report no. 22114-cz czech republic enhancing the prospects...

Report No. 22114-CZ

Czech RepublicEnhancing the Prospects for Growthwith Fiscal StabilityApril 2001

Poverty Reduction and Economic Management UnitEurope and Central Asia Region

Document of the World Bank

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CURRENCY EQUIVALENTS

Currency Unit = Czech Koruna (CZK)

US$1 =CZK 38.84Euro 1 = CZK 34.47

(as of March 30, 2001)

ACRONYMS AND ABBREVIATIONS

CEZ Ceske Energeticke zavodyCNB Czech National BankCLF Czech Land FundCPI Consumer Price IndexCR Czech RepublicCSA Czech AirlinesCSO Czech Statistical OfficeCSOB Ceskoslovenska Obchodni BankaCSSZ Czech Administration of Social InsuranceCZK Czech CrownDEM German MarkEC European CommissionEIB European Investment BankEU European UnionEURO European CurTency UnitFDI Foreign Direct InvestmentGCA General Cash AdministrationGDP Gross Domestic ProductGFS Government Fiscal StatisticsGHIC General Health Insurance CompanyGNP Gross National ProductIMF International Monetary FundIPB Investicni A Postovni BankaKB Komercni BankaKoB Konsolidacni BankaMLS Minimum Living StandardMLSA Ministry of Labor and Social AffairsMoF Ministry of Finance

Fiscal Year

January 1 to December 31

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

MTC Ministry of Transport and CommunicationMTEF Medium Term Expenditure FrameworkNGOs Non-governmental OrganizationsNPAA National Program for the Adoption of the AcquisNPF National Property FundNPL Non-performing LoansO&M Operation and MaintenanceOECD Organization for Economic Co-operation & DevelopmentPAYG Pay-As-You-GoPER Public Expenditure ReviewPGRLF Agricultural and Forestry Guarantee and Support FundPIT Personal Income TaxPPI Producers Price IndexPPT Prague Public TransportPRIBOR Prague Inter-banking Offer RatePSOs Public Service ObligationsROPID Prague Transport Coordination OrganizationSAPARD Special Accession Program for Agriculture and Rural DevelopmentSEF State Environment FundSFA State Financial AssetsSGP Stability and Growth PactSIC Social Insurance CorporationSTIF State Transport Infrastructure FundUTK United KingdomuS United StatesUSAID United States Agency for International DevelopmentUSD United States DollarsVAT Value Added TaxWB World BankWTO World Trade Organization

CONTENTS

CURRENCY EQUIVALENTS

ACRONYMS AND ABBREVIATIONS

ACKNOWLEDGEMENTS

EXECUTIVE SUMMARY ................... v

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

2. EXPENDITURE REFORM OPPORTUNITIES . .19A. Introduction .19B. Bank Restructuring .20C. Social Protection Programs .25D. Health 38E. Education 47F. Transport 58G. Housing 67H. Conclusions .. 76

3. THE FISCAL MANAGEMENT FRAMEWORK . .79A. Introduction .79B. Consolidating Public Finances .80C. Casting Fiscal Choices in the Medium Term .83D. Moving towards Greater Performance Orientation .87E. Strengthening Local Government .88F. Conclusions .98

Tables

Table 1.1: Key Economic Indicators .3Table 1.2: Non-Performing Loans in Central and Eastem European Countries .4Table 1.3: Economic Indicators in Selected Countries, 1993-2000 .5Table 1.4: General Government Revenues and Expendituresok .7Table 1.5: General Government Expenditures by Function .8Table 1.6: General Government Expenditures in OECD Countries, 1998 .9Table 1.7: Financing of the National Program for the Adoption of the Acquis, 2000-2002 . 12Table 1.8: Decomposition of the Fiscal Deficit .14Table 1.9: General Government Deficits under Different Scenarios, 1998-2003 .16Table 2.2: General Government Transfers to Bank Restructuring Institutions .23Table 2.3: State Budget Expenditure on Social Protection Programs .26Table 2.4: MLS for Representative Households in Comparison with Average Net Wage . 34Table 2.5: Child Allowance and Social Supplement, 1998 .35

Table 2.6: Index of Infant Mortality Rate in Selected Central European Countries ........................ 39Table 2.7: Health Care Spending, 1993-2000 ............................................................... 41Table 2.8: Stocks of Liabilities and Receivables of Health Insurance Companies .......................... 42Table 2.9: Enrollment by School Level and Ownership, 1989-1998 ............................................... 50Table 2.10: Structure of Expenditure on Education by Type of School . .......................................... 53Table 2.11: Trends in Goods and Passenger Transport .................................................................... 59Table 2.12: Proposed Investments in the TEN Railway Corridors .................................................. 64Table 2.13: Proposed Investments in Motorways and Expressways . ............................................... 65Table 2.14: Household Housing Expenditure Structure ......................................... 71Table 2.15: Central Government Housing Subsidy Budget and Estimated Total

Expenditures, 1999 ............................................................... 73Table 3.1: Revenues and Expenditures of State Funds and Two Agriculture Funds,

Budget 2001 ............................................................... 81Table 3.2: Mandated and Quasi-Mandated Expenditures ............................................................... 85Table 3.3: Structure of Local Government Operations, 1995-2000 ................................................. 89Table 3.1: Czech Republic Municipalities (Size distribution and adjusted co-efficient) ................. 92Table 3.5: Subsidies to Local Governments Budgeted for 2001 ...................................................... 95

Boxes

Box 1.1: Definitions in Fiscal Statistics of the Czech Republic ......................................................... 6Box 2.1: The Role of the Konsolidacni Banka (KoB) ............................................................... 21Box 3.2: What MTEF means ............................................................... 86Box 3.3: Structure of Local Government ............................................................... 91

Figures

Figure 2.1: Pension Increases Since 1993 ............................................................... 28Figure 2.2: MLS and Average Net Wage (1993-1999) ............................................................... 34Figure 2.3: Level and Composition of GHIC Spending ............................................................... 43Figure 2.4: Estimated Incidence of Budgeted and Non-Budgeted Housing Expenditures,

1999, By Household Income Quintile ............................................................... 74Figure F. 1: Czech Republic: Municipal Debt Outstanding, 1993-99 .97

ACKNOWLEDGEMENTS

This Public Expenditure Review (PER) is based on the findings of several missions thatvisited the Czech Republic throughout 2000. The report analyzes public expendituredevelopments 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 closecollaboration with various ministries and agencies of the Czech Republic, as well as with NGOsand international institutions such as the European Commission. In particular, the PER benefitedfrom the extensive discussions with the Ministry of Finance (MoF). While the MoF was theprincipal partner on the Czech side, the collaboration with almost all line ministries and a largenumber of state agencies greatly improved ours and their understanding of the real fiscal stanceand the challenges that the Czech authorities are facing and will face in the future. This closecollaboration with the Czech authorities has proven to be essential in the preparation of a reportlike this.

The World Bank team was composed of Carlos Silva-Jauregui (team leader), GeoffDixon (public expenditure management), Achim Duebel (housing sector), William J. Hyden(transport sector), William G. Jack (health sector), Stepan Jurajda (education sector), ElenaKatlerova (transport sector), Jorge Martinez (intergovernmental fiscal relationships), TinaMlakar (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). Rossana Polastri and Zhicheng Li alsomade contributions. 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 forImplementing Medium-Term and Performance-Oriented Budgeting in the Czech Republic"(mimeo, September 2000) as well as on an ongoing study by the International Monetary Fundentitled "Developing Policy Frameworks in Central Europe on the Road to EU Accession."(forthcoming) which covers inter alia the Czech Republic. The report finally refers to acompanion study by the World Bank on "Intergovernmental Fiscal Relations in the CzechRepublic" (mimeo, March 2001).

The team benefited from the effective and very close collaboration with governmentofficials, in particular with Deputy Prime Minister and Minister of Finance Mr. Pavel Mertlikand his teams at both the Ministry of Finance and the Deputy Prime Minister's Office. Missionmembers had the opportunity to discuss the main findings of the different topics and sectorsanalyzed with government officials at the Office of the Deputy Prime Minister, Czech NationalBank, Ministry of Agriculture, Ministry of Industry and Trade, Ministry of Interior, Ministry ofEnvironment, Ministry of Labor and Social Affairs, Ministry of Health, Ministry of Finance,Ministry of Education, Ministry of Regional Development, Ministry of Transport andCommunications, National Property Fund, Czech Statistical Office, Supreme Audit Office,Czech Railways, Czech Parliament, Kosolidacni Banka, Revitalization Agency, State HealthInsurance Company and the sub-national government officials in Prague City, Most, KarlovyVary and Plzen.

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

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

The authors would 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 andfriendly discussions. Their cooperation made this report possible. In particular, special thanksare due to Lenka Loudova, Ales Satanek, Dimitrij Loula, and Veronika Znamenackova from theDepartment of International Financial Relations, Ministry of Finance, for their effective supportand organization of the multiple mission agendas. Very special thanks to Mrs. DrahomiraVaskova of the Ministry of Finance and her team for the support and guidance during thepreparation of this report. Mrs. Vaskova's constant drive to improve the government'sunderstanding of the fiscal stance and the implied fiscal risks was a key engine driving the scopeof this analysis. Many thanks also to Milos Vecera, IFC representative in Prague, for hishospitality and support to mission members during the preparation of this report and to ourcolleagues at the IMF and the EU for close collaboration. Finally, special thanks to Tina Mlakarwho provided excellent research support and to Dolly Teju and Anita Correa for theiroutstanding work processing this report.

EXECUTIVE SUMMARY

The Strategic Setting

1. The policies introduced since the 1997 crisis have met with initial success. For the firsttime since 1996, the Czech economy expanded in 2000 (by an estimated 2.7 percent) and therecovery should gather momentum in 2001 and beyond. As its pace accelerates, newemployment opportunities are developing and the unemployment rate is beginning to recede.Furthermore, sizable foreign investment (close to US$3 billion in the first three quarters of2000), in addition to facilitating economic restructuring, also bodes well for the sustainability ofsmall external current account deficits associated with private investment-led economicexpansion.

2. At this stage, the main potential threat to the recovery arises from the deteriorating fiscalsituation. Partly as a result of the crisis, and partly due to structural reasons, the overall balanceof the general government has turned around from a surplus in 1993 to a 3.7 percent of GDPdeficit in 2000. Netting out extraordinary items (such as privatization receipts and bankrestructuring costs) gives perhaps a better appreciation of the underlying dynamics. From abalanced situation in 1993, the deficit excluding such items ballooned to an estimated 4.8 percentof 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 deficitcould perhaps be looked at as the normal operation of automatic stabilizers. With the ongoingeconomic recovery, however, the main focus of fiscal policy should shift to maintaining theexternal current account within bounds as private capital inflows resume and private domesticdemand picks up. Unfortunately, as the pace of economic recovery began to pick up, it alsobecame plain that the observed government deficits were not merely cyclical, but to a largeextent were structural in nature, and that as such they hampered the adjustment of the fiscalstance to the changing macroeconomic circumstances. The widening of the external accountdeficit in 2000 to 4.8 percent of GDP - alongside the widening of the fiscal deficit -- callsattention to the urgent need for the authorities to regain room for fiscal maneuvering.

4. Furthermore, as the Czech Republic has made joining the European Union the centralthrust of its strategy, it will also need at some point to prepare for the discipline of the EU'sStability 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, itwould seem wise to start moving fiscal policy in their direction, rather than to diverge fromthem, as has been the case lately.

5. With these two considerations in mind (i.e., short-term demand management, longer-termconvergence within the EU), the report suggests that an appropriate medium-term target forfiscal policy would be to bring down the overall deficit of the general government (net ofextraordinary items) to 1-2 percent of GDP, as an intermediate step towards SGP objectives. Italso 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 orshould lead to increasing the ratio of fiscal revenue to GDP further. The Czech Republic alreadycompares on that score to Germnany or the United Kingdom, and exceeds by several percentagepoints of GDP the ratios recorded in the so-called cohesion countries (i.e., Spain, Ireland, Greeceand Portugal). Worse, wage taxes already bear down heavily on labor (at 47.5 percent of grosslabor income, they are twice as high as the OECD average), and should be reduced instead tostimulate 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 expenditureshave shot up by 5 percent of GDP in the last three years, up to 45 percent of GDP, a level thatlargely exceeds those observed in comparable countries. Furthermore, they are set to rise furtherin 2001, as most categories of expenditure (e.g., social entitlements, housing, and transport) seemlocked in upward trajectories. Fresh spending pressures arising from EU accession, contingentliabilities, or decentralization might exacerbate tensions.

8. The main purpose of the report is to help the authorities take up this expenditureadjustment challenge in a way that makes the best of potential efficiency gains, while limitingthe 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, thereport seeks to illustrate, for selected sectors: (i) the nature of the issues which will need to bedealt with to bring about a sustainable reduction in spending while maintaining or increasing theeffectiveness of the public sector; as well as (ii) the nature of the dialogue that will need to takeplace 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 expenditurereform needs to be firmly grounded in the development of analytic capacities in both core andline agencies, linked with enhancements in the country's institutions and procedures for fiscalmanagement. These enhancements include continued improvements in the measurement andscope of government accounts, the development of a more systematic medium-term approach tofiscal 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 asthey seek to contain expenditures while making them more effective, the report focuses on sixselected 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 80percent of public spending) and the services they bring to the Czech people, and because it isdifficult to see how the needed expenditure adjustments can be achieved without substantialreforms in most of these areas. However, it must be emphasized that other expenditure areas notdiscussed 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 tonon-financial enterprises amounted to more than 16 percent of public spending in 1999, andclearly should be carefully reviewed.

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11. Cost of Bank Restructuring. In the short run, one of the largest fiscal burdens arisesfrom the cost of the bank bailouts that had to be undertaken to stave off the financial crisis. Thecost of these bailouts is resulting in a step-increase in the public debt (borne either directly by thegovernment 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 bailoutsmay well turn out to be as high as 15 percent of GDP. Unfortunately, this is the legacy of pastexcesses 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 ofthe bailouts, while, as was shown in the case of 1PB, privatizing banks "as is" may not attractstrategic investors able and motivated to turn failed banks around. Furthermore, there is goodreason to hope that, once the canker of bad loans is removed, banks would find greater appetiteto lend again, thereby helping the economy grow out of its current travails.

12. The Government should therefore remain focused on expediting the resolution of the "olddebt" 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 asset disposal methods, with KoB focusing on thefew large debtors and leaving the responsibility for dealing with the 12,000 or sosmaller delinquent debtors to experienced financial institutions and otherindependent agents.

(c) Improving the legal framework for debt resolution will promote restructuring offirms as well as the exit of non-viable enterprises. Not only would this improveKoB's recovery rate, it would also: (i) increase the confidence and interest of theinvestors to participate in the asset recovery process; and (ii) help privatecommercial 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 arerecovered 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 tocontain costs, establish financial sustainability, improve poverty focus, and reduce disincentivesto work. The state pension program in particular faces serious financial difficulties. The ratio ofpensioners to contributors has risen from around 0.47 in 1994 to 0.53 in 1998, and, withoutadditional reforms, is projected to reach over 0.6 by 2010 and continue rising to 0.7 by 2030. Asa result, the gap between pension outlays and contributions (already over 9 percent of pensionoutlays 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 thegradual increase in the statutory age for retirement. Some limited savings can be expected in theshort run without amending pension legislation. As a short-term stopgap, the authorities shouldconsider indexing pensions only by the minimum level required by law and continuing to keep

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the "flat" part of pension benefits constant in nominal terms, as has been done since 1998. Inaddition, steps should be taken now to amend the legislation to adjust some of the policyparameters in the coming year to improve the financial position of the PAYG system. The reportrecommends, among others, to:

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

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

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

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

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

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

18. Health. The health sector has undergone a radical transformation since 1990. Reformshave converted a centralized bureaucratic system into a group of largely decentralizedinstitutions that provide insurance and health care services. These reforms, combined withgeneral improvements in the economy, are associated with significant improvements in healthoutcomes: since 1990, life expectancy rose from 71 years to 74 in 1998, and infant mortalitydropped 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 thehigh side, as it exceeds by about 2 percent of GDP the levels observed in other countries withsimilar income levels and population age structures. This suggests some scope for containingexpenditures. At present, there is, for instance, little incentive on the consumer side to containcosts. Imbalances (though reduced) also remain on the supply side that signal inefficient use ofresources; 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 wherethey now apply, while developing safeguards for those with low incomes. This isprobably the single most important instrument available to promote long-termcost containment and more efficient resource use.

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

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

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

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

23. Fortunately, there is a good chance that this reorientation can be accomplished without anexcessive increase in public spending on education (from the current level of less than 5 percentof GDP), and while enhancing equal opportunity in education. This could be done by takingadvantage of the sharply declining numbers of school-age children, the already small size ofclasses and low teacher workloads, and the growth of private sector schools, to consolidate at theprimary 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 forhigher education. The key elements of a phased expansion of tertiary enrollment over themedium term would be:

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

(b) Encouraging the emergence of new tertiary institutions, largely in the privatesector and financed by tuition, and developed from existing higher professionalschools.

(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 redoubleefforts to consolidate the primary and secondary levels, to reduce costs and increase theorientation 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 ofpoorer social background at the tertiary level.

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

25. Transport. Although public expenditures on transportation have hovered around 3.0-3.2percent of GDP in the 1 990s, this apparent stability masks significant pent up pressures caused inpart by the sweeping shifts in demand for different modes of transport (with rail freight droppingby over 50 percent, while road freight grew by more than 100 percent). This shift hascontributed to large operating losses and mounting debts in railways, a rise in road use (andmaintenance requirements), and growing urban congestion. The priority currently given to majorprograms of new rail and motorway investments (associated with the development of Europeancorridors) has exacerbated pressures by diverting funds from maintenance and contributing to amassive backlog of maintenance in roads, railways and public transport.

26. In addition to reducing fiscal pressures, reforms of expenditure programs could also bringwidespread 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 needto focus public spending exclusively on those activities that yield the highest returns and that theprivate sector cannot perform effectively. To this end, the country needs to complete theremaining areas for transport privatization and commercialize activities that will remain in thepublic sector. Recommendations to deal with these issues include:

(a) A major restructuring of railways: Restructuring the railways will be especiallydifficult due to the major labor force downsizing required, in addition to thetechnical and managerial issues to be resolved in the process of privatization. Amajor commitment of government time and effort will be needed to stop the largeand 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 tomaximize their returns, and adjusting passenger fees also need attention.

(b) A careful management of the road infrastructure: Growing demand for road usecalls for making a reduction of the maintenance backlog a first priority;undertaking only those corridor investments with the highest returns (andundertaking first those that will also help reduce the maintenance backlog);

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introducing appropriate road user charges; and improving efficiency inmanagement of road maintenance.

(c) Focusing public monies on public priorities: Given the critical need to focusscarce human and financial resources on the activities above, the governmentshould avoid involvement where its presence is not essential. Priorities hereinclude systematic use of objective, professional cost benefit analysis and steps toassess and limit the use of guarantees, and to reduce the risks associated withestablishing the extra-budgetary Transport Fund. This would include notfinancing or guaranteeing such investments as those of CSA or Prague Airport, asprivate 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 andre-phase road and rail corridor investments; (ii) start a fundamental restructuring of the railways;(iii) increase spending on maintenance; and (iv) raise passenger tariffs and taxes on diesel andheavy trucks.

28. Housing. The housing program faces serious problems. First, substantial publicexpenditures and implicit subsidies have not generated the outcomes expected. Despite theconsiderable earlier reform efforts, there has been little induced financing and risk-taking by theprivate sector. For example, in 1999, residential construction output totaled about CZK60 billioncompared with total central and local government budget spending on housing at about the samelevel. Second, the program has created large and potentially destabilizing budgeted and implicitsubsidies and contingent liabilities. Government projections indicate that the centralgovernments budgeted subsidies will nearly double to 1.5 percent of GDP by 2005. Implicitsubsidies 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 bulkof the projected increase in spending, and will also have authority to make loans to and guaranteeloans 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 incomequintiles 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 beforeconsidering an expansion of spending. Such reform should involve, among others

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

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

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(c) Subsidy reform. Subsidies should be refocused to support the objectivesidentified above (for example, to support rent reform and to match private fundsmobilized for the modernization of the stock) and better targeted for the mostvulnerable. The currently excessive Bauspar subsidies should be phased out andpart of the savings integrated into such an improved subsidy approach. Taxsubsidies, rent advantages and other indirect housing subsidies should beexplicitly budgeted, their levels be reduced and/or phased out.

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

The Fiscal Management Framework

31. The report emphasizes the need for institutional reforms -- improvements in analyticcapacities, institutions, and processes -- to help the authorities meet the present challenges andemerge 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 continueto complicate expenditure-side fiscal adjustment at the national level. First, the coexistence oftwo budget systems - a formal one centered around the state budget, and another, more informalone of interconnecting extra-budgetary operations backed by privatization receipts and by thecredit of the republic -- obscures the fiscal stance and complicates budget choices. A secondfactor is the inertia created by the so-called "mandatory and quasi mandatory expenditures," i.e.,expenditures mandated by substantive legislation or contractual arrangements (for this reason,the term "mandated" will be preferred to "mandatory" in the rest of the report) which account forabout 80 percent of the state budget. Finally, the budget process itself does not generatemeaningful enough information and analysis (e.g., on the nature, efficiency, and quality of thepublic services being provided) to guide the trade-offs faced in the necessary redeployment ofpublic resources.

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

(a) Lengthen the horizon of fiscal decision to a timeframe into which action onmandated items can reasonably be phased in by expanding the medium-termoutlook (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 wouldbe to: (i) commit the authorities to a clear strategy to bring down the generalgovernment deficit to 1-2 percent of GDP; and (ii) spell out its implication bymajor expenditure chapter and items.

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

xiii

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

33. Local governments need to be included in the design of the needed fiscal consolidationstrategy. They absorb resources equivalent to about 10 percent of GDP and spend close to aquarter of consolidated government expenditure. The ongoing decentralization offers anopportunity to calibrate better the supply of public services to local demands and aspirations,hence there 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 issuesfaced 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 than1,500 inhabitants); (ii) the potential weakening of the fiscal oversight over their operations withthe phasing out, starting 2001, of the national government's district offices; (iii) a rapid, andunregulated rise in municipal debt (to 53 percent of municipal tax revenues in 1999 from 11percent in 1993); and (iv) the recent creation of regional governments ahead of any concretedefinition of their expenditure responsibilities or autonomous revenue sources.

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

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

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

(c) Restrict municipal borrowing to the funding of investment projects, adoptmaximum levels for debt stock and debt service ratios, officially monitor themunicipal credit market; and send unambiguous signals to financial markets thatmunicipal debt is not backed either implicitly or explicitly by the nationalgovernment (including by imposing conservative loan loss provisioningrequirements on municipal debt).

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

35. These institutional reforms do not offer any panacea, nor do they substitute for policyaction 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 andlocal ones wherever possible to the pursuit of public policy goals; and (v) generating feedback onthe effectiveness and efficiency of public interventions.

1. THE STRATEGIC SETTING

A. INTRODUCTION

1.1 The Czech Republic is entering the new millennium on a positive note, as it appears to beemerging successfully from the recession induced by the 1997 currency crisis. However, as thatcrisis revealed, serious challenges remain. One key challenge is reducing the large fiscal deficitwhich 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 theprospect of meeting the obligations of the Stability and Growth Pact (SGP) after joining theEuropean Union (i.e., balanced budget or even slight surplus in normal years). The scope forreducing 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 bemade in public expenditures, in particular by identifying and implementing policies that willreverse the upward pressure on these expenditures, while maintaining or improving theireffectiveness. A critical part of this effort will be developing procedures and institutionalcapacities to measure and manage public expenditures better, and integrating these efforts withthe process of fiscal decentralization already underway.

