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IMFSurvey Magazine: Countries & Regions

Czech Fiscal Reforms Need Further Steps to Consolidate Gains

Shoppers in Prague, Czech Republic, where new fiscal package moves toward taxing consumption rather than income (photo: Dallas Heaton/Newscom)

TAX REFORM IN EASTERN EUROPE

Czech Fiscal Reforms Need Further Steps to Consolidate Gains

By Anita Tuladhar
IMF European Department

March 19, 2008

  • Desirable features of package include shift from income to consumption taxation
  • Tax system expected to become more conducive to investment, growth
  • Package still fails to sufficiently advance goal of fiscal consolidation

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.

IMF staff has prepared a detailed evaluation of the package and discussed the findings with the Czech authorities. The analysis reveals several desirable features such as the 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.

Key features

The key element in the fiscal reform package is a flat rate for personal income tax, following a widespread trend in the region (see table). 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 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 aging pressures.

Challenge 1: Fiscal consolidation:

Since joining the European Union in 2004, Czech public deficits have declined. Yet these budgetary improvements have largely reflected cyclical gains—that is, tax revenues have been strong and expenditures low due to strong growth, and not as a result of policy action.

Consolidation, efficiency, and incentives

To deal with the Czech Republic's fiscal challenges, the IMF has recommended some key policy priorities:

Pension reform: Raise effective retirement age and reliance on private pension systems; early implementation of fiscal consolidation to build up pension reserves.

Health care reform: Undertake early efforts to better link hospital financing to cost of service and reduce distortions in the system.

Social benefit reform: Enhance targeting of social benefits to raise efficiency of social spending.

Tax increases: Improve prioritization between tax and expenditure measures. Absent expenditure restraint, raise consumption taxes and improve tax efficiency.

Labor market reforms: Implement targeted active labor market policies and improve design of tax-benefit system to strengthen labor participation and work incentives.

Similarly, fiscal discipline has been particularly susceptible to the political cycle—that is, it has tended to loosen in pre-election 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 pre-2006-election increase in social spending; 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 and reversed over the next few years. Similarly, plans to compress the public sector wage bill will also be hard to sustain over the medium term.

With the recent tax cuts well-defined and permanent, new and permanent spending reductions need to be identified and implemented to ensure a sustained consolidation. Otherwise, taxes will have to be increased.

Challenge 2: Work incentives

Work incentives continue to be severely hampered by high marginal effective tax rates (METRs, see Chart 1). These rates, which take into account the combined incremental impact on take-home pay of tax, social security contributions, and benefit changes, increased considerably in 2007 as a result of the pre-election spending surge.

Unfortunately, the 2008 reform package fails to reduce the METRs at the low and middle-income levels, leading to persistent, large welfare traps and disincentives for work effort.

An analysis of the distributional impact of the fiscal reform package shows that it mainly benefits the low and high income groups. At the high end, the introduction of a ceiling on social security contributions and the reduction of personal income taxes lowers the tax burden significantly without much evidence that structural improvements will result.

Challenge 3: Long-run debt sustainability

The Czech Republic faces one of the more daunting demographic challenges in the European Union, with the share of elderly people relative to the working-age population expected to nearly triple by 2050 (see Chart 2). Neverthless, the Czech Republic remains one of the few central and east European countries that has not reformed its public health and pension systems to ensure their viability.

The reform package does not adequately address the fiscal pressures arising from this demographic shift. Although political consensus has been reached on extending the statutory retirement age, it remains to be enacted, while a decision on deeper reforms to reduce the burden on the public pension system has been elusive.

In health care, the introduction of a nominal level of copayments marks an important step toward limiting excess demand and reducing inefficiencies in the system. Systemic reforms in both the pensions and health care remain key priorities to effectively deal with the long-run challenge to public debt sustainability.

Comments on this article should be sent to imfsurvey@imf.org.


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