Global Insight Perspective

Significance

Although the government has finally presented a reform package, initially expected shortly after the June 2006 elections, its passage in parliament will be hindered by the government’s lack of a working majority, and opposition even within its own ranks.

Implications

The tax changes proposed are good news for businesses, and the proposal to reduce the basic corporate tax rate to 19% has one of the better chances of success. However, the fate of the proposal for a flat income tax rate is less assured, and elsewhere necessary reforms to healthcare and pensions have largely been put off.

Outlook

The opposition Social Democrats have already signalled that their support will be selective at best, and criticism has also come from within the governing coalition, meaning that the chances of the package being approved as it stands are rather slender.

The government yesterday presented a package of reforms which it agreed on 2 April, designed to implement sweeping tax and welfare changes.

The proposed legislation will be submitted to parliament in June, for approval by September.

Key proposals include the following:

• A 15% flat tax on personal income as of 2008. Taxes will be calculated from the so-called “super-gross wage”, which includes social and health insurance paid by employers. Sole proprietor entrepreneurs will benefit most from this change, with a preferentially low rate.
• Corporate taxes are set to decrease gradually, from the current 24% to 19% by 2010.
• As a way of raising revenues, the basic value-added tax (VAT) rate will remain at 19%, while the reduced rate will be increased from 5% to 9%.
• An environment tax will be implemented.
• Social spending will be cut, including benefits for families with children.
• The government also hopes to save by cutting back on the state administration, to a staff of 417,000 by 2010, down from the current 458,000. According to one press report, the government plans to dismiss 6,800 teachers in 2008, in addition to over 2,000 policemen and fire-fighters, and scores of other state employees. Dismissals will continue in 2009-10.
• The cabinet aims to start with the first phase of pension reform. One of the first measures will be to raise the retirement age to 65.
• In the area of healthcare, radical changes have been proposed, but they are not expected to be implemented until 2009.
• The Labour Ministry has announced only minor changes for 2008, with deeper reforms coming only later.

Fiscal reforms have long been one of the biggest policy challenges facing the Czech Republic. Although major changes were expected during the 2002-06 term, they were repeatedly put off, despite the fact that the high-growth economic environment provided the perfect opportunity for reform. In fact, although modest changes were approved in late 2003, the previous government later backed policies that contributed to a worsening rather than an improvement in fiscal deficits. The need for reforms is especially acute in the area of pensions and healthcare.

Justifications for Reform

Formally, the key reason for reducing the public finance deficit is justified by the Czech Republic’s obligations as a European Union (EU) member state. All of the countries that have joined the EU in recent years are required to eventually adopt the euro. That means bringing the fiscal deficit to within the 3.0%-of-GDP limit, as set by the Maastricht criteria. With the exception of 2004, the Czech Republic has recorded deficits above 3.0% of GDP ever since 1998. In 2005, the public finance deficit (calculated by ESA-95 methodology) stood at a revised 107.6 billion koruna (US$5.1 billion), or 3.6% of GDP. Although preliminary data published by the Czech Statistical Office put the 2006 deficit at 2.95% of GDP (just within the Maastricht limit), Finance Minister Miroslav Kalousek has already questioned the validity of that data, adding that it is the result of accounting tricks by the previous government. According to Kalousek, the preliminary figures do not reflect a loss in reserve funds, which, if included, would bring the deficit up to 5% of GDP. Eurostat is scheduled to publish its preliminary estimates for 2006 budget deficits on 23 April. The state budget bill for 2007 projects that the public finance deficit will reach 4.0% of GDP this year.

Notwithstanding the aim of euro adoption, reducing the deficit is also important from the perspective of long-term economic growth. In November 2006, the International Monetary Fund (IMF) warned that although a delay in Eurozone accession itself would not be overly harmful, rising budget deficits could diminish the Czech Republic’s growth prospects.

In addition to reducing state debt, the tax reforms could also make the Czech Republic a more attractive environment for investors. In a recent survey by Ernst & Young, entrepreneurs in Central Europe commented that although doing business in the Czech Republic is slightly easier than in Poland and Hungary, it is considerably more difficult than in Slovakia, where a package of radical fiscal reforms took effect in 2004. Entrepreneurs said that key obstacles to doing business in the Czech Republic include the complex tax system, the social and political environment, and labour conditions.

Still, it remains unclear whether the latest package of reforms would fulfil the goals of reducing the budget deficit and simplifying the taxation system. One of the main problems with the latest reforms is that changes in the areas that are most urgent—healthcare and pensions—have been put off. Tax cuts that are not accompanied by deeper reforms in other areas may only serve to widen budget deficits rather than diminish them. In 2006, tax cuts in personal and corporate income rates contributed to a decline in state budget receipts in those categories by 3-5% over the previous year’s level. The Czech Republic overshot its state budget target for 2006 by 23 billion koruna.

Outlook and Implications: Prospects for Approval

Global Insight had initially expected that serious fiscal reforms would finally be launched after the June 2006 parliamentary elections. However, the post-election political stalemate—with the parliament equally divided between the left and the right—has made such changes considerably more complicated than we had anticipated. It was not until January 2007 (seven months after the elections) that Prime Minister Mirek Topolanek managed to gain parliamentary approval for his cabinet, and that occurred only thanks to the departure of two rebel deputies from the opposition Social Democrats (CSSD).

Although the Topolanek cabinet has demonstrated its eagerness to push forward with radical reforms, it is far from certain that these changes will gain the necessary support. In order to secure approval for the fiscal legislation, Topolanek will require the support of all 100 deputies representing the ruling coalition, as well as at least one from the opposition. The most likely candidates to provide support will be the two CSSD rebels. The opposition CSSD and the Communists have sharply criticised the proposals, particularly the flat tax, which they claim is aimed at helping the rich get richer. For his part, former finance minister Bohuslav Sobotka (CSSD) has also pointed to the negative impact the reforms would have on the middle class and pensioners. Moreover, the trade unions have criticised the proposals relating to cuts in the state administration, arguing that they would negatively affect the quality of public services. The CSSD has also said that it will not support the package if it is submitted as a whole, further indicating that only certain aspects of the package will be adopted. Sobotka in principle supports the lowering of the corporate tax rate, and the introduction of caps to social contributions—a proposal which has been put forward in the past. However, the “attack on the purses of the middle classes and elderly people’s income” he described yesterday, according to CTK, would also, he fears, result in price increases without the intended boost to economic growth.

Criticism of the new proposals has not been limited to the left, however. Serious reservations have also been expressed by Vlastimil Tlusty, a Civic Democratic Party (ODS) parliamentary deputy who was author of the ODS’s tax proposals that were presented prior to the June elections, and who briefly served as finance minister in the latter part of 2006. According to Tlusty, the government’s plan would not simplify the tax system. Moreover, Tlusty criticised the fact that the tax reforms are not connected with changes to the social welfare and pension systems. He expressed uncertainty about whether he will vote in favour of the reforms.

Even if the latest proposals are approved, doubts are already being raised about the prospects for future rounds of reforms. The next parliamentary elections are scheduled for June 2010 (or possibly earlier, if the government fails to remain intact), and the likelihood of launching any radical reforms will diminish rapidly with the approach of the next elections. That is especially true given that the government will count on the CSSD for support. In addition, although the headline tax changes will benefit some, the proposals for social spending are likely to alienate a raft of voters, and endanger support for the government when it will need it most.

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