This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 03 BUCHAREST 000130 
 
SIPDIS 
 
STATE FOR EUR/NCE - WSILKWORTH, EB/IFD 
STATE PASS USTR - LISA ERRION 
TREASURY FOR STUART 
USDOC FOR 4232/ITA/MAC/EUR/OEERIS/CEEB/BURGESS/KIMBALL 
STATE PASS USAID 
 
SENSITIVE 
 
E.O. 12958: N/A 
TAGS: ECON ETRD EIND EFIN RO
SUBJECT: ROMANIA: NEW GOVERNMENT INAUGERATES FISCAL 
REVOLUTION WITH ADOPTION OF FLAT TAX 
 
RE: Bucharest 01873 
 
THIS MESSAGE IS SENSITIVE BUT UNCLASSIFIED - PLEASE PROTECT 
ACCORDINGLY 
 
¶1. (SBU) SUMMARY: Just before New Year's eve, and the day 
after receiving Parliament's vote of confidence, the new 
center-right government of PM Calin Popescu-Tariceanu 
carried out its campaign pledge to amend the Fiscal Code and 
introduce a 16% flat tax on personal income and corporate 
profits.  The new tax rate was effective January 1, 2005. 
The IMF is concerned that the measure may result in the 
GOR's not meeting this year's programmed budget deficit 
target of 1.5% of GDP.  The Government is counting on new 
revenues from both the hitherto untaxed gray economy and 
from economic growth.  Measures to increase tax compliance 
must still be enacted, but legal actions just taken against 
some of the most dubious objects of economic largesse of the 
last Government may have a salutary impact on revenue 
collections.  END SUMMARY. 
 
ROMANIA JOINS THE FLAT TAX CLUB 
------------------------------- 
¶2. (U)  One of the main pledges of the center-right Liberal- 
Democratic (PNL-PD) alliance throughout the autumn 
parliamentary and presidential campaign was to introduce a 
flat tax of 16% on personal income and corporate profits. 
On December 29, in the first cabinet meeting after receiving 
a Parliamentary vote of confidence, the first major act of 
the new PNL-PD led government was to enact the measure 
through an emergency ordinance effective January 1, 2005. 
Prime Minister Calin Popescu-Tariceanu and the new Finance 
Minister Ionut Popescu declared that the purpose was to put 
more money in Romanian taxpayers' pockets, create more jobs 
and stimulate foreign direct investment (FDI).  Through the 
"multiplier" effect generated by increased employment and 
greater disposable incomes, the Romanian government expects 
to collect more tax revenue over time.  In addition, the GOR 
hopes to reduce tax evasion and bring more money into 
national coffers through "surfacing" the underground (gray) 
economy, in which many workers receive unreported, untaxed 
wages.  (Note: The last Government estimated a full quarter 
of the economy was represented by the informal or gray 
economy in 2004. 
 
¶3. (U) Romania is not the first country in Eastern Europe 
with a flat tax.  According to information available to 
post, Estonia, Latvia, Serbia, Ukraine, Slovakia, Russia, 
and most recently Georgia have adopted flat tax rates 
ranging from 12 to 26%.  Romania's 16% corporate tax is the 
region's second lowest (Georgia's is 12%), while only Russia 
(13%) and Georgia (12%) have lower flat tax rates on 
personal income. 
 
GOVERNMENT MESSAGE: EVERYONE WINS, NO ONE LOSES 
--------------------------------------------- -- 
¶4. (U) The Government promises that no employee will lose 
through replacement of the former personal tax brackets 
(which ranged from 18-40%) with the new 16% flat tax.  Under 
the flat tax, the main deduction an employee receives are 
the personal and dependent deductions.  For employees 
earning up to a gross monthly wage of ROL 10 million ($345), 
the deductions range between ROL 2.5 million ($86), for 
those with no dependents to ROL 6.5 million ($225), for a 
wage-earner with four or more dependents.  Deductions are 
gradually lowered for employees with gross monthly wages 
between ROL 10 and ROL 30 million ($1,037), with no personal 
deductions for those with gross monthly wages exceeding ROL 
30 million.  Other deductions preserved include private 
health insurance (up to euro 200 per year per person), 
social security contributions, optional contributions to 
occupational pension schemes (life insurance, up to euro 200 
per year) and expenditures for employees carrying out 
independent activities (commerce or professions such as 
lawyers, medical doctors). 
 
BUSINESS HAPPY, LABOR COMPLAINS 
-------------------------------- 
¶5. (U) The business community's reaction was predictably 
enthusiastic.  Both the American Chamber of Commerce in 
Romania and the Foreign Investor's Council hailed the 
measure as a step forward toward creating a stable and 
predictable tax environment for investors.  Trade union 
leaders, however, denounced the flat tax as "socially 
unfair," disproportion ally benefiting wealthy taxpayers. 
The former governing Social Democratic Party (PSD) similarly 
characterized the flat tax as a "political measure," 
claiming the flat tax will lead to major medium and long 
term problems for the budget and will have to be compensated 
by either raising excise taxes or by drastic budget cuts. 
 
