Report No. 37321-HR Croatia Restructuring Public Finance to Sustain Growth and Improve Public Services A Public Finance Review February 2008 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank IPPC Integrated pollution prevention and Volatile organic compounds control ISPA Instrument for Structural Policies for Pre- World Trade Organization Accession Country Director: Orsalia Kalantzopoulos, ECCUS Sector Director: Luca Barbone, ECSPE Sector Manager: Bernard Funck, ECSPE 3 ACKNOWLEDGEMENTS This report i s the product o f a collaborative process involving Croatian and other consultants, and staff from the W o r l d Bank. The scope o f the work was developed in consultation with the Croatian Ministry o f Finance, Central State Office for Development Strategy, and staff from the IMF and European Commission in Brussels. A draft report has been shared with and presented to the authorities and the European Commission in June 2007 with comments received in January and June 2008. The team would like to thank Mi. Ante i i g m a n (former State Secretary, Ministry o f Finance), Mr. Zdravko MariC (State Secretary, Ministry o f Finance), Mr. I v o Sutalo (Assistant Director, Central Bureau o f Statistics) and staff at the Ministry o f Finance and other line ministries for their inputs and help at various stages in the preparation o f this report. The responsibility for any data and/or opinion expressed in this paper remains with authors only. The World Bank task team included Sanja-Madzarevic-Sujster (task team leader), Tracey Marie Lane, Velimir Sonje and Matija Laco. Tomislava Ujevic helped with data collection. Dubravka Jerman, Ekaterina Georgieva Stefanova and Mismake Galatis helped edit the report. Background papers for this report were prepared by Ivailo Izvorski, Anton Marcincin, i e l j k o LovrinCeviC, Davor MikuliC (macro and fiscal), Piet Van Heesewijk (public administration), Daniel Dulitzky, Lana AndriEeviC and Danijel NestiC (health), Inguna Dobraja, Lana Andricevic (social spending), Sue Ellen Berryman, Ivan Drabek, Vanja Frajtic, Danijel NestiC, Dina Abu-Ghaida (education), Zoran AnuSiC (pensions), Karin Shepardson, i e l j k a RajkoviC, Tijen Arin, Ani1 Markandya (environment), Agnieszka Grudzinska, Mohamed Essakali, Henry Kerali (transport). Early findings o f the background work were shared with government and non-government officials, including key donor community representatives (UNDP and EC) and the team i s grateful for all their suggestions and feedback received. The report was undertaken under the guidance o f Anand Seth, former Country Director, Cheryl Gray, former Sector Director, and Bernard Funck, Sector Manager. Martina DaliC, former State Secretary for Development Strategy and Coordination o f EU Funds, Athanasios Vamavakidis (former IMF Resident Representative to Croatia), Nikolay Gueorguiev (Senior Economist, IMF), William Dorotinsky (Lead Public Sector Specialist, WB) and U w e Stamm (EU, DGECFIN, Economist for n Croatia) were the peer reviewers o f the report. I addition, the team would like to thank Camille Lampart Nuamah, Nina Amhold, Satu Kahkonen, Hermann V o n Gersdorff, and in particular Ron Hood and Bernard Funck for their comments, advice, and help throughout the course o f this work. CONTENTS EXECUTIVE SUMMARY ............................................................................................................................... 13 PART I : STRATEGIC SETTING ................................................................................................................... 28 1. THE MACROECONOMIC SETTING ................................................................................................. 29 A. MODERATE GROWTH. LOW INFLATION AND EMPLOYMENT .................................................................... 30 B. S m u c m BALANCE FISCAL SUSTAINABILITY .......................................................................... AND 34 C. EXTERNAL VULNERABILITY .................................................................................................................. 38 D. MONETARY Y RESPONSE P LC OI .............................................................................................................. 41 E. CONCLUSIONS ........................................................................................................................................ 42 2 . FISCAL FRAMEWORK ........................................................................................................................ 44 A. FISCALDEVELOPMENTS THE LAST DURING DECADE ............................................................................ 44 B. OPTIMAL SIZE OF GOVERNMENT ........................................................................................................... 47 C. STRUCTURAL REFORMS .......................................................................................................................... 51 D. ECONOMIC COMPOSITION OF GENERAL GOVERNMENTEXPENDITURE .................................................. 53 E. FUNCTIONAL COMPOS~~ION THE GENERAL GOVERNMENT SPENDING .............................................. OF 56 F. REVENUE AND TAX ADMINISTRATION MPLIFICATION SI ........................................................................ 59 G. P B I EXPENDITURE U LC MANAGEMENT ...................................................................................... SYSTEM 64 PART 11: DELIVERING PUBLIC GOODS ................................................................................................... 69 3 . INFRASTRUCTURE .............................................................................................................................. 71 A. BACKGROLTND ........................................................................................................................................ 72 B. RAILWAYS ............................................................................................................................................. 73 EFFECTIVENESS ..................................................... ........................................................................... 73 EFFICIENCY................................ ........................................................... 74 RECOMMENDATIONS ................... ............................................................................ 78 C. ROAD INFRASTRUCTURE ....... ........................................................... 80 EFFECTIVENESS ........................... ........................................................... 80 EFFICIENCY................................................................................................................................................. 81 RECOMMENDATIONS ........................... ................................................................................................. 84 4 . ENVIRONMENT ..................................................................................................................................... 87 A. CURRENTENVIRONMENTALN I I N C DTO S .............................................................................................. O 89 B. GOVERNMENTPLANS............................................................................................................................. 90 C. FINANCING ENVIRONMENTAL SPENDING ............................................................................................... 92 D. ORGANIZATIONAL EFFICIENCY .............................................................................................................. 98 E. RECOMMENDATIONS ............................................................................................................................ 101 5 . EDUCATION ......................................................................................................................................... 103 A. BACKGROUND ...................................................................................................................................... 104 B. EFFECT~VENESS .................................................................................................................................... 105 C. EFFICIENCY.......................................................................................................................................... 107 D. EQUITY ................................................................................................................................................ 114 E. RECOMMENDATIONS ............................................................................................................................ 118 6 . PUBLIC ADMINISTRATION: A HORIZONTAL LINK ................................................................. 121 A. EFFECT~VENESS.................................................................................................................................... 122 B. EFFICIENCY LABOR OF INPUTS ............................................................................................................. 124 C. EFFICENCY OF ORGANIZATIONAL STRUCTURE ................................................................................... 128 D. RECOMMENDATIONS ............................................................................................................................ 129 PART 111: ENSURING SOCIAL SECURITY .............................................................................................. 133 7. HEALTH INSURANCE........................................................................................................................ 135 A. EFFECT~VENESS .................................................................................................................................... 136 B. EFFICIENCY .......................................................................................................................................... 137 C. EQUITY ISSUES I P O I I N OF HEALTH CES ........................................................................... N RVO S SERVI 149 D. RECOMMENDATIONS ............................................................................................................................ 150 8 . PENSION INSURANCE ....................................................................................................................... 153 A. BACKGRO~D ...................................................................................................................................... 154 B. EFFECT~VENESS .................................................................................................................................... 155 C. EFFICIENCY.......................................................................................................................................... 156 D. RECOMMENDATIONS............................................................................................................................ 162 9 . SOCIAL ASSISTANCE ........................................................................................................................ 167 A. EFFECTIVENESS .................................................................................................................................... 168 B. SPENDING EFFICIENCY......................................................................................................................... 171 C. ADMINISTRAT~VE EFFICIENCY ............................................................................................................. 179 D. RECOMMENDATIONS ............................................................................................................................ 180 PART IV: MEDIUM-TERM FRAMEWORK ............................................................................................. 183 10 . MEDIUM-TERM FISCAL FRAMEWORK.................................................................................. 185 A. THEGOVERNMENT’S MEDIUM-TERM FS A PLAN ............................................................................... ICL 185 B. DEFINITIONOF THE PROBLEM .............................................................................................................. 188 C. MID-TERM FISCAL SCENARIO: “BALANCED BUDGET� ......................................................................... 189 D. MID-TERMC L SCENARIO: “BUMPY FS A I ADJUSTMENT� ....................................................................... 192 E. CONCLUSIONS AND SOME GUIDING QUESTIONS .................................................................................... 193 ANNEX A: CONSTRUCTION OF CYCLICALLY ADJUSTED BALANCE .......................................... 194 ANNEX B: CALCULATING THE DEBT-STABILIZING PRIMARY BALANCE ................ 197 ANNEX C: STATISTICAL ANNEX ............................................................................................................. 199 BIBLIOGRAPHY............................................................................................................................................ 207 TABLES Table 1.1: Croatia: Selected Macroeconomic Indicators. 2000-2007 .................................................. 31 Table 1.2: Adjusted Macroeconomic Indicators for Croatia. 2005 ...................................................... 32 Table 1.3: General Government Debt and Interest Payments (% o f GDP) .......................................... 34 Table 1.4: Croatia: Characteristics o f Government Debt. in % ........................................................... 35 Table 1.5: Scenarios for the Debt Stabilizing Balance ........................................................................ 36 Table 1.6: Croatia: Government Debt. Sustainability Analysis and Stress Tests. 2006-201 1 .............37 Table 2.1: Consolidated General Government Expenditure in Selected Countries ............................. 47 Table 2.2: Regression Results .............................................................................................................. 49 Table 2.3: Potential Economic Growth with Respect to Predicted Government Expenditures ........... 51 Table 2.4: Consolidated General Government Expenditures by Economic Classification 2000-2006, % o f GDP ............................................................................................................................................. 54 Table 2.5: Poverty Incidence and Welfare Payments .......................................................................... 55 Table 2.6: Consolidated General Government Expenditures by Functional Classification 1995-2006, % o f GDP ............................................................................................................................................. 57 Table 2.7: Comparative Revenue Ratios, 2000-2006 average (% GDP)� ........................................... 59 Table 2.8: Basic characteristics o f the PIT system .............................................................................. 63 Table 2.9: Effective tax rates in 2004 .................................................................................................. 63 Table 2.10: Characteristics o f SDF ...................................................................................................... 66 Table 2.1 1: Selected Allocations in 2006 and 2007 ............................................................................. 66 Table 3.1 : Traffic Comparison for Selected Railways in Europe in 2006 ........................................... 73 Table 3.2: Key Performance Indicators o f Railways ........................................................................... 74 8 Table 3.3: Productivity and labor costs for selected European railways in 2006 ................................ 75 Table 3.4: Projected Public Finance Needs. HRK millions ................................................................. 77 Table 3.5 Spending on Road Infrastructure 200 1-2008, HRK million“ .............................................. 82 Table 4.1 : Public Investment Needs and Medium-TermBudget Allocations (e million) ...................90 Table 4.2: Planned Investments for County and Regional Waste Management Centers..................... 91 Table 4.3: Croatia Environmental Budget Spending (million euro) .................................................... 93 Table 4.4: Transitional Arrangements for Bulgaria and Romania Post Entry Date o f 2007 ...............95 Table 4.5: Environment Staffing Inflows ............................................................................................ 99 Table 5.1 : Wage Returns to Different Levels o f Education............................................................... 106 Table 5.2: Distribution o f Public Expenditures on Education by Level o f Education, 2002 (%) ...... 108 Table 5.3. Expenditure Shares by Type o f Educational Service and Year ........................................ 108 Table 5.4: Education Spending, as % o f GDP per capita, 2002 ......................................................... 109 Table 5.5: Ratio o f Per Capita Recurrent Expenditures Relative to Primary Education ...................110 Table 5.6: Economic Allocations o f Education Expenditures ........................................................... 111 Table 5.7: Comparative Student-Teacher Ratios ............................................................................... 111 Table 5.8: Annual Compulsory Instructional Hours’ ......................................................................... 114 Table 5.9: Effects o f Gender and on Net Enrollment Rates (2002-04) .............................................. 116 Table 5.10: Distribution o f Scholarships by Household Consumption Quintile (2002-04) ............... 117 Table 5.1 1: Household Expenditures on Education by Consumption Quintiles, 2004 ...................... 117 Table 5.12: Household Expenditures On Education By Region And Location, 2004 ....................... 118 Table 6.1: Governance Indicators: Croatia’s percentile rank in % o f respective EU15 and EU8 levels (2007) ................................................................................................................................................. 122 Table 6.2: Selected Doing Business Indicators, 2007 ........................................................................ 123 Table 6.3: Personnel Cost: Key indicators o f comparison for Croatia vs . other countries, 2005 ...... 124 Table 6.4: Public Sector Employment, 2000-2005 ............................................................................ 125 Table 6.5: Average Wages in Local and Central Government, 2005 ................................................ 127 Table 7.1: Standardized Death Rates, All Ages (per 100,000), 2006 ................................................ 137 Table 7.2: Total Health Spending per Capita, Selected Countries ..................................................... 138 Table 7.3: Spending on Health, % o f GDP, 1999-2008 ..................................................................... 138 Table 7.4: HZZO Expenditures - Basic Health Insurance................................................................. 141 Table 7.5: Co-payment Structure, 2007 ............................................................................................. 143 Table 7.6: Health Sector Institutions by Type and Ownership .......................................................... 145 Table 7.7: Number o f Visits to Health Specialist and Average Cost, 2002-2007 .............................. 147 Table 7.8: Distribution o f Relative Household Expenditure on Health ............................................. 149 Table 7.9: Household Expenditures on Health by Age, 2004 ............................................................ 149 Table 7.10: Household Expenditures on Health by Region and Location, 2004 ............................... 150 Table 8.1: Pension System Indicators for Croatia .............................................................................. 154 Table 8.2: Overall Pension Expenditures to GDP, EU vs . Croatia, 2005 .......................................... 156 Table 8.3 : Pension Contribution Rates in European Countries .......................................................... 159 Table 8.4: Mandatory Pension Funds’ N e t Assets and Members (December 2007) ......................... 159 Table 9.1 : Income Inequality ............................................................................................................. 170 Table 9.2: U s e o f allowances in 2004 ................................................................................................ 171 Table 9.3: Main Non-Contributory Social Spending Programs, 2003-2008, % o f GDP ...................171 Table 9.4: Main State Social Assistance Programs, 2004 - 2006, million HRK, % o f GDP ............173 Table 9.5: Guaranteed MinimumIncome Programs, Beneficiaries, % o f population ....................... 174 Table 9.6: Guaranteed minimum income programs in new EU member countries, Percent o f GDP 174 Table 9.7: Long Term Duration o f Social Assistance Benefits, Percentage o f Total Beneficiaries .. 175 Table 9.8: Expenditures on main non-contributory budget financed family programs (HRK) ......... 176 Table 9.9: Spending on Child Benefits, % o f GDP ........................................................................... 176 Table 9.10: Child Benefit Levels for War Veteran’s and Non-Veteran’s Families (HRK), 2007 ..... 177 Table 9.1 1: Main Characteristics o f other Family Programs ............................................................. 178 9 Table 10.1: Croatian Government’s Fiscal Scenario 2008.2010. % o f GDP .................................... 186 Table 10.2: “Balanced Budget� Scenario .......................................................................................... 191 Table 10.3: “Bumpy Adjustment� Scenario ...................................................................................... 193 FIGURES Figure 1.1: Contribution to Growth ..................................................................................................... 30 Figure 1.2:Cross-Country Macro Comparison. 2007 ........................................................................... 30 Figure 1.3: CGG Balance, % o f GDP .................................................................................................. 33 Figure 1.4:General Government Balance Comparison, % o f GDP...................................................... 33 Figure 1.5: Consolidated General Government Debt and Guarantees, % o f GDP .............................. 33 Figure 1.6: Fiscal stance from 1994 to 2010 ........................................................................................ 35 Figure 1.7: Evolution o f Croatia’s External Vulnerability, 2000-2007 ............................................... 39 Figure 1.8: U L C in Industry................................................................................................................. 42 Figure 2.1: Deviation o f Actual Government Size from Predicted...................................................... 49 Figure 2.2: Actual vs . Predicted Level o f General Government .......................................................... 49 Figure 2.3: Financial Sector Structure, Assets Distribution in 2007 .................................................... 51 Figure 2.4: Private Sector Share in GDP, 2007 ................................................................................... 52 Figure 2.5: Progress with Structural Reforms ...................................................................................... 52 Figure 2.6: State Aid Structure, 2001-2006 ......................................................................................... 56 Figure 2.7: Tax Rates in 2006 .............................................................................................................. 59 Figure 2.8: Revenue Ratios (%GDP) ................................................................................................... 60 Figure 2.9: PEMS Benchmarking Aggregate fiscal discipline ............................................................ 65 Figure 2.10: Prioritization o f Expenditure Composition...................................................................... 65 Figure 2.1 1: Strategy Change Cycle .................................................................................................... 67 Figure 3.1: Trends in Road and Railway Transport (2001=100) ......................................................... 72 Figure 3.2: Education Profile o f Railways’ Workers, 2005 ................................................................. 75 Figure 3.3: State budget support per rail traffic unit (TU), in USD..................................................... 76 Figure 3.4: State Budget Support to Railways, 2001-2007 .................................................................. 76 Figure 3.5: Structure o f Budget Support to the Railways, 2006 .......................................................... 76 Figure 3.6: Age Profile o f HZ Staff, 2005 ........................................................................................... 77 Figure 3.7: HZ Staffby Years o f Service, 2005 .................................................................................. 77 Figure 3.8: Condition o f National Road Network (2006) .................................................................... 80 Figure 3.9: Public Spending on Road Infrastructure, average 2001-2004, % o f GDP ........................ 81 Figure 3.10: Ratio o f Projected HAC’S Fuel L e v y Revenues to Projected Debt Service, 2006-201 1. 82 Figure 4.1 : Environment in Perspective, 2004 ..................................................................................... 89 Figure 4.2: Public Financing for Waste Management ......................................................................... 91 Figure 4.3: Comparison with New Member States .............................................................................. 92 Figure 4.4: Total Environment Expenditure, as % o f GDP ................................................................. 94 Figure 4.5: Private Environment Expenditure, as % o f total ............................................................... 94 Figure 4.6: Environmental Taxes, % o f Government Revenues.......................................................... 97 Figure 4.7: Institutions with Environment Competence ...................................................................... 99 Figure 5.1: Projected Trends in Sizes o f Preschool and School-Age Cohorts ( 2005-30) ................. 105 Figure 5.2: Public Sector Spending on Education, % o f GDP ........................................................... 107 Figure 5.3: Trends in total public education expenditures (1992-2007) ............................................ 107 Figure 5.4: Distribution o f Funding Sources for Public Expenditures in Education (2000-06) ........ 109 Figure 5.5: Trends in Student-Teacher Ratios, 1990-2006 ................................................................ 111 Figure 5.6: Average Monthly Net Compensation .............................................................................. 112 Figure 5.7: Lorenz Curve for Total Expenditures and Concentration Curve for Education Expenditures ...................................................................................................................................... 118 Figure 6.1 : Governance Indicators ..................................................................................................... 122 Figure 6.2: Spending on Wages and Salaries, % o f GDP .................................................................. 124 10 Figure 6.3: Comparison o f Civil Service and Private Sector Pay Levels .......................................... 126 Figure 6.4: Spread o f Wage Increases 2004-2005 By Central Government Ministries And Agencies ........................................................................................................................................................... 127 Figure 7.1: Health Spending to GDP (%) vs . GDP at PPS ................................................................ 135 Figure 7.2: Disability adjusted l i f e expectancy (DALE) vs. GDP p.c. at PPS (Purchasing Parity Standards) .......................................................................................................................................... 136 Figure 7.3:Under-5 Infant Mortality Rate vs . GDP p.c. PPS ............................................................. 137 Figure 7.4: Health spending to GDP (%) vs . GDP p.c. at PPS .......................................................... 139 Figure 7.5: Public Health Spending by Category, 2007 ..................................................................... 140 Figure 7.6: Health Sector Arrears, in % o f GDP ............................................................................... 142 Figure 7.7: Hospital Beds per 100,000 Population1985-2004 ........................................................... 146 Figure 7.8: Average Length o f Stay (ALOS), 1985-2004 ................................................................. 146 Figure 7.9: Lorenz Curve for Income and Concentration Curve for Health Expenditures ................150 Figure 8.1: P A Y G System Performance - Status Quo Simulation..................................................... 157 Figure 8.2: Replacement Rates - Status Quo Simulation ................................................................... 157 Figure 9.1: Overall Social Spending in Croatia, Consolidated General Government, % o f GDP ..... 167 Figure 9.2: Share o f Spending Accruing to Poorest One-Fifth o f the Population ............................. 169 Figure 9.3: Program Coverage Rates, 2004 ....................................................................................... 169 Figure 9.4: Social Assistance and Unemployment Benefits are Generally Well Targeted Geographically ................................................................................................................................... 170 Figure 9.5: Spending on specific non-contributory programs, 2007, % o f total ................................ 172 Figure 9.6: Spending on specific non-contributory programs, 2003-2008, % o f Total ..................... 172 BOXES Box 1.1: Non-Observed Economy in Croatia ...................................................................................... 32 Box 1.2: Lessons from Portugal and Singapore................................................................................... 40 Box 1.3: The Relationship with the IMF ............................................................................................. 43 Box 2.1: The Scope and Organization o f the Public Sector in Croatia ................................................ 47 Box 2.2: Factors Potentially Affecting Government Spending ........................................................... 48 Box 5.1: 2006 PISA Results .............................................................................................................. 104 Box 7.1: Co-Payment Policies Around The World............................................................................ 139 Box 7.2: Hospitals Restructuring in Estonia ...................................................................................... 152 Box 8.1: Pension System Outlook by 2040 ....................................................................................... 157 Box 8.2: Compatibility with pension insurance schemes in the EU countries .................................. 161 Box 8.3: Differences in Pension Levels ............................................................................................. 164 Box 10.1: Medium-Term Structural Reforms, PEP 2008-2010 ......................................................... 187 Box 10.2: The Reform o f the EU Stability and Growth Pact............................................................. 190 11 EXECUTIVE SUMMARY 1. The year 2000 was a turning point in Croatian history, marked by closing the chapter of the war and the first phase of transition. With that, the country turned i t s attention to the "second transition"-the principle goal o f which i s to place Croatia o n a path to the European Union (EU). While opening the economy to global markets through WTO and CEFTA memberships and re- establishing cooperation with i t s Southeast European neighbors, the signing o f the Stabilization and Association Agreement (SAA) marked the first firm milestone o n Croatia's path to EU. In October 2005, Croatia opened EU accession negotiations, with the screening phase concluded a year after. 2. Benefiting from successful economic transformation and the EU accession negotiations, growth has remained solid, and i s roughly on par with the average for the European transition countries. Inflation has been modest despite higher prices for imported oil, and has been kept in n check partly due to exchange rate appreciation. I fact, the central bank has intervened to prevent stronger appreciation in the face o f robust capital inflows. However, the o i l and commodity price increases and the aggregate demand pressures have contributed to a widening o f the current account deficit in 2005-2007, despite somewhat tighter fiscal policy. 3. Building on this foundation, the Government has an unparalleled opportunity to place Croatia on a sustainable growth path to achieve better living standards for all and to integrate into EU. T o seize this opportunity, Croatia needs to sustain macroeconomic stability and continue creating a better climate for investment. 4. In this context, key priorities for the public sector will include: reducing the size o f the state and the fiscal deficit, and thereby helping to increase private sector productivity and competitiveness; and improving public sector efficiency and effectiveness. This report will suggest ways in which these twin priorities may best be addressed. Fiscal and Macro Challenges 5. Recent good progress notwithstanding, Croatia continues to face significant challenges stemming from the legacy of past fiscal profligacy. Despite retrenchment over the last few years, with public spending at 48.6 percent o f GDP in 2007 (almost 10 percentage points o f GDP above the public spending levels in new EU member states), Croatia has one o f the largest public sectors in Europe. From the growth and efficiency point o f view, total public spending i s too high. Cross-country analysis suggests that expenditures over 35 percent o f GDP may have negative implications for growth. 6. So far, Croatia has been able to finance a significant portion o f this large public spending first by increases in tax rates (until 2000) and through improved collection thereafter. But in order to increase competitiveness, the tax burden on the economy-currently at about 40 percent o f GDP, which i s about six percentage points o f GDP above the average for EUlO-would need to be reduced. However, reduction o f taxes requires that in tandem appropriate expenditure reduction and restructuring measures are taken. Without expenditure cuts, tax cuts are not feasible. 7. Unless spending patterns change, the EU accession process may raise public expenditure levels further. For new member states, the fiscal costs o f EU accession have been significant. Similar to their cases, it i s estimated to be close to three percentage points o f GDP for Croatia.. I addition, Croatia will soon face costs related to the potential NATO accession which are n estimated at around 1.5 percent o f GDP. On top o f this, Croatia’s population i s aging which will eventually create additional fiscal pressures. I t i s worth noting however that, faced with s i m i l a r pressures, the new EU member states went through some expenditure restructuring and managed to absorb the accession costs within a declining overall public spending envelope. Croatia needs to find ways to emulate their example. 8. Reducing the tax burden would need to go hand in hand with continued efforts at curtailing the fiscal deficit. While some fiscal consolidation was pursued after the sharp deterioration o f fiscal balances during the economic slowdown in 1999, this was partly reversed in 2003 and early 2004. Since then there have been further efforts at fiscal tightening through the adoption o f improved budgeting processes, and reduced quasi-fiscal activities. Total public spending and general government deficit have declined by three to four percentage points o f GDP-total public spending from 51.3 percent o f GDP in 2003 to 48.6 percent o f GDP in 2007 and the fiscal deficit down from 6.3 percent o f GDP in 2003 to 2.3 percent o f GDP in 2007 (excluding the pensioners’ debt repayment at 1.2 percent o f GDP in 2007 financed off-budget and HBOR deficit at 0.5 percent o f GDP) 9. The high burden of public debt complicates the tasks ahead. The fiscal expansion o f the 1990s has left the country with a mountain o f public debt, which stood at 47.8 percent o f GDP at end- 2007. In sharp contrast to the EU new member states, which have managed significant reductions in public debt over the last ten years, Croatia’s public debt has increased by almost 15 percentage points o f GDP over the same period. Until recently, access to capital has been relatively easy and inexpensive. However, this has shifted with global trends. Also, the privatization receipts will decline. Therefore, Croatia must reinforce recent steps taken to put i t s public debt o n a sustainable path and insulate i t s economy from external shocks. 10. While maintaining a primary deficit equal to 0.2 percent of GDP would be sufficient to stabilize the general government debt, fiscal policy would also need to be managed with an eye on curtailing external vulnerability. This has not always been the case. Evidence from the last decade suggests that, for much o f the period, fiscal policy magnified rather than mitigated the effects o f external shocks. The fiscal tightening that should have accompanied the monetary tightening in the periods o f a large current account deficit was mostly missing. Tight money and a loose fiscal stance not only exacerbated the pressure towards appreciation o f the real exchange rate, but also adversely affected the private sector through the resulting high interest rates. Since 2004, government has followed restrictive fiscal policy with countercyclical behavior which turned neutral in 2007 ahead o f parliamentary elections. 11. Vulnerability to exchange rate changes has been rising, with increased private external and domestic foreign currency-linked debt. While the government has tried to curb fiscal expansion and switch to domestic borrowing in Kuna, rapid credit expansion fueled by capital inflows caused the private sector investment-savings balance to deteriorate. External debt in U S D stood at 95.7 percent o f GDP in 2007 (or at 89.1 percent o f GDP for EUR-denominated debt), o f which roughly 72 percent was private. I addition, a large share o f domestic debt i s denominated in or linked n to foreign currency. O f the government’s domestic debt, about 40 percent o f GDP i s denominated in foreign currency. Similarly, the bulk o f lending by domestic banks t o the private sector i s denominated or linked to foreign currencies. 12. Given Croatia’s ample international liquidity position, no immediate concern arises. However, the large stock of external debt increases the speed and magnitude of transmission of any adverse external financial shock. Such shocks would be transmitted either through higher The government i s o f the view that these transactions are to be treated outside o f the general government. 14 interest rates or through barriers to access to long term finance, thereby affecting real performance o f the Croatian economy. 13. A proper policy mix can help the country to avoid excessive overheating and disorderly adjustments in external balances. Since there are limited monetary policy options for a small-open economy with quasi-fixed exchange rate, fiscal policy remains the most powerful policy instrument for addressing vulnerability. Against t h i s background, Croatia’s fiscal consolidation efforts over the last three years and up until 2007 with general government expenditure reduction by two percentage points o f GDP have been moving in the right direction. However, unless fiscal consolidation accelerates over the next three years, during which Croatia intends to complete the pre-accession process, there i s a significant risk that the additional EU and N A T O accession-related costs may offset the past consolidation efforts. 14. Therefore, the country would be well advised to pursue the path of continued fiscal consolidation towards a more ambitious target: that of reaching a balanced budget position over the business cycle. There are several important reasons reflected in pursuing a balanced budget: Such a fiscal adjustment would reduce immediate external vulnerabilities and help reduce the overall external indebtedness. Increased government savings would contribute to closing the savings-investment gap-- as the current account deficit--and would allow for a reduction o f external debt. Such a fiscal adjustment would allow for the absorption over the long run o the costs f associated with EU accession, NATO membership as well as aging society. These costs together are estimated at above five percentage points o f GDP over the medium term, and thus, without any expenditure restructuring-could significantly deteriorate Croatia’s fiscal and external position. I t would allow for a reduction o tax burden on the economy needed to boost the country’s f competitiveness. If the ambitious expenditure consolidation took place, Croatia would be able to reduce i t s tax burden by more than four percentage points o f GDP. This would make the tax burden in Croatia more comparable to the EU countries. I t would prepare Croatia for the eventual EU accession and meeting o the Maastricht f requirements under the Stability and Growth Pact. To retain macroeconomic stability in the EU and to safeguard the sustainability o f public finances, all EU member states are to pursue a balanced or surplus budgetary position in the medium-term. Since these criteria will apply to Croatia as well upon EU accession, adjusting the fiscal policy targets accordingly would be warranted. A small open economy growing at about its long-term potential needs to balance its fiscal position to make room for counter-cyclical policies in case shocks hit the economy. Croatia should create a cushion for years o f slow growth in the country and EU. Also, given the recent interest rates hikes in EU, i t needs to absorb increased cost o f foreign borrowing. In 2007 alone, the general government borrowing requirements amounted to about five percentage points o f GDP for deficit financing and repayment o f debt, which i s more than double the deficit. 15. The Government’s program for 2008-2011 recognizes the need for further fiscal consolidation efforts with plans for narrowing the general government deficit to 0.5 percent of GDP by 2010. The path to this target represents a real challenge as it will require frontloading significant expenditure adjustment. 16. I n sum, fiscal policy will need to pursue two objectives: (i)reduce the burden of debt and distortionary taxation and (ii) make room to adjust over the cycle and react to shocks. The authorities will need to judge carefully the pace at which they will want to advance towards these two 15 objectives. However, they should not pursue one at the expense o f the other. The only way to reconcile the two objectives i s through expenditure retrenchment. The experience o f the past decade has shown how difficult it can be to achieve a lasting fiscal consolidation. 17. Beyond political constraints, the devil i s in details of sectoral policies. The Government would need to improve its own knowledge base o f the public sector, and strengthen analytical capacities in both core and line agencies to examine expenditure issues and make strategic choices. Ensuring coherence between medium-term strategic plans and the budget planning process would be among the key priorities. This would entail implementation o f a standardized methodology for the preparation o f strategic plans o f ministries, drafting o f an annual strategic document pointing out key policy priorities, and i t s adoption as a supplement to the budget proposal reflecting arguments for the selection o f priorities. 18. Without prejudging the results of a more thorough process, the report attempts to identify expenditure rationalization options in the areas of transport, environment, education, health, pensions, social assistance, subsidies and public administration.These measures would at the same time improve public sector efficiency and effectiveness. I t highlights a number of measures that would allow for expenditure reduction of over seven percentage points of GDP over the medium term, including: I n transport (spending reduction o one percent o GDP): relax the pace o f road network f f expansion; expose road maintenance companies to greater competition to cut the unit costs; deepen railways restructuring including through further staff retrenchments, non-core asset divestment, tying o f subsidies to performance-based contracts, and revenue enhancement measures; and put the draft investment plan for railways at the cost-benefit test. I n environment (improving efficiency o the current spending): time investments taking f into account availability o f EU grant funds and the demand o n the government budgets; focus investments o n areas and projects with the greatest returns; strive for mechanisms that shift finance to the private sector such as the public-private partnership model; consolidate fragmented administration and negotiate transitional arrangements with the European Commission (EC). I n education (improving efficiency and equity o the current spending): rationalize the f wage bill through bringing efficiency ratios in line with international standards on student- teacher ratios; contain growth in non-teaching personnel and administration costs; rationalize the school network in line with demographic factors; expand the use o f multi-grade teaching in small schools and eliminate triple shifts; review carefully the relevance and equity o f the secondary VET program and reform the scholarship system in particular in the tertiary education. I n health (spending reduction o two percent o GDP): introduce stabilization measures f f such as increased use o f co-payments, improved targeting o f l o w income groups by the social protection system, and rationalization o f pharmaceutical spending; and medium-term structural reforms focusing o n payment mechanisms to hospitals and outpatient care providers, rationalization o f the hospital network and hospital-based service delivery system, and reduction o f the drain on the health insurance system arising from excessive sick leaves. I n pensions (improving efficiency and equity o the current spending): offset the negative f fiscal impact o f raising the second pillar contribution rate by (i) gradually raising the retirement age for women to 65; (ii)reducing the wage weight in the indexation formula; and (iii)abolishing the “100 Kuna plus six percent� supplement from the pension base for pre- 1999 pensioners, starting from 2007; and instead use means-testing for targeting the supplement to the poor; (iv) gradually converging privileged new pension benefits to general PAYG; (v) stopping the expansion o f current pension system for disabled Homeland War 16 Veterans and their survivors, and align the minimum pension and pension bonuses envisaged for all other veterans with the general P A Y G system provisions; and (vi) raising the early retirement decrement rate to 7 percent. I n social assistance (spending reduction o one and a halfpercent o GDP): scale up the f f support allowance budget at the expense o f categorical benefits; improve targeting through an extended use o f means testing to categorical benefits; simplify benefits; facilitate the return from “welfare to work�; and consolidate administration. I n subsidies (spending reduction o three percent o GDP): strengthen the implementation f f o f state aid rules as per the 2005 State Aid Law; reduce the sectoral aid; evaluate the effectiveness o f the current horizontal aid; ensure compliance o f local governments; further evaluate Services o f General Economic Interest (SGEI) rule application, especially in the transport sector for proper cost coverage. I n public administration: contain the public sector wage bill through both staff downsizing and pay measures as part o f a broader and longer term reform effort towards performance- based rewarding and promotion system that brings greater flexibility and efficiency to public institutions. The following sub-sections elaborate on these proposed measures. Transport 19. I n the transport sector, the main challenge i s to adopt a more disciplined approach to the planning and prioritization of investments, and to make adequate provision for maintenance o f assets. In the roads sector, Croatia i s in the last phase o f a massive motorway development program (2001-2008) on which it i s currently spending about three percent o f GDP annually. Unit costs o f these investments are high due to excessive standards. This and the pace o f implementation are crowding out expenditure for necessary maintenance and rehabilitation o f existing road networks and a significant maintenance backlog remains to be addressed. Accordingly, the objective o f the Road Construction and Maintenance Strategy for 2005-2008 was to increase the share o f maintenance and rehabilitation expenditure. However, the second objective to reduce the overall public spending on roads relative to GDP was only partially met as from 2007 the spending started growing again. 20. Further steps to support these objectives should include exposing road maintenance companies to a greater competition, use o f competitive contracting, introduction o f appropriate incentive schemes for publicly-owned road operators, and development o f a competitive PPP market for the provision o f road infrastructure. I addition, the government would need to analyze carefully n the liabilities it i s incurring towards concessionaires, i.e., the liabilities that stem from the complex role played by the Government in concession operations as a shareholder. 21. Another priority would be to enhance the operational efficiency of road infrastructure operators and program implementation institutions. There are signs that road maintenance companies have dominant positions in their territories, which tends to limit competition from the private sector. The development o f a competitive contracting market can bring prices down and provide large efficiency gains to Croatian Highway Agency (HAC), Croatian Road Agency (HC) and Rijeka-Zagreb Highway Company (ARZ). Also, given that the HAC’S mission o f construction i s increasingly becoming that o f maintenance and preservation o f the newly created assets, the govepment may want t o think about merging the national roads and motorways under a single implementing agency. This would permit staff downsizing and cutting other operating costs. 22. I n the railways sector, the current level of operating subsidies at 0.6 percent of GDP i s unsustainably high, compared to the EU and neighboring countries. I t could be cut by half. As in other countries o f the region, the sector i s facing sharply increased competition from the rapidly 17 expanding road traffic. The Croatian Railway Company (HZ) i s undergoing a restructuring process, but this would need to be pursued with greater determination with a view to reduce operating costs, especially through further retrenchments, and to increase revenues. Labor productivity has improved, but i s s t i l l l o w at about 50 percent o f the EU27 level and the company’s working ratio has recently slipped back due to overly generous wage settlements. Owing also to excessive staffing and wage rates that are far out o f line with other segments o f the labor market, the revenues o f HZ do not even cover its labor costs. T o become competitive, financially sustainable, and to operate with reduced level o f financial support from the government, HZ would need to reconfigure i t s technology, systems, staffing levels, and investments. 23. Unfortunately, the 2006 mid-term business plan of HZ still focuses on costly additional investments rather than on greater commercial competitiveness. This i s because investment plans are not conditioned by consideration o f debt financing implications nor supported by adequate cost benefit analysis, and insufficient attention i s given to measures to increasing the efficiency o f existing operations. There i s a need to limit the network to commercially viable lines, to privatize or divest all non-core subsidiaries and real estate assets, to expose all internal or external suppliers to competition or benchmark pricing, and to tie all operating subsidies to performance-based contracts. 24. I n particular, to help close the gap between the Croatian and European railways in terms of labor productivity, staff numbers would need to be reduced by 30 percent in the next three years, including the staff in subsidiaries that will not be privatized in that timeframe. The modest staff reductions proposed in the medium-term business plan would not achieve that objective. Moreover, under that plan, the unit labor costs, which are already high, continue to grow. This situation would make HZ extremely vulnerable to competition from other freight carriers, once the network i s opened to competition. As long as the subsidiaries remain sole suppliers to HZ, the cost o f their excess labor i s in fact borne by HZ. Therefore, comprehensive labor cost saving plans need to include the subsidiaries. Environment 25. Challenges in the environmental sector are substantial, with preliminary estimates of the cost of compliance with environment directives of the acquis in the order of €10 to 12 billion. Since the country faces serious fiscal constraints, it will be critical to prioritize and sequence the related government projects to maximize potential benefits within the available resource envelope. Prioritization should be guided taking into consideration the quantifiable economic benefits o f compliance with the environment acquis. Those are estimated to be in the range o f €303 million to €2.4 billion per year, assuming full compliance by 2015 (largely from water and air improvements accruing to Croatian citizens, foreign tourists, and neighboring countries). In addition, the government will need to step up i t s efforts to utilize more o f available EU funds in this sector. Privatization could also help to lower the direct costs to the state, if undertaken with careful integration o f environmental issues and future environmental compliance plans. 26. Organizational reforms in the environment management would also help. At present, organizational effectiveness seems to be sub-optimal, with over fifteen central government institutions involved in environmental management. Reforms are also needed in the area o f municipal infrastructure where large efficiency gains from economies o f scale could be achieved through agglomeration o f utility services across the local government units. The largest investment financing gap in the medium-term budget framework i s in solid waste, and this falls under the responsibility o f municipal utilities. 27. A functional review of the broad environment sector at large would need to be undertaken as a matter of urgency. In the near term key issues to tackle would be the following: consolidation o f policy functions under the Ministry o f Environment, including a transfer o f responsibility for water policy to this ministry; separation o f construction from the Ministry of 18 Environmental Protection, Physical Planning and Construction to avoid conflicts o f interest; and improve coordination between ministries in the design and implementation o f environmental regulations. 28. While the cost of meeting the environmental acquis i s sizable, there are several ways the authorities can keep overall public spending on environment in check at the present level of about one percent of GDP: First, sequence investments and backload as appropriate. The aim should be to delay those investments where EU grant funding i s limited and where private sector involvement i s likely to be enhanced in the future. Second, focus investments on areas and projects with the greatest economic benefits. The data point to a priority for the water sector, with air and IPPC measures generating lower benefits. Some solid waste sites are in the need o f urgent rehabilitation. Third, shift financing to the private sector, wherever feasible. The public private partnership model which Croatia has been experimenting with can deliver, but it s t i l l has some way to go to make a major contribution. Strengthening the capacity o f the public sector to manage PPPs would be the first step. Lastly, following the EU new member states, explore the negotiated transitional arrangements with the EU, where some flexibility exists. Education 29. With high and rising dependency ratios, the main challenge in the education sector i s to build a more competitive labor force that can earn the income levels needed to maintain and improve social welfare for the whole population, and to do this without incurring excessive fiscal costs. The enrollment and completion rates in education are l o w at all levels, except primary education, and there i s a mismatch between skills demanded on the market and the s k i l l s produced by the education system. Although enrollment rates are improving, they are lagging behind EU countries, and still fail to provide a sufficient competitive knowledge base for the future economy. 30. While the amount Croatia spends on education i s in line with other EU15 countries, policies are needed to ensure these resources are spent more effectively. Unit costs have been rising rapidly in recent years, suggesting that little has been done to take advantage o f declining school age cohorts. Institutional and financing arrangements need to be adjusted to ensure that resources are shifted towards the areas o f greatest return. 31. Still, compared to EU countries, the primary school compulsory instructional time i s comparatively low in Croatia, but average for secondary students. The total instructional time at the primary level i s only about two-thirds that o f EU15 students and 80 percent that o f E U 8 students. Although the relationship between instructional time and student outcomes i s not straightforward, students’ opportunity to spend time learning has been shown to be a key driver o f student performance. 32. Croatia will also have to pay the same, if not greater, attention the improving learning outcomes as to sustaining the increases in enrollment among i t s population. The most recent adult literacy rates are only 98.1 percent compared to 98.7 in Albania and over 99 percent in the new EU member states. Life-long learning programs exist, but are not much used. There i s a strong positive correlation between country’s ability to absorb new technology, and thus i t s ability to follow the innovation-frontier countries, and the share o f secondary school educated population. Therefore, increasing secondary education enrollments, education outcomes as well as usage o f life-long learning programs seems critical to increase country’s competitiveness. 19 33. T o complicate matters, the decentralization process in the education sector remains incomplete, creating perverse incentives at several levels of government that work against efficiency and equity. Disparities in education spending across counties result, in part, from weak institutional arrangements for the public education. Currently, there i s a mix o f centralized and decentralized decision-making and financing, depending o n the function and level o f education. The Equalization Fund i s meant to address horizontal imbalances in school financing, but relies on historical expenditure ratios that lock in inherited inefficiencies. 34. The authorities have recognized the general problems in the current education system and they have embarked on a wide reform program. The Strategic Development Framework 2006-2013 as well as the Education Sector Development Plan 2005-2010 are explicit in diagnosing these problems and proposing reform steps. Modernization o f the curriculum has received significant attention in the last couple o f years with plans to finalize a new national curriculum in pre-tertiary education in late 2008. The government has introduced transparent student performance evaluation involving external and internal standards and final Matura exams are expected to be introduced in secondary education in 2010. In 2006, Croatia was for the first time included in the PISA assessment with plans to participate in the next rounds o f TIMSS and PIRLS as w e l l as Vocational and Technical Education (VET) programs have been consolidated, and the tertiary education system in Croatia has begun to function according to the Bologna process. Resource problems have arisen during implementation though it remains to be seen if the Bologna process will be able to tackle Croatia’s chronic problems o f high tertiary drop-out rates and long completion periods. 35. Additional steps are needed to make cost effective improvements in the quality of the education system, including the following: Rationalize the wage bill--in particular, through reduction o f teacher-student ratios to bring efficiency ratios in line with international standards; contain the growth in non-teaching personnel and administration costs. With this in mind, the full decentralization o f the payment o f teacher salaries may not be advisable, unless it i s accompanied by greater local autonomy over hiring and salary decisions. Rationalize the school network in line with demographic factors and enrolment developments; expand the use o f multi-grade teaching in small schools; and eliminate the current triple shifts. Review carefully the relevance and equity o f the secondary VET program; promote life-long learning. Reform the scholarship system to be more equitable. While Croatia has virtually no social differences in enrollment rates in primary education, and small differences in enrollment rates at the secondary level, equity in enrollment for tertiary education remains a concern. Rather than reducing them, the current scholarship system promotes those social differences. Introduce updated standards for service provision and robust cost estimates for meeting those standards as a sound basis for reforming education finance and governance arrangements. Closely monitor the progress being made in reforming the financing o f public tertiary education to ensure that it delivers the promised efficiency and effectiveness gains. Identify the reasons behind the l o w completion and high repetition rates in tertiary institutions; simulate the impacts that Bologna process will have o n trends; analyze how to link expected supply and demand for particular skills and occupations in tertiary education; and introduce greater flexibility for students in choosing curriculum. Health 20 36. While the Croatian health system has performed relatively well compared to other countries in the region in terms o f health outcomes, these results have been achieved at a high cost. As a result, the health insurance fund faces growing deficits. Croatia’s public spending on health care at around 7 percent o f GDP i s well above i t s neighbors’ and that in many EU countries. The efforts to contain costs in the 1990s and early 2000s were not effective and the health system has to be bailed out on average every two years, either through increased contribution rates or through financial injections from the central budget. 37. Health sector arrears have been growing, reaching one percent of GDP at the end of 2007. The growth o f arrears reflects fundamental weaknesses in the system. First, the current payment mechanism creates incentives for excessive demand. Second, o n the supply-side, the absence o f primary health system gate-keeping role to access the more expensive secondary care creates waste. Third, the extensive hospital infrastructure i s expensive to maintain and a source o f cost inflexibility. Fourth, the hospital governance structure i s not making managers accountable for agreed budgets. 38. Further increase in income, life expectancy, age and dependency ratios may lead to unsustainable growth in demand and over-proportional growth in spending. Incentives would have to change to address the problem, in particular to eliminate demand which does not lead to an increase in health outputs. This problem needs to be solved not only for reasons o f economic efficiency, but also to produce better health services for those in need. 39. EU countries have tackled these problems through short-term stabilization measures and medium-termstructural reforms.The common strategy has been the adoption o f a hard budget constraint and strict fiscal discipline. As a first step in that direction in Croatia, a new obligatory health insurance l a w and health strategy were enacted in 2006. While recent measures promise some efficiency gains, they are far from being enough to improve the overall health system performance. 40. Learning from the experience o f EU countries, short-term stabilization measures would need to include: 0 An increase in the use o f co-payments to limit excess demand and generate additional revenues. Improvement o f the copayment exemption targeting to l o w income groups through the social protection system. 0 Rationalization o f pharmaceutical spending. 41. Medium-term structural reforms should in turn focus on: Reforms in the payment mechanisms to hospitals and outpatient care providers. 0 Rationalization o f the hospital-based service delivery system. 0 Reduction o f the duration o f sick leaves and the consequent transfers from the health insurance system to households, which currently account for over 0.8 percent o f GDP. Pensions 42. I n the pension system the main challenge i s how to deal simultaneously with low current and future replacement rates, high fiscal costs and intergenerational equity issues. During the 1990s, demographic trends, loose eligibility criteria and rising life expectancy led to substantial deficits in the pay-as-you go (PAYG) system, while replacement rates declined from over 75 percent to less than 50 percent. I response, the government launched a pension reform in 1998, which aimed n at scaling back the P A Y G system to create fiscal space for the introduction o f the second and third pillar (private mandatory and private voluntary) systems that would make up for the declining P A Y G benefits. These efforts have, however, met with crippling resistance. 21 43. Indeed, the PAYG reforms faced a series of reversals during 1999-2005. Given delays in launching the second pillar, and the l o w and stagnant second-pillar contribution rate o f 5 percent, the financial performance o f the pension system has not met early expectations. Moreover, several o f the basic pension parameters have not been set at sustainable levels, including o n account o f a l o w retirement age for women, l o w decrement for early retirement and high minimum pension benefits. 44. As a result, the pension to GDP ratio rose close to 14 percent by 2001, before settling back to 11.3 percent of GDP in 2007. The rise also stemmed from the Constitutional Court rulings on claims in 1997 and 1998, related to indexation and pension adjustments following reduction o f high inflation in 1993, which in both cases ruled in favor o f higher pensions. 45. At the same time, the second pillar i s still too underdeveloped to generate the hoped-for replacement rates. The contribution rate for the second pillar i s l o w compared to other countries. As a consequence, second pillar benefits will not be sufficient to balance the reduction in P A Y G benefits, even if the rate o f return on assets accumulated in the second pillar pension funds remains above the average real gross wage growth. 46. The following adjustments would be needed to ensure fiscal sustainability and adequate replacement rates: First, the second pillar would need to expand faster and i t s returns improve. T o achieve this: o The 5 percentage points o f contributions that are diverted to finance the second pillar benefits would need to be increased to compensate for the reduction in P A Y G benefits. o The administrative cost of the second pillar would need to be reduced. At present indeed, fund management costs are high compared to other countries and end up reducing assets at retirement by as much as 26 percent. In addition, there are the operating costs o f Insured Members' Registry (REGOS) devoted to second pillar contribution collection and individual account management. Second, to make room for such expansion, the P A Y G system should shrink faster than it currently does. Increasing the contribution rate for the second pillar benefits to say 10 percent would fbrther raise transition cost for about 2.2 percent o f GDP, thus increasing the amount that would have to be raised through savings in other sectors or through further adjustments in the first pension pillar. T o offset this, the government has at i t s disposal several measures to consider: o Raising the retirement age for women to 65, starting in 6-month increments from 2008. This would cut the deficit in the P A Y G system from 2.8 percent o f GDP in 2005 to 0.8 percent o f GDP in 2020 and eliminate i t in 2030. o Reducing the weight o f wages in the benefit indexation formula. Price indexation would be a powerful measure, as it would shrink the deficit quickly to zero in 2015 -- at the cost, o f course, o f a rapidly declining replacement rate in the PAYG system (declining to 30 percent by 2015).2 Indexation with inflation plus 25 percent o f real wage growth (half the Swiss formula) would eliminate the deficit by 2023, with a more gradual reduction in replacement rates. o Raising early retirement decrement from the current 4 to 7 percent for each year o f early retirement3 would reduce the deficit by 0.1 percent o f GDP in the first year, and by 0.25 percent o f GDP in 2022. Fiscal impact o f indexation i s strong because the same indexation pattern is applied for both past earnings valorization as w e l l as for benefit indexation. Such a decrement level was introduced in Germany in 2005. 22 o A fiscally powerful but socially unpopular measure would be to abolish the “100 Kuna plus six percent� supplement from the pension base for pre-1999 pensioners starting from 2008 onward. This would reduce the deficit in that year to 2 percent o f GDP, and gradually bring it down to zero by 2030. 47. There are also persistent perceptions of inequity in the pension system. These stem in part from the higher benefits offered for specific groups including veterans, military, police, MPs, ex- ministers, and members o f academia. In addition, the 2000 and 2004 pension policy hikes and to a smaller extent, the 1998 reforms resulted in opening up benefit differences between individuals with essentially the same work/pay history-especially across cohorts. 48. The following menu of options could be considered for addressing issues of fairness and equity: A gradual convergence o f privileged new pension benefits to general P A Y G benefits by 2027. This would reduce the deficit to 1.5 percent o f GDP by 2027. 0 Stopping the expansion o f the current pension system for disabled Homeland War Veterans and their survivors, and aligning the minimum pension and pension bonuses envisaged for all other veterans with the general P A Y G system provisions. Abolishing the “100 Kuna plus six percent� supplement i s the fiscally most powerful option. This was expected to occur in 2002.4 Abolishing the supplement for all beneficiaries would reduce the differences by more than 50 percent, save about 0.7 percent o f GDP, and open fiscal space to increase the second pillar contribution rate. However, this option seems to be politically and socially unrealistic. Still, it i s worth noting that, with this option, the second pillar contribution rate could be raised to 7-8 percent immediately and to 10 percent by 201 1. Extending the supplement to all current and future beneficiaries, but introducing means testing and separate insurance from social protection objectives. This may cut the fiscal cost o f the supplement by about one-half. Extracting the supplement from the base o f eligible beneficiaries, extending it to all current and future beneficiaries and freezing it or phasing it out over a longer period o f time. This scenario would yield a smaller fiscal savings than the previous one. Fiscal space for the increase o f second pillar rate to 6 percent would be created only in four to five years; Extending the supplement to all current post-1999 retirees not eligible for the supplement (estimated at 300,000). This i s the most fiscally demanding, and would require additional annual pension expenditures o f 0.3 percent o f GDP. This scenario takes away the fiscal space for second pillar contribution rate increase for a longer period; 0 Raise the post-1999 benefits through an alternative supplement or restitution fund. The fiscal impact o f this scenario would similarly work against raising second pillar contribution rate, but for a shorter period. Social Assistance 49. Overall social assistance spending i s high by international standards, but only a small share of it goes towards means-tested programs. At about four percent o f GDP in 2007, social benefit spending i s some two percentage points o f GDP higher than in EU15 countries. Even so, this figure does not include the benefits provided through the tax exemptions--for families with children, non-taxable part o f income etc. Spending i s largely driven by benefits and privileges granted to homeland war veterans and their families, while only a small fraction (0.3 percent o f GDP) i s used for the poverty-related social assistance program. The 1997 law endorsing 100 kuna plus 6 percent supplement was supposed to expire in 2002, but the Government extended it until 2004. 23 50. Croatia has developed a generous social protection system with increasing spending patterns and numerous parallel social safety nets programs. This has resulted in an overly complicated social safety net, which i s not well-targeted to the poor and i s costly to administer. The majority o f social benefits (65 percent) are categorically targeted and many o f the categories overlap, resulting in multiple entitlement provisions. 51. There are over hundred different non-contributory social benefit programs offered at the national and local levels of government and administered b y over 700 offices, but no single institution responsible for overall policy coordination. The number o f programs on offer, the number o f institutions involved, and the lack o f harmonization o n eligibility criteria lead to a system that i s costly to administer, allows for double dipping and causes unequal treatment o f claimants. Adverse effects include the resulting confusion, and errors o f exclusion and inclusion which negatively impacts value for money. In addition, the implementation o f these eligibility criteria i s sometimes subject to the discretion o f local officials. 52. Furthermore, social benefits spending has increased by half percentage point of GDP since 2003 owing to the relaxation o f policies in the area o f maternity leaves, new benefits introduced, changes to eligibility criteria leading to increased beneficiaries, and increased nominal value o f benefits. The National Population Strategy adopted by the Government in late 2006 exerts additional pressures onto the government medium-term financial projections. 53. With Croatia having one of the lowest labor force participation rates in Europe, public provision of social assistance also faces the challenge of establishing a link between the benefits and work incentives. Over 50 percent o f claimants are able-bodied people. Labor market participation could be encouraged by limiting the duration and introduction o f the workfare programs. At present, the duration o f the support allowance in Croatia i s not limited in time, and a large number o f beneficiaries remain in the system for more than five years. 54. The resources involved in eliminating poverty in Croatia would be reasonably affordable and could be found through reallocation of existing resources. A perfectly targeted transfer o f about 1.5 billion kunas (about 0.7 percent o f 2004 GDP) would have been sufficient to eliminate poverty in the country in 2004. Further, even relatively modest increases in average incomes in poorer regions would lead to a considerable narrowing in regional poverty differentials. Instead, the resources are being spread across less effective and multiple programs. I addition, the n tax system on i t s own offers several tax exemptions and deductions that have a limited impact on n reducing income inequality. I fact, the wealthier taxpayers tend to use higher allowances than low- income earners do. 55. The report highlights a number of reform priorities : 0 Scale up the support allowance budget at the expense of categorical benefits by increasing the support allowance from the current 8.3 percent o f the average 2007 net wage to cover at least a minimum food consumption basket (about 600 kuna). The Social Benefit Reform Strategy from 2007 foresees an adjustment to the benefit level. Adjustments should be based o n cost o f living increases and regular revisions and adjustments o f the base amount o f the poverty allowance, as currently the system leaves out many potential beneficiaries. 0 Improve targeting. The good practice o f using means-testing for the support allowance should be used as a basis for targeting other benefits, including family benefits and those in the health insurance and some for war veterans. This would reduce the risk o f underestimating household income due to informal labor arrangements and o f underreporting o f income or that o f providing support to client categories that are not in need. 0 Simplify benefits. Measures to streamline and simplify benefits are important for increasing the efficiency and quality o f the social assistance programs. The most desirable option would be to establish a single, unified welfare benefit. 24 0 Facilitate the return from “welfare to work�. If well designed, an increase in expenditures allocated to targeted social assistance programs should not create poverty traps and over- reliance on social assistance, but instead provide beneficiaries an incentive to return to the labor market. 