FISCAL POLICY RESPONSE DURING THE ECONOMIC CRISIS: EVIDENCE FROM THE FLAT TAX COUNTIES IN THE EUROPEAN

UNION
Schiau (Macavei) Laura Liana1 Ulici (Ciupac) Maria2 ABSTRACT: The financial crisis has shaken the global economy. Policymakers have had to focus on short-term crisis management. The flat tax countries in the European Union seemed to have been the first ones to face major problems regarding their fiscal and monetary life. Small and nimble nations like these slashed taxes and regulation to attract foreign capital and business. The Romanians and the Bulgarians set some of the lowest corporation tax rates in Europe; the Balts and Slovaks went for flat taxes; Iceland became an improbable financial centre. International capital flooded into the smalls. But small open economies are like rowing boats on an open sea. If a global economic storm blows up, such boats can capsize. This article aims to present and analyse the fiscal and monetary policy response of these counties to the economic downturn.
Key words: economic crisis, tax change, policy. JEL codes: E52, E62, H20, G01

Introduction The European Union economy is affected by the deepest recession since the 30s. The forecasts show that the real GDP is projected to shrink by some 4% in 2009. This represents the sharpest contraction in the history of the European Union. As a recent study of the European Commission Department of Economic and Financial Affairs shows, signs of improvement have appeared recently, but recovery matters are still uncertain and fragile. The most affected countries in the EU area seem to be the ex-soviet flat tax counties like Latvia, Lithuania, Estonia, Romania, Bulgaria, Slovakia and Czech Republic. Small nations like these ones slashed taxes and regulation to attract foreign capital and business. The Irish set some of the lowest corporation tax rates in Europe; the Balts and Slovaks went for flat taxes; Iceland became an improbable financial centre. International capital flooded into the smalls. But as Joseph Stiglitz, the economist, once warned: "Small open economies are like rowing boats on an open sea." If a global economic storm blows up, such boats can capsize. Amounts of money that are relatively trifling to the international capital markets can make a huge impact if suddenly withdrawn from a small nation. The economic crisis also brought fewer revenues for the national budget, the number of unemployed has increased dramatically, and the nations` GDP decrease became more and more obvious. Giving the mentioned conditions these countries had to take rapid decisions in order to minimize the effects of the financial and economic crisis. Romania Romania adopted 16% flat tax regime in 2005. The tax revenues of the public budget
1 2

Babes Bolyai University, Faculty of Economics and Business Administration, Cluj-Napoca, Romania, No 12, Marasti Street, Alba Iulia, schiau.laura@yahoo.com
Investing in people! PhD scholarship, Project co-financed by the European Social Fund, SECTORAL OPERATIONAL PROGRAMME HUMAN RESOURCES DEVELOPMENT 2007 2013, Babe-Bolyai University, Cluj-Napoca, Romania

