Impact of fiscal policies changes on the budgetary revenues and sustainable economic growth Cristian Nicolae Stanica Institute for Economic Forecasting, Romanian Academy, Romania

Objectives The estimation of the GDP dynamics, employment and wages as a response to the fiscal policies changes; The estimation of the GDP dynamics, employment and wages as a response to the fiscal policies changes; The presentation of the particular features of the model used for fiscal policy simulation analysis ; The presentation of the particular features of the model used for fiscal policy simulation analysis ; The investigation of the impact on the budgetary revenues and expenditures by the direct effects of the fiscal policies and by the indirect effects of the economic growth changes using a baseline scenario and two alternative scenarios; The investigation of the impact on the budgetary revenues and expenditures by the direct effects of the fiscal policies and by the indirect effects of the economic growth changes using a baseline scenario and two alternative scenarios; The presentation of the scenarios results. The presentation of the scenarios results.

Models used in Romania Macro Models Macro Models “Dobrescu Macro Model of the Romanian weakly structured economy ” “Dobrescu Macro Model of the Romanian weakly structured economy ” Link-Dobrescu Model Link-Dobrescu Model Hermin Model Hermin Model SAM-MEGA Model SAM-MEGA Model RMSM-X Model RMSM-X Model Other specific models Other specific models Determination of the potential output Determination of the potential output Long-term growth models, especially developed by the experts of the National Commission for Forecasting Long-term growth models, especially developed by the experts of the National Commission for Forecasting

Some features of the model used for budgetary forecasts SAM-MEGA model is built on the relationships across macroeconomic indicators of the IMF financial modules and the modules of the institutional sectors (public, private and foreign sector): SAM-MEGA model is built on the relationships across macroeconomic indicators of the IMF financial modules and the modules of the institutional sectors (public, private and foreign sector): National Accounts Indicators (GDP and the aggregate incomes) «NatAcc»; National Accounts Indicators (GDP and the aggregate incomes) «NatAcc»; Public Accounts (General Consolidated Budget) «GovAcc»; Public Accounts (General Consolidated Budget) «GovAcc»; Labor Force Indicators (Unit labor cost, Compensation of employees) «Labor »; Labor Force Indicators (Unit labor cost, Compensation of employees) «Labor »; Foreign Sector (Exchange Rates, Balance of Payments, Romania’s International Investment Position) «Foreign»; Foreign Sector (Exchange Rates, Balance of Payments, Romania’s International Investment Position) «Foreign»; Monetary Sector (Monetary Survey) «MoneyAcc»; Monetary Sector (Monetary Survey) «MoneyAcc»; Private Sector, as a residual for the overall model «PrivSect»; Private Sector, as a residual for the overall model «PrivSect»;

Gross added value GDP transmission The transmission of the influence from the governmental policies to primary blocks Aggregate Demand Gross salary earnings Gross profit transmission Market Private Consumption Investments VAT, Excise duties, Custom taxes transmission Taxes on profit Government Policies transmission Social security contributions, Taxes on income

The transmission of the influence from the governmental policies to primary blocks Any shock in the fiscal policy, particularly related to a fiscal relaxation, would entail a surplus of factors’ incomes which, at their turn, would generate a surplus of aggregate demand (consumption and investments) and supply (GDP); Any shock in the fiscal policy, particularly related to a fiscal relaxation, would entail a surplus of factors’ incomes which, at their turn, would generate a surplus of aggregate demand (consumption and investments) and supply (GDP); During the forecasted period, aggregate demand and supply determines, at their term, the comportment of taxation bases. The budget revenues are estimated in relation with the taxation bases and the empirical collection rates. During the forecasted period, aggregate demand and supply determines, at their term, the comportment of taxation bases. The budget revenues are estimated in relation with the taxation bases and the empirical collection rates. On the demand side, from the national account module it results the taxation bases for indirect taxes: On the demand side, from the national account module it results the taxation bases for indirect taxes: Market private consumption for value added tax ; Market private consumption for value added tax ; Import for Customs taxes. Import for Customs taxes. On the supply side, from the national account module it results the taxation bases for direct taxes: On the supply side, from the national account module it results the taxation bases for direct taxes: Official gross wages for Social contributions and Taxes on income; Official gross wages for Social contributions and Taxes on income; Gross profit (and other incomes) for Taxes on profits. Gross profit (and other incomes) for Taxes on profits.

