metadata: authors: 0: author: Inchauste Comboni,Maria Gabriela
1: author: Militaru,Eva
count: Romania
docna: 0: docna: The distributional impact of taxes and
            social spending in Romania
docty: Policy Research Working Paper
subtopic: Inequality,Educational Sciences,Health Insurance,Health Economics & Finance,Health Care Services Industry,Employment and Unemployment
teratopic: Industry,Education,Health, Nutrition and Population,Social Protections and Labor,Poverty Reduction
abstracts: cdata!: The combined effect of taxes and social
            spending in Romania helps to reduce inequality, although
            less so than in other European Union 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 families with children. Moreover,
            recent reductions in the rates for personal income and
            value-added taxes are expected to have led to an increase in
            inequality, as most of the tax relief accrued to the top of
            the income distribution. Although these changes likely
            helped to reduce poverty, they were an expensive way to
            achieve a small decline in the poverty rate. Higher and
            better targeted social assistance spending could have
            achieved better distributional results at a much lower
            fiscal cost. These results call for greater use of
            simulation tools that could inform policy makers and the
            public of the fiscal costs and redistributive impacts of
            proposed reforms.
geo_reg_key: 517208,517191
repnme: repnme: The distributional impact of taxes and
            social spending in Romania
display_title: The distributional impact of taxes
            and social spending in Romania
listing_relative_url: /research/2018/08/30366947/distributional-impact-taxes-social-spending-romania
topicv3: Poverty m1326687 695,Education m1327048 470,Health Insurance m1327759 1287,Unemployment m1504051 2747,Health m1504661 3480
publishtoextweb_dt: 2018-08-23T00:00:00Z
historic_topic: Industry,Education,Health, Nutrition and Population,Social Protections and Labor,Poverty Reduction
no_of_pages: 51
author_keys: 0: author_key: 1130122
1: author_key: 1132054
model_extractions: WPS8565 Policy Research Working Paper 8565 The Distributional Impact of Taxes and Social Spending in Romania _Gabriela Inchauste Eva Militaru_ Poverty and Equity Global Practice August 2018
Policy Research Working Paper 8565

# **Abstract**

The combined effect of taxes and social spending in Romania helps to reduce inequality, although less so than in other European Union 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 families with children. Moreover, recent reductions in the rates for personal income and value-added taxes are expected to have led to an increase in inequality, as most of the tax relief accrued to the top of the income distribution. Although these changes likely helped to reduce poverty, they were an expensive way to achieve a small decline in the poverty rate. Higher and better targeted social assistance spending could have achieved better distributional results at a much lower fiscal cost. These results call for greater use of simulation tools that could inform policy makers and the public of the fiscal costs and redistributive impacts of proposed reforms.

This paper is a product of the Poverty and Equity Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/research. The authors may be contacted at ginchauste@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **The Distributional Impact of Taxes and Social S endin in Romania** **<u>p g</u>**

Gabriela Inchauste<sup>†</sup> and Eva Militaru<sup>♦1</sup> JEL classification: H22, I38, D31 Keywords: fiscal policy, fiscal incidence, social spending, inequality, poverty, taxes, Romania

> † The World Bank

> ♦ National Research Institute for Labour and Social Protection, Bucharest, Romania

> 1 We are deeply indebted to Tatiana Proskuryakova, Luis-Felipe Lopez Calva, Catalin Pauna, Vlad Grigoras, Maria Davalos, Emilia Skrok, Briana Wilson, Radu Comsa, Suzy H. Yoon, Alina Sava, Andrei Dospinescu, and Huihui Wang for helpful comments, inputs and advice. All remaining errors are our own.
# **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.

2
Existing analysis finds that the redistributive impact of direct taxes and transfers is relatively low compared to the EU average.<sup>7</sup> Focusing on direct taxes and transfers alone, there is evidence that after some improvements in 2016 (Stroe et al, 2017), changes in direct tax and transfers led to a 0.7 percent decline in the disposable income of the poorest deciles in 2017 (Militaru and Tammik, 2017). This was mainly due to increases in health insurance contributions, as the minimum base for contributions increased with the statutory minimum wage. Some of this effect was counterbalanced by the fact that pension income became exempt from health insurance contributions starting in 2017, and the guaranteed minimum social pension increased thanks to a 30 percent increase in its threshold, however the overall effect was negative. Increases in non-means tested child benefits seem to have contributed to income gains for the upper income deciles. For 2018, recent simulations focused on direct taxes and transfers find that the reduction in the PIT rate is likely to increase the degree of redistribution (EC, 2018). The 2017 Emergency Ordinance is expected to increase the degree of redistribution, largely thanks to the increase in the PIT-free allowance and a reduced PIT rate, although there will likely be some losers.<sup>8</sup> Although this work has been very useful, it has not consistently included the impact of indirect taxes, despite recent important changes.<sup>9</sup> VAT, excises and customs duties amounted to over 10 percent of GDP in Romania in 2016, making up more than 40 percent of total tax and social contributions.<sup>10</sup> The government has since reduced VAT rates in several steps since 2015, reducing the standard rate from 24 percent to 20 percent in 2016, further to 19 percent in 2017, and there are plans to further reduce it to 18 percent in 2018, but it is unclear how these changes affect the overall impact of policies. These changes were no doubt also over distributional concerns. For instance, De Agostini et al (2017) found that Value Added Taxes were strongly regressive in 2011, but not so for excise taxes. Despite the very useful work on direct taxes and transfers, analysis using more recent data to comprehensively include indirect taxes is not regularly done. Similarly, the impact of in-kind transfers in the form of public education, health and other services on the welfare distribution have not been typically included. Education and health expenditures make up the largest share of social spending after social protection, amounting to about 2.8 and 4 percent of GDP respectively in 2016. Without empirical analysis of the impact of these policies it is difficult to assess the likely impacts of these reforms in combination with other initiatives taken by the government.

This paper aims to fill this knowledge gap through a more comprehensive analysis of the impact of fiscal policy on inequality and poverty in Romania. Building on existing work, the analysis covers the impact of the contributory pension system, direct taxes and transfers, value added and excise taxes, as well as the 7 See EUROMOD Statistics on the Distribution and Decomposition of Disposable Income. Version H1.0+. Available at: <u>https://www.euromod.ac.uk/using-euromod/statistics.</u> 8 Some people will be net losers because they will face an increased burden of social contributions which will not be compensated by the benefits they receive from a higher minimum gross wage, or a higher PIT allowance. Part-time workers are also likely to lose due to the introduction of a minimum contributory base for their social contributions.

9 Incorporating indirect taxes into the analysis is not consistently done, although there have been recent advances in this regard. For instance, existing EUROMOD analysis typically uses EU-SILC data which do not have information on household spending. Recent work by De Agostini et al (2017) has tried to use survey-to-survey imputations to combine EU-SILC data with household budget survey data, however this is not regularly done.

10 Total tax and social contributions amounted to 24.8 percent of GDP in 2017, of which VAT collection amounted to 6.3 percent of GDP, while excise taxes and customs duties amounted to 3.1 and 0.1 percent of GDP, respectively (General Consolidated Budget, Ministry of Public Finance).

3
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>

4
# **II. The structure of taxes and social spending in Romania: 2016**

## **The Romanian Public Finance System**

Public finance in Romania consists of the central and local governments and public enterprises. The revenue structure is shown in Table 1. Total revenue amounted to 29.3 percent of GDP in 2016, with tax collections amounting to nearly 18 percent of GDP and social security contributions amounting to 8 percent of GDP. Our analysis focused on the major tax items, namely personal income taxes, VAT, and excise taxes. These items made up about 83 percent of all tax revenue in 2016. Corporate taxes were not included given the difficulty of attributing the tax burden to specific households.

### **_Direct taxes and social insurance contributions_**

Personal income tax (PIT) revenues accounted for 3.6 percent of GDP in 2016, which was shared between the central, regional and local self-governments. The personal income tax had a flat rate of 16 percent in 2016 and was paid on employment income, self-employment income and income from investments, while social benefits were exempt. The flat tax rate was reduced to 10 percent in 2018, as discussed further in section VI. For dependent employment, the tax base is the gross wage minus social contributions and tax allowances. For income from self-employment, the tax base is gross income minus deductible expenses and social contributions, and income from investments minus social contributions. Tax allowances for employees vary depending on the level of income and the number of dependents. The system also has deductions for voluntary private pension contributions, and there are other allowances and tax credits (see Appendix 1).

