Wednesday, January 4, 2012

Romania The challenges to long run fiscal sustainability

Romania, along with many other countries in the European Union, faces daunting fiscal challenges. Fiscal balances deteriorated sharply following the global economic crisis, forcing Romania to implement a fiscal consolidation that was one of the largest in the European Union, but which may not be sustainable without a recovery of economic growth. Although the ratio of public debt to gross domestic product is still relatively modest, at around 35 percent, long-term fiscal solvency is threatened by the costs of funding the public pension system in the face of adverse demographic shifts over the next 50 years. Because of widespread tax evasion, the tax system in Romania is one of the least efficient in the European Union. Tax reforms that can reduce the amount of tax lost to evasion and fraud could make a major contribution to enhancing fiscal sustainability.

Fiscal sustainability has emerged as a key policy issue throughout Europe in recent years, in part because the fiscal positions of many countries on the continent were badly affected by the global financial and economic crisis and also because of an increasing public recognition of the magnitude of the long-term fiscal costs of demographic change, notably aging populations. Several of the new member states of the European Union, including Romania, face major challenges to ensure fiscal sustainability. The sustainability of Romania’s public finances deteriorated sharply in the years leading up to the global economic crisis. The global economic crisis triggered a severe recession in Romania, exposing the fragility of public finances. To bring the fiscal deficit back into line with the targets in the EU’s Stability and Growth Pact, the government implemented a draconian fiscal consolidation in 2010, but it still faces huge long-term fiscal costs as a result of population aging. Long-term fiscal sustainability, along with meeting the fiscal criteria required for membership of the Eurozone monetary union, is also threatened by the poor management of public expenditures.

Maintaining fiscal sustainability should be a priority for policy makers. An unsustainable fiscal position threatens both macroeconomic stability and the financial capacity of the state to deliver essential goods and services to citizens. Moreover, if fiscal positions are perceived to be unsustainable over the long term, the reaction of the markets on which governments finance their borrowing requirements could trigger a fiscal crisis much sooner than might be expected by fiscal planners.

Fiscal sustainability is essentially a forward looking macroeconomic concept which is related to the solvency of government. It is closely linked to the future course of the fiscal deficit and the evolution of public debt and to the government’s capacity to mobilize finance for the deficit and/or to refinance its debt. Alvarado et al. (2004) define a sustainable fiscal policy as a set of fiscal policies which will not lead to the government having, at some point in the future, to default on its debt or to monetize its debt, or be forced to undertake a major fiscal retrenchment to avoid default or monetization.

A starting point for analyzing fiscal sustainability is the current levels and medium-term projections of general government fiscal balances and public debt. It is relatively straightforward to determine the impact of such fiscal balances, if extrapolated forward into the future and combined with some basic macroeconomic projections, on the evolution of public debt levels, with debt sustainability being defined as a situation where public debt as a ratio of GDP is stable or falling and/or does not exceed some critical threshold. Section 2 of this paper examines the general government fiscal balances and public debt levels in Romania and the medium-term projections of these variables. The general government fiscal data include the local governments.

The data captured in the general government budget, however, often provide an incomplete and hence misleading picture of the sustainability of public finances over the long term. This is starkly illustrated by a comparison of current public debt levels with calculations of the long-term net worth of the government in Romania, taking into account the long-term costs of aging. Romania’s outstanding public debt amounted to 32 percent of GDP in 2010, a relatively moderate level. In contrast, Velculescu (2010) estimates the inter-temporal net worth of the Romanian government at negative 252 percent of GDP, based on a finite horizon approach and negative 1,097 percent of GDP based on an infinite horizon approach.

Risks to fiscal sustainability may emanate from activities of the public sector, which are not currently part of the general government budget, but which might eventually impose fiscal liabilities on the budget. These could include contingent liabilities of government, such as loan guarantees, or the quasi fiscal deficits (QFDs) of state owned enterprises. The QFDs of the state owned enterprises are discussed in Section 3.

World Bank. Author: Canagarajah, Sudharshan; Brownbridge, Martin ; Paliu, Anca ; Dumitru, Ionut. Document Date: 2012/01/01. Document Type: Policy Research Working Paper.Report Number: WPS5927.


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