Fiscal policies changes and the budget scenarios The presentation of two practical applications of the model to evaluate the impact of the fiscal policies on the evolution of the budgetary revenues and on the economic growth; The presentation of two practical applications of the model to evaluate the impact of the fiscal policies on the evolution of the budgetary revenues and on the economic growth; The quantification of both the direct (budgetary) effects of the fiscal policy and the indirect effects were quantified for every alternative scenario variants; if the direct effects are accounting results of the new tax rates, the indirect effects consist in the influences of the new fiscal policy on the macroeconomic indicators and the impact of their changes upon the budgetary revenues); The quantification of both the direct (budgetary) effects of the fiscal policy and the indirect effects were quantified for every alternative scenario variants; if the direct effects are accounting results of the new tax rates, the indirect effects consist in the influences of the new fiscal policy on the macroeconomic indicators and the impact of their changes upon the budgetary revenues);

Fiscal policies changes and the budget scenarios The definition of a baseline scenario in order to forecast the budgetary revenue, respecting the following requirements: the update of the macroeconomic indicator forecast in relation with the first part of 2011 and the maintenance of the same fiscal policy in as the one from 2010; The definition of a baseline scenario in order to forecast the budgetary revenue, respecting the following requirements: the update of the macroeconomic indicator forecast in relation with the first part of 2011 and the maintenance of the same fiscal policy in as the one from 2010;

BASELINE SCENARIO BASELINE SCENARIO Economic growth GDP (%) Final consumption Private consumption Private consumption Public consumption Public consumption Gross capital formation Gross average earnings (RON) Average number of employees (thou. pers.) Budget deficit (% GDP) -6.5%-4.4%-3.0%

The baseline scenario The baseline scenario for foresees the continuation of positive effects of economic growth recovery recorded in the first quarter of Industry and exports would be further the main catalyst elements of economic growth. The baseline scenario for foresees the continuation of positive effects of economic growth recovery recorded in the first quarter of Industry and exports would be further the main catalyst elements of economic growth. On the labor market, in the private sector, over 80 thousand employees are to be hired in 2011, after losing 160 thousand employees during the crisis year As for the governmental sector, the employees’ number would decrease with 40 thousand persons in 2011, the same with 2010, due to the measures meant to restructuring government expenses negotiated with IMF. On the labor market, in the private sector, over 80 thousand employees are to be hired in 2011, after losing 160 thousand employees during the crisis year As for the governmental sector, the employees’ number would decrease with 40 thousand persons in 2011, the same with 2010, due to the measures meant to restructuring government expenses negotiated with IMF.

The baseline scenario The main targets of the forecasting in the baseline scenario concerning the economic growth, for the , are: GDP will accelerate the growth from 1.5% in 2011 to 3.9% in 2012; GDP will accelerate the growth from 1.5% in 2011 to 3.9% in 2012; Gross fixed capital formation (investments) will be the most dynamic component of the domestic demand; Gross fixed capital formation (investments) will be the most dynamic component of the domestic demand; The government consumption will decrease with 1.1% in 2011 and will have a moderate growth of 1.4% in 2012, as a consequence of the restrictive budgetary expenditures, planned according to the fiscal reform in the Government Program. The government consumption will decrease with 1.1% in 2011 and will have a moderate growth of 1.4% in 2012, as a consequence of the restrictive budgetary expenditures, planned according to the fiscal reform in the Government Program.

