COMMENT: Romania's squabbling politicians could hurt reform

By bne IntelliNews March 2, 2007

Bogdan Preda in Bucharest -

Dressed in orange jackets and clasping each other's hands, President Traian Basescu and Prime Minister Calin Popescu-Tariceanu celebrated the opposition’s victory in the 2004 elections in Bucharest’s University Square. Yet just two months after Romania joined the EU, Basescu and Tariceanu are at loggerheads and propelling the country toward yet another period of infighting among governing parties, political instability and the possible rolling back of economic reforms such as the flat tax.

Earlier this week, Tariceanu and Basescu traded insults on a talk-show broadcast on Romania’s national television station, accusing each other of bribery and lying about preferential energy contracts.

Their behaviour is a far cry from the days when the alliance of Basescu's Democratic Party and Tariceanu’s National Liberal Party promised to make a real difference to the lives of ordinary Romanians by stamping out corruption and introducing the then-lowest flat tax on both corporate and individual income in Central and Eastern Europe. This 16% flat tax, introduced on January 1, 2005, replaced the previous corporate tax of 25% and personal income taxes as high as 40%.

It's actually about the only promise these two former allies are still keeping to this day. Given the breakdown in their relationship, the question is will this tax reform last, and if so, for how long?

An unexpected ally

So far, the original backers of the flat tax are standing behind their reform. Tariceanu’s finance minister, Sebastian Vladescu, has repeatedly said the flat tax, which helped attract a record €9.1bn of foreign direct investments in 2006, will remain as long as he is in his job, while Basescu and the supporters of his Democratic Party have yet to speak out against it. In addition, the Liberal Democrats led by Basescu ally Theodor Stolojan, who recently re-emerged in a new party made of disgruntled former top members of Tariceanu’s own party, are also backing the tax.

Unfortunately, the flat tax now has three serious enemies. The main one is the lack of harmony within the creaking governing alliance, which sooner or later is going to collapse and so lead to early elections. The other two enemies of the tax derive from the first – namely Romania’s widening deficits and, last but not least, the improving fortunes of the opposition Social Democrats, who are pressing for no less than Basescu’s impeachment and a no-confidence vote against Tariceanu’s government.

The Social Democrats, now led by former foreign minister Dan Mircea Geoana after he pushed aside the party’s long-time bosses Adrian Nastase and Ion Iliescu, have made the fight against the flat tax one of their main weapons in any debate about the economy. Among the many arguments against it is that it was introduced primarily to enrich Basescu and Tariceanu and their cronies, rather than attract more investment and fight tax evasion by easing the tax burden on ordinary Romanians.

With Basescu and Tariceanu arguing endlessly and failing to come up with new policies for the government, the Social Democrats could yet gain another ally in their fight against the tax, namely the governor of the National Bank of Romania, Mugur Isarescu, even if he isn't necessarily a fan of their politics.

The governor enters the fray

Isarescu, who oversaw a fall in the inflation rate last year to 4%, the lowest since 1990 and less than half the level in 2005, has repeatedly warned that higher spending on public sector wages at the same time as introducing a flat tax, would lead to a widening of the fiscal deficit and put pressure on consumer prices at a time when Romania has to continue bringing its inflation rate closer to the EU average in order to meet the criteria to join the euro by 2014.

The fiscal deficit isn’t Isarescu’s only problem. The current account deficit is also under pressure from a widening trade gap due to the spurt in imports. This is being fuelled by a rise in personal consumption from all the money left over from the reduction in taxes, a stronger currency and unprecedented lending levels.

The trade deficit rose by almost 71% in 2006 from the previous year, while commercial lending grew 54%. The Romanian leu gained almost 9% against the euro, prompting the International Monetary Fund to warn Tariceanu’s government that Romania could face "economic overheating," which would result in a wider current account gap and faster consumer price growth.

The current account deficit, which FDI financed by more than 90% in 2006, is forecast to widen to as much as 10.4% of GDP this year from about 10.3% in 2006.

The central bank, taking advantage of the falling inflation rate, on February 9 cut its benchmark rate by more than expected to 8% from 8.75%. The move also signalled that the central bank is prepared to counteract would-be sudden moves in the rate of the mighty leu – the best-performing currency against both the euro and the dollar for most of 2006.

There’s another problem for the economy. Romania has few large assets left to sell that would beef up the FDI total this year. Ion Ghizdeanu, the head of the government’s National Forecasting Commission, on February 19 said the government should count on no more than €7.6bn of FDI this year, while the current account deficit could reach €12bn. That contrasts with Basescu's optimistic forecast, which put such investment at more than €10bn.

Temporary help could come from EU funds or even from the sale of international bonds, given Romania’s relatively low indebtedness of about 21% of GDP, although large amounts on sale could again harm Isarescu’s efforts to keep inflation in check.

One way or the other, the future of the flat tax is in question. Without any guarantees that it’s here to stay, the flat tax is now little more than an incentive for foreign investors and Romanians to take advantage of for as long as its political promoters remain hand in hand.

Send comments to Bogdan Preda

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