Report No. 22079-HR Croatia Economic Vulnerability and Welfare Study April 18, 2001 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank CURRENCY AND EQUIVALENT UNITS Currency Unit = Kuna (HRK) US$1.0 = 8.68 Kuna (As of April 12, 2001) ACRONYMS AND ABBREVIATIONS CBS Central Bureau of Statistics CEE Central and Eastern Europe CIS Commonwealth of Independent States Crostat Croatian Bureau of Statistics EBRD European Bank of Reconstruction and Development FDI Foreign Direct Investment GDP Gross Domestic Product HBS Household Budget Survey IDPs Internally Displaced Persons ILO International Labor Organization LFS Labor Force Survey OECD Organization for Economic Co-operation and Development PPP Purchasing Power Parity SME Small and Medium Enterprises -UNICEF United Nations Children's Fund UNU/WIDER United Nations University/World Institute for Development Economic Research WTO World Trade Organization Vice President: Johannes Linn (ECAVP) Country Director: Andrew Vorkink (ECC05) Sector Director: Pradeep Mitra (ECSPE) Sector Manager: Daniela Gressani (ECSPE) Task Team Leader: Ruslan Yemstov (ECSPE) Team Members: Marcelo Bisogno, Paulette Castel, Erzo Luttmer, Jim Lynch, Sanja Madzarevic-Sujster (ECSPE), Elizabeth Gomart (Consultant) CONTENTS CURRENCY AND EQUIVALENT UNITS ...............................................................i ACRONYMS AND ABBREVIATIONS ...............................................................i ACKNOWLEDGEMENTS ...............................................................v EXECUTIVE SUMMARY .............................................................. vi A. ASSESSMENT: POVERTY PROFILE ...................................................................... VI Absolute Poverty is Low ......... ...................................................................... vi ... but Those Who Have the Misfortune to be Poor are Seriously Deprived. vii The Poor Have Distinct Characteristics ........................... viii ... Which in Combination With Limited Opportunities Make Them Likely to Be Stuck in Long-term Poverty .viii B. CAUSES . ................................................................... Xi Macroeconomic and Structural Policies were Key Determinants of Weak Employment Growth ....................... ....................... xi Labor Market Policies Have Worsened the Negative Impact of Macropolicies on Income Distribution ............ ....................... xi Transfers Have Not Played a Countervailing Role to Arrest Rising Inequality and Poverty .................................................... xiii C. ACTIONS ................................................................. xiV Policies to Foster Opportunities: Macroeconomic Stability, Flexible Labor Market and Education ..... . ................................ xiv Towards Greater Security: Protecting Those Who Fall Through the Cracks of the Safety Net ................................................ xvi Empowering The Poor to Make Progress In Poverty Alleviation Irreversible ......................................................................... xvii I HISTORICAL AND POLITICAL CONTEXT FOR UNDERSTANDING POVERTY ..............I A. INDEPENDENCE AND INITIAL CONDITIONS 1..............................................................................I B. WAR AND ITS CONSEQUENCES ...............................................................................2 C. POST-WAR ECONOMIC POLICIES ...............................................................................3 Macroeconomic and Structural Policies .........................................................................................4 Key Sectoral Policies ........................................................................................S Consequences: Uncompetitiveness, Unemployment, Inequality ................................................. , 10 2. WHO ARE CROATIA'S POOR? ...................................... 18 A. THE SCALE OF POVERTY IN CROATIA ........................................... . 18 International Comparisons ................................................. 18 Setting the National Poverty Line ................................................. 19 Dynamics of Poverty ..................................................22 B. WHO ARE THE POOR? ........................................... 23 Poverty Profile .............................................. ... 23 Poverty Risks .................................................. 24 How the Poor Live ..................................................27 C. ECONOMIC CAUSES OF POVERTY ................................................ 29 Limited Economic Opportunities ....................................................... 29 Poor Endowments .......................................................30 Inadequate Safety Nets. ....................................................... 31 D. POVERTY REDUCTION: PROSPECTS AND PROBLEMS . ................................................. 32 3. SOCIAL ASSESSMENT: WHAT DO THE POOR SAY? ........................................... 40 A. CAUSAL FACTORS: HOW THE POOR SEE IT ..................................................... ................... 40 B. CONSEQUENCES: COPING (OR NOT) WITH POVERTY AND THE THREAT OF MARGINALIZATION........... ............... 45 4. ACTION PROGRAM FOR POVERTY REDUCTION . ............................................................... 49 A. OPPORTUNITIES: "ACHIEVING GROWTH WITH EQUITY' ...................................... .................................. 49 Macropolicies and Governance Reform .......................49........... ........................ ................. 49 Labor Market Reforms ................................................................................. 50 Equipping the poor to take advantage of growth opportunities .............. ................................................................... 51 B. SECURITY: "INCLUDING THE EXCLUDED ........................................................................ 52 Rationalizing Social Protection ....................................................................I. ........... 52 Pension System Reform .................................................................................. 53 C. EMPOWERMENT ........ ................................................................ 54 The "Democratic Transition ": Strengthening "Voice ................................................................................. 54 Improving Governance and Participation .............. ................................................................... 55 ii List of Tables Table 1: Absolute poverty in 1998 .................................................... vii Table 2: Percent of GDP in 1998 .................................................... xiii Table 1.1: International Comparison of Human Development Indicators (1997) ........I Table 1.2: Croatia - Selected Macroeconomic Indicators, 1994-2000 .........................4 Table 1.3: Employment Protection Legislation. International Comparison .................6 Table 1.4: Decomposition of inequality in incomes in selected CEE countries . ........ 17 Table 2.1: Absolute Poverty in 1998 .................................................... 21 Table 2.2: Job turnover in selected transition economies ........................................... 30 Table 2.3: Poverty Projections .................................................... 33 Table 2.4: Percent of GDP in 1998 .................................................... 36 Table 2.5: Change in Poverty rate .................................................... 39 List of Figures Figure 1: Absolute Poverty Rates, International Poverty Line ..................................... vi Figure 2: How Many Among the Poor are Deprived .................................................. vii Figure 3: Unemployment Rates in 1998 (ILO methodology) ..................... ............... viii Figure 4: The Extent of Flexibility in Labor Market Arrangements (shares in total employment) .................................................... ix Figure 5: Net Secondary Education Enrollment Rates (percent) .................. ............... ix Figure 6: The Gap Between the Rich and the Poor .....................................................x Figure 7: Employment, Number of Pension Beneficiaries And Real Incomes, 1990=100 .xii Figure 1.1: GDP Growth in Selected CEEs .3 Figure 1.2: Net secondary education enrollment rates (percent) .7 Figure 1.3: Consolidated Government Expenditures, 1993 and 1997 ...............................8 Figure 1.4: Gross Monthly Industrial Wages in Current USD in 1998 ........................... 11 Figure 1.5: Tax Burden as % of GDP by Types of Taxes, Cumulative 1995-98 ............ 11 Figure 1.6: Share of SME in Total Wage Employment in 1998 .................................... 12 Figure 1.7: Unemployment rates in 1998 (ILO methodology) ........................................ 13 Figure 1.8: Non-agricultural Self Employment as % of Total Non-Agricultural Employment ................................................ 14 Figure 1.9: Wage growth rates for low and highly-paid workers: 1998/96 .15 Figure 1.10: The Gap Between the Rich and the Poor . .16 Figure 2.1: Absolute Poverty Rates, International Poverty Line. 9 Figure 2.2: Poverty Profile: Education and Employment Status of Household Head .23 Figure 2.3: Risk to fall in poverty, by labor market status, age, education, and location .25 Figure 2.4: Dimensions of Deprivation Among the Poor .27 Figure 2.5: Sources of income: average person and a poor person .28 Figure 2.6: Performance of Social Assistance .32 Figure 2.7: Poverty Projections with 4% Annual Growth in Consumption .35 Figure 2.8: Poverty reduction by Government interventions .35 Figure 2.9: Pension reform and poverty among retirees (all retirees=100 percent) . 37 iii List of Boxes Box 1.1: Drnis: Echoes of the War .................................. 2 Box 2.1: The Routine of Poverty: Unemployed in Zagreb .................................. 20 Box 2.2: War and Poverty .................................. 21 Box 2.3: Facilitating restructuring: benefits and costs .................................. 34 Box 3.1: Cases of Ethnic Discrimination .................................. 42 Box 3.2: Roma Village: Kursanec, Medimurje District .................................. 43 iv ACKNOWLEDGEMENTS This study was prepared by a joint World Bank - Croatian Bureau of Statistics (CBS) team lead by R. Yemtsov (World Bank) and comprising on the World Bank side M. Bisogno, P. Castel, E. Gomart, E. Luttmer, J. Lynch, S. Madzarevic-Sujster and on the side of our Croatian counterparts T. Cukina (CBS), D. Goles (CBS), D. Knezevic (CBS), M. Kustura (CBS), D. Nestic (Institute of Economics) and Z. Sucur (University of Zagreb). We thank the Director of the CBS I. Rusan and Vice Director M. Butigan for hospitality and for making a wealth of data collected by the Bureau available to the team. The work could not have taken place without the support of the Government of Croatia's Ministry of Labor and Social Welfare. The staff of the Ministry A. Balaban, M. Jurcevic, N. Zganec and S. Plevko provided useful guidance. The team worked closely with social workers in Osijek and Vukovar and in other sites. The contribution of Target research firm in the Social Assessment of Poverty was crucial. The study was conducted in ECA PREM and supervised by H. Ghanem, D. Gressani and K. Peters who provided the quality assurance. Resident Representative of the World Bank in Zagreb, S. Sipos, was actively involved in our discussions with the Croatian Government. Peer reviewers J. Klugman and M. Vodopivec provided comments on the early stages of report preparation. Joint presentation of the study's draft with the Croatian Minister of Labor and Social Welfare D. Vidovic in September, 2000 led to very active discussions on social policy in Croatia, which this final version reflects. We are also grateful for comments and advice provided by the UNICEF and UNU/WIDER staff J. Micklewright, A. Cornia, S. Mehotra and G.Fajth. P. Bocock provided editorial guidance. G. Prennushi, M. Lokshin, B. Milanovic and S. Zaidi helped us on different stages of analysis. The support of the World Bank Croatia Country Team was essential throughout the preparation of the report. v EXECUTIVE SUMMARY 1. With a per capita income over US$4,500 Croatia is the second richest of the former republics of Yugoslavia. Social indicators, such as infant mortality, literacy and life expectancy are at par with rich countries. The system of social transfers is one of the most extended in the region. However, these factors do not preclude the existence of absolute poverty, whose extent depends on how wealth, income and transfers are distributed. 