Fiscal competition and economic freedom


Fiscal competition and economic freedom

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Taxation in Serbia compared to other European tax systems


Monday 2 December 2013, by IREF, Miroslav Tomic

From the perspective of fiscal adjustment, year 2012 was lost. In an attempt to collect more revenues, government increased general VAT rate, excises on tobacco, personal income from capital gains…. Government has also prepared the draft of the Law on Corporate income tax proposing an increase in the rate from 10% to 15%. Simultaneously, government abolished dozens of quasi-fiscal charges (communal taxes, different fees) in an attempt to improve business environment. Despite the tax measures that helped increase the revenues, government’s budget actually ended with higher deficit for the simple reason that additional expenditures were higher than additional revenues. The recently adopted general fiscal rules are not likely to be honoured in the medium term. Getting priorities right is difficult, dispensing with populist policies even harder. Risks of fiscal unsustainability are elevated.

Should government tax more all citizens to grant subsidies to buyers of Fiat produced in Serbia?

Looking at the tax and budget policy in 2012, the answer to questions similar to this one is clearly positive. General VAT rate was raised from 18% to 20% in October 2012. Tax rate on personal income from dividends, interest, personal insurance premium, and capital gains has been increased from 10% to 15%. Fixed share of excise on tobacco was increased from 33 dinars to 43 per 20 cigarettes whereas proportional excise from retail price was reduced by 1 percentage point (from 34% to 33%). An excise on diesel was increased from 37 to 42 dinars per liter, whereas excise on LPG has been increased from 18 to 30 dinars.
The fact that government has prepared a draft law on corporate income tax including an increase in tax rate from 10% to 15% is reflection of the need to provide for permanent increase in revenues, the need which is better understood if a broader picture of fiscal problems is taken into consideration.

Changes in fiscal architecture: recognition of the problems in public finances

Serbia had undergone interesting changes in its fiscal architecture since the onset of the crisis. First and foremost, Fiscal council, independent government body responsible to the National assembly, was established in October 2010 and became operational in April 2011. The need to establish a new body was recognition that existing institutions are insufficient to secure fiscal sustainability and maintain fiscal risks under control. Second, concomitant to the establishment of the Fiscal Council, fiscal rules were enacted providing for general and specific targets to policy makers. The task of the Fiscal council, whose President is proposed by President of the Republic of Serbia and whose two remaining members are proposed one by Minister of Finance and the other by the Central Bank Governor, consists among other things, in the evaluatation of fiscal policy strategy proposed by the government and assessment of the budget execution against the fiscal targets. General fiscal rules set upper limit for public debt to 45% of gross domestic product (gdp), and fiscal deficit in medium term to 1% of gdp. Deficit rules allow for countercyclical fiscal policy, allowing for deviation of the fiscal targets if the gdp is below/above potential gdp growth rate, assessed to be 4% for the period 2011-2013. Specific rules target one of the major weaknesses of public expenditures, namely reduction of current expenditures for the pensions and limiting the growth of the wages of public servants. Serbia spends more than 13% of gdp to the pensions and specific fiscal rule enacted in the Law on budget system sets a target at 10%. Similarly, public wages take around 12% of gdp and the goal is set to reduce it to 8%.

Will that be enough?

Neither introduction of the independent body nor enactment of the fiscal rules will guarantee fiscal sustainability. If the public and politicians are not willing to change the habits, forgone private political interests, rules will not work and targets set will not be achieved. However, the functioning of the Fiscal council represents huge improvement in the availability of information and professional evaluation of the policies proposed by the government. Lack of realism in revenue projections, overoptimism in expectations from the enactment of policy measures, or wrong policies all together are now identified more easily. The establishment of the Fiscal council definitely contributed to the quality of the public debate. Of course, there is no guarantee that Fiscal council will in all instances provide good advice, particularly if it operates under implicit assumption that social/political constraints for adequate policy making are very strong. Quality of the policy making depends ultimately on the demand from general public.

