Republic of Serbia Fiscal Council September 13, 2012 ASSESSMENT OF THE 2012 SUPPLEMENTARY BUDGET AND DRAFT LAWS INCLUDING FISCAL EFFECTS

Basic assessments The first step towards fiscal consolidation has been made in the wrong direction – 2012 supplementary budget increases the deficit instead of decreasing it Two of three pillars of strong fiscal consolidation have been set (taxes and wage and pension control)… – … the third one is also indispensable (public expenditure reform) Proposed amendments to a great number of laws (tax reform, public finance regulation) are mostly in line with good fiscal practice 2

Public debt crisis poses threat “ Serbia is threatened by debt crisis and debt bondage, inability to pay wages and pensions and function normally as a state!... The fire should be put out” – Statements of the Prime Minister Ivica Dačić Facts – public debt reached 56% of GDP… … by the end 2012, it will reach 60% of GDP (it will continue to grow in 2013 as well) So as to finance the deficit and repay public debt principal, €1.7 billion should be provided by the end of 2012 and additional €4-5 billion in 2013 The source and the price are unknown Fiscal Council assessment: without considerable deficit decrease, it is not possible to avert public debt crisis 3

Supplementary budget does not “put out the fire” The first step – supplementary budget – Without the supplementary budget, the whole republican deficit would amount to around RSD 216 billion (6.5% of GDP) – With the supplementary budget, it is increased to RSD 222 billion (6.7% of GDP) – wrong direction – There is mitigation to a certain degree since the increase is not huge, while important structural measures are adopted for permanent deficit decrease However, the credibility of the whole fiscal consolidation programme could be endangered since its first step is deficit increase instead of decrease Therefore, the Fiscal Council considers the supplementary budget inadequate, since deficit should be reduced, as proposed by the Council 4

Two of three pillars of fiscal consolidation are set In order to avert the crisis, three groups of structural measures are necessary: 1.Tax reform (revenue-positive) 2.Restriction of public sector pension and wage growth (lower than inflation) 3.Overall public expenditure reform ( comрanies under the competence of the Privatisation Agency, subsidies, abundant personnel, pension system, disbursing state guarantees, fiscal decentralisation, etc.) The first two pillars are set, but fiscal consolidation requires all three of them 5

Positive changes in legislation Amendments to tax laws (VAT, excise duties, personal income tax)… …bring necessary revenue increase and contribute to public finance regulation – Except for paying VAT liabilities upon collection rather than upon invoicing for small and medium-sized companies, which should be abandoned – bad tax practice System of budget beneficiaries with own-source revenues is regulated (funds, agencies) – Good measure – it increases transparency and brings budget savings Other new laws (on maximum wage, public enterprises and others) – in good direction 6

Republican supplementary budget State budget deficit without the supplementary budget in 2012 would amount to around RSD 197 billion (Fiscal Council’s assessment) In early 2012, RSD 140 billion was planned (agreed with the IMF), but it will exceed this amount: – Due to deteriorating macroeconomic environment (by around RSD 25 billion) – Due to expansionary fiscal policy in the first half of the year (by around RSD 30 billion) However, instead of implying deficit decrease, the supplementary budget implies additional deficit increase – from RSD 197 to 203 billion – With tax increase and some savings, other expenditure will “go sky-high” 7

Tax increase and savings in 2012 – deficit decrease by around RSD 20 billion – General VAT rate from 18 to 20% (RSD 7 billion) – Excise duties increase (RSD 7 billion) – Personal income tax (RSD 2 billion) – Lower wage and pension indexation (RSD 4 billion) – Savings in own-source revenue (RSD 1-2 billion) However, other expenditures will increase by around RSD 25 billion – 13 th pension (RSD 4 billion) – Agricultural subsidies (RSD 9.5 billion) – Budget subsidies and credits for economy (over RSD 10 billion) – Personnel expenditure (some ministries – additional RSD 3-4 billion) 8 Republican supplementary budget – new measures

Expenditure growth is bad and unsustainable since it further increases high fiscal deficit and public debt Bad message is sent to investors, IMF, EU, etc. Funds for new measures and policies could have been provided by prioritising and redistributing, rather than increasing the deficit – Local self-government, expenditures rising in real terms by over 20% Bad assessment is to a certain degree mitigated by the fact that important structural measures were adopted so as to reduce the deficit (taxes, wages and pensions) While the growth of some expenditures will be one-off and temporary 9 Republican supplementary budget - assessments

Fiscal consolidation: as of 2013 Public debt growth should be stopped and “the Greek scenario” avoided – statements of Government officials – Basically, in line with assessments given in Fiscal Council’s May report Public debt growth could be reversed in 2014 at the earliest Fiscal deficit forecast enabling this is as follows: *Fiscal Council’s assessments One can conclude that deficit reduction needs to be dramatic Public debtFiscal deficit

