public expenditure and institutional review public ...€¦ · report no. 36363-ro romania public...

November 8, 2006

Document of the World Bank

Report No. 36363-RO

RomaniaPublic Expenditure and Institutional Review(In Two Volumes) Volume I: Main Report

Poverty Reduction and Economic Management UnitEurope and Central Asia Region

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LG Local Government PIBL Public Institution Building Loan LM Line Ministry PIFC Public Internal Financial Control MAFRD Ministry of Agriculture, Forests and Rural

Development of Romania PIU Project Implementation Unit

MEI Ministry of European Integration PPIBL Public and Private Institution Building Loan

MER Ministry of Education and Research PPD Public Procurement Directorate

MEWM Ministry of Environment and Water Management

PPP Public Private Partnership

MF Memorandum of Financing PPU Public Policy Unit

MIG Minimum Income Guarantee PRAG Practical Guide to contract procedures for EU external actions

MLSS Ministry of Labor and Social Solidarity PRAI Regional Action Plan (for employment and vocational education)

MoHF Ministry of Health and Family PSAL Private Sector Adjustment Loan MoJ Ministry of Justice PSO Public Service Office

MoPA Ministry of Public Administration RDA Regional Development Agency

MRD Maintenance, Repair, and Development RDP Rural Development Program

MTEF Medium Term Expenditure Framework RICOP Industrial Restructuring and Professional Reconversion Program

MTSAB Means Tested Social Assistance Benefit ROL Old Romanian Lei (currency) MoPF Ministry of Public Finance RON New Romanian Lei (currency)

NAFA National Agency for Fiscal Administration ROP Regional Operational Program

NATO North Atlantic Treaty Organization SAMTID Small and Medium-sized Towns Infrastructure Development program

NDP National Development Plan SAPARD EU Special Accession Program for Agriculture and Rural Development

NGO Non-Government Organization SAPS CAP Single Area Payment Scheme

NHIF National Health Insurance Fund SFPS CAP Single Farm Payment Scheme

NHP National House of Pensions SME Small and Medium Enterprise

NIM National Institute of Magistrates SCM Superior Council of the Magistracy

OECD Organization for Economic Co-operation and Development

SOE State-owned Enterprises

OSI Open Society Institute SOP Sectoral Operational Program PARDF Paying Agency for Rural Development and

Fishery SRM Social Response Measures

PAYG Pay As You Go TCMU Treasury Cash Management Unit

PEM Public Expenditure Management TEN European Transport Network

PFM Public Financiall Management TVET Technical and Vocational Education and Training

PFMRC Public Financial Management Reform Committee

UAA Utilized Agricultural Area

PHARE Pologne-Hongrie Assistance pour la Reconstruction Economique

UPP Unit for public Policy

PIAA Paying and Intervention Agency for Agriculture

VAT Value Added Tax

Vice President : Shigeo Katsu Country Director : Anand Seth

Sector Director : Cheryl Gray Sector Leader : Bernard Funck Team Leader : Ron Hood

Contents

EXECUTIVE SUMMARY ...........................................................................................................................I

INTRODUCTION....................................................................................................................................... I INSTITUTIONAL CONSTRAINTS AND ABSORPTION OF EU GRANTS.......................................................II

1. THE MACROECONOMIC SETTING................................................................................................ 13

A. INTRODUCTION .......................................................................................................................... 13 B. SHORT RUN MACROECONOMIC STABILITY............................................................................... 15 C. LONGER RUN GROWTH NEEDS.................................................................................................. 16 D. IMPLICATIONS FOR ROMANIA.................................................................................................... 20

2. PATTERNS OF EXPENDITURE ....................................................................................................... 25

A. THE CURRENT DISTRIBUTION OF EXPENDITURE....................................................................... 25 B. RECENT EXPENDITURE DYNAMICS ........................................................................................... 28

3. SECTORS ............................................................................................................................................ 37

A. INTRODUCTION .......................................................................................................................... 37 B. EDUCATION................................................................................................................................ 37 C. HEALTH ..................................................................................................................................... 41 D. AGRICULTURE ........................................................................................................................... 43 E. TRANSPORT................................................................................................................................ 47 F. ENVIRONMENT........................................................................................................................... 55 G. PENSIONS ................................................................................................................................... 59 H. MANAGING THE PUBLIC SECTOR WAGE BILL........................................................................... 61

4. PUBLIC EXPENDITURE POLICY AND INSTITUTIONS .............................................................. 65

A. STRATEGY, POLICY AND PUBLIC EXPENDITURE ....................................................................... 65 B. DECENTRALIZATION.................................................................................................................. 71 ANNEX 4.1: REVENUE AND EXPENDITURE ASSIGNMENTS................................................................. 87

5. REVENUE ........................................................................................................................................... 89

ANNEX 5.1: IMPACT OF TAX ADMINISTRATION REFORM ON VAT COLLECTIONS ............................. 94

6. IMPACT OF EXPENDITURE OPTIONS .......................................................................................... 97

A. INTRODUCTION .......................................................................................................................... 97 B. THE RESULTS............................................................................................................................. 98 C. CONCLUDING REMARK............................................................................................................ 100

Table 1.1: GDP Growth and Major Aggregates, 1996-2006 ...................................................................... 14 Table 1.2: Expenditure Adjustments in Select EU Countries in the 1990s................................................. 17 Table 1.3: Fiscal Adjustment Prior to Accession, 2000-03 ........................................................................ 19 Table 1.4: Immediate Post-Accession Fiscal Adjustment, 2003-05 ........................................................... 19 Table 1.5: General Government Expenditure Revenue, 2004 .................................................................... 22 Table 2.1: Expenditure by Function (% GDP)............................................................................................ 25 Table 2.2: Expenditure by Economic Classification (% GDP)................................................................... 27 Table 3.1: Budgetary Implications of Sourcing Alternatives for CAP Support Payments, 2007–09 ......... 46 Table 3.2a: Consolidated Expenditures Plan for Roads and Railways in the Alternative Scenario ........... 54 Table 3.3b: Consolidated Expenditures Plan for Roads and Railways in the Alternative Scenario ........... 55

Table 3.4c: Consolidated Expenditures Plan for Roads and Railways in the Alternative Scenario ........... 55 Table 3.5: Summary of Environmental Compliance Cost .......................................................................... 56 Table 3.6: EU Grant Programming in ENV SOP by Sectors, 2007–2013 (€ million)................................ 56 Table 3.7: Draft Environment SOP by Financing Source, 2006 (€ million)............................................... 59 Table 4.1: Structure of Local Government Expenditure, 2003................................................................... 78 Table 4.2: Structure of Local Government Revenue, 2003 ........................................................................ 80 Table 5.1: Collection of Taxes as a Share of GDP, 1995-2004 .................................................................. 89 Table 5.2: Standard Personal, Corporate and Value Added Tax Rates....................................................... 90 Table 5.3: Social Security Contribution Rates in Europe ........................................................................... 91 Table 5.4: Impact of Tax Reform on Collections (%GDP) ........................................................................ 93 Table 5.5: Compliance Rates in Bulgaria ................................................................................................... 93 Table 6.1: Expenditure Projections............................................................................................................. 98 Table 6.2: Projected Revenue and Expenditure .......................................................................................... 99 Table 6.3: Medium-term Projections 1 (no tax increase).......................................................................... 100 Table 6.4: Medium-term Projections 2 (with tax increase)....................................................................... 101 Figure 1.1: Net Lending (+) / Net Borrowing (-) (% GDP) ........................................................................ 18 Figure 1.2: General Government Expenditure, (% GDP) ........................................................................... 20 Figure 1.3: Government Balance (% GDP) ................................................................................................ 20 Figure 1.4: Inflation Rate............................................................................................................................ 21 Figure 1.5: Government Debt (% GDP) ..................................................................................................... 21 Figure 1.6: CA Gap (% GDP)..................................................................................................................... 21 Figure 1.7: Public Expenditure as a Share of GDP, and GNI per capita (%, US$ PPP)............................. 23 Figure 2.1: Expenditure by Function (% GDP) .......................................................................................... 26 Figure 2.2: Expenditure by Economic Classification ................................................................................. 28 Figure 2.3: General Government Capital Spending.................................................................................... 28 Figure 2.4: Patterns and Projections of Revenue and Expenditure (% GDP) ............................................. 29 Figure 2.5: Expenditure by Function (% GDP) .......................................................................................... 31 Figure 2.6: Actual versus Planned Expenditure by Sector (percent) .......................................................... 32 Figure 3.1: Standardized Death Rates, all Causes and Ages per 100,000................................................... 41 Figure 3.2: Estimated Annual Road Expenditures Proposed in the Government’s Plan ............................ 49 Figure 3.3: Annual Road Expenditures Alternative Scenario (% GDP) ..................................................... 51 Figure 3.4: Average Replacement Rate for Old Age Pensioners................................................................ 60 Figure 4.1: Local Government Expenditures as a share of General Government Spending....................... 74 Figure 4.2: Local Government Expenditure ............................................................................................... 78 Box 1.1: Measuring Fiscal Space................................................................................................................ 16 Box 2.1: Data Sources for Expenditures..................................................................................................... 26 Box 4.1: A Proposed New Timetable for Budget Preparation.................................................................... 69 Box 5.1: Challenges in Improving Tax Administration.............................................................................. 92 Box 5.2: The Bulgarian Experience with Tax Administration Reform ...................................................... 93 Box 6.1: Summary of Expenditures and Revenues..................................................................................... 97

ACKNOWLEDGMENTS This report is based on research and missions conducted by a World Bank team working in Romania during 2005 and the spring of 2006. The team wishes to thank the Romanian Government for the cooperation of its senior officials in the Ministry of Public Finance, the Ministry of Public Administration and Interior, the Ministry of European Integration, the Ministry of Economy and Commerce, the Ministry of Agriculture Forests and Rural Development, the Ministry of Transport, Construction and Tourism, the Ministry of Ministry of Labor, Social Solidarity and Family, Ministry of Health, the Ministry of Education and Research, the Ministry of Environment and Waters Management, the General Secretary of Government, the Chancellery, the National Health Insurance Fund, the National House of Pensions, and the National Commission for Prognosis. Ron Hood is the principal author of the report drawing from background papers and contributions prepared by a team composed of Sudipto Sarkar, Karin Shepardson, Catalin Pauna, Kari Nyman, Henry Kerali, Mohammed Dalil Essakali, Gaetan Tracz, Ana Otilia Nutu, Daniel Dulitzky, Silviu Radulescu, Richard Florescu, Doina Visa, Holger Kray, Johannes Stenbaek Madsen, Devesh Chandra Mishra, Tuan Le, Matthew Andrews, Joao Oliveira, Ana Maria Sandi, Gary Reid, Marianne Fay, Bianca Pauna, Costas Christou (IMF), Sorin Ionita (consultant), Alec Gershberg (consultant), Iglika Vassileva (consultant), and Dana Sapatoru (consultant). The team also received valuable input from a group of consultants funded under a Dutch trust fund and providing technical assistance to the Government on budgeting and public expenditure management. These include Jan Herczynski, Russell Robinson, Martin Johnson, Gerard Lepesant, JeanTilly, and Alan Pratley. Useful comments were also received from Anand Rajaram and Bill Dillinger (peer reviewers) and from Lee Travers, Michel Noel, Ali Mansoor, Marianne Fay, and Lucian Pop. The team gratefully acknowledges the support of Raluca Banioti who organized the team’s visits to Romania and Armada Çarçani who assisted in processing the report.

NOTE

This Public Expenditure and Institutional Review emphasizes that the demands of EU accession, including the specific requirements of the acquis communautaire, as well as the need to build up the human capital and infrastructure, will put significant strains on budget policy, programming and implementation capacities. It also suggests that, provided these capacities are enhanced, somewhat greater levels of public spending may be warranted. The Review is based largely on the 2006 budget and Medium Term Expenditure Framework (2007 - 2009). As the Review was finalized, the Government was preparing the 2007 budget and MTEF. Indications are that the new budget and MTEF will embody sharply higher levels of spending, going well beyond the amounts contemplated in the Review. This makes it all the more important that the authorities take the necessary steps to improve budget policy and programming capacities as described below.

EXECUTIVE SUMMARY

INTRODUCTION

1. Romania has achieved a solid fiscal consolidation over the last six years. The deficit has been reduced steadily since 2000 and was under 1 percent of GDP in 2005. Expenditure was cut by more than 5 percentage points of GDP between 1999 and 2004 and is now among the lowest in Europe. In this respect Romania compares favorably with other European countries, and most closely resembles the group of four “good reformers” among the EU-8 (Estonia, Latvia, Lithuania, Slovenia, Slovakia), and the “fiscal consolidators” among the older EU member states (Ireland, Denmark, Sweden, Finland, Spain, Netherlands, UK) who have managed to rationalize expenditures by on average 7.2 percent of GDP.

2. Looking forward Romania needs to focus on improving the quality and effectiveness of public spending. Human and physical capital need to be upgraded in order for Romania to be able to compete effectively in the broader European economy. New investments in infrastructure are needed and will require adequate provision for ongoing operating and maintenance. Romania has major commitments to its future EU partners to achieve higher environmental standards, especially in water and air. These present major planning and implementation challenges.

3. There will be significant budgetary demands over the medium term as Romania joins the EU. The cost of complying with the environment directive of the acquis alone is sometimes estimated at €19 billion. Romania must also contribute to the EU budget an amount roughly equal to 1 percent of GDP per year. In addition, the structural reforms of the transition from the socialist period continue to influence on the budget. Closure of large manufacturing firms has given rise to increased pension costs, and there are still subsidies and transfers to support those dislocated by the economic shifts including early retirement and disability schemes. These demands are magnified by demographic trends.

4. The extent to which Romania should expand its public expenditures in the face of these needs, and how such spending should phased in over time, depends critically on how successful the country is in deepening capacities for planning and implementation of public expenditure programs. Romanian public spending is roughly 5 percentage points of GDP less than countries at a similar level of income per capita, and it is below most of its European partners. However, for increases to be justified Romania needs to do five things: (i) design projects and programs with solid rates of return that make effective use of EU resources, and develop the capacity to implement them as planned; (ii) improve the medium term expenditure framework; (iii) incorporate clearly-defined sector priorities into the budget process; (iv) ensure that spending plans are complemented by tax and financing arrangements that are consistent with macroeconomic stability; and (v) undertake reforms to the budgetary institutions and processes that give greater strategic focus to expenditure planning.

ii Executive Summary

INSTITUTIONAL CONSTRAINTS AND ABSORPTION OF EU GRANTS

5. There has been considerable anticipation that the EU structural funds would provide an easy way to accommodate spending needs without additional demands on domestic resources. Indeed, these could potentially amount to close to 4 percent of GDP annually and, if properly used can contribute both to meeting the specific requirements of the acquis and also to creating the infrastructure needed for higher growth and income convergence.

6. To do this the authorities need to frame the development pipeline of eligible projects within an overall development strategy and with due consideration of implementation constraints. This is likely to have higher returns than if the line ministries and local governments simply seek to fill up the pipeline as a means of capturing “free” EU money.

7. The experience with pre-accession funds should serve as a sobering warning that these hopes might be disappointed. For instance, Romania has been slow to take up the available ISPA funds. Virtually none were disbursed in the first three years and, as of end 2005, only about 15 percent of available funds had been disbursed. Although some improvements have been introduced, similar problems are likely to persist after accession, when there will be three times as much money, to be used in 75 percent of the time available now.

8. What this experience reveals is that there are critical bottlenecks to expanding public spending, or at least to doing so in an efficient and sustainable manner. Some of these bottlenecks are of an institutional nature. This is not simply a matter of planning and filling the project pipeline, although that is important. Much of the delay in using ISPA funds has to do with implementation constraints relating to contracting, land assembly and other stages of the project cycle. At a higher level however, the government has to design its sectoral strategies and expenditure plans in a macroeconomically sustainable manner and to execute them in the light of existing capacity constraints. This involves more far-reaching reforms of institutions and practices.

DEEPENING THE MEDIUM TERM EXPENDITURE FRAMEWORK

9. The recently introduced Medium Term Expenditure Framework (MTEF) should play a central role in expenditure planning, but as of now it is only developed to a rudimentary extent. In fact, the MTEF is only one of several planning instruments. The others include the Sector Operation Plans (SOP) and the Regional Operational Plan (ROP) which are related to the projects that are eligible for EU grant funding. Then there is the Implementation Plan for the acquis communautaire. In addition, there is a whole set of sector strategies and implementation plans prepared by the line ministries and agencies. In principle, the expenditures associated with these various plans should be harmonized and funneled through the budget/MTEF. This is not currently the case. As a result, sectoral ministries have been drawing up spending plans that are not commensurate with the government’s stated fiscal strategy.

10. If these sectoral plans were all implemented, government spending would quickly accelerate to unsustainable levels well in excess of 45 percent of GDP as compared with approximately 31 percent in the MTEF. For instance, there is a new RON 13 billion plan to invest in district heating plan over four years. There is a plan for a three-fold hike in road

Executive Summary iii

spending which would peak at 4.6 percent of GDP in just two years, and a five-fold increase in rail investment. Very little, if any, of this is reflected in the current MTEF (2007-2009). Worse, there appears to be underbudgeting in the MTEF in certain areas. In particular pensions and social assistance are projected in the MTEF to decline from 9.5 to 7.9 percent of GDP. This is despite a public commitment to increase pensions by 30 percent in real terms over the four years ending 2009. Similarly in health, expenditures are projected to decline from 3.3 to 2.5 percent of GDP by 2009. This makes insufficient allowance for the transition costs associated with hospital rationalization. Perhaps most importantly, the costs of meeting the provisions of the acquis are not fully factored into to the MTEF. In short, the planning and budgeting processes are disconnected, and this risks unraveling Romania’s commendable progress on fiscal consolidation.

11. There is a need for a more effective planning process, anchored in a realistic MTEF. The point of this process should be to reconcile sectoral plans with macroeconomic constraints, and adjust macroeconomic policies and sectoral policies and priorities accordingly.

ADDRESSING SECTORAL EXPENDITURE PRIORITIES

12. The following paragraphs illustrate how such a process could unfold. They look at the underlying development challenges across a range of sectors and types of spending (education, health, agriculture, transport, environment, pensions and wages) and the spending pressures they generate, and they identify how the latter could be met, including through policy reforms. 13. Taken together, the measures proposed below would allow the government to contain medium-tem spending plans to about 36.5 percent of GDP. As will be shown in the following sections, even those spending restraint measures would leave the overall fiscal deficit at an unsustainable level. Further iterations will therefore be needed to bring revenues (including EU grants) and spending into closer balance. Given Romania’s legitimate spending needs, this is unlikely to be achieved without fresh efforts on the revenue side.

Education

14. One area where MTEF targets are realistic is education. Education spending as a share of GDP is low relative to other European countries. The priority will be to raise the quality of pre-university schooling, and improve secondary education enrollment. This is likely to be costly. This is because teachers’ secondary wages will need to rise from their current low levels while opportunities for budgetary savings through reductions in numbers of teachers are limited, despite declining numbers of school age Romanians, assuming hoped-for improvements in teaching quality are successful in raising the very low enrollment rates in secondary schools. Indeed, spending is set to rise in the MTEF to 4.2 percent of GDP. If this extra spending is to yield the expected impact, key structural reforms will also be needed to ensure greater flexibility in the assignment of teaching staff and to respond to shifting demographic and enrollment patterns.

iv Executive Summary

EDUCATION: SUMMARY OF RECOMMENDATIONS

Introduce rules ensuring greater flexibility in employment including reforms regarding redeployment of teaching staff, increases in teaching loads, and some increased attrition.

Deepen decentralization and school-based management reforms through limits on the seniority system, removal of the Inspectorat Şcolar Judeţean (ISJ, county school inspectorates) from the hiring process altogether, entrusting most personnel decisions to the school director, subject to local government overview, and conferring the right of school directors to fire teachers and non teachers after negative assessment of their work, perhaps with the ISJ playing the role of "appeals court".

Replace the practice of retaining and automatically allocating local government funds from the VAT to pay salaries (known as the “sume defalcate”) with a strong per student categorical grant, including also allowances for maintenance expenditures.

Conditional on implementation of the above reforms, gradually increase salaries of teachers to be more in line with Romania’s future European partners (in relation to per capita GDP).

Health

15. In health, the reduction in spending from 3.3 percent of GDP in 2006 to 2.5 percent of GDP in 2009 as portrayed in the MTEF is unlikely to be realized (this would also bring spending lower than any other country in the European Union – current or prospective). Health service delivery is compromised by excessive reliance on the hospital system and weaknesses in funding arrangements. These give rise to problems of access, equity and efficiency. To accommodate the transition costs of hospital rationalization and EU accession the budget planning may need to provide for a gradual increase in health spending to around 4.5 percent of GDP by 2010 financed in part with the taxes provided for in the new package of health laws.

HEALTH: SUMMARY OF RECOMMENDATIONS

Redress the bias towards hospital-based service delivery. This will require further reductions in the number of hospital beds, the closure of some hospitals and greater specialization of services among the remaining hospitals and further expansion non-hospital-based service delivery mechanisms, in line with the Hospital Rationalization Strategy.

Anchor reforms in the budget process. The budget and the medium term expenditure framework need to reflect adequately the transition costs of hospital rationalization, a practical approach to the opening of any new regional or local hospital facilities, and the transition to a level of health spending more consistent with that of recent EU accession countries and with Romania’s increasing per capita GDP. A full assessment of the fiscal impact of the new package health laws is needed.

Improve payment systems. This will entail extending the application of diagnostic related group systems, and developing new payment modalities to support models/facilities for service delivery outside the hospital system.

Executive Summary v

HEALTH: SUMMARY OF RECOMMENDATIONS

Deepen accountability. The policy objectives outlined in the framework contracts need to be made consistent with the budget allocations. The misalignment of policy and budget strains accountability and renders the various ceilings ineffective and has resulted in chronic overspending in hospitals and accumulation of arrears.

Agriculture

16. In agriculture, EU accession offers the prospect of budgetary savings in the order of Euro 557 million from replacement of the national system by the EU system paid for by EU funds. Against this must be set additional costs of roughly 300 million in additional administrative costs associated with the CAP. Key issues in the sector involve decisions about the extent of “top-ups” and the need for regional development measures that improve the productivity and competitiveness of the sector.

AGRICULTURE: SUMMARY OF RECOMMENDATIONS

Do not implement the maximum “top-ups” that are additional to the support payments under the EU system, and adopt instead a low-cost 10 percent top-up that takes full advantage of the provision allowing a reallocation of structural funds for this purpose.

Reconsider the line of credit scheme recently introduced, and focus instead on productivity and competitiveness enhancing measures that can leverage structural fund resources.

Eliminate all other subsidies and expenditure programs as the CAP is introduced.

Transport

17. Massive expenditure programs are proposed for road and for rail which go beyond what is required under the acquis and would unduly strain implementation capacities. Additional spending is needed. But current proposals are excessive, and exceed both what is required by the acquis and what the relevant institutions are capable of the implementing. Sectoral plans need to be scaled back and prioritized in line with economic merit.

18. In particular, the road investment program should be prioritized to fit within a smaller budgetary envelop while making effective use of EU grants. This can be achieved through the following: (i) the motorways program should be rationalized, and its implementation staged by considering a longer period for construction of motorways; (ii) costs of rehabilitation and by-pass construction should be reduced (by at least 20 percent) by developing a more competitive construction industry; and (iii) the capacity of the road agency (NCMNR) to plan and implement projects should be improved.

vi Executive Summary

ROADS: SUMMARY OF RECOMMENDATIONS

Revise the investment program based on a comprehensive and technically-sound economic analysis of the productivity and cost effectiveness of projects. In our alternative scenario, expenditure would peak at 2.5 percent of GDP (as compared with 4.5 percent in the current plan).

Review the proposed, as well as ongoing, PPP transactions.

Review the institutional organization of the roads sector (NCMNR) with a view to making road management and maintenance practice more efficient and more cost-effective.

Establish a sustainable framework for road user charges.

19. Steps are also needed to rationalize expenditure plans for the rail sector particularly with respect to planned CFR investments, while improving CFR’s financial performance. These need to reflect CFR implementation capacity constraints. Specific measures to hold back the sector’s burden on the State budget without impeding the sound financial management of the railway companies should include the following practical steps.

RAILWAYS: SUMMARY OF RECOMMENDATIONS

Review the prioritization and planning of CFR investments for the period 2006-2013 according to economic and financial criteria. In our alternative scenario, investment is projected to rise gradually from €200 million to €600 million per year over seven years, compared to a figure of €1 billion in the current investment plan.

Implement Calatori fare increases and some service cuts.

Reinforce Public Service Contracts and improve CFR’s corporate governance.

Implement CFR maintenance efficiency package.

Increase Calatori track access charges.

Restructure Calatori according to the completed market survey along with the implementation of Calatori efficiency package (staff reduction and closure of uneconomic services).

Environment

20. The cost of meeting the environment conditions of the acquis is potentially huge – €19 billion in present value terms over the period to 2019. Budgetary planning for environmental spending is weak. Estimates contained in a PHARE-financed study put the costs of the environmental acquis commitments at €10.4 billion between 2007 and 2013. Yet the environment Sector Operation Plan (SOP) has only €4.9 billion. The MTEF runs only to 2009 but it is clear that only a tiny fraction of the amounts needed for counterpart funds and the grants themselves are reflected there.

21. The portion of environmental expenditures that will ultimately fall on the budget is very difficult to estimate. This is because the vast majority of the necessary investments will be

Executive Summary vii

made by utility companies, particularly for water, waste and district heat. Although owned by local governments, the economic transactions of the utilities are frequently off budget. If the tariffs charged by the utilities are enough to cover costs and if they borrow to cover investment costs, there are no budgetary costs. However, if the local governments capitalize or subsidize the utilities and/or their customers there will be budgetary costs. Moreover, these costs may remain hidden for a long time as quasi-fiscal deficits that nevertheless will have to be covered at some point. Policies relating to tariff regulation, cost recovery and subsidies are important. This issue deserves more study.

22. Regardless of the on-budget, off-budget division, planning and implementation capacities will clearly be a limiting factor in determining the overall pace of investment. This is especially true in respect of the substantial portion of expenditures that will have to take place at the municipal level where these capacities are the weakest. In particular, it would seem unlikely that the four-year 13 billion RON district heating plan will be implemented at the planned pace.

ENVIRONMENT: SUMMARY OF RECOMMENDATIONS

Construct a sequence for environmental project implementation based on economic merit. Conduct a comprehensive analysis of utility tariff regulation and subsidization cost

consequences for the budget and MTEF, especially with respect to water and district heating. Appropriate tariff adjustments and assistance to vulnerable groups should help with private participation (including privatization) and minimization of delays in the implementation of the program agreed with the EU.

Improve the Ministry of Water and Environment budget framework to introduce a clearer budget structure linked to performance and key program functions.

Revisit the recently approved plan for eight district heating projects to assess the probable pace of implementation make appropriate provision for it in the MTEF.

Strengthen the local utilities regulator – ANRSC –so that it can monitor the performance of the utilities through a licensing process (a vast majority of the utilities are not licensed) and the benchmark the performance of the utilities.

Develop programs to accelerate investments in nitrates, energy efficiency, and large air investments by the private sector.

Where privatization of thermal plants does not succeed, factor into the MTEF the costs of rehabilitation investment requirements that demand state guarantees or capital transfers.

Reflect post-accession grant resources and budget for co-financing as well as Nature Protection funding - historically off the budget - in the MTEF.

Develop a more transparent financing framework for nature protection will help to attract future EU grants to these needs.

Pensions

23. In the area of pensions, the challenge that the government is trying to address is that replacement rates are low and will likely slip below 30 percent in the next few years. This undermines the willingness to participate and contributes to the informal economy. The government realizes that the efforts to contain these deficits are resulting in strong public

viii Executive Summary

pressure for change. In 2004, the authorities adopted a medium term plan for contribution rate reductions, adjustment of retirement ages, and other basic pension parameters including those relating to the introduction of the second pillar. Other measures may also be considered in the near future, especially in the area of the early retirement and disability/invalidity pensions, as well as the increase of the number of contributors. However, it is important that the planned changes be taken into account in planning future public finances. In particular, the recently publicized plans to increase pensions by a cumulative 30 percent in real terms by 2009 do not appear to have found full expression in the budgetary framework. Compounding the pressures is the planned phase-in of the private voluntary pillar starting in 2007 or 2008.

PENSIONS: SUMMARY OF RECOMMENDATIONS

Carefully time and phase the introduction of the second pillar in a manner that takes into account other influences on the deficit.

Fully reflect the already planned pension system changes in the MTEF.

Public Sector Wages

24. The number of public employees is modest: 3.8 percent of the population compared with an average of 6.5 for the EU8 and 8.9 for the EU 15. At around 8.5 percent of GDP, the wage bill is also low compared to 11 percent for the EU-25 and even more in the new member states. Core civil servants are paid less than their private sector equivalents, especially at the higher levels, and this affects the government’s ability to attract and retain quality staff. However, steps to improve salaries, and thereby improve quality, need to be tempered by two important considerations. The first is that in the short term such increases would bring pressure on aggregate demand, inflation expectations and private sector wage-setting patterns. So timing is an issue. The second is that, in the medium term, changes are needed to the structure of wages and to wage setting processes. The current practices complicate and segment salary setting and the wage bargaining process, resulting in large wage discrepancies both between public sector categories, as well as within the same group. They also make it virtually impossible for the Government to establish effective oversight and control of the overall public sector wage bill. A plan to introduce the necessary structural changes needs to be devised before significant increases in the level of resources are made.

PUBLIC SECTOR WAGES: SUMMARY OF RECOMMENDATIONS

Complete wage negotiations before the approval of the subsequent year’s budget in order to include the increases in the overall envelope and eliminate multiple within year hikes.

Proceed with the next steps in the implementation of the unitary pay and employment system in the civil service.

Extend the scope of the pay and employment reform beyond civil service, which covers only around 10 percent of total public employment.

Simplify and rationalize the diverse incentives schemes.

Improve the information base on public sector wages and employment.

Complement wage reforms with broader reforms in public administration.

Executive Summary ix

FINANCING EXPENDITURES IN A MACROECONOMICALLY SUSTAINABLE MANNER

25. The measures proposed above would result in spending that would peak at 36.5 percent of GDP, i.e. less than the 40-50 percent of GDP that would be required to fulfill all the proposed spending plans, but still up by 4 - 5 percentage points of GDP compared to MTEF targets. This is despite the fact that the expenditure profiles embody significant cuts vis-a-vis the investment plans prepared for roads and rail, allowance for weakness in planning and implementation capacities and a recommendation that most of the grants under the common agricultural policy be captured as budgetary savings. If no additional revenue measures are taken and no further expenditure cuts are made, the deficit would therefore swell to 6.5 percent of GDP by 2009. This is well above the 3 percent threshold in the Stability and Growth Pact and would trigger the excessive deficit procedures including the possible cut-off of Cohesion Fund grant assistance.

26. This raises the important question of how to carve out the fiscal space to accommodate legitimate spending demands. At present, private sector demand is very strong – for investment and especially for consumption goods and housing. The current account deficit is deteriorating and the authorities are struggling to bring down an inflation rate which is presently the highest in Europe. Romania has taken steps to liberalize the capital account. This is an EU requirement which is an important feature of gaining access to the internal market. In the longer term it will underpin entry into the European Monetary Union and adoption of the Euro. In the shorter term, however, and in the face of strong capital inflows, it limits the effectiveness of monetary policy as a demand management tool. This puts the onus on fiscal policy as the main macro policy instrument. This could change. The recent drop in stock markets has been particularly pronounced in emerging markets. Since May, the Romanian currency has begun to depreciate against the Euro. This could increase the scope for monetary tightening. Indeed monetary policy may have to be tightened simply to counter the inflationary effects of depreciation caused by the higher cost of imported goods in the context of an inflation-targeted monetary policy. However, the trend towards weaker speculative capital inflows needs to be confirmed, and remittances, FDI and privatization receipts are likely to continue. Moreover, the current unexpected strength of tax collections reflects credit boom-induced spending. These collections will weaken as increased domestic interest rates cut into consumer spending, increasing the deficit. This would compound the effects of introducing the flat tax last year which lowered average tax rates reducing tax collections by approximately 1 percent of GDP.

27. In the long term there may be scope for more debt-financed spending. Romania’s external debt at around 36 percent of GDP is well within tolerable limits. And public sector debt at 19 percent of GDP is also low. It can be argued that borrowing to sustain well-planned public investments starting from this sort of initial position is not imprudent.

28. However, deficit spending decisions must also take account of shorter term macroeconomic dynamics which hinge on the level of aggregate demand and its impact on inflation and the current account deficit. In this respect it should be emphasized that, from a purely macroeconomic perspective, public expenditures financed by grants, privatization receipts, remittances or borrowing, all add to aggregate demand in basically the same manner. They are fundamentally different from the more demand-neutral, tax-financed expenditures, and do not provide an equivalent alternative to tax-finance.

x Executive Summary

29. A 6.5 percent of GDP deficit is clearly too large, would violate the Stability and Growth Pact rules and would result in higher inflation and current account deficit. The Government has three options dealing with this challenge:

• Further revenue measures. While some increase in collections may result from improvement of tax administration, this alone is unlikely to result in more than 1.2 percent of GDP over an uncertain time period. This will not be enough, so at least some of the increase will have to come from adjustment in the structure of taxation. This is even more so, given the need to reduce the excessively high social contribution rates.

