FISCAL AND ECONOMIC TRENDS IN 2018 and RECOMMENDATIONS FOR 2019 BUDGET Republic of Serbia Fiscal Council FISCAL AND ECONOMIC TRENDS IN 2018 and RECOMMENDATIONS FOR 2019 BUDGET 9 October 2018

Main recommendations The 2019 budget should support growth, provide a systemic framework for public finance and improve their structure Fiscal crisis has been avoided: surplus for the second consecutive year, public debt approaching the allowed limit of 50% of GDP Remaining challenges: Low growth and lack of structural order in public finance In 2019, up to 450 million Euros (1 p.p. of GDP) are available for fiscal incentives to growth, namely: 1/2 for public investments increase - excellent for GDP growth and improves budget structure 1/2 to be directly channeled into the economy, e.g. by reducing tax burden on labour (from 63 to 60%) Systemic priorities in 2019 are permanent regulation of the pension system and the salary and employment system in the general government Restore objective rules for determining the amount and annual indexation of pensions Start implementing the new salary system, remove observed shortcomings and terminate the harmful employment ban

Space for new policies in 2019: up to 450 million Euros Fiscal trends in 2018 better than planned: instead of a 0.7% of GDP in deficit, most likely an equal surplus Higher public revenue collection (contributions, profit tax) mostly due to macroeconomic improvements, lower expenditures on interest payments Public debt is approaching the 50% of GDP mark unexpectedly quickly - largely due to a recent upward revision of the GDP Appropriate budget plan for 2019 would be a 0.5% of GDP deficit It is not overly restrictive, it leads to a sufficient rate of public debt decrease (by about 2.5 p.p. of GDP per year), guarantees macroeconomic stability, is in line with EU rules... With this objective set, a fiscal space of up to 450 million Euros is available (1 p.p. of GDP) for new economic policies of the Government Provided that expenditures for the pension and wage bill in the general government in 2019 do not grow faster than nominal GDP (6-7%), which is justified The “surplus” would come from an increase in public revenues (economic growth), but also from the decrease in expenditures on interest payments and guarantees

Key structural weaknesses: low economic growth GDP growth in 2018 was relatively high (about 4.4%) but “spurred” by one-offs Agricultural growth due to the comparison with the droughty 2017, normalization of production in EPS after the previous year’s problems in operation... Fiscal Council expected it - we forecast a GDP growth of over 4% for this year Trend of GDP growth (one-offs excluded) in 2018 3.2% - still visibly slower than CEE average Lag behind CEE from 2014 10 p.p., GDP growth trend always below regional average In 2019, deceleration of GDP growth as one-offs are exhausted - according to IMF forecasts, to 3.5% Primary tasks for the Government: pro-growth fiscal policy, reform of the public sector, improvement of the rule of law...

Public investments need to increase by 0.5 p.p. of GDP That is the most efficient leverage that the Government can use to incentivize growth in 2019 Fiscal multiplier is about 3 times higher than in increase in current government spending (e.g. salaries or pensions) Serbia has a chronic deficit in public investments compared to comparable CEE countries - in total, by over 4 bn Euros since 2008 In the last 10 years, on average under 3% of GDP per year and the CEE region, on average, about 4.5% of GDP In 2018, probably around 3.5% of GDP - positive progress, but still not enough In 2019, public investments need to be, and can be increased by 300 m Euros, to about 4% of GDP - current CEE average Primarily in roads and railroads and environment protection In medium term, to over 4.5% of GDP - to close the gap in the quality of infrastructure, and in GDP growth rate When Croatia, Czech Republic, Bulgaria and Romania were building major infrastructure, they invested over 5% of GDP per year

For roads and railroads: additional 200 million Euros By the quality and level of development of road and railroad infrastructure, Serbia is lagging far behind comparable CEE countries Quality: roads 20% and railroads 40% lower than in the region (WEF 2017) Development: on average, 30% of highways less (measured in km per 100,000 population) and 2-3 times less than Hungary, Croatia and Slovenia Two thirds of the railways are not electrified and on 55% of them the trains cannot exceed 60 km/h Needs are indisputable, projects and funding sources exist - insufficiently efficient execution can be a problem Corridor 10: after the first deadline was breached in 2012, new delays every year; the last deadline in line (end of 2018) will probably be breached as well In 2019, it is realistic to plan for an increase in investments into main roads and railroads by about 200 m Euros Key Government projects: Corridor 11, Belgrade ring-road and Belgrade-Budapest and Niš-Dimitrovgrad railroads - implementation is important

