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Proceedings

of the 2nd International

ConferenceEuropean Fiscal Dialog 2016

Fiscal and Monetary Policy: between

Scylla and Charybdis?

ISBN: 978-80-87325-09-4

Organizers: Conference partners:

NEWTON College

Prague, May 20th, 2016

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Proceedings of the 2nd International Conference

European Fiscal Dialog 2016

Fiscal and Monetary Policy: between

Scylla and Charybdis?

NEWTON College

Prague, May 2016

2

Proceedings of the 2nd International Conference

European Fiscal Dialog 2016

Fiscal and Monetary Policy: between Scylla and Charybdis?

SCIENTIFIC COMMITTEE:

Bojka Hamerníková, NEWTON College, Czech Republic

Agniezska Alinska, Warsaw School of Economics, Poland

Egle Butkievicene, Kaunas University of Technology, Lithuania

John Hudson, University of Bath, United Kingdom

Květa Kubátová, University of Economics in Prague, Czech Republic

Klára Major, HETFA, Research Institute and Center for Economic and Social Analysis in Budapest, Hungary

František Ochrana, Charles University, Czech Republic

Marta Orviská, Matej Bel University, Slovak Republic

Katarina Ott, Institute of Public Finance, Croatia

Ladislav Říha, European Movement in the Czech Republic, Czech Republic

Hrvoje Šimović, University of Zagreb, Croatia

Eva Zamrazilová, Czech Banking Association, Czech Republic

Reviewers: prof. Bojka Hamerníková, NEWTON College, Czech Republic

All papers were peer reviewed by two reviewers.

Editor: Bojka Hamerníková

Technical Editor: Helena Hakenová

Publication was not subject to language check.

ISBN 978-80-87325-09-4

Print: Centrum tisku, Purkyňova 8, 612 00, Brno, 2016

Publisher: NEWTON Books, a.s., Politických vězňů 10, 110 00 Praha 1, Czech Republic

Published on September 2016.

© NEWTON College, a.s.

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CONTENTS

Contents.................................................................................................................................... 3

Prologue…................................................................................................................................ 5

The Situation of the Banking Sector and Public Finance in the Polish Economy in the

Context of the Global Crisis…………………………………………………………………. 6

Agnieszka Alińska, Ewa Kosycarz, Katarzyna Wasiak

Prevention of the Activities of the Offshore Networks in the Economy………25

Emil Asenov

How to Obtain Efficiency and Equity in Education ……………………………………34

Predrag Bejakovic

Domestic Debt Trap in the Czech Republic Compared to other Visegrad Group

Countries……………………………………………………………………………………..45

Bojka Hamerníková, Jan Kubát

Impact of the Limitation of Lump-sum Expenses in the Czech Republic ……………56

Petr Hovorka, Jana Stavjaňová

Issues Related to Recent Trends in Fiscal Policy …………………………………………64

Lenka Jurošková

Comparing Real Estate (Property) Tax Revenue within Budgets of Large Cities in the

Czech Republic in 2015 ………………………………………………………..……………71

Milan Lindner

Fiscal Aspects of Cohesion Policy in Hungary ………………………………………84

Klára Major

To the Fiscal Dimension of Health Care Financing ………………………………95

Jan Mertl

Assurance – a Vital Tool of Guiding the Internal Audit..…………………………105

Martina Muchová, Maria Klimiková

The Growing Role of the Central Banker.………………………………………………111

Marta Orviská, John Hudson

The Challenging Field of Budget Transparency Research …………………………….127

Katarina Ott, Mihaela Bronić

Interaction of Fiscal and Monetary Policy in Croatia: Between Scylla and Charybdis...139

Hrvoje Šimović

Pension System Balance Sheet Development Model until 2066…………………………145

Petra Škarýdová

Negative Interest Rates: Impacts on Banking Sector……………………..……………...155 Pavel Štěpánek, Eva Zamrazilová

Calculation of Economically Justified Costs and Calculation of Social Services Rates in

Social Services in Slovak Republic………………………………………………….162

Jana Štrangfeldová, Zuzana Sojaková, Štefan Hronec

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Exchange Rate Commitment, Negative Interest Rates and Current Monetary and Fiscal

Policy Mix in the Czech Republic…………………………………………………………172

Dana Viktorová, Vladimír Tomšík

Financial (Il)Literacy and Czech Retirement Policy ……………………………………183

Jaroslav Vostatek

Toxic Assets of the Fiscal Policy of the Czech Republic………………………………......196

Karel Zeman

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PROLOGUE

In May 2016, NEWTON College organized the 2nd International Conference from the cycle European Fiscal Dialog with over 70 participants from the Czech Republic, Slovakia, the United Kingdom, Poland, Hungary and Croatia. The intention of the organizers is to create a platform for discussion about general and specific issues of public finance.

The topic of this conference was “Fiscal and Monetary Policy: between Scylla and Charybdis?”. The conference was held under the auspices of the Deputy Prime Minister and Minister of Finance of the Czech Republic, Mr. Andrej Babiš. The conference was attended not only by academics but also practitioners and policy makers.

Among the keynote speakers were prof. John Hudson (University of Bath, United Kingdom), prof. Marta Orviská (Matej Bel University, Slovak Republic), prof. Katarina Ott (Institute of Public Finance, Croatia), prof. Hrvoje Šimović (University of Zagreb, Croatia), prof. Eva Zamrazilová (Czech Banking Association, Czech Republic). The conference was also attended by the Deputy Minister of Finance of the Czech Republic, Ms Lenka Jurošková and the vice governor of the Czech National Bank, Mr Vladimír Tomšík.

The papers presented during the conference showed various aspects of public finances and the conference laid conditions for active participation of domestic and foreign attendees.

Conference details are available at the web site of the conference at www.efid.cz.

Bojka Hamerníková

NEWTON College

Prague, Czech Republic

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THE SITUATION OF THE BANKING SECTOR AND PUBLIC

FINANCE IN THE POLISH ECONOMY IN THE CONTEXT OF THE

GLOBAL CRISIS1

Agnieszka Alińska, Ewa Kosycarz, Katarzyna Wasiak

Abstract

The purpose of the article is to present the dynamics of the Polish economy in 2004-2015 where macroeconomic indicators reflect the condition of the financial sector, as well as to outline the strategies, decisions and actions taken by the public authorities in the market in order to implement fiscal instruments to promote economic growth. The authors analyze trends and changes of the fundamental macroeconomic indices that reflect the situation in the financial system (both in the public finance and market sphere) and the sustainability of the social-economic development in Poland. Poland is one of the European states which suffered from the global financial crisis to a lower extent. It is one of the countries which, despite external turbulence, was able to achieve positive results in the three areas. A relatively high level of economic development and positive situation of the labour market were maintained.Moreover, the public sector is characterised by quite low, in comparison to other European countries, level of public debt. In the period 2009 -2014 there were some problems with the level of overall deficit. But after government’s consolidation measures Poland (2010-2014) achieved required level of deficit.

Keywords: financial crisis, macroeconomic performance, banking sector, public finance,

Poland

JEL Classification: E50, E6, E61, E62, E66, H6, G01

Introduction

For several years there has been a visible trend to increase the role and importance of the financial sector in the economy. It involves the development of studies on the functioning and stability of the financial system. This discussion is spreading more and more, because the crisis of recent years which seriously rocked the economy of many countries in different parts of the world, began in the financial sphere. The crisis hit highly developed economies with particular force where the financial sector is characterized by complexity, large size and rapid pace of development of advanced financial services. In this context, issues related to the determination of conditions necessary to maintain the stability and security of the financial system and the consequences of losing them are becoming increasingly important, both nationally and internationally.

The risks to global financial stability have increased in recent years as a result of weaker economic conditions. Fiscal trends have worsened and fiscal risks are rising in many countries in the world. This has led to tighter financial conditions, reduced risk appetite, higher credit risks, and hampered balance sheet repair.

The purpose of the article is to present the dynamics of the Polish economy in 2004-2015 where macroeconomic indicators reflect the condition of the financial sector to a great extent, as well as to outline the strategies, decisions and actions taken by the public authorities in the market

1 Research project is funded by National Science Centre, Poland (Grant No. DEC-2013/09/B/HS4/03610).

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in order to implement fiscal instruments to promote economic growth. The authors analyze trends and changes of the fundamental macroeconomic indices that reflect the situation in the financial system (both in the public finance and market sphere) and the sustainability of the social-economic development in Poland. Security, stability and effectiveness of the financial system as well as dependencies between its elements impact the processes in the financial sphere and real economy.

The factors analysed by the authors on the one hand affect the structure of the financial system and implementation of its functions and on the other hand indicate risks for the stability of the financial system. At the end of the paper the authors aim at identifying of current threats in this regard.

1. GENERAL CHARACTERISTCS OF THE POLISH ECONOMY UNDER

GLOBAL FINANCIAL CRISIS

Fostering economic and social progress has been a key objective of European and also Polish policies in recent years. The current economic crisis has however reversed much of the progress achieved in Europe since 2000. In March 2010, the European Commission launched the Europe 2020 strategy for smart, sustainable and inclusive growth. Its objective is to overcome the effects of the 2008 global financial and economic crisis and to stabilize the financial system and the economy as well as to tackle macroeconomic imbalances (Eurostat a).

Poland is one of the European states which suffered from the global financial crisis to a lower extent. It is important to highlight that the monetary and fiscal authorities have made several anti-crisis decisions and played a vital role in the stimulation of economic activity. During the ECOFIN summit on 7th October 2008, the National Bank of Poland and the Polish government have decided to take steps to maintain the raising economic growth trend in the face of the crisis. The Ministry of Finance have implemented the regulation package which encompassed a set of laws to improve the safety net in Poland and prepare anti-crisis mechanisms (NBP, 2009).

The anti-crisis measures were aimed at stimulation of consumer and investment demand by reducing the burden of tax and social security contributions, including by reduction of administrative barriers and by facilitation in obtaining the EU funds or easing the processes within the public-private partnership.

Avoiding recession is owed to the use of the EU funds. Ministry of Regional Development has estimated that, on average approx. 1 percentage point of the annual growth rate was the result of the investment co-financed by the EU (Ministerstwo Rozwoju Regionalnego, 2016).

Consumer demand supported by rising employment and wages as well as positive household mood remains the main source of economic growth in Poland in recent years. Other growth factors include a growing level of corporate investments, a visible increase in household expenditure on housing, as well as growing exports. Good Polish economic situation is conducive to the growth of imports and translates into high income of foreign direct investors (NBP, 2013).

In the last 25 years in Poland, the process of a rapid real convergence took place, compared with both the European Union and all the transition countries. This process was mainly derived from the economic growth rate – the fastest in the group of the new EU member states (EU-11) and more than twice faster than the average in the ‘old’ EU-15 (Weresa, 2015).

The fact that Poland avoided a decline in the real GDP during the crisis was an undoubted success providing both high resistance to external shocks, as well as good overall health of the

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economy (Weresa, 2015). Poland owes a smooth transition through the crisis to the prior implementation of reductions in the fiscal burden also. It has stimulated consumer confidence, while the depreciation of the Polish zloty was an important factor to support Polish exports (Filar, 2015).

In the following paragraph a set of fundamental macroeconomic indices is presented which are of high importance to the Polish economy and shed light on its current state. GDP is the central measure of national accounts, summarizing the economic position of a country. GDP is used to analyze economic performance and cycles (such as recessions, recoveries and booms). Data in various currencies can be converted into a common currency to make it more easily comparable — for instance, converting into euros or dollars. However, exchange rates do not reflect all the differences in price levels between countries. To compensate for this, GDP can be converted using conversion factors known as purchasing power parities (PPPs). By using PPPs (rather than market exchange rates) these indicators are converted into an artificial common currency called a purchasing power standard (PPS); the use of a PPS makes it possible to compare purchasing power across the regions of EU Member States that use different currencies and where price levels are different (Eurostat).

In 2007-2011, the economy grew at a high rate while generating the highest average annual growth rate in the EU (4.3% compared with EU-27 average of 0.5%) and managed to maintain the path of economic growth even in 2009, the year the most difficult to the majority of countries. The distance between the Polish and the EU-27 average measured by GDP per capita decreased markedly in 2007-2011 – more than 13 percentage points. Thus, in terms of the speed of the process of the equation to the EU average of economic development, Poland was in the first place.

As Eurostat indicated the most rapid economic growth during the period 2008-2013 across regions of the EU was recorded in the Polish region of Mazowieckie, which includes the capital of Warsaw. GDP per capita in Mazowieckie was about four fifths of the EU-28 average in 2008 (Eurostat).

Detailed analysis of the data in Table 1 shows that after two years of positive growth in GDP (3.7% in 2010 and 5% in 2011), the two following years were marked by a slowdown in the rate to 1.6% in 2012 and 1.3% in 2013. This slowdown was directly related to the decline in production or even the stagnation in Western Europe as a result of persistent consequences of the global crisis and debt crisis in the Euro zone. In 2014 the growth rate was at a slightly higher level of 3.3% and in 2015 of 3.6% (GUS). A further increase in investment supported the growth in 2015. Investment activity of companies contributed to the high utilization of capacities and a positive financial outlook. At the same time the tendency of companies to invest was and still is limited by the uncertainty regarding economic prospects abroad. A decrease in growth of the emerging markets affects the weakening of the exports growth. Nevertheless, due to the simultaneous stronger deceleration in imports, the contribution of net exports to GDP growth remained positive in 2015 (NBP, 2015a).

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Table 1 – GDP in Poland, GDP per capita in PPS; Poland vs. EU (2004-2015)

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Gross domestic product per capitaa in PPS (EU 28=100)

49 50 50 53 55 59 62 64 67 67 68 N/A

Gross domestic product (fixed priceb)

105.1 103.5 106.2 107.2 103.9 102.6 103.7 105.0 101.6 101.3 103.3 103.6

Source: own work based on the data from a Eurostat, b GUS – prior year annual average prices used as constant

One of the major economic problems in Europe and the world is unemployment. The importance of this measure has been stressed by the global financial crisis and the problems of the Euro zone in recent years. In most EU countries, unemployment is still high. This is caused by the fact that a significant part of it is posed by the long-term structural unemployment and short-term frictional unemployment, essentially independent of the current economic situation in a given country. Also, changes in the level of employment and unemployment are generally weaker and delayed with respect to changes in production.

The unemployment rate is an important indicator with both social and economic dimensions. The availability of work, existing capacity and employment conditions are an important aspect of welfare and quality of life in a country. These factors directly influence income which level is in turn dependent on education and human capital. Rising unemployment results in a loss of income for individuals, increased pressure with respect to government spending on social benefits and a reduction in tax revenue. From an economic perspective, unemployment may be viewed as unused labour capacity. High unemployment undoubtedly remains in opposition to social welfare (Eurostat).

The time series on unemployment are used by the European Commission, other public institutions, and the media as an economic indicator. Banks may use the data for business cycle analysis. Finally, the general public might also be interested in changes in unemployment.

In Table 2 the unemployment rate for Poland, the Euro zone and EU is presented. An unemployed person is defined by Eurostat, according to the guidelines of the International Labour Organization, as someone aged 15 to 74 without work during the reference week who is available to start work within the next two weeks and who has actively sought employment at some time during the last four weeks. The unemployment rate is the number of people unemployed as a percentage of the labour force (Eurostat).

Although the effects of the crisis were reflected in the increase of unemployment in 2009-2013, in the years 2004-2014 a clear downward tendency in the level of unemployment was observed in Poland. This indicator has been lower than the Euro zone and EU average for the last three years. In 2009, according to Eurostat, unemployment in Poland stood at 8.1%, while in the Euro zone and EU at 9.5% and 9% respectively. Despite the positive trends, Poland failed to repeat the record low level of 2008 of 7.1%.

The demand for labour in Poland has stabilized in recent months on a high level. The accelerating growth in full-time employment is visible in the corporate sector, although it is partly due to the conversion of civil into employment contracts. Despite the low unemployment rate, the wage growth is still moderate. Companies record a slight increase in the pressure on wage rise, which is shown in the latest ‘NBP Quick Monitoring’ of the second quarter of 2016, but wages are increased mainly in the companies where labour productivity growth exceeded wage growth. The most recent forecasts of the Polish labour market prepared

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by the NBP and IMF confirm that the positive trend should continue until 2017 at least. In addition, the positive situation on the labour market and favourable financial outlook of enterprises in the environment of low interest rates on loans helps to maintain stable growth of lending in the economy (NBP, 2016a).

Table 2 – Unemployment rate in Poland, Euro zone and EU (2004-2014)

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Poland

19.1 17.9 13.9 9.6 7.1 8.1 9.7 9.7 10.1 10.3 9.0

Euro zone

9.1 9.0 8.4 7.5 7.6 9.5 10.0 10.1 11.3 12.0 11.6

European Union

9.3 9.0 8.2 7.2 7.0 9.0 9.6 9.7 10.5 10.9 10.2

Source: own work based on the Eurostat data

Another important factor, from the macroeconomic stability perspective, is the level of prices in the economy. The National Bank of Poland is responsible for its stability and it pursues the direct inflation target set at 2.5% in 2004 with a symmetrical tolerance range for deviations of +/- 1%. Currently, Poland experiences deflation, which level is lower in 2016 than in previous quarters. The drop in prices is mainly due to external factors, primarily tied to the decline in commodity prices on world markets, as well as the low price dynamics in the Polish external environment. Persisting deflation in Poland is also promoted by the lack of demand and cost pressures in the domestic economy. It is expected, however, that the continued stable economic growth and the favourable situation on the labour market will be influenced in the direction of a gradual increase in price dynamics.

Tables 3 and 4 present respectively: Poland CPI calculated by the Polish Central Statistical Office (GUS) and HICP indicators for Poland, the Euro zone and EU calculated by Eurostat. HICP is a specific consumer price index developed by European Union – the harmonized index of consumer prices (Eurostat b). In the analyzed period, the CPI deviates from the upper limit of the inflation target in 2008, 2011 and 2012. In 2013-2015, in turn, from the lower limit of the target. The Council emphasized that in the countries with sustained low inflation, the central bank usually does not respond to deviations from the inflation target if it deems them temporary, even when inflation leaves the tolerance band. The global financial crisis has shown that in order to ensure macroeconomic stability, monetary policy should be pursued in such a way as to – while striving to stabilize inflation at the target level – limit the risk of accumulating imbalances in the economy, especially those resulting from unsustainable credit booms. The possibility to flexibly set the parameters and adjust implementation of available monetary policy instruments according to the situation in the domestic financial system is a factor, which may mitigate this risk. The Council’s decisions were primarily based on the assessment of factors influencing inflation developments in the monetary policy transmission horizon, including the character and persistence of shocks resulting in inflation deviating from the target, as well as the outlook for inflation returning to the target (NBP, 2015b). The reflection of the Council decisions made in recent years is the data presented in Table 5. It is shown together with the values for the Euro zone, Great Britain and the United States. A clear expansive character of monetary policy is visible across main central banks which is in response to low inflation or even deflation tendencies in many economies as well as a significant drop in the economic growth rate worldwide.

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Table 3 – Consumer Price Index (CPI) in Poland (2004-2015)prior year = 100

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

101.0 102.5 104.2 103.5 102.6 104.3 103.7 100.9 100.0 99.1

Source: own work based on the GUS data

Table 4 – HICP in Poland, EU and Euro zone (2006-2015) Annual average rate of change

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Poland

1.3 2.6 4.2 4.0 2.6 3.9 3.7 0.8 0.1 -0.7

European Union

2.2 2.3 3.7 1.0 2.1 3.1 2.6 1.5 0.5 0.0

Euro zone

2.2 2.1 3.3 0.3 1.6 2.7 2.5 1.4 0.4 0.0

Source: own work based on the Eurostat data

Given the fall in commodity prices in recent quarters, inflation in many countries, including the United States and the Euro zone, remains at a level close to zero. Under these circumstances, the Federal Reserve and the ECB keep interest rates near zero, even though the FED announced their rise in the near future. In contrast, the ECB is continuing the asset purchase programme and signaled the possibility of further easing of monetary policy.

The Monetary Policy Council of the NBP has maintained the key interest rate at 1.5% since March 2015. Expectations of market participants, however, point to the possibility of interest rates lowering in 2016.

Table 5 – Key interest rates in Poland, the Euro zone, Great Britain and United States (2004-2015)

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Poland – National Bank of Poland

6.50 4.50 4.00 5.00 5.00 3.50 3.50 4.50 4.25 2.50 2.00 1.50

Euro zone – European Central Bank

2.00 2.00 3.25 4.00

VIII.2008 4.25

XII.2008 2.50 1.00 1.00 1.00 0.75 0.25 0.05 0.05

Great Britain – Bank of England

4.75 4.50 5.00 5.75 2.00 0.50 0.50 0.50 0.50 0.50 0.50 0.50

United States – Federal Reserve System

2.25 4.25 5.25 4.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.50

Source: internet websites of NBP, EBC, Bank of England and FED

In conclusion, it is valid to state that the results obtained by Poland in recent years in the context of the situation in Europe were good in terms of the key indicators characterizing the overall condition of the economy. The positive assessment of the state of the Polish economy can be found in, for instance, the OECD reports. (OECD 2014) It is highlighted that the overall results achieved in economic development are impressive in Poland and the relatively fast economic growth in the last decade has helped to shorten the distance from the average standard of living in the European Union.

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Although the recent turbulence on the international markets was felt in Poland, it was to a lesser extent than in other EU countries. During the crisis, the economic authorities have sought to limit the negative effects by introducing the anti-crisis programme aimed at stimulating the economy, attracting foreign investors to the country and maintaing macroeconomic stability, including financial stability. These measures were to protect Poland from the negative consequences of the crisis and at the same time to increase the level of competitiveness of the Polish economy.

2. BANKING SECTOR CONDITION IN POLAND

Maintaining the stability of the banking sector, as the main function of the financial system has gained importance in the context of the global financial crisis affecting economies of single countries. There are many publications indicating the relationship between the financial sector (banking) and the level of economic development of the country. Most analyzes and empirical studies (Levine, 1997, 2005; Wachtel, 2001; Fink et. al., 2005) concluded, that development of the financial sector accelerates economic growth. In Poland, like other CEE countries, banks play the main role on the financial market. The share of banks in the financial system in Poland was calculated at the level of 73.5% at the end of 2014. The share of banks in the financial system is comparable with other CEE countries. For the structure of the financial system, an important issue is to analyze the evolution of the relation between the size of the banking sector and the size and dynamics of economic development measured by the value of GDP.

In Poland, we observe a systematic increase in both assets of the banking system, and the value of GDP. Despite the global turmoil of the financial crisis, the banking sector, as well as the Polish economy has not recorded a downward trend, what was shown in chapter 1.

