Croatian National Reform Programme 2018 has opened the space for a discussion on potential (new) tax cuts in 2019. Many stakeholders have started to openly debate the key options for touching the tax and revenue side of the budget versus still high expenditures.

Many Changes, Still High Burden

Let us first take a quick look at Croatian tax history. During the 1990s Croatia was close to having a personal income flat tax. In 1998, VAT was introduced with a 22% rate (which was later increased twice towards the current level of 25%).

VAT has been the main source of budgetary funding, followed by social security contributions (which cover just a half of health and pension expenditures). In 2001, profit flat tax rate was reduced from 35% to 20%, while tax relief up to 100% was envisaged for private investment projects above a certain threshold.

In 2012, Croatia introduced relief on reinvested profits (majorly for material assets). Health care contribution (payroll tax) was reduced from 15% to 13%. On the other hand, VAT was increased from 23 to 25% (as relatively equal fiscal compensation for payroll cut). Moreover, a 12% dividend and capital gains tax were introduced.

In 2014, health care contribution was restored back to 15%. In 2015, basic personal income tax allowance was increased from HRK 2,200 to 2,600, while the threshold for marginal 40% income tax rate was increased from HRK 8,800 to 13,200.

In the years 2012-2015, dozens of changes on tax rates and administrative requirements have been made. Many enterprises were unable to follow new and unclear tax rules, not accessible in one place and with unified tax authority’s interpretations. Tax inspections were legally motivated to fine enterprises immediately, even for small offenses.

While the 2012 budget was the first to downsize overall central government spending, other budgets were characterized by spending increases. Prolonged economic recession (as compared with other EU Member States) and the absence of spending cuts (which would require serious structural reforms) easily stimulated deficit and public debt increased.

Towards 2017 Tax Reform

In 2016, a more comprehensive tax reform as well as fiscal consolidation started to be planned. In 2017, the tax reform was conducted with moderate tax cuts and certain administrative burden reductions. Marginal profit tax rate was decreased from 20% to 18%, while the 12% rate was introduced for small companies up to HRK 3 million of annual revenues. Investment incentives up to 100% were kept while reinvested profits incentive was removed.

Personal income taxation was simplified to only 2 rates (24% and 36%) instead of 3 previous rates (12%, 25%, and 40%). While the marginal tax rate was reduced, non-taxable personal income and tax thresholds were increased. More low income people were left out of taxation while enterprises saw moderate tax burden relief. VAT threshold was increased from 230.000 to 300.000 HRK. Real estate transfer tax was reduced from 5 to 4%.

Despite the 2016 and 2017 plans, the government abandoned the introduction of real estate/property tax, after the Taxpayers association “Lipa” gathered 146,000 petition signatures.

Tax Simplifications and Red-Tape Cuts

In addition to these tax cuts, the Tax authority started to embark on a partnership with enterprises to provide transparent information, unified interpretations of tax rules, and prevent sanctioning smaller offenses. The majority of enterprises complained mostly about tax rules and rulings. Therefore, the reform aimed to start changing this red tape labyrinth.

In2017 and 2018, comprehensive red tape cuts started to be implemented in many regulatory areas relevant for the economy, including tax procedures, which were simplified and digitalized. These red tape cuts are also related to the fact that Croatia has more than 500 non-tax levies or parafiscal charges, which are considered as small hidden taxes (with annual worth around 3% of GDP).

These include fees for various administrative procedures and licenses, obligatory fees for professional chambers regarding occupational licensing, prices of professional exams, membership in general economic chambers, radio and television, statistical classification of economic activities, water management, tourist promotion board, public forests etc. Specific reform activities focused on lowering burden regarding many administrative fees, certain professional chamber fees, statistics, tourism, and the fees for wood (while more measures have been planned).

It is estimated that overall, the 2017 and 2018 tax cuts released around 1% of GDP value to private sector and citizens’ pockets, while still ongoing red tape and market barriers cuts have simplified the way enterprises comply with tax and many other regulations through more than 400 already concrete measures.

Discussions for New Tax Cuts Created Two Main Options

Following the launched reform path, already strong business community and taxpayers’ requirements, the Croatian National Reform Programme 2018 has opened the space for a discussion on new tax cuts in 2019. Time is a friend since the 2016 central government budget has seen its first surplus (0.9% of GDP, followed by 0.8% of GDP in 2017).

