on the impact of taxes and spending on poverty. This is important, as a system could reduce inequality but still lead to greater poverty levels.

This paper aims to move a step in this direction by presenting a more comprehensive analysis of the distributional impact of taxes and social spending in Croatia. Building on existing work, the analysis covers the impact of the contributory pension system, direct taxes and transfers. In contrast to previous studies, this work also includes the impact of value added and excise taxes, as well as the impact of education and health spending. The analysis assesses the progressiveness of each fiscal instrument and its contribution to poverty and inequality reduction. The approach follows the Commitment to Equity (CEQ) approach (Lustig, 2017), allowing for comparisons between Croatia with other countries where the CEQ methodology has been applied.<sup>3</sup> The results suggest that the existing system leads to higher levels of poverty, mostly on account of indirect taxes. In fact, only the poorest 10 percent of the population receive more in benefits than what they pay in taxes. Starting from a relatively low level of market income inequality, the Croatian direct tax and transfer system is redistributive, with progressive and inequality-reducing direct taxes and transfers, in line with other European countries, and more so than other developing countries. However, indirect taxes are regressive and inequality-increasing, so much so that the redistributive power of direct taxes and transfers is offset. With regards to in-kind transfers, when the value of education and health are included in the analysis, there is an important redistributive effect, mostly on account of primary education.

In terms of the recent changes to taxes implemented, the analysis finds that both direct and indirect taxes became more progressive in 2017 compared to 2014. However, since most of the tax relief accrued to the top of the income distribution, the redistributive impact of personal income taxes and social security contributions was reduced. As a result, inequality after taxes and transfers is expected to increase slightly in 2017 compared to 2014. However, when it comes to poverty, the impact of a lower VAT on electricity and utility bills is expected to be poverty reducing, however this effect is small relative to the relief that is needed. Finally, a simulation of a reduction in the standard VAT rate from 25 to 24 percent is presented, yielding a small decline in inequality and a 0.21 percentage point decline in relative poverty at a cost of about 0.41 percent of GDP. Depending on the sources of financing for such a measure, this impact may be much smaller.

The analysis is built on 2014 household surveys collected by the Croatian Bureau of Statistics, data from National Income Accounts, and public finance accounts from the Ministry of Finance, Ministry of Health and Ministry of Science and Education. In terms of coverage of components of fiscal policy, the analysis includes 50 percent of tax revenue and 49 percent of government spending. The analysis does not cover the corporate profit tax or VAT paid by government or other institutions as these are difficult to assign to individual households based on the available information. On the spending side, the analysis only covers social spending, as it is very difficult

> 3 For more details, see <u>http://www.commitmentoequity.org.</u>

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