**Table 1. Romania. General Government Revenue, 2016**

||Fiscal Ac|counts|Portion of<br>Accounts to b|Fiscal<br>e analyzed|Amounts in<br>survey|Ratio of total<br>amounts in the<br>survey and|
|---|---|---|---|---|---|---|
||(in millions<br>of lei)|% of GDP|(in millions<br>of lei)|% of GDP|(in millions<br>of lei)|external<br>statistics, %|
|**Revenue**|**223,722**|**29.3%**|**167,663**|**22.0%**|**109,526**|49.0%|
|Taxes and social contributions|197,681|25.9%|167,663|22.0%|109,526|55.4%|
|Corporate tax|15,442|2.0%|||||
|Personal income tax|27,756|3.6%|27,756|3.6%|19,189|69.1%|
|VAT|51,675|6.8%|51,675|6.8%|21,100|40.8%|
|Excises|26,957|3.5%|26,957|3.5%|8,050|29.9%|
|Customs duties|883|0.1%|||||
|Social security contributions|61,274|8.0%|61,274|8.0%|61,187|99.9%|
|Other taxes|13,693|1.8%|||||
|Nontax revenue|17,938|2.4%|||||
|Capital revenue|769|0.1%|||||
|Grants 1/<br>_Source: National Institute of Statistics,_<br>_1/ Includes -financed capital projects_|7,332<br>_Ministry of Pu_|1.0%<br>_blic Finance,_|_MFMod, World_|_Bank staff est_|_imates_||

5
In terms of social contributions, the Romanian pension system is based on a three-pillar system, with the first pillar being the most relevant. The 1st pillar is the public pay-as-you-go scheme and is sustained by mandatory social insurance contributions. The 2nd pillar is a private contributions system, mandatory for people who were aged below 35 years in 2008 when it was introduced and on voluntarily basis for people aged between 36 and 45 years. It is sustained by a share carved out of the mandatory social insurance contribution (5.1p.p. in 2017). The 3rd pillar is entirely voluntary based on accumulation. The contribution rate for the latter should not exceed 15% of individual disposable income.

Social contributions amounted to 8 percent of GDP in 2016, of which old-age pensions was the largest, amounting to 2.1 percent of GDP and health contributions amounted to 1.5 percent of GDP. Social contributions are paid by wage and self-employed workers based on different contribution bases. For wage earners, the social contributions base is equal to the gross employment earnings. Employer contributions include payments for social insurance, whose rate depends on the working conditions ranging from 15.8 to 25.8 percent, 5.2 percent for health insurance, 0.5 percent for unemployment insurance, 0.85 percent for sickness, 0.15 percent for work accident insurance, and 0.25 percent for salary guarantee. Employee social contributions include 10.5 percent for social insurance, 5.5 percent for health insurance and 0.5% for unemployment insurance For the self-employed, the contribution base is net self-employment income (gross income minus deductible expenses). Self-employed workers can choose between paying the employee contribution rate (10.5%) or the total contribution rate (employee plus employer - 26.3%), but only the latter is equivalent to full rights in the public pension system. The contribution rate for health insurance is the same as for employed workers while unemployment insurance and all the other insurance programs are optional.

Pension income and income from investments were also subject to health insurance contributions in 2016. Since 2017 all income from pensions is exempted from health insurance contribution and the contribution is now being funded by the state budget. Similarly, income from investments (interests, dividends, rents, etc.) was subject to health insurance contribution (rate of 5.5%) up until 2017, when it became exempted (unless it is the only source of income and it exceeds the national statutory gross minimum wage).

# **_Indirect Taxes_**

VAT is the single largest component of tax revenue, contributing to about 38 percent of total tax collection in 2016. VAT was levied at a standard rate of 20 percent in 2016 on most goods and services, but has since declined to 19 percent beginning in 2017. Reduced rates of 5 and 9 percent apply to a range of goods and services (see Appendix 1).

Excise taxes contributed 3.5 percent of GDP in 2016 and are levied on goods that are deemed to be harmful to the health of the population or create pollution (“sin taxes”). These include: alcoholic beverages, tobacco products, energy products, electricity. Specific excises are imposed on alcohol, and energy products, while tobacco taxes have both specific and an ad valorem rates as detailed in Appendix 1.

6
# **Social spending**

Overall expenditures in Romania amounted to 31.7 percent of GDP in 2016, down from 35 percent in 2012, but have since increased to 32.2 percent in 2017. A large part of public spending is dedicated to social protection (11.4 percent of GDP in 2016), while education (2.8 percent of GDP) and health (4.0 percent of GDP) are also relatively important (Table 2). The analysis presented below covers 52 percent of all government spending and 91 percent of social spending. In what follows, we describe the main highlights of existing social spending, with details available in Appendix 1.

Contributory benefits include the following programs:

- _Old-age pensions_ include the standard old-age pension, (the retirement age is 65 years for men and 63 years for women); early retirement pension (i.e. at most five years until retirement age); survivors pension (for surviving children or spouse of a pensioner or a person who was entitled to a pension in the public pillar); and invalidity pension (for at least 50% loss of working capacity).

- _Unemployment benefits_ granted to persons aged above 16 years, not working or retired, available to start work, who have prior contribution to the unemployment insurance system (at least 12 months during the last 24 months).

- _Parental benefits_ include a child raising allowance and a child raising incentive. The first is a contributory benefit granted to parents with children up to the age of 2 years (or 3 years for disabled children), who are in child care leave. During the receipt of child care allowance, the parent is not allowed to earn employment income (dependent or independent). The child raising incentive is provided as a work incentive targeted to parents who are benefiting from the child raising allowance in order to return to work before the eligible period for the child raising allowance has expired.

- _Health insurance benefits_ include a range of benefits. These include: an indemnity for temporary work incapacity (caused by regular diseases or accidents not related to work), an indemnity for work capacity recovery (after work accidents or professional diseases), a maternity allowance granted to pregnant women or mothers for a total period of 126 days, split before and after giving birth to the child, an indemnity for maternal risk granted to pregnant women in employment whose medical condition prevents them from working, and an indemnity for caring for an ill child.

Direct (non-contributory) transfers include the following programs.

- _Family benefit programs._ These programs include the state allowance for children, a universal benefit granted to children (up to the age of 18 years or up to 26 years if enrolled in education) whose benefit amount is differentiated according to the child’s age. It also includes a means-tested support allowance for families with children, subject to an income and an asset test. Benefit levels depend on income, the number of children and whether it is a single-parent home.

- _Social assistance programs_ include a guaranteed minimum income program, which is the main means-tested benefit received by poor families. It implies both an income and asset test. The net

7
monthly income of the family (all income sources, including other social benefits) is assessed and the thresholds are differentiated according to family size. There is also a home heating aid which is received by poor families as a cash support during the cold season (from November to March). The benefit entitlement is subject to income and asset testing and the benefit amount is differentiated according to the type of heating – energy provided in the centralized system, natural gas or wood, coal and oil fuel. Finally, there is a guaranteed minimum social pension, which is received by public pension system retirees if their public pension due or in payment is less than a threshold, and the benefit amount is the difference between the threshold and public pension.

