Sometimes you have to get creative to get results. This was the case for Romanian finance minister, 40-year-old Ionut Popescu, who left his post in August. His adoption of an aggressive set of tax reforms in January this year was regarded as essential in the country's reform process as it gears up for European Union membership in early 2007.
Before these reforms, the country was regarded as having one of the most onerous tax regimes in the region. Popescu's aim was to introduce measures to simplify the tax system, strengthen fiscal discipline and attract foreign investment.
In 2005 the most important economic measure taken by Popescu was adopting a flat-tax rate at a competitive level of 16%. Previously, rates on personal income tax were set at 18–40%, while corporate profit tax was set at 25%.
"The first half of 2005 brought radical changes to the Romanian tax system. The introduction of the flat tax represented both a reduction and a redesign of taxation," Popescu tells Emerging Markets. One big difference is that the emphasis of the tax system has moved from direct taxes to indirect.
He continues: "In this manner we have found an answer to the old and difficult problems of the economy. The new fiscal philosophy has had positive effects in many directions."
This includes job creation, attacking the country's substantial black economy and promoting foreign direct investments, by introducing low levels of taxation. The reforms also aim to encourage savings.
Clear benefits
Popescu says that the benefits are already tangible. "After only six months we cannot have a complete assessment of the effects generated by the flat tax. But we can already see some positive effects: the number of newly emerged jobs doubled compared to the same period last year, salaries increased and so did the savings of the population."
Also, despite the decrease of labour taxation, tougher administration measures have meant that tax revenues are higher than expected. Popescu says that in the first six months the revenues from the profit tax increased by 21% in nominal terms or by L6,212.7 (10.8% in real terms), while the revenues collected from income tax decreased only by 5.1% in nominal terms, or by L1,696.2.
At the level of general consolidated budget, in the first six months of the year revenues increased by 17.3% in nominal terms or 7.3% in real terms (higher than the expected rate of economic growth of 6%).
New stringency
"We initiated a tougher campaign for the forced execution and opening of bankruptcy procedures against companies with large outstanding debts. The state has been so far a soft creditor. With these measures we intend to make it a hard creditor," says Popescu.
He adds that punishments for tax evasion are also harsher. "The scope of acts defined as criminal activities of tax evasion was enlarged, and so were the imprisonment punishments for such activities."
Further tax reforms are in the pipeline, including plans to double the turnover tax paid by small and medium-sized enterprises to 3%.
VAT decision
Although the proposed increase to VAT has yet to be approved, Popescu is expecting a decision soon. "The increase in VAT is at this moment just a proposal for next year. A decision is still to be made. Overall, the measures are part of the same design of the tax system: low taxes on labour and high taxes on consumption."
However, in the short term the scale and timing of the tax reform may put further pressures on inflation and the country's balance of payments. As a result, there have been extensive negotiations with the IMF over the country's target budget deficit for 2005.
"The budget of Romania for 2005 had been approved in the autumn of 2004 with a deficit of 1.5%, but with different tax rates. Since the beginning of 2005 we have been having negotiations with IMF, due mainly to the changes in the fiscal policy of the Romanian government," says Popescu.
For this reason the IMF initially requested a budgetary deficit of 0.5%. When the effects of the flat tax rate on collection became clearer, this was revised in June to a deficit of 0.7% for 2005.
After the flood
However, since then nature has interfered, and severe floods have caused a further rethink. "The floods caused significant damage: thousands of houses and part of the infrastructure were destroyed and crops were affected. Consequently, the only solution was to increase the budgetary deficit to 1%," says Popescu.
He agrees that the current account deficit is worrying. "In order to reduce this deficit we applied a tight fiscal policy, meaning low budgetary deficits, but also an austere salary policy for state-owned companies. At the same time, the National Bank of Romania issued new norms for loans granted to the population, according to which the monthly instalment may not be higher than 35% of the incomes."
There are concerns that these drastic tax cuts may have a negative impact on the economy, in particular efforts to curb inflation from less than 10% in 2004 to 7% in 2005. "The inflation target was established at the beginning of the year at 7%, but depending on the subsequent evolutions, this target might be changed," says Popescu. "The central bank recently introduced the new monetary regime for inflation targeting ... Romania needs, in the future, low budgetary deficits in order to continue the disinflation process."
Local capital market push
To cushion the country from economic blows, Popescu is a keen advocate of developing the local capital markets. He says that, as finance minister, he had several aims: to build a curve on the domestic market of benchmark T-bills, with maturities between three and 10 years; to improve the market's liquidity and to encourage international financial institutions to issue bonds on Romania's domestic market.
Popescu says that the government has already taken the first step in the effective operation of a mortgage market by adopting mortgage laws. "The markets of municipal bonds and mortgage bonds are set to develop. The introduction of private and optional pension systems will also lead to a diversification of investors."
Privatization deals are also slated for completion, and Popescu is confident that the privatization of the savings bank, CEC, and of BCR (Banca Comerciala Romana) will be finalized in the first quarter of next year.
Investors are responding positively to the reform process. In February, for the first time in its post-communist history, the finance ministry managed to sell local currency denominated bonds on the local market at a yield below 10% – 8.9% for two-year paper and 7.9% for a five-year bond.
"This confirmed the confidence of the investors in the economic and financial policies of the government and the successful introduction by the National Bank of Romania of the inflation targeting process," says Popescu.
For Popescu, the finance ministry needs to promote fiscal policy over the next three to four years "to create a significant period of stability", so paving Romania's way to European Union (EU) membership.
It will be up to his successor, Sebastian Vladescu, to see if he can continue what Popescu successfully began.
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Life lines
1965 Birth
1988 Graduation, Academy of Economic Studies, Bucharest
1990–1996 Journalist with Libertatea, Sportul Romanesc, Meridian; contributor to several publications, radio and television stations
1996 Editor-in-Chief, Capital
2000 Spokesman and Secretary of State, Isarescu Government
Feb 2003–Oct 2004 Joined National Liberal Party, acting as Economic Adviser to the President
Oct 2004 Spokesman, Truth & Justice Alliance (DA)
Dec 2004 – Aug 2005 Minister of Finance