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### Business environment and growth constraints
- Pre-crisis growth (2004–08) driven by capital inflows and domestic demand boom; model vulnerable with:
  - high share of nontradables;
  - low domestic savings;
  - fragile external position.
- Trade and financial integration:
  - goods exports to GDP remained about 20 percent over 2006–11.
  - exports concentrated in agricultural products, textiles, metal industries; automobiles added more recently.
  - remittances and foreign borrowing predominant in financing the trade deficit; FDI inflows volatile.
- Structural bottlenecks:
  - complicated business laws and regulations deterring solid FDI and private sector growth;
  - labor market rigidities (severance pay system, centralized wage bargaining, complex firing procedures);
  - large, subsidized, protected public enterprise sector (Privatization Agency portfolio and SOEs), many loss making and dependent on government support.
- Fiscal burden of SOEs and related statistics:
  - total direct state support to enterprises in the Privatization Agency portfolio and commercial and utility SOEs estimated at 2.5 percent of GDP over 2010–11;
  - stocks of guaranteed debt and arrears estimated at some 12 percent of GDP at end 2011;
  - end-2010: Privatization Agency portfolio enterprises ~5 percent of formal employment; large public utilities and commercial SOEs ~6 percent.
- Privatization momentum slowed: annual privatizations fell from average 320 (2002–2008) to about 47 (2009–2011).

### Policy recommendations to improve business environment and competitiveness
- Overarching goal: comprehensive structural reforms to remove bottlenecks and achieve durable, export-oriented growth; calibrate breadth, balance, and sequence.
- Improve business environment:
  - abolish parafiscal charges (recent initiative cited as a first step);
  - advance competition policy, tax administration, property rights, and real estate legislation;
  - prioritize reforms with clear timeframes.
- Labor market reforms:
  - remove disincentives for job creation;
  - make wage bargaining and employment procedures more flexible while maintaining adequate social protection.
- Public enterprise reform:
  - plan and budget reforms under detailed cost-benefit analysis;
  - front-load implementation while ensuring sustainability;
  - accelerate privatization and corporatization in coordination with the World Bank;
  - enforce rigorous wage and employment policies based on performance;
  - gradually increase public utility tariffs to cost recovery levels;
  - enforce strict limits on subsidies and issuance of guarantees.
- Macroeconomic stance:
  - maintain macroeconomic stability through prudent policies; a well-targeted reform package should boost confidence and can have positive near-term growth effects.

### Labor market — outcomes, rigidities, and reform options
- Key indicators:
  - participation rate: declined from 66 percent in 2004 to about 60 percent in 2012;
  - unemployment rate (Labor Force Survey): increased to more than 23 percent (2012);
  - employment rate: fell to 46 percent in 2012.
- Youth and long-term unemployment:
  - unemployment rate age 15–24: exceeded 51 percent in 2012;
  - long-term unemployment share: 78 percent in 2012.
- Informal and public sector employment:
  - informal employment ≈ 500 thousand persons, or 19 percent of overall employment;
  - public sector employs 43 percent of registered employment in legal entities, or 26 percent of overall employment;
  - 2011 employment profile shares: Public sector incl. SOEs 26%; Legal entities (private) 34%; Entrepreneurs 18%; Informal 22%.
- Labor cost wedges (manufacturing):
  - personal income tax: 12 percent on a taxable base; employee’s social security contribution: 17.9 percent of gross wage;
  - 2012: net average wage in manufacturing ~27 percent lower than average gross wage;
  - 2011: TLC in manufacturing ~23 percent higher than gross wage; employer social security contribution explains 17.9 percent of this difference;
  - 2011: overall tax wedge in manufacturing (TLC minus net wage) amounted to 41 percent of TLC or 70 percent of the net wage;
  - Fiscal Council estimated fiscal burden = 64 percent of the net wage (difference due to exclusion of severance payments and other labor-related expenditures).
- Trends and productivity:
  - 2001–2008: average real gross wage increased by 174 percent while productivity increased by 47 percent;
  - 2009–2011: real wage growth slowed but wage–productivity gap persisted;
  - 2011 TLC in manufacturing: actual TLC = 534 Euros per worker per month; fitted TLC = 475 Euros; deviation = 11.4 percent.
- Labor market policy recommendations:
  - reduce employers’ social security contribution rates when fiscal space allows and strengthen Tax Administration and Labor Inspection to broaden the tax base;
  - revise severance payment formula to base severance on length of employment with the last employer;
  - simplify dismissal procedures and clarify fair dismissal conditions;
  - give priority to firm-level collective agreements or discontinue extending industry agreements to all companies;
  - boost Active Labor Market Policies (ALMP) — spending currently significantly lower than peers;
  - maintain adequate social safety net during increased labor market flexibility.

### Employment Protection Legislation (EPL) and severance specifics
- Serbia’s 2005 Labor Law amendment increased regulation and is more restrictive relative to regional peers.
- Severance payment rule unique: calculated on lifetime employment (⅓ of most recent average monthly salary per year for first 10 years; ¼ for each subsequent year); example: 30 years of employment → 8⅓ monthly salaries.
- Dismissal procedures:
  - collective dismissals require mitigation program, consultations with trade unions and National Employment Service;
  - individual dismissals for performance require proofs and notice 1–3 months; economic dismissals require a letter and severance payment and rehiring obligation within six months if position reopens.
- Fixed-term contracts limited to one year; 5 days over 12 months treated as indefinite duration.
- Unemployment benefits:
  - on average below the minimum wage;
  - duration limited to 12 months for dismissed employees with more than 20 years of service; majority of unemployed have been unemployed over 12 months and are therefore not eligible.
- Global Competitiveness Report 2011 ranks Serbia 122/142 on overall labor market efficiency with several sub-indicators very low (e.g., Cooperation in labor market relations: 136; Brain drain: 139).

### External sector, real exchange rate, and FDI allocation
- Real exchange rate and competitiveness:
  - Serbia’s real exchange rate has been among the most volatile in the region;
  - as of end-2012, REER weaker by nearly 15 percent relative to the pre-crisis peak;
  - a significant real appreciation during 2011 may have held back export recovery.
- FDI allocation:
  - only about 20 percent of FDI destined for manufacturing before the crisis; new EU members average ≈ 36 percent;
  - Serbia ranks lowest in attracting FDI to tradable sector in the sample and among the lowest in greenfield FDI.
- Current account and external vulnerabilities:
  - at end-2012, Serbia and Albania were the only countries in the region with current account deficits > 10 percent of GDP;
  - private sector external indebtedness peaked at 53 percent of GDP in 2010 (from 12 percent in 2004); nonfinancial firms account for 70 percent of private external debt;
  - public external debt more than doubled since 2008 to 41 percent of GDP in 2012;
  - external debt was 86 percent of GDP at end-2012;
  - gross international reserves = EUR 10.9 billion at end-2012 (above three months imports, above 100 percent of short-term debt at remaining maturity, above 20 percent of broad money).
- External sustainability simulations:
  - Unchanged policies scenario: projected underlying current account deficit ≈ 10 percent of GDP; current account norm estimated at 6 percent of GDP; MB and ES approaches suggest REER overvaluation in range 15–20 percent.
  - Illustrative adjustment scenario: durable fiscal consolidation and structural reforms help ensure external sustainability, mitigate dinar overvaluation, preserve reserve buffers, and reduce net indebtedness.
- Policy priorities to reduce external vulnerabilities:
  - durable fiscal consolidation;
  - structural reforms to improve business environment and competitiveness;
  - attract FDI to tradable sectors and greenfield FDI;
  - preserve adequate reserve buffers.

### Fiscal situation, consolidation options, and public spending
- Fiscal trajectory and key figures:
  - fiscal deficit: worsened from average 1¼ percent of GDP (2005–08) to almost 5 percent (2009–11);
  - 2012 fiscal deficit reached 7.6 percent of GDP (or 7½ percent of GDP in some summaries) driven by election-related spending, bank recapitalization, and changes in fiscal decentralization law;
  - public debt rose to about 62 percent of GDP in 2012 (up from ~50 percent in 2011), above legal ceiling 45 percent.
- Spending levels:
  - total spending rose from 42 percent of GDP in 2005 to 49 percent in 2012 (0.8 percent of GDP accounted for bank recapitalization);
  - mandatory spending (wages, pensions, transfers, interest) ≈ 2/3 of total government expenditure;
  - pension spending ≈ double emerging countries’ average and ~50 percent more than advanced economies’ average;
  - net public investment relatively low.
- Revenue and tax structure:
  - revenue-to-GDP ratio favorable relative to emerging economies;
  - social contributions large share of revenues; VAT and excise performance relatively strong; CIT performance weak with extensive tax expenditures.
  - CIT incentives cost in 2011: 0.8 percent of GDP, or 68 percent of total CIT collection.
- Consolidation options — expenditures:
  - freeze public wages and pensions as an option (used 2009–2010);
  - reduce wage bill via workforce reduction, wage level cuts, or lower wage growth (careful given unemployment > 22 percent);
  - improve targeting of transfers and savings at subnational level;
  - contain goods and services spending; rationalize state subsidies and refocus toward productive incentives;
  - comprehensive system to track arrears.
- Consolidation options — revenues:
  - broaden tax base and reduce exemptions; recent VAT rate increased from 18 to 20 percent (reduced rate 8 percent unchanged);
  - consider reducing reduced VAT base and aligning with EU requirements;
  - CIT rate raised from 10 to 15 percent in 2013 but exemptions remain;
  - streamlining tax incentives could yield significant revenue (eliminating all tax expenditures estimated additional revenue ~0.5–0.6 percent of GDP).
- Public financial management and structural reforms:
  - implement parametric pension reforms, contain health spending via procurement and payment system reforms, accelerate SOE reforms and privatization, set binding medium-term expenditure ceilings, move to program and performance budgeting, modernize tax administration, and rationalize public employment.

### Subnational finances, vertical fiscal imbalance (VFI), and reforms
- Decentralization and VFI:
  - 2011 amendments increased LG share in payroll tax from 40 percent to 80 percent without devolution of expenditure responsibilities, increasing VFI and shifting deficit to the center.
  - In 2012 shared taxes and transfers represented 63½ percent of total LG resources (increase of 7½ percent relative to pre-crisis norms).
  - The amount of shared tax revenues in percent of total resources increased on average by 13 percent in 2011–12 relative to pre-crisis (2007–08) while own-source revenues fell by 6 percent.
  - Underlying LG own deficit increased by 1.4 percent of GDP in 2012 relative to 2009–10 average; overall fiscal deterioration 3.3 percent of GDP; 2011 amendments could explain up to 42 percent of recent deterioration.
  - VFI related to 2011 amendment estimated at around RSD30–40 billion or 0.9–1.2 percent of GDP.
- Policy options:
  - short-term approaches: (i) devolve expenditure functions credibly; or (ii) roll-back partially or fully the 2011 payroll tax-sharing amendment and require LGs to prioritize within previous envelopes.
  - core recommendation: dismantle 2011 amendments and restore payroll tax central share to 60 percent to reduce consolidated fiscal deficit by estimated 0.9–1.2 percent of GDP.
  - complementary institutional reforms: introduce LG bankruptcy/receivership regime with credible sanctions.
- Local arrears clearance strategy risks:
  - refinancing LG arrears via CG issuance of inflation-indexed bonds raises moral hazard and implementation risks; stock of arrears unknown; safeguards and strict qualification criteria required.
- Subnational revenue and expenditure reforms:
  - increase own revenues: property tax revaluation and rate increases, reform land development fees, raise utility fees to cost recovery, improve transport tariffs and enforcement.
  - expenditure reforms: cut subsidies (Fiscal Council recommends cutting municipal subsidy expenditures in half between 2013–16), contain LG wage bill (2012 LG wage bill ≈ RSD46 billion or 1.4 percent of GDP; estimated surplus employment costing RSD6 billion or 0.2 percent of GDP).
- Procedural safeguards:
  - close borrowing-waiver loophole for long-term borrowing; require independent third-party assessment for long-term infrastructure project financing (cost-benefit and sustainability analysis).

### Rules-based fiscal framework, measurement, and PFM weaknesses
- Elements to preserve:
  - Budget System Law (BSL) reflects best practices on paper;
  - requirement that legal deficit and spending limits in last budget law not be exceeded;
  - prudent public debt framework elements (government guarantees included in debt up-front, borrowing rules for LGs).
- Key shortcomings:
  - incomplete general government perimeter and partial capture of Indirect Budget Beneficiaries (IBBs);
  - incomplete reporting of arrears and contingent liabilities;
  - fiscal accounts measured on cash basis; accrual would be preferable;
  - revenue projections lose realism during budget process; expenditure overruns drive deficit drift;
  - medium-term plans non-binding; weak enforcement of BSL pay-as-you-go rule (article 48).
- Recommended institutional actions:
  - Statistics Office to produce full list of general government entities and compile accrual fiscal accounts;
  - MoFE to compile full arrears, PPP, and contingent liabilities database and integrate IBBs into final accounts;
  - enforce pay-as-you-go rule with certified deficit-neutrality analyses and three-year offset horizon;
  - consider nominal binding medium-term spending limits and stronger parliamentary and audit capacities;
  - restore personal ministerial accountability for budget outcomes and reestablish 2010 fiscal rules (debt ceiling 45 percent of GDP) on healthier foundations.