• Further expenditure rationalization. The expenditure profiles were developed in this document to reflect efficiency, growth and EU accession commitment considerations, to be politically feasible and to reflect implementation constraints. However, if tax and deficit implications of these are unpalatable, the authorities may need to consider further expenditure rationalization. Areas for further scrutiny may include transfers and subsidies (perhaps jointly with the decisions about municipal infrastructure investments) and the pace of transportation investments. The government is committed to the acquis, however the compliance periods range out as far as 2019. It may be advisable to spread the related expenditures to later years where possible. Other new and old member countries have had difficulty meeting all of their commitments, particularly the environmental directives where high standards observed by existing members are particularly costly for new entrants with lower per capita income levels.The authorities may also need to reconsider the planned increases in pensions and in wages in the public sector to ensure that these result in improvements in quality, and that increased expenditures in health are also accompanied by the appropriate rationalization of the hospital system. Rationalization of public expenditures may also be achieved through carefully planned projects with private participation. This can be done either through partnership arrangements with an appropriate degree of risk sharing, or through purely private projects executed within a regulatory framework that ensures financial sustainability.

IMPROVING EXPENDITURE PLANNING AND MANAGEMENT PRACTICES

30. Enhanced strategic priority setting mechanisms are going to be needed for the government to be able to make those important policy choices. To this end, the role of the Inter-ministerial Council for Strategic Planning (CSP) should be deepened and should incorporate the introduction of some form of strategic budget policy statement to guide the line ministries. The CSP should be assigned the clear role of (i) articulating national priorities on a multi-year basis, to act as the broad framework for other inter-ministerial committee processes, and to set out the budget priorities of Government; (ii) reviewing and prioritizing proposals, and (iii) recommending to the Cabinet as a whole, and by extension to specific Inter-ministerial Councils, relative orders of priority amongst competing inter-ministerial committee policy directions.

31. The GSG and the Chancellery have initiated important reforms to develop strong policy-making processes across government, and these need to be more firmly rooted in practice. The GSG reform has been in progress for a couple of years now, whereas the reforms in the Chancellery are newer. The GSG reform hinges on the introduction of a Public Policy Unit

Executive Summary xi

(PPU), designed explicitly to facilitate improvement in the quality of policy submissions from line ministries. The GSG PPU plays a gatekeeper role for all ministries presenting policy proposals to Cabinet leading to normative acts. The GSG PPU has developed guidelines for preparing these proposals, instilled a process through which they need to pass, and staffed itself to play a review and challenge role. Individual satellite PPUs have been established in line ministries. The role of these units needs to be deepened. They need to work more closely with respective line ministry budget departments and the institutional arrangements and lines of authority made clearer. The goal is to enhance the quality and decrease the quantity of submissions to Cabinet.

32. Improvements could be made to the budget process and calendar. Further steps need to be taken to build on recent improvements to the budget circular. These should give greater policy focus to the budget preparation process. They should make the ceiling setting process more effective. It would also be advisable to start the budget process earlier to enable the line ministries and local governments more time to develop their submissions. In addition, it would be desirable to complete wage negotiations before the approval of the subsequent year’s budget in order to include the increases in the overall envelope and eliminate multiple, within-year hikes and consequent budget rectifications.

33. Steps are needed to clarify responsibility for developing macro-fiscal policy and forecasting, and improve the quality and transparency of these products. It is suggested that these activities be located in the MoPF, close to the budget preparation activities, but not part of the Budget Department, and that the Prognosis Commission be tasked with playing a quality assurance role—challenging MoPF assumptions.

THE WAY FORWARD

34. Going forward, Romania needs to focus on the five areas described above. Full absorption of structural funds of course requires adoption of the EU institutions, practices and procedures, and efforts in this direction need to be redoubled. The authorities need to strive to establish a project pipeline facilitating absorption of EU funds in a manner consistent with clearly articulated strategic priorities. The ability to do so will be significantly enhanced by general improvements in budgetary and expenditure management practices.

35. The Medium Term Expenditure Framework needs to be progressively deepened in successive budgets. This should aim at eliminating excessive initial budgetary submissions and the need for large cuts. It should seek to eliminate under-budgeting and chronic budget rectifications. A process for doing this needs to be agreed and adopted, and should be implemented in a staged manner in concert with the other reforms to public expenditure planning and management.

36. Specific recommendations for sectoral expenditure priorities have been outlined above. These were intended to reflect efficiency, growth and EU accession commitment considerations as well as being politically feasible and implementable. They are meant to be indicative and might well be refined. Needs and capacities will of course change over time so these levels of expenditures should continue to be reviewed on an ongoing basis.

xii Executive Summary

37. Financing expenditures in a macroeconomically sustainable manner will almost certainly involve increasing revenues. If the authorities are successful in planning and implementing increases in public expenditure of the magnitude described above, deficits of a magnitude that would violate the Stability and Growth Pact could emerge. Crafting responsible policies in this area will require balancing of improved revenue collection, increased tax rates, and further expenditure rationalization including perhaps some reconsideration of the timing of certain acquis commitments.

38. Improvements in public expenditure planning and management practices need to be introduced over time. These need to instill a greater strategic focus in expenditure plans. As with the improvement of the MTEF, the government needs to adopt a specific plan for doing this, building on the revised inter-ministerial committee structures recently adopted, clearly defining the roles of the MoPF, the PPU, the Chancellery, the GSG, and the ministry level PPUs and budget departments. The plan needs also to provide for progressive improvements in the budget circular and ceiling setting arrangements. Initial efforts in this area have been promising but a more coordinated approach with full and active participation of all relevant bodies is needed.

39. The government has made significant progress in bringing Romania to the cusp of membership in the European Union. It has gone through a long process structural reform and has put the country on a firmer macroeconomic footing. The challenge now is to make sure that planning and use of public resources is done in a manner that preserves macroeconomic stability while at the same time sustaining growth and competitiveness in the next stage of national development in the larger economic community of the European Union.

1. THE MACROECONOMIC SETTING

A. INTRODUCTION

1.1 Since the late 1990s Romania has instituted a successful stabilization policy and an active program of structural reforms. On the stabilization side the authorities tightened fiscal policies, largely through a succession of expenditure cuts amounting to more than 5 percentage points of GDP starting in 2001 and continuing to present. Monetary policy has shifted from exchange rate targeting to inflation targeting, and inflation has declined steadily from more than 50 percent at the end of the 1990s to around 9 percent as of end 2005.

1.2 Structural reforms have included extensive privatizations, termination of directed lending, a steady withdrawal of the government from banking sector, and a general shift towards use of market prices. There remain some structural issues such as those related to remaining subsidies and arrears. But there has been progress in bringing these down to more manageable levels, and firm transitional plans for them and for restructuring in energy, rail, district heating and mining have been put in place. Similarly, institutional reforms (judiciary, public service) started from about 2000 will be deepened further in the post-accession period.

1.3 The success in charting, and so far following, the reform path is readily seen in the re-emergence of growth, increases in FDI, and improvements in sovereign debt ratings.

1.4 These policy reforms have lead to strong growth, with GDP increasing to 8.3 percent in 2004. Surging private sector demand, fuelled by strong credit growth and wage increases caused the current account deficit to widen to 9.0 percent of GDP in 2005, despite strong growth of export demand, primarily from Europe. Although GDP growth settled back somewhat in 2005, concerns about overheating of the economy continue. At present, the expanding current account deficit is readily financed by a combination of foreign direct investment, privatization receipts, remittances and speculative capital inflows, and foreign exchange reserves continue to accumulate.

1.5 Liberalization of the capital account has facilitated capital inflows to a degree that is complicating the conduct of monetary policy. The strong supply of foreign capital has flooded the financial system with liquidity causing the lei to appreciate in real terms and contributing to a credit boom. The central bank gone as far as is prudent in controlling credit by administrative measures and has recently been sterilizing the inflows by raising interest rates. The difficulty with this, however, is that higher rates tend to induce even further capital inflows and currency appreciation. For this reason the IMF has consistently advised that the onus must be on fiscal policy to guard against overheating. There is further concern that while the appreciation associated with monetary tightening helps dampen inflation in the short run, it will ultimately undermine the competitiveness of the tradable goods sector, especially if accompanied by slack wage policies.

1.6 The Standby Agreement (SBA) that Romania had with the IMF went off track in late 2005 largely over disagreement over the appropriate fiscal stance and concerns about

14 Chapter 1: The Macroeconomic Setting

competitiveness. Contributing to this was a tax reduction embodied in the introduction of the flat tax in January 2005 which reduced revenues by approximately 1 percent of GDP. The Fund argued for tax increases in the course of 2006. None were agreed however. The authorities began discussion of reducing the VAT rate on food, and adopted a higher deficit target. During the Article IV discussion in April 2006 the authorities announced that they wished to discontinue the SBA discussions and would let the agreement lapse in July 2006.

Table 1.1: GDP Growth and Major Aggregates, 1996-2006

1998 1999 2000 2001 2002 2003 2004 2005 1/

Real economy (% change)

Real GDP -4.8 -1.2 2.1 5.7 5.1 5.2 8.4 4.1

Final domestic demand -0.7 -2.9 2.1 7.0 5.5 8.3 11.7 9.4CPI (eop) 40.6 54.8 40.7 30.3 17.8 14.1 9.3 8.6CPI (period avg) 59.1 45.8 45.7 34.5 22.5 15.3 11.9 9.0Unemployment rate (eop %) 10.4 11.8 10.5 8.6 8.4 7.2 6.2 5.8Gross national saving (% of GDP) 11.3 12.2 15.8 17.0 18.3 16.0 13.9 14.0Gross domestic investment (% of GDP) 17.9 16.1 19.5 22.6 21.7 21.8 22.3 22.7

Public finance (general government, % of GDP) 2/

Revenue 29.7 31.9 31.2 30.1 29.6 28.7 30.1 30.3Expenditure 35.1 35.5 35.3 33.3 32.3 30.9 31.1 31.1Overall balance -5.5 -3.6 -4.0 -3.2 -2.6 -2.2 -1.0 -0.8Primary balance -0.7 2.4 0.9 0.6 0.4 -0.2 0.2 0.3Total public debt 23.8 30.5 27.8 27.5 25.9 23.5 22.4 18.9

Money and credit (eoy, % change)

Real domestic credit 20.5 -7.6 7.9 28.0 32.3 56.9 40.4 44.7Broad money 48.7 44.9 38.0 46.2 38.2 23.3 40.1 33.8

Interest rates (%)

NBR interest rate (eop) 105.0 88.7 60.1 39.9 21.5 23.4 18.8 7.2Treasury bill rate (eop) 103.8 104.8 59.4 38.4 17.4 18.4 11.5 5.5

Balance of payments (% of GDP)

Trade balance -6.3 -3.5 -4.5 -7.4 -5.7 -7.5 -8.8 -9.9Curent account balance -7.1 -4.0 -3.7 -5.5 -3.3 -5.8 -8.5 -8.7External debt 23.5 25.6 29.8 32.8 32.8 32.9 35.1 32.4Official reserves (eoy, USD mn) 2,299 2,472 3,466 5,168 6,260 7,143 14,873 22,866Reserve cover (mths imports in EUR) 2.4 2.1 2.3 3.5 3.6 2.8 4.1 5.6

Exchange rate

Lei per EUR (eop) - - 2.4 2.8 3.5 4.2 4.0 3.7Lei per USD (eop) 0.8 1.8 2.6 3.2 3.4 3.3 2.9 3.1NEER appreciation (+) (%) -51.9 -39.8 -22.8 -22.3 -14.4 -11.1 -5.1 9.7REER appreciation (+) (CPI-based, %) 16.5 -15.0 9.3 1.5 2.6 0.4 4.0 17.0REER appreciation (+) (ULC-based, 3 mth MA, %) 37.9 -21.8 -0.3 -0.9 -6.5 -5.5 5.0 23.4

Social indicators (reference year)

Per capita GDP 2005 4445 USD

Income distribution GINI coeff 2000 30.3

Poverty rate 2002 18%

Primary education completion rate 2002 94%

Gender pay gap 2003 18%

Life expectancy at birth 2003 74.9Infant mortality per 1000 live births 2002 19

* September - September

1/ 2005 figures are preliminary estimates.

2/ As per IMF, beginning 2004, fiscal data are based on a new classification and not comparable with series before 2004.

Source: IMF staff reports, national authorities. 1.7 While there is disagreement about the appropriate stance of fiscal policy, there is general recognition that public expenditures should be geared to the needs of sustained growth in the post-accession period. There are several important aspects to this. First, there is a need to upgrade public infrastructure that has deteriorated through years of under investment, poorly planned investment and inadequate maintenance. Second, there are specific requirements for expenditures under the terms of the Acquis Communautaire, many of which are related to environment and transportation infrastructure, and will entail substantial capital outlays and ongoing maintenance expenditures. Third, investments in human capital will be needed to

Chapter 1: The Macroeconomic Setting 15

underpin the competitiveness of the Romanian workforce. Finally, upon accession the budget will have to accommodate the contributions to the EU budget as well as counterpart funds required if Romania is to tap the large package of EU grants.

1.8 The situation with respect to resource constraints is changing. Both public and private access to international capital markets has improved sharply. The European Union will offer substantial grant funding under the Structural and Cohesion funds as well as the remaining Pre-accession resources. Other international financial organizations including the European Bank for Reconstruction and Development, the World Bank and the European Investment Bank stand ready to lend as well, in some cases on favorable terms. Tax revenues have responded to renewed GDP growth, and there is scope for further revenue enhancement through improved tax administration and collection mechanisms. It is tempting therefore to contemplate a major increase in public spending drawing on these new and expanding sources of funds. Such a decision, however, needs to be tempered by two key considerations: the near term need for macroeconomic stability; and the objective achieving longer term economic growth.

B. SHORT RUN MACROECONOMIC STABILITY

1.9 Increases in public spending add stimulus to the economy. The stimulus tends to result in increased output if there is slack in the system (unemployment and excess capacity), and it tends to result in price increases if there is little slack. Such stimulus also tends to increase imports, driving the current account into deficit and increasing external debt. There may be times when such stimulus is needed and when it is appropriate to run external deficits. For instance, if private sector demand slows or if export demand slumps causing the economy to weaken, increases in public sector demand may help bring the economy back up to potential. However, if private sources of demand are strong, additional demand from the public sector may trigger inflation and result in excessive accumulation of external debt.

1.10 The extent of the stimulus from public spending depends on the method of finance. If spending is financed by raising taxes, the stimulus is largely offset by the fact that the higher taxes cause private households and enterprises to reduce their spending. If the spending is financed by borrowing, the stimulus is much stronger because there is no offsetting tax effect. It is for this reason that the IMF focuses on the fiscal deficit as a key policy target when discussing inflation and the current account deficit. When transition economies, including Romania, experience strong private demand and are still struggling to keep inflation in check, it is difficult for them to find the “fiscal space” needed to meet the perceived need of higher public expenditures. Setting stringent fiscal deficit targets precludes the use of borrowing to finance public spending. While there has been an active debate about the appropriate measurement of fiscal space and alternatives to the IMF approach (see Box 1.1) the basic point is that decisions about the level of public expenditure must take into account both the current state of demand emanating from the other sectors of the economy (private and external), and the means of financing such public spending.


Box 1.1: Measuring Fiscal Space The traditional IMF approach to measuring the fiscal stimulus focuses on the overall fiscal balance, sometimes referred to as the cash balance. It is equal to current revenue less recurrent and capital spending. This approach has been criticized by some who note that it treats recurrent and capital the same, despite the fact that investment expenditures yield future returns in the form of services, growth, tariffs and taxes, which recurrent spending does not, and that these future flows are ignored. The contention is that, governments constrained by such a deficit ceiling will be prone spend less than optimal amounts and that there will be an anti-investment bias in expenditure decisions, because of the ignored future returns. Accordingly, alternatives have been proposed including one in which public expenditure is conditioned by a deficit rule based on net worth (as is done in New Zealand) which includes these future streams. In the UK a "Golden Rule" is followed which targets only the current balance. The idea here is that you can borrow for capital spending but not for recurrent because the capital spending will in some sense pay for itself. Roughly speaking these alternatives are likely to result in more borrowing and an increased level and/or share of capital in overall public spending. Indeed the point of the exercise in the UK was to boost what was perceived to be inadequate capital spending. However, there are some caveats to these alternatives: Capital spending adds to aggregate demand too. In the short term, changing the composition of additional spending as between recurrent and capital makes very little difference to the macro situation. There may be small differences in the balance between increases in imports and increases falling in demand on suppliers depending on the nature of the expenditures. But this only shifts the impact effect slightly between bigger current account deficits and higher domestic prices. Grants create price pressures. Grants such as those from the EU structural funds create fiscal space in the technical sense that they allow for additional expenditure without affecting the IMF’s cash balance measure of the deficit and without requiring additional taxation (leaving counterpart fund issues aside). While they do not affect external debt, it should be noted that these expenditures do add to aggregate demand and price pressures just like debt financed expenditure. Similar effects result from expenditures financed form privatization receipts, remittances and in fact any other non-tax source of finance. The Golden Rule is not so golden if the expenditures are inefficient. Capital spending will not “pay for itself” unless the investments yield a reasonable return. This requires that project planning and execution meet certain minimum standards, which may be hard to do in the context of rapid expansion. It is also important to distinguish between investments that increase the future tax base as say highways might, by raising productivity and growth, and those such as pollution abatement, which may have a high social rate of return, but little or no payoff in terms of higher future tax collections.

C. LONGER RUN GROWTH NEEDS

1.11 It is important to distinguish between the short run and the long run in making public expenditure decisions. Cyclical demand, and to a certain extent “fiscal space” issues, are shorter term in nature and are fundamentally different from the issue of choosing the appropriate level of sustained public spending from the point of view of optimal investment and growth.

The Experience of the Older European States

1.12 A number of the older European states have taken steps to cut the size of their public sectors. The so-called “expansionary fiscal contractions” were carried out in Ireland, Denmark and Sweden, where the decrease in public spending was accompanied by significant


improvements in these countries’ macroeconomic performance, led by consumption booms.1 Experience suggests that public expenditure optimization is central for a successful fiscal consolidation.2 Various empirical studies show that expenditures cuts were realized mainly in the economic services provided by the government and in social outlays, such as housing amenities and spending on education and health. Subsidies and current transfers were also reduced.

1.13 The budget expenditures positions, where the largest adjustments were made are as follows:

• Social security and welfare payments. In most of the Nordic countries eligibility criteria for unemployment benefits were tightened and the pension system was thoroughly reformed.

• Wages and salaries. Cuts in the government employment accompanied by moderate increases of the wages in the public sector in an environment of high economic growth were an important factor for the fiscal consolidation in Ireland in 1988-89. Irish government adopted schemes for early retirement of public employees, while the rapidly expanding economy absorbed the released employees in the private sector. As for the wage moderation, it was largely accepted after the government carried out broad tax cuts.

• Health and education. Ireland and Sweden present good examples for successful reforms in the healthcare and education respectively.

• Subsidies and transfers. Subsidies in Romania are high as compared to the new EU member states.

Table 1.2: Expenditure Adjustments in Select EU Countries in the 1990s

Ireland Denmark Finland Spain Sweden

Netherlands

United Kingdo

m

(Changes in percent of GDP)

1988- 89

1995-97

1984-85

1996-97

1994- 97

1994 -97

1994- 97

1994- 96

1994- 97

Average

Total expenditures -11.4 -6.2 -5.2 -3.8 -10.9 -6.6 -8.5 -5.2 -5.9 -7.2

Defense -0.1 -0.2 -0.5 -0.1 -0.2 -0.3 -0.4 -0.4 -0.9 -0.3

Education -1.3 -0.7 -0.8 0.3 -1.5 -0.5 -0.9 -0.6 -0.1 -0.7

Health -1.3 -0.5 0.0 -0.1 -0.2 -0.5 0.6 -0.2 -0.2 -0.3 Social security & welfare -2.5 -2.1 -1.7 -2.5 -8.0 -2.6 -5.8 -2.2 -2.3 -3.4 Housing & other amenities -1.6 -0.3 -0.6 0.0 -0.3 -0.1 -1.9 -1.1 -0.3 -0.7

Economic services -2.9 -0.3 -0.8 -0.1 -1.9 -1.6 -3.7 -0.1 -0.9 -1.4

Interest payments -1.1 -1.8 1.3 -0.8 0.9 -0.3 1.0 -0.5 0.4 -0.2 Current expenditures -10.8 -5.7 -4.7 -3.5 -10.8 -5.5 -7.6 -4.5 -4.4 -6.6 Expenditures on goods and services -1.8 -1.3 -1.1 -0.2 -1.1 -1.8 0.0 -0.2 -1.2 -0.9

Wages and salaries -1.0 -1.1 -0.8 -0.2 -1.0 -1.1 -0.3 0.0 -2.0 -0.7 Other purchases of goods and services -0.8 -0.2 -0.3 0.0 -0.1 -0.6 -0.6 -0.2 1.0 -0.4

Interest payments -1.1 -1.8 1.3 -0.8 0.9 -0.3 -0.6 -0.5 0.4 -0.2 Subsidies and transfers -7.9 -2.7 -4.8 -2.5 -10.6 -3.4 -8.6 -3.8 -3.6 -5.5

Subsidies n.a. n.a. n.a. -0.1 -6.0 -0.4 -3.4 0.5 -0.3 -1.9 Transfers to other levels of government n.a. n.a. -3.5 -1.6 -4.4 -0.6 -1.7 -1.4 -1.7 -2.2

Capital expenditure -0.6 -0.4 -0.5 -0.3 -0.2 -1.2 -0.8 -0.6 -1.5 -0.6

Source: IMF(2003), Hungary: Selected Issues, Country Report No. 03/125.

1 For further information on the expansionary fiscal contractions see Bergman and Hutchison (1997). 2 See for example Sanz and Velazquez (2003) or Schneider and Zapal (2005) for references on studies on the relationship between successful fiscal consolidations and expenditures cuts.


The Experience of the Recently Acceding States

1.14 Within the eight countries from Eastern Europe and the Baltics generally, two groups can be distinguished. These are the countries that are subject to excessive deficit procedures (EDP) under the Stability and Growth Pact (SGP), and those that comply with the 3 percent fiscal deficit rule. Low budget deficits and public debt levels characterize the group of the so-called non-EDP countries, consisting of Estonia, Latvia, Lithuania and Slovenia. Slovakia has recently joined this group of good performers, as its government has carried out a major fiscal reform in the recent years and as a result, has managed to decrease significantly the level of budget deficit and public debt. By contrast the Czech Republic, Hungary and Poland are still struggling to meet the SGP criteria.

Figure 1.1: Net Lending (+) / Net Borrowing (-) (% GDP)

Source: European Commission (2004).

1.15 Table 1.3 indicates that successful fiscal consolidations in the EU8 prior to accession have been accompanied by cuts in public spending between 2000 and 2003, going as high as 18.7 percentage points of GDP in Slovakia. Furthermore, while capital expenditures have generally grown, current spending has been significantly reduced in the group of successful reformers. The largest cuts were made in social transfers and in the compensation of employees. Interest expenditures have decreased as a result of the favorable international conditions and debt restructuring in the five reformers. Public expenditures in the immediate post-accession period appear to have been growing, mostly due to the higher capital expenditures. Meanwhile current spending has declined with the government collective and individual consumption decreasing significantly.

-13.0

-11.0

-9.0

-7.0

-5.0

-3.0

-1.0

1.0

3.0

5.0

% G

DP

2000

2001

2002

2003

2004

2005

2006

2007

CZ

EE

EU-15EU-25SKSLPLHULTLV

Source: European Commission (2004)


Table 1.3: Fiscal Adjustment Prior to Accession, 2000-03 (change in percentage points of GDP)

Estonia Latvia Lithuania Slovenia Slovakia Czech Hungary Poland Government consumption expenditure

-0.9 0.6 -3.0 0.3 0.8 1.6 3.5 0.7

Of which compensation of employees

-0.6 -0.1 -1.7 0.5 0.2 1.2 2.8 -0.1

Social transfers other than in kind

-0.4 -3.0 -1.4 0.0 -1.4 0 1.4 0.9

Interest 0.0 -0.2 -0.4 -0.3 -1.5 0.3 -1.5 -0.2

Subsidies -0.1 -0.2 0.0 0.2 -0.8 -0.1 -0.2 -0.2 Total current expenditure

-1.1 -3.8 -4.9 -0.2 -10.9 2.2 3.5 1.5

Gross fixed capital formation

0.3 0.1 0.6 0.2 -0.2 1.5 0.2 0.9

Other capital expenditure

-0.7 -1.0 -1.9 -0.4 -9.6 6.8 -0.6 0.5

Total expenditure -1.2 -2.9 -5.8 -0.4 -20.2 11.4 2.7 0.6

Total revenue 1.3 -1.3 -3.4 1.0 -11.7 2.5 -0.7 -1.6 Net lending (+) or net borrowing (-)

3.2 1.6 2.3 0.8 8.5 -8.8 -3.5 -3.2

Source: European Commission.

Table 1.4: Immediate Post-Accession Fiscal Adjustment, 2003-05 (change in percentage points of GDP)

Estonia Latvia Lithuania Slovenia Slovakia Czech Hungary Poland Government consumption expenditure

-1.1 -2.6 -1.1 -0.5 -1.1 -1.5 -1.5 -0.7

Of which compensation of employees

-0.4 -0.2 0.0 -0.3 0.1 -0.3 -0.9 -0.6

Social transfers other than in kind

0.6 -0.2 0.2 -0.5 -0.4 -0.4 0.3 -0.9

Interest -0.1 -0.1 -0.4 -0.5 -0.3 0.1 -0.2 -0.3

Subsidies 0.5 -0.2 0.2 -0.2 0.0 0.3 0.2 0.7

Total current expenditure 0.2 -2.2 0.0 -0.8 -1.6 -1.3 -0.9 0.3

Gross fixed capital formation

-1.1 0.8 0.7 0.0 0.0 1.6 -0.1 0.6

Other capital expenditure 0.5 1.2 0.9 -0.4 1.3 -8.7 -0.2 -0.2

Total expenditure 2.2 1.4 1.4 -1.3 1.5 -8.5 -0.9 -0.8

Total revenue 1.1 1.4 0.6 -0.4 1.1 0.8 -0.5 0.5

Net lending (+) or net borrowing (-)

-1.5 0.0 -0.8 1.0 -0.3 9.3 0.4 1.2

Source: European Commission.

1.16 Several studies on successful fiscal consolidations are suggestive of how cuts ought to be made. Sanz and Velazquez (2003) findings on OECD countries suggest that spending on defense can be reduced significantly, while spending on education should decrease less than proportionally to total expenditure cuts, since, if efficiently used, human capital accumulation might contribute significantly for enhancing growth potential in the long run. The rest of the functions—social security, public services, health and transport and communications—do not


have any significant relationship with government size according to Sanz and Velazquez (2003). Therefore these functions may be reduced proportionally to the decrease in total public spending.

D. IMPLICATIONS FOR ROMANIA

1.17 In most respects Romania is like the group of four good reformers among the EU-8, and like the fiscal consolidators among the older EU member states. Romania has already cut expenditure by more than 5 percentage points of GDP. The deficit has been reduced steadily since 2000 and was under 1 percent of GDP in 2005.

1.18 External and public debt are judged to be sustainable over the medium term, with external debt rising slightly to 35 percent of GDP. The ratio of public debt to GDP is lower than all the countries but Latvia and Estonia. It currently stands at 19 percent of GDP and, with primary deficits of 1 percent of GDP, would fall and stabilize at around 13 percent of GDP by 2010-2011.3

1.19 The expenditure, deficit and debt figures are even more modest if one takes into account the effect of the informal economy. GDP is understated because official statistics do not capture Romania’s relatively large informal economy, which means these measures are an even smaller proportion of true GDP. The informal economy is estimated to be 21.5 percent of the formal economy as compared with 16.4 percent in the EU8 and even less in the old member states.4

Figure 1.2: General Government Expenditure, (% GDP)

Figure 1.3: Government Balance (% GDP)

0

10

20

30

40

50

60

LT

U

IRL

ES

T

LV

A

RO

M, 2004

SV

K

ES

P

BG

R

PO

L

CZ

E

LUX

CY

P

GB

R

NLD

GR

C

DE

U

SV

N

MLT

PR

T

ITA

AU

T

BE

L

HU

N

FIN

DN

K

FR

A

SW

E

HU

N

PR

T

GR

C

ITA G

BR

DE

U

MLT

SV

K

FR

A

CZ

E

PO

L

CY

P LU

X

SV

N

AU

T

RO

M, 2004 L

TU

NLD

BE

L

LV

A

IRL E

ST

FIN SW

E BG

R

DN

K

ES

P

-8

-6

-4

-2

0

2

4

6

3 IMF Article IV Staff Report, April 2006 4 United Nations Economic Commission for Europe, Non- Observed Economy in National Accounts, April 2006


Figure 1.4: Inflation Rate Figure 1.5: Government Debt (% GDP)

0

1

2

3

4

5

6

7

8

9

10

FINNLD

DNK

FRAAUT

GBR IT

ABEL

SVNSVK

GRC

LUX

BGR

ROM E

ST

LU

X

LV

A RO

M LT

U

IRL

SV

N

BG

R

CZ

E DN

K

SV

K FIN E

SP

GB

R

PO

L SW

E

NLD H

UN A

UT

PR

T FR

A CY

P MLT

BE

L

ITA

GR

C

DE

U

0

20

40

60

80

100

120

Figure 1.6: CA Gap (% GDP)

MLT

LV

A BG

R

ES

T PR

T

GR

C

RO

M HU

N

ES

P

LT

U CY

P

SV

K

GB

R

CZ

E

PO

L

FR

A

ITA

IRL

SV

N

BE

L

FIN D

NK

AU

T DE

U

SW

E

NLD LU

X

-15

-10

-5

0

5

10

Source: Eurostat.

1.20 The spending cuts made in Romania were made rather differently than in the other reforming countries. Interest payments played a much larger role in the fiscal consolidation than in the other countries. In Romania capital spending declined in the late 1990s and remained at relatively low levels thereafter. Capital spending generally rose in the other countries. Similarly, the other countries maintained higher levels of education expenditure during the consolidation than did Romania. The composition of spending can give strong clues as to the quality of spending, and this issue is explored further in the next chapter.

1.21 Romanian public spending is less than most other European countries and less than many peers at similar levels of income. This leads to the question “Is it spending sufficient to sustain growth?” Table 1.5 shows per capita Gross National Income (GNI), revenue and expenditure revenue as a percent of GDP and real growth rates for selected countries, ranked by level of expenditure5. Romania is about two thirds of the way down the list. Above it are all the new member states and, although not all of them are shown, all the older European states have higher expenditure to GDP ratios than Romania as well. At a similar level of per capita income, Bulgaria spends a full 10 percentage points of GDP more than Romania. Below Romania is a group of countries which includes two distinct categories. The first consists of very poor

5 In the recently adopted ESA95 classification system, Romanian expenditure is also among the lowest in Europe, although slightly higher than the in the data presented here


countries, largely in central Asia, that have small and poorly functioning state sectors. The second is a more dynamic group including such countries as Korea, Chile and Thailand which have small public sectors and which have managed to achieve sustained periods of high growth. This fits with the notion that public spending may “crowd out” private investment and growth.

Table 1.5: General Government Expenditure Revenue, 2004

GNI per capita Revenues Spending Real GDP growth

Country (US$ PPP, 2004) (in % of 2004 GDP) per capita (1999-2004)

Croatia 11,670 47.2 51.6 4

Hungary 15,620 43 49.3 3.3

Greece 22,000 43.6 48.3 3.4

Turkey 7,680 42.2 47.2 2.5

Poland 12,640 41.4 44.2 3

Slovenia 20,730 41.7 43.1 2.8

Czech Republic 18,400 38.6 41.9 3.3

Bosnia and Herzegovina1 7,430 40.3 40.5 3.2

Bulgaria 7,870 41.7 40 5

Spain 25,070 40 39.6 2

Ukraine 6,250 34.9 39.4 7.3

Slovak Republic 14,370 35 38.9 3.3

Estonia 13,190 39.6 37.9 6.3

Latvia 11,850 34.8 35.9 7

Macedonia, FYR 6,480 36.6 35.9 0.7

Moldova 1,930 32 34.4 3.7

Ireland 33,170 34.5 34.3 4.9

Russian Federation 9,620 32 34.1 5.8

Lithuania 12,610 31.4 33.6 6.1

Uzbekistan 1,860 32.3 32 2.8

Romania 8,190 29.6 30.7 4.4

Malaysia 9,630 23.5 28.8 1.4

Albania 5,070 23.7 28.7 4.7

Georgia 2,930 22.1 28.2 4.6

Kyrgyz Republic 1,840 23.5 27.4 3

Azerbaijan 3,830 27.3 26.6 7.2

Kazakhstan 6,980 25.1 23.4 9.7

Chile 10,500 23.3 21.1 3.2

Armenia 4,270 19.2 20.9 9.6

Korea, Rep. 20,400 31.1 20.8 3.7

Thailand 8,020 17.1 16.8 3.4 1/Relative to GDP adjusted for the size of the gray economy. Source: World Bank, national authorities as quoted in the Bosnia and Herzegovina Public Expenditure and Institutional Review.

