Slovak Republic: Selected Issues and Statistical Appendix
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International Monetary Fund
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Publication Date:
20 Oct 1999
eISBN:
9781451835380
Language:
English
Keywords:
ISCR; CR; Slovakia; EU imports; GDP; deficit; government; income tax; Slovak authorities; capital expenditure; value-added tax; debt service; Social security contributions; government deficit
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This Selected Issues paper and Statistical Appendix examines external competitiveness and the exchange rate for the Slovak Republic. The paper describes two simple types of competitiveness indicators: (i) real effective exchange rate measures, which examine underlying fundamentals thought to influence external performance; and (ii) indicators of actual export performance. The results suggest that the unfavorable outcomes in the merchandise trade balance and the current account from 1996 to 1998 reflected, at least in part, competitiveness problems. The paper also presents an assessment of banking conditions and the supervision system in the Slovak Republic.

Abstract

This Selected Issues paper and Statistical Appendix examines external competitiveness and the exchange rate for the Slovak Republic. The paper describes two simple types of competitiveness indicators: (i) real effective exchange rate measures, which examine underlying fundamentals thought to influence external performance; and (ii) indicators of actual export performance. The results suggest that the unfavorable outcomes in the merchandise trade balance and the current account from 1996 to 1998 reflected, at least in part, competitiveness problems. The paper also presents an assessment of banking conditions and the supervision system in the Slovak Republic.

III. Medium-Term Fiscal Issues51

A. Introduction

91. This chapter discusses some key considerations concerning fiscal performance over the medium term, with a view to identifying significant tensions that could emerge and suggesting possible policy responses. The motivation is that large fiscal imbalances have been at the heart of Slovakia’s macroeconomic difficulties, and continued fiscal consolidation is expected to be a key component to achieving and maintaining a stable macroeconomic environment. In this connection, policy will need to contend with several distinctive elements that characterize the structure of both the revenue and expenditure sides. Weakness in tax revenue collection, increases in the spending of the Health funds, and large-scale public investment projects have contributed to the fiscal expansion of recent years. Other distinctive characteristics of the fiscal situation are the heavy reliance on tax revenue, the large role of the state in the economy, and the large size of social transfers.

92. The chapter is organized in the following manner. Section B summarizes Slovakia’s recent fiscal performance and discusses briefly the outlook for 1999. With this as background, Section C analyzes key fiscal issues, pertaining to both the revenue and expenditure sides, that the country will face in the medium term. Section D draws on the analysis of the preceding section to formulate a quantitative medium-term fiscal adjustment scenario and contrasts it with a no adjustment (passive) scenario. Section E provides concluding remarks.

B. Recent Fiscal Performance and the Outlook for 1999

93. Since the ending of the former federation in 1992, developments in public finances witnessed two diametrically different phases. During 1993–95, there was a significant contraction in the fiscal deficit: in fact, the balance of the general government shifted from a deficit of 7.2 percent of GDP in 1993 to a surplus of 0.4 percent of GDP in 1995 (Table III-1 and Figure III-1). During 1996–98, fiscal policy was significantly loosened, with the general government deficit reaching 6 percent of GDP in 1998. The adjustment during the first period was based on measures that contributed to a marked reduction of expenditure while preserving very high tax- and revenue-to-GDP ratios. By comparison, the significant deterioration over the past three years was primarily attributed to significant weakness in tax revenue, increased spending on health, and major public investment projects. The fiscal position became untenable, creating tensions for macroeconomic management, while leaving little room for tax system reform and a lowering of the tax-to-GDP ratio. At the same time, the structure of revenue and expenditure experienced quite a few changes during the 1993-98 period (Figure III-2).

Figure III-1.
Figure III-1.

Slovak Republic: General Government Budget Balance, 1993-98

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 112; 10.5089/9781451835380.002.A003

Sources: Slovak authorities; and staff estimates.
Table III-1.

Slovak Republic: Fiscal Operations of the Consolidated General Government, 1993-98

(In percent of GDP)

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Sources: Ministry of Finance; and staff estimates.
Figure III-2.
Figure III-2.

Slovak Republic: Structure of General Government Revenue and Expenditure, 1993 and 1998

Citation: IMF Staff Country Reports 1999, 112; 10.5089/9781451835380.002.A003

Sources: Slovak authorities; and Fund staff estimates.

94. In the most recent year, fiscal policy fell short of stated objectives, namely achieving a target deficit of the general government of 2 percent of GDP in 1998.52 Importantly, there was a significant expansion in extrabudgetary investment in the pre-election period and cost overruns in the public health sector. Tax collection—particularly of the corporate income tax, VAT, and customs duties—was weak, and weakness in non-tax revenue as well as the elimination of the import surcharge (while welcome) further depressed revenue. Finally, the cost of financing the fiscal deficit increased significantly, as interest rates on government debt increased sharply, reflecting the marked increase in financing needs and a relatively tight monetary policy stance in the face of an expansionary fiscal policy.

95. Recognizing the need for containing the general government deficit, the new government announced an ambitious fiscal adjustment in 1999. The overall fiscal deficit is targeted to be reduced to 3 percent of GDP or less, supported by a number of measures taken early in the year and, most importantly, by a fiscal package that was announced in late May 1999. To this end, measures taken early in the year included a wage freeze in the budgetary sector, strengthened tax collection efforts, a number of administrative price increases and related subsidy cuts (especially the heating subsidy), and a more general expenditure restraint. In late May, the government decided to strengthen its fiscal effort by announcing the following fiscal measures: an increase in the lower value-added tax (VAT) rate from 6 percent to 10 percent, a motor vehicle tax, increases in excises and administrative fees, reductions in the sickness benefit and the duration of unemployment benefits, and a strengthening in the enforcement of eligibility criteria for family benefits, while also introducing a housing allowance to compensate for substantial increases in the administrative prices of gas, electricity, telecommunications, railway, heating, and rents. With a view to containing balance-of-payments pressures, the government also introduced in its fiscal package a 7 percent import surcharge.

