Republic of Serbia Fiscal Council

1. Republic of Serbia Fiscal Council ASSESSMENT OF THE DRAFT BUDGET FOR 2017 AND FISCAL STRATEGY FOR 2017 - 2019 9 December 2016

2. Fiscal consolidation: where do we go from here? • A three-year economic program of the Government has been presented in the Budget for 2017 and the Fiscal Strategy 2017-2019 • Together they define objectives and fiscal policy measures in medium term • State of public finances is still far from satisfactory – burning fiscal issues have not been addressed • Full Governmentterm is needed for a complete recovery of public finances • Greatest challenge: excessive and unsustainable public debt (cca 74% of GDP) • An external “shock” and a new recession, with a debt of this magnitude – crisis threat renewed • Even with a very low deficit, 10 years to the safe zone • The deficit needs to be additionally decreased in the long term • Consolidation does not end with the end of the IMF Arrangement (end of 2017)

3. Assessment of the medium term fiscal plan • Fiscal Strategy for 2017-2019 sets good objectives: further deficit decrease and consequential public debt decrease • Deficit in 2019 1% of GDP; public debt decreased below 70% of GDP; • From 2020, deficit about 0.5%; public debt decreased below 60% after 2023; • Medium-term goals are not supported by firm reform measures and deadlines for their implementation – which constitutes a risk • To maintain the achieved results: Tax Administration reform and a change in approach to rationalization/general government reform • Problems of the unreformed public sector have not been resolved – unplanned and extensive budget expenditures imminent in the medium term • Without new deficit decrease measures, the largest savings to be made once the period covered by the Fiscal Strategy expires – lackscredibility • 2017 – 2019: decrease in deficit by inertia, savings only on expenditures for interests and activated guarantees • 2020 and beyond: achieving a deficit level that is sustainable in the long-term (0.5% of GDP) but without an explanation of how this is to be achieved

4. Bigest risk: unreformed public and state-owned enterprises • Poor performance of public and state-owned enterprises is already an enormous burden for the budget • Guaranteed debts of Srbijagas, Železnice, Galenika and others from 2010-2014 shall rack up about 300 milion Euros of expenditures from the budget in 2017 • Other obligations keep maturing, with the budget picking up the bill: Petrohemija 100 m Eur (2016), Srbijagas cca 200 m Eur (2015), JAT cca 170 m Eur (2014) etc. • The Fiscal Strategy does not envisage similar new expenditures, even though the non-performing enterprises keep accumulating debt • In 2016, about 170 m debt has accumulated to Srbijagas and EPS alone • By issuing new guarantees or taking over these debts, these obligations end up becoming a part of the fiscal deficit after all • Inclusion of thesecosts into public expenditures at the time they arize would increase the deficit by about 0.5% of GDP annually • This is the cleanest solution: transparent budget subsidies would demonstrate the actual costs of keeping the loss-makers afloat

5. Reforms, then rationalization, not vice versa • Savings from general government rationalization have not been achieved in the plannedandsustainable manner • Number of employees decreased by 25,000 instead of the originally planned 75,000 – exclusively through non-selective retirement of both surpluss and necessary employees • By prolonging the employment ban, this bad practice continues in 2017 (although the realistic potential benefit from this measure has probably already been achieved) • Hazard for theoperation of important general government segments (education, healthcare etc) • A similar linear downsizing had already been attempted – yielding only temporary results (IMF Arrangement 2002-2005) • Once the Arrangement expired, the number of emloyees quickly bounced back • To prevent a repeat, important to start the reforms of the major general government systems as soon as possible, primarily education and healthcare • Precise identification of the number and structure of necessary staff in these sectors would prevent excessive increase of employment once the employment ban is lifted