### Pension system — structure, fiscal impact, and reform scenarios
- System overview:
  - mandatory public earnings-related pension-point scheme; contribution rate currently 22 percent with maximum contribution base limited to five times nationwide average salary;
  - minimum pension = 27 percent of average net salary (guaranteed with 15 years contributions).
- Fiscal impact and issues:
  - 2012 pension bill = 14 percent of GDP, with budget transfers covering about one half;
  - pension support ratio fell to 1.2 (1.1 including farmers);
  - disability pensions account for 22 percent of pension spending versus international average 15 percent (additional 7 percent cost ≈ 0.3 percent of GDP per year);
  - low effective retirement ages and extensive early retirement options.
- Reforms adopted 2010–2011:
  - BSL indexing rule: biannual indexation of general point and pensions to CPI plus real GDP growth above 4 percent until pension bill falls to 10 percent of GDP;
  - parametric reforms: increase minimum retirement age for women from 53 to 58; increase required years of service for women from 35 to 38 (2013–2023); reduce service credits for women.
- Baseline projections:
  - old-age dependency ratio 24.9 percent in 2010 projected to grow by additional 13 percentage points by 2050;
  - under current indexation rules the legally targeted 10 percent share of pension expenditure in GDP would be reached in 2027; replacement rate would be reduced to 43.3 percent (down 27.2 percentage points from 2011).
- Selected quantified reform scenarios (preserving all numeric values exactly as presented):
  - Increasing retirement age for women by 5 years, from 2013–2022:
    - Average savings per year (2013–2050): 0.2
    - 2013–2030: 0.1
    - 2031–2050: 0.3
    - Present value (2013) of total savings: 7.2
    - Present value (2013) 2013–2030: 2.1
    - Present value (2013) 2031–2050: 5.1
  - Increasing retirement age for women by 5 years, from 2020–2029:
    - Average savings per year (2013–2050): 0.1
    - 2013–2030: 0.0
    - 2031–2050: 0.2
    - Present value (2013) total: 5.1
    - 2013–2030: 0.7
    - 2031–2050: 4.4
  - Increasing retirement age for both men and women to 67, from 2023–2026:
    - Average savings per year (2013–2050): 0.1
    - 2013–2030: 0.0
    - 2031–2050: 0.2
    - Present value (2013) total: 4.2
    - 2013–2030: 0.4
    - 2031–2050: 3.8
  - Increasing early retirement age for both men and women from 58 to 60, from 2024–2027:
    - Average savings per year (2013–2050): 0.1
    - 2013–2030: 0.0
    - 2031–2050: 0.1
    - Present value (2013) total: 2.3
    - 2013–2030: 0.2
    - 2031–2050: 2.1
  - Introducing actuarial penalties for early retirement, unchanged preferences (6 percent per year):
    - Average savings per year (2013–2050): 0.4
    - 2013–2030: 0.4
    - 2031–2050: 0.5
    - Present value (2013) total: 15.8
    - 2013–2030: 6.5
    - 2031–2050: 9.3
  - Equating retirement ages for men and women + introducing actuarial penalties, unchanged preferences (6 percent per year):
    - Average savings per year (2013–2050): 0.9
    - 2013–2030: 0.7
    - 2031–2050: 1.1
    - Present value (2013) total: 35.0
    - 2013–2030: 12.6
    - 2031–2050: 22.4
  - Equating retirement ages for men and women + introducing actuarial penalties, all retire at statutory age (6 percent per year):
    - Average savings per year (2013–2050): 0.8
    - 2013–2030: 0.6
    - 2031–2050: 1.0
    - Present value (2013) total: 30.6
    - 2013–2030: 11.2
    - 2031–2050: 19.4
- Model caveats and assumptions:
  - projections assume cohort behavior partly fixed at 2007–2011 levels, corrected for contributor declines and projected life-expectancy changes; data limitations noted (e.g., formal employment by age not available).
- Pension policy implications:
  - actuarial penalties and equating retirement ages generate largest savings; linking retirement age to life expectancy recommended; incentives for working longer are expenditure neutral but not preferred given high youth unemployment.

### Banking sector, credit growth, euroization, and monetary policy
- Credit dynamics:
  - annual credit growth fell from about 30 percent pre-crisis to low single digits at end-2012;
  - lending interest rates fluctuated within a narrow band of 7–9 percent;
  - structural break in domestic credit time series in October 2012 due to Nova Agrobanka resolution (effect ~2½ percent of total credit stock).
- Low credit growth driven by both supply and demand factors:
  - supply: reduced availability and higher cost of funding, tightened lending standards, high perceived risk, high NPLs;
  - demand: weak economic activity and limited viable investment projects.
- Financial Stress Index (FSIX) construction:
  - components: (i) spread of interbank (BEONIA) over NBS policy rate; (ii) stock market volatility; (iii) exchange rate volatility; (iv) government borrowing spread over NBS policy rate.
  - positive FSIX → higher-than-average financial stress.
- Banking system buffers and vulnerabilities:
  - pre-crisis high capitalization and provisioning; NPL ratio rose to nearly 20 percent but provisioning remains high;
  - banking system liquidity adequate; system profitable excluding resolved outliers (Agrobanka, New Agrobanka, RBV).
  - main vulnerability: exceptionally high euroization with many unhedged borrowers.
- Policy recommendations to restore credit growth:
  - reduce macroeconomic vulnerabilities and complete structural reforms to boost demand for credit;
  - address NPL stock (out-of-court workouts, clarify creditor rights);
  - implement dinarization strategy: deepen local currency financial markets and institutions;
  - avoid significant relaxation of prudential policies but consider targeted measures to improve balance sheets.
- Inflation targeting in a euroized economy:
  - euroization does not preclude IT, but transmission weaker; non-sterilized FX interventions can be compatible and useful to reduce volatility;
  - need sufficient FX reserves and symmetric FX intervention policy to avoid moral hazard.
- Serbia-specific monetary and currency facts:
  - injection of liquidity equivalent to 9.6 percent of GDP (nonconventional measures during crisis);
  - credit euroization: beginning of 2009 = 66 percent; end-2012 ≈ nearly 70 percent;
  - inflation within NBS band: less than 40 percent of the time since IT adoption.
- Empirical indicators (coefficient of variation):
  - interbank rate volatility and inflation volatility by year:
    - 2006: interbank 16.6; inflation 26.8
    - 2007: interbank 11.3; inflation 45.0
    - 2008: interbank 18.1; inflation 15.2
    - 2009: interbank 22.6; inflation 20.2
    - 2010: interbank 9.6; inflation 38.6
    - 2011: interbank 9.3; inflation 22.2
    - 2012: interbank 8.7; inflation 50.7
- Policy notes on de-euroization and market development:
  - develop domestic dinar bond market and lengthen maturities of public dinar debt;
  - develop hedging instruments and encourage pension funds, insurers to operate in domestic currency;
  - consider deposit insurance pricing that internalizes euroization risks.

*Italic: Source — IMF staff report excerpt and chapter excerpts as presented in the provided content unit.*

### 1. Business Environment and Growth Constraints  _______________________________________  10

### 1. Business Environment and Growth Constraints

### The Pre-Crisis Growth Paradigm and its Legacy Vulnerabilities
- Serbia experienced brisk growth during 2004–08 on the back of capital inflows that supported a boom in the domestic demand, but the underlying growth model proved vulnerable to shocks and was associated with:
  - a high share of nontradables;
  - low domestic savings; and
  - a fragile external position.
- Convergence to EU income levels was relatively moderate; economic growth fell following the onset of the global financial crisis and further slowed the pace of convergence, leaving Serbia’s post-crisis income gap larger compared with more advanced regional economies.
- International trade and financial integration increased from a low base:
  - goods exports to GDP remained about 20 percent over 2006–11.
  - Exports concentrated in agricultural products, textiles, metal industries; automobiles were a more recent addition.
  - Remittances and foreign borrowing have been predominant in financing the trade deficit; FDI inflows have been volatile.
- By regional standards Serbia is relatively closed given its size, with modest world market share growth above comparable SEE countries but substantially below EU CEE new member states.

### Structural Bottlenecks Undermining Competitiveness
- Key structural bottlenecks identified:
  - A complicated system of business laws and regulations that hampers nonprice competitiveness and deters solid FDI inflows, contributing to feeble private sector growth and persistently high unemployment rates.
  - Entrenched rigidities in labor market institutions, including a peculiar severance pay system, centralized wage bargaining and complex firing procedures.
  - A large, heavily subsidized and protected public enterprise sector comprising companies in the Privatization Agency portfolio and state owned enterprises (SOEs) in utility and commercial sectors; many are loss making and dependent on government subsidies and guarantees.
- Fiscal burden and related statistics:
  - Total direct state support to enterprises in the Privatization Agency portfolio and commercial and utility SOEs was estimated at 2.5 percent of GDP over 2010–11.
  - Stocks of guaranteed debt and arrears are estimated at some 12 percent of GDP at end 2011 (World Bank figures, cited by Ministry of Finance).
  - At end-2010, enterprises in the Privatization Agency portfolio accounted for about 5 percent of formal employment; employment in large public utilities and commercial SOEs represented another 6 percent.
- Operational distortions in SOEs:
  - De facto wage policy in many SOEs is set relatively liberally (bonuses, advisory positions, ad-hoc increases), further distorting a high public/private wage ratio.
  - Tariff setting below cost recovery levels in public utilities negatively impacts profitability and disincentivizes investment.
- Privatization momentum slowed: number of privatized companies fell from an annual average of 320 over 2002–2008 to about 47 over 2009–2011, with the most difficult cases remaining in the Privatization Agency portfolio.

### Improving the Business Environment and Growth Model: Policy Recommendations
- Overarching goal: comprehensive structural reforms to remove major bottlenecks and achieve durable, export-oriented growth; calibrate breadth, balance, and sequence since many reforms carry short-term costs but yield long-term benefits.
- Specific policy actions recommended:
  - Improve the business environment through a multi-pronged approach:
    - Abolish parafiscal charges (recent initiative cited as a first step).
    - Advance measures in competition policy, tax administration, property rights, and legislation governing real estate.
    - Prioritize business environment reforms and set clear timeframes for implementation.
  - Labor market reforms to improve cost competitiveness:
    - Remove disincentives for job creation.
    - Make wage bargaining and employment procedures more flexible while maintaining adequate social protection.
    - Referenced Selected Issues Papers: “Labor Market Reforms” and “Pension Reform In Serbia”.
  - Reform public enterprises comprehensively and carefully:
    - Plan and budget reforms under detailed cost-benefit analysis, given fiscal costs and employment implications.
    - Front-load implementation while ensuring sustainability.
    - Accelerate privatization and corporatization plans in coordination with the World Bank; improve transparency of SOE operations.
    - Enforce rigorous wage and employment policies based on performance criteria.
    - Gradually increase public utility tariffs to cost recovery levels.
    - Enforce strict limits on subsidies and issuance of guarantees.
- Macroeconomic policy stance:
  - Maintain macroeconomic stability through prudent policies to mitigate volatility from stronger external linkages.
  - A well-targeted reform package should boost confidence and can have positive near-term growth consequences.

### Improving the Labor Market: Challenges and Options (Summary of Background)
- Labor market outcomes are worrisome:
  - Unemployment rate is one of the highest in Europe.
  - Labor force participation rate is one of the lowest.
- Causes and characteristics:
  - Unfinished transition to a market-based economy: late start and uneven reform implementation constrained FDI inflows, slowed structural transformation, and hampered employment creation.
  - A sharp increase in unemployment without adjustment in labor cost indicates lack of labor market flexibility.
  - Cross-country comparisons suggest average total labor cost in Serbia has risen faster than productivity, potentially attributable to:
    - strong role of the public sector in setting wages;
    - excessive protection of insiders; and
    - a centralized wage bargaining process.
- Policy objective: comprehensive structural reform to strengthen the private sector, boost labor demand, reduce total labor cost, and increase labor market flexibility.

*Source: IMF staff report excerpt (June 17, 2013).*

### 1.      Serbia’s labor market is characterized by low labor force participation and high

### 1.      Serbia’s labor market is characterized by low labor force participation and high

### Overview: participation, unemployment, and employment rates
- Participation rate declined from 66 percent in 2004 to about 60 percent in 2012.
- Unemployment rate (Labor Force Survey) increased to more than 23 percent (2012).
- Employment rate fell to 46 percent in 2012.
- High unemployment reduces labor force participation through discouraged workers exiting the labor force.

### Youth and long-term unemployment
- Unemployment rate for age 15–24 exceeded 51 percent in 2012.
- Overall long-term unemployment share reached 78 percent in 2012.
- Implications: negative effects on potential GDP growth through reduced on-the-job training and human capital accumulation.

### Informal and public sector employment
- Informal employment (difference between overall employment and registered employment) amounts to almost 500 thousand persons, or 19 percent of overall employment.
- Public sector employs 43 percent of registered employment in legal entities, or 26 percent of overall employment.
- Serbian employment profile, 2011 (shares):
  - Public sector, including SOEs: 26%
  - Legal entities (private): 34%
  - Entrepreneurs (self-employed): 18%
  - Informal: 22%

### Structural nature of unemployment and labor market rigidities
- Significant share of unemployment is structural; low Okun’s coefficient in Balkan economies indicates weak responsiveness of unemployment to the business cycle.
- Possible explanations for lack of wage adjustment despite rising unemployment since 2008:
  - Statistical composition effects (average wage bias from attrition of low-skilled workers).
  - Labor market rigidities potentially including:
    - significant role of the public sector in setting wage levels,
    - excessive insider protection imposed by the Labor Law and other institutional arrangements,
    - restrictive wage bargaining system,
    - binding minimum wage.

### Role of the unfinished transition to a market economy
- Successful transitions in emerging Europe and NMS were associated with comprehensive structural reforms that attracted FDI and promoted job creation.
- Serbia and other Balkan economies began significant reforms nearly a decade after NMS; many reforms remained incomplete when the global financial crisis erupted.
- Areas needing more progress: privatization, enterprise restructuring, and competition policy.
- Consequences of delayed reform:
  - Weaker business environment and reduced attractiveness to foreign investors.
  - Lower FDI stock per capita compared with peers; scatter-plot evidence suggests more FDI correlates with lower unemployment across Balkan countries and NMS.
- Structural employment losses since 2008 partly due to layoffs related to pre-crisis privatization and restructuring; post-privatization restructuring focused on employment cuts rather than wage cuts.
- Additional pressures from trade liberalization (first wave early 2000s; second wave starting in 2009 with Stabilization and Association Agreement with the EU) and the 2008 global financial crisis.

### Wage competitiveness: net wages, gross wages, and total labor costs (TLC)
- Definitions:
  - Net wage = gross wage less taxes and social security contributions paid by the employee.
  - Total labor cost (TLC) = gross wage plus employer social security contributions and other labor-related costs.
- Manufacturing sector wedges (as presented):
  - Gross wage vs. net wage: personal income tax (12 percent on a taxable base) plus employee’s social security contribution (17.9 percent of the gross wage). In 2012, net average wage in manufacturing was about 27 percent lower than the average gross wage.
  - TLC vs. gross wage: In 2011, TLC in manufacturing was about 23 percent higher than the gross wage; employer’s social security contribution explains 17.9 percent of this difference. Remaining difference arises from severance payments, allowances for business trips abroad, transport to work, jubilee awards, directors’ fees, scholarships, and wages for occasional employment.
  - Overall wedge: In 2011, the overall tax wedge in manufacturing (TLC minus net wage) amounted to 41 percent of TLC or 70 percent of the net wage. Fiscal Council estimated the fiscal burden to equal 64 percent of the net wage (difference due to fiscal burden excluding severance payments and other labor-related expenditures).

### Trends in wages, productivity, and unit labor costs
- 2001–2008: Average real gross wage increased by 174 percent while productivity increased by 47 percent, indicating erosion of competitiveness.
- 2009–2011: Real wage growth slowed but the wage–productivity gap persisted.
- Unit labor cost (ULC) in manufacturing (based on average gross wage):
  - Increased faster than peers until 2008.
  - Declined during 2009–10 (ULC declined by 7 percent on account of significant dinar depreciation).
  - ULC indexes do not indicate the relative level of competitiveness across countries.
- Cross-country comparisons:
  - Productivity in 2012: Serbia’s productivity was four times lower than in the Euro Area and about one-half of productivity in Croatia and Romania.
  - Gross and net wages in 2012: broadly in line with peers when accounting for Serbia’s low productivity and crisis-era adjustments.
  - TLC in manufacturing in 2010: actual TLC = 534 Euros per worker per month; "fitted" TLC (from EU-27 regression) = 475 Euros per worker per month; deviation from the "fitted" TLC = 11.4 percent.