1.22 Using estimates from a regression of average primary expenditures on GNI per capita, Romania’s level of expenditure is lower than predicted. The gap is the equivalent of almost 5 percentage points of GDP and is likely to become larger as incomes increase. Romanian expenditure is particularly low relative to the other recent acceding countries that, like Romania, face special new demands on the public sector including the need to contribute to the EU budget, and to meet commitments made under the acquis. Among the fast growing “Asian tigers” some


of which have lower levels of public spending, none has to contribute to the EU budget or meet costly environmental and transport sector commitments that Romania and other accession countries are bound to under the acquis.

Figure 1.7: Public Expenditure as a Share of GDP, and GNI per capita (%, US$ PPP)

Finland

Sweden

Denmark

France

Austria

Germany

Netherlands

Ireland

BelgiumItaly

United Kingdom

Hong Kong, China

Singapore

Spain

Korea, Rep.

Slovenia

Portugal

Hungary

Slovak Republic

Estonia

Poland

Croatia

Lithuania

Malaysia

Latvia

Bulgaria

Czech Republic

Greece

Romania

Mexico

y = -1E-08x2 + 0.0007x + 31.39

15.0

20.0

25.0

30.0

35.0

40.0

45.0

50.0

55.0

60.0

5,000 10,000 15,000 20,000 25,000 30,000

Source: World Bank, national authorities as quoted in the Bosnia and Herzegovina Public Expenditure and Institutional Review.

1.23 It does not follow that Romania should automatically raise spending to levels found in other countries. There are two main reasons for this.

1.24 First: expenditure increases, especially in the shorter term should not be made in a manner that creates significant additional fiscal stimulus. This essentially means that additional spending should be largely tax financed. To the extent that revenue increasing measures are ruled out, spending will have to be correspondingly restrained. It is important to bear in mind that, while maximum use should be made of EU grant resources, grant-financed spending creates just as much fiscal stimulus as deficit-financed spending. Moreover, at least in the short run, the degree of fiscal stimulus is independent of whether spending is for public investment or for consumption-sustaining transfers.

1.25 Second: quality matters. While international evidence does not give a clear and unambiguous indication that the level of public spending affects economic growth, it is virtually certain that the quality of spending does. Quality is difficult to measure directly, but on indirect measures such as surveys of corruption and effectiveness of public administration, Romania


scores relatively poorly. This is disturbing. Among countries with poor quality public spending, growth may in fact be greatest for those that spend the least. Put another way, the optimal level of public spending depends on how well expenditures are planned and executed.

1.26 In the following chapters, we explore how Romania can contain expenditures to levels consistent with high quality public investment and meeting the needs of EU accession, while at the same time maintaining macroeconomic stability.

2. PATTERNS OF EXPENDITURE

A. THE CURRENT DISTRIBUTION OF EXPENDITURE

2.1 Table 2.1 shows expenditure by function for a selection of countries for which such data are available on a comparable basis at the consolidated general government level (see Box 2.1). Several features stand out. First, spending on education, at just 4.2 percent of GDP is lower than all but two of all 32 countries in the table, and represents only 74 percent of the average. On the other hand spending on economic affairs and housing and community amenities is well above the average. This reflects in part subsidies for energy, especially for gas and district heating. These patterns do not suggest there has been a strong focus on productivity-enhancing investment in physical and human capital. However, social protection expenditures (including pensions) which form the largest single spending item in most countries are a relatively modest 67 percent of the average in Romania.

Table 2.1: Expenditure by Function (% GDP)

Countr

y

Yea

r

Tota

l E

xpen

dit

ure

Gen

eral

publi

c se

rvic

es

Def

ense

Publi

c ord

er a

nd s

afet

y

Eco

nom

ic a

ffai

rs

Envir

onm

ent pro

tect

ion

Housi

ng a

nd c

om

munit

y a

men

itie

s

Hea

lth

Rec

reat

ion, cu

lture

and r

elig

ion

Educa

tion

Soci

al p

rote

ctio

n

Adju

stm

ent to

tota

l outl

ays

Sweden 2002 58.3 8.7 2.1 1.5 4.8 0.3 0.9 7.1 1.1 7.5 24.1 0.0Denmark 2003 58.2 8.4 1.7 1.1 4.0 na 1.0 5.9 1.8 8.9 25.4 0.0Hungary 2002 53.4 8.9 1.4 2.1 10.5 1.0 1.4 4.8 1.5 6.2 15.7 0.0France 2001 52.5 3.2 2.4 1.0 5.7 1.3 1.1 7.9 0.9 6.3 21.6 1.2Austria 2003 50.9 7.5 0.9 1.4 5.2 0.4 0.8 6.6 1.0 5.7 21.3 0.0Belgium 2002 50.5 9.9 1.2 1.6 4.6 0.7 0.3 6.7 1.2 6.4 17.8 0.0Slovenia 2003 49.4 4.9 1.3 1.9 4.8 0.8 0.9 6.8 1.7 7.5 18.8 0.0Norway 2003 48.9 4.8 2.0 1.2 4.4 0.8 0.5 8.4 1.2 6.6 19.1 0.0Germany 2003 48.9 6.4 1.2 1.6 3.9 0.6 1.2 6.5 0.7 4.1 22.8 0.0Finland 2002 48.7 6.1 1.4 1.4 5.0 0.3 0.5 6.3 1.2 6.6 21.3 -1.4Netherlands 2003 46.6 8.4 1.5 1.6 4.7 0.7 1.4 4.5 1.0 5.0 17.7 0.0Italy 2000 46.4 9.6 1.2 2.0 2.6 0.8 0.8 5.9 0.9 4.9 17.7 0.0Iceland 2002 45.8 7.4 0.0 1.9 6.8 na 1.1 9.1 3.0 7.2 9.3 0.0Portugal 2000 45.6 6.5 2.2 1.9 5.3 0.7 1.0 6.7 1.1 6.9 13.2 0.0Greece 1999 45.4 10.9 3.3 1.2 0.2 0.6 0.2 4.1 0.4 4.3 20.3 0.0Czech Republic 2003 44.4 4.4 1.9 2.4 7.0 1.1 2.0 6.6 1.0 4.4 13.6 0.0Poland 2003 44.1 5.3 1.3 1.9 3.2 0.8 1.3 4.2 0.7 5.8 19.5 0.0United Kingdom 2003 43.5 2.7 3.0 2.3 3.4 0.6 0.8 7.4 0.6 5.5 17.3 0.0Slovak republic 2003 42.0 5.0 1.8 2.0 4.7 0.8 1.1 8.4 0.9 4.4 13.3 -0.3Ukraine 2004 41.1 3.5 1.5 2.3 6.2 0.3 0.9 3.9 0.8 5.2 16.6 0.0Spain 2001 39.6 5.5 1.2 2.1 4.3 0.9 1.1 5.3 1.3 4.3 13.4 0.0Bulgaria 2004 39.5 4.3 2.3 2.8 5.0 na 1.5 4.7 0.8 4.3 13.8 0.0Russian Federation 2003 38.2 8.9 2.9 2.6 5.1 0.1 1.9 1.8 0.8 3.6 10.5 -0.1Switzerland 2002 37.9 5.3 1.2 1.8 4.3 0.7 0.4 4.2 0.9 5.8 13.3 0.0United States 2003 36.5 4.8 4.0 2.1 3.7 na 0.7 7.2 0.3 6.3 7.3 0.0Latvia 2003 35.0 4.6 1.3 2.4 3.5 na 1.8 3.3 1.4 6.1 10.7 0.0Romania 2002 34.4 4.1 1.4 2.4 5.3 0.1 2.0 3.9 0.8 4.2 10.2 0.0Lithuania 2003 33.5 4.6 1.6 2.0 4.4 0.2 0.6 3.8 0.9 5.9 9.7 0.0South Africa 2001 33.4 8.2 1.9 3.1 3.1 0.6 0.8 3.0 0.4 6.3 3.6 2.3Costa Rica 2003 24.9 5.4 0.0 1.8 2.4 na 0.5 5.1 0.2 5.2 4.2 0.1Mauritius 2003 24.5 5.1 0.2 1.9 3.2 1.2 1.4 2.1 0.6 3.9 5.0 0.0Singapore 2003 18.6 1.5 5.3 1.1 2.0 na 2.7 1.5 0.1 4.1 0.4 0.0AVERAGE 42.5 6.1 1.8 1.9 4.5 0.5 1.1 5.4 1.0 5.6 14.6 0.1Source: GFS

26 Chapter 2: Patterns of Expenditure

Figure 2.1: Expenditure by Function (% GDP)

0 2 4 6 8 10 12 14 16

General public services

Defense

Public order and safety

Economic affairs

Environment protection

Housing and community amenities

Health

Recreation, culture and religion

Education

Social protection

Adjustment to total outlays

AVERAGE

Romania

Source: GFS.

2.2 Spending by economic classification shown in Table 2.2 below, again demonstrates the greater share subsidies have in total spending in Romania. The relatively small amount spent on interest reflects the modest public debt levels in Romania. However, the most striking feature of this table is the sharply lower spending on compensation of public employees in Romania. It is less than half the level of other countries. This echoes the low level of spending in the education sector, which accounts for a substantial portion of public employment.

Box 2.1: Data Sources for Expenditures There are several sources and methods for recording public sector data. Individual governments have their own national systems. These are generally best for examining fine line- item detail, administrative structures and time trends within individual countries. However, national practices vary widely so for international comparisons it is more useful to rely on standardized international sources such as the GFS. The GFS data are generally available on a consolidated general government basis showing expenditure by function and economic classification according to a new standard established in 2001. Romania has just begun producing data on this basis and the first data are now published for 2002. These data are therefore used in the tables and figures below that compare the structure of spending across countries. It is important to recognize differences will occur between data from different sources. The GFS tends to have a broader definition of the public sector including some state-owned enterprises and other “off-budget” funds that may not be included in national source data. This tends to give larger measures of overall revenues expenditures and in some instances deficits as well.

Chapter 2: Patterns of Expenditure 27

Table 2.2: Expenditure by Economic Classification (% GDP)

Ye

ar

Exp

en

se

Co

mp

en

satio

n o

f e

mp

loye

es

o

/w w

ag

es

an

d s

ala

rie

s

Use

of

go

od

s a

nd

se

rvic

es

Co

nsu

mp

tion

of

fixe

d c

ap

ital

Inte

rest

Su

bsi

die

s

Gra

nts

So

cia

l be

ne

fits

Oth

er

exp

en

se

Ne

t a

cqu

isiti

on

of

no

n-f

ina

nci

al a

sse

ts

Sweden 2002 58.3 16.3 na 11.3 2.4 3.2 1.5 0.5 20.7 1.6 0.7Denmark 2003 58.2 17.8 16.6 8.7 1.9 3.4 2.1 2.2 18.4 1.9 1.7Hungary 2002 53.4 12.0 8.9 6.8 0.0 4.1 3.4 0.0 16.2 5.1 5.7France 2001 52.5 13.5 9.4 5.6 2.1 3.1 1.3 0.3 23.2 2.1 1.1Greece 1999 51.1 12.3 9.5 4.9 0.1 8.7 0.2 0.6 16.8 3.2 4.3Austria 2003 50.9 9.6 7.1 4.6 1.3 3.1 3.2 1.0 23.8 4.4 -0.1Belgium 2002 50.5 12.0 8.7 3.4 1.6 6.1 1.6 0.3 22.8 2.9 -0.1Slovenia 2003 49.1 12.8 11.1 10.3 0.0 1.6 1.4 0.0 18.6 1.7 2.8Norway 2003 48.9 14.1 11.7 7.1 2.0 1.8 2.6 0.9 17.9 1.5 1.0Germany 2003 48.9 7.9 na 4.0 1.6 3.1 1.4 0.8 27.6 2.7 -0.2Finland 2002 48.4 13.5 10.5 8.6 2.4 2.2 1.4 0.9 18.7 1.8 -1.1Netherlands 2003 46.6 10.3 7.8 6.7 2.4 2.8 1.4 1.2 19.9 1.0 1.0Italy 2000 46.4 10.4 7.4 5.6 1.3 6.5 1.2 0.1 18.9 2.6 0.0Iceland 2002 45.8 16.0 13.9 11.4 2.1 3.3 1.8 0.1 6.6 2.7 2.0Portugal 2000 45.2 15.0 11.8 4.4 2.1 3.3 1.1 0.2 14.0 3.6 1.6Czech Republic 2003 44.4 4.3 3.2 4.8 0.0 0.8 9.6 0.1 12.5 9.7 2.6Poland 2003 44.1 9.7 7.9 8.2 1.7 2.8 0.7 0.0 18.3 2.0 0.6United Kingdom 2003 43.5 10.5 8.7 11.5 1.0 2.0 0.7 0.2 13.7 3.4 0.6Slovak Republic 2003 42.0 8.7 6.5 6.4 0.0 2.5 1.8 0.1 17.5 2.6 2.5Ukraine 2004 39.8 9.7 7.6 6.0 0.0 0.9 2.4 0.1 15.5 3.4 1.9Spain 2001 39.6 10.4 8.0 4.2 1.5 3.2 1.1 0.1 14.2 3.1 1.8Bulgaria 2004 39.0 6.8 5.1 10.1 0.0 1.8 2.3 0.0 14.6 1.1 2.4Russian Federation 2003 38.1 8.1 6.6 7.1 0.0 1.8 5.2 0.0 10.3 0.3 5.4Switzerland 2002 37.9 11.1 9.4 5.7 0.0 1.8 3.5 0.6 9.2 3.5 2.5United States 2003 36.5 10.0 na 8.1 1.3 2.7 0.4 0.2 11.9 0.3 1.4Latvia 2003 35.0 8.9 7.2 6.0 0.0 0.8 0.8 0.0 10.0 6.6 1.8Romania 2002 34.3 6.9 5.4 7.4 0.0 2.2 2.0 0.0 9.6 3.3 2.8South Africa 2001 33.4 12.5 na 8.3 0.0 4.8 0.7 0.7 2.8 1.1 2.4Lithuania 2003 32.8 8.9 6.9 5.7 0.0 1.3 0.3 0.0 12.8 1.4 2.5Costa Rica 2003 24.9 10.3 9.3 3.2 0.0 4.3 0.0 0.0 4.9 1.1 1.1Mauritius 2003 24.5 8.2 8.1 2.9 0.0 2.8 0.8 0.1 4.7 0.6 4.3Singapore 2003 17.5 5.2 5.2 5.8 0.0 0.2 0.0 2.7 3.0 0.0 0.6

AVERAGE 42.5 10.7 8.6 6.7 0.9 2.9 1.8 0.4 14.7 2.6 1.8

Source: GFS

2.3 Figure 2.3 below shows capital spending for a selection of recent accession countries and higher growth emerging economies for which data are available. Capital spending in Romania spends is less than 3 percent of GDP—the second lowest of the group.


Figure 2.2: Expenditure by Economic Classification

0 2 4 6 8 1 0 1 2 1 4 1 6

C o m p e n s a t i o n o f e m p l o y e e s

U s e o f g o o d s a n d s e r v ic e s

C o n s u m p t io n o f f i x e d c a p i t a l

I n t e r e s t

S u b s i d i e s

G r a n t s

S o c ia l b e n e f i t s

O t h e r e x p e n s e

N e t a c q u i s i t i o n o f n o n - f i n a n c ia l a s s e t s

A v e r a g e

R o m a n ia

Source: GFS.

Figure 2.3: General Government Capital Spending

0 1 2 3 4 5 6 7

E s to n i a

R o m a n i a

T h a i la n d

L i t h u a n i a

P o r t u g a l

C h i le

S p a i n

S lo v a k i a

Ir e la n d

G r e e c e

B u lg a r i a

L a t v i a

H u n g a r y

S lo v e n i a

K o r e a

S i n g a p o r e

C z e c h R e p .

M a la y s i a

C a p i t a l E x p e n d i t u r e ( % G D P )

B. RECENT EXPENDITURE DYNAMICS

2.4 Total public expenditure declined by almost 5 percent of GDP between 2000 and 2005. Figure 2.4 captures the patterns of revenue and expenditure of the consolidated budget between 1995-2005 and the Government’s projections for the period up to 2009, measured as a percentage of GDP. In the first decade of transition both revenue and expenditure remained


relatively stable, with expenditure fluctuating somewhere around 34-35 percent of GDP, and revenue around 31-32 percent of GDP. After 2000, overall expenditure has gradually and continuously declined, cumulatively by approximately 4.7 percent, to around 30.5 percent of GDP in 2005. The adjustment in expenditure coincided with the resumption and subsequent robust expansion of growth.

2.5 Growth also enabled the Government to advance fiscal consolidation, and the overall budget deficit continuously declined from around 4.0 percent of GDP in 2000 to 0.8 percent of GDP in 2005. Fiscal consolidation represented a central pillar for the disinflation process during this period. Deficit cuts allowed for the partial containment of the aggregate demand expansion, as it occurred simultaneously with the continued pickup in private sector consumption, which is currently growing above its long term trend. As a result, inflation declined from above 40 percent in 2000 to 8.6 percent in 2005, the lowest level since the start of the transition.

Figure 2.4: Patterns and Projections of Revenue and Expenditure (% GDP)

Goods and services

Personnel expenditure

Capital

Subsidies

Transfers

Interest, public debt

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Romania MoPF.

2.6 Most of the downward expenditure adjustment during 2000-2005 is attributable to the significant decline in interest payments and public debt repayments. Interest payments declined from 5 percent of GDP in 1999 to 0.8 percent in 2005. This is a reflection of the significant reduction in Romania’s cost of borrowing in the international markets as a result of improved ratings as well as of the cutback in public borrowing in recent years, due to the substantial decline of the public sector deficits.


2.7 The Government envisages important changes in the allocation of expenditure by economic classification during 2006-09. For the interval 2006-09, the Government projects relatively stable overall revenue and expenditure shares in GDP, concomitant with a limited widening of the budget deficits, to accommodate the EU integration-related additional spending. However, by expenditure item, substantial reallocations are planned. This includes a large increase in transfers, cuts in good and services, mild increases in wages and salaries and a steady increase in capital expenditure.

2.8 However, there is a discrepancy between these projections, past expenditure patterns and expected costs of accession, which might lead to much higher budget deficits, in the absence of additional revenue enhancing measures, with consequences for macroeconomic stability, as explained below. The patterns of expenditure by economic classification have remained relatively stable in recent years, although the public sector wage bill had a tendency to expand, while capital expenditure has been cut in the last two years. Given the existing rigidity in current spending by item and the relatively low level of capital expenditure, it will be difficult to achieve savings in and/or substitute current expenditure. One needs therefore to realistically assess how credible the proposed changes are, and what the concrete implementation mechanisms would be, to avoid the widening of the budget deficits beyond the current projections.

2.9 Meeting the EU accession commitments can cost up to an additional 5.4 percent of GDP in public and private resources annually. The most expensive item is the implementation of the acquis for environment, which is expected to cost up to 2 percent of GDP on average annually over the next eleven years. This is significantly higher than the current expenditure levels for environment and water, which never exceeded 0.2 percent of GDP in the last ten years. Upgrading roads infrastructure to European standards will add up to another 1.1 percent of GDP per year, while rehabilitating the railway network would cost 0.4 percent of GDP per annum. Other additional large expenditure items include Romania’s contribution to the common EU budget, which is estimated at around 1 percent of GDP yearly, and the cofinancing requirements for the absorption of the European post-accession funds, which could cost up to another 1 percent of GDP, assuming a maximum absorption rate. [See the individual chapters for detailed costs analyses.]

2.10 Tension between current patterns and plans arises in areas which have traditionally exhibited important expenditure rigidity, primarily health, pensions and social assistance, and education. According to Figure 2.5 to accommodate additional expenditure necessary to finance the EU integration process, some important resource reallocations are planned in the functional classification of the budget. Transfers to the public authorities, primarily aimed at financing EU commitments at subnational level, are envisaged to more than double gradually, up to 2009, while expenditure on education would increase by an additional percentage point. To accommodate these changes, the main adjustments, in terms of shares in GDP, are expected to occur in social assistance and pensions and health. Evidence shows however that both the health and pensions systems have been chronically underfunded in the past. The public pension budget is being subsidized generously from the state budget, while health expenditure is already low in comparison to other European countries, which is also reflected in low health outcomes. Current situation indicates that, if anything, pressures will mount to increase public spending on education, health and social assistance.


Figure 2.5: Expenditure by Function (% GDP)

Ed u catio n

He alth

So cial

as s is tance ,

p e n s io n s

Re s e ar ch

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Pu b lic

au th o r it ie s

De fe n s e

Pub lic o r d e r

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

En vir o n m e n t

an d w ate r

A g r icu ltu r e

T r an s p o r t ,

co m m u n icatio n s

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009


2.11 There are systematic gaps between planned and actual expenditure at the level of individual sectors. Figure 2.6 compares the differences between actual expenditure and the initial budgetary allocations6, as approved annually through the budget law. An important feature is that, systematically, actual expenditure tends to be higher than planned. In transportation and agriculture, in particular, budget outturns exceeded initial allocations by more than 10 percent. Health, industry and public order were also sectors where actual spending was

6 The ratio between actual and initially planned expenditure in a sector (in percent), measured as shares of total actual expenditure, and total planned expenditure, respectively. We control this way for adjustments in expenditure in response to changes in the underlying macroeconomic variables.


always higher than planned budgets in recent years. At the other end, resources allocated to education seem to be constantly overstated, although this is one of the sectors that suffer from underfunding.

2.12 Interest payments were consistently overestimated during the period 2002-2005, by as much as 30 percent in 2004. This suggests that improvements in the projection of interest payments could lead to expenditure savings that could be distributed to priority areas during the preparation of the budget, and not subsequently, through rectifications, leading to more predictable revenue flows for the spending agencies.

Figure 2.6: Actual versus Planned Expenditure by Sector (percent)

Tra

nsp

ort

, co

mm

un

icati

on

s

Res

earc

h

Inte

rest

, p

ub

lic

deb

t

Ag

ricu

ltu

re

Ind

ust

ry

En

viro

nm

ent,

wat

er

So

cial

ass

ista

nce

, p

ensi

on

s

Hea

lth

Ed

uca

tio

n

Pu

bli

c o

rder

Def

ense

Pu

bli

c au

tho

riti

es

-40.0%

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

2002

2003

2004

2005


2.13 The erratic expenditure patterns and large departures in budget execution from initial planning, often visible, are a reflected in the rather ad-hoc rectifications that take place throughout the budget cycle. Budget rectifications take place several times a year, although with a reduced frequency in the last couple of years, and for a number of reasons. Some were driven by the need to contain budget deficits within the approved targets, on the back of poorer than expected revenue collection. Others were influenced by deviations in the dynamics of the underlying macroeconomic variables (growth, inflation, exchange rate, etc.) from the values assumed in the construction of the project of the budget, or by pressures to adjust expenditure for specific sectors or even programs, including retiring arrears (such as the arrears to the health suppliers at end-2005.

2.14 Rectifications often took the form of indiscriminate cuts across sectors and expenditure items, and monthly or quarterly caps and freezes, especially for capital


spending and public sector wages. For example, as a contingency measure to achieve the deficit target of 3.5 percent of GDP in 2001, the Government approved in one budget rectification the blocking of 50 percent of the capital expenditure entitlement for the fourth quarter of 2001 for the state budget, the social assistance budget; the Special Fund for Roads Modernization, and the Special Fund for the Development of the Energy System. Sometimes, rectifications resulted in large one off injections of money into the economy, with negative impact on disinflation. The November 2005 budget rectification introduced a fiscal stimulus of around 1.5 percent of GDP and turned an eleven-month budget surplus of 0.7 percent of GDP into a deficit of 0.8 percent of GDP.

2.15 The habit of rectifications seriously undermines the execution of the annual budget process. It thwarts achievement of the objectives of the Government program and implementation of the policy reforms and planned public investments. The establishment of an effective MTEF, improvements in the macroeconomic, revenue and expenditure forecasting capacity and better upfront budget planning, including prioritization and clearer policy direction, should reduce the frequency of the rectifications, improve predictability, and limit the fluctuations in expenditure appropriations.

2.16 The absence of a unitary pay and employment system in the public sector leads to the fragmentation of wage setting, which in turn maintains an endemic pressure on the budget. Currently there are hundreds of regulations that frame wage policy in the public administration. This structure complicates and segments salary setting and the wage bargaining process, resulting in large wage discrepancies both between public sector categories, as well as within the same group. This also makes it virtually impossible for the Government to establish an effective oversight and control of the overall public sector wage bill. As a result, actual spending on wages and salaries often departs from planned expenditure.

2.17 There have been instances when wage increases were not captured by the approved budgets. The 2006 approved budget is an example, where the 11 percent on average increases negotiated with the public sector trade unions (education, health, civil servants, etc.) were not budgeted. These situations exacerbate pressures on the deficit and can lead to arbitrary cuts across the expenditure spectrum or rationalization in other areas in order to stay within the deficit targets. They can also lead to wider budget deficits. There have been cases where public administration-wide wage and hiring freezes were imposed during the budget cycle, hampering the activity of the institutions concerned. In addition, they generate unanticipated inflationary pressures, complicating the conduct of monetary policy.

2.18 Given past patterns of expenditure and rectifications, it would seem that some of the expenditures projected in the most recent MTEF are unlikely to be fulfilled. In particular, the decline in pension spending as a share of GDP is unlikely given public pressures for reforms in the face of rapidly declining replacement ratios. The projected decline in health spending is also doubtful given the transitional costs of hospital rationalization and a well established pattern of underestimation of spending in the past. In education, the projected increases must be weighed against a pattern of chronic underspending in the sector.

2.19 Although the budget calendar is clearly defined, most of the actual budget preparation work takes place in the second half of the year, skewing and affecting the


effectiveness of the process. The absence of a real Medium Term Expenditure Framework compounds the challenges7. The calendar of the yearly budget cycle8 is regulated by the Public Finance Law (Law 500/2002), with the steps to be undertaken in the process clearly specified. However, much of the work done before August 1, when the final submissions come from the line ministries, has limited impact on the final budgetary allocations. This is attributable to a series of constraints ranging from the fragile linkage between strategic planning and budget formulation to the design and timing of the annual budget process. Improvements should be made in several areas. They should come under two main headers: a) reforms that improve the allocation of the public resources in the medium term; and b) reforms that improve the annual budget process.

2.20 Establishing a Medium Term Expenditure Framework (MTEF) is key to enhancing the effectiveness, transparency and predictability of public expenditure. This represents one of the major challenges of the current budget process and is fundamental for strategic planning and annual budget formulation to become effective. In its absence, goals, objectives and standards for key new policy areas may remain unclear and the appropriate level of budgetary resources for delivering these policies will be equally uncertain. The lack of an MTEF also means that there is no systematic process for reviewing the relative priority of the existing key policy areas at the centre of government, such that the existing pattern of resource allocation may result in relatively low priority policies receiving inappropriately high allocations and vice versa, often translating into unfunded mandates, where key policy commitments are constantly under-funded.

2.21 Expenditure allocations can be improved by bringing greater transparency to the economic, revenue, and spending forecasts underpinning the budget. If the budget process is to enjoy greater integrity and effectiveness, the economic and budget forecasts on which it is based need to be improved. The key objective is to ensure the independence and credibility of the forecasts. This can be achieved by: a) making explicit comparisons of the economic forecasts made by the government with forecasts made by others, including those in the EU, the private sector, academia, and the National Bank; b) publishing the assumptions underlying the forecasts, especially those of revenue and expenditure estimates for the medium term, and inviting comments; c) having the Ministry of Public Finance present the forecasts, especially of revenue envelopes, to the Parliament (perhaps in March as part of a Medium Term Budget Policy Statement), and in the Framework Letters, to make clear what the resource availability is anticipated to be, given tax policies; and, d) requiring that a baseline forecast9 is estimated and published in March, alongside the proposed policy changes to revenue and spending legislation. Comparisons of proposed policy changes with the baseline should include an estimate of the impact, if any, that those changes may have on the current law. (More specific recommendations along these lines are presented in Chapter 4)

7 The vulnerabilities of the current budget process and the absence of an effective MTEF, their consequences and suggested remedies are treated extensively in chapter 4. They are briefly touched upon in this section in order to emphasize their importance in determining patterns of expenditure.

8 In Romania, the fiscal and the calendar year coincide (January 1-December 31).

9 The baseline economic forecast should be the best assessment of where the economy is headed over the medium term assuming no change in the current laws and policies and not some kind of target of where the government would like the economy to be in the future.


2.22 The economic forecasting capacity of the Ministry of Public Finance needs to be upgraded. One way to enhance the capacity of the Ministry of Public Finance to produce credible economic forecasts is to establish a separate forecasting unit in the Ministry. Essentially, the role of the macroeconomic forecasting unit would be to produce the baseline forecast, estimate the impact of law and policy changes and feed them into the budget formulation process. To guarantee the integrity of the forecasts, the unit should not be part of the Budget Department. Another way to enhance the credibility and transparency of the budget process would be to create a nonpartisan, independent, objective analytical budgetary unit (similar to the U.S. Congressional Budget Office) that would provide an independent economic and budget assessment to the Romanian Parliamentary Budget, Finance, and Banking Committees. Such units are beginning to be formed in several countries around the world. One option is to relocate the forecasting duties of the National Commission for Economic Forecasting (which has also further responsibilities) from the Prime Minister’s office to a separate, independent entity. The primary purpose of this relocation is to decrease the probability of, or even the appearance of, political influence on the macroeconomic forecasts.

3. SECTORS

A. INTRODUCTION

3.1 This chapter summarizes public expenditure issues in five main sectors of the economy. These are education, health, agriculture, transportation and environment. In addition, there are brief notes on pensions and on the public sector wage bill. The main policy recommendations stemming from the analysis are presented here as well. More detailed analysis of each of the five sectors and the wage issue is provided in volume two.

3.2 Expenditure projection assumptions are given for each of the five sectors. The purpose of these projections is to underpin the macroeconomic analysis presented in Chapter 6. No attempt has been made to align the projections with the most recent Medium Term Expenditure Framework (2007-2009), either individually or in total. The MTEF is, in any event, subject to revision in successive budget cycles and a new one for the period 2008-2010 will be constructed along with the 2007 budget. Instead, the profiles presented here have been conditioned by two factors. The main one is that they conform to the sector analysis and recommendations, and thus reflect efficiency, growth and EU accession commitment considerations. The second is that they be politically feasible and implementable. There is a history of mid-year budget rectifications and there are some consistent patterns of deviation of the budget actuals from the forward MTEF figures. We want to avoid making improbable projections or projections that embody a likely need for corrections. For instance, the sharp expenditure reductions (as a share of GDP) projected for health and pensions in the current MTEF could, in principle, allow for expansion of spending in other areas without any increases in taxes or the deficit, but they are highly unlikely to be realized. On the other hand implementation constraints may prove some of the line ministry investment plans to be over ambitious. In situations such as these, we have tried to anticipate future adjustments and thereby construct expenditure profiles that are plausible as well as appropriate.

B. EDUCATION

3.3 Overall, the education system is underfunded, but spending is also inefficient, with the result that quality is low. Increases in funding are warranted, but only after the factors underlying the inefficiency are corrected.

3.4 The most worrying problem is the upper secondary school enrollment rate, which, at 54.6 percent, is very low by comparison to countries such as Poland, Hungary, Argentina, and Bulgaria, and the rural enrollment rate is just 8.6 percent. This threatens Romania’s growth and competitiveness. International experience shows that poor quality dampens demand for secondary school as much at any other single factor.

3.5 The means for improving quality and efficiency need to be sought, in part, by adjusting the level and composition of spending. By almost any comparative measure, spending on education in Romania is low. Official education spending has hovered between

38 Chapter 3: Sectors

three and four percent of GDP for years—much lower than most emerging economies with the possible exception of Bulgaria. Most years, expenditure is closer to 3 percent of GDP.

3.6 Teacher salaries are relatively low. In most countries with strong education systems, teacher salaries are significantly above the national average net earnings while in Romania they only slightly higher. OECD average teacher salaries are about 1.31 times per capita GDP and primary school teachers with 15 years experience earn about 1.4 times per capita GDP. For the group of middle income countries that are included in the OECD’s World Education Indicators (WEI), the figure is about 1.75 times GDP per capita.10 In comparison our data show that on average Romanian pre-university teachers (at all levels combined) earn about 0.95 times per capita GDP.

3.7 The salaries of the younger, entry level teachers are particularly low. Teaching is no longer attractive, and new entrants in the system are those who cannot find another job; thus, teacher quality appears to be declining.

3.8 Greater flexibility in the funding system is needed to make appropriate adjustments in the allocation of spending within the sector and improve efficiency. Spending is skewed away from primary and secondary schooling more than it is in other countries, and the share of education spending going to tertiary education is among the highest in the world. Basic education gets less than 40 percent of total education spending, just 1.18 percent of GDP.

3.9 Demographics present some special challenges. Adjustments in teaching staff levels have lagged the decline in population growth rates leading to somewhat low student teacher ratios especially in upper secondary school. However, the most pressing need is not to reduce the number of teachers, but to address the unacceptably low enrollment rates at this level and these, in turn, are related to quality and salary issues.

