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A WORLD BANK COUNTRY STUDY

Czech RepublicEnhancing the Prospects for Growth with

Fiscal StabilityPublic Expenditure Review

March 2001

TABLE OF CONTENTS

ACKNOWLEDGEMENTS.........................................................................................................iii

EXECUTIVE SUMMARY.........................................................................................................vii

PART I. THE STRATEGIC SETTING.....................................................................................1A. Introduction............................................................................................................................1B. Macroeconomic Context........................................................................................................2C. The Fiscal Picture...................................................................................................................5D. The Medium-Term Outlook.................................................................................................15E. Conclusions..........................................................................................................................18

PART II. EXPENDITURE REFORM OPPORTUNITIES...................................................19A. Introduction..........................................................................................................................19B. Bank Restructuring..............................................................................................................20C. Social Protection Programs..................................................................................................25D. Health...................................................................................................................................38E. Education..............................................................................................................................47F. Transport...............................................................................................................................58G. Housing................................................................................................................................66H. Conclusions..........................................................................................................................75

PART III. THE FISCAL MANAGEMENT FRAMEWORK................................................76A. Introduction..........................................................................................................................76B. Consolidating Public Finances.............................................................................................77C. Casting Fiscal Choices in the Medium Term.......................................................................81D. Moving towards Greater Performance Orientation.............................................................85E. Strengthening Local Government........................................................................................86F. Conclusions..........................................................................................................................96

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Tables

Figures

Boxes

Annexes

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ACKNOWLEDGEMENTS

This Public Expenditure Review (PER) is based on the findings of several missions that visited the Czech Republic throughout 2000. The report analyzes public expenditure developments in the Czech Republic and the future prospects for growth with fiscal stability.

All the way through the preparation of this report, the PER team benefited from its close collaboration with various ministries and agencies of the Czech Republic, as well as with NGOs and international institutions such as the European Commission. In particular, the PER benefited from the extensive discussions with the Ministry of Finance (MoF). While the MoF was the principal partner on the Czech side, the collaboration with almost all line ministries and a large number of state agencies greatly improved ours and theirs understanding of the real fiscal stance and the challenges that the Czech authorities are facing and will face in the future. This close collaboration with the Czech authorities has proven to be essential in the preparation of a report like this.

The World Bank team was composed of Carlos Silva-Jauregui (team leader), Geoff Dixon (public expenditure management), Achim Dubel (housing sector), William J. Hyden (transport sector), William G. Jack (health sector), Stepan Jurajda (education sector), Elena Katlerova (transport sector), Jorge Martinez (intergovernmental fiscal relationships), Tina Mlakar (EU expenditures and overall expenditure analysis), Daniel Munich (consultant, education sector), Joao C. Oliveira (intergovernmental fiscal relationships), Peter Parker (transport sector) and Xiaoqing Yu (social protection). Contributions were also made by Rossana Polastri and Zhicheng Li. The final report was co-authored by Bernard Funck and James Harrison.

The report also draws extensively on a paper by Allen Schick entitled “Strategies for Implementing Medium-Term and Performance-Oriented Budgeting in the Czech Republic” (mimeo, September 2000) as well as on an ongoing study by the International Monetary Fund entitled “Balancing Fiscal Priorities” which covers inter alia the Czech Republic. The report finally refers to a companion study by the World Bank on “Intergovernmental Fiscal Relations in the Czech Republic” (mimeo, March 2001).

The team benefited from the effective and very close collaboration with government officials, in particular with Deputy Prime Minister and Minister of Finance Mr. Pavel Mertlik and his teams at both, the Ministry of Finance and the Deputy Prime Minister’s Office. Mission members had the opportunity to discuss the main findings of the different topics and sectors analyzed with government officials at the Office of the Deputy Prime Minister, Czech National Bank, Ministry of Agriculture, Ministry of Industry and Trade, Ministry of Interior, Ministry of Environment, Ministry of Labor and Social Affairs, Ministry of Health, Ministry of Finance,

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Ministry of Education, Ministry of Regional Development, Ministry of Transport and Communications, National Property Fund, Czech Statistical Office, Supreme Audit Office, Czech Railways, Czech Parliament, Kosolidacni Banka, Revitalization Agency, State Health Insurance Company and the sub-national government officials in Prague City, Most, Karlovy Vary and Plzen.

The missions' members had also the opportunity to discuss key issues with academicians at Charles University and CERGE-EI. Moreover, the report also benefited from discussions with representatives from Trade Unions, Ceska Sporitelna, Czech Moravian Guarantee Bank, European Commission, International Monetary Fund and the Organization for Economic Cooperation and Development.

The PER also benefited from valuable comments, suggestions and guidance received at different stages of production from: Roger Grawe, Kyle Peters, Sanjay Pradhan, Maureen Lewis, Margret Thalwitz, Eva Molnar, Jana Matesova, Helga Muller, Shekar Shah, David Shand, Bruce Courtney, Roberto Rocha and Pedro Alba. Special thanks to Mr. Grawe for its constant support and encouragement to this project. Valuable comments and discussion with Rachel van Elken (IMF), Andrew Burns (OECD), Alexandra Cas-Granje (EC, ECOFIN DG) and other EC officials, and Czech government officials and academicians further help us improve the focus and analysis of this report.

The authors will like to express their sincere gratitude to various ministries, agencies and local authorities in the Czech Republic for the time they spent with the team in open and friendly discussions. Their cooperation made this report possible. In particular, special thanks are due to Lenka Loudova, Ales Satanek, Dimitrij Loula and Veronika Znamenackova from the Department of International Financial Relations, Ministry of Finance, for their effective support and organization of the multiple mission agendas. Very special thanks to Mrs. Drahomira Vaskova of the Ministry of Finance and her team for the support and guidance during the preparation of this report. Mrs. Vaskova constant strive to improve the government’s understanding of the fiscal stance and the implied fiscal risks was a key engine driving the scope of this analysis. Many thanks also to Milos Vecera, IFC representative in Prague, for his hospitality and support to mission members during the preparation of this report and to our colleagues at the IMF and the EU for close collaboration. Finally, special thanks to Tina Mlakar who provided excellent research support and to Dolly Teju and Anita Correa for their outstanding work processing this report.

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WEIGHTS AND MEASURES

Metric System

ACRONYMS AND ABBREVIATIONS

AADT Average Annual Daily TrafficBOT Build, Operate and TransferCAA Czech Airports AuthorityCBC Cross Border CooperationnCR Czech RailwaysCDJSC CD Joint-stock companyCEE Central and Eastern EuropeCEECs Central and Eastern European

CountriesCEFTA Central European Free Trade

AgreementCEZ Ceske Energeticke zavodyCIMTO Center for Information and

Mechanically Tested PackagingCIT Corporate Income TaxCNB Czech National BankCLF Czech Land FundCompR Comparative RentContR Contractual RentCostR Cost RentCPI Consumer Price IndexCR Czech RepublicCSA Czech AirlinesCSO Czech Statistical OfficeCSOB Ceskoslovenska Obchodni BankaCSSZ Czech Administration of Social

InsuranceCZK Czech CrownDEM German MarkDRG Diagnostic Related GroupEBF Extra-Budgetary FundEC European CommissionEIB European Investment BankERP Electronic Road PricingEU European UnionEURO European Currency UnitFDI Foreign Direct InvestmentFIFO First-in First-out

GCA General Cash AdministrationGDP Gross Domestic ProductGFS Government Fiscal StatisticsGHIC General Health Insurance

CompanyGNP Gross National ProductGPs General PractitionersGS Goods and ServicesIFIs International Financial

InstitutionsIMF International Monetary FundIMR Infant Mortality RateIPB Investicni A Postovni BankaIPPC Integrated Pollution Prevention

and ControlISPA Instrument for Structural

Policies for Pre-AccessionKB Komercni BankaKoB Konsolidacni BankaLHS Left Hand SideMBR Maximum Basic RentMIS Management Information

SystemMLS Minimum Living StandardMLSA Ministry of Labor and Social

AffairsMoF Ministry of FinanceMoRD Ministry of Regional

DevelopmentMoT Ministry of TransportMSMT Ministerstvo skolstvi, mladeze

a telovychovyMTC Ministry of Transport and

CommunicationMTEF Medium Term Expenditure

FrameworkNATO North Atlantic Treaty

OrganizationNGOs Non-governmental OrganizationsNL Net LendingNPAA National Program for the Adoption

of the AcquisNPF National Property FundO&M Operation and MaintenanceO/w Of WhichOECD Organization for Economic Co-

operation & Development

PAYG Pay-As-You-GoPGRLF Agricultural and Forestry

Guarantee and Support FundPHARE Poland Hungary Assistance for

Economic ReconstructionPIT Personal Income TaxPPI Producers Price IndexPPT Prague Public Transport

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PRIBOR Prague Inter-banking Offer RatePSOs Public Service ObligationsR&D Research and DevelopmentRHS Right Hand SideRMD Roads and Motorways DirectorateROPID Prague Transport Coordination

OrganizationRUC Road User ChargesSAPARD Special Accession Program for

Agriculture and Rural DevelopmentSEF State Environment FundSFA State Financial AssetsSGP Stability and Growth PactSIC Social Insurance CorporationSTIF State Transport Infrastructure Fund

STS Secondary Technical Schools

SVS Secondary Vocational SchoolsTEN Trans-European NetworkTF Transport FundTRS Traction and Rolling StockUB Unemployment BenefitUK United KingdomULC Unit Labor CostUS United StatesUSAID United States Agency for

International DevelopmentUSD United States DollarsVAT Value Added TaxWB World BankWTO World Trade Organization

Fiscal Year

January 1 to December 31

Vice President: Johannes LinnCountry Director: Roger GraweSector Director Pradeep MitraSector Leader: Kyle PetersTeam Leader; Carlos Silva-Jauregui

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Executive Summary vii

EXECUTIVE SUMMARY

The Strategic Setting

1. The policies introduced since the 1997 crisis have met with initial success. For the first time since 1996, the Czech economy expanded in 2000 (by an estimated 2.7 percent) and the recovery should gather momentum in 2001 and beyond. As its pace accelerates, new employment opportunities are developing and the unemployment rate is beginning to recede. Furthermore, sizable foreign investment (close to US$3billion in the first three quarters of 2000), in addition to facilitating economic restructuring, also bodes well for the sustainability of small external current account deficits associated with private investment-led economic expansion.

2. At this stage, the main potential threat to the recovery arises from the deteriorating fiscal situation. Partly as a result of the crisis, and partly due to structural reasons, the overall balance of the general government has turned around from a surplus in 1993 to a preliminary 3.7 percent of GDP deficit in 2000. Netting out extraordinary items (such as privatization receipts and bank restructuring costs) gives perhaps a better appreciation of the underlying dynamics. From a balanced situation in 1993, the deficit excluding such items ballooned to an estimated 4.8 percent of GDP in 2000, and is expected to widen by another percentage point of GDP in 2001.

3. While the economy was in a downturn, the widening of the general government deficit could perhaps be looked at as the normal operation of automatic stabilizers. With the ongoing economic recovery however, the main focus of fiscal policy should shift to maintaining the external current account within bounds as private capital inflows resume and private domestic demand picks up. Unfortunately, as the pace of economic recovery began to pick up, it also became plain that the observed government deficits were not merely cyclical, but to a large extent were structural in nature, and that as such they hampered the adjustment of the fiscal stance to the changing macroeconomic circumstances. The widening of the external account deficit in 2000 to 4-5 percent of GDP – alongside the widening of the fiscal deficit -- calls attention to the urgent need for the authorities to regain room for fiscal maneuvering.

4. Furthermore, as the Czech Republic has made of joining the European Union the central thrust of its strategy, it will also need at some point to prepare for the discipline of the EU’s Stability and Growth Pact (SGP), namely for budgets structurally in balance and “cyclical” deficits limited to 3 percent of GDP. While these objectives are not immediate obligations, it would seem wise to start moving fiscal policy in their direction, rather than to diverge from them, as has been the case lately.

5. With these two considerations in mind (i.e., short term demand management, longer term convergence within the EU), the report suggests that an appropriate medium-term target for fiscal policy would be to bring down the overall deficit of the general government (net of extraordinary items) to 1-2 percent of GDP, as an intermediate step towards SGP objectives. It also makes the case that much of the adjustment should come from the expenditure side.

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6. Indeed, while there is clear need for revenue reform, it is doubtful that this could or should lead to increasing the ratio of fiscal revenue to GDP further. The Czech Republic already compares on that score to Germany or the United Kingdom, and exceeds by several percentage points of GDP the ratios recorded in the so-called cohesion countries (i.e., Spain, Ireland, Greece and Portugal). Worse, wage taxes already bear down heavily on labor (at 47.5 percent of gross labor income, they are twice as high as the OECD average), and should be reduced instead to stimulate employment, as soon as fiscal opportunities arise.

7. There is a stronger case -- and greater scope -- for adjustment on the expenditure side, though it will be a challenging task. Leaving aside bank restructuring costs, regular expenditures have shot up by 5 percent of GDP in the last three years, up to 45 percent of GDP, a level that largely exceeds those observed in comparable countries. Furthermore, they are set to rise further in 2001, as most categories of expenditure (e.g., social entitlements, housing, and transport) seem locked in upward trajectories. Fresh spending pressures arising from EU accession, contingent liabilities, or decentralization might exacerbate tensions.

8. The main purpose of the report is to help the authorities take up this expenditure adjustment challenge in a way that makes the best of potential efficiency gains, while limiting the attending costs. As will be made clear, the reforms needed cannot be envisaged as a one-shot set of stroke-of-the-pen decisions. They will require an ongoing process of review, revision, and redefinition of the role and modalities of government intervention. With that in mind, the report seeks to illustrate, for selected sectors, (i) the nature of the issues which will need to be dealt with to bring about a sustainable reduction in spending while maintaining or increasing the effectiveness of the public sector; as well as (ii) the nature of the dialogue that will need to be take place within and across agencies to chart a feasible course of action.

9. Indeed, one of the report’s major messages is that, to succeed, the process of expenditure reform needs to be firmly grounded in the development of analytic capacities in both core and line agencies, linked with enhancements in the country’s institutions and procedures for fiscal management. These enhancements include continued improvements in the measurement and scope of government accounts, the development of a more systematic medium-term approach to fiscal programming, and a move towards a greater performance orientation in budgeting.

Expenditure Reform Opportunities

10. To illustrate the range and complexity of the issues confronting Czech policy-makers as they seek to contain expenditures while making them more effective, the report focuses on six selected sectors – bank restructuring, social protection, health, education, transport, and housing. These six sectors are clearly important, both because of their size (together they absorb about 80 percent of public spending) and the services they bring to the Czech people, and because it is difficult to see how the needed expenditure adjustments can be achieved without substantial reforms in most of these areas. However, it must be emphasized that other expenditure areas not discussed in the report (e.g., enterprise transfers, agriculture, energy, environment, and defense) should also be subject to a similar rigorous review. For example, current and capital transfers to non-financial enterprises amounted to more than 16 percent of public spending in 1999, and clearly should be carefully reviewed.

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11. Cost of Bank Restructuring. In the short run, one of the largest fiscal burdens arises from the cost of the bank bailouts that had to be undertaken to stave off the financial crisis. The cost of these bailouts is resulting in a step-increase in the public debt (borne either directly by the government or indirectly via “transformation institutions” such as Konsolidacni Bank (KoB). Once the carve-outs of bad loans of IPB and KB are finalized, the cost of the post-1997 bailouts may well turn out to be as high as 15 percent of GDP. Unfortunately, this is the legacy of past excesses that cannot now be wished away. The best option instead is to confront it squarely. Delaying the recognition of the underlying losses would only increase the ultimate fiscal cost of the bailouts, while, as was shown in the case of IPB, privatizing banks “as is” may not attract strategic investors able and motivated to turn failed banks around. Furthermore, there is good reason to hope that, once the canker of bad loans is removed, banks would find greater appetite to lend again, thereby helping the economy grow out of its current travails.

12. Government should therefore remain focused on expediting the resolution of the “old debt” while avoiding the resurgence of new bad loans, including by

(a) Relieving KoB from its status as a bank (and associated requirements), as planned.

(b) Streamlining recoveries and assets disposal methods, with KoB focusing on the few large debtors and leaving the responsibility for dealing with the 12,000 or so smaller delinquent debtors to experienced financial institutions and other independent agents.

(c) Improving the legal framework for debt resolution will promote restructuring of firms as well as the exit of non-viable enterprises. Not only would this improve KoB’s recovery rate, it would also (i) increase the confidence and interest of the investors to participate in the asset recovery process; and (ii) help private commercial banks work out those classified assets that remain on their books.

13. The payoffs of such approach can be high. On the assumption that current bad loans are recovered vigorously, and that the health of the banking sector does not cause repeated concerns, the fiscal cost of bank bailouts, after peaking in 2001, could start declining thereafter.

14. Social Protection. The social protection programs are as much, if not more, of a concern. They have benefited from past reforms, but substantial room still exists to improve them to contain costs, establish financial sustainability, improve poverty focus, and reduce disincentives to work. The state pension program in particular faces serious financial difficulties. The ratio of pensioners to contributors has risen from around 0.47 in 1994 to 0.53 in 1998, and, without additional reforms, is projected to reach over 0.6 by 2010 and continue rising to 0.7 by 2030. As a result, the gap between pension outlays and contributions (already over 9 percent of pension outlays and 1 percent of GDP) could rise to over 3 percent of GDP before 2020.

15. Reforming pensions will be a complex -- and undoubtedly politically sensitive -- undertaking. A number of important initial steps have already been taken, including with the gradual increase in the statutory age for retirement. Some limited savings can be expected in the short run without amending pension legislation. As a short-term stopgap, the authorities should consider indexing pensions only by the minimum level required by law and continuing to keep

Executive Summary x

the “flat” part of pension benefits constant in nominal terms, as has been done since 1998. In addition, steps should be taken now to amend the legislation to adjust some of the policy parameters in the coming year to improve the financial position of the PAYG system. The report recommends, among others, to:

(a) Limit indexation to the consumer price index alone (instead of both the CPI and the real wage).

(b) Eliminate the actuarially unfair aspects of early retirement provisions.

(c) Further increase the statutory retirement age after 2007 when the current phased increase ends (and perhaps increase it at a faster pace).

(d) Extend the minimum contribution period for eligibility for a full pension, and reduce the cost of non-contributory periods.

16. Over the medium term, more fundamental structural change of the PAYG program, including a possible shift towards individual accounts in a notional defined contribution scheme and/or introducing a funded scheme, should be seriously considered as ways to bring long-term financial sustainability and effectiveness to the system, by tightening the link between contributions and benefits.

17. Similarly, other welfare programs (particularly those based on the Minimum Living Standard) should be carefully reviewed and redesigned to reflect more accurately the costs of a minimum subsistence level of consumption, to provide stronger incentives to work, and to focus more explicitly on the poor.

18. Health. The health sector has undergone a radical transformation since 1990. Reforms have converted a centralized bureaucratic system into a group of largely decentralized institutions that provide insurance and health care services. These reforms, combined with general improvements in the economy, are associated with significant improvements in health outcomes: since 1990, life expectancy rose from 71 years to 74 in 1998, and infant mortality dropped from 10.8 per 1000 live births to 6 by 1996.

19. At 7.4 percent of GDP in 1999 and 2000, however, health sector spending remains on the high side, as it exceeds by about 2 percent of GDP the levels observed in other countries with similar income levels and population age structures. This suggests some scope for containing expenditures. At present, there is, for instance, little incentive on the consumer side to contain costs. Imbalances (though reduced) also remain on the supply side that signal inefficient use of resources; and the financing mechanism is complex and costly and may be unstable.

20. The priorities to focus on in the short term would thus include:

(a) Expanding the use of consumer co-payments, beyond the very limited areas where they now apply, while developing safeguards for those with low incomes. This is probably the single most important instrument available to promote long term cost containment and more efficient resource use.

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(b) Adjusting provider reimbursement mechanisms to encourage more efficient resource use.

(c) Simplifying financial arrangements, including by piggybacking premium collection on the collection of other social insurance contributions.

21. In the medium term, as copayments start to contain demand and limit costs, it may be possible to lower the contribution rate for employees, and possibly increase contributions from the self-employed and from non-workers. In addition, insurance companies could play a larger role in cost containment through the development of a managed care approach.

22. Education. Three observations indicate a need for significant changes in the output of the education system to meet the needs of a modern market economy: (i) a very high proportion of the labor force has completed secondary school (88 percent vs. an OECD average of 65 percent); (ii) a small proportion of workers has completed tertiary education (12 percent vs. an OECD average of 23 percent); and (iii) a small percentage of upper secondary school students is enrolled in general academic programs as opposed to the traditional vocational programs (16 percent in general academic programs vs. 47 percent in OECD). This would seem to call for an increasing focus on the more general, higher level skills the economy needs, as well as for expanding access to tertiary education.

23. Fortunately, there is a good chance that this reorientation can be accomplished without excessive increase in public spending on education (from the current level of less than 5 percent of GDP), and while enhancing equal opportunity in education. This could be done by taking advantage of the sharply declining numbers of school-age children, the already small size of classes and low teacher workloads, and the growth of private sector schools, to consolidate at the primary and secondary levels. Part of the resources saved could be shifted to the tertiary level, while expanding the use of tuition payment to recover costs and regulate excess demand for higher education. The key elements of a phased expansion of tertiary enrollment over the medium term would be

(a) Increasing enrollment at the existing universities, financed largely by the introduction of tuition, combined with student loan programs and limited, need-based scholarships.

(b) Encouraging the emergence of new tertiary institutions, largely in the private sector and financed by tuition, and developed from existing higher professional schools.

(c) Continuing the expansion of higher professional schools in response to demand.

24. While this strategy is being developed, the government should in the shorter run redouble efforts to consolidate the primary and secondary levels, to reduce costs and increase the orientation toward development of more general skills by

(a) Revitalizing the “optimization program” to reduce the number of public schools, and channeling the related savings to the tertiary level.

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(b) Reviewing and rationalizing funding “normatives” (i.e., per student allocations) to provide stronger incentives that encourage consolidation.

(c) Expanding the academic content of the vocational and technical school curricula, and encouraging an enrollment shift toward general academic secondary schools.

(d) Intensifying measures to ensure equal education opportunities for all children, especially for Roma children at all education levels, but also for children of poorer social background at the tertiary level.

(e) Implementing a program of national education assessments in parallel with the decentralization of responsibility for secondary education to the new regions.

25. Transport. Although public expenditures on transportation have hovered around 3.0-3.2 percent of GDP in the 1990s, this apparent stability masks significant pent up pressures caused in part by the sweeping shifts in demand for different modes of transport (with rail freight dropping by over 50 percent, while road freight grew by more than 100 percent). This shift has contributed to large operating losses and mounting debts in railways, a rise in road use (and maintenance requirements), and growing urban congestion. The priority currently given to major programs of new rail and motorway investments (associated with the development of European corridors) has exacerbated pressures by diverting funds from maintenance and contributing to a massive backlog of maintenance in roads, railways and public transport.

26. In addition to reducing fiscal pressures, reforms of expenditure programs could also bring widespread benefits to the Czech economy by making it more competitive and market oriented, improving the quality and lowering the cost of transport services, facilitating “just-in-time” manufacturing, promoting the development of the service economy, decreasing the cost of trade, and increasing consumer satisfaction. In approaching these issues, the Czech Republic will need to focus public spending exclusively on those activities that yield the highest returns and that the private sector cannot perform effectively. To this end, the country needs to complete the remaining areas for transport privatization and commercialize activities that will remain in the public sector. Recommendations to deal with these issues include:

(a) A major restructuring of railways: Restructuring the railways will be especially difficult due to the major labor force downsizing required, in addition to the technical and managerial issues to be resolved in the process of privatization. A major commitment of government time and effort will be needed to stop the large and growing drain on the economy (about 1.6 percent of GDP per year in 1998) caused by running this oversized system in a structurally downsized market. Reducing the maintenance backlog, selective phasing of corridor investments to maximize their returns, and adjusting passenger fees also need attention.

(b) A careful management of the road infrastructure: Growing demand for road use calls for making reduction of the maintenance backlog a first priority; undertaking only those corridor investments with the highest returns (and undertaking first those that will also help reduce the maintenance backlog); introducing appropriate road user charges; improving efficiency in management of road maintenance; and

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taking an integrated approach to reducing traffic congestion in Prague, including through parking and congestion charges.

(c) Focusing on public priorities: Given the critical need to focus scarce human and financial resources on the activities above, the government should avoid involvement where its presence is not essential. Priorities here include systematic use of objective, professional cost benefit analysis and steps to assess and limit the use of guarantees and to reduce the risks associated with establishing the extrabudgetary Transport Fund. This would include not financing or guaranteeing such investments as those of CSA or Prague Airport, as private sector financing sources should be available for these profitable activities.

27. Among these recommendations, the main priorities in the short term are to: (i) reduce and rephase road and rail corridor investments, (ii) start a fundamental restructuring of the railways; (ii) increase spending on maintenance; and (iv) raise passenger tariffs and taxes on diesel and heavy trucks.

28. Housing. The housing program faces serious problems. First, substantial public expenditures and implicit subsidies have not generated the outcomes expected. Despite the considerable earlier reform efforts, there has been little induced financing and risk-taking by the private sector. For example, in 1999, residential construction output totaled about CZK60 billion compared with total central and local government budget spending on housing at about the same level. Second, the program has created large and potentially destabilizing budgeted and implicit subsidies and contingent liabilities. Government projections indicate that the central governments budgeted subsidies will nearly double to 1.5 percent of GDP by 2005. Implicit subsidies are also likely to grow as a share of GDP, especially if the housing market picks up. Even more worrying, the new State Housing Development Fund will be responsible for the bulk of the projected increase in spending, and will also have authority to make loans to and guarantee loans to municipalities and housing cooperatives. Third, the present range of subsidies is broad, complex and poorly targeted toward different income groups, with the lowest two income quintiles of the population receiving a disproportionately low share of the subsidies.

29. This experience suggests that a serious reform of the present program is needed before considering an expansion of spending. Such reform should involve, among others

(a) Rent reform. This should be pursued as a high priority, since low rents now severely restrict both private housing demand and blunt the incentives to modernize the current housing stock. Subsidies should be refocused to provide a larger and better designed housing allowance to ease the transition to higher rents.

(b) Divestiture and modernization of public housing. A coherent strategy is needed to privatize the bulk of the remaining public housing stock and to manage and modernize a small core that would remain in the public sector until it also can be privatized. All housing policy instruments (e.g., investment, subsidy, or financing/guaranty activity) should be designed to support this strategy. In particular, the program supporting new housing construction by municipalities should be discontinued, as planned, as soon as possible.

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(c) Subsidy reform. Subsidies should be refocused to support the objectives identified above (for example, to support rent reform and to match private funds mobilized for the modernization of the stock) and better targeted for the most vulnerable. The currently excessive Bauspar subsidies should be phased out and part of the savings integrated into such an improved subsidy approach. Tax subsidies, rent advantages and other indirect housing subsidies should be explicitly budgeted, their levels be reduced and/or phased out.

30. In the short term, while a broader reform strategy is being developed, (i) public spending on housing should not be increased; (ii) budget support for construction of new municipal public housing should be discontinued; (iii) the Bauspar subsidies should be scaled back; and (iv) the preferential VAT rate for residential construction should be terminated.

The Fiscal Management Framework

31. The report emphasizes the need for institutional reforms -- improvements in analytic capacities, institutions and processes -- to help the authorities meet the present challenges and emerge from them with permanent improvements in the way public monies are being handled. Despite recent progress under the newly adopted law on budgetary rules, three factors continue to complicate expenditure-side fiscal adjustment at the national level. First, the coexistence of two budget systems – a formal one centered around the state budget, and another, more informal one of interconnecting extrabudgetary operations backed by privatization receipts and by the credit of the republic -- obscures the fiscal stance and complicates budget choices. A second factor is the inertia created by “mandatory and quasi mandatory expenditures,” (i.e., expenditures mandated by substantive legislation or contractual arrangements) which account for about 80 percent of the state budget. Finally, the budget process itself does not generate meaningful enough information and analysis (e.g., on the nature, efficiency, and quality of the public services being provided) to guide the trade-offs faced in the necessary redeployment of public resources.

32. To overcome these problems, the report proposes to:

(a) Lengthen the horizon of fiscal decision to a timeframe into which action on mandatory items can reasonably be phased in by expanding the medium-term outlook (attached to the state budget for the first time with the 2001 submission) into a full-fledged medium term fiscal framework. The point of the latter would be to (i) commit the authorities to a clear strategy to bring down the general government deficit to 1-2 percent of GDP; and (ii) spell out its implication by major expenditure chapter and items.

(b) Consolidate extra-budgetary funds and transformation institutions (including the KoB and the two newly created extra-budgetary funds for transport and housing) within the medium-term framework proposed above and, ultimately within the state budget, and further tighten applicable regulations on sovereign guarantees.

(c) Initiate a move towards a greater performance orientation by developing an activity/service-based articulation of the state budget.

Executive Summary xv

33. Local governments need to be included in the design of the needed fiscal consolidation strategy. They absorb resources equivalent to about 10 percent of GDP and spend close to a quarter of consolidated government expenditure. The ongoing decentralization offers an opportunity to calibrate better the supply of public services to local demands and aspirations, hence is a chance to enhance the cost-effectiveness trade off in public interventions. Unless properly designed and managed, however, it may also involve major risks. Key issues faced in this area are as follows: (i) a fragmentation of municipal government into 6,239 entities, most of which lack the critical size to accomplish much (86 percent of them have fewer than 1,500 inhabitants); (ii) the potential weakening of the fiscal oversight over their operations with the phasing out, starting 2001, of the national government’s district offices; (iii) a rapid, and unregulated rise in municipal debt (to 53 percent of municipal tax revenues in 1999 from 11 percent in 1993); and (iv) the recent creation of regional governments ahead of any concrete definition of their expenditure responsibilities or autonomous revenue sources.

34. To maximize the opportunities offered by decentralization, while minimizing related risks, the authorities should as a matter of priority:

(a) Offer suitably compelling incentives (by adjusting tax sharing ratios or grant programs) and legal frameworks (e.g., for the creation of “supra-municipalities, and inter-municipal utilities) for the voluntary amalgamation of smaller municipalities.

(b) Reorganize the financial oversight over and support to municipalities (previously provided by the defunct districts) possibly within the new regions.

(c) Restrict municipal borrowing to the funding of investment projects, adopt maximum levels for debt stock and debt service ratios, officially monitor the municipal credit market; and send unambiguous signals to financial markets that municipal debt is not backed either implicitly or explicitly by the national government (including by imposing conservative loan loss provisioning requirements on municipal debt).

(d) Define a process of gradual delegation, then devolution of meaningful responsibilities (and attending revenues) to the new regions, while maintaining the continuity of public services.

35. These institutional reforms do not offer any panacea, nor do they substitute for policy action or replace hardheaded choices and political consensus building with ready-made, mechanical recipes. But, properly conceived and applied on an ongoing basis, they can help (i) illuminate the nature of the choices being faced, (ii) create the space needed to deploy policies, (iii) apply public resources where they can be best utilized while (iv) mobilizing private and local ones wherever possible to the pursuit of public policy goals, and (v) generating feedback on the effectiveness and efficiency of public interventions.

PART I. THE STRATEGIC SETTING

A. INTRODUCTION

1.1 The Czech Republic is entering the new millennium on a positive note, as it appears to be emerging successfully from the recession induced by the 1997 currency crisis. However, as that crisis revealed, serious challenges remain. One key challenge is reducing the large fiscal deficit which emerged in its wake, leaving the economy highly vulnerable to macroeconomic shocks. Indeed, this is the government's own policy objectives, an objective which is anchored in the prospect of meeting the obligations of the Stability and Growth Pact (SGP) after joining the European Union (i.e., balanced budget or even slight surplus in normal years). The scope for reducing the deficit through revenue increases is limited, and indeed a decrease in the tax burden, especially on labor, may be desirable. This means that most of the adjustment will need to be made in public expenditures, in particular by identifying and implementing policies that will reverse the upward pressure on these expenditures, while maintaining or improving their effectiveness. A critical part of this effort will be developing procedures and institutional capacities to measure and manage public expenditures better, and integrating these efforts with the process of fiscal decentralization already underway.

1.2 This report examines these issues and challenges. Part I deals with the macroeconomic context, the fiscal trends, and the medium term outlook. It first highlights the major pressure points that have emerged and complicate expenditure management. This part then makes the case (i) that the country should aim at bringing the general government deficit towards 1-2 percent of GDP over the medium term, as an intermediate step towards SGP targets; and (ii) that the bulk of the necessary fiscal adjustment will need to come from the expenditure side. The task will undoubtedly be difficult and perhaps painful. The main point of this report is to help the country take up this challenge in the way that makes the best of potential efficiency gains, while limiting the attending costs.

1.3 With this objective in mind, Part II proceeds therefore to illuminate the challenges faced in some of the key expenditure programs (support to bank restructuring, social protection, health, education, transport and housing), the options available to deal with them, and some of the trade-offs involved. The discussion underscores that the reforms need to be seen, not as a one-shot set of stroke-of-the-pen decisions, but as an ongoing process of review, revision, and redefinition of the role and modalities of government intervention. Rather than elaborate a comprehensive prescription to remedy current fiscal woes, these sectoral discussions therefore seek to (i) present the key issues that need to be resolved in the selected sectors over the medium term to achieve fiscal sustainability (recognizing that expenditure in other sectors would deserve the same type of detailed review); and (ii) illustrate the nature of the dialogue that will need to develop across the board (including in other sectors not discussed) among the relevant agencies to chart a feasible course of action.

