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Transitional Success: USSR to EU

nearly 20 percent. Privatization entered its second round in 1994 for

enterprises being privatized through voucher programs. The first wave of

privatization is considered a remarkable success (a model to be used

farther east). As this first wave ended in 1993, the Prague stock exchange

began trading and the banking system went though increased and improved

reforms. The Czech Republic was a leader in the CEE in trade and

investment. Economic reform efforts, coupled with the above mentioned

political support, put the Czechs at the forefront of CEE success.

Industry

Industrial output by 1993 declined by nearly 21 percent compared with 1991

figures. This can partially be explained by increases in the service

sector, as investment soared in service sectors and dropped dramatically in

the industrial sector. Also, the industrial sector was the most inefficient

sector in the former centrally planned economy and much of those

inefficiencies were corrected with the introduction of market reform. Most

industries produced less as consumption dropped. And they did so more

efficiently as output based economic plans were no longer used.

It is significant to note that the Czech Republic does not have an

industrial policy. They feel the state does not have enough information or

resources and thus it is most efficient to allow the private sector

complete control. Government could assist with exemptions and subventions,

but the market should determine winners and losers.

However, the Czech government continued, through 1994, to bail out state-

owned enterprises, mostly due to their economic (employment) and political

leverage. In essence, this hurts struggling smaller, private, firms that

are unable to compete with giants, let alone subsidized giants. These large

industrial subsidies are all but gone in most industries today, however

they still exist for politically sensitive or economically vital

industries. In some cases the government reluctantly returned to subsidies

as not all of the initial privatization efforts proved successful. Some

large enterprises were not effectively dismantled and the resulting giant

enterprises were simply too large and inefficient for the new market

economy. It took several years, in some cases, to learn this lesson.

Prices

Consumer price inflation by 1993, after the initial shocks of the VAT,

stabilized at 18 percent. Experts estimate the VAT added 7 percent to

inflation during 1993 and an additional 2 percent can be attributed to

government administered price regulations. Price regulations remained

mostly in the utilities sector. Adjustments from 1994-1995 increased prices

in several key areas including gas, oil, transportation, medicine and

telecommunication tariffs.

Wages

Wage restraints through a “tax based income policy” was an important

feature of the CSFR. Wage restraints ended in 1993, but had to be brought

back by the end of the year by the Czech government. The rational behind

bringing the restraints back was that market forces were not yet adequate

to control wage increases. Wage increases had to remain close to increases

in consumer prices to avoid inflationary difficulties. Therefore, as late

as 1995, up to 100 percent tax rates were applied to wage increases over

allowable limits, effectively keeping wages at desired rates.

Monetary Policy: 1993

By 1993, Czech monetary policy began to stabilize in conjunction with

political and economic indications of success. The basic aims of monetary

policy at this point were simply to maintain internal and external currency

stability. Officials kept the Czech crown pegged to stable European

currencies and prevented inflation from rising above 10 percent. In a

somewhat disguised blessing, foreign capital flowed into the Czech Republic

at high rates in 1994 causing officials to raise reserve requirements from

9 to 12 percent to insure inflationary stability. The banking system,

though still flawed, was able to withstand the pressures. The economy

certainly welcomed the increased capital.

By 1993 and even more so by 1994, monetary policy was less of a political

tool in the reform process. Stability in many respects had been achieved.

The nature of further reform and continued stability relied almost entirely

upon fiscal decision-making. To fully understand and appreciate the

political economics of reform from 1993 onward, both fiscal and monetary,

an examination of the Czech budget is helpful. Defining the role of the

state in the new market oriented economy is critical. Two main issues must

be examined, the resources and informational capabilities of the state.

Both are limited and both are not independently effective. The budget and

the political issues surrounding its passage are important in understanding

the Czech approach to stability now that much of the transition has been

rather successfully completed.

Intergovernmental Financial Relations

Before the budget analysis, a brief overview of intergovernmental financial

relations may be helpful. The Department of Finance makes budgetary

estimates for the Ministry of Economy. They regulate spending and

essentially decide which organizations and institutions receive the much

sought after government subsidies. They are also responsible for government

accounting, financial management and regulation of wages. The Department of

Finance is classified under the Ministry’s “Administration and Finance”

section.