### Analytical conclusions and policy-relevant observations
- Serbia’s labor market outcomes reflect a combination of:
  - Low labor force participation,
  - Very high unemployment (including extreme youth and long-term unemployment),
  - Significant informality and large public sector employment share,
  - Structural constraints from an unfinished transition to a market economy that limited FDI and private-sector job creation,
  - Possible labor market rigidities that dampen wage adjustment and labor reallocation.
- Indicators suggest wages (gross and net) are broadly aligned with low productivity levels, while TLC may be somewhat higher than what Serbia’s productivity alone would warrant.
- Addressing Serbia’s labor market performance likely requires advancing structural reforms (privatization, enterprise restructuring, competition policy), improving the business environment to attract FDI, and reviewing labor market rigidities that impede reallocation and wage adjustment.

*Prepared by Srdjan Kokotovic (formerly Belgrade Office) and Dmitriy Kovtun (EUR).*

### 14.      Employment protection legislations (EPLs) refer to laws, regulations, or customary

### 14.      Employment protection legislations (EPLs) refer to laws, regulations, or customary

### Definition and general effects of EPLs
- EPLs are laws, regulations, or customary procedures that govern employers’ ability to dismiss workers, including restrictions on layoffs, required notice periods, penalties for unfair dismissals, mandatory severance payments, etc. (OECD, 1994).
- EPLs protect workers’ rights and are often guided by the International Labor Organization’s (ILO’s) Termination of Employment Convention.
- Trade-off: excessive EPLs constrain job creation because employers adopt greater caution in hiring, protecting those already employed and reducing opportunities for the unemployed; this creates bottlenecks for young workers and prolongs jobless spells, impeding labor re-allocation and exacerbating unemployment.
- Empirical evidence cited: protective labor regulations tend to increase unemployment, particularly for the young (Nickell et al., 2005, Feldmann, 2009, Botero et al., 2004), and decrease labor force participation (Feldmann, 2009).

### Serbia’s 2005 Labor Law Amendment
- The 2005 amendment increased the level of regulation, aligning Serbia with more advanced European countries (primarily Southern Europe) and made it more restrictive relative to Serbia’s regional peers.
- Enacted at the peak of privatization and restructuring, the amendment sought to strengthen job security by introducing disincentives for firing and shortening the length of temporary employment.

### Severance payments (unique feature)
- Severance payment in Serbia is calculated on the basis of lifetime employment rather than on the period with the last employer.
- Formula: sum of ⅓ of most recent average monthly salary for each year of employment for the first 10 years and ¼ for each subsequent year of employment.
- Example: for an employee with 30 years of employment this adds up to 8⅓ monthly salaries.
- The rule creates disincentives for laying off older employees.
- Cross-country comparison: Serbia’s rule is unique; other European countries use either fixed severance payments or link severance to length of service with the last employer.

### Dismissal procedures under the Labor Law
- Dismissing permanent employees is subject to administrative and legal hurdles; the Labor Law distinguishes between collective and individual dismissals.
- Collective dismissals:
  - Must be preceded by attempts of alternative employment and preparation of a mitigation program (training, shorter work hours, etc.).
  - Program must provide causes for dismissal and dismissal criteria.
  - Program must be discussed with trade unions and the National Employment Service, both required to provide non-binding suggestions.
- Individual dismissals for inadequate skills, low productivity or other performance-related reasons:
  - Generally require “proofs” of inadequate performance or skills.
  - Following trade union’s opinion, the employee can be dismissed after a notice period of 1 to 3 months (without notice in case of misbehavior and criminal acts) depending on length of career.
  - No severance payment is required in this case.
  - Dismissed employee can appeal to the court and be reinstated if the employer fails to justify the dismissal (in which case the employee must be reimbursed for loss of wage income).
- Individual dismissals for economic reasons:
  - Require a letter from the employer justifying the reasons for dismissal and a severance payment.
  - Employer must rehire the same person if the same position opens up again within the following six months.

### Fixed-term contracts
- Fixed-term contracts are limited to one year and allowed only for seasonal jobs, projects, temporarily increased workload, replacement of absent employees and similar tasks.
- Employment lasting 5 days more than the prescribed maximum of 12 months is treated as a contract of indefinite duration.
- Likely motivation: eliminate loopholes to avoid severance requirements; effectively prohibit fixed-term contracts for permanent tasks.

### Unemployment benefits
- Unemployment benefits in Serbia:
  - On average below the minimum wage.
  - Duration limited to 12 months in the case of dismissed employees with more than 20 years of service.
  - Majority of unemployed persons have been unemployed for over 12 months and therefore are not eligible.
- Charts referenced: "Unemployment Benefits, 2010 (Percent of Gross Average Wage)" and "Maximum Duration of Unemployment Benefits, 2010 (Months)" (sources: OECD; country authorities; and IMF staff calculations).

### Role of the public sector and collective bargaining
- Public sector average wage is higher than in the private sector; the euro-denominated differential was modest early in the last decade, grew progressively larger, peaking before the 2008 global crisis, was reduced during 2009-10 when public sector wages were frozen, but remains sizeable.
- Trade unions are dominated by public sector member unions, tilting collective bargaining pressure toward public sector wage increases and potentially setting a “reservation wage.”
- Collective agreements:
  - Concluded at national, regional and company levels; bargaining being moved to industry level after the general collective agreement expired in May 2011.
  - Agreements specify “base wages” for skill levels via special multipliers, effectively setting wage floors.
  - Risk: base wages can create undue wage rigidities if pushed above market-clearing levels or when downward wage adjustment is needed.
  - Minimum wage negotiations occur under the Social Economic Council; when agreed, minimum wage becomes mandatory for all employers including those not represented.
  - The Ministry of Labor, Employment and Social Policy has extended application of industry-level agreements to companies not represented in bargaining, forcing compliance on companies without resources to meet obligations (Foreign Investor Council’s White Book, 2011).

### Labor market efficiency: Global Competitiveness Report evidence
- Serbia ranked 122 out of 142 countries on overall labor market efficiency in the 2011 Global Competitiveness Report.
- Sub-indicator placements (out of 142 ranked countries, except noted exceptions):
  - Cooperation in labor market relations: 136
  - Flexibility of wage determination: 64
  - Rigidity of employment: 90
  - Hiring and firing practices: 89
  - Redundancy costs: 50
  - Pay and productivity: 103
  - Reliance on professional management: 133
  - Brain drain: 139
  - Female participation rate: 69
- Conclusion: significant room for improvement across nearly all dimensions.

### Policy implications and recommendations
- Broad view: poor labor market outcomes reflect Serbia’s unfinished transition and require a comprehensive strategy beyond labor-market-only fixes; a dynamic private sector is needed to generate labor demand.
- Recommended structural reforms to reduce labor costs and disincentives for hiring:
  - Reduce employers’ social security contribution rates to lower the total labor cost (TLC) and increase labor demand when fiscal space allows.
    - Complementary measure: strengthen capacity of the Tax Administration and Labor Inspection to increase collection rates—broadening the tax base could create scope for reducing the tax wedge.
  - Revise severance payment formula so severance is calculated on length of employment with the last employer (consistent with other European practice) to provide more opportunities to job-seekers, especially older workers.
  - Simplify dismissal procedures and clarify conditions for fair dismissals to reduce room for misinterpretation.
  - Make collective agreements less restrictive and bring bargaining to the company level:
    - First best: give priority to firm-level agreements over higher level bargaining and allow wage setting at company level (firms without resources could have a choice to “opt-in” for a higher level agreement).
    - Second best: discontinue practice of extending industry agreements to all companies in the industry.
- Active labor market policies (ALMP):
  - Serbia’s spending on ALMP is significantly lower than peers (World Bank Country Economic Memorandum); boosting ALMP could alleviate skills mismatch and help the unemployed adjust.
- Social safety net:
  - An adequate social safety net is needed to protect those affected by increased labor market flexibility and potential layoffs during reallocation.

*Source: IMF staff report text provided in the content unit.*

### 3.      Serbia’s real exchange rate has been one of the most volatile in the region. Though

### 3.      Serbia’s real exchange rate has been one of the most volatile in the region. Though

### Real exchange rate volatility and export performance
- Exchange rate flexibility is essential to buffer against external shocks, but excessive real exchange movements can:
  - cause volatile relative prices,
  - create uncertainty, and
  - shorten investment horizons, thus affecting export performance.
- Several studies show a negative link between real exchange rate uncertainty and export growth, especially for financially-vulnerable firms in countries with low financial sector development.
- High real exchange rate volatility could have undermined the competitiveness of Serbia’s exports, as financial markets are not developed enough to allow firms to hedge against exchange rate risk.
- Source: WEO and IMF staff calculations.

### Recent developments in price competitiveness
- Serbia’s price competitiveness has improved since the onset of the crisis.
- A significant real appreciation during 2011 may have held back a stronger export recovery from the global crisis.
- As of end-2012, price competitiveness seems to be in a better position than before the crisis, with the real exchange rate weaker by nearly 15 percent relative to the pre-crisis peak.
- Risk: A new cycle of real appreciation could hinder the needed recovery in exports to reduce external vulnerabilities (Selected Issues Paper “External Sustainability Assessment”).
- CPI-Based Real Effective Exchange Rate (2007=100) and yoy percentage change charts referenced (Source: WEO and IMF staff calculations).

### FDI allocation and export potential
- Attracting more FDI inflows to the tradable sector would help raise Serbia’s export potential.
- Evidence (Kinoshita, 2011): positive effects on external vulnerability from FDI inflows depend on sectors receiving the flows.
  - Stock of FDI to tradable sectors is positively correlated with export-to-GDP ratios.
  - FDI in nontradable sectors is positively associated with domestic demand booms and large trade deficits.
- Serbia ranks the lowest in attracting FDI to the tradable sector in the sample; FDI into financial intermediation and other services dominated.
- Key figures:
  - In Serbia only about 20 percent of FDI was destined for the manufacturing sector before the crisis.
  - The average of new EU members was about 36 percent.
- Serbia ranks among the lowest in having attracted greenfield FDI, which is critical to enhance export capacity.
- Policy priority: Increase share of FDI to the tradable sector and enhance incentives to attract more greenfield FDI.
- Sources: National Bank of Serbia, Kinoshita (2011), IMF staff calculations, UNCTAD.

### Global competitiveness and non-price factors
- The World Economic Forum’s Global Competitiveness Index ranks Serbia 95th out of 144 countries in 2012–13.
- Serbia scored lower than the regional average in each area considered.
- Competitiveness appears hindered by:
  - macroeconomic environment,
  - business sophistication,
  - goods market efficiency,
  - higher education and training,
  - institutions.
- Perception of corruption could be holding back Serbia’s attractiveness to international investors.
- Sources: World Economic Forum and Transparency International.

### Need for reforms to expand the export base
- Expanding Serbia’s low export base to anchor sustainable growth and external sustainability depends crucially on reforms to improve competitiveness.
- There is some space for real appreciation during the medium-term consistent with Balassa-Samuelson effects from productivity increases and slow convergence to EU standards.
- Urgency to accelerate reforms that tackle competitiveness issues related to non-price factors (Selected Issues Paper, "In Search of an Effective Growth Model").

### External vulnerabilities: overview
- Serbia faces serious external vulnerabilities mitigated by large reserve buffers and a relatively flexible exchange rate.
- Under unchanged policies, significant exchange rate overvaluation could lead to persistently large current account deficits and further deterioration of the net international investment position.
- Projected external financing needs, roll-over risks, and drawdown of reserves would pose a challenge to external liquidity.
- Durable fiscal consolidation and structural reforms are needed to:
  - reduce the current account deficit to a sustainable level,
  - maintain adequate reserve buffers,
  - stabilize the net international investment position,
  - help mitigate exchange rate misalignment.
- Prepared by Cesar Serra (SPR).

### Partial external adjustment and recent balance of payments dynamics
- The current account deficit has consistently been higher than that of regional peers due to low domestic savings and was increasing pre-crisis.
- The crisis led to a sharp reduction in domestic demand, external financing, and net imports, producing a significant current account deficit adjustment.
- At end-2012, Serbia and Albania were the only two countries in the region with current account deficits of over 10 percent of GDP.
- Trade deficits narrowed after the crisis but remain very large, reflecting:
  - a low export base,
  - plateauing exports (despite a boost from Fiat exports),
  - exogenous shocks (e.g., closure of a steel-exporting plant, draught effects on agricultural exports, lower demand from euro area partners).
- Current account deficits were financed by rapid accumulation of private external debt and recently by public indebtedness:
  - Private sector external indebtedness peaked at 53 percent of GDP in 2010 from 12 percent in 2004.
  - Nonfinancial firms account for 70 percent of private external debt.
  - Public external debt more than doubled since 2008 to 41 percent of GDP in 2012.
- Sources: National Bank of Serbia; IMF.

### External vulnerabilities and buffers
- At end-2012:
  - Serbia had one of the lowest export-to-GDP ratios and one of the highest current account deficits as percent of GDP among peers.
  - External debt was 86 percent of GDP.
- Gross international reserves at EUR 10.9 billion at end-2012:
  - above standard rules-of-thumb for three months coverage of prospective imports of goods and services,
  - above 100 percent of short-term debt (at remaining maturity),
  - above 20 percent of broad money.
- Reserve coverage is higher than suggested by the risk-weighted metric recently developed by Fund staff; under that metric, Serbia recorded the highest coverage in the region in 2012.
- Despite large reserve buffers, Serbia’s net foreign liabilities are high; net FDI stock represents only about half of the total.
- Causation: protracted external imbalances associated with long-delayed structural reforms, fiscal imbalances, and pre-crisis private sector over-indebtedness.
- Catão and Milesi-Ferretti (2013) argue external crisis risks increase significantly when net foreign liabilities exceed 50 percent of GDP; Serbia’s large negative net international investment position is an indicator of external vulnerability.
- Risk-weighted metric definition (as noted in source):
  - For countries with floating exchange rates computed as 0.3*short-term debt (at remaining maturity) +0.1*(stock of portfolio and other investment liabilities)+0.05*(broad money) +0.05*(exports of goods and services).
- Sources: National Bank of Serbia; IMF staff calculations.

### External sustainability illustrative simulations and scenarios
- Methodology:
  - Absence of long time series precludes equilibrium real exchange rate method; assessment uses macroeconomic balance (MB) and external sustainability (ES) approaches.
  - Current account norm is modeled as function of saving and investment in medium-term equilibrium (MB) and also via determinants of exports and imports as function of REER (ES).
  - Degree of exchange rate misalignment inferred as proportional change in REER needed to reconcile underlying current account balance with its norm.
- Unchanged policies scenario:
  - Projected underlying current account deficit at about 10 percent of GDP.
  - Current account norm estimated at 6 percent of GDP.
  - Dinar appears overvalued compared to medium-term fundamentals absent fiscal consolidation and meaningful structural reforms.
  - MB and ES approaches suggest overvaluation in the range of 15–20 percent.
  - Adequate reserve coverage would be depleted under external financing constraints and the negative international investment position would worsen.
- Illustrative adjustment scenario:
  - Durable fiscal consolidation and structural reforms targeted at improving the business environment would help ensure external sustainability, mitigate dinar overvaluation, preserve adequate reserve buffers, and reduce Serbia’s net indebtedness to the rest of the world.
- Table excerpt (Serbia: Exchange Rate Assessment, based on IMF CGER methodology extension in Vitek, 2013):
  - Columns: Scenario | Approach | misalignment (percent)
  - Rows shown in source:
    - MB 20.3
    - ES -3.4
    - MB 17.6
    - ES -0.4
  - Labels correspond to Unchanged policy and Adjustment scenarios and REER, per source.
- Figures referenced: IIP projections under Unchanged Policy and Illustrative Adjustment scenarios (percent of GDP); FDI and Other contributions to IIP projections.
- Sources: Serbian Authorities; IFS; WEO; IMF staff projections.

