Home » Czech Republic

Czech Republic

by

From the accounting viewpoint, the Czech government is relatively efficient in taming deficits. The chosen strategy for the whole period 2010–2014 is to raise approximately one extra Czech koruna in taxes for every two korunas saved from previously planned expenditures. On the other hand, the latest Convergence Program update reveals that over the period 2013–2015 only 43% of discretionary measures will be carried out on the expenditure side of the budget. It seems that further expenditure cuts will be increasingly difficult and we can expect increasing tax burden in the near future. But still, given that there is no clear consensus about the optimal solution of the interlinked problem of low economic growth, government revenue, expenditure, and debt, the approach of the Czech government seems to be relatively appropriate.

State budget performance in 2012

The major problem of the state budget was, as in 2011, overoptimistic growth expectations for 2012 at the time the budget has been drafted. But unlike in 2011 when the real GDP growth has been just 0.5 percentage points below its predicted value, the economy has been expected to start to recover from the slump and increase its product by 2.5% in 2012. Unfortunately, due to a sizable drop in both foreign demand and domestic consumption, the reality turned out to be completely different. According to the latest data, the Czech real GDP actually decreased by 1% in 2012. Also the unemployment rate has been higher than predicted. It is, therefore, not surprising that the tax revenue fell short of expectations. From the budgeted amount of tax revenues only 96.5% was realized which is consistent with lower economic growth.

But taking a better look at the composition of tax revenues reveals some puzzling numbers. In 2011 the growth of the Czech economy was only 0.5 percentage points below expected, whereas in 2012 the difference between prediction, upon which the state budget was built, and reality was enormous – 3.5 percentage points. But still, realized tax revenues in 2012 constituted larger proportion of the budget than in previous year (94.6%). Moreover, realized revenue from personal and corporate income tax exceeded the budgeted amounts! Another odd figure is the year-on-year development in realized tax revenues. With the sole exception of property tax, all sources of tax revenue showed an increase even though the gross domestic product of the Czech Republic decreased in absolute terms in 2012. It is no surprise for the VAT because the reduced VAT rate has been increased from 10% to 14% in 2012. But other than that the source of increase is very unclear.

Development of government expenditure has been very similar – realized expenditure has also been lower than originally budgeted. These results follow the trend from the previous year and further strengthen doubts about quality and significance of predictions produced by the Ministry of Finance. Either they do not trust their own macroeconomic predictions and use internally other numbers than they release to the public, or their models are simply wrong. Regardless of the reason, the findings seriously harm transparency of public finances.

From the accounting viewpoint, the Czech government is relatively efficient in taming the deficits. We do not necessarily have to agree with the mix of expenditure and revenue measures, but we have to appreciate that the government expenditure in 2012 were in absolute terms slightly lower than the year before (by CZK 2 billion, € 80 million). And, moreover, it is the second year in a row of decreasing expenditure, even though the decrease is rather small.

Long-awaited pension reform launch

One of the important changes taking place in 2013 is the launch of pension reform. From the beginning of 2013, the existing system has been extended by creation of a new pillar to support saving for old age. Now the pension system comprises of three pillars. Mandatory pension insurance (1st pillar), pension savings (the new 2nd pillar), and supplementary pension savings (3rd pillar), which has replaced the previously existing supplementary pension insurance pillar. Pension savings in the 2nd pillar are optional but participants who opt in must remain in it until they become entitled to receive the old-age pension. Participants in this new pillar will contribute 5% of their gross income and their payments to the mandatory pension insurance pillar will be reduced by 3%. Participants will therefore pay 3.5% of their gross income to the 1st pillar and 5% to the 2nd. Those who won’t participate in the new pension savings scheme will continue to pay 6.5% of their gross income to the mandatory pillar.

After fulfilling conditions for becoming entitled to receive the pension, participants in the 2nd pillar will have their entire pension savings transferred as a single premium to an insurance company responsible for paying out the pension. Then they will have the possibility to select one of three options. First is a 20-year annuity with even monthly payments. In case the participant dies within this 20- year period, the heirs will receive the remaining funds as a one-off payment. Second option is annuity until the death of the participant, without any inheritance. And third option is again annuity until the death but with a supplemental three-year survivor pension.

But what happens if a participant in the savings pillar dies before even reaching retirement age? If the heirs are also participants in the 2nd pillar, accumulated funds will be transferred to their pension savings accounts. If they are not, the inherited funds will be paid out to them in cash. Minors will receive the money in the form of an orphan’s pension over five years.

