CRO NOTE Sept/Oct 2018: Tax Reform Dilemma

Ilustracija: Andreus / Dreamstime

Main events in September

Will the next step in the tax reform bring an additional boost to the economy?
Fiscal surplus in the first half of 2018: is it enough for success if the economy is growing at 2.9%
Pension reform prompted trade unions to abandon social dialogue
Credit rating agency Standard and Poor’s assigned a positive outlook to Croatia but the rating remains below investment grade, BB-
Shipyard Uljanik’s restructuring plan rejected by the European Commission: what is to be expected?

Economic and political trends in Croatia

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Can Tax Reform Help Boost the Croatian Economy?

The Government session on September 20th was meant to be routine. Everybody knew that the package of tax laws will be on the agenda. The topic was widely discussed before, so almost no one expected surprises. However, a kind of surprise happened regarding the reduction of the VAT rate from 25% to 24% starting from 2020.

The scope of foodstuff to be taxed at a lower rate of 13% starting from 2019 was somewhat broadened. It was already announced that it would include meat, fish, fruit and vegetables, and it was broadened to include eggs and edible oil. The Government’s proposal is based on the assumption that these measures will diminish the regressive nature of VAT (regressive means that people with lower income pay relatively more taxes because they spend a larger portion of their income). The annual loss of revenue for the central budget due to broadening of the base taxed at 13% is estimated at HRK 1.4 billion, i.e. 0.37% of GDP.

The proposal about broadening the tax base which is taxed at 13% is not a surprise. Rather, the surprise is related to the commitment to reduce the general VAT tax rate from the existing 25% to 24% starting from the 1stof January of 2020.

It is true that 25% is the second highest VAT rate in the EU, the same as in Denmark and Sweden, but lower than the Hungary’s global maximum of 27%. Given the very broad tax base and a high rate, the Croatian Government collects by far the most in the EU in terms of VAT revenues as a percentage of GDP. According to Eurostat, more than 13% of GDP is collected from VAT (see the table below).

Despite the high burden, it is unusual to propose such an important legal change like reduction in the general VAT rate one year ahead (25% will be reduced to 24% in 2020). This is especially risky when most macroeconomists and experts point out that it would be better to cut direct taxes due to their downward impact on the cost of labor.

The general claim is that lower labor taxation would boost wages and employment, and help prevent emigration. These produce direct positive effects on economic growth, which is in contrast to uncertain effects of lower VAT. Lower VAT may benefit producers and traders rather than consumers, if retailers manage to keep their profit margins.

Highest general VAT rates in the EU and how much governments collect in VAT revenue

COUNTRY GENERAL TAX RATE (VAT) REVENUE FROM VAT IN % OF GDP IN 2017
HUNGARY 27% 9.6%
CROATIA 25% 13.6%
DENMARK 25% 9.5%
SWEDEN 25% 9.3%
FINLAND 24% 9.2%
GREECE 24% 8.1%

Source: Eurostat.

With rates and revenues as high as indicated in the table above, it is very hard for the Minister of Finance to defend the VAT rate of 25% despite alternative tax relaxations being more attractive in terms of impact on growth. As a result, the VAT reduction from 25% to 24% will probably pass in the Parliament. The Government has estimated the effect of a lower general rate (after taking into account 2019 lower rate effects) as additional loss of budgetary revenues of HRK 1.6 billion, i.e. 0.42% of GDP.

With respect to labor taxation, two social contributions totaling 2.2% (now paid on gross wages) will be abolished, while the public health contribution of 15%, which is calculated on the same base, will be raised to 16.5%. In total, social contributions that are calculated on gross wages will decrease by 0.7pp (from 17.2% to 16.5%), which is close to negligible effect (pension contribution, which is part of the gross wage, will remain the same). However, gains will be felt in the public health system budget, where revenue will grow.

In addition, the lower threshold for calculation of the higher rate of personal income tax of 36% (the regular personal income tax rate is 24%) was raised from 17.500 kuna net per month to 30.000 kuna net per month. This change will not have a material impact. Even the impact on inequality will be negligible, as the number of persons who receive wages in the range between HRK 17,500 and HRK 30,000 per month is very small.

The package of proposed tax laws also includes measures which have been debated for months, such as reduction of the real estate turnover tax rate from 4% to 3% starting from 2019. Let’s recall that the Government gave up on real estate tax. Given the new election cycle looming around the corner (more details below), the unpopular real estate tax can be forgotten until 2021. Real estate turnover tax has nothing to do with real estate tax because turnover tax is paid after house purchases, while real estate tax is regular tax paid by real estate owners. It will remain limited to a symbolic communal charge that is already being paid.