Figure 1 – GDP and assets of the banking sector in Poland (1994-2015)

Source: GUS, KNF

Analysis of the data indicates that the Polish banking sector is steadily increasing the value of their assets. It remains at the optimum level for the produced GDP. As pointed out by (A. Barajas et al., 2013) for the development of the economy it is important, not only the size but also the growth of the financial system. Banking sector, too large, could lead to crises. On the other hand, the size and effects of the financial system depends on the structural characteristics of the economy and the institutional environment. The structure and size of the

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banking sector in Poland compared to the size of manufacturing in the economy should be described as safe during the global crisis.

Comparing the assets of the financial system as a percentage of GDP in Poland we have a relatively small share of the financial sector in relation to the size of the economy (Table 6). The average value for countries in the Euro zone is almost four times bigger.

Table 6 – Assets of the banking system as a percentage of GDP in selected Central and Eastern European countries and in the euro area, 2011-2014 (%)

Country

Assets/GDP Credit/GDP Deposit/GDP

2012 2013 2014 2012 2013 2014 2012 2013 2014

Poland 83.5 84.5 88.5 50.0 50.3 51.6 44.8 46.6 49.3

Czech Republic 116.0 129.4 131.0 58.3 64.7 66.4 70.2 76.9 79.2

Hungary 110.1 104.4 102.7 43.1 39.3 36.7 34.8 32.4 31.6

Euro zone 334.1 308.3 309.9 100.0 97.0 94.2 80.5 82.4 83.4

Source: NBP, 2015c

The size of the financial system in Poland, consisting the banking sector has proved to be optimal in relation to the size and potential of the Polish economy. Research conducted by the IMF (Sahay, 2015) indicated that Poland has an optimal financial, supporting economic development (NBP, 2015c).

The environment of low interest rates, stable economic growth and conducive developments on the labor market has supported an expansion of credit action w Poland. Growth in lending to the non-financial sector (4.8% y/y at the end of September 2015) almost mirrored nominal GDP growth and in consequence has neither constrained economic growth nor generated imbalances that could endanger financial stability. When compared to other European countries, Poland registered one of the highest lending growth in recent years (NBP, 2016b).

Figure 2 – Financial development effect on growth

Source: R. Sahay et.al, 2015

Despite financial crisis on global financial markets and the problems with credit activity of banks operating in Poland, the banking institutions didn’t lower their performance, just

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contrary. In the years 2008-2014, one has notified the highest growth rate of loans in the non-financial sector. This is the highest value compared to other countries in Europe.

Figure 3 – Growth (%) of loans to the non-financial sector in the period of 2008-2014

Source: NBP, 2015c

In Poland, in comparison to other EU countries, the banking sector has relatively small size, what is optimal, to the size of the economy measured by the value of GDP. That situation should be assessed positively, especially in the time of turbulence and threats, whose sources were derived from the banking sector, expecting the support from public institutions. In addition, it should be noted, that the banking sector is active in financing the needs of the economy, fulfills its functions on the market, what could cause further positive effects.

3. EVALUATION OF STABILITY OF THE PUBLIC FINANCE SYSTEM

The positive opinion on Polish economy and the banking system is reflected on public finance system. The Polish public finance system is quite healthy in comparison to other European countries if we consider general government consolidated gross debt as a measure of health. (Figure 4) But we should be honest that there is a visible continued growth of this indicator. From the beginning of the crisis (in 2008) until 2013 the general government consolidated gross debt was increasing steadily. In 2014, there was a noticeable significant (7.5 pp) drop of the public debt. It was related to the partial reversal of the pension system reform2. Unfortunately, the statistical data for 2015 indicates that the trend of growth of the public debt is maintained. The prediction for 2016 confirms that the level of public debt will be slightly higher.

According to European Commission’s publications, the impact of the nominal increase of GDP on general government consolidated gross debt in Poland changes periodically from

2 The partial withdrawal consists of a transfer of a part of certain categories of assets (e.g. bonds and bills issued by the State Treasury, bonds issued by Bank Gospodarstwa Krajowego on terms and conditions specified in the Act on Toll Motorways and the National Road Fund guaranteed by the State Treasury) to the Social Insurance Institution by open pension funds.

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Figure 4 – General government consolidated gross debt. Excessive deficit procedure (based on ESA 2010)

Source: European Commission

Figure 5 – Impact of the nominal increase of GDP on general government consolidated gross debt. Excessive deficit procedure (based on ESA 2010)


Among other factors that exerted significant impact on the level of the public debt, there is the cost of interest paid on the public debt and cost of the subsidies to the Social Insurance Fund due to the contributions transferred to open pension funds. In 2008 the significant part of debt’s growth was caused by exchange rate differences. All the above mentioned determinants had negative impact on general government consolidated gross debt (Ministry of Finance, 2015).

In comparison to other European countries, especially the Eurozone, the level of Polish public debt is not huge. Poland achieved this comfortable position because it introduced numerous

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fiscal regulations, which helped to keep the level of public debt under control. Poland complies with the European Union’s rules and has introduced its own, more restrictive, regulations.3

The most important and the most difficult to change are the debt rules which are imposed by the Constitution. They introduce limits for public debt. The maximum limit of the ratio of public debt to GDP may not exceed 3/5.

Additionally, in order to protect the limit from Constitution, the Act on public finance imposed two prudential thresholds for Polish public debt: 55% and 60% of the GDP. Should Poland’s debt exceed these thresholds, the central government and the local governments have to fulfil some obligations relating to fiscal planning and public expenditures.

The Polish law imposes two other types of rules: expenditure rule and revenue rule. The expenditure rule covers almost entire general government sector. The revenue rule applies only to insurance sector.

Too restrictive adherence to fiscal rules could, during periods of economic downturns, reinforce the negative economic phenomena. There are empirical studies (Siwińska-Gorzelak, 2015) showing that too restrictive fiscal policy, aimed at fiscal consolidation, may impair economic growth (in short term), which translates to the opposite effect – an increase of the debt-to-GDP ratio. Hence, there is a certain degree of flexibility in the world in respecting the fiscal rules.

In Poland, the fiscal rules were mitigated several times. In 2013 the lowest prudential threshold in the Act on public finances, the limit of 50% on debt-to-GDP ratio was waived. In the same year the legal provision, which established that the budget deficit must not exceed the deficit planned in Multiyear Financial Plan, was withdrawn. At the end of 2015 there was a modification to the expenditure rule. One of the elements was changed in the algorithm that is used to calculate the maximum limit of public expenditures – the annual average inflation target. This change caused, in current economic conditions, that the limits for expenditure are higher. This significantly mitigates the fiscal rules.

Many countries in the European Union mitigate or cancel fiscal rules during economic slowdown periods. For example, during the last crisis, a lot of countries had their deficits above 3% of the GDP and their public debts above 60% of the GDP. None of these countries has been punished for that. EU's fiscal rules provide that in case of exceeding the limits of debt and/or deficit the countries would pay financial sanctions.

Fiscal rules in Poland are imposed by an act of law. There are two exceptions: Belka’s rule4 and budget anchor5. Both of these rules were short term. One of the debt rules is imposed by the most important act of law – the Constitution. Remaining rules are established in the act on public finance and one in the act on the social security system (revenue rule) (Marchewka-Bartkowiak, 2010).

The next indicator, which is useful during an evaluation of public finance sector, is the level of public deficit (net lending (+) or net borrowing (-) of the general government/balance of the general government sector).

In the first period of the financial crisis, in Poland, as in other European countries, a significant drop of the balance of general government sector (Figure 6) was noted. In 2009 Poland again

3 Pursuant to the provisions of the Stability and Growth Pact, Poland and other EU member states may not exceed the debt level of 60% of the GDP and a deficit of 3% of the GDP. Continuing violation of these limits results in the Excessive Deficit Procedure being imposed on a country. Failue to observe European Commiossion‘s recommendations relating to the procedure may result in imposition of fines. 4 It was an expenditure rule. The name was derived from the name of the minister of finance – Prof. Marek Belka. 5 The deficit rule.

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was under Excessive deficit procedure.6 So, the government had to commence the consolidation procedures. Overall (nominal) deficit, in 2010, reached the lowest value in the analysed period – 7.5% of the GDP. Whereas the structural balance of the general government reached at the same time 8.2% of the GDP. Both indicators were improved by 2015. The European Commission forecasts that in near future the situation will be a bit worse.

Figure 6 – Net lending (+) or net borrowing (-): general government. Excessive deficit procedure


In the period of 2009-2015, the restrictive fiscal policy was required by the Excessive deficit procedure. The government took several measures crucial for public finance. We can divide all consolidated government’s measures into two groups: one related to revenues and the other to expenditures.

Figure 7 – Structural balance of general government. Adjustment based on potential GDP Excessive deficit procedure


6 The first time was in 2004, when Poland joined the EU.

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Below are listed some revenue side measures:

· freezing the tax thresholds and lump sum of tax deductible costs in PIT at the nominal levels of 2009;

· increasing the excise duty for cigarettes, for ethyl alcohol, and for oil and fuel fee;

· increasing the VAT rate from 22% to 23% and from 7% to 8%, while simultaneously decreasing the rate for basic food products from 7% to 5%;

· reducing the right to deduct VAT on purchasing personal vehicles and their fuel;

· reducing the share of the pension contribution transferred to the Open Pension Funds – OFE7;

· increasing the disability contribution of the employer, by 2 percentage points;

· introducing a tax on natural resources8;

· extending the use of the reverse charge mechanism (VAT);

· introducing the CO2 emissions allowances trading system;

· reducing the 50% of tax deductible costs due to copyrights and related rights;

· limiting and modifying some tax relief;9

· limiting the possibility to obtain reimbursement of a part of VAT on certain expenditures incurred for housing;

· gradually increasing road sections for which tolls are collected (Convergence Programme 2015 Update, 2015).

Above mentioned government’s measures impacted positively the level of revenue in relation to GDP. The level of revenues increased from 38 % of the GDP to almost 38.9% of the GDP. Maybe it was not a significant growth, but simultaneously the government prepared some measures on the other side of budget – on expenditure side.

Figure 8 – Total government revenue


7 The part transferred to OFE was reduced as from 7.3% of the base to 2.3%. The voluntary contribution transferred to the Open Pension Funds is 2.92%. 8 Tax on mining copper and silver. 9 Limiting the Internet tax relief and modification of tax relief credit for children.

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Figure 9 – Total expenditure: general government


Below some expenditure side measures are listed:

· reducing entitlements to early retirement;

· temporary lack of acceptance of draft acts that may result in a decrease of revenue in public finance sector units in relation to the amounts resulting from regulations and projects that would lead to an increase in expenditure; then this regulation was changed into stabilisation expenditure rule;

· reducing the remuneration (payroll) fund in the state budget units, through adopting a general rule on freezing this fund at the nominal level of the previous year; in the analysed period only remuneration of certain professional groups increased;

· reducing deductions for the company social benefits fund by establishing the basis for calculating the deduction at the level from 2011;

· introducing the income criterion for the entitlement to receive the one-off allowance due to a child birth;

· changes in the pension system, raising the retirement age for women and men to 67;

· reducing one of the solid expenditure – debt costs; it was achieved by transfer of part of certain categories of assets to the Social Insurance Institution by open pension funds and thanks to consolidating liquidity management of public finance sector units;

· reducing the amounts of sickness benefits for the uniformed employees, judges and prosecutors. At this moment they are treated in the case of sickness as other employees (National Multi Year Financial Plan for 2015-2018, 2015; Convergence Programme 2015 Update, 2015).

The 2010-2014 consolidation measures were definitely more intense on the public expenditures side. Weaker results on the revenues side resulted from the economic slowdown occurring in Poland during that time. Weaker economic growth results in lower budget revenues as the majority of financial instruments that provide revenues are at the same time automatic stabilisers that are intended to stimulate the economy in times of decreased GDP dynamics. Thus the fiscal burden is also reduced.

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Figure 10 – Implicit interest rate: general government. Interest as percent of gross public debt of preceding year. Excessive deficit procedure (based on ESA 2010)


As mentioned at the beginning of this paper, the debt servicing costs were a significant determinant increasing the level of debt in Poland. Figures 9 and 10 show the significance of the debt servicing burden to the public finance, and thus to the economy. One has to remember that this is a “fixed cost” that limits the pro-growth expenditures in the national

Figure 11 – Interest: general government. ESA 2010


budget. However, what should be considered a success is the decreasing of this burden in relation to the total public debt of the general government sector (from 6.4% of the debt in 2004 to 3.7% of the debt in 2015; the forecast indicated that the decreasing trend shall continue in following years), as well as in relation to the GDP (from 2.7% of the GDP to 1.8% of the GDP respectively, with the ratio increased for several years during the crisis).

One should conclude that at present Poland has managed to execute the first stages of fiscal consolidation without significant negative impact on economic growth. However, the reason

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for concern may be that decreasing the debt is not exhibiting lasting trends and was achieved by onetime partial reversal of the pension system reform.

4. GLOBAL RISK FACTORS FOR THE CURRENT ECONOMIC SYSTEM

STABILITY

Analysis of the state of the Polish economy and the situation in the financial sector (banking and public) should cover all of sources of risk and vulnerabilities, which require systematic monitoring of individual components of the financial system (financial markets, institutions and infrastructure) and real economy (households, businesses, the public sector). The analysis must also take into account the intersectoral and international ties, since disparities often arise due to the accumulation of weaknesses deriving from various sources. It is necessary to constantly consider the potential risk.

At the end of this part of the study, the authors would like to refer to the current global economic situation and identify the most important issues that affect and will affect in the near future the functioning of the global economy, Poland and the whole financial system. They are briefly described below.

· In many countries, the consequences of the global financial crisis of 2008, as well as the crisis in the Euro zone in recent years, are still visible. In varying degrees, public debt, debts of businesses and households affect spending and economic growth. In some European countries, credits not paid back on time still affect the condition of banks and lead to a reduction in the supply of credits to new customers. On the other hand, the financial levers are decreasing slowly due to the weak economic growth rate.

· The growth of potential GDP has decreased, on the one hand, as a consequence of the crisis; on the other hand, especially in highly developed countries, as a consequence of aging populations and slowdown revealed in total productivity. A significant decline in investment led to an even smaller increase in capital.

· In the last two years crude oil prices decreased significantly (June 2014 – 114 USD per barrel; January 2016 – 27 USD per barrel). The causes of this situation are seen in the constant increase of supply of oil thanks to the exploitation of unconventional deposits and the change in OPEC. It is possible that the fall in prices will continue in the long term. Declines in oil prices triggered a huge reallocation of real income from countries exporting oil to importers of this raw material. Early data indicate that in the oil-importing countries – from the USA, through the Euro zone, to China and India – the growth in real income increases spending. Oil exporters have reduced spending, but to a lesser extent.

· We are observing significant changes in exchange rates in recent quarters. Adjustment of exchange rates to the economic situation may be considered positive, but it is also associated with the uncertainty of the market (Blanchard, 2015).

· The gradual slowdown and rebalancing of economic activity in China away from investment and manufacturing toward consumption and services continue to influence the global outlook.

· The monetary policy of major central banks remain accommodative, although to varying degrees. The ECB lowered interest rates and increased the scale of quantitative easing in March this year. In contrast, Fed in December last year increased interest rates by 0.25 percentage points. Currently, uncertainty about the future direction of the monetary policy in the USA has increased. In the last period, the monetary policy was still relieved by the Bank of Japan, among others, by reducing one of the interest rates below zero, and the

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People's Bank of China, which increased the scope of liquidity support to the financial sector (NBP, 2016c). The expansive monetary policy and maintaining interest rates close to zero do not bring the effect in the form of economic recovery. At the same time core inflation rates remain well below inflation objectives in advanced economies and pose a threat of deflation occurring, and in some countries continuing for a longer period.

· The above mentioned factors, together with market concerns about the future performance of the Chinese economy, are having spillovers to other economies through trade channels and weaker commodity prices, as well as through diminishing confidence and increasing volatility in financial markets. This impact would be much stronger in the case of Great Britain's termination of membership in the European Union (the so-called Brexit), which would further reduce activity in the Euro zone economy (IMF, 2016).

· Deterioration of the situation in the public finances sector – growing budget deficit and public debt. There is a risk of reducing the credit score of the country, which may translate into an increase in government bond yields. As a result of the possible difficulties with financing government spending, the governments of individual countries would probably be forced to take action leading to a tightening of fiscal policy, thereby reducing economic activity.

Although the impact of these factors on individual countries in the world is not equal, they do constitute a major source of uncertainty.

Summary

Based on the analysis conducted in the study, it can be concluded that modern economies, including Poland, which operate in the crisis environment face the following challenges:

· ensuring long-term economic growth,

· maintaining stability of the market financial system,

· maintaining stability of public finance.

Poland is one of the countries which, despite external turbulence, was able to achieve positive results in the three areas. A relatively high level of economic development and positive situation of the labor market were maintained. Moreover, the public sector is quite healthy in comparison to other European countries. But, of course it suffered from global financial and economic crisis.

A large contribution to achieve these positive results were institutions of the banking sector, having adapted the strategic action. These activities were determined, above all, by the attitude of the supervisory authorities and the decisions of the national monetary authorities, who could adjust monetary politic and monetary instruments to the macroeconomic situation of the country.

Healthy level of public debt, Poland has achieved due to fulfil fiscal rules and quite good economic performance and the one-off partial reversal of the pension system reform.

For the financial policy of the state to be effective and had a positive impact on the economic policy, it should focus on the solutions and financial instruments that will complement, support and strengthen the stability of the financial sector, market and public. Such activities require greater coordination of each of these decisions and actions in the field of fiscal, monetary and macro-prudential at the national level.

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References:

1. Bank of England. http://www.bankofengland.co.uk/ 2. Barajas, A., Orsten, B., Dabla-Norris, E., Yousefi, S. R. (2013). Too Cold, Too Hot, or Just

Right? Assessing Financial Sector Development Across the Globe. IMF Working Paper WP/13/81. Washington: International Monetary Fund.

3. Blanchard, O. (2015). World Economic Outlook. International Monetary Fund, April. 4. Convergence Programme 2015. Update April (2015). Warsaw. 5. ECB. https://www.ecb.europa.eu 6. European Commission.

http://ec.europa.eu/economy_finance/ameco/user/serie/ResultSerie.cfm 7. Eurostat a. http://ec.europa.eu/eurostat/statistics-

explained/index.php/Economy_and_finance_statistics_introduced 8. Eurostat b, http://ec.europa.eu/eurostat/statistics-

explained/index.php/Glossary:Harmonised_index_of_consumer_prices_(HICP) 9. Eurostat. http://ec.europa.eu/eurostat 10. Federal Reserve System. http://federalreserveonline.org/ 11. Fink, G., Haiss, P., Vukšić G. (2005). Importance of financial sectors for growth in

accession Countries. Conference on European Economic Integration (CEEI), Vienna. 12. Filar D. (2015). Między zieloną wyspą a dryfująca krą. Gospodarka Polski w latach 2007-

2015. Arche, Gdańsk. 13. GUS. http://stat.gov.pl/ 14. IMF (2014). Fiscal Monitor, April 2014: Public Expenditure Reform – Making Diffcult

Choices. World Economic and Financial Surveys, Washington. 15. IMF (2016). World Economic Outlook; Update. International Monetary Fund, January. 16. Levine R. (2015). Finance and Growth: Theory and Evidence. In Aghion, P. Durlauf S.N.

(Ed.), Handbook of Economic Growth, Volume 1A, Elsevier, Amsterdam. 17. Weresa M. A. (Ed.) (2015). Polska. Raport o konkurencyjności 2015. Innowacje a pozycja

konkurencyjna polskiej gospodarki w latach 2007-2014, Oficyna Wydawnicza SGH, Warszawa.

18. Marchewka-Bartkowiak, K. (2010). Reguły Fiskalne. BAS, nr 7 (32). 19. Ministersrto Rozwoju Regionalnego (2016). 9 lat członkowska Polski w UE. www.npo.pl

(date of access 10. 04. 2016). 20. National Multi Year Financial Plan for 2015–2018 (2015). Council of Ministers, Warsaw. 21. Narodowy Bank Polski (National Bank of Poland). www.nbp.pl 22. NBP (2009). Raport o stabilności systemu finansowego – grudzień 2009 r. Warszawa. 23. NBP (2013). Raport o inflacji; Marzec 2013. Warszawa. 24. NBP (2015a). Informacja po posiedzeniu Rady Polityki Pieniężnej w dniach 1-2 grudnia

2015 r. 2 grudnia. 25. NBP (2015b). Sprawozdanie z wykonania założeń polityki pieniężnej na rok 2014. RPP,

Warszawa, maj. 26. NBP (2015c). Raport o rozwoju systemu finansowego w Polsce w 2014 r. Narodowy Bank

Polski, Warszawa. 27. NBP (2016a). Szybki Monitoring NBP Informacja o kondycji sektora przedsiębiorstw ze

szczególnym uwzględnieniem stanu koniunktury w I kw. 2016 r. oraz prognoz na II kw. 2016 r. Nr 02/16, kwiecień 2016 r., Warszawa.

28. NBP (2016b). Financial Stability Report. Narodowy Bank Polski, Financial Stability Department, Warsaw, 2016; http://www.nbp.pl/en/systemfinansowy/fsr201602.pdf

29. NBP (2016c). Raport o inflacji; Marzec 2016. Narodowy Bank Polski, Warszawa. 30. OECD (2014). Economic Survey of Poland 2014. Paris.

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31. Sahay, R., Cihak, M., N'Diaye, P., Barajas, A., Pena, D. A., Bi, R., Gao, Y., Kyobe, A., Nguyen, L., Saborowski, C., Svirydzenka, K., Yousefi, S. R. (2015). Rethinking Financial Deepening: Stability and Growth in Emerging Markets. IMF Staff Discussion Note SDN/15/08, May, IMF.

32. Siwińska-Gorzelak J. (2015). Dług publiczny a wzrost gospodarczy. SCHOLAR, Warszawa.

33. Wachtel, P. (2001). Growth and finance – What do we know and how do we know it? International Finance.

Contact information

Agnieszka Alińska

Warsaw School of Economics al. Niepodległości 162, Warsaw, Poland [email protected]

Ewa Kosycarz

Warsaw School of Economics al. Niepodległości 162, Warsaw, Poland [email protected].

