1. This statement reports on recent developments and adds to the information contained in the staff report for the 2010 Article IV consultation. It does not change the thrust of the staff appraisal.
2. First quarter preliminary flash GDP estimates surprised on the downside, highlighting the risks of weaker growth prospects for 2010 than what was assumed in staff’s baseline scenario. GDP fell by 2½ percent year-on-year in the first quarter of 2010 vis-à-vis staff’s projected decline of ½ percent. While there is significant uncertainty around these estimates and the demand components driving this decline are not known at this time, the staff now sees greater downside risks to the 2010 growth projection, with associated negative implications for unemployment, fiscal revenues and non-performing loans.
3. The authorities have taken steps to implement reforms in all ten areas envisaged under the Economic Recovery Program (ERP). In particular, the parliament has approved two laws to (i) reduce privileged pensions of selected groups, and (ii) rationalize the hospital network in Zagreb and reduce exemptions from health service copayments. Both laws will be effective from July 1, 2010. The combined annual fiscal savings from these two measures are estimated to be around 0.1 percent of GDP in 2010, and 0.3 percent of GDP per annum over the medium-term. The stock of public enterprise arrears (0.3 percent of GDP in end-April) was reported to have been halved in May, helping alleviate the tight liquidity position of the corporate sector. The government has prepared amendments to the Income Tax Act to reduce the tax burden on labor income and eliminate numerous exemptions, and to the Profit Tax to increase the tax base and reduce evasion. Both proposals have been submitted to the Parliament for approval.1 The government has submitted amendments to the Labor Law to the Parliament with the objective to limit the duration of collective bargaining and eliminate the automatic extension of the collective agreements to entire sectors, and is currently in discussion with the labor unions to prepare further amendments. Non-tax levies were decreased to lessen the tax burden on businesses through amendments in a number of Acts. The authorities also received four bids for three of the shipyards slated for privatization, and are currently considering these offers.
The amendments to the Income Tax Act propose three personal income tax rates, 12 percent (up to HRK 3,600), 25 percent (HRK 3,601-HRK 10,800), and 40 percent (>HRK 10,800), which replace the current four rates: 15 percent (up to HRK 3,600), 25 percent (HRK 3,601 - HRK 5,400), 35 percent (HRK 5,401 - HRK 16,200) and 45 percent (>HRK 16,200). The authorities intend to contain the negative impact of the rate changes on revenue collections through elimination of exemptions. The amendments to the Profit Tax Act include, among other things, elimination of personal expenses as tax deductibles, and expansion of the 20 percent rate to all types of services paid to companies not based in the EU or to companies based in countries where nominal profit tax rate is below 12.5 percent.