Politics behind Tax Reform

Substantial tax reductions at the mature stage of the business cycle, when the economy is doing fine, are risky per se. This is especially so when tax relaxations are introduced more than a year ahead. Economic situation may change in the meantime, rendering tax relaxations more difficult when the time comes (2020).

The incentive to project a downward trend for taxes is obviously related to elections looming around the corner. Croatia is coming out of a calm period without elections and entering its usual long cycle of elections. Warm-up European elections are scheduled for spring 2019, presidential elections for late 2019/early 2020, regular general parliamentary elections will most probably be in autumn 2020, and local elections will finalize the cycle in spring 2021.

A big political story will also be the Croatian EU Presidency in the first half of 2020. PM Plenković will certainly want to use this opportunity to cement his relatively stable political position. The latest polls give his party around 27% of voters’ support and moving up, while the first follower (social democrats who are tearing apart) is at around 17%. MOST and populists as well as extremists do not appear strong enough to record substantial growth, at least for the time being. However, this does not mean that Plenković can simply sit and wait. His majority is thin, it depends on a very sensitive balance of intra-HDZ interests and a few independent votes. This position is shaky and it is reflected in the political economy of taxation: in order to survive, the Government cannot afford tough reforms that mobilize those affected; every opportunity to create benefits for supporting interest groups has to be utilized.

There were serious rumors and media reports that PM Plenković is thinking about early general elections to re-invent his Government on the basis of stronger majority. This thinking makes sense under present circumstances when the opposition is on its knees. However, probability for this to happen is low despite the obvious tendency of the Government to create occasional surprises.

Therefore PM Plenković and the ruling HDZ can systematically capitalize on the weaknesses of others and build a political position calmly, planning two years ahead, while any short-run election adventure may create more risks than new hands of support. On top of this, one should not forget that Plenković has broader European plans. As a former career diplomat, he certainly keeps this in mind.

On the European front, Plenković is a reliable ally of the Merkel-Macron EU mainstream. His EU contribution of winning the forthcoming European elections in Croatia and adding seats to the European Peoples Party in the European Parliament will be appreciated within the EU political mainstream, which is generally endangered by losing to extremists and populists, as in the recent Italian general elections. There are several ways how Plenković can capitalize his position. He can either influence the Berlin-Paris axis, to bring it more in line with Croatian interests in the Balkans, and/or he can win a ticket for Croatia’s entry to the European Exchange Rate Mechanism II, which is a proclaimed strategy of the Croatian Government, supported by the Croatian National Bank headed by the recently re-appointed central bank Governor Boris Vujčić.

The necessary precondition for this to happen will be the general support for the EU and the euro among Croatians. Plenković has a lot to gain if pro-EU sentiment will be strong, but he has a lot to lose if this sentiment continues to deteriorate. This is still not clear as euroscepticism is on the rise and support for the EU and the euro is marginally shifting around half of the population. According to the Eurobarometer published earlier this year, more Croatians distrust than trust the EU. This is a typical Central European response, similar to that of Poland, Slovenia, Slovakia, Hungary and Austria. It is not clear whether ERM II entry and/or good relations with mainstream EU politics can earn Plenković important advantage.

Trust in the EU

Source: Eurobarometer, March 2018.

With such sentiment among voters, Plenković cannot capitalize his strong EU footing and weak opposition, as he faces constant opposition within his own party and from the political right. For the time being, the Prime Minister has managed to compensate for this by winning more support in the center, which is easy as long as the opposition is in disarray. However, he has to constantly seek new channels of mobilizing support or neutralize the right wing within his own party.

The recent affair with fake SMS messages and the leak of information about criminal investigations, allegedly involving some persons related to the HDZ’s right wing, provides an opportunity for Plenković to take a firmer grip over the HDZ and cement his central political position. However, even with firmer political ground, the Government is unlikely to carry out the tough reform schedule in the fields of public health, pensions, administration, state-owned enterprises (privatization) and in public sector in general.

Fiscal Surplus and the Role of EU funds

Favorable economic circumstances ensure that there are low hanging fruits. European growth has spilled over onto the small and open Croatian economy, which started to recover after EU entry in 2013. Recovery of Croatia’s main trading partner Italy is frail and not helping Croatian recovery, which is in contrast to other countries of New Europe that depend more on Germany. Nevertheless, the emergence of new small companies and exporters has successfully prevailed over the rigid, old economic structure, the problems of which are still reflected in problems in large companies (Agrokor in 2017, Petrokemija and shipyard Uljanik in 2018).

