Transitional Success: USSR to EU
Transitional Success: USSR to EU
The Czech Republic
USSR to EU
Public finance policy
issues during the political
economic transition from
centrally planned socialist
economics to free market
V550 Dr. Mikesell
November 20, 1996
Summary: Restructuring for Transition
III. Transition to
Market Economy: 1990 - 1991
IV. Problems of
Transitional Monetary Policy and the Financial Sector: An Overview
V. Macro Economic
Stability: 1993 - present
VIII. Budgetary Overview:
1993 - present
IX. Tax Reform
Political Economic Considerations: 1996
XI. The EU and NATO
In 1989, after nearly 40 years of Soviet
control, Czechoslovakia once again became an independent nation, the Czech and
Slovak Federalist Republic. This transition from Soviet socialism to democracy
culminated throughout Central and Eastern Europe with the literal collapse of
the Berlin Wall in East Germany, the heroic Gdansk Shipyard Strikes in Poland.
The student and worker protests in Prague and Budapest were no less important.
The Czechoslovakian revolution took place
peacefully and over a much longer period of time than events in other former
Soviet Union or Warsaw Pact nations. Hints of major reform in Czechoslovakia
began as early as 1968. Czechoslovakian officials, under Soviet power, moved
incrementally to begin the long road towards decentralization and independent
Czechoslovakian rule. Their increasingly effective efforts became known as the
Prague Spring, a time of growth, change and development.
Success was, of course, neither immediate nor
easy to achieve. The Cold War reached a pinnacle in the Eighties and the winds
of change began to blow in Central and Eastern Europe. The CEE nations endured
many hardships. Soviet oppression, though waning by this time, became largely
unbearable. Change in Czechoslovakia came from the ground up; dissidents
quietly began to return to popular power. The revolution gained momentum by
1989. ‘Revolutionists’ began to demand sweeping economic and political reform.
They were backed by well organized and very timely strikes and protests. After
a two hour general strike on November 27, 1989, proving the immediate and
widespread power and cohesion of the revolution, the Soviet controlled
authorities finally agreed to negotiate.
Through the negotiation process and threat of
further massive general strikes, former dissidents assumed officially
sanctioned ‘concessional’ positions. Within months, they gained near complete
(and very real) control of the Federal Assembly. On December 29, 1989, Mr.
Havel, a very famous and popular Czech dissident, became President of
Czechoslovakia (renamed the Czech and Slovak Federalist Republic).
This initial political victory represents only
half of the nation’s success. Within the first three years of self rule, harsh
economic (and subsequent political) realities forced the nation to divide once
again. The nation as a whole was unable to accommodate the vast discrepancies
between the western Czech and eastern Slovak regions. Massive economic reforms
brought this to the popular agenda as Slovakia suffered greatly while their
Czech counterparts seemed to benefit from reform.
The government in Prague wished to move swiftly
to further reform efforts. Slovakia hindered Czech success and in turn suffered
greatly by this Czech-led reform. Slovakia simply could not move as rapidly
toward a market economy due to the economic configuration left to them by years
of Soviet planned economics.
Overview: Restructuring for Transition
In 1992, Vladimir Meciar, a very strong
nationalist was elected prime minister of the Slovak Republic, while Vaclav
Klaus, a moderate federalist, was elected in the Czech Republic. Unfortunately,
these two leaders were unable to agree on common economic and political
strategies to govern the CSFR. Klaus’s reform plans, now legendary, were simply
inappropriate for the fledgling Slovak regions. Slovakians felt alienated from
the government reform in Prague. Within a short time it was very clear that the
Czech regions could not completely support their Slovak countrymen through the
transition. The two leaders agreed to divide the Czech and Slovak Federalist
Republic (CSFR) into the Czech and Slovak Republics on January 1, 1993.