0 Establish a central database of welfare system beneficiaries for mandatory use also by other institutions involved in social protection: social sector ministries, employment offices, Croatian Institute for Pension Insurance, Croatian Institute for Health Insurance, family centers, local government departments, etc. Upgrade the social assistance information system. The planned Management Information System o f the Ministry o f Health and Social Welfare needs to implement linkages to the other government information systems. In addition, linkages or clear mechanism o f information exchange should be established with the social assistance systems o f local governments as well as with the employment bureau. Improving information-exchange system would cut the administration cost for government and beneficiaries and reduce errors o f exclusion and inclusion. 0 Consolidate benefit administration to the extent possible by merging relevant functions under fewer ministries and single offices at the local levels with a view to easing access to social spending programs and to coherent planning. Almost one third o f GDP allocated on different social programs require coherent and consistent approaches supported by appropriate monitoring and evaluation system in place. Strategic planning in these areas i s rarely used and lacks coordination with budget planning and other sub-sectors. Subsidies 56. Enterprise subsidies would need to be cut back. Total enterprise subsidies from the consolidated general government (including indirect ones), amounted to over 3.3 percent o f GDP in 2007. They are fairly concentrated in transport (railways, shipping companies), agriculture and shipyards. In comparison, EU15 countries allocate only one-sixth o f the Croatian level o n state aid. I n many cases, direct and indirect subsidies have been used to postpone the resolution o f different forms o f enterprise crises, avoiding what otherwise would have resulted in bankruptcies and healthy restructuring o f the enterprise sector. 57. The structure of state aid in Croatia reveals a strong reliance on sectoral subsidies which according to the EU rules as well as from an economic point of view, are considered particularly detrimental. They are distorting market competition and reduce the country competitiveness over the long run, by keeping afloat unviable companies and wasting public resources in the process. Croatia allocates over half o f the state aid to sectoral aid, while horizontal aid, which primarily tends to address market failures, receives less than one-fifth o f overall aid (excluding agriculture and railways). This i s diametrically opposite to the EU15 state aid structure. 58. Almost 80 percent of the sectoral aid has so far gone to shipyards, transport and steel mills, which suggest that those sectors will be most affected by the unavoidable aid reform. For example, in EU15, in 2004, only two percent o f the overall aid went t o shipyards, while Croatia allocated almost 20 percent to sector, covering as much as 22 percent o f the ships’ value. 59. Strengthened state aid rules (as per the 2005 State Aid Law), harmonized with the EU rules, are triggering a review of state aid provision. Croatia’s attempts to control the level o f aid through the adoption o f the medium-term Subsidy Reduction Plan for 2005-2007 has shown early signs o f success and would need to be continued and accompanied by further efforts to restructure the aid and increase transparency. The EC “State Aid Action Plan for 2005-2009� calls for a further reduction in state aid as a share o f GDP, a shift from sectoral to horizontal aid, and a transparent and efficient approval and control system. 25 60. Going forward, sectoral subsidies in Croatia would have to be limited to development aid, R&D, closures and staff reductions, instead of financial restructuring which has been the main focus so far. In parallel, horizontal subsidies would need to be re-evaluated. The current proliferation o f state-subsidized programs through institutions and agencies without a proper monitoring and evaluation system in place i s prone to abuse and may not provide adequate rates o f returns to tax payers’ money. There i s a need to further evaluate Services o f General Economic Interest rule application, especially in the transport sector to avoid covering excessive margins or providers’ inefficiencies. Local government subsidies should be scrutinized under the same rules. They are major providers o f aid to local utility and transport companies, but reporting and seeking approval o f these i s still inefficient. Public Administration 61. The common thread across the sectoral challenges outlined above i s Croatia’s public administration which i s characterized b y its high cost and large size, but low effectiveness. Despite best efforts, tackling these deficiencies has proven difficult owing to a combination o f factors. One i s the rigidity in the organizational structures and remuneration system. The second factor i s the common, but sometimes misguided, perception that EU accession requires the creation o f a new layer o f new regulatory institutions and administrative functions for managing EU structural funds and implementing acquis. The third factor relates to the government’s decentralization aspirations: shifting further functions to local governments, without commensurate scaling down the central government employment and harmonizing pay levels across levels o f government, would compound the problem o f already high wage bill and inefficiency. 62. The problem i s not only fiscal--the excessive size also hampers decision-making and service delivery. The proliferation o f agencies and subordinate entities with operational autonomy and often revenue-raising capabilities, has led to overlapping functions, lack o f coordination and clarity about lines o f accountability among ministries, agencies and other state subordinate entities. This creates problems for the execution o f government functions, complicates policy-making and implementation, places a huge burden o n coordination and management and ultimately adversely impacts value-for-money and the quality o f service delivery. 63. The key challenge for the government will therefore be to bring the public sector wage bill to a sustainable level, while improving the effectiveness of the public administration and ensuring capacity to implement the EU accession requirements and increasingly complex policy coordination. The experience o f new EU member states suggests that this will take time. The harmonization with the acquis i s not a “one-off’ but a continuing effort, which needs to be supported by the creation o f soundly performing systems across the government, with professional, merit-based, and independent c i v i l service. 64. One set of actions would need to focus on public sector remuneration (both civil service and public service at central and local government levels). The current pay system (based primarily on the characteristics o f individual civil servants and the rank that they occupy, which in turn i s determined by the years in service and the level o f education) would need to be replaced by a system that links remuneration and performance. Over the medium term, performance indicators (currently weakly defined or not defined at all) would need to be developed to accompany salary reform. A pre-requisite for these efforts would be the development o f a Human Resource Management Information System which l i n k s payroll payments to individual staff information. 65. Rationalizing functions, and in some cases personnel, would also help improve the effectiveness of policy making and service delivery. The recently initiated functional reviews o f administrative structures -- with a view to bringing organizational structures o f ministries, state agencies and offices o f state administration at the county level in line with their strategic and authorized tasks and responsibilities - would need to be rolled out across the whole government. The 26 recommendations o f these reviews should then be used for drafting and implementing rationalization programs (including staff retrenchment, reassignments and budgetary impact). The aim should be to remove unnecessary organizational complexity and seek efficiency gains from organizational consolidation. 66. To pave the way for increasingly rational deployment of government administrative resources, policy development and impact assessment processes would require attention. EU accession places increased emphasis on the capacity for and process o f policy making. The Croatian government has initiated the reform in this area by making fiscal, social and environmental impact assessments o f new policies and legislation mandatory in the past couple o f years. In addition, there are plans for the introduction o f the Regulatory Impact Assessment, which would be a welcome development. Concluding Note 67. Croatia i s well positioned to reach the balanced budget objective through expenditure restraint over the medium term. The measures discussed above are demanding but doable. They would go a long way towards that objective, and would create space for absorption o f EU funds. However, best o f all, they would improve the delivery o f public services, while alleviating the burden o f taxation on the citizens and economy. 27 PART I:STRATEGIC SETTING 28 1. THE MACROECONOMIC SETTING 1.1. Benefiting from successful economic transformation after independence and the start of EU accession negotiations, economic activity in Croatia has remained solid, and i s roughly o n par with the average for European transition countries. Inflation has been modest despite higher prices for imported o i l and other commodities and has been kept in check partly by a tendency towards exchange rate appreciation. In fact the central bank has intervened to prevent stronger appreciation o f the exchange rate in the face o f robust capital inflows. However, the o i l and commodity price increases have contributed to a widening o f the current account deficit in 2005- 2007, despite somewhat tighter fiscal policy. 1.2. However, Croatia faces significant challenges stemming from a fiscal expansion over the last decade. While a sharp deterioration o f fiscal balances during the economic slowdown in 1999 induced the government to adopt some consolidation measures, there were reversals in 2003 and 2004. There have been further efforts at fiscal tightening since but these have been hampered by relatively slow progress on structural reforms particularly with respect to non-bank privatization and corporate restructuring, improvements o f the business environment and reforms o f public administration and the labor market. Croatia now confronts the need for a major fiscal adjustment in the next couple o f years in order to reduce and sustain the deficit below the Maastricht level. 1.3. The protracted fiscal expansion resulted in mounting public debt, creating external vulnerabilities. In sharp contrast to the EU new member states which have managed significant reductions in public debt over the last ten years, Croatia’s public debt has increased by 15 percentage points o f GDP. M u c h o f this debt i s external, denominated in foreign currency, and i s short term. Until recently access to capital has been relatively easy and inexpensive, however this has shifted with global trends. Moreover, the significant contribution o f privatization receipts to net inflows in the past will not continue for much longer. Croatia must reinforce recent steps taken to put i t s public debt on a sustainable path and insulate i t s economy from external shocks. 1.4. Vulnerability to exchange rate changes i s rising, with higher private external and domestic foreign currency-linked debt. While the government has tried to curb fiscal expansion and switch to domestic borrowing in kuna, rapid credit expansion fed by capital inflows i s causing the private sector investment savings balance to deteriorate. External debt i s n o w 95.7 percent o f GDP o f which roughly 72 percent i s private. Moreover, a large share o f domestic debt i s denominated in, or linked to foreign currency. O f the government’s domestic debt, the equivalent o f 40 percent o f GDP i s denominated in foreign currency. Similarly, the bulk o f lending by domestic banks to the private sector i s denominated or linked in foreign currencies. The central bank has sought to stabilize the exchange rate and limit foreign borrowing. But the conduct o f monetary policy i s made difficult by the high degree o f euroization which l i m i t s options for interest rate policy and places high expectations on managing the exchange rate. A. MODERATE GROWTH, LOW INFLATION AND EMPLOYMENT 1.5. Fiscal consolidation and a slower increase in exports have slowed economic expansion from early 2000’s to a more moderate pace in recent years. Wage moderation and higher oil prices kept the contribution o f personal consumption on a declining path during Figure 1.1: Contribution to Growth 2005 and 2006 (at 2 percent average), about half the pace o f growth in 2002- 2003. (Figure 1.1, Table 1.1). In 2007 this has been reversed, with the contribution o f personal consumption surging to 3.7 percent. The contribution o f net exports to growth became negative again in 2006- 2007, after some recovery in 2004-2005. This was mostly due to a stronger than expected expansion o f imports and weaker exports o f services (mainly 1888 I889 2WO 2W1 2002 2003 2034 2W5 2006 Mo7 tourism). Accelerating investment was the - key driver o f the overall increase in S ~ ~ ~ ~ ~ : C R O S T A T growth to 4.8percent in 2006 from 4.3 percent in 2005. The economic upturn in 2007, however, was mainly due to personal consumption, investment, and an accelerated growth o f government consumption, at the highest rate over the four-year period. 1.6. I n the period 2000 - 2007 Figure 1.2:Cross-Country M a c r o Comparison, 2007 average growth rate of GDP was 4.6 12 percent which was below the average 10 of 5.6 percent for the EU105’6. In 2008 and 2009 i t i s expected that real GDP 0 growth will continue to lag that o f the 6 EU10. While the impact o f government 4 consumption will be neutral given the 2 announced fiscal consolidation effort, private consumption and investment will 0 ’ Fucal defcit. % of Wgrowth. % hflabn % p a OIrrentaccOUnt remain strong, although at a lower rate W deicd. % of OW than in 2007-due to a-lower pensioners’ Source: EUROSTAT, Central banks, MoF debt repayment (at 0.5 percent o f GDP in 2008 as opposed to 1.2 percent o f GDP in 2007) and slower credit growth affected by further monetary tightening. The current account deficit i s likely to remain high. This raises the question whether such consumption- and investment-driven growth i s sustainable while structural fundamentals are s t i l l weak. 1.7. The sustained output expansion has helped increase employment somewhat, but the low participation rate remains a concern. Employment has risen, albeit modestly, every year since 2001, reversing a decline going back to the mid-1990s. However, the decline in the unemployment rate from 16.1 percent in 2000 to 9.6 percent in 2007 i s to a larger extent attributable to people leaving the labor force (over 65 thousands in the same period), than increases in employment (61.5 thousands). The participation rate declined from 50.7 in 2000 to 48.8 percent in 2007. A more rapid decrease in unemployment has been hampered by high cost o f doing business and, until recently, rigid EUlO stands for EU new member states, i.e. Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia. The latter average i s influencedby the very strong growth in the Baltics. 30 employment protection rules. Also, while there are some indications o f a decline in youth unemployment, long-term unemployment remains stubbornly high. Table 1.1: Croatia: Selected Macroeconomic Indicators, 2000-2007 Outturn 2000 2001 2002 2003 2004 2005 2006 2007 Nominal GDP (in millions ofkuna) 152,519 165,639 181,231 198,422 214,983 231,349 250,590 275,078 GDP per capita (in currentU.S. dollars) 4,148 4,476 5,181 6,663 8,030 8,754 9,666 11,549 (Percent change) Real GDP growth 2.9 4.4 5.6 53 4.3 43 4.8 5.6 Domestic demand 4.3 5.5 11.5 64 3.8 3.7 5.2 5.6 Public consumption -1.5 -62 4.9 13 4.3 0.8 2.2 3.4 Private consumption 4.2 4.5 7.7 4.6 4.8 3A 3.5 6.2 Gross domestic investments -10.3 23.6 27.4 14.1 4.8 6.3 10.5 6.0 Net foreign balance -34.9 23.8 98.9 143 0.7 -0.4 8.8 6.3 Exports 12.0 8.1 1.2 11.4 5.7 4.6 6.9 5.7 hports 3.7 9.8 13.4 12.1 4.6 3.5 7.3 5.8 Consumer Price Index 4.6 3.8 1.7 1.8 2.1 3.3 3.2 2.9 Industrial production 1.7 6 .O 5.4 4.1 3.7 5.1 4.5 5.6 Labor productivity in industry 4.3 9.6 9.6 7.7 5.7 3.6 5.6 5.2 Averagereal grcss wages, CPI 1995=100 2.2 02 4.3 29 4.2 1.1 2.9 3.3 Unemployment, LFS (In percent) 16.1 15.8 14.8 143 13.8 12.7 11.2 9.6 (In percent ofGDP) Current Account Balance -2.9 -3.7 -8.4 -73 -5.3 -6.6 -7.6 -8.6 Gross external debt 62.1 60.4 68.5 84.0 87.6 78.4 89.8 95.7 (In percent o f export o f goods and senices) 132.2 124.4 148.9 167.0 177.5 161.4 179.7 194.9 Short-term external debt (In percent of reserves) 26.5 11.1 10.2 245 40.9 45.7 49.3 47.5 Amortization due within a year (In percent o f reserves) 48.6 43.0 35.4 30.8 31.2 38.1 52.4 49.8 Net FDI 6.0 7 .O 2.4 65 2.1 4 .O 7.5 9.1 Foreign exchange reserves (In millions ofUSD) 3,525 4,704 5,886 8,191 8,759 8,801 11,489 13,675 (In months o f imports) 4.3 52 5.4 5.7 5.2 4.9 5.6 5.6 Exchange rate HRKAJS.dollar, period average 8.3 8.3 7.9 6.7 6.0 5.9 5.8 5.4 Exchange rate HRIUEuro, period average 7.6 7.5 7.4 7.6 7.5 7A 7.3 7.3 (Inpercent ofGDP) General government balance'' -6.7 -6.9 4.5 -63 4.9 -4.1 -3.1 -2.3 Public debt'' 50.1 5 1.5 50.9 51.1 51.7 523 49.7 47.8 (Percent change) Broad money (M4) 0.0 0 .o 0.0 0 .o 8.6 10.5 18.0 18.3 Domestic credit 0.0 0 .o 0.0 0.0 14.0 172 22.9 15.0 Bank deposits 28.6 49.7 3.5 11.4 10.9 9.9 15.6 17.9 1/ General government balance with capital revenues other than privatization receipts included under revenues. 2/ General government debt including guarantees Sources: CROSTAT, Ministry o f Finance, Croatian National Bank; and World Bank staff calculations. 1.8. A decline in unemployment has been helped by wage moderation. Average nominal wages rose just slightly faster than productivity in 2005 and 2006 after lagging substantially in the early years o f the decade. Average nominal wages rose 4.5percent per year during 2005-2006 compared with productivity growth o f 4.6 percent, and average annual inflation o f 3.3 percent. Restrained wage growth reflects, in part, greater labor market flexibility, including the prevalence o f fixed-term contracts that echo the changing structure o f jobs in fast growing sectors. However, the evident mismatch o f labor supply and demand exerts wage pressures. In line with this, and wage pressures in the run-up to 2007 elections, nominal net wage grew faster than productivity in 2007, feeding into already high aggregate demand. 1.9. Consumer price inflation fell slightly to 2.9 percent in 2007 from 3.2 percent in 2006 due to a decrease in regulated prices, particularly the stabilization of prices for housing and utilities, particularly water supply prices and rents, as well as health sector prices which were the main contributors o f price growth in 2006. However, due to the rise o f food and o i l prices at the global market, the inflation started to surge at the end o f the year, and this continued in 2008. Domestic 31 producer prices o f industrial goods increased by 0.5 percent to 3.4 percent in 2007 and continued rising thereafter after the carry-over effect. Box 1.1: Non-Observed Economy in Croatia The non-observed economy could be defined as productive activities that are not covered by the national statistical system either due to socio-economic (underground, illegal, and informal activities) or statistical reasons (non-responding, misreporting and the like). Exclusion o f such activities results in underestimation o f GDP and overestimation o f economic indicators expressed as a share o f GDP. Therefore, the European Commission under the Eurostat Exhaustiveness Programme requires a l l EU member states to include an estimate o f the non-observed economy in their official G D P data. All the new member states corrected their official GDP figures for the value o f the non-observed economy, with adjustments in 2000 varying from 5.8 percent in the case o f Malta t o 18.9 percent in the case o f Lithuania. Croatia participated in the Eurostat-OECD Non-Exhaustiveness o National Accounts Project for Western f Balkan Countries in 2005. The most significant sources o f non-comparability o f Croatian national accounts with those o f EU members arise f r o m the treatment o f underground economy and imputed dwelling rents. The estimated increase in GDP due to a l l types o f non-exhaustiveness (including methodological changes related to the treatment o f rentals o f dwelling services) for period 1998-2004 amounted o n average to 16.9 percent, with the adjustment declining from over 18 percent towards 15.4 percent in 2004. Table 1.2 shows the changes that the correction for non-exhaustiveness has o n the m a i n macroeconomic indicators for Croatian economy. The gap in G D P per capita, in purchasing power standard terms, between Croatia and the EU-25 reduced f r o m 52 to 45 percent. Furthermore, the share o f total public expenditures in GDP declines, placing Croatia below the average level o f the EU15, but s t i l l some 4 percentage points above the average for EU8+2 member states. In terms o f the Maastricht convergence criteria, the adjustments o f GDP level do not change anything significantly. The public sector deficit as well as public debt, although would fulfill the criteria. They remain high nonetheless and the policy implications remain the same. I Public sector deficit, as % o f GDP I -3.6 I -3.1 I Public debt, as % o f GDP 52.3 I 45.5 Current account balance. as % of GDP -6.6 I -5.8 I Foreign debt, as % o f GDP I 78.4 I 68.1 I Source: CROSTAT, forthcoming. Deficit and Public Debt 1.10. The fiscal expansion over the last decade has defined the fiscal challenges Croatia faces at the beginning of new century. The economic slowdown in 1999 revealed many weaknesses in the public expenditure policies o f the 1990's. Reduced tax revenues (in particular indirect taxes) without offsetting expenditure reductions resulted in a rapid deterioration o f the fiscal deficit to 8.4 percent o f GDP in 1999. The government took steps to repay accumulated arrears while focusing at the same time on expenditure cuts and undertaking structural reforms with a longer-term impact including reforms in defense, pension, health, budget management. A reduction o f primary expenditure (mostly current expenditure), paid o f f in 2002 as fiscal policy changes resulted in positive current public sector savings. From then o n the Government contributed positively to the savings investment gap; i.e. a portion o f public investment i s financed through the Government's own savings, meaning that new debt accumulation has been incurred only for capital investments. 32 1.11. Expansionary policies in 2003 Figure 1.3: CGG Balance, YO f GDP o and policy reversals in 2004 offset some of the early long-term reform efforts. Since the beginning o f 2004, government committed itself to put greater emphasis on fiscal consolidation primarily through better expenditure control and improvements in tax collection and tax administration. Results were visible as early as at the end o f 2004 when the general government deficit was reduced from 6.3 percent to 4.9 percent o f GDP. The government has managed to further *Without capital revenues; full local government coverage. decrease the deficit by 2007 to 2.3 Source: MoF WB Staff estimate. percent o f GDP. The primary deficit, Figure 1.4:General Government Balance Comparison, YO f o however, remains at around 0.2 percent GDP o f GDP (2007). d C E E C s -Croatia 1.12. While all three groups of ....... ELI-15 AAV Cohesion comparator countries (EU15, EUlO and Cohesion countries) on average managed to comply with the Maastricht deficit level of 3 percent of GDP, Croatia faces a major fiscal adjustment in the next couple of years in order to reduce and sustain the deficit below the Maastricht level. Maastricht crdwa. -3% of GDP Revenue losses due to the required .g J harmonization o f tax policy with the EU, new spending requests linked to the Nofe Croatia without capital revenues and full local government coverage accession process, as well as pressures Source IMF, WB data base on the social sectors due to an ageing Figure 1.5: Consolidated General GovernmentDebt and population, will require strong fiscal Guarantees, % o f GDP adjustments in the years ahead. 60 1.13. Furthermore, financing of 55 large deficits, up until now, has been facilitated b y relatively easy access to international capital markets, and b y significant privatization receipts. As a result, the share o f overall public debt' to GDP has expanded from 19.5 to 47.8 percent o f GDP from 1995 to 2007. Access to external and domestic financing has, however, become not as I 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 favorable in terms o f costs and Source: CNB, MoF, staff estimate. availability as in 2006. Also, the use o f Public debt i s defined as the debt o f consolidated general government, general government guaranteed debt and the debt o f Croatian Bank for Reconstruction and Development (HBOR). 33 privatization receipts to finance deficits cannot be part o f a long-term strategy as receipts are expected to drop o f f sharply after the privatization o f telecom and o i l company in 2007. B. AND FISCALSUSTAINABILITY STRUCTURAL BALANCE 1.14. As a result of moderate recent Table 1.3: General Government Debt and Interest fiscal consolidation, public debt Pa merits % of GDp growth slowed down and the public I nd T n t n r-.uL I...-& debt ratio stabilized at below 50 General Government Debt Payments percent of GDP in 2006 and 2007. 1997 2006 Difference 1997 2006 Government borrowing shifted towards Lithuania 15.6 18.2 2.6 0.8 0.7 9.6 10.6 1.o 0.9 0.5 6.3 4.0 -2.3 0.3 0.2 13.1 30.1 17.0 1.1 1.1 44.0 47.6 3.6 4.5 2.7 16.5 12.4 -4.1 3.8 0.8 64.0 65.6 1.6 9.8 4.0 105.1 22.8 -82.3 8.3 1.3 23.6 27.1 3.5 2.4 1.4 33.1 30.4 -2.7 2.4 1.5 Av. EUlO 34.3 26.9 -7.4 I 3.4 1.4 EU15 71.0 63.0 -8.0 I 4.5 2.7 has expanded its public sector Croatia 27.6 38.0* 10.6 1.5 2.2 indebtedness over the last decade. Croatia I’ 32.9 47.8* 16.9 1.5 2.2 34 Was the Fiscal Policy Procyclical? 1.19. Assessing the fiscal stance by focusing solely on Table 1.4: Croatia: Characteristics o f Government Debt, in % conventional measures can be 2002 2003 2004 2005 2006 s misleading a some expenditure and revenue components are sensitive to the business cycle. Currency Composition 2/ 100 100 100 100 100 Thus, a higher fiscal deficit cannot Euro 63.2 61.9 64.1 57.3 54.0 always be attributed to a Kuna 4.8 6.7 16.1 23.7 33.3 loosening o f the fiscal stance, but Yen 12.9 13.5 8.3 8 5.1 may simply reflect that the Dollars 17.7 16.9 10.7 10.3 7.2 economy i s moving into a cyclical Others 1.4 1 0.8 0.7 0.4 downturn. This problem, to some degree, can be addressed by Structure o f Interest Rates 100 100 100 100 100 eliminating the self-correcting Fixed 52.8 57.9 62.3 60.0 64.7 Floating 47.2 42.1 37.7 40.0 35.3 cyclical component o f the net deficit. In assessing the fiscal stance, the primary balance i s O f central government debt. general viewed as having two Sources: Selected IMF and World Bank reports. components: a discretionary component or cyclically adjusted balance (which in essence i s a policy variable); and a non-discretionary component that moves with the business cycle'. Construction o f the cyclically-adjusted budget balance entails estimation o f the output gap-defined as the difference between actual and potential (trend) output- -as a business cycle indicator. 1.20. Evidence from the last decade suggests that for much of the period Figure 1.6: Fiscal stance from 1994 to 2010 fiscal policy did not contribute to 70 stability, but instead magnified the 50 effects of external shocks'. From 1995 to 1999, with the exception o f 1998 when fiscal policy was restrictive and countercyclical, discretionary fiscal policy was expansionary and acted n procyclically. I the period 2000-2002 fiscal policy was restrictive and, because the output gap was negative, had a stabilizing influence. In 2003, I DFiscal stance -Output gap 1 discretionary fiscal policy was Source: CROSTAT, MoF, WB staff calculation expansionary and again amplified the business cycle. Since 2004, government carried out restrictive fiscal policy with countercyclical or neutral behavior as the new political cycle approaches. The fiscal tightening that should have accompanied the monetary tightening in the periods o f a large current account deficit was mostly missing. Tight money and a loose fiscal stance not only exacerbated the pressure towards appreciation o f the real exchange rate, but also adversely affected the private sector through the resulting high interest rates." 'For the methodology behind the construction o f the cyclically adjusted balance refer to Annex A. This analysis suggests that fiscal policy was more expansionary between 1995 and 1998 as well as in 2003 than indicated by the conventional primary balance. In 2000-2002, however, it appears that the fiscal policy was more contractionary than what the conventional primary balance would suggest. loThe effect o f the fiscal-monetary policy m i x on the exchange rate can be illustrated by a modified version o f the Mundell-Fleming model in which i t i s assumed that the domestic and foreign financial markets are perfectly 35 What is the Size o the Debt-Stabilizing Primary Balance? f 1.21. Calculations of Table 1.5: Scenarios for the Debt Stabilizing Balance the debt-stabilizing Real Real Balance primary balance are only GDP Interest Inflation Growth Rate Rate Primary Fiscal a stylized tool for (in percent) (in percent o f GDP) assessing debt prospects. 2006 Outcome 4.3 1.1 3.2 -1.8 -4.1 Assuming real GDP growth o f 4.5 percent, Baseline Scenario 4.5 2.0 3.0 -1.1 -3.4 inflation o f 3 percent and Growth Scenarios 2.5 -0.2 -2.5 an average nominal interest 3.5 -0.6 -3.0 rate o f 5 percent, the debt- 5.5 -1.6 -3.9 stabilizing primary balance Interest Rate would be 1.1 percent Scenarios 3.0 -0.6 -3.5 4.0 -0.1 -3.4 (baseline scenario)." 5.0 0.4 -3.4 Including interest outlays o f 2.3 percent o f GDP, this Inflation Scenarios 3.0 2.0 -0.6 -3.0 implies a general 1 .o 4.0 -1.6 -3.9 government balance o f 0.0 5.0 -2.0 -4.4 Source: World Bank staff calculations. 3.4 percent o f GDP under the baseline scenario'*. While maintaining a primary deficit equal to 1.1 percent o f GDP would help stabilize general government debt at below 40 percent o f GDP, excluding government guarantees, fiscal policy i s guided by considerations other than those taken into account in this stylized analysis. The large and increasing current account deficit, for example, implies a need for even tighter fiscal policy. Even abstracting from these considerations, the simple analysis in this section suggests the authorities should have tightened fiscal policy by 0.6 percent o f GDP relative to the preliminary 2007 outcome, with pensioners' debt repayment equal to an additional 1.2 percent o f GDP included, to ensure debt stabilization. The 2008 budget, along with the pensioners' debt repayment scheme taken off-budget, if implemented will be consistent with this policy. 1.22. Fiscal prudence would require consideration of the impact of alternative real GDP growth rates, interest rates and inflation on the debt-stabilizing primary balance. Were growth to be one percentage point lower than assumed under the baseline scenario, or were inflation to be one percentage point lower, or were interest rates to be 100 basis points higher, the debt-stabilizing primary balance would be substantially tighter, a 0.6 percent o f GDP deficit rather than the 1.1 percent deficit calculated under the baseline scenario. These deviations from the baseline scenario are reasonable and the authorities would be well advised to consider their implications for elaborating the fiscal stance. integrated, thus allowing us to use the interest parity condition as in Dombusch (1976). In this model, a contractionary monetary policy mixed with an expansionary fiscal policy leads, unambiguously, to an appreciation o f the domestic currency. 11 With transfers f r o m the central bank to the government amounting to nil during 2003-2005 and 0.1-0.2 percent o f GDP earlier, it i s assumed that seignorage and interest o n foreign reserves i s capitalized by the central bank and i s irrelevant for the debt sustainability analysis presented here. See Annex B for the formula used to calculate the debt-stabilizing primary balance. 36 Table 1.6: Croatia: Government Debt, Sustainability Analysis and Stress Tests, 2006-2011 (in percent of GDP unless indicated otherwise) 2005 2006 2007 2008 2009 2010 2011 Primary Balance -1.8 -0.9 -0.5 -0.4 -0.1 0.4 1.1 Privatization receipts 0.3 1.2 0.7 0.4 0.3 0.1 0.1 Government debt* (In millions of kuna) 108,566 110,412 113,981 113,223 118,279 123,422 126,644 (In % o f GDP) 46.9 44.1 41.4 37.3 35.6 34.0 32.0 Nominal GDP (Inmillions o f kuna) 23 1,349 250,590 275,078 303,800 332,200 362,600 395,500 Real Growth (Inpercent) 4.3 4.8 5.6 4.5 4.7 5.0 5.O Implicit GDP deflator (Percent change) 3.2 3.4 4.0 5.7 4.4 4.0 3.9 - Exchange rates end of period Kuna/Euro 7.38 7.35 7.33 7.27 7.25 7.25 7.27 KunalIJSD 6.23 5.58 4.99 4.69 4.55 4.59 4.59 USDEuro 0.845 0.759 0.681 0.645 0.628 0.633 0.631 Yen/USD 117.5 118.9 113.1 106 106 106 106 Nominal interest rate (Inpercent) 4.7 4.3 4.6 4.9 5 .O 5.0 5 .O Real interest rate (Inpercent) 1.5 1.3 1.7 2.2 2.4 2.4 2.4 Scenarios Scenario with the primary balance at 2005 45.0 45.3 46.0 46.7 47.5 48.5 levels Scenario without privatization receipts 47.0 48.2 47.9 47.3 46.8 46.1 Scenario with all variables at 2005 levels 48.0 49.2 48.9 48.1 47.4 46.6 Stress Tests Real interest rate Up 50 basis points 45.5 46.1 45.9 45.4 45.0 44.5 Up 150 basis points 45.9 47.0 41.2 47.1 47.1 47.0 Real growth Down 1 standard deviation 45.5 45.9 45.5 44.8 44.1 44.0 Down 2 standard deviations 45.5 45.9 45.5 44.8 44.1 44.4 Combined interest rate and growth shock 50bps+l standard deviation 45.5 46.1 45.9 45.4 45.0 45.0 Real depreciation, one-off 20 percent 52.1 52.4 51.8 50.9 50.2 49.5 30 percent 55.4 55.7 55.1 54.1 53.3 52.5 *Including HBOR and excluding guarantees Source: Ministry of Finance, Croatian National bank and World Bank staff calculations. 1.23. Under the authorities’ current medium-term fiscal projections, general government debt i s likely to remain under control over the medium term. With the policies now in place targeting narrowing o f the primary deficit and completion o f privatization o f large companies, borrowing requirements will decline and enable general government debt to fall to 43.5 percent of GDP by 201 1. After that, a primary deficit o f 1 percent o f GDP will stabilize debt at that level. 1.24. Stress tests reveal that fiscal sustainability i s vulnerable to interest rate and exchange rate shocks. Were interest rates to increase by 150 basis points from their current levels, government debt will remain above 47 percent o f GDP despite the assumed fiscal consolidation. Were the kuna to experience a one-off depreciation o f 30 percent, government debt will rise to about 55 percent o f GDP and decline only gradually over the medium term. Government debt appears resilient to modest shocks t o real GDP growth, by contrast, with a 1 standard deviation shock to real GDP growth (or growth o f 3.5 percent rather than 4.5 percent) keeping debt below 45 percent o f GDP. 37 C. VULNERABILITY EXTERNAL 1.25. External imbalances remain large despite some fiscal tightening in 2004-2006 and efforts b y the monetary authorities to curb foreign borrowing b y domestic banks. The renewed increase in the current account deficit in 2006 and 2007 and the ongoing rise in external debt reflect largely private sector imbalances, with savings among companies and households lagging investment outlays. Ailing enterprises, propped in part by state aid to them as large as 2.4 percent o f GDP, added to corporate imbalances and imports. With overly restrictive regulation hampering business creation and exit and a less than favorable business environment limiting inflows o f greenfield foreign direct investment, growth in exports has been substantially below the pace o f most EUlO countries. Households have also reduced savings and increased borrowing from domestic banks to fund purchases o f real estate and consumer durables, the latter increasing imports and the former supporting the strong increase in real estate prices that has been magnified by subdued supply response, including due to substantial construction regulatory and infrastructural costs. 1.26. Slower growth in export volumes, together with higher prices for imported energy and increased earnings accruing to foreign investors, widened the current account deficit to 8.6 percent of GDP in 2007 from 6.6 percent (in USD terms) in 2005. Deterioration o f the foreign trade imbalance in 2006/7 was mainly associated with credit growth-related increase in private investment. Central bank measures that have been introduced in 2005 and 2006 and tightened in 2007 to curb this credit growth and related banks’ foreign borrowing proved to be mostly ineffective, as the profitability o f banks’ new lending remained high by international standards. 1.27. W i t h the public offerings of the oil and gas company INA and T-HT telecom company, as well as recapitalizations of some banks, foreign direct investment (FDI) in 2007 recorded a strong increase. The dominant source o f FDI was reinvested earnings and recapitalizations o f several banks by mother banks abroad. Financial intermediation, telecoms, pharmaceutical production sector remain the sectors that attracted the largest FDI; a similar structure to late 90’s with some initial diversion o f FDI into food and beverages production and real estate services. FDI amounted to U S D 4.8 billion in 2007 (or 9.1 percent o f GDP), which i s 40 percent more than the last year’s successful performance, and over-exceeded CAD financing needs. 1.28. Overall however, net capital inflows have consistently exceeded the current account deficit, boosting foreign exchange reserves. Reserves rose to USD 12.2 billion by the end o f 2007, equivalent to 5.2 months o f imports o f goods and non-factor services, which i s an increase o f 6.3 percent on top o f 30.5 percent increase in 2006. Net capital inflows surged in 2005 and 2006 after slumping in 2004, the first reduction in net capital inflows since 2000. The jump in net capital inflows in 2005 reflected increase in FDI, higher borrowing from abroad by banks and corporate sector, and a significant drawdown on banks’ excess FX holdings abroad. Drawdown o f cash and deposits amounted to U S D 1.6 billion in 2005, which was around one third o f total net capital inflows. Banks boosted deposit drawdowns to fund domestic credit, as direct borrowing from abroad was limited by the growing cost o f regulation. In 2006, this was reversed, while mother banks invested substantially through deposits in daughter banks. 38 Figure 1.7: Evolution o f Croatia's External Vulnerability, 2000-2007 Real GDP Growth has been strong ... ... and injlatwn m o k r a k 6 6 [ 1 2 - m m h percentchange) 5 5 10 8 demand 8 - 2 0 . / - 0 -2 . -2 0 - 0 l 2000 2001 2002 2003 2004 2005 2006 2007 2000 2001 2002 2003 2004 2005 2006 2007 Creditgrowth haspicked up,fun&d in ... ... while the current account widened large part by foreign borrowing anew ... 5 t 2000 2001 2002 2003 2004 2005 2006 2007 i 5 ." -6 -8 4 ... and external debt increasedfurther. Public debt has started declining. 100 , , 100 55, I 95 53 90 51 85 49 80 47 75 45 70 43 65 41 60 55 39 50 37 45 35 2000 ZOO1 2002 2003 2004 2005 2006 2007 2000 2001 2002 2003 2004 2005 2006 2007 Sources: CROSTAT, Ministry ofFinance, CroatianNational Bank; and World Bank staff estimate 1.29. External debt rose further in 2007 and remains a source of potential vulnerability. External debt rose to 95.7 percent o f GDP by the end o f 2007 from 89.8 percent in 200613 after it had more than doubled since 1998. Relative to current account receipts (194.9 percent o f total exports) external debt i s one o f the largest in the region. Relative to GDP, the ratio i s comparable to Estonia's, Hungary's and Latvia's only. Large financing needs impelled considerable external borrowing by public sector and, subsequently, by private sector. Government external debt amounted to 19.2 percent o f GDP at the end o f 2007, while domestic banks and other sectors (including intercompany lending) owed foreign creditors the equivalent o f 25.4 and 50.9 percent o f GDP, respectively. l3Em-denominated debt at the end o f 2007 increased a bit less, from 85.5 percent in 2006 to 89.1 percent o f GDP, due to S U dollar depreciation. 39 Government’s share was declining in the last three years (end-2004 share was 27.7 percent) due to a shift o f deficit financing from foreign to domestic markets. Mirroring this shift, increase in banks’ share was partly reflecting their increased exposure to the government at domestic market. External debt o f banks went down from 31.4 percent at end-2006 to 25.4 percent o f GDP at end-2007. I n contrast, external debt o f other sectors (mostly enterprises) stood at 39.4 percent o f GDP at end-2007, making up 41.2 percent o f total external debt. These debt creation flows were outside the scope o f influence o f monetary policy, thus contributing to the overall increase o f external debt in 2007. Short- t e r m foreign debt was equivalent to 50.8 percent o f foreign exchange reserves at the end o f 2007 and i s consistently fluctuating around 14 percent o f total external debt. BOX1.2: Lessons from Portugal and Singapore Portugal represents the case o f the most severe real adjustment o f imbalances created during the credit boom phase. The large FDI inflows in the non-tradable sector led to a domestic demand boom in the late 1990s and a surge in domestic credit (especially for consumer and housing loans) and in imports. Combined with stagnating domestic savings, these trends together with Euro appreciation on global markets led to a sharp increase in the current account deficit. GDP growth suddenly came to a halt in 2001. As productivity growth stopped, pressures on the REER increased, leading to a loss in competitiveness, which Portugal could not reverse through monetary policy because o f i t s use o f Euro. Hence, the current account deficit remained high, and, with a high fiscal deficit, there was n o room to stimulate aggregate demand. On the other hand, experience of Singapore showed that for a small open economy high level of external imbalance alone might not be the case for concern to policy makers if current account deficits are financed by capital inflows that lead to increase in productivity and technological transfer. Singapore experienced persistent current account deficits from 1965 to 1984 averaging 10 percent o f GNI, financed b y large capital inflows mainly in the form o f FDI. Large capital inflows and external imbalance over two decades were not a cause o f concern for policymakers as these inflows represented the investment needs o f a rapidly developing industrialized economy. Subsequently, since 1998, the current account surplus has accounted for 21 percent o f GNI. The adjustment in external balance did not involve sharp declines in output or adjustments in the exchange rate regime. Persistent current account deficits in Singapore were associated with the rise in domestic investment rather than a fall in savings. Good policies can help countries to avoid excessive overheating and disorderly adjustments in external balances during the convergence path. There are limited traditional monetary policy options for small-open economies with fixed exchange rates, and policy-makers should be aware that: Presence o f current account deficits does not automatically indicate that there i s a problem requiring immediate policy action. However, current account deficits should not be ignored because they might signal that incentives to save and investment decisions may be incorrect, requiring policy interventions b y government; Policy action should be focused on increasing savings, not only on part o f increasing public savings, but also creating proper incentives for encouraging private savings; In absence o f negative external shocks, if current account deficits are financed by attracting capital inflows that contribute to technological transfers and future competitiveness, current account adjustments can occur gradually along the transition path without sharp adjustments in output or currency exchange rate. I Source: World Bank Regular Economic Report EU8+2. January 2007. 1.30. Given values of international liquidity ratios for Croatia, no immediate concern arises; however, the large stock of external debt increases the speed and magnitude o f transmission of any adverse external financial shock. Such shocks would be transmitted either through higher interest rates or through barriers to access to long term finance, thereby affecting real performance o f the Croatian economy (Box 1.2). In 2007, amortization due within a year, with short-term debt included, amounted to 49.8 percent o f reserves, while repayments o f long-term debt and total interest amounted to 32.7 percent o f total exports, up by 11.5 percentage points compared to 2005. Despite growing foreign debt, the debt service ratio has been stable throughout the last couple o f years, mainly due to the more favorable term structure o f external debt. 1.31. The vulnerabilities of the financial sector are significant, posing a substantial threat to hard-won financial stability. Euroization o f the economy i s substantial, limiting options for interest rate policy and placing high expectations on managing the exchange rate. Deposits denominated in foreign currency amount to two-thirds o f total deposits and about 90 percent o f the banking system’s foreign assets. In 2007, around 63 percent o f total bank placements was in foreign currency or 40 indexed to foreign currency. Mirroring these developments, lending in foreign currency or in kuna indexed to foreign currency i s also one o f the highest in the region and requires vigilance. 1.32. Vulnerabilities arise from the large share of domestic debt denominated or linked to foreign currency. O f the government’s domestic debt, the equivalent o f 40percent o f GDP i s denominated in foreign currency. Similarly, the bulk o f lending by domestic banks to the private sector i s denominated or linked in foreign currencies. This i s the typical currency mismatch situation that raised concerns about the relationship between currency and credit risk. For that reason, the central bank introduced additional capital requirement for banks’ credit exposure to clients who do not have adequate foreign exchange (FX) earnings coverage o f their FX and FX-related liabilities in 2006. This regulation came on top o f high capital adequacy ratio for the banking system as a whole (15 percent as o f mid 2007), so banks initiated new cycle o f re-capitalizations in the second half o f 2007. Given generally perceived strength o f accounting and prudential standards, and the degree o f development o f risk management and banking supervision, soundness o f the banking system seems to prevent immediate vulnerability threats or sudden reversals in capital flows. D. MONETARY RESPONSE POLICY 1.33. With monetary policy anchored in maintaining price and exchange rate stability, large capital inflows have boosted domestic liquidity and credit, creating challenges for the central bank. T o slow the pace o f foreign borrowing by domestic banks, the central bank introduced in August 2004 marginal reserve requirements (MRR) on domestic banks’ growth in foreign l i a b i l i t i e ~ ’ ~ . The rate o f M R increased from the initial 24 percent to 30 percent in February 2005, 40 percent in R June 2005 and 55percent in December 2006. Further, the bank introduced special reserve requirements (SRR) levied on domestic banks’ domestic and foreign bond issues, with the rate set at 55 percent o f the growth relative to the average at the beginning o f 2006. 1.34. The above-described moves to slow the pace of foreign borrowing were accompanied by measures that resulted in easier monetary policy, designed with a view to facilitate the government’s shift to borrowing in domestic currency. These measures included the reduction o f the minimum ratio o f liquid foreign assets that banks are required to hold against foreign liabilities from 35 to 32 percent in February 2005 and a cut in the minimum required reserve from 18 to 17percent from the beginning o f 2006. On balance, these measures eased monetary conditions substantially, as reflected in the discussion o f the structure o f net capital inflows in 2005 and associated drawdown o f banks’ FX cash and deposits. The resulting acceleration in domestic credit growth from 13.1 percent during 2004 to 20.3 percent during 2005 prompted the central bank to reverse February 2005 decision by broadening the base for FX assetdliability ratio calculation by introducing FX-linked liabilities. Credit continued growing albeit at a slower pace, at 22.7 percent, in 2006. The fundamental change in the monetary policy stance was confirmed by end-2006 decision to introduce compulsory purchase o f CNB bills on credit growth in excess o f 12 percent per annum. Further tightening happened in July 2007, when the C N B tightened the credit growth ceiling for the second half o f the year to three percent. 1.35. The acceleration in domestic credit was driven by faster lending to nongovernment borrowers in 2006-2007, in contrast with 2004-2005 period when lending to the government also represented a significant portion of new lending. Growth in credit t o private borrowers increased to 23.8 percent in 2006 from 18.5 percent during 2005 and 13.8 percent during 2004. Net lending to the government grew by 11.1 percent in 2006, representing a visible slowdown compared to previous years 44.1 percent. Credit growth has recently been increasingly focused on housing loans and loans to enterprises. Consequently, in 2007 the credit growth rate was 13.4 percent, with significant contribution from household loans, particularly housing loans. Total bank placements t o corporate l4The M R was levied on the excess o f foreign liabilities relative to an initial calculation period, June 2004. R 41 sector continued to slow down which may be the effect o f substitution with direct borrowing from abroad. 1.36. Thirteen interventions in 2006 (net purchase of EUR 1.2bn) and five interventions in 2007 (purchase of EUR 0.8bn) helped limit the Figure 1.8: ULC in Industry kuna appreciation. The currency appreciated one percent against the euro during 2006 (1.9 percent 30 1 against U S dollar) after rising 1.3 percent on average in 2005, boosted by strong capital inflows. In 2007, kuna depreciated 0.2 percent against the euro, but appreciated 8.1 percent against U S dollar. The central bank’s emphasis on maintaining exchange rate -20 I.,, ,/’ t C Z I HU-R-H-SK-SI .._J stability has limited the kuna appreciatioddepreciation against the euro within a band o f 5 percent since 2000. 1.37. With the kuna broadly stable against the euro and inflation contained at low single digits, the real effective exchange rate (REER, CPI deflated) has appreciated by less than 15 percent from 2000 to 2007. During that period, the share o f Croatian exports in EU markets rose by one-third, reflecting structural changes that helped to mitigate cost pressures. Unit labor costs (ULC) appear to have risen more than in most EUlO countries since 2000, and especially during 2006-7, underscoring the need to further accelerate structural reforms (in particular a Source: RER EU8+2, World Bank, 2007 mismatch between labor demand and supply that has exacerbated wage pressures in 2007) and to improve the business environment in order to attract greenfield FDI in the tradable goods sector. E. CONCLUSIONS 1.38. This chapter presented the macroeconomic background against which the detailed fiscal discussion of the rest of the report i s developed. A lot has been accomplished to nurture macroeconomic stability, but potential external vulnerabilities persist and need to be tackled promptly. As authorities decided to conclude tighter collaboration with the IMF upon completion o f the Stand-by Arrangement in November 2006, their responsibility for pursuing sustainable policies have increased, especially in the area o f fiscal adjustment. Policies centered on the level, composition and targeting o f expenditures, as discussed in the remainder o f the report, need to be complemented with efforts to advance structural reforms with renewed rigor to create conditions for stronger growth in output, exports and employment. 42 Box 1.3: The Relationship with the IMF Croatia’s last Stand-By Arrangement (SBA), covering 2004 to November 2006, passed the Third and the last Review on a lapse-of-time basis on September 29,2006. The ultimate objective o f the SBA was to reduce external vulnerabilities by narrowing domestic savings-investment gap and stabilizing the external debt-to-GDP ratio. The main policy to achieve this goal was through fiscal and quasi-fiscal adjustment during 200406. Overall, the program acknowledgedadequate progress on sustaining macroeconomic stability, but emphasized delays in the implementation o f structural reforms, especially privatization and the need to accelerate fiscal consolidation efforts. The Croatian Government confirmed in 2006 i t s intention not to require a successor arrangement, 1.39. While prospects for EU membership provide an impetus for reform progress, greater effort i s required to advance fiscal consolidation if stability i s to be maintained. Policy slippage or failure to sustain export performance and rein in the current account deficit could lead to instability, deterioration in market confidence, reduced capital inflows, and balance o f payment difficulties. While Croatia’s currently still favorable and long-standing market access mitigates this risk to an extent, investor sentiment could s h i f t rapidly as seen from the ongoing global financial turmoil. 43 2. FISCAL FRAMEWORK 2.1 With public spending at about 49 percent of GDP, Croatia has developed one of the largest public sectors in Europe and one that i s larger than optimal from a growth and efficiency point of view.� I t i s also almost ten percent above the public spending levels in new EU member states. Recent work suggests that expenditures over 35 percent o f GDP may have negative implications for growth. Moreover, Croatia s t i l l needs to integrate EU-accession related costs into i t s public finances and there remain large contingent liabilities (debt repayment to pensioners, guarantees issued to shipyards and other sectors, hospital arrears) that underestimate the overall size o f the public sector. Spending on public sector wages, transfers and subsidies, and government consumption are particularly high relative to comparator countries, and capital spending is three times that o f the EU largely because o f an ambitious roads program. These facts point to the need to implement structural reforms in key areas, including pensions, health, social spending, defense, public administration and transport. 2.2 Up to recently, Croatia has been able to finance a significant portion of the increase in public spending by increases in tax burden16, but over the medium term this process must be reversed. In the short run, macroeconomic stability precludes adoption o f deficit-creating cuts in taxation. However, in order to increase competitiveness, the tax burden o n the economy at about 40 percent will need to be significantly reduced in tandem with appropriate expenditure restructuring measures. These changes should be made in a manner that improves the incentive and redistributive characteristics o f the current tax structure which at present features a distortionary combination o f high rates and excessive tax preferences. 2.3 Experience over the last decade has shown how difficult it can be to achieve a lasting consolidation. This suggests that the Government needs to improve i t s own knowledge base o f the public sector, and strengthen analytical capacities in both core and line agencies to examine expenditure issues and assist in making strategic choices. Ensuring coherence between medium-term strategic plans and the budget planning process would be among the key priorities. This would entail implementation o f a standardized methodology for ministry strategic plans, drafting o f an annual strategic document pointing out key policy priorities, and adoption o f an annual strategic document as a supplement to the budget proposal reflecting arguments for selection o f priorities. A. FISCALDEVELOPMENTS NU I R GD THE LAST DECADE 2.4 The expansion of public sector spending from 1990’s due to the need to introduce a new layer of government and to allocate resources to the war effort, continued until the end of the last decade when the public sector size, as measured by consolidated general government expenditure reached almost 57 percent of GDP. Post-war expenditure expansion also reflected reconstruction activities, social spending linked to the war and the Government’s inability to resist social demands aimed at rapidly recovering pre-war levels o f consumption. l5I t needs to be noted that Croatia did not correct i t s official GDP figures fully for non-observed economy, as o posed to all new EU member states (see B o x 1.1). ‘gfvleasured as a share o f tax revenues in GDP. 44 2.5 Up until 1999, fiscal policy played a key role in the Government’s early stabilization efforts, as fiscal deficits were kept relatively low, around three percent of GDP. To reconcile i t s stabilization program with the expenditure expansion, considerable efforts were made on revenue mobilization. In fact, as a result o f successive fiscal reforms, the Government succeeded in improving tax administration and at the same time, made substantial progress in aligning i t s tax system to international standards. A key step in this direction, was the introduction o f the VAT, at the beginning o f 1998, which generated an increase in tax revenues equivalent to almost 4 percentage points o f GDP n in that year. I aggregate, tax collection expanded by 11 percentage points o f GDP between 1991 and 1998, with tax revenues as a share o f GDP reaching 46.9 percent o f GDP in 1998, turning Croatia into one o f the most highly taxed economies in the region. 2.6 The recession that started in late-1998 and continued throughout 1999, boosted low fiscal deficits to unsustainable levels. The expansion o f revenues ended in late 1998 amid a contraction o f the economy, and with government inability to cut expenditures in an election year, fiscal deficits hit eight percent o f GDP. A fiscal consolidation process that started in 2000, supported by the IMF Stand-by Arrangement, helped reduce the overall spending level by some six percentage points o f GDP by end-2002. This was achieved mostly through cuts in mandatory spending, like wages and social transfers. However, fiscal policy slipped again in 2003 due to excessive public investment in highways and roads. At the same time, the overall tax burden was reduced by four percentage points o f GDP resulting in a deficit over 6 percent o f GDP in 2003. 2.7 Restoring fiscal discipline and transparency in public finances after 2003 was important not only from a macroeconomic point of view but also for building credibility and protecting the credit rating of the country. Thus in August 2004, a new Stand-by Arrangement was concluded which supported fiscal consolidation as the main tool for reducing external vulnerability. Fiscal policy has tightened since 2004, with deficit falling from 6.3 percent in 2003 to 2.3 percent o f GDP in 2007 (excluding off-budget pensioners’ debt repayments that add an additional 1.2 percentage point to the deficit figure and h a l f o f percentage point o f HBOR� deficit). The fiscal consolidation was achieved through reductions in expenditures o f about two percentage points o f GDP, led by cuts in the wage bill, subsidies, current transfers and capital expenditures. An equally large contribution to a deficit reduction, however, came also from improved revenue collection (of about 1.8 percentage points of GDP) and consisted mainly o f one-off nontax receipts (dividends from public enterprises and concessions), capital revenues and grants.’* However, this has proven t o be a weak strategy and fiscal slippages emerged from 2004 on, made worse by policy reversals in pension and social spending areas, which were addressed only after costly delay, leading to a less ambitious fiscal deficit target for 2005-200619. If corrected for off-budget pensioners’ debt repayments equal to 1.2 percent o f GDP and the HBOR deficit o f 0.5 percent o f GDP, the 2007 fiscal deficit was marginally reduced compared to 2006. 2.8 The inertia o f spending patterns calls for decisive consolidation actions, a the impact s will be felt only in the medium-term. The current level o f spending at around 49 percent o f GDP i s two percentage points o f GDP above the EU15 level and some ten percentage points o f GDP above the Croatia’s peers (EU new member states). Reducing the deficit to a sustainable level will require further reduction in public expenditures in a way that can be sustained. Such a fiscal consolidation will be made more challenging when one considers that additional expenditures will be necessary to l7HBOR stands for the Croatian Bank for Reconstruction and Development. 18 Notably, tax revenues as a share o f GDP declined by half percentage point o f GDP in 2007 compared to 2003. 19 The 2005 consolidated general government deficit was 4.1 percent as opposed to original 2005 budget deficit target o f 3.7 percent o f GDP. The 2005 M T E F proposed 2006 general government deficit at 3.2 percent, while the outturn was 3.0 percent. However, if off-budget pensioners’ debt repayment would be taken into account, a 2006 overall fiscal deficit would be 4.1 percent o f GDP. 45 meet pre-accession requirements. Prioritization i s important. Although it i s difficult to gauge the net fiscal effect at this point, there i s a need to restructure public spending to absorb current and projected EU funds and transfers. For example, while for the new member states, the fiscal costs o f EU accession have sometimes been estimated at an average three percentage points o f GDP annually, i t i s worth noting that they managed to absorb them within a declining spending envelope. This also highlights the need for appropriate institutional and absorption capacity, and co-financing and bridge financing instruments. 46 Box 2.1: The Scope and Organization o f the Public Sector in Croatia Thepublic sector in Croatia comprises the Central Government, the Extra Budgetary Funds and Agencies and the Local and Regional Governments. The Central Government (CG) and the Extra Budgetary Funds and Agencies (EBFs) combine to form the Consolidated Central Government (CCG); which, in turn, consolidated with Local and Regional Governments (LGs) forms the Consolidated General Government (CGG). The CG, also known as Budgetary Central Government or simply the State Budget; i s composed o f 15 ministries, 13 offices, 4 central state offices and 9 state administrative organizations. There are currently six EBFs and one development bank: Water Management, the Croatian Privatization Fund, State Agency for Deposit Insurance and Bank Rehabilitation, Croatian Roads, Croatian Highways, Environment Protection Fund, and the Croatian Bank for Reconstruction and Development�. LGs are composed o f 426 municipalities, 123 cities and 21 counties. The City o f Zagreb has a special status o f both town and county. I.Central Government I JI ,.............. ............................................................... ! Extra Budgetary Funds and 1 ...................: A gencies j Government i............................................................................ : ,...................................................................... I Local and Regional � In 2008, I 111. General Government l’ e.................... Governments . j ....................................................................... Pension, Health and Employment Fund were transferred under the Budgetary Central Government. The General Government financial reporting excludes the Croatian Bank for Reconstruction and Development (HBOR), except for the debt reporting. B. OPTIMAL SIZE OF GOVERNMENT 2.9 In general, there i s no ‘ideal’ size for the public sector and to some extent the size of the public sector in a democratic society reflects voter preferences. Nevertheless, the need to keep government debt manageable, and to increase competitiveness by limiting the tax burden and associated distortions, define the “sustainable� ratio o f consolidated general government expenditure to GDP that Croatia needs to achieve. Table 2.1: Consolidated General Government ExDenditure in Selected Countries (% o GDP) f 1995-99 1999-06 Difference 2006 Bulgaria 41.0 38.8 -2.2 36.8 Croatia 52.5 50.7 -1.8 48.4 Czech Rep. 43.9 45.1 1.2 44.0 Hungary 53.0 49.8 -3.2 52.9 Poland 46.4 43.6 -2.8 43.6 Romania 39.3 36.7 -2.6 35.0 Slovenia 48.1 48.3 0.2 36.8 Baltic countries l’ 35.1 42.2 7.1 35.1 EU 15 47.0 48.0 1.1 49.3 Cohesion countries2’ 43.3 43.2 -0.1 43.1 �Estonia, Lithuania and Latvia; 21 Spain, Greece, Portugal and Ireland. Sources: Government Finance Statistics, IMF; World Bank database, MoFs. 47 2.10 Government budgets of transition countries prior to the transformation of the economic system were characterized by large subsidies and transfers, to both enterprises and households. In the process o f transition, consolidation o f public finances has been one o f the major tasks faced by policy makers. However, determining the optimal size o f government i s an interesting challenge for all countries regardless o f the level o f economic development. 2.11 Although there i s a large empirical literature on the relationship between government size and economic growth, only a few studies attempt to empirically determine the optimal government size. Even more pronounced i s the lack o f empirical literature o n the size o f the government in transition countries. Below we present estimates o f government spending (as a share o f GDP) as a function o f various underlying factors, using a set o f assumptions and a model developed by Barbone and Polackova (1996). This i s a cross country econometric analysis covering old and new EU countries and Croatia, based on Eurostat ESA95 public finance statistics. 23 Box 2.2: Factors Potentially Affecting Government Spending The determinants o f growth of government spending have been analyzed quite extensively and the existing literature offers a wide range o f potential underlying factors which can be broadly classified to three groups: economic, demographic and societal. Wagner ( 1883)20hypothesized that public goods and services are superior goods (rich societies want proportionately more o f them relative to private goods, than do poor ones.) Accordingly the ratio o f budgetary spending to GDP should rise with per ca ita GDP. Another economic factor found to be positively correlated with government size i s trade openness’! although one might intuitively expect the opposite, since i t i s often assumed that governments in closed economies intervene more in the market via trade restrictions. This paradox i s explained by arguing that government expenditures are used to provide social insurance against the risk o f terms o f trade shocks that open economies face. A further hypothesis i s that centralized governments spend more. The reasoning i s that fiscal decentralization encourages competition for tax bases which may help to reduce the size o f government, and that reliance on grants and transfers from higher levels o f government to finance sub-national governments i s associated with larger governments and fiscal imbalances at the sub- national level. Finally, governments in societies with relatively unequal income distribution may spend more. The growth o f population, as well as demographic changes (ageing population), urbanization etc., are likely to create upward pressures on government spending22.For example, a large share o f elderly in the population increases demand for government spending on pensions, health care, and social security, while a large share o f young in the population should increase government spending on education. Societal factors, including cultural, political, administrative factors, can influence government expenditure levels. For example, democratization o f society, or higher literacy rates, or a high level o f social development would increase the demand for social goods. However, these factors proved to be the most difficult to assess, quantify and predict. 2o German political economist Adolf Wagner (1835-1917) formulated so-called “Law o f increasing state activity�. 21 Rodrik, 1998; Alesina and Warcziarg, 1998. 22 Barbone and Polackova, 1996. 23 In the case o f Croatia, ESA95 shows approximately one percentage point o f GDP lower general government spending in 2007 than spending that follows the GFS 1986 methodology, which was the one used throughout the report. The source for Croatia ESA95 i s Government o f the Republic o f Croatia - 2007 Pre-Accession Economic Programme, November 2007, page 21. 48 2.12 The cross country estimates give a n indication of whether the ratios of total general government expenditure to GDP observed in individual EU economies are in line with the ratios predicted from structural characteristics. Drawing o n the above analysis, regression estimates were made using the following explanatory variables: GDP per capita at purchasing power prices (gdp pc) capturing the effect o f the level o f wealth on demand for public services; the ratio o f public debt to GDP (debt) capturing the effect o f greater debt service costs o n public spending; and the age dependency ratio (old) as a proxy for the social need for public spending. Some other explanatory variables, such as secondary school enrollment, the infant mortality rate (both Table 2.2: Regression Results Dependent variable: Total general government as a proxy for the quality o f government spending), the unemployment rate, and the urbanization rate, were also tested but Estimates o f coefficients Adjusted failed to be statistically significant. The gdp PC debt old R square regression results reveal that, ceteris 7.261415 0.099753 0.38253 0.948 paribus, the wealthier society is, the higher (4.81)* (2.71)* (1.28) social needs are, and the larger i s public *t-statistics in the parenthesis. debt, the greater i s general government Source: Author's calculation. spending. One might also observe that GDP per capita has the greatest explanatory power, followed by the share o f public debt in GDP. The age dependency ratio, however, yielded poor explanatory power, which could partly be a reflection o f the pension reforms that took place Figure 2.1: Deviation o f Actual Government Size from in most countries in the sample. Predicted 2.13 Croatia and Hungary appear to be the top "overspenders" among European transition countries, with government expenditure ratios similar to the Scandinavian countries. Based on the economic and demographic indicators, for each country in the sample, the regression predicted analysis level of yields general a I lndexPCblalbrediclBd. Predicted=lOO Source: Author's calculation. government spending given the Figure 2.2: Actual vs. Predicted Level o f General Government explanatory variables. Figure 2.2 Expenditures, % of GDP, 2005* presents the actual and predicted 60 00 level o f general government expenditures for selected 50 00 countries. The predicted 40 00 government expenditure for 30 00 Croatia i s 43.3 percent o f GDP, which i s 5.7 percentage points less 20 00 than the actual. 1000 2.14 Among selected old EU 0 00 T A BG CZ DK EE FI FR HR HU IE LT LV NE PL RO SE SI SK UK countries, the most pronounced "overspenders" are Denmark, OActual E Predicted Finland, France and Sweden. However, this may be a matter o f Source: Author's calculation. 49 public choice related to a desire for the well developed social safety net characteristics o f these countries. In other countries such as Ireland and the Baltics, the predicted values are even larger than the actuals, revealing a much stronger orientation toward private provision o f goods and services. 2.15 The literature on the impact of government spending on economic growth offers quite a wide range of conclusions -- from a detrimental effect on growthz4to evidence of growth- enhancing role�. The theoretical framework developed by Barro (1989, 1990) helps explain such mixed results. It shows that the relationship between the level o f government spending and economic growth i s expected to be positive in the countries where government spending i s below a certain threshold, but becomes negative beyond the threshold. Such a non-linear relationship between public expenditure and economic growth was also found in Varoudakis et al. (2006). Public expenditure may affect growth in a non-linear manner for at least two reasons. As discussed above, governments promote economic growth through provision o f public goods which raise the marginal product o f capital. As the size o f the government grows, the impact o f additional public expenditure may eventually decline at the margin. Or even more abruptly, additional resources may be allocated to “unproductive� core government functions, social transfers, and subsidies that have virtually n o impact on growth. 2.16 Large public expenditure affects growth through the impact on fiscal balance, and fiscal deficits have proven to be more difficult to control in countries with high public expenditures in proportion to GDP.26Economic literature offers evidence o f a negative correlation between the fiscal deficit and public expenditure in recent years, which could be attributable to more expansionary fiscal policy driven by increases in public expenditures. However, it may also reflect the impact o f fiscal automatic stabilizers when growth slows down but spending i s sustained because o f a large share o f non-discretionary expenditure components (wages, interest payments, social entitlements, subsidies). If such large non-discretionary public expenditures prevent a swift adjustment in the budget in the face o f weakening revenues, a growth slowdown i s likely to be reflected in larger fiscal deficits. This negative association implies that large public expenditures may be detrimental for growth by increasing the fiscal deficit, as larger fiscal imbalances are associated with lower growth. 2.17 Large public expenditure may adversely affect resource allocation and growth through various other channels. Large public expenditures usually lead to high taxation if the solvency o f the government i s to be preserved. High tax rates reduce the rate o f return to saving and investment and may also bring distortions into labor markets. The composition o f spending also presumably matters, as sizeable spending on transfers and welfare services may create disincentives for participation in the labor force, while subsidies may distort the allocation o f resources towards low-productivity activities. Large government spending programs in specific sectors such as infrastructure, housing, or health care are often supported by intrusive regulations that may stifle private participation and investment. Moreover, large public expenditure programs may become counterproductive if they are poorly designed due to limited government effectiveness or, in some cases, if they create more opportunities for corruption and rent seeking. 2.18 According to the results of an empirical study on the impact of the size of government 35 on growth in Europe and Central Asia countries~’ percent of GDP appears to be the critical threshold beyond which public spending negatively affects growth. Above 35 percent, a sustained increase o f 1 percent o f GDP in general government expenditures could reduce growth by an estimated 0.3-0.4 percentage points per year. W h i l e the estimate i s rough it indicates that higher levels o f government spending on goods and services distorting effects become more evident, possibly outweighing the benefits. 24 Gemmel(1983), Falvey and Gemmel(1988), Barro (1989, 1990,), Easterly and Rebelo (1993), Guseh (1997). 25 Ram (1986), Grossman (1990), K m a s (1997), and Ghali (1998). 26 Varoudakis et al., 2006. 2’ Ibid. 50 2.19 The estimates above, suggest that in year 2006, the Croatian economy could have enjoyed growth of between 6.0 and 6.4 percent per year instead of the realized 4.8 percent, had the government expenditures been at the level predicted b y our equation. The differences between actual and predicted government expenditures (and the foregone growth) would have been even larger in previous years given the ongoing consolidation o f government sector. It i s clear that private sector led growth in Croatia has been hampered by a public sector that extracts too much from the economy and fails to allocate an adequate share o f resources in support o f growth. Table 2.3: Potential Economic Growth with Respect to Predicted Government Expenditures 2000 2001 2002 2003 2004 2005 2006 Real growth rate 2.9 4.4 5.6 5.3 4.3 4.3 4.8 Potential growth rate (%) 4.3-4.7 5.8-6.2 7.0-7.4 6.7-7.1 5.7-6.1 5.7-6.1 6.0-6.4 Source: CROSTAT and author's calculation. 2.20 Large discrepancies between the actual and predicted government size, especially if accompanied with unsustainable revenue level can threaten the stability of public finances, evidence of which was given b y recent developments in Hungarian public finances. In light o f that, Croatia should devote more effort towards consolidation o f public finances in order to avoid similar events in the future. c. STRUCTURAL REFORMS 2.21 Progress on structural reforms has been mixed and this has weakened fiscal consolidation efforts. Croatia opened EU accession negotiations in December 2005, and a large number o f reforms, encompassing the financial sector, the judicial system, trade policy and public finance were advanced with determination. But progress has been slow in non-bank privatization and corporate restructuring, improvements o f the business environment and reforms o f public administration and labor market. Inflows o f greenfield foreign direct investment have remained modest, limiting scope for stronger growth in output, exports and employment. Foreign investment has also been curbed by resistance to allowing foreign investors to enter the tourism and manufacturing sectors, with investment broadly limited to banking, telecommunications and retail. 