### Policy implications and recommendations (from scenarios)
- Under unchanged policies, overvaluation and persistent current account deficits would worsen external vulnerabilities.
- Policy priorities to achieve external sustainability include:
  - durable fiscal consolidation,
  - structural reforms to improve business environment and competitiveness,
  - measures to attract FDI to tradable sectors and greenfield FDI,
  - preserving adequate reserve buffers to manage external liquidity risks.

### Fiscal context and consolidation measures (contextual material from subsequent section)
- Fiscal slippages in 2012 breached fiscal rules, increased the fiscal deficit and general government debt.
- Fiscal deficit reached 7.6 percent of GDP in 2012, above the original budget and the maximum deficit allowed under the fiscal deficit rule.
- Drivers: election-related spending, recapitalization of nonviable state-owned banks, changes in fiscal decentralization law worsening vertical imbalances.
- Public debt rose to about 62 percent of GDP in 2012, up from about 50 percent in 2011 and above the legal ceiling of 45 percent of GDP.
- Authorities announced a late-2012 fiscal consolidation package with estimated net budgetary impact of 2 percent of GDP in 2013, including:
  - VAT standard rate increased from 18 percent to 20 percent (reduced rate of 8 percent unchanged);
  - CIT rate raised from 10 to 15 percent, elimination of some tax incentives;
  - Personal income tax on dividends and interest incomes increased from 10 to 15 percent;
  - Excise duties on cigarettes and petroleum products increased;
  - Expenditure measures: capping indexation of wages and pensions, tight ceilings on discretionary spending;
  - Integration of own source accounts into central government budget expected to yield savings.
- Note: Change in VAT law entails revenue loss of about 0.2 percent of GDP (about half is one-off) due to shift to VAT payment upon collection for SMEs, higher VAT refund for farmers, and increase in VAT threshold.
- Prepared by Roland Kpodar (FAD).

*Italic: Source — IMF staff and cited datasets as presented in the provided content.*

### 3.      The level of general government spending in Serbia is high relative to other countries,

### 3. The level of general government spending in Serbia is high relative to other countries

### Expenditure levels and composition
- Total spending 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).
- Current spending accounts for the bulk of expenditures; the largest contributors are 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.
- Serbia’s wage bill also stands out in cross-country comparisons; wage indexation rules (indexed on inflation and real GDP twice a year in April and November) imply a gradual downward trend in the wage bill ratio to GDP if strictly applied, but actual wage growth exceeded the indexation-implied increase due to one-off increases (wage bonuses) and a persistent wage drift.
- Mandatory spending (wages, pensions and transfers, interest payments) accounts for about 2/3 of total government expenditure.
- Net public investment is relatively low compared with peers.

### Revenue and public debt
- Serbia’s revenue-to-GDP ratio compares favorably to the average of emerging economies and is close to that of advanced economies.
- Revenue structure observations:
  - Social contributions make up a large share of government revenues in Serbia.
  - Performance is relatively strong in VAT and excise collection but weak in corporate income tax (CIT) revenue.
  - Serbia relies to a larger extent on nontax revenues, which tend to be more volatile.
- General government debt increased considerably in recent years, reversing earlier debt relief gains.
  - Debt increases were partly due to the global financial crisis and output weakness, but fiscal policy breaches of the deficit rule, issuance of debt guarantees, and bank recapitalizations also contributed.
  - As a result, Serbia’s public debt is relatively high compared to the average of the European emerging economies.

### Possible options to strengthen fiscal consolidation — Expenditure measures
- Principal objective: reduce significantly the share of mandatory spending, particularly wages and pensions, to create fiscal space for investment.
- Specific options and considerations:
  - Freezing public wages and pensions would help contain public spending; a wage and pension freeze during 2009–2010 helped contain mandatory spending growth and could be considered again.
  - Options to reduce the wage bill ratio to GDP include cutting public workforce, reducing wage levels, or reducing wage growth rates; however, with unemployment over 22 percent, shedding public sector jobs could raise unemployment further in the short term.
  - Complementary control of public sector employment requires a comprehensive registry of public employees (not yet completed).
  - Maintaining transfer levels but improving targeting could create savings while protecting vulnerable groups.
  - Savings could be made on transfers to sub-national governments to enforce fiscal discipline.
  - Discretionary spending can be contained by:
    - Controlling goods and services.
    - Rationalizing state subsidies and refocusing them toward incentives for productive investments.
  - Historical averages: Spending on goods and services and subsidies could be reduced to their historical levels (the average levels over 2007–11 are reasonable benchmarks).
  - A comprehensive system to track accumulation of arrears is needed to prevent arrears buildup.

### Possible options to strengthen fiscal consolidation — Revenue measures
- Consider broadening the tax base, particularly following the recent increase in tax rates in 2012, to improve revenue collection without further rate increases and to reduce compliance costs and distortions from exemptions.
- VAT policy:
  - Serbia’s new VAT rate of 20 percent is in line with the average of emerging and advanced economies.
  - Measures to expand the VAT base could include reducing the list of items subject to the reduced VAT rate of 8 percent (in line with EU requirements) and eliminating VAT refunds on the first purchase of residential property.
  - The reduced VAT rate could be increased from 8 to 10 percent following the increase in the main rate, though this may have social implications as food prices would be affected.
  - Recent initiatives to increase VAT refunds (for example for farmers) and expand the reduced-rate list (such as some foods and equipment) undermine fiscal consolidation and should be reversed.
- Corporate income tax (CIT) policy:
  - The CIT rate was increased from 10 percent in 2012 to 15 percent in 2013, but exemptions remain.
  - CIT incentives cost about 90 percent of total CIT collection in 2008, suggesting substantial scope to reduce deductions that erode the tax base.
  - Streamlining accelerated capital allowances, tax credits and tax holidays would improve revenue collection while maintaining the current low statutory CIT rate.

### Strengthening structural reforms to support consolidation
- Structural reforms are critical and should be well prepared, prioritized, and implemented with awareness of capacity constraints and time lags in benefits.
- Identified priority reforms:
  - 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.
  - 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.
    - Rationalizing the number of nonmedical staff in primary health care facilities.
    - These measures can substantially reduce health spending without compromising quality.
  - Speed up reforms of public enterprises and accelerate privatization to contain subsidies and contingent liabilities (in particular government guarantees).
  - Implement key public financial management (PFM) reforms, such as:
    - Setting binding medium-term expenditure ceilings.
    - Establishing effective inter-governmental fiscal coordination.
    - Moving to program and performance budgeting.
  - Accelerate modernization of tax administration to improve compliance.
  - Rationalize public employment and spending on goods and services through outsourcing non-core functions (transport, security, mail, cleaning, catering, maintenance).

### Sub-national spending and decentralization
- Expenditure decentralization trends:
  - Deepening expenditure decentralization is a common trend across European economies.
  - In the EU15, the percent of public expenditure programs carried out at the subnational level peaked at almost 25 percent prior to the European crisis and currently hovers at around 24 percent.
  - Among new member states (EU10), the ratio of subnational expenditures to consolidated government spending increased from 25½ percent in the early 2000s to almost 28 percent as of 2010.
- Serbia’s experience:
  - Legislative changes contributed to an almost doubling in Serbia’s expenditure decentralization ratio to an estimated 16 percent in 2012.
  - While this level remains below European comparators, it is not out of line given Serbia’s stage of development.
  - The 2011 amendments to the decentralization law increased the share of central-government devolved revenues to local governments without matching expenditure responsibilities, exacerbating vertical fiscal imbalances (VFIs).
  - The 2011 modification has an estimated cost of around 1 percent of GDP; rolling back these modifications would help fiscal consolidation, complemented by revenue and expenditure measures to strengthen local-level fiscal outcomes.
- Risks of decentralization financed through transfers and/or borrowing include weaker fiscal outcomes if not accompanied by adequate expenditure controls and intergovernmental frameworks.

*Source: IMF staff report: "The level of general government spending in Serbia is high relative to other countries" (excerpts).*

### 3.      The European financial crisis exacerbated fiscal pressures in many countries and

### 3.      The European financial crisis exacerbated fiscal pressures in many countries and

### Key fiscal developments and statistics
- Fiscal deficit worsened from an average of 1¼ percent of GDP in the pre-crisis period (2005-08) to a post crisis average of almost 5 percent of GDP (2009–11).
- In 2012, economic contraction, election-related spending, and one-off costs related to bank resolution, arrears clearance, and payments for called guarantees amounting to 1 percent of GDP fueled a further deterioration in the deficit to 7½ percent of GDP.
- Public debt rose sharply relative to pre-crisis levels by almost 30 percent of GDP.
- Public debt currently stands at 62 percent of GDP—well above the legislated debt ceiling of 45 percent of GDP.
- Subnational (local government, LG) overall balances moved from roughly balanced pre-crisis to a deficit of around ½ a percent of GDP in the subsequent period (excluding arrears).
- The underlying subnational government deficit averaged 5¾ percent (2007–08).
- The own-source local government deficit amounted to 5¼ percent of GDP on average over 2007–10.
- Shared taxes and transfers represented an average of 56 percent of total LG resources (31 percent and 25 percent respectively) in the pre-crisis period (2007–2008).
- Under the 2006 law LGs received 40 percent of the payroll tax; 2011 amendments increased the LG share to 80 percent.
- LGs received additional revenues estimated at 1½ percent of GDP in 2012 relative to the 2009–10 crisis period.

### Role of subnational spending in Serbia’s fiscal deterioration
- On the surface, subnational spending’s contribution to the deterioration appears limited given the small LG deficit relative to the overall deficit.
- This metric is misleading: overall balance targets can be achieved through higher gap-filling transfers from the center, obscuring underlying subnational fiscal performance.
- “Own balances” of subnational and national governments better depict underlying positions and indicate that subnational deficits account for the bulk of the overall fiscal deficit in both pre- and post-crisis periods.
- Financing of subnational expenditures shifted over the last decade:
  - Self-financed expenditure declined and was replaced by central government resources (transfers and increases in shared taxes) and, to a lesser degree, increased subnational borrowing.
  - This implies an increase in Serbia’s vertical fiscal imbalance (VFI) on average over this period.
- Amendments to the law on LG financing (end-2011) exacerbated weaknesses by increasing the LG share in the payroll tax from 40 percent to 80 percent without devolution of new expenditure responsibilities—effectively shifting deficit from LGs to the center.

### Theoretical considerations on fiscal decentralization
- Conventional public finance theory predicts fiscal decentralization should reduce the size of the public sector via:
  - Enhanced competition between jurisdictions.
  - Increased availability of information on government operations facilitating accountability.
  - Stronger effects when spending is financed through local taxation (tighter tax-benefit link).
- Factors that can reverse these predictions and create upward spending pressures:
  - Lack of overall hard budget constraint (bailouts, subsidized loans, ability to run arrears; common pool problem).
  - Expenditure control failures (narrow/volatile own revenues, pro-cyclical transfers, blurred responsibilities, weak local PFM).
  - Flaws in financing framework and incentives (grant design that encourages overspending, allocation based on actual spending costs rather than expenditure needs).

### Empirical findings relevant to Serbia
- Determinants of subnational spending:
  - The own tax–transfer mix matters: LGs’ propensity to spend intergovernmental transfers is significantly larger than propensity to spend own revenues.
- Impact of decentralization on general government expenditures:
  - Cross-country analyses do not show a consensus that decentralization per se increases the size of the public sector.
  - A consensus exists on problems relating to vertical fiscal imbalance (VFI): spending decentralization raises general government spending when financed from transfers or borrowing (i.e., when associated with large VFIs).
- Evidence from Europe (Eyraud and Moreno Badia, 2013):
  - A significant part of deterioration in public balance sheets in EU15 during the crisis occurred at the subnational level.
  - Decentralizing specific spending functions may create overlap and waste.
  - Expenditure decentralization financed through transfers and/or borrowing is associated with weaker fiscal outcomes.
  - Subnational governments do not fully adjust expenditure to negative revenue shocks, implying weak hard budget constraints.

### Serbia’s decentralization framework and specific vulnerabilities
- Institutional structure:
  - Serbia comprises 165 municipalities.
  - Primary LG responsibilities: infrastructure services and a limited set of social services.
  - Execution often performed by numerous LG-owned public entities partly financed by fees.
- Fiscal rules and constraints (as described):
  - Serbia: BBR; fiscal deficit should not exceed 10 percent of its current year revenues, unless it is a result of capital investments and approved by Ministry of Finance.
  - Borrowing constraint: Long-term borrowing allowed only for financing of capital projects; short-term borrowing is capped at 15 percent of the previous year revenues and has to be repaid within the current [year].
  - Debt rule: Long-term debt outstanding is capped at 50 percent of the previous year revenues; amendments to the law (2009) state that 50 percent limit does not apply to long-term borrowing with maturity above five years as long as debt service is not larger than two thirds of current surplus and if current surplus exceeds [15] percent of revenues collected.
  - Debt service rule: Debt service cannot exceed 15 percent of the previous year revenues.
- Revenue composition and VFI:
  - Four principal municipal revenue sources: shared taxes; central government transfers (mainly equalization); local taxes; fees and charges.
  - The largest single source is the municipal share of the payroll or wage tax.
  - The importance of central government-sponsored revenues relative to own revenue indicates a vertical fiscal imbalance (VFI).
- Problems identified:
  - No significant devolution of expenditure responsibilities to local governments since 2006.
  - The 2011 change to the shared tax formula was a permanent adjustment to subnational financing (increase from 40 percent to 80 percent) rather than a temporary, time-bound transfer fix—contrary to best practice when responding to cyclical shocks.
  - Absence of matching expenditure responsibilities and absence of direct central government mechanisms to control LG spending enable “deficit shifting” with potentially long-lasting consequences.
  - Lack of comprehensive reliable data on LG arrears; a 2010 survey reported arrears of RSD16.9 billion (0.6 percent of GDP) but likely underestimates the problem as several large cities and municipalities did not submit data.

