eotN.331H Cota RestructuringPublicFinance toSustainGrowth andImp Croatia Report No.37321-HR Report No. 37321-HR Croatia Restructuring Public Finance to Sustain

Public Disclosure Authorized Growth and Improve Public Services A Public Finance Review

February 2008

Poverty Reduction and Economic Management Unit Europe and Central Asia Region Public Disclosure Authorized Public Disclosure Authorized rove rove Public Services

Document of the World Bank Public Disclosure Authorized

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

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ACKNOWLEDGEMENTS

This report is the product of a collaborative process involving Croatian and other consultants, and staff from the World Bank. The scope of the work was developed in consultation with the Croatian Ministry of 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 iigman (former State Secretary, Ministry ofFinance), Mr. Zdravko MariC (State Secretary, Ministry ofFinance), Mr. Ivo Sutalo (Assistant Director, Central Bureau of Statistics) and staff at the Ministry ofFinance and other line ministries for their inputs and help at various stages in the preparation ofthis 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, ieljko 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, ieljka RajkoviC, Tijen Arin, Ani1 Markandya (environment), Agnieszka Grudzinska, Mohamed Essakali, Henry Kerali (transport). Early findings of the background work were shared with government and non-government officials, including key donor community representatives (UNDP and EC) and the team is grateful for all their suggestions and feedback received.

The report was undertaken under the guidance of 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 of EU Funds, Athanasios Vamavakidis (former IMF Resident Representative to Croatia), Nikolay Gueorguiev (Senior Economist, IMF), William Dorotinsky (Lead Public Sector Specialist, WB) and Uwe Stamm (EU, DGECFIN, Economist for Croatia) were the peer reviewers of the report. In addition, the team would like to thank Camille Lampart Nuamah, Nina Amhold, Satu Kahkonen, Hermann Von Gersdorff, and in particular Ron Hood and Bernard Funck for their comments, advice, and help throughout the course ofthis work.

CONTENTS EXECUTIVE SUMMARY ...... 13 PART I: STRATEGIC SETTING ...... 28 1. THE MACROECONOMIC SETTING ...... 29 A . MODERATEGROWTH. LOW INFLATION AND EMPLOYMENT ...... 30 B. SmucmBALANCE AND FISCAL SUSTAINABILITY ...... 34 C . EXTERNALVULNERABILITY ...... 38 D. MONETARYPOLICY RESPONSE...... 41 E. CONCLUSIONS ...... 42 2 . FISCAL FRAMEWORK ...... 44 A . FISCAL DEVELOPMENTSDURING THE LASTDECADE ...... 44 B. OPTIMAL SIZE OF GOVERNMENT ...... 47 C . STRUCTURAL REFORMS ...... 51 D. ECONOMIC COMPOSITION OF GENERAL GOVERNMENT EXPENDITURE ...... 53 E. FUNCTIONALCOMPOS~~ION OF THE GENERAL GOVERNMENT SPENDING ...... 56 F . REVENUE AND TAX ADMINISTRATIONSIMPLIFICATION ...... 59 G . PUBLIC EXPENDITUREMANAGEMENT SYSTEM ...... 64 PART 11: DELIVERING PUBLIC GOODS ...... 69 3 . INFRASTRUCTURE ...... 71 A . BACKGROLTND...... 72 B. RAILWAYS ...... 73 EFFECTIVENESS...... 73 EFFICIENCY ...... 74 RECOMMENDATIONS ...... 78 C. ROADINFRASTRUCTURE ...... 80 EFFECTIVENESS...... 80 EFFICIENCY...... 81 RECOMMENDATIONS...... 84 4 . ENVIRONMENT ...... 87 A . CURRENTENVIRONMENTAL CONDITIONS ...... 89 B. GOVERNMENTPLANS ...... 90 C . FINANCING ENVIRONMENTALSPENDING ...... 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. EFFICIENCYOF LABORINPUTS ...... 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 . EQUITYISSUES IN PROVISION OF HEALTH SERVICES ...... 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~VEEFFICIENCY ...... 179 D. RECOMMENDATIONS...... 180 PART IV: MEDIUM-TERM FRAMEWORK...... 183 10. MEDIUM-TERM FISCAL FRAMEWORK...... 185 A . THEGOVERNMENT’S MEDIUM-TERM FISCAL PLAN ...... 185 B. DEFINITION OF THE PROBLEM ...... 188 C . MID-TERMFISCAL SCENARIO: “BALANCEDBUDGET” ...... 189 D. MID-TERMFISCAL SCENARIO: “BUMPYADJUSTMENT” ...... 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 (% of GDP) ...... 34 Table 1.4: Croatia: Characteristics of 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, % ofGDP ...... 54 Table 2.5: Poverty Incidence and Welfare Payments ...... 55 Table 2.6: Consolidated General Government Expenditures by Functional Classification 1995-2006, % of GDP ...... 57 Table 2.7: Comparative Revenue Ratios, 2000-2006 average (% GDP)” ...... 59 Table 2.8: Basic characteristics of the PIT system ...... 63 Table 2.9: Effective tax rates in 2004 ...... 63 Table 2.10: Characteristics of 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 of 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 of 2007 ...... 95 Table 4.5: Environment Staffing Inflows ...... 99 Table 5.1 : Wage Returns to Different Levels of Education...... 106 Table 5.2: Distribution of Public Expenditures on Education by Level of Education, 2002 (%) ...... 108 Table 5.3. Expenditure Shares by Type of Educational Service and Year ...... 108 Table 5.4: Education Spending, as % of GDP per capita, 2002 ...... 109 Table 5.5: Ratio of Per Capita Recurrent Expenditures Relative to Primary Education ...... 110 Table 5.6: Economic Allocations of Education Expenditures ...... 111 Table 5.7: Comparative Student-Teacher Ratios ...... 111 Table 5.8: Annual Compulsory Instructional Hours’ ...... 114 Table 5.9: Effects of Gender and on Net Enrollment Rates (2002-04) ...... 116 Table 5.10: Distribution of 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 % ofrespective EU15 and EU8 levels (2007) ...... 122 Table 6.2: Selected Doing Business Indicators, 2007 ...... 123 Table 6.3: Personnel Cost: Key indicators of 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, % of 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 of Visits to Health Specialist and Average Cost, 2002-2007 ...... 147 Table 7.8: Distribution ofRelative 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’ Net Assets and Members (December 2007) ...... 159 Table 9.1 : Income Inequality ...... 170 Table 9.2: Use of allowances in 2004 ...... 171 Table 9.3: Main Non-Contributory Social Spending Programs, 2003-2008, % of GDP ...... 171 Table 9.4: Main State Social Assistance Programs, 2004 - 2006, million HRK, % of GDP ...... 173 Table 9.5: Guaranteed Minimum Income Programs, Beneficiaries, % of population ...... 174 Table 9.6: Guaranteed minimum income programs in new EU member countries, Percent of GDP 174 Table 9.7: Long Term Duration of Social Assistance Benefits, Percentage ofTotal Beneficiaries .. 175 Table 9.8: Expenditures on main non-contributory budget financed family programs (HRK) ...... 176 Table 9.9: Spending on Child Benefits, % of 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 ofother Family Programs ...... 178

9 Table 10.1: Croatian Government’s Fiscal Scenario 2008.2010. % of 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, % of GDP ...... 33 Figure 1.4:General Government Balance Comparison, % of GDP...... 33 Figure 1.5: Consolidated General Government Debt and Guarantees, % of GDP ...... 33 Figure 1.6: Fiscal stance from 1994 to 2010 ...... 35 Figure 1.7: Evolution of Croatia’s External Vulnerability, 2000-2007 ...... 39 Figure 1.8: ULC in Industry...... 42 Figure 2.1: Deviation of Actual Government Size from Predicted ...... 49 Figure 2.2: Actual vs . Predicted Level of 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 of 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 of 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 of Budget Support to the Railways, 2006 ...... 76 Figure 3.6: Age Profile of HZ Staff, 2005 ...... 77 Figure 3.7: HZ Staffby Years of Service, 2005 ...... 77 Figure 3.8: Condition of National Road Network (2006) ...... 80 Figure 3.9: Public Spending on Road Infrastructure, average 2001-2004, % of GDP ...... 81 Figure 3.10: Ratio of Projected HAC’SFuel Levy 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 % of GDP ...... 94 Figure 4.5: Private Environment Expenditure, as % of total ...... 94 Figure 4.6: Environmental Taxes, % of Government Revenues ...... 97 Figure 4.7: Institutions with Environment Competence ...... 99 Figure 5.1: Projected Trends in Sizes of Preschool and School-Age Cohorts ( 2005-30) ...... 105 Figure 5.2: Public Sector Spending on Education, % of GDP ...... 107 Figure 5.3: Trends in total public education expenditures (1992-2007) ...... 107 Figure 5.4: Distribution of 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, % of GDP ...... 124

10 Figure 6.3: Comparison of Civil Service and Private Sector Pay Levels ...... 126 Figure 6.4: Spread of 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 life 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 % of GDP ...... 142 Figure 7.7: Hospital Beds per 100,000 Population1985-2004 ...... 146 Figure 7.8: Average Length of Stay (ALOS), 1985-2004 ...... 146 Figure 7.9: Lorenz Curve for Income and Concentration Curve for Health Expenditures ...... 150 Figure 8.1: PAYG 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, % of GDP ..... 167 Figure 9.2: Share of Spending Accruing to Poorest One-Fifth of 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, % of total ...... 172 Figure 9.6: Spending on specific non-contributory programs, 2003-2008, % of 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 of 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 of the EU Stability and Growth Pact ...... 190

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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 its attention to the "second transition" -the principle goal of which is to place Croatia on a path to the European Union (EU). While opening the economy to global markets through WTO and CEFTA memberships and re- establishing cooperation with its Southeast European neighbors, the signing of the Stabilization and Association Agreement (SAA) marked the first firm milestone on 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 is 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 check partly due to exchange rate appreciation. In fact, the central bank has intervened to prevent stronger appreciation in the face of robust capital inflows. However, the oil and commodity price increases and the aggregate demand pressures have contributed to a widening of 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. To 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 ofthe 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 of GDP in 2007 (almost 10 percentage points of GDP above the public spending levels in new EU member states), Croatia has one of the largest public sectors in Europe. From the growth and efficiency point of view, total public spending is too high. Cross-country analysis suggests that expenditures over 35 percent of GDP may have negative implications for growth. 6. So far, Croatia has been able to finance a significant portion of 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 of GDP, which is about six percentage points of GDP above the average for EUlO-would need to be reduced. However, reduction of 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 of EU accession have been significant. Similar to their cases, it is estimated to be close to three percentage points of GDP for Croatia.. In addition, Croatia will soon face costs related to the potential NATO accession which are estimated at around 1.5 percent of GDP. On top of this, Croatia’s population is aging which will eventually create additional fiscal pressures. It is worth noting however that, faced with similar 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 of 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 of improved budgeting processes, and reduced quasi-fiscal activities. Total public spending and general government deficit have declined by three to four percentage points ofGDP-total public spending from 51.3 percent of GDP in 2003 to 48.6 percent of GDP in 2007 and the fiscal deficit down from 6.3 percent ofGDP in 2003 to 2.3 percent ofGDP in 2007 (excluding the pensioners’ debt repayment at 1.2 percent of GDP in 2007 financed off-budget and HBOR deficit at 0.5 percent of GDP) 9. The high burden of public debt complicates the tasks ahead. The fiscal expansion of the 1990s has left the country with a mountain ofpublic debt, which stood at 47.8 percent ofGDP 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 of 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 its public debt on a sustainable path and insulate its 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 ofthe period, fiscal policy magnified rather than mitigated the effects ofexternal shocks. The fiscal tightening that should have accompanied the monetary tightening in the periods of a large current account deficit was mostly missing. Tight money and a loose fiscal stance not only exacerbated the pressure towards appreciation of 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 of 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 USD stood at 95.7 percent of GDP in 2007 (or at 89.1 percent of GDP for EUR-denominated debt), of which roughly 72 percent was private. In addition, a large share ofdomestic debt is denominated in or linked to foreign currency. Of the government’s domestic debt, about 40 percent of GDP is denominated in foreign currency. Similarly, the bulk of lending by domestic banks to the private sector is 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 is of the view that these transactions are to be treated outside of the general government.

14 interest rates or through barriers to access to long term finance, thereby affecting real performance of 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 this background, Croatia’s fiscal consolidation efforts over the last three years and up until 2007 with general government expenditure reduction by two percentage points of 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 is a significant risk that the additional EU and NATO 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 of external debt.

Such a fiscal adjustment would allow for the absorption over the long run of the costs associated with EU accession, NATO membership as well as aging society. These costs together are estimated at above five percentage points of GDP over the medium term, and thus, without any expenditure restructuring-could significantly deteriorate Croatia’s fiscal and external position.

It would allow for a reduction of tax burden on the economy needed to boost the country’s competitiveness. If the ambitious expenditure consolidation took place, Croatia would be able to reduce its tax burden by more than four percentage points of GDP. This would make the tax burden in Croatia more comparable to the EU countries. It would prepare Croatia for the eventual EU accession and meeting of the Maastricht requirements under the Stability and Growth Pact. To retain macroeconomic stability in the EU and to safeguard the sustainability of 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 of slow growth in the country and EU. Also, given the recent interest rates hikes in EU, it needs to absorb increased cost of foreign borrowing. In 2007 alone, the general government borrowing requirements amounted to about five percentage points of GDP for deficit financing and repayment of debt, which is 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. In 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 of the other. The only way to reconcile the two objectives is through expenditure retrenchment. The experience of the past decade has shown how difficult it can be to achieve a lasting fiscal consolidation. 17. Beyond political constraints, the devil is in details of sectoral policies. The Government would need to improve its own knowledge base of 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 of a standardized methodology for the preparation of strategic plans ofministries, drafting of an annual strategic document pointing out key policy priorities, and its adoption as a supplement to the budget proposal reflecting arguments for the selection ofpriorities. 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. It highlights a number of measures that would allow for expenditure reduction of over seven percentage points of GDP over the medium term, including: In transport (spending reduction of one percent of GDP): relax the pace of road network 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 of subsidies to performance-based contracts, and revenue enhancement measures; and put the draft investment plan for railways at the cost-benefit test. In environment (improving efficiency of the current spending): time investments taking into account availability ofEU grant funds and the demand on the government budgets; focus investments on 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). In education (improving efficiency and equity of the current spending): rationalize the 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 ofmulti-grade teaching in small schools and eliminate triple shifts; review carefully the relevance and equity of the secondary VET program and reform the scholarship system in particular in the tertiary education. In health (spending reduction of two percent of GDP): introduce stabilization measures such as increased use ofco-payments, improved targeting oflow income groups by the social protection system, and rationalization of pharmaceutical spending; and medium-term structural reforms focusing on payment mechanisms to hospitals and outpatient care providers, rationalization ofthe hospital network and hospital-based service delivery system, and reduction ofthe drain on the health insurance system arising from excessive sick leaves. In pensions (improving efficiency and equity of the current spending): offset the negative fiscal impact of 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 of 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 PAYG system provisions; and (vi) raising the early retirement decrement rate to 7 percent. In social assistance (spending reduction of one and a halfpercent of GDP): scale up the support allowance budget at the expense ofcategorical benefits; improve targeting through an extended use of means testing to categorical benefits; simplify benefits; facilitate the return from “welfare to work”; and consolidate administration. In subsidies (spending reduction of three percent of GDP): strengthen the implementation of state aid rules as per the 2005 State Aid Law; reduce the sectoral aid; evaluate the effectiveness of the current horizontal aid; ensure compliance of local governments; further evaluate Services of General Economic Interest (SGEI) rule application, especially in the transport sector for proper cost coverage. In public administration: contain the public sector wage bill through both staff downsizing and pay measures as part of 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. In the transport sector, the main challenge is to adopt a more disciplined approach to the planning and prioritization of investments, and to make adequate provision for maintenance of assets. In the roads sector, Croatia is in the last phase of a massive motorway development program (2001-2008) on which it is currently spending about three percent of GDP annually. Unit costs of these investments are high due to excessive standards. This and the pace of implementation are crowding out expenditure for necessary maintenance and rehabilitation ofexisting road networks and a significant maintenance backlog remains to be addressed. Accordingly, the objective of the Road Construction and Maintenance Strategy for 2005-2008 was to increase the share ofmaintenance 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 of competitive contracting, introduction of appropriate incentive schemes for publicly-owned road operators, and development of a competitive PPP market for the provision of road infrastructure. In addition, the government would need to analyze carefully the liabilities it is 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 of 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 of construction is increasingly becoming that of maintenance and preservation of the newly created assets, the govepment may want to think about merging the national roads and motorways under a single implementing agency. This would permit staff downsizing and cutting other operating costs. 22. In the railways sector, the current level of operating subsidies at 0.6 percent of GDP is unsustainably high, compared to the EU and neighboring countries. It could be cut by half. As in other countries of the region, the sector is facing sharply increased competition from the rapidly

17 expanding road traffic. The Croatian Railway Company (HZ) is 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 is still low at about 50 percent of 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 of line with other segments ofthe labor market, the revenues ofHZ do not even cover its labor costs. To become competitive, financially sustainable, and to operate with reduced level of financial support from the government, HZ would need to reconfigure its 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 is because investment plans are not conditioned by consideration of debt financing implications nor supported by adequate cost benefit analysis, and insufficient attention is given to measures to increasing the efficiency ofexisting operations. There is 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. In 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 is opened to competition. As long as the subsidiaries remain sole suppliers to HZ, the cost of their excess labor is 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 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 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 its efforts to utilize more of available EU funds in this sector. Privatization could also help to lower the direct costs to the state, if undertaken with careful integration ofenvironmental 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 ofmunicipal infrastructure where large efficiency gains from economies of scale could be achieved through agglomeration of utility services across the local government units. The largest investment financing gap in the medium-term budget framework is in solid waste, and this falls under the responsibility of 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 of policy functions under the Ministry of Environment, including a transfer of responsibility for water policy to this ministry; separation of construction from the Ministry of

18 Environmental Protection, Physical Planning and Construction to avoid conflicts of interest; and improve coordination between ministries in the design and implementation of environmental regulations. 28. While the cost of meeting the environmental acquis is 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 is limited and where private sector involvement is 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 ofurgent 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 still has some way to go to make a major contribution. Strengthening the capacity ofthe 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 is 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 low at all levels, except primary education, and there is a mismatch between skills demanded on the market and the skills 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 is 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 of declining school age cohorts. Institutional and financing arrangements need to be adjusted to ensure that resources are shifted towards the areas ofgreatest return. 31. Still, compared to EU countries, the primary school compulsory instructional time is comparatively low in Croatia, but average for secondary students. The total instructional time at the primary level is only about two-thirds that of EU15 students and 80 percent that ofEU8 students. Although the relationship between instructional time and student outcomes is not straightforward, students’ opportunity to spend time learning has been shown to be a key driver of 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 its 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 is a strong positive correlation between country’s ability to absorb new technology, and thus its ability to follow the innovation-frontier countries, and the share of secondary school educated population. Therefore, increasing secondary education enrollments, education outcomes as well as usage of life-long learning programs seems critical to increase country’s competitiveness.

19 33. To 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 is a mix of centralized and decentralized decision-making and financing, depending on the function and level of education. The Equalization Fund is 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 ofthe curriculum has received significant attention in the last couple of 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 of TIMSS and PIRLS as well 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 ofhigh 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 of 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 ofthe payment of teacher salaries may not be advisable, unless it is 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 of multi-grade teaching in small schools; and eliminate the current triple shifts. Review carefully the relevance and equity ofthe 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 of public tertiary education to ensure that it delivers the promised efficiency and effectiveness gains. Identify the reasons behind the low completion and high repetition rates in tertiary institutions; simulate the 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 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 of 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 of GDP is well above its 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 of arrears reflects fundamental weaknesses in the system. First, the current payment mechanism creates incentives for excessive demand. Second, on the supply-side, the absence of primary health system gate-keeping role to access the more expensive secondary care creates waste. Third, the extensive hospital infrastructure is expensive to maintain and a source of cost inflexibility. Fourth, the hospital governance structure is 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 of 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-term structural reforms. The common strategy has been the adoption ofa hard budget constraint and strict fiscal discipline. As a first step in that direction in Croatia, a new obligatory health insurance law 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 of EU countries, short-term stabilization measures would need to include: 0 An increase in the use of co-payments to limit excess demand and generate additional revenues. Improvement ofthe copayment exemption targeting to low income groups through the social protection system. 0 Rationalization ofpharmaceutical spending. 41. Medium-term structural reforms should in turn focus on: Reforms in the payment mechanisms to hospitals and outpatient care providers. 0 Rationalization of the hospital-based service delivery system. 0 Reduction of the duration of sick leaves and the consequent transfers from the health insurance system to households, which currently account for over 0.8 percent ofGDP.

Pensions

42. In the pension system the main challenge is 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. In response, the government launched a pension reform in 1998, which aimed at scaling back the PAYG system to create fiscal space for the introduction of the second and third pillar (private mandatory and private voluntary) systems that would make up for the declining PAYG 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 low and stagnant second-pillar contribution rate of 5 percent, the financial performance of the pension system has not met early expectations. Moreover, several of the basic pension parameters have not been set at sustainable levels, including on account of a low retirement age for women, low 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 of high inflation in 1993, which in both cases ruled in favor ofhigher pensions. 45. At the same time, the second pillar is still too underdeveloped to generate the hoped-for replacement rates. The contribution rate for the second pillar is low compared to other countries. As a consequence, second pillar benefits will not be sufficient to balance the reduction in PAYGbenefits, even if the rate of 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 its returns improve. To achieve this: o The 5 percentage points ofcontributions that are diverted to finance the second pillar benefits would need to be increased to compensate for the reduction in PAYG 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 of Insured Members' Registry (REGOS) devoted to second pillar contribution collection and individual account management. Second, to make room for such expansion, the PAYG 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 of 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. To offset this, the government has at its 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 PAYG system from 2.8 percent of GDP in 2005 to 0.8 percent ofGDP in 2020 and eliminate it in 2030. o Reducing the weight of 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, of course, of a rapidly declining replacement rate in the PAYG system (declining to 30 percent by 2015).2 Indexation with inflation plus 25 percent of 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 of early retirement3 would reduce the deficit by 0.1 percent ofGDP in the first year, and by 0.25 percent ofGDP in 2022.

Fiscal impact of indexation is strong because the same indexation pattern is applied for both past earnings valorization as well 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 of 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 of 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 of privileged new pension benefits to general PAYG benefits by 2027. This would reduce the deficit to 1.5 percent ofGDP by 2027. 0 Stopping the expansion of 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 PAYG system provisions. Abolishing the “100 Kuna plus six percent” supplement is 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 of GDP, and open fiscal space to increase the second pillar contribution rate. However, this option seems to be politically and socially unrealistic. Still, it is 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 ofthe supplement by about one-half. Extracting the supplement from the base of eligible beneficiaries, extending it to all current and future beneficiaries and freezing it or phasing it out over a longer period of time. This scenario would yield a smaller fiscal savings than the previous one. Fiscal space for the increase ofsecond 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 is the most fiscally demanding, and would require additional annual pension expenditures of 0.3 percent of 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 of this scenario would similarly work against raising second pillar contribution rate, but for a shorter period.

Social Assistance

49. Overall social assistance spending is high by international standards, but only a small share of it goes towards means-tested programs. At about four percent of GDP in 2007, social benefit spending is some two percentage points of 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 of income etc. Spending is largely driven by benefits and privileges granted to homeland war veterans and their families, while only a small fraction (0.3 percent ofGDP) is 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 is not well-targeted to the poor and is costly to administer. The majority of social benefits (65 percent) are categorically targeted and many ofthe 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 by over 700 offices, but no single institution responsible for overall policy coordination. The number of programs on offer, the number of institutions involved, and the lack of harmonization on eligibility criteria lead to a system that is costly to administer, allows for double dipping and causes unequal treatment of claimants. Adverse effects include the resulting confusion, and errors of exclusion and inclusion which negatively impacts value for money. In addition, the implementation of these eligibility criteria is sometimes subject to the discretion of local officials. 52. Furthermore, social benefits spending has increased by half percentage point of GDP since 2003 owing to the relaxation of policies in the area of maternity leaves, new benefits introduced, changes to eligibility criteria leading to increased beneficiaries, and increased nominal value of 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 of claimants are able-bodied people. Labor market participation could be encouraged by limiting the duration and introduction ofthe workfare programs. At present, the duration of the support allowance in Croatia is not limited in time, and a large number ofbeneficiaries 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 of about 1.5 billion kunas (about 0.7 percent of 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. In addition, the tax system on its own offers several tax exemptions and deductions that have a limited impact on reducing income inequality. In 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 ofthe 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 on cost ofliving increases and regular revisions and adjustments ofthe base amount ofthe poverty allowance, as currently the system leaves out many potential beneficiaries. 0 Improve targeting. The good practice of 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 of underestimating household income due to informal labor arrangements and ofunderreporting ofincome or that ofproviding 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 ofthe 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 ofthe Ministry ofHealth and Social Welfare needs to implement linkages to the other government information systems. In addition, linkages or clear mechanism of information exchange should be established with the social assistance systems of 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 of 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 ofGDP allocated on different social programs require coherent and consistent approaches supported by appropriate monitoring and evaluation system in place. Strategic planning in these areas is 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 of GDP in 2007. They are fairly concentrated in transport (railways, shipping companies), agriculture and shipyards. In comparison, EU15 countries allocate only one-sixth ofthe Croatian level on state aid. In many cases, direct and indirect subsidies have been used to postpone the resolution ofdifferent forms of enterprise crises, avoiding what otherwise would have resulted in bankruptcies and healthy restructuring ofthe 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 of the state aid to sectoral aid, while horizontal aid, which primarily tends to address market failures, receives less than one-fifth of overall aid (excluding agriculture and railways). This is 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 of the overall aid went to shipyards, while Croatia allocated almost 20 percent to sector, covering as much as 22 percent ofthe 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 of aid through the adoption of the medium-term Subsidy Reduction Plan for 2005-2007 has shown early signs ofsuccess 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 of 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 of state-subsidized programs through institutions and agencies without a proper monitoring and evaluation system in place is prone to abuse and may not provide adequate rates of returns to tax payers’ money. There is a need to further evaluate Services of 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 of aid to local utility and transport companies, but reporting and seeking approval ofthese is still inefficient. Public Administration

61. The common thread across the sectoral challenges outlined above is Croatia’s public administration which is characterized by its high cost and large size, but low effectiveness. Despite best efforts, tackling these deficiencies has proven difficult owing to a combination of factors. One is the rigidity in the organizational structures and remuneration system. The second factor is the common, but sometimes misguided, perception that EU accession requires the creation of a new layer of 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 of government, would compound the problem ofalready high wage bill and inefficiency. 62. The problem is not only fiscal--the excessive size also hampers decision-making and service delivery. The proliferation of agencies and subordinate entities with operational autonomy and often revenue-raising capabilities, has led to overlapping functions, lack of coordination and clarity about lines of accountability among ministries, agencies and other state subordinate entities. This creates problems for the execution of government functions, complicates policy-making and implementation, places a huge burden on coordination and management and ultimately adversely impacts value-for-money and the quality ofservice 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 of new EU member states suggests that this will take time. The harmonization with the acquis is not a “one-off’ but a continuing effort, which needs to be supported by the creation of soundly performing systems across the government, with professional, merit-based, and independent civil 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 of individual civil servants and the rank that they occupy, which in turn is determined by the years in service and the level of 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 of a Human Resource Management Information System which links 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 of administrative structures -- with a view to bringing organizational structures of ministries, state agencies and offices of 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 ofthese 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 of policy making. The Croatian government has initiated the reform in this area by making fiscal, social and environmental impact assessments of new policies and legislation mandatory in the past couple of years. In addition, there are plans for the introduction of the Regulatory Impact Assessment, which would be a welcome development. Concluding Note 67. Croatia is 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 of EU funds. However, best ofall, they would improve the delivery of public services, while alleviating the burden oftaxation 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 is roughly on par with the average for European transition countries. Inflation has been modest despite higher prices for imported oil 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 of the exchange rate in the face of robust capital inflows. However, the oil and commodity price increases have contributed to a widening of 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 of 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 of the business environment and reforms of public administration and the labor market. Croatia now confronts the need for a major fiscal adjustment in the next couple ofyears 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 of GDP. Much of this debt is external, denominated in foreign currency, and is short term. Until recently access to capital has been relatively easy and inexpensive, however this has shifted with global trends. Moreover, the significant contribution of privatization receipts to net inflows in the past will not continue for much longer. Croatia must reinforce recent steps taken to put its public debt on a sustainable path and insulate its economy from external shocks. 1.4. Vulnerability to exchange rate changes is 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 is causing the private sector investment savings balance to deteriorate. External debt is now 95.7 percent of GDP of which roughly 72 percent is private. Moreover, a large share of domestic debt is denominated in, or linked to foreign currency. Of the government’s domestic debt, the equivalent of 40 percent of GDP is denominated in foreign currency. Similarly, the bulk of lending by domestic banks to the private sector is denominated or linked in foreign currencies. The central bank has sought to stabilize the exchange rate and limit foreign borrowing. But the conduct of monetary policy is made difficult by the high degree of euroization which limits options for interest rate policy and places high expectations on managing the exchange rate. A. MODERATEGROWTH, 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 of personal consumption on a declining path during Figure 1.1: Contribution to Growth 2005 and 2006 (at 2 percent average), about half the pace of growth in 2002- 2003. (Figure 1.1, Table 1.1). In 2007 this has been reversed, with the contribution of personal consumption surging to 3.7 percent. The contribution of 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 of imports and weaker exports of services (mainly 1888 I889 2WO 2W1 2002 2003 2034 2W5 2006 Mo7 tourism). Accelerating- investment was the key driver of the overall increase in S~~~~~:CROSTAT 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 of government consumption, at the highest rate over the four-year period. 1.6. In the period 2000 - 2007 Figure 1.2:Cross-Country Macro Comparison, 2007 average growth rate of GDP was 4.6 12 percent which was below the average of 5.6 percent for the EU105’6. In 2008 10 and 2009 it is expected that real GDP 0 growth will continue to lag that of the 6 EU10. While the impact of government 4 consumption will be neutral given the announced fiscal consolidation effort, 2 private consumption and investment will 0 Fucal defcit. % of Wgrowth. % hflabn % pa 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 of GDP in 2008 as opposed to 1.2 percent of GDP in 2007) and slower credit growth affected by further monetary tightening. The current account deficit is likely to remain high. This raises the question whether such consumption- and investment-driven growth is sustainable while structural fundamentals are still 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 is 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 of 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 is influenced by the very strong growth in the Baltics.