2. This report is the first study of poverty and income distribution in Croatia. Its aim is to provide the assessment of where Croatia stands now in terrns of poverty, to explain why some people are poor, and to recommend ways to help them in the most efficient way. A. ASSESSMENT: POVERTY PROFILE Absolute Poverty is Low ... 3. Using an internationally comparable standard across transition economies (US$4.30 a day per person at purchasing power parity) with recent representative household survey data;1 this study finds that the incidence of absolute poverty in Croatia is very low at 4 percent (Figure 1). Figure 1: Absolute poverty rates, internationally 50%o/ comparable poverty line 25% - 01% IE EL= Croatia Slovenia Hungary Poland Romania Source: Croatia - HBS (1998). Other countries-- World Bank (2000) Making Transition Work for Everyone 4. An international poverty standard, however, may not adequately reflect country- specific conditions. The report has estimated the level of total household expenditure at which families, after paying for essential non-food expenditures, just attain minimal nutritional needs. This level of expenditures therefore represent an absolute poverty line and amounts to HRK 41,500 per year (in 1998 prices) for a couple with two children or l Between 1991 and 1998 there was no representative household budget survey on the territory of Croatia. The analysis presented in this report is based in the first representative survey of incomes and expenditures of households in Croatia since Independence. It was conducted by the Croatian Bureau of Statistics in 1998 and covered 3,123 households randomly selected throughout the country. vi HRK 15,474 for an adult. Fewer than 10 percent of the Croatian population falls below this nationally specific poverty line.2 Table 1: Absolute Poverty in 1998. Intemationally Comparable Poverty Line (USD 4.30/day at PPP) 7,321 HRKIyear National Absolute Poverty Line 15,474 HRK/year Poverty Rate with Intemational Line 4.0% Poverty Rate with National Line 8.4% Source: HBS (1998). Notes: PPP - purchasing power parity. Values are expressed in May 1998 prices, correcting for regional price differences. Poverty with international line uses per capita consumption, national line is based on equivalent consunption (OECD scale: first adult has a weight of I, subsequent adults have a weight of 0.7 and children have a weight of 0.5). 5. It would be affordable for Croatia to eliminate absolute poverty completely. The analysis of poverty in this report shows that poverty is shallow: the poverty gap is 1.8 percent of total consumption, and on average the consumption of a poor household is 20.7 percent below the poverty line. To bring all Croatia's poor above the poverty line with perfect targeting (i.e., to give each poor person a transfer exactly equal to the poverty gap) would cost only 1 percent of GDP. ... but Those Who Have the Misfortune to be Poor are Seriously Deprived 6. The life of the poor differs in many respects from that of the non-poor. The poor tend to live in overcrowded, poorly maintained dwellings; their diet is limited (especially for the urban poor who can afford little beyond basic staples such as bread, potatoes or milk); and, they are poorly educated. Few of the poor have savings; they are often immobile, and their social networks are very limited (Figure 2). Figure 2: How many amnong the poor are deprived Monotonous diet No savings No regular emnployment More than 2 people per room Less than 7 years of school Rotten walls Leaking roof 0% 10% 20% 30% 40% 50% 60% 70% 80% Source: HBS(1 998), baseline definition of poverty based on national line at 8.4 percent of the population. 2 Poverty rate in the Table 1 (8.4 percent) covers only part of the territory not directly affected by occupation during the 1992-95 war and does not cover IDPs and refugees. It is estimated that inclusion of these groups would raise the poverty rate from 8.4 percent to 10.0 percent The statistical error of this estimnate is ±2 percent. vii The Poor Have Distinct Characteristics .... 7. Poverty is not confined to certain areas or ethnic groups: although some regions (Slavonia), especially rural areas, and certain ethnic groups (Serbs, Albanians, Roma, Bosnian Muslims) have higher poverty rates, the poor live in all regions and are predominantly Croats. 8. The poverty profile is dominated by two groups: poorly educated individuals and the elderly. Almost three-fourth of the poor live in families whose head has primary education or less. These individuals are likely to have little prospect of finding work if they are not employed, or to have low earnings if they are employed. The risk of poverty is particularly high when poor education is combined with unemployment. 9. Low or non-existent pension benefits in old age is the second cause of poverty: 40 percent of the poor live in households with a retired household head. In 1998 when the HBS survey was conducted, as many as 25 percent of retirees did not receive pension benefits at all and about half of pension beneficiaries received pensions that were below the poverty line. .. Which in Combination With Limited Opportunities Make Them Likely to Be Stuck in Long-term Poverty 10. Poverty in Croatia already has many features of a permanent state. There are two basic reasons why the poor are unlikely to escape poverty easily: (i) the limited nature of economic opportunities; and (ii) the limited capacity of the poor to benefit from such opportunities as exist. Figure 3: Unemployment rates in 1998 (ILO definition) 14- 12 _ 10 Croatia Czech Romania Slovenia Humgary EU Estonia Poland Slovak Bulgaria Republic average Republic Source: Labor Force Survey Results, Croatia LFS (1998), Czech Republic 1997-99 (World Bank, 1999); Hungary, 1997 (EBRD 1999 Transition Report) Slovak Republic 1997 (OECD-CEET Data Base), other countries 1999 OECD Employment Outlook. 11. Economic opportunities are limited because growth has thus far has not generated enough jobs. Despite positive economic growth in 1995-98, the net change in employment has been persistently negative: many old jobs have been destroyed and very few new ones have been created. Growth has benefited primarily those who have kept their jobs, but for those locked out of employment, the effect has been was close to nil, if not negative. An internationally comparable ILO definition of unemployment shows that Croatia in 1998 had one of the highest unemployment rates in the region (Figure 3). The employment situation by the end of the year 2000 has worsened further (ILO unemployment rate reached 15 percent of the labor force). VI.ii Figure 4: The Extent of Flexibility in Labor Market Arrangements (shares in total employment). 20- Part-time _Non-agricultural Ermployment in 15 - employment se- I emptoyrn-enM 10- __ 77_ 5- - , Croatia EU average Croatia CEE average Croatia CEE average Source: Croatia - LFS (1998), part time employment EU and CEE - OECD Employment Outlook and OECD-CEET Data Base, non- agricultural self-employment: Yearbook of Labor Statistics, ILO, 1998, employment in SME (less than 100 employees) Business Environment and Enterprise Performance Survey (EBRD-World Bank, 1999). All averages are simple across-countries means. 12. Meanwhile, over-regulation of employment is limiting opportunities for small businesses and flexible working arrangements, both of which could constitute a viable alternative to wage employment for the poor. As demonstrated by Figure 4, Croatia has a low rate of employment in SMEs, in self-employment activities outside agriculture, and in flexible part-time employment. 13. The poor are at a disadvantage in benefiting from new opportunities. Once locked out of jobs, the unemployed and economically inactive have difficulty in breaking the circle of impoverishment. Over half of the jobless are long-term unemployed, and analysis of labor market flows suggests that both the unemployed and the inactive are unlikely to find a new job. 14. Most working age individuals who are not employed have either very low educational endowments (primary or less) or narrowly focused skills (vocational school graduates). Meanwhile, the high general level of wages in the Croatian economy compared to other countries in the region puts local labor intensive industries at a competitive disadvantage vis-a-vis those of other CEE countries. Therefore the prospects for future export-based expansion of industries demanding only these narrow or low skills are poor. 15. Those who are currently locked out of remunerative employment due to low levels of education are also likely to see their limited opportunities perpetuated for their children. The education system lags behind other transition economies with respect to post-primary schooling, as UNICEF data suggest (see Figure 5). Household survey data (HBS) also show that the access of children from poor families to upper secondary and higher education is severely limited. Figure 5: Net secondary education ennollment rates 90 80 E- 70- 60 ' Croatia Hungary Poland Estonia Lithuania Latvia Romania Note: Total number enrolled as percent of relevant age group. Source: WDI indicators and UNICEF (TRANSMONEE) database. ix 16. Inequality. The gap between the rich and the poor in Croat'a is wider than in middle or low-inequality countries (Figure 6). Figure 6: The gap between the rich and the poor Mddle Croatia(1998) Poor Rich Poland (1998) Hungry (1997) Belgiun (1992) Italy(1991) ROC Taiwan(1991) Spain (1990) Israel (1992) _ 0 1 2 Note: Left side of the bar is 10ll percentile to the median equivalent income, right side - 90'h percentile. Luxembourg Income Study (LIS) equivalence scale (square root of family size to correct for economies of scale). Source: LIS database, www. lissy.org, for Croatia - staff estimates based on HBS (1998). 17. An increase in inequality is a normal result of transition, as markets start to reward scarce skills and entrepreneurship. However, inequality in Croatia is far higher than generally observed in transition and market economies. 18. Why is inequality an issue? High inequality means a weaker impact of growth on poverty. This report estimates elasticity of poverty with respect to growth at only 2.1 in Croatia: that is for every one percent growth in consumption poverty falls by 2.1 percent.3 Growth that accrues mainly to those at the top of the income distribution does little to improve the living standards of the poor, and increases in inequality can easily swamp the positive impact of growth. Inequality also leads to lower participation in civil society, thus reducing the opportunities for the poor to influence policies (La Ferrara(l 999)). Empirical studies show that higher inequality leads to significantly higher levels of violent crime (Fajnzylber, Lederman and Loyaza(1999)). High inequality leads to sharper crises in response to external shocks, as distributional conflicts between the rich and the poor impair the functioning of democracy (Rodrik(1999)). 19. High relative poverty. Inequality also matters because it determines how many people are poor relative to the middle4 or feel poor. The number of people in Croatia who consider themselves poor relative to others is high, and had fallen only marginally in 1999 compared to 1994 (CEMA 2000), indicating deep discontent among the population about growing inequality. 3 Using data from over a hundred countries Ravallion and Chen (1997) estimate that average growth elasticity of poverty with respect to growth is 3.1. 