Transition to Market

Chapter 3 The Czech and Slovak Federal Republic: Government Finances in a Period of Transition

Vito Tanzi
Published Date:
June 1993
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Jim Prust

This chapter discusses the ongoing transformation of public finances in the Czech and Slovak Federal Republic. It starts with a survey of the constitutional crisis created by pressures for secession from the federal state for the country’s constituent Czech and Slovak Republics. This is followed by a brief overview of the state of the Czechoslovak economy in the late 1980s and of developments since the “Velvet Revolution” of December 1989, then by a summary description of the structure of the public finances, and finally by a discussion of some of the main issues now facing fiscal policymakers. These issues include macroeconomic stabilization, tax reform, subsidy reduction, and price reform, as well as concerns raised by the ongoing, and related, processes of privatization and restructuring of bank balance sheets.

Constitutional Issues

When the communist regime was overthrown in December 1989, the preservation of the federal state encompassing the Czech and Slovak Republics did not appear to be seriously in question. Although demands for greater autonomy for the republics, and especially for the Slovak Republic, were openly voiced from the outset of the reform process, it was generally assumed that the two republics would both continue to adhere to the federal state.

Apart from historical and cultural factors, the appeal for autonomy (and later for secession) in the Slovak Republic was nurtured by distinctive features in the structure of its economy and in its performance during the reform period from 1990. Heavy industry, including an important arms producing sector, has been dominant, relying mainly on intra-CMEA1 trade for its markets and for the supply of relatively cheap raw materials. Consequently, it was hard hit by the collapse of the CMEA and a decline in the arms trade. The period of economic reform thus coincided with a steeper decline in activity and rise in unemployment in the Slovak Republic than in the Czech Republic. These factors have underpinned a widespread attachment in the Slovak Republic to preservation–or at most very cautious reform–of the state-owned industrial sector. In the Czech Republic, by contrast, support for rapid reform of the state sector is stronger, as evidenced by the results of the election in June 1992.

It is conceivable that independence for the two republics would, in the first instance, accelerate the pace of reform in the Czech Republic, while having the opposite effect in the Slovak Republic. However, the outlook is highly uncertain. Any attempt to anticipate future events can only be speculative. Thus, vital though they are to the country’s future, constitutional issues and their implications are not discussed further below.

The Czechoslovak Economy in the Late 1980s

The intensity of macroeconomic imbalances with which post-communist policymakers in the Czech and Slovak Federal Republic have had to contend has been considerably less than elsewhere in Central and Eastern Europe. During the years of communist rule, the extent to which macroeconomic imbalances–as evidenced, for instance, by external debtservicing difficulties and by open or repressed inflation–were allowed to emerge was considerably less than in many other economies in the region. Against this background, the post-communist governments have been able to proceed rather fast with the liberalization of prices and external trade and with the concomitant changes in the tax and subsidy regimes, while avoiding excessive inflation or balance of payments problems.

Prior to World War II, Czechoslovakia was an advanced industrial country with income levels comparable to those then prevailing in Western Europe. Although this favorable heritage eroded over time, it was not completely obliterated during the years of communist rule. Partly as a result of prewar traditions, as well as because of disenchantment with the quality of manufactured imports from other CMEA countries, Czechoslovakia produced an extremely wide range of manufactures. On the eve of the dramatic changes of 1989, its economic situation compared favorably with that of other Eastern European economies. Based on current commercial exchange rates, per capita income in 1988 was estimated at the equivalent of US$3,300, high by Eastern European standards; estimates based on purchasing power comparisons are substantially higher.

Czechoslovakia weathered the problems of the 1980s relatively well. External debt was low to start with, and the authorities pursued a cautious policy with respect to foreign borrowing; the debt-to-export ratio in convertible currencies, which reached a peak at just under 120 percent in 1980, was far lower than in neighboring Hungary and Poland. Modest external financing pressures in the early 1980s necessitated a temporary curtailment of domestic expenditure. Thereafter, however, moderate growth in output and consumption was resumed during the remainder of the decade. Officially recorded prices were virtually stable, and there were no external financing problems.