Katarzyna Wasiak Warsaw School of Economics al. Niepodległości 162, Warsaw, Poland [email protected]

25

PREVENTION OF THE ACTIVITIES OF THE OFFSHORE

NETWORKS IN THE ECONOMY

Emil Asenov

Abstract

The article examines the issues related to the prevention of the negative effects, caused by the activities of “offshore networks” in economic and financial relations. In this regard characteristics of offshore jurisdictions and features of the risk associated with the activities of offshore companies are analyzed.The elements and qualities of the global "offshore networks" are indicated. Counteracting tools against these networks are identified. It is suggested an introduction of a special tax regime as well as achievement of information transparency about property relations, reducing the areas of economic and financial activity and criminalization of actions related to concealing and manipulating information about offshore companies.

Keywords: offshore jurisdictions, companies registered in countries with preferential tax

regime, global "offshore networks"

JEL Classificasion: E02, E26

1. CHARACTERISTICS OF THE OFFSHORE JURISDICTIONS

The role of the offshore jurisdictions in the global economy is again subject to commentaries and analyses of the financiers and policy makers1. This interest is justified, since the direction of assets to areas not covered by the traditional national regulation which combine anonymity, bank secrecy and tax relief is impressive. According to the results of a study conducted by Tax Justice Network the amount of assets transferred to offshore jurisdictions "exceeds the aggregate GDP of the USA and Japan. The amount of these assets is estimated at USD 21 to 32 trillion based on information taken from the Bank for International Settlements (BIS) and International Monetary Fund (IMF)"2.

The emergence of offshore territories has its roots in ancient history. It is considered that the first offshore practices were adopted in Ancient Greece. In order to circumvent the two percent tax, traders avoided the territory of Athens as a place to settle commercial transactions. Later they started to use the neighboring islands to trade free of any taxes and duties3.

In principle, the offshore jurisdictions do not have to be constantly "stigmatised" and determined as a negative phenomenon. One of their main advantages is the achievement of legal tax optimisation.4 In this case, the objective is to declare the profits from operating activities in a territory where the taxes are low or where no taxes are charged, thus allowing the

1The cause was the information was provided by " documents Panama " (Panama Papers) .These documents are related to the global offshore system and were published by " Le Monde "as well as other media around the world.The French newspaper Le Monde and another 106 editions in 76 countries are united in the " International Consortium of Investigative Journalists ", Scandal “Panama Papers” http://epicenter.bg/article/Panama-peypars-Petima-deystvashti-svetovni-lideri-v-ofshorni-kompanii/97492/7/0 2Tax Justice Network“ http://www.financialsecrecyindex.com/ 3Басова С. “Деофшоризация российской экономики“ В-к „КМУ“ Выпуск № 4 / том 3 /2014; http://cyberleninka.ru/article/n/deoffshorizatsiya-rossiyskoy-ekonomiki 4Some authors labelled this technique with the abbreviation "BEPS - base erosion and profit shifting",erosion of (tax) base and transferring profits to fiscally attractive destinations. Хърсев Е..в-к „Сега“ Пазарът на корпоративно гражданство“ http://www.segabg.com/article.php?id=800133

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companies to increase their profitability. There is also a need to execute transactions which, although being legal, require some privacy that can be ensured in the offshore areas. Number of cases of political risk which require preventive transfer of certain funds outside a country where there is a danger of taking acts of repression against the business and property are known in the history.

The current peculiarities of offshore jurisdictions and territories are extremely diverse. At present there is no universal definition of the term “offshore jurisdiction”. At the beginning of the 21st century the Organization for Economic Development and Cooperation defined the following characteristics of offshore jurisdictions: low taxes or lack thereof, lack of effective information exchange, lack of transparency and no requirement for commercial activity.5

Regardless of the specific differences, the regime of the companies in the offshore jurisdictions is characterised by several key features:

Firstly, there is a tax-relief regime which is characterized by:

· Low (or lack) of corporate taxation.

· In addition, the income of the owners of these companies transferred from the offshore area is not subject to taxation. Tax returns are not submitted and the only form of accountability is the annual financial report.

· The accounting requirements are highly formalised and facilitated. The procedures for registration of offshore companies are easy and simplified.

· As a rule, the offshore jurisdictions do not apply any exchange control or in case of such, this exchange control is extremely limited to the foreign companies.

Secondly, there is a mode of confidentiality which involves:

· Confidentiality regarding the real owners of the offshore companies.

· Privacy in terms of the origin of the funds used in the operating activities of the companies.

· The information which is publicly known about these companies, in particular the information on the names of the nominee owners who are usually lawyers or registered agents, is limited.

· Guarantees for protection of the financial privacy. In some offshore jurisdictions the disclosure of banking secrecy is even considered as a crime.

Thirdly, the status of the offshore companies suggests another type of advantages associated with the exercise of the statutory rights and claims on them:

· Through the offshore companies the responsible persons can be concealed in the cases when protection of individual or collective consumer or employment rights is sought through administrative or judicial procedure.

· The legal actions filed by workers and employers against an offshore company, its division, in its capacity as an employer, branch or other agency can be hardly implemented.

· There are difficulties in terms of implementation of orders for payment against offshore companies in the cases when there is a judgement which has the force of res judicata.

The above advantages create, through their systematic interaction, a privileged status of the offshore companies which, in turn, provides those companies with fundamental advantages compared to the other business operators. For example, "the largest French companies pay in France an average of only 8% income tax, while the small and medium enterprises pay an average of 33% income tax. The reasons thereof are completely transparent: the small companies rarely have representation offices .... in the offshore areas."6 In general, these 5 Organization for Economic Development and Cooperation, Harmful Tax Competition: An Emerging Global Issue,1998, p. 23. 6Bridier G.„Peut-onfaire sans les paradis fiscaux?“Slate.fr 20.04.2013 http://www:Slate.fr/story/70989/paradis-fiscaux-mondialisation

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advantages are considered as ineligible in the systems of national regulation of the economic relations outside the offshore areas. The wide use of the unauthorised advantages of the offshore companies has a negative impact on the state and competition in the world markets.

This begs the question which countries and territories can and must be defined as offshore jurisdictions. The first list of offshore jurisdictions of the Organization for Economic Development and Cooperation (known as Table 1) was published as early as the year of 2000. Since then it has been amended multiple times with various supplements and editions. Meanwhile other organizations published their own lists of offshore jurisdictions. The research of Ronen Palan, Richard Murphy and Christian Chavagneux concludes on the presence of 11 different lists of offshore jurisdictions. Even though the list of the Tax Justice Network is the most comprehensive, there are eight countries present in all lists: Bahamas, Bermuda, Cayman Islands, Guernsey, Jersey and Malta. The authors point out that, as regards tax systems, Belgium, Netherlands and Luxembourg can also be defined as offshore territories. Additionally they suggest analysis of some characteristics of the legislations of the United States and the United Kingdom which provide grounds for their identification as tax havens.7

Currently offshore jurisdictions are present globally in all regions of the world. Their territorial distribution can be connected with specifics of national economies and historically established connections and practices. Therefore Nicholas Shaxson proposes a territorial classification of tax havens that includes four categories: (1) Continental Europe havens such as Switzerland and Luxembourg; (2) British zone of influence (including the City of London, the Isle of Man, Bermuda, some of the islands in Western India and the Caribbean); (3) USA zone of influence (the territory of the USA, the Virgin and Marshal Islands, Liberia and Panama) and (4) other offshore jurisdictions8. On the other hand in his research on the Pacific islands used as tax havens Anthony van Fossen points out that the connection of a specific territory to the United Kingdom and the City of London in particular is the most important factor for the establishment of a successful tax haven. On the contrary, the United States have a limited impact in their zone of influence, even though the Marshall Islands are a popular offshore jurisdiction9.

Different interpretations and lists of offshore jurisdictions will continue to exist until the adoption of unified global criteria for evaluation. This process will most likely be slow and difficult as it is connected to the presence of significant multidirectional interests.

In general the influence of the activities of companies registered under offshore jurisdictions on the economies of individual countries can be evaluated as negative. The direct effects include: 1. Decreased state budget mainly due to the lower tax revenues; 2. Increased state budget deficits; 3. Structural deformation of the economy; 4. Decreased innovation potential; 5. Decreased internal investments; 6. Greater dependence on external loans. The listed major problems arising from the activities of companies registered under offshore jurisdictions and the associated risk profile are prerequisites for adoption of suitable instruments for prevention.

7 Ronen Palan, Richard Murphy, and Christian Chavagneux, Tax Havens: How Globalization Really Works, Ithaca, Cornell University Press, 2012. 8 Nicholas Shaxson, Treasure Islands: Uncovering the Damage of Offshore Bankers and Tax Havens, Palgrave MacMillan, New York, 2011. 9Anthony van Fossen, Tax Havens and Sovereignty in the Pacific Islands, St. Lucia, Queensland, Australia, University of Queensland Press, 2012.

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2. FEATURES OF THE RISK ASSOCIATED WITH THE ACTIVITIES OF

COMPANIES REGISTERED IN OFFSHORE JURISDICTIONS

The financial and business operations and relations related to the ownership and control of the offshore companies can be a potential source of risk. The existence and level of this risk arise mainly from the characteristics of these companies. The practices related to the use of their status in the economic and public sector give lots of examples of circumvention of the law or committing criminal activities. Through them, they seriously damage the interests of the society and their counterparties. The following arguments can be used as a basis to conclude that the offshore companies are an object of increased risk:

1. In their practice, the offshore companies have proven to be one of the most important tools for both tax optimisation10 and commitment of tax frauds.

2. The privileged status of the offshore companies is used for execution of sham transactions. For example, by the signature of contracts for provision of consultancy services (sometimes in very large amounts) funds are illegally appropriated, the financial results are changed and the amount of the payable taxes is reduced.

3. The execution of securities transactions with offshore companies is usually followed by refusal to fulfil the obligations under the transaction. Such failure is a reason for transfer of large amount of funds in the form of compensation to the offshore company.

4. The investments made by using offshore companies provide an opportunity to conceal the real owner or real source of funding for the investment.

5. In terms of the commercial activities performed by offshore companies there are lots of examples on the use of transfer pricing11 that allows for direction of the operating profit to offshore areas12.

6. The lack of transparency regarding the ownership and accountability of these companies is a prerequisite for their frequent use to launder money derived from criminal activities, such as drug trafficking, prostitution, terrorism, etc.

These illegal practices give reason to differentiate the offshore companies in a separate category or in an individual risk group. This group is an object of specific risk which must be identified and controlled.

Taking into account the above characteristics of the offshore companies, it can be concluded that the main reason for their use is the opportunity to conceal the real assets and their owners and the reduction of the taxes due. Very often the offshore companies are registered in jurisdictions with special laws for the purpose "to open a bank account which holder remains anonymous. In this way, the holder manages assets by hiding his identity. This is illegal, insofar as the establishment of these companies is aimed at concealing the beneficiary."13 If these assets

10Research results show that about half of all due taxes can be reduced via artificial transfer of intellectual property and intangible assets; Harry Grubert, “Intangible Income, Intercompany Transactions, Income Shifting and the Choice of Locations,” National Tax Journal, vol. 56, March 2003, Part II, pp. 221-242. 11According to estimations conducted by Organization for Economic Cooperation and Development (OECD) transactions between subsidiaries of international companies account for 40 % to 60% of all world trade ;Peut-on faire sans les paradis fiscaux?“ Slate.fr 20.04.2013 12Simon J. Pak and John S. Zdanowicz, U.S. Trade With the World, An Estimate of 2001 Lost U.S. Federal Income Tax Revenues Due to Over-Invoiced Imports and Under-Invoiced Exports, October 31, 2002. 13Menu-Lejeune G, A quoi sert une société offshore ? „La depeche“ 05/04/2016; http://www.ladepeche.fr/article/2016/04/05/2318724-a-quoi-sert-une-societe-offshore.html.

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are registered in several offshore jurisdictions where the relevant company has different nominal owners, it is very difficult and practically impossible to reach its real owners14. It is a widespread practice to "rent names, thus concealing the real owners of these structures. The creation of concealed structures at various levels "is a prerequisite for easy commitment of tax frauds"15. The data from the recent studies confirm this assertion. According to the results of the study of Panama Documents conducted by the international non-profit organisation “Oxfam” fifty large American companies evade taxes in offshore accounts opened abroad which amount to USD 1.4 trillion. The first place is taken by the company Apple which has saved USD 181 billion. It is followed by the company General Electric which has concealed USD 119 billion. The third place is taken by the company Microsoft which has concealed USD 108.3 billion. The pharmaceutical company Pfizer16, the holding Alfabet, Google and Exxon Mobil are among the first ten. The use of offshore companies has enabled the American companies to reduce the level of the taxes paid by USD 4 trillion in the period 2008 – 201417. Even if we assume that in this case legal methods to optimise the taxes have been applied, there are no doubts that great losses have been generated by the public finances in many countries."

3. TOOLS FOR PREVENTION OF THE ACTIVITIES OF THE OFFSHORE

NETWORKS IN THE ECONOMY

The above-mentioned facts on the activities of the offshore companies justify the need for application of countermeasures. In this regard, I would like to point out that in my opinion it is wrong to focus the prevention directly on the offshore companies. Higher level of prevention can be achieved if we look for a wide range. Subject to diagnosis and prevention should be the global offshore networks, rather than the offshore companies themselves. These are networks which include offshore companies, entities associated with or controlled by them, chains of their contractors and internal and external stakeholders. Key role in these networks is played by the attorneys of the offshore companies, majority owners and shareholders who participate in the management of associated companies and contractors. These offshore networks have concealed nature and unclear borders. It is possible that a component of certain offshore network belong to another network. It is also possible to create other parallel offshore networks by using components with various affiliations from certain networks. The borders of these networks are vague and overflow. These networks create uncertainty which results from the grouping of components therein which have no clear identity and certain physical borders.

These features indicate the most important qualities related to the sustainability of the offshore networks:

· Most often the offshore networks have parallel structures which, by using the modern information technologies, ensure their rapid action and flexible reaction.

· The practical experience shows that the offshore networks can easily be created so as to be resistant to regulatory and law enforcement impacts.

· The offshore networks can include a variety of components with different level of

14Иванов Н. Българска търговско-промишлена палата“ Плащаш 3500 долара за офшорка, вземаш ДДС за милиони“ http://www.bcci.bg/pressview/1830 15Vernier E, ,La depeche, A quoi sert une société offshore ? „La depeche“.05/04/2016; http://www.ladepeche.fr/article/2016/04/05/2318724-a-quoi-sert-une-societe-offshore.html 16 Research results show that using the mechanism for transfer of intellectual property rights after 2004 one third of the companies in the pharmaceutical and medical sector and close to 20% of the companies in the computer and electronics industry in the USA have repatriated their profit abroad. CRS Report R40178, Tax Cuts on Repatriation Earnings as Economic Stimulus: An Economic Analysis, by Donald J. Marples and Jane G. Gravelle. 17сп.“Икономист“„US компании крият в офшорки данъци за 1,4 трилиона долара“ http://iconomist.bg/bg/article/52609.US_kompanii_kriiat_v_ofshorki_danyci_za1,4_triliona.

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reliability and an opportunity for quick interchangeability of components contained therein.

In view of the characteristics of the offshore networks attention should be paid to the fact the any application of preventive approach which is not enough comprehensive and large-scale will always fail. Combating these networks implies that systematic global, broadband tools should be used, insofar as sustainable global networks oppose the interest of the society. Decisions can be sought in several ways:

Firstly, it is necessary to introduce "security" tax regime on the activities of the companies registered in countries with an offshore tax regime. In this case, the following fiscal measures can be applied:

· deduction of withholding tax from the cash transfer in favour of the natural / legal person registered in a country with an offshore tax regime (for example in Spain all transfers to offshore jurisdictions are charged withholding tax at a tax rate of 25 percent, etc.).

· The tax may be refunded if the taxable person proves that its costs are real and that they are not made for the purpose of transfer of profits, income or capital so as to evade taxes or to avoid their payment and that the transaction is ordinary and is executed at market prices.

· Non-recognition for tax purposes of costs incurred for the benefit of natural / legal person registered in a country with a preferential tax regime, unless the taxable person proves that its costs are real and that they are not made for the purpose of transfer of profits, income or capital so as to evade taxes or to avoid their payment. To be recognised for tax purposes, the costs should be initially charged withholding tax in a certain amount. This tax is likely to be refunded within a specified period upon completion of the transaction, if the taxable person proves to the national administration that the transaction is ordinary and is executed at market prices.

· Taxable persons owned or controlled by foreign companies must include in the tax base all passive income which the group has directed to its subsidiary due to the more favourable tax rate in the relevant country. The passive income includes interest, royalties, shares and income from transfer of shares, income from movable and immovable property and income from insurance, banking and other financial activities.

Secondly, the prevention of the offshore networks activities could be implemented through the banking institutions. The banks play a particularly important role in the logistics and general operation of the offshore networks. The funds and investments are transferred mainly through the banking system. "Over the past few years the value of the cross-border transactions with companies based in offshore areas has increased on average by 9.3% reaching the amount of EUR 12,1 trillion. Half of these transactions are executed by ten global banks. First of all, these are UBS, Credit Suisse and Goldman Sachs. The other financial institutions which execute such transactions are Bank of America, HSBC, Deutsche Bank, BNP Paribas, Wells Fargo, Morgan Stanley, and JPMorgan Chase"18. This is why the banks should play an important role in the system to combat the offshore networks. It should be pointed out that they are currently engaged in the prevention of money laundering. The scope of the preventive actions, however, is limited and assumes the existence of a previous (precursor) offence. Such an approach complicates and slows down the procedures and implementation of countermeasures. To achieve financial transparency an objective that should apply to all bank customers and mainly to the offshore companies and their contractors should be set. In this connection, the following measures can be implemented:

· identification of all customers of the bank and verification of their identity;

18 Е. Кравченко „$32 трилионах в офшорах“. Ведомости № 3150 от 24.07.2012

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· identification of the real owner of the customer - legal entity - and taking actions for its identification in a manner that gives reason to assume that the real owner has been established;

· collection of information from customers on the purpose and nature of the economic or financial relation which has already been established or is to be established with the real owner;

· ongoing monitoring of the established commercial or professional relations and verification of the transactions executed based on these relations, insofar as they are consistent with the available information on the customer, its business and risk profile, including clarification of the origin of its funds;

· disclosure of information on suspicious transactions and customers.

In the cases where there are suspicious transactions and customers, or reasonable doubt of execution of such transactions the financial institutions should:

· block of funds, financial and other assets;

· impose a ban on the provision of financial services, funds, financial or other assets;

· immediately inform the competent state authorities.

Further, these can be measures aimed at legislative decisions for isolation of the offshore companies from the economic and financial relations in important economic sectors. The objective is to prevent these companies, their affiliates and their real owners to utilise public funds and to manage financial resources contrary to the public interest, as well as to prevent tax evasion.

In this connection, it is possible that these companies be prohibited, directly or indirectly to:

· participate in procedures for obtaining a licence to perform lending, insurance, investment and payment activities;

· participate in public procurement procedures, regardless of the nature and value of the contract;

· participate in procedures for obtaining a concession or permit for mineral exploration, priority investment projects and privatisations to acquire state or municipal property;

· participate in procedures for obtaining a licence for mobile operator or acquiring an interest in such operator;

· establish or acquire an interest in an entity which has obtained a licence for radio and television broadcaster or acquire an interest in a publisher of periodicals.

Fourthly, it is necessary to introduce criminal liability in case of declaration of information requested by the competent state authority and financial institutions that relates to property, economic and financial relations with the natural / legal person registered in a country with an offshore tax regime.

In these cases, it is assumed that an entity is subject to criminal liability if "when intending to obtain for itself or for a third party unlawful pecuniary benefit it damages the property interests of the state or the property of another entity by providing false or incorrect facts or by concealing the real facts for the purpose to mislead or to continue to mislead the other entity"19, or if it:

19Similar texts in clause 263 of the German criminal code; “Strafgesetzbuch” https://www.gesetze-im-internet.de/bundesrecht/stgb/gesamt.pdf.

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· fails to submit the required information and documents that relate to the fact that a company is registered in offshore jurisdictions;

· fails to submit the required information and documents that relate to the business relations with companies registered in offshore jurisdictions;

· provides false information or incomplete documents that relate to property, economic and financial relations with companies registered in offshore jurisdictions;

· provides incorrect or incomplete written information on the economic and financial relations with the offshore company or facts that are significant for the competent authority and financial institutions to make certain decision;

· fails to communicate the changes in the economic and financial relations with the offshore company or fails to provide the information that was previously submitted to the competent state authority and financial institution.

The proposed tools must be implemented in a coordinated, comprehensive and global manner. Organisations, such as the Organisation for Economic Cooperation and Development (OECD, OECD) and G20, have the required resources and opportunities for their implementation. The measures against the offshore networks, however, should not interfere with the tax competition and ability of the states to provide certain incentives to the foreign companies for the purpose to promote their investment. Each nation must be entitled to organise the operation of its country so as to be attractive and competitive, and must be given an opportunity to make it a desirable destination for performance of legal and transparent business.

References:

1. Bridier G. „Peut-on faire sans les paradis fiscaux?“ slate.fr 20.04.2013 http://www.slate.fr/story/70989/paradis-fiscaux-mondialisation

2. Еpicenter.bg ,Скандалът „Панама пейпърс“http://epicenter.bg/article/Panama-peypars-Petima-deystvashti-svetovni-lideri-v-ofshorni-kompanii/97492/7/0

3. Vernier E, „La depeche“A quoi sert une société offshore?.05/04/2016; http://www.ladepeche.fr/article/2016/04/05/2318724-a-quoi-sert-une-societe-offshore.html

4. Fossen А., Tax Havens and Sovereignty in the Pacific Islands, St. Lucia, Queensland, Australia, University of Queensland Press, 2012.

5. Marples D. and Gravelle J. CRS Report R40178, Tax Cuts on Repatriation Earnings as Economic Stimulus: An Economic Analysis,

6. Menu-Lejeune G, La depeche“ A quoi sert une société offshore ? ,La depeche“ 05/04/2016; http://www.ladepeche.fr/article/2016/04/05/2318724-a-quoi-sert-une-societe-offshore.html

7. Shaxson N, Treasure Islands: Uncovering the Damage of Offshore Bankers and Tax Havens, Palgrave MacMillan, New York, 2011.

8. Organization for Economic Development and Cooperation, Harmful Tax Competition: An Emerging Global Issue, 1998, p. 23

9. Palan R., Murphy R., and Chavagneux C, Tax Havens: How Globalization Really Works, Ithaca, Cornell University Press, 2012.

10. Pak J. S, S. Zdanowicz J, U.S. Trade With the World, An Estimate of 2001 Lost U.S. Federal Income Tax Revenues Due to Over-Invoiced Imports and Under-Invoiced Exports, October 31, 2002.

