The banking sector appears in reasonable health. The removal of most exchange rate risks from banks’ balance sheets has freed liquidity. This is temporarily limiting the transmission of tighter euro-area monetary policy into Croatia. Ensuring that the increased liquidity supports economically valuable investment would help make the most of euro-area integration. A large rise in low-quality lending or a deterioration in banks’ health due to contagion from international banking difficulties would imperil credit for investment.

Sustained primary budget surpluses provided fiscal space for the COVID-19 and energy price responses and have contained public debt ratios. Ensuring that public finances act counter-cyclically while investing in infrastructure, the green transition and coping with fiscal headwinds from ageing remains a core challenge.

Economic growth, rising prices and the return to a budget surplus in 2022 have reduced the public debt ratio towards 60% of GDP. Spreads on government bonds and agencies’ ratings improved when euro membership was confirmed and have since been stable. The shift back to budget deficits in 2023 and 2024 will add to demand and inflationary pressures. Looking ahead, fiscal consolidation would help macroeconomic stabilisation and ensure resources are available for future investment needs, including in skills, the green transition and digitalising the public sector. Croatia is gradually improving how it prepares and monitors its budget and is developing spending reviews, that can help improve allocations for more growth-supporting spending. Overall, income tax and indirect tax rates are similar to those in many OECD countries. However, numerous tax expenditures, notably for the tourist sector, narrow the revenue base and distort investment decisions. Despite the ongoing digitalisation of the tax administration, complex processes add to compliance burdens.

Croatia is a relatively large recipient of European Union funds and is advancing well with its Recovery and Resilience Plan. The Plan is accelerating structural reform and investments, from further developing adult skill training to improving energy efficiency and how the state operates and regulates. The government has developed dedicated bodies to implement the Plan. Their success demonstrates how greater organisational capacity and better coordination could help improve how other public programmes and investments are implemented.

Complex government structures plus shortages of key administrative personnel compromise the quality of public services. The number and size of subnational governments is similar to many OECD countries relative to population. However, overlapping responsibilities and coordination challenges reduce the efficiency and delivery of essential social services, and complicate regulatory processes. Civil-service pay may not be competitive, weakening administrative capacity.

Croatia’s greenhouse gas emissions declined modestly in recent years and the economy remains relatively emissions intensive. Raising living standards while reducing emissions will require an accelerated decoupling of emissions from economic activity.

Pricing emissions consistently, as part of a policy mix with regulation and support for investment, can help reduce emission intensity. About one third of Croatia’s emissions are subject to carbon pricing via the European emission trading scheme. However, subsidies or reduced tax rates on some fossil fuels work against emission reduction. Also, Croatia produces more emissions from transport per capita than most OECD countries, partly reflecting relatively under-developed public transport and an ageing vehicle fleet. Addressing these will require substantial outlays by households and the public sector. Building retrofits can cut emissions and reduce energy poverty, but the upfront costs are a barrier.

Croatia is vulnerable to a warming climate. Damages from extreme weather events, such as floods, are likely to increase, raising costs for the private sector and public finances. Meanwhile, insurance coverage is limited.

Stronger productivity and investment growth will be essential to accelerate economic convergence (Figure 2). While the tourism sector has been key for Croatia’s income and export growth, businesses in all sectors tend to be less productive than their OECD peers. Aggregate productivity is dragged down by the many long-established, low productivity firms, and by the relatively small share of dynamic, high productivity firms.

Weak regulatory and governance quality contribute to productivity gaps. The design of some regulatory frameworks present barriers to business. Furthermore, where design is sound, regulations are often burdensome in practice. Measures to reduce these burdens are compromised by shortages of expert staff to design and implement reforms. High caseloads and little use of out-of-court solutions contribute to prolonged legal proceedings. Many citizens lack trust in courts and judges, and perceptive levels of corruption and clientelism to be high.

Businesses have few non-bank financing options, and spend relatively little on R&D. Most firms do not appear constrained in their access to finance. However, banking finance dominates, which is less accessible for younger, smaller, and more innovative firms. Public equity market structures are overly complex. R&D support programmes are fragmented.

State Owned Enterprises (SOEs) continue to play a relatively large role in the economy. SOEs employ about 6% of workers and often compete in the same markets as private firms. Low-productivity SOEs retain workers and capital that private-sector firms could potentially use more productively. SOEs’ financial performance is often weaker than their private-sector peers and SOEs in other countries, in part due to weaknesses in their governance and vulnerability to political influence.

Scarce skills are a growing barrier for investors. School students’ performance lags peer countries. Most adults have only completed intermediate levels of education and few return to upgrade their skills. Employment rates among prime-age men and women are higher than in most OECD countries, but lag among younger and older adults, putting these groups at greater risk of poverty. Population ageing and emigration add to labour supply challenges.

Shortfalls in advanced skills are a key barrier to raising employment and incomes. Reforms are underway to regularise school hours, improve teaching quality, and expand early childhood education. However, gaps with OECD countries, notably in STEM subjects, remain significant. Few adults are motivated to access adult education, and programmes’ cost and availability dissuade many from enrolling (Figure 3), Take-up of a new voucher-based adult education system has been strong and the programme is being expanded.

The government is reforming active labour market programmes. These are providing the more tailored and intensive training, work experience and job search support needed by those with limited formal work experience or skills. In poorer regions especially, active labour market policies will require greater resources.

Early exit from the labour force increases retirees’ risk of poverty. Low employment rates among older adults leads to lower pension savings and retirement incomes. Early retirement is more frequent among those with low skills and suffering ill health. Transfer rules encourage many retirees to shift from self-funded accounts back to the general government-funded pension, undermining earlier pension reforms and increasing fiscal costs. Women’s official retirement age is being aligned to that of men. For the broader population, reforms are strengthening the minimum income social safety net and improving the targeting of social support. However, municipalities provide much social support, and those in the areas with the greatest needs often lack the necessary resources.

High homeownership, rising house prices and a thin rental market impede relocation to the most economically dynamic areas. Little new construction and damage by two earthquakes in 2020 have contributed to housing shortages and overcrowding, especially in the main cities. Unused property and secondary home use further reduce dwelling availability. Low recurrent taxes on property limit incentives for owners to make the greatest use of their properties. Government loan subsidy schemes have contributed to house-price growth. Planning and approval complications constrain new development, while the ongoing clarification of the cadastre can help attract investment.