### Policy implications and risks highlighted
- Serbia’s decentralization framework is vulnerable to known pitfalls that can undermine the consolidated public balance sheet:
  - Increased reliance on central resources and shared taxes without devolution of functions raises VFI and creates incentives for overspending.
  - Permanent changes to shared tax formulas in response to cyclical shocks can entrench deficit shifting and complicate future fiscal consolidation.
  - Weak local PFM, limited control over LG-owned entities, and insufficient central mechanisms to enforce hard budget constraints increase the risk that subnational spending pressures exacerbate sovereign fiscal vulnerabilities.
- Diagnostic and monitoring priorities implied by the analysis:
  - Focus on “own balances” and reliable measurement of LG arrears to reveal underlying fiscal positions.
  - Reassess transfer and shared-tax design to align revenues with de facto expenditure responsibilities and to avoid perverse incentives that reward higher spending.
  - Strengthen PFM and oversight at the subnational level and ensure any changes in subnational revenue shares are accompanied by appropriate expenditure responsibilities or are explicitly temporary.

*Italic: Source — IMF staff analysis from the Republic of Serbia country report chapter provided in the supplied content.*

### 16.      Consequently, Serbia’s vertical fiscal imbalance has increased. The amount of shared tax

### _cr13207 - 16.      Consequently, Serbia’s vertical fiscal imbalance has increased. The amount of shared tax

### Findings on vertical fiscal imbalance (VFI) and fiscal impact
- The amount of shared tax revenues in percent of total resources increased on average by 13 percent in 2011–12 relative to pre-crisis (2007–08) while the share of own-source revenues fell by 6 percent.
- In 2012, shared taxes and transfers represented 63½ percent of total LG resources—a 7½ percent increase relative to pre-crisis norms.
- The underlying or own deficit of LGs increased by 1.4 percent of GDP in 2012 relative to the prevailing average in 2009–10.
- The overall worsening of the fiscal deficit was 3.3 percent of GDP; the 2011 amendment reforms could explain up to 42 percent of the recent deterioration (or deficit shifting) of public finances.
- The underlying LG deficit now exceeds the standards established under the 2006 financing law by between 0.5–1 percent of GDP.
- The VFI related to the 2011 amendment is estimated at around RSD30–40 billion or 0.9–1.2 percent of GDP which, ceteris paribus, directly translates into a structural fiscal deficit of the same magnitude.

### Assessment of the 2011 amendment to subnational financing
- The reform responded to cyclical developments with a relatively permanent policy measure without meaningful devolution of expenditure responsibilities, producing a structural shift in deficit to the center.
- The amendment “overcompensated” as revenues and expenditures are now above pre-crisis benchmark levels.
- The reform has not delivered efficiency gains; the increase in resource devolution has been matched by an increase in discretionary spending (including on wages).
- Given the lack of expenditure devolution since 2006, the upward trend in expenditures beyond pre-crisis norms is difficult to justify.
- Recommendation: a credible fiscal consolidation strategy should include burden-sharing at the LG level.

### Immediate reform priorities and policy options
- Two principal short-term approaches to eliminate VFI pressures and improve consolidated government finances:
  - i) offset the recent increase in subnational revenues by credibly devolving expenditure functions from the CG level; and
  - ii) roll-back (at least partially) the 2011 legislative amendments in the payroll tax-sharing formula, requiring LGs to prioritize expenditures within previous budget envelopes.
- Authorities’ partial measures:
  - In May 2013, the authorities reduced payroll tax rates by 2 percent to incentivize LGs to reduce expenditures. The reform was made revenue neutral by adjusting social contribution rates accordingly.
  - Estimated savings from this measure are ½ percent of GDP, less than savings from a full repeal of the 2011 amendments and subject to implementation risks.
- Constraints on enforcement of expenditure-target penalties:
  - To credibly implement transfer penalties for expenditure-target breaches, conditions for reduced transfers should be legislated.
  - Devolving further expenditure responsibilities is risky given weak expenditure oversight, limited implementation capacity, and weaknesses in local public financial management systems; significant near-term devolution could exacerbate LG arrears.

### Recommended core reform and complementary measures
- Core recommendation: fully dismantle the 2011 amendments and restore the payroll tax as a predominantly central tax by returning its share to 60 percent.
  - This would help reduce the consolidated fiscal deficit by an estimated 0.9–1.2 percent of GDP.
- Complementary institutional reform: introduce a bankruptcy/receivership regime for LGs with credible sanctions (e.g., submission to a CG-approved financial plan or temporary CG management of LG budgets).
- Avoid CG-financed LG arrears clearance programs absent safeguards, due to moral hazard risks.

### Box 1: Local Government Arrears Clearance Strategy (summary of risks)
- Government plan: refinance LG arrears to private enterprises from capital investments prior to October 2012; CG to take over liabilities and issue inflation indexed bonds with 2 percent coupon and three-year maturity (including 1 year grace period) to be repaid by LGs through reduced shared revenues (CIT and PIT) and transfers.
- Fiscal and institutional concerns:
  - Uncertainty the republican government can credibly withhold CIT/PIT payments and transfers to ensure debt repayment.
  - Prevailing stock of arrears is unknown and could be inflated through illegitimate claims, producing a significant short-term CG liability.
  - Moral hazard: setting expectations of future bailouts risks a long-run drag on public finances unless mechanisms prevent new arrears.
- Program qualification criteria temper take-up:
  - i) Arrears must be related to capital investments prior to October 31, 2012;
  - ii) Total amount of arrears to be settled cannot exceed the difference of 50 percent of previous year current revenues and the stock of the debt, or 50 percent of the general transfer; and
  - iii) Creditor must agree to accept the bond.

### Complementary short- and medium-term reform measures — Revenues
- Scope to boost subnational “own” revenues; principal sources and reform options:
  - Property taxes:
    - Urban property tax and land use fee comprise about 11 percent of total LG resources.
    - Problems: valuations of property owned by legal entities understated; tax rates extremely low by European standards; economically unjustified differences across property types.
    - Reform options: value industrial and commercial property at market prices and increase property tax rates; obstacles include legislation capping maximum annual rate increases, incomplete land registries, and poor collection enforcement (particularly from “legal” persons).
  - Land development fees:
    - Current fees are distortionary (highest fees where extending infrastructure is cheapest).
    - Increasing fees in outlying areas would reduce distortion and raise own revenues.
  - Utility fees:
    - Prices (particularly heating) set below cost recovery; increasing prices to cost recovery levels would improve revenues and reduce subsidy needs.
  - Transportation fees and revenues:
    - Public transport (Belgrade) tariffs set well below cost recovery; tariff enforcement traditionally poor.
    - Reform priorities: increased fares, reduced categorical exemptions, strengthened enforcement, and measures to address cost inefficiencies (notably excessive labor costs).

### Complementary short- and medium-term reform measures — Expenditures
- Expenditure structure and reform priorities:
  - Subsidies and transfers constitute almost 30 percent of LG expenditures; wages and subsidies account for about 20 percent of LG budgets.
  - Direct subsidies from local budgets to utility companies in 2012 were RSD25 bn or about 0.8 percent of GDP; concentrated: Belgrade RSD 15.5 billion (62 percent of local subsidies), Novi Sad RSD 2.2 bn (9 percent).
- Priority expenditure reforms:
  - Subsidies:
    - Fiscal Council recommends cutting subsidy expenditures in half between 2013–16.
    - Complement subsidy cuts with reforms to municipal SOEs: reduce redundant employees, align wages with private sector, improve public procurement.
  - Wage bill:
    - In 2012, LG wage bill estimated at RSD46 billion or about 1.4 percent of GDP and grew by 17 percent—almost double the pace at general government level.
    - Fiscal Council estimates surplus employment of 6 to 8 thousand employees costing RSD 6 billion (or 0.2 percent of GDP).
    - Short-run: contain wage inflation and employment growth; medium-run: address over-staffing at municipal level.
  - Efficiency measures:
    - Improve targeting of municipal programs by introducing means-testing using municipal Social Assistance Centers to reduce implicit subsidies.

### Implementation considerations and combined strategy
- Rolling back the 2011 amendments alone is insufficient; must be complemented by measures to bolster own revenues and reduce LG expenditures.
- Risks of rollback without complementary measures: clawing back centrally-sponsored transfers (or increased devolution of expenditure responsibilities) risks exacerbating fiscal pressures through accumulation of local arrears.
- A combined strategy can include partial rollback to 60 percent payroll tax share, strengthened municipal revenue bases, expenditure rationalization, and LG insolvency/receivership frameworks to align incentives and limit moral hazard.

*Sources: National authorities and Fund staff estimates; Fiscal Council and Fund staff estimates.*

### 26.      Enhancing the rules-based fiscal framework: Serbia’s rules-based framework to safeguard

### Enhancing the rules-based fiscal framework: Serbia’s rules-based framework to safeguard subnational government finances

### Assessment of the current subnational rules-based framework
- The framework includes budget balance rules to impose expenditure discipline above the line complemented by municipal borrowing controls to limit excessive financing below the line.
- Short-term debt constraints are described as "relatively restrictive" and, by international standards, the "50 percent debt ceiling on the debt-revenue ration is conservative."
- A waiver currently exists for the debt limit for borrowing with a maturity above five years if both conditions hold:
  - debt service is not larger than two thirds of current surplus, and
  - current surplus exceeds 15 percent of revenues.
- Risk identified: the waiver may allow municipalities to evade prudential debt ceilings owing to a temporary bulge in revenue.
- Proposal flagged as warranted: closing the loophole in favor of an alternative framework that allows for the financing of long-term capital investment.

### Recommended procedural safeguard for long-term projects
- One option suggested:
  - require an independent third party (such as the Fiscal Council) to publicly assess the financing of long-term infrastructure projects following a rigorous cost-benefit analysis of both:
    - the merits of the project, and
    - the sustainability implications on local government (LG) public finances.

### Further analytical and reform priorities at the subnational level
- A deeper analysis of fiscal rules at the subnational level and subnational PFM frameworks is needed to identify other reform priorities.
- Outstanding issues listed for further consideration as input to subnational fiscal reform:
  - the potential need for a stricter budget balance rule,
  - the adequacy of sanctions for a breach in rules,
  - risks related to borrowing exemptions.
- Additional priorities:
  - assessing and identifying mechanisms to improve public financial management frameworks at a subnational level,
  - establishing an effective framework to prevent the occurrences of municipal payment arrears.

### Context on Serbia’s broader fiscal framework weaknesses and outcomes
- Political and institutional drivers:
  - Political fragmentation in coalition governments has reduced top-down control of economic policies and accountability for overall fiscal implications.
  - An ingrained preference for high public spending stemming from inherited social assistance systems and pressures to support or re-state ownership of enterprises.
  - Relatively weak fiscal institutions: gaps and inconsistencies in data and definitions (example noted: different definition of public debt in the Law on Public Debt and in the Budget System Law); weak accountability mechanisms including external and internal audit.
- Political cycle effects:
  - Proximity of elections appears associated with a run-up in fiscal deficits; deficit increases often reflected spending on public wages and pensions or transfers to local governments.
- Market financing dynamics:
  - Through 2008, low recourse to deficit financing partly because of the 2006 Paris and London Club restructuring and privatization proceeds.
  - Financing conditions tightened in 2008 but improved around mid-2009 with increased market appetite for domestic T-bills.
  - Serbia issued a Eurobond in late 2011, and again in late 2012 and early 2013.
- Performance versus plans:
  - Comparing rolling three-year fiscal plans (adopted in 2007–12) for general government with outcomes reveals large deviations from plans, steadily growing over time.
  - In the first year of implementation actual deficits exceeded targets by around 2½ percent of GDP on average; in the second and third years this deviation widened to around 5 percent of GDP.
  - Public debt ratio increases exceeded what deficits alone would explain, reflecting additional increases due to government guarantees to (largely) loss-making public enterprises and exchange rate depreciation on a stock of public debt more than 80 percent denominated in foreign currencies.
  - The spending-to-GDP ratio experienced an upward drift, with a cumulative increase by more than 5 percentage points between 2007 and 2012.
  - Final spending outturn is on average 8½ percent (or almost 3 percent of GDP) higher than targeted at the outset of the budget process.
- Annual budget process and deficit drift:
  - Budget stages: spring memorandum (t-1), autumn memorandum, budget law approved by parliament, supplementary budget, and final outcome after year t.
  - Deficit increases occur mainly between:
    - the spring and the autumn memoranda (reflecting initial bargaining and macro updates), and
    - between the actual and the supplementary budgets (reflecting bargaining, execution patterns, and new initiatives).
  - Revenue projections in the spring memorandum have been conservative relative to ex-post outcomes; revenue projections increase in later stages to accommodate expenditure pressures but are usually not achieved.
  - The deficit drift is largely driven by nominal expenditure overruns rather than revenue shortfalls; in-year overruns often reflect new discretionary spending initiatives from new legislation and government decisions.
  - Structure of spending overruns shows crowding out of productive spending by unproductive spending: investment spending has been under-executed, while current spending items (public wage increases including bonuses, goods and services, subsidies, social assistance, net lending) have been over-executed.

*Source: INTERNATIONAL MONETARY FUND — Republic of Serbia chapter excerpt.*

### 14.      Several elements in Serbia’s existing framework are effective and should be preserved.

### _cr13207 - 14.      Several elements in Serbia’s existing framework are effective and should be preserved.

### Elements of the existing framework to preserve
- Budget System Law (BSL): reflects (at least on paper) best practices in public financial management, though implementation is uneven.
- Well-observed requirement that the legal deficit and spending limits (set in the last (typically, supplementary) budget law) be not exceeded.
- Requirement to not increase the deficits in the budget law relative to the target set in the autumn memorandum.
- Prudent elements related to public debt framework: government guarantees included in the debt upfront, borrowing rules for local governments, and a strict multi-step process of parliamentary approval of government guarantees.

### Key shortcomings in measurement and coverage of fiscal position
- General government perimeter and accounts:
  - No complete, precisely defined list of institutions comprising the perimeter of the general government.
  - Indirect budget beneficiaries (IBBs), such as schools, universities, or kindergartens—are only partially captured in the government accounts.
  - Government expenditure arrears information is not complete and fully reliable at the central government level and limited at the local government level.
  - No system for recording “new” fiscal risks (e.g., PPP law contingent liabilities; recent increase in borrowing by public enterprises without a government guarantee).
  - Fiscal position is measured on a cash basis; accrual methodology would be more economically meaningful.
  - Some budget information is not timely (i.e., on IBBs).

### Budget planning weaknesses
- Gradual loss of realism in revenue projections during the budget process.
- Overly optimistic expenditure projections at all budget stages, including:
  - Under-budgeting of some mandatory spending categories (social spending).
  - Weaknesses in budgeting investment projects financed from project loans.
- Insufficient capacity to develop fiscal projections for sub-central governments (cities and municipalities).

### Comprehensiveness across levels of government
- Budget process centered on the Republican level; other parts of general government only partially addressed.
- Financial plans of social security funds submitted with Republican budget law can be changed subsequently outside the Republican budget process.
- Financial plan of the Road of Serbia enterprise is prepared some two-three months after the budget is submitted to parliament.
- Budgets of cities and municipalities are often negotiated, presented, and passed after the central government budget is adopted.