ALTERNATIVE SCENARIOS Influences on macroeconomic indicators for the year 2012 Variant I – flat tax decrease by 4% Variant II – security contribution decrease by 3% and minimum wage increase by 20%, from 165 euro to 200 euro ALTERNATIVE SCENARIOS Influences on macroeconomic indicators for the year 2012 Variant I – flat tax decrease by 4% Variant II – security contribution decrease by 3% and minimum wage increase by 20%, from 165 euro to 200 euro BaselineScenario Var. I Var. II Economic growth GDP (%) Final consumption Gross capital formation Number of employees (thou. pers.) Gross average earnings (RON)

The alternative scenario Variant 1: flat tax (profits and personal incomes) decrease by 4% The scenario of fiscal projections take into account the tax legislation: reducing the legal rates of profit tax and income tax from an average of 16% in 2010 to 12% in 2012; The scenario of fiscal projections take into account the tax legislation: reducing the legal rates of profit tax and income tax from an average of 16% in 2010 to 12% in 2012; The multiplicative effect of the surplus of income and profits would entail the increase of domestic demand and supply which, at their turn, would lead to the increase, in average, of gross salary earnings and to the generation of new jobs. The GDP growth would change from 3.9% (baseline scenario 2012) to 5% in The number of employees would rise by 60 thousand people in 2012, as against the level forecasted in the baseline scenario; The multiplicative effect of the surplus of income and profits would entail the increase of domestic demand and supply which, at their turn, would lead to the increase, in average, of gross salary earnings and to the generation of new jobs. The GDP growth would change from 3.9% (baseline scenario 2012) to 5% in The number of employees would rise by 60 thousand people in 2012, as against the level forecasted in the baseline scenario; In spite of the fact that fiscal relaxation policies have positive effects, stimulating labor, investments and economic growth, however a decrease is expected for the overall budget revenues by 2.5 billion Lei in 2012 as compared with the baseline scenario In spite of the fact that fiscal relaxation policies have positive effects, stimulating labor, investments and economic growth, however a decrease is expected for the overall budget revenues by 2.5 billion Lei in 2012 as compared with the baseline scenario

The alternative scenario Variant 2: security contribution decrease by 3 percentage points and minimum wage increase from 165 euro to 200 euro The proposal to increase minimum wage is imperatively necessary for Romania’s economy, due to its low level and to employment concentration around low income. However, this measure alone would entail the inhibition of supply and the increase of labor cost on short term, as well as the fast increase of demand that could entail an inflationary shock. The proposal to increase minimum wage is imperatively necessary for Romania’s economy, due to its low level and to employment concentration around low income. However, this measure alone would entail the inhibition of supply and the increase of labor cost on short term, as well as the fast increase of demand that could entail an inflationary shock. Minimum wages indexation by 20% would lead to the increase of average gross salary earnings by 2.5% in 2011 and by 5% in 2012, since the only professional categories which are affected would be those with low salary earnings. In order to minimize the financial effort of salaries increases, the social contributions on the employers’ side must be diminished by 3 percentage points, this being the optimal value resulting from the model’s simulations. Minimum wages indexation by 20% would lead to the increase of average gross salary earnings by 2.5% in 2011 and by 5% in 2012, since the only professional categories which are affected would be those with low salary earnings. In order to minimize the financial effort of salaries increases, the social contributions on the employers’ side must be diminished by 3 percentage points, this being the optimal value resulting from the model’s simulations.

The alternative scenario Variant 2: security contribution decrease by 3 percentage points and minimum wage increase from 165 euro to 200 euro Moderate effect of this package of measures upon GDP growth, being only entailed by the positive effect of increasing salary earnings that would encourage consumption; Moderate effect of this package of measures upon GDP growth, being only entailed by the positive effect of increasing salary earnings that would encourage consumption; The fiscal relaxation of security contributions would not allow the companies to allot funds for investments, but to compensate the additional labor cost. The fiscal relaxation of security contributions would not allow the companies to allot funds for investments, but to compensate the additional labor cost. The combined effects of both economic policy measures at budgetary level, allowing the revenues to remain unchanged: The combined effects of both economic policy measures at budgetary level, allowing the revenues to remain unchanged: Direct effects: net impact upon revenues from the reduction of legal quota by 3 percentage points consists in the diminution of revenues with 0.6 billion Lei in 2011, respectively with 1.2 billion Lei in 2012; Direct effects: net impact upon revenues from the reduction of legal quota by 3 percentage points consists in the diminution of revenues with 0.6 billion Lei in 2011, respectively with 1.2 billion Lei in 2012; Indirect effects: additional revenues of 0.6 billion Lei in 2011 and 1.2 billion Lei in 2012, resulting from consumption encouragement (VAT, excise duties) and the increase of salary earnings (taxes on income). Indirect effects: additional revenues of 0.6 billion Lei in 2011 and 1.2 billion Lei in 2012, resulting from consumption encouragement (VAT, excise duties) and the increase of salary earnings (taxes on income).