The Foreign Economic Relations Department, the European Affairs Department

and the Economic and Social Policy Department are all included under the

Ministry’s “Economic Policy.” They all report to the Ministry and are

essentially charged with the difficult task of improving and encouraging

economic development both home and abroad. The Ministry also supports a

wide variety of business development departments; Small Business, Business

Promotions, Tourism, etc. Though their interactions, cooperation and

communication are limited, they all follow somewhat coordinated general

policy initiatives of the Ministry.

The 1993 Budget

The following budget summary is based on the 1993 budget because that was

the first budget elaborated as the independent Czech Republic. Before the

transition, Czech had one of the more state dominated economies in the CEE.

The state controlled almost all economic activity with government

expenditures reaching as high as 65 percent of GDP in 1989.

The 1993 budget focused on a more developed private sector. The budget is

fundamentally influenced by tax reform which will be discussed in the

following chapter.

Revenues

The 1993 budget is based on three main revenues: the value added and excise

taxes (36.9 percent), income tax from legal entities (25 percent) and

social insurance (28.5 percent). The new tax system (and total

restructuring of public finance to benefit local budgets) reshaped the

revenue system and forced budget developers to complete more in-depth

estimates of revenue flows. They were forced to make more accurate revenue

predictions.

Total revenues in 1993 reached 419 billion crowns (26 Kc per $1USD), of

which 343 billion went to the state, 41 billion to local districts and 35

billion to health insurance. Revenue growth was 13.4 percent and local

budgets rose 35.2 percent in 1993

Expenditures

A large part of the expenditures for the Republic encompassed transfers to

the people. The largest programs are pensions, family allowances and

sickness insurance. Social transfers were increased in 1993 to create

reserves for expected increases in unemployment. Expenditures on branches

of government like health care, for example, increased by 50 percent in

1993, simply responding to demand. A move to create the National Health

Fund was instituted out of a revamped payroll tax and transfers from the

central budget to care for the non-working public. The health fund reduced

local spending on health care thereby reducing local transfers.

Expenditures on education and culture also increased by a third over 1992

levels. These additional expenditures were partially offset by a new wage

tax targeting employers and a combination of the following:

1) Savings in compensatory income support and sickness benefits by a new

means tested model;

2) A freeze on subsidies to agriculture, transportation and mining; and

3) Large cutbacks in real investment, including a public housing plan begun

in 1992.

Transfers from federal accounts to the Czech government totaled 90 billion

crowns, one fifth connected with expiring credits granted abroad and debts

owed by the former Czechoslovakian and CSFR government. Debt service is a

major component of the 1993 budget. The debt reached 115 billion crowns by

1993. 40 billion crowns were transferred liabilities of the Czechoslovakian

Commercial Bank from operations of the so-called ‘central foreign currency

resources’. Total expenditures on debt service reached 23 billion crowns in

1993. Due to its size and proportion of the entire budget, some of those

payments were deferred. Eight billion crowns, the total Czech share of the

1992 debt, was financed through state bonds and money from the national

property fund. Old debt principals were deferred for a year until 1994.

Tax Reform

The main elements of the systems prior to 1993 included taxes on enterprise

surpluses, payroll and turnover. Wage or income taxes existed but were

largely insignificant. The main function of the taxes were to transfer

enterprise surpluses to the state budget and to sustain the

administratively determined price structures. Tax incentives played no role

in the economic system.

Sweeping tax reforms dominated the budget for the 1993 year. They included

new indirect, direct and property taxes and modification to the payroll tax

including a shift in the tax burden from corporate incomes to wage incomes.

From 1992 to 1994, relative to GDP, the share of wage based taxes rose

while the share of corporate income tax fell and indirect taxes remained

unchanged.

These new direct taxes eliminated earlier distinctions for taxation of

businesses based on forms of ownership and employment status. The new

system of VAT and excise taxes expanded the coverage of indirect taxes to

services. It also mitigated the falling implicit rate in the earlier

turnover tax and condensed the range of standard tax rates.

The reforms promoted investment by lowering the cost of capital to

businesses. This reform featured a significant reduction in the statutory

rate of taxation, standardization and acceleration of allowed depreciation

and a 10 percent credit on investment in selected equipment which reduced

the dispersion in effective taxes on investment activities. This is how the

cost of capital was lowered. The tax allowed the rate of taxation on

enterprise profits to drop from 55 to 45 percent.

