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International Monetary Fund
Published Date:
May 2002
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    Appendix I Setting Medium-Term Fiscal Targets: The Role of Public and External Debt and Current Account Considerations

    This Appendix illustrates how public and external debt and current account objectives can be translated into medium-term fiscal targets, applied to the five accession countries. The analysis is undertaken within a simple quantitative framework, in which the medium-term fiscal position is linked to public and external debt objectives—either directly or via the current account. The main rationale for this link is the desire to limit external vulnerabilities and lower the risks of crises. As a country’s vulnerability to crisis depends on many factors beyond the mere size of debt ratios and current account deficits, however, external objectives may well differ across the five accession candidates.1 A comprehensive country-specific assessment of external vulnerability goes beyond the scope of this Appendix. Instead, the exercise below applies a rather mechanical method, as a first pass at informing the setting of country-specific objectives. The focus on applying a consistent methodology to all five countries comes at the expense of a more considered country-specific assessment. Thus, the conclusions can be interpreted as reference points for a more nuanced assessment in individual country studies.

    Public Debt Dynamics

    Decisions about the appropriate fiscal position over the medium term are often linked to the concept of public debt sustainability. The analysis of public debt sustainability typically determines the primary fiscal balance in percent of GDP (PB) that is required to achieve a stable debt-to-GDP ratio (D).2 It is given by the following relationship:

    PB = (r - g)D/(1 + g) - A,

    where r denotes the real interest rate; g the real GDP growth rate; and A nondebt financing (for example, privatization receipts) in percent of GDP. The above condition is expressed in terms of gross debt, although net debt can be a better measure of sustainability (to the extent that financial assets can be liquidated quickly to reduce gross liabilities). The choice here reflects the dominant focus on gross debt (as, for example, in the Maastricht criterion), and the results are identical, in terms of the primary balance, if it is assumed that assets remain constant as a share of GDP.3 It is obvious that a country’s fiscal stance cannot indefinitely defy the notion of public debt sustainability, as growing indebtedness would eventually lead to a vicious circle of rising risk premia on interest rates, mounting fiscal deficits, and a suppression of economic growth. However, it is conceivable that countries with a low public debt burden at the outset can afford deviations from the above rule for some time, particularly if the borrowed resources are used to finance public expenditures that improve the long-run growth potential of the economy. Nevertheless, a rising trend in the debt ratio may be difficult to reverse, and projected (or existing) ratios may be considered too high and costly in terms of their impact on credit ratings and risk premia.

    On the basis of explicit government liabilities, current fiscal plans do not trigger disturbing debt dynamics over the medium term. First, the outstanding (explicit) public debt-to-GDP ratios are not very high in most of the countries, ranging from 15 percent of GDP in the Czech Republic and some 25 percent in the Slovak Republic and Slovenia to some 45 percent in Poland and 60 percent in Hungary.4 Second, with average real GDP growth anticipated in the range of 4—5 percent over the medium term, and current projections of privatization revenues, public debt ratios are likely to decline—or, in the case of the Czech Republic, not to increase substantially—provided major fiscal slippage is avoided. Table A1 illustrates these results, by determining the primary (and implicit overall) fiscal balances consistent with stable public debt ratios. Under the (arbitrary) assumption of a real interest rate of 5 percent, stable public debt ratios would be consistent with average fiscal deficits ranging from about 2 percent of GDP in Slovenia to more than 6 percent of GDP in Hungary—reflecting mainly its higher initial debt level and primary surplus.5 Such deficits would in all cases, but the Czech Republic, imply some fiscal deterioration relative to the 1999 deficit outcome. In other words, reductions in the deficits—as planned—would be associated with falling public debt ratios in these countries. And even in the Czech Republic, where the debt ratio is likely to rise, this is not an overriding concern at the moment either, given the low initial debt level. However, measures to reverse the adverse trend will need to be put in place before debt ratios reach concerning levels.

    Table A1.Fiscal Balances and Public Debt Under Alternative Scenarios(Percent of GDP, unless otherwise indicated)
    Czech Republic1HungaryPolandSlovak RepublicSlovenia
    1999Average 2000–051999Average 2000–051999Average 2000–051999Average 2000–051999Average 2000–05
    Privatization receipts23.
    Real GDP growth (in percent)2-
    Real interest rate (in percent)
    Fiscal conditions for stable public debt ratio
    Primary fiscal balance4-2.6-
    Overall fiscal balance-3.7-3.2-3.7-6.1-3.7-5.7-3.4-4.8-0.7-2.2
    Memorandum item
    Public debt ratio (end of period)
    Sources: World Economic Outlook and IMF staff estimates.

    Fiscal balances include grants to transformation agencies.

    Consistent with staff projections in May 2000 World Economic Outlook.

    Calculated For 1999 as general government interest payments, divided by the average end-period debt shock in 1998 and 1999, and deflated by the GDP deflator. For 2000–05 an illustrative real interest rate of 5 percent is assumed for all countries.

    The primary balance is defined as total revenue (excluding privatization receipts) minus noninterest expenditure

    Sources: World Economic Outlook and IMF staff estimates.

    Fiscal balances include grants to transformation agencies.

    Consistent with staff projections in May 2000 World Economic Outlook.

    Calculated For 1999 as general government interest payments, divided by the average end-period debt shock in 1998 and 1999, and deflated by the GDP deflator. For 2000–05 an illustrative real interest rate of 5 percent is assumed for all countries.

    The primary balance is defined as total revenue (excluding privatization receipts) minus noninterest expenditure

    The above conclusions still hold, in essence, if implicit debt is taken into account. Such debt exists primarily in the Czech and Slovak Republics in terms of state-guaranteed loans to enterprises and nonperforming loans of state-owned banks.6 In the Czech Republic, total government guarantees amounted to 14 percent of GDP at end-1999, and the cost of bank restructuring—while highly uncertain—could amount to 15 percent of GDP. If these potential liabilities were included in full, to provide an upper bound for the measure of public debt, the ratio would nearly triple to almost 45 percent of GDP. In this case, a stable debt ratio would be consistent with a fiscal deficit of 5½ percent of GDP during 2000–05, including average interest payments on the higher debt stock of some 3½ percent of GDP. Thus, provided sizable slippage from the government’s own plans is avoided, public debt ratios, including potential implicit liabilities, should trend down over the medium term. Of course, meeting the fiscal deficit target in the face of rising debt service may not be easy, even with sizable privatization receipts. In the Slovak Republic, the outstanding stock of state guarantees on enterprise borrowing was equivalent to 13 percent of GDP at end-1999, and nonperforming loans taken on by the Consolidation Bank and Agency were estimated at 12 percent of GDP. Adding these implicit liabilities to the explicit public debt would bring the ratio up to 50 percent of GDP. Nevertheless, given large anticipated privatization receipts, public indebtedness would drop fairly rapidly over the medium term, unless the primary fiscal deficit deteriorated to an average of 2½ percent of GDP over 2000‒05—a slippage of almost 2 percentage points of GDP relative to the actual primary deficit in 1999.7

    Although fiscal plans raise no apparent concerns for the medium-term dynamics of public debt, this does not imply that current policies are necessarily consistent with long-term public debt sustainability. Such a conclusion would require a long-term analysis of revenue and spending trends under current policies. As can be inferred easily from the above debt-sustainability condition, the constraint, in terms of the primary balance, will tend to become tighter over time, as privatization receipts wane and real GDP growth rates converge with those in advanced economies, reflecting a narrowing in income gaps and productivity differentials. At the same time, spending pressures related, for example, to population aging are bound to rise substantially in the absence of reforms.8 Meeting these spending pressures without a growing debt ratio will, no doubt, require considerable reform efforts in all five countries. This said, the achievement of a broadly balanced structural position over the longer term—in line with the provisions under the EU’s Stability and Growth Pact (SGP)—would set an even tighter constraint, implying falling debt ratios.9

    External Debt and Current Account Concerns

    Fiscal policy may be constrained by external objectives, arising from a desire to reverse unfavorable external debt dynamics and limit current account deficits. These external objectives are, in turn, tied to efforts to secure overall macroeconomic stability, as the vulnerability to balance of payments crises tends to grow with increasing external imbalances and indebtedness.10 The “anchor” for fiscal policy, in this context, would be a medium-term current account deficit limit, derived ideally in the context of a wide array of vulnerability factors.11 This current account limit—irrespective of its value—can be translated, in a second step, into a fiscal balance target, subject to the outlook for private sector saving-investment balances.

    The earlier assessment of public debt sustainability offers a pragmatic approach that can be applied to external debt, as well.12 This approach takes into consideration the nature of capital inflows by distinguishing between debt and nondebt-creating flows, but leaves other factors aside. A useful starting point for such an analysis is to determine the current account deficit as a ratio of GDP (CAD) that is consistent with a stable net foreign debt ratio (NFD), according to the following relationship:

    CAD = (g*/(1 + g*)) NFD + B,

    where g* denotes GDP growth, in foreign currency terms, and B net nondebt-creating balance of payments inflows.13 While the above relationship implies a stable net foreign debt ratio, a country’s external vulnerability is more often assessed in terms of its gross indebtedness, the evolution of which depends additionally on changes in foreign assets. This exercise assumes, for simplicity (and in parallel to the analysis of public debt sustainability), that foreign assets remain constant as a share of GDP. Hence, the current account balance derived above implies stability in both net and gross external debt ratios.14

    A stable or declining external debt ratio is an arbitrary condition, in the sense that it ignores differences in existing debt levels. An alternative, and arguably more meaningful, benchmark is the average debt ratio in countries with similar development and investment characteristics. The reference group selected for this exercise includes middle-income countries with similar credit ratings, as shown in Table A2.15 Constrained by data availability, Figure A1 illustrates gross and net external debt-to-GDP ratios in 18 of these countries, including the five candidates. The binomial trend line for the net debt ratio shows the typical pattern of falling indebtedness as per capita income rises, with Hungary somewhat above the trend and the Czech Republic clearly below.16 In the case of the gross external debt ratio, a negative trend is observable only for income levels above US$9,000. Indeed, for lower incomes, the positive relationship may reflect the offsetting effect of poorer countries receiving credit ratings due to their comparatively low debt levels. For the group as a whole, gross debt ratios fluctuate broadly around 45 percent of GDP, which is, therefore, chosen as a rough benchmark for the following analysis. Obviously, countries with higher income levels, such as Slovenia and the Czech Republic, may find it appropriate to aim for a lower debt ratio.