30 employment protection rules. Also, while there are some indications of 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 6 4 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 3 A 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 2 9 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 of export of 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 of 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 ofimports) 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 7 A 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 ofFinance, 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 of the decade. Average nominal wages rose 4.5percent per year during 2005-2006 compared with productivity growth of 4.6 percent, and average annual inflation of 3.3 percent. Restrained wage growth reflects, in part, greater labor market flexibility, including the prevalence of fixed-term contracts that echo the changing structure ofjobs in fast growing sectors. However, the evident mismatch of 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 of price growth in 2006. However, due to the rise of food and oil prices at the global market, the inflation started to surge at the end of the year, and this continued in 2008. Domestic

31 producer prices of 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 of such activities results in underestimation of GDP and overestimation of economic indicators expressed as a share of GDP. Therefore, the European Commission under the Eurostat Exhaustiveness Programme requires all EU member states to include an estimate of the non-observed economy in their official GDP data. All the new member states corrected their official GDP figures for the value of the non-observed economy, with adjustments in 2000 varying from 5.8 percent in the case ofMalta to 18.9 percent in the case of Lithuania. Croatia participated in the Eurostat-OECD Non-Exhaustiveness of National Accounts Project for Western Balkan Countries in 2005. The most significant sources of non-comparability of Croatian national accounts with those of EU members arise from the treatment of underground economy and imputed dwelling rents. The estimated increase in GDP due to all types ofnon-exhaustiveness (including methodological changes related to the treatment of rentals of dwelling services) for period 1998-2004 amounted on 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 on the main macroeconomic indicators for Croatian economy. The gap in GDP per capita, in purchasing power standard terms, between Croatia and the EU-25 reduced from 52 to 45 percent. Furthermore, the share of total public expenditures in GDP declines, placing Croatia below the average level of the EU15, but still some 4 percentage points above the average for EU8+2 member states. In terms ofthe Maastricht convergence criteria, the adjustments ofGDP 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 % of GDP I -3.6 I -3.1 I Public debt, as % of GDP 52.3 I 45.5 Current account balance. as % of GDP -6.6 I -5.8 I Foreign debt, as % of 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 ofthe 1990's. Reduced tax revenues (in particular indirect taxes) without offsetting expenditure reductions resulted in a rapid deterioration ofthe fiscal deficit to 8.4 percent of 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 ofprimary expenditure (mostly current expenditure), paid off in 2002 as fiscal policy changes resulted in positive current public sector savings. From then on the Government contributed positively to the savings investment gap; i.e. a portion of public investment is 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, YOof GDP and policy reversals in 2004 offset some of the early long-term reform efforts. Since the beginning of 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 of 2004 when the general government deficit was reduced from 6.3 percent to 4.9 percent of 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 of GDP. The primary deficit, however, remains at around 0.2 percent Figure 1.4:General Government Balance Comparison, YOof GDP of GDP (2007). dCEECs -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 harmonization of tax policy with the .g J 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 Government Debt and population, will require strong fiscal Guarantees, % of GDP adjustments in the years ahead. 60

1.13. Furthermore, financing of 55 large deficits, up until now, has been facilitated by relatively easy access to international capital markets, and by significant privatization receipts. As a result, the share of overall public debt' to GDP has expanded from 19.5 to 47.8 percent of GDP from 1995 to 2007. Access to external and domestic 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 financing has, however, become not as I favorable in terms of costs and Source: CNB, MoF, staff estimate. availability as in 2006. Also, the use of

Public debt is defined as the debt of consolidated general government, general government guaranteed debt and the debt of Croatian Bank for Reconstruction and Development (HBOR).

33 privatization receipts to finance deficits cannot be part of a long-term strategy as receipts are expected to drop off sharply after the privatization of telecom and oil company in 2007.

B. STRUCTURAL BALANCEAND FISCAL SUSTAINABILITY 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 I...-&Tntnrnd-.uL 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 of Government Debt, in % conventional measures can be 2002 2003 2004 2005 2006 misleading as 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 of 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 is 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 ofInterest Rates 100 100 100 100 100 eliminating the self-correcting Fixed 52.8 57.9 62.3 60.0 64.7 cyclical component of the net Floating 47.2 42.1 37.7 40.0 35.3 deficit. In assessing the fiscal stance, the primary balance is Ofcentral 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 is a policy variable); and a non-discretionary component that moves with the business cycle'. Construction ofthe cyclically-adjusted budget balance entails estimation of 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 effects of external shocks'. From 1995 50 to 1999, with the exception of 1998 when fiscal policy was restrictive and countercyclical, discretionary fiscal policy was expansionary and acted procyclically. In 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 of a large current account deficit was mostly missing. Tight money and a loose fiscal stance not only exacerbated the pressure towards appreciation ofthe real exchange rate, but also adversely affected the private sector through the resulting high interest rates."

' For the methodology behind the construction ofthe 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 ofthe fiscal-monetary policy mix on the exchange rate can be illustrated by a modified version of the Mundell-Fleming model in which it is assumed that the domestic and foreign financial markets are perfectly

35 What is the Size of the Debt-Stabilizing Primary Balance? 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 ofGDP) assessing debt prospects. 2006 Outcome 4.3 1.1 3.2 -1.8 -4.1 Assuming real GDP growth of 4.5 percent, Baseline Scenario 4.5 2.0 3.0 -1.1 -3.4 inflation of 3 percent and Growth Scenarios 2.5 -0.2 -2.5 an average nominal interest 3.5 -0.6 -3.0 rate of 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 of 2.3 percent of 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 of 0.0 5.0 -2.0 -4.4 Source: World Bank staff calculations. 3.4 percent of GDP under the baseline scenario'*. While maintaining a primary deficit equal to 1.1 percent of GDP would help stabilize general government debt at below 40 percent of GDP, excluding government guarantees, fiscal policy is 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 of GDP relative to the preliminary 2007 outcome, with pensioners' debt repayment equal to an additional 1.2 percent of 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 of 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 ofthe domestic currency. 11 With transfers from the central bank to the government amounting to nil during 2003-2005 and 0.1-0.2 percent of GDP earlier, it is assumed that seignorage and interest on foreign reserves is capitalized by the central bank and is 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, 2006-201 1 (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 % of GDP) 46.9 44.1 41.4 37.3 35.6 34.0 32.0 Nominal GDP (In millions of kuna) 23 1,349 250,590 275,078 303,800 332,200 362,600 395,500 Real Growth (In percent) 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 (In percent) 4.7 4.3 4.6 4.9 5 .O 5.0 5 .O Real interest rate (In percent) 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 is likely to remain under control over the medium term. With the policies now in place targeting narrowing of the primary deficit and completion of privatization of 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 of 1 percent ofGDP will stabilize debt at that level. 1.24. Stress tests reveal that fiscal sustainability is 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 ofGDP despite the assumed fiscal consolidation. Were the kuna to experience a one-off depreciation of 30 percent, government debt will rise to about 55 percent of GDP and decline only gradually over the medium term. Government debt appears resilient to modest shocks to real GDP growth, by contrast, with a 1 standard deviation shock to real GDP growth (or growth of3.5 percent rather than 4.5 percent) keeping debt below 45 percent ofGDP.

37 C. EXTERNALVULNERABILITY

1.25. External imbalances remain large despite some fiscal tightening in 2004-2006 and efforts by the monetary authorities to curb foreign borrowing by 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 ofGDP, added to corporate imbalances and imports. With overly restrictive regulation hampering business creation and exit and a less than favorable business environment limiting inflows of greenfield foreign direct investment, growth in exports has been substantially below the pace of most EUlO countries. Households have also reduced savings and increased borrowing from domestic banks to fund purchases of 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 of 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 ofbanks’ new lending remained high by international standards. 1.27. With 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 ofFDI was reinvested earnings and recapitalizations ofseveral 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 of FDI into food and beverages production and real estate services. FDI amounted to USD 4.8 billion in 2007 (or 9.1 percent of GDP), which is 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 of 2007, equivalent to 5.2 months of imports of goods and non-factor services, which is an increase of 6.3 percent on top of 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 of cash and deposits amounted to USD 1.6 billion in 2005, which was around one third of total net capital inflows. Banks boosted deposit drawdowns to fund domestic credit, as direct borrowing from abroad was limited by the growing cost ofregulation. In 2006, this was reversed, while mother banks invested substantially through deposits in daughter banks.

38 Figure 1.7: Evolution of Croatia's External Vulnerability, 2000-2007

Real GDP Growth has been strong ...... and injlatwn mokrak

6 6 [ 12-mmhpercentchange) 5 5 10 8 demand 8

-2 0. / -0 -2 . -2 0l-0 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 ...

5t i5 -8-6 4 2000 2001 2002 2003 2004 2005 2006 2007 ."

... 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 of GDP by the end of 2007 from 89.8 percent in 200613 after it had more than doubled since 1998. Relative to current account receipts (194.9 percent of total exports) external debt is one of the largest in the region. Relative to GDP, the ratio is 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 of GDP at the end of 2007, while domestic banks and other sectors (including intercompany lending) owed foreign creditors the equivalent of 25.4 and 50.9 percent of GDP, respectively.

l3Em-denominated debt at the end of 2007 increased a bit less, from 85.5 percent in 2006 to 89.1 percent of GDP, due to US dollar depreciation.

39 Government’s share was declining in the last three years (end-2004 share was 27.7 percent) due to a shift of 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 of banks went down from 31.4 percent at end-2006 to 25.4 percent of GDP at end-2007. In contrast, external debt of other sectors (mostly enterprises) stood at 39.4 percent of GDP at end-2007, making up 41.2 percent of total external debt. These debt creation flows were outside the scope of influence of monetary policy, thus contributing to the overall increase of external debt in 2007. Short- term foreign debt was equivalent to 50.8 percent of foreign exchange reserves at the end of 2007 and is consistently fluctuating around 14 percent of total external debt.

BOX1.2: Lessons from Portugal and Singapore Portugal represents the case of the most severe real adjustment of 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 of its use of Euro. Hence, the current account deficit remained high, and, with a high fiscal deficit, there was no 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 of GNI, financed by large capital inflows mainly in the form ofFDI. Large capital inflows and external imbalance over two decades were not a cause ofconcern for policymakers as these inflows represented the investment needs of a rapidly developing industrialized economy. Subsequently, since 1998, the current account surplus has accounted for 21 percent of 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 of current account deficits does not automatically indicate that there is 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 by government; Policy action should be focused on increasing savings, not only on part of increasing public savings, but also creating proper incentives for encouraging private savings; In absence of 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 of 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 of the Croatian economy (Box 1.2). In 2007, amortization due within a year, with short-term debt included, amounted to 49.8 percent of reserves, while repayments of long-term debt and total interest amounted to 32.7 percent of 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 of years, mainly due to the more favorable term structure of external debt. 1.31. The vulnerabilities of the financial sector are significant, posing a substantial threat to hard-won financial stability. Euroization of the economy is 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 of total deposits and about 90 percent of the banking system’s foreign assets. In 2007, around 63 percent of 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 is also one ofthe highest in the region and requires vigilance. 1.32. Vulnerabilities arise from the large share of domestic debt denominated or linked to foreign currency. Of the government’s domestic debt, the equivalent of 40percent of GDP is denominated in foreign currency. Similarly, the bulk of lending by domestic banks to the private sector is denominated or linked in foreign currencies. This is 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 of their FX and FX-related liabilities in 2006. This regulation came on top of high capital adequacy ratio for the banking system as a whole (15 percent as of mid 2007), so banks initiated new cycle of re-capitalizations in the second half of 2007. Given generally perceived strength of accounting and prudential standards, and the degree of development ofrisk management and banking supervision, soundness ofthe banking system seems to prevent immediate vulnerability threats or sudden reversals in capital flows. D. MONETARYPOLICY RESPONSE 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. To slow the pace of foreign borrowing by domestic banks, the central bank introduced in August 2004 marginal reserve requirements (MRR) on domestic banks’ growth in foreign liabilitie~’~. The rate of MRR increased from the initial 24 percent to 30 percent in February 2005, 40 percent in 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 ofthe growth relative to the average at the beginning of 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 of the minimum ratio of 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 of 2006. On balance, these measures eased monetary conditions substantially, as reflected in the discussion of the structure of net capital inflows in 2005 and associated drawdown of 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 of CNB bills on credit growth in excess of 12 percent per annum. Further tightening happened in July 2007, when the CNB tightened the credit growth ceiling for the second half ofthe 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 to 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 to corporate

l4The MRR was levied on the excess of foreign liabilities relative to an initial calculation period, June 2004.

41 sector continued to slow down which may be the effect of 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 the one percent against euro during 2006 (1.9 percent 30 1 against US 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 US dollar. The central bank’s emphasis on maintaining exchange rate -20 ,/’ tCZI HU-R-H-SK-SI I.,,.._J stability has limited the kuna appreciatioddepreciation against the euro within a band of 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 of 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 is 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 of the Stand-by Arrangement in November 2006, their responsibility for pursuing sustainable policies have increased, especially in the area of fiscal adjustment. Policies centered on the level, composition and targeting of expenditures, as discussed in the remainder of 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 of 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 acknowledged adequate progress on sustaining macroeconomic stability, but emphasized delays in the implementation of structural reforms, especially privatization and the need to accelerate fiscal consolidation efforts. The Croatian Government confirmed in 2006 its intention not to require a successor arrangement,

1.39. While prospects for EU membership provide an impetus for reform progress, greater effort is required to advance fiscal consolidation if stability is 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 of payment difficulties. While Croatia’s currently still favorable and long-standing market access mitigates this risk to an extent, investor sentiment could shift 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 is larger than optimal from a growth and efficiency point of view.” It is also almost ten percent above the public spending levels in new EU member states. Recent work suggests that expenditures over 35 percent of GDP may have negative implications for growth. Moreover, Croatia still needs to integrate EU-accession related costs into its 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 ofthe 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 of the EU largely because of 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 of deficit-creating cuts in taxation. However, in order to increase competitiveness, the tax burden on 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 of the current tax structure which at present features a distortionary combination of 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 its own knowledge base of 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 of a standardized methodology for ministry strategic plans, drafting of an annual strategic document pointing out key policy priorities, and adoption ofan annual strategic document as a supplement to the budget proposal reflecting arguments for selection of priorities.

A. FISCAL DEVELOPMENTS DURING THE LASTDECADE

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 of consumption.

l5It needs to be noted that Croatia did not correct its official GDP figures fully for non-observed economy, as o posed to all new EU member states (see Box 1.1). ‘gfvleasured as a share oftax 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 its stabilization program with the expenditure expansion, considerable efforts were made on revenue mobilization. In fact, as a result ofsuccessive fiscal reforms, the Government succeeded in improving tax administration and at the same time, made substantial progress in aligning its tax system to international standards. A key step in this direction, was the introduction ofthe VAT, at the beginning of 1998, which generated an increase in tax revenues equivalent to almost 4 percentage points ofGDP in that year. In aggregate, tax collection expanded by 11 percentage points ofGDP between 1991 and 1998, with tax revenues as a share ofGDP reaching 46.9 percent ofGDP in 1998, turning Croatia into one ofthe 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 of revenues ended in late 1998 amid a contraction of the economy, and with government inability to cut expenditures in an election year, fiscal deficits hit eight percent ofGDP. 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 of 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 ofGDP resulting in a deficit over 6 percent of 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 of GDP in 2007 (excluding off-budget pensioners’ debt repayments that add an additional 1.2 percentage point to the deficit figure and half of percentage point of HBOR” deficit). The fiscal consolidation was achieved through reductions in expenditures of about two percentage points of 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 of one-off nontax receipts (dividends from public enterprises and concessions), capital revenues and grants.’* However, this has proven to 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 of GDP and the HBOR deficit of 0.5 percent of GDP, the 2007 fiscal deficit was marginally reduced compared to 2006. 2.8 The inertia of spending patterns calls for decisive consolidation actions, as the impact will be felt only in the medium-term. The current level of spending at around 49 percent ofGDP is two percentage points of GDP above the EU15 level and some ten percentage points of 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 of GDP declined by half percentage point of 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 of 3.7 percent of GDP. The 2005 MTEF 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 of GDP.

45 meet pre-accession requirements. Prioritization is important. Although it is difficult to gauge the net fiscal effect at this point, there is 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 of EU accession have sometimes been estimated at an average three percentage points of GDP annually, it is 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 of the Public Sector in Croatia The public 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; is composed of 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 of 426 municipalities, 123 cities and 21 counties. The City of Zagreb has a special status of both town and county.

I.Central Government

JII ,...... ! Extra Budgetary Funds and 1 ...... j: A gencies Government i...... :

,...... I Local and Regional 111. General e...... j. Governments Government l’ ......

” In 2008, Pension, Health and EmploymentI 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 is 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 of consolidated general government expenditure to GDP that Croatia needs to achieve. Table 2.1: Consolidated General Government ExDenditure in Selected Countries (% of GDP) 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 oftransition, consolidation of public finances has been one ofthe major tasks faced by policy makers. However, determining the optimal size of government is an interesting challenge for all countries regardless of the level of economic development. 2.11 Although there is 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 is the lack of empirical literature on the size of the government in transition countries. Below we present estimates ofgovernment spending (as a share of GDP) as a function of various underlying factors, using a set of assumptions and a model developed by Barbone and Polackova (1996). This is 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 of growth of government spending have been analyzed quite extensively and the existing literature offers a wide range of 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 ofthem relative to private goods, than do poor ones.) Accordingly the ratio ofbudgetary spending to GDP should rise with per ca ita GDP. Another economic factor found to be positively correlated with government size is trade openness’! although one might intuitively expect the opposite, since it is often assumed that governments in closed economies intervene more in the market via trade restrictions. This paradox is explained by arguing that government expenditures are used to provide social insurance against the risk of terms oftrade shocks that open economies face. A further hypothesis is that centralized governments spend more. The reasoning is that fiscal decentralization encourages competition for tax bases which may help to reduce the size of government, and that reliance on grants and transfers from higher levels of government to finance sub-national governments is 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 ofpopulation, as well as demographic changes (ageing population), urbanization etc., are likely to create upward pressures on government spending22.For example, a large share ofelderly in the population increases demand for government spending on pensions, health care, and social security, while a large share of 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 of society, or higher literacy rates, or a high level ofsocial 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 of increasing state activity”. 21 Rodrik, 1998; Alesina and Warcziarg, 1998. 22 Barbone and Polackova, 1996. 23 In the case of Croatia, ESA95 shows approximately one percentage point of 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 is Government of the Republic of Croatia - 2007 Pre-Accession Economic Programme, November 2007, page 21.

48 2.12 The cross country estimates give an 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 on the above analysis, regression estimates were made using the following explanatory variables: GDP per capita at purchasing power prices (gdp pc) capturing the effect ofthe level of wealth on demand for public services; the ratio of public debt to GDP (debt) capturing the effect of greater debt service costs on 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 as a proxy for the quality of government Dependent variable: Total general government spending), the unemployment rate, and the urbanization rate, were also tested but Estimates of 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 is public *t-statistics in the parenthesis. debt, the greater is general government Source: Author's calculation. spending. One might also observe that GDP per capita has the greatest explanatory power, followed by the share ofpublic debt in GDP. The age dependency ratio, however, yielded poor explanatory power, which could partly be a reflection of the pension reforms that took place in most countries in the sample. Figure 2.1: Deviation of Actual Government Size from 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 analysis yields a lndexPCblalbrediclBd. Predicted=lOO predicted level of general I government spending given the Source: Author's calculation. Figure 2.2: Actual vs. Predicted Level of General Government explanatory variables. Figure 2.2 Expenditures, % of GDP, 2005* presents the actual and predicted level of general government 60 00 expenditures for selected 50 00 countries. The predicted 40 00 government expenditure for Croatia is 43.3 percent of GDP, 30 00 which is 5.7 percentage points less 20 00 than the actual. 1000

2.14 Among selected old EU 0 00 countries, the most pronounced AT BG CZ DK EE FI FR HR HU IE LT LV NE PL RO SE SI SK UK "overspenders" are Denmark, OActual E Predicted Finland, France and Sweden. However, this may be a matter of Source: Author's calculation.

49 public choice related to a desire for the well developed social safety net characteristics of 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 ofgoods 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 of government spending and economic growth is expected to be positive in the countries where government spending is 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 of public goods which raise the marginal product of capital. As the size of the government grows, the impact of 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 no 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 of 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 of fiscal automatic stabilizers when growth slows down but spending is sustained because of a large share of 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 ofweakening revenues, a growth slowdown is 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 ofthe government is to be preserved. High tax rates reduce the rate of return to saving and investment and may also bring distortions into labor markets. The composition of 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 of 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 on growth in Europe and Central Asia countries~’35 percent of GDP appears to be the critical threshold beyond which public spending negatively affects growth. Above 35 percent, a sustained increase of 1 percent of GDP in general government expenditures could reduce growth by an estimated 0.3-0.4 percentage points per year. While the estimate is rough it indicates that higher levels of 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), Kmas (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 by 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 of government sector. It is 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 of resources in support of 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 by recent developments in Hungarian public finances. In light of that, Croatia should devote more effort towards consolidation of 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 of 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 of the business environment and reforms of public administration and labor market. Inflows of 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 of 33 banks, accounting for Figure 2.3: Financial Sector Structure, Assets Distribution in 5 percent of banking system capital, 2007 are still government-owned. A major Leasing mmpanies ,,,,Jn8urance mmwnies consolidation since the mid-1990s has Pension funds 4% 7 I 5% reduced the number of banks from 60 \I / as of 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 of all financial institution Banks assets held by banks. However, 74% leasing and insurance companies, as 1 Source: HAWA and CNB. well as pension and investment funds are developing quickly. The capital market is becoming stronger, with market capitalization at 143 percent of GDP in 2007 and the turnover ratio (value of shares traded as percent of capitalization) of 16.8 in 2007. Government securities no longer dominate the active trading since the October 2006 IPO of INA Oil Company. Bank capital has been strengthened in recent years with privatization, and average capital is now about USD208 million (end-2007). Average assets per bank stood at USD1,879 million (June 2007). Thus, by transition country standards, Croatia is among the best performers based on balance sheet indicators. The high share of lending in foreign currency andor

51 linked to exchange rate and the high share of foreign currency deposits, however, remain a cause for concern due to potential vulnerabilities created by FX exposures. Despite a reduction in the degree of 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 is less than all new member states, including Romania and

Bulgaria. Although in 2004-05 most of 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 of privatization in the second half of 2006 and eariy 2007, a large portion of the roughly 950 companies (down 40 50 60 70 80 from Over 3 O0 in 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 is changing and the Government pursued mass sales of a 17 percent minority stake in the national oil company (INA), followed by public offering of telecom (T-HT) in its final stage ofprivatization 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 of GDP). Further reduction is likely to be challenging in 2008 amid the planned restructuring of shipyards and postponement of their privatization. With the adoption of 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 still ranks low in terms of the ease of doing business, although there are encouraging signs.*’ Dealing with licenses, protecting investors and registering property seem to be especially burdensome. An inefficient judicial system still hinders the exit ofnon-viable firms, while execution and enforcement of contracts and property rights are still weak compared to OECD countries, despite recent improvements under the judicial reform effort. To 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 of 2.5 percent of GDP. So far, one-quarter ofrecommendations 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 of 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 IT 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 COMPOSITION OF GENERALGOVERNMENT EXPENDITURE

2.27 The next two sections provide an overview and cross-country comparisons of government expenditures in order to facilitate identification of areas where expenditure reductions in the future could be made. It is important to note that identifying reforms in the main expenditure programs is not a one-shot exercise, but must be a continuous process of 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 ofGDP, from 56.6 percent ofGDP in 1999 to 52.0 percent in 2001. Fiscal adjustment was carried out through a reduction of public sector wages, other purchases ofgoods and services and capital expenditure (although the latter was completely reversed in 2002 and especially in 2003 due to the implementation ofthe first phase ofan 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 of fiscal consolidation back on track with the view to reducing general government spending and thus the deficit. Consequently, by the end of 2006, general government expenditures stood at 48.4 percent of GDP, down 2.8 percentage points of 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 of debt to pensioners and deficit of HBOR are taken into account (1.7 percent of GDP taken off budget), the trend in reduction of the general government expenditure was interrupted. 2.30 The analysis of the economic composition of public expenditures in Croatia is based on the Consolidated General Government (CGG) accounts and on a comparison of the economic

29 The World Bank and the IFC, 2007, Doing Business, ~~.doinabusiness.orq,Washington DC. 30 According to TTFSE Iproject funded by the World Bank.

