Czech Republic: Selected Issues
Author: International Monetary Fund
Publication Date:
03 Sep 1999
eISBN:
9781451810028
Language:
English
Keywords:
ISCR; CR; enterprise; bank; privatization; EU accession requirement; bank privatization; capital revenue; revenue reform; Maastricht target; debt stock; tax revenue; Consumption taxes; Western Europe
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This Selected Issues paper on the Czech Republic discusses issues relating to the enterprise sector and corporate governance. This includes an overview and assessment of enterprise performance along with a discussion of the concept of corporate governance and its application in the Czech Republic, including how corporate governance practices compare in an international context. The paper discusses issues related to financial sector performance and restructuring. It also takes stock of banking sector developments and performance and reviews financial policy and supervisory challenges, including the definition of policies for bank privatization and the appropriate prudential framework.

Abstract

This Selected Issues paper on the Czech Republic discusses issues relating to the enterprise sector and corporate governance. This includes an overview and assessment of enterprise performance along with a discussion of the concept of corporate governance and its application in the Czech Republic, including how corporate governance practices compare in an international context. The paper discusses issues related to financial sector performance and restructuring. It also takes stock of banking sector developments and performance and reviews financial policy and supervisory challenges, including the definition of policies for bank privatization and the appropriate prudential framework.

IV. Medium-Term Fiscal Policy Projections and Analysis32

A. Introduction

86. At the beginning of transition, the fiscal position of the Czech Republic appeared quite enviable, at least according to the reported data. Its debt stock was very low—less than 20 percent of GDP—and through 1995, both the central and general government balances were in surplus. Official statements by the government indicated that fiscal policy was, and would continue to be, formulated with a goal of budget balance. However, since 1995 there has been a noticeable deterioration in the fiscal position (Tables IV-1 and IV-2; Figure IV-1). In 1999, the authorities and Fund staff anticipate a general government deficit of around 4 percent of GDP. Although part of this is likely to be cyclical and the underlying or structural deficit smaller, there is a concern that the apparent trend deterioration in the balance will continue. Furthermore, there are numerous looming medium-term challenges facing the Czech government, many of which will be associated with substantial fiscal costs. Some of these include: investment spending related to EU accession (to meet EU directives related to the development of regional governments, the legal system, environmental standards, and the transportation network); bank and enterprise restructuring; and the realization of contingent liabilities (the “hidden” debt). Of course there are also potential benefits associated with these initiatives, including likely transfers from the EU, but also the higher growth that should accompany the whole accession and reform process. Lastly, although the country is not facing an immediate demographic problem, over the longer term, the pension system as currently designed along with related health care expenditures, will introduce a significant drain on the budget.

Table IV-1.

Czech Republic: Central Government (State) Budget, 1993-99

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Source: Czech authorities.
Table IV-2.

Czech Republic: General Government Budget, 1993-99

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Source: Czech authorities.
Figure IV-1.
Figure IV-1.

Czech Republic: State and General Government Deficit and Debt

Citation: IMF Staff Country Reports 1999, 090; 10.5089/9781451810028.002.A004

Source: Staff estimates.

87. The government has argued that fiscal control is necessary to provide the room for investment spending and enable the country to achieve its potential growth. Furthermore, although there are no specific rules dictating fiscal policy for EU accession, candidates are expected to demonstrate that they operate within, or at least close to, the Maastricht fiscal ceiling. These are among the issues that shape fiscal policy over the medium term, and which this paper explores. Section B develops a medium-term baseline fiscal projection assuming unchanged policies and discusses a possible reform scenario. Section C provides several alternative fiscal projections derived from a variety of assumptions about growth, EU accession, and policy alternatives. Section D discusses the implications of these projections and provides some views on policy issues, as well as the potential steps in this analysis.

88. The projections presented in this chapter show that even under somewhat optimistic assumptions, but absent a change in policies, the likely fiscal situation is inconsistent with the stated goal of balance, and the deficit above the indicative Maastricht ceiling of 3 percent of GDP at the time that the country would hope to accede to the EU. Furthermore, in the absence of industrial reform and the accompanying supply-side led growth, or if the government fails to control several expenditure items, the fiscal situation could become unsustainable. Also, in the absence of policy measures, the projections are inconsistent with the underlying macroeconomic framework.

