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risks. However, to the extent that additional rights are established via newly introduced special pension regimes, they risk gradually undoing the achievement of a uniform pension system. This risks breaking the link between accumulated contributions and future pension entitlements, with an adverse impact on the sustainability of the pension system going forward. Table 5: Sustainability indicators Romania European Union Stability/ No-policy- Convergence No-policy- 2014 2014 Convergence change Programme change scenario scenario Programme scenario scenario scenario scenario S2* 1.6 3.9 1.5 1.4 1.7 0.4 of which: Initial budgetary position (IBP) 0.0 2.4 0.0 0.4 0.5 -0.7 Long-term cost of ageing (CoA) 1.6 1.5 1.5 1.0 1.1 1.1 of which: pensions -0.1 0.1 0.1 0.0 0.1 0.1 healthcare 0.8 0.6 0.6 0.8 0.7 0.6 long-term care 0.6 0.6 0.5 0.7 0.7 0.6 others 0.3 0.3 0.3 -0.4 -0.3 -0.2 S1** -1.5 1.1 -2.5 1.4 1.8 0.5 of which: Initial budgetary position (IBP) -0.7 2.1 -0.9 -0.4 -0.3 -1.6 Debt requirement (DR) -1.2 -1.2 -1.8 1.7 1.9 1.8 Long-term cost of ageing (CoA) 0.4 0.3 0.2 0.1 0.3 0.4 S0 (risk for fiscal stress)*** 0.27 : : Fiscal subindex 0.00 : : Financial-competitiveness subindex 0.39 : : Debt as % of GDP (2014) 39.8 88.6 Age-related expenditure as % of GDP (2014) 15.5 25.6 Source: Commission, 2015 Convergence Programme Note: the '2014' scenario depicts the sustainability gap under the assumption that the structural primary balance position remains at the 2014 position according to the Commission 2015 spring forecast; the 'no-policy-change' scenario depicts the sustainability gap under the assumption that the structural primary balance position evolves according to the Commission 2015 spring forecast until 2016. The 'stability programme' scenario depicts the sustainability gap under the assumption that the budgetary plans in the programme are fully implemented over the period covered by the programme. Age-related expenditure as given in the 2015 Ageing Report. * The long-term sustainability gap (S2) indicator shows the immediate and permanent adjustment required to satisfy an inter-temporal budgetary constraint, including the costs of ageing. The S2 indicator has two components: i) the initial budgetary position (IBP) which gives the gap to the debt stabilising primary balance; and ii) the additional adjustment required due to the costs of ageing. The main assumption used in the derivation of S2 is that in an infinite horizon, the growth in the debt ratio is bounded by the interest rate differential (i.e. the difference between the nominal interest and the real growth rates); thereby not necessarily implying that the debt ratio will fall below the EU Treaty 60% debt threshold. The following thresholds for the S2 indicator were used: (i) if the value of S2 is lower than 2, the country is assigned low risk; (ii) if it is between 2 and 6, it is assigned medium risk; and, (iii) if it is greater than 6, it is assigned high risk. ** The medium-term sustainability gap (S1) indicator shows the upfront adjustment effort required, in terms of a steady adjustment in the structural primary balance to be introduced over the five years after the foercast horizon, and then sustained, to bring debt ratios to 60% of GDP in 2030, including financing for any additional expenditure until the target date, arising from an ageing population. The following thresholds were used to assess the scale of the sustainability challenge: (i) if the S1 value is less than zero, the country is assigned low risk; (ii) if a structural adjustment in the primary balance of up to 0.5 p.p. of GDP per year for five years after the last year covered by the spring 2015 forecast (year 2016) is required (indicating an cumulated adjustment of 2.5 pp.), it is assigned medium risk; and, (iii) if it is greater than 2.5 (meaning a structural adjustment of more than 0.5 p.p. of GDP per year is necessary), it is assigned high risk. *** The S0 indicator reflects up to date evidence on the role played by fiscal and financial-competitiveness variables in creating potential fiscal risks. It should be stressed that the methodology for the S0 indicator is fundamentally different from the S1 and S2 indicators. S0 is not a quantification of the required fiscal adjustment effort like the S1 and S2 indicators, but a composite indicator which estimates the extent to which there might be a risk for fiscal stress in the short- term. The critical threshold for the overall S0 indicator is 0.43. For the fiscal and the financial-competitiveness sub-indexes, thresholds are respectively at 0.35 and 0.45. 