53 composition of the CGG expenditure in Croatia with that of EU new member states, the EU15 and EU cohesion c~untries.~’Not only is the current size of both revenues and expenditures larger in Croatia than in other transition countries, but also some of the components and their latest trends differ substantially from those of 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 ofthe highest levels ofexpenditure of the countries in the comparator group (notably, in 2006 only Hungary had higher expenditures), and on average over the period 2000-2006, Croatian expenditure was more than 10 percent ofGDP higher than the average EUlO countries and EU cohesion countries. In fact, Croatia’s public sector was extracting some four percent of GDP more than EU15; Wages and salaries are also on average higher in comparison to EUlO countries (except for Hungary and Slovenia). Croatia’s wage bill has been declining in percent of 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 is still two-thirds higher than the average for EU15 and is 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 ofGDP 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, YO FGDP 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 of GDP less on

31 This analysis is based on estimated accrual basis information for all units of local government; therefore it 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 of 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 of the comparators; however, none of them matches the EU average in terms of government employment. While the EU15 on average employ 8.9 percent of their population in the government sector, this ratio for Croatia and the EUlO is 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 of employment profile, Croatia is similar to Slovakia, Bulgaria, Poland and Estonia, but in terms of public resources spent on public employee wages, Croatia spends one percent of GDP more than the others. 2.33 Average spending on operations and maintenance in Croatia is 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 of defense spending. Given Croatia’s prospects for NATO accession, there is little room for further savings in the non-wage component of defense. A related concern is 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 of GDP which is less than the EU15 countries although it is three to four percentage points of GDP more than the cohesion and new EU countries. The largest portion is for social spending and subsidies both of 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 of 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 of 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 (YOof GDP), 2006 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 is difficult to evaluate if subsidies have achieved these objectives. Overall, subsidies of the CGG, including indirect ones, amounted to over 3.3 percent of GDP in 2007 and were fairly concentrated in transport (railways and the shipping companies), agriculture and shipyards. One third of 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 Horizontal 52.0 29.3 subsidies which according to the EU rules Sectoral 30.4 57.5 as well as from the economic point of view I 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 of GDP, while social spending has grown by 1.9 percentage points of GDP. While 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 of defense (which accounted for the bulk of the four percentage point decline), as well as health and housing due to finalization ofpost-war reconstruction. Table 2.6: Consolidated General Government Expenditures by Functional Classification 1995-2006, YO of 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 1.1 ... affairs 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 as the EUlO countries and cohesion countries. Defense expenditure patterns in the past reveal that adjustment has been accomplished through a reduction of the wage bill and non-wage costs. However, this trend may soon be reversed due to the modernization requirements posed by the country’s NATO accession aspirations. In the future, defense expenditures in Croatia will likely follow the path of EU countries that are already members or in the advanced stage of the adjustment to the NATO standards. This implies that the non-labor cost will need to grow and labor costs decline further.

2.49 In the social sectors the following patterns are emerging: Education spending was approximately 1.3 percentage points of 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 of comparators;

0 Public health spending at 6.8 percent of 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 is anecdotal evidence

57 that maintenance costs deferred over the last decade will weigh on hture budgets, but estimates are not available;

0 Social security, although lower than in EU15, is still at the highest end once compared to the EUlO despite a decline that started in 2001 due to the pension reform impact. The ratio of social security spending to GDP resembles Scandinavian countries, although the relative benefits that systems provide are not comparable. Croatia’s social welfare system still suffers from inadequate targeting and overlapping of benefits for which rationalization could bring significant savings and improvement of services. However, Croatia’s social welfare system also provides substantial benefits to war veterans’, due to consequences ofthe Homeland war, a type ofspending not found in other comparator countries;

0 Spending on housing and community affairs is over 2 percentage points of GDP higher than in comparators due to post-war reconstruction, another type of spending specific to Croatia’s post-war circumstances. 2.50 Transport spending exceeds the comparators’ spending patterns and appears excessive. This is mostly a result ofambitious investment program for roads and motorways started in 2003 that has pushed public spending around two percentage points of GDP higher than in comparator countries. However, in the period 2006-2008 spending on roads and motorways was supposed to decline below three percent of GDP at the expense of allocation for maintenance as planned by the government medium-term road strategy.

2.51 This section examined the trends in the main components of sectoral spending. Pensions, education, health, social protection, transport, environment and public administration amount to 72 percent of overall CGG expenditure (without net lending). Given their significance to the social well being of a large majority of 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 of analysis that needs to be undertaken for all parts of the budget to achieve a comprehensive reform ofpublic 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 of 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). At 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 of 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 of 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 of economic Cohesion countries 39.6 34.4 activity underground during 1990’s and has reduced profitability in the formal sector. ” ConsolidatedGeneral Government, Source: IMF; Government Finance Statistics; International Financial 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 of 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 of fee charges, and, while there is no registry of administrative fees, some estimate that there is over eighty different kinds, some of 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 is a limited room for 20 additional revenue gains from improving tax administration, except in the area of 10 local property tax33 and payroll 0 contributions where the introduction of a VAT Top Corporate Top Wrronal Fayroll Tax unified system of collection is expected to hconm Tax Rats hconm Tax Rate improve resource mobilization in what is Sources: MoFs, www.worldwide-tax.com, United States Social one of the weakest points in the Croatian Security Administration, WI3 staff calculations.

33 Currently Croatia collects tax on real estate transactions. Due to the inadequate state of affairs in the land registry and the lack of a single property registry, the introduction of a modern property tax must be postponed until the preconditions for its assessment are in place.

59 tax administration. 2.56 Tax 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 ofmore 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 ofone ofthe highest VAT rates in Europe. 2.57 Since 2000, following the Figure 2.8: Revenue Ratios (%GDP) “midi” tax reformJ4 the Government , has made substantial efforts to reduce Oh Of OD‘ ...... the overall tax burden which has now 50,0 fallen by three percent of 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 its primary aim 30.0 (of reducing the tax burden), a number of 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 of second pillar contributions (introduced in 2002) was assigned to REGOS, designed as a central registry of socially insured individuals and the second pillar clearing institution. In 2005, the Tax Department took over all responsibilities for collection, control and enforcement of 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 is 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 on employers and create high compliance costs. 2.63 Despite REGOS’ functioning as a central registry of socially insured individuals, 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 of the annual tax statement, with the Tax Department. Although FINA (Financial Agency) introduced electronic one- stop payroll tax registration in 2007 there is still no single reporting shop, initially designed to be in REGOS. Each institution still maintains its own registry oftaxpayers/insured individuals; the registry ofsurtax-payers does not exist which makes control of 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 of REGOS and introduction of unified RS monthly reporting form was done with the objective of creating a central database of 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 of absorbing the RS form into its reporting system, the Tax Department has rejected using it as a key source of information due to its alleged incompatibility with Tax Department data requirements and the monthly frequency of 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 ofconsolidating the reporting on all payroll taxes would not be implemented as scheduled. Finally, in 2004 the Law on Consolidated Reporting on Social Contributions, Personal Income Tax and Surtax was amended and the unified reporting concept was abolished. 2.65 Control and enforcement of 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 of a central database of taxpayers and socially insured individuals, whose status is 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 of personal income tax and surtax liabilities without the need for subsequent reconciliation. Monthly data flow also enables prompt provision ofinformation to insured individuals allowing them to check whether their employer is paying contributions on time.

61 2.66 Recognizing existing inefficiencies in payroll tax registration, reporting, and data warehousing processes, and inadequately defined roles of 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 its institutional framework. If REGOS is 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 of all tax and contribution payers could be created in the Tax Department, with a single registration point in its central registry of 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 of Personal Income Taxes 2.67 Personal income taxes (PIT) account for some 12 percent of total tax revenues in Croatia. At about 4.8 percent of GDP, PIT revenues are comparable to those in other countries: PIT revenues made about 3 percent of GDP in Slovakia and about 7 percent of GDP in Slovenia. Given the fiscal constraints in terms of large spending and a high fiscal deficit, there is 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 of allowances and exemptions and generate higher tax revenues for a given tax rate. The latter assumes higher transparency of 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,it is recommended that countries design their PIT 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 of four tax brackets with four marginal rates of 15,25, 35 and 45 percent and a number of allowances, exemptions and incentives. Because of numerous allowances, which generally can only be used by wealthier taxpayers, effective tax rate at average 9 percent (defined as a ratio of tax paid and gross income reported) is significantly lower than the nominal rates. 2.70 The PIT system is 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 of the national average gross wage (AGW). On top of this, an additional 16.5 percent can be deducted on behalf of an unemployed spouse, and 16.5 percent for one child. Allowances for children are generous; a taxpayer can apply 73 percent of AGW for three children, and almost 119 percent of AGW for four children. The allowances are higher for selected groups of persons, like elderly (66 percent of AGW) or severely disabled (9.9 percent of AGW). Furthermore, all allowances are significantly higher in the first area of the special national concern (more than double), the second area of special national concern (double allowances), and third area of special national concern and a hill and mountain

36 Stepanyan, Vahram (2003). Reforming Tax Systems: Experience of the Baltics, Russia, and Other Countries of 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 of AGW to reduce hisher tax base for 2004 2000-03 proved voluntary insurance and expense Number of taxpayers reimbursements (for housing, rents, housing Total 2,592,520 2,455,838 loans and similar). Several groups are exempt Total (%) 100 100 of 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 of 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 of taxes Pensioners 0 0 collected. Second, their distributional impact is Self-employed 0 0 highly questionable, because only wealthier Source: Tax returns, Tax Office ofCroatia, 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 pays personal income tax. The total Table 2.9: Effective tax rates in 2004 number of taxpayers in Croatia in 2004 Median Average Top 10% was about 2.6 million, of 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 of taxpayers has Effective PIT rate, % 2.5 8.5 14.5 been increasing since 2000 on average Share on PIT revenues, % * 4.5 58.0 by 2.2 percent per year, the shares of the Employees three groups remained almost Annual gross income, HRK 39,200 56,400 161,600 unchanged. Of the overall amount annual real growth 2000-04 2.7 2.5 3.9 collected, employees contributed 89 Effective PIT 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 of Share on PIT revenues, % * 8.8 51.1 social contributions in the total tax Pensioners wedge is, especially for low 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 is that all employees pay 20 Effective PIT rate, % 0.0 1.1 3.3 percent for social contributions, and the Share on PIT 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 PIT rate, % 3.5 14.4 20.2 AGW and the top decile’s employees Share on PIT revenues, % * 1.9 65.5 is less than eight percentage points. * Share on revenues collected within the group. Median: revenues collected by the bottom 50% ofthe population. Source: Tax Office of Croatia, staff calculations. ’’ The first area consist of four settlements, the second area 53 cities and municipalities, and many settlements, and the third area 68 municipalities. The Ministry of Finance, Republic of Croatia (2005). The Croatian Tax System.

63 The total tax wedge (including the 17.2 percent of contributions paid by the employer) ofthe median employee only reaches 36.2 percent. For an average employee (as defined by tax returns) the figure is 40.2 percent, and for an employee in the top it is 45.3 percent. On average, in 2004, a taxpayer paid PIT taxes equal to 8 percent of 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 no 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 is 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 ofthe higher social contributions, the sum oftax and contributions paid by average employee is 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 by 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 ofallowances and, at the same time, reduce the number ofbrackets. G. PUBLIC EXPENDITUREMANAGEMENT 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 of all line ministries and the remaining extra-budgetary funds (the health insurance, pension and employment funds). Also, the Ministry ofFinance 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 still exist (for example in the health sector). The strengthening of 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 of 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 of accounts and ESA 95 methodology, which enables cross-country comparisons of the public finance statistics across EU countries. Furthermore, the state budget coverage has been expanded from the 2006 budget onwards with the inclusion of lottery revenues, road charges, own revenues ofbudgetary users, revenues under the special regulations (administrative taxes and other earmarked revenues), and EU grants. The control of collection and the use of 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

38 The OECD reports effective tax rates in OECD (2003). Taxing Wages 2002-2003. In the other report, the sum of effective tax and social contributions paid by the average income employee, single and without children is 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 of EC, established internal audit units in all line ministries, central state organizations, and extra-budgetary funds. Their establishment is 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 its public expenditure management system (PEMS), but additional efforts have to be undertaken in the fields of: (i) performance and program based budgeting, (ii)analytical foundations of budget allocation decisions, (iii) budget transparency, and (iv) integration of strategic and budgetary planning. Program based budgeting has been formally introduced, but remains of limited relevance due to the absence of proper cost allocation mechanism and a missing set of measurable program performance indicators. Organizational and functional views on the budget still dominate over program perspective, thereby limiting transparency in budgetary presentations and consultations. Consequently, the impact of economic and social analysis of present and future impacts of public expenditures on budget allocation decisions remains limited. The adoption of 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 of systems that integrate choices of strategic priorities and selection of 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 of the Ministry of 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. evaluations of budget programs; open Dominance of central ministries C. Formal constraints; D. Hard budget constraints discussions of competing budget priorities; E. Comprehensiveness of the budget and, generally, lack of cutbacks of existing Figure 2.10: Prioritization of Expenditure Composition programs based on performance evaluations and objective criteria. 2.81 Progress in PEMS development remains limited, as 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 of consultations missing links between strategic goals and C. Flexibility of line agencies D. Comprehensiveness of the budget E. annual budgetary allocations is provided by Use of objective criteria.

39 Supported by the World Bank IDF grant for Strengthening Budget Management in 2005 and based on the methodology of Campos and Pradhan (1995).

65 comparison ofpriority rankings implied by the Strategic Development Framework 2006-20 13 (SDF) and the budget for 2007. This comparison is 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 of strategic areas and goals in the SDF cannot be matched to budgetary allocations easily. The top priority in budget 2007 is 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 is reflected in the definition of only two goals among seven in section VI on Space, Nature, Environment and Regional Development, which does not indicate a high priority ranking. On the other hand, SDF's top priority is reflected in the section on People and Knowledge that is comparable to the section on 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 is a necessary condition for broader and better assessment of relationships between strategic goals and budgetary allocations. The next step to be taken in developing an integrated framework for strategic and budgetary planning is to improve definitions of strategic goals in order to enhance measurability and ease the making of 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 of 75 goals in SDF, 32 are directly measurable. Development ofa set ofmonitoring indicators ofstrategic goal achievements, with a long run view on developing a balanced scorecard for the government is thus highly recommended. This can be achieved only if strategic planning documents are based on the same classification (program classification) as the budget plan. Table 2.10: Characteristics of SDF Table 2.11: Selected Allocations in 2006 and 2007 I 2006 I 2007 I Index I

T.4, p.16 of 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 is higher than kuna 1 bln in both 2006 and 2007; allocation is presented in the Ministry of Finance booklet; allocation is presented in a transparent way (e.g. data from T.5 "Investment in infrastructure" are not presented because it is not clear if these numbers include subsidies. Altogether, seven allocations presented in the table represent 69.1% of 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 is sufficiently regulated by the 2003 Budget Law as shown on the right hand side of the scheme below. This process is supported by macroeconomic

66 analysis and forecasting. Its results are reflected in Fiscal Policy Guidelines which ensure effective macro budgetary limits 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 of the standardized methodology for collecting ministry's strategic plans before budgetary planning process commences, 0 Drafting ofan 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 ofpriorities. These innovations in the planning process could also make substantial contributions to the budget transparency and consultation process, as early statement of priorities in draft form could be shared and discussed with key social partners and other stakeholders. Figure 2.11: Strategy Change Cycle

General scheme ofthe Schematic overview of strategy change cycle current situation

Strategic Framework ...... Visions for Development 2006- I 2013 1 Strategic goals _-_-_-______Guidelines Draft 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 Budget Parliament until 15.1 1 ...... _------I I I Policy evaluation, I I I Key element missing: I effectiveness, I I I Evaluation I efficiency, deviation I I I I analysis I I I______I

2.84 Budgetary allocation decisions are made without sufficient analytical background. Within the Ministry ofFinance and the Government in general, strengthening ofanalytical capacity to perform sectoral analysis and annual fiscal expenditure evaluations would be highly recommended. This is become even more pressing as the EU accession process substantially increases demand for analytical services needed for developing applications for use of EU funds and needs grow for more analytical inputs in regulatory build-up and improvement (for example, FUA-regulatory impact assessment, which is at its infancy stage in Croatia at present). There is an urgent need to consolidate existing, and invest in new, analytical capacity within the Croatian Government. Analysis is not a substitute for, but an aid to, decision-making which is and will always be political. The presence of high-quality analytical support clarifies options and makes political decision-making easier and more transparent. The importance of this factor cannot be over-stressed since analytical investments in general lead to higher quality of 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 ofexpenditure indicators to a complex library of research work and indicators of effectiveness of different types of 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 on a clear division of responsibilities within the integrated process. Drafts of key documents, such as multi-year development strategies, annual strategy statements (composed of 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 is 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 is in the second phase of a massive motonvay development program (2001- 2008) on which it is currently spending about 3.6 percent of GDP annually (2007). While upgrading road infrastructure has multiple benefits to a regional, social and economic development of the country unit costs for these investments are high due to excessive standards, which together with the pace of implementation are crowding out expenditure for necessary maintenance and rehabilitation of existing road networks. Despite recent increases in budget allocation for maintenance, a significant backlog remains to be addressed. Accordingly, an increased share of maintenance and rehabilitation expenditure is an objective of the Road Construction and Maintenance Strategy for 2005-2008. A focus on keeping total transport costs low will increase Croatia’s competitiveness and comparative advantage. Further steps to support this objective should include exposing road maintenance companies to greater competition, use of competitive contracting, introduction of appropriate incentive schemes for publicly-owned road operators, and development of a competitive PPP market for the provision of road infrastructure. In addition, the government needs to analyse carefully the liabilities it is incurring towards concessionaires that stem from the complex role played by the government in these operations as a shareholder. 3.2 In the railways sector the current level of operating subsidies at 0.6 percent of GDP is unsustainable, high compared to the EU and neighboring countries and could be cut by half. Labor productivity has improved, but is still very low at about 50 percent of EU27 level. Excessive staffing and wage rates that are far out of alignment with other segments ofthe labor market translate into revenues of National Railway Company (HZ) not even covering its labor costs. The sector is suffering from sharply increased competition from the rapidly expanding road network. HZ is 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 is because investment plans are not conditioned by consideration of debt financing implications nor supported by analysis of benefits and costs, and insufficient attention is given to measures to increase efficiency of existing operations. Steps are needed to limit the network to commercially viable lines and corridors, to 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 ofmajor 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 its relevance. Over 80 percent of this freight is international in nature. Aside from solid mineral fuel, oil and oil products which represent 74 percent of transit, transit of 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 is hampered by inadequate capacity, operational layout, equipment and tariff policies. Significant increase in port capacity is 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 is extensive. It comprises (a) about 1,163 km of motorways, 27,000 km of classified interurban roads and 22,000 km of local roads; and (b) a 2,664 km railway network, of 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 of Rijeka and Ploce and five secondary sea ports, plus numerous river ports on the 918 km of 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 - --C Freighl .Roads (ton-km) freight transport, for instance, increased +Freighl-Railways (Ion-km) by an average of 8 percent per year, or 160 - Passenger -Railways (pass.km) e RBgislrsd passenger cars (nurber) 1.8 times the average real GDP growth +Rmd Tramc(vehde.km) over the same period. Railway traffic 140 - 130 - has grown faster than road traffic 120 - (Figure 3.1), although roads handle 110. approximately three quarters of inland 100 - freight, while the remainder is 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 of Croatian Railways (HZ). The amount of state subsidies per traffic unit transported by rail in 2000-2007 is 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 of GDP. Implementation of the labor retrenchment program since 2000 doubled labor productivity, but this still lags far behind neighbors’ productivity standards. Subsequent wage increases have substantially raised the cost of 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 of 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 is already clear that average revenue per passenger-km and ton-km is 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 of 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 is now a significant backlog in maintenance on national and local roads. More than one-third of state roads are considered to be in poor condition. Furthermore, the cost of 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 of accountability and financial risks. Contingent liabilities stemming from the PPPs contracts have not been assessed, while the Ministry ofFinance has only recently established a registry of concessionaries and guidelines for structuring ofPPPs contracts together with annual fiscal liability ceilings. B. RAILWAYS EFFECTIVENESS 3.11 Croatian Railways (HZ) is one of the larger carriers in the South Eastern Europe, but it is still a very small railway by European standards and, even more so, by international standards. A number of European railways based in countries with similar population levels-all Baltic countries, Finland, the Slovak Republic-cany much greater volumes of traffic. Size is an important factor because economies of 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, of which 254 km are double tracked and 980 km (or 36 percent) are electrified. The core main lines encompass approximately 850 km of corridors X, Vb and Vc. The network has been relatively well maintained with 65 percent of 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 is 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 PKM 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 is 30-50 percent below Western European railways. HZ's current rolling stock and motive power inventory consists of 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’srolling stock, and motive power inventory is on average old, and the structure ofrolling stock isnot 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 is very short, even by European standards, and this depresses operating efficiency and profitability. The number of 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 of passenger-kilometers fairly steady, and the share of railways in overall passenger transport continued to decline. Although 36 percent of passengers used railways in 2006, the railways accounted for only 18.6 percent of 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 is significantly below the figures attained by other European railways. It stands at 64 percent ofthe staff productivity in Switzerland, 53 percent ofAustria’s or 46 percent of Germany. The staff productivity of HZ in 2006 stands at 50 percent of the average productivity of the EU27 or has just approached only Romanian railways’ productivity level. These figures indicate that in spite of the obtained improvements, the productivity of HZ is still 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 ofthe 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 In 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 ofrailway performance are often difficult because ofthe very different characteristics of the traffic (freight traffic is 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 of 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 TU(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 of 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 Wiry 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 of staff, however, remains very low43 percent of staff has less than secondary education. 3.18 Staff retrenchment, which Source: Annual HZ Statistics, 2005. started at the beginning of the decade, is proceeding slowly. Some ofthe early staff retrenchment was achieved through the separation of 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 of revenues without subsidies) continued to deteriorate until the end of 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 ofjust 580 staff per year, or even 320 in 2007, remains modest. It was only because ofimproved 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 of the former Yugoslavia, continued in 1999 partially due to adverse external circumstances, such as the Kosovo oY, tPZxlrL1$IP~,ri~~ln~~r~~~aryrll$pxl 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 of the 1999 level by the end of2005. 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 of 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 ofstate 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 of GDP. In 2007, budget support at one percent of GDP remains equivalent to one-third of 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 of Budget Support to the 2007 Railways, 2006

1.6 ...... o Sewance i payments Loans repaid 3% Operating ,, ...... i 1 8 assumed I 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 is a heavily unionized and a large employer. Although HZ and its subsidiaries employ some 20,639 employees (2007) or 1.1 percent of the labor force, it has over thirteen unions with apparently strong negotiation skills. The disparity of the wage level vis-a-vis the education profile of staff has been further widened by additional benefits such as bonuses, high severance payments, long layoff notice periods, working conditions, all ofwhich prevent rejuvenation and upgrading ofthe staff profile (Figures 3.6 and 3.7). Bonuses add over 30 percent to the basic wage bill, while working conditions reduce the productivity of railways (for example, an engine driver that spent four hours driving a train cannot then return it to the point of origin as that would exceed his working hour limit).

76 Figure 3.6: Age Profile of HZ Staff, 2005 Figure 3.7: HZ Staff by Years of Service, 2005 40 I 60, ...... ~..~.~.~~...... 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 is because of (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 HZ’s current operating and financial performance is not sustainable and that the company is not prepared for competition-which will certainly increase with the liberalization of rail markets following the EU accession. The implementation of the 2006 Railway Law with the separation of 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 of 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 of 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: Projected Public 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 Loans repaid assumed is fiscally excessive and 680 595 547 464 lacks an overall sectoral Severance payments 105 79 79 52 strategy with proper economicjustification. The Total Public Finance Support 3,681 4,018 6,065 5,669 plan is built around creating a as !% Of GDp 1.5 1.6 2.4 2.3 high-speed railway, using Source: HZ Business Plan 2006-2010. state of art technology, as the

41 McKinsey & Co, Improvement of Competitiveness of 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. In summary, the plan needs to be revised if it is to provide enough technical information for decision makers: The investment program needs a definite framework for investment decisions based on cost- benefit analysis and projected economic rates ofreturn; The proposed investments need to be prioritized, since the state budget is 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 ofassets; 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 of multiple targets for traffic, revenue, staff reduction, cost reduction, staff productivity, working ratio, etc; and The financial forecasts should reflect the impact ofthe proposed investments. The mid-term plan is 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 ofmotive power and rolling stock, in particular, the increased availability and utilization rates oflocomotives, reduced turnaround time for wagons, and the improved utilization and rationalization ofpassenger services. 3.26 The investment program is 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 of normal private businesses, increased investment means an increased debt service requirement, increased depreciation, increased risk, and lower profitability, which limits the scale of investment to a realistic level. Since the HZ Infrastructure company, in particular, is 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 ofinvestment. 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 ofmultiple targets for traffic, revenue, staff reduction, cost reduction, staff productivity, and the working ratio is dynamic and non- transparent unless put in the context of 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 of Croatian Railways and future opening to other carriers, will increase in complexity.

42 Total operating costs, including depreciation and debt service, to operating revenues without any budgetary support.

78 3.29 To 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 of 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 of motorways in Croatia, will inevitably limit the attractiveness and competitiveness of railway passenger services. The focus could be shifted towards urban commuter services to ease urban traffic congestion, while limiting the high costs of 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 of labor is high and will continue to grow. This situation will make HZ extremely vulnerable to competition from other freight carriers, once the network is opened to competition. As long as the subsidiaries remain sole suppliers to HZ, the cost of their excess labor is 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 or 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 is absolutely necessary to the long-term survival of 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. It is 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 its subsidiaries. Tying all operating subsidies whether from the state or local budgets to performance- based contracts such as Public Service Obligation (PSO) contracts and infrastructure 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 on 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 its 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 of disposable assets. Furthermore, divestiture of real estate assets and privatization of subsidiaries is a time-consuming process, which is best done by specialized entities such as the Croatian Privatization Fund and real estate developers.

79 C. ROADINFRASTRUCTURE 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 as the quality - 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 is still seen as an Source: HC. integral part of the development of 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 to 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 of 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 of the network is now well below standard. The Government has through the second stage of the National Road Investment Program aimed to address the backlog which resulted in some improvements ofroads’ condition. Croatian Roads (HC) estimates that third of state roads are in poor condition (Figure 3.Q and a large proportion of structures on state roads (bridges, culverts, etc.) are in immediate need of repair. The condition of county and local roads is not better than that of national roads. HC states that the deterioration of national roads was stopped in 2005. Although this is 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', is 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 of GDP per annum, of 2 5% which two-third quarters were for 20% development and operation ofthe motorway 5% network, and 60 percent of this spending on 10% 05% motorways was covered sovereign or by oo%

sovereign-guaranteed debt. This level of ** &* *o* $6 e* spending is exceptionally high compared & +* fl 8@Q +QAe ,e*"" + with averages in the region and Western %$ 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 ofnew roads was planned to decline towards 2.0 percent of GDP, while maintenance would remain stable at approximately 0.9 percent ofGDP per year. The question that arises is how to balance future investment needs in the network other than motorways, which suffer from a backlog of maintenance, and at the same time maintain the valuable new motorway assets and service the financial liabilities incurred.

