Economics Department

Economic Survey - Slovak Republic 2004: How can fiscal and monetary policies support growth?

 

Fundamental tax reform aims at enhancing efficiency

A comprehensive tax reform has been launched to enhance incentives for entrepreneurship and work, increasing the transparency of the tax system, and reducing distortions from exemptions and double taxation.  The core of the reform consists of a flat marginal rate of 19 per cent on all personal and corporate incomes, while the deductible allowance for low income earners is increased. Virtually all tax exemptions are eliminated, whereas the real estate transfer, gift, and inheritance taxes are abolished.  A uniform value-added tax rate of 19 per cent is applied to all products and entails a major shift in the tax burden from direct to indirect taxes. These changes have become effective from January 2004 and should enhance efficiency by treating different forms of income more equally.  According to official projections, the overhaul of the tax system should be revenue-neutral, but the multi-faceted nature of the changes and data limitations on household incomes make projections tentative.  The authorities should provide for contingency plans and measures to face any revenue shortfalls upon implementation in 2004.

Monetary policy has been fulfilling its tasks but faces a big challenge in managing the transition towards euro adoption

The Central Bank has been successful over the past several years in furthering disinflation despite large, though necessary adjustments in administrated prices towards cost‑recovery levels. Disinflation has been helped by currency appreciation and international price moderation, but the key to successful disinflation thus far has been the ability of the Central Bank to contain second‑round effects of administered price hikes through active policies. Core inflation has been kept slightly below the target range of 3.2 ‑ 4.7 per cent in 2002 and within the target range of 2.1 ‑ 3.6 per cent in 2003. Over the same period the trend appreciation of the currency has been kept on a smooth path, broadly in line with productivity gains, in spite of the strong capital inflows associated with EU accession. Monetary policy will need to continue on its present narrow path between inflation targets and competitiveness considerations. This may become a challenging task in view of possible volatility in capital flows prior to participation in the euro area, as pressures for appreciation are likely to increase and the need for interventions and sterilisation may grow. In these circumstances fiscal consolidation must be geared to alleviate the burden on monetary policy.

Macroeconomic performance

1.    Three first quarters.

2.    National accounts based estimates.

Source : OECD

Rapid fiscal consolidation is required

The fiscal position on a cash basis continues to be undermined by the lasting effects of the distortive policies of the mid‑1990s, notably the ex‑post costs of massive government credits and guarantees granted during that period. Furthermore, important tax cuts since 2000 have decreased government revenues and made fiscal management more difficult. Budget deficits were nevertheless beginning to be tamed in 1999 and 2000 before ratcheting up strongly in the run‑up to the 2002 elections. The 2002 deficit reached 7.2 per cent of GDP on an ESA‑95 (European System of  Accounts) basis. In 2003 the new government succeeded in building up support for a rapid Maastricht criteria compliance strategy, and this underpinned a first cut at consolidation, with a targeted ESA‑95 deficit below 5 per cent of GDP. The authorities have stated their intention to reduce the general government deficit below the Maastricht benchmark of 3 per cent of GDP by 2006. This amounts to a fiscal consolidation of more than 1 per cent of GDP per year. Such a consolidation path is appropriately ambitious, but achieving it will require a substantial effort. The major risks to this strategy pertain to possible spending slippages, notably in health care, and to the uncertain revenue impacts of the tax reform planned for 2004.

…and should  be implemented through a medium‑term fiscal strategy

In these circumstances, a medium‑term fiscal consolidation strategy is indispensable to keep fiscal outcomes in line with objectives on a sustainable basis. The government aims at developing such a policy. The latest pre‑accession economic programme submitted to the EU presents medium‑term objectives which can be made more visible to the public and more operational in domestic policymaking. To this effect, the government intends to submit a three year budget framework to the Parliament starting with the 2005 draft budget. The medium‑term objectives of this framework should be explicitly based on strategic spending priorities and conservative macroeconomic assumptions, and contain built‑in adjustments to contingencies on both the spending and revenue sides. Making such framework conditions binding is a politically challenging task, but the government should seek to achieve this.

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