3.10 Budget processes and institutions are not designed to provide the necessary flexibility. Over the past ten years, Romania has received a great deal of technical assistance for education finance, budgeting and management. Much of this work has been of high quality yet little of it has been implemented. While a great deal of attention has been paid to budget procedures, expenditure norms, educational decentralization and formula funding, there are strong forces at work to preserve historical budgeting patterns and the historical process of budget negotiations between the central MER and MOPF. The key issue is how to deal with declining student-teacher ratios within a highly constrained and contentious human resource management and policy environment. Challenges include the following:

• The budget process is non-transparent, even secretive.

10 The WEI is run jointly by OECD and the UNESCO Institute for Statistics. The 19 countries included are:

Argentina, Brazil, Chile, China, Egypt, India, Indonesia, Jamaica, Jordan, Malaysia, Paraguay, Peru, the Philippines, the Russian Federation, Sri Lanka, Thailand, Tunisia, Uruguay and Zimbabwe. The figures for lower secondary and upper secondary in the OECD are, respectively, 1.30 and 1.39 times GDP per capita and for lower and upper secondary in the WEI countries are 1.94 and and 1.99 times GDP per capita.

Chapter 3: Sectors 39

• Local and county-level data are insufficient to support effective planning, budgeting, and funding formula development

• Local governments are reluctant to take on increased responsibility without control over salary negotiations, which currently are negotiated between the Ministries of Labor, Education and Research, Public Finance and the Labor Union—with intervention from the President.

• The MOER has a very weak hand in the budget and finance process, and thus the sector lacks a political and bureaucratic champion. Consequently:

o Cost savings identified and/or achieved by the MOER accrue not to the education sector but as general budgetary savings for the MOPF (which sets up a skewed incentive environment)

o The MOER must resort to the use of legal norms to defend against cuts and these norms are of questionable quality, thus further compromising effectiveness

o Categorical, per student funding formulas are likely the most effective potential tool for addressing these problems, but to date they have not been properly developed, analyzed, tested, or implemented

• The MOPF makes many decisions that affect the sector without apparently applying educational criteria, and without revealing the justification or logic behind them.

• Large discrepancies between proposed and executed budgets make planning very difficult. Budget timelines practically institutionalize such discrepancies.

Recommendations

3.11 Introduce new funding arrangements. It is critical that increases in resources be made contingent on explicit agreement with the relevant parties on key issues. This means that any increase in salary be used as an incentive to win concessions from teachers unions to achieve important efficiency gains including provisions for the following:

• Redeployment of teachers across levels of schooling to where they are most needed, which would also include local government having full power to restructure the school network (e.g., school closure, opening, and location);

• Redeployment of vocational teaching staff to general education or to other sectors (EU accession funds for the Ministry of Labor could potentially be used to retrain them);

• Redeployment of teachers across geographic jurisdictions;

• An increase in the average work load (number of required hours worked) by between 10 and 15 per cent;

• Increased flexibility of the weekly teacher load, and lengthening of the school year (fixing by law the number of days student should attend schools);

• Allowing some increased attrition in the teaching force;


• Support for the on-going decentralization and school-based management reforms by giving school directors more control over teaching hires, thus requiring

o concessions on the seniority system, o removal of the Inspectorat Şcolar Judeţean (ISJ, county school inspectorates) from the

hiring process altogether, o entrusting most personnel decisions to the school director, subject to local

government overview o conferring the right of school directors to fire teachers and non teachers after negative

assessment of their work, perhaps with the ISJ playing the role of "appeals court".

• Giving local governments full responsibility for setting complete school budgets, subject to some legal requirements. This will require careful coordination of this strategy with the development of the new per capita funding formula - which is likely to require the following:

o The replacement of the practice of retaining and automatically allocating local government funds from the VAT to pay salaries (known as the “sume defalcate”) with a strong per student categorical grant, including also allowances for maintenance expenditures;

o It also requires two very important achievements in the budget processes:

(i) The government must actually fund education at the predicted and budgeted levels;

(ii) Spending projections for local governments must be accurate (not overstated). This may require both carrots (incentives, matching grants, etc.) and sticks (sanctions and mandated spending levels). It will certainly require strengthening of sub-national revenues and perhaps revenue sharing or local control over resources. At a minimum, the rate of increase of the total grant amount to local governments must exceed the rate of increase of salaries.

3.12 Taken together, these concessions would increase the likelihood that increases in salaries would in fact improve returns to educational investment and result in better performance and schooling outcomes.

3.13 Increase the quality of pre-university schooling. Salaries to teacher should be increased to be more in line with Romania’s future European partners (in relation to per capita GDP). This needs to be complimented with additional amounts for teacher in-service training, small development grants to schools, teaching and learning materials, school supplies, texbooks, and library collections.

Expenditure Profile Assumptions

3.14 We have adopted the same increase for education expenditures as was provided in the MTEF namely a rise from roughly 3.7 percent of GDP in 2006 to 4.2 percent of GDP in 2009. (We note that there has been a recent rectification of the budget that will allow for additional transitional payments to teachers as a result of a court settlement relating to prior year wages.)


C. HEALTH

3.15 Romania needs to improve the efficiency of its health care spending and the single most important problem is the bias towards hospital-based service delivery. The evidence on this is clear. Romania has more than 16,000 inpatient surgical procedures per 100,000 population annually, the highest number in the ECA region. This is almost three times the EU average and is among the highest in all of Europe. Approximately 53 percent of the health budget is spent on hospital care, compared to the OECD average of 40 percent. At the same time Romania spends only 15 percent on outpatient care compared to an average of 35 in OECD countries. The proportion of total public spending devoted to primary care was decreasing until 2003. It increased in 2004 but was lower in real terms in than in 2000. The bias towards hospital care is also reflected in the number of inpatient care admissions which is much higher than in the group of countries that joined EU before May 2004, those that joined after and, even in Bulgaria and Croatia which are currently discussing accession arrangements. Moreover, the admission rates in Romania are rising.

3.16 After a period during the mid-1990s when health sector outcome indicators worsened, outcomes have improved slightly. But Romania still lags significantly behind the other European Union members. Moreover, there are large regional disparities in health outcomes, which are masked when looking at national averages. Infant mortality rates at the Judet level vary between 9 (Bucharest) and 25 (Ialoomita) deaths per 1,000 live births. This is partly the result of regional socioeconomic differences but also reflects wide disparities in the distribution of public resources for health.

Figure 3.1: Standardized Death Rates, all Causes and Ages per 100,000 1970-2003

400

600

800

1000

1200

1400

1970

1975

1980

1985

1990

1995

2000

2001

2002

2003

Romania

EU Members beforeMay 2004

EU Members SinceMay 2004

Source: WHO HFADB.

3.17 Romania has made important reforms already. It introduced mandatory universal health insurance. It has separated financing from service provision through the creation of the National Health Insurance House (NHIH), a purchasing agency in charge of buying health services from providers through its district health insurance branches. It has developed a hospital rationalization strategy. And it has recently passed a large package of laws aimed primarily at improving accountability and governance in the hospital sector.


3.18 The principle challenge now lies in implementing these initiatives in a coordinated and coherent manner and particularly in ensuring the reform program becomes more firmly anchored in the budget process. There are two aspects to this. The first is whether the budgetary resources that are envisaged for the sector over the medium term are commensurate with the task. The second is whether specific spending plans are in line with the overall thrust of reform agenda.

3.19 International benchmarking shows that while public spending on health as a share of GDP in Romania is in line with that of other countries with the same level of development, it is much lower than in most of the EU countries, a new reference point for Romania in light of its planned accession in 2007. The MTEF constructed along with the 2007-2009 budget projected a reduction in health spending from 3.3 percent of GDP in 2006 to 2.5 percent of GDP in 2009. This is not a realistic projection, even in a first best scenario in which the main source of inefficient spending—high spending in hospitals—is addressed immediately. Moreover, the experience of most countries in the European Union, is that the proportion of GDP spent on health tends to increase rather than decrease as GDP grows. The GDP growth assumptions in the MTEF would, by the end of the MTEF period, place Romania at a level comparable to the current GDP per capita in the high-income countries among those joining the EU since 2004—like Slovenia—or among low-income EU members like Greece or Portugal. Countries at that level of GDP per capita are spending at least 5 percent of GDP on health.

3.20 The Ministry of Health prepared projections for the 2006 to 2009, period which envisaged a three-fold increase in its own budget in 2007 and 2008 with a significant reduction in 2009. The large increases in 2007 and 2008 correspond to capital investment. The MoH is currently planning the construction of 8 regional hospitals with 500 beds each and 20 Judet level hospitals with 400 beds each. The plans are at a tentative stage and therefore it is not clear how they relate to the hospital rationalization strategy. Building these hospitals without proceeding to close down or restructure existing ones would add around 12,000 new beds to the current stock of hospital beds in Romania—a 7 percent increase in the total number of beds. This would contradict the recommendations of the hospital rationalization strategy that argues for a reduction in the bed stock.

3.21 Neither the MTEF nor the MOH projections fully reflect the potential costs (and savings) that could result from implementing the hospital rationalization strategy. The cost of implementation has not been estimated as part of the master planning exercise and this needs to be done. The Latvians did such estimates, and their experience may be useful since they faced very similar rationalization challenges. The Latvian authorities determined that it would be possible to reduce the total number of acute care beds from a total of 21,594 to 11,606. Some beds would be eliminated and others would be shifted to long term and social care facilities, and nursing homes. At the same time some facilities would have to be renovated and new facilities of different nature would have to be built. The cost of renovation was estimated in US$34.3 million and the cost of new construction in US$250.6 million. Extrapolating these numbers to Romania would mean that the total cost of hospital restructuring would amount to US$2.1 billion. This is not a small number, as the total public health budget per year is about US$2.5 billion. As for savings, a rough estimate suggests that shifting approximately 15,000 beds to long


term and social care would save approximately US$ 47.8 million per year, and closing approximately 60,000 beds would produce savings of the order of US$ 480 million per year.

Recommendations

• Redress the bias towards hospital-based service delivery. This will require further reductions in the number of hospital beds, the closure of some hospitals and greater specialization of services among the remaining hospitals and further expansion non-hospital-based service delivery mechanisms, in line with the Hospital Rationalization Strategy.

• Anchor reforms in the budget process. The budget and the medium term expenditure framework need to reflect adequately the transition costs of hospital rationalization, a practical approach to the opening of any new regional or local hospital facilities, and the transition to a level of health spending more consistent with that of recent EU accession countries and with Romania’s increasing per capita GDP. The full assessment of the fiscal impact of the new package health laws is needed.

• Improve payment systems This will entail extending the application of diagnostic related group systems, and developing new payment modalities to support models/facilities for service delivery outside the hospital system.

• Deepen accountability The policy objectives in outlined in the framework contracts need to be made consistent with the budget allocations. The misalignment of policy and budget strains accountability and renders the various ceilings ineffective and has resulted in chronic overspending in hospitals and accumulation of arrears.


3.22 To accommodate the transition costs of hospital rationalization and EU accession, we suggest that budget planning accommodate a gradual increase in health spending to around 4.5 percent of GDP by 2010 financed in part with the taxes provided for in the new package of health laws.

D. AGRICULTURE

3.23 In the agriculture sector the prospect of EU accession offers the potential for significant budgetary savings. At that time Romania will no longer operate a national agricultural and rural development policy, but will assume responsibility for the national implementation and management of the Common Agricultural Policy (CAP) that has been adopted by all EU members. The programs under the CAP (and the associated grants) offered by the EU will to a large extent substitute for existing national programs. Within the CAP however, there is considerable flexibility and Romania will be able to choose from a wide set of different instruments and implementation options. These strategic choices have implications for both the national budget and for sectoral development and income.

3.24 The focus here is on the budgetary implications of choices under the CAP. There are two basic types of decisions needed and these correspond to the so called “Two Pillars” of the CAP. Pillar 1 funds direct income support payments to farmers and market measures (buying of


products into public storage, surplus disposal schemes, and export subsidies). Pillar 2 supports rural development measures and, with the evolving shift of CAP priorities, will come to dominate policies in the rural sector over time.

3.25 The decision with respect to Pillar 1 directly affects the amount of budgetary savings. Under EU rules each country can supplement or “top up” the direct subsidies or single area payments made to farmers out of EU grant funds. If no top-ups are made, then no demands are made on the national budget for agricultural subsidies. The pre-accession subsidy regime, which in 2006 cost the budget approximately RON 2.0 billion (or Euro 557 million), would be replaced by the 100 percent EU-grant-funded direct payment system. If top-ups are made, they must be fully funded from the national budget (although there is some limited scope for using Pillar 2 grant funds for this purpose.)

3.26 Decisions relating to Pillar 2 also have budget implications. Approximately Euro 2.4 billion is available under Pillar 2 as grants for rural development measures over the first three years of accession. These funds must be matched by a 20-25 percent counterpart fund contribution from the national budget. Progress in this area has been lagging and there is a clear risk that funds will not be fully absorbed and at best will be delayed.

3.27 A third important decision relates to the other agricultural and rural development measures the government may wish to pursue. Volume 2 provides a more detailed assessment of what types of interventions are most effective, but generally, those that support sector restructuring and enhancement of competitiveness are most important. This calls into question whether resources used for interventions such as the large line of credit that the Ministry of Food Agriculture and Rural Development (MAFRD) is launching might be better directed at other activities including those which would promote absorption of Pillar 2 grants.

Recommendations

3.28 Limit the use of top-ups. Romania will have the option of supplementing the EU direct payments with so-called Compensatory National Direct Payments (CNDP) or "top-up" payments. Although MAFRD has not yet taken a formal decision on CNDP implementation arrangements, it has put in place a set of CNDP-type payments for 2006 already. These provide payments on a per-hectare or per-head base mainly to technical crops (e.g. flax, hemp), sugar beets, and milk producers. However, it is not recommended that Romania adopt the maximum CNDPs allowed for the post-accession period. This recommendation is based on several factors and is supported by a farm income impact analysis presented in Volume 2.

• The basic Single Area Payment Scheme (SAPS) payment granted in the first year of accession will, on average, compensate farmers in full for the income loss resulting from the shift to the lower EU market price support levels and would lead to an average income increase of 9 percent over the first three years, and 22 percent over the first five years of EU membership.

• Although other new EU member states have decided to introduce CNDPs, concerns about Romania's potential international competitiveness do not justify introduction of CNDPs


since the initial SAPS payment level (as well as rural development allocations) in Romania are higher than those in most other new member states.

• Although SAPS is granted based on agricultural land, there is no particular need for CNDPs directed at livestock producers as they would enjoy income increases through price increases for outputs, price decreases for inputs, and SAPS payments for forage areas.

• The low competitiveness of Romania's farming sector calls for competitiveness-enhancing investment measures rather than for direct income support payments. Agricultural support schemes targeting specific sectoral adjustment needs such as farm consolidation, productivity or competitiveness-enhancing farm-level investments would better addressed under Pillar 2 measures

• Direct income support payments reduce the incentives for farmers to restructure, consolidate, and modernize. By guaranteeing a minimum income from farming, these payments reduce the incentive for inefficient farmers to sell or lease their assets to more productive entrepreneurs. Direct payments effect land prices and land rental rates which may also make land consolidation more difficult, in particular in a farming environment in which agricultural credit is not well developed.

• The income effects of introduction the SAPS (and potentially CNDP) will be minimal for two groups of farms. First, are the 50 percent of farms below one hectare in size, because MAFRD has decided to establish a minimum farm-size threshold of 1ha. Farms below this size will not be able to apply for SAPS/CNDP payment. While, in the initial year of membership their exposure to changes in prices for agricultural produce under the CAP will safeguard certain income increases, in the medium-term the minimum farm size establishes a strong incentive for farm consolidation. Second, are farms in a size cluster between 5 and 50 hectares which will be disadvantaged by their non-competitive production technologies. As discussed above, low competitiveness as the principal development challenge cannot effectively be addressed via direct payments of SAPS or CNDP type, but calls for a consistent and targeted application of CAP Pillar 2 rural development measures.

3.29 Instead of a maximum top-up, consider a lower-cost strategy that takes advantage of rules that allow reallocation of EAFRD funds to CNDPs. There is a risk that Romania may not be able to use all its EAFRD funds. Such a reallocation would facilitate absorption. However, to fully exploit this opportunity Romania would not need to implement the full (30 percent of EU-15 CNDP) top-up that is allowed—a 10 percent of EU-15 CNDP would be enough and would correspond to an immediate average sectoral income increase of 13 percent for the first year of EU membership. This action is factored into the expenditure profile presented below.

3.30 Concentrate on building a pipeline of Pillar 2 activities. The elaboration of Pillar 2 measures is lagging. MAFRD is in the process of developing its Sector Operational Program for Agriculture and Rural Development and a recent draft of the National Strategic Plan proposes an indicative allocation of resources. But no decision has been made on the measures to be implemented and MAFRD has yet to define national application and eligibility criteria within a


more general set of criteria defined by the EC. If not addressed in a timely and appropriate manner, the implementation of CAP Pillar 2 measures might lead to a repetition of the poor performance and uptake of the SAPARD program. MAFRD programming efforts in particular require a clear family farm focus and must avoid a situation in which only (already well-performing) large-scale farming operations are once again the main beneficiaries of most support schemes. Half of all farmers (or even 98 percent of all farms smaller than 10 hectares are considered) may not benefit from or take advantage of Pillar 2 allocations. The economic and social implications of their failure to benefit from EAFRD allocations could be more pronounced than the exclusion of small farms from Pillar 1 support under the prospective minimum farm-size eligibility criterion.

3.31 Drop the line of credit. Given the urgency of defining the Pillar 2 program, the large the line of credit operation that MAFRD has been trying to implement has been an unfortunate distraction. The credit is based on fund from which banks could borrow at special low rates for onlending at slightly higher rates to farmers for specified purposes and with an eye to absorbing SAPARD funds. It has excessive budgetary resources (€194 million or 35 percent of expenditure on agricultural support) which leaves other pressing reform priorities under funded including those related to: land restitution; parcel demarcation and consolidation; the annuity scheme; upgrading of business advisory services (ANCA); support to setup of producer groups; support to functioning of commodity markets; and establishing the institutional setup for CAP management.

Table 3.1: Budgetary Implications of Sourcing Alternatives for CAP Support Payments, 2007–09

Required national contribution to

Funds available for Top-up (percent of EU-15)

Sourcing of top-upa Pillar 1

direct payments

Pillar 2 RDa

measures

Total Pillar 1 direct

payments

Pillar 2 RDa

measures

Total CAPb

(Pillars 1 and 2)

Share of national

contribution in total available

public funds

(million €) (million €)

0 n.a. 0 606 606 1,586 3,030 5,348 11.3% 10 NB 529 606 1135 2,115 3,030 5,877 19.3%

10 10% P2 + NB

335 558 892 2,115 2,788 5,634 15.8%

10 20% P2 + NB

141 509 650 2,115 2,545 5,392 12.1%

20 NB 1,057 606 1,663 2,643 3,030 6,405 26.0%

20 10% P2 + NB

863 558 1,421 2,643 2,788 6,163 23.1%

20 20% P2 + NB

669 509 1,178 2,643 2,545 5,920 19.9%

30 NB 1,586 606 2,192 3,172 3,030 6,934 31.6%

30 10% P2 + NB

1,392 558 1,949 3,172 2,788 6,691 29.1%

30 20% P2 + NB

1,198 509 1,707 3,172 2,545 6,449 26.5%

Note: a Acronyms: n.a.: not applicable; NB: national budget; P2: EAFRD allocation on Romania; RD: rural development. b includes €732 million for market measures under CAP Pillar 1. Source: World Bank calculations.


3.32 The credit line is an inappropriate instrument for facilitating absorption of SAPARD funds and the promotion of broad-based competitiveness-enhancing investments in family farms. The problem is not the availability or cost of loanable funds. The banking system has plenty of liquidity already. Consequently, the drawdown of the credit for onlending by the banks has been virtually nil. The real problems are the lack of collateralizable assets, appropriate risk mitigation instruments, and advisory services assisting farmers to comply with the complex funding applications. These are the main factors contributing to the low absorption rate of EU funds and the lack of effective rural credit opportunities.

3.33 It is therefore recommended that, going forward, no further resources be put into the line of credit, that MAFRD’s energies be devoted to CAP planning and implementation, and that its budget be directed into the counterpart funding needs of Pillar 2.


3.34 Expenditure for agriculture is projected according to several assumptions.

• The minimum direct payments are made according the requirements of the EU. • Top-up payments are limited to 10 percent and are implemented as recommended above

using resources from Pillar 2. • Absorption of remaining Pillar 1 resources is complete but back-loaded. • Administrative costs for implementing CAP are Euro 300 million per year • All other subsidies and expenditure programs including future line of credit allocations

are eliminated as the CAP is introduced.

3.35 The budgetary implications of the various top-up options are given in the Table 3.1 with the recommended option highlighted in the fourth row.

E. TRANSPORT

3.36 The government has prepared a Sector Operational Program for Transport (SOPT) which elaborates priorities for the allocation of EU grant funds for the development of the transport sector in Romania. The SOPT covers the period 2007–2013 and is targets improving transport infrastructure capacity and (to a limited extent) the network rehabilitation along the Trans-European Corridors IV and IX.

3.37 Romania plans to increase the level of investment in the transport sector in order to improve the quality of its infrastructure and bring this closer to EU averages. The required investments are significant, relative to the size of the country’s economy, primarily because of the historic pattern of underinvestment in the past decades, which has resulted in a large investment backlog. However, the government plans to implement public sector investments within a well defined medium term expenditure framework (MTEF) so as to maintain macroeconomic stability.


Roads

3.38 Funding for the road sector in Romania has been less than that required to maintain an efficient road network. The total spending on roads in Romania over the period 2000-2004 was on average about 1.01 percent of GDP. Maintenance spending in 2000-2002 was particularly low at 0.27 percent of GDP, well below the EU-25 average. The high share of rehabilitation spending in the past years has been due to the National Roads Rehabilitation Program that started in the mid-1990s, aimed at reducing the large backlog in maintenance and rehabilitation. This will need to continue in the medium term until the backlog of rehabilitation has been cleared. However, Romania’s planned accession to the EU in 2007, combined with the emphasis on developing the major Trans European Network Transport (TEN-T) corridors in order to expand infrastructure capacity, has led to a focus on motorway development. As a result, there is a risk that expenditure on maintenance and rehabilitation might be displaced in the coming years to finance construction of the motorway network.

3.39 Most of the increase in spending in the period 2003-2005 was the result of the disbursement of EU ISPA funds for capital expenditures and an increasing reliance on high-interest short-term commercial loans by NCMNR to finance maintenance (recurrent expenditures). The latter poses a serious concern. Analysis of the sources of funds during 2000-2005 needs to take into account the fact that this was a transition period which included the abolition of the Road Fund and the gradual introduction of the vignette system. What emerges from these changes is an increased dependence on borrowing and on EU grants to fund a growing level of expenditures, and less reliance on State budget and payments by road users.

3.40 NCMNR has increasingly used high interest, short-term commercial loans to finance road maintenance works, which should be paid for by road users. The total spending on roads (including debt service) increased during the period 2003 – 2005 to an average 1.51 percent of GDP. This has been financed by contributions from the general budget (32 percent, 0.49 percent of GDP), NCMNR revenues (17 percent, 0.25 percent of GDP), IFI loans (15 percent, 0.23 percent of GDP), Grants (16 percent, 0.24 percent of GDP), sovereign commercial loans (5 percent, 0.07 percent); and short-term high-interest commercial loans (16 percent, 0.24 percent of GDP.

3.41 The quality of spending is also a concern. The capacity to program, prioritize, and implement investments is well below EU benchmarks. The standard of project preparation is relatively weak, and economic analysis of projects is often lacking. Administrative capacity and financial planning for infrastructure projects is an issue for capital intensive projects such as motorway construction as well as for road maintenance. There are significant inefficiencies in the planning and implementation of road works. Any increase in financing for roads should be accompanied by capacity building measures to increase the efficiency and effectiveness of NCMNR operations. In 2004, a World Bank consultant estimated the potential savings on periodic maintenance costs of up to 43 percent. In 2003 and 2004, NCMNR spent on average 0.51 percent of GDP on maintenance or €20,500 per kilometer, significantly higher than the EU-25 average. Routine maintenance is still carried out by force account with close to 90 percent of NCMNR’s 6,700 staff.


3.42 The Government has a very ambitious plan for the road sector outlined in the 11-year strategy covering the period 2005 – 2015.11 Capital investments included in the plan (excluding maintenance) are estimated to cost around €17,655 million (27 percent of 2005 GDP) over the 11-year period, or €1,605 million per year. The plan includes:

• Construction of 1,569 km of motorways at a cost of €10,545 million. • Rehabilitation of 6,843 km of national roads along TEN-T network at a cost of €6,162

million. • Construction of by-passes estimated to cost around €834 million. • Bridge rehabilitation and upgrade estimated to cost €114 million.

3.43 In addition, based on NCMNR estimates, maintenance expenditures over the period 2005-2015 would amount to €4,351 million, or €2,894 million over the period 2007-2013.

Figure 3.2: Estimated Annual Road Expenditures Proposed in the Government’s Plan (% GDP)

Source: World Bank estimates based on “Road Strategy for the Development of the Transport Services during the Period 2005-2015” and NCMNR forecasts.

3.44 The plan would see a sharp increase in the pace of investment beyond levels of the recent past and far more than can be financed with EU grants. Total public expenditures linked to the Government’s Plan for the road sector over the period 2007-2013 amounting to 3.65 percent of GDP is relatively high. Capital expenditures in the roads sector alone would average more than 2.5 percent of GDP, with a peak of 3.5 percent of GDP in 2009. Romania has been spending on average in the three-year period 2003-05 some 1.33 percent of GDP on roads, of which an equivalent of 0.15 percent of GDP has been financed with ISPA funds. After

11 Road Strategy for the Development of the Transport Services during the Period 2005-2015.

% of GDP

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Total Current & Capital & Debt Service

Capital Expenditures

Current Expenditures

Debt Service (Principal)

Debt Service (Interest & Fees)


accession, EU Cohesion Funds and ERDF would annually provide 0.21 and 0.05 percent of GDP, respectively over the period 2007-2013, but the ISPA funds will cease shortly after accession, and the net increase would be only 0.14 percent of GDP annually. Hence, if only new EU grants were used to finance the road spending increase, the new level of spending would amount to some 1.47 percent of GDP annually, only 40 percent of what is needed to implement the Government’s ambitious plan.

3.45 It is unlikely that Romania’s public road agencies have the capacity to implement this increase in spending. It is also doubtful whether the road construction industry has the capacity to handle a three- to four-fold increase in road investment. Without careful planning, the proposed program may have a severe impact on construction prices because of the high demand and limited supply. Consequently, the Government will need to prioritize and pace the investment plan to match the capacity of road agency, the construction industry. Romania will need to increase the efficiency and effectiveness of public expenditures in roads where investments tend to be large. In a situation where the country is faced with significant need for basic public infrastructure combined with the challenge of improving competitiveness, the Government will need to be highly selective in choosing road investments with high economic returns and of strategic importance.

Recommendations

3.46 In view of the fiscal constraints on the government’s overall investment program, it is suggested that the capital investment program be prioritized to fit within a smaller budgetary envelop while making effective use of EU grants. This can be achieved through the following: (i) the motorways program should be rationalized, and its implementation staged by considering a longer period for construction of motorways; (ii) costs of rehabilitation and by-pass construction should be reduced (by at least 20 percent) by developing a more competitive construction industry; and (iii) the capacity of the road agency (NCMNR) to plan and implement projects should be improved.

3.47 Consequently, the main recommendations of this report for the roads sub-sector are:

• Revise the investment program based on a comprehensive and technically-sound economic analysis of the productivity and cost effectiveness of projects. This should also determine the consistency of the proposed investment program with the availability of financing, short-term macroeconomic stability, and (should the need arise) debt sustainability.

• Review the proposed, as well as ongoing, PPP transactions.

• Review the institutional organization of the roads sector (NCMNR) in view of making road management and maintenance practice more efficient and more cost-effective.

• Establish a sustainable framework for road user charges.



3.48 In line with the recommendations above an alternative expenditure program is proposed with a lower investment component and economies generated by more efficient maintenance outlays. Figure 3.3 below shows the expenditures and compares with the governments proposed plan in Figure 3.2 above. The underlying data are for the combined road and rail expenditures are given in Table 3.2 at the end of this section.

Figure 3.3: Annual Road Expenditures Alternative Scenario (% GDP)

% of GDP

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Total Current & Capital & Debt Service

Capital Expenditures

Current Expenditures

Debt Service (Principal)

Debt Service (Interest & Fees)

Source: World Bank estimates based on “Road Strategy for the Development of the Transport Services during the Period 2005-2015” and NCMNR forecasts.

Railroads

3.49 The rail subsector has struggled with a large scale restructuring stemming from a need to reduce an excessive asset base and from sharply increased competition from roads. This has involved tariff adjustments, large scale layoffs, some limited track closures and commercialization and separation of the system into passenger, freight and rail components.

3.50 Despite the adjustments, losses continue to mount especially in the passenger service company. It is unable to pay track access charges resulting in a shortfall in payments to the track company financed in turn by a build-up of arrears to the government. Faced with these challenges it is perhaps not surprising that a significant gap persists between Romanian and EU technical and operational standards.

3.51 The challenge for Romania is to ensure interoperability with other EU railways for a railway network of much the same density as Western Europe but with about 60 percent of the traffic density, half the labor productivity and with a tenth of the Gross National Income/capita. Against this background, the Ministry of Transport, Constructions and Tourism (MTCT) released in August 2005 a long term strategy for the railway sector for the period 2006-


2013 to ensure the financial equilibrium of CFR (the infrastructure manager), to determine efficient levels of Government contribution and to modernize the infrastructure. The main components of this strategy aim to: (i) strengthen Public Sector Contracts (PSC) and corporate governance in railway companies, (ii) develop new methodologies to determine Track Access Charges (TAC) and passenger fares, (iii) increase the market responsiveness of Calatori (the passenger service company) and Marfa (freight company) by dividing the passenger railways into eight regional companies to tailor the services to market demand, with the remainder of the original company to handle long distance and international passenger traffic and restructuring or privatizing freight services, (iv) implement an efficiency improvement package consisting of network downsizing and further labor restructuring, (v) bring the length of interoperable railways from 90 km in 2004 to 4300 km in 2015 and (vi) maintain the market share of freight services on the good transportation market at 25 percent in 2015 and that of passenger services at 35 percent of the total passenger transport market12.

3.52 The Government’s strategy could be further strengthened by: (i) including in the PSC clear economic justifications and comparisons of railway passenger services with bus services especially for low volume routes; (ii) granting the future long-distance passenger services company the commercial freedom to manage by transferring fare setting from MTCT to the new company; (iii) complementing the railway efficiency improvement package with clear passenger service reduction targets and an adequate incentive structure for the railway companies to sustain those efficiency gains over the long term; and (iv) in the medium term, allowing for the competitive tendering of regional and long-distance passenger services based on the lowest subsidy required to run the service.

3.53 The government has a proposed an investment program will require a significant increase in railway expenditures and more specifically CFR investment costs. From 2007 to 2013, total investment and operating costs have been estimated at €14.4 billions including €7.1 billion for operating expenditures and €6 billion for capital costs, or 9.1 percent of 2005 GDP. CFR operating costs are expected to rise from 2005 to 2006 in order to make up for past deferred maintenance expenses. However, following the implementation of an improved maintenance program, CFR recurrent expenditures should decrease by 2 percent per year from €364 million in 2007 to €337 million in 2013. Calatori operating expenditures are scheduled to increase in order to cover the entire marginal cost of running passenger trains on CFR network. The expected increase in Calatori TAC in 2007 will drive its operating costs from €431 million in 2005 up to an average of €520 million over the 2006-2013 period in spite of labor reductions in 2007 and 2008.

3.54 The plan involves a five-fold increase in CFR investments and it is doubtful that the selection and planning of investments are appropriate and that the implementation capacity of CFR is sufficient to cope with the related design and monitoring works. Measures planned to reinforce Public Service Contracts and to improve corporate governance within public companies should be the top priority for MTCT. In addition, the CFR business plan should be clearly geared towards maximizing the railway network capacity wherever demand

12 Those two market shares stood at 28.9 percent and 43.8 percent respectively in 2004 while within the EU, the objective is to bring those market shares from 6 percent to 10 percent for passengers and from 8 percent to 15 percent for goods in 2015.


from freight and passenger operators is the strongest. For this purpose, investment planning should be part of a capital budget planning system which would prioritize investments based on the highest financial return to the company.

3.55 It is unlikely that the Government can afford the entire projected investment program and exemptions of past liabilities over the same period. The cumulative Government contribution to the future railway investment program and to the settlement of State arrears would amount to about 1 percent of GDP from 2007 to 2010. The share of budget support would further grow to 1.45 percent of GDP over the same period when adding State equity injections to absorb past accumulated losses. This appears unsustainable when compared to past levels of total government support, including exemptions, of 1.81 percent in 1998 at the onset of the reform and 0.97 percent in 2004 when the Calatori TAC was increased. Launching such a vast settlement program would therefore require some trade-offs and setting of priorities between the companies. Settling CFR State arrears is the most critical and would cost an annual average of €76.4 million or about 0.09 percent to 0.1 percent of GDP. Also, Calatori restructuring and the related allocation of assets and liabilities to the new regional companies will require the reduction of historic debts and accumulated losses to a level which does not impede sound financial management of these new companies in accordance with EU rules on state aid. Government contribution would need to cover €51 million of arrears and €331 million of accumulated losses. Annualized over the restructuring period 2006-2008, this would represent an annual contribution of 0.02 percent of GDP and between 0.14 percent and 0.16 percent of GDP respectively.

