Letter from... Czech Republic

It has been a long-debated and controversial issue, but public finance reforms in the Czech Republic will be implemented next year, following a tough political debate. But there are questions about whether the reforms are the right solution.

On 21 August the Czech Parliament approved by a narrow margin a government bill to introduce the first round of public finance reforms, including streamlined personal and corporate income tax and amended VAT rates. Drawn up by a coalition led by the right of centre Civic Democrat party (ODS), the bill aimed to cut public finances and decrease the state budget deficit in line with measures for euro introduction, which the Government hopes will be in 2012. 'The main aims of the reform programme include lowering the public deficit to 2.3% of GDP by 2010 and moderately lowering the overall tax burden,' said Jakub Haas, Ministry of Finance spokesman.

The bill was ratified by President Vaclav Klaus, himself the former head of the ODS, on 5 October. The reforms will come into effect on 1 January 2008, and further measures could be introduced by 2010.

Fundamental changes to the tax system will form a major part of the package and, as in several other central and eastern European countries, a single personal tax rate will replace the current progressive taxation arrangement. Currently, the Czech personal income tax system consists of four bands ranging from 12% to 32%. The tax rate will be changed to 15% in 2008 and 12.5% in 2009. At the same time, new ways of calculating personal income tax will be introduced in 2008, with the 15% tax rate calculated based on 'super gross income', i.e. the employer's part of social and health insurance contributions, added to gross income.

Corporate tax will be lowered from the existing 24% to 21% in 2008, 20% in 2009 and 19% in 2010. The lower VAT rate will be increased from 5% to 9%, which will raise prices of certain goods and services. In addition, the benefits system will be trimmed back, with reductions among other things in sickness benefit, and stricter rules governing the payments of unemployment benefit.

The new measures are seen as the first step in addressing the deficit. 'I believe the reforms will at least start a positive trend,' said Marketa Sichtarova, director of Prague-based financial consultancy Next Finance. Miroslav Singer, vice governor of the Czech National Bank, said that the measures will be 'mildly positive in terms of percentage points of the deficit measured in GDP'.

At first sight, the simplified tax system looks good for individuals and companies, who should save money under the new system. In reality, most individuals, apart from the highest earners, will see relatively little change, and what many individuals gain in tax cuts will be offset through increased VAT. In addition, for companies, the tax system is made complicated by tax exemptions and tax deductibles, making the tax cuts less attractive than they appear.

The new corporate tax rate will be an incentive for companies to stay in the Czech Republic, but 'there are many provisions in the Income Tax Act which change many of the tax deductible costs to non-tax deductible costs, and thus extend the tax base of the taxpayer,' said Apolonia Platekova, a tax consultant at international audit consulting group Mazars.

And although taxes will be cut, many analysts argue that the public finance reforms simply do not go far enough. 'The budget deficit should be probably reduced, but we feel that more profound changes are needed to improve public finances significantly,' said Platekova.

Some analysts claim that the biggest problem of the public finance reforms is that they focus on changing the tax structure rather than cutting spending. They argue instead for reduced state benefits first and then taxes to be cut. Pavel Mertlík, chief economist at Raiffeisenbank in the Czech Republic, notes that the Government can take advantage of increased tax revenue through measures such as increased VAT, in 2008, but decreased tax revenues in 2009–2010 will lead to serious difficulties in these two years. Stringent expenditure cuts will then be needed to meet the Convergence Programme's fiscal targets. 'Not an easy task in the pre-election period,' he said.

As the 2010 election and Czech entry to the euro approaches, the reform issue in particular is likely to become pressing. Doubts have been expressed in some quarters about whether the Czech Republic can meet its euro target without more reforms. Other economists take a different view, noting that the Czech Republic is meeting its Maastricht criteria and could meet its euro introduction target, but they say that pension reform, for example, which has not been addressed must be resolved, among other things.

But regardless of which approach is adopted in trying to balance the budget and reduce spending, bold government reform plans are subject to the parliamentary voting system, and the current Government has a very slim majority, making its room for manoeuvre difficult. 'The Government has probably done the most that it can under the circumstances, and the political optimum is different from the economic optimum,' said Sichtarova.

David Creighton is a freelance journalist and regular contributor to Czech Business Weekly.