18 6. FISCAL FRAMEWORK AND QUALITY OF PUBLIC FINANCES8 6.1. Fiscal framework As spelled out in the Country Report9, the fiscal framework in Romania is broadly sound, but lacks effective application. This was confirmed in the first months of 2015 when a number of tax measures with significant budgetary impact were approved outside the regular budget process. Stability and predictability are crucial for a country's economy and a well- functioning fiscal policy. The yearly budget process allows for the joint formulation of revenue and expenditure policies. Hasty and early changes in tax policy put in question the integrity of the budget process and prevent internalising the effects of tax cuts. However, on 14 April, outside of the regular budget process, the VAT cut for food and related services, which has an estimated direct impact of 0.8% of GDP, was enacted as of June 2015 (GEO 6/2015). Similarly, the new draft fiscal code, which includes significant tax cuts over the coming years, was adopted by government on 25 March and sent to the parliament ahead of the budget process. The Convergence Programme is approved by the government. Given that it does not include government policies such as the new draft fiscal code it cannot credibly guide the yearly budget process. The macroeconomic forecast, on which the Convergence Programme is based, is prepared by the Prognosis Commission (Comisia Natională de Prognoză), an institution placed under the authority of the Prime Minister. 6.2. Quality of public finances As emphasised in the Country Report, the tax composition in Romania has been considered relatively growth friendly thanks to the high share of indirect taxation. The tax composition was further improved in October 2014 by the 5 pps. cut in social security contributions to be paid by the employer. However, recent policy decisions like the VAT cut for food and the intention to reduce the standard VAT rate from 24% to 20% of GDP in 2016 and further to 18% in 2018 put this favourable tax composition at risk. The Convergence Programme announces the intention to improve EU funds absorption and to shift capital expenditure away from purely domestic sources towards reimbursable and non- reimbursable sources, such as EU funds. Even against improvements in the absorption of EU funds absorption over the 2013-14, there is a high risk that Romania will not fully absorb the funds available in the 2007-13 programming period. Capital expenditure execution is also highly volatile during the year, which weighs on budget planning. In 2014, around half the annual capital and EU funds related expenditure were executed in the last quarter of the year (calculation based on budget execution in cash terms). Moreover, the country's public investment management suffers from a lack of stronger prioritisation and coordination (see Country Report for more details). The Convergence Programme describes different measures that the tax administration (ANAF) has taken or is planning to improve tax collection and reduce tax evasion. These measures go into the right direction. However, the Convergence Programme also highlights the intention to devolve the large taxpayers unit to regional offices. This unit represents more than 50% of total tax revenue. International good practice suggests that large taxpayers units 8 This section complements the Country Report published on 26 February 2015 and updates it with the information included in the Convergence Programme. 