89. At the outset it should be recognized that this chapter represents a first attempt at providing a quantitative medium-term fiscal outlook for the Czech government and should be viewed as work in progress. It represents a collaborative effort by the Fund staff and the Czech authorities.33 The quantitative as well as the qualitative analysis contained in this chapter represents an important step forward in the area of medium-term fiscal analysis, and the authorities have already begun to refine and improve upon this work as part of their ongoing efforts in this direction.

90. At this time, the chapter is focussed mainly on discussing the methodology and the medium-term projections while only tentatively discussing the structural problems in the budget and the desirable medium-term fiscal strategy, including policy measures to redress the problems and tensions in the fiscal outlook. Furthermore, the analysis is not integrated into a well-articulated medium-term framework as all of the projections assume a given macroeconomic outlook. Since only one fiscal projection is likely to be consistent with a given macroeconomic outlook, at this point the results point to potential inconsistencies and tensions between macroeconomic projections, based on a view of the country implementing significant reform—including control over public finances—and fiscal projections that indicate that the deficit and debt are not well contained. At this stage, until the government engages in a detailed and in-depth examination of expenditure and revenue, much of the analysis will remain very general.

B. A Medium-Term Fiscal Projection

91. The Ministry of Finance (MOF) of the Czech Republic regularly produces a document containing a macroeconomic forecast that includes fiscal data.34 However, the macroeconomic forecast is generally limited to two years ahead and there are no detailed fiscal projections. At best there is a forecast of the current year’s fiscal outturn, but even this is only available at a very aggregate level. Until this year, even within the MOF, a consistent set of fiscal projections beyond the current budget year—whether for the central government or the general government—have not been compiled (fiscal projections are not required in budget documents). However, as part of the EU accession process, the government must provide a medium-term economic forecast, including of the government sector. In addition, during last year’s discussion in the Parliament, the MOF agreed to present a medium-term forecast as part of its annual budget submission.35

Macroeconomic Assumptions

92. Not surprisingly, the macroeconomic assumptions are a critical factor in the forecast and the choice here is much more controversial. If a government is trying to provide a rosy fiscal outlook or to create room for additional fiscal expenditures, there is a strong incentive for overly-optimistic assumptions. For an industrial country, there are usually a large number of macroeconomic forecasts that can be used as a foil to scrutinize the official forecast.36 However, in the Czech Republic, the number of alternative forecasts are more limited, although there are some from the private sector. The macroeconomic forecast used in the fiscal projections is the one contained in the 1999 Czech Republic Article IV Staff Report, and is essentially consistent with a reform view of the Czech economy. As this is not the only realistic set of assumptions, one of the fiscal scenarios presented in Section C illustrates how the outturn can be affected by a less optimistic macroeconomic outlook. In fact, the assumptions used in the staffs forecast are more optimistic than those used by the authorities.

93. In particular, the growth rate of real potential output is assumed to gradually increase to 4 percent and, after several years of disappointing growth, the output gap (estimated at about 6 percent in 1999) is assumed to be gradually eliminated by 2003. Consistent with the return to potential output, actual growth is assumed to pick up to 5 percent in 2002-03 before declining to 4 percent thereafter. Inflation is assumed to decline to less than 4 percent over the medium term consistent with the Czech National Bank’s (CNB’s) monetary strategy. Interest rates are assumed to decline with inflation, with long-term rates falling to below 8 percent. An important, but often overlooked variable in the fiscal forecast, is the wage assumption. Changes in real wages can have important effects on the revenue projections since wages affect disposable income and thus consumption and indirect taxes, as well as personal income tax revenue. The projections assume that the wage bill will grow slower than nominal GDP over the medium term so as to allow for the assumed switch from consumption to investment that underpins the resumption of growth.37

Passive Baseline

94. There are various strategies that one can pursue in creating the projection. The most standard approach, and the one used in this paper, is to assume the current set of tax regulations and expenditures programs.38 This is often referred to as the “current services” or passive baseline. It does not necessarily reflect the “best” forecast of the budgetary outcome since such a forecast may violate the stated goals of the government and be inconsistent with the underlying macroeconomic framework; rather it reflects the likely outturn if new policy actions are not taken.