A personal income tax was also introduced to replace the previous network

(maze?) of taxes on wages of large enterprises, the incomes of artists and

authors, and the various forms of income derived from the emerging private

sector. The new tax had all wage and self employed income taxes on a

progressive scale with marginal rates from 15 to 47 percent, standard

deductions and additional deductions allowed for social insurance

contributions, children, transportation to work, etc. Interest, dividends

and capital gains were subjected to 15 to 25 percent, encouraging

investment only slightly. Social security and health taxes on wages of 36

percent from the employer and 13.5 percent employee replaced the old

payroll tax of differential rates. Net taxes on gifts, inheritance and

motor vehicles were implemented and the import surcharge was eliminated.

Although the system went through amazing changes as outlined above, much of

these changes were to no avail.

Tax evasion and avoidance

The problem with this system is that these any tax structures are still

relatively easy to get around if one is willing to operate in the shadows.

In the first quarter of 1994, the (23% rate) VAT yield was 30 percent below

initial expectations. The corporate and VAT combined barely yield 80

percent of original estimations (one suspects that estimate is high...).

Overall, Czech shadow economic activity, though low, is still significant.

Estimate suggest anywhere between 15 and 25 percent of the economy works in

the shadows.

Police claim it is almost impossible to investigate and prosecute tax

violations. The criminal codes do not allow for them to effectively

investigate such activities, and no other effective mechanisms yet exist.

Change in codes and regulations are too complex and far too frequent. The

Ministry of Finance claims that between 1993 and 1994 there was a change in

the tax codes at least every 4 days. An example is the modification in 1994

of the corporate income tax from 45 percent to 42 percent, a reduction in

the highest marginal personal income tax rates from 47 to 44, and an

increase in allowable expenses. These simple changes required major

modification in software and procedure for the Ministry’s clerks to keep up

with the changes. The Ministry coordinates 12,000 employees in hundreds of

local offices that constantly need to register and update databases with

the latest tax changes.

Due to all the confusion, police estimate they can only catch roughly 10

percent of tax related crimes. A 1994 law adds to the difficulties by

allowing businesses to keep their records secret. Employees can be sworn to

secrecy regarding certain administrative procedures in firms, like tax

issues. The criminal code states that banks can only be forced to reveal

tax information after initial evidence from a formal investigation. With no

information to go on, investigations rarely reach formal status.

Additionally, a great deal of business transactions are still conducted on

cash basis due to the ease and tradition. This opens very easy avenues for

tax evasion and avoidance as cash is barely trackable.

Many of these tax reforms will become obsolete as the Czech Republic bids

for EU membership. Czech will have to compete with EU tax codes, one

example entails small breweries. Parliament passed a law on EU guidelines

that allows a larger consumption tax on alcoholic beverages to be granted

only to small, independent breweries. Breweries producing less than 200,000

hectoliters per year will be eligible for consumer tax cuts of up to 50

percent. The law sets a progressive rate up to the minimum margin limit.

Though it may seem straight forward, experts are unsure whether this brings

the tax code closer to EU standards or drives them farther away. Are they

protecting small business, providing tax shelters to favored companies, or

preparing for entrance into the EU? Currently no one knows. The tax reform

process is slow. Though much has been accomplished on the books, no one is

really sure what the final outcomes will be. One suspects, as with many

recent development in the Czech Republic, change will gravitate toward EU

standards wherever possible. As the potential for EU membership draws near,

one can expect many of these seemingly confusing tax issues to be clarified

immediately as the Czech Republic attempts to do business with one of the

most developed and powerful economic forces in the world.

Current Political Economic Considerations: 1996

Perhaps the most exciting chapter of the Czech political and economic

transition is still to come. In November 1995, the Czech Republic signed a

membership agreement with the Organization for Economic Cooperation and

Development. The Czech Republic is the first CEE country to enter the ‘rich

boys club.’ The Czechs furthered their status by recently declaring that

they were now considering themselves a ‘developed’ economy. Though perhaps

a bit premature and self-serving, OECD membership certainly entitles them

to make such a claim. Many more economic issues still need to be addressed

however, before transition can truly be considered complete.

The Czech Republic should reach growth levels of 7 percent this year. That

growth needs to be achieved for the next ten years to simply double their

income, and even then they will remain far behind their western neighbors.

