Assessment of the Budget Proposal for 2019 Republic of Serbia Fiscal Council Assessment of the Budget Proposal for 2019 28 November 2018

General assessment The 2019 budget plans for an adequate deficit of 0.5% of GDP. A good long-term goal for Serbia - ensures macroeconomic stability and decreases the excessive public debt by 2.5 p.p. of GDP per year (from 54% of GDP to 51.5% of GDP) Public revenues and public expenditures were credibly planned - no risk of the deficit being larger, execution somewhat better than planned is possible However, the budget is not sufficiently pro-growth oriented and fails to resolve major structural issues of Serbian public finances Insufficient investments in road and railroad infrastructure, environmental protection, education and healthcare - at least 200 million Euros more were both necessary and possible The repeated arbitrary salary increase of 7% to 12% by sectors - pay grades have not been established and the harmful employment ban continues Net salaries in general government are growing unjustifiably, almost twice as fast as the private sector (9% on average compared to 5% in private sector) Budget procedures and budget calendar are still being breached Fiscal Strategy and the Draft Bill on the Law on Budget are still running late; although the budget is now in “smooth sailing” the annual financial statement is neither adopted nor published

Key economic issue: low growth GDP growth in Serbia has been lower than other comparable Central and Eastern Europe (CEE) countries for years. In the previous five years, Serbian GDP increased by about 10% while the economies in comparable CEE countries grew, on average, twice as fast (by about 20%). For this reason, the living standard of Serbian citizens is lagging ever farther behind the countries in the region (GDP per capita in Romania is already 50% larger, in Bulgaria 30% larger...) The lag continues in 2018, even with the growth rate of Serbian GDP of over 4% About 1 p. p. is the agricultural recovery from drought - the GDP growth trend in Serbia in 2018 is 3-3.5%, and in CEE over 4% The lag is structural in nature - not a consequence of fiscal consolidation or other temporary factors (floods, droughts etc.) A good budget could contribute significantly to the acceleration of economic growth Together with the improvement of the business climate (rule of law, anti-corruption action, decrease in grey economy etc.)

The proposed budget, however, fails to provide a sufficient incentive for growth acceleration The Fiscal Council proposed (October 2018) concrete measures for the 2019 budget for efficient and sustainable growth promotion A strong increase of infrastructural investments (by 200 m Euros for road and railroad construction and another 100 million for environmental protection) Labor (wage) burden reduction from 63 to 60% There was sufficient space for all these measures in the budget. The Government, however, had other budget priorities Investments into military and police weapons and equipment, larger increase of salaries in the general government etc. And has allocated far less to pro-growth policies than needed Reduction in the wage burden is three times smaller than Fiscal Council's proposal, from 63 to 62% The envisaged increase of investments into infrastructure is a mere 100 m Euros (mostly for expropriation) The share of infrastructural investments in GDP remains at the same level, meaning there is no substantial improvement of budget structure

Estimated budget execution in 2018 Public investments increase in 2019 will have no impact on growth acceleration In % of GDP  CEE average (2006-2016) Estimated budget execution in 2018 Budget proposal for 2019 Total general government public investment 4.6 3.6 4.0 Defense and police 0.3 0.6 0.9 Public investment, excl. defence and security sector 4.3 3.0 3.1 Road and railroad infrastructure 1.5 1.6 Healthcare, education and environmental protection 1.3 0.4 Other 1.4 1.1 Public investments into infrastructure, healthcare, education and environmental protection in Serbia are by one third (1% of GDP) smaller than in comparable countries And, due to the poor quality of infrastructure and many years of insufficient investments, Serbia should be investing more than comparable countries for a while Investments in infrastructure development accelerate growth We are left without a sound and necessary pro-growth budget stimulus in the upcoming year Instead, there’s a strong (and non-transparent) increase of investment into the security sector

Investments into infrastructure are not only needed to accelerate GDP growth Due to insufficient environmental investments, Serbia is among the most polluted countries in Europe The gap in quality and level of development of the road and railroad infrastructure in between Serbia and CEE countries is wide Quality of roads 20% and railroads 40% lower than in the region (WEF 2017); 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... The 2019 budget misses an opportunity to substantially move in the direction of resolving these problems Indicator Serbia CEE average % of city water supplies with safe drinking water 56% 99% % population connected to public sewers 55% 84% % communal wastewater treated < 10% 70% % household waste collected in an oranized manner 80% 95% % of waste treated < 5% 50%

The salary increase is too high and once again ad hoc General government net salaries, on average, increased by 9% (ranging from 7 to 12% by different ministries) The first issue - almost twice the growth of wages in the private sector Wages in the private sector (determined by the market and productivity growth) have grown by a mere 5% in 2018 and we expect a similar growth next year General government salaries already significantly higher than in private sector (with higher job security), the gap widens in 2019 Not in line with the declarative commitment of the Government to encourage the development and attractiveness of employment in private sector over public sector Nevertheless, public expenditures for salaries grow by 7.5% (not by 9%) as the harmful employment ban continues - decreasing the total number of employees The employment ban has been in place for 6 years now, instead of elaborating the appropriate jobs systematization - the original deadline for this was in 2016 There is a shortage of 2-3000 employees in healthcare and shortages in inspections etc. Worst of all, the salary increase has once again been determined arbitrarily by line ministries So, instead of introducing order into the general government salary system, as announced, the Government is additionally increasing its disorder in 2019

