Slovak Republic -- 2003 Article IV Consultation Mission, Preliminary Conclusions
May 7, 2003
1. Slovakia has been one of the fastest growing accession countries over the past two years. In an adverse external setting, output has continued to expand, and exports have shown remarkable resilience. This performance reflects the recent coming on-stream of past investments, particularly foreign direct investments, successful macroeconomic management, and important steps on privatization and financial sector reform. The invitation to Slovakia to join the EU in May 2004 affirms the success of recent reforms.
2. Nevertheless, the Slovak economy continues to be hampered by structural weaknesses—reflected in a persistently large fiscal deficit and high unemployment—and a correspondingly large external imbalance. The government elected in September 2002 is seeking to address these weaknesses, and it is essential that it build on recent successes with policies that will support strong, balanced growth, while reducing inflation.
3. In this context, Slovakia faces a number of challenges:
- First, achieving fiscal consolidation: the 2002 general government deficit was over 7 percent of GDP and thus an annual reduction of about 1 percentage point of GDP would be required to reach the government's objective of meeting the Maastricht deficit criterion (3 percent of GDP) by 2006. Sustained consolidation is also needed to reduce pressures on the external accounts and to ensure fiscal solvency.
- Second, maintaining the course of disinflation: although significant second-round effects from recent administered price adjustments seem unlikely, it is premature to exclude such effects from emerging, and inflation remains well above euro area levels. Moreover, planned further increases in administered prices and indirect taxes are likely to complicate the attainment of the government's goal to reduce inflation to Maastricht levels by 2006.
- Third, reducing the external current account deficit: in spite of recent progress, this deficit is projected to remain around 6 percent of GDP over the next two years—which would be sustainable but would leave the Slovak economy vulnerable to shocks.
- Fourth, lowering unemployment and strengthening the economy's supply response: These challenges are connected: the unemployment rate in Slovakia—over 17 percent—is one of the highest among the accession countries, partly reflecting labor market rigidities, which are also contributing to remaining supply-side constraints.
4. The following policies would best respond to these challenges:
- Permanent reductions in fiscal expenditure—supplemented by pension reform—and reforms to the tax system that are conducive to growth and stability. Enduring primary expenditure reduction has been a key component of successful fiscal consolidation experiences elsewhere in Europe. Moreover, a simpler and more transparent tax system, with minimal exemptions, would broaden the tax base and stimulate investment.
- A monetary framework geared towards low inflation.
- Policies to enhance productivity and promote investment, should help broad-based export growth and contain the economy's dependence on imports.
- Labor market and benefits reform, to improve incentives to work while supporting fiscal consolidation.
5. These policies form an integral part of the government's policy statement of November 2002. The emphasis of the statement is on a set of fiscal and structural reforms that are geared to support entrepreneurship and competitiveness. The mission would stress the need for careful consideration of the sequencing of reforms. In particular, the emphasis on reducing taxes should be accompanied—or indeed preceded—by concerted efforts on expenditure reform. As it stands, there seems to be greater momentum for the former than the latter. Poorly sequenced reforms could be detrimental for the government's overarching fiscal consolidation objective.
The macroecoeconomic outlook
6. Following the strong performance in 2002, the outlook remains for robust growth in 2003. Reflecting a warranted moderation in consumption growth, we project a slowdown in real GDP growth to 4 percent in 2003 from about 4½ percent in 2002. We expect the export boom already underway, accompanied by a recovery in fixed investment, to sustain the expansion on a sounder footing. Underlying inflationary pressures have been mostly absent despite the robust expansion, and this is likely to continue given restraint in recent wage settlements. The inflation outlook remains uncertain, however, because of the unclear timing and magnitude of planned indirect tax increases.