Individuals have to decide whether to opt in to this new savings pillar at the age of 35. Those who were already above 35 in 2013, had to make their choice by the end of June 2013. After that deadline, they cannot choose to participate in the savings scheme and will remain in the mandatory 1st pillar. The 3rd pillar will more or less stay the same as before, only non-negative yield will no longer be guaranteed for participants in supplementary pension savings but there will be a choice of a conservative, balanced, or dynamic investment strategy. Also, unlike the previously existing supplementary pension insurance, supplementary pension savings will not allow for payout before reaching the retirement age.

Employment contracts with sole proprietors and investment incentives

During 2012 the Supreme Administrative Court repeatedly dealt with the problem of firms using contracts with sole proprietors (business entities owned and run by one individual in which there is no legal distinction between the owner and the business) instead of employing the workers in the usual way. This way of providing labor is called the “Švarc system” in Czech and was named after Czech businessman Miroslav Švarc who started to use this kind of arrangement during the 90s. An “employer” of an individual working in the “Švarc system” doesn’t have to pay the part of social security which is, in the case of a normal labor contract, payable by the employer. Also health insurance is only optional in this case and both “employer” and “employee” in the “Švarc system” can lower their taxable income by subtracting some of their expenses.

As a consequence, this arrangement is generally perceived as a tool of tax evasion and was de facto illegal until 2006, when the new Labor code has been adopted. From 1 January 2012 the performance of dependent work by an individual outside employment arrangement is again regarded as illegal work. But the question of legality of the “Švarc system” per se is not the crucial one. The core of the majority of disputes lies in the definition of such “dependent work”. For instance, the Supreme Administrative Court ruled that providing services such as crane operation, welding, assembly and similar work over a long term and on a continuous basis cannot be based on a commercial law relationship, but has to be reclassified as a labor law employer–employee relationship.

But in another case, a similar contract between a self-employed professional sportsman and his sports club has been found unproblematic even though a sportsman has to follow the instructions of the club in almost the same way as a crane operator does. It seems that the rules are still very opaque and that the circumstances of each particular case have to be considered. The problem is that such unclear rules, of course, open door to tax optimization and related corruption.

Also in 2012 an amendment to the Investment Incentive Act has been adopted which introduces several changes to investment support through the CzechInvest organization. The main focus was on making the Czech investment environment more attractive for investors. Among the main changes for manufacturing industry were: extension of corporate income tax relief from five to ten years; lower requirement of machinery proportion in the investment (50% instead of previously required 60%); better conditions for investments in regions with high unemployment or other disadvantages; and the minimum investment in building a new plant or extending an already existing one has been reduced from CZK 100 million (€ 4 million) to CZK 50 million (€ 2 million) for disadvantaged regions.

Proposed solutions to the state budget imbalances

In order to further reduce public finance deficit and follow the path set in the previous years that aimed at pushing the deficit below 3% of GDP in 2013, additional measures had to be adopted. Already during the beginning of 2012, the Czech minister of finance started to prepare a new austerity package of tax increases and budgetary savings. Key proposals were to

– increase personal income tax (PIT) rate by one percentage point to 16% and introduce a second tax bracket with the rate of 31% for incomes above four times the average wage;
– reduce the lump-sum expense deductions for self-employed individuals;
– increase the common VAT rate, which was at that time supposed to be set to 17.5% from 2013, to 19 or 20% with an exception of a couple of items, or, alternatively, maintain two rates but increase both of them by one percentage point to 15 and 21%;
– introduce a new carbon tax;
– implement an excise tax on wine;
– double the electricity tax;
– abolish the excise tax exemption for natural gas for households, and for mineral oils used in agriculture (so-called “green diesel”);
– cancel the childbirth benefit and the poverty threshold housing benefit;
– temporarily freeze pensions;
– increase real estate transfer tax from 3% to 5% and/or real estate tax;
– increase the minimum assessment base for social security premiums of self-employed individuals from 25% to 50%.

After debates in the government, following measures were submitted to the Chamber of Deputies in May 2012:

– New limits on lump-sum expense deductions for PIT;
– increase in withholding tax on passive income (dividends, interest, royalties) vis-à-vis tax havens from 15% to 35%;
– restriction of the excise tax exemption for “green diesel” in 2013 and its abolition in 2014;
– increase of the real estate transfer tax from 3% to 4%;
– unification of social security housing benefits.

Moreover, following temporary measures effective only for the period 2013-2015 were submitted to the Chamber of Deputies as well:

– A 7% “solidarity increase” of PIT on income exceeding 48-times the average wage;
– abolition of the basic PIT allowance for pensioners, which was until 2013 available for all tax payers (in the amount of CZK 24,800 (approx. € 970) per year);
– increase of the VAT rates by 1 pp to 15% and 21%;
– cancellation of the cap on public health insurance premiums (was set at 72-times the average wage).