45 Public Roads Construction and Maintenance of 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 ofFunds Maintenance and periodic rehabilitation 1,086 1,889 2,132 2,659 2,584 2,385 2,603 2,691 7,766 10,262 New 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 3 62 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 Yo of GDP 1.8 3.4 4.8 4.1 3.9 3.8 4.1 3.6 3.5 3.9 Sources ofFunds Toll 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; HAC and HC 2003-2004 audit reports; and HC, HAC and ARZ data. Some discrepancies between total uses and sources of finds are due to the multiple sources of information as well as HAC and HC switch between accrual and cash basis accounting.

3.34 Pressure for future public spending Figure 3.10: Ratio of 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 of GDP; two thirds of it will be used towards reimbursement of the 80% principal. This includes paying off 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 is already reaching its Source:HAC. limit. It is unlikely to be sufficient to service additional debt needed to finance the implementation of the remainder of the program through to 2008 and beyond (Table 3.5). Fuel levy is the second most important source of financing for road infrastructure, and has been providing a steady source of funding to HAC and HC amounting to an average total equivalent to 1.3 of GDP annually in the period 2001-2006. This source of cash flow has been particularly important in allowing HAC 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 of Finance. The fuel levy channels directly to HAC HRK 0.6 per liter of fuel 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 its dedicated character to HAC and HC. Because HAC’S business model depends entirely on the fuel levy, any significant change in the rules of this dedicated fuel levy or a decrease of its level will have an impact on HAC’S financial position and its ability to cover its

82 liabilities. Funds from the fuel levy financed on average 34 percent of 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 is considered, tolls financed 13 percent of the program in 2001-2004 and are planned to finance 27 percent of 2005-2008 program. However, the most important source of financing of road infrastructure in the future will remain a long-term borrowing. On average, long-term borrowing covered 39 percent of spending in road infrastructure, but this share is more than 60 percent for the motonvays program. 3.37 Although efficiency of the current institutional setting has delivered planned programs, there is an opportunity to further reduce the operating costs and improve the planning process. The overall operating cost (that includes interest payments) accounted for over 3 percent of the overall road spending during 2001-2007 period. This is partly due to increased financing cost, but also to the fragmentation of institutions delivering the program. The government’s political decision to invest in the motonvay network lead to the subsequent reshaping of 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 of the motonvay network, except for that which is constructed or maintained by concessionaires; and (ii)Hrvatske Ceste (HC), also a joint-stock company, which became responsible for the construction and management of all other state roads-which constitute the vast majority of the network. At the policy level, the Ministry of Sea, Transport and Infrastructure is responsible for the activities of HAC, HC 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 HAC and 147 km for ARZ). HC, with 320 staff manages maintenance subcontracts for the 7,000 kilometres it is responsible for. All of the routine maintenance work on the state road network managed by HC is carried out by 14 Road Maintenance Companies, which used to be part of the Croatian Road Authority and are all but three or four privatized with a remaining minority stake held by HC and counties. 3.38 Planning for road infrastructure development is a comprehensive process, but does not involve economic appraisal techniques. The planning process follows three stages. First, the strategy for the development of public roads is prepared by the ministry based on the strategic plans of HAC, HC, and counties and is proposed on behalf of 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, HC and the County Roads Administrations, prepare one-year implementation plans for the construction and maintenance of 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 of road institutions also brought with it a new financing model for the development and operation of the road infrastructure. The Public Roads Act allows for the possibility of ceding motonvay construction and operation to a concession company. In this case, the ministry is also responsible for the administration of 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 (iii)Autocesta Zagreb-Macelj (AZM): awarded in 2004 to AZM, a concession company jointly owned by Walter Concession Holding GmbH and the Republic of 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 its Central and Eastern European neighbors under difficult circumstances. However, the current arrangements ofthe two remaining concessions have significant financial implications for the government in terms of financial guarantees, and general involvement that is 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.

RECOMMENDATIONS 3.41 Rigorous prioritization of investments and more focus on maintenance of existing road assets. Now that the government has gone a long way in the implementation of its investment program in the road infrastructure, the critical issue, given the government policy and strategy, is 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 of whether the road infrastructure is 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 on the competitiveness of industries and services in Croatia. Servicing HAC’S accumulated debt will be competing for funds from users, tolls and fuel levy, with a risk oftoo little financial resources being left for maintenance ofmotonvays, and even more seriously for the rest ofthe 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 ofa competitive contracting market can bring prices down and provide large efficiency gains to HAC, HC and ARZ. It will also stimulate the formation ofmore competitive private contractors. At the same time, the government could evaluate present levels of maintenance expenditure to determine the economic benefits that will result from additional spending. This should be done in combination with the introduction of some form of incentive schemes for all publicly-owned road operators so that they are financially rewarded or punished depending on their performance in maintaining the road network. 3.43 Institutional consolidation. Given that the HAC’S mission of construction is increasingly becoming that of maintenance and preservation of 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 ofARZ, the restructuring of some of HAC’Sdebt, the review of the current concession motonvay contracts, and the preparation and procurement of future concession contracts under a fully competitive PPP process. The complexity ofthese issues warrants an in-depth assessment of 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 of lessons for successful PPPs: (i)the importance of a well-designed 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 (iii)adequate program preparation and implementation capacity; (iv) the need for reliable traffic forecasts; (v) the concession structure addressing financial and economic issues such as the duration of the concession, impact of toll levels, extent and type of government support, maximum private sector return, etc., and (vi) proposed projects must have economic merit-private financing is not an alternative for projects that would otherwise not be economically justified. 3.45 An in-depth analysis is 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 ofBina-Istra concession for instance, the government pays a monthly financial contribution, estimated at around EUR 20-25 million annually, which is 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 on the equity. There is 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 is 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 is for Croatia to continue developing administrative capacities on national, regional and local level and to present the time- bound financial plan for implementation of environment acquis. The administrative burden of 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 is considerable. Its 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. In addition, there are potential liabilities arising from the high share of state ownership in industrial facilities which will also need upgrading (at a cost of 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 of 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 of 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 of 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, N02, 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 of waste, incineration of waste, end of 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 of GMOs, Animal Experiments, Asbestos, Biocides); GMOs; 0 Noise; 0 Forestry. 48 Benefits for Croatia of compliance with the environmental ucquis, May 2005, the European Commission, DG Environment (04/08853/AL). The wide range accounts for lower bounds of 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 Law provides foundation for harmonization with the IPPC Directive and SEA Directive. By adoption of by-laws on IPPC in 2008, the whole process of 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 its efforts to utilize more of available EU funds in this sector. Privatization could also help to lower the direct costs to the State, if undertaken with careful integration of environmental issues and future environmental compliance plans. However, the current draft National Water Management Strategy does not endorse the concept ofprivate 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 of municipal infrastructure where large efficiency gains from economies of scale can be achieved through agglomeration ofutility services. The largest investment financing gap in the medium term budget framework is exactly for solid waste that falls under responsibility ofmunicipal utilities. 4.7 This Chapter first takes stock of 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 ofabout 1 percent ofGDP, provided the appropriate priorities and policies are implemented. Section E highlights the required organizational change in the light ofthe experience ofthe NMS, and Section F summarizes the recommendations that arise from the previous ones.

49 There are quantifiable economic benefits of compliance with the environment acquis that are estimated to be in the range of€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 of these estimates is the EC DG Environment (04/08853/AL). The wide range accounts for lower bounds of risk and adjustments for national purchasing power indicators.

88 A. CURRENT ENVIRONMENTALCONDITIONS

4.8 In Croatia, 76 percent of the population receives reliable water supply services, which is 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 of the Sava and Drava where coverage rates 80 are as low as 31 percent. Water losses 70 are high at 46 percent on average, 60 nationally. The sector is being served 50 by 127 municipality-owned water 40 companies, which in a country of 4.5 2030 million people seems highly fragmented. 10 4.9 Access to public sewerage is 0 even lower with only 40 percent of Water suppv Connection rate to Connection rate to Municipal w aste connection rate level public sewage waste water collection system 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 new EU member states. Onlyabout half of the treated wastewater satisfies the effluent requirements of the government, and most of the 74 wastewater treatment plants need to be upgraded to meet EU standards. The discharge of untreated wastewater into open waters is of 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 of wastewater discharges and the wastewater of 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 is 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 In 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 of population has municipal waste collection system coverage, though coverage ranges from 75 percent in a few counties to almost full coverage in the City of Zagreb." Population served by organized waste collection has increased from approximately 2.7 million in 1995 (60 percent) to approximately 93 percent of population in 2006. However, remediation of a large number of "hot spots" or contaminated sites will require significant investments. 4.11 As regards air quality, out of 35 operating Large Combustion Plants (LCP), it is estimated that a large number is not in compliance with the emission limit value (ELV) prescribed by the LCP Directive". Out of 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 of 58 MW, uses gas fuel and has new burners installed), is in

50 The city ofKarlovac was allocated the first ISPA grant support in Croatia for improvement ofthe wastewater system. 51 Waste Management Strategy, Official Gazette No 130/2005. 52 Directive 2001/80/EC is the most costly EU Directive in the area of 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 of certain pollutants into the air (desulphurization unit), but it is not yet in compliance with the Directive. Out of 35 LCPs, 22 belong to Croatian Electrical Company (HEP), generating electric power and heat, 11 are industrial companies, including oil refineries, chemical industry, pulp and paper producers, and two are local heating systems. The estimated total investments for upgrading existing LCP according to EU LCP Directive are €1 billion. B. GOVERNMENTPLANS

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 of €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 ofa capital budget subsidy of50 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 IFIs loans (the World Bank, European Investment Bank, European Bank for Reconstructing and Development, etc.). The budget envisions to partially cover the remediation of “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 ofwaste - recycling and collection yarddunits. There are plans to organize 17-21 County or Regional Waste Management Centers (CWMC or RWMC) for solid waste management that will involve MBT and will be used instead ofexisting landfills for municipal waste. Table 4.2 presents a summary of plans underway for investments in these centers. Some 170 out of 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 of 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 is 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 of large combustion plants are estimated to need investments to be able to comply. Investments would mainly involve the installation of fuel gas desulphurization units at plants burning fuel oil, changing from the use of oil to natural gas and the installation of low-NOx emissions, installations of particles filters as well as the installation ofmonitoring equipment in some plants. 4.15 Many of the same LCPs also need to make investments under the IPPC Directive. The estimated number of IPPC installations is about 150. Investments in the energy sector (seven thermal power plants (HEP) and four oil refineries (INA)) and waste management (32 landfills) are the broad responsibility of the public sector. Out of 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 of volatile organic compounds). 4.16 The government is 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 of the Natural Habitat Directive, distribution and

91 habitats of endangered animal and plant species as listed in Annex I1 ofthe Natural Habitat Directive and Annex Ion Bird Directive in the Republic ofCroatia. Future Natura 2000 ecological network will partly cover already protected areas and those not protected aiming to increase protected areas to a targeted 15 percent.53 Ownership of 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 ofprotected areas is planned. Currently, financing for national and nature parks (which includes operating costs) is allocated on an annual basis in response to budget requests for each park. The adoption of 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 of space and equipment; donations, subsidies, and fines. Since 2004, public entities administering protected areas have been allowed to grant concessions for a period of three years for the economic use of natural resources or conducting other activities in a protected area. The income earned from concessions (for example, whitewater rafting, ski resorts etc.) is also retained locally and designated for nature pr~tection.~~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 still 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 of privatization, an audited separation of accounts would also help establish a more transparent divide between park and tourism related services. C. FINANCING ENVIRONMENTAL SPENDING

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. It is 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 of GDP, below the levels Romama Sbvema observed in the new member states. Sbvakm LnhUalUE Poland 4.19 These figures are however Estoma misleading. Reconciled fiscal data at Lam Hmary all government levels55 point towards Malta the fact that actual spending levels Czech Rep 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 of Culture holds the primary responsibility for nature protection in Croatia. Croatia has 8 national parks and 11 nature parks covering approximately 7 percent ofthe 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 of 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 of GDP on environment. This is well in line with the top EU8 spenders. The level of total environmental expenditure, as a percentage of 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 of Agriculture, Forestry and Water Management 28.9 20.6 24.6 38.8 42.5 Ministry ofEnvironmental Protection, Physical Planning and Construction (includes Environment Agency and 4.3 6.4 11.6 14.3 10.5 Environmental Inspectorate) Ministry of Culture (includes State Institute for Nature ~rotection)’~ 1.7 2.6 10.0 10.6 9.9 Ministry ofthe Sea, Tourism, Transport and Development 1.2 5.1 9.2 7.1 6.0 Ministry of Economy, Labor and Entrepreneurship 1.5 2.3 5.3 5.1 4.7 Ministry ofHealth and Social Welfare 0.06 0.07 0.59 0.03 0.03 Ministry of 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 ~aters’~ 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 of 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 of its 2005 GDP. Similar assessments for the 10 new member states that joined in 2004 had an average cost estimate of 34 percent of their 2001 GDP, and Bulgaria and Romania had estimated costs of 112 percent and 57 percent, respe~tively.~~ 4.21 A closer look at the experience of the new EU member states brings to light other useful lessons. First, the NMS did not exhibit a clear increase in the share as they approached the date of entry to the EU. Second, what happened however in the run-up towards accession is that the share of environmental expenditures undertaken by the private sector rose sharply (Slovenia is the exception).

56 Ministry of Culture Budget for the nature protection category for 2004-2005 is 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 of existing loans for construction of water and wastewater systems in local governments. ’’ The study being referred to is EDC (1997), ‘Compliance Costing for Approximation of EU Legislation in the CEEC’. European Commission: DG Environment, Brussels.

93 Only 10-30 percent of 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 Yo of GDP YOof total 100 90 80 -+-Estonia oEsmna 70 fli:naia 61 -e- Ltthunia OPdard 5: Poland OSawnla 42 lSmka 32 numoxmmm 20 10 0 kbBZ sp& 84&&8d&& 48 P d d 48 48 8 $9 8 8 4Q 8 9 \Q 9 40 8 fp $0 Source: Eurostat, (2007) "Environmental protectionc 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 by the private sector61. Bank estimates of environmental expenditure by the public sector in 2005 are around 0.9 percent (including the government controlled extra budgetary funds). This figure is projected to increase in absolute terms but could be contained in terms of its share of 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 ofcentral government amount to 0.87 percent of 2006 GDP. Adding recurrent expenditure requirements will imply an overall figure that may be just around 1 percent of GDP. From NMS experience, it seems that this share will probably not increase further in the years preceding accession or soon after. If recent experience is any guide, the private sector may undertake large share of the investment needs, reducing the burden on the public budget.

Priority Interventions in the Light of Fiscal Constraints 4.23 In determining which areas should be prioritized, one criterion is to look at which sectoral investment will provide the greatest benefits relative to costs. Approximately 80 percent of benefits would be associated with health improvements from a reduction in incidence of respiratory diseases (for example, bronchitis and lung disease) and waterborne diseases. In addition to health benefits, there are assumed benefits as a result ofreduced damage and aging ofbuildings; new employment; upgraded industrial technology; recreational nonuse values; improved occupational safety; avoidance of ecological and hazardous risks; lowered waste volumes, reduced dangers to fish stocks, increased crop yields; protection ofendangered 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). No estimates are available of the benefits of meeting directives in other areas. Even with these wide ranges of possible benefits, it is clear that the water sector has much higher net returns than the air sector. The costs of programs in

6o Unfortunately 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 of private capital investments. Benefits for Croatia of compliance with the environmental acquis, May 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 of 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 on the water directives should generally have priority. More work is needed though to 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 is potentially even more dangerous than the status quo. Hence coordination of the actions on contaminated sites and the opening ofnew ones are important. 4.26 Be 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. It then allocates the following shares of 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 of the total in the three years 2006-2008 (three years representing 20 percent of the time available). Given that the forecasts envisage a shortfall of 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 of VOCs from storage of petrol 2009 Emissions of VOCs from storage of 2009 petrol Shipment of waste 2009 Shipment of waste 2009 Discharges of dangerous substances into 2009 surface water I Sulfur content of liquid fuels 201 1 Integrated pollution prevention and control 20 11 Integrated pollution prevention and 2015 control Treatment of urban waste water 2014 Treatment of urban waste water 2018 Quality of drinking water 2015 Recovery and recycling of waste 2014 Recovery and recycling of waste 2013 Landfill of certain liquid wastes 2014 Landfill of certain liquid wastes 2/ 2013 I Large combustion plant directive 2014 Large combustion plant directive 2017 (1) Unless otherwise stated it is assumed that the date for compliance is the end ofthe year. (2) The general waste landfills directive has a transitional period till July 2017 for Romania, instead of 2009 for present member states.

Mobilizing Resources for 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 is interesting to note that in the case of Poland only 3 percent of the total annual cost of meeting the environmental acquis was planned from the state budget. In some other countries like Bulgaria, the state’s planned share is

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 of Poland, for example, ecological funds account for around 22 percent of 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 ofthe total financing for the period 2006-2008, that is, not a dissimilar share to the one in Poland. 4.29 To start with, considerable financial assistance is available in the form of EUgrants for the environmental upgrades required thus implying less of a burden on local resources. Starting in 2007, Croatia is 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 of industrial zones, including rehabilitation of 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 of the member states that joined in 2004 is any guide, Croatia could look for around 20 percent of the total costs ofwater and about 15 percent of the costs of waste being met from EC grants. These would amount to only about €60 million a year. 4.30 Improving the _financial performance of local utilities through reduced technical and 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 MWSC competence in tariff setting, billing and collection. The strategy should be coupled with the establishment of an efficient and transparent financing mechanism to channel funds to MWSCs for eligible investments. Key will be the application of uniform and predetermined selection criteria including full cost recovery of 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 is collecting fees for water use and water protection. These are used as non refundable funds for the construction of water and waste water systems in local government units (public potable water supply, sewerage network, and waste water treatment). Croatian Waters are in charge of implementation of projects financed either by grants or international bank loans. Beyond these, Croatian Waters act as a financial intermediary in on-lending of 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 of local utilities, there is a huge efficiency gain from the economies of scale that they could exploit through mergers and consolidation. Other constraints include the lack of technical and financial capacity to plan, lack of well developed project proposals (poor financing plans, lack of building permit), lack of spatiallmaster plans at local or regional level, lack of capacity to manage utilities and the lack of 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 of own revenues cap imposed on new borrowing is probably sensible. 4.33 Another source of finance is 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 of environment and regulations are in the finalization stage. The fee for the emission ofcarbon dioxide was introduced in 2006, and Regulation on calculation and payment of carbon dioxide emission fee in 2007. Discussions are under way on a host of other possible environmental charges. Environmental Funds are an important source of transitional finance and indeed played a critical role in the financing of investments in several of the member states that joined the EU in 2004. There are of course good practice guidelines for the operations of such funds and the Croatian government is well aware of them. The government could be more ambitious in using this as a source of finance for the environmental directives. More could be raised through taxes on 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: Environmental Taxes, YOof Government on environmental taxes and charges, Revenues Croatia does quite well in terms of 0.00001 6 how much of its public revenues are 0.00001 4 from ‘green’ sources. Between 1998 0.000012 and 2002 it increased tax collections from environmental sources from 0.00001 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 of public roads and special motor 0.000002 fuel charges, and vehicle excise taxes. 0 To that end, Croatia resembles more Germany in the share of its taxes that are ‘green’ than Bulgaria or Romania. -- Furthermore, an increase in the share of Note: Data are the latest available, for 2002 in most cases, except such taxes is 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. OECD httr,://www2.oecd.orrr/ecoinstlaueries/ of these additional revenues additional Source: 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 of industries that come under the Large Combustion Plant Directive and the IPPC. There is 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 is supporting private investments. Earlier Bank analysis64 developed three scenarios ofthe role ofthe 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 to 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 of the private sector could increase to 30 percent and the waste share to 60 percent. The implications of these scenarios were that the level of 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 is 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 is a critical need to improve organizational effectiveness to ensure value-for-money with investments in the environment. Responsibility for the environment and public spending is fragmented across the government and this limits capacity to implement the environment acquis. The European Commission Screening Report on Environment emphasizes that the fragmentation of 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 is essential. The share of spending on the environment in any one line ministry is currently below 10 percent of overall spending, including in the Ministry of Environment, Physical Planning and Construction. Consolidation of key environment units would strengthen the environmental focus of the government and strengthen functional requirements for administration of 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 of 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 is fragmented across the government, including subordinated agencies, and there is 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 of the NMS or neighboring South Eastern European countries. ~ -6050 The Ministry of Environmental a Protection, Physical Planning and E 30 E Construction (MEPPC) is the central 120 body responsible for environmental U 10 protection, but specific environmental issues fall under the 00 purview of a broad range of 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 of 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 of the challenges identified through this review include the need for staff with high level of education and experience which are difficult to attract and retain given existing government wages. However, a more systematic review along the lines of the public administrative reform functional reviews is recommended for the environment sector on a thematic rather than line ministry basis, as it seems that consolidation of functions across different government institutions involved in environment would lead to lower or no new staffing requirements. As far as staffing is concerned, it is difficult to 4.41 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 Much also depends on how much is 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 of work (staff working under MoHSW 4 good conditions of employment are more effective than sow 3 3 those where turnover is high and salaries so low as to EPA SINP 19 17 8 cause moonlighting). Hence claims based on Source: MEP 2o05. international comparisons of staffing levels are not a good guide to the degree ofunderstaffing.

65 Ministry of Agriculture, Forestry and Water Management, Ministry of the Economy, Labor and Entrepreneurship, Ministry of Culture, Ministry of the Sea, Tourism, Transport and Development, Ministry of 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. 67 MEP-Ministry of Environment Protection, Physical Planning and Construction; MAFWM-Ministry of Agriculture, Forestry and Water Management; MoC-Ministry of Culture; MoHSW-Ministry of Health and Social Welfare; SORP-State Office for Radiation Protection; EPA-Croatian Environment Agency; SINF'- State Institute for Nature Protection.

99 4.42 What is needed in terms of staffing is a package of 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 of emissions, upstream studies in support of policy etc.), and (c) take advantage of any possible consolidation to reduce staffing needs. When all these are included a staffing plan can be drawn up. Given the substantial demands of the new environmental regulations, more staff may indeed be needed in certain areas. It may, however, be possible to redeploy most required staff from ministries where functions have been shifted. 4.43 In 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 of Environment (especially brining water under this ministry), (b) separation of construction from the Ministry of Environmental Protection, Physical Planning and Construction in order to avoid conflicts of interest and (c) better coordination between ministries in the design and implementation of environmental regulations. There is too much fragmentation of responsibilities for the environment, there are conflicts of interest in the present structuring of 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) is weak. Reforms here are required but they should not have major fiscal implications. 4.44 The government of Croatia is 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 of harmonizing with the environment acquis. However, this was often done late in the accession process with higher costs in terms of building administrative capacity and limiting the ability of 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 is 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 Conversely, Croatia also stands out as 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 of interest with the EL4 Directives particularly for cases when government funds are involved. Croatia is also unique with Nature Protection separated from environment (it is combined with Culture). All EU member states (with the exception of the Netherlands) have nature protection functions consolidated under the core environment ministry. 4.47 Most if not all EU member states have developed organizational structures to achieve a separation of environment policy from the regulatory functions. One of 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 of 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 of 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, PO 90925, November 2006. 69 Latvia had combined construction, tourism, and regional development with environment since 1993. In 2004 they were separated from environment as part of 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 still largely mixed within institutions and the re-assessment and better organization of 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 ofthe NMS shows. Within these transitional periods, there is the question of sequencing. Which investment should be given priority and where is some backloading justified? Here the aim should be to delay those sectoral investments where EU grant funding is limited, where future private sector involvement is likely to be enhanced in the future, and where the demands on the government budget are greatest. 4.50 Another consideration is 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 is only a guide to the broad strategic direction ofpolicy. More details ofthe 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 is there and should be developed as a matter of priority. The public finance impact ofthe investments will also depend on 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 of 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 is envisaged for the waste sector, can deliver, but it still has some way to go to make a major contribution. Strengthening capacity ofthe public sector in this area and promoting PPPs isjustified. 4.52 The extra-budgetary funds can play a bigger role, especially the Environment Fund, if it is 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 of environmental taxes, there is potential for more, and for greater channeling of the additional revenues for the environmental investments, especially in the waste sector, through the Environment Fund. 4.53 In the future one can and should expect the private sector to play a bigger share in financing environmental expenditures. Privatization of 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 ofexpenditure 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 of illegal dumpsites remediation, there is a danger that sequencing the closure of illegal dumpsites before opening new compliant landfills could result in the opening ofnew 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 responsibilities, but this has to be seen in a broader context of public administration reform. In the near term key issues to tackle would be the following: consolidation of policy functions under the

101 Ministry of Environment and brining water under this ministry; separation of construction from the Ministry of Environmental Protection, Physical Planning and Construction in order to avoid conflicts of 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 is 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 of the population, and low labor force participation7' which is partly driven by policy choices as to which segments of the population qualify for social assistance and pensions. The key question thus is how to improve skills base and create an education system that will be producing a base of 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 is 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 low 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 of declining school age cohorts. Institutional and financing arrangements need to be adjusted to ensure that resources are shifted towards the areas of 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 of the payment of teacher salaries may not be advisable unless it is 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 of multi-grade teaching in small schools and definitely eliminate triple shifts. Review carefully the relevance and equity of 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 of public tertiary education to ensure that it delivers the efficiency and effectiveness gains promised. 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 subjects.

70 Ratio of dependent groups, for example, seniors and children, to the working age population. 71 It 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 is expected to exceed the working age population. Between 1960 and 2006 the share of the population over 65 more than doubled from 7.4 to 17.2 percent, while the share of 0-14 year olds almost halved from 27.7 to 15.9 percent. Some of this has been due to declining fertility rates which fell from an average of 2.8 in 1950-55 to 1.4 in 2002-06, but this is projected to level off in the next 20 years to about 1.6. The result is that the age dependency ratio-the sum of under 15 year olds and those 65 and older to working age population- is 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 current education system and have embarked on a wide reform program. In terms of 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 of 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 of teaching for modem soft skills 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 of the national curriculum.

Box 5.1: 2006 PISA Results The Program for International Student Assessment (PISA) is a triennial survey of the knowledge and skills of 15-year-olds in science, reading and mathematics. More than 57 countries (for the first time including Croatia) making up almost 90% of the world economy took part in the third round of PISA in 2006, which had the primary focus on science. On the PISA 2006 science scale, Croatia scored 493 score points, which isjust below the OECD average of 500 score points, ranking 26th out of 57 countries. It ranked better than USA, ten EU member countries and is by far the highest of all participating countries of South Eastern Europe. Looking at PISA 2006 reading proficiency scale, Croatia ranked 30th with 477 score points (comparing to the OECD average of 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. It is important to stress that the PISA 2006 assessed the last generation of students who were educated according to the old primary school program (new Croatian National Educational Standards were fully introduced in September 2006). Analysis of PISA results for Croatia also shows that the Croatian gymnasium students scored significantly better than the VET students, thus further underlining a need to increase the gymnasium and reduce VET enrollments in the Croatian secondary education. 5.7 The government is determined to introduce transparent performance evaluation involving external and internal standards. Lack of quality standards, measurements and evaluation, made criteria for assessments and grades very different across schools in both the primary and secondary systems. In order to eliminate the effects of subjective assessments and grades, and establish a uniform system for evaluation of student potential, authorities introduced in 2006 unique external assessments at the end of the schooling cycle, which serve as the preparation for the matura exam (that will be introduced at the end of the secondary school in 2010). Results ofthese exams will serve two aims: for students, they will provide fair assessment of their knowledge on common grounds, which will be used as a selection criterion for tertiary enrollment; for authorities, they will provide a measure of performance of 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 of TIMSS and PIRLS international assessments. The importance of 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 of 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 is 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 of 9.8 years of schooling in 2005 which is low compared with an average of 12 years among the recent EU entrants72 and closer to the Albanian average of 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 ofeducation 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: Projected Trends in Sizes of Preschool and cohort sizes resulting from Croatia’s School-Age Cohorts ( 2005-30) continuing demographic transformation. Between 1995 and 2006 -c 3-6 year olds -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 is projected to continue, facing a decline in the absolute 1 200 C number of school-age children. By 2030, 100 the number of 3-29 year olds is expected 0 to shrink by 25 percent. However, slower 2005 2010 2015 2020 2025 2030 projected declines in youngest cohort suggest that this school-aged population Source: CROSTAT, Projections of Population ofRepublic of 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 to 100 percent would counter almost all ofthe projected population loss among 3-6 year olds, and just under half of the loss in the 16-19 year age group. 5.11 Although enrollment rates are improving, they are not improving as rapidly as in other 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 is also far below the new EU entrants average of79 percent.