Initial performance under the rules is not encouraging

General government public debt in Serbia increased from 30% in 2007 to 61.5% (63%) at the end of 2012. Several factors contributed to this dramatic increase: nominal depreciation of the dinar, real GDP fall, and huge fiscal deficits. Public debt of the central government increased from € 14.7 billion at the end of 2011 to more than € 17.6 billion end of 2012. The fact that fiscal numerical target (upper limit of the debt to GDP ratio) was exceeded soon after its enactment, did not help to increase credibility of the fiscal policy. On the contrary, if there is enough courage to implement the politically expensive but economically beneficial measures, it is doubtful whether enacting the rules is actually just waste of political energy. The general fiscal rule remains as a sort of the anchor or future goal to be reached. In the meantime, government has to start with bold fiscal adjustment consistent with attainment of the debt rule, under difficult economic circumstance.

After timid recovery of real GDP in 2011 by 1.6%, real GDP felt by 2% during 2012. Faced with lower than expected growth and revenue collection, Government rebalanced the budget, adopting the measures both on the revenue and expenditures sides. Fiscal council was critical of the rebalanced budget because the deficit has actually increased compared to the original budget (see Ocena rebalansa budgeta za 2012 godinu i predloga zakona sa fiskalnim uticajima, available at ).

The revenue measures taken in 2012, should be seen as a firefighting measures in the context of radical increase in public debt and increasing need for financing under unfavorable terms. These measures notwithstanding, the booked fiscal deficit not only was bigger than originally planned but also widened compared to the 2011 by almost 2% of GDP. However, since the real GDP is projected to have fell by almost 2% in 2012 (against 4% assumed potential growth rate used for application of the fiscal rule), the deficit widening for proponents of the countercyclical fiscal policy is not entirely against the logic. This reasoning, however, has to be confronted with the quality of public spending.

Populist measures and delayed adjustment

Professionalization of policy making might not work if the general public demand wrong policies. Radical policies, policies that reduce benefits rarely win elections. Serbia, is not an exception in this regard. Although Fiscal council advocated fiscal consolidation through expenditure reduction, it was actually also advocating further increase in the general VAT rate from 18% to 22% (and to use the additional revenues to decrease labor taxation). The increase in taxes that occurred in 2012 will contribute permanently to the increase in tax revenues, and is therefore expected to contribute to the deficit reduction over the coming years.

The arguments for increase in taxes should be evaluated against additional spending that is financed from higher tax revenue. Securing fiscal sustainability and avoiding debt crisis would require bold policy measures, such as reducing the size of the public system, transformation of the state owned enterprises, reducing the pension benefits, and better targeting grants to individuals. Is this what the government is using the money for? No. Transition that has never finished in Serbia means above all change in the life style, change in habits, and change in expectations from the government. Not true reforms.

Like in many other countries, employees of the public system receive premium over the comparable private sector wages. In addition, again like in many other countries, there are potentials for reducing number of employees in the public sector. But nothing is done. Meanwhile, the answer to the question why government should subsidies FIAT’s car buyers is twofold: an attempt to attract foreign investors and the protect domestic production in difficult times, both justification, in my view, relying on wrong understanding. Therefore, despite expected positive effect of the tax increases to satisfy general fiscal rules (debt to GDP of 45%, deficit 1%), the poor performance on the expenditure side raise concerns whether the consolidation will really occur.

Fight against corruption: real change or populist window dressing?

Year 2012 saw also an inflation of high-profile business fraud and corruption cases. The jury is still out whether these cases where just political processes, window dressing or proper criminal prosecution. The public welcomed arrest of some extremely wealthy persons that get rich in privatization processes. If this is a sign of decisive action that will result in breaking the nexus between corrputed offcials and priviliged business, the outcome might be beneficial not only for cost of goverment, but for creation of an environment more conducive for unpopular measures.

Government’s best bet: continue removing obstacles to business

Government failed to increase credibility of fiscal policy in 2012. Although experts generally welcomed tax measures that are expected to increase revenues permanently, serious threat to the fiscal sustainability results from quasi-impossibility to enact more radical adjustment on vulnerable categories (wages, public employment, and pensions), dangerous increase in debt and violation of the general fiscal rule. On the positive side, removal of more than 100 quasi-fiscal fees with will reduce burden to business, particulary for start ups. More business friendly measures are needed if debt sustainablity is to be secured.

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