Czech Republic: Selected Issues in Fiscal Policy Reform

International Monetary Fund

doi:10.5089/9781451810257.002.A002

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Czech Republic: Selected Issues in Fiscal Policy Reform

Author: International Monetary Fund

Publication Date:: 28 Feb 2007

eISBN:: 9781451810257

ISBN:: 9781451810257

Language:: English

Keywords:: ISCR; CR; expenditure reform priority; spending; EU fund; EU transfer; chapter III; spending ceiling; deficit target; expenditure framework; expenditure ceiling; General government debt; Fiscal governance

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This Selected Issues paper examines two key questions on fiscal policy reform in the Czech Republic. First, how can the fiscal institutional framework be strengthened to maintain discipline and enhance transparency? Second, what are the priorities in expenditure reform that can be implemented without sacrificing the quality of spending? The paper discusses the recent Czech experience with the medium-term expenditure framework and some proposals for strengthening it. It also discusses cross-country analyses of spending efficiency and flexibility, and proposes areas for fiscal adjustment that reduce inefficiencies.

Abstract

II. Strengthening the Fiscal Framework¹

A. Introduction

1. The Czech Republic has made important strides in introducing a fiscal framework as part of the fiscal reform agenda for EU entry. Currently, it has a three-year rolling budgetary framework underpinned by nominal expenditure ceilings. The fiscal targets anchoring the nominal ceilings are spelled out in the Convergence Program and determined by a gradual adjustment path to meet the three percent deficit limit under the Stability and Growth Pact. The framework has helped lower deficits and the introduction of a carryover provision for fiscal underspending has also led to incentives for a more efficient spending of resources.

2. Nevertheless, weaknesses have emerged in the process of implementing the medium term budgetary framework. The upward revision of the spending limits in the medium term budget during the 2006 and 2007 budget process and the abandonment of the 2005 Convergence Program targets suggests that the fiscal framework needs to be strengthened to increase fiscal discipline in good times. Given the current environment of political uncertainty, the fiscal framework takes on added importance as a disciplining device.

3. In the context of these recent developments, the paper reviews challenges to the fiscal framework and seeks to identify some areas that could strengthen it. Section B reviews fiscal trends and key challenges and section C discusses the emerging pressures in the fiscal framework. Section D focuses on policy issues including key considerations for the level of the fiscal deficit target, on whether these targets should be institutionalized as a fiscal rule and possible changes to strengthen the medium term expenditure framework. Section E concludes.

B. Fiscal Trends and Key Challenges

4. Public debt rose rapidly since 2000, with some moderation over 2004-05. Although the debt level at 27½ percent of GDP at end 2006², is relatively low, primary deficit remains among the highest in the region (Chart 1) and debt dynamics have also been relatively unfavorable (Chart 2). Until 2003, these rising deficits were driven mainly by expenditures (Chart 3). This deteriorating trend was reversed in 2004 when, in preparation for EU entry, a three year fiscal reform program with a medium term expenditure framework was introduced.

5. The reduction in deficits in 2004-05, however, was not underpinned by durable expenditure reforms. Two main factors contributed to the lower deficits. In 2004, new budgetary rules allowing unspent budget allocations to be carried forward as reserves, created disincentives for a large year-end spending. In 2005, windfall revenue gains from an export-led boom contributed to lower deficits, but were used to finance an increase in mandatory social spending programs, reversing the favorable fiscal trends.

6. A cyclical analysis of the budget over the past decade suggests that discretionary factors have contributed to the high deficits. Based on estimates of potential output which show a negative but closing output gap³, the fiscal stance has been generally expansionary between 1999-2003 as shown by the positive fiscal impulse (Chart 4 and Table 1.) These trends in the size and direction of the fiscal impulse are robust to different methodologies used for calculating the output gap and structural balance. To better understand the cyclical properties of the Czech fiscal policy, the fiscal stance is also evaluated separately for ‘good times’, defined as periods of narrowing negative output gap, and ‘bad times’ when the negative output gap was widening (Chart 5). This analysis shows that fiscal policy has followed a somewhat asymmetric trend with a procyclical stance during cyclical upturns and a countercyclical stance during downturns, contributing to a rapid rise in debt. The fiscal expansion has been driven primarily by discretionary factors (Chart 6). The automatic stabilizing effect appears to have been small, which could be attributed to the relatively small share of income-related transfers and progressive direct taxes, and lower labor market flexibility compared to the OECD and EU–15 countries.⁴

Table 1.

Structural Balance and Discretionary Fiscal Policy

(In percent of GDP, unless otherwise noted)

Source: IMF staff estimates.

^{^1/}Excludes privatization financed net lending and transformation grants.

^{^2/}Calculated as the change in the difference between actual and structural revenues and expenditures.

^{^3/}Calculated as the difference between the change in the actual primary balance and automatic stabilizers.

^{^4/}Positive impulse implies loosening and negative number implies tightening.

^{^5/}Calculated as the difference between the “neutral” revenues and non-interest expenditures. See Horton (2005) for methodology details.

Table 1.

Structural Balance and Discretionary Fiscal Policy

(In percent of GDP, unless otherwise noted)

