Table of Contents Acknowledgements ............................................................................................................................ 4 Overview .............................................................................................................................................. 5 Restoring Macroeconomic Stability................................................................................................13 Fostering Growth and Competitiveness to Create Jobs ..............................................................26 Strengthening Public Administration .............................................................................................43 Tax Policy and Tax Administration .................................................................................................47 Strengthening Public Investment Management and EU Funds Absorption ...............................52 More Sustainable Subnational Government ..................................................................................58 Strengthening Rule of Law and Judicial Efficiency ......................................................................63 Making a Business Friendly Croatia ...............................................................................................68 Strengthening Real Estate Registration .........................................................................................74 Addressing Energy Affordability .....................................................................................................79 Managing Water Resources, Services and Risks to Growth .......................................................84 Competitive Transport as an Engine for Growth ...........................................................................90 Providing Skills for the Future ......................................................................................................100 Pension System Reform ................................................................................................................106 More Effective, Inclusive and Sustainable Health System ......................................................... 110 Social Welfare ................................................................................................................................. 117 Figures Figure 1. Contribution to GDP Growth .........................................................................................................13 Figure 2. Croatia’s Twin Deficits and Debt, percent of GDP .....................................................................13 Figure 3. Growth Accounting (Contribution to Growth, percentage points) ............................................14 Figure 4. Croatia and EU Productivity ..........................................................................................................14 Figure 5. Corporate Sector Debt, percent of GDP .....................................................................................15 Figure 6. Credit Growth, 2008-15 (annual growth rates, percent) ...........................................................15 Figure 7. Unemployment Rate, 2014............................................................................................................16 Figure 8. Labor Market Performance (ages 15+) .......................................................................................16 Figure 9. Real Wages and Value Added Per Worker (2000=100) ...........................................................17 Figure 10. Productivity and Wages, EU and Croatia in 2014 ...................................................................17 Figure 11. Croatia’s Fiscal Performance, 2008-H12015 (percent of GDP) ............................................17 Figure 12. Evolution of Croatia’s Public Debt, 2008-15 (percent of GDP) ..............................................17 Figure 13. Croatia, EU10 and EU15: General Government Debt, Percent of GDP ..............................18 Figure 14. Croatia, EU10 and EU15: Interest Payments, Percent of GDP .............................................18 Figure 15. Public Debt and Sovereign Ratings, 2014 ................................................................................21 Figure 16. Public Debt and Economic Growth, 2008-14 ...........................................................................21 Figure 17. Croatia’s Administration Effectiveness ......................................................................................24 Figure 18. Examples of Cost Savings ..........................................................................................................25 Figure 19. Croatia’s Competitiveness Indicators ........................................................................................25 Figure 20. Export Growth and Change in Market Share, 2006-2015 Q2 ................................................27 Figure 21. Export Market Distribution, Croatia, 2002 vs. 2014 .................................................................27 Figure 22. Intensive and Extensive Margin of Trade, Croatia ..................................................................27 Figure 23. Economic Complexity of the Export Basket, Croatia vs. Peers (2000 –13) ..........................27 Figure 24. Relative Quality Elasticity, Croatia vs. Peers, 2012 ................................................................28 Page | 2 Figure 25. BERD, Percent of GDP................................................................................................................29 Figure 26. R&D Intensity (Medium Firms) ...................................................................................................29 Figure 27. Entry Density and GDP per capita, 2008–12 ...........................................................................30 Figure 28. TFP Change Decomposition by Type, 2008 –12 ......................................................................30 Figure 29. High-Growth Firms’ Rate (%), 2010 ...........................................................................................30 Figure 30. Gazelles’ Rate (%), 2010 ............................................................................................................30 Figure 31. How Far has Croatia Come in the Areas Measured by Doing Business? ...........................34 Figure 32. Croatia’s Employment Outcomes Lag EU28 Averages ..........................................................35 Figure 33. Poor Basic Cognitive Skills .........................................................................................................35 Figure 34. Participation in lifelong learning in Croatia is low .....................................................................35 Figure 35. Percent of Firms Identifying the Problem as the Main Obstacle: Croatia (2013) ................36 Figure 36. Gaps in Risk Capital Financing Undermine the Innovation Ecosystem in Croatia .............37 Figure 37. Venture Capital Investment and Availability in Croatia Relative to GDP Per Capita ..........38 Figure 38. Competitiveness of Transport Infrastructure ............................................................................91 Figure 39. State Transfers to the Transport Sector ....................................................................................91 Figure 40. Road Sector Debt Service Needs for 2016-2025 ....................................................................92 Figure 41. Croatia LPI, Top Performer and Peers ......................................................................................94 Tables Table 1. Croatia: Key Macroeconomic Indicators (Percent of GDP) ..................................................14 Table 2. Public Debt Structure and Dynamics, Percent of GDP ........................................................19 Table 3. Croatia: Disentangling Crisis from Structural Impact ............................................................19 Table 4. Fiscal Developments and Prospects 2011-2017 ..................................................................20 Table 5. Debt-Stabilizing Balance.......................................................................................................22 Table 6. General Government Expenditures by Economic Classification, Percent of GDP ...............22 Table 7. General Government Expenditures by Function (COFOG) in 2013, Percent of GDP .........23 Table 8. Export Market Share and Growth Decomposition, 2006Q1-2014Q3 ...................................26 Table 9. Croatia’s Top Exports and Their Product Complexity Rank .................................................28 Table 10. Exports of Goods and Services, Croatia and Regional Peers, 2014 (US$ billion) .............28 Table 11. Exports Entry and Exit Rates, Croatia and Eastern European Peers, 2008 –11 (%) .........31 Table 12. Key Railway Data for 2014 .................................................................................................93 Page | 3 Acknowledgements This report was prepared under the guidance of Arup Banerji (Regional Director for Operations in European Union Countries) and Carlos Pinerua (Country Manager for Croatia). It is the product of a collaborative process led by Theo Thomas (Lead Economist), Sanja Madzarevic-Sujster (Senior Country Economist), Isfandyar Khan, Christian Bodewig and Jean-Francois Marteau (all Program Leaders), involving staff and consultants of the World Bank. The following country team members have made significant contributions to this report: Jeremie Amoroso (Consultant), Zoran Anusic (Senior Economist), Aneesa Arur (Senior Public Health Specialist), Blanka Babic (Consultant), Roberta Malee Bassett (Senior Education Specialist), Nataliya Biletska (Public Sector Specialist), Marcelo Bortman (Senior Public Health Specialist), Ana Cestari (Senior Water Resources Specialist), Fernando Dancausa (Financial Sector Specialist), Ivan Drabek (Senior Operations Officer), Jonas Arp Fallov (Senior Public Sector Specialist), Stjepan Gabric (Senior Water and Sanitation Specialist), Iva Hamel, (Senior Private Sector Development Specialist), Georgia Harley (Public Sector Specialist), Mariana Iootty De Paiva Dias (Senior Economist), Caterina Ruggeri Laderchi (Senior Economist),Sanja Madzarevic-Sujster (Senior Country Economist), Moritz Meyer (Economist), David Michaud (Senior Water and Sanitation Specialist), Ismail Radwan (Lead Public Sector Management Specialist), Suzana Petrovic (Consultant), Ljiljana Tarade (Operations Officer), Emil Daniel Tesliuc (Senior Economist), Mika-Petteri Torhonen (Lead Land Administration Specialist), and Winston Yu (Senior Water Resources Specialist). The team benefitted from the comments of Ivailo Izvorski (Practice Manager), Andrea Kucey (Country Program Coordinator), Marina Wes (Country Manager for Poland and Baltics) and Doerte Doemeland (Lead Economist). Disclaimer: This volume is a product of the staff of the International Bank for Reconstruction and Development (the World Bank) of the World Bank Group. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of the World Bank or the governments that they represent. The World Bank does not guarantee the accuracy of the data included in this work. Page | 4 Overview Croatia returned to positive growth in 2015 after more than half a decade of recession, but the structural weaknesses exposed by the financial crisis have yet to be fully addressed. Since 2008, Croatia has witnessed six years of recession, with GDP declining by 13 percent and unemployment doubling to over 17 percent, with youth unemployment reaching 50 percent, and poverty rates rising. The fiscal deficit averaged around six percent of GDP, with public debt more than doubling to 85 percent of GDP by 2014, exposing a large structural deficit due to persistent spending rigidities. Corporate sector debt remains relatively high and the banking sector continues to deleverage and constrain credit, weighed down by declining profitability and high levels of non- performing loans. Productivity and export performance has been lackluster, characterized by low export diversification, loss of competitiveness, a lack of product sophistication, and limited expansion of new products and new markets. These factors increase Croatia’s vulnerability to shocks and continue to drag on growth. Croatia’s prospects for reinvigorating inclusive growth are limited without further reforms to restore macroeconomic stability, boost productivity, invest in people and modernize public services. Croatia’s immediate economic challenges include restoring macroeconomic stability, while promoting private sector productivity and competitiveness to create jobs and growth. Restoring macroeconomic stability will help provide a more stable basis for investment, while freeing the private sector from constraints will help promote productivity and ease the burden of high rates of unemployment. Beyond the short term, Croatia’s projected population decline and aging present significant risk to growth and convergence of living standard with its West European neighbors as well as to fiscal sustainability. The policy response centers around investing in people to raise skills and promote healthy aging so as to prepare Croatians for longer and more productive working lives, while modernizing and rationalizing the social protection system. There is also a need to continue to upgrade public services, key institutions like the judiciary and the governance of state owned institutions, and infrastructure to better support the needs of people and firms. This note explores policy areas to support the objective of restoring macroeconomic stability, competitiveness and inclusion. It identifies policy options that can inform debate and enhance the reform process in these areas. More detailed analysis and reform options are contained in the supporting overview of macroeconomic and competitiveness issues and a series of Policy Notes on individual areas1. Restoring Macroeconomic Stability Despite the gradual recovery, large financial, social and fiscal vulnerabilities remain. Stagnant growth, the poor performance of firms and the high rates of unemployment are rooted in the current structure of the economy and its inability to adjust since the crisis. While growth rates turned positive in 2015, ending a six year recession, the medium-term outlook remains subdued with potential growth estimated at around 1 percent. The quality of bank’s loan portfolios has deteriorated, with a high level of non-performing loans (NPLs of 17 percent in September 2015), profitability has declined and the private sector continues to deleverage rather than invest. While EU integration helped the recovery of exports, competitiveness levels are low, and rigid labor markets hold back job creation and progress in addressing inactivity and unemployment—the main causes of the recent rise in poverty—remains slow. Croatia is facing twin challenges of bringing down the budget deficit, and reversing the growth of public debt, while creating fiscal space needed to utilize large EU funds . Only a portion of the fiscal deterioration is caused by the crisis, while the majority is of a structural nature, with the structural deficit running at 4 percent of GDP. With the current level of debt, assumed growth for 2016, inflation and interest rates on sovereign debt, the fiscal balance required to stabilize the level of debt would be 1.8 percent of GDP, equivalent to turning the 1.1 percent of GDP primary deficit in 2015 into a surplus of 2 percent of GDP. This will require an increase in revenues and/or a reduction in primary expenditures of 3.1 percentage points of GDP, in addition to expenditure switching to make use of substantial EU funds for growth enhancing investment. While the adjustment is urgent (and many countries have successfully undertaken such adjustments), so as not to deepen vulnerabilities and 1 Options for sector reforms are discussed in more detail in later sections and in individual Policy Notes. Page | 5 risks of higher borrowing costs, the strategy needs to balance between a credible consolidation path and the potential impact on depressing growth 2. Publication of a credible medium-term fiscal adjustment plan designed to restore growth and public debt sustainability could help to bolster public and market confidence in Croatia’s prospects. While it is important to manage the speed of adjustment, the burden should largely fall on less productive public expenditures. Strengthening the financial sector to reinvigorate lending growth faces challenges. Despite the decline in profitability and high levels of NPLs the banking sector appears well supervised and capitalized, with perhaps only smaller banks requiring special attention from the regulator. Nonetheless, it is important to expedite the resolution of NPLs by strengthening the pre-bankruptcy settlements system, introduced in October 2012, and insolvency practices. This will enable lending to resume. In addition, completing the regulatory framework and promoting venture capital could provide much needed finance for high growth small and medium enterprises. Reducing the disincentives to work and rigidity of labor markets would help address high and chronic unemployment. Not all of the recent rise in unemployment is of a temporary/cyclical nature. Croatia’s labor market continues to suffer from significant rigidities despite a recent reform to the labor legislation. High relative labor costs explain in part the very high job destruction rates since 2008 . Labor force participation (15 years+), at 52.4 percent in 2014, was also among the lowest in the EU and is strongly linked to low household income and vulnerability to poverty. Policy options to help to reduce disincentives to work and to better align wages with productivity include reducing the high levels of tax of labor and smoothing the rate at which benefits are withdrawn for low wage earners. Consideration could be given to the introduction of a single contract to overcome labor market segmentation between those on temporary and permanent contracts, while the recently revised labor law could be further simplified. In addition, equalizing the expected benefits of public and private sector employment could reduce rigidity that is also, in part, driven by public sector collective wage agreements. Addressing fiscal vulnerabilities and existing social challenges requires faster implementation of structural reforms that underpin private sector growth and job creation. Current revenue and spending patterns offer significant scope for rationalization—particularly in areas where spending is relatively high and/or inefficient, such as subsidies, public wages, and public consumption3— suggesting that an adjustment of 4-5 percentage points of GDP could be implemented over the medium term. Revenue measures could raise 2 percent of GDP through reductions in exemptions, the introduction of a modern property tax, as well as strengthening tax collection. More fiscal space can be created by rationalizing the wage bill, subsidies, procurement, as well as improving the effectiveness and equity of social spending. Undertaking a new series of transparent spending reviews could help the government develop and commit to a clear strategic vision for fiscal consolidation that identifies specific savings and spending options that also meet national priorities. More effective use of EU funds also requires additional fiscal space and expenditure switching, averaging up to 1.8 percent of GDP a year in 2014-2020 (for transfers to the EU budget, pre- and co-financing of projects), but would release much more in available grants for investment. Improving the strategic planning, effectiveness of the administration and the governance of SOEs would support the adjustment and improve competitiveness. Strengthening the public administration in particular in terms of corruption, the rule of law, regulatory quality, and government effectiveness would address some of the main barriers for doing business as well as enhancing the performance of public services and the effectiveness of investment of EU and national funds. In addition, there is scope to reduce fragmentation and overlap between the central and local authorities, introduce a new model of decentralization and rationalize state agencies, and improve State Owned Enterprises (SOEs) governance—the latter is an ongoing source of inefficiency and boosted public debt as many contingent liabilities have been realized or are at risk of being called. Fostering Productivity and Competitiveness to Create Jobs Croatia is facing a prolonged period of sluggish growth where uninspiring export performance is reinforced by low levels of productivity, firm level creative destruction and innovation. Croatia needs to promote more productivity-based innovation-driven growth. One of the most 2 These trade-offs are considered in the Excessive Deficit program (EDP) agreed between the EU and Croatia, which includes an annual adjustment plan 3 Options for sector reforms are discussed in more detail in later sections and in individual Policy Notes. Page | 6 promising signals for the country’s export competitiveness outlook stems from a fringe of dynamic small exporters in innovative niche sectors. Supporting such a strategy, based on employment and productivity increases, exports and innovation, implies investing into innovative SMEs and accompanying human capital. By creating new goods, or upgrading existing ones, implementing new processes or introducing new market strategies these firms can play a key role for lifting Croatia out of recession and back into sustained growth and full employment. Accelerating structural reforms to improve the investment climate would boost competitiveness and prospects for recovery of growth and jobs . These include an unfriendly business environment, limited competition in product markets, a lack of early stage financing and worker skills deficits. Despite the reform efforts in the last years Croatia’s business environment still suffers from major institutional shortcomings, as highlighted by a number of international reviews4. In addition, the lack of early stage financing prevents innovative ideas with commercial potential from reaching the market, which reinforces the vicious cycle of reduced renewal process in the economy. A significant share of Croatian youth leave the education system with poor cognitive foundation skills such as in reading and mathematics, which leaves them ill-equipped for the demands of a competitive, innovation-driven economy. At the same time, the share of Croatian workers participating in lifelong learning activities is one of the lowest in the EU. The Government should continue reforming the business registration. It can eliminate outdated requirements through legal amendments, merging and streamlining the registration processes of multiple departments and agencies, and making all registration processes (including post- incorporation) electronic. Reforms that make regulation more efficient and transparent can also help reduce corruption and informality, which are major costs for businesses. Liberalizing the service sector, in particular professional and business services, is strongly supportive of growing firms as would the full implementation of the new spatial planning and construction permitting system. In the area of construction permits, authorities’ focus should be on enforcing the new laws, ensuring safety standards that protect the public while making the permitting process efficient, transparent and affordable for both building authorities and the private professionals who use it. Further, integration into the EU internal market should help boost productivity. Services account for a large share of GDP and employment, but are also critical as inputs into other sectors, including manufacturing, thus playing a pivotal role in economy-wide productivity. High-quality, low-cost services can boost firm productivity and enhance overall competitiveness. A strong service sector is vital to diversifying and expanding a country’s exports since exporting firms tend to be more productive. Meanwhile, service imports can serve as an important channel for introducing new technologies, boosting exports and helping countries to integrate into global value chains. 5. However, regulation in network and professional services remains particularly rigid in Croatia, compared to the rest of EU and could be made more flexible and streamlined. Enhancing the performance of courts would support firms’ investments and business transactions. Despite recent reforms, the court system still exhibits large inefficiencies as seen through the backlog of cases, large budget allocated for delayed rulings or a comparatively large number of cases rejected by higher courts. Improvements in court efficiency are associated with a lower share of the informal sector in the overall economic activity, increased investor confidence and increased bank financing of firms for new investment. Further efforts could be made to reduce the time needed for enforcement procedures by strengthening the use and capacity of alternative resolution bodies, like Financial Agency (FINA), which can directly execute court judgments and court settlements on debtors’ bank accounts. Moreover, Croatia approved significant amendments to the Civil Procedure Act in 2013 to streamline the way the litigation process is administered, including the way litigants submit evidence. Preparing for Demographic Decline and Aging by Investing in People Croatia can mitigate risks to economic growth and fiscal sustainability resulting from population decline and aging through policies that equip its people for longer and more productive working lives and that modernize education, health and social protection systems. Government efforts to protect social assistance benefits and old-age pensions during the crisis have 4 2016 Doing Business Report, the 2014-15 Global Competitiveness Report of the World Economic Forum and the OECD product market regulation Index. 5 http://www.oecd.org/sti/ind/global-value-chains.htm Page | 7 partially mitigated the impact on poverty and shared prosperity. However, the population is aging rapidly and shrinking, resulting in an increase in the old age dependency ratio. Ensuring that workers productivity rises in this environment requires investment in people’s skills, health and incentives to work for longer. Given the demographic outlook, policies to activate the socially excluded will have a positive economic and social effect. On the other hand, without further reforms, the changing demographics will also put increasing pressure on the budget, with fewer actively contributing workers and larger claims on pension, health and long-term care. Croatia needs to skill up its current and future workforce to cope with rapid technological change and aging population. In addition to expanding employment by increasing the employment rate and the working life of individuals, productivity gains are central to addressing demographic decline and aging. Youth have been particularly affected by the lack of economic growth, with unemployment rates of around 50 percent, limited job prospects, and a skills mismatch. Croatia is one of the EU countries where high shares of 15 year-olds who score poorly in mathematics in the Program for International Student Assessment (PISA) goes hand in hand with high rates of youth who are neither in employment, education or training (NEET). This combination of poor basic skills and idleness risks undermining the next generation’s preparedness for the longer and more productive working lives called for by the aging challenge. Despite recent education reforms, increasing emphasis needs to be placed on improving the quality of general education, lifelong learning programs, and adult education to ensure a competitive and adaptive workforce. Better labor market information on job trends and skills would strengthen labor market outcomes while apprenticeships, reskilling programs, and lifelong learning programs would address high youth unemployment. Croatia can do more to improve health outcomes for all, while containing pressures on spending driven by an aging population and new technologies. While Croatia enjoys relatively good and improving health outcomes, socio-economic and geographic disparities remain wide. Chronic and non-communicable diseases dominate the burden of disease and are projected to rise with rapid population aging. To counteract these trends, hospital service delivery models could be rationalized, and the functioning of primary and preventive care improved, to provide more cost- effective care. A significant portion of long-term care for the elderly is also provided at high cost by hospitals and could be more suitably and cost-effectively provided in other most appropriate settings. Other measures to contain costs and reduce persistent arrears include centralizing procurement systems, notably for drugs, implementing clinical guidelines and pathways, and better linking payments to hospitals and primary care facilities to performance and quality, and developing more transparent systems for monitoring and accountability. Without further reform Croatia’s pension system is fiscally and socially unsustainable in the long run. Croatia’s pension system has seen significant change since the introduction of a multi-pillar design in 1998, although ad-hoc interventions in recent years have led to larger expenditures than expected for the pay-as-you-go (PAYG) pillar, a relaxation of early retirement rules, more generous indexation and rising concerns over fiscal affordability going forward, in addition to substantial equity and adequacy challenges, including as a result of low coverage. Pension reform therefore remains an unfinished agenda, with the need for reforms including tightening early retirement windows, raising the retirement age faster, and stimulating elderly activity (as participation rates remain low). Consideration also needs to be given to awarding pension credits on the basis of contributions, reducing the minimum pension per year of service or means testing it, and accelerating the convergence of the privileged pensions to the general PAYG rules. Overall, these policies need to address both fiscal and equity aspects of pension reform. Consolidating and rationalizing the social protection system would help ensure it is affordable and to better target support to the poor and vulnerable. Croatia’s generous and complex social welfare system is overly reliant on categorical rather than poverty-focused benefits. In order to improve its ability to tackle poverty and promote active inclusion while reducing spending, Croatia has embarked on a critical reform to consolidate the number of social benefit programs and increase the share of spending on poverty-focused programs, including through greater use of means-testing. This would include transferring the administration of the means-tested Guaranteed Minimum Benefit (GMB) into the One Stop Shop (OSS) benefit administration, followed by child allowance, non- contributory maternity/paternity allowances, unemployment benefit, and other social benefits in subsequent years as well as introducing the means-testing for these programs. This would also enhance Croatia’s ability to reduce errors, fraud and corruption in social benefits as well as enhance Page | 8 the screening of new entrants. Lastly, further reducing institutionalized care is more effective and cheaper, especially for child services, for example through community based services. Improving Government, Public Services and Strengthening the Judiciary There is considerable scope to strengthen the efficiency and responsiveness of government, despite the need for fiscal consolidation. Croatia spends more on public services than most EU countries, but performs poorly in indicators of public administration effectiveness, rule of law and administrative barriers to doing business. This presents both a challenge and an opportunity, and will require a transparent strategy that is communicated to all stakeholders to improve the public sector’s performance while managing the fiscal consolidation over the medium-term. Transparently communicating and monitoring of performance should help to bolster support for, and the credibility of, reforms during the transition, and inform the design of any adjustments. The public sector wage bill could be reduced to more sustainable levels, while continuing to deliver, or even improve, public services. The public wage bill, at close to 12 percent of GDP, is already high and could continue to rise with proposed measures for further decentralization, the creation of new agencies, and the need to build additional capacity to absorb sizeable EU funds. However, it is estimated that some 2 percent of GDP could be saved over the medium term through staff rationalization in local/regional and national governments to create a leaner, but more effective administration. Improving the flexibility and performance components of public sector pay agreements—through more merit and performance based pay, recruitment and management systems—would help to align wages to productivity and equalize wages with the private sector. This also requires measures to improve the efficiency, effectiveness, and responsiveness of public institutions. It includes building institutional capacity to manage and coordinate increasingly complex policy issues more efficiently, particularly those related to EU membership. In addition to the sector reforms highlighted above, this includes the professionalization of public institutions, through the depoliticizing of appointments (including in state owned enterprises, SOEs), rationalizing agencies and SOEs across all levels of government, and strengthening strategic planning, M&E and reporting systems. There are also significant opportunities to offer more efficient and responsive services to citizens and businesses through the expansion of e-services. Croatia’s tax system could be more efficient, equitable, and supportive of labor and business. The objective is to build an efficient tax system that raises sufficient revenue in a way that is fair, minimizes distortions, has low compliance costs, and promotes job creation. However, Croatia’s relatively high tax burden falls disproportionately on indirect and labor taxes, while the shadow economy remains large and paying taxes is burdensome. Additional revenue could come from the introduction of a modern property tax—generating revenues of up to 1.5 percent of GDP and abolishing outdated local real estate-related taxes and fees—and eliminating the large number of ineffective tax exemptions given to households and businesses—saving up to 1.1 percent of GDP. Tax policy and administration measures should also incorporate more of the large shadow economy while continued modernization of the tax administration is needed to protect and expand the revenue base, including the implementation of a modern compliance risk management system, and reduce compliance costs for citizens and businesses. Improving Public Investment Management (PIM) would help boost economic growth and competitiveness. Strengthening PIM planning, contracting, and implementation capacity, along with improvements to the strategic planning and medium term budgetary framework (MTBF), can improve the efficiency of public infrastructure and unlock substantial EU funds. Creating the required fiscal space for new investments (and co-financing), through expenditure switching, needs to be combined with greater coordination and alignment between national priorities and EU policies. Strengthening strategic planning, regulation, implementation and monitoring processes could help to better utilize Croatia’s own funds as well as around €10.7 billion of EU funds over the 2014-2020 financial perspective (equivalent to an average of 3.7 percent of today’s GDP per year). For example, the National Transport Development Strategy, once finalized, should provide the overall direction and should be complemented by clear medium-term implementation plans for investment and management of the sector, with central administration guiding the various agencies (e.g. in road, rail and ports) as well as guiding the utilization of EU funds and its coherence with other funding sources. Consolidating and rationalizing local government should improve services for citizens . Large cities provide most decentralized public services, although there are also many small counties and Page | 9 municipalities, and overall subnational government is too fragmented, with overlapping responsibilities and relatively limited taxing powers, and over half of spending going for wages and maintenance. Clarifying responsibilities, amending the revenue collection powers and consolidating subnational government, through a combination of merging units and/or greater use of shared services, would help to avoid duplication and would be the basis for strengthening subnational administrative capacity to improve service delivery and investment, particularly of EU funds. Consolidation of water utilities is an example of such actions. Improving trust and confidence in the court system would also help overcome one of the largest barriers to business, investment and growth. Building on recent reforms, improvements in the quality and speed of court judgements would signal a change to the general public and businesses. This would include further modernization and automation to increase the courts' online services and boost responsiveness for both users and government, in addition to reducing costs through more active caseload management between courts to reduce the backlog, and the consolidation of management functions at hubs in the network (e.g. finance, procurement, maintenance, statistics etc.). Clearer and stricter rules on ethical standards, along with more training and mainstreaming of rules into daily practice, and the clear sanctioning and control in courts and prosecution offices, would enhance the predictability and transparency of the court system as well as enabling greater use of EU funds to upgrade facilities and capacity. Policy Options This report seeks to identify potential policy options that can inform debate and enhance the reform process in Croatia. Some of the overarching policy options for Croatia, along the lines discussed above, are summarized in the table below. These are not designed to be an exhaustive list of potential reforms, but seek to identify possible priorities and inform the debate around the reform process. This is followed by a series of more in-depth Policy Notes, which provide additional analysis along with policy and implementation options in areas where the World Bank often has experience in supporting countries with their reform programs. The subsequent table loosely maps the specific Policy Notes to the four main policy reform areas identified above, although many of the areas are interlinked and often complementary to a number of Policy Notes in practice. Page | 10 Summary of Policy Options SHORT-TERM MEASURES MEDIUM-TERM MEASURES Restoring Macroeconomic Stability  Introduce a credible medium-term fiscal  Make fiscal discipline, budget transparency, and consolidation plan to reverse growth of public streamlined budget planning priorities debt and restore confidence in fiscal  Ensure that the medium-term budget plan sustainability maximizes the use of EU funds for priority  Implement transparent spending reviews to investments develop clear strategic vision for fiscal  Introduce a modern property tax and eliminate consolidation that meets national priorities ineffective tax exemptions  Ensure the fiscal rule is enforced  Publish and implement plans to restructure  Reform the wage system to reduce the public SOEs (transport, energy, utilities etc.) wage bill  Contain costs of SOEs and review subsidies (and limit contingent liabilities) Fostering Productivity and Competitiveness to Create Jobs  Reduce high levels of labor taxation and reduce  Complete regulatory framework and promote tax/benefit wedge for low wage earners venture capital for SMEs  Continue reforming business registration,  Create an administrative agency from the merging and streamlining registration merger of land registry offices and the cadaster. processes, making all electronic.  Continue to make regulation more efficient,  Strengthen the use and capacity of alternative smart and transparent to help reduce red tape, dispute resolution bodies (e.g. FINA) corruption and informality  Expedite resolution of NPLs by strengthening  Consider introducing a single labor contract to pre-bankruptcy and insolvency settlements reduce labor market segmentation Preparing for Demographic Decline and Aging by Investing in People  Clear the stock of health sector arrears, with  Improve the quality and inclusiveness of measures to prevent further arrears preschool and school education and build a  Launch the implementation of the hospital lifelong learning system with appropriate network masterplan, improve hospital financial and regulatory incentives governance and centralize procurement  Reduce the fragmentation in health care,  Transfer administration of the means-tested enhance preventative measures and shift long- Guaranteed Minimum Benefit (GMB) into the term care services from the health to the social One Stop Shop (OSS) benefit administration sector  Introduce means-testing to family and other  Tighten early retirement windows, raise the social benefits retirement age faster, stimulate elderly activity, link credits to contributions, and accelerate convergence of privileged pensions to PAYG  Consolidate other allowances and benefits into the OSS Improving Government, Public Services and Strengthening the Judiciary  Publish clear medium-term strategic and  Depoliticize appointments (inc. SOEs), implementation plans for investment and rationalize agencies and SOEs across all levels management in general and for key sectors of government (water, regulators), strengthen  Improve and streamline public sector collective strategic planning, M&E and reporting systems wage agreements  Strengthen PIM planning, contracting, and  Strengthen strategic planning and medium term implementation capacity, particularly for EU budgetary framework funds  Expand e-services to enhance user- responsiveness, particular for court services  Consolidate and rationalize local government to enhance service delivery Page | 11 Policy Notes Restoring Macroeconomic Stability  Main Note on Restoring Macroeconomic Stability Fostering Productivity and Competitiveness to Create Jobs  Main Note on Fostering growth and Competitiveness to create Jobs  Making a Business Friendly Croatia  Strengthening Real Estate Registration Promoting Inclusive Growth in an Aging Society  Skills for the Future  Social Welfare  More Effective, Inclusive and Sustainable Health System  Pension System Reform  Addressing Energy Affordability Improving Government, Public Services and Strengthening the Judiciary  Strengthening Public Administration  Tax Policy and Tax Administration  Strengthening Public Investment Management and EU Funds Absorption  Competitive Transport as an Engine for Growth  Managing Water Resources, Services and Risks for Growth  More Sustainable Subnational Government  Strengthening Rule of Law and Judicial Efficiency Page | 12 Restoring Macroeconomic Stability 1. Croatia has achieved major development results over the last two decades. Between 1995 and 2008, per capita national income (World Bank Atlas method) more than doubled to $13,960 –making Croatia a high-income country6. During this period Croatia has been fast converging to the EU levels--the average real growth amounted to 4.2 percent, which is 2 percentage points higher than in the EU27. The at-risk-of-poverty rate fell to 19 percent in 2007, while income inequality, measured by the Gini coefficient, at 0.31 made Croatia a country with moderate inequalities. Public debt and fiscal deficit remained low, while inflation declined to low single digit. Important institutional reforms, such as reform of judiciary, regulatory framework, competition policies, supported the transition toward membership of the European Union (EU) that eventually came on July 1, 2013 when it became the 28 th member. These achievements created a sense of optimism about Croatia’s future and the promise of further shared prosperity within the world’s richest economic block. From Boom to Bust 2. However, the 2008 global crisis exposed fundamental weaknesses of the Croatia’s growth model. The economic boom from 2000 to 2008, based on large capital inflows, local credit and real estate growth, created large vulnerabilities. The aggregate demand expansion (Figure 1) supported by large inflow of foreign capital and strong credit growth led to a rise in overall indebtedness. At the same time, the fiscal policy turned pro-cyclical, with government engaging in large public infrastructure and housing projects contributing to further overheating, offsetting largely a restrictive monetary response. Given weak domestic supply, foreign capital created large external imbalances--growing imports worsened the trade balance leading to the widening of savings–investments gap. Croatia’s large current account deficit at close to 9 percent of GDP in 2008 and external debt of above 84 percent of GDP (compared to 52 percent in 2000) (Figure 2) raised immediate concerns in particular after the collapse of the international financial markets in 2008. Figure 2. Croatia’s Twin Deficits and Debt, Figure 1. Contribution to GDP Growth percent of GDP Source: CROSTAT, CNB, World Bank staff calculations. 3. During the boom period, the dominant contribution to growth came from investments, while total factor productivity remained negative (Figure 3). This put Croatia in contrast to peer countries that were in that period converging faster with its productivity well above the level of EU15 countries (Figure 4). Further, with investment ratios high and their small elasticity to growth when compared to the fast-growing economies in the region (especially given its focus on civilian construction), a strategy of expanding potential output based on further capital accumulation did not seem to be realistic. In order to sustain and accelerate growth, Croatia had to shift towards a more productivity-based and export-led growth pattern. Raising productivity of both capital and shrinking labor (given the fast aging population), deepening trade integration and fostering innovation were proposed levers.7 However, Croatia’s response was delayed and lukewarm hoping that adverse global economic conditions were temporary and that the stimulus for a significant share of Croatia’s pre-crisis growth will come back. 6 According to the World Bank classification. 7 World Bank (2009) Croatia’s EU Convergence Report. Page | 13 4. As the large stimulus to growth dried up, Croatia fell into recession. The bust period that followed, led the country into a prolonged recession —one of the longest in the recent economic history in Europe. While the EU accession process helped Croatia’s income, competitiveness and living standards converge toward EU averages8, economic integration and connectivity also meant that the Eurozone recession was quickly transmitted to Croatia. In late 2008, triggered by increasing borrowing costs on financial markets Croatia’s economy went into recession that persisted over the next six years. The cumulative output loss over this period (2009-14) amounted to 13 percent of 2008 GDP. Unemployment doubled by 2013 to 17.3 percent, with youth unemployment reaching 50 percent. Figure 3. Growth Accounting (Contribution to Growth, Figure 4. Croatia and EU Productivity percentage points) Source: CROSTAT, CNB, EUROSTAT, World Bank staff calculations. 5. Fiscal vulnerabilities swiftly deepened as revenues declined and spending rigidity remained unaddressed. Fiscal deficit stood at 6 percent of GDP on average since 2009 resulting in a steady increase in public debt, which more than doubled by 2014 (at over 85 percent of GDP) (Table 1). Structural deficit remained on average at 4 percent of GDP suggesting the root causes are of a structural rather than a temporary/cyclical nature. Further, the growth outlook remained weak within the more competitive, risk adverse post-crisis international environment. Credit agencies took note, reducing Croatia’s sovereign debt to speculative status in 2013. The opportunity cost of not addressing the structural rigidities through fiscal consolidation as well as competitiveness reforms inflated the sovereign risk premium that has by now tripled compared with its peers. The interest payments on Croatia’s sovereign debt amounting to 3.5 percent of GDP—crowds out productive spending. Table 1. Croatia: Key Macroeconomic Indicators (Percent of GDP) Actual Prelim. Indicators 2008 2009 2010 2011 2012 2013 2014 2015 National Accounts Real GDP growth 2.1% -7.4% -1.7% -0.3% -2.2% -1.1% -0.4% 1.7% Total Investment 31.4 25.0 21.4 20.6 19.3 19.1 18.2 18.5 Gross National Savings 22.9 20.4 20.5 20.0 19.4 20.1 19.0 22.5 Foreign Savings 8.8 5.1 1.1 0.7 0.1 -1.0 -0.8 -4.1 Public Sector Revenues 41.9 41.5 41.3 41.0 41.7 42.5 42.6 42.4 Expenditures 44.7 47.3 47.2 48.8 47.1 47.8 48.2 47.1 Interest payments 1.9 2.3 2.5 3.0 3.4 3.5 3.5 3.6 Fiscal Balance -2.7 -5.8 -5.9 -7.8 -5.3 -5.4 -5.6 -4.7 Primary Balance -0.8 -3.5 -3.4 -4.7 -2.0 -1.9 -2.1 -1.1 Balance of Payments Trade Balance -22.4 -16.5 -13.2 -14.3 -14.3 -15.1 -14.8 -14.8 Current Account Balance -8.8 -5.1 -1.1 -0.7 -0.1 1.0 0.8 4.1 FDI 5.5 2.9 2.1 2.6 2.7 1.9 3.0 2.0 Debt Gross External Debt 84.3 101.1 104.2 103.7 103.0 105.6 108.4 106.5 8 In 2014, Croatia stood at 59 percent of GDP per capita in Purchasing Power Standards of EU27, up from 51 percent in 2001, but slipped from 63 percent in 2008. Page | 14 Public Debt 38.9 48.0 57.0 63.7 69.2 80.8 85.1 87.8 Gross Internat. Reserves (months of GNFS imports) 4.9 7.2 7.5 7.3 7.5 8.4 8.0 8.0 Memo items: GDP (EUR millions) 48,135 45,093 45,022 44,737 43,959 43,516 43,045 44,035 GDP (US$ millions) 70,482 62,703 59,680 62,250 56,486 57,770 57,114 48,885 Inflation (p.a. %) 6.1 2.4 0.9 2.2 3.4 2.2 -0.2 -0.5 Debt service to export ratio 32.1 64.8 68.2 66.1 63.6 51.4 52.9 51.0 Exchange rate HRK:US$ (p.a.) 4.93 5.28 5.50 5.34 5.85 5.70 5.75 6.86 Source: CROSTAT, MoF, CNB, World Bank. 6. Croatia returned to growth in early 2015, although large financial, social and fiscal vulnerabilities remain. By September 2015, real GDP reached an annual rate of 1.5 percent - the highest since the end of 2008, supported by external demand and personal consumption. Credit crunch during recession affected loan portfolio quality leading to high level of non-performing loans (at over 17 percent in September 2015) and reducing credit institutions’ profitability, as well as their risk appetite to invest in Croatia. While integration to the EU helped with the recovery of exports, still weak competitiveness, private sector deleveraging (Figure 5) and rigid labor markets hold back the stronger recovery of private sector and jobs. Progress in addressing inactivity and unemployment as the main causes of the recent rise in poverty remains slow. Addressing fiscal vulnerabilities and existing social challenges requires faster implementation of structural reforms that would underpin private sector growth and job creation. Increased Financial Sector Vulnerability 7. Throughout the period, monetary policy continued to operate a tightly managed kuna/euro exchange rate with little volatility, but without a formal peg to the euro. In light of the high degree of euroisation of deposits and loans (more than two-thirds), exchange rate policy options remain limited. However, monetary policy was able to maintain an accommodating position throughout the recession, by ensuring financial system stability and addressing liquidity concerns swiftly through the active use of regulatory requirements and FX interventions. 8. Unlike some European countries, Croatia went through the prolonged recession with a relatively stable banking system. Much of the credit goes to the macro-prudential measures taken during the pre-crisis years that aimed to prevent overheating led by abundant foreign capital inflow. Croatia’s banks had faced comparatively larger reserve requirements rates (including the marginal rate on foreign exchange capital flows) as well as larger requirements on the capital adequacy than its European peers. Although this had to some extent prevented massive credit growth (domestic credits rising by 12 percent annually during the pre-crisis period), still the non-financial corporations debt to GDP ratio grew to 72 percent in 2008 well above average for EU10 and only behind Bulgaria and Estonia (Figure 5). Due to decreased aggregate demand and real estate boom reversal, credit activity came to an abrupt halt at the beginning of 2009. With the exception of 2010, deleveraging trend of domestic sectors persisted until late 2015 (Figure 6). Figure 6. Credit Growth, 2008-15 (annual growth Figure 5. Corporate Sector Debt, percent of GDP rates, percent) Source: CNB, EUROSTAT, World Bank staff calculations. 9. The deleveraging was accompanied by a worsening loan portfolio quality. The share of non- performing loans (NPLs) to total loans increased from 4.9 percent in 2008 to 17.1 percent in September 2015 led by the corporate sector NPLs which quadrupled to 31.1 percent in 2015. The household sector NPLs stayed moderate at 12.1 percent. The resolution of NPLs through pre-bankruptcy settlements, Page | 15 introduced in October 2012, has so far been modest, as companies that entered the procedure had been operating at a loss for an extended period. 10. Profitability indicators in 2014 reached their lowest level since 1998. The only exception was 2013 when preparations for the asset quality review and changes to the regulatory framework took place. Due to the growth in NPLs, provisioning surged from 48.7 percent in 2008 to 53 percent in June 2015. In addition to declining loan quality and high level of provisions, bank profitability declined also due to the banks’ lending focus on lower-yield government financing. Consequently, return on average asset and return on average equity fell to 0.5 percent and 2.8 percent in 2014, respectively, compared to 1.6 percent and 9.9 percent in 2008. 11. Despite decreasing profitability, the banking sector still demonstrates a satisfactory capacity to absorb potential losses. The average capital adequacy ratio (CAR) for the system reached 21.8 percent in 2014 (compared to 15.2 percent in 2008), the region’s highest. The stress test for the banking sector for 2015 and 2016, conducted by the Croatian National Bank in July 2015, indicates that banks are capable of withstanding highly unlikely but plausible shocks. Under the shock scenario, a deterioration of the corporate portfolio quality would generate increase in total NPLs to 24.5 percent by 2016, with banks’ earnings declining further in 2015 and 2016. The capitalization of the system would remain above 15 percent on average. Nevertheless, small banks in particular would show some weaknesses, which indicates the need for special attention from the regulator or would require further banking sector consolidation. 12. The ongoing consolidation of the banking sector9 is expected to proceed further during 2016. This would be further motivated by the impact of the September 2015 law to convert all CHF-loans to EUR-loans addressing 53,000 debtors (or 4 percent of households). The conversion was assessed to result in bank losses of around 2.1 percent of GDP. Additionally, foreign exchange reserves would decline by EUR1 bn or 8 percent, while the capital adequacy would still remain high at 19.7 percent. The process of applying for conversion (that is voluntary) ended in December 2015 and the resulting impact on the banking system is being assessed. High Structural Unemployment and Absolute Poverty 13. The prolonged crisis led to labor market worsening and a rise in poverty. After initial resilience due to labor market support measures, employment contracted sharply with a loss of 230,000 (or 12 percent) jobs since the crisis outbreak. Many companies, especially those trading on the local market, struggled to service debts and there have been notable bankruptcies and job destruction, particularly in manufacturing, construction and trade. The survey-based unemployment rate, the principal determinant of poverty, doubled by 2014 from an average 8.6 percent in 2008 (Figure 7). This has been coupled with labor force withdrawals, particularly among youth. At the same time, the share of long-term unemployment in total unemployment has risen to 58.4 percent. Figure 7. Unemployment Rate, 2014 Figure 8. Labor Market Performance (ages 15+) Source: CBS, World Bank staff calculations. Source: Eurostat, World Bank staff calculations. 14. Six years of recession have undermined poverty reduction gains from 2000s. Real per capita income in 2014 stood 8 percent below its pre-crisis level, while relative poverty rate increased modestly from 18.9 percent in 2008 to 19.4 percent in 2014 as incomes of the high and middle income households declined more significantly. However, the absolute poverty rate measured at US$5 at PPP increased more 9 The number of banks in Croatia shrank from over 50 in 2000 to 28 banks in 2015. Page | 16 severely from 5.9 in 2009 to 9.8 percent in 2014 and is expected to only moderately decline by 2016. This is a high level for the high-income country that Croatia is classified in according its GDP per capita level. 15. However, not all of the rise in unemployment is of a temporary/cyclical nature and will not be resolved by the growth recovery. A high rate of unemployment even during the boom times indicates that the economy has been operating well below its potential. This aspect is important for evaluating the contribution of transitory factors (domestic and external) and of permanent/structural shifts towards more inclusive growth. Labor force participation (15 years+), at 52.4 percent in 2014 (Figure 8), was among the lowest in EU. Low labor force participation (or high inactivity) is a strong determinant of low household income and of vulnerability to poverty in Croatia. This correlation even strengthened after the crisis. Therefore, part of the answer to be sought is how to increase labor participation and job creation. 16. Downward wage rigidity and high relative labor costs explain in part very high job destruction rates Croatia observed since 2008. Wages grew continuously above productivity and adjusted more slowly to the economic contraction (Figure 9) in Croatia than in other EU countries. This wage rigidity is driven by disproportionally large public sector and its collective wage agreements that prevented a faster adjustment to the ‘new normal’ levels of productivity. The unit labor costs (ULC) grew substantially until 2010 followed by high job destruction rate. Despite moderation since 2010, the average wage level (in PPS) in 2014 was still misaligned with the productivity performance and vis-a-vis the EU peers (Figure 10). Figure 9. Real Wages and Value Added Per Worker Figure 10. Productivity and Wages, EU and (2000=100) Croatia in 2014 Source: CBS, World Bank staff calculations. Source: Eurostat, World Bank staff calculations. Worsening Public Finance Sustainability 17. As a heavily euroized economy, there is greater reliance on fiscal policy in the macro policy mix. Yet, the contribution to macro stability from the fiscal policy was largely missing even before the crisis. Over the most of the period since 2000’s fiscal policy was procyclical thus amplifying the boom as well as the recession period that followed. Furthermore, it was misaligned with the monetary policy that acted counter-cyclically thus undermining its stabilization role. Figure 11. Croatia’s Fiscal Performance, 2008-H12015 Figure 12. Evolution of Croatia’s Public Debt, 2008-15 (percent of GDP) (percent of GDP) Source: MoF, EUROSTAT, World Bank staff calculations. 