EUROPEAN COMMISSION Brussels, 21.11.2018 SWD(2018) 503 final COMMISSION STAFF WORKING DOCUMENT Accompanying the documents Recommendation for a Council decision establishing that no effective action has been taken by Romania in response to the Council recommendation of 22 June 2018



Recommendation for a Council Recommendation with a view to correcting the significant observed deviation from the adjustment path toward the medium-term budgetary objective in Romania {COM(2018) 802 final} - {COM(2018) 803 final}



COMMISSION STAFF WORKING DOCUMENT Accompanying the documents Recommendation for a Council decision establishing that no effective action has been taken by Romania in response to the Council recommendation of 22 June 2018



Recommendation for a Council Recommendation with a view to correcting the significant observed deviation from the adjustment path toward the medium-term budgetary objective in Romania 1.Introduction Since 2013 Romania has been subject to the preventive arm of the Stability and Growth Pact, which requires sufficient progress towards the medium-term budgetary objective (MTO) of -1% of GDP. Romania is not subject to the debt rule as its general government debt remains below 60% of GDP. On 16 June 2017, the Council decided in accordance with Article 121(4) of the Treaty on the Functioning of the European Union ("TFEU") that an observed significant deviation from the MTO occurred in Romania in 2016. In view of the established significant deviation, on 16 June 2017 the Council issued a recommendation for Romania to take the necessary measures to ensure that the nominal growth rate of net primary government expenditure does not exceed 3.3% in 2017, corresponding to an annual structural adjustment of 0.5% of GDP. On 5 December 2017 the Council found that Romania had not taken effective action in response to the 16 June 2017 recommendation and issued another recommendation. In the new recommendation the Council asked Romania to take the necessary measures to ensure that the nominal growth rate of net primary government expenditure does not exceed 3.3% in 2018, corresponding to an annual structural adjustment of 0.8% of GDP. On 22 June 2018 the Council found that Romania had not taken effective action in response to the recommendation of 5 December 2017. Moreover, on 22 June 2018 the Council decided in accordance with Article 121(4) TFEU that an observed significant deviation from the adjusment path toward the MTO occurred in Romania in 2017. In view of the established significant deviation, the Council on 22 June 2018 issued a recommendation for Romania to take the necessary measures to ensure that the nominal growth rate of net primary government expenditure does not exceed 3.3% in 2018 and 5.1% in 2019, corresponding to an annual structural adjustment of 0.8% of GDP in each year. It also recommended Romania to use any windfall gains for deficit reduction, while budgetary consolidation measures should ensure a lasting improvement in the general government structural balance in a growth-friendly manner. The Council established a deadline of 15 October 2018 for Romania to report on action taken in response to the recommendation. On 13 July 2018, the Council addressed recommendations to Romania within the context of the European Semester. In the area of public finances, the Council recommended that Romania ensure compliance with the Council Recommendation of 22 June 2018 with a view to correct the significant deviation from the adjustment path toward the medium-term bdgetary objective. The Romanian authorities delivered their report on action taken in response to Council Recommendation of 22 June 2018 (hereafter: "the report") shortly after the deadline. Moreover, on 27-28 September 2018 the Commission undertook an enhanced surveillance mission in Romania for the purpose of on-site monitoring under the Article -11(2) of Regulation (EC) No 1466/97. The findings of the enhanced fiscal surveillance mission were subsequently made public. Section 2 of this document presents macroeconomic developments and outlook in 2018-19. Sections 3 presents fiscal developments in 2018 and updated budgetary projections for 2019. Section 4 assesses compliance with the Council Recommendation of 22 June 2018, while Section 5 proposes a new adjustment path for 2019. Section 6 concludes. 2.Macroeconomic developments and outlook in 2018 and 2019 Romania's economic boom has started to cool down in 2018. The Commission autumn 2018 forecast projects real GDP growth at 3.6% in 2018, a strong deceleration compared to the previous year's growth of 7.3%. Private consumption is weakening, although it still remains the main contributor to growth. That development stems from persistently high inflation, mainly due to energy prices, and the fading-out of public policies directed at increasing disposable income. Investment is expected to remain subdued for the rest of 2018. Import growth, although lower than in 2017, remains dynamic. Export growth is also decelerating but at a higher pace than imports, increasing the drag of net exports on real GDP growth. In 2019, private consumption growth is forecast by the Commission to remain at similar rates as in 2018 as nominal wage growth moderates and inflation continues to weigh on real disposable income. It is expected nonetheless to remain the main driver of growth. Investment is expected to increase its contribution to growth on the back of an improvement in non-residential construction. Overall, real GDP growth is projected to amount to 3.8% in 2019. Imports are projected to continue rising at a higher pace than exports in 2019. However, the overall contribution of net exports, while still negative, is projected to improve. The current account deficit is set to continue widening. It is forecast to reach 3.7% in 2018 and 4.2% in 2019. The worsening trade balance is the main factor behind this development. Romania's labour market is forecast by the Commission to remain tight with new historical lows in unemployment of 4.3% and 4.2% for 2018 and 2019, respectively. The tight labour market is likely to exert further pressure on wages. Compensation per employee continued to increase in 2018 and is forecast at 13% in real terms, before declining in 2019 to 6.7% as increases in public and minimum wages slow down. Inflation further accelerated in early 2018 as the effect of the January 2017 tax cuts faded, reaching 4.7% by August. Inflation is forecast at 4.3% for 2018 as a whole, declining to 3.5% in 2019 as energy price inflation moderates. The output gap, which turned positive in 2017, is projected in the Commission autumn 2018 forecast to narrow in 2018 and 2019. For 2018 it is due to the deceleration of real GDP growth, which is set to more than halve from the peak observed in 2017. At the same time, potential output is set to continue expanding, due to the continued improvement in the labour market, namely lower structural unemployment as measured by the NAWRU and a higher participation rate. In 2019 the projected slight recovery of GDP growth is insufficent to reverse the decreasing output gap trend. Risks to Romania's macroeconomic outlook are tilted to the downside. A main risk is that wage growth could continue to outpace productivity growth, causing Romania’s competitiveness to decline and weakening export growth. Furthermore, volatile food prices and persistently high international commodity prices could cause the current account deficit to widen even further. Uncertainty regarding the government’s policies, with potential negative repercussions on the business environment, and the challenge of budgetary deficit targets could hamper investment decisions. On the other hand, an improved absorption of European Union funds represents a positive risk for GDP growth in 2019 and 2020. Table 1. Macroeconomic developments and forecast