11. Grubert H., “Intangible Income, Intercompany Transactions, Income Shifting and the Choice of Locations,” National Tax Journal, vol. 56, March 2003, Part II, pp. 221-242.

12. Tax Justice Network“ http://www.financialsecrecyindex.com/

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13. Strafgesetzbuch https://www.gesetze-im-internet.de/bundesrecht/stgb/gesamt.pdf. 14. Басова С. “Деофшоризация российской экономики“ В-к „КМУ“ Выпуск № 4 / том 3

/2014;http://cyberleninka.ru/article/n/deoffshorizatsiya-rossiyskoy-ekonomiki 15. Е .Кравченко „$32 трилионах в офшорах“. Ведомости № 3150 от 24.07.2012 16. сп.“Икономист“„US компании крият в офшорки данъци за 1,4 трилиона долара“

http:/iconomist.bg/bg/article/52609.US_kompanii_kriat_v_ofshorki_danyci_za1,4_trilion 17. Хърсев Е..в-к„Сега“Пазарът на корпоративно гражданство“

http://www.segabg.com/article.php?id=800133 18. Иванов Н.; БТПП “Плащаш 3500 долара за офшорка, вземаш ДДС за милиони“

http://www.bcci.bg/pressview/1830

Contact information

Emil Asenov University of National and World Economy-Sofia 1700 Sofia, Students Town, Bulgaria [email protected]

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HOW TO OBTAIN EFFICIENCY AND EQUITY IN EDUCATION

Predrag Bejakovic

Abstract

The article explores this efficiency and equity trade-off in education. While efficiency generally relates to how well an economy allocates scarce resources to meet the needs and wants of consumers, equity concerns the distribution of resources and is inevitably linked with concepts of fairness and social justice. The goal is to identify those circumstances under which equity and efficiency may not trade-off against each other. Economic, political and socio-cultural inequalities fuel differences in life chances, perpetuating them across generations. At least in theory, education is a means by which democracies attempt to equalize opportunities among citizens for economic success. Education and training policies could have a significant positive impact on economic and social outcomes, including sustainable development and social cohesion. It is commonly thought that opportunity equalization, in that dimension, is implemented by the provision of equal access to public resources to all citizens. However, very often this is not so and often existing public services - like education systems - reproduce or even compound existing inequities. Each society must decide the relative weight it ascribes to each of the principles of equity and to the efficient expansion of total production and socio-economic development.

Keywords: education, training, social fairness, efficiency and equity trade-off

JEL Classification: I2, I3, L38

Introduction

Across the developed world and in most transition and post-transition countries, in the context of public budget constraints and the challenges of globalisation, demographic change (particularly population ageing) and technological innovation, greater emphasis is being placed on improving efficiency in providing public services, particularly education, health protection and social welfare. This is, of course, highly desirable but it is frequently assumed that efficiency and equity objectives are mutually exclusive. However, there are cases where equity and efficiency may not trade off against each other.

Many countries have, with or without external assistance, tried to improve access to education and training for specific groups, such as the long-term unemployed or people from marginalised ethnic minority groups. Only recently, the discourse in this area has started to change towards a more general all-encompassing approach which feeds on the thought that inclusive education should not address the needs of certain disadvantaged groups, but of all.Simple as it may sound, this constitutes a radical change in approach that moves the emphasis of inclusive education from additional and extracurricular measures right to the core of education provision, with a particularly important role for the local community, the school, teachers, and indeed parents.

Redistributive policies can reduce inequality and its persistence across generations by mitigating the impact of market imperfections. Two widespread policies are money transfers and educational transfers. Money transfers are mainly targeted at the poor and may be used by recipients to increase their consumption, leave additional bequests, or spend more on their children’s education. Scientists and politicians worldwide disagree greatly about the effectiveness of welfare programmes and transfers, for it's often said that welfare, like other

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good intentions, contains the seeds of its own destruction. Furthermore, formal large outlays for welfare are no guarantee that they will be effectively targeted and used. Most economists take for granted the idea that equity and efficiency cannot be achieved together: greater equity must come at the inevitable cost of a loss of efficiency. Thus, equity and efficiency are seen as mutually conflicting goals: the big trade off.

This article explores the efficiency and equity trade-off. The goal is to identify those circumstances under which equity and efficiency may not trade-off against each other. The topic of analysis is the possible reconciliation of equity and efficiency in education. Markets often work imperfectly in many situations, whether because of intrinsic failures – such as those associated with asymmetric information – and/or because of policy-imposed distortions. With imperfect markets, inequalities in power and wealth translate into unequal opportunities, leading to wasted productive potential and to an inefficient allocation of resources. After introductory notes, in Section 2 the theoretical framework is presented. Section 3 examines the importance of education. The paper in Section 4 deals with the equity and efficiency trade off in in education, while it finishes in section 5 with some general conclusions and recommendations for the improvement of educational policies.

1. THEORETICAL BASICS

In public finance literature, efficiency as well as equity has a number of possible definitions. Most of them state that efficiency generally relates to how well an economy allocates scarce resources to meet the needs and wants of consumers. Efficiency means that all goods or services are allocated to someone (there’s none left over). The criterion for economic efficiency is value. A change that increases value is an efficient change and any change that decreases value is an inefficient change. A situation that is economically efficient may be inefficient when judged on different criteria. The socially efficient level of output and/or consumption occurs when social marginal benefit is equal to social marginal cost.

Equity concerns the distribution of resources and is inevitably linked with concepts of fairness and social justice. When market equilibrium is efficient, there is no way to reallocate the good or service without hurting someone. Head (1993) distinguishes between horizontal equity in the sense of similar individuals being treated in a similar fashion, vertical equity in the sense of taxation in accordance with the ability to pay and the "benefit principle" of equity - taxpayers should pay for public services in the same proportion that they use them. Osberg (1993) reminds us that public policy must also consider intergenerational equity and the legal principles of procedural equity.

By equity in the educational policy related to social welfare, we follow Roemer (1998) and the World Bank approach (2005) that individuals should have equal opportunities to pursue a life of their choosing and be spared from extreme deprivation in outcomes. For Roemer, strict equality of opportunity obtains when people, irrespective of circumstances beyond their control, have the same ability to achieve advantage through their free choices. Roemer sorts people with similar circumstances into types and takes their free choices to be represented by their behaviour relative to other members of the same type or, as he calls it, by their relative effort. Afterwards, he proposes that society should maximize the average advantage of all whose circumstances cause them to be least well-off relative to others who have expended the same degree of relative effort.

Roemer (1998) believes that there are two views of equality of opportunity. The first, which he calls the non-discrimination principle, states that in the competition for positions in society, individuals should be judged only on attributes relevant for the performance of the duties of the

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position in question. Attributes such as race or sex should generally not be taken into account. The second states that society should do what it can to level the playing field among persons who compete for positions, especially during their formative years, so that all those who have the relevant potential attributes can be considered. Common to both positions is that at some point the principle of equal opportunity holds individuals accountable for the achievement of particular objectives, whether they are education, employment, health, or income. Thus, consequently there is a "before" and an "after" in the notion of equality of opportunity: before the competition starts, opportunities must be equalized, by social intervention if need be; but after it begins, individuals are on their own. He acknowledged that individuals bear some responsibility for their own welfare, but also that circumstances over which they have no control affect both how much effort they invest and the level of welfare they eventually attain. Thus, public action should aim to equalise advantages among people from groups with different circumstances.

Equity can be defined in terms of two basic principles:

· Equal opportunity – the outcome of one’s life in its many dimensions, should mostly reflect the person’s efforts and talents, not his or her background. In other words, predetermined circumstances at birth – gender, race, place of birth, family origins and the social group a person is born into should not matter for the person’s chances in life and his or her economic, social and political success.

· Avoidance of absolute deprivation – following the Rawlsian theory of moderate redistribution on the basis of a social agreement and the form of inequality aversion in the space of outcome (Rawls, 1971). The individuals who conclude that agreement incorporate in it an insurance against failure and special protection for the worst in life just because of the risk of outcome of economic activity.

The complementarities between equity and prosperity arise for two broad sets of reasons (World Bank, 2005). First, there are many market failures, particularly in the labour market and in building human capital. As a result, resources may not flow where returns are highest. For example, some highly capable children may drop-out of regular schooling, while others, who are less able, may finish university and obtain their PHD. When markets are missing or imperfect, the distributions of resources and power affect the allocation of investment and developing opportunities. The ideal response is to correct the market failures; but where this is not practical, or far too costly, some forms of redistribution and/or ensured access to services, assets, or political influence can increase economic efficiency.

The second set of reasons why equity and long-term prosperity can be complementary follows from the fact that high levels of economic and political inequality tend to lead to economic institutions and social arrangements that systematically favour the interests of social strata (groups) with more influence. Such inequitable institutions can generate economic costs. When budgetary allocations benefit mainly the politically influential and/or when the distribution of public services favours the wealthy, all other middle and poorer social layers end up with unused possibilities and talent. These adverse effects, of unequal opportunities and political power, on development are all the more damaging because economic, political and social inequalities tend to reproduce themselves over time and across generations.

Such phenomena are called inequality traps because they cause social immobility that is particularly pronounced for low-income citizens. Education and employment are of intrinsic value and affect the capacity of individuals to engage in economic, social, and political life. Yet children face considerably different opportunities to learn and to lead healthy lives in almost all populations, depending on asset ownership, geographic location, or parental education, among others. These inequities are usually associated with differences in an individual’s “agency” -

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the socio-economically, culturally and politically determined ability to shape and influence the world around oneself. Such differences create biases in the institutions and rules in favour of more powerful and privileged groups because the poor usually have less voice, less income, weaker networks, and finally, less access to services than most other people.

The persistence of inequality traps – with mutual reinforcing inequalities in the political, social, economic and cultural areas – has many consequences. The most important is that, because of market failure and the way in which institutions evolve; inequality traps can influence not only the distribution but also the aggregate dynamics of economic growth and socio-political development. This in turn means that, in the long run, equity and efficiency may be complements, not substitutes.

At least three considerations are important at the outset. First, while more even playing fields are likely to lead to lower observed inequalities in educational attainment, the policy aim is not equality in outcomes. Indeed, even with true equality of opportunities, one would always expect to observe some differences in outcomes owing to differences in preferences, talents, effort and luck. This is consistent with the important role of income differences in providing incentives to invest in education and physical capital, to achieve employability, find decent work, and take risks. People are clearly aware that income differentials can provide incentives for work and investment, including in education, if they are coupled with opportunities for rewards to those actions. Outcomes matter, but one should be concerned with them mostly for their influence on absolute deprivation and their role in shaping opportunities.

Second, a concern with equality of opportunity implies that public action should focus on the distributions of assets, economic opportunities, and political voice, rather than directly on inequality in incomes. Policies can contribute to the move from an “inequality trap” to a virtuous circle of equity and growth by levelling the playing field - through greater investment in the human resources of the poorest; greater and more equal access to public services – like education and health protection as a factor for obtaining human capital - and information. The distribution of opportunities and the growth process are jointly determined. Policies that affect one probably will affect the other.

Third, there may be various short-run, policy-level trade-offs between equity and efficiency. These are well recognized and extensively documented. The point is that the (often implicit) cost-benefit calculus that policymakers use to assess the merits of various policies too often ignores the long-term, hard-to-measure but real benefits of greater equity. Greater equity implies more efficient economic functioning, reduced conflict, greater trust, and better institutions, with dynamic benefits for investment and growth. To the extent that such benefits are ignored, policymakers may end up choosing too little equity. One should be aware that in large part some of the economic and behavioural responses to a policy change can take time. What is fixed in the short term may be variable in the longer term or vice versa. Understanding and explaining how short-run losses may result in long-run gains for given groups, or how immediate gains may lead to eventual losses, is one of the challenges inherent in social sciences.

One of the first questions is: “Why do inequalities of opportunity persist, if they are both unfair and inimical to the long-term prosperity”? A possible answer is that political systems do not always ascribe equal weight to everyone’s preferences. Economic and political inequalities are embedded in unequal social and cultural institutions. Policies and institutions do not arise from a benign social planner whose goal is to maximize the present value of social welfare. They are the result of a political economy process in which various groups try to protect their own interest. Some groups are more powerful than others and their interests prevail. Subordinate groups may face adverse terms of recognition, the framework within they negotiate their

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interaction with other social groups. Explicit discrimination can lead to denial of opportunities and to a rational choice to invest less at the margin.

2. THE IMPORTANCE OF EDUCATION

Education is the most important determinant of employability – almost in all countries more highly educated persons find jobs more easily and faster – but also doubtlessly carries ancillary non-market effects (for example, easier access to information, greater care for personal health, more active participation in social life which encourages responsible democratic civic behaviour, election of democratic authorities and actualization of the rule of law). Non-participation in education is especially dangerous for the children of poor citizens. The children of the poor are very likely to drop out of the schooling system early, and differences in access to higher education are now very stark. The lack of access to levels of education that are highly valued on the market tends to lower their employability and increase the danger of staying in poverty. These factors perpetuate existing inequalities in earning prospects between the poor and non-poor and create the potential for the intergenerational persistence of poverty. A considerable number of youths in the World drops out of secondary and higher educational institutions. This is, among other reasons, caused by a serious lack of a network of “second chance” schools, aimed at young people who have either been excluded from education or are on the verge of exclusion. High drop-out rates drive up the costs per graduate. The school drop-out rate should be reduced, and an apprenticeship system should be created or the existing system improved.

With the goal of lessening the number of drop-outs from the educational system and preventing low employability and poverty, it is necessary to establish counsellors and the employment of the young drop-out and provide measures for the on-going training of the counsellors. Counsellors should assist in preparing the young drop-out for entering the labour market. To solve employment problems of the young drop-out, an additional collaboration network should be established comprising various state institutions, private and non-profit organisations involved in employment issues.

Regarding youth education and employment, measures that increase the return and participation in secondary and particularly in tertiary education could enhance employability, reduce unemployment, prevent (or reduce) long-term unemployment, poverty and social exclusion. In all EU members and developed European countries, participation in education has increased in the last 25 years, but there are huge differences among countries, among particular parts in countries, and among particular socio-economic and ethnic groups. On the one hand, in Norway almost the whole youth population finishes secondary education - 60% vocational programs and education, while in Spain only 68% of the youth finishes secondary education - 23% vocational programme and education. Generally, the unemployment rates are lower for persons with higher education and qualification levels. Because of this, it could be assumed that, like France and Finland, various countries would also profit from motivating the youth to further education, while, like in Spain and Italy, there would also be benefits from increasing the possibilities and programs of vocational education, and participation of youth in it. This is an aspect of increasing their employability, which is the most important determinant in evading the fall into poverty and incentives for exit from it.

According to the situation in many countries (Wolf, 2002), we can be relatively certain that educational programs in fact increase existing social differences, because poor citizens profit relatively little from participation in education, while children from richer social strata finish better and higher quality schools that introduce them to advantageous possibilities of further education, employment and professional promotion. In most countries, particularly post-

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transition, existing educational systems are expensive and ineffectual with regard to their results. Students are forced to learn more data, but are weaker in implementation and use of available knowledge and skills in unusual circumstances. Thus, at all levels of education, it is necessary to emphasize active participation of students, improve efficiency and modernization and enhance teaching methods.

Undoubtedly, many long-term unemployed people have finished at most a low level of education and/or have knowledge and skills that are not sought on the labour market. It would be reasonable to assume that many do not have basic skills of literacy and numeracy; some have had no formal education whatsoever. There are many indicators and reports that stress the insufficient incentives for lower paid workers to find jobs and leave the system of protection during unemployment or welfare. Employers complain of the difficulty of finding an adequate work-force even in regions with high unemployment. Long-term unemployed people are in a further adverse position due to the depreciation of knowledge and skills during the period of their unemployment, as well as negative attitudes by employers in providing them with jobs. Therefore, it is necessary in a coordinated way to improve the basic knowledge and skills of long-term unemployed people, develop new programs so that these people will acquire working experience, and expand the programs (courses) of reorientation.

In improving formal education, attention should be directed towards the palliation of widespread functional illiteracy and the increase of the threshold of minimal competencies. The consequences of functional illiteracy are long-term unemployment and a serious reduction of employability. Even in Sweden, the country with the highest percentage of literate people, 8% of the adult population has a severe literacy deficit. In some other countries the percentage even rises to 25%, so a huge part of the population is incapable of understanding and using the information contained in brochures, information bulletins and simple instructions for tools at the workplace. The minimum competence threshold is a certain extent of knowledge without which it is not possible to survive on the labour market. This usually implies minimum computer literacy and minimum foreign language knowledge, but also personal traits and capabilities like willingness to cooperate and participate in team work, providing services to users, learning ability, and motivation.

3. EQUITY AND EFFICIENCY TRADE OFF IN EDUCATION

The history of the 20th century is littered with examples of ill-designed policies pursued in the name of equity that seriously curtail - rather than spur – economic growth processes by ignoring individual incentives. A balance must be sought, taking into account both the immediate costs to individual incentives and the long-term benefits of cohesive societies, with inclusive institutions and broad opportunities. While careful assessment of policy design in local contexts is always important, equity considerations need to be brought squarely into the centre of both diagnosis and policy. Equity is an instrument to the pursuit of long-term prosperity in aggregate terms for a society as a whole.

However, very often this is not so and often existing public services - like education systems - reproduce or even compound existing inequities. For example, Betts and Roemer (1999) examine the relative effectiveness of changing educational expenditures along both the intensive and the extensive margins. Their central point is that for the USA mere equalization

achieves little. Disadvantaged children from families at the bottom of wealth distribution usually do not have the same opportunities as children from wealthier families to receive quality education and achieve higher levels of attainment. Because of their minimal education, these disadvantaged children can expect to find badly paid jobs and earn less as adults. As badly educated citizens they will have less voice and power in the political process and will not be

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able to influence spending decisions to improve public schools for their children. Thus, with respect to equity, the gap in quality between rich and poor districts may widen over time (Fiske, 1996).

Disadvantage in one dimension of opportunity is generally reinforced by disadvantage in others, combined in a way that perpetuates the stark inequalities and the cycle of underachievement continues. The important instrumental function of education implies that inequality in education often translates into inequality in other dimension of welfare, but also the person’s achievements in education are under the influences of inequalities in other spheres. The difference of various health outcomes for children of parents with higher or lower education is a well-known fact. Infant mortality rates are sharply differentiated across population groups, defined by various educational attainments. On the other hand, economic well-being can contribute to improved educational outcomes, but in turn good education is atypically important determinant of economic status.

This situation is worsened by the social networks that influence decisions on investing in education. Calvò-Armengol and Jackson (2005) developed a model where an individual sees higher returns to investments in human capital when their neighbours in a social network have higher levels of human capital. They show that the correlation of human capital across generations of a given family is directly related to the sensitivity of individual investment decisions to the state of the social network. Increasing the sensitivity leads to increased intergenerational correlation, as well as costlier investment decisions on average in society. As the badly educated mostly socialise with similar badly educated peers, there are only limited possibilities that they will profit in their behaviour from their better educated neighbours. Calvò-Armengol and Jackson conclude that the dependence on a social channel leads to inefficient human capital investment decisions.

If the opportunities faced by children from poor families are so much more limited than those faced by children from rich strata, and if this hurts development progress in the aggregate, then public action has a legitimate role in seeking to broaden the opportunities of those who face the most adverse choices. But how to ensure that actions outlined will respect principles of efficiency and equity? The realisation of an efficiency and equity trade-off in education could be obtained through improving accessibility and enhancing quality. For medium level developed countries, with a high participation in primary and secondary education, particular attention should be focused to increase participation in tertiary education and enhance its efficiency.

Although, possible decentralisation of an educational system is an important form of management and institutional reform, we would like to direct attention to the question of introducing student fees as a category of financing reform. A common assumption has been that a free system of higher education (one funded entirely by the state) is, of itself, equitable because it can guarantee accessibility. In fact, this assumption has not been borne out by reality, since the main determining factor in participation is socio-economic background.

The bulk of evidence shows that there are usually significant private returns to those who participate in higher education (the average private rate of return from higher education is close to 9% across ten OECD countries - Commission of the European Communities Brussels, 2006), and that these are not entirely offset by progressive tax systems. This can have a reverse redistribution effect. This regressive effect is particularly acute where school systems exacerbate the effects of socio-economic background on educational attainment.

In order to bring about a more equitable balance between the costs funded by individuals and society and the benefits accrued by each, and to contribute to providing universities with the extra funding they need, many countries are turning to the main direct beneficiaries of higher

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education, the students, to invest in their own futures by paying tuition fees. Evidence also suggests that the market effects of tuition fees may improve the quality of teaching and management in universities, and reinforce student motivation. Most economists maintain that tuition fees – assuming some means tested grants and/or sufficient available students’ loans – are actually more equitable than free higher education in that students are everywhere disproportionately from the middle and upper classes and the taxing systems in most countries tend to be proportional or even regressive (Teixeira, Johnstone, Rosa, Vossensteyn, 2008).

Clearly, the development of tuition fees without accompanying financial support for poorer students’ risks aggravating inequity in access to higher education. The most disadvantaged are frequently the most risk and debt-averse, and are more likely to baulk at spending time studying, rather than earning, when private returns after graduation are not assured. The costs of higher education could be made more bearable through the availability of various types of student financial support, be it in the form of grants, scholarship, loans or the deferred payment of tuitions fees. Other financial incentives could be premium grants to excellent students and/or those who choose science and engineering programmes.

Given the traditional concern with limited public resources for education, and the commonly accepted objectives of expanding access and improving quality, policymakers face a particular unpleasant dilemma. They must choose between expanding the availability of education and providing high quality educational institutions. Analysis of the costs and benefits of educational system reform clearly shows investments that improve the quality of institutions offer exceptional rewards to society. However, higher public spending does not always translate into better student learning. Some progress can be made by countering the stranglehold of the interest group on the equality-enhancing reform, such as improving accountability from clients directly to frontline providers. The crucial steps are to enhance the school’s accountability for performance and to insure the availability of relevant information to monitor their work. The underlying reason is that it might be more salient to note that more could be achieved through re-targeting programme money and a clearer knowledge of the cost of such programmes.

Furthermore, inequities in education and training also have huge hidden costs which are rarely shown in public accounting systems. Policies which reduce such costs can deliver both equity and efficiency benefits. Thus, to achieve equity, one should take into account all the costs as well as the benefits of successful data collection, analysis and prudent cost-management. According to McKeown-Moak (2000), this approach is a self-evident precondition both with regard to enhancing efficiency and cost effectiveness and in making a case for more equitable resources usage.