18. Since the crisis onset, Croatia has experienced a swift deterioration of deficit and public debt. Prolonged recession resulted in weakening revenues and rising expenditures, in part because of Page | 17 automatic stabilizer spending, but in a large part due to assumption of contingent liabilities. The fiscal deficit rose from 2.7 percent of GDP in 2008 to 7.8 percent in 2011, out of which 2.4 percent are paid guarantees for public enterprises. Despite some consolidation efforts in 2012 and entering the Excessive Deficit Procedure (EDP) at the beginning of 2014, fiscal deficit remained elevated at close to 5 percent in 2015 (Figure 11). Public debt, excluding state guarantees, escalated, from less than 30 percent of GDP in 2008 to above 85 percent in September 201510. When guarantees were included, total public debt reached 87.4 percent of GDP (Figure 12). 19. While Croatia’s fiscal trends since 2009 have been similar to other EU countries, its public debt and interest payments are now higher than in EU1011 countries. Comparison with EU10 countries is also indicative of Croatia’s rising vulnerabilities. Croatia’s public debt rose much faster than that of EU10 from the lower level in 2009 (Figure 13). Reflecting the rising strain public debt is putting on the budget, interest expenditures also increased significantly and much faster than in EU10. In 2014, interest spending in Croatia was at 3.5 percent of GDP, three-fourths of total capital investments, while EU10 countries on average decreased the interest burden compared to year before (Figure 14). It is indicative that even though Croatia has lower public debt than mature EU economies (EU15), its interest payments are higher. This suggests that Croatia’s public debt generates a comparatively larger pressure on the budget , squeezing other productive expenditures. Figure 13. Croatia, EU10 and EU15: General Government Figure 14. Croatia, EU10 and EU15: Interest Debt, Percent of GDP Payments, Percent of GDP Note: General Government debt, as defined by Maastricht criteria, does not include guaranteed debt. Source: EUROSTAT, MoF, World Bank staff calculations and estimates. 20. These developments are reflected in Croatia’s debt profile and uncomfortably high cost of sovereign borrowing (Figure 14). In late 2012 and early 2013, rating agencies (Moody’s, Standard & Poor’s) downgraded Croatia’s sovereign debt below the investment grade. Croatia’s cost of borrowing rose as sovereign spreads increased from 124 (at end-August 2008) to above 300 basis points in 2013. Also, because of its fiscal position and macro vulnerabilities, Croatia still does not borrow very long-term in sovereign bond markets (mostly 5-10 years). A large share of Croatia’s debt is denominated in foreign currency (Box 1) making it highly sensitive to changes in the exchange rate. Medium-term bonds recently carried a large premium over the German bund of about 300 basis points. Even this premium, however, is higher than of some EU countries with significant fiscal challenges, indicating the precariousness of Croatia’s sovereign borrowing conditions. Finally, Croatia’s sovereign rates clearly and significantly exceed its medium term growth rate under any reasonable scenario, implying unsustainable debt dynamics. Box 1. Structure of the Croatian General Government Debt The largest share of public debt is in long-term securities (above 50 percent), followed by loans and T- bills. A significant share of debt is denominated in foreign currency, where Euro-denominated debt accounts for two thirds of the overall debt (Eurobonds, project loans from international financial institutions, and borrowing in the domestic market through syndicated loans denominated in Euro). The share of the debt with fixed interest rate amounts to around 80 percent . 10As per the ESA2010 methodology. 11EU10 represents EU countries from 2004 and 2007 enlargement without Malta and Cyprus. EU15 includes Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, United Kingdom. Page | 18 Table 2. Public Debt Structure and Dynamics, Percent of GDP 2008 2009 2010 2011 2012 2013 2014 General government gross debt 38.9 48.0 57.0 63.7 69.2 80.8 85.1 1. breakdown by residents - domestic 21.1 26.0 32.5 38.3 41.3 47.4 50.5 - foreign 17.7 22.1 24.5 25.4 27.9 33.3 34.7 2. breakdown by original maturity - short-term (T-bills) 4.4 5.9 6.3 6.2 5.8 7.1 7.6 - long-term 34.6 42.3 50.7 57.6 63.5 73.7 77.6 Change of General government gross debt 1.8 9.2 9.0 6.7 5.5 11.5 4.4 Implicit interest rate 5.6 5.6 5.2 5.4 5.3 5.0 4.3 Contributions to change of general government gross debt: Primary balance 0.8 3.5 3.4 4.7 2.0 1.9 2.1 Snowball effect -0.8 4.3 3.0 2.3 3.8 3.7 3.8 Interest payments 1.9 2.3 2.5 3.0 3.4 3.5 3.5 Growth of nominal GDP -2.7 2.0 0.4 -0.8 0.4 0.2 0.3 Stock-flow adjustment 1.8 1.4 2.6 -0.3 -0.2 6.0 -1.5 Guaranteed debt 3.9 4.0 4.5 2.4 2.6 2.4 2.3 Public debt (including guaranteed debt) 42.8 52.0 61.5 66.1 71.8 83.2 87.5 Source: MoF, CNB, CROSTAT, World Bank staff calculations and estimates. 21. Disentangling the fiscal accounts shows that only a portion of the fiscal deterioration is caused by the crisis, while large part of it is being of a structural nature (Table 3). This means that even if growth rates return to more ‘normal’ long-run averages, fiscal consolidation will still be required. The structural deficit remains high, on average close to 4 percent over the last five years. Therefore, out of the average general government deficit of 6 percent in the 2010-15 period, 60 percent are due to structural fiscal problems. This is important to recognize, as remedies to be applied are those with longer- term effect than those that would cure the short-term crisis impact. Table 3. Croatia: Disentangling Crisis from Structural Impact (in percent of GDP) 2011 2012 2013 2014 2015e Real GDP, % -0.3 -2.2 -1.1 -0.4 1.7 Potential GDP, % 1.0 1.1 3.0 3.9 4.3 Output gap, % of potential GDP -1.3 -3.3 -4.1 -4.3 -2.6 General government balance, % GDP -7.8 -5.3 -5.4 -5.6 -4.7 Primary balance, % GDP -4.7 -2.0 -1.9 -2.1 -1.1 One-off and other temporary measures -2.7 -0.3 -0.2 -0.3 -0.2 o/w debt assumption and repayment -2.5 -0.1 -0.1 -0.3 -0.2 Government gross fixed capital formation, % of GDP 3.5 3.5 3.7 3.7 3.7 Cyclically-adjusted balance -6.7 -4.1 -3.9 -4.3 -3.5 Cyclically-adjusted primary balance -3.7 -0.7 -0.4 -0.8 0.1 Structural balance* -4.0 -3.8 -3.8 -4.0 -3.3 Structural primary balance* -1.0 -0.4 -0.3 -0.5 0.3 *Cyclically-adjusted balance excluding one-off and other temporary measures. Source: EC, Eurostat, WB staff estimates. 22. Under the EDP, the government committed to bring down the fiscal deficit to the Maastricht criterion by 2016. As an EU Member State with excessive deficit, Croatia was put under the EDP. The EDP for Croatia laid out a three-year fiscal consolidation program that would bring fiscal deficit levels down to Maastricht threshold by 2016. A credible and sustainable adjustment path required Croatia to reach a headline general government target deficit of 4.6 percent of GDP in 2014, 3.5 percent of GDP in 2015 and 2.7 percent of GDP in 2016. This was not met. Although, the EC decided not to activate the corrective action procedure against Croatia in June 2015, it pointed out that the ‘level of ambition’ of the Croatian authorities, ‘remains below expectations in a number of areas’, and gave Croatia six co untry-specific recommendations (CSRs) to meet in 2015 and 2016: (i) ensure the permanent correction of the excessive deficit by 2016, including by introducing the reformed property tax; (ii) discourage early retirement by increasing penalties and remove fiscal risks in the health system; Page | 19 (iii) adjust wages to productivity, including by pursuing reform of social benefits and insurance; (iv) reduce fragmentation and overlap between the central and local authorities, introduce a new model of decentralization and rationalize state agencies, and improve State Owned Enterprises (SOEs) governance; (v) reduce para-fiscal fees, remove excessive administrative barriers for service providers, increase efficiency and quality of the judiciary; and (vi) strengthen the pre-settlement and bankruptcy framework and introduce personal bankruptcy procedures. 23. However, the progress has been slow. By December 2015, progress had been made only on a couple of CSRs, including improvement of the SOEs governance framework, reduction of para-fiscal fees and strengthening of corporate and personal bankruptcy frameworks. Also, the Government accepted only one set of recommendations from the Spending Review, which aimed to rationalize the costs of 187 state agencies (saving about HRK1 billion or 0.3 percent of GDP a year). Except agencies, a broad-based spending review process of budget expenditures was looking for a 10-percent spending reduction in public wages, health, tax expenditures and subsidies. 24. The Economic and Fiscal Policy Guidelines for 2016-18 proposed a delay in achieving the EDP targets to 2017. The revenue side measures included tax base broadening, strengthening the efficiency of the tax inspection, and withdrawal of SOEs profits. On the expenditure side, the biggest savings is expected from lower material expenses, the wage bill and the accelerated SOEs’ restructuring. The estimated structural effort amounted to 1.5 percent of GDP in 2015 and 1.2 percent in 2016. As a result, fiscal deficit is projected at 4.7 percent of GDP in 2015, 3.9 percent in 2016, 2.7 percent in 2017 and 2.4 percent in 2018 (Table 4). Public debt is expected to reach 89.8 percent of GDP in 2015 and stabilize only in 2018. Table 4. Fiscal Developments and Prospects 2011-2017 2015 2016 2017 2011 2012 2013 2014 Percent of GDP estimate plan plan Total Revenue 41.0 41.7 42.5 42.6 42.4 41.8 41.3 Direct Taxes 17.8 17.6 17.6 17.9 17.6 17.4 17.4 Indirect Taxes 17.5 18.3 19.0 18.7 18.8 18.2 17.7 Nontax Receipts 5.4 5.0 5.7 5.7 5.7 5.9 5.8 Capital revenues 0.4 0.8 0.2 0.3 0.3 0.3 0.3 Expenditures and Net Lending 48.8 47.1 47.8 48.2 47.1 45.7 44.0 Consumption 7.5 7.3 7.8 8.0 7.6 7.1 6.7 Wage bill 12.4 12.2 12.1 11.8 11.4 10.9 10.4 Interest 3.0 3.4 3.5 3.5 3.6 3.5 3.5 Current Transfers 16.7 17.1 17.5 17.9 17.7 17.3 16.7 Subsidies 2.4 2.2 2.1 2.0 1.8 1.8 1.7 Capital expenditures 6.7 4.8 4.9 5.0 5.0 5.2 5.0 Overall balance -7.8 -5.3 -5.4 -5.6 -4.7 -3.9 -2.7 Primary balance -4.7 -2.0 -1.9 -2.1 -1.1 -0.4 0.8 External financing 6.9 5.8 9.4 5.2 3.1 3.1 1.9 Domestic financing 0.9 -0.4 -4.0 0.7 1.8 1.0 0.9 o/w privatization 0.1 0.0 0.1 0.3 0.2 0.2 0.2 Note: General Government ESA2010, 2016-2017 data show the July 2015 government MTEF. Source: MoF, EUROSTAT, World Bank staff estimates. Risks and Debt Sustainability Analysis 25. Risks of delayed adjustment as well as implementation risks are high. Unless Croatia implements a sustained and sufficient medium-term fiscal adjustment, fiscal and macroeconomic risks could be escalated:  First, the rise of the fiscal deficit and public debt would likely result in a further downgrade of Croatia’s sovereign ratings, raising its relative cost of external borrowing, and squeezing other productive expenditures in the budget. Croatia’s rating is alread y notably worse than that of several EU countries with significant fiscal problems (e.g., Italy, Spain, and Portugal) even if its public debt is lower (Figure 15).  Second, high sovereign costs adversely affect private sector borrowing costs, stifling investments and adding a drag to the overall economic recovery. Page | 20  Third, unchecked increase in public debt resulted in breaching of the 60 percent debt ceiling in Croatia’s budget law as well as the Maastricht debt ceiling, creating a debt “overhang” that constitutes a drag on growth. Research12 has shown that levels of debt that Croatia is already facing are consistent with particularly weak growth performance and rising fiscal and debt risks, especially after the global crisis (Figure 16). Figure 16. Public Debt and Economic Growth, 2008-14 Figure 15. Public Debt and Sovereign Ratings, 2014 Source: Standard & Poor’s Ratings Services, Eurostat, Source: Eurostat, World Bank staff calculations. World Bank staff estimates. Debt Sustainability Analysis and Required Fiscal Adjustment 26. To reverse adverse debt dynamics, Croatia will need to implement more ambitious, sustained fiscal adjustment over the medium term. With the current level of debt (at above 85 percent of GDP), the assumed 2016 growth, inflation and interest rates on sovereign debt, debt-stabilizing fiscal balance should be 1.8 percent of GDP. Or, specifically to prevent further debt growth, the government will need to turn the 1.1 percent of GDP primary deficit in 2015 into a surplus of 2 percent of GDP. This adjustment is equal to a reduction in primary expenditures and/or rise in revenues of 3.1 percentage points of GDP (Table 5). While the adjustment is urgent not to deepen vulnerabilities and risks of much higher borrowing costs, in a lower potential growth environment, an adequate balance needs to be found between credible consolidation and a burden that an over-excessive consolidation may have on depressing growth and growth expectations. The burden of adjustment should largely fall on unproductive public expenditures. 27. There are additional possible risks and shocks that could derail the needed adjustments. Fiscal prudence would consider the implications of different growth scenarios, interest rates and inflation. Were real growth to be a meager 0.5 percent as opposed to 1.7 percent under the baseline scenario, or were inflation to be zero, or were interest rates to be 50 basis points higher, the debt-stabilizing primary balance would be substantially tighter, between 2.4 and 3 percent of GDP rather than the 2 percent deficit calculated under the baseline scenario (Table 5). These deviations from the baseline scenario are reasonable and the authorities would be well advised to consider their implications for elaborating the fiscal stance. 28. Even with the more ambitious fiscal consolidation strategy than the one presented in the government guidelines in 2015, the debt and interest rate levels will require constant vigilance to deepen and sustain the gains of adjustment. In 2016, debt levels will remain at close to thrice the level before the crisis. Interest spending on public debt at somewhat above 4 percent will still exceed the growth of nominal output, while borrowing requirements will remain large at around 14 percent of GDP over the medium term. 12 Baldacci, Gupta et al., 2010. Page | 21 Table 5. Debt-Stabilizing Balance Real interest rate Real Nominal less real GDP Real GDP Interest Interest Inflation Primary Fiscal growth rate growth Rate Rate rate Balance Balance (In percent) (In percent of GDP) 2015 Outcome 2.9 1.7 4.4 4.4 0 -1.1 -4.7 Baseline Scenario 2.3 1.7 4.0 4.5 0.5 2.0 -1.8 Growth Scenarios 3.5 0.5 4.0 4.5 0.5 3.0 -0.8 3.0 1.0 4.0 4.5 0.5 2.6 -1.2 2.0 2.0 4.0 4.5 0.5 1.7 -2.1 Interest Rate Scenarios 2.8 1.7 4.5 5.0 0.5 2.4 -1.8 3.8 1.7 5.5 6.0 0.5 3.3 -1.8 5.8 1.7 7.5 8.0 0.5 5.0 -1.8 Inflation Scenarios 2.8 1.7 4.5 4.5 0.0 2.4 -1.4 1.8 1.7 3.5 4.5 1.0 1.6 -2.2 0.8 1.7 2.5 4.5 2.0 0.8 -3.1 Source: MoF, Eurostat, CROSTAT, staff calculation Proposed Fiscal Adjustment Scenario 29. The good news is that current spending patterns offer significant scope for rationalization. At 48.2 percent of GDP in 2014, Croatia’s spending level was 6.6 percentage points of GDP higher than in its EU10 peers (Table 6). At the same time, total revenues were 3.7 percentage points higher than in EU10. Table 6. General Government Expenditures by Economic Classification, Percent of GDP EU15 EU10 Croatia 2009-13 2014 2009-13 2014 2009-13 2014 Total Revenues 44.5 45.6 38.1 38.9 41.6 42.6 Direct taxes 12.8 13.2 6.6 6.7 6.4 6.1 Indirect taxes 12.8 13.4 13.1 13.2 18.0 18.7 Social contributions 13.6 13.7 11.9 12.3 11.7 11.8 Sales 3.1 3.2 2.8 2.8 3.3 3.7 Other current revenue 2.2 2.2 3.6 3.9 2.2 2.3 Total Expenditures 49.6 48.7 42.9 41.6 47.6 48.2 Current Expenditures 44.8 44.5 37.1 36.0 41.8 43.2 Consumption 6.5 6.4 6.1 6.1 7.4 8.0 Wage bill 10.7 10.3 9.8 9.6 12.2 11.8 Interest 2.8 2.7 2.2 1.9 2.9 3.5 Subsidies 1.3 1.4 1.1 0.9 2.3 2.0 Social benefits 21.2 21.5 15.9 15.4 16.0 16.6 Current transfers 2.4 2.3 2.1 2.1 1.0 1.3 Capital Expenditures 4.8 4.1 5.8 5.5 5.8 5.0 Capital transfers 1.7 1.4 1.1 1.0 1.9 1.3 Investments 3.2 2.7 4.7 4.5 3.9 3.7 Deficit -5.1 -3.0 -4.8 -2.7 -6.0 -5.6 Gross GG Debt 84.4 92.9 46.9 49.0 63.7 85.1 Note: Data reflect ESA2010 harmonization and are still preliminary. Source: MoF, Eurostat, CROSTAT, WB staff calculation. 30. Public spending is particularly excessive in areas such as subsidies, public wages, and consumption:  Overall subsidies, mostly to railways, shipyards, and agriculture, at 2 percent of GDP are double the EU15 and EU10 spending. Page | 22  The public sector wage bill at 11.8 percent of GDP is 2.2 percentage points of GDP higher than in EU10 or 1.5 percentage point of GDP higher than in EU15.  At 8 percent of GDP that Croatia allocates to current public sector consumption, there is at least 1- 2 percentage points’ space for further rationalization of these costs. Average spending on operations and maintenance in Croatia is higher than the levels observed in the comparator countries which may also reflect inefficient consumption of inputs (e.g., energy consumption, space renting) or higher unit prices resulting from insufficiently competitive public procurement or outsourcing to high operating costs SOE subsidiaries (rail and motorway maintenance). 31. Looking at the functional breakdown of spending, five distinct differences to the comparator groups prevail (Table 7):  Spending on general administration services is 1.9-3 percentage points of GDP higher in Croatia than in EU15 and EU10, respectively.  Spending on public order and safety is at the same level as in EU10, but 0.4 percentage points of GDP higher than in EU15, also reflecting higher spending on judiciary.  Spending on economic affairs is 2-1 percentage points of GDP higher than in comparator groups, suggesting high subsidization of economic sectors.  Health spending is 1.6 percentage points of GDP above the EU10, but below (0.5 percentage points) the EU15, partly reflecting a different basic insurance coverage.  In parallel, spending on environment protection is half of the comparators’ spending, indicating an area of future spending pressures to align environmental standards with those of the EU.  Education spending mostly stayed on par with the comparators in 2013.  Social protection, although much lower than in EU15, is on par with EU10. Croatia’s social welfare system also provides substantial benefits to war veterans', a type of spending not found in other comparator countries. 32. In some of the above areas, Table 7. General Government Expenditures by Function (COFOG) Croatia will have to look for in 2013, Percent of GDP rationalization options; however, it EU15 EU10 Croatia would also need to apply an Total 49.0 41.6 47.7 expenditure switching strategy to support recovery. The fiscal General public services 6.9 5.8 8.8 adjustment will need to be Defense 1.4 1.2 1.4 accompanied by spending reallocation Public order and safety 1.8 2.2 2.2 to those projects that could be Economic affairs 4.2 5.2 6.2 financed by EU grant funds (with substitution sometimes possible, Transport 1.9 3.0 3.2 probably in some agriculture and SME R&D Economic affairs 0.4 0.2 0.4 investment subsidy schemes) as well Environment protection 0.8 0.8 0.4 as privatization, both of which would Housing and community 0.7 0.8 1.0 lead to a faster decline in public debt. Health 7.3 5.2 6.8 33. Moreover, Croatia is rated Recreation, culture and religion 1.0 1.2 1.5 comparatively low with respect to the effectiveness of its Education 5.0 4.8 5.1 administration (Figure 17). World Social protection 19.9 14.5 14.4 Bank governance indicators point to Note: Difference in total expenditure as per Table 6 due to rounding. general weaknesses of Croatian public Source: Eurostat, CROSTAT, WB staff calculation. administration in particular in terms of corruption, the rule of law, regulatory quality, and government effectiveness. Croatia lags behind the EU15 and EU10 by around 20 and 6 percentage points, respectively, on the Governance Indicators ranking. The World Economic Forum's Competitiveness Report 2015-2016 ranked inefficient public administration as the top barrier for doing business in Croatia. Although improvement has been observed in the quality of enforcing contracts and court decisions, simplification of distress procedures, as well as the functioning of the judiciary in general, similarly show the degree to which Croatia lags other EU countries with respect to selected administrative/judicial processes. This happens while the amount of public resources allocated to the sector that is above EU10 and EU15 countries. Page | 23 Figure 17. Croatia’s Administration Effectiveness Composite Governance Indicator Global Competitiveness Index, Institutions’ Score Note: SEE5 refers to South-East European countries: Serbia, Montenegro, FYRoM, Albania and BiH. Source: World Bank (http://data.worldbank.org) and the World Economic Forum (http://www.weforum.org). Options for Ensuring Macro-Fiscal Sustainability 34. Croatia’s fiscal vulnerabilities pose substantial risks for the country’s potential growth . There is a case for sustained medium-term adjustment to substantially reduce those risks, putting its public debt on a downward trajectory. However, addressing this would not be an easy task given the intertwined challenges Croatia is facing today: (i) to bring down the fiscal deficit and reverse adverse public debt dynamics; and (ii) create fiscal space for the absorption of large EU funds, preparing the ground for recovery and sustainable long-term growth. 35. To achieve debt sustainability, the government will need to turn a 1.8 percent primary deficit in 2015 into a surplus. This will require an increase in revenues and/or a reduction in primary expenditures of 3.1 percentage points of GDP. While the adjustment is urgent, so as not to deepen vulnerabilities and risks of much higher borrowing costs, in a depressed environment, an adequate balance needs to be found between credible consolidation and the potential impact this may have on depressing growth and growth expectations. 36. The consequences of not addressing twin challenges might be detrimental to Croatia’s short and long-term growth perspectives: (i) By not insisting on more forceful absorption of EU funds, Croatia may face a possible loss of EU funds and more importantly an opportunity to finance its growth through grants thus helping both its growth and fiscal consolidation objectives. However, Croatia will need to create fiscal space averaging up to 1.8 percent of GDP a year (for transfers to the EU budget, as well as pre- and co-financing of EU projects) in 2014-2020 to support EU funds absorption. This can be achieved through consolidation of spending in other areas funded through the national budget means, combined with substitution of budget funding with EU financing (where allowed). (ii) By not reducing fiscal vulnerabilities, the country may face further deterioration in investors’ sentiment resulting in higher financing costs and/or lack of access to affordable long-term borrowing. This would deepen the recessionary trends and require much more urgent and deeper fiscal consolidation actions. Croatia’s spending and revenue pattern suggest that a sizeable fiscal adjustment of 4-5 percentage points of GDP could be implemented over the medium term. While revenue measures could raise additional revenue of 2 percent of GDP through reducing exemptions (Figure 18), introducing a modern property taxation, as well as strengthening tax collection, more fiscal space can be created on the spending side, in particular of the wage bill, subsidies, procurement, as well as improving effectiveness and equity of social spending. 37. Several countries in the EU have gone through fiscal consolidation episodes in the recent history. When corrected for the cycle, over the last four years Greece achieved an annual rate of primary deficit reduction of 4.1 percentage points of GDP on average (2009-2013), the highest in the developed world in recent years. Latvia had a similar experience over the same period. While one can argue that both countries experienced a large social cost due to such rapid adjustment, the required adjustment in Croatia would be similar to the consolidation episodes of Sweden, UK or Ireland. While such an adjustment is urgent, it is also achievable so Croatia can strengthen the hopes for future prosperity. Page | 24 Figure 18. Examples of Cost Savings Tax expenditure, percent of GDP Eliminating Elite Capture From Social Programs Source: CROSTAT, Household Budget Survey, MOF. Source: OECD 38. Fiscal consolidation process would be less painful if the economy is in an upturn. Without accelerating structural reforms, especially in the area of investment climate, and public sector efficiency, Croatia will face further stifled competitiveness and slow prospects for recovery of growth and jobs. Croatia’s labor markets are still among the m ost rigid in the EU (Figure 19) and this is a large part of the reason behind high and chronic unemployment 13. In the product markets, there are number of barriers to investors (in particular in the network and business services) that prevent stronger competition and thus increase investors’ interest. Although Doing Business indicators rank Croatia 40 th among 189 countries, a country that achieved so much and entered the EU still lags behind EU peers. Broader competitiveness indicators provide similar results (Figure 19). Without additional improvements of the business environment, these weaknesses are also likely to undermine the potential benefits of European financial integration, in terms of lower interest rates and greater, more stable and productive capital inflows. Figure 19. Croatia’s Competitiveness Indicators Labor Market Efficiency Product Market Efficiency Source: World Economic Forum Global Competitiveness Source: World Economic Forum Global Index (2015-16). Competitiveness Index (2015-16). Ease of Doing Business Government Effectiveness Source: Doing Business (2015). Source: Worldwide Governance Indicators (2014). 13World Bank (2011), “Employment Protection Legislation and Labor Market Outcomes: Theory, Evidence and Lessons for Croatia”. Page | 25 Fostering Growth and Competitiveness to Create Jobs Export Performance 39. Croatia’s export sector has displayed an uninspiring performance over the last decade. This is evident along three key dimensions of competitiveness: growth and shares (intensive margin), diversification (extensive margin) and quality and sophistication (quality margin).14 40. In terms of intensive margin, export growth in Croatia has been virtually stagnant, while export market share changes have even declined. Data shows that Croatian exports grew by 4.1 percent on average per year during the 2006-2014 period. Croatia exhibited the slowest export growth against double-digit growth in Poland and the Slovak Republic, and stronger growth in Hungary and Slovenia (Table 8). At the same time, Croatia’s export market share-a common way to measure export competitiveness–showed a declining performance (at -1.4) over the period (Figure 20). This negative performance was mainly driven by pull factors, reflecting negative market and sector composition, a common factor to all its peers. Push factors - describing a country’s own supply-side capacity to expand export market shares (through volume, prices and value) – helped to offset slightly the negative performance. “Push” factors were positive in all peer countries (particularly in Poland and Slovakia). Table 8. Export Market Share and Growth Decomposition, 2006Q1-2014Q3 Export Pull factors Push factors Export market growth share change Geographical Sectoral Values (Overall) Price Volumes Croatia 5.4 -1.4 -1.6 -0.4 0.6 -0.2 0.8 Hungary 6.8 0.1 -0.4 -1.2 1.7 0.6 1.1 Poland 10.7 3.9 -0.7 -0.9 5.5 0.0 5.5 Slovakia 10.7 4.2 -0.6 -0.9 5.6 0.0 5.6 Slovenia 8.1 1.1 -0.8 -0.9 2.8 -0.3 3.0 Source: Export Competitiveness Database. Note: Indicators are expressed in log-difference form, which allows for additivity across indicators. 41. When it comes to extensive margin, Croatia’s export markets were more diversified in 2014 than a decade earlier, mainly due to a shift away from Western European markets and towards emerging and fast growth regional markets (such as the EU12, Middle East and Russia). Data suggests that European countries remained Croatia’s main export destination ( Figure 21), showing almost the same share of about 86 percent of total exports over 2002–14. However, the market composition within Europe changed: while the traditional block of the 15 older EU members (EU15) is still important, their export share fell from 53 percent to 42 percent, explained by increased market saturation and severe export competition. By contrast, the export share to new EU12 member countries increased from 13 percent to 22 percent. Other faster growing markets - as non-EU countries in Europe, Middle East and North Africa and NAFTA – also presented a growing export share. 42. Meanwhile, Croatia’s performance became more concentrated in terms of product scope, and this sectoral specialization has been unfavorable as the growth in these sectors is subdued. Seven sectors covered about two-thirds of Croatia’s export basket in 2013. They were machines (19 percent), mineral products (14 percent), chemicals (10 percent), metals (8.5 percent), foodstuffs (7.1 percent), transportation (6.3 percent) and textiles (5.7 percent). Out of the 3407 products at the HS-6 digit level that Croatia exported in 2012, only four were winners in growing sectors. These products are “medicaments of other antibiotics, for retail sale”, “cane of beet sugar in solid form, n.e.s.”, “articles o f leather or of composition leather”, and “revolvers and pistols”. Behind each of these niche market -leading products is a successful domestic firm or one that has consolidated following infusion of foreign capital. 14This section summarizes the main findings of the 2014 technical note “Croatia’s Trade: Performance, Competitiveness & Potential” authored by Daria Taglioni, Michael Ferrantino, and Swarnim Waglé. Page | 26 Figure 20. Export Growth and Change in Market Share, Figure 21. Export Market Distribution, Croatia, 2002 vs. 2006-2015 Q2 2014 30 2002 2014 Log first differences, y-o-y (%) 20 10 10.7 11.3 EU15 0 2.1 2.1 1.7 2.6 EU12 -10 42.1 -20 CEFTA 19.6 52.7 20.3 -30 Russia -40 USA 2006q1 2006q3 2007q1 2007q3 2008q1 2008q3 2009q1 2009q3 2010q1 2010q3 2011q1 2011q3 2012q1 2012q3 2013q1 2013q3 2014q1 2014q3 2015q1 13.1 21.6 Rest of the World Change in Export Market Share Export Growth Source: Export Competitiveness Database based on Gaulier et al. (2013). Source: CROSTAT. 43. The above findings suggest that Croatia is in a transition phase, specializing in existing markets but showing little growth in new products and markets. The contribution of old products in old markets to export growth is higher than the contribution of old products in new markets, new products in old markets, and, vitally, new products in new markets (Figure 22). Figure 22. Intensive and Extensive Margin of Trade, Figure 23. Economic Complexity of the Export Croatia Basket, Croatia vs. Peers (2000–13) 1.8 Economic Complexity Index (ECI) 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Bulgaria Croatia Hungary Poland Slovakia Slovenia Source: Export Competitiveness Database based on Source: The Observatory of Economic Complexity. Gaulier et al. (2013). 44. In terms of quality margin, Croatia’s export economic complexity has been on the rise but it still lags behind its regional peers. Data shows that although Croatia’s Economic Complexity Index increased from 0.7 in 2000 to 0.9 in 2013, it has yet to match those of peers like Hungary, Poland, the Slovak Republic, and Slovenia (Figure 23). Looking at individual products it emerges that the main reason for this result is compositional: a large proportion of the main exports are goods that, by global standards, are not very complex. Table 9 lists the country’s top 20 exports at the Standard International Trade Classification (SITC) 4-digit level for 2012–13.15 None of Croatia’s most important 15 export sectors rank in the top decile by economic complexity. 15The stage of processing in this SITC classification is easier to identify than that in an HS classification, as the latter emphasizes the description of the material properties of goods. In most cases, they reflect finely grouped industries rather than individual products. Page | 27 Table 9. Croatia’s Top Exports and Their Product Complexity Rank Share in 2012– SITC Export Complexity rank 13 1 9310 Unclassified Transactions 11.00% 552 2 5417 Medicaments 4.00% 277 3 7932 Ships and Boats 3.85% 278 4 2483 Non-Coniferous Worked Wood 2.40% 671 5 7711 Electrical Transformers 1.95% 257 6 6842 Processed Aluminium 1.80% 347 7 8211 Chairs and Couches 1.80% 312 8 5621 Nitrogenous Fertilizers 1.75% 625 9 9710 Gold 1.50% 745 10 980 Miscellaneous Edibles 1.45% 525 11 7731 Electric Wire 1.40% 427 12 2820 Iron Waste 1.35% 528 13 3510 Electric Current 1.32% 480 14 8510 Footwear 1.25% 551 15 3414 Petroleum Gases 1.20% 719 16 6612 Cement 1.10% 649 17 612 Refined Sugars 1.10% 641 18 7284 Machinery for Specialized Industries 1.09% 10 19 7721 Circuit Breakers and Panels 1.05% 201 20 3413 Liquified Petroleum Gases 0.97% 757 Source: The Observatory of Economic Complexity. Note: Products ranked on complexity from 1 to 762 (1 being the most complex). 45. In addition, Croatian manufacturing exports are still dominated by products where price competition is more important than quality competition, which suggests that Croatia has in fact much catching up to do. Croatia’s share of quality-dominated (high relative quality elasticity -RQE) export industries is less than the share dominated by price competition (low RQE) (Figure 24).16 46. When it comes to service exports, Croatia presents an unexpected feature with value of service exports outperforming goods exports. However, the sophistication of these service export is behind that of its peers. While similar countries export a greater value of goods than the value of services, Croatia’s services exports are higher than its goods exports (Table 10). However, despite services exports showing greater sophistication, the increasing share of tourism reduced the share of more sophisticated services, such as transport and other commercial services. Figure 24. Relative Quality Elasticity, Croatia vs. Table 10. Exports of Goods and Services, Croatia and Peers, 2012 Regional Peers, 2014 (US$ billion) Service/goods Country Goods Services ratio (%) Croatia 13.0 13.7 105.5 Slovak Republic 83.1 9.1 10.9 Slovenia 30.5 7.4 24.2 Serbia 14.1 5.0 35.7 Source: IMF BoP statistics. Source: Author’s regrouping of UN Comtrade data based on Aiginger (2001). 47. Despite all these uninspiring performances – on both goods and service exports fronts – there are also some promising signs for the country’s export competitiveness, as a fringe of small dynamic exporters is emerging in sophisticated niche products. The Product Space analysis of Croatia suggests that several exports, marginal at present, are close to existing competencies and 16 Exports are classified as belonging to industries that have high, medium, and low relative quality elasticity (RQE). Industries with high RQE compete on quality, whereas those with low RQE compete on price. More specifically, quality- elastic industries are those where the positive difference between export and import unit values leads to a trade surplus, that is, a positive difference between export and import quantity; low relative unit value, in contrast, leads to a trade deficit. The intuition is that in quality-elastic industries, high price does not necessarily lead to low quantities sold because those products embody intangible traits like design, service, and reliability. Price-elastic industries are those where low costs lead to more exports and higher prices lead to fewer exports. Page | 28 desirable for their industrial complexity. Moreover, many of these emerging and marginal exports are also embedded in dense networks of products, which augurs well for future growth. Inferring from existing capabilities, Croatia is poised to do well in industrial and electronic manufacturing, processed food, and beverages. Innovation 48. Lagging export performance in Croatia reflects weak economic renewal process which is evidenced by a modest innovation performance.17 Innovation performance relative to the EU reached a peak of 59 percent in 2009 and dropped to less than 56 percent in 2013, as measured by the EU Innovation Scoreboard. Croatia is performing below the EU average in most dimensions (except human resources due to above average performance in new doctorate graduates and youth with upper secondary level education). Overall, Croatia has shown a lackluster performance in business research and innovation. Statistics point to a low level of business R&D (BERD) as percentage of GDP, compared with the average of the EU28 region. Croatia BERD has continually underperformed both the EU28 average and Slovenia (Figure 25), a country at a comparable income level. 49. In fact, innovative SMEs are still an exception in the Croatian entrepreneurial landscape despite a generous tax break system and a reasonable infrastructure to support business R&D . Lack of innovation within SMEs is a main explanatory factor of the disappointing aggregate features. The R&D intensity of small firms in Croatia is at 0.34 percent (16 th place in the EU) and the one of medium- sized firms stands at a substandardl 0.16 percent (21st place in the EU) (Figure 26).18 In fact, business investment in R&D in Croatia is concentrated within a few multinational companies, which appear to also have a relatively high research intensity (1.98 percent). 19 The country provided in 2008 a tax break of about 35 percent for US$1 of R&D, second only to France (42 percent).20 A study of R&D tax incentives21 shows that around 77 percent of state aid for R&D came from tax incentives in 2009 (€14.6 million). However, although small firms are the majority of beneficiaries of tax incentives for research and development, the large firms receive most of the benefits. When it comes to infrastructure to support business R&D, estimates indicate that Croatia has 27 regional development agencies, 44 entrepreneurial centers, 23 business incubators (most attached to regional development agencies) and 8 technology parks, including those of the Technology Infrastructure Programme (TEHCRO).22 Figure 25. BERD, Percent of GDP Figure 26. R&D Intensity (Medium Firms) Source: Eurostat Source: Community Innovation Survey (2010) Firm Dynamism and Productivity Growth 50. Another explanation of the subdued performance of Croatian exporters, and the limited capacity of the country to renew its productive structure, is the reduced firm dynamism. 23 Entry in Croatia into the formal sector, measured by registration of new limited liability firms, is low when compared 17 This section summarizes Chapter 3 “Innovation Challenges for Smart Specialization” of 2015 World Bank report “Smart Specialization in Croatia”. 18 World Bank (2014) Smart Specialization in Croatia: Inputs from Trade, Innovation, and Productivity Analysis drawing from the last Community Innovation Survey (2010) 19 Ibid. 20 European Commission 2014. "ERAWATCH Country Reports 2013: Croatia" 21 Švaljek, S. 2012. “R&D Tax Incentives in Croatia: Beneficiaries and their Benefits.” Zagreb, Institut za javne financije. 22 WBC-INCO.NET, 2011, as cited in OECD (2014), OECD Reviews of Innovation Policy: Croatia 2013, OECD Publishing. http://dx.doi.org/10.1787/9789264204362-en 23 Findings from Iootty, M., P. Correa, S. Radas, and B. Škrinjarić. 2014. “Stylized Facts on Productivity Growth: Evidence from Firm Level Data in Croatia: Vol. 1.” Policy Research working paper no. WPS 6990. Page | 29 to what would be predicted by its income level. Figure 27 below displays the relationship between the density in firm entry (measured by the average annual number of new limited liability firms registered per 1,000 working-age people during 2008–12) and the level of economic development (measured by the average per capita income for the same period) across 117 countries. As expected, firm entry is positively associated with GDP per capita, but Croatia’s rate of entry density is substantially below what its income level would suggest. By contrast, regional peers –Bulgaria, Romania, and Hungary–are located above the predicted line, displaying substantially higher entry rates. Figure 27. Entry Density and GDP per capita, 2008– Figure 28. TFP Change Decomposition by Type, 2008– 12 12 25 2.87 2 1.25 20 0.60 0 15 -2 10 -2.88 -4 Montenegro Bulgaria Hungary 5 FYR Macedonia,Romania Slovak Republic -6 Croatia Czech Republic Serbia Bosnia and Herzegovina -7.59 0 -8 6 7 8 9 10 11 (ln) average GDP per capita (PPP) Survival New start-ups New big entry Exit Total Note: TFP is used in natural logarithm form. Figure 29. High-Growth Firms’ Rate (%), 2010 Figure 30. Gazelles’ Rate (%), 2010 1.2% 12% 11.67 1.16 1.08 10.54 1.04 0.9% 0.90 9% 0.85 7.91 7.68 7.78 0.76 0.75 0.76 7.01 0.67 0.67 0.6% 0.62 5.94 6% 5.78 0.55 5.14 5.11 5.20 4.90 0.42 0.42 4.04 0.3% 3.00 0.27 3% 2.53 1.87 1.78 0.64 0% 0% * l y ly ** ia lic * ga ia ia r Ita ia an ga ia l y ly ia ia en lic * ub ga on en tu ia r at Ita at on an ga om ub un ed ep en or st tu v ro ro lo st om un E P ep H or R w v C R C S E lo S P H h R R S c ch ze C ze Manufacturing Services C Manufacturing Services Source: Iootty et al (2014). Note: Rate is defined as the number of high-growth enterprises, measured by turnover growth, as a percentage of the population of enterprises with 10 or more employees. * For Slovenia, data are for 2009. * For Estonia and Slovenia, data are for 2009; ** for Croatia, we did not identify any gazelles in 2010 (a sample of firms was used). 51. Lack of firm dynamism in Croatia is also evidenced by an uninspiring performance of a critical segment of the firm landscape: high growth firms, particularly young ones, known as ‘gazelles’.24 These types of firms are of particular importance because of their extraordinary growth and their innovation driver. First, they can make the largest contribution to net job creation, despite typically representing a small proportion of the business population. Second, because their success often comes from innovation—such as a product or process; or innovative approaches to marketing, distribution, or organization; or from entering a new market—these types of firms (particularly gazelles) outperform average industry growth in a Schumpeterian sense:25 they combine existing factors of production in a new way and thus produce an innovation that enables them to outperform the market. Recent analysis shows that Croatia seems to lag behind selected European countries on high-growth firms and gazelles (Figure 24 Based on the OECD definition, high-growth enterprises are those with average annualized growth in employees (or turnover) greater than 20 percent a year, over a three-year period, and with 10 or more employees at the beginning of the observation period. (“Gazelles” are a subset of high-growth enterprises up to five years old). 25 The Schumpeterian process of “creative destruction” is crucial to fostering innovation and, therefore, economic growth. This process features the entry of new innovative firms in the market, and the exit of uncompetitive, incumbent firms. This entry-and-exit dynamic reallocates factors of production across firms, from unproductive companies to productive firms, increasing aggregate productivity. Entry into innovation activities can occur in two ways: vertical entry or horizontal entry. Vertical innovations are related to the upgrading of the quality of existing products and services; horizontal inventions are associated with the creation of new goods and services. Entry always entails a fixed cost. However, vertical innovations tend to cost less, as they relate to incremental innovations. But horizontal inventions are usually expensive, as they typically involve a breakthrough. Page | 30 29 and Figure 30), although these findings have to be treated with caution because the numbers were not drawn from total population figures.26 52. The lack of vitality of Croatian economy is confirmed when looking at firm entry and exit process. Evidence for developed economies suggests that healthy market economies exhibit a high pace of firm churning, whereby a significant number of business startup or close their operations. 27 Croatia has showed a reduced firm dynamism when compared with regional peers. 28 Only 5.5 percent of all firms were new to the market on average every year in the 2008-12 period; regional peers present an average rate ranging from 9 to 18 percent (Table 11). Croatia also lags behind in terms of exit process: 6.5 percent of total firms leave the market on average every year while exit rate in ECA peers varies from 7 to 26 percent on average. When looking at net entry rates (entry minus exit) Croatia presented negative values, which indicate that exit outpaced entry during the 2008-12 period. This finding reinforces the perception that Croatia is a stagnant economy with a reduced “creative destruction” process, as proxied by net entry .29 Table 11. Exports Entry and Exit Rates, Croatia and Eastern European Peers, 2008–11 (%) Country Entry Exit Net entry Bulgaria 14.54 9.62 4.92 Czech Republic 9.18 8.96 0.22 Latvia 16.57 13.27 3.30 Lithuania 18.61 26.82 -8.21 Hungary 9.83 10.92 -1.09 Poland 13.07 10.42 2.65 Romania 10.92 14.19 -3.27 Slovak Republic 14.86 11.56 3.30 Slovenia 10.89 7.53 3.36 Croatia, 2008-12 5.5030 6.50 -1.00 (“start-ups”) Source: World Bank staff elaboration based on FINA data (for Croatia) and Eurostat data. Note: For all countries except Croatia, values are averages of Eurostat data for 2008 –11 (not 2008–12). Eurostat’s yearly measure of entry is defined as number of enterprise births in the reference period (t) divided by the number of enterprises active in t. The yearly exit rate is defined in Eurostat as number of enterprise deaths in the reference period (t) divided by the number of enterprises active in t. For both entry and exit rates from Eurostat, the sector coverage is “Bu siness economy except activities of holding companies”. 53. Furthermore, the contribution of firm dynamism (proxied by net entry) for productivity growth in Croatia is surprisingly negative suggesting that market selection process appears inefficient. Empirical evidence for developed countries also shows that the churning process is productivity enhancing, in the sense how new business entry and the market exit of less productive firms contribute to spur productivity average.31 The decomposition of this variation in contributions from survival, start-up entry, big entry and exit firms has revealed interesting results, some of them surprising. As expected, productivity growth is largely driven by survival firm performance while the entry effect is normally (but not always) positive (depending on the analytical cut). The striking result comes from the negative contribution from firm exit effect. In addition, as this exit contribution outpaces the positive effect of firm entry, the overall contribution of the net entry effect becomes negative. This is contrary to what is expected and suggests that the destructive creation process in Croatia has not been efficient as the market might be eliminating firms that are potentially productive. 32 26 See Iootty et al (2014) 27 See Bartelsman et al. (2009) for a relevant cross country analysis. 28 See Iootty et al (2014) for more details. 29 There is some sector variation, however. All macro sectors have showed a negative entry effect, but services showed to be the one where this process seems to be less prominent. In addition, when focusing only on service activities there is evidence of a strong firm dynamism for both knowledge intensive services (such as telecom, computer related activities, R&D activities, etc) and other less knowledge services (such as personal activities). 30The rate for “big entry” is 2.5 31 See Bartelsman et al (2009). 32 When performing this exercise across several analytical criteria, results suggest that this inefficient market selection process is more pronounced among private sector firms, Continental region firms and firms in the service sector. Not Page | 31 54. Evidence presented so far points to a sub-optimal equilibrium in terms of export performance, innovation and firm productivity growth. Lagging performance of Croatian exporters reflect the reduced capacity of the country to renew its productive structure, which is then hindered by a modest innovation performance and a reduced “creative destruction” process. 55. Against this backdrop, innovative SMEs can play a key role for lifting Croatia back into sustained growth. In the case of Croatia, SMEs account for a large share of both total number of firms and employment. Recent numbers from Structural Business Statistics, Eurostat, show that SMEs represent more than 99 percent of the total number of firms and account for 68 percent of employment.33 The largest share of the country’s SMEs (67 percent) can be found in services. A particular sub-set of SMEs, those in innovation-driven activities, namely young knowledge-intensive enterprises34, can leverage the country’s cost basis to sustain long periods of substantial export growth. They do so by innovating: they create new goods (products or services) or significantly upgrade existing ones, implement new processes, or introducing new marketing strategies. In Croatia, innovation-driven sectors as computer programming, architectural and engineering activities; technical testing and analysis, scientific activities and research, and manufacturing of computers, electronic, and electrical equipment, account for approximately 8 percent of SMEs.35 Environment for Supporting Businesses and Creating Jobs 56. Croatia’s business environment has been identified as a priority area for reform by the several subsequent Croatian Governments. More recently, under the Government Working Group for Business Climate and Private Investments, the Agency for Investment and Competitiveness has been designated to lead the dialogue with the private sector and coordinate the consultations with stakeholders, including international organizations on the design of a new wave of business environment reforms. 57. Several concrete measures have been undertaken recently to improve the quality of the business environment. The authorities have begun an audit of administrative burden, applying the standard cost model to the Trade Act and the Mediation in Immovable Property Transactions Act. The pilot phase has been completed in April 2015 and an action plan for the simplification of the administrative burden will be presented soon. The initiative was led by the Ministry of Economy and was supported by the Agency for Investment and Competitiveness. Furthermore, there is an ongoing effort to improve the online communication between the public administration and citizens. Despite the introduction of the e- citizen web portal and the online services for businesses provided by HITRO.HR, the Chambers of Commerce, and the Financial Agency FINA, challenges remain for the users having to familiarize themselves with the different interfaces. The authorities are planning the development of a new platform – a single contact point, which would integrate all existing services. In the area of the judiciary, the implementation of the reform of the judicial map could improve the efficiency of some courts. The reform aims to increase specialization and balance out the uneven workload of judges by merging courts. The reform also involves a change in the allocation of cases before second instance civil courts. 58. Although Croatia has implemented business reforms every year since 2006, and was among the global top ten improvers in Doing Business in 2008, the reform momentum in some areas has been stronger and more sustained than in others (Box 2). The getting credit indicator captured the setting up of the new private credit bureau, HROK, and the launching of a unified and geographically centralized collateral registry in 2008. The time required to register property was reduced through improvements at the land registry. Since 2011, litigation proceedings were streamlined and enforcement procedures over cash assets transferred from the courts to the state Financial Agency, FINA. In 2015, further improvements were made with the introduction of an electronic system to handle public sales of movable assets and to streamline the enforcement process as a whole. 59. As a result, Croatia is doing relatively well in the Doing Business 2016 report. It ranks 40th out of 189 economies worldwide and 8th amongst the 26 economies in Europe and Central Asia. Compared with 2015, Croatia dropped one place in its global ranking. On the Distance to the Frontier all service sub sectors had a negative performance however. The exercise showed also some untapped potential for productivity growth in services industry coming entry of knowledge intensive service companies. 33 Eurostat data for 2012 (Structural Business Statistics). According to Eurostat, SMEs are firms that employ between 1-249 persons. 34 Knowledge intensive SMES (and startups) are understood to mean those SMEs (and startups) with a business model that emphasizes intellectual property as the main asset and include technology-based firms (e.g. IT firms), as well as firms that compete on the basis of product, process or service innovation. Innovation can be either incremental or radical, and either new to the Croatian market or new to the world. 35 Eurostat Structural Business Statistics, latest available data (2012). Page | 32 (DTF) metric which shows Croatia’s performance r elative to global good practice, Croatia scores 72.71 points in Doing Business 2016. Compared with 2015, progress has been made mainly in the areas of starting a business and registering property where Croatia improved three and seven positions in the ranking, respectively. In addition, Croatia made enforcing contracts easier by introducing an electronic system to handle public sales of movable assets and by streamlining the enforcement process as a whole, though this has not been reflected in the ranking. Box 2. Recent Reform Efforts in Croatia Doing Business Areas Starting a business became easier with the introduction of HITRO.HR, a one-stop shop (OSS) for company registration, and with the subsequent expansion of its functionality, which allowed limited liability companies to file their registration applications with the court registries electronically through the notary public and HITRO.HR. In 2013 a new form of simple limited liability company with a lower minimum capital requirement was introduced, which further simplified incorporation procedures and in 2014, some notary fees, related to company incorporation, were reduced. The Dealing with Construction Permits indicator captured a series of reforms since 2007. In 2008, a new building code was put in place that eliminated several procedures for obtaining a building permit. In 2009, an OSS for construction permits was set up, which enabled the enforcement of the new building code. Further streamlining followed in 2010 and 2014, including the abolishment of the location permit and project design confirmation, reducing the requirements and fees for building permits, and speedier final building inspections. These improvements led to further simplifying and speeding up the overall construction permitting process. On the Trading across Borders indicator, Croatia has considerably harmonized and streamlined its export and import custom procedures in preparation for the July 1, 2013 accession to the European Union. Important improvements were also introduced in its port infrastructure, resulting in further reductions in the time for exporting and importing. As reflected in the Resolving Insolvency indicator, Croatia made improvements in 2007 through amendments to its Insolvency Act regulating the profession of bankruptcy administrators and in 2013, introduced an expedited out- of-court restructuring procedure. Under Paying Taxes, in 2008, paying taxes became easier for companies through the wider use of online filing. In 2012, the health insurance contribution rate was reduced, followed by the introduction of an electronic system for social security contributions and by the reduction of rates for the forest and Chamber of Economy contributions in 2013. In 2014, the Chamber of Economy contribution was completely abolished. On the other hand, in 2010, a tourist fee was introduced, which made paying taxes more costly for companies and in 2014, Croatia made paying taxes more complicated by raising the health insurance contribution rate and introducing more detailed filing requirements for VAT. 60. However, despite the strong reform momentum Croatia still suffers from a number of shortcomings that entrepreneurs experience in the day-to-day running of their business operations. Doing Business data shows there is room for improvement particularly in the areas of resolving insolvency, protecting minority investors and getting credit (Figure 31). 61. In addition, stricter product market policies have been stifling competition in Croatia while posing excessive burdens on entrepreneurs particularly in service sectors. OECD Product Market Regulation (PMR) Index suggests Croatia performs badly when compared with other EU Member States and intensity of local competition is weak. Croatia is the worst EU Member State performer in the OECD Product Market Regulation Index, which is largely due to a high degree of public ownership and government involvement in network sectors and in general business operations. 36 The large share of public enterprises in the economy creates an uneven level playing field for private businesses. In addition, shortcomings in product market regulation specifically for services hits the cost structure of firms that use the output of services as intermediate inputs in production and affects the whole economy. 