Abstract
This paper mainly examines fiscal decentralization, credit-loss recovery, and unemployment in Croatia. The degree of expenditure and revenue decentralization in Croatia appears limited relative to its peers. At about 16 percent of general government spending, subnational government spending in Croatia is modest compared to other southeastern European countries and to the EU-28 average, and particularly low compared to the most decentralized countries in the EU. Croatia's recovery since late 2014 has been moderate. Croatia's recession lasted six years and was thus the longest among the new EU member states. Croatia's structural and cyclical unemployment rates are very high, at about 11.5 percent and 5 percent respectively in 2015.
Reducing Fragmentation and Improving Fiscal Decentralization in Croatia1
A. Fiscal Decentralization in Croatia
1. The degree of expenditure and revenue decentralization in Croatia appears limited relative to peers. At about 16 percent of general government spending, subnational government spending in Croatia is modest compared to other south-eastern European (SEE) countries and to the EU-28 average, and particularly low compared to the most decentralized countries in the EU. A similar conclusion arises from the revenue comparison. Only a limited range of public functions have been fully decentralized in Croatia. Subnational governments are mostly responsible for communal services (housing and communal infrastructure, waste removal, etc.), and other general public services (road maintenance, etc.). Primary education is only decentralized with regard to school maintenance and investments, while wages are provided centrally.
Expenditure and Revenue Decentralization in Selected European Countries, 2014
Citation: IMF Staff Country Reports 2016, 188; 10.5089/9781498321587.002.A001
Sources: Eurostat.Expenditure and Revenue Decentralization in Selected European Countries, 2014
Citation: IMF Staff Country Reports 2016, 188; 10.5089/9781498321587.002.A001
Sources: Eurostat.Expenditure and Revenue Decentralization in Selected European Countries, 2014
Citation: IMF Staff Country Reports 2016, 188; 10.5089/9781498321587.002.A001
Sources: Eurostat.2. However, fragmentation of the subnational government structure is high and fosters inequality. Croatia has a two-tier subnational government structure consisting of counties representing the regional government and municipalities and cities representing the local level of self-government. There are 128 cities, 428 municipalities and 20 counties. The average population of local governments is relatively low and exhibits a wide divergence, with over one half of the local governments having less than 3,000 inhabitants compared to about 800,000 inhabitants in the city of Zagreb. Around 70 percent of the municipalities have a population below 5,000 residents, which limits their capacity. All municipalities and cities are assigned the same spending responsibilities.2 It is, however, difficult to secure a comparable range and quality of public service provision among local governments with low fiscal and administrative capacity. The limited administrative capacity is reflected in the very low absorption of EU funds at the local government level, with about 85 percent of municipalities covering as much as half the Croatian population not being able thus far to absorb any EU funds. There is also significant disparity in the provision of social protection at the local levels. For example, 7 percent of the households in the higher income regions of Zagreb and Split receive social benefits from the local governments, compared to around only 1 percent of households in some region.
3. The fragmented local governance structure gives rise to numerous para-fiscal charges and burdens both business and citizens. It also complicates the business environment by creating policy uncertainty and worsening transparency. It is often unclear how many documents are needed to obtain a license to operate a business or a building permit. It is not uncommon for the regulations and supervisory requirements by the central government, municipalities, city authorities, and the various public agencies to overlap and complicate the business environment.
Number of Subnational Governments and Population, 2014
Citation: IMF Staff Country Reports 2016, 188; 10.5089/9781498321587.002.A001
Sources: Eurostat, and The Council of European Municipalities and Regions (CEMR).Number of Subnational Governments and Population, 2014
Citation: IMF Staff Country Reports 2016, 188; 10.5089/9781498321587.002.A001
Sources: Eurostat, and The Council of European Municipalities and Regions (CEMR).Number of Subnational Governments and Population, 2014
Citation: IMF Staff Country Reports 2016, 188; 10.5089/9781498321587.002.A001
Sources: Eurostat, and The Council of European Municipalities and Regions (CEMR).4. Subnational government spending has been increasingly tilted towards wages and operational costs. More than half of subnational spending in Croatia was directed to operational costs and wages in 2014 despite the fact that the central government is responsible for the salaries of teachers and doctors. Public investment, on the other hand, constitutes less than a quarter of subnational spending. This spending structure has deteriorated over time. The share of wages and operational costs has increased by some 8 percent since 2006 at the expense of public investment. As a result, at about 1 percent of GDP, public investment at the subnational government level in Croatia is low compared to peers.