**Table 2: Romania: General Government Spending, 2016**

||(in<br>Fiscal Ac|counts|Portion of<br>Accounts<br>analyz|Fiscal<br>to be<br>ed|Amounts in|survey|Ratio of total<br>amounts in the<br>survey and|
|---|---|---|---|---|---|---|---|
||<br>millions<br>of lei)|% of<br>GDP|(in millions<br>of lei)|% of<br>GDP|(in millions<br>of lei)|% of<br>GDP|external<br>statistics, %|
|**Expenditure**|<br>**242,016**|**31.7%**|**126,594**|**16.6%**|**97,973**|**12.9%**|40.5%|
|Social Protection|86,719|11.4%|74,651|9.8%|59,619|7.8%|68.7%|
|Contributory benefits|64,293|8.4%|64,287|8.4%|52,495|6.9%|81.7%|
|Pensions|59,817|7.8%|59,817|7.8%|50,407|6.6%|84.3%|
|Old age|49,168|6.4%|49,168|6.4%|39,888|5.2%|81.1%|
|Early retirement|886|0.1%|886|0.1%|1,998|0.3%|225.5%|
|Disability|4,400|0.6%|4,400|0.6%|3,306|0.4%|75.1%|
|Survivors|3,447|0.5%|3,447|0.5%|1,686|0.2%|48.9%|
|Agricultural workers|1,916|0.3%|1,916|0.3%|3,529|0.5%|184.2%|
|<br>Unemployment benefit|498|0.1%|498|0.1%|358|0.0%|71.9%|
|Indemnity for temporary work incapacity|953|0.1%|953|0.1%|67|0.0%|7.0%|
|Contributory family benefits|3,019|0.4%|3,019|0.4%|1,663|0.2%|55.1%|
|<br>Maternity allowance|695|0.1%|695|0.1%|67|0.0%|9.7%|
|Child raising allowance|2,060|0.3%|2,060|0.3%|1,596|0.2%|77.5%|
|Child raising incentives|264|0.0%|264|0.0%||||
|Other contributory programs|6|0.0%||||||
|Non-contributory benefits|10,399|1.4%|10,364|1.4%|7,123|0.9%|68.5%|
|Noncontributory family allowances|5,111|0.7%|5,111|0.7%|4,755|0.6%|93.0%|
|State allowance for children|4,416|0.6%|4,416|0.6%|4,299|0.6%|97.4%|
|Support allowance: families w/children|526|0.07%|526|0.1%|263|0.0%|50.0%|
|Placement allowance for children|169|0.0%|169|0.0%|193|0.0%|114.0%|
|Minimum social pension|917|0.1%|917|0.1%|455|0.1%|49.6%|
|Guaranteed minimum income|812|0.11%|812|0.1%|690|0.1%|85.0%|
|Heating aid|149|0.0%|149|0.0%|52|0.0%|35.1%|
|Disability benefits|2,297|0.3%|2,297|0.3%|945|0.1%|41.1%|
|Scholarships|971|0.1%|971|0.1%|83|0.0%|8.6%|
|Other indemnities|109|0.0%|109|0.0%|143|0.0%|131.6%|
|Other social benefits|34|0.0%||||||
|Other Social Protection spending|12,027|1.6%||||||
|Education|21,678|2.8%|21,678|2.8%|14,654|1.9%|67.6%|
|Health|30,265|4.0%|30,265|4.0%|23,701|3.1%|78.3%|
|Subsidies|6,605|0.9%||||||
|Other expenditures<br>_Source: National Institute of Statistics, Ministry of Public Fin_<br>_1/ Includes -financed capital projects_|96,750<br>_ance, MFM_|12.7%<br>_od, World_|_Bank staff estim_|_ates_||||

- _Disability benefits_ are granted to people with disabilities and their amounts are differentiated according to the severity of the disability. We mention three such benefits: monthly allowance for

8
adults with disabilities, complementary personal budget and monthly allowance for covering attendant expenses.

- _Educational grants_ are given to children enrolled in education belonging to poor families. There are several types of grants, such as social grants (pre-university and university education), tuition grants (pre-university), scholarships for further learning (pre-university), educational allowance – “Money for high-school” (upper secondary) etc. and their entitlement involves an income test.

Social spending on in-kind transfers in the form of education and health amounted to 6.8 percent of GDP in 2016. The education system is mostly public in Romania (private expenditure on education is small at all levels of education). The Romanian government provides free public education from pre-school and up to tertiary education. There are no direct user fees except for pre-school, though indirect fees in the form of school supplies and uniforms. Compulsory education starts with primary school (at the age of 6 years) and ends with the 10<sup>th</sup> grade (first level of upper secondary, at the age of 16-17 years).

In terms of health spending, a “minimal” set of free medical services is provided for all its citizens and financed directly from the budget. This minimal package is restricted to emergency cases or potential epidemic diseases, pregnancy, family planning, and prevention. In addition, citizens who contribute and participate in the public health insurance system, receive an extended “basic” set of services, including preventive and curative medical services, health care services, medicines, sanitary materials, medical devices and others. Benefits begin on the first day of illness or accident until complete cure. Dependents who are otherwise not insured can also benefit from these “basic” services, including children up to age 18, students up to age 26 without earnings, spouse or parents without insurance, and persons with disabilities without earnings. The public health insurance system is funded through health insurance contributions, which are mandatory on employment, self-employment and investment income. Before 2017, contributions were also mandatory on pension income above a threshold, as well as on investment income irrespective of its amount and the presence of other sources of income. User fees are charged for health care services, medicines and medical devices which are beyond the scope of “basic” package.

# **III. Data sources, methods, and assumptions**

## **Data Sources and Approach**

The 2016 HBS contains both income and expenditure data, along with demographic and household characteristics, thus enabling the identification of indirect taxes across the distribution. Household survey data are combined with data from National Income Accounts and public finance accounts from the Ministry of Finance. This included information on consolidated central government budgets, local government budgets, and annual reports from the National Statistics Institute on various sectors.

## **Approach**

To analyze the incidence of each fiscal intervention, and the impact of taxes and social spending on poverty and inequality, we follow the Commitment to Equity (CEQ) approach of Lustig (2018) and measure per 9
<!-- Start of picture text --> Market<br>Income<br>Contributory + |<br>Pensions<br>Market<br>Income plus<br>Pensions<br>Direct + - Direct<br>Transfers ii |} Taxes<br><!-- End of picture text -->

<!-- Start of picture text --> Disposable<br>Income<br>Indirect So Indirect<br>Subsidies I Taxes<br>Consumable<br>Income<br>In-Kind Transfers oa Copayments,<br>(Education, Health) i User Fees<br><!-- End of picture text -->
# **Assumptions**

We assume that the economic incidence of direct taxes and contributions are borne entirely by the income earner. Personal income taxes (PIT) and employee social security contributions across households are in general directly identified in the household survey. However, they were also imputed according to the tax legislation and contribution rules as detailed in Appendix 1, in order to allow for simulations of different scenarios. In all cases, minimum employer contribution rates were assumed – in practice employer contribution rates are differentiated by economic activity and working conditions but this information is not available in the household survey. Statutory rates are used throughout the analysis. To the extent that informality in the payment of PIT and social contributions is high in Romania, the distributional impacts could differ, and the analysis is closer to an analysis of the de jure impact of policies. The analysis could further be refined under alternative scenarios on informality.

Social contributions are simulated only for individuals who reported that these were paid (either by employers in the case of wage workers or by themselves in the case of self-employed).

The burden of indirect taxes is assumed to be borne entirely by the consumer. The burden of indirect taxes was estimated by first applying statutory rates to each item in the detailed consumption data in the HBS. However, given informality in consumption taxes, we calculate the effective tax rate for VAT (calculated as total VAT collections divided by total private household consumption) and adjust the VAT rate until the ratio of total tax collections observed in the household survey relative to household private consumption matches the effective rate observed in the National Accounts. Similarly, for excise taxes, we apply statutory rates to consumption of alcohol, tobacco, fuel and energy identified in the HBS to estimate the direct burden of these excises on households.

On the spending side, the HBS provides detailed information on who received payment from contributory and non-contributory social protection programs. In terms of contributory benefits, old-age, family, unemployment, and disability benefits are identified in the survey. In terms of non-contributory benefits, a large number of benefits are directly identified, including the guaranteed minimum income, social pensions, heating aid, disability, scholarships and family benefits including the state allowance for children, the support allowance for children, and the placement allowance for children, and many smaller cash and nearcash programs. All are directly identified in the survey. Since these benefits are not taxable, the reported value can be directly used.

The approach to estimate the incidence of public spending on education followed here is the so-called “benefit or expenditure incidence” or the “government cost” approach. In essence, we calculate per beneficiary input costs by level of education from government spending and the number of pupils in each level and assign the per pupil expenditure to each student. This approach is also known as the “classic” or “non-behavioral approach”, and it amounts to asking the following question: how much would the income of a household have to be increased if it had to pay for the free or subsidized public service at the full cost to the government?