37 The OECD’s PMR index for professional services ranks Croatia relatively unfavorably as regards entry restrictions in all regulated professions it covers and among the three worst Member States in terms of conduct restrictions in all professions but accounting services. This overall scenario – combined with the limited ability of the Competition Authority to foster more intense competition in the Croatian economy due to a shortage of 36 The measurement is not updated as of 2015 and, due to more recent acquis harmonization and privatizations, may not reflect the current situation for Croatia. For more information, please visit: http://www.oecd.org/eco/growth/indicatorsofproductmarketregulationhomepage.htm. 37 As highlighted by European Commission Country report – Croatia 2015, examples of sector-specific regulations that pose excessive burdens on entrepreneurs in services include, for instance, laws applicable to specific services that require prior authorization from a competent authority in Croatia, including entry in a register or registration with a professional body or association. Page | 33 staff and other resources 38 - has been limiting competition on the internal market, as suggested by the most recent Global Competitiveness Index (2014-15). According to this indicator, the intensity of local competition in Croatian economy appears to be well below many of its peers: Croatia finds itself in the bottom half of the ranking (out of 144 economies) for the intensity of local competition (83rd), extent of market dominance (110th), and effectiveness of anti-monopoly policy (97th). 62. Additional rigidities Figure 31. How Far has Croatia Come in the Areas Measured by Doing for business environment Business? stems from regulatory 200 Best Performer EU28 Average Croatia Worst Performer instability and low 180 MLT transparency and 160 CYP GRC CYP ROU ITA predictability in the working 140 MLT LUX of administrative bodies. 120 Weak legislative planning has 100 MLT MLT 80 weighed down the quality of 60 IRL new regulations. In 2014, half 40 of the laws passed were not 20 LTU ROU DNK DNK DEU LTU GBR IRL LTU FIN planned. Although there is a 0 * Regulatory Impact Assessment (RIA) mechanism in place, in practice most legislations go through a fast track legislative process and circumvent RIA * AUT, BEL, HRV, CZE, DNK, FRA, HUN, ITA, LUX, NLD, POL, PRT, ROU, SVK, SVN, ESP altogether. Even when Source: Doing Business performed, RIA is not properly done, due to weak quality control and lack of high level commitment. Poor legislative quality in turn leads to frequent amendments to address shortcomings and complications for SMEs. 39 Moreover, the administrative burden in Croatia is higher than in most EU member states. Despite a public wage bill close to 12 percent of GDP, Croatia scores low on the EU Public Administration Scoreboard, particularly on indicators on effective implementation, cost and time to export, and irregular payments and bribes. Businesses find that inconsistencies in decision making at the local level, as well as lack of strict timeframes for issuing opinions on tax issues are a key source of concern. These implementation gaps are often caused by high turnover rates, nonexistence of performance-based wage system, limited training opportunities, and lack of transparency in staff recruitment in public administration. Additional issues that contribute to a poor business environment include long judicial proceedings, in particular in commercial courts, where an upgrade of case management is needed, among other factors.40 63. Structural problems and rigid and complex labor legislation and regulations impede both employment and labor productivity gains. 41 Croatia’s employment rates in general are low relative to the EU28 average, especially for younger and older workers. The low employment rate is due both to high unemployment and, more importantly, to the low labor force participation rate (Figure 32). Unemployment is often long-term. Despite recent changes to labor law, it remains complex and retains rigidities. There is scope to explore the introduction of a single contract to overcome labor market segmentation between those on temporary and permanent contracts. Expected costs of (individual) dismissals are high, impeding 38 Though Croatia has aligned its legislation in the fields of anti-trust and mergers and of state aid, and has also kept up its efforts to build a positive enforcement record, the ability of the Competition Authority to foster more intense competition in the Croatian business environment is hampered by a shortage of staff and other resources. The Authority is small compared with its counterparts in other Member States of similar size, as is its budget (approximately EUR 1.7 million in 2015 for a staff of 47, of which 31 work in the Competition Division). 39 There is a plan in place to introduce the “two out, one in” check for new regulations and other specific measures are being planned to improve the overall quality of impact assessment. For more details, see: Republic of Croatia, National Reform Program, April 2015. The English version of the document can be found at: http://ec.europa.eu/europe2020/pdf/csr2015/nrp2015_croatia_en.pdf 40 Improving the efficiency and quality of the justice system also remains a challenge. In 2014, the length of trials was comparatively long at first instance both in civil and commercial cases (378 days) and in administrative cases (427 days). At first instance administrative courts, backlog increased by 17%, despite more cases being resolved. At the High Commercial Court, backlog increased by 16% and disposition time reached 1234 days in 2014, up from 1142 days the previous year. 41 These problems are documented in World Bank (2011), Employment Protection Legislation and Labor Market Outcomes: Theory, Evidence and Lessons for Croatia, and in Kunovac, M. (2014), Employment protection legislation in Croatia, Financial Theory and Practice, 38(2), 139-172. Page | 34 labor productivity gains which could come from labor reallocation. There is a need to equalize the expected benefits of public and private sector employment, and to support efficient allocation of labor resources. Other notable factors are labor supply disincentives created by the social protection system. Figure 32. Croatia’s Employment Outcomes Lag Figure 33. Poor Basic Cognitive Skills EU28 Averages Source: Eurostat Source: World Bank staff calculations using PISA 2012 and Eurostat data. 64. Croatia also faces challenges in equipping its workforce with cognitive and technical skills (Figure 33). First, cognitive foundation skills of young Croatians are poor. Croatia has one of the highest shares of 15 year-olds (29.9 percent) who perform at the bottom levels (below level 2) of mathematics in the OECD Program for International Student Assessment (PISA). This level of performance is equivalent to functional innumeracy (the equivalent share for reading at 18.7 is lower, though still formidable). Given technological change and Croatia’s challenge of aging and population decline, Figure 34. Participation in lifelong learning in Croatia is low this provides a significant risk to long-term economic growth prospects. Poor cognitive foundation skills like mathematics and reading are a barrier to effective lifelong learning and continued acquisition and upgrading of technical skills. There are also significant gaps in PISA performance between students from the richest and poorest socio-economic quintile (equivalent of two years of schooling) which signals an important equity dimension in skills acquisition. Second, participation in lifelong learning remains rare, with a rate of 2.5 percent – much lower than the EU average of 10.7 percent of the working age population Source: LFS Eurostat (2014) aged 25-64. Croatia’s lifelong learning participation is the third lowest in the EU, slightly higher than Bulgaria and Romania (Figure 34). Risk Capital Financing for Innovative SMEs 65. If supporting innovative SMEs is key to promote trade integration and economic growth in Croatia, it is important to tackle access to finance as this has been constantly cited as an essential constraint for business in the country. Getting credit is still a key constraint for SMEs in Croatia. Data from the last Enterprise Survey (2013) in Croatia reveals that access to finance is among the main obstacles for business for both small (1-19 employees) and medium (20-99) firms (Figure 35). 66. For innovative SMEs in particular this constraint is even more severe, as innovation tends to be underfinanced even in well-functioning markets due to structural market failures. In principle, innovation tends to be underfinanced due to structural market failures as asymmetric information and Page | 35 appropriation risks42. This problem is more apparent for new entrants and startups as they lack track record to signal their ability to investors, and because they produce an intangible asset that does not typically constitute accepted collateral, as well as due to the intrinsically risky nature of innovative ventures. 43 Figure 35. Percent of Firms Identifying the Problem as the Main Obstacle: Croatia (2013) Source: Croatia Country profile 201344 67. In Croatia, the lack of risk capital financing is exacerbated, and this is due not only to the reduced size of economy but also to significant institutional and, more important, coordination failures. Three main problems can be identified: (i) Business environment issues related with weak insolvency regulation. Spurring innovation depends not only on a sound financial market, where financial resources can be easily reallocated across firms, but also on an effective bankruptcy system. Stringent bankruptcy regimes, with high costs for failed entrepreneurs, can provide disincentives for entrepreneurs in general, and SMEs specifically, to innovate therefore preventing the introduction of new products, processes and methods. In Croatia, as shown by recent Doing Business numbers, resolving insolvency practices are still far from the most efficient practices in the world. (ii) Lack of risk capital financing culture. There are predominant coordination failures that are translated into a lack of a proper risk capital culture, which constitutes a typical “chicken and egg” problem.45 Unless the market is fully developed, it will not be able to support the development of a robust and continuous pipeline of promising startups. In turn, this would stall the emergence of a strong business angel community that can back innovative companies in the earlier stages, of lawyers able to negotiate venture capital deals and IP agreements, while sufficient experienced investment professionals and developed exit markets will struggle to emerge. In addition, until venture capital funds have been investing in the country for a relatively longer period, there will be 42 Information asymmetry between the inventor and the potential investor about how promising an innovation project is. As a result there is a gap between the return of private innovation and the cost of capital, which is translated into a reduced willingness to finance new ideas/process. Appropriation risks are related to externalities that prevent inventors to capture all the returns of their invention. As a result the social return to innovation investment is higher than the private return and markets tend to invest less than is socially optimal. 43 In principle, innovation activities are more difficult to finance than other types of investment for several reasons. The most important are: i) the fact that innovation produces an intangible asset that does not typically constitute accepted collateral to obtain external funding; and ii) the technological and market uncertainty of innovation activities makes the returns to investment highly uncertain, creating significant problems for the standard risk adjustment methods used by providers of funds. See Hall and Lerner, 2009. 44 http://www.enterprisesurveys.org/~/media/GIAWB/EnterpriseSurveys/Documents/Profiles/English/Cro atia- 2013.pdf 45 Because innovation happens within a system where actors might have different incentives, there is always the risk that individual actors do not act in a coordinated way. Therefore, “..most (if not all) parts of the system need to be in place for it to function well, and missing parts may not emerge if some others are missing (World Bank (2014)). Page | 36 no history of returns. However, without a history of returns, venture capital investors are reluctant to invest, even when underlying investments may offer the potential for healthy returns. (iii) An incomplete regulatory framework for a venture capital industry. Important regulatory barriers that directly impact seed and early stage finance include the ease with which venture capitalists and business angels can organize themselves. In this regard, Croatia transposed the EU’s AIFM Directive46 into national legislation in 2013 when the Alternative Investment Funds Act was adopted. This primary legislation laid the conditions for establishing and operating alternative investment funds and alternative investment fund managers, including marketing and distribution of such funds, the delegation of duties to third parties and supervising and managing AIFMs, AIFs and depositaries and those marketing AIFs. Recent analysis conducted under World Bank projects suggest there are certain inconsistencies in the way Croatia has transposed the EU AIFM Directive, which prevents the country to replicate best practices in the creation of the seed and venture capital funds. First, the Croatian Alternative Investment Funds Act does not make a distinction between small and large investment funds, and as a result, small funds tend to be overregulated, preventing the pick-up of private VC activity. Second, the same Act does not envisage an option to establish a venture capital fund as a limited partnership, which is best practice. Third, according to Corporate Income Tax Act open-ended investment funds are exempted from tax payment while closed-ended funds are not; while the international practice is to establish venture capital funds in this form. 68. Drawing on these constraints the emerging picture in Croatia is the one with insufficient supply of risk capital financing. Available evidence suggests that Croatian firms have access to financing for the initial (pre-seed) stage, as well as for the expansion stage, but limited funding is available for the critical phase in between these two points of development, the so-called “valley of death”. Figure 36 shows that in Croatia entrepreneurs have access to funds for pre-seed and late expansion and growth stages. However, they have few sources for funding in the seed, start-up and early stages. For the pre- seed stage, and partially for the seed phase, there are programs managed by Croatian Agency for SMEs, Innovation and Investments (HAMAG-BICRO) to help start-ups with the development of new technologies with commercial potential. For the late expansion phase, funds are available, often provided by private equity funds; however these have not trickled down to finance innovative SMEs. Thus, the private sector is not currently a reliable channel for financing technology driven startups in need of early-stage financing. Figure 36. Gaps in Risk Capital Financing Undermine the Innovation Ecosystem in Croatia Source: World Bank 2015 Project Appraisal Document. 69. In addition, data suggests that the supply of risk capital in Croatia is below that of countries at a comparable level of income. The left hand side panel of Figure 37 below shows that Croatia has less venture capital available as a percentage of GDP than a number of other countries in Europe at a comparable level of income. The left hand side panel presents results from the World Economic Forum’s Global Competitiveness Report, which shows that executives in Croatia report lower levels of venture 46The Alternative Investment Fund Managers Directive (AIFMD) or Directive 2011/61/EU was adopted by the EU to regulate and supervise alternative investment fund managers (AIFMs) who manage alternative investment funds (AIFs), including private equity (PE) funds, VC funds, hedge funds etc. operating in the EU. Page | 37 capital availability than most other countries. Results from the Global Competitiveness Report rank Croatia at 114th in the world for the availability of venture capital. Figure 37. Venture Capital Investment and Availability in Croatia Relative to GDP Per Capita Source: Own elaboration based on data from World Development Indicators, the World Economic Forum Global Competitiveness Report 2014, the European Private Equity and Venture Capital Association (EVCA) and the Croatian Private Equity and Venture Capital Association (CVCA) Opportunities for Reforms 70. Against this backdrop, potential (legal, regulatory or administrative) reforms would allow the Government to have a direct impact on business conditions by addressing some of the shortcomings that affect entry, survivability and exit of firms in Croatia. To get out of this low level equilibrium, where uninspiring export performance is reinforced by reduced creative destruction and innovation, Croatia needs to shift more forcefully towards a productivity-based and innovation-driven growth model. One of the most promising signals for the country’s export competitiveness outlook stems from the existence of a fringe of dynamic small exporters in innovative niche sectors. Supporting such a route is consistent with putting in place a new growth model based on employment and productivity increases, exports and innovation, as suggested by the World Bank 2009 EU Convergence Report for Croatia. This implies investing into innovative SMEs and accompanying human capital. These firms - by creating new goods (or upgrading existent ones), implementing new processes or introducing new market strategies – can play a key role for lifting Croatia out of recession and back into sustained growth. 71. In order to foster such development, it is key to tackle factors holding back entrepreneurship in Croatia. These include an unfriendly business environment, limited competition in product markets, lack of early stage financing and skills deficits. Despite the reform efforts in the last years Croatia’s business environment still suffers from major institutional shortcomings, as highlighted by a number of international reviews 47. In addition, the lack of early stage financing undermines the innovation ecosystem by preventing innovative ideas with commercial potential from reaching the market, which reinforces the vicious cycle of reduced renewal process in the economy. A significant share of Croatian youth leave the education system with poor cognitive foundation skills such as in reading and mathematics which leaves them ill-equipped for the fast evolving demands of a competitive, innovation-driven economy. At the same time, the share of Croatian workers participating in lifelong learning activities is one of the lowest in the EU. Business Entry 72. The Government of Croatia should continue reforming the business registration. It can do so by focusing on eliminating outdated requirements through legal amendments, merging and streamlining the registration processes of multiple departments and agencies, and making all registration processes (including post-incorporation) fully electronic without any need for physical paper trails or physical interaction. In Canada, UK, Singapore or Slovenia, for example, an integrated IT system links the databases of relevant agencies (company registry, tax administration, social security system, and statistics institute). The entrepreneur submits the information and the payment electronically via the website through a single form and the company is automatically registered with all agencies. Norway even took this a step further. Since 2005, all public registers and public authorities have a legal obligation to use the data 47 2016 Doing Business Report, the 2014-15 Global Competitiveness Report of the World Economic Forum and the OECD product market regulation Index. Page | 38 registered in the Central Coordinating Register for Legal Entities instead of requiring businesses to resubmit this data to the concerned agency. Survivability of Firms 73. Reducing the cost of doing business through regulatory reforms, reduction of quasi-fiscal fees, and protection of fair market competition can help ensure survivability of firms. Reforms that make regulation more efficient and transparent can also help reduce corruption and informality. Croatia can also benefit from liberalizing its service sector, in particular of professional and business services. 74. Croatia should continue and deepen its efforts to ease the regulatory burden on firms. Croatia should continue with the full implementation of its new spatial planning and construction system, as well as introduce the deadline and procedures for the mandatory update of land registry and cadaster data. After all titles being digitalized and connected to the cadaster data, In the area of construction permits, authorities should focus on enforcing the new laws, ensuring safety standards that protect the public while making the permitting process efficient, transparent and affordable for both building authorities and the private professionals who use it. Croatia has passed three new laws in January 2014: a Building Act, a Physical Planning Act, and an Inspection Act. The new Building Act established a single building permit as the sole administrative act allowing construction, and enabled the building permit to directly reflect zoning maps, thus eliminating the need for a location permit in the vast majority of cases. 48 Furthermore, it introduced disciplinary proceedings for non-performing municipal officials that resulted in more prompt processing of the usage permit. The Physical Planning Act created a Croatian Institute for Spatial Development, a national level body in charge of developing and implementing national zoning plan, and a Physical Planning Information System (ISPU), which – once fully implemented – will enable free and fast access to physical planning data for the whole country. 75. Further, efforts to integrate fully into the EU internal market need to be reinforced. Croatia needs to liberalize its service sector regulation, which is holding back the productivity of other industries. Services account for a large share of GDP and employment in Croatia. They make up 70 percent of its GDP, close to the EU average of 74 percent, but around 64 percent its employment. Growth in services affects many dimensions of the economy. Finance, accounting, transportation, communications, legal support, and other commercial services are not only forms of economic output in themselves, but are also critical as inputs into other economic sectors, including manufacturing, thus playing a pivotal role in economy-wide productivity. High-quality, low-cost services can boost firm productivity and enhance overall competitiveness. A strong service sector is vital to diversifying and expanding a country’s exports since exporting firms tend to be more productive. Meanwhile, service imports can serve as an important channel for introducing new technologies to the domestic economy and thus boosting exports and helping countries to integrate into global value chains.49. 76. Yet, services are not delivering their full potential in Croatia. Even within the EU internal market, services remain limited to borders that the single internal market aims to remove. In 2014, services represented only around 31 percent of Croatia’s intra-EU trade. Low productivity growth in services can partly be explained by regulatory barriers at the national level. Regulation in network and professional services remains particularly rigid in Croatia compared to the rest of EU50. 77. In the absence of efficient courts, firms make fewer investments and business transactions while informal transactions become more attractive. Improvements in court efficiency are associated with a lower share of the informal sector in the overall economic activity, increased investor confidence and increased bank financing of firms for new investment.51 The Enforcement Act from 2012 aimed to reduce the time needed for enforcement procedures by transferring certain procedures from the court to other bodies, such as the Financial Agency (FINA). FINA is competent to directly execute court judgments and court settlements on debtors’ bank accounts. As a result, creditors no longer need to obtain an 48 The location permits is now required only for exceptional situations, such as the construction on properties that have an unclear title or have to be expropriated. 49 http://www.oecd.org/sti/ind/global-value-chains.htm 50 The level of regulation at sectoral level is proxied by the OECD's Product Market Regulation (PMR) indicator that translates policy action into a quantitative indicator. 51 Among other papers, see G.B. Ramello and S. Voigt, 2012. “The economics of efficiency and the judicial system,” International Review of Law and Economics; Mehnaz Safavian and Siddharth Sharma, 2007. “When Do Creditor Rights Work?” World Bank Policy Research Working Paper No. 4296; John Ahlquist and Aseem Prakash, 2010. “FDI and the costs of contract enforcement in developing countries,” Policy Sciences, Springer, vol. 43(2), pages 181 -200, June; Inessa Love, 2011. “Settling Out of Court: How Effective is Alternative Dispute Resolution,” Viewpoint Note No. 329, The World Bank Group, October. Page | 39 enforcement decision from the court in addition to the final judgment. Moreover, Croatia approved significant amendments to the Civil Procedure Act in 2013 to streamline the way the litigation process is administered, including the way litigants submit evidence. However, the court system still exhibits large inefficiencies as seen through the backlog of cases, large budget allocated for delayed rulings or a comparatively large number of cases rejected by higher courts. 78. Reforms to the Labor Law in 2013 and 2014 represented a significant step toward greater labor market flexibility in Croatia. As a result, Croatia is now closer to the OECD average in terms of the strictness of the employment protection legislation. The main objective of the recent labor market reforms was to foster hiring and employment growth by relaxing some regulatory restrictions. As part of the reform, hiring costs were lowered by raising the permissible cumulative duration of employment with Temporary Work Agencies (TWA) from one to three years as well as eliminating the three-year duration of the first fixed-term contracts. Individual dismissals were made easier and less costly by (i) abolishing the requirement to retrain and reassign the redundant worker to a different job; (ii) allowing employers to dismiss worker who are on long-term sick leave (for six months or more), and (iii) reducing the maximum compensation for unfair dismissal from 18 to 8 monthly wages. Collective dismissals were made easier by abolishing the requirement to prepare a “social plan” (which was meant to specify measures taken to minimize the impact of the redundancy). Working time flexibility was enhanced by allowing employers to redistribute working hours (i.e. to increase working hours during the peak periods and to proportionately reduce them during the slack period) with a maximum of 50 working hours per week (60 hours/week if provided for by a collective agreement). Part time employment was made less costly for the employer by introducing a pro rata principle, whereby all monetary benefits (bonuses, allowances, etc.) are paid in proportion to the actual working time. 79. However, a number of rigidities is still in place, and there is room to improve labor market performance through further reforms. The following issues stand out and need to be addressed in order to improve labor market performance.  Complexity of the Labor Law. Despite reforms, Croatia’s Labor Law is difficult to understand, many provisions are unclear or ambiguous and can be subject to different interpretations. There is substantial space to simplify and streamline the Labor Law.  Adjudication of cases of unfair dismissal. The expected costs of (individual) dismissals are high in Croatia because it is difficult for employers to prove poor performance or misconduct, and courts tend to rule in favor of the dismissed worker (almost invariably according to anecdotal evidence). When the court rules that the dismissal was wrongful, the employer is obliged to pay the dismissed worker all forgone wages (from the time the complaint was lodged until the court’s ruling). Given the protracted court’s proceedings (from 3 to 5 years), the cost to the employer can be prohibitive, which can act as an effective deterrent to dismissals. As long as court jurisprudence does not change so as to recognize the right of employers to exercise management prerogatives, the firing costs will remain high.  Collective agreements in the public sector grant public sector employees monetary and non- monetary privileges that are significantly higher than in the private sector, which leads to labor market segmentation and inefficiency. There is a need to equalize the expected benefits of public and private sector employment, and to support efficient allocation of labor resources.  Specific provisions of the Labor Law that limit labor market flexibility include short probation period (maximum of six months), priority rules for redundancies (e.g. the employer is obliged to take into consideration family responsibilities of workers to be made redundant), less working time flexibility in the case of firms not covered by collective agreements (which can be particularly problematic for small firms), and the possibility of a mandatory extensions of collective agreements to non- participating employers (without providing them with an opt-out option). There is room to revise these provisions so as to improve labor market performance, without lowering the overall level of employment protection. 80. Croatia can adopt a strategic approach to building skills along the life cycle starting with ensuring that all students graduate with the right cognitive foundation skills like reading and mathematics to prepare them for continuous learning and with adult education and training policies that help older workers improve their skills, facilitate shifts to sectors with higher productivity, and help the unemployed find jobs. Given the projected decline and aging of Croatia’s population, the imperative is to ensure that schools offer quality education for all students, including children and youth from disadvantaged background. Students in the poorest socio-economic quintile are roughly two years behind their peers in Page | 40 the richest quintile in their reading and mathematics skills measured by PISA. To reduce inequities, it is important to understand the key factors which affect student achievement in the contexts that are specific and particular to the Croatian reality. Such knowledge comes through comprehensive data collection and analysis of existing conditions, to support impact evaluations of any policy and activity levers implemented to address national concerns. One key factor to understand thoroughly is teacher quality. Leading researchers have determined that teacher quality is the main school-based predictor of student achievement.52 As such, to ensure a high quality cadre of teachers, a national system of competence standards for teachers should be developed. The development of such a system is included in Croatia’s education strategy. Implementation of the strategy has been slow, however. Improving the quality of teachers in general education will help to reduce the performance gap among socio-economic groups. 81. Croatia can strategically promote lifelong learning by improving labor market information, providing adequate incentives to firms and workers, and raising the capacity of firms and training providers. The government could use its convening power to create mechanisms to improve the flow of information on skill needs and encourage coordination and cooperation between firms, industry associations, and training providers. Improving the availability and quality of information is a critical first step to building demand-driven lifelong learning. As a holder of information of vacancies and due to its role of placing the unemployed, Croatia’s Employment Services can play an important role in bringing the supply and demand side of training closer together. Government financing could be used strategically by leveraging private resources from employees and firms. Government resources could also be deployed to improve the skills of the unemployed, given the social returns from reduced social welfare payments and higher tax revenue when they transition to paid work. 82. The supply of early stage financing in Croatia is expected to increase in the coming years with funding coming from European Structural and Investment Funds (ESIF). However, unless the country has a risk capital culture already in place this money will not be fully absorbed. In the next few years, Croatia is expected to be the recipient of substantial funds from the European Union. A portion of these funds will be allocated towards supporting science, technology, innovation and entrepreneurship; this will include funding towards venture capital vehicle and other risk financing instruments. Preliminary figures indicate that €20 million will be allocated for venture ca pital in Croatia from structural funds during the upcoming period under Thematic Objective 3 of the Operational Programme Competitiveness and Cohesion 2014-2020.53 Another initiative supported by the European Union is the development by the European Investment Fund (EIF) of a regional venture capital fund for the Western Balkans – the Western Balkans Enterprise Innovation Fund (ENIF). This fund will invest in countries across the region, which will likely include Croatia. As the country will make larger investments in research and innovation systems as part of its integration process in the EU and is preparing itself to receive EU funding, developing a sound mechanism for early-stage financing is even more pressing. There is therefore a need for preparing a framework that will allow the absorption and effective use of the expected inflow of EU funds. From the regulatory review side, Croatia needs to revise the transposition of the Croatian Alternative Investment Funds Act vis-à-vis the EU Alternative Investment Funds Management Directive to guarantee that the legal environment will allow to replicate best practices. Firm’s Exit 83. Evidence from previous work in this area suggests that reforming an insolvency regime can help lower interest rates and increase lending volumes, making credit more affordable. In Italy, the 2005 bankruptcy law reform that deeply reformed the liquidation procedure led to a decrease in interest rates54. In particular, firms with higher numbers of bank creditors saw the most pronounced reduction in interest rates due to the enhanced coordination provided by the bankruptcy law. 84. Croatia has intervened into the bankruptcy framework several times to allow for out-of-court insolvent firm reorganization, to introduce strict deadlines to bankruptcy processes, and increase the capacity of the bankruptcy trustees. Despite all these initiatives, the reform process has not resulted in a significant improvement of the current system and firms still find it difficult to reorganize, while bankruptcy procedures still last three years on average. While the legal framework regulating the prebankruptcy settlement has been significantly improved in 2015, it is widely agreed that the institutions in charge of applying the recent reforms (courts, registries, FINA) lack the resources, skills, leadership, and experience to adequately enforce the law. It would be key to focus future reform efforts on strengthening the 52 Hanushek and Woessmann. (2007). 53 Theventure capital facility is planned to be a 50-50 funding match with private investors. 54 Rodano, Serrano-Velarde, Tarantino (2012). Page | 41 institutional capacity of the system in order to maximize the benefits of recent reforms on corporate insolvency. 85. A series of reforms targeted at strengthening the bankruptcy framework are necessary. These could improve the implementation of the recently approved legal framework and ensure that the legal changes achieve the results initially envisaged by the authorities. Specifically, the following is recommended: i. Closely monitor the application of the new (pre bankruptcy settlement (PBS) provisions in order to ensure its correct implementation by the institutional framework. Some adjustments might be required in the first months. ii. Review the tax treatment of NPLs, including the tax relief from the sale of NPLs below book value, and the tax implications of a write-down (in restructuring or liquidation) to the debtor and creditor. iii. Introduce training programs targeted at members of the judiciary, insolvency trustees, restructuring professionals and borrowers. iv. Develop Out-of-court Workout Guidelines and provide support & incentives to encourage banks to pursue restructuring of the largest, most complex defaulted corporate borrowers. v. On personal insolvency, provide resources and increase the capacity of FINA and the courts to ensure they can effectively play their role in this insolvency framework. vi. Consider the possibility of regulating the profession of insolvency commissioners. vii. Implement a coordinated policy towards NPL resolution in Croatia, by bringing together all relevant public and private sector stakeholders and reviewing, in a holistic way, current impediments to NPL resolution. viii. Review and improve the existing enforcement of executive procedures, especially for mortgages, to reduce the time spent in court proceedings, for example by introducing a limited list of admissible defenses. ix. Introduce an out-of-court enforcement regime for mortgages and, eventually, to pledges over movable assets, if the backlog of cases cannot otherwise be reduced. Page | 42 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs Strengthening Public Administration Key Messages A central challenge will be to reduce the wage bill to a sustainable level while continuing to deliver public services. This requires measures to improve the efficiency and effectiveness of public institutions and build institutional capacity to manage and coordinate increasingly complex policy issues, particularly now that Croatia is an EU member. Key Actions  Review how functions are allocated across the public administration and identify measures to rationalize ministerial structures, agencies, regulators, and local governments. Implementation will likely require the adoption of firm commitments and a time-bound action plan, monitored by a central unit to provide impetus for reform.  Strengthen HR systems and management across the civil service by: (i) Professionalizing public institutions by establishing merit and performance based systems of recruitment, promotion and discipline for civil servants, harmonizing pay scales and facilitating mobility across institutions; and (ii) Reducing the number of political appointees in central and local administrations, and SOEs, and professionalizing leading positions in state administration bodies and professional services, including the management of majority state-owned and public companies.  Promote strategic planning and a stronger performance orientation in public institutions through the strengthening of monitoring and reporting systems. Building on the early success of the e- citizen project there are significant opportunities to offer more responsive services to citizens and businesses. Where Croatia Stands Now reforms, the process has been slow and reversible. Public administration in Croatia is The public sector wage bill, at close to 12 characterized by its high cost and relatively percent of GDP, is well above average EU low effectiveness. According to the World levels. Croatia spends more on public Economic Forum Competitiveness Report 2015- administration than most other EU countries 2016, the two largest barriers to doing business (Figure 1), but performs poorly in indicators of in Croatia are inefficient government public administration effectiveness (Figure 2), bureaucracy and policy instability. Severe rigidity the rule of law and administrative barriers to in organizational structures, politicization of the doing business. civil service and the remuneration system are part of the problem. Functions overlap across Figure 1. General Government Wage Bill, Percent various government institutions and different of GDP layers of government, policy coordination is poor and lines of accountability between ministries, agencies and subordinate public entities are often unclear. Local government units are fragmented into inefficient small units, which are not self-sustained and have excessively high wage bills. A central challenge will be to bring the wage bill to a sustainable level. Further, it would need to make public administration more effective and ensure there is capacity for Source: Eurostat, MOF. Weighted average for EU15 and increasingly complex policy coordination, EU10 (member states that joined the EU after 2004). particularly now that Croatia is an EU member. The high wage bill reflects the growing Although previous governments recognized the number of public sector employees, rather importance of civil service and administrative than high wages. The rationalization of military Croatia Policy Notes | Strengthening Public Administration 43 staff has been more than offset by growing local tend to be of lower quality. These relative government employment in education and health inefficiencies show that there is an opportunity for services. With around 293,000 employees, large savings and efficiency improvements general government represents 17 percent of the without compromising the quality of service labor force and is the largest employer in the delivery. country. This number excludes more than eighty Figure 2. Public Administration Performance thousand staff employed by public enterprises, which jointly amounts to 22 percent of the Croatian labor force, some 4 percentage points above the EU average. The growing number of public servants does not seem to reflect the demand for their services. For example, Croatia’s public education staffing continues to grow despite a significant decline in the number of students enrolled. Croatia has the largest per capita ratio of judges and court personnel in Europe; yet there is evidence of a backlog of cases and concerns about service quality. The Bank Note: a composite index of governance; capacities; and estimates that some 2 percent of GDP in business-friendly design in key areas of companies’ dealings with the administration. cumulative savings could be achieved over the Source:http://ec.europa.eu/growth/industry/competitiveness/ medium term through staff rationalization in civil public-administration/index_en.htm. and public service to create a leaner, but more Dealing with red tape is time-consuming for effective administration. businesses, drawing senior managers away Public sector pay is based on seniority rather from more productive tasks. According to the than performance. The reliance on benefits for World Bank Business Environment and years of service places an additional burden on Enterprise Survey (BEEPS) 2014, senior the wage bill and increases incentives for older managers in firms spend an average of 23 workers to stay. Croatia has a large cohort of percent of their time dealing with public officials middle-aged staff that entered the service around and public services. This is nearly double the independence. Since there is a built-in incentive average in EU countries that joined after 2004. In to stay in the system (i.e. staff receiving 0.5 a worrying trend, the amount of time firms in percent increments per year of service and a Croatia spend dealing with red tape has strong bargaining power of public sector unions), increased by nearly 50 percent since 2008. the rate of natural attrition is low. At the same According to the World Economic Forum Global time, a staff retrenchment program, with Competitiveness Report 2015-2016, Croatia severance packages based on years of service, ranks 137th out of 140 economies for the burden would be costly (for someone with 30 years of of government regulation on business. service it would equal around EUR15,000), and Government decision-making remains will increase as this cohort ages. In addition to opaque. According to the World Economic the years-in-service allowance, there are 15 Forum Global Competitiveness Report 2015- different bonuses that range from 4 to 150 2016, Croatia ranks 113th out of 140 economies percent of basic salary, that are not mutually for transparency in decision-making. With the Act exclusive and can be greater than the basic pay. on the Right of Access to Information as well as None of these allowances are performance the Act on Regulatory Impact Assessment, the related. Extensive use of allowances across the legal framework for ensuring rights to access administration leads to upward pressure on information as well as participating in the policy wages. Total remuneration may therefore tend to formulation has been improved. There have also be driven by bargaining power rather than been improvements regarding the availability of qualifications, merit or performance. data on public finances, political donations, and Croatia’s public administration performance the content and integration of public registers. score is the fourth lowest in the EU better only Nonetheless, further reforms could continue to than Malta, Greece and Lithuania. According to embed open governance practices. the Global Competitiveness Report 2015-2016, The e-citizen project has demonstrated that Croatia ranks 126th out of 140 countries on the Government service delivery can be quick, wastefulness of government spending. Given the easy, accessible and effective. The e-citizen high cost, Croatia’s taxpayers are paying a high project has the potential to transform citizen’s price for public services, close to the level in engagement with the central government and Scandinavian countries, but receive services that Croatia Policy Notes | Strengthening Public Administration 44 public perceptions of service delivery in key classifications could help ensure equitable pay areas such as health, education and pensions. across the public sector. The central payroll Building on recent success with some services, system should be merged with the HR the focus could now shift to full implementation of management information system to strengthen the e-citizen project, embedding the maximum controls and facilitate management. number of services into the online interface. There is also a need to professionalize the Nonetheless, in many areas, interactions with civil service. According to the Global government are slow and performance is Competitiveness Report 2015-2016, Croatia sometimes deteriorating. For example, the ranks 100th out of 140 economies for favoritism number of days that firms wait for new water in decisions of government officials. The lack of connections, electrical connections, operating a clear separation between political and career licenses and import licenses have all risen since posts also creates significant instability among 2008. Some have more than doubled. For senior civil servants, reduces corporate example, according to BEEPs, in 2008, firms institutional memory and learning, as well as waited an average of 27 days for an operating incentives for qualified staff to stay. Depoliticizing license, but by 2014, they were waiting an top managerial positions in ministries, state average of 55 days. agencies and SOEs could prevent brain-drain and operational gaps emerging after elections. How Croatia Can Improve the This should be combined with more continuous Efficiency of Public Administration skills development to help civil servants build Public administration reform needs strong their professional capacities. There is currently no central policy to promote professional political leadership and reform management. development in the civil service, despite the Adoption of firm commitments and a time-bound training infrastructure to support it. The action plan, monitored by a strong central unit experience of EU countries suggests that the could provide impetus for reform. need for more skilled civil servants will grow with While a number of agencies have merged in progress in the process of European integration. recent years, more could be done. The Over time, this will ensure that Croatia has a structure of state administration remains stable, well equipped and agile cadre of civil excessively fragmented with overlapping servants, capable of meeting modern public functions at the level of line ministries and among service delivery challenges. ministries and subordinated bodies. Further Most of the issues described require rationalization should be based on a thorough sustained and long-term attention; however, review of institutional functions, because several important steps could be taken in the mechanical merger of institutions could short term: exacerbate the problems already inherent in the system, especially fragmentation. Restructuring 1. Rationalize the structure of public could incorporate the separation of policy- administration: (i) Conduct a functional making, regulatory, and service delivery review and analysis to inform further functions within ministries, regulatory bodies, rationalization of ministerial structures, and agencies, all based on a revised law that agencies, regulators, and local governments; would define the principles for the organization of (ii) Prepare the time-bound plan for public administration. Such a law could clearly rationalization. allocate functions (policy development, regulatory management, supervision, inspection, 2. Strengthen HR systems across the civil and implementation) and responsibilities service: (i) Install a Human Resource between public institutions. Management Information System to link staff personal information to payroll payments as a Improvements in human resource basis for reforming the civil service salary management within the civil service could system; (ii) Reform salary systems for the civil help develop a professional cadre of officials. service, public service, and local governments The European Quality of Government Index 2013 to harmonize pay scales and facilitate mobility rates Croatia’s public service among the least and better performance. This will require new impartial and the least meritocratic in Europe. job classifications and wage scales and a Systematic use of more objective criteria for reliable system of performance appraisal; (iii) recruitment, evaluation and promotion might help Establish an objective system of evaluation, instill a more merit-based, professional culture promotion and discipline for civil servants; (iv) and reward performance. The wage system also Offer greater continuing education for civil needs to be reformed to make base pay the main servants to build their capacity and boost their component of pay. Standardized job performance; (v) Limit the number of political Croatia Policy Notes | Strengthening Public Administration 45 appointees in ministries, subnational initiated and gaps in rollout and government and other agencies; and (vi) implementation. Professionalize the leading positions in state administration bodies and Government How the World Bank Group Can Help professional services, including the The Bank offers strong experience working with management of majority state-owned and clients on civil service reform – globally, public companies. regionally and in EU countries. This experience 3. Strategic planning and policy coordination is focused on rolling out reforms that increase could be strengthened. Policy-making needs efficiency and effectiveness in the public service to be closely linked to financial planning and delivery to people and businesses. This includes implementation. Effective policy management supporting functional reviews, right-sizing of would imply, for instance, drafting concept public administration, business process re- policy documents along an analysis of the engineering, wage system reforms, citizen- expected impacts before drafting legislation. centric service delivery models and e- The current system for policy coordination government services. The Bank support in EU appears top heavy with little effective countries is also focused on supporting the prioritization, leading to blockages in the establishment of Government Delivery Units, system. There is also no functioning system to aimed at mainstreaming modern techniques of assess the impacts of reforms, which means decision making, monitoring and communicating that the cost and even the desired impact of the reform agenda, and Strategy Units, to help new regulations are often unclear. Fiscal coordinate and monitor strategic planning. impacts are often not well articulated or planned, resulting in reforms that cannot be This Policy Note was produced by the World Bank to inform policy debate in Croatia. This note was prepared by Public Sector Specialist Georgia Harley and Senior Economist Sanja Madzarevic Sujster. The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the Governments they represent. For any questions regarding this note, please contact Vanja Frajtic, Communications Associate (vfrajtic@worldbank.org). THE WORLD BANK OFFICE ZAGREB: http://www.worldbank.org/en/country/Croatia Croatia Policy Notes | Strengthening Public Administration 46 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs Tax Policy and Tax Administration Key Messages Croatia’s tax system raises significant revenue and has undergone major improvements in recent years. Further improvements include making it more equitable, and labor and business friendly. Tax administration could be more efficient and user friendly through ongoing efforts to improve IT systems, consolidate the reorganized administrative structures and upgrade staff skills. Key Actions  Introduce modern property taxation (generating revenues up to 1.5 percent of GDP) while abolishing outdated local real estate-related taxes and fees.  Eliminate a large number of tax exemptions given to households and businesses (saving up to 1.1 percent of GDP).  Shift the tax burden from labor to indirect taxes to help support growth (revenue neutral).  