Estimated change in average salaries, index 2017/2014 Abolishment of one half of the temporary salary cut in PEs is justified, except for EPS No more risk from fiscal crisis - justified staged repeal of the salary cut in public enterprises (5% in 2019 and 5% in 2020) However, the largest state-owned enterprise by far, EPS, never decreased net salaries at the end of 2014 and continued to increase them in the years after   Estimated change in average salaries, index 2017/2014 EPS 108.8 Pošta Srbije 94.4 Telekom 93.2 Srbijagas 92.3 EMS 92.2 At the same time, the enterprise is not investing enough - investments are lower than depreciation Poor performance of EPS in 2017 decreased the GDP growth of the entire country An additional increase of average salaries to almost 90,000 dinars in 2019 and to about 94,000 dinars in 2020 is not justified - these funds should be directed into investments 2014 2015 2016 2017 Average net salary in EPS (official data) 79,657 79,979 81,789 84,205 Approximate average net salary had the Government decision been implemented 72,500 ≈ 73.000

In 2018, it is necessary to reintroduce objective rules for pension indexation A year ago, the main objection of the Fiscal Council to the 2018 budget was that it failed to repeal the temporary pension cut, which was a crisis measure The Parliament revoked the cut with a delay, at the end of September 2018 However, at the same time, it unnecessarily revoked the formula for indexation of pensions with inflation and economic growth And the Government introduced the arbitrary “monetary pension bonus” that undermines the link between the contributions paid during the years of service and level of pension These changes undermine the predictability and integrity of the pension system, which is completely contrary to the European practice In 2019, the disputed amendments to the Law on PDI should be revoked and systemic and objective indexation rules adopted once again

Reduction of the fiscal burden on labour from 63 to 62% is good, but insufficient From 2019, unemployment contributions paid by the employer are revoked (0.75% of gross salary) This decreases the total fiscal burden on labour from 63 to 62% The decrease of fiscal burden on labour is generally a good and efficient pro-growth policy The largest production cost is decreased - increasing economy competitiveness Fiscal incentive (about 75 bn Euros) equally distributed over the entire economy (no one is privileged) However, this decrease is insufficient - the Government allocated the available funds to other priorities (salaries, army, police etc) Hence, this contributions cut will not have a significant impact on the production costs of individual enterprises and will not accelerate economic growth in any detectable degree The Fiscal Council proposed this decrease to be three times higher (October 2018), but the proposed budget does not save enough funds to achieve this

The budgeting process and calendar are still not respected The budget is now stable - but the Draft Law on Budget was once again adopted and submitted to the Parliament too late - no justification for this Instead of November 1st (with the deadline of being adopted by the Parliament by December 15th), it was only submitted on November 22nd - stripping away the time for analysis and productive discussion The Fiscal Strategy that the budget should be based on: instead of the first draft being sent to the Fiscal Council by the end of April, it was sent in mid-November Annual financial statements have not been made public since 2015 Legal obligation of adopting the Law on Annual Financial Statement has not been respected since 2002, but at least until 2014 the Statement was submitted to the Parliament (and was thus available to the public) From the 2015 final statement, this practice has been terminated too - there is no longer any information on how individual budget beneficiaries spent their budget funds And now it’s even more important, as the amendments to the Law on Budget System from 2016 allowed the Government to allocate about 50 bn dinars outside of the adopted budget (from current budget reserves) In 2019, the laws prescribing budget procedures and calendar need to be strictly abided by

Pay grades will not be implemented in 2019 either Even though it was planned that they would substitute arbitrary salary increase by sectors The Fiscal Council supported the commencement of reforms, (four years in the planning), submitting proposals on how to improve it Still, salaries are once again increased by sectors and not by job positions: in healthcare up to 12%, education and security 9%, administration 7% The reform was taken on without the reform approach whatsoever Starting from the negotiations with the unions and not from a single, fair system Agreement with a certain number of employees made negotiations with other sectors more difficult

From the beginning of 2019 a U-turn is needed It is necessary to start working immediately - it is impossible to fit elements into a faulty frame, the frame needs to be changed Based on the economic analysis and comparison with countries with better regulation, which had implemented their reforms And not based on the current position of the Government and the unions Either have suitable pay grades or sector reforms of healthcare and education Poor solutions would lead to new problems (salary compression, unfair wage ratios ...) The alternative is to reform key parts of the society (healthcare, education) and not to implement poor quality pay grades for all

Necessary improvements 1. Include all sectors (primarily security) Different treatment undermines the reform 2. Salary base should be set at the level of minimal wage Resolving the issue of pointlessly low coefficients Setting the minimal wage with greater care 3. Valuation of jobs in line with economic and market parameters Put the employees in their rightful places in a wider range of coefficients (within and between sectors) The principle of “equal pay for equal work” is necessary, but also “unequal pay for unequal work” (where applicable)