### In-year implementation and controls
- Weak constraints on within-year fiscal drift.
- Treasury controls pace of expenditure primarily for legal compliance amid continuously changing rules.
- BSL’s pay-as-you-go rule (offsetting new spending increases or revenue cuts) has not been enforced; new laws often address budget allocation needs pro-forma.
- Budget process permits drift in both deficit and spending targets.

### Medium- and longer-term orientation
- Budget laws are annual; three-year plans are non-binding.
- BSL’s pay-as-you-go rule requires assessing and offsetting initiatives over a three-year period—this horizon is largely neglected.
- No requirement to spell out longer-term implications of selected fiscal legislation.
- Absence of a binding medium-term focus has permitted large and widening deviations of fiscal outcomes from plans.

### Anchoring of mandatory spending
- Mandatory spending is a large share of the budget: public wages and pensions alone amount to more than 50 percent of general government spending.
- Lack of anchors and high growth in 2006–08 led to expenditure indexation sub-rules in the 2010 BSL changes; these have been undermined by ad-hoc initiatives (bonuses, selective wage increases, increases in public employment).

### Public debt reporting, projections, and control
- Different definitions of public debt in the public debt law and the BSL (the narrower public debt law definition is often used).
- Incomplete coverage of public debt in official reports (e.g., nonguaranteed debt of local governments excluded).
- Lack of explicit rules/procedures for calling government guarantees; calls are not formalized or made public systematically.
- Limited reporting and control over contingent liabilities (nonguaranteed debt of public enterprises with implicit guarantees, PPP contracts, deposit insurance, arrears, disputed court cases).

### Fiscal transparency issues
- Limited time for public and parliamentary debate on important fiscal legislation (many laws adopted via “urgent procedures”).
- Insufficient reporting and information on important fiscal items (final account of the budget, financial statements of some general government entities and public enterprises).

### Accountability for budget outcomes
- Vague legal identification of accountability: BSL envisions collective government responsibility for budget implementation.
- Gaps in internal and external audit procedures; State Audit Institution (SAI) is building capacity and expanding coverage.
- Final account of the central government budget was not discussed, voted, or adopted by parliament for more than a decade.
- Lack of sanctions within fiscal federalism; clauses to cut transfers to noncompliant local governments were never meaningfully implemented.

### Legal and regulatory rigidities
- Multiple laws, rules, and “government strategies” not coordinated and potentially conflicting.
- Some entitlements (fixed percentage of GDP or total spending) reduce budget flexibility.

### Progress to build on
- Late 2012 reform of own-source accounts integrated direct budget beneficiaries into the budget process.
- Planned integration of indirect budget beneficiaries.
- Planned streamlining of para-fiscal fees and charges.
- Implementation of a tax administration modernization strategy.

### Importance of enforcing the BSL “pay-as-you-go” rule
- Enforcing article 48 would:
  - Signal priority to implementation of existing legal provisions.
  - Reduce pressures for fiscal deficit drift, especially at supplementary budget stage.
  - Increase medium-term orientation by requiring three-year offsets for new initiatives.
- Practical implementation steps:
  - Build capacity for competent and independent analysis of key fiscal initiatives and proposed offsets (within MoFE or a fiscal council); staff should be protected from political influence.
  - Require properly certified analysis demonstrating deficit-neutrality before initiatives can be submitted to government or parliament.
  - Strictly enforce the three-year horizon for neutrality assessment; consider a longer (say, 10 years) horizon for pension changes.
  - Consider a de-minimis threshold to focus capacity on macro-relevant initiatives.

### Comprehensive structural reform agenda (responsibilities indicated)
Better measurement of deficits and public debt:
- Statistics Office to (a) produce full list of entities comprising general government and (b) start compiling fiscal accounts on an accrual basis.
- Ministry of Finance and Economy (MoFE) to (a) collect full and reliable information on public spending arrears (including local governments); (b) compile a comprehensive database on PPP projects and other contingent liabilities; (c) fully integrate IBB information in final general government accounts.
- Government to propose reconciling the legal definition of public debt to align with the BSL.

Improved budget planning:
- MoFE to guard against overestimating revenue projections and underestimating spending (in particular mandatory spending).
- MoFE/Treasury to improve quality of monthly planning and projections to reveal implementation problems early and allow corrective measures.
- Local governments to develop capacity to better project fiscal outcomes.

Greater comprehensiveness:
- MoFE to (a) integrate budgets of social security funds, IBBs, the Road company, and other public enterprises that meet criteria into the budget law presentation; (b) avoid significant changes in financial plans of SSFs and the Road company outside the broader budget process; (c) assess and coordinate planning of local government budgets when the budget law is presented to parliament.
- Government to (a) alter rules regarding Social Security Funds to allow efficient reallocation of extra savings to other government levels; (b) effectively integrate expenditure arrears into the fiscal envelope and adopt plans to resolve arrears and prevent accumulation.

More effective implementation rules:
- MoFE to consistently observe the budget timetable (as in preparation of the 2013 budget).
- Government may consider additional rules limiting increases in the deficit during the annual budget process (ideally after pay-as-you-go is working), such as limiting scope for increasing the deficit at supplementary budget time.

Better medium-term orientation:
- MoFE could consider (a) introducing nominal binding medium-term spending limits; and (b) improving realism and quality of rolling three-year medium-term strategies, including incorporating fiscal council feedback.

Anchoring and improving mandatory spending quality:
- Government to consider introducing “claw-back provisions” for excessive growth in the public sector wage bill and consider automatic corrective measures.
- MoFE should finalize the register of public employees and propose measures to better control their number.
- Government and relevant SSFs should undertake specific reforms in pensions, health, education, and social assistance.

Improved quality of investment spending:
- MoFE (or another unit) should coordinate investment projects and their cost-benefit analysis.

Stronger accountability:
- State Audit Institution should continue building capacity and expanding audit scope.
- All ministries and agencies should improve and protect internal audit functions from political influence.
- Parliamentary Finance Committee should build capacity and meaningfully screen budget and fiscal initiatives.
- MoFE should enforce a meaningful, evenhanded, rule-based sanctions system for local governments.
- Government should restore personal Minister’s accountability for budget outcomes.

Eliminate inconsistent fiscal legislation:
- Government and MoFE should review, revise, or clarify legislation and regulations to lessen legal rigidities and inconsistencies.

Improved fiscal transparency:
- MoFE should (a) report and publish detailed information on spending arrears by each budget beneficiary; (b) communicate fiscal developments at predetermined regular intervals; (c) enhance published reports on fiscal position and public debt (incorporate IBBs in deficit and non-guaranteed local government debt in general government debt).
- Government should allow full public discussion of the final account of the budget in parliament.

### Reestablishing the 2010 fiscal rules and overall perspective
- Reestablishing the original 2010 fiscal rules is desirable on healthier foundations:
  - Fiscal deficit rule supports balanced and countercyclical policy in normal times.
  - Public debt ceiling of 45 percent of GDP is appropriate for Serbia’s circumstances.
  - Subrules on public wages and pensions would ensure orderly anchoring once recovery occurs.
  - Fiscal council plays a useful monitoring and improvement role; build on this progress.
- Recognize reestablishment may take time (e.g., to bring debt back to 45 percent of GDP).

### Expected benefits of the reform priorities
- Favor fiscal responsibility while minimizing adverse effects on growth.
- Reforms should be adjusted to circumstances but will:
  - Help achieve desired deficit outcomes with less need for sharp disruptive adjustments.
  - Be especially beneficial where transparency-enhancing and PFM reforms:
    - Require relatively small implementation capacity.
    - Do not represent a drag on growth.
    - Have positive political economy spillovers for good fiscal outcomes and support other fiscal reforms.

### Pension context (brief summary from annex)
- Serbia’s public pensions account for about 1/3 of general government spending and 14 percent of GDP.
- Serbia has weakened social contributions collection and faces aging pressures.
- Despite recent reforms, the pension system is not sustainable: without further adjustment, pension spending would remain well above 10 percent of GDP even with a significant projected drop in replacement rates.
- Current deficits of the pension fund are currently 7 percent of GDP.
- Key reform options include: (i) introducing actuarial penalties for early retirement; (ii) equalizing the retirement age of women and men; (iii) rationalizing early retirement privileges for various occupations.

*Source: _cr13207 - 14.      Several elements in Serbia’s existing framework are effective and should be preserved.*

### 1.      Currently, Serbia’s pensions system is built around a mandatory public earnings-

### Currently, Serbia’s pensions system is built around a mandatory public earnings-related pension-point scheme.

### System overview
- The overall system comprises rules and institutions for providing old-age, disability, and survivor pensions.
- For the largest pillar—old-age pensions—benefits depend on earnings during a working life and the length of contributing, adjusted for a number of gender- and occupation-based privileges.
- The contribution rate is currently 22 percent with maximum contribution base limited to five times nationwide average salary.
- The ratio of the individual’s and economy-wide annual wage is applied to a point yielding an individual coefficient. At retirement, the number of accumulated points is multiplied with a nominal economy-wide average point value to calculate the individual’s benefit.
- The personal coefficient is capped at 3.8.
- A minimum pension (27 percent of average net salary) is guaranteed to wage-earners with 15 years of contributions.
- The value of the “general point” is defined nationwide and is adjusted periodically, with such indexation equally applying to the rights of both current and future pensioners.
- Net assets of private pension schemes amounted to 0.4 percent of GDP at end-2011 and only 8 percent of employees used it.
- Currently, public pensions are the only pension income of the elderly. There are no mandatory private pension systems, and voluntary pension schemes have only been introduced in the 2000s with a modest take up.

### Current fiscal impact and structural design issues
- In 2012, the pension bill amounted to 14 percent of GDP, with budget transfers covering about one half.
- The pension support ratio fell to 1.2 (1.1 including farmers, most of whom do not pay contributions).
- Key factors causing rapid rise in pension spending: adverse demographics, ad-hoc indexations, and inefficient design.
- The relatively high pension contribution rates have been a significant obstacle to employment creation, while the pension fund deficit has crowded out more productive public spending.
- Public pensions were frozen during 2009–2010, but could only partially roll back the pensions/GDP ratio.
- Adverse demographics: old-age dependency ratio was 25 percent in 2010 and is higher than in many emerging economy peers.
- Disability pensions are larger than in most countries: old age benefits account for about 60 percent of pension spending; disability pensions account for 22 percent of pension spending versus an international average of 15 percent. These additional 7 percent of disabled pensioners cost Serbia about 0.3 percent of GDP per year.
- During 2008–2011 disabled comprised, on average, less than 15 percent of new pensioners; the average during 2008–2011 was 16.9 percent compared to 12.4 percent during 2005–2007.
- Special retirement conditions: pensioners who retired under previous, more generous conditions have comparable pension levels 20–30 percent higher than more recent retirees.
- Low statutory retirement ages and gender differences:
  - Men can retire at 65 years of age after 15 years of contributing with a possibility to retire at 54 years of age if credited with 40 years of contributions.
  - Women can retire at 60 years of age provided that they have been contributing for at least 15 years, or at 53 years and 4 months after contributing for 35 years and 4 months.
- Extensive options for early retirement and low effective retirement age:
  - Many pensioners retire well before statutory retirement age: around 58 for women and 61 for men for old-age pensioners (and 51 and 55 for disability pensioners respectively).
  - About three quarters of new male pensioners and about a half of female pensioners retire prior to the statutory requirement age.
  - Every year of contributing after 40 years of service is credited as half a year until 45 years of service; beyond 45 years it is not credited at all.
- Comparatively high replacement rate: Ministry of Labor stylized calculation showed net replacement rate of a hypothetical standard pensioner was above 70 percent in 2011.

### Reforms adopted in 2010–2011
- Arbitrary indexation adjustments are not permitted under new fiscal rules. Budget System Law (BSL) sets prudent pension indexation rules: general point and pension benefits are indexed biannually with CPI plus real GDP growth above 4 percent. Such indexation is to be applied until the pension bill falls to 10 percent of GDP.
- Parametric reforms in train aim to very gradually tighten eligibility for early retirement and reduce some occupational and gender privileges:
  - The minimum retirement age will be increased from 53 to 58 for both men and women.
  - Required years of service for women will increase from 35 to 38 over the period 2013 to 2023.
  - The reform will significantly reduce possibility for early retirement for women by narrowing the gap between early and statutory retirement age to only two years. The difference of the two retirement ages for men will remain seven years.
  - Reducing service credits for women from 15 to 6 percent in the period until 2023.
  - Tightening of retirement benefits for military and police.
- The 2011 increases in minimum pensions:
  - Minimum pension increased by more than 10 percent and set at 27 percent of the previous year nationwide net salary.
  - Some 6 percent of regular old age pensioners and about 13 percent of disability pensioners get minimum pension.
  - Minimum farmers’ pension is currently by some 20 percent lower than the regular minimum pension; almost all farmers (99 percent) get minimum pension.
- Pension system’s effect on poverty (2008–2011):
  - Poverty among pensioners in 2009: 12.9 percent relative poverty and 5.3 percent absolute poverty.
  - Nationwide poverty in 2009: 17.7 percent relative poverty and 6.9 percent absolute poverty.
  - Those older than 65 not entitled to pension benefits had absolute poverty at 10.4 percent.

### Baseline projections
- Population dynamics will further strain the public pension system: old age dependency ratio was 24.9 percent in 2010 and is projected to grow by additional 13 percentage points by 2050.
- Simulations indicate current pension system parameters may be socially unsustainable:
  - Under current indexation rules the legally targeted 10 percent share of pension expenditure in GDP would be reached in 2027.
  - The replacement rate would be reduced to 43.3 percent, down by 27.2 percentage points comparing to 2011.
- Stabilizing replacement rates at a more socially acceptable level of 50 percent scenario:
  - To prevent net replacement rates falling below 50 percent, CPI indexation would have to be applied only until 2022 and then substituted by wage indexation.
  - Replacement rates would fall by about 20 percentage points, but the overall pension bill would remain by 0.8 percentage points above the targeted 10 percent of GDP.
  - By 2050 pension bill would grow to 12 percent of GDP.
- Minimum pension implications:
  - Cross-country analysis suggests a 10 percentage point decrease in replacement rates increases those at risk of old-age poverty by 0.9 percentage points.
  - With a 50 percent replacement rate, the share of pensioners receiving minimum pensions will probably double to 10–12 percent.

### Reform options and simulations
- General considerations:
  - Increasing retirement ages and tightening access to early retirement could increase the size of the labor force.
  - Reducing benefits or increasing contributions improves fiscal balances but may reduce domestic demand or labor supply.
  - Contribution rates are already high, with the tax wedge at 37.8 percent as of 2009.
- Administrative reforms:
  - Ongoing Tax Administration reform should help increase efficiency of contribution collections through unifying revenue administration for tax and social security collection.
  - To enhance collection of farmers’ contributions, the decision to de-link subsidies to farmers from the requirement of being current on contribution payments should be reversed.
- Specific reform simulations summarized in the text:
  - Raising statutory retirement age for women by 5 years to equate it with men (to 65):
    - Reform takes effect in 2013 and statutory retirement age raised by half a year each year until 2022.
    - Average yearly savings (including additional contributions) from 2013 to 2030 would amount to 0.1 percent of GDP, and would increase to 0.3 percent of GDP in the period from 2013 to 2050.
    - Total savings by 2050 would amount to 7.2 percent of GDP.
    - Calculations assume that, once effects are fully materialized, 25 percent of women will continue to retire at the statutory retirement age, down from current 50 percent.
    - Postponing the reform to 2020 would reduce total saving to 5.1 percent of GDP.
  - Raising minimum early retirement age for both men and women from 58 to 60 (in the period 2024–2027 by half a year each year) is presented as another measure (impact figures begin to be discussed but are truncated in the source excerpt).