Introduce tax policy and tax administration measures to incorporate the shadow economy and strengthen and modernize tax administration to protect and expand the revenue base, including the implementation of a modern compliance risk management system. Where Croatia’s Tax Policy Stands 5-percent rate, while tourism and catering Now services apply a 13 percent rate. The overall revenue foregone due to these differing The objective of tax policy is to build a thresholds amount to close to 1.8 percent of modern and efficient tax system that raises GDP. sufficient revenue in a way that is fair and Figure 1. Indirect and Direct Taxes in 2014, minimizes distortions. Reform measures Croatia and EU, percent of GDP typically emphasize measures to broaden the tax base, focusing on consumption taxes, eliminating ineffective exemptions or tax expenditures before increasing the rate. This also involves removing negative externalities, such as disincentives to work, and strengthening tax compliance. With a revenue burden at 42.6 percent of GDP in 2014 there is some, but limited scope for additional revenues in Croatia. While the EU15 average is 45.6 percent, Croatia’s tax burden is higher than its neighbors at similar levels of development. Therefore, the focus for Croatia’s Source: EUROSTAT tax policy should be on ensuring the most Direct taxes on the contrary are comparably appropriate composition of taxes that will drive low, largely eroded by large tax exemptions. growth and job creation through efficient tax The effective rate for personal income tax is only collection with minimum distortions or around 9 percent, despite a top marginal rate of exemptions. Both business and government 40 percent. In the case of households, there are benefit from a tax system that is simple to several exemptions e.g. tax allowances on administer and encourages voluntary dependent family members and children, as well compliance. as for underdeveloped regions. Businesses also Croatia has the highest indirect tax to GDP enjoy exemptions if located in underdeveloped ratio among EU countries. To respond to a regions, for reinvested earnings, R&D, and tax revenue fall during the crisis, the basic VAT rate reliefs as part of the investment promotion act, was increased to 25 percent, among the highest with the estimated revenue loss amounting to 2.3 in the EU, and the zero rate was replaced with a percent of GDP in 2014. Croatia Policy Notes | Tax Policy and Tax Administration 47 Croatia has moved to reduce labor taxes exemptions; and (iii) continue its “fiscal further since 2014 through an increase in the devaluation” by reducing labor taxes. non-taxable part of income (or personal Introducing a modern property tax requires allowance, which reduces the revenue collection capable local governments to administer it by 3.5 percent of GDP), and by shifting the and a comprehensive reform plan. Four main highest PIT bracket upwards to reduce the tax reform steps include: (i) identification of the burden on middle-income groups. Social security property being taxed; (ii) assessment of the contributions for young employees have also property value and the tax base; (iii) been reduced to incentivize employers to recruit establishment of the tax rates; and (iv) abolition more. of other property-related taxes. It is unlikely that Croatia has no recurrent property tax and such a tax would generate significant revenue raises the lowest revenues (0.3 percent of until the cadastral registry is updated and the real GDP) in the EU from property taxes. A modern estate market better developed so that valuations value-based property tax could add up to 1.5 can be more transparently calculated. percent of GDP in new tax revenues55. In addition Considering that a fully updated cadaster with all to the revenue potential, the burden of a property necessary information for property valuation will tax would largely rest on middle- and upper- take time to build, a short-term alternative might income families, and be less distortionary for consider an interim self-valuation procedure. business and consumer decisions. Currently the Reducing the large number of tax exemptions property tax base is deeply eroded by a could raise an additional one percent of GDP, combination of legal exemptions, an incomplete while improving effectiveness and fairness. cadastral registry (which fails to capture all For example, a recent review of child tax properties) and a real estate market that does not allowance--a tax rebate offered for families with provide transparent information on valuations. children that results in forgone taxes of around However, the proposed property tax remains 0.6 percent of GDP, undertaken by the World unpopular and in 2015 the previous government Bank, shows that the program is highly postponed the introduction until the land regressive, as it does not cover low-income registration and cadaster data are fully groups and maximizes the benefit for high- harmonized and updated. income groups. The program also discourages The size of the shadow economy, at 28% of work for lower-income groups (in contrast to a tax GDP56 , is one of the largest in the EU. This is credit system). Similarly, reinvested earnings tax challenging for the tax administration and relief for businesses reduces revenue, by 0.6 reduces the tax collection potential. Various percent of GDP in 2013, while the gains through policy and administrative measures can be taken new investments are questionable. Overall, the to tackle the shadow economy. A three-pronged design of taxes and social benefits should also approach could comprise the following elements: reduce disincentives for moving from either benefits or inactivity to work. (a) Introduce strategies to improve tax enforcement, particularly measures to Payroll taxes and social contributions can identify and then reduce underreporting suppress employment and labor-intensive or non-reporting of sales, or inflating growth. In OECD countries, the burden of labor expenses through false invoices; taxes can account for up to 40 percent of labor costs, particularly for lower-wage individuals. (b) Incentivize formal payments for business Labor taxes are also disproportionally high in transactions through banking channels, European countries. For instance, in Poland, including electronic payments, and Romania, and the Slovak Republic, social “plastic money”; security contributions make up 45–49 percent of (c) Enhance tax simplification and taxpayer the gross wage; while in Chile they were 13 services to reduce the costs of tax percent and in the Republic of Korea 16 percent. compliance, including by simplifying tax With the contribution rate of 37 percent Croatia laws, and filing and payment systems. follows the EU path, with the caveat that the pension contribution rate is moderate, while the How Croatia Can Enhance Tax Policy health insurance contributions, at 15 percent of Croatia could: (i) introduce a modern property gross wage, is high--almost double the EU tax; (ii) reduce the large number of tax average. High levels of labor taxation, combined 55 World Bank 2014, Public Finance Review 56 “The Shadow Economy in Europe 2013”, AT Kearney, F. Schneider Croatia Policy Notes | Tax Policy and Tax Administration 48 with tax incentives for capital investment, can electronic filing mechanisms (e-VAT, e-pension, exacerbate high unemployment. e-health and e-PIT) with the percentage of e-filing by the corporate sector increasing from less than Where Croatia’s Tax Administration 3 percent in 2007 to more than 99 percent in Stands Now 2015. CTA has also upgraded its website, which has more than 26 million visits per year, making A modern tax administration ensures that taxes can be paid quickly and cheaply and do it one of the most popular government websites. not deter investment or value adding CTA is moving ahead with the procurement of activities. Modern tax administrations are enhanced hardware and software and the creation of a disaster recovery and business citizen-centric, ensuring that (i) taxpayers know continuity center (DRBC). their rights and responsibilities, (ii) processes are transparent and simplified, and (iii) there is Table 1. Compliance Costs in Croatia support for taxpayers and deterrents for evasion. Strengthening and modernizing Croatia’s tax administration (CTA) would help protect and expand the revenue base. The CTA is responsible for collecting national and some local taxes, social insurance contributions, and a large number of levies, fees, and other charges. The Customs service collects excises, customs and imported VAT. As Croatia becomes more integrated into the global economy, the CTA will face challenges of increasing complexity. For the quality of its services to meet modern standards the CTA will have to move from being procedure- oriented to results-based. The objectives of Source: World Bank, www.doingbusiness.org modern tax administration include: (i) promoting a voluntary compliance culture, (ii) improving Taxpayer compliance has been steadily taxpayer services, and (iii) efficient collection improving. The VAT tax gap in percent of GDP systems. has been steadily falling, from 2.05 percent in 2011 to 1.52 percent in 2013. Croatia also shows Significant progress has been made in significant improvement in its position in the reorganizing the CTA. The CTA has been Doing Business 2015 indicator on paying taxes: reorganized along functional lines at the central rising from position 43 in DB 2013 to 38 in DB and regional levels; a Large Taxpayers Office 2015 (see Table 1). The results show that (LTO) was established at the national level in Croatia’s indicators are very near OECD 2012 along with a Taxpayer Service Unit and a averages in terms of the number of payments per unit for Sector Strategy and Development. The year (19 Croatia/12 OECD); and hours spent on taxpayer identification number (OIB) has been tax compliance per year (206/175). introduced and fully integrated into the e-citizen initiative. Many of these reforms have been The CTA faces three interlinked challenges to introduced in partnership with World Bank further improving performance. These are: support. restructuring its organization; building human capacity; and improving its IT systems. Important tax administration reforms have been implemented. Fiscal registers were CTA can strengthen the role of HQ in introduced from January 2013 for cash-based designing programs and providing strategic services to increase compliance; and public guidance. There are too many field offices and listing of tax delinquents was launched in June they rely heavily on manual procedures and 2012. In 2013, a strengthened tax administration frequent contacts with taxpayers, especially at code strengthened powers to collect tax-related the local level. This not only overwhelms staff, it information from taxpayers and third-parties and prevents them from doing more complex and enforce payment of tax arrears. It also introduced important tasks, such as audits and collection formal tax opinions for taxpayers, thereby enforcement. The inefficiencies associated with a removing ambiguities in tax settlements. large network of local offices will worsen as business processes become more automated Advances are being made to expand the use and e-filing (including CTA pre-filing of tax of technology. These include Information and declarations using third party data) and e- Communication Technology (ICT) tools for enforcement is extended. Compliance Risk Management, e-Audit, and e- Learning. The CTA has overseen the move to Croatia Policy Notes | Tax Policy and Tax Administration 49 The CTA headquarters’ has too few staff to voluntary compliance with tax laws and prevent adequately direct the large number of local noncompliance by understanding the tax base offices, which operate with considerable and taxpayer risk profiles. Pursuing a risk autonomy and minimal effective oversight . management approach would help CTA to: (i) The way CTA is organized does not correspond craft a compliance strategy that directs efforts at to the principles of modern tax administrations, major compliance risks (e.g., large taxpayers who which distinguish between the role of HQ in are the highest compliance risk to revenues); (ii) designing programs and providing strategic reflect the strategy in annual operational plans guidance and the operational role of local and and instructions (e.g., national audit plans, audit regional offices. Consequently, corporate selection parameters, taxpayer service plans, governance should clearly allocate and debt collection plans); and (iii) improve responsibilities between HQ, regional, and local compliance tools (e.g., audit organization and offices. methods, taxpayer services, and enforced collection) and the skills of tax administration Building capacity of CTA staff in the LTO is management and staff to efficiently realize also a high priority for improving revenue strategies and operational plans. collection. This is often a complex task given the various corporate models and requests for highly CTA has a range of strategic planning specialized skills. CTA has made significant documents, but implementation is progress in getting a fully-fledged national LTO in challenging. The Sector Strategy and operation in 2012. The new office has been Development Unit could enhance the institutional assigned 650 large taxpayers who account for awareness and understanding of strategic about half of Croatia’s tax revenue. The LTO is directions and manage coordination efforts fully aligned with the taxpayer segmentation across CTA to ensure that strategic and business approach, which is a core strategy of modern tax planning processes are linked and translated into administration. instructions and procedures for the day-to-day work of local and regional offices. Other priorities Building capacity in the new Office for could include strengthening IT governance to put Taxpayer Services will also help reduce in place an integrated management information voluntary compliance costs. Croatia has system, and improve the planning and recently established a dedicated unit for taxpayer exploitation of information. Strengthening human services and assistance, with a call center, and resource capacity is also central to modernizing services tailored to the unique characteristics and tax administration. The CTA training strategy risk profiles of taxpayers (the taxpayer therefore needs to be aligned with the reform segmentation approach). Strengthening this unit priorities, current organizational conditions, and using the call center to control non-filers and business reengineering processes, and IT delinquent taxpayers is a priority to enhance developments. compliance. CTA could be given more operational How Croatia Can Enhance Tax autonomy to administer the tax system, with Administration stronger accountability provisions. CTA CTA should focus on three issues in the short staffing levels have been eroded due to term: (i) implementing the CRMS system, (ii) recruitment restrictions. Additionally, CTA lacks implementing the disaster-recovery and business the flexibility and autonomy to: (i) design and continuity system, (iii) increasing the capacity and implement its organizational structure to meet training of staff especially within the LTO. changing requirements; (ii) determine the level and mix of staff and influence or negotiate their The CRMS system would include three key remuneration; (iii) influence the staff recruitment modules: (i) a risk management module that will process; (iv) allocate resources to respond select taxpayers for audit on the basis of risk effectively to changed priorities and risks; (iv) analysis, (ii) a data warehouse, and (iii) general make tax rulings; and (v) set service standards. audit support (GAS). The system implementation Therefore, giving CTA semi-autonomous status is underway with the core system provided by the and enough power to administer the tax system private sector and the GAS module developed in- effectively could be considered. A modern Compliance Risk Management System (CRMS) could help improve tax compliance and enforcement. Introducing a CRMS to systematically identify, assess, rank, and deal with tax compliance risks is a priority. Its overarching objective is to stimulate and facilitate Croatia Policy Notes | Tax Policy and Tax Administration 50 house through APIS-IT57. Once implemented the objective within the confines of the broader civil system should enhance CTA’s ability to detect service structure will be extremely challenging. fraudulent practices and thus optimize the Finally, the strategic functions of the CTA effectiveness of the audits system. This will not headquarters need to be strengthened. This only increase recovery of unpaid taxes but, will would include preparing, monitoring and also serve as a powerful incentive to foster evaluating of the CTA medium-term strategic voluntary compliance. plan and its results, proposing policy and system Further, the security and integrity of CTA data reforms that would be needed to increase CTA is of critical importance to Croatia. As such, efficiency, reduce the compliance costs and the CTA is developing a disaster recovery and improve the compliance rates, as well as business continuity (DRBC) facility. Once rendering high-quality analytical inputs for completed the DRBC facility will allow the CTA to decision making to the CTA management, the continue its operations should anything happen MOF and the Government. to the main data center in Zagreb. How the World Bank Group Can Help Training of CTA staff has increased in recent years through the introduction of e-learning The World Bank has significant experience modules in various areas including: working with countries worldwide, including a anticorruption, E-Tax, VAT, value-for-money significant number of EU countries, on tax policy purchasing, information security, effective and tax administration. This experience includes management, specification of unmatched the recently concluded Revenue Administration payments, forced collection and enforcement. Modernization Project (RAMP) in Croatia, which These specialized courses as well as general IT closed in June 2015. The Bank has produced a and language training are important to upgrade number of diagnostic studies on tax policy in the skills of CTA staff. It is important that these recent years, including the Public Finance pilot efforts are mainstreamed into a sustainable Review (PFR) of 2014 and Child Tax Allowance offering including tests and certifications for staff Policy Note of 2015, which looks at both tax and that complete the various modules which are benefit incidence. As outlined above, a number of linked to the CTA modernization strategy. reforms in tax policy were started and have been postponed e.g. the proposed introduction of a The tax office network consolidation needs to property tax. The World Bank would be ready to be continued. As the CTA moves to electronic partner with the government in carrying out communication, in the medium term CTA can proposed reforms along with further consider the physical consolidation of its offices strengthening CTA efficiency. starting with its offices in Zagreb, which continue to be fragmented across more than 13 offices. Bringing them together could greatly improve This Policy Note was produced by the World Bank to inform policy debate in Croatia. This note was prepared by Ismail Radwan, Lead Public Sector operational synergies and reduce administration Specialist and Sanja Madzarevic-Sujster, Senior Economist. costs. The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the CTA staff continues to be skewed towards World Bank or the Governments they represent. clerical and administrative functions. In future For any questions regarding this note, please contact Vanja Frajtic, the ratio of audit staff to other functions should Communications Associate (vfrajtic@worldbank.org). gradually rise to achieve the target of 65 percent THE WORLD BANK OFFICE ZAGREB: of staff in audit functions (up from the current level http://www.worldbank.org/en/country/Croatia of close to 50 percent). This will require strengthened efforts to recruit, train and retain qualified and competent staff. Achieving such an 57 The CRMS system was supported by the World Bank Revenue Administration Modernization (RAMP) project until it closed in June 2015 Croatia Policy Notes | Tax Policy and Tax Administration 51 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs Strengthening Public Investment Management and EU Funds Absorption Key Message Strengthening Public Investment Management (PIM) can improve the growth impact and efficiency of public infrastructure and unlock more of the substantial committed resources from the EU during the 2014-2020 financial perspective. Strengthening PIM planning, contracting, and implementation capacity, along with improvements to the strategic planning and medium term budgetary framework (MTBF), should therefore be a key component of Croatia’s growth reviving strategy. Key Actions  Create fiscal space to support EU funds absorption through expenditure switching and substitution policies.  Strengthen capital budgeting processes, including the link between investment planning and the MTBF, and between national priorities with the Cohesion Policy priorities.  Introduce a broader PIM-decree, with a comprehensive set of underlying regulations and guidelines, and a PIM information system to enhance the planning, selection, procurement and monitoring of public investment projects.  Strengthen individual and organizational PIM capacities, including project management capacity in line ministries and SOEs, and SOE governance arrangements. Where Croatia Stands Now PIM supports the effective absorption of EU Structural and Investment (ESI) Funds. As a Improving Public Investment Management new member of the European Union (EU), Croatia (PIM) has the potential to boost Croatia’s benefits from sizeable EU transfers. ESI funds economic growth and competitiveness. available total around €10.7 billion over the 2014 - Croatia’s overall level of public capital spending is 2020 financial perspective (equivalent to an relatively high, but lower than in other EU member average of 3.7 percent of today’s GDP per year), states that join since 2004: Croatia invested 3.7 while Croatia’s annual contribution to the EU percent of GDP in 2014 for general government, budget is about €530 million. Effectively utilizing compared to an average of 2.7 percent in EU15 ESI funds is an opportunity to boost growth and and 4.5 percent in EU10 (this figure rises in improve public services, including through co- Croatia to 6.2 percent including SOEs). However, financing for public investments. Given that much indicators suggest that this has yet to lead to the of the ESI-funds go towards public investment, expected outcomes in terms of economic growth, effective planning, preparation and competitiveness and improvement of public implementation will make a positive contribution to services. This is at least in part explained by absorption rates. institutional and process weaknesses in the PIM system itself leading to lower quality spending and A key question for Croatia is how to create inefficiencies in implementation. fiscal space through expenditure switching and substitution to support fiscal International evidence suggests there are consolidation and ensure the most efficient significant benefits from improving PIM . use of EU funds to support growth . Croatia’s Countries with the most efficient PIM systems tend pre-accession and post-accession record for to have higher growth for each dollar spent on absorbing EU funds is relatively good. By end- public infrastructure investment than the least October 2015, Croatia had contracted over 89 efficient countries58 . percent of the allocated IPA and ESI 2007-13 funds and paid half of the contracted funds for 58 IMF, Making Public Investment More Efficient, 2015. Croatia Policy Notes | Strengthening Public Investment Management and EU Funds Absorption 52 which the disbursement deadline is end-2016. means that a coherent approach to PIM will have Croatia was also a net recipient of EU funds in the to consider the adequacy of current SOE first two years post accession (by 0.12 and 0.42 governance arrangements as well as more percent of GNI). However, the fivefold increase in centralized regulations and processes. funds available to Croatia under the current EU The lack of clear national regulations and financial perspective raises new challenges — guidelines presents a significant risk for the while ESI Funds are expected to provide the bulk quality and efficiency of core PIM-functions. of investment financing, in the short and medium- Currently, there is little or no assurance that term this will add to the fiscal consolidation projects are effectively screened against pressures as Croatia will need to provide some of government policies and strategies, appraised the upfront funds and co-financing. using formalized appraisal tools and The coordination of the national strategic independently reviewed. The roles and priorities and harmonization with Cohesion responsibilities of key stakeholders lack clarity, Policy objectives is challenging. The EU resulting in ambiguity concerning the levels of Partnership Agreement aims to align strategies at approval and overlap of some functions. There are national, regional and local levels to ensure that also gaps in terms of formalizing the requirements funds have cumulative and long-term impact on for project management and monitoring, growth, rather than being allocated to one-off especially for state budget funded projects. projects. All Operational Programs have been Figure 1: Public Sector Capital Expenditure in adopted along with the preliminary allocation of Croatia, 2014 (Billion HRK) funds among implementing bodies and beneficiaries, although several ex-ante conditionalities remain to be cleared by the EC. However, Croatia’s strategic planning function is still being developed at the national, regional and local level to set clear priorities, objectives and performance indicators. Croatia should continue to strengthen the management of capital expenditures and EU funds management. The adoption of the new Organic Budget Act in 2008 spurred several reforms in public expenditure management, Source: MoF, www.mfin.hr, budgets and financial reports including strengthening the multi-year fiscal planning system and establishing a capital In the absence of a coherent national spending evaluation unit. As envisaged in the regulatory framework, the use of several Budget Act, the Ministry of Finance (MOF) has procurement methods and financing sources launched work on a Decree that will fill an risks creating and deepening parallel important gap in the methodology for appraisal of administrative structures. While governmental public investment projects financed from the State agencies prepare and implement projects co- Budget and other sources. Moreover, the National financed by the EU according to EU regulations, Reform Program emphasized the importance of these need to be translated into a coherent set of enhancing the planning and preparation of public national rules and guidelines. The Government investment projects and the management of public has developed a comprehensive regulation on resources to strengthen the absorption capacity of Public Private Partnerships (PPP) while the EU’s EU funds. However, challenges remain in new Investment Plan for Europe (the so-called establishing clear roles and responsibilities and Juncker plan), comes with a financing vehicle, the formalizing steps in the PIM-cycle. European Fund for Strategic Investments (EFSI) that sees mobilizing private investments into Public investment in Croatia is dispersed commercially viable projects as a key priority. across a number of organizations, with the While leveraging additional funds from the private largest share carried out by SOEs. SOEs sector or other agencies and utilizing new financial continue to play an important role in supplying instruments can be appropriate for certain public infrastructure, although the rationale for the projects, separate institutional arrangements for choice of organization is not always apparent. Of PPPs is a cause for concern as international good an estimated HRK20.6 billion infrastructure practice points towards harmonization of the investment in 2014, 12 billion was carried out by processes at the pre-appraisal, appraisal and SOEs (of which some are part of the general independent review stages for investment projects government coverage), while the remaining 8.6 regardless of the procurement method. This helps billion was shared among central and local to ensure a level playing field in the selection of government. The dispersal of public investment Croatia Policy Notes | Strengthening Public Investment Management and EU Funds Absorption 53 projects. Yet, these processes are largely financed projects are subject to pre-feasibility separate in Croatia. and feasibility studies with demand forecast, financial and economic cost-benefit analysis A comparison with good international practice including risk and sensitivity analysis, and shows gaps in key steps of the PIM cycle. A assessment of environmental impacts. methodology developed by the Bank allows a International financial institutions require similar comparison of current Croatian practices with evaluation for projects that they finance. As in good practices in key stages of PIM. These stages many other EU members, there is scope for include: utilising the capacity created through  Strategic guidance and preliminary screening. compliance with EU requirements at the local The lack of an overarching national strategy and ministry level for nationally-funded projects. clearly articulating public investment Independent review of appraisal is priorities inhibits effective pre-screening of underdeveloped. Good practice countries project ideas. Considerable emphasis should typically formalize independent checks of any be given to filtering out “bad project ideas” at an bias in project documentation. This is early stage. This is to ensure that only those particularly important as line ministries are not projects with a clear rationale in relation to in all cases following a stringent model for government policies and strategies proceed, separating internally the roles of “project and to avoid wasted resources on project proposer”, “appraiser”, “reviewer” and appraisal and design. Projects also tend to get “approver”. For example, pre-feasibility and their own planning momentum, which makes it feasibility studies would in many cases be more difficult to stop at a later stage. Yet, in outsourced with the contractor reporting to the Croatia, the planning framework offers little same unit or authority that has proposed the strategic guidance on which to base screening project. At the same time it is not clear on what of project ideas. There is, consequently, no basis projects would be approved at the line centralized process and guidelines stipulating ministry level and to what extent line ministries the format and requirements for screening initial would use technical committees or other project proposals for consistency with overall methods to ensure quality. Review at the line policy priorities. Line ministries may to some ministry level in some cases also takes place at degree screen proposals from their the program rather than project level, creating a departments for relevance with sector policies. gap in review of the quality of project proposals. However, SOE-investment proposals generally are not subject to systematic screening. Line The role of the Budget Analysis and Capital ministries review SOEs financial plans, but tend Projects Evaluation Department within the to be concerned with the overall capital MoF as an independent reviewer at the investment envelope rather than the relevance central level, is currently inhibited from and rationale of individual projects. effectively filling this role. The regulation and procedures do not specify the submission by  Formal appraisal and independent review. line ministries of sufficiently detailed project Currently, there are no specific guidelines documentation nor a specific approval process for the appraisal of public investment that the independent review could feed into. The projects to be financed by domestic department also has limited capacity – currently revenue. While standardized appraisal tools a total of two officers – that can be assigned to are internationally recognized as important to the task, while four more positions are currently ensure that chosen project options are feasible unfilled. This lack of MoF oversight of appraisals and of socioeconomic value, current regulations is true for domestically financed as well as do not specify any requirements for such externally financed projects, although there are feasibility studies. The PIM decree under the separate procedures for scrutinizing external Budget Act is set to address this gap, but is still financing requiring state guarantees. being developed. The appraisal of capital expenditure requests by the line ministries is  Selection and Budgeting. A fundamental extremely basic without a proper cost-benefit aspect of a well-functioning PIM system is analysis. In a similar vein, there is usually no the appropriate linkage between the pre-feasibility study that would include costing appraisal and selection of projects and the and cost-benefit analysis of a broader range of budget cycle. Desirable features of a selection options contemplated for significant projects. and budgeting system are: transparent criteria for selecting projects; a well-structured budget However, public investment projects preparation process with the scope to integrate intended for EU and other external financing investment and recurrent implications of undergo more comprehensive appraisal, as projects over the medium to long term; effective required by the relevant institutions. EU- gate-keeping to ensure that only appraised and Croatia Policy Notes | Strengthening Public Investment Management and EU Funds Absorption 54 approved projects are selected for budget space is to a large degree decentralized to line financing; and, finally, ensuring adequate ministries, which are given much discretion to financing for selected projects, including decide on resource allocations as long as they operation and maintenance costs after operate within their agreed budget ceilings. completion. Despite these limitations, there is no available data to indicate that adequate financing is not No explicit criteria exists for the made available for selected projects. prioritization and selection of public investment projects other than higher level The operation of an effective MTBF is also programmatic strategic planning. Three-year hampered by capacity constraints in the strategic plans by line ministries should contain MoF. A well-functioning MTBF is normally missions, visions, strategic goals, as well as associated with a longer term shift in the focus actions to achieve them and their correlation of the budget office-function away from with the organizational and program compliance checking and budget administration classifications, and performance evaluation towards budget analysis emphasizing the measures. The program budgeting initiative is analytic scrutiny of budget proposals. Officials however at an early stage and is currently of the MoF have however indicated that there mainly used to classify the budget along are capacity constraints on their ability to program lines rather than consistently arranging effectively play a more analytical role. the budget process according to a program logic.  Project implementation, finalization and ex-post evaluation. While there are no hard data on The selection of projects is further inhibited time and cost overruns, there are by the lack of a comprehensive project indications of implementation challenges pipeline. Save for a list of EU-financed projects e.g. Procurement of public investment was maintained by the Ministry of Regional noted as posing difficulties at this stage of the Development and EU Funds and separate lists public investment cycle. for some sub-sectors, there is no project pipeline that could be used more proactively – Budget preparation and execution from the side of the government – to shape the procedures appear to have a mixed impact composition of capital investment and to speed on effectiveness of implementation. There is up the uptake of EU funding. Nor is there any no evidence to indicate that allocation levels are comprehensive database for on-going and insufficient to ensure timely completion of planned projects. projects, and there are mechanisms in place to allow multiyear commitments with possible The gate-keeping function is currently expenditure consequences for future fiscal inadequate due to the lack of regulation and years. On the other hand, a skewed pattern of guidance on appraisal and approval of in-year spending, with 28 percent of capital projects. The Budget Act requires line spending happening in the last month of the ministries to formally appraise projects before fiscal year, indicates that there are issues either entering into liabilities, but the absence of more with the timely initiation of activities related to specific regulation and guidelines means there investment projects or insufficient in-year and is little certainty that projects selected for end-of-year flexibility. financing have gone through rigorous appraisal and approval. While project management procedures and organization are well established for EU and The capital budgeting process is vested other externally funded projects, including within a MTBF, but design limitations may via dedicated PIUs, there is a lack of affect project prioritization and funding requirements and guidance for state budget predictability. First, it appears that the MTBF funded projects. The level of project does not operate as a rolling framework. While management training and capacity building is a distinction between new and on-going unknown, but interviews with government activities has been introduced, it is not clear that officials have not indicated the existence of any the fiscal year budget takes its starting point in systematic training or capacity building a “roll forward“ of the outer year from the programs, neither at central or line ministry previous year’s budget cycle. Second, there is level, except for some EU-related training. no clear concept of fiscal space for the whole of government and no clear procedure for deciding The absence of a central monitoring system results in the lack of updated information on the priorities for its utilization, including trade-offs between different investment projects and overview of the public investment and between capital and other spending. In portfolio. Various parallel reporting streams practice, decisions on the utilization of fiscal generate partial information. Croatia Policy Notes | Strengthening Public Investment Management and EU Funds Absorption 55 Requirements for adjustments to project  Assessing the capacity of line ministries and values and scope are unclear. No regular other budget users to implement public mechanisms exist in relation to the formal investment projects timely and efficiently, adjustment of public investment projects under including the individual and organizational the Budget Act. For PPP projects, the PPP Act project management capacities. This lack of stipulates the obligation of the public partner to technical capacity and efficient processes a PPP contract to seek the approval of the underscore the importance of connecting with designated PPP-agency for any substantial design firms, universities and other institutions changes. during project preparation. There are also no specific formal  Analyzing project implementation challenges in requirements or institutional arrangements a sample of projects. The assessment should in place to guide ex-post review and include a mapping of the various evaluation of public investment projects. implementation sub-stages, analyze the main Neither the Croatian Budget Act, nor the PPP- causes of delays and make suggestions for law and regulation prescribe completion “unblocking”. The review should also suggest reviews or evaluations. For EU-projects, very how to improve capacity to prepare EU-funded large projects are subject to completion reviews projects, including options for connecting with following relevant EU-guidelines and regulation. design firms, universities and other institutions The national audit office has so far played only during project preparation. a limited role in the evaluation of public investment. 2. Harmonizing the medium-term planning and budgeting framework. The strategic planning How Croatia Can Improve PIM and EU framework should be developed further to better Funds Absorption integrate PIM and foster the development of priorities across different financing sources. An Improvements to PIM and EU-funds absorption overarching medium to long-term development in Croatia fall into four main phases: cum investment strategy should be developed into 1. Enhancing the knowledge base for reform. which future external funding, most importantly Many of the weaknesses of the PIM-system EU-funding, can be slotted. Such a strategy appear to be systemic and inter-related. At the should, besides national and local government same time, data is missing on aspects of the PIM- investment, include strategic infrastructure system, including on the current portfolio of investment financed by non-budgetary funds. investment projects. Without a comprehensive Regional and national priorities of the strategy overview across the PIM-cycle, there is a risk of should be better linked with the Cohesion Policy sub-optimization and initiating ineffective reforms. priorities. Guidance should include ‘when and why’ In the first instance, the Government could different types of financing and different forms of consider: institutional setup should be chosen. The overarching strategy should be underpinned by  Conducting a comprehensive survey of planned coordinated medium to long-term sector and on-going investment projects across all development and investment strategies (from modes of procurement and financing, including transport, environmental protection, energy via data that would allow analysis of various science, R&D, primary education, pre-school implementation patterns. Such a survey could education, health care, social welfare to the support a review and possible rationalization of economy and agriculture) prepared within the the portfolio. strategic parameters set by the overarching strategy and financing envelops derived from  Reviewing the governance arrangements for realistic financing forecasts. The overarching and investment carried out by SOEs with a view to sector strategies should be updated on a rolling assessing whether the governance basis. mechanisms for such investment are still suitable; and identifying any adjustments that Based on the overarching strategy, there is a would strengthen strategic alignment and need to revisit how public investment projects efficiency of such investment. are incorporated and scrutinized as part of the MTBF. This includes decisions on how projects  Assessing the functional, organizational and are prioritized within the medium term whole-of- individual capacities in the MoF to carry out the government fiscal space. oversight role of PIM envisaged in the Budget Act and the draft Decree on appraisal and Budget management systems and processes monitoring of PIM. should be harmonized to avoid different approaches to financing sources. Strategic documents prepared for EU financing should be in Croatia Policy Notes | Strengthening Public Investment Management and EU Funds Absorption 56 line with national strategic documents. Existing including indicators to monitor the outputs and budget regulations separate EU funds results of the projects. In order to track such management from the national budget performance information, it would be necessary to management. This complicates Croatia’s ability to build the information requirements into the original switch resources to the highest priorities through project identification and preparation formats. the budget, while the fiscal consolidation process Requirements for regular monitoring of project will require significant expenditure switching within progress should be defined. A new monitoring a comprehensive budget. system should ideally replace the several existing 3. Formalizing essential steps of the PIM- monitoring and reporting streams and should be system. A set of comprehensive regulations and preceded by a stock-take of existing monitoring. guidelines is necessary to fill the observed gaps in The new system should be based on clear the PIM-system. While the work on a decree guidelines and, at a minimum, capture information covering public investment under the scope of the on cost and time overruns and physical progress Budget Act is a good start, it will need to be of works. The system should keep track of the accompanied by comprehensive guidelines. reasons and scope of contract variation orders in Future regulation will also need to consider order to enhance project management capacity of investment by SOEs, while recognizing the need implementing organizations. for special governance arrangements for SOEs. Objectives of the regulatory changes and How the World Bank Group Can Help accompanying guidelines should include: Croatia could benefit from the experiences from  Drawing on EU requirements, harmonize as Bank-led PIM assessments and technical much as possible the regulations and assistance programs worldwide, including procedures for projects regardless of source of countries in the EU. This would build on the World financing and procurement modality while Bank’s recommendations to improve PIM in specifying the additional steps for PPP and EU- Croatia, submitted to the Government in financing September 2015, which outlined a broad agenda for which further technical assistance is required.  Clarify the roles and responsibilities of In this respect, Bank assessments and policy stakeholders throughout the PIM-cycle, advice provided to date offer comparative including on monitoring of public investment information on issues and practices from best projects, and assigning roles that are currently practice countries as well as those which are in the unclear or not defined process of reforming their systems. The Bank is also providing detailed advice on PIM-related  Strengthen pre-screening and formal appraisal regulations, guidelines and in reforming PIM of investment projects through formalized rules processes and systems. Recent Bank experience and comprehensive guidance includes EU-processes and PPPs. As a next step,  Clarify the levels of appraisal, review and the Bank could facilitate PIM reforms by assisting approval for various project sizes and establish the Government to design a comprehensive clearly defined criteria for project selection program of technical assistance.  Formalize rules and establish effective institutional arrangements for monitoring, This Policy Note was produced by the World Bank to inform policy debate project adjustment and completion review and in Croatia. This note was prepared by Senior Public Sector Specialist Jonas Arp Fallov, Public Sector Specialist Nataliya Biletska and Senior ex-post evaluations. Economist Sanja Madzarevic-Sujster. 4. Building ICT-systems and capacities in The findings, interpretations, and conclusions expressed herein do not support of improved PIM and EU-funds necessarily reflect the views of the Board of Executive Directors of the World Bank or the Governments they represent. absorption. In order to maximize the uptake of projected EU funding, a pipeline of appraised and For any questions regarding this note, please contact Vanja Frajtic, Communications Associate, (vfrajtic@worldbank.org). ready-to-go projects should be prepared in all sectors and linked to the MTBF. A database of THE WORLD BANK OFFICE ZAGREB: http://www.worldbank.org/en/country/Croatia projects planned within the MTBF as well as on- going investment and completed projects regardless of source of financing, should be created. The database should be interfaced with the budget preparation, budget execution, procurement, and accounting modules of the Government Integrated Financial Management Information System. The database should include financial as well non-financial information, Croatia Policy Notes | Strengthening Public Investment Management and EU Funds Absorption 57 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs More Sustainable Subnational Government Key Message The current fragmentation of local government units (LGUs) makes it hard to serve citizens effectively while also limiting their financial and human capacity to effectively absorb EU funds. Large cities provide most decentralized public services, raising questions about the necessity for many counties and municipalities, while over half of spending goes for wages and maintenance. Subnational governments also have relatively limited taxing powers, while the equalization system is a disincentive to collect local taxes. Key Actions  Croatia needs to consolidate the system of overly fragmented LGUs, through a combination of mergers and/or shared services, and increase fiscal and administrative capacities if decentralization is to be sustainable.  Spending responsibilities need to be redefined to avoid duplication and overlap of functions and to increase the accountability of LGUs for the tasks allocated to them.  Strengthening subnational administrative capacity for public investment management, revenue collection, financial and asset management to improve service delivery. Where Croatia’s Decentralization the required threshold of at least 10,000 Stands Now inhabitants. Figure 1. The degree of Decentralization is limited Decision-making, financing and public (LGU spending, % of GDP) service delivery is still highly centralized. Despite legislative improvements after 2001, the degree of decentralization remains low. Subnational government corresponds to 14 percent of general government spending, or 5 percent of GDP, compared with an average of 10 percent in the EU (Figure 1). Governments have been aware of the importance of giving citizens more voice and strengthening accountability in matters of local interest, and recognize this can help deliver public services more effectively. Source: Eurostat, 2015 However, legal and administrative structures Table 1. The average size of LGUs is small constrain further decentralization. LGU Average Averag s Capit Croatia’s two-tier subnational government Popul ation Numb er of populatio n of belo al city e density w in structure is highly fragmented. There are (000s) LGUs LGUs pop total (people (000s) /sqkm) municipalities and cities at the local level and 5000 Croatia 4,285 556 7.7 71% 18% 97 counties at the regional level. The large number of relatively small local and regional self- Serbia 7,749 170 45.6 1% 21% 395 government units (LGUs) weakens fiscal and Slovenia 2,063 212 9.7 52% 14% 102 administrative capacity. Croatia has 21 regional Denmark 5,699 103 55.3 4% 35% 133 (20 counties plus the capital city, Zagreb) and 556 local (127 cities and 428 municipalities) self- Ireland 4,588 31 148.0 0% 28% 65 government units, of which over 70 percent cover Source: national statistical offices fewer than 5,000 inhabitants—the benchmark many countries consider appropriate to enable Functional responsibilities among LGUs are basic self-sufficiency (Table 1). In addition, over complex and unclear. All municipalities and 47 percent of Croatia’s 127 “cities” do not meet cities, except the very largest, have the same Croatia Policy Notes | More Sustainable Subnational Government 58 responsibilities for providing public services no Half of LGU spending is allocated to wages matter what their development level or fiscal and operational costs, while a little less than capacity. Cities that have more than 35,000 a quarter goes to investment. Before the inhabitants (32) or that are county seats are economic crisis, about 23 percent of subnational exceptions because they can also perform tasks budgets were directed to investment. By 2013- otherwise allocated to counties. This creates a 14, investment had fallen to about 17 percent of risk of duplication of tasks and inequality in expenditures. In contrast, employee service provision because small municipalities compensation has increased steadily, without a and cities with little fiscal capacity cannot provide noticeable improvement in the quality of local residents with the same range and quality of services. The second largest category of LGU public services as larger cities. spending is salaries, even though national government pays teachers and doctors (Figure Large cities provide most decentralized 3). Since 2010 the number of LGU employees public services undermining the rationale for increased by almost 7 percent, to over 42 other local government structures. Although thousand, while the time private sector has been counties have been given wide responsibilities shedding labor to respond to the crisis. for subnational public services (primary and secondary education, health care, urban Figure 3. Subnational Expenditures by Economic planning, economic development, and local Classification, unconsolidated, percent of GDP traffic and transport infrastructure), they usually have less fiscal capacity than cities. Thus, the role of counties in providing public services, as measured by spending in per capita terms, is very small. That is also true for municipalities, which perform a limited range of public functions. Consequently, cities are the most active level of local government in terms of service provision. Figure 2. Subnational Expenditures by Functions, unconsolidated, percent of GDP Source: MOF. Subnational governments have relatively limited powers of taxation and the equalization system offers little incentive. Personal income tax and surtax are key sources of revenue, comprising over half the total (Figure 4). Local tax sources (inheritance and gifts; taxes on motor vehicles, boats and vessels, and gambling machines) are often subject to central government caps. Nontax revenues are therefore an important subnational revenue Source: Ministry of Finance (MOF). source, of which communal fees (serving de However, even at the cities’ level, service facto as a flat-fee property tax) account for the provision varies and an asymmetric largest share. However, the second most decentralization approach was pursued important revenue source are grants through the (Figure 2). Only a quarter of Croatian cities equalization fund or direct from central finance primary education (which is government. decentralized at the level of school maintenance Figure 4. Subnational Revenues, unconsolidated, and investments, while wages are provided percent of GDP centrally). Of the four main public functions (education, health care, welfare, and fire protection) that were partly transferred to LGUs after 2001, only fire protection is almost completely decentralized. In effect, subnational governments spend mostly on preschool education, community development (housing and communal infrastructure) and general public services, which in reality means mostly financing the functioning of the LGU executive and Source: MOF. legislative bodies’ i.e. local administration. Croatia Policy Notes | More Sustainable Subnational Government 59 The fiscal equalization system is mainly led minimum guaranteed tax capacity and actual tax by regional development objectives. capacity. Equalization of fiscal and service capacity is While LGUs have relatively low debt, there are realized through tax-sharing (Table 2), the contingent liabilities in terms of guarantees Equalization Fund, and grants. The central to local government-owned utility companies government determines the tax rate and the tax (Table 4). Due to restrictive borrowing limits, base giving LGUs little control over the collection LGUs have relatively little direct debt (1.2 percent of shared revenues. of GDP in 2014). However, LGUs circumvent Table 2. Tax Autonomy of LGUs these limits by borrowing through local- Shared taxes with County Taxes Municipal/City government-owned enterprises. In 2015, the limit Central Taxes of the total borrowing of LGUs increased to 3 Government percent of total operating revenues of all LGUs. Personal income tax Inheritance tax Consumption tax In addition to the cumulative borrowing Real estate transfer Tax on motor Tax on holiday restrictions that seek to limit the total amount of tax vehicles houses local debt, there are individual limitations Tax on vessels Tax on the use of prescribed by the Budget Act. They limit the total public land annual obligation of LGUs, which can be up to 20 Tax on gambling Tax on corporate percent of revenue generated in the previous machines title year. These borrowing limits, however, do not Surtax (on PIT) include borrowing limits for communal utilities and/or guarantees issued by LGUs. Guarantees Source: MOF. for utility companies' borrowing create contingent The equalization system lacks transparency. liability for LGUs amounting to 0.6 percent of Equalization formulas are usually supplemented GDP in 2014. The City of Zagreb holds almost with additional ad-hoc transfers. Grants that have half these guarantees. an equalization purpose for decentralized Table 4. The size and the structure of local functions are also not necessarily used for their government debt, 2014 (in HRK billion) intended purpose. Many current transfers to Citie Zagreb Municip. Counties All municipalities, cities and counties from the s central government are not based on clear Debt 1.8 1.5 0.3 0.4 4.0 criteria and have unclear effects. Guarantees 0.9 1.9 Table 3. Personal income tax sharing scheme as Source: MOF of January 1, 2015 (in %) City/ Count Decent. Equalisati Grants for EU Capita l LGUs own significant financial and non- Group muni cip. y function on grants project project financial assets (33 percent of GDP in 2014). s s s The structure of financial assets are dominated Lagging 88 12 by shares, which are not recorded according to regions their market value since they are not actively Zagreb 76.5 6 16 1.5 traded on the stock exchange. Non-financial Islands 60 16.5 6 1.5 16 assets owned are mostly recorded, but their Other 60 16.5 6 16 1.5 valuation is not systematic. There is no single registry of assets owned by LGUs, nor are there Source: MOF. strategies and/or guidelines for asset The current transfer design does not relieve management. fiscal capacity disparities. Full revenue There are large revenue and efficiency gains equalization reduces the incentives to increase from strengthening the Public Financial the local tax base by attracting new economic Management (PFM) systems in LGUs. Local activity or increasing the efficiency in service units hold high tax arrears--at the end of 2014 delivery. To create this incentive, the national around HRK5.7 billion (1.7 percent of GDP). The government could opt for less than complete structure of uncollected claims is dominated by equalization, so that the gap between the local claims for administrative fees (claims for utility and the average tax base is only partially charges and contributions). LGUs have mostly compensated. The grant system could, for outsourced the function of revenue collection to instance, be designed so that after equalization the Tax Administration and companies the tax capacity of the poorest jurisdiction is performing the collection of the utility charges. within 10–20 percent of average tax capacity. Due to a rather large number of employees, the Another possibility is to design equalization, as in LGUs should not need to delegate such functions Sweden, to reduce the difference between a (especially revenue collection) to other legal entities. There is also significant scope for Croatia Policy Notes | More Sustainable Subnational Government 60 savings through the inclusion of budgetary users Greater reliance on own-source revenues and institutions owned by local government units would create incentives for local economic in the treasury system and processing development and reduce central government transactions through the single treasury account. transfers. The ideal LGU tax is one that can be About 170 local units are currently included in the levied on a relatively immobile and well- treasury system. Savings could be made from demarcated local tax base—e.g. a property tax. other shared services. In addition, Local Administrative capacity is also an important companies are seen as separate entities, and are consideration in defining revenue assignments. under no obligation to draw up consolidated Croatia could start by simplifying the framework financial statements. guiding tax-sharing, eliminating a number of local taxes and relaxing the upper limits for them, and How Croatia Can Restore Fiscally improving the design and administration of Sustainable Decentralization property taxes that can provide a stable yield and The current fragmentation of LGUs makes it are indirectly linked to income so are hard to serve citizens effectively, and there is progressive. scope for consolidation and creating shared The fiscal operations of LGUs need to be closely services. Croatia has one of the lowest numbers monitored to ensure fiscal prudence and of inhabitants per LGU in the EU with a large alignment with the EU Excessive Deficit concentration of citizens in the capital city. Large Procedure. It is critical that LGUs be fully cities provide most decentralized public services. transparent in reporting all balance sheet and off- Defining the optimal territorial organization and budget activities. Timely and comprehensive functional and fiscal decentralization matrix information is needed on both budget operations should be a priority to address the and debt under new EU fiscal governance rules. disproportionate number and resources In this vein, some countries (e.g., Portugal) assigned to LGUs. If consolidation is not require municipal accounts be consolidated with politically feasible, LGUs should be encouraged those of their public enterprises and submitted to to merge for joint provision of public services, i.e. external audit. While the existing legislative with incentives for shared services. Good framework in Croatia does not provide for examples of such approaches include Estonia consolidation of the financial statements of LGUs (integrated back offices, like accounting and and their utility companies, consolidation is payment processing), Finland (incentives for required under International Public Sector mergers) or Spain (integrated service delivery). Accounting Standards (IPSAS). The application The benefits from association would help LGUs of these regulations would allow a capture economies of scale and scope to comprehensive view of the exposure of LGUs to improve service delivery and cost effectiveness. direct and contingent liabilities arising from the Larger, stronger LGUs would have a better financial operations of their utility companies. access to EU funds. Financially stronger LGUs Subnational administrative capacity could be could conduct more profitable infrastructure strengthened in three priority areas: projects and have a better bargaining position. The consolidation process could also enhance (i) Public investment management. This is LGUs administrative and technical capacity to particularly important considering the access and implement EU funds while generally expected availability of large inflows of EU reducing the costs of local administration. funds. Ideally, LGUs should – through the use of EU funds – be the main drivers of Spending responsibilities need to be capital investments. The experience of redefined to avoid duplication and overlap of Estonia and Latvia demonstrate that there is functions and to improve accountability. undoubtedly a correlation between size and Fiscal decentralization should clearly define capacity. The requirement for small functional responsibilities (for example, in such municipalities to employ qualified persons, areas as education, social protection and health) and comply with procedures, proved to be a and identify the resources needed to finance serious problem for the Baltic countries and them. Accountability and efficiency concerns the Czech Republic as there were very few imply that expenditure assignments should have professionals at the local level, and no clear lines of demarcation between various fiscal resources to finance the qualified staff from units. There should be transparent reporting of other areas. The financial absorption progress in carrying out tasks and closely related capacity of Croatia’s LGUs might be activities should be assigned to the same level of strengthened by creating incentives or government. binding rules for local governments to merge or associate to jointly provide shared public services, attract the private capital and Croatia Policy Notes | More Sustainable Subnational Government 61 participate in public-private partnership Cities undertook Public Expenditure and projects. Financial Accountability assessments in four selected cities, as well as conducted several (ii) Revenue Administration. Most LGUs capacity building programs for strengthening transferred authority for the collection of governance and public finance management in revenue to the Tax Administration (with a local governments. commission of 5 percent of revenue), which is subject to provisions regarding tax Support ranges from: confidentiality (Art. 8 of the General Tax Code). As a result, LGUs have little  facilitating peer-exchange with reformers information on tax debtors and debt. The across Europe and the world; collection of tax and non-tax revenues  conducting analyses that address specific related to property, such as taxes on holiday policy problems and inform reform processes; houses, is particularly problematic (owners do not submit data on the status of the  implementing assessments and monitoring property). Similar problems occur with tax on platforms and tools to increase the inheritance and gifts (the Tax Administration effectiveness of public finance management has no obligation to report decisions issued programs; to relevant LGUs).  