4 To measure relative poverty the conventional practice among OECD poverty researchers is to take 50 percent of the median national equivalent disposable income (or consumption) as the poverty line. On this basis, the incidence of poverty in Croatia (7.9 of the population) is higher than in other CEE countries (where relative poverty rate is ranging from 2.6 in the Czech Republic to 7.2 in Poland) - see Making Transition Work for Everyone, Statistical Annex. x 20. In summary, absolute poverty in Croatia is low, but this diagnosis is misleadingly comfortable. Inequality is high; Croatia would have had even a lower poverty rate, if inequality were comparable with other CEE countries. The type of economic growth that Croatia had, failed to generate enough economic opportunities, and the poor are at a disadvantage in benefiting from these limited opportunities. B. CAUSES 21. The poverty profile reveals two main economic causes of poverty: limited employment opportunities and inadequacy of the social safety net. War accompanied by hyperinflation contributed to a sharp deterioration in living standards in 1991-95 and sharpened pre-existing inequities. But war is not the cause of poverty in Croatia today: in the period between 1995 and 1999, the economic policies pursued by the government have tended to exacerbate, rather than to dampen, the consequences of war. Macroeconomic and Structural Policies were Key Determinants of Weak Employment Growth 22. Macroeconomic policy over the period after the successful stabilization in 1994- 95 up until the end of 2000 was characterized by a mixture of loose fiscal and tight monetary policies. The two most immediate outcomes of these policies were high real interest rate, which inhibited capital investment; and the appreciation of the real exchange rate, which led to a loss of competitiveness for traditional Croatian exports. Both effects militated strongly against employment generation. 23. The model of privatization that Croatia has chosen has given strong preference to insiders - managers and employees of formerly socially owned enterprises - over outsiders (including potential foreign investors). This has inhibited FDI flows and further limited prospects for job creation in the country. 24. Insider privatization, in combination with interventionist Government and subsidization of ailing firms, has created strong coalitions that have been able to slow down the restructuring of the economy, protecting privileges and rents for entrenched firms and industries. Soft budget constraints take away the "economic space" for the new entrants to thrive. This strategy has backfired, resulting in obsolete assets and a vanishing competitive edge. Labor Market Policies Have Worsened the Negative Impact of Macropolicies on Income Distribution 25. Against a background of falling demand for labor Croatian Government has relied excessively on early retirement to ease pressures in the labor market. This policy created a gap between the falling number of contributors to the pension system, and to the State transfer system in general, and the growing number of beneficiaries. As a result, transfer recipients had to rely on smaller benefits (Figure 7). The poverty profile which is dominated by the elderly and non-employed, can be traced to these developments. xi Figure 7: Employment,-Number of Pension Beneficiaries and Real Incomes, 1990=100 200 150 150 r. 100 100 50 5 0 0 *,'~4.,0 1990 1993 1994 1995 1996 1997 1998 1999 1990 1993 1994 1995 1996 1997 1998 1999 U Average real net wage - Number of employees A Average real pension benefit A Number of pension beneficiaries -GDP per capita Source: Crostat, 1999; employment in business entities, excluding Ministry of Defense and police forces. 26. The growing number of transfer recipients and the shrinking number of contributors has led to higher taxes on labor. Workers receive only about a half of what it costs a firm to employ them, a larger differential than in other European countries, and making labor more expensive as a factor of production. In addition this generally high tax burden has pushed economic activity underground, contributing to corruption and higher rents. 27. On the other hand, real after tax average wages of those who are employed have reached pre-transition levels. This recovery was also far from equitable. The public sector has been the leader in obtaining rapid wage increases. Sectors under the direct or indirect control of the State (40 percent of employees) absorbed almost all the economy- wide increases in the real wage bill between 1997 and 1999. On the other hand, some workers were subject to persistent wage arrears, and by the end of 2000 one in 10 employees has not been paid on time. 28. The inequitable growth was therefore a result of specific policies. The widening gap in average incomes between the employed and transfer recipients accounted alone for as much as 10 percent of total inequality in incomes by 1998, and, arguably, for a substantial part of the increase in inequality since 1990. The main contributor to inequality, however, is non-wage market income (income from self-employment and informal economic activities), which is distributed very unevenly. Why some of the self employed and entrepreneurs fare so much better than the others? The study argues that rents and barriers to competition explain high inequality in eamings, as well as the high returns for those who are involved in these activities. The non-agricultural self-employed constitute 7 percent of all non-agricultural employment, but collect almost 20 percent of all non-agricultural income. xii 29. Finally, failure to enforce anti-discrimination laws, both by private firms and by the public sector, has, according to the Social Assessment conducted for this study, created an environment where inequality and discrimination based on ethnic origin are entrenched. Non-Croat workers have been turned down by potential employers, or face barriers in obtaining necessary documentation, or suffer from the lack of protection of their rights. Access to social benefits and services for work incapable non-Croats has been reported to be constrained in various ways, including open discrimination practiced by some local officials. Transfers Have Not Played a Countervailing Role to Arrest Rising Inequality and Poverty 30. The Croatian Government spends over 25 percent of GDP on social sectors and social protection programs, more than other countries in CEE, but achieves little real redistribution, because most social spending is costly and poorly targeted, while relatively well targeted social assistance programs are small (see Table 2). The concentration coefficient for total transfers is positive, showing that instead of reducing inequality, they actually increase it. 31. Pension expenditures, which account for the bulk of social transfers, are rising rapidly (from 12 percent of GDP in 1998 to 14 in 1999), leading to a deficit in the pension system covered from general Government revenues. Incidence analysis shows that pensions represent a transfer to the relatively well-off, and do not adequately and equally protect all elderly and disabled from falling into poverty. One quarter of this group do not receive a pension, one-half receive benefits lower than the poverty line. Therefore deficit financing of the pension is a diversion of budget resources that could otherwise be redirected towards the poor. Table 2: Percent of GDP in 1998 How much the How much the How much the government spends poorest 20% of poorest 8.4% of on social programs? population receives? population receives? Pensions 12 1.9 0.7 Social Assistance 0.4 0.2 0.1 Child & Family Allowance 1.4 0.3 0.1 Unemployment benefit 0.4 0.2 0.1 All transfers 17 2.8 1.0 Education spending 3 0.5 0.2 Health care (estimate) 7 0.4 0.2 Total social spending 27 3.7 1.4 Source: staff estimates based on HBS(I 998) and Government expenditure data from Madzarevic-Sujster (2000) xlil C. ACTIONS 32. Successful poverty alleviation will rest on the three pillars of opportunity, security and empowerment. Providing opportunities for the poor to lift themselves out of poverty requires action to create an economic environment more conducive to equitable and sustainable growth. Supporting the long-term poor and extending the safety net to mitigate impoverishment due to shocks will result in greater security. Creating institutions that empower the poor to directly affect policies and social processes will make State interventions more effective in combating poverty. These three elements of the anti-poverty strategy are complementary, with each reinforcing the positive effects of the others, as powerfully demonstrated in the World Development Report on Poverty (2000/01). Policies to Foster Opportunities: Macroeconomic Stability, Flexible Labor Market and Education 33. Equitable growth is of central importance for several reasons. First, it will raise incomes of the working poor, giving them an opportunity to escape poverty. Second, it will provide employment opportunities for unemployed and inactive workers - a group facing especially high poverty risks. Third, it will provide the tax base for programs to alleviate poverty among those who cannot otherwise escape it. 34. Four conditions are required to achieve equitable growth: (i) sustaining macroeconomic stability; (ii) creating an enabling environment for private businesses; (iii) increasing flexibility of the labor market; and (iv) increasing investment in human capital. 35. To maintain and consolidate macroeconomic stability would involve a continued effort towards the following objectives: (a) Strengthen institutions for Government economic policy making, especially for implementing structural reforms; (b) Improve fiscal management and transparency, including by establishing mechanisms to eliminate arrears; and (c) Strengthen fiscal discipline, including by phasing out subsidies and price controls, introducing new wage policy and limiting the structural deficit of the pension system. 36. Enabling private sector-led growth is the key condition for making the growth sustainable. To achieve progress in this direction the Government will need to: (a) Increase flexibility and efficiency of the economy, remove regulatory obstacles for establishing new business, improve and harmonize land, cadastre and real estate registration systems, and streamline administrative procedures involved in FDI; (b) Strengthen market institutions: revise and update competition policy legal framework, ensure proper functioning of competition enforcement agency, xiv and harmonize competition enforcement with new licensing requirements; and (c) Improve governance framework for businesses: amend company law to strengthen minority shareholders rights, amend take-over law to promote pro-competitive mergers, amend company law to encourage nomination of outsiders to boards of directors, streamline the court processing of commercial cases, and strengthen the implementation capacity of commercial courts. 37. Reducing taxes on labor, that the Government has already undertaken, will improve competitiveness and create an environment for job creation. But it will not in itself guarantee the employment generation in the private sector. Other reforms are needed to make labor market more flexible and translating economic growth that would resume in the right economic policy environment, into new jobs. 38. Reforms of the labor market institutions are needed to ensure it works to support the employment generation, and not against it. The thrust of reforms is to remove disincentives to job creation and encourage different part-time and casual working arrangements, while enforcing a minimum level of regulations to ensure workers' rights (e.g., to sick leave, limited work hours, and regular pay; to protection from harassment and discrimination; and to workplace safety). The specific policy actions will consist of: (a) Amend the labor law to reduce costs to employers for hiring and dismissing of workers and encourage flexible working arrangements; (b) Ensure the public has adequate information on main workers rights that are enforceable through the legal system, and monitor cases of discriminatory practices; and (c) Improve labor market information systems to monitor effects of adjustment and to facilitate the evaluation of programs. 