Recommendations

3.56 The government should rationalize its expenditure plans for the rail sector particularly with respect to planned CFR investments. These need to reflect CFR implementation capacity constraints. Specific measures to hold back the sector’s burden on the State budget without impeding the sound financial management of the railway companies, the sector strategy should include the following practical steps:

Within 6 months:

• Review the prioritization and planning of CFR investments for the period 2006-2013 according to economic and financial criteria

• Implement Calatori fare increases and some service cuts • Implement measures to exempt CFR from State arrears • Reinforce Public Service Contracts and improve public corporate governance.

Within 18 months:

• Implement CFR maintenance efficiency package • Implement the new TAC methodology using IRIS system • Increase Calatori TAC • Further adjust Calatori services.


Within 36 months:

• Restructure Calatori according to the completed market survey along with the implementation of Calatori efficiency package (staff reduction and closure of uneconomic services)

• Cancel Calatori historic debts and accumulated losses.


3.57 The period of high budget contribution from 2007 to 2010 stemming from the five-fold increase of CFR investments, raises some concerns as to the fiscal sustainability of projected expenditures. The Government’s contribution to CFR within its historical range and EU grants at a realistic level, CFR annual investment expenditures should be of €450 million on average over the period 2007-2013, instead of €670 million. The Government contribution to CFR would remain below 0.24 percent of GDP instead of about 4 percent of GDP under the earlier investment program, therefore bringing down the annual State support to the railways around 0.7 percent of GDP, closer to its 2004 and 2005 levels, instead of 0.9 percent.

3.58 The table below gives an alternative expenditure program for roads and rail. In the rail portion, the investment program has been scaled back from the government plan, but assumes the full implementation of the network downsizing exercise, which would generate about 3 percent of operating cost savings from 2006 to 2008, and improvement of maintenance business models and practices yielding annual reductions of 3 percent for maintenance costs and 2 percent for labor from 2007 to 2010. It also assumes that, between 2006 and 2013, passenger traffic would stabilize at 8.5 billions passenger-km and freight traffic would grow from 14 billion ton-km to 18.5 billion ton-km. These traffic projections are more conservative than the targets set out by the Government, which assume the passenger and freight traffic demand to reach 9.3 billions passenger-km and 19.7 billions ton-km in 2013.

Table 3.2a: Consolidated Expenditures Plan for Roads and Railways in the Alternative Scenario 2007 2008 2009 2010 2011 2012 2013 Total Avrg. Roads Uses of Funds Current Expenditures 263 276 290 304 319 335 352 2,139 306 Capital Expenditures 1,013 1,463 1,506 1,402 1,342 1,380 1,429 9,535 1,362 Debt Service 207 245 265 301 351 431 588 2,388 341

Interests 99 129 149 177 203 229 257 1,243 178 Principal 108 116 116 124 148 202 331 1,145 164

Total 1,483 1,984 2,061 2,007 2,012 2,146 2,369 14,062 2,009 Sources of Funds Own Operating Revenues 202 223 219 225 232 239 246 1,586 227 State Budget 414 520 551 645 684 783 969 4,566 652 EU Grants 95 257 289 329 293 286 265 1,814 259 Sovereign Borrowing from IFIs 584 795 815 727 717 751 802 5,191 742 Sovereign Borrowing Commercial 99 99 99 82 0 0 0 379 54 PPP Financing 88 88 88 0 86 86 86 522 75 Total 1,482 1,982 2,061 2,008 2,012 2,145 2,368 14,058 2,008

Source: World Bank estimates based on CFR, Caltori and NCMNR projections.

Table 3.3b: Consolidated Expenditures Plan for Roads and Railways in the Alternative Scenario

2007 2008 2009 2010 2011 2012 2013 Total Avrg. Railways Uses of Funds Current Expenditures 822 796 785 779 773 767 762 5,484 783 Capital Expenditures 441 508 579 577 585 601 604 3,894 556 Debt Service 122 126 147 159 167 172 182 1,074 153 Total 1,384 1,430 1,510 1,515 1,525 1,540 1,547 10,452 1,493 Sources of Funds Own Operating Revenues 597 584 582 582 582 582 582 4,092 585 State Budget 549 559 585 589 591 597 611 4,081 583 EU Grants 46 139 229 225 141 141 143 1,064 152 Sovereign Borrowing from IFIs 167 143 170 190 209 207 220 1,305 186 Sovereign Borrowing Commercial Loans PPP Financing Total 1,359 1,425 1,566 1,587 1,522 1,526 1,556 10,542 1,506


Table 3.4c: Consolidated Expenditures Plan for Roads and Railways in the Alternative Scenario

2007 2008 2009 2010 2011 2012 2013 Total Avrg. Total Roads & Railways Uses of Funds Current Expenditures 1,085 1,072 1,075 1,083 1,092 1,102 1,114 7,623 1,089 Capital Expenditures 1,454 1,971 2,085 1,979 1,927 1,981 2,033 13,429 1,918 Debt Service 329 371 412 460 518 603 770 3,462 495 Total 2,867 3,414 3,571 3,522 3,537 3,686 3,916 24,514 3,502 Sources of Funds Own Operating Revenues 799 807 801 807 814 821 828 5,678 811 State Budget 963 1,079 1,136 1,234 1,275 1,380 1,580 8,647 1,235 EU Grants 141 396 518 554 434 427 408 2,878 411 Sovereign Borrowing from IFIs 751 938 985 917 926 958 1,022 6,496 928 Sovereign Borrowing Commercial Loans 99 99 99 82 0 0 0 379 54 PPP Financing 88 88 88 0 86 86 86 522 75 Total 2,841 3,407 3,627 3,595 3,534 3,671 3,924 24,600 3,514 Total Roads % GDP 2.0% 2.6% 2.6% 2.4% 2.3% 2.3% 2.4% 2.4% Total Railways % GDP 1.9% 1.9% 1.9% 1.8% 1.7% 1.6% 1.6% 1.8% Total Roads and Railways % GDP 3.9% 4.4% 4.4% 4.2% 4.0% 3.9% 4.0% 4.1%


F. ENVIRONMENT

3.59 In concluding accession negotiations for the environment chapter of the acquis in 2004, the Government of Romania made commitments for substantial increases in environment investments. Despite the relatively long implementation period, these commitments will strain the financial capacity of the country. Other acceding countries having income levels below those of the pre-existing EU member states, have also found it challenging to meet EU environmental standards.


Table 3.5: Summary of Environmental Compliance Cost Investment Group NPV Cost

(in 2006 € billion) % cost Responsibility

Drinking Water (by 2015) 2.6 15 Municipal Wastewater (2018) 5.2 31 Municipal Solid Waste Management (2017) 1.4 8 Municipal Nitrates 1.6 9 AGRICULTURE Hazardous/Other Waste 0.5 3 Industry/hospital Industrial Pollution

Integrated Pollution Control Large Combustion Plants Volatile Organic Compounds, Fuels

3.2 2.1 0.2

19 12 1

Industry/SOE Industry/SOE Industry/SOE

Nature Protection 0.2 1 Central Govt./Municipality

Note: The costs are based on a 4% discount rate and expressed in 2006 real terms; they cover the transitional period which is from 2007 to 2015 – 2019, depending on the sector. Source: Environmental Cost Assessment and Instrument Plans, 2005.

3.60 Between 2007 and 2013, Romania is expected to receive € 3.96 billion in grants from the EU, but this is not nearly enough to cover the total estimated costs of compliance. The implementation plan drawn up for meeting the terms of the environmental directives has a cost of approximately €17 billion. Some of the costs of compliance will fall on the private sector but a large portion will fall on public sector budgets – particularly those of local governments.

Table 3.6: EU Grant Programming in ENV SOP by Sectors, 2007–2013 (€ million)

EU Grants

National Contribution

EU Co-financing rate (%)

TOTAL

Water/Wastewater 2440 431 85 2871Solid Waste/Contaminated Lands 773 193 80 966District Heating 200 200 50 400Nature Protection 150 378 80 188Flood and Soil Erosion Prevention 237 42 85 279TA 160 40 80 200Total 3960 944 - 4904Source: Draft Environment SOP.

3.61 Even so, the pipeline of projects for the SOP is not yet sufficiently developed to assure that all the grant funds are used. The experience with preaccession funds suggests that there is a risk that grant resources may not be fully utilized unless planning efforts are stepped up and implementation capacities enhanced.

3.62 The SOP spending has not been adequately factored into the MTEF. The EU grants require cofinancing from national sources and these amounts are not currently visible in the MTEF. In summary the cost of the implementation plan exceeds what is included in the SOP, and the national component of what is in the SOP exceeds what has been provided for in the MTEF.


3.63 The cofinancing for the SOP is not the only potential budgetary cost. The overall net impact on the budget depends on three other factors besides SOP cofinance, virtually none of which is currently reflected in the MTEF.

1. SOP Projects That Are Not Fully Covered by SOP Budgets

3.64 The most significant shortfalls between the costs of environmental commitments and what is funded in the environment SOP arise in the air and water sub-sectors. To meet large combustion plant commitments, the government will need to plan for their own investment financing outside of EU Grant funds. Similarly, SOP funding for water is well below the cost of compliance. Some additional but smaller funds will be needed for nature protection. In addition SOP funds relate only to investment costs, not the addition operating and maintenance costs that new investment will entail.

2. Costs Related to Tariffs, Subsidies and Regulatory Practices

3.65 There is lack of clarity regarding the how the domestic resource requirements of the environment acquis commitments will be divided between taxpayers (the budget) and the consumers of key utility services. A massive investment in public utilities will clearly drive up operating and maintenance costs. These may be offset by user charges and connection charges. But the budgetary implications of the regulatory environment for tariffs and service standards as well as the budgetary cost of related subsidies have yet to be analyzed and to find expression in the MTEF. The most important areas are water and district heating.

3.66 For example in the water sector there may be hidden budgetary costs related to regulatory and operating practices. If the water utilities owned by local governments collect tariffs sufficient to cover their costs, they may not place any ongoing burden on public budgets beyond the capital transfers required to establish them. If tariffs are too low however, the utilities may run up losses or fail to do the maintenance necessary to keep their fixed capital from deteriorating. This creates a need for ongoing subsidies or periodic infusions of money from public budgets to the utilities. Decisions to raise tariffs to cost recovery levels may be met with resistance if not accompanied by offsetting subsidies to (poor) consumers which would again give rise to a budgetary cost. In the water sub-sector, hidden budgetary costs arising from these sources (and from collection shortfalls and distribution losses) may be as much as US$597 per year although the issue deserves more study. Tariff regulation and subsidization is therefore important, particularly as the planned expansion of service will largely be in poorer and rural areas where affordability of water tariffs is most critical. Similar issues apply to district heating.

3. Additional Environmental Initiatives

3.67 The government has planned certain new investment programs which will potentially have a major budget impact. A government decree was issued earlier this year to fund a new investment project (District Heating 2006-2009, Quality and Efficiency). The estimated amount of the Project investment is RON 13.4 billion over the three years. Of this, RON 12.2 billion is to be borrowed. Half of the borrowing cost will be covered by the local government and half by the state government. This program would include the (national and EU grant) allocations made in the SOP, but the cost is very much larger than the SOP allocation, and


the additional amount would have to come entirely from national sources. None of this is yet reflected in the MTEF.

3.68 Slow implementation may reduce the budgetary demands The implementation of the pipeline of SOP projects may also be slow as suggested above. Moreover there is uncertainty about the speed at which the eight district heating projects can be implemented. These will require substantial preparation time and will require special individual project by project analysis and assessment of engineering alternatives. At best, this ambitious (€1 billion per year) plan will take longer than the currently projected four years. In the longer term the improvement of district heating systems offers the potential of efficiency gains and cost reduction. This in turn would imply potential budgetary savings through reduction of subsidies. A full analysis of the combined impact of these measures on the budget has yet to be completed.

3.69 With these issues in mind, the following recommendations are offered:

Recommendations

• In view of the financial and implementation constraints the government should construct a sequence for environmental project implementation based on economic merit.

• More comprehensive analysis of utility tariff regulation and subsidization cost consequences for the budget and MTEF is needed, especially with respect to water and district heating. Appropriate tariff adjustments and assistance to vulnerable groups should help with private participation (including privatization) and minimization of delays in the implementation of the program agreed with the EU.

• The Ministry of Water and Environment budget framework should be further improved to introduce a clearer budget structure linked to performance and key program functions.

• The recently approved plan for eight district heating projects has an enormous cost that will fall almost entirely on the budget, although no provision for it appears in the MTEF. It is highly unlikely that this can be implemented at the pace foreseen in the plan. The plan should therefore be revisited and a more reasonable set of costs should be factored into the MTEF.

• In the water sector, the Government has a plan to consolidate utilities and make them into regional operators. Generally, larger utilities have economies of scale but before large utilities are created, the costs and benefits of merging smaller utilities into larger ones should be carefully reviewed.

• The local utilities regulator – ANRSC – should be strengthened so that it can monitor the performance of the utilities through a licensing process (a vast majority of the utilities are not licensed) and the performance of the utilities should be benchmarked.

• Government should develop programs to accelerate investments in nitrates, energy efficiency, and large air investments by the private sector.

• The exclusion of desulphurization from Romania’s EU funding proposal will add to the challenge of privatizing the main thermal plants successfully. If privatization does not succeed, the plants will remain in the public sector and their rehabilitation investment requirements will demand state guarantees or capital transfers that should be factored into the MTEF.


• Post-accession grant resources and budget for co-financing as well as Nature Protection funding - historically off the budget - need to be reflected in the MTEF.

• A more transparent financing framework for nature protection will help to attract future EU grants to these needs.


3.70 Total SOP expenditure and cofinancing for EU grants is assumed to follow the pattern outlined in the draft Environment SOP and given in Table 3.7. The authorities may find it challenging to stick to this plan. However, this is balanced by the assumption that other environmental expenditures outside the SOP proceed at slow pace.

Table 3.7: Draft Environment SOP by Financing Source, 2006 (€ million)

2007 2008 2009 2010 2011 2012 2013 Total Total EU Grants 285 404 535 630 666 702 738 3960National Contribution 68 96 127 150 159 167 176 944Total 353 500 662 780 825 869 914 4904Source: Draft Environment SOP.

3.71 A conservative view is taken of the amounts that will be spent for environment expenditures not covered by the SOP. In particular, the planned district heating expenditures are projected to run at RON 900 million per year from 2007 on, or roughly one quarter the planned rate. These expenditures are consequently spread beyond the currently planned three-year window of 2007-2009. No explicit amount is included for the water expenditures, beyond those covered by the SOP, nor for the “hidden costs” and subsidies described above.

G. PENSIONS

3.72 Romania inherited from the socialist period a generous but unsustainable mandatory PAYGO pension system. Replacement ratios were high and benefits were paid to a wide range of pensioners (complete length of service, early retired, disabled) and there were several non-contributory benefits (sick leave, maternity leave, farmers). As the transition advanced, the system started suffering from several fundamental problems:

• A sharp increase in the number of beneficiaries as a result of the aging population • Introduction of early retirement plans to compensate increasing unemployment • A decline in economic growth. • A decrease in the of number contributors as a result of high unemployment and informal

employment • Increased numbers of disability pensioners • Poor collection performance • Weak institutional capacity of pension system administration.

3.73 A variety of ad hoc measures were introduced:

• Repeated increases in contribution rates from 14.5 percent in 1990 to an average of 34 percent in 2000), with a detrimental effects on labor costs and on revenue collection


• Various experiments in the benefit formulas • Partial indexation of pension benefits and repeated ad-hoc increases granted to all

beneficiaries. 3.74 These measures did little to improve sustainability, and in 2004 the government began implementing a plan for consolidation of the public pension system. The main measures that are being phased in over the period to 2008 include the following:

• Externalization of the short term and non-contributory benefits to other financing sources (farmer pensions and child raise allowances to the State Budget, and sick leave benefits to the Health Insurance Fund)

• Faster increases in the retirement ages • Diminishing the gap between retirement ages for men and women • Introduction of a new price indexation mechanism, to fully cover the inflation • Diminishing the variation range of the pensions point value • Recalculation of all current pensions using the new benefit formula approved in 2000 in

order to restore the equity of the system for the pensioners retiring at different times • A gradual decrease of the contribution rates.

3.75 A third phase is now being entered which will further strain pension finances. The above measures have served, at least for now, to contain a potential explosion of the pension system deficit. The deficit has been kept well under the one percent of GDP ceiling required under the World Bank Programatic Adjustment Loan. However, replacement rates have begun to fall and, without further adjustments to system parameters, they will continue to decline for another 8-10 years. The authorities are very conscious of this and have indicated publicly that they intend to increase pensions by 30 percent in real terms over the period 2005-2008. Final decisions on this have not been made and the implications in terms of the pensions system deficit will depend the evolution of wage rates, inflation among other things. (If inflation remains high the additional cost may not be that much. To the extent that the changes raise the average replacement wage from what it would otherwise be there will be consequences for pension finances.

Figure 3.4: Average Replacement Rate for Old Age Pensioners

A v e r a g e R e p l a c e m e n t R a t e f o r o l d a g e p e n s i o n e r s

( % o f a v e r a g e w a g e )

2 0 . 0 %

2 5 . 0 %

3 0 . 0 %

3 5 . 0 %

4 0 . 0 %

2 0 0 32 0 0 8

2 0 1 32 0 1 8

2 0 2 32 0 2 8

2 0 3 32 0 3 8

2 0 4 32 0 4 8

Source: World Bank (PROUST model projections) 2004.


3.76 In addition to raising benefits, the government intends to introduce a second (private mandatory) pension pillar. The plan will require diverting contributions from the public system to the private one, beginning with two percentage points of contributions in 2008 and gradually increasing this by a further half percentage point each year thereafter until 2016, when the contribution to the second pillar will reach the peak level of 6 percentage points. This transition cost is relatively minor initially (0.17 percent of the GDP in 2008), but will build over time (to 0.9 percent of the GDP in 2016). Moreover, it combines with the planned contribution rate cuts to erode contributions flowing into the public system.

3.77 The implications of these changes have not yet been adequately factored into the medium term fiscal framework. The 2007-2009 MTEF in fact projects that pension spending will decline by a full percentage point of GDP between 2006 and 2009, and that the pension system deficit will decline in nominal terms. This is not consistent with significant benefit increases and the (two types of) contribution reductions.

Recommendations

3.78 In the context of the 2004 reforms, the authorities agreed a medium term plan for contribution reductions, adjustment of retirement ages, and other basic pension parameters including those relating to the introduction of the second pillar. Much of this has been discussed in detail with the World Bank and has been incorporated into the conditions in our adjustment lending program. Other measures may be additionally considered of the near future, especially in the area of the early retirement and disability/invalidity pensions, as well as the increase of the number of contributors However, it is important that the planned changes be taken into account in planning future public finances. We therefore offer one recommendation:

3.79 Fully reflect the planned pension system changes in the MTEF.


3.80 In line with the government’s plan we assume that in addition to inflation, pensions are increased by 3 percent in September 2006 and by a further 7.5 percent in September in each of the following two years.

H. MANAGING THE PUBLIC SECTOR WAGE BILL

3.81 There is a central tension between short term and longer term objectives in public sector wage setting in Romania at present. In the short term one must take into account the fact that public sector wages are an important determinant of economy wide wages, both because public sector employment is significant, and because it affects wage settlement patterns in the rest of the economy. Public sector wage setting therefore plays an important role in inflation dynamics, monetary policy and general macroeconomic developments. The timing of wage changes is an important consideration.

3.82 In the longer term it is important that public sector wages are set in an efficient manner. In particular, they need to be set so as to attract and retain qualified staff at various skill and experience levels, they should be roughly aligned to private sector wage rates in similar skill categories, and they should provide reasonable incentives for employees as they progress along a


career path. Timing is less critical, but over the longer term this has to be done properly or the quality or cost effectiveness of public services (or both) will deteriorate.

3.83 The institutional context has an important bearing on how well this tension can be resolved. This includes the negotiating framework, the job and occupational classifications, the various components of total remuneration, the rules for hiring firing and redeploying, and the degree of standardization of such things over the public sector work force.

3.84 The evolution of public sector wages in the last two years has constituted a major source of inflationary pressures. It significantly hampered the conduct monetary policy and squeezed other areas of public expenditure notably capital spending. Nominal wages have increased in selected subsets of the public sector by as much as 50 percent since October 2004, well above productivity gains at a time when the economy was showing clear signs of overheating. The large public sector wage hikes, acted as a push factor for the increase of the equilibrium wage in the economy. The economy-wide real wage13 increased by around 13.614 percent y/y in 2005. The timing was such that it reinforced the aggregate demand effects of the significant reduction of the marginal income tax embedded in the flat 16 percent profit and income tax in introduced in January 2005.

3.85 Yet despite the recent wage upsurge, the overall public sector personnel expenditure in Romania as a share of GDP is not high by European standards. Following the wage increases of October-November 2004, January and again October 2005, the total public sector wage bill expanded from around 4.9 percent in 2004 to 5.5 percent GDP in 2005. The average EU-25 wage bill was around 11 percent of GDP in 2004, with the average higher in the new member states.

3.86 The number of public employees is not high. The number of public sector positions represents about 3.8 percent of the population, situating Romania again at the lower end in Europe. This suggests that neither the size of public sector employment nor the public sector wage bill in themselves represent a major efficiency burden on the economy.

3.87 For comparable employment categories and job characteristics15, the private sector consistently pays higher wages than the civil service, according to a recent pay study16. This appears to be the case even when all allowances are included, with the gap increasing for leading and higher ranking positions. If the ratio between the average public and private sector salaries for the executive positions is around 60 percent, it comes down to around 20 percent for the senior civil servants.

3.88 There are also wide discrepancies between wages of employees with similar skills within the Romanian civil service. The pay study, which surveyed around 40 percent of the

13 Net real consumption wages (CPI-deflated). 14 Including bonuses paid in December 2005. 15 This distinction is critical, as there are important segments of the private sector that pay less than the public sector (see, for example, the results of the Salary Survey, produced by the National Institute for Statistics). 16 The study was prepared by the Hay Group in 2006 and supported by the Bank, under the PAL program for reforming the civil service in Romania. This is the first comprehensive assessment of pay and employment structures in the Romanian civil service.


total civil servants, concludes that the pay practice is highly diversified and that large pay differences are observed among positions of similar level.

3.89 The wage setting system in Romania is overly complex and fragmented, and this undermines short term cost containment as well as the coherence of wage patterns. There is no unitary pay system in the Romanian public administration as the legal framework differentiates between several public sector employment categories. While the Labor Code (law 53/2003) and other general normative acts, such as the collective contracts legislation, provide the umbrella framework for labor relations in the public sector, these are complemented by category and even entity specific regulations which influence substantially employment policy and pay structures. The affected ministry or public entity (e.g. the National Agency for Civil Servants) negotiates with the relevant labor union (e.g. the Trade Union of the Civil Servants). The Ministry of Labor and the Ministry for Public Finance traditionally participate in the negotiations, together with the relevant line ministry. Once agreement is reached, the Ministry of Labor forwards the final proposal to Government for its approval.

3.90 An additional complication arises each time the Parliament goes on recess, which occurs twice per year. At that time it passes a law authorizing the Government to issue ordinances, with the force of law in pre-specified policy areas, to set salaries for subsets of the public administration (civil servants, contractual workers, justice personnel, defense, dignitaries, etc.). The recess of the Parliament occurs at the beginning of the calendar year, when the debates over the budgeted wage increases and the conclusion of the collective contracts for the coming year start. This leads, in practice, to lengthy negotiations between the Government and the trade unions, where deals struck in the last moment determine the final outcomes. The bargaining process for teachers salary increases in early 2006 is a representative example.

3.91 The situation is further complicated by the cyclical electoral year behavior, when large salary adjustments, often unbudgeted, are granted. The two consecutive wage increases of October and November 2004 for the civil servants, which coincided with the general elections, are an example. The public sector (education, health, civil service) wage increases approved in January and February 2006 were not reflected in the 2006 approved budget.

Recommendations

3.92 Complete wage negotiations before the approval of the subsequent year’s budget in order to include the increases in the overall envelope and eliminate multiple within-year hikes. Wage policy in the public sector has been an endemic source of inflationary pressure, acting as a push factor for real wage growth in the economy, beyond productivity gains. Part of the pressure comes from the segmented and sometimes ad-hoc character of the wage setting process in the absence of clear rules, including due to the limited involvement of the legislative in the process.

3.93 As inflation has been brought down to single digits recently, it is important to restrict wage increases to a one step increment change, ideally in the summer of every year.

3.94 Proceed with the next steps in the implementation of the unitary pay and employment system in the civil service. The reform of the personnel (including wage) policy


in the civil service is ahead of the rest of public administration. The Agency of the Civil Servants has taken the lead in the reform agenda, with support from the Ministry of Administration, and the process is advancing well. The first ever comprehensive civil service pay survey has been completed and will be used as input in the drafting of the Strategy for Pay and Employment in the Civil Service, to be implemented over a 4-7 year period.

3.95 Extend the scope of the pay and employment reform beyond civil service, which covers only about 10 percent of total public employment. Reforming pay structures within the broader public administration should start by reviewing and improving the institutional mechanisms intended to prevent wages slipping out of control, primarily by avoiding situations where the wage bill gets out of line with the budget program. As in the case of the civil service, the approach to reforms should be systemic, and needs to be done within the framework of a medium term Strategy for Pay and Employment, with the first step in the process being a comparative public/private sector salary survey.

3.96 Simplify and rationalize the diverse incentives schemes Reducing the financing available for bonuses, either by eliminating the number of vacant positions or by limiting the authority to employ “own-source” revenues to finance quarterly bonuses should be central to the wage control system and will help to reduce the short run slippages. However, budget ordinators are accustomed to relying on these resources to finance salary top-ups, so such restrictions should probably be done as part of an overall salary reform, which addresses the transition challenges posed by reduction of this salary top-up financing source. Rules and checks that constrain the financing and assignment of quarterly bonuses should be imposed, in parallel with making the assignment more transparent and accountable.

3.97 Improve the information base on public sector wages and employment Lack of detailed and reliable information on public sector employment, including skill composition, and wages makes the thorough assessment of the Romanian public administration difficult. It is important to develop, at the level of the National Agency for the Civil Servants and the Labor Ministry, the systems necessary to generate the information for monitoring the extent to which the implementation of the reform strategy progresses, including to what extent the underlying objectives are achieved, by constantly tracking a comprehensive set of monitoring indicators.

3.98 Complement wage reforms with broader reforms in public administration Strengthening the quality and efficiency of the public administration requires efforts that go beyond pay, and should aim to establish a meritocratic, professional and depoliticized administration, funded with a sustainable public wage bill and transparent, efficient and monitorable rules for the hiring, promotion and dismissal of public employees.

3.99 Better alignment of functions within the public sector, to reflect the development priorities set at the strategic level, and upgrade of the skills of the public sector employees should be central parts of the reform agenda.

4. PUBLIC EXPENDITURE POLICY AND INSTITUTIONS

4.1 This chapter addresses public expenditure policy from an institutional point of view. It identifies opportunities to improve the quality of public expenditures in the various sectors by examining the budget process itself. It begins at the strategic level with a discussion of the relationship between strategy, policy formulation and the budget, and the institutional arrangements involved in that linkage. The analysis is summary in nature, drawing from more detailed assessments and recommendations presented in four separate chapters covering the same topics in Volume 2. The chapter also includes an analysis of challenges in the area of decentralization and intergovernmental fiscal arrangements.

A. STRATEGY, POLICY AND PUBLIC EXPENDITURE

Central Policy Formulation Functions

4.2 Romania has an array of center-of-government policy products and policy-making procedures, but the existing processes are weak. Romanian governments have four year programs, commonly referred to as the national policy. The current Government Program 2005-2008 articulates medium term priorities on a sectoral and/or ministerial basis. The Acquis Implementation Plan is also regularly referenced as a national policy framework. More recently, the National Development Plan (NDP) is spoken of as a document reflecting the highest level national goals, seen from an EU integration perspective. Associated to the NDP there are the Sector Operational Plans and the Regional Operational Plan currently under preparation.

4.3 The problem is that, across these various products, it is difficult to find comprehensive consistency of thought and strategic direction. The various strategic documents all derive from different processes involving different players and with different purposes—some political, some focused on EU accession and some focused on EU fund access. In reality, none is a proper strategic government-wide framework that gives unequivocal direction to the Romanian people and public sector about what the government intends to achieve. This lack of clear strategic direction is a major constraint in Romania’s delegated governance system.

4.4 The lack of clear policy direction in these products is in large part a result of the fragmented processes by which policy is developed. Until 2005, Romania had as many as 130 inter-ministerial committees or task forces working on different policy issues and generating their own policy products. There was no strong central policy ‘channeling’ mechanism in the Cabinet responsible for issuing clear high-level directives and then ensuring that policy proposals all related to these, and that they were reflected in the budget. The fragmented process also results in Cabinet officials (like ministers) becoming involved in detailed aspects of policy delivery (typically the purview of delegated agencies like line ministries). This also led to the introduction of a significant number of policy products (including passing of new laws) that were not disciplined by a policy framework, or costed. In a number of cases, these resulted in

66 Chapter 4: Public Expenditure Policy and Institutions

unfunded mandates, sometimes introduced for implementation within a specific budget period (requiring significant funds movements, which undermined the value of the formulated budget).

4.5 Aware of its policy-making weaknesses, Romania’s government has pursued various reforms in the past few years. These include organizational changes across and within ministries, with the most central involving the dismantling the over 100 Cabinet Committees and Task Forces and establishing eleven permanent Inter-Ministerial Councils (IMCs), which mirror structures at the European level (European Council of Ministers). Given the focus of this section on policy-making and its link to the budget, special note should be made of Committee number 11, the Inter-ministerial Council for Strategic Planning (CSP). This is one of the most innovative and forward-looking elements of the reform and the CSP, if appropriately structured and directed, could play a strong policy-making, reviewing and channeling role in the future.

4.6 Within the Cabinet, the CSP does not yet play the crucial role that it needs to. The CSP needs to focus all policy decisions and facilitate development of broad high-level policy directives. This will facilitate more structured and detailed policy development in other committees and throughout the government. The CSP is not currently playing such a role, however, and it has not yet established a pattern of operation. Likewise, the government has yet to fully define the inter-relationships between the eleven new Inter-Ministerial Councils and the Cabinet as a whole, or their relationships to the general policy-making regime.

Recommendations

4.7 Establish an effective hierarchical policy-making structure with clear roles for committees by taking the following steps:

• The CSP should be assigned the clear role of (i) articulating national priorities on a multi-year basis, to act as the broad framework for other IMC processes and to set out the budget priorities of Government; (ii) reviewing and prioritizing proposals, and (iii) recommending to the Cabinet as a whole, and by extension to specific Inter-ministerial Councils, relative orders of priority amongst competing IMC policy directions. For example, the CSP could guide IMC policy analysis by providing a simplified articulation of national priorities in the Government Program. This should be reflected in a ‘Budgetary Priority Statement’ produced annually to guide budget preparation. Further, if IMCs provide functional and sectoral proposals semi-annually, the IMC will have two opportunities a year to review these forecasts, providing the Cabinet with comprehensive reports on detailed policy proposals and how these relate to broader policy directives. Such a schedule allows the development of policy directives as inputs at the beginning of each year’s budget cycle as well.

• Inter-Ministerial Councils should be given the task of “first review” of all policy issues that fall within their respective functional purviews. Each IMC president will act as a sectoral “gatekeeper” to screen policy proposals in specific areas. This sectoral IMC would assess submissions in light of national priorities and available resource levels, and develop cross-ministry appreciation of the challenges and priorities of their various ministries.

Chapter 4: Public Expenditure Policy and Institutions 67

• The President of each IMC should have authority to develop a semi-annual report on the prospective schedule of major initiatives requiring Cabinet consideration planned for the coming six months (developed from submissions by constituent ministries). There are benefits in seeking from individual ministries advance notice of their prospective policy, legislative and programmatic agendas. (This in itself will give greater structure to the policy-making process).

Line Ministry Functions

4.8 The question of strengthening policy-making in line ministries relates directly to a second set of policy products and processes necessary to facilitate effective policy choice. These products include bottom-up strategic plans as well as revenue forecasts that together facilitate the identification of budget ceilings that are relevant to the policy and fiscal situation. Prior work on this subject in Romania has described these products and the processes as poorly developed.

4.9 Policy development in line ministries has been weak, and the existing capacity has not been focused. This is evident in the inadequate development of policy, legislation and regulation proposals emanating from such entities. Proposals are infrequently subject to rational, structured analysis, costing and review, and there is no formal ‘challenge’ function played by central entities (MoPF, GSG or other) to require this.

4.10 The GSG and Chancellery have initiated important reforms to develop strong policy-making processes across government. The GSG reform has been in progress for a couple of years now, whereas the reforms in the Chancellery are newer. The GSG reform hinges on the introduction of a Public Policy Unit (PPU), designed explicitly to facilitate improvement in the quality of policy submissions from line ministries. The GSG PPU plays a gatekeeper role for all ministries presenting policy proposals to Cabinet leading to normative acts. The GSG PPU has developed guidelines for preparing these proposals, instilled a process through which they need to pass, and staffed itself to play a review and challenge role. The goal is to enhance the quality and decrease the quantity of submissions to Cabinet.

