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Fiscal adjustment continued during 2012 despite the fact that real GDP fell by 0.7%. The rates of major taxes remained unchanged. Fiscal cooperation between different levels of governments substantially improved during 2012, resulting in an early December 2012 adoption of the state (Institutions of BiH) and two entities central government budgets for 2013. Actions by Council of Ministers (CoM) of Bosnia and Herzegovina (BiH), formed at the beginning of the year 2012 after long delay following October 2010 elections, signaled strong determination to reverse the trend in quality of public expenditures. Faced with substantial increase in debt servicing in 2013 and 2014, authorities adopted unpopular measures such as nominal wage and allowance reduction, already in 2012. The adjustment measures are expected to bring fiscal system in primary surplus territory in 2013 and first stabilize, and subsequently, reverse the increasing trend in debt to GDP ratio. IMF program approved in September 2012 provided needed financing and focused policy making to the actions that target structural weaknesses.

Should government increase tax rates if overall public expenditures are too high and of inadequate quality?

Year 2012 didn’t bring major changes in the structure of public revenues. The most important taxes were left unchanged, despite the increasing need for financing, as debt servicing (interest plus principal) had increased by more than 50% in 2012 compared to 2011. The size of government as measured by overall revenue stands close to 47% of gross domestic product and further increase in taxes would hardly be justified. Excises on tobacco have been increased, following the need to reduce discrepancy between tobacco taxation in Europe and potential candidate countries in a smooth manner.

The key challenge with respect to the taxation policy in BiH is related to labour taxation, including mandatory social contributions, given that unemployment at almost 28% (labour force survey definition) is exceptionally high. In that respect, year 2012 didn’t bring any improvement in the incentives for increasing labour force participation and reducing grey economy. Pension and health funds remain under fiscal pressure, making social contribution rate reduction impossible without offsetting pension revenue or expenditure measures.

Wages in Institution of BiH were reduced by 4.5% and hiring of new employees was frozen.

Real GDP is projected to have fallen around 0.7% in 2012, after two years of only modest recovery. Fiscal adjustment continued, partly under the IMF supported program. Authorities decreased wages for the employees in the public sector, and commit to refrain from hiring, tackling the long recognized structural weakness. These measures were needed as public wage bill stands at around 13% of GDP, and wages in public sector are higher than comparable wages in the private sector.
Fiscal cooperation improved and by the end of the year, in early December 2012, budget of the Institutions of BiH, Republika Srpska and Federation BiH Central Government were adopted for year 2013. In addition, fiscal adjustment reflected in the fact that entity budgets are projected to book primary surpluses due to the higher debt servicing, will continue in 2013.

Once politics was removed from budget negotiation process, authorities at different levels started with measures that should ultimately improve the structure of expenditures.
First, the law allowing retirement of the decommissioned soldiers (some as young as at the age of 40!) who took part in the war was annulled at the national level. In spite of several weeks protest by war veterans and demobilized soldiers in front of the government building, and notwithstanding political costs, CoM insisted that privileged pensions must be dealt with in a systematic manner at the entity level. This not only helped to reduce future burden on the budget of Institutions of BiH but also forced preparation of the law on privileged pension that will not jeopardize functioning of the pension system (which operates under PAYG principle.) The Law in Federation BiH is about to be adopted, as precondition for the IMF disbursement.

Politics against policy

Full picture of the positive developments in 2012, however, can only be understood once political events in 2011 are explained. After October 2010 general elections, CoM was not formed until January 2012. Budget for 2011 was not adopted and Institutions of Bosnia and Herzegovina had to operate for the whole 2011 on temporary financing. Once the CoM was formed, the two budgets of Institutions of BiH were adopted, namely for 2011 at the level of execution, in January 2012, and for 2012 in May 2011 . During the political blockage of the adoption of the 2011 budget of the Institutions of BiH, different interpretations of the legal mechanisms for foreign debt servicing led to a bizarre situation that, in spite of the fact that two entities from whose revenues debt is serviced provided enough funds, CBBH couldn’t make the transfer to creditors because of Minister of Finance reluctance to sign the payment order. This damaged country’s reputation, although subsequent actions by government, including through the changes in legislation, minimized the incident (see Moodys report, July 2012).

Fiscal federalism in BiH is very simple to explain: more than 80% of the total tax revenues come from the indirect taxes. Indirect tax revenues are collected centrally to the single account, from which the Institutions of BiH have the first drawing right, in the amount adopted in the annual budget for Institutions of BiH. The remaining is shared by Brcko District (fix share of 3.55%) and the entities based on the registered consumption on their territory. Funds for servicing foreign debt obligations are automatically earmarked at the single account, before disbursement to the entities. Neither Institutions of BiH nor Brcko District participates in the risk stemming from fluctuation in indirect tax collection. Essentially, it is zero sum game with entities taking the burden of fall in revenue as well as taking the increase in indirect tax revenues booked in their territory. Direct taxes as well as social contributions, policy decisions and revenue collection, are under the control of subnational governments. Roughly, Institutions of BiH budget gets between 13-15% of total indirect taxes, whereas, total expenditures at the state level are around 8% of total public expenditures. The key spending decisions are made at the entity level.