The Government announced deficit reduction in 2013 to the amount of € 1 billion (to 4% of GDP), but: 1.This will not be sufficient – public debt will also rise in Planned deficit reduction in 2013 is actually lower (between €650 and 700 million) – Adjustment included one-off revenue (bankrupt companies) – Overestimated savings with budget beneficiaries with own-source revenue – In 2012, the deficit was increased in the first place, then it is decreased from that level… … adjustment seems to be larger  It is necessary to have bigger public expenditure reduction in Less strong adjustment will not do

Necessary fiscal consolidation must have three pillars In May report, the Fiscal Council defined three indispensable group of measures: 1.Revenue-positive tax reform 2.Freezing of wage and pension growth, those are the largest public expenditure items 3.Reduction of public expenditure, via reform and improvement of efficiency in the public sector Fiscal Council’s assessment – the first two pillars are properly set by the Government...But, a true fiscal consolidation requires all three of them 12

I pillar: tax laws amendments (tax reform) Proposal made by the Fiscal Council in May – Increase in general VAT rate from 18% to 22%, while applying higher tax rate for some of non-existential products, excise duty increase – Reduction of fiscal burden on labour from 64% to 54% – Fiscal effect – increase in public revenue by around 1% of GDP Government measures – Increase in general VAT rate from 18% to 20%, increase in excise duties, corporate income tax, personal income tax – Without decrease in fiscal burden on labour, but with abolition of quasi-fiscal levies – Fiscal effect in 2013 – around RSD 40 billion (1.1% of GDP) Slightly different measures, but with almost identical effect on public revenue – generally speaking, adequate measures 13

II pillar: wage and pension growth Proposal made by the Fiscal Council in May – Pension and wage freeze in October 2012 and in 2013 – Supposing the inflation will amount to around 6% during the whole period of limiting indexation Government measures – Indexation in October - 2% and additional 2% in April 2013 – But expected inflation during this indexation will be around 10% Due to inflation growth, Government measures are practically identical to the Fiscal Council’s proposal Fiscal deficit reduction by around 1.2% of GDP – adequate – However, wage growth beyond the statutory indexation raises concerns (local self-government, some ministries) – Thirteenth pension 14

III pillar: public expenditure reforms Proposal made by the Fiscal Council in May – To reform wasteful and unselective system of state subsidies – Shape the destiny of the companies under the competence of the Privatisation Agency (97,000 employees) – Public sector staff streamline (layoffs) – Pension reform – penalties for early retirement – Restriction of purpose and amount of state guarantees (public enterprises debt) – Establishment of a sustainable ratio between central and local finances – Reform of agencies, funds, directorates – with own-source revenue Government measures – Reforms in budget beneficiaries with own-source revenue (agencies, funds) – it is good and in line with the recommendation – But these go along with increased subsidies instead of the decreased ones, thirteenth pension, etc. 15

Success in fiscal consolidation is based on expenditure reduction Short-term deficit reduction (2013): around € 1 billion – 1/3 should origin from revenue growth and 2/3 from expenditure reduction …we still cannot see €300 million from expenditure reduction However, the deficit needs to be reduced as of 2014 as well – If no savings are made in the expenditure area… – …we have bad alternatives: new tax increase or wage and pension freeze – For this reason, for medium-term effects, expenditure reform is the most important Most of expenditure reforms proposed by the Fiscal Council have full effects on the budget only in several years Therefore, it is necessary to start serious structural reforms in public expenditure immediately in the following six months (the third pillar of fiscal consolidation ) 16

Assessment of the tax package It provides adequate increase in public revenue under given socioeconomic circumstances – VAT had to be increased from 18 to 20% Expenditure of average household is thereby increased by 0.9% Paying VAT liabilities upon collection is not an example of good practice – Increase in corporate income tax from 10 to 12% and abolition of exemptions are justified and will not decrease competitiveness – Increase in excise duty on tobacco is justified – Abolition of quasi-fiscal costs is justified System efforts need to be made in future so as to improve business environment without ravaging public sector functions

Assessment of „13 th pension“ programme We evaluate the program negatively because it is arbitrary and poorly targeted – Around 100,000 elderly people who do not receive pensions at all are disqualified – Financial status or income of other household members are not taken into account A pensioner receiving RSD 16,000 whose wife has no pension A pensioner lady receiving RSD 14,000 whose husband receives a high pension – Pensioner receiving RSD 15,000 will get additional RSD 16,000, while the one receiving RSD 15,001 will get nothing Minimum pension rule prevents such abrupt cuts by adding the missing amount of RSD 12,700 to everyone

Assessment of laws On budget system : – Positive change in approach to own-resource revenues and their inclusion in the budget There is still a possibility that part of the funds of public fund beneficiaries will be kept outside the single Treasury account It is important to make an unbiased assessment of budget savings based on this change – Positive change in legislation on fees and charges They can be introduced by law only and the amount is stipulated by the law or the entity is allowed to set the fee amount (with prior approval)

On maximum public sector wage: – Maximum public sector wage and maximum wage for ancillary and supporting technical jobs However, not all jobs are included Exemptions are not fully transparent On public enterprises: – Public enterprises are a part of public sector and they have great influence on public finance – Public advertisement for electing managers is defined in a satisfactory manner A possibility to appoint supervisory board members based on public advertisement should be also considered