2.22 Bank privatization and other financial sector reforms are well advanced. Only two out o f 33 banks, accounting for Figure 2.3: Financial Sector Structure, Assets Distribution in 5 percent o f banking system capital, 2007 are s t i l l government-owned. A major Leasing mmpanies ,,Jn8urance mmwnies consolidation since the mid-1990s has Pension funds 4% 7 5% reduced the number o f banks from 60 I \ I / as o f 1997 to 33 in 2007, and these efforts have been accompanied by strengthened bank and non-bank supervision. The financial system remains quite bank-centric, with 74 percent o f all financial institution Banks assets held by banks. However, 74% 1 leasing and insurance companies, as Source: H A W A and CNB. well as pension and investment funds are developing quickly. The capital market i s becoming stronger, with market capitalization at 143 percent o f GDP in 2007 and the turnover ratio (value o f shares traded as percent o f capitalization) o f 16.8 in 2007. Government securities no longer dominate the active trading since the October 2006 IPO o f INA Oil Company. Bank capital has been strengthened in recent years with privatization, and average capital i s now about USD208 million (end-2007). Average assets per bank stood at USD1,879 million (June 2007). Thus, by transition country standards, Croatia i s among the best performers based on balance sheet indicators. The high share o f lending in foreign currency andor 51 linked to exchange rate and the high share o f foreign currency deposits, however, remain a cause for concern due to potential vulnerabilities created by FX exposures. Despite a reduction in the degree o f unofficial euroization in 2005 and 2006, the phenomenon seems to be structural and difficult to reverse, and therefore calls for special attention by the authorities. 2.23 Progress in privatization in the 1990s was sluggish, and delays in privatization of the state-owned portfolio throughout the first Figure 2.4: Private Sector Share in GDP, 2007 half of this decade have led to the share of GDP generated by the private sector reaching 70 percent of GDP. This i s less than all new member states, including Romania and Bulgaria. Although in 2004-05 most o f the agri- Croatia combinats were sold to domestic private investors, with the metallurgy only in 2007, the Romania state-owned tourism portfolio along with shipbuilding sectors remain in state hands. Despite some acceleration o f privatization in the second half o f 2006 and eariy 2007, a large 40 50 60 70 80 portion o f the roughly 950 companies (down from Over O0 in 3 2004) that are partially Source: EBRD Transition Report 2007 and CROSTAT government owned have financial problems, forthcoming. and the larger ones, including the five state- owned and loss-making shipyards, have repeatedly needed substantial state aid to stay afloat. As far as IPOs are concerned the policy stance i s changing and the Government pursued mass sales o f a 17 percent minority stake in the national o i l company (INA), followed by public offering o f telecom (T-HT) in its final stage o f privatization in autumn 2007. Figure 2.5: Progress with Structural Reforms Initial Phase of Reform Secondary Phase of Reforms Romania Ronrrnia W 2007 Bulgaria 2000 Croatia EU 8 EU 8 I 3.5 3.7 3.9 4.1 4.3 4.5 2.0 2.5 3.0 3.5 Source: EBRD Transition Indicators. 2.24 Subsidies to state-owned enterprises declined by 1.2 percentage point of GDP over the 2003-2007 period� (from over 3.4 percent o f GDP). Further reduction i s likely to be challenging in 2008 amid the planned restructuring o f shipyards and postponement o f their privatization. With the adoption o f more transparent and rigid terms for granting state aid, in accordance with EU state aid rules included under the Stabilization and Association Agreement (SAA), the authorities have little option but to pursue privatization with renewed determination. The Split Steel Mill, Sisak Roll Mill 28 Supported by the World Bank’s Programmatic Adjustment Loan (PAL). 52 and the TLM aluminum plant have been privatized in 2007, while strategic investors are being sought for railways subsidiaries and shipyards. 2.25 The business environment has improved, but major challenges remain. Croatia s t i l l ranks l o w in terms o f the ease o f doing business, although there are encouraging signs.*’ Dealing with licenses, protecting investors and registering property seem to be especially burdensome. An inefficient judicial system s t i l l hinders the exit o f non-viable firms, while execution and enforcement o f contracts and property rights are s t i l l weak compared to OECD countries, despite recent improvements under the judicial reform effort. T o strengthen the investment climate the Government in late 2006 launched the regulatory guillotine, the so-called HITROREZ, which aims to reduce redundant and business-unfriendly legislation by around 40 percent. According to some estimates this alone could bring savings to the private sector, to the tune o f 2.5 percent o f GDP. So far, one-quarter o f recommendations have been implemented thus reducing the administrative burden on businesses. 2.26 Trade liberalization efforts continued along with removal of behind-the-border trade obstacles. With the CEFTA 2006 Agreement signed in December 2006 by all south European governments, the former network o f 32 bilateral trade agreements has been replaced by one which will bring needed trade liberalization and administrative simplification to the Southern European region. Through investments in Selectivity and Risk management systems, as well as I T systems that allow for customs declarations to be submitted electronically in the paperless trading environment, non-tariff costs have been significantly reduced, and Croatian customs rank among the best in the South Eastern Europe.30 D. ECONOMIC COMPOSITIONOF GENERAL EXPENDITURE GOVERNMENT 2.27 The next two sections provide an overview and cross-country comparisons o f government expenditures in order to facilitate identification o f areas where expenditure reductions in the future could be made. I t i s important to note that identifying reforms in the main expenditure programs i s not a one-shot exercise, but must be a continuous process o f review, analysis and change. 2.28 Since the spending peak in 1999 Croatia has reduced the general government spending by 8 percentage points of GDP and this has allowed an equal reduction of taxes at the same time. The fiscal consolidation that began in 2000, supported by an IMF Stand-by Arrangement, reduced spending by almost five percentage points o f GDP, from 56.6 percent o f GDP in 1999 to 52.0 percent in 2001. Fiscal adjustment was carried out through a reduction o f public sector wages, other purchases o f goods and services and capital expenditure (although the latter was completely reversed in 2002 and especially in 2003 due to the implementation o f the first phase o f an ambitious motonvay construction program). 2.29 Progress on reduction of overall public spending was interrupted in 2003, with yet another expansion of the deficit triggered by a surge in capital spending. Starting in early 2004, numerous measures were undertaken to put the process o f fiscal consolidation back on track with the view to reducing general government spending and thus the deficit. Consequently, by the end o f 2006, general government expenditures stood at 48.4 percent o f GDP, down 2.8 percentage points o f GDP from 2003. This reduction was implemented through more effective expenditure controls, but without accompanying robust structural reforms on the expenditure side. According to the data for 2007, once repayment o f debt to pensioners and deficit o f HBOR are taken into account (1.7 percent o f GDP taken o f f budget), the trend in reduction o f the general government expenditure was interrupted. 2.30 The analysis o f the economic composition o f public expenditures in Croatia i s based o n the Consolidated General Government (CGG) accounts and o n a comparison o f the economic 29 The World Bank and the IFC, 2007, D o i n g Business, ~~.doinabusiness.orq, Washington DC. 30 According to TTFSE I project funded by the World Bank. 53 composition o f the C G G expenditure in Croatia with that o f EU new member states, the EU15 and EU cohesion c ~ u n t r i e s . ~ ’o t only i s the current size o f both revenues and expenditures larger in N Croatia than in other transition countries, but also some o f the components and their latest trends differ substantially from those o f the comparator countries. 2.31 Comparing Croatia’s expenditures with those of new EU member states� and EU15 countries, and examining the evolution of the composition of expenditure in Croatia, the following stylized facts emerge: Croatia has one o f the highest levels o f expenditure o f the countries in the comparator group (notably, in 2006 only Hungary had higher expenditures), and o n average over the period 2000-2006, Croatian expenditure was more than 10 percent o f GDP higher than the average EUlO countries and EU cohesion countries. In fact, Croatia’s public sector was extracting some four percent o f GDP more than EU15; Wages and salaries are also o n average higher in comparison to EUlO countries (except for Hungary and Slovenia). Croatia’s wage bill has been declining in percent o f GDP since 2000, and has now approached the average for EU15 countries; Government consumption (excluding wages and salaries) has to some extent contracted relative to GDP throughout the observed period. However, this ratio i s s t i l l two-thirds higher than the average for EU15 and i s double the average for EU cohesion countries; Transfers and subsidies are among the highest among the comparators, despite a decline since 2003. Direct subsidies at 2.7 percent o f GDP are double the average level for EU15, and in addition information on subsidies suffers from a misclassification and non-reporting (debt write-offs) which would further increase the gap to comparators; Capital expenditures are the highest among comparators and increasing - more than three times as high as in EU15 and more than 40 percent higher than the EU new member states levels. Table 2.4: Consolidated General Government Expenditures by Economic Classification 2000-2006, Y FGDP O Croatia Croatia Av. EUlO Av. Cohesion Av.EU1S 2007 Total Expenditure and net lending 48.6 50.7 41.1 42.2 46.9 Current Expenditure 40.6 43.1 35.8 35.65 44.8 Goods and services 19.8 20.9 18.0 15.9 16.9 Wages and salaries 9.8 10.9 9.7 11.1 10.7 Other G&S 9.9 10.0 8.4 4.9 6.2 Interest Payments 2.1 2.1 2.0 3.0 3.1 Subsidies and current transfers 23.7 20.0 15.8 15.6 21.2 Capital Expenditure 7.7 6.9 4.9 4.9 2.1 Net lending 0.3 0.7 0.4 ... ... Source: GFS, IMF staff report, WB data base, staff estimate. 2.32 Croatia spends 20 percent of overall general government spending on wages and salaries. The new EU member states in general spent one to two percentage points o f GDP less on 31 This analysis i s based on estimated accrual basis information for all units o f local government; therefore i t differs from standard MoF reports on government financial statistics which covers only 53 LGUs. Accrual estimates were carried out by adjusting officially reported cash data by net accumulation o f arrears in the public sector. 32 The EUlO inlcudes Estonia, Lithuania, Latvia, Hungary, Czech Republic, Slovak Republic, Poland, Slovenia, Bulgaria and Romania. 54 wages and salaries than Croatia and the rest o f the comparators; however, none o f them matches the EU average in terms o f government employment. While the EU15 on average employ 8.9 percent o f their population in the government sector, this ratio for Croatia and the EUlO i s around six percent. While public service employment seems to be on par with the EU15 average, Croatia maintains smaller central and local administrations than the EU15 countries. In terms o f employment profile, Croatia i s similar to Slovakia, Bulgaria, Poland and Estonia, but in terms o f public resources spent on public employee wages, Croatia spends one percent o f GDP more than the others. 2.33 Average spending on operations and maintenance in Croatia i s higher than the levels observed in the comparator countries which may also reflect inefficient consumption of inputs (e.g., energy consumption, space renting) or higher unit prices resulting from insufficiently competitive public procurement. However, this spending has halved since 1995 due mainly to cuts in non-wage component o f defense spending. Given Croatia’s prospects for NATO accession, there i s little room for further savings in the non-wage component o f defense. A related concern i s that, given an excessive investment program, Croatia will have to devote comparatively more funds for operations and maintenance in the future adding to the current high levels. 2.34 Subsidies and transfers continue to account for the lion’s share of government expenditure in Croatia as well as in EUlO countries, at above 39 and 38 percent, respectively. Croatia spends 20 percent o f GDP which i s less than the EU15 countries although it i s three to four percentage points o f GDP more than the cohesion and new EU countries. The largest portion i s for social spending and subsidies both o f which appear excessive compared to EUlO and cohesion countries. Although Croatia started benefiting from the 2002 pension reform, the ad-hoc interventions in the recent years in social sectors have offset larger fiscal savings. Among the EUlO comparators, most o f the countries appear to have succeeded in keeping a lid on social transfers since 2000. 2.35 Croatia’s social programs may be more efficient than others’. Despite spending a similar percentage o f GDP on social security and welfare programs, Croatia seems to have better targeted programs for poverty alleviation than, for example, Hungary, that has three times as higher poverty rate. Table 2.5: Poverty Incidence and Welfare Payments Poverty Incidence (Percent of Expenditure on Social Security and Population at $4.30/day), 2003 Welfare (YO f GDP), 2006 o Croatia (2004) 4 16.3 Lithuania 24 10.1 Latvia 17 10.5 Estonia 26 11.8 Czech Republic ... 13.6 Poland (2002) 27 18.6 Romania 58 8.9 Hungary (2002) 12 17.2 Bulgaria 33 12.6 Slovenia ... 18.3 Slovak Republic ... 11.1 Av. EUlO 28.1 13.3 Sources: Croatia: Living Standard Assessment, January 2007; Fiscal Data: GFS, IMF, national data. 2.36 Subsidies can be used for a number of different purposes: redressing market failures, achieving economies of scale in production, etc. However, in Croatia it i s difficult to evaluate if subsidies have achieved these objectives. Overall, subsidies o f the CGG, including indirect ones, amounted to over 3.3 percent o f GDP in 2007 and were fairly concentrated in transport (railways and the shipping companies), agriculture and shipyards. One third o f the direct CCG subsidies go to agriculture and almost one third to Croatian Railways. Local governments subsidize local utility 55 2.37 The structure of state aid in Croatia % EU25 Croatia points to a strong reliance on sectoral 52.0 29.3 Horizontal subsidies which according to the EU rules as well as from the economic point of view Sectoral I 30.4 57.5 are considered as distortive and negative Regiona1 I 17.6 13.2 ones. They are distorting market competition Total aid (without 100.0 100.0 and reduce the country competitiveness over a€FicUlme and bansport) 56 reconstruction has also contributed to the fiscal expansion. The post-war 1995-2006 period has reversed the picture - military spending has fallen by 8.1 percentage points o f GDP, while social spending has grown by 1.9 percentage points o f GDP. W h i l e reconstruction spending remained broadly unchanged, road and motonvay construction positively contributed to the expansion. Since 2000, education, transport, social welfare and agriculture increased at the expense o f defense (which accounted for the bulk o f the four percentage point decline), as well as health and housing due to finalization o f post-war reconstruction. Table 2.6: Consolidated General Government Expenditures by Functional Classification 1995-2006, YO o f GI Croatia Av. Croatia Av. EUlO Cohesion Av. EU15“ 2007 Total expenditure 48.3 50.8 42.3 40.5 46.9 General public services 3.7 2.9 3.5 6.8 6.8 Defense affairs and services 1.5 3.7 1.5 1.6 1.6 Public order and safety affairs 2.7 2.8 2.0 1.5 1.7 Education affairs and services 4.7 4.2 5.5 4.6 5.2 Health affairs and services 5.9 6.8 5.0 5.4 6.2 Social security and welfare 14.9 16.8 13.6 13.2 18.8 Housing and community amenity 4.0 3.7 1.7 0.9 1.o Recreational, cultural and religious affairs 1.7 1.3 1.1 0.8 1.o Fuel and energy affairs 0.1 0.0 0.5 ... ... Agriculture, forestry, fishing, hunting affairs 1.1 0.9 1.2 ... ... Mining, manufacturing, construction affairs 1.2 0.6 0.2 ... ... Transport and communication 4.7 4.1 2.2 ... ... Other economic affairs and services 1.o 0.7 1.1 ... ... Expenditures n.c. by major group 0.9 2.3 3.3 ... ... � 1999-2005. Sources: GFS, IMF staff report, WJ3 data base, staff estimates. 2.48 Comparison with the benchmark groups in 2006 suggests that after a significant reduction in defense spending from a 9.5 percent of GDP peak in 1995, to 1.4 percent in 2006, Croatia now has the same level of spending a the EUlO countries and cohesion countries. s Defense expenditure patterns in the past reveal that adjustment has been accomplished through a reduction o f the wage bill and non-wage costs. However, this trend may soon be reversed due to the modernization requirements posed by the country’s N A T O accession aspirations. In the future, defense expenditures in Croatia will likely follow the path o f EU countries that are already members or in the advanced stage o f the adjustment to the N A T O standards. This implies that the non-labor cost will need to grow and labor costs decline further. 2.49 I n the social sectors the following patterns are emerging: Education spending was approximately 1.3 percentage points o f GDP less than in the comparators throughout the observed period. However, the recent shift in Government policy in education area has put Croatia on par with the rest o f comparators; 0 Public health spending at 6.8 percent o f GDP during 2000-2006 was on the high side, but there are some savings expected in the medium term as the system undergoes restructuring and these could support the latest trends in spending reduction. There i s anecdotal evidence 57 that maintenance costs deferred over the last decade will weigh o n h t u r e budgets, but estimates are not available; 0 Social security, although lower than in EU15, i s s t i l l at the highest end once compared to the EUlO despite a decline that started in 2001 due to the pension reform impact. The ratio o f social security spending to GDP resembles Scandinavian countries, although the relative benefits that systems provide are not comparable. Croatia’s social welfare system s t i l l suffers from inadequate targeting and overlapping o f benefits for which rationalization could bring significant savings and improvement o f services. However, Croatia’s social welfare system also provides substantial benefits to war veterans’, due to consequences o f the Homeland war, a type o f spending not found in other comparator countries; 0 Spending on housing and community affairs i s over 2 percentage points o f GDP higher than in comparators due to post-war reconstruction, another type o f spending specific to Croatia’s post-war circumstances. 2.50 Transport spending exceeds the comparators’ spending patterns and appears excessive. This i s mostly a result o f ambitious investment program for roads and motorways started in 2003 that has pushed public spending around two percentage points o f GDP higher than in comparator countries. However, in the period 2006-2008 spending on roads and motorways was supposed to decline below three percent o f GDP at the expense o f allocation for maintenance as planned by the government medium-term road strategy. 2.51 This section examined the trends in the main components o f sectoral spending. Pensions, education, health, social protection, transport, environment and public administration amount to 72 percent o f overall C G G expenditure (without net lending). Given their significance to the social well being o f a large majority o f the population, any expenditure rationalization in these sectors must be done only after considerable analysis and consultation. The analysis carried out in Chapter 3 illustrates the kind o f analysis that needs to be undertaken for all parts o f the budget to achieve a comprehensive reform o f public finance. 58 F. REVENUE AND TAXADMINISTRATION SIMPLIFICATION 2.52 The spending expansion in the 1990’s and Table 2.7: Comparative Revenue Ratios, high expenditure levels during this century were 2000-2006 average (% GDP)� made possible by the significant revenue Total Tax mobilization resulting from the tax reform started Revenue Revenue in 1993. The Government modernized direct taxes and Croatia 45.9 40.2 introduced new types o f revenue-generating taxes, such Bulgaria 39.6 32.3 as, excises, surtaxes on the income tax, as well as the Czech Republic 40.5 37.7 22 percent single-rate VAT (zero and 10 percent rates were introduced in 1999 and 2005). A t the same time, Estonia 35.5 30.5 the Government also made substantial efforts to Hungary 42.9 39.0 improve tax administration. The tax system collects on Latvia 34.4 28.9 average 84 percent o f all general government revenues. Lithuania 33.2 28.8 2.53 Although tax revenues, including social Poland 38.9 34.0 contributions, have been declining as a share of Romania 35.2 29.7 GDP since 1998, they still amount to over 39.5 Slovak Republic 36.3 32.9 percent of GDP. The most important revenue items are VAT and social contributions which account Slovenia 44.2 42.0 together account for about two thirds o f total tax EUlO average 38.1 33.6 revenue. The significant tax burden borne by the EU15 average 45.6 41.2 private sector drove a substantial part o f economic Cohesion countries 39.6 34.4 activity underground during 1990’s and has reduced � ConsolidatedGeneral Government, profitability in the formal sector. Source: IMF; Government Finance Statistics; InternationalFinancial Statistics; World Bank data 2.54 Nontax revenues have been growing base and staff estimates. recently through various charges and fees applied at the central and local government levels. At over 6.5 percent o f GDP, they have an important financing role. However, not only have the revenues from these fees grown, but the compliance cost for taxpayers have increased as well. The business sector complaints about non-transparency o f fee charges, and, while there i s no registry o f administrative fees, some estimate that there i s over eighty different kinds, some o f which are subject to arbitrary rules at the local government Figure 2.7: Tax Rates in 2006 level. 50 1 2.55 Both Croatia’s revenue-to-GDP ratio and its tax-to-GDP ratio are the 40 . .. . . . . . ... highest among EUlO countries, and are well above the EU and cohesion 30 countries. They are on par with the EU15. c This implies that there i s a limited room for 20 additional revenue gains from improving 10 tax administration, except in the area o f local property tax33 and payroll 0 contributions where the introduction o f a VAT Top Corporate Top Wrronal Fayroll Tax hconm Tax Rats hconm Tax Rate unified system o f collection i s expected to improve resource mobilization in what i s Sources: MoFs, www.worldwide-tax.com, United States Social Security Administration, WI3 staff calculations. one o f the weakest points in the Croatian 33Currently Croatia collects tax on real estate transactions. Due to the inadequate state o f affairs in the land registry and the lack o f a single property registry, the introduction o f a modern property tax must be postponed until the preconditions for i t s assessment are in place. 59 tax administration. 2.56 T a x rates for the key types of taxes do not appear excessive, with the exception of the top marginal rate of the personal income tax (at 45 percent). Over the last decade, pension reform as well as use o f more general taxes for financing social security spending helped reduce labor taxes. The government objective to dampen consumption through higher consumption taxes and stimulate entrepreneurship and work through lower direct taxes was supported by tax policy changes including establishment o f one o f the highest VAT rates in Europe. 2.57 Since 2000, following the Figure 2.8: Revenue Ratios (%GDP) “midi� tax reformJ4 the Government , Of OD‘ has made substantial efforts to reduce Oh 50,0 ................................ ................................ the overall tax burden which has now fallen by three percent o f GDP 45,0 ............ ............. concentrating on direct taxes, especially profit and payroll taxes that seemed 40.0 excessive compared to neighboring 35.0 countries. Although the reform has been successful in achieving i t s primary aim 30.0 (of reducing the tax burden), a number o f tax incentives and tax holidays were Tog1 remnue Tax revenue also introduced in parallel to attract 34 For details see IMF (2000). 35 IMF, “Reforming Personal Income Tax in Croatia,� 2006. 60 This was previously conducted independently by three social insurance funds (the Pension Institute, the Employment Fund and the Health Institute). From 2002-2005 responsibility for collection o f second pillar contributions (introduced in 2002) was assigned to REGOS, designed as a central registry o f socially insured individuals and the second pillar clearing institution. In 2005, the Tax Department took over all responsibilities for collection, control and enforcement o f second pillar contributions as well. Collected second pillar contributions are transferred to a transitory account, managed by HANFA, and are distributed to individual accounts by REGOS. The surtax i s paid to local governments by employers directly. 2.62 Unlike collection, reporting on declared income subject to paying payroll taxes has been fragmented, costly and inefficient. Employers submit monthly aggregate non-personified reports to Tax Department for income paid in a particular month (separately for wage and non-wage income such as honorary payments), and to REGOS on personified first and second pillar contributions paid for a particular month. Together with the additional reporting requirement to the Health Institute (income earned to calculate sick-leave compensation or maternity benefit) and the Employment Fund (average earnings to calculate unemployment benefit), these parallel reporting systems impose a high administrative burden o n employers and create high compliance costs. 2.63 Despite REGOS’ functioning a a central registry of socially insured individuals, s parallel registrations of insured individuals still exist. The employer has to register each new employee with the Pension Institute, the Health Institute and, upon submission o f the annual tax statement, with the Tax Department. Although FINA (Financial Agency) introduced electronic one- stop payroll tax registration in 2007 there i s still no single reporting shop, initially designed to be in REGOS. Each institution still maintains i t s own registry o f taxpayers/insured individuals; the registry o f surtax-payers does not exist which makes control o f surtax declarations quite difficult. 2.64 Introduction of monthly personified reporting in 2002 for the purpose of administering the second pension pillar was recognized as an opportunity to consolidate parallel reporting requirements for all social contributions, the personal income tax and the surtax. Establishment o f REGOS and introduction o f unified RS monthly reporting form was done with the objective o f creating a central database o f all contributors, personal income taxpayers and insured individuals, updated centrally with status and monthly income data channeled through a single reporting stream, and providing more frequent and accurate data to all relevant institutions. The unified reporting system has existed for three years during which the requirement for parallel reporting to the Pension Institute was successfully replaced by a unified RS form. Instead o f absorbing the RS form into i t s reporting system, the Tax Department has rejected using i t as a key source o f information due to its alleged incompatibility with Tax Department data requirements and the monthly frequency o f personified data which the Tax Department found irrelevant for them. Data consolidation was further complicated in early 2003 when the Tax Department introduced additional forms to gather data on personal income taxes and social contributions from non-wage income, which was a clear signal that the reform o f consolidating the reporting o n all payroll taxes would not be implemented as scheduled. Finally, in 2004 the L a w o n Consolidated Reporting on Social Contributions, Personal Income Tax and Surtax was amended and the unified reporting concept was abolished. 2.65 Control and enforcement o f the income tax, surtax and social contributions, performed centrally by the Tax Department for all in-line agencies, should rest on a unified flow of data which follows the cash flow. Also, creation o f a central database o f taxpayers and socially insured individuals, whose status i s monitored from birth to death, would provide an opportunity to reduce payroll tax evasion and avoidance. Monthly personified reporting can be used for faster eligibility and benefit level determination (in health and unemployment insurance) and for precise calculation o f personal income tax and surtax liabilities without the need for subsequent reconciliation. Monthly data flow also enables prompt provision o f information to insured individuals allowing them to check whether their employer i s paying contributions on time. 61 2.66 Recognizing existing inefficiencies in payroll tax registration, reporting, and data warehousing processes, and inadequately defined roles o f institutions involved in them, the Ministry of Finance has initiated an assessment of the roles and responsibilities of the Tax Department and other institutions in payroll tax revenue and information flows. This assessment, supported by a World Bank project, should provide recommendations for improving the current payroll tax administration system and i t s institutional framework. If REGOS i s not the appropriate institutional framework for implementing a consolidated payroll tax reporting system, as designed in 2001, other consolidation models could be exploited. For example, a central registry o f all tax and contribution payers could be created in the Tax Department, with a single registration point in its central registry o f taxpayers and socially insured individuals, and a single monthly .personified report as a basis for determining the payment obligation, and consolidating income tax and surtax obligations with obligations to pay contribution. The centralized data system could also be accompanied by a single payment order for the employer, which would further tighten payment discipline. Simplification o Personal Income Taxes f 2.67 Personal income taxes (PIT) account for some 12 percent o f total tax revenues in Croatia. At about 4.8 percent o f GDP, PIT revenues are comparable to those in other countries: PIT revenues made about 3 percent o f GDP in Slovakia and about 7 percent o f GDP in Slovenia. Given the fiscal constraints in terms o f large spending and a high fiscal deficit, there i s no fiscal space for reducing PIT revenues in the short run. Therefore, any policy change in PIT would have to be fiscally neutral. 2.68 Still, the country could benefit from simplification of its current PIT system by reducing distortions in the economy and improving tax administration. The former would assume a reduction in a number o f allowances and exemptions and generate higher tax revenues for a given tax rate. The latter assumes higher transparency o f the tax system. Furthermore, the tax rates need to be low enough to allow the low-income earners to participate in the labor market, and keep high-income earners in the tax system. As noted by the IMF36, i s recommended that countries design their PIT it systems so that they have an administratively simple form, with limited deductions, a moderate top marginal rate, an exemption limit large enough to exclude persons with modest incomes, and a substantial reliance on withholding. 2.69 The number of allowances and tax brackets could be reduced to make the PIT tax more effective. The Croatian PIT system consists o f four tax brackets with four marginal rates o f 15,25, 35 and 45 percent and a number o f allowances, exemptions and incentives. Because o f numerous allowances, which generally can only be used by wealthier taxpayers, effective tax rate at average 9 percent (defined as a ratio o f tax paid and gross income reported) i s significantly lower than the nominal rates. 2.70 The PIT system i s over-used as a social policy tool. Every taxpayer was in 2007 able to deduct from his tax base a basic personal allowance equal to some 33 percent o f the national average gross wage (AGW). On top o f this, an additional 16.5 percent can be deducted on behalf o f an unemployed spouse, and 16.5 percent for one child. Allowances for children are generous; a taxpayer can apply 73 percent o f AGW for three children, and almost 119 percent o f AGW for four children. The allowances are higher for selected groups o f persons, like elderly (66 percent o f AGW) or severely disabled (9.9 percent o f AGW). Furthermore, all allowances are significantly higher in the first area o f the special national concern (more than double), the second area o f special national concern (double allowances), and third area o f special national concern and a hill and mountain 36 Stepanyan, Vahram (2003). Reforming Tax Systems: Experience o f the Baltics, Russia, and Other Countries o f the Former Soviet Union. IMF Working Paper WP/03/173. Moore, David (2005). Slovakia’s 2004 Tax and Welfare Reforms. IMF Working Paper WP/05/133. 62 area.37 The taxpayer can also use up to 20.7 Table 2.8: Basic characteristics of the PIT system percent o f AGW to reduce hisher tax base for 2004 2000-03 proved voluntary insurance and expense Number o f taxpayers reimbursements (for housing, rents, housing Total 2,592,520 2,455,838 loans and similar). Several groups are exempt Total (%) 100 100 o f PIT, like disabled Croatian Homeland War Employees 55 54 veterans. Pensioners 41 42 2.71 The high allowances have actually Self-employed 5 4 had the opposite effect of what the four- PIT revenues (in 2004 prices) bracket design of the PIT system was Total (KN m) 9,108 7,583 intended to accomplish, because they work Total (%) 100 100 against redistributive effect of the brackets. Employees 89 88 A taxpayer in Zagreb with an unemployed Pensioners 3 3 spouse, two children and voluntary insurance Self-employed 8 9 can reduce her tax base by up to 89 percent o f Contribution revenues (in 2004 prices) AGW. In other counties the amount could be Total (KN m) 15,780 13,882 even higher. These high allowances have two Total (%) 100 100 negative consequences: first, they significantly Employees 100 100 reduce tax base and, therefore, amount o f taxes Pensioners 0 0 collected. Second, their distributional impact i s Self-employed 0 0 highly questionable, because only wealthier Source: Tax returns, Tax Office o f Croatia, staff calculations, taxpayers can use all of them, while low-income earners get little or benefit from them. 2.72 Only 59 percent of population Table 2.9: Effective tax rates in 2004 pays personal income tax. The total number o f taxpayers in Croatia in 2004 Median Average Top 10% was about 2.6 million, o f which 55 All taxpayers percent were employees, 41 percent Annual gross income, HRK 28,700 41,500 139,900 pensioners and 4 percent self-employed. annual real growth 2000-04 7.4 3.3 5.1 Although the number o f taxpayers has Effective P I T rate, % 2.5 8.5 14.5 been increasing since 2000 on average Share on P I T revenues, % * 4.5 58.0 by 2.2 percent per year, the shares o f the Employees three groups remained almost Annual gross income, HRK 39,200 56,400 161,600 unchanged. O f the overall amount annual real growth 2000-04 2.7 2.5 3.9 collected, employees contributed 89 Effective P I T rate, % 5.2 10.2 16.3 percent, pensioners 3 percent and self- Social contributions (SC) rate 20.0 19.7 19.6 employed 8 percent. The weight o f Share on P I T revenues, % * 8.8 51.1 social contributions in the total tax Pensioners wedge is, especially for l o w income Annual gross income, HRK 18,700 21,500 51,100 earners, much higher than the PIT. The annual real growth 2000-04 13.2 6.0 3.3 reason i s that all employees pay 20 Effective P I T rate, % 0.0 1.1 3.3 percent for social contributions, and the Share on P I T revenues, % * 4.0 93.8 employers pay another 17.2 percent. Self-employed Annual gross income, HRK 27,900 42,700 186,600 2.73 The difference between the tax annual real growth 2000-04 1.9 -2.0 6.5 wedge of the single worker at the Effective P I T rate, % 3.5 14.4 20.2 AGW and the top decile’s employees Share on P I T revenues, % * 1.9 65.5 i s less than eight percentage points. * Share on revenues collected within the group. Median: revenues collected b y the bottom 50% o f the population. Source: Tax Office o f Croatia, staff calculations. ’’The first area consist o f four settlements, the second area 53 cities and municipalities, and many settlements, and the third area 68 municipalities. The Ministry of Finance, Republic o f Croatia (2005). The Croatian Tax System. 63 The total tax wedge (including the 17.2 percent o f contributions paid by the employer) o f the median employee only reaches 36.2 percent. For an average employee (as defined by tax returns) the figure i s 40.2 percent, and for an employee in the top it i s 45.3 percent. On average, in 2004, a taxpayer paid P I T taxes equal to 8 percent o f hisher gross income, while an employee paid slightly more (10 percent), a pensioner almost nothing (1 percent) and a self-employed paid a maximum (14 percent). These ratios were stable over 2000-2004 and given n o major changes in tax policies over the last three years, these ratios are probably similar. 2.74 The effective tax rate imposed on the average employee i s lower that that in EU15 and OECD, where respective tax rates of 10 to 25 percent of the gross wage are more common. However, because o f the higher social contributions, the sum o f tax and contributions paid by average employee i s very similar to that in EU15 and a bit higher than in OECD.38 2.75 The majority of allowances and relief could be substituted b y other policies, such as social benefits and regional policies, which would be more effective in reaching target groups or regions. Furthermore, membership in the European Union provides an opportunity to design strategies and use EU funds precisely to help the poor or unemployed, and to develop regional policies. Therefore, it would be reasonable to reduce the amount and number o f allowances and, at the same time, reduce the number o f brackets. G. MANAGEMENT PUBLICEXPENDITURE SYSTEM 2.76 The Croatian authorities have made significant progress in strengthening public expenditure management over the last couple of years. The budget execution processes, including accounting and reporting structures, have improved. GFS 200 1 standards have been formally adopted in accounting and reporting, although adherence to these standards by some local governments remains questionable. The Treasury Single Account has been expanded to cover bank accounts o f all line ministries and the remaining extra-budgetary funds (the health insurance, pension and employment funds). Also, the Ministry o f Finance has carried out all the preparatory work to integrate existing financial management information systems in 2007. While the Government has made progress in controlling arrears, they s t i l l exist (for example in the health sector). The strengthening o f financial management processes as well as structural reforms to be undertaken in stressed sectors can be expected to reduce them over time. 2.77 The Croatian Government has made consistent efforts over the last four years to improve the rules and relevance of multi-year fiscal planning. These efforts were supported by the need to introduce a three-year perspective in the Pre-Accession Economic Programmes (PEP) as well as by the need for a general improvement in quality o f macroeconomic forecasting. In 2006, public finance statistics were for the first time constructed according to ESA 95, by using the transfer tables between the national chart o f accounts and ESA 95 methodology, which enables cross-country comparisons o f the public finance statistics across EU countries. Furthermore, the state budget coverage has been expanded from the 2006 budget onwards with the inclusion o f lottery revenues, road charges, own revenues o f budgetary users, revenues under the special regulations (administrative taxes and other earmarked revenues), and EU grants. The control o f collection and the use o f earmarked revenues have also been established. 2.78 A new public debt management and recording system as well as an electronic system for treasury bill auctions have been introduced and the department in the Ministry of Finance covering debt management has been reorganized with separate front (debt issuance), middle (risk management) and back (debt recording, planning and analysis) offices. A public debt 38The OECD reports effective tax rates in OECD (2003). Taxing Wages 2002-2003. In the other report, the sum o f effective tax and social contributions paid by the average income employee, single and without children i s calculated. The figure for Croatia would be 29.9 percent, while average for the EU15 in 2003 was 29.2 percent and for the OECD 25.6 percent. OECD (2004). Recent Tax Policy Trends and Reforms in OECD Countries. OECD Tax Policy Studies No.9, pp.22-26. 64 management strategy has been adopted for 2006 along with the medium-term budget. Further, the authorities have, with the help o f EC, established internal audit units in all line ministries, central state organizations, and extra-budgetary funds. Their establishment i s also underway in local governments. The Law on Financial Management and Control Systems in the Public Sector has been enacted and controllers have been appointed for all line ministries. 2.79 Croatia has made progress in modernizing i t s public expenditure management system (PEMS), but additional efforts have to be undertaken in the fields of: (i)performance and program based budgeting, ( i analytical foundations of budget allocation decisions, (iii)budget i) transparency, and (iv) integration of strategic and budgetary planning. Program based budgeting has been formally introduced, but remains o f limited relevance due to the absence o f proper cost allocation mechanism and a missing set o f measurable program performance indicators. Organizational and functional views on the budget s t i l l dominate over program perspective, thereby limiting transparency in budgetary presentations and consultations. Consequently, the impact o f economic and social analysis o f present and future impacts o f public expenditures on budget allocation decisions remains limited. The adoption o f the Strategic Development Framework 2006- 20 13 by the Government in July 2006 provided an opportunity to link broader strategic considerations with operational budgetary decisions. However, the absence o f systems that integrate choices o f strategic priorities and selection o f strategic goals with budget allocations continued to constrain - policy effectiveness and efficiency. 2.80 Benchmarking of the public Figure 2.9: PEMS Benchmarking Aggregate fiscal expenditure management system discipline (PEMSP’ has shown that problems of budgetary planning lie with prioritization rather than aggregate fiscal discipline. The largest departures from best practice have been found in the following areas: expenditure allocations based on economic analysis; consultation mechanisms (especially with the Parliament); weak dominance o f the Ministry o f Finance in A C D E deciding about conflicting budgetary Max; Best practice = 1 A. Macro framework and coordination allocation decisions; linking allocations to mechanism; B. Dominance o f central ministries C. Formal constraints; D. Hard budget evaluations o f budget programs; open constraints discussions o f competing budget priorities; E. Comprehensiveness o f the budget and, generally, lack o f cutbacks o f existing Figure 2.10: Prioritization o f Expenditure Composition programs based on performance evaluations and objective criteria. 2.81 Progress in PEMS development s remains limited, a witnessed by the limited representation of goals from the Strategic Development Framework (for example, education, promotion of entrepreneurship and the business climate, restructuring and privatization) in actual Max = 1. A. Allocations linked to strategic outcomes B. Breadth of budgetary allocations. An illustration o f consultations missing l i n k s between strategic goals and C. Flexibility o f line agencies D. Comprehensiveness o f the budget E. Use o f objective criteria. annual budgetary allocations i s provided by 39Supported by the World Bank IDF grant for Strengthening Budget Management in 2005 and based on the methodology o f Campos and Pradhan (1995). 65 comparison o f priority rankings implied by the Strategic Development Framework 2006-20 13 (SDF) and the budget for 2007. This comparison i s not meant to provide comprehensive assessment, but rather, to illustrate difficulties in comparing strategic and budget priorities. The framework for comparisons is weak, because definitions o f strategic areas and goals in the SDF cannot be matched to budgetary allocations easily. The top priority in budget 2007 i s attached to regionally balanced growth and fiscal decentralization. The budget allocation for regional development programs almost doubled relative to 2006, and tripled relative to 2003. Looking at the SDF, balanced regional development i s reflected in the definition o f only two goals among seven in section V I o n Space, Nature, Environment and Regional Development, which does not indicate a high priority ranking. On the other hand, SDF's top priority i s reflected in the section on People and Knowledge that i s comparable to the section o n Education and Science in the Budget. This budgetary allocation has been increased by 5.5 percent which, again, seems not to be matched with SDF's priorities. 2.82 Matching frameworks / classifications to be used in strategic and budgetary planning should be a first step in building an integrated strategic and budgetary planning system. Matching frameworks i s a necessary condition for broader and better assessment o f relationships between strategic goals and budgetary allocations. The next step to be taken in developing an integrated framework for strategic and budgetary planning i s to improve definitions o f strategic goals in order t o enhance measurability and ease the making o f priority rankings. Analysis performed by consultants supported by the IDF Grant in 2006 has shown that strategic documents themselves (SDF and PEP) might be significantly improved: e.g. out o f 75 goals in SDF, 32 are directly measurable. Development o f a set o f monitoring indicators o f strategic goal achievements, with a long run view on developing a balanced scorecard for the government i s thus highly recommended. This can be achieved only if strategic planning documents are based o n the same classification (program classification) as the budget plan. Table 2.10: Characteristics o f SDF Table 2.11: Selected Allocations in 2006 and 2007 I 2006 I 2007 I Index I T.4, p.16 o f the official publication "2007 Budget: for more balanced development of Croatia", Ministry of Finance; ** T.lO, p.31;***T.14,p.39;****T.17,p.43;xT.6,p.24;xwT.8,p.28 without information technology, sports and international cooperation. Allocations are selected according to three criteria: allocation i s higher than kuna 1 bln in both 2006 and 2007; allocation i s presentedin the Ministry of Finance booklet; allocation i s presented in a transparent way (e.g. data from T.5 "Investment in infrastructure" are not presentedbecause it i s not clear if these numbers include subsidies. Altogether, seven allocations presented in the table represent 69.1% o f total planned expenditures in 2007. 2.83 Furthermore, in order to develop integrated system of strategic and budget planning a formal relationships between strategic and budgetary planning will need to be established and, a consistent use of analytical inputs in making budget allocation decisions will have to be ensured. At present, the budget planning process i s sufficiently regulated by the 2003 Budget L a w as shown o n the right hand side o f the scheme below. This process i s supported by macroeconomic 66 analysis and forecasting. I t s results are reflected in Fiscal Policy Guidelines which ensure effective macro budgetary l i m i t s as reflected in the aggregate fiscal discipline assessment within our PEMS benchmarking system. Three critical elements are missing from the process at present: links to strategic planning, an implemented expenditure evaluation system and a common analytical platform. There are three key recommendations to overcome present weaknesses: 0 Implementation o f the standardized methodology for collecting ministry's strategic plans before budgetary planning process commences, 0 Drafting o f an annual strategic document pointing out key policy priorities before the budgetary planning process commences, e Adopting an annual strategic document as a supplement to the budget proposal reflecting arguments for selection o f priorities. These innovations in the planning process could also make substantial contributions to the budget transparency and consultation process, as early statement o f priorities in draft form could be shared and discussed with key social partners and other stakeholders. Figure 2.11: Strategy Change Cycle General scheme o f the Schematic overview o f strategy change cycle current situation . . . . . . . . .Visions . . . . . . ...... _ - _ -Strategic_ _ _ _ _ _ _ _ _ _ _ _ _ _ - _ _ goals I Strategic Framework for Development 2006- 2013 1 GuidelinesDraft until 30.4 Polices, measures, Guidelines acceptance until instruments 15.5 ..................... Budget Manual until 30.5 Budget proposals until 30.6 Action plans and Budget proposal until 15.10 programs Acceptance and sending to Parliament until 15.11 . . . . . . . . .Budget . . . . . . ...... _----------I I I Policy evaluation, I I effectiveness, I Key element missing: I I I efficiency, deviation I Evaluation I I I I I analysis I I I _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ I 2.84 Budgetary allocation decisions are made without sufficient analytical background. Within the Ministry o f Finance and the Government in general, strengthening o f analytical capacity to perform sectoral analysis and annual fiscal expenditure evaluations would be highly recommended. This i s become even more pressing as the EU accession process substantially increases demand for analytical services needed for developing applications for use o f EU funds and needs grow for more analytical inputs in regulatory build-up and improvement (for example, FUA-regulatory impact assessment, which i s at its infancy stage in Croatia at present). There i s an urgent need to consolidate existing, and invest in new, analytical capacity within the Croatian Government. Analysis i s not a substitute for, but an aid to, decision-making which i s and will always be political. The presence o f high-quality analytical support clarifies options and makes political decision-making easier and more transparent. The importance o f this factor cannot be over-stressed since analytical investments in general lead to higher quality o f decisions, budgetary presentations, consultations and enhanced budget transparency. 2.85 The improvement of quality of macroeconomic analysis and forecasting needs to be replicated at sectoral and program levels. A common platform for research and analytical support 67 for choice among competing expenditure allocations should serve for both planning and evaluation purposes. Information can range from simple international comparisons o f expenditure indicators to a complex library o f research work and indicators o f effectiveness o f different types o f public expenditures. A small analytical team with specialists for key sectors (expenditure areas) should be developed within the Budget Planning Unit, sharing the same knowledge base platform with the Macroeconomic Unit and the Central Office for Development Strategy and EU Funds. The aforementioned institutions should ensure operational coordination based o n a clear division o f responsibilities within the integrated process. Drafts o f key documents, such as multi-year development strategies, annual strategy statements (composed o f individual ministry strategies to accompany budget proposal), expenditure evaluations and the like, should either be produced or coordinated by these governmental units. 68 PART 11: DELIVERING PUBLIC GOODS 3. INFRASTRUCTURE 3.1 The central challenge for Croatia in the transportation sector i s to ensure fiscal sustainability of the system by adopting a more disciplined approach to the planning and prioritization of investments, and making adequate provision for maintenance of assets. In the roads sector, Croatia i s in the second phase o f a massive motonvay development program (2001- 2008) on which i t i s currently spending about 3.6 percent o f GDP annually (2007). While upgrading road infrastructure has multiple benefits to a regional, social and economic development o f the country unit costs for these investments are high due to excessive standards, which together with the pace o f implementation are crowding out expenditure for necessary maintenance and rehabilitation o f existing road networks. Despite recent increases in budget allocation for maintenance, a significant backlog remains to be addressed. Accordingly, an increased share o f maintenance and rehabilitation expenditure i s an objective o f the Road Construction and Maintenance Strategy for 2005-2008. A focus on keeping total transport costs l o w will increase Croatia’s competitiveness and comparative advantage. Further steps to support this objective should include exposing road maintenance companies to greater competition, use o f competitive contracting, introduction o f appropriate incentive schemes for publicly-owned road operators, and development o f a competitive PPP market for the provision o f road infrastructure. In addition, the government needs to analyse carefully the liabilities it i s incurring towards concessionaires that stem from the complex role played by the government in these operations as a shareholder. 3.2 I n the railways sector the current level of operating subsidies at 0.6 percent of GDP i s unsustainable, high compared to the EU and neighboring countries and could be cut by half. Labor productivity has improved, but i s s t i l l very l o w at about 50 percent o f EU27 level. Excessive staffing and wage rates that are far out o f alignment with other segments o f the labor market translate into revenues o f National Railway Company (HZ) not even covering i t s labor costs. The sector i s suffering from sharply increased competition from the rapidly expanding road network. HZ i s undergoing a restructuring process, but this needs to be pursued with greater determination in order to reduce operating costs and increase revenues, especially through further retrenchments. However, the 2006 mid-term and 2008 business plans for HZ still focus on costly additional investments rather than greater commercial competitiveness. This i s because investment plans are not conditioned by consideration o f debt financing implications nor supported by analysis o f benefits and costs, and insufficient attention i s given to measures to increase efficiency o f existing operations. Steps are needed to limit the network to commercially viable lines and corridors, t o privatize or divest all non- core subsidiaries, to expose all internal or external suppliers to competition or benchmark pricing, and to tie all operating subsidies to performance-based contracts. 3.3 Growth prospects in transit activities through Croatia and its major ports are substantial. Croatia launched a number o f major projects to upgrade capacity in particular in Rijeka, Ploce and Zadar. Port traffic also steadily increased from 18.6 million tons in 2002 to 30.1 million tons in 2007, with transit confirming i t s relevance. Over 80 percent o f this freight i s international in nature. Aside from solid mineral fuel, o i l and o i l products which represent 74 percent o f transit, transit o f ores, coal, and metal products dominates. This transit has grown rapidly over the past ten years (140 percent) and trends indicate a further acceleration. However, overall port efficiency i s hampered by inadequate capacity, operational layout, equipment and tariff policies. Significant increase in port capacity i s being developed but will come late compared to market needs, calling for further corridor-based efficiency gains. Thus the role for cargo transportation through railways and roads becomes important to reduce somewhat the gap between installed capacity and forecasted demand through operational efficiency improvements. A. BACKGROUND 3.4 Croatia’s transport system i s extensive. I t comprises (a) about 1,163 km o f motorways, 27,000 km o f classified interurban roads and 22,000 km o f local roads; and (b) a 2,664 km railway network, o f which about 250 km are double track and 1,000 km electrified. In addition to roads and railways, the transport infrastructure also includes (a) the main sea ports o f Rijeka and Ploce and five secondary sea ports, plus numerous river ports on the 918 km o f the Sava and Drava rivers; and (b) seven international airports. Port and air infrastructure are not discussed here. 3.5 Economic growth, increasing trade with Europe, development of tourism, and reestablishment of transit traffic have been fueling the demand for transport in Croatia over the past six years. In the period 2001-2007, inland 180 - --CFreighl .Roads (ton-km) freight transport, for instance, increased +Freighl-Railways (Ion-km) by an average o f 8 percent per year, or 160 - e Passenger -Railways (pass.km) RBgislrsd passenger cars (nurber) 1.8 times the average real GDP growth +Rmd Tramc(vehde.km) 140 - over the same period. Railway traffic 130 - has grown faster than road traffic 120 - (Figure 3.1), although roads handle 110. approximately three quarters o f inland 100 - freight, while the remainder i s so, transported by rail. 3.6 Despite a favorable increase Source: CROSTAT. in traffic, significant amounts of public funds continue to subsidize the poor operating performance o f Croatian Railways (HZ). The amount o f state subsidies per traffic unit transported by rail in 2000-2007 i s considerably higher than other Central and South European countries. Sector restructuring to date has not yet brought the overall improvements to financial performance necessary to eliminate public in-flows. Budget transfers for operating losses and investments, although declining, are still high at one percent o f GDP. Implementation o f the labor retrenchment program since 2000 doubled labor productivity, but this s t i l l lags far behind neighbors’ productivity standards. Subsequent wage increases have substantially raised the cost o f labor, and now operating revenues are not enough to cover even these costs. The average net wage in railways remains well above the market average (at around 13 percent), with 43 percent o f staff having less than secondary education. 3.7 The continuation of operating losses and need for further restructuring are not likely to decline despite government investment plans of HRK 18 billion over the next 5 years. This would mean total public financial support would double from 2002 to 2008 and further increase to three times 2002-level by 2009, but the proposed investment program would have almost negligible impact on reducing the annual operating subsidy. 3.8 After massive investment in the motorway network since 2001, railways are facing strong domestic competition. It i s already clear that average revenue per passenger-km and ton-km i s declining, and this trend will continue as the market opens up to international market operators. Unprofitable local lines are further eroding E ’ s position because budgetary support for public service obligations has not yet been established at the local level, with some exceptions such as the city o f Zagreb. 72 3.9 Public capital spending on roads and motorways has nearly doubled as a share of GDP from 1.9 percent in 2001 to an average of 3.6 percent over the period 2002-2006; this increase has been at the expense of road maintenance. As a result there i s n o w a significant backlog in maintenance o n national and local roads. More than one-third o f state roads are considered to be in poor condition. Furthermore, the cost o f maintaining the recent and proposed future investments will place an additional strain on a fragile fiscal framework. 3.10 Several attempts to bring in the private sector via private-public partnership (PPPs) projects have resulted in complicated institutional arrangements. These projects remain predominantly public or publicly-owned but with much more complex lines o f accountability and financial risks. Contingent liabilities stemming from the PPPs contracts have not been assessed, while the Ministry o f Finance has only recently established a registry o f concessionaries and guidelines for structuring o f PPPs contracts together with annual fiscal liability ceilings. B. RAILWAYS EFFECTIVENESS 3.11 Croatian Railways (HZ) i s one of the larger carriers in the South Eastern Europe, but i t i s still a very small railway by European standards and, even more so, by international standards. A number o f European railways based in countries with similar population levels-all Baltic countries, Finland, the Slovak R e p u b l i c - c a n y much greater volumes o f traffic. Size i s an important factor because economies o f scale-average haul (distance) and overall traffic levels-play an important role in this sector. 3.12 The 2003 REBIS4' study considered the railway infrastructure to be in medium to good condition on main lines. HZ operates a 2,722 km rail network, o f which 254 km are double tracked and 980 km (or 36 percent) are electrified. The core main lines encompass approximately 850 km o f corridors X, Vb and Vc. The network has been relatively well maintained with 65 percent o f the network allowing speeds over 80 kmh-generally sufficient to maintain competitiveness in the freight transport business, especially given that the average haul in Croatia i s only around 200 km. Table 3.1: Traffic Comparison for Sel :ted Railways in Europe I 2006 Passenger traffic Cargo traffic Total TU Size Railway Avg. %of Avg. company Passengers P K M dist TU Tons TKM haul (PKM+TKM) Comp. Croatia 46.2 1,362 33 29% 15.4 3,305 199 4,667 1.o Serbia (ZS) 14.1 846 63 17% 14.1 4,234 257 5,078 1.o Slovenia 16.1 793 52 19% 17 3,373 192 4,166 1.1 Bulgaria 34.1 2,422 69 32% 21.6 5,227 255 7,649 2.0 Romania 93.3 8,053 87 35% 65.2 14,720 227 22,773 5.8 Hungary (MAV Rt) 119.8 6,742 60 45% 41.7 8,382 183 15,124 3.9 Poland 217.4 16,976 68 28% 150.9 42,651 293 59,627 16.8 Slovak (ZSSK) 47.0 2,194 44 19% 50.0 9,703 194 11,898 3.0 Czech Rep 180.9 6,887 37 30% 88.6 16,306 187 23,193 5.8 Estonia 5.2 260 37 3% 43.3 10,152 221 10,412 2.5 Latvia 27.4 992 34 6% 48.7 15,273 330 16,265 4.5 Lithuania 6.2 430 63 3% 50.2 12,896 255 13,326 3.1 3.13 Rolling stock and motive power utilization i s 30-50 percent below Western European railways. H Z ' s current rolling stock and motive power inventory consists o f 275 traction units, 571 40 European Commission, Regional Balkans Infrastructure Study - Transport, July 2003. 73 passenger cars and 6,813 freight wagons in 2006. This exceeds the requirements posed by current traffic levels. However, E ’ s rolling stock, and motive power inventory i s o n average old, and the structure o f rolling stock i s not well matched to market needs. 3.14 Passenger traffic accounts for nearly a third of overall railway traffic in Croatia, but the average distance traveled i s very short, even by European standards, and this depresses operating efficiency and profitability. The number o f passenger trips per year reached nearly 46 million in 2007-a significant 26 percent increase over 2003. However, a corresponding decrease in distance traveled has kept the overall level o f passenger-kilometers fairly steady, and the share o f railways in overall passenger transport continued to decline. Although 36 percent o f passengers used railways in 2006, the railways accounted for only 18.6 percent o f passenger-kilometers traveled in Croatia and the railways continue not to be price competitive relative to bus and airline services. EFFICIENCY 3.15 The rebound in traffic and a labor retrenchment program which reduced staff by 42 percent between 1998 and 2006, were not sufficient to make a significant improvement in HZ financial performance. Despite doubling the increase of staff productivity since 2000, the current value of productivity i s significantly below the figures attained by other European railways. I t stands at 64 percent o f the staff productivity in Switzerland, 53 percent o f Austria’s or 46 percent o f Germany. The staff productivity o f HZ in 2006 stands at 50 percent o f the average productivity o f the EU27 or has just approached only Romanian railways’ productivity level. These figures indicate that in spite o f the obtained improvements, the productivity o f HZ i s s t i l l under the level that would allow them to compete successfully in a free transportation market. There are only two ways to improve the staff productivity: staff reduction and increase o f the transportation volume. Table 3.2: Key Performance Indicators of Railways 1999 2000 2001 2002 2003 2004 2005 2006 2007 Traffic Units (pkm+ tkm in 2,822 3,040 3,315 3,401 3,650 3,706 4,101 4,667 5,481 millions) Labor Productivity (in 145 164 182 212 245 251 290 343 413 thousands TU/staff) LaborCostsas%ofOperating 88% 92% 96% 133% 126% 124% 113% 96% 100% Revenue Average Unit Operating Costs 0.75 0.73 0.67 0.69 0.73 0.75 0.70 0.62 0.56 (excl. depreciation) Working Ratio (without 202% 213% 195% 240% 240% 242% 220% 190% 193% subsidy) Source: CROSTAT, HZ. 3.16 I n comparison with railways in other countries in Europe having similar population and traffic composition, HZ suffers from particularly low levels of labor productivity and high unit labor costs. International comparisons o f railway performance are often difficult because o f the very different characteristics o f the traffic (freight traffic i s inherently more profitable than passenger traffic), network, railway sector organization, and accounting policies especially when separating tariff revenues from budget support. However, efficiency indicators which relate staff numbers and labor costs to total traffic are not subject to such varied interpretation as measures such as the working ratio or profitability indicators. 74 Table 3.3: Productivity and labor costs for selected European railways in 2006 Croatia Slovenia Bulgaria Romania Finland Austria Area (square km) 57 20 111 239 339 84 Total population (millions) 4.4 2 7.7 21.6 5.2 8.2 Share o f passenger traffic in total traffic 29% 19% 32% 35% 25% 31% Traffic Units (pkm + tkm, in millions) 4,667 4,166 7,671 22,773 14,666 27,646 Staff (in ‘000) 14.2 8.1 33.8 65.9 10.3 45.2 Productivity (in ‘000 TU per staff) 343 5 14 227 346 1,424 612 Total labor costs (in million Euro)* 211 160 61 305 557 2,038 Labor costs per T U (in Euro)* 0.05 0.04 0.01 0.01 0.04 0.07 *for EU countries 2004 Source: UIC, World Bank and Annual Reports for selected railways. 3.17 A substantial increase in wages granted in 2003 and 2008 not only reversed earlier reform progress, but also put an Figure 3.2: Education Profile o f Railways’ Workers, 2005 upward pressure on labor costs, which exceed HZ’s revenue from operations. Labor cost per traffic unit remains even Low and high Less than higher than in Slovenia which has university primary W i r y and degree \ 5% internal considerably higher wages and a smaller railway system. The average gross wage in HZ in early 2008 at 8,282 kuna stood at 12 percent above the country average or 13.6 percent above education sector average. The qualification structure o f staff, however, remains very l o w 4 3 percent o f staff has less than secondary education. 3.18 Staff retrenchment, which Source: Annual HZ Statistics, 2005. started at the beginning of the decade, i s proceeding slowly. Some o f the early staff retrenchment was achieved through the separation o f subsidiaries. However, as subsidiaries remained sole suppliers to HZ, the unit operating costs did not decrease as much as it could be expected. The working ratio (expenditures excluding depreciation and financial costs as a percentage o f revenues without subsidies) continued to deteriorate until the end o f 2004, when it reached a record 240 percent. That trend was finally reversed in 2005 as HZ continued to reduce staff in the core business. However, the average reduction o f just 580 staff per year, or even 320 in 2007, remains modest. I t was only because o f improved traffic and revenue performance that the working ratio declined from 240 to 190 percent in 2006, to be again reversed in 2007 to 193 percent. For faster restructuring, retrenchment numbers will need to be increased significantly. 75 3.19 The railways have continued to place a heavy financial burden on the state budget due to poor Figure 3.3: State budget support per rail traffic unit (TU), in USD HZ operating performance. The decline in traffic, which started with the dissolution o f the former Yugoslavia, continued in 1999 partially due to adverse external circumstances, such as the Kosovo oY, t P Z x l r L 1 $ I P ~ , r i ~ ~aryrll$pxl ~ ~ ln~~r~ crisis. Freight traffic fell by 3 percent, but Source: World Bank database. the average traffic unit revenue was much more severely affected and decreased by 12-14 percent. Since 2000, freight traffic has been slowly recovering, reaching 146 percent o f the 1999 level by the end o f 2005. Passenger traffic has remained more or less constant since 2000. 3.20 The level of state support to the railways in Croatia has been very high by international and domestic standards. When compared to the length o f the network, Croatia allocated US$190,000 per route-km in 2005, 10 percent higher than Turkey (US$172,000), and 422 percent higher than Romania (US$45,000). The amount o f state subsidies per traffic unit transported by rail in 2000-2004 was also considerably higher than in other Central and Southern European countries (Figure 3.4), as was state budget support as percentage o f GDP. In 2007, budget support at one percent o f GDP remains equivalent to one-third o f total social welfare spending or five times the spending on the means-tested support allowance that goes directly to 125,000 living in poverty. There has been an implicit public decision to compensate those that use, or are employed by, the railways. Figure 3.4: State Budget Support to Railways, 2001- Figure 3.5: Structure o f Budget Support to the 2007 Railways, 2006 1.6 .. . . . . . . . . . . . . . o Sewance 1 ,, .................................. .......... .i i Loans repaid 8 assumed payments I 3% Operating subsidv +Operating subwdy 00 subsidy 2001 2002 2003 2004 2005 2006 2007 29% Source: MoF, HZ 2005 Annual Report. Source: HZ Business Plan 2006-2010. 3.21 Soft-budget constraints exercised so far towards railways were partially due to the fact that HZ i s a heavily unionized and a large employer. Although HZ and i t s subsidiaries employ some 20,639 employees (2007) or 1.1 percent o f the labor force, i t has over thirteen unions with apparently strong negotiation skills. The disparity o f the wage level vis-a-vis the education profile o f staff has been further widened by additional benefits such as bonuses, high severance payments, long layoff notice periods, working conditions, all o f which prevent rejuvenation and upgrading o f the staff profile (Figures 3.6 and 3.7). Bonuses add over 30 percent to the basic wage bill, while working conditions reduce the productivity o f railways (for example, an engine driver that spent four hours driving a train cannot then return i t to the point o f origin as that would exceed his working hour limit). 76 Figure 3.6: Age Profile o f H Z Staff, 2005 Figure 3.7: HZ Staff by Years o f Service, 2005 I 60, ............ ............ ~. . . . . . . . . . . ~ . . . . .. .~... . . .~. . . . .. . ~ . 40 35 50 30 40 25 30 20 20 15 10 10 5 0 0 <30 31-45 46-55 56< <5 6-15 16-25 26-35 3% Source: HZ 2005 Annual Report. Source: HZ 2005 Annual Report. 3.22 Continuing with “business as usual� will lead to an increased burden on public resources. This i s because o f (i) investment loans that will add to the debt and interest burden, (ii) further pressure to increase real railway wages, and (iii) increasing competition from other railway operators, alternative international corridors and road transport that will reduce rail freight revenue yields and perhaps even traffic volumes. The government realizes that H Z ’ s current operating and financial performance i s not sustainable and that the company i s not prepared for competition-which will certainly increase with the liberalization o f rail markets following the EU accession. The implementation o f the 2006 Railway Law with the separation o f the railways into four companies and a holding entity (“HZ Group�) has started. In addition, there are still 14 smaller subsidiary companies involved in auxiliary activities, as only two were privatized in 2007 and one sent for bankruptcy procedure. 3.23 The transformation of HZ into a holding structure will not in itself result in higher efficiency and improved financial performance, although it will increase cost transparency and meet EU directives. A report prepared by McKinsey & Co consultants in 20054’ proposes a sequence o f reforms that would ensure that medium-term targets are met and that HZ transformation brings about lasting improvements in efficiency and competitiveness rather than just a new organizational structure. Some o f the critical reform initiatives, including the proposal to rationalize local railway lines and services, and introduce the public service obligation contract, remain to be approved by the government andor parliament. 3.24 The 2006 mid-term and 2008 business plans for HZ do not reflect a change in focus towards greater commercial Table 3.4: ProjectedPublic Finance Needs, HRK millions competitiveness, but instead 2007 2008 2009 2010 they proposed an Operating subsidy 1,357 1,328 1,284 1,291 investment program which Investment support 1,539 2,016 4,155 3,914 i s fiscally excessive and Loans repaid assumed 680 595 547 464 lacks an overall sectoral Severance payments 105 79 79 52 strategy with proper economic justification. The Total Public Finance Support 3,681 4,018 6,065 5,669 plan i s built around creating a as % O GDp ! f 1.5 1.6 2.4 2.3 high-speed railway, using Source: HZ Business Plan 2006-2010. state o f art technology, as the 41 McKinsey & Co, Improvement o f Competitiveness o f the Croatian Railway Transport through Croatian Railways Restructuring, 2005. 77 main objective. Good business ‘principles, however, would dictate that the railways be designed to serve the business at hand in the most cost-effective manner. I summary, the plan needs to be revised n if it i s to provide enough technical information for decision makers: The investment program needs a definite framework for investment decisions based o n cost- benefit analysis and projected economic rates o f return; The proposed investments need to be prioritized, since the state budget i s constrained and funds provided are likely to be less than the amounts requested; The incremental capital and recurring expenditures for services performed as public service obligations should be computed separately and highlighted; The investment proposals should be amended to take into account the potential for increasing productivity o f assets; A central objective, such as “Total Budgetary Support Requirements� or “Operating RatioyA2 needs to be identified in order to enable the government to exercise sector governance more effectively and capture the interplay o f multiple targets for traffic, revenue, staff reduction, cost reduction, staff productivity, working ratio, etc; and The financial forecasts should reflect the impact o f the proposed investments. The mid-term plan i s light on efficiency and productivity improvements, yet a rigorously implemented improvement strategy could lead to substantial savings from cutting the proposed level of investment. Most notably, the rolling stock investment proposals do not take into account potential for increasing efficiency and productivity o f motive power and rolling stock, in particular, the increased availability and utilization rates o f locomotives, reduced turnaround time for wagons, and the improved utilization and rationalization o f passenger services. 3.26 The investment program i s a collection of diverse investment proposals and lacks a pragmatic approach and a financing framework for arriving at a realistic level of investment. In the case o f normal private businesses, increased investment means an increased debt service requirement, increased depreciation, increased risk, and lower profitability, which l i m i t s the scale o f investment to a realistic level. Since the HZ Infrastructure company, in particular, i s not required to service the debt and expects the government to finance the yearly deficit, it is, unfortunately, under no pressure or motivation to limit the level o f investment. 