Romania’s Austerity Package and Public Finances after the Crisis
 |
Iulie 2010 |
 |
JOAN HOEY - Senior Analyst, Central and Eastern Europe
THE ECONOMIST INTELLIGENCE UNIT |
Adresa
26 Red Lion Square, London WC1R 4HQ, United Kingdom
Telefon
+44-020-7576 8181
Fax
+44-020-7576 8476
Website
www.eiu.com
JOAN HOEY
Senior Analyst, Central and Eastern Europe
THE ECONOMIST INTELLIGENCE UNIT
The ruling by Romania's Constitutional Court on June 25th that aspects of the government's proposals to cut pensions by 15% were unconstitutional threw into disarray both the government's austerity programme, designed to keep the budget deficit below 6.8% of GDP, and the policies of the National Bank of Romania (NBR, the central bank) for a gradual reduction in inflation.
The original austerity package, involving cuts in public sector wages of 25% and cuts in pensions and social security payments of 15%, was announced by the president, Traian Basescu, on May 6th, following negotiations with a joint IMF, EU and World Bank mission. During those negotiations the IMF indicated that without further corrective measures, the consolidated budget deficit would reach 9.1% of GDP in 2010, given the further contraction in real GDP in the first quarter of 2010 and the likelihood of further negative growth in 2010 as a whole. The Fund therefore increased the budget deficit ceiling permitted in the stand-by agreement by 1 percentage point, to 6.8% of GDP, but requested a fiscal correction equivalent to a further 2.3% of GDP during the remainder of 2010.
Jeffrey Franks, the head of the IMF mission, said that the Fund's proposal was to narrow the deficit through a combination of tax increases and expenditure cuts. Controversially, however, the government decided that the reduction of the deficit should be effected mainly through expenditure cuts. Mr. Basescu argued that the proposed cuts were preferable to tax increases, which, he suggested, would hinder economic recovery in the private sector.
Mr. Basescu's intervention pre-empted further government discussion, despite evidence of disagreement on the proposed measures among the minority coalition government, led by Emil Boc of the Democratic Liberal Party (DLP) and supported by the Hungarian Union of Democrats in Romania (HUDR). For example, HUDR leader Bela Marko had already indicated that his party would not support further austerity measures that would hurt the poor. Mr. Marko argued, furthermore, that cuts in state-sector wages and pensions should be seen as a temporary measure that should lapse at the end of the year, when the government should implement proposals to stimulate the economy. It was also reported that the finance minister, Sebastian Vladescu, initially proposed measures to introduce a progressive income tax, combined with a reduction in the rate of profits tax, as an alternative to cuts in public-sector wages and pensions. This was rejected by the prime minister and the president.
A house divided
The first test of the austerity package came in a parliamentary vote of no-confidence in the government on June 15th. The vote did not succeed in bringing down the government because the proposers of the motion failed to get a simple majority of both chambers of parliament (which would require 236 votes); the no-confidence vote received 228 votes in favour and only 197 votes against. As the combined members of parliament (MPs) of the DLP (178) and the HUDR (31) should have given the government 209 votes, whereas the opposition Social Democratic Party (SDP) and National Liberal Party (NLP) hold 212 seats, it was apparent that members of the governing parties had not supported the government. It subsequently emerged that at least four members of the DLP had voted against the government. The government also failed to win the support of the majority of members of the newly formed National Union for the Progress of Romania (UNPR), consisting of independent MPs, with whom it had signed a co-operation protocol as recently as May.
Having failed in parliament, the opposition appealed to the constitutional court to rule on the legality of the austerity package. On June 25th, ten days after the no-confidence vote, the court ruled that significant aspects of the government's proposals to cut pensions by 15% were unconstitutional. The government was forced to announce an increase in the rate of value-added tax (VAT), from 19% to 24%, effective from July 1st, at a hastily convened cabinet meeting on June 26th. The increase in the VAT rate was included in an emergency ordinance modifying the fiscal code.
Some legal experts argued that the court's decision invalidated the entire programme of public-sector wage cuts, as well as the pensions cuts, but the government decided to send the amended legislation incorporating the constitutional court's changes back to parliament for approval and to continue with the remainder of the programme. This includes cuts in public-sector wages of 25% and proposals to modify "special pensions" (privileged pensions paid to parliamentarians, magistrates and airline pilots) which the Constitutional Court ruled were constitutional (with the exception of cuts to magistrates' and judges' pensions).
The government will also go ahead with plans to cut public-sector employment (possibly as much as 25% over the next two years), and will implement a range of measures to widen the tax base, and reduce anomalies and opportunities for tax avoidance. The IMF postponed a board meeting on June 28th, which had been expected to complete the fourth review of the stand-by agreement, but approved the release of USD 1.1 bn following completion of the review at a meeting on July 2nd. The IMF will send another mission to Romania on July 20th – 23rd.
Impact of the VAT increase
The direct effect on aggregate demand of the two measures is broadly neutral, though the VAT increase will have a more immediate positive impact on government revenue than reductions in pensions would have had on government expenditure. The finance minister, Sebastian Vladescu, said that the VAT increase would raise RON 3.5 bn - 4 bn (USD 980 mn - 1.1 bn) during the remainder of the year, which the Economist Intelligence Unit (EIU) estimates is equivalent to 0.7-0.8% of annual GDP. The EIU estimates that cutting pensions by 15% would have reduced government expenditure by the equivalent of 0.6% of GDP in the remaining six months of the year.
The NBR has expressed concern that increasing tax rates in Romania, where total tax revenue rarely rises above 32% of GDP, simply results in increased tax evasion and will not bring in the revenue required to meet the budget deficit target. Nevertheless, all purchases through conventional retail outlets will bear the higher rate of VAT. Perhaps of more concern is the decision to place the entire burden of tax increases on VAT and leave income tax unchanged at 16%; this is regressive, in that its impact will be greatest on low-income urban families. For this reason, the trade unions and the opposition Social Democratic Party (SDP), as well as some members of the government, favour the reintroduction of a progressive income tax and higher tax rates on luxury goods.
The VAT increase will have an immediate effect on the rate of inflation, pushing the annualised rate up towards 7-8% in the immediate term, making it virtually impossible for the NBR to meet its year-end inflation target for 2010 of 3.5% (±1 percentage point) and increasing pressures for compensating wage increases. However, many businesses argue that they will be forced to cut wage costs and employment to cope with competition from the shadow economy.
The most worrying factor may be that confidence among foreign investors in the government's ability to formulate and implement a coherent economic strategy may have been so badly weakened that there is a run on the leu, which will in turn further increase prices of energy and raw materials, and the indebtedness of companies and households with debt denominated in foreign currencies. This would dampen aggregate demand even further, and slow the economic recovery. This scenario has led some analysts to argue for the creation of an external anchor in the form of a faster timetable for euro adoption.
