IV – Functioning Market Economy: The Core of the Business Environment
A functioning market economy — one of the two Copenhagen economic criteria — requires that markets operate under conditions of predictability, legal certainty, and competitive neutrality. In addition to macroeconomic stability, these conditions are provided by:
- The rule of law
- The competitive and inclusive operation of the markets for goods and services, finance, and labor
To secure a fundamental improvement in the functioning of Serbia’s market economy, the Reform Agenda focuses on key generators of distortions and shortcomings in its “Business Environment and Private Sector Development” reform area, as well as the strengthening of the judicial system under the heading of “Rule of Law.”
Section IV.1 — Progress on Reform Agenda’s Business Environment Reforms
Within the first policy area of the Reform Agenda — “Business Environment and Private Sector Development” — three reform streams stand out as particularly consequential for economy-wide productivity and the functioning of markets:
The Three Pillars
State Aid: How public support is allocated across firms and sectors determines not only the efficiency of public spending but also the structure of competitive incentives. Serbia’s current state aid architecture is characterized by automatic, threshold-based schemes embedded in tax legislation, many of which fall outside effective institutional oversight and systematically favor large beneficiaries over SMEs.
Public Investment Management: In the absence of a coherent medium-term development planning framework, public investment management represents the practical mechanism through which development priorities are translated into fiscal commitments. With Serbia’s public investment reaching historically high levels, the stakes for effective investment management have never been greater.
Public Procurement: As the primary interface where public money meets the market, procurement directly shapes the competitive conditions faced by domestic firms. If contracts are not awarded on merit, competition degrades, prices rise, and the private sector’s incentive structure shifts from efficiency toward rent-seeking.
These three areas share a common logic: each concerns how the state allocates resources and shapes market access. Together, they determine whether the business environment functions as a level playing field or as a system of selective advantage.
Critical Timing Limitation
A significant limitation of the Reform Agenda is timing. The most substantive reforms in all three areas are scheduled for completion only in late 2026 or 2027:
| Reform | Deadline |
|---|---|
| State aid scheme alignment | December 2027 |
| Upgraded legal framework for public investment management | December 2027 |
| ”Clean-up” of special procurement regimes | June 2027 |
Meanwhile, a substantial share of Serbia’s largest investment commitments — including those associated with EXPO 2027 — will be contracted or completed well before these frameworks take effect.
State Aid
State aid policy is a central determinant of Serbia’s development policy and its capacity to deliver inclusive and sustainable growth. It plays one of the key roles in the EU accession process, and it is decisive in shaping economic structure: productivity dynamics, market entry conditions, regional development, and the credibility of the business environment.
Table 1. Types of State Aid in Serbia
| Aid Category | Primary Objective | Common Instruments | Reality Check |
|---|---|---|---|
| Regional Aid | Attracting investment to less developed regions | Cash grants per job, land transfers, tax holidays | Overused. Intensities at upper legal limits; often used for large FDI at the expense of local value chains |
| Horizontal Aid | Supporting cross-cutting goals (Green, R&D, Innovation) | Direct grants, soft loans, R&D incentives | Policy-declared but underfunded |
| SME Aid | Strengthening small and medium enterprises | Equipment grants, credit guarantees | Systemic crowding out by massive packages for large players |
| Sectoral Aid | Support for specific industries | Subsidies, debt write-offs | High risk in EU negotiations |
| Rescue & Restructuring | Preventing bankruptcy | Recapitalization, debt forgiveness | ”One time, last time” rule bypassed through tolerated arrears |
| De Minimis Aid | Small-scale aid (no distortion) | Various (grants, training) | €300,000 threshold. Fully aligned with EU rules |
Reform Agenda Obligations
Under the Reform Agenda, Serbia’s immediate obligation was to finalize a comprehensive inventory of existing aid schemes by the end of 2024. Although the initial deadline was not met, Serbia completed and formally adopted a comprehensive state aid inventory in 2025 — but it has neither been publicly disclosed nor proactively communicated.
A more substantive obligation concerns the adoption and publication of a time-bound action plan for aligning incompatible state aid schemes, due by June 2025. The plan was returned for substantive revision, and the obligation remains unfulfilled.
