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Wages

Wage restraints through a “tax based income policy” was an important feature of the CSFR. Wage restraints ended in 1993, but had to be brought back by the end of the year by the Czech government. The rational behind bringing the restraints back was that market forces were not yet adequate to control wage increases. Wage increases had to remain close to increases in consumer prices to avoid inflationary difficulties. Therefore, as late as 1995, up to 100 percent tax rates were applied to wage increases over allowable limits, effectively keeping wages at desired rates.

Monetary Policy: 1993

By 1993, Czech monetary policy began to stabilize in conjunction with political and economic indications of success. The basic aims of monetary policy at this point were simply to maintain internal and external currency stability. Officials kept the Czech crown pegged to stable European currencies and prevented inflation from rising above 10 percent. In a somewhat disguised blessing, foreign capital flowed into the Czech Republic at high rates in 1994 causing officials to raise reserve requirements from
9 to 12 percent to insure inflationary stability. The banking system, though still flawed, was able to withstand the pressures. The economy certainly welcomed the increased capital.

By 1993 and even more so by 1994, monetary policy was less of a political tool in the reform process. Stability in many respects had been achieved.
The nature of further reform and continued stability relied almost entirely upon fiscal decision-making. To fully understand and appreciate the political economics of reform from 1993 onward, both fiscal and monetary, an examination of the Czech budget is helpful. Defining the role of the state in the new market oriented economy is critical. Two main issues must be examined, the resources and informational capabilities of the state.
Both are limited and both are not independently effective. The budget and the political issues surrounding its passage are important in understanding the Czech approach to stability now that much of the transition has been rather successfully completed.

Intergovernmental Financial Relations

Before the budget analysis, a brief overview of intergovernmental financial relations may be helpful. The Department of Finance makes budgetary estimates for the Ministry of Economy. They regulate spending and essentially decide which organizations and institutions receive the much sought after government subsidies. They are also responsible for government accounting, financial management and regulation of wages. The Department of
Finance is classified under the Ministry’s “Administration and Finance” section.

The Foreign Economic Relations Department, the European Affairs Department and the Economic and Social Policy Department are all included under the
Ministry’s “Economic Policy.” They all report to the Ministry and are essentially charged with the difficult task of improving and encouraging economic development both home and abroad. The Ministry also supports a wide variety of business development departments; Small Business, Business
Promotions, Tourism, etc. Though their interactions, cooperation and communication are limited, they all follow somewhat coordinated general policy initiatives of the Ministry.

The 1993 Budget

The following budget summary is based on the 1993 budget because that was the first budget elaborated as the independent Czech Republic. Before the transition, Czech had one of the more state dominated economies in the CEE.
The state controlled almost all economic activity with government expenditures reaching as high as 65 percent of GDP in 1989.

The 1993 budget focused on a more developed private sector. The budget is fundamentally influenced by tax reform which will be discussed in the following chapter.

Revenues

The 1993 budget is based on three main revenues: the value added and excise taxes (36.9 percent), income tax from legal entities (25 percent) and social insurance (28.5 percent). The new tax system (and total restructuring of public finance to benefit local budgets) reshaped the revenue system and forced budget developers to complete more in-depth estimates of revenue flows. They were forced to make more accurate revenue predictions.

Total revenues in 1993 reached 419 billion crowns (26 Kc per $1USD), of which 343 billion went to the state, 41 billion to local districts and 35 billion to health insurance. Revenue growth was 13.4 percent and local budgets rose 35.2 percent in 1993

Expenditures

A large part of the expenditures for the Republic encompassed transfers to the people. The largest programs are pensions, family allowances and sickness insurance. Social transfers were increased in 1993 to create reserves for expected increases in unemployment. Expenditures on branches of government like health care, for example, increased by 50 percent in
1993, simply responding to demand. A move to create the National Health
Fund was instituted out of a revamped payroll tax and transfers from the central budget to care for the non-working public. The health fund reduced local spending on health care thereby reducing local transfers.
Expenditures on education and culture also increased by a third over 1992 levels. These additional expenditures were partially offset by a new wage tax targeting employers and a combination of the following:

1) Savings in compensatory income support and sickness benefits by a new means tested model;
2) A freeze on subsidies to agriculture, transportation and mining; and
3) Large cutbacks in real investment, including a public housing plan begun in 1992.

Transfers from federal accounts to the Czech government totaled 90 billion crowns, one fifth connected with expiring credits granted abroad and debts owed by the former Czechoslovakian and CSFR government. Debt service is a major component of the 1993 budget. The debt reached 115 billion crowns by
1993. 40 billion crowns were transferred liabilities of the Czechoslovakian
Commercial Bank from operations of the so-called ‘central foreign currency resources’. Total expenditures on debt service reached 23 billion crowns in
1993. Due to its size and proportion of the entire budget, some of those payments were deferred. Eight billion crowns, the total Czech share of the
1992 debt, was financed through state bonds and money from the national property fund. Old debt principals were deferred for a year until 1994.

Tax Reform

The main elements of the systems prior to 1993 included taxes on enterprise surpluses, payroll and turnover. Wage or income taxes existed but were largely insignificant. The main function of the taxes were to transfer enterprise surpluses to the state budget and to sustain the administratively determined price structures. Tax incentives played no role in the economic system.

Sweeping tax reforms dominated the budget for the 1993 year. They included new indirect, direct and property taxes and modification to the payroll tax including a shift in the tax burden from corporate incomes to wage incomes.
From 1992 to 1994, relative to GDP, the share of wage based taxes rose while the share of corporate income tax fell and indirect taxes remained unchanged.

These new direct taxes eliminated earlier distinctions for taxation of businesses based on forms of ownership and employment status. The new system of VAT and excise taxes expanded the coverage of indirect taxes to services. It also mitigated the falling implicit rate in the earlier turnover tax and condensed the range of standard tax rates.
The reforms promoted investment by lowering the cost of capital to businesses. This reform featured a significant reduction in the statutory rate of taxation, standardization and acceleration of allowed depreciation and a 10 percent credit on investment in selected equipment which reduced the dispersion in effective taxes on investment activities. This is how the cost of capital was lowered. The tax allowed the rate of taxation on enterprise profits to drop from 55 to 45 percent.

A personal income tax was also introduced to replace the previous network
(maze?) of taxes on wages of large enterprises, the incomes of artists and authors, and the various forms of income derived from the emerging private sector. The new tax had all wage and self employed income taxes on a progressive scale with marginal rates from 15 to 47 percent, standard deductions and additional deductions allowed for social insurance contributions, children, transportation to work, etc. Interest, dividends and capital gains were subjected to 15 to 25 percent, encouraging investment only slightly. Social security and health taxes on wages of 36 percent from the employer and 13.5 percent employee replaced the old payroll tax of differential rates. Net taxes on gifts, inheritance and motor vehicles were implemented and the import surcharge was eliminated.
Although the system went through amazing changes as outlined above, much of these changes were to no avail.

Tax evasion and avoidance

The problem with this system is that these any tax structures are still relatively easy to get around if one is willing to operate in the shadows.
In the first quarter of 1994, the (23% rate) VAT yield was 30 percent below initial expectations. The corporate and VAT combined barely yield 80 percent of original estimations (one suspects that estimate is high...).
Overall, Czech shadow economic activity, though low, is still significant.
Estimate suggest anywhere between 15 and 25 percent of the economy works in the shadows.

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