				1996	1997	1998	1999	2000	2001	2002	2003	2004	2005	2006	Average
1	Macroeconomic data
	Nominal GDP (in bill. of CZK.)			1683	1811	1996	2081	2189	2352	2464	2577	2781	2978	3181	--
	Real GDP (percent change)				-0.7	-0.8	1.3	3.6	2.5	1.9	3.6	4.2	6.1	6.0	2.8
	Output gap (in percent of potential GDP)			0.5	-1.6	-4.0	-4.1	-3.6	-3.5	-4.5	-4.1	-3.7	-2.7	-0.9	-2.9
	Potential/Actual GDP			0.99	1.02	1.04	1.04	1.04	1.04	1.05	1.04	1.04	1.03	1.01	1.0
2	Fiscal data
	Revenues			39.5	36.7	35.5	35.4	35.7	36.1	36.8	38.2	38.0	39.1	38.8	37.3
	Expenditures ^1/			41.6	38.0	36.8	38.5	38.8	38.8	40.6	43.0	41.3	41.2	42.5	40.1
		Noninterest		40.3	36.8	35.7	37.6	37.9	38.0	40.0	42.3	40.2	40.3	41.4	39.1
		Interest		1.2	1.1	1.1	0.9	1.0	0.9	0.6	0.8	1.1	0.9	1.1	1.0
	Overall balance			-2.0	-1.2	-1.3	-3.1	-3.2	-2.7	-3.9	-4.8	-3.3	-2.1	-3.7	-2.8
	Primary balance			-0.8	-0.1	-0.2	-2.2	-2.2	-1.9	-3.2	-4.0	-2.2	-1.2	-2.6	-1.9
	Change in primary balance				0.7	-0.1	-2.0	0.0	0.4	-1.4	-0.8	1.9	1.0	-1.4	--
3	Structural balance, (elasticity = 0.94)
	Estimated revenues			39.3	37.3	36.9	37.2	36.9	37.4	38.4	39.8	39.5	40.1	39.1	38.4
	Estimated expenditures			41.6	38.0	36.8	38.8	38.8	38.9	40.6	43.0	41.4	41.1	42.5	40.1
	Non-interest estimated expenditures			40.3	36.8	35.7	37.8	37.8	38.0	40.0	42.2	40.3	40.2	41.4	39.1
	Overall balance			-2.2	-0.7	0.1	-1.6	-1.9	-1.5	-2.2	-3.2	-1.8	-1.0	-3.4	-1.8
	Primary balance			-1.0	0.5	1.2	-0.7	-0.9	-0.6	-1.6	-2.4	-0.7	-0.1	-2.3	-0.8
4	Automatic stabilizers and discretionary fiscal policy
	Change in actual primary balance				0.7	-0.1	-2.0	0.0	0.4	-1.4	-0.8	1.9	1.0	-1.4	-0.2
	of which, automatic stabilizers ^2/				-0.7	-0.8	-0.2	0.2	0.0	-0.4	0.1	0.2	0.4	0.8	-0.1
			discretionary fiscal policy ^3/		1.5	0.7	-1.8	-0.3	0.3	-0.9	-0.9	1.7	0.6	-2.1	-0.1
5	Fiscal stance and fiscal impulse ^4/
	Fiscal impulse 1				-1.5	-0.7	1.8	0.3	-0.3	0.9	0.9	-1.7	-0.6	2.1
	Fiscal stance ^5/				-1.4	-2.3	-0.4	-0.1	-0.4	0.5	1.5	-0.2	-0.7	1.4	-0.2
		Revenue stance			2.8	4.0	4.1	3.9	3.4	2.8	1.3	1.5	0.4	0.7	2.5
		Non-interest expenditure stance			-4.2	-6.3	-4.5	-4.0	-3.8	-2.3	0.2	-1.7	-1.2	0.7	-2.7
	Fiscal Impulse 2				-1.4	-0.9	1.9	0.3	-0.3	0.9	1.0	-1.7	-0.5	2.1

Source: IMF staff estimates.

^{^1/}Excludes privatization financed net lending and transformation grants.

^{^2/}Calculated as the change in the difference between actual and structural revenues and expenditures.

^{^3/}Calculated as the difference between the change in the actual primary balance and automatic stabilizers.

^{^4/}Positive impulse implies loosening and negative number implies tightening.

^{^5/}Calculated as the difference between the “neutral” revenues and non-interest expenditures. See Horton (2005) for methodology details.

Table 1.

Structural Balance and Discretionary Fiscal Policy

(In percent of GDP, unless otherwise noted)

				1996	1997	1998	1999	2000	2001	2002	2003	2004	2005	2006	Average
1	Macroeconomic data
	Nominal GDP (in bill. of CZK.)			1683	1811	1996	2081	2189	2352	2464	2577	2781	2978	3181	--
	Real GDP (percent change)				-0.7	-0.8	1.3	3.6	2.5	1.9	3.6	4.2	6.1	6.0	2.8
	Output gap (in percent of potential GDP)			0.5	-1.6	-4.0	-4.1	-3.6	-3.5	-4.5	-4.1	-3.7	-2.7	-0.9	-2.9
	Potential/Actual GDP			0.99	1.02	1.04	1.04	1.04	1.04	1.05	1.04	1.04	1.03	1.01	1.0
2	Fiscal data
	Revenues			39.5	36.7	35.5	35.4	35.7	36.1	36.8	38.2	38.0	39.1	38.8	37.3
	Expenditures ^1/			41.6	38.0	36.8	38.5	38.8	38.8	40.6	43.0	41.3	41.2	42.5	40.1
		Noninterest		40.3	36.8	35.7	37.6	37.9	38.0	40.0	42.3	40.2	40.3	41.4	39.1
		Interest		1.2	1.1	1.1	0.9	1.0	0.9	0.6	0.8	1.1	0.9	1.1	1.0
	Overall balance			-2.0	-1.2	-1.3	-3.1	-3.2	-2.7	-3.9	-4.8	-3.3	-2.1	-3.7	-2.8
	Primary balance			-0.8	-0.1	-0.2	-2.2	-2.2	-1.9	-3.2	-4.0	-2.2	-1.2	-2.6	-1.9
	Change in primary balance				0.7	-0.1	-2.0	0.0	0.4	-1.4	-0.8	1.9	1.0	-1.4	--
3	Structural balance, (elasticity = 0.94)
	Estimated revenues			39.3	37.3	36.9	37.2	36.9	37.4	38.4	39.8	39.5	40.1	39.1	38.4
	Estimated expenditures			41.6	38.0	36.8	38.8	38.8	38.9	40.6	43.0	41.4	41.1	42.5	40.1
	Non-interest estimated expenditures			40.3	36.8	35.7	37.8	37.8	38.0	40.0	42.2	40.3	40.2	41.4	39.1
	Overall balance			-2.2	-0.7	0.1	-1.6	-1.9	-1.5	-2.2	-3.2	-1.8	-1.0	-3.4	-1.8
	Primary balance			-1.0	0.5	1.2	-0.7	-0.9	-0.6	-1.6	-2.4	-0.7	-0.1	-2.3	-0.8
4	Automatic stabilizers and discretionary fiscal policy
	Change in actual primary balance				0.7	-0.1	-2.0	0.0	0.4	-1.4	-0.8	1.9	1.0	-1.4	-0.2
	of which, automatic stabilizers ^2/				-0.7	-0.8	-0.2	0.2	0.0	-0.4	0.1	0.2	0.4	0.8	-0.1
			discretionary fiscal policy ^3/		1.5	0.7	-1.8	-0.3	0.3	-0.9	-0.9	1.7	0.6	-2.1	-0.1
5	Fiscal stance and fiscal impulse ^4/
	Fiscal impulse 1				-1.5	-0.7	1.8	0.3	-0.3	0.9	0.9	-1.7	-0.6	2.1
	Fiscal stance ^5/				-1.4	-2.3	-0.4	-0.1	-0.4	0.5	1.5	-0.2	-0.7	1.4	-0.2
		Revenue stance			2.8	4.0	4.1	3.9	3.4	2.8	1.3	1.5	0.4	0.7	2.5
		Non-interest expenditure stance			-4.2	-6.3	-4.5	-4.0	-3.8	-2.3	0.2	-1.7	-1.2	0.7	-2.7
	Fiscal Impulse 2				-1.4	-0.9	1.9	0.3	-0.3	0.9	1.0	-1.7	-0.5	2.1

Source: IMF staff estimates.

