This Selected Issues paper examines social spending reform and fiscal savings in Slovenia. Rising expenditure has been at the root of Slovenia’s fiscal deterioration since the onset of the crisis. The paper explores reform options to reduce Slovenia’s social spending over the medium and long term. It discusses key features of the pension system, and analyzes the evolution of pension spending in the absence of reforms. The paper also examines the health and education spending and provides a framework to assess their efficiency relative to other countries.

Abstract

This Selected Issues paper examines social spending reform and fiscal savings in Slovenia. Rising expenditure has been at the root of Slovenia’s fiscal deterioration since the onset of the crisis. The paper explores reform options to reduce Slovenia’s social spending over the medium and long term. It discusses key features of the pension system, and analyzes the evolution of pension spending in the absence of reforms. The paper also examines the health and education spending and provides a framework to assess their efficiency relative to other countries.

Structural Reforms to Support Slovenia’s Recovery1

A. Introduction

1. Slovenia is slowly emerging from a deep and protracted recession, the worst economic crisis in its history as independent nation. The downturn was triggered by a sudden stop of capital inflows in the wake of the global financial crisis, which forced domestic banks to repay their external funding. The ensuing credit crunch resulted in a steep fall in investment (see chart to the right), as companies lost access to bank funding. While investment is now recovering, it is mainly driven by EU-funded public projects rather than by private-sector initiatives.

A02ufig1

Slovenia: Real GDP and Investment Ratio

(Billion)

Citation: IMF Staff Country Reports 2015, 042; 10.5089/9781484310601.002.A002

2. The strength of the recovery, as well as its long-term growth potential, will thus depend on efforts to reignite and sustain domestic demand and, in particular, private investment. This also requires strengthening the economy’s capacity to put its full labor endowment back to use in the most productive occupations. With no scope for fiscal support given fast-growing public debt and the need to steadily reduce the public deficit, boosting investment and employment can be achieved by implementing structural reforms that raise the economy’s overall efficiency, e.g. by reducing the cost of doing business, improving firms’ capacity to access finance (including in the form of equity and FDI), and underpinning employment creation and human capital accumulation.

3. This paper discusses the scope for structural reforms to reignite investment and jobs in Slovenia. It uses the methodology developed by Tavares (2004) for Portugal and expanded to the EU by Cheptea and Velculescu (2014) to prioritize structural reforms in the case of Slovenia. This involves not just estimating the potential growth impact of bringing Slovenia in line with best practice in the various areas, but also factoring in how this may compare with the efforts required to implement the required reforms. Doing so one can assess the relative “efficiency of reforms”, or bang for the buck, and focus on those reforms with the greatest efficiency.

4. The paper is organized as follows. The next section will offer a short overview of the main channels through which institutions can affect growth in the Slovenian context. Subsequently, the paper will present how Slovenia compares to other EU countries and the world’s best practice across several institutional indicators covering a broad range of areas. Then, a methodology to gauge the reforms’ growth impact and prioritize them will be developed, and its results for Slovenia presented. A final section will conclude with policy recommendations.

B. Channels Through which Institutions Affect Growth

5. Institutions are important for growth. The literature on the importance of institutions for growth is extensive.2 The main insights as to how and why institutions matter can be gained from the definition of institutions given by North (1990). As he puts it, institutions are “the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction.” As such, they include laws, regulations, practices and other features of the economic infrastructure, and can lead to better or worse economic outcomes. In particular, they will lead to higher growth if they reduce transaction costs, uncertainty, waste, or if they incentivize savings and thus investment over consumption. Thus institutions help shape the determinants of growth in the neoclassical theory (see, e.g., Solow (1956) or the endogenous-growth variant in, e.g., Romer (1996) and Romer (2000)), namely saving (with the attendant capital accumulation) and technological growth. The implication is that differences in institutions can help explain why economic performance can differ—sometimes starkly—across countries.

6. There are several channels through which institutions can affect growth. These include the extent to which institutions:

  • Facilitate access to finance for firms, thus enabling them to invest, hire, and grow. Low interest rates needed to facilitate financing require sound macroeconomic policies (e.g., stable low inflation and sustainable public debt).3 But the amount of financing available and its cost also depend on the extent to which the laws and their enforcement through the courts protect investors’ property rights (La Porta et al. (1998), Lombardo and Pagano (2002), Lombardo and Pagano (2005)), thus encouraging them to part with their moneys in the expectation of a risk-adjusted return. In the extreme, a legal system which always favors managers over financiers will result in no funding being made available to managers. A conducive legal system is especially important for equity finance, because equity investors, as residual claimants, face the maximum uncertainty as to the payoff that they can expect to receive from their investment. Other important aspects of a conducive environment for finance have to do with the minimization of uncertainty regarding taxation and the establishment of a credible and level playing field between different investors. In particular, foreign funds will not be forthcoming if the interests of foreign investors are systematically subordinated to those of domestic nationals.

