The following OECD assessment and recommendations summarise chapter 3 of the Economic Survey of the Slovak Republic published on 9 February 2009.
The fiscal policy framework should be made more effective
Government finances have improved markedly over the past years, with the debt-to-GDP ratio falling by almost half since 2000, not the least because of consolidation efforts to meet the Maastricht criteria for euro area entry. However, the current fiscal framework does not allow for sufficient cyclical flexibility. Notably, current rules require expenditures to be cut when revenues fall short of the original budget plan, potentially exacerbating a cyclical downturn. In addition, cyclical revenue windfalls tend to provoke additional structural expenditure. Thus, more needs to be done to avoid discretionary adjustments and ensure the full working of the automatic stabilizers.
Euro area entry calls for more flexibility to deal with cyclical shocks that cannot be dealt with by the common euro area monetary policy, whilst at the same time ensuring continued consolidation efforts to reach the medium-term objective of a small structural deficit and fostering long-term fiscal sustainability in the face of population ageing. Given these challenges, a deficit rule consistent with the Stability and Growth Pact could be embedded into the constitution to demonstrate that the government is firmly committed to fiscal consolidation. The deficit rule should be complemented by multi-year expenditure ceilings, reinforced by a strong reporting system and ex-post assessments to increase transparency and the political costs of exceeding the ceilings. OECD experience shows that this considerably enhances the effectiveness of the fiscal framework in achieving and maintaining fiscal sustainability. Cyclical expenditure items such as unemployment benefits could be excluded from the ceilings to ensure that the automatic stabilizers can work fully. As output gaps in a rapidly growing catch-up economy can be estimated only with considerable error, the authorities should consider introducing an adjustment mechanism to claw back accumulated deviations from the rule that arise from inevitable projection errors.
% of GDP
Source: OECD, Economic Outlook database.
The pension system should be kept on the right track …
The size and age structure of the Slovak population will change considerably over the next decades due to low fertility rates and continuous increases in life expectancy, leading to substantial pressures to raise public spending on pensions. Past reforms of the pension system that combined parametric changes to the pay-as-you-go, defined benefit (DB) scheme (the so-called first pillar) with the introduction of a fully funded defined contribution (DC) scheme (the second pillar) have led to significant improvements in the long-term balance of the DB pillar, while at the same time considerably reducing the redistributive elements of the system. This reform has had larger short-term costs for the general government budget than originally expected. Recently, a number of modifications were introduced to the pension system, which will increase future pension costs somewhat. Those currently in the system have been given two opportunities to shift between the pillars, while for new labour market entrants participation in the DC pillar was changed from compulsory to voluntary. The result is likely to be movement out of the DC pillar and into the DB one. These measures, along with an increase in the ceilings for pension contributions, have led to a rise in revenues of the DB pillar.
Population ageing in the Slovak Republic
Population aged 65 and over as percentage of the population aged 15 to 64
Frequent ad-hoc changes to pension legislation reduce transparency and potentially undermine the financial viability of the system. The authorities should avoid such changes and, in particular, refrain from measures that tend to undermine the sustainability of the DB pillar. In this regard, several of the recent measures should be reconsidered. The government should consider making participation in the DC pillar mandatory for new labour market entrants or, at the very least, participation should be made the default option, allowing participants to opt out of the DC pillar. For current workers, no switching between pillars should be allowed. To further strengthen the DB pillar, consideration will need to be given to measures such as raising the retirement age in line with gains in life expectancy and reducing unsustainable components of the pension formula while strengthening solidarity. The increased pension contributions to the DB pillar from recently introduced modifications of the pension system should be used to reduce government debt.
Low real interest rates and a small stock market make it difficult for pension funds to achieve returns that are sufficient for the value of pension savings to rise in line with real wages. Nonetheless, simulations suggest that the returns that can be achieved over the longer term on the capital market should be higher than those provided by the Slovak DB pillar assuming constant contribution rates and declining replacement rates to reflect the impact of ageing. Whilst ensuring sufficient investor protection, it is essential that pension fund regulation does not adversely affect returns by being unduly restrictive. As such, the elimination of the requirement to invest at least 30% of the capital into entities domiciled in the Slovak Republic is welcome. Currently, pension fund management companies are judged against the average of the rates of return achieved by all pension funds of a certain type, which complicates investment decisions due to low transparency and risks this benchmark, which is meant to be a minimum, becoming a low target return. The authorities should therefore shift the responsibility for setting the benchmark to the pension fund level, and require funds to regularly publish information about their performance against an absolute benchmark.
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The OECD Secretariat's report was prepared by Felix Hüfner and Isabell Koske under the supervision of Andreas Wörgötter. Research assistance was provided by Béatrice Guerard.