^{^1/}Excludes privatization financed net lending and transformation grants.

^{^2/}Calculated as the change in the difference between actual and structural revenues and expenditures.

^{^3/}Calculated as the difference between the change in the actual primary balance and automatic stabilizers.

^{^4/}Positive impulse implies loosening and negative number implies tightening.

^{^5/}Calculated as the difference between the “neutral” revenues and non-interest expenditures. See Horton (2005) for methodology details.

7. Looking ahead, budgetary pressures are likely to mount. Regional tax competition and a high tax wedge have led to pressures to reduce tax rates. Corporate tax rate remains among the highest in the new member states despite a phased reduction since 2004. The drying up of privatization revenues, which have been used to finance infrastructure spending and guarantee payments, would further worsen debt dynamics. The authorities also face large high-risk contingent liabilities from past bank restructuring and environmental guarantees. Longer term spending pressures for pensions and health care and co-financing needs of EU-fund pose further significant challenges. Over the medium term, the Czech Republic needs to lower its deficits in a sustainable manner below the three percent threshold to fulfill the Maastricht criteria for euro adoption.

8. Addressing these challenges will require strong fiscal institutions to limit the deficit bias. Reversing the recent tendency to raise spending or cut taxes during favorable cyclical periods is key to avoiding procyclical fiscal policy. A countercyclical policy not only supports output stabilization, which will be increasingly important as the economy integrates with the eurozone, but also prevents a build up of high deficits and debt that could require a procyclical fiscal contraction.

C. The Fiscal Framework and Emerging Pressures

9. The Czech fiscal framework was introduced in 2004. While there is no explicit fiscal rule for a budget balance, the framework requires the government to announce medium-term fiscal targets at the general and central government levels for two years subsequent to the budget year. These targets have been consistent with the Convergence Program, which has sought to gradually lower the general government deficit to below 3 percent of GDP threshold under the Stability and Growth Pact. Based on the medium-term macroeconomic forecasts prepared by the Ministry of Finance, nominal revenues are projected, which together with the deficit targets are used to derive the nominal expenditure ceilings for the state budget and the state funds.

10. The expenditure targets are legally binding and can only be adjusted in specific cases. The medium-term expenditure framework is submitted along with the state budget to Parliament and the conditions under which the annual budget can deviate from these medium term targets are pre-specified. For instance, escape clauses exist for large deviations in CPI developments, EU financed programs, legal changes in budgetary allocation of taxes for decentralization, and extraordinary spending not projected when the framework was determined. A margin of one percent for the budget year and two percent for the following year is allowed. Any positive surprises such as windfall revenue gains are required to be used to lower deficits. In the event of a breach of spending ceilings, however, no sanctions exist.

11. The experience of past three years with the fiscal framework has pointed to several weaknesses in its implementation:

Lack of adherence to fiscal deficit targets: Although the annual budgets for 2005 and 2006 respected the preannounced medium term deficit targets, the 2007 budget relaxed the deficit target significantly (Chart 7), despite stronger than projected growth. Furthermore, no medium term targets were announced. The increase in the deficit was driven by a large mandatory social spending package approved ahead of the 2006 elections, impacting the deficits over the medium term.

Revenue windfalls used to increase spending: In the face of strong revenue growth, spending ceilings have been repeatedly revised upwards (Chart 8). These increases were justified on the premise that the revenue surprise reflected structural changes in the revenue base. The revenue surprises were thus used to lower within-year deficits but not the multiannual budget targets as required by the framework. The upward revision in spending amounted to nearly ¾ percent of GDP in the 2006 budget and 1¾ percent of GDP in 2007. This revision has led to a procyclical stance, undermining the objective of the fiscal framework as an automatic stabilizer.

GDP revisions and macro forecast error: Projecting revenues has been complicated by the forecast errors in the GDP projections (Table 2.). The frequent revisions in the GDP series, structural changes following EU accession, and tax reform measures have added to the difficulties of forecasting structural revenues.

Table 2.

Macroforecasts: Budget versus Outcome, 2004-05

Source: Czech authorities.

Coverage of the fiscal framework: Under the budgetary rules, extra budgetary funds and line ministries are allowed carryover of annual budgetary underspending in both current and capital budgets which can be spent in future years without any limits placed by the Ministry of Finance. At end-2005, these budgetary reserves had accumulated to 1¾ percent of GDP reflecting the persistent overbudgeting of expenditure allocations. Similarly, spending from privatization account remains outside the spending ceiling. Exclusions in the current fiscal framework risk erosion of fiscal control by the Ministry of Finance.

D. Key Considerations for Strengthening the Fiscal Framework

12. Against this backdrop, the fiscal policy framework faces some key questions:

What is the appropriate long-term budget deficit target?
Should the target be fixed in the form of a fiscal rule?
How can the current fiscal framework be strengthened as a commitment device towards achieving these targets?

The following sections discuss some considerations to address these questions.

What is the appropriate long-term budget target?

13. Standard debt sustainability analysis suggests that the present deficits will not stabilize debt. The debt stabilizing primary fiscal balance is given by the following debt dynamic equation,

p b = (r - g) . d

where pb denotes the primary balance as a percent of GDP, r is the real interest rate, g, the growth rate, and, d, the debt to GDP ratio. The Czech Republic’s average primary balance, at 2.5 percent over 2001-05, ranks among the highest in the new member states, easily exceeding the level needed to sustain the debt level of 26 percent of GDP at end-2005 (Table 3.). Even with a more optimistic medium term growth forecast and a higher target deficit level of 30 percent of GDP, the debt stabilizing deficit is below that implied by the deficits projected under the 2005 Convergence Program and the medium term budget. Since the desired target deficit is endogenous to the target level of debt, this raises the question as to the optimal level of debt.

Table 3.

Debt Stabilizing Primary Balance Scenarios

(In percent of GDP, unless noted otherwise)

Source: Staff calculations.

^{^1/}Derived as nominal rate minus change in GDP deflator. Nominal rate is calculated as the nominal interest expenditure divided by previous period debt stock.

^{^2/}Staff projections based on 2005 Convergence Program targets.