Composition of Subnational Government Expenditures
Citation: IMF Staff Country Reports 2016, 188; 10.5089/9781498321587.002.A001
Sources: Eurostat.Composition of Subnational Government Expenditures
Citation: IMF Staff Country Reports 2016, 188; 10.5089/9781498321587.002.A001
Sources: Eurostat.Composition of Subnational Government Expenditures
Citation: IMF Staff Country Reports 2016, 188; 10.5089/9781498321587.002.A001
Sources: Eurostat.5. Subnational governments have limited own-revenue sources. Only one third of total subnational government revenue comes from own-revenues. The reliance on central government grants is even higher in smaller municipalities with low capacity. Own revenues are raised from communal fees and from local taxes on motor vehicles, boats and vessels, and gambling machines. About 45 percent of own-revenue is collected from land use, land development fees (including building permits), and other communal fees on businesses. The remaining gap between local governments’ own revenue and their expenditure responsibilities is filled mostly by the sharing agreement on proceeds from personal income tax (and the municipal surcharge) and the real estate transfer taxes collected by the central government. In addition, grants are provided through a complex system of transfers, either through the Equalization Fund or directly from the central budget.
Croatia: Composition of Subnational Revenue
(In percent, 2014)
Citation: IMF Staff Country Reports 2016, 188; 10.5089/9781498321587.002.A001
Source: Eurostat.Croatia: Composition of Subnational Revenue
(In percent, 2014)
Citation: IMF Staff Country Reports 2016, 188; 10.5089/9781498321587.002.A001
Source: Eurostat.Croatia: Composition of Subnational Revenue
(In percent, 2014)
Citation: IMF Staff Country Reports 2016, 188; 10.5089/9781498321587.002.A001
Source: Eurostat.6. Financial linkages with local government-owned utility companies contribute to further fragmentation and raise additional fiscal risks. Local governments own shares in some 200 commercial and utility firms.3 The size of these shares totals about 5 percent of GDP. The financial linkages between the local governments and the local utility companies take different forms. Local governments allocate to utility companies on average about 10 percent of their budgets on subsidies and capital grants. In addition, local governments often borrow through their utility companies (mainly to finance capital projects). Local governments also provide guarantees for utility companies’ loans. While the subnational government debt is low (about 1.2 percent of GDP in 2014), financial linkages with utility companies create additional fiscal risks that is difficult to fully assess because their financial statements are not properly consolidated.
B. Best Practices in Fiscal Decentralization
7. There are general good practices for the design of subnational government structure that should be complemented with country-specific considerations which are related to the historical, geographical, socio-political, and economic factors. There is no “one size-fits-all” model for, or degree of, fiscal decentralization. Fiscal decentralization can improve efficiency of public service delivery through better internalization of the local preference in policy making and the fostering of strong accountability at the local level (Table 1). It is important, however, that subnational jurisdictions are not excessively small, since larger jurisdictions are often able to deliver services more efficiently due to economies of scale.
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8. It is necessary to broadly match the spending responsibilities to the overall resources available at each level of government. In this regard, the first step is to define spending responsibilities for government units, including reviewing and clarifying when there are overlaps, and reforming and reorganizing when the capacity of the local units falls short of their assigned responsibilities. Spending decentralization could potentially improve the quality of service delivery if accountability links between the key players along the delivery chain are strengthened by the decentralization process.
9. Revenue arrangements should conform to the general principle that funds should follow functions. Overall resources made available at the subnational government level should be sufficient to finance their spending responsibilities. Furthermore, revenue assignments should be contingent on the spending functions they are intended to finance and the whole process be transparent and carefully monitored. Subnational governments could gather revenues from different sources: own-resource revenue, shared taxes, transfers from the central government, and borrowing (within specified limits). Finding the right mix of revenue should strike a balance among various policy objectives. On the one hand, encouraging reliance on own revenue could strengthen local accountability and promote local fiscal discipline. On the other hand, excessive tax autonomy may undermine efficiency and widen local disparity.