1.2 This report examines these issues and challenges. Part 1 deals with the macroeconomiccontext, the fiscal trends, and the medium-term outlook. It first highlights the major pressurepoints that have emerged and complicate expenditure management. This part then makes thecase: (i) that the country should aim at bringing the general government deficit towards 1-2percent of GDP over the medium term, as an intermediate step towards SGP targets; and (ii) thatthe bulk of the necessary fiscal adjustment will need to come from the expenditure side. Thetask will undoubtedly be difficult and perhaps painful. The main point of this report is to helpthe 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 2 proceeds therefore to illuminate the challenges facedin 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 setof stroke-of-the-pen decisions, but as an ongoing process of review, revision, and redefinition ofthe role and modalities of government intervention. Rather than elaborate a comprehensiveprescription 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 toachieve fiscal sustainability (recognizing that expenditure in other sectors would deserve thesame type of detailed review); and (ii) illustrate the nature of the dialogue that will need todevelop across the board (including in other sectors not discussed) among the relevant agenciesto 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, toyield sustained results, this process of expenditure reform will need to be firmly grounded in adevelopment of analytical capacities in core and line agencies alike, and be underpinned by

1. The Strategic Setting 2

institutional reforms of the type put forward in Part 3. These involve continued improvements inthe measurement and comprehensiveness of budget accounts, the development of a more formaland systematic medium-term approach to fiscal programming in both the Ministry of Financeand in line ministries, and a move towards a greater performance orientation in budgeting. In thesame spirit, this final part of the report discusses how to make the best of opportunities presentedby the ongoing decentralization to achieve a better deployment of public resources, whilelimiting the related risks.

B. MACROECONOMIC CONTEXT

1.5 The discussions in this report are taking place against the background of a fledglingeconomic recovery. The economy expanded in 2000 for the first time since 1996 (by anestimated 3.1 percent, see Table 1.1) and all expectations are that the recovery should gathermomentum in 2001 and beyond. The economy may, however, still need to work out the stressesof the recession before it is able to recapture the 5-6 percent growth rates experienced in the run-up to the May 1997 crisis.

1.6 At the heart of the May 1997 crisis and its legacy were the deficiencies in the Czechmodel of transition, particularly those related to the microeconomic foundations of the bankingand enterprise sectors. Mass privatization had succeeded in rapidly transferring ownership to theprivate sector, but had failed to generate sound corporate governance. Instead, the combinationof 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 ina massive "tunneling" or stripping of enterprise assets to insiders, backed by loose access to bankcredit.

1.7 As a result, while the economy appeared to be cruising along an accelerating growthtrajectory, banks were accumulating non-performing loans to levels seen only in the mostdistressed parts of the region (see Table 1.2). Czech banks accumulated, for instance, a farhigher ratio of non-performing loans (NPL) than Hungary, Poland, Slovenia, or Estonia. By theend of 1998, the share of the non-performing loans in the Czech Republic was similar to the onesin Romania or Slovakia.

1.8 Meanwhile, apparently oblivious of the looming tensions and risks, foreign capital waspouring in, further fueling domestic investment, and giving the illusion that ever-wideningexternal 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 7.4percent of GDP in 1996) had become unsustainably high -- forced the authorities to abandon thefixed 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 wentinto recession.


Table 1.1: Key Economic Indicators, 1993-20001993 1994 1995 1996 1997 1998 1999 2000p

Real EconomyReal GDP (growth rate) 0.1 2.2 5.9 4.8 -1.0 -2.2 -0.8 3.1Share of Private Sector in GDP 45.1 56.3 63.8 74.0 74.3 75.0 80.0 80.0

Unemployment rate (end of period) 3.5 3.2 2.9 3.5 5.2 7.5 9.4 8.9Inflation (CPI, pefiod average) 20.9 10.0 9.1 8.8 8.5 10.7 2.1 3.9

Inflation (PPI, period average) 9.2 5.4 7.6 4.8 4.9 4.9 1.0 4.7

Private Consumption/GDP 48.9 50.6 50.1 50.9 52.4 51.5 52.8 54.8

Gross National Savings/GDP 28.7 27.8 29.9 28.1 26.3 27.3 26.6 25.7Gross Domestic Investment/GDP 28.5 28.7 32.0 31.8 30.8 28.3 26.4 27.4

Balance of PaymentsTrade Balance/GDP -1.5 -3.4 -7.1 -10.1 -8.7 -4.7 -3.6 -6.6

Exports of Goods and Services (groth rate) - 12.2 34.5 1 4.8 16.1 -0.6 10.5Imports of Goods and Services (growth rate) - 17.8 44.8 9.6 -0.9 6.1 -2.9 14.5

Current Account Balance/GDP 1.3 -2.0 -2.6 -7.4 -6.2 -2.5 -3.0 -4.8Financial Account/GDP 8.6 8.2 15.8 7.2 2.1 5.2 5.8 6.8

Gross Official Reserves (billion US$, end-year) 3.9 6.2 14.0 12.4 9.8 12.6 12.8 13.1

Reserve Cover (months of imports of GS) - 3.4 5.5 4.4 3.6 4.4 4.4 4.2Gross External Debt/GDP 28.2 28.9 33.1 36.8 44.9 40.4 45.1 43.0

Extemal Debt Service (percent of exports of GS) - 13.1 9.2 10.7 15.6 15.1 12.5 -

Public FinancesGeneral Govemment Balance/GDP 2.6 0.8 0.3 -0.3 -1.2 -1.5 -0.6 -3.7Idem, excluding extraordinary items ... -1.9 -1.6 -1.9 -2.0 -1.5 -3.0 -4.8Public Debt/GDP (excluding debt of transformation agencies) 18.8 17.6 15.3 13.1 13.0 13.4 15.0 17.6

Interest RatesInterbank offer rate (3 month PRIBOR, in percent) 13.1 9.1 10.9 12.0 16.0 14.3 6.8 5.4Average nominal lending rate (in percent) 14.1 13.1 12.8 12.5 13.2 12.9 8.7 7.2Average real lendingrate (deflatedby PPI, in percent) 5.5 7.1 5.2 7.9 7.1 10.4 5.1 1.5Average nominal deposit rate (in percent) 7.0 7.1 7.0 6.8 7.7 8.1 4.5 3.4Average real depositrate (net, deflated by CPI, in percent) -7.5 -1.1 0.8 -0.5 -1.1 2.0 2.2 -0.3

Money and CreditBroad Money (M2, annual growth) 19.8 19.9 19.8 9.2 10.1 5.2 8.1 7.5Quasi-Money (M3, annual growth) 23.3 24.4 24.6 12.8 22.5 9.7 6.8 2.8

Credit to Enterprises and Households (percent growth) 19.1 16.8 13.2 10.6 9.4 -3.5 -3.9 -4.6

Labor and WagesLabor Productivity (percentage change) - 1.1 5.2 4.6 -0.3 -0.8 1.4 3.3Nominal gross wage growth (period average) - - - 18.0 8.8 4.0 6.5 4.9

Real gross wage growth (period average) - - - 8.5 0.3 -6 4.2 0.9

Exchange RatesNominal Exchange Rate (CZK per US$, average) 29.2 28.8 26.5 27.1 31.7 32.3 34.6 38.6Nominal Exchange Rate (CZKper DEM, average) 17.6 17.8 18.5 18.1 18.3 18.3 18.9 18.2Nominal Effective Exchange Rate (previous year=I100)' 99.3 99.9 100.0 99.1 106.5 100.8 104.5 -

Real Effective Exchange Rate (ULC, previous year=I00)1 87.3 91.8 93.0 91.6 101.1 92.0 104.2 -

MemoGross Domestic Product (current CZK billion) 1,020.3 1,182.8 1,381.1 1,572.3 1,668.8 1,798.3 1,833 1,910.6

Gross Domestic Product (current USS billion) 34.9 41.1 52.1 58.0 52.6 55.7 53.1 49.5PerCapitalncome(US$) 3,400 4,017 5,016 5,636 5,198 5,527 5,198 4,818

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 1998

Bulgaria 6.6 6.8 12.6 14.6 12.9 9.5

Czech 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 forTlhe 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, 2.2and 0.8 percent respectively in 1997, 1998 and 1999, and the unemployment rate climbed from3.9 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, whilepushing forward with financial consolidation and structural reforms. Between the summer of1998 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. Thecurrent account deficit of the balance of payments came down in 1999 to a more comfortable 2percent of GDP and the reinvigorated privatization agenda, particularly for the former statebanks, attracted large amounts of FDI. With fresh interest for greenfield investments also, totaldirect investment soared to about US$5 billion in 1999, and the inflow continued to the tune ofclose to US$4.6 billion in 2000. While these amounts may be above trend, the sizable increasein FDI is having a substantial impact on the pace of restructuring in the Czech Republic andbodes well for the sustainability of small current account deficits. Meanwhile, inflation remainsunder control (at 4.2 percent in February 2001) and economic recovery is becoming more robust,as seen above. As its pace accelerates, new employment opportunities are developing and theunemployment rate is beginning to recede.

1. The Strategic Setting S

Table 1.3: Economic Indicators in Selected Countries, 1993-20001993 1994 1995 1996 1997 1998 1999 2000'

Annual Inflation Rate (average CPI, percent)

Czech Republic 20.9 10.0 9.1 8.8 8.5 10.7 2.1 3.9

Estonia 89.8 47.7 29.0 23.1 10.6 8.2 3.3 4.0

Hungary 22.5 18.8 28.2 23.6 18.3 14.3 10 9.7

Poland 35.3 32.2 27.8 19.9 14.9 11.8 7.3 10.1

Slovak Republic 23.2 13.7 9.9 5.8 6.1 6.7 10.6 12.1

Slovenia 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 3.1

Estonia -8.5 2.0 4.3 3.9 10.6 4.7 -1.1 5.1

Hungary -0.6 2.9 1.5 1.3 4.6 4.9 4.5 5.6

Poland 4.3 5.1 7.0 6.0 6.8 4.8 4.1 4.9

Slovak Republic -3.7 4.9 6.9 6.2 6.1 4.1 1.9 1.9

Slovenia 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 -3.7

Estonia -0.7 1.4 -0.5 -1.6 2.6 -0.4 -4.7 -1.5

Hungary -6.0 -7.5 -3.2 0.8 -1.8 -4.4 -3.7 -3.0

Poland -3.1 -3.2 -3.3 -3.4 -2.7 -2.4 -2.1 -1.9

Slovak Republic -7.0 -1.3 0.4 -1.4 -5.2 -5.0 -3.6 -3.5

Slovenia 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 -3.0 -4.8

Estonia 1.3 -7.2 -4.4 -9.2 -12.6 -9.6 -5.8 -5.4

Hungary -9.0 -9.4 -5.6 -3.7 -2.1 4.9 -4.3 -3.9

Poland -3.1 0.7 4.8 -1.1 -2.9 4.3 -7.6 -6.8

Slovak Republic -5.0 4.8 2.3 -11.2 -10 -10.4 -5.8 -2.9

Slovenia 1.5 4.2 -0.1 0.2 0.2 -0.5 -4.0 -2.8

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

C. THE FISCAL PICTURE

1.13 The fiscal situation, however, remains a key concern, both in its own right and for theimpact it has on overall macroeconomic balances. Partly as a result of the crisis, and partly dueto structural reasons (as will be discussed below), the overall balance of the general governmenthas turned around from a surplus in 1993 to a 3.7 percent of GDP deficit in 2000 (see Table 1.4).In parallel, the external current account deficit has expanded again to 4.8 percent of GDP in2000.

1.14 The trend in the overall deficit net of extraordinary items (such as privatization receiptsand bank restructuring costs, see Box 1.1 for definitions) gives perhaps a better appreciation ofthe underlying dynamics. From a balanced situation in 1993, the deficit so measured balloonedto an estimated 4.8 percent of GDP in 2000 and is expected to widen by another percentage pointof 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 Assetsand Liabilities (SFAL). SFAL comprises the central government account at the Czech National bank, in which the state budgetsurpluses and deficits from previous years are deposited. In 2001, the state budget is presented in 41 budgetary chapters.

General Government Budget (or consolidated general govemment budget!: This presentation follows the rnethodology of the IMF'sGovernment Finance statistics. It includes the revenue and expenditure and net lending operations of the state budget, localgovemments, public health insurance funds, and extra-budgetary funds. The overall general govemment balance includesprivatization revenues, as a negative net lending item, and, bank restructuring costs, as expenditure under the heading "subsidies tobanks and enterprises."

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

Tax Ouota: the tenn also used to designate "tax revenues" of the general government (i.e., taxes on goods and services, social securitycontributions, income, property and other taxes).

19971 19981 1999j 20004, 2001 bd

As a share of GDP

State Budget Revenues 30.6 30.5 30.9 31.1 31.2

o.w. State Financial Assets 1.4 1.7 1.0

General Government Revenues 39.7 39.2 41.5 41.1 41.7

o.w. 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

o.w. State Financial Liabilities 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 Govemment 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

Source: Ministry of Finance.

Sources of Fiscal Imbalance

1.15 These trends are not new. Indeed, the general euphoria that preceded the 1997 crisisclouded the fact that regular fiscal operations also were increasingly out of kilter. While generalgovernment revenues (excluding privatization receipts) had lost ground by as much as 4percentage 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 bediscussed below) to the growing burden of social entitlements. A subsequent effort to jackrevenues back up met with only partial success. Meanwhile, hopes for large receipts fromprivatization have underpinned a sharp increase in overall spending from less than 42 percent ofGDP at its low point in 1998 to about 46 percent in 2000.


Table 1.4: General Government Revenues and Ex enditures1993 1994 1 1995 | 1996 1997 1998 1999 2000est | 2 0 0 1 bud

Percent of GDP

1. 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 36.01 37.2 37.3 37.7

2. 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 1.2

Transfers to 2 3

.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 -1.41 -0.9 -0.8 -1.1 -1.2 -6.7

2.2.1 Privatization receipts' -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 0.2

3. 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

privathzaton revenues1] [ 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 -13.4

|d Expenditure -excluding bank | ll

restructuring. 43.4 43.9 43.0 42.0 41.8 40.1 42.5 45.] 45.9

'Privatization receipts of the National Property Fund and Czech Land Fund only. 2/ see Box 1.1 for definition.


1.16 This would be less of a concern if the rise in spending reflected mainly one-time costsassociated with transition, such as the unavoidable costs associated with restructuring of failedbanks. 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 areset to rise further in 2001. An examination of the recent expenditure developments by economicand functional categories (see Tables 1.4 and 1.5) provides a good overview of where the mainpressure points have been, i.e.,:

(a) There has been a gradual, but sustained and substantial (4.4 percent of GDP), risein transfers to households since the early 1990s. This is mainly due to the largerise in social security and welfare payments (3.2 percent of GDP) between 1994and 1999 (Table 1.5),1 and reflects, among other things, generous indexingmethods, and rapid increases in the number of early retirements. Pensionexpenditures, as currently designed, are projected to continue to grow faster thancontributions and will continue to put substantial upward pressures on spendingthat are not likely to be sustainable.

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


Table 1.5: General Government Expenditures by Function19931 19941 19951 19961 19971 1998 1999

Percent of total expenditures

Total 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 GDP

Total 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 capitaltransfers) 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 severalyears. Expenditures on goods and services dropped by over 3 percent of GDPbetween 1993 and 2000, with all of the decrease concentrated in the goods part ofthis category (Table 1.4). This suggests the goods and materials necessary tocomplement service delivery and carry out operations and maintenance activities,may have been severely restricted, leading to a reduction in service quality, abacklog of O&M (as for transport networks, see Part 2), and the need for moreexpensive rehabilitation down the road. Such expenditures are often a first targetfor budget cuts, but unless balanced by deeper reforms, they are not likely to besustained.

(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 2). Expenditures in other categorieshave been relatively stable over time. This does not necessarily mean theirsituation is satisfactory (see for instance the discussion on railroads in Part 2).

Size of Government

1.17 As a result, public expenditure in the Czech Republic has risen to levels that are highrelative to comparator countries. This conclusion emerges from Table 1.6, which comparespublic expenditures2 as a percent of GDP in the Czech Republic with that in selected OECDcountries. While the Czech Republic was in the lower half of the group in 1998, by 2000 it hadmoved up significantly.

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

Sweden 60.8 Portugal 43.6

Denmark 55.1 Japan' 42.3

France 54.3 Canada 42.1

Belgium 51.0 Spain 41.8

Austria 49.4 Greece 41.8Italy 49.1 Czech Republic (1998) 41.6

Finland 49.1 United Kingdom 40.2Netherlands 47.2 New Zealand 39.8Norway 46.9 Iceland 36.2Germany 46.9 Ireland 331

Czech Republic (2000) 46.0 Australia 32.9

Poland 45.7 United States 32.8Hungary 44.3 Korea 25.6

Note: For Czech Republic, excludes net lending.' 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 theCzech Republic with other countries, uses a model that quantifies the effect of factors that areimportant determinants of public expenditures.3 Given the values for these factors in the CzechRepublic, the model predicts that public expenditures in the Czech Republic would be in theorder of 39.4 percent of GDP, over 6 percentage points lower than its current level. Whilecertainly not conclusive, these comparisons suggest that, relative to other countries, the CzechRepublic has substantial scope to reduce its public spending as a share of GDP. As the CzechRepublic continues its development as a market economy, it has opportunities to make choicesabout 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 Defined as consolidated General Government expenditures, excluding net lending and privatization revenues (see Box 1. 1, and line 2.1 in Table1.4).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 andthe ratio of public debt to GDP) that reflect social demands as well as a government's ability to both pursue its own policy priorities andovercome 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 costof bank restructuring. As noted above, the currency crisis of 1997 and the monetary tighteningthat followed brought the deteriorating financial situation of banks and enterprises to a head. Inan effort to stem waves of bank default, the government was forced to step in and, throughvarious mechanisms, assumed responsibility, over the following years, for bad loans with a bookvalue in excess of 20 percent of GDP (including ring-fenced portfolios of private banks). Therescue 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 generalgovernment on account of these bailouts to the amounts of available privatization receipts, whilepushing 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 privatizationreceipts would continue to match the overall costs of transition to the budget. First, the amountsfalling due on account of bank restructuring are rising sharply in 2001 (from 1 percent of GDPlast year to 5 percent of GDP this year). Whether the hoped-for privatization receipts (as muchas 6.9 percent of GDP in 2001) will materialize is a different matter. If the past is any guide theymay not: the 2.4 percent of GDP anticipated in 2000 for instance turned out to be a mere 1.1percent of GDP. Furthermore, bank restructuring costs will continue for a considerable time intothe future as the govermment pays interest and principal on obligations it has already assumed,and as new liabilities come to light. Calculations presented in Part 2 suggest that the ongoingfiscal cost of bank restructuring would continue to hover around 2 percent of GDP for the nextfew years. Against that, future flows of privatization receipts are not only likely to dwindlegradually (as privatization runs its course); they are also heavily mortgaged already, amongothers, to cover environmental liabilities.

1.21 Indeed, another important fiscal challenge for the future is the settlement of theenvironmental liabilities of privatized enterprises. The National Property Fund (NPF) assumedthese liabilities as part of the privatization process and has been in charge of absorbing the costsfor environmental clean-up activities. On the basis of concluded contracts, the clean-upcompensation amount has been estimated at CZK35 billion. If the government approves theconclusion of new contracts between the NPF and privatized companies, an additional CZK42billion can be added to the current amount. In total, environmental liabilities may claim up to 37percent of the current NPF portfolio (depending on the valuation of the NPF portfolio).4

1.22 Furthermore, while many aspects of EU accession will reinforce the Czech Republic'sefforts to rationalize and reduce public expenditures,5 compliance with the EU directives will callfor significant investments of national resources (private and public), especially in the areas ofenvironment, transport and other general economic infrastructure, and agriculture.

4By the end of 1998, the NPF portfolio comprised 358 companies with an aggregate nominal value of shares of CZK177 billion. By 1999, thenominal value declined slightly to CZKI71 billion. However, the market value of some of the NPF holdings is far below the nominal value. Thisis especially true for some of the remaining minority shares and the shares of the large loss-making state enterprises (such as Vitkovice).5 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.


1.23 The government has begun to prepare for this new challenge. First, it has begun toidentify more clearly and quantify how much spending is involved. The National Program forthe Adoption of the Acquis (NPAA) it has formulated puts the amount required to meet EUaccession requirements during 2001 at around CZK59.8 billion (equivalent to about 3 percent ofGDP). The orders of magnitude would be similar for 2002 and 2003 (see Table 1.7). The entireanounts, however, would not have to be funded nationally: NPAA envisages that about 15percent would be financed by EU transfers, and a similar amount from other sources, such as theEuropean Investment Bank for transport. In addition, since 2000, EU-related expenditures arebeing 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. Theywould amount to 2.5 percent of GDP, of which 1.6 percent of GDP would be funded fromdomestic sources.

1.24 While some of these investments would have to take place regardless of the EU accessionprocess, 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 theinvestments might produce only long-term benefits at a very high short-term cost. As such, thegovernment has to be careful to work with the EU to assure adequate transition periods forcompliance to certain EU directives. The European Union itself has shown a willingness to beflexible on transition periods where financial considerations warrant it.6 Similarly, thecomposition of investments should target the most strategic goals. In other words, the EUrequirements should not be crowding out other necessary investments (for example, new Trans-European Networks should not displace funding for the maintenance of existing networks).Instead, a proper balance has to be achieved and the most efficient combination of investmentschosen.

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


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

Proposed flncing prop fi ng 1I001 Proposed fin ncing 2002State budget EU Others TOTAL State budget EU Others TOTAL State budget EU Others TOTAL

Capital Non- Total Capital Non- Total Capital Non- TotalData In mil. CZK capital _ capital . capitalMinistry 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 5,142.9Mlnistry 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 1,251.54 320.0 8,854.3 757.9 6,907.5 7,665.4 1,520.0 320.0 9,505.4Ministry of Justice 906.1 1,243.61 2,149.7 52.5 2,202.2 1,592.1 954.2 2,546.3 80.0 23626.3 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 _ 1,041k5 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 5572 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 5,1773 2,261.8 94.5 2,356.3 2,224.3 4,580.6Ministry of Culture 18.9 1A9 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 78.71 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 Forein Affaires 425.0 425.0 1 425.0 446.5 446.5 446.5 480.0 480.0 480.0State Offlce 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 9.6 16.1 25.7 15.7 41.3 1.0 16.4 1 7.4 5.6 23.0 16.1 16.1 16.1Competition I I_ II_ OMce 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 60.01 262.0Industrial Property Offce 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 8JJ1 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 97.5 . _ _Czech 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 115,581.1 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 59,358.9

Note: This program does not yet include the creation of the State Transport Fund in 2001 and 2002, therefore, the Ministry of Transport EU-related expendituTe includes the expenditure programs that will actually beimplemented by the State Transport Fund.Source: Ministry of Finance, NPAA 2000.


Fiscal Sustainability

1.25 As the Czech Republic has made joining the European Union the central thrust of itsdevelopment strategy however, it will also need at some point to prepare for the prospect ofadhering to the discipline of the Stability and Growth Pact (SGP), which links members of itsexchange mechanisms (ERM2, or euro-zone). Indeed, under the SGP, member countries havecommitted 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, thiswill 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), itwould nonetheless be wise to start moving fiscal policy towards such convergence criteria, ratherthan 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 deficitcould perhaps be looked at as the normal operation of automatic stabilizers (as envisaged underthe 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 anystandard, and certainly by those of central Europe, where public debt ratios range from 25percent of GDP (in Slovenia and Slovakia) to 61 percent in Hungary. Furthermore, the republicas a whole has a net creditor position vis-a-vis the outside world. Finally, the prospect that theCzech Republic may adhere in the future to SGP should give cause for comfort, as the latter'sdeficit rule in itself implies declining public sector debt ratios.

