COMMISSION STAFF WORKING DOCUMENT Assessment of the 2014 national reform programme and convergence programme for CROATIA Accompanying the document Recommendation for a COUNCIL RECOMMENDATION on Croatia’s 2014 national reform programme and delivering a Council opinion on Croatia’s 2014 convergence programme
Date: 2014-06-02
Institutions: European Commission
Subjects: Croatia, budget deficit, competitiveness, economic convergence, economic disparity, economic growth, economic stabilisation, financial control, job creation, macroeconomics, multilateral surveillance, public debt, stability programme













EUR-Lex - 52014SC0412 - EN











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52014SC0412

COMMISSION STAFF WORKING DOCUMENT Assessment of the 2014 national reform programme and convergence programme for CROATIA Accompanying the document Recommendation for a COUNCIL RECOMMENDATION on Croatia’s 2014 national reform programme and delivering a Council opinion on Croatia’s 2014 convergence programme /* SWD/2014/0412 final */









CONTENTS
Executive summary. 3
1....... Introduction. 5
2....... Economic situation and outlook. 6
3....... Challenges and assessment of policy agenda. 7
3.1......... Fiscal policy and taxation. 7
3.2......... Financial sector 20
3.3......... Labour market, education and social
policies. 21
3.4......... Structural measures promoting sustainable
growth and competitiveness. 27
3.5......... Modernisation of public administration. 35
4....... Conclusions. 38
Overview table. 40
Annex. 41

Executive summary 

Croatia is
forecast to experience its sixth consecutive year of recession in 2014. Real
GDP is projected to edge down by 0.6 % in 2014, before returning on a
positive path in 2015 on the back of a mild recovery in net exports. The
unemployment rate is expected to increase further in 2014 and to stabilise at around
18 % in 2015 as the recovery gradually starts to take hold. The employment
rate, already one of the lowest in the EU, is set to continue declining. Weak
economic activity, which contributed to the slowdown of inflation in 2013, is
likely to keep inflationary pressures subdued in the medium term. Fiscal
consolidation measures introduced in the context of the Excessive Deficit
Procedure are expected to help reverse the negative deficit trajectory but,
given subdued nominal growth, are unlikely to stop the increase in the ratio of
public debt to GDP by 2015.
The
2014 national reform programme and the 2014 convergence programme are the first
programmes Croatia submitted following its accession to the EU in July 2013. Croatia participated in the 2013 European Semester on an informal and voluntary basis and consequently
was not issued country-specific recommendations. The 2014 national reform
programme describes measures taken in 2013 and outlines measures to be taken in
2014-17 to address the main structural weaknesses of the Croatian economy,
which were fully exposed by the protracted recession. Notably, the programme
announces measures intended to increase the flexibility of the labour market, simplify
the business environment and boost professionalism and client-orientation in public
administration.
Promoting
competitiveness and job-rich growth, while at the same time reducing fiscal
imbalances and managing the corporate debt overhang, are the key economic policy
challenges for Croatia. In a context of favourable
external developments, growth in the decade before the global financial crisis was
sustained by sizeable accumulation of debt on the part of businesses and large
capital inflows in the least productive sectors of the economy. Weak
productivity growth resulted in substantial competitiveness losses and gradually
eroding export market shares. A range of challenges in the labour market and in
the wider business environment and substantial delays in restructuring large,
non-viable industrial sectors, in particular shipbuilding, have amplified the
impact of the crisis and hindered the recovery, with considerable social
consequences. Loose fiscal policies in the downturn and rising public indebtedness
have substantially reduced the room for fiscal policy and have created an
additional burden for the economy. The range and ambition of the measures
presented in the national reform programme and the convergence programme echo
these challenges. To this end, addressing the most pressing challenges for the
country requires reforms in the following areas: 
·        
Reviving growth and competitiveness: Croatian
companies operate in an environment that is not conducive to improving
productivity and fostering investment. The high administrative and regulatory
burden and lengthy proceedings, numerous para-fiscal charges, weak protection
of investments and policy uncertainty combine to create a substantial drag on
businesses. Significant dependence on public subsidies, the presence of
financially weak and poorly accountable state-owned enterprises across many
sectors and relatively weak corruption prevention mechanisms create an uneven
level-playing field for private investors. 

 Unlocking
     the potential of the labour market and fighting poverty: Croatia
     has one of the lowest employment rates in the EU and unemployment,
     including youth unemployment, has risen to new heights since the onset of
     the recession. Job creation is hindered by various factors including
     labour regulation, high average labour costs compared to peers and limited
     alignment between policies, notably those affecting net labour income and
     social benefits. These in some cases prevent re-activation of inactive and
     unemployed persons and contribute to a high incidence of undeclared work.
     In addition, numerous pathways facilitating an early exit from the labour
     market cement the low participation rates of prime-age workers. The
     adverse economic and labour market trends are reflected in a significantly
     higher proportion of persons at risk of poverty and social exclusion than
     in the EU generally, and in the increasing incidence of poverty. The
     social protection system is fragmented and programmes are often poorly
     targeted, with the result that the provision of benefits   is not always levelled
      to those most in need.

·        
Improving public administration and the justice system: Public administration across different levels of government suffers
from weak coordination and limited capacity, which affects policy formulation
and slows down implementation of reforms. These concerns are a clear challenge
especially in view of ensuring strategic programming  and effective management
of EU Structural and Investment Funds. Inefficiencies in public administration
also impose a high burden on entrepreneurs. Companies continue to face difficulties
with insolvency procedures, contract enforcement and the length of judicial
proceedings, which impinges on the protection of investors’ rights and delays
corporate deleveraging.
·        
Addressing fiscal imbalances: The
deficit in 2013 remained high, because of slippages on the expenditure side and
revenue shortfalls, in a context of overly optimistic budgetary assumptions and
a weak fiscal framework. The public pension and healthcare systems show
important weaknesses that limit their effectiveness and control over public
expenditure in these areas is not achieved. Persistent budget deficits have
contributed to a significant increase in government debt
in recent years and have become a major policy challenge. 
·        
Monitoring the quality of banks’ portfolios: Macro-prudential measures of the Croatian National Bank put in
place to limit the rapid growth in private indebtedness helped to build
resilience in the banking sector. However, given the protracted weakness in the
economy, banks’ non-performing loans to corporates have risen sharply. The asset
quality of the parent banks of the four largest Croatian subsidiaries is being
assessed in the comprehensive assessment exercise performed by the European
Central Bank, but the exercise might not be fully revealing for the Croatian
exposures. This provides an opportunity for the Croatian National Bank to exploit
the synergies of a defined methodological framework and take additional
diagnostic actions that could provide more information on Croatian banks’
balance sheets, including those of the mid-sized and smaller banks.

1.        
Introduction  

Croatia
joined the EU on 1 July 2013 and is participating in the European Semester on a
formal basis for the first time.[1]
This staff working document assesses policy measures in light of the findings
of the Commission’s Annual Growth Survey (AGS) 2014[2] and
the third annual Alert Mechanism Report (AMR)[3],
which were published in November 2013. The AGS sets out the Commission’s
proposals for building the necessary common understanding about the priorities
for action at national and EU level in 2014. It identifies five priorities to
guide Member States to renewed growth: pursuing differentiated, growth-friendly
fiscal consolidation; restoring normal lending to the economy; promoting growth
and competitiveness for today and tomorrow; tackling unemployment and the
social consequences of the crisis; and modernising public administration. The AMR
serves as an initial screening device to determine whether macroeconomic
imbalances exist or risk emerging in Member States. The AMR found positive
signs that macroeconomic imbalances in Europe are being corrected. To ensure
that a complete and durable rebalancing is achieved, Croatia and 15 other Member States were selected for a review of developments in the accumulation and unwinding
of imbalances. These in-depth reviews were published on 5 March 2014 along with
a Commission Communication.[4]

Against the
background of the 2013 Council Recommendations, the AGS and the AMR, and the
in-depth review, Croatia presented a national reform programme and a
convergence programme on 24 April 2014. The information contained in these
programmes provides the basis for the assessment made in this staff working
document. The convergence programme was drafted by the Ministry of Finance in
cooperation with the Croatian National Bank and the national reform programme
was prepared by the Working Group for the Coordination of Participation of
Croatia in the European Semester and its Operative Team, under constrained resources.
The key reform measures included in the programmes were consulted with social
partners and the public.
Regarding
content and quality, the 2014 national reform programme presents a succinct,
yet detailed description of measures taken in 2013 and outlines measures that
are to be implemented in 2014-17. Reform priorities are grouped in four key
areas: public finances (e.g. reforming the fiscal framework, restructuring
state-owned enterprises), the financial sector (supervision activities), labour
market (e.g. increasing its flexibility, improving public employment services)
and competitiveness (e.g. decreasing the administrative burden on businesses).
These priorities echo the main challenges identified in the in-depth review on Croatia and this staff working document. Some of the measures presented in the national
reform programme are accompanied by detailed indicators and their targeted
values that will facilitate their monitoring in the following years. The
priorities presented in the national reform programme and some of the measures
described in greater detail signal welcome reform intentions which could help
to effectively tackle the challenges faced by Croatia if implemented in a
rigorous and timely manner. 

2.        
Economic situation
and outlook 

Economic situation
Croatia has been mired
in recession since 2009. Five years of contraction have reduced Croatia’s real GDP by 12 % and only a muted recovery is forecast from 2015. In 2013,
the economy contracted by 1 % (after a 1.9 % decline in 2012) as a
result of falling household consumption and investment activity. As exports
fell slightly more than imports, the contribution to growth of net exports is
slightly negative. Government consumption growth remained very modest after
three years of decline. In the absence of demand-side pressures, consumer
inflation moderated to 2.3 % in 2013 from 3.4 % a year earlier.
The protracted
recession has hit the labour market. The unemployment
rate kept growing at a high pace in 2013, adding 1.3 percentage points on the
year to 17.2 %, a twofold increase since 2008. The economic crisis has
particularly affected young people and low-skilled workers. Youth unemployment
(in the 19-24 age group) soared to 50 % in 2013. 
Economic outlook
According to the
Commission spring 2014 forecast, the Croatian economy is expected to remain in
recession in 2014 with real GDP declining by 0.6 %. Domestic
demand is expected to remain weak and its negative contribution to GDP growth
is set to outweigh the positive growth impetus from net exports. Factors
holding back a faster recovery in domestic demand include the implementation of
fiscal consolidation measures, rising unemployment, on-going household sector
deleveraging, muted private investment in the context of constrained demand and
an on-going restructuring process related to pre-bankruptcy settlements. A
modest recovery in economic activity is projected in 2015 (GDP growth of 0.7 %)
that will be driven by net exports. In view of subdued demand, consumer price inflation
is expected to ease to 0.8 % in 2014 before edging up slightly in 2015.
The deterioration of the labour market is projected to continue in 2014 and come
to a halt in 2015 as economic activity starts to recover. 
The
macroeconomic outlook underlying the convergence programme and the national
reform programme is optimistic. Both strategic documents share
the same economic outlook. According to the convergence programme, real GDP
growth is expected to be 0.0 % and 1.2 % in 2014 and 2015
respectively, compared to -0.6 % and 0.7 % projected in the
Commission 2014 spring forecast. The difference between the two forecasts
reflects mainly the assessment of domestic demand dynamics: the Croatian
government expects a more limited decline of public and private consumption and
a rebound of gross fixed capital formation already in 2014, followed by a considerable
strengthening in 2015. According to the Commission 2014 spring forecast, the
on-going labour market deterioration and the additional fiscal consolidation
package would have a more sizable negative impact on household consumption.
Furthermore, investment activity is expected to recover at a slower pace than
projected by the authorities due to a more gradual pick-up in public investment
and the constraints to private investment growth arising from the high corporate
debt overhang and still feeble business optimism. The national reform programme
does not quantify the macroeconomic impact of structural reforms.

3.        
Challenges and assessment of policy agenda 
3.1.                
Fiscal policy and taxation

Budgetary
developments and debt dynamics
The two main
objectives of the budgetary strategy as defined in Croatia's 2014 convergence
programme are swift fiscal consolidation and setting
the economy on a sustainable growth path. Although fiscal consolidation
takes place in a context deeply impacted by five years of recession, the
authorities consider it necessary to contain the rising public debt and its
financing costs. Envisaged fiscal policy measures aim to ensure full compliance
with the Council recommendation with a view to bringing an end to the situation
of excessive government deficit in Croatia, namely to bring the deficit below
3% of GDP by 2016 and to bring the public debt on a downward trend. 
The assessment
of budgetary developments in the programme is complicated by the on-going
transition in the Ministry of Finance of applying to budgetary data the
standards set out in the European System of Accounts (ESA). In
October 2013, the Croatian Bureau of Statistics for the first time formally
notified to Eurostat fiscal data for the general government compatible with the
standards of the European System of National and Regional Accounts (ESA).
In April 2014, the second fiscal notification was also validated without
reservations by Eurostat. Except for historical data which, following a
technical corrigendum to the convergence programme, are consistent with the
latest EDP notification, the data reported in the convergence programme do not
correspond fully to the ESA standards. For the purposes of budgetary planning,
the Ministry of Finance uses a different delineation of the general government,
in which some units of the ESA-based general government sector are not included
in the budgetary figures (such as Croatian Radio Television and Croatian
Railways infrastructure operator) and some other entities that are classified
outside the general government sector are included (the State Agency for
Deposit Insurance and Bank Rehabilitation). Moreover, certain transactions
(e.g. reduction of arrears in the health-care sector) have erroneously been
reflected in the deficit reported in the programme.[5] Hence,
projections for 2014 and the following years are not compatible with ESA
standards, giving rise to inconsistencies with past data. This, on the one
hand, constitutes a breach of the Code of Conduct[6]
requirement to "ensure the formal and substantial consistency of the
required information on budgetary aggregates and economic assumptions with ESA
concepts" and, on the other hand, makes comparison with Commission 2014
spring forecast impracticable. Moreover, the convergence programme does not
contain a medium-term objective (MTO), except a single reference that the
fiscal policy upon the exit from EDP will be based on the new fiscal framework
and aimed towards reaching the MTO.[7]