With the sole exception of the social security housing benefits unification, all measures submitted to the Chamber of Deputies in May 2012 were in the end adopted and approved by the president. The set of revenue-side measures has been accompanied by expenditure measures as well. In total, the austerity measures were supposed to cut government spending by CZK 100 billion (€ 4 billion) and increase tax revenue by CZK 37 billion (€ 1.4 billion) in 2012 against the long-term budgetary plan. For 2013 the austerity plan was CZK 96 billion (€ 3.8 billion) on the expenditure side and CZK 47 billion (€ 1.8 billion) on revenue side, and for 2014 CZK 115 billion (€ 4.6 billion) and CZK 76 billion (€ 3 billion). At the beginning of 2013, the Czech National Bank estimated the 2012 government deficit at 4.9% of GDP, and expected it to decrease to 2.7% of GDP in 2013 and 2.5% of GDP in 2014. The structural part of the deficit, according to the European System of Central Banks methodology, went from 3.4% of GDP in 2011 to 2.9% of GDP in 2012 and is expected to further decrease to 1.6 and 1.4% of GDP in the upcoming years.

In place of a conclusion: what does the theory suggest?

Is the chosen strategy of balancing the budget a correct one? Numerous researchers recently tried to analyze whether cutting government spending in the current situation leads to positive or negative economic consequences both in short and longer run. Lawrence H. Summers and J. Bradford DeLong argue in a paper presented at the Spring 2012 Brookings Institution Panel on Economic Activity that as long as the government’s real long-term money-borrowing cost is under 5%, short-term spending cuts in fact worsen the long-run fiscal picture. The authors think that in the current situation the governments should focus on plans and programs for long-run fiscal balance and structural reforms improving business environment. In their opinion, balancing the budget during an economic downturn caused mainly by pessimistic expectations is not an ideal strategy.

Pontus Rendahl in his 2012 article “Fiscal Policy in an Unemployment Crisis” draws a similar conclusion from a theoretical model: Expansion of public spending may replace pessimism about the future with optimism. Whereas the impact of government spending on total output is mostly negative during normal times, because of the crowding-out effect of government money, in recessions the fiscal multiplier may be positive and rather high.
However, when increasing spending, the government has to either increase tax revenue, or let the deficits rise. Now, there is a vast literature on the negative consequences of public debt on economic growth. But as e.g. Panizza and Presbitero in their 2012 article “Public Debt and Economic Growth: Is There a Causal Effect?” point out, negative correlation, which is usually found, doesn’t need to imply causal link from debt to growth. And while many authors, including Panizza and Presbitero, are trying to prove the existence of such causal link, they have been so far unsuccessful.

Even though there may be no convincing proof that high deficits and debts are harmful, the public tends to perceive them negatively. Therefore, growing government debts can significantly contribute to the overall pessimistic climate. If the government cannot increase its debt but wants to boost the economy by increase in spending, it has to increase the taxes as well. In many situations the governments even already have dire deficit and debt problems. Should they balance the budget by cutting spending, or by increasing revenue? In other words, is it more harmful for the economy when the government cuts spending, increases taxes, or increases debt?
As always, there is no simple answer. But there is a couple of interesting results available in the literature. Alesina et al. (2012) in their article “The Output Effects of Fiscal Consolidations” show that fiscal adjustments that put more weight on revenue growth are recessionary and there is no sign of recovery for three years following the adjustments. On the other hand, countries that cut expenses more than increase taxes either face no consequent recession or they go through a short recession and then the output returns to the pre-adjustment level.

Mertens and Ravn (2011) estimate the impacts of tax changes and decompose them into personal income taxes and corporate income taxes. They find that cuts in average personal income tax stimulate the labor market, private consumption, and investment but lead to a drop in tax revenues. On the other hand, cuts in corporate income taxes instead have little impact on tax revenues but also fail to stimulate the labor market and private sector consumption while they stimulate investment. From their analysis follows that increases in corporate taxes may not generate much tax revenue but will lead to lower investment activity. Increasing personal income taxes may help to generate higher tax revenue, but should be expected to have dire consequences for the economic activity.
Hences, even in the academic sphere there is no clear consensus about the optimal solution of the interlinked problem of low economic growth, government revenue, expenditure, and debt. It is, therefore, no surprise that policy makers also often do not know which avenue to take. Possible solutions to short-term issues as well as long-term problems stayed at the core of political debates during the last year not only in the Czech Republic, but practically all around the world. And as long as nothing unexpected happens, the same topics will stay with us during 2013, too.

Ji?í Schwarz jr.
Liberální institut, Prague
http://www.libinst.cz

You may also like

Leave a Comment