C. Medium-term Fiscal Issues

96. After lowering the general government deficit significantly in 1999, a central policy challenge facing Slovakia will be to maintain the momentum for fiscal consolidation in subsequent years while creating conditions for a reduction in the tax burden, which is relatively high for a country of Slovakia’s level of per capita income.53 Continuing high fiscal deficits could have a number of adverse consequences, including; (i) large external imbalances, which would be unsustainable and would increase the country’s vulnerability to external shocks; (ii) the task of regaining and preserving macroeconornic stability would be made more difficult, including by placing a heavy burden on monetary policy; (iii) there would be a risk of a rising public debt and a debt-service burden that could become unsustainable; (iv) national savings could be depressed, thereby limiting the scope for domestic investment without heavy reliance on foreign savings; (v) the ability to attract sustainable foreign savings in the form of foreign direct investment would be diminished by the likelihood of continued macroeconomic instability; and (vi) there would be limited capacity for absorbing the costs of banking and enterprise restructuring, and thus the pace of structural reform could be slowed. In contrast, medium-term fiscal consolidation and reform accompanied by a lower tax burden, would help set the basis for durable economic growth.54

97, Such a fiscal effort would need to be cast in a way that addresses a number of structural weaknesses on both the revenue and expenditure sides.55 In this connection, it is important to identify in advance main areas where tensions may show up and thereby facilitate appropriate and timely policy responses. Clearly, reductions in revenues would imply significant pressure on expenditure, if fiscal consolidation were to continue.

Revenue Considerations

98. This section assesses various individual taxes in Slovakia relative to other countries in the region, and examines issues in tax administration.

Personal income tax

99. Personal income tax (PIT) collection—at 6 percent of GDP—is comparable with that of other countries in the region (Table III-2). Notwithstanding generous personal allowances and statutory tax rates that are not especially high, tax collections have been robust. This is primarily due to the fact that personal income tax brackets have not been significantly adjusted for inflation since 1994, and to the absence of major PIT exemptions. In comparison with other countries in the region, Slovakia’s marginal tax rates are lower than those in Hungary and Poland, while the highest marginal rate becomes effective at a much higher level of income than in those two countries. 56 On the other hand, Slovakia’s PIT does not have exemptions or incentives associated with either housing expenditure or investments like in the other two countries. Recently introduced legislation (which included an adjustment in the lowest-income bracket, abolition of the millionaire tax and introduction of a new highest income tax bracket, and changes in a number of deductions and exemptions) addressed some weaknesses of the Slovak PIT. However, a more comprehensive reform would be a useful element of a medium-term fiscal plan. This could include adjustments in the personal income tax brackets in order to avoid taxation of incomes at middle levels by higher marginal rates, and it could be followed by a move toward a global PIT.57

Table III-2.

General Government Revenue in Selected Transition Countries 1/

(In percent of GDP)

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Sources: Various Recent Economic Development Reports, International Monetary Fund.

Data pertain to 1998 for the Slovak and Czech Republics and Hungary, to 1997 for Bulgaria, Romania, and Slovenia, and to 1996 for Poland.

Includes capital revenue in the cases of Poland, Romania, and Slovenia.

Corporate income tax

100. Corporate income tax collections are relatively high compared with other central European countries, owing primarily to the high corporate income tax rate (40 percent). However, tax collections have recently exhibited significant weakness due to the poor financial performance of enterprises (as evidenced by sharp declines in their profits). Declining financial discipline and governance may also have been a factor leading to a less strict adherence to tax obligations. The high corporate income tax rate (Table III-3), in combination with the tax incentives offered by other countries in the region, is regarded as a disincentive for foreign direct investment (FDI) in Slovakia (which could also reduce the tax revenues that increased FDI could otherwise generate). A medium-term reform strategy for the corporate income tax should consider a gradual reduction in the existing high corporate tax rate. It should also ensure that there is no discrimination between foreign and domestic investment or between industries.58

Table III-3.

Slovak Republic: Value-added and Corporate Income Tax Rates in Selected Countries

(In percent)

article image
Source: International Bureau of Fiscal Documentation.

Effective rate; 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 lower rate applies to distributed profits and the higher rate to retained profits.

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

The lower rate applies to non-resident companies and the higher rate to resident companies.

The rates in the value-added columns pertain to a general sales tax.

Social security tax

101. Social security tax collections are equivalent to 14 percent of GDP and they are high compared with other countries of the region (Table III-2). This is due to the very high social contribution rates, which—at 38 percent and 12 percent of gross labor income for the employers and employees, respectively—are above those of other central European countries and much higher than OECD, European Union (EU) and western European countries (Table III-4). Slovakia’s contribution rates are only comparable with rates in some (higher income) western European countries that provide some of the most generous benefits. When these contribution rates are combined with personal income taxes, the tax wedge between employers’ total labor costs and employees’ take home pay is close to 60 percent (OECD (1999)).59 Adding to that the effect of VAT and excises would bring the tax wedge to even higher levels. Slovakia’s tax wedge is definitely high compared with averages—including the effect of consumption taxes—of 55 percent and 56 percent for Euro-area and other EU countries, respectively (IMF (1999)).

Table III-4.

Slovak Republic: Social Contribution Rates in Selected Countries

(In percent of gross labor income)

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

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

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

Unweighed average of Western Europe (as defined above) and Australia, Japan, Mexico, New Zealand, and the US.

Value-added tax

102. The value-added tax has been designed to follow the EU directives and considerable efforts are being made to keep it in line with EU legislation. Revenue from VAT is a bit high relative to other countries in the region, owing primarily to the high standard rate of 23 percent (compared with EU and OECD averages of 19 percent and 17 percent, respectively) (Table III-3). In addition, the large differential between the standard and the lower rate creates an added source of distortions. Thus, a medium-term fiscal strategy would ideally include an increase in the lower rate accompanied by a gradual decline in the standard rate, while ensuring that the tax-to-GDP ratio is not increased permanently. In addition, harmonization with EU standards would entail moving to the standard rate a number of goods, services, and activities that are now taxed at the lower rate. The most important would include electricity and construction activities.60 As taxation of the latter at the standard rate would have a significant impact on the prices of construction (including housing, highways, and medical facilities), a medium-term strategy could consider a gradual approach, perhaps by first moving commercial activities (i.e., buildings used for commercial purposes) to the standard rate.