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

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

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

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

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

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


(iii) If one would include the KoB debt, total government would thus rise ofabout 29 percent of GDP, with a steep potential downside in excess of 50percent of GDP, should the economic climate turn sour. The recentexperience of East Asia shows that, if and when the economy falters, aseemingly conservative government can swiftly turn over-indebted (seefor instance the case of Indonesia).7

(c) The deficits themselves, far from being merely cyclical, are increasingly structural(see Table 1.8), raising the specter that, rather than converging (howevergradually), the underlying dynamics are actually diverging from the SGP criteriamentioned above. Looking ahead, the Ministry of Finance concludes that, left toits 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 thereturn towards full employment, but rather, are of structural nature".8

Table 1.8: Decomposition of the Fiscal DeficitTotal | Hodrik-Prescott Method 1 Barro Beta-Convergence Method

State Deficit Cyclical Structural Cyclical Structural

Percent of GDP

1994 -1.9 -1.0 -0.9 0.0 -1.9

1995 -1.6 0.3 -1.9 1.1 -2.7

1996 -1.9 0.9 -2.8 1.4 -3.3

1997 -2.0 0.7 -2.7 0.5 -2.5

1998 -2.4 -0.2 -2.2 -1.0 -1.4

1999 -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 domesticdemand management, and the active role which fiscal policy has to play in it. While fiscalexpansion may have been in order to sustain domestic demand through a downturn, guidingconsiderations should now change. As the recovery gathers steam, the government needsgradually to withdraw the impulse it was giving to domestic demand, and make room for privateinvestment to expand without unduly compromising external balances. Furthermnore, in a worldof volatile global markets, it would also be beneficial for fiscal policy to regain some of theflexibility it seems to have lost to modulate demand in reaction to potentially abrupt shifts in thecapital 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 toabout -8 percent of GDP in 1997 with the surge in private activity, the public sector managed tocurtail 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

7See "East Asia: recovery and Beyond," World Bank, 2000.8 Czech Republic, 2001 State Budget (unofficial translation).


beyond 7 percent of GDP (in 1996) helped signal the Czech Republic to the attention of foreigninvestors and contributed to stoking their worries. At the time, the authorities undoubtedlywould have wished they had a greater degree of flexibility to lean against such wide shifts inprivate sector behaviors. This is what happened in the aftermath of the crisis. As the private S-Iratio swung by close to 10 percent of GDP (to positive levels) between 1997 and 1999, its publicsector correspondent was allowed to slide by close to 5 percent (to negative levels), easing anadjustment 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 ofGDP in 2000 (alongside that of the general government) would seem to signal that the time hascome for the government to reverse its fiscal course. Indeed, 5 percent of GDP seems toconstitute a psychological threshold for the external current account that the Czech authoritieswould not want to cross lightly. As long as external deficits are financed by non-debt creatinginstruments, such deficits may feel benign. But the experience of the Czech Republic in 1997 (aswell as the subsequent one in East Asia) has shown how difficult it can be to rein in these deficitsin a timely fashion when they have grown to the point of alarming markets, and financing termstighten as a result. Conversely, with the revival of confidence, massive inflows of foreign directinvestment and the improvements of portfolio positions throughout the economy, there is everyreason to believe that private investment may again outstrip private domestic savings. As thathappens, the government will need to pull back to prevent the expansion of private demand fromeither putting such upward pressure on interest rates and on the real exchange rate as to derail therecovery 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 thefiscal policy to go forward. Calculations by the IMF staff suggest that, to reconcile those growthand external balance objectives, the overall deficit of the general government would need to bereduced over the medium term to about 2 percent of GDP.9 As it happens, this level of deficitshould 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 torecommend itself as an intermediate target towards SGP targets, on both stocks and flowsgrounds. Furthermore, it would set the Czech Republic on track toward meeting the Maastrichtcriteria 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. Boththe government and the leading opposition party are officially and jointly committed tobalancing the state budget within the three years.'0 Commendably, the agreement also commitsthe parties to certain specific quantitative targets. The latter implies that the state budget deficitshould be rolled back to a maximum of CZK20 billion in 2001, CZK1O billion in 2002 andachieve balance in 2003 (using previous accounting methods).

9 IMF 2001. "Developing Policy Frameworks in Central Europe on the Road to EU Accession." (forthcoming).I While the political agreement specifies that no increases in the tax quota will be used to close the deficit, the Ministry of Finance understandsthat 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 taxrates with the EU.


1.33 This report will argue (in Part 3) in favor of using medium-term quantitative frameworksto anchor the fiscal adjustment process over the medium-term (with a suitable degree offlexibility 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 isafter all only a subset of government fiscal operations (see Box 1.1 for definitions). Themeaning 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 thepopulation and leave the unfortunate impression that accounts are being shuffled for conveniencesake. 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 samecannot be said of the means to achieve it. The opposition agreement mentioned above, forinstance, envisages that the targeted deficit reduction should be achieved with no increases in theso-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 reachesa somewhat different conclusion."1 Having established (as noted above) that left to itself, thefiscal deficit would not decline with the recovery, the budget document explores the implicationof three alternative policy scenario ("austerity" focusing on the expenditure side and "reform 1and 2" focusing on two different packages of tax reform, see Table 1.9). It concludes that majoraction on the expenditure side being impractical within the relevant timeframe, so that increasingthe "tax quota" (i.e., tax revenues) becomes unavoidable in the short term (if deficit targets are tobe attained).

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

1998 1 999 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 1: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 11: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 ofrevenue to GDP further would be either desirable or even feasible. As the recent OECD reportputs it: "The overall tax burden is much higher in the Czech Republic than it was in other OECDcountries when they were at similar levels of development. International evidence would seemto suggest that this could slow the pace at which the Czech Republic can expect to converge tothe income levels observed in more developed OECD economies, implying that loweringtaxation could have significant long-term benefits. To do so, however, would require parallel

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


reductions in government expenditures in order to avoid a further deterioration of publicfinances. There may also be an opportunity to rebalance the existing tax burden across differentrevenue 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 propertytaxes are under-used."12

1.37 Indeed:

(a) The tax revenue ratio to GDP in the Czech Republic compares to the ones inGermany or the United Kingdom (in 1998), and exceeds by several percentagepoints 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) exceedby more than 10 percentage points the (unweighted) average in the EU and weretwice as high as those in the OECD at large.

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

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

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

(a) In the absence of a structural reform of "mandated and quasi-mandated"programs, the cuts required in "non-mandated" items would be so deep as to"threaten the continued functioning of the public sector."13

(b) "An assessment of the effectiveness and actual cost of current spending programsand their results has not yet been carried out""' on which to base such structuralreforms.

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

2 OECD 2000. "Economic Survey of the Czech Republic." Paris, France.13 Czech Republic, 2001 State Budget (unofficial translation).14 ibidem.


E. CONCLUSIONS

1.40 This part concludes therefore (i) on the need to bring the general government deficit backdown towards 1-2 percent of GDP over the medium-term in order to put the incipient recoveryon a sustainable financial footing; and, to attain this objective, (ii) on the necessity to engage in astructural reform of government expenditure programs; and (iii) on the existing broad scope,judged by international standards, to reduce the overall level of public spending. The next partexplores in more detail how the authorities could address them in the context of some of themajor expenditure programs. The third and final part will look at the contribution thatinstitutional reforms could make for the necessary restructuring of expenditure programs.

2. EXPENDITURE REFORM OPPORTUNITIES

A. INTRODUCTION

2.1 Part 1 of this report documented the broad scope for reducing public expenditures in theCzech Republic. It also noted the considerable pressures to increase spending, coming both fromwithin certain expenditure programs (i.e., social security; enterprise-bank restructuring), andfrom the wider economic context (extra budgetary funds, contingent liabilities, EU accession anddecentralization). Moreover, much of the expenditure is mandated or quasi-mandated, greatlylimiting the scope for immediate adjustments in spending levels. Realizing the potential forsustainable expenditure reduction will therefore depend on a two-pronged approach:

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

(b) Continued improvements in the institutions, capacities, and processes formanaging public spending in ways that generate and monitor expenditure programreforms. Part 3 will focus on these issues.

2.2 It is worth stressing that while there are some important measures that can be taken in theshort term, the most important measures to contain expenditures in a sustainable way will requirea thorough, comprehensive review of the overall expenditure program, not as a one-shotexercise, 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 animportant part of the effort needs to be developing an understanding and political consensus forthe need for such reforms. This is why Part 3 of this report emphasizes the importance ofdeveloping the institutions, capacities and processes that will help the Czech Republic togenerate the assessments of program performance and designs needed to bring about continuousimprovements 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 theissues that confront Czech policymakers as they seek to contain public expenditures and makethem more effective. While this part of the report proposes both short and medium-termrecommendations, it does not pretend to provide a fully detailed, comprehensive reformblueprint. Rather, it seeks to highlight the kinds of issues that need to be confronted, and at thesame time reinforce the case for improvements in fiscal management on the lines recommendedin Part 3. 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 totalpublic spending in 1999, and it is difficult to see how the needed expenditure adjustment couldbe realized without dealing with these sectors. In each sector, the discussion focuses not onacross-the-board cuts, but on reform options that might help to reduce or contain spending whileimproving the effectiveness of spending.

2: 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 asimilar rigorous review. For example current and capital transfers to non-financial enterpriseswere estimated at about 9.6 percent of GDP in 2000, over five times the EU average, andprojected to rise in 2001. While not discussed fully below (the topic is addressed mainly in thecontext of housing and transport expenditures), this is likely to be an area where substantialexpenditure reduction is possible and desirable. Finally, while most of the discussion below willfocus on expenditures explicitly budgeted in the normal budget documents, as the discussion ofthe housing sector below (Section G) will illustrate, it is important also to consider such implicitexpenditures as the granting of tax reductions or below-market pricing. These policies (such asthe VAT reduction for residential construction and tax preferences for mortgage lenders andborrowers) represent foregone public resources and their effectiveness should be assessed asrigorously 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 pastbank bailouts. Despite the ongoing recovery and a series of bank bailouts, total bad assets in theCzech economy still amounted to around 18.4 percent of GDP at the end of 2000 (excluding notyet recognized bad loans in the books of IPB).15 Various resolution mechanisms have been usedover the years to resolve the problem. Alongside the main one, the Konsolidacni Bank (see Box2.1), a number of other channels and vehicles were initially used, whose multiplicity anddiverging features tended to obscure and complicate overall consolidation. Conversely, some ofthe institutions involved were occasionally given conflicting mandates. KoB, for instance, wassupposed to double up as a development bank.

'5 For a recent evaluation of the bank and enterprise restructuring process see World Bank (2000) Czech Republic: Completing theTransformation ofBanks 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 vithout branches, serving primarily corporate clientele. Its legal status has been a state financial institution. Initially, KoBoperated only with a limited banking license, and its role was to solve problems from the pre-1989 regime. Upon its establishment, KoB assumedreceivables from TOZ (permanently revolving stock loans). These had been extended to over 6,000 clients in the Czech and Slovak FederalRepublic, 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 before1990.After the separation of the Czech and Slovak Federal Republic on I January 1993, the assets of the original federal KoB were divided betweentwo 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.u. started operating as the successor to carry on with the original activities of KoB in the Czech Republic. KoB isa special-purpose bank with the legal status of a state-owned financial institution, and with its liabilities guaranteed by the state. It employs 362employees, and services 4,748 clients. KoB acts within the Czech economy as a centralized institution for the management and disposition ofassumed and purchased assets. It facilitates the completion of the privatization of large state banks as it takes over a major portion and volume oftheir problematic debts. Similarly, KoB is involved in the restructuring of selected enterprises. These transactions are directed at achievingmaximum 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 completerestructuring transactions with large corporate clients. The agency is managed by Lazard & Latona, an intemational consortium focusing on thetum-around of problematic companies, and one of the world's leading investment banks. In 1999, KoB took over assets in the total nominal valueof CZK 56.4 billion in connection with the privatization of Ceska Sporitelna and Komercni Banka. This action further increased KoB'sproblematic assets, the volume of which represented around 9.6 percent of GDP at the end of 2000 (see Table 2.1). Some analyses suggest thatthe figure could increase further when the losses of IPB banka are included and additional bad assets are transferred over from Komercni bankabefore its privatization.KoB had also been active as a developmental agency. It finances extensive development projects of large Czech industrial enterprises, long-termpublic utility projects in transport, telecommunication and water management infrastructure, and environmental protection. In 1999, KoBcontinued to act as a financial manager in EIB funded development programs. However, in December 2000, during the consolidation of thetransformation institutions, these activities, in the amount of around CZK60 billion, have been transferred to the Czech-Moravian Guarantee andDevelopment Bank.Source: KoB Annual Report, 1999; and KoB press releases.

2.6 Fortunately, this is now changing, with (almost) the entire resolution process beingconsolidated around KoB. Ceska Financni, another agency under the Czech National Bank(CNB), was merped with the KoB in July 2000 and various other entities are being broughtwithin its ambit.' Furthermore, KoB's developmental banking activities and loan portfolio havebeen 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 cleanupprocess 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 atthe end of 1999). This left total classified assets of commercial banks at 9.6 percent of GDP; andthis ratio should drop to a projected 3.3 percent after the IPB portfolio is finally disposed of toKoB (see Table 2.1).

2.8 Correspondingly, of course, the nominal amount of bad assets held by KoB has risen to9.6 percent of GDP (see Table 2.1). With the resolution of the IPB failure and the final carve-outassociated with the imminent sales of Komercni Banka (KB), more bad assets are expected to be

16 Another KoB subsidiary, the Revitalization Agency, began its work during late 1999, aiming to restructure and tum around large failedenterprises. In addition, as part of the privatization process for KoB, a separate subsidiary Konpo has been created in March 2000 to take overdistressed assets from KoB. The KoB purchased a participating interest in Konpo from KB, which had CZK60 billion worth of nominalproblematic assets, for CZK36 billion. Two more special purpose vehicles were created: PRISKO for covering potential liabilities duringtransfers 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 intemational trade receivables. This structure will help KoB in itsrestructuring efforts, since the law does not allow KoB (or any of its subsidiaries) to own more than 50 percent of a company. Thus, theownership can be shared with Ministry of Finance (and its Ceska Inkasni), and any debt-equity swaps are therefore easier to implement.


shifted to KoB.17 The precise amounts involved are still unclear but KoB's total bad assetsexposure (own portfolio plus ring-fenced assets in the balance sheet of commercial banks) couldwell 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 ' 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%) (20.7%)'Memorandum itemsLeft with banking system 171.5 80.53

(9.6%) 3 (3.3%)3

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

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 liabilitiesthat KoB has accumulated in the process (i.e., CZK165 billion at the end of 2000 in debt mainlyto banks; that amount is due to rise steeply as part of the IPB cleanup). The latter liabilities carrythe 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 theservice of those liabilities as they fall due, on the other, has been the source of a huge cash drainfor 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 cleanupmay well add up to CZK300 billion, equivalent to about 15 percent of the 2001 GDP."8

7 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 Bankguaranteed its liabilities. The agreement includes two options: (i) put option of CSOB to sell assets to Ministry of Finance; and (ii) call option ofMinistry 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 govemrnment. Both, the KoBand CSOB are performing an audit of the IPB to assess the potential loss assets. KoB officials estimate the loss loan portfolio of IPB at around66 percent of portfolio.Is 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 (L.I 1 .2) 54.8 8.0 7.7 6.1 52.6 19.6 15.9 4.11.1 to Ceska inkasni (Cl) 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 4.11.2.2 Ceska Financni 0.6 1.8 1.6 1.4 9.6 1.0 0.8 0.

(through IKOB)2.From State Budget 5.1 10.4 0 14.4 39.8 10.0 25.0 24.0

to KOBTotal 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 onlythe legacy of the excesses which preceded the 1997 crisis. There is little option now but toconfront it. Indeed, recent experience has clearly demonstrated that (i) delaying the recognitionof the underlying losses would only increase the ultimate fiscal cost of the bailouts (as therecovery value of both loans and collaterals quickly erode); while (ii) the option of privatizingbanks "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 rekindlebanks' 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 offuture relapse (on the part of lenders and borrowers alike). In other words, what is involved is tointensify ongoing efforts to: (i) expedite the resolution of the "old debt"; and (ii) avoid theresurgence of new bad loans. Such measures include:

(a) Completing the refocusing of KoB. Current efforts to transform the KoB into anon-banking institution by August 2001 should be strengthened. At present,otherwise sound banking regulations (especially the conservative requirement toloan loss provisions) unnecessarily hamper KoB's workout activities.Furthermore, the KoB "losses" occur not only due to weak earnings and largeliabilities but also because of the high reserves and provisioning requirements thatit has to face to comply with the Banking Act.19

(b) Streamlining KoB's disposal methods. The work-out of bad assets should beconducted via a diversified, multi-level approach, involving a centralized agency,such as the KoB, for the few large debtors (with the support of the RevitalizationAgency), and active participation of several smaller players for the other 12,000debtors with smaller debts. Independent agents could be chosen within theprivate sector, working under best incentive contracts. Creative ways of assetdisposition should include asset pooling and bundling of smaller loans, and usageof Internet capabilities for on-line sales that would facilitate access of the

19 As KoB is transformed into a non-banking entity, it would make sense to incorporate KoB within the definition of general government andperhaps even within the ambit of the state budget. Not only would this make the operation more transparent, it would also reveal that some ofwhat 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).


investors to asset sales and reduce transaction costs.20 Actually, KoB has alreadybegun to sell part of its bad portfolio in this fashion. The first pool of assets wasauctioned in February 2001. Once this first experiment has been evaluated, theprocess could be expanded.

(c) Improving the legalframeworkfor debt resolution. It is necessary to modify legaland regulatory procedures to enable rapid and more efficient asset disposition.This would promote restructuring of firms, as well as the exit of non-viableenterprises, and could increase the confidence and interest of the investors toparticipate in the process. In particular, the legal changes should include: (i)improvement of debt enforcement mechanisms beyond bankruptcy procedures;2 l(ii) strengthening of the bankruptcy framework; and (iii) adjustments of parts ofother laws, such as the Commercial Code, the Civil Code, the Law on the TaxTreatment of Reserves and Provisions, the Income Tax Law and the Law on TaxAdministration. Not only would this improve KoB's recovery rate, it would alsohelp private commercial banks work out those classified assets that remain ontheir books, and thereby limit the risk that this remaining overhang would everfall on the government's lap.

(d) Strengthening bank governance and regulation. Another important concern willbe to avoid the recurrence of further bank distress. The IPB episode hasdemonstrated 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 asource of moral hazard across the industry.2 2

2.13 The payoffs of such an approach can be high. At 4.5 percent of GDP, the expected costsof bank restructuring would fall particularly heavily on the 2001 accounts (reflecting in part thedelayed coverage of KoB's cash drain of earlier years). However, on the assumption thatcurrent bad loans are recovered vigorously, and that the health of the banking sector does notcause repeated concerns from now on, the fiscal cost of bank bailouts could decline after 2001towards 1-2 percent of GDP (see Table 2.2), as the absolute amounts involved diminish andgrowth gathers strength.

Conclusions

2.14 In the short term, the priorities are to end KoB's banking operations (and associatedprovisioning requirements), to improve recoveries (including streamlining of asset disposal), andto avoid new bad loans and contingent liabilities. For the medium term, work should be startednow to strengthen the legal framework for debt resolution and the regulatory framework forbanks. In terms of the fiscal management framework discussed in Part 3, it will be important to

20 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.21 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 toeight years. In May 2000, the amendmnents to Bankruptcy Act came into force. However, there are still many gaps that need improvement. Thedefinition of insolvency has to be clarified and creditor rights strengthened. Time bound rules would also speed up the process. Sincebankruptcy is still a court-driven process, training for the professionals involved in the bankruptcy process has to be ensured.22 Much controversy surrounds the most recent state bailout of IPB bank, another troubled privatized bank. Some of the main reasons for the IPBproblems are the non-transparent ownership links via options and other similar contracts, and a materially and legally complicated operationsstructure that blurred the real quality of the assets.


continue to consolidate the fiscal cost of these operations, and associated contingent liabilitieswithin a consolidated budget and a Medium-Term Expenditure Framework, and to developrealistic projections of both costs and privatization receipts. Finally, the lasting cost of bankbailouts serves as a constant reminder to keep contingent exposures under careful watch. Therecent banking distress episode in the Czech Republic is hardly an exception. Internationalexperience 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-balancesheet obligations are being called. This is one of the reasons for the serious concerns noted inthe sector discussions below about the rise in extra-budgetary funds and their ability to issueguarantees and take loans. Part 3 will put forward some suggestions as to how the Czechauthorities 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, butthere is still substantial room to improve them to contain costs, establish financial sustainability,improve poverty focus, and reduce disincentives to work.23 The review highlights that:

(a) The state pension program faces serious financial difficulties given the agingpopulation. Projections show that the system will run into increasing deficits inthe next decade and become unsustainable. The government needs to implementfundamental reforms of the Pay-As-You-Go (PAYG) system, taking steps in boththe short and medium term to adjust the system's parameters and design andintroduce more fundamental structural reforms to ensure long-term financialviability.

(b) The welfare programs aimed at assisting the poor still lack adequate targetingand discourage work. This is because the Minimum Living Standard (MLS), towhich most benefits are linked, is higher than the minimum subsistence level formany families. For certain types of households and certain regions, it is higherthan average net wages and is likely to be a strong work disincentive. Benefitlevels may need to reflect more accurately the costs of a minimum subsistencelevel of consumption, and to be more modest relative to labor income. TheGovernment needs to strengthen its poverty monitoring, and adjust the benefitcriteria 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 insuranceprograms based on insurance principles (albeit loosely defined in most cases), including statepensions, sickness and maternity benefits, and unemployment benefit; and (ii) non-insurance-based social welfare programs, such as state social support and assistance. Social insuranceprograms are financed mainly through payroll taxes; and benefits are linked to individual's wage

23 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 thebeneficiaries.

2.17 Some of these programs have undergone significant reforms in the past decade, with aview to make them both more efficient and financially sustainable. These changes strengthenedthe insurance principles in the pension and unemployment benefit systems, and improvedtargeting of welfare benefits. However, given the government's limited fiscal capacity and theneed 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 2.3.24

Table 2.3: State BudgExpenditure on Social Protection Programs(CZK Billion) 1993 1994 1995 1996 1997 1998 1999' 2000'

Pensions 76.6 88.2 110.6 129.3 153.0 169.1 180.9 186.7PAYG state pensions 76.6 88.2 109.8 127.6 150.2 166.1 177.8 183.1Supplement to voluntary pensions 0.8 1.7 1.9 1.9 1.9 2.3Increased pensions 0.9 1.1 1.2 1.3

Sickness and maternity benefits2 12.0 16.6 18.4 20.4 19.8 18.6 19.3 25.6Unemployment benefit 1.4 1.8 1.8 2.1 3A 4.2 5.8 7.6Social Welfare, 31.4 33.2 30.3 34.1 36.3 38.5 43.5 45.8Total 121.4 139.8 161.1 185.9 212.5 230.4 249.5 265.7(As a percentage of GDP)Pensions 7.6 7.5 8.0 8.2 9.1 9.3 9.8 9.7PAYG state pensions 7.6 7.5 8.0 8.1 8.9 9.1 9.6 9.5Supplement to voluntary pensions 0.1 0.1 0.l 0.1 0.1 0.1Increased pensions 0.1 0.1 0.1 0.1

Sickness and maternity benefits2 1.2 1.4 1.3 1.3 1.2 1.0 1.0 1.3Unemployment benefit 0.1 0.2 0.1 0.1 0.2 0.2 0.3 0.4Social Welfare' 3.1 2.8 2.2 2.2 2.2 2.1 2.4 2.4Total 12.1 11.8 11.7 11.8 12.6 12.7 13.5 13.8rData 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 inrelatively good shape until recently. This is because the Czech Republic has not experienced therapid increase in unemployment, the collapse of revenue collection, that has afflicted othertransition economies, and the surge of disability pensions seen when the old age pension age wasincreased. The system also eschewed many of the special categories and privileges provided inmost transition countries.

2.19 As they currently stand, state mandatory pensions consist of

(a) Old age pensions (accounting for about 70 percent of the total pensionexpenditure since 1994). Eligibility is normally linked to reaching the statutoryretirement age and effectively retiring from the labor force, but special provisions

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


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 earningsduring the reference years preceding retirement.25

(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 pastfew 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 thestate budget to cover non-contributory periods for people engaged in designated activities,26 andto cover remaining gaps between revenues and expenditures.