72 Includes EU8 countries. 73 See “Edstats” average years schooling for those age 25 and above; Barro-Lee (2000). 74 This is 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 its 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 of education spending across countries is important as it supports evaluation of relative quality of outcomes in terms of the accumulation of human capital among its students. Equally important is to introduce adequate programs to assess the quality of education at the national or sub-national levels, which is a major prerequisite for effective policy making. An introduction of the so-called ‘e-Matice’, a general education system database as well as strengthening of 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 of the Program for International Student Assessment (PISA).75. Students from 57 countries making up almost 90 percent of 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 of some of the old EU countries (such as Italy, Spain or Norway), they still had lower scores than the students of neighboring EU 8 countries such as Slovenia, Hungary, Poland or the Czech Republic.

5.14 Nevertheless, there is strong Table 5.1: Wage Returns to Different Levels of evidence that investing in education in Education Croatia has positive returns. Having more Level of education Wage premium (% higher wage) years of education not only significantly completed relative to having an incomplete increases the probability of being employed, primary education but also the earning potential once Primary 6.7 employed. The evidence is clear-the Voc. Secondary 13.3 returns are increasing at higher levels of 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 of 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.

75 PISA assesses literacy in reading, mathematics, and science for a sample of 15 year olds in each participating country, evaluating their understanding of key concepts, mastery of certain processes, and abilities to apply knowledge and skills in different situations. PISA is 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 skills per se or their mastery of a specific school curriculum.

106 C. EFFICIENCY

Overall ‘pending On education Figure 5.2: Public Sector Spending on Education, % of as a share of GDP is comparable to EU GDP neighbors. Croatia spends around 5.6 1 percent of GDP on education which is on 10.0 par with EU15 countries (around 5.6 8.0 71 percent) and new EU entrants (5.7 percent WlO average, 2005 ofGDP). The public sector contributes 4.9 6.0 percent of GDP which is less than the 4.0 EU15 and EU25 averages (5.4 percent of GDP) with a higher level of private 2.0 spending making up the gap. 0.0 5.16 Private sector participation in education is higher than in EU25. Private spending on education in Croatia ’ is around 0.75 percent ofGDP76 compared Source: M°F, IMF>wB database* with ratios of around 0.4 percent in the EU15 and EU25. This represents around 0.7 percent of household spending, but is predominantly spent on pre-school and tertiary education. Despite the relatively high private spending on education there are very few private schools, but there is a growing number of private pre-school providers. Private primary schools have 0.19 percent of students (an increase from only 0.07 percent in 1996/7) and secondary schools 1.1 percent ofenrolled students (up from 0.24 percent in 1996/7). While there are no 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 of GDP to 5.1 percent ofGDP between 1995 and 2000 and has declined marginally since then. The share of public 2.0 expenditures on education, increased from -TPEE as % of TPE 0.0 a low of 8.2 percent in 1997-98 to 10.1 percent in 2007 reflecting increased government priority for education sector. Source: Ministry ofFinance

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 spending among education Level of Education, 2002 (YO) Countries Preschool Primary Secondary Tertiary subsectors remains comparable to Croatia (average 11.2 43.9 21.1 18.0 its EU peers, a bit less so for 2003-06) tertiary education, the increases in N~~EU members 11.4 40.5 23.2 22.0 public spending on education have ~~15 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 of 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 of increased tertiary education, while the share for secondary education has remained stable.

Table 5.3. Expenditure Shares by Type of 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 of 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 of 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 its 1998 level, after peaking in 2000.

108 5.20 As a share of GDP per Table 5.4: Education Spending, as % of GDP per capita, 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 its 23 percent of 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 of the Ireland 12.3 18.1 25.7 comparator groups; a very high 3 1 and Hungary 20.9 20.5 31.9 percent of its 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 of centralized and decentralized decision making and financing, depending on the function and level ofeducation. 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 is 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 is planned to decline further fiom 74 percent of total education expenditures in 2003 to 69 percent by 2008. Local government financing for education comes from three sources: (i)a specified share of personal income tax (PIT) that local governments retain - 2.9 Local Gowrnrnent percent for primary education and 2 Central Gowrnrnent percent for secondary education - with the PIT rates being set nationally; (ii) 2003 2004 2005 2006 allocations from the centrally-controlled I I Equalization Fund; and (iii)in very few Source: Data for 2000-02 from SEE data files; Data for 2003-06 from the Ministry ofFinance. cases, own revenues.

109 5.23 The Equalization Fund is meant to address horizontal imbalances in school financing, but relies on historical expenditure ratios that lock in old inefficiencies. Allocations are based on the gap between the local government’s earmarked share ofthe PIT and expenditures required to meet minimum standards per school, the number of schools, and the number of 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 of local administrations providing these services. Second, secondary schooling usually has higher unit costs, due to the provision of specialized teaching staff, laboratory and other facilities, which is not the case in Croatia, but is across EU countries.

Table 5.5: Ratio of 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) of its general77 education budget on capital investments, leaving almost 10 percentage points less for recurrent costs. The high share of capital investments should also be scrutinized in light of demographic trends. Wages, on the other hand, dominate recurrent costs (they constitute 90 percent) compared to the EU countries where they represent around 75-80 percent of recurrent costs. The result is a critically low share, around eight percent of the total budget, for non-wage recurrent items. While the international evidence does not provide a proven recipe ofinputs, recent work at the World Bank on efficiency in the sector found that countries in which the wage bill represents a higher fraction of total expenditure tend to be more ineffi~ient~~.Of concern is the small share of non-wage 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 of Education Expenditures Countries Basic and Secondary Education % capital % recurrent of which: wages of 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 EU (2002) 7.6 92.5 67.4 25.1 Countries Tertiary Education % capital % recurrent of which: wages of 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 EU (2002) 11.0 89.0 50.6 38.4 Source: Ministry ofFinance; OECD 2005, Table B6.3.

5.26 In tertiary education on the other hand very little is devoted to capital investments. In the tertiary sub-sector, recurrent spending dominates at 96 percent of 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 of 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 sincethe early 1990~. Student-teacher ratiosTable 5.7: Comparative Student-Teacher Ratios are an accepted indicator of educational system Europe & efficiency worldwide. It has already been Croatia Central noted that Croatia continues to spend far more 2006 Asia EU8* OECD of its education budget on wages and salaries Primary 14.4 16.6 15.5 16.3 than its comparators. While there is no Seconds 11.3 11.6 12.2 13.5 internationally accepted nom for the *Excludiz Croatia. minimum Or efficient number Of 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 this report reveals that if 16 B Croatia were to achieve the ratios of the E OECD in these subsectors, it could 14 reduce the teaching staff for public primary education by around 11 percent 12 and for secondary by around 17 percent. Given the current levels of 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 of GDP. Source: CROSTAT, MOSES.

'9 Including non-teaching staff.

111 5.29 While teacher compensation appears adequate, there is a significant wage premium for advancing to administrative positions. Available data suggest that after accounting for some differentiation based on age and years of 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 is a premium of around 20 percent associated with moving from the teaching corps to the group of 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 of full-time teachers mentors, and teachers. among staff in primaryeducation Source: Croatia Labor Force Survey pooled data for 2002-04. went down from 89 to 82 percent during 2000-06, while the percentage of 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 of their working hours teaching. Teachers with a full-time position in grades 14are required to spend around 15 working hours teaching (around 20 instruction hours of 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 of schools and programs tends to be less efficient because it reduces opportunities to allocate resources efficiently. It is noteworthy that almost half of 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 of focus results in seriously fragmented offerings within and across schools and an inefficient use of specialized equipment and faculty. The authorities have recently adopted a new strategic framework for VET resulting in the reduced number of sectors covered by VET programs. In the tertiary subsector, however, the lack of a policy framework to govern the growth of new, or new branches of, public institutions at the college, polytechnic, and university levels is creating a major fiscal risk in terms of downstream public commitments. 5.32 There is 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 of a school mapping database and national standards for service provision-for example, studendteacher ratios, studentklass ratios, number of cleaners per square meter, number of administrative staff as defined by school size-that should inform central and local government decisions to open or merge schools. The Ministry of Science, Education and Sports has addressed this problem through development of an

112 electronic database of 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 In 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 of primary schoolsg0, which constitute almost two-thirds of 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 is important to note that these estimates do not take into account other critical factors to the design of the school and class network, notably geographic distribution of the population. 5.34 The utilization of infrastructure in the education sector is relatively intensive through the significant use of double shift schools. The primary school network is 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 of 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 of triple shifting is very unevenly distributed across counties, with some counties having no triple shift schools, while 26 percent of the schools in the City of Zagreb were operating on triple shifts, with as many as 35.8 percent of Zagreb students enrolled in triple shift schools in 2005/0681.The burden of triple shifting on students also used to be unevenly distributed-and distributed differently than triple shift schools. For example, only 8 percent of schools in Zadarska county worked on triple shifts in 2005/06, but 25.4 percent of its students study learned under triple shift conditions, versus only 5.7 percent of Istarska county schools and 5.9 percent of students enrolled in triple shift schools. The government’s policy of eliminating these is to be commended, and, given the small number of triple shift schools, is 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 is routinely used in many countries, including much wealthier OECD countries, to deal with the type of “spot” overcrowding and demographic transitions that Croatia is now facing. Eliminating Croatia’s over six hundred double shift schools would be resource intensive both in terms of 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 of 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 is scope for improving efficiency in small schools through multi-grade teaching. Croatia’s small schools are heavily associated with inefficiently low studenvteacher ratios, indicating there is scope for expanding the use of multigrade teaching, the efficient response to small schools. Although counties vary in the percent of their schools that have very low studenvteacher ratios (0-5 students per teacher and 6-10 students per teacher), between 30 and 46 percent of the schools in almost 40 percent of the counties have studenvteacher ratios of 10 or less. There is a 0.79

8o Calculated as the total number of schools including branch schools divided by total number of primary education students. Data as of 2005/06 school year as collected under the School Network Optimization project by MOSES.In the school year 2006/07 the number oftriple shifts schools in Zagreb has been reduced from 23 to 16 schools.

113 correlation coefficient between counties’ low student-school ratios and those with low studendteacher ratios suggesting that small schools still tend to be relatively overstaffed. Technical Efficiency 5.38 The primary school compulsory instructional time is comparatively low in Croatia compared to its EU peers, but average for secondary students. Although the relationship between instructional time and student outcomes is not straightforward, students’ opportunity to spend time learning has been established as a key driver of student performance. Compulsory instructional time for Croatian students at the secondary level (age 15) is comparable to that for the average EU15 and EU8 student. However, it is much lower at the primary level (grades 1-8); the total instructional time being only about two-thirds that of EU15 students and 80 percent that of EU8 students. Although Croatia has a regime of optional courses at all grades, these do not constitute non-compulsory instruction, and most of 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 Instructional Hours’ 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 is defined as the number ofminutes per class hour times the number of compulsory class hours per week times the number ofweeks of instruction per year, divided by 60. ”The higher number is 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 In 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 ofan education system by focusing on the progress students make through the system and the length oftime it takes students to complete their education. In Croatia, available data (Edstat) indicate that repetition rates of 0.4 and 0.5 percent for primary and secondary students are below average for the new EU entrants, with averages of 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 of Science and Technology estimated that those in four-year degree (B.A.B.S.) programs took an average of seven years to complete and those in two-year programs took an average of five years to complete. Non-completion rates at tertiary education were also very high, with the Ministry estimating that only one-third of all those enrolled were completing their courses of study8*.In 2006, the University of Rijeka confirmed these numbers-the average time for completion of 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 of Rijeka is 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 is not only desirable from a “moral” perspective, but from an efficiency perspective, too. For an education system to get the most out ofits spending, it needs to be able to ensure that the country accumulates the maximum amount of 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 of skills, regardless of their socioeconomic backgrounds. Since educators have no prior knowledge regarding the distribution of potential and effort across a given cohort, access should be equitable. Therefore, the objective of public policy in this regard is to mute the effect of 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 of household members 15 years and older. The age range for secondary education is assumed to be 15-18 years of age; for tertiary education, 19-24 years of age. Around 86 percent of all 15-18 year olds are enrolled in one form of secondary education or another. Students from households in the highest consumption quintile have only a 7 percent higher likelihood of being enrolled in secondary schools than those from the lowest consumption quintile. However, there are bigger differences between the two quintiles in the type of 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 is 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 of five. Take a hypothetical five year old child in a given quintile. If that child has the same probability ofenrolment at each year ofhisher lifetime as those who are now five and older in his or her quintile, how many years of formal education will the hypothetical child from that quintile complete? The hypothetical Croatian six-year old, regardless of quintile, can be expected to complete 15.8 years of 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 Iurban residence has a positive effect on enrolments in both types of 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. It has a positive effect on 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 ofsecondary ed~cation.'~ 5.46 However, the current stratification within the education system should be carefully reviewed in light of recent international findings. Stratification of students either between classes within schools or among school types has been a traditional method of trying to maximize human- capital accumulation per student. However, there is new evidence that in systems that separate students, especially during the upper-primary grades into different types of 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 of 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 is of greatest concern. In special analyses ofthe 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 of Croatia's secondary students in the .three-year vocational program has been declining since a steep rise in the early 199Os, it is still relatively high. It is 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 of Zagreb, and in 2007 extended to the whole ofCroatia) 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 is an example of a costly measure with limited impact on learning outcomes, and the equity impact is 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 of2007 GDP on 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 of males with tertiary education is now shrinking relative to that for females. 84 Bialecki, 2002. 85 MOSES acknowledges that means testing (as supported by the introduction of the personal identification number) will 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 still Table 5.10: Distributionof Scholarshipsby account for 93 percent of government funded Household Consumption Quiutile (2002-04) scholarships. Between 1993-94 and 2003-04, the Average Share of total percent of 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 of 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 oftotal 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 on scholarships for Source,, Authors, calculations based on the students from this quintile than for those from the 2002-2004 Household Budget Survey. lowest. 5.50 The average value of a scholarship is approximately the same for students in quintiles 1- 4, it is almost 50 percent higher for students from the highest quintile. The higher value of the average scholarship awarded students in quintile 5 probably reflects an interaction between quintile and level of education for which the scholarship is receivedS6-childrenof quintile 5 families have higher tertiary enrolment rates, and the average award at this level ofeducation is therefore higher. 5.51 There is some progressivity in household spending on education, and differences in ruraYurban household expenditures for education. The HBS 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 of the population allocated 0.3 percent of total household spending to education, while the highest allocated about 0.9 percent of their overall spending to education. The highest quintile accounted for about 40 percent of total household spending on education.

Table 5.11: Household Expenditures on Education by Consumption Quintiles, 2004 Consumption Mean Household Education Mean Percent of Total Share of Share of 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 is more marked at the tertiary level, but is almost negligible at the preschool, primary and vocational secondary levels. Figure 5.7 shows cumulative household expenditure shares for different levels of education. Household expenditures on 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 ofthe population, generally in line with the inequities found in enrolment rates at these levels and types of education.

86 Sample size even in the pooled 2002-04 HBS are too small to allow a quintile by education level analysis.

117 F ire 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 is also substantial variation in household education spending by region. In the Zagreb Region, the average per capita spending on education is more than five time higher than in the Central Croatia Region. Some of this variation is 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 is between urban and rural areas. About half of the population that lives in urban areas accounts for more than 80 percent of overall household expenditures on education. On average, per capita spending on education in urban areas is four times that of 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 of 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 of 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 of the payment of teacher salaries may not be advisable unless it is accompanied by autonomy at the local level over the number and salary levels of 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 of 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 oftheir 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 of declining school age cohorts. As a result the share of public education spending on capital investments is 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. While remaining triple shifts at some schools should be eliminated, social consequences ofdifferent 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 of strategic focus in program design may be limiting the market relevance of skill development. The tertiary system suffers from higher levels of inequality (compounded by the state scholarship program) and very low internal efficiencies. The recent introduction of free textbooks at the primary level is an example of a costly measure with limited impact on learning outcomes, and the equity impact is 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 of 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 to provide the services efficiently and cost effectively. Without better information on 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 between wealthier and poorer local government units. In the latter case, it would raise the costs of education significantly without commensurate improvements in outcomes. This has serious implications for any reform of education financing in Croatia. 5.59 Closely monitor the progress being made in reforming financing of public tertiary education to ensure that it 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, it 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 of the faculties.

” The Bologna Process is an intergovernmental initiative launched in 1999 which aims to create a European Higher Education Area (EHEA) by 2010 and to promote the European system ofhigher education worldwide. It 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 is characterized by its high cost, large size, but low effectiveness. Despite best efforts, tackling these deficiencies has proven difficult as a result of a combination of factors. One is the high level of rigidity in the organizational structures and remuneration system in the public administration. A second factor is a common perception within the administration that EU accession requires the creation of a new layer of new regulatory institutions and administrative functions for managing EU structural funds and implementing acqui~.~~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 without harmonizing pay levels across levels of government, would compound the problem of already high wage bill and inefficiencies. 6.2 The problem is not only fiscal: the excessive size also hampers decision making and service delivery. There has been a proliferation of agencies and subordinate entities with operational autonomy and often revenue-raising capabilities. There are many instances of overlapping functions, lack of coordination and lack of clarity about lines of accountability among ministries, agencies and other state subordinate entities. This creates problems for the execution of 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 ofservice 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 is capacity to undertake the re uirements of EU accession and increasingly complex policy coordination. The experience ofEU8 82 suggests that this will be a long haul effort. More than two years after accession it has become clear that the harmonization with the acquis rather than being a “one-off’ effort needs to be supported by a creation of soundly performing systems across the whole government, with professional, merit-based, and independent civil service in place. This chapter ofthe PFR will further elaborate on the conflicting pressures on the wage bill and on the steps that can be taken to manage the development and reform of 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 of delivery public services (Section B), and concludes by sketching out an agenda of 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 oflocal government units. 90 In fact, additional staffing for issues related to EU accession is estimated at 0.6 percent over 2005 levels which would impact the staffing levels at the margin. ’’ There are few examples ofa good practice, like in the case ofthe 2007 Law on Environmental Protection and Law on Spatial Planning and Construction, whereby bylaws require a transfer of 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 of Croatian public Effectiveness Quality Law Corruption administration in terms of Croatia as % corruption, rule of law, ofEU8 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 of law), while the magnitude of 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 of regulatory quality it lags behind Bulgaria and Romania. Figure 6.1: Governance Indicators I Regulatory Quality I Other SE€C

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 1000 800 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 ofthe list of 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 of Croatia 22 255 722.4 starting the business and obtaining building Registering Property licenses, as well as with the number of 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 oflow Enforcing Contracts effectiveness of public services in Croatia, but OECD 31.3 443.3 17.7 these are also indications of generally Croatia 38 561 13.8 inadequate qualityof provision of public *% of GNI per capita, **%property value, ***% ofdebt Source: Doing Business 2008, www.doingbusiness.org. administrative services. 6.7 The problem is 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 of a favorable business and investment environment. 6.8 Already some improvement has been observed in various dimensions, notably as regards the enforcement of debt contracts, where only speed remains an issue, and more generally in terms of number of administrative procedures. The gaps remain still very high in terms ofthe number of days required for completion of administrative procedures as well as in terms of their costs. Simplified procedures for starting a business have been implemented through Hitro.HR project, with further simplification expected in 2008 through a roll out of e-company registration. A regulatory guillotine effort aimed at simplifying business regulations has been initiated in late 2006, with almost half of the recommendations for simplification or elimination implemented year and a half later. Further improvements should be expected in the coming years given significant backlog of court cases has been resolved. Land registry reform also produced some improvement in the reduction ofthe ratio of solved vs. unsolved court cases. However, it is still too early to say if recent data represent a lasting change in trend.

95 Doing Business in 2006, World Bank.

123 B. EFFICIENCYOF LABORINPUTS

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 of the wage bill is higher than in almost all EU new members and despite efforts in recent years, the wage bill (without employers’ contributions) remains around 10 percent of 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

YO of Ranking YO of Total Ranking YOof Current Ranking YO of 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 NMS 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 is 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 EUAccession countries. 6.10 The high wage bill reflects the large number of public sector employees, rather than high wages. It is indicative that 4.9 percent of population is employed by the civilian public administration (see Table 6.4). This is more than sixty percent higher than a median value of 3 percent in Europe and Central Asia. At between 260,000 and 270,000 employees, the general government sector employment represents over 15 percent of the labor force and is 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 of staff employed by the state-owned companies with majority state ownership held in the Croatian Privatization Fund portfolio. All inclusive, the total number of people employed in the public sector would amount to more than 20 percent of Croatian labor force.

124 6.11 To contain the overall cost while increasing individual pay, the government will need to downsize the staffing. Some ofthe areas, where staffing numbers could probably be reduced without affecting much the delivery ofpublic services, include the following: Local governments: A high fragmentation of 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 of military personnel and attendant spending. With over 45,000 employees in internal affairs and defense, uniformed personnel still 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 ofpublic service employees, including teachers, judicial and medical personnel. In 2005, these three sectors accounted for almost 53 percent of total public administration. As discussed in the education section, there is a potential for efficiency gains in bringing teacher to pupil ratios back to mid-1990s’ levels and by reducing the ratio ofnon-teaching staff to pupils from its current high level. Judicial sector: Croatia has one ofthe largest numbers ofjudges 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 oftime on filing and retrieving documents, instead ofdealing with clients or policy issues; Contracting: There is also lot of staff time being spent on auxiliary services that could be outsourced, like IT services, cleaning, catering and the like on the basis ofpublic 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 1 1,626 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 % of labor force 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 of 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) is over 50 percent (Figure 6.3). Another symptom is that while labor turnover within public Source: Croatia Civil Service Review ofCurrent Pay and Benefits System, Final administrations is in general Report, May 2005. Source: Croatia Civil Service Review of Current Pay and low, the only segment where Benefits System, Final Report, May 2005. mobility occurs is at the top end as younger and more ambitious public servants leave for employment in the private sector after a few years of acquisition of know-how. Past that point the wage differential with the private sector becomes too high to be compensated by job security. 6.13 Although pay-compression in Croatia is 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 is within a narrow band. This in turn is a likely factor for the use ofbonuses or annual increments to decompress total remuneration ranges. There are 13 different bonuses in addition to years-in-service allowance96 that range from 15 to 150 percent of the basic salary, are not mutually exclusive and could even be larger than the basic pay. None of them though is performance related. This non-standard approach across the administration leads to upward pressure on wages and relates total remuneration to the strength of bargaining power rather than qualifications, merit or performance. 6.14 Part of the reason for the low turnover is 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 of state institutions (Figure 6.4) show that Croatian public administration has middle-aged staff. This is because ofthe large cohort ofpeople who entered the service around the time ofindependence and who now have between 20 and 30 years of service. Given that the current remuneration policy is driven by ‘years in service,’ it is clear that the cost ofthe public administration will continue to rise as employees move through the system. Since there is 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 on years of service, will be costly, and it will become more so as this cohort stays in service.

96 These 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 To obtain and retain competent staff requires competitive recruitment and remuneration accompanied with attractive career opportunities and merit-based incentives. In the past few years progress has been made with the enactment of Civil Service Law in 2005 and adoption of horizontal HR management functions. The Law represents a major progress, but there remain several issues.97 For example, most provisions of 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 of state employees), which in turn needs to be coordinated with the design of 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 of years ahead. The recently negotiated six percent increase for all civil and public service staff (with the exception of education sector that was granted 8.1 percent per year to catch up with the rest of public service) without appropriate correction of ‘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 is related to overly complex government organization. There is a tendency to provide public services through extra ministerial agencies which might function as organizational units of particular ministries hence showing no obvious reasons why such activities have to be performed outside ministries. While the overall number and organization of ministries (15) is somewhat on a high side for a country like Croatia, there are also five other categories of organizational structures within the government: Offices ofthe 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 is that of the 13 organizational entities responsible for environmental management or over 700 entities involved in delivery and policy planning of social services. Among all entities in the sector, the Ministry of Environment, Physical Planning and Construction receives only nine percent of the total national budget allocated for environment, while within that envelope only 8-9 percent is actually spent on management of environmental issues. This type of fragmentation of a core government function will lead to inefficient use of staff, knowledge, and financial resources. 6.23 This fragmented organization has evolved for two main reasons: (i)in some cases there was confusion between organization and demonstration of importance for political action, so some Offices and Agencies remain as independent units only to show the importance of some intervention (for example, office for prevention of drug abuse) at a cost of deeper integration and ability for horizontal coordination with the sector they belong to (health care); (ii)in some cases opening a new

97 SIGMA: Croatia, Public Service and the Administrative Framework Assessment, June 2005. The assessment is based on the common benchmarks that SIGMA uses to assess the public administration in EU accession countries. Given the absence of common standards for public administration in the acquis communautaire, this assessment is therefore the main instrument that is used by the EC to determine the readiness ofcandidate 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 is not clear how ministries manage the multitude ofagencies that operate within their sector ofresponsibility. 6.25 Fragmentation of organization is 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 is drafted without preliminary analysis of the problem, likely consequences and implications of possible alternative solutions. The government has in February 2005 amended the Government Rules of Procedures to introduce a mandatory system of fiscal, social, economic and environmental impact assessments. This would provide ministers with a stronger factual basis on 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 still in the phase ofpiloting. 6.26 EU accession will place more strain in respect of introducing regulatory impact assessments, implying a need for faster restructuring of administrations’ activities in terms ofshifting away from low-skill routine jobs (that should be left to outsourcing partners where justified) towards more complex high-skill policy-making activities. Lack of education and on-the-job-training may prove to be bottlenecks in this respect, requiring rapid remedial action in the field of education and training that should accompany reforms in the fields of salaries’ setting mechanism and performance based management in general. Successful EU accession will require substantial speeding-up of 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 Law on the Civil Service was adopted by Parliament that addresses deficiencies in the legal basis of the status of civil servants and other employees, most notably with regard to the depoliticization of public administration, recruitment selection, promotion and training policies, as well as the regulation of possible conflicts of interest. The Government has also made progress in developing e-government, streamlining the number of ministries and establishing the Civil Service Training Centre for continued education of administration. However, the limited progress made has tended to be in a piecemeal manner rather than as part of 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 of the proposed reform efforts and is not covering all segments ofpublic admini~tration.~~ 6.28 A more comprehensive approach is now required. Reform will need to focus on a reduction of the size and cost of the public administration, from strengthening the administrative

’*Produced European policies and rules that imply an active role of the national administrations - in which the national administrations are called upon, in the name ofthe uniformity of the rights of citizenship and enterprise within the EU, to assure homogeneous levels of service efficiency and quality (8th meeting of Ministers of Public Function of the EU countries, Strasbourg, 7 November 2000). 99 A National Council for State Administration Modernization Evaluation is to be established to monitor the PAR progress and propose recommendations for strategy improvements.