Faculty of Economics and Business Administration Street,ulici_maria@yahoo.com

Cluj-Napoca, Romania No 58-60, Teodor Mihali

increased the following years substantially, but the increase was generated mainly by the revenues from VAT and not by the personal income tax revenues and corporate income tax revenues. This indicates the fact that the reform stimulated consumption and not investment and tax compliance. A study conducted by the Romanian research organization GEA (Group of Applied Economics) shows that the effects of the flat tax on income distribution were not the ones which were predicted initially. 40% of the benefits of the flat personal income tax were experienced by the very high earner, which represent 10% of the population. 84% of the high earners` flat tax benefits and 74% of low earners` flat tax benefits were consumed. In the same time the 16 percent flat tax registered in one way a success in relaunching Romanias economic growth, not only because it provided citizens increased buying power, but also because it made it less expensive for companies to hire top managers. Nowadays, Romania, one of the newestand poorestkids in the European bloc is experiencing the full force of the economic downturn, but some analysts remain optimistic in the long run. In order to minimize the impact of the economic crisis few measures where taken. One new piece of legislation foresees that each legal person has to pay a mandatory minimum income tax from the first of May. In other words "you must pay, no matter what". The reasons for implementing this law were the following: - This will reduce the number of illegal enterprises that develop suspicious activities and dont have enough payments to the state budget. - This piece of legislation will encourage the national economy that has slaked because of the economic crisis. But this new law seemed to forget that Romania is still struggling to reduce tax evasion and increase the welfare state. The effects of the new fiscal measure were unexpected and undesirables: - In the first semester of 2009, 129,900 companies have shut down, in various forms: bankruptcy, temporary abeyance or permanent suspension, etc. - Many of these entities have ceased, choosing to supply the black economy. - The number of unemployed increased. - The number of tax payers of VAT and the numbers of contributors for the national budget decreased. - More precisely the impact of these new regulations was highly negative and consists of: - The unemployment rate is September 6,9% from 6,6% in august 2009, 6,3% in July 2009 and 3,9% September 2008. - An impressive number of companies with operations suspended, closed, etc. no longer contributing to the state budget encouraged to perform work in an illegal way. - The number of PFA in 2009 (which does not equalize the taxes paid to the state budget by the other categories of legal persons) increased with more than 30% from 2008. - The deficit after the first 9 months of 2009 is of 25,56 thousand million lei in the national budget, determining the government to borrow from EU and IMF, in order to be able to pay salaries and pensions. There were also other measures taken by the Romanian government. Romanian general business and tax Overview conducted by Deloitte Tax S.R.L shows that during 2009 the following measures are or will be put into practice by the Romanian government: - The income obtained from trading of shares on the market regulated by the Romanian National Securities Commission is considered as non-taxable income for corporate income tax purposes, while the deductibility of the relevant expenses will be disallowed. - The profits obtained by foreign legal entities from trading of shares held in a Romanian company, performed on a market regulated by the Romanian National Securities Commission, is not be taxable.

An additional 20% deduction is applicable for qualifying R&D expenses, and accelerated depreciation applies to equipment used for R&D activities. - Interest income derived from term deposits and/or other saving instruments are deemed non taxable income when derived by individuals. If such individuals are resident in non-EU member states, such income is exempt from withholding tax in Romania. Recent figures from INS, place Romania at a budget deficit of 5.1 percent in 2009, compared to 5.4 percent in 2008. But this wouldnt be a catastrophe because in January 2009 the European Commission was foreseeing a 7.2 percent deficit for Romania, competing with the Romanian government which was suggesting an unbelievable level of 2 percent. The Romanian deficit is still fine compared to major states such as Ireland, the United Kingdom, Latvia, Spain, France and Portugal, in the range of 12 to 6.5 percent. On the other hand, Finland, Luxembourg, Bulgaria and Cyprus will cash in budgetary surpluses between 4.2 and 0.9 percent.
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Latvia Latvia was in the first wave of more than a dozen ex-communist European countries that have implemented a single rate of tax for personal earned income. The so-called "Baltic tigers" enjoyed among the highest growth rates in Europe in the last decade. But nowadays all three face a severe economic contraction due to the economic crisis. According to the seasonally non-adjusted data of the Central Statistical Bureau of Latvia, compared to the first half of 2008 gross domestic product (GDP) in the first half of 2009 has decreased by 18.4%. Compared to the 2nd quarter of 2008, in the 2nd quarter of 2009 GDP has diminished by 18.7% The decrease in GDP was due to the drop in the following sectors: trade (share in GDP structure 15.8%) by 29.0%, transport and communications (11.2%) by 15.0%, manufacturing (9.2%) by 24.4% and construction (7.1%) by 29.5%. In the 2nd quarter of 2009 compared to the 2nd quarter of 2008 (at current prices) in final private consumption expenditure on education has decreased by 9.5%, on food by 18.5%, on transport, communications by 18.5%, on alcoholic beverages, tobacco by 26.3%, on restaurants and hotels by 43.7%. Decrease in private final consumption at constant prices mainly was caused by reduction of goods purchase volume. Government final consumption expenditure dropped by 6.9%, but expenditure on gross capital formation by 38.1%. Export of goods (63.6% of total exports) has reduced by 19.1% and exports of services by 15.7%. However, volume of imports of goods (78.8% of total imports) has decreased by 39.4%, but volume of imports of services by 38.2%. As a study called Tax Response to the economic crisis by Deloitte shows, in order to overcome the economic crisis in a series of amendments to the Corporate Income Tax Law became effective on 1 January 2009, the main purpose of which is to both encourage Latvian companies to accumulate retained earnings and attract investment in new manufacturing equipment. - A "notional" interest expense deduction is granted (the real financial effect of which will first be felt in 2011). - The special tax depreciation regime for new manufacturing equipment was extended to 2013. - An option is given to reduce taxable income derived from the sate of fixed assets if "similar" fixed assets are acquired within a 12-month period before or after the sale. The loss carry forward period will be gradually increased from five to eight years. During a transition period, it will be possible to reduce the taxable income of FY 2008 by the amount of losses incurred in the previous six tax periods, and in 2009 for losses incurred in the previous seven tax periods. Estonia Estonia is a small ex-soviet country. In 2004 The Heritage Foundation classes Estonia on the