10. A sound and transparent public financial management (PFM) framework should lend support to successful decentralization. Therefore, strengthening the PFM framework is usually required, particularly at the subnational government level, especially when capacity limitations arise. The following are a few good aspects of such a PFM system:
Accounting framework. The accounting framework should be adequate in capturing the fiscal risks and should preferably be reconcilable with international standards.
Budgeting. The budget envelope for subnational government should be realistic, prepared in a timely matter, and be well-aligned with the budgeting process at the national government level.
Monitoring. Effective audit and control mechanisms should be in place, including timely and regular reporting as well as provisioning for corrective measures in case of misuse of public funds.
11. An adequate institutional environment is essential for a successful fiscal decentralization. Recent empirical work finds that regional autonomy generally leads to efficiency gains in delivering public services such as health and education, while corruption has a negative impact. Therefore, transparency, good governance, and effective anti-corruption measures are important to ensuring successful decentralization. Furthermore, a prerequisite for successful decentralization is that subnational governments possess the administrative and technical capacity required to effectively carry out their assigned responsibilities. Supporting institutions, including democratic representation, sound budget processes, revenue collection capacity, and mechanisms to ensure coordination and cooperation between different levels of government—both at the political and the technical level—are crucial for the functioning of a multi-tier system of government.
C. Improving Fiscal Decentralization in Croatia
12. Croatia’s fiscal decentralization structure lacks an elaborate concept and a regional development strategy. The optimal size of subnational governments needs to be reviewed to take into account the administrative capacity of local governments in the provision of public services to avoid excessive disparities in scope and quality. In the meantime, some form of shared provision of public services should be encouraged (Box 1). This cooperation would help smaller local governments deal with economies of scale and administrative and technical limitations, and thereby reduce the cost of providing public services and improve their quality. By engaging in building shared infrastructure projects, subnational governments would also increase their capacity to utilize access to EU funds.
Alternative ways of providing local public services
In the presence of large economies of scale, there are alternative ways in which local governments can provide public services without relying solely on own capacity and still retaining the benefits of local policy making and accountability:
Contracting with the private sector. A local government may choose to contract with a private provider to produce a certain service, such as garbage collection or the operation of a local market. By doing so, it would be possible to capture the capacity and experience of specialized private sector providers.
Contracting with other local governments or creating special service districts. Another possibility is for a number of small jurisdictions to collaborate on the production of certain public services by creating special service districts. For instance, two or more small local jurisdictions can share water supply services to improve cost-effectiveness. Or small jurisdictions can contract these services directly from a larger neighboring local government.
13. A review of spending responsibilities should be guided by the general principle of reducing regional disparities. It should consider the financial and administrative capacity of local governments, avoid duplication and overlap of functions, and improve transparency and accountability. A clear allocation of spending functions should be made, and a minimum set of financial standards established. The mandatory functions of subnational governments can be formulated based on (i) pre-determined minimum quality standards and (ii) functions that can be assumed depending on the available financial resources and administrative capacity.
14. Subnational governments should gradually increase their reliance on a limited and well-defined number of own-source taxes. Ideally local governments should reduce the number of administrative fees and be funded primarily from taxes. Direct grants from the state budget should be provided mostly for decentralized services based on costs per user. A modern property tax is a good candidate for raising local governments own resources, as it can be levied on a wide tax base with the potential of providing a relatively stable revenue stream. The scope for collaboration with the central government in this area is significant, particularly in the initial steps of transition, which requires a large investment in updating cadastres and land registries and in enhancing administrative capacity.
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Prepared by Ernesto Crivelli and Wei Shi.
With the exception of large cities that have more than 35,000 inhabitants and are thus more capable to perform spending responsibilities otherwise allocated to counties.
Local government-owned companies operate typically in areas such as water supply, drainage, sanitation and spatial development, cemeteries, retail markets and transport.