Tax administration

103. Tax administration in Slovakia continues to face significant challenges in mobilizing revenue. This is due to the continuing transformation of the economy and the dramatic changes in the taxation systems that were adopted during the transition to a market economy. The biggest problems pertain to tax arrears, which are reportedly very high; problems in collecting VAT, reflecting large-scale evasion through claiming inappropriate credits; and significant inefficiencies in the administration of social security contributions (including the lack of power by the agencies responsible for collecting contributions to enforce collections).61 Thus, the tax-to-GDP ratio would be even higher, if these problems in the tax administration did not exist.

104. To address these administrative problems, the government has recently approved legislation to improve the collection of VAT and excises.62 In addition, tax offices have been reorganized and work is currently under way to improve corporate tax collection. Looking into the medium-term, it is important to recognize that additional demands will be generated to modernize tax administration quickly so as to prepare and implement new legislation, systems, and procedures that must be in place to comply with the criteria necessary to join the EU. For example, accession to the EU will require fundamental changes in the way customs administration is organized and operated, and it will also imply more comprehensive administration of domestic excise taxes.

Expenditure and Net Lending Concerns

105. Two main characteristics of the expenditure side are: (i) the very high level of public expenditure, which equaled 48.3 percent of GDP in 1998, a very high level even for a transition country, and, (ii) the dominant role of social transfers and spending on health care and general government administration.63 In this connection, important elements of a medium-term fiscal strategy would encompass reducing government expenditure, including social spending, and shrinking the government sector to a size more consistent with the country’s per capita income level.64

General government administration 65

106. Expenditure on general government administration is about 14 percent of GDP, which is high in comparison with other countries in the region (Table III-5). A wage freeze in the budgetary sector for 1999 will contribute to a decline in spending on this item, but expenditure on wages will still remain relatively high. Moreover, there exist some notable imbalances in the structure of government wages: the average wage in administration (excluding public education and health) is well above, and has been growing at a higher rate than, the economy-wide average wage; the average wage in public education and health has been below the economy-wide average wage.66 Thus, important elements of a medium-term strategy could include implementation of a civil service reform, possibly embracing reductions in the size of the civil service; strengthening institutions that ensure control over recruitment and the civil service payroll; introducing competitive wages for highly-skilled civil servants; and providing realistic severance packages with appropriate incentives to redundant workers. Finally, expenditure on other goods and services, which declined to 6 percent of GDP in 1998, could be reduced further over the medium term, including through restraint on spending on equipment, maintenance, and other non-personnel items.

Table III-5.

General Government Expenditure in Selected Transition Countries 1/

(In percent of GDP)

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Sources’. Various Recent Economic Development Reports, International Monetary Fund.

Data pertain to 1998 for the Slovak and Czech Republics and Hungary, to 1997 for Bulgaria, Romania, and Slovenia, and to 1996 for Poland.

For Hungary, interest expenditure includes National Bank of Hungary expenditure.

Table III-6.

Slovak Republic: Social Security System Expenditure, 1995-98

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Sources: Ministry of Finance; and staff estimates.

Includes transfers to individuals and non-profit insitututions.

107. Interest expenditure is relatively low (2.4 percent of GDP in 1998), but it has been growing recently owing to an increase in public debt and the fact that financing must now be raised at market-determined interest rates. Following the expansion in the fiscal deficit over the past few years, the stock of public debt rose to 31 percent of GDP in 1998. Moreover, until recently, Slovakia financed its deficits to a large extent by borrowing domestically (including from the National Bank of Slovakia) at below-market interest rates. The shift to market borrowing in the context of high deficits has meant an increase in interest expenditure. Over the medium-term, bank restructuring—involving clearing up bad loans and recapitalizing problem banks—is going to have substantial fiscal implications (see below), including the interest costs on bonds that could be issued to recapitalize problem banks.

Subsidies

108. Subsidies have been recently declining as a share of GDP, but, at 3.7 percent of GDP, they are still considered relatively high in comparison with other countries in the region (Table III-5). The largest subsidies pertain to heating and transportation. Regarding the former, the government’s program for 1999 includes a substantial reduction in subsidies to Sk 1.6 billion from Sk 3.4 billion in 1998, in tandem with substantial increases in gas and hot water prices. In a medium-term context, it is important to move more aggressively with adjustments in administered prices so as to achieve full-cost recovery and gradually eliminate subsidies.

Social benefits and the social safety net system

109. Slovakia has a broad system of social security programs, which are extensive in their coverage. These programs comprise the health, pension and sickness, and employment funds, as well as state and social assistance benefits, and aim at ensuring that all households are able to meet a certain minimum standard of living. Total expenditure of the social security system amounted to 21.5 percent of GDP in 1998 (Table III-6), which is above most other central European countries (Table III-5), but well below the EU average of 26.5 percent of GDP (OECD (1999)). As for the composition of total expenditure, pensions and health care accounted for about 40 percent and 30 percent of total spending, respectively.

State benefits and social assistance

110. State benefits comprise 13 different programs, many of which overlap with more than 20 social assistance programs that form part of the social safety net operated by regional offices. Spending on these programs increased to 4.7 percent of GDP in 1998, comprising expenditure equivalent to 2.4 percent of GDP for state benefits and 2.3 percent of GDP for other transfers to individuals and non-profit institutions, including social assistance. This increase, combined with the recent increase in the personal exemption for those with the lowest incomes, suggests that there is room to rationalize and scale back state benefits without adversely affecting social protection for the neediest. To this end, important challenges of a medium-term strategy would include strengthening eligibility criteria and means testing for state benefits, which could generate significant savings.67

Pensions

111. Slovakia has a pay-as-you-go pension system, which provides employment-related pensions for old age, disability, and survivors. Pension expenditure has been declining steadily as a share of GDP since 1993 and, at about 8 percent of GDP in 1998, is relatively low compared with the shares of other central European countries (Table III-5). The low pension expenditure is primarily attributed to the low, and continuously declining, replacement rate (i.e., the ratio of average pensions to average wage) (Table III-7). This ratio—at 45 percent in 1998 for old-age pensions—is very low compared with the ratios of other central European countries.68 The reasons for this low ratio include the non-existence of an indexation formula for pensions and the fact that pension benefits are linked to wage history, but the benefits progressively decline for higher wages. However, while most pensions are comparatively low, the number of and amount spent on disability and early retirement pensions are very high compared with OECD countries (OECD (1999)).

