Budget Deficit and Tax Evasion

Running head: RESEARCH PAPER – Why is Moldova the Poorest Country in Europe

Research Paper – Why is Moldova the Poorest Country in Europe:

Ecaterina Curova

John Pankratz

LCC International University

March 8th, 2013

Introduction

“You can take a man out of the Soviet Union but it is much more difficult to take the Soviet Union out of the man….”

Morten Hansen

Moldova, the country which used to be a source of wealth for the Soviet Union, now is considered the poorest country in Europe in terms of GDP (“Europe’s poorest country,” 2009). I found it interesting to investigate the reasons behind it. Therefore, this research paper tries to prove the hypothesis which can answer the question “Why is Moldova the poorest country in Europe?” In order to make the analysis and confirm the hypothesis I will take a closer look at several reasons that lead to the current situation and generate ideas regarding the actions needed for improvement.

There are many elements that influence the development of a country. I tried to mention as many as possible, but the research itself focuses just on the most important ones. Therefore, the key factors analyzed include the taxation system, government spending, unemployment, and net exports.

Background

In order to get a better understanding of the situation I will briefly describe the country from several perspectives before starting to analyze the economic problems.

Moldova is a small country in the Eastern Europe with a population of 3.6 million people. It borders with Romania and the Ukraine. Moldova is situated between Western Europe and CIS both geographically and economically. It has an agriculture-based economy because the country lacks mineral resources. The main production for trade consists of fruits, vegetables, wine and tobacco (“Moldova,” 2012).

Historically, this land has been under different occupations. Starting with the year 1991, after the collapse of the Soviet Union, Moldova gained its independence. However, the country is still linked economically in a big proportion to Russia. Firstly, Russia represents the biggest market for the Moldovan wine and agricultural production. Secondly, it imports energy from Russia. Yet, several disputes created difficulties for economic development. In 2005 there was a conflict regarding the pricing of energy, because Russia wanted to increase it. In early 2006 Russia banned the production of wine and agricultural products (“Moldova,” 2012). In addition, Moldova also trades with CIS countries. Because of its soviet past, creating trade linkages to such countries as Russia and CIS represents an opportunity with fewer risks.

Compared to its neighbors Moldova has a small economy. Therefore it cannot reach economic growth only through domestic sales and it needs to reach other markets. Apart from the agricultural production, Moldova’s trade is limited to construction materials and furniture. Even though there have been some improvements compared to previous years the country’s trade balance remains to be a negative one. Moldova cannot easily access the western markets because it is not able to comply with the required standards. Moreover, the poor infrastructure, chaotic system of visas and permits complicate the trade process. Talking about trade, Moldova has a floating exchange rate, though with the National Bank’s interventions in order to support the MDL. According to the National Bank of Moldova the official exchange rates are: 1 U.S. dollar = 11.7984 Moldovan lei (MDL); 1 EUR = 15.4725 Moldovan Lei (MDL) (National Bank of Moldova, 2012).

The domestic environment also has impediments for the local businesses. Private industries and businesses make decisions in the detriment of governmental regulations as long as it advantages the company. An illustrative example would be the tax evasion. The fiscal policy, tax incentives, and their regulation create a hostile environment for conducting a business. The number of needed permits and procedures for a business to operate is burdensome and it can range from 5 to as many as 31. Also, VAT reimbursement is a slow process which affects the efficiency and competitiveness of exporting companies mainly. Moreover, the customs’ regulations are costly, not transparent and change frequently. Because of conservative lending approach, businesses have limited access to finance (Dimireva, 2010).

It is important to point out that Moldova has good conditions for development, but the results are unsatisfactory. To begin with, it has a favorable geographical position. The country has the ability to collaborate with stable and demanding western markets as well as with growing but risky eastern markets. Secondly, Moldova has good soil, climate and topography, but the agriculture is stagnating. And the last but not the least, it has relatively cheap and skilled labor force. However, low paid jobs and the lack of work opportunities, especially in the rural areas; force a lot of people to emigrate in such countries as Italy, Greece, and Russia (“Moldova,” 2011).

Apart from the economic problems there are several other factors that made it hard for Moldova to progress. One, the country was ruled by a communist government for eight years. Two, for the past three years, Moldova was politically instable since it didn’t have a president (“Moldova,” 2009). Three, the Transnistrian territory wants to gain independence, as a result it doesn’t want to subordinate to the government. One of the most important things is that much of the country’s heavy industry plants are situated there (Cooke, 2003). And the last but not the least, the country is still ruled in a “Soviet-style bureaucracy” which means that there is a lot of corruption and the law can be circumvented (“Chisinau’s Charm Offensive,” 2010).