Although monetary aggregates increased faster than nominal output, most commentators, supported by anecdotal evidence, are of the view that problems of repressed inflation and shortage were far less acute in Czechoslovakia than in many other countries of the region. The general perception–although hard to corroborate unequivocally–is that this relatively fortunate state of affairs was partly attributable to the greater importance attached to financial developments by the central planners in Czechoslovakia than in most other planned economies.

In sum, the change of regime in Czechoslovakia in 1989 was not preceded by any dramatic economic crisis. The weakness in economic performance was primarily a secular one, which the–in some ways–favorable performance of the economy in the 1980s had done little to address. In fact, the upward trend in consumption that had been maintained during the decade had only been possible at the cost of a falling share of resources being devoted to investment. Gross investment in real terms in 1989 was only slightly higher than in 1980. Meanwhile, net investment was lower by almost one half because of rising provisions for capital depreciation. The result was a growing obsolescence of the country’s capital stock and an increasingly poor performance of manufactured exports in world markets.

The communist regime recognized, albeit belatedly and only after the adoption of perestroika in the U.S.S.R., that the country’s economic strength was eroding progressively. In December 1987, the Communist Party adopted a reform plan to be introduced in stages. A number of the envisaged measures were implemented in 1988-89. These included a simplification of the administrative hierarchy overseeing industry and agriculture and the breakup of a number of large enterprises into smaller units; a considerable reduction in the degree of detail incorporated in plan directives; increased scope for activity by cooperatives; a weakening of the state monopoly on foreign trade; adoption of a new joint venture law allowing foreign majority participation and profit repatriation; and preparations for the establishment of a two-tier banking system to replace the existing monobank system. A foreign exchange retention scheme for exporters and a foreign exchange auction were introduced, although the latter operated only on a very small scale. As a first step in price reform, wholesale prices were restructured to reflect the requirement of a uniform rate of return on capital, and a reduction in the incidence of price controls was planned.

The initiatives of the post-communist government had thus, in some respects, been anticipated. The program of economic reform and the associated legislation adopted in 1990 were, however, qualitatively different from their immediate antecedents.“Reform within the system” was abandoned as an objective and the new point of departure was the desirability of a massive reduction in the role of the state in economic life and of a correspondingly drastic increase in the importance of private activity.

As in Poland and Hungary, the architects of the current economic reform in the Czech and Slovak Federal Republic had earlier relevant experience on which to draw, notably from the “Prague Spring” period of 1968 and the buildup to it. At that time, considerable thought was given, and some concrete progress achieved, in decentralizing economic structures. In fact, the reform plans formulated in the late 1980s had many similarities to what had been attempted twenty years earlier. Although the reformists’ experimentation was stopped in its tracks by the Soviet invasion of August 1968, the experience gained at that time is likely to have left some intellectual legacy in the form of a relatively high level of awareness on the part of policymakers and officials of the issues to be faced. However, as noted above, the boldness of the reform plans adopted in 1990 had no parallel in earlier experience.

In the first six months after the installation of the post-communist government, the authorities were largely preoccupied with the preparation and passage of a large body of reform legislation. Its essential aim was to remove restrictions on private economic activity, to encourage foreign investment and foreign trade, and to pave the way for the denationalization of state enterprises.

Although certain basic objectives were generally supported, views diverged on the appropriate pace of change and on the details of particular measures. These were discussed within the Government in the first half of 1990. In May, a resolution dealing comprehensively with a range of economic reform issues was adopted by the interim Government and subsequently endorsed by the Government that assumed office after elections in June. The resolution called for, inter alia, the rapid liberalization of prices and external trade and major changes in the exchange system and depreciation of the exchange rate as parts of the macroeconomic context in which the transformation to a market economy was to take place. The potential inflationary impact of these measures was to be contained by restrictive monetary and fiscal policies.

In their broad thrust, policies have subsequently remained faithful to these early guidelines. Fiscal policy, which has been supported by a tight monetary policy, has so far successfully prevented the emergence of large budget deficits and, consistent with the objective of reducing the economic role of the state, both revenues and expenditures have fallen in real terms. In particular, price subsidies have been sharply reduced, which has led to a drop in real incomes. The authorities aim to prevent the emergence of a major imbalance in the fiscal position. A continuing curtailment of expenditure will be needed to achieve this objective until the declining trend in output, and thus in the tax base, is reversed.