  • Increase economic efficiency and/or reduce the cost of doing business. When the costs of doing business (e.g., applying for licenses and permits, complying with the relevant laws and regulations, etc.) are reduced, investments are incentivized because the hurdle rate that they have to overcome is lower. This is true for all regulations, including those on trade and on product and service markets. A less burdensome regulatory framework also encourages more FDI (World Bank (2012), which in turn brings funding as well as technological advances, thus boosting growth. Countries with pervasive public sector intervention in the economy, over and beyond the provision of essential public services, tend to remain well within the production possibility frontier. This is because public companies might have less incentive to maximize profits and adopt the most efficient cost-minimizing strategies, either because they face soft budget constraints or because they have other objectives in addition to profit maximization.

  • Increase the economy’s capacity to approach full employment. Certain labor market institutions, such as high unionization and centralized wage bargaining, can hinder wage adjustment to evolving economic conditions, and result in higher structural unemployment. More generally, however, the impact of labor market institutions on growth is somewhat ambiguous. For example, strong employment protection legislation can lower equilibrium employment, especially in sectors exposed to greater volatility. But, by giving more security to workers, it may also give them greater incentive to accumulate job-specific human capital, thus raising their productivity.4

  • Encourage innovation, research, development and technological progress. For example, institutions that support the receipt of commercial gains from discoveries, e.g. a strong protection of intellectual property rights and patents, lead to greater investment in research and development, thus boosting the average rate of technological growth, and thus growth. An education system that better adopts its curricula to the evolving needs of the economy is likely to produce generations of graduates with higher average productivity than a less dynamic and flexible one.

C. Slovenia’s Institutions in an International Perspective

7. This section attempts to assess Slovenia’s institutional quality in various areas relative to the best performers in the EU and world-wide. The 116 indicators covered5 span eight main areas: labor market; product and service markets; business regulations; legal system; finance and corporate governance; trade; infrastructure and corruption; and education and R&D.

8. The data indicate that Slovenia lags best performers in both the EU and the overall sample across many indicators in all areas covered (Figure 1). Specifically:

Figure 1.
Figure 1.
Figure 1.

Slovenia: Indicators of Institutional Quality

Citation: IMF Staff Country Reports 2015, 042; 10.5089/9781484310601.002.A002

Notes: For each indicator, “World Best Practice” is defined as the average of the five best performers and is set equal to 100, while the worst performer in the EU27 is set equal to zero. For a description of the indicators and their sources, see Cheptea and Velculescu (2014).
  • In the labor market, burdensome hiring and firing regulations and a relatively weak link of wages to productivity exhibit large gaps to best practice. These indicators, however, do not reflect the impact of the 2013 reform, which, according to a recent study,6 has brought the OECD Employment Protection Legislation index for regular contracts against individual dismissals closer in line with the average in the OECD, although the protection against collective dismissals remains higher than in the OECD average.7

  • In product and service markets Slovenia lags many of its peers mainly as a result of the pervasive involvement of the state in the economy, higher barriers to entry into some professions, and weak anti-monopoly practices.

  • The business environment is also characterized by a high level of red tape and regulations, as attested by lower scores along general indicators (such as regulatory burden and regulatory quality) as well as on more specific ones (such as days to register a property).

  • The legal system is also less business-friendly than that of peers, in particular when it comes to efficiency with which many types of contracts are enforced, as well the impartiality and independence of the courts.

  • In the areas of finance and corporate governance, Slovenia fares worse than EU peers in particular in terms of protection of minority shareholders’ rights and of the restrictions imposed on foreign ownership.

  • Trade regulations (e.g., procedures to import and export, barriers to trade and investment) are also relatively burdensome.

  • The quality of infrastructure (especially railroad) is another dimension in which Slovenia falls short of best performance, including because of the heavier involvement of the government, and the scope that this generates for perceived favoritism and corruption in key decisions.

  • Finally, in terms of innovation, Slovenia has fewer scientists and engineers, obtains fewer patents per capita and spends less in corporate R&D.