2.21 The latter gaps have been growing in recent years. Under current conditions indeed, thesystem does not appear to be financially sustainable. The ratio of pensioners to contributors hasrisen from around 0.47 in 1994 to 0.53 in 1998, and, without additional reforns, is projected toreach over 0.60 by 2010, and continue rising to 0.71 by 2030. Alongside, pension outlays havebeen 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: thegap between pension outlays and contributions was over 9 percent of outlays (over 1 percent ofGDP) in 1999.27 Unless reforms are implemented, this gap will rise to over 3 percent of GDP by2020.28

2.22 Several factors have interacted to produce this emerging cnsis:

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

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

(c) Slow growth in contributions, reflecting a slower growth of the age groupsentering the labor force, significant periods of non-contribution, low contributionsfrom the self-employed, higher unemployment and slower wage growth since the

25 As part of the reform initiated in 1995, the reference period is being lengthened from 10 to 30 calendar years. This adjustment will becompleted during a 20-year period, starting from 1996.2 6 i.e., to cover periods of unemployment, higher education, military service and child rearing.27 This gap also includes transfers from the budget for certain non-contributory periods, so is somewhat larger than the underlying system deficit.2S The projected gap may be understated. Since 1998, when the projection was mnade, gaps have been larger than projected. The projectionexercise should be updated.


1997-99 recession, and large-scale early retirement (as previous contributorsmoved to beneficiary status).

Figure 2.1: Pension Increases Since 1993Although replacement rate has been relatively stable the growth of average pension benefit has been

in recent years, significantly higher than that of consumer price.(Average pension as percent of average wage) (percent)

25 _ Inflation

Net wage Average nominal

60 20 gross wage

50 15 Average old

199 1994 1995 1996 1997' 1998 1999 199 1995 1996 19927 198 199Note: Growvth rates are yearly averages and do not coincide with the changes in a particular month when pensions wereadjusted.

Source: MLSA

Reforming Pensions

2.23 Pension reforms during the 1990s initially focused on eliminating various specialtreatments inherited from the old system. Subsequently, a supplementary voluntary privatep)ension system (supported by the state) was established. From 1995 onwards, statutoryr-etirement ages have been raised (by 2 months for men and 4 months for women every year, untilthe retirement age reaches 62 for men and 57-61 for women, depending on the number ofchildren, by 2007) and the linkage between contributions and benefits was strengthened throughlengthening 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).2 9

2.24 While these earlier reforms were important (without them the system would be facingmuch deeper problems than it is today), it is clear that further fundamental reforms are needednow. The reforms should aim at: (i) strengthening the link between an individual's pensionbenefit 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 takeaction without modifying existing legislation:

29 Pensions for certain sectors (military, judicial, etc.) covering about 2% of total pension expenditure are administered by the Ministry ofFinance, but are governed by the same rules for contributions and benefits.


(a) Indexation. The Government should consider indexing pensions by the minimumlevel required by law. As noted above, the Government's past indexationdecisions have been above what is required by law.30

(b) Flat pensions. Adjustments to the flat part of the pension (which amounts toabout 23 percent of the total pension) are not specified in legislation. Thus, theGovernment could consider continuing its recent (since 1998) practice of keepingthis part of the pension constant in nominal terms. This is suggested only as ashort-term expedient to be used if other, more fundamental reforms proveimpractical. Even so, the impact of this measure on the poorest pensioners shouldbe 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 thesystem toward sustainability while deeper reforms (e.g., to establish NDC and/or fundedschemes) are being developed.

2.27 Indexation Rules. One option to consider is limiting indexation to the consumer priceindex (CPI) alone -- instead of using both the CPI and the real wage. In any case, the indexationrule should be transparent and apply to all pensioners.31 And, it might be better to baseadjustments 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 pointlower indexation factor would result in initial savings in the order of CZK 1.8 billion a year at2000 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 newearly retirees in 1996 to nearly 58,000 in 1999) reflects the incentives built into the earlyretirement provisions (which unfairly benefit the early retiree), the economic recession, and therising statutory retirement age. The shift to early retirement needs to be reversed as it reducesthe contribution base and increases required expenditures at the same time. Measures to achievethis could include:3 2

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

(b) Reducing (or at least preventing an increase in) the minimum period betweenearly retirement and the statutory retirement age.

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

2.29 Statutory Retirement Age. One should also consider further increases in the statutoryretirement age beyond 2007 when the current phased increase ends, and perhaps increasing it ata faster pace. While it would not have an impact in the near term, MLSA projections indicate

30 In 1999, for example, the Govemment made large adjustments for price increases that never materialized, substantially raising program costs.31 Recently, different adjustments have been applied to different groups of pensioners.32 Some measures to reduce the incentives for early retirement are expected to come into effect Julyl, 2001.


that, everything else being equal, continuing the increase in retirement age to 65 for both menand 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 ofduration and the choice of reference wage.33 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 ofeach insured person. Moreover, during non-contributory periods, an individual's average wageduring 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 areseveral ways to achieve this, including

(a) Reducing the duration of coverage of certain non-contributory periods, especiallyperiods recognized for unemployrnent, childcare, and higher education. Forexample, the duration for the unemployed could coincide with the period whenunemployment benefits are received.

(b) Using a lower reference wage (like the minimum wage or unemployment andsickness 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 arenot paying wages, with a view to not counting these periods (until/unless thecontribution is paid), or at least using a lower reference wage.

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

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

2.33 From Parametric to Systemic Reform. While moving ahead with the parametric reformssuggested above, the Government could also start to consider more systemic reforms, aimed attightening the link between contributions and pension benefits and thus provide a strongincentive for individuals to contribute more and retire later. This might involve one, or acombination of, the following approaches:

(a) A notional defined contribution system. One option would be for the PAYGsystem to transit to a notional defined contribution scheme based on individualaccounts. As these reforms are introduced, the system should be calibrated tobalance contributions (presumably based on a share of the payroll tax) andbenefits. In such a system, transfers from the state budget could be limited to

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


transparent and defined amounts designed to achieve specific objectives (e.g.,ensuring some redistribution toward the poor through a reformed flat pension orminimum pension guarantee; or supporting other social objectives through areformed, 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 linkagebetween benefits and contributions through individual accounts and bydownsizing the PAYG pillar could help set the stage for the development of thefunded pillar. Implementing such a reform requires implementing a fundingstrategy in a healthy macroeconomic environment and parallel reforms of thefinancial 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 entitywould do nothing in itself to solve the underlying financial problems of the pension system.Rather, experience in other countries has shown that such a framework has not been particularlyconducive to undertaking the reforms needed. As an alternative, the Government shouldconsider developing a separate administrative entity within the MLSA, possibly based on theexisting CSSZ, with clear reporting links and accountability. It could maintain the socialinsurance budget as a separate account, tracking revenues, expenditures and the balance,following sound accounting and financial management standards that allow this account to beincorporated easily into the consolidated general government accounts.

2.35 The Government should also continue to strengthen capacities in at least two specificareas: (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 tomake programs more effective.

Sickness and Maternity Benefits

2.36 The sickness and maternity benefits provided by social insurance (which provide benefitsduring periods of leave taken for sickness, maternity and family emergencies)3 4 would alsowarrant a thorough review. This program involves a substantial amount of money (about 1.3percent of GDP, see Table 2.3); its costs are relatively high in comparison with similar programsin other countries of the region; and, it contributes to the burden of wage costs (the program isfunded by a 4.4 percent payroll tax). The program should also be assessed in terms of itsinteraction with the health insurance program. For instance, if doctors must be consulted tovalidate sick leave requests, this could contribute to the unusually high incidence of doctor'svisits in the Czech Republic (see Section D). There may be ways to modify this program toimprove its cost-effectiveness and pave the way for cutting back the related contributions.

34 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 interms of benefit level and overall expenditure, totaling 0.3 percent of GDP in 1999. This isequivalent to 0.9 percent of the payroll, compared to the 3.6 percent payroll tax that is designatedto finance this benefit. However, program costs have risen rapidly due to rising unemploymentafter 1996, and recent increases in benefit levels. Rather than modifying the benefit level andstructure or establishing new active labor market programs, the government should give seriousconsideration to cutting back contribution rates or redirecting that part of the payroll tax to thepension fund.

Social Welfare Programs

2.38 Social welfare programs were reformed in 1995 to move them towards a more targetedsystem. However, more could be done to: (i) contain overall expenditure; (ii) improve programefficiency in assisting the groups at risk; and (iii) minimize disincentives to work. This sectionargues that policy changes would involve revising the Minimum Living Standard (MLS) andtightening several categories of benefits that are currently not targeted at the poor. Policyanalysis needed for program evaluation and design should include a greater focus on programimpact 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 thestate budget and administered by the central government. Out of the total ofabout 2.4 percent of GDP spent on social welfare programs, about 75 percent, (1.8percent of GDP) is spent on this component. These programs aim primarily atproviding cash assistance to families with children. About 90 percent of thesebenefits are child-related. This includes: (i) income-tested child allowances andsocial supplements; and (ii) non-income tested parental benefits, childbirthgrants, and foster care benefits.3 5 In addition, transportation allowances aregranted to assist children commuting to school. Besides benefits to families withchildren, housing benefits, death grants, and support to families of those incompulsory military services ("providing for benefit") are also given.36 About 66percent of these benefits are subject to income testing. Others are granted onuniversal basis.

(b) Social assistance benefits are funded by the state budget, but administered at thedistrict or community level.37 Spending on these programs has been rising rapidlyup to about 0.5 percent of GDP in 2000. These benefits include: (i) the socialneed benefit, aimed at supplementing household income (including benefits fromsocial support programs) to ensure that it reaches at least the Minimum Living

At the suggestion of MLSA we use the terminology defined by the Czech Statistical Office.36 From 1997, heating and rent contributions are added to cash transfer programs, but they are not included formally as "state social supportprograms."3 For a comprehensive descniption of the policies of theseprograms, see Dlouhy (1999) and Visek (1999).

2: Expenditure Refonn Opportunities 33

Standard (MLS) defined according to household size and the age profile ofhousehold 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 aremore 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 includecounseling services for particular vulnerable groups, help offered to the old anddisabled, as well as community and institutional care. Spending on theseprograms 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. Thecurrent MLS was developed in early 1990s to reflect the cost of living of individuals at variousages 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 andlevels of benefits (both the income testing thresholds and benefit levels are expressed in terrns ofMLS).

2.41 Several problems have become evident regarding MLS.

(a) MLS may not accurately reflect today's true minimal subsistence level. Since theearly 1 990s, the cost of different essential components (such as food and housing)has changed at widely different rates. While this problem has been partiallycorrected by adjusting different components at different rates, it is advisable, inview of the large structural changes that have taken place, to re-examine thecomposition and cost of basic consumption items, and to modify the structure andlevel of the MLS accordingly.3 8

(b) The level of MLS appears to be too high for certain categories of households andgenerates strong work disincentives. For larger families, the MLS is very close oreven higher than the average net wage (Table 2.4). Under such circumstances, the

38 Due to the faster increase of housing costs, the amounts needed to assure housing have increased more dramatically than amounts needed forfood and other basic needs. (Note: the MLS is determined by the sum of the amounts necessary to meet personal needs and the sum of housingcosts 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 withmore members is corrected gradually.


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 unemploymenttrap.39

(c) Given the significant regional disparities in the Czech Republic in terms ofincome, cost of living, and unemployment, there is a case for developing differentMLS for different regions.40 For example, the government could considerdifferentiating Prague from the rest of the country, or even further differentiatingaccording to towns and regions. In some regions, the average net wage issignificantly lower than the MLS in a household with two adults and one or twochildren. 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 adult I,700 1,700 1,960 2,160 2,440 2,890 3,040 3,430 3,430Two adults 3,050 3,050 3,500 3,860 4,360 5,110 5,370 5,960 5,960Two adults with one child 4,200 4,200 4,810 5,300 5,960 6,970 7,330 8,100 8,100(age 6-10)Two adults with two children 5,400 5,400 6,170 6,800 7,580 8,820 9,270 10,150 10,150(age 8,12)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 ... And for lower income regions.

high for larger households...MLS for 2-adult 2-children family Average net wage1260(C in East Bohemia and South Moravia

1000(- MIS for 2-adult 3-children family 12000

\000- ~ Z 10000 2-children family8800C

6000~~~~~~~~~~~~~~~80

Average 60004000 ~~~~~~~~~net wage O

2000 - L LL e V R g 20°00

1993 1994 1995 1996 1997 1998 1999 1993 1994 1995 1996 1997 1998 1999Source: MLSA.

39 In the opinion of MLSA, the MLS amounts are determined correctly. The MLSA views the use of the MLS to determine the eligibility for andlevel of social benefits as a separate question. In the system of state social support, the payment of benefits depends on the adjustment of thecorresponding parameters. There is no entitlement to social assistance benefits (in accordance with the Act on the social need), by which theinsufficient 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 ofan individual household are tested, especially the possibility of increasing the income by the endeavour of its members, e.g., by their employmentin particular. For informnation and for the evaluation of the level of disincentives to work caused by the generosity of the benefits assigned for theprotection against material need, MLSA stresses that social assistance benefits in 1998 represented only 3 percent of the total incomes of thecitizens. In 1999, they increased up to 3.9 percent due to the rise in unemployment and other economic problems of enterprises.43 According to MLSA, it is not necessary to treat regional disparities in the level of living expenditures, in particular in view of the differenttrends in housing costs, by the development of different MLS for different regions as for this purpose the Act on social need and the system ofbenefits provided according to this act suffice to cover the regional differences.


2.42 Since the MLS is high for certain types of household, the Government could considerreducing the real value of MLS (and benefits) for certain categories to reduce the distortions thatit produces on work incentives. Alternatively, a "survival minimum" can be developed toreplace 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 roomfor further targeting in these programs. This is true both for income-tested and non income-tested programs.

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

Table 2.5: Child Allowance and Social Supplement, 1998Income threshold Benefit per child' 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%0X

Social supplement (test family income of the previous quarter) 453,000<=I.O 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

'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 childallowances. The current threshold (3 times the MLS) will offer child allowance toany 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 mostvulnerable.

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


(c) Consolidating the child allowance and social supplement programs andintroducing 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 aregressive tax provision, and especially benefits those whose monthly incomes isabove CZK20,000. Removing this tax deduction would bring a net gain to thefiscal balance of over CZK6.1 billion.

2.46 There have been active discussions and debates in the government on reforming the cashtransfer programs. One proposal is to change the child allowance program from income-tested toa universal one. While recognizing the advantages of low universal benefit in terms ofadministrative simplicity and less distortion in labor supply decisions, the potential cost of suchproposals is a serious concern.

2.47 Parental Benefit. The parental benefit accounts for about 26 percent of the total socialsupport expenditure. The level of benefit is slightly higher than the MLS for a single adult, orabout 25 percent of the average net wage (20 percent of gross wage). The duration is four yearsper child and seven years per disabled child. The number of beneficiaries decreased from3.5 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 adisproportionate share of women would become unemployed during transition, it is not clear thatthe parental benefit helps improve women's job opportunities and earning potential in the longrun. Consideration should be given to shorten the benefit period and to introduce a decliningbenefit scale to encourage reentry into the labor force. Savings in this area could be used to helpwomen find jobs or for child care services designed to encourage women's labor forceparticipation.

2.49 Transportation Contribution. The transportation contribution is universal for all childrengoing 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 overCZK 1 billion. It is a complicated scheme to administer and it is not clear that poor families areable to benefit significantly from this subsidy. The government could review this benefit andmay consider eliminating this benefit category, or using the savings to finance enhanced childbenefits for the poorest families.

Locally Administered Social Assistance Programs

2.50 Locally administered programs may have significant advantages in identifying the poorand monitoring developments in the field more closely.41 However, such decentralization shouldbe accompanied by adequate monitoring, probably at the central level, of expenditureeffectiveness, including in particular its impact on reducing poverty, in meeting the differentneeds for social services, and in ensuring that there is adequate access to services for all regions

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


and ethnic groups. The crucial information needed for regular evaluation of the impact of socialassistance and for poverty monitoring is lacking.

2.51 In addition, the MLSA analysis shows that some communities do not or cannot providenecessary funds to close the gap between the amount of transfer from the state budget and thereal costs of operations for the services they provide. Therefore the quality of local programsvaries across regions. Developing community-based and driven social services with activeinvolvement 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 andpoverty analyses are needed. They would inform on the evolving nature of poverty to be tackledby various instruments, and the incidence and effectiveness of assistance. Currently, householdsurveys of appropriate sample size are conducted only once every four years. As a result, someof the analysis is not well grounded. Some qualitative surveys with specific focus would provideuseful information regarding the extent to which different regions and ethnic groups arebenefiting from the system. The fiscal and poverty impacts of the policy measures discussedabove 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 intendedresults and enhanced the targeting of social welfare benefits, there is an urgent need to reform thepension 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 reducedisincentives to work and to improve their targeting and poverty focus while reducing their cost.

2.54 In the area of pensions, the authorities should first consider -- as short term, stop gapmeasures -- indexing pensions only by the minimum level required by law, and continuing tokeep 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 policyparameters 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.42

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

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

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


(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 schemeand/or introducing a funded scheme) should be seriously considered as ways to bring long-termfinancial sustainability and effectiveness to the system. These longer-term reforms will tightenthe 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 suchmedium-term reforms should start as soon as possible. Similarly, reviews should be carried outof the sickness and maternity, and unemployment benefits to identify medium-term reforms totarget these benefits better and reduce costs or tax rates, as suggested above.

2.56 The social welfare programs should be carefully reviewed to improve targeting, reducedisincentives 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 subsistencelevel of consumption; the minimum income test level for the child allowance should be loweredand its duration reduced; the child allowance and the social supplement could be consolidatedinto one simpler system, with benefits better focused on the most vulnerable; and the parentalbenefit and transportation benefit could be assessed for better targeting and possibleconsolidation with the income-tested benefits.

2.57 To design and manage such reforms in social protection programs, it will be important tohave in place the capacity to analyze policy options and to design and monitor policy andprogram reforms. For pension reforms, the considerable capacities of the CSSZ can be used andfurther strengthened. For assessing social welfare (and other) programs, more frequent, well-designed household surveys, with samples adequate to measure program impact across andwithin regions will be critically important. Such surveys will enable a quantitative analysis ofthe poverty situation in the country and an assessment of the impact of policy and programoptions on the poor. These surveys will also be increasingly important as a way to monitor theeffectiveness of decentralized regional governments and municipalities in delivering services tothe people. The analytical work both on pensions and on social welfare programs should beorganized to feed into the fiscal management approach (performance budgeting within aMedium-Term Expenditure Framework) outlined in Part 3 of this report, by providing ongoingassessments of the impact of program expenditures and identifying measures to increase theireffectiveness.

D. HEALTH

Introduction

2.58 Deep reforms of the health sector in the 1990s have brought about major improvementsin health indicators, but substantial scope remains for further reforms aimed at preventingexcessive growth in demand and costs, encouraging more efficient use of human and physical


resources, and making sector financing more sustainable.43 This section analyzes the structureand trends in health sector expenditures and then identifies reform issues and options. The mainareas 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 moreefficient resource use.

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

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

2.59 Further development of capacity for health policy analysis and formulation to design andimplement these and subsequent reforms, and to feed into a continuing assessment of programperformance and expenditure effectiveness in the context of a Medium-Terrn ExpenditureFramework (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 preventthe 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 the Czech Republic has undergone a radical transformation since1990. Reforns have converted a centralized bureaucratic system into a group of largelydecentralized institutions that provide insurance and health care services. The progress made inreshaping the environment in which physicians and other providers work has been remarkable.Moreover, these reforms, combined with general improvements in the economy, are associatedwith significant improvements in health outcomes. Since 1990, life expectancy rose from 71years 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 thepath of reform, exhibiting a willingness to adopt additional reforns as the need has becomeapparent.

Table 2.6: Index of Infant Mortality Rate in Selected Central European Countries1990 1990 1991 l 1992 1993 1994 1 1995 1996lIMR Index (Base 1990=100)

Czech Republic 10.8 100 96 92 79 73 71 56

Hungary 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.

This section draws on a background paper on "Public Expenditure Analysis of the Health Sector."


2.62 The continuing commitment to health sector reform is justified, especially in the area ofcontaining costs and rationalizing expenditures: (i) costs are high compared with other countrieswith similar demographics and income levels; (ii) there are signs of excess consumption ofservices; (iii) imbalances appear in the supply of certain inputs; (iv) the funding mechanism iscomplex, and possibly unstable; (iv) arrears have emerged in both revenue receipts and paymentsto providers; and (v) pressures on spending are likely to grow as the population ages and asincomes grow. Focusing and further strengthening the Czech Republic's demonstratedcapacities for policy analysis, formulation, and monitoring could help develop reforms to dealwith these problems and subsequently identified problems. The key challenge will be designingand 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 similarincome levels and population age structures.44 This suggests some scope for containingexpenditures. Although expenditures have been relatively stable as a share of GDP (see table2.7),4 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 thereformed Czech health system. The functions of health care delivery and insurance have beenseparated, and while most funding derives from the consolidated public sector, the Ministries ofHealth and Finance now play much more passive roles than in the past. The bulk (about 83percent) of expenditure, and a growing share, is paid by insurance companies to decentralizedproviders, 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) which has 75percent of the market share. The other companies are mainly based on client groups fromspecific trades or industries (e.g., banking, or Skoda-VW) and operate on a not-for-profit basis.

" Komai and McHale, "Is post-communist health spending unusual?" Economics of Transition (2000).45 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( ZK billions, or percent)

1993 1994 1995 1996 1997 1998 1999 2000Actual Actual Actual Actual Actual Actual Expected Projected

I 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 69.7 84.2 95 104.1 111.6 121.7 124.8 130.7(1-8)

3 State budget (including transfers) 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

3cl 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 I 0 0 0 0.5 0.1 0 0HlCs

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

3d Insurance contributions for state 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 7.5 8.7 9.6 7.2 7.5 7.8 7.4 6.9budget (3a+3b+3c3) ..

4' As % of total expenditures 10.2% 9.R7 9.4% 6.4% 6.2% 5.9% 5.4% 4.8%

5 Local authorities 6.4 6.1 7.3 6.5 5.9 5.8 5.7 5.7


6 Health Insurance Companies 55.8 69.4 78.1 90.1 97.3 107.5 111.6 118.1(6a+6b+6c)


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' 0 0 0 0.3 0.9 0.6 0.1 0claim s__ _ _ _ _ _ _ _ _ ___ _ _ _ _ _ _ _ _ _ _ _

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

8' As % of total expenditures 5.2% 6.0% 7.2%6 7.4% 8.1% 8.0%1 8.3% 8.4%

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 healthprovision. Expenditures from the state budget are mostly related to transfers of insurancepayments to the insurance companies either for the states' own employees (line 3d in Table 2.7),or for the non-workers (line 3cl). Direct (non-transfer) expenditures4 6 on health by both centraland local governments (lines 4 and 5) have declined as a share of total spending, falling by morethan a half over the period 1993-2000 to less than 9 percent of total spending. Non-transferexpenditures mainly finance investment and some operational expenses of government-runhospitals.

2.66 In the present setting however, patients still have little incentive to limit their use ofmedical services. Patient's co-payments are limited to a small share of a few items (mainly

46 State budget transfers are those made to health insurance companies on behalf of state employees and the non-working, plus transfers to localauthorities.


pharmaceuticals and dentist services beyond standard norms). It is interesting that despite thevery 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 contribution payments are based on an individual's actual or notional income,47 andthere is no direct link between this contribution and the expected benefits for individuals or risksto insurance companies. The system is also highly redistributive, with over half of thepopulation (the non-workers) paying nothing directly, and the self-employed paying only 35percent of what other workers pay.

2.68 Collection has been a problem. The insurance industry has amassed both liabilities andreceivables over the past seven years, due to unpaid contributions by individuals, and delayedcompensation of providers by the insurers themselves. Table 2.8 reports the stock of paymentsthat 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.) 4.8' 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 togo in rationalizing its resource allocations. As noted above, total health spending is 1-2 percentof 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 rapidprice escalation as the population ages and incomes rise. This indicates that better incentives areneeded on both the demand and the supply side to contain costs. There are also problems withthe currentfinancing mechanism, including the build up of significant arrears. Over the mediumterm, further attention needs to be given to the role of insurance companies and their regulatoryframework. Finally, further attention should be given to strengthening and focusing thecountry's considerable capacity to analyze health policy issues and design and implementsubsequent reforms.