Fiscal System

As in other planned economies, general government revenues and expenditures have been relatively large. Both expanded in the second half of the 1980s, and in 1989 accounted for about 70 percent of GDP.

Relations Between Levels of Government

The main components of general government are Central Government, which includes the budgets of the Federal Government and of the Czech and Slovak Republics, and local authorities operating at the regional, district, and local levels. In 1989, the last full year before the revolution, the Central Government accounted for 60 percent of general government outlays and the local authorities for just over one fourth. Central Government's share in general government revenues was higher (more than 70 percent) and that of local authorities lower (about 18 percent). Operations by the small number of extrabudgetary funds have been minimal. Of greater importance until their virtual elimination in 1990 were the so called Funds of the Ministries, controlled by certain ministries and largely used for cross-subsidization of enterprises.

Excluding intragovernmental transfers, in 1989 the Federal Government and the Czech Republic accounted for 45 percent and 34 percent of central government budget expenditure, respectively, while the direct expenditures of the Slovak Republic accounted for just over 20 percent of the total. The pattern of revenue collection was markedly different. The Federal Government accounted for two thirds of central government receipts, while the Czech Republic contributed 21 percent of the total and the Slovak Republic the remaining 10 percent. These disparate shares of different components of government in revenue and expenditure, respectively, were made possible by substantial transfers of funds from the Federal Government to the republics. In 1989, such transfers were equivalent to two thirds of the total direct expenditure of the Czech Republic and over three fourths of that of the Slovak Republic. In addition to their direct expenditures, the republics were responsible for transfers to various local government units in their territories, and to the extrabudgetary funds.

Arrangements for the allocation of revenue and expenditure responsibilities have been modified over time. Prior to 1986, each level of government received the income taxes paid by the enterprises and labor force under its jurisdiction. The Federal Government was responsible for “strategic” industries, such as energy, metallurgy, railroads, and communications. The republics managed other industries, while services and small businesses reported to local authorities. The proceeds of the turnover tax and foreign trade levies accrued to the Federal Government. Some changes to these arrangements were made in 1986. Wage tax revenues previously accruing to the republics were diverted to local authorities, with transfers to the latter being reduced by an equivalent amount. Further major changes took place in 1990-92 to eliminate the need for transfers to the republics from the Federal Government; some transfers were, however, reinstated in 1992 as part of an overall agreement on revenue sharing. At the time of writing, revenue from the profits tax and the turnover tax–the two main taxes–is divided among the Federal Government, which receives 35 percent of the total, and the Czech and Slovak Republics, which receive 41.5 percent and 23.5 percent of the total, respectively. At the same time, the republics have taken over some of the expenditure responsibilities hitherto assigned to the federation as well as some others from the local authorities.

Structure of Government Expenditure

Most general government expenditure (approaching 90 percent) was on current items in the late 1980s. Capital expenditure consisted mainly of transfers to enterprises. Subsidies, whose share in expenditure fell sharply in 1990 and 1991, and social transfers together constituted well over one half of total current expenditure; most of the remainder consisted of wages and salaries and expenditure on goods and services. The social security system provides benefits to retired and disabled persons and widows, child allowances, and maternity, sickness, and (since 1990) unemployment benefits. The Government's domestic debt–to the banking system–has been insignificant and interest payments correspondingly small; external debt has been carried on the books of the banks.

Revenue System

About three fourths of general government revenues have derived from taxes; in the late 1980s, enterprise profits tax and turnover tax both contributed about 25 percent of the total. The payroll tax, conceived as the employer’s contribution to social security, accounted for about 10 percent of general government revenue and the wages tax for a similar share of the total. The payroll tax is paid by enterprises and the wages tax is withheld by them. The vast majority of tax receipts have thus been collected directly from the enterprises. Taxes collected from individuals and private businesses have been minimal.