1.4 These themes set the stage for one of the main messages of this report which is that, to yield sustained results, this process of expenditure reform will need to be firmly grounded in a development of analytical capacities in core and line agencies alike, and be underpinned by

Part I: The Strategic Setting 2

institutional reforms of the type put forward in Part III. These involve continued improvements in the measurement and comprehensiveness of budget accounts, the development of a more formal and systematic medium-term approach to fiscal programming in both the Ministry of Finance and in the line ministries, and a move towards a greater performance orientation in budgeting. In the same spirit, this final part of the report discusses how to make the best of the opportunities that the ongoing decentralization presents to achieve a better deployment of public resources, while limiting the related risks.

B. MACROECONOMIC CONTEXT

1.5 The discussions in this report are taking place against the background of a fledgling economic recovery. The economy expanded in 2000 for the first time since 1996 (by an estimated 2.7 percent, see Table 1.1) and all expectations are that the recovery should gather momentum in 2001 and beyond. The economy may however still need to work out the stresses of the recession before it is able to recapture the 5-6 percent growth rates experienced in the runup to the May 1997 crisis.

1.6 At the heart of the May 1997 crisis and its legacy were the deficiencies in the Czech model of transition, particularly those related to the microeconomic foundations of the banking and enterprise sectors. Mass privatization had succeeded in rapidly transferring ownership to the private sector, but had failed to generate sound corporate governance. Instead, the combination of mass privatization, inadequate regulation of capital markets, and lax financial discipline (caused by weak bankruptcy and foreclosure laws, incestuous relationships between enterprises, investment privatization funds and state banks, and political interference in the latter) resulted in a massive ”tunneling” or stripping of enterprise assets to insiders, backed by loose access to bank credit.

1.7 As a result, while the economy appeared to be cruising along an accelerating growth trajectory, banks were accumulating nonperforming loans to levels seen only in the most distressed parts of the region (see Table 1.2). Czech banks accumulated, for instance, a far higher ratio of non-performing loans (NPL) than Hungary, Poland, Slovenia, or Estonia. By the end of the 1998, the share of the non-performing loans in the Czech Republic was similar to the ones in Romania or Slovakia.

1.8 Meanwhile, apparently oblivious of the looming tensions and risks, foreign capital was pouring in, further fueling domestic investment, and giving the illusion that ever widening external current account deficits could be financed relatively easily.

1.9 That illusion was shattered in May 1997. At that time, a speculative attack on the crown -- driven by investors’ perceptions that the current account deficit (which had ballooned to 7.4 percent of GDP in 1996) had become unsustainably high -- forced the authorities to abandon the fixed exchange rate regime maintained since 1991, and to introduce a strict austerity program. With real interest rates shooting up to 12 percent, financial distress spread and the economy went into recession.


Table 1.1: Key Economic Indicators, 1993-2000

1/ Growth of the exchange rate indices indicates depreciation of the Czech crown.Source: Ministry of Finance, Czech National Bank, Czech Statistical Office, and IMF.


Table 1.2: Non-Performing Loans in Central and Eastern European Countries(Percent of total loans)

1993 1994 1995 1996 1997 1998Bulgaria 6.6 6.8 12.6 14.6 12.9 9.5Czech Republic ... 36.0 34.5 34.4 32.8 33.0

Estonia 6.8 3.3 2.9 2.3 1.2 1.4

Hungary 29.0 28.0 20.0 12.0 8.0 2.8

Latvia 5.0 10.0 19.0 20.0 10.0 7.0

Lithuania ... 27.0 17.0 32.0 28.0 12.9

Poland 29.3 28.2 20.9 12.9 10.3 9.8

Romania ... 18.5 37.9 48.0 57.0 34.2

Slovak Republic 12.2 30.3 41.3 31.8 33.4 44.3

Slovenia/ 7.5 5.7 3.9 3.8 3.2 3.3

Note: Total non-performing balance and off-balance sheet assets in total assets. Source: Mlakar (2000) “Enterprise and Financial Sector Restructuring in Central and Eastern Europe.” Background paper for The World Bank (2000) Progress toward the Unification of Europe, Prague 2000 Series, (The World Bank, Washington, DC).

1.10 The downturn proved longer and deeper than originally anticipated. GDP fell by 1.0, 2.2 and 0.8 percent respectively in 1997, 1998 and 1999, and the unemployment rate climbed from 3.9 percent of the labor force in 1996 to 9 percent in 1999.

1.11 In response, the authorities began to relax monetary policy from 1998 onward, while pushing forward with financial consolidation and structural reforms. Between the summer of 1998 and the end of 1999, the central bank cut back its policy rate by about 10 percentage points (from 15 to 5 percent).

1.12 The policies introduced since the 1997 crisis have met with initial success. In particular, the risks associated with the large external imbalances of the mid-1990s began to abate. The current account deficit of the balance of payments came down in 1999 to a more comfortable 2 percent of GDP and the reinvigorated privatization agenda, particularly for the former state banks, attracted large amounts of FDI. With fresh interest for greenfield investments also, total direct investment soared to about US$5 billion in 1999, and the inflow continued to the tune of close to US$3billion in the first three quarters of 2000. While these amounts may be above trend, the sizable increase in FDI is having substantial impact on the pace of restructuring in the Czech Republic and bodes well for the sustainability of small current account deficits. Meanwhile, inflation remains under control (at 4.2 percent in February 2001) and the economic recovery is becoming more robust, as seen above. As its pace accelerates, new employment opportunities are developing and the unemployment rate is beginning to recede.


Table 1.3: Economic Indicators in Selected Countries, 1993-20001993 1994 1995 1996 1997 1998 1999 20001/

Annual Inflation Rate (average CPI, percent)Czech Republic 20.9 10.0 9.1 8.8 8.5 10.7 2.1 3.9Estonia 89.8 47.7 29.0 23.1 10.6 8.2 3.3 4.0Hungary 22.5 18.8 28.2 23.6 18.3 14.3 10 9.7Poland 35.3 32.2 27.8 19.9 14.9 11.8 7.3 10.1Slovak Republic 23.2 13.7 9.9 5.8 6.1 6.7 10.6 12.1Slovenia 32.9 21.1 13.5 9.9 8.4 7.9 6.2 8.3

Real GDP Growth (percent)Czech Republic 0.1 2.2 5.9 4.8 -1.0 -2.2 -0.8 2.7Estonia -8.5 2.0 4.3 3.9 10.6 4.7 -1.1 5.1Hungary -0.6 2.9 1.5 1.3 4.6 4.9 4.5 5.6Poland 4.3 5.1 7.0 6.0 6.8 4.8 4.1 4.9Slovak Republic -3.7 4.9 6.9 6.2 6.1 4.1 1.9 1.9Slovenia 2.8 5.3 4.1 3.5 4.6 3.9 4.4 4.5

General Government Fiscal Balance (percent of GDP)Czech Republic 2.6 0.8 0.3 -0.3 -1.2 -1.5 -0.6 -3.7Estonia -0.7 1.4 -0.5 -1.6 2.6 -0.4 -4.7 -1.5Hungary -6.0 -7.5 -3.2 0.8 -1.8 -4.4 -3.7 -3.0Poland -3.1 -3.2 -3.3 -3.4 -2.7 -2.4 -2.1 -1.9Slovak Republic -7.0 -1.3 0.4 -1.4 -5.2 -5.0 -3.6 -3.5Slovenia 0.1 -0.3 -0.5 -0.2 -1.1 -0.7 -0.7 -1.0

Current Account Balance (percent of GDP)Czech Republic 1.3 -1.9 -2.6 -7.4 -6.1 -2.4 -1.9 -4.3Estonia 1.3 -7.2 -4.4 -9.2 -12.6 -9.6 -5.8 -5.4Hungary -9.0 -9.4 -5.6 -3.7 -2.1 -4.9 -4.3 -3.9Poland -3.1 0.7 4.8 -1.1 -2.9 -4.3 -7.6 -6.8Slovak Republic -5.0 4.8 2.3 -11.2 -10 -10.4 -5.8 -2.9Slovenia 1.5 4.2 -0.1 0.2 0.2 -0.5 -4.0 -2.8

1/ Projections.Source: Ministry of Finance; World Bank Regional Database.

C. THE FISCAL PICTURE

1.13 The fiscal situation, however, remains a key outstanding concern, both in its own right and for the impact it has on overall macroeconomic balances. Partly as a result of the crisis, and partly due to structural reasons (as will be discussed below), the overall balance of the general government has turned around from a surplus in 1993 to a preliminary 3.7 percent of GDP deficit in 2000 (see Table 1.4). In parallel, the external current account deficit has expanded again to 4-5 percent of GDP in 2000.

1.14 The trend in the overall deficit net of extraordinary items (such as privatization receipts and bank restructuring costs, see Box 1.1 for definitions) gives perhaps a better appreciation of the underlying dynamics. From a balanced situation in 1993, the deficit so measured ballooned to an estimated 4.8 percent of GDP in 2000 and is expected to widen by another percentage point of GDP in 2001 (see Table 1.4).


Box 1.1: Definitions in Fiscal Statistics of the Czech Republic

Fiscal discussions in this report and in the Czech Republic refer to a number of concepts which are defined below.

(Consolidated) State Budget: covers central state revenues and expenditures, as voted by Parliament, as well as State Financial Assets and Liabilities (SFAL). SFAL comprises the central government account at the Czech National bank, in which the state budget surpluses and deficits from previous years are deposited. In 2001, the state budget is presented in 41 budgetary chapters.

General Government Budget (or consolidated general government budget): This presentation follows the methodology of the IMF’s Government Finance statistics. It includes the revenue and expenditure and net lending operations of the state budget, local governments, public health insurance funds, and extra-budgetary funds. The overall general government balance includes privatization revenues, as a negative net lending item, and, bank restructuring costs, as expenditure under the heading “subsidies to banks and enterprises.”

General Government Balance (net of extraordinary items): equal to the overall balance of general government operations, excluding all privatization receipts (including those of local governments as well as telecom licenses) and bank restructuring costs.

Tax Quota: the term also used to designate “tax revenues” (i.e., taxes on goods and services, social security contributions, income, property and other taxes). .

1997 1998 1999 2000est 2001bud

As a share of GDP

State Budget Revenues 30.6 30.5 30.9 31.1 31.2

SFA 1.4 1.7 1.0 ... ...

General Government Revenues 39.7 39.2 41.5 41.1 41.7

Tax Quota 36.4 36.0 37.2 37.3 37.7

State Budget Expenditures 31.7 31.9 32.8 35.6 33.7

SFL 1.5 1.5 1.3 ... ...

General Government Expenditure and Net Lending 40.9 40.8 42.0 44.8 44.4

State Budget Balance -1.0 -1.4 -1.9 -4.5 -2.4

General Government Balance -1.2 -1.6 -0.6 -3.7 -2.8

Idem, net of extraordinary items -2.0 -1.5 -3.0 -4.8 -6.0

Tax Quota minus General Government Expenditures -5.4 -5.6 -5.9 -8.7 -13.4

Source: Ministry of Finance.

Sources of Fiscal Imbalance

1.15 These trends are not new. Indeed, the general euphoria that preceded the 1997 crisis clouded the fact that regular fiscal operations also were increasingly out of kilter. While general government revenues (excluding privatization receipts) had lost ground by as much as 4 percentage points of GDP between 1993 and 1997 (see Table 1.4), regular expenditure (excluding net lending and participations) had only shrunk by 1.6 percent, due mainly (as will be discussed below) to the growing burden of social entitlements. A subsequent effort to jack revenues back up met with only partial success. Meanwhile, hopes for large receipts from privatization have underpinned a sharp increase in overall spending from less than 42 percent of GDP at its low point in 1998 to about 46 percent in 2000.


Table 1.4: General Government Revenues and Expenditures1993 1994 1995 1996 1997 1998 1999 2000est 2001bud

Percent of GDP1. Revenue (excl. privatization) 43.8 42.6 41.9 40.4 39.7 39.2 41.5 41.1 41.7 Tax Revenue 38.5 37.7 37.0 36.2 36.4 36.0 37.2 37.3 37.72. Expenditure and Net Lending 41.2 41.8 41.5 40.6 40.9 40.8 42.0 44.8 44.4 2.1 Expenditure 43.4 43.9 43.0 42.0 41.8 41.6 43.1 46.0 51.1

2.1.1. Current expenditure 37.2 36.8 35.9 35.6 36.3 36.4 37.5 39.8 44.7 Goods and services 12.4 11.0 8.9 8.9 8.18 8.2 8.5 9.4 9.4

Wages and salaries 3.6 4.1 3.6 3.7 3.7 3.5 3.8 3.8 3.9 Interest Payments 1.7 1.3 1.0 1.0 1.25 1.2 1.1 1.1 1.2 Transfers to 23.0 24.5 25.8 25.7 26.8 27.0 27.9 29.3 34.1 Enterprises and banks 6.4 7.1 8.3 8.0 7.9 7.7 7.6 8.3 13.1 o.w. bank restructuring costs … … … … … 1.5 0.6 0.9 5.2 Households and Others 16.6 17.4 17.5 17.7 19.0 19.2 20.3 21.0 21.0 2.1.2 Capital expenditure 6.2 7.1 7.1 6.4 5.5 5.2 5.6 6.3 6.3

2.2 Net Lending and Participat. -2.2 -2.0 -1.5 -1.4 -0.9 -0.8 -1.1 -1.2 -6.7 2.2.1 Privatization receipts1/ -2.6 -2.7 -2.0 -1.6 -0.8 -0.9 -1.4 -1.1 -6.9 2.2.2 Other 0.4 0.7 0.5 0.3 -0.1 -0.01 0.3 -0.1 0.23. Overall Balance 2.6 0.8 0.3 -0.3 -1.2 -1.6 -0.5 -3.7 -2.7

Memo items

a. Overall balance excluding privatization revenues 1/

0.0 -1.9 -1.6 -1.9 -2.0 -2.5 -1.9 -4.8 -9.6

b. Overall balance net of extraordinary items 2/

0 -1.9 -1.6 -1.9 -2.0 -1.5 -3 -4.8 -6.0

c. Tax revenue minus expenditure -4.9 -6.2 -6 -5.8 -5.4 -5.6 -5.9 -8.7 -13.4d. Expend. - excl. bank restructuring.

43.4 43.9 43.0 42.0 41.8 40.1 42.5 45.1 45.9

1/ privatization receipts of the National Property Fund and Czech Land Fund only. 2/ see Box 1.1 for definition.Source: Ministry of Finance.

1.16 This would be less of a concern if the rise in spending reflected mainly one-time costs associated with transition, such as the unavoidable costs associated with restructuring of failed banks. This has however not been the case. Even leaving aside bank restructuring costs, regular expenditures have similarly shot up by 5 percent of GDP between 1998 and 2000 and are set to rise further in 2001. An examination of the recent expenditure developments by economic and functional categories (see Tables 1.4 and 1.5) provides a good overview of where the main pressure points have been, i.e.,

(a) There has been a gradual, but sustained and substantial (4.4 percent of GDP), rise in transfers to households since the early 1990s. This is mainly due to the large rise in social security and welfare payments (3.2 percent of GDP) between 1994 and 1999 (Table 1.5),1 and reflects, among other things, generous indexing methods, and rapid increases in the number of early retirements. Pension expenditures, as currently designed, are projected to continue to grow faster than

1 There was a reclassification of expenditures between social protection and health in 1994.


contributions and will continue to put substantial upward pressures on spending that are not likely to be sustainable.

Table 1.5: General Government Expenditures by Function1993 1994 1995 1996 1997 1998 1999

Percent of total expendituresTotal Expenditure 100 100 100 100 100 100 100 General Public Services 7.7 8.2 8.7 9.4 5.6 5.5 5.8 Defense and Public Order 10.6 10.9 10.5 10.7 8.8 8.8 9.1 Defense 5.5 5.3 4.8 4.7 3.9 4.1 4.3 Public Order and Safety 5.1 5.6 5.7 6 4.8 4.6 4.8 Social Services 54 53.4 54.2 54.8 59.7 59.4 60.1 Education 12 11.9 12.1 12.3 11 10.1 10.3 Health 6.3 15.4 15.4 15.4 15.7 16 15.8 Social Security and Welfare 35.7 26.2 26.7 27.1 33 33.3 34 Housing 8.8 7.8 6.8 6.8 8.5 7.4 7.4 Recreation, Cultural, etc. 1.8 2.1 2.2 2.3 2.3 2.2 2.3 Economic Services 13.5 15.6 15.5 14.3 13.6 15.2 14 Transport and Communication 6.4 7.3 7.7 7.3 7.7 7.2 7.5 Other Expenditures 4.7 3.2 3.3 3 2.9 2.8 2.5

Percent of GDPTotal Expenditure 43.4 43.9 43.0 42.0 41.8 41.6 43.1 General Public Services 3.3 3.6 3.7 3.9 2.3 2.3 2.5 Defense and Public Order 4.6 4.8 4.5 4.5 3.7 3.7 3.9 Defense 2.4 2.3 2.1 2.0 1.6 1.7 1.9 Public Order and Safety 2.2 2.5 2.5 2.5 2.0 1.9 2.1 Social Services 23.4 23.4 23.3 23.0 25.0 24.7 25.9 Education 5.2 5.2 5.2 5.2 4.6 4.2 4.4 Health 2.7 6.8 6.6 6.5 6.6 6.7 6.8 Social Security and Welfare 15.5 11.5 11.5 11.4 13.8 13.9 14.7 Housing 3.8 3.4 2.9 2.9 3.6 3.1 3.2 Recreation, Cultural, etc. 0.8 0.9 0.9 1.0 1.0 0.9 1.0 Economic Services 5.9 6.8 6.7 6.0 5.7 6.3 6.0 Transport and Communication 2.8 3.2 3.3 3.1 3.2 3.0 3.2 Other Expenditures 2.0 1.4 1.4 1.3 1.2 1.2 1.1


(b) Subsidies to public utilities and other non-financial enterprises (including capital transfers) have risen from 8 to close to 10 percent of GDP since 1998.

(c) In contrast, some categories of spending have been squeezed over the past several years. Expenditures on goods and services dropped by over 3 percent of GDP between 1993 and 2000, with all of the decrease concentrated in the goods part of this category (Table 1.4). This suggests the goods and materials necessary to complement service delivery and carry out operations and maintenance activities, may have been severely restricted, leading to a reduction in service quality, a backlog of O&M (as for transport networks, see Part II), and the need for more expensive rehabilitation down the road. Such expenditures are often a first target for budget cuts, but unless balanced by deeper reforms, they are not likely to be sustained.


(d) One functional category actually showing a decline is education (Table 1.5), reflecting both declines in the primary and secondary school-age population and austerity efforts of the past years (see Part II). Expenditures in other categories have been relatively stable over time. This does not necessarily mean their situation is satisfactory (see for instance the discussion on railroads in Part II).

Size of Government

1.17 As a result, public expenditure in the Czech Republic has risen to levels that are high relative to comparator countries.2 This conclusion emerges from Table 1.6, which compares public expenditures3 as a percent of GDP in the Czech Republic with that in selected OECD countries. While the Czech Republic was in the lower half of the group in 1998, by 2000 it had moved up significantly.

Table 1.6: General Government Expenditures in OECD Countries, 1998Country Percent of GDP Country Percent of GDP

Sweden 60.8 Portugal 43.6Denmark 55.1 Japan1/ 42.3France 54.3 Canada 42.1Belgium 51.0 Spain 41.8Austria 49.4 Greece 41.8Italy 49.1 Czech Republic (1998) 41.6Finland 49.1 United Kingdom 40.2

Netherlands 47.2 New Zealand 39.8Norway 46.9 Iceland 36.2Germany 46.9 Ireland 33.1Czech Republic (2000) 46.0 Australia 32.9Poland 45.7 United States 32.8Hungary 44.3 Korea 25.6Note: For Czech Republic, excludes net lending1/ It takes into account the debt of the Japan Railway Settlement Corporation and the National Forest Special AccountSource: OECD and World Bank estimates.

1.18 Another, more systematic approach to comparing the level of public expenditures in the Czech Republic with other countries, uses a model that quantifies the effect of factors that are important determinants of public expenditures.4 Given the values for these factors in the Czech Republic, the model predicts that public expenditures in the Czech Republic would be on the order of 39.4 percent of GDP, over 6 percentage points lower than its current level. While certainly not conclusive, these comparisons suggest that, relative to other countries, the Czech Republic has substantial scope to reduce its public spending as a share of GDP. As the Czech Republic continues its development as a market economy, it has opportunities to make choices about what activities the public sector should fund, how much of these selected activities to fund, and what interventions are the most effective to achieve the desired outcomes. 2 This section draws on a background paper on the “Level and Composition of Government Expenditures” 3 Defined as consolidated General Government expenditures, excluding net lending and privatization revenues (see Box 1.1, and line 2.1 in Table 1.4). 4 See Barbone, L. and R. Polastri, Hungary’s Public Finances in an International Context, in Public Finance Reform during the Transition, The World Bank, Washington D.C., 1998. The model includes factors (such as the age structure and growth rate of the population, income levels and the ratio of public debt to GDP) that reflect social demands as well as a government’s ability to both pursue its own policy priorities and overcome its financial constraints.


New Sources of Expenditure Pressure

1.19 High as it is, there are fresh pressures to expand spending further. A major one is the cost of bank restructuring. As noted above, the currency crisis of 1997 and the monetary tightening that followed brought the deteriorating financial situation of banks and enterprises to a head. In an effort to stem waves of bank default, the government was forced to step in and, through various mechanisms, assumed responsibility, over the following years, for bad loans with a book value in excess of 20.7 percent of GDP (including ring-fenced portfolios of private banks). The rescue of Investicni a Postovni banka (IPB) has been the most recent episode in that saga. So far, the authorities have by and large been successful in containing the actual payments of the general government on account of these bailouts to the amounts of available privatization receipts, while pushing back the brunt of the fiscal costs into the future.

1.20 There is no reason to assume however that the amount and timing of privatization receipts would continue to match the overall costs of transition to the budget. First, the amounts falling due on account of bank restructuring are rising sharply in 2001 (from 1 percent of GDP last year to 5 percent of GDP this year). Whether the hoped-for privatization receipts (as much as 6.9 percent of GDP in 2001) will materialize is a different matter. If the past is any guide they may not: the 2.4 percent of GDP anticipated in 2000 for instance turned out to be a mere 1.1 percent of GDP. Furthermore, bank restructuring costs will continue for a considerable time into the future as the government pays interest and principal on obligations it has already assumed, and as new liabilities come to light. Calculations presented in Part II suggest that the ongoing fiscal cost of bank restructuring would continue to hover around 2 percent of GDP for the next few years. Against that, future flows of privatization receipts are not only likely to dwindle gradually (as privatization runs its course); they are also heavily mortgaged already, among others, to cover environmental liabilities.

1.21 Indeed, another important fiscal challenge for the future is the settlement of the environmental liabilities of privatized enterprises. The National Property Fund (NPF) assumed these liabilities as part of the privatization process and has been in charge of absorbing the costs for environmental clean-up activities. On the basis of concluded contracts, the clean-up compensation amount has been estimated at CZK35 billion. If the government approves the conclusion of new contracts between the NPF and privatized companies, an additional CZK42 billion can be added to the current amount. In total, environmental liabilities may claim up to 37 percent of the current NPF portfolio (depending on the valuation of the NPF portfolio).5

1.22 Furthermore, while many aspects of EU accession will reinforce the Czech Republic’s efforts to rationalize and reduce public expenditures,6 compliance with the EU directives will call for significant investments of national resources (private and public), especially in the areas of environment, transport and other general economic infrastructure, and agriculture.

1.23 The government has begun to prepare for this new challenge. First, it has begun to identify more clearly and quantify how much spending is involved. The National Program for 5 By the end of 1998, the NPF portfolio comprised 358 companies with an aggregate nominal value of shares of CZK177 billion. By 1999, the nominal value declined slightly to CZK171 billion. However, the market value of some of the NPF holdings is far below the nominal value. This is especially true for some of the remaining minority shares and the shares of the large loss-making state enterprises (such as Vitkovice).6 In particular, the implicit move toward the tighter macro policy targets of the EU Stabilization and Growth Pact; the limits EU places on state

aid; and the assistance the EU could provide in developing capacities to manage public expenditure and improve program design.


the Adoption of the Acquis (NPAA) it has formulated puts the amount required to meet EU accession requirements during 2001 at around CZK59.8 billion (equivalent to about 3 percent of GDP). The orders of magnitude would be similar for 2002 and 2003 (see Table 1.7). The entire amounts however would not have to be funded nationally: NPAA envisages that about 15 percent would be financed by EU transfers, and a similar amount from other sources, such as the European Investment Bank for transport. In addition, since 2000, EU-related expenditures are being specifically identified in the budget of line ministries and other state agencies. For 2001, the amounts involved are, it turns out, somewhat lower than contemplated in the NPAA. They would amount to 2.5 percent of GDP, of which 1.6 percent of GDP would be funded from domestic sources.

1.24 While some of these investments would have to take place regardless of the EU accession process, it is unlikely that they can all be accommodated if expenditures are to be contained. Consequently, it will be important to subject them to rigorous cost-benefit analysis. Some of the investments might produce only long-term benefits at a very high short-term cost. As such, the government has to be careful to work with the EU to assure adequate transition periods for the compliance to certain EU directives. The European Union itself has shown a willingness to be flexible on transition periods where financial considerations warrant it.7 Similarly, the composition of investments should target the most strategic goals. In other words, the EU requirements should not be crowding out other necessary investments (for example, new Trans-European Networks should not displace funding for the maintenance of the existing networks). Instead, a proper balance has to be achieved and the most efficient combination of investments chosen.

7 “For those areas of the acquis where considerable adaptations are necessary and which require substantial effort, including important financial outlays in areas such as environment, energy and infrastructure, transition arrangements could be spread over a definite period of time, provided candidates can demonstrate that alignment is under way.” Annual Report on Progress Towards Accession, European Commission, Brussels, 2000.

PartI: The Strategic Setting 12

Table 1.7: Financing of the National Program for the Adoption of the Acquis, 2000-2002(by budgetary chapters)

Data in mil. CZK

Proposed financing 2000 Proposed financing 2001 Proposed financing 2002State budget EU Others TOTAL State budget EU Others TOTAL State budget EU Others TOTAL

Capital Non-capital

Total Capital Non-capital

Total Capital Non-capital

Total

Ministry of Labor and Social Affairs 418.1 4,355.5 4,773.6 156.1 4,929.8 551.6 8,404.6 8,956.2 234.7 9,190.9 718.5 9,884.0 10,602.5 254.6 10,857.1Ministry of Transport and Communicat. 7,879.9 7,879.9 1,879.9 9,471.5 19,231.3 8,155.9 39.2 8,195.1 1,300.0 9,060.0 18,555.1 8,497.8 25.1 8,522.9 1,300.0 7,060.8 16,883.7Ministry of Environment 449.4 218.5 667.9 1,437.0 2,196.0 4,300.9 578.2 453.1 1,031.3 1,542.0 2,591.0 5,164.3 329.8 715.1 1,044.9 1,507.0 2,591.0 5,142.9Ministry of Industry and Trade 636.3 6,245.2 6,881.5 489.7 7,371.2 670.6 6,612.2 7,282.8 1,251.5 320.0 8,854.3 757.9 6,907.5 7,665.4 1,520.0 320.0 9,505.4Ministry of Justice 906.1 1,243.6 2,149.7 52.5 2,202.2 1,592.1 954.2 2,546.3 80.0 2,626.3 1,177.9 390.5 1,568.4 1,568.4Ministry of the Interior 2,493.5 547.9 3,041.4 260.0 3,301.4 1,006.0 573.2 1,579.2 9.0 1,588.2 1,128.1 633.6 1,761.7 1,761.7Ministry of Health 33.1 84.5 117.6 117.6 30.4 89.5 119.9 119.9 32.0 90.3 122.3 122.3Ministry of Education, Youth and Sport 1,041.5 1,041.5 3.2 1,044.7 20.0 1,336.6 1,356.6 177.8 1,534.4 10.0 1,607.2 1,617.2 273.8 1,891.0Ministry of Finance 312.1 245.1 557.2 81.5 25.3 664.0 1,656.4 782.5 2,439.0 66.3 12.4 2,517.6 1,506.4 911.7 2,418.1 2,418.1Ministry for Regional Development 1,953.5 311.5 2,265.0 1,960.9 4,225.9 2,157.1 153.2 2,310.3 2,867.0 5,177.3 2,261.8 94.5 2,356.3 2,224.3 4,580.6Ministry of Culture 18.9 18.9 3.5 22.4 1.8 58.9 60.7 30.0 90.7 1.1 58.2 59.3 30.0 89.3Ministry of Agriculture 205.6 379.3 584.9 581.2 15.5 1,181.6 331.1 677.7 1,008.8 592.7 13.7 1,615.2 358.2 791.1 1,149.3 592.7 10.9 1,752.9Czech Statistical Office 78.1 78.1 10.6 88.7 3.0 76.6 79.6 19.6 99.2 9.2 72.0 81.2 6.6 87.8Ministry of Foreign Affaires 425.0 425.0 425.0 446.5 446.5 446.5 480.0 480.0 480.0State Office for Nuclear Safety 12.5 12.5 0.5 13.0 23.0 23.0 23.0 33.0 33.0 33.0Off. for the Protection of Economic Competition

9.6 16.1 25.7 15.7 41.3 1.0 16.4 17.4 5.6 23.0 16.1 16.1 16.1

Office for the State Information System 80.0 113.0 193.0 8.0 201.0 46.0 145.0 191.0 57.0 248.0 47.0 155.0 202.0 60.0 262.0Industrial Property Office 10.0 9.6 19.6 19.6 27.7 11.9 39.6 47.7 87.3 17.5 13.2 30.7 30.7State Reserves Administration 133.7 506.3 640.0 405.9 1,045.9 200.0 1,395.3 1,595.3 1,595.3 200.0 1,429.5 1,629.5 1,629.5Office of the Ombudsman 40.0 40.0 80.0 80.0 50.0 50.0 50.0 50.0 50.0 50.0Government Office 2.3 111.0 113.3 92.3 205.6 2.0 86.1 88.1 18.0 106.1 2.1 91.1 93.2 93.2Czech Security Information Service 2.3 7.1 9.3 9.3 0.7 7.6 8.3 8.3 0.2 5.6 5.8 5.8Czech National Bank 72.5 25.0 97.5Czech Securities Commission 15.6 15.6 15.6 15.6 15.6 32.4 48.0 15.6 15.6 72.0 87.6Supreme Audit Office 4.9 4.9 0.4 5.3 9.8 9.8 9.8 9.8 9.8 9.8TOTAL 15,581.1 16,015.0 31,596.1 7,105.0 12,139.7 50,840.8 17,047.2 22,403.2 39,450.3 8,331.3 11,997.1 59,778.7 17,071.2 24,464.0 41,535.2 7,841.0 9,982.7 59,358.9Note: This program does not yet include the creation of the State Transport Fund in 2001 and 2002, therefore, the Ministry of Transport EU-related expenditure includes the expenditure programs that will actually be implemented by the State Transport Fund.Source: Ministry of Finance, NPAA 2000.


Fiscal Sustainability

1.25 As the Czech Republic has made of joining the European Union the central thrust of its development strategy however, it will also need at some point to prepare for the prospect of adhering to the discipline of the Stability and Growth Pact (SGP), which links members of its exchange mechanisms (ERM2, or euro-zone). Indeed, under the SGP, member countries have committed themselves to targeting balanced budgets under “normal” circumstances (and to limit “cyclical” deficits to no more than 3 percent of their respective GDPs). Over the long term, this will become the main anchor and guiding principle of Czech fiscal policy. While it is clear that “convergence criteria are not accession criteria” (in the words of the European Commission), it would nonetheless be wise to start moving fiscal policy towards such convergence criteria, rather than to diverge from them, as has been the case lately.

1.26 While the economy was in a downturn, the widening of the general government deficit could perhaps be looked at as the normal operation of automatic stabilizers (as envisaged under the SGP), and, as such, be treated with relatively benign neglect. After all, it could be argued, the official government debt stood at only 18 percent of GDP in 2000. This is low by any standard, and certainly by those of central Europe, where public debt ratios range from 25 percent of GDP (in Slovenia and Slovakia) to 61 percent in Hungary. Furthermore, the republic as a whole has a net creditor position vis-à-vis the outside world. Finally, the prospect that the Czech Republic may adhere in the future to SGP should give cause for comfort, as the latter’s deficit rule in itself implies declining public sector debt ratios.

1.27 With the recovery however, any complacency would now be misplaced, if only for the three following reasons:

(a) The level of the general government debt has risen by close to 5 percent of GDP in just the last three years.

(b) These debt figures provide only a partial picture of the overall government exposure. To the 18 percent, one should add the debt of Konsolidacni Bank (KoB), for which the general government has assumed responsibility. The latter amounted to 8.7 percent of GDP at the end of 2000; and may rise to close to 11 percent of GDP once KoB assumes responsibility for the IPB cleanup. This would bring the total (direct and indirect) general government debt (excluding implicit or explicit guarantees) to 26 percent of GDP.

