In the last week of July the Bulgarian Government announced plans to introduce a flat tax on personal income in 2008.

The Government said the new rate, which will be among the lowest in a region where flat taxes have become popular, will encourage foreign investment and help shrink the country's informal economy. Labour organisations, however, believe the new rate will, in fact, leave poorer sectors of the community with even less disposable income.

The decision to introduce a flat tax on personal income, to be set at 10 per cent, follows the introduction of a flat corporate tax, also set at 10 per cent, put in place at the beginning of 2007. Both measures are designed to attract foreign direct investment in a country where outside capital is crucial in offsetting the current account deficit, which, according to some sources, is expected to reach 18 per cent of GDP this year.

In a statement, Economy and Energy Minister Petar Dimitrov said, "This will undoubtedly encourage foreign capital and bring to our country more jobs and higher incomes". Bulgaria received $5.6 billion in foreign direct investment in 2006 and is expected to receive almost $6.2 billion in 2007.

Across Eastern Europe, former communist economies seem to be benefiting from the implementation of flat taxes. Romania (16 per cent), Slovakia (19 per cent), Latvia (25 per cent) and Lithuania (27 per cent) are all experiencing strong economic growth. On the other side of the continent, the Irish economy is performing well with a flat income tax rate of 12.5 per cent.

The new tax policy will be the lowest in the region and will replace the current three-tier system in which citizens are taxed between 20 and 24 per cent depending on their income. Despite the lower rate, the Government is confident the move will provide more income for the treasury. In changing the tax rate, the Government expects to streamline tax collection and make it more cost efficient. It is hoped that the 10 per cent rate will encourage people involved in the grey economy to declare their income.

Prime Minister Sergei Stanishev said the introduction of the flat tax is expected to generate more money for the country and bring undeclared incomes "to light".

In the two decades since the end of communist rule, a robust informal economy has detracted from government tax revenues. While the exact figure is hard to measure, Labour and Social Policy Minister Emilia Maslarova, said Bulgarians spend 25 per cent more than they officially earn and that "one-fourth to one-third of employees receive a higher salary than they declare."

The situation is improving. Finance Minister Plamen Oresharski recently said to the press "the trend [for informal trade] is a decreasing one."

However, some analysts argue that the flat tax needs to be coupled with stricter rules on tax evasion and greater powers and resources for the tax authorities.

The move has met opposition from labour groups who believe the flat tax will hit the poorer sectors of society hard, especially those earning less than 350-400 leva a month ($245 to $280), about two-thirds of Bulgaria's working population.

According to local media, the Government is planning to abolish a number of tax breaks including the child rebate given to families. However, the Government has said the tax reform is part of a wider programme of reform in the social security system, which began in July with a 10 per cent increase in state pensions and public sector salaries.

The introduction of what is essentially a very un-socialist measure by the ruling Socialist coalition also sheds light on the current political situation.

Krassimir Tahchiev, head of research at Sofia-based First Financial Brokerage House, told Oxford Business Group he believed that "currently in Bulgaria there are no major ideological distinctions between the major parties. With the exception of the ultra-right parties, they all inhabit the centre ground, are pro-business and pro-investment. Each party is keen to claim popular ideas, such as the flat tax, for their own."

Tahchiev played down the scale of the impact of the new tax. He said, "The Government [..] would be better off focusing on cutting the country's high social security burden. In terms of attracting foreign investment, the move is a positive step but while low tax rates are useful, other factors such as the improvement of government services and infrastructure and judicial reforms are far more important in the investor's eyes."

Stanishev said he expected the tax and welfare reforms to pass through Parliament when they are tabled in September. While the flat tax is unlikely to prove the "miracle cure" for the problems of the informal economy and taxation system that the Government seem to present it to be, it is consistent with the current move towards attracting foreign business to the country. If the government can make progress in the fight against corruption then Bulgaria could reap the rewards that the flat tax system has brought to its neighbours.

Matthew Youkee is the new Oxford Business Group editorial manager for Bulgaria.
Youkee, previously OBG editorial manager in Egypt, holds a degree in history from Nottingham University, and speaks fluent Spanish and Portuguese. Earlier he worked in London for Exclusive Analysis, a political risk forecasting company, and was an international observer for this year's Guatemalan elections. He recently spent three years working and travelling in Latin America, where he wrote for The Buenos Aires Herald, Argentina's international daily newspaper, and worked for NGOs in both Rio de Janeiro and Sao Paulo.