    Table A2.Sovereign Ratings of Middle-Income Countries’ Long-Term Foreign Currency Debt1(As of January 2001)
    Moody’sStandard & Poor’s
    Investment GradeInvestment Grade
    A2SloveniaAMalta, Slovenia
    A3China, Malta, HungaryA-Barbados, Chile, Czech
    Baa1Chile, Czech Republic, Estonia, PolandRepublic, Hungary
    Baa2Barbados, Korea, Latvia, Malaysia, Mauritius, OmanBBB+Estonia, Poland
    BBBChina, Korea, Latvia, Malaysia, Tunisia
    Baa3Croatia, El Salvador, Mexico, Saudi Arabia, South Africa, Thailand, Trinidad and Tobago, Tunisia, UruguayBBB-Croatia, Egypt, Lithuania, Oman, South Africa, Thailand, Trinidad and Tobago, Uruguay
    Speculative GradeSpeculative Grade
    Ba1Bahrain, Costa Rica, Egypt, Lithuania, Morocco, Panama, Philippines, Slovak RepublicBB+El Salvador, Mexico, Panama, Philippines, Slovak Republic
    Ba2Belize, Colombia, Fiji, GuatemalaBBColombia, Costa Rica, Morocco
    Ba3Jamaica, Jordan, PeruBB-Argentina, Jordan, Peru
    Sources: Moody’s and Standard & Poor’s.

    Includes all middle-income countries, defined according to World Bank Global Development Finance 1999, with ratings of at least Ba or BB (for Moody’s and Standard & Poor’s, respectively).

    Sources: Moody’s and Standard & Poor’s.

    Includes all middle-income countries, defined according to World Bank Global Development Finance 1999, with ratings of at least Ba or BB (for Moody’s and Standard & Poor’s, respectively).

    Figure A1.External Debt-to-GDP Ratios in Selected Middle-Income Countries, 19991

    Sources: IMF, World Economic Outlook; and International Financial Statistics.

    1Gross debt as reported in World Economic Outlook. Net debt is derived from International Financial Statistics as total foreign liabilities minus total foreign assets, both excluding direct investment and equity securities; *marks countries with one investment grade rating by either Moody’s or Standard & Poors; **marks countries with investment grade ratings by both.

    2Refers to 1998

    With (crude) debt objectives established, the second step is a translation of these debt ratios into current account deficits. The results of such a simulation are summarized in Table A3, assuming constant gross foreign asset ratios and real GDP growth rates consistent with IMF staffs’ medium-term projections in the May 2000 World Economic Outlook.17 For simplicity, nondebt-creating inflows are assumed to be equivalent to net FDI, which may under- or overstate their actual level, depending on the size of nondebt-creating portfolio inflows relative to that of debt-creating FDI (that is, intercompany loans). On the basis of these assumptions, two scenarios are illustrated: one postulating a stable gross (and by assumption net) external debt ratio and the other a gross debt ratio of 45 percent of GDP in 2005. For Hungary and the Slovak Republic, with existing external debt ratios above 45 percent of GDP, reaching this ratio by 2005 sets the tighter constraint, whereas in the other three countries, a stable external debt ratio is a more ambitious objective. As indicated earlier, stability in debt ratios is not a convincing constraint, particularly if indebtedness is low to begin with. Thus, the following simulations will generally impose the alternative constraint of limiting debt ratios to 45 percent of GDP. The only exception is Hungary, where this would imply an unreasonably stringent constraint on current account deficits. This translates into rough limits for the current account deficit of 4 percent of GDP in Hungary, 5 percent of GDP in Poland and Slovenia, and 7 percent of GDP in the Czech and Slovak Republics. The relatively high levels in the last two countries are a direct reflection of very large FDI inflows projected over the coming years (some 7½–9 percent of GDP), which are assumed here to be entirely nondebt-creating.

    Table A3.External Current Account Balances and Foreign Indebtedness Under Alternative Scenarios(Percent of GDP, unless otherwise indicated)
    Czech RepublicHungaryPolandSlovak RepublicSlovenia
    1999Average 2000–051999Average 2000–051999Average 2000–051999Average 2000–051999Average 2000–05
    Nondebt creating flows111.
    Nominal GDP growth (in U.S. dollar terms)2-
    Current account balance consistent with:3
    Stable gross external debt ratio-6.7-4.2-4.1-9.4-1.3
    Gross external debt ratio of 45 percent of GDP in 2005-6.8-1.0-4.8-7.2-5.0
    Implicit net external debt ratio (end of period)-
    Memorandum items
    Actual/projected current account balance4-3.0-4.2-4.3-5.5-7.5-4.9-5.7-4.5-3.9-2.6
    Actual gross external debt ratio (end of period)544.860.541.453.427.4
    Actual net external debt ratio (end of period)5-26.220.711.710.3-0.8
    Sources: International Finance Statistics, World Economic Outlook, and IMF staff calculations.

    Net direct investment inflows, as projected in May 2000 World Economic Outlook. Actual nondebt creating inflows may be lower or higher, depending on the size of debt-creating direct investment inflows relative to nondebt creating portfolio investment.

    Projections for 2001–05 assume a stable real exchange rate and foreign inflation of 2 percent, both on a GDP deflator basis. This implies that nominal GOP in U.S. dollar terms grows by two percentage points more than real GDP.

    Assumes that foreign assets remain constant as a share of GDP.

    Consistent with IMF staff projections in May 2000 World Economic Outlook.

    Gross external debt as reported in Word Economic Outlook. Net external debt is derived as the difference between foreign liabilities and assets, both excluding direct investment and equity securities, as reported in International Financial Statistics.

    Sources: International Finance Statistics, World Economic Outlook, and IMF staff calculations.

    Net direct investment inflows, as projected in May 2000 World Economic Outlook. Actual nondebt creating inflows may be lower or higher, depending on the size of debt-creating direct investment inflows relative to nondebt creating portfolio investment.

    Projections for 2001–05 assume a stable real exchange rate and foreign inflation of 2 percent, both on a GDP deflator basis. This implies that nominal GOP in U.S. dollar terms grows by two percentage points more than real GDP.

    Assumes that foreign assets remain constant as a share of GDP.

    Consistent with IMF staff projections in May 2000 World Economic Outlook.

    Gross external debt as reported in Word Economic Outlook. Net external debt is derived as the difference between foreign liabilities and assets, both excluding direct investment and equity securities, as reported in International Financial Statistics.

    Once limits for the current account deficit have been established, the consistent fiscal target can be determined, subject to assumptions about developments in the private sector saving-investment balance. Based on the definition of the current account balance (CAB) as the sum of the public sector saving-investment balance (GB) and the private sector saving-investment balance (PB), changes in the current account are equivalent to:

    ΔCAB = ΔGB + ΔPB,

    with all variables expressed as ratios to GDP. With a given current account limit, solving for ΔGB (that is, the targeted adjustment in the fiscal balance)18 requires an assumption about ΔPB. Besides exogenous changes, private saving and investment ratios are likely to respond to adjustments in fiscal policy itself, with the magnitude depending on the existence of Ricardian effects and on accompanying shifts in the level and structure of revenues and expenditures. While neither theoretical analysis nor empirical evidence are unambiguous (see Box A1 for an overview), a reasonable assumption would be that fiscal consolidation reduces private saving relative to investment, irrespective of whether it is expenditure or revenue driven. Thus, the overall change in the private sector saving-investment balance can be split into an exogenous part (ΔPBexo) and an endogenous (fiscal-policy induced) part (ΔPBend = –xΔGB), where x denotes the Ricardian “offset factor” (that is, the tall in the private sector saving-investment balance induced by a 1 percentage point of GDP improvement in the fiscal balance).19 Substituting for ΔPB in the above equation, and solving for ΔGB, determines the required fiscal adjustment as a function of (i) the current account objective; (ii) the projected exogenous change in the private sector saving-investment balance; and (iii) the assumed magnitude of the private sector offset:

    ΔGB = 1/(1 - x) [ΔCAB - ΔPBexo].

    The observed volatility in private sector saving-investment balances gives an indication of the potential “margins of error” involved in calibrating fiscal policy to meet external objectives. As illustrated in Figure A2, the current account fluctuations in the past were driven by highly volatile private sector saving-investment balances, whereas public balances fluctuated considerably less from year to year. Thus, any assessment of future trends—and of the impact resulting from fiscal adjustment itself—is highly uncertain. Looking ahead, three factors in particular may influence the (exogenous) trend in the private sector saving-investment balances:

    Figure A2.Saving-Investment Balances in the CEC5, 1993–99

    (Percent of GDP)

    Source: IMF, World Economic Outlook.

    1Defined as saving minus investment.

    (i) investment ratios are likely to increase, due to profit opportunities offered by the ongoing transition process and real convergence;

    (ii) private saving ratios may fall with the expectation of rising real income levels in the future and growing financial liberalization (reducing liquidity constraints on household consumption);20 and

    (iii) higher corporate profits would tend to raise private saving.

    While the first two suggest a deterioration in the private sector balances, the last works in the opposite direction. How these and potentially other factors will influence private saving-investment balances in the individual countries is a crucial element in linking fiscal to external objectives.

    This said, the following simulations rely on a rather mechanical approach to project private sector saving-investment balances. As noted earlier, such an approach has the advantage of uniformity, leaving country-specific considerations and a more nuanced assessment to more comprehensive individual country studies. In this vein, it as assumed that, in the absence of fiscal action, the private sector saving-investment balances in all countries return to their average levels of 1997–99, as a share of GDP.21 In addition, the simulations build in a “safety margin” for volatility (equivalent to the standard deviation of the private sector balance over this period), which raises the fiscal adjustment needed to achieve a given current account objective. Such a safety margin can be justified to protect the credibility of fiscal targets, which should imply external balances that are attainable within normal “cyclical” fluctuations in private sector saving-investment behavior. Finally, it is assumed that the Ricardian offset (x) is 50 percent.22

    The implications of this approach for medium-term fiscal policy targets are illustrated in Table A4. The differences between the actual current account balances (using 1999 as the illustrative reference point) and the earlier established limits determine the target for the required improvement (or maximum deterioration) over the medium term.23 On this basis, Poland would need to achieve the largest current account improvement, relative to 1999, by 2½ percentage points of GDP. The size of the fiscal adjustment can then be determined, in a second step, building in the assumed exogenous changes in the private sector saving-investment balances (based on past trends and volatility) and the offset factor. The simulations imply that all countries but Slovenia would have to tighten fiscal policy over the medium term. The magnitude of the fiscal adjustment relative to 1999 differs, however, from some 1–2½ percentage points of GDP in Hungary and the Czech and Slovak Republics, to 4 percentage points of GDP in Poland. In Slovenia, in contrast, the medium-term fiscal deterioration could be 3½ percentage points of GDP—a result driven, in part, by the technical assumption of an improvement in the private sector saving-investment balance over the medium term.