Since the education system is mostly public at all levels of education in Romania and there is no evidence of wide-spread opting-out of public education, benefits were assigned to households according to the 11
number of children attending each level of education. We use SIRUTA<sup>12</sup> level data on enrollment and public spending on primary and secondary schools (see World Bank 2018b), and national-level data for tertiary education. The cost-per-pupil of delivering education service at each level is calculated for urban and rural areas. Since we are unable to identify households in the survey at the SIRUTA-level, the cost-per-pupil is allocated by differentiating between urban and rural areas.

For health services, all individuals have access to services, so we use the cost of insurance approach and assign a per capita benefit equally to all individuals. This is to ensure that sicker individuals are not seen as being “better off”, simply because they use public services more often. We estimate the individual benefit (minimum and basic) based on administrative data on spending for health services taken from the health insurance budget and the number of beneficiaries of basic and minimum packages. The corresponding value is assigned to individuals depending on whether they are beneficiaries of the basic package. The identification of individuals as beneficiaries of the basic or minimum package depends on their relationship with the health insurance system (insured with contribution paid, other categories insured without contribution due, not insured) and the health insurance legislation. To account for the fact that some households may choose to opt-out of public health care, we identify households with positive expenditures on family/general medicine, dental care, and outpatient specialty services and assume that these households relinquish the benefits associated with these services, which are included in the basic service package. For those cases, we reduce the amount of basic-package allocated to that household by the share of public spending on those items.<sup>13</sup> Since the amounts of education and health spending are taken from administrative data, they are scaled down to prevent overestimation bias.<sup>14</sup> There are some important caveats about what is not addressed. First, the analysis does not account for any behavioral, lifecycle or general equilibrium effects and focuses on average incidence rather than incidence at the margin. Our tax shifting and labor supply response assumptions are strong because they imply that consumers have perfectly inelastic demand and that labor supply is perfectly inelastic too. Second, the analysis does not account for the intra-household distribution of consumption. Third, the analysis cannot account for the quality of services delivered by the government. In addition, we are unable to include some important taxes and spending. Corporate profit taxes, VAT paid by government or institutional consumption, and spending on infrastructure investments are excluded, even though the impacts of these may be substantial simply because the methods to assign these taxes and transfers are not robust. Finally, the analysis does not capture the growing debate on how asset accumulation and returns to capital impact income inequality.

> `12` <mark>SIRUTA is the Information System of the Register of Territorial - Administrative Units in Romania, corresponding to LAU 2 classification code.</mark>

> 13 The incidence of spending on health is less pro-poor without this assumption. Alternative estimates excluding this assumption are available upon request.

> 14 For a detailed description of the scaling down procedure, see Higgins and Lustig (2017).

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# **IV. Impact of taxes and social spending on poverty and inequality**

In this section we present the overall impact of taxes and social spending on poverty and inequality and we compare this impact with other countries. The next section then delves deeper to disaggregate the impacts of individual tax and transfers policies.

## **The impact on inequality**

The combined effect of taxes and social spending help to substantially reduce inequality in Romania. Figure 2 shows the change in the Gini coefficient on account of taxes and social spending following the income concepts defined above for 2016. Prior to any fiscal intervention, market income inequality had a Gini of 0.378, if oldage contributory pensions are included and are treated as deferred income, but much higher (0.487) if these pensions are not included. Once direct taxes, social security contributions and noncontributory transfers are accounted for, we end up with a measure of disposable income that has a Gini of 0.334 in both scenarios. The net impact of indirect <!-- Start of picture text --> Figure 2. Romania. Gini Coefficient<br>0.50<br>0.487 Old-age pensions as transfers<br>0.45<br>Old-age pensions as deferred<br>income<br>0.40 0.378<br>0.340<br>0.35 0.334<br>0.310<br>0.30<br>0.25<br>Market Income Disposable Consumable Final Income<br>Income Income<br>Source: Own estimates using the Romanian 2016 HBS.<br><!-- End of picture text --> taxes and subsidies is unequalizing as the Gini increases slightly for consumable income to 0.340, which includes the impact of VAT and excise taxes.<sup>15</sup> Finally, in-kind transfers in the form of education and health helped to reduce inequality. The overall reduction in inequality was equivalent to 0.068 Gini points from market income to final income when old-age pensions are considered as deferred income, but as much as 0.176 Gini points when pensions are treated as transfers.

The overall redistributive effort in Romania is relatively large compared to other developing countries, but lower than other countries in Europe, with most of the reduction in inequality largely being achieved by pensions (Figure 3). When pensions are considered as deferred income, Romania is less redistributive than Poland and Croatia, in line with the existing literature that has so far focused on the impact on disposable income (see Euromod H1.0). However, once indirect taxes and in-kind transfers are considered, Romania is less redistributive than other countries with similar levels of GDP per capita (in PPP terms) such as Croatia and Chile, but also less distributive than some countries with lower levels of GDP per capita, such as Brazil, Costa Rica, Mexico and Tunisia.

> 15 Romania has some indirect subsidy schemes in electricity, heating and transport. However, given their complexity they were difficult to take into account in this exercise.

13
<u>Figure 3. Decline in Inequality from Market to Final Income</u> <!-- Start of picture text --> 0<br>-0.05<br>-0.1<br>-0.15<br>-0.2<br>-0.25<br>-0.3<br>Pensions as deferred income Pensions as transfers<br>Source: CEQ Data Center on Fiscal Redistribution, 2018 and references therein. Poland: Goraus & Inchauste (2016);<br>Croatia: Inchauste and Rubil (2014); Romania: own estimates using HBS 2016.<br>Pensions are treated as transfers in this figure to ensure comparability with Euromod.<br>The impact of indirect taxes Figure 4. Emerging markets: Gini Coefficient<br>is relatively important in all (pensions as deferred income)<br>cases. Once indirect taxes 0.50<br>are taken into account, the Argentina<br>redistributive effort is<br>0.45<br>somewhat reversed as the<br>Poland<br>Gini coefficient for<br>consumable income is 0.40<br>Russia<br>United States<br>slightly higher than what is<br>observed for disposable<br>0.35<br>income as indirect taxes<br>tend to be regressive and Romania<br>unequalizing (Figure 4). In 0.30 Croatia<br>the case of Romania, the<br>effect of indirect taxes is<br>0.25<br>less severe than in Poland<br>Market income Disposable Consumable Final income<br>and Croatia. Spending on plus pensions income income<br>Change in Gini<br>Argentina, 2012-13 South Africa, 2010-11 Poland, 2014 Georgia, 2013 Brazil, 2008-09 United States, 2011 Costa Rica, 2010 Uruguay, 2009 Croatia, 2014 Iran, 2011-12 Mexico, 2010 Tunisia, 2010 Chile, 2013 Ecuador, 2011-12 Colombia, 2010 Romania, 2016 Russia, 2010 Venezuela, 2012 Bolivia, 2009 Dominican Rep., 2006-07 Tanzania, 2011-12 Paraguay, 2014 Nicaragua, 2009 Armenia, 2011 El Salvador, 2011 Peru, 2009 Ghana, 2012-13 Uganda, 2012-13 Sri Lanka, 2009-10 Honduras, 2011 Indonesia, 2012 Guatemala, 2011 Jordan, 2010-11 Ethiopia, 2010-11<br><!-- End of picture text --> The impact of indirect taxes is relatively important in all cases. Once indirect taxes are taken into account, the redistributive effort is somewhat reversed as the Gini coefficient for consumable income is slightly higher than what is observed for disposable income as indirect taxes tend to be regressive and unequalizing (Figure 4). In the case of Romania, the effect of indirect taxes is less severe than in Poland and Croatia. Spending on education and health further reduce inequality, however, the redistributive effect is Source: Argentina: Rossignolo (2017); Poland: Goraus & Inchauste (2016); Russia: Lopez-Calvo et al (2016); Croatia: Inchauste and Rubil (2014); United <u>States: Higgins et al (2016), Romania: own estimates using 2016 Romanian HBS.</u> much lower than in other countries. This reflects the fact that education spending is less equalizing in Romania, as discussed below.