4.11 PPUs have been introduced in most line ministries, providing a new and important policy-making ‘network’ across the government. The most important dimension of this reform lies outside of the GSG, in the new policy units established across the government. These units have developed under the guidance of the GSG PPU in most cases. They have an automatic capacity building partner in the GSG PPU. Establishing these entities across Government has allowed for the initial development of a ‘policy-making network’ in which the GSG PPU is the central node and the guidelines, process requirements etc. form the ties linking all PPU’s together. This kind of structure is an important step towards establishing a consolidated bottom-up policy choice capacity in Romania (instead of the fragmentation that previously existed).

Recommendations

• Assign the GSG PPU the role of coordinating and guiding line ministry policy development and regulating policy proposal flows to Cabinet, to resolve any eventual tensions with the Chancellery.


• Formally expand the focus of the PPU’s to handle more issues than simply the development and promulgation of new policies, and develop revised guidelines that facilitate (over a period of time) the assessment of existing policies as well.

• Begin the process of coordinating policy work with budget preparation at the line ministry level, through collaboration between the PPUs and the Budget Departments, and expand also to incorporate engagement with the NDP units, etc. This requires an expansion of the ‘policy-making network’ and will necessitate clear thought about the roles and responsibilities of the various entities,17 and the mechanisms that can be used to connect them. The PPU would still play the central policy coordination role, but with clear engagement and linkage (established through carefully developed PPU guidelines, budget circulars, etc.) with the other entities.

• Clarify responsibility for developing macro-fiscal policy and forecasting, and improve the quality and transparency of these products. It is suggested that these activities be located in the MoPF, close to the budget preparation activities, but not part of the Budget Department, and that the Prognosis Commission be tasked with playing a quality assurance role—challenging MoPF assumptions, etc.

The Budget Process and Calendar

4.12 Improvements could be made to the budget process and calendar. The technical aspects of the process (budget guidelines, etc.) are focused on analysis of item allocations, which matches the input-focus entrenched in the institutional and organizational set-ups (the large number of accountants in budget departments is an example). Budget negotiations center tensely on overall resource maximization and not policy content, and budget products are consequently unreliable and unfocused.

4.13 Recent steps suggest an awareness of these problems and an attempt to develop what could be called a strategic stage in the budget process. The impetus to introduce such a stage (in February and March) came from a Government Decision in July 2005, which itself emerged from Government’s desire for effective programmatic budgeting in Romania. The MoPF developed guidelines for this purpose, providing the first requirement for some pre-budget planning in line ministries. The programmatic planning requirement allowed for interesting overlap with the work of PPU’s in some line ministries. The Government needs to consider how it wishes to develop this stage in its budget process, and formally alter the Budget Timetable to reflect it. There are many opportunities for developing synergy with the ‘policy choice’ reforms underway in Cabinet and the GSG, but these will only be fully enjoyed with clear decisions about what the process should look like in the future. One-off initiatives like the programmatic

17 This suggestion is captured in proposals by advisers under a Dutch trust fund: Martin Johnson and Russ Robinson: “The MoPF should establish a working relationship with the GSG over the future development of the policy formulation process. In particular, it would be important for the MoPF to ensure that the development of future guidelines for policy design and review results in the clear specification of…objectives and associated standards for all key policy areas such that an appropriate level of funding for each key policy area can be more easily specified. This would then constitute the starting point for the design and introduction of a new strategic planning process, possibly through the future application of a modified version of the Romanian program budget tool in advance of annual budget preparation.”


planning in 2006 do not ensure that such opportunities are fully exploited, or that a strategic stage is institutionalized.

Recommendations

Adopt a new policy-centered budget preparation process as outlined in Box 4.1.

Box 4.1: A Proposed New Timetable for Budget Preparation January • Prepare macro-fiscal framework (based on new Budget Law) • Issue National Policy Direction from centre of government (The Budget Priority Statement from CPS) • Line ministries specify and clarify policy goals and objectives, through simplified procedure (with oversight

from the GSG PPU and MoPF) February • Prepare strategic planning guidelines (primarily by MoPF but with GSG PPU involvement) • Prepare line ministry medium term expenditure preparation ceilings March – May • Issue strategic planning guidelines and ceilings to line ministries (an early version of the Budget Framework

Letter –BFL A- now produced in June) • Line ministries carry out strategic planning activities (possibly through revised program budget exercise) • Results from strategic planning exercise presented to MoPF • Discussions / Negotiations between MoPF and line ministries regarding proposed medium term resource

allocation proposals • Revise macro-fiscal framework • Revise medium term expenditure preparation ceilings • Prepare of detailed budget preparation instructions • Preparation of full Budget Framework Letter—for formal budget preparation June – July • Detailed budget preparation instructions and ceilings issued through BFL-B • Line ministries prepare budgets for submission to the MoPF • MoPF – line ministry budget negotiations / discussion August – September • MoPF – line ministry budget negotiations / discussion • Revised macro-fiscal framework • MoPF prepares draft Budget Law for submission to Government October - December • Government revision / approval of draft Budget Law • Government submission of draft Budget Law to Parliament

• Parliamentary approval of budget

4.14 The idea is to transform the budget formulation process from a one-stage engagement, starting de facto in June, to a two-stage process beginning in January and anchored in top-down and bottom-up policy-making processes. The first stage will take place between January and late May, and will allow for a more structured approach to identifying policy goals for the budget and budget ceilings included in the Budget Framework Letter. This stage will allow for preparation of the macro-fiscal framework, communication of high-level policy goals in a Budget Priority Statement and the determination of line ministry objectives and strategies. Specific first steps to achieve this transformation are as follows:


• The MoPF and National Prognosis Commission should provide, by each January, an agreed macro-fiscal framework that will underlie budget preparation.

• The work of the CSP should focus on preparing, by each January, an initial Budget Priority Statement for Cabinet endorsement. This statement should be a brief summary of the budgetary dimensions of the existing Government Program, intended to provide broad directives for policy content in the budget.

• Line ministry PPU’s and budget departments should build on the 2006 Programmatic planning exercise to produce short policy products—by January 2007—that clarify policy goals and objectives. These should all be passed through the new IMC’s, so that there is a clear agreement of their relevance and value.

• The MoPF should identify preliminary budget ceilings for the medium term in February, and submit these to the spending units with an explanation of where the ceilings come from—referencing both the macro-fiscal framework and the national and sectoral policy information at their disposal. These explanations will be a new dimension for the MoPF but are vital to ensuring that ministries respect ceilings.

• All spending units should receive preliminary budget ceilings in early March, accompanied by a clear and uncomplicated set of planning guidelines (an early version of a Budget Framework Letter). Through these guidelines, the MoPF (in collaboration with the GSG PPU, which should ensure complementarities of these guidelines with its own, and with the NDP unit that has also issued recent guidelines) will ask spending units to develop preliminary medium-term budget plans, on a programmatic basis.18 The guidelines will require spending units to show what can be spent within the ceilings and to also identify (and prioritize) what spending (current and proposed) cannot be spent because of the limit. In the first few years of the reform, these guidelines must be simple; the progressive improvement of these guidelines should mirror improvements in line ministry planning capacity.

• The CSP budgetary priorities document should be included in the guidelines, and spending units should show how each program relates to these priorities.

• Between March and early May, spending units will have an opportunity to develop and refine the plans, showing their policy-oriented spending requirements. During this process, it will be vital to engage the policy-making units in the line ministries, where these exist, or to ensure that a member of the Public Policy Unit is seconded to each spending unit. It will also be important to have members from line ministry NDP teams engaged in this process. The final documents will show objectives, and programs and activities (costed according to economic items) falling under the ceiling, and outside of the ceiling. The final document will be produced in late April/early May. It will be signed by the head of the Budget Department in each line ministry, and representatives from the spending unit’s UPP and NDP units (this is an important step to ensure collaboration across organizational barriers). It will be presented to the Minister responsible, to receive his unofficial endorsement (an official endorsement is not required at this stage because this is a planning document).

18 This means that the plans would identify (1) objectives (with measurable medium-term indicators)—as the basis of identifying individual programs, (2) activities within each program (related to meeting set objectives and (3) costs of each program (these could be identified by economic item within each program, given that this is the approach spending units are comfortable with). The guidelines will explain what these concepts mean and will provide basic tables for each spending unit to complete, as a means of organizing the plan.


• In May, the spending units and MoPF would have two sets of information to sit together and negotiate a hard budget limit (the initial ceiling identified by MoPF and the policy-oriented spending plan of the line ministry). The discussion would center on the prioritized spending options that spending units say cannot be funded under the ceiling. The discussion would be policy-oriented and focused. The MoPF would determine new ceilings after these discussions, for inclusion in the formal Budget Framework Letter due for development in June. The MoPF would be able to provide a clear explanation of how it was calculated, what policy activities will (and will not) be funded under it, etc. This will foster greater buy-in by Ministers and acceptance by spending units. The MoPF would also be able to re-structure the Budget Framework Letter to require spending units to provide more policy information into their budget submission—based on the planning guidelines issues in March.

B. DECENTRALIZATION

4.15 The decentralization process adds to the challenges of improving policy-making and budgetary systems, structures and processes. Historically, piecemeal budgetary decisions on decentralization of public service delivery and functions to local self-government, without a clear strategic vision of objectives have confused the competences of the decentralized and the de-concentrated authorities, reduced fiscal transparency, and weakened accountability. Looking forward, a balance needs to be struck between policy-centered budgetary cycle (formulation, execution, monitoring and evaluation) and the local autonomy given by the Constitution to county and local authorities on fiscal matters of local self-interest, as defined by the legal and institutional frameworks.19 This Section summarizes key cross-cutting decentralization issues faced by Romania, and presents policy options and recommendations.

Decentralization, Local Budgeting and Accountability

4.16 Local governments (County and Local Councils) are prevented from exercising budgetary autonomy on both the expenditures and revenues sides. Although Romania has gone a long way on the implementation of decentralization and local self-government budgeting in line with the national budget system law, there are still problems of unfunded mandates and incomplete divestiture of decision-making authority. Without local autonomy, accountability runs vertically to higher level authorities and less horizontally to citizens, as intended by the decentralization principles of the European Charter of Local Self-Government ratified by Parliament in 1997, and reflected in Romanian Laws on the Decentralization Framework, the Local Public Administration, and the Local Government Finance.20 Also, unpredictable and poorly coordinated intergovernmental fiscal relations have affected local budget formulation, execution, and monitoring and evaluation phases.

19 The main communication channel between the central and the local budgets runs through the transfer mechanism (conditional and unconditional).

20 Respectively Laws # 195/2006 (which replaced Law 339/2004), 215/2003, and EO 45/2003. The first was recently reviewed and approved, while a draft amendment for the second and third are under advanced stage of discussion in Parliament. A major institutional problem in Romania, however, is a detachment between what is codified by the laws and what has been practiced.


Budget Preparation

4.17 Fundamental problems still remain both in regard to revenue forecasting and expenditure setting, causing execution to diverge from the approved budget. Recently the MoPF has made efforts to improve local budget formulation, especially through clearer annual budget instructions to local authorities. Local authorities have been encouraged to forecast revenues by assuming full compliance rates, although in practice collections have systematically fallen short of potential revenues for most LGUs. The practice of using budgetary norms to set local expenditures still prevails, and the inefficiencies this introduces increase when the resource allocation is essentially done on the basis of existing physical capacities.

4.18 While there is a merit in the present LGUs’ three-year capital investment projections, these tend to be wish lists with little prioritization and feasibility studies. Through a separate exercise, the capital expenditure budget in Romania should follow all the steps of the regular budget process and a firmer commitment of the financial authorities. In the medium term, local investment programs should integrate a MTEF, by including recurrent expenditures in a consistent manner.21

Budget Execution

4.19 While sub-national budgets are executed through local branches of the unified national Treasury, counties and local governments can operate with banks only in two circumstances. These are: (a) to facilitate payment of local taxes and fees by taxpayers; and (b) to receive loans for local investments contracted with banks. According to the current regulations, local government short term borrowing is only allowed from the Treasury itself, which has imposed some inefficiency owing to bureaucratic and political influences.

4.20 Nevertheless, there has been accumulation of sub-national government payment arrears. This is attributed to mismatch between the expenditure and revenue flows during the year and unfunded mandates. Arrears largely take the form overdue payments to suppliers.22 On the one hand, the expenditure-revenue mismatch could be resolved with more flexible access of sub-national authorities to banks. On the other hand, unfunded mandates and overdue payment to suppliers could only be resolved by tightening regulations, by expressly: (i) prohibiting assignment of additional responsibilities without commensurate revenue source to the local budget;23 and (ii) prescribing and effectively implementing sanctions to budget managers who over-commit expenditures and transgress budgetary execution rules.24

21 This is critically important in Romania, since the extent to which the new EU financed regional/ municipal projects are sustainable is not yet clear. In this respect, concerns should go beyond the mere required municipal capital counterpart for the EU grants, by including the prospective recurrent expenditures as well—in order to keep the new public facilities functioning with local budget resources.

22 In 2004, overdue payments to suppliers represented 80 percent of the sub-national government total arrears (see Caluseru and Johnson (2005)).

23 Which does not mean earmarked revenue.

24 On the latter, good international practices are represented by the New Zealand’s Accountability Act and the Brazilian Fiscal Responsibility Law.


Budget Monitoring, Audit and Evaluation

4.21 Although local governments report budget execution to MoPF every quarter and present a more comprehensive budgetary execution report once a year, neither the aggregate data nor a systematic analysis and periodic evaluation report is disseminated by the central authorities. Dissemination would benefit the local authorities and the public in general. The latter could provide valuable feedback to the budgetary formulation process increasing the efficiency of use of public resource use, as well as better informing the national debate on intergovernmental fiscal relations and policies.

4.22 External ex-post audit and general oversight over local budget performance needs to be further developed.25 It is questionable whether the CoA and all sub-national governments (including the small towns and communes) have the resources to execute their audit functions as prescribed by law. Alternative routes could be to require that audit of local government budgets be carried out by other sub-national audit institutions and/or by private auditors. In the near future, Romania has to conform to the EU directives and develop its audit system, including sub-national governments, to go beyond the simple verification of legal and financial compliance, to include the budget performance vis-à-vis programmed policy outcomes.

Administrative Arrangements for Local Provision of Public Service

4.23 Besides policy formulation and overall control, the central government remains heavily involved in direct service delivery at local level through the de-concentrated agencies of its ministerial structure. Since the early 1990s, the decentralization process began with local self-government institutions taking increased responsibility for service delivery, although the divestiture of decision power lags. The 1991 Constitution (amended in 2003) awards local governments (County and Local Councils) with territorial-administrative and political autonomy on matters of local interest, while it allocates legal supervisory authority to the central government through the Prefect.26

4.24 Unlike most European countries, Romania does not have a specific law on local self-government which coherently consolidates the country’s local governance rules—including political, administrative and fiscal aspects. Instead, local self-governance issues are treated by several separate laws including Local Public Administration (Law#215/2003), Local Public Finance (GEO#45/203), Prefects (340/2004), and the Civil Servant Statute.27 The dispersed local governance legal system has left room for several inconsistencies and weaknesses in the regulatory framework.

25 According to GEO 45/2003, ex-post audit is an attribution of the Court of Accounts. Law 672/2002 mandates all sub-national governments to have an internal audit department.

26 Articles 119-122.

27 In 2004 a “Decentralization Framework Law” was passed (law # 339/2004) with the purpose to discipline the decentralization process. Although amended by law # 195/2006 this framework law still remain generic on established decentralization and local governance principles of subsidiarity, transparency, predictability, and accountability. While GEO 45/2003 addresses the issue of local borrowing, local debt management system remains vague and contradictory (see below).


The Administrative Structure of Local Self-government

4.25 Romanian local government is still small compared to neighboring unitary European states, and accounts for only 17 percent of general government expenditure. 28 The Romanian two-tier local self-government structure is composed of 3,127 Local Councils (the first tier)29 and 42 County Councils (the second tier, or Judets),30 which are supervised on their legal acts by 42 Prefectures, whose geographic jurisdiction coincides with the Counties’.31

4.26 While the government is currently submitting a package of legal reforms regarding decentralization, major outstanding challenges concerning the local self-government administrative structure remain. These include: (a) an incomplete institutional framework and inadequate enforcement of the legislation; (b) excessive fragmentation of LGUs and uneven capacity; (c) limited administrative autonomy of Local Councils; and (d) unclear role of the EU NUTS II Regions.

• Incomplete and dysfunctional institutional environment. While the legal intergovernmental relations framework is still being formulated, confusion between de-concentration and decentralization has been quite common rendering institutions dysfunctional. The intergovernmental fiscal relations, roles and rules have been highly unstable (including a fragmented tax administration and collection, a complex equalization grant mechanism, non-transparent conditional transfers, unclear access to borrowing). Also, regulating policy matters through the annual budget laws, rather than through well-established provisions in organic law, make the system unpredictable. For instance, in education, devolution of authorities to school boards on a pilot basis has remained on hold at the MoPF for too long. In social assistance, responsibility for topping up entitlements and service delivery are still unclear as between the County

28 This share compares to 20 percent in Bulgaria, 25 percent in Hungary, and 34 percent in Poland. The Romanian 17 percent is already overstated, because it includes payment of teachers’ salary, a pure agent function delegated by the central government since 2001—the share of local budget in the national education expenditure jumped to 56 percent in 2001, from 10 percent during the period 1995-2000 (Source IMF/GFS).

29 Constituted by 104 municipalities, 207 towns and 2816 communes.

30 Including the City of Bucharest with a special status of a county, formed by six Sectors.

31 As a spin-off of the preparation for the EU accession, Romania adopted eight NUTS II Regional Development Agencies (RDA) to conform to the EC statistical requirements for EU grants disbursement and management. RDA does not have an administrative status, and results from juxtaposition of the existing local government structure.

Figure 4.1: Local Government Expenditures as a share of General Government Spending

0 5 10 15 20 25 30 35 40 45 50 55 60 65

Slovenia (2003)Slovak Republik

Croatia (2001)Albania (1998)

Romania (2001)France (2002p)Bulgaria (2002)

Lithuania (2003)Azerbaijan (1999)

Czech Republic (2003)Kyrgyz rep. (2001)

Estonia (2002)Hungary (2002)Moldova (2002)

United Kingdom (2002)Latvia (2003)

Italy (2000)Ukraine (2001)

Tajikistan (2001)Netherlands (2002)

Poland (2002)Georgia (2001)Finland (2001)Belarus (2002)

Kazakhstan (2002)Sweden (2001)

Denmark (2002)

Source: IMF, Government Finance Statistics series.


Councils and the Local Councils. Although local authorities have been involved in primary health care voluntarily on a small scale, there is no well-established health sector strategy on service delivery and financing. Regulations and practice for public utilities (including investment, tariff policies and regulation, and debt management) are still faulty. Law enforcement has become ineffective in such weak institutional environment.

• Excessive fragmentation of LGUs and uneven capacity. Increasing fragmentation of administrative units has been an outstanding characteristic of the Romanian decentralized system. Although the size of the country may justify the existence of an intermediate level of government (the Judets), there are too many of them. More serious even is the excessive number of extremely small Local Councils. Although local representation is a desirable feature of these communities (since decision power is close to the citizen), they tend to become inefficient, since these small communities are unable to retain minimum required managerial, technical and financial capacities. Consequently, they tend not to have a minimum local economic basis for reasonable revenue collection, and the population size is not big enough to benefit from economies of scale and scope in production and consumption of public goods, which could justify their separate existence.32

• Limited administrative autonomy of Local Councils. Although directly elected and autonomous according to the Constitution, subnational government authorities (County and Local Council President and Majors) in practice operate under the tutelage of the Prefect, who reports directly to the central Government. The Prefect can “de jure” suspend any local authority decision which (s)he deems illegal, and it is up to the local authority to appeal to the Court. In the case of the Local Council, this unduly hierarchical relationship is in practice even stronger in regards to local decision-making: (i) the Secretary of the Local Council is appointed by the central government and reports to the Prefect, and influences the setting and conducting the Local Council’s agenda; and (ii) through “technical assistance” offered to the local authorities the County Council ends up having a major influence on local council’s budgetary decisions.

• Unclear role of the EU NUTS II Regions. Although the RDA could perform an important role in rationalizing the intermediate level of government, its current status is unclear, since it has no legal administrative authority, no budget of its own, and the regional population is only indirectly represented in its board by the respective County Council’s Presidents. So far, it has mainly served as a bureaucratic branch of the central government, to collect information on potential regional development projects. Although its board is formed by indirectly “elected” representatives, the RDA does not even have power to take decision on the projects candidate for EU Grant financing.

32 Some countries (e.g., Poland, Lithuania) have adopted compulsory amalgamation, with doubtful results. Others have adopted an asymmetric approach for the allocation of responsibilities and resources (e.g., Croatia). Others have opted for voluntary associations for joint service delivery (e.g., Italy,). Many countries have emphasized privatization of services (particularly utilities: water supply, wastewater, solid waste collection) for more efficient provision of services, while preserving the current fragmented administrative structure. To increase efficiency of public service delivery, Romania may adopt a combination of these arrangements.


Local Public Utilities

4.27 Most of the public utility services (water supply, waste water treatment, solid waste management etc.) are delivered by sub-national government autonomous companies.33 As these companies are regulated by the commercial code, they are managed off-budget.34 The relationship between the sub-national governments and their autonomous companies is mainly through the financial support provided by the former to the latter, including current transfers (operational subsidies), capital transfers (for capitalization of the companies), guarantees (provided to banks and suppliers), and taxes and dividends/concession fees from the companies.

4.28 The financial relations between the sub-national governments and their companies are not always uniform and transparent. On the one hand, loans to invest in utilities have been taken through different modalities, including: (i) the sub-national government takes the loan and keeps the liability in its books, while charging the utility company a concession/development fee intended to pay back the debt service generated by the loan (mainly EBRD loans); (ii) the local government takes the loan and onlends to the utility company, with the latter becoming responsible for the debt service (mainly IFI loans, sometimes with a sovereign guarantee); (iii) the company takes the loan directly, with the local government guarantee (or sovereign guarantee, and local government counter-guarantee). As described in Volume 2 Chapter 5, the policies for tariff setting can have an important impact on the finances of these utilities. This in turn has implications for local budgets, including the potential for the accumulation of arrears and the build up of quasi-fiscal deficits.

Intergovernmental Relations and Cooperation

4.29 Intergovernmental coordination and cooperation are key factors for successful decentralization and good local governance. Frequently discussions of service delivery and fiscal decentralization at the ministerial level have been difficult, especially when both the Ministry of Administration and Interior (MAI) and the Ministry of Public Finance have been involved. To a lesser extent this has been the case between these ministries and some line ministries. Problems here weaken cooperation between levels of government reducing the quality and efficiency of local service delivery. Signs of this are confusion of authority, under-provision of essential services, unrealistic user charges, accumulation of payment arrears, financially unsustainable utilities, lack of transparency due to faulty reporting mechanisms, insufficient data dissemination, and weak monitoring and evaluation systems.

Expenditure Responsibilities

4.30 The current weaknesses in fiscal decentralization can be traced to lack of clarity in the assignment of responsibilities to Local and County Councils. Until now, responsibilities have been assigned by line ministers in a rather loose and non-transparent manner. Resource allocation systems are mainly controlled by of the MoPF with the heavy influence of County

33 Electricity and district heating (most co-generated), however, are provided by the central government.

34 Public utility provision in Romania are regulated by Law 326.This fiscal treatment has important implications for fiscal risk assessment. For instance, according to the Maastricht treat criteria the country’s public debt constraint does not include the indebtedness of these companies.


Councils, but are not well defined. This situation has left room for unfunded mandates, confused local authorities, and weakened accountability. 35

4.31 The authorities are now taking significant steps to overcome these problems. Early in 2006 MAI began putting together information (scattered regulations and practices) from several Ministries and sub-national government Councils. MAI’s thorough consolidation work, allowed the Government to approve a memorandum setting out more clearly the assignment of competences and expenditure responsibilities of the sub-national governments for service delivery. Now, at the regulatory level at least, a distinction between exclusive, shared and delegated responsibilities is being made as between Local Councils, County Councils and the central authorities. Further work is needed, however, especially regarding the fiscal resources attached to these decentralized functions, and this will require the committed engagement of the MoPF in the process.

4.32 Although sub-national government expenditures have increased substantially since early 2000 (more than doubled as a share of the consolidated expenditure—from 11 percent to 22 percent) this should not be seen as a measure of the degree of decentralization of fiscal decision powers downwards to Local and County Councils. For instance, most of the observed increase was due (among other “delegated” tasks) to teacher wages’ payment to which the local government structures have been used as a mere agent for the central government (the principal).36

Expenditure by Economic Classification

4.33 In 2003 the bulk of sub-national expenditure (47 percent) was executed by municipalities, while counties’ and communes’ share were 23 percent each, and towns’ 7

35 Annex 4.1 summarizes the statutory expenditure responsibilities as generically set up by Law 215/2003, basic secondary and sector legislation, and the annual budget laws. Essentially, Counties’ exclusive responsibilities have included: maintenance of county health institutions, county public monuments, regional airports, regional civil protection (including firefighting), regional economic development, tourism information centers. Local Councils’ exclusive responsibilities include: maintenance of local health units, local cultural institutions, parks, monuments, shelters for elderly, territorial and urban planning, market places and fairs, water supply, sewage, rain draining water, water treatment, sanitation (including solid waste collection, and maintenance of cemeteries), public lightening, local transport and transportation infrastructure. Counties have shared responsibilities with central government on: prevention of emergencies, civil registry, special education, maintenance of county roads, rehabilitation and reintegration centers, day care centers, residential and maternal centers, adoption centers, child and family support, medical and social assistance for the disable. Local Councils share responsibilities with the central government on police, fire fighting, emergency situations, local civil registry, community housing, boarding schools, social assistance regarding the payment of the minimum guaranteed income, district heating, social benefits for the needy, maintenance of national roads. Local Councils also share responsibilities with the County Councils in the following: pre-school, primary, secondary and vocational education, sport facilities, day care facilities, child, woman and family assistance (including prevention of domestic violence), extension of water supply and transportation infrastructure to Communes/villages. Actually, on the above, local government involvement on public services in Romania is heavily focused on: exclusive municipal public services (particularly on the mentioned environmental and infrastructures areas, where services are delivered by off-budget utility companies); and (b) the several delegated social assistance functions (mentioned as shared responsibilities), where the Local Council has to top up expenditures.

36 In fact, the share of local budget in national education expenditure jumped to 56 in 2001, from 10 percent during the period 1995-2000.


percent. About 36 percent of these expenditures were for “personnel” (Table 4.1) while “material and services” and “subventions and transfers (including for utility companies)” absorbed one fourth each, and about 13 percent were “capital expenditures” (including investment and maintenance). It is interesting to note that allocation to “personnel” increases as one goes down from the county’s, to town’s and communes’ budgets. This would be expected since the lack of economies of scale and scope tends to push “productivity” down to smaller administrative units. However, one has to consider the following caveats in this observation regarding economic classification of local expenditures in Romania: (a) expenditures with “subventions and transfers” (including to the utility companies) are usually assumed by the counties, and larger municipalities and towns; and (b) teachers’ wage bill is included, which magnifies the actual sub-national “personnel” expenditure.

Figure 4.2: Local Government Expenditure

0.0

5.0

10.0

15.0

20.0

25.0

1999 2000 2001 2002 2003 2004

perc

enta

ge o

f consolid

ate

d e

xpenditu

re

County ConcilbudgetLocal CouncilbudgetLocal budgets

Source: Ministry of Public Finance.

Expenditure by Functional Classification

4.34 One might expect, the share of administrative expenditure to increase as one moves from municipalities, to towns, to communes. Service delivery expenditures tend to vary according to statutorily assigned responsibilities, with delegated tasks featuring prominently. For instance: (i) County Councils’ education expenditure tends to be less than a third of Local Councils’; (ii) Counties spend relatively more on social assistance and transport and communication than Local Councils; and (iii) Expenditures with community development and housing tend to absorb larger proportions of urban jurisdictions budgets (municipalities and towns) as compared to rural communes.

Table 4.1: Structure of Local Government Expenditure, 2003 TOTAL

EXPENDITU

RE

(col.12+13+14

+15+16)

(col.17+18+19

+20+21+22+2

3)

Personnel

(wages)

Material and

Services

Subventions and

transfers

Capital

expendituresOther expenditures Administration Education Culture Social Assistance (*)

Service for

community

development and

housing

Transport and

CommunicationOther ex

11 12 13 14 15 16 17 18 19 20 21 22

Local Govt. 100 35.6 25.5 24.7 13.5 0.8 9.4 32.7 4.2 15.2 25.9 7.5

Counties 100 17.2 28.4 38.5 14.9 1.1 6.3 9.5 10.8 22.1 22.3 23.6

Municipies 100 34.8 27.7 22.2 14.4 0.9 6.3 37.9 2.1 9.8 35.8 2.9

Towns 100 46.5 23.4 16.5 13.3 0.3 11.5 40.9 3.2 13.1 24.6 0.8

Communes 100 51.7 18.8 18.7 10.5 0.4 17.8 42.5 2.3 19.8 10.1 3.3

(*) Mandate partially funded. Local Governments have to top up.

Source: Ministry of Public Finance

Of which: (functional classification)

LOCAL

JURISDICAT

ION

Of which: (economic classification)


4.35 To promote internal social cohesion and convergence to EU standards of public service provision, Romania has to reduce its enormous regional expenditure disparities. Per capita expenditure across counties and across Local Councils with counties varies considerably. Excluding Bucharest, in 2001 the Local Councils average per capita spending was 173 RON (less than € 50), with a maximum of 2,292 RON and a minimum of 34 RON—three-quarters of LGUs spent 100-200 RON. Minimizing these imbalances, so that every citizen enjoys similar public service standards regardless where they live in the country, constitutes a major challenge.

4.36 An important limitation of the current decentralized Romanian public expenditure system is the absence of service standards and reliable defined indicators, against which the county and local authorities’ performance can be monitored and evaluated—and used as a feedback for policy reform. Local authorities are currently instructed by the center and/or influenced by the County (especially in regarding to the delegated tasks) to follow budgetary allocation criteria based on top-down expenditure norms (financial input). This procedure has created rigidities and has not always been effective in reaching objectives or reflecting local priorities. In the medium term, more flexibility and autonomy is needed in local expenditure allocation, so that more attention can be paid to outputs and outcomes, ensuring the annual allocation is consistent with the MTEF and the recurrent costs of investment programs are adequately accounted for.

Financing Sources

Tax and Non-tax Revenues

4.37 Most Romanian sub-national authorities have not yet managed to become reliant on their own resources, partially because of weak local economic bases, and partially because of a continued culture of dependence and payment arrears.37 Sub-national budgets are financed by State shared taxes, own local taxes and fees, other non-tax revenues, and indebtedness Currently 82 percent of the Personal Income Tax (PIT) and the all of the sub-national companies’ profit tax [i.e., the Corporate Income Tax (CIT)] are shared with sub-national governments on a derivation basis38. The 82 percent PIT share is allocated as follows: 47 percent goes directly to the Local Council budget, 13 percent goes directly to the County Council budget, and 22 percent remains in a County Council account to fund part of the “equalization pool” for subsequent distribution between the respective County Council and its Local Councils on a formula basis.

37 The latter includes accumulating cross-indebtedness, particularly between off-budget utility companies and public budget institutions. This represents a fiscal risk, and a Government’s implicit contingent liability. On the “non-payment culture and arrears in Romania”, see IMF Country Report No. 04/220, July 2004 (pp. 15-16). The study identifies that: (i) public expenditure arrears in Romania are concentrated in local government and the health sector; (ii) “local authorities account for a substantial share of outstanding arrears to the utility companies”; and (iii) these companies (especially local heating companies) have been cross-subsidizing local authorities. This situation has confused management control and decision making overall.

38 I.e., the tax share has been allocated to the jurisdiction where revenue proceeds are collected. This includes withdrawals from the wage bill (in the case of PIT), and the entire CIT tax liability has sometimes been retained by the companies themselves on account of subsidies to cover part of financial insufficiencies generated by the so-called “affordable” public service tariff policy (mainly for the utilities).


4.38 The Romanian legislation on own local taxes (Property Tax—on buildings, land, and motor vehicles—and Hotel Tax) fixes a reference rate, around which the County/Local Council can opt to set its own rate up/down 50 percent.39 There is also a myriad of fees that Local and County Councils are legally allowed to regulate and collect, some of them shared among the sub-national authorities (e.g. license issuance for planning, building permits, business registration fees described in Annex 4.1. The non-tax revenues include: conditional transfers (earmarked for specific purpose, both current and capital), general purpose equalization transfers, profits from autonomous companies and institutions, proceeds from privatization, rents from State assets and charges from the provision of specific services.