39. To equip the poor to take advantage of growth opportunities, a reform of the education system is needed, that will help workers adapt to the market economy and foster an entrepreneurial culture. In the context of closer integration with Europe, and in partnership with European institutions and programs, Croatia needs to reform the curriculum by focusing on general skills and abilities valued by the market economy, and to change the governance by making the whole system more equitable, flexible and adaptable to a changing environment. 40. Local authorities should be given more of a role in defining the profile of public education, post-compulsory education should reflect individual need and user choice, and vocational programs should be more closely connected to economic actors (through provisions, funding and guidance). A new structure will need to be more flexible and take into account the increasing demand to change one's individual schooling and educational career, switch between tracks, leave and re-enter education, and find continuing opportunities for further training and re-training. All these principles are reflected in the Govermment's proposal of education system reform (discussed at social xv policy workshop in January, 2001), specifically in its principle of "school of success for all" with the emphasis on those who under perform or drop out of school. 41. However, the Government is only at he beginning of a long and complex process of reform which will involve the following steps: (a) Finalize sector strategy and policy agenda for dialogue with the stakeholders; (b) Prepare the legal and administrative framework for increasing the role of private sector in education; (c) Adopt a framework for the new core curriculum, which promotes skills and facilitates active learning and teaching; and (d) New standard examinations will need to be piloted and introduced to improve transparency and quality. Towards Greater Security: Protecting Those Who Fall Through the Cracks of the Safety Net 42. Enhancing security has two dimensions: reforming the safety net to prevent new people slipping into poverty, and extending the protection to the poor who are currently not served by the system. 43. Putting the social protection of a strong financial footing will involve introduction of the new multi-pillar pension system and reform of social assistance - including reallocation of spending towards better targeted programs and improved monitoring and governance of social policy as a whole. Steps now underway to reform the pension system will eliminate poverty among pension beneficiaries, but will leave open the issue of coverage. 44. Hence, a simulation using LFS data and the legal framework laid out in the proposed pension reform shows that by 2018 the new multi-pillar pension system would create a fiscally sustainable system which would eradicate poverty among those eligible for pensions. At the same time, however, as many as one-fifth of new retirees will not qualify for a pension under the new system. 45. Therefore it will be essential to increase coverage under the system, to expand social assistance programs, or to design new programs to address the needs of those who are currently left out. Given the strong capacity of current welfare programs in Croatia to reach the poor, the Government may want to assess the need for expanding well-targeted social benefits. Simulations using the 1998 HBS show that reallocating a mere 1 percent of GDP from untargeted subsidies to poverty oriented benefits would reduce poverty by 1.2 percentage points (from 8.4 percent to 7.2 percent). 46. The Government faces an even greater challenge in mitigating the negative impact of reform and preventing new groups from falling into poverty. Alongside budgetary reallocation, substantial changes will be required in the management, the competencies and responsibilities of line ministries and individual social protection schemes. The current fragmented system of social benefits should be made simpler and easier to monitor. The process of reforming the system should rely on improved xvi governance, as already started with the first steps in the development of National Program for Fighting Poverty and Social Exclusion. 47. As the Government stands at the very start of the reform process, it is important to lay out the full policy "package" to reform the social protection, which will consist in: (a) Conducting an evaluation of existing social assistance programs (including the recently amended child allowance program) using the most recent household survey data and administrative information; also conduct a beneficiary assessment; (b) Ensuring that the level of public expenditure per beneficiary on major anti- poverty programs remains adequate (i.e., cash assistance program); over the medium term employ the official poverty line as a base for defining the level of means-tested benefits; (c) Rationalization of the targeting of anti-poverty programs with the objective to eliminate leakage to non-poor beneficiaries (by improving means testing); (d) Preparation of a plan for increasing budgetary allocations to the better targeted programs through the increase in the number of beneficiaries/amount of assistance, and for decreasing spending and number of beneficiaries of programs not well targeted to the poor; and (e) Improvement in coordination among different agencies managing multiple types of benefits and programs through the creation of inter-agency body responsible for design and monitoring the enforcement of social policy (Ministry of Labor and Social Welfare, Ministry of Reconstruction, Office of Refugees and Displaced Persons, Ministry of Health, Pension Fund, Employment Service, and regional and local governments). 48. To meet these objectives and implement these measures in the most efficient way, Croatia needs to establish a poverty monitoring system to track and report the social impact of economic reforms and evaluate the results of efforts to improve targeting and access to social assistance programs. The initial step in this area will be to establish a Government commission for drafting the legislation on the social minimum (poverty line), and to adopt official guidelines for calculation of poverty line and for poverty monitoring. Empowering The Poor to Make Progress In Poverty Alleviation Irreversible 49. Empowerment involves giving the poor "voice" to influence the institutions and policies that affect their lives. Currently Croatia's poor are afflicted with voicelessness and powerlessness, reflecting fragile democratic institutions, an immature civil society, and a weak enforcement of laws - especially anti-discrimination laws. xvii 50. The new Government of Croatia is the result of the first democratic transition. Its commitment to strengthen the democratic institutions of Croatian society needs to be sustained not only because such institutions are a basic human right, but also because the quality of governance and democracy, the rule of law and the efficacy of a country's public administration are important factors that promote the inclusion of the poor in policy making. This inclusion is possible when a democracy is firmly based on a fabric of civil society that gives citizens voice to influence policy making. 51. Fostering civil society will require bringing about a change in the nature of existing NGOs and social movements by creating an enabling institutional environment, i.e., a framework for encouraging poor people themselves to take an active role. Such an environment is best created through better governance of State-run institutions and a greater tolerance in society. 52. Finally, empowerment will include first and foremost the enforcement of anti- discrimination laws by: (i) reorganization of the civil service, improving capacity and monitoring administration at the local level; (ii) judicial reform, eliminating undue influence on the nomination of judges and improving the access of all citizens to courts; and (iii) reform of the media, including measures to turn the State media into public service broadcasters. xviii 1. HISTORICAL AND POLITICAL CONTEXT FOR UNDERSTANDING POVERTY A. INDEPENDENCE AND INITIAL CONDITIONS 1.1 Croatia's experience with the transition to a market economy differs in many respects from that of other CEEs. The country was initially well positioned for transition, with a high level of economic and social development, a sizable private sector and a strategic location. Its less centralized approach to socialism created some market institutions in factor markets in general and in the labor market in particular. During the past decade, however, the combination of war devastation and a number of specific policy choices has frustrated initially high expectations with respect to transition. 1.2 Despite war and devastation, Croatia has managed to preserve its high level of human development. The majority of the population has access to high quality health and education services, as reflected in key social indicators (Table 1.1). Table 1.1: International Comparison of Human Development Indicators (1997) GNP per Life Infant Net secondary Country capita, Expectancy Mortality (per enrollment (% of (US $) (years) 1,000 life births) relevant age group) Croatia 1997 4,060 72 8 66 Croatia 1992 2,079 12 62 Hungary 4,510 71 10 87 Poland 3,590 73 10 85 Estonia 3,360 70 10 83 Lithuania 2,260 71 10 80 Latvia 2,430 69 15 79 Romania 1,410 69 22 73 Russia 2,680 67 17 High income countries 25,890 77 6 91 World Bank World Development Indicators, 1993-99, and refer to 1997 or the most recent year available. 1.3 Immunization rates for, e.g., polio, tetanus, and TB never fell below 85 percent even in the worst years of the war;' nutritional standards were satisfactory even among the most vulnerable.2 Access to public utilities was traditionally high (75 percent of the population have piped water supply, and 99.7 percent have electricity connections).3 'UNICEF TRANSMONEE database, 1999. 2According to the UNICEF monitoring program in 1993, only 1.2 percent of children aged 1-6 were undemourished. This share was not statistically different among the refugees and IDPs, and dropped to 0.9 by 1997 (UNICEF, 1998). 3 World Bank (1999) "Croatia: A Policy Agenda for Reform and Growth", Chapter 5. 1 Education is the only source of concern in this otherwise rather positive picture. Upper secondary school enrollment rates in Croatia are low for its level of development, and inequality in educational attainment is high (for a European country). B. WAR AND ITS CONSEQUENCES 1.4 The war not only led to loss of lives;4 it also forced over half a million people from their homes and inflicted severe physical destruction on infrastructure and housing. The war also adversely affected the economy. War led to heavy direct economic losses (US$27.5 bln., more than a year's GDP). Croatia lost its main traditional foreign markets; the war interrupted trade flows with the former members of SFRY, and seriously hurt the tourism industry, Croatia's main source of overseas earnings.5 In addition, the war-induced increase in country risk contributed to a loss of foreign direct investment flows. Meanwhile, the political circumstances associated with conflict led to increasing post-war international isolation, denying Croatia important flows of international assistance. And finally, the occupation of over one-third of Croatian territory resulted in a four-year interruption of the main traffic links between the central part of the country and the east and south. Box 1.1. Druls: Echoes of thg War; Drnis is a smail town (witb 2700 inhabitants in 1999, dowa fromn 460 in 1991) with a miXed populaion (20percentSeb befoe fte war) locatdinadtweShnk and K .