Table III-7.

Slovak Republic: Characteristics of the Pension System, 1991-98

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Sources: Ministry of Labor, Social Affairs and Family; Ministry of Finance; and staff estimates.

112. While the long-term sustainability of the system may be alarming, there are relatively minor concerns over the medium-term pension funding prospects. Underlying the medium-term prospects are the projected increase in the share of working population to 68 percent by 2005 combined with the relative stability of the share of population over 65 years at around 11 percent until 2010 (Figures III-3 and III-4). However, a projected increase in the share of the population over 65 years to 17 percent combined with a decline in the share of the working population to 64 percent by 2030, point to longer-term pressures on the finances of the Slovak pension system. These pressures are of a similar nature to the ones facing other central and western European countries, but appear to be weaker and more delayed than for other countries, as evidenced by more favorable projections of Slovakia’s dependency ratio (Figure III-5).

Figure III-3.
Figure III-3.

Slovak Republic: Population Structure, 1990-2030

Citation: IMF Staff Country Reports 1999, 112; 10.5089/9781451835380.002.A003

Source: World Population Projections Database, World Bank.
Figure III-4.
Figure III-4.

Slovak Republic: Share of Population Over Age 65 in Selected Countries, 1990-2030

Citation: IMF Staff Country Reports 1999, 112; 10.5089/9781451835380.002.A003

Source: World Population Projections Database, World Bank.
Figure III-5.
Figure III-5.

Slovak Republic: Dependency Ratios in Selected Countries, 1990-2030

Citation: IMF Staff Country Reports 1999, 112; 10.5089/9781451835380.002.A003

Source: World Population Projections Database, World Bank.

113. Nevertheless, a reform of the pension system should be considered before the longer-term difficulties set in. This reform should consider replacing the pay-as-you-go system with a fully-funded system and raising the retirement age in line with projected increases in life expectancy.69 As these reforms would entail additional fiscal costs during the transition process, it would be useful for long-term sustainability to be examined in a comprehensive framework, which would take into account all these costs.

Health

114. Health spending is coordinated by four health funds and six medical insurance companies provide services. Regarding the contributions to the health care system, 96 percent comes from public sources compared with an average of 78 percent for EU countries (in the latter, 21 percent of the funding originates from private sources). Health care spending currently stands at about 6.5 percent of GDP (Table III-6), which is less than the average of 7.7 percent average in the EU and 8.2 percent in OECD countries. The main characteristic of the structure of health expenditures is the disproportionately high spending on medication (1.7 percent of GDP compared with an average of 1.2 percent for EU countries). In relation to total health spending, medication expenses account for 35 percent of spending compared with an average of about 15 percent in the EU. At the same time, spending is disproportionately low for nursing (Demes, Ginter, Kovac, and Butora (1998)).

115. The main issue regarding the finances of the Health funds pertains to the efficiency and the sustainability of the current system. High and persistent deficits (Sk 5.4 billion or 0.7 percent of GDP in 1998) are attributed primarily to the significant growth of expenditure, which is not matched by similar increases in revenues (owing to significant revenue arrears and weakness in revenue administration noted below). Expenditure had been rising at a very fast pace until 1997, because of the inability to effectively contain costs in a system with an oversupply of physicians and hospitals, increasing pharmaceutical prices, and few constraints on the utilization of services (World Bank (1999)). Despite the moderate containment of expenditure in 1998—following a number of steps taken by the Ministry of Health to establish a better control over costs—the sector is still facing serious problems. The very high level of payments arrears by the Health funds (Sk 12 billion at end-1998), combined with large arrears on the revenue side (Sk 14 billion at end-1998)—particularly those associated with companies in bad financial position which stop making social security contributions for their employees—creates a vicious circle of indebtedness. Moreover, the projected increase in the aging population over the longer term is expected to have a significant impact on the demands on the health sector, thus raising concerns about the sustainability of the current system and making the case for the reforming of the system before the longer-term pressures materialize.

116. In this connection, a medium-term strategy would have the task of addressing these weaknesses so as to alleviate the potential risks of deterioration in the quality of the provided services and, in turn, in the health status of the population. Useful elements of that strategy could, among others, include: (i) reviewing of the collection system and increasing compliance with payments of contributions; (ii) developing a system of risk-related premiums with transparent and reasonable cross-subsidization; (iii) discouraging unwarranted patient demand, perhaps through demand-side incentives for cost control, such as deductibles and co-payments; and (iv) improving the cost structure of health facilities.70

Unemployment benefits

117. Unemployment benefits are administered by the Employment fund—operated under the National Labor Office—and spending on those benefits is just above one percent of GDP. This level of spending is relatively low, given the current rate of unemployment of 16.5 percent.71 The main reasons for the low spending are: (i) the limited duration of unemployment benefits—a maximum of 6 months for those with less than 15 years of service and 12 months for the ones with longer service history; (ii) the fact that unemployment benefits are quite modest—60 percent of the previous salary for the first 3 months and 50 percent thereafter, with a maximum which is just under one half of the economy-wide average monthly earnings 72; and (iii) the fact that that only about one-quarter of job-seekers (including those in training programs) receive unemployment benefits.