3.27 The government and HZ first need to agree on a framework for investment decision making, which takes into account the fiscal constraints and limits on the state budget. There are at least four such approaches for investment decision-making that the government may want to consider: (i) technical standards approach; (ii) gradual improvement approach; (iii) feasibility approach; and (iv) simulated operating ratio approach. These approaches are not necessarily exclusive and, if desirable, can be applied simultaneously. RECOMMENDATIONS 3.28 HZ restructuring and reduction of its heavy reliance on budgetary support should continue to be a central objective in the medium term. The interplay o f multiple targets for traffic, revenue, staff reduction, cost reduction, staff productivity, and the working ratio i s dynamic and non- transparent unless put in the context o f one central objective, such as “Reduction in Total Budgetary Support� or the sector’s “Operating & Debt Service Ratio� (total operating costs, including depreciation and debt service, to operating revenues without any budgetary support). Only such clear focus on a central objective will enable the government to exercise governance more effectively in a sector which, with the transformation o f Croatian Railways and future opening to other carriers, will increase in complexity. 42Total operating costs, including depreciation and debt service, t o operating revenues without any budgetary support. 78 3.29 T o become competitive, financially sustainable, and to operate with reduced level of financial support from the government, at below the current level of one percent of GDP, the railways will need to reconfigure their technology, systems, staffing levels, and investments, including the following steps over the medium term: Prioritization of investments with first priority given to assets generating the bulk of revenues and/or critical to increased operating efficiency. The primary investment goal should be to best serve the existing markets and customers in the most efficient manner. The cost o f investments needs to be reflected in comprehensive financial forecasts, whether or not they will be borne directly by the railways or subsidized by the state. Closing uneconomic lines and recalibrating the network to fit the traffic demand forecast, beyond what has been proposed in the recent program prepared by HZ. The extremely short average distance traveled, combined with the excellent state o f motorways in Croatia, will inevitably limit the attractiveness and competitiveness o f railway passenger services. The focus could be shifted towards urban commuter services to ease urban traffic congestion, while limiting the high costs o f maintaining regional passenger services and network. Reducing staff numbers by 30 percent in the next three years, including staff in subsidiaries, which will not be privatized in that timeframe. HZ lags behind most European railways in labor productivity, and the modest staff reductions proposed in the medium-term business plan are not likely to change that situation. Moreover, the unit cost o f labor i s high and will continue to grow. This situation will make HZ extremely vulnerable to competition from other freight carriers, once the network i s opened t o competition. As long as the subsidiaries remain sole suppliers to HZ, the cost o f their excess labor i s in fact borne by HZ. Therefore, comprehensive labor cost saving plans need to include the subsidiaries. Implementing a rigorous efficiency improvement program (beyond the staff reduction program) and exposing all internal or external suppliers to competition o r at least international best-practice benchmark pricing. A rigorously implemented efficiency and productivity improvement strategy can lead to substantial cutbacks in necessary investment levels and operating state subsidies in the medium term, and i s absolutely necessary to the long-term survival o f HZ in the competitive post-EU accession railways market. In the medium term, several subsidiaries will continue to be sole suppliers to HZ, possibly even after they are privatized. I t i s therefore critical for HZ competitiveness and overall cost transparency that internal transfer pricing be replaced as soon as possible by competitive benchmark pricing. If the supplier cannot maintain profitability at benchmark pricing, it should be privatized or wound down. HZ should not be expected to subsidize i t s subsidiaries. Tying all operating subsidies whether from the state or local budgets to performance- based contracts such a Public Service Obligation (PSO) contracts and infrastructure s maintenance contracts, with targets derived from the efficiency improvement program. Although operating subsidies will continue to be needed for the infrastructure and the passenger service companies, subsidy regimes which focus o n covering the operating deficit are particularly harmful and tend to engender complacency rather than competitiveness. They should be replaced by dynamic sewice contracts, which could eventually be subject to competitive bidding. 0 Privatizing or divesting all non-core subsidiaries and dispensable real estate assets. HZ has limited time left to streamline i t s operation, reduce costs and distractions to top management and develop a transparent financial structure and asset base. All necessary subsidies should be channeled through PSO and infrastructure maintenance contracts rather than potential proceeds from the divestiture o f disposable assets. Furthermore, divestiture o f real estate assets and privatization o f subsidiaries i s a time-consuming process, which i s best done by specialized entities such as the Croatian Privatization Fund and real estate developers. 79 C. INFRASTRUCTURE ROAD EFFECTIVENESS 3.30 Croatia has doubled the length of the motorway network in the period 2001-2007 to bring it to over 1,100 kilometers, and it has Figure 3.8: Condition of National Road Network become an example in the region of good (2006) - program implementation as well a the quality s of the motorways. The decision to invest in the motonvay network, however, was not always based on a high-quality cost-benefit analysis or economic justification, and several studies concluded that the road network in the late 1990s provided sufficient capacity (with few exceptions) for actual and projected demand43. Fair, However, the investment decision was made on 24% political, strategic and development grounds-the motonvay network was and i s s t i l l seen as an Source: HC. integral part o f the development o f tourism industry in regions that were neglected by the road network inherited from the former Yugoslavia. The government also considers the motonvay network as an important factor t o strengthen regional cohesion, especially given Croatia’s geography, and expects the motonvay network to provide an effective link with the EU. There are analytical evidences that confirm such consideration^^^. 3.31 Croatia’s heavy investments in new motorways have been at the expense of maintaining the non-motorway network and have resulted in considerable financial obligations to service the debt needed to finance this investment. Croatia has more developed motonvay network than EU15 countries, measured either by density o f motonvays per 100 km2 (Croatia 2.06 versus EU15 1.65) or by motonvays per 100 thousands inhabitants (Croatia 26 km versus EU15 14 km). However, due to a significant maintenance backlog, the present state o f the network i s n o w well below standard. The Government has through the second stage o f the National Road Investment Program aimed to address the backlog which resulted in some improvements o f roads’ condition. Croatian Roads (HC) estimates that third o f state roads are in poor condition (Figure 3.Q and a large proportion o f structures on state roads (bridges, culverts, etc.) are in immediate need o f repair. The condition o f county and local roads i s not better than that o f national roads. HC states that the deterioration o f national roads was stopped in 2005. Although this i s a positive step, clearing the accumulated maintenance backlog will require a fundamental shift in the government policy regarding spending priorities going forward. 43 Transport Infrastructure Regional Study (TIRS) in the Balkans (03/2002), Louis Berger SA for the Stability Pact, and REBIS 2003. 44 World Bank (2007), Croatia: Living Standard Assessment 80 EFFICIENCY 3.32 The ongoing road investment program, which started in 20014', i s large relative to the size of the country's economy and its Figure 3.9: Public Spending on Road Infrastructure, neighbours, and future liabilities of these average 2001-2004, % of GDP investments on the State's books are also 40% not negligible. Total public spending on 35% road infrastructure in the period 200 1-2004 3 0% averaged 3.5 percent o f GDP per annum, o f 2 5% which two-third quarters were for 20% development and operation o f the motorway 5% 10% network, and 60 percent o f this spending on 05% motorways was covered by sovereign or oo% ** sovereign-guaranteed debt. This level o f spending i s exceptionally high compared & &* fl*o* 8@Q $6 +A Qe * e , *" e" * + + with averages in the region and Western $ % GL Europe (Figure 3.9). However, the results achieved were also significant. Source: Trends in transport infrastructure investment 1985-2000, ECMT 2003, Croatia 2001-2006, and World Bank estimates. 3.33 The cost of the government program for the 2005-2008 period after 2007 revision amounts to an estimated 3.4 percent of GDP per annum, with somewhat modest increase in the share for road maintenance. By 2008, the construction o f new roads was planned to decline towards 2.0 percent o f GDP, while maintenance would remain stable at approximately 0.9 percent o f GDP per year. The question that arises i s how to balance future investment needs in the network other than motorways, which suffer from a backlog o f maintenance, and at the same time maintain the valuable new motorway assets and service the financial liabilities incurred. 45 Public Roads Construction and Maintenance o f Program for the period 2001-2004 and 2005-2008 81 Table 3.5 Spending on Road Infrastructure 2001-2008, HRK million’’ 2001 2002 2003 2004 2005 2006 2007 2008 2001-2004 2005-2008 Actual Actual Actual Actual Actual Actual Prelim Plan Used o f Funds Maintenance and periodic rehabilitation 1,086 1,889 2,132 2,659 2,584 2,385 2,603 2,691 7,766 10,262 N e w Construction 1,883 4,081 7,010 5,874 5,380 5,826 6,825 6,073 18,848 24,104 Other 0 212 238 241 307 412 396 362 69 1 1,477 Debt Service 60 17 48 32 642 936 1,538 1,834 157 4,950 o/w Interest 60 17 48 32 492 659 922 1,109 157 3,181 o/w Principal 0 0 0 0 150 277 616 726 0 1,769 Total 3,029 6,199 9,428 8,806 8,912 9,559 11,362 10,960 27,461 40,793 o Y o f GDP 1.8 3.4 4.8 4.1 3.9 3.8 4.1 3.6 3.5 3.9 Sources o f Funds T o l l Revenue 156 606 775 1,072 1,262 1,279 1,401 1,494 2,609 5,43 6 Fuel Levy 1,247 2,486 2,639 2,677 2,761 3,232 5,004 3,260 9,049 14,258 Other own revenues 390 577 581 283 1,231 1,417 1,485 1,257 1,83 1 5,391 VAT Return 72 152 250 306 0 0 0 0 780 0 General budget 151 206 235 0 0 0 0 0 592 0 Long-term borrowing 1,080 2,652 3,848 4,659 3,785 3,102 3,161 3,095 12,239 13,143 Total 3,096 6,679 8,328 8,997 9,040 9,030 11,051 9,106 27,100 38,227 I’ Includes Bina-Istra and AZM concessions. Source: World Bank estimates based on 2005-2008 program; H A C and H C 2003-2004 audit reports; and HC, H A C and ARZ data. Some discrepancies between total uses and sources o f f i n d s are due to the multiple sources o f information as well as H A C and H C switch between accrual and cash basis accounting. 3.34 Pressure for future public spending Figure 3.10: Ratio o f Projected HAC’SFuel Levy will also increase as a result of the debt service Revenues to Projected Debt Service, 2006-2011 associated with the heavy reliance on long-term 360% borrowing for the motorway program. Debt 140% service will reach a peak between 2008 and 2012 1209b at between 0.7 and 0.8 percent o f GDP; two thirds o f i t will be used towards reimbursement o f the 80% principal. This includes paying o f f a domestic bond in 2008, a Eurobond in 2010 and a bullet loan in 201 1. 40% 20% 3.35 Croatian Highways (HAC) current 0% model of using future cash flow from the fuel 2006 2007 2008 2009 2010 2011 levy to service the debt i s already reaching i t s Source:HAC. limit. I t i s unlikely to be sufficient to service additional debt needed to finance the implementation o f the remainder o f the program through to 2008 and beyond (Table 3.5). Fuel l e v y i s the second most important source o f financing for road infrastructure, and has been providing a steady source o f funding to H A C and HC amounting to an average total equivalent to 1.3 o f GDP annually in the period 2001-2006. This source o f cash flow has been particularly important in allowing H A C to contract long-term borrowing from IFIs and commercial banks, backed by sovereign guarantees, as well as to raise funds indirectly in the capital markets through the Ministry o f Finance. The fuel l e v y channels directly to H A C HRK 0.6 per liter of f u e l sold and another HRK 0.6 per liter to HC. In 2006, this dedicated levy was consolidated in the state budget, but did not affect i t s dedicated character to H A C and HC. Because HAC’S business model depends entirely on the fuel levy, any significant change in the rules o f this dedicated fuel l e v y or a decrease o f its level will have an impact on HAC’S financial position and i t s ability to cover i t s 82 liabilities. Funds from the fuel l e v y financed on average 34 percent o f Croatia’s spending on road infrastructure in the period 200 1-2007. 3.36 Tolls levied on motorways are the third source of financing providing 11 percent for the total program in the period 2001-2006, and they are planned to contribute 14 percent of the program for 2008. When only the motonvay program i s considered, tolls financed 13 percent o f the program in 2001-2004 and are planned to finance 27 percent o f 2005-2008 program. However, the most important source o f financing o f road infrastructure in the future will remain a long-term borrowing. On average, long-term borrowing covered 39 percent o f spending in road infrastructure, but this share i s more than 60 percent for the motonvays program. 3.37 Although efficiency of the current institutional setting has delivered planned programs, there i s an opportunity to further reduce the operating costs and improve the planningprocess. The overall operating cost (that includes interest payments) accounted for over 3 percent o f the overall road spending during 2001-2007 period. This i s partly due to increased financing cost, but also to the fragmentation o f institutions delivering the program. The government’s political decision to invest in the motonvay network lead to the subsequent reshaping o f the road infrastructure institutions, driven by the need to implement this program while adopting different financing mechanisms. In 2001, the Public Roads Act reorganized the Croatian Road Authority into two separate entities: (i) Hrvatske Autoceste (HAC), a joint-stock company, 100 percent-owned by the state, which became responsible for the construction and management o f the motonvay network, except for that which i s constructed or maintained by concessionaires; and (ii) Hrvatske Ceste (HC), also a joint-stock company, which became responsible for the construction and management o f all other state roads-which constitute the vast majority o f the network. A t the policy level, the Ministry o f Sea, Transport and Infrastructure i s responsible for the activities o f HAC, H C and the 21 Counties and approves their strategic plans through road development planning and day-to-day administrative processes. Currently HAC, with 2,485 staff, and ARZ, with 555 staff, perform all operation and maintenance activities in-house for the motonvays they manage (app. 800 km for H A C and 147 km for ARZ). HC, with 320 staff manages maintenance subcontracts for the 7,000 kilometres it i s responsible for. All o f the routine maintenance work on the state road network managed by H C i s carried out by 14 Road Maintenance Companies, which used to be part o f the Croatian Road Authority and are all but three or four privatized with a remaining minority stake held by H C and counties. 3.38 Planning for road infrastructuredevelopment i s a comprehensive process, but does not involve economic appraisal techniques. The planning process follows three stages. First, the strategy for the development o f public roads i s prepared by the ministry based on the strategic plans o f HAC, HC, and counties and i s proposed on behalf o f the government, and adopted, as appropriate, by Parliament. Second, based on the adopted strategy, the ministry prepares a four-year program. So far, two such programs have been prepared: the “Public Roads Construction and Maintenance of Program for the period 2001-2004�, and that for the period 2005-2008. Then, HAC, H C and the County Roads Administrations, prepare one-year implementation plans for the construction and maintenance o f public roads. However, at no stage are cost-benefit techniques being used to review and prioritize the investment program. 3.39 Although Croatia has attempted to bring in private sector funds to finance road infrastructure since the early 1990s, the overall experience has not been particularly successful. The reorganization o f road institutions also brought with i t a new financing model for the development and operation o f the road infrastructure. The Public Roads Act allows for the possibility o f ceding motonvay construction and operation to a concession company. In this case, the ministry i s also responsible for the administration o f the concession contract. So far, three concession contracts, which can be described as PPP projects, have been awarded: (i) Bina-Istra: awarded in 1995 to Bina- Istra, a concession company jointly owned by Bouygues SA, HAC, INA Industrija Nafte, and Istarska Autocesta; (ii) Autocesta Rijeka-Zagreb (ARZ): awarded in 1997 to ARZ, a 100 percent government- 83 owned concession company; and ( i ) i i Autocesta Zagreb-Macelj (AZM): awarded in 2004 to AZM, a concession company jointly owned by Walter Concession Holding GmbH and the Republic o f Croatia, which reached financial closure only in 2004. 3.40 A study of PPPs in the road sector in Croatia46concluded that these concessions enabled Croatia to develop innovative funding packages to implement more major new infrastructure projects than many of i t s Central and Eastern European neighbors under difficult circumstances. However, the current arrangements o f the two remaining concessions have significant financial implications for the government in terms o f financial guarantees, and general involvement that i s not necessary for the concessions to operate. The two concessions have been organized in a way that allows a non-competitive process to be undertaken. International experience shows that the financial implications for the government would have been more favorable if these concessions had been procured through a competitive PPP process. RECOMMENDA TIONS 3.41 Rigorous prioritization of investments and more focus on maintenance of existing road assets. N o w that the government has gone a long way in the implementation o f i t s investment program in the road infrastructure, the critical issue, given the government policy and strategy, i s how the country can better use, operate, and manage the existing and future road infrastructure to further improve Croatia’s competitiveness and comparative advantage. Croatia’s competitiveness depends to a large degree on how much it can keep total transport costs low. Regardless o f whether the road infrastructure i s provided by the public or private sector, road users and beneficiaries ultimately pay for the investment through user fees or taxes, and this has an impact o n the competitiveness o f industries and services in Croatia. Servicing HAC’S accumulated debt will be competing for funds from users, tolls and fuel levy, with a risk o f too little financial resources being left for maintenance o f motonvays, and even more seriously for the rest o f the network. 3.42 Enhancing operational efficiency of road infrastructure operators. There are signs that road maintenance companies have dominant positions in their territories, which tends to limit competition from private sector companies. The development o f a competitive contracting market can bring prices down and provide large efficiency gains to HAC, HC and ARZ. I t will also stimulate the formation o f more competitive private contractors. At the same time, the government could evaluate present levels o f maintenance expenditure to determine the economic benefits that will result from additional spending. This should be done in combination with the introduction o f some form o f incentive schemes for all publicly-owned road operators so that they are financially rewarded or punished depending o n their performance in maintaining the road network. 3.43 Institutional consolidation. Given that the HAC’S mission o f construction i s increasingly becoming that o f maintenance and preservation o f the newly created assets, the government may think about merging the national roads and motonvays under the single implementing agency. This could create room for staff downsizing and cutting other operating costs. 3.44 Development of a competitive PPP market for the provision of road infrastructure. This may entail the possible privatization o f ARZ, the restructuring o f some o f HAC’S debt, the review o f the current concession motonvay contracts, and the preparation and procurement o f future concession contracts under a fully competitive PPP process. The complexity o f these issues warrants an in-depth assessment o f the current institutional setup with a view to defining an adequate reform program. Experience gained from road PPPs in countries such as Hungary, Portugal, Spain, Chile, and Mexico have demonstrated a number o f lessons for successful PPPs: (i) importance o f a well-designed the legal, regulatory and institutional framework; (ii) transparent and competitive bidding procedures; 46 Private Sector Participation Options for Second Generation Road Investment and Rehabilitation Program in Croatia, Atkins, 2005. 84 i i adequate program preparation and implementation capacity; (iv) the need for reliable traffic (i) forecasts; (v) the concession structure addressing financial and economic issues such as the duration o f the concession, impact o f toll levels, extent and type o f government support, maximum private sector return, etc., and (vi) proposed projects must have economic merit-private financing i s not an alternative for projects that would otherwise not be economically justified. 3.45 An in-depth analysis i s needed to estimate the government liabilities towards the concessionaires because of the complex involvement of the government in these operations as shareholder, through HAC, and as grantor of the concession. In the case o f Bina-Istra concession for instance, the government pays a monthly financial contribution, estimated at around EUR 20-25 million annually, which i s meant to cover, after deducting all projected toll revenues, all the concessionaire’s operating and maintenance costs, debt service requirements and a guaranteed fixed return o n the equity. There i s no performance formula used in calculating this contribution, so it does not provide incentives for the concessionaire to provide the service in the most efficient manner. 85 4. ENVIRONMENT 4.1 Croatia i s currently negotiating the environment chapter with the European Union. In February 2007, the European Commission issued Screening Report for Chapter 27 - Environment. The Report acknowledges that Croatia achieved a great deal in alignment with the acquis. One opening benchmark for the Environment Chapter has been set, and that i s for Croatia to continue developing administrative capacities on national, regional and local level and to present the time- bound financial plan for implementation o f environment acquis. The administrative burden o f transposing over 200 legislative acts under environmental directives4’ that constitute the environmental acquis and in ensuring compliance with the new legislation in the coming years i s considerable. I t s financial implications are substantial too. 4.2 Preliminary estimates of the cost of compliance with environment directives suggest that it might amount to around €10-12 billion. The largest estimated investments are for solid waste management (around €3.25 billion) followed by Industrial Pollution and Prevention Control (IPPC), water supply and sewerage upgrades. I addition, there are potential liabilities arising from the high n share o f state ownership in industrial facilities which will also need upgrading (at a cost o f app. €2 billion) to comply with EU directives, including that on “Large Combustion Plant� (LCP). 4.3 There are of course quantifiable economic benefits of compliance with the environment acquis. Those are estimated to be in the range of €303 million to €2.4 billion per year, assuming full compliance by 20154argely from water and air improvements accruing to Croatian citizens, foreign tourists, and neighboring countries.48 4.4 Taking into account the experience o f the new EU member states (NMS), including possible transition periods for complying with the acquis, the government drafted in 2005 a Water Management Strategy that contemplates the completion o f total investment program for 2023, with about 23 percent going to the water supply, 28 percent to investments in the waste water systems and treatment and 49 percent on construction and maintenance o f flood protection systems. In addition, 47 The EU Environment acquis includes over 200 legislative acts under eight broad categories: Horizontal legislation (Environmental Impact Assessment, Access to Information, Strategic Environmental Assessment, Public Participation, and Environmental Liability); 0 Air Quality (ambient air, VOCs from petrol stations, S02, NOx, N 0 2 , particulate and lead emissions; Sulphur content in Fuel, Vehicle emissions, Emission Trading, Emission Ceilings, Ambient Ozone); 0 Waste Management (hazardous waste, packaging waste, wastewater treatment sludge, waste oils disposal, PCBsRCTs, battery disposal and labeling, landfill o f waste, incineration o f waste, end o f life vehicle management, electric and electronic waste and hazardous substances); 0 Water Quality (Urban Wastewater, Drinking Water, Nitrates, Bathing Water, Groundwater, Dangerous Substances to water, Surface Water, Water for Aquaculture) Nature Protection (Habitats, Wild Birds, Zoos); 0 Industrial Pollution Control (Pollution Prevention and Control, Solvents, Large Combustion Plants); Chemicals (Dangerous Substances, Release o f GMOs, Animal Experiments, Asbestos, Biocides); GMOs; 0 Noise; 0 Forestry. 48 Benefits for Croatia o f compliance with the environmental ucquis, M a y 2005, the European Commission, DG Environment (04/08853/AL). The wide range accounts for lower bounds o f risk and adjustments for national purchasing power indicators. the Government adopted Waste Management Strategy and Waste Management Plan for 2007-20 15 period. A new Environmental Protection L a w provides foundation for harmonization with the IPPC Directive and SEA Directive. By adoption o f by-laws o n IPPC in 2008, the whole process o f issuing IPPC permits for new and existing units will be fully regulated. 4.5 Given that the country faces serious fiscal constraints, the challenge will be to prioritize and sequence the related government investments so as to maximize potential benefits within the available resource. In addition, the government will need to step up i t s efforts to utilize more o f available EU funds in this sector. Privatization could also help to lower the direct costs to the State, if undertaken with careful integration o f environmental issues and future environmental compliance plans. However, the current draft National Water Management Strategy does not endorse the concept o f private capital investments. 4.6 Organizational reforms in the environment management would be required if the full benefits from the improved environment are to be realized through the potential impact on public health, tourism, and ~ompetitiveness.4~ However, organizational effectiveness seems to be suboptimal with over fifteen central government institutions involved in environmental management. Reforms are also needed in the area o f municipal infrastructure where large efficiency gains from economies o f scale can be achieved through agglomeration o f utility services. The largest investment financing gap in the medium term budget framework i s exactly for solid waste that falls under responsibility o f municipal utilities. 4.7 This Chapter first takes stock o f current environmental conditions (Section B), then outlines what the government proposes to do to bring them up to EU standards (Section C). While the costs involved are sizable, Section D argues that they could be met over time within the current fiscal envelope o f about 1 percent o f GDP, provided the appropriate priorities and policies are implemented. Section E highlights the required organizational change in the light o f the experience o f the NMS, and Section F summarizes the recommendations that arise from the previous ones. 49 There are quantifiable economic benefits o f compliance with the environment acquis that are estimated to be in the range o f €303 million to €2.4 billion per year, assuming full compliance by 20 15 - largely from water and air improvements accruing to Croatian citizens, foreign tourists, and neighboring countries. The source o f these estimates i s the EC DG Environment (04/08853/AL). The wide range accounts for lower bounds o f risk and adjustments for national purchasing power indicators. 88 A. CURRENT ENVIRONMENTAL CONDITIONS 4.8 I n Croatia, 76 percent of the population receives reliable water supply services, which i s lower than in the new EU member states. The figures are much lower in Figure 4.1: Environment in Perspective, 2004 the rural and inland river basins o f the Sava and Drava where coverage rates 80 are as l o w as 31 percent. Water losses 70 are high at 46 percent on average, 60 nationally. The sector i s being served 50 by 127 municipality-owned water 40 companies, which in a country o f 4.5 30 20 million people seems highly fragmented. 10 4.9 Access to public sewerage i s 0 Water suppv Connectionrate to Connection rate to Municipalw aste even lower with only 40 percent of connection rate level public sewage waste water collectionsystem the population connected and less treatrent plants than 20 percent of all municipal wastewater treated. This compares Source: National Development Programs, various countries. poorly with 63 percent coverage in the U new E member states. Onlyabout half o f the treated wastewater satisfies the effluent requirements o f the government, and most o f the 74 wastewater treatment plants need to be upgraded to meet EU standards. The discharge o f untreated wastewater into open waters i s o f a particular concern along the Adriatic coast (which generates significant tourism revenues). The Urban Wastewater Directive, which aims to help protect the environment from the adverse effects o f wastewater discharges and the wastewater o f certain industries, requires household wastewater to be collected and treated in all communities with a population greater than 2,000. In communities with populations over 10,000, secondary or biological treatment i s generally required. The government's draft Water Management Strategy (2005) seeks to (i) increase sewerage coverage to 60 percent overall, with 100 percent coverage for municipalities with more than 15,000 people and 50 percent serving municipalities with 2,000 to 15,000 people; and (ii) construct and upgrade wastewater treatment plants5'. 4.10 I n contrast, Croatia has a wide coverage of municipal waste collection, though problems remain with organization of regional waste management centers and with illegal dumpsites and contaminated land. Around 80 percent o f population has municipal waste collection system coverage, though coverage ranges from 75 percent in a few counties to almost full coverage in the City o f Zagreb." Population served by organized waste collection has increased from approximately 2.7 million in 1995 (60 percent) to approximately 93 percent o f population in 2006. However, remediation o f a large number o f "hot spots" or contaminated sites will require significant investments. 4.11 As regards air quality, out of 35 operating Large Combustion Plants (LCP), it i s estimated that a large number i s not in compliance with the emission limit value (ELV) prescribed by the LCP Directive". Out o f all LCPs located in 14 industrial or electricity and heat generating subjects, two are coal fired, while the rest use liquid or gas fuels. Only one LCP, Thermal power plant Karlovac (thermal input o f 58 M W , uses gas fuel and has new burners installed), i s in 50 The city o f Karlovac was allocated the first ISPA grant support in Croatia for improvement o f the wastewater system. 51 Waste Management Strategy, Official Gazette N o 130/2005. 52 Directive 2001/80/EC i s the most costly EU Directive in the area o f air quality which aims at reducing air pollution (through dust, SOZ, and NO,) from combustion plants with thermal inputs exceeding 50MW. 89 compliance with the Directive 2001/80/EC. A power plant Plomin 11, uses a modem equipment to reduce emission o f certain pollutants into the air (desulphurization unit), but i t i s not yet in compliance with the Directive. Out o f 35 LCPs, 22 belong to Croatian Electrical Company (HEP), generating electric power and heat, 11 are industrial companies, including o i l refineries, chemical industry, pulp and paper producers, and two are local heating systems. The estimated total investments for upgrading existing L C P according to EU L C P Directive are €1 billion. B. PLANS GOVERNMENT 4.12 In line with the findings above, the medium-term budget framework devotes the lion’s share of planned spending to water supply and wastewater issues. Between 2008 and 2023, investment o f €1.4 billion and €1.6 billion for drinking water and wastewater, respectively, are required to implement the government’s strategy to increase overall water supply coverage to 90 percent with an appropriate focus on the Sava and Drava River Basins. The EC Screening Report for Chapter 27 Environment emphasizes that Croatia will need to invest around €5 billion for the full alignment with the Water Framework Directive. The Croatian Waters and Environment Protection Fund, extrabudgetary and budgetary agencies, respectively, along with local government units are allocating the largest amounts to these sectors, which relate to their role in water supply and wastewater issues (flood control, imgation, and water resource control expenditures were excluded). The financing plan consists o f a capital budget subsidy o f 50 percent for water supply and 60 percent for wastewater with local water utilities covering the remaining costs through tariffs and user fees. Table 4.1: Public Investment Needs and Medium-Term Budget Allocations (€ million) Estimated Estimated 2006-2008 Croatian Waters Total Investment Budget and Period Investments Needs 2006-2008 Projections Environment Gap Needs Fund Water 2005-2020 1,400 262.2 77.0 155.2 30.0 Wastewater 2005-2020 1,600 300.0 163.4 211.6 0 Waste 2005-2025 3,252 464.6 146.9 105.1 212.6 Air I IPPC 2006-2016 2,000 545.5 Nature 75 2006-2010 40.0 26.6 0.7 12.7 Protection TOTAL 8,327 1,6 12.3 413.9 412.6 255.3 Sources: Government Strategy documents 2005/2006 and State Budget (Straight line investment was assumed except for nature protection) 4.13 The government’s Waste Management Strategy estimates investment needs of €3.3 billion between 2005 and 2025 to improve waste management, the financing burden of which will fall largely on municipal authorities. Possible financing sources are presented in the Waste Management Plan for the period of 2007 to 2015. Funds will be provided from both public and private sources. Public sources include state, local and regional government budgets as well as funds from municipal companies, EU funds, Environmental Protection and Energy Efficiency Fund, and I F I s loans (the World Bank, European Investment Bank, European Bank for Reconstructing and Development, etc.). The budget envisions to partially cover the remediation o f “hot spots� or contaminated sites for which legally liable person no longer exists. Private investments are envisaged for waste management centers (through public-private partnerships, concessions, etc.) and primary separation and collection o f waste - recycling and collection yarddunits. There are plans to organize 17-21 County or Regional Waste Management Centers ( C W M C or RWMC) for solid waste management that will involve MBT and will be used instead o f existing landfills for municipal waste. Table 4.2 presents a summary o f plans underway for investments in these centers. Some 170 out o f total EUR 350 million should come from private investments. The government’s Environment Fund has allocated €20.1 million between 2006 and 2008 to help finance early actions at these sites. Three 90 sites have also received ISPA Technical Assistance and one (Sibenik) has been allocated ISPA funds. The Environment Fund has allocated €22.4 million between 2005 and 2008 to cover costs o f drafting remediation and protection measures and to begin early remediation works on contaminated sites. Figure 4.2: Public Financing for Waste Management Table 4.2: Planned Investments for County and Regional Waste Management Centers Count € million Waste management financing from public revenues SisaEko-moslavaEka (2006-2015) ibensko-kninska Local Istarska Regional 10% DubrovaEko-neretvanska KarlovaEka 19 LiEko-senjska (35 percent) KoDrivniEko-kritevaEka Medimurska Primorsko-goranska LiEko-seniska (15 Dercent) Brodsko-posavska PoZeSko-slavonska Zadarska LiEko-seniska (50 Dercent) OsjeEko-baranj ska Vukovarsko-srii emska VirovitiEko-podravska Bielovarsko-bilogorska Grad Zagreb 19 ZagrebaEka (w/o PTOO) TOTAL 350 Source: Waste Management Strategy, 2005 4.14 Air quality investments are largely the responsibility of companies. Many of those are - state-owned companies which has the potential to create sizeable contingent liabilities. The needs for investment in air and industrial pollution improvements are similarly large on an annual basis and although these costs would be born by commercial entities, there i s significant state ownership in affected industries. Costs for harmonizing with directives aiming at improving ambient air quality are estimated at €2 billion in the period 2006-2025. Some 80 percent o f large combustion plants are estimated to need investments to be able to comply. Investments would mainly involve the installation o f fuel gas desulphurization units at plants burning fuel oil, changing from the use o f o i l to natural gas and the installation o f low-NOx emissions, installations o f particles filters as well as the installation o f monitoring equipment in some plants. 4.15 Many of the same LCPs also need to make investments under the IPPC Directive. The estimated number o f IPPC installations i s about 150. Investments in the energy sector (seven thermal power plants (HEP) and four o i l refineries (INA)) and waste management (32 landfills) are the broad responsibility o f the public sector. Out o f a €2 billion cost estimate for compliance with the IPPC directive, approximately 75 percent will be borne directly by INA and HEP (costs are not given for terminals and gas stations, for chemical industry and for emission reduction o f volatile organic compounds). 4.16 The government i s also preparing to adopt the Natura 2000 system through Ordinance on Ecological Networks on Special Protected Areas in response to the EU acquis. The proposal will cover Natural habitat types as listed in Annex 1 o f the Natural Habitat Directive, distribution and 91 habitats o f endangered animal and plant species as listed in Annex I1 o f the Natural Habitat Directive and Annex I Bird Directive in the Republic o f Croatia. Future Natura 2000 ecological network will on partly cover already protected areas and those not protected aiming to increase protected areas to a targeted 15 percent.53 Ownership o f land in Natura 2000 ecological network will be both state and private. Investments will be required for infrastructure, equipment, capacity building, and data collection and reporting. Increase o f protected areas i s planned. Currently, financing for national and nature parks (which includes operating costs) i s allocated o n an annual basis in response to budget requests for each park. The adoption o f the first park management plans and action programs in 2007 will provide a longer term framework for strategic planning and financing. 4.17 Privatization and/or a transition to concession arrangements should be considered for commercial activities still under state ownership in parks and there should be a clear separation of responsibilities for nature conservation and park management from commercial activities. The national parks operate commercial activities in addition to their responsibility for conservation and nature management. The legislative framework allows parks to retain revenues from their primary activity (entrance tickets, filming, etc.); scientific, research and expert activities; renting o f space and equipment; donations, subsidies, and fines. Since 2004, public entities administering protected areas have been allowed to grant concessions for a period o f three years for the economic use o f natural resources or conducting other activities in a protected area. The income earned from concessions (for example, whitewater rafting, s k i resorts etc.) i s also retained locally and designated ~~ for nature p r ~ t e c t i o n .Some national and nature parks are raising revenues for park management. Privatization and a transition to concession arrangements should be considered for large hotel and hospitality services s t i l l under state ownership in parks, for example, the hotels at Plitvice National Park, as a way to better separate the nature conservation and park management financing needs from these operations. Short o f privatization, an audited separation o f accounts would also help establish a more transparent divide between park and tourism related services. C. FINANCING ENVIRONMENTALSPENDING 4.18 Will the financing needs Figure 4.3: Comparison with New Member States identified above add up to a major GDP % (Governments Envlronment Expendlture 2004) increase in public spending? Not necessarily. I t i s true that current Serbla BIH (oniy spending levels look low. Official AbW Monte statistics, suggest that Croatia’s public Croatla expenditure on the environment is, as a Kosovo Macedoma share o f GDP, below the levels Romama Sbvema observed in the new member states. Sbvakm LnhUalUE 4.19 These figures are however Poland Estoma misleading. Reconciled fiscal data at Lam Hmary all government levels55 point towards Malta Czech Rep the fact that actual spending levels may be over three times higher than I 0, O 02 0,4 0,6 0,8 1.0 12 I,4 officially captured. According to these Source: Eurostat, CROSTAT � The Ministry o f Culture holds the primary responsibility for nature protection in Croatia. Croatia has 8 national parks and 11 nature parks covering approximately 7 percent o f the territory. 54 Larger concession arrangements can extend up to 30 years and can be granted by the parliament, government, or a ministry with revenues going to the state or local government budget. ’’ For the purpose o f this review, a detailed budget consolidation was developed by aggregating budget line items for environment spending across central and local government and the main off-budget funds with environmental responsibility. 92 numbers, the Croatian government would actually spend around 1 percent o f GDP on environment. This i s well in line with the top EU8 spenders. The level o f total environmental expenditure, as a percentage o f GDP, ranges between 0.5 and 1.2 percent in the NMS. Alignment to Eurostat methodology in the future will help provide a more dependable and regular comparison. Table 4.3: Croatia Environmental Budget Spending (million euro) Actual Estimate State Institution 2004 2005 2006 2007 2008 Ministry o f Agriculture, Forestry and Water Management 28.9 20.6 24.6 38.8 42.5 Ministry o f Environmental Protection, Physical Planning and Construction (includes Environment Agency and 4.3 6.4 11.6 14.3 10.5 Environmental Inspectorate) Ministry o f Culture (includes State Institute for Nature ~rotection)’~ 1.7 2.6 10.0 10.6 9.9 Ministry o f the Sea, Tourism, Transport and Development 1.2 5.1 9.2 7.1 6.0 Ministry o f Economy, Labor and Entrepreneurship 1.5 2.3 5.3 5.1 4.7 Ministry o f Health and Social Welfare 0.06 0.07 0.59 0.03 0.03 Ministry o f Science, Education and Sport 0.87 0.85 0.71 0.71 0.73 Regional Development Fund 0.17 0.90 2.9 3.7 3.4 Croatian Bank for Reconstruction and Development 8.9 6.8 6.7 6.6 10.5 State Office for Radiation Protection 0.08 0.04 0.08 0.22 0.24 State Office for Nuclear Safety 0.02 0.04 0.04 0.05 0.03 SUBTOTAL (Central Government) 47.7 45.7 71.6 87.2 88.6 Environmental Protection and Energy Efficiency Fund 4.6 27.757 54.3 54.7 56.7 Croatian ~ a t e r s ’ ~ 97.1 102.9 121.6 124.3 121.7 TOTAL (Consolidated General Government) 235.8 -- - .- 268.3 342.8 - - - ._ - .- .- 364.9 370.7 - - .._ - . - .. % GDP (Consolidated General Government) 0.82 0.86 1.01 1.00 0.95 Source: Government o f Croatia Budget 2006-2008. 4.20 Furthermore, given current standards, Croatia has less ground to cover to meet EU standards than recent members of the EU, including Bulgaria and Romania, have had to do. The cost for Croatia to meet EU requirements would amount to about 25 percent o f i t s 2005 GDP. Similar assessments for the 10 new member states that joined in 2004 had an average cost estimate o f 34 percent o f their 2001 GDP, and Bulgaria and Romania had estimated costs o f 112 percent and 57 percent, r e s p e ~ t i v e l y . ~ ~ 4.21 A closer look at the experience of the new EU member states brings to light other useful lessons. First, the N M S did not exhibit a clear increase in the share as they approached the date o f entry to the EU. Second, what happened however in the run-up towards accession i s that the share o f environmental expenditures undertaken by the private sector rose sharply (Slovenia i s the exception). 56 Ministry o f Culture Budget for the nature protection category for 2004-2005 i s based on a different concept than in 2006-2007 and only relates to funds for programs and not for management and administration. 57 Data for Environmental Protection and Energy Efficiency Fund are actuals for 2004 and 2005. Investment costs for environmental protection through Croatian Waters include 30 percent o f existing loans for construction o f water and wastewater systems in local governments. ’’ The study being referred to i s EDC (1997), ‘Compliance Costing for Approximation o f EU Legislation in the CEEC’. European Commission: DG Environment, Brussels. 93 Only 10-30 percent o f environmental expenditures were made by the public sector in 200360in the NMS. Figure 4.4: Total Environment Expenditure, as Figure 4.5: Private Environment Expenditure, as o Y of GDP YO f total o 100 90 c 80 -+-Estonia oEsmna 70 fli:naia 61 -e- Ltthunia OPdard 5: Poland OSawnla 42 lSmka 32 numoxmmm 20 10 0 sp& 8 4 & & 8 d & & 4 k 8 b Pdd B Z 4 8 48 8 $98 8 4Q 8 9 Q \9 40 8 fp $0 Source: Eurostat, (2007) "Environmentalprotection Source: Eurostat, (2007)"Environmental protection - expenditure in Europe detailed data." - expenditure in Europe detailed data" 4.22 The implications for Croatia are twofold. First, official fiscal data are not a good guide as to the direction that environmental spending should take in the future. Second, given the right policy framework, much of the cost of complying with the acquis could be borne b y the private sector61. Bank estimates o f environmental expenditure by the public sector in 2005 are around 0.9 percent (including the government controlled extra budgetary funds). T h i s figure i s projected to increase in absolute terms but could be contained in terms o f i t s share o f GDP. The budget projections for the period 2006-2008 are around €414 million for the budget and €472 million for the extra budgetary funds, so total investment needs o f central government amount to 0.87 percent o f 2006 GDP. Adding recurrent expenditure requirements will imply an overall figure that may be just around 1 percent o f GDP. From N S experience, it seems that this share will probably not M increase further in the years preceding accession or soon after. If recent experience i s any guide, the private sector may undertake large share o f the investment needs, reducing the burden on the public budget. Priority Interventions in the Light o Fiscal Constraints f 4.23 I n determining which areas should be prioritized, one criterion i s to look at which sectoral investment will provide the greatest benefits relative to costs. Approximately 80 percent o f benefits would be associated with health improvements from a reduction in incidence o f respiratory diseases (for example, bronchitis and lung disease) and waterborne diseases. In addition to health benefits, there are assumed benefits as a result o f reduced damage and aging o f buildings; new employment; upgraded industrial technology; recreational nonuse values; improved occupational safety; avoidance o f ecological and hazardous risks; lowered waste volumes, reduced dangers to fish stocks, increased crop yields; protection o f endangered plants and animals. 4.24 The annual benefits of full compliance have been estimated6* as follows: water and wastewater (€154421862 million) and air (€14850 million). N o estimates are available o f the benefits o f meeting directives in other areas. Even with these wide ranges o f possible benefits, it i s clear that the water sector has much higher net returns than the air sector. The costs o f programs in 6oUnfortunately more recent data are not available from the OECD on environmental expenditures. 6' A current draft National Water Management Strategy does not endorse the concept o f private capital investments. Benefits for Croatia o f compliance with the environmental acquis, M a y 2005, the European Commission, DG Environment (04/08853/AL). 94 the water sector are about 50 percent higher than in the air sector, but the benefits are considerably higher. In making this comparison we are excluding the benefits accruing outside o f Croatia, which are present with the air sector measures. Even if we include such external benefits the gains from water related investments are likely to exceed those from the air related ones. This suggests that action o n the water directives should generally have priority. M o r e work i s needed though t o establish exactly which specific investments yield the highest net benefits. 4.25 The benefits in the waste sector are more difficult to estimate, but some more work could be done to determine priorities. In the meantime, the focus on the ‘hot spots’ or contaminated sitedwild dumps where public health and safety are at risk makes sense. In this regard we should note that closing the contaminated sites before alternatives are open could result in illegal dumping that i s potentially even more dangerous than the status quo. Hence coordination o f the actions on contaminated sites and the opening o f new ones are important. 4.26 B e as it may, there may also be a case to backload some of the investments toward the end of the transition periods the government will negotiate. The government’s fiscal plans seems to assume a transition period running up to 2023 for water and wastewater, 2023 for solid waste and 2016 for air and IPPC. I t then allocates the following shares o f the total program for the first three years (2006-2008): water and wastewater (18 percent), waste (14 percent), and air and IPPC (27 percent). These are more or less proportional to the time period allowed for the transition, so the water and waste program spends 18 percent o f the total in the three years 2006-2008 (three years representing 20 percent o f the time available). Given that the forecasts envisage a shortfall o f available funds, backloading may well be justified. Indeed if one looks at the proposed program for the ten counties that joined in 2004, one finds that their actual spending was slightly back loaded. Table 4.4: Transitional Arrangements for Bulgaria and Romania Post Entry Date of 2007 Bulgaria Romania Waste and electronic equipment 2008 Waste and electronic equipment 2008 Emissions o f VOCs from storage o f petrol 2009 Emissions o f VOCs from storage o f 2009 petrol Shipment o f waste 2009 Shipment o f waste 2009 Discharges o f dangerous substances into 2009 surface water I Sulfur content o f liquid fuels 201 1 Integrated pollution prevention and control 20 11 Integratedpollution prevention and 2015 control Treatment o f urban waste water 2014 Treatment o f urban waste water 2018 Quality o f drinking water 2015 Recovery and recycling o f waste 2014 Recovery and recycling o f waste 2013 Landfill o f certain liquid wastes 2014 Landfill o f certain liquid wastes 2/ 2013 I Large combustion plant directive 2014 Large combustion plant directive 2017 (1) Unless otherwise stated it i s assumed that the date for compliance i s the end o f the year. (2) The general waste landfills directive has a transitional period till July 2017 for Romania, instead o f 2009 for present member states. Mobilizing Resourcesfor the Environment 4.27 The experience of the NMS also indicates that the central government does not by any means need to be the main source of finance for the environment. It i s interesting to note that in the case o f Poland only 3 percent o f the total annual cost o f meeting the environmental acquis was planned from the state budget. In some other countries like Bulgaria, the state’s planned share i s 95 higher at around 12 percent.63In contrast, Croatian forecasts for 2006-2008 are around 26 percent, which seems in comparison to be too high a share. 4.28 In addition to direct interventions from the central budget, there are various options for financing the investment costs of compliance with the environment acquis, including own-revenues from municipal companies; EU Grants; the Environment Fund; and the Croatian Bank for Reconstruction and Development. In all the 12 countries that have joined the EU since 2004, extra budgetary environmental funds and, to a lesser extent, the private sector, have played an important financing role. In the case o f Poland, for example, ecological funds account for around 22 percent o f total environmental financing and other sources, mainly private, accounted or around 9 percent. In the Croatian plans there are two extra budgetary sources - Croatian Waters and the Environment and Energy Efficiency Fund - which are estimated to provide around 30 percent o f the total financing for the period 2006-2008, that is, not a dissimilar share to the one in Poland. 4.29 T o start with, considerable financial assistance i s available in the form of EUgrants for the environmental upgrades required thus implying less of a burden on local resources. Starting in 2007, Croatia i s eligible to receive IPA funds from the EU as a precursor to future Structural (Regional Development Fund) and Cohesion Funds. Regional development assistance under this program will include financing for environment projects in waste management, water supply, urban wastewater and air quality, energy efficiency, renewable energy, and urban transport. The funds also support restructuring o f industrial zones, including rehabilitation o f contaminated sites and land. Similar amounts under EU PHARE and ISPA funds are anticipated in the early programming years (approximately €30-40 million). If the experience o f the member states that joined in 2004 i s any guide, Croatia could look for around 20 percent o f the total costs o f water and about 15 percent o f the costs o f waste being met from EC grants. These would amount to only about €60 million a year. 4.30 Improving the _financial performance o local utilities through reduced technical and f financial losses, and higher tariffs and collection rates will also help reach targets for investment financing. The 2005 Water Management Master Plan proposes a strategy to make Municipal Water and Sewerage Companies (MWSCs) more technically and financially sustainable. This requires improving M W S C competence in tariff setting, billing and collection. The strategy should be coupled with the establishment o f an efficient and transparent financing mechanism to channel funds to MWSCs for eligible investments. Key will be the application o f uniform and predetermined selection criteria including full cost recovery o f operation and maintenance expenses. This will also improve MWSCs’ ability to access financing from private banks as well as from the Croatian Bank for Reconstruction and Development. 4.31 At present, the system remains dominated by an independent government agency- Croatian Waters. The agency i s collecting fees for water use and water protection. These are used as non refundable funds for the construction o f water and waste water systems in local government units (public potable water supply, sewerage network, and waste water treatment). Croatian Waters are in charge o f implementation o f projects financed either by grants or international bank loans. Beyond these, Croatian Waters act as a financial intermediary in on-lending o f foreign fhds and in allocating state grants. 4.32 A key constraint to increasing efficiency and mobilizing finance in the water sector has been, and continues to be, the affordability of the systems to the communities they serve. Given the fragmentation o f local utilities, there i s a huge efficiency gain from the economies o f scale that they could exploit through mergers and consolidation. Other constraints include the lack o f technical and financial capacity to plan, lack o f well developed project proposals (poor financing plans, lack o f building permit), lack o f spatiallmaster plans at local or regional level, lack o f capacity to manage utilities and the lack o f cooperation between neighboring municipalities. Actions are under way to 63 See CEM for Bulgaria, environment chapter. 96 improve municipal technical and financial performance, but it will take time. Given the capacity and revenue raising difficulties that municipalities face, the 20 percent o f own revenues cap imposed on new borrowing i s probably sensible. 4.33 Another source of finance i s the Environment Protection and Energy Efficiency Fund, which has an estimated budget of around €50 million euros annually over the years 2006-2008. Revenues arise from charges levied on polluters; environmental users, charges levied for municipal, hazardous and industrial waste, waste packaging system revenues; and environmental charges levied on motor vehicles. There are many new charges on polluters and users o f environment and regulations are in the finalization stage. The fee for the emission o f carbon dioxide was introduced in 2006, and Regulation on calculation and payment o f carbon dioxide emission fee in 2007. Discussions are under way on a host o f other possible environmental charges. Environmental Funds are an important source o f transitional finance and indeed played a critical role in the financing o f investments in several o f the member states that joined the EU in 2004. There are o f course good practice guidelines for the operations o f such funds and the Croatian government i s well aware o f them. The government could be more ambitious in using this as a source o f finance for the environmental directives. More could be raised through taxes o n hazardous waste and product charges. 4.34 The Environment Fund has become the primary government vehicle for initiating investments in the waste management sector. Their funds, however, are not adequate to cover the full needs in waste management and contaminated sites and will need to be combined with other financing resources. Their approach so far has been to provide seed financing across all places where illegal dumpsites were identified to be closed; and they have allocated funds to stimulate preparation (for example,. feasibility studies and designs) for new EU compliant solid waste facilities at the municipal and regional level. They are similarly engaging in assistance to direct finance to priority contaminated sites. 4.35 According to the OECD data Figure 4.6: EnvironmentalTaxes, YO Government of on environmental taxes and charges, Revenues Croatia does quite well in terms of 0.000016 how much of its public revenues are 0.000014 from ‘green’ sources. Between 1998 0.000012 and 2002 it increased tax collections 0.00001 from environmental sources from US$672 million to US$1130 million 0.000006 (€555 to €1194 million). This was 0.000006 achieved largely though new taxes on 0 000004 use o f public roads and special motor 0.000002 fuel charges, and vehicle excise taxes. 0 T o that end, Croatia resembles more Germany in the share o f i t s taxes that are ‘green’ than Bulgaria or Romania. - - Furthermore, an increase in the share o f Note: Data are the latest available, for 2002 in most cases, except such taxes i s possible, as indicated Germany and the UK, where they are for 2004. In some cases the above. With some judicious earmarking revenues are from an earlier year. Source: OECD httr,://www2.oecd.orrr/ecoinstlaueries/ o f these additional revenues additional resources for waste management could be mobilized. 4.36 Finally, as already noted, a growing source of non-budgetary resources for the environment should be the private sector. The biggest contribution here could come from privatization o f industries that come under the Large Combustion Plant Directive and the IPPC. There i s also considerable potential for private sector involvement in the water and waste sectors, despite 97 the current government thinking. National Waste Management Plan for 2007-20 15 i s supporting private investments. Earlier Bank analysis64developed three scenarios o f the role o f the private sector in meeting the environmental acquis. In the base case the private sector’s environmental-related investments over the four-year period were assumed t o be 10 percent in the water sector, 25 percent in the waste sector and 50 percent in the energyhndustry sector. With a medium reform program these shares were estimated to rise to 21 percent in the water sector, 43 percent in the waste sector and almost 100 percent in the industrial sector. Under a high reform scenario the water share o f the private sector could increase to 30 percent and the waste share to 60 percent. The implications o f these scenarios were that the level o f state expenditures in meeting the environmental directives fell by 39 percent in going from the base case to the medium reform scenario and by 67 percent in going to the high reform scenario. 4.37 Actual progress in increasing the share of the private sector has so far been quite slow- the current pattern resembling probably more the base case than the medium-case reform scenario. If privatization i s taking longer than expected, there would be all the more reason for backloading investments to when the private sector’s role will be greater. D. ORGANIZATIONAL EFFICIENCY 4.38 Whatever the level of environmental spending is, there i s a critical need to improve organizational effectiveness to ensure value-for-money with investments in the environment. Responsibility for the environment and public spending i s fragmented across the government and this l i m i t s capacity to implement the environment acquis. The European Commission Screening Report on Environment emphasizes that the fragmentation o f the system could influence realization, monitoring, implementation and reporting on Chapter 27. Given the sums involved, a much more coherent approach to managing the sector i s essential. The share o f spending o n the environment in any one line ministry i s currently below 10 percent o f overall spending, including in the Ministry o f Environment, Physical Planning and Construction. Consolidation o f key environment units would strengthen the environmental focus o f the government and strengthen functional requirements for administration o f the acquis. Strong coordination mechanisms should be established to link environmental concerns with policy towards tourism, energy, and the economy. The administration should also strengthen mechanisms for public participation in environmental policy development and ensure greater dissemination o f relevant information to the public especially related to enforcement and compliance with the acquis. 64 The World Bank Country Economic Memorandum, 2003. 98 4.39 At present, responsibility and financing for the environment i s fragmented across the government, including subordinated agencies, and there i s significant scope to improve policy consolidation and coordination. Figure 4.7: Institutions with Environment Competence Croatia has environmental functions dispersed across more organizations than any o f the N M S or neighboring South Eastern European countries. - 6 500 ~ The Ministry o f Environmental a Protection, Physical Planning and E 30 Construction (MEPPC) i s the central E 1 2 0 body responsible for environmental U 10 protection, but specific 00 environmental issues fall under the purview o f a broad range o f other central government bodies.65 In addition, there are numerous independent or subordinate Source: World Bank, 2006. agencies.66 The MEPPC has a Directorate for Strategic and Integration Processes and the Ministry o f European Integration and Foreign Affairs coordinates overall government activities regarding EU integration. 4.40 Reflecting this dispersion of efforts, most environment units have insufficient staffing for the performance of their activities-particularly at the local level, with the exception being Croatian Waters-according to a recent EU assessment. Some o f the challenges identified through this review include the need for staff with high level o f education and experience which are difficult to attract and retain given existing government wages. However, a more systematic review along the lines o f the public administrative reform functional reviews i s recommended for the environment sector o n a thematic rather than line ministry basis, as it seems that consolidation o f functions across different government institutions involved in environment would lead to lower or no new staffing requirements. 4.41 As far as staffing i s concerned, it i s difficult to Table 4.5: Environment Staffin Inflows67 make the case for more staff on the grounds of a simple comparison of numbers in different countries. 2005 2006 2007 M u c h also depends on how much i s outsourced and on MEP 48 12 6 how effective staff are at their jobs, which in turn will be MAFWM 4 4 influenced, among other things, by their experience, MoC 30 8 6 training and conditions o f work (staff working under MoHSW 4 good conditions o f employment are more effective than sow 3 EPA 3 those where turnover i s high and salaries so l o w as to SINP 19 17 8 cause moonlighting). Hence claims based on Source: MEP 2o05. international comparisons o f staffing levels are not a good guide to the degree o f understaffing. 65 Ministry o f Agriculture, Forestry and Water Management, Ministry o f the Economy, Labor and Entrepreneurship, Ministry o f Culture, Ministry o f the Sea, Tourism, Transport and Development, Ministry o f Health Care and Social Welfare, Meteorological and Hydrological Service. 66 Environment Agency, State Institute for Nature Protection, Environmental Protection and Energy Efficiency Fund, Croatian Waters, National Institute for Protection against Radiation, State Office for Nuclear Safety. 67MEP-Ministry o f Environment Protection, Physical Planning and Construction; MAFWM-Ministry o f Agriculture, Forestry and Water Management; MoC-Ministry o f Culture; MoHSW-Ministry o f Health and Social Welfare; SORP-State Office for Radiation Protection; EPA-Croatian Environment Agency; SINF'- State Institute for Nature Protection. 99 4.42 What i s needed in terms of staffing i s a package o f measures that (a) improve working conditions for existing staff and prevent excessive turnover, (b) look to outsource those tasks that are not central to the policy making and inspection functions (for example, monitoring o f emissions, upstream studies in support o f policy etc.), and (c) take advantage o f any possible consolidation to reduce staffing needs. When all these are included a staffing plan can be drawn up. Given the substantial demands o f the new environmental regulations, more staff may indeed be needed in certain areas. I t may, however, be possible to redeploy most required staff from ministries where functions have been shifted. 4.43 I n the same spirit, another recent review-this one carried out by the World Bank6*- calls for (a) a greater consolidation of policy functions under the Ministry o f Environment (especially brining water under this ministry), (b) separation of construction from the Ministry o f Environmental Protection, Physical Planning and Construction in order to avoid conflicts o f interest and (c) better coordination between ministries in the design and implementation of environmental regulations. There i s too much fragmentation o f responsibilities for the environment, there are conflicts o f interest in the present structuring o f the ministry with a title that includes environment and construction, and coordination between ministries on environmental policy making (or on economic policy making that has environmental implications) i s weak. Reforms here are required but they should not have major fiscal implications. 4.44 The government of Croatia i s lucky in that it can learn from the new EU members in designing a process of reorganizing responsibility for the sector. Many new member states have indeed reorganized their environment functions to better respond to the demands o f harmonizing with the environment acquis. However, this was often done late in the accession process with higher costs in terms o f building administrative capacity and limiting the ability o f the government to enforce environmental laws and critically to absorb EU funds. Croatia now has the opportunity to do better. 4.45 One of the most common organizational reforms undertaken in the NMS has been the consolidation of responsibilities for water and environment. This i s now the universal model in the NMS as well as the predominant one in the EU as a whole. Croatia would be well inspired to follow this example. 4.46 s Conversely, Croatia also stands out a unique in that it combines responsibilities for construction with environment within one agency. Construction functions are typically not combined with environment6’ to help manage potential conflicts o f interest with the EL4 Directives particularly for cases when government funds are involved. Croatia i s also unique with Nature Protection separated from environment (it i s combined with Culture). All EU member states (with the exception o f the Netherlands) have nature protection functions consolidated under the core environment ministry. 4.47 Most if not all EU member states have developed organizationalstructures to achieve a separation of environment policy from the regulatory functions. One o f the common solutions has been to establish an Environment Protection Agency (EPA) to coordinate environment regulatory functions and to correspond with the European Environment Agency on environmental data and coordination. About three quarters o f EU countries have an EPA as a separate institution from the environment ministry. In EU8 countries, 60 percent have created EPAs during the pre-accession process. The remaining 40 percent developed other solutions to separate key regulatory functions such as creation o f independent IPPC permitting and EIA bodies. Not all EPAs have full regulatory functions and some have only data reporting, collection, and sharing responsibilities. “Building an Institutional Road Map for the Environment Acquis�. The World Bank ECSSD, P 90925, O November 2006. 69 Latvia had combined construction, tourism, and regional development with environment since 1993. In 2004 they were separated from environment as part o f the pre-accessionreforms. 100 4.48 Similarly, over half of the South Eastern Europe countries have recently established EPAs (including Croatia). However none have full regulatory responsibilities. Most consolidate report, manage, and share environment information with the public and act as the key interface with the European Environment Agency. Environment policy and regulatory functions are s t i l l largely mixed within institutions and the re-assessment and better organization o f these competencies remains a key reform task for Croatia. E. RECOMMENDATIONS 4.49 While the costs of meeting the environmental acquis are sizable, the authorities have at their disposal several instruments to keep overall public spending in check around their present levels of about 1 percent of GDP. First are the negotiated transitional arrangements with the EC, where some flexibility exists, as the experience o f the N M S shows. Within these transitional periods, there i s the question o f sequencing. Which investment should be given priority and where i s some backloading justified? Here the aim should be to delay those sectoral investments where EU grant funding i s limited, where future private sector involvement i s likely to be enhanced in the future, and where the demands on the government budget are greatest. 4.50 Another consideration i s to focus investments on areas and projects with the greatest benefits. Here the data point to slightly higher priority for the water sector, compared to air and IPPC. This i s only a guide to the broad strategic direction o f policy. More details o f the benefits need to be looked at in deciding which projects have priority. These should include the waste sector, where there are some sites needing continued rehabilitation. 4.51 The potential for realistic shifts in finance to the private sector i s there and should be developed a a matter of priority. The public finance impact o f the investments will also depend o n s how much the private sector can provide and how much can be raised from extra-budgetary sources. On the former, progress in the water and waste sectors will require improvements in the structuring o f the facilities so that technical and financial losses are reduced and returns to private investors are adequate. The public private partnership model, with which Croatia has been experimenting and which i s envisaged for the waste sector, can deliver, but i t s t i l l has some way to go to make a major contribution. Strengthening capacity o f the public sector in this area and promoting PPPs i s justified. 4.52 The extra-budgetary funds can play a bigger role, especially the EnvironmentFund, if it i s managed and run in accordance with the St. Petersburg Principles set out for such transitional funds by the OECD. Although Croatia had a relatively high level o f environmental taxes, there i s potential for more, and for greater channeling o f the additional revenues for the environmental investments, especially in the waste sector, through the Environment Fund. 4.53 I n the future one can and should expect the private sector to play a bigger share in financing environmental expenditures. Privatization o f state-owned companies thus would be more than welcome as the responsibility for environmental due diligence will be passed to or shared with the private sector. Most transitional countries that joined the EU in 2004 showed a substantial increase in the share o f expenditure undertaken by the private sector prior to joining. 4.54 The investments in the sector should be combined with strengthening administrative capacity for environmental enforcement. In the case o f illegal dumpsites remediation, there i s a danger that sequencing the closure o f illegal dumpsites before opening new compliant landfills could result in the opening o f new illegal sites. This risk underlines to strengthen enforcement to ensure that waste haulers use the new facilities, which are constructed. 4.55 Functional review of the broad environment sector should be undertaken as a matter of urgency. There might be the argument for increasing staffing in the ministries with environmental n responsibilities, but t h i s has to be seen in a broader context o f public administration reform. I the near term key issues to tackle would be the following: consolidation o f policy functions under the 101 Ministry o f Environment and brining water under this ministry; separation o f construction from the Ministry o f Environmental Protection, Physical Planning and Construction in order to avoid conflicts o f interest; and better coordination between ministries in the design and implementation of environmental regulations. 102 5. EDUCATION 5.1 With high and rising dependency ratios:' the main challenge in the education sector i s to build a more competitive labor force that can earn the income levels needed to maintain and improve social well-being for the whole population without incurring excessive fiscal costs. High dependency ratios are driven by declining fertility, ageing o f the population, and l o w labor force participation7' which i s partly driven by policy choices as to which segments o f the population qualify for social assistance and pensions. The key question thus i s how to improve s k i l l s base and create an education system that will be producing a base o f the labor force capable for reaching comparatively very high productivity levels to compete in the European and global economy. 5.2 While the amount that Croatia spends on education i s in line with EU 15 countries, policies are needed to ensure resources are spent more effectively. Skills produced by the education system need to be more closely matched to those demanded by the market. Enrollments need to be increased at all levels, especially, tertiary. Completion rates are l o w and repetition rates are high in tertiary institutions. Unit costs have been rising rapidly in recent years suggesting that little has been done to take advantage o f declining school age cohorts. Institutional and financing arrangements need to be adjusted to ensure that resources are shifted towards the areas o f greatest return. 