The profits tax is currently collected under three different laws applying to different types of enterprise. The general rate of tax is 55 percent, compared with rates of 75-85 percent before revisions started to be made to the relevant laws in 1989. There are, however, certain exceptions to these general rules. Lower rates apply to joint ventures with at least 30 percent foreign participation (40 percent) and to agriculture and the food industry (50 percent); a special progressive rate structure applies to hotels and restaurants. The definition of profit for tax purposes is restrictive: various items, including advertising, are treated as a discretionary use of profit rather than a cost. In addition, depreciation schedules are typically very long.

Individual incomes are liable to various taxes depending on their type. The most important is the wages tax, which is a withholding tax on wages, salaries, and any other employment compensation. Exempt incomes include sickness benefits and social security payments. The tax is imposed on a monthly basis without annual adjustment and is remitted by the employer. There is no aggregation of the income of different family members; credit for dependents may only be claimed by one taxpayer with one employer. Rates are adjusted depending on taxpayers’ family circumstances. For taxpayers with two dependents, a sliding scale of tax rates from 5 percent to 20 percent applies on monthly income of up to Kčs 10,000 and a flat rate applies to incomes above this level. In 1992, the latter rate was set at 33 percent and, at the same time, tax rates, at all income levels, were doubled for those receiving both a pension and a wage. These changes were made to increase the progressivity of the tax system and the targeting of (after tax) social benefits.

Two other taxes apply to individual incomes. The so-called citizens’ income tax was introduced in 1990 and applies, among others, to income from trade, crafts, private agriculture, the liberal professions, and investment income from real and financial assets (but excluding interest on bank deposits). There is a progressive rate structure from 15 percent to 45 percent on net income up to just over Kčs 1 million; a 55 percent rate applies on income above that level. Another tax on income from literary and artistic activities has a rate schedule ranging from 3 percent to 33 percent on a progressive scale on income up to Kcs 50,000 annually. Thereafter, a rate of 33 percent applies.

In addition to the above, a payroll tax, which notionally finances the social security system, is applied to all wages at a rate of 50 percent (20 percent prior to 1989) for most sectors but at lower rates for some, including the expanding services sector.

The main indirect tax is the turnover tax. It is levied principally on final consumption goods; exports are exempt. Until 1991, the tax was typically levied as a proportion of the difference between the relevant wholesale and retail prices net of allowed trading margins. This has now been replaced by a system of ad valorem rates.

Property is also subject to taxation, although, partly as a result of numerous exemptions, revenues from this source have been small. An agricultural land tax is levied as varying amounts per hectare depending on terrain, soil, and climatic conditions. There is also a tax on buildings, but it does not apply to those under socialist ownership.

Current Fiscal Issues

Overall Objectives of Fiscal Policy

The salient features of Czechoslovakia’s macroeconomic position on the eve of its post-communist transformation were that foreign debt was low, the balance of payments relatively strong, open inflation minimal, and repressed inflation less of a problem than in other formerly planned economies. In the late 1980s, the fiscal balance weakened somewhat. Transfers and budget-financed social consumption were on an unsustainable rising trend; the immediate effect of price restructuring was a jump in subsidies, particularly on food; and the sluggish output affected revenue. As a result, the general government’s financial position was in deficit throughout the second half of the 1980s; abstracting from some once-for-all transfers, the deficit was equivalent to about 2.7 percent of GDP in 1989. Nevertheless, this situation constituted a relatively propitious point of departure compared with that of many other reforming economies. Correspondingly, the need for fiscal adjustment as measured by changes in the Government's net financial balance has been relatively small, particularly given the tight credit policies that the monetary authorities have been following.

In 1990, the authorities planned for a small central government budget surplus. Abstracting from the effects of transfers to the banking system to cover devaluation losses on net liabilities in foreign currencies and the takeover of export credits from the State Bank, this target was achieved, largely because virtually all categories of expenditure were restrained.

In 1991, the authorities planned a further surplus of just under 1 percent of GDP. Consistent with the objective of systematically reducing the role of government in the economy, budget plans called for substantial cuts in the real value of both revenues and expenditures. In the event and excluding some exceptional items, the share of general government revenues in GDP fell by almost 10 percentage points to less than 53 percent, mainly owing to reductions in the rates of profits tax and certain turnover taxes and the abolition of foreign trade levies. In addition, revenues were adversely affected by the permitted lags in the collection of citizen's income tax on private sector employees and, more generally, by the increase of the share of the less easily taxed private sector in the tax base.