A comprehensive picture would also take note of other potential sources of future liabilities, including:

(i) The amount of classified loans which would remain on bank books, even after the IPB cleanup, amounting to an estimated 15 percent of GDP.

(ii) Outstanding government guarantees extended for a variety of developmental purposes; after adjusting for the respective risks associated with each of them, the latter were estimated to amount to about 6 percent of GDP at the end of 1998 (viz. unadjusted for risk: 16 percent of GDP).


If one would include the KoB debt, total government would thus rise of about 29 percent of GDP, with a steep potential downside in excess of 50 percent of GDP, should the economic climate turn sour. The recent experience of East Asia shows that, if and when the economy falters, a seemingly conservative government can swiftly turn over-indebted (see for instance the case of Indonesia).8

(c) The deficits themselves, far from being merely cyclical, are increasingly structural (see Table 1.8), raising the specter that, rather than converging (however gradually), the underlying dynamics are actually diverging from the SGP criteria mentioned above. Looking ahead, the Ministry of Finance concludes that, left to its own, the deficit of the state budget (excluding net lending and participations) would continue to hover around 6 percent of GDP in the coming years. Hence, “budget deficits are not of a cyclical nature – they will not go away with the return towards full employment, but rather, are of structural nature.”9

Table 1.8: Decomposition of the Fiscal DeficitTotal Hodrik-Prescott Method Barro Beta-Convergence MethodState Deficit Cyclical Structural Cyclical Structural

Percent of GDP

1994 -1.9 -1.0 -0.9 0.0 -1.91995 -1.6 0.3 -1.9 1.1 -2.71996 -1.9 0.9 -2.8 1.4 -3.31997 -2.0 0.7 -2.7 0.5 -2.51998 -2.4 -0.2 -2.2 -1.0 -1.41999 -5.1 -0.6 -4.5 -2.2 -2.9


Fiscal Policy and Demand Management

1.28 Furthermore, and perhaps more immediately relevant, are the requirements of domestic demand management, and the active role which fiscal policy has to play in it. While fiscal expansion may have been in order to sustain domestic demand through a downturn, guiding considerations should now change. As the recovery gathers steam, the government needs gradually to withdraw the impulse it was giving to domestic demand, and make room for private investment to expand without unduly compromising external balances. Furthermore, in a world of volatile global markets, it would also be beneficial for fiscal policy to regain some of the flexibility it seems to have lost to modulate demand in reaction to potentially abrupt shifts in the capital account position.

1.29 The experience of the 1990s illustrates the point. When the savings-investment (S-I) balance of the private sector dropped from a negative half a percent of GDP around 1993-94 to about –8 percent of GDP in 1997 with the surge in private activity, the public sector managed to curtail its own demands on savings by only 2 percent of GDP. Although not the only factor, there is little doubt that the resulting deterioration of the external current account deficit to

8 See “East Asia: recovery and Beyond,” World Bank, 2000.9 Czech Republic, 2001 State Budget (unofficial translation).


beyond 7 percent of GDP (in 1996) helped signal the Czech Republic to the attention of foreign investors and contributed to stoking their worries. At the time, the authorities undoubtedly would have wished they had a greater degree of flexibility to lean against such wide shifts in private sector behaviors. This is what happened in the aftermath of the crisis. As the private S-I ratio swung by close to 10 percent of GDP (to positive levels) between 1997 and 1999, its public sector correspondent was allowed to slide by close to 5 percent (to negative levels), easing an adjustment process which would otherwise have been considerably more brutal.

1.30 With that in mind, the widening of the external current deficit to close to 5 percent of GDP in 2000 (alongside that of the general government) would seem to signal that time has come for the government to reverse its fiscal course. Indeed, 5 percent of GDP seems to constitute a psychological threshold for the external current account that the Czech authorities would not want to cross lightly. As long as external deficits are financed by non-debt creating instruments, such deficits may feel benign. But the experience of the Czech Republic in 1997 (as well as the subsequent one in East Asia) has shown how difficult it can be to rein in these deficits in a timely fashion when they have grown to the point of alarming markets, and financing terms tighten as a result. Conversely, with the revival of confidence, massive inflows of foreign direct investment and the improvements of portfolio positions throughout the economy, there is every reason to believe that private investment may again outstrip private domestic savings. As that happens, government will need to pull back to prevent that the expansion of private demand from either put such upward pressure on interest rates and on the real exchange rate as to derail the recovery or leading to a further widening of the external current account deficit.

1.31 These considerations should help define what an appropriate target should be for fiscal policy going forward. Calculations by the IMF staff suggest that, to reconcile those growth and external balance objectives, the overall deficit of the general government would need to be reduced over the medium term to about 2 percent of GDP.10 As it happens, this level of deficit should also allow stabilizing the ratio of (direct) government debt to GDP. For the medium term A deficit target of 2 percent of GDP (net of extraordinary items) would therefore seem to recommend itself, as an intermediate target towards SGP targets, on both stocks and flows grounds. Furthermore, it would set the Czech Republic on track toward meeting the Maastricht criteria for joining the euro-zone at an appropriate time.

D. THE MEDIUM-TERM OUTLOOK

1.32 The authorities are well aware of the need to reverse the direction of fiscal policy. Both the government and the leading opposition party are officially and jointly committed to balancing the state budget within the three years.11 Commendably, the agreement also commits the parties to certain specific quantitative targets. The latter implies that the state budget deficit should be rolled back to a maximum of CZK20 billion in 2001, CZK10 billion in 2002 and achieve balance in 2003 (using previous accounting methods).

1.33 This report will argue (in Part III) in favor of using medium-term quantitative frameworks to anchor the fiscal adjustment process over the medium-term (with a suitable 10 IMF 2001. “Balancing Fiscal Priorities: Challenges for the Future” forthcoming.11 While the political agreement specifies that no increases in the tax quota will be used to close the deficit, the Ministry of Finance understands that further consideration will have to be given to the need to adjust the revenue side of the budget, if only, but not exclusively, to harmonize tax rates with the EU.


degree of flexibility to take into account general economic developments, particularly on the revenue side). One might however debate the wisdom of using the state budget deficit as an anchor as this is after all only a subset of government fiscal operations (see Box 1.1 for definitions). The meaning of different rules to calculate the deficit (e.g., the “old,” and “new” state budget rules, the IMF’s Government Finance Statistics definition) is likely to escape the largest numbers of the population and leave the unfortunate impression that accounts are being shuffled for convenience sake. This is indeed the risk of focusing attention on a partial notion of government operations, whose definition can, and has, varied over time.

1.34 While the need for fiscal consolidation is clear and relatively uncontroversial, the same cannot be said of the means to achieve it. The opposition agreement mentioned above, for instance, envisages that the targeted deficit reduction should be achieved with no increases in the so-called “tax quota” (i.e., general taxation) and while protecting expenditure in selected areas, such as defense.

1.35 In contrast, the medium-term outlook for 2001-2003 attached to the 2001 budget reaches a somewhat different conclusion.12 Having established (as noted above) that left to itself, the fiscal deficit would not decline with the recovery, the budget document explores the implication of three alternative policy scenario (“austerity” focusing on the expenditure side and “reform 1 and 2” focusing on two different packages of tax reform, see Table 1.9). It concludes that major action on the expenditure side being impractical within the relevant timeframe, so that increasing the “tax quota” (i.e., tax revenues) becomes unavoidable in the short term (if deficit targets are to be attained).

Table 1.9: General Government Deficits under Different Scenarios, 1998-2003(Percent of GDP)

1998 1999 2000 2001 2002 2003Passive scenario:Total public deficit -1.6 -0.6 -5.2 -1.4 -4.5 -5.1Total public deficit (minus net lending) -2.4 -1.6 -7.7 -6.8 -6.9 -6.3Austerity scenario:Total public deficit -1.6 -0.6 -5.2 -1.4 -2.8 -1.7Total public deficit (minus net lending) -2.4 -1.6 -7.7 -6.8 -5.1 -3.0Reform scenario I:Total public deficit -1.6 -0.6 -5.2 -1.2 -2.9 -1.7Total public deficit (minus net lending) -2.4 -1.6 -7.7 -6.6 -5.2 -3.0Reform scenario II:Total public deficit -1.6 -0.6 -5.2 -1.2 -3.6 -2.3Total public deficit (minus net lending) -2.4 -1.6 -7.7 -6.6 -6.0 -3.6

Source: Czech Republic: 2001 State Budget

1.36 Without disputing the need for revenue reform, it is doubtful that increasing the ratio of revenue to GDP further would be either desirable or even feasible. As the recent OECD report puts it: “The overall tax burden is much higher in the Czech Republic than it was in other OECD countries when they were at similar levels of development. International evidence would seem to suggest that this could slow the pace at which the Czech Republic can expect to converge to the income levels observed in more developed OECD economies, implying that lowering taxation could have significant long-term benefits. To do so, however, would require parallel reductions in government expenditures in order to avoid a further deterioration of public finances. There may also be an opportunity to rebalance the existing tax burden across different

12 Czech Republic, 2001 State Budget (unofficial translation).


revenue sources. Indeed, the Czech tax system – which was subject to a major reform in 1993 – relies relatively heavily upon social security contributions, while personal taxes and property taxes are under-used.”13

1.37 Indeed,

(a) The tax revenue ratio to GDP in the Czech Republic compares to the ones in Germany or the United Kingdom (in 1998), and exceeds by several percentage points of GDP those recorded in the so-called cohesion countries (i.e., Spain, Ireland, Greece and Portugal).

(b) Total social security contributions (at 47.5 percent of gross labor income) exceed by more than 10 percentage points the (unweighted) average in the EU and were twice as high as those in the OECD at large.

(c) Although the Czech corporate income tax rate is among the highest in central Europe, its yield is among the lowest (in terms of GDP), due in part to extensive exemptions.

(d) The EU-Czech Republic Joint Assessment of Economic Priorities (“pro-growth scenario”) envisages that revenue may erode by a further 3 percent of GDP between 1999 and 2005, hence contemplates a 7 percentage point (of GDP) cutback in government expenditure (in order to reach a 1 percent of GDP deficit for the general government).

1.38 In the circumstances, it does not seem that the Czech Republic can afford to sidestep or delay action on the expenditure side. The budget medium-term outlook mentions two reasons why expenditure-side fiscal adjustment may not be feasible:

(a) Absent a structural reform of “mandatory and quasi-mandatory” programs, the cuts required in “non-mandatory” items would be so deep as to “threaten the continued functioning of the public sector.”14

(b) “An assessment of the effectiveness and actual cost of current spending programs and their results has not yet been carried out”15 on which to base such structural reforms.

1.39 The purpose of this report is to help the authorities to take up those twin challenges.

E. CONCLUSIONS

1.40 This part concludes therefore (i) on the need to bring the general government deficit back down towards 1-2 percent of GDP over the medium-term in order to put the incipient recovery on a sustainable financial footing; and, to attain this objective, (ii) on the necessity to engage in a 13 OECD 2000. “Economic Survey of the Czech Republic.” Paris, France.14 Czech Republic, 2001 State Budget (unofficial translation).

15 ibidem.


structural reform of government expenditure programs; and (iii) on the broad scope there is, judged by international standards, to reduce the overall level of public spending. The next part explores in more detail how the authorities could address them in the context of some of the major expenditure programs. The third and final part will look at the contribution that institutional reforms could make the necessary restructuring of expenditure programs.

PART II. EXPENDITURE REFORM OPPORTUNITIES

A. INTRODUCTION

2.1 Part I of this report documented the broad scope for reducing public expenditures in the Czech Republic. It also noted the considerable pressures to increase spending, coming both from within certain expenditure programs (i.e., social security; enterprise-bank restructuring), and from the wider economic context (extra budgetary funds, contingent liabilities, EU accession and decentralization). Moreover, much of the expenditure is mandatory or quasi-mandatory, greatly limiting the scope for immediate adjustments in spending levels. Realizing the potential for sustainable expenditure reduction will therefore depend on a two-pronged approach:

(a) Significant reforms of major spending programs to reduce or contain their spending while maintaining or improving program impact. This is the topic of this part of the report.

(b) Continued improvements in the institutions, capacities, and processes for managing public spending in ways that generate and monitor expenditure program reforms. Part III will focus on these issues.

2.2 It is worth stressing that while there are some important measures that can be taken in the short term, the most important measures to contain expenditures in a sustainable way will require a thorough, comprehensive review of the overall expenditure program, not as a one-shot exercise, but as a continuous process of identifying reforms of the main expenditure programs. This will involve choices over time of what the public sector should do, how much it should do, and how it can do it most effectively. Many of these choices may be politically sensitive, so an important part of the effort needs to be developing an understanding and political consensus for the need for such reforms. This is why Part III of this report emphasizes the importance of developing the institutions, capacities and processes that will help the Czech Republic to generate the assessments of program performance and designs needed to bring about continuous improvements in the effectiveness of the public sector and the efficiency of public expenditure.

2.3 The sections below seek to illustrate, for selected sectors, the range and complexity of the issues that confront Czech policymakers as they seek to contain public expenditures and make them more effective. While this part of the report proposes both short and medium-term recommendations, it does not pretend to provide a fully detailed, comprehensive reform blueprint. Rather, it seeks to highlight the kinds of issues that need to be confronted, and at the same time reinforce the case for improvements in fiscal management on the lines recommended in Part III. The sections below focus on the areas of bank restructuring, social protection, health, education, transport, and housing. These sectors together accounted for about 80 percent of total public spending in 1999, and it is difficult to see how the needed expenditure adjustment could be realized without dealing with these sectors. In each sector, the discussion focuses not on across-the-board cuts, but on reform options that might help to reduce or contain spending while improving the effectiveness of spending.

Part II: Expenditure Reform Opportunities 20

2.4 It should be emphasized that other important expenditure areas, not discussed here (e.g., agriculture, energy, environment, enterprise transfers, and defense), should also be subject to a similar rigorous review. For example current and capital transfers to non-financial enterprises were estimated at about 9.6 percent of GDP in 2000, over five times the EU average, and projected to rise in 2001. While not discussed fully below (the topic is addressed mainly in the context of housing and transport expenditures), this is likely to be an area where substantial expenditure reduction is possible and desirable. Finally, while most of the discussion below will focus on expenditures explicitly budgeted in the normal budget documents, as the discussion of the housing sector below (Section G) will illustrate, it is important also to consider such implicit expenditures as the granting of tax reductions or below-market pricing. These policies (such as the VAT reduction for residential construction and tax preferences for mortgage lenders and borrowers) represent foregone public resources and their effectiveness should be assessed as rigorously and systematically as ordinary budgeted expenditures.

B. BANK RESTRUCTURING

2.5 As noted above, one of the largest sources of strains on public finances arises from past bank bailouts. Despite the ongoing recovery and a series of bank bailouts, total bad assets in the Czech economy still amounted to around 18.4 percent of GDP at the end of 2000 (excluding not yet recognized bad loans in the books of IPB).16 Various resolution mechanisms have been used over the years to resolve the problem. Alongside the main one, the Konsolidacni Bank (see Box 2.1), a number of other channels and vehicles were initially used, whose multiplicity and diverging features tended to obscure and complicate the overall consolidation. Conversely, some of the institutions involved were occasionally given conflicting mandates. KoB, for instance, was supposed to double up as a development bank.

16 For a recent evaluation of the bank and enterprise restructuring process see World Bank (2000) Czech Republic: Completing the Transformation of Banks and Enterprises, World Bank, 200


Box 2.1: The Role of the Konsolidacni Banka (KoB)

Konsolidacni Banka was founded on 25 February 1991, by the Ministry of Finance of the Czech and Slovak Federal Republic as a special-purpose bank without branches, serving primarily corporate clientele. Its legal status has been a state financial institution. Initially, KoB operated only with a limited banking license, and its role was to solve problems from the pre-1989 regime. Upon its establishment, KoB assumed receivables from TOZ (permanently revolving stock loans). These had been extended to over 6,000 clients in the Czech and Slovak Federal Republic, in the total volume of CZK 110.8 billion. In 1992, the bank purchased other bad debts worth CZK 14.7 billion from the period before 1990. After the separation of the Czech and Slovak Federal Republic on 1 January 1993, the assets of the original federal KoB were divided between two separate entities – Czech and Slovak. The TOZ loans transferred to the Czech part amounted to CZK 80.1 billion. On 23rd February 1993, Konsolidacni Banka Praha s.p.ú. started operating as the successor to carry on with the original activities of KoB in the Czech Republic. KoB is a special-purpose bank with the legal status of a state-owned financial institution, and with its liabilities guaranteed by the state. It employs 362 employees, and services 4,748 clients. KoB acts within the Czech economy as a centralized institution for the management and disposition of assumed and purchased assets. It facilitates the completion of the privatization of large state banks as it takes over a major portion and volume of their problematic debts. Similarly, KoB is involved in the restructuring of selected enterprises. These transactions are directed at achieving maximum effectiveness, identifying key parts of the production, and subsequently finding a suitable strategic partner. In 1999, KoB established a subsidiary, Revitalization Agency, to handle selected specific cases. It specializes in implementing complete restructuring transactions with large corporate clients. The agency is managed by Lazard & Latona, an international consortium focusing on the turn-around of problematic companies, and one of the world's leading investment banks. In 1999, KoB took over assets in the total nominal value of CZK 56.4 billion in connection with the privatization of Ceska Sporitelna and Komercni Banka. This action further increased KoB’s problematic assets, the volume of which represented around 9.6 percent of GDP at the end of 2000 (see Table 2.1). Some analyses suggest that the figure could increase further when the losses of IPB banka are included and additional bad assets are transferred over from Komercni banka before its privatization.KoB had also been active as a developmental agency. It finances extensive development projects of large Czech industrial enterprises, long-term public utility projects in transport, telecommunication and water management infrastructure, and environmental protection. In 1999, KoB continued to act as a financial manager in EIB funded development programs. However, in December 2000, during the consolidation of the transformation institutions, these activities, in the amount of around CZK60 billion, have been transferred to the Czech-Moravian Guarantee and Development Bank. Source: KoB Annual Report, 1999; and KoB press releases.

2.6 Fortunately, this is now changing, with (almost) the entire resolution process being consolidated around KoB. Ceska Financni, another agency under the Czech National Bank (CNB), was merged with the KoB in July 2000 and various other entities are being brought within its ambit.17 Furthermore, KoB’s developmental banking activities and loan portfolio have been transferred to the Czech-Moravian Guarantee and Development Bank in December 2000.

2.7 Although the size of the bad loan portfolio in the economy remains daunting, the cleanup process is showing the first signs of success. By the end of September 2000, the share of non performing loans in bank portfolio was beginning to decline (to 18 percent from 22 percent in at the end of 1999). This left total classified assets of commercial banks at 9.6 percent of GDP; and this ratio should drop to a projected 3.3 percent after the IPB portfolio is finally disposed of to KoB (see Table 2.1).

2.8 Correspondingly, of course, the nominal amount of bad assets held by KoB has risen to 9.6 percent of GDP (see Table 2.1). With the resolution of the IPB failure and the final carve-out associated with the imminent sales of Komercni Banka (KB), more bad assets are expected to be

17 Another KoB subsidiary, the Revitalization Agency, began its work during late 1999, aiming to restructure and turn around large failed enterprises. In addition, as part of the privatization process for KoB, a separate subsidiary Konpo has been created in March 2000 to take over distressed assets from KoB. The KoB purchased a participating interest in Konpo from KB, which had CZK60 billion worth of nominal problematic assets, for CZK36 billion. Two more special purpose vehicles were created: PRISKO for covering potential liabilities during transfers of shares in Skoda company to Volkswagen; and Sanakon, for future projects. Finally, the KoB closely cooperates with Ceska Inkasni – owned by Ministry of Finance – which holds around CZK27 billion of international trade receivables. This structure will help KoB in its restructuring efforts, since the law does not allow KoB (or any of its subsidiaries) to own more than 50 percent of a company. Thus, the ownership can be shared with Ministry of Finance (and its Ceska Inkasni), and any debt-equity swaps are therefore easier to implement.


shifted to KoB.18 The precise amounts involved are still unclear but KoB’s total bad assets exposure (own portfolio plus ring-fenced assets in the balance sheet of commercial banks) could well reach a face value of, say CZK450 billion, representing as much as 20.7 percent of GDP (see Table 2.1).

Table 2.1: Loan Portfolio and Contingent Risk Exposure of KOB Group(Billions of CZK)

Estimates December 2000 1/ Projected Exposure June 2001Total Ring fencing Transfer Total

Gross loans 2/ 205.3 95 150 450Standard 18.7 18.7Non-performing 186.6 431.6

(9.6%) 3/ (20.7%) 3/Memorandum itemsLeft with banking system 171.5 80.5 5/

(9.6%) 3/ (3.3%) 3/

Source: Ministry of Finance, staff calculations.1/ Data for affiliates up to end-September.2/ Loans only. KOB loans to affiliates have been netted out.3/ As a percentage of GDP.

2.9 Needless to say, the market value of those assets is likely to represent only a fraction (10-20 percent at best) of that face value. The same unfortunately cannot be said of the liabilities that KoB has accumulated in the process (i.e., CZK165 billion at the end of 2000 in debt mainly to banks; that amount is due to rise steeply as part of the IPB cleanup). The latter liabilities carry the full faith and credit of the Czech Republic, and need to be serviced in full.

2.10 That discrepancy between what bad assets can be recovered, on the one hand, and the service of those liabilities as they fall due, on the other, has been the source of a huge cash drain for KoB which the government has had to plug, either directly or via the National Property Fund (see Table 2.2). When all is said and done, the total fiscal cost of the post-1997 bank cleanup may well add up to CZK300 billion, equivalent about 15 percent of the 2001 GDP.19

18 The conservatorship has been imposed on IPB bank, followed by a rapid sale to CSOB, another previously state-owned bank. In the process, the state issued a guarantee to CSOB for the IPB assets, including claims not contained in accounting books, while Czech National Bank guaranteed its liabilities. The agreement includes two options: (i) put option of CSOB to sell assets to Ministry of Finance; and (ii) call option of Ministry of Finance to buy assets related to revitalization process (only assets of those companies that are undergoing the revitalization process). The most likely situation will be an execution of the call option by which the KoB will be a buyer on behalf of the government. Both, the KoB and CSOB are performing an audit of the IPB to assess the potential loss assets. KoB officials estimate the loss loan portfolio of IPB at around 66 percent of portfolio.19 Including the amounts that would remain to be settled beyond the timeframe of Table 2.2.


Table 2.2 General Government Transfers to Bank Restructuring Institutions(Billions of CZK)

Actual Projection

1991-1997 1998 1999 2000 2001 2002 2003 2004

1. From NPF (1.1+ 1.2) 54.8 8.0 7.7 6.1 52.6 19.6 15.9 4.11.1 to Ceska inkasni (CI) 19.0 6.0 6.2 3.7 4.4 4.0 3.6 01.2. to KOB group 35.9 2.1 1.6 2.4 48.2 15.6 12.3 4.1 1.2.1 KOB proper 35.3 0.3 0 1.1 38.6 14.7 11.6 4.1 1.2.2 Ceska Financni (through IKOB)

0.6 1.8 1.6 1.4 9.6 1.0 0.8 0.

2. From State Budget to KOB

5.1 10.4 0 14.4 39.8 10.0 25.0 24.0

Total 59.9 18.4 7.7 20.5 92.4 29.6 40.9 28.1

Source: Ministry of Finance

2.11 These amounts are no doubt enormous. The sad truth however is that they represent only the legacy of the excesses which preceded the 1997 crisis. There is little option now but to confront it. Indeed, recent experience has clearly demonstrated that (i) delaying the recognition of the underlying losses would only increase the ultimate fiscal cost of the bailouts (as recovery value of both loans and collaterals quickly erode); while (ii) the option of privatizing banks “as is” may not attract strategic investors able and motivated to turn failed banks around. Furthermore, there is good reason to hope that removing the canker of bad loans could rekindle banks’ appetite to lend, thereby helping the economy grow out of its current travails.

2.12 The order of the day now is to limit the attending fiscal costs while obviating the risk of future relapse (on the part of lenders and borrowers alike). In other words, what is involved is to intensify ongoing efforts to (i) expedite the resolution of the “old debt”; and (ii) avoid the resurgence of new bad loans. Such measures include:

(a) Completing the refocusing of KoB. Current efforts to transform the KoB into a non-banking institution by August 2001 should be strengthened. At present, otherwise sound banking regulations (especially the conservative requirement to loan loss provisions) unnecessarily hamper KoB’s workout activities. Furthermore, the KoB “losses” occur not only due to weak earnings and large liabilities but also because of the high reserves and provisioning requirements that it has to face to comply with the Banking Act.20

(b) Streamlining KoB’s disposal methods. The work-out of bad assets should be conducted via a diversified, multi-level approach, involving a centralized agency, such as the KoB, for the few large debtors (with the support of the Revitalization Agency), and active participation of several smaller players for the other 12,000 debtors with smaller debts. Independent agents could be chosen within the private sector, working under best incentive contracts. Creative ways of asset disposition should include asset pooling and bundling of smaller loans, and usage

20 As KoB is transformed into a non-banking entity, it would make sense to incorporate KoB within the definition of general government and perhaps even within the ambit of the state budget. Not only would this make the operation more transparent, it would also reveal that some of what appears now as primary expenditure under the heading “transfer to banks and enterprises” (e.g., in Table 1.4) is actually “interest payment”; and that another part is actually “debt amortization” (that part of the subsidy to KoB which serves to cover principal maturities).


of Internet capabilities for on-line sales that would facilitate access of the investors to the asset sales and reduce the transaction costs.21 Actually, KoB has already begun to sell part of its bad portfolio in this fashion. The first pool of assets was auctioned in February 2001. Once this first experiment has been evaluated, the process could be expanded.

(c) Improving the legal framework for debt resolution. It is necessary to modify legal and regulatory procedures to enable rapid and more efficient asset disposition. This would promote restructuring of firms, as well as the exit of non-viable enterprises, and could increase the confidence and interest of the investors to participate in the process. In particular, the legal changes should include (i) improvement of debt enforcement mechanisms beyond bankruptcy procedures;22 (ii) strengthening of the bankruptcy framework; and (iii) adjustments of parts of other laws, such as the Commercial Code, the Civil Code, the Law on the Tax Treatment of Reserves and Provisions, the Income Tax Law and the Law on Tax Administration. Not only would this improve KoB’s recovery rate, it would also help private commercial banks work out those classified assets that remain on their books, and thereby limit the risk that this remaining overhang would ever fall on government’s lap.

(d) Strengthening bank governance and regulation. Another important concern will be to avoid the recurrence of further bank distress. The IPB episode has demonstrated that privatizing banks was not enough to ensure sound banking. Vigilance is all the more in order since the bailout of this private bank may be a source of moral hazard across the industry.23

2.13 The payoffs of such approach can be high. At 4.5 percent of GDP, the expected costs of bank restructuring would fall particularly heavily on the 2001 accounts (reflecting in part the delayed coverage of KoB’s cash drain of earlier years). However, on the assumption that current bad loans are recovered vigorously, and that the health of the banking sector does not cause repeated concerns from now on, the fiscal cost of bank bailouts could decline after 2001 towards 1-2 percent of GDP (see Table 2.2), as the absolute amounts involved diminish and growth gathers strength.

Conclusions

2.14 In the short term, the priorities are to end KoB’s banking operations (and associated provisioning requirements), to improve recoveries (including streamlining of asset disposal), and to avoid new bad loans and contingent liabilities. For the medium term, work should be started now to strengthen the legal framework for debt resolution and the regulatory framework for 21 For details on these workout activities and legal and regulatory framework aiming to improve bank restructuring process see World Bank (2000) The Czech Republic Completing the Transformation of Banks and Enterprises.22 In the Czech Republic, the bankruptcy process itself has been very slow and costly, lasting on average four and a half years, but even up to eight years. In May 2000, the amendments to Bankruptcy Act came into force. However, there are still many gaps that need improvement. The definition of insolvency has to be clarified and creditor rights strengthened. Time bound rules would also speed up the process. Since bankruptcy is still a court-driven process, training for the professionals involved in the bankruptcy process has to be ensured.23 Much controversy surrounds the most recent state bailout of IPB bank, another troubled privatized bank. Some of the main reasons for the IPB problems are the non-transparent ownership links via options and other similar contracts, and a materially and legally complicated operations structure that blurred the real quality of the assets.


banks. In terms of the fiscal management framework discussed in Part III, it will be important to continue to consolidate the fiscal cost of these operations, and associated contingent liabilities within a consolidated budget and a Medium Term Expenditure Framework, and to develop realistic projections of both costs and privatization receipts. Finally, the lasting cost of bank bailouts serves as a constant reminder to keep contingent exposures under careful watch. The recent banking distress episode in the Czech Republic is hardly an exception. International experience has shown time and again that the public debt accumulated in the “routine” operations of the government can pale in comparison to the amounts involved when off-balance sheet obligations are being called. This is one of the reasons for the serious concerns noted in the sector discussions below about the rise in extra-budgetary funds and their ability to issue guarantees and take loans. Part III will put forward some suggestions as to how the Czech authorities could manage these problems better in the future.

C. SOCIAL PROTECTION PROGRAMS

Introduction

2.15 The Czech Republic’s social protection programs have benefited from past reforms, but there is still substantial room to improve them to contain costs, establish financial sustainability, improve poverty focus, and reduce disincentives to work.24 The review highlights that

(a) The state pension program faces serious financial difficulties given the aging population. Projections show that the system will run into increasing deficits in the next decade and become unsustainable. The government needs to implement fundamental reforms of the Pay-As-You-Go (PAYG) system, taking steps in both the short and medium term to adjust the system’s parameters and design and introduce more fundamental structural reforms to ensure long term financial viability.

(b) The welfare programs aimed at assisting the poor still lack adequate targeting and discourage work. This is because the Minimum Living Standard (MLS), to which most benefits are linked, is higher than the minimum subsistence level for many families. For certain types of households and certain regions, it is higher than average net wages and is likely to be a strong work disincentive. Benefit levels may need to reflect more accurately the costs of a minimum subsistence level of consumption, and to be more modest relative to labor income. The Government needs to strengthen its poverty monitoring, and adjust the benefit criteria and categories so they are better targeted to meet the needs of the poor.

Overview of Social Protection Systems

2.16 The social protection programs in the Czech Republic consist of (i) social insurance programs based on insurance principles (albeit loosely defined in most cases), including state pensions, sickness and maternity benefits, and unemployment benefit; and (ii) non-insurance-based social welfare programs, such as state social support and assistance. Social insurance programs are financed mainly through payroll taxes; and benefits are linked to individual’s wage 24 This section draws on a background paper on “Public Expenditure on Social Protection Programs.”


history, hence contributions. Social welfare programs are financed by general tax revenue; benefit levels and eligibility are linked to the MLS, or to the particular characteristics of the beneficiaries.

2.17 Some of these programs have undergone significant reforms in the past decade, with a view to make them both more efficient and financially sustainable. These changes strengthened the insurance principles in the pension and unemployment benefit systems, and improved targeting of welfare benefits. However, given the government’s limited fiscal capacity and the need to ensure labor market flexibility, further modifications of these programs are called for. The trends in spending on most of these programs are given in Table 2.3.25

Table 2.3: State Budget Expenditure on Social Protection Programs(CZK Billion) 1993 1994 1995 1996 1997 1998 19991/ 20001/

Pensions PAYG state pensions Supplement to voluntary pensions Increased pensionsSickness and maternity benefits2

Unemployment benefitSocial Welfare3

Total

76.676.6

12.01.4

31.4121.4

88.288.2

16.61.8

33.2139.8

110.6109.8

0.8

18.41.8

30.3161.1

129.3127.6

1.7

20.42.1

34.1185.9

153.0150.2

1.90.9

19.83.4

36.3212.5

169.1166.1

1.91.1

18.64.2

38.5230.4

180.9177.8

1.91.2

19.35.8

43.5249.5

186.7183.1

2.31.3

25.67.6

45.8265.7

(As a percentage of GDP)Pensions PAYG state pensions Supplement to voluntary pensions Increased pensionsSickness and maternity benefits2

Unemployment benefitSocial Welfare3/

Total

7.67.6

1.20.13.1

12.1

7.57.5

1.40.22.8

11.8

8.08.00.1

1.30.12.2

11.7

8.28.10.1

1.30.12.2

11.8

9.18.90.10.11.20.22.2

12.6

9.39.10.10.11.00.22.1

12.7

9.89.60.10.11.00.32.4

13.5

9.79.50.10.11.30.42.4

13.81/ Data for 1999 is expected value, data for 2000 as in the state budget. 2/ Includes family member care benefit, maternity benefit and pregnancy and maternity compensation benefit.3/ Includes different benefit categories before and after 1995, special housing benefits, and some other benefits.Source: Ministry of Finance.

Social Insurance Programs

Pensions

2.18 Compared with many other countries in the region, the Czech pension system was in relatively good shape until recently. This is because the Czech Republic has not experienced the rapid increase in unemployment, the collapse of revenue collection, that has afflicted other transition economies, and the surge of disability pensions seen when the old age pension age was increased. The system also eschewed many of the special categories and privileges provided in most transition countries.