    Table A4.Medium-Term Fiscal Targets Anchored on External Debt and Current Account Constraints(Percent of GDP)
    Czech RepublicHungaryPolandSlovak RepublicSlovenia
    Current account balance
    Actual for 1999-3.0-4.3-7.5-5.7-3.9
    Targeted limit for 20051-7.0-4.0-5.0-7.0-5.0
    Change (2005 relative to 1999)-
    Private sector saving-investment balance
    Assumed exogenous change (2005 relative to 1999)2-5.2-0.30.5-2.40.7
    Fiscal policy induced change3-1.2-0.6-2.0-1.11.7
    Total change (2005 relative to 1999)-6.4-0.9-1.5-3.42.4
    Fiscal adjustment between 1999 and 200542.
    Implied fiscal balance in 2005-1.3-2.40.2-1.3-4.2
    Memorandum items:
    Fiscal balance in 1999-3.7-3.7-3.7-3.4-0.7
    Sources: World Economic Outlook, and IMF staff simulations.

    Targets are derived on the basis of the (rounded) results in Table A3.

    Incorporates technical assumptions, as discussed in the text.

    Assumes that a fiscal tightening of 1 percentage point of GDP worsens the private sector saving-investment balance by 0.5 percentage points of GDP.

    Change in fiscal balance is assumed to be equivalent to change in the public saving-investment balance.

    Sources: World Economic Outlook, and IMF staff simulations.

    Targets are derived on the basis of the (rounded) results in Table A3.

    Incorporates technical assumptions, as discussed in the text.

    Assumes that a fiscal tightening of 1 percentage point of GDP worsens the private sector saving-investment balance by 0.5 percentage points of GDP.

    Change in fiscal balance is assumed to be equivalent to change in the public saving-investment balance.

    Box A1.The Impact of Fiscal Policy on Private Saving and Investment

    The impact of fiscal policy on private saving is typically linked to the Ricardian equivalence theorem.1 This basically states that the effect on the current account of changes in the fiscal position (for example, a reduction in taxes) is entirely offset by adjustments in private saving, in anticipation of future reversals in the fiscal stance. The empirical literature has sometimes found fairly large Ricardian effects in advanced economies, with changes in private saving offsetting as much as 90 percent of changes in public saving.2 Ricardian effects in low- and middle-income countries have been found to be significantly smaller, however, at around 50 percent, reflecting, among other things, less developed financial markets.3

    In addition, for a given fiscal balance, a cut in the ratio of current expenditure to GDP (the empirical results for public investment are less clear-cut) has been found to increase the private saving ratio.4 This may reflect either the positive effect of lower taxes (required for a given fiscal balance) on disposable income (as saving ratios tend to rise with higher income), or stronger incentives to save due to a less generous social safety net. Thus, expenditure-based fiscal consolidation (that is, spending cuts without changes in revenues) should result in only a small (if any) reduction in private saving, whereas fiscal consolidation based on higher taxes should lower private saving significantly.

    The empirical literature on private investment responses to a permanent change in the level of public expenditure and revenue is less developed, suggesting caution with regard to the magnitude of the effects. Nevertheless, it suggests that fiscal consolidation, which is expenditure driven, tends to raise private investment ratios, while revenue-based consolidation would have the opposite effect, but likely of significantly smaller magnitude.5

    The overall effect of fiscal consolidation on the private saving-investment balance is likely to be negative (that is, saving falls relative to investment), but its magnitude is uncertain. Expenditure-based fiscal tightening is not expected to reduce the private saving ratio by much, but has a (possibly strong) positive effect on private investment. Revenue-driven consolidation, on the other hand, is expected to reduce the private saving ratio significantly, but should also result in a reduction in the investment ratio. In the same vein, the effect of a combined deficit-neutral cut or increase in revenue and expenditure on the private saving-investment balance is uncertain, as both the saving and investment ratio are expected to rise in the former and fall in the latter case.

    1This box builds on a similar presentation in IMF (2000e).2See Ul Haque and others (1999).3See Masson and others (1995).4See Ul Haque and others (1999), Masson and others (1995), and Callen and Thimann (1997).5Alesina and others (1999) find that a permanent cut in expenditure by 1 percentage point of GDP, raises private investment by 0.8 percentage points of GDP after five years, and by significantly more if the expenditure restraint is focused on public sector wages. A revenue increase by the same amount lowers the private investment ratio by about 0.2 percentage points, with a larger reduction in the case of rising taxes on labor income.

    In sum, while public debt dynamics currently imply no serious constraint for medium-term fiscal policies in any of the five countries, external vulnerability considerations may. Based on a crude but consistent methodology for determining potential current account limits and forecasting private sector saving-investment balances, four of the five countries are found in need of tightening their fiscal positions. However, these results have to be interpreted as mere reference points for a more comprehensive and country-specific assessment of external vulnerabilities and a forward-looking consideration of private sector saving and investment behavior. These qualifications notwithstanding, the above analysis has illustrated how quantitative medium-term frameworks can provide a useful consistency check between fiscal and external objectives.

    Appendix II Revenue Trends and Tax Structures

    This Appendix provides information on the recent revenue performance and current tax structures in the five accession candidates, as background for the discussion of reform proposals in Chapter 7. Given the context of EU accession, comparisons are mostly undertaken with reference to the European Union.24

    Recent Revenue Trends

    General government revenue has recently been on a declining trend, driven by both advances in economic liberalization and reductions in tax rates. The five countries covered in this paper have experienced declines in their general government revenue shares during 1994–98 (Table A5). The revenue losses in individual countries ranged from a modest ½ percentage point of GDP in Slovenia to 6⅓ percentage points of GDP in Poland. The main factors behind these revenue losses were further advances in transition, which included additional liberalization and restructuring of the economy, and reductions in tax ratios. Reflecting tax system reforms, the declines in tax ratios ranged from 1⅔ percentage points of GDP in the Czech Republic and Slovenia to 5⅔ percentage points of GDP in Poland (Figure A3).

    Table A5.General Government Revenue in the CES5, 1994–98(Percent of GDP)
    19941995199619971998Change 1994–98
    Czech Republic
    Total revenue42.641.940.339.738.7-4.0
    Tax revenue37.737.036.236.436.0-1.7
    Personal income tax4.
    Corporate profit tax5.
    Social security tax13.713.914.114.814.60.9
    Value added/sales tax6.
    Excise tax4.
    Import taxes1.
    Other taxes1.
    Nontax revenue4.
    Total revenue47.642.742.444.943.5-4.1
    Tax revenue40.940.039.938.938.6-2.3
    Personal income tax7.
    Corporate profit tax1.
    Social security tax14.713.313.013.813.6-1.1
    Value added/sales tax7.
    Excise tax3.
    Import taxes4.
    Other taxes2.
    Nontax revenue6.
    Total revenue50.045.845.045.443.7-6.3
    Tax revenue43.239.639.438.937.6-5.7
    Personal income tax9.
    Corporate profit tax3.
    Social security tax12.812.112.312.512.1-0.7
    Value added/sales tax6.
    Excise tax3.
    Import taxes2.
    Other taxes1.
    Nontax revenue6.
    Slovak Republic
    Total revenue46.546.147.742.840.5-5.9
    Tax revenue38.839.841.136.635.4-3.4
    Personal income tax4.
    Corporate profit tax7.
    Social security tax11.713.214.813.713.41.7
    Value added/sales tax9.
    Excise tax3.
    Import taxes1.
    Other taxes1.
    Nontax revenue7.
    Total revenue43.443.142.742.143.0-0.4
    Tax revenue41.741.240.439.840.0-1.7
    Personal income tax6.
    Corporate profit tax0.
    Social security tax17.116.314.713.813.8-3.3
    Value added/sales tax12.712.913.
    Excise tax0.
    Import taxes3.
    Other taxes0.
    Nontax revenue1.
    Sources: Revenue Statistics, OECD, 1999; various Recent Economic Development Reports; and IMF staff estimates.

    Data for Hungary are on a GFS-consolidated basis for 1998 only.

    Sources: Revenue Statistics, OECD, 1999; various Recent Economic Development Reports; and IMF staff estimates.

    Data for Hungary are on a GFS-consolidated basis for 1998 only.

    Figure A3.Tax Ratios in the CEC5 and the European Union, 1994 and 1998

    (Percent of GDP)

    1The ratio for Greece refers to 1997.

    Sources: OECD, Revenue Statistics, (1999); various Recent Economic Development Reports; and IMF staff estimates.

    1In the case of Greece, 1997 relative to 1994.

    Notwithstanding the decline in tax ratios in all five countries, there are significant differences in individual taxes. The most prominent declines were in the corporate income tax collection in the Czech and Slovak Republics; social security contributions and import taxes in Hungary and Slovenia; and the personal income tax and import taxes in Poland.

    The decline in corporate income tax collection in the Czech and Slovak Republics occurred despite—and partly because of—high tax rates, due to strong incentives for tax avoidance in both the private sector and state-owned enterprises, and drops in firms’ profitability (owing to the restructuring of the enterprise sector, the elimination of direct and indirect subsidies, and reductions in monopolistic profits in the face of increased competition). Social security and import tax collection declined significantly in Hungary and Slovenia, in response to a decline in the social security contribution rates and import tariffs, respectively. Finally, a decline in import tax collection in Poland reflected both a reduction in tariffs and the elimination of the import surcharge.

    It is important to note that although reforms were undertaken to reduce individual tax rates, these were often not the only reason for a declining trend in revenue ratios. Reforms included reductions in the statutory rates of personal and corporate income taxes, but their negative impact on revenues was often compensated by reductions in or elimination of tax relief, or a broadening of the tax base. In the case of Hungary, for example, a dramatic cut in the corporate tax rate was more than offset by a higher tax base, because of the resulting increase in foreign direct investment and the improved profitability of the enterprise sector. Conversely, as noted above, the Czech and Slovak Republics experienced a fall in revenues from corporate income taxes, despite, or perhaps because of, high rates.

