impact of education and health spending. The analysis assesses the progressiveness of each fiscal instrument and its contribution to reducing poverty and inequality. The approach follows the Commitment to Equity (CEQ) methodology (Lustig, 2018), allowing for comparisons between Romania and other countries where the CEQ methodology has been applied.<sup>11</sup> The analysis is built on the 2016 Romanian Household Budget Survey (HBS) collected by the Romanian National Statistics Office, and data from National Income Accounts and public finance accounts from the Ministry of Finance for 2016. In terms of coverage of components of fiscal policy, the analysis includes 75 percent of total revenue and 52 percent of government spending, in line with other CEQ studies. The analysis does not cover the corporate profit tax and VAT paid by government or institutional consumption as these are difficult to assign to individual households based on the available information. On the spending side, the analysis only covers social spending, as it is very difficult to assign benefits of other types of spending to individual households.

The results suggest that the combined effect of taxes and social spending in Romania help to reduce inequality, although less so than in other EU countries. However, the combination of direct and indirect taxes and transfers leads to an increase in poverty, as direct cash transfers to poor households are not large enough to compensate them for the burden of indirect taxes. This is especially important for rural households and for families with children.

With the objective of encouraging private investment and reducing the tax burden on citizens, and consequently, to contribute to the improvement of living standards, the government has recently reduced the rates for personal income and value added taxes. The combined fiscal effect of these changes is estimated to lead to a 5.4 percent reduction in total revenue and a substantial increase in the primary deficit, holding all other economic variables constant. On the distributional side, our simulations show that these changes have likely led to an _<u>increase</u>_ in inequality, as most of the tax relief accrued to the top of the income distribution. Moreover, the reform was a very expensive way to achieve what is actually a very small decline in the poverty rate. In fact, our simulations show that higher and better targeted social assistance spending could have achieved much better distributional results at a much lower fiscal cost. These results are problematic, not only because Romania engaged in procyclical policies that could put is sustainability at risk, but also because much of this fiscal effort was not used to efficiently reduce poverty. It is yet unclear whether these policy changes made a substantial difference in generating higher private investment. More generally, the results of this analysis call for greater use of simulation tools that could inform policy makers and the broader public of the fiscal costs and redistributive impacts of proposed reforms.

The rest of the paper is organized as follows. The next section describes the structure of taxes and social spending in Romania, followed by the general methodology, the data used and assumptions made in estimating the taxes paid by households and the benefits received. Section IV describes the overall impact of fiscal policy on poverty and inequality. The incidence of taxes and spending are presented in section V, followed by simulations of personal income and value added taxes in section VI. Section VII concludes.

> 11 For more details, see <u>http://www.commitmentoequity.org.</u>

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