Start with Children – Bratislava Summit 2024
16/05/2024
Urban Regeneration Talk #4, Italy
30/05/2024
Conversation #63
Abolition of the income tax surtax for financing Croatian municipalities and cities
by Dubravka Jurlina Alibegović
The Institute of Economics, Zagreb
Surtax on income tax was introduced in Croatia in 1994. The main reason was to provide local authorities with more fiscal space in the acquisition of revenue. Cities with more than 40,000 inhabitants were given the authority to determine the surtax at a maximum rate of 30 percent on their share of the income tax, while the city of Zagreb as the capital could collect an income tax surtax on its share of the income tax up to 60 percent. The surtax on income tax was extended to all local self-government units in 2001.
Until the change of the Law on Local Taxes (December 2023), municipalities and cities were limited in terms of the amount of the surtax rate they could levy. Depending on the type of local self-government unit and its population size, income taxpayers residing in municipalities paid an income tax surtax of between 10 and 15 percent. Only the City Assembly of the City of Zagreb could establish a surtax rate of up to a maximum of 18 percent.
The abolition of the income tax surtax is likely to have an adverse impact on municipalities and cities in Croatia. Sub-national governments generate revenues from three main sources: tax revenue, grants and subsidies and other revenues, but none with the (limited) autonomy of the surtax.
Surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Income tax surtax is on top of the taxable personal income or on the personal income tax liability already being levied by the central government. It provides more tax autonomy to sub-national levels of government since they are given the authority to set and levy the surtax rate within the limits established by central government.
Among tax revenues, municipalities and cities in Croatia generate revenues from local taxes. Until the end of 2023, they generated revenues from the income tax surtax. The decision on the introduction of a surtax, changes in the rates range, or the abolition of the income tax surtax could be made by the municipal and city councils on the proposal of the municipal head and mayor. Other local tax revenues of municipalities and cities include consumption tax (owners of catering service companies must pay 3% on the sales price of beverages), vacation home tax (owners of holiday houses must pay 0,60 to 5,00 euros per square meter), tax on the use of public spaces (added to the cost of using public land) and real estate transfer taxes (real estate owners must pay a 3% real estate transfer tax).
The experiences of municipalities and cities with the introduction of income tax surtax were different. According to the Tax Administration, in 2023, 209 Croatian municipalities (49 percent of the total number) and 94 cities (74 percent of the total number) introduced a surtax. Of that number, only 12 cities and 60 municipalities or 13 percent of all local self-government units introduced the highest permitted rate of surtax. A total of 33 cities (a quarter of the total number of cities) and 219 municipalities (half of the total number of municipalities) did not introduce a surtax.
According to the OECD's methodology, the degree of autonomy of local self-government vis-à-vis central government in determining the surtax rate is limited. The abolition of the surtax from the Croatian tax system, without the consent of the local self-government, has certain consequences. They can be seen from at least two perspectives. The first is residents as taxpayers, and the second is the residents who want their local communities to be well-equipped with utilities and to be able to use all the local facilities. Taxpayers always welcome news about the abolition of the obligation to pay any tax. The same applies to the abolition of the obligation to pay the surtax and, consequently, the expected higher net income for taxpayers. This, though, may be at the cost of quality service provision.
Another perspective is the impact of surtax revenues on total budget revenues. Surtax on income tax is not the most important and generous public revenue because 45% of local self-government units do not generate revenues based on surtax (having chosen not to introduce it). Since there are differences in the collection of income tax revenues in cities and municipalities, as well as differences in the established rates of surtax, the collected revenue from surtax differs among local units. Consequently, it is not possible to finance public services to citizens with the collected revenues.
Among the municipalities that introduced a surtax, the share of revenue from the surtax accounted for up to 9.41%; cities received up to 8.67%.
The abolition of the surtax from the beginning of 2024 will result in an insignificant increase in the net income of residents, but a significant decrease in total revenue in city and municipal budgets. The abolition of the surtax was not contained in any reform measure, nor described in any strategic document of the Croatian Government. There are no publicly presented reasons that led the Government to propose the abolition of the surtax. It was not discussed with the Association of Cities and the Association of Municipalities. The analysis, which was supposed to indicate the expected positive and negative results of the abolition of the surtax was not publicly shown. Doubts about the real reasons for the changes in the tax system are highlighted by the moment the changes were announced – in the pre-election year with implementation in the election year.