sharing know-how and international best (iii) Financial management. Improvements in practice in cutting-edge areas of financial management capacity would help decentralization reforms, such as in the design LGUs rationalize their costs and generate of fiscal equalization transfers and shared revenues from improved asset management. service centers; Many local units do not have inventories of  implementing capacity building programs for their assets in their balance sheets, and do public finance management programs for not have professional departments and LGUs; and individuals trained to deal with asset management. Deploying existing local  providing finance, and financial instruments, property could also bring additional revenues for capital investment, capacity building and along with the privatization of companies information systems. involved in commercial business. How the World Bank Group Can Help The Bank offers experience working with Ministries of Finance and Administration – globally and in EU countries – in implementing reforms that increase the sustainability of This Policy Note was produced by the World Bank to inform policy debate in Croatia. This note was prepared by Senior Economist Sanja Madzarevic subnational governments. This includes Sujster. supporting strategic development planning in the The findings, interpretations, and conclusions expressed herein do not context of EU funds absorption, infrastructure necessarily reflect the views of the Board of Executive Directors of the World Bank or the Governments they represent. planning and upgrades, automation of processes and ICT improvements, strengthening debt, For any questions regarding this note, please contact Vanja Frajtic, Communications Associate (vfrajtic@worldbank.org). revenue, financial and asset management of LGUs, and the implementation of institutional THE WORLD BANK OFFICE ZAGREB: http://www.worldbank.org/en/country/Croatia reforms that embed sustainable fiscal and functional decentralization. More recently, the Bank in a cooperation with the Association of Croatia Policy Notes | More Sustainable Subnational Government 62 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs Strengthening Rule of Law and Judicial Efficiency Key Messages Despite progress in recent years, inefficiencies and the unpredictability of the courts is one of the largest barriers to business, investment and growth. Improving user trust and confidence in the court system requires further improvements in the quality and speed of judgements to signal change to the general public and businesses, with reforms led by the Ministry of Justice and the Supreme Court. Key Actions  Harness technology and intensify modernization and automation to increase the courts' online services and boost two-way electronic exchange with both users and government systems. Modernization could utilize available EU structural funds for capital investment.  Embed reform of the new court network: Reduce costs by consolidating management functions (finance, procurement, maintenance, statistics etc.) at hubs in the network. Equalize caseloads by transferring judges and staff between courts with the heaviest workloads or by transferring cases across courts. Prioritize reducing the case backlog with targets and incentives at the court level. Intensify training for consolidated court presidents as key agents of change and harmonize case law through improved dialogue among heads of departments and the training of judges on new laws.  Gradually adjust the resource mix across the sector to raise productivity. Reduce the number of judges and staff by attrition and use the savings to finance greater investments in infrastructure, ICT and specialist roles that drive innovation and productivity. Where Croatia Stands Now However, reforms remain incomplete. The Government’s 2013 reform strategy prioritizes EU countries that have tackled under- efficiency, independence, EU integration, human performing rule of law institutions over the resource (HR) management and ICT upgrades. last decade are now benefitting from Yet, results have been less than anticipated. The revitalized growth. These includes Poland, inefficiency and unpredictability of the court Czech Republic and Slovenia. These countries system continues to be among the greatest are now better able to attract FDI and spur impediments to business and investment. And innovation because their business climates offer the public has yet to ‘feel’ much change, so greater certainty and speed, with easier firm perceptions remain negative. entry and exit and a more equal playing field, with Despite progress, courts of general fewer ambiguities and constraints. By contrast, jurisdiction and commercial courts are still those jurisdictions which did not make progress too slow in processing cases, and this experienced slower growth. causes frustration for providers and users In Croatia, the performance of the justice alike. Businesses continue to perceive the courts system has improved significantly in recent as too slow for their needs. The 2015 World years, as recognized by the completion of Economic Forum ranks Croatia 137th out of 140 Croatia’s EU accession negotiations and economies in terms of the efficiency of the legal monitoring benchmarks59. According to the framework for settling disputes. According to the European Commission for the Efficiency of Doing Business Report 2016, contract Justice (CEPEJ) EU Justice Scoreboard 2015, enforcement takes 572 days and costs 16.7 Croatia now has rates of case efficiency for civil percent of the value of the claim, which is lower cases comparable with other EU member states. than OECD averages and of countries across 59 The World Bank Justice Sector Support Project (JSSP) has supported the MOJ, courts and SAOs in this process. Croatia Policy Notes | Strengthening Rule of Law and Judicial Efficiency 63 Europe and Central Asia. In the 2014 World Bank This is unlike most EU member states, where Business Environment and Enterprise small claims courts have eased peoples’ Performance Survey (BEEPS), only 15 percent interface with courts, often combined with of firms report that the court system is quick. automation, websites and apps. Applying lessons from other EU member states and This poor performance is an obstacle to getting small claims right has the potential to business. According to BEEPS, only 60 percent significantly boost user confidence and public of firms report that the courts are not an obstacle perception of the justice system. More could also to their current operations. This is 12 percent be done to ensure that urgent cases (such as lower than the average of member states that labor disputes) are resolved within the legal joined the EU after 2004 (excepting Cyprus and timeframes. Malta). Against a backdrop of poor perceptions, firms try to resolve their disputes outside of the The business community lacks confidence in court system. Despite a series of piecemeal the courts’ ability to enforce decisions. reforms, the promise of an Alternative Dispute According to BEEPS, only 43 percent of firms Resolution (ADR) mechanism remains elusive report that the court is able to enforce its for most court users. In 2014, less than 5 percent decisions, which is 12 percent lower than the of resolved civil litigation cases were resolved average of member states that joined the EU using court-annexed mediation. For many after 2004 (excepting Cyprus and Malta). After a businesses, disputes languish and remain series of stop-starts, the 2012 reforms regarding unresolved, thereby hampering operations. A enforcement rights over cash assets have been targeted in-depth analysis of the constraints to partially successful – caseloads have reduced in ADR and possible solutions is needed. the courts, and procedures have been streamlined. But much of the workload has Backlogs have fallen, but there are still too shifted to the Financial Agency (FINA), at least many old unresolved cases lingering idle in for the enforcement over cash assets. To prevent the system. The number of unresolved cases the enforcement problem merely shifting from has fallen by half over the last decade. Average one actor to another, FINA needs greater support clearance rates in courts have improved, and and capacity building to fulfill its mandate. were above 100 percent in 2014 and 2015. Further, commensurate improvements are Nonetheless, Croatia still has among the largest needed to increase court efficiency to enforce number of old pending cases per capita in the claims over immovable and movable property. EU, according to CEPEJ. Essentially, the pace of backlog reduction is too slow, with many judges Spending on the Judiciary is around the EU focused on resolving easier cases, while leaving average. In the current fiscal environment, the old cases unresolved. With over 366,000 justice sector will likely have no option but to use backlogged cases still in the courts, at these its resources more efficiently, and to finance rates, elimination of the backlog would take longer-term goals out of savings it generates. another decade. Further, the legacy of backlogs After two phases of court network reforms, and long case duration diverts much-needed lasting over 7 years, there remain large funds. From 2011 to 2013, Croatia paid more inefficiencies in the ways courts operate. So far, than 10 million EUR in compensation to the 2015 rationalization has done little more than individuals whose right to a trial within a convert ‘courts’ to ‘court units’. The real work of reasonable timeframe had been violated. Such the reform has only just begun, and there are funds would be better spent on reforms that opportunities to embed the rationalization, make improve efficiency for all citizens and businesses. savings and improve user satisfaction By purging backlogs and improving timeliness, simultaneously. Croatia could both reduce delays and save Uneven caseloads have long been a key money. source of inefficiency in court operations. In A further challenge for the general public and the past, the proposed remedy for uneven small businesses is the lack of an effective distributions has been to transfer cases between fast-track procedure for resolving minor courts. More than 70,000 cases were transferred disputes. For the majority of the population, during 2011-2013. Under the new court network, especially the poor and micro and small judges and staff as well as cases can be businesses, disputes such as contract disputes transferred more easily to nearby courts. The over small sums, tenant/landlord disputes, sector should take advantage of this increased consumer claims and other minor matters are the flexibility to finally equalize caseloads across most likely interaction with the justice system courts, based on sound analysis. (other than traffic violations). Despite reforms in There are also potential efficiency gains in 2008 to simplify case processing of some of ‘hubbing’ management functions. A range of these cases, little expedition occurs in practice. Croatia Policy Notes | Strengthening Rule of Law and Judicial Efficiency 64 functions, such as procurement, financial ‘Building-centric’ performance measures to management, maintenance, training, statistics, monitor the health of infrastructure capitalization and performance tracking, could all be co-located could assist in budgeting and maintaining at hubs in the network and deployed among facilities. Developing a medium-term plan and several courts to maximize efficiency. This prioritizing key locations to build modern shared-service model has been adopted in many courthouses equipped with ICT to meet basic countries across the EU. requirements and better serve users would signal Figure 1. Demand for Judicial Service and reform to judges, staff and users alike. Resources Transparency, corruption & undue influence remain a concern. Croatia continues to struggle with judicial corruption. Among the EU member states that joined since 2004, Croatia has the 5th highest rate of perceived corruption, according to Transparency International. The judiciary ranks poorly in comparison to neighboring countries, including both EU and non-EU members. Respondents reported the judiciary as being the institution that is most affected by corruption and undue influence, worse than the perception for politicians and political parties. Rules regulating conflicts of interest are not well understood within Source: Justice-at-a-Glance, World Bank the judiciary. Clearer and stricter rules on ethical standards are needed, along with more training There are too many judges and staff in the and mainstreaming of rules into daily practice, court system. Croatia has one of the highest and the clear sanctioning and control in courts numbers of judges per capita anywhere in the and prosecution offices. Court presidents and world – 45.3 per 100,000 inhabitants, which is heads of State Attorney Offices (SAOs), under more than double the EU average of 21. Salaries the leadership of the Councils, have a clear role of Croatian judges are 2.3 times higher than to improve the operational efficiency, but also national average salaries, which is on par with improve the system’s transparency. CEPEJ and new EU member countries. Further, Croatia has one of the highest court staff-to- The lack of predictability in decision-making judge ratios and one of the highest staff-to- also highlights the need for greater court population ratios in the world. For example, practice consistency. This can occur by Croatia has 163 non-judge staff per 100,000 convening more regular meetings of heads of inhabitants, as opposed to 67 for the EU departments and judges to discuss recent average. As a result, the wage bill for judges and reforms and emerging cases. There is also scope staff is extremely high and crowds out almost all for more intensive continuing education for other expenditure, leaving little room for judges in emerging areas of law, particularly on innovation, infrastructure and automation. the rollout of new legal reforms. Again, ICT can help harmonize case law. Cases could be A part of the explanation behind the high uploaded to the web more quickly after judgment demand for judicial service is that the justice and ongoing efforts to integrate Croatian case sector provides a large range of non-litigious law with EU case law, via the e-justice portal administrative services. Company registration, (European case law identifier – ECLI), could be land ownership registration, electorate intensified to ensure that case law is harmonized commissions, are services provided in many EU and user friendly for judges. countries as out-of-court administrative services. The lack of predictability in dealing with Meanwhile, the sector is not investing courts impacts the business climate. In the enough in capital planning and upgrading. 2014 BEEPS Survey, only 36 percent of firms in Most courthouses are small and in poor condition Croatia report that their court system is fair, – some are unfit to be courts and incapable of impartial and uncorrupted. This lags the EU accommodating modern needs, such as wiring averages, and this view has remained for ICT and service-delivery interfaces to meet unchanged for at least the last 5 years. Similarly, citizen expectations. For example, an average of the WEF ranks Croatia 101st out of 140 4 judges share a single office in Croatia’s largest economies in terms of undue influence and 99th court, the Zagreb Municipal Court. Croatia’s in terms of judicial independence. While not a expenditures for physical facilities have been panacea, increased automation plays a role in roughly half the EU average. Infrastructure asset reducing vulnerabilities to corruption and acting management could be strengthened at the MOJ. as a confidence-building measure for users. Over Croatia Policy Notes | Strengthening Rule of Law and Judicial Efficiency 65 time, intensified automation can improve - Enable more two-way electronic perceptions of professionalism and integrity communication between courts and users. among court users. - Intensify automation in externally-facing How Croatia Can Improve Judicial services, via improvements to websites, e- Efficiency service, e-filing, fee calculators, e-payment, mobile apps etc. There are significant opportunities to strengthen the justice system to stimulate - Use EU structural funds to upgrade investor and public confidence, drive courthouses in critical locations. competitiveness, and improve the business 3. Embed court network reforms for a leaner, environment. Examples include: smarter system focused on service- 1. Signal change to the public and business. delivery. - Ensure effective rollout of the 2015 personal - Equalize caseloads by transferring cases, bankruptcy reforms, with training and public judges and staff, based on sound analysis. awareness campaigns. - Consolidate management functions (financial - Ensure FINA has the resources and training it management, procurement, statistics, needs to fulfill its mandate for enforcing performance tracking, etc.) at hubs across the judgments expeditiously. network. - Eliminate backlogs through targets and - Adjust the resource mix to spend less on incentives for individual courts. salaries and operational costs and more on capital and innovation. Gradually reduce the - Establish a fast-track procedure for minor wage bill by attrition and equalize workloads disputes, applying lessons from EU member via transfers and secondment opportunities in states. Encourage the public and small areas of need. business to use streamlined services through public information campaigns and training How the World Bank Group Can Help court providers. The Bank offers experience working with - Embed the practice of user surveys. Use the Ministries of Justice and judiciaries – globally and results to inform reform and managerial in EU countries – in rolling out reforms that decision-making to instill a more user-oriented increase efficiency in the delivery of justice culture. services to people and businesses. This includes supporting infrastructure planning and upgrades, - Consider removing non-adjudicative work automation of processes and ICT improvements, (company and land registration) from the court process re-engineering, caseload analysis courts, based on sound analysis (see also the and equalization (including reforms to case Policy Notes on Land Administration and weighting methodologies), performance Business Environment). management, and the implementation of - Clarify conflicts of interest and provide training institutional reforms that embed new court across the justice system to signal a new era networks and rollout of legal reforms. Support of higher judicial integrity. ranges from: 2. Intensify modernization and automation  facilitating peer-exchange with reformers efforts. across Europe and the world; - Continue upgrades of the Integrated Court  conducting analyses that address specific Management System (ICMS) in courts and policy problems and inform reform processes; Case Tracking System (CTS) in SAOs,  sharing know-how and international best leveraging the results so far from JSSP. practice in cutting-edge areas of justice Transition to paperless methods across all reform; and courts and SAOs. Ensure availability of case data and integration with ECLI.  financing capital investment and automation. - Hasten processing and strengthen Through the existing JSSP, the Bank has coordination by improving information applied some of its expertise to support exchange between ICMS and CTS with Croatia’s justice sector in key areas. The government systems (FINA, tax project has helped to reduce backlogs, increase administration, land registry, licensing etc.) clearance rates, reduce case processing times and modernize internal processes through automation, among other reforms. The existing Croatia Policy Notes | Strengthening Rule of Law and Judicial Efficiency 66 JSSP has performed well and is due to close in June 2016, but it can support emerging needs This Policy Note was produced by the World Bank to inform policy debate in and priorities of the new government. Croatia. This note was prepared by Georgia Harley, Public Sector Specialist. The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the Governments they represent. For any questions regarding this note, please contact Vanja Frajtic, Communications Associate (vfrajtic@worldbank.org). THE WORLD BANK OFFICE ZAGREB: http://www.worldbank.org/en/country/Croatia Croatia Policy Notes | Strengthening Rule of Law and Judicial Efficiency 67 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs Making a Business Friendly Croatia Key Message There has been steady improvement in the Business Environment in Croatia. However, despite the strong reform momentum Croatia still suffers from a number of shortcomings that entrepreneurs experience in the day-to-day running of their business operations. Croatia is also still grouped with the poor performing EU countries. Key Actions  There is room for improvement particularly in the areas of land registry, business registration, resolving insolvency, construction permits.  Incorporate a more consultative process with the private sector on existing barriers as well as while initiating new reforms.  E-government would enable the public sector to play a more facilitative role to businesses. Where Croatia Stands Now operations. Some of the most burdensome challenges in the business environment, as Croatia has implemented business reforms highlighted in the 2015 EC Country Report on every year since 2006, and was among the Croatia, include regulatory instability; high global top ten improvers in Doing Business in administrative burden; low transparency and 2008. Several concrete measures have been predictability in the working of administrative undertaken to improve the quality of the business bodies; and long judicial proceedings. environment over the last three years. These Weak legislative planning has weighed down include simplification of business registration, the quality of new regulations. In 2014, half of strengthening of the contract enforcement, the laws passed were not planned. Although bankruptcy framework as well as land there is a Regulatory Impact Assessment (RIA) registration. The authorities have also begun an mechanism in place, in practice most legislations audit of administrative burden, applying the go through a fast track legislative process and standard cost model to the Trade Act and the circumvent RIA altogether. Even when Mediation in Immovable Property Transactions performed, RIA is not properly implemented, due Act. Despite the introduction of the e-citizen web to weak quality control and lack of high level portal and the online services for business commitment. Poor legislative quality in turn leads provided by HITRO.HR, the Chambers of to frequent amendments to address Commerce, and the Financial Agency FINA, shortcomings and complications for SMEs. challenges remain for the users having to familiarize themselves with the different How Croatia Can Strengthen its interfaces. The authorities are planning the Business Environment development of a new platform – a single contact point, which would integrate all existing services. Consultation with private sector is a crucial In the area of the judiciary, the implementation of aspect of any reform process affecting the reform of the judicial map could improve the businesses. Without understanding the private efficiency of some courts. The reform aims to sector’s concerns and the barriers that prevent increase specialization and balance out the them from starting, operating and growing their uneven workload of judges by merging courts. businesses, no government can claim to set up a The reform also involves a change in the comprehensive reform agenda that will bring a allocation of cases before second instance civil real difference to its businesses. courts. Business Start-up. Economies with the most Despite the strong reform momentum, efficient registration systems use simplified and Croatia suffers from a number of standardized laws and documents, operate a shortcomings that entrepreneurs experience single electronic interface between the user and in the day-to-day running of their business authorities, a central database with Croatia Policy Notes | Making a Business Friendly Croatia 68 interoperability between agencies involved, one  Eliminate the paid-in minimum capital single company ID, and one flat fee. To achieve requirement for Limited Liability Companies measurable results in the short to medium term, (DOO). the Government of Croatia may want to focus on eliminating outdated requirements through legal  Make the notarization of the articles of amendments, merging and streamlining the association optional and introduce clearer fee registration processes of multiple departments schedules for notary services. Presently, and agencies, and making all registration companies must notarize the articles of processes (including post-incorporation) fully association with a public notary. This is the electronic without any need for physical paper most expensive step in the process of trails or physical interaction. It also may consider company registration. Private sector the following: practitioners state that the fee schedules used to calculate the notary fees are not  Give HITRO.HR full powers to handle all transparent. The Croatian government could transactions at the Commercial Court and lower the cost of starting a business by undertake an information campaign to developing standardized articles of publicize the services provided by HITRO.HR. incorporation that are flexible enough to At the moment, HITRO.HR officials can assist accommodate the majority of small entrepreneurs in carrying out the steps businesses, thus allowing entrepreneurs to necessary to complete a company draft and file deeds of incorporation registration, but in certain transactions, their themselves. Eliminating the requirement to power is limited. For instance, they can check notarize incorporation documents would whether the chosen company name is represent a significant cost-saving measure, available and submit a name reservation especially for small businesses. Larger request through the e-Company Service (e- companies, with more complex structures, Tvrtka), but if the request is rejected by the could still resort to notary services, if needed. Court, HITRO.HR cannot retrieve the documents on their client’s behalf. These  Introduce single business identifier for limitations reduce HITRO.HR’s appeal to interactions with all government agencies. To entrepreneurs, who often choose more achieve greater integration of registration expensive –but effective- intermediaries. services, the Government could introduce a single business identification number, which  Transfer the power to decide on company businesses would use as unique identifier for registration applications to qualified Court all interactions with government agencies. administrative personnel. Currently company This would reduce the risk of errors in registration in Croatia is a judicial procedure. identifying the same companies and facilitate The Commercial Courts in Zagreb, for enforcement. instance, effectively employ 55 judges, 7 of which are tasked with procedures related to  Introduce a single platform for out-of-court company registration60. Such tasks could be business registration by integrating the performed by qualified court clerks, which may incorporation process with the registration to decrease the time to start a business. It could (1) all taxes, the (2) the Croatian Bureau of also speed up the resolution of litigation and Statistics, the (3) Croatian Institute for Health insolvency cases, since judges currently Insurance, and the (4) Croatian Institute for allocated to company registration could be Pension Insurance. After the introduction of a used elsewhere. single registration form for all agencies, it is recommended that the systems and  Implement e-signatures for individuals and databases of multiple agencies be gradually make all registration processes fully electronic linked towards a “single interface” for business with no need for submission of physical registration, which would allow an documents or physical interactions. At the entrepreneur to complete company creation in moment, the biggest obstacle to the one interaction with the Government. implementation of an efficient online registration system is the lack of a functioning Registering Property. Since 2008, the time to e-signature system for individuals. register property in Croatia has decreased from 956 to 72 days. Such an astonishing result is due to legislative improvements introduced by the Land Registry Act of 2004 and the subsequent computerization efforts undertaken by the 60 The remaining judges are mainly tasked with was collected by the team during a visit to the litigation cases and insolvency cases. The information Commercial Court of Zagreb in March 2015. Croatia Policy Notes | Making a Business Friendly Croatia 69 Croatian government. Further improvements has three new laws regulating this area since include: January 2014: a Building Act, a Physical Planning Act, and an Inspection Act and their full  Complete Land Registry and Cadaster data enforcement may require to: harmonization. The Land Registry is under the jurisdiction of the Ministry of Justice while the  Engage stakeholders and private sector Cadaster is managed by the State Geodetic practitioners in an information campaign Administration. Currently, the data contained aimed at explaining the benefits introduced by in the two databases is not fully integrated, the new legislation. At the moment, not all the though the process is ongoing as the Joint benefits of the new legislation are clear to the Information System is rolled out and the data building sector professionals operating in the harmonized. The current lack of data country. For instance, many of them still visit harmonization contributes to delays and the Cadaster to obtain a list of neighbors that inconsistencies in Government to Business has then to be submitted to the Municipality services. To solve this problem and give full together with the application for the building implementation to the Land Registry Act, permit (i.e. geodesic study annex). Given the Croatian authorities should give priority to progress introduced by the ISPU, such finalizing the Real Estates Registration and procedure should no longer be necessary, Cadaster Joint Information System (JIS) since such list can be retrieved online. project – which will harmonize the two databases mentioned above61 (see also Policy  Expedite integration of all the necessary IT Note on Real Estate Registration). systems and databases into the ISPU. The geographic information system (ISPU)  Allow electronic Land Registry extracts to be represents a great leap ahead towards a fast considered as official documents and make and efficient building permitting process. In them accessible through e-citizen government order to fully reap the benefits of this important portal. At the moment, only extracts obtained reform, Croatian authorities should press in paper directly at the Land Registry (or ahead with the harmonization of all the stamped by a Land Registry official) have legal necessary databases that might contribute to standing. Considering the progress in the its completeness. At the moment, the Ministry computerization of the Land Registry over the of Construction and Physical Planning is past years, these restriction could soon be working to harmonize the ISPU system with abolished to allow electronic extracts to be the databases of Ministry of Maritime Affairs, used officially62. Also, extracts should be Transport and Infrastructure and the Ministry accessible through the e-citizen government of Culture. Also, additional work will be portal. necessary to harmonize Cadaster and Land Registry entries, especially at the local level.  Consider institutional reform in the county These measures are a priority. courts, the Land Registry and the Cadaster. The land registration as well as cadastral  Review the current statutory time limits for processes should be considered permit-related approvals, introducing - where administrative processes as elsewhere in necessary – stricter deadlines. According to modern societies and Croatia can consider the Administrative Procedures Act of 2009 making them out-of-court processes (see (OG 47/09), for instance, the Municipality of Land Registration Note). Zagreb has 8 days to check whether the application for a building permit is complete Building Permitting System. Efficient building (i.e. all the necessary documents have been permitting systems share key features. Clear submitted) and in line with the urban plan. This building codes written with a consultative process is only one of the first steps required for the are at the core of well-designed construction issuance of a building permit, and a lengthy permitting systems, and countries like Canada one. Considering technological progress and New Zealand are increasingly steering brought about by the physical planning towards performance-based codes63. Croatia database, which allows a quick confirmation of 61 http://www.uredjenazemlja.hr/default.aspx?id=22 documents can be found here: 62 Article 7 of the Land Registration Act (Official http://www.uredjenazemlja.hr/default.aspx?id=101 63 Performance-based codes provide more flexibility Gazette No. 91/96, 68/98, 137/99, 114/01, 100/04, 107/07, 152/08, 126/10, 55/13 and 60/13) currently and support innovation by focusing on outcomes to be says “Extracts from the main register and copies or achieved rather than prescribing how the building must print-outs from the collection of deeds shall be issued be constructed. The use of performance-based codes, by the land registries”. Additional information on why however, requires a higher level of technical electronic extracts are not considered official competence to enforce than do other approaches. Croatia Policy Notes | Making a Business Friendly Croatia 70 the information provided in the application, the economies covered by Doing Business, deadline for first formal check performed by including Denmark, Germany, and the United the Municipality could be shortened to 48 or 24 Kingdom. Doing so is an effective way of hours. In order to make the new deadlines expanding coverage by credit bureaus. effective, their implementation should be Legal Rights of Creditors and Borrowers in accompanied by tighter monitoring of the Secured Transactions. The legal and performance of the municipal officials charged institutional framework plays an important role in with document review. facilitating the use of movable assets as  Eliminate the requirement to stamp the copy of collateral. Having to give up the possession of the cadastral plan at the County Office before the asset pledged to a creditor would disable the it can be submitted as part of the application debtor from using such asset, which could for the building permit. Following the hamper the business’s productivity and ability to introduction of the Physical Planning operate. Croatia considerably strengthened its Information System, cadastral maps can now secured transactions system in 2006 by be found online. The online system eliminates launching a unified and geographically the need for architects and engineers to visit centralized collateral registry (Law on Register of the Cadaster to finalize their projects. The City the Judicial and Notary Public Insurance of of Zagreb, however, does not consider Claims Over Movable Properties and Rights). cadastral maps that have not been stamped at Since then, the Croatian Financial Agency (FINA) the Cadaster as valid documents when has been keeping a public registry on the processing building permit applications. As a securities (pledge and fiduciary transfer of result, architects and engineers continue to ownership) acquired over movables and rights. visit the cadaster unnecessarily to obtain a This may further be improved through: stamp on a map they have downloaded online.  Allowing businesses to grant a non-  Further streamline construction-related possessory security right in a single category approvals and clearances by improving the e- of movable assets, without requiring a specific permitting system and extend its usage to all description of collateral. In addition, security counties. The application for a building permit rights should extend to future or after-acquired is composed, among other documents, by a assets and extend automatically to the set of approvals that are a necessary condition products, proceeds or replacements of the for the building permit application to be original assets. These arrangement offers considered valid (and thus processed by the flexibility because it gives creditors both the city or county). For a simple two-story incentive to extend credit, as well as the warehouse, such approvals are issued by the security of knowing that they will be able to Inspectorate for Fire (Ministry of Internal realize their security interest if the debtor Affairs), the National Croatian Electric Grid, defaults. the Waste Collection Department, and the  Creating an integrated or unified legal Water Authority. framework for secured transactions that Credit Information. A credit reporting system is extends to the creation, publicity and an integral part of a well-functioning credit enforcement of four functional equivalents to market. In 2007, Croatia set up a new private security interests in movable assets like: credit bureau - the Croatian Credit Information fiduciary transfer of title; financial leases; Registry (HROK) - that distributed positive and assignment or transfer of receivables; and negative information only on individuals. Starting sales with retention of title. from July 2010, HROK expanded its coverage to Commercial Dispute Resolution. In the firms. In December 2010, the bureau started absence of efficient courts, firms make fewer distributing this information to financial investments and business transactions while institutions. Currently, the HROK database informal transactions become more attractive. In counts more than 3 million individuals and over Croatia, a new Enforcement Act came into force 130 thousands firms. Further, it can: in October 2012. Its aim was to reduce the time  Expand the sources of information to include needed for enforcement procedures by retailers and utility companies. In addition to transferring certain procedures from the court to the data provided by financial institutions, other bodies, such as FINA. Under the new more advanced credit reporting systems also Enforcement Act, FINA is competent to directly collect credit information from retailers or utility execute court judgments and court settlements companies (electricity, water, and mobile on debtors’ bank accounts. As a result, creditors phone providers) and include such data in the no longer need to obtain an enforcement credit reports. This is the case in 58 of 189 Croatia Policy Notes | Making a Business Friendly Croatia 71 decision from the court in addition to the final (2) recommendations for policy options to be judgment. The authorities still may want to: pursued based on the findings of the analysis.  Assess court procedures to identify points of The World Bank Group also offers support in: delay and formulate solutions. In Zagreb, it (i) Improving Business start-up and takes almost 20 months on average to resolve operations a commercial dispute. It is recommended to map out both the procedures required by the  Streamlining and simplifying business law and the steps required in practice by the registration and licensing procedures; court to take a case from filing through  Reforming inspections – regulatory, enforcement. procedural and institutional reforms;  Strengthen efforts to promote Alternative  Inventories of business laws, regulations and Dispute Resolution (ADR). Promoting ADR procedures; measures could help reduce the current  Implementing e-registries for business backlog in the Croatian courts. ADR, along registration, licenses, permits, inspections and with other measures aimed at speeding up other formalities; judicial proceedings and their enforcement,  Deployment of risk assessment and risk does not only increase efficiency but also classification tools to focus regulatory reduces the cost of legal fees entrepreneurs oversight. have to pay for dispute resolution.  Promotion of regulatory compliance through incentives, guidance, and strategic  Continue improving the e-courts system by communications campaigns. introducing e-filing and electronic service of process. Since 2007, Croatia has achieved (ii) Integrating government services important progress towards the establishment  Process mapping and re-engineering of G2B of an e-court system. Over the past years, all and G2G services. county, commercial, and municipal courts  Establishing integrated G2B and G2G have been connected to an Integrated Case services such as one-stop shops, Management System (ICMS/eSpis)64. In spite informational and transactional portals (e.g. of these efforts, the process of business registration and licensing portals). computerization is not yet completed. E-filing and electronic service of process are not yet (iii) Promoting good regulatory practice available. Similarly, the submission of  Timely notification and open and inclusive evidence by the parties (as well as witnesses’ consultation on new regulatory measures. opinions) must be carried out in paper format.  Appropriate assessment of the impact of Because of this, court staff, judges and users proposed regulations. have to cope with a dual system where only a  Efficient coordination in the delivery of reform. part of the information they are required to assess - e.g. minutes of the hearings and past  Systematic review and monitoring of court decisions - can be found online. regulatory performance and quality, and Adequate measures chould be taken to reduction of implementation gaps. gradually introduce a paperless e-court  Provision of regulatory information that is system. accessible, reliable, and timely.  Efficient mechanism for grievances and How the World Bank Group Can Help complaints. The World Bank Group is recognized as a world (iv) In all programs WBG client support could leader in supporting the design and include: implementation of business environment reforms.  Diagnostics,  Mapping and re-engineering of business Currently, there is a technical assistance project processes, under preparation aiming to upgrade the  Legal and regulatory review and reform, business registries in line with global good  Stakeholder mapping and consultations, practice standard. The project will include: (1) an  Institutional reform including the establishment analysis of the current legal and administrative of clear and transparent legal mandates for framework, stakeholder analysis, and analysis of the EU directives in the business registries; and 64The eSpis system was introduced starting from 2008, all courts were covered by August 2013 with the World Bank support. Croatia Policy Notes | Making a Business Friendly Croatia 72 regulatory agencies and improved coordination across regulatory agencies,  Transparency through greater access to laws and regulations in force,  Peer to peer learning. This Policy Note was produced by the World Bank to inform policy debate in Croatia. This note was prepared by Iva Hamel, Senior Private Sector Development Specialist, World Bank Group. The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the Governments they represent. For any questions regarding this note, please contact Vanja Frajtic, Communications Associate (vfrajtic@worldbank.org). THE WORLD BANK OFFICE ZAGREB: http://www.worldbank.org/en/country/Croatia Croatia Policy Notes | Making a Business Friendly Croatia 73 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs Strengthening Real Estate Registration Key Message Ineffective real estate registration is limiting Croatia’s economic development, in part due to weaknesses in the current governance framework, which hinders the delivery of public services, increases the workload for courts and undermines the development of a modern property tax. The majority of EU real estate registration agencies have been transformed through the adoption of OECD good practices and management within a single, self-financed agency. Key Actions  Create a new, independent real estate registration agency from the merger of the land registry offices of the courts and the cadastre of the State Geodetic Administration.  Provide a self-financing business model for the agency to collect the majority of its income from registration fees and electronic services – with the necessary safeguards.  Implement a two-tier board system: a supervisory board of non-executive members appointed by a responsible line minister; and management board of agency executives. Where Croatia Stands Now with good practices in public agencies and real estate registration governance in the EU and Croatia’s land and real estate sector is under- internationally. performing and hinders economic Real estate registration agencies tend to be development in key areas. Land and real estate public agencies capable of generating reform has been slower in Croatia than in substantial incomes from registration fees comparable countries across Europe and its and services. A number of good practices have neighbors in the region, mainly due to the emerged regarding the governance of public fragmentation of the institutions – i.e. the land sector agencies across the OECD that have registry is located in the Courts, with a parallel informed the reform of real estate agencies system for the cadastre and a separate inventory across the EU. This section describes common of state real estate. The impact of incomplete governance arrangement improvements that can and ineffective real estate registration is guide the real estate registration reforms in significant and includes the following: Croatia:  Poor quality information deters investment:  Integration of institutions: Reflecting the Investors are deterred by the lack of clarity of global public sector trends, single agencies real estate title. Also, the use of real estate as that combine the cadastre and registration collateral for credit is seriously hampered. service and collect their income from service  Use of the State real estate portfolio is fees have been identified as more efficient and constrained: State-owned real estate is often less administratively costly than public budget a valuable asset, but cannot be managed funded institutions and dual agency systems. effectively unless it is properly inventoried,  EU guidance on administrative vs. judicial valued, audited, maybe saleable, or managed. systems: The EU recommends that real  Lost opportunities for property taxation: estate registration activities fall under the Current fiscal records collected from real administrative function that is most estate transactions are inadequate for a fair appropriate and efficient to apply the rules of and efficient recurrent real estate taxation land tenure. However, the right of appeal (See Policy Note on Tax). should remain under the court system as the judiciary is entitled to interpret and apply the Therefore, there is an immediate need to law, as well as resolve disputes. However, reform the real estate sector. In particular this land registries should not be vested in judicial means addressing the fragmentation and systems, as is the case in Croatia. modernizing governance arrangements in line Croatia Policy Notes | Strengthening Real Estate Registration 74  Role of and trends in agency governance: Revenue generating agencies typically aim to There has been a trend in the EU towards operate a balanced budget, (i.e. to cover their improving the performance of government costs) and be sustainable. Clear principles and agencies by enhancing governance practices, rules are needed for: a) setting fees and in particular, through better definition of achieving full cost recovery; b) determining how functions versus agency management. In the to handle surpluses or deficits; c) providing for past, the lack of clarity on roles often permitted earnings to cover future investment needs; d) excessive political intervention in agency defining the proper level of retained earnings and operations which, in turn, contributed to poor investment; and e) safeguarding agency financial performance. In addition, there has been a autonomy. Given that agencies have the power trend among agencies with revenue to set prices in a captive market, financial generating capacity towards greater financial autonomy should be accompanied by systems and operational independence. for incentivizing performance and efficiency. The system design should provide incentives for The principal method for achieving better quality service delivery, cost reduction, and the performance has been to draw clearer efficient use of resources. distinctions between decision-making responsibilities of government versus Reporting and disclosure norms, as well as agency executives. Ideally, government regulated fee and profit margins, are key for provides strategic policy direction while good governance in revenue collecting executives take day-to-day managerial public organization. EU cadaster and real decisions. Clearer distinctions are generally estate registration agencies tend to agree on accompanied by greater decision-making annual targets and investments with the autonomy of executives while, at the same time, government in a form of either rolling multi- ensuring stronger accountability. Stronger annual plans / contracts or annual plans. They accountability to the State and stakeholders is publish activity reports and audited financial entrenched through proper documentation that statements annually and manage operational sets out policies and procedures, and defines profits and losses in a regulated and transparent missions, roles, and internal structures. Better manner. accountability and planning are also supported Allocating core tasks and modernizing staff by formal performance contracting and management would improve efficiency. EU performance measurement. cadastre and real estate registration agencies Enhancing Board structures is important to tend to maintain cadastre and registry records improve governance. Though unitary Board and maps and often also produce core structures are feasible for agencies, the goal of topographic maps of the country. Real estate creating clear distinctions between policy setting registration and/or cadastral surveys generate and oversight, and operations can be reinforced the main duty and source of income, and are able by the use of a two-tier board. In a two-tier to raise considerable revenue. In a stable and structure, a supervisory board, composed predictable operational and financial exclusively of non-executives, exercises environment, agencies are able to pay oversight of a management board composed competitive salaries for high market value exclusively of executives. Irrespective of the personnel and operate efficient infrastructure structure, success is typically determined by the and services. capacity of board members and executives to New approaches to agency governance have work together while respecting each other’s shown tangible benefits. As decision-making is distinct roles. made more politically independent, both Supervisory Boards should have a mix of government and executives are able to focus on skills and backgrounds not limited to public their respective responsibilities, and agencies sector representatives. It is critical that Board are able to better focus on achieving their nominations, while subject to political overview, mission. Self-financing and greater financial be based on merit and competence. Other independence also bring important advantages: important contributors to good agency stable funding by delinking from government governance are stakeholders and users. budgets and funds for critical investments; and Stakeholders need not sit on Boards, however, agencies are less of a drain on state budgets. As their views should be taken into account through a whole, new governance techniques help formal or informal consultative groups. Proper agencies focus on their mission, and result in stakeholder input promotes a client focus and better services for end users. enhances public accountability. Key success factors are organization and business models. The World Bank’s experience Croatia Policy Notes | Strengthening Real Estate Registration 75 from real estate registration projects in various the advice of the Users’ Council and the countries, including in the EU region, indicate Supervisory Board. In addition, the Kadaster that organization and business models are key receives about 15 percent of its funding from for sustainable governance of such agencies. the State Budget as project financing, mainly Lithuania and the Netherlands provide good related to e-Government. illustrations as both are leaders in governance The responsibilities for real estate improvements. Due to their success in managing registration in Croatia are currently split. The and delivering real estate registration, their division is between the Land Registration governments have extended their remit to Management Sector (LRMS), a department include further government registers. within the MoJ that regulates and monitors the  Lithuania: The Centre of Registers (Centre) Court-based Land Registers; and the State administers the Real Property Cadastre and Geodetic Administration (SGA), an authority Register, the Address Register, the Register of within the Ministry of Construction and Physical Legal Entities and a mass property valuation Planning that operates the cadastre in Croatia. system for Lithuania. The Centre is The SGA manages a network of 20 Regional established in law as a State-Owned Offices and 112 Cadastral Offices across Croatia Enterprise (SOE) liable to taxation and vested to deliver cadastral services and maintain a fiscal to the Ministry of Justice. Its governance is cadastre. The LRMS coordinates the network of further established in a number of internal Land Registration Offices within 107 courts that rules that define work procedures, staff maintain independent Land Book Registers policies and codes of conduct, and relations under the judicial system. between the employees and the Centre. The The cadastre and the court-based land Centre has a board of seven members that registers are financed through the state reports to the Ministry of Justice (MoJ). Board budget. The World Bank has supported the members and the Chairperson are appointed establishment of a Joint Information System (JIS) and dismissed by the MoJ and the Board also that manages and integrates a joint land includes the Director General of the Centre, database unifying the land register and cadastre who manages the SOE with sole powers. The data. The development of the JIS is currently Centre is financed from fees and being rolled out to all cadastre and land programmatic funds allocated by the MoJ from registration offices. the State Budget and is a profitable operation that retains 5 percent of annual profits in a Real State assets are also separately reserve fund. Annual reports and financial managed. In addition, the Central State Office of statements are published and annual plans State Asset Management (DUUDI) is a central are submitted to the MoJ for approval. The state body vested with the duty to coordinate, Centre adheres to national business inventory and manage all state assets including accounting and disclosure standards and is real estate. It currently lacks proper records and subject to an annual independent audit. resources, but is investing in property management information systems as a first step  The Netherlands: The Cadastre, Land towards a fit-for-purpose inventory. Registry and Mapping Agency (Kadaster) is the legal land registry and cadastre of the The current real estate registration Netherlands, established as a non- arrangements are not effective and are departmental public body. The governance having a number of negative impacts. These framework and structure is stipulated in the include: Civil Code and in the Kadaster-specific, and  Poor quality services: The fragmentation of public sector generic, legislation and norms. real estate registration institutions impacts The Kadaster is subordinated to the Ministry of services and customers. Legal and cadastral Infrastructure and the Environment and processes of real estate registration remain governed by a two-tier board structure with the separated and complex. This has led to Supervisory Board overseeing the expensive real estate transactions and also Management Board that manages the contributed to the historical inconsistencies in Kadaster. A legally stipulated Users’ Council is land information. This has resulted in poor part of its formal governance structure. Annual quality services, reduced public trust in the reports and financial reports are published and institutions and an increase in real estate an independent parliamentary review of the transaction costs without current legal Kadaster’s activities is conducted every five registration. years. Kadaster is financed through fees on a balanced budget basis, with fees being agreed  Inefficient use of court resources: The legal annually with the Ministry having considered land registration system continues to be Croatia Policy Notes | Strengthening Real Estate Registration 76 judicial and ties up scarce court resources on long-term strategies and business plans. This real estate registration which is, essentially, an is due to unpredictable funding decisions and administrative function. overarching changes in public administration policies. Closing the gap in institutional  Limited support for wider land sector arrangements, processes and services to those development: The lack of available needed in the digital era requires further comprehensive, authoritative real estate investment. State funding is both insufficient and registration and cadastral information reduces unreliable for such long-term investments, and the effectiveness of spatial planning, restricts new approaches to financing and corporate the option to implement local property taxes management maybe needed to bolster and prevents essential revenue streams to investment, predictability and operational support local government. enhancement.  