The Low-Flat Option

Economic News

22 Jul 2010
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In the last week of July the Bulgarian government announced plans to introduce a flat tax on personal income in 2008.

The government said the new rate, which will be among the lowest in a region where flat taxes have become popular, will encourage foreign investment and help shrink the country's informal economy. Labour organisations, however, believe the new rate will, in fact, leave poorer sectors of the community with even less disposable income.

The decision to introduce a flat tax on personal income, to be set at 10%, follows the introduction of a flat corporate tax, also set at 10%, put in place at the beginning of 2007. Both measures are designed to attract foreign direct investment in a country where outside capital is crucial in offsetting the current account deficit, which, according to some sources, is expected to reach 18% of GDP this year.

In a statement, the Economy and Energy Minister Petar Dimitrov said, "This will undoubtedly encourage foreign capital and bring to our country more jobs and higher incomes." Bulgaria received $5.6bn in FDI in 2006 and is expected to receive almost $6.2bn in 2007.

Across Eastern Europe, former communist economies seem to be benefiting from the implementation of flat taxes. Romania (16%), Slovakia (19%), Latvia (25%) and Lithuania (27%) are all experiencing strong economic growth. On the other side of the continent, the Irish economy is performing well with a flat income tax rate of 12.5%.

The new tax policy will be the lowest in the region and will replace the current three-tier system in which citizens are taxed between 20% and 24% depending on their income. Despite the lower rate, the government is confident the move will provide more income for the treasury. In changing the tax rate, the government expects to streamline tax collection and make it more cost efficient. It is hoped that the 10% rate will encourage people involved in the grey economy to declare their income.

Prime Minister Sergei Stanishev said the introduction of the flat tax is expected to generate more money for the country and bring undeclared incomes "to light".

In the two decades since the end of communist rule, a robust informal economy has detracted from government tax revenues. While the exact figure is hard to measure, Labour and Social Policy Minister Emilia Maslarova, said Bulgarians spend 25% more than they officially earn and that "One-fourth to one-third of employees receive a higher salary than they declare."

The situation is improving. Finance Minister Plamen Oresharski recently told the press "the trend [for informal trade] is a descending one."

However, some analysts argue that the flat tax needs to be coupled with stricter rules on tax evasion and greater powers and resources for the tax authorities.

The move has met opposition from labour groups who believe the flat tax will hit the poorer sectors of society hard, especially those earning less than 350-400 leva ($245 to $280), about two-thirds of Bulgaria's working population.

According to local media, the government is planning to abolish a number of tax breaks including the child rebate given to families. However, the government has stated the tax reform is part of a wider programme of reform in the social security system, which began in July with a 10% increase in state pensions and public sector salaries.

The introduction of what is essentially a very un-socialist measure by the ruling Socialist coalition also sheds light on the current political situation. Krassimir Tahchiev, head of research at Sofia-based First Financial Brokerage House, told OBG he believed that "currently in Bulgaria there are no major ideological distinctions between the major parties. With the exception of the ultra-rightist parties, they all inhabit the centre ground, are pro-business and pro-investment. Each party is keen to claim popular ideas, such as the flat tax, for their own."

Tahchiev played down the scale of the impact of the new tax. He said, "The government [..] would be better off focusing on cutting the country's high social security burden. In terms of attracting foreign investment, the move is a positive step but while low tax rates are useful, other factors such as the improvement of government services and infrastructural and judicial reforms are far more important in the investor's eyes."

Stanishev said he expected the tax and welfare reforms to pass through parliament when they are presented in September. While the flat tax is unlikely to prove the 'miracle cure' for the problems of the informal economy and taxation system that the government seem to present it to be, it is consistent with the current move towards attracting foreign business to the country. If the government can make progress in the fight against corruption then Bulgaria could reap the rewards that the flat tax system has brought to its neighbours.

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