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Report No. 114618-XK Public Disclosure Authorized DOCUMENT OF THE WORLD BANK GROUP FOR OFFICIAL USE ONLY Republic of Kosovo Systematic Country Diagnostic Public Disclosure Authorized (P151814) Public Disclosure Authorized January 2017 Public Disclosure Authorized Europe and Central Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY AND EQUIVALENT UNITS Currency Unit = Euro €1.00 = US$1.13 (As of May 15, 2015) FISCAL YEAR January 1 – December 31 WEIGHTS AND MEASURES Metric System ACRONYMS AND ABBREVIATIONS BEEPS Business Environment and Enterprise MFI microfinance institution Performance Survey CIT corporate income tax NSDI National Spatial Data Infrastructure CPF Country Partnership Framework OECD Organisation for Economic Co-operation (World Bank Group) and Development EU European Union PIT personal income tax FDI foreign direct investment RAE Roma, Ashkali, and Egyptian GDP gross domestic product SAA Stabilization and Association Agreement (EU) HBS household budget survey SCD Systematic Country Diagnostic ICT information and communication SEE Southeastern Europe technology IT information technology SFRY Socialist Federal Republic of Yugoslavia KRPP Kosova e Re Power Project SMEs small and medium enterprises LFS labor force survey UN United Nations VAT value added tax Regional Vice President: Cyril Muller International Finance Corporation Vice President: Karin Finkelston Country Directors: Ellen Goldstein Senior Directors: Felipe Jaramillo and Ana Revenga Practice Managers: Ivailo Izvorski and Carolina Sánchez-Páramo Task Team Leaders: Stefano Curto and Kenneth Simler TEAM MEMBERS AND ACKNOWLEDGEMENTS This report has been prepared by a World Bank team led by Stefano Curto and Kenneth Simler. Additional core team members are Ihsan Ajwad, Lundrim Aliu, Philippe Ambrosi, Aanchal Anand, Nebojsa Arsenijevic, Aneesa Arur, Bernard Atlan, Trandelina Baraku, Rhedon Begolli, Raymond Bourdeaux, Elizabeth N. Ruppert Bulmer, Rinku Chandra, Jieun Choi, Zhenia Viatchaninova Dalphond, Syzana Dautaj, Agim Demukaj, Nichola Dyer, Majed El-Bayya, Baher El-Hifnawi, Nathan Engle, Edgardo Favaro, Michael Ferrantino, Natalija Gelvanovska, Stephanie Gil, Lucas Gortazar, Andrea Guedes, Nermina Hadziabdic, Georgia Harley, Claire Honore Hollweg, Kirsten Hommann, Lola Ibragimova, Hasan Ican, Aylin Isik-Dikmelik, Johanna Jaeger, Kathrine Kelm, Flora Kelmendi, Gregory Kisunko, Gokhan Kont, Ewa Korczyc, Violane Leacy, Martin Lokanc, Pamela Madrid, Andres Federico Martinez, Igor Matijevic, David Michaud, Jacques Alain Miniane, Sagita Muco, Ana María Muñoz Boudet, Kiril Nejkov, Jan-Peter Olters, Oliver Orton, Marvin Ploetz, Blerta Qerimi, Rodrigo Salcedo Du Bois, Anita Schwarz, Will Seitz, Ahmed Shawky, Christopher Sheldon, Hilda Shijaku, Evis Sulko, Tarik Sahovic, Meeta Sehgal, Michael Stanley, Mahesh Uttamchandani, Katelijn van den Berg, Gonzalo J. Varela, and Gallina Vincelette. The report has been prepared under the overall guidance of Ellen Goldstein (Country Director), Ivailo Izvorski (Practice Manager, Global Practice for Macroeconomics and Fiscal Management), Carolina Sánchez-Páramo (Practice Manager, Poverty), Jan-Peter Olters (Country Manager), Andras Horvai (Manager, Europe and Central Asia Vulnerability Mapping), Gallina Vincelette, Tim Johnston, Raymond Bourdeaux (Program Leaders), Tom Lubeck, Sagita Muco, and George Konda (Coordinators, International Finance Corporation). The team would like also to thank Ana Revenga (Senior Director, Poverty Global Practice), Satu Kahkonen (Director, Macroeconomics and Fiscal Management Global Practice), Abebe Adugna, Simon Davies, Roumeen Islam, Luis F. López-Calva, Trang Nguyen, and Ambar Narayan for their advice to the team during the preparation of the report. The team is grateful for comments received from the peer reviewers, Bernard Funck and Caterina Ruggeri Laderchi. The report has been enriched by several rounds of discussions held within the country team as well as in-country consultations with government, research entities, donors, and civil society organizations. A list of persons and organizations that participated in the consultations appears in annex F, and the team is grateful for the discussions. Finally, the team would like to thank Ivana Bojic, Helena Makarenko, Mjellma Rrecaj, Indiana Taylor, and Robert Zimmermann for their support in the preparation of the report. Table of Contents EXECUTIVE SUMMARY ................................................................................................................................... 9 I. INTRODUCTION .................................................................................................................................... 