Croatia Must Hit the Brakes and Limit Wage Growth in the Public Sector

It is time to deepen structural reforms to support Croatia’s convergence towards advanced European countries and to increase productivity and potential economic growth, the IMF stated on Tuesday, suggesting among other things to limit wage growth in the public sector.

In the concluding statement of the IMF Mission at the end of its visit to Croatia as part of regular consultations with member countries, during which meetings were held with representatives of the Ministry of Finance and the Croatian National Bank (HNB), it was emphasized that the growth of the Croatian economy remains among the fastest in the Eurozone, with significant progress achieved in the living standards of citizens, partly thanks to strong absorption of funds under the implementation of the National Recovery and Resilience Plan (NPOO).

The IMF expects that after last year’s real GDP growth of nearly four percent, the Croatian economy will slow down to a still solid 3.1 percent in 2025, while for 2026, they forecast a growth of 2.7 percent.

– Strong domestic demand, positively influenced by increased real household incomes, lower interest rates, and investments financed by EU funds, would more than compensate for possible negative effects of increased global uncertainty and weak growth of trading partners – they wrote.

However, they also warn that the expansionary fiscal policy during a period of strong economic growth has caused an increase in fiscal deficits and intensified pressure on the domestic demand side, contributing to rising inflation and a current account deficit.

Stronger Fiscal Consolidation

They believe there is a risk of ‘prolonged overheating’, as maintaining an ‘accommodative’ fiscal policy and wage and credit growth that exceeds expectations could further stimulate domestic demand, slow down disinflation, and undermine competitiveness.

They warn that Croatia continues to struggle with low productivity, a lack of qualified labor, and challenges related to green and digital transitions. Thus, in the current global environment characterized by increased uncertainty and structural changes, they state that it is ‘crucial for Croatia to timely address the imbalances that arise and to protect macroeconomic and financial stability, strengthen resilience and protective layers, and increase productivity’.

They consider that stronger and more immediate fiscal consolidation is key to achieving these goals. They also state that now is the time to deepen structural reforms to support Croatia’s convergence towards advanced European countries and strengthen its position to respond to future shocks and challenges.

Significant Role of Wage Reform

– We call for a stronger reduction of the fiscal deficit, which should be largely implemented in the initial period to achieve a structural primary balance by 2030 – the IMF stated, predicting that inflation will approach the target level of the European Central Bank (ECB) of around two percent by the end of 2026 or early 2027.

They say that the general government budget deficit has been continuously increasing since 2023 and is close to three percent of GDP this year, primarily due to the increase in wage mass and social benefits.

– Our analysis shows that expansionary fiscal policy, especially in the part related to public sector wage reform, has played an important role in inflation since 2024. Furthermore, the rapid growth of permanent consumption on wages and social benefits increases the rigidity of the budget, which can jeopardize public investments in the event of negative shocks – the IMF experts stated.

Although they forecast that the general government budget deficit will remain at around 2.9 percent of GDP in 2026, they recommend reducing it next year to around 2.5 percent of GDP, which they believe can be achieved, among other things, by limiting wage growth in the public sector and increasing social expenditures, along with better VAT collection.

They also state that it is important to abolish the remaining measures ‘to reduce the cost of living’ and to introduce and improve fiscal discipline in local government units to prevent the weakening of their fiscal position.

In the medium term, consolidation should focus on increasing the efficiency of public spending, as well as expanding the tax base and improving the tax system, the IMF stated.

Rationalize the VAT System

They say that although Croatia’s tax revenues are close to the EU average, they are lower than pre-pandemic levels and there is plenty of room for improvement in the tax system, thus they believe that the VAT system should be ‘rationalized’ in terms of exemptions and reduced rates. For stronger tax collection and increased fairness in the tax system, they also suggest taxing property and income from short-term rentals based on real estate values.

The head of the IMF mission in Croatia, Yan Sun, stated at a media briefing that the government made the right move by introducing a property tax as of January 1 of this year, as well as increasing the tax burden for short-term rentals.

– These are steps in the right direction, but we would like to see a shift to taxing properties according to their value – she stated and warned about the issue of affordable housing, emphasizing the need to increase supply rather than stimulate demand for real estate, including speculative investments, which should be addressed by tax policy.

The IMF also notes that Croatia can consider introducing a carbon tax along with an emissions trading system (ETS) and eliminating explicit and implicit subsidies for fossil fuels.

When it comes to improving the efficiency of public spending, they point out that the wage mass in the public sector, which is already among the highest in the Eurozone, could further increase this year to around 13.5 percent of GDP.

They also support functional mergers of local government units and welcome the government’s plan to review and rationalize employment in the public sector, suggesting that the focus should be on the health and education sectors.

Reforms in Health and Education

They note that public spending on education and health exceeds the EU average by about 0.5 percent of GDP.

They say that the health sector reform should focus on both reducing costs and improving outcomes. “The central role of hospitals in the health system should be reconsidered, especially regarding the provision of outpatient care, to reduce costs and free up resources for preparing a reorganization that needs to meet the needs arising from an aging population,” they wrote, among other things, from the IMF.

In the education reform, they emphasize reducing skill mismatches, along with measures to increase participation in adult education.

Necessary investments in human capital and skills, along with health and education reforms, are seen by the IMF as key to stimulating productivity and potential economic growth.

Changes in the Pension System

In the pension system segment and measures to increase future pensions, they advise reducing the numerous options for early retirement, increasing the retirement age and linking it to life expectancy, and increasing the minimum number of years for contribution payments.

They also state that immigration helps Croatia address the labor shortage and aging population issues, but they emphasize that better integration of workers is needed to realize their full potential.

They wrote that increased risks require close monitoring and further caution to protect financial stability.

– Despite reduced profits, the banking system remains very profitable, well-capitalized, and highly liquid. Although still moderate, cyclical systemic risks have increased due to synchronized rapid growth of bank loans and housing prices, as well as relatively lenient lending criteria for new loans – the IMF stated, while also welcoming the macroprudential measures of the Croatian National Bank (HNB), which tightened lending conditions.

They also supported the recently announced increase in the countercyclical capital buffer rate to two percent from January 1, 2027, which they say will strengthen the resilience of the banking system and increase the protective layers that can be released in the event of shocks.