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The return to progressive income taxation is a theme that has been recently revived in the domestic political discourse in Romania and presented as a solution to the lack of money in the budget, especially in the context of falling consumption tax revenues.
However, Romania’s low tax rates are also mentioned in the European Commission’s latest Country Report. It points out that Romania has relatively high taxes on low wages and too low taxation of capital, thus calling into question the effectiveness of the single rate. In the recently published document, Brussels experts point out that this low tax rate affects the state’s ability to redistribute revenue from the budget and could also lead to negative effects on the labour market.
The country report for Romania was published as part of the Spring Package of the European Semester 2023, in which the Commission provides guidance to Member States on how to build a strong economy fit for the future, ensuring long-term competitiveness and prosperity for all in the current difficult geopolitical context. The paper presents assessments in several areas, including on the implementation of the NRRP, and makes some recommendations to policy makers in Romania.
On the tax side, the report highlights that in the structure of state budget revenues, contributions from taxes on labour are low and capital taxation – even lower.
“A relatively high tax on low wage earnings could lead to a decrease in demand for unskilled labour,” the report also points out.
As a contribution to GDP, taxes on labour in Romania stand at 12.1%, just over half the European average of 20.9%. At the same time, taxes on capital account for only 4% of GDP, less than half the European average of 8.5%, according to data presented in the Report. According to the figures analysed by experts in Brussels, the only tax close to that of European countries is the tax on consumption, which stands at 10.4% of GDP, compared to the European average of 11.2%, despite a lower VAT collection in Romania.
The country report shows that “digitisation of public services” is low
The topic of progressive taxation has recently returned to the domestic political discourse in Romania. Supporters of the idea of reintroducing the system that Romania abandoned 18 years ago argue that Romania needs to align itself with most European countries that have such a system. According to economic experts, switching to progressive taxation in Romania after almost two decades would be an administrative and economic challenge.
Progressive taxation means that as taxpayers’ incomes rise, so do the tax rates they owe to the state. Citizens would contribute to the functioning of the state according to their means. Those who earn more, therefore contribute more. The main benefit is that it would introduce more fairness in income redistribution and reduce the gap between high and low income earners. In the medium to long term, progressive taxation could create more equity in the system. Supporters of the idea of reintroducing progressive taxation agree with those who oppose the idea in terms of time horizon: such a major change cannot be implemented immediately, from one day to the next, and one of the main obstacles is the lack of digitisation of the National Tax Administration Agency. In theory, any progressive tax system is accompanied by a series of tax deductions to give taxpayers access to essential public services. These tax deductions, relate to non-taxable amounts for health, education or culture, which benefit mainly lower-income individuals or families.
Digitisation of public services in Romania is low
According to those who support the introduction of the flat tax, the system is much more manageable and therefore encourages productivity. The reasoning is that citizens tend to be discouraged if they know that when they earn more, they will pay higher and higher taxes.
“It’s a fundamental discussion of progressive taxation. I know and you know that this progressive taxation cannot be implemented from next year. But I continue to support progressive taxation and I think it is the only solution for Romania at this time (…) I think it is right that, first, ANAF does its job, digitize and then ask the population for another tax regime,” says PSD President, Romania’s Prime Minister, Marcel Ciolacu.
“Romania’s future lies with progressive taxation, as it is in all European countries,” he adds.
“Progressive taxation is a solution that can only be applied when we have all the necessary tools, namely digitisation at the level of the Ministry of Finance, to determine the overall income, because we are talking about progressive taxation when we can determine the overall income. As today all these figures are still kept with a pencil in the books, it is impossible to apply progressive taxation,” PNL President, former Prime Minister Nicolae Ciucă, told the press. Moreover, the Country Report pointed out that “the digitisation of public services – such as cloud, e-government and telemedicine – is low, despite the recently implemented measures, from 2022, through the NRRP”.
Progressive taxation is mainly practised in countries with stable economies. In these mainly Western European countries, the middle class produces enough value to be redistributed in society. Also, after paying taxes, what is left to the taxpayer must be enough for a decent living. In this context, economists who oppose the progressive tax system argue that in Romania, 35 years after the fall of communism, a sufficiently strong middle class has not formed. Such a middle class should earn enough so that, after tax increases, it can continue to earn a satisfactory income.
In the case of Romania, from an administrative point of view, the application of the progressive tax is not easy. Experts either supporting or opposing progressive taxation argue that this new tax tool such as progressive taxation needs additional bureaucracy and a higher administrative capacity on the part of the state. Why? The answer is simple: more paperwork comes with a progressive rate. This would mean more tax deductions with the associated documents, which would increase the number of tax office staff and consultants paid by taxpayers to help them take advantage of tax deductions. A move to progressive taxation in Romania would mean that 6.5 million people would have to file tax returns every year. Currently, the number is less than one million. To provide predictability for the business environment, the substantial change in tax philosophy needs to be announced well in advance, at least two to three years.
Romania is not the only European country that still has a flat income tax rate, with similar systems operating in neighbouring Bulgaria and Hungary. Significantly progressive tax rates are in place in countries such as Austria, Slovakia, Belgium and Germany. The introduction of the single tax rate was a policy mainly pursued by Central and Eastern European countries during the transition to a market economy and was used, among other things, as an incentive to attract foreign investment.
After 1990, income taxation in Romania was carried out in various forms of progressive taxation until 2004
Between 2000 and 2004, when the concept of “total personal income” was introduced into the legislation, there were five taxable income thresholds in Romania: 18%, 23%, 28%, 34% and 40%. From 2005 onwards, a flat rate of 16% was introduced and maintained at this level until 2017, when the flat rate fell to 10% of gross overall income.
Romania’s deficit in the first 5 months of 2023 reached 7.4 billion euros (2.3% of GDP). It is known that the deficit increases more in the second part of the year and thus would reach 6% of GDP in December. In the relationship with the European Union, Romania is in the “excessive deficit” procedure. Thus, in order to comply with the Maastricht rules, Romania must, by end of 2024, reduce its budget deficit to below 3% of GDP.