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Republic of Serbia: 2013 Article IV Consultation

Author(s):
International Monetary Fund. European Dept.
Published Date:
July 2013
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Exploring Options for Enhancing Fiscal Consolidation1

Fiscal slippages in 2012 have led to the breaching of the fiscal rules, and increased the fiscal deficit and general government debt. Recognizing the associated risks, the authorities have implemented a range of tax increases, lowered the indexation of wages and pensions, and adopted a medium-term fiscal strategy. In order to put the public finances on a sustainable footing, additional measures should be considered. These could include reducing discretionary spending, tackling high wage and pension bills, and accelerating the implementation of structural reforms, notably on pensions, SOEs, tax administration and PFM.

A. Background

1. Fiscal slippages occurred in 2012. The fiscal deficit reached 7.6 percent of GDP in 2012, well above the original budget and the maximum deficit allowed under the fiscal deficit rule.2 This was mainly driven by election-related spending, recapitalization of nonviable state-owned banks, and changes in the fiscal decentralization law which worsened vertical imbalances. High fiscal deficit combined with large issuance of guarantees propelled public debt to about 62 percent of GDP in 2012, up from about 50 percent of GDP in 2011 and well above the legal ceiling of 45 percent of GDP.3

2. To tackle rising fiscal deficit, the authorities announced in late 2012 a fiscal consolidation package which included tax increases and expenditure rationalization. Among the revenue measures: (i) the standard VAT rate was increased from 18 percent to 20 percent, while the reduced rate of 8 percent remained unchanged;4 (ii) the CIT rate was raised from 10 to 15 percent, and some tax incentives are eliminated; (iii) the personal income tax rate on dividends and interest incomes increased from 10 to 15 percent; and (iv) excise duties on cigarettes and petroleum products also increased. On the expenditure side, the measures focused on capping the indexation of wages and pension indexation, and setting tight ceilings on discretionary spending. Moreover, efforts to integrate own sources accounts into central government budget are expected to yield some savings. Overall, the net budgetary impact of the measures is estimated at 2 percent of GDP in 2013.

Fiscal Deficit Estimates, 2012

(Percent of GDP)

Sources: National authorities and IMF staff estimates.

Public Debt Estimates, 2012

(Percent of GDP)

Sources: National authorities and IMF staff estimates.

B. Achieving a Credible and Durable Fiscal Consolidation

Serbia’s general government finances in a cross-country setting

Expenditure

3. The level of general government spending in Serbia is high relative to other countries, reflecting mainly large wage and pension bills (Figure 1). Spending as a share of GDP rose from 42 percent of GDP in 2005 to 49 percent of GDP in 2012 (of which 0.8 percent of GDP accounted for bank recapitalization). While investment spending is relatively low, current spending accounts for the bulk of expenditures, with the biggest contributors being the wage and pension bills. Pension spending has been particularly high as a share of GDP—double the average for emerging countries, and about 50 percent more than the average of advanced economies.5 Similarly, Serbia’s wage bill also stands out in a cross-country comparison. The wage indexation rule was designed in a way that, if strictly applied, the wage bill ratio to GDP will trend down gradually over the time.6 But, in practice the wage bill growth has exceeded the percentage increase implied by the indexation rule due to one-off increases (wage bonuses) and a persistent wage drift.

Figure 1.General Government Expenditure in Serbia and Selected Economies

1/Latest data available.

Sources: National authorities, World Economic Outlook and IMF Staff estimates.

Revenue

4. Serbia has a relatively strong revenue collection. Serbia’s revenue to GDP ratio compares favorably to the average of emerging economies, and is close to that of advanced economies. Looking at the structure of revenue offers more insights. In contrast to many other countries, social contributions make up a large share of government revenues in Serbia. Furthermore, while Serbia performs better than its peers in VAT and excise collection, it lags behind in corporate income tax revenue. Finally, it relies to a larger extent on nontax revenues, which tend to be more volatile.

General Government Revenue in Selected Economies, 2012

(Percent of GDP)

Sources: National authorities and World Economic Outlook.

Structure of Government Revenue, 2012

(Percent of GDP)

Sources: National authorities and World Economic Outlook.