Federal assets and liabilities were split
between the two nations in a two to one ratio. The Czech Republic received the
larger portions reflecting both size and population. Again, the split was
achieved peacefully, without massive debate. The two countries agreed to form a
customs union. They implemented identical foreign policies with respect to
third countries, and forbid tariffs or ‘bans’ between themselves. They also
formed a temporary monetary union, which collapsed within months as both
countries unexpectedly experienced a massive drain on foreign reserves during
this time. To more fully understand the current developments in the Czech
Republic, one must examine the historical economic decisions made before the
break-up in 1993 as outlined below.
to Market Economy Overview: 1990-1991
CSFR economic reformers went to work immediately
following the collapse of Soviet rule. The reform package included near
complete liberalization of prices, a complete reversal of former exchange and
trade systems and an impressive preparation for massive and rapid
privatization. These efforts were supported by financial policies including a
“pegged” exchange rate, currency devaluations, and restrictive fiscal, monetary
and wage policies.
Although monetary policy is discussed in a
separate section, it needs to be briefly addressed here to understand the
conditions in which the transition occurred. Monetary policy in the initial
stages of transition ensured that inflation remained in control throughout
currency devaluations and price liberalizations. The CSFR devalued its currency
by 20 percent in 1991 after several smaller devaluations before hand. Taken as
a whole, these devaluations reduced the value of the currency by half within
six months. Generally, monetary policy remained tight throughout the entire
Undoubtably, the goals of the CSFR economic
reformers were to drastically reduce government spending. The former
centrally-planned, output-driven economic policies were no longer effective for
the new capitalist democracy. Restructuring government expenditures was a key
component of reform. The main changes, aside from massive privatization
discussed below, forced reduced subsidies wherever possible. Every sector of
society, with the exception of health, welfare and education, saw an abrupt end
to government subsidies. In 1991 alone, for example, officials reduced
government spending by 12 percent to reach 47 percent of GDP. This trend
continued throughout the transition. Massive government spending, a hallmark of
socialism, ended virtually overnight.
Areas where government spending remained high
would remain so throughout the reform process. Health and welfare for poor,
elderly, unemployed and children is a very difficult situation in any
government, especially one in transition. Reformers focused primarily on
industry and energy in the initial stages, leaving the areas of greater
uncertainty to be dealt with in a more stable political environment.
As an almost immediate measure, subsidies to
foodstuffs and energy were reduced by nearly 50 percent. Retail prices for most
household items increased by nearly 25 percent literally overnight. By the end
of 1991, the Czech government controlled only 6 percent of prices in the
country as compared with 85 percent in early 1990. Only basic necessities, oil,
and agricultural products remained under state control. To offset some of these
shocks, wages increased, though only slightly and not nearly enough to meet the
increased cost of living. Politically powerful trade unions prevented the
passage of even more drastic reform measures. Plans in 1991 to increase the
price of electricity, heating oil and coal by nearly 400 percent and rent by 300
percent were delayed until 1992 and 1993.
Foreign Trade and Investment
After an initial currency devaluation of nearly
50 percent, the government adopted an adjusted exchange rate connected to a
“basket” of convertible hard currencies. Internal convertibility of hard
currencies was established in 1991. These two measures combined to foster trade
and investment. Initially, the CSFR set a 20 percent surcharge on imports
coupled with a 5 percent tariff. These obstacles soon ended as major provisions
were passed to more actively encourage trade and investment. Initial steps
toward private property rights and the dissemination of publicly owned lands
further enhanced the investment environment.
Privatization is by far the most critical and
complicated development the CSFR had to address. Speed was critical. The
‘default mechanism’ ensured that current managers and persons of powers would
assume control and create their own joint venture agreements with foreign
State firms that were nearly completely
vertically integrated needed to be desegregated by form and function. And the
process had to be done well, for flailing industries would simply increase
state expenditures. Failures did not decrease expenditures in compliance with the
transitional reform strategy. The CSFR privatization plan was threefold.
Small-scale privatization was the easiest. Retail stores, restaurants and small
service or industrial workshops were sold to the highest bidders in weekly
public auctions. Where no CSFR buyers were found, a second round of auctions
allowed foreigners to bid.