Current GDP in the Czech Republic is only about $3500, which according to

the World Bank, ranks them near Malaysia. Fortunately, unemployment is

practically non-existent at about 3.2 percent, the lowest rate in all of

Europe. And the Czech trade deficit runs about 5-7 percent of GDP. Some

experts suggest that rapid appreciation of the crown in recent times is to

blame.

Furthermore, wages are a problem. Though they remain low, they are rising

very quickly even with governmental controls. To stay competitive Czech

business must increase productivity. This tends to be very difficult

without cheaper capital. Though tax designs are in place to ‘cheapen’

capital, it is not immediate nor as effective as necessary. Finally,

average savings rates throughout the CEE are about 18 percent, which is

just half of the very successful East Asian Tigers (and two to three times

that of developed economies). Czech needs to decide how fast and how much

more they will grow in the near future. Regardless of some of these more

negative indicators, Czech has made a significant transition. The numbers

above simply indicate that their journey is not yet complete.

OECD membership is just a small step toward the Czech’s ultimate goal of EU

membership. The Czech Republic is revamping their policies in order to

comply wherever possible to EU regulations, guidelines and policies in

order to facilitate their membership bid. Some of these changes include a

decrease in the number of income tax brackets, decreases in the VAT from 22

percent to below 20, and the end to all tariffs with EU countries by 1997

(excluding “sensitive products”). These changes are helpful to the Czech

economy but slightly premature. Experts claim they are done solely to

impress the EU application reviewers.

The EU and NATO

EU membership is inextricably tied to NATO membership. It is important to

understand the similarities and differences between these two

organizations, especially as they concern the Czech Republic and the

continuation or completion of the transition. The transition is both

economic and political and therefore should be examined in terms of both EU

and NATO powers. The EU and NATO are arguably the most advance powers

economically and politically in the world. NATO includes the US, while the

EU, of course does not. It is interesting, then, that many claim EU

membership is virtually predicated on NATO membership. This creates an

interesting foreign policy situation for the Czechs. It is not

contradictory, but perhaps a bit dispersed in terms of goals and

objectives.

Originally, NATO was created as a response to the communist threat. Recent

discussions between NATO and Russia suggest this threat no longer exists.

So what is NATO’s role today? For the time being, NATO has a very powerful,

though perhaps indirect role in the continuation of EU expansion. EU

membership would bring long term economic and political stability to the

CEE (a NATO objective as well). NATO must continue to work in association

with the EU to bring stability throughout the region to insure that the

“communist threat” is indeed diffused indefinitely. It is not out of the

question that massive economic and political upheaval in the FSU could

result in some nationalist power rising up and posing a serious threat to

European interests. It is in this sense that NATO and EU have a very

common, and perhaps final goal.

Recently while in Detroit campaigning, President Clinton set a date for

NATO expansion. He did not specifically mention which countries he was

referring to, however, he did say that ‘their’ inclusion into NATO is

expected by 1999 (by ‘their’ most experts assume, Poland, Czech and

Hungary). If the Czech Republic becomes a NATO member by the year 2000, EU

membership could come as early as 2003 or 2004.

Therefore, politically, the Czech Republic needs to satisfy the goals of

both EU and NATO. Economically, they need to address the EU a bit more

thoroughly then the US as the EU will be their main trading partner, but

the US will remain a powerful ally, investor and trade partner. Although

membership in either of these prestigious world powers would be remarkable

for a country just a decade after socialist rule, the Czechs need to

proceed carefully.

In joining the EU, the Czech Republic will face a somewhat unpleasant

reality. After years of being the political and economic leader of the

transitional Warsaw Pact countries, they would be immediately subverted to

the lowest status in EU member countries, lower than Portugal. Though this

would enable them to receive EU assistance, both technical and financial,

it would also require them to adapt possibly painful domestic policies

involving increased environmental standards, increased costs and

drastically high competition in terms of quality and markets. It would also

find them having to compete with Hungary and perhaps the most important

country from the EU perspective, Poland. If Czech is forced to split

benefits and favors with Poland and its huge 40 million person markets,

they will indeed have their work cut out for them. Another major problem

are the EU legal requirements for issues like consumer protection.

The benefits to EU membership, of course are many. The Czech Republic

currently meets four of the five requirements for EU membership under the

recent Maastricht Treaty. The Czechs reached EU membership levels for

currency stability, interest rates, debt as a percentage of GDP and public

expenditures as a GDP percentage. They still fall short on the inflation

determinant. 1996 inflation is still at 9.1 percent. This would have to be

lowered to 3.8 percent to conform to EU standards, a daunting task. The

country will continue to reduce taxes wherever possible to stimulate the

economy, but this is increasingly difficult as the Czechs are now in a

relatively comfortable position where increased reductions in taxes would

seriously hurt social benefits.