6. Number of employees in healthcare and education 2002 - 2009

7. Tax Administration reform for tax revenue collection maintenance and growth • The key to the success of fiscal consolidation so far lies in the increased tax revenue collection in 2015 and 2016 • More than 50% of the achieved permanent deficit decrease • Partly due to grey economy suppression through Tax Administration’s ad hoc field measures • Sustainability of the achieved results depends on Tax Administration modernisation – which is not being implemented according to plan • The Fiscal Strategy should provide an answer to the obvious delay in implementing (the otherwise good) Transformation Program and define new deadlines • Successful reform of the Tax Administration could provide additional revenues from grey economy (about 1% of GDP in medium term) • This would require an increase in number of tax inspectors, reinforcement of analytical capacities, better organisational structure, introduction of modern IT systems etc

8. Fiscally responsible solution for the temporary character of salary and pension cut? • Cuts of public sector salaries and pensions represent a fundamental measure of fiscal consolidation on the expenditure side of the budget • About 40% of the permanent deficit decrease (1.7% of GDP); without it, no chance of success • However, this measure has been defined as temporary in the law – which is a major fiscal risk • By abandoning this measure, the deficit would increase to 3.5-4% of GDP in the short term – renewed public debt growth • The Government must define a fiscally responsible model for the transition from the temporary to a permanent regulation of salaries and pensions • Regulation of slaries in the general government probably with no fiscalcosts (pay grades?) • Special challenge is to lift the temporary salary cut in public enterprises: this will increase the deficit by about 0.4% of GDP and, in some, lead to an unjustified increase in salaries as the salary cut has already been compensated for (EPS)

9. Assessment of the proposed 2017 budget • The Budget calls for a deficit of 69 bn dinars (1.6 % of GDP) which is, in principle, a good objective • Public debt decreases, albeit slowly (from about 74% of GDP to 73% of GDP) • The annual plan of budget revenues and expenditures is mostly plausible, without pronounced and significant risks • Risk from unplanned takeover of obligations from state-owned enterprises and accumulated debts of local governments and healthcare institutions • Absence of major risks stems from the lack of ambition in the 2017 Budget – no major savings have been planned • The envisaged deficit is close to the deficit that will be achieved in 2016, excluding one-off factors (debt of Petrohemija and one-off payment to pensioners) • The most important deficit reduction measure is relatively small (about 5 bn dinars) – amendments to the Law on Local Government Funding • No major progress has been planned for the status resolution of enterprises undergoing privatization: funds for severance payments (3 bn dinars) sufficient for a mere 5,000 workers (out of 45,000)

10. Expenditures for state-owned enterprises comprise an ever increasing share of the Budget • More than half of the planned deficit is for the repayment of old debts of public and state-owned enterprises (about 40 bn dinars or 0.9% of GDP) • Mostly expenditures for activated guarantees: Srbijagas (about 200 m Eur), Železnice (35 m Eur), Air Serbia and Galenika (10 m Eur each), Železara (5 m Eur) • Newarrears towards Srbijagas and EPS keep accumulating (about 20 bn dinars in 2016) – greatest threat to the budget • The list of those who fail to pay is long: RTB Bor, MSK, Azotara, Galenika, Resavica, PKB, Jumko, city heating plants (Jagodina, Zrenjanin), cities of Kragujevac and Novi Pazar etc. • A new item: current liquidity funds for RTB Bor of 2 bn dinars – which, in the budgetting sense, is an improvement • If the Government wants to stand by its decision to keep RTB Bor operating, it is justified that the expenditure for its operation is covered as soon as it arises – similar for other loss-makers? • The Budget envisages guarantees for a loan to Resavica in the amount of 10 m Eur –a new guarantee that will almost certainly be activated