Exports and personal consumption have kept the economy growing for four years since late 2014. In fact, the Croatian economy is going through a period of deep changes in terms of export orientation. We expect total (merchandise and services) exports to GDP ratio to grow from 35% in 2009 to 55% in 2019, which is a rapid change primarily driven by EU accession.

Total exports to GDP ratio in 2009-2017 and forecast for 2018 and 2019

Sources: CNB and Arhivanalitika (forecast).

The related increase in fiscal revenues has opened doors for pleasant compromises reflected in parallel tax reductions and steep declines in the fiscal deficit and public debt to GDP ratio. Fiscal data in the table below show a small worsening of the central government deficit in Jan-Jun 2018 vs the same period last year. However the balances of extrabudgetary funds (e.g. Croatian Highways, Croatian Railways etc.) and local governments’ budgets improved immensely, which is why the consolidated result shows a higher surplus in the first half of 2018 than in 2017, despite tax cuts. The Government expects this to continue, primarily driven by economic growth.

Government balance in the first half of 2018

Source: Government of the Republic of Croatia.

The room for tax cuts obviously did not arise from lower expenditure. Expenditure growth continued, widely shared among major expenditure components. Room for increased expenditure was created thanks to the stronger economy that enabled simultaneous growth of expenditure and reductions in the deficit and public debt, the lack of pressures on election spending (as there were no elections since spring 2017) and EU funds.

There are two key pieces of information related to EU funds. First, the use of EU funds has been growing rapidly (13%). The total amount expected to be withdrawn in 2018, based on data for the first six months, is higher than 10 billion kuna, i.e. 2.6% of GDP. This amount became significant from the macroeconomic point of view after several years of meagre inflows. Second, EU funds play an important role in deficit reduction. Their role is twofold in this respect. Larger inflows from the EU budget than outflows are recorded above the deficit line, directly contributing to deficit reduction. The indirect effect is reflected in politicians’ behavior. It is now much easier for the Minister of Finance to redirect budgetary demands coming from line ministries to be financed from largely non-deficit creating EU funds, rather than from deficit creating domestic funding sources, such as taxes.

There is Economic Growth, but Rating Climbs Slowly

The desire for fiscal adjustment was shared by both PM Plenković and Minister of Finance Zdravko Marić in order to regain the sovereign investment grade status from credit ratings agencies. Croatia enjoyed unchanged sovereign investment grade of BBB- from the first ratings in 1997 until 2012. Late into that year, credit rating agencies downgraded Croatia below the threshold of BBB-. Croatia has been struggling with sovereign ratings since then. While the come-back to a BBB- investment grade would probably mean very little in terms of government bond prices and yields, it would certainly mean a lot to PM Plenković, being a seal of approval of his leadership of Croatia on its way out of the crisis, despite widespread criticism fueled by the lack of structural reforms.

Sovereign credit rating of selected countries (Standard & Poor’s)

Selected country S&P sovereign credit rating 10y government Eurobond yield, end-September
Bulgaria BBB-, positive outlook (investment grade) 0.99%
Cyprus BBB-, stable outlook (investment grade) 2.50%*
Croatia BB+, positive outlook 2.16%
Azerbaijan BB+, negative outlook 4.50%*
Serbia BB, positive outlook 3.50%*

Sources: Standard & Poor’s and Tradingeconomics. *Estimated by Arhivanalitika.

So, why has the sovereign credit rating been recovering so slowly, when the Croatian economy is growing, government budget is in surplus, and fiscal deficit as well as public debt to GDP ratio declined substantially? In particular, with a balanced or surplus government budget in the last couple of years, the public debt to GDP ratio declined from the maximum of 84% of GDP in 2015 to 74% expected by the end of this year. According to government projections of fiscal policy and economic growth, the downward trend will continue. The public debt to GDP ratio expected in 2021 currently stands at 65%. This is higher than the Maastricht limit of 60%, but is not the condition for entry to the Eurozone. Fast convergence towards 60%, as implied by the aforementioned downward path, is enough to meet criteria of the Stability and Growth Pact. Hence, why the slow change in rating?

There are three explanations. First, Croatian growth is relatively slow. For example, GDP in the second quarter of 2018 was 2.9% higher than in the second quarter of 2017. Generally, a 2.5%-3% growth at an annual level has been a norm for quite some time in Croatia. This is much slower than in other countries in New Europe (except the Czech Republic), as shown in the figure below. And expected growth (see Annex “Key Forecasts and Statistics” at the end of the document) does not deviate from the norm either.

Second quarter 2018 GDP growth vs second quarter 2017

Source: Eurostat.

