This paper evaluates the main effects of the implementation of tax flat system in Romanian economy. If accompanying measures are not going to be enforced, the introduction of the flat rate of 16% in Romania will lead to unsustainable budgetary deficits and inflationist pressures. The flat tax favors the workers with big salaries and also big and financially solid companies (which, mainly “export” the profit). It will attack the fragile macroeconomic stability. It is uncertain if it will lead to the increase of the degree of employment, having in view the fact that the contributions to the social insurances have a very high level. The alternative scenario is simple. Romania should have chosen to continue what it was confirmed to be a valid element of the economic evolution towards a European standard (progressive fiscal system).flat tax; fiscal policy; inflation; AD-AS model

Marinas, Marius

Socol, Aura Gabriela

Socol, Cristian

English

Research Papers in Economics

THE FLAT TAX IN ROMANIA. A GOOD 
ECONOMIC STRATEGY ? 
 
Cristian Socol
1, Aura Socol
2, Marinas Marius
3 
Ph. D. Lecturer . 
Phd. Assistant Teacher   
Phd. Assistant Teacher   
Academy of Economic Studies, Bucharest 
 
      This paper evaluates the main effects of the implementation 
of  tax  flat  system  in  Romanian  economy.  If  accompanying 
measures are not going to be enforced, the introduction of the 
flat rate of 16% in Romania will lead to unsustainable budgetary 
deficits and inflationist pressures. The flat tax favors the workers 
with big salaries and also big and financially solid companies 
(which,  mainly  “export”  the  profit).  It  will  attack  the  fragile 
macroeconomic  stability.  It  is  uncertain  if  it  will  lead  to  the 
increase of the degree of employment, having in view the fact 
that the contributions to the social insurances have a very high 
level. The alternative scenario is simple. Romania should have 
chosen to continue what it was confirmed to be a valid element 
of  the  economic  evolution  towards  a  European  standard 
(progressive fiscal system).  
 
At the end of 2004, the Romanian Government introduced flat 
tax of 16% on the incomes of individuals and on the profit of the 
companies.  According  to  the  opinion  of  the  authorities  who 
proposed it, this measure represented the structure of a fiscal 
relaxation.  Subsequently,  the  numerous  increases  of  taxes 
questioned the relaxation thesis regarding taxation. The present 
study  is  not  mainly  aimed  to  clarify  the  concept  of  fiscal 
relaxation. However, one remark has to be made. We can state 
that  the introduction  of  the  flat tax is nothing  but  a  perverse 
reduction of fiscality (taxation system). The contribution rate to 
the social insurances has a significant share in the aggregated 
supply and demand and unfortunately it still remained at a high 
level (47,5%).        
 
The  potential  expansion  of  businesses,  the  increase  of  direct 
investments, the reduction of the share of underground economy, a sustainable economic growth, more jobs, the increase of saving 
and  investments,  were  considered  ingredients  of  a  successful 
program.  However,  many  specialists  showed  their  concern 
regarding the timeliness of introducing the flat tax. What are the 
conditions for a successful introduction of the flat tax? Do strong 
inflationist pressures appear in Romania due to the introduction 
of  the  flat  tax?  Does  the  macroeconomic  stability  disappear? 
Will  the  benefits  of  the  flat  tax  observed  in  Slovakia  show 
themselves in Romania as well?  
      In the search for answers regarding the introduction of the 
flat  tax,  we  showed  our  concerns  regarding  the  numerous 
approaches  to  a  macroeconomic  instrument  of  policy 
incongruous  with  the  pattern  of  European  economy  and 
exaggerated for an economy in full process of restructuring.     
 
The Model  
 
      When  planning  a  tax  reform,  you  have  to  know  the 
magnitude of the multiplying effect of the tax rate reduction due 
to the fact that this can lead to an aggregated demand in excess 
thus causing almost unstoppable inflationist effects.  
 
