Contractionary Fiscal Policy·macroeconomics

Romania's 2025–26 Fiscal Consolidation: Contractionary Fiscal Policy

Romania raised taxes and froze public wages and pensions to reduce its large budget deficit, weakening aggregate demand in the process.

Romania2025–2026

Economic relevance

Contractionary Fiscal Policy

contractionary fiscal policyfiscal consolidationVATgovernment spendingbudget deficitaggregate demandinflationRomania

Romanian government budget with higher taxes and restrained public spending reducing aggregate demand.

Key figures

Standard VAT rate

21%

Romania increased the standard VAT rate from 19% to 21% in August 2025.

2026 fiscal package

3.4% of GDP

The IMF estimated the combined revenue and expenditure measures at 3.4% of GDP in 2026.

2024 fiscal deficit

8.7% of GDP

IMF cash-basis estimate before the full 2025–26 consolidation package took effect.

Projected 2026 fiscal deficit

5.8% of GDP

The IMF projected the deficit to fall substantially as the consolidation measures took effect.

At a glance

Romania introduced a large fiscal consolidation package in 2025–26 after its budget deficit had risen sharply.
The standard VAT rate increased from 19% to 21% in August 2025, while excise duties and several other taxes also increased.
The government froze public-sector wages and pensions, restraining government expenditure and household income.
The IMF estimated that the package would amount to about 3.4% of GDP in 2026.
The policy is contractionary because higher taxes and restrained spending reduce aggregate demand, although this can also slow economic growth.

Background

Romania entered 2025 with a very large government budget deficit. According to the IMF, the fiscal deficit had reached 8.7% of GDP in 2024 on a cash basis, after large increases in pensions, public-sector wages and government investment.

A budget deficit occurs when government spending exceeds government revenue. Persistently large deficits can increase government debt and borrowing costs.

Contractionary fiscal policy involves increasing taxes, reducing government spending, or both. Higher taxes reduce households' disposable income and consumption, while lower or slower-growing government spending directly reduces aggregate demand.

The Romanian government therefore introduced a fiscal consolidation programme designed to narrow the deficit and improve confidence in the sustainability of public finances.

What happened

Romania introduced several fiscal consolidation measures during 2025 and 2026.

From August 2025, the standard value added tax (VAT) rate increased from 19% to 21%. Reduced VAT rates were also increased, the VAT base was broadened and excise duties rose by 10%. Other measures included higher taxes on dividends, banks and property.

On the spending side, the government froze public-sector wages and pensions. According to the IMF, the full package was worth about 3.4% of GDP in 2026, with around 2.1% of GDP coming from revenue measures and 1.3% from expenditure measures.

The aim was to reduce Romania's large fiscal deficit. The IMF projected the deficit to decline from 8.7% of GDP in 2024 to 5.8% in 2026. The European Commission also described Romania's fiscal stance in 2025 as contractionary.

However, the tax increases also had a short-run effect on prices. The IMF noted that the VAT increase contributed to higher headline inflation in 2025. This means contractionary fiscal policy can reduce demand pressure over time even while an indirect tax increase temporarily raises the price level.

Timeline

Late 2024
Romania adopted an initial consolidation package including a freeze in public-sector wages and pensions for 2025.
June 2025
A new coalition government took office amid pressure to reduce the large fiscal deficit.
August 2025
The standard VAT rate increased from 19% to 21%, reduced VAT rates rose and excise duties were increased.
January 2026
Further measures took effect, including higher dividend and property taxation and continued restraint on public wages and pensions.
2026
The IMF projected the fiscal deficit to fall to about 5.8% of GDP as consolidation continued.

Using this in the exam

Paper 1 Paper 2Part (a) · 10 marksPart (b) · 15 marksData response

Use this case in an answer about contractionary fiscal policy or fiscal consolidation.

Start by explaining that Romania increased taxes and restrained government spending. Higher VAT and other taxes reduce households' real disposable income and consumption, while freezes on public wages and pensions restrain government expenditure and household income. This reduces aggregate demand.