Core Weakness: Legal Architecture
The core weakness of existing schemes lies primarily in their legal architecture and systemic design rather than in their stated economic objectives:
| Scheme | Alignment Status | Key Issue |
|---|---|---|
| State Aid Control Law | Largely aligned | Requires consistent implementation |
| Inventory of existing schemes | Aligned (formally) | Needs time-bound action plan |
| PPP incentives (Corporate Tax Law) | Not aligned | Highly selective, unclear objective, no cumulation control |
| Large investment tax relief (Art. 50a) | Not aligned | Thresholds effectively exclude most SMEs |
| Employment tax relief package | Not aligned | Lacks transparency and incentive effect tests |
| Free zones customs incentives | Not aligned | Overly broad, creates scope for discretionary support |
| State guarantees (Public Debt Law) | Not aligned | Selective advantage for state-owned entities |
SME Disadvantage
EU alignment would primarily reduce discriminatory outcomes against SMEs by:
- Strengthening transparency and rule-based allocation
- Emphasizing objective eligibility criteria
- Requiring aid to be applied for before projects begin
- Limiting opaque overcompensation
Contrary to common misconceptions, EU alignment expands the range of tools available to support SMEs rather than restricting them to “de minimis” aid. Through the General Block Exemption Regulation (GBER), Serbia can implement targeted investment aid, financial instruments, and R&D incentives specifically for SMEs.
Investment Management
Good investment management is central to the functioning of a market economy because it determines how development priorities are translated into fiscally binding investment decisions.
The Fundamental Deficit
The fundamental deficit in Serbia’s economic governance is the total absence of a coherent, medium-term structural development strategy. While sector-specific initiatives exist, there is no overarching policy framework designed to transition the economy toward higher complexity or sustainable growth.
This Report treats Public Investment Management (PIM) as the central pillar of development and structural policy — the investment pipeline not merely as a list of construction projects, but as the de facto “structural plan” of the state.
Reform Timeline
| Milestone | Deadline |
|---|---|
| Policy document and time-bound action plan | December 2026 |
| Upgraded legal framework aligned with international standards | December 2027 |
The Current Investment Surge
Serbia’s recent surge in public investment has significantly raised the stakes for effective investment management:
- Capital spending reached a peak of around 7.3% of GDP in 2024
- One of the highest levels in Serbia’s recent history
- Elevated spending increases fiscal and economic costs of weak project selection
Systematic Bypass of Standard Procedures
A substantial share of major projects continues to be prepared and executed through exceptional procedures:
- Projects designated as being “of special importance”
- Projects financed through specific bilateral arrangements
- Investments linked to EXPO 2027
These arrangements systematically bypass standard appraisal, procurement, and prioritization protocols. The Fiscal Council has repeatedly warned of:
- Chronic lack of ex ante justification
- Dangerous reliance on special legal regimes (Lex Specialis)
- Circumvention of national laws for large-scale infrastructure projects
Public Investment Efficiency
World Bank estimates suggest Serbia’s public investment efficiency stands at around 65.6%:
- Above regional average (~58%)
- Below aspirational peers (~70%)
- Pointing to a persistent efficiency gap
Proposed Monitoring: Investment Integrity and Execution Score (IIES)
A useful complement would be the introduction of an Investment Integrity and Execution Score (IIES):
- Planning Variance — tracking deviations between planned and executed capital spending for large projects (>€10 million)
- PIM System Coverage — assessing the share of capital spending formally appraised within the official PIM system
Public Procurement
Public procurement sits at the core of the “fundamentals first” logic because it represents the primary interface where public money meets the market.
Why Procurement Matters
If public sector contracts are not awarded based on merit:
- Competition among private sector suppliers becomes about rent-seeking
- The state is likely to overpay
- Service quality diminishes
- Public trust in institutions erodes
Small and medium-sized enterprises are particularly affected, as most rely on predictable rules and open competition rather than insider networks.
Reform Agenda Approach
In Serbia’s Reform Agenda, public procurement is framed primarily as an anti-corruption priority. Under Reform 1.2.1, the state commits to publishing procurement information for projects under intergovernmental agreements by June 2025.
However, the current formulation is insufficiently precise — the Agenda lists only limited data points (project names and basic contractor info), leaving significant room for divergent interpretations.
The Competition Gap
While the Reform Agenda rightly prioritizes transparency, it pays far less attention to competition as a deliberate outcome of procurement design. Transparency is necessary but not sufficient:
- A process can remain formally transparent yet economically distorted
- Resulting in fewer bids, inflated prices, and stifled innovation
Lotting: A Critical Design Choice
One of the most consequential design choices is whether to divide large contracts into smaller, more manageable lots:
- Reduces contract size and scope
- Lowers entry barriers
- Creates opportunities for SMEs to compete
Serbian procurement law already reflects this logic, but systematic statistics on the use of lots are not publicly available.