The reduction of fiscality has effects on the aggregated demand 
as well as on the aggregated supply. However, the effects are 
differentiated as size (Figure 1). The incidence of the reduction 
of fiscality is stronger on the aggregated demand (AD0-AD1) and 
more reduced on the aggregated supply (AS0-AS1). The theorists 
motivate  the  increase  of  the  aggregated  supply  by  the 
improvement  of  working  incentives,  although  recent  studies 
show that the introduction of the flat tax has as main quality the 
reduction of the administrative costs (its simplicity).   
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fig 1 Fiscal relaxation with flat tax system 
     
  We have to distinguish between the short term effects and the 
long  term  effects  of  the  taxation  reduction.  On  short  term 
following  the  taxation  reduction,  the  aggregated  demand 
increases  (AD0-AD1)  (in  Romania,  34%  in  2005)  and  the 
economy moves from E0 to E1. The gross domestic product is 
increasing  with  a  big  measure  causing  the  decrease  of  fiscal 
incomes cashed in the budget with a percentage which is smaller 
than the decreasing percentage of the marginal taxation rate. On 
long  term,  the  economy  will  reach  point  E2  (following  the 
movement  of  the  aggregated  supply  AS0-AS1  ).  As  a 
consequence  of  the  taxation  reduction  the  working  incentives 
grow and in this way the potentialGDP moves from potential 0 GDP to 
potential  1  GDP  (in  Romania,  11%  in  2005).  The  increase  of 
potentialGDP is smaller than the one obtained by stimulating the 
aggregated demand. It results that the fiscal incomes collected 
from the state budget increase with a rate which is much smaller 
than the decreasing rate  of  the  collections  to the budget  as a 
consequence  of  applying  the  flat  tax  →  the  budget  deficit 
Price Level 
P 
P0 
0  GDPpotential 0  GDPpotential1  Gross Domestic 
Product GDP 
E2 
E0 
E1 
AS0  AS1 
AD1  AD0 
P1 increases → strong inflationist pressures appear. The analysis of 
the diagram also shows that the inflation increases (P0→P1).  
 
Complex Reality in Romanian Economy  
 
      The fiscal relaxation expected to come from the flat tax will 
lead to a boom of businesses, will stimulate us to work more, 
will  bring  to  surface  an  important  part  of  the  “underground” 
businesses (20% in Romanian GDP), will attract direct foreign 
investments, will lead to a sustainable economic growth, more 
jobs, the increase of saving and investments etc. However, the 
specialists  of  the  International  Monetary  Fund  (and  not  only 
them) expressed their opinion saying that timing is wrong.  
      The  expansionist  economic  policies  of  the  current 
authorities,  under  the  conditions  of  an  already  “superheated” 
economy  will  cause  a  price  increase  of  more  than  5%,  the 
inflation  target  forecasted  by  the  National  Bank  for  2006 
(inflation targeting strategy was introduced in Romania in 2005). 
The alarming growth rate of the deficit of current account (12% 
of  GDP  in  2006),  the  budgetary  “holes”  created  after  the 
introduction of the flat tax (1% of Romanian GDP in 2006), the 
increase  of  public  expenses,  a  still  unwise  wage  policy,  the 
liberalization  of  the  capital  current  account,  the  inefficient 
restructuring, the increase of the expenses for adhering to the 
European Union and NATO (3% in Romanian GDP, annually, 
in average), the exponential growth of consumer credits are all 
factors pressing on the growth of inflation above the forecasted 
level. 
 
Who losses and who gains?  
       
      The families with big incomes gain, the families with small 
incomes  loose.  The  calculations  of  the  Ministry  of  Finance 
shows that the average incomes of the population have increased 
with 21% in the first four months of 2005, compared with the 
same period of 2004. However, the reality is totally different like 
in many other situations. A study made by Mercury Research 
showed that an important part of the Romanians (65%) consider 
that the introduction of the flat tax caused a decrease of their standard of living. The segment of workers with incomes that 
are bigger than the average (which represent a low percentage 
from the total in Romania – 12%, are the only ones who benefit 
from the introduction of the flat tax. And still, somebody keeps 
helping the flat tax to become a ‘winner”. That somebody is the 
taxpayer. He is the one bearing the burden of higher prices. We 
are  talking  about  prices  hiding  the  increase  of  taxes,  the 
elimination  of  the  exemptions  from  V.A.T.,  the  increase  of 
interests. The sellers of real estate properties, the depositors to 
the banks etc., also contribute to the covering of the budgetary 
“hole” created by the flat tax.   
   
What Comes Next?  
 