There was also a cut—of about 8 percentage points to around 55 percent—in the share of general government expenditure in GDP, again excluding some items related to once-for-all stock adjustments. Subsidies were cut most drastically. Even after completion of the takeover of responsibility by the budget for subsidies on low-interest loans for housing and to newly married couples, budgetary subsidies were reduced from 13 percent to 7 percent of GDP. The remaining retail subsidies were abolished in May 1991 and subsidies to agricultural producers were cut by one third. Real government consumption is estimated to have fallen by about one quarter, reflecting in part lags and restraint in adjusting government wages. Real capital expenditure and transfers fell by almost 40 percent. Social security outlays were also considerably eroded in real terms, since pensions were not fully adjusted for price rises and then only with a lag, and family benefits were not adjusted at all.

The budget balance was very strong in the first half of 1991 with the general government surplus equivalent at an annual rate to about 5 percentage points of GDP. Partly because of the initial effects of price liberalization on profits and the value of inventories, revenues were buoyant and, in addition, expenditures were particularly tightly controlled. With GDP falling, however, this situation unwound rapidly in the second half, and a general government deficit equivalent to approximately 2 percent of GDP was recorded for the year as a whole.

Containment of the fiscal deficit in 1992 and beyond will not be easy, especially as the scope for further expenditure cuts diminishes. The Czech and Slovak Federal Republic faces many of the same problems as other reforming economies in this connection. These include a falling revenue base in the contracting portions of the state enterprise sector, partly induced by the abrupt decline in trade with the former Soviet Union; administrative difficulties in immediately extending the tax net to the nascent private sector; and growing demands for certain types of expenditure, including unemployment benefits, during the period of transition. Clearly, the earlier that structural reforms lead to a reversal of the current declining trend in output, the easier will policy choices become.

As described above, the authorities have already substantially reduced the size of government revenues and expenditures in relation to that of the economy as a whole. The old system of economic management involved–to a much greater extent than in typical market economies—the provision by the state sector (including enterprises) of goods and services that were either free or heavily subsidized, such as housing, education, health care, transportation, and various cultural and recreational amenities. These items were, in effect, largely paid for by heavy taxes and other levies on the financial surplus of the enterprise sector. The corollary of these levies was that wages paid directly to the work force had to be relatively low. (Indeed, the disparity with, say, Western Europe in average wages per capita was greater than that in GDP per capita.) The advent of a market economy will require substantial modifications to these arrangements. Essentially, reduced provision of goods and services by the state through nonmarket channels will, other things being equal, permit a reduction in the relative size of government revenues. In addition, a shift of the total tax burden away from the enterprise sector to indirect taxes and personal income taxes will be needed if corporate tax rates are to be brought closer to levels typically prevailing in market economies—an important objective if foreign investment is to be attracted and domestic investors placed on a comparable basis to their foreign competitors.

Tax Reform

The authorities’ ultimate aim is a full-fledged reform of the system of taxation of incomes and expenditure. In essence, a system dominated by discretionary levies by the central authorities on enterprises' financial surplus is to be replaced by one in which an arms-length relationship, governed by predetermined and legally binding rules, exists between taxpayers and the tax authorities. The introduction of such a system will, of course, require major changes in the philosophy and practice of tax administration with regard, for example, to the registration of taxpayers, the filing of returns, collection of payments, and audit procedures.

On January 1, 1993, the authorities plan, according to the provisions of legislation that have already been passed, to introduce a value-added tax (VAT), a new regime for the taxation of corporate profits corresponding in its essential features to arrangements typically applied in market economies, and a “global” income tax applying to all personal sector incomes. Also in 1993, the authorities plan to create separate social security funds; these are to be financed by wage-based contributions from both employers and employees that will replace the existing payroll tax. The implementation of these reforms will, of course, be affected by the way in which the powers of the governments of the republics evolve.

Pending implementation of a full-fledged tax reform, the authorities have been quick to recognize the need for interim changes in the tax system. This need stems both from the necessity to safeguard revenues as well as to support the liberalization of the pricing and exchange and trade systems that has already been undertaken.