    Tax Structure

    While a number of changes in the tax systems of the five accession candidates have led to tax structures broadly in line with the EU-average, some important differences can still be identified (Figure A4). The contribution of personal income taxes, in terms of both total revenue and GDP, is relatively low in the five central European countries compared with the respective EU average; and social security contributions are a relatively more important component than the personal income tax with respect to taxes on labor income.

    Figure A4.Structure of Tax Revenue in the CEC5 and the European Union, 1998


    Sources: OECD, Revenue Statistics, (1999); various Recent Economic Developments Reports; and IMF staff estimates.

    Social security contributions combined with personal income taxes have led to a high tax burden on labor income. All five countries have implemented mandatory, payroll-based social security contributions (which generally cover pension, unemployment, and health insurance), with rates that are high compared with the EU or the OECD average (Table A6). This reflects labor market and social policies that have encouraged early retirement (there is little difference between net wages and pension incomes) and the generous provision of disability benefits (for example, in Poland and the Slovak Republic). Combined with the personal income tax, the nominal tax wedge between the cost of labor to the employer and the return received by the employee reached (in 1999) 43 percent of gross salaries in the Czech Republic, 57 percent in Hungary, 45 percent in Poland, and 60 percent in the Slovak Republic—significantly above the average rate of about 40 percent prevailing in the EU.25 Reducing taxes on labor would tend to raise employment and output, and offset (at least partly) the negative revenue effect of lower labor taxes.26 Reducing the taxation on labor income would also tend to reduce incentives to operate in the gray economy, which would help raise revenue.

    Table A6.Social Contribution Rates in the CES5, Europe, and the OECD(Percent of gross labor income)
    Employer’s ContributionEmployees’ ContributionTotal
    Czech Republic35.012.547.5
    Slovak Republic38.012.050.0
    European Union323.612.936.5
    Western Europe422.111.733.8
    Sources: International Bureau of Fiscal Documentation; and World Bank (1998).

    Includes sickness contributions.

    Also includes maternity contributions, and a health contribution paid by the employees.

    Unweighted average of the European Union countries (excluding Denmark).

    Unweighted average of European Union countries (excluding Denmark) and Iceland, Norway, and Switzerland.

    Unweighted average of Western Europe (as defined above) and Australia, Japan, Mexico, New Zealand, and the United States.

    Sources: International Bureau of Fiscal Documentation; and World Bank (1998).

    Includes sickness contributions.

    Also includes maternity contributions, and a health contribution paid by the employees.

    Unweighted average of the European Union countries (excluding Denmark).

    Unweighted average of European Union countries (excluding Denmark) and Iceland, Norway, and Switzerland.

    Unweighted average of Western Europe (as defined above) and Australia, Japan, Mexico, New Zealand, and the United States.

    Revenue generation from the personal income tax (PIT) in some of the five countries is hampered by a vast system of deductions and exemptions, and high tax rates. In general, the PIT has a progressive structure of marginal rates, and the number of brackets is in line with the systems in the EU (Table A7). The top marginal rates are around 40 percent (with the exception of Slovenia: 50 percent), broadly in line with an EU average of 44½ percent. However, low effective tax collection compared with the EU suggests a relatively narrow base. This can be attributed, in part, to various tax credits and specific exemptions. For example, in contrast to the EU, interest on government bonds is exempt in the central European countries, and interest on bank deposits is taxed only in the Czech and Slovak Republics, while fully taxed (either as part of ordinary income or at separate rates) in all EU countries. Also, in contrast to many (but not all) EU countries, social security benefits are tax exempt.27 In addition, as noted above, high tax rates on labor income reduce employment in the official economy. Finally, the size of the gray economy in some countries only compounds problems already experienced in strengthening tax administration.28

    Table A7.Main Elements of the Personal Income Tax System in the CEC5 and the European Union(Percent, unless otherwise indicated)
    Marginal Tax RateTreatment of Interest Income1Treatment of DividendsInterest on Loan for Owner-Occupied Housing
    Number of tax schedules2LowestHighestBank depositsGovernment bonds
    Central European Countries
    Czech Republic5154015Exempt15Taxed
    Hungary32040ExemptExempt20, 35Deductible
    Slovak Republic6154215Exempt15Taxed
    EU Countries
    Austria5215025253253Partially deductible
    United Kingdom31040O.I.O.I.O.I.Taxed
    Sources: International Bureau of Fiscal Documentation; Surveillance of Tax Policies: A Framework for EDRC Country Reviews, OECD, 1999; and Individual Taxes 1999–2000, PriceWaterhouseCoopers.

    O.I. indicates ordinary income; and the number in percent refers to the withholding tax rate.

    Excluding zero band or allowance.

    Withholding tax is either final or creditable against the income tax liability, at the taxpayer’s option.

    Dividends paid to shareholders are not taxed in their names because the underlying profits have already been taxed in the name of the distributing corporation.

    Final witholding tax or 10 percent tax, creditable against ordinary income tax liability.

    All rates have to be increased by 2.5 percent for a contribution to the employment fund (e.g., the maximum rate would be 47.15 percent).

    Includes social security premiums.

    As ordirary income; or ordinary income with 25 percent withholding and tax credit; or exempt.

    As ordinary income; or at 28.57 percent creditable withholding tax; or exempt.

    Sources: International Bureau of Fiscal Documentation; Surveillance of Tax Policies: A Framework for EDRC Country Reviews, OECD, 1999; and Individual Taxes 1999–2000, PriceWaterhouseCoopers.

    O.I. indicates ordinary income; and the number in percent refers to the withholding tax rate.

    Excluding zero band or allowance.

    Withholding tax is either final or creditable against the income tax liability, at the taxpayer’s option.

    Dividends paid to shareholders are not taxed in their names because the underlying profits have already been taxed in the name of the distributing corporation.

    Final witholding tax or 10 percent tax, creditable against ordinary income tax liability.

    All rates have to be increased by 2.5 percent for a contribution to the employment fund (e.g., the maximum rate would be 47.15 percent).

    Includes social security premiums.

    As ordirary income; or ordinary income with 25 percent withholding and tax credit; or exempt.

    As ordinary income; or at 28.57 percent creditable withholding tax; or exempt.

    Corporate income tax rates and investment incentives differ significantly across the accession candidates. Tax rates vary from 18 percent in Hungary to 31 percent in the Czech Republic; these compare with an average of about 33 percent for the EU (Table A8).29 The wide divergence in tax rates of central European countries reflects to a large extent different strategies to attract foreign direct investment (FDI), with some governments favoring special tax treatments and nontax incentives.30 The latter have included a number of desirable measures, such as improved legal and institutional frameworks, complemented by public sector reforms to enhance transparency and governance. However, all five governments have also adopted, to different degrees, discriminatory practices, including tax holidays and import duty exemptions for foreign investors.31 Their main objective was to stimulate investment in underdeveloped regions or sectors, or in regions with high unemployment, but the actual benefits of such measures may be hard to judge relative to their cost.32 At all events, effective corporate tax rates have been much lower than nominal CIT rates (shown in Table A8): the effective rates were 10.9 percent in the Czech Republic, 13.1 percent in Hungary, 22.1 percent in Poland, 16.9 percent in Slovakia, and 12.4 percent in Slovenia (see IMF, 2000b).33

    Table A8.Corporate and Value-Added Tax Rates in the CEC5 and the European Union(Percent)
    Value-Added Tax Rates
    Corporate Income TaxLowerStandard
    Central European Countries
    Czech Republic31522
    Poland303, 722
    Slovak Republic291023
    EU Countries
    Belgium4011, 6, 1221
    Finland288, 1722
    France36.7–4022.1, 5.519.6
    Greece35–4034, 818
    Ireland323.6, 10, 12.521
    Italy374, 1020
    Luxembourg303, 6, 1215
    Portugal345, 1217
    Spain25–3544, 716
    Sweden236, 1225
    United Kingdom30517.5
    Sources: international Bureau of Fiscal Documentation; Surveillance of Tax Policies; A Framework for EDRC Country Reviews, 2000, OECD, 1999; and Individual Taxes 1999–2000, PriceWaterhouseCoopers.

    Effective rote; it comprises a corporate income tax rate of 39 percent and a 3 percent austerity surcharge.

    Effective rate; it comprises a corporate income tax rate of 33.3 percent and a surtax of 10–20 percent.

    The higher rate applies to companies in the Athens Stock Exchange and the lower rate to other companies.

    The lower rate applies to nonresident companies and the higher rate to resident companies.

    Sources: international Bureau of Fiscal Documentation; Surveillance of Tax Policies; A Framework for EDRC Country Reviews, 2000, OECD, 1999; and Individual Taxes 1999–2000, PriceWaterhouseCoopers.

    Effective rote; it comprises a corporate income tax rate of 39 percent and a 3 percent austerity surcharge.

    Effective rate; it comprises a corporate income tax rate of 33.3 percent and a surtax of 10–20 percent.

    The higher rate applies to companies in the Athens Stock Exchange and the lower rate to other companies.

    The lower rate applies to nonresident companies and the higher rate to resident companies.

    Regarding indirect taxation, alignment with EU norms has progressed considerably, but rates are generally still on the high side. Value-added taxes have been designed to follow EU guidelines, and, with the exception of Slovenia, the standard rates exceed the EU average of 19.4 percent (Table A8). Moreover, there tends to be a large differential between the standard and the lower rate, which creates distortions. Tariffs will generally need to be cut—although not by much more—to comply with WTO agreements and the provisions of the single market. While excises will need to be aligned with those in the EU, the required changes are in both directions.


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    The Authors

    Costas Christou

    Costas Christou is the IMF resident representative in Slovakia. He joined the IMF in 1994 and has worked in the African, European, and Treasurer’s Departments. He holds a Ph.D. in Economics from the University of Maryland. Prior to joining the IMF he worked at the World Bank and the Interindustry Forecasting Group. He has published a number of articles on macroeconomics, monetary economics, international finance, and applied econometrics in several academic journals.

    Christina Daseking

    Christina Daseking is a senior economist in the Policy Development and Review Department of the IMF. She was previously in the European I Department, working on Finland and Poland. Prior to that she worked on the HIPC Initiative. She received her Ph.D. from the University of Goettingen, Germany.

