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Kosovo: Economic, political, and social uncertainties pose challenges to fiscal sustainability

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2001
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Kosovo, a province of Serbia in the Federal Republic of Yugoslavia, is rebuilding from the conflict of March–June 1999 under the provisional authority of the United Nations (UN) Mission in Kosovo (UNMIK). In a recent IMF publication, Kosovo: Macroeconomic Issues and Fiscal Sustainability, Robert Corker (of the IMF’s European I Department), Dawn Rehm (Fiscal Affairs Department), and Kristina Kostial (formerly in the European I Department and now in the African Department) review aspects of this rebuilding. The authors argue that establishing a sound tax base, as well as properly controlled and targeted public spending, is crucial to the sustainability of economic recovery.

Economic and political developments

The conflict set back an economy already in serious decline. Kosovo had not yet started the transition to a market economy; per capita GDP was low even for southeastern Europe; banks were essentially insolvent; and infrastructure was neglected. During hostilities, housing, utilities, and industry suffered extensive damage, and population flight disrupted commerce and created a severe shortage of experienced workers.

Postconflict, the provisional authority is empowered by a UN Security Council resolution to pass regulations that override Yugoslav law; there is no recognized indigenous government, and Kosovo’s political status is in limbo.

Recovery, say the authors, is well under way, spurred by a donor-financed reconstruction boom. But just how much has the economy rallied? Preliminary IMF estimates place the per capita GDP level for 2000 in the $650–$850 range—below the level in other regional postconflict countries (in Albania, per capita GDP is about $1,000; in Bosnia and Herzegovina, it is about $1,100). Income levels exceed GDP, but only because of sizable humanitarian aid and private remittances.

The economic recovery program has several important dimensions other than merely repairing the infrastructure. Foremost, it is essential that basic institutions and regulations be put in place to foster private sector development. The adoption of the deutsche mark and regulations to reestablish a payments system and properly regulated banks were important early steps in this regard. But the public sector also has a vital role to play as provider of essential services, such as health care, education, policing, and a welfare net. Accordingly, the authors stress, a priority for Kosovo is to develop tax and expenditure policies to ensure that public services are comprehensive, efficiently provided, and financed mainly from locally generated resources. However, as long as Kosovo’s political status remains unresolved, medium-term planning exercises are fraught with uncertainty. In particular, the degree of Kosovo’s future economic and political autonomy will have an important bearing on the structure of the tax system and the extent to which public expenditures remain devolved from the rest of the Federal Republic of Yugoslavia. “Recent political change in the Federal Republic of Yugoslavia,” the authors say, “opens up possibilities for moving forward on the issue of Kosovo’s status, but there are as yet no firm clues as to direction.”

Fiscal structure and the 2000 budget

Given Kosovo’s unique circumstances, its fiscal policy is rather rudimentary. The tax system relies mostly on tax collection at the border, and almost all revenues stem from imports; the domestic economy, in contrast, escapes virtually untaxed. On the spending side, the structure of expenditure is not comprehensive, and a large share is financed by donor grants. The initial budgets for the last few months of 1999 and for 2000 focused on essentials, such as reestablishing the provision of basic goods and services, setting up a minimal welfare net, and rehabilitating utilities. It covered only recurrent spending; reconstruction spending was drawn up separately and financed in full by donors.

According to the authors, execution of the recurrent budget has worked remarkably well so far, helped by the establishment (with technical assistance from IMF staff) of the Central Fiscal Agency, which exercises firm control over all aspects of the budget. The large foreign-financed reconstruction program has temporarily raised total government expenditure to a high level, but if capital spending is excluded, expenditure levels in Kosovo are not high by international standards. On–budget recurrent spending amounts to about 14 percent of GDP, against an average of 20–23 percent in the low- and middle-income countries with which Kosovo might reasonably be compared. Most of the difference can be accounted for by the exclusion from the Kosovo budget of defense and debt service. But welfare and social security spending is also low by international standards, primarily because the government makes no payments for public pensions and because social spending has, at least until recently, been augmented by sizable off-budget humanitarian assistance. The wage bill, too, is low, mainly because employment levels are lean and because some functions (for example, military, police, judges) are not fully developed. Spending on health care and education, where employment levels are relatively high, is broadly in line with that in other economies of comparable size.

Path toward sustainability

Kosovo needs to make budget decisions now with a clear view to achieving a sustainable fiscal position. According to the authors, the objective should be to avoid the need for sharp expenditure adjustments in the future, when external financing sources are likely to dry up. Although donor support for reconstruction could continue for several years, donors have stressed that support for recurrent expenditure will decline substantially in the next few years (see box, page 92). In the short term, this will constrain spending options as increases in tax revenue replace declining donor grants. In the longer term, the authors suggest, a fully sustainable fiscal position would require all expenditures—including large off-budget items, such as investment, defense, and debt service—to be financed mainly from local revenues.

