EU: Romania’s progress on fiscal adjustment is at risk of being undone. New warning on corruption

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Since 2009, Romania pursued a significant fiscal consolidation which led to achieving its medium-term objective in 2014 and 2015. However, the authorities are pursuing an expansionary fiscal policy that led to a substantial departure from the objective, European Commission’s semester country report reveals, pointing out that Romania’s progress on fiscal adjustment is at risk of being undone.

At the same time, the EC warned that “while some of the structural reforms are at risk of being reversed, ohters have stalled and gthe irreversibility of progress in the fight against corruption was recently put at risk”. “Delays and potential reversals of recent reforms are holding back investment.”

Brussels officials consider that the fiscal policy in Romania turned pro-cyclical in 2016 and the deficit is expected to widen, in breach of the fiscal framework. As a consequence of significant tax cuts and expenditure increases, the general government deficit widened in 2016 and is projected to further widen in 2017.

“This increase breaches the country’s fiscal framework, the provisions of which are sound in theory but lack enforcement. With a worse fiscal balance, the public debt ratio is expected to deteriorate gradually but remain below 60 percent of GDP. High tax evasion and low tax compliance remain a challenge,” the report reads.

Structural challenges may dampen the medium-term outlook

The report also mentions that for the first time since 2008, actual output was above potential and is expected to remain so in 2017-2018 and that expansionary fiscal policy is boosting domestic demand. Yet, the European officials launch new warning on the risk of anti-corruption fight being slowed down.

“Although Romania made progress, particularly in governance, employment policies and poverty reduction, these reforms are not yet anchored in a sustainable manner. While some of these structural reforms are at risk of being reversed, others have stalled and the irreversibility of progress in the fight against corruption was recently put at risk. In the absence of an impetus in Romania’s structural reform agenda, non-price competitiveness and potential growth will be constrained.”

The document is clearly mentioning the Government’s recent controversial intentions to amend the criminal laws and decriminalize certain graft offenses, abuse of office included. According to the EC, the fight against corruption is jeopardized by the emergency ordinance 13, noting that such initiatives threaten the progress registered in the past ten years. “Corruption persists at all levels and is an impediment for business”, reads the working document preceding the official half-yearly report on Romania.

 

Tax system, favourable to economic growth

As regards taxation, EC notes the overall structure of the tax system is favourable to economic growth. Compared with the EU average, tax revenues depend to a larger extent on consumption taxes and to a lesser extent on taxes on corporate income and on labour.

Instead, undeclared work represents approximately 15-20 percent of GDP. Despite increased number of joint controls of labour and tax authorities, their impact remains limited, partly because preventive measures are not yet sufficiently developed. At the same time, tax compliance remains low as evidenced by Romania having the largest VAT gap in the EU.

Refering to the fiscal framework, this is sound, but lacks enforcement. “The fiscal rules, which are contained in the fiscal responsibility law, are well designed. However, the 2016 budget law was non-compliant as the deficit ceiling of RON 20.9 billion breached the medium-term budgetary objective of a structural deficit of 1 percent of GDP,” EC points out.

Moreover, the medium-term fiscal strategy does not guide the annual budget process. However, in 2016, as in previous years, the authorities did not send an update of the fiscal strategy to the Parliament by 15 August, the statutory deadline, EU officials stress.

 

Legislative initiatives tend to undermine investor’s confidence

As regards financial stability, this has improved in 2016, but legislative initiatives tend to undermine legal predictability and investor’s confidence. In this context, the banking sector remains well capitalised and liquid, and profitability recovered in 2016. However, banks continue to be burdened by the quality of corporate exposures and consumer loans, which are the loan portfolios with the highest level of delinquency. Not least, the full impact of the debt discharge law remains difficult to assess.

On macroeconomic perspective, total investment in Romania has weathered the crisis well. After a sharp correction in 2010, investment has been on an upward trend since 2011, EU remarks, noting that all investment components are expected to contribute to investment growth in 2017 and 2018, with a slightly stronger role played by investment in equipment.

 

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