IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
In 2009 Poland was the only country in the European Union (EU) with positive economic growth. This was a result of both good policy and favorable circumstances. In 2010 Poland is no longer the sole “green island” of growth in EU. Furthermore, the state of public finance is a growing risk factor for sustainable economic growth. Although there is some progress in implementation of structural reforms (as opposed to time wasted in 2005-2007), in our opinion fiscal challenges are still not addressed sufficiently.
Nowadays, one of the main barriers to cure Polish public finance is the forthcoming parliamentary elections. Political unwillingness to carry out bold reforms prevails.
Since the beginning of the century economies of Central and Eastern European (CEE) countries have experienced fast GDP growth triggered by structural reforms and ongoing integration—and therefore free trade—with EU. However, over time, signs of overheating started to show up: growth started to be credit-driven, current account balance deteriorated, inflation started to rise.
The main source of the following boom was a rapid expansion of credit. Domestic demand soared, increasing the level of imports, but also decreasing the level of exports, as competitiveness of domestic producers deteriorated. One of the aspects of the boom was growing asset prices, particularly real estate. Another source of growing domestic demand was public expenditure. Many governments in the CEE region used windfall revenues associated with the asset price boom and unsustainably high GDP growth to permanently increase public spending, further fuelling the boom. It should be noted, however, that in countries with relatively low wages in the public sector and very poor infrastructure restraining public expenditures was politically implausible. 1 Growth of GDP in Poland during 2003-2007 was rather moderate when compared to other CEE countries, so the macroeconomic imbalances were rather limited as well. Credit growth did not reach the magnitude of the boom in Baltic States, but in 2007 it was still accelerating (see: EBRD Transition Report 2009, IMF World Economic Outlook IV 2010).
Despite the booming economy before the Global Financial Crisis, the Polish government was continuously maintaining budget deficits. Unfortunately, these good times were not used for crucial reform in public finance. In 2005 and 2006 nominal general government expenditures were growing faster than nominal GDP. Only after elections in 2007 have some reforms started. The Polish government abolished the early retirement age of 55 for woman (statutory retirement age for women is 60) and 60 for men (statutory retirement age for men is 65). Reform covered approximately one million Poles. Further reforms were stopped with the beginning of the crisis.
Poland avoided recession thanks to the convergence of various factors. As mentioned before, macroeconomic imbalances were rather moderate before the crisis. What is more, budget balance remained stable (in contrast to the Baltic States). It was due to the floating exchange rate which allowed for large depreciation of Polish currency (PLN)–although export felt, import felt even further. Thus, positive net export has contributed to GDP growth. Another important factor was the size of Polish domestic market and relatively low trade-openness (Poland is the largest economy among new member states and accounts for nearly 40% of new member states population and GDP). Last but not the least, the factor mitigating the impact of the global crisis was tax cuts introduced by previous (populist) government in 2007. The personal tax rates felt from 19%, 30% and 40% in 2008 to 18% and 32% in 2009 and later. 2 This, coupled with cuts in social contribution gave a fiscal impulse of about 40 billion PLN (3% of GDP) annually. The populist government of 2005-2007 did not adjust the expenditure side to these large revenue cuts. On the contrary, it even increased spending further, introducing some new social benefits, e.g. double baby bonus.
Figure 1. Public finance in New Member States 2010
Source: EU Commission, Spring Forecast 2010.
Above mentioned factors allowed Poland to record positive GDP growth of about 1.7% in 2009. But nowadays, one year later, the deteriorating state of public finances is the major threat to further growth of the Polish economy. It is plainly visible when comparing Poland to other CEE countries that have reached similar levels of development. However, the Polish government, confronted with the electoral calendar (summer 2010 – presidential elections, autumn 2010 – regional elections, autumn 2011 – parliamentary elections) is very reluctant to take any decisive actions and, in particular, to cut expenditures.
Instead of cutting on public spending to reduce the general government deficit and to minimize the risk of exceeding the constitutional threshold of 60% GDP for gross debt, the Polish government decided to increase basic VAT rate by 1 percentage point – from 22% to 23%. A decision is widely criticized by economic experts.
According to Polish constitution and Public Finance Act, during peace time, public debt should not exceed 60% of GDP. In case it does, harsh expenditure cuts are written into both Acts to reduce debt below threshold. As the public gross debt is now at the level of about 55% GDP and growing fast, Polish citizens were asked in a recently conducted poll what in their opinion the government should do. Approximately 44% of respondents wanted to change the domestic law and also to negotiate with the European Commission about analogous debt ceilings in EU law. It is important to notice, that even among the managers, 54% wanted to increase the limit (see Figure 2).
