1. Summary

For the third time the Institute for Market Economics prepared an alternative government budget with the goal to show that tax cut is possible and can be achieved within a relatively short period. The IME alternative budget for 2006 envisages revenues totaling 35.2% of GDP and expenditures amounting to 34.8% of GDP and a surplus of 0.4% of GDP.

The alternative budget is based on the following reforms:

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

• Elimination of the dividend tax

• 8% of the social security tax goes to private pension fund

• Public expenditure cuts – through decrease of public sector staff and maintenance expenditures, 50% cut of the subsidies for loss making activities

• Elimination of the inefficient meddling in the labor market, transfer of activities to the private sector and faster privatization, smaller “structural reform” reserve

• Using budget surpluses for pension reform

As a result of the overall decrease of the tax burden the disposable incomes will increase, the economic activity will accelerate, incentives for work, entrepreneurship, risk-taking, saving and investment will increase, economic development will be faster and the wealth will increase.

2. Taxes and revenues

Tax and social security reform

The decrease of the tax burden, especially direct taxes, has a strong impact on incentives for choice between work and leisure, between paying and evading taxes, between saving and investment, between taking entrepreneurial risk and avoiding it, between job creation and job destruction. As a result, the tax burden has a strong negative impact on economic growth, employment, and incomes. The opposite is also true – lower tax burden has a positive effect on economic growth, job creation, income growth, and decrease of the shadow economy.

Having that in mind and aiming at accelerating the rate of economic growth, the alternative government budget for 2006 envisages a bold decrease of the tax burden. We propose the following reforms in the tax system:

• Decrease of the corporate tax to 10% (15% in 2005)

• Decrease of the income tax to 10% (10-24% in 2005)

• Abolition of the dividend tax (7% in 2004)

• Decrease of the social security tax to 10% (42.7% in 2005)

In addition, we in the alternative budget 8 percentage points of the social security tax go to private pension fund (3% in 2005). In this way a long-term financial stability of the pension system is ensured.

Revenues in the consolidated government budget

The budget, proposed by the government, has revenues of 18.3 billion leva for 2006, which is 40% of GDP. The alternative budget, prepared by the Institute for Market Economics, has revenues of 16.3 billion leva or 35.2% of GDP. The difference is 2 billion leva – therefore the alternative budget withdraws 5% less resources from the economy and citizens.

The alternative budget provides for a considerable decrease of tax burden, measured not only by tax rates, but also by the redistribution through the budget. Bulgarian economy and companies become far less taxed and as a result – more competitive, which can be expected to increase the value added and the incomes.

Table 1: Revenues in the alternative budget compared to the government draft

A. Taxation of profits

The decrease of the corporate tax cut and the elimination of the dividend tax has the following effects on the economy:

• Mechanical (theoretical) decrease of revenues because of the lower tax rate
• Growth of revenues because of the economic growth
• Growth of revenues because of increase of the taxable income – the social security tax cut increases the profits of the companies because a part of the tax cut remains in the companies
• Growth of revenues because of decline of the shadow economy – the cost of staying in the shadows and avoiding taxes is probably between 5-10%. Therefore a tax of 10% will greatly diminish the profitability of hiding corporate incomes and more companies will leave the shadow economy.
• Growth of revenues because of increased business activity – the cut of direct taxes will increase the incentives for work, saving, investment, entrepreneurship. As a result the business activity will increase, the corporate revenues will also increase, as well as profits.

To illustrate these effects, we can observe the response of the economy to the profit and dividend tax cuts in 2005. In the beginning of 2005 the dividend tax was cut to 7% (from 15% before that). Despite the much lower tax rate, the revenues in the budget collected from this tax increased - by 11.5% in nominal terms, as a share of GDP they remained flat and even recorded a small increase.

Since 2005 the profit tax in Bulgaria became 15% after being 19.5% in 2004. The decrease of the tax rate is about a quarter and still the revenues from the profit tax are higher than a year ago. As a share of GDP the revenues remained at the same level. Obviously, as a result of the lower tax rate, the corporate profits increased much faster than the nominal growth of the economy.

If the same situation repeats in 2006, the decrease of the profit tax to 10% will be entirely compensated by the increase of the tax base. In addition, as the rate is lower, the response will be even higher. Moreover, the decrease of the social security tax will also increase the revenues form the corporate tax by almost 100 million leva. Therefore, in 2006 the revenues will be higher than 2005 despite the 10% tax rate envisaged in the alternative budget.

