Republic of Croatia: Selected Issues and Statistical Appendix
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International Monetary Fund
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Publication Date:
12 Aug 2002
eISBN:
9781451817355
Language:
English
Keywords:
ISCR; CR; Croatia; export; country; expenditure; transition country; expenditure trends of the country; Croatia's revenue structure; EU member countries' average; public debt debt ratio; Structural reforms; Government debt management; deficit dynamics
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This Selected Issues paper and Statistical Appendix examines the revenue and expenditure trends of the Croatia from a cross-country perspective and illustrates the medium-term fiscal outlook under two scenarios: one assumes gradual fiscal adjustment and structural reforms; the other assumes stronger fiscal adjustment and a more aggressive approach to structural reforms. The paper analyzes Croatia’s revenue structure to provide a perspective for the medium-term revenue policy. It also identifies the expenditure items that could be streamlined over the medium term, and presents alternative medium-term fiscal frameworks.

Abstract

This Selected Issues paper and Statistical Appendix examines the revenue and expenditure trends of the Croatia from a cross-country perspective and illustrates the medium-term fiscal outlook under two scenarios: one assumes gradual fiscal adjustment and structural reforms; the other assumes stronger fiscal adjustment and a more aggressive approach to structural reforms. The paper analyzes Croatia’s revenue structure to provide a perspective for the medium-term revenue policy. It also identifies the expenditure items that could be streamlined over the medium term, and presents alternative medium-term fiscal frameworks.

I. medium-term fiscal issues: a cross-country perspective 1

A. Introduction and Overview

1. Fiscal policy represents the main macroeconomic policy instrument in Croatia, as monetary policy aims at realizing price stability through a broadly stable nominal exchange rate against the euro. This chapter discusses the revenue and expenditure trends of the country from a cross-country perspective and illustrates the medium-term fiscal outlook under two scenarios: one assumes gradual fiscal adjustment and structural reforms; the other assumes stronger fiscal adjustment and a more aggressive approach to structural reforms.

2. The overall fiscal picture in recent years does not compare favorably with other Central and Eastern European countries (CEECs), the EU countries, or the Baltic countries (Figure 1). The overall deficit of the general government has been significantly higher than in these three groups. A comparison of the primary balance, which reflects past fiscal trends, provides an even more worrisome picture: the primary balance of other CEECs, the Baltics, and the EU countries is in surplus or close to balance, but Croatia has run a significant deficit for the past five years. Croatia’s general government debt stock is still lower than that of the EU countries on average, but it is considerably higher than in other transition economies. More alarmingly, however, Croatia’s public debt to GDP ratio has risen by about 20 percentage points of GDP over the past five years, while it has gradually declined in the EU countries and other CEECs. The generous extension of public guarantees has contributed to the rising public debt ratio in Croatia.

Figure 1.
Figure 1.

Croatia and Selected Other Countries: General Government Balance, primary Balance, and Public Debt Stock, 1997-2001

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 179; 10.5089/9781451817355.002.A001

Sources: Ministry of Finance and IMF staff estimates1/ Includes Albania, Bulgaria, Czech Rep., Hungary, Poland, Romania. Slovak Rep., and Slovenia.2/ 15 EU member countries’ average weighted by each member’s GDP.3/ 14 EU member countries’ (excluding Luxembourg) average weighted by each member’s GDP.4/ Inclusive of guarantees and arrears.5/ Except for Czech Rep., direct debt only. Debt stock of Czech Rep. includes guarantees. Central government debt for Hungary.6/ Direct debt only.7/ Inclusive of guarantees.

3. The reduction of the fiscal deficit and public debt ratios is the most important policy challenge. In view of the high expenditure ratio, it is prudent to realize fiscal consolidation mainly through expenditure cuts (Figure 2). There would be little room to increase revenues as the country’s tax system already imposes a heavy burden on the economy, compared with other transition economies. Experience in other transition countries also suggests that consolidation tends to be more successful when it is based on expenditure cuts rather than revenue increases.2

Figure 2.
Figure 2.