118. Although there are currently no significant concerns about the financial position of the Employment fund, a medium-term strategy could usefully address some issues. Unemployment benefits affect job search behavior and thus the length of unemployment spells and the average level of unemployment depends not only on their generosity, but also on the way they are administered. In this regard, there is a need for imposing strict criteria for eligibility or for availability for work. This becomes more important as over the medium-term, and despite projected declines, unemployment will remain high for some years to come.

Capital expenditure

119. Despite a decline to about 6 percent of GDP in 1998, capital expenditure remains very high compared with other transition economies (Table III-5). This is the result of a rapid expansion in public investment spending in recent years. Particular emphasis was given to the road sector—the construction of major east-west and north-south highway links—which aimed at improving transportation infrastructure but also creating employment in the construction sector. Highway construction has been financed mainly through borrowing and transfers from the state budget. As for the composition of borrowing, there has been a shift from domestic financing to foreign borrowing—under government guarantees (see below). Encouraging more participation by the private sector in the building and maintenance of roads could contribute to a medium-term strategy of reducing the share of government capital expenditure in GDP.

Net lending

120. Over the past few years, the government has been providing guarantees for a large share of the borrowing of enterprises in support of their investment activities. However, in 1998, the government incurred a cost of Sk 2.3 billion for called guarantees, and, owing to the deteriorating performance of enterprises, it may face very high potential obligations associated with debt service payments of those enterprises. 73 At the same time, additional costs are going to be imposed by the potential obligations for bonds that have been issued by the National Property Fund to compensate the holders of privatization vouchers after the mass privatization program was canceled. Those bonds—with a face value of Sk 28 billion—are going to mature at end-2000. To help deal with this very high level of liabilities on the government accounts, a medium-term strategy would benefit significantly from an accelerated program of privatization of the government’s holdings in state enterprises, accompanied by timely adjustments in administrative prices and pressure from the government on enterprises to reduce operating costs and thereby meet debt service obligations on loans guaranteed by the government.

Other Issues

121. Over the medium term, Slovakia will face a number of other changes which fiscal policy will need to take into account. These include bank and enterprise restructuring and efforts aimed at EU accession. In addition, several reforms to the medium-term fiscal process could be helpful and are under active consideration by the government.

Bank restructuring

122. Bank restructuring is going to be a prominent issue over the next few years. This process will include undertaking operations to clear up bad loans and recapitalize and privatize problem banks. The costs of these operations are expected to be significant, and they need to be recorded transparently in the fiscal accounts. 74 As noted above, the first-round effects involve the spending pertaining to the operation itself: the transfer of funds to the banks and the interest paid on bonds issued in the recapitalization operation. However, as Lane (1996) indicates, there might be important fiscal and monetary secondary effects resulting from the way the operation influences banks’ behavior, and thus the flow of bad loans. The nature of these effects—which are more difficult to quantify—depends on the extent to which there are accompanying changes associated with moral hazard problems and incentives for prudent lending.75

Enterprise restructuring

123. Accelerated public enterprise reform is also an important element of the government’s medium-term agenda. Although such reform could have some fiscal implications over the medium-term (arising from labor shedding and its effect through severance pay and lower personal and social security taxes), it would also contribute to fiscal adjustment. In this regard, improved profitability of public enterprises would boost dividend payments to the budget and reduce the need for direct budget support, including through government guarantees on enterprise borrowing. The government’s medium-term strategy includes useful elements for the rehabilitation of enterprises, and the improvement of bankruptcy procedures and corporate governance, which could have important fiscal consequences of a positive nature.

EU accession

124. Slovakia’s efforts for accession to the EU have gathered momentum recently and it is important for a medium-term strategy to be cast in a way that the associated costs and benefits are taken into account In this context, sustainable fiscal adjustment is very important as achieving and maintaining macroeconomic stability could be linked to accession. In addition, a key requirement set by the EU for accession candidates is that they have functioning market economies and demonstrate the capacity to manage economic policy consistent with the obligations of EU member-states. On the fiscal side, this means the ability to conduct fiscal policy with standard tools, standard revenue and expenditure categories, and budget accounting. It also means that countries eventually avoid any from of direct central bank financing of government deficits. Compliance with these guidelines as well as building up necessary infrastructure prior to accession would entail some costs. On the other hand, revenue is going to be favorably affected by EU transfers that could be used for agricultural support and for creating necessary infrastructure. These transfers have been a significant source of revenue for some members (Greece, Portugal, and Spain) and are expected to also be high for countries that are included in the first wave of entrants (projected at about an annual 0.5 percent of GDP for the period leading up to accession in the case of Hungary).

Medium-term budget process

125. Developing a medium-term fiscal program also requires an appropriate institutional setting. To this end, the government is in the process of developing methods to strengthen the budgeting process, including by formulating a given year’s fiscal policy within a medium-term framework. In addition, it recognizes the need to improve and consolidate the accounts of extrabudgetary and social security funds, to compile fiscal information more frequently and comprehensively, and to put mechanisms in place to better control fiscal activities. Projections of tax receipts and the preparation and regular updating of medium-term fiscal projections are also essential in upgrading the capacity for budget preparation and implementation.76

D. Medium-term Fiscal Scenarios

126. Two alternative scenarios have been prepared (an adjustment scenario and a passive scenario), in order to provide a quantitative basis to illustrate fiscal consolidation and the means to achieve it. Building upon the results of the analysis of the previous section, which identified some detailed fiscal considerations that Slovakia should take into account in the medium-term, the two scenarios are cast in the context of an integrated macroeconomic framework which attempts to ensure consistency between projections of the real, fiscal, monetary, and balance-of-payments sectors.

127. The adjustment scenario is broadly consistent with the government’s strategy for 1999 as outlined in the budget and as reinforced by the recent fiscal package. This scenario assumes, beginning in 1999, strong fiscal adjustment and a reduced role of the state in the economy, as well as the accelerated implementation of major structural reforms, including privatization. On the other hand, the passive scenario assumes much weaker fiscal adjustment and a slower pace of structural reforms.