The most obvious candidate for immediate modification was the turnover tax system. As described above, turnover tax rates had previously, in effect, been determined as the difference between wholesale and retail prices. Small changes in the relationship between the two prices could thus have large, and unintended, effects on tax receipts–a phenomenon that was clearly inconsistent with a regime of flexible prices. The authorities made several important changes to address these problems in late 1990. Turnover tax rates were expressed in ad valorem form, and four rates were established (0, 12, 22, and 32 percent); these rates were reduced in mid-1991 to 0, 11, 20, and 29 percent. A consumer tax (in effect an excise tax) applies at higher implicit rates–the tax is generally specific–to selected items such as alcoholic beverages, tobacco, petroleum products, and passenger cars.

Reform of the pricing and foreign trade system has also necessitated changes in the taxation (and subsidization) of foreign trade. Previously, levies (or subsidies) applied on the difference between import prices and domestic wholesale prices for selected items, including energy products, steel, and other raw materials. This system, which had already been modified in 1989, represented the remnant of an earlier system in which taxes and subsidies had been deliberately and comprehensively applied to remove the difference between domestic and international prices. The rationale of this system lay in the major differences in relative prices between Czechoslovakia (and CMEA countries generally) and the rest of the world. However, with the collapse of the CMEA system and the authorities' desire to link domestic and world prices, this rationale collapsed. The remaining taxes on international trade thus consist only of customs duties and a surcharge, imposed in 1991, of 20 percent (later reduced in two stages to 10 percent) on imports of consumer goods.

Regarding taxes on income and profits, the authorities have also inherited a regime many of whose features–in addition to the high level of tax rates–are inconsistent with their market-oriented policies. One main problem concerns the treatment of capital depreciation, which is markedly different from practices in market economies. Prior to the recently introduced changes described below, depreciation schedules–of which there were over 140–were typically much longer than in market economies. There was a simpler regime for firms with less than 100 employees for which annual rates of depreciation of 2 percent and 12 percent applied to fixed and movable assets, respectively. This provision is thus available to recently established small businesses. In a further effort to allow new businesses to avail themselves of depreciation provisions more similar to those in effect in market economies, a number of changes were introduced in 1991. Accelerated depreciation was made available to cooperatives, joint ventures with over 30 percent foreign participation, and for physical persons taxable under the profits tax law. Fifty percent of the value of movable assets may be depreciated in the first three years of their life.

Another important issue is the lack of provision for loss carryforward in existing arrangements for corporate taxation. Tax holidays are being used as a substitute. Tax holidays are granted at the discretion of the level of government (federal or republic) having jurisdiction over the relevant enterprise. Governments are empowered to grant tax holidays to newly established enterprises—whether domestic or joint ventures—for up to a maximum of two years on condition, inter alia, that savings from nonpayment of taxes be applied to investment. Of the total of 1,600 joint ventures founded in 1990, about 150 received tax holidays. Almost all applications were granted.

In addition to tax holidays granted ex ante, the authorities have considerable discretion in easing tax liabilities ex post. Again, the authority lies with the level of government having jurisdiction over the enterprise in question. In practice, though, this provision has been little used and a further similar provision in the profits tax law to allow a reduced rate of profits tax for joint ventures has not been used at all.

Subsidies and Price Reforms

Budgetary subsidies in Czechoslovakia were relatively less important than in many other planned economies and were concentrated on a narrow range of items. While prices for energy and most primary materials were low, this to a large extent arose from the peculiarities of the pricing arrangements that applied in intra-CMEA trade. Domestically generated price distortions were, by contrast, fairly limited. In fact, the structure of prices was typically revised at the beginning of each five-year plan period to take into account changes in costs. Subsidies tended to rise in the course of each quinquennium but, in connection with the next major revision of prices, would be reduced again.

In 1989, budgetary subsidies were equivalent to 16 percent of GDP (25 percent if cross subsidization through the Funds of Ministries is included), compared with 12-13 percent for several years previously; the increase resulted from the fact that cost changes were not permitted to be reflected in the prices of foodstuffs and other agricultural items. Thus, in 1989, subsidies to agricultural producers and retail subsidies on foodstuffs together accounted for about 60 percent of total budgetary subsidies. Producer subsidies were conferred through various channels, the most important of which was the subsidy to high-cost producers.2 Consumer subsidies were mostly conferred in the form of negative turnover tax to cover the excess of wholesale prices over retail prices. In 1989, it was estimated that the negative turnover tax on foodstuffs was equivalent to almost a quarter of the value of retail sales of such items.