25 Note: Table excludes certain programs funded and administered by the local level; while not strictly comparable with Tables 1.4 and 1.5, it shows similar trends.3


2.19 As they currently stand, state mandatory pensions consist of

(a) Old age pensions (accounting for about 70 percent of the total pension expenditure since 1994). Eligibility is normally linked to reaching the statutory retirement age and effectively retiring from the labor force, but special provisions allow for early retirement and receiving pensions while continuing to work. Standard old age pensions consist of two components:

(i) A flat component that is the same for all pensioners and

(ii) A variable component whose amount is related to an individual’s earnings during the reference years preceding retirement.26

(b) Disability pensions are granted to individuals with either full or partial disability. It has accounted for about 18-19 percent of total pension expenditure in the past few years.

(c) Survivor pensions are granted to surviving spouses and children.

2.20 The benefits are financed by a 26 percent payroll tax, supplemented by transfers from the state budget to cover non-contributory periods for people engaged in designated activities,27 and to cover remaining gaps between revenues and expenditures.

2.21 The latter gaps have been growing in recent years. Under current conditions indeed, the system does not appear to be financially sustainable. The ratio of pensioners to contributors has risen from around 0.47 in 1994 to 0.53 in 1998, and, without additional reforms, is projected to reach over 0.60 by 2010, and continue rising to 0.71 by 2030. Alongside, pension outlays have been rising steadily as a percent of GDP, reaching 9.8 percent of GDP in 1999 (Tables 1.4, 1.5, and 2.3). As a result, the pension system is financially out of balance and becoming more so: the gap between pension outlays and contributions was over 9 percent of outlays (over 1 percent of GDP) in 1999.28 Unless reforms are implemented, this gap will rise to over 3 percent of GDP by 2020.29

2.22 Several factors have interacted to produce this emerging crisis:

(a) Increases in the benefit levels, reflecting changes in the reference wage and, more importantly, generous interpretation of indexing rules, so that pension adjustments have been consistently higher than inflation (See Figure 2.1).

(b) Increases in the numbers of pensioners, reflecting the start of a bulge in the proportion of the population reaching retirement age, longer life expectancy, and overly generous early retirement provisions. These factors have more than offset the impact of a gradually rising statutory retirement age.

26 As part of the reform initiated in 1995, the reference period is being lengthened from 10 to 30 calendar years. This adjustment will be completed during a 20-year period, starting from 1996.27 i.e., to cover periods of unemployment, higher education, military service and child rearing.28 This gap also includes transfers from the budget for certain non-contributory periods, so is somewhat larger than the underlying system deficit. 29 The projected gap may be understated. Since 1998, when the projection was made, gaps have been larger than projected. The projection exercise should be updated.


(c) Slow growth in contributions, reflecting a slower growth of the age groups entering the labor force, significant periods of non-contribution, low contributions from the self-employed, higher unemployment and slower wage growth since the 1997-99 recession, and large scale early retirement (as previous contributors moved to beneficiary status).

Figure 2.1. Pension Increases Since 1993Although replacement rate has been relatively stable

in recent years,the growth of average pension benefit has been significantly higher than that of consumer price.

(Average pension as percent of average wage)

0

10

20

30

40

50

60

70

1993 1994 1995 1996 1997 1998 1999

Gross wage

Net wage

(percent)

0

5

10

15

20

25

1994 1995 1996 1997 1998 1999

Inflation

Average nominalgross wage

Average old age pensions

Note: Growth rates are yearly averages and do not coincide with the changes in a particular month when pensions were adjusted.

Source: MLSA.

Reforming Pensions

2.23 Pension reforms during the 1990s initially focused on eliminating various special treatments inherited from the old system. Subsequently, a supplementary voluntary private pension system (supported by the state) was established. From 1995 onwards, statutory retirement ages have been raised (by 2 months for men and 4 months for women every year, until the retirement age reaches 62 for men and 57-61 for women, depending on the number of children, by 2007) and the linkage between contributions and benefits was strengthened through lengthening the reference period used to determine the reference wage for pension calculation. The bulk of the pension system is administered by the Czech Administration for Social Insurance (CSSZ) under the Ministry of Labor and Social Affairs (MLSA).30

2.24 While these earlier reforms were important (without them the system would be facing much deeper problems than it is today), it is clear that further fundamental reforms are needed now. The reforms should aim at (i) strengthening the link between an individual’s pension benefit and contributions made (so that the incentive to work and contribute remains strong); and (ii) reducing costs. Specific options to consider are outlined below.

2.25 Short-run adjustments appear possible in two areas where the Government can take action without modifying existing legislation:30 Pensions for certain sectors (military, judicial, etc.) covering about 2% of total pension expenditure are administered by the Ministry of Finance, but are governed by the same rules for contributions and benefits.


(a) Indexation: The Government should consider indexing pensions by the minimum level required by law. As noted above, the Government’s past indexation decisions have been above what is required by law.31

(b) Flat pensions: Adjustments to the flat part of the pension (which amounts to about 23 percent of the total pension) are not specified in legislation. Thus the Government could consider continuing its recent (since 1998) practice of keeping this part of the pension constant in nominal terms. This is suggested only as a short-term expedient to be used if other, more fundamental reforms prove impractical. Even so, the impact of this measure on the poorest pensioners should be carefully considered.

2.26 Given enough time to change existing legislation, more options do open up. However, some of the changes could be introduced rather quickly (e.g., indexation) to start moving the system toward sustainability while deeper reforms (e.g., to establish NDC and/or funded schemes) are being developed.

2.27 Indexation Rules. One option to consider is limiting indexation to the consumer price index (CPI) alone -- instead of using both the CPI and the real wage. In any case, the indexation rule should be transparent and apply to all pensioners.32 And it might be better to base adjustments on actual movements in the CPI, rather than on expectations (as was done in 1999). Since these changes would apply to the whole stock of pensions, and are cumulative over time, they could begin to have a significant impact soon after implementation. A one-percentage point lower indexation factor would result in initial savings on the order of CZK 1.8 billion a year at 2000 spending levels, accumulating to several billion Czech Crowns within three years.

2.28 Early Retirement. The rapid growth in early retirements (from fewer than 11,000 new early retirees in 1996 to nearly 58,000 in 1999) reflects the incentives built into the early retirement provisions (which unfairly benefit the early retiree), the economic recession, and the rising statutory retirement age. The shift to early retirement needs to be reversed as it reduces the contribution base and increases required expenditures at the same time. Measures to achieve this could include:33

(a) Increasing the pension reductions associated with early retirement so that they are actuarially fair.

(b) Reducing (or at least not letting it widen as the current law provides) the minimum period between early retirement and the statutory retirement age.

(c) Increasing the minimum number of years of contribution for early retirement from the current 25 years to 35 years.

2.29 Statutory Retirement Age. One should also consider further increases in the statutory retirement age beyond 2007 when the current phased increase ends, and perhaps increase it at a faster pace. While it would not have an impact in the near term, MLSA projections indicate that, 31 In 1999, for example, the Government made large adjustments for price increases that never materialized, substantially raising program costs. 32 Recently, different adjustments have been applied to different groups of pensioners.33 Some measures to reduce the incentives for early retirement are expected to come into effect July1, 2001.


everything else being equal, continuing the increase in retirement age to 65 for both men and women would reduce the pension deficit from 3.4 percent of GDP to 1.8 percent by 2025.

2.30 Non-Contributory Periods. The current policy in this area is generous both in terms of duration and the choice of reference wage.34 There are about 1.5 million such cases each year, and the periods covered represent on average more than a quarter of the total insurance period of each insured person. Moreover, during non-contributory periods, an individual’s average wage during the contributory period is used to calculate pension benefits and contributions, unnecessarily increasing the costs of the system and the level of state contributions. There are several ways to achieve this, including

(a) Reducing the duration of coverage of certain non-contributory periods, especially periods recognized for unemployment, childcare, and higher education. For example, the duration for the unemployed could coincide with the period when unemployment benefits are received.

(b) Using a lower reference wage (like the minimum wage or unemployment and sickness benefits) for pension calculations during the non-contribution period, instead of the individual’s average wage.

(c) Review the treatment of contribution arrears during periods when employers are not paying wages, with a view to not counting these periods (until/unless the contribution is paid), or at least using a lower reference wage.

2.31 Minimum Contribution Period for Full Pensions. In the same spirit, the Government should consider increasing the minimum contribution period for eligibility for a full pension from the current 25 years to 40 years.

2.32 Collections from the Self-Employed. Collections are low relative to the pension received. Measures to improve, and make transparent the link between benefits and contributions (see below) should help correct this. Meanwhile, the Government should continue efforts to improve enforcement of collections.

From Parametric to Systemic Reform

2.33 While moving ahead with the parametric reforms suggested above, the Government could also start to consider more systemic reforms, aimed at tightening the link between contributions and pension benefits and thus provide a strong incentive for individuals to contribute more and retire later. This might involve one, or a combination of, the following approaches:

(a) A Notional Defined Contribution System. One option would be for the PAYG system to transit to a notional defined contribution scheme based on individual accounts. As these reforms are introduced, the system should be calibrated to balance contributions (presumably based on a share of the payroll tax) and

34 The law stipulates that periods of compulsory military service, registered unemployment (up to 3.5 years), taking care of children (up to 4 years per child), taking care of family dependents (partially disabled and those over 80), receiving sickness benefit, education (up to 6 years from age 18), etc. are treated as contributory periods in pension calculation.


benefits. In such system, transfers from the state budget could be limited to transparent and defined amounts designed to achieve specific objectives (e.g., ensuring some redistribution toward the poor through a reformed flat pension or minimum pension guarantee; or supporting other social objectives through a reformed, more limited and less costly set of contributions for certain non-contributing periods).

(b) A Fully Funded Pillar. Reforms of the PAYG scheme which strengthen the linkage between benefits and contributions through individual accounts and by downsize the PAYG pillar could help set the stage for the development of the funded pillar. Implementing such a reform requires implementing a funding strategy in a healthy macroeconomic environment and parallel reforms of the financial market.

Developing the Institutional Framework

2.34 The Government should carefully review the proposal to set up a separate tri-partite-managed company to administer social insurance programs. Setting up this separate entity would do nothing in itself to solve the underlying financial problems of the pension system. Rather, experience in other countries has shown that such framework was not been particularly conducive to undertaking the reforms needed. As an alternative, the Government should consider developing a separate administrative entity within the MLSA, possibly based on the existing CSSZ, with clear reporting links and accountability. It could maintain the social insurance budget as a separate account, tracking revenues, expenditures and the balance, following sound accounting and financial management standards that allow this account to be incorporated easily into the consolidated general government accounts.

2.35 The Government should also continue to strengthen capacities in at least two specific areas: (i) the technical capacity to maintain millions of individual records and accounts; and (ii) the analytic capacity to monitor program effectiveness and identify and implement reforms to make programs more effective.

Sickness and Maternity Benefits

2.36 The sickness and maternity benefits provided by social insurance (which provide benefits during periods of leave taken for sickness, maternity and family emergencies)35 would also warrant a thorough review. This program involves a substantial amount of money (about 1.3 percent of GDP, see Table 2.3); its costs are relatively high in comparison with similar programs in other countries of the region; and, it contributes to the burden of wage costs (the program is funded by a 4.4 percent payroll tax). The program should also be assessed in terms of its interaction with the health insurance program. For instance, if doctors must be consulted to validate sick leave requests, this could contribute to the unusually high incidence of doctor’s visits in the Czech Republic (see Section D). There may be ways to modify this program to improve its cost-effectiveness and pave the way for cutting back the related contributions.

35 These are separate from health insurance benefits, discussed below in the health section, which finance the cost of medical services.


Unemployment Benefits

2.37 The unemployment benefit program in the Czech Republic is relatively modest both in terms of benefit level and overall expenditure, totaling 0.3 percent of GDP in 1999. This is equivalent to 0.9 percent of the payroll, compared to the 3.6 percent payroll tax that is designated to finance this benefit. However, program costs have risen rapidly due to rising unemployment after 1996, and recent increases in benefit levels. Rather than modifying the benefit level and structure or establishing new active labor market programs, the government should give serious consideration to cutting back contribution rates or redirecting that part of the payroll tax to the pension fund.

Social Welfare Programs

2.38 Social welfare programs were reformed in 1995 to move them towards a more targeted system. However, more could be done to (i) contain overall expenditure; (ii) improve program efficiency in assisting the groups at risk, and (iii) minimize disincentives to work. This section argues that policy changes would involve revising the Minimum Living Standard (MLS) and tightening several categories of benefits that are currently not targeted at the poor. Policy analysis needed for program evaluation and design should include a greater focus on program impact on the poor.

Program Structure

2.39 The current social welfare programs in the Czech Republic consist of three components:

(a) State social support, which includes major cash transfer programs funded by the state budget and administered by the central government. Out of the total of about 2.4 percent of GDP spent on social welfare programs, about 75 percent, (1.8 percent of GDP) is spent on this component. These programs aim primarily at providing cash assistance to families with children. About 90 percent of these benefits are child-related. This includes (i) income-tested child allowances and social supplements, and (ii) non-income tested parental benefits, childbirth grants, and foster care benefits.36 In addition, transportation allowances is granted to assist children commuting to school. Besides benefits to families with children, housing benefits, death grants, and support to families of those in compulsory military services (“providing for benefit”) are also given.37 About 66 percent of these benefits are subject to income testing. Others are granted on universal basis.

(b) Social assistance benefits are funded by the state budget, but administered at the district or community level.38 Spending on these programs has been rising rapidly up to about 0.5 percent of GDP in 2000. These benefits include (i) the social need benefit, aimed at supplementing household income (including benefits from social support programs) to ensure that it reaches at least the Minimum Living Standard

36 At the suggestion of MLSA we use the terminology defined by the Czech Statistical Office.37 From 1997, heating and rent contributions are added to cash transfer programs, but they are not included formally as “state social support programs”.38 For a comprehensive description of the policies of these programs, see Dlouhy (1999) and Visek (1999).


(MLS) defined according to household size and the age profile of household members; and (ii) benefits provided to households with special needs, in particular due to disability. Benefits can be paid in cash or in kind. There are more than twenty kinds of such benefits, some of which are one-time benefits, others recurrent.

(c) Social services, which are administered and funded at the local level and include counseling services for particular vulnerable groups, help offered to the old and disabled, as well as community and institutional care. Spending on these programs has been about 0.1 to 0.2 percent of GDP.

Main Policy Issues and Options

Minimum Living Standard (MLS).

2.40 The MLS needs to be revised to contain costs and avoid disincentives to work. The current MLS was developed in early 1990s to reflect the cost of living of individuals at various ages and households of different size. Since then, it has been adjusted at least seven times, taking into consideration changes in the price level. It is widely used to determine access to and levels of benefits (both the income testing thresholds and benefit levels are expressed in terms of MLS).

2.41 Several problems have become evident regarding MLS.

(a) MLS may not accurately reflect today’s true minimal subsistence level. Since early 1990s, the cost of different essential components (such as food and housing) has changed at widely different rates. While this problem has been partially corrected by adjusting different components at different rates, it is advisable, in view of the large structural changes that have taken place, to re-examine the composition and cost of basic consumption items, and to modify the structure and level of the MLS accordingly.39

(b) The level of MLS appears to be too high for certain categories of households and generates strong work disincentives. For larger families, the MLS is very close or even higher than average net wage (Table 2.4). Under such circumstances, the family might opt not to work, or to work on informal activities in the household, while receiving income tested benefits, and thus fall into the unemployment trap.40

39 Due to the faster increase of housing costs, the amounts needed to assure housing have increased more dramatically than amounts needed for food and other basic needs. (Note: the MLS is determined by the sum of the amounts necessary to meet personal needs and the sum of housing costs depending on the number of persons living together). By this way the difference of the MLS for a single adult and that of a household with more members is corrected gradually.40 In the opinion of MLSA, the MLS amounts are determined correctly. The MLSA views the use of the MLS to determine the eligibility for and level of social benefits as a separate question. In the system of state social support, the payment of benefits depends on the adjustment of the corresponding parameters. There is no entitlement to social assistance benefits (in accordance with the Act on the social need), by which the insufficient income of a needy household can be raised up to the level of the MLS. In every case, the economic and social situation and means of an individual household are tested, especially the possibility of increasing the income by the endeavour of its members, e.g., by their employment in particular. For information and for the evaluation of the level of disincentives to work caused by the generosity of the benefits assigned for the protection against material need, MLSA stresses that social assistance benefits in 1998 represented only 3 percent of the total incomes of the citizens. In 1999, they increased up to 3.9 percent due to the rise in unemployment and other economic problems of enterprises.


(c) Given the significant regional disparities in the Czech Republic in terms of income, cost of living, and unemployment, there is a case for developing different MLS for different regions.41 For example, the government could consider differentiating Prague from the rest of the country, or even further differentiating according to towns and regions. In some regions, the average net wage is significantly lower than the MLS in a household with two adults and one or two children. The work disincentive is apparent (Figure 2.2).

Table 2.4: MLS for Representative Households in Comparison with Average Net WageHousehold Type 1991 1992 1993 1994 1995 1996 1997 1998 1999Single adultTwo adultsTwo adults with one child (age 6-10)Two adults with two children (age 8,12)

1,7003,0504,200

5,400

1,7003,0504,200

5,400

1,9603,5004,810

6,170

2,1603,8605,300

6,800

2,4404,3605,960

7,580

2,8905,1106,970

8,820

3,0405,3707,330

9,270

3,4305,9608,100

10,150

3,4305,9608,100

10,150

Average net wage 3,087 3,715 4,613 5,398 6,341 7,538 8,349 9,144 9,924Note: End of period figures.Source: MLSA.

Figure 2.2: MLS and Average Net Wage (1993-1999)With respect to average net wage, MLS is too

high for larger households…… And for lower income regions.

0

2000

4000

6000

8000

10000

12000

1993 1994 1995 1996 1997 1998 1999

MLS for 2-adult 3-children family


Average net wage

0

2000

4000

6000

8000

10000

12000

1993 1994 1995 1996 1997 1998 1999


Average net wagein East Bohemia and South Moravia

Source: MLSA.

2.42 Since the MLS is high for certain types of household, the Government could consider reducing the real value of MLS (and benefits) for certain categories to reduce the distortions that it produces on work incentives. Alternatively, a “survival minimum” can be developed to replace the MLS by linking some of the benefits to this new, lower standard.

State Social Support Programs

2.43 The main state social support programs are discussed below. There is significant room for further targeting in these programs. This is true both for income-tested and non income-tested programs.

41 According to MLSA, it is not necessary to treat regional disparities in the level of living expenditures, in particular in view of the different trends in housing costs, by the development of different MLS for different regions as for this purpose the Act on social need and the system of benefits provided according to this act suffice to cover the regional differences.


2.44 Child Allowance and Social Supplement. The combined expenditure on these two-child allowance programs accounts for about 60 percent of total state social support expenditure. The income test is not very discriminating, since about 90 percent of the families receive some kind of child allowance. The program is also very complicated as the social supplement is superimposed on the child allowance program in terms of income testing threshold and it is divided into many income brackets (Table 2.5).

Table 2.5: Child Allowance and Social Supplement, 1998Income threshold Benefit per child1 Number of beneficiaries

Percent of MLS CZKChild allowance (test family income of the previous year) 1,769,000

<1.1 MLS 32% 1,053 45%1.1 – 1.8 MLS 28% 921 46%1.8 – 3.0 MLS 14% 461 9%

Social supplement (test family income of the previous quarter) 453,000<=1.0 MLS 1,234 46%<1.1 MLS 1,029 10%<1.2 MLS 823 11%<1.3 MLS 617 11%<1.4 MLS 412 10%<1.5 MLS 206 8%<1.6 MLS 50 5%>1.6 MLS 0 -

1/ Benefit for social supplement depends on the age of child. This example is for a family with two children ages 5 and 8.Source: MLSA.

2.45 The following measures could be considered to improve the targeting of the program:

(a) Reducing the income test level below which one becomes eligible for child allowances. The current threshold (3 times the MLS) will offer child allowance to any two-adult one-child family with monthly income below about CZK28,500, twice the average wage. As a result, the program lacks focus on the most vulnerable.

(b) Shortening the duration of benefits. Currently, the child allowance is provided for children up to age 26 who are full time students. Explicit support, involving grants and loans for higher education, are likely to be more effective than this general allowance in meeting the education finance needs of young adults.

(c) Consolidating the child allowance and social supplement programs and introducing a simple benefit structure, which offers higher benefit to the poor, defined by a lower income

(d) Removing the income tax deduction for dependent children. This is considered a regressive tax provision, and especially benefits those monthly incomes is above CZK20,000. Removing this tax deduction would bring a net gain to the fiscal balance of over CZK6.1 billion.

2.46 There have been active discussions and debates in the government on reforming the cash transfer programs. One proposal is to change the child allowance program from income-tested to a universal one. While recognizing the advantages of low universal benefit in terms of


administrative simplicity and less distortion in labor supply decisions, the potential cost of such proposals is a serious concern.

2.47 Parental Benefit. The parental benefit accounts for about 26 percent of the total social support expenditure. The level of benefit is slightly higher than the MLS for a single adult, or about 25 percent of the average net wage (20 percent of gross wage). The duration is four years per child and seven years per disabled child. The number of beneficiaries decreased from 3.5 million in 1997 to about 3.3 million in 1998.

2.48 Although the design of the program was partially driven by the concern that a disproportionate share of women would become unemployed during transition, it is not clear that the parental benefit helps improve women’s job opportunities and earning potential in the long run. Consideration should be given to shorten the benefit period and to introduce a declining benefit scale to encourage reentry into the labor force. Savings in this area could be used to help women find jobs or for child care services designed to encourage women’s labor force participation.

2.49 Transportation Contribution. The transportation contribution is universal for all children going to primary school and mean-tested for children going to secondary and higher education (for those whose income is less than twice the MLS). In 2000, the benefit was budgeted at over CZK 1 billion. It is a complicated scheme to administer and it is not clear that poor families are able to benefit significantly from this subsidy. The government could review this benefit and may consider eliminating this benefit category, or using the savings to finance enhanced child benefits for the poorest families.

Locally Administered Social Assistance Programs

2.50 Locally administered programs may have significant advantages in identifying the poor and monitoring developments in the field more closely.42 However, such decentralization should be accompanied by adequate monitoring, probably at the central level, of expenditure effectiveness, including in particular its impact on reducing poverty, in meeting the different needs for social services, and in ensuring that there is adequate access to services for all regions and ethnic groups. The crucial information needed for regular evaluation of the impact of social assistance and for poverty monitoring is lacking.

2.51 In addition, the MLSA analysis shows that some communities do not or cannot provide necessary funds to close the gap between the amount of transfer from the state budget and the real costs of operations for the services they provide. Therefore the quality of local programs varies across regions. Developing community based and driven social services with active involvement of NGOs is an area where attention is needed in the next few years.

Regular Household Surveys and Poverty Monitoring

2.52 Regular and more frequent nationally representative household budget surveys and poverty analyses are needed. They would inform on the evolving nature of poverty to be tackled

42 However, there is evidence that this is not always the case, in particular for the Roma group.


by various instruments, and the incidence and effectiveness of assistance. Currently, household surveys of appropriate sample size are conducted only once every four years. As a result, some of the analysis is not well grounded. Some qualitative surveys with specific focus would provide useful information regarding the extent to which different regions and ethnic groups are benefiting from the system. The fiscal and poverty impacts of the policy measures discussed above should be assessed before such changes are introduced.

Conclusions

2.53 In sum, although the reforms in the mid-1990s have generated many of the intended results and enhanced the targeting of social welfare benefits, there is an urgent need to reform the pension system to make it financially sustainable, including increasing incentives to work longer, contribute more and retire later. In social welfare programs, there is scope to reduce disincentives to work and to improve their targeting and poverty focus while reducing their cost.

2.54 In the area pensions, the authorities should first consider -- as short term, stop gap measures -- indexing pensions only by the minimum level required by law, and continuing to keep the “flat” part of pension benefits constant in nominal terms, as has been done since 1998. In addition, steps should be taken now to amend the legislation so that some basic policy parameters are adjusted over the coming year to make the PAYG system financially viable. Specifically, the report recommends to:

(a) Limit indexation to the consumer price index alone.

(b) Eliminate the actuarially unfair aspects of early retirement provisions.43

(c) Further increase the statutory retirement age after 2007, when the current phased increase ends (and perhaps increase it at a faster pace).

(d) Reduce the duration and the reference wage used for some non-contributory periods.

(e) Improve collections from the self-employed.

(f) Extend the minimum contribution period for eligibility for a full pension.

2.55 Over the medium-term, more fundamental structural change of the PAYG program (including a possible shift towards individual accounts in a notional defined contribution scheme and/or introducing a funded scheme) should be seriously considered as ways to bring long-term financial sustainability and effectiveness to the system. These longer-term reforms will tighten the link between contributions and pension benefits, thereby strengthening the incentives for all, including the self-employed, to contribute more and retire later. The analysis to underpin such medium-term reforms should start as soon as possible. Similarly, reviews should be carried out of the sickness and maternity, and unemployment benefits to identify medium-term reforms to target these benefits better and reduce costs or tax rates, as suggested above.

43 Some steps in this direction are expected to come into effect on July 1, 2001.


2.56 The social welfare programs should be carefully reviewed to improve targeting, reduce disincentives to work and lower costs. In particular, the Minimum Living Standard (MLS) should be redefined and reduced to reflect more accurately the costs of a minimum subsistence level of consumption; the minimum income test level for the child allowance should be lowered and its duration reduced; the child allowance and the social supplement could be consolidated into one simpler system, with benefits better focused on the most vulnerable; and the parental benefit and transportation benefit could be assessed for better targeting and possible consolidation with the income-tested benefits.

2.57 To design and manage such reforms in social protection programs, it will be important to have in place the capacity to analyze policy options and to design and monitor policy and program reforms. For pension reforms, the considerable capacities of the CSSZ can be used and further strengthened. For assessing social welfare (and other) programs, more frequent, well-designed household surveys, with samples adequate to measure program impact across and within regions will be critically important. Such surveys will enable a quantitative analysis of the poverty situation in the country and an assessment of the impact of policy and program options on the poor. These surveys will also be increasingly important as a way to monitor the effectiveness of decentralized regional governments and municipalities in delivering services to the people. The analytical work both on pensions and on social welfare programs should be organized to feed into the fiscal management approach (performance budgeting within a Medium Term Expenditure Framework) outlined in Part III of this report, by providing ongoing assessments of the impact of program expenditures and identifying measures to increase their effectiveness.

D. HEALTH

Introduction

2.58 Deep reforms of the health sector in the 1990s have brought about major improvements in health indicators, but substantial scope remains for further reforms aimed at preventing excessive growth in demand and costs, encouraging more efficient use of human and physical resources, and making sector financing more sustainable.44 This section analyzes the structure and trends in health sector expenditures and then identifies reform issues and options. The main areas recommended for further consideration and development by the Czech authorities are:

(a) Increased consumer cost sharing, with safeguards for those with low incomes.

(b) Continued development of provider payment mechanisms that encourage more efficient resource use.

(c) Improvements in the way health insurance is financed.

(d) Insurance company reform, including moving toward a more managed care approach.

44 This section draws on a background paper on “Public Expenditure Analysis of the Health Sector.”


2.59 Further development of capacity for health policy analysis and formulation to design and implement these and subsequent reforms, and to feed into a continuing assessment of program performance and expenditure effectiveness in the context of a Medium-Term Expenditure Framework (see below).

2.60 Such reforms could yield some near-term budget savings. Their main impact however would be to make existing spending levels more effective and equitable, and also to help prevent the kind of rapid rises in expenditure, which have destabilized health systems in other countries, especially as the population ages and incomes rise.

Sectoral Overview

2.61 The health sector in Czech Republic has undergone a radical transformation since 1990. Reforms have converted a centralized bureaucratic system into a group of largely decentralized institutions that provide insurance and health care services. The progress made in reshaping the environment in which physicians and other providers work has been remarkable. Moreover, these reforms, combined with general improvements in the economy, are associated with significant improvements in health outcomes. Since 1990, life expectancy rose from 71 years to 74 in 1998, and infant mortality dropped from 10.8 per 1000 live births to 6 by 1996 (see Table 2.6). In addition, the authorities have responded effectively to challenges along the path of reform, exhibiting a willingness to adopt additional reforms as the need has become apparent.

Table 2.6: Index of Infant Mortality Rate in Selected Central European Countries1990 1990 1991 1992 1993 1994 1995 1996IMR Index (Base 1990=100)

Czech Republic 10.8 100 96 92 79 73 71 56Hungary 14.8 100 105 95 84 78 72 74

Poland 19.3 100 94 90 83 78 70 63

Slovakia 12.0 100 110 105 88 93 92 85

Slovenia 8.4 100 98 106 81 77 65 56

Note: Infant mortality rate (IMR), per 1000 live births.Source: Transmonee database.

2.62 The continuing commitment to health sector reform is justified, especially in the area of containing costs and rationalizing expenditures: (i) costs are high compared with other countries with similar demographics and income levels; (ii) there are signs of excess consumption of services; (iii) imbalances appear in the supply of certain inputs; (iv) the funding mechanism is complex, and possibly unstable; (iv) arrears have emerged in both revenue receipts and payments to providers; and (v) pressures on spending are likely to grow as the population ages and as incomes grow. Focusing and further strengthening the Czech Republic’s demonstrated capacities for policy analysis, formulation, and monitoring could help develop reforms to deal with these problems and subsequently identified problems. The key challenge will be designing and implementing policy interventions that will both contain costs and improve health outcomes.


Expenditure Trends and Sector Structure

2.63 At about 7.4 percent of GDP in 1999 and 2000, health sector spending is on the high side, by about 2 percent of GDP, when compared with health spending in other countries with similar income levels and population age structures.45 This suggests some scope for containing expenditures. Although expenditures have been relatively stable as a share of GDP (see table 2.7),46 this could change as the population ages and incomes grow.

2.64 The expenditure trends shown in Table 2.7 also highlight some of the main features of the reformed Czech health system. The functions of health care delivery and insurance have been separated, and while most funding derives from the consolidated public sector, the Ministries of Health and Finance now play much more passive roles than in the past. The bulk (about 83 percent) of expenditure, and a growing share, is paid by insurance companies to decentralized providers, either (mostly private) individual or group practitioners, or (mostly public) hospitals. Insurance coverage is mandatory and uniform for all citizens. There are 10 insurance companies. The market is dominated by the General Health Insurance Company (GHIC) with has 75 percent market share. The other companies are mainly based on client groups from specific trades or industries (e.g., banking, or Skoda-VW) and operate on a not-for-profit basis.

45 Kornai and McHale, “Is post-communist health spending unusual?” Economics of Transition (2000).46 Note: figures from Table 2.7 include patient copayments which account for most of the difference with Table 1.5.

Table 2.7: Health Care Spending, 1993-2000(CZK billions, or percent)

1993 Actual

1994 Actual

1995 Actual

1996 Actual

1997 Actual

1998 Actual

1999 Expected

2000 Projected

1 Total Expenditures (4+5+6+7+8) 73.5 89.6 102.4 112.4 121.5 132.3 136.1 142.7

As % of GDP 7.3% 7.6% 7.4% 7.1% 7.2% 7.3% 7.4% 7.4%

2 Expenditures without co-payments (1-8)

69.7 84.2 95 104.1 111.6 121.7 124.8 130.7

3 State budget (including transfers) (3a+..+3e)

29.4 28.9 30 31.5 35.2 39.8 44.2 44

3' As % of total expenditures 40.0% 32.3% 29.3% 28.0% 29.0% 30.1% 32.5% 30.8%

3a Ministry of Health 6.6 7.7 7.8 6.2 5.6 6 5.5 5.6

3b Ministry of Defense 0.9 1 1.4 0.9 0.8 1.5 0.9 1.2

3c General Fiscal Administration 17 14.3 13.7 16.5 19.9 23.9 28.8 28.3

3c1 Contributions to HICs 16 14.3 13.3 16.4 18.3 23.5 27.8 28.2

3c2 Subsidies and interest free loans to HICs

1 0 0 0 0.5 0.1 0 0

3c3 Other health care expenditures 0 0 0.4 0.1 1.1 0.3 1 0.1

3d Insurance contributions for state employees

3.7 4.7 5.6 6.4 6.7 6.7 7.1 7.1

3e Transfers to local authorities 1.2 1.2 1.5 1.5 2.2 1.7 1.9 1.8

4 Non-transfer spending of state budget (3a+3b+3c3)

7.5 8.7 9.6 7.2 7.5 7.8 7.4 6.9


5 Local authorities 6.4 6.1 7.3 6.5 5.9 5.8 5.7 5.7


6 Health Insurance Companies (6a+6b+6c)

55.8 69.4 78.1 90.1 97.3 107.5 111.6 118.1


6a Payment of claims 52.3 65.5 74.1 86.1 92.9 101.4 106.6 113

6b Operational expenses of HICs 2.8 3.9 3.9 3.8 4.2 3.8 4.1 4

6c Other expenses 0.7 0 0.1 0.2 0.2 2.3 0.9 1.1

7 State purchases of health institutions' claims

0 0 0 0.3 0.9 0.6 0.1 0

8 Patients' co-payments 3.8 5.4 7.4 8.3 9.9 10.6 11.3 12


9 Per capita expenditures (CZK) 7112 8671 9922 10903 11797 12857 13238 13885


2.65 There has been a continuing reduction in the direct role of government in health provision. Expenditures from the state budget are mostly related to transfers of insurance payments to the insurance companies either for the states’ own employees (line 3d in Table 2.7), or for the non-workers (line 3c1). Direct (non-transfer) expenditures47 on health by both central and local governments (lines 4 and 5) have declined as a share of total spending, falling by more than a half over the period 1993-2000 to less than 9 percent of total spending. Non-transfer expenditures mainly finance investment and some operational expenses of government-run hospitals.