Public debt

5. Serbia’s general government debt has considerably increased in the recent years. This has reversed the gains from the earlier debt relief (Figure 2).7 Although the recent increase in debt was partly due to the global financial crisis and the associated output weakness, fiscal policy was also played a role as the deficit rule was breached. Issuance of debt guarantees and more recently bank recapitalizations, have also contributed. As a result, Serbia’s public debt is relatively high compared to the average of the European emerging economies.

Figure 2.Public Debt in Serbia and Selected Economies

Sources: National authorities and World Economic Outlook.

Possible options to strengthen fiscal consolidation

Expenditure measures

6. A sustainable reduction in spending would have to rely, in large part, on mandatory spending. Mandatory spending (wages, pensions and transfers, interest payments) accounts for about 2/3 of total government expenditure. Therefore, any credible and durable expenditure-based consolidation would have to reduce significantly the share of mandatory spending, particularly wages and pensions. This would also be key to creating fiscal space for investment to support growth. Maintaining the level of transfers to households but improving their targeting could create savings, while the vulnerable segments of the population would remain protected. However, there is a room to make savings on transfers to sub-national governments in order to enforce fiscal discipline.8 Discretionary spending can also be contained, notably by controlling goods and services and rationalizing state subsidies.

7. Freezing public wages and pensions would help contain public spending. Options to reduce the wage bill ratio to GDP include cutting public workforce, reducing wage levels or its growth rate. Given the currently high unemployment rate (over 22 percent), shedding public sector jobs at a time when the private sector has limited room to absorb them would further increase the unemployment rate in the short-term. A wage and pension freeze during 2009–2010 has helped contain the growth of mandatory spending, and could be considered again.9 This could be complemented by a control of the public sector employment, but this requires a comprehensive registry of public employees which has yet to be completed.

8. A credible consolidation strategy should also tackle discretionary spending. Spending on goods and services and subsidies could be reduced to their historical levels,10 but this should be backed by an effective reduction of functions and programs performed by the line ministries. In the case of subsidies, not only there is a need to reduce their overall size, but it would also be critical to refocus them towards those that incentivize productive investments. Efforts to contain spending on goods and services and subsidies should be complemented with a comprehensive system to track accumulation of arrears in order to prevent their accumulation.

Revenue measures

9. Consideration should be given to broadening the tax base, given the recent increase in tax rates in 2012. This would help improve revenue collection without further increasing tax rates, minimize economic distortions from numerous tax exemptions, and reduce compliance costs.

10. Serbia’s new VAT rate of 20 percent is in line with the average of emerging and advanced economies, but the tax base could be expanded. In particular, the following measures could be considered: reducing the list of items subject to the reduced VAT (8 percent)—this in line with EU requirements—and eliminating VAT refunds on the first purchase of residential property. Additionally, the reduced rate could also be increased from 8 to 10 percent following the recent increase in the main rate, although this may have social implications given that food prices will be affected.11 Moreover, recent initiatives to increase VAT refunds (for example for farmers) and expand the list of items subject to the reduced rate (such as some foods, and equipment) undermine fiscal consolidation, and should be reversed.

Standard VAT Rates, 2012

(Percent)

Sources: National authorities

Standard CIT Rates, 2012

(Percent)

Sources: National authorities

11. The CIT rate was increased from 10 percent in 2012 to 15 percent in 2013, but exemptions remain. That CIT incentives cost about 90 percent of total CIT collection in 2008 (IMF, 2010b), suggesting that there is room to reduce the numerous deductions that erode the tax base. Streamlining current accelerated capital allowances, tax credits and tax holidays would improve revenue collection significantly while maintaining the current low CIT rate.12

Strengthening structural reforms

12. Successful fiscal consolidations are often supported by structural reforms. While the authorities’ fiscal strategy adopted in November 2012 lays out a number of critical structural reforms, details about the key policy actions, the implementation schedule, and the prioritization of the reforms need to be fleshed out. Also, the reforms need to be well prepared, and their implementation should take into account capacity constraints. Their implementation often takes time and their benefits are not always immediate. The most critical structural reforms to support fiscal consolidation include health care and pension reforms, reforms of SOEs, and PFM reforms.13 Priorities include:

