The Romanian tax reform: fiscal policy options and directions for labour income taxation

The urgent need for tax reform has become apparent as the authorities have postponed making a concrete decision for various reasons, including administrative challenges in designing efficient, effective, and equitable tax measures whose economic and social impact needs to be assessed, as well as political considerations.

Moreover, through the National Recovery and Resilience Plan (NRRP), Romania has committed to reforming the tax system to increase overall tax revenues, review existing tax exemptions, and develop effective strategies to combat tax evasion and fraud.

To achieve the objectives outlined within the NRRP, the Ministry of Public Finance has signed a Reimbursable Technical Assistance Services Agreement with the International Bank for Reconstruction and Development (IBRD) aimed at improving Romania's fiscal framework. This partnership resulted in the publication of a Report in March 2023 on Romania's tax system, which includes a comparative analysis and recommendations for fiscal framework reform (the Report). The ultimate goal of these changes is to transform Romania into a competitive economy, ensure fiscal sustainability, and establish a tax system that is fair, efficient, simple, and transparent. Additionally, IBRD experts propose an implementation timeline that can be applied immediately or phased in over the period from 2023 to 2030.

Currently, income from salaries is subject to a flat tax rate of 10%, along with social contributions paid by both the employee (a 25% social security contribution - CAS, and a 10% health insurance contribution - CASS) and the employer (a 2.25% work insurance contribution). In addition to these, the current tax system includes various tax incentives for specific sectors. For instance, in the IT industry, employees are exempt from the 10% income tax, while individuals in the construction and agriculture sectors enjoy an income tax exemption, as well as reduced social contributions (CAS and CASS).

It is clear that the taxation of labour income is characterised by a very high tax burden and inequalities, as highlighted in the analysis conducted by IBRD’s experts. This is evident when compared to the level of taxation on capital and when considering the phenomenon of tax arbitrage, which is frequently encountered in practice. Tax arbitrage often refers to the choice of providing services in the form of independent activities or through a microenterprise as an alternative to entering into an employment contract, even when the conditions for qualifying as an independent contractor are not properly met. This practice creates significant distortions in the labour market, creating disparities between taxpayers who strictly adhere to the law and those who exploit legislative loopholes or abuse various forms of organisation.

As a result of the analyses conducted by the IBRD experts, several fiscal policy options for Romania have been identified in relation to labour income. These options aim to increase revenues for this type of income and transform the tax system into a unified one. Additionally, the goal is to reduce disparities in the taxation of different categories of individuals based on their sector of activity, the legal form in which they conduct their activities, and the type of income they earn.

The principle of equity, which has not only been theoretically supported in the IBRD report but has also become a common topic in political discourse among leaders, is a current topic. However, the major challenge lies in defining the appropriate fiscal measures to achieve the goal of tax fairness while simultaneously maintaining the efficiency of the system in terms of administration and tax collection costs. Additionally, it is crucial to avoid unintended consequences, such as the emigration of high-income individuals who may be impacted by tax increases or the intensification of undeclared work, which is a persistent issue in Romania.

For labour income, we discuss below some of the options proposed in the IBRD report:

• Introduction of progressive taxation of wage income

This reform option proposes that the taxation of wage income be differentiated according to the amount of income earned by the employee by applying several thresholds of 10%/20%/25%. In addition, it is also suggested to move from a monthly to an annual tax period.

Romania is among the few European countries that still apply a flat rate for taxing earned income, along with Bulgaria, Hungary, and Estonia. At the other end of the scale, other European countries apply progressive tax rates (France, Germany, Austria, Spain, Portugal).

Although there are arguments both for and against the current flat tax system and progressive taxation, the implementation of the latter must ensure the fairness of taxation, as well as the efficiency and feasibility of changing the system for both taxpayers and authorities.

Without delving into discussions about specific tax rates for a progressive taxation system in Romania, which essentially represents a decision for policymakers, it is important to note that implementing progressive taxation requires improving the administrative capacity of tax authorities, primarily through digitalisation.

However, in this regard, the current experience in the interaction between taxpayers and tax authorities highlights that digitalisation poses a significant challenge for the National Agency for Fiscal Administration (ANAF). This is due to outdated information systems currently in use, the low level of digital skills among system employees, some resistance to change, and inflexibility in the mode of interaction (continued predominant use of physical documents, difficulty in communicating with tax inspectors through electronic or phone means, etc.).

• Elimination of exemptions in the IT, construction, and agriculture sectors

This option aims to revoke the tax benefits granted in the IT, construction, and agriculture sectors. The objective is not only to increase revenues for the state budget but also to ensure a fair and uniform approach to taxation for all taxpayers earning the same category of wage income, regardless of the industry they work in.

These fiscal incentives were implemented to retain the workforce in the country, stimulating investments, and supporting the development of certain key economic sectors. However, in the effort to improve fund collection for the budget, consideration is given to removing these tax benefits to ensure equitable taxation for all taxpayers.

• Employed versus self-employed activity

Romania's tax system offers individuals the option of becoming self-employed if their profession and the nature of their activity allow this. This can be done in the form of a PFA or even by setting up a micro-enterprise.

Although the tax framework allows a choice between several forms of organisation, the level of taxation should not be the criterion for adopting a particular form of activity but rather the fulfillment of the independence criteria outlined in the Tax Code and the correlation with the substance of the activity being carried out. In practice, abusive situations of using the status of an independent contractor as a form of tax arbitrage are often encountered. This occurs mainly due to significant differences in taxation compared to salaried work, primarily because of the application of CAS and CASS on a capped taxable base for independent activities instead of gross earnings.

The World Bank's report recommends aligning the taxation of both forms of activity by eliminating the caps on CAS and CASS for independent activities, thus eliminating the possibility of tax arbitrage.

• Reducing the tax burden for low-income workers

This can be achieved either by eliminating the 10% CASS on earned salaries and financing medical services from general taxation or by introducing a refundable tax credit for earned incomes to offset a portion of the current CAS burden for low-income workers.

• Reducing the tax burden on CAS

Given that CAS is currently imposed at a rate of 25% on gross salary incomes, the possibility of reducing this rate, especially for low-income employees, is being discussed. However, it is mentioned that implementing such a reform is challenging, as it is closely tied to the pension rights of taxpayers, which could be affected by a decrease in contributions. Furthermore, it is considered that such a reform cannot be implemented without a comprehensive and profound reform of the public pension system, given the perpetual budget deficit in the pension system.

In conclusion, the reform proposals discussed regarding the taxation of labour income vary in complexity. Some of them are relatively easy to implement administratively and would have an immediate impact, such as eliminating tax exemptions. Others are more complex and involve a comprehensive review of the entire system, such as transitioning to progressive taxation.

In this context, the statements made by the government at the end of August regarding possible tax changes are partially in line with the World Bank's recommendations. However, the proposed measures aim to restrict benefits for employees in the IT industry by limiting the income tax exemption to a threshold of RON 10,000 per month, as well as for employees in the construction and agriculture sectors by eliminating the exemption from paying social security contributions (CAS). These measures are relatively easy to implement from a legislative and administrative perspective, but their impact and effectiveness in terms of revenues to the state budget are not yet clear and appear to be only partial solutions.

A significant reform of the labour income tax system represents a sensitive topic for policymakers, given the complexity of this process and the effort required for digitalization and a comprehensive system overhaul. However, it is essential to remain attentive to public discourse and developments in the field of taxation to be prepared for any changes or "surprises" regarding labour taxation following the fiscal policy options formulated by the World Bank.