Table 3.

Debt Stabilizing Primary Balance Scenarios

(In percent of GDP, unless noted otherwise)

	Average	Average
	2001-05	2006-11 ^2/	Optimistic	Pessimistic	Optimistic	Pessimistic	Optimistic	Pessimistic
Target debt level	26	30	40	40	50	50	60	60
Growth rate (in percent)	3.7	4.6	5.0	3.0	5.0	3.0	5.0	3.0
Real interest rate (in percent) ^1/	2.2	3.1	2.5	3.5	2.5	3.5	2.5	3.5
Required primary balance	-0.4	-0.4	-1.0	0.2	-1.3	0.3	-1.5	0.3
Actual primary balance	-2.5	-1.4	…	…	…	…	…	…

Source: Staff calculations.

^{^1/}Derived as nominal rate minus change in GDP deflator. Nominal rate is calculated as the nominal interest expenditure divided by previous period debt stock.

^{^2/}Staff projections based on 2005 Convergence Program targets.

Table 3.

Debt Stabilizing Primary Balance Scenarios

(In percent of GDP, unless noted otherwise)

	Average	Average
	2001-05	2006-11 ^2/	Optimistic	Pessimistic	Optimistic	Pessimistic	Optimistic	Pessimistic
Target debt level	26	30	40	40	50	50	60	60
Growth rate (in percent)	3.7	4.6	5.0	3.0	5.0	3.0	5.0	3.0
Real interest rate (in percent) ^1/	2.2	3.1	2.5	3.5	2.5	3.5	2.5	3.5
Required primary balance	-0.4	-0.4	-1.0	0.2	-1.3	0.3	-1.5	0.3
Actual primary balance	-2.5	-1.4	…	…	…	…	…	…

Source: Staff calculations.

^{^1/}Derived as nominal rate minus change in GDP deflator. Nominal rate is calculated as the nominal interest expenditure divided by previous period debt stock.

^{^2/}Staff projections based on 2005 Convergence Program targets.

14. Long-run growth rates and the time rate of preference are important factors in determining the optimal debt target level. As an economy catching up with EU income levels, higher investment spending would support faster growth rates. This justifies following a golden rule where investment spending can be financed through debt. Furthermore, debt stabilizing deficits are arguably higher than in more mature markets, as growth will be stronger in the process of income convergence and real interest rates will be lower due to the higher equilibrium rate of inflation. Under this optimistic scenario with a 5 percent long term growth, a primary deficit of 1.4 percent of GDP as projected in the medium term plans would stabilize debt at around 55 percent of GDP. However, after income convergence, the deficit level would need to much lower in order to stabilize debt given a slowdown in growth and a higher interest burden.

15. Additional considerations are market expectations of a sustainable debt leveland risks stemming from output volatility and debt rollover. When debt is at an unsustainable level and the market perceives that fiscal consolidation is not credible, with debt on an explosive path, a rational investor could refuse to buy the debt. Vulnerability to this risk is particularly high if output growth is volatile, and a growth slowdown necessitates larger financing needs. Cross country data show that debt levels are negatively related with output variability (Chart 9). Using output volatility as a benchmark for European countries, a sustainable level of debt for the Czech Republic would be higher than the current levels, at around 40 percent of GDP. Also, refinancing risk for Czech state debt is relatively low with the average time to maturity of 5.9 years, close to most European nations (IMF, 2005b) ⁵.

16. The main motivation for debt reduction is to create fiscal space for age-related spending pressures. Over the next few decades, the Czech Republic faces one of the largest demographic shifts among the new member states.⁶ Yet, it remains one of the few countries in the region which has not yet reformed its pension and health care system. Old-age income support and health care are almost entirely provided by the public sector. Longer term debt sustainability analysis projects that age-related spending would rise by nearly 7 percent of GDP by 2050 leading to unsustainable debt dynamics. To maintain debt within a 60 percent of GDP limit by 2050, a permanent fiscal adjustment of 6 percent of GDP is required which translates into a surplus of 2 percent of GDP. If consolidation is delayed, the additional adjustment needed will increase by ⅓ percent of GDP every 2 years. Generational equity considerations argue for lowering debt to limit the interest cost on future generations who will be facing the burden of higher pension and health expenditures. In the absence of systemic pensions and health care reforms to address the long-run pressures, the Czech Republic should seek to generate budget surpluses as reserves to pay for these future spending needs.

17. Based on these competing considerations, a target of a structural balance or a small surplus by early next decade appears to be appropriate (Chart 10). This would require a sustained reduction in the structural balance of at least ½ percent of GDP annually starting from a 3 percent structural deficit in 2007 and reaching structural balance by 2013. This target will also allow a cyclical margin below the Maastricht requirement of 3 percent of GDP (Chart 11). Historical GDP data suggests that the size of the largest negative output gap was 4½ percent in 2002. Based on an estimate of semi-elasticity of budget to output gap of 0.39 (OECD, 2005), this would imply a cyclical fluctuation of 1¾ percent. This is below the threshold of 3 percent of GDP under the Stability and Growth Pact, providing a margin forforecast errors, especially in case of large shocks.

Should the deficit targets be fixed in the form of a fiscal rule?

18. The current ’soft’ approach to fiscal targets highlights the tradeoffs between a commitment to long-run fiscal goals and short-term fiscal flexibility. A flexible deficit target allows more discretion on the short term fiscal policy stance, even though this could contradict longer term fiscal goals of lowering debt. But this discretion can also be misused in the face of weakening discipline and short term spending pressures. International experience has shown that these political pressures tend to be particularly acute during cyclical upswings, providing a procyclical bias.

19. The loss of fiscal discipline and a history of procylical fiscal policy call for an institutional mechanism to ensure stronger fiscal commitment. A budget balance rule, in the form of a permanent deficit target, would serve to directly address the deficit bias. In a highly fragmented political system with the presence of coalitions and a ’commitment’ form of budgeting, such rules can help to limit spending bias arising from a ’common pool’ problem. ⁷ Empirical evidence also shows that deficits have been lowered following introduction of budget balance rules, although these findings may be subject to endogeneity bias which makes it difficult to establish causality.