129 capacity to implementing the policies required for European Integration as well as from improving the quality of 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 of individual civil servants and the rank that they occupy, which in turn is determined by the years in service and the level of education) will need to be replaced by system that links more firmly remuneration and performance. A review of 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 of performance budgeting and associated set of 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 of 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 of 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 of the Ministry ofFinance. 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 of functional reviews of administrative structures in order to bring organizational structures of ministries, state agencies and offices of 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 of 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 of sectors should be pursued with the purpose to review the mandates, the allocation of functions and the alignment ofresources 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 is a strong case for reviewing all of the institutions

130 individually, to determine whether each is 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 is 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 or privatized / left to market at the basis of public tenders. 6.34 In 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 of agencies, their relations with their parent ministries, the relation to the national budget and the lines of accountability for these agencies. This could serve as a basis for developing and implementing a comprehensive program of outsourcing routine activities, such as filing, archiving, IT services, cleaning and the like. If based on public tenders, such arrangements may produce significant efficiency gains. Substantial managerial educational effort is required in this respect. Policy Design and Evaluation 6.35 To pave the way for a more rational deployment of government administrative resources, a third priority area is 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 of the problem from stakeholders’ perspectives, identify the options and assess the consequences of each option, including issues of 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 of information provided by the Government to the Parliament in support of draft laws should be improved and accompanied with findings of 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 of policy outcomes. Consultations with all stakeholders affected by any proposed regulation should commence at an early stage of drafting regulations and consultations’ outcomes should be properly reflected in regulations and accompanying documents. Systematic arrangements should be introduced to asses the likely impact of 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 of ministry-level strategic plans. Strategic Development Framework 2006-20 13 is 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 PART 111: ENSURING SOCIAL SECURITY

7. HEALTH INSURANCE

7.1 The Croatian health system has performed relatively well compared to countries in the region in terms of 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 of independence have been politically difficult to roll back, and the complementary health insurance system introduced in 2002 has not accomplished its 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)vs. GDP at care is well above its neighbors and many PPS countries in Europe. The Croatian health system is based on principles of solidarity and 14 1 universality, while it also allows for participation of the private sector in both the provision of health care services and the health insurance. However, the generous basic insurance limits the scope for private sector initiatives. Furthermore, the quasi-absence of 0 0 50 100 150 200 :; co-payments (due to numerous exemptions for :; specific groups) indicates a tendency to GDP p.c. at PPS emphasize redistributive objectives at the cost ofthe financial stability ofthe sector. Source: WHO (2003 data), Eurostat, Croatia (2005). 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 ofthe health care system while maintaining past health outputs, a new health insurance law and health strategy were enacted in 2006. The law sets a marginally stricter benefit package by reducing the generosity ofHZZO’s drugs reimbursement policy and limits 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 ofthe 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 of GDP at the end of 2007 (the Ministry of Finance data). The trend of arrears reflects more fundamental weaknesses ofthe 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 ofthe 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 ofhealth spending. The common strategy was adoption ofhard budget constraint and strict fiscal discipline. 7.6 This chapter of the report will elaborate on the conflicting pressures on the health spending, inefficiencies and inequities in the current system of service delivery and will propose the steps that can be taken to address them on the supply and demand side of the health sector. It first looks at effectiveness indicators (Section B), then reviews the factors that limit the efficiency of delivery of public services (Section C), analyzes the equity ofhealth service delivery (Section D) and concludes by sketching out an agenda of 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 life 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 of 2005. However, although the trend in life expectancy has been increasing, matching the progress achieved in the best performing countries in Europe, the lag behind EU15 (average 79.1) is still significant. Average life 62 - expectancy is not necessarily a very 60 4 , good measure of health system's 0 50 100 150 200 outputs though. It may show higher GDP p.c. PPS sensitivity to cultural and environmental variables, such as nutrition and sanitation development, than to effectiveness of the health Note: Croatian GDP adjusted for 16% upwards at the basis of estimate of the size of 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 of WHO'S 2002 estimates. GDP 2005 measured as % of "disability-adjusted life expectancy" EU25= 100. (DALE) indicator, sometimes also Source: World Health Report 2004, Eurostat. referred to as healthy life expectancy. It measures expected number of years to be spent in good health, which is 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), is positioned close to the expected value for DALE indicating expected health output given income level.

looEU25 (without Luxembourg), Croatia, Norway, Iceland, Switzerland.

136 around 58 percent of EU27 average is 30 expected to have under-5 infant mortality f,, 25 - rate around eight per thousand live births. p- 2o a With an outcome of 6 in 2006, Croatia was 5 -- below average for EU8, but had still a long E 15 way to go to reach the value of 4.7, which is 5 10 - representative for developed European 5 5 - countries. The standardized death rates OT 5 I

Table 7.1: Standardized Death Rates, All Ages (per 100,000), 2006 Ischemic Alcohol Smoking Circulatory Cancer of 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 health for 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 is more than in other countries at similar income levels. Croatia's public spending of $917 per capita in PPP is the median value of the comparison group (EU new member states). In aggregate terms, however, Croatia spends 8.4 percent of GDP on health (2007), which is 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

lo'Similar to Ireland and Norway.

137 correcting for the non-exhaustiveness of 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 of 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 of 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 of 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 is 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 low private sector spending.lo2 A mirror image of this fact was reflected in the consumption pattern of Croatian households, which spent on average 2.4 percent oftheir total budgets on health in 2004. This figure is low compared to other countries in Europe. The large share of public spending is explained mainly by the large number of 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 of private funding; for example, the share of 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, YOof GDP, 1999-2008 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008l Croatian Institute of 7.6 7.7 7.4 7.2 6.2 6.6 6.0 6.4 6.1 5.6 Health Insurance/ Ministry ofHealth 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 9.01 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 of GDP, but includes operating expenses ofHZZO. 'Direct budget ofMinistry ofHealth for policy, regulation, public health, and related activities. Government estimates. Source: MoF, MoHSW, WHO.

lo2Data problem is illustrated by large discrepancy between government estimate of private sector spending at 2 percent of GDP which is being peculiarly flat over the long run, and WHO estimate of 1.5 percent of 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, of 18.17 euro per visit in an outpatient department, 10.90 euro if referred by GP or specialist with an upper limit of 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 of co-payments on equity and access to 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, all 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 on their social benefits as well as premium. The unemployed in Switzerland also have to pay regular fixed premium. The criteria of payments for pensioners are also mixed. Some required pensioners to pay the same fixed percentage of their pension as employees pay theirs (Germany and Netherlands for example) and others have special exemptions (Belgium). A general trend is to move away from categorical eligibility for co-pay exemption to broad-based eligibility which is tied to household means for living. In Britain, the prescription charges cover about 40 percent of average prescription costs, but only 12 percent of prescriptions are charged, with exemptions for patients with specific chronic diseases or elderly people and those with very low income. In the USA, the Medicare scheme, which covers elderly people, reimburses only certain selected drugs and Medicaid, which covers some ofthe poor, reimburses only drugs that are on the formulary in that state. In France, co-payments are based on the drug reimbursement rate. Drugs for serious and chronic conditions and exceptionally expensive drugs are fully reimbursed. However, only about 10 percent ofthe 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 of Pressure 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)vs. GDP outputs; however, arrears and future D.C. at PPS challenges further underline sustainability problem. Further increase in income, life .. expectancy, ageing and dependency ratios, may AfterGDP cOrr(Icti0 lead to unsustainable growth in demand and 16 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. It should be well understood that this 13 problem needs to be solved not only for reasons EU15 EM Croatia of economic efficiency-system with well Wrcent of populabon aged 65 or tmre aligned incentives may produce better health *Total health expenditures as X of GDP services for those in the need. Source: WHO, European Health for All Database, MoF, MoHSW, WHO 7.13 A number of factors are combining to drive up health spending. The ageing of the population is one of them. Financing and delivering health care for the elderly population is 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 ofchanges both in the number ofpeople and in the age-gender composition of the population. Total health spending in ECA is 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 is quite stable, the change would largely be due to age structure changes, especially increases in older population. This is a low figure compared to other regions; for example, in Latin American population changes are expected to lead to an increase of47 percent in health spending. In Croatia, elderly consume several times more health services in real terms than population stratum between 15 and 24 years of age. In these terms, it is worth noted that the share of population aged 64 or more is 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 of 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 is assessed to be at around 20 percent Inpatient care with inpatient care at 33 percent, and 49% the above partially reflects the change Pharmaceuticals23% Outpatient4% care in health budgeting in 2006). The largest increase in public spending recently has been for pharmaceuticals,

lo3Co-payments are paid as a lump sum per prescription for drugs or per visit to GP or specialist. They range 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- is less than US$15. lo4Among the groups exempted from paying contributions are: pensioners, unemployed, children and students.

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, 1,697.0 1,999.0 2,133.0 1,628.0 2,272.0 2,559.0 2,663.3 533.3 604.1 specialist services Prescription 1,529.0 2,238.0 2,096.0 1,952.0 2,397.0 2,773.0 2,815.6 3,074.9 3,487.2 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 261.0 353.0 337.0 365.5 427.0 467.0 511.0 478.2 467.0 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 331.0 406.0 345.0 533.0 315.0 288.0 294.0 319.6 619.0 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 of 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) In % of total health care Primary care 19.2 19.9 21.0 21.0 19.8 19.1 20.3 19.7 19.3 Polyclinics, 16.6 17.5 19.1 14.9 19.4 19.9 20.1 3.8 4.0 specialist services Prescription 14.9 19.6 18.8 17.9 20.4 21.5 21.2 21.9 23.1 drugs Hospitalization 41.9 37.2 36.7 42.3 35.5 33.6 33.2 49.2 48.4 ” Stock ofshort-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 of 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. On 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 is 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 of arrears in Croatia (hospital and 08 HZZO arrears) has been increasing 06 almost continuously since 2004 and was 04 around 1 percent of GDP at the end of 02 2007. Most of the EU new member 00 states have been or still 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 of GDP. The stock of debt in the health sector in Slovakia in 2003 was approximately 2 percent of GDP.’” However, these two countries have been addressing these issues through a mix of supply (mid-term) and demand-side (short-term) measures. 7.17 The rising arrears reflect the difficulties the Croatian health system is 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 of the primary health care is urgent to reduce shifts to more expensive secondary care. Third, the extensive hospital infrastructure is expensive to maintain and there is inflexibility to reduce costs. Fourth, hospitals governance structure is 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 of the health system-it inevitably increases the cost of future supplies to a non-credible buyer, and even more importantly it threatens with supply shortages and thus depriving patients ofadequate cure. Demand Side Inefficiencies 7.19 On the demand-side, co-payment is a commonly used instrument in OECD countries to deter excessive utilization of health services. Most health insurance systems rely on some kind of co-payment as a means to control “moral hazard” that is, as the price of health services is reduced through the effect of insurance, consumers tend to demand more services. Patients’ demand for services, particularly drugs, is sensitive to the payments that they have to make out-of-pocket. Many countries in the world, including Poland in the group of NMS, have introduced private payments without negative effects on health outputs, but with positive effects on efficiency in the provision of health services. The impact on equity should also be monitored. 7.20 Croatia’s co-payment share in total health expenditure is less than one percent as opposed to ratios among Western European countries, from 7 percent in Luxemburg to 33 percent in Switzerland. In addition to existing co-payments, the Croatian government introduced in 2005 a flat administrative fee (or flat co-payment) at the minimum amount of 5 Kuna per person and a cap of 30 Kuna per person per month. The revenues from administrative fees were expected in an amount of 320 million Kuna per year, or approximately two percent oftotal health expenditures. The average fee level of 10 Kuna per visit, that is around 0.5 percent of minimum salary for health

lo’World Bank Financing in EU8 countries report.

142 contribution payment, with a cap of 1.5 percent of minimum salary, seems not to have changed behavior of beneficiaries. The presence of a monthly cap in the administrative fee per patient might have created the opposite of 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 of 15 percent of Table 7.5: Co-payment Structure, 2007 cost for specialized care, 25 percent Categories Number of HRK million for hospital accommodations for users per year (per treatment of 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 5 00 are three classes of 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 there are many categories of Based on income census 529,625 378 Other categories 580,500 40 1 individuals for whom the Total insured 4,.361,008 1,379 government takes care of the co- Source: HZZO. payments (for example, unemployed, students up to 26 years of age, spouse of deceased insured person, wartime disabled, war veterans, disabled, and farmers who are at least 65 years of age); second, there is an additional list 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 of 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 no indications that the introduction of administrative fee has deterred unnecessary demand and prevented further subsidization of groups with the ability to pay. There was also a possible lack of incentives for doctors to collect the fees (this system was implemented successfully in Slovakia in the pado7,but is absent in Croatia). Overlapping social and health care functions may be legitimate in the short run in a country where the system of 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 is 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 of 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 list with 1,700 specialties, out of which 700 require a co-payment of 10, 25, 50 or 75 percent. This system was introduced in 2002 and led to one-off decline in expenditures on prescription drugs. However, on top of 57 percent of population exempted from co-payments, additional 20 percent did not pay due to complementary public health insurance with a very low

Source: Croatian Health Insurance Fund lo’Although the next government reverted the policy and eliminated the user fee in 2006.

143 premium, hence attracting high spending segments ofthe population to insure. A subsequent catch-up in demand after introduction of supplementary insurance is visible in the Table 7.4. This is in stark contrast to other countries in Europe, where the trend is towards reducing public participation in favor ofadditional 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 of expenditures on prescription drugs, but require further efforts. A major part of 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 ofcoverage (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 of Australia, when comparing the Croatian wholesale prices of a sample of 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 list ofreference countries.lo8Furthermore, it 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 is 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. Two types of prescriptions were introduced - those on the HzZO’s free list and those requiring co- payment. A major revision ofthe list was made before introduction of the new system, so incentives were created on the side of suppliers to cut their prices in order to include the drug on the first list. Complementary incentives were created with the introduction of co-payments, thus increasing price elasticity of 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 on prescription drugs become sustainable. 7.27 The picture would not be complete without noting that Croatia’s sick leave program is exceedingly generous. In fact, after the first 42 days of sick leave (paid by the employer), beneficiaries are entitled to up to six months with a possible extension beyond one year ofsick 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 on a sick leave in 2007, the indicator that is increasing over the last couple of years. Over 19.2 million days were lost in terms ofproductivity gains due to sick leaves. Another 1 1.6 million days were spent on 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 of age (for mothers with twins, three or more children). Anecdotal evidence points to a widespread misuse of sick leaves by enterprises as a way to temporarily hide redundant

It included Slovenia, France, Czech Republic and two additional countries where necessary.

144 employment. This points towards a relatively easy process of granting/approving sick leaves, which needs to be strengthened, if Croatia wants to address the problem of low productivity ofits labor. Supply Side Inefficiencies 7.29 Croatia, unlike many former socialist countries, has not inherited an excessively overbuilt health care system. Nevertheless, there is significant scope for rationalizing and modernizing the hospital infrastructure. There are 165 institutions in the health sector, of which 68 are hospitals and policlinic~'~~.Hospital network consists of a large number of multi-specialized hospitals in a close catchments areas and few centers of 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 ofBudget '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 of the EU new member states. However, most of the large fixed costs observed in hospitals do not arise from the number ofbeds but from the need to maintain a large infrastructure and the inflexibility to adjust inputs-besides the number of logRegister of Budget Users, Official Gazette 81/2007

145 beds. Reducing the number of beds will not contribute to a large reduction in costs if the same number of staff now has to care for fewer beds and if in response to it hospitals increase occupancy rates. This is indeed what is 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, is the long average length of stay. Inpatient admissions are in line with EU average, however, patients stay in hospitals for extended periods of time. The trend followed by many countries in Europe is to reduce the average length of stay (ALOS). There was a large reduction in ALOS during the 1980s and 1990s in Croatia, but in the last three years the length of stay has remained at 11 days on average. Other countries outside Europe rely on using outpatient care as much as possible, including the development of day surgery care, resulting in a significant reduction in ALOS. In the United States, for example, ALOS is 4.8 days and 57 percent ofpatients are hospitalized for three days or less. In addition, only 16 percent of patients stay in hospitals more than eight days and almost half of all surgical interventions in the United States are now done on 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 of 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 of 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 of Stay (ALOS), Population1985-2004 1985-2004

15

n$ 10

I -+- EU manbas before May 2W 5 -0-EUmanbasaln~cMayZW4 :I:- :I:- 0 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 limits to the volume of services to be provided, based on the number of points, and includes financial penalties if a hospital exceeds its 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 on the basis of 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 of resources. This strategy is intended to reduce the waiting list while improving control over the total costs. The initial results indicate that the introduction of PPTP has had an impact in reducing the average length ofstay in most ofthe 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. Low occupancy rates also increase the risk that the annual contract for the

'loWE3 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 ofwaiting lists, suggesting that hospitals prefer to keep the same patient longer, rather than taking new patients. The sanctions to hospitals that spend above the limits 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 ofarbitrary internal controls, for example, by restricting the use of medications, rather than productivity improvements. Parallel reforms in hospital management and realignment of incentive structure are essential in order to protect access and ensure appropriate quality of care. Two aspects of such reforms are of critical importance: introduction of flexibility in wages and employment bargaining (without larger flexibility of staff costs at micro level, delaying services is the only managerial tool available to control costs), and elimination of 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 on Diagnostic Related Groups (DRGs). This will represent an important step in rationalizing incentives in the system, and will alleviate some ofthe above concerns. The government is implementing pilots in four hospitals that were rolled out to 50 hospitals at the end of2007, and is 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 still provides too few incentives to support gatekeeping functions of General Practitioners (family doctors-GPs). Prescriptions' quotas have proved to be ineffective and a more sophisticated standard cost controls system is required, as GPs and specialists in polyclinics have to respond to demand for services. The demand has continued to rise in recent years irrespective of measures taken prior to 2004. 7.38 General practitioners are acting as Table 7.7: Number of 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 of 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 of time per patient. Balancing these three factors will allow early 2002 384.02 12.86 prevention, optimum use of 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 of incentives for 2007 138.5 1 16.78 investment in human capital and equipment in Source' HZZo primary health care have kept the quality ofgatekeeping in Croatia at a low level during transition. As patients' demand pressures begun to grow rapidly in the second half ofthe 90's and continued to grow in this decade, reforms were too slow to contain the outburst of 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 of the health care system and consummation of drugs. Annual choice of GP was coupled with an option for GPs to run private general practice (doctors of family medicine). This was a step taken in the 1990s in the direction of 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 is expected to cany a minimum ofabout 1,700 patients per year on a standard roster (the actual average is somewhat below this standard), which is low compared with GP rosters of 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 is set at 850 patients per GP. Nevertheless, the doctors are paid according to the standard of 1,700. Despite lower average number ofpatients, most Croatian GPs had to deal with larger average number of visits compared to their colleagues in EU due to weak regulation of 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 of 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 by the weak deterrence provided by the co-payment deterring mechanism. Unjustified demand for general health care services is one of two main obstacles for effective gatekeeping, as unnecessary visits by patients consume significant amount of doctors' resources undermining quality of gatekeeping. As long as social protection measures do not target low 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 is that co-payment limit be raised, in tandem with a substantial improvement on the targeting of low income groups by social protection measures and in line with real income growth. Short of that, further increases may not be feasible in the short run. 7.41 The EU accession is 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 of the majority of GPs, meeting a necessary condition for increased quality of service. As specialization implies broadening ofthe scope of medical procedures and treatments that GPs are allowed to perform, extension of PPTP remuneration system to a wider range of procedures

11' Anecdotal evidence confirms that patients with de facto or de jure free access to the system tend to consume significant amount of physicians' resources (time primarily) by demanding consultations, examinations and procedures that are clearly not justified from the perspective of immediate health needs. This problem may be particularly acute in regions with elderly andlor unemployed population. 'I3In the last couple of years there has been a slight change in the remuneration system for primary care and specialists, but to date the impact of this change has not been systematically measured. Anecdotal evidence suggests that positive changes have happened, calling for implementation of 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 of the implementation of this new mechanism of payment was to stimulate the performance of 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 of GPs started to invest in know-how and equipment in order to expand the scope of services. Unfortunately, there are no systematic data which would point to the amount or quantity of investment by GPs as their associations work very imperfectly. GPs' associations should be strengthened in order to enable data collection, sharing of know-how, facilitation of procurement, and ease access to finance for purchases ofnew equipment.

148 and treatments, coupled with lifting up of the total limit, will create mutually reinforcing incentives for investment in general health care both in terms ofhuman capital and equipment. c. EQUITYISSUES IN PROVISION OF HEALTHSERVICES

7.42 Average per capita Table 7.8: Distribution of Relative Household Expenditure on spending on health increased Health from around 2 percent of total Proportion ofPopulation (%) 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 0 Yo 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 of 3-5% 8.9% 11.6% relative household expenditures on 5-10% 7.9% 7.6% health was changed in 2001-2004 in +lo% 2.9% 3.7% the that proportion Of Source: Authors' calculations based 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 % of total (Croatia=100) protection mechanism does not target capita, per expenditures) low income groups well. Analysis of Year) expenditures per income brackets Age <=15 386 1.8% 88.5 indicates very stable share of 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 of equity issues. Similarly, households 65+ 902 4.3% 86.5 headed by retired, and disabled Source: Authors' calculations based on the 2004 Household Budget persons face higher per capita Survey. expenditures on health. Education of household heads seems not to influence significantly health spending pattern in relative terms. Female-headed households are spending more on health, which is probably connected with relatively high proportion of single old 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 HRK (HRK, per capita, (as a YOof total (Croatia=lOO) per year) expenditures) 1,000 per person per year is 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 is spent on urban 782 2.8% 113.3 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 expenditures on health are closely connected to Concentration Curve for Health Expenditures 10- income, so that income inequality is transformed into inequality in health spending. 20 percent of the poorest people in Croatia dispose some eight percent oftotal income, and the same poorest people spend on health around 10 percent of total household spending on health. Similarly, unemployed persons over proportionally face zero or very low spending on health. It is highly possible that their dire

0 01 02 01 I, 0.1 0.1 07 08 0.0 1< financial straits are a major reason for such a Eun",.,,". mDmYI.t,Dn .h.,. low spending' The report the hole: Population is ranked by its per capita household similar health status as the employed, but they live in household where average income is 20 Source: Authors' calculations based on the 2004 Household percent below the average and spend Budget Survey. substantially less on health. The situation is even more pronounced if an unemployed person is head ofhousehold, in which case the whole household has low health spending, often no spending at all (in almost 40 percent of cases) or ofvery small amounts. Since these groups may be in a higher need for health services (especially retired persons), this could be an indication of 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 of a loss of contribution base and increase in the number ofbeneficiaries could compromise the financial stability of the health insurance system. It has been established that there are currently a large number of individuals exempted from contributing to health insurance. This is not unique to Croatia and countries have dealt with this issue in different ways. The current trend however is to avoid granting all individuals in a certain category free services. It is more equitable to set some kind of income or means testing to accomplish the same outcome. One such category, for

150 example, is pensioners. They consume the largest amount of resources in the provision of health services, but do not pay contributions or co-payments. If the state is going to continue paying for the care of the elderly it would be important to determine how much this cost in order to predict future outlays in this respect. Currently there is 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 of low income groups by the social protection system. The annual cap might be introduced and the level could be reassessed, as the current level is not contributing to excess demand control. The introduction of 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 of 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 of some indicator in the economy; (iii)reduction of the number and categories ofindividuals exempted from the co-payments in conjunction with better targeting of social policies. This could be done for example through the use of 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 is a common phenomenon to most countries in the region. The solution involves actions in multiple fronts. The most immediate action that can be adopted is to increase the share paid by the consumer in the form ofa 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 of 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 on 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 of 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. It may also lead to significant efficiency gains in handling and distribution of 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 of the impact of the changes to the payment mechanism for outpatient care implemented in 2005 to see if it has resulted in lower referrals and lower utilization in hospitals for the procedures paid according to PPTPs; (ii)eliminating the option for hospitals to opt out of case-based methods wherever it is implemented. In the case of 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 to 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 of DRGs. This will also allow estimating the actual cost of providing health services, as it is likely that some services are currently being paid below cost, contributing to the increase in arrears. Reduced rates of hospital and specialist care utilization would translate into significant savings for the health system. Using the available HZZO data, it is estimated that a 10 percent reduction in hospital and specialist health care utilization will decrease total health sector expenditures by 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 its 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 ofknow-how, facilitation ofprocurement, and ease access to finance. Restructure the hospital sector. The first step in this process is to assess the needs of the population by type of 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 of 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 of hospitals, like in the case of Estonia, where a restructuring plan was set up in 2000 with the goal of reducing the number of 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 of facility with the maximum time limit to reach the hospital of one hour. Based on these criteria Estonia identified three regional hospitals for tertiary care with catchments populations of 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 of hospitals went from 115 to 67, the number ofbeds decreased from 14,000 to 9,000, and average length ofstay 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 work, care for family members when ill, pregnancy complications and maternity leaves, collectively accounting for over 0.7 percent of GDP (2007). With the exception of 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 ofHZZO funds as those are part of 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 of 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 is how to deal with low current and future replacement rates, high fiscal costs and intergenerational equity 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 of the basic pension parameters in the reform were not set in a sustainable fashion. These include a low retirement age for women, high minimum pension benefits, and a low PAYG contribution rate (20 percent) that covers only 58 percent oftotal expenditures. The contribution rate for the second pillar is also low compared to other countries and is 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 of 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 of 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 of 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 privatization. In a post-1995 wave of economic-restructuring-induced retirement, the system dependency ratio (number of insured to number of pensioners) declined rapidly, and the share of pension expenditures in GDP reached double digits. Table 8.1 tracks the evolution of 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 (Insured to 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 of 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 of 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 of Statistics, Pension Institute (HZMO).

8.7 The PAYG pension system deficit, coupled with unfavorable demographic trends and an expected increase in life expectancy, triggered a major reform. In July 1998, the Parliament enacted the Pension Insurance Act, the first in a series of legislation setting the framework for the new pension system. The Act stipulated that the pension defined benefit (DB) system in Croatia would consist of three pillars: a scaled-down PAYG DB pillar; a mandatory fully-funded defined contribution (DC) pension pillar; and a voluntary fully-funded DC pension ~i1lar.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 of the second pillar. Fiscal savings in the system were expected to come from (i)a reduced inflow ofnew pensioners due to a higher retirement age, (ii)price-wage indexation and (iii)a longer basis period for benefit calculation. The second pillar was launched in 2002, after a two year delay. It had a 5 percent contribution rate that was to gradually increase in parallel with fiscal savings in the ~ystem.”~ 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. ‘15 The initial draft of the Pension Fund Law contained a schedule of 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 low and stagnant second-pillar contribution rate of 5 percent, fiscal performance of the pension system did not meet early expectations. The pension to 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 of high inflation in 1993. In both cases Constitutional Court ruled in favor of 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 of the Law on pension supplements attempted to reduce the gap between old and new retirees by raising the benefits of new retirees (from 4 to 27 percent), but with a consequence of opening a gap for future ones.ii6 In parallel, July 2007 amendments to the Pension Insurance Law reduced the penalty rate for early retirement and increased minimum and disability pensions, reversing thus some of the achievements of the 1998 pension reform. Consequently, the past interventions in the PAYGO system make it 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 of the government on how to proceed with the pension reform - revert to its initial multipillar design, which reaches long term economic, social and intergenerational sustainability, or refocus on 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. In 2007, the old-age net replacement rate of a new average-wage entrant with 40 years of service is assessed to stand at 52 percent compared with an average OECD replacement rate of69.1 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 of "pension wealth",1i8 initial estimates show that Croatian pensioners are closer to the OECD average than the initial replacement rates s~ggest.''~ 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 of service before retirement have in fact dropped by one year to 29.1 since the launch of 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 ofearly 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) is 1.41, compared with an age dependency ratio of 2.5 (20-60 years old to 60 plus). The OECD definition of the dependency ratio (15-64 to 65 plus) is over 4 for Croatia. This also highlights need to create incentives for later retirement.