Access to schooling matters - especially for very poor families – but very often, it is only a small part of the problem. Greater access needs to be complemented by supply-side policies (to raise quality) and demand-side policies (to correct for the possibility that parents may underinvest in the education of their children for various reasons). Some of the possible reasons for such underinvestment are that resource constrained households lack money to keep their children healthy and in school and/or that some groups only see insignificant returns to schooling because of discrimination. Thus, providing financial possibilities and incentives for education is necessary, but not sufficient because it is important to eliminate the perception of discrimination, conscious or not, that can affect investment in human capital.

Human capital decisions are more a product of culture and traditions than of a cold calculation of benefits. Benefits are relevant, but the responsiveness to them may not be as large as one might have expected because negative stereotypes cause loss of self-confidence, create anxiety and affect early decisions about prospective careers and attitudes towards society. If enforcing anti-discrimination laws today reduces the taste for discrimination throughout society in the

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future, then there could be beneficial income and productivity gains for the minority population that more than outweigh the costs of the programme.

To economists, efficiency is a relationship between ends and means. When a situation is called inefficient, we believe that we could achieve the desired ends with less means, or that the means employed could produce more of the ends desired. Less and more in this context necessarily refer to less and more value. Thus, economic efficiency is measured not by the relationship between the physical quantities of ends and means, but by the relationship between the value of the ends and the value of the means.

The policy question becomes how much leakage a society is willing to accept in order to achieve a certain level of equity. While Okun’s leaky bucket is a reality for many transfers programmes, with adequate organization, targeting and evaluation the level of leakage can vary substantially across programmes and be significantly reduced. Average estimates of the inefficiencies induced by redistributive social policies do not adequately characterize the diversity of efficiency costs across individual policies. In a number of real-world policy situations, equity and efficiency are not inevitably in conflict with each other.

4. CONCLUSION AND RECOMMENDATION

To economists, efficiency is a relationship between ends and means. When a situation is called inefficient, we believe that we could achieve the desired ends with less means, or that the means employed could produce more of the ends desired. Less and more in this context necessarily refer to less and more value. Thus, economic efficiency is measured not by the relationship between the physical quantities of ends and means, but by the relationship between the value of the ends and the value of the means.

Unfortunately, in many countries – particularly developing and/or post-transitional - in providing services the state magnifies - rather than attenuates - inequalities at birth. Economic, political and socio-cultural inequalities fuel differences in life chances, perpetuating them across generations. For a long-run and sustainable economic and social development, the situation should be drastically changed. A guiding principle is to shape public action so that the acquisition of human capacities is not driven by circumstances of their birth, although it can reflect people’s preferences, tastes, and talents. It is necessary to expand people’s capacities to lead fuller lives through investing in their education, health, employment and professional advance.

The policy question becomes how much leakage a society is willing to accept in order to achieve a certain level of equity. While Okun’s leaky bucket is a reality for many transfers programmes, with adequate organization, targeting and evaluation the level of leakage can vary substantially across programmes and be significantly reduced. Average estimates of the inefficiencies induced by redistributive social policies do not adequately characterize the diversity of efficiency costs across individual policies. In a number of real-world policy situations, equity and efficiency are not inevitably in conflict with each other.

Free access to higher education does not necessarily guarantee equity. To strengthen both efficiency and equity it is necessary to create appropriate conditions and incentives to generate higher investment from public and private sources, including, where possible through tuition fees combined with accompanying financial measures for the disadvantaged.

The aggregate effect of any reform, including educational system on efficiency and equity are not always clear. Whether diverse impacts translate into inequalities in opportunities depends on how new activities open up and are accepted by the wider community, but certainly there

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will be winners and losers. Outcomes depend on the ability and willingness of government to mitigate losses to particularly hard-hit social groups, possible by redistributing some of the gains accruing from winners.

To prosper, a society must create incentives for the vast majority of the population to invest and innovate. The best specific policy mix is a function of country context. Each society must decide the relative weight it ascribes to each of the principles of equity and to the efficient expansion of total production and socio-economic development. Finally, we need to get a better handle on what works and what does not. Too often, there is no regular evaluation of policies and programmes. And when evaluations are conducted, they frequently focus on inputs to the system rather than on user achievement and long-term outcomes. This underscores the need to assess user outcomes that are related to both new and existing programmes. The key element is measuring user performance directly. Without objective data about student achievement, programmes and policies often proceed in unproductive directions.

References:

1. Betts, J. R., Roemer, J. E., 1999. “Equalizing Opportunity through Educational Finance Reform”, Working Paper, San Francisco: John D. and Catherine T. MacArthur Foundation and the Public Policy Institute of California, on line available on http://time.dufe.edu.cn/wencong/johnroemer/EOptext1201.pdf

2. Calvò-Armengol, A., Jackson, M. O., 2005. Like Father, Like Son: Social Networks, Human Capital Investment, and Social Mobility, Social Science Working Paper 1242, Pasadena, California: Division of the Humanities and Social Sciences, California Institute of Technology, on line available on http://www.hss.caltech.edu/SSPapers/wp1242.pdf

3. Commission of the European Communities Brussels, 2006. Communication from the

Commission to the Council and to the European Parliament: Efficiency and equity in

European education and training systems, Brussels: Commission of the European Communities.

4. Fiske, E. B., 1996. Decentralization of Education: Politics and Consensus. Washington, DC: World Bank.

5. Head, J. G., 1993 "Tax Fairness Principles: A Conceptual Historical and Practical Review", pp. 3-62. in Maslove, A. M., (Ed.), Fairness in Taxation: Exploring the Principles, Toronto, Ontario: University of Toronto Press.

6. McKeown-Moak, M., 2000. A View from the States: A Survey of the Collection and Use of

Cost Data by States, in Higher Education Cost Measurement: Public Policy Issues,

Options, and Strategies, Washington, DC: The Institute for Higher Education Policy and TIAA-CREF Institute.

7. Okun, A., 1975. Equality and Efficiency: The Big Trade-off, Washington, D.C.: The Brookings Institution.

8. Osberg, L., 1993. "What's Fair? The Problem of Equity in Taxation", pp. 63-86. in Maslove, A. M., (ed.), Fairness in Taxation: Exploring the Principles, Toronto, Ontario: University of Toronto Press.

9. Rawls, J., 1971. Theory of justice, Cambridge, Mass: Harvard University Press 10. Roemer, E. J., 1998. Equality of Opportunity, Boston: Harvard University Press. 11. Teixeira, P.N., Johnstone, D.B., Rosa, M.J., Vossensteyn, H., (Eds.), 2008. Cost-sharing

and Accessibility in Higher Education: A Fairer Deal? Dordrecht: Springer. 12. World Bank, 2005. World Development Report: Equity and Development, Washington

DC.: The International Bank for Reconstruction and Development and World Bank.

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Contact information

Predrag Bejaković Institute of Public Finance Smiciklasova 21, Zagreb, Croatia [email protected]

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DOMESTIC DEBT TRAP IN THE CZECH REPUBLIC COMPARED TO OTHER VISEGRAD GROUP COUNTRIES

Bojka Hamerníková, Jan Kubát

Abstract

Long-term sustainability of fiscal policy also means a stable public debt to GDP ratio, i.e. a situation where the relative weight of public debt is not increasing and there is no “snowball effect”. The sustainability of public finances has been brought to the fore by significantly increasing debt levels in the aftermath of the economic and financial crisis that started in 2008. Whilst high public debt was not at the origin of the crisis in most euro area countries, the present higher public debt ratios pose a risk to sustainability.1 The objective of this paper is to analyze the public debt development in terms of the so-called debt trap in the Czech Republic compared to other Visegrad Group countries (Slovakia, Poland, and Hungary) and to define increasing trends in this important area of public finances, such as the deficit and public debt.

Keywords: public debt, domestic debt trap

JEL Classification: E62, H60

Introduction

In order to eliminate impressive perception of the public debt development in absolute terms and to ensure more thorough analysis of its dynamics in the wider context of economic development, an indicator examining the public debt to GDP ratio is used. It is the so-called relative weight of public debt.

If we were to track the public debt development in absolute terms, we would see it has been increasing all over the world. On the other hand, the development of the so-called relative weight of public debt, which also takes into account changes in the size and development of individual economies, may not be as dramatic.2

Long-term sustainability of fiscal policy also means a stable public debt to GDP ratio, i.e. a situation where the relative weight of public debt is not increasing and there is no “snowball effect”. The sustainability of public finances has been brought to the fore by significantly increasing debt levels in the aftermath of the economic and financial crisis that started in 2008. Whilst high public debt was not at the origin of the crisis in most euro area countries, the present higher public debt ratios pose a risk to sustainability.3 The objective of this paper is to analyze the development of public debt and of the so-called debt trap in the Czech Republic compared to other Visegrad Group countries (Slovakia, Poland, and Hungary) and to define increasing trends in this important area of public finances, such as the deficit and public debt.

1 Fiscal Sustainability Report 2015. EC Institutional Paper 018, January 2016. (http://ec.europa.eu/malta/news/fiscal-sustainability-report-2015_n) 2 Dvořák P. Veřejné finance, fiskální nerovnováha a finanční krize. (Public finances, fiscal imbalances and the financial crisis.) 1st edition. C. H. Beck, Prague 2008. 343 pp. ISBN 978-80-7400-075-1. 3 Fiscal Sustainability Report 2015. EC Institutional Paper 018, January 2016. (http://ec.europa.eu/malta/news/fiscal-sustainability-report-2015_n)

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1. THEORETICAL ASPECTS FOR THE ANALYSIS OF THE SO-CALLED RELATIVE WEIGHT OF PUBLIC DEBT

If we were to track the public debt development in absolute terms, we would see it has been increasing all over the world. On the other hand, the development of the so-called relative weight of public debt, which also takes into account changes in the size and development of individual economies, may not be as dramatic.

In order to eliminate impressive perception of the public debt development in absolute terms and to ensure more thorough analysis of its dynamics in the wider context of economic development, an indicator examining the public debt to GDP ratio is used. It is the so-called relative weight of public debt.

The following charts depict the differences between the public (government) debt development in absolute terms (on the left) and based on the so-called relative weight of public debt (on the right) in the Visegrad Group countries in the last 20 years.

Figure 1 – Public debt development – in absolute and relative terms

Source: Eurostat, Government statistics

As emphasized by P. Dvořák (2008), there have been various trends in the development of the so-called relative weight of public debt worldwide, and particularly in Europe (roughly from the middle part of the 20th century to date). For example, the relative weight of public debt increased significantly in a number of countries from the late 1970s to the mid-1990s, mainly due to the existence of considerable government budget deficits.

In the EU, the aforementioned developments were positively affected and mitigated by the adoption of the so-called Maastricht convergence criteria in 1993.

Issues concerning the public finance sustainability, including questions of the development of deficit and

debt in the Czech Republic, are addressed by V. Izák (2008).4 The area of public debt deficit is also

covered by another essay of V. Izák (2009). The author states, among others, that only Poland had on

4 Izák, V. Udržitelnost veřejných financí a dynamická efektivnost. (Sustainability of public finances and dynamic efficiency) Politická ekonomie, Vol. 56, No. 2, Prague 2008. pp. 162-181. ISSN 0032-3233. DOI: 10.18267/j.polek.635.

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average higher real long-term interest rate than the growth rate during the period under review (1996-

2006).5

An essay of L. Mihóková (2011)6 represents an interesting contribution to the analysis of the relative

weight of public debt in the EU, particularly in Slovakia.

The situation in the area of the public finance sustainability is also analyzed by the study of

Z. Komárková, V. Dingová and L. Komárek (2013)7. Issues relating to public debt, development of its

relative weight, and the so-called debt trap in the Czech Republic are also covered by a paper of P.

Štěpánek and E. Zamrazilová (2015).8 Domestic and foreign specialized literature usually mentions four

factors that affect the so-called relative weights of public debt, specifically:

- Initial debt amount (1); - Primary deficit amount for the given budget period (2); - Debt monetization rate (3); - Ratio of interest payable on debt to the GDP growth rate (4).9

According J. Bispham (1987), growth factors of the so-called relative weight of public debt can be analyzed in three different situations:

- No interest payable with regard to public debt (1); - Interest is payable with regard to public debt, with interest rate below the GDP growth rate (2); - Interest is payable with regard to public debt, with interest rate being greater than or equal to the

GDP growth rate (3). While the relative weight of public debt does not necessarily have to increase in the first two situations, the third case may result in a dangerous situation consisting in a “debt trap” and “snowball effect”. In this case, the relative weight of public debt would increase even if the relevant countries do not have significant primary deficits.

The following formula describes the effect of different factors on the so-called relative weight of public debt:

,

where – public debt to GDP ratio;

d0 * R – component that describes the change of the initial share of public debt as a result of exogenous factors, i.e. interest rate (r) and GDP growth rate (q):

5 Izák, V. Primary balance, public debt and fiscal variables in post-socialist members of the European Union. Prague Economic papers, Vol. 18, No. 2, 2009, pp. 114-130. ISSN 1210-0455. DOI: 10.18267/j.pep.345 6 Mihóková, L. Faktory ovplyvňujúce relatívnu váhu verejného dlhu. (Factors influencing the relative weight of public debt) In: Young Scientists 2011: Proceedings of the 4th International Scientific Conference: Herľany, 6 – 7 October 2011 - Košice: TU, 2011 pp. 223-235. ISBN 978-80-553-0760-2. http://www3.ekf.tuke.sk/mladivedci2011/herlany_zbornik2011/zbornik2011_complet.pdf 7 Komárková, Z., Dingová, V., Komárek, L. Fiskální udržitelnost a finanční stabilita.(Fiscal sustainability and financial stability). Financial Stability Report 2012/2013. Czech National Bank. Prague, 2013. pp. 104-113. ISBN 978-80-87225-44-8. https://www.cnb.cz/miranda2/export/sites/www.cnb.cz/cs/financni_stabilita/zpravy_fs/fs_2012-2013/fs_2012-2013_clanek_ii.pdf 8 Štěpánek, P., Zamrazilová, E. Fiscal Sustainability of the Czech Public Finance: Some Reflections. Proceedings of the 1st International Conference European Fiscal Dialog 2015 – Current Issues of Fiscal Policy. pp. 127-137. ISBN: 978-80-87325-05-6. 9 Dvořák P. Veřejné finance, fiskální nerovnováha a finanční krize. (Public finances, fiscal imbalances and the financial crisis.) 1st Edition .C. H. Beck, Prague 2008. 343 pp. ISBN 978-80-7400-075-1.

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– primary deficit to GDP ratio;

– debt monetization amount to GDP ratio.10

In case of the “snowball effect”, the relative weight of public debt increases rapidly – even if the relevant countries do not have significant primary deficits.

2. ANALYSIS OF THE DEVELOPMENT OF PUBLIC DEBT AND THE SO-CALLED RELATIVE WEIGHT OF PUBLIC DEBT IN THE CZECH REPUBLIC COMPARED TO MEMBERS OF THE VISEGRAD GROUP (SLOVAKIA, POLAND, AND HUNGARY)

We shall focus on analyzing the development of public debt and “debt trap” in all member states of the Visegrad Group, i.e. in the Czech Republic, Slovakia, Poland, and Hungary.

2.1 Analysis of the public debt development in the Visegrad Group countries

Figure 1 clearly indicate increasing public debt in all four countries during the period of 1995-2015.

A correlation coefficient and the so-called sign test were used to analyze the pairs of countries to detect their similarities and similar development in time. The standard Pearson correlation coefficient for time series pairs were used as a correlation measure. However, interpretation of the coefficient is limited due to a small number of observations.

The sign test was verified by the binomial test. The sign test for time series pairs was conducted as follows:

- If both values for time series of differences were either increasing or decreasing simultaneously in the given year, it was marked as a match (1).

- The number of matches was determined for the whole series (2).

- One-tailed Binomic test is calculated for independence hypothesis. We suppose that 2 time series are independent if the number of matches and variances are around the same. If there is a similarity than number of matches increases. The binomial test parameters are number of matches and number of observations with tested probability for independence of 0.5 (3).

10 Dvořák P. Veřejné finance, fiskální nerovnováha a finanční krize. (Public finances, fiscal imbalances and the financial crisis.) 1st Edition. C. H. Beck, Prague 2008. 343 pp. ISBN 978-80-7400-075-1.

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Public debt / GDP

Figure 2 – Development of public debt and its differences in V4 countries


Figure 2 clearly indicates that even though the development of public debt to GDP ratio is similar for V4 countries (chart on the left), the annual differences vary significantly (chart on the right).

Using the sign test, we were able to verify positive (consistent) development of two pairs of countries – Czech Republic vs. Slovakia and Hungary vs. Poland – with 90% reliability. On the other hand, the test verified negative (opposite) development for Hungary vs. Slovakia with 90% reliability11. Two-tailed test did not corroborate any significant pair of similar/dissimilar countries with 90% reliability. The negative development between Slovakia and Hungary is particularly interesting.

Table 1 – Correlation matrix for public debt to GDP ratio and its annual differences

CZ HU PL SK CZ HU PL SK

CZ 1.00 0.51 0.84 0.57 1.00 0.27 0.52 0.24

HU 0.51 1.00 0.81 -0.04 0.27 1.00 0.60 -0.34

PL 0.84 0.81 1.00 0.22 0.52 0.60 1.00 -0.16

SK 0.57 -0.04 0.22 1.00 0.24 -0.34 -0.16 1.00 Source: own calculation

The correlation matrices (Pearson correlation coefficients) further supported the sign test results.

We conducted identical analysis for government deficit ( ) as well as the R parameter. Let us first focus on the government deficit analysis.

11 One-tailed hypothesis on the number of shod (positive – number of matches > 50%, negative – number of matches < 50%).

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Figure 3 – Development of government deficit and its differences in V4 countries


Neither the sign test nor correlation coefficients (matrices) determined significant consistency / similarity of the first differences in the government deficit to GDP ratio.

Table 2 – Correlation matrix for government deficit to GDP ratio and its annual differences

CZ HU PL SK CZ HU PL SK CZ 1.00 0.51 0.41 -0.25 1.00 0.46 0.35 -0.25 HU 0.51 1.00 0.20 -0.09 0.46 1.00 0.14 -0.19 PL 0.41 0.20 1.00 0.21 0.35 0.14 1.00 -0.18 SK -0.25 -0.9 0.21 1.00 -0.25 -0.19 0.18 1.00

Source: own calculation

If we examine government deficit (without differences), the Pearson correlation coefficient in Table 2 indicates similar development of government deficits for the Czech Republic-Poland and Hungary-Poland pairs. However, the correlation for government deficit increments/differences was not as strong; nevertheless, the Czech Republic-Poland and Hungary-Poland pairs can be considered relatively similar.

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Figure 4 – Development of government deficit and its differences for the CZ – PL and PL-HU pairs


The government deficit analyzed above includes public/government debt interests.

If we subtract the public debt interest from the government deficit, we arrive at the so-called primary deficit. We also examined the primary deficit interdependence for V4 countries using the sign test. All test failed to disapprove the independence hypothesis for individual V4 countries pairs with 90% reliability. The results were even more convincing than those for government deficit; therefore, we do not even provide charts this time. The Czech Republic-Poland pair was the most similar, demonstrating consistent development with 84% reliability. It is necessary to recall the fact that the primary deficit time series for Poland is only available since 2000; for the remaining V4 countries, data are available since 1995.

2.2 Analysis of the “debt trap” development in the Visegrad Group countries

The debt trap parameter (R) was once again calculated using the Eurostat data. The interest rate was

calculated as the interest payable to GDP ratio for the year in question – using the average public debt to

GDP for the current year and the previous year. Consequently, the average public debt amount in year T

is estimated using the public debt at the end of year T-1 and at the end of year T. The nominal GDP

growth was calculated using GDP at current prices in national currency, as a year-to-year index:

, where (2)

IT – interest payable on public debt to GDP ratio in year T;

-14

-12

-10

-8

-6

-4

-2

0

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15


Czech Republic Poland

-10

-8

-6

-4

-2

0

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15


Hungary Poland

-6

-4

-2

0

2

4

6

8

10

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15


CZ PL

-6

-4

-2

0

2

4

6

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15


HU PL

52

DT – public debt to GDP ratio at time T;

GDPT and GDPT-1 - GDP at market prices in national currency.

Figure 5 and Table 3 indicate the development of “debt trap” in all four Visegrad Group countries.

Figure 5 – Domestic debt trap for V4 countries


Table 3 – Correlation matrix for domestic debt trap

CZ HU PL* SK

CZ 1.00 0.57 0.28 0.72

HU 0.57 1.00 -0.24 0.50

PL* 0.28 -0.24 1.00 0.32

SK 0.72 0.50 0.32 1.00 Source: own calculation

The data for Poland were only available for the period of 2000-2015; for the remaining countries, data

were available for the period of 1996-2015. Therefore, the correlation coefficients as well as the sign test

for any pair that involves Poland were only calculated for the period of 2000-2015.

With regard to the sign test, any situation where debt trap either existed / did not exist for both countries

under review simultaneously was a match. Using the sign test, we were able to prove similar development

of the debt trap parameter for the Czech Republic-Hungary and Czech Republic-Slovakia pairs with 90%

reliability; the Czech Republic-Poland was also statistically significant with 89% reliability.

With regard to all the analyzed parameters (i.e. relative weight of public debt, deficit, and debt trap), the

debt trap indicator showed the most similar development for individual countries under review.

0.9

0.95

1

1.05

1.1

1.15

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

Czech Republic Hungary

Poland Slovakia

53

Conclusion

In order to eliminate impressive perception of the public debt development in absolute terms and to ensure more thorough analysis of its dynamics in the wider context of economic development, an indicator examining the public debt to GDP ratio is used.

The objective of this paper is to analyze the development of public debt and of the so-called debt trap in the Czech Republic compared to other Visegrad Group countries (Slovakia, Poland, and Hungary) and to define increasing trends in this important area of public finances, such as the deficit and public debt. For the purpose of our analysis, we used the standard correlation coefficient as well as the so-called sign test.

The analysis has shown that the public debt amount increased in all four Visegrad Group countries. We

have demonstrated that public debt differences (increments) are similar for the Czech Republic-Slovakia

and Poland-Hungary pairs; on the other hand, the test of public debt differences (increments) verified

negative/opposite development for the Hungary - Slovakia pair.

Two components of the public debt growth were examined in the paper: government budget deficit

differences (with/without interest) as well as domestic debt trap (R). With regard to the deficit differences

(with/without interest), we were unable to demonstrate similarities for any pair of the Visegrad Group

countries. On the other hand, the debt trap analysis revealed similarities for the Czech Republic - Slovakia

and Czech Republic - Hungary pairs.

Long-term sustainability of fiscal policy also means a stable public debt to GDP ratio, i.e. a situation where the relative weight of public debt is not increasing and there is no “snowball effect”. The analysis of the public debt development and its relative weight for the Visegrad Group countries made it possible to compare the situation in this important area of public finances in the given countries.

