Alternative (Low Tax) Budget for 2005 Georgi Angelov

 

1. Summary

For the second time the Institute for Market Economy prepared an alternative government budget. In the 2005 alternative budget we envisage revenues totaling 34.5% of GDP (39% in the government draft) and expenditures amounting to 32.8% of GDP (39.3% in the government draft). The main reforms supporting the budget are:

·         10% flat rate for all direct taxes – corporate tax, income tax, social security tax

·         Public expenditure cuts – through decrease of public sector staff, optimization of the maintenance expenditures, decrease of the subsidies for lossmaking activities, reducing the inefficient meddling in the labor market, transfer of activities to the private sector and faster privatization.

·         Using the budget surpluses for pension reform (privatization of the pension system), capitalization of the social security and other structural reforms.

As a result of the 10% flat tax rate:

·         The taxation of the companies and individuals will be cut by half

·         The incentives for work, entrepreneurship, risk-taking, saving and investment will increase

·         The distortions, caused by the taxation will decrease (deadweight loss)

·         The economic development will be faster and the wealth will increase

·         The incentives for tax avoidance and tax evasion will diminish as well as the gray economy

·         The net incomes of the taxpayers will increase by 30-40%

In addition to that, we propose a 3-year budget reform, including additional reforms for 2006 and 2007:

·         Zero corporate tax

·         Private competitive health funds and hospitals, pension reform, voucher system in the education

·         Program budgeting, continuing reduction of the public service staff and the subsidies

The proposed reforms will ensure a stable double-digit economic growth and corresponding rapid increase of the incomes of Bulgarian citizens. In addition, the reforms will increase the efficiency of the public spending and the quality of the public services, healthcare and education.

 

2. Alternative budget: taxes and revenues

Tax Reform

The main goal of the alternative budget for 2005 is to show that it is possible to achieve a considerable reduction of the direct taxes and at the same time to maintain a balanced budget or even budget surplus. We propose the following reforms in the tax system:

·         Decrease of the corporate tax to 10% (19.5% in 2004)

·         Decrease of the income tax to 10% (12-29% in 2004)

·         Decrease of the social security tax to 10% (42.7% in 2004)

·         Abolition of the dividend tax (15% in 2004)

Revenues in the consolidated budget

The total revenues in the alternative budget, prepared by the Institute for Market Economy, are 14.4 billion levs [1] or 34.5% of GDP (see table 1 below). The revenues in the budget prepared by the government are about 16 billion levs, i.e. 39% of GDP. These revenues, however, are underestimated by about 1 billion levs, therefore we assume that expected revenues are about 17 billion levs, i.e. more than 41% of GDP (like in 2004). Therefore the alternative budget seizes 6.5% of GDP less resources from the economy than the budget of the government.

 

Table 1: Revenues in the alternative government budget, prepared by IME

Note: The differences between the budget, prepared by IME and the budget, prepared by the Government are due to the tax reforms proposed by IME and the fact that the revenues in the government budget for 2005 are underestimated.

 

A. Taxation of labor

As a result of the proposed tax cuts we expect several effects on the revenues from taxation of labor:

·         Lower incentives for hiding of incomes – a great part of the labor incomes are misreported because of the high rates of social security and income taxes. When the rates are lower, the incentives for misreporting are also lower and the tax base is increasing.

·         Increase of incomes – because of the economic growth and the additional economic activity and employment because of the lower taxes.

·         Increase of the companies’ profits – the social security burden is shared between the employer and employee (according to the elasticity of supply and demand of labor). We expect 30% of the social security tax cuts to go to the employer.

The total effect of the above-mentioned effects is about 15% increase of the declared labor costs in 2005 as compared with 2004. Therefore the labor costs of employers are to reach about 16 billion levs.

 

Table 2: Taxation of labor under 10% income and social security taxes

 

B. Taxation of profits

The 10% corporate tax rate will have the following effects on the government revenues:

·         Social security effect – as mentioned, we expect 30% of the reduced social security taxation to go to the employers thus increasing their taxable profits.