    Peter Doyle

    Peter Doyle is Deputy Division Chief in the Central European II Division of the European I Department. Since joining the IMF in 1991, he has worked on a variety of transition and African countries in surveillance, program, and technical assistance capacities. Prior to joining the IMF, he worked at the Bank of England and prior to that was an Overseas Development Institute fellow in Swaziland. He received his M.Phil in Economics from Oxford University, University College, where he had previously obtained his M.A. in Politics, Philosophy, and Economics.

    Robert A. Feldman

    Robert A. Feldman is Chief of the Central European II Division of the European I Department. He received his Ph.D. from the University of Wisconsin-Madison, and joined the IMF in 1984 after spending five years at the Federal Reserve Bank of New York. While in the European I Department, he has led missions to Croatia, Finland, Hungary, and the Slovak Republic, and published on various EU accession issues. He was also the Assistant to the Economic Counsellor and Director of Research of the IMF, and worked in the IMF’s Policy Development and Review Department on program countries, including those in transition.

    Dora lakova

    Dora lakova is an Economist in the Asia and Pacific Department of the IMF. She contributed to the papers in this book while she was an economist in the European I Department, working on Hungary. Prior to joining the IMF in 1999, she had worked as a Senior Consultant in the international tax practice of KPMG; and as an Economist in the Fixed Income Research Department at Merrill Lynch. She is a graduate of New York University.

    Guorong Jiang

    Guorong Jiang is an Economist in the European I Department of the IMF. He is currently on leave from the IMF and is Senior Manager in the Hong Kong Monetary Authority, responsible for debt market development issues. Since joining the IMF in 1995, he has been involved in country surveillance activities, program work, and debt reduction initiatives. He received his Ph.D. in Economics from Cornell University, his M.A. in Communication from Miami University, and his B.A. from Nanjing University.

    Louis Kuijs

    Louis Kuijs is an Economist in the European I Department, currently working on the Slovak Republic. Prior to joining the IMF in 1997, he worked at Oxford Economic Forecasting, on macroeconomic modeling and fore-casting. He studied Economics at the University of Amsterdam and holds an M.Sc. degree in Economics from the London School of Economics.

    Rachel van Elkan

    Rachel van Elkan is a Senior Economist in the European I Department, currently working on the Czech Republic. She has also worked on Croatia, Hungary, and Slovenia from the European I Department. She received her Ph.D. in Economics from the University of Chicago.

    Nancy Wagner

    Nancy Wagner is a Senior Economist in the European I Department, currently working on Hungary and Finland. While in European I, she has also worked on the Netherlands, Poland, the Slovak Republic, and Slovenia. She received her Ph.D. from The Johns Hopkins University, Baltimore, Maryland.

    C. Maxwell Watson

    Max Watson, Deputy Secretary of the IMF, worked on European issues at the IMF from 1992 to 2001. He coordinated relations on EU accession with the European Commission, and led missions to a range of the IMF’s European members—from Italy and Spain to Hungary, Croatia, and Romania. He joined the IMF from the Bank of England in 1979, as personal assistant to the then Managing Director Jacques de Larosiere, and later became chief of the International Capital Markets Division and head of the Debt Issues Unit. He is a graduate of Cambridge and INSEAD, a former visiting research fellow at Oxford, and a fellow of the U.K. Institute of Bankers.

    For a detailed description of the acquis communautaire see Box 2.1 in the next chapter.

    During the first half of the 1990s, the European Community and its Member States progressively concluded Association Agreements or so-called Europe Agreements with ten countries of central and eastern Europe. These Europe Agreements provided the legal basis for bilateral relations between these countries and the EU. Temprano-Arroyo and Feldman (1999) provide a summary of the institutional relations between the EU and these countries (including the five central European countries in this study) following the fall of the Berlin Wall and leading up to accession negotiations.

    Candidate countries need to provide cofinancing, of about 25 percent, for most of the projects financed by the pre-accession funds; and they must have in place the necessary administrative infrastructure.

    November 2001. The other three functioning market economies were deemed to be Estonia, Latvia, and Lithuania. Since 1998, the European Commission has prepared annual Regular Reports that describe the progress of individual accession candidates in meeting the Copenhagen criteria and in transposing the EU’s acquis.

    The accession treaty will be subject to approval on the EU’s side by the Council and by the European Parliament, taking account of the final Opinion which the Commission will submit on the outcome of the negotiations. The Treaty resulting from the accession negotiations will then be formally signed by the parties concerned (Member States and candidate countries) and submitted for ratification by the contracting States in accordance with their respective constitutional requirements. Given the time needed to complete this process, new members could join by early 2004.

    The Helsinki European Council in 1999 clarified in precise terms which countries would he eligible for candidate status and agreed that negotiations would be started with all candidates that met the Copenhagen political criteria. Accession negotiations with the Czech Republic, Poland, Hungary, Slovenia, and Estonia began in March 1998; with Bulgaria, Latvia, Lithuania, Romania, and the Slovak Republic in February 2000. The EL) has said that every candidate country would be judged on its own merits, so that countries that started negotiations later would have a chance to catch up with those that started earlier—as has been the case, for example, with the Slovak Republic—opening the door potentially to simultaneous accession by a large group.

    See “The Economic Impact of Enlargement,” by the Directorate General for Economic and Financial Affairs, Enlargement Papers Number 4, June 2001, available at

    The growth accounting framework utilizes the following identity:

    dY/Y = αdK/K+ βdL/L + dA/A,

    where the production function takes the form of Y = AKαLβ and, α and β are the elasticity of output with respect to capital and labor. In practice, α and β are approximated by the profit and labor shares in national income, and dA/A (total factor productivity growth) is calculated as a residual.

    Between 1989 and 1999, the cumulative increase in GDP ranged from -6 percent in the Czech Republic to 28 percent in Poland (and in Hungary, the Slovak Republic, and Slovenia it was -0.8, 2, and 5.8 percent, respectively).

    The fall in employment during transition led to a significant decrease in the ratio of employment to total population. This fall was particularly steep in Hungary: around 15 percent, compared to some 5-8 percent in the other countries. The particularly large fall in employment in Hungary has not led to a relatively large increase in measured unemployment as many laid-off people withdrew from the labor force altogether.

    Ideally, these weights would he determined according to the share of capital and labor, respectively, in GDP. But data on these shares in the CEC5 is weak. For example, where the share of self-employed in employment is high, as in Poland, the official estimate of profit share in national income is exaggerated. The assumption of 35 and 65 percent simply follows evidence from other countries. As noted in Box 3.2, however, the overall results are not sensitive to even quite large adjustments in these assumptions.

    For a summary of various estimates of the Balassa-Samuelson effect, see Box 1 of Doyle, Kuijs, and Jiang (2001).

    The 2000 EBRD Transition Report (Chapter 6) highlights a number of ways in which the education systems during the socialist period, as well as worker experience during that era, badly prepared workers for the market economy, including relatively highly educated workers. It notes that these shortcomings have not yet been overcome and will slow growth.

    At the steady state, the capital output ratio will remain constant, and dY/Y = (dA/A)/β + dL/L. As a result, per capita GDP growth at the steady state will be total factor productivity growth over the labor share plus changes in the quality of the labor force.

    Fischer and others (1998) estimate that it would take the CEC5 between 11 and 24 years to catch up with the “low income EU countries” of Greece, Portugal, and Spain.

    If the Balassa-Samuelson effects prove to be strong, with corresponding high inflation of nontraded prices, nominal GDP expressed in euros will rise more rapidly towards EU levels. But in the context of significant differences between tradable and nontradable inflation, convergence of real incomes will only be apparent from income comparisons at PPP rather than market exchange rates.

    See Levine (1997) for a literature review on the impact of financial systems on growth. For cross-country evidence, see Levine and Zervos (1998); Beck, Levine, and Loayza (2000a).

    After controlling for simultaneity bias and for other determinants of growth, Beck, Levine, and Loaysa (2000b) find that measures of the initial level of financial depth and stock market liquidity (but not the size of the stock market) have independent causal effects on the subsequent rates of GDP growth and economic efficiency improvements. Rajan and Zingales (1996) find that, for a large sample of countries, industries relying heavily on external funding grow taster in countries with well-developed financial intermediaries.

    The structure of taxation can significantly influence the development of the financial system in the direction of bank-based or market-based. For example, the introduction of a capital gains tax in Hungary at the beginning of 2001 further depressed interest in the local stock exchange, which was already struggling with a drop in liquidity.

    The high ratio in the Czech Republic reflects, in part, incomplete consolidation of the aggregate balance sheets, with double-counting of interbank credits.

    In 2000, ING Bank withdrew from retail banking and sold its branches to Citibank. In 2001, ? & H Bank and ABN Amro, the third and fifth largest banks, respectively, in Hungary, merged to form the second largest bank in Hungary. Moreover, in 2001, Hungary’s OTP decided on a cross-border purchase of Slovakia’s IRB, a stepping stone to regional expansion and into less competitive markets. Consolidation is also picking up pace in Poland, driven largely by the expansion of strategic investors and parent company mergers. Thus, WBK and Bank Zachodni merged in 2000, and the merger of BPH and PBK in 2001 will create Poland’s third largest bank. See also BIS (2001).

    In fact, in Hungary, there are legal limits on the amount that a company can publicly issue.

    Liquidity is inversely related to price, as more liquid stock exchanges provide cheaper financing.

    Even some much larger and more mature exchanges in Europe and the United States have been attempting to capture a larger slice of global liquidity through mergers.

    U.S. Federal Reserve Chairman Alan Greenspan, in a speech Riven at the Financial Crisis Conference, Council on Foreign Relations, New York, July 12, 2000. Davis (2001) finds empirical evidence that the existence of active securities markets alongside banks is beneficial to the stability of corporate financing.

    Barth, Caprio, and Levine (2000) find that the greater the share of bank assets controlled by the state, the lower is the depth of financial development, and the lower the development of nonbank financial intermediaries and the stock market.

    Slovenia passed a new banking law in 1999. Foreign banks may now open up branches, and foreign investors may purchase stakes in Slovene banks.

    Levine (1999) finds that capital control liberalization leads to higher market liquidity, with a positive impact on long-run growth.

    Enoch, Garcia, and Sundararajan (1999) provide a comprehensive discussion on operational and technical issues of the use of public funds in helping to recapitalize banks and restructure assets.