47 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 13.5percent of 80 percent of the minimum wage for those not working. Payments for the first two groups are collected from employers or individualsby the insurance companies. Payments for the non-workers are transferred to the companies from the state budget. These amounts aresubsequently transferred to a central pool and then reallocated to the companies afler 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 costsfor the resources they use since nearly all services are free. One indicator of this is the frequencyof outpatient visits. In 1995, there were 15.0 outpatient visits per inhabitant. In contrast, thenumber of outpatient visits per person in most OECD countries in 1985 ranged from 2.7 inSweden to 7.8 in Australia, with only Italy (10.1) and Japan (12.7) having rates approachingthose of the Czech Republic. The comparatively high rate of physician visits suggests thatfinancial savings could accrue to insurers, and passed on to the consolidated govemment budget,with little impact on health outcomes.

2.71 The most straightforward, and probably most effective way to put downward pressure onusage 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 tocontain costs and would reduce the moral hazard in the current system. Although some limitedcost sharing exists for pharmaceuticals and dental care, there is a serious concern in the CzechRepublic that introducing a broad-based co-payment system would face formidable politicalobstacles. 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 effectiveand sustainable path. Consequently, the authorities are encouraged to identify ways in whichdemand-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 relativelyhigh share of the system's costs.

Figure 2.3: Level and Composition of GHIC Spending

Aligning Supply Side Incentives (per standardized covered individual)

600 -

2.72 Despite significant changesover the past decade, various signs 5 _of imbalance persist on the supply 4,

side. While the number of hospitalbeds has steadily declined, it is still s -*r

high relative to the needs of the 2M

population and the utilization ratesare lower than in most OECD l-0_countries. Moreover the mix ofbeds is out of balance, with a ,,4 1"5 .9, 1"7 . s

surplus of acute care beds and a UGP. D-tits Out-pti.,nt OIn-p.tiet UBths T`rn.prtr Drugs

shortage of beds for long-termcare. There is also a concem that there may be a growing surplus of doctors.48 More generally,as Figure 2.3 demonstrates, in-patient, hospital care still dominates health expenditures, with theshare of spending on (usually more cost-effective) outpatient care rising only slowly since theearly 1990s.

4 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 withdesired health sector outcomes. A variety of financing mechanisms has been used for each typeof medical provider. When an initially adopted fee-for-service mechanism threatened to causeexcessive cost increases, the authorities introduced alternative systems. Since 1997, generalpractitioners have been paid on a (modified) capitation basis, receiving a more or less fixed feefor each registered patient; specialists have continued to be paid on a fee-for-service basis; andhospitals have been subject to something of a fixed budget allocation mechanism. This globalbudgeting approach is intended as an interim arrangement while a new approach, based on aDRG (diagnostic related group) model, is developed and tested. This approach is intended notonly to contain costs, but also to remove the incentive, imbedded in the current system, forhospitals to avoid patients with problems that are expensive to treat.

2.74 The authorities should continue to analyze carefully the effects of various providerpayment mechanisms on the costs and effectiveness of health services and adopt changes asneeded. In general, the imbalances in input use and resource misallocation currently faced by thesector 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 inducethe required shift in supply could be to alter the way in which services provided to the two typesof patient are reimbursed. The advantage of this approach is that it can be applied uniformly toall institutions, avoiding to some extent the politically costly process of apparently arbitrary andselective ward closures. It should be emphasized, however, that such supply-side measures arelikely to be more effective if they work in association with a broad-based cost sharing byconsumers as recommended above.

Improving the Financing Mechanism

2.75 The present financing mechanism for insurance companies merits careful review. Itsfinancing source is potentially unstable. It is complex, with significant administrative costs,relatively weak enforcement of collection, and major redistribution across client types, but notnecessarily 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 healthneeds are, if anything, counter-cyclical. If the economy falls into recession, lower incomes andunemployment lead not only to lower insurance revenues but also both to greater healthproblems and lower willingness to pay for preventative and curative services. Since there isnaturally 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 badyears. In the event that costs are contained to below revenues in a given year, mechanismsshould be put in place to prevent that this savings be dissipated, but rather set aside to offsetdeficits 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 eachinsurance 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 onthe social insurance payments that it already collects. This should cause almost no additionalcost to the Government and substantial savings in administrative overheads to the insurancecompanies. Moreover, it could help increase the collection rate, including collection of thegrowing stock of receivables, because the central tax authority would have both more effectivesanctions and higher ranking than insurance companies among creditors of firms in financialdistress.

2.78 Finally, the government should carefully assess the effects of the redistribution acrossclient groups now built into the financing mechanism. The incidence could be regressive inways not intended, for example for the working poor. Analysts should look for policycombinations (such as lowering the health insurance contribution rate for employees, whileintroducing 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 adjustmentformula.

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 rolein cost containment, by moving towards managed care arrangements, in which insurancecompanies and providers interact closely with each other. Included in this would be a moreactive role for general practitioners as gatekeepers to specialized care in order to reduce the rateof referral to more expensive specialists for outpatient services. To support such a move, and tomaximize its benefits, the policy toward the health insurance companies and their regulationwould 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 todevelop healthy competitive conditions, both in the insurance market and in the medical labormarket. Insurance companies would need to compete in ways that enable consumers to share inthe benefits of cost containment through lower prices, better contractual terms, and/or higherquality. The regulatory framework would need to support competition on these lines, permittingconsumer choice while ensuring adequate minimum standards and preventing cream skimming.To ensure adequate competition would likely require the break up of large players, especially theGeneral Health Insurance Company. While the government is understandably keen to maintain ahigh level of quality for all Czech citizens, some product and price variation seems unavoidableif the discipline of consumer demand is to be used to control costs. These would be fundamentalchanges in the way insurance companies operate, and would require substantial preparation todesign and implement.

Capacities for Health Policy Reform

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


quality and cost containment are examples of issues that policy analysis can inform. Developinga high quality, interactive management information system to assist the government, insurers andmanagers track the volume and costs of care would provide an important building block for suchanalysis as well as for regular management of the system. Such analysis would allow adjustmentto the health system and its financing through a more transparent and consistent assessment, andcould lead to more coherent health policies that adapt to the country's changing conditions andneeds. One of the most important tasks of health policy analysis should be to contribute directlyto analyzing health expenditures in the context of a Medium-Term Expenditure Framework (seePart 3), 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 policyanalysis and strategy development. The analysis can be contracted out, carried out in-house, or amix of both approaches, as appropriate. However, there is a need for a strategic approach inidentifying priorities for analysis. At present, health policy formulation is fragmented. Policyshifts 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 the Czech Republic have achieved a great deal. Theimprovements in health outcomes, while not all directly attributable to the reforms, are alsoencouraging. Still the system faces serious risks because there are no incentives on the consumerside to contain costs. Implementing consumer cost-sharing across the broad range of healthexpenditures is probably the single most important instrument available to promote long-termcost containment and more efficient resource use.

2.84 In the short run, the cost sharing principle could be expanded beyond the very limitedareas 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 inplace. Other areas of reform that need attention include: (i) reforms of provider paymentmechanisms to reduce further the supply-side imbalances and resource misallocation, whichcontinue to impair the overall efficiency of the health system; and (ii) reforms of the complex,costly and potentially unstable financing mechanism, possibly including piggybacking premiumcollection 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 bepossible to lower the contribution rate for employees, and possibly increase contributions fromthe self-employed and from non-workers. In addition, insurance companies could play a largerrole in cost containment through the development of a managed care approach. Such anapproach, however, is likely to be effective only if supplemented by deep, but difficult toimplement reforms of the legal and regulatory framework of the insurance market. Answers tothe policy challenges facing the Czech Republic call for careful analysis and design ofinterventions, and this highlights the need for a focal point for coordinating health policyanalysis and formulation. It will be important for this analysis to feed into the Medium-TermExpenditure Framework and performance budgeting process (discussed in Part 3) to helpestablish expenditure levels and program priorities.


E. EDUCATION

Introduction

2.86 The sweeping changes brought by the transition from communism have had a majorimpact on the education system. As a result, the education system needs to be reoriented to meetthe needs of a modem market economy by increasing its focus on the more general, higher levelskills the economy needs, and by expanding access to tertiary education.49 As this sectionargues, there are good reasons to believe that this can be done while keeping public spending oneducation at its current level of under 5 percent of GDP.50 The key elements of this approachwould be:

(a) Phased expansion of tertiary enrollment by:

(i) Increasing enrollment at existing universities, financed largely by tuition,combined with student loan programs and limited, need-basedscholarships. The costs could be kept low since the expansion couldmainly mean more intense use of existing resources, including faculty.5'

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

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

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

(i) Revitalizing and expanding the "optimization program", which seeks toconsolidate public schools by taking into account the declining numbers ofschool-age children; the already small size of classes and low teacherworkloads, 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 provideincentives that encourage consolidation.

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

49 This section draws on a background paper on "Public Expenditure in the Education Sector."50 Different sources show education spending ranging between 4.4 to 4.7 percent of GDP in 1999. The two sources differ in using a slightlydifferent method for aggregating education spending, but they show nearly identical trends. See Table 1.5." The university student-faculty ratio is less than 12, compared with an OECD average of neariy 17.


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

(c) Implementing decentralization in ways that ensure accountability for achievingagreed outcomes, and that permit savings realized at primary and secondary levelsto be reallocated to improving quality and to be used for expanding the tertiarylevel.

(d) Ensuring the capacity is in place for education policy analysis and formulation todesign reforms, monitor results and feed into the continuous, systematic review ofexpenditure perforrmance in the context of the Medium-Term ExpenditureFramework. A systematic program of national assessments is an essential tool formonitoring the progress and impact of education both at the national level andbetween 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 alsoto 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 ithas also brought other changes creating some scope to meet these demands without majorincreases 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 skillsassociated with a shift from traditional manufacturing to services, finance and publicadministration. At the same time, there has been a rapid increase in the market valuation ofeducation, with widening salary differentials between workers with different education levelsthat suggest greater scope for charging tuition, especially for higher levels of education. Therehas also been a dramatic decline in fertility, resulting in smaller numbers of school-aged childrenand excess school capacity at primary and secondary levels.

2.88 There are three significant differences between the Czech Republic's labor force and thatof other OECD countries that suggest the need for significant changes in the output of theeducation system to align with other modem market economies: (i) a very high proportion of thelabor 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 averageof 23 percent); and (iii) a high percentage of upper secondary school students is enrolled intraditional vocational programs, as opposed to more general academic programs (16 percent inacademic programs vs. 47 percent for OECD).

2.89 To some extent, the Czech Republic's education system, building on its considerablestrengths, has responded to the need for change. The decision in the early 1990s to allow theprivate sector to provide education has been particularly significant. The newly emerging privateschools 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 positiveimplications 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 trendspresented 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 exceptionof the Roma minority) has dropped significantly over the 1990s. This reflects thefall in the school-aged population. The latter is expected to decline by another 19percent in the next 5 years. There has not yet been significant private sector entryat this level of schooling.

(b) The three streams of secondary education -- the vocational schools, the technicalschools, and the general academic schools (gymnasia) -- have all shown largeenrollment declines. The sharp reductions in enrollment in public schools morethan offset the rise in private schools, which expanded rapidly to about 12.6percent of total secondary enrollments by the end of the decade. While theprivate schools charge tuition, public schools cannot.52

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

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

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


Table 2.9: Enrollment by School Level and Ownership, 1989-1998('Thousands of students)

Year| 891901 90/91 9192 92/93 93/94 94/95 95/96 96/97 97/98 98/99

Panel A: Basic Education (prinary + lower secondary)

Public 1l235.71 1192.61 1 16.3[ 1112.81 1058.5 1023.6 1000.2 1095.4 1085.2 1076.6

Privatel -I 1.21 .2[ 1I 1.1 ' 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 0.3 250.8 241.2 242.6 234.7 178.61 156.8 132.9

Private 0.0 0.0 - 17.4 27.5 26.0 27.3 21.61 19.3 17.5

Commercial 0.0 0.0 - 17.3 27.4 25.9 27.1 21.41 19.2 17.4

Church 0.0 0.0 - 0.1 0.2 0.1 0.2 0.11 0.1 0.2

Panel E: AU Upper Secondary Schools

Public 569.6 570.2 266.6 512.4 498.1 508.0 507.1 396.81 375.8 351.0

Private - 0.2 - 36.3 63.8 79.0 87.0 67.61 59.0 50.5

Commercial - 0.1 - 33.8 60.0 74.3 82.1 63.51 55.1 46.5

Church - 0.1 - 2.5 3.8 4.7 4.9 4.01 3.9 4.0

Panel F: Higher Professional Schools

Public -j -j -i 1.1o 1.41 3.11 4.11 9.1 1 14.61 18.7Private 0.41 1.01 1.51 2.21 5.91 9.0 10.8

Panel G: Tertiary Level

Public | 113.41 118.21 112.01 114.21 122.31 129.51 139.81 155.91 165.81 174.2

Private - - - - - - - - -I

- 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 begrowing.5 3 This excess demand seems to coexist with substantial capacity forexpansion at the university level, given the low student faculty ratio (less than 12compared with an OECD average of about 17). There is scope for much greaterreliance on tuition payments to finance expansion of tertiary education, given theemergence of significant wage premiums for higher levels of education.

(b) At the secondary and basic levels, there is a vast scope for consolidation of publicschools, not only because of the decline in the relevant age cohorts, but also

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


because of the growing enrollments in private schools. The Government's"Optimization Programn," launched in 1997, was intended to deal with this, but itsimpact was less than expected and it has come to a virtual halt. So far, despitethese efforts, the drop in enrollments has been associated with a rise in the totalnumber of schools and a decline in class size, indicating that appropriateconsolidation at this level has not taken place.54 Nor are there clear signs of areduction of the dominance of vocational education at the secondary level, as thegymnasia accounted for less than 19 percent of secondary enrollments in 1999.The opening up of more university places could induce higher general academicenrollments as the bulk of students admitted to universities are from gymnasiumgraduates.

Expenditure Trends and Funding Mechanisms

2.92 The expenditure trends in education do not yet fully reflect the major structural changesunderway in the sector, especially the sharp drop in primary and secondary school enrollmentsdescribed 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 inthe early 1990s (Table 2.10). Since enrollments have declined dramatically, this suggests anoverall substantial increase in real spending per student. While some of this increase probablyreflects real increases in teachers' salaries, general quality improvements, and, at the tertiarylevel, enrollment growth, it is likely that it also reflects substantial scope for additional efficiencygains from further consolidation.

2.93 At the same time, there are serious concerns about the composition of spending, as mostof the increase in spending appears to be driven by teachers' salaries, which have grown muchfaster than other expenditure categories. This trend is likely to continue in the near future and ithas already dried up any room for growth of other current expenditures. This is likely togenerate a pent-up demand for investment and maintenance spending that could become morecostly to deal with in the future (as deferred maintenance could lead to expensive rehabilitation).Moreover, excessive constraints on current expenditures that are important for qualityenhancement (e.g., teacher training, instructional materials, etc.) will have long-term costs. Thepresent funding mechanism allows schools to pay higher wages to smaller numbers of teachers,55

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 thefunding mechanisms foreducation to identify ways in which they can support a smoother response to the structuralchanges underway and more efficient resource use. Most funding for education (about 85percent) comes from the public sector, with the central state budget providing the bulk (over 82percent) of public funding. This covers most of the costs of public schools and providessubstantial subsidies to private schools. Municipalities are the other important channel of publicfunding, providing about 17 percent of public spending, and are responsible for administration ofkindergartens and basic schools and for co-financing their investment and maintenance. Underthe new regional government system, the maintenance and investment funds for the upper-

54 For example, class size in vocational schools has dropped from 21 students to 14.55 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 statebudget will continue to cover wages and educational equipment.56

2.95 The normatives used to fund schools 57 do not appear to be working as well as one mightexpect to provide incentives for more efficient resource use, such as more rapid schoolconsolidation. 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 wasabout 45 percent more than for a basic school with more than 251 pupils. This mayovercompensate for fixed costs and offset any incentive to consolidate. Moreover, there is littleflexibility 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 allocatedresources within a given spending category) and preclude efficient use of resources. Thenormatives do not appear to have been structured to reinforce efforts to consolidate, useresources more efficiently, or provide incentives to increase enrollments in more generalacademic training.

2.96 In addition to these issues, for non-public schools there is an additional issue of theadequacy of public funding provided through this mechanism. Non-public schools receivebetween 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. Additionalfunding varies according to school quality as evaluated by local schools offices. The stateprovides no investment or rental support for non-state schools and these costs have to be coveredfrom tuition and other private sources. Overall, private schools receive just under 3 percent oftotal education spending, while they enroll about 3.7 percent of all students.58 However, privatesecondary schools (and all higher professional schools, including public ones), are allowed tocharge tuition. For example, in 1998, private gymnasia charged an average tuition ofCZK15,000, equivalent to about 55-65 percent of the per student normative payment to publicgymnasia. This, combined with the rapid expansion of private schools, suggests that the currentarrangements provide very strong incentives indeed for establishing private schools.

56 See Part 3 for a discussion of the Czech Republic's decentralization program.57Budget funds for current (recurring) spending and investment (capital) spending are allocated according to different rules. Current budgetallocations constitute about 90 percent of total education spending and are determined by multiplying per-student expenditure norms (referred toas normnatives) by the total number of students enrolled in different sorts of accredited schools. The per-student norms pTimarily cover wages andother current expenditures. They are set each year by the Ministry of Education, with different normatives used for schools with differentcharacteristics (e.g., level, type, ownership, and size). The normatives have separate, non-fungible subcategories for different types ofexpenditure (e.g., wages, operating costs, etc.). Investment funds, amounting to about 10% of total spending, are allocated on a case-by-casebasis.5S This implies that private schools receive just under 80 percent of the per student allocation that public schools receive.


Table 2.10: Structure of Expen iture on Educ ation T yype of SchoolPanel A: In current prices /CZK billion] 1993 1994 1995 1996 1997 1998 1999

Total expenditures' 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

Secondary Technical Schools (STS)3 8.6 9.7 9.5 8.8 9.0 8.1 8.8


Special schools 3.7 3.8 4.2 4.2 4.5 4.6 4.9


Other expenditure'4 22.7 20.2 18.0 17.4 18.7 19.5 19.5

Panel C. In constant 1993 prices (CZKbillion] 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

Secondary Technical Schools (STS_ 4.6 5.5 5.7 5.5 5.0 4.1 4.8


Special schools 2.0 2.2 2.5 2.6 2.5 2.3 2.7


Other expenditure4 12.2 11.6 10.8 10.9 10.4 10.0 10.6

Consumer price index l993= 1004 j °° °Ill - 120.0 130.6 141.7 156.9 160.1

Total expenditure on education by type of school in years 1993 -1998 from budget of Ministry of Education, municipalities and otherdepartments (Ministry of Economy, Ministry of Health, Ministry of Agriculture, Ministry of Defense; data from Ministry of Interior Affairsand Ministry of Justice is not available).2 Gymnasia include sport schools.3 Seconday Technical Schools include financial means of Higher Professional Schools from year 1993 (experiment) - 1997 (independent).4Other expenditure: expenditure related to education, accommodation, and meals for school children and students, physical training.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 growingrecognition 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 bestprovided in general academic high schools rather than in programs leading to a specificoccupation; therefore, enrollment in academic schools should be encouraged. Students whoenroll in vocational programs commit themselves to a specific occupation at ages as young as 12or 14. They are unlikely to be able to shift easily to radically different occupations as labormarket conditions change. In a dynamic labor market, where an individual can be expected tohold several different jobs over his or her lifetime, it is important that students learn how to learnrather than learn specific skills. The quality of education may also vary by school ownership aspublic 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 suggeststhey have helped enhance quality, particularly in focusing on learning how to learn. Operating ina semi-competitive environment with public schools, they are likely to help raise performancethroughout the system. They thus have a dynamic, qualitative role to play, well beyond theirweight in total enrollments. The policy framework should continue to support this role, whilemaintaining incentives for efficient resource use.

2.99 In light of the excess demand for workers with tertiary education and the excess studentdemand for university education, public funds would be spent efficiently by extending the supplyof 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 moresuccessful colleagues to become unemployed and rely on public resources. Hence, increasingthe 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 ofthe costs involved. Moreover, tuition could also provide a market-based signal to regulate excessdemand. 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 incomeresulting from attending university, could be introduced to support an expansion of opportunitiesfor tertiary education. Scholarship programs should be available to ensure access by studentsfrom low-income families.

2.101 However, the strategy for tertiary expansion needs to be carefully developed. Theexcess demand apparent now may quickly evaporate once tuition is introduced more widely andas 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 providequality education. As a part of this strategy, it may also be desirable to consider establishment ofnew tertiary institutions in regions so that educational opportunities at the tertiary level aredeveloped beyond the two major urban areas of Prague and Brno. It may be possible to identifysurplus buildings that could be provided for new regional tertiary schools that could be certifiedto grant, for example, the lower-tertiary Bakalar (Bachelor's) Degree. The fixed costs ofestablishing new tertiary institutions are extremely high, so building on existing higherprofessional schools may be an attractive option. Expansion of existing universities may be themost efficient approach. Present policies supporting the response of higher professional schoolsto 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 uppersecondary levels, which should be used as a source of much needed fiscal space, allowing theadministration to direct freed-up resources to improve the quality of education and expandtertiary education.

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

Improving Funding Mechanisms

2.104 The financing method of normative subsidies as used in the Czech Republic has its prosand cons. Pros include the transparency for all institutions involved and a large degree ofpredictability and limited scope for discretion. The system facilitates identification of schoolsdeviating from 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 privateschools.59 The cons are that the normative method is highly quantitative and does notsufficiently reflect quality. It is also rigid across expenditure categories, which can reinforceinefficiencies at the school level, and it does not appear to offer adequate incentives forconsolidation. It relies heavily on individual choice of students/parents concerning the type/fieldof education. Although some consider this as a disadvantage, parents and students do notnecessarily make worse decisions than the administrative authorities in evaluating quality andpredicting medium/long-term market needs/trends. One could argue that the normative approachprovides incentives for the system to react to student demands, which are more likely tocorrespond 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 theyare 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 spendingcategories (e.g., wage vs. non-wage) is allowed. It may also be useful to review the way thenormatives are applied to private, tuition-charging institutions to ensure that the right balance isstruck 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 secondaryeducation as much as one might expect. For investment spending, which constitutes about 10percent of total spending on education, and which now appears to be allocated in an ad hocmanner, it would be useful to explore identifying more systematic norms and criteria to setpriorities and allocate funds more transparently.

59 see Filer and Munich, 2000


Making a Success of Decentralization

2.106 The regional governance reform may introduce major changes to the administrative andfinancial structure of the educational system. Few changes will affect basic education (as basicschools already fall under municipal administration), but at the secondary level, the mainadministrative responsibility is expected to be transferred from the Ministry to the regions.Greater local involvement may add new dynamism to the "optimization program" and, moregenerally, to overall improvements in education outcomes. However, this process will needcareful development and monitoring. Ways will need to be found to ensure resources freed upby consolidation at the basic and secondary levels can be used not only for quality improvementsat those levels, but also to meet the needs of the tertiary level. More generally, it will beimportant to ensure that local education objectives are aligned with national objectives and thataccountability for achieving agreed outcomes is ensured. This will be particularly important toavoid inter-regional and rural/urban disparities in learning achievements.60 A system of nationalassessments of educational outcomes will be an essential tool for monitoring differences inresults 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 lessequal. The exceptions are Roma minority children, only 2.5 percent of whom enter any form ofsecondary education.61 Most Roma children are transferred from the elementary schools into thespecial auxiliary schools caring for mentally disabled children. Needless to say, the relativedisabilities of Roma children are social, not mental, and should be remedied with the help of theState. Especially those with only special education will likely find it impossible to becomeemployed and will stay on welfare rolls throughout their lives. This poverty trap needs to bebroken. Providing extensive help aimed at educating the Roma youth would be an efficient useof public funds. Recently, District School Offices in few localities began to organize one year ofpre-elementary education for Roma children in order to eliminate their language and socialhandicap. Although the number of such classes and pupils attending has been rather low, thereare some plans to extend the program. These are steps in the right direction. It would makesense to evaluate the program, make any needed improvements or modifications and then expandand 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 poorerbackgrounds is common to many countries. The expansion of opportunities at the tertiary levelshould help reduce the problem on the margin. More importantly, if tuition is introduced morewidely as a source of finance, loan and scholarship programs will be needed, particularly for thelower income students.

