## _cr1580 ## Source details **Canonical URL:** [_cr1580](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1580.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1580.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1580.pdf.json) --- ### Overview - Document date indicated: March 10, 2015. - Sections covered in the supplied content include: - "ROMANIAN STATE-OWNED ENTERPRISES: CHALLENGES AND REFORM PRIORITIES" - "EXPORT PERFORMANCE AND EXTERNAL COMPETITIVENESS" - "EXCHANGE RATE PASS-THROUGH AND INFLATION TARGETING" - "CUTTING LABOR TAXES IN A CONSTRAINED BUDGET ENVIRONMENT" - "MORE FISCAL DECENTRALIZATION—THE PREREQUISITES" - "BENEFITS OF BOOSTING QUALITY PUBLIC INFRASTRUCTURE SPENDING IN ROMANIA" - Boxes referenced in the supplied content include: - "Rail Freight SOE CFR Marfa's Performance" - "Details of SOE Arrears" - "Oltchim and Hidroelectrica: A Tale of Two Insolvencies" - Prepared by John Ralyea, Vahram Stepanyan, and TengTeng Xu (European Department); document dated March 10, 2015. ### Infrastructure quality and public investment portfolio - Key findings on infrastructure quality: - Romania’s infrastructure is perceived as low quality despite relatively high public-sector capital spending. - Contributing governance/implementation factors: lack of robust framework for project development/prioritization/execution; political incentives to announce and begin projects without ensuring completion; dominance of large, inefficient, financially vulnerable SOEs in transportation and network industries. - Procurement weaknesses: Romania had the second highest average number of red flags per contract in a World Bank dataset covering 14 countries in East Europe and Central Asia. - Central government project portfolio (end-2013): - 543 projects with an investment value equivalent to 31 percent of GDP. - 85 projects receive non-reimbursable funding from the European Union; 97 projects received no funding at all in 2013. - Cost overruns amount to 2 percent of GDP. - Project duration issues: - 78 projects expected to take more than 10 years to complete. - One project with a duration of 42 years. - Many projects lack full budget funding for projects of duration less than a year; many projects may no longer align with current objectives given long portfolio durations. - Annex — highest priority significant projects by primary funding source (selected figures preserved verbatim): - Non-reimbursable funds (EU grants): 49.730.0 (Billons of lei) - o/w top 3 projects of 36 total: - Motorway Lugoj-Deva: 5.74.8 2011 2017 - Railway rehabilitation Brasov-Simeria: 5.03.5 2007 2018 - Motorway Sebes-Turda: 4.64.6 2014 n/a - Reimbursable funds (loans): 7.95.7 - o/w top project of 10 total: - Metro line to Otopeni Airport: 5.35.3 2009 2019 - State-budget and pre-accession funds: 55.534.6 - o/w top 6 projects of 54 total: - Motorway Bucuresti-Brasov: 8.36.0 2006 2017 - Railway rehabilitation Bucuresti-Constanta: 2.10.1 2006 2014 - Bucharest by pass roadway: 3.23.2 2008 2020 - Ministry of Economy building: 0.10.1 2004 2016 - Metro modernization: 1.51.2 2004 2017 - Motorway Brasov-Cluj-Bors: 12.86.1 2004 2017 ### EU Structural and Cohesion Funds (SCF): availability, absorption, and constraints - SCF availability: - 2007–13 programming period: Romania eligible for EUR 19.1 billion (15.3 percent of 2007 GDP); transportation and environment accounted for 46 percent of available resources. - 2014–20 programming period: Romania eligible for EUR 22.5 billion (13.7 percent of estimated 2014 GDP); large infrastructure OP allocated EUR 9.4 billion (part contingent on EC approval of a Master Transportation strategy). - SCF defined here as EFRD, ESF, and CF. Total EU funds during 2007–13 were EUR 34.6 billion including other instruments (not the focus here). - Absorption performance (as of early November 2014): - Romania’s absorption rate, including pre-financing, was 50 percent compared to an average of 71 percent in other new member states. - Human resources OP absorption rate was 41 percent. - Cumulative unabsorbed resources from 2007–13 as of that date: EUR 8.6 billion (5.3 percent of GDP). - Romania has until the end of 2015 to absorb remaining 2007–13 resources under the N+2 rule. - Reasons for low SCF absorption: - Weak beneficiary capacity to identify, elaborate, and manage projects. - Public administration deficiencies in evaluating and monitoring projects. - Some OPs experienced suspension or interruption and reimbursement of received amounts. - Possible preference by officials for solely central/local government financed projects due to lower monitoring and evaluation relative to EU-funded projects. ### Reforms to improve project prioritization and absorption - Adopted measures: - Emergency Ordinance 88/2013 and Government Decision 225/2014: legally-binding project prioritization methodology for projects value > RON 100 million funded by the state budget. - Creation in 2013 of the Public Investment and Valuation Unit (PIEU) in the Ministry of Public Finance (MoPF) to strengthen quality control for significant central-government projects. - Practical limitations and coverage gaps: - Many project life-cycle steps remain line-ministry responsibilities. - PIEU activities limited to reviewing pre-feasibility studies for projects > RON 100 million and compiling priority lists; PIP lacks multi-annual time dimension; priority list for 2015 budget cycle was not approved. - For EU-funded projects, prioritization often follows "first come, first-served". - Coordination between Ministry of European Affairs (MEF) and MoPF remains limited. - More than 350 central government and over 3,000 local government projects fall outside government-approved prioritization framework. - Local project prioritization and funding transparency remain rudimentary per Fund technical assistance. - Recommended near-term actions (selected, timing preserved where given): - Amend GEO 88/2013 to align project prioritization with the budget cycle. - Amend the Public Finance Law to include substantive elements of GEO 88/2013 and ensure prioritization covers all projects over time. - Upgrade central-government project database for cost/benefit selection and improved monitoring; encourage consistent reporting by line ministries. - Update, approve, and publish project prioritization list prior to commencement of the 2016 budget process; within 15 days after approval of the 2016 budget by parliament, update the published list with actual amounts allocated to each project and estimated medium-term expenditures. - Empower PIEU to reject projects based on the prioritization methodology. ### Growth impact of increasing quality public investment and higher EU-fund absorption - Rationale: - Romania has post-crisis slack, low labor participation rate, and low government borrowing costs/policy rates—favorable for increased quality public investment. - EU-funded investment typically benefits from higher monitoring and evaluation implying higher quality. - Quantitative estimates (staff scenarios and model results preserved verbatim): - Raising EU funds absorption rate from 75 percent in the baseline to 100 percent over 2016–20, equivalent to an average of RON 6.2 billion annually (¾ percent of GDP), could increase output by 1½–3 percent over the medium term under the most plausible assumptions. - Production function approach indicates potential GDP growth rate could be 0.5 percentage point higher by 2020. - Simulations summarized elsewhere in the document indicate "1.4 percentage points on average from 2015 to 2020" (phrase preserved from source). - Aggregate conclusion: both supply- and demand-side estimates yield similar growth benefits from increased quality public investment financed primarily through increased EU-funds absorption. ### Model-based assessment of public investment (GIMF simulations) - Simulation setup: - Additional government capital spending: temporary increase for five years equal to 0.8 percent of GDP per annum, financed by EU grants. - Model used: IMF’s Global Integrated Monetary and Fiscal model (GIMF) calibrated for Romania. - Output elasticity assumptions: - Benchmark output elasticity of public capital: 0.2. - Alternative simulated elasticity: 0.3 (to represent "right" investment projects). - Reference meta-analysis average cited: 0.2; meta-regression estimate cited: 0.1. - Simulated impacts (preserved exactly as presented): - Growth benefits from higher and more efficient investment could be up to 0.5–0.7 percentage point on real growth and potential growth by 2020. - The cumulative impact on the level of GDP and potential GDP could be up to 1.3 to 1.5 percentage point by 2020. - Real GDP increases by approximately 1 percent on impact because of increased domestic demand, particularly investment. - In subsequent periods, real GDP is higher by around 1.5 percent. - A simulation with output elasticity of public capital of 0.3 shows a bigger impact than the 0.2 benchmark. ### Multiplier approach and sensitivity analysis - Empirical multipliers and findings: - Recent research suggests a public investment multiplier of about 1–1.3. - Alternative estimates indicate a 1 percentage point of GDP increase in public investment has a multiplier of 0.5–0.9 over the medium term (IMF, 2014b). - Varga and Veld (2010) estimated an impact multiplier of SCF funding for infrastructure in EU members to be around 0.5 after accounting for unproductive spending, import leakage, and possible crowding out. - Lungu (2013) found the multiplier for SCF-funded projects in Romania in the range of 0.5–0.9 across operational programs. - Stoian (2012) estimate cited: short-term multiplier of 0.5 for Romanian government investment. - Financing and effective cofinancing: - Effective national cofinancing ratio cited for 2013: 25 (percent). - National co-financing ranges from 15 percent for ERDF and ESF projects to 20 percent for CF projects; VAT and land acquisition costs largely on national authorities; top-up financing from EU up to 10 percent for SCF projects. - Persistence and projection assumptions: - Output effect of an exogenous fiscal shock often vanishes within 5 years even if fiscal measures are permanent; for permanent change multipliers may be permanent, rising toward long-run values. - Varga and Veld (2010) model result: multiplier for all SCF financed investment rises gradually to one after seven years and 2.6 after nearly two decades. - Projection assumption for a policy scenario: increased quality of investment modeled as annual shock to expenditure on EU-funded projects by RON 1.7 billion per year relative to the baseline over 2016–20; increase funded by SCF grants and cuts in national capital spending (budget neutral); output effect projected to vanish after five years (modeled via a persistence factor). - Projected outcomes under multiplier scenarios (percentage points relative to baseline): - The increase in the GDP growth rate in 2020 relative to the baseline ranges from 0.3 to 1.2 percentage points. - The cumulative change in GDP in 2025 relative to the baseline ranges from 1.9–6.2 percent. - Multiplier scenarios table entries preserved verbatim: - 10.50.50.52.7 - 20.70.50.84.3 - 30.90.51.26.2 - 40.500.31.9 - 50.700.52.7 - 60.900.63.5 ### State-owned enterprises (SOEs): performance, governance, and reform priorities - Aggregate SOE performance and fiscal impact: - During 2008–12, cumulative SOE losses amounted to around 2 percent of 2012 GDP. - In 2013, aggregate SOE sector became profitable driven largely by SOEs in oil and gas; excluding five large SOEs (Romgaz, Hidroelectrica, Nuclearelectrica, Transgaz, and the Road Company) the remaining sector was still loss making. - SOEs account for bulk of arrears; more than 70 percent of arrears are owed to the consolidated budget and other SOEs; less than 1 percent to banks. - SOE sector features: - More than 1,000 SOEs in Romania; about 250 majority-owned by the central government and the remainder by local governments. - Aggregate SOE share: around eight percent of non-financial companies’ total employment and around 4 percent of their annual turnover. - The top 20 enterprises account for about two-thirds of SOE turnover and half of SOE employment. - Five SOEs generate the bulk of profits; a handful account for the large part of losses and about half of SOE arrears. - SOE presence by sector: more than 40 percent of the energy and gas sector, around 40 percent of postal and courier services, and more than 20 percent of the transport sector turnover. - Only central government SOEs are included in program conditionality under the 2013 Stand-By Arrangement (SBA). - Reasons for poor performance and governance weaknesses: - Many SOEs have not faced hard budget constraints; management compensation not linked to performance; non-wage benefits continue despite weak finances. - Line ministries reluctant to initiate liquidation/insolvency; insolvency processes often protracted without addressing inefficiencies. - Political appointments and tutelary interference: no clearly defined SOE ownership policy; SOE monitoring unit not empowered to call for remedial actions. - Reporting and audit weaknesses: few SOEs publish IFRS-based reports; audits may contain material qualifications that remain unaddressed. - Impact of reforms to date: - Mixed progress: IPOs and privatization focused on energy sector; three successful IPOs under SBA (including majority IPO of Electrica and Romgaz IPO); Hidroelectrica under insolvency expected to exit during 2015 after restructuring; Oltenia’s performance deteriorated. - GEO 109/2011 introduced governance provisions but implementation weak; selection/appointment of professional management implemented only in 33 SOEs; many boards dismissed and replaced with interim members. - SOE monitoring improved (quarterly→monthly reporting) but analytical depth and enforcement limited. - Box on CFR Marfa (rail freight SOE) — selected indicators for 2012 (as reported): - CFR Marfa: Global traffic, thousand tonnes: 31,282; Average number of employees: 8,411; Tonnes per employee: 3,719. - PKP Cargo (Polish): Global traffic, thousand tonnes: 126,745; Average number of employees: 28,100; Tonnes per employee: 4,510. - CD Cargo (Czech): Global traffic, thousand tonnes: 73,188; Average number of employees: 8,900; Tonnes per employee: 8,223. - GFR SA (private Romanian): Global traffic, thousand tonnes: 12,000; Average number of employees: 2,368; Tonnes per employee: 5,068. - CFR Marfa’s market share shrank by almost 50 percent during the last decade; losses since 2008; labor productivity essentially halved (World Bank, 2013). - Privatization assessed as the only viable option to enable radical restructuring; staffing reduced by almost 30 percent in 2014 after failed privatization attempt in October 2013. - SOE reform priorities (selected recommendations): - Move ahead with IPO and privatization agenda; HLC to ensure privatization unit employs expertise and resources. - Assess SOE performance against clear targets and publish timely annual reports. - Swiftly submit revised draft legislation on SOE corporate governance for parliamentary approval (appointment/dismissal of boards, mandate contracts, administration/management plans, annual budgets, MoPF oversight). - Exercise political will to implement legislation; HLC to monitor and propose reduction in ministerial orders that interfere with management. - Restructure, place into insolvency, or liquidate non-viable loss-making SOEs (energy and transportation highlighted). - Establish a clear ownership policy separating ownership, governance, and monitoring functions. - Continue energy market deregulation: implement electricity roadmap to achieve full competitive market sourcing for households by end-2017; adopt new gas deregulation roadmap and strengthen