9. Figure 2 describes how Slovenia ranks in each dimension relative to its EU-27 peers. Looking at the simple average in each area, Slovenia lags in particular in the areas of finance and corporate governance and in the labor market (in both cases the average rank is 21). The area with the lowest (i.e., better) average rank is that of business regulations (average rank 14).

Figure 2.
Figure 2.
Figure 2.

Slovenia’s Rank in EU27

Citation: IMF Staff Country Reports 2015, 042; 10.5089/9781484310601.002.A002

Note: For a description of the indicators and their sources, see Cheptea and Velculescu (2014).

D. A Methodology for Prioritizing Reforms

10. Given that Slovenia lags peers in many areas, one challenge for policymakers is to find a way to choose and prioritize reforms. This section summarizes a methodology for doing so on the basis of the impact of reforms on growth, also taking into account the cost of reforms and their relative efficiency, following Tavares (2014) and Cheptea and Velculescu (2014).

11. In a first step, the growth effect of reforms is estimated. To do so, we use the results of cross-country regressions of long-run growth against the initial level of GDP (to control for convergence) and the relevant indicator. The effect of a given reform will then be quantified as the product of the estimated regression coefficient Beatai^ and the distance between a country’s starting position and the frontier, as measured by the average of the five EU best performers (along the given dimension) in the sample:

Ri=Betai^*(BestiXi)

12. In a second step, the cost of reforms is quantified. We follow the original approach in Tavares (2004), and assume that cost of reaching the frontier depends positively on how far the frontier is, relative to the starting position (i.e., on the required percent improvement). In formal terms, let’s denote with the cost function C(Xi, Besti) the cost of reaching the frontier (i.e., Besti) for indicator i starting from a level Xi. The cost function is then assumed to be:

C(Xi,Besti)=|XiBestiXi|

13. In a third step, a measure of reform efficiency is developed. Armed with an estimate of the benefit from the reform, i.e. Ri, and the functional form for its cost C(Xi, Besti), we can then estimate the “efficiency” of a given reform by dividing the benefit (the “bang”) by the cost (the “buck”):

Ei=Beta^i(BestiXi)|BestiXi|Xi=|Betai^|.Xi

Note that this measure of efficiency would not change if the particular indicator is rescaled. This is because if the units of measurement of the institutional indicators i are multiplied by a constant K, then the estimated coefficient Betai^ will be divided by the same constant, leaving the measure of efficiency unchanged. This is an important feature for our purposes, since we will be comparing efficiency from reforms captured by indicators which come from different sources and whose units do not have the same scale or a natural interpretation necessarily. 16

E. Results

14. According to our methodology, reforms in a number of areas could help maximize the impact on long-run GDP, with some also being associated with high efficiency (Table 1 and Figure 3):

Table 1.

Slovenia: Impact on Long-run GDP, Required Reform Effort and Efficiency of Reform

article image
article image

*, **, *** indicate significance at the 10 percent, 5 percent, and 1 percent levels, respectively.

  • Labor market: the most promising reform appears to be improving the relations between employers and employees, say by improving collective bargaining processes to facilitate cooperation. Closing the gap with best practice in the EU is estimated to boost long-run GDP by 1.8 percent. This also appears to be relatively more efficient than other labor-market reforms. Three other reforms have estimated impact on long-run GDP of about 1 percent, related to wage formation mechanisms and hiring and firing regulations (the scope for the latter, as discussed above, may have been already partly addressed with the 2013 reform).

  • Product and services markets: strengthening the effectiveness of anti-monopoly policies, say by providing the anti-monopoly institution with more resources and powers, appears to have the largest impact on long-run GDP (1.6 percent) and to also be highly efficient. The estimated growth impacts of the other reforms in this area are generally smaller, with one other reform, namely limiting price controls to industries for which economies of scale may reduce the effectiveness of competition (e.g., power generation), having an impact close to 1 percent.

  • Business regulations: improving the general quality of the regulatory framework and reducing bureaucracy costs by cutting “red tape” could yield the largest estimated impact on long-run GDP (1-1.2 percent). Reforms strengthening business regulations are also associated with high efficiency indices, suggesting relatively low implementation costs.