The general
government deficit remained broadly unchanged in 2013, reaching 4.9% of GDP,
after 5.0% of GDP in 2012. When compared with the planned 2013
general government deficit in last year's economic programme (3.6% of GDP) the
outturn in 2013 was 1.3 pp. higher. In 2013, the government revised the budget
twice, in April and December, due to higher expenditures relative to the
initial plan and some unexpected revenue shortfalls. In particular, corporate
income tax receipts were weaker than expected after the introduction of a tax
break on reinvested profits. Revenues were also adversely impacted by the
change in the VAT collection system, in the context of joining the EU.
Meanwhile, total expenditures increased, chiefly due to higher social expenditures,
including a 1%-of-GDP clearance of arrears of the health sector and growing
interest expenditures. This, together with some methodological issues such as
differences in the number of local government units included in the general
government budgetary statistics, largely explains the difference to the deficit
target of 3.6% of GDP in the economic programme of 2013. 
In the
convergence programme, the headline deficit is targeted to gradually decline
from 4.4% of GDP in 2014 to 3.5%, 2.7% and 2.5% of GDP over 2015 – 2017. The
ratio of the (recalculated) structural balance[8]
to GDP underlying these headline targets would deteriorate by 0.2 pp. in 2014[9] and
improve by 0.9 ppt., 1.3 ppt. and 0.1 ppt. over 2015 – 2017. The headline
deficit target for 2014 incorporates the March 2014 budget revision and the
additional set of measures that were adopted in April to ensure compliance with
the Council EDP recommendation to Croatia (for details see Box 1 and Box 2). 
The profile of
the general government headline balance in 2014 and 2015 is strongly affected
by the transfer of pension assets from the second pillar to the pay-as-you-go
scheme.
In line with currently prevailing accounting rules, the programme's 2014 and
2015 headline deficit targets include the impact of the two-step transfer of
accumulated pension assets from the capitalised second pillar to the central
government budget. However, under new national accounting rules that will come
into force as of September 2014 (ESA 2010), such asset transfers will no longer
be deficit reducing. Excluding the asset transfers, the headline deficit
foreseen in the programme would amount to 4½% and 4% of GDP in years 2014 and
2015, respectively[10].
The profile of the general government headline balance in the Commission 2014 spring
forecast is also affected by the transfer of pension assets.[11] 
A large part of
the consolidation measures are taken in 2014. The amount of
envisaged measures stands at 2.3% in 2014 and 1.0% of GDP in 2015 and 2016.
This profile has to be seen against a gradual turnaround in a persistently high
underlying deficit, a positive corollary to a successful fiscal consolidation.
As regards the structure of the consolidation package, the bottom-up
presentation in the programme indicates broadly equal amount of measures on the
expenditure and the revenue side of the budget throughout the programming
period. However, despite sizable revenue side measures and, somewhat
surprisingly, against the background of the projected reacceleration of GDP,
the revenue-to-GDP ratio drops slightly in 2015. The expenditure-to-GDP ratio
is targeted to drop by 1.5 pps in 2015 and reach 45.7%, mostly on account of
envisaged savings in the health sector. Thereafter, it is expected to keep
decreasing in the next two years, and reach 45.2% in 2017. Overall, a
decreasing share of social transfers due to the savings in the health and
pension system is mostly offset by rising expenditure in co-financing of EU
funds-related projects[12].

     || Box 1. Main measures from the convergence programme of Croatia In 2014, the main measures on the revenue side are the increase in social security contributions for health, increase in concession fees (including telecom fees for the usage of RF spectrum), withdrawal of SOEs profit and changes in the lottery and gambling tax. Pension contributions will increase due to a shift in some contributions from the second pillar to the pay-as-you-go public pillar. On the expenditure side, savings  are planned in many categories, most importantly  subsidies, intermediate consumption and social transfers. For 2015, on the revenue side the government plans to introduce a new tax on deposit interest and to reduce corporate income tax credits for reinvested earnings. Planned expenditure savings are again piecemeal and across-the-board, with relatively small cuts distributed across many categories. Savings in intermediate consumption depend on the further implementation of common public procurement procedures and the application of more business-type processes in the public sector. Social transfers are expected to decline through the re-negotiation of the contracts with private providers of social security services. Lower compensation of employees hinges on the introduction of a plan on the restructuring of the existing school network. In 2016, the main measure on the revenue side is the introduction of a real estate tax,  which still faces many uncertainties. On the expenditure side, similarly to 2015 relatively small savings are planned across many different categories, most of them subject to implementation risk. Main budgetary measures ||   
   || Revenue || Expenditure ||   
   || 2014 ||   
   || ·         Transfer of accumulated assets from the second pension pillar (+0.8% of GDP)* ·         Increase of the rate of healthcare  contributions from 13% to 15% (+0.5% of GDP) ·         Increase of telecom fees and other concession fees (+0.16% of GDP) ·         SOEs dividend and profit withdrawal (+0.15% of GDP) ·         Increased social security contributions due to the shift of part of the future pension contributions to first pillar (+0.12% of GDP) ·         Changes in the lottery and gambling taxes (+0.1% of GDP) ·         Higher fuel excises (+0.1% of GDP) || ·         Reduction of subsidies, mostly to shipyards and HBOR (-0.33% of GDP) ·         Lower intermediate consumption due to savings, among other, on maintenance costs, transportation allowances, IT services (-0.2% of GDP) ·         Savings in social transfers, mostly in health sector (-0.2% of GDP) ·         Reduction of current transfers, mostly due to replacement with EU funding (-0.14% of GDP) ·         Lower public investment (-0.1% of GDP) ·         Net savings on the compensation of employees (-0.03% of GDP) ||   
   || 2015 ||   
   || ·         Transfer of accumulated assets from the second pension pillar (+0.6% of GDP)* ·         Partial reduction of corporate income tax credits for reinvested earnings (+0.15% of GDP) ·      Introduction of a tax on deposit interest (+0.1% of GDP) || ·         Lower intermediate consumption due to centralized public procurement for telecom services, fuel and energy; integration/outsourcing of supporting activities in the public sector (-0.14% of GDP) ·         Savings in transfers to science and higher education institutions and additional savings in the social security  system (-0.1% of GDP) ·         Reduction of subsidies in agriculture (-0.09% of GDP) ·         Reduction of transfers to higher education sector (-0.09% of GDP) ·         Savings on compensation of employees due to reorganization of the school network (-0.07% of GDP) ||   
   || 2016 ||   
   || ·      Introduction of a real estate property tax (+0.4% of GDP) || ·      Reduction in social transfers due to further implementation of hospital masterplan and new contracting arrangements in the social security system (-0.16% of GDP) ·      Reduction of intermediate consumption due to further introduction of centralized public procurement and outsourcing/integration of supporting activites in the public sector (-0.14% of GDP) ·      Reduction of other transfers obtained through suspension of third (voluntary) pension pillar and housing savings benefits (-0.14% of GDP) ·      Reduction of subsidies in agriculture (-0.09% of GDP) ·      Additional savings on compensation of employees due to reorganization of school network (-0.03% of GDP) ||   
   || Note: The budgetary impact in the table is the impact reported in the programme, i.e. by the national authorities. A positive sign implies that revenue / expenditure increases as a consequence of this measure. * These measures have an impact on revenues under ESA95 but not under ESA2010. ||   
The
consolidation measures are not spelled out in sufficient detail, especially in
the later years of the programme, and the quality of the consolidation merits
greater attention. Measures on the expenditure side lack
sufficient detail, especially in the outer years; moreover they are mainly of
temporary character and carry less weight in the consolidation than what would
be desirable. A large share of expenditure measures concern cutting
capital spending, which may be counterproductive in the longer run. The
revenue-increasing measures appear to be of a more permanent nature, but even
in this case the information provided is sparse. For example, as regards the
real estate tax, no information on tax rates, tax basis and exemptions is
provided, which hinders an assessment of the projected yields. In
order to reduce the negative impact on growth of the consolidation and ensure a
sustainable correction of the excessive deficit, greater attention to the
quality of the measures and a transition to expenditure based measures would be
warranted. The programme provides estimates of the budgetary impact of most
envisaged measures for the period 2014-2016 (see Box 1). Additional measures
for 2017 and their estimated impact are not presented. Some additional
measures, such as the introduction of a new electronic form for the provision
of data to the tax administration, organizational changes in tax administration
and customs administration, the introduction of a centralized payroll system
for civil servants, are mentioned in the programme but their estimated impact
is not presented due to difficulties in the assessment of potential savings.
However, as mentioned in the National Reform Programme, the macroeconomic
projections incorporate the effect of all measures in the package.
The balance of
risks to the programme deficit targets overall is tilted to the negative side. The
macroeconomic scenario underlying the convergence programme is overly
optimistic; however, revenue projections are slightly inconsistent with the
scenario and appear to be prudent. The most substantial risks to the programme
targets therefore relate to the implementation of the measures. For 2014, the
achievement of the headline target from the programme appears broadly within
reach but residual risks persist, related in particular to some savings on
subsidies, notably in the shipbuilding sector. Implementation risks widen
further towards the end of the programme period, partly due to the piecemeal
design of the adjustment package. Estimated expenditure savings depend on a
relatively high number of small measures dispersed across many different
categories and items, which multiplies the possibility that not all measures
are followed through. Implementation risks also apply to some revenue side
measures, as specific legislation will need to be adopted and a number of
flanking measures will have to be in place. This is the case of the real estate
tax, on which relies a large part of the adjustment in 2016. Risks of slippages
in healthcare expenditure also may continue to persist, in case of delays of
the on-going process of reform and if monitoring and control mechanisms are not
strengthened. 
Croatia is
currently subject to the corrective arm of the Pact. The
Council opened the Excessive Deficit Procedure for Croatia on 20 January 2014
and recommended to bring the government deficit down to 4.6% and 3.5% of GDP in
2014 and 2015, and to correct the excessive deficit by 2016 by reaching 2.7% of
GDP (see Box 2). Moreover, the EDP recommendation requires Croatia to achieve
an improvement in the structural balance of 0.5 pp. of GDP in 2014 and of 0.9
pp. of GDP in 2015, and take measures for an amount of 2.3 pp. of GDP in 2014
and of 1.0 pp. of GDP in 2015, in order to reach the required adjustment of the
structural balance. Croatia was given a deadline of 30 April 2014 to take
effective action to ensure a sustainable correction of the excessive deficit. Croatia submitted a report on action taken in the context of its convergence programme.
On the basis of the
programme and the Commission 2014 spring forecast, the nominal target set in
the Council recommendation for 2014 is expected to be reached. The
deficit objectives of the Convergence Programme amount to 4.4%, 3.5% and 2.7%
of GDP in 2014-16, in line with the recommended levels. The Commission
services' baseline scenario does not incorporate the full set of measures in
the consolidation package, because of insufficient specification of some of the
measures (such as savings on subsidies or social transfers) and of some
uncertainties about the accounting treatment of some measures (such as in the
case of withdrawal of profits from state-owned enterprises). In the Commission 2014
spring forecast the general government deficit is projected to reach 3.8% of
GDP in 2014 and 3.1% of GDP in 2015. If these projections are adjusted to
exclude the transfer of pension assets (in line with the statistical rules that
will be in effect as of September 2014), they would stand at 4.6% and 3.8% of
GDP in 2014 and 2015, respectively. Hence, with this adjustment the nominal
target set in the context of the EDP is expected to be attained in 2014, while
in 2015 the nominal target would be missed by ¼ pp of GDP. 
The change in
the structural balance in 2014 is slightly below the recommended effort. The
structural balance as recalculated based on the programme deteriorates by 0.2%.
of GDP in 2014; however, this is to a large part due to the programme's
deviation from the ESA methodology. In 2015, the programme's planned structural
improvement of 0.9% of GDP is exactly in line with the EDP recommendation. The
structural balance according to the Commission 2014 spring forecast, on the
other hand, improves by 0.4% in 2014 and by 0.8% in 2015, with a small
shortfall in both years compared to the improvement of 0.5% and 0.9% of GDP
required in the EDP recommendation. 
The budgetary
adjustment envisaged in the programme is underpinned by a large set of
measures.
The overall size of the package, according to the Croatian authorities, is 2.3%
of GDP in 2014 and 1.0% of GDP in 2015, as indicated in the recommendation.
Similarly,
the bottom-up assessment of the fiscal effort based on the Commission 2014
spring forecast is estimated to be delivered, both in 2014 and 2015, with
measures amounting to 2.3% of GDP in 2014, in line with the requirement, and
1.1% of GDP in 2015, slightly above the recommended 1% of GDP. When corrected
for the downward revision in potential growth since the January 2014 Council
Decision as well as for revenue developments compared to the forecast
underlying the Council Decision, the adjusted structural balance would show an
improvement in 2014 of  0.2% and an effort of 0.8% for 2015; this would be 
below the requirement in 2014, but only marginally so in 2015.In
the context of the careful analysis it should be considered that all of these
measures were adopted after and in response to the January 2014
Council decision on the existence of excessive deficit. Strong commitment to
adhere to the Council recommendation is reflected in the fact after it became
evident that the revision of the 2014 budget in March 2014 was not sufficient
to meet the EDP recommendations the authorities have taken additional measures
of 0.4% of GDP. 
To conclude, in
2014 the nominal target is expected to be attained and the deviation from the
structural improvement requirements is minimal. Moreover, the
careful analysis and other qualitative factors point out that the required
fiscal effort in 2014 is currently expected to be delivered. However,
considering that
in 2015, and prior to the presentation of the 2015 budget, the Commission
services expect the headline balance and the structural improvement to be below
the targets recommended by the Council, the 2015 budget needs to include
structural adjustment measures to ensure compliance with the Council
recommendation.
Box
 2. Excessive deficit procedure for
Croatia 
Croatia is currently
subject to the corrective arm of the Pact. The Council opened an Excessive
Deficit Procedure for Croatia because of non-fulfillement of both the deficit
and the debt criteria on 28 January 2014. Croatia was given a deadline of 30
April 2014 to take effective action to ensure a sustainable correction of the
excessive deficit by 2016 while at the same time ensuring that the government
gross debt ratio will approach the 60% of GDP reference value at a satisfactory
pace. To this end, Croatia was invited to reach a headline general government
deficit target of 4.6 % of GDP for 2014, 3.5 % of GDP in 2015 and 2.7 % of GDP
in 2016, which is consistent with an annual improvement in the structural
balance of 0.5 % of GDP in 2014, 0.9 % of GDP in 2015 and 0.7 % of GDP in 2016.
Also, Croatia should specify and rigorously implement the measures that are
necessary to achieve the correction of its excessive deficit by 2016, use any
windfall gains for deficit reduction and report
in detail on the consolidation strategy that it envisages in order to achieve
the targets; thereafter the Croatian authorities should report on progress made
in the implementation of recommendations at least every six months until the
excessive deficit has been fully corrected..
Furthermore, the Council invites
the Croatian authorities to:
(i) carry out a thorough
expenditure review with the objective of rationalising wage, social security
and subsidy outlays and to provide sufficient fiscal space for the
implementation of growth-enhancing expenditure, including co-financing of
projects funded by the Union;
(ii) further improve tax compliance
and increase the efficiency of its tax administration, and
(iii) improve the institutional
framework of public finances, including by enhancing multi-annual budgetary
programming, by strengthening the role and independence of the Fiscal Policy Committee,
and by ensuring compliance with fiscal rules.
In addition, the Council invites
the Croatian authorities to implement structural reforms, in particular as
regards addressing labour market rigidities and an unfavourable business
environment and improving the quality of public administration, with a view to
promoting potential GDP growth.
An
overview of the current state of excessive deficit procedures is available on: http://ec.europa.eu/economy_finance/economic_governance/sgp/deficit/index_en.htm.
Uncertainty
towards the end of the programme period emphasises the importance of a more
decisive and clearer budgetary consolidation strategy.
Although in the short term revenue based measures are unavoidable and
warranted, when they aim to broaden the tax base and redistribute the tax
burden, excessive reliance on the increase in revenues in a will eventually
become counterproductive. Moreover, reliance on tax increases cannot
indefinitely postpone the need to decisively tackle expenditure dynamics.
Against this background and in line with the need for additional consolidation
efforts towards the end of the EDP deadline additional structural expenditure
cuts would have to be considered. A comprehensive expenditure review could
identify the additional sources of savings, reduce inefficiencies, lead to a
more targeted cost reduction and reallocate spending to areas with greater
growth potential.
The projected
stabilisation of general government gross debt at around 71% of GDP is not
substantiated by the programme. Debt is projected to decrease to
71.0% of GDP in 2015 from 71.7% in 2014 and then to increase marginally to
71.2% at the end of the programme period. The discussion of public debt
developments in the convergence programme is very limited. Discrepancy between
projected deficit levels and ensuing debt levels is explained by huge and
largely unexplained negative stock-flow adjustments throughout the programme period.
The only explanation provided in the programme for the stable public debt ratio
is the positive effect of the fiscal consolidation measures which is
"expected to stabilize the debt ratio at the level of 71.2% of GDP by the
end of the programme period."  
 Risks to the
debt-to-GDP ratio are tilted to the upside. These risks arise from the
factors listed in relation to the deficit targets and from possible additional
financial transactions. Possible slippages in the privatisation proceeds,
planned in the convergence programme in the amount of 0.5% of GDP on average in
the period 2014-2017, constitute another negative risk. 
Fiscal
framework
Croatia’s fiscal
framework continues to exhibit weaknesses despite significant reforms
implemented in recent years. In the run-up to EU accession, Croatia adopted the Budget Act in 2009 and the Fiscal Responsibility Law in 2011. The latter
was amended in January 2014 with the aim of transposing Council Directive
2011/85/EU on requirements for budgetary frameworks of the Member States. A
Fiscal Policy Committee, Croatia’s fiscal council, was established in 2011.
Despite these reforms, budgetary planning and consistent application of fiscal
rules remain challenging, with a negative impact on fiscal policymaking. The legislative
timeline for the preparation of the budget is not being respected. 
There have been repeated
discrepancies between macroeconomic and budgetary variables and actual
outcomes.
Official macroeconomic forecasts by the Ministry of Finance tend to be overoptimistic,
impairing budgetary planning. This leads to frequent budgetary revisions[13] and
affects the credibility of the fiscal policies conducted by the authorities. Discrepancies
– sometimes significant- are common between the Guidelines for Economic and
Fiscal Policy, a three-year document that serves as the basis for annual
budgetary planning, and the draft budgets. Recurrent changes to the budgetary
projections that extend beyond the annual horizon undermine the credibility of
the Guidelines as a basis for medium-term budgetary planning. Some
improvements, in line with the Council Directive, have been implemented but
some gaps remain, notably in terms of addressing the observed forecast bias and
publishing alternative fiscal scenarios (e.g. the unchanged policies baseline).
Despite progress
with numerical fiscal rules that was made with recent legislative amendments,
there is scope for further improvement. The structural
balanced budget rule introduced in January 2014 establishes the need for the
structural balance to respect the medium-term objective and follow the
convergence path towards it. However, preliminary assessment of the amended law
raises two concerns. First, the medium-term objective as defined in the law (a structural
balance that ensures that the general budget deficit is not higher than 3% of
GDP and that the debt-to-GDP ratio does not exceed 60 %) does not
necessarily coincide with the one used at EU level. Secondly, escape clauses
can be triggered in cases where the annual growth rate of real GDP is ‘significantly
below’ the potential GDP growth. However, the law does not define what level
may be considered as significantly below, which might lead to excessive use of
escape clauses. This risk will be to some extent mitigated by the required
assessment for the occurrence of such clauses by the fiscal policy body.
The efficiency
of the debt rule that was introduced with the 2009 Budget Act is undermined by
the absence of preventive mechanisms and a track record of weak compliance. The
rule stipulates that the central government debt-to-GDP ratio can exceed the
previous year’s ratio only if the latter did not exceed 60 % of GDP. The
debt ceiling was raised to 62 % with the 2014 budget. The transparency and
credibility of the rule could be improved by extending the scope of its
application to include the general government rather than the central
government and elaborating preventive mechanisms that should apply earlier in
the process to avoid breaching the numerical limit. Furthermore, the credibility
of this fiscal policy anchor is undermined by the lack of information on the monitoring
process and the absence of corrective mechanisms in case of non-compliance.
In early 2014, a
Fiscal Policy Commission was established to replace the previously existing
Fiscal Policy Committee that was chaired by the Minister of Finance. The power
of appointment of the Commission members was transferred from the government to
the Croatian Parliament. The Commission chair is the head of the Finance and
State Budget Committee: the other six members of the body, all of whom have a
five-year mandate and should not be politically affiliated, are experts from
the National Bank of Croatia, the State Audit Office, research institutes and
academia. While these are useful steps, the Fiscal Policy Commission still lacks
a strong legal grounding: it was established only by a Parliamentary Decision. Its
independence from the national budgetary authority is open to question as it is
headed by a Member of Parliament. Furthermore, the mandate of the Commission is
not sufficiently specific in particular regarding the ex ante and ex post
assessment of macroeconomic and budgetary forecasts. The Commission’s work would
also benefit from enshrining in law adequate resourcing and timely access to
data requirements. 
Pensions
There
is still scope to improve the sustainability and adequacy of the pension
system.
The pension system remains fragmented into a high number of special pension
schemes which increases its cost, gives rise to unequal treatment and
facilitates early exit from the labour market. Pensions under special schemes[14]
accounted for 15 % of beneficiaries and 19 % of all pension
expenditures. The inequalities between pensions paid under different pillars gives
rise to non-systemic policy reversals such as the 2014 transfer of funds from
the second pillar to the first pillar for military personnel, police and some
other categories of public servants. In 2013, standard disability pensions
accounted for more than 25 % of overall pension expenditure (one of the
largest shares in the EU), suggesting that eligibility criteria for disability
pensions are too generous. 
Current
plans for increasing the statutory retirement age do not seem sufficiently
ambitious.
Since November 2010, the statutory retirement age, the early retirement age and
the qualifying period for women have all been gradually increasing and are set
to be fully harmonised by 2030. The current statutory retirement age is
65 years for men and 61 years for women. Amendments to the Pension Insurance
Act adopted in December 2013 further raise the statutory retirement age from 65
to 67 and the early retirement age from 60 to 62. This is a step in the right
direction but as the increase will be implemented only as of 2031, the ambition
of the measure is low. The retirement age has not yet been linked to life
expectancy. 
Various
avenues for early retirement remain open, contributing to the low labour market
participation. Despite reforms implemented over recent years,
various possibilities for early retirement still exist and new ones have
recently been introduced. With the 2013 reform, the government introduced two
institutes for early retirement without penalisation – one applying to people
with more than 41 years of service and 60 years of age, and another concerning
people who have been registered as unemployed for a minimum of two years
following insolvency of their employer (subject to meeting minimum requirements
on age and years of service). Considering the extent of exemptions, existing
penalties for early retirement and the late retirement bonus offer little
incentive to work until or even beyond the statutory retirement age. The early
retirement gap of five years remains wide compared with the EU average, decreasing
labour supply and the sustainability of the pension system. 
In
the absence of long-term projections of ageing-related expenditure based on the
common macroeconomic assumptions and validated by the EU’s Economic and
Financial Committee, it is not possible to assess the impact of population
ageing in Croatia on a basis comparable with the other Member States. The
country will be a part of the regular Ageing Report on long-term economic and
budgetary projections from 2015 onwards. However, taking into account the age structure
of the population and the low ratio of workers to pensioners, it can be
expected that the long-term budgetary impact of ageing will be above the EU
average. Improving the structural budgetary position over the medium term would
thus contribute to containing risks to the sustainability of public finances. Croatia also faces serious problems regarding current and future pension adequacy, as the
already low aggregate replacement ratio continues to decrease (0.36 as compared
with 0.54 in the EU-28 in 2012). In combination with short working lives, in
particular for women, this constitutes a severe risk of poverty in old age.
The
Act on the Single Forensic Expertise Body was adopted in 2013 to help limit the
inflow of disability pensioners and reduce fraud by unifying disability
assessments. Obligatory checks of both new and existing claims
have now been introduced with the new Pension Insurance Act, including the
possibility of ad hoc examinations. Stricter controls in 2013 resulted
in a decrease on disability pensioners by 4.6 %. The likely positive
effect of these measures on expenditure will depend on their rigorous enforcement.