    The estimate for the restructuring in the Slovak Republic, which took place in 2000, is about 12 percent of 2000 GDP.

    This has changed, however, in 2001. Konsolidacna Banka, the Czech AMC, auctioned some of its assets in 1999-2001, and its banking license was subsequently revoked, thereby allowing it to concentrate on the debt workout function.

    See Klingebiel (2000) for cross-country experiences in the use of AMCs in the resolution of banking crisis, Giorgianni (2001) has an overview of the Asian experience to date.

    Bolivia allowed private asset management agencies to keep a portion of recovered as-sers, with the portion retained an increasing function of the speed of recovery.

    James (1991), in a study of bank failures in the United States, finds that the rate of recovery of defaulted assets lor banks taken over by the FDIC is significantly lower than the rate of recovery for banks taken over by private banks. This could, however, also reflect selection bias to some degree.

    Nevertheless, some banks perceived as “too big to fall” may nor respond sufficiently even to a well designed incentive structure.

    Even in the absence of Ricardian equivalence, the aggregate demand impact of fiscal recapitalization can be difficult to ascertain, as it depends on the counterfactual. Thus, for example, if the alternative to recapitalization is wiping out deposits, then the demand impact of recapitalization is likely to be positive. On the other hand, if the alternative is to allow banks to continue to function and to delay recapitalization, then the demand impact could even be negative if, in the absence of recapitalization, the insolvent banks would “gamble for redemption” and lend more freely now, anticipating an even larger recapitalization if things went wrong.

    Daniel (1997) discusses in more detail the aggregate demand impact of bank recapitalization due to changes in interest rate spreads, wealth effects, and recurrent recapitalization.

    Dziobek, Hobbs, and Marston (2000) provide a comprehensive discussion on systemic liquidity policy frameworks.

    Powell (2000) notes that a possible modification for countries with floating exchange rates and inflation targets (as in the CEC5) would be to maintain reserve cover for total public debt coining due, conditioned on the maximum depreciation consistent with the inflation target.

    See also Powell (2000). The choice of 20 percent of deposits is arbitrary (and indeed was chosen by Powell “in sympathy with the ratio for Argentine liquidity requirements”), but is an attempt to capture the amount that might flee the country in the event of loss of depositor confidence.

    Calvo and Kumar (1994) note that, seemingly perversely, injecting central bank liquidity could prove counterproductive and actually exaggerate a credit crunch, with higher inflation reducing the demand for money and the stock of real bank credit.

    Calvo (1992) discusses how high interest rates can actually jeopardize the success of an inflation stabilization program, a situation exacerbated by the segmented and incomplete credit markets which characterized the CEC5, particularly in the catty years of transition.

    In July 1998, the Czech National Bank issued a regulation requiring commercial banks to fully provision against loss loans (overdue over one year) collateralized by real estate. The requirement was phased in over three years.

    The legacy of hyperinflation at the end of the 1980s (with inflation reaching 13,000 percent per year in 1989) led to a practice of widespread indexation for most financial contracts. Indeed, interest rates for households and corporates are still quoted in real terms, and a revaluation clause is added as compensation for past inflation.

    The Bank of Slovenia, however, did not choose an initial exchange rate targeting framework, but instead relied on regulating the quantity of money in circulation, with a managed float for the exchange rare regime.

    The Reports on Observance of Standards and Codes (ROSCs) for the financial sectors (published on the IMF’s public website for the Czech Republic, Hungary, Poland, and Slovenia), while recognizing the great strides made by each of the countries in assimilating international standards and best practices, also highlight the need to enhance enforcement of the regulatory and supervisory frameworks for banking and securities markets.

    Notably, however, stock market liquidity in both Hungary and Poland dropped sharply by 2000.

    Interestingly, there is no specific EU directive regarding bankruptcy or collateral legislation, so that the EU accession process has provided minimal guidance in this regard.

    For example, problems with repossession of (even highly liquid) collateral have impeded the development of an interbank repo market in Hungary. However, Hungary is currently in the process of amending its legal framework for financial institutions, and this issue is being addressed.

    Even FDI, which is typically viewed as the most stable form of capital inflow, could be increasingly vulnerable to reversals, since a growing proportion of FDI is coming in the form of intercompany loans and retained earnings.

    Nevertheless, there is some evidence to date that derivatives markets may remain underdeveloped in the CEC5 to the extent that the costs of domestic currency debt issuance makes hedging too costly.

    The failure of Hungary’s Postabank in 1997 was a clear case of weak corporate governance, including management misconduct, lack of strong control over management (owing in part to a highly dispersed private ownership structure), and low internal prudential standards (World Bank, 1999a).

    Moreover, according to Business Central Europe (2001b), the inexperience with derivatives markets led many company managers to use the nascent derivatives markets to play the market and attempt to hike profits, as opposed to containing risks.

    In May 2001, Hungary widened its ±2¼ exchange rate band to ± 15 percent. Hungary fully liberalized its capital account in June 2001, in part to support the development of hedging markets needed for a more flexible exchange regime.

    He (2000) examines in derail the appropriate circumstances and modalities of LOLR support.

    Again, in some of the CEC5, it is not just a matter of having the appropriate legal framework in place as regards financial safety nets, hut father the practice. For example, in the Czech Republic, in seven out of ten cases, depositors were reimbursed for the full value of their deposits, exceeding the legal limit on deposit insurance coverage (by a factor of ten, in the most recent case).

    Slovakia’s FSAP was scheduled for the 2002 fiscal year.

    The exception was Hungary. As a pilot participant in the FSAP, it was unable to publish its FSSA.

    CAMELS encompasses information on Capital adequacy, Asset quality, Management soundness, Earnings/profitability, Liquidity, and Sensitivity to market risk.

    This chapter builds on Corker and others (2000) in light of continuing experience in the central European countries, and elaborates certain themes in more detail—including notably medium-term goals for inflation, the implications of capital inflows, operational aspects of more flexible exchange rate regimes, and capital controls and policy safeguards.

    ERM2 is the transition regime toward adopting the euro. Its key features include an exchange rate hand with margins of ±15 percent around a declared central rate against the euro.

    An alternative would lie in a very hard peg, but none of the central European economics has adopted a currency board, and the circumstances that might favor that approach now lie largely in the past.

    A broader development affecting monetary policy implementation for the central banks concerned has been the shift: from direct to indirect monetary instruments. Although not always easy in terms of the uncertainties about the monetary transmission channels that came with it, such a shift has been generally successful and necessary in light of the need to create incentives for competition in financial markets (and help prepare for future EU/EMU membership).

    See, for example, Fischer (2001) and the citations therein.

    See Temprano-Arroyo and Feldman (1999) and European Central Dank (2000) for a fuller discussion of the requirements for EU accession and adoption of the euro.

    The second of the EU’s three Copenhagen Criteria.

    See van der Haegen and Thimann (2000) for additional discussion.

    The only clear incompatibilities with ERM2 are fully floating exchange rates, crawling pegs, and pegs against currencies other than the euro.

    See, for example, Halpern and Wyplosz (1997).

    The Boskin Commission concluded that 1-2 percentage points of measured inflation in the United States was due to improvements in the quality of goods and services. The potential for quality improvements in the transition countries is likely to he considerably higher.

    A range of research suggests that economic growth in market economies is reduced if inflation is above a threshold of about 10 percent; below this level, no significant effect is found (Sarel, 1996, and Khan and Senhadji, 2001). In the transition countries, Christof-fersen and Doyle (1998) found evidence of a somewhat higher inflation threshold (around 13 percent). They suggest that this threshold will decline toward the level found in market economies as inflation-inducing relative price adjustments subside. They found no clear evidence of a high output cost of disinflation in transition countries.

    One might therefore reasonably expect that inflation thresholds below which a reduction in inflation has no effect on growth are higher in advanced transition countries which are experiencing equilibrium real appreciation.

    Convergence plays are motivated by nominal interest differentials in favor of emerging market currencies which exceed the perceived risk of exchange rate depreciation.

    Also see Flood and Marion (1998) for an excellent review of the currency crisis literature.

    However, hedging is possible only to the extent that counter parties are willing to assume open currency positions.

    Among the transition countries, foreign direct investment has been important in financing a part of the current account deficit, but for the most part, these flows have been related to privatization, and will die out over the next few years. Unless an alternative financing source is found—whether autonomous FDI or tapping foreign debt markets—current account deficits will have to be reduced.

    In a general equilibrium framework, Bacchetta and van Wincoop (2000) show that trade is higher under a fixed exchange rate regime than under a flexible regime only when consumption and leisure are substitutes in households’ utility functions.

    Generally thin foreign exchange markets could create excessive exchange rate variability in the absence of official support, while large, lumpy capital inflows (associated for example, with major privatizations) can exert strong upward pressure on the rate. Moreover, given the shallowness of foreign exchange trading, sizable appreciations may occur in anticiparion of large future foreign currency receipts (a planned privatization, for example).

    The likelihood of conflicts between inflation and external objectives can he reduced by setting a relatively wide range for the inflation goal.

    Mishkin (1999) recommends introducing hard inflation targets only after adequate progress with disinflation has been achieved.

    Inflation targeting countries often assign foreign exchange intervention to deal with temporary external shocks, including smoothing excessive exchange rate fluctuations: for example, Australia, Canada and Chile engaged in sterilized intervention in response to the Asian and Russian crises to moderate the pace of exchange rate depreciation. See Schaechrer, Stone, and Zelmer (2000).

    Almeida and Goodhart (1998) and Bemanke and others (1999) find that output losses associated with disinflation are the same under inflation targeting and other monetary frameworks.

    For more discussion of the relevant technical aspects of inflation targeting see Bléjer and others (2000) and Schaechter, Stone, and Zelmer (2000).

    Among the reasons for signaling exchange rate prominence may be a concern to communicate to the market that, in leaving a regime involving a closely managed exchange rate, there is no intention to transition disruptively or envisage benign neglect. It would, however, be important to communicate that there would be significantly more flexibility than before.

    Also, since hedging costs may not be insignificant, agents may decide to assume the exchange rate risk rather than incur the cost of hedging.

    Moreover, the case for choosing a specific central-parity entry exchange rate under ERM2 may he strengthened if the prospective entrant can show that it has already successfully maintained that rate with limited variability for an extended period.

    Potential conflicts between wide exchange rate bands and an inflation targeting framework can be reduced by avoiding aggressive disinflation goals and by garnering support from fiscal policy.