Table 4.2: Structure of Local Government Revenue, 2003

TOTAL

REVENUE

(col.2+4+5+6

+7+8+9+10)TOTAL

Of which:

with

especial

destination

1 2 3 4 5 6 7 8 9 10

Local govt. 100 20.9 2.4 26.1 5.1 19.5 15.3 5.6 0.7 6.7

Counties 100 8.5 1.4 8.8 4.0 32.6 16.8 11.1 2.2 15.9

Municipies 100 28.6 2.7 28.7 8.5 20.6 6.8 2.2 0.4 4.3

Towns 100 25.0 3.6 34.6 3.4 13.9 16.9 3.3 0.0 2.9

Communes 100 16.6 2.6 35.8 0.1 5.8 30.3 7.6 0.2 3.7

(*) Includes payment for teachers' wage bill.

Source: Ministry of Public Finance.

LOCAL

JURISDICATIO

N

Lump-sum

from PIT as

equalization

transfer

Lump-sum

from the

County

Council as

equalization

transfer (the

15% share)

Subsidy for

investment

financing (as co-

finance for

foreign assitance)

Other

Revenues

OWN REVENUE

Shared PIT

(general

purpose

transfer)

Lump-sum

from VAT

for Educa-

tion(*) and

Social Assist.

Lump-sum

from VAT

for

Residential

Heating

subsidy

4.39 Besides some leeway on policy decisions, the Romanian sub-national authorities are also empowered to administer and collect their own local taxes, fees, and charges, although most of the communes and small towns use the services of the County tax administration office for this purpose. Nevertheless, all sub-national financial transactions (including revenues, expenditures, and borrowing) have to transit through the single National Treasury system.40

4.40 The pattern of the sub-national government revenue collection by jurisdiction shows an excessive dependence on transfers and shared taxes (about three-fourths of the total), and a decreasing reliance on own revenue sources as one moves from municipalities (29 percent), to towns (25 percent), to communes (17 percent), and to the counties (8.5 percent). Moreover, part of own revenue has been tied to specific expenditure items. This overall picture demonstrates how little room is effectively left for local revenue autonomy and the lack of incentive for local authorities be accountable to the citizens.

39 The entire Motor Vehicle Tax is legislated as a local own tax earmarked for road maintenance and construction, whose proceeds are shared between the County Council (40 percent) and the Local Council (60 percent).

40 The National Treasury System control the Romanian consolidated budget, which comprises the State Budget, the Social Security System, Special Fund Budgets, institutions fully or partially financed by the State budget, and the Local Budgets. Local Budget authorities are not allowed to operate bank accounts independently, except to open long-term loans (Art. 70, Law 500/2002).


per capita Own Revenue

+PIT share (in RON)

N 2,945 N 2,945 N 2,945 N 2,945

MAX 1,804 MAX 2,428 MAX 2,438 MAX 2,647

MIN 0 MIN 0 MIN 41 MIN 71

SD 80 SD 113 SD 135 SD 163MEAN 56 MEAN 76 MEAN 201 MEAN 330

Coef.Var. 1.42 Coef.Var. 1.49 Coef.Var. 0.67 Coef.Var. 0.50


(in RON)


+ PIT

share+equaliz.trnfs.(in

RON)

per capita total local

budget expenditure (in

RON)

Table 3.3 Romania: Local Govt. Revenue Disparities,Coeffient of Variation, 20034.41 Furthermore, own local revenue per capita varies considerably among Local Councils, and the derivation-basis PIT shared tax has increased these disparities (Table 4.3).41 Nevertheless, the data indicates that equalization transfers have indeed been a strong factor to reduce revenue and expenditure disparities among Local Councils—in 2003 the coefficient of variation increased from 1.42 to 1.49 when shared PIT is included, but reduced to 0.67 when equalization transfers are included.

4.42 In summary Romania is facing the following main challenges in respect of the sub-national government revenue:

• Low reliance by local authorities on their own local revenue sources, which tends to undermine accountability and good governance. This runs against one of the most important objectives of decentralization. When local authorities are more reliant on local own revenue sources, local citizens can easily associate costs with the benefits they receive from the local administration, i.e., greater local revenue autonomy and transparency are essential features of a decentralized system which is driven by citizens’ voice and local authority accountability in public service delivery. In this regard, property taxes should be better exploited in Romania, since they are non-exportable revenue sources, they can be justifed on equity grounds, and they are a buoyant revenue source if assessed on a market value basis. The property tax on land can significantly increase Commune autonomy. If well exploited, property taxes can improve local authorities’ creditworthiness and credit access for local infrastructure investments, thereby helping revitalize the real estate market segment of the Romanian capital market.

• Inefficient and inequitable allocation of shared taxes on pure derivation basis, so that: (i) the PIT has been shared according to the place of work criteria, instead of the place of residence of the tax payer, where in fact most of the public expenditures take place42; and (ii) the CIT is not an adequate revenue source to be shared on a derivation basis with sub-national authorities, since its basis tends to be unstable and exportable, with the tax yields being captured mainly by the most prosperous jurisdictions. A natural solution for these inadequacies could be, while still keeping these taxes shared, to allocate the PIT share to the place of residence of the taxpayer, and shift the CIT to become a funding source for the formula-distributed “equalization pool” (see below).

41 This data, however, does not allow any inference on the extent that this reflects a lack of tax capacity or a lack of effort to collect local taxes.

42 E.g., education, primary healthy care, social assistance, transportation, street lighting, sports facilities, parks, as well as utility services.


• Large revenue disparities across sub-national government units. Owing to diverse regional economic bases, the decentralization process tends naturally to increase the own local and shared revenue disparities across Counties and Local Councils. Although incentives are needed for maximum tax collection effort (in order to encourage local self reliance), it is critical to recognize that fiscal transfers to regions (both County and Local Councils) are still needed to reach central economic development objectives (through conditional transfers) and national cohesion principles (mainly through unconditional transfers) in line with the EU.

• Fragmented and non-transparent tax collection and administration. Shared state taxes are centrally regulated,43 but their collection and administration is highly fragmented, with the sub-national government’s shares directly retained at the county level.44 This peculiarity of the Romanian tax administration system is not conducive to promoting transparency.45 The system involves a complicated bureaucracy (including the 42 County Councils participating in the collection/administration process), which has created enormous inefficiencies for businesses, particularly large companies which run multiple operation units nationwide. It has been reported that, in the process, the authority of the National Agency for Tax Administration (ANAF) has been weakened and ex-post control has become increasingly difficult. One possible solution would be to have all state tax administration fully undertaken by ANAF centrally, with a uniform methodology and control system, and then the MoPF/National Treasury would allocate the shared tax proceeds back to the each respective county and locality according to what is prescribed by law.46

Transfer Mechanisms

4.43 For reasons mentioned above, vertical and horizontal fiscal imbalances have been perceived in the current Romanian decentralized system. In principle, on the one hand, vertical fiscal imbalance would exist when even the richest LGUs could not discharge their assigned responsibilities satisfactorily. Since neither public service delivery standards nor indicators of performance are available in Romania, it is not clear to what extent is there any LGU in the country discharging its responsibilities satisfactorily.

4.44 On the other hand, the observed considerable disparities in own local revenues is an indication of strong horizontal fiscal imbalances in Romania. This calls for a simple, transparent and predictable equalization funding instrument for the poorer LGUs to improve

43 By the Tax Code (Law 571/2003), the EO 45/2003, and specific legislation, including annual budget execution laws. The latter has been making the system highly unstable and unpredictable.

44 Now being proposed to be more directly controlled by the de-concentrated Office of the Ministry of Public Finance, but still at the county level.

45 This system of retaining shared taxes at the County level is also used for the VAT, where part of it is retained at the County level since 2001 on account of financing teachers’ wage payments by the Local Councils. This holding of the VAT at County level is undertaking regardless of the fact that this tax is legislated as a non-shared State tax by the Tax Code (Law # 571/2003), which generates great confusion on the country’s tax administration system.

46 ANAF and the MoPF/National Treasury should be (if it is not yet) fully equipped with the required information technology for this task.


service delivery. However, Romania has tried to resolve horizontal fiscal imbalances through a rather complex two-stage hierarchical fiscal transfer mechanism, which actually ends up approaching an inefficient annually negotiated “gap-fill” system of transfers. This unconditional and conditional system of transfers has also proved to be unpredictable and non-transparent, with the following main features:

• The unconditional general purpose equalization transfers. Both the size and the distribution of the unconditional general purpose equalization transfers are difficult for the beneficiaries of the system to comprehend. They are basically done by a complex two-stage mechanism, as follows (see Annex 4.1):

o The determination of the size of the equalization pool is non-transparent and unpredictable (the “sume” component results from annual ad hoc negotiations47), and it runs against the decentralization principle (since the 22 percent “cote” from the PIT is allocated directly to the County on a derivation basis—see above).

o The distribution mechanism of the equalization pool is unnecessarily complex, inefficient, and inequitable. It has been unnecessarily complex because it has to transit through the County Council before reaching the final beneficiary, i.e., the municipalities, towns and Communes—without any monitoring mechanism in place to ensure proper implementation of the regulated distribution formula.48 It has been inefficient because it dissipates the available scarce resources throughout all LGUs—including the richest as well as the poorest—instead of focusing on the more basic needs of the financially weakest LGUs.49 It is inequitable because it essentially equalizes, by stages, inside Counties, instead equalizing all Local Councils across the nation simultaneously.

• The conditional specific transfers (both for recurrent and capital expenditures) also needs improvement.

o The conditional specific recurrent transfers are to finance State delegated functions, but they remain unstable and poorly defined, which has generated confusion in the intergovernmental fiscal relations in Romania. This has been particularly the case with: (1) the social assistance programs (including minimum income and district and household heating), which used to be tied to PIT and now to VAT, where the LGUs are supposed to top up these expenditures; and (2) the payment of teachers’ salary,

47 Which opens the system to political and bureaucratic influences.

48 It has been said that the implementation from the County level downwards is quite vulnerable, since concepts and measurement criteria for the variables in formula are not very precise and may change from County to County. Also the 15 percent component whose allocation is left for the County Council’s discretion (in principle “primarily” for co-financing foreign financed investments) has not been submitted to any sort of monitoring or verification.

49 The Government now is proposing to introduce the concept of exclusion to deal with this issue. Through this, the Local Councils which are above the average of per capita tax capacity would be excluded from the distribution formula. However, the proposed exclusion concept would still be applied only inside each County Council, separately. This means that, only because they are situated in different County Councils, Local Councils with the same per capita tax capacity may end up being treated differently—i.e., while some may be receiving equalization transfers, others may not.


where the Government is supposed to cover the whole bill. In recent years, the annual budget law has confused these earmarked state transfers, by indicating in the budget law specific lump-sum of VAT to be retained by Counties as the source of resource for these delegated expenditures by LGUs. This procedure, however, has confused the overall fiscal management system, since VAT is not legally considered a shared tax in the Tax Code (and there is no organic law regulating the contrary). Actually, as money is fungible, linking those recurrent transfers to VAT becomes a source of confusion, and is a meaningless financial and accounting procedure, since in this case it is the single State Treasury account which is actually funding those transfers.

o The specific conditional capital transfers to sub-national governments have been associated with central government programs, but are mostly allocated on a discretionary basis, in general without sufficient competition or pre-established technical criteria to ensure efficiency in the allocation of funds.

Access to Borrowing

4.45 Sub-national government borrowing and guarantee issuance are allowed by Romanian legislation, and the debt service is limited to 25 percent of the previous year own local revenue.50 These borrowings must be authorized by the local Borrowing Authorization Commission.51 However, the legal and institutional frameworks of Romanian municipal capital market are still in the making, and most municipalities are not yet creditworthy enough to access the market by their own. Many are too small, do not have enough own local revenue capacity (even when the shared taxes are included), and may continue for some time to be highly dependent on fiscal transfers. Consequently, the aggregate sub-national indebtedness in Romania is still quite low, although some few larger municipalities are already individually accessing the capital market and are running high indebtedness.52

4.46 A major challenge faced by the country at the moment is to design a consistent system of local infrastructure financing, which could satisfy the domestic pre-financing and the counterpart funding the EU structural and cohesion funds, especially for regional development projects—including environment projects, such as water supply, sanitation, and solid waste. In this area, Local and County Councils and their respective utility companies

50 GEO # 45/2003, Law 108/2004. Law # 45/2003 (Art. 59) still maintain the own local revenue (here including the shared PIT) as a guarantee for lenders. There are proposals to change this definition and also to remove this condition being discussed in Parliament.

51 Government Decision # 1258/2005. There is also an implicit limitation on debt for all sub-national governments to the annual ceiling for the sovereign debt (domestic and external) as approved by the Romanian Parliament. Moreover, Romania has to observe the Maastricht criterion of 60 percent debt limit of GDP.

52 Among other major municipalities, Bucharest has been shown to be creditworthy, has issued bonds and borrowed to its indebtedness limit, including in foreign currency. See “Romania: Municipal Finance Policy Note”, World Bank, June 2006, and “Study on the Reform of the Legal and Regulatory Framework for Borrowing by Local Governments”, G. Caluseru and B. Johnson, June 2005.


will play a prominent role, and the way they access financing on a sustainable basis is critically important from the local and macroeconomic perspectives.53

4.47 Beyond planning, monitoring and control are also central. In this respect, although borrowing is ex-ante controlled by the Borrowing Commission, and the LGUs report debt information to the MoPF periodically, a sound consolidated sub-national debt management system is not yet in place. Proper prudential rules and institutional development are now under way.

Recommendations

4.48 The Government is moving forward with the decentralization process by submitting reform measures on the legal and institutional frameworks that regulates local and intergovernmental relations. Supported by donors (including World Bank, under PAL and other interventions), the Government of Romania has recently approved a Memorandum which proposes a method to better specify the attribution of functional responsibilities to Counties, municipalities, towns and communes. In addition, the Parliament has approved amendments to the Law on Prefects, the Law on Decentralization Framework, and the Law on Civil Public Service. However, the proposed draft amendments on the Law on the Local Public Administration and on the Law on Local Public Finance are still waiting for Parliament approval. Moreover, the preparation for a draft of new Public Debt Law is long overdue.

4.49 In any case, a coherent strategic direction for the fiscal decentralization of decision-making and adequate incentives for local governance and accountability to the citizens is still illusive in Romania. To improving local fiscal capacities, transparency, accountability, and creditworthiness, critical reforms will be required not only on the formal passing/adoption of legal and institutional frameworks. In addition implementation of these reforms should be enforced more effectively with respect to the following:

• Resolve the fragmentation of local administrative units, by using an asymmetric assignment of responsibilities and encouraging joint service delivery.

• Clarify responsibilities, authorities and increased local autonomy, by further improving specification of competences of each government level, and effectively circumscribing the powers of Prefects and County Councils over the Local Councils.

• Increase the flexibility and predictability of local budgets by: (i)making the size of the equalization pool predictable; (ii) anchoring as many intergovernmental fiscal relations structural parameters as possible in organic laws; and (iii) allocating conditional capital investment grants on the basis of open, competitive basis.

• Improve the fairness of resource allocation and local authorities’ accountability by: (i) redefining the derivation basis of shared taxes (PIT) from the place of work to the residence of the taxpayer; (ii) centralizing the administration of state taxes (including shared taxes) and the management of the equalization pool nationally to be allocated by formula to each spending unit directly; (iii) bringing in the profit tax (CIT) as one of the sources for the equalization pool..

53 “Romania: Municipal Finance Policy Note”, World Bank, June 2006


• Upgrade local capacities, and increasing transparency and self-reliance in local revenue sources by: (i) overhauling the local tax/fee structure and legislation to expand the local revenue base; (ii) improving property cadastres and restructuring property taxes to be assessed on the basis of market value; and (iii) disentangling utility tariff policies from social policies, so that the former could be exclusively determined by corporate efficiency principles (cost recovery), while the latter could be exclusively supported by the budget on the basis of targeted social subsidies.

• Enhance local government access to borrowing, by promoting local government creditworthiness (through the above improved local budget predictability and autonomy), and developing a municipal debt market (through improved capital market regulation—in line with best international practices, and the “World Bank Municipal Policy Note” recommendations.


ANNEX 4.1: REVENUE AND EXPENDITURE ASSIGNMENTS

Exclusive Shared (s) Delegated Exclusive Delegated2

National Defense Military conscription

-Central Tax

Administration

-civil registry -Territorial and urban

planning

-National Treasury

System

-Market places, fairs

-Statistics

- Public Health -Medical & social

assitance for the

needy- Health Protection

- Primary Health care

-Hospitals

-Maintenance of

county public

monuments

-Financial assistance for

people with severe

disability (s)

Maintenance of

airports

Maintenance of

county roads

-Electricity

-Gas

Environment, and

public sanitation

Environmental

protection (Prefectures)

-Sanitation, including

solid waste collection

-Cemitery maintenance

-Local cultural instit. -

Parks, monuments -

Shelters for elderly

-Assist. to desabled (j)

-Sport facilities (j) (s)

-Communes'

community housing(s)

-Day care facility (j)

-Children assist. (j)

-Family assist. (j)

-Women assist. (j)

-Domestic violence

prevention (j)

-Social aide

(minimum guaran-teed

income) (s) -

Household heating

aide (coupons) (s)

-Social benefit for the

needy (s)

-Water supply -

Sewage, rain draining

water, water treatment -

Public lighting

Responsibility \ financed by:

Decentralized Functions to :Central Govt. Counties/(Judets) Municipalities/Towns/Communes

Shared (j)(s)

Nati

on

al

Po

lici

es,

Pla

nn

ing

an

d S

erv

ices

Justice/Internal

Security

-Police servs. and -

Firefighting

Regional training

centers for civil

protection

-Police (s)

-Fire fighting (s) -

Emergency

situations (s)

Prevention of

emergencies

-Regional economic

development -

Tourist information

centers

Economic Develop-

ment, Planning &

Financial Control

-Local civil registry

(s)

So

cia

l S

ecto

rs

Education

Social Assistance,

Cultural, and

Recreational

- Policy formulation/

regulation

Special Education

-Assitance to the

disabled -

Rehabilitation and

reintegration

centers

-Day care centers

-Residential/

dwelling centers

-Maternal centers

-Children support

-Family support

center -

Adoption centers

-Cultural

institutions

- Policy formulation/

regulation (including

teaches' wages, hiring

and firing

-Pre-school ed. (j)(s)

-Primary ed. (j)(s)

-Secondary ed. (j)(s)

-Vocational Schl.

(j)(s) -

-Boarding Schl. (s)

-Pgt. of teachers' salary

(s) (_VAT)

Health care Maintenance of

county health

institutions

-Maintenance of local

health units

-Prevention health

services (j)

-Medical and social

assistance for the

needy (j)

-Extension of water

supply to village (j)(s)

-District heating (s)

Traffic and Public

Transport

Table 4A.1. Romania – Assignments of Expenditure Responsibilities to Local Government

-Local transportation

infrastructure

-Public transportation

-Communes'

transportation

infrastructure (s) (j)

-Maintenance of

national roads (s)

Infr

a S

tru

ctu

re &

Pu

bli

c

Uti

liti

es

Infrastructure and

Public Utilities

Notes: (s) means that expenditures are shared with the State; (j) means that expenditures are shared with counties/judets.


Table 4A.2:Tax Structure and Assignment, 2005 (Law 571/2003, The Tax Code of Romania)

State County Munc./Towns/Com

munes

Customs duties State State 100% Point of entryAd-valorem, varying

according to goods

Excise State State 100%Domestic production

and imports

Some specific

Some ad valorem

VAT State State 100% Goods & Servs. 19% standard rate

Income taxes (on physical persons, independent

activities, micro-enterprises)State

1 State/Counties 40%1

13%1

47%1 Personal incomes

16% flat tax rate

(micro-enterprises

the tax rate is 3%)

Profit taxes (including on juridical persons in general,

and on autonomous public enterprises)State State/Counties 100% 100%

4100%

4 Business profits 16% flat tax rate

TAXES

Property taxes State/ L.Council Local Council

Building property tax State/ L.Council2 Local Council 100% value grid set by law

0.1-0.2% for

individuals, and 0.5-

1.0% for companies

Land tax State/ L.Council2 Local Council 100%

value grid set by law

developed/underdev

eloped land

Motor vehicle tax3 State/L.Council Local Council 40% 60%

Engine power, axels,

and weight

Indicative rate set by

law, with adjustment

by LA Property transaction tax ???? State/ L.Council Local Council 100% ? ?

Hotel tax State/L.Council Local Council 100% room charge 0.5-5%

FEES

Licence issuance fees (incl. planning, building

permits, business registration fees)Law

Local/County

Councils50% 50% Constructions specific

Advertisement fee Law Local Council 100%Contract value or

advert. Space

Based on legal

reference rates Entertainment fees (incl. shows, sports, festivals,

competition events)Law Local Council 100%

Ticket prices or

specific fee

Based on legal

reference rates Temporary road use (incl. car parking, market places,

vehicle circulation)Law Local Council 100% specific fee

Base on legal

reference rates

Special fees and charges (late pgt. interest and fees,

judicial and notory charges, stamp duties, extra-judicial

stamp duties, sanitary-veterinary fees, slaughter house fee,

dog licence fees, hunting and fishing fees, disease and

pest control fees, nursery school fee)

LawLocal/County

Council100% 100% Specific fee

Determined by

Local Council

Other fees Law Local Council 100%

Specific fee, mainly

admission fee to

museum, memorial

etc.

Determined by

Local Council

Specific purpose/conditional transfers Central Government Distributed by State 100% 100%

State budget

(sometimes

inappropriately

indicated as attached

to VAT)

-Size: "ad hoc" lump-

sums '-

Allocation:

negotiated

General purpose/equalization transfers [from 22% of

PIT and a "lump sum" from the State Budget, to be

distributed (through the County Council) according to

quasi-formula for equalization]

Central GovernmentDistributed by

State/Counties25% 75% Equalization pool

-Size: partially PIT

share, partially "ad

hoc" '-

Allocation: partially

formula based,

partially negotiated

Profit from Local and County Councils' autonomous

companies and institutionsLaw

Local/County

Councils100% 100% Companies' Profits

Determined by

Companies' Board

Receipt from privatization LawLocal/County

Councils100% 100% Asset privatization Total proceeds

Other revenues (including rent of State assets, special

charges to be used exclusively to finance provision of

specific local service)

Local/County

Council-according

to the Law

Local/County

Councils100% 100%

As determined by

Council

To be set by the

Local/County

Council

Rate

Sh

are

d-t

axes

no

n s

ha

red

ta

xes

an

d f

ees

Base

L

oca

l

Ta

xes

, F

ees

an

d C

ha

rges

No

n-T

ax

Re

-ve

nu

es

Sta

te T

ax

es

Tax Policy

Regulation

Assignment

Tax Tax

Administration

Allocation of Proceeds

5. REVENUE

5.1 Table 5.1 shows the collection of taxes over the last decade. Currently, taxes are approximately 27.3 percent of GDP, lower by around 1.5 percent than the tax-GDP ratio in 1995. Taxes on corporate income and wage, and social security contributions account for more than half of total taxes. The VAT and excise, the two major indirect taxes, account for about 29 and 12 percent, respectively, of the total tax revenues.

Table 5.1: Collection of Taxes as a Share of GDP, 1995-2004

1995 2000 2001 2002 2003 2004 2005

Profits 3.9 2.5 1.9 2.0 2.3 2.7 2.3 Wages and salaries 6.4 3.4 3.2 2.8 2.8 3.0 2.3 Social security 8.2 10.8 10.7 10.7 9.8 9.4 9.3 VAT 5.2 6.3 6.3 6.9 7.2 6.9 7.8 Customs 1.4 1.1 0.8 0.6 0.7 0.7 0.7 Excise 1.5 2.6 2.3 2.1 3.2 3.3 3.2 Other direct and indirect taxes 2.3 2.7 2.8 2.5 2.1 1.9 1.6 Total tax revenue 28.8 29.2 28.0 27.6 28.2 27.9 27.3


5.2 A number of changes in the tax regime and administration have been introduced in recent years. On January 1, 2005 the profit and income taxes rates were cut and streamlined with the introduction of a flat tax following the general trend in the region. The flat tax was set at 16 percent. The aim was to simplify the administration of two main taxes, encourage investment and bring a part of the large informal sector into the formal economy, boosting employment and reducing tax evasion.

5.3 As a result of these changes, Romanian personal and corporate tax rates are significantly lower than those of other countries in the region. The VAT rate is also lower than average, but only slightly so.

5.4 The introduction of the flat tax has resulted in lower revenues from profits and wages and salaries in 2005, measured as shares in GDP. Although it is probably early to appreciate the medium term impact of the recent tax reforms, the contribution of revenue from profit taxes declined from 2.7 percent in 2004 to 2.3 percent in 2005, while that of wages dropped from 3.0 percent to 2.3 percent of GDP. The cumulative revenue loss from the two taxes was therefore around one percent of GDP in 2005. The loss was however almost fully compensated by the pick up in VAT collection, which increased from 6.9 percent in 2004 to 7.8 percent of GDP, attributed to the stubbornly high aggregate consumption growth, which continues to expand above long term trends.

5.5 The situation for social security contributions, however, is the reverse; as Romania has one of the highest contribution rates in Europe. This represents a significant distortion affecting both the supply and demand sides of the formal labor market and increasing transaction costs for companies. Labor force participation rates are correspondingly low, although slowly

90 Chapter 5: Revenue

increasing since 2004. The authorities also recognize that the high contribution rates encourage migration into the informal sector in a manner that undercuts collections and complicates tax administration. The government has introduced a series of reductions in payroll taxes and plans additional cuts to align them with the regional standards. However, in the short run, the scope for further social tax rate reductions has been limited by the introduction of flat tax, which generated a loss in overall revenue collections.

Table 5.2: Standard Personal, Corporate and Value Added Tax Rates Personal Income

Tax Rate (max rate) Corporate Income

Tax Rate Value Added Tax

Rate Albania 30 20 20

Armenia 20 20 20

Belarus 30 24 18

Bulgaria 24 15 20

Czech Republic 32 26 19

Georgia 20 20 20

Hungary 38 16 25

Kazakhstan 30 30 20

Lithuania 33 15 18

Macedonia 24 15 18

Moldova 22 18 20

Poland 40 19 22

Romania * 16 16 19

Russia * 13 24 18

Serbia 23 10 18

Montenegro 23 9 17

Slovak Republic * 19 19 19

Turkey 35 30 18

Turkmenistan 25 25 20

Ukraine * 13 25 20

AVERAGE 25.5 19.8 19.5 *flat tax for PIT (others are progressive). Source: IBFD (2005).

5.6 The Government is aware of the need to increase budget revenues and envisages further tax reforms, both in tax policy and administration. The Fiscal Code and legislation of the major taxes including the value added tax (VAT) are being reviewed in light of the requirements by and commitments to the EU. While it is unlikely that the new Fiscal Code will stipulate increases in the main taxes (VAT or profit and income tax), important changes are envisaged. The Code intends to replace the turnover tax for microenterprises with the standard profit tax; to hike selected property taxes; to increase taxes on dividends and currency transaction; to eliminate VAT exemptions; and to increase taxes on vehicles and leased assets. The Government also considers a tax on oil and gas extraction, probably in the form of a windfall tax on the abnormal profits of the companies operating in this field. The updated version of the Code has been recently approved by the Cabinet, but is yet to be vetted by the

Chapter 5: Revenue 91

Parliament. The Government is also launching a comprehensive revenue administration reform project with support of the World Bank (see below).

Table 5.3: Social Security Contribution Rates in Europe

Old Age, Disability, Survivors All Social Security Programs

Insured Person Employer Total

Insured Person Employer Total

Netherlands 19.15 8.90 28.05 39.45 17.20 56.65

Czech Rep. 6.50 21.50 28.00 12.50 37.00 49.50

France 6.65 9.80 16.45 15.45 33.86 49.31

Albania 9.50 29.90 39.40 9.50 39.50 49.00 Poland 16.26 16.26 32.52 26.96 19.68 46.64

Romania 9.50 19.75 29.25a) 17.00 29.25 46.25b)

Hungary 8.50 18.00 26.50 13.50 32.00 45.50

Bulgaria 21.75 7.25 29.00 25.00 17.70 42.70

Austria 10.25 12.55 22.80 17.15 24.95 42.10

Germany 9.75 9.75 19.50 20.00 21.33 41.33

Italy 8.89 23.81 32.70 8.89 30.90 39.79

Average 9.53 16.44 25.98 14.11 25.05 38.57

Slovenia 15.50 8.85 24.35 22.10 15.90 38.00

Spain 4.70 23.60 28.30 6.25 31.58 37.83

Croatia 20.00 0.00 20.00 20.00 17.20 37.20

Greece 6.67 13.33 20.00 11.55 24.10 35.65

Slovakia 7.00 19.00 26.00 9.40 25.60 35.00

Estonia 2.00 33.00 35.00 2.00 33.00 35.00

Portugal 11.00 23.75 34.75 11.00 23.75 34.75

Sweden 7.00 11.91 18.91 7.00 25.87 32.87

Finland 4.60 22.75 27.35 6.10 25.36 31.46

Lithuania 2.50 23.40 25.90 3.00 28.00 31.00

Belgium 7.50 8.86 16.36 13.07 17.92 30.99

Latvia 2.00 18.00 20.00 .. .. 24.32

United Kingdom 11.00 12.80 23.80 11.00 12.80 23.80

Ireland 8.00 10.75 18.75 8.00 10.75 18.75 Note: a) For normal working conditions. Contributions are higher for exceptional and special working conditions (Law 380/2005); b) Refers only to social insurance, health fund and unemployment fund contributions. Employers also contribute to the social solidarity fund for the handicapped, the fund for work accidents and occupational illnesses, etc., which adds another few percentage points to the burden. Source: United States Social Security Administration.

5.7 There is considerable scope for improvement in tax administration. The Government has started the process of revenue administration reform aimed at enhancing the effectiveness and efficiency in revenue collection, lower the compliance burden, reduce the size of the informal economy, and promote integrity and transparency. In January 2004, the National Agency for Fiscal Administration (NAFA) was established as a centralized revenue collection agency, separate from the MoPF. The Customs Agency and Financial Guard have been attached to NAFA since January 2005. The Fiscal Code (now under revision) and the Tax Procedure


Code were enacted to provide legal support for the functioning of NAFA. There is a significant task of implementing the reform program, and the World Bank is offering technical assistance (see Box 5.1).

Box 5.1: Challenges in Improving Tax Administration With support from the World Bank, the Government is launching a project to improve tax administration. This is expected to improve tax collection, but, as the following list of challenges suggests, the process is complicated and the results will be felt only over time. NAFA does not have the capacity to estimate compliance--overall, by tax type, by economic sector, or by region. The lack of information on the tax gap and on taxpayers’ perceived risk of detection means NAFA cannot effectively allocate its limited resources to conduct compliance activities. The process of integrating the social collections under NAFA is incomplete and fragmented. The detailed declaration, employee by employee, is made separately by the employer to each of the social houses. NAFA currently does not receive and does not process these declarations. NAFA receives one single declaration from the employer corresponding to the total of the payroll and each of the social contribution totals. This is a problem because: first, the amount declared to the social houses differs from time to time from the amount declared to NAFA; and, second, there is no way to know which employees paid and who did not when the total amount is not paid. Because of information time lags there is no way for the social houses to act on the problem. Also, NAFA recognizes as full payment a payment that matches the declaration made to NAFA even if it does not correspond to the sum of the declarations made to the social houses. Discrepancies are thought to be in the order of 20 percent. The processing of tax returns and payments is further complicated by the fact that the bases for pension, health, and unemployment contributions are non-uniform. Taxpayers now use unique TIN for all their transactions with NAFA. However, an integrated database has yet to be built to facilitate cross-checking of data with the social houses. NAFA does not currently process the social contribution declarations of the self-employed persons, a growing part of the employed. These are processed solely by the social houses. The various laws on the social houses have no reference to NAFA. To compensate for this absence, the Government Directive on the establishment of NAFA is to override any conflicting clauses in the existing laws and legislation on the social houses that are related to how NAFA administers the contribution collection. NAFA is not able to effectively exploit its access to third party information on bank accounts of taxpayers for tax auditing, enforcement, and arrears management functions. The legislation allows NAFA to request the rapid attachment of financial assets in cases of enforced payments and arrears collection. The law, however, does not give NAFA priority to excise the government’s recovery of taxes due in cases when firms are being restructured or undergoing bankruptcy procedures. NAFA appears to have no specific activity directed toward detecting unregistered potential taxpayers, and to executing forced registration.

5.8 These suggest that there is considerable potential for revenue gains from the VAT system. The Bulgarian tax reform efforts have also seen the greatest improvements in compliance in the VAT (see text box). Using input output data for 2002, and allowing for zero-rated and exempt goods and services, and other for features of the system as provided for in the VAT code, it is estimated that the compliance rate for the Romanian VAT was just 55.4 percent in 2004. In other words, almost half of what should have been collected was missed. While compliance is expected to have increased since 2004, the gains cannot be large in the absence of a comprehensive reform of the collection system. This rate of compliance is low by comparison to other countries. Nam et al. (2001) provides estimates for selected EU countries with results


ranging from 66 percent (Italy) to 98 percent (the Netherlands). A study done for the UK by HM Customs & Excise found a compliance rate of approximately 84 percent. If the Romanian administrative reforms were able to boost the compliance rate from 55.4 to 64 percent (still a modest level of compliance of the VAT by international standards), the revenue increase would exceed that which would result from hiking the VAT rate from 19 to 22 percent at a fixed rate of compliance. Annex 5.1 provides details of these calculations.

