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Labor taxes and fiscal policy in CroatiaSandra 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

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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?

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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

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Total tax revenue in Croatiacompared to the EU and CEE countries*

Figure 1: Total tax revenue as percentage of GDP, general government, 1995 - 2002

Source: OECD, IMF, Ministry of Finance of Croatia and Slovenia, author’s calculations

Note: *Poland, Hungary, Czech Republic, Slovakia and Slovenia

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20

30

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50

60

1995. 1996. 1997. 1998. 1999. 2000. 2001. 2002.

EU15 - unweighted averageEU15 - minimumEU15 - maximumCroatiaCEE5 - unweighted average (without Croatia)

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Structure of tax revenues in Croatia

Table 1: Tax structure as percentage of total tax receipts, general government, 1994 - 2003

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Personal and corporate income taxes 18.3 18.3 20.1 19.4 19.5 19.1 16.5 14.9 15.1 14.8

Personal income tax 15.7 14.7 16.0 14.1 13.6 13.3 12.5 10.4 10.0 9.6

Corporate income tax 2.6 3.6 4.1 5.3 5.9 5.9 4.0 4.5 5.1 5.3

Social Security Contributions 34.0 35.8 35.9 37.2 32.6 34.2 33.8 34.7 32.1 32.4

Domestic I ndirect Taxes 47.7 45.9 44.0 43.4 47.9 46.7 49.7 50.4 52.8 52.8

Source: Ministry of Finance, author’s calculations

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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 15 40.3

OECD – EFTA 3 30.7

OECD – non-Europe 7 23.5

OECD – transition economies 42.9

OECD – unweighted average 36.4

CROATIA 39.1

CROATIA (Zagreb) 40.4

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Tax wedge and the rate of unemployment

Figure 2: Tax wedge and the ILO rate of unemployment in Croatia, 1994 - 2004

Source: Croatian Bureau of Statistics, The Institute of Economics, Zagreb

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60

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 20040

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Tax wedge Unemployment rate

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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

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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

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Demographic projections: underlying assumptions

Table 3: Medium demographic projection variant, underlying assumptions

Source: UN, 2003.

2005 - 2010 2045-2050 change

Total fertility rate 1.67 1.85 0.18

Life expectancy (both sexes)

74.9 79.6 4.7

Male life expectancy 74.1 76.6 5.5

Female life expectancy 78.6 82.6 4.0

Population growth rate (%) -0.26 -0.58 -0.32

Net migration (thousands) -5 -5 -

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Demographic projections: main trends

Table 4: Medium demographic projection variant, total population and demographic dependency ratios

2005 - 2010 2045-2050 change

Total population (in 000) 4405 3581 -824

Median age 40.2 44.9 4.7

Elderly (as % of total population)

17.0 25.0 8.1

Working age population (as % of total population)

66.5 59.1 -7.4

Old age dependency ratio 25.5 42.3 16.8

Older workers (as % of working age population)

16.8 21.2 4.4

Very old (as % of elderly) 18.1 30.4 12.3

Source: UN, 2003; author’s calculation.

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Fiscal effects of demographic changes: public pension expenditures

Figure 3: Projected public pension expenditures (as % of GDP)

Source: author’s estimates.

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2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

Baseline scenarioHigh average wage growth scenarioLow average wage growth scenario

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8,5

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9,5

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10,5

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2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

Medium variant High variant Low variant Constant- fertility variant

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)

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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