    These commitments, however, do not necessarily foreclose the temporary reimposition of controls on short-term flows in the event of financial market turbulence.

    The safeguard clause of the Maastricht treaty allows countries to introduce temporary restrictions, including on capital movements, in the case of serious balance of payments difficulties. These restrictions can be introduced overnight, but must subsequently be sanctioned by the Council. There may be instances in which this safeguard can be activated for countries wanting to prevent surges in capital inflows in order to avoid serious external difficulties, but the conditions under which this might be permitted, if at all, have not been tested for the CEC5.

    Their main preoccupation has been with the case for transition periods on the purchase of land and real estate by nonresidents.

    Realigning the central parity in the downward direction (in the case of capital outflows) would delay accession to the euro since it would restart the clock on the exchange rate criterion. An upward realignment of the central parity (in the case of capital inflows) may permanently hurt competitiveness to the extent that the market exchange rate Subsequently gravitates to the more depreciated part of the (now higher) band.

    In addition, during the 1992 ERM crisis, Ireland, Spain, and Portugal were permitted to introduce or tighten existing controls on capital outflows.

    Net debt ratios are calculated as total external liabilities minus total external assets, both excluding direct investment and equity securities, using data reported in the IMF’s International Financial Statistics. This definition may differ from national classifications.

    Note that current account deficits are not strictly comparable across countries because of measurement issues. For example, the current account deficit in Hungary would be larger if retained earnings were included, but official estimates are not yet available.

    Recently, the Czech Ministry of Finance revised historical fiscal data, implying a lower deficit of 2.2 percent of GDP in 1999.

    All deficit measures are defined exclusive of privatization receipts (by the central government, in the case of Hungary). For the Czech Republic, the deficit measure used here includes grants to transformation agencies.

    In their PEP submissions, countries are requested to report their fiscal accounts on an ESA-95 basis, recognizing, however, that it may take some time to be fully compliant with this standard. By necessity, the analysis undertaken in this paper is based on fiscal data using current accounting standards. In Hungary, an attempt to derive the deficit on a system of national accounts (SNA) basis, broadly in line with ESA-95, suggests that the 1999 deficit on this measure would have been higher by, perhaps, 2½ percent of GDP. In Slovenia, it is estimated that past deficits would have been higher by ½–1 percentage point of GDP.

    For all countries, the primary balance is defined here as total revenue minus noninterest expenditure.

    The effect of data revisions on the 2000 deficit measure was only marginal.

    Nevertheless, several indicators suggest that the scope of government is still too large, for example, measuring government in terms of consumption and transfers relative to the OECD average. For a fuller discussion see Begg and Wyploz (1999). Also see Gupta and others (2001).

    Such contractionary effects may in any case be muted by high import shares—ranging from some 30 percent of GDP in Poland to 70 percent in Hungary and the Slovak Republic—and flexible exchange rate systems of varying degrees.

    A vast theoretical and empirical literature has emerged in recent years on the factors contributing to currency crises. For a comprehensive review, see Flood and Marion (1998), or, for a more succinct overview, Berg and others (1999).

    See Gupta and others (2000), who define large emerging market by annual private sector capital inflows of at least US$100 million a year—which would include all five countries under study.

    For empirical evidence, see, for example, Frankel and Rose (1996). An important advantage of FDI and other equity flows is their more favorable risk-sharing features, as the value of equity typically declines in the event of external crisis, while the value of external debt (if foreign-currency denominated) increases with a depreciating currency (see Lane and Milesi-Ferretti, 2000).

    External vulnerability may be of wider concern in economies with higher systemic importance, as spillovers into neighboring countries are more likely—and may also generate adverse feedback effects.

    For an earlier analysis of fiscal targets by country, based on information available in April 2001, see “Balancing Fiscal Priorities: Challenges for the Central European Countries on the Road to EU Accession” (pages 18–20), in “The Road to EU Accession—A Collection of Papers Covering the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia,” IMF 2001.

    The magnitude of the tax wedge has important implications for employment and output, as large tax wedges increase labor costs and thus reduce the offered wage and/or the demand for labor. Take-home pay is lower and workers therefore substitute toward leisure or home production, reducing labor supply. High taxation on labor income can also reduce formal employment and encourage gray market activity, with negative consequences on tax revenue.

    In theory, though probably unlikely in practice, the increase in the base can dominate the effect of the rate cut, with the result of rising overall tax revenues. This is generally referred to as the “Laffer-curve effect,” and is associated with high rates at the outset.

    These efforts would build on past successes in moderating tax distortions and lowering rates. Appendix II provides a brief overview of revenue trends and tax structures. It indicates that all five countries have introduced comprehensive tax reforms in the past and adopted market-oriented taxation systems that are generally compatible with those in EU countries. In this regard, it was particularly important to eliminate the most glaring distortions and to restructure the tax system in a way that enhanced its transparency and efficiency and brought it closer to EU-accepted norms. At the same time, many tax rates were reduced, while the restructuring and liberalization of the economies dried up traditional sources of revenue (for example profit transfers of state-owned enterprises).

    The EU accession requirements for tax administration are not as formal as the ones pertaining to tax policy, in that accession countries have the flexibility to define their own organization, systems, and procedures. However, it is crucial that these efforts be incorporated into overall tax administration reform strategies and not be implemented in isolation of other reform initiatives. In general, prospective measures toward accession include: establishment of a computerized system for exchanging information between tax and customs offices; introduction of a unique tax identification number across revenue agencies; establishment of a tax fraud unit; and preparation of a code of conduct for tax administration officials. However, the removal of border controls will pose administrative challenges for the collection of the value-added tax (VAT),

    Low effective collection could also be attributed to taxpayer characteristics (a different income distribution in transition countries than in western Europe, for example).

    Corporate income tax rates differ significantly across the accession candidates, ranging from 18 percent in Hungary to 31 percent in the Czech Republic. However, effective rates, which include incentives, are much lower, pointing to a fair degree of exemptions.

    There is no general agreement on the appropriate difference between marginal tax rates on capital and labor. A dual income tax with a lower tax rate on capital (the “Nordic Model”), which can be justified on economic efficiency grounds, has a number of practical advantages (related to the administrative difficulties of capturing capital income in the tax base), and can be viewed as one aspect of international tax competition for highly mobile capital (see IMF, 2000d). Opponents of this system, on the other hand, stress the economic and social cost of higher labor taxes, in terms of its negative impact on employment creation and equity.

    Tax holidays can do more harm than good to some firms when no proper loss carryforward provisions are in place (see Holland and Vann, 1998).

    An exception would be Slovenia whose standard VAT rate (at 19 percent) is slightly below the EU average of 19½ percent. For Hungary, which has the highest standard rate among the group, it has been suggested that revenue losses associated with its reduction could be possibly offset by an increase in the lower rate (Vamosi-Nagy and others, 1998).

    Such costs should not endanger the key objectives of the macroeconomic framework, however, including those pertaining to the external current account deficit. One important reason is that the additional impact on aggregate demand of interest payments on recapitalization bonds is likely to be small: these payments would serve to compensate for losses that would otherwise have been incurred by state-owned banks; and the recapitalization would go hand in hand with significant restructuring and financial discipline in the recapitalized banks. For more discussion, see Lane (1996).

    Another way of looking at demographic pressures—in addition to the demographic dependency ratio—is through the effective ratio of pensioners to contributors (the so-called system dependency ratio), which takes into account labor force participation and the level of unemployment. This ratio is also quite high in all countries, for example, 54 percent in the Czech Republic and almost 60 percent in Slovenia.

    Savings from the pension reform in Hungary have been projected to reach 3 percent of GDP by 2010 and 5 percent by 2040 (see Palacios and Rocha, 1998). For a description of the reformed pension system in Hungary, see World Bank (1999b) and Rocha and Vittas (2000), and of the new pension system in Poland, OECD (1997/98).

    Such measures could include reductions in both replacement incomes and financial incentives for early retirement, as well as stricter enforcement of eligibility requirements for disability pensions.

    Thus, the external current account should not be much affected. The Polish government reports both the actual fiscal balance and the balance adjusted for the “pension-switching effect.” The use of an adjusted balance is appropriate for developing a mediumterm macroeconomic framework and setting fiscal targets, as long as care is taken to correspondingly adjust private saving downward.

    Experience with pension reforms in some countries shows that markets may attach higher risk to explicit than implicit debt.

    Poland has adopted a major reform of its health care system at the beginning of 1999, involving the introduction of a compulsory insurance system and a split between purchaser and provider functions. While this should ultimately improve the efficiency and quality of services, a number of “teething problems” have emerged (see IMF, 1999c). For a discussion of the new health system’s main features, see OECD (1999/2000). The Slovak Republic will also face some upfront costs in the process of health reform, associated with the high debts that have been accumulated by the health funds.

    Such measures could include improved incentives for cost control, for example, by reducing pharmaceutical subsidies and introducing deductibles and co-payments.

    In Agenda 2000, the European Commission initially introduced the idea that certain parts of the acquis were a higher priority than others and, in that connection, it outlined a three-stage framework for the adoption of the acquis by the applicant countries. The Commission has defined its policy on transition periods in the following way: for areas linked to the functioning of the Single Market, regulatory measures should be implemented quickly, and any transition periods should be few and short. However, for those areas where considerable adaptations are necessary and which require substantial effort, including important financial outlays (in areas such as environment, energy, and infrastructure), transition arrangements could be spread over a definite period of time, provided candidates can demonstrate that alignment is under way and that they are committed to detailed and realistic plans for alignment, including the necessary investments (see European Commission, 1997).

    In Hungary, for example, almost one-third of estimated annual accession-related spending of 2½ percent of GDP in 2000 and 2001, was projected to be covered by EU assistance under Phare, ISPA, and SAPARD (see IMF, 2000b). Similarly, with regard to environmental and infrastructure investments, fairly long transition periods would move a substantial part of the cost into the post-accession period, when transfers (from the Common Agricultural Policy, the Structural Fund, and the Cohesion Fund) would be expected to be more sizable.

    The presentation excludes Luxembourg, with the highest per capita income and the lowest public consumption ratio within the EU. Including Luxembourg would result in a flat trend line for the relationship between income and consumption. The positive income correlation with total primary current spending and transfers would still hold.