14
# **The impact on poverty**

Beyond the impact on inequality, which measures the relative position of households across the distribution, it is important to see the impact on poverty, which depends on the absolute level of income of a household with respect to a poverty threshold. The results suggest that the combination of taxes and social spending was poverty increasing in 2016 **.** The share of the population whose market income (including pensions) was below the per capita US$5.50 PPP-a-day poverty line was 13.9 percent (Table 3). Once the burdens of direct and indirect taxes are considered, these are larger than the direct benefits received from transfers, so that the share of the population whose consumable income is below the US$5.50 PPP-a-day poverty line increases to 15.4 percent. Similarly, if one were to use Eurostat’s relative poverty line of 60 percent of the median equivalized disposable income, the headcount poverty rate increases from 21.8 percent for disposable income to 27.5 percent for consumable income. Most of the increase in poverty is due to the burden of indirect taxes, as households are not being compensated for this burden through direct transfers. Even for extreme levels of poverty (such as those captured by the US$3.20-a-day poverty line), social transfers are insufficient to mitigate the burden of taxes so that the level of extreme poverty after taxes and transfers is higher than before taxes and transfers are considered (Table 3). The poverty gap and the severity of poverty decline when going from market to disposable income for the absolute poverty lines, but once indirect taxes are incorporated into the analysis, part of this effect is reversed. Both the poverty gap and the severity of poverty look worse when using the relative line. Given that households do not observe the value of the benefits of in-kind education and health, we refrain from measuring poverty including those benefits, as standard in the literature.

Table 3. Romania. Changes in Poverty on account of taxes and transfers

||Market<br>income +<br>old-age<br>pensions|Disposable<br>income|Consumable<br>income|
|---|---|---|---|
||(1)|(2) = (1) - direct<br>taxes - social<br>contributions +<br>~~direct transfers~~|(3) = (2) -<br>indirect taxes|
|**Poverty headcount**||||
|US $3.20 PPP-a-day per capita|7.3|3.5|4.9|
|US $5.50 PPP-a-day|13.9|12.1|15.4|
|60% of median equivalized disposable income|22.5|21.8|27.5|
|**Poverty gap**||||
|US $3.20 PPP-a-day per capita|3.4|0.8|1.3|
|US $5.50 PPP-a-day|6.3|3.6|5.0|
|60% of median equivalized disposable income|34.7|37.3|42.6|
|**Poverty severity**||||
|US $3.20 PPP-a-day per capita|2.1|0.3|0.6|
|US $5.50 PPP-a-day|4.0|1.5|2.3|
|60% of median equivalized disposable income<br>Source: Own estimates based on Romanian HBS 2016.|21.8|22.0|26.1|

15
Aggregate indicators of poverty are important, but further disaggregation lends some additional insight. Figure 5A shows the poverty headcount rate for urban and rural households for each income concept. Poverty headcount is strikingly higher in rural areas. The measure of consumable income, which includes the effect of all taxes and social transfers, indicates that 24.9 percent of the rural population was poor at the US$5.50 PPP line and 42.8 percent was poor at the relative poverty line. In terms of household type, Figure 5B shows that the impact of indirect taxes on poverty was particularly large among households with multiple children.

<u>Figure 5. Romania. Poverty Headcount Rate, 2016</u> <!-- Start of picture text --> A. Urban and Rural B. By household type<br>(US$5.50 PPP-a-day)<br>45 42.8 70 65.5<br>61.5<br>36.2<br>40 60<br>35.0<br>35 50<br>30 22.8 24.9 27.5 40<br>22.5 27.5<br>25 20.1 21.8 30 21.3 21.7<br>18.1<br>13.9 15.4 20<br>20 12.5<br>15 12.1 9.0 10 1.91.3 2.53.1 7.68.4 0.10.1 0.30.2<br>6.2 9.0 0<br>10<br>5.<br>4.3<br>5<br>0<br>All Urban Rural All Urban Rural<br>US $5.50 PPP 60% of median disposable<br>income<br>Market income + pensions Disposable income Market income + pensions Disposable income<br>Consumable income Consumable income<br><!-- End of picture text --> <u><mark>Source: World Bank estimates based on the Romanian 2016 HBS.</mark></u>

# **V. Progressivity, Marginal Contributions, and Pro‐poorness of Taxes and Transfers**

How did each of the fiscal interventions contribute to the observed changes in poverty and inequality? Figure 6 presents the distributional impact of different components of the tax and benefit system as a share of market income (including pensions) in 2016. Most components of the system are progressive, with the bottom 10 percent of the distribution being net receivers of social benefits. However, in cash terms, households beginning in the second decile were net payers to the treasury in 2016, as the share of taxes paid exceeded the cash benefits received for all but the poorest 10 percent of the population.

16
Figure 6. Romania. Distributional Impact of the Tax and Benefit System in 2016 <u>(benefit/burden as a share of market income + pensions)</u> <!-- Start of picture text --> 140%<br>120%<br>100%<br>80%<br>60%<br>40%<br>20%<br>0%<br>-20%<br>-40%<br>Poorest 2 3 4 5 6 7 8 9 Richest<br>All direct taxes Non-pension contributions All Direct Transfers<br>Indirect subsidies All indirect taxes Education<br>Health Net cash position Total<br>Share of Market Income + Pensions<br><!-- End of picture text --> Source: Own estimates based on the 2016 Romanian HBS.

The Net Cash position of the household is measured as the difference between consumable and market income plus <u>pensions, and is equivalent to all the cash transfers to households minus all taxes.</u> Since the influence of specific interventions may be different from that of the overall system, a fundamental question in the policy discussion is whether specific fiscal instruments (or a combination of them) are equalizing. If there were a single fiscal intervention, using the typical indicators such as the Kakwani index<sup>16</sup> to determine whether an intervention is progressive or regressive would be sufficient to unambiguously determine whether that intervention was equalizing. Given there is more than one fiscal intervention, this one-to-one relationship between the progressivity of an intervention and its effect on inequality breaks down. For instance, the proceeds of a regressive indirect tax _could_ be used very effectively in a pro-poor transfer, leading to a situation where post-fisc incomes are more equal than in the absence of that regressive tax (Lambert, 2001). One way to calculate the effect of each fiscal instrument on inequality is to calculate its marginal contribution. The marginal contribution of a tax (or transfer) is calculated by taking the difference between the inequality indicator _with_ and _without_ the tax (or transfer).<sup>17</sup> Table A2.1

> 16 The Kakwani index for taxes is defined as the difference between the concentration coefficient of the tax and the Gini for market income. For transfers, it is defined as the difference between the Gini for market income and the concentration coefficient of the transfer. See, for example, Kakwani (1977).

> 17 Note that there is path dependence in estimating these marginal contributions, since the order in which each intervention is considered matters for the size of the estimated marginal contribution. The estimation approach uses

17
in Appendix 2 shows both the Kakwani progressivity index for each tax and transfer in 2016 along with their marginal contribution to reducing inequality and poverty under the scenario where old-age pensions are treated as deferred income. Results for the alternative scenario where old age pensions are considered as transfers are presented in Appendix 2. We describe each of these in turn.

# **Taxes**

|Direct taxes and social|Figure 7. Progr|essivity and Redistributive Effect of|Direct|Taxes|
|---|---|---|---|---|
|contributions<br>are||and contributions<br>|||
|progressive and inequality-|(|rom market to disposable income)|||
|reducing, however they also|0.16<br>ve||0.014|ng|
|place a burden on the poor.|0.14<br>ssi||0.012|lizi|
|That they are progressive|0.12<br>nt<br>ogre||0.010|ect<br>qua|
|can be seen by the fact that|0.10<br>icie<br>Pr||0008|e eff<br>-> E|
|the Kakwani coefficient is|0.08<br>oeff<br>--->||.|utiv<br>-----|
|positive, the fact that they|0.06<br>ni c<br>-----||0.006|strib<br>g <-|
|are inequality-reducing can|0.04<br>wa<br><-||0.004|edi<br>lizin|
|be seen by a positive|0.02<br>Kak<br>sive||0.002|R<br>qua|
|marginal contribution to the|0.00<br> <br>gres||0.000|Une|
|redistributive effort (Table|tax<br>xes<br>Re|tion<br>nce<br>on -<br>nce<br>yer<br>nce<br>ss<br>yer<br>nce<br>er|||
|A2.1).<br>Personal<br>income|ome<br>ct ta|ribu<br>sura<br>n<br>buti<br>sura<br>plo<br>sura<br>yer<br>ckne<br>mplo<br>sura<br>ploy|||
|taxes are more progressive|inc<br>dire|cont<br>nt in<br>utio<br>ntri<br>r<br>nt in<br>- em<br>s in<br>mplo<br>/ si<br>- e<br>e in<br>em|||
|and<br>redistributive<br>than<br>social contributions, with<br>health<br>insurance|Personal<br>Other|h insurance<br>nemployme<br>contrib<br>insurance co<br>employe<br>nemployme<br>ontribution<br>t and disease<br>ribution - e<br>indemnities<br>contribution<br>ary guarante<br>ontribution -|||
|contributions being slightly||ealt<br>U<br>alth<br>U<br>c<br>den<br>cont<br>ical<br>nce<br>Sal<br>c|||
|more<br>progressive<br>and<br>redistributive<br>than<br>other<br>types<br>of<br>contributions|Source: Own estimates ba<br>Kakwani Coefficient|sed on the 2016 Romanian HBS.<br>H<br>He<br>Acci<br> <br>Med<br>insura<br>Marginal Contribution|||