vulnerable consumer support. ### Export performance and external competitiveness - Export performance (key statistics and patterns): - Exports of goods as percent of GDP rose to 34 percent in 2013 (pre-crisis average 28 percent during 2000–07). - EU received more than 70 percent of Romania’s goods exports during 2009–13. - Composition of exports (Average of 2007-2014): - Machinery and Transport Equipment: 40% - Manufactured Goods by Material: 18% - Miscellaneous Manufactured Articles: 17% - Mineral Fuels, Lubricants and Related Materials: 6% - Chemicals And Related Products: 6% - Crude Materials, except fuel: 6% - Others: 7% - Transport equipment more than doubled international sales between 2007 and 2013 and was the major driver of recent export growth. - Domestic value-added embodied in exports (OECD-WTO TiVA 2009): almost 76 percent of total exports for Romania in 2009—the highest among regional peers. - Export decomposition (CMSA, 2006–13) highlights: - Competitiveness (domestic “push”) effect was the main driver of positive export growth during 2006–13. - Romania’s export market share in global trade increased from 0.26 percent in 2006 to 0.35 percent in 2011. - CMSA year-over-year export market share entries (percentage changes): - Export market share: 2006 1.3, 2007 7.9, 2008 5.7, 2009 6.2, 2010 0.2, 2011 6.1, 2012 -8.4, 2013 11.2 - Competitiveness effect: 2006 -0.3, 2007 2.1, 2008 5.6, 2009 10.8, 2010 3.3, 2011 7.8, 2012 -0.8, 2013 10.7 - Non-price and price competitiveness: - WEF GCI ranking: Romania 76th out of 148 countries in 2013–14. - GCI strengths: macroeconomic environment and market size; weaknesses: institutions and infrastructure. - CPI-based REER appreciated 7¾ percent between 2012Q3 and 2014Q4. - Policy priorities: improve export quality, diversification, vocational training, infrastructure, promote FDI and participation in global value chains, and maintain exchange rate flexibility. ### Regression evidence on competitiveness determinants (Box 1 methods & results) - Regression design: - Cross-industry panel at ISIC 2-digit level; 64 industries across 8 years; dependent variable: industry-level competitiveness effect from CMSA. - Explanatory variables include year-on-year change in ULC-based REER and selected GCI indicators (institutions, infrastructure, macroeconomic environment, training, goods market efficiency, labor market efficiency). - Key coefficient estimates (dependent variable = yoy change in export market share; robust standard errors in parentheses): - REER (yoy change): Model (1) -0.02* (0.01); Model (2) -0.01* (0.01) - Infrastructure: Model (1) 0.35** (0.17); Model (2) 1.63** (0.71) - Macroeconomic environment: Model (1) 2.85* (1.50); Model (2) 13.48* (6.98) - Specialized and on-the-job training services: Model (1) 2.61* (1.42); Model (2) 12.05* (6.45) - Goods market efficiency: Model (1) 1.13 (0.76); Model (2) 7.98* (4.12) - Labor market efficiency: Model (1) 2.58 (1.63); Model (2) 11.01 (6.85) - Number of observations: 512; Number of industries: 64; R-squared: 0.36 (both models). - Quantitative illustration: - Upgrading Romania’s infrastructure index (GCI level 3.33 in 2013–14) to Poland’s level (GCI 3.96) could potentially expand Romania’s export market share by almost 15 percent (illustrative; GCI indices based on opinion surveys). - A 10 percent REER appreciation could potentially reduce Romania’s export market share by about 12 percent (based on estimated REER coefficient). ### Exchange rate pass-through and inflation targeting - Historical inflation context and regime: - Consumer and producer price inflation peaked at around 40 percent, averaged around 25 percent between January 2000 and July 2005. - Since announcement of moving toward inflation targeting from August 2005, inflation fell to an average of around 5½ percent for both consumer and producer prices. - Mid-point inflation targets by year (Percent): 2005 7.5, 2006 5.0, 2007 4.0, 2008 3.8, 2009 3.5, 2010 3.5, 2011 3.0, 2012 3.0, 2013 2.5, 2014 2.5. - Pass-through findings (structural VAR analysis, monthly data 2000M1–2014M8): - Degree of pass-through reduced sharply since adoption of inflation targeting. - For CPI inflation: degree of pass-through reduced to below 10 percent after IT adoption (two-year horizon numbers preserved below). - For PPI inflation: degree of pass-through reduced to below 25 percent after IT adoption. - Specific changes (two year horizon, pre- vs post-IT): - Dollar-lei: CPI declined to 4 percent from around 38 percent; PPI declined to 7 percent from around 45 percent. - Euro-lei: CPI declined to 7 percent from 28 percent; PPI declined to around 19 percent from 38 percent. - Variance decomposition: - Exchange rate accounts for about 5 percent of fluctuations in CPI inflation since IT adoption (was around 10–30 percent prior). - For PPI, share explained by dollar-lei exchange rate declined to about 10 percent; world commodity prices account for almost 30 percent of PPI fluctuations in recent years. - Policy implications: - Credible low-inflation regime and clear central bank communications help anchor expectations and reduce pass-through vulnerabilities. - Decline in pass-through and falling share of foreign-currency loans suggest Romania could afford more exchange rate flexibility. - Permanent decline in pass-through is favorable for inflation convergence and meeting euro-zone convergence criteria. ### Labor taxes, labor market, and policy design for tax cuts - Labor market snapshot and fiscal measures: - Romania’s overall unemployment rate: "6.8 percent" in 2014 (EU-28 average "10.2 percent"); youth unemployment "23.3 percent" in 2014Q3 (EU-28 average "21.8 percent"). - Participation rates (2014Q3): total 56.1 percent; female 47.6 percent; youth 32.3 percent. - Informal sector estimated up to "one third" of total output and includes "1.45 million" workers. - Employer pension contribution cut of "5 percentage point" effective October 1, 2014 resulted in net annual budget cost of about "0.8 percent of GDP". - Tax wedge and distributional specifics: - Romania has flat-rate PIT at 16 percent; allowances introduce some progressivity. - 2012 personal allowance: RON 250 per month for those earning less than RON 1,000; phased out linearly to zero at RON 3,000 per month. - Pension contributions capped at five times the average worker’s salary. - Total annual social security contribution rate fell from 60 percent in 2001 to 44.5 percent in 2013; standard employer rate now 15.8 percent. - Simulation and policy options: - A 10 percentage-point cut in the employer contribution rate for workers earning less than 50 percent of the average wage would reduce budget revenues by about 0.4 percent of GDP. - World Bank elasticity: employment rate elasticity to the tax wedge is -0.23 in Eastern Europe for all workers. - A 10 percentage-point cut targeted on low-income workers would: - Reduce the tax wedge for an employee earning half the average wage by 14.2 percent (table entry preserved). - Imply an increase in the overall employment rate of 3.5 percentage points over the medium term. - A 5 percentage-point across-the-board reduction in employer SSC enacted in 2014 is estimated to increase employment by 1.3 percentage points. - Potential offsets and revenue measures: - Base-broadening measures could generate up to "0.3–0.4 percent of GDP", enough to mostly offset revenue loss from a "10 percentage point" cut in employers’ SSC targeted on low-income earners. - Suggested measures: increase cap on pension contributions from "5 to 8 times the average wage"; require self-employed to make pension contributions based on total earned income and pay the employer portion of health contribution; expand health contribution base. - Proposed Fiscal Code changes (announced February 2015): - Reduce employer pension contribution rate in 2017 from "15.8 to 13.5 percent". - Reduce employee pension contribution rate in 2017 from "10.5 to 7.5 percent". - Reduce flat PIT rate from "16 to 14 percent" in 2019. - Base-broadening measures for 2016: require self-employed to make pension contributions based on total earned income and include all income in the employee health contribution base, with a contribution cap of "five times the average wage". - Design principles and recommendations: - Target employer SSC reductions at low-income earners and youth to maximize employment impact per revenue loss. - Phase cuts across wage levels and deliver via tax credits to preserve pension-contribution benefit link and simplicity. - Offset revenue loss via base-broadening (self-employed pension base, health contribution base), increases in property/environmental taxes, and improved VAT collection. ### Fiscal decentralization — status, risks, and prerequisites - Current status and trends: - Decentralization started in 1991; share of subnational government expenditure in general government expenditure doubled from about 12 percent in mid-1990s to 25 percent in 2013 but remains below EU average (~33 percent). - Share of own taxes (full discretion) declined and is among the lowest in the EU; when shared taxes included, own revenue expanded from ~20 percent in early 1990s to ~50 percent to date. - Vertical fiscal imbalance (VFI) has worsened; local budgets heavily dependent on transfers; earmarked funds and transfers exceed 30 percent of local revenue in recent years. - 2013 decentralization draft law: - Rejected by Constitutional Court; government adopted a gradual/pilot approach instead. - Draft envisaged transfer of responsibilities and assets to local authorities; asset values not presented. - 2014 budget foresaw transfers of about RON 674 million (0.1 percent of GDP) from ministries to local governments. - Benefits, risks, and empirical findings: - Decentralization can improve service delivery, accountability, and efficiency if accompanied by strong institutions and capacity. - Stochastic frontier analysis shows Romania’s public expenditure efficiency lags peers; fiscal decentralization alone can worsen efficiency unless combined with stronger institutions and capacity. - Risks: loss of economies of scale, weakened central redistribution, soft budget constraints, increased borrowing costs for local governments, and potential deterioration of service quality if assets transferred without capacity. - Preconditions and recommendations: - Expand local own taxes (e.g., property tax) to reduce vertical imbalance while protecting the poor. - Strengthen PFM at local level: implement commitment control, fiscal reporting, budget formulation/execution improvements; set aside fiscal buffer of 10 percent of total expenditure at local level. - Assess values and maintenance costs of assets proposed for transfer and put safeguards in place. - Strengthen fiscal rules enforcement at local level: implement alert mechanisms, sanctions, media visibility, and effective corrective actions. - Consider asymmetric decentralization where responsibilities are devolved according to readiness/capacity; prioritize decentralization of functions where economies of scale are limited. - Selected exact numeric allocation figures preserved: - Fiscal buffer recommendation: 10 percent of total expenditure. - Annex I income tax sharing (Bucharest Municipality): - 20 percent to budgets of Bucharest districts, - 44.5 percent to budget of Bucharest Municipality, - 7 percent for balancing district budgets and Bucharest Municipality, - 28.5 percent for central government. - Annex I income tax sharing (other cases): - 41.75 percent to local budgets where income taxpayers carry out activities, - 11.25 percent to local budget of the county, - 18.5 percent to equalization fund, - 28.5 percent for central government. ### Selected exact numeric and policy takeaways (high priority) - Central government project database (end-2013): 543 projects equal to 31 percent of GDP. - Cumulative cost overruns: 2 percent of GDP. - SCF eligibility and unabsorbed funds: - 2007–13 eligibility: EUR 19.1 billion (15.3 percent of 2007 GDP). - 2014–20 eligibility: EUR 22.5 billion (13.7 percent of estimated 2014 GDP). - Cumulative unabsorbed 2007–13 resources as of early November 2014: EUR 8.6 billion (5.3 percent of GDP). - Absorption rate as of early November 2014: 50 percent (Romania) vs. 71 percent (other new member states average). - Growth impact scenarios: - Raising SCF absorption from 75 percent to 100 percent over 2016–20 (average RON 6.2 billion annually = ¾ percent of GDP) -> output increase estimated 1½–3 percent over medium term; potential growth 0.5 percentage point higher by 2020. - GIMF simulation shock: temporary increase 0.8 percent of GDP p.a. for five years -> cumulative GDP and potential GDP up to 1.3–1.5 percentage point by 2020; real GDP rises ~1 percent on impact and ~1.5 percent in subsequent periods. - Labor market and tax policy headline numbers: - Unemployment 2014: "6.8 percent"; youth unemployment 2014Q3: "23.3 percent". - Participation 2014Q3: total 56.1 percent; female 47.6 percent; youth 32.3 percent. - Informal sector up to "one third" of total output; "1.45 million" workers. - Employer pension contribution cut of "5 percentage point" (effective Oct 1, 2014) -> net annual budget cost ~ "0.8 percent of GDP". - A targeted 10 percentage-point cut in employer SSC for workers earning <50 percent of average wage -> revenue loss ~ "0.4 percent of GDP" and medium-term employment rate increase ~ "3.5 percentage points". - SOEs: - More than 1,000 SOEs; about 250 majority-owned by central government. - Aggregate SOE share: ~8 percent of non-financial companies’ total employment; ~4 percent of annual turnover. - Top 20 enterprises account for ~two-thirds of SOE turnover and half of SOE employment. - Cumulative SOE losses 2008–12: ~2 percent of 2012 GDP. *Source: IMF staff estimates and Romanian authorities (excerpts from the IMF report contained in the supplied content).