-Atteoteof tbe war in 1991, most of th resids fled by foot Howevevr some sed b Most f e p e who stayed were eMerly, handapped elderly and thr chidren who ref˘060 abadontM, There were as those who did not want to abandon teir property. in 1995, there wee officidfly 200 peopleregisfteed as living in Dnzis during the war. However, according to inteviews with tbose who stayed, de umober is closer to 40-. Life was ifXt during thewar sce socanetworksa weetol rleded a mw lost their jobs Thes ateia woes were overshadowed' bythe p - j ad ifld upon rd Serb parabm-iitay Iorces. - * misforhas tt endd With liberation. Apswt it'i the a *it cv,tt reantoa o an te,ths h remaine ar eeey amra be I.whvet.a traiors Those who stay viw e returnees with reat eny v in by thse fir f Years with fod b' and' vide* t ' t polic and enterrises also feed this antagonism by makin iti verydifulfo oewhstydo e t papers, and n r wio do t ( ID, ete). Thus~, they forg eat nsrne welfar said napomtbneus Souvw: E :. 'oai ''(20;'00)'. bz 1.5 Between 1990 and 1993, the combination of war and transitional recession contributed to a particularly severe economic crisis. GDP fell by almost 30 percent, the most severe decline among Central European Economies (CEEs, see Figure 1.1). 410,668 people were killed, 2,915 reported missing, and 37,180 wounded. 5A key source of foreign exchange before the war, tourism revenues dropped to 10 percent of pre-war levels by 1993. 2 1.6 Preserving the living standards of the population under these circumstances has taken a huge toll in terms of government finances. Defense expenditure, mounting demands for social protection from people affected by the war, and the unsatisfied demand emerging from the diminished role of enterprises in the social area, have all led to an expansion of the role of the State that has continued after the end of the war, to the point where public expenditure amounted to over 55 percent of GDP by 1999. The effects of war have fostered a culture of interventionism that has characterized most of the Government's post-war activities and its overall relationship with the real sector. Figure 1.1: GDP Growth in Selected CEEs 160 - -- -- 140. 120. t1 bulgWa Croatia Czech Hungary Poland Romaria Sovah Sloueia Republic RePublic ju1993/1989=10(01998/1993=10to 1999/1989=10 Source: WDI, World Bank 1.7 In October 1993, the Government launched what turned out to be one of the most successful exchange-rate-based stabilization programs in the region. Subsequent growth performance was strong. In fact, only Poland and the Slovak Republic grew faster than Croatia between 1994 and 1998. However, recovery has been insufficiently strong and ran out of steam too soon to restore pre-transition levels of output. Export performance has been particularly disappointing, and external imbalances have grown (Table 1.2). Croatia's GDP in 1999 was at only 78 percent of its 1989 level. Industrial production has followed an even more adverse path; by 1999 it remained about 40 percent below its 1989 level. C. POST-WAR ECONOMIC POLICIES 1.8 Lack of political will to undertake painful structural reforms and extensive use of macroeconomic instruments as temporary remedy to a structurally ill economy were distinctive features of economic policies in 1995-98. This course has exacerbated old and created new imbalances which made the past-war economic recovery unsustainable and resulted in the loss of competitiveness. Croatia's reform agenda remains unfinished until today, and efforts are needed to bring the country into the mainstream of the European economy. 3 Macroeconomic and Structural Policies 1.9 Growth in the period 1995-98 was based largely on booming domestic consumption and reconstruction (pnrmarily of the housing stock), not on productive investment. These high levels of consumption and residential construction were financed by large private transfers from abroad. The boom was also fueled by rising public spending, mainly in the form of higher public sector wages and overly generous entitlements for privileged groups. This fiscal expansion ran contrary to a commitment to a stable exchange rate and low inflation. Table 1.2: Croatia - Selected Macroeconomic Indicators, 1994-2000 GDP per capita in current USD 3,137 4,029 4,422 4,398 4,805 4,456 4,229 Change from previous period (in %) Real Gross Domestic Product 5.9 6.8 6.0 6.5 2.7 -0.3 3.8 Retail Price Index (annual avg.) 97.5 2.0 3.5 3.6 5.7 4.2 6.5 Exports (GNFS, current dollars) 14.1 1.3 10.6 2.2 4.4 -0.2 n.a. As % of GDP Govenmnent Expenditures* 44.1 48.9 51.9 50.9 53.6 55.9 50.1 Direct Foreign Investment (net) 0.7 0.5 2.7 1.8 3.4 5.1 4.2 Source: "Croatia. Beyond Stabilization." World Bank, 1997, staff estimates based on CBS data, see www.worldbank.hr; * on accrual basis, staff estimates; n.a. - not available. 1.10 The expansion of the Government sector has put Croatia in an unusual position compared to other transition economies of Eastern Europe, the majority of which have managed to decrease their share of public expenditure in GDP over the same period. To finance this increase, Croatia has expanded taxation levels. But even becoming one of the highest-taxed Central European economies did not helped to balance the Government's finances, and the budget deficit has gradually risen out of control. High levels of taxation have in turn hampered private sector growth and contributed to driving economic activity underground. 1.11 Tight monetary policy has been extensively used to counter the effects of loose fiscal policy, resulting in sharp increases in the current account deficit. The most immediate consequence of monetary "over" tightening was a high real interest rate (over 10 percent throughout the period), adversely affecting investment and slowing down restructuring of the economy. In addition, tight monetary policy generated pressures toward a real appreciation of the exchange rate. As shown in Domac (1999), this artificially increased consumption of imported goods to the detriment of employment in potential export activities. 1.12 Despite years of stable exchange rate and low inflation, dollarization remained a prevailing mode of financial transactions, reflecting lack of confidence in the sustainability of economic policies. In 1999, amidst the banking crisis that led to a depreciation of the kuna, the indexation of contracts in DM has adversely affected living standards: as shown in Miljenovic (1999) it was the major factor explaining the fall in personal consumption in 1999 as the interest payments of households for consumer loans rose dramatically. 4 1.13 The key problem undermining public confidence was patchy progress in the structural reforms necessary to ensure long term stability and sustainable growth. More specifically, the progress with privatization and enterprise restructuring, reforming public finance and creating conditions for flexibility and competitiveness of economy has been slower than desired. 1.14 Privatization, Governance and Role of the State. The Socially-Owned Enterprise (SOE) model inherited from the Yugoslav socialist system largely determined the privatization process launched with the 1993 Law on Transformation of SOEs. This law gave an overwhelming preference to manager and employee buy-outs. Although many SOEs are completely privatized, their governance has changed little. Compared to Hungary and Poland for example, fewer Croatian SOEs have changed their managers after privatization. The prevailing enterprise culture remains centered around two concerns: first, to preserve existing employment (rather than improving the company's results); and second, to maintain political connections. In the past the Government had been bailing out enterprises through a variety of methods: straight subsidies, debt write offs, non-enforcement of fiscal obligations, etc., amounting to soft budget constraints.6 The Government indirectly subsidized some sectors under State control (such as shipbuilding) in a variety of ways. Shipyards had very easy access to government guarantees, and have not been paying social security contributions - or sometimes even their workers' wages (which have been paid directly from the Ministry of Economy budget). This created an environment prone to rent-seeking, anti-competitive behavior and persistent inequities. 1.15 Failure to create competitive markets. Emerging coalitions between SOE managers, banks (often controlled by enterprises) and local Governments have prevented the development of a fully competitive market structure. The tightly controlled distribution system is rivaled only by the lack of competition in the retail sector and the absence of any foreign distributors as illustrations of remaining barriers to competition. 1.16 Trade policies prior to accession to the WTO were oriented towards maintenance of the status quo. The new Custom Tariff Law adopted in 1996 was broadly consistent with WTO requirements, but protection has been set at very high levels for some sectors. The average tariff on agricultural production exceeded 35 percent (before some rates for imported food products, directly competing with domestically produced exceeded 1000 percent). The reduction of protection in 2000-01 for Croatia's bid to join the WTO has severely hit these industries that had few prior incentives to restructure and further underscored the structural nature of economic problems. Key Sectoral Policies 1.17 Sectoral policies in the 1990s have had also some very distortive outcomes. Particularly worrisome were developments on labor markets, in the social sectors (health and education) and in the social welfare policies. 6 Though direct subsidies amounted to 2 percent of GDP, there are many off-balance forms of subsidies that lead to high costs to the economy because of misallocation. 5 Labor Market Policies 1.18 Croatia inhenrted sizeable excess employment from the socialist regime. The best strategy for dealing with labor hoarding is rapid reallocation of labor from shrinking and overstaffed enterprises to new expanding sectors. This strategy requires flexible labor markets and an emphasis on new job creation. The Govemment has chosen a different strategy aimed to minimize the pain of restructuring by slowing down the pace of labor reallocation. 1.19 Labor regulations and labor market policies in Croatia have been greatly influenced by job protection objectives, focusing on "core" full time employees, while placing restrictions on temporary and fixed-term contracts and imposing penalties on job terminations. For the workers that they cover, these laws and regulations may have increased job stability, but at the cost of flexibility; they have also created a bias against formal contracting of "outsiders". 1.20 The current labor code (Labor Act No. 758/95) impose high direct costs on employers (see Table 1.3) compared to EU countries. Termination of employment is particularly cumbersome; the law provides for advance notice of up to six months in some cases, and requires the agreement of a workers' council. Severance pay is set at a minimum level of one-half of average monthly salary for each year of tenure. These restrictions inevitably hinder employment creation, because employers are unwilling to hire new workers to avoid future risks and liabilities. There are also limits on part-time work, and restrictions on the duration or renewal of part-time (or contractual) employment. Table 1.3: Employment Protection Legislation. International Comparison Lay-offs procedural Notice and severance pay for no-fault Difficulty of dismissal inconveniences individual dismissals Procedure Delay Notice period after Severance pay after Definit. Compensa 9m 4y 20y 9m 4y 20y of unfair tion Score Days Months Score Months Croatia 3 15 1 3 6 0 2 10 1 18 EU mean 1.7 12.3 0.9 1.9 4.9 0.1 0.7 3.7 0.8 16.9 Germany 3 10 1 1 4.5 0 0 0 2 18 Spain 2.25 40 1 3 3 0.2 1.3 6 2 35 Austria 2 5 0.8 1.2 2.5 0 2 9 1 9 Source: OECD The OECD Job Study. 