A TIME FOR CHANGE
This week, the people of Croatia have spoken. With unemployment at 13% and only 58% of the working-age population actually working; with GDP falling by 1.2% in 2010 and estimated to grow at best by 0.5% in 2011, Croatians have voted for change. The newly elected government now faces the difficult task of finding an economic path that creates jobs and generates growth.
Here, the government should set two priorities: fiscal sustainability and increased competitiveness.
Fiscal sustainability means putting your public finances in order by not spending more than you can collect in taxes and borrowing only for growth-enhancing projects that can ensure repayment of those loans. There are only two ways to do this: increasing what comes in as revenues or reducing waste in what goes out as expenditures. Since tax evasion in Croatia is estimated to amount to 8% of GDP (almost HRK 30 billion), there is a lot of room for improvement on the revenue side. Tax collection can be improved, for example, by capturing cash-based transactions in restaurants, coffee shops, hair dressers, professional handyman services and the like. Revenues can also be raised by introducing capital gains and property taxes and incorporating “quasi-fiscal fees,” such as water management fees, utility connection fees, and Chamber of Commerce and notary fees, into the formal tax system.
The up-front priority must however be expenditure consolidation. This does not mean cutting spending across the board, or eliminating social programs for the poor or basic healthcare provision. But it does mean better targeting, to ensure that precious public resources go to the truly needy and vulnerable, and not, as they so often do now, to the wealthy and entitled. Moving in this direction will require structural reforms in the main areas of public expenditure – the pension and healthcare systems, social security benefits and the public administration. But there are some obvious places to look to eliminate waste: merit pensions consume 1.9% of GDP; subsidies to railways, shipyards and agriculture swallow another 2.5% of GDP; and public sector wages consume 10.5% of GDP – a far higher share than Czech Republic, Germany, Slovakia, or Austria. Better targeting in these areas would free up public funds for investment in areas that promote growth and competitiveness, for example in R&D and innovation, exports and dynamic industries.
The second priority is to increase competitiveness. Quick fixes, like devaluing the currency, will not make the country more competitive. Competitiveness entails support for R&D to spur innovation and growth; improved labor productivity through better education policies and more flexible labor legislation; and a better business environment to end the stranglehold of bureaucrats over businesses. This requires a wholesale change in the interaction between the public sector and private sector, as equal partners with a common goal.
Despite high rates of technology adoption, and the high level of research in universities and scientific think-tanks, the ability to forge research into commercially viable manufacture has eluded Croatia. Croatia spends a meager 0.8% of GDP on R&D, whereas the world’s leaders in innovation – Germany, Sweden, Finland, Israel, and Korea – devote at least 3-4% of GDP. This is a missed opportunity. For Croatia, a World Bank study has shown that investing an additional 3% of GDP in R&D now could yield an increase in GDP of as much as 6% by 2025.
While Croatian workers are generally perceived as hard-working and diligent, ‘hidden costs’– pensions, social benefits, and the like – make the average Croatian worker more expensive that his peer in other EU member states. Investors are also put off by the near-impossibility of firing redundant or even non-performing employees. This is where Government regulations hinder competitiveness and deter investors – foreign or domestic – from setting up shop in Croatia. Moreover, specialized, skilled staff are in short supply amidst a surplus of low-skilled labor. This is one reason it takes Croatian employers twice as long to fill a skilled vacancy than it does for their Bulgarian or Romanian counterparts. An outmoded skills mix highlights the urgent need to modernize the education system in Croatia. A recent World Bank study entitled “Skills, Not Diplomas” highlights this very issue in Croatia and across Central and South Europe.
The responsibility for reform lies squarely with the Government. The Government needs to reduce the red tape that is paralyzing business (and encouraging corruption) and pass laws and regulations that make it easier for business to work. There is an urgent need for a change in the way the public sector interacts with the private sector, so that businesses will start to feel welcome in Croatia and appreciated for creating jobs and contributing to the economy. Governments do not create jobs; it is the private sector – both local firms and foreign investors – that does this. This means government officials at the central, regional and local levels need to ask, "how can we make this happen?" or "how can we fix this problem?" It is a mindset change from one of restricting and regulating private businesses to one of assisting and nurturing them.
These reforms, like all economic reforms, are inter-twined and must be addressed in a comprehensive way. With a fresh mandate from the people, the new administration must focus on making Croatia a more competitive society that can create the private-sector jobs that are the only possible foundation for durable prosperity inside the EU. Without addressing core structural problems, things can in fact turn for the worse for Croatia, especially given the fragile state of the world economy. The need for bold, sweeping reforms is clear. The time for change is now.
The authors Hongjoo Hahm is the World Bank Country Manger for Croatia and Louisa Vinton is the United Nations Development Programme Resident Representative in Croatia.