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

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