*Prepared by Desanka Nestorovic (Belgrade Office). Source: IMF staff analysis as presented in the provided chapter excerpt.*

### 0.1 percent after 2030, and total savings of 2.3 percent of GDP assuming that actuarial penalties

### _cr13207 - 0.1 percent after 2030, and total savings of 2.3 percent of GDP assuming that actuarial penalties

### Pension reform options and projected savings
- Raising statutory retirement age of both men and women to 67 (in the period 2023–2026 by half a year each year)
  - Average savings: 0.2 percent of GDP per year in the period 2031–2050.
  - Total savings: 4.2 percent of GDP (assumes no actuarial penalties for early retirement and that 80 percent of both men and women would retire early).
  - Note: Life expectancy at age 60 is lower in Serbia than in EU countries (for women by 5.4 years and for men by 4.4 years), suggesting linkage of retirement age to life expectancy in the future.
- Introducing penalties for early retirement of 6 percent per year (actuarially-neutral range 6–9 percent for ages 60–70 referenced)
  - Average savings if introduced in 2013 and penalties do not discourage early retirement (assumes 75 percent of men and 50 percent of women still retire early): 0.4 percent of GDP per year in the period 2013–2050.
  - Cumulative savings 2013–2030: 6.5 percent of GDP.
  - Additional savings 2031–2050: 9.3 percent of GDP.
- Introducing incentives for working longer in the amount 6 percent per year (assumed actuarially neutral)
  - Expenditure neutral compared to the option with only penalties where all pensioners retire at statutory age.
  - Not preferred given very high unemployment rate, particularly among the young.
- Combination: equating retirement ages and years of service as a retirement condition (including elimination of 6 percent service credits for women) + introducing actuarial penalties
  - Savings per year: between 0.8 percent of GDP (should all pensioners decide to retire at statutory age) and 0.9 percent of GDP (should pensioners keep current preferences unchanged).
  - Total savings over entire period: between 30.6 and 35.0 percent of GDP.

### Selected quantified policy scenarios (exact figures preserved)
- Increasing retirement age for women by 5 years, from 2013–2022
  - Average savings per year (2013–2050): 0.2
  - 2013–2030: 0.1
  - 2031–2050: 0.3
  - Present value (2013) of total savings: 7.2
  - Present value (2013) 2013–2030: 2.1
  - Present value (2013) 2031–2050: 5.1
- Increasing retirement age for women by 5 years, from 2020–2029
  - Average savings per year (2013–2050): 0.1
  - 2013–2030: 0.0
  - 2031–2050: 0.2
  - Present value (2013) total: 5.1
  - 2013–2030: 0.7
  - 2031–2050: 4.4
- Increasing retirement age for both men and women to 67, from 2023–2026
  - Average savings per year (2013–2050): 0.1
  - 2013–2030: 0.0
  - 2031–2050: 0.2
  - Present value (2013) total: 4.2
  - 2013–2030: 0.4
  - 2031–2050: 3.8
- Increasing early retirement age for both men and women from 58 to 60, from 2024–2027
  - Average savings per year (2013–2050): 0.1
  - 2013–2030: 0.0
  - 2031–2050: 0.1
  - Present value (2013) total: 2.3
  - 2013–2030: 0.2
  - 2031–2050: 2.1

- Introducing actuarial penalties for early retirement, unchanged preferences
  - 6 percent per year
    - Average savings per year (2013–2050): 0.4
    - 2013–2030: 0.4
    - 2031–2050: 0.5
    - Present value (2013) total: 15.8
    - 2013–2030: 6.5
    - 2031–2050: 9.3
  - 4 percent per year
    - Average savings per year (2013–2050): 0.3
    - 2013–2030: 0.2
    - 2031–2050: 0.3
    - Present value (2013) total: 10.5
    - 2013–2030: 4.3
    - 2031–2050: 6.2
  - 2 percent per year
    - Average savings per year (2013–2050): 0.1
    - 2013–2030: 0.1
    - 2031–2050: 0.2
    - Present value (2013) total: 5.3
    - 2013–2030: 2.2
    - 2031–2050: 3.1

- Introducing actuarial penalties for early retirement, all retire at statutory age
  - 6 percent per year
    - Average savings per year (2013–2050): 0.4
    - 2013–2030: 0.3
    - 2031–2050: 0.4
    - Present value (2013) total: 13.4
    - 2013–2030: 5.7
    - 2031–2050: 7.7
  - 4 percent per year
    - Average savings per year (2013–2050): 0.2
    - 2013–2030: 0.2
    - 2031–2050: 0.2
    - Present value (2013) total: 8.1
    - 2013–2030: 3.5
    - 2031–2050: 4.6
  - 2 percent per year
    - Average savings per year (2013–2050): 0.1
    - 2013–2030: 0.1
    - 2031–2050: 0.1
    - Present value (2013) total: 2.8
    - 2013–2030: 1.4
    - 2031–2050: 1.5

- Equating retirement ages for men and women + introducing actuarial penalties, unchanged preferences
  - 6 percent per year
    - Average savings per year (2013–2050): 0.9
    - 2013–2030: 0.7
    - 2031–2050: 1.1
    - Present value (2013) total: 35.0
    - 2013–2030: 12.6
    - 2031–2050: 22.4
  - 4 percent per year
    - Average savings per year (2013–2050): 0.7
    - 2013–2030: 0.5
    - 2031–2050: 0.8
    - Present value (2013) total: 25.7
    - 2013–2030: 9.1
    - 2031–2050: 16.7
  - 2 percent per year
    - Average savings per year (2013–2050): 0.4
    - 2013–2030: 0.3
    - 2031–2050: 0.5
    - Present value (2013) total: 16.5
    - 2013–2030: 5.6
    - 2031–2050: 10.9

- Equating retirement ages for men and women + introducing actuarial penalties, all retire at statutory age
  - 6 percent per year
    - Average savings per year (2013–2050): 0.8
    - 2013–2030: 0.6
    - 2031–2050: 1.0
    - Present value (2013) total: 30.6
    - 2013–2030: 11.2
    - 2031–2050: 19.4
  - 4 percent per year
    - Average savings per year (2013–2050): 0.5
    - 2013–2030: 0.4
    - 2031–2050: 0.7
    - Present value (2013) total: 21.3
    - 2013–2030: 7.7
    - 2031–2050: 13.6
  - 2 percent per year
    - Average savings per year (2013–2050): 0.3
    - 2013–2030: 0.2
    - 2031–2050: 0.4
    - Present value (2013) total: 12.1
    - 2013–2030: 4.3
    - 2031–2050: 7.8

### Model assumptions (projection methodology and key parameter choices)
- Number of pensioners projected by adjusting previous year’s figure by projected number of newcomers and exits.
- Projected number of new beneficiaries assumes shares of cohorts of new pensioners in population cohorts remain at 2007–2011 levels; data corrected for about 30 percent fall in contributors from 1989 to 2011.
- Projection of exits based on shares of exits in 2005–2011 by gender and cohorts; adjusted by projected changes in life expectancy (assuming changes for the elderly follow those of newborns).
- Adjustments made for disabled and farmers:
  - Number of contributing farmers significantly lower than two decades ago (at least one half).
  - Share of new disabled in new pensioners was somewhat below 15 percent; overall number of disabled projected to fall to 15 percent of total pensioners and remain stable through 2050.
- Pension indexation rule:
  - Current CPI (plus real GDP growth above 4 percent) rule up to point where net replacement rate of a standard pensioner falls to 50 percent; from that point pensions indexed to nominal wage growth to preserve 50 percent replacement rate.
- Corrections for enacted parametric reforms: changes in early retirement age for men and women (old age only) and reduction of service credits for women.
- Data limitations affecting reliability:
  - Data on formal employment by age cohorts not available.
  - Demographic projections do not include migrations.
  - Projections of life expectancy at age 60 not available.
  - Detailed data on survivors and pensioners with accelerated years of service not available.

### Pension policy implications emphasized in the text
- Actuarial penalties for early retirement can generate significant savings and enhance labor supply if they do not overly discourage work.
- Equating retirement ages and removing gender-based service credits combined with actuarial penalties yields the largest savings.
- Linking retirement age to life expectancy is recommended given lower Serbian life expectancy at age 60 relative to the EU.
- Incentives for working longer (6 percent per year) are expenditure neutral compared with certain penalty options but are not preferred given high youth unemployment.

### Corporate tax and non-tax levies (selected findings)
- Serbian corporate income tax (CIT) collection: 1.2 percent of GDP (far below EU unweighted average of 2.7 percent of GDP, 2010).
- CIT rate change: increased from 10 to 15 percent as part of late 2012 reform.
  - EU average statutory rate cited: 23.5 percent.
  - Regional peers rates: Macedonia, Bosnia and Herzegovina, Bulgaria, and Albania have 10 percent; Montenegro has 9 percent.
  - Capital gains taxed at 15 percent separately.
- Tax expenditures eroded revenue base; total fiscal cost of incentives in 2011: 0.8 percent of GDP, or 68 percent of total CIT collection.
- Recent reform changes to incentives expected to reduce CIT tax expenditure by about one third (0.2–0.3 percent of GDP); full effect delayed by 10-year carry-forward of investment credits.
  - Even after reform, share of incentives in CIT collection projected to remain about 45 percent.
  - Eliminating all tax expenditures would bring additional revenue of about 0.5–0.6 percent of GDP to the budget.
- Non-tax levies: NALED identified 370 non tax levies in 2012; at least 179 charges paid without equivalent goods or services; base for calculating 25 levies was operating revenue.
- 2012 reforms on levies:
  - Charges can only be introduced through new legislation; level must correspond to cost of provision; approval by finance minister unless otherwise specified.
  - Own resource revenue accounts abolished; revenues collected through single treasury account; decisions on spending via regular budget procedures.
  - Abolition of 138 charges (28 at local level); revenue loss replaced by increased CIT collection from higher CIT rate (reliable net effect estimates not available).

### Table highlights (2009–11 incentives and impacts)
- Total incentives (2009–2011): 20.8, 19.8, 25.6 (in RSD bn as shown in table).
- CIT collection (2009–2011): 31.2, 32.6, 37.8 (in RSD bn).
- Total incentives as percent of CIT collected (2009–2011): 66.8, 60.8, 67.7.
- Projected savings from cutting tax incentives shown in table: 0.8 (presumably percent of GDP) in the tenth year projection (table header context indicates projected savings cutting tax incentives of 0.8 and 8.4 in RSD bn columns).

*Source: IMF staff calculations and analysis in the provided document.*

### References

### _cr13207 - References

### Macro-Financial Linkages — overview
- Credit growth is important for economic activity in Serbia; current credit growth rate is lower than during the onset of the global financial crisis, making durable economic recovery challenging.
- The slowdown of credit reflects domestic and external vulnerabilities, elevated uncertainty, and an underdeveloped export-oriented private sector, which increase lending risk and suppress both demand for and supply of credit.
- Banking-sector buffers accumulated before the global crisis helped maintain stability, but the system faces challenges including a significant level of nonperforming loans (NPLs) and exceptionally high euroization.
- Reducing macroeconomic vulnerabilities and addressing high level of NPLs would decrease perceived risk and facilitate financial intermediation.

### A. Low Credit Growth: demand vs supply
- Findings on credit dynamics:
  - Credit to Serbia’s private sector is weak though dynamics remain more favorable than in peer countries.
  - Credit from both the domestic banking system and external sources is no longer growing in nominal terms and is declining in real terms.
  - Cross-border credit is being unwound, requiring Serbia’s enterprises to find alternative financing.
  - After recovery in 2009–10, domestic credit has been decelerating; current growth is lower than during the onset of the global financial crisis.
  - In real terms (nominal credit in local currency at current exchange rates adjusted for CPI inflation) domestic credit has been declining, though more slowly than in several New Member States of the EU (NMS).
  - Credit growth continued to decelerate in late 2012 and 2013:Q1 despite a subsidized credit program— a significant share of loans under this program went to refinancing old loans rather than new financing.
  - Domestic credit is positively correlated with GDP growth; bank credit is important for investment, housing construction, and durable consumption.
  - Low private sector credit growth may drag on investment and consumption and hence on economic recovery.

- Conceptual framing:
  - Supply-side determinants of lending include availability and cost of funding (domestic and external), lending standards, and risk premia.
  - Demand depends on availability of projects with expected returns above the interest rate, which is influenced by the cyclical position of the economy and structural characteristics (technology, intertemporal discounting).
  - A purely demand-driven slowdown would call for demand-stimulating policies; a supply-driven shock can itself cause broader slowdown and requires policies addressing credit supply.

- Empirical observations and interpretation:
  - Disentangling demand and supply is challenging; lending surveys (e.g., BLS) are useful but not available for Serbia.
  - Serbia’s outcomes suggest both supply and demand factors mattered since 2008: annual credit growth fell from about 30 percent before the crisis to low single digits at end-2012 while lending interest rates fluctuated within a narrow band of 7–9 percent.
  - This pattern is consistent with simultaneous shifts in demand and supply, producing large volume changes with little change in interest rates.
  - Demand was affected by weaker economic activity; supply was restricted by availability and cost of funding and tightening lending standards from rising perceived risk.

- Funding and decomposition:
  - Availability of funding declined and cost increased since 2008. Domestic deposits and foreign liabilities slowed significantly after the crisis onset.
  - Deposits contracted beginning 2009, recovered late 2009–early 2010, then slowed again.
  - Foreign funding (gross foreign liabilities in the monetary survey) picked up in 2009 but plateaued afterwards.
  - Decomposition of period-average credit growth into contributions of deposits, net foreign assets, net claims on government, net claims on NBS, and net other items shows:
    - In 2008 credit was propelled mainly by deposit growth.
    - In later years deposit contribution diminished and credit was consistently crowded out by increases in net claims on government.
  - Relatively high price of funding contributed to high lending interest rates; price of funding correlated with external risk premium.

- Risk perception and financial stress:
  - Since the crisis, risk perception increased and lending standards tightened: difficult external financing environment and domestic vulnerabilities (volatile inflation, large twin deficits, weak real sector) increased banks’ lending risk.
  - Large stock of nonperforming assets and provisioning eroded profitability and raised lending margins.
  - In absence of a lending survey, a Financial Stress Index (FSIX) approximates risk perception by aggregating exchange rate and stock market volatility, and spreads of the interbank rate and government bond over the NBS policy rate.
  - Credit growth is correlated with the inverse of FSIX; periods of financial stress buildup (2009 and 2011) associated with credit slowdown.
  - FSIX declined since 2012:Q3 (lower exchange rate and stock market volatility, declining sovereign yields) but credit growth continued slowing.