Achieving fiscal consolidation: permanent reductions in expenditure—supplemented by pension reform—and reforms to the tax system
7. The mission supports the government's objective of meeting the Maastricht fiscal deficit criterion by 2006, which should secure fiscal solvency and stabilize public debt well below the Maastricht debt ceiling. The government recently announced a deficit target of 3.4 percent of GDP for 2004, clearly stating its intentions to achieve this target through expenditure measures. These intentions are welcome as empirical evidence points to the role of permanent expenditure reduction in fiscal adjustment, and we see scope to contain social spending, reform the health system, and rationalize public administration.
8. However, this fiscal consolidation path hinges on the outcome in 2003. On current trends, we project the general government deficit at about 5⅓ percent of GDP this year, with risks skewed towards the downside on both revenues and expenditures, against the budget target of 5 percent of GDP. This projected slippage reflects primarily lower-than-budgeted VAT and corporate income tax, partially offset by higher collections of payroll contributions and lower interest payments. For the state budget, our projection of the revenue shortfall—consistent with the authorities' estimates—is about Sk 20 billion (1¾ percent of GDP), but half of this amount reflects lower accrued tax in earlier years. Nevertheless, the government's objective still to reach the 5 percent of GDP general government deficit target in 2003 is appropriate, and the fiscal correction from 2002 is a good—and required—start to the medium-term fiscal consolidation. But downside risks should be monitored carefully, in particular the municipal budgets, for which little information is yet available for 2003. We are concerned that any significant fiscal slippage this year would risk compromising fiscal solvency, hinder the needed reduction in the external current account deficit, and unduly burden monetary policy. Reaching the 2003 objective will require decisive measures, preferably on the expenditure side. Structural spending reform should be accelerated, and some increases in indirect taxes planned for 2004 may need to be advanced to 2003.
9. For 2004, under the baseline scenario of no tax reform, we project revenues about 1 percentage point of GDP lower than the government's draft budget outline on account of the 2003 revenue shortfall. The government will need to continue work on the budget outline with a view to closing this gap, and maintaining a 3.4 percent of GDP general government deficit. The government should find ways to cover the gap through cuts in expenditures or postponements of some elements of the tax reform.
10. As envisaged in the Pre-accession Economic Program, the government is developing its strategy to lower primary expenditures sustainably. In this context, we offer these observations:
- The first priority is to put an end to additional spending requirements on the state budget—which were already stretching resources before the new estimates of lower revenues were known.
- On the wage bill, the carry-over effects of large pay increases in 2002 imply a rise in the 2003 public sector wage bill of over 10 percent. Against a background of diminished resources, the government may need to revisit the increases for state and education workers planned for August.
- On decentralization, there are risks of continued lack of financial discipline following costly write-offs of debts for health and education units transferred to subnational governments, and the government should find ways to contain new accumulation of debts. More generally, the authorities should make special efforts to track expenditures by subnational governments, and accelerate budget reporting requirements, to avoid risking loss of expenditure control.
11. Fundamental tax reform is part of the much broader effort by the government—which includes social spending reform—to create a more market-oriented economy, partly by providing better incentives to work and save. The main aims of the reform are to have a more transparent and simpler tax law, with minimal exemptions, whereby the tax burden would shift from direct to indirect taxes. The proposed uniform VAT rate should improve administration and compliance, while leading to a more neutral taxation of goods and services. Despite its appropriate aims, the ambitious program could be difficult to implement, especially on a fast track. In this context, it will be essential to reduce risks with respect to loss of revenue, net of expenditures to compensate vulnerable groups, given the government's commitment to deficit reduction.
12. Although important details remain to be determined, the Ministry of Finance has presented a tax reform concept featuring a unified 20-percent rate for VAT and a 20-percent flat rate for personal and corporate income taxes. As part of the reform, most excise tax rates would be increased. Several considerations are important to evaluate this proposal:
- A revenue neutral reform inevitably means that there will be a large number of losers as well as gainers. At very low levels of income, the only tax burden is indirect taxation (VAT and excises) on spending, and therefore the distributional burden of the reform could be skewed towards those with lower incomes.