SME Participation Statistics
| Indicator | 2024 Value |
|---|---|
| SME share of number of awarded contracts | >75% |
| SME share of total awarded value | ~73% |
While these figures suggest strong overall participation, they do not reveal how SME participation is distributed across contract sizes, sectors, or procurement design choices.
Proposed Monitoring: Procurement Market Contestability Index (PMCI)
A value-weighted measure designed to capture whether procurement is actually competitive:
- Effective competition — procedures with at least two valid bids
- Competition-enabling design — use of lots or published justification for non-lotting
- Market access at the top end — SME participation in highest-value tenders (top decile)
Section IV.2 — Rule of Law: Focus on the Executive
The Reform Agenda aims to bridge the gap between “nominal” laws and “real” implementation. Serbia’s path to a functional market economy is constrained not only by the absence of good policy ideas but by a persistent deficit in the rule of law.
The “Two Regulatory Environments”
Serbian economy functions within two regulatory environments simultaneously:
- Nominal: defined in laws, strategies, and program documents
- Real: constituted by the fact that rules are interpreted, sequenced, delayed, selectively applied, or quietly ignored
Where the gap between these two environments widens, predictability collapses — even when the formal legal architecture appears intact.
Evidence from Business Episodes
Based on a structured review of company-reported “business episodes” gathered through consultations with the private sector (25 distinct companies), clear concentration of pain points emerges:
| Problem Category | Companies Affected | Description |
|---|---|---|
| Cross-border administration | 10 | Import/export, customs, phytosanitary clearances, sampling, certificates, quotas |
| Discrimination against domestic agents | Multiple | Foreign investors get facilitation; domestic firms face thinner, less predictable toolkit |
| Permits and multi-agency workflows | 5 | Construction permits, planning procedures, sequencing failures |
| Tax and fiscal implementation | 4-5 | Tax credits that don’t work, inconsistent administration |
| Energy and utility exposure | 6 | Electricity pricing, connection delays, sanctions-related supply chain risk |
| Human capital constraints | 3+ | Dual education burdens, friction in hiring foreign workers |
Key Pattern: Execution Risk
The binding constraint is less the nominal regulatory framework and more the predictability and neutrality of execution. In this environment, compliance does not buy certainty — and that is precisely why firms discount long-horizon commitments even when formal rules appear stable.
Case Study 1: R&D Social Contribution Exemption
The regulation allows employers to be exempt from paying social contributions on R&D salaries. However:
- Employees discovered their retirement contributions had simply not been paid into the pension system
- The Tax Administration would “recognise” service years only after inspection
- Inspections were never conducted due to understaffing
- Workers formally employed in R&D roles appear as if contributions were never paid
Result: What was intended as support for innovation becomes a source of uncertainty.
Case Study 2: Wind Energy Projects
Investors sign binding contracts with EPS requiring electricity delivery within a fixed three-year period. If the deadline is missed, penalties apply regardless of reason.
However:
- The sequence of state procedures (grid connections, permits, environmental consents) moves through multiple institutions with unclear timelines
- EPS does not function as an administrative authority with defined procedures or appeal mechanisms
- It behaves as a contractual counterparty whose position is protected
Result: FDI declined from €600 million (January 2024) to €220 million (January 2025) — not because markets became unpredictable, but because the state did.
Case Study 3: Moravski Market
A local-development instrument designed to create a publicly supported marketplace for local food and craft products:
- The city signaled commitment through annual grants and a co-financing agreement
- Grants declined from RSD 800,000 (2023) to RSD 500,000 (2024), eliminated entirely in 2025
- A separate contract for RSD 300,000 — formally signed and listed in the city’s accounts — was never paid
- The municipality failed to secure promised public premises
Result: A programme designed to stabilise local producers becomes itself a source of instability. Formal commitments do not translate into delivery.
Conclusion: The Implementation Gap
The message is clean and defensible — this is not a “red-tape problem” nor a catalogue of complaints; it is an evidence-backed distribution of recurring implementation failures.
The strategic implication is straightforward: the binding constraint is less the nominal regulatory framework and more the predictability and neutrality of execution.
In this environment, compliance does not buy certainty — and that is precisely why firms discount long-horizon commitments even when formal rules appear stable.