Is coordination better than centralization in terms of securing fiscal sustainability?

Fiscal and budget policy coordination is done through the Fiscal Council—an intergovernmental body established in 2008 whose voting members are the Chairman of the CoM, the Minister of Finance and Treasury of BiH, and the prime minister and minister of finance of each entity. The Governing Board of the Indirect Taxation Authority, whose voting members include state and entities’ ministers of finance, makes policy decisions regarding indirect taxes. Fiscal council, according to the Fiscal council law, set up primary fiscal targets.

The essence of political disagreement over 2011 budget was the size of the indirect tax share that should be spent through the budget of Institutions. In the past, Institutions of BiH were regularly taking more from the single account than they could spent, leaving less for the entities who had to borrow to finance mandatory expenditures assigned to them. Once realistic revenue figure for the budget of Institutions of BiH was agreed at the Fiscal council, the budget adoption at the Parliament was secured.

When looked from a non-political point of view, the budget of Institutions of BiH is mostly used to fund foreign affairs, defence spending, and indirect tax authority—exclusive competencies that are assigned at the national level. A majority of functions of government and public expenditures (police, education, social spending, subsidies, judicial system etc.) are therefore assigned to subnational governments. The ideology of state building, partly supported by a still strong presence of international community in BiH, insisted that the more money will be allocated at the state level—the level of Institutions of BiH, the stronger the BiH will be. This approach follows the logic “functions would follow funds”, which is non-implementable since at least one subnational government, with de facto veto mechanism in the BiH Parliamentary assembly, is strongly opposing it.

Beauty of federalism: can’t err fast

Reasonably low level of direct tax rates (10%) and the fact that single VAT rate of 17% was left unchanged since its introduction in 2006 are direct consequence of the fiscal architecture and decision making process with several actors. Faced with lower economic activity Republika Srpska government introduced changes to the corporate income tax, exempting the interest paid to loans for financing assets, machinery and buildings used for production. Similarly, Federation BiH Corporate income tax law envisages tax exemption of the corporate income tax if the company exports 30% of its sales. If, despite those decisions, BiH scores poorly on different indexes that measure quality of institutions, and private sector associations frequently complain on the high cost and expensive tax compliance, this is imputable to the poor quality of the bureaucratic apparatus, not to poor policy choice or inadequate fiscal architecture.

There are implicit checks and balances between subnational governments (entities and Brcko District) with respect to the potential attempts to increase direct taxes. Indeed, the entity government that would try to increase direct taxes would look bad in comparison to the entity that leaves its rates unchanged. That would create incentives for businesses to register in the lower tax jurisdiction. Although tax system sometimes may seem overly complicated, or may be presented in such a manner by those who would prefer more centralized organization of the country, it did not trigger any irresponsible behaviour during the crisis. As explained, during 2012 governments opted to remove the most obvious weaknesses in the structure of expenditures.

Are existing fiscal rules sufficient?

The uncertainty with respect to economic recovery in a wider regional context, a possible fall in revenues, or the arrangement with the IMF going off track, may triger different policy behaviour, namely, re-examination of the spending side measures.
Since major spending decisions are made at the entity level, as well as debt servicing, it is worth mentioning here what existing fiscal rules are. In Republika Srpska, there is a total consolidated debt limit of 60% of GDP. In addition, short term debt is limited at 8% of the consolidated revenues from previous year, whereas guarantees (exposure) are limited at 15% of GDP in given year. Local units (municipalities) may contract additional debt, if and only if future repayments are not exceeding 18% of revenues from the previous fiscal year. Short term debt of local units can’t exceed 5% of total revenues from the previous year whereas guarantees are limited to 30% of previous year revenues.
In Federation, there is a similar rule fixing a maximum of debt servicing at 18% of previous year revenue, consolidated for Federation Central Government and Cantonal governments. Cantons and local government can borrow if the debt servicing in future period doesn’t exceed 10% of the revenues collected in the previous year.

EU accession, or plan B?

BiH, still without formal application submission, lags behind neighbouring countries in the EU accession process. Resolution of the major political issue is still uncertain:,implementing the decision of the European Court of Human rights that requires removing the obstacles for citizens which do not declare themselves as members of one of three major nationalities (Bosniaks, Croats, Serbs) to be elected in Presidency. The social and political consensus necessary to find a solution to suppress the discrimination is missing. In the meantime, it is said that corruption in public tenders takes away almost 800 millions KM annually, or more than 80% of the budget of Institutions of BiH! (see more details on www.tender.ba) Assuming this information even only half correct, who could still argue for more taxation when the public sector is so much abused for private interests?

EU accession process could help to establish rule of law, but plan B, prolonged non-accession, should not be ruled out. In any case, although growth is expected to return to positive territory in 2013, the need for further reductions in public expenditures will be present in years to come.

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