The EU is currently in the process of implementing their monetary union.

Though this is a fantastic goal for the Czech Republic, they are not yet in

a position to completely abandon their own monetary policy and rely

entirely on fiscal policy. Even though they could not be permitted to join

the EMU upon their EU membership (it has much stricter requirements than

general membership), it would be strange for the Czech Republic to enter

the EU knowing that they are a far cry from EMU membership. This is not to

say it is inadvisable. The Czechs must join the EU at almost any cost. It

is simply a concern worthy of mention. As the EU expands, the core states

will be able to continue a favored status or elite power center, revolving

around EMU involvement and not simply EU membership. This could be an

important strategic leveraging issue for the core states (and a major point

of contention for the Czech Republic as a new member).

There are many concerns and areas for excitement both politically and

economically for the Czech Republic. They are in a very good position to

come out far ahead of anyone’s expectations. Perhaps even their own. EU and

NATO membership will both be achieved within the next 5-10 years, no matter

what difficulties are faced along the way.

Conclusions

In just seven years, the Czech Republic transformed itself from a

socialist, Soviet-controlled industrial-based economy to an increasingly

service oriented OECD member and number one contender for the next wave of

EU and NATO expansion in the region.

The Czech Republic’s success can be largely attributed to its small size

and population and its relative ethnic and religious homogeneity. More

important, however, is the Czech determination and persistence in meeting

the challenges of transition. The transition that began in 1989 entailed a

great many hardships. Not all of the CEE countries made it through the

transition so successfully. The Czechs succeeded because they were able to

stick to their plan when most other countries were forced to abandon for

political reasons and popular discontent.

When the reform package became difficult, the Czechs didn’t revolt, they

didn’t strike and they didn’t complain. They showed remarkable foresight in

taking early steps to revamp their tax system and banks, keep inflation and

unemployment and wage increases low, and keep their currency at stable

levels. These were not all easily accomplished. They survived the difficult

times and came out on top of the CEE as the only country to make it through

the transition virtually unscathed. This smooth transition earned their

revolt the nickname, “the Velvet Revolution.”

The Czech Republic is now poised to embark upon a greater challenge, that

of becoming one of the world’s power core with EU and NATO membership. It

will entail further difficulties, but compared with the accomplishments of

the past and their ability to overcome Soviet oppression and transition

from central planning, there is little doubt that the Czech Republic will

succeed in their final step toward complete transition from the USSR to the

EU.

References

Economist. Country Profile: Czech Republic. The Economist, London. 1996.

Economist. Saving Graces. The Economist November 9, 1996.

Freiden Jeffrey. International Political Economy 3rd Edition. St. Martins

Press, NY. 1995, Section IV.

Heady, Christopher. Tax Reform and Economic Transition in the Czech

Republic. Fiscal Studies, Feb. 1994.

Heady, Christopher. Tax and Benefit Reform in the Czech and Slovak

Republics. Center for Economics and Policy Research, Discussion Paper

Series No. 1151. March 1995.

Klaus, Vaclav. The Ten Commandments of Systemic Reform. Occasional Paper

43, Group of Thirty, Washington, DC, 1993.

Munk, Eva. Trouble Brews Over Tax Break. The Prague Post, January 18, 1995.

Munk, Eva. 25 Year Old Sports Car Picking Up Speed. The Prague Post,

January 18, 1995.

OECD Economic Surveys. Czech Republic. OECD, Paris, 1996.

State Budgets and the 1993 Fiscal Policy. CTK Business News. May 4, 1993.

Svejnar, Jan. The Czech Republic and Economic Transition in Eastern Europe.

CERGE-EI, Prague, Academic Press, NY, 1995.

Untitled. CTK National News Wire. December 11, 1992.

Web Sites: http://www.cerg.cuni.cz

http://www.aifs.org/czoo.htm

http://alta vista.digital.com - simple query cz repub,

transitional economies

http://www.lbs.lon.ac.uk/school/wpaps

http://www.ssc.upenn.edu/east/spring95/janusz

http://www.hiid.harvard.edu/pub

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