·         Grey economy effect – corporate taxation is one of the most avoided (and evaded) taxes. The lower tax rates will diminish the incentives for tax avoidance and tax evasion.

·         Increase activity effect – lower taxes increase the economic activity and thus the tax base.

As a result of these effects and because a part of the corporate taxes are paid for previous-year profits we expect a relatively small drop in the corporate tax revenues – about 10% drop. So the forecast for revenues from the corporate taxes is 917 million levs.

C. Revenues from excises

The lower taxes lead to higher (net) take-home pay so Bulgarian citizens will be able to consume more goods, including goods that are taxed with excises. In addition, the higher economic activity needs more transportation, i.e. more fuels – taxed with excises. We expect this effect to amount to about 10% increase in the excise revenues.

D. Revenues from Value-added tax (VAT)

As far as the excises are a part of the taxable base for VAT, the additional excises lead to additional revenues from VAT. We expect 1% more revenues from VAT.

E. Non-tax revenues

They can be increased by privatization and public-private partnership. We expect 100 million or 4% increase of these revenues as a result of these actions.

 

3. Alternative budget: expenditures

Total expenditures and budget balance

The alternative budget has revenues of 13.8 billion levs, i.e. less than 33% of GDP. The expenditures og the government budget are expected to reach about 40-41% of GDP in 2004 so the alternative budget ensures a 7% cut in the expenditures as a share of GDP.

We envisage a budget surplus of 730 million levs. This money is to be used to cover unexpected changes in the economic environment and realization of pension reform (capitalization of the pension system) and/or redemption of government debt (thus decreasing the interest payments of the budget).

Government expenditures reform

A. Salaries and social security taxes (for government employees)

We propose at least a 3% cut of the number of public sector employees. Thus the personnel expenditures will decrease. On the other hand, the decrease of the social security and income taxes will increase the net wage of the public employees and at the same time it will decrease the expenditures of the budget (we divide the income and social security tax cut between the employees and the budget at 50:50 proportion). The institutions that decrease the staff by more than 3% can ensure additional increase of the salaries of their employees.

B. Maintenance

The decrease of the public sector staff combined with the sell of inefficient and unnecessary assets (buildings, cars, land, forests), an increased control over the expenditures and increased efficiency of the expenditures allows the expenditures to be frozen at the 2004 level.

C. Defense and security

The defense expenditures in Bulgaria are at a very high level as a share of GDP compared to most of European countries. Also, the army has lots of assets that are not needed and can be sold – the money obtained in this way can be used for financing part of the capital expenditures of the army. That allows for a 100 million levs reduction of the budget. Again, the decrease of the social security and income taxes will increase the net wage of the public employees and at the same time it will decrease the expenditures of the budget by about 300 million levs (we divide the income and social security tax cut between the employees and the budget at 50:50 proportion).

D. Subsidies, credits and temporary financial aid

The subsidies for loss-making companies and activities distort the market and hold resources in loss-making activities and thus impede the economic growth. We propose a 50% cut in the subsidies through reform and privatization of the state railways company, faster reform in the coal industry, increase of the efficiency of the state-owned media, continuation of the healthcare reform, privatization of the hospitals etc. In addition, the Agriculture fund needs to start working on market principles and must be privatized eventually.

E. Social expenditures

In this article are included pensions, healthcare, social benefits, compensations etc. We propose elimination of the inefficient programs for meddling in the labor market that cost more than 200 million levs.

F. Capital expenditures

Using privatization and/or public-private partnership for transferring infrastructure to the private sector and more competitive public procurement procedures will lead to a better quality of infrastructure and, at the same, time lower budget expenditures.

G. Reserve for unexpected and urgent expenditures

This article includes funds for natural calamities as well as funds for “structural reform”. The money for structural reform increase quite fast although no structural reform is being done. It seems that is a way for additional spending by the ministries. This additional spending is not justified, because the expenditures of the government institutions are too large and inefficient anyway.

H. Interest expenditures

The fiscal reserve and the proceeds from a faster privatization can be used for capitalization of the pension system and/or for payoff of the government debt (that will reduce the interest payments).

 

Table 3: Expenditures of the alternative government budget, prepared by IME