With the end of the summer holidays and the date for the submission of Budget 2007 approaching, discussions and debate over the next year's tax rates have intensified.
The first reading of changes to corporate and individual tax laws have already been approved by Parliament, but they do not provide the specific tax rates. The second reading of the bills should be approved by the end of October, and the revised tax parameters should be set out in the national budget draft for next year that outlines the fiscal policy of the Government.  

At present, Bulgarian taxpayers are getting various signals about upcoming revisions to the tax rates but there seems to be no consensus among the coalition partners. Here are some of the directions of the discussion. 

Taxation of personal income
Bulgarian Socialist Party (BSP) proposals about changes to the personal income tax were greatly opposed by the National Movement Simeon II as well as by the right-wing parties. The proposal was to levy personal income tax at a rate of 28 per cent on incomes of more than 1400 leva a month. This means that a new band should be adopted because, at present, all monthly incomes over 600 leva are levied at a rate of 24 per cent. Deputy Finance Minister Georgi Kadiev opposed that idea by saying that, according to National Statistical Institute (NSI), statistics only 17 000 people would fall into the new category and this would lead to greater complications in the administration of the tax system, but little revenue for the budget. A simple cost benefit analysis of this proposal will show that the proposal will lead to negative effects for the economy. There are many costs associated with such a step - higher administration costs, more incentives to hide income, less supply of labour and at the same time, the benefits are zero. 

Other proposed income tax changes appeal for an increase of the tax-free allowance up to 200 leva from the 2006 level of 180 leva and abolition of one of the medium scales in the personal income tax bands, that of 22 per cent. These would be positive revisions as they would lead to a flattening of the income tax and a reduction of the effective tax rate due to the higher tax-free allowance. A reduced tax burden, together with simplification of the tax payment process, is the right path towards enhanced economic growth in the country.

After the abatement of the social security burden in 2006 to 36.7 per cent of earnings from 42.7 per cent in 2005, a further decrease in social security rates in 2007 would be highly appreciated by business and employees. Last year the pension insurance security was reduced by six per cent, and the portion of money going to private pension funds increased from three to four per cent. The fiscal stability of the economy was not threatened, just the opposite - a budget surplus was achieved that exceeded 1.3 billion leva (3.1 per cent of GDP). The redistribution of GDP by the Government reached 42.9 per cent, which is an indicator of an ineffective public finance governance and tax system.

In 2007 the portion to the private pension funds is set to rise to five per cent, but still, the system is inefficient and is not forward-looking in regard to trends such as aging of the population and labour mobility. According to employers and employees, social insurance contributions and taxes are too big a burden. Bulgaria's social insurance burden is among the highest in comparison to the European Union, and should be further reduced together with reform of the current pension system. A private, capital-based pension system should replace the PAYG (pay-as-you-go) government system that is characterised by inherent problems and imbalances.

As a whole, it seems that the Government is failing to reduce significantly taxation of personal income despite the high budget surplus that is expected to pass  four per cent of GDP at the end of the year and the positive effects that the economy experienced after the social security tax cuts in 2006.

Taxation of business 
The BSP proposed a reduction of the corporate tax rate to 10 per cent from the current 15 per cent, but the most likely reduction of corporate tax rate for the moment is by three per cent - to 12 per cent. However, despite pre-election promises, ceding of corporate tax on reinvested profit is still not among the ruling coalition's priorities. Steps have been taken to adopt the rules concerning the double-taxation and taxation of subsidiaries of EU companies in the country.   

According to Doing Business 2007, the World Bank index that indicates the regulatory costs of business in many countries, the effective tax that a medium size company in Bulgaria must pay in 2006 is 40.74 per cent of gross profit. Entrepreneurs must make 27 payments, and spend 616 hours to make these payments. Bulgaria has made slight progress in tax policy in recent years because of the decrease in social security rates, but still the average tax rates that are levied on business are higher than the rates in the most rapidly-growing economies in the world. According to the indicator "Paying Taxes", Bulgaria has dropped by three places in comparison to 2005. There is no improvement in the overall estimated hours for paying taxes, nor in the number of payments.
     
