The Tax System Lacks Vision and Strategy Amid Cuts and Adjustments

Change is the only constant. And tax changes. Croatia seems to be on the brink of a new round of ‘tax adjustments’ – from the potential abolition of pension taxes to the introduction of a universal child allowance and possible corrections to personal deductions. Although there is no official confirmation, experts estimate that it will all boil down to a series of partial interventions without a coherent strategy. A recent statement by Minister Marko Primorac that it makes no sense to increase pensions while simultaneously taxing them has been interpreted as an announcement of tax abolition. Although it initially sounds like a socially just measure, economists are generally not in favor of its abolition.

– The question is based on what principle this tax would be abolished. The previous taxation of pensions was a consequence of the fact that contributions were not taxed when calculating salaries, hence pensions were taxable. If it is a social measure, I agree, but again the question is who it is intended for. Not all retirees are in the same economic position – emphasizes tax expert Hrvoje Zgombić.

Economist Željko Lovrinčević is also skeptical about the abolition of this tax, stating that he is not a proponent of this solution because, in that case, those with privileged pensions, whose amount is not tied to their contributions, would benefit the most. Furthermore, one must consider the fiscal consequences of tax changes, which is pointed out by the chief economist of the Croatian Employers’ Association Hrvoje Stojić.

Automatic Indexation

– In the last two years, pensions have increased by more than thirty percent, which is a significant shift. At the same time, the introduction of new measures such as the inclusive allowance and the reduction of contributions on salaries up to 1300 euros gross further burdens public finances. Instead of a general abolition of pension taxes, which is not the practice in most EU member states, it would be more reasonable to introduce automatic indexation of personal deductions and pensions in line with inflation and wage growth to protect those with lower incomes while keeping the system sustainable – emphasizes Stojić.

For this reason, Lovrinčević believes that personal deductions need to be indexed.

– Since personal deductions have not been increased during high inflation, the average burden of income tax has increased. A universal child allowance should have been introduced earlier because people with lower incomes cannot utilize child benefits at all. However, this will likely lead to the abolition of child benefits on salaries, which may not be well received by those with higher incomes – believes Lovrinčević.

Such a measure should, in theory, help households with lower incomes, but its implementation, according to Zgombić, could open a series of operational and social questions.

– Who will design the implementation mechanism? Will citizens, as usual, have to futilely fight with state bodies to issue them decisions on their right to such an allowance in some administrative procedure? – Zgombić lists questions.

A compromise solution to this question is offered by Stojić, citing the example of Germany, where the tax authority automatically selects whether a benefit or child allowance is more favorable for the user.

– In this way, the system ensures that everyone receives the maximum possible benefit and, after all, gains broad social support – states Stojić.

How the Minister of Finance envisioned the universal allowance is unknown, but a year ago, during the last tax reform, he stated that he plans to abolish deductions for dependent family members and replace them with an equal salary supplement for each child. On the other hand, the response from the Ministry of Demography and Immigration suggested that the child allowance should not be equal for everyone, but should again depend on the economic status of the family.

Various Opinions

The Ministry of Finance did not respond to a number of our questions regarding these and other potential tax changes, including what conclusions were reached by the working group established a few months ago tasked with analyzing the existing contribution system, proposing solutions for creating a sustainable financing system for contributions, and standardizing the coefficients for calculating contributions with the rights that are realized.

When it comes to the payment of contributions and associated rights, expert proposals go in different directions. A significant focus is on the issue of lump-sum crafts, which have turned into a real tax microsystem in recent years, often used as an instrument to avoid standard employment. There is also the additional raising of the VAT threshold, about which there have been announcements from the Ministry of Economy.

– We understand the need to increase the threshold for entering the VAT system, but its increase with unlimited time application simultaneously favors the development of unfair competition of lump-sum crafts over regular forms of employment. Increasing the threshold for entering the VAT system also effectively reduces the tax obligation based on income from short-term rentals, which we assume was not the intention of the legislator who is gradually migrating the tax burden from personal income to rental income – states Stojić.

Lovrinčević also believes that there is no necessary need to raise the VAT threshold, noting that lump-sum crafts are a tax undervalued form of work and have turned into a loophole in the law that is abundantly exploited. In his opinion, the Tax Administration should react faster and close this loophole before it is exploited by more and more people over time, making it increasingly difficult to reduce their rights later.

– The same is true for individuals who are registered at the minimum wage but earn millions. In some countries, there is a restriction on profit distribution if an appropriate salary is not paid. We do not have that here – says Lovrinčević.

