The Parties Unified for the Public Sector

Česká verze ZDE

For the last eighteen months, businesses and individuals have sweated while the government debated, rejected and otherwise delayed any measures that might have helped the private sector withstand the financial crisis. Despite the collapse in orders and the drastic cuts in the workforce, the political community seemed quite serene. When leading politicians announced that the country would be a prosperous island in the middle of meltdown, businesspeople closer to the action wondered whether they had descended into insanity.

The last week brought good and bad news. The good news is that the government- as well as the political parties twisting its arms behind its back- has finally acknowledged that the economic crisis is impacting the Czech Republic. The bad news is that the government seems concerned only with finding ways of minimizing its impact on the public sector. Their solution may make things worse for the private sector- and, as a consequence, for the government as well.

The government awoke to reality when 2009 tax revenues dropped by 19% year-on-year. On Friday, the haggling parties achieved a compromise on the 2010 budget. After a long weekend, the government met Tuesday to confirm the details and to announce the numbers. Yet, there is no real news, and no real solution, in this budget. We will pay more so the government will spend more. Since the government has never been able to estimate revenue or control spending, the numbers announced Tuesday should be treated as a finger in the wind. Outside of parliament, this budget creates more questions than it answers. Let’s ask and attempt to answer some of the more prominent.

Revenue Comparison, IIIQ, 2007-2009

Source: Ministry of Finance

Will it boost the economy?

The only way to produce sustainable government finance is to create the conditions for economic growth. If the government is truly concerned with stable long-term government, they should not take short-term measures that might delay the return of economic expansion. Yet, the government readily admits that their measures will turn growth back into recession. The Finance Ministry was predicting GDP growth of .3% in 2010. Minister Janota announced that the package will reduce that number by .6-.7%, turning the economy shaky growth back into recession.

This should come as no surprise to anyone who has studied economic history. The past tells us that raising taxes during a recession delays recovery and may deepen the crisis. So why is this government and parliament adopting policies that take such a risk? To reduce the public deficit for one year.

Deficit, Budget vs. Actual Comparison, 1998-2008

Source: Ministry of Finance

Will the 2010 budget restore financial stability?

The deal was good public relations and shaky economics. The purpose was to reduce the deficit to below the magical threshold of CZK 200 billion. As many economists have pointed out, CZK 200 billion is a lot, but so is the CZK 167 billion deficit finally passed by the government. For financial stability, the number is not as important as the formula for reaching it. The Czech formula appears to be broken, and this agreement puts even more stress on the point of fracture.

Since 1998, Czech policymakers have followed a simple equation in public finance. They kept an accumulating deficit- averaging CZK 60 billion annually- under control by covering spending increases with rising revenues from an expanding economy. During the period, revenues increased 98% while expenditures rose by 91%. Even with this excess in income, the combined deficit mounted to CZK 661 billion between 1998 and 2008. This number did not seem to concern politicians or the ministry of finance, because, they explained, the Czech Republic maintained relatively low debt levels as a percentage of the GDP.

This easy formula cracked wide open this year. In the first three quarters of 2009, the treasury collected CZK 150 billion less than for the same period in 2008- a drop of 19%. In the past, the government ran healthy surpluses through the first nine months of the year. This year, the budget imploded and reached a deficit of CZK 89 billion through September. Since the government turned a September surplus into a substantial deficit in previous years, we can expect some deeply red numbers by December of this year.

That result explains the government’s sudden acknowledgement that the economic crisis is real. Instead of changing the formula, however, the government is relying on it even more. They will squeeze the economy by raising taxes. And they will become yet another example of a government which “cuts” spending by actually increasing it. This raises serious concerns on both the revenue and the expenditure side of this year’s budget.

Revenues, Budget vs. Actual, 1998-2008

Source: Ministry of Finance

Source: Ministry of Finance

Will increased taxes bridge the revenue gap?

The government believes the extra taxes will make up some of the shortfall. Economists raise their eyebrows. Governments depend on jobs, profits, and spending to generate revenue. Jobs are fewer. Profits are lower. As a consequence, spending has slumped. Many doubt whether the revenue exists- no matter what the rate of taxation- to close up the hole caused by economic contraction. Tax increases will likely shift revenue between categories- the higher social and income tax revenues from raising social caps will reduce the VAT revenue as those people cut spending to compensate- than raise it.