    In the Czech Republic, the high share of transfers and the associated low share of public consumption reflects differences in classifications as transfers to health insurance funds, which were equivalent to more than 5 percent of GDP in 1998, are not included in consumption but in transfers to household.

    See Gupta and others (1999) for a discussion of the effects of public spending on education and health.

    These institutional requirements include, among others, program budgeting, performance orientation, output costing, comprehensiveness of the budget, proper internal and external accounting procedures, and economic impact analysis.

    This section draws on similar analyses in IMF (1999d) and IMF (2000c), and the literature cited there. The papers are available on the IMF’s website at

    Retiring public debt could also foster market confidence and have a favorable signaling effect by reducing risk premia and thus leading to lower future borrowing costs.

    Efficiency gains from fiscal decentralization are associated with the benefit (or sub-sidiarity) principle, suggesting that a given service should be provided by the level of government that most closely represents the region benefiting from such service. For an in-depth discussion of issues of fiscal federalism, see Ter-Minassian (1997), and Dunn and Wetzel (2000) for a focus on transition economies.

    To improve budgetary discipline, fiscal ROSC (Reports on the Observance of Standards and Codes) modules—based on the IMF’s “Code of Good Practices on Fiscal Transparency” available on the IMF’s website—are a useful instrument. These modules, usually prepared by the IMF in collaboration with country authorities, describe fiscal operations, reporting and their legislative basis, and identify areas for possible improvement.

    Such factors include, among other things, the exchange rate system, the sources of the current account deficit, the nature and maturity profile of capital inflows and debt stocks, and the soundness of the financial sector. For a discussion of these and other factors contributing to currency crises, see Berg and others (1999).

    It should be noted that the condition of a nonincreasing debt ratio is not identical with the theoretical notion of fiscal sustainability, derived on the basis of the government’s present value budget constraint (PVBC). An analysis of the latter typically answers the question whether current (or alternative) policies can be sustained over the long run. This is not the question addressed here, as countries are assumed to target a long-term balance or surplus. In any event, the above condition is often used as a substitute for the PVBC (see, for example, Blanchard, 1990), due to its appeal in terms of intuition and simplicity. Its principal weakness—which is further discussed below—is its arbitrariness. For a discussion of alternative approaches to assessing fiscal sustainability, see Chalk and Hemming (2000).

    Buiter (1985) analyzes fiscal sustainability on the basis of net debt (or net worth) as a share of GDP, but the gross debt concept, used by Blanchard (1990), finds a wider application, reflecting the general difficulty of obtaining accurate information on the true size of government net worth (see Chalk and Hemming, 2000).

    The figures are actual ratios of nominal general government debt, as a share of GDP, in 1999, consistent with the definitions used in IMF staff reports and the World Economic Outlook.

    If interest rates were 1 percentage point higher, the fiscal positions would have to he tighter by 0.1 percentage points of GDP in the Czech Republic (with the lowest initial debt ratio) and 0.6 percentage points in Hungary (with the highest ratio).

    The other three countries have already incurred most of the fiscal cost of their banking and enterprise restructuring.

    The debt ratio (including the implicit liabilities) would remain close to 50 percent it privatization receipts were zero over the 2001–05 period and the primary deficit was kept below 1/2 percent of GDP.

    The pension effect can alternatively be accounted for directly in the debt sustainability analysis by adding the unfunded net pension liabilities (that is, the present value of the projected pension expenditures minus projected contributions) to the debt level (see Chalk and Hemming, 2000), However, this approach—which can be useful for assessing the sustainability of current policies—would assume that no reforms be taken to curb the fiscal implications of the demographic shock, which is not the position taken in this paper. Thus, future pension expenditures are treated in a manner consistent with other spending obligations, discussed in Chapter 7.

    In the absence of adverse demographic developments, this argument can he used to justify targeting a small fiscal deficit, rather than balance or surplus, over the longer term.

    For empirical support see, for example, Milesi-Ferretti and Razin (1996) and (1998), and Frankel and Rose (1996).

    For an attempt, applied to Poland, see IMF (2000d).

    For a similar approach applied to Hungary, see IMF (1999a) and IMF (2000e).

    Alternatively, the exercise could be tied to a constant net foreign liability ratio that also includes nondebt-creating liabilities and assets, as the latter also lead to prospective outflows in the form of dividends and profit transfers abroad. This exercise chooses debt ratios for three reasons: they (i) receive more attention by markets when external vulnerabilities are concerned; (ii) are less subject to valuation effects than equity investments (through stock price fluctuations); and (iii) avoid the problem of inconsistent treatments of retained earnings in the individual country’s current account measures.

    It should be noted that a country’s debt burden is often assessed in relation to its exports rather than GDP. This is particularly relevant for less developed countries with foreign exchange constraints, due to limited access to international financial markets—a situation that does not pertain to the five accession candidates. Here, relating the external debt burden to GDP is more suitable for determining the countries’ overall debt-servicing capacity.

    A similar approach is used for the case of Hungary in IMF (1999a).

    Net external debt is defined, in this context, as gross foreign liabilities minus assets, as reported in the IMF’s International Financial Statistics, both exclusive of FDI and equity portfolio investment.

    To translate real GDP growth into growth rates in foreign currency terms, foreign inflation, on the basis of the GDP deflator, is assumed to be 2 percent annually, in line with recent historical averages in the United States. The bilateral real exchange rate (also on a GDP deflator basis) is assumed to be constant. This is a conservative assumption for net debtors, as an appreciation of the real exchange rate (expected, due to higher productivity growth in the catch-up process) would translate into a higher current account deficit limit to maintain a given debt ratio. For example, if an appreciation of the real exchange rate increased GDP growth in foreign currency terms by 1 percentage point, the current account deficit in the net debtor countries could be 0.1–0.3 percentage points of GDP higher to maintain a stable debt ratio.

    The fiscal balances in the five countries are not always identical with the national accounts definition of public saving and investment. However, the changes in both can reasonably be assumed to be of similar magnitude.

    For simplicity and lack of empirical clarity, it is assumed that the offsetting adjustment in the private sector balance is independent of the structure of fiscal adjustment. However, as indicated in Box A1, the individual reaction of private saving and investment ratios (as opposed to their balance) is expected to depend strongly on whether the fiscal adjustment is revenue or expenditure driven.

    The presumption of falling saving ratios in expectation of rising income levels finds its theoretical foundation in the life-cycle and permanent income hypotheses, both of which stress the role of private saving to smooth consumption over time. Liquidity constraints and uncertainty, however, may prevent full intertemporal consumption smoothing, and empirical evidence is mixed. For the above and other factors that have been found empirically to influence saving rates, see, for example, Masson and others (1995), Savastano (1995), Callen and Thimann (1997), and Dayal-Gulati and Thimann (1997). For an empirical application to advanced transition economies, see IMF (2000b).

    This fairly short reference period is chosen as being more representative of current structures, given the fast structural changes in these economies over recent years,

    As indicated earlier, a higher offset would imply larger changes in the fiscal position to achieve a given current account objective. For example, if the “offset factor” is two-thirds, rather than one-half, a 1 percentage point of GDP revision in the exogenous outlook for the private investment ratio (assuming unchanged projections for private saving) would imply a change in the fiscal target by 3 rather than 2 percentage points of GDP.

    Strictly speaking, the targeted current account deficits in Tables A3 arid A4 are nor fully compatible, as the former refers to the average over 2000–05 and the latter to the deficit in the year 2005 only. However, given the fairly arbitrary nature of the underlying debt targets this discrepancy is further ignored.

    While providing yardsticks, comparisons are not meant to imply that the revenue structures and levels in the EU are necessarily the most appropriate targets for the accession countries. Indeed, many EU countries are in the process or reforming their tax systems, in order to lower the tax burden, particularly on labor income.

    See IMF (1999d) and OECD (1999). The effective tax wedge (including the effect of indirect taxes) would be even higher (70 percent in Hungary, for example).

    There has been a lot of discussion in the literature on the direction of the effect of labor taxation on the level of income and the rare of economic growth. Plosser (1992) finds that taxes on income (and profits) are growth depressing: an increase in the average income tax of 0.05 percent is associated with a reduction in the annual growth rate of more than 0.4 percentage points. Various other studies have also found a negative relationship (see Slemrod, 1995, for an overview), hut some have raised doubts about the robustness of such a relationship (for example, Easterly and Rebelo, 1993, point out that that “the evidence that tax rates matter for growth is disturbingly fragile” as the negative correlation disappears when the initial level of income is controlled for).

    This implies that the effective tax ratio would he higher in the central European countries (or lower in the EU), it derived on a comparable basis.

    Lacko (1995) estimated that the size of the hidden economy in Hungary was 30 percent of official GDP in 1990 and that it increased by 4–5 percentage points between 1990 and 1993, In Slovakia, official statistics point to a gray economy of about 20 percent of official GDP, but unofficial estimates suggest an even bigger size.

    It was not until 2000 that the CIT for Poland and Slovakia were reduced to 30 percent from 34 percent and to 29 percent from 40 percent, respectively.

    As IFC (1999) notes, although several countries in the region have offered special incentives for privatization, foreign investors are more likely to be attracted by basic opportunities to earn profits. In the case of privatization, low asset prices—which yield immediate and certain benefits—are more cost-effective than tax incentives in attracting foreign investors.

    It has been reported that Hungary is planning to eliminate most of the existing allowances by 2002–03.

    Tax incentives granted to particular sectors may be justified on the grounds of domestic market failures, if the industry under consideration generates a positive externality to the rest of the economy. These externalities, however, are hard to quantify, and it is therefore difficult to determine how much government support a particular industry should receive. In the absence of any spillovers, artificial investment incentives misallocate resources, since they create effective tax rates that differ across sectors and regions. Broadway and Shah (1992) conclude that a number of incentives provided by developing countries yielded windfall gains to investments that would have occurred even without government support. Holland and Owens (1997) review investment incentives used in a number of transition countries, and provide recommendations on the use of taxation to attract FDI.

    These calculations are based on a 40 percent rate for Slovakia (that is, before the recent rate cut) and do not capture the impact of Poland’s end-1999 CIT reform. This latter reform foresaw a gradual reduction in Poland’s CIT rate from 34 percent in 1999 to 30 percent in 2000, 28 percent in 2001–02, 24 percent in 2003, and 22 percent in 2004. It also included the abolition of some tax incentives. Moreover, the effective rate for the Czech Republic may be distorted by recession-related loss carryovers.

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