# **I. Introduction**

Croatia is committed to a fiscal consolidation agenda in the context of its National Reform Program, aimed at achieving sustainable economic growth, increased employment, and the reduction of macroeconomic imbalances. As part of that effort, the government has recently designed and begun to implement a set of tax reforms and aims to align the education sector with labor market needs, improve the sustainability of the health care and pension systems, and improve the efficiency of the social benefit system, with the goal of reducing the number of persons at risk of poverty and social exclusion (National Reform Plan, 2017).<sup>2</sup> Given the potential tradeoffs in terms of meeting fiscal consolidation and social inclusion goals, comprehensive empirical analysis of the distributional impact of changes in taxes and social spending can help to inform policy by ensuring that the combination of policies recently implemented and policies being envisaged achieve the goals laid out by the government.

In this context, work on the role of fiscal policy in Croatia has recently expanded significantly. Early work using 2007 data highlighted the relatively high pre-fiscal income inequality in Croatia and despite the relatively large redistributive effect of the policies, these were still less redistributive compared to Slovenia (Čok et al., 2012). In particular, earlier work using data for 2010 emphasized the fact that horizontal inequities arising from the benefit system dampened to some extent the redistributive role of fiscal policy (Urban 2014 and 2016). More recent work has been done in the context of a broader effort to build microsimulation models in the EU through EUROMOD (Urban and Bezeredi, 2016). This analysis includes the distributional impact of changes in subsistence and means tested benefits undertaken in 2014, as well as changes in personal income taxes in 2015. The results suggest that these policies led to an overall increase in average household disposable income, driven by changes in the increase in personal income tax allowances. Nevertheless, the main beneficiaries were people located in the upper and middle part of the income distribution (Urban and Bezeredi, 2016). Similarly, analysis of subsequent changes that entered into force in 2017 found only slight increases in disposable income in the middle of the distribution, while most of the gain was concentrated in the top two deciles. As a result, both the 2015 and the 2017 reforms somewhat increased income inequality (European Commission, 2017).

However, the existing analysis has so far not included the redistributive effects of indirect taxation, despite the fact that it makes up about half of total tax collections and imposes a relatively large burden on the population. In addition, most studies do not include the impact of spending on education and health, despite the fact that they make up more than 40 percent of total social spending, and are at the root of the National Reform Plan. Finally, existing studies have not focused

> 2 Croatia has recently exited the Excessive Deficit Procedure as a result of its fiscal consolidation efforts. See: <u>http://europa.eu/rapid/press-release_MEMO-17-1339_en.htm.</u>

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