      An increase of the budgetary deficit (around 3% of GDP, in 
2007). A deepening of the trade balance deficit. Probably, an 
increase of the current account deficit until the level of 12% in 
the  years  to  come.  Inflationist  pressures.  The  decrease  of  the 
credibility of the National Bank of Romania, without being its 
fault. The Central Bank will continue increasing the rate of the 
interest of reference, strengthening in this way the governmental 
option for restrictive macroeconomic policies, in accord with the 
need  to  touch  the  short  and  long  term  sustainability  of  the 
disinflation process. On the other hand, the transition costs (the 
current budgetary costs, the costs related to the social insurances 
reform, the additional costs allocated to health, education, army 
etc.) superposed to the costs related to the adhering to the EU 
(approximately 1,3% of GDP – the contribution to the common 
EU budget, 1% of GDP – co financing of structural funds) will 
lead to high budgetary deficits in the following years.     
 
What to Be Done? 
       
      The increase of aggregated demand will go far beyond the 
increase of GDP potential (even if there is a small increase of the 
productivity  of  labor).  If  NBR  wishes  to  obtain  a  sustained 
economic growth and the stability of prices, on long term, it will 
have  to  promote  a  proactive  monetary  policy  –  to  take  the 
measure of increasing the interest rate of reference. NBR does not  have  to  act  upon  the  current  situation  of  the  aggregate 
demand but it has to respond to the inflationist pressures which 
will appear if the economy grows too fast. For the introduction 
of the flat tax not to lead to strong budgetary deficits and to high 
inflationist pressures, we think that the following accompanying 
measures are needed: 
a) The Improvement of the Financial System:  
-  The  reduction  of  the  public  expenses  by  reducing  the 
dimension of the governmental sector, a prudent wage policy 
etc.  
-  The  intensification  of  execution  debt  enforcements  and  of 
imposing strong constraints to the bad payers; 
-  The reduction of the share of the contribution to the social 
insurances - long term equilibrium between the work taxation 
and capital taxation. 
b)  The  Implementation  of  the  Policies  of  Stimulation  of  the 
Aggregated Supply   
-  A  higher  legislative  stability,  institutions  capable  of 
exercising the governing; 
-  The reducing of the internal lags of the fiscal policy (which 
are already big); 
-  Predictability in the fiscal reform; 
-  A  stable  and  predictable  competitive  environment  (the 
functionalizing of the Council of Competition); 
-  The  granting  of  state  grants  only  in  accordance  with  the 
European legislation in this field; 
-  The stimulation of internal investments and economies; 
-  Coherent strategies of attracting direct foreign investments; 
-  The reduction of social contributions in order to increase the 
degree of employment; 
-  The  increase  of  manpower  by  formulating  a  Labor  Code 
unmarked  by  ideological  prevalence  and  which  admits  the 
flexibility of the labor market and generates the responsibility 
of the economic actors.  
c) The Reduction of Market Distortions by Limiting/Stimulating 
the Effects of Negative/Positive Externalities, by:  
-  The rigorous setting of proprietary rights; 
-  The reduction of transaction costs; -  The using of taxes and subsidies in order to eliminate the 
effects of negative externalities;  
-  An  efficient  restructuring  and  privatization  process, 
accompanied by the enforcement of active industrial policies; 
-  The free entry and exit on/out of a market of the economic 
agents  (especially  the  liberalization  of  the  exits  from  the 
system). 
 
The “Reloaded” Model  
 
The matrix of the policies accompanying the flat rate (proposed 
above) is able to lead to a bigger increase of the GDP potential 
(GDP potential 0→GDPpotential1) as compared to the increase 
of GDP potential from the initial model. The aggregated supply 
AS will increase with a higher measure and consequently the AS 
curve will change its place more to the right (compared to the 
initial model) (AS0→AS1). 
 
   
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fig 2 The “Reloaded” Model 
 
      In this way, the budgetary deficits will be smaller, and the 
inflationist  pressures  a  little  less  unbearable  (P0→  P1).  The 
Price Level 
P 
P0 
0  GDPpotential 0     GDPpotential 1  Gross Domestic 
Product GDP 
E2 
E0 
E1 
AS0      AS1 
AD1  AD0 
P1 National Bank of Romania will be able to reach the inflation 
target for the next years, and the deficit of current account will 
no longer be at “concerning levels”. In this way a virtuous circle 
is  created.  We  will  be  able  to  re  motivate  the  hope  that  the 
introduction of the flat tax will be a success.  
 

The flat tax in Romania. A good economic strategy?

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