- Forecasting the revenue impact of the reform involves major uncertainties. These reflect the scale of taxpayer responses, the wide range of other factors affecting economic activity and output in any particular year, and some serious gaps in the statistics that are presently available for estimating the impact of important taxes.
- Revenue effects of excise tax increases, in particular, are difficult to estimate because of the impact of the corresponding price increases on smuggling and on demand.
- With these caveats, we estimate that the tax reform proposal in its present form risks revenue losses. For 2004, we project a loss of about Sk 1-2 billion, subject to downside risks on excise tax collections, with respect to a baseline of no reform. This loss would need to be more than offset by other measures if the government is to achieve its 2004 fiscal objectives.
Therefore, to mitigate revenue risks, it would be more prudent to introduce the tax reform gradually, by first adjusting indirect taxes and then phasing in the reduced income taxes over a number of years. More generally, we would recommend phasing reforms in such a way that popular aspects of the overall reform strategy (tax reductions) are not implemented ahead of less popular measures (spending reductions and tax increases), since there would then be a clear risk that the reform would get stuck in the first phase.
13. Moreover, social expenditure reform is even more important than tax reform for improving incentives. The composite rate of taxation on marginal earnings in Slovakia—taking account of the impact of income, payroll, and consumption taxes—is of the order of 50-65 percent, depending mainly on the applicable tax bracket. There is little scope for reducing this composite rate of tax simply through shifts among different rates—from the income tax to the VAT—although some taxpayers will benefit from the restructuring of individual taxes. Indeed, a substantial reduction in marginal composite tax rates on labor income requires long-term and sustained action to reduce the corresponding expenditure burden of social insurance. Social insurance reform will be important to provide incentives for increased work by those who retire today while still relatively young, or otherwise drop out of the labor force because transfer benefits are high relative to after-tax wages.
14. As the mission noted last November, pension reform is key to achieving a sustainable long-term fiscal position. The government is planning to reform the current pay-as-you-go system by gradually increasing retirement ages and tying benefits more closely with contributions, and introducing a second, fully funded pillar. The planned second pillar could be a golden opportunity not only to reduce the burden on the first pillar, but also to promote old-age security by diversifying the sources of retirement income, and to assist the development of Slovak capital markets. But a decision to proceed with the second pillar should be taken only after careful consideration of the costs as well:
- The large-scale diversion of contributions from the first to the second pillar could potentially complicate efforts to meet the Maastricht fiscal deficit criterion. Privatization receipts set aside for the reform will play an important role in financing but cannot substitute as revenues.
- The funded pillar will require a strong prudential and supervisory framework. The government should thus continue with the institutional strengthening of the Financial Market Authority.
- The administrative costs of individual accounts could be significant, especially on a per capita basis given Slovakia's small population.
Regardless of the government's decision on the second pillar, it should nevertheless deepen the reform of the first pension pillar, including through much faster increases in retirement ages than currently provided for in the Social Insurance Act approved last year.
15. Looking ahead, the fiscal balance should continue to be strengthened not only to meet the Maastricht deficit criterion, but also in the longer term, consistent with the requirements of the Stability and Growth Pact. In this context, the authorities should balance the need to carry out some key infrastructural investments against joining a system that will impose serious constraints on fiscal spending. Nevertheless, we support the government's objective to reduce the expenditure ratio over time, and indeed believe that carefully prioritized expenditure reduction will be the only way to combine fiscal consolidation with the envisaged tax reform. Managing decentralization will also be central to the authorities' objectives. The central government should strictly enforce fiscal discipline rules embodied in the fiscal decentralization legislation, strengthening these rules if they prove insufficient for close fiscal control.
16. We welcome government efforts to improve fiscal transparency, and to end the practice of using government guarantees to provide implicit subsidies.