3.Fiscal developments and outlook in 2018 and 2019 On 27 and 28 September 2018 the Commission undertook an enhanced surveillance mission in Romania for the purpose of on-site monitoring under the Article -11(2) of Regulation (EC) No 1466/97. After having transmitted its provisional findings to the Romanian authorities for comments, the Commission reported its findings to the Council on 21 November 2018 and made its findings public. The mission found that the Romanian authorities continue to target a headline deficit of just below 3% of GDP in 2018 and thus do not intend to act upon the Recommendation of 22 June 2018. The 2018 budget amendment, published in early September, maintained the original 2018 target of a headline deficit of 2.97% of GDP in cash, which translates into 2.96% in ESA (accrual) terms. The mission also confirmed that the government's target for 2019 is a headline deficit of 2.38% in ESA (accrual) terms, the same as announced in the 2018 Convergence Programme. However, the measures remain to be specified. The draft 2019 budget, to be adopted by the government in mid- to end-November, will contain the details on how to achieve those targets. In their report on action taken, the authorities confirmed the general government deficit target from the 2018 Convergence Programme of 2.96% of GDP in 2018, close to the outturn in 2017. For 2019 the authorities confirmed that they will target a headline deficit of 2.38% of GDP. The report does not contain a comprehensive projection of individual budgetary categories. According to the authorities, the corresponding structural balance would amount to 3.2% of GDP in 2018 and 2.7% of GDP in 2019. Table 2 below presents new measures/policies listed in the report. The report does not mention new measures for 2018. For 2019, the report relies on containing expenditure on compensation of employees and goods and services, without backing it by sufficiently detailed and adopted, or at least credibly announced measures. On the revenue side the report mentions a prolongation of already existing measures and some actions aimed at increasing tax compliance. It mentions policies with a potential positive impact on the budget but without giving a complete list of estimates. New measures which are set to reduce revenues or increase expenditures (such as an enacted cut of the VAT rate on hotels and restaurants from January 2019) were not included in the report. Moreover, the report explicitly mentions that its estimates do not take into account the provisions of the draft pensions law adopted by the government which contains increases to the old age pensions in 2019 and beyond.



