Interview with Josip Funda, World Bank Country Economist for Croatia, originally published in the print edition of Lider, on March 3, 2023.
With ambitious reforms, Croatia could reach EU average income in fifteen years, and with moderate reforms only in 2050, is the conclusion of the recently presented World Bank report, which analyzed in detail the causes of the big lag in Croatian productivity and highlighted areas policymakers should focus their efforts on to change that. We talked about that report, productivity, and needed reforms with Josip Funda, the World Bank Country Economist for Croatia.
Lider: You analyzed in detail the productivity in Croatia compared to other countries. What are the key reasons for reduced productivity in our country?
Josip Funda: I would not talk about reduced but about stagnant productivity compared to Croatia’s peers. Many factors impact productivity, both at the level of the regulator and at the level of companies. For example, enterprises should increase their investments in research and development and continuously invest in managerial skills and the skills of employees However, in our research, we mostly looked at market mechanisms and state institutions that affect productivity. A lot of research demonstrates a positive correlation between the quality of institutions and the productivity of the economy. It has become clear that the business environment, for example the issuing of permits, the entry and exit of firms from the market, insufficient level of competition affects productivity. Furthermore, we have noted that resources are not directed at the most productive purposes, again due to inefficient market mechanisms and institutions. In addition, bankruptcy proceedings are hindering the exit of companies from the market and the release of resources towards more productive companies. In essence, one finds a series of institutional restrictions that lead to market failures.
The solution to these problems mainly lies with the Ministry of Economy and the Ministry of Justice?
JF: These are key areas where reforms are needed. We need a judiciary that makes decisions faster, while the business environment needs to provide support to domestic and foreign investors. An interesting piece of information comes from World Bank research that analyzed what drives multinational companies to invest in specific countries. Political stability and efficiency of the judicial system as well as the regulatory environment are the most important. Availability of the labor force, taxes, and other factors come after. This suggests in which areas need to make the most progress. However, one of the factors that certainly affects productivity is also the quality of the workforce. It reflects the education system, as well as lifelong learning, in other words, how much companies invest in the education and skills of their employees.
In general, we are talking about national policies, and government policy, since ministries are often merged and or divided. That's why I think we need to focus on areas that are key drivers of growth, while it is less important which ministry at the moment is responsible for the implementation of a particular reform.
So the judiciary is in the first place...
JF: The judiciary is certainly one of the reform priorities because it affects all processes, both in the economy and in society.
The theory that the main problem is the structure of the Croatian economy, i.e. too much tourism, is refuted by the report.
JF: We have demonstrated that our challenge is not the structure of the economy. We applied the German economy structure to the Croatian productivity and found that the gap in comparison to Germany has narrowed only slightly. Croatia is still below 50% of German productivity.
Our main problem is that entire sectors such as the processing industry, ICT, and the utilities are extremely unproductive when we compare them with Germany. Of course, there are also examples such as the oil industry and the food and beverage industry where we have a somewhat smaller productivity gap, but in some sectors, such as other means of transport, motor vehicles and the textile industries, it amounts to around 98%.
In part this may be due to economies of scale, but other factors are much more important. The main factors are insufficient investments in digital processes, in research and development but in the report, we specifically looked at the institutions. An interesting fact is that companies that leave the market have higher productivity than those that stay. And that our resources are moving from more productive to less productive companies. This is an indication that something is not right with the competition. How is it possible for the low performer to survive and take resources away from the better performer?
One of the recommendations from the report is to improve the implementation of antimonopoly regulations. What is needed for their better implementation?
JF: We analyzed the laws on the protection of market competition, the work of the Croatian Competition and we even conducted a large survey among companies asking them about the situation on the ground. Our regulations are harmonized with European ones. The issue is that our companies are insufficiently informed about how to report irregularities and violations of market competition and they do not trust that institutions will resolve their problem. So, on the one hand, we need to educate companies, and on the other hand, judges who are in charge of enforcing the law on market competition. Yet, I repeat, our biggest problem is the dynamism on the market - how to facilitate market entry and exit of companies. The net entry of companies, meaning market entries minus exits, shows very low exits from the market. The question is why the market does not force less successful companies to exit. In this matter, we are at the lower end of of the EU.