20. Fiscal rules also have potential drawbacks. A rigid rule that targets an annual deficit can introduce a procyclical bias. It could also lead to a poor quality of fiscal adjustment if expenditure cuts fall on areas which are more productive yet may be easiest to cut due to more discretion. In the case of a ’golden rule’ that excludes capital spending, there may also be a tendency for creative accounting such as through reclassification of spending from current to capital items. Other methods of circumventions include using off-budget government operations, or changing cash-accrual adjustments if targets are in accrual terms. For these reasons, at the general government level, a fiscal balance rule is less frequent or is applied with more flexibility over a multi-year horizon, or with cyclical margins and escape clauses for periods of low growth (Table 4). Instead, rules on annual budget balance appear to be more prevalent at local government levels, especially in countries with a ‘delegation’ type of budget formulation where the Finance Ministry is provided more responsibility and held accountable for overall fiscal performance.

Table 4.

Deficit Target Rules in Select EU Countries.

Source: IMF.

Table 4.

Deficit Target Rules in Select EU Countries.

	Fiscal objective	Planning horizon
Finland	Structural surplus	Four years on a rolling basis
Netherlands	Below 3 percent of GDP under normal economic fluctuations	Four years at beginning of coalition period
Sweden	Surplus of 2 percent of GDP over the business cycle	Three years
Switzerland	Balanced structural budget	Permanent
United Kingdom	Golden Rule: balanced current account	Three years on a two year rolling basis
United States	Balanced budget	Four year reform program ending in 2002

Source: IMF.

Table 4.

Deficit Target Rules in Select EU Countries.

	Fiscal objective	Planning horizon
Finland	Structural surplus	Four years on a rolling basis
Netherlands	Below 3 percent of GDP under normal economic fluctuations	Four years at beginning of coalition period
Sweden	Surplus of 2 percent of GDP over the business cycle	Three years
Switzerland	Balanced structural budget	Permanent
United Kingdom	Golden Rule: balanced current account	Three years on a two year rolling basis
United States	Balanced budget	Four year reform program ending in 2002

Source: IMF.

21. Experience with a budget balance rule as a percent of GDP to support the existing expenditure rule suggests difficulties in interpretation. A few countries with an expenditure rule have also adopted a form of a budget balance rule (Denmark, Finland, Sweden), which acts as a permanent constraint, on the basis of which the expenditure ceilings are derived. Since the targets are usually applied over multiple years, there are variations on its interpretation, complicating the task of setting expenditure ceilings and monitoring performance. Targets set in structural terms are also challenging particularly in the case of a transition economy where the extent of the cyclical adjustment is even more uncertain.

22. Without political commitment, enforcing any fiscal rule will be a challenge. Country practices show that sanctions are applied more commonly at the local government level. Such sanctions may be at the institutional level such as through withholding of transfers, credit restriction, and fines or even, at times, personal sanctions aimed at the responsible official (IMF, 2005a). Where rules have been applied at the general government level, sanctions have been reputational rather than judicial in nature, highlighting the difficult nature of enforcement of such rules. Adoption of fiscal rules often reflect the underlying social preferences for fiscal adjustment and political commitment is a precondition for its implementation. Given these considerations, more prominence needs to be given to fiscal deficit target requirements during budgetary debates. Although a numerical fiscal balance rule itself would not ensure greater compliance, introduction of such a rule would highlight the importance of fiscal discipline and increase the reputational costs of deviating from the rule.

23. Efforts to safeguard the pre-announced fiscal targets need to be stepped up. One approach entails specifying the deficit targets of the Convergence Programs in the coalition agreement, as in the fiscal framework of many ‘commitment’ type of countries. This allows the targets to be more transparent, allowing public scrutiny and debate—the main mechanism to provide incentives for compliance and build up credibility. A requirement that any measures on taxes and mandatory spending that will lead to a deviation from these targets be budget neutral, much alike the US Budget Enforcement Act, would also facilitate more discipline.

24. Since the existing expenditure rule covers only the central government level, rules for local governments could be considered. At present, local governments face a debt rule limiting debt servicing to 30 percent of revenues. Local government debt is low and stable. Nevertheless, recent legislative changes to devolve responsibilities for education, healthcare, social care, and implementation of EU-funded projects to the regional governments, increase risks for the future. A balanced budget rule for regional governments could be considered. Furthermore, sanctions on municipalities for breaches in the debt rule are weak and could be strengthened. The debt servicing rule should also be revised to exclude debt repayments under the definition of ‘debt servicing’ which provides disincentives for earlier debt repayments and inceases tendencies towards longer term borrowing (OECD, 2006).

25. Special consideration for funding future pension liabilities is also needed. While a separate spending ceiling covers extra-budgetary funds, state pensions remain within the state budget. Assuming pension spending is contained, state pensions are expected to run a surplus in the near-term due to an upward revision in the contribution rate and the gradual extension of the statutory retirement age. Preserving the pension surpluses in a separate account could be considered in order to prefund the impending cost of aging on public finances.

How can the expenditure framework be strengthened as a commitment device?

26. The breach of the expenditure rule highlights the importance of political commitment. Although reputational sanctions are supposed to provide sufficient incentives to comply with the rule, a lack of significant public debate can limit reputational costs. Reputational sanctions may also be ineffective if fiscal policy does not figure substantially on the voters’ agenda. Hence, additional sanctions for lack of compliance during implementation are sometimes introduced. Introducing such sanctions would require strengthening the legal foundations to make the spending ceilings legally binding at a disaggregated level of the budgetary chapters (OECD 2005, Convergence Program 2005). In practice, however, these sanctions are more common at the level of local governments. At the central or general government level, a number of countries require the government to prepare a plan to offset the overspending within a certain time horizon, which could also be introduced in the Czech budgetary rules.

27. Monitoring of the expenditure rule could be made more transparent in order to strengthen enforceability. Independent fiscal institutions are sometimes established to limit time-inconsistent behavior of policymakers. The model for an independent fiscal institution varies considerably by country.⁸ Their roles range from providing macroeconomic forecasts for the budget to an independent monitoring and analysis of fiscal policy developments. They frequently provide normative statements on fiscal policy implementation, including on adherence to fiscal rules. Studies show that their presence has led to more transparency and public debate and contributed to fiscal discipline. In the Czech Republic, macroforecasts used in the budget by the Ministry of Finance have been on the conservative side (MFCR, 2005a). Neverthless, an institutional mechanism that allows for independent assumptions, for example, in assessing if revenue increases are structural, and monitoring of budget plans, could help strengthen the credibility of the expenditure framework.