(Figure 7). However, direct taxes are much less redistributive relative to other countries, such as Croatia, Poland, or Mexico (Figure 8A), either because they collect relatively lower amounts (for instance compared to Poland) or because they are less progressive (with a lower Kakwani when compared to Croatia or Mexico). Moreover, they are also poverty increasing, as shown by a negative marginal contribution to poverty reduction when poverty is measured using the 2011 PPP US$5.50 a-day line. These results point to potential improvements that could be achieved to improve the progressivity and redistributive impact of direct taxes in Romania.

> a Shapely decomposition to address this issue, which involves estimating marginal contributions in every possible path and then taking the average.

18
<!-- Start of picture text --> Figure 8. Progressivity and Redistributive Effect of Taxes<br>Figure A. Direct Taxes<br>0.7 0.04<br>0.6 0.03<br>0.5 0.03<br>0.4 0.02<br>0.3 0.02<br>0.2 0.01<br>0.1 0.01<br>0 0.00<br>Kakwani Marginal contribution<br>Figure B. Indirect Taxes<br>0.05 0.005<br>0.000<br>0<br>-0.005<br>-0.05<br>-0.010<br>-0.1 -0.015<br>-0.020<br>-0.15<br>-0.025<br>-0.2<br>-0.030<br>-0.25 -0.035<br>Kakwani Marginal contribution<br>(change in Gini points)<br>Kakwani Index<br>Marginal contribution to equity<br>Regressive <------------------> Progressive Guatemala (2010) Colombia (2014) Sri Lanka (2010) El Salvador (2011) Peru (2009) Jordan (2010) Russia (2010) Romania (2016) Chile (2013) Poland (2014) Mexico (2010) Brazil (2009) Armenia (2011) Georgia (2013) Croatia (2014) South Africa (2010)<br>Kakwani Index (change in Gini points)<br>Marginal contribution to equity<br>Regressive <------------------> Progressive<br>Croatia (2014) Georgia (2013) Poland (2014) Bolivia (2009) Romania (2016) Guatemala (2010) Russia (2010) Indonesia (2012) Colombia (2014) Jordan (2010) Brazil (2009) Armenia (2011) El Salvador (2011) Sri Lanka (2010) South Africa (2010) Chile (2013) Mexico (2010)<br><!-- End of picture text --> Source: Armenia: Younger & Khachatryan (2017); Bolivia: Paz Arauco et al (2014); Brazil: Higgins & Pereira (2014); Chile:Martinez Aguilar et al (2017); Colombia: Melendez and Martinez (2015); El Salvador: Beneke et al., (2014); Georgia: Cancho & Bondarenko (2017); Guatemala: Cabrera and Moran (2015); Indonesia: Jellema et al (2017); Jordan: Alam et al (2017); Mexico: Scott (2014); Peru: Jaramillo (2013); Poland: Goraus & Inchauste (2016); Russia: Lopez-Calvo et al (2017); Sri Lanka: Arunatilake et al (2017); South Africa: Inchauste et al (2017); Uruguay: Bucheli et al (2014); Croatia: Inchauste and Rubil (2017); Romania: own estimates using 2016 HBS. Note: Old-age pensions are treated as deferred income for all countries shown. Marginal contributions are the <u>difference between the consumable income Gini coefficient with and without indirect taxes.</u> 19
|In contrast, indirect taxes<br>are regressive and<br>contribute to increasing|Figu|re 9.|Progres<br>(fr|sivity an<br>an<br>om marke|d Redistri<br>d contrib<br>t to cons|butive Effect of I<br>utions<br>umable income)|ndirect|Taxes|
|---|---|---|---|---|---|---|---|---|
|poverty and inequality in<br>2016. While it is true|0.15<br>0.20<br>essive||||||0.020<br>0.025|alizing|
|that regressive taxes can|0.10<br>nt<br>ogr||||||0.015|fect<br>Equ|
|be equalizing,<sup>18</sup>this was|000<br>0.05<br>ficie<br>> Pr||||||0010|e ef<br>-->|
|not the case in Romania<br>in 2016 (Figure 9). In|-010<br>-0.05<br>.<br>ni coef<br>--------||||||0.005<br>.|stributiv<br>g <-----|
|particular, VAT placed a|-0.15<br>.<br>kwa<br>e <-||||||0.000|Redi<br>lizin|
|large burden on low-<br>|-0.20<br>Ka<br>ssiv||||||-0.005|<br>equa|
|income households,|-0.25<br>gre||||||-0.010|Un|
|leading to an overall<br>increase in poverty and<br>inequality. Excise taxes<br>were also regressive, but<br>since they are not as|Re|All direct taxes|All contributions<br>s and contributions|VAT<br>Excises tobacco|Excises alcohol<br>Excises fuel|Excises energy<br>All indirect taxes<br>All taxes<br>s and contributions|||
|large as VAT, their|||taxe|||taxe|||
|impact on poverty and|||rect|||All|||
|inequality was<br>substantially smaller<br>(Table A2.1). When|Source: Own|estim|ates base<br>All di|d on the 20<br>Kak|16 Roma<br>wani Coef|nian HBS.<br>ficient<br>Marginal|Contribu|tion|

taken together, although indirect taxes are regressive and unequalizing, this effect is smaller relative to other countries, including many other middle-income countries (Figure 8B).

# **Social Spending**

Contributory benefits and direct cash and near-cash transfers are all progressive, reducing both poverty and inequality (Table A2.1). These programs are progressive in both relative and absolute terms – that is, they represent a larger share of the budgets of the poor, and are pro-poor, as most of the benefits are concentrated at the bottom 40 percent of the distribution for almost all categories of benefits (Figure 10). For instance, the state allowance for children spent 0.6 percent of GDP in 2016 and concentrated 59 percent of benefits to the bottom 40 percent of the distribution. Similarly, 65 percent of the 0.3 percent of GDP spending on disability benefits went to the bottom 40, while 70 percent of the 0.1 percent of GDP spending on the minimum social pension did so. Most progressive were the 0.11 percent of GDP spent on the guaranteed minimum income and the 0.07 percent of GDP spent on the support allowance for families with children, of which 99 and 97 percent benefited the bottom 40 percent of the distribution. The only exceptions are relatively small programs, including programs for persecuted persons for ethical or political reasons, and near-cash benefits for medicines and transportation.<sup>19</sup> Overall, 60 percent of the 1.4 percent of GDP spent

> 18 For instance, the case of Chile. See Martinez-Aguilar et al (2017) and Lustig (2017).

> 19 This last result should be interpreted with caution given the relatively small sample size of beneficiaries to these smaller programs.

20
on non-contributory social benefits went to the bottom 40 percent of the distribution in 2016. Similarly, 52 percent of the 0.6 percent of GDP spent on contributory social benefits (excluding old-age pensions) went to the bottom 40.

