7% of GDP on current account deficit, but you think that is basically the thinking of foreign investors. As long as you have external financing, that you have through these National Plan for Recovery and Resilience funds, EU money, you also have some foreign investment of several billions, then basically the worries about defaulting are very low.

How do you see progressive taxation? Is it good or bad for Romania?

It is clear that we need tax reform.
Labour taxation is very high in Romania.
If you add to income tax other contributions such as social security contributions, health contributions, unemployment and so on, you end up with very large amounts that the state takes from your gross salary. Those who earn less are affected more because you don’t have some regressivity on the tax system. Basically this is the basic argument for progressive taxation.

Those who earn a little also have a lot of taxes and could use a breather, through various artifices – put a lower income tax ceiling, give them some tax deductions.

But I don’t think it’s such a good measure. That’s why I say, I would put the progressive tax issue on a tax reform that makes sense.

Maybe we need to think about another structure, it matters a lot what odds you go for. There are a lot of scenarios that can be done, I have been working on that.

I think it has to be considered wisely, because nowadays it is very easy to move your tax residence to Europe or elsewhere. The risk is to have a boomerang effect.

We know of countries that have increased income tax a lot and many have left the country, I mean the better earners.

Progressive taxation must be done with a head; politically you can make such statements because we are talking about a large mass of people, but let’s not forget that Romania needs productivity growth and that comes from people who have well-paid skills.

Why do authorities prefer to raise taxes when they have problems, but collection remains low?

I did a study in 2008 with Daniel Daianu and Ella Kalai and we looked at the evolution of taxes, basically everything since 1995. And we did a 15-year analysis, as there have been many tax changes over the years.

According to the survey results, tax revenue contributions as a percentage of GDP remained relatively unchanged, adjusting for the number of employees. The point is that, whatever happened, the authorities could not significantly increase the level of revenue as a percentage of GDP.

Here are two answers.

First of all you have the rocking effect. If, for example, the government increases income tax, it calculates the accounting impact – I increase income tax by one figure, I will collect X amount to the budget. But the point is that you have perverse effects. If you increase the income tax, people don’t consume as much because they don’t have any more money and then the VAT receipts go down.
You have to do the analysis on all the budget revenues, you don’t do it in accounting, you have to calculate it on each budget category, you have to take into account certain elasticities.

The second answer, which is really the substance, is that we have weak institutions, we have high tax evasion, and we are practically not going down the path of eliminating tax evasion. For example, from VAT, we are 9 billion short.

And the Fiscal Council recently issued a report saying that tax evasion has become endemic. It’s become a national security issue, if you’re missing a third of the VAT revenue, which you’re supposed to collect and which is the biggest revenue, that money could be invested in schools, infrastructure, health.

The fight against tax evasion, let’s face it, we have known about it for years, it is not yesterday’s news. Nothing has been done, because if you look at the trend, it has practically increased. We are talking about tax evasion on VAT, but there is also tax evasion on other components of tax revenue.

To me it gives me one answer: the institutions are weak, they don’t walk the line to solve the problem.

Photo: Bucharest on a rainy day (souce: Pixabay, CC0)

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