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Contents | Executive summary | How to obtain this publication | Additional information
The following OECD assessment and recommendations summarise chapter 2 of the Economic survey of the Czech Republic published on 24 April 2008.
Contents
Ensuring fiscal sustainability is the main policy challenge…
The main policy challenge is to ensure fiscal sustainability through reform-driven deficit reduction. Budget processes need attention to improve spending efficiency and discipline. In addition, the healthcare and pension systems require reform in the light of upcoming spending pressures from population aging. According to UN population projections, Czech demography will have two phases of accelerated aging in the first half of this century. One will begin as soon as 2012 and end in the early 2020’s and the other will start in the mid 2030’s, ending around 2050. Calculations made by the European Commission suggest that, with unchanged policies, the additional spending pressure would be equivalent to nearly 7% of GDP by 2050, one of the largest age-related fiscal pressures among European-Union countries. Coping with these medium and long-term challenges will require not only reforms in ageing-related areas, but also efficiency gains in other areas of spending. A number of the government measures make a start on this challenge.
Deficit goals need to be more ambitious
Rapid growth has presented a golden opportunity for deficit reduction and structural reform but neither the previous nor current governments have fully exploited it. The general-government deficit targets (expressed as a percentage of GDP) are not providing strong enough support for responsible fiscal policy. Indeed, the current government has so far been sticking to the targets set when growth prospects were weaker. There is a medium-term expenditure framework comprising nominal spending ceilings that, in principle, drives budgeting. In this respect, if the government adheres to the current ceilings, deficits well below the targets are likely (although there are risks from scheduled cuts in direct tax rates in 2009 and 2010). The risk is that, as has happened in the past, policymakers choose to ignore the Framework and focus only on reaching the relatively easy deficit targets. Therefore, deficit targeting needs to be more ambitious through commitment to use positive economic developments to adjust the consolidation path, rather than to dissipate the gains on additional spending.
Deficit reduction should be helped by further reform of the budgeting system, but political commitment is crucial
To its credit, the government is working on difficulties for budget control posed by large reserve funds that are partly under the control of line Ministries and which have accumulated through liberal rules on the carry-over of unspent budgetary allocations. An innovative publication, the Fiscal Outlook, is helping communicate policy and technical issues. In addition, improvements have been made to the general account that is supposed to cover only miscellaneous items (the “general treasury chapter”). Political commitment is essential for further improvement to central-government budgeting. This should translate concretely into further reforms:
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Most important, there should be deeper scrutiny of spending plans in the preparation phase, greater transparency in the budget material submitted to parliament and wider use of programme budgeting. And there should be less opportunity for “pork-barrel” spending in the parliamentary phase of the budget process.
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Improvement to the Medium Term Expenditure Framework ought to be considered. The experience with this system of three-year rolling spending ceilings since its introduction in 2004 suggests there is scope for improvement. Most important, enhanced enforceability of the spending ceilings would help, for instance through more political and public scrutiny and sanctions for breaking the ceilings. Alternative formulations of the spending ceiling could also be considered.
The tax reform is broadly welcome…
A flat rate of personal-income tax of 15% (equivalent to 23% under a typical base, see below) has been in place since January this year, replacing a schedule of four rates (which ranged from 12 to 32%). As would be expected, high earners have gained the most. Low earners have benefited in terms of average tax burdens because of a large increase in the universal tax credit. The Czech government introduced the flat tax with the aim of bringing about structural benefits to economic behaviour by smoothing effective tax schedules. Two elements of the revenue reforms raise questions:
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The reform included the introduction of a ceiling on the social contribution assessment base, set at four times the average salary. This has further boosted the benefits of the tax reform to high income earners. Although ceilings are common internationally, the case for imposing them in a flat tax rate context is weaker because they introduce discontinuity in the marginal tax schedule that such systems aim to avoid.
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In an effort to make the headline rate low, the tax base has been widened as it now includes both employers’ and employees’ social contributions. This “super-gross” base is unusual. Indeed, no other OECD country has such a system. In theory, it does not create significant distortions but neither are there large advantages.
The flat rate tax and social-contribution ceiling have been accompanied by more cuts in corporate taxation. By 2010 the rate will be 19% which is five percentage points below the current level. The revenue losses from these measures are being offset by an increase in the lower rate of value-added tax and a large hike in excise duty on cigarettes. As regards future plans, there is the welcome intention to remove unnecessary clutter in taxation through a complete re-write of legislation. A phased cut back in support for home ownership and also for renovation ought to be added to this agenda; at every possible juncture there is either very light taxation or substantial subsidy. In overall terms, the tax reform has brought a welcome narrowing of the gaps between taxation on personal and corporate income and a shift from direct to indirect taxation. Indeed, further reduction in the gap between the VAT rates could be considered, allowing greater adjustment in the tax mix. Currently, as in many other OECD member countries, differences in VAT taxation are motivated by social concerns. However, these are better addressed through the welfare system. Given that many changes have been made to taxes and benefits simultaneously, the impact on efficiency and distribution should be closely monitored.
Fiscal developments and upcoming challenges
Note: The deficit for 2007 is an estimate and for 2008 to 2010, government targets.
Source: European Commission (2006) “The impact of ageing on public expenditure”, Special Report No. 1/2006; OECD Economic Outlook Database, December 2007; UN, World Population Prospects: The 2006 Revision, medium-variant population projections.