The government, however, is betting that the public has extra income to spare. The 2010 budget calls for revenue to be 92% of the budgeted revenue for 2009. As stated earlier, the actual 2009 revenue is running at 81% of what the government budgeted. Higher taxes will not account for an 11% increase in revenue, if it accounts for any at all. The rest will have to be raised by economic growth. During the golden years of expansion, revenues rose by an average of 7%. In 2008, the increase dipped to 4%. The number will be negative in 2009. The prediction here is that the government has overestimated 2010 revenues, perhaps substantially. Each 1% shortfall represents CZK 10 billion. The government missed the budget revenue by an average of 7% for the last decade. Do the math.

The difference between budget and reality should come as no surprise. It is hard to measure future economic activity with any precision. It is also hard to gauge how businesses and individuals will pay their taxes. Evasion is a major problem here. With profits and income tighter than before and taxes increasing, one can assume that the black market will grow. This creates a major policy issue for the future: how fair is it to depend on a smaller group of the population to pay higher taxes?

Social, Income vs. Spending, 1998-2008

Source: Ministry of Finance

Source: Ministry of Finance

Will the government compensate for decreased revenues by less spending?

Over the past months, we have witnessed business and individuals react to less revenue by cutting spending. The government has chosen a different path. Spending in 2010 is scheduled to increase by 3%. It will likely increase by more.

Since 1998, the government has spent 3% more than it budgeted; this amounts to CZK 20 billion in overspending annually. In election years- which 2010 will be- the government has averaged CZK 30 billion more spending than is budgeted. There are some flashes of optimism: the government spent less than budget in 1999, 2004 and 2008. In fact, the government reduced actual spending from the previous year. The reduction, however, was only 1%.

If is history is a good guide, we can expect expenditures to be anywhere between 1-6% more than the budget. Any 1% increase amounts to CZK 10 billion. With a technocratic government composed of long-term state employees, and political parties focused on winning elections, Mr. Janota will have a major challenge to keep expenditures within sight of the budget.

Will we actually keep the deficit below CZK 200 billion?

The budget does not seem to reflect the rapid deterioration in the economy and tax revenues. The government historically has spent much more than budgeted. This evidence paints an ugly picture. For the past two weeks, the politicians have sweated and battled and threatened to resign over what the budget deficit should be, but the budget deficit is a shimmering oasis of a number, and has a plus or minus of tens of billions of crowns.

Can the current model be fixed?

Even if we do keep to the announced deficit, the 2010 budget is not a long-term fix. It continues to rely on increased revenue to contain, but not control, the deficit. The economy is not likely to grow by 5% annually for the next 10 years. The tax increases are meant to be temporary (we will see about that). The spending remains out of control.

There is a truth that we must face: the government is outgrowing the country. While the Czech GDP has increased by 85% since 1998, tax revenues have increased by 98%, and state expenditures have increased by 91%. If this continues, financial instability will increase incrementally each year. The model has to change.

What needs to be addressed for real reform?

The new model must move in an opposite direction than the 2010 budget. Revenues have not been the problem. Spending has. To fix spending, the government has to address two areas that combine for more than 50% of total expenditures: social payments and internal transfers within the government.

Social program costs have increased by 81% since 1998, and now comprise 37% of the total budget. Transfers to other bodies-such as regions and municipalities- have grown more egregiously: they are now 2.5 times their 1998 levels and take up 25% of the budget.

Those two areas are not the only budget chapters where spending has increased faster than revenue since 1998. Remuneration of state employees has doubled. Interest payments have increased 2.2 times. However, those two areas combined only comprise 14% of the overall budget. Temporarily reducing the salaries of constitutional employees by 4% is like battling the deficit wave with a plastic beach shovel. Unless something is done about social costs or state transfers, the country can not have budget stability.