Pensions
from special schemes above a certain threshold were cut by 10 % as of
2014, albeit on a temporary basis, while their indexation has been tied to a
GDP trigger.[15] Despite
recent attempts to curb expenditure and increase transparency, the pace of
convergence of special pension schemes towards general rules is still limited. A
separation of standard pension entitlements from pensions paid under special arrangements
is under way. This could help elucidate the actual costs of the special regimes
and improve the targeting of future policy measures, including differentiated
indexation. Once the indexation freeze for special schemes is revoked, their
indexation is set to mimic the generous formula for regular pensions, thus
further slowing their convergence. 
Limited
progress has been made on ensuring the adequacy of pensions. The
amended Pension Insurance Act introduces a more favourable indexation formula
for old-age pensions and adjusts the basic pension formula. On the other hand,
the previously announced increase in contribution rates to the second pillar has
been postponed. The proposal for social pensions for those not receiving
another form of pension or basic social assistance seems
to have been abandoned. The national reform programme informs about plans to
extend the current pension supplement paid to pensioners who do not participate
in the second pillar. While this measure would help increase adequacy of
pensions, it would also impose significant costs on the state budget and needs
therefore to be carefully considered in the context of the sustainability of
public finances. Overall, by simultaneously implementing the adopted measures
and seeking to prolong working lives, the high and increasing risk of old-age
poverty is being addressed
to some extent.
Health
care
The
health sector achieves reasonably good health outcomes and, with some regional
variation, services are accessible, but the system contributes significantly to
pressure on the public finances. While public expenditure on
health (6.6 % of GDP in 2011) is below the EU average (7.8 %), it is
higher than in most central and eastern European Member States, continuously
generates arrears, and accounts for a large proportion of public expenditure[16]. The
absence of comparable long-term projections hinders a precise assessment of the
impact of population ageing on healthcare expenditure. However, the current
(public) expenditure on healthcare, the age structure of the population and
non-demographic drivers point to a substantial long-term budgetary impact of
increasing healthcare expenditure. Funding of health expenditure relies largely
on health insurance contributions. Private co-payments on health expenditure
are in place. Co-payments cover a small proportion of health expenditure and
their primary purpose is to address the moral hazard and tendency towards
over-consumption that arise within insurance-based systems. However, Croatia's supplemental insurance system fully covers these co-payments, effectively
exempting large numbers of patients from co-payments and cancelling-out the
system's intended behavioural incentives. Furthermore, over a third of those
benefitting from supplemental insurance receive it for free, with the financing
coming straight from the state budget. This system brings additional
administrative costs and complexities and introduces an adverse selection
problem, attracting the patients with the highest healthcare costs, which could
jeopardise the system's ability to break even over time. The existing coverage
of co-payments by supplemental insurance is incompatible with achieving the
co-payments system's objectives. The underlying co-payments system, which has
financial effects on only a minority of patients, may also discourage use of
and limit access to preventive and chronic care so there is room for better
targeting of the instrument.     
The
national reform programme identifies remediable inefficiencies in the hospital
network.
There is scope to achieve savings through reorganisation of the services
provided by hospitals, better allocation of hospital beds, reducing the high
share of administrative staff and catching up with trends on the provision of
ambulatory care, while nevertheless ensuring broad access to high quality care.
The Croatian Health Insurance system seems to have inadequate capacity and
responsibilities to ensure efficient use of funds. In 2013, the government
cleared the accumulated arrears of hospitals and the Croatian Health Insurance
Fund. The arrears had stood at close to 1 % of GDP but they may re-emerge
in 2014 given the underlying trends and the track record of budgetary
projections and budgetary control throughout the health system. As regards
long-term care, services are dispersed between the health and the social
welfare systems, with low coverage rates of formal care associated with a high
degree of family care which is mainly provided by female relatives, [17] which
alongside childcare responsibilities, may constrain female labour supply. In
many cases, formal care is provided at high cost and the pressure on
institutional forms of care is constant with long waiting lists, even in cases
when social services would satisfy user needs better than medical services,
while community based services or formal home care services are in scarce
supply.[18] 
In line with the 2012 National
Healthcare Strategy and earlier policy initiatives, the government has taken a
number of useful steps to improve the efficiency of the system. As
recalled in the national reform programme, notable reform measures in recent
years include the partial centralisation of procurement for hospitals, the
reduction of approved prices for pharmaceuticals and medical devices,
principally through the introduction of generics, reorganisation of emergency
medical services, the introduction of e-health in primary healthcare, a new
model of referrals to specialist examinations and hospital treatment and the
final roll-out of diagnosis-related groups in hospital care. There is, however,
a lack of systematic evaluation of the impacts of these reforms. In March 2014,
the Ministry of Health presented a master plan for the reorganisation of
hospital care, which seeks to address many of the limitations identified above.
In particular, it outlines plans for a changeover of some hospitals into
rehabilitation centres, reduction of the average length of hospital stays, and
further changes in hospital financing. The plan could help improve the
cost-effectiveness of the healthcare sector and contribute to containing risks
to the sustainability of public finances in the medium term. As presented, the
plan is ambitious and complex and would therefore require strict monitoring and
implementation capacity in both hospitals and central government.
Tax
system
To pursue fiscal
consolidation, Croatia faces the challenges of increasing revenues without
impairing growth prospects, by broadening tax bases, shifting the tax burden
towards immobile assets such as real estate and further improving tax
compliance. The overall tax burden in Croatia is lower than the EU
average[19]
and some scope for improving tax efficiency and broadening the tax base does exist.
The tax structure is heavily skewed towards consumption, whereas receipts from
labour and, in particular capital, are well below the EU average.[20] The
relatively low proportion of taxes on labour is not fully consistent with the
statutory tax rates applicable in the Croatian economy. While tax exemptions
and reliefs may partly explain the relatively low revenue from taxes, under-reporting
of earnings and profits and undeclared work are also likely to play a role.
There is also scope for efficiency gains in corporate income taxation, in
particular for streamlining tax expenditures. 
The previous shift
of taxation away from labour was reversed in 2014. In April, the
authorities revoked the reduction by two percentage points of the contribution
rate for health insurance, which had been introduced in 2012 with the aim of
alleviating the tax burden on employers. In addition, from 2014 indirect taxes
were further increased: the reduced VAT rate was hiked by three percentage
points to 13 %, excises on energy products and tobacco were raised and the
base on the tax on lotteries was broadened. A tax break on reinvested earnings
introduced in 2013, although decreasing the effective tax rate, has contributed
to some loss in budget revenues by narrowing the tax base. According to the
national reform programme, the tax break will be modified in the course of 2014
with the objective to better contribute to encouraging investment activity,
while reducing its negative revenue impact. 
Recourse to less
distortionary taxes, such as a recurrent property tax, is not sufficiently
exploited and the base of the personal income tax can be broadened to tax additional
sources of capital income.[21] Receipts
from property taxes, which offer a stable tax yield and are considered to have
little distortionary impact on growth, currently amount to only 0.3 % of
GDP in Croatia - the lowest ratio in the EU.[22]
As announced in the national reform programme, Croatia plans to introduce an ad
valorem property tax from 2016 but its operational design, including that of
the tax base, is yet to be specified. Furthermore, the authorities plan to broaden
the tax base of the personal income tax to cover interest on savings. If
implemented, and accompanied by a comparable decrease of taxation of labour, these
measures would represent positive steps towards shifting the burden towards
taxes that are less harmful to job creation and growth.
The authorities
have taken important measures to fight tax fraud and evasion and to improve tax
collection but are still facing substantial challenges in this area. Uncollected
taxes represent a significant amount.[23]
There appears to be scope to improve the efficiency of VAT revenue collection by
improving compliance and reducing VAT fraud. In 2013, in order to reduce the
amount of untaxed transactions and to improve tax collection, Croatia introduced electronic fiscal cash registers and directed that wages could be paid
to employees only after social contributions had been paid to the government. Since
mid-2013, reporting obligations for individuals and income of non-profit
organisations have been strengthened while at the same time reporting was
simplified with the introduction of a single e-form, which has also broadened
the information access powers of tax officials. The tax administration is
undergoing restructuring aimed at improving its efficiency. It was authorised
to publish lists of employers not complying with their tax obligations and the
names of taxpayers whose assets cannot be justified by their declared income. Croatia has joined the OECD/Council of Europe Multilateral Convention on Mutual
Administrative Assistance in Tax Matters. These are all highly relevant
measures to fight tax evasion and fraud and improve tax collection; however,
they may not be sufficient to fully address the challenge. Croatian customs are
currently also being reorganised. It is too early however to evaluate the
effect of the reorganisation and to assess whether it has an impact on the time
to import and export.[24]