1994 and Labor Act for Croatia (No.758/95). Explanations: Lay-off procedural inconveniences when issuing a regular dismissal notice: I for a statement in writing to the employee of reasons for dismissal, 2 for notification to a third party, 3 when permission for dismissal must be obtained from a third party. (higher number indicates stricter procedure). Delay in effectiveness of notice: the delay between a decision to dismiss and the time that notice can become effective after following required procedures, days. Notice period, 9m, 4y, 20y: the period between issuance of dismissal notice and the effective cessation of employment, in months. The columns refer to workers who have been with the employer 9 months, 4 years and 20 years, respectively. Severance pay, 9m, 4 y, 20 y: a lump-sum payment to the dismissed employee at the time of cessation of employment. The columns refer to workers who have been with the employer 9 months, 4 years and 20 years, respectively. Definition of unfair dismissal: 0 when worker performance or redundancy are adequate grounds for dismissal, I when social considerations (age, health status, etc.) influence the choice of which worker to dismiss, 2 when attempt to retrain worker to adapt for a different job is compulsory prior to dismissal, 3 when worker capability can never be a basis for dismissal. Compensation at 20y: the compensation payable to worker who has been unfairly dismissed after 20 years with employer, in months of regular salary. 6 1.21 Flexible working arrangements are considerably underdeveloped. The vast majority of employees in Croatia work full-time; only about 3 percent are part-timers, substantially lower than in the EU (almost 18 percent). The difference is particularly great for female workers. In the EU, 33.1 percent of female employees work on a part time basis; the comparable figure for Croatia is only 4.1 percent (see Bisogno 2000). Human Capital Development and Education Policies 1.22 The Government of Croatia has kept education reform on its. agenda since the country gained its independence in 1991. However, a coherent national strategy has not been pursued, as education remained mostly a political issue, and reforms implemented in 1991-95 did little to improve quality, efficiency and equity of access to education. To date, the Government's foremost priority and politically most visible item on the reform agenda has been replacement of the old "Yugoslav" content of education with a "Croatized" curriculum and national traditions. This goal covers a whole range of issues in history, geography, literature, language training and beyond. However, these objectives also feed into traditional approaches to pedagogy, which relies on the learning and repetition of facts (even if these facts are considered new and modern ones). This is an approach that has been considered outdated across Europe, including a number of other countries of the CEE. 1.23 Outdated curricula are not the only weakness of the Croatian education system. The system accumulated handicaps across other dimensions: governance, finances, assessments and quality control, institutional structures, teachers policies.7 The key issue is an early tracking into highly specialized inflexible programs. In the present system it is very difficult for the individuals to modify their education and training profile within the school system. Most importantly, in absence of adequate forms of second choice training and bridging programs, the system does not provide an adequate strategy of schooling and intellectual development for those whose performance is considered to be at medium or low levels. This is an undesirable direction for a new market economy and an open society. Figure 1.2: Net secondary education enrollment rates (percent) 90 80 70 - 060 -LLLLLL Croatia Hungary Poland Estonia Lithuania Latvia Rormnia Source: WDI indicators and TRANSMONEE database. ' See Wold Bank (1999) Croatia: A Policy Agenda for Reform and Growth. Vol. 2 Chapter 6 "Towards Education System Reform". 7 1.24 Structural problems in education system lead to its low efficiency and the fall in demand for its services. Figure 1.2 shows that post-primary education in Croatia lags behind other transition economies, even at a rather basic level (secondary). Thus the system is not including a substantial fraction of labor market entrants, lowering their chances for getting productive employment in the future. 1.25 The health sector in Croatia offers almost universal access to a wide range of health services and benefits. However, the present range of services is not fiscally sustainable, and does not represent a cost-effective response to the existing burden of disease in the country. The sector represents a major fiscal problem, and increases the vulnerability of overall public sector finances.8 At the same time, there is a sizeable group of population which is excluded from the system (see Chapter 3). Social Insurance and Social Assistance Programs 1.26 The Croatian public sector is the largest in Central Europe and has been on a rising trend, unique in the region (Figure 1.3). Figure 1.3: Consolidated Government Expenditures, 1993 and 1997 Consolidated Government Expenditures, Consolidated Government 1993 Expenditures, 1997 50 - _ _ StJ 40 ' 20 20 O ''0S 10 XS'. Croatia Transition Developed Euopca- Croatia ransition Desetoped European avg axg ,vg avg O Other Governm-nt Expendi-ue &Net loding C Giber Goveh- menlt Lpe-doure &Net lending 0 Ed-a.,oa oO Education * Health * Health * S t eit a d pensions * So.tat Security &Werfare (inctading penuions) Source: Consolidated Central Government Expenditures (does not include municipal budgets). Madzarevic-Sujster (2000) 1.27 Social spending (social insurance, protection, social sectors, including education, employment, unemployment, social protection, pensions and health care, war-related expenditures including reconstruction) were to large extent responsible for such a rapid expansion. In 1999, net of administration costs, all layers of government spent 26.4 percent of GDP on social programs, or 48 percent of consolidated Government expenditure. In 2000 this trend continued, and the share of social programs has expanded 8 The structural problems of health sector and outcome of health policies are discussed in detail in the upcoming World Bank Public Expenditure and Institutional Review. 8 further to half of State spending. The total cost of all social spending programs, including the salaries of public employees who are administrating them, was around 34.4 percent of GDP in 1999.9 Figure 2.9 also illustrates why Croatia has such a high level of social spending: public expenditure on health and social transfers (including pensions) clearly outpace what is observed in other countries. 1.28 Pension system. Pensions represent the largest item in social expenditures of the public sector. Croatia still operates a mandatory, pay-as-you-go (PAYG) pension system, although the reform to introduce a multi-pillar system is in full swing. Generous benefits combined with a rapid fall in number of contributors per beneficiary has meant that spending is high and unsustainable. A low retirement age, easy access to early retirement, the creation of merit pensions after the war, as well as the Constitutional ruling against the Government's decision to adjust pensions with prices, have pushed pension expenditures from 9.2 percent of GDP in 1994 to 13.5 percent in 1999. Despite this high level of spending, many pensioners receive very low benefits. In 1998, 47 percent of pensioners received benefits of less 1000 kunas per month. Moreover, more than one fourth of individuals aged 60 years old and older did not receive any benefit. 1.29 Housing subsidies is an example of poorly targeted, expensive and inefficient system. Utilities' policies present serious equity problems. Electricity, communication and gas companies dominate their sectors and enjoy quasi-monopolies. Tariffs were twice as high as in comparable economies pnror the oil prices increases.10 The weak enforcement of payment discipline, which so far has been the strategy in Croatia to address social considerations, is the most inefficient way to alleviate the social burden related to increased costs of energy. Recently, as much as 25 percent of electricity consumed was not paid for, or paid for with considerable delay." On the other hand, there is no coherent assistance program for the poorest segments of the population that lack the income to pay utility bills. Municipalities run special assistance programs to help the poor with payments of debts to utilities, but multiple criteria are used in different parts of the country with no attempt to unify the approaches and develop a consistent policy. 1.30 The energy tariff system applied in Croatia is profoundly anti-poor. There are two tariffs for household electricity consumption for different hours of the day, but households are unable to control the costs of consumption because only some households have two tariff counters for electricity use and those with one counter always pay at the higher rate. As international comparisons show, the Croatian tariff system and the 4 These data are derived from the official finance statistics (on a cash basis for Croatia). Payments made through shares or through humanitarian sources are not included in the estimation, neither are private sources. Detailed table on social expenditures can be found in the background paper for this study by Madzarevic-Sujster. 0) The electricity tariff at the end of 1999 was US$ 0.06 as opposed to a range of US$0.03-0.045 in CEE countries. See Wold Bank (1999) Croatia: A Policy Agenda for Reform and Growth. Vol. 2. 9 policies of ad-hoc assistance perform poorly compared to two or three block tariffs (Lovei (2000)). 1.31 Reconstruction of demolished homes. This is another example where the unintended social consequences of the program are far from being pro-poor. The cost of the program to the budget amounted to an average of 1 percent of GDP each year from 1995 to 1998 (see Madzarevic-Sujster (2000)). The program requires substantial matching spending by beneficiaries, which the poor often cannot afford.12 In the social assessment participants in the areas affected by war complained that government- financed reconstruction of their homes has been slow, insufficient and of very low quality. The program is also prone to corruption and discrimination. Consequences: Uncompetitiveness, Unemployment, Inequality 1.32 The piecemeal approach to structural reforms followed in the 1990s and accompanied by lax fiscal policy backfired through loss of competitiveness, rising unemployment and growing inequality. Uncompetitiveness 1.33 Overvalued exchange rate together with high taxes is putting many sectors of the Croatian economy at a competitive disadvantage, as demonstrated in lackluster export performance: for example, in 1993 Croatia's exports were at the same level as those of the Czech Republic, Poland and Hungary; subsequently, however, these other countries' exports have quadrupled, while Croatia's have stagnated. 1.34 Insufficient enterprise restructuring is one of the root problems of the poor financial performance of the enterprise sector,13 and the growing problem of arrears. Poor profitability limits investment resources, while arrears erode the proper system of market-driven incentives; as a result growth in productivity is compromised. 1.35 Resolution of social and political tensions through granting wage increases in a environment of highly centralized wage bargaining led to escalating wage increases. The level of wages in Croatian industry is substantially higher than that of other CEE countries (Figure 1.4). Those high wage levels limit Croatia's comparative advantage in labor intensive production and thus limit employment opportunities for unskilled workers. 12 The Government finances only reconstruction of the outside structures (exterior walls and roof), and a standard number of square meters per inhabitant registered at the address. Households are left with the costs of renovating interior walls, painting, etc. 3 Losses of loss-making enterprises still exceed the profits of profitable ones 10 Figure 1.4: Gross Monthly Industrial Wages in Current USD in 1998 600 600 200 0 Bulgaria Roimania Slovak Hungary Czech Republic Poland Croatia Republic Source: IMF (1999). 