References:

1. Dvořák P. Veřejné finance, fiskální nerovnováha a finanční krize. (Public finances, fiscal imbalances and the financial crisis.) 1. edition .C. H. Beck, Praha 2008. 343 pp. ISBN 978-80-7400-075-1.

2. Fiscal Sustainability Report 2015. EC Institutional paper 018, January 2016. (http://ec.europa.eu/malta/news/fiscal-sustainability-report-2015_n)

3. Eurostat, Goverment statistics, Government deficit/surplus, debt and associated data (gov_10dd_edpt1). http://ec.europa.eu/eurostat/data/database

4. Izák, V. Udržitelnost veřejných financí a dynamická efektivnost. (Sustainability of public finances and dynamic efficiency) Politická ekonomie, Vol. 56, No. 2, Prague 2008. pp. 162-181. ISSN 0032-3233. DOI: 10.18267/j.polek.635

5. Izák, V. Primary balance, public debt and fiscal variables in postsocialist members of the European Union. Prague Economic papers, Vol. 18, No. 2, 2009, pp. 114-130. ISSN 1210-0455. DOI: 10.18267/j.pep.345

6. Komárková, Z., Dingová, V., Komárek, L. Fiskální udržitelnost a finanční stabilita. (Fiscal sustainability and financial stability) Zpráva o finanční stabilitě 2012/2013. Česká národní banka. Praha, 2013. pp. 104-113. ISBN 978-80-87225-44-8 https://www.cnb.cz/miranda2/export/sites/www.cnb.cz/cs/financni_stabilita/zpravy_fs/fs_2012-2013/fs_2012-2013_clanek_ii.pdf

7. Mihóková, L. 2011. Faktory ovplyvňujúce relatívnu váhu verejného dlhu. (Factors influencing the relative weight of public debt) In: Young Scientists 2011: Proceedings of the 4th International

54

Scientific conference: Herľany, October, 6.-7., 2011. - Košice : TU, 2011 pp. 223-235. ISBN 978-80-553-0760-2. http://www3.ekf.tuke.sk/mladivedci2011/herlany_zbornik2011/zbornik2011_complet.pdf

8. Štěpánek, P., Zamrazilová, E. Fiscal Sustainability of the Czech Public Finance: Some Reflections. Proceedings of the 1st International Conference European Fiscal Dialog 2015 – Current Issues of Fiscal Policy. pp. 127-137. ISBN 978-80-87325-05-6.

9. Eurostat, Goverment statistics, Government deficit/surplus, debt and associated data (gov_10dd_edpt1). http://ec.europa.eu/eurostat/data/database

Contact information

Bojka Hamerníková NEWTON College, a.s. Václavské náměstí 11, Prague 1, Czech Republic [email protected] Jan Kubát [email protected]

55

Annex

- I

np

ut

dat

a

Tab

le 4

– I

np

ut

dat

a

G

ross

dom

esti

c pro

duct

at

mar

ket

pri

ces

Gover

nm

ent

conso

lidat

ed g

ross

deb

t N

et l

endin

g (

+)

/net

borr

ow

ing (

-)

Inte

rest

, pay

able

C

urr

ent

pri

ces,

mil

lion u

nit

s of

nat

ional

cu

rren

cy

Per

centa

ge

of

GD

P

Per

centa

ge

of

GD

P

Per

centa

ge

of

GD

P

TIM

E/G

EO

C

zech

R

ep.

Hungar

y

Pola

nd

Slo

vak

ia

Cze

ch

Rep

. H

ungar

y

Pola

nd

Slo

vak

ia

Cze

ch

Rep

. H

ungar

y

Pola

nd

Slo

vak

ia

Cze

ch

Rep

. H

ungar

y

Pola

nd

Slo

vak

ia

1995

1 5

80 1

15

5 8

07 9

87

344 6

83

19 6

86

13.6

84.5

47.6

21.7

-1

2.4

-8

.6

-4.2

-3

.3

1.0

8.8

:

2.3

1996

1 8

12 6

22

7 0

95 7

63

431 2

22

21 9

52

11.6

71.6

42.4

30.5

-3

.1

-4.4

-4

.5

-9.7

1.1

9.1

:

2.5

1997

1 9

53 3

11

8 8

03 5

06

521 7

95

24 4

16

12.1

62.1

42.3

33.0

-3

.5

-5.5

-4

.6

-6.2

1.0

8.5

:

2.4

1998

2 1

42 5

87

10 4

23 1

83

606 0

69

26 6

64

13.9

60.0

38.4

33.9

-4

.6

-7.5

-4

.2

-5.2

1.1

7.0

:

2.5

1999

2 2

37 3

00

11 6

27 9

67

673 2

87

28 5

48

15.2

59.9

39.0

47.1

-3

.4

-5.1

-2

.2

-7.3

0.9

6.7

:

3.3

2000

2 3

72 6

30

13 3

10 3

57

747 0

32

31 6

01

17.0

55.1

36.5

49.6

-3

.5

-3.0

-3

.0

-12.0

0.8

5.3

3.0

4.0

2001

2 5

62 6

79

15 3

71 8

98

779 9

75

34 3

11

22.8

51.7

37.3

48.3

-5

.3

-4.1

-4

.8

-6.4

0.9

4.7

3.1

3.9

2002

2 6

74 6

34

17 4

10 0

35

810 6

17

37 2

80

25.9

55.0

41.8

42.9

-6

.3

-8.9

-4

.8

-8.1

1.1

4.0

2.9

3.5

2003

2 8

01 1

63

19 0

65 7

35

845 9

30

41 4

04

28.1

57.6

46.6

41.6

-6

.4

-7.1

-6

.1

-2.7

1.0

4.0

3.0

2.5

2004

3 0

57 6

60

21 0

12 8

00

933 0

62

46 1

02

28.5

58.5

45.3

40.6

-2

.7

-6.4

-5

.1

-2.3

1.1

4.3

2.7

2.1

2005

3 2

57 9

72

22 4

59 2

00

990 4

68

50 2

51

28.0

60.5

46.7

33.9

-3

.1

-7.8

-4

.0

-2.9

1.1

4.1

2.5

1.7

2006

3 5

07 1

31

24 1

38 8

30

1 0

69 8

24

56 1

07

27.9

64.7

47.2

30.8

-2

.3

-9.3

-3

.6

-3.6

1.0

3.9

2.4

1.4

2007

3 8

31 8

19

25 5

38 6

41

1 1

87 6

05

62 8

85

27.8

65.6

44.2

29.9

-0

.7

-5.1

-1

.9

-1.9

1.1

4.1

2.2

1.4

2008

4 0

15 3

46

27 0

38 1

15

1 2

86 0

69

68 3

23

28.7

71.6

46.6

28.2

-2

.1

-3.6

-3

.6

-2.3

1.0

4.1

2.1

1.2

2009

3 9

21 8

27

26 2

58 7

00

1 3

72 2

08

63 8

19

34.1

78.0

49.8

36.0

-5

.5

-4.6

-7

.3

-7.9

1.2

4.5

2.5

1.4

2010

3 9

53 6

51

27 0

51 6

95

1 4

45 0

60

67 3

87

38.2

80.6

53.3

40.8

-4

.4

-4.5

-7

.5

-7.5

1.3

4.1

2.5

1.3

2011

4 0

33 7

55

28 1

33 8

26

1 5

66 5

57

70 4

44

39.9

80.8

54.4

43.3

-2

.7

-5.5

-4

.9

-4.1

1.3

4.2

2.5

1.5

2012

4 0

59 9

12

28 6

27 8

89

1 6

28 9

92

72 4

20

44.7

78.3

54.0

52.4

-3

.9

-2.3

-3

.7

-4.3

1.4

4.6

2.7

1.8

2013

4 0

98 1

28

30 0

65 0

05

1 6

56 3

41

73 8

35

45.1

76.8

56.0

55.0

-1

.3

-2.6

-4

.0

-2.7

1.3

4.5

2.5

1.9

2014

4 3

13 7

89

32 1

79 6

66

1 7

19 1

46

75 5

61

42.7

76.2

50.5

53.9

-1

.9

-2.3

-3

.3

-2.7

1.3

4.0

1.9

1.9

2015

4 5

54 6

15

33 7

11 8

40

1 7

89 6

96

78 0

71

41.1

75.3

51.3

52.9

-0

.4

-2.0

-2

.6

-3.0

1.1

3.6

1.8

1.8

Sou

rce:

Eur

osta

t, G

over

nmen

t sta

tist

ics

56

IMPACT OF THE LIMITATION OF LUMP-SUM EXPENSES IN THE

CZECH REPUBLIC

Petr Hovorka, Jana Stavjaňová

Abstract

The paper deals with the evaluation of impact of measures adopted in the Czech Republic in order to reduce the imbalance in tax treatment between employees and self-employed. As from 2013 self- employed persons are limited in using lump-sum expense deductions and tax credits for spouse and children simultaneously. Taxpayers’ reactions to the mentioned discretionary measure is tested by investigating empirical cumulative density functions and we also test the statistical relevance of distribution changes by the Kolmogorov–Smirnov two sample distribution test. Our results show that the number of self-employed has declined however; the decrease is not statistically significant. We believe that the reasons for insufficient reaction can be various, e.g. child tax credit can be transferred to the spouse, that up to certain amount of income taxpayers do not pay any taxes even if applying no expenses thanks to basic tax credit and so on.

Keywords: self-employed, lump-sum expenses, cumulative density function

JEL Classification: H25, C40

Introduction

Lump-sum expenses have a long tradition within the Czech tax system being the part of Czech Income Tax Act (No. 586/1992, Coll., further just “Income Tax Act”) from the very beginning (Czech Republic, 1992). The lump-sum expenses were initially introduced to reduce tax burden of taxpayers and make it easy to comply. However, significant increase of lump-sum expenses between the year 1993 and 2012 has raised a question of necessity and reasonability. Whereas at the end of 1993 the lump-sum expenses were of 25% 30% and 50%, in 2012 self-employed could apply lump-sum expenses of 40%, 60% and 80% depending on the type of business activity. In any other country the lump-sum expenses are not so high if even applicable. For example in Slovakia, which has very similar tax system like the Czech Republic, the lump-sum expenses enables to deduct only 40% of reported income but only up to 5 040 EUR a year (Slovak Republic, 2003).

International organizations such as OECD (e.g. OECD 2010, 2011) or European Commission (2014) have regularly pointed out the different tax treatment of self-employed and employees recommending the reduction of these discrepancies. Several academic studies dealing with the issue of lump-sum expense were also published in the Czech Republic. Reasons for significant decrease in tax revenue from self-employed persons was discussed by Moravcová (2014), application of lump-sum expenses is very well described by Láchová and Tepperová (2013), the adequacy of the height of lump-sum expenses by Stavjaňová (2015) and finally the impact of lump-sum expenses on public revenue by Tepperová, Pavel and Láchová (2015). All the mentioned papers have however analysed lump-sum expenses before the Income Tax Act has been changed and limitation for lump-sum expenses was in force.

Even if the Czech government has introduced some measures to reduce lump-sum expenses application in the last years, the percentages of lump-sum expenses are still the same and both OECD (2014) as well as European Commission (2015) do not consider these changes as

57

sufficient. Ongoing recommendations of international organisations made us to look at the impact of recently adopted measures on lump-sum expenses application. The goal of this paper is to assess whether the limitation of lump-sum expenses really led to the decrease of their using and if so – was the decline statistical significant?

1. LUMP-SUM EXPENSES IN THE CZECH REPUBLIC

In the Czech Republic self-employed persons can choose how they declare their expenses to calculate the tax base. They can either use real expenses which have to be supported by invoices and bills paid or they can apply so called lump-sum expenses which do not require any specific documentation and are set by law depending on the type of the business.

As mentioned in the introduction chapter, lump-sum expenses are relatively high in the Czech Republic. According to data from Automated Tax Information System (Automatizovaný Daňový Informační system, further just ADIS), around half million of taxpayers apply lump-sum expenses every year which is about half of all self-employed. The development of number of taxpayers using lump-sum expenses illustrates Table 1.

Table 1 - Number of taxpayers applying lump-sum expenses

Business activity Lump-sum

expenses

Number of taxpayers applying lump-sum

expenses

2010 2011 2012 2013 2014

Income from agricultural production, forestry and water management

80% 131 094 142 408 146 445 134 514 138 887 Income from entrepreneurial activity under a handicraft trade license

Income from entrepreneurial activity under a trade license

60% 292 316 318 227 325 731 295 173 304 771

Other income from independent activity

40% 45 196 49 645 51 585 50 931 50 522

Total - 468 606 510 280 523 761 480 618 494 180

Source: ADIS (2016)

The number of taxpayers applying lump-sum expenses has been increasing since 2010. Decline in 2013 might be connected with limitation of lump-sum expenses (see further) however, in 2014 the number of lump-sum expenses users increase again. This may be due to trend of increasing share of self-employed persons in population and the decrease in 2013 can be only on-off structural break. True is, that total number of self-employed was increasing since 2010 with only exception in 2013 (substantial decline) and 2014 (approximately stagnation).

Limitation of lump-sum expenses

Two measures were recently implemented to reduce the magnitude of lump-sum expenses. As from 2013 taxpayers applying lump-sum expenses are not entitled to spouse tax credit and child tax credit if the tax base on which lump-sum expenses were applied account for more than half

58

of total tax base. Taking into account the high of these tax credits – 24 840 CZK a year for spouse (49 680 CZK for disabled spouse) and 13 404 CZK for the first child (since 2015 child tax credit depends on the number of children), this restriction may considerably influence the tax liability of self-employed as well as their decision of the way of declaring expenses.

The second measure consists in limitation of maximum level of revenues (2 mil. CZK) to which lump-sum expenses can apply. Since 2013 for self-employed using 40 % and 30 % lump-sum expenses cannot exceed 1.2 mil CZK or 1.4 mil CZK respectively. This restriction was extended at the beginning of 2015 also to 80 % and 60 % lump-sum expenses however; our analysis only contains the first step of the limitation because of the availability of data.

2. DATA AND METHODOLOGY

a. Data collection and description

Every self-employed person has to file a tax return where he declares his revenues and expenses either the real one or lump-sum expenses. Therefore the number of self-employed applying lump-sum expenses can easily be obtained from ADIS – a database of all tax returns administered by the General Financial Directorate. The data used in our analysis was provided by the Ministry of Finance and consist in number of self-employed applying certain lump-sum expenses (80%, 60%, 40% and 30%) structured according to the amount of revenues from business activity. The data covers all self-employed no matter if they have income from other activities and no matter if business activity is only a supplementary activity.

b. Analysis

Our analysis is through investigation of empirical cumulative density function for all self-employed and individual groups of self-employed persons. The x axis for cumulative density function is created by revenues from business activity.

Figure 1 - Cumulative density functions – all self employed

Source: own calculations

We tried to investigate intertemporal changes in cumulative density function and test the significance of the differences using Kolmogorov-Smirnov test for two sample distribution as described for example in Wooldridge (2012). For each sample we have 39 observations, because the sample is divided into 39 revenue intervals.

0

0,2

0,4

0,6

0,8

1

1,2

revenues in 10^3

2010

2011

2012

2013

2014

59

Table 2 – Critical value for two sample KS test

sig. level 10 % 5 % 1 %

critical value 0.28 0.31 0.37


We expected the above mentioned discretionary measure to influence the revenue structure of lump-sum self-employed persons shifting the cumulative density function. As we can see despite gradual increasing of self-employed persons mainly in 2010 to 2012 their relative income structure remained stable over time, or changed only slightly. This observation is fully consistent with our hypothesis, because we expected substantial shift only in lump-sum self -employed. In case of using data only for non-lump-sum self-employed the curves would probably be practically identical.

If we focus on the sum of all self-employed using lump-sum expenditure rule we can see higher curve shift, then in previous case mainly in the interval between 250 000 CZK and 850 000 CZK, but the change is statistically insignificant. If we compare curve shift in 2012 compared to 2013 the KS criteria result is only 0.02 which is highly below even 10 % significance level.

Figure 2 - Cumulative density functions – lump-sum self-employed


Focusing on individual groups (80 %, 60 % and 40 % lump-sum expenses) we can see higher differences in income distribution. We omitted 30 % lump-sum group from our analysis, because the total number of tax payers in this group is negligible.

0

0,2

0,4

0,6

0,8

1

1,2

revenues in 10^3

2010

2011

2012

2013

2014

60

Figure 3 - Cumulative density functions – 80 % lump-sum




0

0,2

0,4

0,6

0,8

1

1,2

revenues in 10^3

2010

2011

2012

2013

2014

0

0,2

0,4

0,6

0,8

1

1,2

revenues in 10^3

2010

2011

2012

2013

2014

61



Table 3 – KS test criteria between 2012 and 2013

all 80 % 60 % 40 %

KS test 0.02 0.01 0.01 0.04


As we can see in previous Figures and Tables the differences between individual years are more substantial in some individual groups compared to sum of all lump-sum groups. Also the biggest differences are in the 80 % group of lump-sum expenses (2014 compared to 2010). In case we take strictly only changes between years 2012 and 2013 in order to evaluate the effect of discretionary measure we can see, that according to KS test, the most substantial reaction was in 40 % group, but all results are statistically insignificant. In case of 40 % group, the changes in cumulative density function can be seen from the first revenue interval, because there was quite huge increase in the number of self-employed persons with revenues lower than 50 000 CZK.

To conclude we can see some differences among cumulative distribution functions mainly in the case of individual group and these differences are substantial higher than in case of non-lump-sum self-employed persons. But we see no statistically significant evidence. The above mentioned discretionary measure brought some tax payers reactions, but probably relatively small.

To bring some indicative (not fully statistically relevant) figures, we can also look at the result of the KS test among all presented years. We marked each year as a year with or without above mentioned discretionary measure. Then we took average of all combination of years purely with or without discretionary measure and combination of years with and without discretionary measure. The main hypothesis was that differences between cumulative density functions are on average higher in case of the pair of years with rather than without discretionary measure.

0

0,2

0,4

0,6

0,8

1

1,2

revenues in 10^3

2010

2011

2012

2013

2014

62

Table 4 – KS test criteria average of all combinations

all 80 % 60 % 40 %

KS test with change 0.04 0.06 0.04 0.04 KS test without change 0.03 0.04 0.03 0.02


As we can see in our indicative table, the results are fully consistent with expectations. On average, the differences between cumulative density functions are higher in case of years including the change compared to years without change. The most significant results can be seen in 80 % and 40 % group (in 40 % is slightly higher if we take into account other significant digits).

Conclusion

In the paper we focus on the impact of measures adopted in the Czech Republic in 2013 which should limited the magnitude of lump-sum expenses. Our results show that the number of self-employed has declined however; the decrease is not statistically significant. The most significant results can be indicatively seen in 80 % and 40 % group. To explain this insufficient reaction we can mention some facts about the Czech tax system. Firstly, up to certain amount of income, taxpayers do not pay any taxes thanks to basic tax credit of 24 840 CZK. For self-employed having income of around 165 000 CZK yearly it means that even if applying no expenses, he will pay no taxes and can still claim child and spouse tax credit. Another issue for example deals with child tax credit. Child tax credit can be claimed by one of the parents. It implies that if one of them apply lump-sum expenses and therefore is limited in using child tax credit, it may be transferred and applied by the spouse.

Acknowledgement

The contribution is processed as an output of a research project „Public finance in the Czech Republic and the EU“ registered by IGA VŠE under the registration number F1/1/2016.

References:

1. ADIS (2016). Automatizovaný Daňový Informační Systém (Automated Tax Information System). Accessed February 2016

2. Czech Republic (1992). Act No. 586/1992 Coll., Act on Income Taxes, as amended [Zakon č. 586/1992 Sb., o danich z přijmů, ve zněni pozdějšich předpisů]. In: Sbirka zákonů České republiky

3. European Commission (2014). COUNCIL RECOMMENDATION on the Czech Republic’s 2014 national reform programme and delivering a Council opinion on the Czech Republic’s 2014 convergence programme. [online]. [2015-02-10], available at: http://ec.europa.eu/europe2020/pdf/csr2014/csr2014_czech_en.pdf

4. European Commission (2015). COUNCIL RECOMMENDATION on the 2015 National Reform Programme of the Czech Republic and delivering a Council opinion on the 2015 Convergence Programme of the Czech Republic (2015/C 272/09). [online]. [2015-02-10], available at: http://ec.europa.eu/europe2020/pdf/csr2015/csr2015_czech_en.pdf

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5. Láchová, L. & Tepperová, J. (2013). Lump-sum expenses for self-employed in the Czech Republic. XVII. International conference – Theoretical and Practical Aspects of Public Finance. Prague

6. Slovak Republic (2003). Act No. 595/2003 Coll., Act on Income Taxes, as amended [Zákon č. 595/2003 Z.z., o dani z príjmov, v znení neskorších predpisov]. In: Zbierka zákonov Slovenskej republiky

7. Moravcová, J. (2014). Taxation of self-employed in the Czech Republic - are the lump-sum expenses the only problem?. In Recenzovaný sborník příspěvků XII. mezinárodní vědecké konference hospodářská politika v členských zemích Evropské unie. Opava: Slezská univerzita v Opavě, 2014, s. 667-674. ISBN 978-80-7510-045-0.

8. Tepperová, J. & Pavel, J. & Láchová, L. (2015). Impact of Lump-sum Expense Rates on Public Revenue. Acta Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, 63(3): 1023–1030.

9. Stavjaňová, J. (2015). Are Lump-sum Expenses for Self-Employed in the Czech Republic Adequate? In THEORETICAL AND PRACTICAL ASPECTS OF PUBLIC FINANCE (KONFERENCE) (2015 : PRAHA, ČESKO), -- SEDMIHRADSKÁ, L. (ed.). Theoretical and practical aspects of public finance 2015: proceedings of the 20th international conference. Praha: Oeconomica, 2015, s. 233--237. ISBN 978-80-245-2094-0

10. OECD (2010). OECD Economic Surveys: Czech Republic 2010. [online]. [2015-01-20] Available at: http://dx.doi.org/10.1787/eco_surveys-cze-2010-en



13. Wooldridge, J. M. (2012). Introductory Econometrics: Modern Approach 5th edition, ISBN 1111531048

Contact information

Petr Hovorka University of Economics, Prague nám. W. Churchilla 1938/4, Prague 3, Czech Republic [email protected] Jana Stavjaňová University of Economics, Prague nám. W. Churchilla 1938/4, Prague 3, Czech Republic [email protected]

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ISSUES RELATED TO RECENT TRENDS IN FISCAL POLICY

Lenka Jurošková

Abstract

This article deals with the fiscal policy and the adopted fiscal measures in response to the global financial crisis. The main aim of the article is to describe the practical functioning of the individual fiscal measures at EU level and their impact on the Member States’ budgets. The second part of the article describes the fiscal measures at the Czech Republic level.