  • Legal system: a number of reforms in this area are estimated to have significant growth effects. For example, improving the efficiency of the legal framework in settling disputes and challenging regulations, strengthening the impartiality of courts and their independence, and boosting the legal basis of property rights by ensuring that collateral and bankruptcy laws protect the rights of borrowers and lenders, are all associated with estimated impacts on longrun GDP in excess of 2 percent. A further four legal reforms related to the protection of property rights, insolvency processes, legal enforcement of contracts, and integrity of the judicial system, have estimated growth impacts in excess of 1 percent. Strengthening property rights and the integrity of the legal system are also some of the most efficient reforms in this area.

  • Finance and corporate governance: the highest growth impact would stem from reforms enhancing the protection of minority shareholders’ interests, improving access to loans, expanding the availability of venture capital, and increasing foreign ownership. For each of these areas, closing the gap with EU best practice would be associated with a permanent increase in Slovenia’s GDP of about 2 percent. In addition, improving financing through equity markets and strengthening auditing and reporting standards would also bring substantial growth dividends, with the latter being particularly efficient.

  • Trade: reducing the number of documents required to import could boost GDP by about 1.4 percent of GDP. Reducing nontariff trade barriers and the compliance cost of importing and exporting would be associated with a 1.1 percent higher long-run GDP. Reducing the burden of customs procedures and the prevalence of trade barriers appear to be associated with low relative cost and therefore high efficiency.

  • Infrastructure and corruption: reducing favoritism by government officials to well-connected firms and individuals and strengthening the quality infrastructure (in particular for railroads) are associated with long-run GDP impacts in excess of 2 percent. Strengthening infrastructure in other areas also appears important to long-term growth (impact of 1 percent or higher on long-term GDP), while also relatively efficient (while political costs may be low, actual economic costs of strengthening infrastructure may be higher than proxied by the cost function assumed in this paper).

  • Education and R&D: reforms in most areas covered by the indicators included in this paper have estimated long-run GDP impacts in excess of 1 percent. The largest impact (2 percent) is associated with providing adequate incentives to increase company spending on R&D. Improvements in some areas (such as bringing the per-capita number of utility patents in line with EU best practice) are estimated to be rather difficult/costly, while the least cost per point of long-run GDP impact is found to be associated with the prevalence of internet access in schools.

15. Looking across the various areas, reforms improving corporate governance, access to finance, and judicial processes appear most important for growth in Slovenia (see text chart on next page). Together, they represent 10 entries in the top 15 reforms that have the highest long-run GDP impact, estimated—on average—at around 2 percentage points. Strengthening the protection of minority shareholders’ interest tops the chart, and is also in line with the need to expand equity versus debt finance, which is critical to reducing the large corporate debt overhang that was exposed by the crisis. Judicial reforms enhancing the efficiency, predictability, and independence of the courts are also key not only to facilitate access to finance, but also to facilitate corporate restructuring.17 Other areas that are important for growth include reducing the scope for corruption and favoritism by government officials, improving the quality of the railroad infrastructure, increasing spending on R&D, reforming the education system to form more scientists and engineers, and strengthening the cooperation in labor-employer relations.

A02ufig2

15 Highest Long-Run GDP Impacts from Closing Gap with EU

(Percent)

Citation: IMF Staff Country Reports 2015, 042; 10.5089/9781484310601.002.A002

16. Corporate governance and legal reforms, in addition to reforms in other areas, are also among those reforms with most efficient reforms (see text chart below). Looking at the “efficiency” of a given reform, i.e. its benefits in relation to its costs, reforms from a broader set of areas could be prioritized, including corporate governance (i.e., enhancing the strength of auditing and reporting standards), legal system (e.g., strengthening the structure and security of property rights), administrative regulations (reducing the burden associated with custom and business regulations, strengthening anti-monopoly policy), trade (reducing trade barriers), infrastructure (improving port and air infrastructure), education and R&D (expanding internet in schools, improving the quality of research institutions and their cooperation with industry, increasing the number of scientists and engineers) and fight against corruption (clamping down on irregular payments and bribes).

A02ufig3

15 Reforms with Highest Estimated Efficiency

(Percent)

Citation: IMF Staff Country Reports 2015, 042; 10.5089/9781484310601.002.A002

F. Conclusions

17. This paper attempts to estimate the potential impact on long-run GDP of various reforms in the Slovenian context and to develop a framework to prioritize reform efforts.

The main findings are as follows:

  • First, Slovenia can increase economic efficiency and thus activity and growth by closing gaps vis-à-vis the best performers in the EU and worldwide in several areas.