95. In designing the projections, decisions have to be made about the degree of disaggregation. This includes the extent to which projections are made of the various levels of government as well as the degree of detail in the revenue and expenditure projections. Although information from the state (central) and general government budgets were provided to the staff at a fairly disaggregated level, and reasonable forecasting methods could be applied to individual items, less information was available for the other levels of government.39 In particular detailed information on inter-governmental transfers, that is essential when aggregating up to the general government level, was not readily available.40 Although separate forecasts for each level of government might have been the preferred approach, based on data availability the projections were made only for the general government. As far as the level of disaggregation of revenues and expenditures is concerned, the forecast includes nearly 20 different categories. A thorough description of the assumptions underlying the fiscal forecast were included in a version of this paper presented to the authorities and summarized below.

96. The medium-term revenue projections (through 2003) were largely based on input from the tax forecasting experts in the MOF who used micro-simulation models to produce their own forecasts. In particular, this information was used in the forecasts for the direct, indirect, and social security taxes. Unless otherwise noted, the revenue items are assumed to grow at the rate of the scale variable which implicitly assumes an elasticity of one (Table IV-4). However, there are several important revenue categories such as indirect and direct taxes, and non-tax revenue which are assumed to grow faster or slower than their scale variable. Several assumptions may appear arbitrary, but they are based on historical patterns, as welt as information about consumption patterns, tax administration, and tax elasticities. Over time, these projections should be increasingly refined as the ex-post data become available, are compared to the forecast, and the differences evaluated.

Table IV-3.

Czech Republic: Macroeconomic Assumptions for Passive Baseline

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Source: Staff projections.
Table IV-4.

Czech Republic: Medium-Term Forecast - General Government Revenues

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Source: Czech authorities and staff estimates.

97. Personal income taxes are expected to grow more slowly than wages in 1999 reflecting some continued increase in unemployment, and the indexation of income tax brackets approved in December 1998.41 Thereafter, these taxes are forecasted to grow slightly faster than wages on the assumption that neither exemptions nor tax brackets are indexed. Enterprise taxes would grow only modestly despite the increasing profit share implicit in the macroeconomic assumptions owing in part to the 7 year loss-carryover rules (which effectively results in income averaging). Indirect taxes would initially grow slower than nominal GNP reflecting in part an assumed change in the consumption pattern toward lower VAT rated goods during a period of low growth, but this should be reversed as growth picks up.42 However, as long as there are specific excise taxes, the growth in these taxes will be somewhat restricted. Also, VAT revenues as a percent of GDP, will decline over the medium term as wages (which affect disposable income) are expected to grow slower than GDP, and custom duty rates are assumed to decline in accordance with agreements with the WTO. This is consistent with the underlying view in our reform scenario that there will be a significantly greater increase in investment and exports, than in consumption. Social security contributions grow directly with wages and would thus decline modestly as a share of GDP over the medium term. The projections for the final three revenue items (other taxes, non-tax current revenue, and capital revenue), which comprise less than 10 percent of total general government revenue, all used the same projection methodology.43 These projections are consistent with both the assumptions that there will be less government ownership in enterprises and that fixed fee revenues will not be systematically indexed to inflation. Also, VAT revenues, as a percent of GDP, will decline over the medium-term as wages (which affect disposable income) are expected to grow slower than GDP, and custom duty rates are assumed to decline in accordance with agreements with the WTO.

98. Taken together, these assumptions imply that the significant decline in revenue (as a share of GDP) that has been occurring since the early 1990s (from 45 percent in 1993 to 40 percent in 1998) is broadly arrested. While a revenue ratio of close to 40 percent is not high by European standards, the split between social security contributions and income related taxes on the one hand, and indirect taxes on the other, is a source of concern as it creates a significant labor tax wedge.

99. The expenditure forecast is based on informed, but crude assumptions about real or nominal spending derived from discussions with the authorities and assumed macroeconomic developments (Table IV-5). While it would have been preferable to divide the spending items into their mandatory and non-mandatory components, or work from a “bottom-up” approach based on specific information about individual programs, those details were not available. The expenditure forecasts could be refined over time by building on detailed information provided by the line ministries. The projections generally reflect containment of several items that could easily increase substantially if the government is not resolute in holding the line. For example, there could be significant costs related to the restructuring of banks and enterprises, investment and other spending needs related to the EU accession process, realization of the contingent liabilities beyond what is already included in the projections, and a private sector demand for social and transfer programs equal to those of Western European countries.44 The potential fiscal costs related to several of these risks are not included in the baseline projection but are explored further below.

