Abstract
This Selected Issues paper highlights key policy challenges for accelerating growth on a sustainable basis and reducing external and financial vulnerabilities in the Republic of Croatia. A significant reduction in public expenditure would be needed to simultaneously provide room for cutting taxes, boost growth, and lower the budget deficit to help narrow the current account deficit. The analysis finds that Croatian banks are not necessarily passing on the higher risk of foreign exchange-linked loans to unhedged clients by charging higher interest rates.
III. Economic Effects of Reducing the Size of the Government in Croatia: A Note Based on the IMF’S Global Fiscal Model 1
A. Introduction
1. In Croatia, the government redistributes a larger share of GDP than in peer countries in central and eastern Europe (Figure III.1). This large redistribution is a burden on growth, as the required heavy taxation causes significant distortions between pre-and after-tax returns on factors of production, and thus impedes incentives to work and invest. Moreover, the sizable and generally inflexible expenditure hampers fiscal policy’s ability to manage domestic demand.
General Government Accounts, 2005
(In percent of GDP)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: WEO.General Government Accounts, 2005
(In percent of GDP)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: WEO.General Government Accounts, 2005
(In percent of GDP)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: WEO.2. Recognizing the problem, the authorities aim to reduce the size of the general government budget and its deficit, as envisaged in their 2007 budget law and medium-term fiscal framework.2 Over 2007–2009, the envisaged reduction in revenue and expenditure is 1.7 and 2.1 percentage points of GDP, respectively, thus cutting the deficit by 0.4 percentage points of GDP in an effort to lean against private demand pressures and mitigate the rise in the current account deficit.
3. A mounting body of theoretical and empirical literature suggests that a strategy of lasting fiscal adjustment accompanied by cuts of direct taxes would encourage, under certain conditions, growth in the medium term.3 The adjustment is more likely to be successful if it is based on cuts in the government wage bill and transfers, accompanied by permanent changes in entitlements. Putting public debt on a sustainable path, such an adjustment stimulates growth both by creating fiscal space for cuts in taxes on capital and labor (which improve incentives to invest and work) and by inducing favorable expectations about medium-term tax policy and interest rates. For example, the EU-15 countries underwent significant fiscal consolidation in the 1 990s, reducing their budget deficit by 4.2 percentage points of GDP on average. Though other factors surely affected their economies, the average GDP growth of the EU-15 increased from 1.5 percent in 1992–1997 (before and during fiscal consolidation) to 2.7 percent in 1997–1 999.
4. This note analyzes the likely economic effects of further expenditure-based fiscal consolidation in Croatia as envisaged by the authorities, with the help of the IMF’s Global Fiscal Model. Motivated by the large excess of Croatia’s revenue and expenditure over those of its peers in central and eastern Europe, as well as by the need to significantly reduce the budget deficit for a number of reasons described in the staff report for the 2006 Article IV consultation, the note also analyzes an alternative package, involving deeper expenditure and tax cuts and a lower deficit.
B. Methodology
5. The Global Fiscal Model (GFM) is a general equilibrium dynamic model, which includes consumers, firms, and a government. 4 The optimizing behavior of consumers and firms subject to their budget constraints generates demand for consumption, investment, and labor. The government collects taxes and spends the proceeds to purchase goods and services or transfers part of them back to the consumers. The model contains a number of empirically relevant features that induce real effects of fiscal policy—finite planning horizons, liquidity-constrained as well as forward-looking consumers, and distortionary capital and labor taxation that affect capital accumulation and labor supply. The model is calibrated to match, to the extent possible, Croatia’s projected national account and fiscal data for 2006. Its results should be viewed as indicating the direction of change and possible order of magnitude of the effects spurred by the tax and expenditure cuts rather than their precise quantification.