FISCAL IMPLICATIONS SUBSTANTIAL... 
---------------------------------- 
¶6. (U) According to Finance Minister Popescu's estimate, the 
budget revenue losses could amount to $242 million from the 
profit tax cut and $830 million from the 16% flat income 
tax.  While conceding a transition period of budget revenue 
losses, the Finance Minister is optimistic that budget 
revenues will ultimately increase, as has happened in other 
countries that have adopted a flat tax. 
 
...SOME TAXES SET TO RISE 
-------------------------- 
¶7. (U) To compensate for these projected losses, the new 
Government introduced a series of tax hikes.  The micro- 
enterprise tax, applicable to firms with nine employees or 
less, was doubled from 1.5% to 3.0% of total turnover. 
According to the Finance Minister, the doubling of the tax 
paid by mico-enterprises is an attempt to uncover personal 
incomes disguised as micro-enterprise revenues.  A 
significant number of these enterprises are organized to 
circumvent payment of employee-employer payroll taxes 
through "spinning off" operations into micro-enterprises for 
favorable tax treatment. 
 
¶8. (U) Other tax increases include: 
Dividends obtained by individuals will be taxed at 10%, 
level with the corporate dividend tax; 
- Agricultural income tax is increased from 15% to 16%; 
- Gambling tax is increased from 10% to 16%. 
 
¶9. (U) Despite the fact that the former PSD government 
approved a 2% cut in payroll taxes for 2005, the new 
government annulled this measure, maintaining social 
insurance contributions at 49.5%. The downside to this is 
with social contributions remaining high, a strong incentive 
remains for employees to continue working in the untaxed 
"gray" economy. 
 
IMF'S CAUTIOUS REACTION 
----------------------- 
¶10. (U) The IMF initially expressed concern regarding the 
GOR's recent fiscal step.  The IMF resident representative 
met with Finance Minister Popescu prior to the cabinet 
meeting of December 29, 2004.  He conveyed the message that 
the 1.5% of GDP deficit for 2005 is the maximum Romania can 
afford and perhaps should be decreased in order to ensure 
Romania meets inflation and current account deficit targets. 
He also advised the GOR to refrain from taking any step 
prior to the visit of the IMF's technical team scheduled for 
January 25.  Nevertheless, he conceded the new Cabinet's 
move to introduce the 16% flat tax was in line with regional 
trends to reduce taxation.  He subsequently softened his 
position, noting that the IMF visitors would examine 
budgetary implications. 
 
REFORM BY DECREE - THE MECHANISM 
-------------------------------- 
¶11. (U) The government introduced the flat tax on December 
30, 2004, through Emergency Ordinance 138 to Law 571/2003 of 
the Fiscal Code.  In the preface to the ordinance the 
Government stated it was necessary for the measure to take 
effect at the beginning of the year (2005), because waiting 
until later would result in fiscal confusion and uncertainty 
for taxpayers and complicate tax collection. 
 
¶12. (U) Two issues cloud the issuance of the emergency 
ordinance.  Formal consultations with the Social and 
Economic Council (CES), required before passage of emergency 
ordinances, did not occur as the CES was on vacation. 
However, the new Government stated it had received the CES's 
approval "in principle."  Secondly, as with all emergency 
ordinances, the flat tax measure will ultimately have to be 
ratified by the Parliament at a later date.  Parliament 
could ultimately reject the flat tax, although this is 
unlikely given the current majority held by the Government. 
 
COMMENT 
------- 
¶13. (U) The new GOR's ordinance has positive and negative 
implications for the new government.  On the positive side, 
it demonstrates the Tariceanu government's commitment to 
keep its election promises to cut taxes to improve living 
standards and build a more business friendly environment. 
Further, the new government's tax philosophy makes sense as 
long as the 2005 tight budget deficit (1.5% of the GDP) and 
disinflation process are not endangered.  The flat tax 
simplifies fiscal legislation, cuts fiscal administration 
and collection costs, and renders the economy more 
transparent.  On the negative side, however, there is a risk 
of macroeconomic disequilibria, with government revenues 
initially expected to decline. 
 
¶14. (SBU) Changing the mentality of Romanians is another 
major obstacle.  A high payroll tax (49.5% of wages) is 
still the main obstacle to bringing the wages actually 
earned, but not reported, out in the open.  It will keep 
substantial numbers of Romanians in the "gray" economy. 
What is likely to be more openly reported is the incomes of 
self-employed persons (architects, accountants, lawyers, 
physicians), who might elect to pay the 16% flat income tax 
rather than risk being charged with tax evasion.  It is 
significant that anti-tax dodging measures have not been put 
into place.  Nevertheless, the average taxpayer and 
corporation can hardly fail to absorb lessons carried in the 
daily press in recent days about new indictments issued 
against some of the country's corrupt "big fish" who had 
taken advantage of favorable tax debt for shares swaps or 
tax holidays. 
 
¶15. (SBU) Post does not perceive that a major problem has 
arisen between the IMF and the GOR regarding the flat tax or 
that the IMF doubts the GOR's commitment to continuing 
prudent fiscal policies.  Nonetheless, post plans to speak 
with the local IMF representative to gauge IMF flexibility 
with the new government and report Septel. 
DELARE