Keywords: fiscal policy; public finances; global financial crisis; six-pack; two-pack; Stability

and Growth Pact; Excessive Deficit Procedure; Alert Mechanism Report; Annual Growth

Survey; Country Reports; Treaty on Stability, Coordination and Governance in the Economic

and Monetary Union; Fiscal Responsibility Act; National budget council

JEL Classification: E62

Introduction

Fiscal policy as one of economic policy mix instruments is used to stabilize the macroeconomic performance, and to smoothen the economic cycle. The use of public funds as a stabilizing tool was first introduced mainly in response to the Great Depression. It was explained by the “crowding-out” effect, where the government borrows on the financial market and thus drains out part of the funds that have been available to the private sector, which leads to an increase in interest rates and corresponding decrease in private investments. However, the main boom for fiscal policy came after the Second World War thanks to the new Keynesian economics, which had become the mainstream until the 1970s and even made its way into practical economic policy.

In a way, the discussion on fiscal rules emerged from discussions on monetary policy. In monetary policy the discussion has been on whether it is preferable to use it in a discretionary manner (as needed), or to set a rule anchoring expectations and helping the smooth economic development more than discretion. Later, a similar debate emerged in fiscal policy, complemented by the incentive of keeping public finances in check in order to prevent their misuse by politicians. In fiscal policy the rules are linked to certain values (ex. a structural deficit of -1 % of GDP) or a benchmark (ex. the growth of expenditure with respect to growth of potential product, etc.). That does not mean that fiscal rules are a phenomenon of recent years. Their expansion, however, is a relatively recent affair.

In this article I deal with fiscal policy measures adopted at both European level and in the Czech Republic.

1. EUROPEAN-LEVEL MEASURES

Many European countries have been significantly affected by the economic downturn caused by global financial crisis. High and unsustainable levels of public debt in some countries have been pointed out, as well as fragility in the financial sector, but also the accumulated macroeconomic imbalances, making even countries with exemplary fiscal policies suddenly face serious problems.

As a response to the crisis, the EU has taken measures to strengthen its economic governance. Central to these efforts have been the legislative packages known as the “Six-Pack” (in force

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since 2011, applies, for the most part, to all EU Member States) and the “Two-Pack” (in force since 2013, applies only to euro area Member States). The “Two-Pack” legislation further reinforces economic and budgetary surveillance of euro area Member States with special provisions applying to those subject to an excessive deficit procedure or experiencing difficulties in terms of financial stability, respectively.

The “Six-Pack” legislation strengthens the budgetary surveillance under the Stability and Growth Pact; sets minimum requirements for budgetary frameworks of the Member States; introduces a macroeconomic imbalance procedure, which serves as an early-warning system for detecting and addressing potentially harmful macroeconomic imbalances, and codifies in legislation an integrated economic and budgetary surveillance in the form of the European Semester. The Six-Pack consists of five regulations amending two regulations from 1997 as parts of the Stability and Growth Pact, and one directive (2011/85/EU on requirements for budgetary frameworks of the Member States). The directive on requirements for budgetary frameworks of the Member States lays down basic rules on accounting and statistics, forecasts, numerical fiscal rules, medium-term budgetary frameworks, and the transparency of public finances. The Member states had to bring into force provisions necessary to comply with the Directive by the end of 2013.

Strengthening of the Stability and Growth Pact consisted of the following measures: structural budget balance rules were supplemented by an expenditure benchmark; the debt rule was operationalised; semi-automatic financial sanctions for the euro area Member States in cases of breach of the fiscal rules were introduced.

Stability and Growth Pact consists of two parts – preventive and corrective. The preventive part should ensure avoidance of excessive deficits, which simply denotes situations where the government deficit exceeds 3% of GDP and/or public debt exceeds 60% of GDP and is not decreasing to this level with sufficient pace. If there already is excessive deficit, the corrective part should ensure its credible and sustainable elimination.

In the preventive part of the SGP Member States should comply with the objective of almost balanced or surplus budget. In other words, the medium term budgetary objective (MTO) is defined as the budget balance in relation to GDP adjusted for the impact of the economic cycle and one-off and other temporary measures (“structural balance”). The purpose of the MTO is to provide a sufficient margin against the reference value of nominal deficit at 3 % of GDP and thus to enable the country to deal with normal fluctuations of the economic cycle. At the same time the MTO should ensure long-term sustainability of public finance. For each Member State a minimum MTO is established, having regard to the nominal deficit margin with respect to the 3% of GDP value and also with regard to the economic and budgetary impact of ageing populations. The EU Member States subsequently lay down their specific MTOs, which may be more stringent than the minimum MTO.

In the medium term of approximately four years each country should gradually1 achieve its MTO and then keep their economic performance close to this value. Progress towards the MTO is evaluated on the basis of an overall assessment of two indicators – annual change in the structural balance, and development of real public expenditure adjusted for items outside the government control, such as interest costs. Every spring the Commission evaluates whether the economic performance for the previous year complies with rules of the preventive part. If deviating significantly from the MTO or the path to achieve it, a significant deviation procedure can be initiated which can lead to the financial sanctions in case of euro area countries. Euro

1 Approximately in the pace of yearly improvement of structural balance by 0.5 % of GDP, faster in good economic times, slower in bad times.

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area Member States describe how they want to achieve medium term budgetary objective in stability programmes. Countries outside the euro area describe their plans in convergence programmes. The European Commission and EU Member State representatives in the relevant Council bodies and in the EU Council evaluate these programmes in an annual cycle of coordination of economic and budgetary policies of EU member states – in the European Semester.

In cases where the preventive part failed and there is an excessive deficit or threat of it, the corrective part of the Pact should provide remedy for the situation. The Commission continuously monitors compliance of Member States with budgetary discipline and, if necessary, initiates the Excessive Deficit Procedure (EDP). “Excessive deficit” denotes a situation where the state has exceeded or runs a risk of exceeding:

- reference value of 3% of GDP for (nominal) public finance deficit, unless that excess is small, temporary and exceptional, and/or

- reference value of 60% of GDP for public debt, and this ratio is not decreasing sufficiently (debt reduction of 5 % of the excess over the reference value per year on average over three-year period is considered sufficient).

EDP can only be launched after an overall assessment of economic and budgetary situation of the country, also accounting for the “relevant factors”. If the excess in terms of deficit or debt reference values is caused by factors beyond control of the Member State (ex. a natural disaster), EDP might not be launched. Another relevant factor is the costs of the rescue loan granted to some euro area Member States in 2010 – 2014. In the overall balanced assessment other factors are considered as well, as labelled “relevant” by the respective state. EDP is launched, at the request of the Commission, by a Council decision on existence of an excessive deficit, followed by a Council recommendation for correction. Even if the state violates or is expected to violate the reference values only in terms of public debt indicator, it is subjected to an excessive deficit (not excessive debt) procedure, because that is the terminology as enshrined in EU primary law.

In its recommendation to correct the excessive deficit the Council indicates the requested year of elimination of excessive deficit and targets for public finance deficit in relation to GDP for each year in the meantime. Another key component of the Council recommendations is the quantification of the amount of action in the public finances consolidation as considered necessary for the correction of the excessive deficit by that year – “effective measures” in the Pact terminology. Finally, the Council recommendations specify the deadline for taking effective measures. Implementation of recommendations is continuously monitored. If a state does not take sufficient effective measures to eliminate its excessive deficit and it is a euro area Member State, it can lead to financial sanctions amounting to 0.2 % of GDP. The Council, acting on a Commission proposal, can suspend access to resources from EU cohesion policy funds for all Member States.

In case of a Member State which has taken effective measures to correct its excessive deficit, but extraordinary events beyond its control prevented it from adequately reducing the deficit, the remedy deadline may be extended. The Council may only terminate the excessive deficit procedure if confirmed results of past economic performance show that the deficit has been reduced to a maximum of 3 % of GDP. At the same time the current deficit according to the European Commission economic forecast must remain at this level during the assessment until the end of the forecast horizon. Excessive deficit procedures launched after entry into force of the latest amendment to the Pact in December 2011 may be terminated only if, in addition, the public debt to GDP ratio is also developing satisfactorily.

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The economic crisis of 2008 – 2010 showed that even relatively strict surveillance of Member States budgetary policies cannot ensure economic stability of the EU. As the causes and main symptoms of this crisis were gradually analysed, proposals emerged to introduce a new monitoring mechanism. Its aim is to provide advance alert of the risk of macroeconomic imbalances that could cause a new economic crisis if not removed in time. The tool that is supposed to provide alert of impending imbalances is called a scoreboard. It is a set of 11 indicators, each having one or more thresholds that states in equilibrium should not exceed. The scoreboard also includes a set of complementary indicators, eight of which monitor the employment and social situation in individual Member States. Complementary indicators, however, only serve to illustrate the situation and exceeding them is not a sign of macroeconomic imbalance.

Updated scoreboard along with the necessary comments is published by the Commission every autumn as the Alert Mechanism Report (AMR). If, on the basis of the AMR, the Commission concludes that a Member State could be threatened by an imbalance, an in-depth review follows. This allows the Commission to study the situation in each Member State very carefully and to also take account of the broader context. Only on the basis of this in-depth review can the Commission determine whether a country is genuinely threatened by macroeconomic imbalances and to what extent is the possible imbalance serious. In case of countries at risk of macroeconomic imbalances the Commission shall propose (and the Council after consultation shall recommend) specific measures that should lead to elimination of the imbalance. Implementation of Council recommendations is closely monitored in the context of the European Semester. If the Commission finds that the state suffers from excessive imbalances, the corrective part of the macroeconomic imbalances procedure is initiated. When conditions of the corrective part are not observed, especially if, contrary to the Council recommendations, the country is not taking measures to eliminate it, a euro area Member State can even be fined in extreme cases.

Following the outbreak of the economic crisis in the EU in 2008 the discussion was not only about the possibilities to expand the range and effectiveness of tools used for coordinating economic policies in the EU, but also on ways to improve the timing of established procedures. This resulted in a decision on dividing the calendar year into two parts – the European

semester when all the formal steps under the coordination of economic policies at EU level take place, and national semester when the Member States have the time to fulfil their obligations towards the EU stemming from the European semester. The European Semester model was first launched in 2011 and is basically followed it both budgetary surveillance and in surveillance of macroeconomic imbalances. It is launched in November by the Commission publishing the Annual Growth Survey (AGS) and Alert Mechanism Reports. After debate in the EU Council the challenges arising from these reports should be taken into account by the Member States in national reform programmes (NRP) and in Stability and Convergence Programmes (SCP) to be handed over to the Commission in April of the following year. The Stability and Convergence Programmes should define the budgetary strategy of the state in question in the horizon of at least three years after the submission and describe actions taken or envisaged to achieve the budgetary targets.

The Commission issues reports on individual Member States (Country Reports) and on the euro area. The Country Reports also include the results of in-depth reviews in countries where the Commission deemed them necessary to be performed. In May the Commission proposes Council opinions on budgetary policy and Council recommendations on structural reforms, collectively known as Country Specific Recommendations (CSRs), for individual EU Member States and recommendations for the euro area, to be discussed and adopted by the EU Council (June/July). Several times a year the Commission organizes bilateral meetings with Member

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States on implementation of the recommendations and after the reports on individual Member States are published also on preparing the proposals for new recommendations.

2. CZECH REPUBLIC MEASURES

Following the changes adopted at European level an Act on Fiscal Responsibility is being legislated in the Czech Republic. Besides efforts to strengthen the national fiscal framework this Act follows some of the requirements of the Stability and Growth Pact as reformed in 2011. This Act also transposes the Council Directive No. 2011/85/EU of 8 November 2011 on requirements for budgetary frameworks of Member States into national law. The Act is based on the assumption that implementation of budgetary policy and responsibility for it fall within EU Member States competence. This fact has not been changed the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (hereinafter the “Fiscal Compact”). The aim of the Fiscal Compact is to tighten the fiscal discipline and strengthen the economic policy coordination of EU Member States. So far the Fiscal Compact has been signed by 25 EU Member States. For the Czech Republic, the United Kingdom and Croatia, which have not signed the treaty, it remains open for possible future acceding to it.

The Act on Fiscal Responsibility, however, reflects the requirements of Fiscal Compact, as seen particularly in the provisions devoted to determining the total expenditures of public institutions sector, to automatic corrective mechanism, to the definition of exceptional circumstances and to activities of the National Budgetary Council.

The draft Act on Fiscal Responsibility Rules requires public institutions to draw up a draft budget for a year and a medium-term budget perspective for the next two years. The present proposal respects the current practice of financial planning at the level of individual types of public institutions while seeking to enforce at least a minimum level of its harmonization and coordination. The goal of this legislation is to enhance the transparency and credibility of public resources management and extend the horizon for an effective and predictable public finance management.

The draft Act contains rules for determining the total expenditure of public institutions sector. This rule is inspired by Swiss numerical fiscal rule applied at the federal government level. The rule takes into account the characteristics of the Czech environment, current state of public finances, and the political cycle impact, while respecting the supranational European Union rules. Expenditure rule (or, alternatively, the rule of structural balance) is based on a concept of a “structural balance,” where the total balance is decreased by subtracting revenue that the government gained via GDP growth in the economic cycle (essentially temporary revenues, as the boom does not last forever) and one-off items (as the difference between one-off revenues and one-off expenditures). Structural balance should allow fiscal policy to be countercyclical by setting (in bad times the balance is allowed to worsen, in good times better balance is required).

Moreover, in terms of expenditure it is also considered that the Czech Republic MTO is set at -1% of GDP, which allows for increasing the spending above the level of “structural” revenues. Finally, expenditures may also be tightened by “correction component,” if past expenditures were higher than what corresponds to the fiscal rule. Correction component acts as an “account” depositing the difference between expenditures according to the rules and actual expenditures. If the government spends more than it should, the correction component should automatically correct this trend.

The Act also includes a rule regulating the development of public sector debt to GDP ratio. The debt and nominal GDP for the previous calendar year notified in the first half of the current

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year by the Czech Statistical to the European Commission is used to determine the level of public sector debt. The concept of debt rule applies the definition of public sector debt as used for the purpose of the excessive deficit procedure in the European Union (Protocol no. 12 on the excessive deficit procedure) and in the framework of the Stability and Growth Pact. The debt rule will act as a correction mechanism supporting the stability of public finance and maintaining the debt level safely below the reference value for the convergence criterion of ratio of gross “government” debt to GDP at current prices (60% of GDP). The debt rule will be activated when the debt level as announced by the newly created National Budgetary Council reaches 55 % of GDP (more precisely, from the 1st day of the 2nd month following the announcement of the debt level). Until then the economic performance of public sector is only covered by “operational numerical fiscal rules” (the total public sector expenditures rule and the rule of economic performance of local government units). In case this limit is exceeded automatic corrective measures will be launched – responsibilities defined by the draft Act on Fiscal Responsibility Rules that the public institutions will be obliged to fulfil.

Debt rule for local government units is provided as follows: the local government unit, whose debt has exceeded 60 % of its average revenues over the last four financial years, is bound to reduce its debt by at least 5 % of the difference between the level of its debt and 60 % of the average revenues over the last four financial years. If the local government unit does not reduce its debt and at the end of the year its debt still exceeds 60 % of its average revenues over the last four financial years, in the following year the Ministry of Finance takes a decision to suspend part of its share of the tax revenue in the amount specified in the decision (5 % of the difference between the debt level and 60 % of its average revenues over the last four financial years). On the basis of the Ministry of Finance decision the tax administrator shall suspend the corresponding part of the share of tax revenues, in the amount specified in the decision. Suspended funds are kept by the tax administrator on a deposit account (foreign funds account).

The aforementioned National Budgetary Council, a new body established by law, should be an independent institution with a Board (3 members elected for 6 years), to be supported by an analytical team (of about 10 persons as foreseen). It should be funded from a separate state budget chapter. In addition to monitoring and analyses it will also give its consent to the amount of certain items in the fiscal rule (ex. Consenting to the amount of one-off measures or correction account etc.). It will also contribute to the methodology of cyclical adjustment of income required for the calculation of the structural balance.

Conclusion

The issue of budgetary discipline and budgetary institutions (more specifically of “budgetary councils”) came to the forefront mainly due to the financial and economic crisis, which has its roots in 2008, and that was (mainly in Europe) followed by a debt crisis. This has brought about tightening of existing or creation of new budgetary rules that were intended to prevent further debts of individual countries.

Modification of the fiscal rules can be considered as a step in the right direction, in that some macro-economic improvements have already reflected, such us the average deficit of the Member States decreased from 4,5 % GDP in 2011 to 3 % GDP in 2014, while the number of Member States suffering from the excessive deficit is decreasing as well. On the other hand, there is no way to deny the fact that for the comprehensive evaluation of the new fiscal policy measures did not elapse sufficient time, as confirmed by the European Commission in its evaluations. In order to fiscal policy, any measures have to be rigorously analysed in respect of both European and national level because that is the only way for the new implemented fiscal rules to have such parameters to successfully fulfil their own objectives.

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References:

1. Draft Act on Budgetary Responsibility, including the Explanatory Memorandum (Vládní návrh ústavního zákona o rozpočtové odpovědnosti) http://www.psp.cz/sqw/text/tiskt.sqw?O=7&CT=411&CT1=0

2. Stability and Growth Pact http://ec.europa.eu/economy_finance/economic_governance/sgp/index_en.htm

3. Internal documents of the Ministry of Finance for Ecofin Council meetings

Contact information

Lenka Jurošková Ministry of Finance of the Czech Republic Letenská 15, Prague 1, Czech Republic [email protected]

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COMPARING REAL ESTATE (PROPERTY) TAX REVENUE WITHIN

BUDGETS OF LARGE CITIES IN THE CZECH REPUBLIC IN 2015

Milan Lindner

Abstract

Today, property taxes may first be viewed as a supplementary form of taxation for individuals – in addition to direct taxes, the revenue of which often flows directly to local and regional budgets. This paper aims to compare the budget revenue coming from real estate taxes collected by Czech municipalities with more than 25,000 inhabitants – not only in terms of their size, but also in terms of their socioeconomic status and stability, expressed as the median gross monthly income and the share of unemployed. The objective of this paper is to identify inappropriate disparities relating to the approach of the municipalities under review to using the real estate tax potential as it currently is the only tax in the Czech Republic, where the revenue may be influenced by autonomous decision-making process of individual municipalities. Our comparative study results confirm the first of the initial hypotheses concerning the active approach of municipalities to influencing the real estate tax revenue; however, the second hypothesis claiming the relation of the total real estate tax revenue per capita and the socioeconomic status of the relevant municipalities has not been confirmed. The paper also formulates specific recommendations – both in terms of the individual municipalities being compared and in terms of future research.

Keywords: property taxes, real estate tax, local finance, local budget revenues

JEL Classification: H21, H71

Introduction

Property taxes as direct taxes levied on taxpayers’ property or property value increases represent one of the oldest forms of taxation, dating back to ancient history. Even today, they represent a traditional component of most countries’ tax systems, even though their contributions in terms of the total budget revenue is rather marginal. The main importance of these taxes is determined by the fact the revenue from property taxes, particularly from real estate taxes, often flows directly to the relevant local budgets; therefore, property taxes usually have some features of local taxes that may be affected, to a greater or lesser degree, by individual municipalities (e.g. see Boháč, 2013, Kubátová, 2015, etc.).

Property taxes fall within the group of “de jure” taxes – i.e. general (multipurpose) and nonequivalent transfers of financial funds. Such transfers are not associated with taxpayers’ rights to claim any specifically defined consideration on the part of the public sector (government, region, or municipality); the public sector is not required to use such collected financial funds to cover any specifically defined expenditure.

Property taxes include real estate taxes, taxes on movable assets, net worth taxes (wealth taxes), as well as taxes levied on property transactions and transfers. Considering the nature of such taxes – i.e. they are levied on values cumulated or claimed by taxpayers (taxpayers’ current or future wealth) and generated from already taxed earnings – property taxes are viewed as controversial, not only by taxpayers, but also by many experts (e.g. see Široký et al., 2008).

The aforementioned controversy concerning property taxes is further fueled by other arguments used to advocate such taxes – whether it is the redistribution-oriented appeal aimed at promoting

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the horizontal equity, reference to the government-guaranteed inviolability of property used by taxpayers, or reasons emphasizing specific involvement of the government, regions, and municipalities on behalf of taxpayers (e.g. in the form of the necessary infrastructure development in case of real estate taxes, etc.).

In the Czech Republic, property taxes include a road tax, the revenue of which goes to the State Fund of Transport Infrastructure (SFDI) and which may be viewed as a special-purpose fee and not a tax in its true sense, real estate acquisition tax, with any collections representing the government (budget) revenue, and finally a real estate tax, with ultimate tax revenue beneficiaries being the municipalities, within the territory of which individual properties are located.

Real estate tax is the only “entrusted/mandated tax” in the Czech Republic (e.g. see Maaytová, Ochrana & Pavel et al., 2015). At the same time, it is the only tax that may be characterized as a local tax, with individual municipalities being able to affect such tax revenue through their own autonomous decision-making process. However, the resulting proportion of the real estate tax revenue relatively to the total (tax) revenue of municipal budgets still remains very low compared to other countries, including other member states of the European Union (Radvan, 2012).

The presented study focuses on the comparison of the amount of budget revenue collected by Czech municipalities with more than 25,000 inhabitants from real estate tax - not only in terms of their size, but also in terms of their socioeconomic status and stability, expressed as the median gross monthly income and the share of unemployed. The initial hypotheses are as follows: In most cases, the municipalities under review use the opportunity to affect the real estate tax revenue through their own decision-making process (H0). The total real estate tax revenue per capita reflects the socioeconomic reality of the municipalities under review – i.e. municipalities with lower share of unemployed and higher gross monthly income would also feature higher real estate tax revenue per capita and vice versa (H1).

1. METHODS

The study compares the conduct of different entities under comparable conditions during a single budget period, specifically during 2015. With regard to approximately 6,250 municipalities in the Czech Republic, only municipalities with more than 25,000 inhabitants have been selected, including the City of Prague and statutory cities Brno, Ostrava, and Pilsen.

Although the status of the latter cities (Prague, Brno, Ostrava, and Pilsen) is somewhat specific due to applicable mechanisms of tax revenue budget allocation, their comparison with other municipalities is fully practicable for the purpose of analyzing the real estate tax revenue.

