Czech republic: Selected Issues in Fiscal Policy Reform

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

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.

IV. Absorption of Eu funds: Issues and Challenges1

A. Introduction

1. The expected increase in the use of EU funds in coming years presents important issues for policy and institutions. Increasing allocations of EU funds provide the Czech Republic with a unique opportunity to increase its growth potential and accelerate the economic catch-up. There are, however, a number of policy challenges. While now at par with most regional peers, the absorption of structural funds has been slow to pick up and, looking forward, a part of the committed amounts may be lost if bottlenecks are not removed. Strengthening personnel capacities, simplifying the institutional framework, and ensuring a better coordination in managing structural funds could help to further improve absorption. EU transfers appear to have had a drag on the budget so far, to the extent that they have not substituted domestic spending programs. The challenge ahead is to reconcile the full utilization of EU funds with the need for fiscal consolidation.

Funds allocated to the Czech Republic

2. Growing allocations of EU funds provide the Czech Republic with increasing economic opportunities. The main role of EU funds in new member states (NMS) is to support their economic catch-up,2 and the income level relative to the EU average is the key criterion in allocating structural funds. The Czech Republic, relatively advanced in convergence, received only modest allocations for 2004-06 compared to other NMS (Figure 1). Still, at close to 2 percent of GDP and set to rise considerably under the EU’s new financial perspective 2007-13, they provide a unique opportunity to support economic and social cohesion.

Figure 1:
Figure 1:

New Member States: Available EU Allocations

Citation: IMF Staff Country Reports 2007, 085; 10.5089/9781451810257.002.A004

Sources: European Commission, and staff estimates.

3. Structural and cohesions funds, the EU’s main vehicles to promote economic convergence, represent a growing share in total allocations. Allocations for these funds are increasing (Figure 2)3: while they accounted for less than ½ of total allocations in 2004-06, the share increases to around ¾ in 2007-13. This trend reflects EU-wide policy priorities, but also the expiration of the non-structural EU transfer (budget compensation) which was aimed at preventing NMS from becoming net contributors to the EU budget.

Figure 2.
Figure 2.

Czech Republic: Structure of EU Commitments and Spending Priorities

Citation: IMF Staff Country Reports 2007, 085; 10.5089/9781451810257.002.A004

Source: European Commission, data from the authorities

4. EU funds are spent on domestically designed programs to support the national development strategy. EU funds finance projects promoting economic and social cohesion through a myriad of nationally designed programs. The Czech Republic’s national development strategy puts particular emphasis on basic infrastructure, human resources, and the support to productive environment (Figure 2).4

Net transfers from the EU and absorption of structural funds

5. As in other new member states, net transfers have remained below committed amounts. The allocations described above are gross amounts, representing a maximum of what the country could receive out of the EU’s budget. Actual net flows are bound to be significantly lower, reflecting several factors:

  • As other member states, the Czech Republic has to contribute to the EU budget, with annual payments at around one percent of GDP.

  • Commitments from a given year are spent over several years, reflecting the duration of project cycles, implying that annual payments are generally below the commitments.

  • EU funds may be lost (de-committed) if there is no adequate capacity to prepare and implement projects financed by the EU in a timely manner.

Net transfers from the EU amounted to 0.2-0.3 percent of GDP in 2004-06, slightly below the original projections (0.4 percent of GDP) mainly reflecting lower than planned utilization of structural funds. Net transfers are projected to peak at close to 2 percent of GDP around 2011-13. This, however, depends crucially on the absorption capacity.

6. The Czech Republic was initially slow to absorb structural funds, but absorption picked up in 2006. Absorption of structural funds suffered some teething problems as regulatory and institutional frameworks had to be established. This early stage took somewhat longer than elsewhere in the region, as reflected in a low absorption rate at end–2005 (Figure 3). By late 2005, however, the preparatory stage had been completed, implementing agencies had gained experience, and many projects had been contracted. All this laid the grounds for better absorption. As a result drawing of EU funds had increased to levels comparable with regional peers by late 2006.

Figure 3:
Figure 3:

Absorption of Structural Funds

Citation: IMF Staff Country Reports 2007, 085; 10.5089/9781451810257.002.A004

Source: Data from national authorities.

7. Despite uneven progress among programs, no major funds are currently at risk. There are differences in the absorption paths of various programs (Figure 3). Rural development funds have done better than human resource development programs, financed by the social fund (ESF). Nevertheless, no major funds were at risk in 2006.5 In part this reflects the treatment of advance payments which are added to absorption figures even if they are not yet spent on any project.6 Only small funds could be de-committed in the Prague region, where advance payments were lower.7

8. But the future absorption challenge is increasing. While advances may provide a temporary relief, they can only be a short-term solution—all the 2004-06 structural funds will have to be spent by the end of 2008. This implies a sharp increase in absorption challenges, compounded by the need to start drawing funds under the new financial perspective. Extrapolating current absorption trends shows that there is a risk that some funds could be decommissioned.