5.3 Steps needed to make cost effective improvements in the quality of the education system would include the following: Rationalize the wage bill - in particular, bring student-teacher efficiency ratios in line with international standards; contain growth in non-teaching personnel and administration costs. The full decentralization o f the payment o f teacher salaries may not be advisable unless i t i s accompanied by greater local autonomy over hiring and salary decisions. Rationalize the school network in line with demographic factors and enrolment developments; expand the use o f multi-grade teaching in small schools and definitely eliminate triple shifts. Review carefully the relevance and equity o f the secondary VET program and reform the scholarship system, in particular in the tertiary education, to be more equitable. Introduce updated standards for service provision and robust cost estimates for meeting those standards, as a sound basis for reforming education finance and governance arrangements. Closely monitor the progress being made in reforming financing o f public tertiary education to ensure that i t delivers the efficiency and effectiveness gains promised. Analyze l o w completion and high repetition rates in tertiary institutions; simulate impacts that Bologna process will have on trends; analyze how to link expected supply and demand for particular s k i l l s and occupations in tertiary education; and introduce higher flexibility for students in choosing subjects. 70 Ratio o f dependent groups, for example, seniors and children, to the working age population. 71 I t stood at 63.2 percent in 2007, covering population from 15 to 64. A. BACKGROUND 5.4 By 2025, the number of dependent persons in Croatia i s expected to exceed the working age population. Between 1960 and 2006 the share o f the population over 65 more than doubled from 7.4 to 17.2 percent, while the share o f 0-14 year olds almost halved from 27.7 to 15.9 percent. Some o f this has been due to declining fertility rates which fell from an average o f 2.8 in 1950-55 to 1.4 in 2002-06, but this i s projected to level o f f in the next 20 years to about 1.6. The result i s that the age dependency ratio-the sum o f under 15 year olds and those 65 and older to working age population- i s expected to fall marginally from 49 (per 100 working-age persons) in 2006 to 47 in 2010, but then rise rapidly to 53 by 2025. 5.5 Authorities have recognized general problems of both quantity and quality in the n current education system and have embarked on a wide reform program. I terms o f quantity, enrollment rates and completion rates, especially at the tertiary level, are still low, although increasing, while quality suffers from a mismatch between skills demanded at the market and the skills produced by the education system. The Strategic Development Framework 2006-20 13 as well as the Education Sector Development Plan 2005-2010 adopted by the government are explicit in elaborating these problems and proposing reform steps. 5.6 Modernization of the curriculum has been undertaken in the last couple of years. Despite the lack o f qualitative evaluations, anecdotal evidence suggested that curriculum had not been well structured at primary and secondary education levels. Memorizing rather than learning was coupled with lack o f teaching for modem soft s k i l l s and competences. The government introduced in September 2006 new learning standards (HNOS) in primary education, which are being used as an input for a major current revision o f the national curriculum. Box 5.1: 2006 PISA Results The Program for International Student Assessment (PISA) i s a triennial survey o f the knowledge and skills o f 15-year-olds in science, reading and mathematics. More than 57 countries (for the first time including Croatia) making up almost 90% o f the world economy took part in the third round o f PISA in 2006, which had the primary focus on science. On the PISA 2006 science scale, Croatia scored 493 score points, which i s just below the OECD average o f 500 score points, ranking 26th out o f 57 countries. I t ranked better than USA, ten EU member countries and i s by far the highest o f all participating countries o f South Eastern Europe. Looking at PISA 2006 reading proficiency scale, Croatia ranked 30thwith 477 score points (comparing to the OECD average o f 492 score points), better than eight EU countries. Croatia scored the lowest (36" rank) in mathematics performance with 467 points, although still better than five EU members. I t i s important to stress that the PISA 2006 assessed the last generation o f students who were educated according to the old primary school program (new Croatian National Educational Standards were fully introduced in September 2006). Analysis o f PISA results for Croatia also shows that the Croatian gymnasium students scored significantly better than the V E T students, thus further underlining a need to increase the gymnasium and reduce VET enrollments in the Croatian secondary education. 5.7 The government i s determined to introduce transparent performance evaluation involvingexternal and internal standards. Lack o f quality standards, measurements and evaluation, made criteria for assessments and grades very different across schools in both the primary and secondary systems. I order to eliminate the effects o f subjective assessments and grades, and n establish a uniform system for evaluation o f student potential, authorities introduced in 2006 unique external assessments at the end o f the schooling cycle, which serve as the preparation for the matura exam (that will be introduced at the end o f the secondary school in 2010). Results o f these exams will serve two aims: for students, they will provide fair assessment o f their knowledge on common grounds, which will be used as a selection criterion for tertiary enrollment; for authorities, they will provide a measure o f performance o f individual schools. External assessments have been expanded to primary education levels in 2007. In 2006, Croatia was for the first time included in the PISA 104 assessment with the plans to participate in the next rounds o f TIMSS and PIRLS international assessments. The importance o f external and internal evaluations should play a critical role in the future resource allocations. 5.8 The tertiary education system in Croatia has begun to function according to the Bologna process. Resource problems have arisen during implementation so that it remains to be seen if the Bologna process can tackle Croatia’s chronic problems o f high tertiary drop-out rates and long completion periods. B. EFFECTIVENESS 5.9 The skills base of working age groups will have to improve rapidly if Croatia i s to become competitive with its EU peers, yet Croatians spend approximately two years less time in school than its European peers. Currently, Croatia’s working age population (25-64 years) had an average o f 9.8 years o f schooling in 2005 which i s l o w compared with an average o f 12 years among the recent EU entrants72 and closer to the Albanian average o f 9.6 years.73 Recent improvements in enrollment, repetition, drop-out and completion rates, are projected to increase this, such that the average six-year old today will accumulate 15.8 years o f education across hisher lifetime74. 5.10 Gross enrollment rates have been improving steadily over the past few years which could moderate the dramatic decline in Figure 5.1: ProjectedTrends in Sizes o f Preschool and cohort sizes resulting from Croatia’s School-Age Cohorts ( 2005-30) continuing demographic transformation. Between 1995 and 2006 - 3-6 year olds c -m- 7-1 5 year olds enrollments rose from 33 percent to 53.3 700 __ --&- 16-19 year olds -20-29 year olds percent at the pre-school level, from 83 to 96 at the primary level, from 75 to 88.8 percent at the secondary level and from B 400 26 to 45.7 percent at the tertiary level. c Croatia has been, and i s projected to continue, facing a decline in the absolute C 1 200 number o f school-age children. By 2030, 100 the number o f 3-29 year olds i s expected 0 2005 2010 2015 2020 2025 2030 to shrink by 25 percent. However, slower projected declines in youngest cohort suggest that this school-aged population Source: CROSTAT, Projections of Population o f Republic o f may stabilize over the longer term. Croatia 2004-205 1 (Table 7.1). Incieasing enrollment in preschools to the EU’s 75 percent and in secondary schools t o 100 percent would counter almost all o f the projected population loss among 3-6 year olds, and just under half o f the loss in the 16-19 year age group. 5.11 Although enrollment rates are improving, they are not improving as rapidly a in other s countries, and still fail to provide a sufficient competitive knowledge base for the future economy. Net enrollment rates for primary and secondary education were 92.7 percent and 80.6 percent respectively in 2006, well below the rates for the EU8 which are 94 percent and 90 percent, respectively. The gross enrollment at the tertiary level, although increasing over the last few years, stood at 45.7 percent in 2006 compared to 53 percent in the EU8. Finally, the pre-primary gross enrollment rate stands at 53.3 percent having increased rapidly over the last few years (compared to 33 percent in 1995), but i s also far below the new EU entrants average o f 79 percent. 72 Includes EU8 countries. 73 See “Edstats� average years schooling for those age 25 and above; Barro-Lee (2000). 74 This i s an average and will in fact vary across consumption quintiles. 105 5.12 Croatia will also have to pay as close, if not greater, attention to the quality of learning outcomes as to sustaining the increases in schooling among i t s population. The most recent adult literacy rates are only 98.1 percent compared to 98.7 in Albania and over 99 percent in the new EU member states. Life-long learning programs exist, but are little used. 5.13 The authorities have taken important steps to improve information basis on which to evaluate the quality of Croatian education outcomes against global competitors. The comparison o f education spending across countries i s important as it supports evaluation o f relative quality o f outcomes in terms o f the accumulation o f human capital among i t s students. Equally important i s to introduce adequate programs to assess the quality o f education at the national or sub-national levels, which i s a major prerequisite for effective policy making. An introduction o f the so-called ‘e-Matice’, a general education system database as well as strengthening o f the External Assessment Center with adequate capacity and data to provide assessments at the school level will allow the decision makers at national and subnational levels to adopt well informed policies. The country participated in the 2006 round o f the Program for International Student Assessment (PISA).75. Students from 57 countries making up almost 90 percent o f the world economy participated in the assessment, which had the primary focus on science. Croatia scored relatively good, ranking 26th in science, 30th in reading and 36* in mathematics. While the results for Croatian students were surprisingly better than o f some o f the old EU countries (such as Italy, Spain or Norway), they s t i l l had lower scores than the students o f neighboring EU 8 countries such as Slovenia, Hungary, Poland or the Czech Republic. 5.14 Nevertheless, there i s strong Table 5.1: Wage Returns to Different Levels of evidence that investing in education in Education Croatia has positive returns. Having more Level o f education Wage premium (% higher wage) years o f education not only significantly completed relative to having an incomplete increases the probability o f being employed, primary education but also the earning potential once Primary 6.7 employed. The evidence i s clear-the Voc. Secondary 13.3 returns are increasing at higher levels o f Gen. Secondary 21.5 completed education. Table 5.1 details the 2-year college 33.4 wage premium earned in Croatia by workers College graduate 46.3 for each level o f education they have Post-graduate 69.0 completed, relative to the wage they Source: Labor Force Survey, 2004. received by those that have not completed primary school. 75PISA assesses literacy in reading, mathematics, and science for a sample o f 15 year olds in each participating country, evaluating their understanding o f key concepts, mastery o f certain processes, and abilities to apply knowledge and s k i l l s in different situations. PISA i s particularly relevant for assessing how well students are prepared to function in a higher value-added economy: it measures respondents’ ability to manipulate information to solve problems in the real world, not their academic s k i l l s per se or their mastery o f a specific school curriculum. 106 C. EFFICIENCY Overall ‘pending On education Figure 5.2: Public Sector Spending on Education, % of as a share o f GDP i s comparable to EU GDP neighbors. Croatia spends around 5.6 1 percent o f GDP on education which i s on 10.0 par with EU15 countries (around 5.6 percent) and new EU entrants (5.7 percent 8.0 1 7 WlO average,2005 o f GDP). The public sector contributes 4.9 6.0 percent o f GDP which i s less than the 4.0 EU15 and EU25 averages (5.4 percent o f GDP) with a higher level o f private 2.0 spending making up the gap. 0.0 5.16 Private sector participation in education i s higher than in EU25. Private spending on education in Croatia ’ i s around 0.75 percent o f GDP76compared Source: M°F, IMF> wB database* with ratios o f around 0.4 percent in the EU15 and EU25. This represents around 0.7 percent o f household spending, but i s predominantly spent o n pre-school and tertiary education. Despite the relatively high private spending on education there are very few private schools, but there i s a growing number of private pre-school providers. Private primary schools have 0.19 percent o f students (an increase from only 0.07 percent in 1996/7) and secondary schools 1.1 percent o f enrolled students (up from 0.24 percent in 1996/7). While there are n o private universities, there are 16 private two-, three-, or four-year colleges, polytechnics, or academic programs. Figure 5.3: Trends in total public education expenditures f 1992-2007) 5.17 Despite the fall in the number of school age children, public spending on I lZO1 education in proportion to GDP and as 10.0 a share of total public expenditure has 8.0 been increasing over the past decade. Public education spending increased from 6.0 ~ 3.6 percent o f GDP to 5.1 percent o f GDP between 1995 and 2000 and has declined marginally since then. The share o f public 2.0 -TPEE as % of TPE expenditures o n education, increased from 0.0 a l o w o f 8.2 percent in 1997-98 to 10.1 percent in 2007 reflecting increased government priority for education sector. Source: Ministry o f Finance 76 Based on the CROSTAT Household Budget Survey data. 107 5.18 However, increases in public spending have gone mainly to overheads and to a growing pre-school subsector. Although in general, the dishbution of Table 5.2: Distribution of Public Expenditures on Education by Level o f Education, 2002 (YO) spending among education Countries Preschool Primary Secondary Tertiary subsectors remains comparable to Croatia (average 11.2 43.9 21.1 18.0 i t s EU peers, a bit less so for 2003-06) tertiary education, the increases in N~~ membersEU 11.4 40.5 23.2 22.0 public spending on education have ~ ~ 1 5 7.8 42.0 25.2 22.7 gone mainly to expanding Source: MoF, OECD. overhead functions-surprisingly attributable to increases at the central, not local, level o f government-and to preschool education. Namely, the central government has agreed with unions on over 6 1 percent nominal increase in wages for the period 2007-2012 and allowed for around 5,300 new teaching staff being employed. The share devoted to primary education has declined at the expense o f increased tertiary education, while the share for secondary education has remained stable. Table 5.3. Expenditure Shares by Type o f Educational Service and Year Functions 200 1 2002 2003 2004 2005 2006 Planning, Management, & Admin 4.4 4.1 4.5 5.5 6.1 7.4 Preschool 10.9 11.3 11.3 11.0 10.8 11.6 Primary education 44.9 45.9 44.5 45.0 44.4 41.5 Secondary education 20.9 20.7 22.0 21.0 20.8 20.5 Tertiary education 18.9 18.0 17.8 17.4 17.9 18.9 Total 100.0 100.0 100.0 100.0 100.0 100.0 Source: MoF, Ministry o f Science, Education and Sports. 5.19 Per student spending has also increased in real terms for preschool to secondary levels, but has fallen for tertiary. The inflation-adjusted bill per child in preschool and at the primary and secondary levels o f education ballooned during 1998-2006. Public recurrent spending per student enrolled in pre-school, primary and secondary school increased in real terms - by 36 percent, 49 percent and 56 percent respectively over that period. Only in tertiary education did real per student recurrent spending drop, as spending returned closer to i t s 1998 level, after peaking in 2000. 108 5.20 As a share of GDP per Table 5.4: Education Spending, a % of GDP per capita, s capita, spending levels per student are higher at all levels-primary, Primary Secondary Tertiary secondary, and tertiary-in Croatia Croatia (2005) 23.8 23.3 31.4 than the average for the EU entrants Recent EU Members 23.6 19.8 26.1 and other international Romania 10.5 15.7 24.4 comparators. However, the Slovak Republic 12.0 18.7 30.0 differences in levels are much more Czech Republic 12.8 22.9 31.5 pronounced at the secondary and Bulgaria l' 16.9 19.1 19.7 tertiary levels. Croatia spends around Poland 24.5 21.1 21.2 23 percent o f i t s per capita income on Slovenia 60.1 13.6 26.2 secondary students, compared with Latvia 24.5 25.9 17.5 around 20 percent for both o f the Ireland 12.3 18.1 25.7 comparator groups; and a very high 3 1 Hungary 20.9 20.5 31.9 percent o f i t s per capita income on Spain 18.9 24.7 22.6 tertiary students compared with 26 for Chile 15.8 15.6 17.7 the new EU entrants, and 18 for the Korea, Rep. 16.4 23.7 5.0 international comparators. Source: MOF, OECD. Expenditure Allocations 5.21 The decentralization process in the education sector remains incomplete, creating perverse incentives at several levels of government that work against efficiency and equity. Disparities in education spending across counties result, in part, from weak institutional arrangements for public education financing in Croatia. Currently, the Government uses a mix o f centralized and decentralized decision making and financing, depending o n the function and level o f education. Local governments finance and have responsibility for regular preschools, for which they control the non- wage recurrent and capital budgets. The central government hires, fires, and pays all teachers. Regular primary and secondary education involve both central and local government with each controlling different functions and different budgets. The central government has responsibility for, and finances, pre-schools, primary and secondary schools for special needs children, minorities, and talented children, with local governments providing some additional funding. Finally, the central government funds public tertiary education, but management i s fully decentralized to the individual institutions. 5.22 The central government Figure 5.4: Distribution of Funding Sources for Public remains the main source of public Expenditures in Education (2000-06) funding for education. The share I I attributable to central government has been declining and i s planned to decline further f i o m 74 percent o f total education expenditures in 2003 to 69 percent by 2008. Local government financing for education comes from three sources: (i) a specified share o f personal income tax (PIT) that local governments retain - 2.9 Local Gowrnrnent Central Gowrnrnent percent for primary education and 2 percent for secondary education - with the PIT rates being set nationally; (ii) allocations from the centrally-controlled I 2003 2004 2005 2006 I Equalization Fund; and (iii) very few in Source: Data for 2000-02 from SEE data files; Data for 2003-06 from the Ministry o f Finance. cases, own revenues. 109 5.23 The Equalization Fund i s meant to address horizontal imbalances in school financing, but relies on historicalexpenditure ratios that lock in old inefficiencies. Allocations are based on the gap between the local government’s earmarked share o f the P I T and expenditures required to meet minimum standards per school, the number o f schools, and the number o f students. However, the minimum standards are based on historical central government expenditures from 1999. Although influenced by enrollments, allocations from the fund are not fully capitation based. 5.24 An examination of unit costs within education subsectors demonstrates important imbalances and suggests allocations may be suboptimal. First, the higher unit costs for locally- financed pre-school relative to primary schooling may signal potential to improve the efficiency o f local administrations providing these services. Second, secondary schooling usually has higher unit costs, due to the provision o f specialized teaching staff, laboratory and other facilities, which i s not the case in Croatia, but i s across EU countries. Table 5.5: Ratio o f Per Capita Recurrent Expenditures Relative to Primary Education Croatia EU15 EU8 1999 2000 2001 2002 2003 2004 2005 2006 2004-06 (2002) Recurrent expenditures Preschool 1.25 1.16 1.15 1.18 1.41 1.35 1.35 1.44 1.38 Secondary 1.05 1.02 0.97 0.93 0.99 0.99 1.04 1.06 1.03 Tertiary* 1.91 1.88 1.65 1.73 1.59 1.53 1.46 1.46 1.48 Total expenditures Preschool 1.51 1.19 1.14 1.14 1.14 1.15 1.08 1.18 1.11 0.65 1.10 Secondary 0.95 0.97 0.98 0.98 0.94 1.01 0.95 1.03 0.99 1.17 1.73 Tertiary * . 1.30 1.18 1.18 1.29 1.22 1.25 2.41 *Preliminary. Source: MoF, CROSTAT, OECD 2005, Table B1.l. 5.25 With the exception of tertiary education, non-wage recurrent costs appear vastly underfinanced, with an unusually large share of spending on capital investments and wages. Croatia spends a significantly higher portion (almost three times more than EU15 average) o f i t s general77 education budget o n capital investments, leaving almost 10 percentage points less for recurrent costs. The high share o f capital investments should also be scrutinized in light o f demographic trends. Wages, o n the other hand, dominate recurrent costs (they constitute 90 percent) compared to the EU countries where they represent around 75-80 percent o f recurrent costs. The result i s a critically l o w share, around eight percent o f the total budget, for non-wage recurrent items. While the international evidence does not provide a proven recipe o f inputs, recent work at the World Bank on efficiency in the sector found that countries in which the wage bill represents a higher fraction o f total expenditure tend to be more i n e f f i ~ i e n t O~ concern i s the small share o f non-wage ~ f. recurrent costs in secondary programs-specially VET secondary programs- where inputs include books for libraries, and laboratory equipment. 77 Pre-tertiary. 78 Herrera and Pang (2005). 110 Table 5.6: Economic Allocations o f Education Expenditures Countries Basic and Secondary Education % capital % recurrent o f which: wages o f which: non-wage Croatia (average 2004-06) 20.7 79.3 70.1 9.2 EU15 (2002) 7.3 92.7 75.6 17.1 Recent entrants to E U (2002) 7.6 92.5 67.4 25.1 Countries Tertiary Education % capital % recurrent o f which: wages o f which: non-wage Croatia (average 2004-06) 3.9 96.1 64.5 31.6 EU15 (2002) 11.4 88.6 60.4 28.2 Recent entrants to E U (2002) 11.0 89.0 50.6 38.4 Source: Ministry o f Finance; OECD 2005, Table B6.3. 5.26 I n tertiary education on the other hand very little i s devoted to capital investments. In the tertiary sub-sector, recurrent spending dominates at 96 percent o f the budget, with a distribution between wage and non-wage costs comparable to other countries, but with only 3.9 percent for capital investment compared to an average o f 11 percent among both the EU15 and recent entrants. Human Resource Efficiency 5.27 Croatia's student-teacher ratios in primary and secondary schools are comparatively low and have been systematically falling sinceearly9 0 ~ . the 19 Student-teacher ratios 5.7: Comparative Student-Teacher Ratios Table are an accepted indicator o f educational system Europe & efficiency worldwide. I t has already been Croatia Central noted that Croatia continues to spend far more 2006 Asia EU8* OECD o f i t s education budget on wages and salaries Primary 14.4 16.6 15.5 16.3 than its comparators. While there i s no Seconds 11.6 11.3 12.2 13.5 internationally accepted n o m for the * E x c l u d i z Croatia. minimum O r efficient number O f students per Source: Edstat and Basic Education Data. teacher, current rates in primary and secondary schooling at 15 and 11 students per teacher respectively, are slightly lower in Croatia than the new EU entrants and the OECD average. 5.28 This indicates that the supply Figure 5.5: Trends in Student-Teacher Ratios, 1990-2006 side in Croatia has not yet responded 20 to demographic changes and the declining student population, despite 18 recent increases in enrollment rates. Analysis for t h i s report reveals that if 16 Croatia were to achieve the ratios o f the B E 14 OECD in these subsectors, i t could reduce the teaching staff for public 12 primary education by around 11 percent and for secondary by around 17 percent. Given the current levels o f spending on ~taffing'~, Croatia could have saved --cPreschool *Primary (regular schools only) around HRK 760 million in 2007 or 0.27 -+-Secondary (regular schools only) +TerUary percent o f GDP. Source: CROSTAT, MOSES. '9 Including non-teaching staff. 111 5.29 While teacher compensation appears adequate, there i s a significant wage premium for advancing to administrative positions. Available data suggest that after accounting for some differentiation based on age and years o f experience, educators (teachers and other professionals) in Croatia are paid on average the same as other public and private sector professionals. However, it is important to note that there i s a premium o f around 20 percent associated with moving from the teaching corps to the group o f other school professionals. This may _. the Observed gradual shift Note: other professionals include the headmaster, teacher advisors, and toward higher numbers of non- teacher mentors. All primary school professionals and all secondary teaching staff. Specifically, the school professionals include headmasters, teacher advisors, teacher percentage o f full-time teachers mentors, and teachers. among staff inprimary education Source: Croatia Labor Force Survey pooled data for 2002-04. went down from 89 to 82 percent during 2000-06, while the percentage o f full-time teachers at secondary level went down from 70 to 50 percent. 5.30 Teacher resources could be used more effectively. Teachers in Croatia spend less than half o f their working hours teaching. Teachers with a full-time position in grades 1 4 are required to spend around 15 working hours teaching (around 20 instruction hours o f 45 minutes), in grades 5-8 between 13.5 and 15 working hours (18-20 instruction hours), and in secondary education 16 working hours (21 instruction hours including extra-curricular activities). At between 2 1-24 hours per week, the average for teacher instruction hours in the OECD exceeds Croatia's level. In the medium term, teacher instruction hours could be raised towards international norms. Network Efficiency 5.31 Croatia's public school network probably has more types of schools at all education levels than can be managed efficiently and authorities should seriously consider some simplification of the network. In general, a school network with more types o f schools and programs tends to be less efficient because i t reduces opportunities to allocate resources efficiently. I t i s noteworthy that almost half o f the VET schools cover only five programs or less per school, and the other half offers between 6 and 33 programs per school. This lack o f focus results in seriously fragmented offerings within and across schools and an inefficient use o f specialized equipment and faculty. The authorities have recently adopted a new strategic framework for VET resulting in the reduced number o f sectors covered by VET programs. In the tertiary subsector, however, the lack o f a policy framework to govern the growth o f new, or new branches of, public institutions at the college, polytechnic, and university levels i s creating a major fiscal risk in terms o f downstream public commitments. 5.32 There i s an increased effort to set up appropriate information base to manage the system. Even the best formulated strategies' implementation may be hindered by the lack o f a school mapping database and national standards for service provision-for example, studendteacher ratios, studentklass ratios, number o f cleaners per square meter, number o f administrative staff as defined by school size-that should inform central and local government decisions to open or merge schools. The Ministry o f Science, Education and Sports has addressed this problem through development o f an 112 electronic database o f all relevant school-level information, so called ‘Matice’, and ‘Pedagogic Standards’ that stipulate national standards for service provision, recently adopted by the Parliament. 5.33 I n terms of the physical network, class and school sizes have fallen substantially in recent years, suggesting significant opportunities for cost savings. At the primary level, classes have fallen from around 25 students in 1994 to 21 in 2006. At the secondary level, they have fallen from around 29 to just over 25 students per class. The average size o f primary schoolsg0, which constitute almost two-thirds o f all schools in the network, declined by 19 percent between 1994 and 2006, while the average secondary school has declined by 32 percent. Grammar schools declined by only 16 percent, while VET schools by almost 34 percent. Maintaining the 1994 average class and school sizes today, would result in almost 3,500 or 13 percent fewer class units and 20 percent fewer schools than currently used. It i s important to note that these estimates do not take into account other critical factors to the design o f the school and class network, notably geographic distribution o f the population. 5.34 The utilization of infrastructure in the education sector i s relatively intensive through the significant use of double shift schools. The primary school network i s now running with 25.8 percent single shift schools, 69.6 percent double shift schools, and 4.6 percent triple shift schools, respectively. The distribution o f students differs markedly with 13.3 percent enrolled in single shift schools, 77.4 percent in double shift schools, and 9.3 percent in triple shift schools. 5.35 The use of triple shift schools in high density areas remains pedagogically unacceptable, and plans to reduce them are advisable. The burden o f triple shifting i s very unevenly distributed across counties, with some counties having no triple shift schools, while 26 percent o f the schools in the City o f Zagreb were operating on triple shifts, with as many as 35.8 percent o f Zagreb students enrolled in triple shift schools in 2005/0681.The burden o f triple shifting on students also used to be unevenly distributed-and distributed differently than triple shift schools. For example, only 8 percent o f schools in Zadarska county worked on triple shifts in 2005/06, but 25.4 percent o f i t s students study learned under triple shift conditions, versus only 5.7 percent o f Istarska county schools and 5.9 percent o f students enrolled in triple shift schools. The government’s policy o f eliminating these i s to be commended, and, given the small number o f triple s h i f t schools, i s feasible. 5.36 However, the Government’s objective of completely eliminating all double shift schools may not be an efficient solution given the challenges facing the system. Double shifting i s routinely used in many countries, including much wealthier OECD countries, to deal with the type o f “spot� overcrowding and demographic transitions that Croatia i s now facing. Eliminating Croatia’s over six hundred double shift schools would be resource intensive both in terms o f time, management and implementation capacity, and transitional expenditures, and may not yield as great gains to the education system as other policy reforms focusing on quality and equity. Social consequences o f different models should be considered and efforts should be made to come up with acceptable solutions taking into account demographic factors as well as enrollment developments. 5.37 Finally, there i s scope for improving efficiency in small schools through multi-grade teaching. Croatia’s small schools are heavily associated with inefficiently l o w studenvteacher ratios, indicating there i s scope for expanding the use o f multigrade teaching, the efficient response to small schools. Although counties vary in the percent o f their schools that have very low studenvteacher ratios (0-5 students per teacher and 6-10 students per teacher), between 30 and 46 percent o f the schools in almost 40 percent o f the counties have studenvteacher ratios o f 10 or less. There i s a 0.79 8o Calculated as the total number o f schools including branch schools divided by total number o f primary education students. Data as o f 2005/06 school year as collected under the School Network Optimization project by MOSES.In the school year 2006/07 the number o f triple shifts schools in Zagreb has been reduced from 23 to 16 schools. 113 correlation coefficient between counties’ l o w student-school ratios and those with l o w studendteacher ratios suggesting that small schools still tend to be relatively overstaffed. Technical Efficiency 5.38 The primary school compulsory instructional time i s comparatively low in Croatia compared to its EU peers, but average for secondary students. Although the relationship between instructional time and student outcomes i s not straightforward, students’ opportunity to spend time learning has been established as a key driver o f student performance. Compulsory instructional time for Croatian students at the secondary level (age 15) i s comparable to that for the average EU15 and EU8 student. However, it i s much lower at the primary level (grades 1-8); the total instructional time being only about two-thirds that o f EU15 students and 80 percent that o f E U 8 students. Although Croatia has a regime o f optional courses at all grades, these do not constitute non-compulsory instruction, and most o f the comparator countries have similar regimes. As such, adding the non- compulsory instructional time to compulsory instructional time for all parties should not change the comparative picture significantly. Table 5.8: Annual ComDulsorv InstructionalHours’ 7-8 yrs 9-11 yrs 12-14 yrs Total instructional 15 yrs hours grades 1-8 Croatia (2006) 473 508 656 4,436 8 14/8403 EU15 (2003) 78 1 836 902 6,776 830 EU8 (2003) 583 680 770 5,516 83 1 �Annual compulsory instructional time i s defined as the number o f minutes per class hour times the number o f compulsory class hours per week times the number o f weeks o f instruction per year, divided by 60. �The higher number i s for the mathematics gymnasium; the lower number, for all other gymnasium programs. Source: Croatia: MOSES;EU15 and EU8: OECD, Education at a Glance, 2005, Table D1.1. 5.39 I n general, the pre-tertiary education system in Croatia seems to have an adequate level of internal efficiency with low repetition and dropout rates. Repetition and dropout rates measure the internal efficiency o f an education system by focusing on the progress students make through the system and the length o f time it takes students to complete their education. In Croatia, available data (Edstat) indicate that repetition rates o f 0.4 and 0.5 percent for primary and secondary students are below average for the new EU entrants, with averages o f 1.6 and 1.8 percent, respectively. 5.40 However, evidence for tertiary subsector suggests that Croatia suffers from serious internal inefficiency in this area. In 2000, the then-Ministry o f Science and Technology estimated that those in four-year degree (B.A.B.S.) programs took an average o f seven years to complete and those in two-year programs took an average o f five years to complete. Non-completion rates at tertiary education were also very high, with the Ministry estimating that only one-third o f all those enrolled were completing their courses o f study8*.In 2006, the University o f Rijeka confirmed these numbers-the average time for completion o f a four-year program was 6.7 years and only about a third completed, implying a two-thirds dropout rate. In other words, serious internal inefficiencies at the tertiary level do not seem to have diminished in recent years. The University o f Rijeka i s finding that those that pay fees complete at higher rates, in a shorter time period, and with better grades. D. EQUITY Equity as Efficiency 5.41 An equitable system i s not only desirable from a “moral� perspective, but from an efficiency perspective, too. For an education system to get the most out o f i t s spending, i t needs to be able to ensure that the country accumulates the maximum amount o f human capital from the pedagogical inputs that it finances. This would require, among other things, that students with higher World Bank, PEIR, 2000. 114 potential and those willing to invest more effort be able to accumulate a higher level o f skills, regardless o f their socioeconomic backgrounds. Since educators have n o prior knowledge regarding the distribution o f potential and effort across a given cohort, access should be equitable. Therefore, the objective o f public policy in this regard i s to mute the effect o f existing social and economic conditions on student performance and educational outcomes. 5.42 While Croatia has virtually no differences in enrollment rates by household consumption quintile in primary education, and small differences in enrollment rates at the secondary level, equity in enrollment for tertiary education remains a concern. At the secondary level, Croatia’s Household Budget Survey measures the enrollment status o f household members 15 years and older. The age range for secondary education i s assumed to be 15-18 years o f age; for tertiary education, 19-24 years o f age. Around 86 percent o f all 15-18 year olds are enrolled in one form o f secondary education or another. Students from households in the highest consumption quintile have only a 7 percent higher likelihood o f being enrolled in secondary schools than those from the lowest consumption quintile. However, there are bigger differences between the two quintiles in the type o f secondary education attended, with those in the highest quintile being less likely to be enrolled in secondary VET and more likely to be enrolled in secondary gymnasia. The gap between the quintiles i s much larger for the tertiary level, with those from the highest quintile being about 2.5 times more likely to be enrolled than those from the lowest quintile. Table 5.9: Net Enrollment Rates (2004/05) for Those 15 Years and Older Household consumption quintiles Secondary Secondary Secondary Tertiary VET Gymnasium Total All quintiles 59.4 26.3 85.6 37.7 I 68.1 13.6 81.8 22.2 I1 65.9 19.7 85.6 27.9 I11 60.2 26.2 86.3 34.6 IV 52.6 33.8 86.4 41.8 V 46.5 42.3 88.9 54.9 Gap between QV & QI -2 1.6 28.7 7.1 32.7 Source: HBS, 2002-2004. 5.43 The concept of expected lifetime years of education can be used to summarize differences in educational flows between quintiles. The standard calculation starts at the age o f five. Take a hypothetical five year old child in a given quintile. If that child has the same probability o f enrolment at each year o f hisher lifetime as those who are now five and older in his or her quintile, h o w many years o f formal education will the hypothetical child from that quintile complete? The hypothetical Croatian six-year old, regardless o f quintile, can be expected to complete 15.8 years o f education across his or her lifetime. These rates vary from 14.2 years in the lowest quintile to 17.4 years in the highest. 5.44 Urban (versus rural) residence has a positive effect on enrolments in general secondary and in tertiary education. For quintile I urban residence has a positive effect o n enrolments in both types o f secondary education and in tertiary education. For quintiles 2-5 urban residence depresses enrolment in secondary VET, especially for quintile 5, and enhances enrolment in secondary gymnasia. I t has a positive effect o n enrolment in tertiary education for all quintiles. 115 5.45 At the secondary level enrollments are Table 5.9: Effects of Gender and on Net Enrollment Rates (2002-04) virtually gender-neutral, Secondary Secondary Secondary Tertiary while at the tertiary level VET Gymnasium Total girls have a 9.5 percentage 58.9 27.7 86.6 42.4 Doint enrolment advantage 59.8 24.9 84.6 32.9 consideied, girls retain their enrolment advantage over boys at the tertiary level for all quintiles and at the overall secondary level for all but the fifth quintile. There are less patterned enrolment differences by gender between the two types o f secondary ed~cation.'~ 5.46 However, the current stratification within the education system should be carefully reviewed in light of recent international findings. Stratification o f students either between classes within schools or among school types has been a traditional method o f trying to maximize human- capital accumulation per student. However, there i s new evidence that in systems that separate students, especially during the upper-primary grades into different types o f schools, students' performance tended to be more strongly correlated with their social backgrounds. In systems that kept students together in comprehensive schools, the relationship between social background and educational performance was weaker, although not absent. 5.47 Croatia currently splits students into three tracks, at the secondary level. At the beginning o f the secondary level (ages 14-15 years) students move into the academic track (grammar), four year technicalhocational track (technical), or the three year vocational track. Croatia's three year vocational program i s o f greatest concern. In special analyses o f the PISA results for Polish students, students in academic lycees had reading comprehension scores that were 16 percent higher than the average score; those in secondary vocational schools, about the same as the average, and those in basic vocational schools, scores that were 23 percent lower than the average.84 Although the share o f Croatia's secondary students in the .three-year vocational program has been declining since a steep rise in the early 199Os, i t i s s t i l l relatively high. I t i s recommended that Croatia move to phasing out the three-year vocational program. Equity in Expenditures 5.48 Households in Croatia receive a variety of direct educational subsidies from the public sector, including preschool tuition fees for poorer households and free textbooks, transportation and dormitories for all primary students and lower secondary grades (started in the City o f Zagreb, and in 2007 extended to the whole o f Croatia) or certain categories of students (other local governments) as well as housing and other cash allowances and scholarships. The former are difficult to capture because they are not implemented through cash transfers and households would have to accurately estimate their monetary value. This i s an example o f a costly measure with limited impact on learning outcomes, and the equity impact i s minimal given it does not target the vulnerable. Since scarce resources might be allocated more efficiently, this measure could be reconsidered to be applied only for the vulnerable groups through the means-testing mechanism and thus saving some HRK 300 million or 0.1 percent o f 2007 GDP o n annual basiss5. 83 If the enrolment advantage for women at the tertiary level continues or increases, it may ultimately impact marriage rates. Women tend to select mates with the same or better education, and the pool o f males with tertiary education i s now shrinking relative to that for females. 84 Bialecki, 2002. 85 MOSES acknowledges that means testing (as supported by the introduction o f the personal identification number) w i l l allow for better social targeting and that these policies would be reconsidered. 116 5.49 Although the number of publicly-funded tertiary students has been steadily declining in recent years, the allocation of public scholarships (mainly to tertiary sector) remains very inequitable. Scholarships for tertiary students s t i l l Table 5.10: Distributionof Scholarships by account for 93 percent of government funded Household Consumption Quiutile (2002-04) scholarships. Between 1993-94 and 2003-04, the Average Share o f total percent o f students that receive full scholarships from scholarship (million the state-full-time entrants who scored above a (HRK) HRK)* prespecified threshold in the entrance exam-has Quintile 1 7,133 6.6 fallen from 88 percent o f total tertiary enrolees to 47 Quintile 2 8,757 17.9 percent. However, students from households in the Quintile 3 6,346 11.3 highest quintile continue to receive both the largest Quintile4 7,913 32.4 share o f total scholarships and educational allowances Quintile5 11,428 65.2 and the highest value scholarships. The state spends All quintiles 9,167 133.4 almost 10 times the amount o n scholarships for Source,, Authors, calculations basedon the students from this quintile than for those from the 2002-2004 Household Budget Survey. lowest. 5.50 The average value of a scholarship i s approximately the same for students in quintiles 1- 4, i t i s almost 50 percent higher for students from the highest quintile. The higher value o f the average scholarship awarded students in quintile 5 probably reflects an interaction between quintile and level o f education for which the scholarship i s receivedS6-childreno f quintile 5 families have higher tertiary enrolment rates, and the average award at this level o f education i s therefore higher. 5.51 There i s some progressivity in household spending on education, and differences in ruraYurban household expenditures for education. The H B S data reveal notably progressive education spending by consumption quintiles in absolute and relative terms (Table 5.12 and the Figure 5.7.). In 2004, the lowest quintile o f the population allocated 0.3 percent o f total household spending to education, while the highest allocated about 0.9 percent o f their overall spending to education. The highest quintile accounted for about 40 percent o f total household spending on education. Table 5.11: Household Expenditures on Education by Consumption Quintiles, 2004 Consumption Mean Household Education Mean Percent o f Total Share o f Share o f Quintile Expenditure Household Population Household (HRK, Per Capita, Per Expenditure Education Year) Expenditure 1 (lowest) 40 0.3 20.0 4.4 2 91 0.5 20.0 10.1 3 157 0.7 20.0 17.3 4 249 0.9 20.0 27.4 5 (highest) 369 0.9 20.0 40.7 Source: Authors' calculations based on the 2004 Household Budget Survey. 5.52 This progressivity i s more marked at the tertiary level, but i s almost negligible at the preschool, primary and vocational secondary levels. Figure 5.7 shows cumulative household expenditure shares for different levels o f education. Household expenditures o n preschool, primary education and vocational secondary education are close to their proportion in the population. For the general secondary and tertiary education, the higher quintiles spend much more than their share o f the population, generally in line with the inequities found in enrolment rates at these levels and types o f education. 86 Sample size even in the pooled 2002-04 H B S are too small to allow a quintile by education level analysis. 117 F i r e 5.7: Lorenz Curve for Total ExDenditures and Concentration Curve for Education ExDenditures 10 - OB - --- P0.IGI.dU.I. 05 - 04 - 03 . 0.0 0 10 0 20 0 30 0 40 0 50 080 0 10 0 80 0 DO 1 00 0 01 02 03 04 05 08 07 08 OS 10 CumuI.tIw popuI.tlon sham cYmyI.1h.popll.don sh". .o 2 Note: Population is ranked by its per capita household expenditures. Source: Authors' calculations based on the 2004 Household 5.53 There i s also substantial variation in household education spending by region. In the Zagreb Region, the average per capita spending on education i s more than five time higher than in the Central Croatia Region. Some o f this variation i s attributable to regional differences in household welfare, but even in relative terms (expenditure shares) there are notable regional disparities in household education spending. The most striking gap i s between urban and rural areas. About half o f the population that lives in urban areas accounts for more than 80 percent o f overall household expenditures on education. On average, per capita spending on education in urban areas i s four times that o f rural areas. Table 5.12: Household Expenditures On Education By Region And Location, 2004 Region*" Mean education Average Share of Share of total expenditure share of total population household household education (HRK, per capita, expenditure expenditure per year) (YO) (%I (%) Central Region 69 0.3 23.2 8.8 Eastern Region 124 0.6 20.1 13.7 Zagreb Region 366 1.2 24.5 49.6 Adriatic North 170 0.7 12.7 12.0 Adriatic South 148 0.6 19.4 15.9 Urban 28 1 1.o 52.8 81.9 Rural 70 0.3 47.2 18.1 Source: Authors' calculations based on the 2004 Household Budget Survey. E. RECOMMENDATIONS 5.54 Rationalize wage bill, in particular, to bring student-teacher efficiency ratios in line with international standards; contain growth in non-teaching personnel and administration 87 For purposes o f living standards assessment, regions are defined as follows. The Central Region includes Krapina-Zagorje, Sisak-Moslavina, Karlovac, Varazdin, Koprivnica-Krizevci, Bjelovar-Bilogora, and Medimurje counties. The Eastern Region includes Virovitica-Podravina, Pozega-Slavonia, Slavonski Brod- Posavina, Osijek-Baranja, and Vukovar-Sirmium counties. Zagreb Region includes both Zagreb county and the City o f Zagreb. Adriatic North includes Istria, Lika-Senj and Primorje-Gorski Kotar counties. Adriatic South includes Zadar, Sibenik-Knin, Split-Dalmatia and Dubrovnik-Neretva counties. 118 costs. The full decentralization o f the payment o f teacher salaries may not be advisable unless it i s accompanied by autonomy at the local level over the number and salary levels o f teachers. Schools currently have almost no scope for reducing their teacher corps except through attrition. Moreover, if teacher salaries continue to be set through national collective bargaining, schools can only “top up�, not reduce salaries. At the same time, if schools remain the direct employers o f teachers, local governments will not be able to rationalize the teaching force by reallocating staff among schools. Additionally, municipalities, cities, and counties are not forced to confront the downstream staffing costs o f their decisions to addexpand schools or programs. 5.55 Rationalize the school network in line with demographic factors and enrolment developments; expand the use of multigrade teaching in small schools and eliminate triple shifts. The rapid increase in unit costs in recent years suggests that little has been done to take advantage o f declining school age cohorts. As a result the share o f public education spending on capital investments i s unusually large and wages dominate recurrent spending, leaving very little for non-wage recurrent costs. Further reductions projected in school age cohorts offer the opportunity for significant savings from rationalizing both the teaching force and the school network. W h i l e remaining triple shifts at some schools should be eliminated, social consequences o f different models for double shift schools should be considered and efforts should be made to come up with acceptable solutions taking into account demographic factors. 5.56 Further development of the management information system to make the change management as efficient as possible. The information base for policy making could be further improved before accelerating devolution, reforming the Equalization Fund or the tertiary financing model, for example, analyze more carefully regional and education stage variances in unit costs. 5.57 Review carefully the relevance and equity of the secondary VET program and reform the scholarship system to be more equitable. The traditional stratifications may be exacerbating social inequities, while a lack o f strategic focus in program design may be limiting the market relevance o f s k i l l development. The tertiary system suffers from higher levels o f inequality (compounded by the state scholarship program) and very l o w internal efficiencies. The recent introduction o f free textbooks at the primary level i s an example o f a costly measure with limited impact on learning outcomes, and the equity impact i s minimal. Since scarce resources might be allocated more efficiently, this measure should be reconsidered. 5.58 Introduce updated standards for service provision and robust cost estimates for meeting those standards, as a sound basis for reforming education finance and governance arrangements. The MoSES urgently needs to establish a mechanism for measuring variations in total educational expenditures between counties and attributing these to various causes, such as different resource mobilization capacities and household income. For example, the unusually high unit costs o f preschool education-the most decentralized subsector4ould indicate either that: (i)local governments are responding effectively to client willingness to pay for better services; or (ii) local governments have not been able t o provide the services efficiently and cost effectively. Without better information o n both the preschool quality and local revenues, the central government cannot fully resolve this anomaly. Under the first scenario, full decentralization may increase horizontal inequities n between wealthier and poorer local government units. I the latter case, it would raise the costs o f education significantly without commensurate improvements in outcomes. This has serious implications for any reform o f education financing in Croatia. 5.59 Closely monitor the progress being made in reforming financing of public tertiary education to ensure that i t delivers the efficiency and effectiveness gains promised. In 2006, the Government began implementing a restricted lump-sum financing model for tertiary education, but with prior MoSES approval for institutions’ expenditures. In 2007, i t was planned to replace the prior approval requirement with expenditure post audits. The new arrangement introduces hard budget constraints and gives university administrations more power to rationalize their institutions and to 119 implement the financial management and accountability reforms required by the Bologna Process.� However, the formula governing individual institutional needs has to be examined fully to ensure that it has not locked in historical inefficiencies and does not contain loopholes that would continue to allow “deal making�. 5.60 Analyze low completion and high repetition rates in tertiary institutions; simulate impacts that Bologna process will have on trends; analyze how to link expected supply and demand for particular skills and occupations in tertiary education; and introduce higher flexibility for students in choosing curriculum. In addition performance-based funding models for higher education should be developed and further emphasis should be placed on quality assurance in higher education and the integration o f the faculties. � The Bologna Process i s an intergovernmental initiative launched in 1999 which aims to create a European Higher Education Area (EHEA) by 2010 and to promote the European system o f higher education worldwide. I t now has 45 signatory countries. The reforms include shifting management focus from faculty workloads and teaching inputs to student credits and learning outcomes. 120 6. PUBLIC ADMINISTRATION: A HORIZONTAL LINK 6.1 Public administration� in Croatia i s characterized b y i t s high cost, large size, but low effectiveness. Despite best efforts, tackling these deficiencies has proven difficult as a result o f a combination o f factors. One i s the high level o f rigidity in the organizational structures and remuneration system in the public administration. A second factor i s a common perception within the administration that EU accession requires the creation o f a new layer o f new regulatory institutions . ~ third and administrative functions for managing EU structural funds and implementing a c q u i ~The ~ factor relates to the government’s decentralization aspirations. Shifting further functions to local governments, without commensurate scaling down the central government employment� and without harmonizing pay levels across levels o f government, would compound the problem o f already high wage bill and inefficiencies. 6.2 The problem i s not only fiscal: the excessive size also hampers decision making and service delivery. There has been a proliferation o f agencies and subordinate entities with operational autonomy and often revenue-raising capabilities. There are many instances o f overlapping functions, lack o f coordination and lack o f clarity about lines o f accountability among ministries, agencies and other state subordinate entities. This creates problems for the execution o f government functions, it hampers policy making and implementation, places a huge burden on coordination and management and ultimately adversely impacts value-for-money and the quality o f service delivery. 6.3 The key challenge for the government will therefore be to bring the wage bill to a sustainable level while improving the effectiveness of the public administration and ensuring that there i s capacity to undertake the r e uirements of EU accession and increasingly complex 8 policy coordination. The experience o f EU8 2 suggests that this will be a long haul effort. More than two years after accession i t has become clear that the harmonization with the acquis rather than being a “one-off’ effort needs to be supported by a creation o f soundly performing systems across the whole government, with professional, merit-based, and independent civil service in place. This chapter o f the PFR will further elaborate on the conflicting pressures o n the wage bill and o n the steps that can be taken to manage the development and reform o f the public administration in a way that strengthens the administration while reducing the burden on fiscal resources. It first looks at effectiveness indicators (Section A), then reviews the factors that limit the efficiency\burden the cost o f delivery public services (Section B), and concludes by sketching out an agenda o f recommendations for a comprehensive public administration and civil service reform strategy (Section C). By legislation, public administration employees in Croatia are divided into three separate categories: (i) civil service, (ii) public service (health sector workers, teachers, social welfare workers and judiciary) and (iii) employees o f local government units. 90 In fact, additional staffing for issues related to EU accession i s estimated at 0.6 percent over 2005 levels which would impact the staffing levels at the margin. ’’ There are few examples o f a good practice, like in the case o f the 2007 Law on Environmental Protection and Law on Spatial Planning and Construction, whereby bylaws require a transfer o f national level servants to local governments to carry forward public functions. Some 568 servants have been transferred so far from the state administration. 92 2006 EU8 Fiscal Studies, World Bank, 2007. A. EFFECTIVENESS 6.4 Several indicators point towards the low effectiveness of Croatia's public The Table 6.1: Governance Indicators: Croatia's percentile rank in % of Bank governance indicatorsg3 respective EU15 and EU8 levels (2007) point at more general Government Regulatory Rule of Control of weaknesses o f Croatian public Effectiveness Quality Law Corruption administration in terms o f Croatia as % corruption, rule o f law, o f E U 8 92% 78% 80% 86% regulatory quality, and Croatia as % government effectiveness. ofEU15 80% 71% 62% 66% Table 6.1 shows that Croatia Source: World Bank Governance Indicators. lags behind EU15 between 20 percentage points (government effectiveness), and 38 percentage points (rule o f law), while the magnitude o f lag behind EU8 ranges from 8 to 22 percentage points. Overall, institutional indicators point at weaknesses in pursuing institutional reforms. Although Croatia compares well with other countries in the South and Eastern Europe, in the case o f regulatory quality it lags behind Bulgaria and Romania. Figure 6.1: Governance Indicators I I Other SE€C Regulatory Quality Pornanla Bulgarb Ooab I2007 BJ.8 0.0 20.0 40.0 60.0 80.0 100.0 County's percentile rank Rule of Law Control of Corruption 00 200 400 600 800 1000 00 20 0 40 0 00 0 800 1000 Country3 prcenble rank Country's percenble rank 6.5 Other independent as well as government sources point to the same problem as well. The World Economic Forum's Competitiveness Report 2005-2006 ranked inefficient public administration at the top o f the l i s t o f barriers for doing business in Croatia.94 93 Anticorruption in Transition 3, World Bank, and WJ3 Governance Indicators 2007. 94 Strategic Development Framework 2006-2013, Government p. 65. 122 6.6 Selected Doing Business indicatorsg5 Table 6.2: Selected Doing Business Indicators, 2007 similarly show the degree to which Croatia lags No. of DuratiodDays Cost* OECD benchmarks with respect to four Procedures administrative/judicial processes, including Starting Business those for starting a business, dealing with OECD 6 14.9 5.1 Croatia 8 40 11.7 building licenses, registering a property, and Dealing with Building Licenses enforcing contracts. The largest gaps are OECD 14 153.3 62.2 observed with respect to transaction costs o f Croatia 22 255 722.4 starting the business and obtaining building Registering Property licenses, as well as with the number o f days OECD 4.9 28 2.4 required for registering property and starting the Croatia 5 174 5.0 business. These data serve as illustrations o f l o w Enforcing Contracts effectiveness o f public services in Croatia, but OECD 31.3 443.3 17.7 these are also indications o f generally Croatia 38 561 13.8 *% o f GNI per capita, **%property value, ***% o f debt inadequate quality of provision of public Source: Doing Business 2008, www.doingbusiness.org. administrative services. 6.7 The problem i s well recognized within the country. Indeed, the Government Strategic Development Framework for 2006-2013 outlined the need to reform the public administration as a tool for increasing competitiveness and effective social inclusion. In the government view, a competent, efficient and motivated public administration, simpler and cheaper operating procedures and an efficient and independent judicial system are the basic institutional determinants o f a favorable business and investment environment. 6.8 Already some improvement has been observed in various dimensions, notably as regards the enforcement o f debt contracts, where only speed remains an issue, and more generally in terms o f number o f administrative procedures. The gaps remain s t i l l very high in terms o f the number o f days required for completion o f administrative procedures as well as in terms o f their costs. Simplified procedures for starting a business have been implemented through Hitro.HR project, with further simplification expected in 2008 through a r o l l out o f e-company registration. A regulatory guillotine effort aimed at simplifying business regulations has been initiated in late 2006, with almost half o f the recommendations for simplification or elimination implemented year and a h a l f later. Further improvements should be expected in the coming years given significant backlog o f court cases has been resolved. Land registry reform also produced some improvement in the reduction o f the ratio o f solved vs. unsolved court cases. However, i t i s s t i l l too early to say if recent data represent a lasting change in trend. 95 Doing Business in 2006, World Bank. 123 B. EFFICIENCY LABOR OF INPUTS 6.9 Low effectiveness unfortunately has been accompanied by low efficiency, as reflected in the high shares of personnel cost in Figure 6.2: Spending on Wages and Salaries, YOof GDP public expenditure. Table 6.3 compares public administration wage bill with macroeconomic and fiscal indicators for Croatia and new EU member states, pointing to excessively high ratios for Croatia. The overall size o f the wage bill i s higher than in almost all EU new members and despite efforts in recent years, the wage bill (without employers’ contributions) remains around 10 percent o f GDP in 2007. Along with Hungary, Croatia has the highest wage bill in the Source: World Bank, ECA Fiscal database, Croatia MoF.. region. Table 6.3: Personnel Cost: Key indicators of comparison for Croatia vs. other countries, 2005 YOo f Ranking YOo f Total Ranking YO Current of Ranking YOo f Domestic Ranking GDP� Expenditure Expenditure Revenues Croatia 12.4 2 27.3 2 30.9 1 26.2 3 Albania 6.4 22.0 26.6 3 26.7 2 Estonia 7.0 17.8 20.1 17.5 Latvia 7.2 20.1 22.2 21.0 Lithuania 6.7 19.9 22.2 21.3 Romania 4.8 15.0 16.9 16.0 Bulgaria 4.1 12.0 13.6 11.5 Slovakia 7.0 18.0 19.8 19.9 Hungary 12.3 3 25.4 29.4 2 28.1 1 SAM 10.3 22.8 24.3 22.8 Macedonia 8.5 23.2 25.4 Slovenia 9.5 22.1 24.3 22.8 Czech Republic 8.3 15.7 Poland 11.8 26.5 3 BiH 13.0 1 36.8 1 EU 25 10.9 22.7 N M S 10 11.3 24.4 Note: In all countries doctors and hospital workers wages are included. If Croatian GDP gets adjusted according to Eurostat standards, this ratio amounts to 10.6 percent, which does not influence the conclusion: public wage bill over GDP i s comparatively very high. Note that this correction does not influence indicators to the right in the table. Sources: MoF, Eurostat, BiH PER, Albania PER, WB Study on Civil Service Reform in E U Accession countries. 6.10 The high wage bill reflects the large number of public sector employees, rather than high wages. I t i s indicative that 4.9 percent o f population i s employed by the civilian public administration (see Table 6.4). This i s more than sixty percent higher than a median value o f 3 percent in Europe and Central Asia. A t between 260,000 and 270,000 employees, the general government sector employment represents over 15 percent o f the labor force and i s the major employer in the country. This number does not even include the additional 73,000 staff employed by twenty strategic public enterprises and dozen thousands o f staff employed by the state-owned companies with majority state ownership held in the Croatian Privatization Fund portfolio. All inclusive, the total number o f people employed in the public sector would amount to more than 20 percent o f Croatian labor force. 124 6.11 T o contain the overall cost while increasing individual pay, the government will need to downsize the staffing. Some o f the areas, where staffing numbers could probably be reduced without affecting much the delivery o f public services, include the following: Local governments: A high fragmentation o f local government units (over 570 LGUs) bloats employment numbers. Large efficiency gain could be generated if some functions are amalgamated at grouped municipalities’ level. Further decentralization also needs to be followed by respective cuts at the central government level. Internal Affairs and Defense: The defense sector reform launched in 2000 have already resulted in a significant downsizing o f military personnel and attendant spending. With over 45,000 employees in internal affairs and defense, uniformed personnel s t i l l outnumber the civilian one at the central level exercising all other civil service functions at central level, leaving room for further downsizing both military personnel and administrative staff in the defense sector. Civilian Staff: Recently, there have been increases in the number o f public service employees, including teachers, judicial and medical personnel. In 2005, these three sectors accounted for almost 53 percent o f total public administration. As discussed in the education section, there i s a potential for efficiency gains in bringing teacher to pupil ratios back to mid-1990s’ levels and by reducing the ratio o f non-teaching staff to pupils from i t s current high level. Judicial sector: Croatia has one o f the largest numbers o f judges and court personnel per capita in the Europe and Central Asia region, while this overstaffing does not translate into the high effectiveness. Administrative support: Functional reviews carried out in 2005 suggested large inefficiencies exist in the line ministries as staff spends an inordinate amount o f time o n filing and retrieving documents, instead o f dealing with clients or policy issues; Contracting: There i s also lot o f staff time being spent o n auxiliary services that could be outsourced, like I T services, cleaning, catering and the like o n the basis o f public tenders. Table 6.4: Public Sector Employment, 2000-2005 Category 2000 2001 2002 2003 2004 2005 Civil servants 73,294 71,284 64,712 65,074 72,495 71,738 Central government 47,776 45,681 39,024 39,300 41,382 40,625 -ministries 24,384 22,136 2 1,609 20,604 21,203 21,178 -agencies 17,443 17,509 12,041 13,631 15,083 15,146 - central admin at county levels 5,435 5,43 5 4,833 4,536 4,545 3,735 - outside the executive 514 60 1 541 529 55 1 566 Public servants 152,391 152,316 159,454 159,339 157,441 146,263 - teachers and other education staff 72,812 73,186 83,424 83,874 80,480 69,147* -health employees (doctors, nurses, 58,028 57,481 57,140 56,584 56,952 56,952* etc) -culture 1,289 1,306 1,329 1,300 1,306 1,306 -social workers 9,093 9,008 5,935 5,945 5,963 5,963 -judiciary 11,169 11,335 11,626 11,636 12,740 12,895 Local Self Government 25,518 25,603 25,688 25,774 31,113 31,113 Uniformed Services 63,939 60,265 56,188 53,882 46,746 45,757 Grand Total 289,624 283,865 280,808 281,532 276,682 263,759 % ofpopulation 6.6 6.4 6.3 6.3 6.2 5.9 % o labor force f 15.7 16.3 15.7 15.7 15.3 14.6 *Preliminary Source: MoF. 125 6.12 Despite an excessive Figure 6.3: Comparison o f Civil Service and Private Sector Pay Levels wage bill overall, the remuneration package offered to high skilled staff remains unattractive. For highly educated and top caliber staff, the wage gap between the public and private sector (after correcting for education level) i s over 50 percent (Figure 6.3). Another symptom i s that while labor turnover within public Source: Croatia Civil Service Review o f Current Pay and Benefits System, Final administrations i s in general Report, May 2005. Source: Croatia Civil Service Review o f Current Pay and low, the only segment where Benefits System, Final Report, May 2005. mobility occurs i s at the top end as younger and more ambitious public servants leave for employment in the private sector after a few years o f acquisition o f know-how. Past that point the wage differential with the private sector becomes too high to be compensated by j o b security. 6.13 Although pay-compression in Croatia i s more or less comparable to the OECD levels (a ratio of 7.6 compared to between 8 and 9 in OECD), for the majority of employees the basic salary range i s within a narrow band. This in turn i s a likely factor for the use o f bonuses or annual increments to decompress total remuneration ranges. There are 13 different bonuses in addition to years-in-service allowance96that range from 15 to 150 percent o f the basic salary, are not mutually exclusive and could even be larger than the basic pay. None o f them though i s performance related. This non-standard approach across the administration leads to upward pressure on wages and relates total remuneration to the strength o f bargaining power rather than qualifications, merit or performance. 6.14 Part of the reason for the low turnover i s that the pay package puts excessive emphasis on seniority (years of service) and none on performance. This heavy reliance on benefits for years of service in turn burdens the wage bill. The allowances that are based on years in service have been proven as counterproductive as incentives. Detailed personnel data collected for a sample o f state institutions (Figure 6.4) show that Croatian public administration has middle-aged staff. This i s because o f the large cohort o f people who entered the service around the time o f independence and who now have between 20 and 30 years o f service. Given that the current remuneration policy i s driven by ‘years in service,’ i t i s clear that the cost o f the public administration will continue to rise as employees move through the system. Since there i s a built-in incentive to stay in the system, natural attrition will be a slow mechanism for reducing employee numbers. At the same time, a staff retrenchment program, with severance packages based o n years o f service, will be costly, and it will become more so as this cohort stays in service. 96These include bonuses for special working conditions, overtime, work at night, work on Saturdays, work on Sundays, work on second shift, working on shifts, work on holidays, non-working days and Easter, duty roster bonus, on-call bonus, Christmas bonus and child gift. 126 6.19 T o obtain and retain competent staff requires competitive recruitment and remuneration accompanied with attractive career opportunities and merit-based incentives. I n the past few years progress has been made with the enactment o f Civil Service L a w in 2005 and adoption o f horizontal HR management functions. The Law represents a major progress, but there remain several issues.97 For example, most provisions o f the 2005 Civil Service law entered into force only after parliamentary elections, that is, in 2008, while some necessary implementing legislation have not yet been adopted (for example, job classification and remuneration o f state employees), which in turn needs to be coordinated with the design o f civil servants salary system. Finally, the salary system across the public administration, and not only for civil service, needs to be adjusted to ensure merit-base promotion and rewards system. 6.20 In the meantime however, the Government has negotiated new collective agreements with civil service and public service unions and in a way has frozen the current situation for a couple o f years ahead. The recently negotiated six percent increase for all civil and public service staff (with the exception o f education sector that was granted 8.1 percent per year to catch up with the rest o f public service) without appropriate correction o f ‘denominator’ will push the wage bill hrther up without leaving the room for properly motivating the high performers. c. EFFICIENCYOF ORGANIZATIONAL STRUCTURE 6.21 Part of the problem with the effectiveness and efficiency of administration in Croatia i s related to overly complex government organization. There i s a tendency to provide public services through extra ministerial agencies which might function as organizational units o f particular ministries hence showing no obvious reasons why such activities have to be performed outside ministries. While the overall number and organization o f ministries (15) i s somewhat on a high side for a country like Croatia, there are also five other categories o f organizational structures within the government: Offices o f the Government (13), Central State Administrative Offices (4), State Administrative Organizations (9), Public Sector Agencies (25), and 0 Local Self-Government (576). 6.22 This multi-layered and complex structure creates problems for the allocation of functions, places a huge burden on coordination and it creates difficulties for the efficient allocation of human and financial resources. The extreme case i s that o f the 13 organizational entities responsible for environmental management or over 700 entities involved in delivery and policy planning o f social services. Among all entities in the sector, the Ministry o f Environment, Physical Planning and Construction receives only nine percent o f the total national budget allocated for environment, while within that envelope only 8-9 percent i s actually spent on management o f environmental issues. This type o f fragmentation o f a core government function will lead to inefficient use o f staff, knowledge, and financial resources. 6.23 This fragmented organization has evolved for two main reasons: (i) some cases there in was confusion between organization and demonstration o f importance for political action, so some Offices and Agencies remain as independent units only to show the importance o f some intervention (for example, office for prevention o f drug abuse) at a cost o f deeper integration and ability for horizontal coordination with the sector they belong to (health care); (ii) some cases opening a new in 97 SIGMA: Croatia, Public Service and the Administrative Framework Assessment, June 2005. The assessment i s based o n the common benchmarks that S I G M A uses to assess the public administration in EU accession countries. Given the absence o f common standards for public administration in the acquis communautaire, this assessment i s therefore the main instrument that i s used by the EC to determine the readiness o f candidate countries to undertake the tasks that come with EU accession. 128 office or agency was a convenient way to go around the rigid salary system and keep high quality staff and run some programs that would otherwise be impossible to create and run inside ministries’ hierarchies. 6.24 The flows of information within this overly complex structure of atomized units become distorted and decision making powers remain overly diffuse. This leads to decision making bottlenecks which slow down the normal operations and the reform process. In an extreme case it may lead to decision-making paralyses, especially when it i s not clear h o w ministries manage the multitude o f agencies that operate within their sector o f responsibility. 6.25 Fragmentation of organization i s also related to insufficient analysis of policy problems, lack of effective mechanisms for monitoring and evaluation of government decisions and absence of structured public-private policy dialogue, which set limits to policy effectiveness in Croatia. Policy development capacities within ministries are often weak. Too often a law i s drafted without preliminary analysis o f the problem, likely consequences and implications o f possible alternative solutions. The government has in February 2005 amended the Government Rules o f Procedures to introduce a mandatory system o f fiscal, social, economic and environmental impact assessments. This would provide ministers with a stronger factual basis o n which to take real choices. Although the plan was to introduce them gradually, with clear procedures, practical guidance and hands-on training for ministries’ staff, only fiscal impact assessment went alive by 2007, while SIA, EIA and RIA are s t i l l in the phase o f piloting. 