In the same poll, the majority of respondents stated that they cannot afford (and accept) any spending cuts that would decrease their income. 73% of respondents agreed, that if the cuts are really necessary, then the wages of politicians should be cut. 40% of respondent would accept a freeze on wages in public administration. However, current expenditure of budgetary entities in Poland constitute less then 4% of GDP. Finally only 2% of respondents would support increases in VAT or PIT tax rates.
Figure 2. Poll result (September, 2010)
Source: GFK, Polonia, rp. pl
Clearly, a dangerous gap prevails between, on one hand, public opinion as revealed by such polls and, on the other hand, the state of public finances, the later constituting, in our opinion, the biggest obstacle and threat to sustainable development of Poland. To fill up the gap, NGO such as The Civil Development Forum Foundation (FOR) have launched public campaigns to raise social awareness of the problem of lax fiscal policy and exert pressure on policy makers. The most visible part of a recent FOR campaign is the debt clock in Warsaw city center. Similar projects were developed previously in neighboring countries such as Czech Republic (Liberální Institut) or Slovakia (INESS – Institute of Economic and Social Studies).
Besides raising public awareness of the problem and developing educational activities, one must work on proposals that can improve the situation of public finances. Public expenditures are at a high level in Poland (around 45% of GDP 3 ). Tax increases would be perceived as short-sighted and unwelcome. Thus, we are focusing on expenditure side. In our opinion the area with the biggest potential for expenditure cuts are social expenditures. Social protection spending amounted to 15.6% of GDP in 2008, that is, about 6 percentage points more than in Latvia and Slovakia and 4 percentage points more than in Estonia. The scope for potential savings can be shown by the example of the death grant (introduced to help meet part of the funeral costs). Today it is the highest in absolute terms in the whole of the EU (see Figure 3). According to the proposed 2011 budget, the death grant will be cut by 1/3. However, despite this reduction the benefit will still be among the highest in EU.
Figure 3. Death grant in countries in 2010
Source: Budget proposal for 2011
Besides searching for opportunities for immediate spending cuts like the death grant, One must also promote long term reforms. Along those lines, FOR has started recently a public debate about primary and secondary education. Although the ratio of students to teachers is among the lowest in OECD countries, classes are rather crowded. It is so, because Polish teachers 4 spend an average of just 513 hours teaching per annum, compared with an average of 786 hours in other OECD countries. Clearly, there should be space for increasing efficiency and thus financial savings without compromising quality of teaching. Furthermore – fewer teachers, but better motivated, better paid and working more can deliver better quality than more teachers, but poorly paid and working little (negative selection in the teaching profession seems quite apparent now).
Another well recognized structural problem of the Polish economy, strongly connected with overgrown social spending and accordingly public finance imbalance, is the low labour employment rate. 5 High and poorly addressed social benefits from one side and high tax rates from the other side discourage people from working, resulting for government in high expenditures and low tax income. According to government estimates, 1 percentage point higher employment rate corresponds to higher tax income by 0.3 percentage point of GDP. As already mentioned, pension reform implemented by the government 2 years ago was important step to address this issue. But further reforms are still needed. A good step would be the elimination of separate (government funded) pension systems for farmers, police officers and military. In some cases, an additional public spending could increase employment rate and tax income (see for example the FOR Report highlighting what should be done to increase employment rate of mothers of young children).
The Polish government should not be afraid of bold reform. Firstly, the opposition in Poland is very weak. The main political opponent of Civil Platform – the populist party, Law and Justice, is more betting on political games than on constructive public debate. Secondly, as history and even current events show, the courageous reformers are not doomed to lose power. Enough is to remember that, despite the broad program of reforms of the Thatcher government between 1979 and 1983, support for the Conservatives was not significantly diminished: in the 1983 election they received 13 million votes, only 0.7 million fewer than in 1979; and thanks to the collapse of the opposition, they gained an additional 58 seats in the House of Commons. After a further four years of reforms, support for the Tories grew even higher. Even more encouraging is the recent example from Latvia where the austerity government of Valdis Dombrovskis was re-elected in October 2010 in spite of the large cuts in wages and public spending – a fiscal adjustment in Latvia that amounted to some 14% of GDP.
The paper contains personal opinions reflecting the views of the authors, not institution they represent.
The authors would like to thank Mr. Alexander Waksman for his language support.
3. From Western European perspective it might seem rather low, however Poland’s level of development should be taken into account. Today Poland has public expenditures above regional mean and much higher than majority of western European countries in times when their GDP per capita was at today’s Polish level.
5. Employment rate 2009: Poland 59.3%, EU15 65.9%, New members states from CEE: 61.6%. IT should be noted however, that particularly in case of CEE countries the employment rate was biased by the crisis. In pre-crisis 2008 the rates were: Poland 59.2%, EU15 67.3%, CEE 64.4%.