4th place of the top by its rate of economic freedom. The incredible metamorphosis from a soviet economy to a functional market economy is the result of a range of reforms begun by prime minister Mart Laar in the early 1990s. After the dissolution of the Soviet Union and after obtaining the independence in 1991, Estonia has implemented radical fiscal policies, foreign trade liberalization and extensive privatization. In 1994, ignoring the suggestion of IMF, Estonia has adopted a flat tax. Additionally, the tax on the reinvested profit was eliminated. The flat tax encouraged the capital formation and had led to higher productivity, bigger salaries and creation of new jobs. Estonia has become a friendly business environment because of its simple and low taxation. The international economic crisis has affected very bad the Estonian economy. As Eduard Hugh shows in its article Estonian GDP Shrinks By An Annual 15.6% In The First Three Months Of 2009 in 2009 Estonias economy contracted the most in the first quarter, making it the second-worst performance in the European Union. Behind the number lays a sharp fall in consumer spending and a plunge in industrial output. GDP was down by an annual 15.6 percent, the sharpest drop since at least the first quarter of 1994, according to the flash estimate from the statistics office. The fall follows a 9.7 percent drop in the last three months of last year.

Fig. No.1 - Estonias GDP Evolution Source: Hugh, Eduard, 2009 The decrease of 15.6% year on year was significantly above the forecasts made at the beginning of the year 2009. This will obviously have important implications, but in particular for the government budget deficit forecast. The latest figures of GDP from all three Baltic counties are showing that Lithuanian economy contracted by 12.6% and the Latvian by 18%. This indicates the extreme weakness in the baltic economies. Todays number obviously lends support to the idea that Estonias economy might decline by more than 15% in 2009. A lot depends on what the next quarter looks like. If the slowdown accelerates the final annual number might be even worse. In Estonia no tax changes have been made in response to the global economic crisis in 2009 till now. The Estonian government makes just budget cuts to address the downturn in the economy so there would be no state budget deficit. Estonia is likely to use state revenues to address the reduction in GDP. Slovakia In 2003 Slovakia has adopted flat tax of 19% both for corporation and individuals. Before deciding to implement the new system, the Slovak government has conducted five surveys in order to eliminate a negative effect of the flat tax on the economy. More transparency, less tax dodging, this was the slogan used by Slovakia in implementing the flat tax system. In 2004 Slovakia received from

