Inequality and potentially painful reforms

Those who grew up in the former Yugoslavia remember a time when they lived well and could travel freely abroad. Nowadays many more people feel poor than are picked up by standard income-based measures.

Poverty measurement based on official poverty lines is often used to orient and prioritize policy actions. The crisis, however, brought an increase in poverty, though with significant variation across countries, and overall to a lesser extent than in Central and South-Eastern Europe.

Macro-level data suggests that Albania and Montenegro saw the sharpest pick-ups in poverty since the crisis, though poverty in Serbia also increased.

At first sight privatizations appear to have a negative effect, increasing inequality and the share of the top, while reducing the share of the bottom and increasing poverty. However, this effect is channeled through its impact on unemployment. There is a striking correlation between unemployment and inequality, even more so in the Western Balkans than in the New Member States. This raises the question whether government policy, and in particular social safety nets are successful in mitigating the impact of shocks, in particular on the poor, who appear to be harder hit.

What governments spend on matters. Goods and services expenditure, likely acting as an overall stimulus to the economy is significantly pro-poor, reducing inequality, the share of the top quintile and poverty. Surprisingly, social security expenditure does not have a significant effect. In part this could be explained by the fact that we are looking at differences across countries rather than individuals as such, social security/unemployment spending is higher when poverty/unemployment is higher. However, it may also be due to low coverage rates and regressive targeting of social safety nets.

At first sight capital expenditure appears to increase inequality and the share of the top, possibly linked to corruption surrounding large investment projects. It should however be emphasized that the beneficial effects of, for example, improved infrastructure for the poor are likely underestimated here as the regression only captures immediate (contemporaneous) effects, whereas the beneficial effects of improved infrastructure are likely only visible with a delay. Furthermore, countries with larger infrastructure gaps (that may also have lower incomes and higher poverty rates) may also have higher capital expenditures, further confounding the effect captured in this regression.

Several countries in Emerging Europe introduced flat tax rates in the 2000s, with an on-going debate on whether its benefits in terms of reducing tax evasion outweigh its regressive impact. The impact of a flat income tax is mixed: it reduces the share of the top (perhaps on account of fewer loopholes in the tax system), but also reduces the share of the lowest decile, and increases poverty (probably on account of its regressive nature). It should however be added that the impact may depend further on its level, as well as its interaction with other taxes and benefits.

Another legacy of the crisis is an increasing disparity between urban and rural areas. At the country-year level a larger urban population increases inequality, the share of the top and reduces the share of the bottom, in line with the observation that poverty is usually more prevalent in rural areas.

Looking at descriptive statistics from the 2006 round of the Life in Transition Survey we find that median (and mean) household expenditure is only slightly lower in the Western Balkans than in Central and Eastern Europe, though with considerable variation across countries (with spending in Croatia and Montenegro being around 60 percent higher than in the other four economies).

The reported minimum income’ is however around 10 percent lower in the Western Balkans than in Central and South Eastern, picking up differences in the cost of living, as well as different reference groups. More people feel relatively poor (on the bottom two rungs of the expenditure ladder) in the Western Balkans than in Central and South-Eastern Europe.

While the role of the state acting as a stimulus to the domestic economy and as an employer has shrunk, the development of the private sector is often lagging behind, as reflected in high unemployment rates.

During the crisis and its aftermath, government revenues decreased, resulting in pressures to reduce spending, including on wages, pensions and social protection. The demand for unemployment benefits and social assistance has however increased, placing even more weight on the design of social safety nets and the targeting of welfare transfers. Improved targeting and extended coverage of the poor could help, and poorly targeted social assistance could in many cases be improved at no additional fiscal cost by shifting from categorical to means-tested benefits.

Complementing this, and in light of increasing demographic pressures, governments should improve labor market institutions to enhance employment as well as participation rates. Governments should also pay more attention to the urban-rural divide and the prominent regional aspect of poverty.

The uncertainty and vulnerability of the transition period are in sharp contrast with this experience and appear to be driving dissatisfaction even following years of high growth. The crisis likely further worsened the situation as it hit households in the Western Balkans particularly hard, even more so than in Central and South-Eastern Europe, resulting in job losses, reductions/ delays in wages and lower remittances.

This context is both an opportunity and a threat to policymakers in the region: an opportunity because it creates a sense of urgency in trying to improve people’s lot, but also a threat because there may be a reluctance to push ahead with potentially painful reforms.