Public
subsidies and guarantees
Public support to
companies has been an integral part of Croatia’s development strategy. In
the period between 2009 and 2013, public subsidies decreased from 2.5 % of
GDP to 2.1 % but remained relatively high compared to both the EU-28 (1.2 %
of GDP in 2009-13) and the average of the 12 newest Member States (0.9 %
of GDP in the same period). In recent years, subsidies to public corporations
(mainly to Croatian Railways, Croatia Airlines and public service broadcasting)
were higher than subsidies paid to private enterprises (mainly to agriculture).
According to the convergence programme, public guarantees reached 16.4 %
of GDP in 2013. Compared to 2012, the level of guarantees is reported to have
decreased by 0.2 pp.[25]
The highest share of guarantees was granted to companies involved in the construction
and operation of roads and highways. The programme envisages that revenues
generated from the concession contract on highways, to be finalised in 2014,
will be used to repay part of the guaranteed loans. However, new guarantees are
planned to be issued in the context of the restructuring of Croatian Airlines
and HZ Cargo. While some level of well-designed, targeted and monitored financial
support can contribute to achieving Croatia’s sustainable development goals, it
may also prevent the necessary restructuring towards activities with higher
productivity growth. 
There is scope
to rationalise and improve control over public subsidies and guarantees. The high
amount of subsidies to the private sector is combined with a degree of
decentralisation in their distribution. Many different instruments and
institutions are involved, including, at national level, several line
ministries and funding agencies, the Croatian Bank for Reconstruction and
Development and the Croatian Agency for SMEs and Investment, each of which applies
its own criteria and procedures. This indicates that there is substantial room
for efficiency gains. Moreover, a central public register of supported
companies and individuals, including those receiving financial support from the
regional and local level of government, does not exist at present and creation
is not announced in the national reform programme.

3.2.                
Financial sector

Croatia is a
small economy, subject to volatile capital flows and exhibiting a high degree
of euroisation. In contrast to some neighbouring countries, Croatia’s banking sector is characterised by a very high degree of foreign ownership,
minimum presence of the state and overall high capital levels.
Croatia
operates a tightly managed float, and the kuna has remained broadly stable
against the euro over the past few years, despite a challenging external and
domestic environment. Together with relatively low inflation,
this has allowed the National Bank of Croatia to maintain an accommodative
monetary policy stance. Tight macro-prudential policies in the past have ensured
the build-up of high reserves and liquidity buffers in the financial system,
some of which were gradually released in the course of the crisis. The
authorities also implemented credit support schemes involving the Croatian
Development Bank to stimulate lending, but the protracted recession has reduced
demand for bank loans and domestic credit has contracted since mid-2012. With
the exchange rate as a monetary policy anchor, and given the high level of euro-denominated
debt, the central bank’s room for manoeuvre remains limited. An improvement in
macroeconomic fundamentals, in particular export competitiveness, would help to
underpin exchange rate stability in the medium term and increase leeway for
monetary policy to support economic recovery.
During
the years before the global financial crisis, the authorities relied on
macro-prudential measures to contain credit growth and limit balance sheet
risks for banks. These policies helped to build the
necessary resilience in the banking sector by ensuring adequate capital and
liquidity buffers. While lending from domestically-supervised banks was
constrained, indebtedness still grew very rapidly. This was partly due to
external borrowing (directly from foreign parent banks) and partly due to
borrowing from non-banks (e.g. leasing companies). Since the crisis, the
corporate sector’s financial position has deteriorated significantly due to the
protracted weakness in the economy, and banks’ non-performing loans to corporates
have risen sharply. Overall non-performing loans reached 15.6 % at the end
of 2013, up from 5 % in 2008. Corporate non-performing loans stood at 28 %
in the same period, up from 23 % in the previous year, with construction,
real estate and trade being the sectors most affected. Household indebtedness
also increased to high levels, but non-performing loans are much lower in this
sector, notwithstanding some risks related to past high borrowing in Swiss
francs.
In
comparison with other countries that experienced a similar contraction in GDP
in recent years, non-performing loans in Croatia are high.
While provision coverage ratios have been increasing recently, they remain low
compared to other Member States and to the pre-crisis period. However, Croatian
banks have high capital buffers, well above the levels of most EU countries,
which could easily accommodate further provisioning needs. Nonetheless, high levels
of non-performing loans represent a challenge for the banking sector, which
could become more acute in the event of a further worsening of the economy. While
it is welcome that the four largest Croatian subsidiaries are participating in
the European Central Bank’s Comprehensive Assessment exercise via their parent
banks, there is scope for the Croatian National Bank to complement this by
undertaking additional supervisory diagnostic actions that could provide more
information on Croatian banks’ balance sheets (e.g. the adequacy of banks’
asset classification and collateral valuation and related provisions, the
treatment of forbearance, etc.), and possibly including other institutions that
will not participate in the Comprehensive Assessment, in particular mid-size
and smaller banks which may have lower capital levels and worse asset quality
than the average. This would assure compliance with the recommendations of the
European Banking Authority. Moreover, ensuring that there is a high degree of
comparability between the supervisory diagnostic actions for Croatia and the Comprehensive Assessment exercise of the European Central Bank would guarantee
consistency across exercises and enhance their credibility and transparency.
Faced
with reduced private demand for credit, banks have compensated by increasing
lending to state-owned enterprises. Going forward,
these trends should be closely monitored, both in view of doubts about the
viability and indebtedness of some state-owned enterprises, and to avoid any
future potential bias in lending to the detriment of newer, private companies.
In
2013, the Croatian government introduced a number of measures to regulate
interest rates, which are impacting banks’ ability to lend and reducing their
profitability. There are three different types of interest rate arrangements
that banks are obliged to apply. First, on housing loans denominated in Swiss francs,
a maximum interest rate of 3.23 % was set, which is lower than the rate on
domestic currency loans. Second, a ceiling on the maximum interest rate that
can be charged to clients in arrears (11 % for retail and 15 % for
corporates) was introduced, which may constrain loans granted to some client
categories. Third, banks are required to base interest rates offered to clients
on an official interest rate as a reference plus a margin, with the aim to
increase transparency for customers. Overall, these measures limiting banks’
ability to set interest rates could have adverse effects on competition and
could hinder some borrowers from accessing loans, thus further constraining
credit supply to the economy.
The conditions
for access to finance for small and medium-sized enterprises in Croatia have deteriorated due to increased risk aversion in the financial system. Only
a quarter of the small and medium-sized enterprises meet the necessary conditions
for loans, and they face shortened loan periods. Regional disparity with regard
to access to finance is also visible, especially in peripheral regions. Financing
constraints, including for small and medium-sized enterprises, also come from
the very limited availability of alternative funding sources such as private
equity and venture capital. Furthermore, existing state venture capital funds, as
well as the Funds for Economic Cooperation, appear to be geared towards the restructuring
of large businesses rather than towards supporting start-ups. The role of
venture capital financing is likely to gradually increase in the future, as several
state institutions consider setting up venture capital funds for start-up and
export-oriented companies.

3.3.                
Labour market[26], education and social policies

Employment and activity rates are among the
lowest in the EU, and are particularly low for young people and older people.
Beyond cyclical developments, these dismal labour market outcomes are partly
related to aspects of underlying institutional and policy settings. While
employment protection legislation is being revised, a number of potentially
problematic labour market regulatory issues remain. The employment challenge is
particularly acute, notably in terms of improving the labour market attachment
of people with weaker employment potential. Persistent weaknesses in labour
market matching particularly stemming from the outdated vocational education
and training system and uninformed higher education choices, present obstacles to
successful school-to-work transitions and may contribute to the low employment
rates of younger age cohorts. Croatia’s youth unemployment rate has increased
markedly and reached 50 % in the course of 2013, becoming one of the highest in
the EU. The proportion of young people not in education, employment or training
also increased and is above the EU average. Inadequate alignment of policies
and the complex system of social benefits stand in the way of better activation
and, in some cases, they create disincentives to work. The high and
increasing incidence of poverty highlights the limitations in terms of  effectiveness
and adequacy of the social protection system. Generous pension
eligibility criteria, various early retirement schemes, and low participation
in lifelong learning combine to restrict participation of older workers. Compared
with the rest of the EU, active labour market policy measures still have
limited budgets and coverage.
Labour
market
Croatia is facing
worsening labour market conditions due to the protracted crisis with continued
lack of job creation and severely underutilised labour market potential. The
employment rate has been decreasing annually since 2008 from an already low
level (62.9 % in 2008 to 53.9 % in 2013) and was one of the lowest in the EU in
2013. The activity rate is also significantly below the EU average and reached
a record low in 2012. In common with southern European labour markets, there is
particular under-representation of young people, the elderly and women and these
groups account for a major proportion of long-term unemployment, which itself
stands at more than double the EU-28 average. The average labour market exit
age was 60.6 years in 2009 (61.5 in the EU-27). As a result the duration of
working lives is also substantially below the EU average (31.1 years vs. 35
years in the EU-27 in 2012). The labour market situation of young people is
of particular concern. Youth unemployment has increased to 49.7 % in 2013 and
is now among the highest in the EU. The proportion of young people not in
employment, education or training is also increasing; it reached 18.6 % in
2013. The crisis has impacted employment levels much more severely than wages.[27] The national
reform programme recognises the cyclical employment challenge facing Croatia, particularly for younger people, but does not clearly diagnose or recognise
important underlying structural challenges that were identified in the in-depth
review, including as regards labour costs and competitiveness. Accordingly, the
national reform programme outlines a number of useful policies to improve
labour market performance and help key groups, as assessed in this section, but
it stops short of presenting a full strategy addressing the root causes of low
employment and labour force participation across most age groups.
Box 3: The delivery of a Youth Guarantee
in Croatia[28]

Important challenges that need to be addressed to
deliver on the Youth Guarantee[29]
in Croatia:
- Lack of data and analysis about young people not
in employment, education or training, which calls for measures to identify the
most vulnerable groups and their particular needs;
- Insufficient outreach activities to non-registered
young people not in employment, education or training and increased pressure on
the capacities of the Public Employment Service;
- Insufficient labour-market relevance and quality
of vocational education and training and higher education;. 
- Lack of effective systems for labour market monitoring
and evaluation and skills forecasting; 
- Heavy reliance on subsidized offers instead of a
better mobilization of the private sector.
Until
recently the Croatian labour market was considered relatively rigid in
international comparison. As well as having possible effects on
overall employment levels, labour legislation can also affect segmentation,
which is materialising in increased use of fixed-term contracts, especially for
the young. One of the aims of the first phase of amendments to the Labour Act
in June 2013 was to facilitate the use of fixed-term employment contracts and
to provide employers with the possibility to employ workers on an extended
fixed-term basis, when necessary and justified. Implementation of this first
phase would require close monitoring to assess the extent to which it promotes
employment while guarding against unjustified use of fixed-term contracts and
further labour market segmentation. In January 2014, the government launched the
second phase of the labour market reform, proposing to amend dismissal
procedures and working time arrangements, and re-opened discussions with social
partners on the draft law. The national reform
programme remains rather vague as to the content of this second phase. As and
when the envisaged changes to the Labour Act are in force, the authorities
expect an improvement in Croatia’s Employment Protection Index. If these
expectations are realised, the reforms would bring the country largely on a par
with its peers. However, Croatia’s adjustment challenge may be greater than
those of its peers, as indicated by the weak labour market outcomes described
above, even after accounting for the continued economic downturn. Overall,
measures taken so far show an appropriate direction of reform but effective
implementation will be crucial. 
Average
labour costs remain high compared with Member States with similar levels of
economic development, despite some moderation in recent years. Average
compensation of employees in Croatia is nearly 50 % higher compared with
countries with comparable GDP per capita. Even after correcting for the low
proportion of employed population, compensation per employee is still above the
levels recorded in Member States with similar labour productivity. Given the
poor labour market conditions, unit labour costs in Croatia have grown at a
slower pace than those in most other central and eastern European countries
since 2008, correcting part of the accumulated imbalances. The applicability of
rules derived from overlapping collective agreements and the frequency under
which they can be re-negotiated are two aspects of the wage-setting system that
may currently facilitate wage developments out of line with productivity growth.
In the government sector and state-owned enterprises, employment conditions and
wage negotiations, including the timing of negotiations in relation to budget
approvals, can also have relevant impacts due to their potential signalling
role for the private sector.  
The
incidence of undeclared paid activity is relatively high and the prevalence of
cash (‘envelope’) wages is above the EU average. Lack of regular
jobs on the labour market is the most common reason given for undertaking
undeclared work.[30]
In 2012, simplified rules for employment and payment of contributions for
seasonal workers (voucher system) were introduced which, according to national
data, has led to an increase in the number of registered workers. The 2013 Law
on Nannies aims to regularise the employment of women providing childcare in
the home. Positive effects are expected but it is too early to assess the full
impact of the law. Overall, Croatia has a fragmented approach to addressing the
issue as no lead department has been assigned, and coordination between
government bodies and levels is lacking, as too are adequately inter-connected
databases. Remedial measures are less common and soft action to foster tax
morale is relatively new[31]
while trust in state institutions remains low.[32]

