After a sharp deterioration in the public finances in 2009 pushed the budget into its first significant deficit since independence in 2006, the deficit in 2010 remained largely unchanged, at an estimated 4.4% of GDP, with a sluggish recovery keeping tax receipts weak. The outlook for the forecast period is brighter, and we forecast that the deficit will decline to 3.6% of GDP in 2011 and to 2% of GDP in 2012, as economic growth accelerates. Stronger economic growth should lift retail sales, which will increase receipts of value-added tax (VAT), the single largest source of budget income. Until the rebound in real GDP growth helps to produce a budget surplus in the medium term, the authorities will remain under pressure to reverse the loosening of fiscal policy that took place in 2009, as the de facto adoption of the euro reduces the range of policy tools that can be used to narrow the current-account deficit.

The authorities cut the rate of personal income tax from 12% to 9% in January 2010-following a cut of 3 percentage points a year earlier-despite the deteriorating fiscal situation. As in the first three quarters of 2010, the impact of the cut on the full-year budgets of 2011-12 will be limited, because personal income tax makes up a small share of revenue. Increased social insurance contributions, introduced at the same time, will offset the decline in revenue resulting from lower taxes. Nevertheless, the IMF, which had earlier urged the authorities to reconsider the tax cuts, has called on the government to pursue more prudent fiscal policies, while increasing the share of capital expenditure in spending.