Svetla Kostadinova, Senior Economist, Institute for Market Economics

Autumn 2006 is seeing significant changes to the tax system in Bulgaria. The most “radical” change is a reduction of corporate tax rate from its current 15 per cent to 10 per cent in 2007. Bulgaria will enter the EU with the lowest profit tax rate in the union. The estimated effects are:

1. An increase in foreign investments as result of a favourable tax environment
2. An increase in the business activity of local companies
3. An increase in start-up companies
4. Higher economic growth - various forecasts are 5.9 per cent growth of GDP for 2006 and six per cent in 2007
5. An increased stimulus to pay taxes and a decrease in misreporting (meaning a decrease of the informal economy)

The second important change that is being discussed at the moment is a possible cut in personal income tax rates. Currently, they are 20 per cent, 22 per cent and 24 per cent with a minimum threshold of 180 leva (about 92 euro) a month. However, the draft 2007 Budget, just released for public discussion, does not provide for such a change, because of the cautious policy adopted by the Finance Ministry for Bulgaria’s first year as a EU member and the light of its obligations towards the EU budget.

The only certain change is an increase in the minimum tax threshold to 200 leva with effect from 2007.

Irrespective of a lack of changes to personal income tax, Bulgaria will be highly competitive when it joins the EU in 2007 in regard to profit and income taxation (still low by EU average standards).

However, one should consider the total tax burden when comparing Bulgaria and Europe. This, taken together, means profit tax, income tax and social contributions.

Social contributions in Bulgaria - a brief preview

The current Social Security Code enacted in 1999 says that the state social security system is based on the principles of insurance being compulsory and universal, the solidarity and equality of insured people, social dialogue in governing the security system and fund organisation of collected social insurance contributions. Since 1999, the Code has been amended more than 30 times to reflect changes in Government policy. 

As can be seen from the table, the rate is decreasing over the years, but still remains at a high level. We should not forget that in 2004 the state introduced minimum insurance thresholds (differentiated by professions) that increased the insurance base to a certain extent, and increased the overall insurance burden on employees and employers. Of course, there is nothing wrong in the state trying to increase the rate of collection, but the approach should be different - instead of using administrative measures and increased monitoring and administration costs, it should decrease social security rates and by do doing, decrease avoidance and increase collection.

Administrative reform

Until 2005, the National Social Security Institute (NSSI) was the institution in Bulgaria that implemented social security policy. The Institute administered eight out of nine insurance risks: temporarily disability, maternity and family allowances for children, workplace injuries and professionally-related illnesses, invalidity, old age, death and unemployment. The National Health Insurance Fund administered the insurance, in spite of the fact that health insurance contributions were collected and controlled by NSSI.

In 2006, major reform was finally implemented by unifying collection and servicing of central taxes (income tax, patient tax, VAT and corporate tax) and mandatory social security contributions (health insurance, pension, as well as mandatory additional social security contributions).

Apart from this, several reforms widened the insurance base and improved collection:

1. Introducing electronic communication (filing declarations) and paying taxes using an electronic signature;
2. Introduction of compulsory registration of labour contracts;
3. And the introduction of minimum insurance thresholds according to occupation.

One should not forget that employment in Bulgaria is increasing constantly (unemployment fell from 17.3 per cent in 2001 to 10.7 per cent in 2005) which means that more people are working and obliged to pay social contributions.

Core reform

Changes in the security system can be classified in two groups:

- Changes in expenditures (type and size)
- Changes in revenue (rate of social security contributions and proportion to be paid by the employee and employer).

State expenditure on social security in 2006

Bulgaria’s population has been declining for more than 15 years. This has had several effects on the social security system. First, it is leading to an increase in the number of pensioners. Second, the ratio of people paying contributions to number of pensioners is decreasing; at the moment it is 1:2, meaning a heavy burden on the system.

State spending on social security is constantly increasing, and in 2006 are projected to be 6 160.2 mln. leva which is about 33.7 per cent of the state budget. The increase is because of:

1. An increase of the maximum threshold of pensions;
2. An increase of all pensions. This complements the Government’s socially-oriented policy;
3. An increase of maternity leave payment;
4. A increase of unemployment benefits;
5. Actualisation of the minimum insurance threshold.

