Report No.37321-HR Report No. Croatia 37321-HR andImp toSustainGrowth RestructuringPublicFinance 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 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 3 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