Croatia’s near-term economic outlook is favorable, an International Monetary Fund Mission says in its concluding statement, published on Friday, projecting growth at 3.4% in 2024 and noting that "subdued productivity and labor shortages pose challenges to its medium-term growth prospects."

Following an “exceptionally strong post-pandemic recovery during 2021-22… Croatia’s growth moderated to 3.1 percent in 2023, still among the highest in the euro area,” the Mission said after its regular visit to Croatia during which staff met with Finance Ministry and central bank representatives.

The robust growth performance reflects buoyant domestic demand as the strong labor market and the authorities’ policies have supported household income and EU funds have boosted investment.

A 2.9% growth is projected in 2025.

Inflation has “receded significantly” but remains above the euro area average and is projected at 4.2% this year, approaching the European Central Bank’s target of 2% in late 2025. “Services inflation would be sticky reflecting strong wage increases and tourism demand.”

The government is well positioned to advance deep-seated reforms

The multidimensional nature of labour shortages requires coordinated policies to foster higher labour participation, facilitate labour mobility, and integrate foreign workers, while boosting productivity requires comprehensive reforms to encourage innovation, strengthen business dynamism, and facilitate access to financing.

With a renewed four-year mandate and leveraging the commendable steadfast implementation of the National Recovery and Resilience Plan (NRRP), the government is well positioned to advance deep-seated reforms to further lift Croatia’s standards of living.

Policies should focus on preserving fiscal prudence and pursuing decisive reforms to build buffers for future shocks and meet long-term spending needs, and “staying vigilant in safeguarding financial stability.”

The authorities should reduce the fiscal stimulus, the IMF recommends and projects an overall deficit of 2.5% in 2024, “driven by generous increases in social payments and compensation of public employees.”

The expansionary and procyclical fiscal stance could fuel domestic demand and risks hampering the disinflation and undermining competitiveness, therefore the IMF supports the Finance Ministry’s plan to meaningfully reduce the overall deficit starting from 2025.

For promptly reversing the broad-based cost-of-living measures

The Mission staff are “for promptly reversing the broad-based cost-of-living measures (notably tax cuts and price controls)”, which would yield about 1/3 percent of GDP in savings. Any remaining support measures should be temporary and target the most vulnerable, while revenue over-performance should be saved.

Croatia faces large investment needs, including for the green and digital transitions, and increasing fiscal costs from an aging population. “Currently, a large share of public investment is financed by the EU. “It is important to generate and reserve fiscal space for future investment as the importance of the EU funding recedes.”

Tax policy favours investing in housing properties and short-term rental

The IMF recommends the introduction of a value-based property tax and removing the excessively favorable taxation on short-term rental income.

The head of the IMF mission in Croatia, Yan Sun, told the press that a “value-based” tax referred to the taxation of property according to its value, rather than its physical size or square footage, which would contribute to the fairness of the tax system. An example are houses located in areas with developed tourism, which are much more valuable than equally sized properties in less attractive locations.

Sun said that housing affordability in Croatia had worsened in recent years and that, in this regard, Croatia was among the worst-off countries in the euro area and the EU.

Policies to address housing affordability need to tackle the underlying supply gap in housing rather than helping demand.

Boosting supply calls for making better use of the sizable existing vacant stock and modernizing and streamlining regulations. Reducing or removing the favorable tax treatment of residential real estate investment and short-term rental would help reduce speculative demand and activate idle housing. It is also recommended to develop the currently thin longer-term rental market.

Residential real estate sector may face renewed pressures

The authorities should continue to assess the need for introducing explicit borrower-based macroprudential limits and stand ready to do so as warranted.

Despite signs of market cooling, the residential real estate sector may face renewed pressures, given favorable taxation, growth of disposable incomes, and high bank liquidity.

“Should strong market momentum begin to resume, the authorities should stand ready to introduce explicit borrower-based measures (BBMs) to preempt future financial stability risks. To alleviate inequality or other social concerns, first-time house buyers could be subject to different BBM thresholds, coupled with targeted measures to improve housing affordability and bearing in mind that BBMs should be used predominantly to contain systemic risks. The welcome expiration of housing loan subsidies and the decline of foreign demand have eased structural obstacles for implementing effective BBMs.”

The recent wage reform could enhance the fairness and competitiveness of the public remuneration system, the IMF said, adding that further reforms are needed to reduce the size of public wage bill in the coming years and that there is scope to rationalise the public workforce.