Inadequate
alignment of policies and lack of transparency have tended to inhibit
activation and, in some cases, have created disincentives to work. The
issue is most evident with low-income families, families with inactive members
and families with many children, but it also affects a wider range of persons. The
challenge was recognised in the 2013 Social Welfare Act, which merged four of
the more than 70 existing benefits at national level into the new guaranteed
minimum benefit, subject to: stricter means testing (including also for assets);
a limitation of duration to two years; restricted possibilities to reapply and
to refuse job offers; gradually decreased benefits in case of employment for
persons who have been drawing them for more than 12 months; adapted equivalence
scales favouring single and single-parent households; and a maximum amount per
household at approximately the level of the minimum gross wage. Despite the
lack of an integrated response, cooperation between the public employment
service and social welfare centres is now slowly improving, also due to higher
normative standards on cooperation and data exchange under the new Social
Welfare Act. However, it is still possible to accumulate overlapping income
support entitlements, which may affect incentives to work, although individual
benefits are not high.[33]
At the same time, some benefits are abruptly reduced upon entering paid
employment depending on the type of benefits received, suggesting scope to fine
tune the combined effect of the tax and benefits systems to reduce inactivity
traps. In short, progress has been made in aligning policies but lack of
transparency remains.
Despite
recent improvement, active labour market policy measures are still little used
in Croatia. In 2012 the Law on Employment Incentives was
adopted addressing the young and long-term unemployed and active labour market
policy measures were revised. In July 2013, new measures targeting the most
vulnerable groups, such as the young and long-term unemployed, were introduced.
Active labour market policies have until now been over-concentrated in public
works. Both the financial allocations for active labour market policies and
their coverage have increased, according to national data, but they remain well
below the EU average. Lifelong career guidance centres were established as part
of the public employment service along with Youth Centres to support the young.
Low coverage of older workers in active labour market policy measures is an
issue. The extent of the employment challenge
in Croatia and new work procedures place the administrative capacity of the
public employment service under severe pressure and regional variations are
substantial.[34] However,
the national reform programme reports that targeted training for public
employment service staff and new on-line tools for the unemployed are planned.
Across all initiatives, regular evaluations and effective labour market
monitoring systems are missing, so programme effectiveness is not well
understood. The national reform programme also reports on an Act on State Aid
for the Preservation of Jobs, under preparation, which would serve to regulate
employer-facing support for job preservation schemes such as short-time working
and schemes for education and re-training. Such schemes are already in
existence but have low take-up and the national reform programme does not
clearly explain how the new regulation will boost their effectiveness and
reduce inflows into unemployment by the expected amount.   
Challenges
remain regarding longer working lives, despite recent changes. The
new Pension Insurance Act introduced a possibility for old-age pensioners to
work part-time (but not in self-employment) while still receiving a full
pension. The national reform programme reports that plans to extend the
possibility to combine pension with income from work are under way but details
of this measure have not been disclosed. The system of assessing capacity to
work has also been improved and a new Law on Vocational Rehabilitation was
adopted in 2013 in order to prolong working lives. However, an integrated
active ageing strategy to encourage and enable older workers (notably women) to
stay in employment longer is yet to be pursued. The challenges facing measures
to prolong working lives and to raise the effective retirement age remains
substantial given the slow phasing-in of the new statutory retirement age and
the persistence of numerous early retirement options. 
Measures
are being taken to improve work-life balance and gender equality in the labour
market but there is still a long way to go. Only 51 % of
children between the age of three and the mandatory school age are in formal
childcare, one of the lowest rates in the EU, and regional differences in
provision are large. This may result from widespread lack of access and the
related high use of informal care (itself facilitated by low labour force
participation). The Early Childhood Care and Education Act was amended in 2013
to introduce compulsory pre-school education starting from August 2014.
Parental leave rights for both mothers and fathers, self-employed and foster
parents were aligned and the Law on Nannies was adopted, all in order to boost
female employment. It is still too early to assess the impact of these
measures. However, it is clear that the current set-up of early childhood education
and care still does not ensure universal access to all families needing such
services and does not support employment of parents. 
Social
policy
The increasing incidence of poverty reflects adverse
economic and labour market trends and highlights the limits to the
effectiveness and the adequacy of the social protection system. The proportion of persons at risk of
poverty and social exclusion is significantly higher than in the EU as a whole
(32.3 % in Croatia, as compared with 24.8 % in the EU in 2012) and has
increased from 30.7 % in 2010. In addition, overall government spending on
social protection was well below the EU average (20.6 % of GDP in Croatia, as compared with 29.1 % in the EU in 2012) and skewed towards disability and
healthcare and away from social assistance and family benefits. A large
proportion of spending is devoted to ‘categorical benefits’ that are neither
means nor income tested, predominantly in the form of cash payments linked to
disability or special status. In addition, the allocation of income support
schemes and benefits is scattered across many different institutions and levels
of government where unified criteria are lacking and overlaps occur[35].
Overall benefit entitlements have not kept up with inflation.
A series of reforms seeks to improve the
effectiveness and adequacy of social protection but progress is uneven. According
to the national reform programme, the poverty reduction target has been
increased to 150 000 people in the draft Strategy for Fighting Poverty and
Social Exclusion (2014-20); the strategy’s effectiveness is conditional on
clearly defining responsibilities, timelines, quantitative indicators and
sub-targets as well as on implementing ambitious targeted measures. Whereas the
above-mentioned 2013 Social Welfare Act has been
implemented, including the introduction of the Guaranteed Minimum Benefit, the
scheduled adoption of the Disability Inclusion Allowance Act, which aimed at
consolidating various rights, has been postponed. Crucially, despite several
reforms since 2011,[36] the proportion of non-means tested
cash benefits for specific population groups remains high, diverting spending
from people most in need. A single electronic
database now covers all social welfare centres but full administrative roll-out
and connections to other entities administering benefits are pending. A
national ‘one-stop shop’ for national-level cash benefits[37]
is gradually being implemented up to 2016, according to the national reform
programme, but does not cover substantial local, regional and categorical
benefits. This very complex and opaque system
makes policy development, systematic monitoring and evaluations difficult.
Consequently, although targeting and, to a certain extent, transparency are
continuously being improved, overall progress has been limited. 
Education
The
main challenges in education are labour market relevance and quality of
provision across all educational sectors. Achievements of
15-year-olds, as measured by the Programme for International Student Assessment
(PISA), remain below the EU average, particularly in mathematics[38].
There is no national system of systematic evaluation and quality assurance of
educational establishments to promote improvements in outcomes. More than 95 % of 20-24 year olds complete a form of upper
secondary education, and the majority of vocational education and training
students continue onto higher education. However, according to the Agency for
Vocational Education and Training and Adult Education, fewer than half
of vocational education and training graduates on the labour market end up
employed in a job that matches their field of study.
More than 70 % of first year students surveyed in 2011 planned to eventually
enrol in a graduate course. This level of attainment and ambition masks the
fact young people may be lacking skills or motivation to enter the labour
market at an earlier stage. Employer engagement, work-based learning and career
guidance across secondary and tertiary education are lacking. At tertiary
level, some 60 % of students study social sciences and humanities,
whereas the numbers graduating in technical and medical sciences continue to
fall. Employment rates of recent graduates are
significantly lower than in the EU-28 and statistics show that between 29 % and
54 % of young people worked in a job outside their field of study.[39]
Although tertiary education enrolment has risen, attainment has levelled off
since 2010 and drop-out rates are extremely high. Croatia’s population has
lower digital skills than the EU average.[40]

Croatia
is reforming several sectors of the education system to improve educational
outcomes and align them with labour market needs, but implementation is
delayed. The
outdated vocational education and training system is undergoing reform in the
form of new school curricula based on sector skills analyses and comprehensive
occupational and qualification standards. Pilot curricula tested on a sample of
54 schools in 2013-14 will be evaluated and expanded to all vocational
education and training schools. The ordinance implementing the Croatian
Qualifications Framework is still pending. The national reform programme
envisages that a large survey of employers’ needs would take place in 2014,
followed by the work of sector councils on occupational standards, which in the
long run feed into updated school curricula. However, the Croatian
Qualifications Framework under preparation may not be fully consistent with the
draft Strategy for Education, Science and Technology,
to be adopted in 2014, which aims to build national consensus
around the quality culture in education and
envisages
an enhanced system of self-assessment of schools and external evaluation of
educational outcomes. In addition, the tracking
of labour market outcomes of trade and craft graduates and higher education
graduates has recently been launched to improve the evidence base. However,
skills forecasting systems are missing. 
Adult participation in education and training is one of the lowest
in the EU. Only 2.6 % of Croatian adults participate in education and
training, compared to the EU average of 10.7 %. Incentives for employers
in the form of tax deductions of up to 50 % of adult education and
training costs (70 % in the case of small and medium-sized enterprises)
are in place, but their uptake by companies is low, in part because of a lack
of awareness and in part because of the complexity of the administrative
procedures involved.[41] Lifelong learning is one of the
pillars of the new Strategy for Education.

3.4.                
Structural measures
promoting sustainable growth and competitiveness 

Croatia has
been mired in a recession since 2009. Weak export
competitiveness, which reflects a combination of cost and non-cost factors, has
exacerbated the deep and prolonged economic downturn triggered by the global
financial crisis. Export performance was also negatively affected by delayed
restructuring of major economic sectors such as shipbuilding and transport. Structural
weaknesses, including a poor business environment and a malfunctioning labour
market, have added to the competitiveness challenges. Slow progress with
restructuring of state-owned enterprises, which still play a dominant role, also
had a negative impact on economic performance. In this context, in which
moreover private sector balance sheet repair continues, albeit at a slow pace,
productive investments, including foreign investments, have been curtailed. The
ensuing lower potential growth increases the required fiscal consolidation
effort, severely restricting the margins available to support growth through
fiscal policy. Hence, improvement of the business environment, coupled with further
strengthening of the labour market adjustment capacity, is essential to
encourage a new investment cycle, in particular in export-oriented sectors. Further
development of energy and transport infrastructure and concerted efforts to
unleash Croatia’s innovative capacity will be also of major importance to lead
the country out of recession and support sustainable and job-rich economic
growth.
Box
 4. Conclusions of the March 2014 in-depth
review on Croatia 
The first in-depth
review on Croatia under the Macroeconomic Imbalances Procedure was published on
5 March 2014.[42]
On the basis of this review, the Commission concluded that Croatia is experiencing excessive macroeconomic imbalances which require specific
monitoring and strong policy action. The main observations were:
·        
External
rebalancing is beset by important risks pending the reduction of Croatia’s high foreign liabilities. Domestic economic weakness reduces the
affordability of foreign liabilities and limits the appeal of Croatia to lenders and existing investors in inward-oriented industries, thereby increasing Croatia’s vulnerability to capital flow reversals. 
·        
Croatia’s
low competitiveness had been eroding export market shares, particularly for
goods exports, even before the crisis. Despite
moderate cost dynamics since 2009, cost levels remain relatively high and this
combines with a wide range of non-cost competitiveness deficiencies to
disadvantage export performance. 
·        
Weaknesses
in the labour market and in the wider business environment have amplified the
impact of the crisis and prevent adjustment towards stronger, more sustainable
growth and employment. Beyond cyclical developments, which
have caused a jump in unemployment (overall, youth and long-term), dismal
labour market outcomes are also partly related to aspects of underlying
institutional and policy settings. There are numerous, severe obstacles in the
business environment.
·        
The
non-financial private sector, and in particular non-financial corporations,
entered the crisis highly leveraged as a result of rapid credit growth in the
preceding years. The reduction in corporate sector indebtedness is
proceeding at a rather slow pace. Many state-owned enterprises, in particular,
appear to have comparatively high debt levels. Household balance sheets,
although also under pressure, are somewhat less vulnerable.  
·        
The
largely foreign-owned banking system has shown resilience.
Previous macro-prudential measures led to significant capital and
liquidity buffers that proved useful during the crisis. Still, the weak economy
has started to interact with the banking sector, and non-performing loans to
corporate borrowers have risen to high levels. Banks have compensated
for reduced private sector demand for credit by increasing lending to public
entities.
·        
Loose
fiscal policies in the downturn have exerted sustained pressure on the general
government deficit and caused the debt to rise sharply in comparison with peers.  
The in-depth review
also discusses possible policy avenues to address the challenges identified.
·        
Carefully
reconsidering, and where necessary, adjusting a number of institutions and
policies affecting labour market functioning would be instrumental to
addressing the low activity and employment rates and facilitate the labour
market adjustment.
·        
Building
on reforms recently undertaken, there could be further scope to reduce
inactivity traps, to make employment protection less onerous for businesses and
to enhance the effectiveness and reach of active labour market policies.
·        
Improving
the business environment would help to attract foreign capital and innovations
into productive sectors, which in turn would increase export competitiveness.
·        
There
is scope to consider complementing the ongoing European Central Bank's
comprehensive assessment exercise with additional supervisory diagnostic steps.
·        
Implementing
high-quality, structural fiscal consolidation measures to reverse the rapidly
deteriorating public debt trajectory.
·        
Ensuring
the conditions for a smooth continuation of the deleveraging process, including
through the proper functioning of insolvency and debt-restructuring regimes, in
order to address the over-indebtedness of the private sector.
Business
environment 
Croatian
companies operate in an environment that is not conducive to improving
productivity and attracting foreign investors. High administrative
burdens and lengthy proceedings, numerous para-fiscal charges, prolonged
litigation and bankruptcy procedures, weak protection of investments and high
policy uncertainty combine to create a substantial drag on businesses. All
these shortcomings are reflected in Croatia’s poor ranking in various
international surveys in terms of business climate and competitiveness.
Specifically, Croatia is among the worst EU performers in the Doing Business
survey of the World Bank, the Global Competitiveness Index of the World
Economic Forum and the Index of Economic Freedom of the Heritage Foundation.
A
consistent methodology for measuring the overall administrative burden is not
being used. The authorities are actively involved in the World
Bank Doing Business exercise and have set up a high-level working group to map
Croatian legislation to the Doing Business’ indicators in order to identify and
remove some of the obstacles. While this approach may result in improving
Croatia's ranking in this particular survey, it covers only part of the multiple
challenges businesses face in complying with central- or local-level regulations,
administering and paying various charges and fees, and handling administrative
proceedings, in particular at local level.[43]
Developing an own methodology based on international best practices would allow
the authorities to better reflect the specificities of the Croatian business
environment and would facilitate the setting of measurable targets and
monitoring of their achievement. A review of para-fiscal charges conducted in
2013 detected 572 administrative charges and, according to the information
provided in the national reform programme, 41 of them have been removed or
reduced (such as those paid for forest maintenance and the Croatian Chamber of
Economy). In 2014-15, the authorities plan to remove or reduce further 12
charges (the programme is not specific about which charges will be removed). This
is a step in the right direction which, however, does not significantly
decrease the excessive administrative burden on businesses. 
Policy
uncertainty and weak policy coordination are significant deterrents for
investments and business activity. The high number of legislative
as well as non-legislative regulatory changes (averaging to more than two legal
acts per day), in some cases adopted through a series of marginal amendments
and without adequate consultation with business stakeholders, impinge on the
predictability of the policy framework, increase compliance costs and reduce
the effectiveness of the regulatory impact assessment. Additional uncertainty
stems from an uneven interpretation and enforcement of the
legislation across local administrative units and from legislative vacuums
created by a delayed issuance of bylaws implementing already effective
legislation. In an effort to improve the quality of legislation, the regulatory
impact assessment was introduced in 2012. However, available administrative
capacity is insufficient to carry out the assessment fully in accordance with
the prescribed procedure, mainly because the current set-up does not allow
applying it proportionately to the likely impact of the new legislation.
Similarly, the ‘SME Test’ and a regular dialogue with stakeholders are not
systematically used and their funding is currently dependent on support from EU
funds.[44]
 
