1 Labor taxes and fiscal policy in Croatia Sandra Švaljek, The Institute of Economics, Zagreb Conference on Labor Markets, Growth and Powerty Reduction Strategies May 27-28, 2005 Thessaloniki, Greece Parallel session: Labor taxes and fiscal policy

2 Outline 1. Persistent macroeconomic problems in Croatia 2. Tax structure and labor taxation - tax revenues in Croatia (size and structure) - labor taxation (tax wedge) 3. Achievements in labor taxation and fiscal policy - decrease in labor taxation - pension reform 4. Fiscal challenges - need for fiscal adjustment - high social security expenditures - unpleasant demographics 5. What else should be undertaken?

3 Persistent macroeconomic problems in Croatia Sluggish growth (war, reconstruction, transition, restructuring) High tax burden Large state sector and huge government consumption - persistent fiscal imbalance High rate of unemployment and low participation rate Lack of competitiveness – current account deficits and growing external debt Low inflow of FDI-s

4 Total tax revenue in Croatia compared to the EU and CEE countries* Figure 1: Total tax revenue as percentage of GDP, general government, Source: OECD, IMF, Ministry of Finance of Croatia and Slovenia, author’s calculations Note: *Poland, Hungary, Czech Republic, Slovakia and Slovenia

5 Structure of tax revenues in Croatia Table 1: Tax structure as percentage of total tax receipts, general government, Source: Ministry of Finance, author’s calculations

6 Tax wedge in Croatia compared to the OECD countries Table 2: Tax wedge as percentage of labor cost of worker in manufacturing, 2002 Source: OECD Taxing Wages (2003), The Institute of Economics, Zagreb OECD – EU OECD – EFTA OECD – non-Europe OECD – transition economies42.9 OECD – unweighted average36.4 CROATIA39.1 CROATIA (Zagreb)40.4

7 Tax wedge and the rate of unemployment Figure 2: Tax wedge and the ILO rate of unemployment in Croatia, Source: Croatian Bureau of Statistics, The Institute of Economics, Zagreb

8 Achievements in labor taxation and fiscal policy Several tax reforms and minor tax changes brought about the reduction of tax wedge, but total tax receipts remain sufficiently high Tax reforms consisted of lowering social security benefits to some extent, but even more in reduction of labor tax burden Tax burden reduced especially for the poor, among which there is a largest proportion of long-term unemployed In the same time, the state relied more heavily on less distortionary taxes on goods and services – tax structure in Croatia differs very much from those in EU 15 The problem of employment in the informal sector addressed by imposing social security benefits on earnings based on independent work contracts The Government opted for a “second-best” solution On the expenditure side, pension reform introducing fully-funded three-pillar pension system remains the most important fiscal success story in past ten years

9 Fiscal challenges However, there are still many unresolved fiscal issues –High deficits (5 percent of GDP or more) call for urgent fiscal adjustment –Deficits are caused by enormous government consumption –Expenditures on social security (healthcare, pension) extremely high –Ageing population does not make the problem any easier

10 Demographic projections: underlying assumptions Table 3: Medium demographic projection variant, underlying assumptions Source: UN, change Total fertility rate Life expectancy (both sexes) Male life expectancy Female life expectancy Population growth rate (%) Net migration (thousands)-5 -

11 Demographic projections: main trends Table 4: Medium demographic projection variant, total population and demographic dependency ratios change Total population (in 000) Median age Elderly (as % of total population) Working age population (as % of total population) Old age dependency ratio Older workers (as % of working age population) Very old (as % of elderly) Source: UN, 2003; author’s calculation.

12 Fiscal effects of demographic changes: public pension expenditures Figure 3: Projected public pension expenditures (as % of GDP) Source: author’s estimates.

13 Fiscal effects of demographic changes: expenditures on health and long-term care Source: author’s estimates. Figure 4: Projected public expenditures on health and long-term care (as % of GDP)

14 What elso should be undertaken? Improvement in budget balance as soon as possible is essential This should be broght about by the reduction in government expenditures (on wages, subsidies etc.) Healthcare expenditures as a share of GDP should be reduced and better control over public expenditures on health should be achieved Labor market shoud be made more flexible since neither the labor costs nor the unemployment benefits cannot explain stagnant job creation in Croatia More robust economic growth would surely have positive effects on job creation