# **1. Introduction**

**Despite the progress achieved since independence, in large part due to the pull of EU accession negotiations, the income gap with the wealthier EU members remains sizeable.** Income per capita has been converging towards the OECD and the EU average, with the income gap narrowing from 28 percent to 39 percent of the OECD average between 1993 and 2006 or 46 to 63 percent (at GDP PPS) of the EU27 average between 1995 and 2008.

**In order to sustain growth and improve competitiveness, a second generation of reforms has been launched to help the country’s successful integration in EU and global markets.** A cornerstone of this reform agenda is the implementation of product market policies that are less restrictive of competition, in order to enable firms to put resources -both capital and labor- to their most efficient use.

**Adoption of pro-competitive product market policies would enhance Croatia’s ability to converge to higher income levels.** In the long run, an economy where competition is restricted will be less productive because its firms will face reduced incentives to be efficient. In this context, Acemoglu et al. (2006) and Aghion and Griffith (2005) note how incentives to enhance productivity are crucially affected by institutions and policies that promote or hinder firm rivalry and entry of new firms. In particular, regulations that promote competition may increase the incentive and lower the cost of incorporating new technologies into the production process, as suggested by neo-Schumpeterian growth theories (Aghion and Howitt, 2005). Along similar lines, Conway et al. (2006) provide empirical evidence of the negative effects of anticompetitive regulations on productivity growth and, in particular, on the convergence to higher productivity levels using sectoral data for OECD countries; Alesina et al. (2005) emphasize the link between pro-competitive regulation and investment, while Bassanini and Ernst (2002) find a connection between anticompetitive regulations and innovation. Ultimately, the consequences of dampened incentives may be particularly severe for economies that are far from the technological frontier, since the ability to absorb new technologies is essential to allow convergence to the levels of more developed economies.

**This paper uses a number of benchmarking tools to assess the extent to which Croatia’s product market policies are restrictive of firm rivalry, entry and exit.** This is done by benchmarking various dimension of the Croatian regulatory framework to a best practices worldwide, and, more specifically across the OECD and the European Union. Various tools are employed for this benchmarking exercise. The first is the OECD indicator of product market regulation (PMR), which offers a structured approach to benchmark the Croatian regulatory environment and will therefore be used as a blueprint to guide the assessment.<sup>1</sup> Complementary sources of information are provided by the World Bank Doing Business indicator, as well as, to the extent possible, by the Croatia Investment Climate Survey (ICS). The paper also includes a benchmarking of Croatia’s regulation in seven network industries (post, electricity, gas, telecoms, air, rail and road transport). This is done by using the OECD ETCR indicator. Regulation in these sectors is relevant, because it has cascade effects on the rest of the economy. Indeed, Conway and Nicoletti (2006) argue that regulation is most invasive in service rather than in manufacturing

1 The approach used relies on a methodology developed by the OECD (Conway, Janod and Nicoletti 2005), and the associated data which is available for all OECD members (2003), Brazil in 2004 (See OECD 2005), Bulgaria in 2006 (See De Rosa, Fay and Ilieva, 2007), Romania in 2006 (See De Rosa, Fay and Pauna, 2007), Ukraine in 2007 (See OECD, 2007), and Albania in 2007 (See De Rosa, Sulko and Uregian 2008). Data for Croatia were collected following the same methodology in late 2007. Comparators include countries at similar levels of income and development, as well as high income EU and OECD countries.

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