2.66 In the present setting however, patients still have little incentive to limit their use of medical services. Patient’s co-payments are limited to a small share of a few items (mainly pharmaceuticals and dentist services beyond standard norms). It is interesting that despite the 47 State budget transfers are those made to health insurance companies on behalf of state employees and the non-working, plus transfers to local authorities.

very limited scope for co-payments, they have been rising as a share of total health spending, reaching a projected 8.4 percent in 2000 (line 8).

2.67 The insurance companies are funded by payments made by, or on behalf of, individuals. Insurance contributions payments are based on an individual’s actual or notional income,48 and there is no direct link between this contribution and the expected benefits for individuals or risks to insurance companies. The system is also highly redistributive, with over half of the population (the non-workers) paying nothing directly, and the self-employed paying only 35 percent of what other workers pay.

2.68 Collection has been a problem. Insurance industry has amassed both liabilities and receivables over the past seven years, due to unpaid contributions by individuals, and delayed compensation of providers by the insurers themselves. Table 2.8 reports the stock of payments that are past due since 1993.

Table 2.8: Stocks of Liabilities and Receivables of Health Insurance Companies(Billions of CZK)

Year Liabilities to providers Receivables from individuals1993 1.9 0.51994 1.8 2.51995 2.7 3.91996 4.5 3.41997 3.8 5.61998 4.3 8.2

1999 (est.) 3.6 10.82000 (proj.) 4.81 13.9

1/ CZK3 billion of this debt was expected to be paid off in 2000 through a commercial bank loan.Source: Ministry of Finance.

Reform Issues and Options

2.69 Based on international comparisons, the Czech system appears to have still some way to go in rationalizing its resource allocations. As noted above, total health spending is 1-2 percent of GDP higher than in comparable countries, suggesting substantial scope for efficiency gains. While so far costs have not risen greatly as a share of GDP, there is a significant risk of rapid price escalation as the population ages and incomes rise. This indicates that better incentives are needed on both the demand and the supply side to contain costs. There are also problems with the current financing mechanism, including the build up of significant arrears. Over the medium term, further attention needs to be given to the role of insurance companies and their regulatory framework. Finally, further attention should be given to strengthening and focusing the country's considerable capacity to analyze health policy issues and design and implement subsequent reforms.

48 The payments are 13.5 percent of taxable wages for the employed, 13.5 percent of 35 percent of pretax income for the self-employed and 13.5 percent of 80 percent of the minimum wage for those not working. Payments for the first two groups are collected from employers or individuals by the insurance companies. Payments for the non-workers are transferred to the companies from the state budget. These amounts are subsequently transferred to a central pool and then reallocated to the companies after a rough adjustment for the riskiness of their client base.

Containing Excess Demand

2.70 On the demand side, access to care is, if anything, too easy and consumers face no costs for the resources they use since nearly all services are free. One indicator of this is the frequency of outpatient visits. In 1995, there were 15.0 outpatient visits per inhabitant. In contrast, the number of outpatient visits per person in most OECD countries in 1985 ranged from 2.7 in Sweden to 7.8 in Australia, with only Italy (10.1) and Japan (12.7) having rates approaching those of the Czech Republic. The comparatively high rate of physician visits suggests that financial savings could accrue to insurers, and passed on to the consolidated government budget, with little impact on health outcomes.

2.71 The most straightforward, and probably most effective way to put downward pressure on usage would be to introduce some form of demand side cost sharing (e.g., co-payments) resulting in positive consumer prices. This would give all consumers at least some incentive to contain costs and would reduce the moral hazard in the current system. Although some limited cost sharing exists for pharmaceuticals and dental care, there is a serious concern in the Czech Republic that introducing a broad-based co-payment system would face formidable political obstacles. Yet no other policy measure is likely to have as strong an effect in containing costs, and in reinforcing the other policies being considered to put health services on a more effective and sustainable path. Consequently, the authorities are encouraged to identify ways in which demand side cost sharing could be introduced. Possibly such a step could be accompanied by (i) a system of refunds of co-payments or waivers for the poorer segments of the population; and (ii) an appropriately calibrated reduction in the tax/contribution rate for employed workers, who, as noted above, bear a relatively high share of the system costs.

Aligning Supply Side Incentives

2.72 Despite significant changes over the past decade, various signs of imbalance persist on the supply side. While the number of hospital beds has steadily declined, it is still high relative to the needs of the population and the utilization rates are lower than in most OECD countries. Moreover the mix of beds is out of balance, with a surplus of acute care beds and a shortage of beds for long term care. There is also a concern that there may be a growing surplus of doctors.49 More generally, as Figure 2.3 demonstrates, in-patient, hospital care still dominates health expenditures, with the share of spending on (usually more cost-effective) outpatient care rising only slowly since the early 1990s.

49 In 1996, the number of doctors per 1,000 people was already 3.5, well above the OECD average of 2.7.

2.73 To deal with these and related issues, the authorities have actively experimented with, and changed, provider payment mechanisms so that incentives would be aligned better with desired health sector outcomes. A variety of financing mechanisms has been used for each type of medical provider. When an initially adopted fee-for-service mechanism threatened to cause excessive cost increases, the authorities introduced alternative systems. Since 1997, general practitioners have been paid on a (modified) capitation basis, receiving a more or less fixed fee for each registered patient; specialists have continued to be paid on a fee-for-service basis; and hospitals have been subject to something of a fixed budget allocation mechanism. This global budgeting approach is intended as an interim arrangement while a new approach, based on a DRG (diagnostic related group) model, is developed and tested. This approach is intended not only to contain costs, but also to remove the incentive, imbedded in the current system, for hospitals to avoid patients with problems that are expensive to treat.

2.74 The authorities should continue to analyze carefully the effects of various provider payment mechanisms on the costs and effectiveness of health services and adopt changes as needed. In general, the imbalances in input use and resource misallocation currently faced by the sector could be corrected through the pricing system, and not necessarily by administrative fiat. Thus, if there is a shortage of long-term care beds but an excess of acute beds, one way to induce the required shift in supply could be to alter the way in which services provided to the two types of patient are reimbursed. The advantage of this approach is that it can be applied uniformly to all institutions, avoiding to some extent the politically costly process of apparently arbitrary and selective ward closures. It should be emphasized, however, that such supply side measures are likely to be more effective if they work in association with a broad-based cost sharing by consumers as recommended above.

Improving the Financing Mechanism

2.75 The present financing mechanism for the insurance companies merits a careful review. Its financing source is potentially unstable. It is complex, with significant administrative costs, relatively weak enforcement of collection, and major redistribution across client types, but not necessarily in favor of the poor.

2.76 First, the financing base, a tax on employee wages, could generate fiscal imbalances. This is because wages, and the insurance revenues they generate, are pro-cyclical, while health needs are, if anything, counter-cyclical. If the economy falls into recession, lower incomes and unemployment lead not only to lower insurance revenues but also both to greater health problems and lower willingness to pay for preventative and curative services. Since there is naturally a tendency for the (non-profit) system to spend all available resources in a given year, there is no mechanism to ensure surpluses in good years are accumulated to offset deficits in bad years. In the event that costs are contained to below revenues in a given year, mechanisms should be put in place to prevent that this savings be dissipated, but rather set aside to offset deficits in bad years. Such surpluses could also be used to pay the liabilities owed to providers (see Table 2.8).

2.77 The current complex funding mechanism could be greatly simplified. Now each insurance company is meant to collect its own premiums, and then submit them to a central pool, which then reallocates them back to the insurance companies (after making a rough adjustment

for risks). The government should consider collecting these premiums itself, piggy-backing on the social insurance payments that it already collects. This should cause almost no additional cost to the Government and substantial savings in administrative overheads to the insurance companies. Moreover, it could help increase the collection rate, including collection of the growing stock of receivables, because the central tax authority would have both more effective sanctions and higher ranking than insurance companies among creditors of firms in financial distress.

2.78 Finally, the government should carefully assess the effects of the redistribution across client groups now built into the financing mechanism. The incidence could be regressive in ways not intended, for example for the working poor. Analysts should look for policy combinations (such as lowering the health insurance contribution rate for employees, while introducing co-payments for all clients with refunds for the poor) that could reduce moral hazard, help contain costs and improve equity. It may also be worthwhile to reassess the risk adjustment formula.

Developing the Role of the Insurance Companies

2.79 Over the longer run, it may be possible for the insurance companies to play a larger role in cost containment, by moving towards managed care arrangements, in which insurance companies and providers interact closely with each other. Included in this would be a more active role for general practitioners as gatekeepers to specialized care in order to reduce the rate of referral to more expensive specialists for outpatient services. To support such a move, and to maximize its benefits, the policy toward the health insurance companies and their regulation would need to be developed in a consistent way.

2.80 For the full benefits of a managed care approach to be realized, it would be important to develop healthy competitive conditions, both in the insurance market and in the medical labor market. Insurance companies would need to compete in ways that enable consumers to share in the benefits of cost containment through lower prices, better contractual terms, and/or higher quality. The regulatory framework would need to support competition on these lines, permitting consumer choice while ensuring adequate minimum standards and preventing cream skimming. To insure adequate competition would likely require the break up of large players, especially the General Health Insurance Company. While the government is understandably keen to maintain a high level of quality for all Czech citizens, some product and price variation seems unavoidable if the discipline of consumer demand is to be used to control costs. These would be fundamental changes in the way insurance companies operate, and would require substantial preparation to design and implement.

Capacities for Health Policy Reform

2.81 The Czech Republic has a clearly demonstrated capacity and track record in the design and implementation of health policy reform. That capacity should be built on and strengthened to meet the country’s ongoing need for future reforms. Policy analysis can advise policymakers and guide policymaking on issues such as those raised above, and can be an important means of fostering clearer policies and greater internal consistency. Tracking costs, assessing the effectiveness of incentives, evaluating regulatory measures or determining how to foster both

quality and cost containment are examples of issues that policy analysis can inform. Developing a high quality, interactive management information system to assist the government, insurers and managers track the volume and costs of care would provide an important building block for such analysis as well as for regular management of the system. Such analysis would allow adjustment to the health system and its financing through a more transparent and consistent assessment, and could lead to more coherent health policies that adapt to the country’s changing conditions and needs. One of the most important tasks of health policy analysis should be to contribute directly to analyzing health expenditures in the context of a Medium Term Expenditure Framework (see Part III), including an ongoing assessment of program performance and ways to improve it.

2.82 It will be important to identify an institutional focus for coordinating overall health policy analysis and strategy development. The analysis can be contracted out, carried out in-house, or a mix of both approaches, as appropriate. However, there is a need for a strategic approach in identifying priorities for analysis. At present, health policy formulation is fragmented. Policy shifts and implementation have been led by multiple actors often not working in concert, including the Ministry of Health, the Health Insurance Fund and the Parliament, among others.. Without well-coordinated leadership, progress will be difficult.

Conclusions

2.83 Health sector reforms in Czech Republic have achieved a great deal. The improvements in health outcomes, while not all directly attributable to the reforms, are also encouraging. Still the system faces serious risks because there are no incentives on the consumer side to contain costs. Implementing consumer cost-sharing across the broad range of health expenditures is probably the single most important instrument available to promote long term cost containment and more efficient resource use.

2.84 In the short run, the cost sharing principle could be expanded beyond the very limited areas where it now applies, while options for a broader reform with widespread use of co-payments, possibly combined with refunds for the most vulnerable, are designed and put in place. Other areas of reform that need attention include: (i) reforms of provider payment mechanisms to reduce further the supply-side imbalances and resource misallocation, which continue to impair the overall efficiency of the health system; and (ii) reforms of the complex, costly and potentially unstable financing mechanism, possibly including piggybacking premium collection on the collection of other social insurance payments.

2.85 In the medium term, as co-payments start to contain demand and limit costs, it may be possible to lower the contribution rate for employees, and possibly increase contributions from the self-employed and from non-workers. In addition, insurance companies could play a larger role in cost containment through the development of a managed care approach. Such approach however is likely to be effective only if supplemented by deep, but difficult to implement reforms of the legal and regulatory framework of the insurance market. Answers to the policy challenges facing the Czech Republic call for careful analysis and design of interventions, and this highlights the need for a focal point for coordinating health policy analysis and formulation. It will be important for this analysis to feed into the Medium Term Expenditure Framework and performance budgeting process (discussed in Part III) to help establish expenditure levels and program priorities.

E. EDUCATION

Introduction

2.86 The sweeping changes brought by the transition from communism have had a major impact on the education system. As a result, the education system needs to be reoriented to meet the needs of a modern market economy by increasing its focus on the more general, higher level skills the economy needs, and by expanding access to tertiary education.50 As this section argues, there are good reasons to believe that this can be done while keeping public spending on education at its current level of under 5 percent of GDP.51 The key elements of this approach would be:

(a) Phased expansion of tertiary enrollment by:

(i) Increasing enrollment at the existing universities, financed largely by tuition, combined with student loan programs and limited, need-based scholarships. The costs could be kept low since the expansion could mainly mean more intense use of existing resources, including faculty.52

(ii) Encouraging new tertiary institutions, largely in the private sector and financed by tuition. To reduce startup costs, these could be developed from existing higher professional schools.

(iii) Continuing the expansion of higher professional schools in response to demand, also financed mainly by tuition.

(b) Consolidation at the primary and secondary level, to reduce costs and increase the orientation toward development of more general skills by:

(i) Revitalizing and expanding the “optimization program”, which seeks to consolidate public schools by taking into account the declining numbers of school-age children; the already small size of classes and low teacher workloads, and the growth of private sector schools.

(ii) Reviewing and rationalizing the way funds are allocated to schools, particularly the “normatives,” or per student allocations, to provide incentives that encourage consolidation.

(iii) Providing incentives to encourage more students to move toward schools offering the more general academic training in "learning how to learn" that is needed to function effectively in a dynamically changing economy,

50 This section draws on a background paper on “Public Expenditure in the Education Sector.”51 Different sources show education spending ranging between 4.4 to 4.7 percent of GDP in 1999. The two sources differ in using a slightly different method for aggregating education spending, but they show nearly identical trends. See Table 1.5.52 The university student-faculty ratio is less than 12, compared with an OECD average of nearly 17.

combined with steps to adapt the curriculum at technical and vocational schools to increase general academic learning.

(c) Implementing decentralization in ways that ensure accountability for achieving agreed outcomes, and that permit savings realized at primary and secondary levels to be reallocated to improving quality and to be used for expanding the tertiary level.

(d) Ensuring the capacity is in place for education policy analysis and formulation to design reforms, monitor results and feed into the continuous, systematic review of expenditure performance in the context of the Medium-Term Expenditure Framework. A systematic program of national assessments is an essential tool for monitoring the progress and impact of education both at the national level and between and within regions.

(e) Intensifying the efforts to ensure equal education opportunities for all children. This applies especially to Roma minority children at all education levels, but also to children of poorer social background at the tertiary level.

Transition and the Education System

2.87 The transition from communism has placed new demands on the education system, but it has also brought other changes creating some scope to meet these demands without major increases in total public spending on education. The transition has brought sweeping, economy-wide changes in the structure of employment and a demand for more general, higher level skills associated with a shift from traditional manufacturing to services, finance and public administration. At the same time, there has been a rapid increase in the market valuation of education, with widening salary differentials between workers with different education levels that suggest greater scope for charging tuition, especially for higher levels of education. There has also been a dramatic decline in fertility, resulting in smaller numbers of school-aged children and excess school capacity at primary and secondary levels.

2.88 There are three significant differences between the Czech Republic’s labor force and that of other OECD countries that suggest the need for significant changes in the output of the education system to align with other modern market economies: (i) a very high proportion of the labor force has completed secondary school (88 percent vs. an OECD average of 65 percent); (ii) a small proportion of workers has completed tertiary education (12 percent vs. an OECD average of 23 percent); and (iii) a high percentage of upper secondary school students is enrolled in traditional vocational programs, as opposed to more general academic programs (16 percent in academic programs vs. 47 percent for OECD).

2.89 To some extent, the Czech Republic’s education system, building on its considerable strengths, has responded to the need for change. The decision in the early 1990s to allow the private sector to provide education has been particularly significant. The newly emerging private schools are partly funded from public funds and partly by tuition. They play three main roles. First, they create competition among themselves and also with the public schools, with positive implications for school quality and allocative and technical efficiency of the whole schooling

system. Second, they fill the inherited gaps in the field structure of education supply. Third, they channel additional (private) funds into schooling.

2.90 The changing structure of the education system is shown in the enrollment trends presented in Table 2.9.

(a) Enrollment in the 9 years of basic (primary plus lower secondary) education (which is free, compulsory, and nearly universal -- with the important exception of the Roma minority) has dropped significantly over the 1990s. This reflects the fall in the school-aged population. The latter is expected to decline by another 19 percent in the next 5 years. There has not yet been significant private sector entry at this level of schooling.

(b) The three streams of secondary education -- the vocational schools, the technical schools, and the general academic schools (gymnasia) -- have all shown large enrollment declines. The sharp reductions in enrollment in public schools more than offset the rise in private schools, which expanded rapidly to about 12.6 percent of total secondary enrollments by the end of the decade. While the private schools charge tuition, public schools cannot.53

(c) At the tertiary level, enrollments in universities have risen significantly, but substantially less than demand, as qualified applicants apparently outnumber available places by a factor of two. There are no private universities, and universities are not allowed to charge tuition.

(d) Enrollments in higher professional schools, established in both the public and private sectors after the 1995 legislation in response to the rising demand for tertiary education, have grown rapidly to about 14 percent of total tertiary enrollment. These schools charge tuition and normally provide two years of education leading to specialized professional diplomas. About one-third of higher professional school enrollment is in private institutions.

53 Public schools can and do charge for some related expenses, such as catering.

Table 2.9. Enrollment by School Level and Ownership, 1989-1998(in thousands of students)

Year 89/90 90/91 91/92 92/93 93/94 94/95 95/96 96/97 97/98 98/99

Panel A: Basic Education (primary + lower secondary)

Public 1235.7 1192.6 1165.3 1112.8 1058.5 1023.6 1000.2 1095.4 1085.2 1076.6

Private — 1.2 1.2 1.1 1.1 1.0 1.0 1.1 1.1 1.1

Panel B: Gymnasia (at upper levels only)

Public total 100.7 101.8 95.9 89.9 80.5 76.6 77.1 66.8 66.3 68.4

Private total — 0.1 0.9 3.5 5.8 8.4 9.2 8.3 7.9 7.4

Commercial — 0.0 0.7 2.5 4.2 6.0 6.5 5.8 5.3 4.9

Church — 0.1 0.2 1.0 1.6 2.3 2.7 2.5 2.5 2.6

Panel C: Technical Schools

Public 158.7 166.6 170.4 171.7 176.5 188.8 195.3 151.4 152.7 149.7

Private 0.0 0.2 4.6 15.5 30.4 44.7 50.5 37.7 31.8 25.5

Commercial 0.0 0.1 4.1 14.1 28.4 42.4 48.4 36.3 30.6 24.3

Church 0.0 0.0 0.5 1.4 2.0 2.3 2.1 1.3 1.2 1.2

Panel D: Vocational Schools

Public 310.2 301.8 0.3 250.8 241.2 242.6 234.7 178.6 156.8 132.9

Private 0.0 0.0 — 17.4 27.5 26.0 27.3 21.6 19.3 17.5

Commercial 0.0 0.0 — 17.3 27.4 25.9 27.1 21.4 19.2 17.4

Church 0.0 0.0 — 0.1 0.2 0.1 0.2 0.1 0.1 0.2

Panel E: All Upper Secondary Schools

Public 569.6 570.2 266.6 512.4 498.1 508.0 507.1 396.8 375.8 351.0

Private — 0.2 — 36.3 63.8 79.0 87.0 67.6 59.0 50.5

Commercial — 0.1 — 33.8 60.0 74.3 82.1 63.5 55.1 46.5

Church — 0.1 — 2.5 3.8 4.7 4.9 4.0 3.9 4.0 Panel F: Higher Professional Schools

Public — — — 1.0 1.4 3.1 4.1 9.1 14.6 18.7

Private — — — 0.4 1.0 1.5 2.2 5.9 9.0 10.8

Panel G: Tertiary Level

Public 113.4 118.2 112.0 114.2 122.3 129.5 139.8 155.9 165.8 174.2

Private — — — — — — — — — —

—. Not available.Source: Vyvojova rocenka skolstvi v Ceske republice: 1989/90-1998/99.

2.91 Despite these significant developments, there are clear signs of a large unfinished agenda:

(a) At the tertiary level, the excess demand for university education appears to be growing.54 This excess demand seems to coexist with substantial capacity for expansion at the university level, given the low student faculty ratio (less than 12 compared with an OECD average of about 17). There is scope for much greater reliance on tuition payments to finance expansion of tertiary education, given the emergence of significant wage premiums for higher levels of education.

(b) At the secondary and basic levels, there is a vast scope for consolidation of public schools, not only because of the decline in the relevant age cohorts, but also because of the growing enrollments in private schools. The Government’s “Optimization Program”, launched in 1997, was intended to deal with this, but its

54 Applications have grown faster than admissions during the 1990s.

impact was less than expected and it has come to a virtual halt. So far, despite these efforts, the drop in enrollments has been associated with a rise in the total number of schools and a decline in class size, indicating that appropriate consolidation at this level has not taken place.55 Nor are there clear signs of a reduction of the dominance of vocational education at the secondary level, as the gymnasia accounted for less than 19 percent of secondary enrollments in 1999. The opening up of more university places could induce higher general academic enrollments as the bulk of students admitted to universities are from gymnasia graduates.

Expenditure Trends and Funding Mechanisms

2.92 The expenditure trends in education do not yet fully reflect the major structural changes underway in the sector, especially the sharp drop in primary and secondary school enrollments described above. While spending on education has declined as a percent of GDP (see Table 1.5) to about 4.4-4.7 percent of GDP, real spending at the end of the decade is about the same as in the early 1990s (Table 2.10). Since enrollments have declined dramatically, this suggests an overall substantial increase in real spending per student. While some of this increase probably reflects real increases in teachers’ salaries, general quality improvements, and, at the tertiary level, enrollment growth, it is likely that it also reflects substantial scope for additional efficiency gains from further consolidation.

2.93 At the same time, there are serious concerns about the composition of spending, as most of the increase in spending appears to be driven by teachers’ salaries, which have grown much faster than other expenditure categories. This trend is likely to continue in the near future and it has already dried up any room for growth of other current expenditures. This is likely to generate a pent-up demand for investment and maintenance spending that could become more costly to deal with in the future (as deferred maintenance could lead to expensive rehabilitation). Moreover, excessive constraints on current expenditures that are important for quality enhancement (e.g., teacher training, instructional materials, etc.) will have long-term costs. The present funding mechanism allows schools to pay higher wages to smaller numbers of teachers,56

but they cannot reallocate savings on wage payments to non-wage expenditure categories.

2.94 These trends suggest that it would be worthwhile to review the funding mechanisms for education to identify ways in which they can support a smoother response to the structural changes underway and more efficient resource use. Most funding for education (about 85 percent) comes from the public sector, with the central state budget providing the bulk (over 82 percent) of the public funding. This covers most of the costs of public schools and provides substantial subsidies to private schools. Municipalities are the other important channel of public funding, providing about 17 percent of public spending, and are responsible for administration of kindergartens and basic schools and for co-financing their investment and maintenance. Under the new regional government system, the maintenance and investment funds for the upper-

55 For example, class size in vocational schools has dropped from 21 students to 14.56 i.e., by increasing workloads and class size, and reducing employment, schools can reallocate their wage budgets to a smaller number of better-paid teachers.


secondary schools is expected to come from the regional governments' budgets, while the state budget will continue to cover wages and educational equipment.57

2.95 The normatives used to fund schools 58 do not appear to be working as well as one might expect to provide incentives for more efficient resource use, such as more rapid school consolidation. This could in part be due to the way the normatives are structured and applied. For example, in 2000, the per student subsidy for a basic school with less than 150 pupils was about 45 percent more than for a basic school with more than 251 pupils. This may overcompensate for fixed costs and offset any incentive to consolidate. Moreover, there is little flexibility to reallocate savings in one area, such as salaries, to other expenditure categories. This can create wrong incentives (e.g., inefficient spending aimed at exhausting allocated resources within a given spending category) and preclude efficient use of resources. The normatives do not appear to have been structured to reinforce efforts to consolidate, use resources more efficiently, or provide incentives to increase enrollments in more general academic training.

2.96 In addition to these issues, for non-public schools there is an additional issue of the adequacy of the public funding provided through this mechanism. Non-public schools receive between 50 and 90 percent of the normative subsidy provided to state schools. Base support (typically 50 percent of the normative) is given according to the type of school. Additional funding varies according to school quality as evaluated by local schools offices. The state provides no investment or rental support for non-state schools and these costs have to be covered from tuition and other private sources. Overall, private schools receive just under 3 percent of total education spending, while they enroll about 3.7 percent of all students.59 However, private secondary schools (and all higher professional schools, including public ones), are allowed to charge tuition. For example, in 1998, private gymnasia charged an average tuition of CZK15,000, equivalent to about 55-65 percent of the per student normative payment to public gymnasia. This, combined with the rapid expansion of private schools, suggests that the current arrangements provide very strong incentives indeed for establishing private schools.

57 See Part III for a discussion of the Czech Republic's decentralization program. 58 Budget funds for current (recurring) spending and investment (capital) spending are allocated according to different rules. Current budget allocations constitute about 90 percent of total education spending and are determined by multiplying per-student expenditure norms (referred to as normatives) by the total number of students enrolled in different sorts of accredited schools. The per-student norms primarily cover wages and other current expenditures. They are set each year by the Ministry of Education, with different normatives used for schools with different characteristics (e.g., level, type, ownership and size). The normatives have separate, non-fungible subcategories for different types of expenditure (e.g., wages, operating costs, etc.). Investment funds, amounting to about 10% of total spending, are allocated on a case-by-case basis.

59 This implies that private schools receive just under 80 percent of the per student allocation that public schools receive.


Table 2.10. Structure of Expenditure on Education by Type of SchoolPanel A: In current prices [CZK billion] 1993 1994 1995 1996 1997 1998 1999

Total expenditures1/ 53.6 63.2 71.8 81.7 78.9 80.3 86.8

Kindergartens 4.8 5.5 6.5 7.6 7.4 7.3 7.9

Basic schools (primary+lower secondary) 15.5 18.2 20.9 25.4 24.2 24.3 26.8

Gymnazia2/ 2.2 3.1 3.9 4.2 3.5 3.4 3.7

Secondary Technical Schools (STS)3/ 4.6 6.1 6.8 7.2 7.1 6.5 7.7

Secondary Vocational Schools (SVS) 6.6 7.7 8.6 9.1 7.3 6.9 6.9

Special schools 2.0 2.4 3.0 3.4 3.5 3.7 4.2

Tertiary schools 5.8 7.4 9.1 10.6 10.7 12.0 12.7

Other expenditure4/ 12.2 12.8 12.9 14.2 14.7 15.7 16.9

Panel B: in percent of total expenditures: 1993 1994 1995 1996 1997 1998 1999


Kindergartens 8.9 8.8 9.1 9.3 9.3 9.1 9.1


Gymnazia2/ 4.0 4.9 5.4 5.2 4.5 4.2 4.3



Special schools 3.7 3.8 4.2 4.2 4.5 4.6 4.9



Panel C: In constant 1993 prices [CZK billion] 1993 1994 1995 1996 1997 1998 1999


Kindergartens 4.8 5.0 5.4 5.8 5.2 4.6 4.9


Gymnazia2/ 2.2 2.8 3.3 3.2 2.5 2.2 2.3



Special schools 2.0 2.2 2.5 2.6 2.5 2.3 2.7



Consumer price index 1993=1004/ 100.0 110.0 120.0 130.6 141.7 156.9 160.1

1/ Total expenditure on education by type of school in years 1993 -1998 from budget of Ministry of Education, municipalities and other departments (Ministry of Economy, Ministry of Health, Ministry of Agriculture, Ministry of Defense; data from Ministry of Interior Affairs and Ministry of Justice is not available).

2/ gymnasia include sport schools.3/ Secondary Technical Schools include financial means of Higher Professional Schools from year 1993 (experiment) – 1997 (independent).4/ Other expenditure: expenditure related to education, accommodation, and meals for school children and students, physical training. Source: Statisticka rocenka skolstvi. UIV. 1999. pp.20-21.Source: Statisticka rocenka skolstvi. UIV. 1999. pp.20-21.

Reform Issues and Options

Reorientation toward more general, higher level skills, and expansion of tertiary education

2.97 While the quality of human capital in the Czech Republic is high, there is growing recognition that it needs to be reoriented toward more general, flexible and higher level skills,


which will help workers learn and adapt throughout their lives. This sort of learning is best provided in general academic high schools rather than in programs leading to a specific occupation; therefore, enrollment in academic schools should be encouraged. Students who enroll in vocational programs commit themselves to a specific occupation at ages as young as 12 or 14. They are unlikely to be able to shift easily to radically different occupations as labor market conditions change. In a dynamic labor market, where an individual can be expected to hold several different jobs over his or her lifetime, it is important that students learn how to learn rather than learn specific skills. The quality of education may also vary by school ownership as public schools tend to be overly focused on memorization rather than creative thinking.

2.98 At the same time, the experience in the Czech Republic with private schools suggests they have helped enhance quality, particularly in focusing on learning how to learn. Operating in a semi-competitive environment with public schools, they are likely to help raise performance throughout the system. They thus have a dynamic, qualitative role to play, well beyond their weight in total enrollments. The policy framework should continue to support this role, while maintaining incentives for efficient resource use.

2.99 In light of the excess demand for workers with tertiary education and the excess student demand for university education, public funds would be spent efficiently by extending the supply of tertiary education. Currently, students who do not succeed in enrolling into tertiary level (even though they passed the qualifying entrance tests) may be more likely than their more successful colleagues to become unemployed and rely on public resources. Hence, increasing the share of the workforce with tertiary education still further should be a goal of public policy.

2.100 However, this raises budgetary issues. Since education is an investment in students' future labor market success, it is entirely appropriate that they pay at least a substantial part of the costs involved. Moreover, tuition could also provide a market-based signal to regulate excess demand. Tuition payments covering the bulk of tertiary education costs even in public schools, combined with appropriate loan funds to enable repayment out of the future increased income resulting from attending university, could be introduced to support an expansion an expansion of opportunities for tertiary education. Scholarship programs should be available to ensure access by students from low-income families.

2.101 However, the strategy for tertiary expansion needs to be carefully developed. The excess demand apparent now may quickly evaporate once tuition is introduced more widely and as the economy’s backlog of demand for workers with tertiary education is reduced. Moreover, it will be important to ensure that tertiary institutions have the critical mass needed to provide quality education. As a part of this strategy, it may also be desirable to consider establishment of new tertiary institutions in regions so that educational opportunities at the tertiary level are developed beyond the two major urban areas of Prague and Brno. It may be possible to identify surplus buildings that could be provided for new regional tertiary schools that could be certified to grant, for example, the lower-tertiary Bakalar (Bachelor's) Degree. The fixed costs of establishing new tertiary institutions are extremely high, so building on existing higher professional schools may be an attractive option. Expansion of existing universities may be the most efficient approach. Present policies supporting the response of higher professional schools to student demands and the needs of the economy should be continued.


Consolidating primary and secondary schools

2.102 The demographic trends have resulted in growing unused capacity at basic and upper secondary levels, which should be used as a source of much needed fiscal space, allowing the administration to direct freed-up resources to improve the quality of education and expand tertiary education.

2.103 It will be beneficial to continue and intensify the optimization program so that savings could be used for expansion of educational programs that are permanently in shortage. Aligning normatives with this objective should be considered. Since increases in funding are needed the most at the central level (tertiary education), while savings will be realized mainly at the regional level, it is not clear that this outcome will be achieved. Attention should be given to finding a mechanism to enable a shift of resources across educational levels in the new decentralized environment.

Improving Funding Mechanisms

2.104 The financing method of normative subsidies as used in the Czech Republic has its pros and cons. Pros include the transparency for all institutions involved and a large degree of predictability and limited scope for discretion. The system facilitates identification of schools deviating from the national "standards”, thus highlighting potential inefficiencies (class sizes, pupil/teacher ratio, teacher/administrative staff ratio, wage tariff/performance bonuses ratio, etc.). The normative method also stimulates school competition, including public and private schools.60 The cons are that the normative method is highly quantitative and does not sufficiently reflect quality. It is also rigid across expenditure categories, which can reinforce inefficiencies at the school level, and it does not appear to offer adequate incentives for consolidation. It relies heavily on individual choice of students/parents concerning the type/field of education. Although some consider this as a disadvantage, parents and students do not necessarily make worse decisions than the administrative authorities in evaluating quality and predicting medium/long term market needs/trends. One could argue that the normative approach provides incentives for the system to react to student demands, which are more likely to correspond to the real economy needs than the existing field distribution of public schools.