* ### References________________________________________________________________________________ 16 ### References ### Overview and Structure of Document - Document contains sections including: "ROMANIAN STATE-OWNED ENTERPRISES: CHALLENGES AND REFORM PRIORITIES"; "EXPORT PERFORMANCE AND EXTERNAL COMPETITIVENESS"; "EXCHANGE RATE PASS-THROUGH AND INFLATION TARGETING"; "CUTTING LABOR TAXES IN A CONSTRAINED BUDGET ENVIRONMENT"; "MORE FISCAL DECENTRALIZATION—THE PREREQUISITES"; and "BENEFITS OF BOOSTING QUALITY PUBLIC INFRASTRUCTURE SPENDING IN ROMANIA". - Boxes referenced include: "Rail Freight SOE CFR Marfa's Performance", "Details of SOE Arrears", and "Oltchim and Hidroelectrica: A Tale of Two Insolvencies". - Document date indicated: March 10, 2015. ### Key Findings — Infrastructure Quality and Investment - Romania’s infrastructure is perceived as low quality despite relatively high public-sector capital spending. - Contributing factors to poor infrastructure outcomes: - Lack of a robust framework for developing, vetting, prioritizing, and executing public-investment projects. - Political incentives to announce and begin projects without ensuring completion. - Dominance of large, inefficient, and financially vulnerable state-owned enterprises (SOEs) in transportation and network industries. - Infrastructure density, particularly the road network, is relatively low; governance, management, and leadership problems in the transport sector are highlighted. - Evidence of procurement and contracting weaknesses: Romania had the second highest average number of red flags per contract in a World Bank dataset covering 14 countries in East Europe and Central Asia. ### Central Government Project Portfolio (Status and Statistics) - Central government project database at end-2013 included 543 projects with an investment value equivalent to 31 percent of GDP. - Only 85 of the projects receive non-reimbursable funding from the European Union, while another 97 projects received no funding at all in 2013. - Cost overruns amount to 2 percent of GDP. - Project duration issues: - 78 projects expected to take more than 10 years to complete. - One project with a duration of 42 years. - Many projects lack full budget funding for projects of duration less than a year; given long portfolio durations, many projects may no longer align with current objectives. ### EU Structural and Cohesion Funds (SCF) — Availability and Absorption - For the 2007–13 programming period: - Romania was eligible for EUR 19.1 billion (15.3 percent of 2007 GDP) from SCF. - SCF allocated across seven operational programs; transportation and environment accounted for 46 percent of available resources. - For the 2014–20 programming period: - Romania is eligible for EUR 22.5 billion (13.7 percent of estimated 2014 GDP). - Large infrastructure OP allocated EUR 9.4 billion (part contingent on EC approval of a Master Transportation strategy). - Absorption performance: - As of early November 2014, Romania’s absorption rate, including pre-financing, was 50 percent, compared to an average of 71 percent in other new member states. - Human resources OP absorption rate was 41 percent. - Cumulative unabsorbed resources from 2007–13 as of that date: EUR 8.6 billion (5.3 percent of GDP). - Romania has until the end of 2015 to absorb remaining 2007–13 resources under the N+2 rule. - SCF definition and scope within this analysis: - SCF include the European Fund for Regional Development (EFRD), the European Social Fund (ESF), and the Cohesion Fund (CF). - Note: Total EU funds available to Romania during 2007–13 were EUR 34.6 billion including other EU instruments, but this section focuses only on SCF. ### Reasons for Low SCF Absorption - Domestic governance and capacity issues: - Weak beneficiary capacity and skill to identify, elaborate, and manage projects. - Public administration deficiencies in evaluating and monitoring projects. - Some operational programs experienced suspension or interruption and reimbursement of received amounts. - Possible preference by public officials for projects financed solely by central and local government due to lower levels of monitoring and evaluation compared with EU-funded projects. ### Recent Reforms Aimed at Improving Project Prioritization and Absorption - Adoption of a legally-binding project prioritization methodology (Emergency Ordinance 88/2013 and Government Decision 225/2014) for significant projects (value greater than RON 100 million) funded by the state budget. - Creation in 2013 of the Public Investment and Valuation Unit (PIEU) in the Ministry of Public Finance (MoPF) with mandate to strengthen quality control in preparation, prioritization, appraisal and management of new significant public investment projects financed by the central government. - Practical limitations of reforms: - Many project life-cycle steps remain the responsibility of line ministries. - PIEU activities have been limited to reviewing pre-feasibility studies for projects > RON 100 million and compiling priority lists for an inter-ministerial committee. - Public Investment Plan (PIP) lacks a multi-annual time dimension accommodating full life cycles of projects. - Prioritization process not well integrated into budget preparation and medium-term budget projections; the priority list prepared for the 2015 budget cycle was not approved. - For EU-funded projects, "first come, first-served" principle guides prioritization. - Responsibility for managing 2014–20 OPs centralized under the Ministry of European Affairs (MEF) except regional development OP; coordination between MEF and MoPF remains limited. - Coverage gaps: - More than 350 central government and over 3,000 local government projects fall outside the government-approved prioritization framework. - Local project prioritization and funding transparency remain rudimentary; Ministry of Regional Development maintains a database but uses simple thresholds (e.g., percentage-of-completion) for financing. - Recurrent costs from investment projects do not appear fully recognized and provided for in budgets per Fund technical assistance. ### Growth Impact of Increasing Quality Public Investment and EU-Funds Absorption - Rationale for increased quality public infrastructure investment: - Romania has economic slack post-crisis, low labor participation rate, and low government borrowing costs/policy rates—conditions that support increased quality public investment. - EU-funded investment typically has higher monitoring and evaluation, implying higher quality. - Quantitative estimates and scenarios: - Staff estimate that raising EU funds absorption rate from 75 percent in the baseline to 100 percent over 2016–20, equivalent to an average of RON 6.2 billion annually (¾ percent of GDP), could increase output by 1½–3 percent over the medium term under the most plausible assumptions. - Production function approach indicates potential GDP growth rate could be 0.5 percentage point higher by 2020. - Aggregate conclusion: Both supply- and demand-side estimates yield similar growth benefits from increased quality public investment financed primarily through increased EU-funds absorption. ### Production Function Approach (Method and Partial Findings) - Methodology: - Staff used the EU’s production function methodology with a Cobb-Douglas production function together with projections for capital stock, labor supply, and total factor productivity (TFP). - Baseline and upside scenarios simulated; the upside scenario assumes additional investment of ¾ percent of GDP per annum, boosting investment growth relative to baseline. - Result summary: - Simulations show significant growth benefits from higher quality infrastructure spending; upside scenario yields output and potential growth improvements relative to baseline (quantified earlier as 1½–3 percent output increase and 0.5 percentage point higher potential growth by 2020). *Prepared by John Ralyea, Vahram Stepanyan, and TengTeng Xu (European Department); document dated March 10, 2015.* ### 1.4 percentage points on average from 2015 to 2020. Simulations suggest that the growth benefits ### _cr1580 - 1.4 percentage points on average from 2015 to 2020. Simulations suggest that the growth benefits ### Model-based assessment of public investment (GIMF simulations) - Setup: - Additional government capital spending: temporary increase for five years equal to 0.8 percent of GDP per annum, financed by EU grants. - Model used: IMF’s Global Integrated Monetary and Fiscal model (GIMF) calibrated for Romania. - Output elasticity assumptions: - Benchmark output elasticity of public capital: 0.2. - Alternative simulated elasticity: 0.3 (to represent "right" investment projects). - Reference meta-analysis average cited: 0.2; meta-regression estimate cited: 0.1. - Simulated impacts: - Growth benefits from higher and more efficient investment could be up to 0.5–0.7 percentage point on real growth and potential growth by 2020. - The cumulative impact on the level of GDP and potential GDP could be up to 1.3 to 1.5 percentage point by 2020. - Real GDP increases by approximately 1 percent on impact because of increased domestic demand, particularly investment. - In subsequent periods, real GDP is higher by around 1.5 percent. - A simulation with output elasticity of public capital of 0.3 shows a bigger impact than the 0.2 benchmark. ### Multiplier approach and sensitivity analysis - Literature and empirical multipliers: - Recent research suggests a public investment multiplier of about 1–1.3. - Alternative estimates indicate a 1 percentage point of GDP increase in public investment has a multiplier of 0.5–0.9 over the medium term (IMF, 2014b). - Varga and Veld (2010) estimated an impact multiplier of SCF funding for infrastructure in EU members to be around 0.5 after accounting for unproductive spending, import leakage, and possible crowding out. - Lungu (2013) found the multiplier for SCF-funded projects in Romania in the range of 0.5–0.9 across operational programs. - Stoian (2012) estimate cited: short-term multiplier of 0.5 for Romanian government investment. - Financing and effective cofinancing: - Effective national cofinancing ratio cited for 2013: 25 (percent). - Note: national co-financing ranges from 15 percent for ERDF and ESF projects to 20 percent for CF projects; VAT and land acquisition costs largely on national authorities; top-up financing from EU up to 10 percent for SCF projects. - Persistence of multiplier: - General finding: output effect of an exogenous fiscal shock often vanishes within 5 years even if fiscal measures are permanent. - For permanent change in public investment, multipliers may be permanent, rising toward long-run values. - Varga and Veld (2010) model result: multiplier for all SCF financed investment rises gradually to one after seven years and 2.6 after nearly two decades. - Persistence stronger when economic activity is weak and/or monetary policy is accommodative. - Projection assumptions for policy scenario: - Increased quality of investment modeled as annual shock to expenditure on EU-funded projects by RON 1.7 billion per year relative to the baseline over 2016–20. - Increase assumed funded by SCF grants and cuts in national capital spending (budget neutral). - The output effect of the fiscal shock is projected to vanish after five years (modeled via a persistence factor). - Projected outcomes under multiplier scenarios (percentage points relative to baseline): - The increase in the GDP growth rate in 2020 relative to the baseline ranges from 0.3 to 1.2 percentage points. - The cumulative change in GDP in 2025 relative to the baseline ranges from 1.9–6.2 percent. - Multiplier scenarios table entries (preserved exactly as presented): - 10.50.50.52.7 - 20.70.50.84.3 - 30.90.51.26.2 - 40.500.31.9 - 50.700.52.7 - 60.900.63.5 ### Considerations and policy recommendations for public investment - Fiscal and strategic resource allocation: - Shift state- and local-government capital spending toward projects financed by the European Union SCF to increase quality investment while maintaining fiscal discipline. - Reflect maintenance costs adequately in medium-term budget projections. - Improve and make more predictable Romania’s strategic framework to better align EU and national strategies and preserve project priorities. - Project selection, management, and implementation: - Undertake an assessment of the effectiveness of project selection methods and implement corrective measures as necessary. - Mainstream good management practices of EU-funded programs (project design and monitoring and evaluation) across all projects. - Expand scope of projects overseen by the technical team to encompass most central and local-government projects over the medium term. - Specific measures to take during 2015: - Amend Government Emergency Ordinance (GEO) 88/2013 to align the project prioritization process with the budget cycle timeline. - Amend the Public Finance Law to include substantive elements of GEO 88/2013 and ensure the prioritization system covers all projects over time. - Upgrade the database of central-government projects to allow for a cost/benefit approach to project selection and better monitoring and encourage more consistent reporting by line ministries of project values and costs. - Update, approve, and publish a project prioritization list prior to commencement of the 2016 budget process; within 15 days after approval of the 2016 budget by parliament, update the published list with actual amounts allocated to each project in the 2016 budget and estimated expenditures over the medium term. - Governance and political economy: - Empower the PIEU to reject projects based on the existing prioritization methodology to help mitigate politically driven project selection. - Address perception and evidence that project selection is sometimes driven by political considerations rather than economic and financial ones. - Recognize that increased vigilance in tackling governance issues may have contributed to a significant shortfall in capital spending in 2014. - State-owned enterprises (SOEs): - SOEs play a critical role in infrastructure development, maintenance, and service provision; further reforms of these enterprises will be important to realize the full benefit of increased quality public investment. - Key policy priorities for SOEs: create incentives for performance, strengthen corporate governance, improve public oversight, and steadfastly restructure or liquidate non-viable loss-making SOEs. - Romania SOE statistics and features: - More than 1,000 SOEs in Romania; about 250 majority-owned by the central government and the remainder by local governments. - Aggregate SOE share: around eight percent of non-financial companies’ total employment and around 4 percent of their annual turnover. - The top 20 enterprises account for about two-thirds of SOE turnover and half of SOE employment. - Five SOEs generate the bulk of profits; a handful account for the large part of losses and about half of SOE arrears. - SOE presence by sector: more than 40 percent of the energy and gas sector, around 40 percent of postal and courier services, and more than 20 percent of the transport sector turnover. - Only central government SOEs are included in program conditionality under the 2013 Stand-By Arrangement (SBA). ### Annex — Highest priority significant projects by primary funding source (selected figures as presented) - Non-reimbursable funds (EU grants): 49.730.0 (Billons of lei) - o/w top 3 projects of 36 total: - Motorway Lugoj-Deva: 5.74.8 2011 2017 - Railway rehabilitation Brasov-Simeria: 5.03.5 2007 2018 - Motorway Sebes-Turda: 4.64.6 2014 n/a - Reimbursable funds (loans): 7.95.7 - o/w top project of 10 total: - Metro line to Otopeni Airport: 5.35.3 2009 2019 - State-budget and pre-accession funds: 55.534.6 - o/w top 6 projects of 54 total: - Motorway Bucuresti-Brasov: 8.36.0 2006 2017 - Railway rehabilitation Bucuresti-Constanta: 2.10.1 2006 2014 - Bucharest by pass roadway: 3.23.2 2008 2020 - Ministry of Economy building: 0.10.1 2004 2016 - Metro modernization: 1.51.2 2004 2017 - Motorway Brasov-Cluj-Bors: 12.86.1 2004 2017 *Source: IMF staff estimates and Romanian authorities (excerpts from the IMF report contained in the supplied content).