Despite some progresses, Moldova failed to keep pace with the rest of the Eastern European countries. Even though it is a small country it encounters a lot of problems and difficulties in its development process. I focused on four major factors of economic progress: the taxation system, government spending, unemployment, and net exports in more details.

Budget Deficit

Once the Republic of Moldova has moved from planned economy to free market economy, the state has been fighting with high inflation (7.8% in 2011) (See Appendix 2), high unemployment (7.4% in 2011) and a chronic budget deficit (-3.4% in 2011) (See Appendix 1) (National Bureau of Statistics, 2012).

Budget Deficit is the situation where the government spending exceeds the total tax revenue and thus it has to borrow money from the private sector (“Budget deficit,” 2012).

Nowadays, one of the biggest concerns of the Republic of Moldova is the chronic budget deficit. A budget deficit can reduce savings and investments and in addition shrink the capital stocks. In the long run it can lead to a huge current account deficit and rapid growth of the external debt (78% in 2010) which is a slowdown in economic growth (National Bank of Moldova, 2012).

Tax on Income

Tax Revenue is the obligatory transfers to the government. The Tax Revenue as percentage of GDP has never been very high (~ 15 %) and in addition started to decline since 2007 (See Appendix 3). The main driver for this decline was low gatherings on income taxes (“Moldova Country Report,” 2012).

It seems to be logical that the population with the highest income should contribute the most to the budget revenue. However, 22% of the income to be paid as taxes is quite painful. As a result the biggest proportion of the population that evades paying taxes is the people with the highest income.

Here we can draw a parallel to the Laffer’s Curve. Laffer’s Curve represents the relationship between the potential revenue of the government as a result of the increased tax rate. It states that tax-cuts can generate additional revenue (Dornbusch & Fischer, 6^th ed.). At this moment, the Republic of Moldova is situated on the right side of the Laffer’s Curve where an increase in the tax rate leads to a decrease in the tax revenue as people prefer not to declare their official income (See Appendix 4).

It is well-known that people in the Republic of Moldova evade paying income taxes in a massive way. In an interview with Nicolae Jelemalai, a sole trader – owner of a restaurant, I found out that all his employees sign the paper for a minimal wage of 890.00 lei that is to be taxable; however they get paid around 2000 lei. Mr. Jelemalai claims that he would very much like to be an honest taxpayer, but it would be impossible for him and many other companies to run the business in Moldova (Personal Communication, April 3, 2012).

The biggest tax evaders are privately owned companies. Their share in the market was 61% and they generated 56% of total sales back in 2009. Municipal and state enterprises had a 23% share in the market and only 14% in sales (“Criza in Moldova,” 2007).

Budget Deficit and Tax Evasion

In order to ameliorate the budget deficit in the Republic of Moldova it is crucially necessary to fight against tax evasion. If people pay taxes it would help to stimulate the production. Other policies unfortunately are not very effective in the current situation of the Republic of Moldova.

It is unacceptable for the Republic of Moldova to raise the tax rate because it is already on the right side of the Laffer’s Curve. Firstly, according to the calculations of the State Fiscal Service of the Republic of Moldova a 1 % increase in tax will lead to 2-3% additional tax evasion which will lower the total Tax Revenue. Secondly, if the tax rate goes up it will lower the disposable income. The population will consume less and it will shrink the production and as a result GDP (The State Fiscal Service of the Republic of Moldova, 2012).

One can argue that a reduction in the government spending can improve the budget deficit. Unfortunately, it will be only a short run effect. A decrease in government spending is very difficult to implement from both economic and social point of view. From the social point of view cutting down the salaries for teachers or doctors is not ethical and can bring a lot of discussions and protests. From the economic point of view it will lower the GDP and create even higher unemployment.

Taking credits is also not an option as Moldova has done it on regular basis and the external debt of the country in 2010 was around 78 % of GDP (National Bank of Moldova, 2012). If Moldova continues to borrow, it can lead to default.

Printing money could have been an option if Moldova wouldn’t have overused it previously. The data of the National Bank of Moldova shows that the high – powered money (M0) rose from 4757.5 million MDL in January 2007 to 10627.4 million MDL in February 2012 (National Bank of Moldova, 2012). In addition, printing money will lead to inflation and all of its negative effects.

Date: 2015-12-17; view: 711