Reduced opportunities for e-Government: The overall impact of these deficiencies is a The implementation of successful e- restricted inward investment. Many investors Government services is dependent upon using find the insecurity of real estate rights too high a spatial base registers, such as real estate risk for investment in Croatia. Many families and registry, cadastre maps, buildings and entrepreneurs encounter problems in accessing addresses. These registers should be credit due to the risk associated with their land provided by LRMS and SGA, but the lack of rights and restricting economic development of nationally harmonized data limits the the land market. . effectiveness of a range of e-Government services. How Croatia can improve real estate  Embedded cultural differences: Although registration real estate registration institutions do collaborate on a daily basis at local levels in The current system is detrimental to both delivering land administration services, there economic development and social stability. A is no evidence that these institutions integrate new governance structure might be considered, the sector or make joint decisions. Resistance informed by international good practice, for real to change is embedded and a stalemate has estate registration and could include: been reached between professional groups  Creating an independent agency: from the that have distinct professional cultures. merger of the land registry offices of the courts  Impact on staff capacity and retention: and the cadaster. A number of options are Organizations do not have the freedom to available for creating semi-autonomous legal manage staff outside of the constraints of civil entities within the Croatian public sector. service policies. This restricts their ability to  Combining registration and cadastral attract and retain high market value personnel services: The new agency’s remit could with the necessary skills, such as ICT. include core real estate registration and  Overcapacity of office network: The current cadastral services (covering all private and office network is still designed around the state real estate), and mass property valuation manual era and includes over 200 offices. In for multiple purposes, e.g. property market comparison, the Netherlands has five offices. information improvement, state asset The implementation of the Joint Information valuation, and revenue enhancement. System allows the office network to be Geodetic and topographic responsibilities rationalized and the introduction of a one-stop- could also remain in the domain of the new shop for all property transactions. agency. The scope could be extended to include state land management at a later  No common vision and strategy: Although stage. these issues are well known, there is no joint business strategy for the sector across the  Introducing a self-financing model: The institutions or even mutually sensitive new agency would be self-financing, perhaps strategies. Instead, the LRMS have developed an SOE or another financially and a short-term business strategy (as part of the operationally independent entity, which new Ministry-level strategy) without any input collects the majority of its income from from SGA while SGA has initiated separate registration fees and electronic services, and strategy work in parallel. operates on a balanced budget. Funding from the state budget would only be obtained and Over the long run, Croatian real estate ring fenced for government-specific activities registration institutions cannot focus and new development, e.g. support of specific adequately on the design and alignment of e-Government initiatives or maintaining and Croatia Policy Notes | Strengthening Real Estate Registration 77 developing the geospatial infrastructure and  Introducing legislation as needed: New services. Accountability for the use of funds, legislation would be introduced, when mechanisms for dealing with operational required, to transform real estate registration surpluses and retained earnings to cover from a judicial to an administrative-based future investments would be needed for the service. new agency to achieve its mission and maintain a high level of trust among the public.  Conducting reforms over a two-year Fee levels could be reviewed annually through period: This is a significant change consultation with key stakeholders and set by management process and best practice a supervisory board and confirmed by a indicates that if a new agency is responsible minister. A self-financing agency created/merged a two-year timespan might be should adhere to national business accounting appropriate. and disclosure standards and be subject to an How the World Bank Group Can Help annual independent audit.  Adopting new governance arrangements: The World Bank has significant experience in The implementation of a two-tier Board system providing advisory services, technical assistance in the new agency would include: (i) A and financing on land registration and cadaster supervisory Board of 5 to 7 non-executive programs in many countries worldwide including members appointed by the minister based Croatia and other EU countries, on national land exclusively on professional merit; and (ii) a registration and cadastre programs. This management Board composed of the CEO experience includes implementing institutional and other executives also appointed reforms involving the merger of land registration exclusively based upon merit. The role of the and cadastre organizations. The ongoing work on the Integrated Land Administration System, a supervisory Board would be to approve the strategy of the new agency, measure progress Bank-financed project, is supporting the roll-out against strategic goals and performance of the Joint Information System. The project is objectives, and ensure that systems are in closing in April 2017. place to safeguard that the agency operates in a transparent and effective fashion. The management Board would be composed wholly of full-time directors employed at the This Policy Note was produced by the World Bank to inform policy agency and would be responsible for the debate in Croatia. This note was prepared by, Mika-Petteri Törhönen, institution’s day-to-day operations. The Lead Land Administration Specialist. management board would answer to the The findings, interpretations, and conclusions expressed herein do not supervisory board through the CEO. necessarily reflect the views of the Board of Executive Directors of the World Bank or the Governments they represent.  Adjusting the regulatory framework: The For any questions regarding this note, please contact Vanja Frajtic, creation of a new independent agency within Communications Associate, (vfrajtic@worldbank.org). the Croatian public sector would require robust THE WORLD BANK OFFICE ZAGREB: and transparent regulation. Therefore, an http://www.worldbank.org/en/country/Croatia appropriate regulatory framework would have to be created. Croatia Policy Notes | Strengthening Real Estate Registration 78 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs Addressing Energy Affordability Key Message Energy sector reforms are well advanced, but addressing affordability concerns—by finalizing the design and the implementation of effective compensatory measures for vulnerable groups—is a priority. However, two major obstacles to include: the highly decentralized system that is dependent on municipal resources, with no accountability mechanisms to ensure reforms are delivered; and the lack of fiscal resources available for a compensation scheme. Key Actions  Tailored policy responses to help vulnerable households cope with energy price increases include:  Reaching poor and vulnerable households with means-tested social assistance, as part of central social assistance;  Promoting energy efficiency investments and other efforts to help consumers manage energy demand for all income levels; and  Communication and transparency to enhance consumers’ acceptance of market liberalization. Where Croatia Stands Now Croatian households’ energy budget share declines with income such that high energy Croatia has made speedy progress in budget shares coincides with low household liberalizing energy prices for commercial and income. This along with evidence on high shares public sector users. This was enacted through of the population being in arrears on their utility a number of laws introduced between 2004 and bills, and qualitative evidence on poor 2012. In 2012, with the passing of a new Energy households having already limited their Act and the Act on Regulation of Energy consumption to the minimum suggests that with Activities, Croatia liberalized its energy market in further tariff increases, concerns about line with requirements of the European Union's affordability will emerge particularly for the poor (EU) Third Energy Package. In comparison with and for those in rural areas. In addition to a focus peer countries like Romania and Bulgaria, on improving affordability for the poor, an Croatia has advanced quickly in the integrated and broader approach to addressing implementation of this agenda. A set of well- affordability is needed for vulnerable households designed measures that protect vulnerable of all income levels who face growing concerns consumers, however, is lagging. related to high spending on energy. The deregulation of prices alongside Croatian households use a variety of energy common tariff setting mechanisms initially sources. They use energy for lighting, heating, led to increased energy prices for cooking, and hot water, and there is significant consumers. From 2007 to 2014, electricity and heterogeneity in spending patterns on energy gas prices for domestic consumers increased across income groups (Figure 1). The poorest from 0.09 Euro/KWh to 0.13 Euro/KWh and 8.20 quintile has extremely limited access to district Euro/GJ to 12.90 Euro/GJ, respectively. Looking heating and rarely use in-house central heating ahead, further price increases are expected for systems. There is also significant heterogeneity electricity and gas to reach cost recovery levels, in spending patterns on energy across regions. even if the trend in international prices has This reflects the geographical concentration of currently reduced some of that pressure. In poverty in rural areas, and in Central and Eastern addition, the investment needs in the District Croatia, as well as the climate variation across Heating system suggest that prices for this regions. Also, seasonality plays an important role service will also have to increase going forward. in household energy expenditures. Based on the estimates of expenditures from the Household Croatia Policy Notes | Addressing Energy Affordability 79 Budget Survey (HBS) data, there is moderate between 0.3 and 0.9 percentage points above its seasonality in expenditures on electricity and 2011 level. The indirect impact of price increases high seasonality in expenditure on natural gas have not been modelled as these are not and district heating. expected to be significant. Figure 3: Composition of Household's Energy Table 1: Simulated poverty impact (using Expenditure by Quintiles of Per Capita anchored poverty line, in percentage terms) Expenditure, 2011 Real Further price increa Baseli increa ses to % ne se cost 2011 2011- recove 2013 ry Poverty 13.2 13.7 14.6 headcount rate Poverty gap 2.9 3.0 3.3 Squared poverty 1.0 1.0 1.1 gap Note: Poverty indicators are calculated using the poverty line anchored (fixed) at 60% of median per capita expenditure in the baseline case. In simulations, expenditure of each household is reduced by the amount equal to the increase in energy expenditure compared to the baseline case. Source: Estimates based on the 2011 HBS. Source: Authors’ estimates based on the 2011 Household Policy makers need to have a better Budget Survey (HBS). understanding of vulnerability to price increases. Key variables associated with being Households differ significantly in the a ‘high energy spender’ were identified in order availability of energy sources they can rely to construct “profiles” of groups most likely to be on, with the availability of gas and district heating affected by price increases. This exercise helped being the two most important heating options reveal that vulnerability to energy price increases whose coverage is limited. District heating is compounds a number of other deprivations which available in 18 cities, reaching an estimated 8.5 already limit opportunities available to poor percent of all households while the gas network households, such as having a head-of- reaches only 30 percent of households and does household with low education or out-of-work. not extend at all to the Adriatic south. This exercise also illustrated that even groups Affordability represents a challenge. This is which have characteristics typically associated illustrated by delays in bill payment, reflecting with better off households (such as living in a households’ inability to pay on time, and by modern multi-family building), could face households choosing to under-heat their homes significant stress on their budgets and see their in an effort to lower bills. Furthermore, energy poverty more than double. households rely on other energy savings Households lack understanding of the measures, like a two tariff meter, whereby “cheap justification for increasing energy tariffs. electricity” is available for off-peak demand hours Institutional and stakeholder assessments (after 10pm). However this means that through focus group discussions revealed that households are trying to meet their electricity households associate price increases with needs at night, which can have detrimental corruption or bad sector governance. One of the impacts on quality of life, especially of women advantages of liberalization, the benefit of a more who are typically in charge of domestic chores. competitive market, is not panning out for Simulations suggest that increasing energy respondents – the majority of participants in the prices since 2011 have resulted in an focus group discussions do not trust new increase in poverty of 0.5 percentage points electricity providers and so do not transfer their (Table 1). Although price increases have not yet services. Respondents often complain about seen a large impact on poverty rates, impacts do energy providers, namely about high and unclear appear to have been felt across the income bills for electricity and district heating and are distribution, with substantial heterogeneity also dissatisfied with the quality of natural gas. across regions. Simulations based on the additional increases needed to align electricity How Croatia Can Mitigate the Social and gas prices with international prices and to Impact of Rising Energy Prices bring district heating to cost-recovery levels, International evidence shows that the suggest that poverty rates could increase government can rely on three complementary Croatia Policy Notes | Addressing Energy Affordability 80 approaches to support energy affordability big disparities among eligible households for the population: depending on the finances of the municipality they live in. The possibility to accumulate benefits  First, Guaranteed Minimum Benefit (GMB), is not monitored either. Furthermore, there is no that adequately covers the poor, can be used common registry of beneficiaries (except for effectively to deliver cash compensation to the GMB) which further hampers coordination bottom quintiles in order to prevent adverse between local and central government structures coping mechanisms in the face of rising and leads to poorly targeted support in many electricity and gas prices. cases. Qualitative evidence points to the fact that  Second, demand management measures for households are aware of the disparities in poor and vulnerable households, especially treatment among inhabitants of rich or poor energy efficiency investments to improve municipalities as well as the lack of oversight to heating, will help households meet their ensure that local authorities with less revenue heating needs efficiently. still provide these benefits and that the beneficiaries to whom they are providing it are in  Finally, a tailored public communications fact those who need it. The unsatisfactory campaign together with measures to enhance performance of these measures stands out in transparency of the energy sector will Croatia’s current social assistance system which strengthen sustainability of reform efforts. is overall well targeted, though it provides Finishing the design and operationalizing relatively low coverage and generosity. Simple efforts to protect vulnerable consumers scenarios suggest that cushioning the impacts of remains a priority. The reforms started before the tariff increases required to reach cost Croatia joined the Energy Community in 2006, recovery would require mobilizing significant and continue now that it is an EU Member State. resources, even if those could be perfectly In 2013, the government adopted a Social Action targeted. Plan detailing its intentions to address the broad Consideration needs to be given to the social consequences of energy sector reform. As financing and targeting of compensation far as protection of vulnerable consumers is programs, particularly given the fiscal concerned, the Plan envisages measures aimed constraints. Simulations suggest that fully at: (a) supporting energy consumption through compensating the bottom 20 percent of the direct subsidies for the poorest citizens, including welfare distribution (roughly equivalent to the both social assistance recipients, and those who share of the poor in 2011) for the energy price would fall into poverty due to a price increase, increases since 2011 and those that are even if they are not currently receiving social expected, could cost 0.13 percent of Croatia’s assistance; and (b) providing support to a GDP. To implement such an agenda, the broader category of households which would be potential conflict between targeting programs to affected by tariff increases, most probably support affordability to “the vulnerable” if those through support for energy efficiency measures. are identified in terms of energy poverty, and Among the crucial steps identified in the plan is targeting “the poor” as it is done through targeted establishing criteria for the identification of social assistance needs to be explored and vulnerable energy consumers to receive state clarified. Simulations also showed that current support, making explicit reference to energy expected budget for support of vulnerable poverty as the relevant criteria in this respect. consumers, to be collected through solidarity Removing indirect support to households tariff, is enough to support a significant part of through subsidies embedded in the tariff either electricity or heating needs of social calls for strengthening other tools to bolster assistance recipients, but it is far from sufficient affordability. Current social assistance to cover significant part of needs of low-income programs offer limited support measures for families. energy affordability of vulnerable groups Energy efficiency investments can help in (through local government heating allowance reducing heating expenditures. This can and, from end-2015, the energy vouchers), and consist of interventions such as thermal result in wide disparities in treatment of renovation of the building envelope or more vulnerable households. While the GMB support efficient and cleaner stoves. Their is financed by the central government, housing implementation can reduce energy consumption and fuel wood transfers are financed by local between 40 and 50 percent, but this savings level governments and there is no enforcement is characterized by a payback time of more than mechanism to guarantee that they meet their 10 years given current prices. Modelling work on assistance obligations. The uncoordinated potential energy and cost savings from thermal nature of the system means that there are often modernization in residential buildings in Croatia Croatia Policy Notes | Addressing Energy Affordability 81 highlights that low cost energy efficiency can provide necessary support to investment for family houses can bring down governments, regulators, beneficiaries and modelled energy budget shares, however, for other; organizations involved in households in the bottom quintile who are implementation; already under-heating, the budget share would remain unchanged and they could experience  Develop a system for the supervision of payback times of over a century. renovation works quality. In an environment where energy prices are The gaps in households’ understanding of increasing to cost-recovery levels, different aspects of the energy sector reform governments are well advised to scale up need to be addressed. A shared aspiration to residential building energy efficiency become an EU Member State appears to have programs. If public subsidies are used in a smart facilitated the implementation of reforms. way to leverage private financing, a large number However, now that the goal has been achieved it of households would benefit from such programs seems that a greater effort to communicate and would be less exposed to higher heating effectively about the next generation of reforms costs. For those low-income households that are might be needed, especially in light of gaps in already experiencing high energy budget shares households’ understanding of different aspects and/or under-heating and who should be among of the reform ranging from price-setting the first to benefit from public programs, mechanisms to electricity suppliers to billing additional public financial support is required to processes or compensatory measures to support make up for the lack of access to commercial energy affordability. financing. There is also need to clearly articulate a Sources of funding could include the vision for the future reform process and following: identify the public compensatory measures that are going to be put in place. This is  State government budgets, European particularly the role that energy efficiency Structural funds and other funds from financial investments and the new program to protect institutions (See Policy Note on Public vulnerable households are going to play. In Investment Management), although this is addition to closing information gaps, special also dependent on the general fiscal attention should be paid to simplifying processes consolidation program; and procedures as well as facilitating better government coordination to lower transaction  Special sources such as electricity (or other costs, and ensure access to support services for fuel) levies, climate change levies, special vulnerable households. The communication purpose EU funds, and others, such as Green effort should convey the reform as a means of Investment Schemes; achieving economic and social objectives such  Heating subsidies redirected to provide grants as better service delivery and sustainable and for energy efficiency investments, where secure energy sector. applicable; How the World Bank Group Can Help  Special resources at the municipal level, such The Bank offers experience working with as income from the sale of dwellings in governments – globally and in EU countries – in municipal buildings; rolling out reforms that increase energy  Instead of spending funds regularly for efficiency, design affordable and well targeted compensating poor and vulnerable compensatory schemes and manage the design households for energy price increases, one- of supportive institutional reforms and strategy time payments to improve the energy development. This includes analytic and advisory efficiency of their homes may be preferable. support, as well as supporting infrastructure planning and upgrades, automation of processes Additional supporting measures could and ICT improvements. include: The recommendations to improve the energy  Adapt Home Owners Associations or owner’s affordability program in Croatia submitted to the legislation to facilitate decision processes; Government in January 2016 outline a broad  Provide technical assistance to Home Owners agenda to be addressed. In this respect, Bank Associations/owners for capacity building in assessments and policy advice provided to date management and financial issues; offer a wealth of comparative information on issues and practices from best practice countries  Set up a strong interdisciplinary/inter- as well as countries which are in the process of ministerial and intergovernmental unit which reforming their energy affordability and energy Croatia Policy Notes | Addressing Energy Affordability 82 efficiency systems. The Bank is also supporting This Policy Note was produced by the World Bank to inform policy the modernization of the social assistance debate in Croatia. This note was prepared by Caterina Laderchi, Moritz Meyer, staff of the World Bank. system through the investment operation (See Policy Note on Social Welfare). The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the Governments they represent. For any questions regarding this note, please contact Vanja Frajtic, Communications Associate, (vfrajtic@worldbank.org). THE WORLD BANK OFFICE ZAGREB: http://www.worldbank.org/en/country/Croatia Croatia Policy Notes | Addressing Energy Affordability 83 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs Managing Water Resources, Services and Risks to Growth Key Message The overall water management framework in Croatia is sound, but EU membership compliance with water Directives is bringing operational and financial challenges that require the largest investment cycle in its history and in parallel reforms to improve technical and operational efficiency. Irrigation of agricultural land was neglected over an extended period of time, which undermines agricultural competitiveness, and exacerbates the risks of climate change impacting agricultural production. While flood protection systems in Croatia are fairly well developed, the country still needs to improve river basin based cross border cooperation, and develop additional flood protection infrastructure, in response to the increased frequency and intensity of extreme weather events. Key Actions  Finalize preparation of and implement the water utilities sector reform.  Strengthen capacity and remove barriers for preparation, implementation and optimal utilization of EU compliance investments.  Implementation the National Irrigation Strategy and develop water user associations (WUAs).  Strengthen the water quality monitoring system and improve flood forecasting and real time coordination with neighboring countries. Where Croatia Stands Now demonstrated the growing human and economic impact of extreme weather events. The Water Management Strategy adopted by Prior to joining the EU in 2013, Croatia the Government of Croatia in 2009 sets the undertook significant efforts to meet the EU number of important objectives for the water environmental acquis communautaire. sector. These include: (i) provision of sufficient Differently from many candidate countries in the quantities of drinking water of good quality for the region, in 1995 Croatia established a strong population; (ii) provision of the required quantities national water agency, Croatian Waters65 . of water of adequate quality for various economic Thanks to rich water resources and functional purposes; (iii) protection of people and assets organization of the water management sector, against floods and other adverse effects of water; Croatia today is in a more advanced position than and (iv) achieving and preserving the good status other recent EU members in terms of compliance of water in order to protect aquatic and water- with EU requirements: River Basins dependent ecosystems. Management Plan have been adopted and are These objectives underline the importance of under implementation; the Floods Directive sound management of water resources, 2007/60/EC has been already transposed into water services and risks for the economy and national legislature (Water Act, 2009) and is the environment. Indeed, Croatian tourism being implemented; and the Government has put generates significant income, which is heavily forward and is implementing a comprehensive dependent on good quality of coastal waters, plan to achieve compliance with the relevant EU representing 17 percent of the GDP; and directives (Urban Wastewater Directive and agriculture, which is heavily dependent on water Drinking Water Directive). However, some very availability, provides employment to 9.5 percent important implementation challenges remain, as of the labor force (compared to 5 percent of highlighted in the following paragraphs. EU27), while recent floods and droughts have Water Resources and Status 65 estate, and protective and hydro-ameliorative water The public institution is a non-profit institution responsible for managing water and public water structures. Croatia Policy Notes | Managing Water Resources, Services and Risks to Growth 84 In the Constitution, water is stated as a good inorganic substances (from domestic and of public interest alongside to sea, airspace, industrial polluters). mineral resources, land and forests. All water Water Services matters are legally regulated by three main laws: Law on Waters, Law on Water Management Water and sanitation services are provided Funding and Law on Local Public Utilities. The through more than 150 local or regional line ministry (usually the Ministry of Agriculture) public water utility companies. However, the supervises the operation of Croatian Waters, as local service providers are regulated and the agency that is responsible for management supported by national-level institutions, and administration of all water issues. Croatia including: National Water Council, Ministry of cooperates with other riparian countries through Agriculture, Croatian Waters, and Water international agreements and conventions, which Services Council. Croatia has benefited from are part of the legal framework for water having Croatian Waters as a strong water management in Croatia and in the region. management agency that represents important technical and financial resource for the water Croatia is endowed with relatively abundant service provision sector. Service regulator role is water and is characterized by great rivers . being played by Water Services Council that The Sava and Drava on the northern/eastern reviews and approves any tariff revision. Slavonia plain, and the karst coastal area in the Economic regulation is based on the cost west and south. The northern and the eastern recovery principle and a price-cap approach, with area of Croatia belongs to the Danube/Black Sea a requirement that tariff structures consider catchment area (about 60 percent of the territory) subsidy schemes in case an expected water bill and the coastal zone to the Adriatic Sea is over 2.5 percent of average household income. catchment area (about 40 percent of the The Council also monitors service quality and territory). Despite being a water-rich country performance through the collection of a series of according to FAO (Aquastat 2015), water flow is performance indicators. very seasonal, especially in the Adriatic Sea catchment area. The sector reform agenda remains unfinished. Since 2010, the government has The reduction of industrial activity and the initiated a series of utility sector reforms. Besides decline in the use of fertilizers and pesticides establishment of a proper water sector regulatory in agriculture have considerably eased the framework, this includes proposed merger of pollution in surface water sources. However, utility service providers into smaller number of surface water still shows relatively high nutrient regional utilities to take advantage of economies pollution, especially in the Danube basin. The of scale, ensure improved performance and more entire Danube basin, and smaller parts of the efficient operating costs, and provide further Adriatic basin are classified as “sensitive areas” cross-subsidies inside the service area. in the context of the EU Water Framework However, this reform has not yet been Directive (EC 2000). Only a small portion of all implemented, and the reorganization of the utility available water resources is actually used (for service areas that currently exists as a proposal, example only 4 percent of renewable is waiting for the new government decisions. groundwater is being used against 96 percent of potable water supply), indicating overall water Water service provision at household level in richness. Croatia is generally good and similar to other countries in the region. 99 percent of the Although climate change is expected to population has access to piped water, 75 percent exacerbate floods and droughts, water has access to organized water supply, 45 availability is not an immediate concern as percent of population has wastewater collection demand is low, although localized climate and 95 percent has flush toilets. change impact could be expected. However, water supply and wastewater The quality of groundwater is generally infrastructure is in need of a major considered good throughout the country, rehabilitation and upgrading to reach EU with noticeable exceptions on some of the required levels. There are still significant islands, where salinity is an issue in a dry challenges linked with: (i) the quality of drinking season. The reports on the state of the sea and water where only 85 percent of samples are its water quality indicate that a considerable part compliant, against good practices of above 99 of the Croatian portion of the Adriatic Sea is percent in particular in areas not covered by oligotrophic and clean, but some of the big cities public utilities; and (ii) only 45 percent of all ports, and the industrial zones along the coast wastewater collected and only 28 percent are at some locations polluted by organic and treated, which is much below than in EU15 countries. Croatia Policy Notes | Managing Water Resources, Services and Risks to Growth 85 The efficiency of public water and sanitation Floods management service providers remains an issue. At 44 While Croatia has a relatively well-developed percent, nonrevenue water is much higher than and operational flood protection system, the levels in the Western Europe. Commercial including flood protection structures practices are largely sound with universal (combination of dikes, canals pumping metering, despite a billing collection ratio of stations and flood retention areas), heavy around 90 percent on average. With an average seasonal rainfalls still pose a risk of severe of 3 staff per 1,000 connections, the sector is less flooding. The southern part of the Sava river productive than the international best practices, basin has been most affected during the 2014 but still more productive than the countries in the floods. At the same time, torrential rains have region. caused more localized but widespread flooding, Sector is relying on transfers to cover its power outages, landslides, transport operational costs. Water use and water infrastructure damages, and have disrupted protection fees represent around 18 percent of water and wastewater services, with severe the sector funding, while tariffs collected by economic impacts. Croatia is planning to scale utilities account for 57 percent of the total up its efforts to further build its flood resilience, financing coming into the sector, but failed to fully and improve flood predication and cooperation cover O&M utility costs. As a result, funding of with neighboring countries (particularly in Sava investment costs rely heavily on national taxes and Danube catchment area). and transfers. External transfers represent 23 To address its flood risk, Croatia is working percent of overall sector financing, and this within the Floods Directive 2007/60/EC. The proportion is expected to rise significantly as EU directive was transposed into national legislature Cohesion Funds become dominant form of (Water Act) in 2009. Preliminary Flood Risk financing necessary for EU alignment Assessment – PFRA was completed in 2013, investments. reported to the EU in 2014. With the EU support, Current investment levels are much lower Croatia has completed Flood Hazard and Flood than needed to achieve compliance with the Risk Maps. Croatia’s Flood Risk Management EU acquis. They can cover only around one- Plan (FRMP) is an integral part of its River Basin third of the level necessary to achieve the Management Plan (RBMP), over which Croatian country’s commitments. An estimated €0.85 Waters has a full responsibility. Croatia’s draft billion of investments are needed to achieve RBMP with FRMP were completed and compliance by 2023 with the Drinking Water published for public review in April 2015, while Directive and another €2.9 billion for the Urban reporting to the EU is scheduled for March 2016. Wastewater Treatment Directive. While EU Irrigation Cohesion Funds will cover important part of investments needs (around 70 percent of EU- An important constraint to increased financed capital expenditures), overall EU performance in the agricultural sector is the allocations will likely be less than 70 percent of lack of adequate and reliable supply of water investment needs for full EU directive for irrigated agriculture. The country has one compliance, indicating considerable financial of the lowest ratios of irrigated-to-irrigable land in gap. the region: only 18,000 ha are currently irrigated out of 244,000 irrigable ha. This is a considerable Tariffs are expected to continue rising in the limitation on the country’s agricultural potential, future to help cover the financial gap . Tariffs as analysis shows that it is not feasible to has increased on average by 7.5 percent increase the production of high-value crops annually between 2005 and 2012 (while average without supplemental irrigation. Overcoming this annual inflation was 3 percent), and are expected constraint would involve (i) the repair, to continue increasing, given the significant modernization and expansion of the on-farm investments and subsequent operating costs irrigation facilities, (ii) the more secure provision linked to Croatia meeting the European of bulk water in the summer season and the environmental acquis. Affordability is still not a drainage of surplus water in the wetter seasons, serious constraint for most people in Croatia, but and (iii) the strengthening of the institutions for is likely to become growing issue for a poorer sustainable water management and increased segments of the population as tariffs continue productivity of irrigated agriculture. These rising. In 2012, the water bill for an average challenges prevail across the country, despite family was around 2.3 percent of household the diversity of meteorological and topographic income, and 3.6 percent for the bottom 40 conditions (with marked differences, say, percent of population, which is above the between the karstic mountainous coastal region designated Croatian affordability level of 2.5 and the Slavonian plain). percent. Croatia Policy Notes | Managing Water Resources, Services and Risks to Growth 86 The productivity of agricultural sector is its National Plan for Irrigation and Management comparably low. Its productivity in the period of of Agricultural Land and Water Use (“National 2012-2014 was at 1/5 of average productivity Irrigation Plan”) as part of its policies to level in EU15. In fact, it declined over the last modernize its agricultural base. In recent years, three years by close to 16 percent if measured as Croatia has made some progress towards gross value added per worker. While before pursuing important agricultural reforms that 2009, Croatia had nearly twice as high include: (i) transferring the management and productivity than new EU member states, this maintenance responsibilities of irrigation advantage has been almost entirely lost over the systems from the state to the counties (requiring last three years. A high share of small and institutional strengthening at local levels), (ii) subsistence-oriented agricultural holdings introducing payment for water use, determining weakens overall labor productivity. Three the tariff of irrigated water to cover O&M costs of quarters of all farms operate on less than 5 the infrastructure and developing an effective fee hectares, and almost 60 percent of these (or half collection system; and (iii) initiating the of the total number) consume more than half of development of water user associations (WUAs). their agricultural output66 . However, the sector All counties have now also completed a County budget currently slightly exceeds 1 percent of Irrigation Strategy. GDP, which is higher than in most other EU countries, where levels generally range between How Croatia Can Manage Its Water 0.3 and 0.8 percent. Resources Figure 1. Farm Labor Productivity, Croatia and Despite seasonal and regional disparities, the EU (2005-11 average) Croatia is a water rich country, and those potentials could be better deployed. Croatia’s water sector could contribute to economic stability of the country, reviving growth and creating jobs in a number of ways, including:  Water Resources. The areas of improvement for water resource management in Croatia are following: (i) strengthening of water quality monitoring system in the rivers and coastal areas to be able to track changes in water Note: EU12 countries that joined after 2004 w/o Croatia. quality status, (ii) improving cooperation with Source: Eurostat neighboring countries with whom Croatia shares its main river basins with the objective The revitalization of the agricultural rests, of optimizing water use, but also improving inter alia, on the following policies: (i) land management of flood and draught risks. consolidation; (ii) modernization and expansion of irrigation; and (iii) a system of agricultural  Flood and drought management. The 2014 subsidies that is harmonized with the EU rules. floods represented an overall damage of €80 The irrigation effort aims at mitigation of water million, and with frequent occurrence of the shortages that have a seasonal (notably in the extreme weather events, similar events could northern part of the country) or structural nature be expected in the future. (notably in the southern Adriatic coastal zone that Elimination/reduction of flood risks (both from is predominantly karstic). In nearly all cases, the large rivers as well as from torrential rains) irrigation is supplemental, i.e. only required to would minimize damages, and create supplement rainfall and bridge dry spells. The additional jobs for flood protection first National Communication of the Republic of infrastructure construction sector. The Croatia to UNFCC on the impact of climate Government needs to scale up its efforts to change notes that soil moisture during the improve flood risk management, including summer months in lowland Croatia is expected developing additional structural measures, to decrease by 30-60 percent and in the coastal like: (i) improvement of flood protection areas by 25-56 percent, as a result of increased infrastructure (including modernization of temperatures and lower rainfall during the lower Sava River dikes); (ii) development of summer. Natural Water Retention Measures; (iii) Despite some progress on the institutional development of remote sensing for flood and policy framework, implementation defense, and improvement of Flood Defense remains slow. The Government in 2005 adopted Centers, with state of the art information management and communications systems. 66 Eurostat, Agricultural Census 2010 Croatia Policy Notes | Managing Water Resources, Services and Risks to Growth 87 Croatia Waters estimated that this would by the introduction of a functional require about €1.5 billion over the next 30 benchmarking platform. years, of which large part will be financed by EU. On non-structural measures, Croatia  Irrigation. The main issues that need to be needs to: (i) improve the flood forecasting and addressed in the next period are the following: early warning and alert systems (including (i) implementing NAPNAV and developing data collection, modeling, data exchange water user associations (WUAs) in parallel. platform); (ii) improve modelling and Importantly, WUAs need to commit up-front to simulation of flood hazards; (iii) improve flood payment of water use fees, be closely involved risk management planning, systems, maps in the design of the irrigation schemes, and be etc. The above measures present an supported through a dedicated extension integrated approach to floods/drought risk service and credit system that can help them management, and they require extensive and achieve water efficient irrigation, link to effective regional cooperation. Real time data markets and maximization of the on-farm exchange and joint forecasting are the critical investments; (ii) identifying and preparing steps Croatia is working on. Croatia’s efforts priority irrigation investments that are are compounded by similar undertakings in economically, financially and environmentally the other countries sharing the river basins. sustainable within a regional or local rural water management vision. Irrigation charges  Water services. The main issues that need to should cover the costs of the irrigation be addressed in the coming period are the infrastructure, at the very least, to ensure the following: (i) secure sufficient financial financial sustainability of these investments; resources to cover EU compliance needs (iii) strengthening the institutions in charge of estimated at around €3.75 billion, requiring the development, management, operation and almost triple the current levels of investments, maintenance of the irrigation systems. This (ii) secure project preparation and would also include introducing the principle of implementation capacity needed for EU payment for water use, outlining the compliance - the implementation capacity of methodology for determining the water the water utilities will need to be significantly irrigation tariff as well as the fee collection improved trough capacity building and better system; and (iv) developing a set of actions to organization of utilities; (iii) implement utility support the farmers that would benefit from sector reform to strengthen capacity and new irrigation infrastructure or improved improve service efficiency - operation, services (including agriculture knowledge and maintenance and assets depreciation of the technical information regarding the use of new EU financed infrastructure will represent irrigation methods (if any), and WUA financial and operational challenge, unless organization, management, and financing). capacity of service providers is timely strengthened and sufficient financial How the World Bank Group Can Help resources are provided. Utility regionalization The World Bank has been a leading and long- process aiming to merge service providers into standing partner of the Croatian water sector for a smaller number of regional utilities, and the last 15 years, providing financial and cover the whole country with better organized technical assistance worth of €335 million, in the service provision is yet to be implemented; (iv) field of water supply and wastewater ensure affordability of future tariffs - management, water quality monitoring, flood appropriate mitigating mechanisms will need protection and irrigation planning. Through its to be developed to address affordability of last projects: the Inland Water project and the tariff hikes needed to cover the construction Coastal Cities Pollution Control 1-2 (APL) and operation of the new infrastructure to projects, the Bank has supported financing of the comply with the environmental acquis, as well investments in flood protection, wastewater as apply cost recovery principle; (v) strengthen collection and treatment, contributing in regulation in the water sector - despite the particular to a much cleaner coastal area even relatively well-developed legal and regulatory before EU accession, and establishment of a framework, the Water Service Council is still in comprehensive seawater monitoring system for the process of fully deploying its regulatory a thriving tourism industry. During this last period, reach. It has developed instruments for that the Bank has enabled knowledge sharing and purpose, including specific bylaws on provided continued technical assistance to the performance standards, but those have not yet water utility sector regulation and reform process. been widely applied. As a result, regulation of water services needs to be strengthened in Today’s Croatia is very different from the one 15 terms of human and financial resources, and years ago. Joining the EU meant that the Croatian water sector had to adopt a water Croatia Policy Notes | Managing Water Resources, Services and Risks to Growth 88 management approach based on River Basins  Programmatic engagement. The Bank could Management Plan; commit to ambitious drinking also provide direct technical and financial water and wastewater management targets to support to the implementation of the satisfy EU water directives and revise the way government’s operational program, by floods management and irrigation infrastructures agreeing on a series of concrete milestones are being developed. Based on the involvement and results and supporting those financially in many EU countries, the Bank’s engagement in and technically. In this case, the Bank’s water sector could take a number of different engagement would be focused on helping the forms: government in delivering the overall program and achieving the specific results agreed  Technical engagement. The Bank could upon, rather than reviewing individual provide continued support to the government investment packages – a relationship that in addressing sector challenges of EU reflects the increased maturity of the country membership, such as the implementation of compared to past times. the water services reform, the adaptation of water infrastructure and climate change The World Bank strives to maintain an active management, the prioritization of investments policy and sector dialogue building on its to optimize EU funds usage and absorption excellent knowledge of Croatia, its regional while supporting government priorities, or the knowledge of EU membership compliance introduction of new technologies for more issues and its unique global knowledge of water efficient water use in irrigated agriculture and sector. water supply. Such a technical support could be financed from the Bank or from EU funds, as is the practice already in Romania and This Policy Note was produced by the World Bank to inform policy Bulgaria. debate in Croatia. This note was prepared by Senior Water and Sanitation Specialist Stjepan Gabric, Senior Water and Sanitation  Financial engagement. The Bank could also Specialist David Michaud, Senior Water Resources Specialist Ana Cestari and Senior Water Resources Specialist Winston Yu. provide co-financing for EU funds as is currently the case in Poland, either to the The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the national or local governments, in order to World Bank or the Governments they represent. support and accelerate the investment For any questions regarding this note, please contact Vanja Frajtic, program necessary to comply with EU Communications Associate (vfrajtic@worldbank.org). requirements. It could also contribute to THE WORLD BANK OFFICE ZAGREB: finance investments not eligible from EU funds http://www.worldbank.org/en/country/Croatia but important to accomplish the government’s strategy, such as irrigation or floods protection infrastructure, or support to smaller settlements below EU water supply or urban wastewater requirements. Croatia Policy Notes | Managing Water Resources, Services and Risks to Growth 89 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs Competitive Transport as an Engine for Growth Key Messages Transport SOEs are not managed on a commercial basis and their restructuring is slow and inefficient, leading to a drain on the public budget, worsening deteriorated services, and hampering the use of EU funds. The road companies’ debt, equal to 11 percent of GDP, is one of the largest pressure points on public finances. The transport sector lacks effective multi-modal planning, which takes account of available financial resources and implementation capacity. Transport projects can take up to 10 years, with substantial delays due to weak project management capacities, and inefficient permitting and procurement processes. Key Actions  Form a task force coordinated by the transport ministry to develop sector-wide and multi- year implementation plans for sector investments. A separate team in the ministry could be assigned to introduce electronic portfolio monitoring according to predefined key performance indicators (KPIs).  Accelerate SOE restructuring by strengthening management and governance, imposing budgetary limits and supervision on public expenditures, increasing private sector involvement, and ensuring that European Structural and Investment (ESI) funds are prioritized for planned investments.  For railways, review the network size, discontinue low traffic services, and rationalize asset management. For roads, urgently restructure companies’ debt and operations.  Simplify, shorten and digitalize permitting processes for infrastructure projects. Likewise, standardize procurement processes, improve the quality of tender documentation and the evaluation procedures. within a sub-sector (e.g. HZ Infrastructure investing in railway lines that are not priorities for Where Croatia Stands Now HZ Passenger Transport) or across sub-sectors (e.g. Rijeka port investing in terminal expansion Croatia does not have a strategy and for which road and rail access is not developed). implementation plan for the transport sector. Moreover, it creates a discrepancy between the After more than 15 years, Croatia approved an companies/sub-sector objectives, as defined by interim National Transport Development Strategy these plans, and available financial and human in July 2014, which is expected to be finalized in resources to implement them, i.e. European 2016. The Strategy defines a new approach to Structural and Investment (ESI) funds require transport planning, emphasizing multimodal, additional staff capacities. safe and sustainable transport services and the completion of the Croatian part of the Trans- At an operational level, implementation of larger European network of corridors. However, an transport projects often span 3-5 years, with 2-4 overarching implementation plan that would years spent beforehand on project preparation, define, prioritize, and sequence transport including technical documentation, permitting, infrastructure investments in a complementary, land expropriation and procurement. Planning affordable and consistent manner in the medium documents usually do not estimate correctly term is still missing. Transport investment these constraints, especially project preparation planning still rests upon respective sub-sector or and procurement phases, which leads to companies’ strategies and plans (e.g., Public suboptimal delivery and a lack of credibility of Road Construction and Maintenance Programs, planning documents themselves. In 2013, the HZ Infrastructure Business Plan), which are government passed a law on Strategic independently prepared by companies and Investment Projects, which enables priority approved by the government. This approach projects to follow an accelerated track for often leads to inconsistent policy making, either permitting, procurement complaints resolution, and approval of various administrative Croatia Policy Notes | Transport 90 procedures. The development of a container and insufficient administrative implementation terminal in Rijeka port is the only transport project capacity. declared as strategic, but with little visible impact Many companies have taken expensive on the speed of delivery as internal processes in commercial loans or rely on the State budget to various parts of the administration still seem to finance their business plans. These investments be a hindrance.67 do not entail the level of monitoring and Investment and Sector Financing. Despite evaluation associated with EU-funded projects, increased budget financing, Croatia resulting in HRK1.6 billion of capital transfers to continues to rank relatively low in the quality transport in 2014, of which two thirds went to of infrastructure, especially in rail68. In 2014 railways. At the same time, the transport ministry alone, the state allocated over 1.3 percent of received HRK1.5 billion71 in subsidies, primarily GDP in direct subsidies and transfers. to cover operational losses in railways. The State Figure 38. Competitiveness of Transport has also been a lender of last resort for a number Infrastructure of transport SOEs, either by providing loan guarantees, taking over loans, or by covering operating losses through subsidies. In 2014, state guarantees outstanding to transport companies exceeded HRK12 billion72 and were used mostly for refinancing rail and road debt. The cost of borrowing remains high and access to finance limited for companies due to their indebtedness. Figure 39. State Transfers to the Transport Sector Source: The Global Competitiveness Report 2015-2016, WBF Although over EUR 1.3 billion of ESI funds 69 is available for the 2014-2020 period for transport connectivity and mobility, transport infrastructure investments in Croatia have been largely financed by the State budget and State Owned Enterprises (SOEs). The ESI funds allocation Source: Ministry of Finance, World Bank varies by sector, but appears to exceed the Prolonged recession and weak recovery absorption potential. This was evident in the sub- exacerbated losses and exposed operational optimal utilization of the Instrument for Pre- weaknesses of transport SOEs. Most accession Assistance (IPA) during 2007-2013. companies are now in a dire financial state, as Transport was eligible for some EUR 280 million, suggested by financial data of 22 transport SOEs of which EUR 237 million was allocated and EUR of strategic and special interest.73 Many SOEs 93 million paid, resulting in one of the lowest have not faced hard budget constraints and were absorption rates in the EU.70 The main obstacles the largest recipients of subsidies and transfers to higher absorption are inadequate project from the budget.74 High operating costs (and documentation (feasibility studies and technical financing costs for some) arose primarily due to designs), ineffective procurement, co-financing overdesigned maintenance standards (for requirements (especially for land acquisition), infrastructure managers), large wage bills, contracting to subsidiaries, and non-transparent 67 Rijeka port’s development of the Zagreb Pier (HRK States are difficult to compare due to the extended use 1.6 billion) was declared a strategic project of national of IPA in Croatia. 