Figure 10. Romania. Concentration of Social Protection Programs <u>(by market income plus pensions quintiles)</u> <!-- Start of picture text --> 100%<br>90%<br>80%<br>70%<br>60%<br>50%<br>40%<br>30%<br>20%<br>10%<br>0%<br>Contributory Non-contributory<br>Poorest 2 3 4 5 6 7 8 9 Richest<br>Source: World Bank estimates based on Romanian HBS 2016.<br>The distribution of these benefits Figure 11. Romania. Concentration of Social Protection<br>between urban and rural areas Programs<br>(by rural and urban areas)<br>shows that many of these programs<br>have a higher impact in rural areas 100%<br>90%<br>(Figure 11). For instance, 84 80%<br>percent of the Guaranteed 70%<br>Minimum Income program is 60%<br>50%<br>devoted to rural areas, where 81 40%<br>percent of benefits are spent on the 30%<br>poorest 20 percent of the 20%<br>10%<br>population. In contrast, most of the 0%<br>contributory programs benefit<br>urban areas, as do near-cash<br>benefits such as school supplies,<br>medicines and transportation<br>benefits.<br>As mentioned in the previous<br>section, despite the progressivity of<br>Contributory Non-contributory<br>Scholarships Heating aid<br>children<br>Unemployment benefit Child-raising + incentive benefit Temporary incapacity and maternity State allowance for Placement allowance for children Support allowance for families with children Disability benefits Guaranteed minimum income Minimum social pension Other social benefits Near-cash school related benefits Other near-cash social benefits Direct transfers<br>Unemployment benefit State allowance for children Scholarships Disability benefits Guaranteed minimum income Minimum social pension Heating aid Other social benefits Direct transfers<br> Child raising+incentive benefit Temporary work incapacity and... Support allowance for families... Other near-cash social benefits<br>Placement allowance for children Near-cash school related benefits<br><!-- End of picture text --> As mentioned in the previous section, despite the progressivity of existing social transfer programs, <u>Source: Own estimates based on the 2016 Romanian HBS.</u> 21
the benefits received by the poor and vulnerable are not high enough to overcome the impact of direct and indirect taxes. The marginal contribution of the different transfer programs varies, depending on the size and progressivity of the programs. For instance, the state allowance for children has the biggest distributional impact, even though it is not the most progressive, simply because it is the largest program (Figure 12A). When it comes to the combined effect of taxes and social spending, we find that the marginal contribution of social transfers to poverty reduction is reversed by the combination of direct and indirect taxes and contributions (Figure 12B).

<!-- Start of picture text --> Figure 12. Romania. Poverty Headcount Rate, 2016<br>A. Progressivity and Redistributive effect of Taxes B. Marginal contributions to Poverty Reduction<br>and Contributions (from market to consumable income)<br>(from market to consumable income)<br>0.20 0.025 0.05 0.04<br>0.15 0.020 0.04<br>0.10<br>0.015 0.03<br>0.05<br>0.00 0.010 0.02<br>-0.05 0.005 0.01<br>0.00<br>-0.10<br>0.000 0.00<br>-0.15<br>-0.005 -0.01 0.00 0.00<br>-0.20 -0.01<br>-0.01-0.01<br>-0.25 -0.010 -0.02<br>-0.03 -0.02-0.02<br>-0.04 -0.03<br>Kakwani Coefficient Marginal Contribution<br>Source: World Bank estimates based on the Romanian 2016 HBS.<br>Kakwani coefficient Redistributive effect<br>VAT<br>Regressive <---------> Progressive Unequalizing <-------> Equalizing<br>Excises fuel All taxes VAT<br>Contribution to Poverty Reduction<br>All direct taxes All contributions Excises tobacco Excises alcohol Excises energy All indirect taxes<br>Excises fuel<br>(Change in poverty headcount at US$5.50 PPP) All direct taxes All contributions Excises tobacco Excises alcohol Excises energy All indirect taxes<br>All direct taxes and contributions All taxes and contributions pensions<br>Direct transfers excl contributory All direct taxes and contributions<br><!-- End of picture text --> In terms of in-kind transfers for education and health, we must caution that our analysis does not address the quality of such spending. We use government expenditure data on the various forms of education and health services to estimate unit costs of these programs. The analysis thus assumes that the actual benefit received by individuals is equal to the amount spent per student or per patient. Although we differentiate between rural and urban areas for primary and secondary education, a finer disaggregation was not possible. Given that the quality of school infrastructure, teachers, and health clinics and hospitals varies across the country, this is a clear limitation of the analysis.

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With these caveats in mind, the results show that education is progressive in relative terms, and given the amounts spent, it is also equalizing.<sup>20</sup> In other words, the amount of spending on education is relatively high as a share of the incomes of those at the bottom of the distribution, although there is variation across educational categories, with lower secondary education being the most redistributive (Table A2.1). On average, 49 percent of all spending on education is devoted to the poorest 40 percent, however while 61 percent of primary and 66 percent of lower secondary spending is devoted to the bottom 40 percent of the distribution, only 23 percent of tertiary spending does so (Figure 13). This is because students in poorer households never make it into tertiary education.

Figure 13. Romania. Concentration of Education and Health <u>(by market income plus pensions quintiles)</u> <!-- Start of picture text --> 100%<br>80%<br>60%<br>40%<br>20%<br>0%<br>In-kind education In-kind health<br>Poorest 2 3 4 5 6 7 8 9 Richest<br>Preschool Primary Tertiary<br>benefit<br>Lower secondary Upper secondary Post-secondary Net education transfers Minimum health Basic health benefit Net health transfers<br><!-- End of picture text --> <u>Source: World Bank estimates based on Romanian HBS (2016).</u> However, this does not mean that the resources devoted to education spending are adequate. Most striking is the fact that despite being progressive, the redistributive power of primary education is relatively low, not just in terms of other social spending in Romania, but also when compared to other countries (Figure 14). This is because the amount spent on education is relatively low compared to other countries (World Bank, 2018b). In Romania, only 1 percent of high-performing schools and about 83 percent of lowperforming schools are in rural areas. In fact, the gap in the quality of education between rural and urban areas (using PISA 2015 scores) is as high as 1.8 years of schooling. This is in part due to density, and the fact that public resources are allocated on a per-student basis. High-performing schools tend to have more than double the number of students than low-performing schools. This is not unexpected as it is difficult to attract and retain high-quality teachers in rural schools (and those situated in the outskirts of cities), so that they often have a higher proportion of substitute teachers, with teachers that are generally not as experienced as in those in urban schools. These factors negatively impact the quality of education and contribute to low student performance. Local authorities from large cities or rich rural areas add to the envelope of basic

> 20 We do not assess the poverty reducing impact of health and education spending as the recipients do not necessarily value these services at the cost of provision.

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financing with funds from local revenues mainly for the top schools in their catchment areas. Consequently, such schools have strong reputations, and attract students and families from relatively well-off socioeconomic backgrounds (World Bank, 2018b).

Although health spending is progressive and equalizing in relative terms, in the sense that spending on health makes up a larger share of the incomes of the poor. However, it is not pro-poor in the sense that a larger share of spending accrues to the top of the distribution. The main reason for this is that households at the bottom of the distribution do not have access to basic health benefits (Figure 11). In fact, basic health benefits amount to 3

|Figure<br>Pri<br>|14.<br>mary|Pro<br>Sc|gre<br>ho|ssivity<br>ol (from|and<br>m|Redistribu<br>arket to fin|tive Effect of<br>al income)|
|---|---|---|---|---|---|---|---|
|0.0<br>0.2<br>0.4<br>0.6<br>0.8<br>1.0<br>1.2<br>Kakwani Index<br>Regressive <------------------><br>Progressive|Romania (2016)|Armenia (2011)|Ethiopia (2011)|Croatia (2014)<br>Indonesia (2012)|Jordan (2010)|Chile (2013)<br>Poland (2014)<br>South Africa (2010)|0.000<br>0.005<br>0.010<br>0.015<br>0.020<br>0.025<br>0.030<br>0.035<br>Marginal contribution to equity<br>(change in Gini points)|
||Ka|kwa|ni|Marg|inal|contribution||

Source: Armenia: Younger & Khachatryan (2017); Chile: Martinez Aguilar et al (2017); Croatia: Inchauste and Rubil (2017); Ethiopia: Hill et al (2017); Indonesia: Jellema et al (2017); Jordan: Alam et al (2017); Poland: Goraus & Inchauste (2016); South Africa: Inchauste <u>et al (2017); Romania: own estimates using 2016 HBS.</u> percent of GDP, with 33 percent of these benefits going to the bottom 40 percent. In contrast, minimum health benefits are progressive and pro-poor, with 87 percent of spending going to the bottom 40 percent of the distribution. However, these benefits are relatively small, making up only 0.1 percent of GDP.

