# **I. Introduction**

Romania’s income is well below the EU average and its rates of poverty and inequality are among the highest in the EU. Although poverty rates are declining, poverty and social exclusion persist for young people, the rural population, families with children, people with disabilities, the Roma, and those who are inactive people. Romania’s inclusion challenge is predominantly a rural problem, with 75 percent of the poor living in rural areas (World Bank, 2018a). Disparities in endowments (notably human capital) and differences in the returns to endowments combine to shape high levels of social and regional disparities.

However, things are looking up, as the Romanian economy has been on a cyclical upswing for the past three years. Growth has been strong, and unemployment reached its lowest level in more than 20 years in 2017. However, significant challenges remain, and policies are at risk of deteriorating. In line with other developing countries experiencing strong growth, fiscal policy turned pro-cyclical in 2016, reversing past consolidation.<sup>2</sup> Driven by significant tax cuts and wage and pension increases, the general government deficit increased to 3 percent of GDP in 2017 and is projected to exceed 3 percent of GDP in 2018, placing Romania on a trajectory towards re-entering the EU Excessive Deficit Procedure.<sup>3</sup> Recent changes in fiscal and social policies were aimed at fostering private investment, reducing the tax burden on citizens and therefore improving living standards.<sup>4</sup> In terms of fiscal policies, the government has cut the VAT rate from 20 to 19 percent in 2017, reduced the personal income flat tax rate from 16 to 10 percent beginning in 2018, and raised the tax-free allowance. In addition, the government substantially changed the structure of social contributions by shifting their burden almost entirely to the employees beginning in 2018.<sup>5</sup> On the expenditure side, public wages and old-age pensions were significantly increased in 2017<sup>6</sup> and are set to advance further in 2018. To compensate for the shift of social contributions, the government increased the minimum gross wage by 31 percent and requested social partners to renegotiate the wages in the private sector. While the implications of these policies have led and will continue to lead to important increases in the deficit, less is known about the redistributive impact of these policies and what is expected going forward.

2 For an overview of the procyclicality in fiscal policy in developing countries see Kaminsky, Reinhart and Végh, (2004); for recent evidence on the sources of procyclical government spending see Ardanaz and Izquierdo (2018).

> 3 See IMF Country Report No. 17/133, 2017; European Commission (2018), and World Bank (2018a).

> 4 Government Press release, November 8, 2017, <u>http://gov.ro/ro/media/comunicate/comunicat-de-presa-edinta-deguvern-modificari-ale-codului-fiscal-privind-impozitul-pentru-imm-uri-impozitul-pe-venit-i-contributiilesociale&page=8).</u>

> 5 Beginning in 2017, social security and health contributions apply to the entire income earned. Health contributions for pensioners have been eliminated, as well as personal income taxes for pensions below RON 2 000 (EUR 440) (EC, 2017). In November 2017 the government adopted Emergency Ordinance No 79/2017 which changed contributions from 22.75 % for employers and 16.5% for employees to 2.25% and 35%, respectively.

6 The Unified Wage Law adopted in summer 2017 provides for a 25% gross wage increase for most government employees in January 2018 and additional increases in health and education sectors.

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