Abstract

This book examines the opportunities and challenges involved for five central European applicants-the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia-in joining the European Union. The central focus is on the issues that policymakers in central Europe face as they craft macroeconomic and financial sector policies to help ensure growth that is both strong and sustainable, in a setting that may feature large and potentially volatile capital flows. It examines the competing pressures on these countries in the run-up to EU accession later, and monetary union.

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)

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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)

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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.
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)

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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.
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)

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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.

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)

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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.
Figure A3.

Tax Ratios in the CEC5 and the European Union, 1994 and 1998

(Percent of GDP)

1The ratio for Greece refers to 1997.
app02fig03c
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.
Figure A4.

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

(Percent)

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)

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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)

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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)

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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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