Table 2. Discretionary fiscal measures and policies listed in the report (fiscal impact in % of GDP) Reported fiscal impact in 2019 Comments Revenues Dividends from SOEs at 90% of their net profits +0.2 A prolongation of a measure already in force since 2017 Starting the procedure for selling 5G licences +0.1 According to the ESA-2010 accounting rules, the impact of this measure shoud be smoothed out over several years Maintainance of tax on natural resources +0.1 A prolongation of a measure already in force since 2013 Measures aimed at improving tax collection: introduction of electronic cash registers, amendment of insolvency law, modernisation of border-crossing points. n/a Expenditures Freeze of gross wages of public employees at the December 2018 levels and giving holiday vouchers at the same level as in 2018, keeping the average number of employees in the public sector at the 2018 level -0.3 Subsequent public announcements questioned the introduction of the wage freeze Freeze of maintenance and operating expenditures at the level of 2018 -0.3 Note: The budgetary impact in the table as estimated by the national authorities in their report or in the subsequent exchanges with the Commission, following the reception of the report. A positive sign implies that revenue/expenditure increases as a consequence of the measure. Table 3. Discretionary revenue measures included in the Commission 2018 spring forecast (fiscal impact in % of GDP) Measure 2018 2019 Social contributions shift almost entirely on the employees, from 22.75% for employers and 16.5% for employees to 2.25% and 35% respectively +1.2 Increasing excise duties for energy products as of October 2017 +0.3 A decrease of the share of social contributions transferred to the second pension pillar from 5.1% to 3.75% of gross wages +0.2 Cut of flat Personal Income Tax rate from 16% to 10% and increase of tax allowances -1.5 Remaning measures +0.1 -0.1 Total impact +0.2 -0.1 Note: The budgetary impact in the table as included in the Commission 2018 autumn forecast. A positive/negative sign implies that revenue increases/decreases compared to the previous year. Based on the Commission autumn 2018 forecast, the general government deficit is projected to increase to 3.3% of GDP in 2018. The unified wage law, enacted in summer 2017, increased gross public wages by 25% as of January 2018 and contains additional wage increases in health and education sectors, leading to an increase of spending on compensation of employees relative to GDP by 1.0 percentage point. The fiscal cost of those increases of gross wages is set to be partially compensated by a shift of social security contributions from 22.75% for employers and 16.5% for employees to 2.25% and 35% respectively. Moreover, the government partially reversed the past systemic pension reform by lowering the proportion of social contributions transferred to the second pension pillar (which is classified outside of the general government) from 5.1% to 3.75% of gross wages. At the same time, the flat personal income tax (PIT) rate was cut from 16% to 10%. As a consequence, the revenue from social contributions is set to increase by 2.1 percentage points of GDP while the revenue from direct taxes is set to decrease by 1.4 percentage points. The general government deficit is projected in the Commission autumn 2018 forecast to slightly increase to 3.4% of GDP in 2019, driven by public expenditure on compensation of employees. Despite the projected increase of the headline deficit, Romania’s structural deficit is forecast by the Commission to remain broadly stable, at 3.4% of GDP in 2017, 3.3% in 2018 and 3.4% in 2019, thanks to the decreasing output gap. A positive risk to the 2018 budget balance forecast comes from possibly lower than budgeted public investment. A possible freeze in public wages and potential changes to the draft pension law represent a positive risk for 2019 and beyond. On the other hand, a potential rebound of public investment from its record-low levels represents a negative risk to the general government balance projection in 2019 and 2020 via increased expenditure. The composition of the budget and its adjustments in nominal and structural terms are presented in Table 4.



Table 4. Composition of the budgetary adjustment