28. Removing certain categories of spending from expenditure ceilings couldfacilitate adherence to the rule. A few spending items warrant consideration:

(i) Removal of interest expenditure is a common practice which will be increasingly relevant with rising interest rates and debt stock.
(ii) The ceilings sometimes also exclude pensions and cyclical items such as unemployment benefits. In such a case, a separate rule for pensions will be needed.
(iii) Public investment spending is also excluded sometimes to prevent reduction in desirable investments to meet the expenditure target. Based on this principle, EU-financed spending has been excluded from the Czech spending ceilings. Similarly, some countries have adopted a ‘golden rule’ limiting borrowing to finance capital spending. To the extent that spending ceilings have been revised up due to higher than planned allocations for infrastructure spending, this exclusion could be considered. This would help to better monitor how current spending, where growth has picked up more significantly, is adhering to its limits (Chart 12). However, such exclusions from a fiscal rule have also been criticized on the grounds that returns on public investment spending do not necessarily ensure a return higher than the cost of borrowing. Furthermore, the distinction between capital and current spending is not always very clear.
(iv) Exclusion of some unpredictable items such as guarantee payments have been used in the Czech fiscal targeting methodology for spending ceilings. The existing rule that new guarantees are limited to 40 percent of annual expenditures has been largely met. In order for the issuing government to bear the cost of these guarantees, it was proposed that payments for guarantees deemed to be high risk be put into reserves at the time of the issuance of the guarantees. However, the guarantee fund is currently being used merely as a short-term fund for making payments on called guarantees. To ensure more equitable burden-sharing, the guarantee fund needs to be serve as a reserve to fund future guarantee payments.

29. To minimize the risk that binding multiyear spending ceilings become too rigid, a cyclical contingency margin could be considered. A potential drawback of such margins is that they are fully used during downswings with no adjustment during cyclical upturns. To address this concern, one suggestion is to introduce spending ceilings set at central values consistent with potential growth and desired structural adjustment while allowing margins for overruns or savings depending upon output deviations from trend.

30. The coverage of central government institutions under the expenditure ceiling needs to be broadened to help ensure compliance with the overall deficit target. Spending from reserve funds that have accumulated from prior years by line ministries is excluded. While it is desirable to maintain the efficiency gains from such carryover provisions, limits on the extent of the rollover of budgetary allocations and their drawdown are needed to ensure sufficient fiscal policy control. Spending from the carryover reserves could to be tied to the efficiency outcome of the budgetary spending.

31. Higher transparency could help prevent circumvention of the rules. For example, international experience shows that tax expenditures are often resorted to get around the spending ceilings. Hence, annual reports on the use of tax expenditures are needed. Finally, budgetary rules and procedures at the implementation level, and expenditure management represent important elements of the fiscal framework, which deserve further review.

E. Concluding Remarks

32. Recent years have witnessed some erosion of fiscal discipline. Over the past decade, discretionary policy led to a steady rise in deficit and debt in the Czech Republic. The introduction of a fiscal framework with a multi-year expenditure ceilings helped to reverse this trend. But in the face of strong revenue growth from a cyclical upswing, populist pressures led to abandonment of the medium term fiscal targets and spending ceilings. Against this background, the paper examined considerations for strengthening the framework and whether the medium term targets should be permanently fixed under a fiscal rule.

33. Strengthening the fiscal framework and greater political commitment would help compliance with the framework. In light of long-run sustainability concerns, fiscal policy should aim for a gradual adjustment that leads to a structural balance or a surplus early in the next decade, if systemic pension and healthcare reforms to address long-run spending pressures are not addressed soon. These targets need to be integrated in the fiscal framework more prominently while recognizing that, in the absence of a stronger political commitment, fixing targets under a fiscal rule alone would not necessarily lead to greater compliance. Efforts need to focus on strengthening the design of the expenditure framework through greater flexibility and independent monitoring that allows more public debate and sanctions, helping to enforce the framework.

Table 5.

Key features of Expenditure Rules in Select Countries

Source: Danninger (2002); European Commission (²⁰⁰³, 2006).

Table 5.

Key features of Expenditure Rules in Select Countries

	Type of expenditure	Definition of target	Level of government	Additional Rule	Timeframe	Statutory base	Sanctions for non- compliance	Escape clause	Body responsible for monitoring
Belgium	Primary expenditure	Annual medium term growth rate of 1.5 percent	Federal government	Revenue rule	Medium term (4 years)	Coalition agreement	No measures specified exante	No exceptions exante	Independent Court of Auditors, High Council of Finance and National Parliament
Denmark	Public consumption	Real expenditure growth rate in accrual terms	General government	Budget balance rule, revenue rule	Multiannual	Political agreeement	No measures specified exante	No exceptions exante	Ministry of Finance
Finland	Total expenditure	Freezing of real expenditure at 1999 levels	Central government	Budget balance rule, debt rule	Cabinet period (5 years)	Political agreeement	No measures exante. Government proposes corrective action.	No exceptions exante	Ministry of Finance
Ireland	Total expenditure	Annual nominal growth of 4 percent over 1998-2002	Central government	Expenditure rule for pension fund	Government’s term (5 years)	Legal act	No measures specified exante	No exceptions exante	Government
Netherlands	Expenditures as defined by ceilings (central government expenditures less non-tax revenues and infrastructure funds, ceilings for social security, health care and general government	Medium term real expenditure ceilings translated into annual nominal amounts	General government		Cabinet period (4 years)	Coalition agreement	Commit to offset overruns by expediture cuts	Rules to divide windfalls and shorfalls between tax cuts and lowering deficit	Ministry of Finance
Sweden	Primary expenditure plus old age pension expenditure outside budget	Annual nominal expenditure ceiling: annual expenditure should not rise faster than projected nominal	Central government excluding extra budgetary funds	Budget balance rule	three years -rolling	Legal act	Bi-annual monitoring required y budget law. Government shall prepare a plan for correction if signs of overruns.	No exceptions exante	Independent Court of Auditors, Government and National Parliament
Switzerland	Central government expenditures including investments	Annual nomial expenditure ceiling equal to one-year reveue forecasts adjusted for cyclical position of	Central government	Budget balance rule	Annual		Judicial
United Kingdom	Departmental Expenditure Limits (DEL)	Nominal expenditure	Government departments	Budget balance rule, debt rule	three years		Although DELs are binding, they can be altered during budget. Under or over spending can be offset in another year within the	No exceptions exante	Independent (National Audit Office), Ministry of finance, Treasury, and National Parliament

Source: Danninger (2002); European Commission (²⁰⁰³, 2006).

Table 5.