Capacityfor Policy Analysis

2.109 To design and manage an education reform strategy to deal with the issues outlinedabove, it will be important to have in place the capacity to analyze policy options and to designand monitor policy and program reforms. A system of regular, systematic assessments of

' Mickelwright, 1999.61 Source: Czech Republic: Toward EU Accession. Main Report, p. 211 (World Bank, 1999).


educational outcomes should be an important tool in this effort. The analytical work should alsoinclude an ongoing assessment of the impact of program expenditures and identify measures toincrease their effectiveness within the broader Medium-Term Expenditure Framework.

Conclusions

2.110 Reorienting the education system to the needs of the Czech Republic's modem marketeconomy calls for an increasing focus on the more general, higher level skills the economyneeds, as well as expanding access to tertiary education. Luckily, there is a good chance that thisreorientation can be accomplished while keeping public spending on education at its currentlevel of less than 5 percent of GDP, and enhancing equal opportunity in education. This couldbe done by taking advantage of the sharply declining numbers of school-age children, the alreadysmall size of classes and low teacher workloads, and the growth of private sector schools toconsolidate at the primary and secondary levels and shift resources to the tertiary level, whileexpanding the use of tuition payment to recover costs and contain the prevailing excess demandfor higher education.

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

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

(b) Introduce tuition more widely at the tertiary level, both to finance the neededexpansion of enrollment at existing and new institutions and to contain excessdemand.

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

(d) Develop a medium-term strategy for more fundamental reforms to expand tertiaryenrollment 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 andsecondary school level to be used by the central government to support demand-driven expansion at the tertiary level, including for the program of need-basedscholarships.

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

(c) Encouraging a greater proportion of students to learn the general academic skillsneeded for lifetime learning by expanding enrollments in general secondary


schools, and reforming the technical and vocational school curriculum to increasethe general academic content.

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

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

2.113 To design and implement these reforms over time, it is important that a focal point beidentified for coordinating the analytical work needed, and integrating the results of that workinto specific policies and programs. It will also be important for the results of this work to feedinto the fiscal management process of performance budgeting in a Medium-Term ExpenditureFramework, as outlined in Part 3 of this report. In this way, the reforms identified can betranslated 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 3.0-3.2percent of GDP in the 1990s) masks significant pent up expenditure pressures. The latterinclude: (i) the sweeping, transition-induced shifts in demand across transport modes (with railfreight dropping by over 50 percent, while road freight grew by more than 100 percent); (ii) largeoperating losses and mounting debts in railways, in part due to that declining demand; (iii) thebuild up of a massive backlog of maintenance in roads, railways and public transport; and (iv) amajor 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 toconcentrate scarce public resources exclusively on those activities where the private sectorcannot operate effectively. To this end, the country needs to focus on completing the remainingareas for transport privatization and on commercializing activities that will remain in the publicsector. It will also need to balance carefully the urgent needs for repair and maintenance againstproposals for new investment. Recommendations to deal with these issues include:

(a) Major railway restructuring. Restructuring the railways will require a majorcommitment of government time and effort, but it is essential to stop the large andgrowing 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 tomaximize their returns and adjusting passenger fees also need attention.

(b) Careful management of the road infrastructure and its use. Growing demand forroad use calls for placing first priority on reducing the maintenance backlog inroads and public transport; undertaking only those corridor investments with high


returns (and undertaking first those that will also help reduce the maintenancebacklog); introducing appropriate road user charges; and taking an integratedapproach to reducing traffic congestion in Prague through parking and congestioncharges.

(c) Focusing public resources on public priorities. Given the critical need to focusscarce human and financial resources on the activities above, the governmentshould avoid involvement where its presence is not essential. This would includeprivatizing most railway operations, and not financing or guaranteeing suchinvestments as CSA or Prague Airport, as private sector financing sources shouldbe available for these profitable activities.

(d) Improving expenditure management and program analysis. Priorities hereinclude taking steps to assess and limit the use of guarantees and to contain therisks associated with establishing the extrabudgetary Transport Fund. It will alsobe important to set up a process to ensure that transport expenditures are subjectedto a rigorous, objective and systematic costs/benefit analysis, and to incorporatethis analysis in the Medium-Term Expenditure Framework and performancebudgeting approach outlined in Part 3.

Transition and Transport Demand

2.116 Transition has brought major shifts in the structure of demand for freight and passengertransport, 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 automobileand aviation transport, and the reorientation of trade to the West. A further decline in railtransport is possible as the Czech Republic approaches modal splits observed in other WesternEuropean countries (railways currently carry about 35 percent of freight and 9 percent ofpassengers). Conversely, automobile, truck and air traffic are expected to continue to growrapidly, which will require careful planning for road investments and for measures to control thegrowth 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 -6Passenger TransportRail 13.36 7.02 -47Automobile 39.90 60.80 +52Bus 12.34 8.68 -30Inland Water 0.003 1 0.008 +166Air 2.18 3.68 +69Total 67.78 80.18 +18

(Thousand passengers/workday)Prague Public Transport (PPT) 4,186 | 3,349 1 -20Source: Ministry of Transport and Municipality of Prague.


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

Railways

2.118 The Czech railway system has not yet adjusted to compete in the post-transitionenvironment. One of the densest systems in Europe,62 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 itsoperating costs. As a result, Czech Railways has a serious financial problem, with the ratio ofoperating costs to total revenues ranging from 107 to 115 percent in recent years.63 Freightservices 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 Railwaysestimates its maintenance backlog at CZK1 30 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 isimplemented. The Government's total support for Czech Railways in 1998 is estimated atCZK28.4 billion, or about 1.6 percent of GDP. It is likely that the Government will need toprovide around CZK40 billion annually in railway support in one form or another during thecoming years. The approved Transport Investment Plan calls for the Government to investCZK15-17 billion annually in railways infrastructure in coming years. In addition, CzechRailways cannot avoid replacing aging traction and rolling stock or carrying out othermaintenance at a cost of around CZK7 billion annually. These requirements would add up tomore 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 tocomply with EU requirements. Some privatization had taken place, but has been too marginaland limited in scope to generate much apparent benefit to date. The main constraints affectingCzech Railways' performance remain the same: rising labor costs, the major maintenancebacklog, 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, andincreasing road competition.

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

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


2.122 A comprehensive program of restructuring and downsizing is recommended, whichcould be carried out in a period of two to five years. In order to improve labor productivity whiledealing with the real concerns of labor, well-designed personnel measures are required, includingtraining and development, redundancy packages and resettlement. The accounts of CzechRailways' infrastructure and operations divisions need to be completely separated. Separatemarket-led businesses need to be established for freight, long-distance passengers, and suburbanpassengers, and their managers adequately empowered. Czech Railways should prepare its ownannual and operational budgets that support the different roles of the different profit centers andhold 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 costallocation system, and business evaluation and monitoring systems are needed to implement theprocess.

2.123 The new distribution of powers and accountabilities between the government andCzech Railways should also include a significant increase in Czech Railways' freedom to priceits services, and lead to a significant increase in passenger fares. Long-distance rail passengertariffs and services should be deregulated because there is sufficient competition from othertransport modes to prevent monopoly abuses. Some subsidy for suburban passenger servicesmay be justified as a way to reduce the congestion and pollution costs of motorization, but it isrecommended that this be done through explicit payments64 to the service provider from theconcerned 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-coreactivities, dispose of surplus assets, and seek private funding. Procurement needs to be improvedby divesting and outsourcing loss-making activities, involving the private sector in terminals andservices, and contracting maintenance on a competitive basis.

2.124 The quality of all services needs to be improved, partly through the improvement ofbusiness processes, but also through capacity and resource reviews, improved productivity andmaintenance, and service and reliability reviews. In order to implement the above measures,Czech Railways' objectives, powers and public service contract need to be drawn together, andanalysis 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 laborforce will be politically and technically difficult and call for strong committed leadership over asustained period both in the government and in the enterprise. But in view of the huge potentialgains both in savings of public resources in the order of 1.5 percent of GDP, and in the potentialof a more competitive transportation sector and economy, this is a matter of the highest priority.

64 Based on a Public Service Obligation (PSO) agreement between the provider and the regional govemment.


Roads and Road Transport

2.127 Funding for road maintenance has not kept up with the increase in traffic (see Table2.1 1). Furthermore, most of resources that were available appear to have been diverted to theconstruction of motorways. As a result, the existing road network is deteriorating. Theconservation of the existing road network has a higher economic priority than most newconstruction. It is recommended to increase expenditures for the maintenance and repair ofroads to about CZK1O billion per annum with a view toward eliminating the existing backlog in5-10 years. It is also recommended that routine and periodic maintenance be carried out bycontractors selected on a competitive basis rather than by force account. The Ministry ofTransport has already been considering consolidating some or all of the 72 Road andAdministration Units into the 14 new regional governments, which should indeed beimplemented. It is also recommended that the road administration be given more responsibilityto allocate funds between new construction and maintenance/rehabilitation.

2.128 The existing system of road taxes and user charges could be modified to support moreefficient road use, greater neutrality between modes, and full cost recovery, including externaland environmental costs. In particular, there is a need to increase annual vehicle taxes on heavytrucks (as well as the diesel tax) in order to cover the road damage which heavy trucks cause, toassure 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 extemal costs of congestion,environmental damage, noise, and accidents. The Czech Republic should undertake a road usercharges 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 itencourages 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 thegrowing 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 passengersper workday dropped by 20 percent (see Table 2.11), while road passengers increased by 111percent. With a cost recovery rate as low as 27 percent, PTT is lacking the resources to improveservices. It is recommended that the Municipality increase PPT's cost recovery rate over a threeto 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 theycreate in order to correct the currently distorted signals commuters face in choosing betweenpublic transport and private auto. A parking program, already initiated by the Municipality, isthe most practical method in the short run.65

65 The responsibility for parking, including enforcement, could be centralized in a single agency, and include existing designated spaces, reservedpermit 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 parkingcan be improved.


2.132 In the longer run, that Prague should consider introducing a system of electronic roadpricing, with revenues designated for urban transport improvements. Such a system is nowworking well in cities like Singapore or Hong Kong. Furthermore, Prague's system ofconcessioning bus routes by competitive tender is commendable, and should be extended. It isalso 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, andtraffic is declining. Still, the 2000-2010 Investment Program includes CZK5.0 billion to deepensections of the Elbe and Labe rivers to 2.2 m. To be justified, traffic should continue at the 1998level for 20 years, and this investment should be recovered from users in an amount of at leastCZK172 per ton (not including interest or maintenance expenses). It is doubtful that bothconditions could be met.

Air Transport

2.134 In the field of aviation, there is little reason for the Government to participate in thefinancing of future improvements at Prague Airport, or to guarantee Czech Airlines (CSA)aircraft purchases or leases, because these activities are profitable. The government would bebetter 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 someUS$10 million per annum. There are currently 13 international and 72 domestic airports in theCzech 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 remainingairports to the 14 new regional governments.

Cross-Cutting Expenditure Issues

Trans-European Corridors

2.135 The Czech Republic is preparing to join the EU, and the expenditure program is largelyoriented towards improving the TEN corridors. The 1997 Pan-European Conferencerecommended 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. The approvedTransport Investment Program (2000-2010) envisages that the Czech Republic would investCZK773 billion in transport during 2000-2010 (including CZK480 billion in roads,CZK211 billion in railways, CZK43 billion in urban public transport, and CZK25 billion in othermodes). TENs would absorb the lion's share of these investments. While corridor investmentshave 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 railwaycorridor 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 theproposed level of expenditure.

2.136 In rail, for instance, investment would concentrate on two TEN corridors (CZK45.3billion) plus two other corridors of national interest (CZK65.4 billion). The lines would bemodernized and speeds increased to 160 kph (minimum 100 kph), double track and electrifiedthroughout, and tunnels enlarged (see Table 2.12). The Ministry of Transport estimates that theinternal rate of return for each of these investments is 12 percent. Even if this number is correct,it is not clear that such a high level of investment in these corridors is justified by traffic levels.One rule of thumb is that diesel traction is justified on lines carrying up to 10,000 tons of freighttraffic and electric traction above. Available estimates (by Halcrow consultants) suggest that theTEN railway infrastructure program has a benefit cost ratio of only 0.7:1.66 The benefit costratio for the other two corridors is likely to be lower even though lower design standards (singletrack) is proposed in some sections. All corridor investments run the risk of being poorlyutilized unless complementary investments are made in traction and rolling stock, which are notincluded in the investment plans. As noted above, it would be preferable to scale back thesecorridor investments in favor of undertaking investments needed to restructure the Czechrailways and catch up with its maintenance backlog.

Table 2.12: Prop sed Investments in the TEN Railway CorridorsCost Proposed Remaining

Length (km) (US$ million) Construction 1998 Traffic (000) Costkm

Corridor Total To Do Total To Do Period net tons Passengers (USS million)

I. (E55, E40, E61) 392.5 254.6 1,040 680 1993 - 2002 7,409 8,882 2.6

11. (E65) 296.7 226.5 700 530 1997 - 2005 12,639 3,356 2.4

Total 689.2 481.10 1,740 1,210Source: Ministry of Transport, 2000 - 2010 Investment Program

2.137 As far as roads are concerned, proposed investments concentrate on the construction of1,413 km of motorways and expressways (see Table 2.13). It is true that the current "motorwaydensity" is significantly below Westem Europe when measured against population or surfacearea. However, income levels in the Czech Republic are also lower. The proposed constructionof 525 km of motorways in ten years is more than 20 times the rate at which the wealthierWestern European countries are adding to their own motorway networks at present. As a rule ofthumb, the construction of a four-lane motorway is economically justified when it is forecast tocarry around 15,000 vehicles per day (vpd; less in flat terrain, more in mountainous terrain);expressways require less traffic. Halcrow estimated that the aggregate TEN road corridorprogram has a benefit-cost ratio of 1.3:1, which may appear satisfactory. However, some of theroads in the 2000-2010 program carry less traffic than appears needed to justify the investment.It is, therefore, recommended that the program be reviewed with a view to including more stagedimprovements and rehabilitation of existing roads, and to increase the maintenance budget withfreed up funds.

66 PHARE, Multi-Country Transport Program, Improvements of Competitiveness of Rail Transport in the CEECs,October 1999.


Table 2.13: Pro posed Investments in Motorways and ExpresswaysMotorway (D) / Cost (1999) Proposed Average Daily Traffic Remaining

Expressway (R) Length (km) (US$ millions at 1999) Construction Estimated Cost/km

Section Total Remains Total Remains Period 1995 2000 (US$ million)

Dl 69 68 495 487 2000 -2011 13000-36000 15000-41000 7.1

D3 184 183 1,327 1,320 2002 -2013 5000-16000 6000-18000 7.2

D5 21 20 250 240 1999 -2007 6000-19000 7000-21000 12.2

D8 70 62 778 695 1999- 2009 6000-12000 7000-14000 11.2

DlI 114 114 835 834 2000- 2011 7000-12000 10000-14000 7.3

D47 79 78 1,063 1,051 1999 -2011 6000-14000 7000-16000 13.4

RI 57 56 1,097 1,071 1999 -2012 8000-17000 9000-20000 19.1

R4 48 47 190 190 2000- 2009 2000-17000 2300-20000 4.0

R6 142 135 704 668 1999- 2016 5000-12000 6000-14000 4.9

R7 67 65 288 280 1999- 2014 4000-15000 5000-17000 4.3

R35 234 216 1,124 1,040 1999 -2017 5000-20000 6000-23000 4.8

R43 70 70 357 357 2006 -2015 4000-11000 5000-13000 5.1

R48 76 74 290 284 2000 -2012 6000-14000 7000-16000 3.8

R49 62 62 517 517 2010 -2021 1000-12000 1200-14000 8.3

R52 17 17 46 46 2010 -2018 4000-7000 5000-10000 2.7

R55 104 103 740 729 2000 -2015 6000-22000 7000-25000 7.1

tTotal 61,413 1,3711 10,099 9,80_

Source: Ministry of Transport, 2000 - 2010 Investment Program.

State Fundfor Transport

2.138 The creation of the new transport extrabudgetary fund raises important issues ofexpenditure management and transparency, which will be discussed more systematically in Part3. For the Transport Fund, one of the major concerns is its large potential to create liabilities forthe state. While this extrabudgetary fund seems to have been created as a second-bestmechanism to tap the privatization resources of the National Property Fund, the advantage forthe transport sector of tapping these resources directly (rather than through the state budget) doesnot appear to compensate for the additional risks associated with the creation of this fund. It isrecommended that these extrabudgetary activities be returned to the state budget.

Expenditure and Program Analysis

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

2.140 While cost/benefit studies are usually carried out for major investments, they need to bedone more objectively and rigorously as current proposals include a number of questionableactivities and do not provide for enough maintenance. It is recommended that the governmentbase 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 areclear. 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 thatexpenditure decisions are subject to such systematic and objective analysis. This analysis shouldbe used in setting budget priorities within the Medium-Term Expenditure Framework andperformance budgeting approach discussed further in Part 3.

Conclusions

2.141 The reforms proposed above should reduce Government transport expenditures by atleast CZK12 billion per annum during the next five years, and by some CZK33-46 billionannually (or 1.9-2.6 percent of 1998 GDP) between 2006 and 2010, even taking into accountsubstantial increases recommended for maintenance.

2.142 The main priorities in the short term are to:

(a) Reduce and rephase corridor investments for railways and roads (saving at leastCZK12 billion annually in the next five years and CZK24 billion annually in2006-2010).

(b) Start a major restructuring of the railways (reducing operating costs on the orderof CZK5 billion annually for the next five years and CZK1O billion annually inthe subsequent five years).

(c) Increase road taxes on heavy trucks and diesel fuel (raising revenues by aboutCZK5 billion annually).

(d) Increase passenger tariffs for railways and PPT (savings rising from aboutCZK2.8 billion annually initially to about CZK5.5 billion annually in the secondfive years).

(e) Improve road maintenance efficiency (saving about CZK1 billion annually).

(f) Avoid financing Prague Airport or guaranteeing CSA borrowing (saving aboutCZK1 billion annually. And,

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

2.143 These savings would be partly offset by increases in road, railway and urban transportmaintenance expenditures (by about CZK13 -14 billion annually) to reduce the large backlog,and some increased investment in railway restructuring (about CZK2 billion annually for the2001-2005 period only).

2.144 In the medium-term, the focus should be on implementing the railway restructuring anddivestiture 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 areprivatized. 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 tofocus investment expenditures only on the highest priorities.

2.145 As noted above, to realize these savings, it will be important for the government to putin place institutional arrangements to ensure objective and systematic analysis of expenditureoptions, and incorporating this analysis in setting budget priorities through the Medium-TermExpenditure Framework and performance budgeting approach outlined in Part 3. In addition toreducing fiscal pressures, these reforms and restructuring of expenditure priorities should alsobring widespread benefits to the Czech economy by making it more competitive and marketoriented, 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 oftrade, and increasing consumer satisfaction.

G. HOUSING

Introduction

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

2.147 First, substantial public expenditures and implicit subsidies have not generated theoutcomes expected. Despite the considerable earlier reform efforts, there has been little inducedfinancing and risk-taking by the private sector. For example, in 1999, residential constructionoutput totaled about CZK60 billion compared with total central and local government budgetspending 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), VATreductions (0.6 percent), and below market rents for municipal housing (0.7 percent)), generatedroughly another CZK24 billion in housing subsidies not reflected in the budget.6 7 As a result, thegovernment clearly dominates financial flows in housing, and carries many of the risksassociated with those flows.

2.148 Second, the housing program has created large and potentially destabilizing budgetedand implicit subsidies and contingent liabilities, that are likely to grow and could threatenmacroeconomic stability over time. Government projections indicate that the centralgovernment'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 marketpicks up. Even more worrying, the newly created State Housing Development Fund will beresponsible for the bulk of the projected increase in spending, and will also have authority tomake loans to and guarantee loans to municipalities and housing cooperatives. This shift to lesstransparent expenditure management and greater potential to create contingent liabilities posesserious risks of its own.

67 Of the total budgeted and non-budgeted public spending on housing of roughly CZK82 billion, the central govemment's share is about CZK28billion.


2.149 Third, the present range of subsidies is broad, complex and poorly targeted towarddifferent income groups, with the lowest two income quintiles of the population receiving adisproportionately low share of the subsidies. Furthermore, the subsidies are also not alwayswell calibrated for desired outcomes. For example, the large subsidies for Bauspar (the heavilysubsidized contractual savings scheme for housing) have generated liquidity for housing loansfar in excess of likely demand. While the total residential mortgage portfolio from all lendinginstitutions stood at only CZK30 billion at end-1999, Bauspar alone had enough liquidity toprovide about CZK50 billion in housing loans.

2.150 The experience with the current mix of programs strongly suggests that a fundamentalrestructuring is needed before considering any expansion of spending. Housing policy reformefforts currently under consideration should use this experience to develop a focused strategyaimed at improving and expanding the stock of affordable housing by: (i) enabling andleveraging the private sector to play a much more dynamic role in housing and mortgagemarkets, by removing fundamental obstacles to private sector activity; (ii) simplifying andrefocusing the many existing subsidies to make them more coherent and better targeted; and (iii)developing a comprehensive divestiture and modernization strategy for the housing stockremaining in the public sector.

2.151 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 nowseverely restrict both private housing demand and blunt the incentives tomodernize the current housing stock. Subsidies should be refocused to provide alarger and better designed housing allowance to ease the transition to higher rents.

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

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

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

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


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

Rationale for Government Intervention

2.152 The current Czech housing program69 reflects considerable efforts to: (i) identifypriority areas of the housing sector; (ii) conceptualize housing policy objectives; and (iii)introduce individual housing policy instruments, some of which have been best practiceelsewhere in Europe. However, ten years into transition, the government needs to adopt astrategy in which policy instruments are designed to achieve explicit goals in terms of qualityaffordable housing. The strategy should focus on the two main justifications for public policyinterventions in housing: (i) unlocking private sector initiative to provide liquidity and takelender'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 stockof public housing at both the central and municipal levels should be an integral part of thisstrategy.

2.153 While the Housing Policy Concept outlined by the Ministry for Regional Developmentemphasizes the role of the state in setting the enabling environment for the private sector, and theresponsibility of individuals for housing provision, the comprehensive and weakly-targetedsubsidy program currently in place contradicts this rationale. 70 The danger is that a continuationof the current subsidy program, without identifying and subsequently removing the underlyingreasons for the sluggish private housing service demand and supply response, may lead to thepermanent, 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 ofcapital, leading to increasing incapacity of the market to react quickly to shifts in the demandstructure, which may be triggered by varying tenure preferences, migration, household formationpatterns, or income shifts. Entering the European Union without this economic and socialburden that is common to its key competitors could prove to be a decisive competitive advantagefor the Czech economy.

Policy Recommendations

2.154 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 atincreasing the availability of affordable, quality housing by: (i) removing the deep distortions inhousing 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 andtargeting them better; and (iii) establishing a program for managing the stock of public housingthrough divestiture and selective investment.

69 Including the approaches outlined in the "Housing Concept Paper," Ministry for Regional Development, 1999.70 See National Response Paper developed for the UN-ECE workshop on Housing Finance in Timisoara, January 2000.


Reform Rents

2.155 Over 50 percent of the Czech housing stock is rental housing, so the level of rents isboth 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 ofhousehold income in 1998 (see Table 2.12), compared with 15-20 percent in Western Europe. Adeep rent reform adopting the comparative rent system has first priority, since the current lowlevel of rents severely restricts both private housing demand and incentives to modernize andexpand the current housing stock. The government's approach to move from strong rent controlto a more market-friendly, "comparative rent" system71 is welcome, but some importantmodifications of the initial concept are needed for successful implementation:

(a) Both public housing rents, and the currently controlled private stock rents shouldbe gradually, but completely, converted to the comparative rent system. Ifdifferent 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 inefficientdecisions for both private and public investment.

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

(c) To support the move to the comparative rent system, and the higher rent levels itimplies, it will be necessary to consider raising housing allowances for atransitional period. Similarly, low-income households in public housing could beprotected by individualized discounts from their - varying - market rent levels.Ideally, rent discounts in public housing should be managed in the same way asprivate rental housing allowances. At the same time, a review of their designshould be carried out to ensure appropriate targeting so that there are matchingefforts from households, support is limited to achieving basic standards, and theallowance declines over time. The higher rent allowances could be financed fromsavings from reforms of other subsidies (see Table 2.14).