The relatively slow growth is related to the second explanation – lack of structural reforms. The concept of structural reforms sometimes sounds like a fuzzy idea that is impossible to define. However, it relates to a well-defined set of evidence-based policies aiming at boosting competitiveness and growth that Croatia is lacking. For example, well-documented inefficiencies in widespread state-owned enterprises are not reflected in government targets and policies as there are no efforts to privatize or at least professionalize management in this sector. Boards are populated on the basis of political criteria. The large government sector wage bill and purchases of intermediary goods (Croatia is an aberration compared to peers with 11%-12% of GDP in the government sector wage bill and 7% of GDP in government purchases) are not recognized as structural problems that have to be dealt with via structural reforms. The business and investment environment reform has started recently, but its results are thin, as reflected in the measurement of Doing Business, showing that Croatia is still struggling to enter the top 50 countries in the world (see Annex C). Tougher areas for reform, such as the public health system, public administration and territorial organization (Croatia has 4 million people and 576 units of local government), have not yet been addressed. Finally, the lack of structural reforms in several large industrial companies, which have carried over their problems from socialist times, poses a direct budgetary risk. For example, government exposure to shipyard Uljanik, which hardly has any business prospects, is estimated at EUR 650 million, i.e. around 1.3% of GDP.

The slow growth and lack of structural reforms provide the third explanation for why the rating has been climbing slowly and why Croatia still pays a relatively high interest rate on government bonds (which mainly consists of the risk premium) – fiscal policy is not yet credible. Fiscal improvement in good times is something that is relatively easy to achieve. No one knows yet whether Croatia has learned the lessons from the last crisis well. In 2009 and 2012, different governments imposed (and never reversed) additional tax burdens that prolonged the crisis and turned it into a six-year long agony comparable to long-run economic declines elsewhere in Southern Europe. Before the crisis, the Croatian fiscal position seemed to be sustainable, just as it seems now. As a result, Croatia has one of the highest tax burdens in terms of general government revenue given the level of economic development (as shown in the figure below).

General government revenue to GDP ratio vs. real GDP per capita in 2017 (Croatia is a red circle)

Source: Eurostat.

Each dot is an EU country (figure is without Ireland and Luxembourg because these countries are outliers) and Croatia is a red circle. It shows that the government burden is 6pp of GDP higher than the line of expected values – just look at a vertical distance.

Conclusion

Coming back to the initial question of whether tax reform which was widely debated recently can help boost the Croatian economy, the answer is it can, but very little. Given the position of Croatia in the figure above, any tax relaxation will probably do some good for the economy; however, impacts of tax changes are limited as long as Croatia lags behind in terms of structural reforms. Structural reforms are primarily needed in the public sector in order to control corruption, eliminate unnecessary public expenditures based on criteria of merit and professionalism, and increase efficiency of public outlays. Another critical area is related to state-owned enterprises. Reforms aiming at these areas would help growth on the basis of improved allocation of economic resources and creation of wider space for stronger, credible and sustainable tax reform.


Annex A: Main Features of the Croatian Tax System

 VAT rates: 0%, 13% and the general rate of 25%, expected to be reduced to 24% as of the 1stof January 2020.

Corporate income tax rate: 18% and 12% for companies with annual revenue below HRK 3 million. In addition, Croatian residents pay special 12% final tax plus local surcharges on the payout of profits or dividends. For more details on local surcharges see below.

Personal income tax (PIT) rate: 24% and 36%, the latter being currently applied to monthly net wages above 17.500 kuna and expected to be raised to 30.000 kuna as of the 1stof January 2019. PIT is the base for calculation of local surcharges that range between 0% and 18% depending on the local government unit.

Other similar personal taxes: tax on rent and capital gains tax. A 12% final tax rate plus a local surcharge is paid on income from renting real estate and other forms of income from capital, subject to resale within three years. Assets ranging from real estate to equity are not taxed if they are held for more than 3 years. If natural persons record substantial gains from buying and selling assets such as real estate often, they may pay income tax.

Excise: Excise tax is paid on alcohol, tobacco, refined oil products and luxuries.

Social contributions: pension contribution is 20% from workers’ gross wages paid by employers as paying agents; for most workers, 15% is paid to the government pay-as-you-go pension system and 5% is paid to private pension accounts managed by obligatory pension funds. Health contribution is paid at a rate of 15% on the gross wage and there are two other contributions totaling 2.2%, which are paid in the same way. It is expected that from 2019. total burden of 17.2% will reduce to 16.5%.