Maintaining the course of disinflation: a monetary policy geared towards low inflation
17. The authorities' flexible monetary policy framework has been working well. The National Bank of Slovakia (NBS) aims mainly to achieve low inflation, announcing benchmark ranges for headline and core inflation. In the past, these benchmark ranges have been relatively effective in guiding expectations. However, over the past 18 months there seems to have been an upward bias in the inflation forecasts, which may have also biased wage negotiations and budget preparation. In the future, the central bank will need to guide inflation expectations more finely, and more proactively. To this end, the welcome efforts now underway to enhance the NBS's inflation modeling capabilities should also support a more forward-looking monetary policy. Improvements to the monetary framework should also include better coordination between the NBS and the Ministry of Finance on communications to the public, and enhanced communications from the NBS to the public regarding guidance on inflation.
18. In a challenging policy environment, we believe that the present monetary stance is broadly appropriate. The main policy interest rate is at 6½ percent following the reduction by 175 basis points in the Fall of 2002, in the wake of very substantial short-term inflows. We believe that this move to deter the inflows was appropriate. Although the case could be made for further lowering the policy rate, at this stage an unchanged stance would better reflect the balance of risks. Some trading partners—led by the euro area—have been easing monetary policy in a deflationary environment, and inflationary expectations have been subdued in Slovakia; but the NBS is increasingly constrained by the medium-term goal of reducing inflation to Maastricht levels—already made more difficult by the price shock earlier this year, and prospective increases in taxes and administered prices in 2004. A further constraint is the rapid rise in credit to households, albeit from a low base.
Reducing the external current account deficit: policies to enhance productivity and promote investment
19. The external current account deficit has started to narrow, from over 8 percent of GDP in 2002, as exports have accelerated and import growth has remained subdued in recent months. However, the sharp recovery of exports has relied on the expansion of production by a few large exporters. The dynamism of these companies needs to be extended more widely to the economy, including to producers of import-competing goods, and policies should be geared to facilitate this process.
20. The government's emphasis on developing entrepreneurship in Slovakia appropriately aims at enhancing competition and expanding productive capacity. In particular, we support plans to improve the legal framework, such as strengthening the judicial system, creditor rights, and accounting standards, as they would level the playing field for SMEs. We also welcome ongoing progress to liberalize the energy sector, which should make the Slovak economy more competitive. Finally, and most importantly, we are encouraged by steps to strengthen the financial system, which is key for private sector development and the economy's resilience to shocks. In this respect, we note the substantial enhancement of the banking supervision department at the NBS, through sustained implementation of their institutional development plan and improved regulations. The authorities should use this progress as a springboard to improve on-site and off-site supervision practices, as well as develop appropriate consolidated supervision and procedures for troubled banks and for resolution policies, to keep up with ongoing changes in the banking business in Slovakia.
Reducing unemployment and strengthening the economy's supply response: labor market and benefits reform
21. Unemployment remains one of Slovakia's most pressing social and economic problems, and measures to improve work incentives and promote labor market flexibility are critical. The authorities should continue to concentrate their actions in two areas. First, measures are needed to redesign the social safety net to improve incentives to work as well as to reduce the burden on the budget. Government plans to control state and social assistance benefits strictly, through better enforcement of eligibility rules and other measures to control abuse, are a good first step; and we are encouraged by the fundamental rethinking of the benefits system now underway at the Ministry of Labor. Second, we support the government's proposal to revise the labor code to improve labor market flexibility, including less restrictions on part-time employment and overtime, and more flexible separation arrangements.
EU accession and EMU entry
22. The authorities are preparing a strategy for adopting the euro. The 2006 timetable for meeting the requirements for euro adoption is feasible, but hinges on full implementation of the planned fiscal consolidation, and the goal of early euro adoption could provide welcome momentum to the implementation of reforms. Indeed, there is a need to make further significant progress in structural reforms and fiscal consolidation before committing to the exchange rate rigidity implied by ERM2. Nonetheless, once Slovakia meets all the Maastricht criteria on a sustainable basis, without jeopardizing infrastructural and other investment required for real convergence, then the country's already significant integration with the EU would represent an economic argument for adopting the euro.