6.26 EU accession will place more strain in respect of introducing regulatory impact assessments, implying a need for faster restructuring o f administrations’ activities in terms o f shifting away from low-skill routine jobs (that should be left to outsourcing partners where justified) towards more complex high-skill policy-making activities. Lack o f education and on-the-job-training may prove to be bottlenecks in this respect, requiring rapid remedial action in the field o f education and training that should accompany reforms in the fields o f salaries’ setting mechanism and performance based management in general. Successful EU accession will require substantial speeding-up o f these reform activities. D. RECOMMENDATIONS 6.27 The Croatian authorities have recognized the importance of civil service and administrative reforms. As noted above, in July 2005, a L a w on the Civil Service was adopted by Parliament that addresses deficiencies in the legal basis o f the status o f civil servants and other employees, most notably with regard to the depoliticization o f public administration, recruitment selection, promotion and training policies, as well as the regulation o f possible conflicts o f interest. The Government has also made progress in developing e-government, streamlining the number o f ministries and establishing the C i v i l Service Training Centre for continued education o f administration. However, the limited progress made has tended to be in a piecemeal manner rather than as part o f an overall public administration reform strategy aimed at enabling Croatia to meet the requirements posed by the integration process into the European Administrative Spacea9*In March 2008, the Government has adopted a Strategy for State Administration Reform, which lacks results framework with objectives, targets, deliverables and indicators that can be used to monitor progress o f the proposed reform efforts and i s not covering all segments o f public a d m i n i ~ t r a t i o n . ~ ~ 6.28 A more comprehensive approach i s now required. Reform will need to focus on a reduction o f the size and cost o f the public administration, from strengthening the administrative ’* Produced European policies and rules that imply an active role o f the national administrations - in which the national administrations are called upon, in the name o f the uniformity o f the rights o f citizenship and enterprise within the EU, to assure homogeneous levels o f service efficiency and quality (8th meeting o f Ministers o f Public Function o f the EU countries, Strasbourg, 7 November 2000). 99A National Council for State Administration Modernization Evaluation i s to be established to monitor the P A R progress and propose recommendations for strategy improvements. 129 capacity to implementing the policies required for European Integration as well as from improving the quality o f service provision. To achieve this, inputs based on best EU practice are needed, adapted to provide the best fit with the existing situation. Public Administration Reform 6.29 One set of actions needs to focus on public sector (both civil service and public service at central and local government levels) remuneration. The current pay system (based primarily on the characteristics o f individual civil servants and the rank that they occupy, which in turn i s determined by the years in service and the level o f education) will need to be replaced by system that links more firmly remuneration and performance. A review o f the existing pay and benefits system for civil and public service as well as options and proposals for civil and public service pay and grading reform was carried out in 2005 and 2006 as an input for drafting the current legislation. 6.30 Over medium term, performance indicators (currently weakly defined or not defined at all) will need to be developed. Therefore, a substantial effort directed towards development o f performance budgeting and associated set o f performance indicators (see section on PEMS in this report) will have to be undertaken to accompany salaries’ reform in order to make overall public administration reform successful. 6.31 As first steps in that direction, immediate priorities are: 0 To prepare the secondary legislation to fully implement the Civil Service Law (CSL) and harmonize all legislation with the CSL. 0 To implement fully the CSL, including depoliticizing high level posts to be filled by civil servants appointed after competitive recruitment. 0 To develop a Human Resource Management Information System to link personal information o f staff to the payroll payments. To harmonize pay scales and systems across government with a view to facilitating mobility, and move towards a pay system that rewards performance. This will require devising new job classification, wage scales and introducing a reliable system o f performance appraisal. To design competitive recruitment rules. 0 To streamline the salary bargaining process in order for it to start earlier each year, during the regular budget preparation process, with strengthened central decision making power o f the Ministry o f Finance. 6.32 Improving the effectiveness of the public sector’s policy-making and service delivery role can be achieved by rationalizing functions and in some cases personnel. The recently initiated process o f functional reviews o f administrative structures in order to bring organizational structures o f ministries, state agencies and offices o f state administration at the county level in line with the strategic and authorized tasks and responsibilities that they need to undertake need to be rolled out across the state structures. These tasks should remove justifications for unnecessary organizational complexity and pave the way for extracting efficiency gains from organizational consolidation. To that extent, the functional reviews piloted in two ministries and two offices o f state administration at the county level during 2005 have been rolled out to other ministries and subordinated state administrative bodies. Recommendations from functional reviews should be then used for drafting and implementing rationalization programs (including staff retrenchment, reassignments and budgetary impact). 6.33 The functional review process should be designed with the following considerations in mind. First, a vertical functional assessment o f sectors should be pursued with the purpose to review the mandates, the allocation o f functions and the alignment o f resources with those functions within a single sector. The prime purpose should be to identify where staff reductions are possible without disrupting service delivery, Second, there i s a strong case for reviewing all o f the institutions 130 individually, to determine whether each i s performing a useful function, to gauge whether their functions would better be transferred to the private sector or to a ministry, and to ensure that each institution i s clearly responsible for its functions and finances to a particular minister. These reviews should also cover the subordinate agencies. In order to do that, the government will need to develop policy criteria to facilitate decisions with respect to: Whether a function needs to be undertaken by central government or not; If so how this function should be organized (in a central ministry or “at arms length�); If not, whether the function should be dissolved, devolved to local government o r privatized / l e f t t o market at the basis o f public tenders. 6.34 I n parallel, the authorities will be well advised to set up an appropriate institutional and legal framework for the creation, structuring and operation of government bodies, a framework applicable to all those operational tasks that need to be undertaken by government, though not necessarily by the Ministries. This institutional framework would include rules for the establishment o f agencies, their relations with their parent ministries, the relation to the national budget and the lines o f accountability for these agencies. This could serve as a basis for developing and implementing a comprehensive program o f outsourcing routine activities, such as filing, archiving, I T services, cleaning and the like. If based on public tenders, such arrangements may produce significant efficiency gains. Substantial managerial educational effort i s required in this respect. Policy Design and Evaluation 6.35 T o pave the way for a more rational deployment of government administrative resources, a third priority area i s that of policy development improvement and impact assessment. EU accession aspirations places increased emphasis on the need to improve capacity for policy making. The following should be considered: Before drafting a law or initiating any major regulatory proposal, line ministries should prepare an analysis o f the problem from stakeholders’ perspectives, identify the options and assess the consequences o f each option, including issues o f policy implementation, evaluation and monitoring. To support this analysis, appropriate impact assessments need to be in place and regularly submitted to the relevant decision-making bodies. The quality and timeliness o f information provided by the Government to the Parliament in support o f draft laws should be improved and accompanied with findings o f regulatory impact assessments. Each new law and any other substantial proposal submitted to the Government should be accompanied by an implementation plan and a mechanism for monitoring the implementation and evaluation o f policy outcomes. Consultations with all stakeholders affected by any proposed regulation should commence at an early stage o f drafting regulations and consultations’ outcomes should be properly reflected in regulations and accompanying documents. Systematic arrangements should be introduced to asses the likely impact o f legislation being initiated by the Parliament (for example, on the state budget). The government should adopt, implement and monitor a comprehensive strategic plan for reforms over the short to medium term. This plan would also set the framework for development o f ministry-level strategic plans. Strategic Development Framework 2006-20 13 i s a useful first step in this respect, but implementation guidelines which would coordinate line ministries’ efforts and ensure fiscal and other resources for implementation, are still missing. 131 0 The inter-ministry consultation process should be strengthened. Issues need to be discussed and if possible resolved before proposals are submitted for consideration by the Government’s Coordinating Committees. 132 1: PART 1 1 ENSURING SOCIAL SECURITY 7. HEALTH INSURANCE 7.1 The Croatian health system has performed relatively well compared to countries in the region in terms o f health outputs achieved; however, these results have been achieved at a high cost and the public health insurance fund faces growing deficits posing considerable fiscal risks. The generous benefits and exemptions established during the early years o f independence have been politically difficult to r o l l back, and the complementary health insurance system introduced in 2002 has not accomplished i t s objective to modulate excess demand for health care. On the contrary, together with other system inefficiencies, it has further contributed to widening financial problems in the basic health insurance. 7.2 Croatia’s public spending on health Figure 7.1: Health Spending to GDP (YO) GDP at vs. care i s well above i t s neighbors and many PPS countries in Europe. The Croatian health 14 1 system i s based o n principles o f solidarity and universality, while i t also allows for participation o f the private sector in both the provision o f health care services and the health insurance. However, the generous basic ; insurance l i m i t s the scope for private sector initiatives. Furthermore, the quasi-absence of co-payments (due to numerous exemptions for : 00 50 100 150 200 specific groups) indicates a tendency to GDP p.c. at PPS emphasize redistributive objectives at the cost Source: WHO (2003 data), Eurostat, Croatia (2005). o f the financial stability o f the sector. 7.3 The efforts to contain costs in the 1990s and early 2000s were not effective, as HZZO’s expenditures continued to grow in excess of revenues, and arrears have accumulated further. Either through increased contribution rate or through financial injections from the central budget, the system was bailed out on average every two years. Eventually, in an effort to improve the financial situation o f the health care system while maintaining past health outputs, a new health insurance law and health strategy were enacted in 2006. The l a w sets a marginally stricter benefit package by reducing the generosity o f HZZO’s drugs reimbursement policy and l i m i t s exemptions by redefining the eligibility criteria for beneficiaries, while the strategy aims to address the inherent trade-offs required to simultaneously ensure broad access, and increase effectiveness, quality and cost efficiency o f the health system. These measures are yet to be implemented though. 7.4 Although recent measures promise some efficiency gains, they are far from being enough to improve the overall health system performance. The health sector arrears, although difficult to monitor given constantly changing methodology, are growing continuously, reaching over one percent o f GDP at the end o f 2007 (the Ministry o f Finance data). The trend o f arrears reflects more fundamental weaknesses o f the entire system. Efficiency measures on the demand side will have limited effects unless becoming bolder and supported by supply side improvements, mainly related to hospital management system and strengthening the gatekeeping role o f the primary health care. 7.5 The growing debt in the public system of health care suggests that there are structural problems in the provision, financing, and demand for health services. The reforms, therefore, have to address all these aspects. Other countries-like Slovakia and Austria- have tackled these problems through both short-term stabilization and medium-term structural reforms. Most countries in Europe continue to fine-tune their systems in order to limit the growth rate o f health spending. The common strategy was adoption o f hard budget constraint and strict fiscal discipline. 7.6 This chapter o f the report will elaborate on the conflicting pressures on the health spending, inefficiencies and inequities in the current system o f service delivery and will propose the steps that can be taken to address them on the supply and demand side o f the health sector. I t first looks at effectiveness indicators (Section B), then reviews the factors that limit the efficiency o f delivery o f public services (Section C), analyzes the equity o f health service delivery (Section D) and concludes by sketching out an agenda o f recommendations for a comprehensive health sector reform strategy (Section E). A. EFFECTIVENESS 7.7 Croatia has performed well in terms of health outcomes, especially when compared to countries at a similar level of income. With an average life expectancy at birth at 75.9 years in 2006, Croatia has the second highest l i f e expectancy compared to recently Figure 7.2: Disability adjusted life expectancy (DALE) vs. accessed EU countries: only Czech GDP p.c. at PPS (Purchasing Parity Standards) Republic (76) and Slovenia (77) had higher life expectancy as o f 2005. However, although the trend in l i f e expectancy has been increasing, matching the progress achieved in the best performing countries in Europe, the lag behind EU15 (average 79.1) i s still significant. Average life 62 - expectancy i s not necessarily a very 60 4 , good measure o f health system's 0 50 100 150 200 outputs though. I t may show higher GDP p.c. PPS sensitivity to cultural and environmental variables, such as nutrition and sanitation development, than to effectiveness o f the health Note: Croatian GDP adjusted for 16% upwards at the basis o f estimate of the size o f the shadow economy in order to make GDP accounting system. For that reason, World Health method approximately comparable to European countries. DALE at the Organization (WHO) calculates a basis o f WHO'S 2002 estimates. GDP 2005 measured as % o f "disability-adjusted life expectancy" EU25=100. (DALE) indicator, sometimes also Source: World Health Report 2004, Eurostat. referred to as healthy l i f e expectancy. It measures expected number o f years to be spent in good health, which i s supposed to be influenced by the health system performance. Figure 7.2 plots DALE against GDP per capita at purchasing power standard for 30 European countries."' Croatia (circled), i s positioned close to the expected value for DALE indicating expected health output given income level. EU25 loo (without Luxembourg), Croatia, N o r w a y , Iceland, Switzerland. 136 around 58 percent o f EU27 average i s 30 f,25 - expected to have under-5 infant mortality rate around eight per thousand live births. - , p 2o a With an outcome o f 6 in 2006, Croatia was 5 E 15 -- below average for EU8, but had s t i l l a long way to go to reach the value o f 4.7, which i s 5 10 - representative for developed European 5 5 - countries. The standardized death rates 5 O T I Table 7.1: Standardized Death Rates, All Ages (per 100,000), 2006 Ischemic Alcohol Smoking Circulatory Cancer o f All Causes System heart Related Related Tuberculosis the Cervix diseases Causes Causes Czech 837.6 419.0 177.5 81.0 359.3 0.5 5.3 Republic" Estonia" 993.6 498.2 264.2 158.3 448.6 3.4 6.8 Hungary" 1015.5 502.4 261.3 129.5 490.5 2.1 6.5 Latvia 1112.3 563.9 279.4 159.1 511.1 7.4 7.1 Lithuania" 1081.6 562.8 355.0 190.8 548.1 10.3 9.8 Poland ' I 862.4 384.2 114.4 89.5 283.1 2.0 7.8 Slovakia" 945.0 508.7 268.3 90.6 414.1 0.9 6.8 Slovenia 680.5 261.2 68.2 99.2 189.4 0.6 4.3 Croatia 842.3 417.7 160.3 87.2 365.2 2.4 3.1 EU15" 606.2 213.8 82.6 57.9 200.3 0.6 2.2 " 2005. Source: WHO-European healthfor all database (HFA-DB). B. EFFICIENCY 7.10 Although in terms of per capita spending, these health outcomes come at a comparatively moderate price, in proportion to economy size, public spending on health i s more than in other countries at similar income levels. Croatia's public spending o f $917 per capita in PPP i s the median value o f the comparison group (EU new member states). In aggregate terms, however, Croatia spends 8.4 percent o f GDP on health (2007), which i s far above the 6.9 percent of GDP in the new member states, though close to the 8.8 percent spent on average by the EU15. After Similar lo' to Ireland and Norway. 137 correcting for the non-exhaustiveness o f Croatia GDP to make it comparable across countries, spending to GDP ratio in 2006 drops to 7.4 percent, which sets Croatia in the group o f top spenders on health among EU8 (like Czech Republic and Hungary) and still well above the EU8 average. While the health spending reached a peak in 2000 with 9.1 percent o f GDP, in the years after, the country struggled to reduce the fiscal pressure with mixed successes. Table 7.2: Total Health Spending per Capita, Selected Countries GDP per Capita ($, Total health spending Public health Total public PPP adjusted), 2004 (PPP%per capita) expenditure as % spending (PPP$ per o f total capita) expenditure Latvia 11,653 852 57 482 Lithuania 13,107 843 75 633 Estonia 14,555 752 76 571 Poland 12,974 814 69 559 Croatia 12,191 917 81 743 Slovakia 14,623 1,06 1 74 782 Hungary 16,814 1,308 72 937 Czech R. 19,408 1,412 89 1,259 Slovenia 20,939 1,815 76 1,372 Source: WHO, European Health for All Database. 7.11 What distinguishes Croatia markedly from EU countries i s that Croatia has one of the lowest shares of privately funded spending in total health consumption (see Box 7.1). There are no reliable health accounts and private sector spending estimates, but indicators do point to comparatively l o w private sector spending.lo2 A mirror image o f this fact was reflected in the consumption pattern o f Croatian households, which spent on average 2.4 percent o f their total budgets on health in 2004. This figure i s l o w compared to other countries in Europe. The large share o f public spending i s explained mainly by the large number o f individuals exempted from co-payments and generous basic insurance that discourages private sector initiative. Most new EU countries have introduced additional co-payments that resulted in a relative increase o f private funding; for example, the share o f out-of-pocket spending in Slovakia increased from eight in 1998 to 11 percent in 2003; Latvia and Poland followed the same policy reforms. Table 7.3: Spending on Health, YO f GDP, 1999-2008 o 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008l Croatian Institute o f 7.6 7.7 7.4 7.2 6.2 6.6 6.0 6.4 6.1 5.6 Health Insurance/ Ministry o f Health and 0.3 0.2 0.1 0.2 0.2 0.3 0.5 0.5 0.5 0.7 Social Welfare/ 2 Local Government 0.1 0.0 0.1 0.3 0.3 0.3 0.3 0.3 0.3 0.3 Total Public 8.0 7.9 1.6 7.7 6.7 7.2 6.8 7.2 6.9 6.6 Expenditure on Health Private Spending on 1.2 1.2 1.2 1.3 1.3 1.5 1.5 1.5 1.5 1.5 Health, WHO Estimate Total Health Care 9.2 9.1 8.8 .0 91 8.0 8.7 8.3 8.6 8.4 8.1 Expenditure '/ Excludes cash transfers for sick and maternity leave which amounts to 0.7 percent o f GDP, but includes operating expenses o f HZZO. ' Direct budget o f Ministry o f Health for policy, regulation, public health, and related activities. Government estimates. Source: MoF, MoHSW, WHO. Data problem i s lo2 illustrated by large discrepancy between government estimate o f private sector spending at 2 percent o f GDP which i s being peculiarly flat over the long run, and WHO estimate o f 1.5 percent o f GDP. 138 Box 7.1: Co-Payment Policies Around The World Many countries have introduced or increased co-payments over time, especially for inpatient care and pharmaceuticals, in an attempt to control the growth rate of public spending on health. For example, Austria introduced a flat co-payment for outpatient treatment in hospitals in 2001, o f 18.17 euro per visit in an outpatient department, 10.90 euro if referred by GP o r specialist with an upper limit o f 72.67 per person per year. Switzerland introduced mandatory co-payments with a legal maximum in 1996. Belgium increased out-of pocket amounts 16 times between 1993 and 1997. In the Netherlands, co-payments for hospitals stay and specialist care with a maximum was increased in 1997, but abolished two years later. In order to limit the adverse effects o f co-payments o n equity and access t o health, the countries with social health insurance system do exempt co-payments from certain groups or certain services to influence utilization. For this reason many countries have a different insurance policy for three population groups: the unemployed, pensioners and low-income citizens: The requirements for unemployed to stay insured vary among countries. In Germany, a l l required payments for insuring unemployed are made by the unemployment agency, while in France public tax-raised funds make such payment. In the Netherlands, the unemployed must pay the normal percentage o n their social benefits as well as premium. The unemployed in Switzerland also have t o pay regular fixed premium. The criteria o f payments for pensioners are also mixed. Some required pensioners to pay the same fixed percentage o f their pension as employees pay theirs (Germany and Netherlands for example) and others have special exemptions (Belgium). A general trend i s to move away from categorical eligibility for co-pay exemption to broad-based eligibility which i s tied to household means for living. In Britain, the prescription charges cover about 40 percent o f average prescription costs, but only 12 percent o f prescriptions are charged, with exemptions for patients with specific chronic diseases or elderly people and those with very l o w income. In the USA, the Medicare scheme, which covers elderly people, reimburses only certain selected drugs and Medicaid, which covers some o f the poor, reimburses only drugs that are o n the formulary in that state. In France, co-payments are based o n the drug reimbursement rate. Drugs for serious and chronic conditions and exceptionally expensive drugs are fully reimbursed. However, only about 10 percent o f the population with health insurance is exempted from co-payments. Source: “Social health insurance system in western Europe�, “Critical Challenges for Health Care Reform in Europe� Saltman, Figuras and Sakellarides eds; Freemantle and Bloor, “Lessons from international experience in controlling pharmaceutical expenditure�, BMJ 1996. Sources o Pressure f 7.12 At present, total health spending may be reasonably sized given current income level, age structure of the population- and health Figure 7.4: Health spending to GDP (YO) GDP vs. outputs; however, arrears and future D.C. at PPS challenges further underline sustainability problem. Further increase in income, life .. AfterGDP cOrr(Icti0 expectancy, ageing and dependency ratios, may 16 lead to unsustainable growth in demand and over-proportional growth in spending. 15 Incentives will have to be changed to address the problem, in particular to eliminate demand 14 which does not lead to increase in health outputs. I t should be well understood that t h i s 13 problem needs to be solved not only for reasons EU15 EM Croatia o f economic efficiency-system with well Wrcent of populabon aged 65 or tmre *Total health expenditures as X of GDP aligned incentives may produce better health services for those in the need. Source: WHO, European Health for All Database, MoF, 7.13 A number of factors are combining to MoHSW, WHO drive up health spending. The ageing of the population i s one of them. Financing and delivering health care for the elderly population i s a growing concern in health care systems all over the world. 139 Gottret & Schieber (2006) project the change in total health spending over time in various regions as a result o f changes both in the number o f people and in the age-gender composition o f the population. Total health spending in E C A i s expected to rise 14 percent from 2005 to 2025, with 1 percentage point due to increases in the population and 13 percentage points due to changes in the age-gender structure. Given that the gender structure i s quite stable, the change would largely be due to age structure changes, especially increases in older population. This i s a l o w figure compared to other regions; for example, in Latin American population changes are expected to lead t o an increase o f 47 percent in health spending. In Croatia, elderly consume several times more health services in real terms than population stratum between 15 and 24 years o f age. In these terms, it i s worth noted that the share o f population aged 64 or more i s higher in Croatia than in both EU8 and EU15 country groupings (Figure 7.4). preventive care. Similar to EU countries, inpatient care absorbs the largest share o f public spending in Other health. In 2007, Croatia spent 49 percent on hospitals, 23 percent on pharmaceuticals and 4 percent on specialist care (outpatient care i s assessed to be at around 20 percent Inpatient care with inpatient care at 33 percent, and 49% 23% Pharmaceuticals Outpatient care 4% the above partially reflects the change in health budgeting in 2006). The largest increase in public spending recently has been for pharmaceuticals, Co-payments are paid as a lump sum per prescription for drugs or per visit to GP or specialist. They range lo3 basically from US$0.7 to US$2.5, rarely reaching US$6 for special medical procedures. The co-payment for one of the most expensive special medical procedures -the MRI- i s less than US$15. Among the groups exempted from paying contributions are: pensioners, unemployed, children and students. lo4 140 Table 7.4: HZZO Expenditures - Basic Health Insurance (million HRK, 1999 2000 2001 2002 2003 2004 2005 2006 2007 current) Health Care 10,252.0 11,425.0 11,170.5 10,915.5 11,731.0 12,888.0 13,254.0 14,028.8 15,101.5 Primary care 1,965.0 2,270.0 2,350.0 2,290.0 2,319.0 2,463.0 2,691.0 2,764.5 2,908.1 Polyclinics, 1,628.0 2,272.0 2,559.0 2,663.3 533.3 604.1 1,697.0 1,999.0 2,133.0 specialist services Prescription 2,773.0 2,815.6 3,074.9 3,487.2 1,529.0 2,238.0 2,096.0 1,952.0 2,397.0 drugs Hospitalization 4,300.0 4,245.0 4,102.0 4,618.0 4,165.0 4,331.0 4,395.2 6,909.0 7,309.7 Orthopedic 365.5 427.0 467.0 511.0 478.2 467.0 261.0 353.0 337.0 devices Other health care-related 500.0 320.0 152.5 62.0 151.0 295.0 178.0 268.9 325.5 expenditures Compensations 1,139.0 1,859.0 1,593.0 2,023.0 2,090.0 2,014.0 1,971.3 2,117.0 2,450.5 HZZO Operating 288.0 294.0 319.6 619.0 331.0 406.0 345.0 533.0 315.0 costs Other costs (investments, loan 122.0 237.0 198.0 239.0 84.0 70.0 63.0 361.5 62.0 repayments, special expenses) Stock o f short- 3,635.0 2,714.0 2,750.0 3,047.0 2,296.0 2,537.0 2,250.0 2,884.5 2,795.8 term liabilities/’ TOTAL EXPENDITURES 11,642.0 13,006.0 13,342.5 14,007.5 13,469.0 15,501.0 15,295.3 17,461.3 18,144.4 4) I n % o f total health care Primary care 19.2 19.9 21.0 21.0 19.8 19.1 20.3 19.7 19.3 Polyclinics, 14.9 19.4 19.9 20.1 3.8 4.0 16.6 17.5 19.1 specialist services Prescription 17.9 20.4 21.5 21.2 21.9 23.1 14.9 19.6 18.8 drugs Hospitalization 41.9 37.2 36.7 42.3 35.5 33.6 33.2 49.2 48.4 � Stock o f short-term liabilities is accounts payable for purchases made in the current fiscal year but paid in the following fiscal year. ‘ ’ In this estimation, it was assumed that the stock o f short-term liabilities represented the full stock of accounts ayable in the following fiscal year, and that the payments were made in the following year. Receipts from borrowings are included in the 2002 calculation. O n the revenue side, accounts receivable were not included in this estimation. 4’ HZZO’s total expenditures minus operating costs. Source: Croatian Health Insurance Institute Annual Report. 141 7.16 The actual consumption of rigure 7.6: Health Sector Arrears, in % of GDP health care i s running ahead of the funding available. As a result, arrears 1 in the health sector are substantial 12 and show no sign of reduction. The 10 stock o f arrears in Croatia (hospital and 08 HZZO arrears) has been increasing 06 almost continuously since 2004 and was 04 around 1 percent o f GDP at the end o f 02 2007. Most o f the EU new member 00 states have been or s t i l l are confronted by health arrears. In Hungary, for example the gap between revenues and expenditures in 2003 was approximately Sources: HZZO, MoF. 1.6 percent o f GDP. The stock o f debt in the health sector in Slovakia in 2003 was approximately 2 percent o f GDP.’� However, these two countries have been addressing these issues through a mix o f supply (mid-term) and demand-side (short-term) measures. 7.17 The rising arrears reflect the difficulties the Croatian health system i s experiencing in matching supply and demand. The resulting inefficiencies have negative impact on the health system’s sustainability and quality in the medium run. First, the current payment mechanism creates incentives for excessive demand. Second, on the supply-side, strengthening the gate-keeping role o f the primary health care i s urgent to reduce shifts to more expensive secondary care. Third, the extensive hospital infrastructure i s expensive to maintain and there i s inflexibility to reduce costs. Fourth, hospitals governance structure i s not conducive to making managers accountable for overspending above the agreed budget. 7.18 The accumulation of arrears in Croatia needs to be resolved through a reform package that deals both with the demand and the supply side. Arrears are costly not only for suppliers, but also for the overall performance o f the health system-it inevitably increases the cost o f future supplies to a non-credible buyer, and even more importantly it threatens with supply shortages and thus depriving patients o f adequate cure. Demand Side Inefficiencies 7.19 On the demand-side, co-payment i s a commonly used instrument in OECD countries to deter excessive utilization of health services. Most health insurance systems rely o n some kind o f co-payment as a means to control “moral hazard� that is, as the price o f health services i s reduced through the effect o f insurance, consumers tend to demand more services. Patients’ demand for services, particularly drugs, i s sensitive to the payments that they have to make out-of-pocket. Many countries in the world, including Poland in the group o f N M S , have introduced private payments without negative effects o n health outputs, but with positive effects o n efficiency in the provision o f health services. The impact o n equity should also be monitored. 7.20 Croatia’s co-payment share in total health expenditure i s less than one percent as opposed to ratios among Western European countries, from 7 percent in Luxemburg to 33 n percent in Switzerland. I addition to existing co-payments, the Croatian government introduced in 2005 a flat administrative fee (or flat co-payment) at the minimum amount o f 5 Kuna per person and a cap o f 30 Kuna per person per month. The revenues from administrative fees were expected in an amount o f 320 million Kuna per year, or approximately two percent o f total health expenditures. The average fee level o f 10 Kuna per visit, that i s around 0.5 percent o f minimum salary for health World Bank Financing in EU8 countries report. lo’ 142 contribution payment, with a cap o f 1.5 percent o f minimum salary, seems not to have changed behavior o f beneficiaries. The presence o f a monthly cap in the administrative fee per patient might have created the opposite o f the intended effect on demand as patients tended to use the services in excess, once the cap was binding. The Government thus decided to abolish the administrative fee in early-2008. 7.21 Widespread exemptions exacerbate the problem. The current health insurance law calls for co-payments o f 15 percent o f Table 7.5: Co-payment Structure, 2007 cost for specialized care, 25 percent Categories Number o f HRK million for hospital accommodations for users per year (per treatment o f chronic diseases, and 2004 data) 30 percent for accommodation in Insured paying individuals 1,758,154 100 hospitals for other treatments. There Insured paying individuals with 656,534 500 are three classes o f individuals, complementary insurance however, for whom co-payment Children below 18 836,195 113 regulations are not binding: first, Exempted from co-payments 1,110,125 779 Based on income census 529,625 378 there are many categories o f Other categories 580,500 40 1 individuals for whom the Total insured 4,.361,008 1,379 government takes care o f the co- Source: HZZO. payments (for example, unemployed, students up to 26 years o f age, spouse o f deceased insured person, wartime disabled, war veterans, disabled, and farmers who are at least 65 years o f age); second, there i s an additional l i s t for whom co-payments are exempted (for example, children under 18, disabled, voluntary blood donors, and individuals passing an income test). Finally, those with complementary health insurance do not pay co-payments as they are fully covered by that program. There is also a cost element to such a policy. The revenues’ forgone, as a direct cost, amounted in 2004 to about 0.4 percent o f GDP~O~. 7.22 Prevailing weaknesses in the system of social transfers (see Chapter 9 ) have left health insurance unduly burdened with social protection considerations. This has prevented more credible reforms. There are no indications that the administrative fee introduced in 2005 has deterred socially vulnerable groups from using the health care since the truly vulnerable groups (the social welfare beneficiaries) are reimbursed for fee payments. At the same time, there are n o indications that the introduction o f administrative fee has deterred unnecessary demand and prevented further subsidization o f groups with the ability to pay. There was also a possible lack o f incentives for doctors to collect the fees (this system was implemented successfully in Slovakia in the pado7,but i s absent in Croatia). Overlapping social and health care functions may be legitimate in the short run in a country where the system o f social transfers and criteria for exemptions work imperfectly. But even in this case, there are inefficiencies that can be eliminated in the short term without negative social impact before social protection system i s improved. Inefficiencies related to drugs coverage belong to this group. 7.23 As a result, spending on pharmaceuticals has represented a major source of cost- escalation in 2003-2004. To start with, drugs coverage was overly generous. Over 95 percent o f prescription drugs were financed by HZZO, either through reimbursement in the outpatient sector or via hospital budgets or through a special fund for new expensive inpatient drugs. HZZO offers a comprehensive positive l i s t with 1,700 specialties, out o f which 700 require a co-payment o f 10, 25, 50 or 75 percent. This system was introduced in 2002 and led to one-off decline in expenditures on prescription drugs. However, o n top o f 57 percent o f population exempted from co-payments, additional 20 percent did not pay due to complementary public health insurance with a very l o w Source: Croatian Health Insurance Fund Although lo’ the next government reverted the policy and eliminated the user fee in 2006. 143 premium, hence attracting high spending segments o f the population to insure. A subsequent catch-up in demand after introduction o f supplementary insurance i s visible in the Table 7.4. This i s in stark contrast to other countries in Europe, where the trend i s towards reducing public participation in favor o f additional out-of-pocket spending for drugs. 7.24 There are no reliable, comprehensive and comparable price/volumes statistics on drugs consumption presently available, but preliminary assessments made clear that the development of price/volumes statistical and monitoring system might open an avenue for significant savings. Reforms undertaken so far in 2005 and 2006 had promising beginning, as reflected in 2005 moderation o f expenditures o n prescription drugs, but require further efforts. A major part o f cost containment on prescription drugs in 2005 can be explained by higher preference for generic drugs and stronger bargaining with suppliers who were forced to cut their prices. Health insurance agencies around the world have typically resorted to tight monitoring and regulation o f coverage (for example, positive lists), pricing policies (including co-payment rates), and rational prescribing practice by the providers. 7.25 The 1999 drug reference pricing was in 2005 accompanied with a more effective system of price monitoring and bargaining with drugs suppliers and distributors. An initial assessment by Health Insurance Commission o f Australia, when comparing the Croatian wholesale prices o f a sample o f drugs against the Australian price for comparable products, showed that there might be opportunities for further cost savings by changing the reference pricing process, including possible changes in the l i s t o f reference countries.lo8Furthermore, i t has been concluded that price monitoring reform should complement incentives-based reforms such as co-payments, in order to make the overall reform effort effective. Also, retailers have not been allowed any more to distribute more expensive comparable drug if the prescribed drug i s not available. 7.26 Further reform of drugs’ lists was undertaken in 2006 in order to further cut prices and introduce more generics with an expected cost-savings of 0.2 percent of GDP per annum. T w o types o f prescriptions were introduced - those on the HzZO’s free l i s t and those requiring co- payment. A major revision o f the l i s t was made before introduction o f the new system, so incentives were created on the side o f suppliers to cut their prices in order to include the drug o n the first list. Complementary incentives were created with the introduction o f co-payments, thus increasing price elasticity o f demand and promoting price competition among drug suppliers. These measures should be strengthened further, and complemented with other control measures to ensure the cost- containment o n prescription drugs become sustainable. 7.27 The picture would not be complete without noting that Croatia’s sick leave program i s exceedingly generous. In fact, after the first 42 days o f sick leave (paid by the employer), beneficiaries are entitled to up to six months with a possible extension beyond one year o f sick leave, covered by the HZZO. The replacement rate has been reduced in 2002 towards 70 percent up to six months and 90 percent afterwards up to one year and could even reach 100 percent for special cases (such as occupational-related sickness, pregnancy complications, work-place accidents, etc.). 7.28 Around 98 thousand people or 6.1 percent of the active labor force has been sick or had pregnancy complications on a daily basis during 2007. Every actively insured person has spent on average 12.4 days per year o n a sick leave in 2007, the indicator that i s increasing over the last couple o f years. Over 19.2 million days were lost in terms o f productivity gains due to sick leaves. Another 11.6 million days were spent o n a sick leave due to pregnancy complications and extended maternity leave, while another 1.7 million days have been used to stay at home for extended maternity leave up to child’s three years o f age (for mothers with twins, three or more children). Anecdotal evidence points to a widespread misuse o f sick leaves by enterprises as a way to temporarily hide redundant I t included Slovenia, France, Czech Republic and two additional countries where necessary. 144 employment. This points towards a relatively easy process o f granting/approving sick leaves, which needs to be strengthened, if Croatia wants to address the problem o f l o w productivity o f its labor. Supply Side Inefficiencies 7.29 Croatia, unlike many former socialist countries, has not inherited an excessively overbuilt health care system. Nevertheless, there i s significant scope for rationalizing and modernizing the hospital infrastructure. There are 165 institutions in the health sector, o f which 68 are hospitals and p o l i c l i n i c ~ ' ~ ~ . Hospital network consists o f a large number o f multi-specialized hospitals in a close catchments areas and few centers o f excellence. This leads to low capacity utilization in small cities/counties' hospitals and over-utilization in regional centers and clinical hospitals. The multiple ownership over hospital network and decentralized responsibilities for maintenance and new investments make the hospital network consolidation as well as needed staffing adjustment politically very difficult task. Table 7.6: Health Sector Institutions by Type and Ownership State Level County Level City Level Policlinics I Emergency Medical Care Source: Register o f Budget 'sers, Official Gazette 8 1/2007. 7.30 With around 6 beds per 1,000 inhabitants, Croatia has achieved EU15 average, which indicates lower overcapacity problem than in some o f the EU new member states. However, most o f the large fixed costs observed in hospitals do not arise from the number o f beds but from the need to maintain a large infrastructure and the inflexibility to adjust inputs-besides the number o f Register of log Budget Users, Official Gazette 81/2007 145 beds. Reducing the number o f beds will not contribute to a large reduction in costs if the same number o f staff n o w has to care for fewer beds and if in response to it hospitals increase occupancy rates. This i s indeed what i s being observed in Croatia, where occupancy rates are almost 90 percent, higher than any country in the EU. 7.31 The main source of inefficiency in inpatient care, however, i s the long average length of stay. Inpatient admissions are in line with EU average, however, patients stay in hospitals for extended periods o f time. The trend followed by many countries in Europe i s to reduce the average length o f stay (ALOS). There was a large reduction in A L O S during the 1980s and 1990s in Croatia, but in the last three years the length o f stay has remained at 11 days on average. Other countries outside Europe rely on using outpatient care as much as possible, including the development o f day surgery care, resulting in a significant reduction in ALOS. In the United States, for example, ALOS i s 4.8 days and 57 percent o f patients are hospitalized for three days or less. In addition, only 16 percent o f patients stay in hospitals more than eight days and almost h a l f o f all surgical interventions in the United States are now done o n a same-day-in-same-day-out basis."' 7.32 The current payment system does not offer enough incentives to contain spending. Payments to hospitals consists o f three separate components: (i)accommodation services, paid as a flat payment per bed per day; (ii) physician services, paid by procedure using the WHO point system; (iii) pharmaceuticals and other materials, paid separately according to the cost o f each item. The current system does not allow hospital management to be rewarded for productivity gains. Figure 7.7: Hospital Beds per 100,000 Figure 7.8: Average Length o f Stay (ALOS), Population1985-2004 1985-2004 15 $ n 10 I -+- EU manbas before May 2W 5 : I -0 -0-EUmanbasaln~cMayZW4 0 I 1983 1990 199J 20W 2001 2002 2003 2001 1985 1990 1995 2000 2001 2002 2003 200+ Yea Source: WHO. 7.33 Some elements in the payment system do foster cost containment. First, hospital contracts with HZZO set l i m i t s to the volume o f services to be provided, based o n the number o f points, and includes financial penalties if a hospital exceeds i t s ceiling. Second, in July 2002, the Government introduced a case-based payment system based on the average cost weights determined for some 33 cases selected o n the basis o f interventions that are either high cost, high volume, or have a long a waiting list"'. Under this system, referred to as PPTP, HZZO negotiates volume contracts prospectively with all hospitals for these selected interventions, using case-based reference price in order to encourage a more efficient use o f resources. This strategy i s intended to reduce the waiting l i s t while improving control over the total costs. The initial results indicate that the introduction o f PPTP has had an impact in reducing the average length o f stay in most o f the interventions. 7.34 But the current payment system has also created an incentive for hospitals to keep beds full and extend the length of stay, since high occupancy results in steady funding based on the per diem reimbursement. L o w occupancy rates also increase the risk that the annual contract for the 'lo E W3 Bulgaria Policy Note on Health (2005). ''I In 2006, there were 188 PPTPs available. 146 hospital would be decreased by HZZO. In effect, there is anecdotal evidence documenting the presence o f waiting lists, suggesting that hospitals prefer to keep the same patient longer, rather than taking new patients. The sanctions to hospitals that spend above the l i m i t s established in the contracts are not strongly enforced. 7.35 The main problem remains how to align managerial incentives to undertake sustainable structural reform (for example, adjusting staffing levels) with current funding system. Cost overruns are likely to result in imposition o f arbitrary internal controls, for example, by restricting the use o f medications, rather than productivity improvements. Parallel reforms in hospital management and realignment o f incentive structure are essential in order to protect access and ensure appropriate quality o f care. T w o aspects o f such reforms are o f critical importance: introduction o f flexibility in wages and employment bargaining (without larger flexibility o f staff costs at micro level, delaying services i s the only managerial tool available to control costs), and elimination o f flexibility given to hospitals to choose whether to bill HZZO under PPTP or under the point-based system on a case by case basis. 7.36 Hospitals' free choice of billing mechanism defeats the cost-controlling motivation behind the hospital payment reform. The hospitals are implicitly guaranteed the highest rates as long as they can choose the billing system. For that reason, the Government intends eventually to move fully towards a comprehensive prospective case-adjusted payment system based o n Diagnostic Related Groups (DRGs). This will represent an important step in rationalizing incentives in the system, and will alleviate some o f the above concerns. The government i s implementing pilots in four hospitals that were rolled out to 50 hospitals at the end o f 2007, and i s expecting to start billing under DRG system in 2008. 7.37 Large unexploited reserve for efficiency gains in hospitalization and polyclinics remains with strengthening of the gatekeeping role within the primary health care. The system s t i l l provides too few incentives to support gatekeeping functions o f General Practitioners (family doctors-GPs). Prescriptions' quotas have proved to be ineffective and a more sophisticated standard cost controls system i s required, as GPs and specialists in polyclinics have to respond to demand for services. The demand has continued to rise in recent years irrespective o f measures taken prior to 2004. 7.38 General practitioners are acting as Table 7.7: Number o f Visits to Health Specialist points of transmission of patients towards and Average Cost, 2002-2007 specialists' care and hospitals, rather than as Year Avg. cost o f Avg. number of filters at the entry point to the system. outpatient specialist outpatient specialist Effective gatekeeping by GPs can be achieved service per insured services per insured by proper incentives, high service quality and person person effective allocation o f time per patient. Balancing these three factors will allow early 2002 384.02 12.86 prevention, optimum use o f upstream medical 2003 528.76 15.09 services and effective outpatient treatment, 2004 594.68 16.82 leading to more effective and better managed 2005 6 15 .OO 17.72 health care system. Excess demand for general 2o06 122.39 16.11 health services and lack o f incentives for 2007 138.5 1 16.78 investment in human capital and equipment in Source' HZZo primary health care have kept the quality o f gatekeeping in Croatia at a l o w level during transition. As patients' demand pressures begun to grow rapidly in the second h a l f o f the 90's and continued to grow in this decade, reforms were too slow to contain the outburst o f the capacity problem in the general health care. 7.39 The first steps towards introducing quasi-market incentives have been made, but their impact has been ambiguous so far. Annually, each citizen signs up with a specific GP who becomes 147 responsible for patients' access to the rest o f the health care system and consummation o f drugs. Annual choice o f GP was coupled with an option for GPs to run private general practice (doctors o f family medicine). This was a step taken in the 1990s in the direction o f introducing quasi-market allocation elements to the system. However, these two elements did not create properly balanced incentives. Consequently, time allocation per patient became distorted. Each GP i s expected to cany a minimum o f about 1,700 patients per year on a standard roster (the actual average i s somewhat below this standard), which i s l o w compared with GP rosters o f 2,000-2,500 patients in other European countries. A lower threshold was established deliberately to encourage physicians to work in the underserved areas, as the minimum i s set at 850 patients per GP. Nevertheless, the doctors are paid according to the standard o f 1,700. Despite lower average number o f patients, most Croatian GPs had to deal with larger average number o f visits compared to their colleagues in EU due to weak regulation o f access to the system, which is, in part, not justified by real needs for the health service."' Also, GPs were paid by HZZO according to per capita criteria adjusted for age structure o f patients. There were neither demand controls mechanisms nor efficient investment incentives embedded in the system until very re~ent1y.I'~ 7.40 Growing utilization of general practitioners' and specialists' services is, in part, determined b y the weak deterrence provided by the co-payment deterring mechanism. Unjustified demand for general health care services i s one o f two main obstacles for effective gatekeeping, as unnecessary visits by patients consume significant amount o f doctors' resources undermining quality o f gatekeeping. As long as social protection measures do not target l o w income groups properly (see Chapter 9), the government will, understandably perhaps, be reluctant to regulate excess demand for primary health services by raising co-payment per visit. What should happen i s that co-payment limit be raised, in tandem with a substantial improvement on the targeting o f l o w income groups by social protection measures and in line with real income growth. Short o f that, further increases may not be feasible in the short run. 7.41 The EU accession i s a strong force behind growing relevance of the gatekeeping role of primary health care, as 75 percent of GPs have to finish extensive specialization programs before 2010. Traditionally, GPs had to maintain their licenses, but specialization in general medicine was not a precondition for practice. In order to meet EU requirements, GPs will have to finish extensive specialization programs ("family doctors model"). This puts an enormous strain on the medical education system at present, but this effort will substantially extend and modernize knowledge base o f the majority o f GPs, meeting a necessary condition for increased quality o f service. As specialization implies broadening o f the scope o f medical procedures and treatments that GPs are allowed to perform, extension o f PPTP remuneration system to a wider range o f procedures 11' Anecdotal evidence confirms that patients with de facto or de j u r e free access to the system tend to consume significant amount o f physicians' resources (time primarily) by demanding consultations, examinations and procedures that are clearly not justified from the perspective o f immediate health needs. This problem may be particularly acute in regions with elderly andlor unemployed population. 'I3In the last couple o f years there has been a slight change in the remuneration system for primary care and specialists, but to date the impact o f t h i s change has not been systematically measured. Anecdotal evidence suggests that positive changes have happened, calling for implementation o f more ambitious reforms in this direction. A major innovation was introduced in 2005, as GPs started to be paid according to the PPTP for certain procedures and treatments, up to the limit. The intention o f the implementation o f this new mechanism o f payment was to stimulate the performance o f additional procedures in primary health care, rather than in hospitals, in order to achieve a reduction in spending and to relieve out-patient and hospital specialist- consultative health care. More innovative and entrepreneurial segment o f GPs started to invest in know-how and equipment in order to expand the scope o f services. Unfortunately, there are no systematic data which would point to the amount or quantity o f investment by GPs as their associations work very imperfectly. GPs' associations should be strengthened in order to enable data collection, sharing o f know-how, facilitation o f procurement, and ease access to finance for purchases o f new equipment. 148 and treatments, coupled with lifting up o f the total limit, will create mutually reinforcing incentives for investment in general health care both in terms o f human capital and equipment. c. EQUITYS S U E S IN PROVISION OF HEALTH I SERVICES 7.42 Average per capita Table 7.8: Distributionof Relative Household Expenditure on spending on health increased Health from around 2 percent of total Proportion o f Population (%) household expenditure in 2001 to Spending on health in % of around 2.4 percent of total in total 200 1 2004 2004. An increase in health 0Y o 23.7% 16.0% expenditures was mostly due to 0-1% 30.4% 29.5% higher spending on medical 1-3% 26.3% 31.5% products. Distributional pattern o f 3-5% 8.9% 11.6% relative household expenditures o n 5-10% 7.9% 7.6% health was changed in 2001-2004 in +lo% 2.9% 3.7% the that proportion Of Source: Authors' calculationsbased on the 2001 and 2004 Household population with zero spending has Budget Surveys. shrunk, and proportion of population with moderate spending has expanded. 7.43 Age and household type are important correlates to health expenditures, where elderly persons (age Of 65 and more) incur Table 7.9: Household Expenditures on Health by Age, 2004 the highest out-of-pocket Mean Total Household expenditures. This indicates potential Health Exp. Share Expenditures social problem as long as the social (HRK, per (as a % o f total (Croatia=100) protection mechanism does not target capita, per expenditures) l o w income groups well. Analysis o f Year) expenditures per income brackets Age <=15 386 1.8% 88.5 indicates very stable share o f health Age 16-30 458 1.8% 105.0 expenditures in the first three Age 31-49 535 2.1% 106.1 quintiles, calling for further analyses 50-64 664 2.5% 109.6 o f equity issues. Similarly, households 65+ 902 4.3% 86.5 headed by retired, and disabled Source: Authors' calculationsbased on the 2004 Household Budget persons face higher per capita Survey. expenditures o n health. Education o f household heads seems not to influence significantly health spending pattern in relative terms. Female-headed households are spending more on health, which i s probably connected with relatively high proportion of single o l d female households, which incur substantial health spending. 149 7.44 Croatia faces Table 7.10: Household Expenditures on Health by Region and substantial regional Location, 2004 inequalities in health Mean Total Household spending, with Zagreb Health Exp. Share Expenditures Region, where some H K R (HRK, per capita, (as a YO f total o (Croatia=lOO) per year) expenditures) 1,000 per person per year i s Central Region 41 1 1.9% 87.0 spent on health products and Eastern Region 400 1.9% 85.2 services, spending more than Zagreb Region 997 3.3% 124.2 twice as much as in Central AdriaticNorth 556 2.2% 104.4 and Eastern Region. Adriatic south 532 2.2% 97.4 Similarly, in urban areas more than double i s spent on 782 2.8% 113.3 urban health as compared to rural Rural 385 1.9% 85.1 areas. Source: Authors' calculations based on the 2004 Household Budget Survey. 7.45 The lowest income groups spend significantly less on health. Household Figure 7.9: Lorenz Curve for Income and Concentration Curve for Health Expenditures expenditures on health are closely connected t o 1 0 - income, so that income inequality i s transformed into inequality in health spending. 20 percent o f the poorest people in Croatia dispose some eight percent o f total income, and the same poorest people spend o n health around 10 percent o f total household spending o n health. Similarly, unemployed persons over proportionally face zero or very l o w spending o n health. I t i s highly possible that their dire financial straits are a major reason for such a 0 0 1 0 2 0 1 I, Eun",.,,". 0.1 mDmYI.t,Dn 0.1 .h.,. 0 7 0 8 0.0 1 < low spending' The report the hole: Population i s ranked b y its per capita household similar health status as the employed, but they live in household where average income i s 20 Source: Authors' calculations based on the 2004 Household percent below the average and spend Budget Survey. substantially less on health. The situation i s even more pronounced if an unemployed person i s head o f household, in which case the whole household has l o w health spending, often n o spending at all (in almost 40 percent o f cases) or o f very small amounts. Since these groups may be in a higher need for health services (especially retired persons), this could be an indication o f exclusion. However, given these groups are subject to exemptions, their private out-of-pocket spending may be indeed close to zero. D. RECOMMENDATIONS 7.46 Stabilization measures to reduce the overall arrears in the system: 0 Perform actuariaYsimulation analysis of changes to the current contribution base for health insurance. Over the long run, the combination o f a loss o f contribution base and increase in the number o f beneficiaries could compromise the financial stability of the health insurance system. I t has been established that there are currently a large number o f individuals exempted from contributing to health insurance. This i s not unique to Croatia and countries have dealt with this issue in different ways. The current trend however i s t o avoid granting all individuals in a certain category free services. It i s more equitable t o set some kind o f income or means testing to accomplish the same outcome. One such category, for 150 example, i s pensioners. They consume the largest amount o f resources in the provision o f health services, but do not pay contributions or co-payments. If the state i s going to continue paying for the care o f the elderly i t would be important to determine h o w much this cost in order to predict future outlays in this respect. Currently there i s no such calculation. Increase co-payments and introduce annual cap for calculation of the co-payment limit. Any further increase in co-payments amount should go in tandem with improved targeting o f l o w income groups by the social protection system. The annual cap might be introduced and the level could be reassessed, as the current level i s not contributing to excess demand control. The introductionof additional co-payments should be viewed not as a means to generate additional revenues but as a way to limit excess demand. Several measures at the government disposal include, among others: (i) review o f existing rules to collect the fees, allowing providers to retain part or all the proceeds; (ii) setting the amount to be paid and the cap as a proportion o f some indicator in the economy; (iii) reduction o f the number and categories o f individuals exempted from the co-payments in conjunction with better targeting o f social policies. This could be done for example through the use o f means testing, so that only the most vulnerable socially and health-wise are exempted. Other countries like Slovakia eliminated exemptions completely and instead complemented the assistance to poor and vulnerable groups with additional cash transfer to help pay for co-payments. Rationalize spending on pharmaceuticals. HZZO spending in pharmaceuticals has been increasing constantly. This i s a common phenomenon to most countries in the region. The solution involves actions in multiple fronts. The most immediate action that can be adopted i s to increase the share paid by the consumer in the form o f a co-payment. The first steps in this direction have been taken in 2006. This should obviously be accompanied by additional actions to prevent the poor from foregoing treatment or acquiring drugs when needed. The effects o f measures introduced in 2006 should be watched closely, frequently evaluated and strengthened in order to make effects sustainable. Summary limit to GPs for consultations and prescriptions may be separated for practical calculation purposes in order to obtain more direct impact o n deterring unnecessary demand for general health services. In general, changes in the co-payment system should be introduced after careful behavioral experiments involving representative samples o f citizens. Potential effects of obligatory large quantity purchases of drugs for patients with chronic diseases should be analyzed, as producers offer large discounts for large package purchases. I t may also lead to significant efficiency gains in handling and distribution o f drugs. 7.47 Structural measures to reduce the overall spending for approximately 1.5 percent of GDP: Payment mechanisms to hospitals and outpatient care providers should be reviewed. This requires various steps: (i) evaluating o f the impact o f the changes to the payment mechanism for outpatient care implemented in 2005 to see if i t has resulted in lower referrals and lower utilization in hospitals for the procedures paid according t o PPTPs; (ii) eliminating the option for hospitals to opt out o f case-based methods wherever it i s implemented. In the case o f legitimate, high cost cases (that is, due to medical severity and complications) an objective criteria for additional compensation to the hospital should be established; (iii) increasing the extent to which the hospital management can respond t o the new performance- based payment systems. Hospital management will need to have greater flexibility and autonomy in decision-making in order to achieve the desirable productivity gains; (iv) 151 continuing with the full implementation o f DRGs. This will also allow estimating the actual cost o f providing health services, as i t i s likely that some services are currently being paid below cost, contributing to the increase in arrears. Reduced rates o f hospital and specialist care utilization would translate into significant savings for the health system. Using the available HZZO data, it i s estimated that a 10 percent reduction in hospital and specialist health care utilization will decrease total health sector expenditures b y about 4.2 percent. The effectiveness of the PPTP remuneration system in strengthening the gatekeeping role of primary health care should be tested on the basis of a comprehensive study, as anecdotal evidence points to i t s beneficial impact. Parallel incentives to broaden the knowledge base and stimulate investments into equipment should be created by further innovations in the PPTP system. GPs’ associations should be strengthened in order to enable data collection, sharing o f know-how, facilitation o f procurement, and ease access to finance. Restructure the hospital sector. The first step in this process i s to assess the needs o f the population by type o f service and geographic location and identify potential areas for efficiency gains and delivery gaps-a master plan. The next step should be a progressive implementation o f the plan, which could possibly include closing down some facilities, reorienting other facilities to alternative uses like long term care and private sector practice, and improving the infrastructure and upgrading equipment in the remaining facilities. Box 7.2: Hospitals Restructuring in Estonia There have been some successful experiences with the restructuring o f hospitals, like in the case o f Estonia, where a restructuring plan was set up in 2000 with the goal o f reducing the number o f hospitals from 78 to 21 by 2015. Using demographic and epidemiological models the demand for health care was estimated, as well as optimal catchments’ areas by type o f facility with the maximum time limit to reach the hospital o f one hour. Based on these criteria Estonia identified three regional hospitals for tertiary care with catchments populations o f 600 to 800 thousands, four central hospitals (100 to 150 thousands), 11 country hospitals (30 to 50 thousands), and three smaller hospitals. Between 1993 and 2001 the number o f hospitals went from 115 to 67, the number o f beds decreased from 14,000 to 9,000, and average length o f stay moved from 15 to 8.7 days. Reduce transfers from health insurance to households in the form of sick pay, maternity benefits, etc. Currently, the HZZO pays transfers to households for sick-leaves, accidents at l, work, care for family members when i l pregnancy complications and maternity leaves, collectively accounting for over 0.7 percent o f GDP (2007). With the exception o f additional maternity leave and equipment for newborn children, which are paid for by the state and only routed through the HZZO, all other allowances are paid out o f HZZO funds as those are part o f the basic health insurance package. Since these expenditures do not constitute health care expenditures, they should be either financed through other means, such as social welfare finance for maternity leaves, or cut in the level and duration. The maximum period o f sick leave should be reduced below six months, while the assessment procedure for extended sick leave eligibility should be strengthened. This will cause significant savings in health-related expenditures. 152 8. PENSION INSURANCE 8.1 The main challenge in the pension system in Croatia i s how to deal with low current and future replacement rates, high fiscal costs and intergenerationalequity issues simultaneously. Demographic trends and rising life expectancy caused the substantial deficits in the pay-as-you go (PAYG) system over the 199Os, while replacement rates declined from over 75 percent to less than 50 percent. The government therefore launched a reform in 1998 which aimed at scaling back the PAYG system to create fiscal space for introducing second and third pillar (private mandatory and private voluntary) systems that would make up for the declining PAYG benefits. 8.2 The anticipated improvements in pension system finances and benefits have not materialized as anticipated because of reversals in the original set of reforms and delays in introduction of the second pillar. Reversals included hikes in the PAYG pension benefits in 2001 and 2004 and certain other adjustments. Moreover, several o f the basic pension parameters in the reform were not set in a sustainable fashion. These include a l o w retirement age for women, high minimum pension benefits, and a l o w PAYG contribution rate (20 percent) that covers only 58 percent o f total expenditures. The contribution rate for the second pillar i s also l o w compared to other countries and i s not enough to balance the reduction in PAYG benefit for second pillar participants. 8.3 There are persistent perceptions of inequity in the pension system. These stem in part from the higher benefits offered for specific groups including veterans, military, police, MPs, ex- ministers, and members o f academia. In addition, the 2001 and 2004 pensions policy hikes, and to a smaller extent, 1998 reforms resulted in benefit differences opening up between individuals with essentially the same work/pay history-especially across cohorts. 8.4 The following adjustments are needed to ensure fiscal sustainability, adequate replacement rates and higher system equity: 0 Increase the second pillar contribution rate. This should be accommodated by additional PAYG savings measures or by fiscal savings in other public programs; 0 Raise the retirement age for women to 65; 0 Use the non-contributory social protection system for the vulnerable retirement groups, especially for the post-1999 pensioners’ cohorts. 8.5 The following alternative options should be considered for addressing issues of fairness and equity: 0 Reduce differences in pensions o f pre-1999 and post-1999 retirees in a fiscally sustainable manner; 0 Revise privileged pensions to reduce inequities to the general PAYG system benefits, and 0 Stop expansion o f the current pension system for disabled Homeland War Veterans and their survivors, and align the minimum pension and pension bonuses envisaged for all other veterans with the general PAYG system provisions. A. BACKGROUND 8.6 Prior to 1998, the pension system in Croatia was a pure PAYG system featuring low retirement ages (60 for men, 55 for women), full old-age pension entitlement based on 40 and 35 years of service for men and women regardless of the age, early retirement provisions and various supplements to years of service irrespective of contributions actually paid. During the early 1990s pension system finances worsened significantly due to the war, recession and n privatization. I a post-1995 wave o f economic-restructuring-induced retirement, the system dependency ratio (number o f insured to number o f pensioners) declined rapidly, and the share o f pension expenditures in GDP reached double digits. Table 8.1 tracks the evolution o f pension spending in the 1990s, 2000s as well as other key data. Table 8.1: Pension System Indicators for Croatia 1990 1995 1998 1999 2000 2001 TotalPensionInstituteoutlays,%ofGDP� 9.9 10.8 12.0 13.5 13.3 13.9 13.1 12.4 12.1 11.8 11.5 11.3 System dependency ratio (SDR) 3.00 1.81 1.54 1.38 1.36 1.36 1.36 1.37 1.37 1.39 1.40 1.41 (Insuredto Pensioners) Age dependency ratio’ 3.0 2.7 3.0 3.0 2.5 2.5 2.5 2.5 2.5 2.6 2.5 2.5 Net replacement rate, %� 75.3 45.9 46.8 48.3 46.7 50.6 49.5 47.9 46.7 46.3 45.0 42.9 Contributors, 000,eoy 1,969 1,568 1,472 1,406 1,381 1,402 1,422 1,444 1,460 1,499 1,538 1,579 oiw second pillar members, eoy 983 1,071 1,170 1,249 1,322 1,396 Beneficiaries,000,eoy 656 866 955 1,018 1,019 1,032 1,042 1,055 1,066 1,081 1,100 1,122 -o/w old age, % of total� 48.9 51.2 51.8 50.9 52.2 52.3 52.3 52.5 52.3 52.2 52.0 51.6 .oiw disability, % of total� 25.3 21.9 21.0 23.1 23.3 23.1 22.7 22.4 22.3 21.7 21.5 21.4 -o/w survivors, % of total4’ 25.6 22.1 21.6 20.6 20.9 21.0 21.0 21.2 21.3 21.4 21.2 21.0 � including overall spending on pensions and administration cost o f the Pension Institute. � 20-60 year-old, over more than 60 year-old; 2001 census and official estimates forward and backward 3’ average net old-age pension as a percentage o f average net wage; pension supplements paid since 1999 and included in giension base in March 2004 are included for the whole period. Excluding military and Homeland War beneficiaries. Source: Central Bureau o f Statistics, Pension Institute (HZMO). 8.7 The PAYG pension system deficit, coupled with unfavorable demographic trends and n an expected increase in life expectancy, triggered a major reform. I July 1998, the Parliament enacted the Pension Insurance Act, the first in a series o f legislation setting the framework for the new pension system. The A c t stipulated that the pension defined benefit (DB) system in Croatia would consist o f three pillars: a scaled-down PAYG DB pillar; a mandatory fully-funded defined contribution (DC) pension pillar; and a voluntary fully-funded D C pension ~ i 1 l a r . l ’ ~ 8.8 The 1998 reform of PAYG parameters was expected to result in a gradual decline in first pillar spending as a share of GDP from more than 13 percent to less than 10 percent by 2020 and 6 percent by 2040, thereby creating fiscal space for introduction and deepening o f the second pillar. Fiscal savings in the system were expected to come from (i) reduced inflow o f new a pensioners due to a higher retirement age, (ii)price-wage indexation and (iii)longer basis period for a benefit calculation. The second pillar was launched in 2002, after a two year delay. I t had a 5 percent contribution rate that was to gradually increase in parallel with fiscal savings in the ~ y s t e m . � ~ 8.9 The second pillar was introduced in an unstable PAYG environment that included a series of reversals of the PAYG reforms over the period 1999-2005. Given delays in launching the ‘14 The pension system concept was similar to reform concepts applied in Hungary, Poland, and Argentina. ‘15The initial draft o f the Pension Fund Law contained a schedule o f gradual increases in the second pillar contribution rate from 5 percent in 2000 to 10 percent in 2005, but the final draft set the rate at “no less than 5 percent�. 154 second pillar, and the l o w and stagnant second-pillar contribution rate o f 5 percent, fiscal performance o f the pension system did not meet early expectations. The pension t o GDP ratio rose above 13 percent by 2002, and declined somewhat by 2005 towards 11.8 percent. This outcome stemmed from increases in replacement rates attributable mainly to Constitutional Court rulings on claims in 1997 and 1998 related to indexation and pension adjustments following reduction o f high inflation in 1993. In both cases Constitutional Court ruled in favor o f higher pensions. By 2007, the pension to GDP ratio declined to 11.3 percent. 8.10 Differences in pension levels among pre and post-1998 pensioners, induced primarily by post-reform 2001 and 2004 interventions in the PAYGO system were tackled in July 2007. The enactment o f the L a w on pension supplements attempted to reduce the gap between old and new retirees by raising the benefits o f new retirees (from 4 t o 27 percent), but with a consequence o f opening a gap for future ones.ii6 In parallel, July 2007 amendments to the Pension Insurance L a w reduced the penalty rate for early retirement and increased minimum and disability pensions, reversing thus some o f the achievements o f the 1998 pension reform. Consequently, the past interventions in the PAYGO system make i t increasingly difficult to strengthen the second pillar, which may end up being not a best choice for the 40-50 cohorts that switched to the second pillar. These recent changes are posing a challenge ahead o f the government on how to proceed with the pension reform - revert to i t s initial multipillar design, which reaches long term economic, social and intergenerational sustainability, or refocus o n the PAYGO pillar only. B. EFFECTIVENESS 8.11 Despite the relatively heavy fiscal burden of overall pension expenditures, initial net replacement rates of the Croatian PAYG system are among the lowest in OECD countries. I n 2007, the old-age net replacement rate o f a new average-wage entrant with 40 years o f service i s assessed to stand at 52 percent compared with an average O E C D replacement rate o f 69.1 percent for old-age entrants in 2002117. However, due to a mixed wage-price indexation formula, individual replacement rates in Croatia are falling at a slower pace than individual replacement rates in countries with price indexation. According to the OECD concept o f "pension wealth",1i8 initial estimates show that Croatian pensioners are closer to the OECD average than the initial replacement rates s ~ g g e s t . ' ' ~ 8.12 Despite higher early retirement penalty by 2007 and mandatory retirement age, the system continued producing young retirees. Contrary to expectations, the average years o f service before retirement have in fact dropped by one year to 29.1 since the launch o f the reform. By 2008, the statutory retirement age in Croatia reached 65 for men and 60 for women, while the early retirement penalty was reversed back from 4 percent to 1 percent for each year o f early retirement. As a consequence, early retirement pensions have increased accordingly. 