On the other hand, Zgombić is against establishing a minimum base on which contributions are paid (as in the case of directors) because the revenues of small businesses are often not sufficient to cover them.

– Every contribution should be payable on the basis represented by the actual amount paid for work – believes Zgombić.

Regular professor in permanent selection from the Department of Finance at the Faculty of Economics in Zagreb Nika Šimurina believes that it is justified to pay a smaller amount of contributions for certain categories such as lump-sum crafts.

– Lump-sum taxation is actually a system of taxation of presumed income in which the taxpayer agrees to pay a predetermined amount of tax regardless of the outcome of their business, that is, regardless of the amount of actual earnings, and in return receives certain benefits – says Šimurina, noting that it is thankless to comment on any announcements without a concrete proposal for amendments to a specific tax law or regulation.

She states that reforms in the income tax system and related contributions must be designed so as not to further disrupt the already poor and unevenly distributed tax burden, and that a serious analysis of their fiscal and non-fiscal effects, that is, effects related to social and pronatalist policy, must be conducted before their introduction.

Long List of Wishes

In principle, she agrees that ‘the contribution system is one of the segments that should be analyzed to see how to reduce the burden that most affects workers’.

With that sentence, of course, everyone will agree, including member of the Supervisory Board of the Entrepreneurs’ Voice Association Dražen Oreščanin, who says that all changes that will reduce the burden of labor are welcome and adds that he does not currently see a significant trend to reduce the tax burden on income.

If we look at Eurostat data on the share of taxes and contributions in GDP, his statement can be confirmed by numbers. The mentioned share was 37.8 percent ten years ago and has decreased by only 0.5 percentage points by 2023.

– Due to one of the lowest employment rates among EU members, it is justified for Croatia, according to OECD recommendations, to boldly reduce labor taxes. The Croatian Employers’ Association believes that it is necessary to relieve highly qualified employees of taxes for the development of the economy and the sectors of the future – states Stojić.

The Employers’ Association therefore proposes raising the threshold for the higher income tax rate to 80,000 euros, reducing the lower rate by at least five percentage points, and also seeks to limit the base for health contributions to approximately two average annual salaries (the practice of Germany, France, Austria).

There is no shortage of proposals for tax changes and reforms. Zgombić believes that the tax system should be simplified and some taxes ‘for which no one knows why they were introduced today’ (e.g., tax on interest or capital gains tax) should be abolished, Oreščanin advocates for tax incentives for business angels, which has also been timidly announced, and Lovrinčević believes that non-taxable income has been too broadly expanded and that property tax should be assessed based on value. On paper, the wish lists are different, but on one point, the interlocutors easily agree: the goal is to reduce the tax wedge on labor. And small and partial changes make this harder to achieve.

– A good tax reform is one that simplifies taxation while simultaneously reducing the tax burden. Also, if you only change some tax forms, you will likely disrupt the coherence of the system. It is best to implement a comprehensive reform of the tax system. Constant changes bring costs to everyone, foster distrust, and rarely have positive fiscal effects. It is better, if more frequent changes are needed, to make a comprehensive reform than to constantly make minor corrections within a specific tax form – explains Šimurina.

Another point of consensus is that tax policy cannot fix what the expenditure side of the budget fails to address.

– Reforming the bloated public spending alongside tax changes focused on competitiveness must be the top-line basis before any new decisions on increasing expenditures – says Stojić.

Decisions, he adds, should be made means-tested, and it is especially important to rein in the wage mass in the public sector, which has jumped by 58 percent in two years.

Who Gains, Who Pays?

However, whenever Croatia has tried to implement reform, it has ended up in partial solutions.

– The last real tax reform was in 1994 – reminds Zgombić – since 2001, we have had chaotic changes motivated by short-term budget revenues, without considering the effects on the economy and citizens.

The result is what we see today: every new round of announcements raises the same questions: who gains, who pays, and why. And the system remains more complex, unequal, and unpredictable. So far, we have only a few public statements about potential tax changes, but no announcements of legal amendments. It is possible that the Ministry of Finance will wait for the establishment of a household register to have a firmer analytical basis for designing measures. Until then, Croatia stands once again at a familiar crossroads. One direction leads to yet another round of small changes that increase complexity, the other towards a comprehensive reform: redesigning the tax system and expenditures, relieving labor, and eliminating exceptions that encourage tax circumvention. The first is easier and faster but short-lived. The second is more demanding but the only one that long-term reduces the tax wedge. Regardless of whether we first discuss pension tax, lump-sum crafts, or the VAT threshold, the key remains the same: one consistent reform that connects the revenue and expenditure sides. Everything else is temporary solutions that obscure the problem instead of solving it.