# **VI. What is the impact of recent changes in taxes and benefits?**

Reforms introduced since 2016 were aimed at improving the social impacts of tax and benefit policies. The government cut the VAT tax standard rate from 20 to 19 percent in 2017. In addition, the PIT rate was cut from 16 to 10 percent beginning in 2018 and the tax-free allowance was raised. The government also substantially changed the structure of social contributions by shifting their burden almost entirely to the employees beginning in 2018.<sup>21</sup> Here we focus on the impact of the changes in the VAT and the PIT.

The reduction in the VAT rate only slightly reduced the VAT paid by all households, while the reduction in PIT was more substantial (Figure 15). 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. In terms of distributional impacts, the reduction in the VAT has had virtually no effect on fiscal redistribution. Value added taxes become slightly more regressive as measured by the Kakwani index (from -0.0955 to -0.0966). In fact, since richer households consume more, 37 percent of the

> 21 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.

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reduction in value added taxes was captured by the top of the two deciles of the distribution. However, since everyone is now paying less taxes, the marginal contribution to inequality is now smaller, but this change is only minor, a decline in the impact from 0.0051 to 0.0048 Gini points.

In contrast, the reduction in the tax rate for personal income taxes had a much larger impact on inequality. Since personal income taxes continue to have a flat tax, the level of progressivity in relative terms, as measured by the Kakwani index, has not changed. However, when considering the absolute amount of tax relief, since the top of the distribution have higher incomes, most of the gains of the changes in policy were concentrated at the top of the distribution. In fact, 55 percent of the PIT tax relief benefited the top two deciles. As a result, the redistributive impact of personal income taxes has been substantially reduced, as their marginal contribution to the redistributive effort fell from 0.012 to 0.007 Gini points.

<!-- Start of picture text --> Figure 15. Impact of changes in the PIT and VAT by decile<br>(percent of market income + pensions)<br>A. Value Added Taxes B. Personal Income Taxes<br>20% 12%<br>Baseline Simulation Baseline Simulation<br>10%<br>15%<br>8%<br>10% 6%<br>4%<br>5%<br>2%<br>0% 0%<br>Source: World Bank estimates based on Romanian HBS (2016).<br><!-- End of picture text --> Thus, the result of the decline in PIT and the VAT rates was an increase in inequality. The Gini coefficient for Disposable Income increased with a lower PIT flat rate, while there is nearly no impact from the change in VAT (Figure 16A).<sup>22</sup> An increase in inequality is likely not what the authorities were hoping to achieve with these reforms.

However, when it comes to poverty, the impact of lower VAT and PIT rates is expected to be poverty reducing. Poverty after taxes and transfers, measured by consumable income and using the US$5.50 PPPa-day poverty line is expected to have declined from 15.4 to 15.0 percent due to the lower PIT rate (Figure 16B), which is still higher than the poverty rate prior to taxes and transfers. If the VAT rate were to decline to 18 percent, this would further reduce the poverty rate, but only to 14.8 percent, which would still be insufficient to mitigate the impact of the burden of taxes in the system.

> 22 Note that the reduction in the redistributive effort of the PIT might be even larger if the household survey were able to accurately account for top incomes, which are typically underreported in household surveys.

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<!-- Start of picture text --> Figure 16. Impact of lower VAT and PIT rates on poverty and inequality<br>A. Gini Coefficient B. Poverty Headcount rate<br>(US$5.50 PPP)<br>0.380 18 15.0<br>15.4 14.8<br>16<br>0.370 13.9<br>14<br>0.360 12.1 11.8<br>12<br>0.350 10<br>0.340 8<br>6<br>0.330<br>4<br>0.320<br>2<br>0.310 0<br>Market income + Disposable Consumable<br>0.300<br>pensions income income<br>Market Disposable Consumable Final Income<br>Income + Income Income 2016 Baseline<br>Pensions<br>VAT decline to 18%<br>Baseline<br>PIT decline to 10%<br>Simulation PIT rate=10% & VAT 18%<br>Decline in both PIT and VAT<br><!-- End of picture text --> <u><mark>Source: World Bank estimates based on Romanian HBS (2016).</mark></u> If the purpose of these reforms was to reduce poverty and inequality, a much more efficient way of achieving this objective would have been to keep the PIT rate constant and to increase targeted social transfers. Such an alternative would not only have been less costly, but also more redistributive. To illustrate this point we undertook a final simulation in which we assumed that the PIT was kept at 16 percent, and that half of the cost of the reduction to 10 percent was instead spent on higher social transfers (Figure 17). Such an alternative would not only have halved the impact on the fiscal deficit, it would have also reduced poverty by 1.4 percentage points (compared to only 0.6 percentage points with lower PIT and VAT rates) and reduced inequality by 0.006 Gini points, as opposed to an increase with a lower PIT.

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<!-- Start of picture text --> Figure 17. Impact of increasing social transfers instead of reducing the PIT rate<br>A. Gini Coefficient B. Poverty Headcount rate<br>(US$5.50 PPP)<br>0.380 18<br>15.4<br>0.370 16 14.8<br>13.9 14.0<br>0.360 14 12.111.8<br>0.350 12 10.8<br>0.340 10<br>0.330 8<br>0.320 6<br>0.310 4<br>0.300 2<br>Market Disposable Consumable Final Incom 0<br>Income + Income Income Market income + Disposable income Consumable<br>Pensions pensions income<br>Baseline<br>2016 Baseline<br>Simulation PIT rate=10% & VAT 18%<br>Decline in both PIT and VAT<br>Simulation: Social benefits increase by 1/2 of cost of P Social benefits increase by 1/2 of cost of PIT reduction<br>reduction<br>Source: World Bank estimates based on Romanian HBS (2016).<br><!-- End of picture text -->

# **VII. Conclusions**

Romania has high levels of poverty and inequality relative to other EU countries. In this context, the combined effect of taxes and social spending in Romania helps to reduce inequality, although less so than other EU countries. Direct taxes and transfers are progressive and redistributive, more so than other developing countries, but less than other European countries such as Poland and Croatia. In contrast, indirect taxes are regressive and unequalizing. In-kind transfers are progressive and equalizing, particularly spending on primary and lower secondary education, and spending on the minimum health benefit. However, spending on primary education is much less equalizing than in other developing countries, while health spending is not necessarily pro-poor.

The impact of taxes and transfers on poverty is much worse. When we compare the poverty rate before and after taxes and transfers, we find that poverty is higher after all taxes and cash transfers. The main reason for this is that taxes are poverty increasing, so much so that the poverty-reducing power of direct transfers is completely wiped out once indirect taxes are included in the analysis. In fact, households beginning in the second decile were net payers to the treasury in 2016, as the share of taxes paid exceeded the cash benefits received for all but the poorest 10 percent of the population. The main problem is that direct cash transfers to poor households (in the form of social assistance and non-contributory benefits) 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.

However, things are looking up for Romania, as growth has been strong, and unemployment reached its lowest level in more than 20 years in 2017. In this context, fiscal policy has turned pro-cyclical, driven by significant tax cuts and wage and pension increases which has placed Romania on a trajectory towards re27
entering the EU Excessive Deficit Procedure. The adopted policies, estimated to have led to a 5.4 percent reduction in government revenue, were meant to foster private investment and improve the living standards of the population and redistributive and poverty-reducing impact of fiscal policies. So far it is unclear if the adopted policies led to higher investment. On the distributional side, these policies have not been effective in reaching their objective.

The results in this report show that the recent reduction in the PIT rate likely led to an _<u>increase</u>_ in inequality, while the reduction in the VAT rate had no impact. This is because most of the tax relief accrued to the top of the income distribution. Moreover, the analysis shows that the adopted policies were a very expensive way to achieve what is actually a very small decline in poverty. A larger and more targeted social assistance system could have achieved better distributional results at a much lower fiscal cost. The results call for the use of simulation tools that could better inform the fiscal and redistributive impacts of proposed reforms.

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