128. The adjustment scenario targets achievement of a sustainable external position and durable economic growth of 4½ to 5 percent during 2001–2003. Following a substantial fiscal adjustment in 1999—which leads to a decline in the general government deficit to under 3 percent of GDP—further adjustment takes hold in later years so that the deficit falls to 0.6 percent of GDP by the end of the period (Tables III-8 and III-9, and Figure III-6). The driving force of the fiscal adjustment is a decline in the expenditure of the general government: indeed, this scenario illustrates a bold and ambitious effort, with expenditure falling to about 39 percent of GDP by 2003 from about 48 percent of GDP in 1998 77 This permits a decline in the tax burden to 33 percent of GDP by 2003 from 37 percent of GDP in 1998, and in the general government revenue to 38 percent of GDP by 2003 from 42 percent of GDP in 1998. 78

Figure III-6.
Figure III-6.

Slovak Republic: Medium-term Fiscal Scenarios--Government Budgetary Operations

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 112; 10.5089/9781451835380.002.A003

Sources; Ministry of Finance; and staff estimates and projections.1/ State budget only.

129. Achieving the envisaged decline in government expenditure will clearly not be easy, confronting the authorities with difficult decisions. However, Table III-8 (which shows the operations of the state budget) and Table III-9 (which shows the operations of the general government) aim to provide some guidance. Drawing on the expenditure analysis of Section C—which pointed out the relatively high spending on general government administration and subsidies, as well as certain desirable aspects of cutting and reforming social expenditure and scaling back capital outlays—expenditure restraint could be considered in several areas

Table III-8.

Slovak Republic: Medium-Term Adjustment Scenario-Government Budgetary Operations, 1998-2003

(In percent of GDP)

article image
Sources: Ministry of Finance; and staff estimates and projections.

130. In line with Tables III-8 and III-9, the authorities might consider: 79 (i) a reduction in general administration expenditure, including wage moderation and civil service reform, to 11.6 percent of GDP by 2003 from 13.9 percent of GDP in 1998; (ii) rationalization of state benefits and social assistance programs, by strengthening eligibility criteria and means testing for those benefits, accompanied by moderate pension increases for the Pension funds, so as to reduce social transfers to 13 percent of GDP by 2003 from 15 percent of GDP in 1998; (iii) rationalization of expenditure of the Health Funds—including the introduction of larger copayments for users of public health services—so as to reduce expenditure of these funds to 5.3 percent of GDP by 2003 from 6.5 percent of GDP in 1998; (iv) timely adjustments in administrative prices and pressure from the government on enterprises to reduce operating costs and thereby meet debt service obligations on loans guaranteed by the government (see paragraph 131 below); (v) lower subsidies (equivalent to 2.7 percent of GDP in 2003 compared with 3.7 percent of GDP in 1998), reflecting adjustments in administrative prices; and (vi) rationalization of capital spending in the state budget and of investment expenditure of the extra-budgetary funds (especially the Road fund), coupled with increased private sector participation in the building and operation of major infrastructure projects—these could contribute to a reduction in capital expenditure of the general government to 3.4 percent of GDP by 2003 from 6.1 percent of GDP in 1998.

131. Otherwise, on the expenditure side, the fiscal costs of bank restructuring are accounted for these costs (equivalent to about 1 percent of GDP annually) include the interest on government bonds to bring the problem banks’ net worth to zero and to recapitalize these banks bringing their capital-adequacy ratio to international standards. As an offsetting factor, net lending declines sharply to 0.1 percent of GDP by 2003 from 0.7 percent of GDP in 1998, reflecting the decline in the amount of government guarantees that are called and future privatization. Finally, it is assumed that the National Property Fund exchanges its bonds maturing at end-2000 (some Sk 28 billion) for shares in the Gas and Electricity Companies.

132. Revenues are lowered by the reform of the personal income tax and reductions in the corporate income tax, as well as lower personal and social security taxes (including because of labor shedding in the restructured enterprise sector). However, revenue capacity is favorably affected by growing economic activity, increases in enterprise profitability, strengthened efforts to reform the tax system, and significant improvements in tax administration. Specific revenue measures, which are broadly consistent with the main elements of the government’s program for 1999 and whose impact is presented in Table III-9, include:80 (i) an increase in the lower VAT rate and a reduction in the higher VAT rate to bring them in line with rates in EU countries; (ii) taxation of electricity at the higher VAT rate—the combined effect of these measures pertaining to the VAT would contribute to a gradual reduction in the VAT collection to 7.3 percent of GDP by 2003 from 7.7 percent of GDP in 1998; (iii) a gradual reduction in the corporate income tax rate such that tax collection would drop to 2.6 percent of GDP by 2003 from 3.6 percent of GDP in 1998; (iv) reform of the personal income tax, including an adjustment in the personal income tax brackets and a subsequent move toward a global personal income tax, leading to a decline in personal income tax collection to 5.4 percent of GDP by 2003 compared with 5.9 percent of GDP in 1998; (v) increases in excise taxes so as to bring them in line with taxes in EU and other transition countries, thus leading to an increase in excise collection to 3.8 percent of GDP by 2003 from 3.2 percent of GDP in 1998; (vi) introduction of a tax on motor vehicles; (vii) increases in administrative and other fees; and (viii) better tax administration and compliance of taxpayers, particularly regarding the personal income tax, social security contributions, VAT, and excises.

Table III-9.

Slovak Republic: Medium-Term Adjustment Scenario-Operations of the General Government, 1998-2003

(In percent of GDP)

article image
Sources: Ministry of Finance; and staff estimates and projections.

133. The fiscal adjustment effort is expected to be accompanied by several positive developments. In particular, the adjustment scenario envisages a continued narrowing of the external current account deficit throughout the period (Table III-10). Fiscal adjustment helps restrain import demand, while strong export growth also contributes to external adjustment while raising economic growth. In addition, public debt declines to 26 percent of GDP by 2003 from 31 percent of GDP in 1998, thus also facilitating the reduction of the debt service over the medium term. The reduction in the general government deficit is also reflected in the increase in government savings over the period to almost 3 percent by 2003.