Key features of Expenditure Rules in Select Countries

	Type of expenditure	Definition of target	Level of government	Additional Rule	Timeframe	Statutory base	Sanctions for non- compliance	Escape clause	Body responsible for monitoring
Belgium	Primary expenditure	Annual medium term growth rate of 1.5 percent	Federal government	Revenue rule	Medium term (4 years)	Coalition agreement	No measures specified exante	No exceptions exante	Independent Court of Auditors, High Council of Finance and National Parliament
Denmark	Public consumption	Real expenditure growth rate in accrual terms	General government	Budget balance rule, revenue rule	Multiannual	Political agreeement	No measures specified exante	No exceptions exante	Ministry of Finance
Finland	Total expenditure	Freezing of real expenditure at 1999 levels	Central government	Budget balance rule, debt rule	Cabinet period (5 years)	Political agreeement	No measures exante. Government proposes corrective action.	No exceptions exante	Ministry of Finance
Ireland	Total expenditure	Annual nominal growth of 4 percent over 1998-2002	Central government	Expenditure rule for pension fund	Government’s term (5 years)	Legal act	No measures specified exante	No exceptions exante	Government
Netherlands	Expenditures as defined by ceilings (central government expenditures less non-tax revenues and infrastructure funds, ceilings for social security, health care and general government	Medium term real expenditure ceilings translated into annual nominal amounts	General government		Cabinet period (4 years)	Coalition agreement	Commit to offset overruns by expediture cuts	Rules to divide windfalls and shorfalls between tax cuts and lowering deficit	Ministry of Finance
Sweden	Primary expenditure plus old age pension expenditure outside budget	Annual nominal expenditure ceiling: annual expenditure should not rise faster than projected nominal	Central government excluding extra budgetary funds	Budget balance rule	three years -rolling	Legal act	Bi-annual monitoring required y budget law. Government shall prepare a plan for correction if signs of overruns.	No exceptions exante	Independent Court of Auditors, Government and National Parliament
Switzerland	Central government expenditures including investments	Annual nomial expenditure ceiling equal to one-year reveue forecasts adjusted for cyclical position of	Central government	Budget balance rule	Annual		Judicial
United Kingdom	Departmental Expenditure Limits (DEL)	Nominal expenditure	Government departments	Budget balance rule, debt rule	three years		Although DELs are binding, they can be altered during budget. Under or over spending can be offset in another year within the	No exceptions exante	Independent (National Audit Office), Ministry of finance, Treasury, and National Parliament

Source: Danninger (2002); European Commission (²⁰⁰³, 2006).

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Appendix I. Cyclical Stance of the Czech Budget: Estimation Methodology

Following Hagemann (1999), we estimate the structural budget balance, which reflects the approach used in the World Economic Outlook calculations. This involves three steps: (i) estimation of the underlying potential output and the associated output gap; (ii) quantification of the cyclical expenditures and revenues; and (iii) subtraction of the cyclical components from the observed levels.

Potential Output and Output Gap:Potential output is estimated using the production function approach. Under this method, output is a Cobb Douglas function of capital, labor and total factor productivity. The potential output is the level of GDP at which the labor input is consistent with the natural rate of unemployment and the total factor productivity is at the trend level given normal levels of capital utilization. For the Czech Republic, an average of two estimates are used: one assuming a varying scrap rate and the other with a fixed rate of depreciation. The main assumptions are as follows:

Labor: Labor input is calculated by estimating the structural unemployment level, and a smoothed series for labor participation and demographic data on working age population.
Capital: Estimates of the capital stock uses investment data from national accounts and also assumes varying scrap rate for the ‘old’ and ‘new’ sectors.
Total factor productivity: A trend growth in total factor productivity is estimated, based on historical experience.

An alternative is to use a filtering method such as an HP-filter. This is the method used by the European Commission. Table (1) presents the estimates of the potential GDP growth using the production function approach as well as estimates of output gap using alternative filtering methods.

Estimates of Potential Output Growth under Alternative Methodologies

Sources: AMECO, OECD database, staff estimates.

Quantification of Cyclical Revenues and Expenditures: The budget balance comprises of the structural and cyclical components. In analysing the fiscal policy stance, the structural budget is interpreted as the discretionary policy component while the cyclical budget reflects the automatic stabilizing part of the budget. Much of the cyclical effect of the budget emerges from the revenue side.

Cyclical revenues represent the revenues that arise from the variation in the tax base due to the deviation of output from its underlying potential level. They are calculated using tax revenue elasticities, which have been estimated by Girouard and Andre (2005) for personal income taxes, corporate income taxes, social security taxes and indirect taxes. An aggregate revenue elasticity, Îù, is computed using the share of each revenue in total current revenue as of 2005 (table 1).

Revenue Elasticity Estimates

Source: OECD.

Revenue Elasticity Estimates

	Personal Income Tax	Social Security Contributions	Corporate Income Tax	Indirect Tax
Tax elasticity	1.19	0.80	1.39	1.00
Share of current revenues	0.13	0.37	0.13	0.31
Total tax revenue elasticity				0.94

Source: OECD.

Revenue Elasticity Estimates

	Personal Income Tax	Social Security Contributions	Corporate Income Tax	Indirect Tax
Tax elasticity	1.19	0.80	1.39	1.00
Share of current revenues	0.13	0.37	0.13	0.31
Total tax revenue elasticity				0.94

Source: OECD.

Structural revenues, R_{s, t}, is the revenues obtained after adjusting for cyclical revenues from actual revenues. It is assumed that capital revenues are largely structural in nature since they comprise dividends from public enterprises. The structural component of current revenues are computed by adjusting observed current revenues by the amount of the output gap $Y_{t}^{*} ∕ Y_{t}$ and the elasticity of revenues to the output gap, ε, while taking into consideration the impact of a collection delay on taxes, as expressed by the elasticity of tax revenues on previous years’ output gap. This can also be expressed by the following equation:

R_{s, t} = R_{t}^{c u r r e n t} . {(\frac{Y_{t}^{*}}{Y_{t}})}^{ϵ} . {(\frac{Y_{t - 1}^{*}}{Y_{t - 1}})}^{l a g g e d ϵ} + R_{t}^{c a p i t a l}

In the case of the Czech Republic, all the tax revenues are assumed to be collected in the concurrent year. Consequently, lagged ε, is set to be zero.

On the expenditure side, only the spending on unemployment insurance benefits, UB_t, is considered to be cyclically sensitive. These are then adjusted for the variation in the cyclical component of unemployment, $({U R}_{t}^{n} / {U R}_{t})$ as computed for output gap estimations. Thus, structural expenditures, E_s,_t, are estimated as:

E_{s, t} = (E_{t} - U B_{t}) + (U B_{t} * (U R_{t}^{n} / U R_{t}))

The structural budget balance, SBB_t, is then derived as:

{S B B}_{t} = R_{s, t} - E_{s, t}

This is also taken as a measure of the discretionary component of the budget, while the cyclical budget is the component that works as the automatic stabilizer. To measure the impact of the budget on the economy, the fiscal impulse is measured as the change in the structural budget balance.