Croatia and Selected Other Countries: General Government Expenditure and Net Lending, 1997-2001

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 179; 10.5089/9781451817355.002.A001

Sources: Ministry of Finance and IMF staff estimates.1/ Includes Albania, Bulgaria, Czech Rep., Hungary, Poland, Romania, Slovak Rep., and Slovenia.2/ 15 EU member countries’ average weighted by each member’s GDP.

4. This chapter is organized as follows. Section B analyzes Croatia’s revenue structure to provide a perspective for the medium-term revenue policy. Section C identifies the expenditure items that could be streamlined over the medium term. Section D presents alternative medium-term fiscal frameworks, and concluding remarks are provided in Section E.

B. Revenue Policy

5. The total revenue and tax burdens in Croatia are high compared with other CEECs and the Baltic countries. In 2001, the total revenue and grants to GDP ratio was more than 6 percentage points above the average of other CEECs and more than 8 percentage points above the average of the Baltic countries, but it was slightly lower than in the EU countries (Table 1). A similar situation prevails with respect to tax collections (Table 2).

Table 1.

Croatia and Selected Other Countries: Total Revenue and Grants of General Government, 1997-2001

(In percent of GDP)

article image
Sources: Ministry of Finance; OECD; and IMF staff estimates.

The 15 EU member countries’ average, weighted by each member’s GDP.

Table 2.

Croatia and Selected Other Countries: Tax Collections of General Government, 1997-2001

(In percent of GDP)

article image
Sources: Ministry of Finance; OECD; and IMF staff estimates

The 15 EU member countries’ average, weighted by each member’s GDP.

6. Croatia’s tax rates are not out of line with those in other transition countries in the region (Table 3). Croatia’s VAT rate is about the average of those of other CEECs, although it is four percentage points higher than that of the Baltic countries. The statutory top corporate income tax rate and the payroll tax rate are among the lowest in transition economies of the region. The top personal income tax rate is in line with those of other CEECs, although it is higher than those in the Baltic countries. Tax rate comparisons suggest that a limited number of exemptions and tax incentives and the simplicity of the tax system have apparently contributed to the high revenue collections in Croatia. Despite the introduction of various exemptions and tax incentives since late 1999, the revenue-generating capacity of Croatia remains strong among transition economies in the region.3

Table 3.

Croatia and Selected Other Countries: Tax Rates in 2002

(In percent)

article image
Source: Ministry of Finance; PricewaterhouseCoopers, Corporate Taxes 2001-2002, Worldwide Summaries and PwC, Individual Taxes 2001-2002.

7. The proper agenda for tax policy over the medium term is to preserve and develop existing strengths, and to broaden tax bases where possible. Due to political pressures, the parliamentary discussion of legislation to extend the collections of social security contributions to all income tax-payers has been postponed. Thought is being given to replacing standard income tax deductions with itemized deductions in 2003. There are also pressures for providing more generous tax incentives for investment. Experience—including from tax incentives that have been offered in Croatia itself—suggests that such measures have only a limited effect in attracting investments. Instead, success in raising revenue through the broadening of tax bases and better tax administration offers the possibility of competitiveness enhancing tax rate cuts.

C. Scope for Expenditure Reform

8. In view of the relatively heavy tax burden, expenditure reduction should play the dominant role in fiscal adjustment in Croatia. While there are no normative guidelines on the optimal size of government from a positive perspective, Begg and Wyplosz (1999) found that, except for Bulgaria, all transition economies in their sample had oversized governments when controlling for political and economic variables. Tanzi and Schuknecht (1996) study historical trends in public expenditure and improvements in social and economic indicators in industrial countries. They conclude that, as a rule of thumb, total spending could be reduced to about 30 percent of GDP without sacrificing much in terms of social and economic objectives. Croatia’s total spending ratio is well above this level. Endogenous growth theories suggest that some elements of government expenditure, particularly investment in human and physical capital, can play a role in the growth process.4 In empirical work on OECD countries, for example, Kneller et al. (1999) find that “productive” expenditure (education and infrastructure) tends to increase growth, while “non-productive” expenditure (mainly wages and social welfare) has a very limited impact. Reduction of non-productive spending would create savings for productive expenditures and spending necessitated by EU accession (particularly environmental protection) and NATO membership. It would also address the long-term pressure for pension spending resulting from population aging.