* ### 3. Romanian SOEs are not efficient providers of high quality infrastructure. Romania has ### Romanian SOEs are not efficient providers of high quality infrastructure ### Infrastructure quality and sectoral outcomes - Romania has ranked consistently low in terms of satisfaction with the state of its infrastructure; the World Economic Forum’s assessment of the quality of infrastructure ranks Romania lowest in the EU. - Quality remains very low, especially in the road and railroad infrastructure. - The SOEs operating in road, rail, and related transportation sectors are among the largest arrears holders and loss-makers. ### SOE aggregate performance and fiscal impact - During 2008–12, cumulative SOE losses amounted to around 2 percent of 2012 GDP. - With the exception of a few energy companies, the majority of Romanian SOEs have been operating for years at low profitability or making losses. - Losses have been concentrated in the transport and energy sectors (notably the three rail companies, the national air carrier, and coal-based energy producers). - SOEs account for the bulk of arrears in the Romanian state sector and are a drain on public finances in the form of foregone tax revenues, dividends and, to a lesser extent, subsidies. - The transport sector has been the largest recipient of subsidies and transfers from the state budget, with the bulk of those payments for public sector obligations. - In 2013, the aggregate SOE sector became profitable following several years of losses; in aggregate it even surpassed the private sector in terms of net profit margins, driven largely by SOEs operating in the oil and gas sector. - However, when five SOEs are excluded (Romgaz, Hidroelectrica, Nuclearelectrica, Transgaz, and the Road Company), the remaining SOE sector was still loss making, albeit with a declining trend. - The total SOE wage bill did not change much since the global financial crisis while the average wage increased, indicating notable labor shedding. - SOEs’ relatively low debt level and adequate liquidity suggest that systemic risk related to debt repayment is moderate, though some SOEs hold low-quality assets (in particular, accounts receivables) not reflected in unaudited financial statements. - SOE arrears have declined substantially during the last three years, but some SOEs still have large and increasing arrears. - More than 70 percent of arrears are owed to the consolidated budget and other SOEs (creating a risk of being considered as state aid), less than 1 percent to banks and the remaining to other creditors. - Reducing arrears can generate public resources for investment and help restore financial health of businesses, especially small- and medium-sized enterprises. ### Reasons for poor SOE performance and governance weaknesses - Many SOEs have not faced hard budget constraints; management compensation is generally not linked to performance and non-wage benefits continue despite precarious financial positions. - Line ministries have usually been reluctant to initiate liquidation or insolvency procedures; where insolvency has been initiated, the process is often dragged on without addressing core inefficiencies. - SOEs generally lack professional management at both executive and board levels; appointments have often reflected political affiliations and connectedness to line ministries. - Government Emergency Ordinance (GEO) 109/2011 on corporate governance started to materialize improvements in some SOEs, but progress stalled and at times partially reversed. - Example governance failures: CFR Infrastructura management was dismissed three times since late 2012; Tarom’s board composition changed four times during two years. - There is no clearly defined SOE ownership policy and tutelary authority interference is extensive, creating conflicts of interest as line ministries exercise ownership while setting sectoral strategies and implementing policy. - SOE monitoring has been weak: the monitoring unit collects detailed financial data but reports need more analytical depth and recommendations; the unit is not empowered to call for remedial actions or hold SOEs and line ministries accountable. - Reporting issues: only a few SOEs publish financial reports based on IFRS; audits may not follow international standards and often contain material qualifications that remain unaddressed. ### Impact of reforms to date - The government’s reform approach has included: (i) SOE IPOs and privatization; (ii) improved monitoring of SOE financial performance and arrears reduction; (iii) professionalization of SOE boards and management (GEO 109); (iv) restructuring or liquidation of unviable SOEs; and (v) energy market deregulation. Progress has been mixed. - IPOs have focused on the energy sector; three successful IPOs occurred under the SBA arrangement including a majority IPO of Electrica and a landmark IPO of Romgaz. IPOs of Hidroelectrica and Oltenia have been delayed. - Hidroelectrica has been under insolvency and is expected to exit during 2015 after substantial restructuring. - Oltenia’s performance deteriorated reflecting inefficient management, bad accounts receivables and highly depreciated assets, calling for long overdue restructuring. - Majority privatization attempts have generally not succeeded (political economy and organizational issues). Example: rail freight company Marfa’s privatization failed in late 2013; restructuring measures only began mid-2014, including a staff reduction of over one fourth. - SOE monitoring improved: moved from quarterly to monthly collection and reporting of financial indicators for central government-owned SOEs and started collecting age profile of SOE liabilities. Reporting quality still needs improvement. - GEO 109 (2011) introduced provisions for depoliticization, professionalization, transparency, and minority shareholder protection, but implementation has been weak. - Selection and appointment of professional management under GEO 109 was implemented only in 33 SOEs; many newly appointed boards were dismissed and replaced with interim members not selected per GEO 109 procedures. - A High Level Commission (HLC) was set up to ensure proper implementation of GEO 109, with the SOE monitoring unit at the Ministry of Public Finance as supporting unit; however, so far there has been no tangible action by the HLC and its effectiveness remains to be seen. - Very few tangible restructurings of SOEs have occurred; government has been highly selective in initiating insolvency or liquidation. Examples of SOEs unlikely to become financially sustainable under current operations include Hunedoara and Oltenia and several rail sector SOEs and subsidiaries. - Energy market deregulation progress: - Electricity sales to non-residential consumers are fully sourced from competitive markets; for residential consumers, deregulation has proceeded according to the roadmap but still leaves 60 percent sourced from non-competitive market. - Gas prices were fully deregulated for non-residential consumers as of beginning of 2015 after delays in late 2014. - For residential consumers, the government decided to postpone gas price deregulation and extend the deadline until 2021; a new roadmap remains to be approved. ### Further reform priorities and policy recommendations - Move ahead steadfastly with the IPO and privatization agenda. The HLC should ensure the privatization unit fully employs existing expertise from successful IPOs and is provided with additional resources. The objective is improved SOE operations and resource allocation, not the method of private ownership per se. Cases in point: Oltenia and Marfa. - Assess SOE performance against clearly set targets and performance indicators and report transparently. Targets should include general indicators such as profitability as well as sector-specific indicators; they must be set and reviewed timely to allow SOE budget preparation and approval. Increase SOE governance transparency and ensure SOE annual reports are published on time. - Swiftly submit the revised draft legislation on SOE corporate governance for parliamentary approval, adequately reflecting suggestions provided by partner international institutions (covering appointment and dismissal of board members, mandate contracts and administration/management plans, SOE annual budgets, and MoPF’s oversight role). - Exercise political will to implement the new legislation’s provisions; improved legislation alone will not ensure progress. The HLC could: - Ensure regular monitoring and assessment of SOE corporate governance by requesting progress reports from tutelary authorities on implementation and financial performance against targets. - Review and propose a reduction in the scope of ministerial orders that interfere with SOE management functions and promote stability of management boards. - Restructure loss-making SOEs, put them into insolvency, or liquidate them to ensure improved resource allocation. Immediate restructuring is needed for a number of loss-making SOEs, particularly in energy and transportation. Restructuring is likely to involve substantial downsizing and should be well planned with public resources budgeted to mitigate social costs. Avoid using insolvency to keep non-viable SOEs operational for prolonged periods. - Establish an ownership policy to complement the SOE governance framework with a clear separation of government functions of ownership, governance, and monitoring. Centralizing the ownership function may constrain line ministries’ influence, but institutional setup without political will will not ensure separation. The HLC could play a coordinating role. - Continue energy market deregulation: - Implement the electricity market deregulation roadmap to achieve full competitive market sourcing for households by end-2017. - Adopt a new roadmap for gas price deregulation for household consumers while strengthening support for the most vulnerable consumers. *Source: IMF staff report excerpt on Romanian SOEs and infrastructure performance.* ### Box 1. Rail Freight SOE CFR Marfa’s Performance ### Box 1. Rail Freight SOE CFR Marfa’s Performance ### Performance decline and productivity - CFR Marfa’s market share shrank by almost 50 percent during the last decade due to competition from private rail freight operators as well as road freight. - The company has been making losses since 2008 and faced the prospect of bankruptcy. - According to the World Bank (2013), the company’s labor productivity had essentially halved, as had locomotive and rail car productivity. - In 2013, CFR Marfa managed to somewhat improve its performance, but it still retained far more staff and assets than its operations justified. - Low productivity is evidenced by comparative indicators (Selected Indicators for Rail Freight, 2012) showing CFR Marfa trailing regional peers and a domestic private operator. ### Selected indicators for rail freight, 2012 (as reported) - CFR Marfa: Global traffic, thousand tonnes: 31,282; Average number of employees: 8,411; Tonnes per employee: 3,719. - PKP Cargo (Polish): Global traffic, thousand tonnes: 126,745; Average number of employees: 28,100; Tonnes per employee: 4,510. - CD Cargo (Czech): Global traffic, thousand tonnes: 73,188; Average number of employees: 8,900; Tonnes per employee: 8,223. - GFR SA (private Romanian): Global traffic, thousand tonnes: 12,000; Average number of employees: 2,368; Tonnes per employee: 5,068. ### Restructuring, privatization, and policy recommendations - The report concludes that privatizing CFR Marfa is the only viable option to give the company commercial freedom and opportunity to aggressively restructure and achieve radical improvements in productivity and asset utilization. - Timeline and actions taken: - CFR Marfa’s privatization has been on the government’s agenda since 2012; the government approved a decision to privatize CFR Marfa in February 2013. - One privatization attempt failed to materialize in October 2013. - In 2014, after protracted preparations of a restructuring plan and delays with its implementation, the company reduced its staffing by almost 30 percent. - To make CFR Marfa more attractive to potential private investors, restructuring should continue with a focus on: - (i) improving the management of the company by appointing professional management and implementing sound corporate governance principles; - (ii) rationalization of services with possible re-pricing to limit loss-making operations; - (iii) further reduction in staffing; - (iv) disposal and scrapping of non-utilized assets. *Source: Ministry of Public Finance.* ### References ### _cr1580 - References ### References - Dochia, A., 2014, “Assessment of the Implementation of the Emergency Ordinance 109/2011,” Report under a project contracted by the Romanian Ministry of Public Finance, unpublished. - European Commission, 2015, “The Role of State-Owned Enterprises in Romania,” ECFIN Country Focus, Volume 12, Issue 1, January 2015, European Union. - European Commission, 2014, “Network Industries – Transport,” under “Key Areas: Comparing Member States' Performances,” at http://ec.europa.eu/europe2020/making-it-happen/key-areas/index_en.htm. - European Commission, 2014, “The Economic Impact of Late Payments,” Economic Papers 531, European Union. - International Monetary Fund, 2014, “Greece: Staff Report for the Fifth Review under the Extended Arrangement,” IMF Country Report No. 14/151, Washington, DC. - International Monetary Fund, 2012, “Romania: Selected Issues Paper,” IMF Country Report No. 12/291, Washington, DC. - Organization for Economic Co-operation and Development, 2010, “Accountability and Transparency: a Guide for State Ownership,” OECD, Paris. - World Bank, 2013, “Romania: Reviving Romania’s Growth and Convergence Challenges and Opportunities,” A Country Economic Memorandum, Washington, DC. ### Core Questions and Findings - How did Romania’s exports perform in recent years? - Romania’s export growth performed well during the post global crisis period, as reflected in steady gains in market share and increases in export-to-GDP ratios. - The market share in the imports of main trading partners rose by 37 percent during 2008–13. - The share for transport equipment more than doubled. - Most industries have a fairly high domestic value-added content in their exports. - The quality of exports is lower compared to regional peers. - What were the key driving forces behind Romania’s strong export performance? - Export decomposition analysis suggests that domestic push factors (competitiveness effect) were the main driving forces of the positive export growth during 2006–13. - External demand factors contributed positively to export growth until the global crisis, but became unfavorable for Romania since then. - What are policy priorities for securing a vibrant and sustainable export sector? - Maintaining price competitiveness and alleviating structural impediments are key ingredients for future sustainable export growth. - Continue allowing for exchange rate flexibility. - Upgrade infrastructure and improve vocational training to attract FDI and boost export growth. - Raise export quality, promote export diversification and reposition toward higher-skill export products to protect against shocks and create opportunities for export-led growth in the medium term. - Promote FDI and facilitate participation in global value chains. ### Introduction — External Account Developments - Prior to 2008, net export contribution to overall economic growth was mostly negative and trending down. - The crisis forced a swift adjustment in the external sector, with the net export contribution rising by about 16½ percentage points during 2008–09. - The current account deficit fell to 4.2 percent of GDP in 2009 from its peak of 13.4 percent in 2007. - Exports of goods and services witnessed remarkable growth since 2010, replacing import compression as the major contributor to the improvement in the current account. - The analysis focuses on goods exports only. ### Export Performance (Key Statistics and Patterns) - Exports of goods as a percent of GDP rose to 34 percent in 2013, surpassing the pre-crisis average of 28 percent of GDP during 2000–07. - The EU received more than 70 percent of Romania’s goods exports during 2009–13. - Revealed comparative advantages (RCA): - Romania has RCA in labor intensive goods and low and medium-skill manufactures, but disadvantages in high-skill manufactures. - RCA in labor intensive and low-skill manufactures has been declining in the past ten years; RCA in medium-skill manufactures increased steadily. - High-skill manufactures continued to show comparative disadvantage, with moderate improvement in 2010–11. - Composition of exports (Average of 2007-2014): - Machinery and Transport Equipment: 40% - Manufactured Goods by Material: 18% - Miscellaneous Manufactured Articles: 17% - Mineral Fuels, Lubricants and Related Materials: 6% - Chemicals And Related Products: 6% - Crude Materials, except fuel: 6% - Others: 7% - Transport equipment more than doubled international sales between 2007 and 2013 and has been the major driver of recent export growth. - Market share in EU imports: - Romania’s exports as a share of total