In an AD-AS diagram, show AD shifting to the left. In the short run, this can reduce demand-pull inflation and help narrow an inflationary output gap, but it can also lower real GDP and increase unemployment.

Use the fall in the projected budget deficit to show why the government introduced the policy. The IMF expected the deficit to fall from 8.7% of GDP in 2024 to 5.8% in 2026.

For evaluation, distinguish between the immediate effect of higher VAT on prices and the broader demand effect. VAT can directly raise the price level in the short run, even though weaker aggregate demand may reduce inflationary pressure later.

Syllabus topics

Variations in Economic Activity: Aggregate Demand and Aggregate Supply

Unit 3.2: Variations in Economic Activity: Aggregate Demand and Aggregate Supply

Macroeconomic Objectives

Unit 3.3: Macroeconomic Objectives

Demand Management (Fiscal Policy)

Unit 3.6: Demand Management (Fiscal Policy)

Diagrams to use

Contractionary Policy – Fiscal and Monetary Impact on AD AD–AS Diagram – Short-Run Macroeconomic Equilibrium

Test yourself

Macroeconomic Fundamentals

GDP measurement, inflation, unemployment, AD & AS basics.

Demand- and Supply-Side Policies

Monetary, fiscal, and supply-side strategies for managing the economy.

Questions this example can answer

Explain how contractionary fiscal policy can reduce aggregate demand.
Using a real-world example, evaluate contractionary fiscal policy as a method of reducing a government budget deficit.
Discuss the likely effects of higher taxation and lower government spending on inflation and economic growth.

Evaluation

Arguments in favour

Higher taxes can reduce aggregate demand
Higher VAT and other taxes reduce households' purchasing power and consumption. Lower consumption shifts aggregate demand to the left, which can reduce demand-pull inflationary pressure.
Spending restraint can reduce the fiscal deficit
Freezing public-sector wages and pensions slows government expenditure. Together with higher tax revenue, this can narrow the budget deficit and reduce the amount the government needs to borrow.
Fiscal consolidation can improve confidence
A credible plan to reduce a very large deficit can lower concerns about future government debt and borrowing. This may support investor confidence and reduce the risk of higher government borrowing costs.

Arguments against

Lower aggregate demand can weaken economic growth
Higher taxes and restrained public spending reduce consumption and income. The IMF expected fiscal consolidation to moderate private consumption, limiting real GDP growth in the short run.
VAT increases can temporarily raise inflation
Although contractionary fiscal policy reduces demand pressure, higher indirect taxes directly increase consumer prices. The IMF noted that the August 2025 VAT increase contributed to elevated headline inflation.
Lower-income households may be affected more strongly
VAT is charged on consumption, so households that spend a larger share of their income may face a relatively larger burden. Wage and pension freezes can also reduce real incomes when prices are rising.

Context and assumptions

The size of the effect depends on the fiscal multiplier

If households sharply reduce spending in response to higher taxes and weaker income growth, the fall in aggregate demand will be larger. Strong EU-funded investment can partly offset this effect.

Romania still maintained substantial public investment

The European Commission projected public investment to remain high even while current expenditure was restrained. This means the policy was not simply an across-the-board cut in government spending.

Deficit figures vary by accounting method

The IMF's 8.7% of GDP figure for 2024 is on a cash basis, while EU general-government accounting gives a different figure. Students should keep figures from one source and definition consistent.

Key terms

Contractionary fiscal policy: An increase in taxation, a reduction in government spending, or both, designed to reduce aggregate demand.Taught in Unit 3.6: Demand Management (Fiscal Policy)
Fiscal consolidation: Government measures designed to reduce a budget deficit through higher revenue, lower expenditure, or both.Taught in Unit 3.6: Demand Management (Fiscal Policy)
Aggregate demand: The total spending on domestically produced goods and services in an economy at each price level.Taught in Unit 3.2: Variations in Economic Activity: Aggregate Demand and Aggregate Supply
Budget deficit: A situation where government spending exceeds government revenue over a period of time.
Value added tax (VAT): An indirect tax placed on spending on goods and services.
Fiscal multiplier: The ratio of the final change in national income to the initial change in government spending or taxation.