The priorities are thus to diversify the tax system and contain expenditure growth through a careful review of spending needs. On tax policy, IMF technical assistance staff have outlined a sequenced plan to improve existing instruments and introduce new ones. The main steps include an immediate strengthening of existing tax collections by raising and refining excise duty rates, reducing exemptions from import and sales taxes, and continuing to improve border administration; introducing a value-added tax (VAT) and wage tax in 2001; and, beyond 2001, taxing profits.

Kosovo: medium-term scenario

million deutsche mark1

Citation: 30, 6; 10.5089/9781451934304.023.A006

1 DM 1 million is approximately $462,900 at current rates.

Data: IMF staff estimates

The key issues for expenditure policy include maintaining a lean public sector; avoiding industrial subsidies; avoiding commitments on public pensions that cannot be honored in the future; and ensuring adequate provision for the rising maintenance cost of public investment under the foreign-financed reconstruction program. At the same time, Kosovo will need to continue building an efficient intergovernmental structure.

The 2001 budget focuses on raising revenue and containing overall expenditure growth. Assuming that tax administration improves and that planned taxes, like the VAT, are introduced, revenue will increase by 40 percent to DM 338 million ($156 million). Meanwhile, expenditures are budgeted to rise by about DM 70 million ($32 million) in 2001 to DM 500 million ($231 million), even assuming that wages are frozen and that employment is reduced to the level originally budgeted for in 2000. Donors have been asked to contribute about DM 160 million ($74 million), or about one-third of recurrent expenditures, rather than the one-half provided in 2000.

The 2001 budget involves considerable uncertainties and risks. For instance, the projections assume that the VAT will be introduced by mid-2001 (which is projected to raise DM 30 million ($14 million) on domestic value-added in 2001) and that the strong performance of border collections will continue. If these projections fail to materialize, spending may have to be constrained if additional donor financing is not forthcoming. Thus, the authors stress, it is particularly important to enforce the intended wage freeze, to reduce employment in some budget sectors, and to contain subsidies to the utilities—a particular drain on scarce budget resources to date.

Beyond 2001: longer-term scenarios

An examination of fiscal sustainability requires looking beyond the near term. As the authors note, this exercise is highly uncertain in the case of Kosovo. Nevertheless, starting from the assumption that Kosovo remains an autonomous economic entity, they construct a medium-term scenario that assumes real GDP growth of 10 percent a year, inflation of 2 percent a year, full implementation of the IMF staff’s tax policy proposals, and the cessation of donor support for the recurrent budget in 2003. It is assumed, however, that more than half of capital spending would continue to be financed by foreign donors.

The assumed strong recovery in GDP and the broadening of tax instruments are projected to permit tax growth to average about 25 percent a year in 2001–06, bringing the revenue-to-GDP ratio close to 15 percent. Even so, the authors stress, the elimination of donor support for the recurrent budget by 2003 would impose tight limits on spending. After 2003, continuing revenue growth would not be offset by declining donor support, implying scope for more rapid expenditure growth. But, the authors caution, the extra room for spending could easily be eaten up by the need to incorporate potentially big ticket items (defense, debt service, and pensions) into the budget (see chart, page 93).

Kosovo’s expenditure constraints would be more severe if the economy were to grow less strongly in the medium term. For example, if real GDP growth were limited to 5 percent a year, there would be no room for an increase in current expenditures in 2001–03 if donors kept to their intention of removing budget support by 2003. The constraints on expenditure would also be tighter if there were delays in introducing new taxes, like the VAT and the wage tax, given that it takes time for revenue from new taxes to build up.

At the same time, some of the spending constraints could potentially be alleviated. First, tax revenues could turn out to be more buoyant in the future and there might also be scope to broaden tax instruments and raise marginal rates. Second, Kosovo will likely have alternative financing sources in the medium term, including domestic borrowing. Finally, donors may be more generous than the scenario assumes.

Conclusions

The UN provisional authorities, the authors note, have made a good start in budget implementation and have taken an important step toward budget sustainability for 2001. However, the small tax base and the expectation of diminishing donor support for recurrent spending imply a very tight constraint on expenditure—especially with pressures to expand the budget’s scope.

Policies to foster economic growth are essential to ensure that constraints on spending are not unbearable. Because growth will hinge on private sector development, an enabling environment is crucial—solutions to property rights problems, establishment and enforcement of modern commercial codes and regulations, and a deeper banking system.

Maintenance of law and order and lessening of ethnic tensions are also essential ingredients. Other important priorities include avoiding delays in diversifying the tax system and exercising caution against introducing spending programs that carry long-term commitments.

Copies of Kosovo: Macroeconomic Issues and Fiscal Sustainability, by Robert Corker, Dawn Rehm, and Kristina Kostial, are available for $18.00 each from IMF Publication Services. See page 98 for ordering information. The text is also available on the IMF’s website (www.imf.org/external/pubs/ft/kosovo/index.htm).

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