Measures
to improve the business environment have been introduced, but more concerted
and systematic efforts are needed to improve the competitive edge of the
economy.
In 2012, company registration procedures and costs were significantly
streamlined through the introduction of a ‘simple limited liability company’
and online procedures for setting up other types of activity. Moreover, some
licensing procedures were shortened by the introduction of a ‘silence is
consent’ clause after 30 days. In 2013, the issuance of construction permits
and registration with the Land Register were also simplified. These all are
relevant steps to improve specific aspects of the business environment in Croatia. In parallel to these changes, the authorities adopted the Law on Strategic
Investments, which allows selected large-scale private investors to bypass
standard administrative procedures and expedite their projects. While this
measure may help kick-start selected investments, much needed in the current
macroeconomic context, it also illustrates that the authorities are aware of the
difficulties in the normal procedure applied to smaller investments concerning the
length and transparency of administrative procedures, regulatory uncertainty
and the institutional capacity of public administration, in particular at local
level. Investment activity will continue to be promoted through the Investment
Promotion Act that entered in force in October 2012. The Act created a new
system of investment incentives such as tax advantages, non-refundable
financial support or exemption from custom duty.
Some
progress with digitising government services relevant for businesses has been made. Croatia has introduced some e-services for businesses; notable examples include the
electronic system for social security contributions launched in 2013, e-Customs
system supporting imports and exports and the e-Company service enabling online
establishment of a limited liability company. In addition, a number of
e-projects in construction and physical planning are being implemented with the
aim to decrease the number of days needed to obtain a construction permit from
314 to 74 in 2014. However, only relatively basic services can be accessed
through the point of single contact, partly due to the lack of a clear
cooperation framework across government bodies. Ensuring full
interconnectedness of databases relevant for businesses, with due regard to
adequate protection of private information, will be of critical importance for
lowering the regulatory burden on businesses.
Box
 5. Potential impact of structural reforms
– results of a benchmarking exercise
Structural reforms are
crucial for boosting growth. It is therefore important to know the potential
benefits of these reforms. Benefits of structural reforms can be assessed with
the help of economic models. The Commission uses its QUEST model to determine
how structural reforms in a given Member State would affect growth if the Member State narrowed its gap vis-à-vis the average of the three best EU performers on key
indicators such as labour market participation. Improvements on these
indicators could raise Croatia's GDP by about 5 % in a 10-year period.
Some reforms could have an effect even within a relatively short time horizon.
The model simulations corroborate the analysis of Sections 3.1 and 3.3,
according to which the largest gains would likely stem from reducing the
pathways to early retirement and strengthening the labour market participation
of women. The simulations also support the priority placed by the authorities
on reforming the labour market legislation and improving public employment
services. The potential impact of other promising reform areas, such as the
degree of competition in the economy, labour taxes, or the benefit replacement
rate cannot be simulated due to data limitations.
Table:
Structural indicators, targets and potential GDP effects[45]
Source:
Commission services. Note: Simulations assume that all Member States undertake
reforms which close their structural gaps by half. The table shows the
contribution of each reform to total GDP after five and ten years. If the
country is above the benchmark for a given indicator, we do not simulate the
impact of reform measures in that area; however, the Member State in question can still benefit from measures taken by other Member States.[46] *The
long-run effect of increasing the share of high-skilled labour in the
population could be 4.3% of GDP and of decreasing the share of low-skilled
labour could be 2.8%. **EU average is set as the benchmark.
State-owned
enterprises
The
state still maintains a strong role in the economy through ownership in a large
number of companies. Despite some improvement compared with
the previous year, these continue to pose a risk to public finances through
operational losses, debt assumptions and the extension of financial guarantees.
While the national reform programme indicates that financial results of 59 state-owned
companies of strategic interest are expected to improve in 2014, their
indebtedness should further rise from nearly 25 % of GDP reached in 2013.
The
institutional framework for management and privatisation of the state-owned
enterprises is in place, but its implementation faces delays. In
June 2013, the Parliament adopted a new strategy for the management of public
assets in the period 2013-17. Under the strategy, by end-October each year the
government, through the State Property Management Office, is obliged to present
a programme for public property management for the following year. A plan for
2014, due in October 2013, has been adopted only in April 2014. Convincing
steps to speed up the disposal of state assets and restructuring of
state-owned enterprises are needed to limit the amount of financial support and
to provide a level playing field that would help bolster competitiveness and
efficiency of the real sector. To this effect, the national reform programme
outlines a plan to introduce a system to report on the financial situation of state-owned
enterprises. This is a relevant step as up-to-date monitoring is a precondition
for sound public oversight and effective management. The programme also
specifies that the Restructuring and Sale Centre, which manages the state
portfolio of stocks and equity shares in non-strategic companies (561 companies
at the end of 2013), is to conduct privatisation of companies under its
disposal within three years. Respecting international best practices when
implementing the sales would be key to maximising the value received by the state
(nominally, the portfolio is worth 1.9 % of GDP).    
The
authorities stepped up efforts to privatise state assets but the implementation
record is limited. The sale of the biggest domestic
insurance company, Croatia osiguranje, was finalised in March 2014. However, the
tender for the sale of the largest state-owned bank, Hrvatska Postanka Banka,
did not succeed as the offer submitted was deemed unsatisfactory. In early
2014, talks failed with the only bidder for the sale of a 75 % stake in
the railway cargo company HZ Cargo and consequently the government initiated a
restructuring and recapitalisation plan for the company. While the national
reform programme outlines concrete plans regarding HZ Cargo, it is less
specific about the passenger transport branch of railways. Attempts to attract strategic
partners for fertiliser company Petrokemija and the national air carrier
Croatia Airlines have broken down recently. In 2013, the government has
initiated a multiannual restructuring programme for Croatia Airlines with
expected total costs of 0.5 % of GDP, which is underpinned, among others,
by a reduction in operating costs and a conclusion of new collective agreement.
In the national reform programme, the authorities further expect to receive 6.8 %
of GDP (this information is not factored in the convergence programme) at end
2014 from granting a concession for toll collection and highway maintenance, activities
outsourced from public companies HAC and ARC. Core activities (design and
construction of highways) should continue to be carried out by the state.
The
governance of state-owned enterprises remains problematic, weighing on the profitability
of companies under state control. Legislative amendments adopted
in 2012 replaced a competitive selection procedure for members of supervisory
boards of state-owned enterprises with direct political appointments. Only
general criteria apply to the background of nominees but these do not relate to
expertise in the particular field of activity of a company or experience on
similar boards.[47]
According to the 2014 EU Anti-corruption Report, mechanisms for verification of
conflicts of interests remain weak. Inadequate safeguards between state-owned
enterprises and the political sphere risk impinging on the allocation of public
funds and creating room for mismanagement of public resources. 
Energy,
climate and environment 
Reforms
in the electricity and gas sectors, also required by the internal market rules,
aim to improve the market model and increasing transparency and competition. In
2013, Croatia continued to introduce regulatory reforms in these areas. As a
result of the unbundling obligations in the new Electricity Market Act, changes
were made in the structure of the Transmission System Operator and the capital
and structure of the parent company Hrvatska Elektroprivreda, but the process
of unbundling is still to be finalised. There is still no clarity about the
process of certification by the energy regulatory agency HERA. In the gas
sector, the new gas law addressed some barriers to competition such as price
caps. However, the limitation on exports of domestically produced gas, which
does not seem compatible with the internal market rules, was retained.
The
electricity supply market was opened up to competition, in practice, in July
2013.
Several providers, both domestic and international, have entered the market that
was previously dominated by the incumbent power operator Hrvatska Elektroprivreda.
Competition is more restricted in the gas sector, where prices for households
remain administratively regulated and are currently set at low levels.
Excluding taxes and levies, gas prices for households are the third lowest in
the EU. Further regulation of gas prices was introduced with legislative
changes from early 2014. Under these, the incumbent energy utility company became
a wholesale gas supplier for three years from April 2014. Furthermore, the oil
and gas company INA was obliged to sell domestically produced gas to Hrvatska
Elektroprivreda at a regulated price. These changes, coupled with export
restrictions on gas, risk depressing competition and investments in the sector and
undermining the basis for the integration of Croatia in the internal market. 
Croatia
achieved progress in implementing specific energy efficiency measures, in
particular in the public sector. These included improvements in the
advanced energy network and the introduction of a web-based tool for monitoring
public sector energy use. A two-year energy renovation programme for public
buildings is in place with the objective of reducing energy consumption and
greenhouse gas emissions. Nevertheless, energy-saving opportunities remain
largely untapped across all sectors. The coverage of advanced metering systems
is still very limited, leading to elevated energy consumption in buildings.
Across sectors, there seems to exist significant scope for improvement in energy
efficiency of households.[48]
The
proportion of renewable energy increased to 16.8 % in 2012 from 14.3 %
in 2010.
As a result, the country is well placed to meet its renewable energy target of
20 % in 2020. The production of renewable energy is mainly promoted
through a feed-in tariff for renewable electricity generation, a quota
obligation and tax exemptions for biofuels, and state financial assistance.
However, future development of renewable energy will be constrained by a cap on
the capacities of such sources (in particular for wind and solar power) that
was introduced with the National Renewable Energy Action Plan adopted by the
government in October 2013. The plan envisages a limit of 20.1 % on the
share of renewable sources in final energy consumption by 2020. It also
provides that, in the years from 2015 to 2020, the installed capacities of
solar and wind power must not increase. Croatia’s carbon intensity is almost
twice as high as the EU average despite the decrease of greenhouse gas emissions
by 14 % in 2005-12.
Preventing
and reducing waste generation, together with the necessary increase in reuse
and recycling, could improve the resource efficiency of the Croatian economy
and increase business opportunities. However,
managing waste efficiently and fulfilling obligations under the EU directives
on waste remains a challenge. Separate collection is critical to developing the
value of waste, and creating the market: incentives for private sector actors
to engage are therefore crucial. In July 2013, Croatia adopted the Sustainable
Waste Management Act to align national legislation with the requirements and
targets set out in the EU directives on waste. In particular, landfill fees
planned in the Act, one for the local government and the other for the landfill
operator, will have to be adopted. Moreover, pay-as-you-throw schemes for waste
collection and extended producer responsibility are mentioned but without the
necessary level of detail. A well thought-through design and thorough implementation
of these measures will be crucial to ensure that they contribute to improving
resource efficiency.
Transport
Croatia is
in the process of developing its first comprehensive transport strategy. It
will serve as a basis for developing the necessary transport infrastructure in
the country, with full interoperability and connection to the trans-European
transport network. The effective implementation of the strategy requires clear
policy choices regarding the organisation of the sector, potentially in a form
of a specialised agency. The main weaknesses of the Croatian transport system
are the imbalance between modes of transport in favour of the least
environmentally friendly – road - and an outdated railway infrastructure with historically
insufficient maintenance and rehabilitation funds. 
While
the motorway network in Croatia is relatively well developed, rehabilitation of
the rail infrastructure network is a major challenge.
Sizeable investment gaps have negative effects, in particular as regards the infrastructure
network of commercial speeds of trains, especially those of international rail
freight services on the core trans-European transport network corridors. Rail
access to major shipment points, such as industrial sites, ports, and inland
ports, and safety at level crossings (‘distributed
projects’) require specific attention in infrastructure development programmes.
In this context, opening of the monopolistic railway market, even if
challenging, would bring new opportunities.
The
modal shift in the transport sector from road to rail and other cleaner
transport modes is lagging behind. This is mainly
due to the investment deficit in rail infrastructure but the connection of the
land transport network with inland waterways (Danube, Sava) and with maritime
ports is also underdeveloped. Both inland waterways are mostly shared with Serbia and Bosnia and Herzegovina respectively; any improvement therefore requires a joint effort.
Research
and innovation
Croatia’s
research and innovation capacity is constrained by limited public funding, low quality of the public research system, weak
commercialisation, and a venture capital market too shallow to provide funding
for risk investment.[49] The
legal framework for innovation, including taxation, is not sufficiently well
developed[50]
and a long-term strategy for research or innovation has not yet been adopted. The
level of investment in research and development in Croatia stagnated at 0.75 %
of GDP in 2012, significantly below the government’s 1.40 % target for
2020. The share of government co-funding in business research and development
expenditure was nearly zero in 2012. Apart from the use of the European Structural
and Investment Funds, there is no real prospect of increasing Croatia’s investment in research and innovation capacity in the coming years.
A
major challenge for Croatia is to build up research and innovation capacities
through targeted public investment from ESI funds and national resources to leverage
private investment. This requires designing and implementing
a smart specialisation strategy to provide a long-term investment framework to
focus efforts in fields where there is a potential for the development of
related competitive economic activities. Such a smart specialisation strategy,
to be based on the industrial and innovation strategies, is in preparation. Recognising
innovation priorities through a coordinated inter-ministerial process,
involving stakeholders and complementing it with measures to further develop
research and innovative skills and create attractive conditions for researchers
would maximise its positive effects for the economy. In terms of digital
technologies, a plan for full deployment of broadband connection is outlined in
the Strategy for Broadband Development for 2012-15. The coverage of very fast
broadband lines is currently substantially below the EU average.[51]
Targets laid set in the Digital Agenda for Europe envisage that until 2020
Croatia should achieve download rates of 30 Mbps for 100 % of the
population and above 100 Mbps for 50 % of households.  
With
respect to the key European Research Area priorities, Croatia has introduced performance-based criteria for institutional research funding.
Project funding has been entirely outsourced to the National Science Foundation.
This should result in more open and competitive financing based on
international peer review principles. Furthermore, scientific centres of
excellence will be established in 2014. However, concerning cooperation between
public research organisations and the private sector, there has been no
progress towards encouraging the commercialisation of research results and
transfer of technology. In addition, there have been delays in the adoption of policy
frameworks[52]
that should have facilitated integration of Croatian research entities in
European networks and participation in Horizon 2020, the new Union programme
for research and innovation. 