  • Implementation of parametric pension reforms, including introduction of actuarial penalties for early retirement, equalization of the retirement age of women and men, and raising both to 67 years;14
  • Contain health spending by improving the procurement system of the Health Fund, phasing in a capitation based payment system in primary care and an output-based system in hospital care, imposing a cap on the duration of sick leave benefits, increasing the level of co payments, and rationalizing the number of nonmedical staff in primary health care facilities. These measures can substantially reduce health spending without compromising quality of health care services;
  • Speed up reforms of public enterprises and accelerate the privatization process to contain subsidies and contingent liabilities (in particular government guarantees);15
  • Step up efforts to implement key PFM reforms, such as setting binding medium-term expenditure ceilings, putting in place an effective inter-governmental fiscal coordination, and moving to program and performance budgeting;16
  • Accelerate the modernization of tax administration to improve tax compliance;
  • Rationalize public employment, and spending on goods and services through outsourcing in non-core functions, such as transport, security, mail, cleaning catering, and maintenance.
References

    International Monetary Fund, 2010a, Strategies for Fiscal Consolidation in the Post-Crisis World. Washington: International Monetary Fund.

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    International Monetary Fund, 2010b, “Serbia: Options for Growth-Enhancing Tax Reform,”Technical Assistance Report. Washington: International Monetary Fund.

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    International Monetary Fund, 2010c, “Serbia: Options for Expenditure Rationalization: Addressing Symptoms and Causes,”Technical Assistance Report, Washington: International Monetary Fund.

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    World Bank, 2009, “Doing More with Less: Addressing the Fiscal Crisis by Increasing Public Sector Productivity,”Washington: The World Bank.

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1

Prepared by Roland Kpodar (FAD).

2

According to the fiscal responsibility law enacted in 2010, the fiscal deficit should not be higher than the fiscal deficit of the previous year, corrected for 40 percent of the output gap (potential real GDP growth rate is set at 4 percent) and 30 percent of the deviation from the medium target of 1 percent of GDP.

3

The public debt rule was breached ex post in 2011 following a downward revision in GDP, and higher issuance of guarantees in late 2011. Appendix 1 summarizes issues with the definition of public debt in Serbia.

4

The change in the VAT law entails revenue loss of about 0.2 percent of GDP (of which about half is one-off revenue loss) due to the shift to VAT payment upon collection for small and medium enterprises, higher VAT refund for farmers, and the increase in the VAT threshold.

5

See Selected Issues Paper, “Pension Reform in Serbia.”

6

Wages and pensions are indexed on inflation and real GDP twice a year in April and November. Wages increase in April by the past six month CPI inflation plus half of the previous year real GDP growth, and in November wages are adjusted upward by the past six month CPI inflation, provided that inflation and real GDP growth are positive. With regard to pensions, the April indexation is based on the past six month CPI inflation plus any percentage points of the previous year’s real GDP growth above 4 percent (the authorities’ potential GDP growth), whereas the November indexation allows an increase in pensions by the past six month CPI inflation.

7

Serbia inherited a large share of the former Yugoslavia’s external debt. The Paris Club agreed in 2001 to cancel 66 percent of US$4.6 billion of Serbia’s debt, (23.4 percent of total external debt in 2000—US$2.4 billion upon signing a Stand-By arrangement with the IMF (2002) and USD$ 0.6 billion upon successful completion of the arrangement (2006). The remaining US$1.6 billion was rescheduled. This was followed by the London Club which in 2004 wrote off 62 percent of the US$2.7 billion external debt Serbia owed to commercial creditors.

8

Selected Issues Paper “Has Sub-National Spending Added to Fiscal Pressures?”

9

The Selected Issues Paper “Pension Reform in Serbia” provides additional reform options which focus on fixing the structural imbalance in the pension system.

10

The average levels over 2007–11 are reasonable benchmarks.

11

However, the use of reduced VAT rates is an inefficient way to provide relief for low-income families; expenditure policies, in areas such as education and health, may be more effective tools for pursuing equity objectives than the use of differential VAT rates (IMF, 2010c).

12

Selected Issues Paper “Corporate Income Tax and Other Corporate Taxes” and IMF (2010b).

13

These measures are discussed in depth in IMF (2010c), and the 2009 Public Expenditure Review conducted by the World Bank.

14

Selected Issues Paper “Pension Reform in Serbia.”

15

See Selected Issues Paper “In Search of an Effective Growth Model.”

16

Structural reforms are discussed in depth in the Selected Issues Paper “Diagnosing and Addressing Serbia’s Structural Fiscal Challenges.”

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