71 Excluding subsidies to agriculture and to road and interest in 2014. 68 World Economic Forum, Global Competitiveness rail infrastructure managers for routine maintenance. 72 Ministry of Finance, Overview of State Guarantees Report 2015-2016. 69 EUR 1.3310 billion of ESI funds are available to in 2014 73 Aggregate data for 9 transport SOEs of strategic and Croatia for transport sector during 2014-2020, of which EUR 910 million is from the Cohesion Funds and EUR 13 transport SOEs of special interest for the Republic 400 million from the European Regional Development of Croatia. 74 In 2014, the State support to 22 transport SOEs was Fund. 70 Data as of December 31, 2015; MRDEUF. HRK 4.4 billion (HRK 1.7 billion to HC and HRK 1 Absorption rates for OP Transport in other Member billion to HZI). Croatia Policy Notes | Transport 91 procurement processes for external services, exacerbated by unfavorable borrowing terms for while revenue generation has remained limited. most loans, short maturities of around seven years, variable interest rates (as high as 6-7 Though some restructuring has recently percent), and euro denomination that creates been initiated, notably in the rail sector, foreign exchange risk. progress has been slow. Companies were tasked with preparing and implementing their Figure 40. Road Sector Debt Service Needs for own restructuring programs, and had few 2016-2025 incentives to improve performance because operating deficits were covered by the State. Their strategic direction was often subject to change, as evident in the suspended Initial Public Offering (IPO) of HZ Cargo (HZC) and Croatian Motorways (HAC). Most companies still carry excess-staff with over 21,000 employees in 22 strategic and special interest SOEs, with many staff hidden in subsidiaries, which increases employees by at least 5,000. Favorable collective agreements and inflexible labor laws also make Source: HAC, ARZ, HC, World Bank staff retrenchment problematic during restructuring. Voluntary departures are the norm, In addition to capital expenditures and poor whereas collective redundancies take at investment planning, road sector liabilities minimum 6-9 months, during which companies increased because of operating inefficiencies. must consult with the worker’s council and Though the quality of the road network is adhere to a three months termination period. This perceived as good, road conditions have further reduces productivity and increases costs deteriorated in recent years and road safety is a for cash-strapped companies. On the other hand, concern. Croatia ranks among the five worst EU retention and promotion of qualified staff is performers in terms of fatalities by population. 75 challenging given overstaffing coupled with well- In an effort to rationalize motorway operations paid low qualified staff. and increase efficiency, HAC-ONC was created as a joint subsidiary of HAC and ARZ to perform Roads. Croatia has one of the highest density routine maintenance and toll collection. However, motorway networks in Central and Eastern it is contracted on a non-competitive basis and Europe (22.79 km of network /1000 km2 land per-km maintenance costs charged by HAC- area); in part due to the expansion during 2001- ONC largely exceed that incurred by private 2008. Development of 660 kilometers of concessionaires in Croatia and comparable motorways marked a significant achievement, companies abroad. with high quality construction and design. The road sector SOEs (Croatian Roads-HC, HAC, Similarly, HC needs to review maintenance and Rijeka-Zagreb Motorway-ARZ) largely standards, contracting and investment financing financed their network expansion with strategies to the level of traffic and available commercial loans fully covered by government funds. HC’s capital investment program has been guarantees. By 2013, some EUR7.7 billion of underfunded from public sources, leading to guarantees had been issued, with a combined higher borrowing needs and over EUR1.2 billion debt of public road companies of EUR5.6 billion of debt. The inability of some local authorities to or approximately 11 percent of GDP. The debt manage country and local roads also led HC to currently cannot be serviced by the revenue assume these roles. Some improvements were generated by the companies. made through pilot performance-based contracting and asset management systems, but In 2012, the government began to explore ways improving road preservation is imperative as a to reduce the debt burden of HAC and ARZ. A condition for EU funding. long-term concession process was cancelled in late 2014, as well as a subsequent IPO of HAC- Railways. Croatia initiated a restructuring of the ONC amid concerns about the attractiveness of railway sector and dissolved the railways holding such a model. Meanwhile, around EUR2.3 billion, into three separate companies in 2012. Despite or 41 percent of outstanding loans, matures in significant level of State support, the railway 2017-19, putting burden on public finances. sector has deteriorated from all standpoints. While the government is deciding how to Decline in traffic (by 36 percent for freight and 48 restructure and manage the sector, the risks are percent for passenger services between 2008 75 European Road Safety Observatory, 2015 Scoreboard. Croatia Policy Notes | Transport 92 and 2014), low productivity and high cost of labor, gradually bringing competition, while its cargo and slow implementation of infrastructure services are deemed uncompetitive. It has also investments that could improve the overall quality started revamping its commercial policy to of service, have all contributed to the dire introduce block train workings and undertaken situation of the sector. several redundancy programs since 2014. The company, however, has been in the most critical There are no clear service requirements or financial position of all transport SOEs. measures to rationalize subsidies, which account for over 85 percent of operating costs of HZ Ports & Logistics. Croatia’s geographical Infrastructure-HZI and 52 percent of HZ location at the crossing of major European Passenger Transport-HZP. Likewise, the corridors make it well positioned to become a separation of assets between companies has yet logistics hub for Central and South-Eastern to be finalized. The potential to commercialize Europe. Rijeka has evolved from a feeder port for these assets is limited, while a significant number small vessels to a port of call for containers, with are still classified as public domain. much larger vessels calling (up to 11,000 TEU in Table 12. Key Railway Data for 2014 capacity). Container throughput in Rijeka grew HZ from 15,000 TEU in 2002 to 162,000 TEU in In HRK HZ HZ 2015, with significant upwards potential. The Passenger million Cargo Infrastructure Transport growth was a result of a surge in container Staff 2885 2939 5097 transport from the Far East to Central European Net income 7.96 -169.72 0.16 markets and increasing use of the North Adriatic Subsidy 504.55 20.03 989.18 ports76 because of favourable transit times, lower Investments - 60.17 998.47 land transport and port costs. In total, Far East Guarantees 816.22 250.00 1554.88 container ships can save about USD 400,000 per Source: HZ companies, Ministry of Finance, World Bank trip by calling at North Adriatic ports 77. Similar potential also exists for bulk traffic in Rijeka and Compared to earlier years, HZI has constrained Ploce. its investment plans in 2014-15. Significant maintenance backlogs have not been addressed The World Bank Logistics Performance Index 78 due to lack of resources, old-fashioned planning places Croatia 55th out of 160 surveyed practices, and significant works costs charged by countries, the lowest ranking of EU Member its subsidiary, Pruzne Gradjevine, whose States. Development of the logistics sector restructuring has started but is long overdue. The largely depends on the ability to control costs, company also struggles to implement its EU- which are in part a function of infrastructure funded program due to weak management quality, efficiency of trade facilitation, and capacities. HZI retains a very strong position to integration of various components into a logistics influence railway operations through traffic chain. Infrastructure outside roads is considered management, especially for freight, and has largely underdeveloped, in particular ports-rail been taking little feedback from operators as interfaces. Port competitiveness is further regards programming of its investment. hindered by slow and unreliable rail operations that handle low capacities. Integration of the The ongoing restructuring of the operators, HZC Inland Waterways Transport into the overall and HZP, needs to be vetted by the European logistics chain remains an untapped Commission because of state aid implications. opportunity.79 HZP’s restructuring is aimed at improving the quality of service with newly acquired rolling Trade and logistics also suffer from the lack of stock and the still ongoing ticketing cooperation and communication among modernization. However, it still runs very stakeholders. For example, instead of port unprofitable services and has not rationalized its authorities, most initiatives to develop a cost, including that of staff. HZC is seeking competitive logistics chain are driven by private opportunities in strategic partnerships with stakeholders. Cargo management is inefficient foreign operators, as the open railway market is due to paper data exchange and few links 76 Ports of Rijeka, Koper, Trieste and Venice (50th), infrastructure (55th), logistics competence 77 The distance between Hong Kong and Rijeka is (56th), tracking and tracing (59th), international 7,700, and North European ports about 10,040 shipments (61st), timeliness (62nd). 79 In 2014, the Word Bank discontinued negotiations of nautical miles. This translates into 3-4 days in costs savings of between USD 80,000 to 100,000 per day. a regional project for the Sava river rehabilitation The land distance between Rijeka and Central project, in spite of EU funding provided for it and a full European markets is also shorter by about 500 km. project appraisal by the Bank. 78 The World Bank International LPI 2014. The ranking between the sub-components is as follows: customs Croatia Policy Notes | Transport 93 between computerized systems. Customs still inefficient, and non-transparent, with weak need to strike a balance between efficient trade quality of tender documentation and too little facilitation and securing logistics chains. Around emphasis placed on bid quality vis-à-vis the 18 percent of import shipments still undergo price. This led to frequent appeals and physical inspection, while transit to non-EU complaints, repeating or extending the duration countries is more complex. of the process. Complaint resolution deadlines Figure 41. Croatia LPI, Top Performer and Peers are generally unclear and often span several months, with inconsistencies in decisions for complaint resolutions by the State Commission for Supervision of Public Procurement Procedure. EU funded investments are not exempted from these problems, as shown by the railway line rehabilitation between Dugo Selo and Krizevci.81 Moreover, many bids face limited or distorted competition due to participation of current or former subsidiaries of public companies in tenders, whereas independent local companies are still building capacities to participate both in works and consulting services.82 Source: WB Logistics Performance Index 2014 Procurement weaknesses in infrastructure There are also cross-cutting challenges projects: affecting transport sector competitiveness as well as most infrastructure sectors:  Low level of technical document preparation (i) Permitting. Despite series of reforms,  Limited benchmarking and cost related statistics construction permitting remains one of the  Fragmented tendering processes biggest obstacles to timely implementation of  Lack of standardized tendering documentation transport infrastructure. Removing location  Non-uniformed recording of information permits was one of the biggest simplifications,  High costs of tendering process for clients and suppliers although they are still required in case of phased  No ex-post evaluation of contracts construction and land ownership issues.  Inefficient complaint handling mechanism Construction permits often take several months  Insufficient staff capacity or even years to be issued, and even minor changes in project description may require the (iii) Management and governance. SOE process to start anew. Such significant delays ownership policy does not clearly separate the compound preparation delays or lead to disputes role of the State from that of the transport and penalties with contractors during companies. The State, through the transport implementation. The process is further ministry, exercises ownership, regulatory, complicated by the many actors, including policymaking and client roles. SOE management several local and state administrations, and is also often reluctant to sign-off on projects with frequent changes in secondary legislation. Ministry endorsement amidst increased anti- (ii) Procurement processes. Among the 10 corruption efforts and frequent accusations of largest users of public procurement are three conflict of interest. Exercising ownership rights, transport SOEs80, which alone accounted for 21 while avoiding meddling in management, could percent of the public procurement value in 2014. be achieved through the Supervisory Board and Open tender procurement procedure was used in its committees. Government control of SOE around 85 percent of contracts, with on average performance is weak mostly due to inadequate only 3 bids received per tender. Moreover, the technical capacity and lack of monitoring tools for most economically advantageous tender SOEs. The Ministry collects very detailed criterion was used in less than 2 percent of operational and financial data from SOEs, but is contracts, leading to sub-optimal outputs and unable to provide comprehensive status of difficulties with contract management. performance (e.g., SOE liabilities, which can Procurement in transport projects is paper heavy, neither be accurately reported by the Ministry of 80 Croatian Roads, HZP and HZ Cargo. 82 HZ Infrastructure’s current subsidiary, Pruzne 81 The Dugo Selo-Krizevci railway project, estimated at Gradjevine, and a former one dealing with technical over EUR 200 million, was initiated in 2009. It was studies, ZPD. tendered three times since the EC approved its financing in 2013, but has still not been contracted. Croatia Policy Notes | Transport 94 Finance). The organization of the Ministry is also be defined at project preparation, as projects fragmented with capacity issues in most used to apply to several different EU calls and for technical areas and coordination with other state IFI funding. The budgeting procedures for EU institutions. The 2013 Act on the Management funds would also need to be better integrated into and Disposal of State Assets further complicates the national budgeting system in terms of supervision of transport SOEs, as the Ministry counterpart funding. At individual project level, shares the ownership function in companies of the government should re-introduce the need for strategic and special interest with the State Office economic feasibilities with alternatives, where for State Property Management (DUUDI) applicable (see specific Note on Public Investment Management and EU funds SOEs lack professional management and boards absorption). have been appointed according to political affiliations. Nominations are made by the The Ministry of Transport plays a major role, ministry, with DUUDI’s prior approval, and in particular by providing guidance and approved by the government. Turnovers are strategic direction defined at the government frequent, as in the example of HZI where level, ensuring consistent policy decisions across management was dismissed three times in four different sectors, endorsing strategies and years. Board compensation is not linked to the facilitating operations of companies, and leading performance and includes various benefits that efforts to increase private participation when recur post-employment. In 2015, the government preferable. The Ministry could create a task force passed a regulation on criteria for appointment of whose mandate would be to prepare and publish management board members in SOEs of sector-wide implementation plans before the strategic and special importance which should be next budget approvals by the parliament, as well selected through public tenders. It marks a major as to strengthen the quality of project step towards professionalization and increased prioritization, appraisal, and management. Such accountability of management and supervisory task force needs to include the Ministry of boards. Finance’s Department for Capital Investments. How Croatia Can Restore Stability, Investment and sector financing needs to be Revive Growth and Create Jobs balanced with the sovereign budget constraints. The overall approach to sector Croatia needs to strengthen strategic financing needs to be revisited, in particular to planning in the transport sector. The National reduce the amount of State support and Transport Development Strategy, once finalized, incentivize the companies to perform. The State together with a sector traffic model that is already could play a role in refinancing existing loans to in place, should provide an overall framework for transport SOEs, specifically by taking the the transport sector development. The Strategy advantage of low interest rate environment. should be translated into robust multi-year and Capital spending control across all transport multi-modal implementation plans for sector SOEs needs to be introduced, together with a investments that define priority projects in a redefined criteria for obtaining State guarantees holistic manner, lead to a stable pipeline of for commercial borrowing. Subsidy allocation projects and ensure consistency in decision– could be made more effective to ensure value for making. For example, should the improvement of money. This too pertains to public service a competitive position of the Rijeka port be obligations in rail, air and ferry transport. defined as a strategic objective of Croatia, the implementation plan should lay out specific Considering the fragile financial situation of projects to be implemented over 5-7 years to most transport SOEs, Croatia could maximize meet this goal, such as competitive rail corridors, the EU funds absorption and leverage various multimodal connections to port terminal, EU investment initiatives. In addition to development of a port community system, and EUR1.3 billion of ESI funds, Croatia has at its introduction of a block train working. A similar disposal EUR456 million from the Connecting approach to integrated planning needs to be Europe Facility (CEF) for development of continued for the largest agglomerations in corridors between 2014-20, as well as an Croatia, especially Zagreb and Rijeka. opportunity to participate in the EC’s EUR315 billion Investment Plan for Europe supported by Multi-year implementation plans should be private investment. Under the CEF, the EC regularly updated with optimized proposes financial instruments, such as project investments based on the overall budget bonds, loan guarantees and other debt and constraints for a given period. Further, equity instruments in order to incentivize more investments need to be linked to appropriate private and public funding in large infrastructure funding sources, such as national budget or projects. Most eligible candidates for the use of different EU sources. Sources of funding should financial instruments for EU funds are railways Croatia Policy Notes | Transport 95 and water transport infrastructure, public green integrate financial and investment planning and transport and infrastructure development for procurement systems, should support electric vehicles. Strengthening administrative management decisions. Companies need to and technical capacities for EU funds absorption introduce realistic medium-term financial should be an immediate effort, recognizing that planning, define targets and benchmarks against they would take time to yield results. sector peers, and take preventive measures when needed. Such incentives are limited for To complement EU funds and pending fiscal road sector companies that hold significant public space, the government could use IFIs to support domain assets in their books, as the capital the immediate sector restructuring and obtain approach method defined in the Roads Act favorable loans and guarantees for investments allows them to book losses against the public that are critical but not eligible for EU financing capital they hold.83 Professionalizing HR services (e.g., retrenchment or road or railway periodic in transport SOEs is imperative to attract, retain maintenance). Once the restructuring of SOEs is and promote talent, introduce modern HR well underway and fiscal space less constrained, policies, better administer staff compensation, other capital raising instruments, such as project and improve labor relations. bonds, could be considered. Project bonds provide access to cheaper capital with longer Roads. As a priority, the government needs to maturities and allow institutional investors to decide the reform path for the motorway sector. participate in projects. The bond financing is The sector’s organizational restructuring would undoubtedly more complex to structure and start with a review and redefinition of asset negotiate, given the risk that projects may not be ownership roles, affordable level of services, and able to generate cash flows to service the debt. operational merger of HAC and ARZ. An optimal As such it may be challenging to find investors in sector debt management plan would consist of non-investment grade bonds. Also some forms of refinancing existing road debt to maximize the Private-Public Partnerships in transport projects share that the sector can service from own may result in faster project implementation, sources in the long-term and reduce the extent to increased transparency, transfer of knowledge which future debt is guaranteed by the State. and skills through private sector innovation, Additional opportunities to reduce debt would be reduced costs and budgetary certainty. Logistics, by involving private investors in the motorway building on the successful Brajdica container sector at the time when doing so can optimize terminal concession in Rijeka, and urban state revenue. Concurrently, sustainable transport projects could qualify for such mechanisms should be put in place to fund road opportunities. companies. Fuel tax and toll revenue provide secure, though unpredictable, funding for Restructuring of loss-making SOEs, in maintenance, but are not based on the service particular in railways and roads. The EC has definition and cannot cover investment and requested Member States to improve SOE financing costs. Options include e-tolling, GPS performance through restructuring, privatization based road usage, and vignette systems, and review of financing. The primary aim is to together with charging other commercial parts of bring down the level of SOE liabilities and the network for heavy vehicles that need to be arrears. Restructuring would entail substantial shifted to highways. rightsizing of operations for which the government should adequately budget public Operations and maintenance (O&M) funds. Unviable SOEs and subsidiaries should improvements in all companies would move from be liquidated or put into insolvency, while non- input- to output-based O&M (e.g., contract a level core subsidiaries divested. To ensure efficiency of service, not for quantities), roll-out of a and improved resource allocation, the performance-based contracting, definition of government could consider greater involvement performance improvement targets to assess of the private sector through concessions, IPOs, future sector costs, development of modern strategic majority investors, or full privatizations. asset management and investment planning Such actions cannot be taken by the companies, tools, and restructuring of HAC-ONC to make it but should be guided by the Ministry with support more cost effective. In the medium term, an from specialized financial, legal and technical overall reclassification of the 26,778km of the advisors. road network should be considered. State, county, and local road assets should be Appoint professional managers to implement managed coherently, which implies determining sound restructuring programs. Modern long- term planning and monitoring tools, which would 83Between 2011 and September 2015, the public capital in HAC decreased by HRK 2.2 billion. Croatia Policy Notes | Transport 96 new sources of funding for these road assets Authority.84 It is not advisable to have competing based on their condition. system promoted by the Port Authority and the port operator, as is the case in Ploce. The Railways. There are opportunities to reinforce Ministry could limit its involvement in safety government oversight and determining the related systems and not deter the port affordable level of service and investment, based communities to build an integrated system at on a realistic budget constraint. The network size local level. could likely be reduced, with discontinuation of unviable passenger services or replacement by Private sector participation could help improve bus a priority. Such efforts should be translated both the services and the infrastructure. For into new multi-annual and performance based example, multi modal hubs still need to be infrastructure contracts for HZI and Public developed in Zagreb and Rijeka (Skrljevo). Many Service Obligation contracts for HZP. Repartition bulk activities could be developed with external of assets among companies should be finalized partners of Luka Rijeka in grain, timber and to limit the public domain to what is really needed wood, while Luka Ploce has already started such for rail operations and commercialize “dead partnership for oil products. The concession of capital”. the Zagreb Container Terminal in Rijeka is soon to be relaunched. Similarly, the selection of a In all companies restructuring and EU-related strategic operator should be considered for the opportunities require a significant change of Danube River port of Vukovar, where the EU- mindset and an overall capacity building. Project funded port upgrade has opened door to further management in HZI needs to be overhauled, or logistics chain integration. The initiative to restore outsourced if performance remains weak. the Sava River navigability could be relaunched Government needs to obtain from HZI a clear with the support of institutional partners and the picture of the network condition and its main neighboring states. rehabilitation priorities to ensure a minimum quality of service. The government needs to Permitting. Croatia has improved its physical ensure equal access to the network for all planning, building permitting and inspection operators – HZI’s operating requirements should processes. A newly introduced physical planning not restrict competitiveness of operators. The information system (ISPU) linked the systems of privatization of HZ Cargo could be considered, the Cadaster, the Registry and the Ministry of while encouraging some forms of private-public Finance, and set preconditions for establishing e- partnership, such as for rolling stock leasing. permitting facility. However, these reforms have HZC should fully implement a commercial policy mostly benefited individual or business related based on block trains rather than individual permits and simple projects For major public wagon consignments at earliest. Similarly, HZP investments to benefit fully several additional needs to review its commercial policy to adapt to improvements should be done including the current conditions and modernize its operations following: beyond the introduction of new trains and IT systems.  Integrate databases of the Ministry of Maritime Affairs, Transport, and Ports & Logistics. Logistics and trade Infrastructure in the ISPU system to allow for development rest upon resolute and rapid faster processes and reduce the amount of finalization of the Corridors from Rijeka, including paperwork needed. rail intermodal yards and road interfaces (D403), and improvement in port operations. The planned  Fully digitalize permitting system, introduce expansion of the Port of Rijeka would increase its online tracking of applications, requests for total container capacity to about 900,000 TEU clearances and submission of various after 2018. Though other North Adriatic ports forms. have announced expansion plans that could add  Implement shorter times and stricter 700,000 TEU, Rijeka should preserve its first deadlines for permit-related approvals. mover advantage and accommodate the largest container vessels.  For construction permits, which process remains essentially unchanged except for Development of a “single window” and port partial introduction of digitization in the case community system for all of its stakeholders of infrastructure projects, further streamline needs to be started in Rijeka as a matter of processes by eliminating steps, and simplify urgency, with a strong coordination by the Port g permit amendments., 84Port Community System only exists in the Port of data among stakeholders and is mostly dedicated to Ploce, but is not fully in use. The Ministry also runs its safety. parallel system that collects but does not disseminate Croatia Policy Notes | Transport 97  Evaluate opportunity to remove usage support. The transparent appointment of permits, which may not always be needed experienced and independent individuals to its as contracting authorities carry out a Supervisory Boards according to clear eligibility technical acceptance already. criteria are highly recommended. Following a competitive selection of a professional  For public investments of special management, management contracts should be importance, designate ministry staff in enhanced with performance targets linked to charge of handling processes and resolving salaries and revised remuneration levels to issues at local and state levels, which is not attract talent. However, efforts to professionalize always the case, will remain a second best staff and strengthen human resource option. management should begin with the Ministry. Procurement Processes. Once all primary Recruitment system and terms of reference for legislation (procurement and PPP laws) have civil servants need to be improved, as been adjusted to recent EU directives, secondary competencies are currently low both in terms of legislation for public procurement needs to be technical and soft skills (IT, languages). As for the enhanced to improve the quality of tender entire public administration, regular performance documentation and process efficiency. The appraisals and setting of yearly performance introduction of clearer guidelines for public objectives in line with modern HR practices procurement, standard bidding documents and should be mandatory for all ministry employees. requests for proposals, as well as being more Performance incentives and penalties, as well as standardized and quality oriented on bid regular training opportunities, should be specifications or terms of reference could make introduced. public procurement less open to subjective Public oversight could be improved by moving to interpretation. Replacing the lowest bid price electronic collection and distribution of reports on criterion with the most economically sector performance. Such reports could be advantageous tender criterion would allow more simplified and enhanced with more analytical weight towards quality, in particular for complex assessments and recommendations. SOE advisory services and technically sophisticated performance could be measured against set goods. Evaluation would take into account the targets and sector-wide KPIs. Particular focus price associated with the life cycle of assets, should be placed on financial performance, use including their renewal/maintenance costs. of subsidies, and reduction of arrears. A small Besides these, a unified supplier registry and SOE monitoring unit could be developed to further upgrade of the e-procurement system are disclose performance results and publish timely needed, e.g. availing bids in languages other annual reports. In contrast, SOEs reporting cold than Croatian to foster competition, or to improve be improved in line with International Financial fraud or collusion detection through use of Reporting Standards. This includes, and inter electronic bid data. alia, addressing qualifications in audit reports, From a regulatory point of view, the complaint timely preparation and disclosure of financial handling mechanism could be improved, in statements. particular to avoid complete stoppage of projects, To exercise its various roles, the Ministry could and to introduce stricter deadlines and unified also be reorganized and HR policy revised to approach to complaints resolution. SOEs attract and retain qualified staff. Organization by operating in the competitive market should either sectors is considered more efficient (contrary to be privatized or liquidated, and when this the current separation of infrastructure from situation is not possible be subject to clear operations), while the Minister’s cabinet could be requirements to avoid conflict of interest. Tools to supported by the aforementioned units for SOE detect irregularities and corruption in public monitoring and reporting, and investment procurement could be improved, including by planning and financing. Any initiatives related to detailed screening of specifications and bids, full restructuring or private sector involvement in disclosure of bid results, and use of post review SOEs needs to be handled by highly-qualified processes by procurement authorities for the ministerial staff with strong coordination with the SOEs that are more efficient in contracting. MoF and DUUDI. Corporate Governance of SOEs. Relationships between the State and the transport SOEs could How the World Bank Group Can Help be designed as per the best practices outlined in The World Bank has a long-standing the OECD Guidelines on Corporate Governance engagement in the transport sector in Croatia, of SOEs. They usually take the form of multi- which comprises a third of the lending portfolio. annual contracts that include clear and Most recently, the World Bank proposed, at the measurable conditions for allocation of financial request of the government, a concept for the Croatia Policy Notes | Transport 98 Modernization and Restructuring of the Roads Sector, designed as a blend of an investment loan and guarantees, aimed at supporting operational and financial restructuring. The loan portion would fund reform implementation, while the guarantee aims to help restructure liabilities to better match road asset cash flows, reducing interest costs and lengthening maturities. In 2015, the Bank approved three loans totaling EUR 163.5 million to Croatian railways companies as a part of the Sustainable Croatian Railways Project. The Project is aimed at improving the operational efficiency and the financial sustainability of the sector. It finances investments in critical infrastructure bottlenecks and safety measures, the modernization of IT systems, rolling stock rehabilitation, separation and management of assets, and staff right-sizing. Further support can be directed towards subsidies optimization and cost-efficient maintenance in HZ Infrastructure. Rijeka Gateway II and Trade and Transport Integration Project for Ploce, worth EUR 192.8 million, are helping transform the largest international seaports in Croatia. The projects envisage long- term concessions by private investors and development of additional capacity in the ports, integrating them with existing transport corridors. The Bank is well positioned to provide sustainable solutions in multiple transport modes, through financing and by providing advisory services in areas of improving and simplifying infrastructure permitting processes; the reform of the legal and regulatory framework for public procurement and process streamlining; as well as multi-modal operational planning, supervision of transport SOEs, transport public investment management and project selection. This Policy Note was produced by the World Bank to inform policy debate in Croatia. This note was prepared by Consultant Blanka Babic and Program Leader Jean-Francois Marteau. The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the Governments they represent. For any questions regarding this note, please contact Vanja Frajtic, Communications Associate (vfrajtic@worldbank.org). THE WORLD BANK OFFICE ZAGREB: http://www.worldbank.org/en/country/Croatia Croatia Policy Notes | Transport 99 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs Providing Skills for the Future Key Message Youth have been significantly affected by the lack of economic growth, evident in youth unemployment rates around 45 percent, limited job prospects, and a skills mismatch. Despite a number of recent education reforms, including a national curriculum framework in preschool, primary, and secondary education, as well as a secondary school-leaving exam and the piloting of performance-based financing in tertiary education, demographic decline means that increasing emphasis needs to be placed on improving the quality of general education, lifelong learning programs, and adult education to ensure a competitive and adaptive workforce. Key Actions  Improve the quality of general education to mitigate the challenges posed by population decline, aging, and the skills mismatch.  Provide better labor market information on job trends and skills to strengthen labor market outcomes of graduates from education in its different levels.  Consider piloting performance-based financing in non-university education.  Maximize skills for jobs through apprenticeships, reskilling programs, and lifelong learning programs to address high youth unemployment. Where Croatia Stands Now spends three years in unemployment or inactivity. This number doubles among 55-64 Since the global financial crisis that began in year olds. Among women, the average female in 2008, growth in Croatia has been marred by a Croatia spends 17 years of her working life in prolonged recession. Recent accession to the unemployment or inactivity. This compares EU has contributed to the return to positive, but unfavorably with other EU countries (Figure 1). low, economic growth in 2015. The effects of the Figure 1. Average years of lost employment for an recession, however, point to areas for overdue individual, circa 2010 policy reforms to reduce poverty and unemployment which have increased in recent years. Demographic decline, aging, and lost years of employment are significant barriers to growth. As the recovery from the lengthy recession continues, Croatia’s growth prospects remain vulnerable to dual demographic trends of a population that is both aging and shrinking. These challenges prompt the need to balance policy reforms in education and the broader economy. For Croatian living standards to converge with its Western European neighbors, Source: World Bank (2014), Back To Work: Growing with Jobs in Europe and Central Asia the labor force must be more productive and become more flexible in a rapidly changing labor These adverse population trends have market, where the employment participation rate current and long-term implications for has experienced a downward trend since 2008. Croatia’s human capital and macroeconomic In addition to demographic decline and aging, agenda. Human capital remains critical to years of lost employment is also a significant Croatia’s service sector which dominates the problem. Among 25-34 year-olds, 35-44 year- country’s employment landscape. Expanding olds, and 45-54 year olds, the average Croatian employment, both through increasing the Croatia Policy Notes | Providing Skills for the Future 100 employment rate and the length of the working The skills gap is evident throughout the life, will be key to resolving the impacts of Croatian education system. In 2009, a World demographic decline and population aging. Bank report on Croatia’s convergence process to join the EU, noted the factors contributing to the Opportunities to enhance skills are not skills gap. These factors included: deficiencies in leveraged, as evident in low labor the provision of vocational education and training productivity. Participation in lifelong learning (VET), in addition to an inadequate match remains rare, with a rate of 2.5 percent – much between courses offered and labor market lower than the EU average of 10.7 percent. needs; low participation in lifelong learning; and Croatia’s lifelong learning participation is the third rigidities of tertiary education in adapting to the lowest in the EU, slightly higher than Bulgaria needs of the economy.85 Given these factors and and Romania. recent data, it is apparent that the skills gap Croatia’s lack of economic growth in recent remains largely unaddressed. years is reflected in low labor productivity. In Addressing the Challenges in Education and addition to expanding employment by increasing Training86 the employment rate and the working life of individuals, productivity gains are central to International evidence shows the economic addressing demographic decline and aging. impact of workforce skills on growth and While many European neighbors experienced shared prosperity. This evidence suggests that low, but positive growth in productivity relative to quality of education is one of the most important the United States, Croatia’s productivity declined determinants of long-term economic growth. significantly (Figure 2), and now lags many EU There are three dimensions of skills . It is countries. As such, there is a dual challenge to possible to differentiate skills along separate, yet increase both labor force participation and labor mutually reinforcing dimensions. These force productivity. dimensions are cognitive, socio-emotional, and Figure 2. Productivity Levels in Europe compared technical skills. Cognitive skills include literacy to the United States and numeracy – as measured in PISA (Programme for International Student Assessment) – but can also include competencies like critical-thinking and problem- solving. Socio-emotional skills capture one’s ability to interact with others, as well as determination, and focus on getting a job done. Technical skills capture one’s ability to perform technical tasks in any occupation – e.g. work performed as a plumber or engineer. It is important to note that measuring the level of educational attainment is not necessarily a Source: International Labor Organization, Key Indicators of the Labor Market Database proxy for measuring actual skills. While many countries in Central and Eastern Europe have Youth are most affected by the struggling seen educational attainment expand – such as economy. There is a strong generational years of education and level of education dimension to employment. Youth are among the completed – since the start of the economic most affected by the struggling economy. Youth transition, they have not necessarily seen without tertiary education struggle more to find a improvements in their performance in job than in other EU countries. The employment international student assessments that measure rate of recent tertiary education graduates aged cognitive skills, such as PISA87. 25-29 years old is 69 percent – below the EU average of 79 percent. Among those in the same PISA evidence has been used to measure the age group, the employment rate of early school impact of cognitive skills on GDP growth . leavers is alarming at 30 percent – significantly Leading researchers estimate that a score lower than the EU average of 52 percent. improvement of roughly 50 points in PISA would imply an increase of the annual growth rate of 85 World Bank (2009). Croatia’s EU Convergence 87 Sondergaard, Lars; Murthi, Mamta; Abu-Ghaida, Report – Overview Dina; Bodewig, Christian; Rutkowski, Jan. 86 World Bank (2015a). Central Europe and Baltics 2011. Skills, not just diplomas: managing education for PISA Analysis. This section draws from the discussion results in Eastern Europe and Central Asia. on the importance of cognitive skills. Croatia Policy Notes | Providing Skills for the Future 101 GDP per capita by 1 percentage point 88. Figure 3. PISA 2012 Math Scores for Croatia Evidence also suggests that both the share of students achieving basic literacy and the share of top-performing students matter for growth. A recent OECD (2015) report presents economic returns to universal basic skills, defined as all students enrolled in secondary schooling, and the performance of those young people currently not in school raised to achieving Level 1 skills (420 points) in PISA by 203089. While low income countries with lagging education systems stand to gain the most, advanced middle income and high income countries can expect a significant boost in long run economic growth Source: Authors’ elaboration of PISA 2012 data (until 2095) solely from making their education The lack of cognitive skills constrains the ability systems deliver better for the weakest students. of individuals to learn in higher education, The report on universal basic skills finds that, on vocational education and training, as well as average, high income countries could gain a 3.5 lifelong learning, or find and retain a productive percent higher discounted average GDP over the job. Further, the lack of cognitive skills are next 80 years if they were to ensure that all hurdles given population aging and technological students achieve basic skills defined as Level 1 change. Some countries with a high share of in PISA. A significant share of Croatian 15 year- poor performers in math such as Croatia also olds currently perform below Level 1 of PISA. have high shares of youth who are not in Ensuring universal basic skills in Croatia would education, employment, or training (NEET) add 3.9 percent discounted future GDP. (Figure 4). Croatia’s performance in PISA has improved, Figure 4. NEET and Basic Cognitive Skills but the skills gap remains significant. Croatia’s performance indicates marginal improvement since its initial participation in 2006, with a decline across all subjects – math, reading, and science – in the 2009 PISA test. Overall, between 2006 and 2012, there was a slight increase in the share of low performers in math, while there was a marginal decline in reading. In PISA, roughly 40 points equals to one year of schooling. Using this estimate, there is a wide gap between the top and bottom socio- Source: World Bank staff calculations using OECD PISA economic groups in Croatia (Figure 3). This gap 2012 and Eurostat data of 84 score points is roughly equal to two years Improving the skill level of low-performers of schooling, similar to OECD countries. would narrow the skills gap and boost long- The high share of low performers has adverse run growth. As mentioned above, Croatia would implications for individuals at various stages observe a boost to long run growth by focusing of life and for the economy overall. Based on on the weakest students, given its classification PISA 2012 Croatia has reduced the share of 15 as a high-income country. Beyond aggregate year-olds performing below Level 2 in reading, growth, education improves the living standards compared with 2006. However, the share of 15 of individuals. More educated individuals are able year-olds performing below the same level in to acquire even more skills – and higher-order mathematics increased to 30 percent. This skills as well – making them more productive and increase is alarming, and points to significant employable. Through more, higher-order skills, challenges regarding cognitive skills for the individuals can extend their labor market present and the future at various levels of the participation over their lifetime. This skill education system. The high share of 15 year-olds acquisition, in turn, leads to higher earnings and performing below Level 2 in math indicates a better quality of life. The declining labor force poor foundation of cognitive skills. participation rate requires policy reforms to reduce unemployment – particularly among 88 89 Hanushek, E., and L. Woessmann. (2007). The OECD (2015). Universal Basic Skills: What Role of Education Quality in Economic Growth. World Countries Stand to Gain Bank Policy Research Working Paper 4122 Croatia Policy Notes | Providing Skills for the Future 102 youth – and increase productivity. As such, included in the education strategy. education reforms designed to provide higher- Implementation of the strategy has been slow, order skills address this need. however. Education is an engine of social mobility: Croatia needs to remedy the large share of its 15- human capital is a key asset in income year olds with poor math skills to ensure growth generation and hence critical to reducing poverty in the long-term and mitigate the challenges and increasing shared prosperity. Croatia’s youth posed by population decline, aging, and the skills are being left behind, however. At more than 45 mismatch. Improving the quality of teachers in percent, Croatia has one of the highest rates of general education will help reduce the youth unemployment in Europe, trailing only performance gap among socio-economic Greece and Spain. groups. How Croatia Can Ensure Maximizing 2. Better labor market information is Skills for Jobs and Economic Growth needed to improve the relevance of skills developed through education. A growing Croatia’s education reforms in recent years challenge for policymakers globally is the need have covered many aspects of the system, not only for more immediate job creation but to ranging from preschool to university. The supply the job market with a workforce equipped most recent education strategy – the Strategy for with the relevant and adaptable skills for both the Education, Science, and Technology – was present and the future labor market. Improved adopted in 2014, with a focus on reforming the labor market information on job trends and skills education and training system. is needed to overcome these challenges. Better labor market information would help to reduce The next wave of policy reforms should be skills mismatches and enhance the guided by the need to promote a more modern skills agenda. Specifically, additional responsiveness of education, at various levels, to labor market needs. reforms in education should prioritize the development of relevant cognitive and adaptive The demographic trends facing Croatia require skills. These skills are central to policies intended strategic thinking about skills for the present and to expand employment and productivity. As such, skills for the future. Periodic skills assessments a number of policy options are presented below and surveys of the business environment can to emphasize the need for such skills. provide key evidence-based insight into 1. Improve the quality of general balancing labor force needs in the short-, education to reduce inequities and stem the medium-, and long-term. impact of the demographic decline. Evidence Regarding evidence-based insight on skills, from PISA suggests a need to address the quality Croatia participates in many global assessments of general education to reduce the inequity such as PIRLS, PISA, and TIMSS. Students in between the top and bottom socio-economic the cohorts being assessed, however, are at groups. As discussed, students in the bottom most 15 years old. On average, these students socio-economic group are roughly two years are still a few years away from joining the labor behind their peers in the top group. force. In upper secondary education, there are no evidence-based tools to support reforms To reduce inequities, it is important to understand designed to: evaluate the quality of student the key factors which affect student achievement competencies over time and across countries. in the contexts that are specific and particular to the Croatian reality. Such knowledge comes Students participating in the first PISA cohort through comprehensive data collection and from Croatia in 2006 are between 23-25 years analysis of existing conditions, to support impact old today. While PIAAC (Programme for the evaluations of any policy and activity levers International Assessment of Adult implemented to address national concerns. Competencies) evaluates competencies, it focuses on the working-age population. The One key factor to understand thoroughly is cohorts being assessed in PIAAC include teacher quality. Leading researchers have individuals of upper secondary school age, but determined that teacher quality is the main the assessment is intended for working-age school-based predictor of student adults, not students. Croatia’s absence from achievement90. As such, to ensure a high quality competency-based assessments – such as cadre of teachers, a national system of PIAAC – which evaluate adults is a missed competence standards for teachers should be developed. The development of such a system is 90 Hanushek and Woessmann. (2007). Croatia Policy Notes | Providing Skills for the Future 103 opportunity to gather critical data on various skills These reforms would not, however, impact to help address the skills mismatch. individuals who have already graduated, and remain unemployed. 3. Build on the progress of current higher education reforms. The implementation The longer an individual is unemployed, the more of performance-based funding (PBF) in higher hurdles he/she has to face in (re)joining the labor education is a growing global trend as countries market. The long-term unemployed face both a face persistent budgetary pressures in education deterioration of skills and social stigma. As such, and across their fiscal obligations. In countries a combination of complementary programs where the majority of higher education targeted toward apprenticeships, reskilling, and institutions (HEIs) receive public funding, PBF is lifelong learning are policy options which can a recognized tool to implement more efficient and address high youth unemployment in Croatia. adaptive funding norms. Moreover, PBF can help Regarding apprenticeships, an EU-led response to achieve improved quality and relevance, research excellence, and better accountability to utilizing apprenticeships more effectively was and autonomy, among others important launched in 2013. The European Alliance for outcomes of finance reform. PBF allows for Apprenticeships convenes policymakers, leaders flexibility in selecting appropriate indicators to of industry, businesses, and education/training achieve wide-ranging goals. providers, among others, to promote apprenticeship programs across Europe. It Existing PBF reforms in Croatia began in recent remains to be determined how useful a broader years with a pilot funding agreement for its public universities. These reforms aim to maximize the apprenticeship system would be for Croatia, but quality and accessibility of the higher education given the focus on jobs and skills across the system. Full funding agreements will be region—particularly to reduce youth implemented in another phase of reforms. The unemployment—the utility of apprenticeships transition to performance-based funding in deserves closer consideration. As a member of Croatia coincides with the unforeseen advent of the Alliance, therefore, Croatia has indicated its a new public university and anticipated fiscal commitment to this potential tool by outlining its challenges across the entire national budget. plans to develop a system of quality The existence of indicators as the basis for apprenticeships to provide relevant skills and funding norms, however, results in clear competencies based on labor market needs. guidelines for both established and nascent institutions to contribute to the national agenda. To date, the Alliance’s progress is foundational: This agenda prioritizes an increase in the number youth guarantees; and pledges from chambers of of low-income students; enrolled STEM students; commerce, social partners, and VET providers. student transitioning to their second year; grants As such, there is a need to accelerate the provided to students; as well as improved initiatives of the Alliance locally to achieve its university management. objectives, and reduce youth unemployment. High youth unemployment requires strong action In addition to governments introducing PBF in in the short- and medium-term. higher education globally, the policy interest in implementing this funding approach for other How the World Bank Group Can Help sectors of education is also growing. The non- In recent years, the World Bank has supported university higher education sector could build on education reforms in Croatia to develop a the existing public university reforms to further national curriculum framework for preschool, improve the education sector by introducing PBF primary, and secondary education. In addition, to all public HEIs. These HEIs would include the Bank has supported the introduction of a polytechnic institutions and colleges. secondary school-leaving exam and the 4. Accelerate policies to address high implementation of major school construction and youth unemployment. Workforce development rehabilitation programs91. can also contribute to a significant reduction in As Croatia continues to develop its path for youth unemployment. Performance-based growth after a prolonged recession, the World funding reforms being implemented in public Bank Group can support the Government’s universities would be a driver of workforce ongoing efforts to reform and strengthen the development as the higher education sector education system utilizing tools such as advisory becomes more relevant and cost efficient services, technical assistance, investment through the selected performance indicators. 91World Bank (2015b). Croatia Partnership, Country Program Snapshot. Croatia Policy Notes | Providing Skills for the Future 104 financing for policy reform, and strategic unemployment rate. Students who enter the frameworks to enhance the use and absorption workforce as graduates with in-demand skills will of EU funds. help to improve the quality of Croatia’s dwindling labor force. The state has an important role to play in developing and financing education policies that foster improved learning outcomes and This Policy Note was produced by the World Bank to inform policy debate in Croatia. This note was prepared by Jeremie Amoroso and adaptable skills. Students enrolled in general Roberta Malee Bassett. education require a strong foundation of The findings, interpretations, and conclusions expressed herein do not cognitive skills that can lead them toward futures necessarily reflect the views of the Board of Executive Directors of the World Bank or the Governments they represent. in the dynamic economies of today and tomorrow. Students who are enrolled in tertiary For any questions regarding this note, please contact Vanja Frajtic, Communications Associate (vfrajtic@worldbank.org). education need strong incentives to obtain knowledge and skills and to forgo emigrating for THE WORLD BANK OFFICE ZAGREB: http://www.worldbank.org/en/country/Croatia better opportunities, given the alarming youth Croatia Policy Notes | Providing Skills for the Future 105 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs Pension System Reform Key Message Croatia’s pension system has seen significant change since the introduction of a multi -pillar design in 1998. While performance of the second pension pillar has been adequate, ad-hoc interventions in recent years in the first, pay-as-you-go (PAYG) pension pillar have led to larger expenditures than expected and became less affordable going forward. In addition to concerns about future adequacy, the system overall faces substantial equity and fiscal challenges, because of low labor activity and coverage. Without further reforms, Croatia’s pension system will remain fiscally and socially unsustainable in the long run. Key Actions  Tighten early retirement windows, raise retirement age faster, and stimulate elderly activity.  