8.13 The wide gap between the system dependency ratio and age dependency ratio points to lost productivity and fiscal gains that could have been achieved through higher labor force participation rates. The system dependency ratio (insured to pensioners) i s 1.41, compared with an age dependency ratio o f 2.5 (20-60 years old to 60 plus). The O E C D definition o f the dependency ratio (15-64 to 65 plus) i s over 4 for Croatia. This also highlights need t o create incentives for later retirement. The 27-percent supplement w i l l also be paid to all post-2009 first-pillar only retirees. 'I7The average old-age replacement rate in Croatia stood at 63 percent in 2007, which i s comparable to average replacement rate o f EU countries. 'IsRatio o f present value o f lifetime pension entitlements o f an average-wage earner to current average wage. N e t pension wealth in Croatia would in 2005 be 8.7, OECD average 10.8; UK 7.1; U S 7.3; N e w Zealand 6.0; 'I9 Mexico 6.0; Ireland 6.5; Denmark 7.8. 155 8.14 The lower mandatory retirement age for women discriminates against women in the labor market and yields lower replacement rates for female retirees if the same benefit formula i s applied. Many OECD and EU countries have already equalized male and female statutory retirement age, and the others have been considering it. 120 Equalizing the retirement age i s not an explicit EU directive, but it i s implicit in other directives that regulate gender equality. Given a rising l i f e expectancy, further actuarial studies should be carried out to determine whether the retirement age for both genders needs to be raised further.12' 8.15 The Croatian PAYG system pays relatively high minimum pension benefits. Each year o f service earns 0.825 percent o f the price-adjusted 1998 average gross wage. For 35 years o f service the average net replacement rate i s 42.9 percent, almost equal to average old-age replacement rate. With growth in real wages, the minimum replacement rate would decline faster than the regular replacement rate for the same service period. C. EFFICIENCY 8.16 Despite these pension reform steps, the PAYG pension hikes in 2000 and 2004 have kept the share of pensions in GDP well above the EUlO average (Table 8.2), and almost equal to the EU15 level. Without the policy actions described below, this share would be 10.1 percent in 2005, below the highest spenders o f the EU15 countries. Starting from i t s current level o f 11.3 the pension reforms should allow the share o f pensions in GDP to decline gradually to 8.9 percent by 2040. Table 8.2: Overall Pension Expenditures to GDP, EU vs. Croatia, 2005 Cyprus 6.8 Austria 12.7 Czech Republic 8.4 Belgium 11.2 Estonia 5.9 Denmark 10.9 Hungary 9.8 Finland 11.2 Latvia 6.3 France 13.3 Lithuania 6.6 Germany 13.1 Malta 9.3 Greece 11.9 Poland 12.7 Ireland 4.9 Slovak R. 7.6 Italy 14.8 Slovenia 10.5 Netherlands 12.6 Bulgaria 8.0 Portugal 12.3 Romania 6.2 Spain 8.9 Sweden 12.5 EU New Members 8.18 United Kingdom 11.0 EU15* 11.5 *without Luxembourg Source: EU and OECD. 120 The Constitutional Court decision from April 18, 2007 requires equalization o f retirement age for women and men and recommends this to be done gradually by 2018. The Croatian legislation even today allows for voluntary women retirement at the age o f 65. Current life expectancy at birth for 2006 i s 72.5 for men and 79.3 for women; at retirement it stands at 73 and 8 1. With women retiring earlier, average pension use i s eight years for men and 2 1 years for women. If Croatian GDP gets adjusted according to Eurostat standards, this ratio amounts to 10 percent, which does not influence the conclusion: pension spending over GDP i s comparatively high and spending pressures w i l l continue. 156 8.17 T w o policy changes since the launch o f the reform contributed significantly to P A Y G pension deficit in the 2002-2005 period-the 2000 Pension Differences Alleviation law’23 and the 2004 incorporation o f 100 kuna + six percent supplement in the pension base. In this period, the P A Y G pension deficit, defined as total expenditures less revenues including budget transfer for merit pensions, declined from 3.6 percent in 2002 to 2.8 percent o f GDP in 2005. Without these P A Y G system policy interventions in 2000 and 2004, the deficit would have been 1.1 percent o f GDP in 2005 (which matches the second pillar transition cost). Box 8.1: Pension System Outlook by 2040 According to initial pension reform estimates, introduction o f the second pillar was expected to yield a cumulative transition deficit o f 5-9 percent o f GDP over the 2002-2012 transition period and that system was expected to reach break-even by 2012.124However, pension increases in 2001 and permanent inclusion o f pension supplements in the base in 2004 raised the fiscal burden o f financing P A Y G pensions and the burden o f financing the second pillar transition deficit simultaneously. The status quo projection o f pension system revenues and expenditures (Figures below) under moderately optimistic macroeconomic a s s ~ m p t i o n s ’ ~ ~ indicates that annual P A Y G system deficits are expected to persist for the whole simulation period. Due to mixed wage-price indexation, the initial P A Y G replacement rate falls progressively from 40 percent in 2009 to around 23 percent by 2040. However, due to the l o w second pillar contribution rate, the initial replacement rate o f those participating in both pillar i s expected to be lower than the replacement rate o f old- system participants, and then gradually increase from 35 to 40 percent, which i s far below public expectations when second pillar was launched. Apart from macroeconomic assumptions,126 two-pillar replacement rate i s affected by a low contribution rate o f only 5 percent and a much stronger reduction in P A Y G benefit o f 50 percent. Not surprisingly, setting the second pillar contribution rate at 10 percent raises the initial replacement rate from 40 percent in 2011 to 62 percent in 2040, but also boosts the fiscal deficit due to high transition cost. In the whole simulation period pension system deficit stands above 3 percent o f GDP. Figure 8,l: PAYG System Performance - Status Figure 8.2: Replacement Rates - Status Quo luo Simulation Simulation 1 14 - 1 12 - +ONLY PAYGO 10 - P 8- +PAYGO PLUS PLLAR TWO 8 ’ s - 2- -cPension Expenditure -Pension -+Deficit Rewues 2005 2008 2011 2014 2017 2020 2023 2026 2029 2032 2035 2038 I Source: MoF. HZMO. I 123 Granting 0.5 to 20 percent increase in pensions regarding the retirement year as a response to 1998 Constitutional Court decision. 124 Anusic, Madzarevic-Sujster and O’Keefe, “Pension Reform in Croatia�, World Bank Pension Primer, 2003. 12’ Simulations assume real B D P growth o f 4 percent in 2006-2009,3.5 percent in 2010 and 20 11, and 3 percent afterwards. Real wages are expected to grow at 4 percent per annum in the whole simulation period. Rate o f return on accumulated assets i s assumed at relatively high 4.5 percent, and in the payout stage 3.5 percent. 126 Rate o f return on second pillar accumulation only slightly higher than the real wage growth yields a very gradual rise o f second pillar annuity replacement rate. 157 8.18 Merit (privileged) pensions'*' account for 23 percent of overall pension expenditures, or 2.5 percent of GDP. The privileged pension beneficiaries account for 16 percent o f all beneficiaries, underlining the fact that they have higher average pensions than regular pensioners. The largest privileged group, which absorbs 55 percent o f all privileged pension expenditures, i s Homeland War Veterans (HWV). HWV's pensions are determined as a percentage o f the corresponding wage in the military held prior to deathhnjury but are indexed using general rules. The minimum pension for this cohort i s guaranteed at 45 percent national average wage in Croatia, which i s on par with the average replacement rate for old-age pensions. 8.19 The average Homeland War Veteran pension i s three times higher than the average pensions, which raises the equity issue of the pension system, but more importantly discourages veterans from active participation in the labor market. The share o f HWV's pensions in GDP i s expected to remain at around 1.4 percent o f GDP without the revision o f HWV's disability pension eligibility.'28 Maintaining a special pension system for war veterans regardless o f the welfare status o f the veterans and their families i s socially unfair and poorly targeted, and i t s relative generosity discourages veterans' productive activities. 8.20 The system of Croatian police and army pensions underwent a comprehensive reform in 1999-2000 to reduce the replacement rate. Eligibility for early retirement was reduced, the vesting period was increased from 10 to 20 years, the calculation period was extended from last annual wage to last 10 years, wage indexation was replaced with mixed wage-price indexation and various service- related bonuses were eliminated or reduced. As a consequence, replacement rates shrank from almost 100 percent to 60 percent which helped reduce the share o f central budget spent for military purposes. The alignment with the acquis has triggered further changes o f the military pension system with the early 2008 enactment o f retirement age equalization for female and male military staff. 8.21 The pension contribution rate in Croatia i s 20 percent of gross wages and other contributable income, and i s at the lower end of the rates applied in European countries'29 (Table 8.3). However, contribution revenues cover only 58 percent o f total expenditures, while transfers for non-contributory merit pensions determined in corresponding laws account for an additional 19 percent o f expenditures. The remaining 23 percent o f expenditures for contributory benefits are financed from general taxation. These policies lower the contribution burden and unit labor costs, but they increase the general tax burden, thus increasing the burden on the broad taxpayer base instead to participants in the pension insurance system only. H a d the deficit been fully paid by the participants in the pension system, the contribution rate would have to be raised to 28.5 percent, a rate comparable to that paid in EU member and candidate countries with similar replacement rates. lZ7 Pensions for certain occupations or groups determined outside o f the Pension Insurance Act and their financing i s provided in the central budget. lZ8There are indications of some 1,600 pending requests for HWV disability retirement. Iz9 Law on Mandatory Social Contributions, adopted in 2002, has widened the contribution base to all other The labor-related incomes, such as temporary work contracts, honorary payments, and work compensations. This law equalized the contribution base with labor-related part o f the personal income tax base which simplified and improved reporting and control. 158 Table 8.3: Pension Contribution Rates in European Countries Countrv Percent Countrv Percent Albania 39 Austria 23 Bulgaria 32 Belgium 16 Czech Republic 28 Cyprus 16.6a Estonia 35" Finland 27 Hungary 26.5 France 16 Latvia 20 Germany 20 Lithuania 26 Greece 20 Malta 20" Ireland 1ga Moldova 30 Italy 33 Poland 33 Netherlands 28 Romania 34 Norway 22a Russia 28 Portugal 35a Serbia 32 Spain 28 Slovak R. 18 Sweden 19 Slovenia 24a UnitedKingdom 24" Turkey 20 Ukraine - ~. 33Xb - - .- Croatia - statutory 20 Croatia - required 28.5 . Includes I other social insurance programs; total o f employer and employee contribution in 2006. Source: ISSA, EU. 8.22 The 5 percentage points of contributions that are diverted to finance the second pillar benefits need to be increased in order to compensate for the reduction in PAYG benefits. However, this would further hike transition costs, increasing the amount that would have to be raised from fiscal savings in other sectors. The contribution rate for the second pillar i s l o w compared to other countries. On the other hand, the PAYG benefit for years o f service o f participants in the new system i s reduced stronger than the share contributed for the second pillar would ~uggest'~'. a As consequence, second pillar benefits will not be sufficient to compensate for the reduction in PAYG benefits, particularly if the rate o f return o n assets accumulated in the second pillar pension funds proves to be insufficient to compensate for the lower contribution rate. 8.23 I n the long run, second Table 8.4: Mandatory Pension Funds' Net Assets and Members pillar coverage i s expected to ecember2o07 reach 100 percent of insured Eandatory Net assets % Members % individuals (by 2025), and the pension fUnd total accumulation should AZ OMF 8,272,117 39.4 510,098 36.5 peak 25 percent of GDp in ErstePlaviOMF 2,706,903 12.9 211,886 15.2 2032. Starting from January P B Z K O O M F 3,539,690 16.9 231,070 16.6 2002, second pillar participation Raiffeisen O M F 6,483,150 30.9 442,639 31.7 i s mandatory for insured Total 21,001,886 100.00 1,395,693 100.0 individuals below 40 years o f %*fGDp 7.6% Source: Hanfa Monthly Report, January 2008. age. addition, insured between 40 and 50 years o f age had a choice to j o i n the second pillar or permanently stay only in the first pillar. At the end o f 2007, second pillar coverage reached 1.4 million or 88.4 percent o f all insured individuals. By December 2007, total second pillar accumulation reached 7.6 percent o f GDP with 70 percent concentrated in two largest finds (Table 8.4). 130 The initial draft o f the Pension Funds Law contained a schedule o f gradual increases in the second pillar contribution rate from 5 percent to 10 percent over five years, similar to schedules established in Hungary, Latvia and Estonia. Had that schedule been adopted, the contribution rate in Croatia would already have reached 10 percent. 159 8.24 The real average rate of return on pension fund assets was 5 percent which i s well above the average real gross wage growth of 3.1 percent per year during 2002-2007 period. The average rate o f return ranged between 7.12 percent and 8.11 percent per annum. This was due to favorable initial pricing o f government debt in 2002, positive price developments in fixed income markets in 2002 and 2003, and in equity markets during 2004-2007. Over the same period, the inflation rate averaged 2.5 percent annually. Such performance was better than in most new EU member states that introduced a second pillar. However, it i s unlikely that the high rates o f return, induced by rising Government bond prices during the EU convergence process, will continue. Hungarian experience with the second pillar, where around 70 percent o f assets are invested in government bonds, indicates that there may be periods o f negative real rates o f return, particularly if combined with deteriorating fiscal di~cip1ine.I~' 8.25 Government bonds still account for a relatively large 63.6 percent share of the pension fund portfolio at the end of 2007. This i s down 8 percentage points from previous levels, but remains well above the 50 percent minimum required for t h i s asset class. With a 14.8 percent share, stocks and GDRs emerged as the second largest asset class. Pension fund assets can from 2007 be invested in equity or fixed income instruments o f companies listed o n the Zagreb stock exchange top tier, but also o n so-called J D D quotation up to 15 percent o f i t s assets.I3' While this restriction protects the pension funds from investment in high-risk assets, i t also prevents them from investment in some less r i s k y assets as well. A partial relaxation o f domestic equity eligibility criteria has been included in the 2007 amendments to the law that regulates pension fund investment. 8.26 Fund management costs in Croatia are very high and overall administrative costs in the long run reduce assets at retirement by 26 percent. Pension fund management companies charge three different fees: Maximum 0.8 percent front-end fee o n paid-in contributions; Maximum 1.2 percent o f net asset value (NAV) per annum management fee; Switching feelexit fee. In addition there are the operating costs o f Insured Members' Registry (REGOS) devoted to second pillar contribution collection and individual account management. 8.27 There i s need for serious redesign of the cost structure. Furthermore, serious consideration should be given to having pension fund participation bear some o f the costs o f account management and fund administration incurred by REGOS, and taking a share in REGOS ownership. This option i s allowed under the Funds Law, and has shown positive results in countries like Mexico. 8.28 I n contrast to the second pillar, development of the voluntary funded system (the third pillar) has been slow. The voluntary pension system operates in the EET'33framework. Individual contributions to voluntary pension fund accounts can be deducted from the personal income tax base up to kuna 12,000 ($2,000) annually. In addition, the state tops up the contribution to an individual account by 25 percent, up to an annual contribution cap o f 5,000 kuna per individual. Pension benefits received from the voluntary system are taxed as regular income under the personal income tax rules. Despite these tax preferences there are requests to broaden the tax deductions to the employers as well in order to stimulate the development o f the third pillar.'34Until mid-2003 there were only two open-type voluntary pension funds. By the end o f 2007, there were six open-type voluntary pension funds with 103,923 members and kuna 692.8 million under management (0.25 percent o f GDP) and 13' In 2000 the real rate o f return was -2.2 percent and in 2003 i t was -2.3 percent. 13' Stocks that meet the corporate governance standards and have larger market capitalization. 133 EET means: i) contributions are tax exempt, i ) i) i investment income i s tax exempt, and i i pensions are taxed. 134 If employers pay voluntary pension contributions on behalf o f their employees these are treated as regular wage payment and regular taxes and contributions have to be paid. I t has been argued that this introduces disincentive for employers to participate in the voluntary pension system. 160 twelve ~losed’~’-type voluntary pension funds with 11,943 participants and kuna 119.1 million under management (0.04 percent o f GDP). Other than a 20 percent ceiling on foreign assets there are few restrictions on pension investments. The remaining restrictions will be lifted upon the EU accession. Assets o f voluntary pension funds (like the mandatory pension funds), are invested in government bonds (43.8 percent), domestic corporate bonds and stocks (24.1 percent), open-ended investment funds (20.2 percent) and foreign assets (4 percent), and a small fraction in cash (5.4 percent). 8.29 Pension reform has had a positive impact on wage reporting and fiscal discipline by broadening the base for collection of taxes and contributions. Introduction o f the second pillar provided an opportunity to expand monthly reporting to include all contributions, personal income tax and local income surtaxes. The individualized monthly reporting was introduced in January 2002 to collect monthly documentation from employers that includes separate records for each employee and could therefore be used to track accumulations o f individual benefit entitlements. I period 2002- n 2005, collection o f all payroll taxes was significantly above the levels forecast by the budget. Since 2002, the covered wage bill has grown faster than the actual wage bill (augmented by non-wage income included in the pension base). The ratio o f the (approximated) contribution base to (the proxy for) the actual wage bill grew from 76 percent in 1999 to 85 percent in 2006. Box 8.2: Compatibility with pension insurance schemes in the EU countries The mandatory second and voluntary third fully-funded pillars of the Croatian system are fully portable with similar schemes in the EU countries. The Sapir report’36 points out that variation in benefits and eligibility criteria imposed in EU countries’ national pension systems create a serious obstacle for effective intra-EU labor mobility. Indeed, EU pension systems vary from pure P A Y G DB schemes o f Germany, France, Spain, Portugal, Czech Republic and Slovenia, pure P A Y G D C (Italy), P A Y G D C combination with funded second pillars (Sweden, Poland), and combinations o f P A Y G DB and funded schemes (UK, Netherlands, Hungary, Slovak Republic). Croatia currently falls in the group that combines P A Y G DB and funded second pillar features. The current Croatian P A Y G pillar, however, provides replacement rates that are on the lower end on the EU and OECD countries. For each year o f service an average EU worker earns a higher relative pension than his Croatian counterpart, which makes employment abroad more attractive to Croatian labor. The Sapir Report concludes that “non-compatibility of acquired rights in terms of basic provisions for health, pensions and unemployment need to be removed�. Ideas and discussions about a common EU pension system have been maturing gradually. Holzmann (2004)’37 proposes an EU system o f notional D C accounts that would gradually replace the existing P A Y G DB If such an agreement on a common EU pension system were reached, introduction o f the N D C system instead o f the German point formula into Croatia’s P A Y G pillar would not cause serious problems. First, current second pillar administration i s based on monthly individualized reporting which could equally efficiently service the N D C pillar. Second, the current German point formula i s a subset o f the N D C system, and the benefit level would most likely not be reduced significantly. 139 13’ Open funds offer shares to the public continuously and perpetually, whereby shares are redeemed at a specific price determined by the net asset value. Closed funds offer shares exclusively for the sponsor’s employees or members. 13‘ “An Agenda for a Growing Europe: Making the EU System Deliver�, Report for the EC, also known as the Sapir Report, July 2003. 137 R. Holzmann: “Toward a Reformed and Coordinated Pension System in Europe: Rationale and Potential Structure�, Social Protection Discussion Paper Series, 0407, World Bank, March 2004. 13’ Notional account P A Y G D C systems exists in Latvia, Sweden, Poland and Italy. Individual contributions are notionally credited to individual accounts. Since the money i s recycled for current pension payments instead o f being invested, notional deposits earn an ex ante rate o f return determined by the state. Indeed, the N D C system, which i s f i l l y portable because o f i t s D C nature, provides benefits fully proportional to contributions. Issues that would need to be resolved for migrant workers are o f an administrative nature: i s the system administered 161 8.30 However, since 2005 the unified monthly individualized reporting for all contributions and personal income tax was abolished, which also raised the administrative burden on private sector.'40 Monthly individual reporting was retained for the first and the second pillar pension contributions, while the personal income tax reverted to reliance on aggregate monthly reporting submitted to the Tax Department. The effects should be monitored carefully because this change may as well weaken fiscal discipline. D. RECOMMENDATIONS 8.31 An increase in the second pillar contribution rate i s urgently needed and should be accommodated by additional PAYG savings measures or by fiscal savings in other public programs. The second pillar contribution rate o f 5 percent will not generate an annuity large enough to compensate future pensioners for the reduced P A Y G benefit, especially for the oldest second pillar participants first to retire. However, larger second pillar contributions imply lower revenues for the P A Y G system. Pension hikes in 2001 and 2004 have reduced the fiscal space for a higher second pillar contribution rate. Unless measures to reduce P A Y G expenditures are implemented to reduce the high pension fiscal burden, the additional transition cost o f a higher second pillar contribution rate will have to be fully financed from the budget, and fiscal space would have to be found in other public programs. Increase in the basic pension instead o f second pillar contribution rate would be a definite step back in the pension reform in Croatia as it would reverse the policy o f pension pillar substitution and risk diversification and eliminate the chance for higher replacement rates in the future emerging from capitalization rates above the wage rates. 8.32 Further parametric changes could be introduced to support a larger second pillar contribution and reduction o f differences between old and new pensions. These would include the following: 14' Raising the retirement age for women to 65 starting in 6-month increments from 2008 would cause the deficit to decline from 2.8 percent o f GDP in 2005 to 0.8 percent o f GDP in 2020 and vanishing in 2030; Reducing the wage weight in the indexation pattern. Price indexation would be a powerful fiscal measure which shrinks the deficit quickly to zero in 2015, however at the high social cost with rapidly declining replacement rates-to 30 percent by 20 15 .14* Indexation with inflation plus 25 percent o f real wage growth (half the Swiss formula) eliminates the deficit by 2023 with a more gradual reduction in replacement rates; separately or jointly? I s the accumulation transferred to the host country, or does the host country transfer the account balance to the domicile country? What rate o f return does the worker earn while in the host country? 139 The N D C formula yields similar results to the German point formula which takes into account demographic factors (change in l i f e expectancy) and the change in contribution rate factor. 140 Amendments to Law on Data Collection on Contributions and Personal Income Tax, Official Gazette, December 2004. 14' With the model used to simulate various policy options we were unable to simulate the impact o f reducing minimum pensions. However, with approximations, the model suggest that lowering minimum pension per one year o f service to 0.4125 percent o f average 1998 wage for the first 30 years would have a small fiscal impact in the first ten years and somewhat stronger afterwards, when the share o f those eligible for minimum pension starts increasing. 14* Fiscal impact o f indexation i s strong because the same indexation pattern i s applied for both past earnings valorization as well as for benefit indexation. 162 Raising early retirement decrement from current 4 percent to 7 percent for each year o f early retirement,'43 would reduce the deficit by 0.1 percent o f GDP in the first year, and by 0.25 percent o f GDP in 2022; 0 Gradual convergence o f privileged new pension benefits to general P A Y G O benefits by 2027 would reduce the deficit to 1.5 percent o f GDP by 2027; Fiscally powerful but socially unpopular measure would be t o abolish the 100 kuna plus six percent supplement from the pension base for pre-1999 pensioners starting from 2008. This reduces the deficit in that year to 2 percent o f GDP, gradually falling to zero by 2030. B y contrast, other polices would lead to much higher deficit levels. These would include measures such as equalizing benefits o f post-1999 retirees to the level o f pre-1999 participants, reducing the il calculation period from f l career to 10 or 15 best years, or introducing a more generous indexation pattern. 8.33 Differences in pension levels among pensioners should be dealt with very carefully in order to avoid worsening the fiscal problem for this and future generations of pensioners. Present differences in pension levels are the unintended consequences o f ad hoc interventions in the P A Y G system over the last few years (Box 8.3 below). There are four basic options to tackle differences caused by permanent inclusion o f 100 kuna plus six-percent supplement in pre-1999 pensions. Abolish the supplement. This i s the fiscally most powerful option which was expected to materialize in 2002.144 Abolishing the supplement for all beneficiaries would reduce the differences by more than 50 percent, save about 0.7 percent o f GDP, and open fiscal space to increase the second pillar contribution rate. However, this option would be politically and socially most difficult to carry out. With this option the second pillar contribution rate could be raised to 7-8 percent immediately and to 10 percent by 201 1. Extend the 100 kuna plus 6 percent supplement to all current and future beneficiaries but introduce means-testing. While means-testing may cut the fiscal cost o f the supplement by about one-half, the administrative costs o f means testing may eat up a significant part o f the savings. Fiscal savings could be used to increase the second pillar contribution rate to 6 or 7 percent. Extract the supplement from the base o f eligible beneficiaries, extend i t to all current and future beneficiaries and freeze i t or phase it out over a longer period o f time. This scenario would yield a smaller fiscal savings than the previous one. Fiscal space for the increase o f second pillar rate to 6 percent would be created only in four to five years. Extend the supplement to all current post-1999 retirees not eligible for the supplement (estimated at 300,000). This i s the most fiscally demanding, and would require additional annual pension expenditures o f 0.3 percent o f GDP. This scenario takes away the fiscal space for second pillar contribution rate increase for a longer period. Raise the post-1999 benefits through an alternative supplement or restitution fund. The fiscal impact o f t h i s scenario would similarly work against raising second pillar contribution rate, but for a shorter period. On the other hand, t h i s option would reopen the problem o f pension differences between current and fiture generations o f pensioners, because the latter would not be eligible for the restitution. 143 Such a decrement level was introduced in Germany in 2005. 144 The 1997 law endorsing 100 kuna plus 6 percent supplement was supposed to expire in 2002, but the Government extended it until 2004. 163 Box 8.3: Differences in Pension Levels Difffences in benefits for people in different cohorts but with the same pre-retirement profile has induced a wide dissatisfaction with the outcomes of the 1998 pension reform. In January 2006, the average benefit o f those that retired in the 1999-2005 period (at 1737 kuna) was 17 percent lower than the average o l d age pension benefit (including early retirement) o f pre-1998 retirees (at 2082 kuna), while the replacement rate for o l d age benefits was 46 percent. These discrepancies have spurred initiatives for revisions intended to make pensions more uniform across cohorts. The initiatives focused o n shortening the calculation period to the 10 best years, reducing the early retirement reduction and/or increasing the post- 1999 benefits to catch up with the pre-1999 levels. However, these initiatives do not effectively correct for the actual sources o f the pension level differentials. Differences in old-age benefit levels can be attributed to several factors: Including the 100 kuna+6 percent supplement in the pension base for a l l eligible pre-1999 pensioners. This contributes more than h a l f o f the difference in pension levels; il The widening o f the calculation period from 10 best years t o f l career. This leads to lower initial benefits for everyone, but was not compensated for by longer service periods as expected. Widening o f the calculation period contributed about one quarter o f the pension differentials; Increasing the early retirement benefit reduction f r o m 1.3 percent to 4 percent for each year o f early retirement. For the maximum five-year early retirement, this implies a 20 percent reduction instead o f the previous 6.5 percent. On average this reduction contributed one-eight o f the pension differences; Ending the transition period for addition o f female years o f service in 2004. This may have contributed less than one-eight o f the differences. On an individual level the differences may end up greater than the 17 percent average. For example, a women with steep earnings curve that retires in 2006, 5 years earlier than the statutory retirement age, may end up with a benefit 50 percent lower than a woman with similar characteristics who retired before 1999. Individual cases like this have been fueling the demand for reform and draw attention away from the inequities of the old system which redistributed from those paying higher insurance contributions to those paying low insurance contributions, from short service to long service careers and from men to women. Shortening the calculation period, lowering the early retirement decrease o r re-introducing the female service bonus would reinstate the inequities o f the o l d system. I t i s therefore recommended that these three parameters o f the system not be changed. Inclusion o f the 100 kuna+6 percent supplement in 2004 has indeed caused a significant difference in benefits across cohorts. 8.34 Privileged pensions should gradually be absorbed into the general system. Partial reforms in military and police pension systems have already been made. Pensions o f WWII participants and ex-political prisoners will continue to decline gradually. Benefits provided to MPs, ex-ministers, and members o f academia have no real justification-their above average wages would earn proportionally more points in the regular P A Y G system. 8.35 The current pension system for disabled Homeland War Veterans and their survivors should not expand, and the minimum pension and pension bonuses envisaged for all other veterans should be aligned with the general PAYG system provisions. The largest individual pension program, accounting for 1.4 percent o f GDP, i s for Homeland War Veterans. It not only covers disability and survivor benefits, but also envisages a minimum pension equal to 45 percent o f average wage for all currently working veterans and pension bonuses to regular P A Y G pensions. The minimum pension and bonuses for veterans are not only discriminatory, but they also discourage veterans from contributing to the public system and from active participation at the labor market. 8.36 Diversification of second pillar pension fund portfolios away from government bonds should be promoted. The steadily growing second pillar accumulation has been invested t o a large extent in government debt instruments. In the absence o f risk ratings, equity and private fixed income investment have been restricted to five companies in the stock market top tier and some high market capitalization second-tier shares. Development o f municipal fixed income instruments has been slow and limited. The process o f securitization, such as mortgage bonds, i s just beginning. Second pillar 164 fund managers have been experiencing difficulties investing funds domestically, and have been increasing their foreign portfolios up to the legal maximum. The recent revision o f investment rules and quantitative restrictions i s the first step in the direction o f diversification, but an inherent conflict between the domestic market development and the l i m i t s to foreign investment remain. Either the domestic capital market should be developed with active participation o f financial policy makers (IPOs, securitization, etc), or in absence o f domestic instruments, international investment ceilings should be raised as a substitute, particularly in a country approaching EU membership. Lifting the limit for international investment andor defining EU instruments as domestic ones are two realistic options. 8.37 Second pillar administrative costs should be reduced by steps to contain all types of fund management fees and costs of REGOS. Current administrative costs in the second pillar are high. Despite the centralized second pillar administration function performed by REGOS, management fees collected by the fund management companies are as high as in countries where the fund management companies administer all functions individually. Furthermore, pension fund management companies do not bear any o f the costs o f REGOS, as these are financed from the central budget. Revision o f the second pillar administration system and the level o f management fees should tackle two issues. First, the fees are higher than warranted given the type o f administration system and the fact that administrative functions are centralized in REGOS. Second, the current functions o f REGOS are broader than just servicing the second pillar and include collecting and transferring data to other institutions, primarily the Pension Institute. If the l i s t o f REGOS’ functions continues to include service to other institutions, they should share REGOS’ costs as well. Finally, REGOS outsources most o f the work to the Financial Agency and the Agency for Support to Information Systems on a sole-source basis. If these tasks could be provided o n a competitive open tender process basis, outsourcing costs could be reduced. 8.38 Third pillar tax treatment should be revised. Current legislation stipulates that individual contributions to voluntary pension accounts be both tax-exempt and tax-subsidized, while the employer contributions are fully subject to corporate profit tax. Employers claim that they have no incentive to participate in voluntary pension contributions directly, since it i s cheaper for them to pay extra wages rather than to contribute to voluntary pension find. Employers require that contributions should be tax- and contribution-free. The Government position when launching the funded phase o f the pension reform was to prevent the use o f the voluntary pension system for alternative (and cheaper) wage payments by excluding the employers from favourable tax treatment. Instead, all tax concessions were passed on to individuals. Most countries that have a third pension pillar exempt voluntary pension contributions for both employees and employers up t o a certain limit. Some countries also exempt voluntary contributions from paying mandatory social contributions. While personal income tax can be collected in the benefit payment stage, social contributions cannot. The taxation scheme could be revisited, and tax exemption o f contributions from corporate profit tax up to the same level as individual contributions could be considered. Exemption o f voluntary contributions from the mandatory social contribution base, however, would bring a permanent fiscal loss to the social insurance budget and stimulate intensive voluntary pension contribution at the expense o f higher wages, and, consequently, social insurance benefits. Identical treatment of contributions in voluntary and mandatory pension systems i s therefore not recommended. 165 9. SOCIAL ASSISTANCE 9.1 Overall social spending in Croatia i s Figure 9.1: Overall Social Spending in Croatia, high by international standards, but only a Consolidated General Government, YO f GDP o small share of it goes towards means-tested I programs. For instance, recent data show that while total social spending has been declining from the 1999 peak o f 31 percent o f GDP towards 26 percent o f GDP in 2007 (with the largest share going to social security and welfare services), only a very small fraction (0.6 percent o f GDP) i s used for the poverty- related social assistance program. Most o f decline in overall social spending was due to pension reform impact. 1 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2008 2007 9.2 I n 2007, Croatia spent 4.3 percent of GDP on over hundred different non- Source: MoF. contributory social benefit programs offered at the national and local levels of government. This i s some two percentage points higher than what EU15 countries spent and it does not include tax allowances provided for social protection. Out o f these, the social assistance program, as administered by the centers for social welfare, i s clearly the most targeted at the poor given the means-tested eligibility criteria, but receives around five percent o f the total. The majority o f other programs are not targeted at l o w income groups, but at specific beneficiary groups, like war veterans and pensioners. 9.3 The number of programs on offer, the number of institutions involved, and the lack of harmonization on eligibility criteria lead to a costly system to administer, allows for double dipping and causes unequal treatment of claimants. Adverse effects include the resulting confixion, and errors o f exclusion and inclusion which negatively impacts value for money. In addition, the implementation o f these eligibility criteria i s sometimes subject to the discretion o f local official^'^^. In the country with among the lowest labor force participation rate in Europe, public provision o f social assistance also faces the challenge o f establishing a link between benefits and work incentives. Over 50 percent o f claimants are able-bodied people. 9.4 Social benefits spending has increased by half percentage point of GDP since 2003 as a result o f reversals o f some reform policies in the area o f maternity leaves, new benefits introduced, changes to eligibility criteria leading to increased beneficiaries, and increased nominal value o f benefits. The National Population Strategy enacted by the Government in late 2006, exerts additional pressures onto the government medium-term financial projections. 9.5 The Government has during 2007 adopted the Social Benefit Reform Strategy. A key feature o f the government's program i s to improve the effectiveness o f the social protection system, Individuals can benefit from different income census applied by municipalities as oppose to thresholds applied by the centers for social care. by (i) rationalizing spending and improving targeting, and (ii) strengthening system administration. The strategy aims to gradually rationalize social benefit spending and cap at four percent o f GDP. A. EFFECTIVENESS 9.6 Poverty in Croatia i s low if compared intern at ion all^,'^^ but stagnant despite relatively robust growth performance, thus requiring an action. Around eleven percent o f the population i s poor, and only about 1 percent o f the population faces severe deprivation in Croatia. The recent Living Standards Assessment finds that over the last decade there has been a real increase in GDP per capita by more than 40 percent'47resulting in a reduction in the headcount measure o f income poverty by approximately one percentage point; consumption poverty, however, remained stagnant. As o f 2004, approximately 11 percent o f the population i s considered poor and a further 10 percent at risk o f poverty. Poverty i s associated with being retired, unemployed or economically inactive, and the incidence o f poverty i s highest among the elderly. As a result the poor get around 57 percent o f their income from pensions (38 percent) and state transfers (19 percent). 9.7 Poverty i s also quite shallow. The poverty gap i s about 2.6 percent (based on 2004 HBS data) and only four percent o f the population lives below the U S $ 4.30 a day poverty-line (at purchasing power parity). This i s the lowest rate among middle-income countries in the region. However, there are considerable urbadrural differences and poverty i s more prevalent in the rural areas (in urban areas the incidence o f poverty i s 5.7 percent while in rural areas it reaches 17 percent). 9.8 The resources involved in eliminating poverty are reasonably affordable and could be found through reallocation of existing resources. A perfectly targeted transfer o f approximately 1.5 billion kunas (about 0.7 percent o f 2004 GDP) would have been sufficient to eliminate poverty in the country in 2004. Further, even relatively modest increases in average incomes in poorer regions would lead to a considerable narrowing in regional poverty differentials. For example, if average per capita expenditures in rural Central Croatia were to increase by the equivalent o f only 10 percent o f the national average, the national poverty rate would be halved (i.e. drop from 22 to 11 percent). If the increase were 20 percent, this would eliminate entirely the differential in poverty rates with the urban Zagreb region. 9.9 Of all non-contributory social programs the social assistance (support allowance) i s the best-targeted program in Croatia given the highest effectiveness in targeting low income groups. More than two-thirds o f the total spending under this program accrues t o the poorest one- fifth o f the Croatian population. Unemployment benefits are found to be the next-best targeted program, with about 40 percent o f total benefits reaching the target group o f interest; moreover, the targeting o f unemployment benefits appears t o have improved significantly between 2002 and 2004, probably as a result o f the employment legislation changes that occurred in 2003. By contrast, neither child nor other family allowances appear to be particularly well targeted: the poorest fifth o f the population receive only 34 and 29 percent o f the spending o n these allowances, respectively--only slightly more than 20 percent this group would receive if the program were completely untargeted. 9.10 Overall, about 35 percent of the population in Croatia i s covered b y transfer programs. Child allowances are much the largest o f the various programs considered here, and reach about 26 percent o f the country's population. The population coverage rates o f other family allowances (10 percent), the social assistance program (5 percent), and unemployment benefits (6 percent) are considerably lower. 146 World Bank, Living Standard Assessment, 2006. 147 LSA (2006). Increase in GDP per capita 1996-2005. 168 an. 70 I 60 50 40 0 &era11 population Iborest one-fifth 30 20 10 0 Child A l l o w c c Other Family Scsl Unemployment Any ofthese Child Other Family Social Lhenploymnl Any of these Allowances ASPUtance knefits hefits 1- Allowance Allowances Assistance benefits benefits Source: World Bank estimates based on 2002 and 2004 HBS. 9.11 The social assistance program, however, does not cover the great majority of poor people: it covers only about 13 percent of the poorest one-fifth. Total transfers under social assistance are small in relation to other programs-at about five percent o f total social spending by the general government, but are an important income source for the poor, supplying 16 percent o f i t s beneficiaries’ consumption per-adult equivalent. A high proportion o f social assistance beneficiaries report the main labor market status o f their household head as “retired,� “other,� or “unemployed�. Before possibly recommending an expansion o f the social assistance program because o f its relatively good targeting performance and l o w coverage rate, one must first consider the adverse impact that an expansion might have on Croatia’s already low labor market activity rates and current beneficiaries’ profile. 9.12 Fiscal transfers, however, are effective of reducing regional disparities. While regional disparities in GDP per capita may appear stark at first sight, taxes, social security contributions, and social and other transfers help to equalize incomes across regions. This in turn translates into smaller regional variations in consumption per capita. Worse-than-average living standards in the Central and Eastern regions are linked to the poorer labor market outcomes in these regions, with lower participation rates, lower employment rates, and lower wages. 9.13 Social transfers to counties are inversely correlated with county-level GDP per capita and hence clearly help to reduce inter-county and interregional inequalities. Most o f t h i s inequality-reducing impact comes from social transfers other than pensions-which are positively correlated with GDP per capita at the county level and reflect historic employment profile. The geographic targeting o f social assistance benefits in Croatia i s quite good, with the above-average poverty regions in general having an above-average share o f the social welfare beneficiaries (Figure 9.4, left panel). 9.14 A similar picture emerges on comparing survey-based estimates of unemployment with the regional distribution of unemployment beneficiaries (Figure 9.4, right panel). At the same time, however, the graphs show that the Central region i s relatively under-servedin terms o f social welfare benefits, and the Eastern and Adriatic South regions are relatively underserved in terms o f unemployment benefits. 169 Figure 9.4: Social Assistance and Unemployment Benefits are Generally Well Targeted Geographically 4 14 1.4 f B ;:: 0.8 0.6 0.4 0.2 0.0 Zagreb Central Adriatic Adriatic Easte Croatia Zagreb Central Adriatic Adrial Eastern Croatia North SouIh Overall North South Overall Social Assistance Benefits Unemdovment Benefits a * Note: A comparison o f the relative heights o f the two bars for each region thus illustrates graphically the extent to which benefits are geographically well-targeted in that region-for instance, if the two sets o f bars are equal in each region, this would indicate perfect geographic targeting o f benefits. The “odds ratio� presents poverty and unemployment rates across regions expressed as a ratio o f the national poverty or unemployment rate. Source: World Bank, LSA. Distributional Policy o Tax System f 9.15 The tax system on its own has only limited impact on Table 9.1: Income Inequality income inequality. The tax system o f four brackets and rates 2004 2000-03 varying from 15 to 45 percent was expected to significantly reduce GINI for gross income inequality. However, generous allowances act in the income opposite direction, Le., increase inequality. GINI coefficient Total 0.44 0.44 measures o f inequality, based on 33 income intervals, point to very Employees 0.38 0.37 little or n o difference in inequality before and after taxes. These Pensioners 0.33 0.34 measures also indicate little changes in 2000-2004 both for gross Self-employed 0.56 0.49 and net income, except for the self-employed, where inequality has GINI for net income been rising. Total 0.38 0.39 9.16 The low impact of tax system on the income inequality 0.35 0.34 Employees suggests that wealthier taxpayers indeed tend to use higher 0.33 0.33 Pensioners allowances than low-income earners do. Allowances are high 0.52 0.47 Self-employed enough to cover more than 50 percent o f gross income of almost o f Croatia, staff O ei Source: Tax cff all median taxpayers. They are reducing the tax base o f the top decile’s employees and self-employed by some 20 percent, and o f a pensioner by almost 80 percent. The latter i s because pensioners have the lowest income and the highest allowances. The absolute values o f allowances between three selected income groups show that while median and average taxpayers use almost the same allowances, top decile’s taxpayers use allowances significantly higher. 9.17 This being said, an almost half of the Croatian PIT revenues i s collected from the top decile. The highest decile’s taxpayers paid 58 percent and employees 46 percent o f PIT revenues in Croatia. The bottom 50 percent o f employees collected only nine percent o f taxes. The ratio i s much lower for pensioners and self-employed, and overall has been rather stable in 2000-2004. 170 Table 9.2: Use of allowances in 2004 O TP Median Average Deciles Maximum Allowances, YO f gross income o Total 72.1 47.4 24.1 ... Employee 47.9 34.7 18.8 ... Pensioner 99.8 92.8 78.9 ... Self-employed 75.0 45.5 22.8 ... Average nominal allowances (KN ) Total 20,700 19,700 29,100 30,800 Employee 18,800 19,500 26,200 27,200 Pensioner 18,700 19,900 38,600 53,700 Self-employed 21,000 19,400 35,000 4 1,200 Source: Tax Office o f Croatia, staff calculations. B. SPENDING EFFICIENCY 9.18 Croatia has developed a generous social protection system with increasing spending patterns and numerous parallel social safety nets programs. This has resulted in an overly complicated social safety net which i s not well-targeted at the poor and i s costly to administer. Total consolidated general government social spending has increased from 3.97 percent o f GDP in 2003 to 4.27 percent o f GDP in 2007148. This number does not include the tax benefits for families with children, income non-taxable part etc. During the same observed period, public spending on social assistance has been declining steadily in relative terms. Its share in overall social spending declined from 16.8 percent in 2003 down to 15.1 percent in 2007. Table 9.3: Main Non-Contributory Social Spending Programs, 2003-2008, YO f GDP o Budget 2003 2004 2005 2006 2007 2008 Total Spending (HRK million) 7,871 9,042 10,100 10,572 11,749 12,967 Percent o f GDP 3.97 4.21 4.37 4.22 4.27 4.27 Social Welfare 0.67 0.65 0.65 0.63 0.57 0.55 olw social support allowance 0.25 0.23 0.22 0.19 0.16 0.15 Population and family policy measures 0.94 0.88 0.93 0.86 1.oo 0.93 olw child allowance 0.78 0.70 0.62 0.54 0.68 0.63 Care for Croatian war veterans and their families 1.32 1.60 1.63 1.63 1.70 1.80 olw war veterans pensions 0.99 1.27 1.27 1.29 1.39 1.49 Unemployment benefits 0.39 0.41 0.39 0.37 0.3 1 0.30 Post-war reconstruction and return o f displaced persons and rehgees 0.09 0.09 0.10 0.07 0.04 0.02 Protection o f disabled war veterans and civilians 0.22 0.22 0.19 0.17 0.14 0.12 - Local government social spending 0.34 0.36 0.47 0.49 0.52 0.55 Source; Croatia Social Benefit Reform Strategy 2007, MoF, staff calculation. 14' Totals include non-contributory pensions for war veterans. 171 9.19 Social benefit spending i s high by regional standards, largely driven by benefits and privileges granted to homeland war veterans and their families149, but social spending targeted at the poor i s relatively low. Spending on social protection programs (social welfare/assistance and family programs) within the overall envelope amounted to 49 percent o f total in 2007. While war veterans spending i s increasing in relative and absolute terms, spending o n social assistance, which accounted for less than 17 percent o f total, i s projected to further decline below 13 percent by 2008. Even within the social protection envelope, the share o f social assistance i s declining and most o f the funds are directed to population and family programs. Over the next couple o f years, the share of population and family programs i s set to increase to over 45 percent o f the total, largely at the expense o f the social assistance program. 9.20 With over 2 percent of GDP spent on social assistance and family programs, Croatia spends slightly less than the EU and several regional comparators on similar program^.'^' The EU15 countries spend o n average 2.6 percent o f GDP and several new member states also spend over 2 percent o f GDP on similar social assistance and family programs - such as Hungary 2.8 percent o f GDP and Czech Republic 2.1 percent o f GDP. Both the social assistance program and the child allowances program are targeted programs, though in different ways, and with somewhat different objectives. Traditionally, child allowances were intended for low-income workers, to ease some o f the cost o f child rearing and to minimize work disincentives at the lower end o f the wage scale. In contrast, the primary focus o f social welfarehocial help programs o f different types was to deliver social services, cash and in-kind support to those unable to care for themselves, such as the disabled, and elderly without support. This inheritance i s important, as i t remains relevant to current program objectives, and issues o f stigma attached to programs. Figure 9.5: Spending on specific non-contributory Figure 9.6: Spending on specific non-contributory programs, 2007, % of total programs, 2003-2008, % o f Total Population and family policy measures 4ML 42% '."Population and family \ Care for Croatian 35% policy rneasurw +Care for Croatianwar veterans and their families 15% =Postwar reconstruction \ *a Social WeHare 24% I \ Protection of disabled war veterans and civilians and returnof displaced persons and refugees 2% and return of displaced persons and refugees +Protection of disabled war veterans and civilians 6% Source: Croatia Social Benefit Reform Strategy 2007, staff calculation. '49 As a result o f the Law on the Rights o f Croatian Homeland War Veterans and Their Family Members, Official Gazette 174/2004 and 9212005. If corrected for GDP non-exhaustivenessthis ratio would be 1.8 percent o f GDP. 172 Social Welfare Programs 9.21 Within this overall envelope, the share of social welfare program has been eroding. Social welfare program expenditures are declining, comprising 0.57 percent o f GDP in 2007. Most o f the social assistance programs are cash benefits - around 70 percent o f the total welfare program spending - and nearly 25 percent o f the total social welfare expenditures are used to finance the main guaranteed minimum income program or support allowance. Social welfare programs are developed and administered by the Ministry o f Health and Social Welfare (MHSW). Along with providing direct support to beneficiaries through social assistance benefits, the Ministry i s also responsible for financing institutional care for children and adults. Table 9.4: M a i n State Social Assistance Programs, 2004 - 2006, million HRK, YO f GDP o Type o f Benefit 2004 2005 2006 HRK %of HRK %of R H K %of GDP GDP GDP Support allowance 500.4 0.23 497.8 0.22 479.8 0.19 Personal disability allowance 151.1 0.07 162.9 0.07 171.6 0.07 Supplement for assistance and care at 266.8 0.13 307.0 0.13 322.0 0.13 home Salary compensation to parents o f 103.9 0.05 113.9 0.05 131.3 0.05 children with disabilities One time assistance 56.5 0.03 44.2 0.02 42.5 0.2 Allowance for personal needs o clients in f 11.1 0.01 7.0 0.00 11.6 0.00 institutions or foster families Assistance in meals 6.8 0.00 7.2 0.00 7.0 0.00 Clothing and footwear allowance 0.7 0.00 0.7 0.00 0.7 0.00 Funeral allowance 4.4 0.00 4.5 0.00 5.4 0.00 One-time special allowance for textbooks 8.8 0.00 13.8 0.01 15.9 0.01 Trainingfor independent living and work 12.9 0.01 12.8 0.01 12.8 0.01 Assistance and care at home 4.5 0.00 4.8 0.01 4.7 0.00 Placement o children in foster families f 51.3 0.02 51.3 0.02 51.5 0.02 f Placement o adults in foster families 67.6 0.03 73.6 0.03 79.0 0.03 Total cash benefits: 1246.7 0.58 1301.4 0.56 1335.8 0.53 Placement in state institutions 492.6 0.23 533.4 0.23 550.5 0.22 Placement in non-state institutions 155.1 0.07 158.0 0.07 168.6 0.07 Other 78.5 0.04 91.0 0.04 98.0 0.04 Total: 1973.0 0.92 2083.9 0.90 2152.9 0.86 Source: Ministry o f Health and Social Welfare. 9.22 I n addition to central government spending, at least an additional HRK 1 billion i s also spent b y local governments annually. Local governments, depending o n their fiscal capacity or political will, can develop their own social assistance programs or supplement the ones that are provided by the central government. These mostly include supplements to pensioners, housing and fuel allowances, public kitchens, free o f charge summer vacation for children o f socially vulnerable families, etc. Local governments can also define the eligibility criteria and use the income census that differs from the nationally set levels. Without the data available on spending and beneficiaries, i t i s impossible to determine whether these programs are reaching the needy. According to the data collected by the MHSW, municipalities spent slightly over H R K 9 0 million or 0.04 percent o f GDP to 173 finance housing and fuel allowances, the average monthly housing allowance was HRK170, the average fuel allowance - HRK 826.’� 9.23 The Support Allowance program or guaranteed Table 9.5: Guaranteed Minimum minimum income program i s the core safety net benefit. I t i s Income Programs, Beneficiaries, well targeted but coverage i s l o w and the base amount has not ‘YOof population been changed since 200 1. This type o f program exists in almost Country 1999 2004 all EU countries; they are means-tested but differ substantially Croatia 1.8 2.7 in terms o f determination o f the qualifying income threshold Czech Republic ... 3.6 (national versus regional), generosity o f the system (level o f Estonia 5.9 2.5 benefits) and in administration practices. Croatia’s program o f Latvia 2.2 3.2 support allowance provides means-tested income support to poor Hungary 0.3 1.4 households who fall below arbitraw-set threshold. Lithuania 2.9 2.4 Poland 4.2 1.5 9.24 This main poverty benefit covers 2.7 percent of the total population and generally i s in line with guaranteed Slovakia 5.5 3.3 Slovenia 1.6 2.7 minimum benefit coverage rate in new EU member Source: WB, S c l i n oa Assistance i countries, where the coverage varies on average between 1.4 Central Europe and Baltic States, draft, and 3.6 percent of the total population. The number of Juiy2006. beneficiaries o f the support allowance program has increased from around 90 thousand in 2000 to 113 thousand in 2006, mostly as a result o f increased threshold in 2001. The number o f support allowance beneficiaries differs regionally: the most developed regions-Zagreb and Adriatic-have the lowest number o f support allowance beneficiaries, while Eastern Croatia has the highest number o f beneficiaries and the largest proportion o f beneficiaries in the total number o f inhabitants (1.4 percent). 9.25 Total spending on the support allowance was around 480 million in2006, or 0.19 Table 9.6: Guaranteed minimum income HN - percent of GDP15’ a slight decrease from 0.25 programs in new E U member countries, PercentofGDP percent of GDP in 2004. Croatia’s program o f guaranteed minimum income, similar to most 1999 2004 countries in the region, i s one o f the smallest social Croatia 0.20 0.24 assistance programs and aims to address the needs o f Czech Republic 0.38 0.46 the poorest. The program i s well targeted with 69 Estonia 0.41 0.17 percent o f program resources reaching poorest 20 Latvia 0.03 0.05 percent o f population. However, total transfers under Lithuania 0.17 0.11 this program are small and over 85 percent o f the Poland 0.4 0.19 poorest are not receiving support. Spending on Slovakia 1.13 0.48 guaranteed minimum income programs varies in the new EU member countries ranging fkom 0.1 to 0.5 0.22 0.48 percent o f GDP. The smallest programs are in Lamia Source: WB, Social Assistance in Central Europe and (0.05 percent o f GDP) and Poland (0.1 1 percent o f States, draft, *Oo6. GDP) and the largest programs in Slovakia and Slovenia (0.48 percent o f GDP).Is3 9.26 Entitlement to the support allowance i s determined by (a) family size, (b) combined family income, (c) combined family assets, and also (d) a limited number o f proxy means, for example a second property or a car. There i s a minimum error o f inclusion. The duration o f benefit i s not limited in time and the benefit level i s arbitrarily set by the Government and i s based on a monthly entitlement for a single person plus a reduced amount for additional family members. The level o f the Data from the Ministry o f Health and Social Welfare Correcting lS2 this number for GDP non-exhaustiveness would lower the social protection spending to 0.19 percent o f GDP. WB, Social Assistance in Central Europe and Baltic States, draft, July 2006. 174 support allowance has been set at HRK 400 and has not changed since 2001 (the average benefit amount in 2005 was HRK 345, as the monthly benefit entitlement i s adjusted according to family size and set against the actual income o f the household). In early 2008 government adopted a decision to increase a poverty benefit to HRK 500 from November 1,2008. 9.27 At 8.3 percent of average 2007 net wage, the current level of support allowance in Croatia i s low and cannot provide for even a minimum food consumption basket.’54 The current legislation has foreseen an adjustment to the benefit level to the arbitrarily set level o f HRK5OO. Adjustment either based on cost o f living increases or regular revision and adjustment o f the base amount o f the poverty allowance i s not foreseen, which i s leaving many potential beneficiaries excluded from the system. 9.28 Labor market participation can be encouraged by Table 9.7: Long Term Duration limiting the duration and introduction of the workfare o f Social Assistance Benefits, programs. At present the duration o f the support allowance in Percentage o f Total Croatia i s not limited in time and a large number o f beneficiaries Beneficiaries remain in the system for more than five years. Almost 50 percent 12 24 o f beneficiaries receiving a support allowance are working-age months months or and persons (18-60 years). Unemployed persons constitute over 45 more more percent o f the support allowance beneficiaries and, while for the Sweden 33.6 14.3 majority unemployment i s a transient phase, a significant number Germany 38.3 20.3 o f working-age recipients o f the welfare allowance in Croatia have Italy 43.9 24.7 been unemployed for a long time. Portugal 75.3 58.0 9.29 Many EU countries face similar problems and, to Croatia 79.2 60.3 prevent the long term dependence on social assistance benefits, Spain 80.3 61.0 they have reformed their social assistance systems to promote UK 83.0 69.1 work incentives and return beneficiaries to work. Measures Sources: Saracen0 2002, UK: include financial incentives for beneficiaries to return to work. Gassman and Deszka, 2003, Ministry There are several examples o f such reforms introduced in the EU o f Health and Social Welfare, 2006 new member states. Hungary modified the design o f its regular social assistance benefit so that beneficiaries could continue to receive some benefits for up to 6 months after getting a j o b (50 percent for the first three months and 25 percent for the following 3 months). Similarly, Latvia has introduced a guaranteed minimum income benefit o f limited duration (9 months per year) that can be received in reduced amounts after getting a salaried j o b (75 percent in the first month, 50 percent in the second, and 25 percent in the third month o f e m p l ~ y m e n t ) . ’In~ ~ Slovakia, the program o f reforms to mitigate any adverse impact o n incentives to j o i n the labor market included tax policy reforms, active-labor market policies (ALMP) as well as the social assistance benefit itself, Large deductions as well as tax credits for children are allowed for families in which at least one adult works. In ALMP, the unemployed can work in locally organized works to increase their social assistance benefits. Some benefits are collected by recipient in some temporary period after the beneficiary started to work. Child and Family Programs 9.30 The family benefit system in Croatia has two main objectives: first, the benefits should help to support families with low incomes and, second, it should serve as a measure to improve the demographic situation by encouraging families to have more children. Child and family programs include child allowance, mandatory maternity leave, voluntary maternity leave, rights to work part time, and a birth grant. Mandatory maternity leave for up to 6 months i s financed from In the WB LSA assessed to be at around 534 kuna. Slovakia has introduced one o f the most aggressive set o f social benefits reforms by launching a ‘Wew Social Policy� that aims to modernize and consolidate benefit programs to eliminate poverty and avoid unemployment traps. 175 insurance contributions, while the rest o f the programs are non-contributory and financed from the central government budget. Table 9.8: Expenditures on main non-contributory budget financed family programs (HRK) Program 2003 2004 2005 2006 2007 prel Child allowance 1,553,221,627 1,508,866,316 1,435,018,283 1,358,654,487 1,877,912,517 Y of GDP o 0.78 0.70 0.62 0.54 0.68 Additional maternity 291,878,884 404,155,373 624,774,046 785,421J78 900,000,000 leave o/w up to 1 year 267,129,548 3 17,062,118 3 88,785,265 o/w up to 3 years 6,453,374 33,544,575 117,228,623 o/w for unemployed 17,887,995 5 3,025,475 118,160,716 mothers o/w right to part -time 407,967 523,205 599,442 work Birth grant 52,984,240 53,916,042 68 $2 9,73 3 Total 1,898,084,751 1,966,937,725 2,153,143,127 2,145,666,745 2,709,336,000 Total Y o f GDP o 0.96 0.91 0.93 0.86 0.98 Sources: Croatia, 2007, Social Benefit Reform Strategy, Croatia Institute for Pension Insurance. 9.31 Total expenditure for the main non-contributorybudget financed family programs has increased slightly towards 1 percent of GDP. While the costs o f the child allowance program have hovered at around 0.7 percent o f GDP, the expenditures o n maternity leave programs are projected to increase in 2008 after Table 9.9: Spending on Child growing in 2007 due to threshold adjustment. The EU15 average for Benefits, Yi of GDP family programs i s 2.2 percent o f GDP. 1999 2004 Croatia (2007) 0.8 0.7 9.32 Croatia i s at the lower end of the range of spending by EU new member states. In 2003, spending on family programs Czech Republic 0.6 0.4 ranged from 2.7 percent o f GDP in Hungary to 1 percent o f GDP in Latvia and L i t h ~ a n i a . ’ ~ ~ Estonia 0.8 0.7 Hungary 0.3 0.2 9.33 The average level of child allowance in Croatia ranges Latvia 0.7 0.5 from € 27 to € 51 - in the middle of the average allowance in new EU member co~ntries’~’, which range from €9 per month in Lithuania .. 0.2 Czech Republic to € 108 Euro in Slovenia15*.The main program in Poland 0.5 0.3 the Croatian family benefit system i s the child allowance program, S1ovakia 1.1 0.6 amendments to which introduced in 2001 broadened eligibility (to Slovenia 0.9 0.9 include all children regardless o f the employment status o f their Source: WB, Social Assistance in parents) introduced income test and increased the amount o f child Central Europe and Baltic States, benefit. The effect was for the number o f beneficiaries to increase draft, July 2006, Croatia MoF. by almost 50 percent (from 466 thousands in 2000 to 629 thousands Eurostat, ESPROSS. 157The basis for determining the level o f the child allowance i s the “budgetary base� - an arbitrarily-set amount that i s determined annually during the budget preparation process and is formalized in the L a w on Budget Execution. The base (HRK 3,326 in 2006) is used to determine the eligibility for the child allowance and the level o f benefit. The mechanism to determine the eligibility for benefits is quite complex. From March 2007, there is a “three income� threshold system (below 16.33 percent o f the budgetary base, between 16.34 and 33.66 percent o f the budgetary base and between 33.67 and 50 percent o f the budgetary base) according to which the benefit levels vary. This complex system o f eligibility and entitlement i s further complicated by various additional entitlements for specific groups (disabled children, children with one parent, orphans, and war veterans’ children) that increases total allowances available between 15 and 25 percent. WB, Social Assistance in Central Europe and Baltic States, draft, July 2006. 176 in 2001) and to double spending (reaching HRK 2.4 billion or 1.46 percent o f GDP in 2001).159 9.34 The child allowance program covers about 26 percent of the population, but the poorest fifth of the population receive only 34 percent of resources allocated to this program. This relative spending pattern suggests a significantly more efficient use o f resources within social assistance in terms o f poverty reduction. This pattern i s different to some neighboring countries such as Hungary, where family allowances outperform social assistance in poverty reduction terms. The share o f the other family benefits reaching the poorest quintile i s even smaller - only 29 percent. 9.35 While child allowance programs are income-tested and should be reaching the poor, - several categories of beneficiaries not subject to income testing children with serious health impairment and children of war veterans16', reduce the target effectiveness of the program and raise the issue of equity. The children o f war veterans have a right to the maximum amount o f benefit set in the legislation, while for other children the ceiling o f the benefit, even for those with health impairment, i s established at 25 percent o f the budgetary base. However, a child with serious health impairment i s eligible for a child benefit amounting 25 percent o f budgetary base n o matter the family income. A child o f a war veteran's family at the same income level as that o f the non-veteran's family will receive a 25 percent higher allowance. While the non-veteran's family will lose the child allowance if the family income level exceeds through the Budget Execution l a w defined threshold, the child o f a war veteran will be eligible to continue receiving the allowance even if the family income level exceeds the threshold. Table 9.10: Child Benefit Levels for War Veteran's and Non-Veteran's Families (HRK), 2007 Household Household dependent Status Total Benefit per Total head 1 2 3 household child per monthly monthly month child income (HRK) benefits (HRK) (HRK) Father Mother Child Child Non-WV 534.14 299.34 598.68 Father Mother Child Child Non-WV 1,119.53 249.45 498.90 Father Mother Child Child Non-WV 1,663.00 199.56 399.12 Father Mother Child Child WV 534.14 374.18 748.35 Father Mother Child Child WV 1,119.53 374.18 748.35 Father Mother Child Child WV 1663.00 374.18 748.35 Sources: HZMO, World Bank staff calculations. 9.36 Several other benefits that are part of the family programs-mandatory maternity leave, additional maternity leave and the birth grant or layette assistance were accompanied from 2007 with a pro-natal supplement for all third and fourth child. The right to maternity benefits has been expanded to include unemployed and self-employed persons. Following the practice o f the EU legislation, parental leave has also been introduced in the place o f additional maternity leave. Although this change i s in line with the practice in EU countries, there i s in Croatia a longer period o f parental leave in the case o f twins or the third and following children (of up to three years) which i s not common in the EU.I6' 159 The financing o f child benefits i s from central government revenues, but i s administered by the Croatian Institute for Pension Insurance. I6O In accordance with the Law on Rights o f Croatian Homeland War Veterans and Their Family Members. 161 Only a few countries have introduced longer maternity leave for twins and triplets (France) or for the second and subsequent births (Poland). 177 Table 9.11: Main Characteristics o f other Family Programs Program I Description Eligibilitv Criteria I _ FinancingI Administrative o f Benefits Source Body Mandatory Mandatory, up to 6 months, All persons (hired Insurance Croatian maternity leave based on previous wage with employees, self- contributions Institute for 100% replacement ratio with employed, unemployed, and state budget Health the cap of 4,250 HRK. For uninsured) for uninsured Insurance uninsured persons 1,663 HRK persons minus all other benefits Additional Voluntary, after 6 months, up All persons (hired State Budget Croatian parental leave to 1 year (from 1,663 - 2,500 employees, self- Institute for HRK, determined by average employed, unemployed, Health wage or up to 3 years in case uninsured) Insurance of twins or the 3rd and following children (1,663 HRK) , for uninsured persons 1,663- minus all other benefits Right to part time Voluntary, up to 1 year or 3 All persons State Budget Croatian work years in case o f twins or the Institute for 3" and following children Health Insurance Pronatal Lump sum 500 HRK for third All persons State Budget Croatian supplement and fourth child per month Pension Insurance Croatian Institute Birth Grant Lump sum o f 2,328.20 HRK All persons (hired State Budget (layette employees, self- Institute for allowance) employed, unemployed, Health uninsured) Insurance Sources: Official Gazette. 9.37 The maternity benefits are designed to offset loss of income during the period of statutory maternity leave and additional maternity leave (parental allowance) pays allowance to parents who choose to take a career break or work part-time to bring up their child. The duration o f statutory maternity leave in Croatia i s in line with current EU practices where benefit duration ranges from 16 weeks in Austria, Poland, and Slovenia to 28 weeks in Denmark.16* The mandatory maternity leave program i s insurance-based and financed from insurance contributions. In 2007, the mandatory maternity leave was used by 34,138 women and almost the same number prolonged i t to the full year. The number o f persons using the additional maternity leave has increased over the last three years: while the number o f persons using the maternity leave up to 1 year increased by around 15 percent, the number o f persons taking leave o f up to 3 years has increased by almost 15 times (from 353 beneficiaries in 2003 to 5,475 in 2007) and the number o f unemployed persons using additional maternity leave has tripled. 9.38 A number of new government initiatives that stem from the recently adopted National Population Policy (NPP) aim to increase the family programs spending by approximately 0.3 percent of GDP per year. Immediate measures introduced in 2007 were new pro-natal supplement for the third and fourth kid in an amount o f 500 per child monthly, three-income threshold system for child benefits, increased minimum maternity benefit, free school textbooks, dormitory and transport to schools. While over the medium term the NPP defines measures with significant fiscal impact and administrative complexity, there i s no assurance that such measures would help reverse demographic trends. Most o f these measures are not income-tested, thus working against the poverty elimination objective. Missoc lci2 database, 2006. 178 War Veterans Programs 9.39 M o r e than one-third of social spending i s channeled through programs for war veterans - the share o f expenditures for these programs i s projected t o further increase in 2008. A wide range o f benefits are extended to war veterans, such as a disability allowance, family disability allowance, living costs allowance, care allowance, compensation for transportation, education allowance, funeral allowance, special cash allowances, orthopedic supplement, education scholarships, free access to universities, and personal income tax exemption. 