After food and agriculture, the next most important subsidies were for housing and construction. The most important component was subsidies on state-owned housing, rents for which did not cover costs let alone any return on the state's investment. (In 1988, the average monthly rent on state-owned apartments was equivalent to less than 5 percent of average monthly earnings in the state and cooperative sectors, and presumably to an even smaller proportion of average family income.) In addition, heating for apartment buildings was subsidized and quasi-fiscal subsidies were provided through low-interest housing loans to individuals and cooperatives. Finally, relatively small subsidies were provided for transportation and, at the consumer level, on gas and coal. Electricity generation operated without budgetary subsidies, since profitable gas and nuclear power plants cross-subsidized loss-making coal-fired plants.

The first major step in reducing subsidies was made in July 1990 when retail subsidies on food were eliminated. As a result, food prices rose by about 25 percent and retail prices overall by about 7 percent. The authorities provided direct and universal income support (at a rate of Kcs 140 a person a month or the equivalent of about 5 percent of the monthly wage at that time) to the population in compensation for these price increases. (In principle, there could have been simultaneous and equal reductions in subsidies and in the taxes that financed them. In practice, things are not so simple, partly because of the–possibly major–distributional effects of rapid changes in the prices of essential items. Another consideration is that, to the extent that tax reductions benefited the enterprise sector, the authorities would have had little control over the extent to which the benefits would be passed on to the households to which they would primarily have been targeted.) In order to improve the targeting of government-supplied benefits, the general income support for the economically active population was abolished in January 1992; it was retained for children and pensioners.

Further steps to reduce subsidies were taken in 1991. Negative turnover tax on industrial and most energy products was abolished; no special compensation was given for industrial products, and the revenue effects were balanced by cuts in turnover tax rates on other items. However, for the subsidy reductions on energy items that took effect in May 1991, a modified version of the income support scheme applied in 1990 was used, with income compensation for pensioners and children only. As a result of these measures, budgetary subsidies in 1991 fell to the equivalent of about 7 percent of GDP. Of this total, the major components, each accounting for about one third, were subsidies to agricultural and foodstuff producers and subsidies for housing (including low-interest loans) and residential heating.

Privatization and Bad Debts

The restructuring of assets and liabilities in the Czechoslovak economy taking place as part of the reform process could have an important impact on the public finances. At issue are principally the effects of, first, the privatization of enterprises and, second, the restructuring of banks’ and enterprises’ balance sheets to deal with the problem of “bad debts.” It is too early to assess accurately the likely impact of these factors.

The authorities have developed a range of methods for the privatization of enterprises. (The privatization of land is to be effected largely through restitution to original owners or their heirs, while plans for the privatization of housing have yet to be worked out.) Essentially, different schemes will apply to the privatization of small- and large-scale enterprises, respectively. In devising these arrangements, the authorities have sought to strike a balance among various considerations; these include equity—to achieve widespread share ownership; efficiency—to achieve a sufficient concentration of ownership for effective enterprise management; fiscal impact–to ensure that enterprise sales yield satisfactory amounts of revenue; and the desirability of attracting foreign investment, and associated know-how and market access, to privatized businesses. Privatization of property confiscated after 1948 will be by restitution except that, where the assets in question have been substantially modified, compensation will be paid in lieu of a return of the assets to the original owners or their heirs. Those to whom property is restituted are responsible for defending their claim, if need be in the courts, against any other claims that may be made to the same assets by other parties.

Privatization of “small” enterprises is proceeding by competitive auction. Units are sold without their liabilities, which are being taken over by the National Property Funds. These funds are also the recipients of privatization proceeds. Only citizens may participate in the first round of auctions; units that fail to sell in the first round even at 50 percent of the starting price are reoffered in a second round at which foreigners may participate. By early 1992, about 25,000 small enterprises had been sold—mostly in the first round and for prices on average about 50 percent above the starting price. Sales proceeds were about Kcs 25 billion. The number of units that have been restituted is thought to be several times higher than those privatized by auction.