Such overriding of local autonomy does not appear uncommon. Earlier Conversations have already highlighted such threats, including Iván Tosics (#57) , who focused on Hungary. It raises a concern as to where this centralising agenda might end?
The Government proposed legislative changes that could replace the abolition of the surtax. A novelty for municipalities and cities is an opportunity to independently prescribe income tax rates (lower and higher rates) for annual income tax within pre-set limits. Many municipalities and cities did not take advantage of this option, and the income tax rates remained unchanged. At the end of the 2024 budget year, it will be possible to assess to what extent the abolition of the surtax affected the “loss” of revenue in local budgets, and to what extent changes in income tax rates affected the compensation of the loss of revenue or, in general, generating of revenue in local budgets.
Tax surcharges or “additional taxes” provide the most crucial element of fiscal autonomy to local authorities – the ability to independently determine tax rates. Their application signifies an increase in the level of fiscal decentralization and is in line with the recommendations of the European Charter of Local Self-Government. The Charter recommends that local self-government authorities have sufficient resources of their own with which to freely exercise their powers. On the other hand, higher local revenues mean more resources for public investment and opportunities to provide quality public goods and services.
Periodically, in Bulgaria, the introduction of a tax surcharge on personal income tax is also brought into focus on the public debate agenda. Years ago, the National Association of Municipalities in the Republic of Bulgaria proposed the introduction of tax surcharges. This idea included the possibility for the municipal council to determine a tax surcharge on the income base of individuals. The proposal included reducing the central flat tax rate on personal income from 10% to 9%, with each municipality being granted the authority to impose a tax surcharge ranging from 0.5% to 2%. To date, Bulgarian municipalities do not receive revenues from „additional taxes“ in their budgets. At the same time, the level of fiscal decentralization of municipalities in Bulgaria is decreasing, and the dependence on transfers is becoming increasingly high.
By abolishing the tax surcharge that Croatian municipalities can impose, the tax powers of local authorities are limited. According to current legislation, municipalities have the right to decide whether to impose a tax surcharge or not. In this way, when identifying issues with the population’s purchasing power, this tax surcharge can be set at 0%. The lack of financial justification and reasons for canceling the tax surcharges are also concerning. Without additional financial analyses, the decision to abolish the tax surcharges may be deemed populist.
The 2024 reform in Croatia abolishes the local surtax on income tax, previously a significant source of autonomous revenue for local governments. Instead, local governments can now set the rates for the central personal income tax (PIT) within limits determined by the central government. However, many local governments did not utilize this option in the first year, raising questions about the reasons behind this inaction.
The reform reduces the fiscal autonomy of Croatian local governments. Previously, local governments had the freedom to set surtax rates and decide on their implementation or removal. Now, their influence is limited to adjusting the central PIT rate within centrally imposed boundaries. This shift was introduced without local government consultation or financial impact assessments, suggesting potential populist motivations, as noted by Desislava Kalcheva in her above comment. This could be supported by the fact that 2024 is the year of parliamentary and presidential elections in Croatia.
In Poland, the past eight years have seen local government financing become more reliant on conditional state grants, reducing the share of own revenues and non-earmarked grants. A similar trend is evident in Bulgaria, with municipalities increasingly dependent on state transfers and earmarked funding. Desislava Kalcheva highlighted this issue in Conversation #65.
A change in Poland’s central government in 2023 promised a new direction for fiscal decentralization, as discussed by Marta Lackowska in her commentary on Conversation #57 by Iván Tosics. Poland has never had a local surtax on PIT or a local PIT. Local governments receive a share of central tax revenues through tax sharing but lack influence over tax rates or reliefs. The new government plans to reform local government financing to strengthen own revenues, making local revenues from PIT independent on central-level changes and linking them to local taxpayers’ incomes. The proposal also aims to reduce the role of earmarked transfers and subsidies, allowing local governments to co-decide on equalization system indicators. This project is under consultation with local governments and associations.
Dubravka Alibegović’s text raises questions about why central governments limit local autonomy, possibly due to economic crises. Hlepas (2016) suggests that crises reinforce centralization in countries with centralist traditions while promoting decentralization in those with a tradition of innovation. Local governments often cut discretionary services during fiscal stress, a trend observed in the UK. One might contemplate whether comparable motives influenced the reform in Croatia, or if issues related to the electoral cycle were pivotal.