Conclusions After the end of recession, which lasted 2 years in Romania, the application of economic policy measures is imposed in order to ensure economic recovery and to consolidate sustainable economic growth; After the end of recession, which lasted 2 years in Romania, the application of economic policy measures is imposed in order to ensure economic recovery and to consolidate sustainable economic growth; One of the factors encouraging the economic growth and improving the employment by reducing the “hidden economy” is the fiscal relaxation. One of the factors encouraging the economic growth and improving the employment by reducing the “hidden economy” is the fiscal relaxation. According to the model results, the best policy measure for Romania is the one consisting in the reduction of flat tax by, at least, 4 percentage points; According to the model results, the best policy measure for Romania is the one consisting in the reduction of flat tax by, at least, 4 percentage points; In these conditions, the medium term economic growth ( ) will continue to have a high level - of more than 5% - and will continue to be sustainable, even if the public finance will be less balanced due to the fiscal relaxation; In these conditions, the medium term economic growth ( ) will continue to have a high level - of more than 5% - and will continue to be sustainable, even if the public finance will be less balanced due to the fiscal relaxation;

Conclusions The fiscal relaxation will affect the budgetary revenues (mainly the direct taxes) by 1 percentage point as share in GDP on the short term; The fiscal relaxation will affect the budgetary revenues (mainly the direct taxes) by 1 percentage point as share in GDP on the short term; On medium and long term, the economic growth would be able to ensure the surplus of revenues necessary to fill the gaps entailed by fiscal relaxation; On medium and long term, the economic growth would be able to ensure the surplus of revenues necessary to fill the gaps entailed by fiscal relaxation; In order to preserve the target of budgetary deficit weight in GDP of 3% in 2012, other compensatory measures would be needed for supplementing budgetary revenues with, at least, 2.5 billion lei; In order to preserve the target of budgetary deficit weight in GDP of 3% in 2012, other compensatory measures would be needed for supplementing budgetary revenues with, at least, 2.5 billion lei;

Conclusions The solutions to increase the budgetary revenues and to consolidate the public finance, on medium term, are the following: The solutions to increase the budgetary revenues and to consolidate the public finance, on medium term, are the following: Tax collection rate increase by fiscal control strengthening; Tax collection rate increase by fiscal control strengthening; Tax base extension by the taxation of agricultural lands at market value. Since the price for a hectare of land outside localities should not fall below some hundreds of Euros, an average taxation with 20 euro per hectare per year would be entirely reasonable. The 15.7 million hectares of agricultural land would thus entail about 215 million Euros (about 0.3% of GDP) net gain for the consolidated budget; Tax base extension by the taxation of agricultural lands at market value. Since the price for a hectare of land outside localities should not fall below some hundreds of Euros, an average taxation with 20 euro per hectare per year would be entirely reasonable. The 15.7 million hectares of agricultural land would thus entail about 215 million Euros (about 0.3% of GDP) net gain for the consolidated budget; Increase of budget receipts from the privatization of the viable units from the portfolio of the Authority for State Assets Recovery and from the closure of those (consuming subventions) without survival chances. Increase of budget receipts from the privatization of the viable units from the portfolio of the Authority for State Assets Recovery and from the closure of those (consuming subventions) without survival chances.