1.36 Dealing with the falling demand for labor the Croatian Government has relied excessively on early retirements, pushing redundant workers out of economic activity altogether. While this strategy helped to minimize the social stress of reducing excess employment, it effectively slowed down the pace of labor reallocation, limited potential productivity gains and further compromised the competitiveness of economy. 1.37 The rising number of transfer recipients and the smaller number of contributors forced the Government to rise taxes, including payroll taxation, making labor more expensive as a factor of production. The current level of payroll taxes and personal income taxes creates a differential of about 80 percent between take-home pay and employers' labor cost, a level far higher than in Croatia's main competitors (see Figure 1.5). These high total labor costs inhibit new employment growth, and lead to a proliferation of informal payments,14 even for workers in the formal sector,15 to avoid taxes. Figure 1.5: Tax Burden as % of GDP by Types of Taxes, Cumulative 1995-98 50%/ 405% 30%!A _____ _._i 20°/o - v ~~~~~VATVA 20% Croatia CEE average EU average Note: Payroll - total social security contributions and other payroll taxes, VAT - value added tax, PIT - personal income tax, CIT - corporate income tax, tariffs - taxes on foreign trade, other -excises and property taxes. Source: M. Keen et al (IMF, 2000). 14 As shown in Madzarevic and Mikulic (1997) the growth of the informal economy is largely due to economic activities seeking to avoid regulation and taxation. Informal activities were estimated to represent between 23 and 33 percent of recorded GDP in 1995. 15 In HBS (1998) 30 percent of wage employees declared additional labor eamings. 11 1.38 Nowhere is the failure to create an economic environment conducive to innovation and productivity growth as evident as in Croatia's underdeveloped Small and Medium Enterprises. Croatia still lacks an active and dynamic SME sector. Like other transition countries, Croatia inherited from the previous system a preponderance of large enterprise and a business culture which emphasized economies of scale, mass production, vertical integration, and self-sufficiency marked by in-house production instead of subcontracting/outsourcing. Total private SME employment has not increased at all between 1996 and 1999. Figure 1.6 shows how far Croatia lags behind other CEE countries in the extent of SME development-mainly reflecting a poor business environment; difficulties in finding financing at reasonable terms; high taxation; and the lack of a well articulated pro-SME policy in the country. Figure 1.6: Share of SME in Total Wage Employment in 1998 Note- SME - small and medium enterprises with less than 100 employees in all sectors of economy. Source: Business Environment and Enterprise Performance Survey (EBRD- World Bank, 1999). 1.39 Privatization favoring insiders also deterred the flow of Foreign Direct Investment (FDI). During 1994-98 FDI amounted to only 2.2 percent of GDP - below the GEE average and less than half that of Hungary16 In particular, "greenfield" investment was very low, reflecting a general lack of incentives and a relatively poor investment climate. Recent granting of substantial incentives to FDI has not changed the situation dramatically. Unemployment 1.40 Unemployment responded to higher labor costs and poor incentives structure. Domac (1999) investigated the wage - unemployment dynamics in Croatia using a VAR model based on monthly data. His findings show that, while most of the upward trend in unemployment is structural in nature, wage increases and high payroll taxes also contribute to rising levels of unemployment, after controlling for the level of economic activity. Specifically, over a 36- month timeframe, variations in real wages explain 26 percent of the variation in unemployment. Decision making dominated by insiders is also not conducive to employment generation.17 16IMF( 1 999) 7As the literature on structural unemployment in Europe witnesses- see Nickel (1995). 12 1.41 Unemployment, when measured in a consistent and internationally comparable way is not nearly as high as registered, although it is higher than in most CEE countries and is on a rising trend. There are two different measures of unemployment in Croatia, which give quite different numbers. Taking the number of unemployed persons registered at the Croatian Employment Office (CEO) and dividing it by the total labor force, estimated by taking employment levels from administrative sources, gives the registered unemployment rate. By the end of 1999, and after years of growing more or less steadily, this rate reached 20.8 percent of the labor force (in the year 2000 it increased to 21.4 percent). But taking the number of unemployed persons and the total of the active population from the Labor Force Survey gives a completely different LFS unemployment rate, which stood at 12.6 percent by the first semester of 1999, and increased to 15 percent by the mid-2000. 1.42 The difference between the registry and LFS unemployment numbers is among the largest in Central Europe, second only to Slovenia (see Bisogno). The LFS reveals that only 60 percent of those registered as unemployed at the CEO are truly (ILO) unemployed. The remaining 40 percent either are working in the informal sector (15 percent) or, more often, are not looking for a job or have no intention to work (and hence count as inactive by ILO standards). There is no or little check on the willingness and availability for work among those who are registered. Therefore the registered unemployment rate reflects the incentives to register, primarily in order to receive health insurance and other social benefits. The LFS-based measure of unemployment is less subject to distortions and consequently more reliable. In addition, this indicator of unemployment, unlike the registered unemployment rate, is internationally comparable as it is not subject to the international variations in registration procedures and regulations. Croatia's rate, though roughly half that of the registered unemployed, is nevertheless high by international standards (Figure 1.7). Figure 1.7 Unemployment rates in 1998 (ILO methodology) 14 - 12 _ __ __ _ 10 ' 6 64 .rF'If Croatia Czech Ronania Slovenia Hungary EU Estonia Poland Slovak Bulgaria Republic average Republic Source: Croatia LFS (1998), Czech Republic 1997-99 (World Bank, 1999); Hungary, 1997 (EBRD 1999 Transition Report) Slovak Republic 1997 (OECD-CEET Data Base), other countries, 1999 OECD Employment Outlook. 1.43 There are very limited opportunities for those unable to find jobs as wage employees, because the environment for self-employment activities is poor. Non- agricultural self-employment is also low in Croatia compared to other CEE economies (see Figure 1.8, despite the considerable premium associated with self-employment, as revealed by HBS: the self -employed in Croatia earn 2.5 times more than an average employee, a figure which far exceeds the crude premium in Hungary (40 percent), Poland 13 (70 percent) or the Czech Republic (90 percent).'8 This suggests the existence of high rents associated with entrepreneurial activities. Usually, such high rents reflect entry barriers and corruption.'9 1.44 The businesspersons interviewed in the social assessment see a sharp division between the legal environment before and since 1994, when registration laws increased the cost and complexity of registration. In addition, since 1998, many self-employed respondents have noted a culture of non-payment of contracts (by government agencies and other private entrepreneurs), and a restrictive tax and legal environment. The resulting trend of fewer people starting their own businesses is also evident from other 20 sources. Figure 1.8 Non-agricultural Self Employment as % of Total Non-Agricultural Employment 12% 9% 6% 3%, Slovakda Romania Croatia Slovenia Hungary Poland Czech Republic Source: Croatia: own estimates based on LFS (1998), other countries Yearbook of Labor Statistics, ILO, 1998. Maldistribution of Gainsfrom Growth 1.45 The economic environment created by Croatia's distinctive transition experience has tended to create substantial divergence in living standards between different social groups and households. 1.46 Sectoral data reveal deeply unequal growth of earnings for those who do have jobs. The state sector has led the process of wage increases, generating the most significant percentage increase in the wage bill; it is also the only sector that has consistently expanded employment. The overall improvement in wages has been concentrated in three activities marked by direct or indirect state intervention (transport and communications, finance, and the public sector), which accounted for 40 percent of 18 Earle J., Sakova Z. "Entrepreneurship from Scratch: Lessons on the entry decision into self-employment from transition economies". IZA DP no 79. 1999. 19 Croatia exhibits levels of rents in self-employment similar to those in Russia, a country notorious for a poor business environment. - Ibid. 20 Malekovic et al. (1998). 14 1998 formal employment and absorbed almost all the economy-wide increase in the real wage bill between 1997 and 1999.21 Figure 1.9: Wage growth rates for low and highly-paid workers: 1998/96 3000% 2000% 25th 40th l edian mean 60th 75th percentile percentile percentile percentile (pOOTest) E Source: LFS (1996 and 1998) nominal after tax wages, percentiles of wages in 1996, only full-time workers in paid employment 1.47 Labor Force Survey data on the actual growth of nominal wages of individual workers between 1996 and 1998 confirm this picture. They show that the pay of those with wages below the median level has been growing more slowly over the period than that of higher paid workers at the 60th and 75th percentile of the wage distribution (see Figure 1.9). Clearly, the benefits of growth have not been distributed equally. 1.48 Average wage in public administration exceeded the average manufacturing wage, and this gap has been increasing from 19 percent in 1997 to over 70 percent at the end of 1999. Wage increases granted to civil servants in the end of 1990s have had an effect on wage expectations of workers in private and privatized enterprises. Particularly strong increases in salaries have been recorded in the least competitive, but highly unionized industries (textiles, rubber and plastic). It soon became evident that much of these wage claims were not sustainable. Wage arrears, which are confined mostly to FSU countries and that can hardly be found anywhere else in CEE, have spread through the Croatian economy; at the beginning of 2001 one in ten employees in Croatia was not paid on time. Arrears are a very powerful driver of inequality and a source of risk and volatility for household welfare. 1.49 The gap between the rich and the poor in Croatia is wider than in other countries (Figure 1.10). Increasing inequality was a common feature of transition, as markets started to put a premium on scarce skills and enterpreneurship. However, inequality in Croatia is substantially greater than that observed in successful transition and established market economies. 21 Data from CBS. 15 Figure 1.10: The Gap Between the Rich and the Poor Middle Croatia (1998) Poor ___________________________ Rich Poland (1998) Hungary (1997) _ Belgium (1992) Italy(1991) Taiwan(1991) Spain (1990) j I _ Israel (1992) __ l 0 1 2 Note: Left side of the bar is 10k' percentile to the median equivalent income, right side - 90oh percentile. Square root of family size is used to correct for economics of scale, data bottom coded at I percent. Source: LIS database, HBS (1998) 1.50 Inequality weakens the impact of growth on poverty. Inequality reduces the likely future effects of growth on poverty. The estimated elasticity of poverty with respect to growth in Croatia is 2.1: that is, for every one percent growth in consumption, poverty falls by 2.1 percent. This relatively low elasticity is due to high inequality: Ravallion and Chen (1997) estimates that average growth elasticity for low inequality countries is 3.1. High inequality also amplifies the negative effects of growth shocks, leading to sharper crisis in response to adverse external developments as distributional conflicts between the rich and the poor impair the functioning of democracy (Rodrik,1999). 