9. A further reduction of the wage bill ratio would be advisable. Despite its reduction over the past two years, the wage bill to GDP ratio in Croatia is very high in international comparison (Table 4). Notably, it is about twice as high as that in other CEECs. It is also more than 3 percentage points above that of the Baltic countries. Although the number of employees of the general government declined by about 5 percent over the past five years, the wage bill ratio in 2001 remained at the same level as in 1997. In 2002, the wage bill is expected to decline to 10.6 percent of GDP, close to the EU countries’ average in 2001, mostly due to planned employment cuts in the defense and health sectors. Efforts to reduce government employment should keep up momentum to contain the wage bill in view of the planned easing of the three-year wage freeze in 2003, which was originally planned to continue until 2004. Further decentralization and rationalization of administration, which are currently under consideration, will help to downsize the general government without jeopardizing the quality of public services, if the institutional capacity of local governments is improved as a part of the public sector reform. To mitigate the short-term social impact of employment cuts, well defined and targeted active labor market policies and social safety net measures, such as a retraining program for laid off employees, should be implemented. While wage increases to attract and retain competent staff are necessary over the medium term, greater reliance should be placed on an incentive-based compensation system.5

Table 4.

Croatia and Selected Other Countries: Wages and Salaries of General Govenrment, 1997-2001

(In percent of GDP)

article image
Sources: Ministry of Finance; IMF estimates; and European Commission General Goernment Data (ESA 95).

10. Subsidies and other current transfers leave much to be streamlined. Their ratio to GDP in Croatia is substantially higher than that in the EU countries, the Baltic countries, and other CEECs, except for the Czech Republic, Poland, and Slovenia (Table 5). In 2002, the ratio of subsidies and other current transfers to GDP is expected to decline marginally to 19.7. The social reform package, which was approved by parliament in late 2001, has led to a substantial reduction in social transfers.6 7 However, increases in subsidies to small and medium-sized enterprises and export industries, and new employment subsidies, reflecting the creation of two extrabudgetary funds for employment and growth and for regional development, offset the savings from the social package. In addition, a recently approved amendment of the agriculture law aims at increasing agricultural subsidies to the OECD average level of 1.3 percent of GDP. The authorities intend to review all subsidies with a view to reversing the recent increase in employment and economic subsidies and more than offsetting the increase in agricultural subsidies to be introduced in 2003. All subsidy programs should remain temporary so that companies that cannot operate without subsidies could exit. Although the social package and first pillar pension reform, whose implementation started in 1999, created some relief from pressures on pension spending, further reform and rationalization of the pension system would be necessary to offset the unfavorable demographic dynamics over the medium term, by raising the retirement age, establishing actuarially neutral incentives for retirement, and lowering the frequency and degree of indexation.8 Payments under the small pension law could be discontinued as originally envisaged at the end of 2002.9 Substantial room remains to raise efficiency in the delivery of health services, encourage their rational use, and reduce the cost of sick pay benefits, which remain very generous.

Table 5.

Croatia and Selected Other Countries: Subsidies and Other Current Transfers of General Government, 1997-2001

(In percent of GDP)

article image
Sources: Ministry of Finance; IMF estimates; and European Commission General Government Data (ESA 95).