Taxation of consumption
Taxes on consumption include VAT and excise duties on special goods such as cigarettes and alcoholic beverages. Bulgaria has to harmonise its tax regime with that of the EU by introduction of the minimum excise duties of the European Community on tobacco, alcoholic beverages and fuels. Having started in 2002, the harmonisation process is scheduled to be completed by the end of 2013. In 2007 excise duties on petrol and diesel fuel will increase, while on tobacco and alcohol there will be no price adjustment for next year.  

Despite deductions of the social insurance and corporate tax, the increase of the excise duties and the widening of the tax base due to "lightening up" of a part of the informal economy will ensure greater revenue from indirect taxation than expected. As far as the excises are a part of the taxable base for VAT, the additional excises lead to additional revenues from VAT. This will result again in a budget surplus at the end of 2006. 

As a whole, indirect taxes are the largest and most rapidly growing component of tax revenues, accounting for 18.4 per cent of GDP in 2005. In 2006 this share will be even larger.

Some unavoidable truths about taxation

* High marginal tax rates lead to less payment for each additional unit of labour and as a result, to fewer incentives for work and preference of leisure to labor - this is called a substitution effect of marginal tax rates which reduce economic efficiency by shifting people towards less work and more leisure at the margin.

* Higher taxes (including social securities burden) mean higher labor costs to employers which serves as a disincentive for business people to hire additional employees. This is a cause of higher unemployment.

*  Taxation does not only provide redistribution of incomes and redirection of undertakings to less profitable business sectors due to market signal distortions, but it also generates deadweight loss in the economy - lost revenues that are received neither by the private, nor by the public sector. 

* Taxes of all kinds discourage production by reducing the present incentive for future production of valuable assets and thereby also lower future income and the future level of consumption.

* Imposing or raising taxes leads to less business activity, e.g. less entrepreneurship and innovations which are the driving forces of the economic growth.

* High levels of taxation lead to bigger share of shadow economy because the incentives to evade taxation become higher.

* The forgone revenue for the private sector of each lev taken by the Government is greater than one lev due to the multiplication effect of the business activity. This means that the value of the public goods that we receive in exchange of the taxes we pay are less than the value of the goods and services we would gain if we spend all the money we earn by our own.   

This list can continue. However, the essence of the theory, proven by facts, is that high taxes decrease economic growth and lead to adverse effects that are greater than the positive effects of supplying public goods. As taxes become higher, economic distortion increase due to rapid expansion of informal economy and corruption practices. 
Bulgaria has the lowest level of GDP per capita in 2005 from all EU member states, as well as Croatia and Romania. This is the reason why it is so important for politicians in power to initiate a package of tax cuts in 2007 if they want to improve the economy's lagging performance.

The main objective of tax policy is to raise the amount of revenue needed to fund legitimate functions of government while imposing the least harm to the economy. This is the idea of tax-system efficiency. Taking this goal into consideration, a low-rate flat tax is the right approach. It also avoids special preferences and distortions that lead individuals and businesses to make choices based on tax considerations rather than on economic basis. A flat tax also is based on the principle that all taxpayers are equal before the law regardless of how they earn or spend their income, or the level of their income. The system can be both justified from an economic and moral point of view.

Available data and facts also confirm the sound theory that high taxes harm the economy, while lower rates increase the incentives to work, save, invest, and take risks - all at the same time, which leads to economic boost. That is why economies with less corporate tax on average have higher economic growth.

Our proposals  about efficient and sound fiscal policy

* Abatement of personal income tax, corporate tax and the social security burden - 10 per cent flat rate for all direct taxes.

* Elimination of all tax preferences for special groups (such as farmers) or special goods and services (such as law services or gambling). 

* Decrease in the time length of payment of taxes for both legal entities and individuals - by introduction of simpler tax declarations, establishment of working e-government, submission of tax declarations and payment through the internet.

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

* Reform in the pension system from PAYG to capital-based system, capitalisation of the social security and other structural reforms (e.g. in the sphere of education) using the budget surpluses.

Paying taxes (for 2006) in Bulgaria and some new EU member states