6. The scenarios run with the model are:
a. A reduction of budget revenue by 1.7 percentage points of GDP and expenditure by 2.1 percentage points of GDP over 2007–2009, split between absorption and transfers as envisaged in the 2007 budget law and Economic and Fiscal Policy Guidelines for the period 2007–2009. These policies set in motion dynamics that lead to a long-run equilibrium in which revenue and expenditure are lower than their 2006 values by 2.5 and 3.1 percentage points of GDP, respectively (Table III.1).5 This scenario is called the “baseline scenario” in the rest of this chapter.
b. A more ambitious expenditure reduction of 4.3 percentage points of GDP over 2007–2012, so that the ratio of expenditure to GDP roughly halves the distance to the average for 10 EU New Member States (Figure III.1). This is accompanied by gradual revenue reduction of 2.5 percent of GDP over the same period, with a view to cut the deficit to 1.5 percent of GDP in 2009 and 1 percent of GDP in 2012. Thereafter, revenue and expenditure continue their gradual decline, reaching a long-run equilibrium around 40 percent of GDP each, broadly in line with the average for Croatia’s peers in central and eastern Europe (Table III.1 and Figure III.1). This scenario is labeled the “ambitious scenario” thereafter.
Budget Revenue, Expenditure, and Balance Under The Two Scenarios
As implied by the model; see footnote 5.
Budget Revenue, Expenditure, and Balance Under The Two Scenarios
| 2006 Est. | 2007 Budget | 2008 | 2009 | 2012 | Long Run 1/ | ||
|---|---|---|---|---|---|---|---|
| Baseline Scenario | |||||||
| Revenue | 45.0 | 44.8 | 44.0 | 43.3 | … | 42.5 | |
| Expenditure | 47.8 | 47.6 | 46.6 | 45.7 | … | 44.7 | |
| Balance | -2.8 | -2.8 | -2.6 | -2.4 | … | -2.2 | |
| Ambitious Scenario | |||||||
| Revenue | 45.0 | 44.8 | 44.3 | 43.8 | 42.5 | 39.8 | |
| Expenditure | 47.8 | 47.6 | 46.3 | 45.3 | 43.5 | 40.2 | |
| Balance | -2.8 | -2.8 | -2.0 | -1.5 | -1.0 | -0.4 | |
As implied by the model; see footnote 5.
Budget Revenue, Expenditure, and Balance Under The Two Scenarios
| 2006 Est. | 2007 Budget | 2008 | 2009 | 2012 | Long Run 1/ | ||
|---|---|---|---|---|---|---|---|
| Baseline Scenario | |||||||
| Revenue | 45.0 | 44.8 | 44.0 | 43.3 | … | 42.5 | |
| Expenditure | 47.8 | 47.6 | 46.6 | 45.7 | … | 44.7 | |
| Balance | -2.8 | -2.8 | -2.6 | -2.4 | … | -2.2 | |
| Ambitious Scenario | |||||||
| Revenue | 45.0 | 44.8 | 44.3 | 43.8 | 42.5 | 39.8 | |
| Expenditure | 47.8 | 47.6 | 46.3 | 45.3 | 43.5 | 40.2 | |
| Balance | -2.8 | -2.8 | -2.0 | -1.5 | -1.0 | -0.4 | |
As implied by the model; see footnote 5.
7. To analyze the responsiveness of the economy to different tax cuts, three potential tax-cutting policies are examined for each of the scenarios outlined above:
A cut in direct income taxes (corporate and personal income taxes);
A cut in social security contributions;
A cut in consumption taxes (VAT is assumed for simplicity).
The tax and expenditure cuts are phased in annually according to the authorities’ and staff’s projections for 2007–2009 and 2007–2012, respectively.6
C. Results
8. The baseline scenario following the authorities’ medium-term framework delivers positive but modest results (Table III.2 and Figures III.2–III.4). In the long run, GDP rises by ¼–2¾ percent relative to the no-change baseline, consumption increases by 2–3 percent, and investment improves by up to 6½ percent. The current account deficit is reduced by ½–1 ½ percentage points of GDP.