Equalize the eligibility to the supplement of 27 percent for PAYG-only and multi-pillar pensioners.  Converge privileged pensions to general PAYG rules faster.  Award PAYG pension credit only for paid contributions.  Consolidate the fiscal space for financing the second pillar transition cost. Where Croatia Stands Now raised to 65 (in 3-month increments, until 2030) and early retirement age to 60, but with reduced Reforming Croatia’s pension system is a penalty. critical priority in view of the projected rapid population aging. Croatia’s population pyramid Figure 1. Croatia’s population is shrinking and aging is inverting and thinning, with an aging and shrinking population and a resulting increase in the demographic dependency ratio (Figure 1). In anticipation of demographic change, Croatia launched reforms of its pension system in 1998 by changing the pay-as-you-go (PAYG) system parameters and in 2002 introducing a second, mandatory fully funded pillar. However, pension reform remains an unfinished agenda. Numerous interventions in Source: UN Population Prospects the pension system between 2001 and 2007 92 created additional fiscal pressures, induced large A number of distortive changes were also differences in pension benefits paid to introduced in the pension system in 2013 and consecutive cohorts, and delayed the planned 2014: a penalty-free retirement with 40 years of increase of the contribution rate for the second service (decrements for service below 40 years pillar from 5 percent to 10 percent over five of service were slightly increased) and a more years93. Ad-hoc interventions in the pension generous (wage growth dominant) pension system continued during the recent financial indexation pattern for both PAYG pensions and crisis. In 2010 the retirement age for women was 92 93 Including pension supplements of 1999 and 2001 for Initial pension reform package in 1998 envisaged certain cohorts, the 2004 repayment of “pensioners’ initial contribution rate to the second pillar of 5%, rising debt,” restoring wage indexation in 2005, and a 2007 to 10% over five years. However, in the law this pension supplement of 27 percent on total PAYG schedule was formulated less strictly with „at least 5% pension for PAYG-only retirees, but not for PAYG to be paid into the second pillar“. benefit of the multipillar participants. Croatia Policy Notes | Pension System Reform 106 second pillar annuities94. The PAYG pension for Source: Pension Reform Working Group and World Bank calculations. multi-pillar participants (both basic and points parts) was increased in proportion to the PAYG Second pillar performance has been positive share of the contribution (currently 75 percent), and close to public expectations. The as a compensation for not raising second pillar annualized rate of return on second pillar contribution rate above 5 percent. Inability to accounts since inception in 2014 has been at 5.9 finance larger transition cost will transform into percent - 2.4 percentage points above nominal higher future PAYG expenditures. Closing the wage growth, and almost 4 percentage points second pillar savings for employees with above consumer price inflation (CPI) 95. Second extended service periods (hazardous and pillar accumulation in 2015 reached HRK 72 arduous occupations), nationalizing their second billion (22 percent of GDP). However, more than pillar accounts and restoring their PAYG-only 70 percent of funds are invested in public debt, benefit yielded a temporary fiscal relief in 2014 with fund management fees, although low by but added to the future PAYG deficit and implicit international standards, set relatively high for pension debt. such passive portfolio96. At the same time, there were several positive Distortions and ad hoc measures have measures taken: the retirement age was worsened Croatia’s pension system increased to 67 (with a full transition by 2038), sustainability. The largest distortion in the privileged pensions were reduced and system is the 27-percent supplement that PAYG rationalized, while a new functionally-based only participants get for all years of service and disability assessment methodology and new those in second pillar only for the pre-2002 integral disability assessment infrastructure has service: been introduced. The inflow of new disability Service before Service after pensioners has been significantly slowed and Benefit structure 2002 2002 relative pension expenditures curtailed. PAYG-only Points + 27% pensioners Points + 27% Ad-hoc interventions in the pension system have led to larger PAYG expenditures than 75% of points Multipillar expected and locked contribution rate to the Points + 27% pensioners + II pillar annuity second pillar at 5 percent. Instead of an expected continuous decline of PAYG With higher PAYG benefit for second pillar expenditures, providing fiscal space for financing participants (both basic and points part), transition costs of increasing the portion of introduced in 2013, the gap is somewhat contribution rates going to the second pillar, the narrowed and average replacement rate actual PAYG expenditures remained high stabilizes in the long run, but the gap still remains (Figure 2). As a consequence, second pillar (Figure 3). Second pillar annuity compensates for contribution rate remained at 5 percent while its the reduced PAYG benefit, but not for the 27- transition cost continued to fuel into the pension percent supplement. Participants that had the system deficit. choice to voluntary join the second pillar in 2002 Figure 2. Expected and Actual Pension (those aged 40–50) have been given the Expenditures to GDP, 2000-2014 opportunity to opt back to PAYG-only at retirement. Opting back gives them full pension benefit including the 27-percent supplement to post-2002 PAYG pension. This unfair choice makes the decision easy (and currently automatically executed by the authorities unless an individual indicates otherwise): in 2015 less than 1 percent of the pensioners (i.e. those with large second pillar accumulations and short service periods) chose the multipillar benefit. As Figure 3 shows, without the adjustment, combined multi-pillar pension would remain 94 96 Given the uncertainty and lack of matching assets, In 2014 life-cycle portfolios were introduced, but the such an indexation pattern is uncommon in the second effective floors for investing in public debt were not pillar. As a consequence, initial second pillar annuities reduced. 95 percent of funds remain in balanced could be reduced by 20 percent or more. portfolios with heavy exposure to public debt. 95 The real rate of return on second pillar accounts, commonly quoted and expected by the analysts was 3 percent. Croatia Policy Notes | Pension System Reform 107 below the PAYG-only pension for the next second pillar requires a double-dip into current decade or two, i.e. prolong into the retirement of tax and contribution payers’ income – to pay mandatory participants without the opt-out PAYG pensions and to fill the gap of diverting a option, which may provoke reversal appeals. As part of pension contributions (presently 5 indicated earlier, measures implemented in 2013 percent) to the second pillar accounts. Transition and 2014 have further worsened the system’s costs currently stand at 1.5 percent of GDP, and fiscal sustainability (Figure 3), and reduced fiscal are largely financed by selling debt second pillar space for action. pension funds. Second pillar annuities would Figure 3. Projected Replacement Rate and PAYG thus be financed predominantly by future Deficit in Croatia generations’ interest payment instead of from higher activity rates stemming from productive and diversified second pillar investment. How Croatia can Strengthen its Pension System Several simultaneous reforms could improve system equity and adequacy. The key systemic issue to be addressed is whether to extend the 27 percent supplement to all beneficiaries or to abolish it for current beneficiaries. With 27 percent supplement extended to all (proportional PAYG deficit to service in the PAYG pillar) or abolished for all, 2.0% for most individuals the multipillar pension would 1.0% exceed the PAYG-only one. Opting-out, if 0.0% 2012 2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 needed, would then be made a fair choice. -1.0% Abolishing it is both politically and socially -2.0% difficult. Extending it generates more PAYG -3.0% expenditures, rising in parallel with retiring -4.0% second pillar cohorts. In addition to already -5.0% narrowed fiscal space with redefinition of pension -6.0% for second pillar participants and other 2013-14 -7.0% PAYG deficit before 2013 measures PAYG deficit after 2013 measures measures, extending the supplement would Source: World Bank team calculations, PROST model cause the PAYG deficit to remain at 4 percent of GDP. A set of policies to strengthen the PAYG Croatia’s pension system still faces system, addressing both fiscal and equity substantial coverage and adequacy aspects could provide the needed fiscal space. challenges. Compared to EU, Croatia has the The list includes i) abolishing early retirement or lowest labor force participation rates (of 15-64 reducing it to 1-2 years prior to retirement age cohorts - 59.6 vs. 71.9 percent for the EU28), (with a bridging system for hazardous second lowest average service period (31.1 occupations), ii) abolishing or faster convergence years vs. 35 years for the EU28), and among the of privileged pensions to PAYG rules, iii) faster lowest exit age from work in the EU (1.2 years increase in legal retirement age, iv) awarding below EU for both men and women)97. Croatia pension credits only for contributions, v) already pays the lowest relative pension in EU, introducing wage valorization of initial pensions which, without further reforms, is likely to and CPI indexation of pensions in payment, and deteriorate further. Recent PAYG measures vi) reducing minimum pension per year of service improved future adequacy but not as much as or means testing it. would higher second pillar contribution rate. Abolishing or reducing the second pillar Croatia’s second pension pillar requires would bring short-term fiscal relief but fiscal support as well as policy and outcome exponentially raise the long run pension monitoring. In the long run, the second pillar is liabilities and implicit debt. Multi-pillar pension expected to provide a higher value-for- reform was designed as a reform for the future, a contributions than the PAYG pillar. With equal contribution of the current generation to lower PAYG conditions and the same contribution rate, burden for the future generations. At the launch the multi-pillar replacement rate would yield up to of the second pillar it was emphasized that it 10 p.p higher replacement rate. However, the would require fiscal support in the form of a fiscal 97 EU: The 2015 Aging Report: Economic and Budgetary Projections for 28 EU States 2013-2060. Croatia Policy Notes | Pension System Reform 108 surplus or a small sustainable deficit and debt. pension system (so-called PROST pension Instead, public spending exploded, added to both model delivered to counterparts in 2011 and deficit and public debt, postponing the second 2012), policy reports on severance pay in the pillar’s diversification towards more productive context of the pension system (2013) and the investment and abroad. Among the countries extended service period (2013), as well as recognizing the inability of the current generation supported the pension policy reforms through to curtail fiscal deficits for longer run benefits, Development Policy Loans (2011-13). only two (Argentina and Hungary) annulled the Further World Bank support to pension policy reform by abolishing second pension pillar. A in Croatia could include analyzing and larger group of countries, including Poland, evaluating policy options and assisting the Estonia, Latvia, Lithuania, Bulgaria, Romania, counterparts to efficiently implement them . and Slovak Republic, have striven through the Croatia has prepared its pension system fiscal crisis by temporary freezing or reducing forecasts together with other EU countries. EU’s second pillar contribution rate, and/or allowing 2015 Aging Report findings for Croatia are similar some degree of voluntary participation in the to the World Bank’s. The status quo projection for system. Unless truly temporary, such relief Croatia indicates long-run social inadequacy measures carry serious long-run risks. despite fiscal sustainability, but does not address Prolonged reduction or freeze of second pillar or evaluate policy options and implementation contribution rate bites into future adequacy and patterns in both PAYG and funded pension worsens the elderly poverty prospects. Similarly, pillars, as well as on the labor market side. The those that opt-out from the second pillar are more World Bank could facilitate such an integrated likely to appear as social assistance beneficiaries pension, social and labor market reform review in the future. and assist in implementing policies emerging How the World Bank Group Can Help from it. Reimbursable Advisory Services (RAS) may include policy and financial analyses, The World Bank has supported pension modeling (PROST), preparing reports such as reform in Croatia from its beginning through the Active Aging Report (the World Bank analyses, investment projects, policy adjustment prepared a similar report for several EU Member operations, and advisory services. In the last five States) or other type of active engagement. years, the World Bank produced a Pension Policy Note (2011), simulation model of Croatian This Policy Note was produced by the World Bank to inform policy debate in Croatia. This note was prepared by Zoran Anusic, Senior Economist. The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the Governments they represent. For any questions regarding this note, please contact Vanja Frajtic, Communications Associate, (vfrajtic@worldbank.org). THE WORLD BANK OFFICE ZAGREB http://www.worldbank.org/en/country/Croatia Croatia Policy Notes | Pension System Reform 109 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs More Effective, Inclusive and Sustainable Health System Key Messages Croatia’s main challenge in the coming decade is to improve health outcomes for all, while containing upward pressures on health spending driven by an aging population and new technologies. Chronic and non-communicable diseases dominate the burden of disease and projected rapid population aging will exacerbate this. Croatia’s hospital-centric health system and service delivery network is not well suited to its changing care needs. Improving the functioning of primary care is critical for strengthening more cost-effective preventive care and rationalizing hospital service delivery. Key Actions  Upgrading and rationalizing the service delivery model: modernizing the health network through changes to the structure and organization of health care institutions to improve integration of care and implementing clinical guidelines.  Expanding public health and preventive services: expanding coverage of individual preventive care and public health services, particularly among the less well-off.  Improving quality, efficiency and fiscal responsibility through active purchasing: linking primary care and hospital payments to clinical guidelines, improving performance feedback, and enforcing fiscal discipline, improved hospital management and accountability.  Rationalizing spending on drugs and devices and prescription patterns: implementing Health Technology Assessment and expanding centralized procurement. Where Croatia Stands Now causes of death101. Circulatory diseases and cancers combined account for approximately 75 Croatia enjoys relatively good and improving percent of deaths. Risk factors underlying this health outcomes. Between 1990 and 2013, life burden of disease include a combination of expectancy increased from 72.5 to 77.85 years, unhealthy diet, physical inactivity, smoking and infant mortality fell from 6.3 to 4.06 infant deaths high alcohol consumption, and metabolic per 1,000 live births98 and the age-standardized conditions such as high blood pressure, high mortality rate decreased by 33 percent from blood sugar, obesity and high cholesterol. Death 1,060 to 713 deaths per 100,000 inhabitants 99. rates due to ischemic heart disease in Croatia Life expectancy at birth is one to two years longer are twice the EU average, those due to than that of neighboring countries with similar circulatory conditions are 70 percent higher and income levels, such as Hungary and Slovakia but those due to lung, trachea and bronchus cancers over three years less than the EU average are 22 percent higher102. Croatia’s population is (Figure 1)100. rapidly aging. The population aged 65 and above But Croatia could do much better in tackling now makes up over 17 percent of the Croatian chronic and non-communicable diseases population and will rise to over 20 percent by which dominate the burden of disease. 2020103. Aging means that the burden of chronic Ischemic heart disease, cerebrovascular disease and non-communicable disease will increase, and lung and colorectal cancers are the top four with concomitant implications for increases in health care costs. A concerted policy focus on 98 101 European Health for All Database (HFA-DB). http://www.healthdata.org/croatia 99 102 All causes all age SDR, European Health for All European Health for All Database. Data presented Database (HFA-DB) are Standardized Death Rates all ages per 100,000. 100 Comparison for 2010 as this is the latest year data 103 World Bank. 2015. Golden Ageing: Prospects for are available for many comparator countries. Healthy, Active and Prosperous Ageing in Europe and Central Asia Croatia Policy Notes | More Effective, Inclusive and Sustainable Health System 110 tackling chronic and non-communicable expenditures by international standards, in diseases and promoting healthy aging is estimates of health expenditures. These therefore particularly important in Croatia. accounted for about 0.7 percent of general Figure 1. GDP and Life Expectancy at Birth in government spending. Complementary health Selected Countries insurance expenditures, which were a little under 82 ESP ITA 0.7 percent of GDP in 2014, are also considered 80 SVN GRC GBR FRA to be public health spending in Croatia, while Life expectancy at birth, in years GER 78 PRT some part of it (those that do not refer to 76 ALB 76.5 CROATIA CZE vulnerable groups access to health services) BIH MKD POL EST SVK R² = 0.8404 should be considered ‘private’ health spending 74 MNE HUN ARM GEO SRB BGR ROM TUR LTU LVA since they are voluntary supplementary 72 insurance premium payments made by 70 UKR individuals109. MDA RUS 68 Figure 2. Total Health Expenditure Trends 0 10000 20000 30000 40000 US$ per capita GDP Source: World Development Indicators, World Bank. By regional and international standards, financial protection is good and the health system is responsive to public expectations. At approximately 12 percent of total health expenditure, out of pocket spending by households in Croatia is lower than the WHO’s 15 percent threshold for financial protection and also lower than the EU average of 14 percent104. Finally, some 70 percent of respondents are satisfied with the quality and efficiency of the Source: WHO-European Health for All Database 2014 public health system. This puts Croatia just below Health sector arrears are an important Western Europe, Turkey, and Estonia (80, 79, concern. Stock of arrears as of September 2015 and 78 percent, respectively) and at the same are substantial at approximately HRK2.8 billion level as Slovenia and Latvia105. or about 0.8 percent of GDP. Hospital arrears are Croatia’s health expenditure is converging three-quarters of health sector arrears with with that of its neighbors in Central Europe clinical centers (tertiary care category 0 and 1 and the Baltics. In 2013, Croatia spent hospitals) accounting for half of arrears (Table1). approximately 7.3 percent of GDP on health, Table 1. Arrears, stocks which puts the country above the average of 6.8 percent for EU members since 2004 and above Billion Kuna 2013 2014 2015 comparator countries like Estonia which spent As of 31-Dec 31-Dec 30-Sep 5.7 percent but below the average for EU HZZO 1.43 0.94 0.59 members before 2004 (Figure 2)106. Hospitals 2.35 1.74 2.11 Other HCIs* 0.22 0.13 0.09 Public health spending in Croatia appears Total 4.00 2.80 2.79 higher than the EU average but this also Source: Ministry of Health, HZZO. Note: HCIs=Health Care reflects differences in the definition of public Institutions health spending. The Croatian Health Insurance Fund (HZZO), the Ministry of Health The health sector as a whole added no new (MoH) and local government spending on health arrears in 2015, and HZZO achieved was about 15.3 percent of general government substantial reductions in its arrears stock. spending in 2014107. This is higher than the After peaking in 2013, the stock of arrears – average of 14.7 to 14.8 percent for EU member calculated after taking into account debt states in 2013108. However, national accounting forgiveness ‘rehabilitation’ transfers–has standards in Croatia include mandatory (first six dropped substantially. HZZO achieved savings months) maternity and sick leave compensation, of HRK0.35 billion in the first nine months of which are not considered to be health 2015, and non-hospital health facilities also achieved some savings. Although hospitals 104 107 World Development Indicators 2015, The World HZZO annual report 2014-HZZO expenditures; Bank. Data are for 2013 Budget execution data for MoH and local government 105 EBRD, Life in Transition- After the Crisis, 2010 2014. 106 European Health for All Database (HFA-DB). 108 Eurostat, COFOG methodology 109 HZZO annual report 2014 Croatia Policy Notes | More Effective, Inclusive and Sustainable Health System 111 under rehabilitation added HRK0.38 billion in interventions and other policy actions to ensure new arrears in Jan-Sep 2015, this represents a that additional years of life are healthy and on 76 percent decline in new arrears generated health expenditure increases driven by new relative to 2014 and continues a trend of decline technologies112. Nevertheless, projections under since 2013. all scenarios suggest that health care will continue to exert continuous upward pressures Halting the growth of arrears at hospitals, on public spending from a baseline of 5.7 percent particularly at clinical centers, will be key to of GDP in 2013 to between 6.7 percent and 9.7 fiscal sustainability. Of the new arrears added percent in 2060113. in 2015, Kuna 0.36 billion are at the clinical centers (tertiary care, category 0 and 1 Socio-economic and geographic disparities hospitals). This represents a 64 percent decline in health remain wide. Geographic disparities over the previous year but merits attention as the between rich and poor districts imply main generators of new arrears (Figure 3). An considerable room for improvement. In rich analysis of hospital arrears from 2012 found that districts like Zagreb, Zadar, Bjelovar and Bilogora most arrears are for pharmaceuticals, medical and Karlovac, infant mortality rates have been materials, blood, and blood derivatives110. This is comparable to the EU average or even lower. By unsurprising since supplier contracts are the contrast, infant mortality rates in poorer areas more ‘flexible’ part of hospital expenditures such as Lika and Semk, Osijek and Baranja, (relative to, say, staff costs which are close to half Virovitica and Podravina are double those in of all hospital expenditures). Tackling arrears will richer areas. require policy actions at and beyond hospitals to Croatia needs to optimize hospital inpatient improve fiscal responsibility and deliver better capacity and adjust the service delivery value from health spending without network to changing care needs. Croatia’s compromising access to or quality of care. health system is not well suited to its needs. A Figure 3. Share of Arrears Stock significant portion of long term care for elderly people is provided at high cost by hospitals. This is care that could be more suitably and cost- effectively provided in other settings. There is a growing need for palliative and chronic care which is also better provided in non-hospital settings. Advances in technology, anesthesia and surgical techniques mean that more services can be delivered in ambulatory and day care settings therefore reducing the need for acute care beds and increasing the need for integrated Source: Ministry of Health, HZZO. Hospital data are for health networks. hospitals under financial rehabilitation. 2015 data are for Jan-Sep 2015 Croatia’s network of facilities is fragmented. The health system’s sustainability is The national figures also mask the geographical complicated by rapid population aging. The concentration of these health services. A large burden of chronic and non-communicable number of Croatia’s hospitals are in Zagreb diseases typically increases in aging populations (more than two per 100,000 inhabitants), of along with the need for long term social and which several are small-scale and have narrow medical care111. Mobilizing the resources to medical profiles. High referral rates from primary finance the increasing demand for health care to hospitals in Croatia – 25 percent as services from a shrinking working age population compared to the typical range of 5 to 12 percent with payroll taxes will be increasingly – suggest that improving the functioning of challenging, as contribution levels for mandatory primary care has a part to play in rationalizing health insurance are already quite high. hospital service delivery as well as improving However, the impact of aging on health spending preventive care in order to improve health in Croatia will depend critically on health system outcomes. 110World Bank. 2014. Croatia Public Finance Review; 112 Studies in the U.S. suggest that so called ‘death - authors calculations as of December 2013 related’ costs in the final few years of life, and 111 Considering demographic change alone, public especially in the last year of life, are high, and range expenditures on health and long term care as a between 25-30 percent of total Medicare expenditure. proportion of GDP are projected to increase by 1.3 World Bank, 2015 percentage points in a ‘medium case’ scenario. Long 113 European Commission. The 2015 Ageing Report: Term Care and Ageing. World Bank Report. November Economic and budgetary projections for the 28 EU 2010. Member States. Croatia Policy Notes | More Effective, Inclusive and Sustainable Health System 112 How Croatia Can Strengthen its of care failures: Hospitals in Croatia now report Health System on sentinel events, i.e., extreme events that signal critical quality of care failures at hospitals Croatia’s main challenge in the coming and primary care facilities, providing vital decade is to improve health outcomes while information that are a first step to diagnose and containing upward pressures on health address quality failures. The implementation of spending driven by an ageing population and technical audits of hospital quality and hospital new technologies. This will mean improving the accreditation – currently at a design stage – quality and efficiency of health spending, needs to be accelerated urgently. targeting inequities in health outcomes, and containing cost escalations, particularly from new Expanding public health and preventive drugs and technologies. Policy makers should services give priority to: (i) upgrading and rationalizing the Expanding coverage of individual preventive service delivery model; (ii) expanding public care and public health services, particularly health and preventive services; (iii) improving among the less well-off, will be key to quality, efficiency and fiscal responsibility improving health. About 50 percent of the life through active purchasing; and (iv) rationalizing expectancy gains from the so-called spending on drugs and devices and prescription ‘cardiovascular revolution’ in the EU-15 have patterns. come from primary and secondary prevention Upgrading and rationalizing the service activities that promoted healthy lifestyles, delivery model targeted reductions in alcohol and tobacco consumption and aimed to prevent or reduce Modernizing the health network: This includes complications from obesity, high blood pressure a number of changes to the structure and or diabetes. These are all key contributors to the organization of health care institutions to improve burden of disease in Croatia. The educated and integration of care. This means: better off are more likely to use preventive services in most countries, and this is likely the  Defining networks of health care institutions; case in Croatia as well. Improvements in the  Rationalizing the number, distribution and coverage and quality of preventive services could service profile of hospitals to reduce acute also be a tool to reduce socio-economic and care, removing from the public basic insurance geographic inequities in health outcomes in health spas and increase sub-acute, long- Croatia. Strategies to increase private term, palliative care and day bed capacity; participation in health care costs must protect the poor from catastrophic health spending and  Promoting ambulatory services, including avoid copays or cost sharing for primary and specialized ambulatory surgeries, diagnostic secondary preventive services or drugs. and treatment services; Improving quality, efficiency and fiscal  Strengthening first level care; and responsibility through active purchasing  Promoting two-way referrals across levels of Linking primary care payments to clinical health care institutions. guidelines, and improve performance HZZO has reduced the number of acute care feedback: Payment reforms since 2008 have beds contracted by 12.5 percent and increased increased the share of activity-based payments the number of day beds contracted by 11 percent to General Practitioners to 30 percent to in contracts for 2015. This is a step in the right incentivize preventive care and increase access direction. A hospital masterplan, which lays out a to primary care services. In addition, doctors proposal to reshape hospital service delivery was receive approximately 5 percent more as a bonus approved by Parliament in 2015. Accelerating for joining a group practice. Over 50 percent of implementation of the hospital masterplan will be primary care doctors now work in multi- important to realign the service delivery network disciplinary group practices enabling them to and realize further gains in quality and efficiency. share resources and expertise. This should have Pilot projects, potentially supported through EU the effect of expanding the range of services that funds, could help to fine tune the organization of can be delivered at the first level of care, and the service delivery network by trying out reduce referral rates. HZZO reviews prescription different models to identify the right one for practices of doctors to identify over-prescribers Croatia. and provide feedback to reduce over- prescription. The impact of these changes on Implementing clinical guidelines through patient care needs to be assessed hospital accreditation and technical audits, systematically. Possible interventions to consider and monitoring sentinel events to flag quality include linking payments to appropriate Croatia Policy Notes | More Effective, Inclusive and Sustainable Health System 113 prescription practices, preventive service based on technical audits: Hospital payments coverage/ quality and appropriate referral now promote ambulatory service delivery for practices. Providing systematic feedback on key elective surgeries. Payment rates for elective quality parameters to GPs based on adherence surgeries are 10 percent higher if performed in to clinical protocols would be a complementary an ambulatory setting. As a result, delivery of ‘enabling’ intervention to consider. E-prescription elective surgeries on an outpatient basis has systems to monitor prescribing behavior are increased considerably in 2015. To illustrate, 57 already in place, and on-going e-health percent of elective surgeries for five tracer investments will enable better oversight and elective surgeries are now performed on an monitoring. outpatient basis, potentially reducing unit costs by 30-70 percent. By contrast, only 1.8 percent Incentivizing fiscal discipline and improving were performed on an outpatient basis in 2011. hospital management and accountability: These reforms should continue. Until recently, hospital payment mechanisms contributed to poor fiscal discipline. Although Hospitals can also earn a performance bonus of hospital payments were notionally based on up to 5 percent based on a set of five indicators Diagnosis Related Groups (DRGs), hospitals intended to capture quality of care and hospital received all of their estimated DRG payments in efficiency. This is a step towards incentivizing advance as a monthly transfer of 1/12th of the hospitals to improve quality and efficiency. annual contract amount. Underperforming However, the current performance bonus hospitals seldom returned funds they were not formula rewards hospitals delivering a low entitled to at the end of the year and inflexible volume of services at high quality levels contract ceilings meant that funds could not be disproportionately over hospitals that deliver a redistributed from poor-performing to high- high volume of services at high quality levels. performing hospitals therefore rewarding poor Furthermore, the quality indicators could be performers. refined to better capture clinical quality of care, given differences in hospital case mix. These Adjustments to hospital payments made in mid- concerns can be addressed in the immediate 2015 are a step forward to improving hospital future. Ultimately, hospital payments should be fiscal discipline. Funding now follows patients. linked to accreditation scores and Reimbursement ceilings are flexible and funds implementation of clinical guidelines as can be redistributed from hospitals that do not monitored through technical quality audits. deliver services to those that do. The proportion of contract funds disbursed in advance to Rationalizing spending on drugs and devices hospitals is being reduced with a target of 25 Implementing Health Technology percent by end-2016. At the moment, the Assessment and expanding centralized proportion of advance funds stands at 80 procurement: Access to prescription drugs in percent. Croatia has increased while the average cost per Organizational reforms to introduce professional prescription has declined (Figure 4). HZZO management at hospitals and improve hospital expenditures on prescriptions medicines governance – a key factor mediating impact – decreased from HRK3,447 million in 2010 to remain an important as-yet unaddressed priority. HRK3,260 million in 2014114 accounting for Measures to improve the fiscal accountability of approximately 16 percent of HZZO health care hospitals should also consider, and if necessary, expenditure. Expenditures on orthopedic devices address, the real autonomy that hospital also declined by HRK174 million and were about managers have to manage and control 3 percent of HZZO health care spending in 2014. expenditures. The MoH has established a robust Overall, spending on prescription drugs, system of regular financial and performance orthopedic devices, insulin pumps and expensive reporting by clinics and hospitals under drugs was 23 percent of HZZO health care rehabilitation, and monthly monitoring meetings spending in 2014. with managers. This is good practice that Croatia has taken important steps to regulate the increases accountability and should be drugs market and public expenditures on drugs continued. since 2009115, which have contributed to these Linking hospital payments to clinical results. In line with international best practices, guidelines and improving feedback on quality HZZO monitors GPs’ prescription patterns to 114HZZO annual report 2014 criteria for including medicines in HZZO’s basic and 115Two ordinances have been key to this. The first supplementary reimbursement drug lists, based on ordinance put in place a mechanism for setting a medical evidence and cost-benefit analysis. HZZO maximum wholesale price based on international price comparisons. The second ordinance defined the Croatia Policy Notes | More Effective, Inclusive and Sustainable Health System 114 identify and nudge over-prescribers into cost-effective. More broadly, the World Bank rationalizing prescription practices. Moving stands ready to support Croatia in strengthening forward, monitoring and feedback should focus its health system through a range of types of more closely on aligning prescription practices support including: with clinical guidelines to maximize impact on (i) Supporting a systematical measurement of the outcomes and costs. impact of health sector reforms so far, and Expenditures on expensive drugs for hospitals diagnosing drivers of arrears. Croatia has have continued to grow at a high rate, however, implemented key reforms to re-orient the increasing by 44 percent from HRK450 million in country’s service delivery model and improve 2010 to HRK634 million in 2014, although it still quality and efficiency of care. The impact of accounts for a relatively small proportion these reforms on patient care and satisfaction (approximately 3 percent) of HZZO health care as well as implications for efficiency and health expenditures. These need to be monitored outcomes needs to be assessed carefully and the potential for value-based systematically to supplement the evidence purchasing explored and exploited. already available. Given concerns around Figure 4. Expenditures on Prescriptions Medicines hospital arrears, a diagnostic of the main (HRK) remaining health systems drivers of arrears both at and beyond hospitals, could complement current monitoring by the Ministries of Health and Finance. A systematic evaluation could help to deepen successes, inform course corrections and also serve as a basis for future communications on the reforms. (ii) Supporting the implementation of the hospital masterplan: realigning the hospital infrastructure by reducing acute care beds, Source: HZZO Annual Report 2014 while increasing sub-acute, long-term and Joint procurement of hospital drugs, supplies and palliative beds and day beds and services will devices are a strategy to standardize quality and be critical to reorient service delivery to lower costs through economies of scale. The first Croatia’s changing needs cost-effectively. round of centralized procurement for generic Implementation of the hospital masterplan drugs in 2012 yielded about HRK187 million in needs to be accelerated, and detailed plans savings. However, the potential for savings could for at least one ‘hospital reshaping’ schemes be further exploited by expanding joint developed and implemented. procurement to cover more supplies and medical (iii) Supporting implementation of quality-related devices after an assessment of the experience reforms: The implementation of hospital so far. The Ministry of Health has taken steps accreditation and technical audits is lagging towards this: by issuing an order expanding the relative to other elements of Croatia’s health scope of joint procurement to also include reforms. Not a single hospital has been devices and consumables. However, accredited yet, nor are technical audits being implementation progress on this needs to be implemented. Clarifying the role of the accelerated. Agency for Quality and resourcing it How the World Bank Group Can Help appropriately will be key to facilitate implementation of these reforms. The World Bank has been supporting the Organizational changes are also needed at development of Croatia’s health system for over the hospital level to reinforce a focus on 15 years through two investment projects, improving quality. Hospital performance current program-for results, and a number of bonus indicators could be revised to link technical assistance activities. performance bonuses more closely to quality Currently, the Government of Croatia is of care. In addition, hospital payments could implementing Health Program-for-Results, be reviewed to identify medium-term with financing from the World Bank, in opportunities to incentivize improvements in support of a set of reforms to strengthen the quality and efficiency. country’s health system and make it more also defined reimbursement limits for most agreements to ensure that suppliers have a financial prescription medicines through annual internal interest in keeping within budget limits. reference pricing. HZZO also uses risk-sharing Croatia Policy Notes | More Effective, Inclusive and Sustainable Health System 115 (iv) Identifying opportunities to improve health services with a focus on preventive and public health services and poor areas. Reviewing the quality and coverage of service delivery for primary and secondary prevention and implementation of tobacco and alcohol use public health campaigns with a focus on service delivery to the poor is a good starting point to identify intervention opportunities to address socio-economic disparities in health. This Policy Note was produced by the World Bank to inform policy debate in Croatia. This note was prepared by Marcelo Bortman and Aneesa Arur, Sr. Public Health Specialists. The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the Governments they represent. For any questions regarding this note, please contact Vanja Frajtic, Communications Associate, (vfrajtic@worldbank.org). THE WORLD BANK OFFICE ZAGREB: http://www.worldbank.org/en/country/Croatia Croatia Policy Notes | More Effective, Inclusive and Sustainable Health System 116 Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs Social Welfare Key Messages Croatia’s generous and complex social welfare system relies excessively on categorical rather than poverty-focused benefits. To improve its ability to tackle poverty, and to do so in a more cost-effective way, Croatia needs to consolidate its social benefit programs and increase the share of spending on poverty-focused programs, including through a broader use of means- testing mechanism. The previous Government has embarked on a reform program to strengthen its social welfare system and to increase its efficiency and effectiveness in combatting poverty. These efforts would need to be continued. Key Actions  Initiate transfer of the administration of the GMB into the OSS in 2016, followed by the consolidation of the child allowance, non-contributory maternity/paternity allowances, the unemployment benefit, and subsequently of other social benefits, into the GMB in subsequent years.  Introduce means-tested eligibility procedures for family-related benefits and review family-related tax expenditures.  Accelerate the deinstitutionalization process by speeding up the transformation of large residential institutions into smaller care units, with a reduction in the inflow of new entrants into institutions and an expansion of alternative care models. Where Croatia Stands Now benefits. Croatia allocates 4.8 percent of public spending to non-contributory programs and Six consecutive years of recession since the policies, but only 0.3 percent allocated to social start of the global financial crisis in 2008 have assistance (Table 1) is well targeted to the poor. led to a rise in poverty in Croatia. Using an This suggests significant scope to raise the absolute poverty line of $5 per day, the poverty effectiveness of social welfare to address poverty rate was estimated at 9.8 percent in 2013, while and vulnerability by scaling down on some of the relative poverty (the share of population with categorical programs and replacing them with equivalized incomes below 60 percent of the income- or means-tested programs. median) was 19.4 percent in 2014, falling slightly from a high of 20.9 percent in 2011. Table 1. Targeting Accuracy of Social Protection Programs, 2011 Spending on non-contributory social welfare is high and was protected during the crisis. Croatia spends 4.8 percent of GDP on different types of non-contributory programs and policies116, which is significantly higher than other Central and Eastern European countries. Spending is substantial even for cash transfer programs; Croatia spends about 2.5 percent of GDP on such programs. Government efforts to protect social assistance benefits and old-age pensions during the crisis have served to partially mitigate the impacts of the crisis on poverty. Croatia operates a generous and complex social welfare system that relies heavily on categorical as opposed to needs-based Source: Based on the latest available 2011 HBS. 116 This definition includes traditional cash transfer programs for poor, war veterans’ pensions and child tax allowance. Croatia Policy Notes | Social Welfare 117 Croatia’s social welfare system has over time December 2013. The law created a new also become costly to administer, with Guaranteed Minimum Benefit (GMB), introduced responsibilities scattered across different in 2014, which consolidated four different social ministries and institutions. Three separate welfare benefits (the social allowance program, ministries are in charge of setting social welfare the extended unemployment benefit, the policy (Ministry of Social Policy and Youth, homeland war veterans’ benefit and the disabled Ministry of Labor and Pension System, Ministry World War II support allowance) and applied of War Veterans) and four ministries with multiple means-testing with a changed equivalence scale specialized agencies and their networks to protect the most vulnerable (single elderly and administer social welfare programs. This single parents). fragmented administration raises the personal Another important step towards costs to beneficiaries applying for benefits at consolidating the administration of major multiple agencies, augments the risk of error and social welfare benefits and the fraud in the social protection system, and hinders unemployment benefit is the planned policy making. creation of a One-Stop-Shop (OSS), to be How Croatia Can Strengthen Its placed in the existing network of public Social Welfare System administration offices throughout the country. In addition to reducing the personal costs to The Government has embarked in 2013 on a beneficiaries and the administrative costs of reform program to strengthen its social processing applications and paying benefits, the welfare system and to increase its efficiency OSS will lay the foundations for deeper structural and effectiveness in combatting poverty. It reforms, such as stronger policy coordination, includes reforms to consolidate and improve the harmonization of rules and procedures, and targeting and administration over its social benefit consolidation. It is a gradual process welfare programs in recent years, with the which is expected to take several years. introduction of the means-tested Guaranteed According to initial plans, the creation of the OSS Minimum Benefit (GMB), the launch of a One was supposed to commence in 2015 with the Stop Shop (OSS) approach to benefit transfer of the administration of the GMB into the administration, a centralized disability public administration offices. This reform has certification, and efforts to reduce error, fraud been postponed to 2016, however. and corruption in social benefits. Croatia has also Administration of the child allowance, non- launched a process of deinstitutionalization and contributory maternity/paternity allowances, the transformation of its social welfare institutions, unemployment benefit and, subsequently, of along with a reduction in the inflow of new other social benefits is expected to be transferred entrants into large institutions. The reform into the OSS in subsequent years. agenda would benefit from continued efforts to reach wanted results. Croatia’s 2015 National Reform Program articulates the objective of consolidating Consolidating and improving the targeting of social benefits through the GMB and social welfare implementing the OSS. It describes key In 2013 Croatia started to implement a set of milestones that need to be achieved and sets a reforms to consolidate and improve the deadline for completing the transfer of targeting and administration of the social administration of four main benefits to the OSS by 2017. European Commission’s 2015 Country welfare system to better and more efficiently Specific Recommendations117 provide proposals protect those in need. As a first step, social to further consolidate social benefits (as there are policy was centralized under the Ministry of still over 80 different social benefits) and increase Social Policy and Youth to improve the share of means-tested social benefits administrative coordination. The Government (currently accounting for less than 7 percent of all also rolled out a comprehensive management social protection benefits). information system, developed with World Bank support, which increases the transparency and Strengthening the administration of disability availability of information for policy making, and benefits reduces the scope for error and fraud. Croatia’s system of disability benefits is Efforts to consolidate some cash transfer among the largest in the EU, both as a legacy programs and improve targeting were of the conflict in the early 1990s and of legislated in a Social Welfare Law adopted in weaknesses in the design and administration 117 EC, Country Report Croatia 2015, and Council Recommendation of July 14, 2015 Croatia Policy Notes | Social Welfare 118 of the programs. Croatia spends about 3.6 needs to be developed in the first quarter of percent of GDP on disability programs (disability 2016. Successful implementation of the strategy pensions, transfers and other benefits), and the action plan could generate significant significantly above EU averages. This is largely fiscal savings in the system. the legacy of the Homeland War, but is also due Promoting deinstitutionalization to non-standard and loose disability criteria, lack of control, and lack of governance in the disability Croatia has made progress over the last assessment system. This has resulted in large years in the deinstitutionalization and numbers of Croatians on the disability rolls. transformation of residential social welfare institutions. Deinstitutionalized care is Reforms to disability certification introduced overwhelmingly more effective than institutional in early 2015 are showing first positive care, especially for children, and effects. Until the recent creation of a Central deinstitutionalization has been a longstanding Disability Certification Institute (CDCI) within the policy objective in Croatia. The implementation of Institute for Disability Certification, Professional deinstitutionalization had been lagging behind, Rehabilitation and Employment of Persons with however. Toward this end, Croatia developed a Disability, disability certification was spread Master Plan on Deinstitutionalization and across six sectors and agencies with no Transformation of Social Welfare Institutions in consistent methodology. Under the reforms, 2010, adopted an Operational Plan to implement disability certification previously conducted the Master Plan in late 2014, and formed a separately by the pension, health, veteran, national team for deinstitutionalization social, employment and education systems were comprising of four full-time engaged experts in consolidated, and a unified disability certification early 2015. Each residential institution has come methodology was adopted and applied as of up with a transformation plan, and the Ministry of January 2015. Social Policy and Youth has been actively CDCI’s technical and operational capacity supporting the transformation process to date in has been improving and initial results have 32 such institutions. been encouraging. The reform has helped Significant progress has been made on the reduce the inflow into disability programs, which deinstitutionalization of individuals from a was higher in Croatia than in comparable number of large institutions into organized countries and might have been affected by error housing and foster care. Continuous support is and fraud. New disability pensioners in 2015 also being provided to the residential social stood at around 2,100, almost 4 times below the welfare institutions in the preparation of project average new disability pensioners in the last proposals for developing new community decade. Strong implementation of the new services or the transformation of existing social methodology for disability assessment in 2015 welfare institutions, to be financed under the yielded direct savings of almost 0.1 percent of European Social Fund (ESF) and the European GDP. Apart from fiscal savings, this reform is Regional Development Fund (ERDF). expected to result in faster, more transparent, Unfortunately, the inflow of new entrants into and more client friendly certification process and institutions has not being reduced. As a result, service for clients. the targets for deinstitutionalizing individuals Tackling error, fraud and corruption have not been reached. Croatia’s institutions and mechanisms to Strengthening work incentives in the social combat error, fraud and corruption (EFC) in welfare system the social protection and labor system need A significant reliance of Croatia’s jobless on strengthening. Croatia operates a number of social welfare benefits raises questions on cash benefits with high a-priori risk of EFC, how to ensure that programs do not create including disability pensions and allowances, disincentives to work. More than 36 percent of income and means-tested programs (the child the unemployed population and about 47 percent allowance and GMB programs), and income of the out-of-work population118 in the bottom replacement programs. In November 2015, the quintile receive some kind of social welfare Government approved a Strategy for Combating benefits. The new Social Welfare Act introduced Error, Fraud and Corruption in the Area of Social a number of provisions aimed at encouraging Protection in the Republic of Croatia 2015-2020 work-able beneficiaries to transition from and an action plan to operationalize the strategy 118 Out of work is defined as the combination of inactive and unemployed individuals, as opposed to employed, retired, in education or training and with disabilities Croatia Policy Notes | Social Welfare 119 assistance to work, including: penalties for work- More broadly, the World Bank stands ready to able beneficiaries who refuse a job offer; support Croatia in strengthening its social welfare incentives for beneficiaries to transition to work, system through a range of types of support by offering a 3-month period when the benefit is including via (i) ex-ante evaluation of social gradually adjusted downwards; and measures to protection reforms (in pensions, active aging, ensure cooperation between social welfare employment policies; social welfare and social centers and local public employment offices. The services); (ii) implementation support for such Croatian Employment Service (CES) has to cater reforms; and/or (iii) evaluation of the to the needs of a larger and more heterogeneous performance of existing programs (i.e. population of jobseekers, making it more assessments of the quality of implementation challenging to fulfil its mission of counseling. The processes, their success in reaching the poor, CES does not have clear rules to establish their impact on the welfare outcomes of their categories of jobseekers and no systematic way beneficiaries and the cost-benefit ratio of these to prioritize resources and allocation of programs programs). Support efforts could further include based on categories. The World Bank provides data collection and analysis in areas where the technical assistance for statistical profiling evidence base on the Government’s reforms techniques as a tool to support activation and efforts is limited. counselling work. How the World Bank Group Can Help This Policy Note was produced by the World Bank to inform policy debate in Croatia. This note was prepared by Ivan Drabek, Senior Operations Officer and Emil Tesliuc, Senior Economist. The World Bank has been supporting the development of Croatia’s social welfare system The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the for over 17 years through two investment projects World Bank or the Governments they represent. and a number of technical assistance activities. For any questions regarding this note, please contact Vanja Frajtic, Communications Associate, (vfrajtic@worldbank.org). Currently, the Government of Croatia is implementing a EUR70 million Social THE WORLD BANK OFFICE ZAGREB: http://www.worldbank.org/en/country/Croatia Protection System Modernization Project, with financing from the World Bank, in support of a set of reforms to strengthen the country’s social protection system and make it more cost-effective. Reforms supported by the project include (i) the consolidation of major social welfare and unemployment benefits under a one-stop-shop network; (ii) harmonization of disability certification; (iii) development of a system to prevent, detect, and correct error and fraud; (iv) de-institutionalization of vulnerable children and adults by increasing family-type environments outside of the institutions, and improving care and quality standards for these groups; and (v) development of better activation measures for those at risk of becoming long-term unemployed. The project combines a results-based approach, with EUR50 million allocated for disbursement upon the achievement of 14 results indicators, and another EUR20 million allocated for critical investments and technical assistance. The project became effective in December 2014 and has so far disbursed EUR1.9 million or 2.7 percent of the loan. Another EUR4 million is ready to be disbursed for two achieved disbursement-linked indicators. The project has initiated activities in all areas supported by the operation, albeit at a slower pace in the second half of 2015. The World Bank team stands ready to provide strong implementation support to enable the government’s reform efforts. Croatia Policy Notes | Social Welfare 120