2.105 It would be useful to review the normatives, and adjust them if needed to ensure they are as useful as possible in encouraging an efficient use of resources. In particular, the (much) higher per-student subsidy for smaller schools seems to undercut efforts to consolidate. Moreover, it may be possible to achieve better resource use if greater flexibility across spending categories (e.g., wage vs. non-wage) is allowed. It may also be useful to review the way the normatives are applied to private, tuition-charging institutions to ensure that the right balance is struck between adequate support and a level playing field for different types of schools. Finally, the normatives do not seem to be supporting a move to more general, academic secondary education as much as one might expect. For investment spending, which constitutes about 10 percent of total spending on education, and which now appears to be allocated in an ad hoc manner, it would be useful to explore identifying more systematic norms and criteria to set priorities and allocate funds more transparently.

60 see Filer and Munich, 2000


Making a Success of Decentralization

2.106 The regional governance reform may introduce major changes to the administrative and financial structure of the educational system. Few changes will affect basic education (as basic schools already fall under municipal administration), but at the secondary level, the main administrative responsibility is expected to be transferred from the Ministry to the regions. Greater local involvement may add new dynamism to the “optimization program” and, more generally, to overall improvements in education outcomes. However, this process will need careful development and monitoring. Ways will need to be found to ensure resources freed up by consolidation at the basic and secondary levels can be used not only for quality improvements at those levels, but also to meet the needs of the tertiary level. More generally, it will be important to ensure that local education objectives are aligned with national objectives and that accountability for achieving agreed outcomes is ensured. This will be particularly important to avoid inter-regional and rural/urban disparities in learning achievements.61 A system of national assessments of educational outcomes will be an essential tool for monitoring differences in results both among and within the regions and identifying areas for corrective action.

Access and Equity

2.107 For most children, access up to the tertiary level is open and opportunities more or less equal. The exceptions are Roma minority children, only 2.5 percent of whom enter any form of secondary education.62 Most Roma children are transferred from the elementary schools into the special auxiliary schools caring for mentally disabled children. Needless to say, the relative disabilities of Roma children are social, not mental, and should be remedied with the help of the State. Especially those with only special education will likely find it impossible to become employed and will stay on welfare rolls throughout their lives. This poverty trap needs to be broken. Providing extensive help aimed at educating the Roma youth would be an efficient use of public funds. Recently, District School Offices in few localities began to organize one year of pre-elementary education for Roma children in order to eliminate their language and social handicap. Although the number of such classes and pupils attending has been rather low, there are some plans to extend the program. These are steps in the right direction. It would make sense to evaluate the program, make any needed improvements or modifications and then expand and intensify it, so that all children can be mainstreamed in the education system.

2.108 At the tertiary level, the de facto discrimination against children from poorer backgrounds is common to many countries. The expansion of opportunities at the tertiary level should help reduce the problem on the margin. More importantly, if tuition is introduced more widely as a source of finance, loan and scholarship programs will be needed, particularly for the lower income students.

Capacity for Policy Analysis

2.109 To design and manage an education reform strategy to deal with the issues outlined above, it will be important to have in place the capacity to analyze policy options and to design

61 Mickelwright, 1999.62 Source: Czech Republic: Toward EU Accession, Main Report, p. 211 (World Bank, 1999).


and monitor policy and program reforms. A system of regular, systematic assessments of educational outcomes should be an important tool in this effort. The analytical work should also include an ongoing assessment of the impact of program expenditures and identify measures to increase their effectiveness within the broader Medium Term Expenditure Framework.

Conclusions

2.110 Reorienting the education system to the needs of the Czech Republic’s modern market economy calls for an increasing focus on the more general, higher level skills the economy needs, as well as expanding access to tertiary education. Luckily, there is a good chance that this reorientation can be accomplished while keeping public spending on education at its current level of less than 5 percent of GDP, and enhancing equal opportunity in education. This could be done by taking advantage of the sharply declining numbers of school-age children, the already small size of classes and low teacher workloads, and the growth of private sector schools to consolidate at the primary and secondary levels and shift resources to the tertiary level, while expanding the use of tuition payment to recover costs and contain the prevailing excess demand for higher education.

2.111 In the short run, the main priorities are to:

(a) Revitalize and expand the "optimization program" to consolidate primary and secondary schools, capitalizing on the sharp drop in the school age population to generate savings.

(b) Introduce tuition more widely at the tertiary level, both to finance the needed expansion of enrollment at existing and new institutions and to contain excess demand.

(c) Intensify efforts to ensure equal opportunities for Roma children at primary and secondary levels and for all students at the tertiary level. Student loans and need-based scholarships will become increasingly important as use of tuition expands at the tertiary level.

(d) Develop a medium term strategy for more fundamental reforms to expand tertiary enrollment and improve quality at all levels.

2.112 The priorities for such a medium-term strategy include:

(a) Developing a mechanism to enable part of the savings at the primary and secondary school level to be used by the central government to support demand-driven expansion at the tertiary level, including for the program of need-based scholarships.

(b) Revising the "normatives" system to reinforce better such sector policy objectives as more efficient use of resources, including more rapid school consolidation.


(c) Encouraging a greater proportion of students to learn the general academic skills needed for lifetime learning by expanding enrollments in general secondary schools, and reforming the technical and vocational school curriculum to increase the general academic content.

(d) Developing a program of quantitative national educational assessments to monitor progress in meeting education objectives nationally, across and within regions.

(e) Ensuring that the education system works well for all regions and socio-economic groups in the newly decentralized setting, by aligning national and local objectives, specifying accountabilities and monitoring outcomes.

2.113 To design and implement these reforms over time, it is important that a focal point be identified for coordinating the analytical work needed, and integrating the results of that work into specific policies and programs. It will also be important for the results of this work to feed into the fiscal management process of performance budgeting in a Medium Term Expenditure Framework, as outlined in Part III of this report. In this way, the reforms identified can be translated into more effective educational programs and more efficient use of public funds.

F. TRANSPORT

Introduction

2.114 The apparent stability in public expenditures on transportation (hovering around 3.0-3.2 percent of GDP in the 1990s) masks significant pent up expenditure pressures. The latter include (i) the sweeping, transition-induced shifts in demand across transport modes (with rail freight dropping by over 50 percent, while road freight grew by more than 100 percent); (ii) large operating losses and mounting debts in railways, in part due to that declining demand; (iii) the build up of a massive backlog of maintenance in roads, railways and public transport; and (iv) a major program of new rail and motorway investments, mainly for the Trans-European Network (TEN) corridors.

2.115 In dealing with the resulting expenditure pressures, the Czech Republic will need to concentrate scarce public resources exclusively on those activities where the private sector cannot operate effectively. To this end, the country needs to focus on completing the remaining areas for transport privatization and on commercializing activities that will remain in the public sector. It will also need to balance carefully the urgent needs for repair and maintenance against proposals for new investment. Recommendations to deal with these issues include:

(a) Major railway restructuring. Restructuring the railways will require a major commitment of government time and effort, but it is essential to stop the large and growing drain on the economy (about 1.6 percent of GDP per year in 1998) caused by running this oversized system in a structurally downsized market. Reducing the maintenance backlog, selective phasing of corridor investments to maximize their returns and adjusting passenger fees also need attention.


(b) Careful management of the road infrastructure and its use. Growing demand for road use calls for placing first priority on reducing the maintenance backlog in roads and public transport; undertaking only those corridor investments with high returns (and undertaking first those that will also help reduce the maintenance backlog); introducing appropriate road user charges; and taking an integrated approach to reducing traffic congestion in Prague through parking and congestion charges.

(c) Focusing public resources on public priorities. Given the critical need to focus scarce human and financial resources on the activities above, the government should avoid involvement where its presence is not essential. This would include privatizing most railway operations, and not financing or guaranteeing such investments as CSA or Prague Airport, as private sector financing sources should be available for these profitable activities.

(d) Improving expenditure management and program analysis. Priorities here include taking steps to assess and limit the use of guarantees and to contain the risks associated with establishing the extrabudgetary Transport Fund. It will also be important to set up a process to ensure that transport expenditures are subjected to a rigorous, objective and systematic costs/benefit analysis, and to incorporate this analysis in the Medium Term Expenditure Framework and performance budgeting approach outlined in Part III.

Transition and Transport Demand

2.116 Transition has brought major shifts in the structure of demand for freight and passenger transport, as shown in Table 2.11. These changes are structural and not expected to be reversed. They reflect the decline of heavy industries, the emergence of a service economy and “just-in-time” manufacturing which favor road transport, the explosive growth of the private automobile and aviation, and the reorientation of trade to the West. A further decline in rail transport is possible as Czech Republic approaches modal splits observed in other Western European countries (railways currently carry about 35 percent of freight and 9 percent of passengers). Conversely, automobile, truck and air traffic are expected to continue to grow rapidly, which will require careful planning for road investments and for measures to control the growth of congestion in Prague and other urban areas.


Table 2.11. Trends in Goods and Passenger Transport(Ton-km or passenger-km billions)

1990 1998 Percent changeGoods TransportRail 41.14 18.76 -54Road 16.80 33.91 +102Inland Water 1.40 0.82 -41Air 0.057 0.056 -2Oil Pipeline - 2.08 -Total 59.397 55.63 -6

Passenger TransportRail 13.36 7.02 -47Automobile 39.90 60.80 +52Bus 12.34 8.68 -30Inland Water 0.003 0.008 +166Air 2.18 3.68 +69Total 67.78 80.18 +18

(Thousand passengers/workday)Prague Public Transport (PPT) 4,186 3,349 -20Source: Ministry of Transport and Municipality of Prague.

2.117 The rest of this Section outlines expenditure issues in each of the main transport subsectors: railways, roads and road transport, air transport, waterways, and transport issues in Prague. It then discusses some expenditure issues that cut across the subsectors.

Railways

2.118 The Czech railways system has not yet adjusted to compete in the post-transition environment. One of the densest systems in Europe,63 it is too extensive for the (declining) volume of traffic it carries. Costs however have remained sluggish while demand dropped. The system is particularly affected by high labor costs, which account for 49 percent of its operating costs. As a result, Czech Railways has a serious financial problem, with the ratio of operating costs to total revenues ranging from 107 to 115 percent in recent years.64 Freight services are profitable, but passenger services suffer major losses. Due to financial constraints, much of the system is in poor condition because maintenance was deferred. Czech Railways estimates its maintenance backlog at CZK130 billion.

2.119 The growth in road competition and high labor costs suggest that Czech Railways’ financial position will continue to worsen unless a complete and fundamental restructuring is implemented. The Government’s total support for Czech Railways in 1998 is estimated at CZK28.4 billion, or about 1.6 percent of GDP. It is likely that the Government will need to provide around CZK40 billion annually in railway support in one form or another during the coming years. The approved Transport Investment Plan calls for the Government to invest CZK15-17 billion annually in railways infrastructure in coming years. In addition, Czech Railways cannot avoid replacing aging traction and rolling stock or carrying out other maintenance at a cost of around CZK7 billion annually. These requirements would add up to more than two percent of 1998 GDP, which does not appear sustainable.

2.120 The Government recognizes the need for change and has taken some measures to comply with the EU requirements. Some privatization had taken place, but has been too marginal and

63 The Czech Republic has 120 km of rail per km2, compared with Poland (74), Hungary (83), or Slovenia (59).64 If operating subsidies are excluded from revenue, the ratios rise to over 130 percent.


limited in scope to generate much apparent benefit to date. The main constraints affecting Czech Railways’ performance remain the same: rising labor costs, the major maintenance backlog, limited funds for investment except in the Trans-European Network (TEN) corridors, the slow pace of organizational reform and privatization to date, tariff controls, trade unions’ resistance, low employee and capital productivity, the poor quality of regional services, and increasing road competition.

2.121 Furthermore, although Czech Railways is held responsible for achieving business targets, it has in fact only limited powers to do so. Czech Railways cannot appoint senior managers; change its organizational structure at a high level; decide annual operational or investment plans; prepare its own long-term plans, or establish its own pricing, leasing, or procurement policies. Government also imposes some constraints on day-to-day operational management. Moreover, Czech Railways has lacked leadership continuity, with at least 5 different managers since 1993, reflecting also frequent changes in the leadership of the Ministry of Transport and Communications (MTC).

2.122 A comprehensive program of restructuring and downsizing is recommended, which could be carried out in a period of two to five years. In order to improve labor productivity while dealing with the real concerns of labor, well-designed personnel measures are required, including training and development, redundancy packages and resettlement. The accounts of Czech Railways’ infrastructure and operations divisions need to be completely separated. Separate market-led businesses need to be established for freight, long-distance passengers, and suburban passengers, and their managers adequately empowered. Czech Railways should prepare its own annual and operational budgets that support the different roles of the different profit centers and hold them accountable, with a view to making decisions which achieve value for money. Long-term business plans are required. A management information system, resource and cost allocation system, and business evaluation and monitoring systems are needed to implement the process.

2.123 The new distribution of powers and accountabilities between the government and Czech Railways should also include a significant increase in Czech Railways’ freedom to price its services, and lead to a significant increase in passenger fares. Long-distance rail passenger tariffs and services should be deregulated because there is sufficient competition from other transport modes to prevent monopoly abuses. Some subsidy for suburban passenger services may be justified as a way to reduce the congestion and pollution costs of motorization, but it is recommended that this be done through explicit payments65 to the service provider from the concerned regional government, which benefits from the service. Subsidies of national interest (e.g., for school children or disabled passengers) can continue to be paid from the state budget. The government should consider increasing Czech Railways’ authority to divest non-core activities, dispose of surplus assets, and seek private funding. Procurement needs to be improved by divesting and outsourcing loss-making activities, involving the private sector in terminals and services, and contracting maintenance on a competitive basis.

2.124 The quality of all services needs to be improved, partly through the improvement of business processes, but also through capacity and resource reviews, improved productivity and maintenance, and service and reliability reviews. In order to implement the above measures, 65 Based on a Public Service Obligation (PSO) agreement between the provider and the regional government.


Czech Railways’ objectives, powers and public service contract need to be drawn together, and analysis and plans for the disposition of non-core and loss making activities prepared.

2.125 Finally, the new railway corridor investments should be carefully evaluated and phased. The proposed investments should be based on an objective, incremental cost-benefit analysis, and priority given to those that have high returns and meet the most pressing maintenance needs.

2.126 Implementation of a comprehensive restructuring and downsizing such a large labor force will be politically and technically difficult and call for strong committed leadership over a sustained period both in the government and in the enterprise. But in view of the huge potential gains both in savings of public resources on the order of 1.5 percent of GDP, and in the potential of a more competitive transportation sector and economy, this is a matter of the highest priority.

Roads and Road Transport

2.127 Funding for road maintenance has not kept up with the increase in traffic see in Table 2.11. Furthermore, much of the what resources has been available appears to have been diverted to the construction of motorways. As a result, the existing road network is deteriorating. The conservation of the existing road network has a higher economic priority than most new construction. It is recommended to increase expenditures for the maintenance and repair of roads to about CZK10 billion per annum with a view toward eliminating the existing backlog in 5-10 years. It is also recommended that routine and periodic maintenance be carried out by contractors selected on a competitive basis rather than by force account. The Ministry of Transport has already been considering consolidating some or all of the 72 Road and Administration Units into the 14 new regional governments, which should indeed be implemented. It is also recommended that the road administration be given more responsibility to allocate funds between new construction and maintenance/rehabilitation.

2.128 The existing system of road taxes and user charges could be modified to support more efficient road use, greater neutrality between modes, and full cost recovery, including external and environmental costs. In particular, there is a need to increase annual vehicle taxes on heavy trucks (as well as the diesel tax) in order to cover the road damage which heavy trucks cause, to assure that transit traffic covers its road costs, and to move road/rail competition onto a more “level playing field”. Road taxes should also recover the external costs of congestion, environmental damage, noise, and accidents. The Czech Republic should undertake a road user charges study to identify practical ways to adjust its system of road tax.

2.129 In road transport, there is no economic rationale for subsidizing buses because it encourages the continuation of excess capacity. As with long-distance rail passenger traffic, subsidized fares should be phased out.

Prague Urban Transport

2.130 One of the most visible symptoms of the shift in transport demand has been the growing traffic congestion and pollution problem in the city of Prague, due to motorization. Between 1990 and 1998, the Prague Public Transport Company’s (PPT) number of passengers per workday dropped by 20 percent (see Table 2.11), while road passengers increased by 111


percent. With a cost recovery rate as low as 27 percent, PTT is lacking the resources to improve services. It is recommended that the Municipality increase PPT’s cost recovery rate over a three to five year period to 40-50 percent, close to the average for EU countries.

2.131 The city of Prague should also find ways to charge motorists for the external costs they create in order to correct the currently distorted signals commuters face in choosing between public transport and private auto. A parking program, already initiated by the Municipality, is the most practical method in the short run.66

2.132 In the longer run, that Prague should consider introducing a system of electronic road pricing, with revenues designated for urban transport improvements. Such is now working well in cities like Singapore or Hong Kong. Furthermore, Prague’s system of concessioning bus routes by competitive tender is commendable, and should be extended. It is also recommended that the Municipality and its transport coordinating organization (ROPID) explore ways to increase PPT’s productivity and adjust services in line with demand. Prioritization of traffic signals, done for trams since 1993, should be extended to cover buses, and consideration given to creating a network of bus lanes.

Inland Waterways

2.133 In contrast, one could question the wisdom of continuing to invest in inland waterways. Only 1.45 million tons of international traffic was transported by inland waterways in 1998, and traffic is declining. Still, the 2000-2010 Investment Program includes CZK5.0 billion to deepen sections of the Elbe and Labe rivers to 2.2 m. To be justified, traffic should continue at the 1998 level for 20 years, and this investment should be recovered from users in an amount of at least to CZK172 per ton (not including interest or maintenance expenses). It is doubtful that both conditions could be met.

Air Transport

2.134 In the field of aviation, there is little reason for the Government to participate in the financing future improvements at Prague Airport, or to guarantee Czech Airlines (CSA) aircraft purchases or leases, because these activities are profitable. The government would be better advised to focus on rationalizing CSA operations and consolidating the number of airports. Improvements in labor efficiency could lead to a reduction of about 900 staff, saving some US$10 million per annum. There are currently 13 international and 72 domestic airports in the Czech Republic, which is excessive. It is suggested that the central state authority investigate (i) reducing the number of airports, and (ii) shifting the financial responsibility for most remaining airports to the 14 new regional governments.

66 The responsibility for parking, including enforcement, could be centralized in a single agency, and include existing designated spaces, reserved permit spaces and illegal parking. Coverage areas can be expanded. Additional parking garages and park-and-ride facilities can be built (possibly by concession), and tariffs coordinated with on-street parking and set so as to discourage commuters. Enforcement of illegal parking can be improved.


Cross-Cutting Expenditure Issues

Trans-European Corridors

2.135 The Czech Republic is preparing to join the EU, and the expenditure program is largely oriented towards improving the TEN corridors. The 1997 Pan-European Conference recommended that accession countries spend 2.0 percent of GDP on transport investments, compared to the Czech actual expenditure of 1.2 percent of GDP in 1999. However, (i) there is a substantial road and rail maintenance backlog which needs to be addressed, (ii) road transit traffic (heavy trucks) is unprofitable at present; and (iii) while rail freight transit is marginally profitable, the railway as a whole suffers severe losses. While corridor investments have a role to play, it is recommended that the investment and expenditure program be re-balanced to take other investment priorities into account. It is recommended that railway corridor investments in particular, but also some motorway/expressway and river transport investments, be reassessed because they do not appear to carry enough traffic to justify the proposed level of expenditure.

State Fund for Transport

2.136 The creation of the new transport extrabudgetary fund raises important issues of expenditure management and transparency, which will be discussed more systematically in Part III. For the Transport Fund, one of the major concerns is its large potential to create liabilities for the state. While this extrabudgetary fund seems to have been created as a second-best mechanism to tap the privatization resources of the National Property Fund, the advantage for the transport sector of tapping these resources directly (rather than through the state budget) does not appear to compensate for the additional risks associated with the creation of this fund. It is recommended that these extrabudgetary activities be returned to the state budget.

Expenditure and Program Analysis

2.137 The Czech Republic faces tight resource constraints and large pressing expenditure needs. This means it must bring to bear the most rigorous analysis possible in selecting which programs merit public funding. Public expenditure programs and investments should be assessed by their actual or expected results in meeting the economy’s transport needs as outlined above. In particular they should be subject to an objective, professional assessment that the activity (i) cannot be carried out effectively by the private sector (either alone or in partnership with the public sector through a public service obligation); (ii) has reasonably high returns; and (iii) has a realistic financing plan.

2.138 While cost/benefit studies are usually carried out for major investments, they need to be done more objectively and rigorously as current proposals include a number of questionable activities and do not provide for enough maintenance. It is recommended that the government base its decisions on objective cost/benefit analyses, and that it structure the analysis so that least cost solutions and the trade-offs between rehabilitation/maintenance and new investments are clear. The analysis should also factor in external costs such as environmental impact, pollution, and congestion. The government should put in place institutional arrangements to ensure that expenditure decisions are subject to such systematic and objective analysis. This analysis should


be used in setting budget priorities within the Medium-Term Expenditure Framework and performance budgeting approach discussed further in Part III.

Conclusions

2.139 The reforms proposed above should reduce Government transport expenditures by at least CZK12 billion per annum during the next five years, and by some CZK 33-46 billion annually (or 1.9-2.6 percent of 1998 GDP) between 2006 and 2010, even taking into account substantial increases recommended for maintenance.

2.140 The main priorities in the short term are to:

(a) Reduce and rephase corridor investments for railways and roads (saving at least CZK 12 bn. annually in the next five years, and CZK 24 bn. annually in 2006-2010).

(b) Start a major restructuring of the railways (reducing operating costs on the order of CZK 5 bn. annually for the next five years and CZK 10 bn. annually in the subsequent five years).

(c) Increase road taxes on heavy trucks and diesel fuel (raising revenues by about CZK 5 bn. annually).

(d) Increase passenger tariffs for railways and PPT (savings rising from about CZK 2.8 bn. annually initially to about CZK 5.5 bn. annually in the second five years).

(e) Improve road maintenance efficiency (saving about CZK 1 bn. annually).

(f) Avoid financing Prague Airport or guaranteeing CSA borrowing (saving about CZK 1 bn. Annually. And,

(g) Return the activities of the State Fund for Transport to the normal budget framework.

2.141 These savings would be partly offset by increases in road, railway and urban transport maintenance expenditures (by about CZK 13-14 bn. annually) to reduce the large backlog, and some increased investment in railway restructuring (about CZK 2 bn. annually for the 2001-2005 period only).

2.142 In the medium term, the focus should be on implementing the railway restructuring and divestiture efficiently, for much of the increased savings in the outer years depends on this, especially on the speed with which rail freight and long-distance passenger services are privatized. Other important medium-term measures include developing methods to charge motorists in Prague and other urban areas for the external costs of congestion, and continuing to focus investment expenditures only on the highest priorities.

2.143 As noted above, to realize these savings, it will be important for the government to put in place institutional arrangements to ensure objective and systematic analysis of expenditure


options, and incorporating this analysis in setting budget priorities through the Medium-Term Expenditure Framework and performance budgeting approach outlined in Part III. In addition to reducing fiscal pressures, these reforms and restructuring of expenditure priorities should also bring widespread benefits to the Czech economy by making it more competitive and market oriented, improving the quality and lowering the cost of transport services, facilitating “just-in-time” manufacturing, promoting the development of the service economy, decreasing the cost of trade, and increasing consumer satisfaction.

G. HOUSING

Introduction

2.144 Public expenditures for housing, after declining to less than 3.0 percent of GDP in the mid-1990s, had risen again to about 3.2 percent by the end of the decade and appear poised for a further increase. Yet despite a substantial level of spending and ten years of experimentation with housing sector reforms, the Czech housing program faces serious problems.

2.145 First, substantial public expenditures and implicit subsidies have not generated the outcomes expected. Despite the considerable earlier reform efforts, there has been little induced financing and risk-taking by the private sector. For example, in 1999, residential construction output totaled about CZK60 billion compared with total central and local government budget spending on housing at about the same level (CZK58 billion). In addition, indirect, non-budgeted subsidies (mainly tax preferences other than VAT (0.14 percent of GDP), VAT reductions (0.6 percent), and below market rents for municipal housing (0.7 percent)), generated roughly another CZK24 billion in housing subsidies not reflected in the budget.67 As a result, the government clearly dominates financial flows in housing, and carries many of the risks associated with those flows.

2.146 Second, the housing program has created large and potentially destabilizing budgeted and implicit subsidies and contingent liabilities, that are likely to grow and could threaten macroeconomic stability over time. Government projections indicate that the central government’s budgeted subsidies will nearly double to 1.5 percent of GDP by 2005. The non-budgeted subsidies are also likely to grow as a share of GDP, especially if the housing market picks up. Even more worrying, the newly created State Housing Development Fund will be responsible for the bulk of the projected increase in spending, and will also have authority to make loans to and guarantee loans to municipalities and housing cooperatives. This shift to less transparent expenditure management and greater potential to create contingent liabilities poses serious risks of its own.

2.147 Third, the present range of subsidies is broad, complex and poorly targeted toward different income groups, with the lowest two income quintiles of the population receiving a disproportionately low share of the subsidies. Furthermore, the subsidies are also not always well calibrated for desired outcomes. For example, the large subsidies for Bauspar (the heavily subsidized contractual savings scheme for housing) have generated liquidity for housing loans far in excess of likely demand. While the total residential mortgage portfolio from all lending 67 Of the total budgeted and non-budgeted public spending on housing of roughly CZK82 billion, the central government’s share is about CZK28 billion.


institutions stood at only CZK30 billion at end-1999, Bauspar alone had enough liquidity to provide about CZK50 billion in housing loans.

2.148 The experience with the current mix of programs strongly suggests that a fundamental restructuring is needed before considering any expansion of spending. Housing policy reform efforts currently under consideration should use this experience to develop a focused strategy aimed at improving and expanding the stock of affordable housing by (i) enabling and leveraging the private sector to play a much more dynamic role in housing and mortgage markets, by removing fundamental obstacles to private sector activity; (ii) simplifying and refocusing the many existing subsidies to make them more coherent and better targeted; and (iii) developing a comprehensive divestiture and modernization strategy for the housing stock remaining in the public sector.

2.149 More specifically, the key elements of such a reform would include:

(a) Rent reform. This should be pursued as a high priority, since low rents now severely restrict both private housing demand and blunt the incentives to modernize the current housing stock. Subsidies should be refocused to provide a larger and better designed housing allowance to ease the transition to higher rents.

(b) Divestiture and modernization of public housing. A coherent strategy is needed to privatize the bulk of the remaining public housing stock and to manage and modernize a small core that would remain in the public sector until it also can be privatized.68 All housing policy instruments (e.g., investment, subsidy, or financing/guaranty activity) should be designed to support this strategy. In particular, the program supporting new housing construction by municipalities should be discontinued, as planned, as soon as possible.

(c) Subsidy reform. Subsidies should be refocused to support the objectives identified above (for example, to support rent reform and to match private funds mobilized for the modernization of the stock). The currently excessive Bauspar subsidies could be integrated into such an improved subsidy approach. Tax subsidies, rent advantages and other indirect housing subsidies should be explicitly budgeted, their levels be reduced and/or phased out.

(d) Legal, regulatory, and institutional reform. Like rent reform, this would remove basic constraints on a more dynamic private sector role in housing and its finance. Priorities include deregulation of urban land supply, comprehensive mortgage reform, and privatization of the remaining public mortgage bank.

(e) Extra-budgetary housing fund. In this context, the role of the new State Housing Development Fund should be reassessed and focused on supporting the priority reforms above.

68 A residual part of the public housing stock will be in such poor condition that it cannot be privatized or modernized and maintained would need to be removed from the market.


Rationale for Government Intervention

2.150 The current Czech housing program69 reflects considerable efforts to (i) identify priority areas of the housing sector; (ii) conceptualize housing policy objectives; and (iii) introduce individual housing policy instruments, some of which have been best practice elsewhere in Europe. However, ten years into transition, the government needs to adopt a strategy in which policy instruments are designed to achieve explicit goals in terms of quality, affordable housing. The strategy should focus on the two main justifications for public policy interventions in housing (i) unlocking private sector initiative to provide liquidity and take lender's or owner's risks; and (ii) providing limited, housing subsidies designed to achieve well-defined objectives and well-targeted audiences. Decisions on how to manage the existing stock of public housing at both the central and municipal levels should be an integral part of this strategy.

2.151 While the Housing Policy Concept outlined by the Ministry for Regional Development emphasizes the role of the state in setting the enabling environment for the private sector, and the responsibility of individuals for housing provision, the comprehensive and weakly targeted subsidy program currently in place contradicts this rationale.70 The danger is that a continuation of the current subsidy program, without identifying and subsequently removing the underlying reasons for the sluggish private housing service demand and supply response, may lead to the permanent, costly housing sector interventions which have bedeviled most of Western Europe. This could result in permanent distortions both of intra-sectoral relative prices and user costs of capital, leading to increasing incapacity of the market to react quickly to shifts in the demand structure, which may be triggered by varying tenure preferences, migration, household formation patterns, or income shifts. Entering the European Union without this economic and social burden that is common to its key competitors could prove to be a decisive competitive advantage for the Czech economy.

Policy Recommendations

2.152 Rather than embarking on a program that would increase public spending on housing, the government should focus on designing and implementing a reform strategy aimed at increasing the availability of affordable, quality housing by (i) removing the deep distortions in housing and mortgage markets that inhibit a dynamic and appropriate private sector response; (ii) simplifying and rationalizing the many existing subsidies, focusing them on clear goals and targeting them better; and (iii) establishing a program for managing the stock of public housing through divestiture and selective investment.

Reform Rents

2.153 Over 50 percent of the Czech housing stock is rental housing, so the level of rents is both a decisive price signal for the housing sector and an important element in housing subsidies. Most rents are low and subject to strong controls. Rents averaged about 5-6 percent of household income in 1998 (see Table 2.12), compared with 15-20 percent in Western Europe. A deep rent reform adopting the comparative rent system has first priority, since the current low level of rents severely restricts both private housing demand and incentives to modernize and

69 Including the approaches outlined in the "Housing Concept Paper", Ministry for Regional Development, 1999a.70 See National Response Paper developed for the UN-ECE workshop on Housing Finance in Timisoara, January 2000.


expand the current housing stock. The government's approach to move from strong rent control to a more market-friendly, “comparative rent” system71 is welcome, but some important modifications of the initial concept are needed for successful implementation:

(a) Both public housing rents, and the currently controlled private stock rents should be gradually, but completely, converted to the comparative rent system. If different forms of rent control, such as cost pricing, were used for public housing, new pricing distortions vis-a-vis market rents would emerge, leading to inefficient decisions for both private and public investment.

(b) A transition period may be required. Assuming a conservative 5 percent growth rate in market (contractual) rents over the next years, current rents in Prague would have to grow by 21 percent annually until 2006 in order to reach 70 percent of the market level, a level which may be suitable to allow conversion to a comparative rent system. Market rent growth could be lower, reducing the gap substantially, if additional supply would be generated through a cycle of deregulation and private investment in the current stock.

(c) To support the move to the comparative rent system, and the higher rent levels it implies, it will be necessary to consider raising housing allowances for a transitional period. Similarly, low-income households in public housing could be protected by individualized, discounts from their - varying - market rent levels. Ideally, rent discounts in public housing should be managed in the same way as private rental housing allowances. At the same time, a review of their design should be carried out to ensure appropriate targeting so that there are matching efforts from households, support is limited to achieving basic standards, and the allowance declines over time. The higher rent allowances could be financed from savings from reforms of other subsidies (see below).

Table 2.12: Household Housing Expenditure Structure During the 1990s

1989(CZK)

%1

%2

1996(CZK)

%1

%2

%3

1998(CZK)

%1

%2

%3

RentWater FeesOther Communal ServicesElectricity, Central Heating and FuelMaintenance and Repair

161

254

106

30.9

48.8

20.3

2.7

4.2

1.8

558175114

922

232`

27.98.75.7

46.1

11.6

3.61.10.7

5.9

1.5

19.4

20.2

11.8

1021231152

1392

365

32.37.34.8

44.0

11.5

5.51.20.8

7.5

2.0

35.314.915.5

22.9

25.4Total Housing CostsNet Household Income

5215993

100 8.7100

200115692

100 12.8100

21.214.7

316118589

100 17.0100

25.78.8

1/ Relative to total housing costs.2/ Relative to income.3/ Annualized growth rate over previous observation.Source: Ministry of Regional Development (1999b), mission calculations.

71 The comparative rent is a 'soft' rent control system that essentially defines a permissible distribution of rents over a mean that is moving under market conditions. Its main characteristics are: (i) free setting of rent levels according to the rent level usually applied to similar dwellings in the municipality; (ii) prohibition against setting rents above a certain percentage over average rent levels; (iii) maximum adjustment of rents remains capped by central government; (iv) rent increases otherwise set upon prior contractual agreement and/or new contract; and (v) modernization costs may be rolled over within a pre-specified period.


(d) During the transition to the comparative rent system, rent increases due to modernization should be set as a proportion of agreed investment costs, rather than as a multiple of the rent ceiling. This would allow greater flexibility for the landlords and tenants to agree on the scale of investment and would ease the transition to the comparative rent system.