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


Table 2.14: Household Housing Expenditure Structureduring the 1990s

1989 % % 1996 % % % 1998 % % %(CZK) I I (CZK I 2 3 (CZK) 1 2 3

Rent 161 30.9 2.7 558 27.9 3.6 19.4 1021 32.3 5.5 35.3Water Fees 175 8.7 1.1 231 7.3 1.2 14.9Other Communal Services 114 5.7 0.7 152 4.8 0.8 15.5Electricity, Central Heating and Fuel 254 48.8 4.2 922 46.1 5.9 20.2 1392 44.0 7.5 22.9Maintenance and Repair 106 20.3 1.8 232 11.6 1.5 11.8 365 11.5 2.0 25.4Total HousingCosts 521 100 8.7 2001 100 12.8 21.2 3161 100 17.0 25.7Net Household Income 5993 100 15692 100 14.7 18589 100 8.81/ Relative to total housing costs.2/ Relative to income.3/ Annualized growth rate over previous observation.Source: Ministry of Regional Development (I 999b), mission calculations.

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

Establish a Public Housing Divestiture and Modernization Strategy

2.156 A more effective national strategy for dealing with the large stock of public housing72 isneeded, focusing on privatizing the bulk of the remaining public housing stock, and managingand modernizing a small core that would remain in the public sector until it too could beprivatized. In developing this strategy, it will be useful to divide the public housing stock intothree different segments: (i) the majority of the stock, to be privatized with priority - before orafter modernization; (ii) a small core social housing stock to be modernized and to remain underpublic ownership (but preferably not management), for a defined transition phase until it can beprivatized; and (iii) a segment to be removed from the market, if it can neither be privatized norefficiently modernized and maintained.7 3

2.157 All housing policy instruments (e.g., public investment, subsidies, or, eventually,financing and guarantee activities) should be selected and designed to support this strategy. Inparticular, the program supporting new public housing construction by municipalities should bediscontinued, as planned, as soon as possible. Rather than running a large and high cost publichousing stock, public housing subsidies should be refocused to buy occupancy rights foreconomically 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 themodernization and rent adjustment path. Owners, in particular municipalities, that wish to tapcentral government modernization programs for funds, should be required to incorporate theiroperations, demonstrate a sensible track record in operations, and provide a detailed strategy forprivatization and modernization. Such privatization strategy could exploit the whole range ofpossible tenure forms, from new, non-profit tenure forms yet to be created (e.g., cooperatives) to

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 thecombination of declining or negative capital gains relative to other housing forms and low rental yields - even assuming swift rent reform.


for-profit rental investment by private developers. Alternative public support instruments couldbe considered, based on limited matching investment grants, to enhance investment in privatizedunits.

Reform and Refocus Subsidies

2.158 Before considering an increase in housing subsidies, the latter subsidies should becarefully reviewed and refocused to support the type of strategy outlined above (i.e., to supportrent reform and to match private funds mobilized to modernize the rental housing stock). Themain central government housing subsidies in 1999, both on budget and off budget, are shown inTable 2.15.74 Those explicitly in the budget include: (i) a range of subsidies, mainly forconstruction at the municipal level; (ii) the "Bauspar" subsidies which boost retums for depositsheld by households in the contractual savings schemes for housing; (iii) housing allowances; and(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 residentialconstruction (5 percent rather than the usual 22 percent); and, (ii) various tax breaks formortgage lenders and borrowers. The table also shows as a memo item the subsidy implicit inthe below-market rents charged at the municipal level. Taken together, these implicit subsidiesamount to nearly 1.5 percent of GDP and, since they represent forgone public revenues, shouldbe subjected to the same kind of analysis and justification as explicit budget outlays.

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

2.160 Moreover, the budgeted housing subsidies accrue mainly to the middle class, i.e., thethird and fourth quintile of the income distribution, rather than to lower income groups. Thehigh share of untargeted subsidies, such as the Bauspar subsidy, drives this result. If currentnon-budgeted subsidies are considered as well, the incidence shifts even further towards thehighest income groups (See Figure 2.4). The main reasons for this result are that the subsidiesarising both from the VAT reduction and from mortgage tax preferences to lenders, bondholdersand borrowers, are likely to accrue almost entirely to high-income households.76 This picturewill not change if housing demand picks up. Not only will the spending incidence worsenbecause of the dominance of untargeted entitlement programs, but also demand for high qualityhigh price housing will further rise, potentially increasing the per capita expenditure andcrowding out low cost construction from the market.7

74 In addition to these central explicit and imiplicit expenditures of about CZK28 billion, municipalities budgeted about CZK46 billion in 1999,and incurred about CZKI2 billion in implicit subsidies in the form of below-market rents.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 littleconstruction aimed at small-scale modernization of the existing rent-controlled stock. Even assuming the same level of demand across incomesegments, low-income households would likely benefit less from the VAT reduction because of (i) smaller construction volumes, and (ii) higherlevels of self-help or intra-family construction contracts." These effects have been the main reason why all large Western European countries have partly or fully abolished mortgage interestdeductibility and other tax preferences for housing.


Table 2.15: Central Government Housin y Subsidy Budget and Estimated Total Expenditures, 1999Instrument Class 1999 Approved Housing 1999 Explicit and Implicit Main Programs

:udget Ex pendituresCZK mn % %of CZK mn %of % of

1998 1998 1998GDP 1998 GDP

Grants_Lump sum 4271 28.6 0.23 4271 15.5 0.23 Municipal Housing Construction, Others

6350 42.6 0.35 6350 23.0 0.35 Bauspar SubsidiesCash Flow 2550 17.1 0.14 2550 9.2 0.14 Housing Allowances

Foregone TaxRevenueLump sum' Not Budgeted 10200 37.0 0.56 VAT Reduction for Residential HousingCash Flow Not Budgeted 2478 9.0 0.14 Mortgage Interest Deductibility, Income

______ _________ Tax Exempt Mortgage Bonds

Financial ContractsLoans 1750 11.7 0.10 1750 6.3 0.10 State Interest Free LoansGuarantees _

Total 14921 100 0.82 17399 0.96Including VAT 27599 100 1.52

exemptionMemorandum Item: NotMunicipal Rental BudgetedHousing _ 12144 0.67 Below-market rentsSource: Ministry of Regional Development (1999a, 1999b) mission calculations and estimates.

2.161 In addition, the present mix of subsidies has led to an excessive build-up of liquidity forhousing finance in the Bauspar scheme, and is structured to provide greater subsidies forhomeownership over rental housing, and for new rental housing over rehabilitation. TheBauspar 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 risingincome, the deposits generated by the high subsidies may eventually be converted into demand.However, under current housing sector distortions, there is a risk that increased demand couldeither drive house prices up (if supply does not become more elastic) or fuel an exodus ofhouseholds with high ability-to-pay out of the multi-family stock, thereby undercutting themodernization objective.

2.162 Better targeting could be achieved by shifting emphasis away from new housingconstruction and refocusing on rent reform, modernization of the housing stock, and directhousing subsidies for vulnerable households. Development of such a program has priority overexpanding the existing program. The currently excessive Bauspar subsidies can be integratedinto such an improved subsidy program. Tax subsidies, rent advantages and other indirecthousing subsidies should be explicitly budgeted, and their levels reduced and/or phased outunder a sunset clause.

78 At the 30 percent financing rate typical of Bauspar loans. Only a small part of the annual housing output is private.


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

6000 ~ ~ - - --

swoo

5000

4000I Budgeted

N

53000

I ,,i,,, [z~~~ll v V_

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

Reassess the Extra-Budgetary Housing Fund

2.163 The role of the extra-budgetary State Housing Development Fund should be reassessedto focus on the strategic issues facing the housing sector outlined above. As recently created, theState Housing Development Fund is designed to tap into the privatization resources of theNational Property Fund, add flexibility to the central government housing policy and bringhligher leverage to municipal investment by undertaking targeted banking and insuranceoperations.79 In creating this instrument, the government is seeking to create a long-term sourceof financing by using extrabudgetary resources for construction of rental houses, technicalinfrastructure, and remodeling.

2.164 The creation of the state housing fund is a source of concern due to the size andprojected rapid growth of its operations and the types of activities it is programmed to do. TheFund is intended to issue guarantees and extend loans as well as manage subsidies. Theguarantees will be granted for loans by mortgage and construction savings banks tomunicipalities and housing cooperatives. The guarantees will be used for financing of the state-subsidized construction, repair and modernization of rental apartments and prefabricated panelbuildings. The Fund will also subsidize interest rates for loans granted by mortgage andconstruction savings (Bauspar) banks to municipalities, housing cooperatives, and individuals forrepair of panel buildings, construction of rental apartments, and development of technicalinfrastructure in municipalities. The Fund's operations are projected to grow rapidly, by about43 percent per year between 2001 and 2007 (from 0.16 percent of GDP to 0.8).

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


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

2.166 In the current situation, the best approach would be to sequence the activities of theFund 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 surveyingpublic 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 tocreate the conditions in which financially sound private sector lending and guarantee operationscan function. With this more focused mandate, there would be little need to maintain the fundoutside the state budget.

Reform Laws, Regulations and Institutions

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

Conduct Rigorous Policy and Program Analysis

2.168 Finally, the design of a housing strategy aimed at achieving measurable improvementsin the availability of affordable, quality housing on the lines discussed above, will call forconsiderable preparation and analysis of program and policy options, as well as monitoring ofresults and modification of approaches as needs dictate. It will be important to identify a focalpoint for this work and provide it with a well-defined mandate and resources to draw onexpertise as needed. In particular, the policies for rent reform need to be carefully designed andsequenced, along with a revised housing allowance. The legal and regulatory frameworks willalso 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 theyachieve for their costs. This assessment should include implicit expenditures as well as budgetexpenditures. The need for such analysis is likely to continue over time as the economy evolvesand new challenges emerge. This focal point could provide the background work for a fiscalmanagement process on the lines recommended in Part 3. In that process, housing policies andprograms would be subject to the regular discipline of a budget review in which expenditures areassessed against expected and actual outcomes within a Medium-Term Expenditure Framework.

Conclusions

2.169 At present the housing program absorbs substantial resources but is not achieving thedesired impact. In the short term, pending the design of a fundamental, medium-term housingsector 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 ratefor residential construction should be terminated.

2.170 A revised medium-term reform strategy should be prepared alongside, which wouldfocus 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 thebulk of the public housing stock and modernization and management of a small core remainingstock; and (iii) a rigorous reassessment of the range of explicit and implicit housing subsidieswith 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 themost vulnerable). The State Housing Development Fund should be refocused on managing theredesigned subsidy program and helping implement the public housing divestiture strategy,rather than on risky lending and guarantee operations, and its activities returned to the normalbudget framework.

2.171 A focal point should be designated and provided an adequate mandate and budget tocoordinate 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 amedium-term expenditure framework as described in Part 3. Implementing a coherentlydesigned reform program with the elements indicated will not be easy. But the deep distortionsin the housing sector currently retard growth and competitiveness not only in the housing sectorbut also throughout the economy (including as it hinders labor mobility). Their correction willboth reduce threats to fiscal stability and put the economy on a more competitive footing as itmoves towards EU accession. It will also help to ensure better housing opportunities for theCzech people.

H. CONCLUSIONS

2.172 As noted at the end of Section B, above, this review of sector expenditure programswas not intended to be comprehensive. It does not cover all sectors, only selected sectors thattogether generate about 80 percent of the Czech Republic's public spending. While these sectorsare 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 andcontain expenditures; but that (ii) this will not be easy, since containing expenditures will meannot just cutting budgets, but also making often deep structural reforms of programs. Though thetask is difficult, the result can mean more than an improved fiscal balance. It can also meangreater efficiency for the economy and better services for the people.

2.173 This should not be seen as a one-time exercise. Rather it is likely to become an ongoingprocess, as policy makers adapt the role of the public sector to confront a constantly changing setof challenges. The Czech Republic has demonstrated a considerable capacity to design andimplement reforms in the past, and that capacity should be built on for the future. The sectorsections above recommend that this kind of analytic and policy design capacity be maintainedand strengthened, and directed toward a continuous effort to improve the focus and effectivenessof public spending. Part 3 of this report will discuss further some approaches, notablyperformance budgeting within a medium-term expenditure framework, to bringing this capacityto bear systematically on the expenditure and program reform issues that the country faces andwill continue to face.

3. THE FISCAL MANAGEMENT FRAMEWORK

A. INTRODUCTION

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

3.2 The discussion focuses on three issues. The first is that public finances have evolved in adualistic manner since the beginning of the transition, with a relatively well-oiled and regulatedsystem of the state budget operating alongside a vast complex of interconnecting extra-budgetaryfunds and off-balance sheet operations where discretion often prevails and liabilities are assumedwithout sufficient analysis of options and trade-offs. The parallel coexistence of these tworealms tends to obscure the reality of fiscal developments, sometime to the point of leaving theauthorities ill aware of mounting risks -- as was the case in the run-up to the banking crisis. Thisis the topic of the first section below.

3.3 Second, there are considerable rigidities within the state budget itself. They ariseprimarily from the growing burden of mandated and quasi mandated expenditures," i.e.,expenditure items arising from legislative or contractual obligations over which the executivebranch has little discretion. The presence of these items (which absorb over 80 percent of the2001 state budget) constricts the government's room for fiscal maneuvering in the short run. Tocomplicate matters, the budgeting process itself can be mechanistic, paying more attention toinputs and processes than to the services being delivered or the performances expected fromthem. As a result, the process yields insufficient information to guide budget choices and trade-offs. The two issues (i.e., mandated expenditures, and budgeting process) will be taken up inturn in the second and third sections, respectively.

3.4 Third, the ongoing decentralization presents both opportunities and risk: opportunities tocalibrate 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 belowdiscusses ways to maximize the opportunities, and minimize the risks. In so doing, it drawsheavily on the much more comprehensive companion study on local finances in the CzechRepublic, which was prepared in parallel with this one.80 This companion study addresses alsosuch important issues as the necessary reforms in revenue assignments and tax sharing, whichare not discussed here, and expands on others which are only touched upon in the followingparagraphs (e.g., oversight framework, human resource requirements).

3.5 The discussion below will suggest that, to achieve the kinds of expenditure reductionsthat are needed, it will be useful to: (i) take further steps towards consolidating the generalgovernment budget and bringing contingent exposures under its oversight; (ii) extend the

s Interested reader should refer to "Intergovernmental Fiscal Relations in the Czech Republic," mimeo, World Bank, March 2001.

3. The Fiscal Management Framework 80

expenditure programming horizon beyond the annual budget cycle in the context of a medium-term expenditure framework; and (iii) move the budget process towards a greater performanceorientation. At the local level, the discussion highlights the need to: (i) amalgamate smallermunicipalities into larger entities; (ii) rationalize inter-governnmental transfers; (iii) furtherregulate municipal borrowing; as well as (iv) organize an orderly transfer of meaningfulresponsibilities 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 systemswhich must be made to converge towards overall and sectoral objectives. Indeed, two parallelfiscal management processes have emerged during the transition:

(a) A formal system centered on the state budget. This formal system dealsprincipally 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) andtransformation institutions (i.e., created to lodge transition costs, such as KoB, seeabove), feeding primarily on the resources of the National Property Fund (seeTable 3.1) and underpinned by the credit of the Czech Republic. Until therecently adopted Law on Budgetary Rules, this system was more looselyregulated than the state budget.

Box 3.1: Extrabudgetary Funds in the Czech Republic

The state funds are govemed by the recently adopted Law on Budgetary Rules. Under the Law, the funds have to comply with the same reportingrequirements towards the Ministry of Finance as ministries and other state agencies. They have to submit a budget of revenue and expenditureclassified 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):

I. 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), and8. 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 twostandards as a trade organization and is thus not included among state funds. The revenues are included in the chapter of Ministry of Agricultureand/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 theESA standard, while as a financial institution according to the GFS. After 2001, PGRLF will be classified among other state funds according toboth 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 (foradministration costs), shared central budget revenues (for example, certain taxes), loan repayments, privatization revenues (transfer from theNPF), and borrowings.Source: Ministry of Finance


Table 3.1: Revenues and Expendi ures of State Funds and Two A riculture Funds, B dget 2001State Fund State Fund for State Fund State Fund for State Fund for State Fund for Czech National TOTAL As a share As a share PGRLF State

for Soil Environment for Cinematography Transportation Housing Land Property STATE of State of GDP AgricultureFertilization Culture Development Fund Fund FUNDS' Budget 2001 20012 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 4,230.0

From 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 4,230.0

Own 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.' 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 buildingthe formal system into a highly transparent operation. Transactions have been routinized inprocedures for preparing and implementing the annual budget. The government has establisheda modern budget process, along with timely financial reporting and sound internal controls.81

The formal budget system is fairly stable and predictable, with similar procedures recurring yearafter year, and with reliable estimates of revenues and expenditures. Clear roles andresponsibilities have been defined for the Government, Parliament, the Ministry of Finance, andchapter administrators in preparing and implementing the state budget, and the government hasstrengthened the capacity of civil servants at the center and in budgetary institutions to carry outassigned 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 tobe more ad hoc, responding to crises and pressures rather than to fixed budget routines. Ratherthan being financed largely through recurring revenue, it is supported by privatization revenueand borrowed funds, often secured with sovereign guarantees. The resources channeled throughthis system are far from trivial: in 2001, the revenues of the eight state funds are expected toamount 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 ofcontingent liabilities, especially through the issuance of state guarantees. Therefore, rather thandealing with the direct obligations of Government, this informal system is generally driven bycontingent and implicit obligations. Much of the money goes to bailing out banks, assistingailing enterprises and (recently) financing infrastructure investment in certain priority sectors.Unlike the formal budget in which the government's financial exposure normally is known inadvance, in the off-budget system, much of the cost and liability is known retrospectively orwhen 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. Whenpayment comes due, the Government must make good on its prior obligations, and it often doesso outside the budget.

3.10 Recourse to extra-budgetary devices has been deemed an appropriate means forpromoting the transformation from state enterprise to a market economy and for easing theunavoidable pain of adjustment. But as other countries have learned with bank bailouts, costsand liabilities that are hidden for good cause do not disappear. In fact, when they impact on statefinances, 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 (seeBox 3.1). For instance, where a government decree used to be sufficient to createinstitutions authorized to spend public monies, it now takes an act of Parliament;

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


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

3.12 There is a legitimate question, however, as to whether the new rules are sufficientlycomprehensive and airtight. First, the law not only left six extrabudgetary funds standing, but itdid not even prevent the creation of two more funds in 2000 in the area of transport and housing(see Part 2, 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 theCzech Republic and other countries, that the costs of the extra-budgetary activities outweigh thebenefits, several more ministries have been contemplating setting up similar funds (e.g., fortourism).

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

3.14 A key challenge in the adjustment process remains therefore to create a comprehensivebudget system that includes all financial commitments and flows. Short of it, the balkanizationof public resources is always going to frustrate the overall prioritization in the use of publicresources. Such consolidation should not necessarily prevent separate accounting, if deemednecessary, for privatization revenues and other special transactions within a comprehensivebudget framework. But, as long as it maintains informal budget arrangements alongside theformal system, the Government will have difficulty enforcing fiscal discipline and achievingefficiency 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 statebudget. If the main motive in establishing the housing and transport infrastructurefunds was indeed, as is claimed, to exempt them from the budget rule that allunused appropriations expire at the end of the fiscal year, it would be preferableto amend the Law on Budgetary Rules so as to authorize the Government bydecree or Parliament by a special law to permit some carryovers and otherflexibilities 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 turnKoB into a non-banking institution (Ceska konsolidacni agentura).83 As this isdone, there will no longer be any logical basis for excluding KoB from the statebudget or from the accounts of the general government.

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


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

(d) Establishing, in the context of the state budget, ceilings not only on the aggregatevolume of guarantees authorized each year,8 4 but also on the amount ofguarantees that may be issued by each ministry, agency, or budgetary institution,and the maximum volume of guarantees that may be outstanding for each suchentity.

(e) Publishing annual audited financial statements listing all known contingentliabilities. To the extent that information is available, these statements shouldspecify the amounts guaranteed, past payments made pursuant to the guarantees,the firm or other entity receiving the guarantee, the event(s) that may triggerpayment, and an estimate of the risks for 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 ofexpenditure programs.8 5 A key reason for existing budget rigidity is that a large part of recurrentexpenditures are mandated by legislation or other contractual obligations. Substantial delays arelikely to be involved in reducing outlays in these areas. The estimated share of mandated andquasi-mandated expenditures has increased in recent years, from 67.8 percent of the stateexpenditures in 1995 to 81.5 percent in the budget 2001 (see Table 3.2). Being covered bylegislative or contractual commitments, mandated outlays are not easily changed in the course ofthe annual budget process, due to the time taken to identify, plan, legislate, and implement thechanges. This section will argue that up-front policy commitments and medium-termframeworks can help tackle this challenge.

" The new law on budgetary rules also puts an absolute cap on the total approval of sovereign guarantees at 40 percent of approved state budgetexpenditure.5 This section and the next draw on a background paper on "Public Expenditure Management."


Table 3.2: Mandated and Quasi-Mandated Expenditures1995 1996 1997 1998 1999 2000' 20012

(billions of CZK and percent)TOTAL (A+B) 293.4 344.1 385.2 425.4 445.8 506.1 530.3

Asashareofstatebudget 67.8 71.0 73.4 75.1 74.7 81.0 81.5

As a share ofGDP 21.2 21.9 23.1 23.7 24.3 26.7 26.4

A. Mandated 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-Mandated 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 440.0 482.8 509 537.4 567.3 584.9 630.7

State 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

Preliminary estimates.Budgeted.

Source: Ministry of Finance, State Budget 2001.

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

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

3.19 There is a consensus that, to achieve the kinds of expenditure rationalizationcontemplated in this report, it will be necessary to review and modify the underlying legal andother agreements that govern mandated and quasi-mandated expenditures. While the annualbudget process is well suited to the provision of funding for existing programs, and marginaladjustments 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 andprogram options than time usually allows when the annual budget is put together as well as moreexplicit 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 theEuropean 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 andinfluence over the legislative process.

3.21 To regain room for maneuvering in a constrained situation, the remedy adopted by asmall but growing number of countries is for the Government to make annual budget decisionswithin 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 onlyexpenditures). 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 termsof the resources available - through current revenue or borrowing - in future budgets. The basic elements of an MTEFinclude aggregate fiscal constraints set in advance of specific spending bids; baseline (or forward) estimates of thespending contemplated for each of the next several years under approved policies; the allocation of spending targets toeach budget chapter; rules for updating the baseline in response to new data or decisions; procedures for trading offbetween or within budget chapters and for measuring the budgetary impact of proposed or adopted policy changes; andpreparation of annual budgets that are consistent with the MTEF.

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

3.22 The main advantages of looking beyond the annual budget cycle, and of casting budgetoptions, constraints, and strategies in the medium term are: (i) to illuminate the underlyingbudget 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 canbecome visible, and to commit the parties concerned to it; (iii) provide a timeframe in which linedepartments can articulate meaningful policy change, and in which legislative action can bephased and be allowed to take effect. This is particularly important in the context of expenditurecontraction.

3.23 The new budget rules law manifests the Government's and Parliament's conviction thatthe annual budget does not suffice to manage state finances: it directs the Government toestablish a "medium-term budgetary outlook" covering the two years beyond the year for whichthe budget is submitted, and including projections of state revenues and expenditures, approvedfinancing of asset replacement programs, the surplus or deficit, and a survey of state guarantees.


Abundant reference has already been made in Part 1 to the first such outlook, presented intandem with the 2001 budget.