The 27-percent supplement will 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 is comparable to average replacement rate of EU countries. 'IsRatio ofpresent value of lifetime pension entitlements of an average-wage earner to current average wage. 'I9 Net pension wealth in Croatia would in 2005 be 8.7, OECD average 10.8; UK 7.1; US 7.3; New Zealand 6.0; 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 is 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 is not an explicit EU directive, but it is implicit in other directives that regulate gender equality. Given a rising life 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 of service earns 0.825 percent ofthe price-adjusted 1998 average gross wage. For 35 years ofservice the average net replacement rate is 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 of the EU15 countries. Starting from its current level of 11.3 the pension reforms should allow the share ofpensions 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 of 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 of65. Current life expectancy at birth for 2006 is 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 is 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 is comparatively high and spending pressures will continue.

156 8.17 Two policy changes since the launch of the reform contributed significantly to PAYG pension deficit in the 2002-2005 period-the 2000 Pension Differences Alleviation law’23 and the 2004 incorporation of 100 kuna + six percent supplement in the pension base. In this period, the PAYG 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 of GDP in 2005. Without these PAYG system policy interventions in 2000 and 2004, the deficit would have been 1.1 percent of 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 of the second pillar was expected to yield a cumulative transition deficit of 5-9 percent of GDP over the 2002-2012 transition period and that system was expected to reach break-even by 2012.124 However, pension increases in 2001 and permanent inclusion of pension supplements in the base in 2004 raised the fiscal burden of financing PAYG pensions and the burden of financing the second pillar transition deficit simultaneously. The status quo projection of pension system revenues and expenditures (Figures below) under moderately optimistic macroeconomic ass~mptions’~~ indicates that annual PAYG system deficits are expected to persist for the whole simulation period. Due to mixed wage-price indexation, the initial PAYG replacement rate falls progressively from 40 percent in 2009 to around 23 percent by 2040. However, due to the low second pillar contribution rate, the initial replacement rate of those participating in both pillar is expected to be lower than the replacement rate of old- system participants, and then gradually increase from 35 to 40 percent, which is far below public expectations when second pillar was launched. Apart from macroeconomic assumptions,126 two-pillar replacement rate is affected by a low contribution rate of only 5 percent and a much stronger reduction in PAYG benefit of 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 of GDP. Figure 8,l: PAYG System Performance - Status Figure 8.2: Replacement Rates - Status Quo luo Simulation Simulation

1114 - 12 - 10 - +ONLY PAYGO

P 8- +PAYGO PLUS PLLAR TWO 8 - -cPension Expenditure -Pension Rewues ’s -+Deficit 2-

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 BDP growth of 4 percent in 2006-2009,3.5 percent in 2010 and 20 1 1, and 3 percent afterwards. Real wages are expected to grow at 4 percent per annum in the whole simulation period. Rate of return on accumulated assets is assumed at relatively high 4.5 percent, and in the payout stage 3.5 percent. 126 Rate of return on second pillar accumulation only slightly higher than the real wage growth yields a very gradual rise of 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 of all beneficiaries, underlining the fact that they have higher average pensions than regular pensioners. The largest privileged group, which absorbs 55 percent of all privileged pension expenditures, is Homeland War Veterans (HWV). HWV's pensions are determined as a percentage of the corresponding wage in the military held prior to deathhnjury but are indexed using general rules. The minimum pension for this cohort is guaranteed at 45 percent national average wage in Croatia, which is on par with the average replacement rate for old-age pensions. 8.19 The average Homeland War Veteran pension is 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 of HWV's pensions in GDP is expected to remain at around 1.4 percent of GDP without the revision of HWV's disability pension eligibility.'28Maintaining a special pension system for war veterans regardless ofthe welfare status of the veterans and their families is socially unfair and poorly targeted, and its 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 ofcentral budget spent for military purposes. The alignment with the acquis has triggered further changes of the military pension system with the early 2008 enactment ofretirement age equalization for female and male military staff. 8.21 The pension contribution rate in Croatia is 20 percent of gross wages and other contributable income, and is at the lower end of the rates applied in European countries'29 (Table 8.3). However, contribution revenues cover only 58 percent of total expenditures, while transfers for non-contributory merit pensions determined in corresponding laws account for an additional 19 percent of expenditures. The remaining 23 percent of 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. Had 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.

lZ7Pensions for certain occupations or groups determined outside of the Pension Insurance Act and their financing is provided in the central budget. lZ8There are indications of some 1,600 pending requests for HWV disability retirement. Iz9The Law on Mandatory Social Contributions, adopted in 2002, has widened the contribution base to all other labor-related incomes, such as temporary work contracts, honorary payments, and work compensations. This law equalized the contribution base with labor-related part of 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 United Kingdom 24" Turkey 20 Ukraine- ~. 33Xb- - .- Croatia - statutory 20 Croatia - required 28.5 .I Includes other social insurance programs; total ofemployer 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 is low compared to other countries. On the other hand, the PAYG benefit for years of service ofparticipants in the new system is reduced stronger than the share contributed for the second pillar would ~uggest'~'.As a consequence, second pillar benefits will not be sufficient to compensate for the reduction in PAYG benefits, particularly if the rate of return on assets accumulated in the second pillar pension funds proves to be insufficient to compensate for the lower contribution rate. 8.23 In the long run, second Table 8.4: Mandatory Pension Funds' Net Assets and Members pillar coverage is expected to ecember2o07 reach 100 percent of insured Eandatory Net assets % Members % individuals (by 2025), and the pensionfUnd 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 PBZKOOMF 3,539,690 16.9 231,070 16.6 2002, second pillar participation Raiffeisen OMF 6,483,150 30.9 442,639 31.7 is mandatory for insured Total 21,001,886 100.00 1,395,693 100.0 individuals below 40 years of %*fGDp 7.6% age. addition, insured Source: Hanfa Monthly Report, January 2008. between 40 and 50 years of age had a choice to join the second pillar or permanently stay only in the first pillar. At the end of 2007, second pillar coverage reached 1.4 million or 88.4 percent of all insured individuals. By December 2007, total second pillar accumulation reached 7.6 percent ofGDP with 70 percent concentrated in two largest finds (Table 8.4).

130 The initial draft of the Pension Funds Law contained a schedule of 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 is well above the average real gross wage growth of 3.1 percent per year during 2002-2007 period. The average rate of return ranged between 7.12 percent and 8.11 percent per annum. This was due to favorable initial pricing of 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 is unlikely that the high rates of return, induced by rising Government bond prices during the EU convergence process, will continue. Hungarian experience with the second pillar, where around 70 percent of assets are invested in government bonds, indicates that there may be periods ofnegative real rates of 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 is down 8 percentage points from previous levels, but remains well above the 50 percent minimum required for this 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 of companies listed on the Zagreb stock exchange top tier, but also on so-called JDD quotation up to 15 percent of its assets.I3' While this restriction protects the pension funds from investment in high-risk assets, it also prevents them from investment in some less risky assets as well. A partial relaxation of 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 on paid-in contributions; Maximum 1.2 percent of net asset value (NAV) per annum management fee; Switching feelexit fee. In addition there are the operating costs ofInsured Members' Registry (REGOS) devoted to second pillar contribution collection and individual account management. 8.27 There is need for serious redesign of the cost structure. Furthermore, serious consideration should be given to having pension fund participation bear some of the costs of account management and fund administration incurred by REGOS, and taking a share in REGOS ownership. This option is allowed under the Funds Law, and has shown positive results in countries like Mexico. 8.28 In 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 of 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 of the third pillar.'34Until mid-2003 there were only two open-type voluntary pension funds. By the end of 2007, there were six open-type voluntary pension funds with 103,923 members and kuna 692.8 million under management (0.25 percent of GDP) and

13' In 2000 the real rate of return was -2.2 percent and in 2003 it 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, ii)investment income is tax exempt, and iii)pensions are taxed. 134 If employers pay voluntary pension contributions on behalf of their employees these are treated as regular wage payment and regular taxes and contributions have to be paid. It has been argued that this introduces disincentive for employers to participate in the voluntary pension system.

160 twelve ~losed’~’-typevoluntary pension funds with 11,943 participants and kuna 119.1 million under management (0.04 percent of 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 of 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 of 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 of individual benefit entitlements. In period 2002- 2005, collection of 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 of 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 PAYG DB schemes of Germany, France, Spain, Portugal, Czech Republic and Slovenia, pure PAYG DC (Italy), PAYG DC combination with funded second pillars (Sweden, Poland), and combinations of PAYG DB and funded schemes (UK, Netherlands, Hungary, Slovak Republic). Croatia currently falls in the group that combines PAYG DB and funded second pillar features. The current Croatian PAYG pillar, however, provides replacement rates that are on the lower end on the EU and OECD countries. For each year of 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 of notional DC accounts that would gradually replace the existing PAYG DB If such an agreement on a common EU pension system were reached, introduction of the NDC system instead of the German point formula into Croatia’s PAYG pillar would not cause serious problems. First, current second pillar administration is based on monthly individualized reporting which could equally efficiently service the NDC pillar. Second, the current German point formula is a subset of the NDC 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 PAYG DC systems exists in Latvia, Sweden, Poland and Italy. Individual contributions are notionally credited to individual accounts. Since the money is recycled for current pension payments instead of being invested, notional deposits earn an ex ante rate ofreturn determined by the state. Indeed, the NDC system, which is filly portable because of its DC nature, provides benefits fully proportional to contributions. Issues that would need to be resolved for migrant workers are of an administrative nature: is 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 is urgently needed and should be accommodated by additional PAYG savings measures or by fiscal savings in other public programs. The second pillar contribution rate of 5 percent will not generate an annuity large enough to compensate future pensioners for the reduced PAYG benefit, especially for the oldest second pillar participants first to retire. However, larger second pillar contributions imply lower revenues for the PAYG system. Pension hikes in 2001 and 2004 have reduced the fiscal space for a higher second pillar contribution rate. Unless measures to reduce PAYG expenditures are implemented to reduce the high pension fiscal burden, the additional transition cost of 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 of second pillar contribution rate would be a definite step back in the pension reform in Croatia as it would reverse the policy of 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 of 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 of GDP in 2005 to 0.8 percent of 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 of real wage growth (half the Swiss formula) eliminates the deficit by 2023 with a more gradual reduction in replacement rates;

separately or jointly? Is the accumulation transferred to the host country, or does the host country transfer the account balance to the domicile country? What rate ofreturn does the worker earn while in the host country? 139 The NDC formula yields similar results to the German point formula which takes into account demographic factors (change in life 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 of reducing minimum pensions. However, with approximations, the model suggest that lowering minimum pension per one year of service to 0.4125 percent ofaverage 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 of those eligible for minimum pension starts increasing. 14* Fiscal impact of indexation is strong because the same indexation pattern is 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 of early retirement,'43 would reduce the deficit by 0.1 percent of GDP in the first year, and by 0.25 percent ofGDP in 2022; 0 Gradual convergence ofprivileged new pension benefits to general PAYGO benefits by 2027 would reduce the deficit to 1.5 percent ofGDP by 2027; 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. This reduces the deficit in that year to 2 percent of GDP, gradually falling to zero by 2030. By contrast, other polices would lead to much higher deficit levels. These would include measures such as equalizing benefits of post-1999 retirees to the level of pre-1999 participants, reducing the calculation period from fill 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 of ad hoc interventions in the PAYG system over the last few years (Box 8.3 below). There are four basic options to tackle differences caused by permanent inclusion of 100 kuna plus six-percent supplement in pre-1999 pensions. Abolish the supplement. This is 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 ofGDP, 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 of the supplement by about one-half, the administrative costs of means testing may eat up a significant part of 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 of eligible beneficiaries, extend it to all current and future beneficiaries and freeze it or phase it out over a longer period of time. This scenario would yield a smaller fiscal savings than the previous one. Fiscal space for the increase of 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 is the most fiscally demanding, and would require additional annual pension expenditures of0.3 percent ofGDP. 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 of this scenario would similarly work against raising second pillar contribution rate, but for a shorter period. On the other hand, this option would reopen the problem of pension differences between current and fiture generations of 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 of those that retired in the 1999-2005 period (at 1737 kuna) was 17 percent lower than the average old age pension benefit (including early retirement) of pre-1998 retirees (at 2082 kuna), while the replacement rate for old age benefits was 46 percent. These discrepancies have spurred initiatives for revisions intended to make pensions more uniform across cohorts. The initiatives focused on 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 ofthe 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 all eligible pre-1999 pensioners. This contributes more than half ofthe difference in pension levels; The widening of the calculation period from 10 best years to fill career. This leads to lower initial benefits for everyone, but was not compensated for by longer service periods as expected. Widening ofthe calculation period contributed about one quarter ofthe pension differentials; Increasing the early retirement benefit reduction from 1.3 percent to 4 percent for each year ofearly retirement. For the maximum five-year early retirement, this implies a 20 percent reduction instead of the previous 6.5 percent. On average this reduction contributed one-eight of the pension differences; Ending the transition period for addition of female years of service in 2004. This may have contributed less than one-eight ofthe 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 or re-introducing the female service bonus would reinstate the inequities ofthe old system. It is therefore recommended that these three parameters ofthe system not be changed. Inclusion ofthe 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 of WWII participants and ex-political prisoners will continue to decline gradually. Benefits provided to MPs, ex-ministers, and members of academia have no real justification-their above average wages would earn proportionally more points in the regular PAYG 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 of GDP, is for Homeland War Veterans. It not only covers disability and survivor benefits, but also envisages a minimum pension equal to 45 percent of average wage for all currently working veterans and pension bonuses to regular PAYGpensions. 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 to a large extent in government debt instruments. In the absence ofrisk 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 of municipal fixed income instruments has been slow and limited. The process of securitization, such as mortgage bonds, is 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 of investment rules and quantitative restrictions is the first step in the direction of diversification, but an inherent conflict between the domestic market development and the limits to foreign investment remain. Either the domestic capital market should be developed with active participation of financial policy makers (IPOs, securitization, etc), or in absence of 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 of the costs of REGOS, as these are financed from the central budget. Revision ofthe second pillar administration system and the level ofmanagement fees should tackle two issues. First, the fees are higher than warranted given the type of administration system and the fact that administrative functions are centralized in REGOS. Second, the current functions of REGOS are broader than just servicing the second pillar and include collecting and transferring data to other institutions, primarily the Pension Institute. If the list ofREGOS’ functions continues to include service to other institutions, they should share REGOS’ costs as well. Finally, REGOS outsources most of 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 on 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 is 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 of the pension reform was to prevent the use of 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 to 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 ofcontributions from corporate profit tax up to the same level as individual contributions could be considered. Exemption ofvoluntary 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 of higher wages, and, consequently, social insurance benefits. Identical treatment of contributions in voluntary and mandatory pension systems is therefore not recommended.

165

9. SOCIAL ASSISTANCE

9.1 Overall social spending in Croatia is Figure 9.1: Overall Social Spending in Croatia, high by international standards, but only a Consolidated General Government, YOof GDP 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 of 31 percent of GDP towards 26 percent of GDP in 2007 (with the largest share going to social security and welfare services), only a very small fraction (0.6 percent of GDP) is used for the poverty- related social assistance program. Most of 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 In 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 is some two percentage points higher than what EU15 countries spent and it does not include tax allowances provided for social protection. Out of these, the social assistance program, as administered by the centers for social welfare, is clearly the most targeted at the poor given the means-tested eligibility criteria, but receives around five percent of the total. The majority of other programs are not targeted at low 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 of exclusion and inclusion which negatively impacts value for money. In addition, the implementation ofthese eligibility criteria is sometimes subject to the discretion oflocal official^'^^. In the country with among the lowest labor force participation rate in Europe, public provision of social assistance also faces the challenge of establishing a link between benefits and work incentives. Over 50 percent of claimants are able-bodied people. 9.4 Social benefits spending has increased by half percentage point of GDP since 2003 as a result of reversals of some reform policies in the area of maternity leaves, new benefits introduced, changes to eligibility criteria leading to increased beneficiaries, and increased nominal value of 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 of the government's program is to improve the effectiveness ofthe 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 of GDP. A. EFFECTIVENESS

9.6 Poverty in Croatia is low if compared intern at ion all^,'^^ but stagnant despite relatively robust growth performance, thus requiring an action. Around eleven percent ofthe population is poor, and only about 1 percent of 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 ofincome poverty by approximately one percentage point; consumption poverty, however, remained stagnant. As of 2004, approximately 11 percent of the population is considered poor and a further 10 percent at risk of poverty. Poverty is associated with being retired, unemployed or economically inactive, and the incidence of poverty is highest among the elderly. As a result the poor get around 57 percent oftheir income from pensions (38 percent) and state transfers (19 percent). 9.7 Poverty is also quite shallow. The poverty gap is about 2.6 percent (based on 2004 HBS data) and only four percent of the population lives below the US$ 4.30 a day poverty-line (at purchasing power parity). This is the lowest rate among middle-income countries in the region. However, there are considerable urbadrural differences and poverty is more prevalent in the rural areas (in urban areas the incidence ofpoverty is 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 ofapproximately 1.5 billion kunas (about 0.7 percent of2004 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 of only 10 percent of 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) is the best-targeted program in Croatia given the highest effectiveness in targeting low income groups. More than two-thirds of the total spending under this program accrues to the poorest one- fifth of the Croatian population. Unemployment benefits are found to be the next-best targeted program, with about 40 percent of total benefits reaching the target group of interest; moreover, the targeting of unemployment benefits appears to have improved significantly between 2002 and 2004, probably as a result ofthe employment legislation changes that occurred in 2003. By contrast, neither child nor other family allowances appear to be particularly well targeted: the poorest fifth of the population receive only 34 and 29 percent of the spending on 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 is covered by transfer programs. Child allowances are much the largest of the various programs considered here, and reach about 26 percent of the country's population. The population coverage rates of 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 Allowcc Other Family Scsl Unemployment Any ofthese Child Other Family Social Lhenploymnl Any of these Allowances ASPUtance knefits hefits -1 -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 of total social spending by the general government, but are an important income source for the poor, supplying 16 percent of its beneficiaries’ consumption per-adult equivalent. A high proportion of social assistance beneficiaries report the main labor market status of their household head as “retired,” “other,” or “unemployed”. Before possibly recommending an expansion of the social assistance program because of its relatively good targeting performance and low 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 of this 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 of social assistance benefits in Croatia is quite good, with the above-average poverty regions in general having an above-average share of 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 is relatively under-served in terms of social welfare benefits, and the Eastern and Adriatic South regions are relatively underserved in terms of 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 Unemdovmenta* Benefits Note: A comparison ofthe relative heights ofthe 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 ofbars are equal in each region, this would indicate perfect geographic targeting ofbenefits. The “odds ratio” presents poverty and unemployment rates across regions expressed as a ratio ofthe national poverty or unemployment rate. Source: World Bank, LSA.

Distributional Policy of Tax System

9.15 The tax system on its own has only limited impact on Table 9.1: Income Inequality income inequality. The tax system of 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 ofinequality, based on 33 income intervals, point to very Employees 0.38 0.37 little or no 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 been rising. income Total 0.38 0.39 9.16 The low impact of tax system on the income inequality Employees 0.35 0.34 suggests that wealthier taxpayers indeed tend to use higher Pensioners 0.33 0.33 allowances than low-income earners do. Allowances are high Self-employed 0.52 0.47 enough to cover more than 50 percent of gross income of almost Source: Tax Office ofCroatia, staff all median taxpayers. They are reducing the tax base of the top decile’s employees and self-employed by some 20 percent, and of a pensioner by almost 80 percent. The latter is because pensioners have the lowest income and the highest allowances. The absolute values of 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 is collected from the top decile. The highest decile’s taxpayers paid 58 percent and employees 46 percent of PIT revenues in Croatia. The bottom 50 percent of employees collected only nine percent of taxes. The ratio is 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 TOP Median Average Deciles Maximum Allowances, YOof gross income 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 ofCroatia, 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 is not well-targeted at the poor and is costly to administer. Total consolidated general government social spending has increased from 3.97 percent of GDP in 2003 to 4.27 percent of 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, YOof GDP Budget 2003 2004 2005 2006 2007 2008 Total Spending (HRK million) 7,871 9,042 10,100 10,572 11,749 12,967 Percent of 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 of displaced persons and rehgees 0.09 0.09 0.10 0.07 0.04 0.02 Protection of 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 is 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 is relatively low. Spending on social protection programs (social welfare/assistance and family programs) within the overall envelope amounted to 49 percent of total in 2007. While war veterans spending is increasing in relative and absolute terms, spending on social assistance, which accounted for less than 17 percent of total, is projected to further decline below 13 percent by 2008. Even within the social protection envelope, the share of social assistance is declining and most of the funds are directed to population and family programs. Over the next couple of years, the share of population and family programs is set to increase to over 45 percent of the total, largely at the expense ofthe 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 on average 2.6 percent ofGDP and several new member states also spend over 2 percent of GDP on similar social assistance and family programs - such as Hungary 2.8 percent of GDP and Czech Republic 2.1 percent of 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 of the cost of child rearing and to minimize work disincentives at the lower end of the wage scale. In contrast, the primary focus of social welfarehocial help programs of 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 is important, as it remains relevant to current program objectives, and issues ofstigma 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, % of Total

Population and family policy measures 42% 4ML '."Population and family 35% \ Care for Croatian policy rneasurw

+Care for Croatian war veterans and their families

15% *a =Postwar reconstruction \ \ and returnof and return of displaced Protection of displaced persons persons and refugees Social WeHare disabled war and refugees 24% I veterans and 2% +Protection of disabled civilians war veterans and civilians 6%

Source: Croatia Social Benefit Reform Strategy 2007, staff calculation.

'49 As a result of the Law on the Rights of 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 of 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 ofGDP in 2007. Most of the social assistance programs are cash benefits - around 70 percent of the total welfare program spending - and nearly 25 percent of 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 of Health and Social Welfare (MHSW). Along with providing direct support to beneficiaries through social assistance benefits, the Ministry is also responsible for financing institutional care for children and adults. Table 9.4: Main State Social Assistance Programs, 2004 - 2006, million HRK, YOof GDP Type of Benefit 2004 2005 2006 HRK %of HRK %of HRK % 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 of 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 of clients in 11.1 0.01 0.00 11.6 0.00 institutions or foster families 7.0 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 of children in foster families 51.3 0.02 51.3 0.02 51.5 0.02 Placement of 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 of Health and Social Welfare.

9.22 In addition to central government spending, at least an additional HRK 1 billion is also spent by local governments annually. Local governments, depending on 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 of charge summer vacation for children of 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, it is impossible to determine whether these programs are reaching the needy. According to the data collected by the MHSW, municipalities spent slightly over HRK90 million or 0.04 percent ofGDP 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 is the core safety net benefit. It is Income Programs, Beneficiaries, well targeted but coverage is low and the base amount has not ‘YOof population been changed since 200 1. This type of program exists in almost Country 1999 2004 all EU countries; they are means-tested but differ substantially Croatia 1.8 2.7 in terms of determination of the qualifying income threshold Czech Republic ... 3.6 (national versus regional), generosity of the system (level of Estonia 5.9 2.5 benefits) and in administration practices. Croatia’s program of 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 3.3 total population and generally is in line with guaranteed Slovakia 5.5 Slovenia 1.6 2.7 minimum benefit coverage rate in new EU member Source: WB, Social Assistance in 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 of the support allowance program has increased from around 90 thousand in 2000 to 113 thousand in 2006, mostly as a result of increased threshold in 2001. The number of support allowance beneficiaries differs regionally: the most developed regions-Zagreb and Adriatic-have the lowest number of support allowance beneficiaries, while Eastern Croatia has the highest number of beneficiaries and the largest proportion of beneficiaries in the total number of inhabitants (1.4 percent). 9.25 Total spending on the support allowance was around 480 millionHN in 2006, or 0.19 Table 9.6: Guaranteed minimum income percent of GDP15’ a slight decrease from 0.25 programs in new EU member countries, - Percent ofGDP percent of GDP in 2004. Croatia’s program of guaranteed minimum income, similar to most 1999 2004 countries in the region, is one of the smallest social Croatia 0.20 0.24 assistance programs and aims to address the needs of Czech Republic 0.38 0.46 the poorest. The program is well targeted with 69 Estonia 0.41 0.17 percent of program resources reaching poorest 20 Latvia 0.03 0.05 percent of population. However, total transfers under Lithuania 0.17 0.11 this program are small and over 85 percent of the Poland 0.4 0.19 poorest are not receiving support. Spending on 1.13 0.48 guaranteed minimum income programs varies in the Slovakia new EU member countries ranging fkom 0.1 to 0.5 0.22 0.48 percent of GDP. The smallest programs are in Lamia Source: WB, Social Assistance in Central Europe and (0.05 percent of GDP) and Poland (0.1 1 percent of States, draft, *Oo6. GDP) and the largest programs in Slovakia and Slovenia (0.48 percent of GDP).Is3 9.26 Entitlement to the support allowance is determined by (a) family size, (b) combined family income, (c) combined family assets, and also (d) a limited number of proxy means, for example a second property or a car. There is a minimum error of inclusion. The duration of benefit is not limited in time and the benefit level is arbitrarily set by the Government and is based on a monthly entitlement for a single person plus a reduced amount for additional family members. The level of the

Data from the Ministry of Health and Social Welfare lS2Correcting this number for GDP non-exhaustiveness would lower the social protection spending to 0.19 percent ofGDP. 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 is adjusted according to family size and set against the actual income of 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 is low and cannot provide for even a minimum food consumption basket.’54The current legislation has foreseen an adjustment to the benefit level to the arbitrarily set level of HRK5OO. Adjustment either based on cost of living increases or regular revision and adjustment of the base amount of the poverty allowance is not foreseen, which is 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 of Social Assistance Benefits, programs. At present the duration of the support allowance in Percentage of Total Croatia is not limited in time and a large number of beneficiaries Beneficiaries remain in the system for more than five years. Almost 50 percent 12 24 of beneficiaries receiving a support allowance are working-age months months persons (1 8-60 years). Unemployed persons constitute over 45 or and more more percent of the support allowance beneficiaries and, while for the Sweden 33.6 14.3 majority unemployment is a transient phase, a significant number Germany 38.3 20.3 ofworking-age recipients ofthe 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 Measures work incentives and return beneficiaries to work. Sources: Saracen0 2002, UK: include financial incentives for beneficiaries to return to work. Gassman and Deszka, 2003, Ministry There are several examples of such reforms introduced in the EU ofHealth and Social Welfare, 2006 new member states. Hungary modified the design of its regular social assistance benefit so that beneficiaries could continue to receive some benefits for up to 6 months after getting a job (50 percent for the first three months and 25 percent for the following 3 months). Similarly, Latvia has introduced a guaranteed minimum income benefit of limited duration (9 months per year) that can be received in reduced amounts after getting a salaried job (75 percent in the first month, 50 percent in the second, and 25 percent in the third month of empl~yment).’~~In Slovakia, the program of reforms to mitigate any adverse impact on incentives to join 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 is financed from

In the WB LSA assessed to be at around 534 kuna. Slovakia has introduced one ofthe most aggressive set ofsocial 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 of 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

Yo of GDP 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 Yo of GDP 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 of the child allowance program have hovered at around 0.7 percent of GDP, the expenditures on 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 is 2.2 percent of GDP. 1999 2004 Croatia (2007) 0.8 0.7 9.32 Croatia is 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 ofGDP in Hungary to 1 percent of GDP in Latvia and Lith~ania.’~~ 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 is the child allowance program, S1 ova kia 1.1 0.6 amendments to which introduced in 2001 broadened eligibility (to Slovenia 0.9 0.9 include all children regardless of the employment status of their Source: WB, Social Assistance in parents) introduced income test and increased the amount of child Central Europe and Baltic States, benefit. The effect was for the number of 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 of the child allowance is the “budgetary base” - an arbitrarily-set amount that is determined annually during the budget preparation process and is formalized in the Law on Budget Execution. The base (HRK 3,326 in 2006) is used to determine the eligibility for the child allowance and the level ofbenefit. 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 of the budgetary base, between 16.34 and 33.66 percent of the budgetary base and between 33.67 and 50 percent ofthe budgetary base) according to which the benefit levels vary. This complex system ofeligibility and entitlement is 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 ofGDP 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 of resources within social assistance in terms of poverty reduction. This pattern is different to some neighboring countries such as Hungary, where family allowances outperform social assistance in poverty reduction terms. The share ofthe other family benefits reaching the poorest quintile is 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 of war veterans have a right to the maximum amount of benefit set in the legislation, while for other children the ceiling of the benefit, even for those with health impairment, is established at 25 percent of the budgetary base. However, a child with serious health impairment is eligible for a child benefit amounting 25 percent ofbudgetary base no matter the family income. A child of a war veteran's family at the same income level as that ofthe 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 law defined threshold, the child of 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 of the EU legislation, parental leave has also been introduced in the place of additional maternity leave. Although this change is in line with the practice in EU countries, there is in Croatia a longer period ofparental leave in the case oftwins or the third and following children (of up to three years) which is not common in the EU.I6'

159 The financing of child benefits is from central government revenues, but is administered by the Croatian Institute for Pension Insurance. I6O In accordance with the Law on Rights of 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 of other Family Programs

ProgramI Description EligibilitvI_ Criteria FinancingI Administrative of 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 oftwins 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 InstituteCroatian Birth Grant Lump sum of 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 of statutory maternity leave in Croatia is 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 is 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 it to the full year. The number ofpersons using the additional maternity leave has increased over the last three years: while the number ofpersons using the maternity leave up to 1 year increased by around 15 percent, the number ofpersons taking leave ofup to 3 years has increased by almost 15 times (from 353 beneficiaries in 2003 to 5,475 in 2007) and the number ofunemployed 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 of 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 is no assurance that such measures would help reverse demographic trends. Most of these measures are not income-tested, thus working against the poverty elimination objective.

lci2Missoc database, 2006.