11. It is crucial to recognize that restraint on spending for wages and subsidies and transfers can be only sustained over the medium term if it is achieved through structural reforms. In addition to civil service reform, it is necessary to increase labor market flexibility to avoid prolonged increases in unemployment as a result of government employment reduction. A substantial reduction in subsidies might create additional unemployment in the short run and increase the cost of the social safety net. The more flexible the labor market is, the less costly the social safety net program is. The prompt approval of the new labor law, whose parliamentary discussion has been postponed until the fall of 2002, should be given high priority. Vigorous cuts in the wage bill and in subsidies and transfers, which are growth inhibiting, would create room for an increase in growth promoting expenditure (education and infrastructure) and the EU (environmental protection) and NATO accession costs over the medium term, as well as reduce the public debt ratio.

D. Medium-Term Fiscal Frameworks

12. Two medium-term fiscal frameworks are presented in this section to assess the fiscal challenges. The first scenario assumes a gradual approach on fiscal adjustment and structural reforms (Table 6). The second is an alternative scenario that assumes more front-loaded fiscal adjustment and a more aggressive approach to privatization and structural reforms (Table 7). Details of the assumptions underlying these scenarios are given in the Appendix.

Table 6.

Croatia and Selected Other Countries: Gradualist Adjustment Scenario

(In percent of GDP)

article image
Table 7.

Croatia and Selected Other Countries: Front-Loaded Adjustment Scenario

(In percent of GDP)

article image

13. The first scenario shows that the debt dynamics on current trends are not sustainable. Fiscal adjustment to reduce the overall deficit to 3.8 percent of GDP and the primary deficit to 1.3 percent of GDP over the medium term from the 2001 levels of 6.6 percent and 4.5 percent, respectively, would not be enough to fully stabilize the public debt ratio. The scenario assumes real GDP growth of 4 percent and an average interest rate of 5 percent, which corresponds to the current average interest paid on the country’s public debt. Under these macro assumptions and deficit dynamics, the public debt ratio (assuming no further increase in public guarantees) temporarily drops to 53 percent of GDP in 2004 due to the assumed realization of privatization receipts, mostly from the oil (INA) and electricity (HEP) companies. However, after financing from privatization receipts has dried up, the debt ratio will start rising again, albeit gradually. To stabilize the public debt ratio over the medium term, the primary deficit should not be larger than 1.25 percent under the baseline assumption on GDP growth.10

14. The alternative scenario, which is presented in the staff report, highlights the importance of front-loaded fiscal adjustment and vigorous structural reforms. The stronger fiscal adjustment would reduce the overall deficit to 3 percent of GDP, which is consistent with the Stability and Growth Pact of the EU, by 2005 and the primary deficit to 0.5 percent by 2006. The debt stock would decline to less than 50 percent of GDP by 2004, to a level lower than the other CEECs’ current average by 2006, and to less than 40 percent by 2009. Allocations to productive expenditures, such as education and infrastructure investment, are assumed to be significantly higher under this scenario than under the first scenario.

15. The sizable fiscal adjustment combined with forceful structural reforms under this scenario would achieve higher growth for output, productivity, and employment. Several recent empirical studies have found that fiscal adjustment could lead to higher economic growth (see Box). Institutional or political economy arguments for strong fiscal adjustment in Croatia are as follows:

Fiscal Adjustment and Economic Growth

While empirical evidence regarding the effects of fiscal consolidation is mixed (see Alesina, et al. (1998) and IMF (2001b)), more recent studies have argued that, in some circumstances, fiscal contraction can increase growth even in the short run. For example, a smaller fiscal deficit can lead to higher growth by reducing large risk premia on interest rates associated with a public debt sustainability problem. This underlines the importance of credible fiscal policy as a precondition for the automatic stabilizers to work (see IMF (2001a)). If the deficit or debt ratio is already high, as in Croatia, an increase in the government deficit in response to an economic downturn may even have an adverse—rather than a stabilizing—effect on output, as confidence effects and increases in interest rates dominate the multiplier effect.