Property restitution was more difficult. The
government needed to equitably redistribute land that had been taken nearly 40
years earlier. This is a difficult and involved issue. CSFR citizens are
allowed to claim land taken from them, though the burden of proof is on them.
Where no proof exists, special arrangements can be made for state assistance.
In areas of conflict, the issue will be brought to the courts. A large part of
the country was not in private hands before Soviet rule. Some of this land can
be used as an offering to parties where disputes over ownership exist. Also,
lands that have been improved (shops, developments, houses, etc.) are sold at
specially determined rates to the former property owners. Prices and possible
alternative compensation for those owners who do not wish to purchase these
‘improvements’ are again settled by a special court arrangement.
Large-scale privatization progressed swiftly.
Some state-owned firms were sold outright to private interests while others
remained under indirect state control until buyers were found, legal or
economic concerns settled, or parliamentary debate resolved.
The strong tradition of labor unions and their
political strength proved crucial to social security reforms throughout CEE.
The CSFR was no exception. Labor unions were instrumental in keeping CSFR
unemployment at very low levels and social safety net benefits quite high.
Essentially the state guaranteed incomes at a minimal level to meet the ‘cost
of living’ for the unemployed or the under-employed. Pensioners and parents of
children received benefits adequately covering bare essentials. Further
benefits for health care were distributed at the local level as the health
system still remained under state control.
of Transitional Monetary Policy and the Financial Sector
Since the introduction of reforms, monetary
policy played a key role in the economic stability of the Czech Republic throughout
the transition. Inflation remained surprisingly low (though relatively high in
1989 and 1990), exchange rates were relatively stable (after initial
fluctuations), and external reserves stayed strong throughout the period
(spurred by unusual and unexpected outside interest in the Czech Republic as
the first reformer to prove its success).
What is perhaps most impressive are the
obstacles Czech officials overcame in developing an effective monetary policy.
First, the entire CMEA trading block was virtually dismantled. Reform and
transition would be difficult even with stable trading partners. In the CMEA,
all of the countries were experimenting with and adjusting prices, exchange
rates and policies. It was very difficult to set monetary conditions correctly,
in real or absolute terms.
Second, within just a few short years, the CSFR
itself broke apart for economic and political reasons. This was largely
unexpected and proved difficult in the policy making arena. As the break-up
drew near, officials had a difficult time determining which policies should be
enacted based upon which of many scenarios might occur in the CSFR.
Third, after finally establishing the terms of
the CSFR split and negotiating a seemingly effective customs and monetary union
between the two new countries, the monetary union failed miserably. Within a
few months, the union caused significant drains on much needed foreign reserves
in both countries and had to be abandoned.
Finally, the Czech tax system had to be
completely overhauled. Additionally, the banking system needed massive reform.
Large spreads in interest rates were common and overall the banks were simply
reluctant to lend on any long term basis, a major impediment to domestic
investment and growth.
All of these massive changes occurred within
just a few years. Throughout these developments, monetary policy remained
extremely tight. At the onset of the reform period, it was at its tightest,
with a minor break late in 1991, once the political economic dust had settled.
Otherwise, the next monetary reprieve didn’t occur until the second half of
1993. By 1994, broad money grew at 30 percent compared with growth of 15
percent a year earlier. More important than doubling growth figures is that the
economy was able to withstand this growth by 1994!
Interest rates were high throughout the period,
and continue to remain high by most western standards (over 9 percent).
Interest rates were not directly controlled but were subject to central bank
reserve requirements and discount rate announcements. Liquidity was further
controlled through regular auctions of treasury bills.
Bank reform focused primarily on establishing
the legal framework for transactions between the central bank and newly
established commercial banks. Weaknesses still remain in reporting and
accounting and the reluctancy for banks to lend. Several commercial banks have
had to come back under government control to prevent major economic problems.