Establish a Public Housing Divestiture and Modernization Strategy

2.154 A more effective national strategy for dealing with the large stock of public housing72 is needed, focusing on privatizing the bulk of the remaining public housing stock, and managing and modernizing a small core that would remain in the public sector until it too could be privatized. In developing this strategy, it will be useful to divide the public housing stock into three different segments: (i) the majority of the stock, to be privatized with priority - before or after modernization; (ii) a small core social housing stock to be modernized and to remain under public ownership (but preferably not management), for a defined transition phase until it can be privatized; and (iii) a segment to be removed from the market, if it can neither be privatized nor efficiently modernized and maintained.73

2.155 All housing policy instruments (e.g., public investment, subsidies, or, eventually, financing and guarantee activities) should be selected and designed to support this strategy. In particular, the program supporting new public housing construction by municipalities should be discontinued, as planned, as soon as possible. Rather than running a large and high cost public housing stock, public housing subsidies should be refocused to buy occupancy rights for economically vulnerable households in the private or non-profit rental stock. In the interim, investment in the narrowly defined core social housing stock may be required to start the modernization and rent adjustment path. Owners, in particular municipalities, that wish to tap central government modernization programs for funds, should be required to incorporate their operations, demonstrate a sensible track record in operations, and provide a detailed strategy for privatization and modernization. Such privatization strategy could exploit the whole range of possible tenure forms, from new, non-profit tenure forms yet to be created (e.g., cooperatives) to for-profit rental investment by private developers. Alternative public support instruments could be considered, based on limited matching investment grants, to enhance investment in privatized units.

Reform and Refocus Subsidies

2.156 Before considering an increase in housing subsidies, the latter subsidies should be carefully reviewed and refocused to support the type of strategy outlined above (i.e., to support rent reform and to match private funds mobilized to modernize the rental housing stock). The main central government housing subsidies in 1999, both on budget and off budget, are shown in Table 2.13.74 Those explicitly in the budget include: (i) a range of subsidies, mainly for construction at the municipal level; (ii) the "Bauspar" subsidies which boost returns for deposits held by households in the contractual savings schemes for housing; (iii) housing allowances; and 72 Roughly 70-80 percent of rental housing is in some form of non-private ownership.73 Experiences in other transition countries show that the latter stock, mostly badly built large panel housing, will grow gradually due to the combination of declining or negative capital gains relative to other housing forms and low rental yields - even assuming swift rent reform.74 In addition to these central explicit and implicit expenditures of about CZK28 billion, municipalities budgeted about CZK46 billion in 1999, and incurred about CZK12 billion in implicit subsidies in the form of below-market rents.


(iv) interest free loans, largely to the municipalities. The implicit, non-budgeted "expenditures" on housing are foregone tax revenues from (i) the lower VAT rate applied to residential construction (5 percent rather than the usual 22 percent); and, (ii) various tax breaks for mortgage lenders and borrowers. The table also shows as a memo item the subsidy implicit in the below-market rents charged at the municipal level. Taken together, these implicit subsidies amount to nearly 1.5 percent of GDP and, since they represent forgone public revenues, should be subjected to the same kind of analysis and justification as explicit budget outlays.

Table 2.13. Central Government Housing Subsidy Budget and Estimated Total Expenditures, 1999

Central Government MeasurementInstrument Class 1999 Approved Housing

Budget1999 Explicit and Implicit

ExpendituresMain Programs

CZK mn % % of 1998 GDP

CZK mn % of 1998

% of 1998 GDP

Grants Lump sum 1/

Cash Flow

427163502550

28.642.617.1

0.230.350.14

427163502550

15.523.09.2

0.230.350.14

Municipal Housing Construction, Others Bauspar Subsidies Housing Allowances

Foregone Tax Revenue Lump sum1

Cash FlowNot BudgetedNot Budgeted

10200 2478

37.09.0

0.560.14

VAT Reduction for Residential Housing Mortgage Interest Deductibility, Income Tax Exempt Mortgage Bonds

Financial Contracts Loans Guarantees

1750 11.7 0.10 1750 6.3 0.10 State Interest Free Loans

Total Including VAT exemption

14921 100 0.82 1739927599 100

0.961.52

Memorandum Item:Municipal Rental Housing

Not Budgeted

12144 0.67 Below-market rents1. Or predeterminedSource: Ministry of Regional Development (1999a, 1999b) mission calculations and estimates.

2.157 The current mix of subsidies and expenditures has not yielded the results that might have been expected in terms of residential housing output.75 Poland reportedly generates about the same rate of residential housing output with about half the rate of spending.

2.158 Moreover, the budgeted housing subsidies accrue mainly to the middle class, i.e., the third and fourth quintile of the income distribution, rather than to lower income groups. The high share of untargeted subsidies, such as the Bauspar subsidy, drives this result. If current non-budgeted subsidies are considered as well, the incidence shifts even further towards the highest income groups (See Figure 2.4). The main reasons for this result are that the subsidies arising both from the VAT reduction and from mortgage tax preferences to lenders, bondholders and borrowers, are likely to accrue almost entirely to high-income households.76 This picture will not change if housing demand picks up. Not only will the spending incidence worsen because of the dominance of untargeted entitlement programs, but also demand for high quality

75 CZK60 billion in residential output in 1999, compared with implicit and explicit public spending of over CZK80 billion.76 Demand is heavily concentrated in the upper income groups because of the high house-price-to-income ratio, and because there is little construction aimed at small-scale modernization of the existing rent-controlled stock. Even assuming the same level of demand across income segments, low-income households would likely benefit less from the VAT reduction because of (i) smaller construction volumes and (ii) higher levels of self-help or intra-family construction contracts.


high price housing will further rise, potentially increasing the per capita expenditure and crowding out low cost construction from the market.77

2.159 In addition, the present mix of subsidies has led to an excessive build-up of liquidity for housing finance in the Bauspar scheme, and is structured to provide greater subsidies for homeownership over rental housing, and for new rental housing over rehabilitation. The Bauspar subsidies have generated enough liquidity for about CZK50 billion in housing loans, i.e., four to five times the amount needed to finance the annual housing output.78 With rising income, the deposits generated by the high subsidies may eventually be converted into demand. However, under current housing sector distortions, there is risk that increased demand either drive house prices up (if supply does not become more elastic) or fuel an exodus of households with high ability-to-pay out of the multi-family stock, thereby undercutting the modernization objective.

2.160 Better targeting could be achieved by shifting emphasis away from new housing construction and refocusing on rent reform, modernization of the housing stock, and direct housing subsidies for vulnerable households. Development of such a program has priority over expanding the existing program. The currently excessive Bauspar subsidies can be integrated into such an improved subsidy program. Tax subsidies, rent advantages and other indirect housing subsidies should be explicitly budgeted, and their levels reduced and/or phased out under a sunset clause.

Figure 2.4: Estimated Incidence of Budgeted and Non-Budgeted Housing Expenditures 1999,By Household Income Quintile

0

1000

2000

3000

4000

5000

6000

Budgeted

Not Budgeted

Source: Ministry of Regional Development (1999a, 1999b), mission calculations and estimates. See accompanying paper on "Public Expenditure in the Housing Sector" for details.

77 These effects have been the main reason why all large Western European countries have partly or fully abolished mortgage interest deductibility and other tax preferences for housing.78 At the 30 percent financing rate typical of Bauspar loans. Only a small part of the annual housing output is private.


Reassess the Extra-Budgetary Housing Fund

2.161 The role of the extra-budgetary State Housing Development Fund should be reassessed to focus on the strategic issues facing the housing sector outlined above. As recently created, the State Housing Development Fund is designed to tap into the privatization resources of the National Property Fund, add flexibility to the central government housing policy and bring higher leverage to municipal investment by undertaking targeted banking and insurance operations.79 In creating this instrument, the government is seeking to create a long-term source of financing by using extrabudgetary resources for construction of rental houses, technical infrastructure, and remodeling.

2.162 The creation of the state housing fund is a source of concern due to the size and projected rapid growth of its operations and the types of activities it is programmed to do. The Fund is intended to issue guarantees and extend loans as well as manage subsidies. The guarantees will be granted for loans by mortgage and construction savings banks to municipalities and housing cooperatives. The guarantees will be used for financing of the state-subsidized construction, repair and modernization of rental apartments and prefabricated panel buildings. The Fund will also subsidize interest rates for loans granted by mortgage and construction savings (Bauspar) banks to municipalities, housing cooperatives, and individuals for repair of panel buildings, construction of rental apartments, and development of technical infrastructure in municipalities. The Fund’s operations are projected to grow rapidly, by about 43 percent per year between 2001 and 2007 (from 0.16 percent of GDP to 0.8).

2.163 While the legislation on the Fund incorporates some measures to contain risks, significant risks remain. The public housing sector is largely unrestructured, with many municipal housing operations facing financial distress. There are significant risks that a major part of municipal housing assets, notably large panel buildings, will decline in value as household preferences and incomes change. Moreover, the corporate governance conditions for a financially disciplined lending and guarantee operation (including incorporation, technical reserves, regulation, independent financial oversight, clear split of housing policy and financial operations, etc.) are not yet in place. In this environment, a guarantee facility could reduce the incentives for other lenders and borrowers to behave prudently. Thus, the proposed setup has the potential for creating large future unbudgeted state subsidy flows.

2.164 In the current situation, the best approach would be to sequence the activities of the Fund along the following lines: rather than entering into risky lending and guarantee operations, the Fund should focus on delivery of a refocused subsidy program, monitoring and surveying public and non-profit owners, improving the operational performance of municipal and non-profit housing bodies, and designing and implementing privatization and modernization plans. In this way, the Fund could help spearhead the restructuring of the housing sector, helping to create the conditions in which financially sound private sector lending and guarantee operations can function. With this more focused mandate, there would be little need to maintain the fund outside the state budget.

79 The Fund will be administered by the Ministry of Regional Development, with the Minister acting as the chairman of the board. The government will appoint the supervisory board, and the Director of the Fund will manage the operational activities.


Reform Laws, Regulations and Institutions

2.165 In addition, legal and regulatory reforms - in particular deregulation of urban land supply, and comprehensive mortgage and rent reform - would directly remove some of the key reasons inhibiting private sector activity in housing and mortgage supply. Mortgage reform, for instance, would need to create a viable foreclosure system to enable development finance and second mortgage finance. Other key reforms of the mortgage sector include (i) speeding up the privatization of the remaining public mortgage bank; and (ii) phasing out and abolishing the current mix of non-targeted subsidies supporting private mortgage lenders. Successful institutional reform will require not only comprehensive legal and regulatory reform but also improvement of enforcement, notably settlement procedures both in and out-of-court. There is a need also to develop a better regulatory framework and supervision system for both housing and mortgage markets. The impact of the combination of restitution and the limited rent liberalization on new private rental activity since 1993 has shown the potential strength of policies focusing on contractual freedom and legal security to unleash latent housing demand.

Conduct Rigorous Policy and Program Analysis

2.166 Finally, the design of a housing strategy aimed at achieving measurable improvements in the availability of affordable, quality housing on the lines discussed above, will call for considerable preparation and analysis of program and policy options, as well as monitoring of results and modification of approaches as needs dictate. It will be important to identify a focal point for this work and provide it with a well-defined mandate and resources to draw on expertise as needed. In particular, the policies for rent reform need to be carefully designed and sequenced, along with a revised housing allowance. The legal and regulatory frameworks will also need careful preparation, as will divestiture and modernization plans for the public housing stock. The current mix of subsidies should be carefully assessed in terms of the results they achieve for their costs. This assessment should include implicit expenditures as well as budget expenditures. The need for such analysis is likely to continue over time as the economy evolves and new challenges emerge. This focal point could provide the background work for a fiscal management process on the lines recommended in Part III. In that process, housing policies and programs would be subject to the regular discipline of a budget review in which expenditures are assessed against expected and actual outcomes within a Medium-Term Expenditure Framework.

Conclusions

2.167 At present the housing program absorbs substantial resources but is not achieving the desired impact. In the short term, pending the design of a fundamental, medium-term housing sector reform strategy, (i) the public expenditure program for housing should not be increased; (ii) budget support for construction of new municipal public housing should be discontinued; (iii) the Bauspar subsidized saving scheme should be phased out; and (iv) the preferential VAT rate for residential construction should be terminated.

2.168 A revised medium-term reform strategy should be prepared alongside, which would focus on (i) rent reform as a top priority, along with associated reforms of the legal, regulatory, and institutional framework for the housing market; (ii) a coherent strategy for divestiture of the bulk of the public housing stock and modernization and management of a small core remaining stock;


and (iii) a rigorous reassessment of the range of explicit and implicit housing subsidies with a view to reducing them and focusing them more effectively to support the reform strategy (through, for example, transitional subsidies to support rent reform and subsidies targeted for the most vulnerable). The State Housing Development Fund should be refocused on managing the redesigned subsidy program and helping implement the public housing divestiture strategy, rather than on risky lending and guarantee operations, and its activities returned to the normal budget framework.

2.169 A focal point should be designated and provided an adequate mandate and budget to coordinate the analytical, policy design and monitoring work needed to prepare such reforms. This work should be linked to the fiscal management process of performance budgeting within a medium term expenditure framework as described in Part III. Implementing a coherently designed reform program with the elements indicated will not be easy. But the deep distortions in the housing sector currently retard growth and competitiveness not only in the housing sector but also throughout the economy (including as it hinders labor mobility). Their correction will both reduce threats to fiscal stability and put the economy on a more competitive footing as it moves towards EU accession. It will also help to ensure better housing opportunities for the Czech people.

H. CONCLUSIONS

2.170 As noted at the end of Section B, above, this review of sector expenditure programs was not intended to be comprehensive. It does not cover all sectors, only selected sectors that together generate about 80 percent of the Czech Republic’s public spending. While these sectors are important, clearly spending in other sectors, including enterprise subsidies, agriculture, energy, environment and defense, merits similar scrutiny. Nor does this report cover all issues in the selected sectors. Rather, it seeks to illustrate (i) that there is substantial scope to reduce and contain expenditures; but that (ii) this will not be easy, since containing expenditures will mean not just cutting budgets, but also making often deep structural reforms of programs. Though the task is difficult, the result can mean more than an improved fiscal balance. It can also mean greater efficiency for the economy and better services for the people.

2.171 This should not be seen as a one-time exercise. Rather it is likely to become an ongoing process, as policy makers adapt the role of the public sector to confront a constantly changing set of challenges. The Czech Republic has demonstrated a considerable capacity to design and implement reforms in the past, and that capacity should be built on for the future. The sector sections above recommend that this kind of analytic and policy design capacity be maintained and strengthened, and directed toward a continuous effort to improve the focus and effectiveness of public spending. Part III of this report will discuss further some approaches, notably performance budgeting within a medium term expenditure framework, to bringing this capacity to bear systematically on the expenditure and program reform issues that the country faces and will continue to face.

PART III. THE FISCAL MANAGEMENT FRAMEWORK

A. INTRODUCTION

3.1 The restructuring of expenditure programs envisaged above obviously cannot be thought of outside of the institutional framework of public finance under which they will need to be conceived, decided, and implemented. While much progress has already been achieved in this respect, further institutional reforms can help the authorities meet the present challenges and indeed, emerge fortified from them.

3.2 The discussion focuses on three issues. The first is that public finances have evolved in a dualistic manner since the beginning of the transition, with a relatively well-oiled and regulated system of the state budget operating alongside a vast complex of interconnecting extra-budgetary funds and off-balance sheet operations where discretion often prevails and liabilities are assumed without sufficient analysis of options and trade-offs. The parallel coexistence of these two realms tends to obscure the reality of fiscal developments, sometime to the point of leaving the authorities ill aware of mounting risks -- as was the case in the run-up to the banking crisis. This is the topic of the first section below.

3.3 Second, there are considerable rigidities within the state budget itself. They arise primarily from the growing burden of the so-called “mandatory and quasi mandatory expenditures,” i.e., expenditure items arising from legislative or contractual obligations on which the executive branch has little discretion. The presence of these items (which absorb over 80 percent of the 2001 state budget) constricts the government’s room for fiscal maneuvering in the short run. To complicate matters, the budgeting process itself can be mechanistic, paying more attention to inputs and processes than to the services being delivered or the performances expected from them. As a result, the process yields insufficient information to guide budget choices and trade-offs. The two issues (i.e., mandatory expenditures, and budgeting process) will be taken up in turn in the second and third sections, respectively.

3.4 Third, the ongoing decentralization presents both opportunities and risk: opportunities to calibrate better the supply and demand of public services, risks of service delivery disruption, fragmentation of public finances, and over-indebtedness, in particular. The last section below discusses ways to maximize the opportunities, and minimize the risks. In so doing, it draws heavily on the much more comprehensive companion study on local finances in the Czech Republic, which was prepared in parallel with this one.80 This companion study addresses also such important issues as the necessary reforms in revenue assignments and tax sharing, which are not discussed here, and expands on others which are only touched upon in the following paragraphs (e.g., oversight framework, human resource requirements).

3.5 The discussion below will suggest that, to achieve the kinds of expenditure reductions that are needed, it will be useful to (i) take further steps towards consolidating the general government budget and bringing contingent exposures under its oversight; (ii) extend the expenditure programming horizon beyond the annual budget cycle in the context of a medium

80 The interested reader should refer to “Intergovernmental Fiscal Relations in the Czech Republic,” mimeo, World Bank, March 2001.

Part III: The Fiscal Management Framework 77

term expenditure framework; and (iii) move the budget process towards a greater performance orientation. At the local level, the discussion highlights the need to (i) amalgamate smaller municipalities into larger entities, (ii) rationalize inter-governmental transfers, (iii) further regulate municipal borrowing; as well as (iv) organize an orderly transfer of meaningful responsibilities to the newly created, decentralized regions.

B. CONSOLIDATING PUBLIC FINANCES

3.6 A first difficulty is that, under current arrangements, it is not one but two budget systems which must be made to converge towards overall and sectoral objectives.81 Indeed, two parallel fiscal management processes have emerged during the transition:

(a) A formal system centered on the state budget. This formal system deals principally with ongoing financing of government organizations and programs, including the provision of services, operating costs, and various benefit schemes. The financial flows in this sphere are included in the state budget.

(b) A parallel system of interconnecting extrabudgetary funds (see Box 3.1) and transformation institutions (i.e., created to lodge transition costs, such as KoB, see above), feeding primarily on the resources of the National Property Fund (see Table 3.1) and underpinned by the credit of the Czech Republic. Until the recently adopted Law on Budgetary Rules, this system was more loosely regulated than the state budget.

Box 3.1. Extrabudgetary Funds in the Czech Republic

The state funds are governed by the recently adopted Law on Budgetary Rules. Under the Law, the funds have to comply with the same reporting requirements towards the Ministry of Finance as ministries and other state agencies. They have to submit a budget of revenue and expenditure classified according to the budget classification, including the financing of the balance, which is then approved in parliamentCurrently, there are legally eight extra-budgetary funds in the Czech Republic that are included into the government accounts under a category of ‘state funds’ (according to both the ESA and GFS standards):

1. State Environment Fund, 2. State Fund for Soil Fertilization, 3. State Fund of Culture, 4. State Fund for Support and Development of Czech Cinematography, 5. State Fund of Transport Infrastructure (NEW),6. State Housing Development Fund (NEW),

and two privatization funds:7. National Property Fund (NPF), and 8. Czech Land Fund.

In addition to these funds, two budget funds have a specific treatment within the government accounts: 9. State Fund of Market Regulation, recently transformed into State Agriculture Intervention Fund, has been classified in both two

standards as a trade organization and is thus not included among state funds. The revenues are included in the chapter of Ministry of Agriculture and/or General Cash Administration; and

10. Agricultural and Forestry Guarantee and Support Fund (PGRLF) which has been described as a state extra-budgetary fund in the ESA standard, while as a financial institution according to the GFS. After 2001, PGRLF will be classified among other state funds according to both standards. The revenues of PGRLF derive from Ministry of Agriculture. The main sources of revenues of extrabudgetary funds are their own revenues (fees and fines, sales of commodities), state budget subsidies (for administration costs), shared central budget revenues (for example, certain taxes), loan repayments, privatization revenues (transfer from the NPF), and borrowings.Source: Ministry of Finance

81 This section draws on a background paper on “Level and Composition of Government Expenditures.”


Table 3.1. Revenues and Expenditures of State Funds and Two Agriculture Funds, Budget 2001

State Fund for Soil

Fertilization

State Fund for

Environment

State Fund for Culture

State Fund for Cinematography

State Fund for Transportation

State Fund for

Housing Development

Czech Land Fund

National Property

Fund

TOTALSTATEFUNDS1

As a share of State Budget

2001

As a share of GDP 20012

PGRLF State Agriculture Intervention

FundIn millions of CZK In percent In millions of CZK

Total Revenue 2.1 3,279.7 4.7 79.2 31,200.0 6,190.0 650.0 109,600.0 151,005.7 23.2 7.5 2,000.0 4,230.0From state budget 0.0 0.0 0.0 10.0 0.0 0.0 0.0 0.0 10.0 0.0 0.0 2,000.0 4,230.0 From line ministry 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 2,000.0 0.0 From GCA 0.0 0.0 0.0 10.0 0.0 0.0 0.0 0.0 10.0 0.0 0.0 0.0 4,230.0Own revenue 2.1 3,279.7 4.7 69.2 0.0 0.0 650.0 109,600.0 113,605.7 17.5 5.7 0.0 ...From NPF 0.0 0.0 0.0 0.0 13,100.0 5,990.0 0.0 ... 19,090.0 2.9 1.0 0.0 ...Other revenue 0.0 0.0 0.0 0.0 18,100.0 200.0 0.0 0.0 18,300.0 2.8 0.9 0.0 ...

Total Expenditure (including loans)

2.1 3,279.7 0.0 162.8 31,200.0 1,530.0 1,327.0 84,325.0 102,736.6 15.8 5.1 ... ...

BALANCE (including loans)

0.0 0.0 0.0 -83.6 0.0 4,660.0 -677.0 25,275.0 10,084.4 1.6 0.5 ... ...

BALANCE (excluding loans)

-2.1 -494.3 0.0 -83.6 2,500.0 5,660.0 -1,047.0 -83,525.0 -96,082.0 -14.8 -4.8 . .

Note: PGRLF – Support and Guarantee Farmer and Forestry Fund.1/ Consolidated balance between the NPF expenditures and state funds’ revenues.2/ 2001 forecast.Source: Ministry of Finance, State Budget 2001; and the extrabudgetary funds.


3.7 The Czech Government has made great progress during a decade of transition in building the formal system into a highly transparent operation. Transactions have been routinized in procedures for preparing and implementing the annual budget. The government has established a modern budget process, along with timely financial reporting and sound internal controls.82 The formal budget system is fairly stable and predictable, with similar procedures recurring year after year, and with reliable estimates of revenues and expenditures. Clear roles and responsibilities have been defined for the Government, Parliament, the Ministry of Finance, and chapter administrators in preparing and implementing the state budget, and the government has strengthened the capacity of civil servants at the center and in budgetary institutions to carry out assigned tasks.

3.8 The parallel system on the other hand, lacks many of these salutary characteristics. Although each of its components comes under specific legislation, its mode of operation tends to be more ad hoc, responding to crises and pressures rather than to fixed budget routines. Rather than being financed largely through recurring revenue, it is supported by privatization revenue and borrowed funds, often secured with sovereign guarantees. The resources channeled through this system are far from trivial: in 2001, the revenues of the eight state funds are expected to amount to 7.5 percent of GDP, not counting any loan they may take.

3.9 Furthermore, as was noted above, this informal system has led to a significant buildup of contingent liabilities, especially through the issuance of state guarantees. Therefore, rather than dealing with the direct obligations of Government, this informal system is generally driven by contingent and implicit obligations. Much of the money goes to bailing out banks, assisting ailing enterprises and (recently) financing infrastructure investment in certain priority sectors. Unlike the formal budget in which the government’s financial exposure normally is known in advance, in the off-budget system, much of the cost and liability is know retrospectively or when payments come due. Often, as in the case of Konsolidacni Banka, they are open ended, with no limit on the Government’s exposure at the time the commitment is made. When payment comes due, the Government must make good on its prior obligations, and it often does so outside the budget.

3.10 Recourse to extra-budgetary devices has been deemed an appropriate means for promoting the transformation from state enterprise to a market economy and for easing the unavoidable pain of adjustment. But as other countries have learned with the bank bailouts, costs and liabilities that are hidden for good cause do not disappear. In fact, when they impact on state finances, the burden may be significantly higher than if hard choices had been made earlier.

3.11 The new Law on Budgetary Rules takes several steps in the right direction in this respect, including by

(a) Regulating more tightly the creation and operation of extrabudgetary funds (see Box 3.1). For instance, where a government decree used to be sufficient to create institutions authorized to spend public monies, it now takes an act of Parliament;

82 The formal budget system is managed by the Finance Ministry, which issues guidelines on submission of the estimate, compiles the budget submitted to Parliament, and oversees the expenditure of funds. The Finance Ministry has bolstered its role in developing macroeconomic forecasts and in linking economic conditions to budget policies. Its program financing initiative has improved the quality of information available to the government on infrastructure investments and related budgetary issues.


(b) Requiring that guarantees be issued only by vote of Parliament, rather than merely by Government decree, as had been the prevailing practice.

3.12 There is a legitimate question, however, as to whether the new rules are sufficiently comprehensive and airtight. First, the law not only left six extrabudgetary funds standing, but it did not even prevent the creation of two more funds in 2000 in the area of transport and housing (see Part II, sections J and H). This precedent will only serve to whet other appetites. Indeed, while in principle there is a general consensus, based on the experiences with such funds in the Czech Republic and other countries, that the costs of the extra-budgetary activities outweigh the benefits, several more ministries have been contemplating setting up similar funds (e.g., for tourism).

3.13 Similarly, the provision requiring an act of Parliament to authorize new guarantees may be too weak, and should be supplemented as envisaged by more detailed regulation.83 The latter could provide for instance that risk assessment be completed before the commitment is made, that funds be set aside funds in the budget for projected calls on guarantees, that cost or risk be shared with lenders, enterprises, or other risk takers, and that counter-guarantees be required from beneficiaries.

3.14 A key challenge in the adjustment process remains therefore to create a comprehensive budget system that includes all financial commitments and flows. Short of it, the balkanization of public resources is always going to frustrate the overall prioritization in the use of public resources. Such consolidation should not necessarily prevent from separately accounting, if deemed necessary, for privatization revenues and other special transactions within a comprehensive budget framework. But as long as it maintains informal budget arrangements alongside the formal system, the Government will have difficulty enforcing fiscal discipline and achieving efficiency in the allocation of resources.

3.15 The next steps in consolidating public finances could involve:

(a) Bringing transformation institutions and other extra-budgetary funds to the state budget. If the main motive in establishing the housing and transport infrastructure funds was indeed, as is claimed, to exempt them from the budget rule that all unused appropriations expire at the end of the fiscal year, it would be preferable to amend the Law on Budgetary Rules so as to authorize the Government by decree or Parliament by a special law to permit some carryovers and other flexibilities where warranted by the situation.

(b) Completing the ongoing separation of Konsolidacni Banka’s banking activities. As noted above, the Government has submitted to Parliament a proposal to turn KoB into a non-banking institution (Česká konsolidační agentura).84 As this is done, there will no longer be any logical basis for excluding KoB from the state budget or from the accounts of the general government.

83 As different from the legislation which it replaced, the new law on budgetary rules (#218/2000) which entered into force on January 1, 2001 does not specifically regulate the issuance of sovereign guarantees, but refers to the need for a separate law to do so.84 The draft law contains a sunset clause in 2011.


(c) Enacting legislation (or a decree) establishing policies and practices to be followed by all public institutions authorized to issue or manage guarantees. The guidelines should require or encourage risk sharing by recipients of state guarantees, including through counter-guarantees.

(d) Establishing, in the context of the state budget, ceilings not only on the aggregate volume of guarantees authorized each year,85 but also on the amount of guarantees that may be issued by each ministry, agency, or budgetary institution, and the maximum volume of guarantees that may be outstanding for each such entity.

(e) Publishing annual audited financial statements listing all known contingent liabilities. To the extent that information is available, these statements should specify the amounts guaranteed, past payments made pursuant to the guarantees, the firm or other entity receiving the guarantee, the event(s) that may trigger payment, and an estimate of the riskiness of each guarantee.

C. CASTING FISCAL CHOICES IN THE MEDIUM TERM

3.16 A second challenge in redirecting the ship of state is to overcome the built-in inertia of expenditure programs.86 A key reason for existing budget rigidity is that a large part of recurrent expenditures are mandated by legislation or other contractual obligations. Substantial delays are likely to be involved in reducing outlays in these areas. The estimated share of the so-called “mandatory and quasi-mandatory” expenditures has increased in recent years, from 67.8 percent of the state expenditures in 1995 to 81.5 percent in the budget 2001 (see Table 3.2). Being covered by legislative or contractual commitments, mandatory outlays are not easily changed in the course of the annual budget process, due to the time taken to identify, plan, legislate, and implement the changes. This section will argue that up-front policy commitments and medium term frameworks can help tackle this challenge.

85 The new law on budgetary rules also puts an absolute cap on the total approval of sovereign guarantees at 40 percent of approved state budget expenditure.86 This section and next draw on a background paper on “Public Expenditure Management.”


Table 3.2: Mandatory and Quasi-Mandatory Expenditures1995 1996 1997 1998 1999 20001 20012

(billions of CZK and percent)TOTAL (A+B) 293.4 344.1 385.2 425.4 445.8 506.1 530.3As a share of state budget 67.8 71.0 73.4 75.1 74.7 81.0 81.5

As a share of GDP 21.2 21.9 23.1 23.7 24.3 26.7 26.4

A. Mandatory Expenditures 193.7 230.8 266.6 299.6 310.7 335.8 355.1

As a share of state budget 44.8 47.6 50.8 52.9 52.1 53.8 54.6

As a share of GDP 14.0 14.7 16.0 16.7 16.9 17.7 17.7

B. Quasi-Mandatory Expenditures 99.7 113.3 118.6 125.9 135.1 170.3 175.2

As a share of state budget 23.0 23.4 22.6 22.2 22.6 27.3 26.9

As a share of GDP 7.2 7.2 7.1 7.0 7.4 9.0 8.7

Memo: (In billions of CZK)State Revenue 440.0 482.8 509 537.4 567.3 584.9 630.7State Expenditure 432.7 484.4 524.7 566.7 596.9 624.5 650.7

GDP 1,381.1 1,572.3 1,668.8 1,798.3 1,836.3 1,895.0 2,007.0

1/ Preliminary estimates.2/ Budgeted.Source: Ministry of Finance, State Budget 2001.

3.17 What are those mandatory and quasi-mandatory items? Among mandatory expenditures, social transfers absorb the largest share of the state budget, followed by health insurance system and debt service, including calls on sovereign guarantees (e.g., for KoB). Other mandatory expenditures have their background in other legal documents and contractual obligations, but their importance is declining to the point of becoming negligible. Quasi-mandatory expenditures represent another quarter of state budget. By far the largest “quasi-mandatory” item is the payroll of the civil service (accounting for 21.6 percent of mandatory and quasi-mandatory expenditures in the 2001 budget) followed by defense commitments arising from the country’s recent membership in NATO (around 8 percent of total mandatory and quasi-mandatory expenditures in the last two years) followed by ongoing capital expenditures (though their share was halved in the 2001 budget.

3.18 And why are they expanding? Four main factors are at play: (i) the growth of democracy has been accompanied by a greater activism on the part of the legislative branch; (ii) social entitlement programs (especially on pensions) have been drifting upwards, as discussed above; (iii) state guarantees have been massively invoked during the recent banking crisis, as previously discussed also; and finally, sometimes most damagingly, (iv) expenditure reductions in response to the 1997 crisis focussed mainly on non-mandatory items which were easier to cut. This could have contributed to imbalances in public expenditure (e.g., the constraints on O&M referred to above). It is likely that this process has compressed non-mandatory items to levels that will be virtually impossible to cut in the future without unacceptable costs.

3.19 There is a consensus that, to achieve the kinds of expenditure rationalization contemplated in this report, it will be necessary to review and modify the underlying legal and other agreements that govern mandatory and quasi-mandatory expenditures. While the annual budget process is well suited to the provision of funding for existing programs, and marginal adjustments in funding in response to changed activity levels, it is less well suited for a


substantial re-prioritization of outlays. That task requires more thorough analysis of policy and program options than time usually allows when the annual budget is put together as well as more explicit parliamentary support.

3.20 Two factors complicate the task of making changes in legislation governing spending. First, the legislative agenda is already heavy with the many draft laws needed to adopt the European acquis communautaire in time for an early accession. Second, and irrespective of that, the current Czech government is a minority government, and thus has only limited control and influence over the legislative process.

3.21 To regain room for maneuvering in a constrained situation, the remedy adopted by a small but growing number of countries is for the Government to make annual budget decisions within the context of a medium-term expenditure framework (MTEF), or even better in a “Medium Term Fiscal Framework” (because revenues must also be considered, not only expenditures). Box 3.2 clarifies what the concept means.

Box 3.2: What MTEF means

In its basic configuration, a Medium Term Expenditure Framework (MTEF) frames annual budget decisions in terms of the resources available – through current revenue or borrowing – in future budgets. The basic elements of an MTEF include aggregate fiscal constraints set in advance of specific spending bids; baseline (or forward) estimates of the spending contemplated for each of the next several years under approved policies; the allocation of spending targets to each budget chapter; rules for updating the baseline in response to new data or decisions; procedures for trading off between or within budget chapters and for measuring the budgetary impact of proposed or adopted policy changes; and preparation of annual budgets that are consistent with the MTEF.