100. After increasing in 1999 as a result of the large wage increase agreed in December 1998 to compensate for the freeze in government wages in 1997-1998, the wage bill should decline slowly as a share of GDP reflecting the authorities intentions to reduce the size of the civil service and restrict the rate of increase in real wages. Similarly, the government believes that spending on other goods and service can be held constant in real terms. Transfers are largely dictated by mandatory programs such as social security, but are also subject to considerable political pressure for increased funding. Consistent with demographics and current programs, real spending on health and pensions is projected to grow by 4 percent a year.45 The pension system is not facing an immediate problem, but unless changes are made, pension expenditures will begin to rise at a very fast rate sometime after 2010. Other transfers, which include unemployment and disability payments, are assumed to grow at a fairly fast rate in the next couple of years owing to continued high unemployment. To the extent that the government undertakes additional labor market programs or adds to the social safety net, this spending category may face significant pressure over the medium term. Subsidies to enterprises include direct and indirect support for various financial and non-financial enterprises and should decline over the medium term as the restructuring process is advanced. Interest payments are calculated based on the debt dynamics and excludes any interest imputed on contingent liabilities. Capital expenditures will likely rise over the medium term, primarily because of the need to meet several of the EU directives associated with the accession process: real fixed investment spending is assumed to grow at a modest rate of 2 percent. Other investment and net lending are assumed to be unchanged in nominal terms.

101. On this basis, total expenditures as a share of GDP will grow over the medium term, before declining gradually toward the current ratio by around 2005, The overall fiscal deficit rises and remains in the range of 5 percent of GDP over the medium term, before declining gradually to below 3 percent of GDP by 2008 (Table IV-6; Figure IV-2). The debt ratio (excluding hidden liabilities) increases from 14 percent of GDP in 1998 to nearly 35 percent of GDP by 2008. If the hidden liabilities are added as a debt item, and assuming no increase in these liabilities, the debt ratio reaches 40 percent by 2003. These fiscal prospects are quite worrisome, not least because the projections are based on relatively optimistic assumptions.46

Table IV-6.

Czech Republic: Passive Medium-Term Forecast - General Government

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Source: Czech authorities and staff estimates.
Figure IV-2.
Figure IV-2.

Czech Republic; Medium-Term Fiscal Scenarios - Deficit to GDP

Citation: IMF Staff Country Reports 1999, 090; 10.5089/9781451810028.002.A004

102. Although the medium-term fiscal problem is apparent from these projections, it is less clear whether the underlying reasons for the deterioration are to be found on the revenue or expenditure side. The trend decline in the revenue ratio suggests a lack of buoyancy in the tax system, whether due to inelastic taxes, a relative decline in tax bases, or even weakening tax administration, as there has been little change in the relatively high tax rates (especially on personal income and wages, including social security contributions). Revenue reforms should thus focus on shifting the burden from direct to indirect taxes and increasing the buoyancy of revenues—especially those that are relatively unresponsive to nominal income growth. On the expenditure side, several categories have already been severely compressed, including capital expenditures, and it will be necessary to consider reforms to mandatory programs (that make up the bulk of expenditures) as well as containing certain expenditure items that have been allowed to grow very rapidly in recent years (notably subsidies to financial and non-financial enterprises).

The Augmented Expenditure Scenario

103. There are two obvious sources of added strains on government finances. First, there are likely to be additional costs related to the EU accession process. Although the costs associated with this process could be very large if the government were to meet all the legal, environmental, infrastructure, and other requirements of accession, for the sake of realism it is assumed that the government will increase investment spending, relative to the passive baseline, by 1 percent of GDP a year, phased in gradually starting in 2000.47 Second, there will be significant costs associated with the hidden liabilities, which the government is committed to explicitly acknowledging.48 This expenditure has been incorporated into the projection by capitalizing 50 percent of the estimated value of these liabilities.49 In this scenario, the deficit rises to over 6 percent of GDP in 2000 and remains at this level over the medium term, while the debt ratio (including the hidden liabilities) rises to 45 percent of GDP by 2003 (Table IV-8).

Table IV-7.

Czech Republic: Passive Medium-Term Forecast by Ministry of Finance - General Government

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Source: Czech authorities and staff estimates.