Bad timing for flat tax?

BUCHAREST (Reuters) – Romania’s shift to a flat tax this year coincides with major economic policy challenges, making the move a bigger gamble for the EU candidate than for other ex-communist economies that have adopted the regime. The Baltic states Russia, Ukraine and Slovakia have all successfully swapped progressive tax scales for flat rates and few economists question the merits of the reform in a country plagued by tax dodging and craving for more foreign investment. Many worry, however, that in Romania’s case it may be the right move at the wrong time. They fear the cuts will add fuel to the economy which grew more than 8 percent last year and had shown signs of overheating even before Jan. 1, when a 16 percent rate replaced a 25 percent corporate tax and an 18-40 percent personal income tax scale. The new centrist government made the tax cuts a cornerstone of its economic policy and has said long-term benefits for growth and investment for the European Union candidate would outweigh the impact of a possible temporary dip in income. But the International Monetary Fund argues in the case of Romania – which only last year pushed inflation below 10 percent for the first time in almost 15 years – stability is more important for investor confidence than tax incentives. «Tax cuts can attract investors but what is more important to sustained investment is a continued track record of stable macroeconomic policies; this is key,» IMF resident representative Graeme Justice told Reuters. An IMF mission will discuss the government’s plans during a regular review of its standby agreement late this month and analysts say its stamp of approval is crucial for international investors, given Romania’s poor performance in the past. An overshoot of this year’s 6-7 percent goal would not only be an embarrassment for the central bank, which shifts to formal inflation targeting in mid-year, but also leave it badly exposed when Romania opens its leu deposits to foreigners. The move, agreed to with Brussels and planned for April, is widely expected to open the floodgates to hot speculative cash lured by high yields and Romania’s EU membership prospects. The central bank can respond by cutting interest rates to limit the leu’s appeal to speculators, but if it sees an inflation threat its hands will be tied. «Flat tax is not a bad idea, but the timing is unfortunate,» said Radu Craciun, ABN AMRO analyst. «This will put the central bank against the wall, creating inflationary pressures at a time when it should cut interest rates further to reduce the rate differential.» The IMF has said the government should help the central bank by cutting the budget deficit below last year’s estimated gap of 1 percent of gross domestic product. The new Cabinet so far has committed itself only to the original 1.5 percent target, and Deputy Prime Minister Adriean Videanu, the Cabinet’s top economic official, played down fears tax cuts could stimulate the economy too much. «This tax reduction can at first look like a shock relaxation, but it’s a move to reduce tax to levels that are bearable for the people and the economy,» Videanu told Reuters. He said estimates showed that because of tax dodging and payment delays, the actual level of income taxation was around 15 percent.