3.5.                
Modernisation of public administration

Despite
some important initiatives, the quality of public governance remains low, holding
back progress in growth-oriented reforms and posing risks for effective access
to EU funds. At all levels of government, inadequate capacity to
implement sound policies for the private sector is the common denominator of
the serious issues analysed in previous sections. Specifically, Croatia ranks as the worst-performing Member State in terms of regulatory quality in the 2013
Worldwide Governance Indicators.[53]
  Croatia also scores very low on indicators of accountability, rule of law and
control of corruption. High turnover rates, the lack of transparency in staff
recruitment and the absence of evidence‑based approaches for implementing
reforms are other weak points. 
These
concerns are a clear challenge especially in view of ensuring strong and
effective management of EU Structural and Investment Funds in 2014-20. The
experience of the implementation of the pre-accession funds points to
deficiencies in terms of strategic planning and institutional capacity and
weaknesses in project elaboration and follow-up. The total allocation for Croatia amounts to EUR 8.3 billion. Its commitment is conditional on
proposing a clear, prioritised and results-oriented investment strategy. The
use of these funds also requires that a strong and effective implementation,
monitoring and evaluation system is in place, as well as the necessary
capacities to manage the funds and ensure a proper preparation and
implementation of projects. Stable staffing levels of units entrusted with the
management of funds helps build a knowledge –base and ensure institutional
memory which is needed to ensure an efficient use of funds. Experience of other
Member States also suggests that submitting a large number of proposals early
in the programming period is instrumental to  minimise the risk of decommitment
of funds. 
Administrative
fragmentation weighs on the efficiency and transparency of public administration. Public administration responsibilities
are shared among 20 counties, 126 cities and 429 municipalities. At central
level, competencies are split between ministries and a number of agencies
entrusted with implementing policies but also some strategic tasks. This complex
distribution of responsibilities gives rise to significant uncertainties that
complicate business decisions and lengthen administrative procedures. The high
fragmentation of governance is also a challenge for policy coordination,
monitoring and evaluation and may hinder a broader policy perspective.
Restructuring regional and local responsibilities and consolidating small individual
administrative units and central agencies performing similar tasks would
facilitate the transformation of Croatian public administration towards a
client-oriented approach.
The
national reform programme presents relevant measures that could help increase
the administrative capacity of government and subordinated bodies.
Following the roll-out of a central payroll system for public employees (to be
completed in October 2014), which is expected to increase transparency and
consistency in salaries, a strategy for public administration reform for
2014-20 is expected to be approved in the third quarter of 2014. The reform
defines standards for performance management and key competencies for all categories
of public officials and improves training and hiring procedures. It also aims
at merging several state administrative agencies and at replacing the current
county-based organisation of public administration with fewer sub-national
offices with wider territorial jurisdiction. This is a relevant step towards
better coordination and more harmonised decision-making. The effectiveness of
these reforms will depend on implementation and application to all levels of
government. In 2014, the government also plans to launch the e-Citizens portal
as a one-stop shop for citizens to access information and receive certificates
from a range of interconnected public registers (framework conditions will be
defined in the Act on the State Information Infrastructure).
Anti-corruption
policies
A convincing
track-record for an effective implementation of preventive anti-corruption
policies is yet to be established. A number of
anti-corruption safeguards are in place (e.g. an ethics code for civil
servants, hotlines to report corruption, internal control mechanisms) and the ‘conflict
of interest’ and ‘freedom of information’ legislation is being implemented. Public
entities and state-owned enterprises publish regular reports on monitoring the
corruption risk.[54] Moreover,
some ministries and agencies publish a complete list of grant recipients,
including the level of the grant. Beyond developing a strong track record of
implementing the safeguards already in place, the key elements currently
missing in the anti-corruption framework include verification mechanisms for
conflicts of interest and asset disclosure of public officials, protection of
whistle-blowers, specific safeguards for the healthcare sector and effective
risk control in public procurement. The verification powers of the Commission
for the Resolution of Conflicts of Interest rely heavily on the competences and
pro-activeness of other authorities; its own tools and databases to perform
checks that cannot be covered in a systematic manner by other institutions are
still being developed.[55]
According to the national reform programme, a new Strategy for the Suppression
of Corruption and an accompanying action plan are going to be developed in
2014.
Some progress
has been made in improving the transparency of public procurement rules but
significant challenges remain regarding the operational aspects of existing
legislation. Notably, all public bodies are obliged to
publish concluded and executed contracts. Contracting authorities are also
obliged to publish a list of businesses with regard to which conflicts of
interest may arise or to expressly confirm the absence of such situations. A
public contract concluded in breach of these provisions is null and void. Furthermore,
the Ministry of Justice has started monitoring the level of transparency of
local governments. In 2012, a Freedom of Information Act was adopted, aiming to
make public administration more transparent. The above-mentioned efforts to
increase transparency are steps in the right direction. However, there appears
to be some discrepancy between the formally compliant and fairly sound legal
and institutional framework and its effective and transparent implementation.
Notably, risk assessment tools are not being systematically used, in particular
at local level, and there is no systematic reporting on costs of public works
and contracted services. Responsibilities for monitoring of public procurement
rules are shared by a number of public institutions, which may decrease the
effectiveness of oversight. The capacity of the State Commission for
Supervision of Public Procurement Procedure (less than 20 professional
councillors in 2012) appears low given the considerable challenges it faces. Moreover,
vulnerable sectors (those with more prominent corruption risks) appear to be insufficiently
prioritised. Adequate monitoring and reporting, in particular of the
implementation of rules on access to public information, is a precondition for building
up the envisaged anti-corruption environment. 
Justice
system
Despite reforms
adopted in 2012 and 2013, improving the quality and efficiency of the civil
justice system remains a challenge. The
effectiveness of enforcement of rulings on monetary assets has improved
following the introduction of immediate enforcement through the financial
agency FINA. However, the effectiveness of enforcement on immovable property is
a weak point in view of low recovery rate; the national reform programme
outlines relevant amendments for improving the transparency, efficiency and
timeliness of enforcement (e.g. by introducing electronic auction of immovable
property). The time to resolve land registry cases was shortened from 50 days
in 2010 to 38 days in 2013, and the backlog was reduced by 38 %.[56]
However, the impact of reforms improving the effectiveness of the justice
system in other areas has yet to materialise. Despite a slight reduction, the
length of proceedings at courts of first instance in 2013 remained very high in
litigious civil and commercial cases (417 days) and in administrative cases
(493 days). In both of these areas, the courts are having difficulties in
responding to a rise in incoming cases and
in enforcing procedural discipline to arrive to a final sentence in a timely
manner: as a result, the backlogs in 2013 increased and are very high
particularly in civil and commercial proceedings.[57] The
incentives to use alternative dispute resolution mechanisms, especially for
small claims, appear insufficient. One important aspect that weighs on the
efficiency and quality of the justice system is the lack of a comprehensive ICT
system for registration and management of cases based on a consistent
methodology — such a system is currently being developed. According to the 2014
EU Justice Scoreboard, the ICT tools for communication between courts and
parties are not sufficiently developed. At the beginning of 2014, the
government announced a reorganisation of the court system with a view to
improving efficiency by merging courts and improving allocation of workload. 
Strengthening
the out-of-court debt settlement procedure could ensure successful financial
restructuring of distressed companies. The widespread
application of the pre-insolvency procedure in 2013 had a certain degree of
success in addressing debt-servicing problems faced by companies in the context
of complex, expensive and lengthy insolvency procedures that still prevail in
the country. However, significant shortcomings remain. Above all, the role of
commercial courts in the monitoring of transparency and legality in the
application of the procedure is relatively weak; this concerns particularly
checking the correctness of reported claims and the validation of restructuring
plans. An important feature of the current system is that it provides a
compulsory formal test of insolvency or illiquidity as a pre-condition to
access the pre-insolvency procedure. This means that proceedings are likely to
be opened only when the company is already insolvent, thereby severely limiting
the chances of success of the restructuring process and lowering the total
value for creditors and employees. The obligation to enter pre-insolvency
proceedings in all cases also results in delaying the liquidation procedure for
those companies which are unviable.[58]
Finally, the role of the state in the process, currently acting as both an
administrator/supervisor and as a creditor in the same proceedings, could
appear disproportionate and give cause to public concern about potential
conflicts of interests. The national reform programme does not provide
detailed information on how the pre-insolvency procedure could be
improved; it only mentions its possible integration into the insolvency
framework. In terms of the insolvency procedure, a significant problem that lengthens
the closure of liquidation proceedings is that the current limitation to three
attempts to sell debtor's assets is not respected in practice. A reform
imposing the closure of the insolvency proceedings after all legal sale
attempts regardless of possible parallel civil proceedings is expected to be
adopted in summer 2014. Introduction of personal bankruptcy is also announced
for the first half of 2014.

4.        
Conclusions

Croatia
has been experiencing a prolonged downturn, in which a range of external and
internal imbalances have come to the fore. These include
uncompetitive exports, a corporate debt overhang and public sector indebtedness
as particular vulnerabilities. Structural deficiencies have contributed to
these imbalances and are now impeding a swift rebalancing process. A poor
business environment and an impaired labour market stand out among the
shortcomings. State-owned enterprises still play a dominant role in some
sectors and some of them are highly indebted. These factors also combine to
lower potential growth, which hinders private‑sector balance sheet repair and
increases the required fiscal consolidation effort.   
Having
joined the EU in July 2013, Croatia participated in the 2013 European Semester
on an informal and voluntary basis only and was not issued country-specific
recommendations. Croatia has undertaken reforms aimed at ending the
prolonged recession and returning to a sustainable and job-rich growth path.
Recent reform efforts, in particular targeting improved labour market
flexibility and streamlining the benefits system, are welcome steps, although
their success will largely depend on robust implementation. The national reform
programme also outlines relevant plans to enhance the businesses environment
and the efficiency of public administration but further concerted efforts are
needed. Improving the functioning of the justice system would help reinforce Croatia’s appeal to investors. Acceleration of the restructuring of state-owned enterprises
would be conducive to increased competitiveness and would ultimately also
reduce contingent liabilities for the state arising from loan guarantees and
capital injections.
The
priorities presented in the 2014 national reform programme echo the main
challenges identified in the 2014 in-depth review on Croatia and this staff
working document. These measures signal welcome reform
intentions, which could help to effectively tackle the challenges faced by Croatia, if implemented in a rigorous and timely manner.  
The convergence programme
affirms Croatia's commitment to correct the excessive deficit by 2016 and to
bring the public debt on a downward trend in line with the excessive deficit
procedure. The two main objectives of the budgetary strategy as defined in Croatia's 2014 convergence programme are swift fiscal consolidation and setting the economy
on a sustainable growth path. Greater details on the further fiscal
consolidation measures required to sustainably achieve the stated objectives of
the programme would further enhance the robustness of the document.


Overview table
 
 Europe 2020 (national targets and progress) 
 Policy field target || Progress achieved 
 Employment rate target set in the 2014 national reform programme: 62.9 % of the population aged 20-64 || Employment rate of the population aged 20-64 in 2013: 53.9 % 
 Target on the reduction of population at risk of poverty or social exclusion in number of persons in the 2014 national reform  programme: Reduction to 1 220 000, equivalent to a decrease by 152 000 persons compared to 2011 || 1 370 000 (2012) 
 Early school-leaving target: 4 % || The rate dropped to 3.8 % in 2013 from 4.2 % in 2012. This is far below the EU average of 12 %. 
 Tertiary education target: 35 % || Tertiary education attainment (30-34 year olds) amounted to 24.6 % in 2013 (EU average of 36.6 %). High drop-out rates and unequal access to higher education are main barriers to tertiary attainment. 
 2020 Renewable energy target: 20 % Share of renewable energy in all modes of transport: 10 % || The percentage of renewable energy 16.9 % in 2012. The share of renewables in the transport sector was only 0.4 % in 2012. 
 Energy efficiency target: 20 % Croatia has set an indicative national energy efficiency target of 20%, which implies reaching a 2020 level of 9.19 million tonnes of oil equivalent (Mtoe) primary consumption and 7.82 Mtoe final energy consumption. || Croatia's energy intensity is above the EU-28 average. Croatia notified the policy measures it plans to adopt to implement Article 7 of the Energy Efficiency Directive. Progress has been made in implementing specific energy efficiency measures in the public sector at local and regional levels.  
 Non-Emissions Trading System emission reduction target: +11 % compared to 2005 emissions. || Change in total greenhouse gas emissions between 2005 and 2012: -14 %. According to the latest national projections and taking into account existing measures, the target is expected to be achieved: -6 % in 2020 compared to 2005 (with a margin of 17 percentage points). 
 R&D target: 1.4 % of GDP || R&D intensity amounted to 0.75 % of GDP in 2012 (of which 0.41 % public R&D intensity and 0.34 % business R&D intensity) The level of investment has stagnated at 0.75 % of Croatia’s GDP since 2010: this level of investment is not only much lower than the EU average of 2.06 %, but also lower than the level in most of the other Member States in central and eastern Europe. Public R&D intensity is only 0.41 % of GDP (2012) compared with 0.5 % in 2008, which means a decrease. Building up the required research and innovation capacities therefore requires a reversal of this decreasing trend.  