Economic Stability 1992 - present
By 1992, the CSFR began to show significant
signs of success. Though they were in fact more disadvantaged than many other
countries in the CEE, they fared well. Their export market consisted almost
entirely of former members of the Council for Mutual Economic Assistance (CMEA)
who were in the same transitional position as the CSFR, impeding efficient
trade. Fortunately, inflation on the whole in the CSFR remained remarkably low
when compared to the rest of the CMEA, as did external debt. Inflation did jump
just before the CSFR breakup into the Czech and Slovak Republics. Experts
suggest this occurred in part due to the fear of instability during the breakup
and in part due to an anticipated VAT. As expected, in 1993 (in the Czech
Republic), inflation rose again after introduction of the VAT.
In 1993, free from its less advantaged Slovak
counterpart, the Czech Republic better targeted its economic recovery plan. The
plan encompassed three main elements:
1) A balanced state budget that encompassed
sweeping tax reform;
2) A tight monetary policy to reduce the
inflation caused by VAT and other lesser effects (which also
improved its external position for trade and investment); and
3) Moderate wage increases (adjusted to
inflation) and a stable exchange rate.
This reform policy was backed by an IMF “stand
by” arrangement as a precautionary measure. The IMF would assist if the Czech
Republic needed financial assistance. This happened once early in 1993 and
Czech officials repaid the loan before it came due (much to the delight of the
Unemployment remained remarkably low in the
Czech Republic at 3 percent in 1993, while Poland’s figures (another major
success story in CEE) still remain in double digits. Low, virtually
non-existent unemployment certainly contributes to greater political and
popular acceptance of the above fiscal and monetary policies.
Many attribute a major setback in the Polish
“Shock Therapy” reform efforts to the political demands of the labor unions.
The Polish President, Lech Walesa, understood the need to keep wages low to
implement the reform. But he feared for his political power and caved in to
labor pressures by granting wage increases. By doing so he nearly destroyed the
entire economic reform process. He claimed that had he not, the entire
political reform process would have crumbled.
Czech officials didn’t face this obstacle as
unemployment throughout the transition remained low. The political reform
process was slightly segregated from the economic reform process. The small
Czech population (roughly 10 million) was easier to organize than Poland’s 40
million. Regional differences were less and political factions less pronounced.
Regardless, by 1993, the Czech Republic had a very cohesive popular political
support base which facilitated the economic reforms.
By 1994, foreign trade increased substantially,
with much of the growth occurring between EU member nations. Tourism in Prague,
now a “must see” on any European vacation, contributed to increased trade to
maintain a strong balance of payments and a surplus in the current account.
Though FDI by 1994 had decreased (after very high initial investments in 1992
and 1993), the
capital account maintained high inputs due to
the rise in borrowing of Czech firms (which proved even better for Czech long
term economic success).
GDP began to rise slightly after a period of
decline from 1991-1993 of 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.
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.
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
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
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 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
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.
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
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.
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.
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
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
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
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
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.
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
Country Profile: Czech Republic. The Economist, London. 1996.
Saving Graces. The Economist November 9, 1996.
Jeffrey. International Political Economy 3rd Edition. St. Martins Press,
NY. 1995, Section IV.
Christopher. Tax Reform and Economic Transition in the Czech Republic.
Fiscal Studies, Feb. 1994.
Christopher. Tax and Benefit Reform in the Czech and Slovak Republics.
Center for Economics and Policy Research, Discussion Paper Series No. 1151.
Vaclav. The Ten Commandments of Systemic Reform. Occasional Paper 43,
Group of Thirty, Washington, DC, 1993.
Eva. Trouble Brews Over Tax Break. The Prague Post, January 18, 1995.
Eva. 25 Year Old Sports Car Picking Up Speed. The Prague Post, January
Economic Surveys. Czech Republic. OECD, Paris, 1996.
Budgets and the 1993 Fiscal Policy. CTK Business News. May 4, 1993.
Jan. The Czech Republic and Economic Transition in Eastern Europe.
CERGE-EI, Prague, Academic Press, NY, 1995.
CTK National News Wire. December 11, 1992.
vista.digital.com - simple query cz repub, transitional economies