  • Second, the biggest estimated dividend in terms of permanent increase in GDP would stem from reforms addressing the weak corporate governance framework, the low legal and judicial efficiency, the limited access to finance (including by foreign owners). Closing the gap in these areas vis-à-vis best performers in the EU would increase Slovenia’s GDP by some 2-2¾ percent. Going further and aligning these areas with world-wide best practices would be associated with an even greater GDP dividend. Other promising areas include reforms limiting the scope for favoritism in government decisions, improving railroad infrastructure, and enhancing the economy’s capacity to innovate.

  • Third, when resources are limited (including political capital), prioritization of reforms is important. Taking implementation costs into account, a reform strategy that would maximize the growth impact while minimizing the costs could encompass more areas in addition to corporate governance and judicial reforms, to also include reforms to reduce business regulations (red tape), simplify trade and customs procedures, and boost research and development, among others.

18. The corporate governance and judicial reforms identified above are also important to address the large corporate overhang that was exposed by the crisis. The continued deleveraging needs of the corporate sector make for a subdued outlook for investment. As such, reforms that facilitate equity finance directly (such as the availability of venture capital, among the top 15 most efficient reforms) or indirectly through improving governance (by protecting minority shareholder rights or strengthening auditing and reporting standards, which top the charts for growth impact and efficiency, respectively) can be important to strengthen firm viability and their ability to repay debts and reignite investment. Enhancing the efficiency of the courts can also help facilitate equity financing as well as promote debt restructuring.

19. The quantitative results estimating the growth effect of reforms should be interpreted with caution. Individual results are sensitive to assumptions and are only indicative of the relative importance of various reforms for growth. Moreover, they should not be interpreted as independent from each other, so that introducing multiple reforms would lead to an impact equal to the sum of the individual impacts. To obtain such an estimate one would need to run a cross-country growth regression including simultaneously all the relevant indicators. But the small number of observations and the high collinearity of many of these indicators reduce the significance of the estimates.

20. Moreover, reform efficiency results are sensitive to the cost specification. As discussed in Cheptea and Velculescu (2014), results depend on whether the cost function is assumed convex or concave. While the convex function adopted here is intuitive, it also implies that reform efficiency, as defined in this paper, increases with the starting level of the institutional quality, which could be seen as counterintuitive. This is partly due to the assumed linearity of the effect of institutional quality on growth. Assuming diminishing returns to scale to closing the gap with best practice would, for example, result in greater efficiency, all else equal, for reforms in areas where the initial gap is larger. The challenge is that it is difficult to estimate with precision non-linear relationships between long-run growth and institutional variables, including because the cross-country samples are usually small. In addition to generalizing the functional form for the effect of institutional reforms on growth, future research could also consider other functional specifications for the costs of reform, which would possess desirable qualities while still remaining invariant to linear transformations of the institutional indicators.

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1

Prepared by Davide Lombardo. The author would like to thank Delia Velculescu for helpful comments and, especially, Cristina Cheptea for providing the data used for this study.

2

For a discussion and relevant references, see Acemoglu et al. (2004).

3

Structural fiscal reforms are often essential in this respect, but are not covered in this paper. For a discussion of important structural reform needs in Slovenia, see Halikias and Tapsoba (2015).

5

The indicators used here are from a recent study by Cheptea and Velculescu (2014), and were compiled from various sources, such as the OECD (2013 data, as per end-2014 vintage), the World Bank’s Doing Business Report (2014 data as per their 2015 report), the World Economic Forum (2012), etc. (for a description of the indicators and their sources, please see the appendix in Cheptea and Velculescu (2014)). Where possible, the data in Cheptea and Velculescu (2014) have been updated to reflect latest releases.

7

In particular, the 2013 Employment Relationships Act has simplified hiring and firing procedures and lowered redundancy costs (including by shortening notice periods and reducing severance pay). IMAD (2014) discusses the reform in greater detail.

16

Cheptea and Velculescu also consider a “concave” specification for the costs of reform, i.e.: C(Xi, Besti) = ln(|Xi–Besti|+1). However, under this specification, the measure of the efficiency of a reform is given by: Ei(concave)=Betai|BestiXi|ln(|BestiX|+1), which is not invariant to a linear transformation of the indicator i and thus in principle cannot be used to compare across reforms, unless the units in which each indicator is expressed are meaningful enough (Note also that this estimate of efficiency also depends of how far a given country is from the best practice).

17

See Garrido (2015).

Republic of Slovenia: Selected Issues Paper
Author: International Monetary Fund. European Dept.