EU imports rose from 0.3 percent in 2000 to 0.8 percent in 2013. - Exports of transport equipment market share in the EU more than doubled between 2008 and 2013. - Domestic value-added in exports: - According to OECD-WTO TiVA 2009 indicators, domestic value-added embodied in exports was almost 76 percent of total exports for Romania in 2009—the highest among regional peers. - Most industries’ domestic value-added contents were above 70 percent in 2009 and higher than in 2000. - Increase in domestic value-added was particularly large in transport equipment and textile industries. - Export diversification and quality: - Export diversification improved considerably prior to the crisis but stagnated during 2008–10. - Romania scored well in diversification across trading partners but lagged in product diversification. - Romania’s export product quality moved from 83 percent to 88 percent of the world frontier between 2003 and 2010 for car exports, indicating gradual improvement but scope for further upgrading. ### Export Decomposition Analysis (Constant Market Share Analysis, 2006–13) - Methodology: - Annual merchandise exports data from UNTCAD Stat for 2006–13. - Industries grouped by ISIC 2-digit classification. - Focus on intensive margin variation; uses mid-point growth rate to address extensive margin changes. - Key result: - Competitiveness (domestic “push”) effect was the main driving force of positive export growth from 2006–13. - Romania’s export market share in global trade increased from 0.26 percent in 2006 to 0.35 percent in 2011. - Among “pull” factors, sectoral specialization contributed negatively during the onset of the global financial crisis. - Changes in external demand had positive impacts prior to 2009, but became unfavorable since the start of the Euro zone crisis in 2009–10. - Geographical composition effect accounts for most of the decline in 2012. - CMSA results (Percentage changes, year-over-year): - Export market share: 2006 1.3, 2007 7.9, 2008 5.7, 2009 6.2, 2010 0.2, 2011 6.1, 2012 -8.4, 2013 11.2 - Competitiveness effect: 2006 -0.3, 2007 2.1, 2008 5.6, 2009 10.8, 2010 3.3, 2011 7.8, 2012 -0.8, 2013 10.7 - Structure effect: 2006 1.6, 2007 5.9, 2008 0.2, 2009 -4.6, 2010 -3.0, 2011 -1.7, 2012 -7.6, 2013 0.5 - Sectoral effect: 2006 -0.8, 2007 0.3, 2008 -1.8, 2009 0.0, 2010 -0.4, 2011 -1.6, 2012 -0.3, 2013 1.5 - Geographical effect: 2006 1.5, 2007 3.7, 2008 0.9, 2009 -3.3, 2010 -4.8, 2011 -0.4, 2012 -5.1, 2013 -0.2 - Mix structure effect: 2006 0.9, 2007 2.0, 2008 1.1, 2009 -1.3, 2010 2.2, 2011 0.3, 2012 -2.2, 2013 -0.8 ### External Competitiveness — Drivers and Policy Priorities - Non-price competitiveness: - World Economic Forum’s Global Competitiveness Index (GCI) ranks Romania 76th out of 148 countries in 2013–14. - Improvements: macroeconomic environment and technological readiness over the past three years. - Deteriorations: institutions, infrastructure, health and primary education, labor market efficiency. - Romania’s comparative advantage in 2013–14: macroeconomic environment and market size. - Romania’s comparative disadvantage in 2013–14: institutions and infrastructure. - Price competitiveness: - The Romania leu appreciated in real effective terms vis-à-vis the currencies of trading partners since 2012. - The CPI-based REER appreciated 7¾ percent between 2012Q3 and 2014Q4. - The ULC-based REER has moved closely with the CPI-based REER since 2011, though historically it showed much larger movement during 2007–10. - Policy implications drawn: - Address structural impediments identified by non-price indicators (institutions, infrastructure, education, labor market). - Maintain exchange rate flexibility to preserve price competitiveness. - Improve infrastructure and vocational training to support FDI and export growth. - Focus on export quality upgrading and product diversification to reduce vulnerability to concentrated demand shocks. *Source: IMF staff compilation from _cr1580 - References (PDF chapter/section).* ### Box 1. Methods and Data Used to Estimate the Factors for Competitiveness ### Box 1. Methods and Data Used to Estimate the Factors for Competitiveness ### Methods and data overview - Regression analysis is used to examine how measures of price and non-price competitiveness impact determinants of supply-side export performance (the competitiveness effect from the CMSA decomposition). - Sample design: - Analysis uses a cross-industry panel regression at ISIC 2-digit level. - Data covers 64 industries across 8 years. - World Economic Forum’s GCI starts from 2006 and is available annually; due to annual series limitations, only 6 out of the 12 GCI indicators are tested in the regression model. - Price competitiveness measure: - ULC-based REERs (year-on-year change) are used; CPI-based REERs were examined but results were statistically insignificant. ### Regression model specifications - Dependent variable: - Industry-level competitiveness effect identified in the CMSA export decomposition (the “push” factor). - Explanatory variables: - Year-on-year change in ULC-based REER. - Selected GCI indicators covering: institutions, infrastructure, macroeconomic environment, higher education and training (focus on specialized/on-the-job training), goods market efficiency, and labor market efficiency. - Two model specifications: - Model (1): Estimates constant marginal effects (uses level of the global competitiveness index). - Model (2): Estimates variable marginal effects (uses natural log of the competitiveness index). - Estimation details: - Industry fixed effects included. - Robust standard errors reported. - Note: The ULC-based REER is chosen because analysis focuses on goods exports; CPI includes services and non-tradables. ### Key regression results (Dependent variable = yoy change in export market share) - Model (1) and Model (2) coefficient estimates and robust standard errors (in parentheses): - REER (yoy change): Model (1) -0.02* (0.01); Model (2) -0.01* (0.01) - Global Competitiveness Index — Institutions: Model (1) 0.62 (0.69); Model (2) 0.10 (1.89) - Infrastructure: Model (1) 0.35** (0.17); Model (2) 1.63** (0.71) - Macroeconomic environment: Model (1) 2.85* (1.50); Model (2) 13.48* (6.98) - Specialized and on-the-job training services: Model (1) 2.61* (1.42); Model (2) 12.05* (6.45) - Goods market efficiency: Model (1) 1.13 (0.76); Model (2) 7.98* (4.12) - Labor market efficiency: Model (1) 2.58 (1.63); Model (2) 11.01 (6.85) - Sample and fit: - Number of observations: 512 (both models) - Number of industries: 64 (both models) - R-squared: 0.36 (both models) - Significance notation: - *** p<0.01, ** p<0.05, * p<0.1 ### Quantitative illustrations and implications from results - Infrastructure: - Romania’s infrastructure index (GCI level of 3.33 in 2013–14) upgraded to Poland’s level (GCI level of 3.96 in 2013–14) could potentially expand Romania’s export market share by almost 15 percent (illustrative; GCI indices based on opinion surveys). - Price competitiveness: - A 10 percent REER appreciation could potentially reduce Romania’s export market share by about 12 percent (based on estimated REER coefficient). - Interpretation: - Infrastructure stands out as an important factor for export growth; favorable macroeconomic environment and better specialized training services also enhance export performance. - Goods market efficiency effect is statistically robust in Model (2) only, suggesting its impact may be non-constant. - Estimated coefficients are average marginal effects at the industry level; to assess aggregate export effect multiply by 64 (number of industries). ### Exchange rate assessment (CGER-type methodologies) - Macroeconomic balance approach: - Projected underlying current account deficit is lower than the current account norm of 4.1 percent of GDP. - Assuming only exchange rate changes can deliver the adjustment, an appreciation of 3.1 percent would be needed to close the gap between the underlying current account and the norm. - External sustainability approach: - Points to a modest undervaluation of 3.2 percent, given the current account norm required to maintain the IIP at the current level (60 percent of GDP) is higher than the projected underlying deficit. - Equilibrium real exchange rate approach: - Suggests a marginal overvaluation of 2.1 percent when taking into account adjustment in the baseline projection. - Summary judgement: - Considering margins of error, the real exchange rate is assessed to be in line with medium-term fundamentals. - Exchange Rate Assessment table (values in percent of GDP or percent): - Macroeconomic balance: -3.1 - Current account norm: -4.1 - Underlying current account: -3.3 - External sustainability: -3.2 - Current account norm: -4.1 - Underlying current account: -3.3 - Equilibrium real exchange rate: 2.1 ### Policy discussion and recommendations - Strategic priorities to strengthen medium-term sustainable export growth: - Improve export quality, promote diversification, and reposition toward high-skill export products to build resilience to external shocks. - Promote foreign direct investment (FDI) and greater participation in global value chains: - Foreign investment companies’ contribution to total exports was more than 70 percent in 2013. - Reviving FDI inflows requires a favorable business environment, sound and predictable macroeconomic policy, economic flexibility, and strengthened governance institutions. - Maintain price competitiveness: - Continue allowing for exchange rate flexibility and safeguard recent competitiveness gains. - Alleviate structural impediments: - Upgrade infrastructure and improve vocational training. - Secure sufficient fiscal space for public investment and increase the quality of capital spending. - Enhance the quality and efficiency of project spending and boost absorption of EU funds. ### Data and indicator list (GCI components used) - Institutions (selected items include 1.01–1.21 with scales and some 0–10 items). - Infrastructure (2.01–2.09, includes measures like available airline seat km/week, mobile subscriptions/100 pop., etc.). - Macroeconomic environment (3.01–3.05, includes Government budget balance, Gross national savings, Inflation, General government debt, Country credit rating). - Training (5.07 Availability of research and training services; 5.08 Extent of staff training). - Goods market efficiency (6.01–6.16, includes intensity of local competition, extent of market dominance, total tax rate, number of procedures/days to start a business, trade tariffs, prevalence of foreign ownership, business impact of rules on FDI, burden of customs procedures, imports as % of GDP, etc.). - Labor market efficiency (7.01–7.10, includes cooperation in labor-employer relations, flexibility of wage determination, hiring and firing practices, redundancy costs, effect of taxation on incentives to work, pay and productivity, capacity to retain/attract talent, women in labor force ratio to men). *Source: _cr1580 - Box 1. Methods and Data Used to Estimate the Factors for Competitiveness (IMF staff).* ### References ### _cr1580 - References ### Core Questions and Findings - How has the degree of exchange rate pass-through to consumer and producer prices in Romania changed since the adoption of inflation targeting? - The introduction of inflation targeting has led to a decline in the level and volatility of consumer and producer price inflation, and likely better anchored inflation expectations. - The degree of pass-through reduced to below 10 percent for CPI inflation, and to below 25 percent for PPI inflation, compared with a maximum of 45 percent prior to introducing inflation targeting. - The reduction in pass-through is typically less prevalent in the lei-euro exchange rate, compared with the lei-dollar exchange rate. - What are the main drivers of Romanian inflation dynamics, especially in more recent years with relatively low inflation? - The role of the exchange rate in explaining fluctuations in consumer prices has declined: the exchange rate accounts for about 5 percent of fluctuations in CPI inflation since the adoption of inflation targeting, while this number was higher at around 10 to 30 percent prior. - For PPI inflation, the share of innovations explained by the dollar-lei exchange rate has declined to about 10 percent, while the importance of the lei-euro exchange rate has been stable. - World commodity prices have overtaken the exchange rate as the most important factor in explaining PPI inflation in recent years, after its own innovations, accounting for almost 30 percent of the fluctuations in PPI inflation. - What are the potential policy implications from the declined pass-through? - The impact of exchange rate pass-through appears to depend on the monetary policy regime and the level of inflation in the economy. - The credibility of a low inflation regime, and clear communications from the central bank could help anchor inflation expectations and reduce vulnerabilities to external shocks. - The reduction in the degree of pass-through, combined with a declining share of foreign-currency denominated loans, suggests Romania could afford more flexibility in its exchange rate, which could in turn lead to a reduction in pass-through. - The decline in exchange rate pass-through, if permanent, is favorable for sustainable inflation convergence and for meeting the convergence criteria for joining the euro zone in the medium and long run. ### Introduction and Motivation - Historical inflation context: - Consumer and producer price inflation peaked at around 40 percent, and averaged around 25 percent between January 2000 and July 2005. - Since the announcement of moving toward inflation targeting from August 2005, the inflation rate fell drastically, to an average of around 5½ percent for both consumer and producer prices. - In September 2013, CPI entered the National Bank of Romania’s (NBR) target band of 2.5 percent (±1 percent) and fell below the lower bound for most of 2014. - Summary statistics (selected): - Full sample (2000M1–2014M8) Mean: PPI 14, CPI 12.6, Lei-dollar ex rate 3.3, Lei-euro ex rate 3.7; Std. Dev.: PPI 14.6, CPI 12.6, Lei-dollar ex rate 0.4, Lei-euro ex rate 0.7. - Pre-IT (2000M1–2005M7) Mean: PPI 27.9, CPI 24.4, Lei-dollar ex rate 33.2; Std. Dev.: PPI 15.1, CPI 13.7, Lei-dollar ex rate 0.4, Lei-euro ex rate 0.7. - Post IT (2005M8–2014M8) Mean: PPI 5.4, CPI 5.3, Lei-dollar ex rate 34; Std. Dev.: PPI 3.7, CPI 2.3, Lei-dollar ex rate 0.4, Lei-euro ex rate 0.4. ### Inflation Targeting Regime in Romania (Box 1) - Inflation targets are formulated as the annual change in the consumer price index and set as midpoints within a target band of +/-1 percentage points. - Two phases: - 2005–12: phase of declining inflation targets, set over a 2-year horizon as year-end annual rates to consolidate disinflation and achieve a sustainable annual inflation rate in the medium term. - 2013–present: phase of a flat multi-annual inflation target, an intermediate stage toward long-term continuous inflation targeting—aligned with the ECB’s quantitative definition of price stability. - Mid-point targets by year (Percent): 2005 7.5, 2006 5.0, 2007 4.0, 2008 3.8, 2009 3.5, 2010 3.5, 2011 3.0, 2012 3.0, 2013 2.5, 2014 2.5. ### Empirical Approach - Methodology: - A structural VAR framework is adopted, consistent with literature (McCarthy, 2000; Gueorguiev, 2003; Billmeier and Bonato, 2004; Cozmanca and Manea, 2010). - Analysis conducted on full sample and split into pre-inflation-targeting and post-inflation-targeting periods to assess changes in pass-through patterns. - Data: - Monthly observations from January 2000 to August 2014. - Variables: three exchange rate variables (lei-dollar, lei-euro, NEER), two price measures (CPI, PPI), commodity price variable, wages, and output gap. Short term interest rate included in VAR ordering. - Pass-through definition: - Degree of pass-through defined as the ratio of the cumulative impulse response in prices to one Cholesky standard deviation shock on the exchange rate. - Model period and scope: - Structural VAR with variables ordered: commodity prices, wages, output gap, exchange rate, PPI, CPI, and short term interest rate (in this order). ### Key Results - Pass-through magnitudes: - Higher degree of pass-through for PPI than for CPI in the first twelve months: around 20 to 30 percent of exchange rate passed to producer prices (full sample). - For consumer prices, around 15 percent of the impact is felt in the first year (full sample). - Euro-lei exchange rate has a larger impact than dollar-lei in the full sample, especially at longer horizons. - Change after inflation targeting: - Pass-through reduced sharply since adoption of inflation targeting; reduction most prevalent in the dollar-lei exchange rate. - Dollar-lei pass-through (two year horizon): CPI declined to 4 percent from around 38 percent; PPI declined to 7 percent from around 45 percent. - Euro-lei pass-through (two year horizon): CPI declined to 7 percent from 28 percent; PPI declined to around 19 percent from 38 percent. ### Policy Implications - A credible low-inflation regime and clear central bank communication help anchor inflation expectations and reduce exchange rate pass-through vulnerabilities. - Reduced pass-through and declining foreign-currency loan share may allow greater exchange rate flexibility. - Permanent decline in pass-through supports sustainable inflation convergence and meeting euro zone convergence criteria in the medium and long run. *Prepared by TengTeng Xu; References listed in source PDF.