A World Bank Country Study

A WORLD BANK COUNTRY STUDY

Czech Republic

Enhancing the Prospects for Growth with Fiscal Stability

Public Expenditure Review

March 2001

vi

TABLE OF CONTENTS

ACKNOWLEDGEMENTS iii

EXECUTIVE SUMMARY vii

PART I. THE STRATEGIC SETTING 1

A. Introduction 1

B. Macroeconomic Context 2

C. The Fiscal Picture 5

D. The Medium-Term Outlook 15

E. Conclusions 18

PART II. EXPENDITURE REFORM OPPORTUNITIES 19

A. Introduction 19

B. Bank Restructuring 20

C. Social Protection Programs 25

D. Health 38

E. Education 47

F. Transport 58

G. Housing 66

H. Conclusions 75

PART III. THE FISCAL MANAGEMENT FRAMEWORK 76

A. Introduction 76

B. Consolidating Public Finances 77

C. Casting Fiscal Choices in the Medium Term 81

D. Moving towards Greater Performance Orientation 85

E. Strengthening Local Government 86

F. Conclusions 96

Tables

Figures

Boxes

Annexes

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, 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, CeskaSporitelna, 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 TinaMlakar who provided excellent research support and to Dolly Teju and Anita Correa for their outstanding work processing this report.

vi

WEIGHTS AND MEASURES

Metric System

ACRONYMS AND ABBREVIATIONS

vi

AADT Average Annual Daily Traffic

BOT Build, Operate and Transfer

CAA Czech Airports Authority

CBC Cross Border Cooperationn

CR Czech Railways

CDJSC CD Joint-stock company

CEE Central and Eastern Europe

CEECs Central and Eastern European Countries

CEFTA Central European Free Trade Agreement

CEZ Ceske Energeticke zavody

CIMTO Center for Information and Mechanically Tested Packaging

CIT Corporate Income Tax

CNB Czech National Bank

CLF Czech Land Fund

CompR Comparative Rent

ContR Contractual Rent

CostR Cost Rent

CPI Consumer Price Index

CR Czech Republic

CSA Czech Airlines

CSO Czech Statistical Office

CSOB Ceskoslovenska Obchodni Banka

CSSZ Czech Administration of Social Insurance

CZK Czech Crown

DEM German Mark

DRG Diagnostic Related Group

EBF Extra-Budgetary Fund

EC European Commission

EIB European Investment Bank

ERP Electronic Road Pricing

EU European Union

EURO European Currency Unit

FDI Foreign Direct Investment

FIFO First-in First-out

GCA General Cash Administration

GDP Gross Domestic Product

GFS Government Fiscal Statistics

GHIC General Health Insurance Company

GNP Gross National Product

GPs General Practitioners

GS Goods and Services

IFIs International Financial Institutions

IMF International Monetary Fund

IMR Infant Mortality Rate

IPB Investicni A Postovni Banka

IPPC Integrated Pollution Prevention and Control

ISPA Instrument for Structural Policies for Pre-Accession

KB Komercni Banka

KoB Konsolidacni Banka

LHS Left Hand Side

MBR Maximum Basic Rent

MIS Management Information System

MLS Minimum Living Standard

MLSA Ministry of Labor and Social Affairs

MoF Ministry of Finance

MoRD Ministry of Regional Development

MoT Ministry of Transport

MSMT Ministerstvo skolstvi, mladeze a telovychovy

MTC Ministry of Transport and Communication

MTEF Medium Term Expenditure Framework

NATO North Atlantic Treaty Organization

vi

NGOs Non-governmental Organizations

NL Net Lending

NPAA National Program for the Adoption of the Acquis

NPF National Property Fund

O&M Operation and Maintenance

O/w Of Which

OECD Organization for Economic Co- operation & Development

PAYG Pay-As-You-Go

PGRLF Agricultural and Forestry Guarantee and Support Fund

PHARE Poland Hungary Assistance for Economic Reconstruction

PIT Personal Income Tax

PPI Producers Price Index

PPT Prague Public Transport

vi

PRIBOR Prague Inter-banking Offer Rate

PSOs Public Service Obligations

R&D Research and Development

RHS Right Hand Side

RMD Roads and Motorways Directorate

ROPID Prague Transport Coordination

Organization

RUC Road User Charges

SAPARD Special Accession Program for Agriculture and Rural Development

SEF State Environment Fund

SFA State Financial Assets

SGP Stability and Growth Pact

SIC Social Insurance Corporation

STIF State Transport Infrastructure Fund

STS Secondary Technical Schools

SVS Secondary Vocational Schools

TEN Trans-European Network

TF Transport Fund

TRS Traction and Rolling Stock

UB Unemployment Benefit

UK United Kingdom

ULC Unit Labor Cost

US United States

USAID United States Agency for International Development

USD United States Dollars

VAT Value Added Tax

WB World Bank

WTO World Trade Organization

vi

Fiscal Year

January 1 to December 31

Vice President: / Johannes Linn
Country Director: / Roger Grawe
Sector Director / Pradeep Mitra
Sector Leader: / Kyle Peters
Team Leader; / Carlos Silva-Jauregui

Executive Summary xv

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.

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.