Real estate: 4% real estate turnover tax is paid by buyers of real estate, expected to be reduced to 3%; there is no real estate tax or tax on assets, but investors pay a one-off communal contribution in amounts which differ among local government units. Owners of real estate regularly pay a communal charge which has the same effect as real estate tax. It differs among local units.

Inheritance tax: no inheritance tax for those first in line, the rest pay tax at 4%.

Local taxes: local government units can impose additional taxes such as sales tax of up to 3%, communal charges and communal contributions.

Other: there are many parafiscal duties (e.g. obligatory membership in chambers etc.) that every investor in Croatia should pay special attention to.

Annex B: Labor Market and Human Development

The rate of unemployment in the second quarter of 2018 stood at 7.5%, which is the second lowest unemployment rate ever recorded according to the Labor Force Survey Methodology (LFS). Employment was growing at 2.3% per annum and around 1.6 million people worked during the second quarter according to LFS. At the same time, with more than 1.2 million pensioners, Croatia has one of the worst dependency ratios in the world (approx. 1.2 officially employed per pensioner). Population is aging and it is expected that the population aged 65+ will increase from around 750 thousand in 2011 to close to a million in 2031. Demographic problems may get worse due to emigration, which has speeded up after Croatia’s EU entry. Generally, it is considered that scarce qualified labor is one of the main constraints to potential growth, which is estimated at around 1% by the European Commission. Scarcity of labor has been manifested for years in the booming industries of ICT and tourism, but recently the problem has been seen in more traditional industries, such as retail and construction. 

The upward pressure on wages currently stands at around 3% per annum in real terms. The average net wage per employee is around EUR 850 and the average total cost of labor is around EUR 1.333 per employee per month. The general price level is at 63% of the EU average, with food and clothing close to the EU average, and utilities, health and education significantly below.

With 15 years of expected schooling and life expectancy of close to 78 years, Croatia is 46thin the world in terms of the UN’s Human Development Index, preceded by Chile and Hungary and followed by Argentina and Oman.

According to Eurostat, in population between 25 and 64 years of age, 23.7% had tertiary education in 2017, which is significantly below the EU average of 31% and the highest achievers above 40% (Scandinavian countries, the UK and Ireland with a 45% share). The Croatian share is comparable to that of the Czech Republic, Slovakia and Portugal and higher than that of Italy, Malta and Romania.

Croatians are relatively used to corruption. According to Transparency International, which measures perception of corruption, there are 56 less corrupted countries in the world. Being 57th on the Corruption Perception List, Croatia is preceded by Slovakia and Italy and followed by Saudi Arabia and Greece.

Annex C: Doing Business

*DTF – distance to frontier is % of best global practice.
Source: The World Bank.

Croatia has a particular administrative problem with construction permits. Anecdotal evidence shows wide variations across the country. The World Bank measures data in Zagreb, but there are local government units where construction permits can be obtained in a faster and less costly manner. The second largest problem is resolving insolvency and getting credit. With around 70% of best global practice used as the key criteria, problems remain in the areas of enforcing contracts, paying taxes and registering property. Three areas are not problematic: starting a business, getting electricity and international trade.

Annex D: Interest Rates and Financial Markets

Kuna deposits and loans not indexed to foreign currency

Kuna deposits and loans indexed to foreign currency

Deposits and loans in foreign currency

Source: Croatian National Bank, data for August 2018

Zagreb Stock Exchange (CROBEX index)

Annex E: Key Forecasts and Statistics

 Comparison of the most relevant macroeconomic forecasts (annual growth in % in real terms)

 

GDP COMPONENT IN % PER ANNUM

EUROPEAN COMMISSION CROATIAN GOVERNMENT CROATIAN NATIONAL BANK INSTITUTE OF ECONOMICS ZAGREB IMF
2018 2019 2018 2019 2018 2019 2018 2019 2018 2019
GDP 2.6% 2.5% 2.8% 2.7% 2.8% 2.8% 3.0% 2.9% 2.8% 2.6%
PERSONAL CONSUMPTION 2.9% 2.8% 3.6% 3.1% 3.8% 3.1%
GOVERNMENT CONSUMPTION 2.2% 2.2% 2.5% 1.7% 2.6% 2.0%
INVESTMENT 6.7% 6.3% 6.4% 6.7% 5.3% 5.1%
EXPORTS 5.3% 5.2% 4.9% 4.7% 4.3% 4.9%
IMPORTS 7.4% 6.8% 7.1% 6.0% 6.9% 6.8%
 

Inflation in Croatia closely resembles price changes in the Eurozone

Source: CNB Bulletin No. 245.

 

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