A real tax reform or a new patch?

Through the National Recovery and Resilience Program (PNRR), Romania has committed to carrying out tax reform in 2025. Until the elections for the Romanian Parliament in December 2024, citizens would have the opportunity to participate in an in-depth debate on the proposed tax reform, based on the electoral programs of political parties.

Where are we with this debate? Currently, at the level of roundtable discussions. In the absence of an integrated tax reform project, participants generally refer to one aspect or another of the expected reform. Political parties are busy with campaigns for local and European Parliament elections, followed directly by the summer holiday period. Consequently, political parties are not yet aiming to substantiate their political programs for parliamentary elections, in which we would find an answer to the future tax reform.

The Minister of Finance reminds us that Romania is overdue for tax reform in 2025 if we want funding from the European Union to continue through the PNRR, and if the reduction of the public budget deficit is to become sustainable. Romania's development has become heavily dependent on European funds and loans. In recent years, public debt has grown twice as fast as gross domestic product; the same minister reaffirms that the best form of taxation for personal income remains the flat tax rate. The Prime Minister declares that we no longer have a flat tax rate for a long time and that he would like to introduce a new system of tax deductions to support vulnerable individuals and stimulate the achievement of other social assistance objectives.

Employers' associations and trade unions consider that labor is overtaxed, as about 43% of gross income goes to the public budget and social insurance funds - pensions and health - and only 57% goes back to the employee. In fact, it is not taxes that are high, but social security contributions, pensions, and health, without these two social security systems being financially sustainable.

Romanian citizens are dissatisfied that public services are still far from European standards, and one of the causes is the chronic underfunding of these services. In Romania, the share of tax revenues (including social security contributions) in gross domestic product is only 27%, compared to an average of 40% in the European Union and between 34% and 39% in the other neighboring member states. Other causes stem from the lack of substantive reforms in public institutions providing public services, corresponding to the challenges posed by the transformations in Romanian society and the economy.

The European Commission, the International Monetary Fund, the World Bank, and more recently, the Organisation for Economic Co-operation and Development (OECD), unanimously recommend the introduction of progressive forms of income taxation so that the tax system contributes not only to increasing state revenues but also to reducing the growing social inequality in Romania. These international organizations also warn us that we have the highest VAT revenue shortfall in the European Union (about 36%, compared to 6% at the EU level) and a high level of tax evasion. A Romanian lawyer specializing in tax law demonstrates to us that these organizations, in their proposals for progressive taxation, do not take into account the tax yields of the flat tax rate, recorded over a longer period of time, which have been good as long as there has been no political and abusive intervention in Romania's tax regime.

Various experts point out that global mega-trends - decarbonization, digitalization, fragmentation of supply chains, loss of peace dividends and increased military spending, increased sovereign debts, growing social inequalities, attainment of "strategic autonomies" in essential industries - require a rethink and flexibilization of fiscal policies to provide the necessary incentives to address these new challenges. In the case of Romania, we are also facing an aging population.

Therefore, there are strong arguments why a public debate on proposals for tax reform should start as soon as possible in Romania, so as not to end up, as usual, in a time crisis, and to come up again with patches for an outdated and inefficient tax regime. In any serious debate on the tax system in Romania, taxes (at the state budget and local budgets) should no longer be mixed with contributions to social insurance systems.

As citizens and businesses, we pay taxes and expect central and local public authorities to finance public services offered at European standards. We are one of the countries with the lowest percentage rates of direct taxes in Europe: 10% income tax for individuals; 16% corporate profit tax (excluding temporarily introduced anomalies, such as additional taxes for some companies); a favorable tax system for micro-enterprises, sole traders; 8% dividend tax; 1% capital gains tax from the sale of shares and other financial assets held for more than a year, and 3% for those held for less than a year.

Regarding the tax system, in addition to the obligatory reduction of tax evasion, Romanian citizens should make a fundamental choice: (1) we want to maintain a tax system with low tax rates and accept to contribute more through direct payments from personal incomes to benefit from public services at European standards; or (2) we promote a tax system with higher tax rates to finance public services at European standards from the state budget and local budgets. Of course, there are other options to consider for tax reform: the proportion between taxes on personal income, corporate taxes, consumption taxes, property taxes; necessary changes in the tax regime driven by decarbonization and the reduction of revenues from excise taxes on fossil fuels; expanding online commerce, etc.

Social security contributions are based on the principle of social solidarity. Conceptually, the two social security systems - pensions and health - should be self-financed from contributions paid by insured persons, and the financial intervention of the state should be justified only by the financing of vulnerable individuals through social assistance. In reality, both systems operate with substantial subsidies from public budgets, either due to demographic imbalance and migration (the pension system) or due to the lack of reforms (the health system).

In the case of the pension social security system - pillar 1, the principle of social solidarity requires that generations in employment transfer insurance contributions to the pension fund, from which pensions are paid to currently retired persons. This system is sustainable only when the number of pensioners is much smaller than that of employed contributors. For example, if we want pensions to represent 50% of the average income, then at a ratio of 1 pensioner to 10 employees, the contribution rate per employee would be 5% of income; at a ratio of 5 pensioners to 10 employees, the contribution rate would be 25% of income; at a ratio of 8 pensioners to 10 employees, as is currently the ratio in Romania, the system would be sustainable with a contribution rate of 40%. Since the legal contribution is only 25%, pillar 1 pensions require subsidies from the state budget for balancing. As the long-term trend is towards an increase in the proportion of elderly persons, the economic solution is to accentuate the role of pillars 2 and 3 of pensions, namely each person establishing their own pension fund during their active life, complemented by optional pension insurance.

In the case of the health social security system, the principle of social solidarity assumes that all persons pay a health insurance contribution, from which the medical expenses of sick persons are covered. In Romania, in fact, this pyramid is inverted with the peak downwards: we have 19 million insured persons of which only about 7 million pay health insurance contributions.

Currently, there is no connection between the size of the percentage contribution rate to health insurance and the size of medical expenses. The economic solution is to reform the health social security system by switching to insured persons paying a health insurance premium determined based on the cost of medical services, the frequency, and the structure of diseases specific to the Romanian population. If the state wants certain categories of the population, for example, parents, to be exempt from paying health insurance contributions for their children who are students, then the state should cover the insurance premiums for those students. In addition, the state will remain involved with subsidies in situations of pandemics and chronic diseases.

Until we establish the health social security system on healthy economic foundations, we will not have the desired responsibility in this public system for the use of human, material, and financial resources.

Of course, there is also the alternative of the healthcare system in Denmark, where medical care is generally free, but the VAT rate is 25%.

Postponing the debate on tax reform proposals is not a solution, especially since the government is obliged to publicly debate the draft law on public sector salary restructuring.