Critical: Investments into environment Due to low investments in this field, Serbia is among the most polluted countries and its citizens among the most at risk in Europe Only 7% of surface water have a good environmental status, tap water is unsafe for drinking in about 40% of city water supply networks, over 2.5 million citizens breathe overly polluted air... Quality of communal infrastructure is extremely poor - we are at the bottom of the list in the region in practically all indicators Only 55% of the population is connected to the sewers (in CEE, as much as 84%) Less than 10% of communal wastewater is treated (in CEE, about 70%) Only 80% of household waste is collected in an organized manner (in CEE, 95%) and of that, almost nothing is treated (in CEE, 50%, in EU, 75%) etc. The government needs to make enormous investments in this field in the upcoming 10-15 years - also due to EU accession negotiations A total of almost 9 bn Euros, corresponding to a growth of about 500 m Euros (1.2% of GDP) at the annual level

The 2019 budget provides a chance for a real U-turn Investments into environment can be increased already in 2019, by about 130 m Euros (0.3% of GDP) There are priority projects and the funds are partially provided by IPA funds and other donations (about 50 m Euros) About 60 m Euros for landfill regulation, about 60 m Euros for the construction of wastewater treatment plants and about 10 m Euros for other projects This is a significant increase, but the needs are much greater - conditions need to be created for a manyfold increase in 2020 Allocating budget funds for a mass preparation of project documentation in 2019 - the general plans are ready Strengthen capacities of the line Ministry (needs about 150 staff) and SEPA (professional staff and procurement of modern equipment) We believe that a significant increase of the MoEP’s budget would be justified - from only 5 bn dinars in 2018 to a little over 20 bn dinars The largest share of this increase for infrastructural investments (about 10 bn dinars), the rest on building a more efficient environment protection system

About 200 m Euros of fiscal space for tax cuts in 2019 From the viewpoint of economic growth and employment, tax and contributions cuts are an obvious choice Sector tax decreases have not proven effective in practice Budget space of 25 bn dinars allows for a cut in taxes and contributions on salaries from 63% to 60% Taxes and contributions, % of net salary Half an average salary Average salary Two average salaries Burden in 2018   58.8 63.3 65.7 1. - Non-taxable base 28. 000 dinars 51.4 59.3 63.6 2 - Decrease in contributions paid by employer by 1.9 p.p. 56.2 60.7 63.1 3 - Non-taxable base 22,000 and decrease in contributions by 0.75 p.p. 53.7 60.1

Increase in pensions in 2019 Budget space ~35 bn dinars for a pension increase Repeal of the temporary pension cut 25 bn dinars Over 10 bn dinars for regular pension indexation (~2.5%) It was possible to keep the regular pension indexation in 2019 and then adopt a new, more generous formula for 2020 Instead, the Government revoked the indexation formula and introduced “monetary pension bonus” This undermines the predictability and integrity of the pension system A new formula for indexation needs to be introduced as soon as possible, bringing the pensions back into a systemic framework

Pay grades are mostly suitable, education has been given quite a high status By the end of the year, for about 400,000 employees (about 85% of the overall number) Doctors have a suitable place in the matrix and classification by job complexity Similar for culture and other institutions Similar for generic job positions Teachers in primary and secondary education are mostly in the same pay group with general practitioners. In other countries, doctors without specialisation have over 30% more than teachers In other countries, university professors have double the salary of teachers, in Serbia by 30-40%

Parts of the government still outside the system Police, military and appointed officials will represent an important test for pay grades Job positions catalogue is unknown, as are which pay grade the employees will be classified in and with which coefficient It would only be justified to set the same coefficient for all comparable jobs (special valuation for specific jobs) Large sectors (education, police) are important: if they get a special status - the funds are channeled towards them (more), others see that and demand the same

Low salary base reduces the range between the highest and lowest wages Unjustified: compression and responsible jobs get paid less Our proposal is 18,000 dinars (instead of 14-15,000) - reaching objective salary parity in three years Important in the upcoming budgeting process: Increase salaries by job positions, not linearly by sectors Start publishing data on employees, salaries and bonuses by ministries and, starting from next year, by institutions as well

Example of the Slovenian Central Registry

Employment ban should be partially revoked and targeted recruitment should start 18,000 employees less in five years and Serbia does not have too high number of employees in the general government However, consequences of the employment ban: Increase in temporary and periodic engagement Disrupted employment structure - already chronic and impermissible shortages in some sectors (healthcare, Tax Administration, environment, sector for managing the EU funds in agriculture) Necessary: Finally complete sectoral analyses and job systematizations In 2019, hire one employee for each employee that leaves (substitution rate of 1:1 and not 1:5 as it was), about 13,000 positions: two thirds through the Consent Committee, a third with targeted recruitment to the most at-risk institutions