Over time, the effect of fiscal consolidation on economic growth is increasingly determined by non-Keynesian factors and by the way it is achieved. In general, an adjustment through tax increases is more likely to have a persistent contractionary impact (see Leibfritz et al. (1997)). On the contrary, expenditure-driven adjustment can be expansionary over the medium term, depending on which categories of spending are cut. Durable adjustments in the public sector wage bill and subsidies and transfers, which the front-loaded adjustment scenario assumes, are more likely to contribute to sustained growth. Cuts in investment and education spending can have the opposite effect. The front-loaded adjustment scenario assumes significantly higher spending on investment and education over the medium term than the first scenario.

  • First, strong fiscal adjustment would reduce the likelihood of crowding out more productive private sector investment, and help to maintain the low level of interest rates by justifying the continuation of the current relaxed monetary policy.

  • Second, moving toward a balanced budget would improve investors’ perception of the country and would provide the authorities with the flexibility to borrow at low interest rates, if needed to respond to temporary shocks. Such flexibility is particularly important if the monetary authorities stick with a broadly stable nominal exchange rate even over the medium term, possibly in the context of EU accession. Stronger fiscal adjustment and structural reforms would lead to the realization of higher privatization receipts as investors react to the country’s improved prospects.

  • Strong adjustment would help to ensure fiscal sustainability in the long run, considering the demographic pressures related to population aging. Consumers’ and investors’ confidence would be more positively affected by the long-run sustainability than by the short-term Keynesian story as the demographic pressures increase.

E. Conclusion

16. Against the background of international experience, this chapter makes the case for front-loaded fiscal consolidation focused on expenditure cuts in Croatia. Considering the internationally high public debt ratio and excessive spending on wages and subsidies and transfers, there should be room for fiscal adjustment and higher growth to coexist over the medium term. Growth enhancing public spending could be increased through sustained cuts in non-productive spending. It should be noted that such a growth friendly fiscal adjustment over the medium term could be possible only if structural reforms, particularly public administration reform, privatization, rationalization of subsidies and transfers, and labor market reform, receive additional momentum.

APPENDIX Assumptions on the Medium-Term Fiscal Projections

Assumptions on the medium-term fiscal projections are summarized as follows:

Gradual adjustment scenario

  • The deficit will be gradually reduced to 3.8 percent of GDP by 2005.

  • Christmas bonus (Hrk 200 million) will be paid in 2002.

  • Wages will grow at one half of real GDP growth in 2003. After 2004, it will increase at the rate of inflation.

  • Small Law related transfers (Hrk 1,750 million) will continue after 2003.

  • No structural cuts in subsidies. Subsidies and transfers will increase at the rate of inflation.

  • Purchases of goods and nonwage services will grow at the rate of nominal GDP growth. The highway construction program will proceed as planned by the authorities. Other capital spending will grow at the rate of nominal GDP growth.

  • Infrastructure spending (part of capital expenditure) can be discretionarily increased after 2003 within the modest deficit target (5.7 percent of GDP in 2003, 4.5 percent in 2004, 3.8 percent after 2005). Capital spending will be considerably smaller than that in the front-loaded adjustment scenario. Education related spending (part of other purchases of goods and services) can be discretionarily increased after 2006 within the deficit target. Insufficient spending on infrastructure and education will contribute to the modest real GDP growth.

  • All or some part of each of the following companies will be privatized in 2002, 2003, and 2004: Dubrovačka banka, Splitska banka, Riječka banka, PBZ, Croatia banka, the insurance company (CO), the food company (Podravka), HEP, INA, the pipeline (JANAF), and the telecommunications (HT). Total privatization receipts from these companies are assumed at Hrk 2,141 million in 2002, Hrk 1,706 million in 2003, and Hrk 4,459 million in 2004.

  • No privatization is assumed after 2005.

Front-loaded adjustment scenario

  • The deficit will be swiftly reduced to 3 percent of GDP by 2005.

  • In 2002, no Christmas bonus will be paid.

  • The wage bill will be frozen at the 2002 budget level in 2003 and 2004. After 2005, it will increase at the rate of inflation.