I m p u l s e = {S B B}_{t} - {S B B}_{t - 1}

It is also common practice to measure the fiscal impulse as the change in the primary structural budget balance, as the interest component is not directly under the control of policymakers.

Appendix II. How Does the Automatic Stabilizing Property of the Czech Budget Compare to the Region?

The estimated elasticity of the budget is relatively low, compared to OECD countries, including Poland and Hungary (Table 5) This is consistent with a trend of lower output elasticities of revenues and expenditures in emerging market economies compared to more developed economies. Some of the key factors explaining the automatic stabilizing properties are the size of the progressivity of tax, share of direct taxes in total revenues, share of unemployment benefits, and other income related transfers, and size of government.

Budget Elasticity Estimates

Source: OECD (2005).

^{^1/}Includes only unemployment-related transfers.

Budget Elasticity Estimates

	Personal Income Tax	Social Security Contributions	Corporate Income Tax	Indirect Tax	Expenditure (current primary expenditure) ^1/	Total
Czech Republic	1.19	0.80	1.39	1.00	-0.02	0.39
Hungary	1.70	0.63	1.44	1.00	-0.03	0.47
Poland	1.00	0.69	1.39	1.00	-0.14	0.44
Slovak Republic	0.70	0.70	1.32	1.00	-0.06	0.37
OECD average	1.26	0.71	1.50	1.00	-0.10	0.44

Source: OECD (2005).

^{^1/}Includes only unemployment-related transfers.

Budget Elasticity Estimates

	Personal Income Tax	Social Security Contributions	Corporate Income Tax	Indirect Tax	Expenditure (current primary expenditure) ^1/	Total
Czech Republic	1.19	0.80	1.39	1.00	-0.02	0.39
Hungary	1.70	0.63	1.44	1.00	-0.03	0.47
Poland	1.00	0.69	1.39	1.00	-0.14	0.44
Slovak Republic	0.70	0.70	1.32	1.00	-0.06	0.37
OECD average	1.26	0.71	1.50	1.00	-0.10	0.44

Source: OECD (2005).

^{^1/}Includes only unemployment-related transfers.

Degree of progressivity of income tax: A higher progressivity of tax strengthens the role of revenue stabilizers as high income growth shifts taxpayers to higher income tax brackets. The top statutory rate on wage income in the Czech Republic is higher than in the Slovak Republic which has adopted a flat tax system, but is lower than those of Hungary, Poland and most OECD countries.

EU-8: Income Tax Rates, 2006

(In percent)

Sources: KPMG, IMF.

Tax on Income and Profits, 2005

Source: OECD.

^{^1/}2004 data

Tax on Income and Profits, 2005

	Total tax (In percent of GDP)	Direct tax (In percent of GDP)	Direct Tax (In percent of total tax)
Czech Republic	39	9	24
Hungary	37	9	24
Poland ^1/	34	6	18
Slovak Republic	29	5	18
OECD ^1/	36	13	35
EU15 ^1/	40	13	34

Source: OECD.

^{^1/}2004 data

Tax on Income and Profits, 2005

	Total tax (In percent of GDP)	Direct tax (In percent of GDP)	Direct Tax (In percent of total tax)
Czech Republic	39	9	24
Hungary	37	9	24
Poland ^1/	34	6	18
Slovak Republic	29	5	18
OECD ^1/	36	13	35
EU15 ^1/	40	13	34

Source: OECD.

^{^1/}2004 data

Share of direct taxes: A higher share of direct taxes strengthens the automatic stabilizing property of taxes. The Czech Republic shows a much lower share of income and profit tax than in the OECD and EU–15 countries, though higher than those of some neighboring countries such as Poland and the Slovak Republic. This low share contributes to a lower wage elasticity of income tax. However, the tax wedge is relatively high, owing in particular to employer social security contributions. Unlike many other countries, there is no cap on social security contributions. As a result, this has led to a stronger elasticity of social security contributions relative to income.

Unemployment and income-related benefits: On the expenditure side, government spending on income-related items also impact the stabilizing property of the budget. This consists mainly of unemployment benefits. Public spending on unemployment benefits, including part-time unemployment benefits, is very low by regional standards, especially in comparison to the EU–15 where these benefits generally exceed 1 percent of GDP. Hence, it is assumed that the output elasticity of government spending is close to zero.

Unemployment Benefits and Beneficiaries, 2004

Source: OECD.

Size of government: As a first approximation, the size of the government indicates the extent of the automatic stabilizing property of the budget as reflected in the budget (semi) elasticity of output. After expanding rapidly until 2003, the size of the government was reduced in 2004 due to reforms in sickness insurance and a change in budgetary rules that allowed carryover of unspent spending allocations encouraging year-end savings by line ministries. In 2006-07, government spending is expected to pick up significantly owing to increased social benefits spending. While this level of spending is above average central European levels, it is still below the average EU-15 levels.

Size of Government, 2004

Source: OECD.

Flexibility of labor and product markets: Another important factor affecting the degree of budget elasticity is the degree of the flexibility of the income bases such as the wage bill and the gross surplus. Given the short data period, formal econometric estimates of the elasticity of wage bill and employment are highly unreliable. Nevertheless, a preliminary estimate of the elasticity of employment to output gap (–3.3) appear relatively low by OECD standards, which is consistent with the observation that long term structural unemployment has been persistently high in the Czech Republic, accounting for almost half of the unemployment rate.

Other factors also affect the degree of the automatic stabilizing effect of the budget. These include the openness of the economy which negatively affects the size of the fiscal multiplier. In addition, the lags with which the policy changes are transmitted to the change in the structural budget balance and, in turn, to the rest of the economy also affect the degree of the stabilizers.

Prepared by Anita Tuladhar.

In GFS 1986 terms. On ESA–95 basis, gross debt stood at 30 percent of GDP at end 2005.

See Appendix I for details on calculation of potential output and structural deficits.

See Appendix II for further details.

Other theoretical considerations on optimal debt provide limited policy guidance. For example, on efficiency grounds, a positive debt level is preferable to the use of distortionary taxes. On the other hand, a lower debt level is desirable to raise national savings.

For detailed discussion on long-term fiscal sustainability analysis, see Czech Republic, Selected Issues, Country Report No. 05/275.

See Ylaouten (2004) for a discussion on political systems and budgetary framework.

See European Commission (2006) for a more detailed discussion of the type of independent fiscal institutions.

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