The cost of the tax reform will amount to approximately 3.6 billion kuna

The implementation of all proposed changes in the Croatian tax system should reduce the share of taxes in gross domestic product (GDP) from the current 37.5 percent to 36.9 percent in 2017 and to 36.5 percent in 2018, while the nominal cost of the reform is estimated to be around 3.6 billion kuna, according to calculations from the Ministry of Finance.

Already in the first year, according to earlier statements by Finance Minister Zdravko Marić, the cost of the reform will be up to 2 billion kuna, which is the nominal estimate of the effect of reducing labor costs through changes in income taxation, relieving entrepreneurship through changes in corporate tax, and reducing the regressiveness of value-added tax (VAT) through the redefinition of products and services to which the reduced VAT rate will apply. In 2018, this should be supplemented by the effect of the planned reduction of the general VAT rate, raising the threshold for entering the VAT system, and more.

Changes in the VAT system

In the area of value-added tax (VAT), the most significant proposal is to reduce the general VAT rate from the current 25 percent to 24 percent starting January 1, 2018, and to introduce a single reduced rate of 12 percent, thereby abolishing the previously reduced rates of 5 and 13 percent. These changes would impact the reduction of state budget revenues by approximately 1.8 billion kuna annually. Currently, in Croatia, VAT is paid at three rates (5, 13, and 25 percent) at an average rate of 15.6 percent. Non-residents, i.e., foreigners, pay an average of 15.45 percent, while Croatian citizens pay between 15.7 and nearly 16.6 percent, depending on their income bracket.

With the proposed changes, the average VAT rate would drop to 15.5 percent in 2017 and to 15.3 percent in 2018, with the application of the higher VAT rate on hospitality services being most felt by non-residents, who also use services taxed at the reduced rate (hospitality services and accommodation) the most, the Ministry states. They also add that the poorest layer of Croatian citizens, with the lowest incomes, currently pays an average VAT of 15.7 percent, which should fall to 14.8 percent by 2018.

The intention to increase VAT on hospitality services from the current 13 to 25 percent has caused the most ‘noise’ in the public after the announcement of the details of the tax reform, and even the Minister of Tourism Gari Cappelli stated that this increase would be negative for the sector and that he sees a moratorium on this increase as one of the options until the market and other effects on tourism are carefully studied, or that the rate remains as it is now. However, the Ministry of Finance dismisses such a possibility, explaining that it concerns an increase in budget revenues from VAT of about one billion kuna, which is too high an impact on the budget to abandon, and that it is one of a series of changes in the tax system, which are conceived as a comprehensive reform, and changing one part of it would undermine the entire reform. In addition, they remind that the reform proposes a series of measures to compensate hospitality providers for the higher costs due to the higher VAT: changes in income tax would increase citizens’ disposable income for greater consumption; a lower corporate tax rate is proposed for entrepreneurs with annual revenues below 3 million kuna; lower VAT on the supply of electricity and waste disposal would reduce overhead costs for hospitality providers, who would also be allowed a higher income through the recognition of an increased deduction for representation (from 30 to 50 percent), and more.

There has also been criticism of the announced changes in the VAT system in 2018, where the reduced VAT rate would drop from the current 13 to 12 percent, and the 5 percent rate would be abolished. This lowest rate currently applies, for example, to bread and milk or books and newspapers. In response, the Ministry of Finance calculates that changes in consumption taxation will mean a higher average monthly cost for hospitality services of approximately 8 kuna, and for food of 12 kuna, while lower taxes on the supply of electricity and waste disposal should reduce overhead costs by an average of about 300 kuna annually.

At the same time, a lower VAT (from 13 percent) is proposed for agricultural raw materials, i.e., seedlings, seeds, animal feed, etc., which results in an overall cost for the budget, or lower costs for farmers on an annual basis of about 170 million kuna.

Changes in income taxation

The Ministry’s argument is the same in response to criticism that the proposal for changes in income tax favored individuals with higher incomes, while nothing changes for those with lower incomes.

The main changes in income tax would be a reduction in tax rates from 25 to 24 and from 40 to 36 percent, along with an increase in the personal deduction, which would instead of the current four levels, be at a uniform level of 3,800 kuna for all. Higher and more progressive personal deductions for children and higher deductions for fewer other dependents are also proposed, as well as raising the threshold above which income is taxed at the highest rate to above 21,300 kuna gross (17.5 thousand net).