134. In the passive scenario, it is assumed that the fiscal deficit remains large and following a temporary decline to 4.2 percent of GDP in 1999 it expands to close to 6 percent by 2003 (Figure III-6). The expansion of the fiscal deficit under the passive scenario reflects: (i) continued high interest costs owing to very high borrowing costs; (ii) a need for the government to make payments for enterprises whose guarantees are called; (iii) costs of bank restructuring, which are higher than in the adjustment scenario owing to higher interest rates; (iv) low revenue capacity owing to weak economic activity; (v) further declines in enterprise profitability; and (vi) a slow pace of privatization. All these factors would put significant strains on the budget and would thus leave hardly any room for streamlining the tax structure and lowering interest rates.

135. The absence of an adjustment effort in the passive scenario would have other negative consequences (Table III-10). With increasing inflationary pressures and high interest rates, growth would likely stagnate at significantly lower rates than in the adjustment scenario during the period 2000–03. Public debt would rise to 36 percent of GDP, and the government would continue to absorb a big part of national savings. In addition, high interest payments suggest continued vulnerability of the budget to changes in macroeconomic conditions. Associated with the deterioration in the fiscal position is a widening in the current account deficit to an unsustainable level of almost 10 percent of GDP by 2003. Of course, this scenario assumes the availability of sufficient external financing. In case of sizeable shortfalls in this financing, the country could experience some combination of a rapid depletion of the NBS’ reserves, large currency depreciation, rising interest rates, and weaker economic activity.

E. Concluding Remarks

136. The preceding analysis has identified a number of important considerations that would need to be taken into account in designing a program of continued fiscal consolidation over the medium term. Reducing the tax burden is one key priority, and in line with the intentions of the Slovak authorities. But achieving a significant reduction in taxes—and revenues more broadly—will require a determined effort to reduce government expenditure and the role of the state in the economy. It will also involve difficult policy decisions. Efforts to scale back expenditure could focus on a medium-term plan for civil service reform and rationalization; increasing the efficiency and targeting of social spending; reforming budgeting and control systems, including by ensuring transparency and accountability; and reducing state involvement in the construction of large-scale infrastructure projects, while encouraging more participation by the private sector in the building and maintenance of those projects.

51

Prepared by Costas Christou.

52

This target was expected to be achieved through strong tax revenue growth (including through an increase in excises and in value-added tax rates on some services, bracket creep for personal income tax, and improved collection of corporate income tax) combined with significant expenditure restraint (particularly reductions in capital expenditure, subsidies, and social security spending).

53

Slovakia’s tax-to-GDP ratio of 37 percent is among the highest among transition economies with similar per capita GDP (tax-to-GDP ratios of 27 percent for Bulgaria, 37 percent for the Czech Republic, 41 percent for Hungary, 25 percent for Lithuania, 37 percent for Poland, and 27 percent for Romania) and it is well above the ratio of other European countries with much higher per capita GDP (tax-to-GDP ratios of 32 percent for Greece, 26 percent for Malta, 34 percent for Portugal, 35 percent for Spain, and 28 percent for Turkey).

54

See Musgrave (1959), Feldstein (1994), Fullerton, Walker, Long (1994), and Andersson (1997) for theoretical arguments and empirical evidence to suggest that lowering the tax burden can raise economic growth.

55

The composition of fiscal adjustment has important implications for the likelihood of success (defined as a long-lasting deficit reduction), as demonstrated by Alesina and Perotti (1997), and Perotti (1996) and (1999). Their main point is that fiscal adjustments that rely primarily on spending cuts in transfers and the government wage bill have a better chance of success (and, in fact, may turn out to be expansionary over time), in contrast with fiscal adjustments that rely primarily on tax increases that tend not to last. Moreover, Mackenzie, Orsmond, and Gerson (1997) provide evidence for the importance of civil service and enterprise reforms, good public expenditure management systems, and a well-functioning tax administration for economic growth.

56

See IMF (1998a) for a more detailed comparison of the PIT in selected central European countries.

57

Currently, individuals are not required to file a tax return if the only sources of income are salaries and interest, as taxes on those are withheld by the employers and banks, respectively. However, individuals with rental income or capital income other than interest are required to file tax returns. The main advantage of a global PIT is that the goal of vertical equity can be achieved more easily, since the tax is based on an aggregate measure of income. A global tax may also have administrative advantages if there are many taxpayers with multiple sources of income, because only one tax return is filed for each taxpayer, but it could also generate high administrative costs if there are many taxpayers with only labor or interest income—which is now subject to tax withholding—who are not currently required to file a tax return (see Muten (1992) and International Monetary Fund (1995)).

58

In an effort to attract FDI, the government approved in early-1999 a package of tax and non-tax incentives. These incentives included an improved legal and institutional framework, and public sector reforms to improve transparency. However, they also included discriminatory elements, like tax and import duty exemptions for foreign investors, contingent on firms’ lines of business and export performance. See Holland and Owens (1997) for a review of investment incentives used in a number of transition countries, and for important recommendations on the use of taxation to attract FDI.

59

The magnitude of the tax wedge has important implications for aggregate employment and output: by driving a wedge between the prices of labor as seen by the worker and the employer, taxes on labor hamper the mutually beneficial exchange of labor for income. Large tax wedges increase labor costs and thus reduce the offered wage and/or the demand for labor. When large tax wedges are a result of higher contributions by the employees, take-home pay is lower and thus workers substitute leisure or home production for labor, reducing labor supply. The overall impact on employment and output is negative, the magnitude of which depends on the wage elasticities of the wage-setting, labor supply, and labor demand schedules.

60

Taxation of construction at the lower rate results in extensive VAT refund claims as construction materials and equipment (taxed at the standard rate) may be purchased by contractors for use in taxable construction activities. These latter activities are taxable at the 6 percent rate, whereas they may take full credit for the 23 percent tax that has been paid on inputs.

61

IMF (1998b) reviews problems with tax administration in Slovakia and makes detailed recommendations on improving the administration of tax, customs, and social security collections.