5.9 Table 5.4 also presents estimates of the potential for raising rofit tax, income tax VAT and excise tax collections based on the experience of the first three years of the Bulgaria administrative reform program and on the assumption that VAT compliance rates improve from 55.4 to 64.0 percent.

5.10 The overall improvement is on the order of 1.24 percent of GDP with roughly 87 percent of this coming from the VAT. This gain could even be larger, given more time and given the fact that the Romanian compliance rates are generally lower than in Bulgaria, so there is more headroom for improvement. However, several points should be emphasized. First considerable uncertainty attaches to the speed at which gains may be realized. Second, the gains require a strong commitment and resolution of inter-institutional issues that may prove difficult to address. Third, the estimates do not cover the social contributions. Bulgaria managed a 1.62 percent increase in compliance on social contributions, which in Romania would translate into a further 0.15 percent of GDP. However, it makes sense to leave the social contributions out of the current discussion in the sense that reforms in the administration of social contributions are unlikely to create fiscal space for expenditures outside the social transfer system. There are three reasons for this. First, improved collection/compliance of social contributions needs to be used to reduce the high, and highly distorting contribution rates, and indeed such rate reductions will themselves for part of the compliance improvement strategy. Second, any success such measures have in reversing the flight into the informal economy, while broadening the contributor base, will also ultimately increase the number of eligible beneficiaries. Third it is the intention of the authorities to introduce a private mandatory pension system that will generate transition costs for the pension system.

Table 5.4: Impact of Tax Reform on Collections (%GDP) Profit Tax 0.10 Income Tax 0.05 VAT 1.08 Excises 0.02 Total 1.24 Source: World Bank calculations.

Box 5.2: The Bulgarian Experience with Tax Administration Reform Bulgaria has begun a tax administration reform project similar to the one proposed for Romania. Early results indicate that compliance rates are increasing as a result of the project. The table below shows the early patterns of compliance rate changes in the two years since the project was initiated in 2002. The greatest gains are being made in the VAT. Romanian VAT compliance is much lower than Bulgaria’s was at the outset, suggesting that Romania potentially has even more to gain than Bulgaria has managed.

Table 5.5: Compliance Rates in Bulgaria

2002 2003 2004

CIT 55.0 55.5 57.0

PIT 80.0 81.7 81.3

VAT 77.0 80.9 82.9

Excise Duty 86.3 87.2 86.8

Social and Health Contributions 80.0 81.7 81.3

Source: Bulgaria Tax Reform Project.


ANNEX 5.1: IMPACT OF TAX ADMINISTRATION REFORM ON VAT COLLECTIONS

Introduction

The potential VAT revenue and the realization of such potential in the actual collection are determined by a complex set of factors such as tax policy regime (e.g., coverage of the VAT, rate structure), general tax culture, effectiveness of the administration—and related to it, the extent of tax evasion and avoidance. For VAT modeling, there are three major approaches: the input – output (I-O) approach, the sector-wise national account approach, and the aggregate national account approach. Jenkins et al. (2000) review the three approaches and provide detailed account of the I-O methodology. Zee (1995) offers a step-by-step description of the aggregate national account approach. To make extensive use of the latest I-O tables available in Romania, we apply the I-O methodology for the VAT base and revenue simulation.

VAT Base and Revenue Modeling for Romania: The Data and Assumptions

The data

The main sources of data for the I – O modeling are:

1. The latest I-O tables for 2002 (Romanian National Institute of Statistics, 2005). These tables are used as the primary data for the modeling.

2. The Romanian Statistical Yearbook 2004 (Romanian National Institute of Statistics 2005). The data are used as supplementary.

3. The VAT code.

Assumptions and estimation of key parameters

1. Residential and non-residential building. To capture the revenue impact of the VAT on residential building, construction contracts—as presented in Romanian Statistical Yearbook 2004—are divided into residential and non-residential. The estimates for the base year 2002 are 29 and 71 percent respectively.

2. Shares of private and public consumption subject to reduced VAT rate of 9 percent. These shares are estimated based on the VAT provision on goods/services subject to a reduced rate of the VAT and on the high level disaggregate I – O tables (for 105 sectors) 2002.

3. Shares of private and pubic consumption exempt from VAT. The estimation is also based on the VAT provisions on exemption and on the data from the 105-sector I – O tables.

4. Modeling size of inputs and turnover of small businesses below the current threshold of RL 2 billion. The tax base needs to be adjusted by the difference between inputs purchase (taxable) and output sales (exempt) of the small businesses with turnover below the current threshold of RL 2 billion.

5. Growth factors. The growth factors are estimated separately for three different types of consumptions (household, government, and business consumptions). The estimation is based on the historical pattern of the respective components of the GDP. The annual


growth rates (in nominal terms) are 23, 21, and 28 percent for private, government, and business consumptions, respectively.

The I-O Approach

We start with the domestic consumption expenditures by goods and services. The expenditures are then subtracted for zero-rated goods and services, exempt goods and services as provided in the VAT code and netted out from the VAT embedded in the gross value of consumption. The VAT base is further adjusted by adding new residential construction, and intermediate goods of exempt business activities. The adjustment is due to the principle that only those domestic expenditures in the final demand categories that are meant for personal and government use—not those for the further production of goods and services for commercial purposes—are considered as the final consumption. In a general form, the VAT revenues (R) are estimated as follows.

( ){ } { } ( ){ } ( ){ }⎥⎦

⎤⎢⎣

⎡−++−+−−++−+= ∑ ∑ ∑ ∑

j n nnnnnnnnnjjjiiiii rrErrSrrKrrCR **** 11)1(1 ββαββαββββα

Where, - C denotes the before-VAT final expenditures. - α denotes the proportion of the final consumption subject to VAT. - β denotes the proportion of the final consumption, adjusted by the taxable proportion,

that is subject to standard VAT rate of r.

- *r denotes the reduced VAT rate. - S denotes the outputs sold by small traders which are below threshold. - E denotes the inputs purchased by below-threshold small traders.

For internal consistency and validity, we first simulate the VAT base, using the I – O data for 2002. The comparison between the actual VAT collection and the estimated hypothetical VAT indicates that the VAT compliance rate in 2002 was about 54.4 percent. Then the 2002 effective VAT base is grossed up to 2004 VAT base, using specified assumptions and estimated parameters. The 2004 VAT is estimated with the 2002 compliance. The 2004 estimated revenues (RL16.2 billion) are close to the 2004 actual collection (RL 16.5 billion), with the estimate being less than the actual collection by just 1.8 percent. From a different perspective, an estimate of the 2004 VAT revenue without leakage (at hypothetical 100 percent compliance) is compared with the 2004 actual collection; and the results suggest a slight improvement in compliance (55.4 percent in 2004, compared with 54.4 percent estimated for 2002).54

54 Tax economists and administrations worldwide have made attempts to estimate the compliance rates for the VAT. The results indicate a wide range, with conceivably low compliance in developing countries and high in developed countries. The UK HM Customs & Excise applies the full-blown simulation similar to the one presented for the case of Romania finds that the VAT gap was almost 16 percent (or the compliance was approximately 84 percent) (Andy Leggett 2005). Jenkins et al. (2000) cites a study by Daniel Alvarez-Estrada, who applies the same input-output model to the Mexican VAT for 1997 and estimates that the compliance rate for the country is about 58 percent. Nam et al. (2001) apply a full simulation of the VAT base estimation for the selected EU countries: The compliance rates in these countries widely range from 66 percent (Italy) to 98 percent (the Netherlands). Gallagher (2005) provides rough estimate of the Gross Compliance Rate (CGR) for countries in Latin America. The CGR is defined as the ratio between the actual VAT collection and the total potential VAT collection. The total potential VAT collection in turn is roughly estimated as the product of the share of private consumption in GDP and the nominal VAT rate (applicable for cases with one standard VAT rate). He finds that the CGR ranges from merely 8


The Results

After the internal validity test, we simulate the VAT revenue for 2005-2011. Three scenarios have been established. In the base case scenario, we assume there is no administration reform and the compliance remains unchanged, at 55.4 percent—or the level of the compliance estimated for 2004. We conduct a sensitivity analysis to test the impact of changes in the compliance rate and standard VAT rate for the year 2005. Both the standard VAT rate and the compliance rate are allowed to increase by an incremental 1 percentage point. The results indicate that if there were no improvement in compliance (55.4 percent compliance remains unchanged), then the increase of standard rate from the current 19 to 22 percent (recently suggested) would result in an increase of the VAT collection by 15 percent, from RON 20.7 billion to RON 23.8billion. If the rate were unchanged, but the administration were substantially improved and hence increased the compliance rate from the current 55.4 to 64 percent (still a modest level of compliance of the VAT by international standards), the revenue collection would exceed the amount that would result from raising the rate to 22 percent with no change in the effectiveness of the tax administration. Table 5A.1 provides the results of the sensitivity analysis.

Table 5A.1: Simulation of VAT collections (2004 basis, RON billion)

Compliance Standard statutory VAT rate

Rate 15% 16% 17% 18% 19% 20% 21% 22%

50% 14.9 15.8 16.8 17.7 18.6 19.6 20.5 21.5

51% 15.2 16.1 17.1 18.1 19.0 20.0 20.9 21.9

52% 15.5 16.5 17.4 18.4 19.4 20.4 21.3 22.3

53% 15.8 16.8 17.8 18.8 19.8 20.8 21.8 22.8

54% 16.1 17.1 18.1 19.1 20.1 21.1 22.2 23.2

55.40% 16.5 17.5 18.6 19.6 20.7 21.7 22.7 23.8

56% 16.7 17.7 18.8 19.8 20.9 21.9 23.0 24.0

57% 17.0 18.0 19.1 20.2 21.3 22.3 23.4 24.5

58% 17.3 18.4 19.4 20.5 21.6 22.7 23.8 24.9

59% 17.6 18.7 19.8 20.9 22.0 23.1 24.2 25.3

60% 17.9 19.0 20.1 21.2 22.4 23.5 24.6 25.8

61% 18.2 19.3 20.4 21.6 22.7 23.9 25.0 26.2

62% 18.4 19.6 20.8 21.9 23.1 24.3 25.4 26.6

63% 18.7 19.9 21.1 22.3 23.5 24.7 25.9 27.0

64% 19.0 20.2 21.5 22.7 23.9 25.1 26.3 27.5

65% 19.3 20.6 21.8 23.0 24.2 25.5 26.7 27.9

66% 19.6 20.9 22.1 23.4 24.6 25.8 27.1 28.3

67% 19.9 21.2 22.5 23.7 25.0 26.2 27.5 28.8

68% 20.2 21.5 22.8 24.1 25.4 26.6 27.9 29.2

69% 20.5 21.8 23.1 24.4 25.7 27.0 28.3 29.6

70% 20.8 22.1 23.5 24.8 26.1 27.4 28.7 30.1

Source: Staff calculations based on national input output tables.

percent (Bolivia) to 68 percent (Chile). Note, however, the CGR has limited meaning as it assumes away any impact of exemptions and does not account for the size of government consumption.

6. IMPACT OF EXPENDITURE OPTIONS

A. INTRODUCTION

6.1 This chapter ties together the various expenditure scenarios presented in the previous chapters and combines them to assess the overall financial and macroeconomic implications. For purposes of comparison we show revenues and expenditures for both 2007-2009 MTEF and for the alternative expenditure scenario. The relationship between the two is summarized below in Box 6.1.

Box 6.1: Summary of Expenditures and Revenues Education We have adopted the same increase for education expenditures as was provided in the MTEF, namely a rise from roughly 3.7 percent of GDP in 2006 to 4.2 percent of GDP in 2009. (We note that there has been a recent rectification of the budget that will allow for additional transitional payments to teachers as a result of a court settlement relating to prior year wages.) Health To accommodate the transition costs of hospital rationalization and EU accession, we suggest that budget planning accommodate a gradual increase in health spending to around 4.5 percent of GDP by 2010. Agriculture Expenditure for agriculture is projected according to several assumptions. • The minimum direct payments are made according the requirements of the EU and are covered by EU CAP resources. • Top-up payments are limited to 10 percent and are implemented as recommended above using resources from Pillar 2. • Absorption of remaining Pillar 1 resources is complete but back-loaded. • Administrative costs for implementing CAP are €300 million per year • All other subsidies and expenditure programs including future line of credit allocations are eliminated as the CAP is

introduced.

Transport Transport sector spending is based on scaled down versions of the Ministry’s plans for road and rail. In road the scaling reflects (i) rationalization and staging of the motorways program, (ii) a 20 percent cost reduction of rehabilitation and by-pass construction through more efficient processes and contracting mechanisms. This would result in a reduction and spreading of the expenditure profile so that the peak of 4.6 percent of GDP in 2009 to 2.6 percent of GDP peak in the same year in the scaled down plan. The budget scenario also reflects introduction of cost recovery measures from road users. The year-by-year details are laid out in Table 4.10 of Volume 1. In the rail portion, the investment program is scaled back from the government plan, but assumes the full implementation of the network downsizing exercise, which would generate about 3 percent of operating cost savings from 2006 to 2008, and improvement of maintenance business models and practices yielding annual reductions of 3 percent for maintenance costs and 2 percent for labor from 2007 to 2010. It also assumes that, between 2006 and 2013, passenger traffic would stabilize at 8.5 billions passenger-km and freight traffic would grow from 14 billion ton-km to 18.5 billion ton-km. Again the details are laid out in table 4.10 of Volume 1.

Environment Expenditures in environment are assumed to follow those outlined in the draft Environment SOP. The authorities may find it challenging to stick to this plan. However, this is balanced by the assumption that other environmental expenditures outside the SOP proceed at slow pace. In particular, the planned district heating expenditures are projected to run at RON 900 million per year from 2007 on, or roughly one quarter the planned rate. These expenditures are consequently spread beyond the currently planned three-year window of 2007-2009. No explicit amount is included for the water expenditures, beyond those covered by the SOP, nor for any “hidden costs” or additional subsidies.

Pensions In line with our understanding of the government’s plan, we assume that in addition to inflation, pensions are increased by 3 percent in September 2006 and by a further 7.5 percent in September in each of the following two years. We have also factored the planned reductions in social contributions.

98 Chapter 6: Financial Summary

Box 6.1: Summary of Expenditures and Revenues Tax Revenue Tax revenues are assumed have the same share of GDP as in the most recent Article IV report which is very close to what was assumed in the MTEF.

6.2 We use the general financial programming approach developed by the IMF for the calculations. Since the alternative scenario involves a higher overall level of spending there is also a higher level of nominal GDP. Both revenues and expenditures identified in Box 6.1 are calibrated to the higher level of nominal GDP.

B. THE RESULTS

6.3 Under these assumptions there is a significant increase overall spending. As indicated in Table 6.1, under the alternative expenditure scenario (referred to as PEIR) spending reaches 36.2 percent of GDP in by 2009 as compared with 30.9 percent in the MTEF in 2009 and 32.0 in the original 2006 budget. While it may take time for increases to build, as explained above we do not find the MTEF to paint a realistic picture of spending prospects. Over the medium term it may even prove difficult to contain the spending to the levels in the PEIR scenario. The positive differences are concentrated in transportation, health, pensions and environment, while there is a small negative contribution from agriculture.

Table 6.1: Expenditure Projections

MTEF PEIR

2007 2008 2009 2007 2008 2009 2010 2011

Pension and social assistance 9.0 8.4 7.9 9.0 9.0 8.9 8.9 9.0

Education 4.3 4.3 4.2 4.3 4.3 4.2 4.3 4.3

Health 3.0 2.8 2.5 3.6 3.9 4.2 4.5 4.5

Transportation 2.3 2.7 2.7 5.8 6.3 6.2 5.8 4.9

Public order and safety 2.2 2.0 2.0 2.2 1.9 1.8 1.8 1.7

Agriculture forestry fishing and hunting 1.1 1.0 0.8 0.8 0.8 0.6 0.6 0.6

Public authorities and external 2.4 3.7 4.1 2.3 3.4 3.7 3.6 3.5

Defense 1.6 1.6 1.5 1.6 1.5 1.3 1.3 1.3

Housing and comm. Services 1.1 1.0 1.1 1.0 1.0 1.0 0.9 0.9

Environment 0.3 0.3 0.3 0.6 0.7 0.7 0.7 0.7

Transactions on public debt 0.8 0.8 0.6 0.8 0.7 0.6 0.6 0.6

Other general public services 0.4 0.3 0.2 0.4 0.3 0.2 0.2 0.2

General economic activities 0.7 0.7 0.7 0.7 0.7 0.7 0.6 0.6

Other 2.0 2.1 2.2 2.1 2.2 2.2 2.0 1.9

Culture recreation and religion 0.6 0.6 0.6 0.6 0.6 0.5 0.5 0.5

Fuel and Energy 0.5 0.4 0.4 0.7 0.6 0.6 0.4 0.4

Mining manuf. and constr. 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1

Communications 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Economic research and dev. 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Other economic activities 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2

Cercetare fundamentala si cercetare 0.5 0.7 0.9 0.5 0.7 0.8 0.8 0.8

Total 31.3 31.7 30.9 35.2 36.5 36.2 35.7 34.8

Source: Romania authorities, WB and Fund staff estimates and projections.

6.4 As a consequence of this higher level of spending the prospects are for significantly higher deficits than contemplated in the MTEF. As shown in Table 6.2 instead of a deficit of 1.0 percent of GDP in 2007, the PEIR deficit is 5.2 percent of GDP—a gap of 4.2 percent of GDP—which widens to 5.0 percent in 2009. This is despite a higher level of EU grant utilization than is incorporated in the MTEF. Grants are between 0.2 and 0.7 percent of GDP higher in the PEIR scenario.

Chapter 6: Financial Summary 99

Table 6.2: Projected Revenue and Expenditure MTEF PEIR

2007 2008 2009 2007 2008 2009 2010 2011

Revenue 30.3 30.2 29.4 30.0 30.1 29.7 29.8 29.8

Current Revenue 29.1 28.8 28.3 28.5 28.2 28.0 28.0 28.0

Capital Revenue 0.2 0.2 0.2 0.2 0.1 0.1 0.1 0.1

Grants 1.1 1.2 1.0 1.4 1.8 1.5 1.6 1.6

Expenditure 31.3 31.7 30.9 35.2 36.5 36.2 35.7 34.8

Current Expenditure 27.8 28.1 27.3 28.7 29.3 28.5 28.1 27.4

Capital Expenditure 3.5 3.5 3.6 6.5 7.1 7.7 7.6 7.4

Net lending 0.1 0.0 0.1 0.1 0.0 0.0 0.0 0.0

Deficit -1.0 -1.5 -1.5 -5.2 -6.4 -6.5 -6.0 -5.0

Source: Romania authorities, WB and Fund staff estimates and projections.

6.5 Deficits of this magnitude are not being recommended. They are simply a consequence of the expenditure and revenue policies that have been described. It should be remembered that these PEIR expenditure plans represent scaled down versions of the infrastructure investment plans proposed by the ministries and included in the draft SOPs. They also include adjustments for health, education and pensions expenditures which are, in all likelihood, under-budgeted in the current MTEF.

6.6 In addition to increasing the government deficit, this level of expenditure would swell the current account deficit and slow the disinflation process (see table 6.3). It is estimated that the current account would continue to widen, exceeding 13 percent of GDP in 2007 unless offset by exchange rate depreciation and monetary tightening. Inflation would come down more slowly, reaching 5.7 percent in 2007 and tapering down to 3.8 percent by 2011.

6.7 If these levels of expenditure are pursued, steps are needed to adjust taxes so that deficits are reduced. Table 6.4 provides an alternative scenario which incorporates increases in tax revenues that will keep the public deficit from exceeding 3.0 percent of GDP in 2007. This would require additional revenues of up to 2.2 percent of GDP. It was suggested above that given the current relatively low compliance rates, improvements in tax administration could over time contribute as much as 1.4 percent of GDP – largely from the VAT. However, this could take some time to accomplish. Adjustments would be necessary to tax rates and or bases. This would require revising the flat tax rate, raising the VAT rate, or introducing changes in excise, land or other taxes. The latter option might be difficult to accomplish with out having to resort to rates that are at highly distortionary levels. Whatever the combination of policies used to achieve this overall increase in taxation, it could be expected to cut the current account deficit by one percentage point of GDP in 2007 and allow a slightly faster reduction in inflation.

6.8 It is not necessarily recommended that expenditures be automatically raised to the levels in the PEIR scenario. As stated in the opening of chapter 3, the expenditure scenarios were developed with several important objectives in mind. These included efficiency, growth and EU accession commitments and that they be politically feasible and consistent with implementation ccapacities. These are important objectives. However, if the authorities are not comfortable with tax increases that would enable this level of spending without introducing deficits that might threaten macroeconomic stability, they may have to consider further scaling back or delaying of the investment plans or trimming of other expenditures. Increased infrastructure spending assumes that pipelines of suitable projects can be developed. The


authorities need to ensure that, particularly in roads and rail, the expenditure plans are both well designed and within the implementation capacities of the relevant institutions. In addition, some of the expenditure increases outlined in the baseline scenario are predicated on introduction of measures to enhance efficiency. For instance in education increases in teacher salaries should be made conditional on improvements in the flexibility employment conditions and the adoption capitation formulas. In health, there is a need to ensure that hospital rationalization plans and other elements of the sector strategy are pursued actively and complement the commitment of additional resources.

C. CONCLUDING REMARK

6.9 All ministries of finance face the challenge of reconciling the competing demands for public resources and that this challenge is particularly acute in Romania at this time. The analysis presented here is intended not a criticism of the efforts of the authorities in this respect. It is intended to show the tradeoffs and consequences in higher relief, and to help the authorities in rising to the challenge.

Table 6.3: Medium-term Projections 1 (no tax increase)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009Prel.

EstimatesIncome and prices

Nominal GDP (in millions of re-denominated lei) 804 1,168 151,475 197,565 246,372 287,186 333,533 374,619 429,643 481,406Nominal GDP (in billions of US dollars) 37.1 40.2 45.8 59.5 75.5 98.6 116.8 136.3 159.0 180.5(growth rates)Real GDP 2.1 5.7 5.1 5.2 8.4 4.1 5.4 5.6 5.6 5.6Domestic Demand 4.3 8.4 3.9 8.4 12.1 8.3 8.8 11.3 9.1 6.7

Household consumption -0.8 6.9 5.3 8.5 14.1 9.8 8.5 7.2 6.9 6.8Government consumption 12.3 3.6 3.0 7.5 5.0 4.4 -0.5 11.7 3.5 -0.5

Gross fixed investment 5.5 10.1 8.2 8.6 10.8 13.0 12.6 16.6 9.9 9.0 of which: non government 7.7 10.9 8.3 8.1 11.6 14.1 11.1 8.9 8.6 8.1 of which: government -11.2 3.6 8.1 13.2 2.7 1.0 33.6 101.6 17.8 13.7Increase in stocks (contribution) 1/ 2.2 1.6 -1.6 0.1 0.5 -1.1 0.3 -0.6 0.9 0.1

External Demand (contribution) -2.3 -3.1 0.9 -3.6 -4.5 -5.0 -3.4 -4.9 -3.4 -1.3Exports of goods and services 23.4 12.1 17.5 8.4 13.9 7.6 7.8 6.3 7.6 8.0Imports of goods and services 27.1 18.4 12.0 16.0 22.1 17.2 13.7 16.6 13.0 8.8

GDP deflator, p.a. 44.2 37.4 23.4 24.0 15.0 12.0 10.1 6.3 8.6 6.1CPI, e.o.p. 40.7 30.3 17.8 14.1 9.3 8.6 6.5 5.0 4.5 4.2CPI, p.a. 45.7 34.5 22.5 15.3 11.9 9.0 7.2 5.8 4.7 4.4

Saving and investment balances 2/Total domestic saving 14.2 14.9 16.0 14.5 13.1 12.3 13.9 11.9 14.3 15.8

Net factor receipts and transfers from abroad 1.6 2.1 2.3 1.6 0.7 1.7 1.5 1.5 2.1 2.2Total national saving 15.8 17.0 18.3 16.0 13.9 14.0 15.4 13.4 16.4 18.0

Non-government 16.7 17.1 17.7 14.9 12.1 12.1 13.0 11.6 15.8 17.4Government -1.0 -0.1 0.6 1.2 1.7 1.8 2.5 1.8 0.6 0.6

Total investment 19.5 22.6 21.7 21.8 22.3 22.7 24.6 26.3 27.2 27.6Non-government investment 16.4 19.4 18.5 18.5 19.6 20.1 21.3 20.0 20.4 20.5Government investment 3.0 3.1 3.2 3.4 2.8 2.6 3.3 6.3 6.7 7.1Gross fixed capital formation 18.9 20.7 21.3 21.4 21.6 23.1 24.7 27.0 26.9 27.2Increase in stocks 0.6 1.9 0.4 0.4 0.7 -0.4 -0.1 -0.7 0.2 0.3

Savings - investment balance -3.7 -5.5 -3.3 -5.8 -8.5 -8.7 -9.2 -12.9 -10.7 -9.6Non-government 0.3 -2.3 -0.7 -3.6 -7.4 -7.9 -8.3 -8.5 -4.6 -3.1Government -4.0 -3.2 -2.6 -2.2 -1.0 -0.8 -0.9 -4.5 -6.1 -6.5

1/ Includes statistical discrepancy.2/ Beginning 2004, fiscal data are based on a new classification and thus ratios are not comparable to series before 2004.3/ Includes domestic and external public debt, public and publicly guaranteed.Source: Romania authorities, WB and Fund staff estimates and projects.

(in percent of GDP unless otherwise indicated)

Staff Projections

Chapter 6: Financial Summary 101

Table 6.4: Medium-term Projections 2 (with tax increase) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Prel.Estimates

Income and prices

Nominal GDP (in millions of re-denominated lei) 151,475 197,565 246,372 287,186 333,700 376,974 434,454 495,655 554,495 612,869

Nominal GDP (in billions of US dollars) 45.8 59.5 75.5 98.6 116.9 137.3 161.1 186.5 212.0 238.1

(growth rates)

Real GDP 5.1 5.2 8.4 4.1 5.5 5.8 5.8 5.5 5.4 5.4

Domestic Demand 3.9 8.4 12.1 8.3 9.3 12.1 12.0 9.8 7.5 7.6Household consumption 5.3 8.5 14.1 9.8 8.4 8.4 8.2 7.9 6.9 6.6

Government consumption 3.0 7.5 5.0 4.4 -0.5 13.8 5.7 2.2 3.7 5.1Gross fixed investment 8.2 8.6 10.8 13.0 12.6 17.6 11.0 10.3 7.7 7.0

of which: non government 8.3 8.1 11.6 14.1 11.1 9.2 9.1 8.7 7.9 7.6 of which: government 8.1 13.2 2.7 1.0 33.6 109.1 21.9 18.0 6.6 4.1

Increase in stocks (contribution) 1/ -1.6 0.1 0.5 -1.1 0.8 -1.3 1.4 0.6 -0.2 -0.1

External Demand (contribution) 0.9 -3.6 -4.5 -5.0 -3.7 -5.5 -5.4 -3.6 -1.8 -1.7Exports of goods and services 17.5 8.4 13.9 7.6 7.8 6.3 7.6 8.0 8.0 7.9

Imports of goods and services 12.0 16.0 22.1 17.2 14.5 17.9 17.8 14.0 10.2 10.2

GDP deflator, p.a. 23.4 24.0 15.0 12.0 10.1 6.7 9.0 8.1 6.2 4.8

CPI, e.o.p. 17.8 14.1 9.3 8.6 6.5 4.9 4.3 4.1 4.0 3.6CPI, p.a. 22.5 15.3 11.9 9.0 7.2 5.7 4.5 4.2 4.0 3.8

Saving and investment balances 2/

Total domestic saving 16.0 14.5 13.1 12.3 14.0 11.4 13.1 15.1 15.9 16.0

Net factor receipts and transfers from abroad 2.3 1.6 0.7 1.7 1.5 1.5 2.1 2.2 2.4 2.5

Total national saving 18.3 16.0 13.9 14.0 15.5 12.9 15.2 17.3 18.2 18.5

Non-government 17.7 14.9 12.1 12.1 13.1 11.6 14.5 16.1 16.7 16.2Government 0.6 1.2 1.7 1.8 2.5 1.3 0.7 1.2 1.6 2.4

Total investment 21.7 21.8 22.3 22.7 25.1 26.2 27.6 28.2 27.9 27.8

Non-government investment 18.5 18.5 19.6 20.1 21.7 19.7 20.5 20.5 20.3 20.4Government investment 3.2 3.4 2.8 2.6 3.3 6.5 7.1 7.7 7.6 7.4

Gross fixed capital formation 21.3 21.4 21.6 23.1 24.7 27.0 27.1 27.2 27.1 27.1

Increase in stocks 0.4 0.4 0.7 -0.4 0.4 -0.9 0.5 1.0 0.8 0.7

Savings - investment balance -3.3 -5.8 -8.5 -8.7 -9.5 -13.3 -12.4 -10.9 -9.6 -9.3Non-government -0.7 -3.6 -7.4 -7.9 -8.7 -8.1 -6.0 -4.4 -3.7 -4.3Government -2.6 -2.2 -1.0 -0.8 -0.9 -5.2 -6.4 -6.5 -6.0 -5.0

1/ Includes statistical discrepancy.

2/ Beginning 2004, fiscal data are based on a new classification and thus ratios are not comparable to series before 2004.3/ Includes domestic and external public debt, public and publicly guaranteed.

Staff Projections

Source: Romanian authorities; WBV and Fund staff estimates and projections.


Table 6.4: Medium-term Projections 2 (with tax increase) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Prel.Estimates

Income and prices

Nominal GDP (in millions of re-denominated lei) 151,475 197,565 246,372 287,186 333,700 376,434 427,214 479,580 526,564 577,374

Nominal GDP (in billions of US dollars) 45.8 59.5 75.5 98.6 116.9 137.2 158.9 181.3 202.8 226.4

(growth rates)

Real GDP 5.1 5.2 8.4 4.1 5.5 5.7 5.6 5.6 5.6 5.6

Domestic Demand 3.9 8.4 12.1 8.3 9.3 10.7 9.7 6.8 5.9 5.9Household consumption 5.3 8.5 14.1 9.8 8.4 6.8 6.6 6.2 5.8 5.6

Government consumption 3.0 7.5 5.0 4.4 -0.5 13.9 5.0 1.5 4.1 5.3Gross fixed investment 8.2 8.6 10.8 13.0 12.6 16.9 10.2 9.7 7.6 7.1

of which: non government 8.3 8.1 11.6 14.1 11.1 8.5 8.4 8.3 8.1 7.8

of which: government 8.1 13.2 2.7 1.0 33.6 109.0 20.2 16.4 5.4 3.7Increase in stocks (contribution) 1/ -1.6 0.1 0.5 -1.1 0.8 -1.2 1.1 0.1 -0.3 -0.2

External Demand (contribution) 0.9 -3.6 -4.5 -5.0 -3.7 -4.4 -3.7 -1.4 -0.7 -0.7

Exports of goods and services 17.5 8.4 13.9 7.6 7.8 6.3 7.6 8.0 8.0 7.9Imports of goods and services 12.0 16.0 22.1 17.2 14.5 15.3 14.0 9.0 7.4 7.4

GDP deflator, p.a. 23.4 24.0 15.0 12.0 10.1 6.7 7.4 6.3 4.0 3.8

CPI, e.o.p. 17.8 14.1 9.3 8.6 6.5 4.7 4.1 3.9 3.7 3.5CPI, p.a. 22.5 15.3 11.9 9.0 7.2 5.6 4.3 4.0 3.8 3.6

Saving and investment balances 2/

Total domestic saving 16.0 14.5 13.1 12.3 14.0 12.4 14.1 16.1 16.2 16.4

Net factor receipts and transfers from abroad 2.3 1.6 0.7 1.7 1.5 1.5 2.1 2.2 2.5 2.7

Total national saving 18.3 16.0 13.9 14.0 15.5 13.9 16.3 18.3 18.6 19.1Non-government 17.7 14.9 12.1 12.1 13.1 10.4 13.4 15.3 15.3 15.0

Government 0.6 1.2 1.7 1.8 2.5 3.5 2.8 3.1 3.3 4.1

Total investment 21.7 21.8 22.3 22.7 25.1 26.1 27.5 27.8 27.9 27.9Non-government investment 18.5 18.5 19.6 20.1 21.7 19.7 20.3 20.2 20.3 20.5

Government investment 3.2 3.4 2.8 2.6 3.3 6.5 7.1 7.7 7.6 7.4

Gross fixed capital formation 21.3 21.4 21.6 23.1 24.7 26.9 27.1 27.4 27.8 28.0Increase in stocks 0.4 0.4 0.7 -0.4 0.4 -0.7 0.4 0.4 0.1 -0.1

Savings - investment balance -3.3 -5.8 -8.5 -8.7 -9.5 -12.2 -11.2 -9.5 -9.3 -8.9

Non-government -0.7 -3.6 -7.4 -7.9 -8.7 -9.3 -6.9 -4.9 -5.0 -5.5Government -2.6 -2.2 -1.0 -0.8 -0.9 -2.9 -4.3 -4.6 -4.3 -3.3

1/ Includes statistical discrepancy.2/ Beginning 2004, fiscal data are based on a new classification and thus ratios are not comparable to series before 2004.

3/ Includes domestic and external public debt, public and publicly guaranteed.

Staff Projections

Source: Romanian authorities; WBV and Fund staff estimates and projections.

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