And in terms of the number of zombie companies, we are on the top...
JF: By definition, zombie companies cannot cover interest expenses from operating revenue. They reduce overall productivity and are a risk for banks. There are 13% of such companies in Croatia and they account for 8% of employment. The question is how such unproductive companies survive on the market. It would be interesting to do the analysis we did in Bulgaria and analyze how public procurement impacts non-productive companies and their survival on the market.
I assume that the responsibility also lies in the duration of the bankruptcy proceedings?
JF: Bankruptcy procedures are too slow in Croatia. They lock up resources in bad companies and prevent them from being transferred to good companies. This dynamism on the market is obviously problematic. This slows down the process of market clearing and the entry of new companies. The National Resilience and Recovery Plan sets out ambitious plans for clearing the backlog, as well as shortening procedures. We hope that by 2026, these ambitious plans will be fulfilled.
The long duration of the proceedings creates legal uncertainty, which we could see recently in the case of the Swiss Franc, where the final verdicts have not yet been passed...
JF: There is very low trust in the judiciary in Croatia. Among the lowest in Europe. But on the other hand, the number of cases is among the highest in the EU. This is contradictory.
You mentioned the NRRP and the judiciary. Which reforms from the NRRP can have a long-term effect on Croatia's potential growth?
JF: The Plan lists primarily the judiciary and also education as key areas of reform. In education, among other things, the Plan is looking to prepare schools’ infrastructure for the implementation of the Whole Day School program, which the World Bank supports through a project with the Ministry of Science and Education. According to international tests, such as the PISA tests, our results are below average. And the main reason is that we have too few instructional hours compared to the EU. Reforms of a school system gives results only after a number of years. According to our simulations, the first results are expected only in 2030. It is only then that these children, who will be better educated in the meantime, will enter the labor market. On the other hand, the return on this "investment" will be very high in terms of growth.
Furthermore, there is the R&D agenda, a new system of incentivizing research and development. With better links between the economy and research centers and also securing funding for research. There are also a number of programs for small entrepreneurs, incentives for the private sector, through the digital and green agendas. There are also small reforms in the area of improving the business environment through the reduction of parafiscal levies. NRRP indeed brings a lot of good reforms, but not all and this is why the reform agenda needs to be constantly upgraded.
Are you optimistic about the NRRP? Can Croatia achieve the reform goals?
JF: I would say that I am cautiously optimistic. It is much easier to pass a law than to implement it later. This can often be a challenge in Croatia. We all know what needs to be done, but when it really needs to be done, it is difficult to reach a political and social consensus. However, I think that the NRRP results in reforms implementation so far are very good. I trust that some of the reforms will help in faster convergence with income levels we observe in the EU. By 2025 Croatia could reach the level of Poland or Latvia, but it will be difficult to catch up with Slovenia and the Czech Republic in the medium term.
Which country should we emulate in terms of reforms?
JF: It is difficult to compare countries because of their specific paths and situations. Fifteen years ago, everyone was talking about why Croatia should be more like Slovakia. Today, Slovakia is behind Croatia in terms of income level. We often compare ourselves to Slovenia because of the same background, but even in the former republic they were more developed than us by some 30%. We focus on a particular reform, not on the country as a whole. For example, when it comes to education, we have looked a lot at examples from Scandinavian countries as they are achieving very good education outcomes.
The study also touches on the accelerated aging of the population in Croatia and the lack of labor force. What can we do to reverse the negative trends?
JF: We have two challenges here. The first is demographics. It is difficult to change the average fertility rate in the short term. The state can help with financial incentives and infrastructure improvements, through the construction of kindergartens and their longer working hours. However, research has shown that the factors that contribute most to the natality rate improvements are favorable economic trends and the certainty that they will continue to exist in the future.
The other challenge in Croatia is the low labor force participation rate.
In the main age group, from 29 to 55, Croatia is at the level of developed countries. We stand out in the older age groups 55+ and in the young age groups, from 15 to 24 years old, especially for women. We do have to note a fairly high proportion of women in the education system, which is why they are outside of the labor market.