3.24 The Government has several other activities underway that may facilitate the transition toan MTEF. One is the preparation and publication of periodic macro-economic forecasts by theMinistry of Finance; another is the development of medium-term plans. The Government has forinstance produced a "national program" for accession to the European Community, itemizing foreach budgetary chapter the additional spending that will be undertaken to comply with theacquis. The Government has also established quasi commitments and expectations throughelection campaign platforms and party manifestoes. These set forth the priorities theGovernment intends to pursue, and, though they are not legally binding, they do influence debateon the budget and are used from time to time by ministries to mobilize support for additionalresources. Moreover, some of the larger, more prominent ministries have prepared multi-yearsectoral plans that make a case for additional spending. Finally, the program financing initiativehas led the Government to make quasi commitments covering the years required to completebudgeted 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 reviewedor compared. The result is that by the time the Government gets around to preparing a newbudget, most (in some cases, all) prospective resources have been claimed or committed, leavingit with little margin for priorities and initiatives.

3.26 Thus, the Czech Government still has to take additional steps in order to reap the benefitsin fiscal discipline and allocative efficiency of a true MTEF. Key to this is to transform thecurrent medium-term outlook from a prospective exercise into an authoritative budgetarystatement 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 beuseful, the MTEF should establish the fiscal boundaries within which the annual budget is madeand 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 onwhich budget estimates are prepared and voted. To encompass government financecomprehensively, the MTEF must include all financial flows to or from state entities, includingproceeds to and distributions from the National Property Fund, the Konsolidacni Banka, and anyextra-budgetary funds established by law. An MTEF will add little value if it is confined to theroutine transactions that are now formally included in the state budget. One of the biggest gainsfrom having a medium-term framework would come from incorporating matters that have beenexcluded from the budget.

3.28 In concept, an MTEF is simple; in application, it entails an array of rules and proceduresas well as political engagement and support. The approach will fail, however, if it is seen merelyas a technocratic exercise in which Ministry of Finance experts specify budget limits. To beuseful, 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 and departments. For it tosucceed, it must therefore be supported by a similar effort at building expenditure programmingcapacity 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, andperhaps also with amounts set forth for the most important Govermnent initiatives. The detail ofexpenditure 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 bettersense, not only of where public monies are being spent, but also what is being achieved withthem. Such information would also make difficult trade-offs, which the need for fiscaladjustment makes unavoidable, easier to judge. The Czech state budget unfortunately resemblesthose in many other countries in that spending tends to vary incrementally from one year to thenext. This behavior breeds status quo budgeting: calculating the resources needed to continueexisting services, and paying little attention to how the budget might be used to improve theefficiency or quality of public services or what the real trade-offs are in the necessaryredeployment of public resources.

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

3.31 A first step in that process might therefore be to enhance the budget classification in away that better identifies what services are being rendered. At present, the state budget isstructured 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 managingexpenditures. Chapters break down into line items defined by (i) general indicators, common toall chapters (i.e., essentially an economic classification); and (ii) specific indicators, specific tothe activity or structure of each budget institution. As presently structured, the specificindicators are too few, too poorly defined, and not linked enough with government policies to beof much use to assess and guide performance.

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

3.33 A second step would be to integrate gradually performance budgeting with the MTEFinitiative discussed earlier. It is highly unlikely that performance budgeting will succeed if it isperceived 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 budgetbaseline would for instance number the schools/classrooms to be built and operated underapproved policies, and the additional schools and classrooms to be built and operated underproposed or adopted policy changes. It would show similar baselines and adjustments for othermajor education activities as well as for activities in other sectors. Projected changes in servicelevels 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 ofsignificant funds and operational responsibilities, which will now be discussed, makes the needfor better inforrnation on performance all the more compelling. The Czech Republic, like othernational governments which have embraced decentralization, is moving toward a situation inwhich the central government is responsible for producing most public revenue but sub-nationalgovermments are responsible for delivering a growing number of public services that mostdirectly affect citizens. When fiscal decentralization is implemented before the government is ina position to define objectives and monitor performance, there is the heightened risk that publicfunds will be poorly used. The launching of new regions should therefore be an opportunity forthe Government to define its budgetary expectations in terms of the results to be achieved withpublic monies.

E. STRENGTHENING LOCAL GOVERNMENT

3.35 Local governments can hardly be ignored in the design of the needed strategy for fiscalconsolidation. Do they not absorb resources equivalent to about 10 percent of GDP (see Table3.3) and spend close to a quarter of consolidated government expenditure (a respectableproportion by European standards)?

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

Budget Executed Bdg. Est.Opration 1993 11994 11995 11996 11997 11998 11999 12000

(in percent ofGDP)Total Revenue 9.2 9.5 9.4 10.4 | 7 8.7 10.2 9.3Tax revenue 3.8 4.6 4.9 4.5 4.6 4.6 4.7 4.8Shared tax revenues 2.8 4.1 4.6 4.1 4.1 4.2 4.3 4.3'Own' txes- 0.9 0.5 0.4 0.3 0.5 0.5 0.4 0.5

Transfers from State & State Funds 2.8 2.6 2.5 3.9 2.1 2.1 2.3 2.1

Capital revenue 0.8 0.5 0.4 0.5 0.5 0.5 1.7 0.7

&lwpnvaization 0.6 0.5 0.3 0.5 0.3 0.4 0.3 0.0Other nortax revenues' 1.9 1.7 1.6 1.5 1.5 1.5 1.6 1.6

Total Expenditur & Net Lending S.9 9.5 9.6 10. 9.0 8.7 9.2 9.Current Expendhwue 5.S 5.9 5.9 7.5 6. 5.9 6.4 6.6Capial Expenditure 3.2 3.5 3.6 3.3 3. 2.9 29. 3.I

BaIincl.privatization receipts 0.2 0 -0 -0.3 -03 0.1 1.0 -0.0Bal.excl. privatization revenue -0.4 -04. -0.5 -0.9 ,o.0 -0.3 0.7 -0.

Sources: Ministry of Finance, World Bank Staff* includes estate tax** includes entrepreneurial and income from property

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


resources, disparities in access to public services, over-indebtedness). The section below takesstock of recent achievements and puts forward a number of ideas to strengthen them, focusing onthe priorities of the day. These are: (i) the consolidation of municipal governments; (ii) arationalization of inter-governmental transfers; (iii) a tighter oversight of municipal finances,particularly their indebtedness; and (iv) the orderly transfer of meaningful responsibilities to thenewly-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 govermnent. Reflecting along historical tradition going back to the 19'h century, there is a proliferation of municipalities inthe Czech Republic. As a result of the consolidation policy pursued under the communistregime, their number declined from about 11,000 in 1951 to 4,100 in 1990. Their numberescalated back thereafter however. A blanket repudiation of the previous socialist planning andcentral control system based on the "national committees", and of the generally unsuccessfulexperience with forced amalgamation of smaller communities tried during the 1960s and 1970sboth contributed to this phenomenon. In the early 1990s, when popular pressures for moredemocracy were strong, it was especially difficult to discipline the fiscal decentralization processand contain the creation of new municipalities. As a result, by 1999, the Czech Republic wasagain 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 mostmunicipalities lack the critical size to accomplish much. Currently, 86 percent of themunicipalities 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 smallestcommunities do not have enough tax revenue capacity and have been incapable of: (i) retainingqualified staff with the necessary expertise; and (ii) taking advantage of externalities in theconsumption 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 localdemands. The lack of qualified staff, the small population size, and the absence of an adequatescale for the production of public goods and services may have seriously jeopardized the efficacyof 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 amongthem, or outsourced to the private sector enough of the public service delivery to overcome theseproblems. 8 6

S The economic downside of municipality fragmentation (lack of administrative capacity, lack of fiscal resources, and lack of realization of scaleeconomies) should be weighted against the potential for increased political accountability. Smallness of communities and the proximity of votersto decision-makers facilitate the identification of local preferences and potentially strengthen political accountability. Against that, of course, isthe risk that, because of their small sizes, 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-govemments: the higher self-goveming units (the "regions"), and the basic self-goveming units (the "municipalities").The latter provision was implemented only gradually however, with the regions being only formally created under theAct. No. 347/97, Coll., of December 3, 1997 on Creating Higher Territorial Entireties and on a Change of theConstitutional Law.

Municipalities. Until then, municipalities were for all practical purpose, the only operating bodies of local self-govemment. They manage their "own" affairs, as defined by the municipal law, as well as "delegated" responsibilities onbehalf of the national government. Municipalities have a considerable degree of autonomy with respect to ownexpenditures financed either by their own local revenue or by non-conditional transfers (i.e., revenue sharing in Statetaxes). 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, asestablished by law. The Municipal Council, the legislative branch of the municipal govemment, indirectly elects themembers 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 isappointed by the Mayor in consultation with the Municipal Council and (until 2000) the head of the District Office.

As the capital city, Prague enjoys special status. In addition, Prague and the other three largest municipalities (Bmo,Plzen, and Ostrava) also have district status (see below). Thirteen other municipalities of relatively large size, and witheconomic, social and cultural importance, are the so-called "statutory" towns to which extended delegated competencehas been granted by the State. There are also 383 "designated" municipalities which are authorized to perform somedelegated State competencies, including some functions on behalf of smaller surrounding communities. The rest aresmall communities, which have gained the legal status of municipality.

Regions. The regions envisaged by the Constitution were originally created as geographical jurisdictions in 1997 underLaw 347/1997. In April 2000, Parliament approved Law # 129/2000 which created regional govemment, with electedrepresentatives. 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 newregions geographically were basically created around the old thirteen "statutory towns" plus Prague. No expenditureresponsibility or revenue sources have been assigned to them as yet.

The Law on Regions defines, however, the basic administrative structure for regional self-govemment. This structureincludes the Regional Assembly as the legislative body, the Regional Council as its executive body, the President of theRegional Assembly, and the Regional Office. Regional representatives directly elected by the population in the regionform the Assembly. The Regional Council members and the govemor are indirectly elected to the Assembly, whileofficers and staff of the Regional Office are appointed by the Regional Council. The Regional Office can also carry outstate-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 deconcentratedbranches of the national govemment used to play an important role at the local level. The 73 districts offices were incharge of overseeing the implementation of state policies at the local level, and supervising the legality of performance oflocal authorities (Municipal Council, Board, and Office) on "delegated" functions (Section C). They also coordinatedinter-municipal affairs and supported smaller municipalities in the discharge of their duties. District offices also representsome ministerial departments, as territorial divisions of the State administration. The head of the district office wasappointed, dismissed by, and reported to the central govemment (Minister of Interior). The districts also had anAssembly that deliberated and approved the budget and the policy agenda submitted by the district office. The membersof the District Assembly were the Mayors (or their Deputies) of municipalities in the district, which ordinarily convenedtwice a year to approve the district budget and the final accounts. Nevertheless, the District Assembly also provided aforum where municipalities could discuss issues of common interest. For example, state transfers to municipalities forthe execution of delegated functions were made through the district budget. Also, to a certain extent, the DistrictAssembly was also used for conflict resolution, and as a complement to the Courts, at the district level. It is commonlyassumed 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 horizontalfiscaldisparities 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 untilthe recent reform of April 2000 are some of the forces behind this trend. In particular, theindustrial depression and the economic restructuring efforts since the mid-1990s have led toincreased unemployment (e.g., Most, Karvina, Chomutov, and Ostrava-mesto), with seriousconsequences for the respective local government budgets of decreased tax revenue andincreased social assistance needs. On the other hand, the most prosperous industrial and touristareas (e.g., Plzen, Brno, and Prague) have enjoyed buoyant revenues, gained more fiscalindependence, and have even successfully accessed financial markets through bond issues toexpand their opportunities for capital investments.

3.40 If decentralization is to live up to expectation of improving public services, it will beindispensable to consolidate the operations of the small municipalities to economically andadministratively viable sizes. One option is to put in place incentives (including financialincentives) for smaller communities to merge, wherever possible. The new tax-sharing systemintends 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 aresufficiently powerful. These incentives are not yet clearly targeted either, as they provide largermunicipalities (with 100,000 inhabitants and even bigger) the same incentives to merge as toosmaller. One would rather wish that incentives to merge would stop at a point where economiesof scale have been internalized for most public services.

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

Inhabitant brackets No. of Munic.' % distrib. No. of Citizens2 % distrib. ApprovedCoefficient

<100 592 9.5 41,844 0.4 0.42130

101-200 1,166 18.7 174,254 1.7 0.53700

201-300 876 14.0 214,982 2.1 0.56300

301-1500 2,772 44.4 1,820,722 17.7 0.58810

1,501-5,000 567 9.1 1,452,584 14.1 0.59770

5,000-10,000 134 2.1 927,426 9.0 0.61500

10,001-20,000 66 1.1 929,334 9.0 0.70160

20,001-30,000 27 0.4 660,344 6.4 0.71020

30,001-40,000 11 0.2 371,306 3.6 0.74490

40,001-50,000 6 0.1 269,836 2.6 0.81420

50,001-100,000 17 0.3 1,252,788 12.2 0.84880

100,001-150,000 1 0.0 103,372 1.0 1.03930

150,001-150,000 3 0.0 875,260 8.5 1.67150

Prague I 0.0 1,193,270 11.6 2.76110

Sum 6,239 100.0 10,287,322.00 100.0 12.6137

Source: Ministry of Finance' 1999

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


the small municipalities to the regions or to "designated towns."87 One can imagine for instance,smaller municipalities being enticed (or directed) to rely on regional administrations to providepublic services on their behalf (e.g., road maintenance) or to offload on them the discharge ofpart of their administrative and financial duties (e.g., accounting). In addition, where straightmerger are likely to be bitterly resisted, national authorities could offer other legal vehicles (andincentives) 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 andadministrative assignments) might provide an enticing package for smaller municipalities toconsolidate on a voluntary basis. Such a 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 "percapita" share in the tax-sharing system;88 an amplified tax-base and revenuecapacity; better access to quality services).

(b) The provision of public services become more effective and efficient, as a resultof being able to internalize current externalities in consumption and economies ofscale 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 moredirectly 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 municipallevel. The government may be well advised to review its options in this fieldbefore inequalities widen further.

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

Horizontal equalization

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

s7 One such financial incentive could be for the national government to provide some of the matching funds for EU pre-accession Funds tosmaller communities that would decide to amalgamate.88 This kind of incentive should explicitly represent a redistribution of the tax-sharing pool. A small reduction of the shares in the largestmunicipalities (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 actuallystarted 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 wouldactually take place in favor of the poorest regions may thus depend primarily on where EUstructural funds are directed.

3.45 The potential merits of an explicit equalization scheme can be debated. One reason forits absence at the present time might be that existing disparities in fiscal capacity, while notinsignificant are not (yet?) large by international standards, and in particular when compared toother transition countries.8 9 This is in part because the existing, nation-wide safety net hashelped prevent that diverging economic fates translate into commensurate differences in livingstandards across the country. Disparities would thus be linked as much to difference in sizes asto underlying social conditions.

3.46 On balance, however, the case in favor of some equalization mechanism would seemstrong. 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, asnow, on the tax sharing arrangements. The way the tax-sharing formula currently works bluntsthe 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 singleinstrument. The use of a separate equalization mechanism may prove helpful if the governmentrevised the revenue assignments for municipalities to put greater emphasis on the developmentof local tax bases.

Rules vs. Discretion

3.47 At present, the Czech Republic operates essentially three transfer programs for localgovernments90 (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 governmentresponsibilities legally delegated to municipalities. In general, these transfers aredistributed on a "per client" or "per head" basis and cover expenditures in theareas of social assistance and benefits, kindergarten and primary education,9 'selected hospital and assistance institutions, fire brigades, and the execution ofgeneral government services, including registration and permits.

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

89 The aggregate evidence available at the level of NUTS II regions shows that in the period 1995-1997 average revenues per capita from thepersonal income tax in Prague were 219 percent of the national average while all the other NUTS 11 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 from106 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 inCentral Moravia.90 All these grants are earmarked for specific purposes and, in most cases, local govemments have to provide separate accounts on their usage.9' These subsidies to schools are exclusive of teacher salaries. The latter are paid directly by the central government to the School Boards at thedistrict level.


(c) Capital grants extended for a variety of purposes, including schools, hospitals,social care facilities, gas distribution, equipment of fire brigades, development ofindustrial zones, public transport, water and sewerage treatment plants and so on.Municipalities also receive capital transfers from the State Environmental Fund.92

Capital grants are typically discretionary and almost all require matching fundsfrom the municipalities.

3.48 Taken together, these transfers added up to about 19 percent of municipal revenues in1999.

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

Current Capital All transfers Share in totalTransfers transfers (percent)

Subsidies from Central Govermment 17.89 8.01 25.9 93.1

Subsidies from State Environmental Fund 0.08 1.85 1.93 6.9

Total transfers 17.97 9.86 27.83 100.0Source: Ministry of Finance

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

3.50 The discretionary grants, however, have also many drawbacks. First, the actualallocation of discretionary grant transfers, including the criteria for eligibility and award is notalways transparent. In particular, there is a sense that the award of many of these transfers stilldepends heavily on political connections and bargaining skills or political power of specificmunicipalities. Furthermore, the discretionary grants have been a rather unstable source ofrevenue for local governments, which in turn has damaged the ability of local govermnents toplan and budget their expenditures in an efficient manner. In addition, funding practices forspecific transfers may have created negative incentives for revenue mobilization at the local levelif the central government is perceived to have reduced the level of discretionary transfers anytime that local governments increased their own revenues. Finally, until recently, there was littletransparency of how the system works. For example, the list of subsidy recipients was neverpublished. This is now changing, and the database of the amounts and beneficiaries of centralgovernment subsidies is now available on the Ministry of Finance's web site.

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

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

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

3. The Fiscal Management FTamework 96

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

(c) Develop efficiency benchmarks for local public services through periodic cross-municipalities/regions performance evaluations to orient municipal grantprograms 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.9 3 Also,pending a more specific enquiry, the level of overall operational efficiency seems to bereasonable, given the current level of budgetary discretion. The widespread use of public bidsfor the procurement of services may have also contributed to keeping delivery costs reasonablyin check and may have lowered opportunities for corruption in the public sector. Lowadministrative capacity, which is for the most part due to the proliferation of very smallmunicipalities, remains one of the problems at the local level.

3.53 To a large extent, the acceptable budget execution performance of many municipalitiesmay be attributed to the oversight and assistance provided to them, until now, by the DistrictOffices, particularly in the case of the smaller municipalities. The envisaged elimination of theDistrict Offices at the end of 2002 raises the important issue of whether the new regions will bewilling to do this same work, and whether they will be able to do so, given that the load ornumber 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. Oneoption is to find an acceptable way to make the new regional governments responsible for theoversight and assistance to smaller municipalities in budget execution matters. The new regionalgovernments may find it more efficient to contract out these services with private accountingfirms. Beyond that, there will be a need to introduce also a new kind of audit that focuses on theevaluation of budget performance, i.e., on the outputs and outcomes from local expenditureprograms, based inter alia on the benchmark exercises mentioned above. These evaluations maybe carried out by the local governments themselves and discussed by local councils at the time ofpresentation of the annual financial audits.

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


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 expenditurebeyond the level of their revenues and grants. The single most important instrument available tofinance deficits has been through borrowing from commercial sources (banking and non-bankingloans and credit, including bond issuing) and non-commercial sources (interest-free or subsidizedloans from the State, mainly the Ministry of Finance, and the State Environmental Fund). Inaddition to their own requirements, municipalities have also often provided guarantees to relatedbodies (and even businesses) and thereby assumed contingent liabilities.

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

3.57 Although municipal debt is still arguablyrelatively small to be of any immediate threat to Figure F.: Czech Republic: Municipal Debtmacroeconomic stability,94 and although it has Outstanding, 1993-99

2.5 6~~~~~~~~~~~~~~~~0.0plateaued lately following government 25 1 -00

intervention, it is rather troubling that it could 5002.0.

have grown so fast (more than six-fold) during the 43Q

earlier period (see Figure F.1).95 While most of 1 X.4

this debt may have been placed with banks and s . 300

bond markets (especially foreign ones) by large, 1.0 . 2GDP

affluent cities (e.g., Prague, Ostrava, Plzen, Bmo, rL:-% Mun,TxRv.

Liberec, Usti and Labem), there is a concern that a t0

number of smaller and middle-sized municipalities oo. I oomay have borrowed from local banks beyond their 1993 1994 1995 1996 1997 1998 1999

capacity to service debt.

3.58 The situation is all the more worrisome that the authorities have only limited capacity tooversee and regulate municipal borrowing, other than through moral suasion. Reflecting theirconcerns, the Ministry of Finance has since 1997, directed the Exchange Commission to bar newbond-issues, including by local governments in foreign markets,9 6 and recommended to themunicipalities not to increase their debt exposure and warned them that it would stop subsidies tothose municipalities that had already reached a 15 percent debt service ratio (regardless of theway of borrowing).

94 Even if we assume upper-bound level of 4 or 5 percent of GDP, including contingent liabilities in the Czech Republic, the level of indebtednessof subnational governments would appear not to be high by intemational standards. For example, in Germany subnational govemment debtrepresented 21 percent of GDP in 1996 and in Australia this figure was 11 percent.95 Note that the apparent stabilization in 1999 of the municipal debt outstanding in relation to GDP (and even a slight drop in relation to municipaltax 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 alsocashed in a substantial part of their stockholder rights in energy distribution companies.96 Only Prague has issued bonds on foreign financial market since then.


3.59 The government should upgrade existing regulations and institutions related tomunicipal/regional credit markets, for instance by:97

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

(b) Formulating a "local government bankruptcy law" which clearly definesresolution procedures in case of municipal/regional government default.

(c) Establishing an official monitoring agency to keep records and to monitormunicipal/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 whereappropriate.

(b) Send unambiguous signals to financial markets that municipal debt is not backedeither implicitly or explicitly by the national government. One way to pass thatmessage might be to impose suitably conservative loan loss provisioningrequirements on municipal debt, as it is held by banks, insurance companies, andother 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: whatwill 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 isthat 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, regionalplanning), or through its district offices (e.g., oversight and support to municipalities).9 8

Initially, these responsibilities would be discharged on a delegated basis. Over time, some mightbe properly devolved. The new government structure will be phased-in over a period of twoyears through December 2002 and during the interim period whatever the new regions do will befully funded via transfers from the state budget. The method of financing the new regionsbeyond 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 toshaping the functions, responsibilities, and revenue sources of the new regional authorities issensible. This may avoid major disruptions in service delivery in particular, since the olddistricts being phased out over the same period will be used as an administrative bridge. Insectors where major, and probably painful restructuring is still needed, such as in secondary

97 Available options are laid in the comprehensive companion study on "Intergovernmental Fiscal Relations in the Czech Republic," mimeo,World Bank. March 2001.98 Other state functions currently performed by Districts, however, would be absorbed by "designated" municipalities -- which the Minister ofInterior 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 seemto strike a better balance between a desire to involve local inputs, and the need to maintain thenecessary leadership and flexibility at the national level to drive the process; gradual devolutioncould follow over time, after the system has been reconfigured.

3.63 Still, the decision to organize the election of regional representatives before theirmandates are determined is certain to generate tensions, as elected representatives mav claimresponsibilities from understandably apprehensive national administrations. The governmentshould therefore strive to minimize the period of iimbo, and come to closure as soon as possibleon the assignment of responsibilities and autonomous revenue sources to the regions. It will alsoneed to ensure that the important oversight function (previously by districts) over themunicipalities is not interrupted. It should furthermore ensure that the new regions do not buildbureaucracies afresh, but draw on existing resources (e.g., staff, buildings and other facilities) ofnational and district administrations.

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

F. CONCLUSIONS

3.65 Institutional reforms in public expenditure management are not a substitute for policyaction, 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 ofthe choices being faced; (ii) create the space needed to deploy policies; (iii) apply publicresources where they can be best utilized while mobilizing private and local ones whereverpossible to the pursuit of public policy goals; and (iv) generate feedback on the effectiveness andefficiency of public interventions. The discussions highlighted number of practical measureswhich could help at the national level in this respect, including:

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

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

(c) Anchoring greater performance orientation in an activity/service-basedarticulation of the state budget.


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

(a) Offer suitably enticing incentives and legal frameworks for the voluntaryamalgamation of municipalities.

(b) Reorganize the financial oversight over and support to municipalities (previouslyprovided by the defunct districts) and further regulating municipal borrowing.

(c) Streamline discretionary grant programs to municipalities by moving toward moreformula or rule-based approaches.

(d) Define a process of gradual delegation, then devolution of meaningfulresponsibilities (and attending revenues) to the newly created regions, whilemaintaining the continuity of public services.

report no. 22114-cz czech republic enhancing the prospects...

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