BLACK SEA BLOG: Romania gambles now with hike in VAT

By bne IntelliNews June 30, 2010

Bogdan Preda in Bucharest -

Want to buy at a 19% tax rate? You've only got a few days left. That's how Romanian retailers were luring prospective buyers ahead of July 1, when the government will embark on what had seemed like a doomsday scenario just less than a month ago: increasing its value-added tax from 19% to 24% - the second highest level in the EU, just 1 percentage point below the 25% in Hungary, Sweden and Denmark.

Believe it or not, Romanians flocked to hypermarkets to buy either large quantities of food staples or the more expensive electronics, house appliances and even cars they otherwise had planned to purchase after the summer holidays.

So how did Romania get to this position less than a month after the government said it would plump for the lesser of two evils by avoiding a higher VAT rate but instead cut social spending, including pensions and public sector pay? The answer is simple: the country's Constitutional Court, which proofs all decisions that are to be turned into laws, decided at the end of June that cutting pensions by 15% was an unconstitutional move, hence rejecting parts of the government's original austerity plan.

The government must by any means find the money necessary to plug the budget deficit, as it cannot continue to pay salaries and pensions with money from large lenders while allowing its budget deficit to widen. The increase in budget spending and decline in revenue widened the budget deficit by a further €1bn in May to 3.1% of GDP, threatening the year-end 6.8% target agreed with the IMF.

With the IMF knocking on the door to see progress before it disburses its next instalment of about €900m from the IMF-EU-World Bank €20bn bailout loan to the country, the government said it had no faster solution but to increase VAT. But was that the only solution? And will it yield the results the government expects?

Beyond arithmetic

Unfortunately, a VAT-rate increase isn't just about arithmetic and merely charging more in order to get more.

The government hopes that decreasing state employees' wages by 25%, while also introducing new taxes on other gains such as foreign-exchange operations and bank deposits, as well as slashing social payments, would offset the VAT increase, thus avoid a massive increase in consumer prices. Seeing producers and retailers cut prices in Romania is unrealistic though, especially as the VAT rise has come in unexpectedly. Sooner rather than later the central bank might have to massively revise upwards its 3.5% inflation target for this year, thus even threatening Romania's planned adoption of the euro by 2014.

Then again, the Romanian leu will most likely see a further depreciation against the euro and the dollar in the next months to come, as it already did on June 29 when it fell to its lowest level ever at RON4.35 per euro. That meant a plunge of 4% in just three days.

In its efforts to find more money, the government seems to overlook one of the economy's most serious problems: insufficient tax collection. The Finance Ministry counts on a VAT collection rate of no more than 70% after the hike in the VAT rate. That shows that Romania's problems are systemic rather than caused by the global crisis or the taxation level.

Basically, what the government wants to do is to offset its own inability to collect taxes by increasing some of them, thus hoping that budget income would increase proportionally. That's what is already prompting some Romanians to move their businesses into neighbouring Bulgaria where they will enjoy lower tax levels as well as protect themselves from would-be increases in the corporate income tax.

"We'll see a deeper recession than we originally estimated,'' Finance Minister Sebastian Vladescu told a news conference on June 29, without giving numbers. He admitted that the VAT increase would trigger higher consumer prices and weaken the leu. However, he said a weaker leu would encourage exports.

What next?

The Romanian government's hasty decision to increase the VAT rate in less than just a week leaves one guessing about what might come next. For example, in a country that has a high rate of smokers, cigarettes and alcoholic drinks enjoy the same VAT levels as basic food staples such as bread, cooking oil and milk.

On the other hand, the government doesn't seem to think about doing the right thing for encouraging foreign investments. In most cases it delays payments of VAT returns to companies by many months, making Romania a less-desirable investment destination for entities that want to produce locally and export, especially under the higher VAT rate circumstances.

Even though the global economic crisis had started to bite in Romania by the middle of 2009, the contenders in the December presidential elections turned a blind eye to its consequences for the sake of either gaining or consolidating their political power and, thus, business-making positions for their supporting parties. So they kept promising voters that the crisis wouldn't hit Romania as badly as it did other countries, while all the time knowing that the social bills exceeded the state's ability to pay them without piling up huge losses. Those losses need to be paid back today, together with many more that have been racked up in the form of subsidies for the country's ailing industries.

In a way, Romania has become like a hidden Greek crisis, with the only exception that it still has the chance to fix things a bit earlier in the crisis stage. The problem, however, is that the government doesn't seem to acknowledge the urgency of drastic change needed in its attitude and improved accountability, so will have to resort to loans for many years to come.

Whichever government comes next will face the same problems, so the issue is no longer about who runs the country, but a matter of decisive attitude. Not with increasing taxes, but with making sure the existing ones are collected timely and properly and laws implemented thoroughly.

In recent evidence, though, it's clear that most Romanian politicians still fail to get this. One of the latest laws passed by parliament, the Private-Public Partnership law that sets the framework for procurement and concession contracts with the state, barely allows for real competition criteria. Basically, what the law does is that it almost allows for the direct selection of a partner followed by superficial negotiation and eventual signing of a contract with a Public-Private Partnership label, leaving the door open for corruption rather than competition.

The good governance attitude problem in this latest case derives from the fact that no large party, not even from the opposition, seemed to be bothered by the fact that the law lacks the competition and transparency ingredients generally required in an EU state: the law was passed with just one vote against it by the lower Chamber of Deputies on June 28.

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