Czech Fiscal Reforms need Further Steps to Consolidate gains

• Author: By Anita Tuladhar
• Position: IMF European Department
• Pages: 79

Page 79

Fiscal reform measures adopted by the Czech Republic in January 2008 aim to strengthen government finances, lower the tax burden, and promote growth and employment. But some of the measures may be hard to sustain over the medium term.

The IMF has prepared a detailed evaluation of the package, which reveals several desirable features, such as a shift from income to consumption taxation, making the tax system less distortionary to savings and investment.

The reduced reliance on internationally mobile tax bases, such as corporate profits, is an important step in an era of increasing globalization. As a result, the system is expected to become more conducive to investment and growth.

The key element in the fiscal reform package is a flat rate for personal income tax, following a widespread trend in the region. The corporate income tax rate is also lowered in a phased manner, reflecting, in part, growing pressure from regional tax competition.

To partly offset the revenue loss from these tax cuts, the lower rate of the value-added tax is raised, and new environmental excises are introduced. On the spending side, social benefits are streamlined, and health care user fees introduced in an effort to stem rapidly rising social spending.

Nevertheless, the reform package stops short of addressing the key fiscal challenges that the Czech Republic faces in terms of fiscal consolidation, strengthening of work incentives, and long-run debt sustainability in the face of population aging.

Fiscal consolidation. Since joining the European Union in 2004, the country's public deficits have declined. Yet these budgetary improvements have largely reflected cyclical gains-that is, tax revenues have been strong and expenditures low because of strong growth and not because of policy action.

Similarly, fiscal discipline has been particularly susceptible to the political cycle-that is, it has tended to loosen in preelection periods. This has contributed to a procyclical fiscal policy that is expansionary even during economic upswings.

Social spending. To correct the excessive deficits, the reform package partially reverses previous slippages, such as the large increase in social spending that preceded the 2006 election. But it still fails to sufficiently advance the goal of fiscal consolidation.

The most serious shortcoming is that measures to contain social spending, such as deindexation and nominal freezing of social benefits, are likely to be temporary...