178 War Veterans Programs 9.39 More than one-third of social spending is channeled through programs for war veterans - the share of expenditures for these programs is projected to further increase in 2008. A wide range of 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). Many raise equity issues. The veterans’ benefit system provides generous benefits that are not well aligned with the rest of the social protection system, allowing for significant differences in the method of determining eligibility and level of benefits. Veterans’ benefits are generally higher than other social protection benefits that aim to address the same client group. For example, the ratio of 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 of beneficiaries including the poor and socially vulnerable, the disabled and those with special needs, the elderly, unemployed, war veterans (Homeland War and World War II),parents and children, pupils and students, returnees, displaced persons, and refugees. The majority of social benefits are categorically targeted and many of the categories overlap, resulting in multiple entitlement provisions. In 2007, more than 60 percent of all social safety net expenditure was categorically targeted. These are administered by a wide range ofinstitutions with no single institution responsible for overall coordination. In addition, local self-governments provide a range of benefits that aim to serve the same groups ofpopulation, 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 of the state system is 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 of social benefits - 88 percent from the total social benefit spending in 2007 is financed from the central government budget. The primary responsibility for the welfare system rests with the Ministry of Health and Social Welfare (MHSW) which is responsible for overall policy formulation. The administration ofthe system is 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 MHSW provides the safety net programs to target the most disadvantaged, the elderly and disabled. At the same time the Ministry of Family, Veterans’ Affairs and Intergenerational Solidarity (MFVAIS) is responsible for family policy formulation and implementation and provides the maternity and child programs, homeland war veteran benefit programs. The MFVAIS 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 MFVAIS has also established its own local administrative offices called “family offices” - to date, dozen new family offices have been established and new staff employed. The Ministry of the Economy, Labor and Entrepreneurship (MoELE) is responsible for unemployment policy formulation and the Employment Institute ofCroatia through 22 branch offices in 20 counties and 94 field offices is responsible for: payment ofunemployment 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 is costly, complicated, cumbersome and confusing for the client and the staff. Comprehensive information on benefits and beneficiaries is not readily available and there is little cooperation among the numerous institutions that are involved in benefits’ administration. As a result, evaluating the effectiveness of social policies, the equity of the benefits system, or even an assessment of the performance of individual social protection programs is 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 is no central database of welfare system beneficiaries and no 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 its own records, either electronically or on paper. That makes the exchange of information difficult, time consuming and provides opportunities for errors and fraud. The system is cumbersome and complex for the beneficiaries/applicants requiring visits to a range of government offices to obtain the required information and increasing the scope for false or incomplete information. D. RECOMMENDATIONS

9.45 Croatia’s social assistance is in a need of comprehensive overhaul. In 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 of social expenditures for the support allowance could improve the capacity ofthe best targeted program to reach more low-income families. To 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 on living cost increases should be legislated and implemented.

0 Improving targeting. While the analysis of the main social assistance programs demonstrates that they are well-targeted, the other social programs are not. The good practice ofusing 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 of underestimating household income due to informal labor arrangements and underreporting of income or that of 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 ofthe social assistance programs. It is also important for improved monitoring and evaluation of the results of these programs. The Ministry ofHealth 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 of these programs is complicated by the fact that providing assistance to poor families is only part of the main objectives of child and family allowances-an important additional policy goal of these programs is to provide incentives to boost the overall population growth rate. Further study of the impact of 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 of 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 term 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 skills of the long-term unemployed recipients ofwelfare, so that they can reconnect with the world ofwork. 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 of information exchange should be established with the social assistance systems of local governments as well as with the employment bureau, if Croatia aims to strengthen the poverty impact of 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 of 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 of GDP spent on social programs require coherent and consistent approaches supported by appropriate monitoring and evaluation system in place. Strategic planning in these areas is 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 is that: a. Croatia’s public sector remained large despite years of consolidation attempts. The size of 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 on the economic and demographic indicators, general government spending would need to shrink by five percentage points ofGDP 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 ofexternal finance and significant privatization revenues. However, the possibility of a less generous external environment and increases in the cost of financing, as well the prospective end of privatization receipts after 2008-10, suggests the need for faster tightening of fiscal policy. The fiscal sustainability exercise points to the need for further tightening of primary expenditure by more than a half a percentage point of GDP if Croatia wants to reduce its stock ofdebt below the current fraction ofGDP, with the precondition that growth is 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 is 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 of 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 of goods and services, capital spending (transport) are the spending outliers when compared to the EU countries and involve important efficiency issues. e. Finally, there is 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 is 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 is aware of the need to continue with fiscal adjustment. It 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 of the consolidated general government are expected to grow at a lower rate compared to GDP, leading to a declining share of public revenues in GDP, from 44.8 percent in 2006 to 41.8 percent in 2010163.Expenditures as a of share in GDP are expected to follow a stronger adjustment path than revenues, leading to a decline in the deficit from 4.1 percent of GDP in 2005 and 2006164to 0.5 percent in 2010. Authorities expect robust and stable real growth at an average rate of 6.5 percent per year with a standard deviation of 0.5 for the period 2008-2010. They also expect continuation of privatization which would, in conjunction with robust growth and an absence of interest rate shocks, lead to a significant decline of the general government debt to GDP ratio. This is expected to drop from 46.4 percent of 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 its current level of approximately three percent of GDP.

Table 10.1: Croatian Government’s Fiscal Scenario 2008-2010, YOof GDP 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 Net 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 gr~wth’~ 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 of growth of revenues -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 is partially adjusted to accrual basis. Deficit is 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 its growth projections for 2008-2010 to 4.5 percent. Source: Government ofthe Republic ofCroatia: 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 NATO accession. Nevertheless, these pressures are manageable within the Maastricht deficit limit of 3 percent of GDP but only if done in parallel with serious expenditure restructuring. The medium- term Government reform program that accompanies the above fiscal scenario is 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 is 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 of GDP than the CGG spending presented throughout the report. 164 Official figure for 2006 deficit stands at 3 percent of GDP. However, repayment of pensioner debt and HBOR deficit are not included in this figure. After correction, the 2006 deficit to GDP ratio has declined from 4.5 percent of GDP in 2005, to 4.1 percent of GDP.

186 is no scenario in the PEP that leads to a breach of 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 is relatively resistant to shocks, shocks to the fiscal deficit lead to breaches of the Maastricht criteria in the medium term. For example, halving the rate of GDP growth leads to a deficit that is higher by between 1.6 and 2.2 percentage points of GDP, depending on the year in question. Similarly, the effect ofhalving the growth of tax revenues produces a shock ofbetween 0.9 and 2.4 percentage points of GDP. Finally, a one billion HRK increase in transfers or subsidies leads to a permanent rise in the deficit of0.3 percentage points ofGDP. Box 10.1: Medium-Term Structural Reforms, PEP 2008-2010 Anricultural Sector. The primary objective of the agricultural policy is to strengthen competitiveness of the sector and realign its policies with the EU acquis. One of the important priorities is 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 competitive human resources. ImDrovinn the investment climate. One of the main priorities should remain the reduction of administrative barriers. The government will systematically reduce subsidies to companies, which will enhance free market competition. A shift from direct to horizontal subsidies is of utmost importance. Reconstruction and Drivatization. Railway restructuringprocess with the aim to establish the financial sustainability of the sector as well as strengthen its competitiveness is to be continued. The reconstruction of inefficient public companies is a key precondition for the creation of a competitive environment in the Croatian economy. The adoption of the National Shipbuilding Restructuring Program is expected along with continued activities aimed at final definition of the amount of equity capital of the shipyard Uoanik, privatization of which should begin in 2008. The Government announced the transformation of 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 is 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 is to establish an efficient and fiscally acceptable public service, based on expertise and political neutrality in accordance with the EU best practices. In view of 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 of local and regional self- government. Health reform. In 2006, the National Strategy for Health Sector Development in the period 2006-201 1 was enacted, together with the laws related to the health sector reform. The main novelty of these reforms is 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 of benchmark pricing system for the establishment of basic and additional drug list, rationalization of transport costs, delegation of financial responsibility to the owners of health institutions, limitation of costs through the use of public procurement procedures and auctions for drugs. The preparation of the further revisions of public health leagislation is underway and its adoption is expected in 2008. Following its 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 of social benefits. The possibility of reducing total expenditure for social benefits will be explored, with simultaneous increases of 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 of 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 ofrobust output growth accompanied with relatively high tax rates which hinder competitiveness of 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. DEFINITION OF THE PROBLEM

10.6 It is not clear what the cyclical role of the fiscal policy in Croatia is. The authorities’ position, as expressed in the 2008-2010 PEP, is that the nature of fiscal policy was moderately restrictive and pro-cyclical at the same time, with the exception of 2004. The authorities claim that moderate expansion which started in 2004 and saw an average rate ofgrowth ofnominal expenditures of6.9 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). It should be noted however that the government calculated very small output gap. Given small number ofobservations, one may consider a more prudent view that the cyclical role of the recent fiscal policy remains an open issue. In any case, the role of fiscal policy in generating cyclical movements, whatever its role was, was of the second order ofimportance 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 term output fluctuations is 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 - is appropriately used. Here the authorities should recognize the increasing vulnerability to external shocks, particularly those related to international capital flows. If fiscal policy is frozen by virtue being locked into large non-discretionary spending patterns and already high taxes, or if it is 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 Tax 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 of 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 is to obtain permanent and sustainable cuts in the relative size of fiscal expenditures (Alesina and Perotti, 1995). 10.9 The potential for expenditure controls is limited by 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 of risks over the medium term. Fiscal vulnerability is relatively high because unexpected adverse shocks to output growth and/or interest rates may easily push the trajectory of the fiscal deficit off the sustainable path. Also, such a shock may provoke procyclical fiscal policy responses. But if a larger deficit at times of slower growth is allowed to absorb a larger proportion ofdomestic savings, it may crowd out private investment that could otherwise had a more immediate positive impact on output. The only way to prevent this kind of dynamic is to adopt credible reforms targeting the expenditure side ofthe budget.

188 10.10 The quality of the fiscal adjustment is crucial to its success. Empirical evidence suggests that the credibility of fiscal adjustment is enhanced by reliance on expenditure reductions. In particular, reductions in transfers and the government wage bill tend to be more permanent and even e~pansionary.’~~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 of 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 its long-term potential needs to balance its 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 of the EU and NATO accession as well as aging society-related costs over the long run;

0 It would allow for a reduction of 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 is the limit, whereas the long run fiscal position should be neutral.

C. MID-TERMFISCAL SCENARIO: “BALANCEDBUDGET”

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 is 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 is 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 is stable, meaning that there are no external shocks to financing costs and repayments due to currency mismatch. 10.13 The main assumption is that the macroeconomic environment is 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 is 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 is the correct interpretation of Maastricht (3 percent deficit to GDP ratio is the limit, whereas the long run fiscal position should be neutral), but also because it is reasonable to believe that a small open economy, which is growing at around its long- term potential, needs to balance its fiscal position in order to widen maneuvering room for counter-

165 See, for example, Alesina and Perotti (1 995).

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 of the savings-investment gap i.e. current account deficit.

Box 10.2: The Reform of 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, this has led to a certain degree ofde facto relaxation ofthe rules. To some extent, the 2005 reform ofthe Pact represents adjustment to this reality. At the same time, the rules have become more complex, which is contrary to the original concept ofa simple, rules-based system. The aim ofthese changes was to improve governance, strengthen the preventive (anticipating) function, and improve implementation ofthe 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 ofrespectively 3 percent and 60 percent ofGDP. 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 how they intend to achieve or maintain their medium-term objectives. The medium-term objective 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 of departure is low 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 ofGDP; (ii)for member states with high government debt or low potential growth, the differentiation ofthe medium-term objective is not likely to be ofany 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 ofthe budgetary position, but improve the sustainability ofpublic 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 ofthe 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 no longer be included when compliance with the medium-term objective and the relevant adjustments are assessed. The sanctions are imposed within 16 months ofthe time it is 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 of0.2 per cent ofthe member state's GDP plus a premium determined by how much the deficit diverges from the 3-percent limit. The deposit must not exceed 0.5 per cent of GDP per annum. If the deficit is 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 political strength. The main message ofthis mid-term scenario is that achieving a balanced budget as of 2010 is 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 is 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 is attainable with the following dynamic expenditure limits and revenue assumptions: 0 Current revenues grow by 5 percent in the projected period, which is slightly below nominal GDP growth. Growth of revenues that is slower than nominal GDP growth reflects reduced tariff revenues due to trade liberalization and declining dividend inflows after privatizations. 0 Potential inflows of grants are related to utilization of EU funds. Potential withdrawal is around EUR15O million per annum or 0.2 percent of GDP, and it is expected that the rate of 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 ofthe public sector wage bill to GDP ratio from 10 percent in

190 2005 to 9.2 percent in 2010. This framework is comfortable enough to conduct thorough public administration reform that would lead to a reduction in of the number of civil servants and increases in their efficiency and the quality oftheir output. Other purchases of goods and services grow by 3 percent per year in 2008-2010. The relative reduction of around 1 percentage point of GDP is 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 of this target is also related to moderation of 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 of adjustment is related to moderation of investment activity which will result in a drop of public sector investment from 6 percent of 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 of GDP) due to significant reforms of sectoral spending, more precisely in improving health financing; rationalizing social benefits; improving fiscal and social sustainability of 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 of subsidies would be around 1.6 percent of GDP which is in line with the comparator countries. This public sector envelope which is simultaneously defined by a limited increase in wages and salaries, other purchases of goods and services, and investment, should be comfortable enough to absorb all extra reform costs. Privatization revenues are significant until 2009 because the government is assumed to sell its remaining shares in INA, Telecom and launches the first stage of HEP Electricity Company privatization. Tat 10.2: "Balanced Budget" Scenario Scenaris : CROATIA - MEDIUM TERM FISCAL FRAMEWORK Average Consolidated General Government, %of GDP Comments 2005 2008 2007.2008 2009.2010 'OTAL REVENUE & GRANTS 45.3 48.0 48.4 42.1 I Reflsts tMredu& there is no mmfor tax adjustment so revems gmw CURRENT REVENUES 44.8 45.2 45.3 41.9 bmady in line with nominal GDP 9% in 2W7 and 7.7% thereafter. Saneuhal sbw gmthmprad to~ln~GDP~m~tad~sb~~~afta~~en~~ shaQ mdud!m in dlUenda aRer malath- CAPITAL REVENUES 0.5 0.6 0.8 0.5 ExMeamatizabn remipis GRANTS 0.0 0.1 0.3 0.3 Reflects substantial inmse in absorbbn capachy faEU funds OM EU grants 0.0 0.1 0.3 0.3 'OTAL EXPENDITURE AND NET LENDING 48.9 48.4 47.5 41.8 CURRENT EXPENDITURE 41.1 39.8 39.5 35.4 ohWages 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 lmludes substantial reduction In inveatmentin mads and hbhwaya and wbstanllal OM lnvesfments 5.3 6.0 5.5 4.0 Ibut 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 DEFlClTlSURPLUS wlo capital revenues 4.1 9.1 .1.9 0.8 WERALL DEFICITISURPLUS wlth pensloners' debt -1.1 -1.1 4.1 0.4 Prlvsflza flon recelpfs 0.3 1.2 2.2 0.8 IRIMARY DEFIC(TlSURPLUSwith pensioners' debt .1.8 .1.8 4.8 2.2 URRENT DEFlClTlSURPLUS with 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 is expected to become marginally positive in 2010, even if repayment of debt to pensioners is taken into account, while the public debt to GDP ratio is expected to diminish significantly: by 12-14 percentage points of GDP by 2010 compared to 2006. With this pace of fiscal adjustment there is 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 of these investments as reflected in average growth performance within the peer group of countries. Given the past nature of public choices, any sign of 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. MID-TERMFISCAL SCENARIO: “BUMPY ADJUSTMENT’’

10.18 It is a rare case that the external environment remains stable in the medium term and that fiscal adjustment flows smoothly. The “Bumpy Adjustment” fiscal scenario is designed under an assumption of adverse macroeconomic shocks: the average rate of growth of 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 it 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 of public expenditures to GDP will decrease only marginally, from 48.4 percent in 2006, to 47.1 percent in 2010. The deficit will still be around the Maastricht limit of 3 percent by 2010. General financial vulnerability will be higher (e.g. if interest rates turn out 150-200 bps higher instead of 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 is 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 of privatization (faster privatization will lead to a sharper drop in the public debt to GDP ratio with a given deficit). Hence the focus of fiscal policy - if it is aiming at five qualitative goals as defined at the end of Section B, should be achieving a stronger permanent reduction of public expenditures in terms oftheir 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 of goods and services grow at 6.7 percent on average in nominal terms and bear the minimum fiscal adjustment of 0.2 and 0.5 percent of GDP in 20 10 as compared to 2007, respectively. 0 The growth of subsidies and other current transfers is around 7 percent in 2008-2010 period, leading to a marginal decline of their share in GDP. 0 In this scenario, the general government capital investment to GDP ratio would fall to 5.4 percent of GDP in 2010, which is a decline of around 0.5 percentage points of 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 of 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 Refmcls unffrea.cmn mw .) no mom lo( ma aaprmeni so mienws gm 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 maim 10 som gmuth of DlYt mm.u an0 Sharp IWUCILUI E Bl1O.WS ab‘ 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 OM EU granfs 0.0 0.1 0.3 0.3 ‘OTAL EXPENDITURE AND 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 grom Assmea awmal ~essn Inmmsi rate d 1W bps (in mmpakon lo Sunam & lnferest Payments 2.3 2.2 2.1 2.3 LnlY 2010

&as msrs for Raikar Ihipyared ana Poslal Bank mslr~nmgas ml, es & Subsidies and curmnf transfen 19.5 18.7 18.6 18.7 Increase in SLDSIOI&S for apmn.n AAO relro pKwags noornoun d psnsbtu arm SLDILYIO~M in gmnrele of lord awa IO 3% pranwm CAPITAL EXPENDITURE 7.4 8.3 8.1 7.8 mau %branos rsaucoon n inwsmennl h maes arm nghayand swsuntal & hvesfrnents 5.3 6.0 5.8 5.5 bn Lmer prowmma meseon nrulmenl in mflmnmsl msr ana *BSlma1m

& Capifal transfers 2.2 2.2 2.3 2.3 LENDING MINUS REPAYMENT 0.4 0.4 0.3 0.3 WERALL DEFlClTlSURPLUS wlo 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 govmmmt s4s remaining stakes In I4A and HT and launches Um first PrlvaUzaUon recelpts 0.3 1.2 2.3 0.9 sme 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 is to 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. To start with, tax side adjustments should begin by increasing the share of the gross wage allocated to second pillar pension funds to at least ten percent, as soon as possible. 10.22 The Maastricht limits ofpublic debt and fiscal deficit are only one ofthe possible criteria for assessing fiscal policy. Declaration of a balanced budget target in the medium term alongside the EU standard is 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 is much more to be gained by pursuing described policy efforts. 10.23 The following questions regarding qualitative targets should help design the fiscal adjustment efforts: (i)Do taxes ensure competitive environment? (ii)Is fiscal policy flexible enough to ensure anti-cyclicality and contribute to reduction ofexternal vulnerabilities? (iii)Is the size of expenditures manageable in the sense that efficiency ofpublic expenditures can be monitored and corruption kept under control? (iv) Are expenditures flexible enough to allow for required structural adjustment? (v) Isthere assurance that balanced budget is attainable in the long run?

193 Annex A: Construction of Cyclically Adjusted Balance

The actual government budget balance is 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 is computed to show the underlying fiscal position when cyclical or automatic movements are removed. Such a measure gives a better impression of the soundness of 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 of 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 of the public finances.

Finding the cyclical component of the budget requires a measure of how far the economy is from its potential level. There are two main approaches to calculating structural balance: (i)an aggregated and (ii)a disaggregated method. In the aggregated method, the cyclical component of the budget is assumed to be a constant fraction of the output gap.'66 This constant expresses a total elasticity of the budget with respect to the output gap and is determined on the basis of estimated elasticities for some subitems of the budget with respect to the output gap. This aggregated method is used by the OECD, the IMF and the European Commission. With the aggregated method, the problem lies in estimating the output gap. The latter is actual GDP less potential GDP, and as the potential GDP cannot be observed, it must be estimated. Potential output is 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 of 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 of 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 is in the growth phase, relatively more taxes are being collected and government transfers to households decrease. As a result, the growth of disposable income of households and consumption slows down, inhibiting economic growth. At the same time, the budget position of the public sector improves. In a reverse situation, i.e. during an economic downturn, tax burden is relatively smaller and government transfers to households increase, which curbs the fall of consumption and economic growth. When GDP equals its potential volume, the actual fiscal balance

The output gap is 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 is negative, then potential output exceeds demand. The output gap cannot be maintained over the long run, because adjustments of wages and prices will be established to reach a balance in which supply and demand are equal. In the economics literature there are different explanations of 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 this case, the output gap is an important measure to balance overall demand and supply in the economy and it can provide useful information on price pressures. According to another theory, an economy is best characterized by business cycle models, where actual output differs from trend output because of occasional productivity shocks. In this case, the output gap reflects temporary deviations provoked by adjustment ofoutput through technological changes and unexpected supply-side trends.

194 is equal to structural balance, changing only as a result of discretionary policy. Changes in the balance of the budget caused by the economic cycle form the cyclical component of the budget, which characterizes the size of automatic stabilizers. Thus, the size and variation of AFS gives a quantitative assessment ofthe extent ofthe impact ofeconomic 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 is thought to be merely a cyclical effect. When assessing fiscal prospects, it is essential to adjust fiscal indicators for the effects ofthe 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 is operating above the trend and weaker when the economy is 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 is computed on the basis of a standard two-step procedure. First, the cyclical position ofthe economy (output gap) is assessed by comparing the actual GDP with the potential one. The estimate of the potential GDP is based on modified Hodrick-Prescott filter,167due to its transparency and simplicity, with the standard smoothing parameter (A) 100 for annual data. Second, the impact on the budget of the cyclical is calculated using fiscal elasticities. Four broad revenue categories and one expenditure category are dependent upon the cycle. These are: direct taxes on households and companies, indirect taxes, social contributions and unemployment-related expenditure. After calculating the overall sensitivity of the budget balance, the cyclical component of the budget balance is then the product of the output gap and the overall sensitivity. To show what kind of discretionary fiscal policy was applied, fiscal stance is computed. Fiscal stance is measured as a change in primary balance. The case for focusing on the primary deficit is simply that interest costs on accumulated debt are outside the scope of government control and while they may vary with interest rate changes, this variation does not reflect the quality offiscal control.

'" According to Bruchez, P.-A. (2003). The modified Hodrick-Prescott filter solves the problem of bias in final points, which is a shortcoming of standard HP filters.

195

Annex B: Calculating the Debt-Stabilizing Primary Balance

Calculating the debt-stabilizing primary balance is one of the simplest tools for debt sustainability analysis. The analysis starts from the government’s intertemporal budget constraint, such as in equation (1):

To 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 of government debt at the end of year t; Mt is the stock of high-powered money and i is the one-period interest rate, assumed constant. This specification assumes the government pays interest on the average stock of debt (thus, the average of the stock of debt at the end of the previous year and the end of the current year) and, similarly, the interest revenues ofthe government are from the average stock ofhigh powered money.

Given the lack of transfers from the central bank to the government over the last several years, it is reasonable to assume that the central bank will capitalize all its profits, including those from seignorage. The analysis below, therefore, is an analysis of the sustainability of government debt, excluding any transfers from the central bank. In this case, equation (1) is replaced with the simpler equation (2), which is an accounting statement ofthe stock ofgovernment debt:

Dl=Dl-l-pl+i( 4-1 +Dl )

Nominal GDP in year t is 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 is the equation used in the calculations in Section A:

(4) 2

This expression is 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)- (1 + g)(l+ n)]= d(i - n - g) (5)

Annex C: Statistical Annex

Table AC.l: Croatia: CG Finances by Government Level, 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 FundiEnviron Fund 1.3 ...... 0.1 0.1 0.4 ... Development and 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 ofFinance 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 wce: Ministry ofFinance 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 Education affairs 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 of 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 64.m 1. Central Government 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. Publlcly Guaranteed Debt ... 2,119 6,641 17,632 18,684 20,636 25,389 26,194 15,419 12,262 12,455 14,194 17,282 Domestic ... 521 1,349 2,482 3,245 3,377 5,958 7,424 6,797 4,552 5,269 7252 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 percentage of 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 percentage of 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 percentage of 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 ofFinance, CNB, CROSTAT.

20 1 Table AC.5: Comparative data: Croatia and EU, Consolidated General Government Deficit (GFS 1986) and Debt, as % of GDP Overall Balance of 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 of CGG, accrual, YOof GDP 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 CROATIA' -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 SLOVAK 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 of 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 of 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 99,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 ohunemployment 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 Income Tax Rate VATrate 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

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