  B. Taxation of labor

The decrease to 10% of the income tax and the social security tax, as well as the increase from 3% to 8% of the payment to private pension fund has the following effects on the revenues in the budget:

• Mechanical (theoretical) decrease of revenues because of the lower tax rate

• Decrease of the shadow economy – because of lower rates and higher share of social security tax rate that goes to private pension fund
• Higher incentives for work, higher rate of job creation – which will increase the taxable income in the economy.

On table 2 below we can see the probable effects from the lower tax rates. We increase the forecast for labor costs in the economy by 5%, because of the practice of the Ministry of Finance to underestimate the expected revenues (for example, in 2005 the social security tax revenues are 5% higher than the forecast). At the same time, we decrease the expected labor costs by one billion because a part of the social security tax cut will go to the employers. After that, we include in the calculation that shadow economy will decrease – to be conservative, we assume this effect will be 10% of the labor costs. In addition, we include also the effect of more jobs and more work.

After all calculations, we expect in 2006 the revenues from income tax to be a little more than one billion leva. The revenues form the social security tax are 1.45 billion leva – about 0.5 billion will go in private pension finds and the other – in the government budget.

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

C. Indirect taxes

In 2005 revenues from indirect taxes are much higher than expected. We expect the same will happen in 2006 – because the Ministry of Finance underestimated the revenues for years.

  D. Non-tax revenues

We expect the forecast of the Ministry of Finance for a decrease of the non-tax revenues will not happen (they had the same forecast for 2005 and it didn't happen). In addition, these revenues can be increased by faster sell of state property and concessions.

3. Expenditures

Total expenditures and budget balance

The revenues in the alternative government budget for 2006 are a bit higher than 16 billion leva, i.e. nearly 35% of GDP. Compared to the government budget draft, the revenues are 5% of GDP less. Compared to 2005 the expenditures are a bit lower in nominal terms. In the alternative budget a small budget surplus is forecasted – in order to prevent any negative developments or errors in the forecasts.

Reform of expenditures

A. Salaries

In 2006 we propose 10% cut in the budget personnel. The social security tax cut will be split by half between the government and its employees. This will allow for a 13% increase of the budget labor costs. The total result is a small increase of the expenditures for salaries.

  B. Social security contributions

As far as the social security tax is cut significantly – from more than 42% to 10%, the budget expenditures for social contributions decrease substantially. At the same time the budget continues to cover the social security contributions of pensioners, unemployed etc.

C. Maintenance

These include expenditures for fuel, electricity, heating, phones, communications, water, outsourcing (consultancy, transport, etc), repair, membership fees, state reserve, food, medicines, R&D, books.

In the government draft the maintenance expenditures for 2006 increase 9 times faster than 2005. This is not justified. The cur of the personnel and a possible optimization of long-term assets (buildings, offices, cars) and a better control over the expenditures allows for a slower growth of maintenance expenditures.

D. Subsidies, credits and temporary financial help

Subsidies for loss-making companies distort the market environment, retain resources in loss-making activities and harm the economic development. In the alternative budget the subsidies are cut by half – this can be done if the programs for restructuring government enterprises are realized (including Bulgarian State Railways). The good development of the banking sector and the credit expansion are good reasons for the budget not to meddle in the credit market.

E. Social security

In 2006 alternative budget we propose elimination of the inefficient programs for labor market intervention. They cost 200 million leva without having any impact on the long-term prospects of the unemployed for finding job.

F. Long-term assets

Expenditures for long-term assets are not enough efficient. Some investments can be transferred to the private sector. In addition, the mechanism of the public procurement often does not reach the best proportion between price and quality. The usage of privatization and concession as well as more competitive public procurement procedures can save a part of the increase in the expenditures.

G. Reserve for emergencies and structural reform

The emergency reserve is relatively small, while the structural reform reserve is quite high, although no structural reform is being done. It seems that is just an additional source of spending for the ministries.

H. Interest expenditures

The huge fiscal reserve and a possible faster privatization free considerable amount of money that can be used for repaying government debt. This, in effect, will decrease the interest expenditures.

Table 3: Expenditures in the alternative budget compared to government draft

Table 4: Expenditures of the alternative budget compared to previous year budget