The privatization of large enterprises on a significant scale started in 1992. Privatization plans were submitted by individual enterprises and other interested parties for review and final decision by the privatization ministries of the respective republics. Privatization may take place through a mixture of direct sale—to either residents or nonresidents—and of “voucher” transactions. Further, not all of a given enterprise's equity need necessarily be disposed of in the same way and some part may be retained in state ownership. Vouchers have been issued to citizens over the age of 18 against payment of a relatively small fee. Voucher holders may invest their vouchers in Investment Privatization Funds. These funds will hold a range of equities in privatized enterprises, depending on the investment strategy of the particular fund, and are being established primarily to make it possible for individuals to acquire a diversified portfolio of assets relatively easily, as well as to facilitate sufficient concentration of ownership for efficient corporate governance. Vouchers may also be used by their holders to acquire equity directly in enterprises undergoing privatization. Sales against vouchers are taking place in a series of rounds, which began in June 1992. Starting prices are based on book value and, in the first round, vouchers purchased equal amounts of book value. Assets not privatized in the first round (either because of heavy excess demand or deficient demand) will be reoffered in subsequent rounds (up to a total of five) with asking prices adjusted to reflect market response in the previous round. Not all large enterprises will be covered in the first wave of privatization and some, particularly in the heavy engineering and metallurgical sectors, will remain under full state ownership, at least for the immediate future. Of the total book value of enterprises to be covered in the first round (of about Kcs 500 billion), about 60 percent will be privatized through the voucher scheme.

Privatization operations are being kept completely separate from the budget. Clearly, though, they will have important implications for the macroeconomy and for the Government's financial position in particular, which will depend on the mix of privatization operations taking place against cash and vouchers, respectively, and on the prices realized for equity in enterprises that are sold for cash.

The authorities also need to reappraise the value of the banking system’s claims on enterprises. The level of bank debt carried by an enterprise may be an accident of financial arrangements in effect during the period of central planning. As such, it may have no relation to the enterprise’s current, or future, profitability—a fact that could conceivably lead, in the extreme case, to the liquidation of potentially viable units. Bad loans also pose problems for banks themselves and their ability to fulfill efficiently their role as financial intermediaries; to cover the costs of nonperforming loans, banks may be obliged to operate with higher spreads between deposit and lending rates than would otherwise be desirable.

Banks and the Government, especially the ministries of privatization, have started the process of identifying “bad loans” with a view to their being written off or restructured. (Obviously, the treatment of such loans has a vital bearing on the value of enterprises undergoing privatization.) The Government has–on an avowedly once-for-all basis–provided an injection of funds (totaling about Kcs 50 billion) to the banking system to enable it to write off loans. This transaction took the form of a take-up by the banks of bonds issued by the National Property Funds to which the proceeds of privatization will accrue; most of the bonds replaced bad loans in the portfolios of the banks.

The Government does not anticipate any further injections of funds to facilitate debt write-offs and is anxious to avoid the moral hazard problems that could arise if the state were perceived to be the de facto guarantor of all loans to enterprises. Whether the operations already undertaken will prove adequate will depend to a large extent on the scale of assets that banks are in the end obliged to write off and on the possibilities for covering the resultant losses from other sources, including current earnings.

This paper was mainly written in the first half of 1992 and takes no account of developments since that time and, in particular, of the dissolution of the Czech and Slovak Federal Republic on December 31, 1992 into the Czech Republic and the Slovak Republic. At the time of writing, Jim Prust was an Advisor in the Fiscal Affairs Department. The author gratefully acknowledges the helpful suggestions and factual corrections provided by Tessa van der Willigen, who, however, is not responsible for any errors that may remain.

The former Council for Mutual Economic Assistance. Its members included, among others, the former Soviet Union and the planned economies of Central and Eastern Europe.

Agricultural land was divided into 42 districts according to soil and geography. Prices for agricultural output were determined according to production costs in the 20 most productive districts. The remaining districts received a subsidy per unit of output whose rate was inversely related to productivity and which, for the highest cost producers, came close to 100 percent.

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