... and the proposed healthcare reforms have potential
Getting healthcare on track to cope with population aging is a key hurdle to ensuring fiscal sustainability. Small user fees have been introduced in a first phase of reform, a move that was recommended in previous OECD assessment and should help curb healthcare consumption. In principle, a multiple-insurer system aims at generating efficient provision through negotiation on the cost and quality of services between health insurers and providers. A second phase of reform is currently under discussion in the governing coalition which moves in this direction. Central to the reform is a proposal to bring profit motivation to the insurance funds by converting them into joint-stock companies, thereby strengthening their incentives to seek cost effective provision. This would be accompanied by several measures: improved definition of the basic package of healthcare services, establishment of an industry regulator, widening of options for insurance products and a “cash back” mechanism that would channel some of the insurers’ profits back to their clients. The impact of the second phase of reform could be significant in strengthening competition on the quality and cost of services. However, OECD experience is limited so far in this type of reform. Particular attention is needed to the following:
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Undesirable reaction of the insurers. Attention to cream skimming is required as the incentives for this may well increase under the reform. Furthermore, measures to facilitate switching between insurers are important. Conflict of interest among the owners of the joint-stock companies will need to be avoided.
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Close monitoring of the reaction of providers to the reform. Providers may have local monopolies in a number of areas in which case incentivising insurers is unlikely to generate significant efficiency gains. Regulators will also need to ensure that intensified provider-market competition does not reduce the quality of care. This, in turn, will require better information systems on provider performance.
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Further work on what is included in the basic package of healthcare services. The second phase of reform aims to better define the healthcare package. But, further work is needed to narrow the package or allow other sources of finances into the public system (for example, by extending co-payments), particularly in the context of population ageing and ever growing treatment possibilities.
A final decision on pension reform is still pending…
Another major issue in fiscal sustainability is ensuring the pension system can cope with population aging. The immediate problem is the age of retirement. A schedule of retirement age increases is underway but will end in the late 2010s when men’s retirement age reaches 63 years and women’s between 59 and 63 years (depending on the number of children they have raised). Under all plausible demographic projections, remaining at this retirement age implies large deficits in the public pension fund. It is therefore very important that the draft parametric reforms that include extending retirement-age increases are implemented.
A final decision should be made soon about further old-age pension reform. The current pay-as-you-go (PAYG) system focuses on providing a safety net pension through a highly redistributive payout formula. It is sustainable as long as appropriate parametric adjustments are made, in particular to the retirement age. However, there is a case for reform especially if it is believed a stronger link between contributions and payouts is required. One way forward, currently under discussion, is a defined contribution (DC) carve out, i.e. a share of the pension contribution would be channelled into private pension funds, as it is already the case in Slovakia, Hungary and Poland. The implications of the transition deficit need to be considered. A DC carve-out brings fiscal complications because contributions fall immediately but savings on the payout side do not begin until the first pensioners on the new scheme retire. Also, the “switching rules” are critical to the fiscal and microeconomic implications of DC carve outs. Mandatory switching that would phase out the “full” PAYG pension should be considered, rather than the current proposal that would allow all future generations to choose between the two systems. Providing a permanent choice risks additional public expense because net contributors are likely to switch whilst net beneficiaries will stay with the full PAYG pension.
Voluntary pension saving (i.e. third-pillar pensions) is common but saving per contributor is low. This is because a combination of direct subsidy and tax incentive makes some saving attractive, but beyond this returns are low. The regulations on private pension funds need an overhaul, notably the restrictive regulation that annual returns to policyholders cannot be negative. In addition, the subsidy and tax breaks ought to be critically assessed. The first best solution would be if the regulatory overhaul makes saving attractive without support.
… and more work is needed in other areas of public spending
The government’s public-spending reform extends beyond healthcare and pensions. Economies in welfare benefits are being made, in part, to claw back some large increases that were voted in the run-up to the 2006 general election. This has partly involved bringing more discretion in the indexation of welfare benefits. Although this indeed creates possibilities for fiscal savings, it brings no reduction to the risks of political pressures for unwarranted increases. On balance, an appropriate system of comprehensive automatic indexation should ultimately be considered. Saving has also been made by postponing the implementation of acts on workplace injury insurance and sickness insurance. The act on sickness insurance makes employers responsible for the first 14 days of sick pay in exchange for a reduction in social contributions. Although a three-day “waiting period” has been introduced in the interim, the 14 day scheme should not be postponed further because a period of employer responsibility would help considerably in tackling abuse of the sick pay system.
As regards public administration, more is needed to encourage efficiency gains via job cuts, especially as lay offs can easily be absorbed given current labour-market conditions. The recent attempt to induce savings by limiting wage-bill allocations for 2008 10 is encouraging but it is too early to assess its results. In addition, given the significant opportunities in EU funding, administration of the allocations needs to be simplified and decentralisation offset by stronger communication and the pooling of expertise in administration.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded in English and in Czech language. It contains the OECD assessment and recommendations.The complete edition of the Economic survey of the Czech Republic 2008 is available from:
- Subscribers and readers at subscribing institutions can access the online edition via SourceOECD , our online library.
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Government officials with accounts ( subscribe) can go to the "Books" tab on OLIS
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Additional information
For further information please contact the Czech Republic Desk at the OECD Economics Department at eco.survey@oecd.org. The OECD Secretariat's report was prepared by Philip Hemmings, Alessandro Goglio and Zuzana Smidova under the supervision of Andreas Wörgötter. Research assistance was provided by Margaret Morgan.
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