  • Small Law related transfers (Hrk 1,750 million) will be eliminated at end-2002.

  • Structural cuts in subsidies in 2003 by Hrk 300 million. After that, subsidies and, transfers will increase at the rate of inflation.

  • Purchases of goods and nonwage services will grow at the rate of inflation. The highway construction program will proceed as planned by the authorities. Other capital spending will grow at the rate of nominal GDP growth.

  • Infrastructure spending (part of capital expenditure) and education related spending (part of purchases of goods and nonwage services) can be discretionarily increased after 2003 within the ambitious deficit target (4.4 percent of GDP in 2003, 3.3 percent in 2004, 3 percent in 2005). Infrastructure and education spending will help to boost real GDP growth, which will gradually rise to 7 percent by 2006.

  • The same sets of companies as in the gradual adjustment scenario will be privatized in 2002, 2003, and 2004. Total privatization receipts from these companies are assumed at Hrk 2,390 million in 2002, Hrk 6,367 million in 2003, and Hrk 2,937 million in 2004.

  • No privatization is assumed after 2005.

references

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1

Prepared by Tetsuya Konuki.

2

See, for example, IMF (2001a).

3

For example, zero rating for bread, milk, books, and prescription drugs was introduced into the VAT in November 1999, and that for organized foreign tourism was introduced in January 2001. Investment incentives in the form of reduced profit tax rates and tax holidays were also introduced in January 2001.

5

Performance based pay is currently being negotiated in the health sector.

6

In October 2001, parliament approved a social reform package, consisting of amendments to eleven laws, aimed at rationalizing the country’s ill-coordinated and overly generous system of social transfers. The package fully or partially harmonized social benefits of privileged groups (e.g., war veterans, members of parliament) with those for the general population regarding pensions, child benefits, disability and health allowances. It also reduced the social benefits of the general population by cutting the amounts and duration of child benefits, making the sick and maternity leave benefits less generous, and increasing the patients’ burden of copayments for drugs.

7

Savings from the social reform package are estimated at 1.4 percent of GDP annually on a permanent basis. A small part of these savings accrues to revenues and expenditures on goods and non-wage services.

8

Starting from January 1, 1999, the statutory retirement age has been raised by six months every half year, to raise it by 2004 from 60 to 65 years for men and from 55 to 60 years for women. Also, a significant reduction in pension benefits applied to early retirement has been introduced. In addition, the calculation period for the pension benefit is gradually being shifted from the most favorable 10 years to the full length of service.

9

For several years after the stabilization program was introduced in October 1993, the budget did not transfer the amounts due the then existing “merit pensions.” The constitutional court ruled this action unconstitutional and mandated the government to compensate the non-payment of these transfers. This is called “Small Law” restitution, in contrast to larger, open-ended restitution payments for past inadequate indexation that have been made since 2001.

10

For each percentage of change in GDP growth, the primary balance needed to stabilize the debt ratio changes by 0.3 percent of GDP.

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Cover IMF Staff Country Reports
Republic of Croatia: Selected Issues and Statistical Appendix
Author:
International Monetary Fund
Volume/Issue:
Volume 2002: Issue 179
Publisher:
International Monetary Fund
ISBN:
9781451817355
ISSN:
1934-7685
Pages:
100
DOI:
https://doi.org/10.5089/9781451817355.002
  • Figure 1.
    View in gallery
    Figure 1.

    Croatia and Selected Other Countries: General Government Balance, primary Balance, and Public Debt Stock, 1997-2001

    (In percent of GDP)

  • Figure 2.
    View in gallery
    Figure 2.

    Croatia and Selected Other Countries: General Government Expenditure and Net Lending, 1997-2001

    (In percent of GDP)

Figure 1.

Croatia and Selected Other Countries: General Government Balance, primary Balance, and Public Debt Stock, 1997-2001

(In percent of GDP)
Figure 2.

Croatia and Selected Other Countries: General Government Expenditure and Net Lending, 1997-2001

(In percent of GDP)