9.40 Some of those benefits remain unfunded, passing the cost over to the main service providers (like in the case of universities). M a n y raise equity issues. The veterans’ benefit system provides generous benefits that are not well aligned with the rest o f the social protection system, allowing for significant differences in the method o f determining eligibility and level o f benefits. Veterans’ benefits are generally higher than other social protection benefits that aim to address the same client group. For example, the ratio o f the war veteran benefit to poverty related disability benefit in 2004 was 2.35 to 1. C. ADMINISTRATIVE EFFICIENCY 9.41 Although programs generally follow the typology of official OECD countries, they are additionally characterized by a complicated administration rendering them far less cost- effective. There are over one hundred different benefit schemes available to a wide range o f beneficiaries including the poor and socially vulnerable, the disabled and those with special needs, the elderly, unemployed, war veterans (Homeland War and W o r l d War I ) , I parents and children, pupils and students, returnees, displaced persons, and refugees. The majority o f social benefits are categorically targeted and many o f the categories overlap, resulting in multiple entitlement provisions. I 2007, more than 60 percent o f all social safety net expenditure was categorically n targeted. These are administered by a wide range o f institutions with n o single institution responsible for overall coordination. In addition, local self-governments provide a range o f benefits that aim to serve the same groups o f population, resulting in double-dipping and leakages. 9.42 Indeed, social safety net programs are delivered through half a dozen government institutions at the national level and over 700 at local levels with little coordination and allowing benefits to be collected from multiple sources. The administration o f the state system i s divided among several ministries and agencies at the central level and the implementing agencies are de- concentrated (and located) throughout the country or decentralized to local self-government units. The bulk o f social benefits - 88 percent from the total social benefit spending in 2007 i s financed from the central government budget. The primary responsibility for the welfare system rests with the Ministry o f Health and Social Welfare (MHSW) which i s responsible for overall policy formulation. The administration o f the system i s centralized with 80 centers for social welfare (CSW) that are legal entities, owned and financed by the central Government. The CSWs administer the compensations in cash and in kind, and provide services for social welfare beneficiaries. The M H S W provides the safety net programs to target the most disadvantaged, the elderly and disabled. At the same time the Ministry o f Family, Veterans’ Affairs and Intergenerational Solidarity (MFVAIS) i s responsible for family policy formulation and implementation and provides the maternity and child programs, homeland war veteran benefit programs. The M F V A I S programs are provided through a separate organizational structure and financing model that involves several government agencies: State Administration Offices in Counties, the Croatian Health Insurance Institute and the Croatian Pension Insurance Institute. The M F V A I S has also established i t s o w n local administrative offices called “family offices� - to date, dozen new family offices have been established and new staff employed. The Ministry o f the Economy, Labor and Entrepreneurship (MoELE) i s responsible for unemployment policy formulation and the Employment Institute o f Croatia through 22 branch offices in 20 counties and 94 field offices i s responsible for: payment o f unemployment benefits, determining 179 labor market demand, seeking employment opportunities, professional orientation, and organizing special training programs. Around 570 local and regional self-government units also have departments that provide social assistance benefits. These programs are financed from local and regional government budgets and are administered separately from the state benefits. 9.43 The organization and administration of the social safety net programs in Croatia i s costly, complicated, cumbersome and confusing for the client and the staff. Comprehensive information o n benefits and beneficiaries i s not readily available and there i s l i t t l e cooperation among the numerous institutions that are involved in benefits’ administration. As a result, evaluating the effectiveness o f social policies, the equity o f the benefits system, or even an assessment o f the performance o f individual social protection programs i s not done. This leaves policy-making to be undertaken in a vacuum. 9.44 The inefficiencies in the current administration system increase the errors of inclusion and exclusion and hinder the effective targeting of benefits. There i s no central database o f welfare system beneficiaries and n o shared databases with other institutions involved in social protection - employment offices, Croatian Institute for Health Insurance, Croatian Institute for Pension Insurance, local government departments. Each institution keeps i t s own records, either electronically or o n paper. That makes the exchange o f information difficult, time consuming and provides opportunities for errors and fraud. The system i s cumbersome and complex for the beneficiaries/applicants requiring visits to a range o f government offices to obtain the required information and increasing the scope for false or incomplete information. D. RECOMMENDATIONS 9.45 Croatia’s social assistance i s in a need of comprehensive overhaul. I n order to reduce the overall cost for at least one percentage point of GDP with in parallel improved spending effectiveness, the analysis above highlighted the following immediate priorities: Scaling up the support allowance at the expense of categorical benefits. Increasing the share o f social expenditures for the support allowance could improve the capacity o f the best targeted program to reach more low-income families. T o increase the allocation for poverty- focused programs within the spending envelope, the budgetary basis for determining categorical benefits should be frozen and budget expenditures from other non-contributory social protection programs redirected to the means-tested support allowance program. In addition, annual adjustments based o n living cost increases should be legislated and implemented. 0 Improving targeting. While the analysis o f the main social assistance programs demonstrates that they are well-targeted, the other social programs are not. The good practice o f using means-testing for the support allowance should be used as a basis for targeting other benefits, including family benefits and those in the health insurance and some for war veterans. This would reduce the risk o f underestimating household income due t o informal labor arrangements and underreporting o f income or that o f providing support to client categories that are not needy. 0 Simplification of benefits. Measures to streamline and simplify benefits are important for increasing the efficiency and quality o f the social assistance programs. It i s also important for improved monitoring and evaluation o f the results o f these programs. The Ministry o f Health and Social Welfare has prepared a proposal to simplify the benefits under its jurisdiction. The most desirable option would be to establish a single, unified welfare benefit. The possibility to simplify benefits that are administered by other Government Ministries needs to be further analyzed and assessed (e.g., using the same support allowance means-testing mechanism to target child allowances). 180 Over the medium term government should focus on: 0 Improving the overall mix of total social spending by spending relatively less on veterans’ benefits, child allowances and family benefits, and more on well-targeted programs like social assistance. A direct comparison o f these programs i s complicated by the fact that providing assistance to poor families i s only part o f the main objectives o f child and family allowances-an important additional policy goal o f these programs i s to provide incentives to boost the overall population growth rate. Further study o f the impact o f reduced spending on child allowances between 2001 and 2004 on the overall fertility rate in Croatia thus merits serious consideration, so as to ascertain the extent to which this program provides a cost- effective means o f increasing the country’s birth rate. 0 Facilitating the return from “welfare to work�. If well designed, the proposed increase in expenditures allocated to targeted social assistance programs should not create poverty traps and overreliance on social assistance, but instead provide beneficiaries an incentive to return to the labor market. Introducing reforms that provide financial and other incentives to return to work and specific welfare programs for the long t e r m unemployed should be considered. This should include targeting active labor market measures (ALMM) (employment subsidies, labor market training, and measures to promote jobs for disabled workers and youth) to the long-term unemployed and long-term social beneficiaries. Intensifying“activation� measures for those groups, including by introducing compulsory job-search workshops and by improving the basic s k i l l s o f the long-term unemployed recipients o f welfare, so that they can reconnect with the world o f work. Upgrading the social assistance information system. The planned MHSW Management Information System needs to implement linkages to the other government information systems that are already available or are in the planning phase. In addition, linkages or clear mechanism o f information exchange should be established with the social assistance systems o f local governments as well as with the employment bureau, if Croatia aims to strengthen the poverty impact o f social spending by improving geographic targeting through increasing the program coverage rates in poorer regions. Improving information-exchange system would also cut the administration cost and would reduce errors o f exclusion and inclusion. 0 Consolidating administration to the extent possible by merging relevant functions under fewer ministries and single offices at the local levels with a view to easing access to social spending programs and to coherent planning. The 26 percent o f GDP spent on social programs require coherent and consistent approaches supported by appropriate monitoring and evaluation system in place. Strategic planning in these areas i s rarely used and lacks coordination with budget planning and other subsectors. 181 PART IV: MEDIUM-TERM FRAMEWORK 10. MEDIUM-TERM FISCAL FRAMEWORK 10.1 The previous chapters have reviewed fiscal policy in Croatia over the past decade and looked in detai1 at the sector spending efficiency, effectiveness and equity issues. What stands out clearly i s that: a. Croatia’s public sector remained large despite years of consolidation attempts. The size o f the public sector needs to be reduced to create more space for private sector activity and address the spending pressures associated with upcoming EU accession and an aging society. Based o n the economic and demographic indicators, general government spending would need to shrink by five percentage points o f GDP in order address the above challenges. b. Fiscal policy has been procyclical for much of the last decade compromising macroeconomic stability. Financing these deficits has been relatively easy up to now, due to the ready availability o f external finance and significant privatization revenues. However, the possibility o f a less generous external environment and increases in the cost o f financing, as well the prospective end o f privatization receipts after 2008-10, suggests the need for faster tightening o f fiscal policy. The fiscal sustainability exercise points to the need for further tightening o f primary expenditure by more than a h a l f a percentage point o f GDP if Croatia wants to reduce i t s stock o f debt below the current fraction o f GDP, with the precondition that growth i s sustained at 4.5 percent. C. Croatia taxes it economy more heavily than all new EU member states and EU15 countries, so the scope for eliminating deficits through increases in revenue i s extremely limited. A lower tax burden would undoubtedly be beneficial to the private sector, but requires careful policy sequencing. Only after durable and sustainable reductions have been made in expenditures should the Government embark upon tax reform aimed at lowering the tax burden. The government could start with the simplification o f the PIT tax and then address the relatively high health insurance contribution rate. d. All of the above point to the need for expenditure reduction to place fiscal policy on a more appropriate and sustainable path. Transfers and subsidies (social security, health, railways, shipyards), purchases o f goods and services, capital spending (transport) are the spending outliers when compared to the EU countries and involve important efficiency issues. e. Finally, there i s a need for improving integration between strategic choices and the government’s expenditure rationalization efforts and ensuring adherence to the medium-term fiscal plans. This need persists despite improvements in the public expenditure management, and i s evident in the mixed results in fiscal consolidation (arrears’ accumulation, large guarantees, and slippages in the pre-election years). A. THE GOVERNMENT’S MEDIUM-TERM FISCAL PLAN 10.2 The Croatian Government i s aware of the need to continue with fiscal adjustment. I t envisages a moderate pace of adjustment as shown in the 2007 Pre-Accession Economic Program (PEP) and the Medum-Term Budget Framework for the period 2008-2010. Fiscal revenues o f the consolidated general government are expected to grow at a lower rate compared to GDP, leading to a declining share o f public revenues in GDP, from 44.8 percent in 2006 to 41.8 percent in 2010163. Expenditures as a o f share in GDP are expected to follow a stronger adjustment path than revenues, leading to a decline in the deficit from 4.1 percent o f GDP in 2005 and 2006164 to 0.5 percent in 2010. Authorities expect robust and stable real growth at an average rate o f 6.5 percent per year with a standard deviation o f 0.5 for the period 2008-2010. They also expect continuation o f privatization which would, in conjunction with robust growth and an absence o f interest rate shocks, lead to a significant decline o f the general government debt to GDP ratio. This i s expected to drop from 46.4 percent o f GDP in 2006 to 37 percent in 2010. This figure, however, does not capture the Croatian Bank for Reconstruction and Development (HBOR) debt which was planned to grow faster in 2008 and 2009 rising from i t s current level o f approximately three percent o f GDP. Table 10.1: Croatian Government’s Fiscal Scenario 2008-2010, YO f GDP o 2006 20072’ 2008 2009 2010 Revenues 44.8 46.2 43.7 42.8 41.8 o/w taxes 26.5 26.6 26.0 25.4 24.8 o/w social contributions 13.7 13.6 13.3 13.1 12.9 Expenditures� 47.0 47.8 45.2 43.4 41.6 o/w gross interest payments 2.2 2.0 2.0 1.9 1.8 o/w subsidies 2.6 2.5 2.2 2.1 2.0 o/w gross fixed capital formation 3.4 4.3. 3.3 3 .O 2.8 N e t lendinghet borrowing� -2.2 -1.6 -1.5 -0.6 0.2 Deficit’/ -3.0 -2.6 -2.3 -1.4 -0.5 General Government debt (incl. 46.4 44.9 42.7 40.1 37.0 guarantees) Memo: main assumption Real GDP g r ~ w t h ’ ~ 4.8 6.0 6. I 6.5 7.0 Sensitivity analysis (impact on deficit) a) Halving real GDP growth -1.6 -2.2 -1.6 b) Halving rate o growth o revenues f f -0.9 -2.4 -2.3 c) One bill HRK increase in current transfers -0.3 -0.3 -0.3 �Expenditures and net lendinghet repayment are shown according to ESA 95 methodology which i s partially adjusted to accrual basis. Deficit i s recalculated per GFS1986 methodology and fully adjusted to accrual basis, hence the difference between net lendinghet borrowing and the deficit. �The 2007 and 2008 represent the plan, varying from 2007 outturn or 2008 Budget. �In the 2008 Budget adopted in March 08, government revised i t s growth projections for 2008-2010 to 4.5 percent. Source: Government o f the Republic o f Croatia: 2006 Pre-Accession Economic Program. 10.3 Croatia seems to be moving in the right direction in terms of reaching the Maastricht fiscal criteria, but there are significant risks related to realization of the Government fiscal scenario. Pressures on public expenditures are mounting not only due to dependent groups’ demands for social transfers, but some new expenditure are also emerging and these are related to EU and N A T O accession. Nevertheless, these pressures are manageable within the Maastricht deficit limit o f 3 percent o f GDP but only if done in parallel with serious expenditure restructuring. The medium- term Government reform program that accompanies the above fiscal scenario i s summarized in the Box 4.1 below. 10.4 The 2007 PEP contains a useful set of sensitivity scenarios which show that aforementioned developments are robust in terms of the public debt limit, while there are substantial risks related to realization of the deficit limit. As far as public debt i s concerned, there 163 Data are based on the ESA95 methodology and cover only 53 local government units. These figures are lower by some 3.8 percent o f GDP than the CGG spending presented throughout the report. 164 Official figure for 2006 deficit stands at 3 percent o f GDP. However, repayment o f pensioner debt and H B O R deficit are not included in t h i s figure. After correction, the 2006 deficit to GDP ratio has declined from 4.5 percent o f GDP in 2005, to 4.1 percent o f GDP. 186 i s no scenario in the PEP that leads to a breach o f the 60-percent threshold. The sensitivity analysis has been done with the general government debt including guarantees, but without the HBOR debt. While public debt i s relatively resistant to shocks, shocks to the fiscal deficit lead to breaches o f the Maastricht criteria in the medium term. For example, halving the rate o f GDP growth leads to a deficit that i s higher by between 1.6 and 2.2 percentage points o f GDP, depending on the year in question. Similarly, the effect o f halving the growth o f tax revenues produces a shock o f between 0.9 R and 2.4 percentage points o f GDP. Finally, a one billion H K increase in transfers or subsidies leads to a permanent rise in the deficit o f 0.3 percentage points o f GDP. Box 10.1: Medium-Term Structural Reforms, PEP 2008-2010 Anricultural Sector. The primary objective of the agricultural policy i s to strengthen competitiveness of the sector and realign its policies with the EU acquis. One of the important priorities i s consolidation of agricultural land areas with the aim to improve the structure of agricultural farms, and continue with the elimination of the remaining obstacles to the efficient agricultural land market. The enerm sector develooment. Focus will be on the efficient energy use and cogeneration, as well as the use of renewable energy sources. A complete liberalization of the electricity market was envisaged for July 2008 and for the gas market for August 2008. The biofuel quality regulation determined the indicative objective of 5.75 percent share of biofuel in total annual consumption of petrol and diesel fuels, which should be achieved by end-2010. The biofuels act and the respective subordinate legislation will be adopted by end-2008. Education and science. Further reform of education and science systems will remain a government priority. Special attention will be devoted to stimulation of research and development, innovation and strengthening the educational system with a special emphasis on lifelong learning. This, therefore, implies increases of investments in these areas important for development, which will contribute to the creation of quality and competitivehuman resources. ImDrovinn the investment climate. One of the main priorities should remain the reduction o f administrative barriers. The government will systematically reduce subsidies to companies, which will enhance free market competition. A shift from direct to horizontal subsidies i s o f utmost importance. Reconstruction and Drivatization. Railway restructuringprocess with the aim to establish the financial sustainability of the sector as well as strengthen its competitiveness i s to be continued. The reconstruction of inefficient public companies i s a key precondition for the creation of a competitive environment in the Croatian economy. The adoption o f the National Shipbuilding Restructuring Program i s expected along with continued activities aimed at final definition of the amount of equity capital o f the shipyard Uoanik, privatization o f which should begin in 2008. The Government announced the transformation o f the Croatian Privatization Fund (CPF) into an institution which will efficiently and actively manage the state assets. Notwithstanding, the privatization of the remaining government portfolio should continue at a more rapid pace. Thus the goal i s to complete the privatization of companies in the state portfolio, as well as exit from the market of companies with no future, making adequate provision for the employees through labor market institutions and social policy. Public administration reform. The key aim i s to establish an efficient and fiscally acceptable public service, based on expertise and n political neutrality in accordance with the E U best practices. I view o f the identified deficiencies, in the 2008-2010 period, a special attention will be paid to the fulfillment of the following objectives: improvement of the organizational efficiency and reduction of state administration costs (state administration rationalization); simplification of administrative procedures to make it easier for citizens to exercise their rights; continued development of a more efficient system of providing public services to citizens and improvement of quality of providing public services; improvement of oversight of the work of state administration bodies and regulation of the labor-law relations for civil servants and civil service employees in the units o f local and regional self- government. n Health reform. I 2006, the National Strategy for Health Sector Development in the period 2006-2011 was enacted, together with the laws related to the health sector reform. The main novelty o f these reforms i s the introduction of co-payments on drugs not included in the basic drug list, and opening up the system to allow private participation in the provision of supplementary insurance for drugs and health services. The government has also introduced supply-side measures aimed at strengthening financial discipline such as: an introduction of categorization of hospitals to rationalize spending especially in the administration of diagnostic procedures, introduction o f benchmark pricing system for the establishment of basic and additional drug list, rationalization of transport costs, delegation o f financial responsibility to the owners of health institutions, limitation o f costs through the use of public procurement procedures and auctions for drugs. The preparation of the further revisions of public health leagislation i s underway and its adoption i s expected in 2008. Following i t s adoption the implementation of other implementing measures envisaged for the area of public health system reform will begin. Social benefit svstem reform. The government adopted a strategy for social benefit system reform with the goal of establishing better targeting of the most vulnerable persons, and defining additional criteria which will enable means-tested targeting. The establishment of a single registry of all social benefit users and their systematic monitoring as well as the simplification of administrative procedures will enable a faster and better quality approach to the provision o f social benefits. The possibility of reducing total expenditure for social benefits will be explored, with simultaneous increases o f social benefits for the most vulnerable groups. Judicium reform. The government plans to continue reform of the judiciary in the coming period. The reform will primarily aim to modernize and increase the efficiency of courts, increase the speed of case-solving, complete digitalization o f the land registry and support the fight against corruption. Source: Croatia PEP 2008-2010. 187 10.5 The fiscal direction seems to be the right one, but a number of sustainability problems are emerging. The high and sensitive deficit in the period o f robust output growth accompanied with relatively high tax rates which hinder competitiveness o f the economy present several challenges to Croatian fiscal policy. These challenges may be classified as follows: (a) cyclicality issues, (b) fundamental issues related to revenues, and (c) fundamental issues related to expenditures. B. EI II N D FNTO OF THE PROBLEM 10.6 I t i s not clear what the cyclical role of the fiscal policy in Croatia is. The authorities’ position, as expressed in the 2008-2010 PEP, i s that the nature o f fiscal policy was moderately restrictive and pro-cyclical at the same time, with the exception o f 2004. The authorities claim that moderate expansion which started in 2004 and saw an average rate o f growth o f nominal expenditures o f 6.9 percent during 2004 - 2007, was helpful to the economy, as actual output was expanding at less than potential (as determined by the Hodric-Prescott filter). I t should be noted however that the government calculated very small output gap. Given small number o f observations, one may consider a more prudent view that the cyclical role o f the recent fiscal policy remains an open issue. In any case, the role o f fiscal policy in generating cyclical movements, whatever i t s role was, was o f the second order o f importance relative to the role played by the international capital flows. 10.7 Given the rigid structure of expenditure, a very small portion of fiscal expenditures is, and was, available for counter-cyclical purposes. Moreover, leaning against short t e r m output fluctuations i s probably not an appropriate focus for fiscal policy in Croatia at this time. The scope for an independent monetary policy narrows as the Croatian economy becomes more internationally integrated and as the process leading to euro adoption between 2012 and 2015 deepens. This makes it all the more important that the remaining major macro policy instrument - fiscal policy - i s appropriately used. Here the authorities should recognize the increasing vulnerability to external shocks, particularly those related to international capital flows. If fiscal policy i s frozen by virtue being locked into large non-discretionary spending patterns and already high taxes, or if it i s directed at short term demand management targets, it will not be available to counter external shocks which are arguably a greater and growing concern. This strongly suggests the need for steady and concerted medium term efforts to reduce expenditures even if this means enduring some cyclical bumps along the way. 10.8 T a x levels are rigid and lower taxes are needed to boost competitiveness of the Croatian economy and sustain potential output growth. However, for the time being, significantly lower tax rates would increase vulnerability and threaten long term fiscal solvency, perhaps leading to unsustainable deficit levels in the short run. On the other hand, solving the deficit problem with higher taxes would lead to a significant and unsustainable deterioration o f competitiveness and likely have an adverse impact on output growth. For these reasons, any reasonable mid-term deficit reduction projection should not rely on revenue side adjustments. The only policy to allow for sustainable tax cuts i s to obtain permanent and sustainable cuts in the relative size o f fiscal expenditures (Alesina and Perotti, 1995). 10.9 The potential for expenditure controls i s limited b y structurally driven demands for services of the welfare state (due to an aging population and a high dependency ratio), and to new types of expenditures related to international integration (e.g. EU and NATO accession, knowledge economy expenditures). For these reasons, the overall framework for fiscal policy seems to be burdened with a number o f risks over the medium term. Fiscal vulnerability i s relatively high because unexpected adverse shocks to output growth and/or interest rates may easily push the trajectory o f the fiscal deficit o f f the sustainable path. Also, such a shock may provoke procyclical fiscal policy responses. But if a larger deficit at times o f slower growth i s allowed to absorb a larger proportion o f domestic savings, i t may crowd out private investment that could otherwise had a more immediate positive impact on output. The only way to prevent this kind o f dynamic i s to adopt credible reforms targeting the expenditure side o f the budget. 188 10.10 The quality of the fiscal adjustment i s crucial to its success. Empirical evidence suggests that the credibility o f fiscal adjustment i s enhanced by reliance on expenditure reductions. In particular, reductions in transfers and the government wage bill tend to be more permanent and even e ~ p a n s i o n a r y .The reforms discussed in this report do have significant fiscal effects, and the report ’~~ proposes how to address them. But there are other reforms undertaken in parallel by the government that have to be phased in and reflected in the fiscal projections, including in defense, agriculture, judicial, etc. Some o f these reforms may have additional costs which would require possibly more adjustments in cost-saving reforms. 10.11 The country may thus be well advised to pursue a more ambitious deficit-reduction target than currently plans: that of reaching a balanced budget position over the business cycle through a reduction of relative size of fiscal expenditures. There are several good reasons for that: 0 Such a fiscal adjustment would notably reduce immediate external vulnerabilities. Increased government savings would contribute to closing the savings-investment gap--that is, the current account deficit; 0 A small open economy growing at around i t s long-term potential needs to balance i t s fiscal position to make room for counter-cyclical policies in case shocks hit the economy; 0 Such a fiscal adjustment would allow for the absorption o f the EU and N A T O accession as well as aging society-related costs over the long run; 0 I t would allow for a reduction o f tax burden on the economy needed to boost the country’s competitiveness; and 0 It would help to prepare for EU Maastricht requirements--a 3 percent deficit to GDP ratio i s the limit, whereas the long run fiscal position should be neutral. C. FISCAL S E AO MID-TERM CN R : I BUDGET� “BALANCED 10.12 The first mid-term fiscal scenario shows the potential for an exceptional fiscal adjustment: Croatia may reach a balanced general government budget by 2010 under intense political efforts. The underlying assumptions are that there are no significant macroeconomic shocks occurring within the forecast period (2008-2010), but there are significant structural reforms that will in the end produce the balanced budget. Output growth i s projected at 5.1 percent in 2007-2008 and 4.9 percent in 2008-2010. The GDP deflator moves within a narrow range (between 3 and 4 percent p.a.) and the interest rate path i s the same as in PEP 2008-2010; three month Euribor reaches 4.5 percent and the 10-year kuna bond yield sets around 4.5 percent in 2010. Also, the exchange rate i s stable, meaning that there are no external shocks to financing costs and repayments due to currency mismatch. 10.13 The main assumption i s that the macroeconomic environment i s favorable for undertaking fiscal adjustment efforts, because there are no additional shocks that may require more fiscal restraints. Within this framework, balancing the budget by 2010 i s achievable. This represents a substantially more ambitious fiscal target than any similar fiscal goal publicly expressed by the government so far (including goals expressed in PEP). Nevertheless, a balanced budget should become a declared goal not only because this i s the correct interpretation o f Maastricht (3 percent deficit to GDP ratio i s the limit, whereas the long run fiscal position should be neutral), but also because it i s reasonable to believe that a small open economy, which i s growing at around i t s long- t e r m potential, needs to balance i t s fiscal position in order to widen maneuvering room for counter- 165 See, for example, Alesina and Perotti (1995). 189 cyclical policies when potential shocks begin to hit the economy. Last but not least, such a fiscal adjustment would notably reduce external vulnerabilities; increased government savings would contribute to a closing o f the savings-investment gap i.e. current account deficit. Box 10.2: The Reform o f the EU Stability and Growth Pact The Stability and Growth Pact (SGP) contains common rules that ensure government debt and deficits are controlled within specific limits chosen to encourage a stable economic environment. In recent years many member states have had difficulty in observing the Pact. In practice, t h i s has led to a certain degree o f de facto relaxation o f the rules. To some extent, the 2005 reform o f the Pact represents adjustment to this reality. At the same time, the rules have become more complex, which i s contrary to the original concept o f a simple, rules-based system. The aim o f these changes was to improve governance, strengthen the preventive (anticipating) function, and improve implementation o f the corrective (rectifymg) function. The Treaty on European Union (Maastricht Treaty) states that Member States shall avoid excessive government deficits. In particular, Member States shall comply with budgetary discipline by respecting two criteria: a deficit ratio and a debt ratio not exceeding reference values o f respectively 3 percent and 60 percent o f GDP. The SGP expands and specifies these fundamental rules, and also puts down a more detailed procedure for correcting excessive deficits. Under the Pact, the EU member states have an obligation to prepare annual stability programs (euro area member states) or convergence programs (non-euro area member states) indicating h o w they intend to achieve or maintain their medium-term objectives. The medium-termobjective should peruse a triple aim: (i)to preserve a safety margin with respect to the 3 percent of GDP, (ii) ensure rapid progress towards sustainable public finances and (iii) allow room for budgetary maneuver. For euro area and ERM I1member states, the objectives must lie within certain limits: (i) member states whose point o f departure is l o w government debt or high potential growth are given the increased flexibility that their medium-term budget deficit can possibly be up to 1 per cent o f GDP; (ii) member states with high government debt or l o w potential growth, for the differentiation o f the medium-term objective i s not likely to be o f any great significance. Under the Treaty's excessive deficit procedure, a member state's budget deficit may exceed the 3-percent limit, provided that the circumstances are exceptional and temporary. However, only reforms which have direct long-term cost-saving effects are taken into account (like pension reforms introducing multi-pillar systems that lead to short-term deterioration o f the budgetary position, but improve the sustainability o f public finances in the long term). A deficit exceeding 3 percent must still be corrected the year after it has been determined, unless special circumstances apply. The cyclically adjusted deficit must be reduced by at least 0.5 per cent of GDP per annum. This will entail enhanced consolidation o f the nominal budget balance in "good times", i.e. when activity is higher than the potential level, and more limited consolidation when economies are growing below trend. To ensure sustained budget improvements, one-off measures and other temporary budgetary measures will n o longer be included when compliance with the medium-term objective and the relevant adjustments are assessed. The sanctions are imposed within 16 months o f the time it i s determined that a member state does not comply with the deficit criteria. Normally, the sanctions must always include a primary non- interest-bearing deposit with the EU o f 0.2 per cent o f the member state's GDP plus a premium determined b y how much the deficit diverges from the 3-percent limit. The deposit must not exceed 0.5 per cent o f GDP per annum. If the deficit i s not corrected, the deposit is usually converted into a fine after two years. So far these sanctions have not been applied. ~~~ ~ 10.14 The efforts needed to adjust expenditures along this path would require considerable politicalstrength. The main message o f this mid-term scenario i s that achieving a balanced budget as o f 2010 i s more about political will than about overcoming economic and political obstacles. Overcoming political obstacles may turn out to be less problematic than expected, if policy makers understand that there i s more to be gained than lost by addressing inefficiencies, stabilizing the economy and laying the groundwork for significant tax burden reduction. 10.15 Budget balance by 2010 i s attainable with the following dynamic expenditure limits and revenue assumptions: 0 Current revenues grow by 5 percent in the projected period, which i s slightly below nominal GDP growth. Growth o f revenues that i s slower than nominal GDP growth reflects reduced tariff revenues due to trade liberalization and declining dividend inflows after privatizations. 0 Potential inflows o f grants are related to utilization o f EU funds. Potential withdrawal i s around EUR15O million per annum or 0.2 percent o f GDP, and it i s expected that the rate o f utilization will increase to close to maximum from 2008 onwards. 0 The public sector wage bill grows by 5 percent per year in 2008-2010 period. Wage bill adjustment will lead to a drop o f the public sector wage bill to GDP ratio from 10 percent in 190 2005 to 9.2 percent in 2010. This framework i s comfortable enough to conduct thorough public administration reform that would lead to a reduction in o f the number o f civil servants and increases in their efficiency and the quality o f their output. Other purchases o f goods and services grow by 3 percent per year in 2008-2010. The relative reduction o f around 1 percentage point o f GDP i s comfortable enough to allow stressless adjustment, but at the same time narrow enough to promote a search for efficiency, especially in critical sectors such as education and health. Achievement o f t h i s target i s also related to moderation o f investment activity. The public investment plan should assume substantial reductions in investment in roads, highways and similar infrastructure and a slight increase in environmental investment. This kind o f adjustment i s related to moderation o f investment activity which will result in a drop o f public sector investment from 6 percent o f GDP in 2006 to 3.9 percent in 2010. Subsidies and other current transfers would bear the largest cut by 2010 (more than 2 percentage points o f GDP) due to significant reforms o f sectoral spending, more precisely in improving health financing; rationalizing social benefits; improving fiscal and social sustainability o f the pension system; and reducing subsidies to railways. Subsidies are projected to drop on average by 5 percent in 2008-2010 period. This would mean that by 2010 the level o f subsidies would be around 1.6 percent o f GDP which i s in line with the comparator countries. This public sector envelope which i s simultaneously defined by a limited increase in wages and salaries, other purchases o f goods and services, and investment, should be comfortable enough to absorb all extra reform costs. Privatization revenues are significant until 2009 because the government i s assumed to sell i t s remaining shares in INA, Telecom and launches the first stage o f HEP Electricity Company privatization. Tat 10.2: "Balanced Budget" Scenario Scenaris - : CROATIA MEDIUM TERM FISCAL FRAMEWORK Average Consolidated General Government, % o f GDP Comments 2005 2008 2007.2008 2009.2010 'OTAL REVENUE & GRANTS 45.3 48.0 48.4 42.1 I Reflsts t M redu& there is no m m for tax adjustment so revems gmw CURRENT REVENUES bmady in line with nominal GDP 9% in 2W7 and 7.7% thereafter. Saneuhal sbw 44.8 45.2 45.3 41.9 gmthmpradt o ~ l n ~ G D P ~ m ~ t a d ~ s b ~ ~ ~ a f t a ~ ~ e n ~ ~ shaQ mdud!m in dlUenda aRer malath- CAPITAL REVENUES 0.5 0.6 0.8 0.5 E x M e a matizabn remipis GRANTS 0.0 0.1 0.3 0.3 Reflects substantial i n m s e in absorbbn capachy faEU funds OM EU grants 0.0 0.1 0.3 0.3 'OTAL EXPENDITUREAND NET LENDING 48.9 48.4 47.5 41.8 CURRENT EXPENDITURE 41.1 39.8 39.5 35.4 o h Wages and salaries 10.0 9.6 9.6 8.8 sumea 5% nominal wage growth &Other purchases of goods and sew'ces 9.3 6. 9 9.8 8.6 basis points and dwlim of pure kuni OMlnteresf Payments 2.3 2.2 2.0 1.8 OM Subsidies and current transfers 19,5 18.7 18.1 16.2 CAPITAL EXPENDITURE 7.4 8.3 7.7 5.9 OM lnvesfments 5.3 6.0 5.5 4.0 I lmludes substantial reduction In inveatmentin mads and hbhwaya and wbstanllal but under pmporhal increasa In lnvestmenlin envimment. waler end wastewale4 syatems. & Capital transfers 2.2 2.2 2.2 1.9 LENDING MINUS REPAYMENT 0.4 0.4 0.3 0.2 )VERALL DEFlClTlSURPLUSwlo capital revenues 4.1 9.1 .1.9 0.8 WERALL DEFICITISURPLUS wlth pensloners'debt -1.1 -1.1 4.1 0.4 Prlvsflzaflon recelpfs 0.3 1.2 2.2 0.8 IRIMARY DEFIC(TlSURPLUSwith pensioners' debt .1.8 .1.8 4.8 2.2 URRENT DEFlClTlSURPLUSwith pensloners' debt 3.1 4.5 5.0 8.3 iENERAL GOVERNMENT DEBT, lncludlng HBOR. eop 46.9 44.1 38.9 30.1 'UBLIC DEBT, GUARANTEED DEBT and ARREARS, eop 55.6 53.3 41.5 37.3 I demo: Real GOP growth 4.3% 4.6% 5.1% 4.9% burces' MoF, CNB, WB staff estimate 191 10.16 In this scenario, the general government balance i s expected to become marginally positive in 2010, even if repayment o f debt to pensioners i s taken into account, while the public debt to GDP ratio i s expected to diminish significantly: by 12-14 percentage points o f GDP by 2010 compared to 2006. With this pace o f fiscal adjustment there i s some additional fiscal reserve for governing fiscal policy under the EU rules. Policy makers could use this dynamic “fiscal reserve� to undertake significant tax cuts. 10.17 Public investment preferences have to be reconsidered, and cutting taxes and contributions in line with permanent reduction in expenditures should be considered as a policy priority. Croatia has the strongest preference in Europe for public investments measured by the investment to GDP ratio, despite the doubtful efficiency o f these investments as reflected in average growth performance within the peer group o f countries. Given the past nature o f public choices, any sign o f a “fiscal reserve� will probably lead to competition for public sector investment projects by political elites. However, recommendations in this report indicate that a priority should be given to solving structural problems, such as imbalances within the pension system and the need to increase the contribution allocation for the mandatory second-pillar pension accounts. D. FISCAL MID-TERM SCENARIO: “BUMPYADJUSTMENT’’ 10.18 I t i s a rare case that the external environment remains stable in the medium term and that fiscal adjustment flows smoothly. The “Bumpy Adjustment� fiscal scenario i s designed under an assumption o f adverse macroeconomic shocks: the average rate o f growth o f GDP declines by 1 percentage point on average 2008-2010 and interest rates rise by 1 percentage point faster than in the “normal� scenario. Furthermore, the government does not take the necessary reforms as enthusiastically as i t could have. As a result, Croatia finds itself much farther from a balanced budget in 2010. The public debt to GDP ratio will hover around 39 percent (45 percent with arrears and guarantees included), however, the ratio o f public expenditures to GDP will decrease only marginally, from 48.4 percent in 2006, to 47.1 percent in 2010. The deficit will s t i l l be around the Maastricht limit o f 3 percent by 2010. General financial vulnerability w i l l be higher (e.g. if interest rates turn out 150-200 bps higher instead o f only 100 bps as envisaged in the balanced-budget scenario) and fiscal policy will certainly fail to provide stronger contribution to external adjustment. 10.19 The main lesson to be drawn from here i s that the evolution of the public debt to GDP ratio and maintenance of a deficit below the 3 percent limit are not criteria that should be used to judge the success of fiscal policy. After all, the public debt trajectory can be regulated by choosing the path o f privatization (faster privatization will lead to a sharper drop in the public debt to GDP ratio with a given deficit). Hence the focus o f fiscal policy - if i t i s aiming at five qualitative goals as defined at the end o f Section B, should be achieving a stronger permanent reduction o f public expenditures in terms o f their share in GDP. 10.20 Table 10.3 shows that adjustment under moderate macroeconomic shocks in the period 2008-2010 would require a substantial savings effort on the expenditure side in the years ahead in order to generate a sustainable path of the deficit. Assumptions used in the below scenario are the following: 0 The wage bill and other purchases o f goods and services grow at 6.7 percent on average in nominal terms and bear the minimum fiscal adjustment o f 0.2 and 0.5 percent o f GDP in 20 10 as compared to 2007, respectively. 0 The growth o f subsidies and other current transfers i s around 7 percent in 2008-2010 period, leading to a marginal decline o f their share in GDP. 0 n I this scenario, the general government capital investment to GDP ratio would fall to 5.4 percent o f GDP in 2010, which i s a decline o f around 0.5 percentage points o f GDP over the observed period. 192 Failure to address current structural weaknesses lead to rapid fiscal slippage in the adverse macro environment - deficit accumulation in 2007-20 10 period as compared to the “balanced-budget� scenario requires higher borrowing needs amounting to more than 7 percentage points o f GDP. This assumes the same privatization schedule as in the previous scenario which would reduce the borrowing needs for deficit financing. Tablc 10.3: “Bumpy Adjustment� Scenario - Scenaric : CROATIA MEDIUM TERM FISCAL FRAMEWORK Average Consolidated General Government, 16 of GDP Comments 2005 2000 2007.2008 20094010 ‘OTAL REVENUE 8 GRANTS 45.3 40.0 47.4 47.0 I w Refmcls unffrea.cmn m .) no mom lo(m aaprmeni so mienws g m a orcaa ) in LM nin nom M GDP 8% in 2907 ana 5% meaBRer sOmeH*ul sbvra CURRENTREVENUES 44.8 45.2 46.3 46.1 gmwh mmpaiw 10 mm N GDP s m a i m 10 som gmuth of DlYt m m . u an0 Sharp IWUCILUI E Bl1O.WS a b ‘ PnraQWQon CAPITAL REVENUES 0.5 0.6 0.8 0.6 ExdLMS pnva!Jzaom raapls GRANTS 0.0 0.1 0.3 0.3 Rehcrs swsfsnlia icrease in aoswoon capacny for EJ hms O EU granfs M 0.0 0.1 0.3 0.3 ‘OTAL EXPENDITUREAND NET LENDING 48.9 48.4 49.2 48.7 CURRENT EXPENDITURE 41.1 39.8 40.8 40.6 & Wages and salaries 10.0 9.8 9.9 9.8 Assunes 6% nom nal wags gmwm &Other purchases of goods and selvices 9.3 8.9 10.1 9.8 Assmes 7 5% mmina, wage g r o m Assmea a w m a l ~ e s nsInmmsi rate d 1W bps (in mmpakonlo Sunam & lnferest Payments 2.3 2.2 2.1 2.3 LnlY 2010 & a s msrs for R a i k a r Ihipyared ana Poslal Bank mslr~nmg ml, es as & Subsidies and curmnf transfen 19.5 18.7 18.6 18.7 Increasein SLDSIOI&S for apmn.n AAO relro p K w a g s noornound psnsbtu arm SLDILYIO~ g m n rele of lord a w a IO 3% p r anwm M in CAPITAL EXPENDITURE 7.4 8.3 8.1 7.8 mau %branos rsaucoon n inwsmennlh maes arm n g h a y and swsuntal & hvesfrnents 5.3 6.0 5.8 5.5 b n Lmer prowmma m e s e o nrulmenl in mflmnmsl msr ana *BSlma1m n & Capifal transfers 2.2 2.2 2.3 2.3 LENDING MINUS REPAYMENT 0.4 0.4 0.3 0.3 WERALL DEFlClTlSURPLUSwlo capital revenues 4.1 -3.1 -2.0 -2.3 Adjusted for recondplllar lntroductloncosts -3.0 -2.2 .1.8 .IS WERALL DEFICITBURPLUS wlth penoloneers’debl -4. I -4. I 5.4 -2.5 2W7-2010 govmmmts 4 s remaining stakes In I4A and HT and launches Um first PrlvaUzaUon recelpts 0.3 1.2 2.3 0.9 m s e d HEP pivaUzaUon IRIMARY DEFICITBURPLUSwlth penslonen’ debt 4.8 4.8 4.3 4.3 :URRENT DEFICITBURPLUSwith pensloners’ debt 3.7 4.5 4.7 5.3 ;ENERAL GOVERNMENT DEBT, lncludlng HBOR, eop 40.9 44.1 40.2 37.0 IUBLIC DEBT, GUARANTEED DEBT and ARREARS, eop 55.0 53.3 48.3 43.3 lemo: Real GDP growth 4.3% 4.8% 4.0% 3.4% Iources: MoF, CNB, WB staff asfirnate E. CONCLUSIONS AND SOME GUIDING QUESTIONS 10.21 The most efficient way to boost growth and competitiveness i s t o cut taxes and contributions which cannot be achieved in the short run due to pressing deficit. Permanent cuts in the size of expenditures relative to GDP are required in order to pave the way for policy measures on the revenue side. T o start with, tax side adjustments should begin by increasing the share o f the gross wage allocated to second pillar pension funds to at least ten percent, as soon as possible. 10.22 The Maastricht l i m i t s o f public debt and fiscal deficit are only one o f the possible criteria for assessing fiscal policy. Declaration o f a balanced budget target in the medium term alongside the EU standard i s much more powerful and would secure the long built macroeconomic stability. These fiscal disciplining measures are attainable, even under moderate adverse macroeconomic shocks, if policy makers perceive that there i s much more to be gained by pursuingdescribed policy efforts. 10.23 The following questions regarding qualitative targets should help design the fiscal adjustment efforts: (i) taxes ensure competitive environment? (ii) fiscal policy flexible enough to ensure Do Is i iI anti-cyclicality and contribute to reduction o f external vulnerabilities? ( i )s the size o f expenditures manageable in the sense that efficiency o f public expenditures can be monitored and corruption kept under control? (iv) Are expenditures flexible enough to allow for required structural adjustment? (v) I s there assurance that balanced budget i s attainable in the long run? 193 Annex A: Construction o f Cyclically Adjusted Balance The actual government budget balance i s an insufficient measure of the economic policy stance. There is, therefore, an interest in measuring the budget balance adjusted for cyclical influences. The structural balance i s computed to show the underlying fiscal position when cyclical or automatic movements are removed. Such a measure gives a better impression o f the soundness o f public finances. The actual government budget balance includes structural (invariant to the cycle) and cyclical component, and can be represented as: Actual budget balance = structural (cyclically adjusted) + cyclical component of the budget balance The cyclically adjusted budget balance gives an indication o f the balance that would prevail if actual GDP were equal to potential GDP. Cyclically-adjusted fiscal indicator, therefore, plays an important role in assessing the true state o f the public finances. Finding the cyclical component of the budget requires a measure of how far the economy i s from its potential level. There are two main approaches to calculating structural balance: (i) an aggregated and (ii)disaggregated method. In the aggregated method, the cyclical component o f the a budget i s assumed to be a constant fraction o f the output gap.'66 This constant expresses a total elasticity o f the budget with respect to the output gap and i s determined on the basis o f estimated elasticities for some subitems o f the budget with respect to the output gap. This aggregated method i s used by the OECD, the IMF and the European Commission. With the aggregated method, the problem l i e s in estimating the output gap. The latter i s actual GDP less potential GDP, and as the potential GDP cannot be observed, i t must be estimated. Potential output i s not an observable variable and must therefore be computed using information set that contains observable variables, using techniques that combine macroeconomic theory with statistics and econometrics. The ECB has opted for a disaggregated method whereby a number o f cyclically sensitive budget items are treated separately. These items are each dependent on a budget determining base. The ECB does not calculate an output gap in order to avoid direct calculation o f the base gaps. These are implicitly assumed to be fixed in relation to the output gap. The functioning of cyclical component of the budget balance or automatic fiscal stabilizers (AFS) shows how the government sector budget reacts to changes in the economic activity. When economy i s in the growth phase, relatively more taxes are being collected and government transfers to households decrease. As a result, the growth o f disposable income o f households and consumption slows down, inhibiting economic growth. At the same time, the budget position o f the public sector improves. In a reverse situation, i.e. during an economic downturn, tax burden i s relatively smaller and government transfers to households increase, which curbs the fall o f consumption and economic growth. When GDP equals i t s potential volume, the actual fiscal balance The output gap i s defined as the difference between actual and potential output. The positive gap corresponds to excess demand in the economy, which make cause inflationary pressure. If the gap i s negative, then potential output exceeds demand. The output gap cannot be maintained over the long run, because adjustments o f wages and prices w i l l be established to reach a balance in which supply and demand are equal. In the economics literature there are different explanations o f why actual and potential output often diverge. According to one theory, actual output differs from potential output because rigidities in the economy imply a certain period for prices and wages to adjust. In t h i s case, the output gap i s an important measure to balance overall demand and supply in the economy and i t can provide useful information on price pressures. According to another theory, an economy i s best characterized by business cycle models, where actual output differs from trend output because o f occasional productivity shocks. In this case, the output gap reflects temporary deviations provoked by adjustment o f output through technological changes and unexpected supply-side trends. 194 i s equal to structural balance, changing only as a result o f discretionary policy. Changes in the balance o f the budget caused by the economic cycle form the cyclical component o f the budget, which characterizes the size o f automatic stabilizers. Thus, the size and variation o f A F S gives a quantitative assessment o f the extent o f the impact o f economic activity on budgetary position. Serious policy mistakes can occur if purely cyclical improvements in the public finances are treated as if they represent structural improvements, or if a structural improvement i s thought to be merely a cyclical effect. When assessing fiscal prospects, it i s essential to adjust fiscal indicators for the effects o f the economic cycle. Government expenditure and revenue are both highly cyclical, with expenditure falling and revenue rising in economic upswing. Hence, the public finances will be stronger when the economy i s operating above the trend and weaker when the economy i s below trend. Allowing the automatic stabilizers to operate, however, must not jeopardize the underlaying fiscal positions. For the calculation of cyclically adjusted consolidated general government (primary) balance of Croatia in the period from 1994 to 2012, the cyclically adjusted balance i s computed on the basis of a standard two-step procedure. First, the cyclical position o f the economy (output gap) i s assessed by comparing the actual GDP with the potential one. The estimate o f the potential GDP i s based o n modified Hodrick-Prescott filter,167due to i t s transparency and simplicity, with the standard smoothing parameter (A) 100 for annual data. Second, the impact on the budget o f the cyclical i s calculated using fiscal elasticities. Four broad revenue categories and one expenditure category are dependent upon the cycle. These are: direct taxes o n households and companies, indirect taxes, social contributions and unemployment-related expenditure. After calculating the overall sensitivity o f the budget balance, the cyclical component o f the budget balance i s then the product o f the output gap and the overall sensitivity. T o show what kind o f discretionary fiscal policy was applied, fiscal stance i s computed. Fiscal stance i s measured as a change in primary balance. The case for focusing o n the primary deficit i s simply that interest costs o n accumulated debt are outside the scope o f government control and while they may vary with interest rate changes, this variation does not reflect the quality o f fiscal control. '" According to Bruchez, P.-A. (2003). The modified Hodrick-Prescott filter solves the problem o f bias in final points, which i s a shortcoming o f standard HP filters. 195 Annex B: Calculating the Debt-Stabilizing Primary Balance Calculating the debt-stabilizing primary balance i s one o f the simplest tools for debt sustainability analysis. The analysis starts from the government’s intertemporal budget constraint, such as in equation (1): T o fix notation, G, and T, denote noninterest government spending and revenues in year t ; P, denotes the primary balance (G-GJ; D, denotes the stock o f government debt at the end o f year t; Mt i s the stock o f high-powered money and i i s the one-period interest rate, assumed constant. This specification assumes the government pays interest on the average stock o f debt (thus, the average o f the stock o f debt at the end o f the previous year and the end o f the current year) and, similarly, the interest revenues o f the government are from the average stock o f high powered money. Given the lack o f transfers from the central bank to the government over the last several years, it i s reasonable to assume that the central bank will capitalize all i t s profits, including those from seignorage. The analysis below, therefore, i s an analysis of the sustainability of government debt, excluding any transfers from the central bank. In this case, equation (1) i s replaced with the simpler equation (2), which i s an accounting statement o f the stock o f government debt: Dl=Dl-l-pl+i( 4 - 1 +Dl ) Nominal GDP in year t i s denoted with Y,, the real GDP growth rate by g and the change in the implicit GDP deflator (inflation) by n. Divide equation (2) by nominal GDP: Using small letters to denote ratios to GDP, solve for the debt stabilizing primary balance in equation (4). This i s the equation used in the calculations in Section A: (4) 2 This expression i s somewhat more precise than the traditional formula, which assumes that the interest payments reflect only the previous year’s debt stock: p = d[(l+i)- ( + g)(l+ n)]= d(i - n - g) 1 (5) Annex C: Statistical Annex Table AC.l: Croatia: CG Finances by GovernmentLevel, 1994-2006 (Accrual Basis), GFS 1986 %of GDP 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total revenue and grants 45.6 47.6 49.7 48.3 51.8 48.8 47.2 45.7 45.8 45.5 45.7 45.3 46.0 47.2 Budgetary central government 26.1 27.8 28.5 27.2 30.8 28.4 27.4 29.2 36.8 35.9 35.8 35.3 36.4 37.8 Extrabudgetary funds 15.6 15.3 15.5 15.4 15.3 14.9 14.5 11.1 3.0 3.0 3.0 3.0 2.3 1.4 Pension fund 8.1 8.6 8.7 8.6 7.5 7.4 7.3 3.5 0.1 0.1 0.1 0.0 0.1 ... Health insurance fund 4.3 4.6 4.8 4.6 5.9 6.0 5.8 5.7 0.2 0.4 0.3 0.4 0.3 ... Employment fund 0.6 0.7 0.6 0.5 0.5 0.5 0.5 0.6 0.0 0.0 0.0 0.0 0.0 ... Child benefit fund 0.8 0.8 0.8 0.8 0.4 0.0 0.0 0.0 ... ... ... ... ... ... Public water management fund 0.5 0.6 0.6 0.8 0.8 0.7 0.7 0.6 0.6 0.6 0.6 0.5 0.6 0.7 Road FundiEnvironFund 1.3 ... ... ... ... ... ... ... ... ... 0.1 0.1 0.4 ... Developmentand Employment Fund .I. ... ... ... ... ... ... ... 0.0 ... ... ... ... ... Regional Development Fund ... ... ... ... ... ... ... ... 0.0 ... ... ... ... ... Croatian Road Agency ... ... ... ... ... ... ... 0.1 0.7 0.6 0.7 0.6 0.0 0.0 Croatian Highways ... ... ... ... ... ... ... 0.4 0.9 1.O 1 .o 1.1 0.6 0.5 BRA ... ... ... ... 0.0 0.2 0.2 0.2 0.3 0.3 0.3 0.2 0.2 0. I HFP ... ... ... ... 0.1 0.0 0.0 0.0 0.1 0.1 0.0 0.1 0.0 0.0 Local government 3.9 4.4 5.7 5.7 5.7 5.5 5.3 5.4 6.1 6.5 6.9 7.0 7.4 7.7 Total expenditure and lendlng 44.1 49.5 52.0 50.7 54.2 56.6 53.4 52.0 49.8 51.3 50.2 48.9 48.4 48.6 minus repayments Budgetary central government 23.6 27.0 25.7 23.5 25.4 25.5 23.3 25.8 36.8 38.1 37.2 36.6 35.5 35.2 Extrabudgetary funds 16.9 18.3 20.6 21.6 22.9 25.2 24.4 20.3 6.9 6.1 5.7 4.6 4.7 4.0 Pension fund 7.6 9.0 9.7 11.1 11.8 14.0 13.0 7.3 0.7 0.9 0.2 0.2 0.2 ... Health insurance fund 6.0 7.2 8.6 8.0 8.7 8.4 8.3 7.8 0.7 0.2 0.6 0.5 0.5 ... Employment fund OS 0.5 0.6 0.6 0.6 0.6 0.7 0.6 0.1 0.1 0.1 0.0 0.0 ... Child benefit fund 0.8 0.8 0.8 0.8 0.8 0.8 0.8 1.5 ... ... ... ... ... ... Public water management fund 0.6 0.8 0.9 1 .o 1.1 1.1 0.9 0.8 0.8 0.9 0.8 0.7 0.8 0.9 Road FundlEnvironment Fund 1.4 ... ... ... ... ... ... ... ... ... 0.1 0.0 0.3 ... Development and Employment Fund ... ... ... ... ... ... ... ... 1.2 ... ... ... ... ... Regional Development Fund ... ..I .I. ... ... ... ... ... 0. I ... ... ... ... ... Croatian Road Agency ... ... ... ... ... ... ... 0.7 0.6 0.7 0.8 0.9 I.o 1.1 Croatian Highways ... ... ... ... ... ... ... 0.8 2. I 3.2 2.9 2.2 I.8 I .9 BRA ... ... ... ... 0.0 0.4 0.7 0.9 0.3 0.1 0.2 0.1 0.0 0.0 HFP ... ... ... ... 0.1 0.0 0.0 0.0 0.1 0.1 0. I 0.1 0.1 0.1 Local government 3.7 4.2 5.7 5.1 5.8 5.9 5.7 5.9 6.2 7.0 7.2 7.7 8.2 9.0 Overall deficlUsurplus 1.5 -2.0 -2.2 -2.4 -2.4 -7.8 -6.2 -6.3 -4.0 -5.8 -4.4 -3.6 -2.5 -1.4 Budgetary central government 2.5 0.8 2.8 3.8 5.4 2.9 4.1 3.4 0.0 -2.2 -1.4 -1.3 0.9 2.5 Extrabudgetary funds -1.2 -3.0 -5.1 -6.1 -7.7 -10.2 -9.3 -8.6 -3.9 -3.3 -2.7 -1.7 -2.6 -2.7 Pension fund OS -0.4 -1.0 -2.5 -4.2 -6.5 -5.7 -3.8 -0.6 -0.9 -0.2 -0.1 -0.1 ... Health insurance fund -1.7 -2.6 -3.9 -3.4 -2.7 -2.4 -2.6 -2.2 -0.5 0.2 -0.3 -0.1 -0.1 ... Employment fund 0.2 0.2 0.0 -0.1 0.0 -0.1 -0.1 0.0 -0.1 -0.1 -0.1 0.0 0.0 ... Child benefit fund 0.0 0.0 0.0 0.0 -0.4 -0.8 -0.8 -1.5 ... ... ... ... ... ... Public water management fund -0.1 -0.2 -0.2 -0.2 -0.3 -0.4 -0.2 -0.1 -0.2 -0.3 -0.2 -0.2 -0.2 -0.2 Road FundlEnvironment Fund -0.1 ... ... ... ... ... ... ... ... ... 0.0 0.0 0.0 0.0 Development and Employment Fund ... ... .I. ... .I. .I. ... ... -1.2 ... ... ... ... ... Regional Development Fund ... ... ... ... ... ... ... ... -0.1 ... ... ... ... ... Croatian Road Agency ... ... ... ... ... ... ... -0.6 0.0 -0.1 -0.2 -0.2 -1.0 -1.0 Croatian Highways ... ... ... ... ... ... ... -0.3 -1.1 -2.2 -1.9 -1.1 -1.2 -1.5 BRA ... ... ... ... 0.0 -0.2 -0.6 -0.7 0.0 0.2 0.1 0.1 0.2 0.1 HFP ... .I. ... ... 0.0 0.0 0.0 0.0 0.0 0.0 -0.1 0.0 0.0 -0.1 Local government 0.2 0.2 0.0 0.0 -0.1 -0.4 -0.3 -0.3 0.1 -0.6 -0.3 -0.7 -0.8 -1.3 Note: Capital revenues (excluc g privatizations receipts) above the line. Includes all LGUs. Source: Ministry o f Finance and staff estimates. able AC.2: Croatia - CGG, economic classification, accrual basis, GFS 1986 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 otal revenue and grants 46.0 48.2 50.4 48.6 53.2 53.2 49.2 49.1 47.2 47.3 45.9 45.6 47.1 48.4 Tax revenue 43.4 44.4 44.4 43.0 46.9 44.1 42.6 41.0 40.8 40.3 39.6 39.3 39.9 39.7 Taxes on individual income 6.1 5.8 6.4 5.4 5.9 5.3 4.9 4.2 4.6 4.7 4.8 4.6 4.7 4.8 Taxes on corporate income 1.0 1.4 1.6 2.0 2.5 2.4 1.6 1.7 2.1 2.3 2.1 2.5 3.0 3.2 Social security contributions 13.2 14.1 14.4 14.3 14.0 13.7 13.3 13.0 12.1 12.0 11.9 11.6 11.8 11.7 Taxes on property 0.3 0.5 0.5 0.6 0.6 0.5 0.5 0.5 0.5 0.4 0.5 0.5 0.5 0.5 General sales tax I VAT 15.0 13.0 12.5 12.2 16.1 14.3 14.4 14.1 14.6 14.5 14.3 14.3 14.4 14.2 Excises 3.1 5.0 5.0 4.3 4.2 4.4 5.0 5.0 5.4 5.2 4.9 4.7 4.6 4.4 Local taxes on goods and services 0.4 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.2 0.2 0.2 0.2 0.2 0.2 Taxes on internationaltradeand transactions 4.0 4.0 3.7 3.8 3.1 3.0 2.5 1.9 1.1 0.9 0.7 0.7 0.6 0.6 Other tax revenues 0.3 0.4 0.2 0.2 0.4 0.3 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 Vontax revenue 2.2 2.8 4.5 4.6 4.3 4.2 4.0 4.1 4.5 4.7 5.6 5.5 5.3 6.5 2apital revenue wlo privatization receipts 0.4 1.0 1.5 1.0 2.0 4.9 2.6 3.9 1.9 2.3 0.7 0.8 1.8 2.0 3rants 0.4 0.7 0.6 0.3 1.4 4.4 2.0 3.4 1.4 1.8 0.2 0.3 1.2 1.1 otal expenditure and net lendlng 44.1 49.5 52.0 50.7 54.2 56.6 53.4 52.0 49.8 51.3 50.2 48.9 40.4 48.6 2urrent expenditure 40.7 44.5 44.3 43.9 45.8 48.0 47.6 46.3 43.2 42.6 41.0 41.1 39.9 40.6 Wages and salaries 10.4 11.9 11.2 11.0 11.9 12.8 12.9 11.5 10.7 10.7 10.3 10.0 9.8 9.8 Other purchases of goodsand services 15.6 16.2 14.6 12.6 13.7 12.2 11.9 11.0 10.8 9.6 6.8 9.3 8.9 9.9 Interest payments 1.3 1.4 1.2 1.5 1.5 1.7 1.9 2.2 2.1 2.1 2.1 2.3 2.2 2.1 Subsidies 2.4 2.1 2.2 2.2 2.7 2.8 2.8 2.6 2.3 3.1 2.7 2.6 2.7 2.8 Current transfers 11.1 12.9 15.2 16.7 15.9 18.5 18.1 18.9 17.3 17.1 17.2 16.9 16.2 16.0 Zapital expenditure 3.1 4.7 7.2 6.3 7.5 7.5 5.0 5.1 6.1 8.2 8.6 7.4 8.2 7.7 Vet lending 0.4 0.3 0.5 0.5 0.9 1.1 0.8 0.7 0.6 0.5 0.5 0.4 0.4 0.3 GO Current Balance 4.8 2.7 4.6 3.7 5.4 0.3 -0.9 -1.1 2.2 2.3 4.2 3.7 5.4 5.6 GO Overall Balance 1.5 -2.0 -2.2 -2.4 -2.4 -7.8 -6.2 -6.3 -4.0 -5.8 -4.4 -3.6 -2.5 -1.4 GG Overall Balancewlocapltal revenues 1.4 -2.3 -3.1 -3.1 -2.9 -8.4 -6.7 -6.9 -4.5 -6.3 -4.9 -4.1 -3.1 -2.3 GO Primary Balance 2.7 -0.8 -1.9 -1.6 -1.4 -6.7 -4.8 -4.7 -2.3 -4.2 -2.0 -1.8 -0.9 -0.2 w c e : Ministry o f Finance and staff estimates. Includes all LGUs. Table AC.3: Croatia: Consolidated General Government, functional classification, accrual basis 1994 1995 1996 1997 1998 1999 2000 2001 2001 2003 2004 2005 2006 2007 Total expenditure 43.8 49.3 51.5 50.2 53.3 55.5 52.5 51.3 49.3 50.8 49.6 48.6 48.0 48.3 General public services 2.4 2.7 2.9 2.7 3.3 3.2 3.0 2.9 2.8 2.7 2.7 2.8 3.3 3.7 Defense affairs and services 8.1 9.5 6.6 5.3 5.0 3.6 2.9 2.5 2.2 1.9 1.6 1.5 1.5 1.5 Public ordm and safety affairs 3.0 3.0 3.0 2.9 2.9 2.8 2.8 2.8 2.8 2.7 2.7 2.6 2.6 2.7 Educationaffairs and services 3.4 3.6 3.7 3.6 3.7 4.3 4.4 4.6 4.6 4.6 4.6 4.7 4.6 4.7 Health affaim and services 5.4 7.0 7.5 6.7 7.4 7.7 6.6 6.5 6.7 6.5 6.4 6. I 6.1 5.9 Social security and welfare affairs and smices 12.3 13.5 14.8 16.1 17.1 19.1 19.0 19.1 17.9 17.1 16.7 16.4 15.7 14.9 Housing and cammunity amenity affairs and services 1.9 3.1 4.9 4.5 4.4 3.7 3.0 3.0 3.0 3.6 3.7 3.8 3.8 4.0 Recreatimal, cultural and religious affairs 1.0 1.0 0.9 1.2 1.1 1.6 1.5 1.3 1.3 1.3 1.3 1.4 1.5 1.7 Fuel and energy affairs and services 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.0 0.1 0.1 Agriculture, forestry, fishing, hunting affairs 0.8 0.6 0.6 0.6 0.9 1.0 1.0 1.0 1,l 1.2 1.2 1.1 1.1 1.1 Mining, manufacturing,wnsmction affairs 0.3 0.4 0.6 0.7 0.7 0.8 0.7 0.5 0.4 0.7 0.5 0.4 1.2 1.2 Transgot?and wmmunication affairs and services 3.1 2.7 3.8 3.4 3.8 4.6 4.1 4.0 3.6 5.5 5.1 4.8 4.7 4.7 Other cconomic affairs and services 0.5 0.4 0.5 0,s 0.5 0.7 0.7 0.7 0.7 0.6 0.7 I.o 0.9 1.0 Expendituresnot classified by major group 1.7 1.8 1.7 2.0 -2.5 2.7 2.8 2.4 2.3 2.5 2.3 - 2.2 1.1 0.9 Source: Ministry o f Finance and staff estimates. 200 'able AC.4: Croatia - Public Debt 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Uomesnc Yubltc Uebt 17.888 17.4U8 15.847 15.7U2 17.6bU Z2.4YY 26.187 32.455 35.642 43.1U3 56.581 61,425 4m 6. 1. CentralGovernment 17:631 17;261 Mi467 14;583 16;012 18;SlO 21;468 23320 28;161 37;224 50;560 54;217 56;506 T-Bills 0 272 450 566 777 2,565 4,892 5,633 6,548 9,022 12,533 12,662 11,975 CNB credits 390 219 0 0 24 0 0 I I 3 I I I DMBs credits 1,087 460 814 884 1,337 1,848 1,152 1,799 4,189 5,118 7,308 6,726 5,735 Bonds 16,020 16,055 14,159 13,036 13,721 14,083 15,416 15,888 17,422 23,080 30,716 34,828 38,795 Other 135 254 44 97 153 14 7 0 0 0 I 0 0 2. ExtrnbudgetnryFunds 110 2 71 465 716 2,777 3,380 7,659 6,248 3,911 3,935 5,168 6,333 DMBs credits I10 2 71 465 716 1,090 1,744 3,551 2,829 2,185 3,935 5,168 6,333 Bonds 0 0 0 0 0 1,687 1,636 4,108 3,418 1,726 0 0 0 Money market instruments 0 0 0 0 0 0 0 0 0 0 0 0 0 3. Locnl Government 147 145 309 654 906 1,175 1,280 1,033 906 1,586 1,552 1,692 1,955 DMBs credits 147 145 309 654 904 1,168 1,248 1,003 889 1,375 1,315 1,349 1,418 Bonds 0 0 0 0 0 I I 0 0 204 196 314 500 Money market instruments 0 0 0 0 1 6 31 30 17 7 41 29 37 4. HBOR 0 0 0 0 26 37 59 442 328 382 534 348 191 DMBs credits 0 0 0 0 26 37 59 90 130 68 357 94 69 Bonds 0 0 0 0 0 0 0 353 198 314 177 253 122 Money market instruments 0 0 0 0 0 0 0 0 0 0 0 0 0 11, Externd Publlc Debt 1,271 13,466 18,271 24,417 30,900 40,487 44,086 43,797 50,245 55,680 51,985 48,961 49,201 1. Centrnl Government 1,226 13,147 17,514 21,905 28,028 36,808 39,733 37,432 41,042 42,231 36,415 32,557 29,363 Credits 1,226 5,047 5,194 7,789 8,733 10,727 8,748 8,713 8,927 9.312 9.394 9.720 8.966 Bonds 0 8,100 12,319 14,116 19,295 26,081 30,984 28,719 32,115 32,919 27,020 22,837 20,398 2. ExtrabudgetaryFunds 45 319 757 1,203 1,186 1,197 1,137 2,585 4,286 7,747 8,750 8,913 10,148 Credits 45 319 757 1,203 1,186 1,197 1,137 2,585 4,286 7,747 8,750 8,913 10,148 Bonds 0 0 0 0 0 0 0 0 0 0 0 0 0 3. Locnl Government 0 0 0 166 424 457 485 397 321 242 216 152 225 Credits 0 0 0 I66 424 457 485 397 32 I 242 216 152 215 Bonds 0 0 0 0 0 0 0 0 0 0 0 0 0 4. HBOR 0 0 0 1,143 1,263 2,026 2,731 3,383 4,597 5,459 6,605 7,339 9,466 Credits 0 0 0 758 869 1,626 2,001 2,702 3,780 2,613 3,739 3,436 3,557 Bonds 0 0 0 385 394 400 730 680 817 2,847 2,867 3,903 5,909 U1. PubllclyGuaranteed Debt Domestic ... ... 2,119 521 6,641 1,349 17,632 2,482 18,684 3,245 20,636 3,377 25,389 5,958 26,194 7,424 15,419 6,797 12,262 4,552 12,455 5,269 14,194 7252 17,282 7,868 Foreign ... 319 1,047 8,956 8,824 9,995 9,09 I 8,655 8,623 7,710 7,187 6,942 9,414 IV. Arrenn 580 1,956 3,335 6,106 7,686 5,824 5,310 5.697 5.866 6.820 7.666 8.898 7343 Central Government 580 1,000 1,080 2,600 3,276 2,700 1,800 (858 2;250 2;584 3;020 3;474 3;319 Extrabudgetary Funds 0 956 2,255 3,506 4,410 3,124 3,160 3,192 3,042 3,612 4,011 4,561 2,961 Local Government xn > " , 647 573 624 635 862 1,062 otal Publlc Debt 19,159 30,875 34,118 40,119 48,560 62,986 70,273 76,251 85,888 98,783 108,566 110,386 114,186 as a percentageof GDP 19.5 28.6 27.6 29.2 34.3 41.3 42.4 42.1 43.3 45.9 46.9 44.1 41.5 otnl Publlc and Gunrnnteed Debt 19,159 32,994 40,758 57,750 67,244 83,622 95,662 102,445 101,307 111,045 121,021 124,580 131,468 as a percentageof GDP 19.5 30.6 32.9 42.0 47.5 54.8 57.8 56.5 51.1 51.7 52.3 49.1 47.8 otal Publlc nod Guaranteed Debt an 19,739 34,950 44,093 63,856 74,931 89,446 100,971 108,142 107,173 117,865 128,687 133,478 138,811 as a percentageof GDP 20.1 32.4 35.6 46.4 52.9 58.6 61.0 59.7 54.0 54.8 55.6 53.3 50.5 mrce: Ministry o f Finance, CNB, CROSTAT. 20 1 Table AC.5: Comparative data: Croatia and EU, Consolidated General Government Deficit (GFS 1986) and Debt, as % o f GDP Overall Balance o f CGG, accrual, % of GDP 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1995-2006 AV. EU8+2 -4.9 -5.1 -3.9 -3.4 -3.8 -3.4 -4.1 -4.0 -3.3 -2.4 -2.1 -2.0 -3.6 CROATIA' -2.3 -3.1 -3.1 -2.9 -8.4 -6.7 -6.9 -4.5 -6.3 -4.9 -4.1 -3.1 -4.7 EU15 -5.3 -4.1 -2.5 -1.7 -0.8 0.5 -1.1 -2.2 -2.9 -2.6 -2.3 -1.3 -2.2 AV.COHESION -5.7 -4.0 -2.8 -1.9 -1.2 -0.7 -2.1 -2.1 -2.1 -2.4 -2.3 -0.5 -2.3 1/ with caoital revenues below the line Primary Balance o f CGG, accrual, YO f GDP o 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1995-2006 AV. EU8+2 -1.1 -0.7 -0.5 -0.6 -0.9 -0.7 -1.6 -1.9 -1.5 -0.7 -0.5 -0.6 -0.9 R AA COT'I -0.6 -0.9 -0.9 -0.5 -5.9 -4.5 -4.2 -2.0 -3.8 -2.2 -1.5 -0.2 -2.3 EU15 0.0 1.2 2.3 2.8 3.1 4.2 2.4 1.0 0.2 0.3 0.5 1.5 1.6 AV.COHESION 1.2 2.4 2.7 2.9 3.0 3.2 1.4 1.0 0.7 0.3 0.2 2.0 1.7 [I! with capital revenues below the line I General Government Debt 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 BULGARIA .. 105.1 79.6 79.3 74.3 67.3 53.6 45.9 37.9 29.2 22.8 CZECH REP. 14.6 12.5 13.1 15.0 16.4 18.5 25.1 28.5 30.1 30.4 30.2 30.1 ESTONIA 9 7.5 6.3 5.5 6.1 5.2 4.8 3.5 5.5 5.1 4.4 4.0 HUNGARY 87.4 73.7 64.0 62.0 61.1 54.2 52.1 55.6 58.0 59.4 61.6 65.6 LATVIA 15.1 13.9 11.1 9.6 12.5 12.3 14.0 13.5 14.4 14.5 12.5 10.6 LITHUANIA 11.9 14.3 15.6 16.6 22.8 23.7 23.1 22.4 21.2 19.4 18.6 18.2 POLAND .. 44.0 39.1 40.3 36.8 37.6 42.2 47.1 45.7 47.1 47.6 ROMANIA 16.1 14.1 16.5 18.8 22.1 24.7 26.0 25.0 21.5 18.8 15.8 12.4 S L O V A K REP. .. 30.6 33.1 34.0 47.2 50.4 49.0 43.4 42.4 41.4 34.2 30.4 SLOVENIA .. 23.6 24.9 27.4 27.2 28.4 27.9 27.6 27.4 27.1 AV. EU8+2 25.7 23.8 34.3 30.4 33.3 32.8 32.6 31.6 31.4 30.0 28.1 26.9 CROATIA' 19.5 30.6 32.9 42.0 47.5 54.8 57.8 56.5 51.1 51.7 52.3 49.7 EU15 70.8 72.6 71.0 68.9 67.9 63.2 62.2 61.6 63.0 63.3 64.2 63.0 1/ includes guaranteed debt 202 Table AC.6: Comparative data: Croatia and EU, Consolidated General Government, Revenues, as YO o f GDP Total Revenue and Grants 2000- 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1995-1999 2006 LITHUANIA 34.7 34.6 39.0 37.6 37.6 35.8 33.2 32.9 32.0 31.8 33.1 33.4 36.7 33.2 LATVIA 37.4 37.1 38.4 40.7 38.3 34.6 32.5 33.4 33.2 34.7 35.2 37.0 38.4 34.4 ESTONIA 44.3 41.1 39.4 38.0 37.5 34.9 33.9 35.3 36.4 35.9 35.4 36.6 40.1 35.5 CZECHREP. 42.4 40.4 40.2 38.8 39.1 38.8 39.2 39.9 41.1 42.4 41.3 40.7 40.2 40.5 POLAND 43.3 46.1 41.8 40.1 40.4 38.0 38.7 39.3 38.4 36.9 40.9 40.0 42.3 38.9 ROMANIA 31.4 29.0 28.6 44.2 48.0 43.8 36.7 37.6 32.1 31.2 32.2 33.2 36.3 35.2 HUNGARY 52.4 47.9 46.0 44.7 44.4 44.4 44.0 43.0 41.9 42.4 42.1 42.6 47.1 42.9 BULGARIA 40.2 36.7 36.2 38.1 39.1 39.0 38.6 38.4 39.9 40.3 41.1 40.0 38.0 39.6 SLOVENIA 45.4 44.5 43.7 44.5 44.6 43.6 44.1 44.6 44.4 44.2 44.5 44.1 44.5 44.2 SLOVAKREP. 45.3 44.2 42.8 40.6 40.6 38.3 37.8 36.6 37.4 35.4 35.3 33.5 42.7 36.3 AV.COUNTRY 41.7 40.2 39.6 40.7 41.0 39.1 37.9 38.1 37.7 37.5 38.1 38.1 40.6 38.1 CROATIA' 47.6 49.7 48.3 51.8 48.8 47.2 45.7 45.8 45.5 45.7 45.3 46.0 49.2 45.9 1/ Other capital revenues (excluding privatization receipts) above the line Tax Revenue 2000- 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1995-1999 2006 LITHUANIA 29.0 28.3 31.5 32.2 32.4 30.3 29.0 28.6 28.3 28.5 28.7 29.7 28.9 28.8 LATVIA 33.7 31.4 32.7 34.4 32.6 29.7 28.7 28.4 28.7 28.5 28.9 30.0 28.8 28.9 ESTONIA 39.9 38.0 35.9 34.9 34.6 32.2 29.4 30.6 31.1 30.8 30.3 30.6 30.7 30.5 CZECH REP. 39.0 37.5 37.6 35.8 36.4 36.0 36.2 37.1 38.0 39.2 38.4 37.5 37.5 37.7 POLAND 41.3 41.7 40.6 39.4 39.2 34.3 34.6 36.7 32.6 31.6 34.5 33.9 34.0 34.0 ROMANIA 28.8 26.9 26.5 32.1 34.3 36.7 29.5 30.5 29.8 28.7 29.1 30.7 30.7 29.7 HUNGARY 42.9 44.3 42.6 41.2 40.9 40.8 40.5 39.7 38.7 39.1 38.0 38.0 39.5 39.0 BULGARIA 30.9 27.5 28.0 30.1 29.4 29.9 29.3 30.1 32.6 33.4 34.4 33.8 31.6 32.3 SLOVENIA 43.4 42.4 41.4 42.1 42.5 41.4 41.6 42.1 42.1 41.9 42.2 41.8 41.9 42.0 SLOVAKREP. 40.7 41.7 39.8 38.3 37.3 35.7 34.4 34.5 34.9 32.4 31.3 29.5 33.9 32.9 AV .CEECs 37.0 36.0 35.7 36.1 36.0 34.7 33.3 33.8 33.7 33.4 33.6 33.6 33.8 33.6 CROATIA 44.4 44.4 43.0 46.9 44.1 42.6 41.0 40.8 40.3 39.6 39.3 39.9 40.6 40.2 203 Table AC.7: Comparative data: Croatia and EU, Consolidated General Government, Expenditures, as YO o f GDP Total Expenditure and Net Lending ZOO& 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1995-1999 2o06 LITHUANIA 37.2 39.0 52.1 42.5 43.4 39.9 35.5 34.5 33.1 33.0 33.4 33.9 42.8 34.8 LATVIA 39.8 38.2 37.9 44.8 45.4 40.6 37.7 38.4 37.3 37.8 37.2 38.2 41.2 38.2 ESTONIA 48.3 46.0 40.0 39.7 38.9 37.1 36.2 36.9 36.3 34.0 33.6 33.2 42.6 35.3 CZECH REP. 53.1 41.3 42.3 42.4 40.3 42.2 44.8 45.0 48.2 45.9 45.6 44.0 43.9 45.1 POLAND 47.7 51.0 46.4 44.3 42.7 41.1 43.8 44.3 44.7 42.6 45.4 43.6 46.4 43.6 ROMANIA 34.7 33.8 33.9 46.8 47.5 41.4 39.9 40.4 33.6 33.0 33.6 35.0 39.3 36.7 HUNGARY 57.4 52.5 52.8 52.4 49.9 47.4 48.1 52.1 49.1 48.9 49.9 52.9 53.0 49.8 BULGARIA 45.4 52.0 34.1 35.5 37.9 38.7 39.1 38.5 39.9 39.0 39.3 36.8 41.0 38.8 SLOVENIA 54.0 45.6 46.1 46.9 47.8 47.4 51.0 49.7 48.6 47.8 47.3 46.4 48.1 48.3 SLOVAKREP. 48.3 53.7 49.9 46.5 54.2 49.4 43.6 41.4 39.2 37.7 37.0 36.8 50.5 40.7 AV.COUNTRY 46.6 45.3 43.5 44.2 44.8 42.5 42.0 42.1 41.0 40.0 40.2 40.1 44.9 41.1 CROATIA 49.6 51.8 50.6 53.8 56.4 53.7 52.2 50.0 51.4 50.1 49.1 48.4 52.5 50.7 Source: MoFs, OECD, IMF GFS, EC (ESA 9 9 , WDI - World Bank, EUROSTAT, staff estimates. 1994 1995 1996 I997 1998 1909 2000 2001 2002 2003 2004 2005 2006 2007 Employer pays 123.03 121.78 121.78 121.78 120.98 120.98 118.98 116.6 117.07 117.2 117.2 117.2 117.2 117.2 o/w health insurance 7.5 7 7 7 9 9 7 7 7 15 15 15 15 15 ohv professionaldisease 0 0 0 0 0 0 0 0 0.47 0.5 0.5 0.5 0.5 0.5 ohv pension insurance 13.5 12.75 12.75 12.75 10.75 10.75 8.75 8.75 8.75 0 0 0 0 0 ohv unemployment insurance 0.85 0.85 0.85 0.85 0.85 0.85 0.85 0.85 0.85 1.7 1.7 1.7 1.7 1.7 ohv water contribution 0.8 0.8 0.8 0.8 0 0 0 0 0 0 0 0 0 0 ohv chamber of commerce contribution 0.375 0.375 0.375 0.375 0.375 0.375 0.375 0 0 0 0 0 0 0 Workefa gross wage 100 100 100 100 100 100 100 100 100 100 100 100 100 100 ohv health insurance 7.5 7 7 7 9 9 9 9 9 0 0 0 0 0 ohv pension insurance 13.5 12.75 12.75 12.75 10.75 10.75 10.75 10.75 10.75 20 20 20 20 20 ohv child allowance contribution 2.5 2.2 2.2 2.2 0 0 0 0 0 0 0 0 0 0 o h unemployment insurance 0.85 0.85 0.85 0.85 0.85 0.85 0.85 0.85 0.85 0 0 0 0 0 ohv personal income tax (effective) 17.75 14.2 14.5 12.4 14.5 12.1 11.1 9.4 10.1 9.9 10.3 10.0 10.6 11.3 Worker's net wage 57.9 83 62.7 64.8 64.9 67.3 68.31 69.97 69.33 70.09 69.74 70.04 69.38 68.70 Netwageasa percentof employer's costs 47.1 51.7 51.5 53.2 53.8 55.6 58.4 60.0 59.2 59.8 59.5 59.8 59.2 58.6 Employetscostsas a percent of net wage 212.5 193.3 194.2 187.9 186.4 179.8 171.2 166.7 168.9 167.2 168.0 167.3 168.9 170.6 Overall contrlbution rate (payroll taxes) 47.4 44.6 44.8 44.8 41.6 41.6 37.6 37.2 37.7 37.2 37.2 37.2 37.2 37.2 204 'able AC.9: Tax Rates in 2006 Top Personal Top TOP Corporate (In percent) Income Tax Payroll Tax VAT rate Income Tax Rate Rate Croatia 22 20 45 31.2 Average EU8+2 19.3 18.8 29.9 41.2 Bulgaria 20 15 24 35.9 Czech Republic 19 24 32 47.5 Estonia 18 24 24 36.5 Hungary 20 16 36 45.5 Latvia 18 15 25 33.09 Lithuania 18 15 33 33.98 Poland 22 19 40 46.89 Romania 19 16 16 50.75 Slovak Republic 19 19 19 43.6 Slovenia 20 25 50 38.2 EU15 20.0 29.4 45.9 35.4 Austria 20 25 50 42.2 Belgium 21 33 50 37.84 Denmark 25 28 59 ... Finland 22 26 32.5 33 France 19.6 34.43 48.09 45.04 Germany 19 40 47.5 41.53 Greece 19 29 40 33.65 Ireland 21 12.5 42 12.5 Italy 20 33 43 40.86 Luxemburg 15 29.63 38.95 27.71 Netherlands 19 29.6 52 53.78 Portugal 21 27.5 42 34.75 Spain 16 35 45 37.83 Sweden 25 28 58 30.43 UK 17.5 30 40 23.8 Source: MoFs, www.worldwide-tax.com, United States Social Security Administration, staff calculations. 205 BIBLIOGRAPHY 1. Afonso A., L. Schuknecht and V. Tanzi, (ECB) (2008), “Income Distribution Determinants and Public Spending Efficiency�, April 2008 2. Agell, J.; Lindh T., Ohlsson H. (1997), “Growth and the Public Sector: A Critical Review Essay�, European Journal o f Political Economy, 13, 33-52, 1997 3. Agell, J.Lindh T., Ohlsson H. (1999), “Growth and the Public Sector: A Reply�, European Journal o f Political Economy, 15, 359-366, 1999 4. Alesina, A,, Wacziarg, R. (1998), “Openness, Country Size and the Government�, Journal o f Public Economics, Vol69, p. 305-321, 1998 5. Alves, H. 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