Romania had until 2005 a system of progressive taxation on the income made by individuals, with rates ranging from 18% up to 40% of the net income (the intermediate rates being 23%, 28% and 34%). The income thresholds used in order to determine the application of the percentage of the income tax were in fact very low - for monthly income exceeding about 300 Euro – so it was actually very easy to reach the limit beyond which the tax would be of 40%. The introduction of the 16% flat tax in 2005 (which applied not only to individuals, but also to companies) revolutionized the whole system: not only that the budgetary revenues from the payment of the income tax increased at a fast pace (until Romania was hit by the economic crisis), but also the reduced taxation made Romania a more enticing destination for investment (and attracted criticism from Western Europe due to so-called “fiscal dumping”).

Now, Romania is again facing difficult economic challenges. The IMF and domestic political factors advanced proposals to switch back to the progressive tax system, or, at least, to increase the rate of the flat tax. At first sight this makes sense – progressive taxation is the system of choice for most developed countries, and, in addition to that, why should we not tax more the rich people.

On the other hand, we should be careful to avoid a copy-paste of solutions which may work elsewhere, but may be not appropriate for Romania. An equitable tax system should be designed having in mind the specific realities of our country and should take into account the experience which is already available here related to the functioning of both the progressive and the flat tax systems. We shall therefore briefly examine below some of the arguments which are in favor of the preservation of the current flat tax system in Romania.

A Reasonable Flat Tax Is an Effective Mean to Improve Tax Collection

Let us take a look at the figures. According to Romania’s National Statistics Institute, immediately prior to the introduction of the flat tax system (i.e. in 2004), income tax revenue totaled about 7.1 billion lei. In the first year of existence of the 16% flat tax, budget revenues in absolute figures (pertaining to income tax) declined with about 6% (which is remarkably low, since the previous progressive tax system reached easily the rate of 40%).

After 2006 however, the collection of income tax revenue quickly increased, with growth rates ranging between 33% (in 2008) and 46% (in 2006), reaching a total revenue in absolute figures of 18.5 billion lei in 2009 (which is about three times the corresponding amount in 2004, when tax rates were significantly higher). Part of its evolution can be attributed, naturally, to the growth of the GDP. However, this was clearly not the single factor (GDP has not increased with 30% or 40% in none of these years…).In fact one this growth of the income tax revenue results from the very achievement of one of the main purposes of establishing the flat tax, which was to bring income out from the shadows of the black market.

Romania Needs the Competitive Edge that Only the Flat Tax System Can Give

One of the favourite arguments of the supporters of the progressive tax is that this system has been in use for a considerable number of years in practically all economically developed countries. This in itself is not sufficient to justify the abolishment of the flat tax in a place like Romania, which is surrounded by countries which use a flat low tax system. The most notable example in that regard is Bulgaria, where the flat tax rate is even lower than Romania’s, i.e. 10%; a few days ago Hungary announced also the intention to introduce for the following years an income flat tax at a rate of 16% and a tax cut for small and medium businesses.

In addition, we should not forget how Romania looks to both domestic and foreign investors: a place with crumbling infrastructure, poor governance, uncontrollable corruption, poor life quality, and unions marching in the streets. Romania clearly needs policy measures to compensate for these shortcomings (which show no sign of going away in the following years…); the existence of a relatively low flat tax is one of the most persuasive arguments that one might put on the table in order attract new investments here. Relinquish the flat tax in favor of the progressive tax – and nothing much will remain on our side (apart, maybe, from the dubious advantage of having one the lowest paid workforce in Europe…)

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