20 II. COUNTRY CONTEXT ............................................................................................................................ 23 THE SOCIOPOLITICAL CONTEXT .............................................................................................................................................. 23 ECONOMIC GROWTH AND GROWTH INCIDENCE ................................................................................................................. 29 The nature of economic growth ............................................................................................................................... 33 Sectoral composition of economic growth ................................................................................................................... 35 The role of the public sector ................................................................................................................................... 41 The role of external sources of financing ................................................................................................................... 43 Household-Level Evidence on Growth and Shared Prosperity ...................................................................................... 45 The role of employment ........................................................................................................................................ 46 The role of remittances and transfers ....................................................................................................................... 51 CONCEPTUAL FRAMEWORK ....................................................................................................................................................... 53 BUILDING BLOCKS ...................................................................................................................................................................... 58 III. REPRIORITIZING PUBLIC EXPENDITURES AND REORIENTING TAXATION TO ADDRESS CRITICAL DEVELOPMENT CHALLENGES ............................................................................................... 61 MAINTAINING FISCAL DISCIPLINE AND ALIGNING BUDGETS TO DEVELOPMENT NEEDS ......................................... 61 Improving the allocation and efficiency of public expenditure ......................................................................................... 63 Strengthening tax administration and shifting toward direct taxation ............................................................................. 67 IV. A MORE ATTRACTIVE ENVIRONMENT FOR PRIVATE SECTOR INVESTMENT AND BUSINESS EXPANSION IN TRADABLE SECTORS .................................................................................... 71 GOOD GOVERNANCE AND STRENGTHENING THE RULE OF LAW .................................................................................... 72 STRENGTHENING THE BUSINESS CLIMATE ............................................................................................................................ 77 INCREASING THE INTEGRATION INTO GLOBAL VALUE CHAINS ......................................................................................... 79 SECURING PROPERTY RIGHTS AND AN EFFICIENT LAND MARKET ..................................................................................... 82 MAINTAINING FINANCIAL STABILITY AND DEEPENING FINANCIAL INTERMEDIATION................................................ 83 REDUCING THE INFRASTRUCTURE GAP ................................................................................................................................... 87 Reliable and Affordable Energy............................................................................................................................. 90 Increasing Connectivity ......................................................................................................................................... 97 V. GREATER INCLUSION BY BUILDING HUMAN CAPITAL AND PROVIDING EQUAL OPPORTUNITIES .......................................................................................................................................... 103 INCREASING SKILLS, EMPLOYMENT AND LABOR PRODUCTIVITY ..................................................................................... 103 PAYING ATTENTION TO THE QUALITY AND EQUALITY OF OPPORTUNITIES ................................................................. 110 Social Protection ............................................................................................................................................... 110 Health ..........................................................................................................................................................