* ### 8. Our findings are consistent with studies for other inflation targeting small open ### 8. Our findings are consistent with studies for other inflation targeting small open ### Consistency with prior studies - Floerkemeier (2013): using a GARCH framework, found that the introduction of inflation targeting tends to reduce pass-through from the exchange rate to domestic prices, and reduce both exchange rate and interest rate volatility. - Cozmanca and Manea (2010) (Romania): showed that the degree of exchange rate pass-through into producer and consumer prices display a decline in magnitude in more recent times. - Gueorguiev (2003): found that pass-through to producer prices tends to be larger than that to consumer prices. ### Exchange rate pass-through: key empirical findings - The degree of pass-through: - Reduced to below 10 percent for CPI inflation after the adoption of inflation targeting. - Reduced to below 25 percent for PPI inflation after the adoption of inflation targeting. - Was as high as a maximum of 45 percent prior to introducing inflation targeting. - Differences by currency: - Reduction in pass-through is typically less prevalent for the lei-euro exchange rate compared with the lei-dollar exchange rate. - Relative importance: - Pass-through is typically higher for PPI than for CPI. ### Variance decomposition — drivers of inflation dynamics - Exchange rate role over time: - For CPI inflation: the share of innovation explained by the exchange rate fell from around 30 percent to 2 percent for the dollar-lei exchange rate, and from around 10 to 7 percent for the euro-lei exchange rate (comparing pre-August 2005 to post-August 2005). - Since adoption of inflation targeting, the exchange rate accounts for about 5 percent of fluctuations in CPI inflation, whereas it accounted for around 10 to 30 percent prior. - For PPI inflation: - Up to 35 percent of innovations in producer prices could be explained by the exchange rate in the pre-inflation targeting period. - The share explained by the dollar-lei exchange rate declined from around 35 percent before August 2005 to around 9 percent thereafter. - The importance of the lei-euro exchange rate for PPI has been stable. - World commodity prices have overtaken the exchange rate as the most important factor in explaining PPI inflation in recent years, accounting for almost 30 percent of fluctuations in PPI inflation. - Other factors: - Wage developments account for a smaller share of consumer price fluctuations post-inflation targeting. - Inflation appears to have become more persistent after adopting inflation targeting. ### Methodology and identification (summary) - Model: structural VAR with variables ordered as commodity prices, wages, output gap, exchange rate, PPI, CPI, and short term interest rate. - Pass-through measure: ratio of cumulative impulse response in prices to one Cholesky standard deviation shock on the exchange rate. - Data frequency and sample: monthly series; sample periods include (2000M1–2014M8), pre-IT (2000M1–2005M7), and post-IT (2005M8–2014M8). - Unit-root treatment: variables non-stationary in levels and stationary in first differences (I(1)) were differenced and incorporated in first differences in the structural VAR. ### Policy implications - Pass-through dependence: - The impact of exchange rate pass-through appears to depend on the monetary policy regime and the level of inflation; the degree of pass-through tends to decline in an environment of low inflation and low volatility of inflation. - Central bank credibility: - Credibility of a low inflation regime and clear communications from the central bank can help anchor inflation expectations and reduce vulnerabilities to external shocks. - Exchange rate flexibility: - The reduction in the degree of pass-through suggests Romania can afford to allow more flexibility in its exchange rate; literature indicates a rise in exchange rate volatility can lead to a reduction in pass-through (Corsetti, Dedola, and Leduc, 2008). - Euro convergence: - A permanent decline in exchange rate pass-through is favorable for sustainable inflation convergence and for meeting the convergence criteria for joining the euro zone in the medium- and long-term horizon (Beirne and Bijsterbosch, 2011). *Source: IMF staff analysis in the chapter on Romania (structural VAR pass-through and variance decomposition results).* ### 38.0 percent, still above the EU average of 34 percent in 2013. ### _cr1580 - 38.0 percent, still above the EU average of 34 percent in 2013. ### Key findings - Romania’s overall unemployment rate stood at "6.8 percent" in 2014, lower than the EU-28 average of "10.2 percent", but youth unemployment reached "23.3 percent" in the third quarter of 2014 vs. the EU-28 average of "21.8 percent". - Participation rates are low: total participation rate at "56.1 percent" in 2014Q3; female participation declined to "47.6 percent" and youth participation to "32.3 percent" in 2014Q3 (from around "56 percent" and "42 percent" in early 2000s). - The informal sector is large: estimated to produce up to "one third" of total output and includes "1.45 million" workers; tax evasion from undeclared work estimated at "1 and 3 percent of GDP" for personal income tax and social security contributions, respectively. - The employer pension contribution cut of "5 percentage point" effective October 1, 2014 resulted in a net annual budget cost of about "0.8 percent of GDP". - Cuts in labor taxes targeted at low-income/low-skilled workers and youth yield larger employment per dollar of tax relief because labor demand and supply elasticities for these groups are relatively large. ### Labor market conditions and issues - Low participation and employment rates reflect both demand and supply constraints: shortage of employment opportunities, lack of work experience, and skills mismatch. - Skill mismatch: about "20 percent" of the workforce affected; "7–9 percent" over-qualified (EU average "15 percent") and about "10 percent" under-qualified (EU average "21 percent") over 2001–11. - Tax wedge specifics: - Romania’s tax wedge is relatively high for individuals on low and low-to-medium incomes; prior to the October 1, 2014 cut, Romania had one of the highest tax wedges in the EU for employees earning "50 percent of the average wage". - The tax wedge rises steeply, reaching three-quarters of its maximum already for incomes around the minimum wage of "RON 975 per month". - Self-employment distortions: - Self-employed can choose declared income for pension contributions with a floor at the minimum wage (~"45 percent of the average wage"). - Self-employed pay only the employee part of the health contribution. - Romania has the second highest ratio of self-employed to employees in the EU. ### Active labor market policies (supply and demand side) - Supply-side measures: - Vocational training schemes and pilot projects under the Youth Employment Initiative to provide career development and training to youth. - Secondary legislation for the Apprenticeship Law (dual apprenticeship model) and law facilitating professional training stages for higher education graduates adopted in December 2013. - New work-based professional school training scheme to improve school-to-work transition. - Overall expenditure on labor market policies remains one of the lowest in the EU. - Demand-side measures and reforms: - 2011 Labor Code reforms: extended fixed-term contracts, introduced performance evaluation in layoff criteria, extended probationary periods, increased flexibility in compensation for overtime. - Social Dialogue Law: abolished national-level collective wage negotiations, tightened firm-level union representativeness criteria, removed automatic extension of collective sectoral contracts. - Proportion of fixed-term contracts increased from "3.9 percent" at the beginning of 2011 to "8.7 percent" in May 2014. - Unemployment benefit rules: - Unemployment benefits cease nine months after formal job separation. - In the first month of unemployment, an unemployed person earning "100 percent of the relevant average wage" and no children can expect about "37 percent" of their employment wage in benefits in Romania (compared to "77" in Bulgaria and "50" in Poland). ### Considerations for reducing labor taxes - Targeting vs. across-the-board cuts: - Targeting employer social security contribution (SSC) reductions at low-income earners (e.g., those earning half the minimum wage or less) or youth likely yields the largest gain in formal employment for a given revenue loss. - Targeting based on broad characteristics (low-paid, young) preferred over targeting by contract type or employer size to minimize substitution effects. - Phasing reductions across wage levels (rather than capping at a threshold) avoids creating a low-paid trap. - Delivery via tax credits suggested to preserve pension-contribution benefit link and keep administration simple. - Employer vs. employee SSC cuts: - Empirical evidence suggests cuts in employer SSC have a longer-lasting positive impact on employment than cuts in employee SSC, on average. - In the long term, wage renegotiation tends to capture cuts as higher wages; targeted employer SSC reductions are more effective where the link with benefits is weak. - Fiscal constraints and pension implications: - Romania must meet its medium-term budgetary objective (MTO) under the Fiscal Compact; ageing population projects additional health and pension costs of estimated "1¾ percent of GDP by 2030". - Reductions in labor taxes need offsets to maintain fiscal balance; ideal offsets are revenue-neutral tax shifts or permanent expenditure cuts. - Social security peculiarities that narrow the contribution base (self-employed reporting minimum wage; limited health contribution from self-employed) need addressing to avoid distortions. ### Potential offsets and revenue measures - Base-broadening and less-distortive tax increases (property and environmental taxes) offer best potential offsets. - Example package in text: - Increase in the cap on pension contributions from "5 to 8 times the average wage". - Require self-employed to make pension contributions based on total earned income and pay the employer portion of the health contribution. - Expand health contribution base to include all income. - These measures could generate up to "0.3–0.4 percent of GDP", enough to mostly offset the lost revenue from a "10 percentage point" cut in employers’ SSC targeted on low-income earners. - Proposed Fiscal Code changes (announced February 2015) noted in the text: - Reduce the employer pension contribution rate in 2017 from "15.8 to 13.5 percent". - Reduce the employee pension contribution rate in 2017 from "10.5 to 7.5 percent". - Reduce the flat PIT rate from "16 to 14 percent" in 2019. - Base-broadening measures for 2016: require self-employed to make pension contributions based on total earned income and include all income in the employee health contribution base, with a contribution cap of "five times the average wage". ### Policy recommendations and design principles - Maximize employment impact per revenue loss by: - Targeting employer SSC reductions on low-income earners and youth. - Phasing cuts across wage levels and delivering them via tax credits to preserve pensions link. - Ensuring measures are administratively simple and well-publicized to reduce evasion and compliance costs. - Offset revenue loss with: - Base broadening (self-employed pension base, health contribution base). - Increases in less-distortive taxes (property, environmental). - Consider contribution-cap increases (from "5 to 8 times the average wage") as part of a package. - Adopt conservative assumptions about benefits from labor tax cuts given uncertainty and the size of the informal economy—large payroll tax cuts may shift activity from informal to formal sectors rather than substantially raise total employment. *Source: _cr1580 - 38.0 percent, still above the EU average of 34 percent in 2013.