11. A part of the budget expenditures have not been presented in a transparent manner • 2017 Budget comrpises expenditures for large infrastructural projects (Corridords 10 and 11) – which is a positive change • These expenditures are a natural part of the budget as they are funded from loans to be repaid by the Republic of Serbia • Major increase in capital expenditures compared to 2016 budget stems from this methodological change – actually, the increse is from 1.1 bn to 1.2 bn Euros • About 500 m Eur of the expenditures from the Budget are not presented in a transparent manner – expenditures for activated guarantees, subsidies for investors and fines and penalties • The National Parliament and the public at large are thus deprived of the pertinent information of how exactly 60 bn dinars from the Budget are to be spent • Activated guarantees are still only presented in total amounts (about 35 bn dinars), not mentioning which enterprises are to receive support and in which amount • Subsidies for investors are also presented as a total (12.4 bn dinars), but the list of investors stated fails to show individual amounts awarded to them from the Budget • Expenditures for fines and penalties represent an ever increasing burden on the budget (12 bn dinars), but the budget fails to provide sufficient data for the analysis of this increase

12. Budgeting shortcomings • Departure from the budget calender • Insufficient budget scope • Still no Register of national institutions • Insufficient budget transparency • Amounts for activated guarantees of state-owned loss-makers missing, as are subsidies for investors etc. • No system in place for monitoring and resolvingarrears • State-owned enterprises and local governments accumulatearrears that then have to be covered from the national Budget

13. Budgeting shortcomings (2) • No register of state employees • Largest expenditure item is not under adequate control • In the last year, the amount of funds available to the Government wihtout Parliamentary control has been quadrupled (from 10 to over 40 bn dinars) • Decreased budgetting transparency • No need for re-balancing throughout the year? • Annual (budgetexecution) statement is not adopted by the Parliament

14. Performance indicators – straying off the path? • Instead of resolving key shortcomings, program budget and performance indicators are being introduced • Contrary to international practice and warnings from experts • 1,000 pages of programs and indicators provide no foundation for a productive parliamentary debate • Example 1: main performance indicator for the National Parliament is the number of MPs • Target value for all years is 250 • Example 2: performance indicator for the President of the Republic of Serbia is the percentage of successfully performed activities • Target value for all years is 100%

15. The status of enterprises under privatization is not being resolved • No necessary U-turn in operation • In 2016, direct budget expenditure was about 20 bn dinars while unpaid tax, electricity and gas bills add up to another 15 bn • Pre-packed restructuring plans (UPPR): either not adopted or not implemented • RTB Bor: no lay-offs, no professional management • Resavica: no downsizing, no closing of individual mines, attracting private investors into the parts of the system with a better perspective • Reviving enterprises in bankruptcy: FRA, FAP, MSK

16. In 2017, potential consequences are even more severe: • Fiscal Strategy fails to list either the risks or the plan • The Budget calls for new direct budget support (subsidies to RTB Bor and guarantees for Resavica) • Plan for Resavica implausible • Possible takeover of commercial debt (Galenika, to banks, 9 bn dinars; RTB Bor, 10 bn dinars unregulated) • Only 3 bn dinars in the Transition Fund (sufficient for 5,000 workers) – no lay-offs planned? • What is needed is: • To stop tollerating debt and to plan for subsidies to finance the survival of the selected enterprises • The remaining enterprises should be allowed to go to bankrupcy with hard budgetconstraints

17. Insufficient concrete progress in public enterprise reform • Greatest progress from Železnice Srbije • Divided into four enterprises, assets and debts distributed between the newly formed companies • Subsidies depend on efficiency • Expected downsizing (by 3,000) • About 400 km of railroads that were not being used were closed • Still untouched: the issue of low prices and poor collection

18. Srbijagas – poor reform indicators • Debts for gas delivered increasing (mostly MSK and Azotara) • Conversion of claims to ownership continues (Toza Marković, private enterprise) • Srbijagas is not paying for the guaranteed debt in the extent planned • EPS – delaying the necessary changes • Still tolerating state-owned enterprises which are not paying for their electricity bills (mostly RTB Bor) • Uncertain, insufficient and non-targeted downsizing • Fiscal Strategy does not envisage an increase in tariff