9 http://ec.europa.eu/europe2020/pdf/csr2015/cr2015_romania_en.pdf 19 operate most efficiently as centralised bodies. In order to avoid an adverse impact on tax collection, a thorough assessment of current challenges is warranted before taking a decision. 7. CONCLUSIONS In 2014, Romania achieved a structural balance of 1.0% of GDP, which is in line with the MTO. This implied an improvement of the structural balance of 0.4% of GDP, which is better than the required adjustment towards the MTO. The growth rate of government expenditure, net of discretionary revenue measures, was below the applicable expenditure benchmark rate by 1.2% of GDP, thereby also pointing towards compliance. Therefore, Romania complied with the recommendation the Council addressed to it in July 2014. Romania plans a deterioration of the structural balance of ¼% of GDP in 2015, followed by an adjustment of ¼% of GDP in 2016, when it intends to return to the MTO. Romania further plans to stay at the MTO in 2017 and 2018. The deviation of ¼% of GDP in 2015 is in line with a deviation granted under the balance-of-payments financial assistance programme in the form of an EU funds adjustor to allow for the acceleration of EU funds absorption. However, according to the Commission's 2015 spring forecast, there is a risk of some deviation for 2015. The deviation is small, as the forecast structural deficit of 1.3% of GDP only slightly exceeds the deviation granted under the balance of payments programme. In 2016, there is a risk of a significant deviation based on both the structural balance and expenditure benchmark pillars, as forecast by the Commission. The difference between the Convergence Programme and the spring forecast is to a large extent explained by the fact that the new draft fiscal code, which includes important tax cuts as of January 2016, is not included in the deficit targets underlying the Convergence Programme, despite being already adopted by the government and, with amendments, by the senate. Due to the decision not to include significant fiscal policy intentions, the Convergence Programme does not fully reconcile priorities on the revenue and the expenditure side. 20 ANNEX Table I. Macroeconomic indicators 1997- 2002- 2007- 2012 2013 2014 2015 2016 2001 2006 2011 Core indicators GDP growth rate 0.1 6.3 1.7 0.6 3.4 2.8 2.8 3.3 Output gap 1 -3.9 3.2 2.0 -3.9 -2.1 -1.3 -0.9 -0.3 HICP (annual % change) 68.0 13.1 6.1 3.4 3.2 1.4 0.2 0.9 Domestic demand (annual % change) 2 1.6 9.1 2.3 -0.5 -0.9 2.6 3.0 3.7 3 Unemployment rate (% of labour force) 6.9 7.7 6.5 6.8 7.1 6.8 6.6 6.4 Gross fixed capital formation (% of GDP) 19.9 23.4 30.7 27.5 23.8 22.0 22.1 22.3 Gross national saving (% of GDP) 14.3 17.9 21.3 22.3 23.4 22.5 22.7 22.8 General Government (% of GDP) Net lending (+) or net borrowing (-) -4.0 -1.6 -5.9 -2.9 -2.2 -1.5 -1.6 -3.5 Gross debt 20.3 18.5 22.6 37.3 38.0 39.8 40.1 42.4 Net financial assets 41.1 19.0 -5.1 -18.8 n.a n.a n.a n.a Total revenue 32.7 32.4 33.4 33.5 33.0 33.4 33.1 30.8 Total expenditure 36.7 34.0 39.3 36.4 35.2 34.9 34.7 34.3 of which: Interest 4.1 1.5 1.2 1.7 1.7 1.6 1.6 1.6 Corporations (% of GDP) Net lending (+) or net borrowing (-) -4.2 -1.8 1.0 n.a n.a n.a n.a n.a Net financial assets; non-financial corporations -86.1 -85.2 -111.3 -112.5 n.a n.a n.a n.a Net financial assets; financial corporations -0.2 -1.2 4.2 8.4 n.a n.a n.a n.a Gross capital formation 12.9 18.6 18.3 n.a n.a n.a n.a n.a Gross operating surplus 24.5 25.0 26.9 n.a n.a n.a n.a n.a Households and NPISH (% of GDP) Net lending (+) or net borrowing (-) 3.1 -2.2 -2.3 n.a n.a n.a n.a n.a Net financial assets 35.3 38.4 48.6 45.9 n.a n.a n.a n.a Gross wages and salaries 29.5 31.8 32.3 n.a n.a n.a n.a n.a Net property income 6.9 1.0 0.5 n.a n.a n.a n.a n.a Current transfers received 17.7 16.0 15.7 n.a n.a n.a n.a n.a Gross saving 0.5 -5.4 -3.0 n.a n.a n.a n.a n.a Rest of the world (% of GDP) Net lending (+) or net borrowing (-) -5.2 -5.6 -7.5 -3.3 1.1 1.9 1.6 1.4 Net financial assets 12.7 31.1 66.2 80.2 n.a n.a n.a n.a Net exports of goods and services -6.4 -8.8 -9.1 -5.0 -0.7 0.1 0.0 -0.2 Net primary income from the rest of the world -1.0 -2