* ### Box 1. Deriving the Labor Tax Wedge in Romania ### Box 1. Deriving the Labor Tax Wedge in Romania ### Personal income tax and allowances - Romania has a flat-rate personal income tax (PIT) with a tax rate of 16 percent. - Tax allowances based on income and number of dependents introduce some progressivity. - In 2012: - Personal allowance stood at RON 250 per month for those earning less than RON 1,000; declining linearly to zero for those earning RON 3,000 per month. - No allowance for those above RON 3,000 per month. - The tax allowance is withdrawn from just under half of the average wage (RON 2,200 per month). - Dependent allowance is RON 125 each, with the total allowance not to exceed RON 650 per month. - Effective PIT rate is less than 16 percent because PIT is imposed on income excluding employee social security contributions and allowances. - The average PIT rate is already two thirds of the maximum for someone earning around half the average income, illustrating the narrow income range over which the tax allowance is granted. ### Social security contributions and tax wedge definition - Romania requires substantial social security contributions for health, pensions, unemployment and invalidity. - Total annual social security contribution rate fell from 60 percent in 2001 to 44.5 percent in 2013, driven by a 12.5 percentage-point drop in the employer’s contribution rate. - The employer’s pension contribution rate was reduced another 5 percentage points in 2014. - The standard employer rate is now 15.8 percent. - Pension contributions are capped at five times the average worker’s salary (current cap). - Tax wedge definition (as presented in source, formula preserved verbatim): ݁݃݀݁ݓ ݔܽܶ ൌ ൅ܶܫܲ൫ ሺ ܥܵܵ ݁݁ݕ݋݈݌݉ܧ ሻ ∗ ሺ ܶܫܲ1େ ሻ ݏݎ݂݁ݏ݊ܽݎܶሻെܥܵܵ ݈ܽܐ݋ܶ∗ሺݕݎ݈ܽܽݏ݁ݏݽݾ൅ ݕݎ݈ܽܽݏ݈݁ݾܽݔܽܶ൯∗ ሻܥܵܵ ݎ݁ݕ݋݈݌݉ܧ∗ሺ1൅ݕݎ݈ܽܽݏ ݁ݏܽܤ - Note: SSC = social security contributions; PIT = personal income tax. - Income-dependent transfers are granted to those on lowest incomes but are minimal. - Following the OECD approach, employee social security contributions going to funded private pensions are excluded from the tax wedge calculation as they are treated generally as compulsory savings rather than taxation. ### Pension system deficits and fiscal implications - Romania’s unfunded pension system has incurred annual deficits since 2008, projected to continue for decades. - From 2010–14, subsidies from the central government covered about one quarter (2 percent of GDP) of the total annual revenues of the social security budget. - After the 5 percentage point cut in the employer pension contribution rate in 2014: - Subsidies are budgeted to jump to 36 percent (2.8 percent of GDP) of social security budget revenues in 2015 and remain around that level through 2018. - A cut in pension contribution rates without a similar reduction in benefits creates a net actuarial liability for the system. ### Options for reducing the labor tax wedge - Two broad groups of options: - Stimulate labor demand: cuts in employer social security contribution rates (pensions and health). - Stimulate labor supply: reductions in effective personal income tax rate and cuts in employee social security contributions. - Scenario analysis (using 2012 government income distribution and tax data): - A 10 percentage-point cut in the employer contribution rate for workers earning less than 50 percent of the average wage would reduce budget revenues by about 0.4 percent of GDP. - Suggested base broadening measures to largely offset this cut: - Raise the cap on pension contributions from 5 to 8 times the minimum wage. - Require the self-employed to make pension contributions based on their declared income (alternatively increase the floor on pension contributions from the minimum wage level). - Have the self-employed pay the employer portion of the health contribution, in addition to the employee portion. - Alternative delivery: graduated reductions through a tax credit (as France did in 2008) to protect the social security budget and preserve contribution-benefit link. - Employment effects and elasticities: - World Bank estimate: elasticity of the employment rate to the tax wedge is negative 0.23 in Eastern Europe for all workers. - A 10 percentage-point cut in the employer social security contribution targeted on low income workers would: - Reduce the tax wedge for an employee earning half the average wage by 14.2 percent (table entry preserved). - Imply an increase in the overall employment rate of 3.5 percentage points over the medium term. - By contrast, a 5 percentage-point across-the-board reduction in employer SSC rate enacted in 2014 is estimated to increase employment by 1.3 percentage points. - Costly alternative measures and offsets: - Increasing the personal income tax allowance to RON 1,000 per month for salary and self-employed income earners who earn less than half the gross average wage would cost about 0.7 percent of GDP. - Based on World Bank estimates, this would likely reduce the labor tax wedge by 4–6 percentage points. - Across-the-board reduction in the employee SSC rate of 5 percentage points would reduce budget revenue by 0.8 percent of GDP. - Given social security base broadening measures would garner about 0.4 percent of GDP, additional tax or expenditure offsets would be required to maintain budget neutrality. - Possible budget offsets: - Increase VAT as well as property and environmental tax revenue (Romania’s tax collection relative to EU countries of property and environmental taxes is particularly low; VAT gap is the highest). - Quantify tax expenditures to identify areas to improve tax efficiency and potential offsets. - Enact permanent cuts in key spending items, such as personnel expenditures. ### Conclusion and policy recommendations - Romania’s relatively high labor tax wedge likely constrains formal labor market participation and contributes to low participation rates and a sizable informal economy. - Recommendations: - Target reductions in labor taxes on low-wage workers or youth to maximize benefits, given higher labor demand and supply elasticities for low-income/low-skill workers. - Prefer targeted payroll tax cuts over across-the-board cuts to generate larger increases in formal employment for the same revenue loss. - Offset lost revenue from reductions in payroll taxes, ideally through tax base broadening measures; also consider increases in property and environmental taxes and stronger VAT collection efforts. - Specific quantitative finding: - A significant cut in the employer social security contribution rate of 10 percentage points, focused on low-income workers, is estimated to generate a 4 percent increase in the formal employment rate over the medium term (as summarized in the text). ### Annex — key data points (2012) - Around 14½ million Romanians paid PIT in 2012. - Nearly 12 million (79 percent of the total) paid PIT on a declared income of less than RON 12,000 per year (RON 1,000 per month). - Majority paid PIT on a declared income close to the minimum income, which stood at around RON 700 per month in 2012. - A further 15 percent paid PIT on declared income between RON 12,000 and 36,000 annually (this group includes those on the average income of about RON 24,000 per year). - Only around 6½ percent of PIT payers had declared incomes of more than RON 36,000 per year. - Income shares: - Those with declared annual incomes of less than RON 12,000 made up nearly 80 percent of taxpayers but their share in total taxable income was only 15 percent. - The 0.1 percent of taxpayers with declared incomes above RON 500,000 per year contributed nearly 12 percent of total taxable income. - Income composition by group: - Share of labor income in total taxable income exceeds 80 percent for those on incomes up to RON 60,000 per year, dropping to less than 10 percent for the top income bracket. - Income from self-employment plays a minor role across all income groups. - Social security contributors: - Out of 7 million social security contributors, 90 percent were employed rather than self-employed. - For those with declared incomes above RON 500,000 per year (fewer than 10,000 people), there were nearly four times as many self-employed as employed. *Source: IMF staff summaries of Box 1 from the supplied IMF document.* ### References ### References ### Reference list - European Commission, 2012, Study to Quantify and Analyse the VAT Gap in the EU-27 Member States, prepared by a consortium led by CPB Netherlands Bureau for Economic Policy Analysis, Warsaw. - Gora, M., Radziwill, A., Sowa, A., and M. 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Honjo, 2014, A Targeted Cut in Social Security Contributions in Spain—Can it Boost Employment, Selected Issues Paper, International Monetary Fund, Washington, D.C. - Ministry of European Funds, 2014, Romanian Partnership Agreement for the 2014–2020 Programming Period, Bucharest. - Nickell, S., 2003, "Employment and Taxes,” CESifo Working Paper No. 1109, CESifo Group, Munich. - Organization for Economic Co-operation and Development (OECD), 2011, “Taxation and Employment,” OECD Tax Policy Studies, No. 21, Paris. - Romania Fiscal Council, 2013, 2012 Annual Report—Macroeconomic and Fiscal Developments, Bucharest. - Schneider F., Buehn A., and C. Montenegro, 2010, New Estimates for the Shadow Economies all over the World, International Economic Journal, 24: 4, 443–461. - Rutkowski, J., 2007, “Taxation of Labor,” in C. Gray, T. Lane, and A. Varoudakis (eds), “Fiscal Policy and Economic Growth: Lessons from Eastern Europe and Central Asia,” The World Bank, Washington D.C., (mimeo). - Schwarz, A., 2007, “Pensions,” in C. Gray, T. Lane, and A. Varoudakis (eds), “Fiscal Policy and Economic Growth: Lessons from Eastern Europe and Central Asia,” The World Bank, Washington, D.C. - __________, and O. S., 2014, The Inverting Pyramid: Pension Systems Facing Demographic Challenges in Europe and Central Asia, The World Bank, Washington, D.C. - World Bank, 2013, Labor Taxation in Romania: Issues and Reform Options,” Washington, D.C. ### Core Questions and Findings - What is the current status of fiscal decentralization in Romania and how does it compare to peers? - Decentralization in Romania started in 1991. - The share of subnational government expenditure in general government expenditure doubled from about 12 percent in the mid-1990s to 25 percent in 2013 but is still below the European Union average. - What is the authorities’ plan to accelerate decentralization? - A bold initiative was launched in 2013 to shift important responsibilities and assets of some ministries to local authorities; the Constitutional Court rejected the initiative. - The government is identifying smaller-scale pilot areas for decentralization and intends to gradually expand the initiative. - What are the main weaknesses in the current system and potential risks from the plan going forward? - Low share of revenue at the full discretion of local authorities, large vertical imbalance, weak effectiveness of fiscal rules at the local level, weak commitment control system, and mismatch between central and local reserve funds. - The plan could worsen the vertical imbalance and jeopardize public assets unless certain conditions are put in place. - How can Romania reap further benefits from decentralization and mitigate associated risks? - A stochastic frontier analysis indicates room to improve the efficiency of public expenditure, allowing larger and better growth-enhancing public investments without additional budgetary pressures. - Cross-country analysis suggests decentralization can improve efficiency but requires strong institutions and capacity. - Recommendations include enhancing local governments’ own taxes (such as property taxes), strengthening public financial management (including rolling out the new commitment control system to local public institutions), and setting aside a budget buffer of 10 percent at the local level in line with the requirement for the central government. - Effectiveness of fiscal rules at the local level should be enhanced and local authorities should be strongly accountable to the local population. ### Introduction and background - Decentralization process: - Started in 1991 with the adoption of the new constitution establishing three administrative layers. - Responsibilities devoluted over time: public utility services, local public transportation, community services, social protection in the 1990s; health, education, agriculture, and local police thereafter. - Progress and comparison: - Romania was among the most centralized countries in the early 1990s by share of local governments in general government revenue and expenditure. - Efforts doubled the share of subnational expenditure to reach the CESEE average, but Romania remains more centralized compared to many EU countries. - 2013 draft law: - Aimed to accelerate subsidiarity by shifting responsibilities/resources to local authorities but was rejected by the Constitutional Court for lacking impact analyses, preparatory measures, cost standards, quality standards, and compliance with constitutional property regime. - Government opted for a gradual approach with pilot areas and specific laws per pilot. ### Merits and risks of decentralization - Potential benefits (with literature references preserved): - Improved public service delivery through preference matching, stronger accountability, and competition (Hayek, 1945; Tiebout, 1956; Oates, 1972). - Positive relationships found between education and health outcomes and degree of decentralization (Ahmad et al., 2008). - Allocative and productive efficiency gains can create budgetary savings and stronger fiscal performance (Escolano et al., 2012; Neyapti, 2010; Baskaran, 2010). - Decentralization encourages competition among local governments and innovation, potentially reducing waste and corruption (Brennan and Buchanan, 1980). - Local accountability and better identification of local needs can support economic growth (Fredriksen, 2013; Bénassy-Quéré et al., 2007; Kappeler and Valila, 2007; Arze del Granado et al., 2005). - Potential risks and failure modes: - Loss of economies of scale when responsibilities are devolved to small local governments can increase costs and reduce efficiency. - Weak local accountability (e.g., appointed rather than elected local authorities) can lead to misallocation of resources (Davoodi and Zou, 1998; Woller and Phillips, 1998; Zhang and Zou, 1998; Gonzalez Alegre, 2010; Grisorio and Prota, 2011). - Reduced central ability to redistribute resources and ensure minimum public services if central share of revenue/expenditure is reduced (Ter-Minassian, 1997). - Risk of loosening fiscal discipline via the “common pool” problem and deficit bias (Oates, 2006); central government may be unable to enforce consistent hard budget constraints (Rodden et al., 2003). - Decentralization can increase financing costs as borrowing conditions typically favor central over local governments. ### The current system in Romania - Revenue structure and discretion: - Share of “discretionary” own revenue is low; share of earmarked funds has increased. - Revenues at local level comprise own taxes, shared taxes, earmarked and non-earmarked funds and transfers. - Share of own taxes (full discretion) declined and is now amongst the lowest in the European Union. - When shared taxes are included in own revenue, the share expanded from about 20 percent of total revenue in the early 1990s to about 50 percent to date. - Earmarked funds and transfers have exceeded 30 percent of total revenue of most local governments in recent years. - Expenditure patterns: - Share of local government expenditures in general government expenditures doubled over two decades, reaching about 25 percent in 2013 (CESEE average) but still below the EU average of about 33 percent. - Education and health represent the largest share of local governments expenditures, leading to predominance of non-discretionary items (personnel and goods and services). - Vertical fiscal imbalance (VFI): - VFI has been on a worsening trend; Romania displayed one of the largest vertical imbalances across the European Union. - Low VFI implies heavy dependence on central government transfers. - Frequent changes in legislation impede predictability and efficient multi-year budgeting at local level. - Fiscal rules and debt: - Local government budgets must be balanced (excluding loans to finance investment and debt refinancing) — the “golden rule.” - Local governments cannot contract or guarantee loans if annual public debt service including the new loan is higher than 30 percent of their own revenue. - From 2013, each government budget should be balanced, excluding investment projects financed by drawings on loans contracted before 2013. - Local government debt is among the lowest in the European Union, but arrears have frequently accumulated, particularly for EU-funded projects and in the health sector. ### Proposal for further decentralization (2013 draft law) - Objectives and scope: - Strengthen subsidiarity by shifting specified services to local governments to increase quality/effectiveness and strengthen administrative capacity to reduce disparities in economic development. - The draft law specifies a list of local directorates of key ministries to be managed by local authorities and stipulates a timeline to accelerate decentralization. - It aims to improve EU funds absorption through more fluid decision making and stronger local capacity. - Financing and fiscal impact: - Revenue sharing methodology would remain unchanged; new decentralized competences would be financed with additional transfers. - The 2014 budget foresaw budgetary transfers from ministries to local governments amounting to about RON 674 million (or 0.1 percent of GDP), of which about half would relate to personnel expenditures and the other half to goods and services. - The overall budget balance would not be impacted as lower central balance from transfers would be compensated by a similar higher balance at the local level. - Asset transfers: - The draft law envisages transfer of significant assets (e.g., public transportation equipment and facilities, sports and tourist facilities) to local authorities under the premise that full ownership would enhance accountability in usage and maintenance. - The value of those assets has not been presented yet; implications for the government balance sheet may be significant. ### Policy recommendations — Institutional environment - Preconditions and empirical findings: - International experiences emphasize the need for a favorable institutional environment to capture decentralization benefits. - A new empirical study by Sow and Razafimahefa (forthcoming) of 64 countries—including advanced, emerging and developing countries—over the period 1990–2012 analyzes the impact of fiscal decentralization on the efficiency of public service delivery (Annex III). - Findings: effective autonomy of local governments is required for preference matching and allocative efficiency; strong accountability of local authorities vis-à-vis the local population (for instance through direct election) is necessary to improve productive efficiency; corruption must be tackled; and capacity at the local level must be strengthened. - Absent these conditions, fiscal decentralization can worsen public service delivery. *Source: _cr1580 - References* ### 18. Romania’s efficiency of public expenditure lags behind that of peers. Sow and ### _cr1580 - 18. Romania’s efficiency of public expenditure lags behind that of peers. Sow and ### Efficiency of public expenditure: methodology and findings - Efficiency estimated via a stochastic frontier technique (Battese and Coelli, 1988; Jayasuriya and Wodon, 2003; Grigoli and Kapsoli, 2013). - Outcome variables: infant mortality rate and secondary school enrolment rate. - Inputs: public expenditure on health (and alternatively education) as percent of GDP, plus control variables. - Error decomposition: itε = itω + μit, where itω is idiosyncratic disturbance and μit is the one-sided disturbance capturing country-specific and time-varying efficiencies. - Finding: the efficiency of public service delivery in Romania has improved over time but remains below that of countries in the region. ### Decentralization and its impact on efficiency - Model for efficiencies μit regresses estimated efficiencies on lagged fiscal decentralization (share of local government expenditure or revenue in general government expenditure or revenue), interactions with institutional and capacity variables, other controls, and a stochastic error. - Institutional and capacity variables include: level of corruption, degree of autonomy of the regions, strength of democracy, bureaucracy, political stability, and checks and balances. - Empirical result: fiscal decentralization variable alone worsens public expenditure efficiency. - Interaction effect: when fiscal decentralization is combined with stronger institutions and capacity, the impact on efficiency becomes positive (Annex III). - Policy implication: fiscal decentralization needs to be accompanied by measures to strengthen institutions and capacity at central and local levels. ### Vertical imbalance and local own revenue - Risk: decentralizing resources without matching decentralization of spending (or vice versa) can deteriorate general government fiscal performance through mismatched balances at central and local levels (examples cited: Colombia in the 1990s, Indonesia in 2000, Nigeria during oil-boom years). - Romania’s situation: - Shares of subnational government revenue and expenditure in general government revenue and expenditure doubled between 1995 and 2013; however, Romania remains more centralized than the EU average. - Low property tax rate contributes to low share of own revenue at the local level; revenue collected from property tax is much below the EU average. - Options to enhance own revenue: - Increase property tax rate while protecting the poor. - Change tax base (for instance, a shift from “ownership” to “use” principle or a more frequent reevaluation). - Benefits of higher own revenue: enforces a hard budget constraint on local authorities, increases independence in spending allocation, allows preference matching. - Risks of insufficient own revenues: over-reliance on transfers, soft budget constraints, spending without regard to revenue performance. - Horizontal imbalance: ensure all subnational governments possess minimum resources to provide standard public goods and services. ### Public financial management (PFM) requirements - Essential PFM elements: commitment control, fiscal reporting, budget formulation, execution, accounting and control. - Recommendation: local governments should set aside a fiscal buffer of 10 percent of total expenditure, in line with the requirement for the central government. - Operational measures: - Swift use of new commitment control and fiscal reporting systems by local authorities to improve real-time budget management. - Accelerate training of users to address reluctance. - Rigorous and timely reporting on fiscal operations at the subnational level. - Expand central-level investment prioritization initiative to local projects. - Prioritize financing through European funds before national financing to improve efficiency and reduce budgetary pressures. - Strengthen capacity at the local level; consider asymmetric arrangements where decentralization varies across subnational governments depending on readiness. ### Asset transfers and safeguards - If assets are transferred to local authorities (as envisaged in the 2013 decentralization draft law), their value should be assessed. - Noted asset categories in the 2013 draft law include transport and tourism facilities. - Need to analyze capacity for management and maintenance costs; absent assessment, near- and medium-term quality of public services from those assets could deteriorate. ### Economies of scale and assignment of responsibilities - Romania ranks among countries with a small population size per local government; population size at local and intermediate levels is smaller than the EU average. - Risks: transferring responsibilities where scale economies matter could worsen efficiency and increase production costs. - Recommendation: shift responsibilities based on efficiency and capacity considerations; clearly define roles at each government level. - Note: some overlapping task assignments exist in the current decentralization legal framework; transfers of large transport and tourism facilities should be cautiously analyzed. ### Fiscal rules for local governments - Fiscal rules for local governments in Romania are broadly similar to peers, but enforcement framework is significantly weaker. - Romania ranks poorly on the European Commission’s Fiscal Rule Strength Index at the local level. - Index components include: C1 - Statutory base; C2 - Adjustment margin; C3a - Monitoring body; C3b - Alert mechanism; C3c - Enforcement body; C4a - Non-compliance actions; C4b - Escape clauses; C5 - Media visibility. - Identified weaknesses: - Lack of an alert mechanism to trigger action in case of deviation from rules. - Fiscal Council actions have focused on general government and have not sufficiently covered local governments’ fiscal rules. - Insufficient corrective actions and sanctions for non-compliance despite controls by the Court of Accounts and some penalty provisions. - Recommendation: design and enforce sanctions; strengthen media visibility; implement alert mechanisms and effective corrective actions. ### Conclusions and prerequisites for successful decentralization - Potential gains: room to improve public expenditure efficiency and growth-enhancing investments via further decentralization; improved efficiency can allow larger and better public investments without additional budgetary pressures. - Preconditions required before accelerating decentralization: - Expand local governments’ own taxes to reduce vertical imbalance; consider enhancing property tax base and rate. - Design and enforce sanctions for non-compliance with local fiscal rules; strengthen media visibility and implement alert mechanisms. - Swiftly deploy and use the new commitment control system across central and local institutions. - Encourage local governments to set aside fiscal buffers consistent with the central government requirement (10 percent of total expenditure). - Assess values of public assets to be transferred to local authorities and put adequate safeguards in place. - Tackle corruption to prevent efficiency leaks from decentralization. - Warning: absent these prerequisites, further decentralization can worsen public expenditure efficiency and macroeconomic performance. ### Selected exact numeric and allocation figures cited - Fiscal buffer recommendation: 10 percent of total expenditure. - Subnational shares: subnational government revenue and expenditure shares in general government revenue and expenditure doubled between 1995 and 2013. - Annex I income tax sharing (Bucharest Municipality): - 20 percent to the budgets of Bucharest districts, - 44.5 percent to the budget of Bucharest Municipality, - 7 percent for balancing the district budgets and the budget of Bucharest Municipality, - 28.5 percent for the central government. - Annex I income tax sharing (other cases): - 41.75 percent to the local budgets of communes, cities and municipalities where the income tax payers carry out their activities, - 11.25 percent to the local budget of the county, - 18.5 percent to balance the budgets of communes, cities and municipalities, as well as the budget of the county (equalization fund), - 28.5 percent for the central government. - Equalization transfers to counties from certain state budget revenues: - (i) 70 percent according to the financial capacity of the county, - (ii) 30 percent according to the county area. - From the income tax equalization fund and the equalization transfers: 27 percent to county’s budget, and 73 percent to the budgets of communes, cities and municipalities; of the 73 percent, distribution is: - 80 percent decided by the head of the county public finance general directorate, based on population, land area and financial capacity, - 20 percent decided by the county council to clear arrears. *Source: IMF staff analysis in _cr1580 (selected section text).* ### References ### _cr1580 - References ### Major themes covered by the referenced literature - Fiscal decentralization (design, macro policy lessons, impact on growth, deficits, composition of public expenditure) - Efficiency of public expenditure and sectoral spending (health, education, infrastructure) - Tax competition and tax incentive conflicts among subnational governments - Fiscal federalism theory and hard budget constraints - Empirical methods for efficiency and frontier analysis - Country and regional case studies, including Romania, Brazil, China, Italy, Spain, OECD countries, Africa, and emerging/developing economies ### Key referenced works (authors, year, title, outlet) - Ahmad, E., Brosio, G. and Tanzi, V., 2008, “Local Service Provision in Selected OECD Countries: Do Decentralized Operations Work Better?,” IMF Working Paper 08/67. - Arze del Granado, F.A., Martinez-Vazquez, J. and McNab, R., 2005, "Fiscal Decentralization and The Functional Composition of Public Expenditures," International Center for Public Policy Working Paper Series. - Ayres dos Santos, J., 2013, “Tax Incentive War among Brazilian States,” The Institute of Brazilian Issues, George Washington University. - Baskaran, T., 2010, “On the Link between Fiscal Decentralization and Public Debt in OECD Countries,” Public Choice, 145, pp. 351–378. - Battese G.E. and Coelli, T.J., 1988, “Prediction of Firm-level Technical Efficiencies: With a Generalized Frontier Production Function and Panel Data,” Journal of Econometrics, 38, pp. 387–399. - Bénassy-Quéré A., Gobalraja N. and Trannoy A., 2007, "Tax and Public Input Competition," Economic Policy, CEPR & CES & MSH, 22(4), pp. 385–430. - Brennan, D. and Buchanan, J., 1980, The Power to Tax: Analytical Foundations of a Fiscal Constitution, Cambridge University Press, Cambridge. - Castilho, F. B. and R. F. Silveira, 2009, ”Brazilian States Tax War,” Law and Business Review of the Americas, Vol. 15. - Davoodi, H. and Zou, H. F., 1998, “Fiscal Decentralization and Economic Growth: A Cross-country Study,” Journal of Urban Economics, 43(2), pp. 244–257. - Escolano, J., Eyraud, L., Moreno-Badia, M., Sarnes, J. and Tuladhar, A., 2012, “Fiscal Performance, Institutional Design and Decentralization in European Union Countries,” IMF Working Papers 12/45. - Fredriksen, K., 2013, “Decentralization and Economic Growth-Part 3: Decentralization, Infrastructure Investment and Educational Performance,” OECD Working Papers on Fiscal Federalism, 16. - Gonzalez-Alegre, J., 2010, "Decentralization and the Composition of Public Expenditure in Spain," Regional Studies, 44(8), pp. 1067–1083. - Grigoli, F. and Kapsoli, J., 2013, “Waste Not, Want Not: The Efficiency of Health Expenditure in Emerging and Developing Economies,” IMF Working Papers 13/187. - Grisorio, M.J. and Prota, F., 2011, “The Impact of Fiscal Decentralization on the Composition of Public Expenditure: Panel Data Evidence from Italy,” Societa italiana degli economisti, 52. - Gupta, S. and Verhoeven, M., 2001, “The Efficiency of Government Expenditure. Experiences from Africa,” Journal of Policy Modelling, 23, pp. 433–467. - Hayek, V. F., 1945, “The Use of Knowledge in Society,” American Economic Review, 35(4), pp. 519–530. - International Monetary Fund, 2009a, “Macro Policy Lessons for a Sound Design of Fiscal Decentralization,” Policy Paper, Washington, DC. - International Monetary Fund, 2009b, “Macro Policy Lessons for a Sound Design of Fiscal Decentralization—Background Studies,” Policy Paper, Washington DC. - Jayasuriya, R. and Wodon, Q., 2003, “Efficiency in Reaching the Millennium Development Goals,” World Bank Working Paper, 9. - Kappeler, A. and Valila, T., 2008, "Fiscal Federalism and the Composition of Public Investment in Europe,” European Journal of Political Economy, 24(3), pp. 562–570. - Neyapti, B., 2010, “Fiscal Decentralization and Deficits: International Evidence,” European Journal of Political Economy, Vol. 26(2), pp. 155–166. - Oates, W.E., 1972, Fiscal Federalism, New York: Harcourt Brace Jovanovich. - Oates, W.E., 2006, "On the Theory and Practice of Fiscal Decentralization," Working Papers 2006–05, University of Kentucky, Institute for Federalism and Intergovernmental Relations. - Rodden, J., G.S. Eskeland and J. Litvack, 2003, Fiscal Decentralization and the Challenges of Hard Budget Constraints, The MIT Pres. - Ter-Minassian, T., 1997, “Decentralization and Macroeconomic Management,” IMF Working Paper 97/155. - Tiebout, C.M., 1956, “A Pure Theory of Local Expenditures,” Journal of Political Economy, 64, pp. 416–424. - Woller, G.K., K. Phillips, 1998, “Fiscal Decentralization and LDC Growth: An Empirical Investigation,” Journal of Development Studies 34, 138–148. - World Bank, 2011, “Romania: Reining in Local Government Spending,” World Bank, Washington DC. - World Bank, 2013, “Romania’s Decentralization Agenda: Moving Forward,” Concept Note, World Bank, Washington DC. - Zhang, T. and Zou, H., 1998, "Fiscal Decentralization, Public Spending, and Economic Growth in China," Journal of Public Economics, 67(2), pp. 221–240. *Source: _cr1580 - References (PDF).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1580.pdf_