Comparison of Long-Run Economic Effects Between the Two Scenarios
(In percent of the initial steady state)
Comparison of Long-Run Economic Effects Between the Two Scenarios
(In percent of the initial steady state)
| Income Taxes | Social Security | VAT | |||||
|---|---|---|---|---|---|---|---|
| baseline | ambitious | baseline | ambitious | baseline | ambitious | ||
| Improvement in: | |||||||
| GDP | 2.8 | 6.0 | 1.1 | 2.3 | 0.3 | 0.6 | |
| Consumption | 3.0 | 7.4 | 3.1 | 7.5 | 2.3 | 5.9 | |
| Investment | 6.6 | 14.7 | 1.2 | 2.6 | 0.4 | 0.9 | |
| Current Account | 1.5 | 4.4 | 0.6 | 2.3 | 0.6 | 2.5 | |
| Real Wage | 3.1 | 6.9 | 4.5 | 12.4 | -0.2 | -0.2 | |
Comparison of Long-Run Economic Effects Between the Two Scenarios
(In percent of the initial steady state)
| Income Taxes | Social Security | VAT | |||||
|---|---|---|---|---|---|---|---|
| baseline | ambitious | baseline | ambitious | baseline | ambitious | ||
| Improvement in: | |||||||
| GDP | 2.8 | 6.0 | 1.1 | 2.3 | 0.3 | 0.6 | |
| Consumption | 3.0 | 7.4 | 3.1 | 7.5 | 2.3 | 5.9 | |
| Investment | 6.6 | 14.7 | 1.2 | 2.6 | 0.4 | 0.9 | |
| Current Account | 1.5 | 4.4 | 0.6 | 2.3 | 0.6 | 2.5 | |
| Real Wage | 3.1 | 6.9 | 4.5 | 12.4 | -0.2 | -0.2 | |
Croatia: Corporate and Personal Income Tax Cuts, Baseline Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.Croatia: Corporate and Personal Income Tax Cuts, Baseline Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.Croatia: Corporate and Personal Income Tax Cuts, Baseline Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.
Croatia: A Cut in Social Security Contributions, Baseline Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.Croatia: A Cut in Social Security Contributions, Baseline Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.Croatia: A Cut in Social Security Contributions, Baseline Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.
Croatia: A VAT Cut, Baseline Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.Croatia: A VAT Cut, Baseline Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.Croatia: A VAT Cut, Baseline Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.9. Turning first to cuts in direct income taxes, both GDP and aggregate consumption are higher by close to 3 percent in the long run relative to the no-change baseline (Figure III.2). This is largely the result of an investment pick-up as the after-tax return on capital improves owing to the cut in the corporate income tax. Moreover, this investment expansion raises the demand for labor as well, and thus lifts the real wage. The cut in the personal income tax contributes to the consumption rise by increasing the consumers’ disposable income; however, its effect on labor supply is minor owing to the latter’s generally low price elasticity. As the cut in government expenditure falls entirely on nontradables, the real exchange rate depreciates and output of tradables increases faster than that of nontradables, leading to an initial improvement in the trade balance; later, the rise in consumption and investment pushes it back. Nevertheless, the current account improves by about 1 ½ percent of GDP, as both the initial trade balance improvement and the falling government debt cause a rise in the economy’s net foreign assets and thus cut its interest rate bill, which more than offsets the gradual and modest subsequent decline in the trade balance.
10. While cutting social security contributions appears to produce more moderate benefits in terms of GDP growth and external adjustment, but a somewhat higher response by the real wage and consumption, the response of output and exports to the social security contribution cuts may be understated (Figure III.3).
Investment now rises only a little, as it benefits solely from the slightly depreciating real exchange rate and the lower labor cost to firms; correspondingly, GDP rises by a modest 1 percent over the long run. The gains in investment and GDP are not as pronounced as in the case of a corporate income tax cut because the elasticity of labor supply to labor tax cuts is small relative to investment’s sensitivity to the after-tax return on capital, a common feature of models of this type. However, as the wedge between the pre-and after-tax cost of labor declines, employers demand more labor, which, given the limited supply response, raises the real wage and consumption by more than in the previous case. The trade balance and current account improvements are moderate, reaching less than half of the gains in the corporate income tax cut case. This is because the more modest real exchange rate depreciation (to which investment in tradables is very sensitive) results in a more modest increase in investment and output of tradables as well.
In the model, output growth is constrained by the limited availability of additional labor to satisfy the strong rise in labor demand reacting to the reduced labor costs. In reality, however, the effective labor supply increase could be significantly stronger than predicted by the model on account of the large available pool of unemployed (12 percent of the labor force by mid-2006), who could be rapidly employed should the costs of labor fall sufficiently. As the model starts from a full-employment equilibrium, it does not capture this likely effect.