Annex

Table I. Macro-economic indicators                                                                        
Table II. Comparison
of macroeconomic developments and forecasts                            
Table III.
Composition of the budgetary adjustment                                                        
 
Table
IV. Debt dynamics                                                                                                      
Table V. Taxation
indicators                                                                       
Table VI. Financial
market indicators                                                        
Table VII. Labour
market and social indicators                                                                
Table VIII. Product
market performance and policy indicators                                      
Table IX. Green
growth
List of indicators
used in Box 5 on the potential impact on growth of structural reforms. 
Final goods sector mark-ups: Price-cost
margin, i.e. the difference between the selling price of a good or service and
its cost. Final goods mark-ups are proxied by the mark-ups in selected services
sectors (transport and storage, post and telecommunications, electricity, gas
and water supply, hotels and restaurants and financial intermediation but
excluding real estate and renting of machinery and equipment and other business
activities[59]).

Source: Commission services estimation
using the methodology of Roeger, W. (1995). "Can imperfect
Competition explain the Difference between primal and dual Productivity?" Journal
of Political Economy Vol. 103(2) pp. 316-30, based on
EUKLEMS 1996-2007 data. 
Entry costs: Cost of
starting a business in the intermediate sector as a share of income per capita.
The intermediate sector is proxied by the manufacturing sector in the model. 
Source: World Bank, Doing Business
Database. www.doingbusiness.org. 2012 data.
Implicit consumption tax rate:
Defined as total taxes on consumption over the value of private consumption. In
the simulations it is used as a proxy for shifting taxation away from labour to
indirect taxes. The implicit consumption tax-rates are increased (halving the
gap vis-à-vis the best performers) while labour tax-rates are reduced so that
the combined impact is ex-ante budgetary neutral.
Source: European Commission, Taxation
trends in the European Union, 2013 edition, Luxembourg, 2013. 2011 data.
Shares of high-skilled and low-skilled: The
share of high skilled workers is increased, the share of low-skilled workers is
reduced (halving the gap vis-à-vis the best performers). Low-skilled correspond
to ISCED 0-2 categories; high-skilled correspond to scientists (in mathematics
and computing, engineering, manufacturing and construction). The remainder is
medium-skilled. 
Source: EUROSTAT. 2012 data or latest
available. 
Female non-participation rate: Share
of women of working age not in paid work and not looking for paid work in total
female working-age population
Source: EUROSTAT. 2012 data or latest
available.
Low-skilled male non-participation
rates: Share
of low-skilled men of working age not in paid work and not looking for paid
work in total male working-age population
Source: EUROSTAT. 2012 data or latest
available.
Elderly non-participation rates (55‑64
years): Share
of the population aged 55‑64 years not in paid work and not looking for paid
work in total population aged 55‑64 years.
Source: EUROSTAT. 2012 data or latest
available.
ALMP: Active Labour
Market Policy expenditures as a share of GDP over the share of unemployed in
the population. 
Source: EUROSTAT. 2011 data or latest
available.
Benefit replacement rate:  Share
of a worker's pre-unemployment income that is paid out by the unemployment
insurance scheme. Average of net replacement rates over 60 months of
unemployment. 
Source:
OECD, Benefits and Wages Statistics. www.oecd.org/els/benefitsandwagesstatistics.htm.
2012 data.
[1] Croatia participated in the 2013 European Semester on a voluntary
and informal basis by submitting its economic programme to the Commission.
[2] COM(2013) 800 final
[3] COM(2013) 790 final
[4] Aside from the 16 Member States identified in the AMR, Ireland was also covered by an in-depth review, following the conclusion by the Council
that it should be fully integrated into the normal surveillance framework after
the successful completion of its financial assistance programme.
[5] Such data issues may be further aggravated by the methodological
changes which will ensue with the switch-over from ESA 95 standards to ESA 2010
standards in September 2014.
[6] Specifications on the implementation of the Stability and Growth
Pact and Guidelines on the format and content of Stability and Convergence
Programmes.
[7] The absence of MTO in the convergence programme is not in line with
the Code of Conduct However, setting an MTO was hindered by the fact that
problems with the availability and quality of demographic projections prevented
the Economic Policy Committee from approving projections for the cost of ageing
in Croatia which, in turn, did not allow the Commission to set a minimum MTO.
[8] Cyclically adjusted balance net of one-off and temporary measures
recalculated by the Commission services on the basis of the information
provided in the programme, using the commonly agreed methodology.
[9] As noted above, the convergence Programme uses different accounting
methodologies for past and future years. This artificially and substantially
(by at least 0.5% of GDP) reduces the improvement in the (recalculated)
structural balance from 2013 to 2014.
[10] These figures also adjust for the healthcare arrears that were
erroneously included in the government projections for 2014.
[11] Excluding these the Commission deficit projections for 2014 and
2015 would stand at 4.6% and 3.8% of GDP respectively.
[12]Although grants paid from structural funds are in general channelled
through the government budget they represent an expenditure of the EU rather
than of the government itself and hence these are filtered out from government
accounts. Therefore, payments from EU funds only affect government deficit
either when a government unit is the final recipient of the funds (i.e. it is a
revenue for the government) or when government is co-financing the project
(i.e. the co-financing is a genuine government expenditure).
[13] For example, the 2013 budget was revised twice in the course of the
year.
[14] This refers to pensioners who have a legal entitlement to receive
pensions under privileged conditions based on their status, such as homeland
war veterans.
[15] The reduction is
automatically revoked once real GDP growth exceeds 2% during three consecutive
quarters compared with the same quarter in the previous year, and the budget
deficit is below 3%. The cut does not apply to war veterans with 100%
disability or to surviving children of war veterans. Indexation has been put on
hold until the same conditions are met.
[16] There are potential data comparability issues, to the extent that
cash entitlements such as maternity pay are channelled through the health
insurance fund and captured within public health expenditure totals.
[17] The scale of family care in Croatia is above the EU27 average,
with, notably, 24 % of female respondents and 13 % of male
respondents in the 50-64 age group involved in elderly care. These are the
third highest rates in Europe, after Italy and Estonia (Eurofound, 2010,
available at: 
 http://www.eurofound.europa.eu/pubdocs/2010/02/en/1/EF1002EN.pdf).
[18] The World Bank (2012) Croatia Policy Notes
[19] The tax-to-GDP ratio in Croatia was 35.7 % of GDP in 2012,
compared with 39.4 % in the EU.
[20] Taxes on consumption account for 17.5 % of GDP, ranking Croatia first in the EU. Taxes on labour account for 14.5 % of GDP (EU average 19.7 %),
while taxes on capital represent 3.7 % of GDP (8.2 %). Given the
extent of unemployment and inactivity, the scope for increased taxes on labour
appears limited in the short term.
[21] Croatia did take some steps to broaden the tax base of both
personal and corporate income taxes. In particular, in January 2014 incentives
for regions under special government protection and for hilly areas were
replaced by incentives for assisted areas, which is projected to lead to a
reduction of tax expenditures of HRK 490 million.
[22] Croatia currently levies a real estate transfer tax and a tax on
second homes. Sources: Institute of Public Finance, Croatian Tax System (as of
January 2014) and Taxes in Europe Database.
[23] They are estimated at HRK 22 billion, or nearly 7 % of GDP, in
early 2014 (for more information see http://www.ijf.hr/upload/files/file/newsletter/84.pdf).
[24] The 2014 World Bank Doing Business survey ranks Croatia 99th country globally in terms of the ease of trading across borders,
from 104th rank in the 2013 report, but this remains the second
worst result in the EU. 
[25] However, the 2013 economic programme reported that guarantees
amounted to 11.7 % of GDP in 2012. The difference between the reported figures
for 2012 is not explained in the convergence programme.
[26] For further details, see the 2014 Joint
Employment Report, COM(2013)801, which includes a scoreboard of key employment
and social indicators.
[27] Vuksic (2014), available at http://www.ijf.hr/upload/files/file/ENG/newsletter/86.pdf 
[28] Croatia adopted a Youth Guarantee Implementation Plan in May 2014.
[29] Pursuant to the Council Recommendation of
22 April 2013 on establishing a Youth Guarantee (2013/C 120/01): "ensure
that all young people under the age of 25 years receive a good-quality offer of
employment, continued education, an apprenticeship or a traineeship within a
period of four months of becoming unemployed or leaving formal education".
[30] Special Eurobarometer 402 – Undeclared work
in the European Union
[31] Eurofound - Tackling undeclared work in Croatia and four EU candidate countries (2013)
[32] ESDE 2013 report
[33] The levels and coverage of unemployment benefits and social
assistance are particularly low.
[34] EEPO review (August 2013) - Labour market
reforms in Europe 2011-2013; Guidelines for the implementation of ALMP measure
for 2014; World Bank (2010) Social Impact of the crisis and building
resilience. 
[35] According to the Ministry of Social Affairs, there are more than 50
different welfare programmes managed by local self-governments which cost HRK
1.5 billion HRK annually, more than double the amount envisaged for the new
guaranteed minimum benefit.
[36] Since 2011 a Social Welfare Reform Strategy (2011-16) and two acts have
been adopted, standardising the conditions for granting social assistance,
clarifying means-testing, linking the level of social assistance to the
official poverty threshold and defining the parameters for a new database to increase
transparency.
[37] According to the national reform programme, the plan is to
standardise processes for child allowance,
maternity and parental benefits, and unemployment benefits, which would cut
costs and reduce administrative burden.
[38] See PISA (2012). In mathematics, the proportion of 15-year-old
pupils who fail to achieve basic skills in the PISA test (‘low achievers’) is
29.9 % (the EU-25 average is 23 %). In reading and science, Croatia is slightly below EU average, although there are striking gender differences in
reading (27.6 % low achievers among boys and 9.5 % among girls). 
[39] Matkovic (2009) UNDP and Croatian Ministry of Health and Social
Welfare, Youth between education and employment: is it worthwhile going to
university?
[40] The proportion of the population with medium or high internet
skills is 37.5 % compared with a 46.8 % EU average. The proportion of
the population with medium or high computer skills is also below the EU average
(44.7 % compared with 50.9 %).
[41] Rinaldi, S., Klenha, V., Feiler, L. and Petkova, E. (2012). Croatia – Review of human resources development.
[42] http://ec.europa.eu/economy_finance/economic_governance/macroeconomic_imbalance_procedure/index_en.htm
[43] Other indicators used by the Commission to assess the business
environment and business-friendliness of public administration include criteria
related to the implementation of the Small Business Act and 'SME Performance' and
indicators covered by the Innovation Union Scoreboard.
[44] The 'SME Test' analyses the likely economic, environmental and
social effects of legislative proposals by assessing the costs and benefits of
policy options and thus helps reach balanced and sustainable decisions. Examples
of relevant projects being implemented include the 'BIZIMPACT II' project
(2013-15), which promotes the economic impact assessment system in Croatia,
with a specific focus on the SME sector and the 'Improvement of Administrative
Efficiency at the National Level' project, which introduces the ‘SME Test’ and
the 'Think Small First' principle to regional groupings of local governments
and entrepreneurs.
[45] Final goods sector
mark-ups is the difference between the selling price of a good/service and its
cost. Entry cost refers to the cost of starting a business in the intermediate
sector. The implicit consumption tax rate is a proxy for shifting taxation away
from labour to indirect taxes. The benefit replacement rate is the % of a worker's pre-unemployment income that is
paid out by the unemployment scheme. For a detailed explanation of indicators see
Annex.
[46] For a detailed explanation
of the transmission mechanisms of the reform scenarios see: European Commission
(2013), "The growth impact of structural reforms", Chapter 2 in QREA No.
4. December 2013. Brussels; http://ec.europa.eu/economy_finance/publications/qr_euro_area/2013/pdf/qrea4_section_2_en.pdf
[47] The Decision on the determination of the requirements of 17
February 2012 lists conditions such as a university degree, five years of work
experience at 'adequate' (further unspecified) positions within the candidate's
profession and clean criminal record.
[48] Energy efficiency in the household sector rose by 4 % in the period
1995-2010 compared with a 20 % improvement for the industrial sector
[49] The Innovation Union Scoreboard 2014 classifies Croatia as a moderate innovator. Croatia’s innovative performance relative to the EU has
deteriorated from 60 % in 2011 to 55 % in 2013 mainly due to declining sales of
new innovative products.
[50] Croatia offers a generous R&D tax incentive. Up to 150 % of
expenses for R&D can be deducted from the corporate income tax base. The
limited number of beneficiaries, however, suggests that the efficiency of the
tax support may be hampered by administrative obstacles.
[51] The coverage of very fast broadband lines is one of the lowest in
the EU (21.9 % in Croatia compared with 53.8 % in the EU. Only 63.6 % of
households have broadband connection (75.9 % in the EU). 
[52] The Strategy on Higher Education, Science and Technological Development
and the Strategy on Innovation
[53] The World Economic Forum’s Global Competitiveness Report 2013 ranks
  Croatia’s competitiveness 75th overall (up six places compared with 2012) and
93rd in terms of the quality of institutions. This is in particular due to the
high perceived burden of government regulation (143rd), wastefulness of
government spending (123rd) and efficiency of legal framework in settling
disputes (140th).
[54] The fifth consolidated report on the anti-corruption programme for
companies with majority public ownership was published in February 2013 and
covered 86 enterprises. Six implementation reports have been published since
November 2012 to provide systematic monitoring of the anti-corruption strategy.
A report on transparency of local and regional self-governments was published
in February 2013 covering more than 600 units.
[55]
European Commission (2014), EU Anti-corruption Report.
[56] Disposition time. Sources: Croatian Ministry of Justice and Council
of Europe (CEPEJ), Study on the functioning of judicial systems in the EU
Member States: Facts and figures from the CEPEJ 2012-2014 evaluation exercise,
study prepared for the European Commission (DG Justice).
[57] In 2013, pending civil and commercial cases increased by 12 %
(compared with 2010) and pending administrative cases increased by 70 %
(compared with 2012). The rate of resolving civil and commercial cases
decreased from 102 % in 2010 to 95 % in 2013, while the rate in
administrative cases increased from 41 % in 2012 to 64 % in 2013.
Sources: Croatian Ministry of Justice, 2014 EU Justice Scoreboard, CEPEJ Study.
[58] According to the 2013 SBA Fact Sheet on Croatia, the time and costs
required to close a business are approximately 50 % higher than the EU
average, and the degree of support for a second chance for honest entrepreneurs
trails the EU average by 10 percentage points.
[59] The real estate sector is excluded because of statistical difficulties
of estimating a mark-up in this sector. The sector renting of machinery and equipment
and other business activities is conceptually part of intermediate goods
sector.