With a surplus far from the 3% deficit limitation rule, Croatia left the EU’s Excessive deficit procedure. Moreover, Croatian Convergence Programme for 2018-2021 plans further downsizing of public debt. While its ratio in GDP was reduced from 84% to 78% in 2018, the fiscal consolidation plan aims to reach 66% of public debt in GDP by 2021. This could move Croatia closer to the EU’s fiscal discipline limit, which is necessary for entering the Euro zone.

The fiscal consolidation path is a necessary condition for a discussion on sustainable tax cuts. Market-oriented stakeholders reached a broad agreement that Croatia cannot afford new taxes but should rather go for (very) deep spending cuts through public sector reforms, which might finally (and at least moderately) be put on the implementation policy agenda. While further public debt should remain the priority, necessary for long-run prevention of new taxes and tax skyrocketing, there is a growing demand to control and reduce health care, pension and other budgetary costs.

Health costs are driven mostly by a huge public hospital network, while ¾+ of all pension costs are directed towards beneficiaries who are not regular pensioners. Therefore, many early and/or privileged pensioners will remain the hot issue for a sustainable budget development, starting with war veterans.

Two main options are on the agenda: labor taxation and VAT. If any of these tax policy options wins, the current health and pension system, financed half by both social security contributions and half by general taxes (VAT), would not remain sustainable in the same way. The excessive welfare systems are not sustainable in the long-run while high social security contributions distort and break many job opportunities. Therefore, Croatia should also consider options on what to do after the welfare state and how to downsize circa 46% of GDP general government spending.

The first option, related to labor taxation, also includes progressive personal income taxation created by a marginal 36% rate. Despite tax burden cuts in 2017, many enterprises are complaining that this 36% rate is uncompetitive with Croatia’s competing countries. This could put flat tax again on the agenda, especially among more free-market-minded stakeholders.

While flat tax Laffer curve effect has been proved on examples of Estonia and Slovakia (higher budgetary revenue due to dynamic effect of tax cuts), potential cases of downsized budgetary revenues in local and regional administrations should be on table in order to foster rationalization of excessive bureaucracy costs, territorial defragmentation and increasing revenues through enterprise and investments promotion.

The second option is to reduce VAT (the 2nd highest rate in the EU) from 25% to at least 24%. It should be taken into account that 1 or even 2 percentage points would have only small price effects, with a significant budgetary gap, which could limit the realistic space for ambitious first option as well as for further public debt reductions.

Taking into account very small VAT reduction effects and the fact that counting on both options would still limit desired effects on employment and investments, only labor taxation reductions should be considered.

Within newly launched project Croatia 2025 Centre for Public Policy and Economic Analysis stands for lower labor tax burden, which should tackle the main barriers that distort economic competitiveness, employment, and investment opportunities:

1. Eliminating progressive 36% personal income tax rate and keeping flat tax rate only (especially due to high chance for Laffer curve effect);
2. Abolishing social security contributions for unemployment protection (1.7%) and work injuries (0.5%), since necessary public money should be compensated through general taxes and spending rationalization;
3. Considering moderate social security contributions reductions regarding health care (15%) and general solidarity pension pillar (15%). The conditions for this option are significant health and pension cuts which would directly influence the dynamics of these cuts.

Moreover, besides labor tax reliefs, which should be the priority, the elimination of dividend and capital gains taxation, taxation of reinvested profits, and almost all administrative fees should be considered.

Conclusions

The first results of fiscal consolidation open a space for a sustainable discussion about tax cuts. Previous tax cuts released 1% of GDP worth value to taxpayers’ pockets, followed by ongoing red tape cuts and market deregulations. These moderately intensive reform trends have created a methodologically based contribution for slight increase of economic freedom.

Both policy options for new tax cuts are not easy solutions. It is hard to play with taxes without a serious reform agenda for public sector expenditures. Due to the fact that Croatia has the biggest tax burden in the EU (taking into account the second lowest level of economic standard) and due to sound budgetary balance, further and even more ambitious tax cuts should happen in 2019 (and with no new taxes under consideration).

This way, Croatia might be able to open the way to increase economic freedom, which simply means more money in taxpayers’ pockets.