1.51 Inequality has an adverse societal impact. Empirical research has demonstrated that, other things being equal, higher inequality leads to significantly higher violent crime rates, because of the relatively higher pay-off from crime to those who are poor (Fajnzylber, Lederman and Loyaza(l 999)). Inequality also leads to lower participation in civil society groups, thus reducing opportunities for the poor to influence policies (La Ferrara(1999)). 1.52 To understand better the reasons behind the higher levels of inequality in Croatia than in other countries, Table 1.4 presents a decomposition of inequality in disposable income. The main driver of inequality in Croatia is income from entrepreneurial activities and informal sector earnings ("other market income", including net income from self-employment, additional earnings, free-lance income, income "from direct negotiations", and profits). These sources account for more than half of all inequality and close to a third of total incomes. This is in sharp contrast with the fact mentioned earlier that the self-employed constitute only 7 percent of non-agricultural employment, and demonstrates the existence of high rents. 1.53 State transfers in aggregate do not act to reduce inequality, which means that richer people, on average, get higher absolute amounts of state transfers than poorer individuals. This is a disappointing result given the high share of transfers in GDP. In Croatia a substantial part of income is informal and therefore not directly taxed; hence, 16 similar tax rates on total income imply much higher taxes on formal income in Croatia than in comparator countries. Table 1.4: Decomposition of inequality in incomes in selected CEE countries. Croatia Hungary Czech Republic Slovakia Share I Contrib. Share Contrib. Share Contrib. Share Contrib. in To *in to in i to in to income inequality income inequality income inequality income inequality Wage income 59,6% 0.188 74.1% 0.277 77.6% 0.237 77.3% 0.214 Other market income 1 32.2% 0.232 4.7% 0.025 8.7% 0.032 6.1% 0.027 In-kind income. 6.5% 0.008 7.9% 0.0O15 5.7% 0.010 7.3% 0.015 Private transfers 5.7% 014 2.6% 0.006 1.3% 0.004 1.2% 0.003 Pensions 15.6% 0.002 24.2% 0028 12.6% -0.048 11.1% -0.036 Othertransfers 3.9% 0.001 10.0% -0.019 10.2% 0008 11.5% -0.008 Taxes and contributions | -23.5% -0.092 -23.4% -0.100 -16.1% -0.054 -14.5% -0.047 Net incomelloo.0%j 0.352* 1100.0% 0.232* 100.0%! 0.174* 100.0% 0.168* Note: all sources of income are gross pre-tax incomes; * Gini index; ** Includes self-employrnent, entrepreneurial income, additional (informal) eamings, interest income, income from property; *** excludes imputed rent for owner-occupied housing. Source: Croatia - own estimates based on HBS (1998), OECD equivalence scale, data for Hungary - own estimates based on 1997 HHP, Czech and Slovak Republics (1993): Gamer and Terell (1998). 1.54 Thus, inequality is high, and is driven primarily by the size of the informal economy, by the lack of a competitive environment, and by a failure to redistribute. Whether existing income disparities increase or fall in the future depends crucially on the ability of the Government to implement reforms in the real sector, together with reforms in public expenditure, especially with respect to targeting of social spending. 1.55 The pattern of inequitable distribution is evident from LFS data, which show substantial sectoral, regional and gender gaps, even controlling for the human capital characteristics of workers (see Bisogno). All other characteristics being equal, a professional without post-graduate studies earns on average 69 percent more than someone with uncompleted primary education, and a worker who has attained post- graduate education level earns twice more than a worker with uncompleted primary. These high returns are combined with relatively high dispersion of education to produce highly inequitable outcomes: the standard deviation for years of schooling of the population over 25 years old is 4.2 in Croatia (with a mean of 9.5), higher than in Argentina and Uruguay and significantly higher than in European countries.22 This points to the existence of a stratified educational system which fails to operate as a mechanism for social mobility. 22 See "Facing Up Inequality in Latin America". IDB, 1998, Ch. 2. 17 2. WHO ARE CROATIA'S POOR? 2.1 Analyzing Croatia's poverty profile is essential to understand the causes of poverty, and to formulate actions that address these causes in the most efficient way. This chapter asks how many are the poor people in Croatia, who are the poor, and identifies key economic causes of poverty. A. THE SCALE OF POVERTY IN CROATIA 2.2 In the broadest definition, poverty is the status of a person who falls short of a level of economic welfare deemed to constitute a reasonable minimum, either in some absolute sense or by the standards of a specific society. This minimum level is usually called the "poverty line". Analysis of poverty depends on the accurate measurement of incomes or consumption levels. Information on consumption and income is obtained through sample surveys, during which households are asked to answer detailed questions on their spending habits and sources of income. Between 1991 and 1998 there was no representative household budget survey on the territory of Croatia. The analysis presented in this report is based in the first representative survey of incomes and expenditures of households in Croatia since Independence. It was conducted by the Croatian Bureau of Statistics in 1998 and covered 3,123 households randomly selected throughout the country. International Comparisons 2.3 Any poverty number depends critically on the choice of methodology, especially on the poverty line chosen. It is therefore often hard to compare poverty rates across countries; comparisons can be meaningless if countries' poverty lines are widely different. It is therefore necessary to choose a comparable poverty line and limit comparisons to countries which have recent representative household survey data - the only basis for determining how incomes and consumption are distributed in a society. 2.4 The World Bank23 uses internationally comparable poverty figures based on a line of US$4.30 per person per day at purchasing power parity (PPP). This poverty line is applied to per capita consumption expenditures. The results of a recent update for countries in transition indicate that Croatia's poverty rate is among the lowest in the region (Figure 2.1), but this diagnosis is deceptively comfortable. 2.5 Two factors determine the poverty rate: the average level of well-being in a society and how this well-being is distributed between individuals and social groups. The countries shown in Figure 2.1 have widely different incomes expressed in PPP dollars. One way to assess more accurately where Croatia stands in terms of poverty is to 23 See WDR 1996 From Plan to Market 18 simulate what the poverty rate might be if the distribution of welfare were comparable to other countries. Applying this method we estimate that the poverty rate in Croatia would in fact be lower by a third (3 percent poor instead of 4 percent)24 if inequality were comparable to that in a range of other CEE countries. Figure 2.1: Absolute Poverty Rates, International Poverty Line 50% 25% - Croatia Slovenia Hungary Poland Romania Source: Croatia - HBS (1998). Other countries:: World Bank (2000) Making Transition Work for Everyone. Setting the National Poverty Line 2.6 As already noted, however, there are drawbacks to applying a single standard to different countries, and there are many methodological difficulties in estimating PPP. Moreover, for policy makers what matters is the extent of poverty based on a nationally relevant standard. Basic needs do vary across time and societies. Therefore and each country uses its own lines which are appropriate to its level of development, societal norms and values. Thus, poverty needs to be defined in a particular cultural context and in terms of specific local conditions. 2.7 A Social Assessment conducted specifically for this study aimed to establish what people in Croatia identify as poverty. It found little public awareness of absolute deprivation in the country. The non-poor focus group respondents assume the poor to be marginal, lazy (unwilling to work), alcoholics, etc. The higher up on the social ladder, the less knowledge there is about the situation of the poor. But for the poor, the stereotype does not seem to fit their own experience, since for the most part they are neither beggars nor homeless. The continued lack of information about poverty reflects the fact that poverty is mostly experienced behind closed doors, among home owners and working families who generally seek help from their immediate relatives. It also confirms the expectation that in a relatively wealthy society, extreme poverty is rare and such poverty as exists is a matter of social exclusion rather than physical deprivation. 24 This result applies Hungary's distribution (TARKI household survey) of consumnption to Croatia mean per capita consumnption at PPP. Similar, but smaller order of effects are obtained using Polish or Romanian data. 19 2.8 Poverty can be considered as the inability to meet what a given culture defines as basic physical and social needs. In Croatia, basic needs include: - food (a varied diet which includes meat, milk, fruits and vegetables); - clothes; - housing, utilities (electricity, water, heat, phone) and basic appliances (refrigerator, gas or wood stove, heating stove, TV); - school supplies and textbooks; - health costs; and - resources that are in line with cultural and social norms such as reciprocity in social networks. Box 2.1: The Routine of Poverty: Unemployed in Zagreb BZ is 58 years old and lives with his wife, daughter and eight-year-old grandson in an apartment.in Z&jmb. The building is old but well kept. The 73-square meter apartment consists of two rooms. a k46itci a-n a bedroom. It is very cold because the bniily is saving on utility costs. All the furnitwe and pims`oO6' twenty years old. BZ inhted the right to the apartment from his mother in 99 and they ivi- paying the mortgage since then. In accepting the apartment, they lost the right to 56 kumn in, benefits. BZ worked for 29 years at the "Koncar" ftory until he was fired as "surplus laboro in 1991. AtAif time, he sold their old car for 300 DEM. His 29-year-old-daughter works as an unregistered w in private shops eaming 1500 kuna a tonth (when she works). BZ's nwif is a houswie and has. ur worked. They are all regiered at the unemloyment office to receive heal beft. InAthret y#s will be eligible fir a 750 kma pension. He manages to get small jobs two to ee times a two he days. His wife also cleans for a neighbor who pays her 6&-80 kuna a month pus ai cocofte batfoXr her grandson and some coffee. Last autum BZ's wife sold on the street some of her old clothesi, ss and bathrobe for 10 to 15 kuna on a few occasions. All these activities do not add up to their tota expenses. Without a permanent income, they are now "riddled with debts.' They have bread every day in the household, rnilk stewed cabbage, greens, leeks, potatoes or bean They eat meat once a nonth, but only the cheapest chicken or 300 grams of ground meat (12 kp per kilo), which they eat with pasta. On several occasions a month, they run out of coMe or ta -hit gandson eats the same as the adults; his only extra is a monthly chocolate bar. They get some _ two to three times a year from BZ's sister who has a garden But she is on a pension and ca oti-olf4t help them much. Several times a year, BZ gets 200 to 250 kuna from one of his friends who rices a. pension. He doesn't have the courage to borrow more because he kn