By reducing labor costs, a cut in social security contributions also improves the external competitiveness in the economy and thus could be expected to provide a boost to exports. However, model simulations do not fully reflect this effect.
11. Finally, the cut in VAT is disappointing (Figure III.4). Investment hugs the baseline, as the return on capital does not improve directly. Moreover, as the direct cost of labor does not drop either, there is no pick-up in labor demand, and the increase in labor supply (spurred by the higher return on labor in terms of consumption owing to falling prices of goods and services) mostly serves to depress the real wage. GDP stays close to the baseline as well. Consumption still rises, though, as the price reduction stemming from the VAT cut is larger than the decline in the real wage. The trade balance and the current account improve about as much as in the social security contribution cut case.
12. The more ambitious scenario of revenue and expenditure reduction based on staff recommendations shows some notable differences (Table III.2 and Figures III.5–III.7). First, the deeper tax cuts—leaving in the long run twice as much funds with the private sector as under the authorities’ scenario—generally translate into at least double-sized benefits in terms of GDP, consumption, investment and the real wage. Second, the even larger reduction in government expenditure associated with the lower deficit targets provides for correspondingly larger and faster improvements in the trade balance and the current account. Third, these improvements in the external accounts come at the cost of somewhat larger initial drop in the consumption of liquidity-constrained consumers, owing to the larger cuts in budget transfers. The ongoing trend of rapidly rising credit to households would reduce the share of the liquidity-constrained consumers and thus alleviate this effect.
Croatia: Corporate and Personal Income Tax Cuts, Ambitious Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.Croatia: Corporate and Personal Income Tax Cuts, Ambitious Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.Croatia: Corporate and Personal Income Tax Cuts, Ambitious Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.
Croatia: A Cut in Social Security Contributions, Ambitious Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.Croatia: A Cut in Social Security Contributions, Ambitious Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.Croatia: A Cut in Social Security Contributions, Ambitious Scenario
Deviations from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.
Croatia: A VAT Cut, Ambitious Scenario
Deviation from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.Croatia: A VAT Cut, Ambitious Scenario
Deviation from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.Croatia: A VAT Cut, Ambitious Scenario
Deviation from steady state, unless stated otherwise
(In percent or percentage points of GDP, as indicated)
Citation: IMF Staff Country Reports 2007, 082; 10.5089/9781451817454.002.A003
Source: Fund staff simulations.D. Policy Implications and Concluding Remarks
13. The analysis suggests a number of benefits stemming from a strategy of cutting taxes and expenditure while also reducing the deficit. Such a strategy would raise the private benefit of producing and working and thus stimulate investment and labor supply, leading to higher output and consumption. At the same time, it would also mitigate the macroeconomic vulnerabilities in the economy, in particular those stemming from the rising current account deficit.
14. The revenue and expenditure paths in the authorities’ current medium-term fiscal framework imply positive but moderate effects relative to their macroeconomic targets. A more ambitious but still feasible expenditure reduction of about double the envisaged size over five years would provide room for both deeper tax cuts and lower budget deficit. Such a package would at least double the benefits in terms of growth, consumption, and improvement in external accounts, bringing the economy closer to the ambitious macroeconomic objectives envisaged in the government’s Strategic Development Framework 2006–2013.
15. This note finds that a cut in consumption taxes fares the worst in terms of investment, GDP growth, and external accounts improvement.B A revenue-equivalent cut in direct income taxes, especially the corporate income tax, delivers large benefits, while a reduction in social security contributions falls in between (producing, however, the strongest improvement in the real wage and consumption). Two main reasons explain this ranking. First, owing to its easy mobility, capital (investment) is much more sensitive to changes in its after-tax return relative to labor supply. However, in discussions with staff, employers did not see the effective corporate tax burden as particularly high, and it apparently has not been impeding investment (which has been growing strongly since mid-2005).7 Second, consumption tax cuts affect production only indirectly through increasing demand without directly affecting the returns and costs of capital and labor.