State transfers have been increasing 22% annually over the last 11 years. In 2008, the government delivered CZK 266 billion to other state bodies. That comes to CZK 26,401 per citizen. How effectively has this money been spent? As taxpayers, we have no way of knowing, and we can hold no one accountable. The solution may be to devolve taxation authority to regional and local bodies, and to cut their connection to the state budget. This would also allow taxpayers to determine more directly whether benefits match costs: a comparison of a local municipal tax rate versus the services supplied would reveal which local authority worked most efficiently to improve the lives of their constituents.

We are able to make such a comparison with social programs. And the news is not good. The programs are running about 23 billion in the red every year. Over the past decade, the social shortfall has contributed 49% of the overall deficit. Since 2004, the situation has improved, but the reason for this- revenues that have outpaced rising costs- has probably been reversed due to higher unemployment.

The long-term outlook for social programs is not rosy. If nothing changes, the aging population could conceivably bankrupt the country in the next fifty years. The first step to addressing reforms seriously is to shift the cost of social programs entirely onto social taxes. That means increasing the social tax while lowering the personal and company tax the same amount. Doing so would make the burden of the country’s social programs clear to the people who pay them, and force an honest debate about their value and effectiveness.

Revenue Breakdown, 1998-2008

Source: Ministry of Finance

What is preventing these changes?

Today’s budget reform appears to be much ado about nothing. At best, it applies a very loose band-aid to a bleeding public sector while shifting the economy into neutral. At worst, it could infect both the economy and the public budget with something more serious. What is needed is real reform. Real reform, however, requires a real election.

Whatever his reasons, CSSD Chair Jiri Paroubek was right to oppose cuts to social programs. No party and certainly no technocratic government has the mandate to change government in the fundamental ways necessary to achieve long-term financial stability. Parties can only receive such a mandate if they campaign on specific platforms. They cannot get it with orange platitudes or solutions backed by an empty blue sky.

We now must accept that we do not have the political leadership that will prevent companies and individuals from getting further bruised by the crisis. We should expect more in the future. As citizens, we can begin the process of budgetary reform by asking our political parties four questions during the upcoming elections, and voting according to who answers best.

Expenditure Breakdown, 1998-2008

Source: Ministry of Finance

Question One

How can economic policy, including tax policy, increase economic growth?

To be fair, no one can predict how an economy will perform in the most stable of times. Stability is a synonym for lower (or ignored) risk. The current crisis is risk realized. In such a situation, individuals respond in drastically different ways. The essential unpredictability of these responses shred the generalizations on which economic models are built. We cannot criticize the budgetbuilders for not hitting the budget numbers exactly on the mark. We can question, however, why parties have responded so forcefully to the gaping holes in public finance after they were so ambivalent about helping the private sector on which the public sector is built.

Question Two

Should government spending grow more or less than the GDP?

State spending is growing faster than the economy. This is a fundamental source of instability not only for public finance, but also for the economic well-being of the country. Parties should clearly state whether they are willing to curb spending to levels that are below the rate of GDP growth.

Question Three

How can social payments be balanced with social tax revenue?

Parties that wish to continue the current benefits should make explicit how they will pay for them. Parties that wish to change the current benefits should explain clearly which benefits will be modified. All parties should agree to fund social programs only through social tax revenues so that the real costs are transparent.

Question Four

How will your party increase transparency and accountability in the state transfers, as well as other areas of the budget?

A good government should operate its services more efficiently- more value per crown spent- than other governments. The Czech government cannot measure how well it does its job, because revenues are not placed together with expenditures. In this respect, it is like a family which does its finances according to another family’s bank account.

Wrapping up

Each party should state how it will measure the efficient use of public money, and should propose how the system of taxing can be better aligned with spending.

These are not easy questions to answer. The country is fortunate to have an election period, because it allows these questions to be debated and for people to choose the leaders who best reflect their own opinions. The risk, however, is that the political debate has become a sterile mask to hide the machinations of an elite that spans across the political parties and is buried deep within the bureacracy. This forces the people to choose between Dalik or Tvrdik, despite the fact that the two work together more often than they oppose one another.

Nothing much can be done now but work hard and demand answers from the people who want to be our leaders. The era of the parties unified for the public sector has begun, and, if the people do not demand their representatives back, even elections may not end it.

Source: AmCham analysis