Overall, there is quite some room for reform on expenditure side, including:

1) State employees should pay their contributions themselves - important and society - a sensitive issue is the current situation in which the state budget pays social security contributions to all state employees. There are already signs that the Government is to consider change and abolish this practice, but the accompanying idea to increase civil servants’ salaries by more than 10 per cent to compensate for the change will negate much of the positive effects.

2) Maternity leave payments should be raised only if the employee had made payments, and the time for receiving such payments should not be prolonged.

3) There should be more comprehensive reform of monitoring of spending. Many people have been abusing the system by using false documents to claim that they are eligible.

4) The logic of the system should be changed radically - the generosity of social payments diverts working-age people from active participation in the labour force. At the same time, a number of low-paid jobs are not being sought by certain groups that find it more convenient to sit back on welfare benefits and |Government support, while making additional cash income on the side, or, even don’t bother working because welfare pays well (as in Germany, other EU countries). New EU member states, with virtually no exception, have adopted market-based solutions to social welfare, working time and mandated benefits. The choice should be between reforming social welfare and resistance to change that could have long-term and far-reaching negative implications.

Revenues for social security system in 2006

The reduction of the rate of social security contribution for the first pillar (PAYG system) in 2006 by six percent from 29 per cent to 23 per cent already leads to increased collection, according to the latest Finance Ministry data. This shows that people are willing to pay regularly if the rate is lower. On the other hand, we should not forget that people would be more inclined to pay if they are certain that they will receive good services in case of events they are insured against. However, this is not the case. The size of pensions is relatively small in comparison to the average salary; unemployment benefits are not enough for a decent living, and the health care system still delivers poor quality services. All these factors lead to opposition to paying social contributions, or at least using real wages as a basis for calculations.

At the moment, discussions on the 2007 Budget are ongoing, and there is talk of a further reduction of the rate of contributions by three per cent, but it is becoming increasingly unlikely that such a decision will be made. The Government is still not sure about what effect a decrease of the rate will have on collection, and will most probably wait for mid-2007 to decide on this. 

No matter whether this changes, estimates are that the expected deficits in the first pillar of the pension system, which is funded on the pay-as-you-go (PAYG) principle, will continue to increase. These deficits will continue to be covered by transfers from the central Government. The problem is that if the Government would not want to threaten overall fiscal sustainability, so there should be additional efforts to evaluate social security reforms’ long term implications in the context of the aging of the population.

The second and the third pillars are both excluded from the general government sector. It is important to note, from a sustainability point of view that all future changes - if any - in social insurance legislation should be supplemented by measures that neutralise or at least minimise their impact on the structural general government balance.
IME proposals for reform

The most radical, but most efficient, is the elimination of a so-called “welfare state”. This includes reforms in pension and health care system to increase the share of capital pillar and the saving rate. Systems based on solidarity should be reduced to provide the minimum of a certain service while the main package should be secured by individual accounts in separate capital funds. Pension system deficits become very important in the case of worsening demographic indicators and require faster actions in this direction. These principles will optimise expenditures, will bring back many of the long-term “customers” of social assistance programs to the labour market and will make possible to grant dignifying assistance for those who really need it.

As for social assistance programs, the following changes are of great importance:

1) Put into practice one of the basic principles set out in the law on social assistance, which is “Receiving of monthly social welfare payments is bounded by expanding socially useful work “.

2) Removal of the possible restoration of the right to social payments after a defined period of time, or if there is such restoration, it should be at least five years after its imposition.

3) Acceleration of the process of transferring the responsibility of social support from central administration to municipalities. Monitoring and control on local level could produce amazing results.

4) Introduction of a maximum period for social payments in one person’s lifespan. Some states in the US have introduced a limit of 60 months in total for social payments in the course of a lifetime. The results were amazing - the claims for assistance dropped 65 per cent and then stabilised at a low level, despite rising unemployment at various times.

Overall, when reforming social security system we think that two basic principles should be pursued:  “For those who work - lower social contributions left to the people to decide where to invest them. For those who can work - assistance from the state only in return for work. Those who receive social assistance - should be regarded as able to work until all possibilities are exhausted”.

Finally, the assessment of the results of the proposed reforms should be made by a comparison with those who are employed. Often, opponents of the proposed system argue that social payments will be less than the current ones. We can only say that social welfare payments should be compared with income of one normal working family but not with those of the past social assistance system. The expected dropping out of false recipients and their inclusion in the labour market will benefit society.