the World Bank the title of The most reformed economy of the globe. The flat taxing system has replaced a mechanism with 90 tax exceptions, 19 non taxed income sources, 66 exonerations and 27 products with different level of taxation. In the same time, Slovakia has eliminated the VAT reduced rates and established a new unique rate for the VAT of 19%. The consequences were: in 2003 in Bratislava there were 22 new projects and 7500 new jobs created and in 2004 there were 47 new projects and 12700 jobs were created. The flat tax and other reforms have improved economic performance. Economic growth, after adjusting for inflation, has averaged 6.6 percent per year. The flat tax reform has generated a supplyside feedback effect. But Slovakias reign as central Europes leading economy is no longer a reality. Why? The answer is simple: exports plunge, unemployment increases and the deficit grows. 2009 was supposed to be Slovakias best year ever as a culmination of its rapid progress from a marginal ex communist country under the reign of an autocratic government in the early 1990s, to a fully integrated member of the European Union. The final step of that process was Slovakia joining the euro on January 1. But even as the fireworks shot into the sky, and politicians showed off the gleaming new euro coins decorated with Slovakias national symbol, a double cross, there were increasing indications that Slovakias economy was going to feel the full force of the economic crisis. The very factors that helped Slovakia notch up a 10.4 per cent growth in gross domestic product in 2007 its burgeoning export industries centered on electronics and three car factories that give it the highest per capita car production in Europe are now the causes of its rapid economic deceleration. (Cienski, J. 2009). Giving the existent conditions the Slovakian government had to take rapid measures in order to counter the undesirable effects of the crisis. As the study Tax Response to the economic crisis by Deloitte shows some amendments to Slovakias Income Tax Act effective from 1 March 2009 were not introduced specifically to address the financial crisis, but they may have some ancillary effects: - The input price of tangible assets and technical improvements on tangible and intangible assets is increased to EUR 1.700 and that for intangible items increased to EUR 2,400. - For depreciation of tangible assets, "component depreciation" allow taxpayers to depreciate certain identified individual separable parts (for buildings, computer network infrastructure, personal and cargo elevators, escalators, etc.). - Recent changes in the VAT law (effective 1 April 2009) were not introduced specifically to address the financial crisis, but they may have some ancillary effects. Included in the changes is the ability to obtain a VAT refund within 30 days {rather than 60) if specific conditions are satisfied and the ability of lessors to recover input VAT incurred in connection with real estate is extended to non resident lessors that are taxable persons. Bulgaria Bulgaria on of the country with the lowest personal tax rate among European Union member states adopted the flat tax system in 2008. This country also has one of the lowest social security rates in the region which coupled with a 10% flat rate, makes it very attractive any entrepreneur. The government plans to keep the current tax rate, as envisaged in the mid-term fiscal policy document, which brings together the country's key macroeconomic forecasts for 2010-2013 and which was approved by the government. But the economic crisis affected also the Bulgarian economy. The gross domestic product (GDP) has contracted by 3,5% in the first quarter of 2009 on an annual basis, the statistics office announced on Wednesday, confirming flash data. This is the first time that the country's GDP marks a drop since the financial and economic crisis in 1997 and the slump is much sharper than macroeconomists' forecasts. The data is being