With an MTEF in place, the government limits budget allocations to the amount it intends to spend in each of the next several years. Moreover, when the government decides the budget for the year immediately ahead, it also decides the amounts that should be spent on account of policy changes in the out-years as well. Although there is no standard time length, the MTEF typically extends two or three years beyond the budget year. The amounts authorized for each year covered by the MTEF comprise the budget baseline (or forward estimates). This baseline is maintained by the Finance Ministry and represents, in budgetary terms, all approved government policy. The baseline is the starting point for each year’s budget cycle. In lengthening the time horizon of the budget, the MTEF also shifts the focus of budget decisions from the details of expenditures to policy changes, and it encourages ministries and budgetary institutions to shift resources from lower to higher priority programs. Budgeting becomes the process by which the baseline is rolled forward, updated, and changed each year.

3.22 The main advantages of looking beyond the annual budget cycle, and of casting budget options, constraints, and strategies in the medium term are: (i) to illuminate the underlying budget dynamics, identify incipient trends, and give time to correct them before they fully set in; (ii) to articulate an overall fiscal strategy in a timeframe where macroeconomic benefits can become visible, and to commit the parties concerned to it; (iii) provide a timeframe in which line departments can articulate meaningful policy change, and in which legislative action, can be phased and be allowed to take effect. This is particularly important in the context of expenditure contraction.

3.23 The new budget rules law manifests the Government’s and Parliament’s conviction that the annual budget does not suffice to manage state finances: it directs the Government to establish a “medium-term budgetary outlook” covering the two years beyond the year for which the budget is submitted, and including projections of state revenues and expenditures, approved financing of asset replacement programs, the surplus or deficit, and a survey of state guarantees.


Abundant reference has already made in Part I to the first such outlook, presented in tandem with the 2001 budget.

3.24 The Government has several other activities underway that may facilitate the transition to an MTEF. One is the preparation and publication of periodic macro-economic forecasts by the Ministry of Finance; another is the development of medium-term plans. The Government has for instance produced a “national programme” for accession to the European Community, itemizing for each budgetary chapter the additional spending that will be undertaken to comply with the acquis. The Government has also established quasi commitments and expectations through election campaign platforms and party manifestoes. These set forth the priorities the Government intends to pursue, and, though they are not legally biding, they do influence debate on the budget and are used from time to time by ministries to mobilize support for additional resources. Moreover, some of the larger, more prominent ministries have prepared multi-year sectoral plans that make a case for additional spending. Finally, the program financing initiative has led the Government to make quasi commitments covering the years required to complete budgeted projects.

3.25 In effect, the Czech Government has many medium-term budget plans but no medium-term budget or any other framework yet within which the various out-year claims are reviewed or compared. The result is that by the time the Government gets around to preparing a new budget, most (in some cases, all) of prospective resources have been claimed or committed, leaving it with little margin for priorities and initiatives.

3.26 Thus, the Czech Government still has to take additional steps in order to reap the benefits in fiscal discipline and allocative efficiency of a true MTEF. Key to this is to transform the current medium term outlook from a prospective exercise into an authoritative budgetary statement of the spending approved under authorized policies for each of the next several years.

3.27 This involves much more than merely lengthening the time horizon of budgeting. To be useful, the MTEF should establish the fiscal boundaries within which the annual budget is made and expenditures are authorized; and span all the financial resources allocated by government. To constrain spending, the MTEF must be approved by the government and be the basis on which budget estimates are prepared and voted. To encompass government finance comprehensively, the MTEF must include all financial flows to or from state entities, including proceeds to and distributions from the National Property Fund, the Konsolidacni Banka, and any extra-budgetary funds established by law. An MTEF will add little value if it is confined to the routine transactions that are now formally included in the state budget. One of the biggest gains from having a medium-term framework would come from incorporating matters that have been excluded from the budget.

3.28 In concept, an MTEF is simple; in application, it entails an array of rules and procedures as well as political engagement and support. The approach will fail, however, if it seen merely as a technocratic exercise in which Ministry of Finance experts specify budget limits. To be useful, the MTEF must become an instrument to commit senior policy makers to common goals, and to share a common vision of strategic priorities across ministries departments. For it to succeed, it must therefore be supported by a similar effort at building expenditure programming capacity in line ministries, as within the budget department. To maintain this strategic value, the


MTEF can remain highly aggregated, with only a sum specified for each budgetary chapter, and perhaps also with amounts set forth for the most important Government initiatives. The detail of expenditure programs, however, can be dealt with on an annual basis in the state budget.

D. MOVING TOWARDS GREATER PERFORMANCE ORIENTATION

3.29 Expenditure rationalization would also be easier if the budget process generated a better sense, not only of where public monies are being spent, but also what is being achieved with them. Such information would also make the difficult trade-offs, which the need for fiscal adjustment makes unavoidable, easier to judge. The Czech state budget unfortunately resembles that in many other countries in that spending tends to vary incrementally from one year to the next. This behavior breeds status quo budgeting: calculating the resources needed to continue existing services, and paying little attention to how the budget might be used to improve the efficiency or quality of public services or what the real trade-offs are in the necessary redeployment of public resources.

3.30 As it seeks to orient the budget toward performance, the government will be well advised to proceed in a pragmatic way. Perhaps the most effective, if cruder, way to start linking resources and services is to specify the activities that will be carried out if the money is forthcoming. Indeed, many countries seeking to inject sophisticated performance measures into policy debate have been stalled by sterile controversy over whether particular indicators are outputs or outcomes. Measuring performance can then become an exercise in taxonomy, and those trapped in this mindset often lose sight of that basic link between the government and its citizens: the services being provided.

3.31 A first step in that process might therefore be to enhance the budget classification in a way that better identifies what services are being rendered. At present, the state budget is structured into more than 30 budgetary chapters, one for each ministry and each central agency. The chapters are the basic unit for compiling the budget, voting appropriations, and managing expenditures. Chapters break down into line items defined by (i) general indicators, common to all chapters (i.e., essentially an economic classification); and (ii) specific indicators, specific to the activity or structure of each budget institution. As presently structured, the specific indicators are too few, too poorly defined, not enough linked with government policies to be of much use to assess and guide performance.

3.32 These specific indicators are nonetheless the place to start anchoring performance measures. A service/activity classification of specific indicators would the way for line departments to identify their main lines of work performed within each budgetary chapter, and possibly within each budgetary institution as well. In performance-oriented budgeting, they would be the main means by which the Government provides budgetary information and guidance on its services and activities. They would be the channels through which information would flow concerning the impact of expenditure policies on the volume, cost, and quality of services.

3.33 A second step would be to integrate gradually performance budgeting with the MTEF initiative discussed earlier. It is highly unlikely that performance budgeting will succeed if it is perceived to be a separate activity that has no bearing on the allocations and priorities decided in


the MTEF. In the suggested activity-based approach to performance budgeting, the budget baseline would for instance number the schools/classrooms to be built and operated under approved policies, and the additional schools and classrooms to be built and operated under proposed or adopted policy changes. It would show similar baselines and adjustments for other major education activities as well as for activities in other sectors. Projected changes in service levels would be estimated for each year covered by the MTEF.

3.34 The creation of a new tier of elected regional governments, and the transfer to them of significant funds and operational responsibilities, which will now be discussed, makes the need for better information on performance all the more compelling. The Czech Republic, like other national governments which have embraced decentralization, is moving toward a situation in which the central government is responsible for producing most public revenue but sub-national governments are responsible for delivering a growing number of public services that most directly affect citizens. When fiscal decentralization is implemented before the government is in a position to define objectives and monitor performance, there is heightened risk that public funds will be poorly used. The launching of new regions should therefore be an opportunity for the Government to define its budgetary expectations in terms of the results to be achieved with public monies.

E. STRENGTHENING LOCAL GOVERNMENT

3.35 Local governments can hardly be ignored in the design of the needed strategy for fiscal consolidation. Do they not absorb resources equivalent to about 10 percent of GDP (see Table 3.3) and spend close to a quarter of consolidated government expenditure (a respectable proportion by European standards)?

Table 3.3: Czech Republic – Structure of Local Government Operations, 1995-2000

3.36 The ongoing decentralization offers an opportunity to calibrate better the supply of public services to local demands and aspirations, hence a chance to enhance the cost-effectiveness trade off in public interventions. Unless properly designed and managed, it may also involve major risks (disruption of services, fragmentation of public interventions, balkanization of public


resources, disparities in access to public services, over-indebtedness). The section below takes stock of recent achievements and puts forward a number of ideas to strengthen them, focusing on the priorities of the day. These are: (i) the consolidation of municipal governments; (ii) a rationalization of inter-governmental transfers; (iii) a tighter oversight of municipal finances, particularly their indebtedness; and (iv) the orderly transfer of meaningful responsibilities to the newly created, decentralized regions. These four topics are now examined in turn.

Consolidating Municipalities

3.37 At the local level, the key issue is the atomization of municipal government. Reflecting a long historical tradition going back to the 19th century, there is a proliferation of municipalities in the Czech Republic. As a result of the consolidation policy pursued under the communist regime, their number declined from about 11,000 in 1951 to 4,100 in 1990. Their number escalated back thereafter however. A blanket repudiation of the previous socialist planning and central control system based on the “national committees”, and of the generally unsuccessful experience with forced amalgamation of smaller communities tried during the 1960s and 1970s both contributed to this phenomenon. In the early 1990s, when popular pressures for more democracy were strong, it was especially difficult to discipline the fiscal decentralization process and contain the creation of new municipalities. As a result by 1999, the Czech Republic was again fragmented into 6,239 municipalities, close to the level reached in the 1960s.

3.38 While this is perhaps a healthy sign for democracy, it is also the case that most municipalities lack the critical size to accomplish much. Currently, 86 percent of the municipalities have fewer than 1500 inhabitants, and 42 percent have fewer than 300 inhabitants (Table 3.4). This has been a major problem for a rational local administration, since the smallest communities do not have enough tax revenue capacity and have been incapable of: (i) retaining qualified staff with the necessary expertise; and (ii) taking advantage of externalities in the consumption and economies of scale in the production of public services (especially utilities). The lack of tax revenue capacity has left small municipalities hard pressed to meet basic local demands. The lack of qualified staff, the small population size, and the absence of an adequate scale for the production of public goods and services may have seriously jeopardized the efficacy of local public service delivery and efficiency of local public expenditures in general. Moreover, small municipalities in the Czech Republic have not yet cooperated or associated enough among them, or outsourced to the private sector enough of the public service delivery to overcome these problems.87

87 The economic downside of municipality fragmentation (lack of administrative capacity, lack of fiscal resources, and lack of realization of scale economies) should be weighted against the potential for increased political accountability. Smallness of communities and the proximity of voters to decision-makers facilitate the identification of local preferences and potentially strengthen political accountability. Against that, of course, is the risk that, because of their small sizes also, smaller municipalities are easy preys for state capture by local elites.


Box 3.3: Structure of Local Government

The 1993 Constitution declared the Czech Republic a sovereign unitary state and established two levels of territorial self-governments: the higher self-governing units (the “regions”), and the basic self-governing units (the “municipalities”). The latter provision was implemented only gradually however, with the regions being only formally created under the Act. No. 347/97, Coll., of December 3, 1997 on Creating Higher Territorial Entireties and on a Change of the Constitutional Law.

Municipalities. Until then, municipalities were for all practical purpose, the only operating bodies of local self-government. They manage their “own” affairs, as defined by the municipal law, as well as “delegated” responsibilities on behalf of the national government. Municipalities have a considerable degree of autonomy with respect to own expenditures financed either by their own local revenue or by non-conditional transfers (i.e., revenue sharing in State taxes). However, in the case of delegated functions, the decision-making power of municipalities is practically non-existent, since “subsidies” are earmarked

Within municipalities, the directly elected Municipal Council exerts ultimate power within the municipal jurisdiction, as established by law. The Municipal Council, the legislative branch of the municipal government, indirectly elects the members of the Municipal Board, which is the municipal executive body. The head of the Municipal Board is the Mayor, who is chosen among the Board’s representative members. The Chief Administrative Officer of the Municipal Board is appointed by the Mayor in consultation with the Municipal Council and (until 2000) the head of the District Office.

As the capital city, Prague enjoys a special status. In addition, Prague and the other three largest municipalities (Brno, Plzen, and Ostrava) also have district status (see below). Thirteen other municipalities of relatively large size, and with economic, social and cultural importance, are the so-called “statutory” towns to which extended delegated competence has been granted by the State. There are also 383 “designated” municipalities which are authorized to perform some delegated State competencies, including some functions on behalf of smaller surrounding communities. The rest are small communities, which have gained the legal status of municipality. Regions. The regions envisaged by the Constitution were originally created as geographical jurisdictions in 1997 under Law 347/1997. In April 2000, Parliament approved Law # 129/2000 which created regional government, with elected representatives. That law became effective on January 1, 2001. The first election for the Regional Assemblies’ representative was held on November 12, 2000, together with the election for one-third of the Senate. The fourteen new regions geographically were basically created around the old thirteen “statutory towns” plus Prague. No expenditure responsibility or revenue sources have been assigned to them as yet.

The Law on Regions defines however the basic administrative structure for regional self-government. This structure includes the Regional Assembly as the legislative body, the Regional Council as its executive body, the President (“hetjman”) of the Regional Assembly, and the Regional Office. Regional representatives directly elected by the population in the region form the Assembly. The Regional Council members and the President of the Assembly are indirectly elected to the Assembly, while officers and staff of the Regional Office are appointed by the Regional Council. The Regional Office can also carry out State-delegated functions, but regional special bodies can be created (by the State) to perform special delegated functions.

The law on regions also provided for the phase out of the former districts by December 31, 2002. These deconcentrated branches of the national government used to play an important role at the local level. The 73 districts offices were in charge of overseeing the implementation of state policies at the local level, and supervising the legality of performance of local authorities (Municipal Council, Board, and Office) on “delegated” functions (Section C). They also coordinated inter-municipal affairs and supported smaller municipalities in the discharge of their duties. District offices also represent some ministerial departments, as territorial divisions of the State administration. The head of the district office was appointed, dismissed by, and reported to the central government (Minister of Interior). The districts also had an Assembly that deliberated and approved the budget and the policy agenda submitted by the district office. The members of the District Assembly were the Mayors (or their Deputies) of municipalities in the district, which ordinarily convened twice a year to approve the district budget and the final accounts. Nevertheless, the District Assembly provided also function as a forum where municipalities could discuss issues of common interest. For example, state transfers to municipalities for the execution of delegated functions were made through the district budget. Also, to a certain extent, the District Assembly was also used for conflict resolution, and as a complement to the Courts, at the district level. It is commonly assumed that these responsibilities will from now on be taken on by the new regions.


3.39 As a result of varying fiscal capacity and expenditure needs, increasing horizontal fiscal disparities have been observed among municipalities. Dislocation of economic activity, worsening conditions in the labor market, and the nature of the tax-sharing system in place until the recent reform of April 2000 are some of the forces behind this trend. In particular, the industrial depression and the economic restructuring efforts since the mid-1990s have led to increased unemployment (e.g., Most, Karvina, Chomutov, and Ostrava-mésto), with serious consequences for the respective local government budgets of decreased tax revenue and increased social assistance needs. On the other hand, the most prosperous industrial and tourist areas (e.g., Plzen, Brno, and Prague) have enjoyed buoyant revenues, gained more fiscal independence, and have even successfully accessed financial markets through bond issues to expand their opportunities for capital investments.

3.40 If decentralization is to live up to expectation of improving public services, it will be indispensable to consolidate the operations of the small municipalities to economically and administratively viable sizes. One option is to put in place incentives (including financial incentives) for smaller communities to merge, wherever possible. The new tax-sharing system intends to provide some incentives for administrative consolidation. It is not certain, however, that the incentives provided by the approved structure of the per capita adjusted coefficients are sufficiently powerful. These incentives are not yet clearly targeted either, as they provide larger municipalities (with 100,000 inhabitants and even bigger) the same incentives to merge as too smaller. One would rather wish that incentives to merge would stop at a point where economies of scale have been internalized for most public services.

Table 3.4: Czech Republic Municipalities(size distribution and adjusted co-efficient)

3.41 Another, not necessarily exclusive, option would be to take advantage of the opportunity presented by the restructuring of the territorial administration and shift some responsibilities of


the small municipalities to the regions or to “designated towns”.88 One can imagine for instance, smaller municipalities being enticed (or directed) to rely on regional administrations to provide public services on their behalf (e.g., road maintenance) or to offload on them the discharge of part of their administrative and financial duties (e.g., accounting). In addition, where straight merger is likely to be bitterly resisted, national authorities could offer other legal vehicles (and incentives) under which municipalities could cooperate, either by creating “supra-municipalities” to pool common services or by joining in operating inter-municipal utilities.

3.42 A combination of both options (i.e., tax incentives and rearrangement of expenditure and administrative assignments) might provide an enticing package for smaller municipalities to consolidate on a voluntary basis. Such package could articulate reform measures such that:

(a) The affected communities realize that the changes make them relatively better-off, both immediately and in the long-term (e.g., a substantially higher “per capita” share in the tax-sharing system;89 an amplified tax-base and revenue capacity; better access to quality services).

(b) The provision of public services become more effective and efficient, as a result of being able to internalize current externalities in consumption and economies of scale in the production of public services (such as water and sewerage treatment, garbage collection).

(c) The changes visibly improve the affected communities’ chances to benefit more directly from EU pre-accession funds.

Revisiting Intergovernmental Transfers

3.43 Against the background (depicted above) of growing disparities among municipalities, two features of the intergovernmental transfer system stand out:

(a) The absence of a clearly defined system of equalization grants at the municipal level. The government may be well advised to review its options in this field before inequalities widen further.

(b) The discretionary nature of many of the existing grants. The discussion below suggests ways to enhance their predictability and transparency.

Horizontal equalization

3.44 Although the new tax-sharing system introduced under the April 2000 reform has significant equalizing features (sharing coefficients calculated on an adjusted per capita basis), it has no other explicit mechanism of equalization grants at the municipal level. There appears to

88 One such financial incentive could for the national government to provide some of the matching funds for EU pre-accession Funds to smaller communities that would decide to amalgamate.89 This kind of incentive should explicitly represent a redistribution of the tax-sharing pool. A small reduction of the shares in the largest municipalities (the municipalities situated in the highest 2 or 3 size brackets) could have a large impact on the mid-lower range of the present tax-sharing distribution (the municipalities between 1,500 and 10,000 inhabitants). The 2000 tax-sharing reform approved by Parliament actually started providing some of these incentives, but should go further. Also, for macroeconomic reasons, it is important that the reform be deficit-neutral. The premise of hard budget constraint is essential in order to avoid moral hazard behavior and keep the reform sustainable.


be no government plan to use any at the new regional level either. What equalization would actually take place in favor of the poorest regions may thus depend primarily on where EU structural funds are directed.

3.45 The potential merits of an explicit equalization scheme can be debated. One reason for its absence at the present time might be that existing disparities in fiscal capacity, while not insignificant are not (yet?) large by international standards, and in particular when compared to other transition countries.90 This is in part because the existing, nation-wide safety net has helped prevent that diverging economic fates translate into commensurate differences in living standards across the country. Disparities would thus be linked as much to difference in sizes as to underlying social conditions.

3.46 On balance, however, the case in favor of some equalization mechanism would seem strong. Such scheme would (i) help redress horizontal imbalances before they get exacerbated; and (ii) deal with them with a specifically tailored instrument, rather than relying exclusively, as now, on the tax sharing arrangements. The way the tax-sharing formula currently works blunts the incentives for smaller municipalities to consolidate (which is desirable for separate reasons, as seen above). This happens often when trying to achieve various objectives with one single instrument. The use of a separate equalization mechanism may prove helpful if the government revised the revenue assignments for municipalities to put greater emphasis on the development of local tax bases.

Rules vs. Discretion

3.47 At present, the Czech Republic operates essentially three transfer programs for local governments91 (see Table 3.5), of which only the first one listed below is non-discretionary:

(a) Categorical Grants financing the full current cost of the central government responsibilities legally delegated to municipalities. In general, these transfers are distributed on a “per client” or “per head” basis and cover expenditures in the areas of social assistance and benefits, kindergarten and primary education,92 selected hospital and assistance institutions, fire brigades, and the execution of general government services, including registration and permits.

(b) Other current grants. Other subsidies are awarded at the discretion of the granting central government agencies and often require matching funds from the municipalities. These subsidies cover a variety of areas, including crime and drug-addiction prevention, environmental issues, and employment and development policies.

90 The aggregate evidence available at the level of NUTS II regions shows that in the period 1995-1997 average revenues per capita from the personal income tax in Prague were 219 percent of the national average while all the other NUTS II regions were below the national average. The lowest standing was for Central Moravia at 79 percent of the national average. Excluding Prague, the other NUTS II regions ranged from 106 percent of the national average for the Southwest and 94 percent for Central Moravia. The differences are less marked for GDP per capita, when also measured at the NUTS II regional level. For 1996, GDP per capita in Prague was 186 percent of the national average and 84 percent in Central Moravia.91 All these grants are earmarked for specific purposes and, in most cases, local governments have to provide separate accounts on their usage.92 These subsidies to schools are exclusive of teacher salaries. The latter are paid directly by the central government to the School Boards at the district level.


(c) Capital grants extended for a variety of purposes, including schools, hospitals, social care facilities, gas distribution, equipment of fire brigades, development of industrial zones, public transport, water and sewerage treatment plants and so on. Municipalities also receive capital transfers from the State Environmental Fund.93 Capital grants are typically discretionary and almost all require matching funds from the municipalities.

3.48 Taken together, these transfers added up to about 19 percent of municipal revenues in 1999.

Table 3.5: Subsidies to Local Governments Budgeted for 2001(Billions of CZK)

CurrentTransfers

Capital transfers

All transfers Share in

total (percent)

Subsidies from Central Government

Subsidies from State Environmental Fund

17.89

0.08

8.01

1.85

25.9

1.93

93.1

6.9

Total transfers 17.97 9.86 27.83 100.0 Source: Ministry of Finance

3.49 This system has many positive features, including the fact that legal mandates are fully funded, and that others require matching funds, and most of all, that in many cases, they are targeted (however successfully) at the delivery of specific public services

3.50 The discretionary grants, however, have also many drawbacks. First, the actual allocation of discretionary grant transfers, including the criteria for eligibility and award is not always transparent. In particular, there is a sense that the award of many of these transfers still depends heavily on political connections and bargaining skills or political power of specific municipalities. Furthermore, the discretionary grants have been a rather unstable source of revenue for local governments, which in turn has damaged the ability of local governments to plan and budget their expenditures in an efficient manner. In addition, funding practices for specific transfers may have created negative incentives for revenue mobilization at the local level if the central government is perceived to have reduced the level of discretionary transfers any time that local governments increased their own revenues. Finally, until recently, there was little transparency of how the system works. For example, the list of subsidy recipients was never published. This is now changing, and the database of the amounts and beneficiaries of central government subsidies is now available on the Ministry of Finance’s website.

3.51 It would therefore seem advisable for the government to conduct an in-depth review of the current system of discretionary grants with the objective to

(a) Generalize the use of formulas for their allocation whenever possible or else use explicit rules for the selection and award of projects. Those rules should also make sure that there is no explicit or implicit claw-back of local revenue efforts.

93 For environmental purposes, including water supply systems and the introduction of gas, flood control, the revitalization of the countryside, and energy conservation measures.


(b) Make transfer funds more predictable for local governments, at least for a period of two or three years within the context of a medium term expenditure framework.

(c) Develop efficiency benchmarks for local public services through periodic cross-municipalities/regions performance evaluations to orient municipal grant programs in the context of the performance budgeting approach proposed above.

Overseeing Municipal Finances

Budget Oversight

3.52 In all appearance, local budget execution has not displayed any major problem.94 Also, pending a more specific enquiry, the level of overall operational efficiency seems to be reasonable, given the current level of budgetary discretion. The widespread use of public bids for the procurement of services may have also contributed to keeping delivery costs reasonably in check and may have lowered opportunities for corruption in the public sector. Low administrative capacity, which is for the most part due to the proliferation of very small municipalities, remains one of the problems at the local level.

3.53 To a large extent, the acceptable budget execution performance of many municipalities may be attributed to the oversight and assistance provided to them, until now, by the District Offices, particularly in the case of the smaller municipalities. The envisaged elimination of the District Offices at the end of 2002 raises the important issue of whether the new regions will be willing to do this same work, and whether they will be able to do so, given that the load or number of municipalities will be much higher per region. Moreover, at least at this initial stage, it is understood that there will be no hierarchical relationship among the self-governing entities, which makes it difficult to exert any oversight by the regions.

3.54 This is an important issue that requires the immediate attention of the government. One option is to find an acceptable way to make the new regional governments responsible for the oversight and assistance to smaller municipalities in budget execution matters. The new regional governments may find it more efficient to contract out these services with private accounting firms. Beyond that, there will be a need to introduce also a new kind of audit that focuses on the evaluation of budget performance, i.e., on the outputs and outcomes from local expenditure programs, based inter alia on the benchmarking exercises mentioned above. These evaluations may be carried out by the local governments themselves and discussed by local councils at the time of presentation of the annual financial audits.

94 In particular, there has been at the local level, at least in recent years, no sequestering of the budget or any reported significant development of budget arrears to suppliers or wage arrears to employees. Local governments are required to send the Ministry of Finance a monthly report on a uniform basis.

Figure F.1: Czech Republic: Municipal Debt Outstanding, 1993-99

0.0

0.5

1.0

1.5

2.0

2.5

1993 1994 1995 1996 1997 1998 1999

% o

f GDP

0.0

10.0

20.0

30.0

40.0

50.0

60.0

% o

f Mun

.Tx.

REv.

% GDP% Mun.Tx.Rv.


Containing Municipal Debt

3.55 Monitoring municipal debt will be similarly important. As is the case in other countries, local governments in the Czech Republic have only limited leeway to expand expenditure beyond the level of their revenues and grants. The single most important instrument available to finance deficits has been through borrowing from commercial sources (banking and non-banking loans and credit, including bond issuing) and non-commercial sources (interest-free or subsidized loans from the State, mainly the Ministry of Finance, and the State Environmental Fund). In addition to their own requirements, municipalities have also often provided guarantees to related bodies (and even businesses) and thereby assumed contingent liabilities.

3.56 Although perhaps not yet excessive in the aggregate, the debt exposure of municipalities has risen substantially since 1992 (zero debt exposure), if one considers that they were only in 1993 were the municipalities allowed to borrow. Their outstanding debt has jumped to 53 percent of municipal tax revenues in 1999 from 11 percent in 1993. This debt corresponds to 2.2 percent of GDP and about 20 percent of the state debt in 1999.

3.57 Although municipal debt is still arguably relatively small to be of any immediate threat to macroeconomic stability,95 and although it has plateaued lately following government intervention, it is rather troubling that it could have grown so fast (more than six-fold) during in the earlier period (see Figure F.1).96 While most of this debt may have been placed with banks and bond markets (especially foreign ones) by large, affluent cities (e.g., Prague, Ostrava, Plzen, Brno, Liberec, Usti nad Labem), there is a concern that a number of smaller and middle-sized municipalities may have borrowed from local banks beyond their capacity to service debt.

3.58 The situation is all the more worrisome that the authorities have only limited capacity to oversee and regulate municipal borrowing, other than through moral suasion. Reflecting their concerns, the Ministry of Finance has since 1997 directed the Exchange Commission to bar new bond-issues, including by local governments in foreign markets,97 and recommended to the municipalities not to increase their debt exposure and warned them that it would stop subsidies to those municipalities that had already reached a 15 percent debt service ratio (regardless the way of borrowing).

95 Even if we assume upper-bound level of 4 or 5 percent of GDP, including contingent liabilities, in the Czech Republic, the level of indebtedness of subnational governments would appear not to be high by international standards. For example, in Germany subnational government debt represented 21 percent of GDP in 1996 and in Australia this figure was 11 percent.96 Note that the apparent stabilization in 1999 of the municipal debt outstanding in relation to GDP (and even a slight drop in relation to municipal tax revenue) might be largely a reflection of one-off developments on the revenue side, such as the result of significant sales of financial assets, which allowed municipalities to cope with their entire financial needs for the year, including debt amortization. In 1999 municipalities also cashed in a substantial part of their stockholder rights in energy distribution companies.97 Only Prague has issued bonds on foreign financial market since then.


3.59 The government should upgrade existing regulations and institutions related to municipal/regional credit markets, for instance by:98

(a) Formally establishing basic parameters for subnational governments to access to capital markets, such as: (i) restricting medium and long term loans to investment projects only; (ii) limiting debt service ratio to subnational governments to say 10 percent; (iii) limiting their debt stock to revenue ratio to perhaps 80 percent.

(b) Formulating a “local government bankruptcy law” which clearly defines resolution procedures in case of municipal/regional government default.

(c) Establishing an official monitoring agency to keep record and to monitor municipal/regional indebtedness, including contingent liabilities.

3.60 As the authorities consider their options in this regard, they may be wise to

(a) Maintain existing administrative restrictions in place, tightening them where appropriate.

(b) Send unambiguous signals to financial markets that municipal debt is not backed either implicitly or explicitly by the national government. One way to pass that message might be to impose suitably conservative loan loss provisioning requirements on municipal debt, as it is held by banks, insurance companies, and other regulated financial institutions.

Setting Regions Off to a Good Start

3.61 The main questions facing the newly created regions (see Box 3.3) are more basic: what will they do? And how will they administer and finance it? Because of the transitional period, no autonomous revenue sources were assigned to the new regions. The general proposition is that the new regions would assume a number of responsibilities currently exercised by the state, either at the national level (e.g., secondary education, inter-city transport, environment, regional planning), or through its district offices (e.g., oversight and support to municipalities).99 Initially, these responsibilities would be discharged on a delegated basis. Over time, some might be properly devolved. The new government structure will be phased-in over a period of two years through December 2002 and during the interim period whatever the new regions do will be fully funded via transfers from the state budget. The method of financing the new regions beyond December 2002, including the assignment of revenues, has not yet been defined.

3.62 While one may have expected somewhat more clarity at the outset, a gradual approach to shaping the functions, responsibilities, and revenue sources of the new regional authorities is sensible. This may avoid major disruptions in service delivery in particular, since the old districts being phased out over the same period will be used as an administrative bridge. In sectors where major, and probably painful restructuring is still needed, such as in secondary

98 Available options are laid in the comprehensive companion study on “Intergovernmental Fiscal Relations in the Czech Republic,” mimeo, World Bank, March 2001.99 Other state functions currently performed by Districts, however, would be absorbed by “designated” municipalities -- which the Minister of Interior intends to reduce to a smaller group of no more than 200.


education, a delegation of authority to the regions, rather than immediate devolution would seem to strike a better balance between a desire to involve local inputs, and the need to maintain the necessary leadership and flexibility at the national level to drive the process; gradual devolution could follow over time, after the system has been reconfigured.

3.63 Still, the decision to organize the election of regional representatives before their mandates are determined is certain to generate tensions, as elected representatives may claim away responsibilities from understandably apprehensive national administrations. The government should therefore strive to minimize the period of limbo, and come to closure as soon as possible on the assignment of responsibilities and autonomous revenue sources to the regions. It will also need to ensure that the important oversight function (previously by districts) over the municipalities is not interrupted. It should furthermore ensure that the new regions do not build bureaucracies afresh, but draw on existing resources (e.g., staff, buildings and other facilities) of national and district administrations.

3.64 Finally, as they proceed with the gradual delegation, then devolution of responsibilities to the regions, the Czech authorities will be well advised to (i) articulate clearly and explicitly the public policy objectives such moves are pursuing; (ii) define up-front the performance indicators which they will monitor in this respect; and (iii) provide opportunities for mid-course corrections, should realities diverge from expectations.

F. CONCLUSIONS

3.65 Institutional reforms in public expenditure management are not a substitute for policy action, nor do they replace hard-thought choices and political consensus building with ready-made, mechanical recipes. But, properly conceived, they can help (i) illuminate the nature of the choices being faced, (ii) create the space needed to deploy policies, (iii) apply public resources where they can be best utilized while mobilizing private and local ones wherever possible to the pursuit of public policy goals, and (iv) generate feedback on the effectiveness and efficiency of public interventions. The discussions highlighted number of practical measures which could help at the national level in this respect, including:

(a) Expanding the medium-term outlook attached to the budget since this year into a full-fledged medium term fiscal framework committing the authorities to a clear strategy to bring down the general government deficit to 1-2 percent of GDP (i.e., the target identified in Part I), and spelling out its implication by major expenditure chapter and items.

(b) Consolidating extra-budgetary funds and transformation institutions (particularly the KoB) within the MTEF and, ultimately within the state budget, and further strengthening applicable regulations on sovereign guarantees.

(c) Anchoring a greater performance orientation in an activity/service based articulation of the state budget.

3.66 The latter initiatives should be supported by complementary measures in the field of local government finances by measures to


(a) Offering suitably enticing incentives and legal frameworks for the voluntary amalgamation of municipalities.

(b) Reorganizing the financial oversight over and support to municipalities (previously provided by the defunct districts) and further regulating municipal borrowing.

(c) Streamlining discretionary grant programs to municipalities by moving toward more formula or rule-based approaches.

(d) Defining a process of gradual delegation, then devolution of meaningful responsibilities (and attending revenues) to the newly created, while maintaining the continuity of public services.

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