The main issue is therefore the older labor force that left the labor market early and ithey are difficult to bring back.
Velimir Šonje recently said that the wave of emigration from the Republic of Croatia could stop when we reach 80% of the average EU GDP. Could we expect that then people would start to return?
JF: There is research according to which emigration to certain countries stops or slows down when the country reaches 80% of the GDP of the country where people most often emigrate. The situation is a bit more complex but the fact remains that from some Eastern European countries, which are at around 90% of the average EU income, there has never been any significant emigration (Czech Republic or Slovenia). On the other end, countries like Bulgaria, Romania or Poland where the average income is lower than 80% of the average EU income have experience high levels of emigration. they There is a high possibility of the return of 'new' emigrants if the economic and social climate improves. State incentives do not help much here, rather the perspective of a better economic growth of the country is key.
One of the recommendations of the World Bank a few years ago was the introduction of property tax. Do you still recommend that tax and what other tax changes are needed?
JF: The tax system should always be seen as a whole. The fact is that we do not have real estate tax. We do have a utility fee which is a different type of levy. In theory, the real estate tax has certain advantages over other taxes because it has a less adverse effect on the economy, unlike a tax on labor or capital. It is also possible to introduce a fairer real estate tax system where newer and more valuable real estate will be taxed more, and the first real estate will be taxed less... But that real estate tax is also connected to taxes on inheritance and gifts, on rental and daily rent taxes. Ultimately, this can have an impact on the labor market because people who rent apartments have no incentive to join the labor market. Tax on daily rent in Croatia is extremely low compared to other forms of income and this is an area where certain reforms are needed
Is there room for further tax relief of the economy? Is work in Croatia overtaxed compared to other countries?
JF: We are highly taxed only when it comes to high salaries. For salaries that are 300% higher or more than the average salary, we really stand out in comparison to the countries of Central Europe in terms of total taxes and contributions. Here, we are at the level of the most developed countries. However, when it comes to the average salary and lower salaries, we do not stand out, and when it comes to the lowest, we are doing much better. However, reducing the tax burden for the highest salaries is a very sensitive issue and it would be easier to implement it together in a package with other tax system changes, such as the introduction of the real estate tax.
The World Bank is working on an analysis of the Croatian pension system. Are there already recommendations for its improvement?
JF: That analysis is still not completed. Now I can say that the hypothesis that this financial system is unsustainable is wrong. It is very sustainable. But the problem is its social unsustainability because by 2070 these pensions could be so low that they could create a social problem. One of the unpopular, but also better solutions, is a longer working life. You cannot expect a high pension with a short working life.
Inflation in 2022 was higher than originally predicted. How do you predict inflation to move this year and when can we expect the return of the target inflation of 2%?
JF: We corrected our inflation estimate and now it is at 6% for 2023. Toward the end of the year and in particular in 2024 can we expect a decrease in inflationary pressure, but this will depend on a number of factors. Primarily it will depend on the energy accessibility in Europe, foremost of gas. Inflation will also be greatly affected by the normalization of supply chains, which we have been talking about since COVID-19. If the energy and supply chains situation remains stable we can say that inflation will slow down faster. Of course, there is also the monetary policy and the question of how aggressively the European Central Bank will raise interest rates.
Growth estimates for Croatia in 2023 and 2024 also depend on all of the above. What are the growth estimates now?
JF: For 2023, it is 0.8%, and in 2024 we expect somewhat quicker growth, around 3%. In this year, we also expect a significant slowdown in personal consumption compared to last year. The reason is the rise in prices, which reduces purchasing power. We are also noticing slower growth in the export of goods. The tourist season, on the other hand, should be excellent. Unfortunately, the tragedy in Türkiye (the earthquake, of course) will bring about a greater influx of tourists to Croatia. The government has set the goal of reaching 75% of the EU income by 2030, but I think that we will achieve that level even earlier. So, our medium-term perspectives are good, but the long-term is more uncertain. That is why these reforms we are discussing are important.