16. Cutting social security contribution rates may prove more beneficial than it appears at first sight. The output response to such cuts may be underestimated, as the model does not take into account the additional increase in labor input from a likely decline in the high unemployment rate once labor costs are cut. Moreover, unit labor costs have risen since 2000 relative to a number of competitors in central Europe (Figure 4 of the accompanying staff report). In view of the limited room for exchange rate flexibility, cuts in social security contributions could thus strengthen external competitiveness in addition to stimulating employment. Ongoing pension and health reforms should be among the measures providing the offsetting expenditure reduction to keep the deficit on the targeted path.
17. While the relationship between fiscal policy and growth is far from clear-cut, there is some reason to believe that the analysis above may understate the benefits of fiscal adjustment. To the extent that fiscal consolidation is perceived as credible and lasting—reinforced, for example, by a realistic and transparent medium-term strategy—confidence effects can emerge which, while difficult to capture in the model, can certainly be a plus for investment and other components of growth, even in the short run. To ensure that growth is sustainable, fiscal policy over the medium term needs to safeguard public debt and external sustainability. In this regard, rising public and external debt ratios and large current account deficits have been found to increase a country’s vulnerability to crisis. Thus, the benefits associated with the policy alternatives studied in this paper also include obtaining some insurance against crisis, though the model does not take this into account.
References
Alesina, Alberto, and Roberto Perotti, 1995, “Fiscal Expansion and Adjustments in OECD Countries,” Economic Policy, Vol. 10, No. 21, pp. 205–248.
Alesina, Alberto, and Silvia Ardagna, 1998, “Tales of Fiscal Adjustment,” Economic Policy, Vol. 13, No. 27, pp. 487–545.
Alesina, Alberto, Silvia Ardagna, Roberto Perotti, and Fabio Schiantarelli, 2002, “Fiscal Policy, Profits, and Investment,” American Economic Review, Vol. 92, No. 3, pp. 571–589.
Bertola, Giuseppe, and Allan Drazen, 1993, “Trigger points and budget cuts: explaining the effects of fiscal austerity,” American Economic Review, Vol. 83, No. 1, pp. 11–26.
Botman, Dennis, Douglas Laxton, Dirk Muir, and Andrei Romanov, 2006, “A New-Open-Economy-Macro Model for Fiscal Policy Evaluation,” IMF Working Paper 06/45 (Washington: International Monetary Fund).
Botman, Dennis, and Manmohan Kumar, 2006, “Fundamental Determinants of the Effects of Fiscal Policy,” IMF Working Paper 06/72 (Washington: International Monetary Fund).
Švaljek, Sandra, Alexander Klemm, Nenad Kukić, Danijel Nestić, and Sunčana Slijepčević, 2006, “Effective Tax Burden on Companies in Croatia” (in Croatian), Economic Institute of Zagreb, Zagreb, Croatia. An English-language summary is available at: http://www.eizg.hr/AdminLite/FCKeditor/UserFiles/File/summary-etr.pdf.
Von Hagen, Jurgen, Andrew Hughes Hallett, and Rolf Strauch, 2001, “Budgetary Consolidation in EMU,” CEPR Economic Papers No. 148, March.
Prepared by Nikolay Gueorguiev.
Republic of Croatia, Economic and Fiscal Policy Guidelines for the period 2000–2009, Zagreb, July 2006.
A partial list includes Bertola and Drazen (1993), Alesina et al. (1995, 1998, 2002), and von Hagen (2001).
The model is described in detail in Botman et al. (2006), and Botman and Kumar (2006).
The long-run equilibrium (steady state) fiscal values are determined by the new steady state government debt level, set according to the condition of “smooth transition”, i.e., that no large endogenous revenue jump occurs at the points where policy guidance ceases (2010 and 2013 for each scenario, respectively).
The authorities’ framework does not explicitly envisage tax cuts; thus, the analysis is hypothetical, assuming that the projected revenue decline stems from tax policy changes. Moreover, the authorities’ scenario may soon evolve, as they indicated support for a more ambitious expenditure-led fiscal consolidation, along the lines suggested by staff, in the discussions for the 2006 Article IV consultation.
Švaljek et al. (2006) found that Croatia’s effective corporate income tax burden compares favorably to that of 19 OECD countries, mostly owing to accelerated asset depreciation and untaxed dividends.