9. Developing a coordinated framework for managing EU funds could help to improve the utilization of available resources. The framework for managing EU funds seems more disaggregated in the Czech Republic than elsewhere in the region. The number of EU financed programs is large and line ministries act as managing authorities for their programs. This implies institutional rigidities as resources can not be moved easily among programs. Looking forward, regional authorities (which are often untested in dealing with EU funds) are set to gain more control at the same time as the number of programs under the 2007-13 funds will increase. These plans go against the regional trend of limiting the number of programs and creating strong central agencies to coordinate the management of EU funds.

Fiscal implications of EU transfers

10. Measuring the fiscal impact of EU transfers is complicated by methodological caveats and the lack of data. Fiscal implications of EU transfers are important for countries trying to meet the Maastricht criteria and to comply with the excessive deficit procedure. However, measurement is not a straightforward d task. There are differences between cash and accrual (ESA95) statistics reflecting:

Sector coverage—ESA95 includes only transfers to government beneficiaries; cash statistics may include transfers to non-government intermediated by the government agencies;

Time of recording—every spending on EU programs has an automatic revenue counterpart in ESA95 (neutral for fiscal balance); cash statistics books spending and receipts on EU separately depending on the actual time of effecting the transactions (not deficit neutral).

Importantly fiscal implications depend on whether EU transfers, and related national co-financing, are spent on new programs—expansionary effect—or if they substitute existing programs—no expansionary effect. Unfortunately, data on fiscal substitution are not directly available. A simple accounting framework (Box 1.) will have to suffice to assess the direct (first-round) budgetary impact of EU transfers.

Measuring the Fiscal Impact of EU Transfers

Given methodological and data constraints, the following framework for measuring the fiscal impact is proposed:

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Fiscal balance is improved by the (+) items and the (-) items deteriorate fiscal position. Spending on refundable EU programs, i.e., programs financed with transfers other than budget compensation, is by definition equal to revenues on these programs in ESA95.

11. The budgetary impact of EU transfers appears to have been negative if one assumes no substitution between domestic spending programs and EU transfers.Within the framework proposed in Box 1, EU transfers appear to have created a direct fiscal drag in the order of 0.3-0.8 percent of GDP (Table 1). These estimates represent the maximum possible negative effect. The actual impact would be lower to the extent that there is a substitution between expenditures financed with EU transfers and domestic spending programs.

Table 1.

Direct Fiscal Impact of EU Transfers

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Source: Data from the authorities and staff estimates.

12. Reconciling full utilization of growing EU funds and meeting the Maastricht criteria poses a number of policy challenges. As the authorities pursue fiscal consolidation, they will need to address a number of issues related to the use of EU funds:

Co-financing: Utilization of growing funds puts pressures on finding domestic co-financing. This would lead to pressures on deficit unless room is made by cutting expenditures elsewhere in the budget.

Fiscal management: Budgeting for EU funds has been too optimistic so far, leaving unused budget appropriations booked as reserve funds. Large reserve funds may loosen the grip on fiscal policy as they could be spent on top of the annual budget law.

Assessment of the fiscal impulse: Increasing spending of EU transfers may obscure the assessment of the fiscal impulse. Such spending adds a demand stimulus which is not captured in fiscal accounts—the revenue counterpart (EU grants) do not represent any withdrawal of domestic demand. Increasing EU-financed spending would thus be neutral for headline deficit, but associated with an underlying positive fiscal stimulus.

1

Prepared by Robert Sierhej (Warsaw Regional Office).

2

This role is served by structural and cohesion funds, but there are also funds financing EU policies in agriculture, nuclear safety, or cross-border cooperation.

3

Structural funds are for regional programs, research and development, supporting economic competitiveness, and human resource development; cohesion funds are for country-wide transport and environment projects. To ensure intertemporal comparability, rural development and fishery funds are classified under agriculture in 2004-06.

4

The structure of spending shown at Figure 2 reflects both the EU and domestic expenditure component.

5

Structural funds have to be drawn within so called N+2 rule: funds committed in year N must be drawn by the year N+2. The 2004 commitment should be utilized by end–2006.

6

Advance payments amounted to 16 percent of total allocations, and 2004 commitments were 24 percent of the allocations. Thus, actual spending of only 8 percent was needed to formally comply with the N+2 at end–2006.

7

Prague region projects are under the so-called Objective 3 for regions where income is above 75 percent of the EU average.

Czech Republic: Selected Issues in Fiscal Policy Reform
Author: International Monetary Fund