Do We Have Enough Rich People to Tax Them Out?

The de facto insolvency of Romania’s budget pushes politicians to propose the reinstatement of progressive taxation on individuals’ income

July 2010 - From the Print Edition

Romania had until 2005 a system of progressive taxation on the income made by individuals, with rates ranging from 18% up to 40% of the net income (the intermediate rates being 23%, 28% and 34%). The income thresholds used in order to determine the application of the percentage of the income tax were in fact very low - for monthly income exceeding about 300 Euro – so it was actually very easy to reach the limit beyond which the tax would be of 40%. The introduction of the 16% flat tax in 2005 (which applied not only to individuals, but also to companies) revolutionized the whole system: not only that the budgetary revenues from the payment of the income tax increased at a fast pace (until Romania was hit by the economic crisis), but also the reduced taxation made Romania a more enticing destination for investment (and attracted criticism from Western Europe due to so-called “fiscal dumping”).

Now, Romania is again facing difficult economic challenges. The IMF sustained by our country’s domestic political factors advanced proposals to switch back to the progressive tax system, or, at least, to increase the rate of the flat tax. At first sight this makes sense – progressive taxation is the system of choice for most developed countries, and, in addition to that, why shouldn’t we tax the rich people more?

On the other hand, we should be careful to avoid a copy-paste of solutions which may work elsewhere, but may not be appropriate for Romania. An equitable tax system should be designed having in mind the specific realities of our country and taking into account the experience related to the functioning of both the progressive and the flat tax systems which is already available here. We shall therefore briefly examine below some of the arguments which are in favor of the preservation of the current flat tax system in Romania.

A reasonable flat tax is an effective mean to improve tax collection

Let us take a look at the figures. According to Romania’s National Statistics Institute, immediately prior to the introduction of the flat tax system (i.e. in 2004), income tax revenue totaled about 7.1 billion lei. In the first year of existence of the 16% flat tax, budget revenues in absolute figures (pertaining to income tax) declined with about 6% (which is remarkably low, since the previous progressive tax system reached easily the rate of 40%). After 2006 however, the collection of income tax revenue quickly increased, with growth rates ranging between 33% (in 2008) and 46% (in 2006), reaching a total revenue in absolute figures of 18.5 billion lei in 2009 (which is about three times the corresponding amount in 2004, when tax rates were significantly higher).

Part of its evolution can be attributed, naturally, to the growth of the GDP. However, this was clearly not the single factor (GDP has not increased with 30% or 40% in none of these years…). In fact, this growth of the income tax revenue results from the very achievement of one of the main purposes of establishing the flat tax, which was to bring out income from the black market.

Romania needs the competitive edge that only the flat tax system can give

One of the favorite arguments of the supporters of the progressive tax is that this system has been in use in practically all economically developed countries for a considerable number of years. This in itself is not sufficient to justify the abolishment of the flat tax in a place like Romania, which is surrounded by countries which use a flat low tax system. The most notable example in that regard is Bulgaria, where the flat tax rate is even lower than Romania’s, i.e. 10%. More so, a few days ago Hungary has also announced the intention to introduce an income flat tax at a rate of 16% for the following years and a tax cut for all small and medium businesses.

In addition, we should not forget how Romania is seen by both domestic and foreign investors: a place with crumbling infrastructure, poor governance, uncontrollable corruption, poor life quality and unions marching in the streets. Romania clearly needs policy measures to compensate for these shortcomings (which show no sign of going away in the following years…); the existence of a relatively low flat tax is one of the most persuasive arguments that one might put on the table in order attract new investments here. Relinquish the flat tax in favor of the progressive tax – and nothing much will remain on our side (apart, maybe, from the dubious advantage of having one the lowest paid workforce in Europe…)

The flat tax is more equitable than the progressive tax

“From each according to its ability, to each according to its needs”. Most of the Romanians would immediately recognize this famous slogan, which was very popular with communist propaganda (no surprise here, one of the guys who actually enjoyed saying this was Karl Marx). The argument for progressive taxation is that it is natural for the rich pay more taxes than the poor. Apart from the fact that the very basis of this argument is flawed (the rich do not benefit more from the services financed from the state budget than the poor - in fact the very opposite might be true), the way the problem is presented is simply deceiving: under the flat tax system, the “rich” already pay more taxes. One person earning 100 lei per month will pays 16 lei in income tax. Its neighbor receiving a salary of 1000 lei per month, will pay ten times more, which is 160 lei. It is as simple as that.

The costs to manage the flat tax system are lower

One major advantage of the flat tax system is that it’s less prone to abuse or random application by the tax authorities. When you make 100 lei as income, you just know that you have to pay to the state 16% applied to that amount. On the other hand, an effective progressive tax system needs to be associated with legislation granting the possibility of tax deductions for certain expenses. This means unfortunately a more complicated legislation, entailing more bureaucracy and less predictability in the way the legislation will be interpreted and implemented.

The flat tax rewards the active members of the middle class

Critics of the flat tax argue that this would be a system which would be beneficial mostly to the very rich. It is indeed a reality that the gap between the wealthiest and the poorest Romanians is widening, while this is bringing frustration to many individuals who came to the belief that our country is not offering fair and equal chances to all. “Property is theft!” said once a 19th century French anarchist. “Big property is theft!” cries out now the Romanian media and public opinion, confronted with the unexplained and often unexplainable manner in which the immensely rich have amassed their fortune. While the accusation of theft might be true in at least some of the cases, the adequate remedy for stealing remains the appropriate and consistent enforcement of criminal law, and not an increase of the financial burden of all citizens via the establishment of a progressive tax system.

After 20 years or so of capitalism, Romania still lacks an authentic and well established middle class. The income flat tax encourages the active members of the middle class, supporting them to work harder and collect immediately and directly the reward of their efforts. We are still decades away, both economically and socially, from the most advanced members of the EU. The only way to reduce this gap is to give to the most active and capable members of our society the motivation they need and deserve. Taxing them more is not going to do the trick…

A few conclusions

The return of the progressive tax system is simply not the right way to go for Romania. However, the economic crisis and the current condition of the public finances dictate tough measures; these days the Government proposed to the Parliament a cut in the public spending to be achieved by reductions with 25% of all salaries paid by the state institutions and 15% of the pensions. If these measures will stand the vote of the Parliament and the review of the Constitutional Court remains to be seen. Irrespective of the fate of these proposals, there are still things that ought to be done and that could be done by the Government in order to improve the condition of the public finances, such as to (and the list is inherently incomplete):

Encourage employment by simplifying the procedures related to the employment of personnel and the payment of salary-related taxes and contributions;
Enhance the efficiency of public money spending;
Improve legislation on public acquisitions to ensure free competition, fair chances to all bidders, and the reduction of capital costs for the state budget;
Encourage more domestic and foreign investment in production capacities;
Ensure observance of the law – fight smuggling and “black” economy.

Last, but not least, we need an education system which should be able to instill a true entrepreneurial culture and dismiss the pernicious idea that state employment would be somehow safer and more beneficial than working in a private company...

Cornel Popa,
cornel.popa@tuca.ro
Partner
Ţuca Zbârcea & Asociaţii
4-8 Soseaua Nicolae Titulescu, America House, West
Wing, 8th Floor, Sector 1, 011141, Bucharest
Tel: 00 40 21 204 88 90
Fax: 00 40 21 204 88 99