For craftsmen, the circle of those who will be able to choose flat-rate income taxation is expanded to include hospitality providers and traders, if they fiscalize their receipts, along with an increase in the threshold for determining income at the flat rate up to the threshold for entering the VAT system. However, exemptions for income from employee shareholding and from investments of the Fund for Croatian Veterans are abolished.

With all these changes, the Ministry of Finance estimates that about 1.5 million taxpayers, those with the lowest incomes, will be excluded from the ‘scissors’ of income tax instead of the current 915 thousand, including, for example, families with children, who will be placed in a more favorable position than singles, as part of the government’s pronatalist policy. Additionally, the average labor cost is expected to fall from the current 7.6 to 6.3 percent.

Corporate tax remains without exemptions

In terms of corporate taxation, a lower tax rate is proposed – from 20 to 18 percent and the introduction of a rate of 12 percent for entrepreneurs with annual revenues below 3 million kuna. The possibility of choosing the method of determining profit (according to accounting principles or cash flow) is also foreseen, but the exemption for reinvested profit is to be abolished, which, according to the Ministry of Finance, was used last year by only 0.8 percent of entrepreneurs.

At the same time, due to the need to maintain a certain level of revenue from corporate tax for fiscal sustainability, it is proposed to broaden the tax base by abolishing the tax exemption for reinvested profit and changes in the way regional tax exemptions are used.

Regarding regional tax exemptions, the exemption prescribed for assisted areas would be abolished for areas of local self-government units classified in Group II, while for areas of local self-government units classified in Group I according to the degree of development according to a special regulation on regional development and the area of the City of Vukovar, corporate tax would be paid at a reduced rate of 50 percent of the prescribed tax rate.

The amendments to the Corporate Tax Act also propose, as a one-time measure in 2017, the write-off of partially recoverable and fully non-recoverable placements, determined in accordance with the Decision on the Classification of Placements and Off-Balance Sheet Liabilities of Credit Institutions of the Croatian National Bank as of December 31, 2015, from unrelated legal and natural persons, without initiating court or enforcement proceedings or other procedures prescribed by law, to be a tax-deductible expense. In the legal amendments themselves, this is explained by the observed need to expedite the process of deleveraging and reduce the share of hard-to-collect and uncollectible credit placements, and the Ministry did not further clarify this decision, nor its fiscal effects.

Among other things, the proposed law prescribes changes in the way expenses are recognized based on the use of means for personal transport and representation, so that 50 percent of the representation cost would be determined as a tax-deductible expense, instead of the current 30 percent. For the costs of means for personal transport, a change is introduced in the form of reducing the tax-deductible expense from 70 to 50 percent.

The total effect of all changes in corporate taxation is estimated at approximately 375 million kuna, and the Ministry emphasizes that the changes are designed to be primarily stimulative for small and medium-sized enterprises and craftsmen.

Contributions and other income

In the contribution system, the biggest novelty is the introduction of the obligation to pay contributions for pension and health insurance on other income, but at half-reduced rates (pension I pillar instead of 20 and 15 to 10 and 7.5 percent, for II pillar instead of 5 to 2.5 percent, and health from 15 to 7.5 percent).

It is also proposed to reduce the difference between the minimum wage and the lowest base and to abolish exceptions from paying contributions, e.g., for copyright, for delivered artistic works or income of pensioners. Namely, data from the Ministry of Finance shows that in 2005, out of about 300 thousand citizens who earned other income, approximately 60 thousand were exempt from paying contributions, while in 2015, out of 362 thousand, more than 217 thousand did not pay contributions.

At the same time, the rights of authors to 30 percent and artists to 55 percent of expenses are retained.

Is the tax reform on an urgent basis?

In addition to these, for the implementation of the comprehensive tax reform, new laws need to be amended or adopted that regulate the issue of real estate transfer tax, local taxes, special tax on road vehicles, fiscalization in cash transactions, excise duties, administrative fees, the work of the Tax and Customs Administration, tax consultancy, and administrative cooperation with the European Union.

All these legislative proposals should be on the agenda of the Government at the meeting on Thursday, November 10, and although it was initially planned to go through the regular parliamentary procedure, with two readings, the Ministry of Finance now announces the possibility that the entire package will be sent for urgent procedure, as well as that the public discussion on all legislative changes will be conducted uniformly for the entire reform.

However, whether the proposed changes will remain as they are, among other things, depends on the positions of one of the ruling parties, Most, which has announced them but has not yet published them. The Ministry of Finance emphasizes that they, regarding the expert part, remain with this proposal, and that changes can only occur by political decision.