62

Amendments to the VAT legislation pertain to: the provisions on tax refunds and provisions on tax exemptions for export; the provisions on the application of the tax to selected financial operations; and the eligibility criteria for claiming refunds.

63

Slovakia’s expenditure-to-GDP ratio is the highest among transition economies with similar per capita GDP (corresponding ratios of 33 percent for Bulgaria, 43 percent for the Czech Republic, 47 percent for Hungary, 47 percent for Poland, and 34 percent for Romania).

64

These objectives are consistent with empirical evidence that shows the importance of expenditure cuts (and particularly of transfers and the government wage bill) for the sustainability of fiscal adjustment and growth (see footnote 55 above).

65

Expenditure on general government administration includes salaries, wages, and social security contributions paid for government employees, and other goods and services.

66

See IMF (1998a) for a comparison of wages in the budget sector during 1992–95.

67

The government has indicated its intention to request technical assistance from the World Bank in this area.

68

In Poland, the average replacement rate for non-farmers is about 80 percent and for farmers about 40 percent. In Hungary, the same rate is about 60 percent.

69

The retirement age (55–60 for men and 53–57 for women) is low and savings through private pension funds is underdeveloped.

70

The government has indicated its intention to request assistance from the World Bank in these areas.

71

Spending on unemployment (as a share of GDP) is generally around three or four times as high in western European countries with comparable unemployment rates (OECD (1999)).

72

This compares with an average initial replacement rate—i.e., initial unemployment benefit divided by the previous earned income—of 61 in the Euro area, 73 in the other EU countries, 60 in the US, and 73 in Switzerland (IMF (1999)).

73

The budget includes a provision of Sk 4.2 billion for expenditure related to guarantees that might be called in 1999.

74

See Daniel, Davis, and Wolfe (1997) for a review of problems with current practices in accounting for these costs and a new recommended approach.

75

In all, the extent to which the resulting increase in the fiscal deficit implies a more expansionary fiscal policy is difficult to gauge. Indeed, several authors have argued that the fiscal cost of bank recapitalization could be an illusion: Calvo and Frenkel (1991) on the basis that a government transfer to recapitalize state-owned banks involves no net transfer for the public sector; Begg and Portes (1993) in the sense that the money disappeared from the state finances when the bad debts were incurred and not when this was acknowledged; Fleming (1994) since the interest received by depositors is realty being paid by the government; and Lane (1996) on the basis that fiscal costs are incurred regardless of whether or not recapitalization takes place.

76

The government has already requested technical assistance from the Fund for developing mechanisms for improving the monitoring, control, and consolidation of general government accounts, as well as for shifting to fiscal planning over a two- to three-year horizon.

77

There are a number of countries with successful episodes of significant fiscal adjustment, primarily originating from dramatic expenditure cuts. For example: (i) in Ireland during 1985-91, primary expenditure was reduced to 34 percent of GDP from 41 percent of GDP, while tax revenue declined to 34 percent of GDP from 36 percent of GDP; and (ii) in Hungary during 1994-96, the primary balance improved by almost 7 percentage points, owing to a decline in primary expenditure to 38 percent of GDP from 45 percent of GDP.

78

The declines in the expenditure-, revenue-, and tax-to-GDP ratios would bring them in line with the ones for countries of similar per capita income levels, as noted in footnotes 53 and 63 above. Of course, for a given fiscal target, there would be less room for revenue reduction were expenditure reduction to be less ambitious.

79

These measures are broadly in line with the objectives of the government’s fiscal package that was announced in May 1999, which contained important expenditure measures that would underpin medium-term fiscal consolidation. These included continued rationalization of social benefits beyond 1999, reform in the pension system (including through an increase in the retirement age), significant reduction in the government payroll beginning in 2000, and establishing mechanisms to provide better control over the expenditures of the extrabudgetary and social security funds. At the same time, further adjustments in administrative prices were envisaged.

80

In addition to the measures mentioned in paragraph 95, which pertain only to 1999, the government’s fiscal package that was announced in May 1999 contained the following important medium-term revenue measures; a reform of the personal income tax, a reduction in the upper VAT rate, and a lowering of the corporate income tax.

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Cover IMF Staff Country Reports
Slovak Republic: Selected Issues and Statistical Appendix
Author:
International Monetary Fund
Volume/Issue:
Volume 1999: Issue 112
Publisher:
International Monetary Fund
ISBN:
9781451835380
ISSN:
1934-7685
Pages:
130
DOI:
https://doi.org/10.5089/9781451835380.002
  • Figure III-1.
    View in gallery
    Figure III-1.

    Slovak Republic: General Government Budget Balance, 1993-98

    (In percent of GDP)

  • Figure III-2.
    View in gallery
    Figure III-2.

    Slovak Republic: Structure of General Government Revenue and Expenditure, 1993 and 1998

  • Figure III-3.
    View in gallery
    Figure III-3.

    Slovak Republic: Population Structure, 1990-2030

  • Figure III-4.
    View in gallery
    Figure III-4.

    Slovak Republic: Share of Population Over Age 65 in Selected Countries, 1990-2030

  • Figure III-5.
    View in gallery
    Figure III-5.

    Slovak Republic: Dependency Ratios in Selected Countries, 1990-2030

  • Figure III-6.
    View in gallery
    Figure III-6.

    Slovak Republic: Medium-term Fiscal Scenarios--Government Budgetary Operations

    (In percent of GDP)

Figure III-1.

Slovak Republic: General Government Budget Balance, 1993-98

(In percent of GDP)
Figure III-2.

Slovak Republic: Structure of General Government Revenue and Expenditure, 1993 and 1998
Figure III-3.

Slovak Republic: Population Structure, 1990-2030
Figure III-4.

Slovak Republic: Share of Population Over Age 65 in Selected Countries, 1990-2030
Figure III-5.

Slovak Republic: Dependency Ratios in Selected Countries, 1990-2030
Figure III-6.

Slovak Republic: Medium-term Fiscal Scenarios--Government Budgetary Operations

(In percent of GDP)