followed extremely carefully by analysts in a bid to track down the impact of the global economic crisis on the country. The drop in GDP is the first tangible proof that Bulgaria has been hit by the crisis, whose impact has been measured so far in terms of the amount of foreign investments, industrial output, trade and incomes. The European Bank for Reconstruction and Development estimated that Bulgaria's GDP growth will shrink by 3% this year and a further 1% in 2010, echoing the predictions made by the European Commission at the beginning of the month. (Novinite News Agency, 2009) Bulgaria's exports and imports shrank by almost one third in the first quarter of 2009 on an annual basis in the wake of the global financial and economic crisis. Preliminary data of the Bulgarian Statistical Institute shows that Bulgaria's exports were marking a drop of 26,8% and Bulgaria's imports contracted by 29,9%. In order to counter the economic and financial crisis the Bulgarian government decided to make some changes regarding the fiscal policy: - A five-year tax corporate income tax holiday for investments in distressed regions (still to be approved by the European Commission) was introduced. - Individual tax relief is granted for young families paying interest on home loans. - Some administrative VAT relief has been granted (e.g. reverse charge instead of VAT registration and effective payment/refund claims and changes to the grounds for electronic invoicing without an electronic signature). (Deloitte, 2009) Czech Republic From January 2008 the new Czech corporate tax rate became 21%, replacing the 2007 corporate tax rate of 24%. The Czech corporate tax rate would go down to 20% in 2009 and 19% in 2010. The new income tax rate for individuals became a flat 15% rate, replacing the 2007 rates of 12% to 32%. The 15% flat rate would be reduced to 12.5% from 2009.From 2008 the joint tax assessment for married couples was cancelled. In 2008 the standard Czech VAT rate remained 19%, while the reduced VAT rate was 9%. From January 2009 the new Czech corporate income tax rate is 20%, compared to 21% in 2008. The personal income tax rate remains a flat 15%, same as in 2008. The social security rate for employees was reduced from 12.5% to 11%. There are no changes in the standard and reduced V.A.T. rates compared to 2008. Advance income tax payments for self-employed individuals and companies with up to five employees (as from 1 January 2009) have been cancelled on a temporary basis. There were also other measures proposed in order to counteract financial and economic crisis. Nowadays they are different stages of the legislative process. For example the social insurance rates were reduced for poorer and low-income employees. Another measure is referring to tax depreciation which will be calculated on a monthly basis for certain assets (e.g. computers, cars. machines, etc.) acquired between 1 January 2009 and 30 June 2010. There will be a change in the tax deductibility of lease payments for selected assets (e.g. computers, cars, machines, etc.) acquired from 1 January 2009 to 30 June 2010. The VAT refunds will become faster for taxpayers submitting electronic tax returns and also the VAT input deduction for passenger cars will be extended. Conclusions As we have seen from the examples above the fiscal costs of the financial crisis will be enormous. A sharp deterioration in public finances is now taking place and the decline in GDP due to the crisis may add further pressure on national budgets of these countries. In order to counter the effects of the financial and economic crisis the countries flat tax jurisdictions of the European Union are taking different steps in the fiscal direction. From the tax

perspective the measures range from formal stimulus packages to ad hoc approaches, to temporary provisions, to acceleration of planned measures of mixes of the one mentioned before. References 1. Cienski, J. (2009) A victim of its own success, available on-line at http://media.ft.com/cms/df4c1042-7b80-11de-9772-00144feabdc0.pdf 2. Deloitte (2009), Romanian general business and tax Overview, available on-line at http://www.deloitte.com/assets/Dcom-Romania/Local%20Assets/Documents/EN/Tax %20and%20Legal/ro_Romanian_business_and_tax_overview_0309.pdf 3. Deloitte (2009), Tax Response to the economic crisis, available on-line at https://www.deloitte.com/dtt/cda/doc/content/dtt_tax_respondingtoeconcrisis__032009.pd f 4. European Commission Department of Economic and Financial Affairs (2009). Economic Crisis in Europe: Causes, Consequences and Responses, available on-line at http://ec.europa.eu/economy_finance/publications/publication15887_en.pdf 5. Hugh, E. (2009), Estonian GDP Shrinks By An Annual 15.6% In The First Three Months Of 2009, available on-line at http://fistfulofeuros.net/afoe/economics-countrybriefings/estonian-gdp-shrinks-by-an-annual-156-in-the-first-three-months-of-2009/ 6. KPMG (2009), Bulgaria with EU Lowest Personal Tax Rate available on-line at http://www.novinite.com/view_news.php?id=107188 7. Novinite News Agency (2009) Bulgaria GDP drops sharply by 3,5% in Q1 2009, available on-line at http://www.export.by/en/?act=news&mode=view&id=10337.