- Anecdotal evidence on demand vs supply (recent quarters):
  - Banks report few credit applications; excess liquidity has not translated into new loans.
  - Lending interest rates have not adjusted downwards to reflect excess supply, suggesting a disequilibrium or implicit supply-side restrictions preventing downward rate adjustment.

- Notable numeric references preserved from source:
  - Structural break in domestic credit time series in October 2012 due to resolution of Nova Agrobanka; effect amounts to some 2½ percent of total credit stock.
  - Annual credit growth changed from about 30 percent pre-crisis to low single digits at end-2012.
  - Lending interest rates fluctuated within a narrow band of 7–9 percent.
  - Time references and quarters: 2009–10, late 2012, 2013:Q1, 2012:Q3, October 2012.

### Box 1 — Construction of a Financial Stress Index (FSIX)
- FSIX is a composite index capturing functioning of financial channels using deviations from averages of four components:
  - (i) spread of the interbank money market rate (BEONIA) over the NBS policy rate,
  - (ii) stock market volatility,
  - (iii) exchange rate (ER) volatility,
  - (iv) government borrowing spread over the NBS policy rate.
- Positive FSIX values imply higher-than-average financial stress; negative values indicate less-than-average stress.

### B. Changing banks’ business models and external deleveraging
- Shift in European banks’ business models:
  - Pre-crisis host-country subsidiaries relied on external funding including parent banks, pushing loans-to-deposit ratios high.
  - Since crisis onset, banks are re-orienting toward local deposits, implying external deleveraging and asset downsizing.

- Financial linkages and data caveats:
  - Foreign parent banks finance Serbia’s subsidiaries (bank-bank, BB) and directly finance Serbia’s corporates (bank-corporate, BC). Other foreign sectors (multilaterals) provide financing (OB, OC).
  - BIS data are useful but do not include some foreign banks (e.g., Russian banks) that may provide financing.

- Empirical evidence on deleveraging and exposures:
  - Monetary and external debt data indicate Serbia’s enterprises were affected by deleveraging, while foreign liabilities of Serbia’s banks remained broadly stable.
  - Total foreign liabilities of Serbia’s banks (excluding shares)—sum of links BB and OB—increased in 2009 and have marginally unwound since; on a net basis foreign liabilities oscillated around a broadly stable level.
  - Compared with peers, deleveraging in Serbia was relatively limited: overall claims on Serbia declined only marginally (and increased for Serbia’s banks) though claims on Serbia’s banks fell in 2012 in BIS data.
  - BIS locational banking statistics show:
    - Gross external claims reduction in many countries was substantial; for Serbia overall claims declined marginally.
    - BIS data indicate considerable reduction of claims on Serbia’s banks in both gross and net terms in 2012.
    - Gross exposure of BIS-reporting banks to Serbian enterprises is dominated by loans.
    - In 2012, deleveraging in gross terms was driven mostly by reduction in loans; net exposure patterns were broadly similar.
  - Loan-to-deposit ratios and changes in BIS-reported bank exposures referenced across peer countries and periods (Q4 2008, Q3 2012) were used for comparative assessment.

- Numeric and period references preserved:
  - Loan-to-deposit ratio comparisons span 2008–2012Q3.
  - BIS exposure series cover 2006 through 2012Q3 with specific quarterly markers (e.g., 2006Q4, 2007Q4, 2008Q4, 2009Q4, 2010Q4, 2011Q4, 2012Q3).
  - Net exposure of BIS reporting banks includes FX reserves of the central bank into assets (footnote).

### C. How is Serbia’s banking system coping with macroeconomic strains?
- (Section heading present in source; substantive text beyond heading not included in supplied content.)

*Source: _cr13207 - References*

### 13.      Buffers of Serbia’s banking system helped to preserve its stability during the crisis. At

### _cr13207 - 13.      Buffers of Serbia’s banking system helped to preserve its stability during the crisis. At

### Banking system buffers and performance
- At the outset of the crisis, Serbia’s banking system had one of the highest capitalization rates among the peer countries and the very high level of provisioning.
- Nonperforming loans (NPLs) were substantial but well-provisioned.
- Since 2008:
  - Capitalization declined (also partly due to introduction of the Basel II supervisory standard at end-2011), but it remained substantially higher the regulatory minimum and still stronger than in many peers.
  - The NPL ratio rose to nearly 20 percent, but the increase was smaller than in some of the peer group countries.
  - The level of provisioning declined but remains one of the highest in Emerging Europe.
- The level of banking system liquidity is adequate.
- The banking system—excluding a few exceptional cases that needed resolution—is still profitable.
- Profitability indicators for Serbia in 2012 are affected by outliers (Agrobanka, New Agrobanka and RBV that have been resolved).

### Key vulnerabilities and challenges
- Current macroeconomic environment—including anemic economic activity in the environment of strained balance sheets—increases the risk of non-payments and further rise of NPLs.
- Exceptionally high euroization of the lending portfolio is the Achilles’ heel of the banking system:
  - Many borrowers are unhedged and therefore are subject to a significant exchange rate risk, implying credit risk for the banks.
- Return on assets declined but is still positive; return on equity is moderate but still positive.
- Capital-to-asset ratio is much higher than in peers.
- The CAR decreased since 2008 (in part due to switching to Basel II), however the system remains well-capitalized.

### Policy implications and recommendations to restore credit growth
- Context:
  - Bank credit is the most important financing channel for Serbia’s private sector; reviving credit growth to a healthy level would be instrumental for supporting the revival of the economy.
  - Low credit growth could create a drag on economic activity and obstruct realizing Serbia’s potential.
- Broad actions required:
  - Reduce macroeconomic vulnerabilities — maintaining macroeconomic stability would:
    - Alleviate supply-side limitations,
    - Reduce banks’ perceptions of lending risks,
    - Possibly improve banks’ external financing terms,
    - Reduce crowding out of private investment,
    - Improve trust in the financial system and prospects for channeling savings to banks rather than “mattress money.”
  - Finish structural reforms to support private sector development and increase return on investment — this would increase demand for credit.
- Financial-sector specific measures to address supply-side credit restrictions:
  - Address the high stock of nonperforming loans to improve banks’ balance sheets and reduce costs of dealing with NPLs; specific measures could include:
    - Fostering out-of-court debt workouts;
    - Clarifying creditor classes in bankruptcy procedures and creditor rights under the mortgage law.
  - Implement the strategy of dinarization to reduce credit risk stemming from non-hedged borrowers, including:
    - Deepening local currency financial markets;
    - Fostering development of institutions that operate in these markets (pension funds, insurance companies, etc.).
  - Avoid significant relaxation of tight prudential policies:
    - Serbia’s tight regulatory policies (e.g., required level of provisioning is one of the highest in Europe) probably added to the cost of credit, but safety cushions built as a result could be vital in financial stress.

### Inflation targeting (IT) in a euroized economy — main findings
- General effects of euroization on IT:
  - Euroization does not preclude implementing IT.
  - The monetary policy transmission mechanism is generally weaker in the presence of euroization.
  - Non-sterilized interventions in the FX market are not contradictory to an IT regime and may be optimal.
  - FX interventions must be symmetric (both sales and purchases), should not target the level of exchange rate but aim at reducing excess volatility, and their effect on the exchange rate is non-linear.
  - Given interventions are at times necessary, maintaining sufficient FX reserves to conduct such operations is important.
- Specific mechanisms and risks:
  - In a euroized economy, interest rate changes produce offsetting substitution and income effects for net debtors, weakening policy interest rate potency.
  - High euroization reduces the impact of changes in policy interest rates on banks’ lending and deposit rates, particularly long-term rates.
  - Financial euroization poses balance sheet risks: currency mismatches can cause depreciation to generate rapid rises in NPLs.
  - Design and implementation of IT in a euroized economy may require special features, including intermediate targets and non-monetary tools (financial or macro-prudential policies).
  - The exchange rate often becomes an additional operational target to smooth sharp movements that threaten inflation outlook and financial stability.
  - Sterilized FX interventions are common and operate via portfolio reallocation and expectations (signaling) channels; their effects are generally non-linear and small but statistically significant on exchange rates, and stronger on volatility than on levels.

### Practical considerations and international experience
- Emerging market IT economies often use FX interventions and implicitly target the exchange rate as part of policy reaction functions.
- Maintaining sufficient FX reserves is important for credible interventions and for the central bank’s role as lender of last resort in foreign currency when deposit euroization is significant.
- Higher reserve requirements on foreign currency liabilities help share reserve costs between the central bank and commercial banks and encourage banks to internalize balance sheet mismatch risks.
- To promote de-euroization:
  - Avoid excess interventions that create “fear of floating,” which discourage hedging and create moral hazard.
  - Promote greater stability of real returns on domestic-currency assets to encourage de-dollarization.
  - Use interest rates as the main monetary policy instrument to reduce interbank rate volatility and strengthen pass-through, supporting IT’s role in de-euroization.

### Case study — Peru’s experience with IT in a dollarized economy
- When Peru adopted IT in 2002, credit dollarization was close to 80 percent in 2002; by end-2012, dollarization was much lower at just under 50 percent.
- Peru’s policy choices and institutional steps:
  - Adopted an inflation target of 2.5 percent, +/- 1 percentage point, close to the U.S. long-run inflation, promoting a relatively stable real exchange rate.
  - Issuance of long-term public debt instruments in domestic currency helped develop a benchmark yield curve and encouraged private issuance of long-term domestic instruments.
  - In mid-2004, Parliament ordered prices to be listed in domestic currency (option to list prices also in foreign currency was left open).
  - In 2006, banking supervision required banks to either routinely evaluate currency risks of their foreign-currency credit or set up a reserve ranging from 0.25 percent to 1 percent of the credit in foreign currency that had not been evaluated.
  - The Central Bank of Peru (BCRP) announces a target for the interbank market rate within a corridor maintained by deposit and standing facility rates; there is an escape clause allowing the target interest rate to increase temporarily outside the corridor to prevent a large depreciation (used once in 2002 before the financial crisis).

*Source: IMF staff report — Republic of Serbia (selected sections reproduced from the provided content).*

### 21.      The BCRP intervened heavily in the foreign exchange market during the financial

### _cr13207 - 21.      The BCRP intervened heavily in the foreign exchange market during the financial

### BCRP actions during the international financial crisis
- Starting in September 2008, the BCRP raised interest rates and intervened heavily throughout early 2009 amid exchange rate pressures.
- Once exchange rate pressures abated, monetary policy priority shifted to countering the crisis-induced fall in aggregate demand driven by a drop in exports and investment flows.
- The BCRP implemented aggressive interest rate cuts reaching unprecedented historical levels and adopted nonconventional measures to improve credit conditions and strengthen transmission to longer-term rates. Measures included:
  - extending the term of swap operations;
  - reducing the average term of placements with the central bank to maintain banks’ availability of liquidity;
  - widening the range of accepted collateral for repo operations;
  - exempting small liabilities from reserve requirements, effectively lowering the reserve requirement for smaller financial entities and increasing their liquidity access.
- The monetary easing measures represented an injection of liquidity equivalent to 9.6 percent of GDP and contributed to maintaining the flow of credit, supporting GDP growth in 2009, and keeping core inflation and inflation expectations within the target range.

### Peru: inflation targeting (IT) experience and de-dollarization
- The first four years of inflation targeting in Peru delivered encouraging results:
  - Peru’s announced annual inflation target was achieved every year since IT was adopted.
  - Output variability moderated significantly.
  - Financial dollarization declined steadily, though it remained significant.
- De-dollarization drivers noted:
  - an explicit inflation targeting framework with more predictable inflation and domestic currency interest rates;
  - development of the local government debt market in domestic currency, providing a benchmark for private domestic-currency issuance.

### Implications and lessons for Serbia
- Mixed success of Serbia’s IT:
  - IT reduced interbank interest rate volatility considerably.
  - Inflation stabilization progress was modest: inflation has been within the National Bank of Serbia’s (NBS) band less than 40 percent of the time since adoption of IT.
  - Adoption of full-fledged IT in 2009 occurred against a difficult global backdrop, complicating policy.
- Major challenge:
  - Reducing inflation volatility remains the central challenge; Serbia’s inflation volatility is the highest in the region even excluding the hyper-inflation period, discouraging dinar-denominated saving and investment.
- Exchange rate policy and interventions:
  - When exchange rate movements affect the inflation outlook, adjusting the policy rate to prevent large exchange rate swings (and consequent shifts in inflation expectations) can be optimal.
  - The NBS has been effective at managing inflation expectations via communications and inflation reports.
  - Credibility requires two-way foreign exchange interventions (responding to appreciation as well as depreciation). One-way interventions create moral hazard and encourage bets against the currency. The NBS has intervened on appreciation episodes (e.g., April–early May 2013) and should continue two-way intervention.
- Financial instruments and market development:
  - Instruments to hedge currency risks should be developed; there is demand for forward contracts by agents holding domestic currency assets who seek coverage against possible depreciation.
  - Natural suppliers of forward contracts include pension funds (with long-term domestic currency liabilities) and exporters.
  - Deepen domestic bond markets: lengthen maturities of public dinar debt, develop a yield curve for private paper, and foster a secondary bond market.
- Deposit insurance and euroization risk:
  - Deposit insurance could better internalize euroization risks by charging higher insurance costs for euro-denominated deposits relative to dinar deposits, rather than basing premiums solely on overall bank risk.
- Coordination on liquidity management:
  - Close cooperation between the NBS and the government in liquidity management is essential. While the NBS has ultimate responsibility for liquidity management, government actions (as the largest consumer) materially affect day-to-day liquidity fluctuations.
  - The government can assist by strengthening and lengthening the domestic yield curve.

### Key statistics and indicators (preserved exactly as presented)
- Injection of liquidity equivalent to 9.6 percent of GDP.
- Credit euroization in Serbia:
  - beginning of 2009: 66 percent;
  - end-2012: nearly 70 percent.
- Inflation within NBS band: less than 40 percent of the time since IT adoption.
- Volatility of interbank rate and inflation volatility (coefficient of variation, Source: NBS, Staff calculations):
  - 2006: Volatility of interbank rate 16.6; Inflation volatility 26.8
  - 2007: Volatility of interbank rate 11.3; Inflation volatility 45.0
  - 2008: Volatility of interbank rate 18.1; Inflation volatility 15.2
  - 2009: Volatility of interbank rate 22.6; Inflation volatility 20.2
  - 2010: Volatility of interbank rate 9.6; Inflation volatility 38.6
  - 2011: Volatility of interbank rate 9.3; Inflation volatility 22.2
  - 2012: Volatility of interbank rate 8.7; Inflation volatility 50.7

*Source: IMF staff summary of chapter on BCRP interventions and implications for Serbia from _cr13207.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr13207.pdf_