The selection of individual entities in the form of larger municipalities contributes to the overall study reliability and objectivity as we can assume considerably lower probability of pragmatic conduct by local authorities with a view to collect high real estate tax revenue as a result of specific local factors. These factors typically include ownership of significant share of real estate located within the territory of specific municipalities by owners who cannot easily relocate their operations (e.g. power plants, refineries, incineration plants, etc.), highly popular locations in terms of recreation and tourism (such as popular ski resorts, spa resorts, municipalities featuring prominent historic landmarks, etc.), or great demand for housing within specific locations (e.g. suburbs near Prague).

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The comparison results are presented in the form of tables and a chart. The graphical presentation of the study results also includes an outline of the range of optimality for the real estate tax revenue based on the size and socioeconomic status of individual municipalities.

2. DATA COLLECTION

Data relating to all entities under review have been collected from publicly available sources. The relevant inputs (dataset) used during the study can be considered complete and reasonably consistent.

The website and databases of the Czech Statistical Office were used to collect demographic data on population for individual municipalities under review as of 31 December 2014 and 31 December 2015, as well as the figures for the share of unemployed relating to individual municipalities as of 31 December 2015.

The aforementioned indicator, which replaced the originally used registered unemployment rate in 2012, shows the share of registered available1 job applicants aged 15 to 64 years in the total population aged 15 to 64 years (in each case within the relevant territory; the number of job applicants is shown as of the end of the period under review, population is always updated once a year) (CZSO, 2014).

The database of the Czech Statistical Office was also used to collect data about the structure of average gross monthly income and median gross monthly income for individual regions of the Czech Republic in 2015; relevant figures are not available for this indicator and individual municipalities.

The data about the total effective budget revenue of the municipalities under review after consolidation, total effective tax revenue, and effective real estate tax revenue (in each case in 2015) were taken from the MONITOR information portal of the Ministry of Finance of the Czech Republic. Specific coefficients within the meaning of Act no. 338/1992 Coll., on Real estate tax, as amended, were taken from the Tax Portal of the Financial Administration of the Czech Republic, as applicable in 2016.

3. DATA ANALYSIS

All inputs for the analysis were organized in an overview table, sorted ascendingly according to the size of individual municipalities under review, with additional ratios required for further procedures subsequently added to the table.

These ratios namely include the proportion of effective real estate tax revenue for 2015 to the total effective tax revenue for 2015 per capita for each municipality under review.

Other additionally identified ratios then express the proportion of the effective real estate tax revenue to the total effective tax revenue for 2015 as well as the total effective municipal budget revenue after consolidation in 2015 (the last ratio is not shown in Table no. 1 below).

Another integral part of the data analysis is an overview chart that shows the relations between the real estate tax revenue per capita for a specific municipality and the socioeconomic

1 Note: Available job applicant means a person, who is able to immediately take up a job, if an appropriate position

opens up, i.e. he or she has no objective obstacles to accepting such position. Available job applicants do not include applicants incapable of work, enrolled in requalification courses, collecting maternity benefits or unemployment benefits during maternity leave, or applicants in custody in prison.

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characteristics of the given municipality in the form of the share of unemployed and the median gross monthly income determined at the level of individual regions of the Czech Republic.

4. RESULTS

The comparison of the above mentioned ratios for the set of all 41 entities under review (i.e. municipalities in the Czech Republic with more than 25,000 inhabitants) has resulted in a number of interesting findings. The comparison results indicate that there are significant differences between individual municipalities in terms of the real estate taxation intensity, as well as the total effective real estate tax revenue per year.

The proportion of the effective annual real estate tax revenue to the total effective tax revenue per year (2015) varied from 1.70% (Prague) to 12.10% (Mladá Boleslav). Other municipalities with very low ratios are Orlová (2.51%) and Brno (2.87%); on the other hand, the results are very high for Hradec Králové (12.00%) and Pardubice (10.43%).

The results of another ratio, specifically the proportion of the effective annual real estate tax revenue per capita, were also quite diverse in 2015. Consistently with the previous ratio, the highest results were achieved by Mladá Boleslav (CZK 1,927), Hradec Králové (CZK 1,849), Pardubice (CZK 1,547), and Karlovy Vary (CZK 1,546); the lowest results were recorded for Příbram (CZK 531), Třebíč (CZK 528), Karviná (CZK 523), and Orlová (CZK 293).

The total effective annual tax revenue per capita was the highest in Prague (CZK 37,156) and the three largest statutory cities (Brno, Ostrava, and Pilsen) – however, the aforementioned cities cannot be subject to relevant comparison with other municipalities due to the existing form of the mechanisms for the tax revenue budget allocation to territorial self-governing units (see Czech Act no. 243/2000 Coll. or Maaytová, Ochrana & Pavel et al., 2015).

However, significant differences – of up to CZK 4,200 per capita – exist for other individual municipalities under review (Mladá Boleslav: CZK 15,923; Znojmo: CZK 15,469; Hradec Králové: CZK 15,413; ... Kroměříž CZK 11,877; Jablonec nad Nisou: CZK 11,833; Orlová: CZK 11,691). In case the potential difference in the total annual tax revenue of a municipal budget is expressed absolutely, we discover that this may amount to nearly CZK 125 million per year for a municipality with a population over 30,000.

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Table 1 - Selected ratios for Czech municipalities with a population over 25,000 (2015)

Population Tax revenue

(real; 2015; ‘000 CZK) Ratio (4) / (3)

Ratio (4) / (2)

Ratio (3) / (2)

Share of unemployed

(31.12.15; %)

Regional median gross

monthly income

(2015; CZK) As of

31.12.14 As of

31.12.15 Total

Real estate tax

(1) (2) (3) (4) (5) (6) (7) (8) (9)

1 Prague AA 1,259,079 1,267,449 47,093,258 800,207 1.70% 631 37,156 4.16 28,677

2 Brno BM 377,440 377,028 8,263,452 237,110 2.87% 629 21,917 7.25 23,328

3 Ostrava OT 294,200 292,681 6,509,471 227,618 3.50% 778 22,241 10.01 23,116

4 Pilsen PM 169,033 169,858 3,805,191 137,641 3.62% 810 22,402 4.12 24,135

5 Liberec LI 102,562 103,288 1,446,829 142,950 9.88% 1,384 14,008 7.07 23,946

6 Olomouc OL 99,809 100,154 1,472,510 84,062 5.71% 839 14,702 7.53 21,918

7 Ústí n. L. UL 93,409 93,248 1,352,828 108,976 8.06% 1,169 14,508 10.76 22,644

8 Č. Budějovice CB 93,285 93,513 1,270,900 61,323 4.83% 656 13,591 4.37 22,697

9 Hradec Králové HK 92,808 92,891 1,431,707 171,768 12.00% 1,849 15,413 5.54 22,521

10 Pardubice PA 89,693 89,638 1,329,604 138,635 10.43% 1,547 14,833 4.08 22,283

11 Zlín ZL 75,112 75,171 1,045,223 53,835 5.15% 716 13,905 5.21 21,770

12 Havířov HA 75,049 74,101 928,803 40,497 4.36% 547 12,534 11.92 23,116

13 Kladno KD 68,552 68,466 915,977 38,210 4.17% 558 13,379 7.81 24,582

14 Most MO 67,089 67,002 907,932 89,874 9.90% 1,341 13,551 10.82 22,644

15 Opava OP 57,772 57,676 816,209 63,459 7.77% 1,100 14,152 7.58 23,116

16 Frýdek-Místek FM 56,945 56,879 791,427 63,587 8.03% 1,118 13,914 7.20 23,116

17 Karviná KI 55,985 55,163 728,279 28,834 3.96% 523 13,202 14.08 23,116

18 Jihlava JI 50,521 50,714 711,828 47,099 6.62% 929 14,036 5.94 22,600

19 Teplice TP 50,079 49,959 702,805 35,942 5.11% 719 14,068 7.85 22,644

20 Děčín DC 49,833 49,739 622,792 28,393 4.56% 571 12,521 9.30 22,644

21 Karlovy Vary KV 49,781 49,326 749,598 76,257 10.17% 1,546 15,197 6.68 21,747

22 Chomutov CV 48,913 48,913 634,423 65,289 10.29% 1,335 12,970 10.01 22,644

23 Jablonec n.N. JN 45,594 45,510 538,500 20,009 3.72% 440 11,833 5.42 23,946

24 Ml.Boleslav MB 44,318 44,199 703,792 85,177 12.10% 1,927 15,923 3.58 24,582

25 Přerov PR 44,278 43,994 600,890 35,780 5.95% 813 13,658 9.55 21,918

26 Prostějov PV 44,094 43,977 603,971 28,586 4.73% 650 13,734 5.25 21,918

27 Česká Lípa CL 36,943 37,158 489,152 43,119 8.82% 1,160 13,164 5.71 23,946

28 Třebíč TR 36,880 36,641 471,355 19,359 4.11% 528 12,864 8.36 22,600

29 Třinec TN 35,884 35,760 455,954 35,633 7.82% 996 12,750 5.73 23,116

30 Tábor TA 34,716 34,641 495,065 39,364 7.95% 1,136 14,291 6.50 22,697

31 Znojmo ZN 33,761 33,787 522,635 42,629 8.16% 1,262 15,469 9.60 23,328

32 Příbram PB 33,160 33,058 424,053 17,552 4.14% 531 12,828 8.96 24,582

33 Cheb CH 32,351 32,355 456,433 32,535 7.13% 1,006 14,107 6.94 21,747

34 Kolín KO 30,946 30,995 452,167 42,571 9.41% 1,373 14,588 7.20 24,582

35 Trutnov TU 30,893 30,812 405,824 17,706 4.36% 575 13,171 5.96 22,521

36 Orlová OR 29,967 29,524 345,170 8,647 2.51% 293 11,691 11.49 23,116

37 Písek PI 29,824 29,838 409,050 22,427 5.48% 752 13,709 4.08 22,697

38 Kroměříž KM 29,035 29,066 345,231 18,407 5.33% 633 11,877 7.24 21,770

39 Šumperk SU 26,697 26,478 352,815 14,952 4.24% 565 13,325 6.88 21,918

40 Vsetín VS 26,504 26,394 358,022 26,009 7.26% 985 13,565 7.94 21,770

41 Uh.Hradiště UH 25,287 25,254 354,364 28,288 7.98% 1,120 14,032 5.62 21,770

Sources: CZSO, 2015 (1) (2) (3), MoFCR, 2015

For the sake of transparency, the limit values of individual ratios are highlighted in Table no. 1. Just by looking at the numbers, it is safe to say that some municipalities reflect their socioeconomic potential and, accordingly, effectively take advantage of the opportunities set down by the applicable legislation of the real estate tax (see the highly economically developed Mladá Boleslav on one end or the structurally affected town of Orlová on the other end of the spectrum). However, it is impossible to draw such unambiguous conclusions for the vast majority of the remaining towns and cities.

The ratios shown in Table no. 1 represent the basis required for either confirming or rejecting hypothesis H1 formulated in the study introduction. In order to relevantly assess the first of the

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outlined hypotheses (i.e. H0) as well, it is also necessary to supplement data that describe the rate of activity of individual municipalities under review in affecting the real estate tax revenue (see Table no. 2).

Table 2 - Real estate tax coefficients for Czech municipalities with a population over 25,000 (2016)

Population as of

31.12.15

Coefficient - Section 6 of the Act

(land) BASIC

Coefficient - Section 11 of the

Act (buildings)

BASIC

Coefficient - Section 6 of

the Act (land)

SELECTED*


the Act (buildings)

SELECTED*


the Act (surcharge)

SELECTED

Local coefficient – Section 12 of

the Act

SELECTED

(1) (2) (3) (4) (5) (6) (7)

1 Prague AA 1,267,449 4.5 4.5 5.0 5.0 1.5 1.0

2 Brno BM 377,028 3.5 3.5 3.5 3.5 1.5 1.0

3 Ostrava OT 292,681 3.5 3.5 3.5 3.5 1.5 1.0

4 Pilsen PM 169,858 3.5 3.5 4.5 4.5 1.5 1.0

5 Liberec LI 103,288 3.5 3.5 3.5 3.5 1.0 2.0

6 Olomouc OL 100,154 3.5 3.5 3.5 3.5 1.5 1.0

7 Ústí n. L. UL 93,248 3.5 3.5 3.5 3.5 1.5 2.0

8 Č. Budějovice CB 93,513 3.5 3.5 3.5 3.5 1.0 1.0

9 Hradec Králové HK 92,891 3.5 3.5 4.5 2.0 1.5 3.0

10 Pardubice PA 89,638 3.5 3.5 4.5 3.5 1.5 2.0

11 Zlín ZL 75,171 3.5 3.5 4.5 4.5 1.5 1.0

12 Havířov HA 74,101 3.5 3.5 3.5 3.5 1.5 2.0

13 Kladno KD 68,466 3.5 3.5 3.5 3.5 1.0 1.0

14 Most MO 67,002 3.5 3.5 3.5 3.5 1.5 2.0

15 Opava OP 57,676 3.5 3.5 3.5 2.0 1.0 2.0

16 Frýdek-Místek FM 56,879 3.5 3.5 3.5 3.5 1.5 2.0

17 Karviná KI 55,163 3.5 3.5 3.5 3.5 1.5 1.0

18 Jihlava JI 50,714 3.5 3.5 4.5 4.5 1.5 1.0

19 Teplice TP 49,959 3.5 3.5 4.5 4.5 1.5 1.0

20 Děčín DC 49,739 3.5 3.5 3.5 3.5 1.0 1.0

21 Karlovy Vary KV 49,326 3.5 3.5 4.5 4.5 1.5 2.0

22 Chomutov CV 48,913 3.5 3.5 4.5 4.5 1.5 2.0

23 Jablonec n.N. JN 45,510 3.5 3.5 2.5 2.5 1.0 1.0

24 Ml.Boleslav MB 44,199 3.5 3.5 3.5 3.5 1.5 2.0

25 Přerov PR 43,994 3.5 3.5 3.5 3.5 1.5 1.0

26 Prostějov PV 43,977 3.5 3.5 3.5 3.5 1.0 1.0

27 Česká Lípa CL 37,158 2.5 2.5 2.5 2.5 1.5 2.0

28 Třebíč TR 36,641 2.5 2.5 2.5 2.5 1.5 1.0

29 Třinec TN 35,760 2.5 2.5 2.5 2.5 1.5 1.0

30 Tábor TA 34,641 2.5 2.5 2.5 2.5 1.5 2.0

31 Znojmo ZN 33,787 2.5 2.5 2.5 2.5 1.5 2.0

32 Příbram PB 33,058 2.5 2.5 2.5 2.5 1.0 1.0

33 Cheb CH 32,355 2.5 2.5 2.5 2.5 1.0 2.0

34 Kolín KO 30,995 2.5 2.5 2.5 2.5 1.0 2.0

35 Trutnov TU 30,812 2.5 2.5 3.5 3.5 1.0 1.0

36 Orlová OR 29,524 2.5 2.5 2.5 1.6 1.0 1.0

37 Písek PI 29,838 2.5 2.5 3.5 3.5 1.5 1.0

38 Kroměříž KM 29,066 2.5 2.5 2.5 2.5 1.0 1.0

39 Šumperk SU 26,478 2.5 2.5 2.5 2.5 1.0 1.0

40 Vsetín VS 26,394 2.5 2.5 2.5 2.5 1.0 2.0

41 Uh.Hradiště UH 25,254 2.5 2.5 3.5 3.5 1.0 2.0

* The given coefficient applies to city center; the selected coefficient may vary for individual

parts/districts of a municipality.

Sources: Czech Act no. 338/1992 Coll., CZSO, 2015 (1), FACR, 2015

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Individual municipalities may influence the total municipal budget revenue from real estate tax by issuing generally binding municipal decrees that modify one or several tax assessment coefficients predefined by law (Czech Act no. 338/1992 Coll.).

Table no. 2 indicates that the vast majority of the municipalities under review takes advantage of the opportunity to influence the real estate tax revenue, as such revenue represents the municipal budget revenue in full; this is usually executed by increasing (or specifying) individual tax assessment coefficients.

Municipalities most often increase the coefficient specified under Section 11 of the Act – i.e. applicable to buildings used for family recreation, garages, and taxable buildings used for business activities (see column (6) of Table no. 2). Furthermore, municipalities relatively commonly increase the local coefficient pursuant to Section 12 of the Act; however, usually to 2. Potential reductions of the coefficients predefined by law are usually applied in respect of residential houses (see the coefficient pursuant to Section 11 of the Act for Hradec Králové, Opava, Jablonec nad Nisou, and Orlová).

5. DISCUSSION

5.1 Findings and their Interpretation

Based on the results presented above, it is clear that most municipalities under review actively use the opportunity to influence the real estate tax revenue through their autonomous decision-making process by issuing generally binding municipal decrees; the initial hypothesis H0 is thus deemed verified.

However, the assessment of the second hypothesis, i.e. H1, claiming existing relation between the total real estate tax revenue per capita and selected socioeconomic status indicators of the relevant municipalities (median gross monthly income and share of unemployed) is much more complicated.

In order to either definitely confirm or reject the hypothesis, it is necessary to expand the above presented Table no. 1 with an alternative view of the above mentioned ratios (see Chart no. 1).

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Chart 1 - Relation between real estate tax revenue and socioeconomic characteristics of municipalities

Sources: CZSO, 2015 (1) (2) (3), MFCR, 2015, processed by author

The graphical presentation of the relation of the total real estate tax revenue per capita, share of unemployed, and median gross monthly income for each of the 41 entities under review (entity codes are shown in Table no. 1 and Table no. 2) offers a much more suitable tool for assessing hypothesis H1.

Based on Chart no. 1, we can deduce, for example, that the total real estate tax revenue per capita is similar for Prague – a city that has one of the lowest shares of unemployed (4.16%) while featuring the highest median gross monthly income (CZK 28,677) – and for a municipality with one of the highest unemployment rates (share of unemployed) and medium level of the median gross monthly income (Karviná; 14.08%, CZK 23,116). Similarly, when comparing the statutory cities Hradec Králové and Jablonec nad Nisou that have similar share of unemployed (5.54% vs. 5.42%) and median gross monthly income (CZK 22,521 vs. CZK 23,946), we find out that the total annual real estate tax revenue is more than four times higher in Hradec Králové than in Jablonec nad Nisou (CZK 1,849 vs. CZK 440), etc.

Therefore, Chart no. 1 clearly indicates that there is no significant relation between any of the indicators used in hypothesis H1 in respect of the set of Czech municipalities with a population over 25,000; consequently, hypothesis H1 must be rejected.

The confirmation of hypothesis H0 with subsequent rejection of the second hypothesis (H1) represents a relatively surprising result of the comparative study as a whole; therefore, it inevitably requires relevant interpretation.

Municipalities – as the lowest level of territorial authorities/self-government – are clearly interested in using or at least effectively influencing tax instruments in the form of local taxes.

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Their motivation usually originates from the need and interest to contribute to their respective budgets and thus to acquire extra financial funds to cover budget expenditure; however, some municipalities also use these instruments to promote local economic or even sustainable development (also see, for example, Macháček, Toth & Wokoun, 2011).

This may be in line with the thinking and practice of Czech municipalities when it comes to real estate tax, as they may promote housing within residential buildings by reducing tax coefficients below the level predefined by law (see the practice in Orlová within the set of municipalities under review). Another relevant strategy may be to “exploit” above-average economic situation of a municipality and its population (e.g. see Mladá Boleslav), or “penalization” of property owners in the form of abrupt tax coefficients increases with a view to discourage massive development within a municipality, either completely or solely in respect of certain forms of land development (e.g. recreational housing).

However, the fact that municipalities define their own real estate tax coefficients in line with their specific needs may not always be based solely on economically-oriented expert deliberations. It may often be affected by political factors as well, either in the form of various efforts aimed at influencing decisions of future voters in favor of certain political representation or a failure on the part of municipal councils to reach consensus in respect of the necessary generally binding municipal decree, etc.

5.2 Implications for Research and Practice

The results of the performed analysis offer relatively unambiguous recommendations for further research and practice. In terms of research, it is necessary to better understand the reasons for the significantly contradicting results of the comparative study, as presented in Chart no. 1 above.

Research may also focus on deliberations concerning the real estate tax revenue maximization or optimization by different types of municipalities (based on their size, facilities, economic development, geographical characteristics, etc.), including the deduction of functional dependencies or even construction of comprehensive mathematical models.

Based on the comparative study results presented in Chart no. 1, individual municipalities should consider their own position in terms of the current vs. attainable level of the real estate tax revenue, taking into account the local socioeconomic characteristics.

It is obvious that municipalities with lower share of unemployed and higher median gross monthly income may target higher real estate tax revenue per capita without posing a significant burden to individual taxpayers, limiting their proactivity (e.g. see Ambrozová, Koleňák, Ullrich & Pokorný, 2016) in terms of their business and other activities within the territory of the given municipalities, or otherwise impairing the present or future socioeconomic status of such municipalities.

The position of municipalities with high unemployment and low average income is very different, as efforts of such municipalities aimed at increasing the real estate tax revenue may even escalate the risk of overall declining interest in property ownership within the territory of such municipalities, with a number of other negative consequences (exodus, declining municipal budget revenue, declining property prices, trends toward ghettoization, and emergence of socially excluded locations, etc.).

The above described relations are reflected in Chart no. 1 in the form of the grey area; this area may be viewed as a certain range of optimality of the real estate tax revenue depending on the socioeconomic status of municipalities.

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At the same time, the graphical presentation indicates that the selected real estate tax coefficients may be too ambitious in case of some municipalities from the set under review, inconsistent with the local socioeconomic characteristics. In particular, this concerns cities from structurally affected regions, specifically Karviná, Most, Ústí nad Labem, Chomutov or even Znojmo; the question is whether they should not actually consider the reduction of either the coefficient pursuant to Section 11 for residential buildings or the local coefficient pursuant to Section 12 of the Real Estate Tax Act.

However, the number of municipalities under review that do not adequately capitalize on the available economic potential given by the combination of the current real estate tax configuration vs. present socioeconomic characteristics is considerably higher. These municipalities can be found within the category of highly developed large cities (Prague, Pilsen, Brno), as well as within the category of municipalities with low share of unemployed and lower level of median gross monthly income (Písek, České Budějovice, Zlín, Prostějov, Jablonec nad Nisou, etc.). In case of these municipalities – namely in case of the largest cities – it is recommended to definitely increase the relevant coefficients, particularly the local coefficient pursuant to Section 12 of the Real Estate Tax Act.

The comparative study results indicate that the local coefficient increase of up to 3 may be considered for the City of Prague; this would lead to an estimated increase in the total real estate tax revenue by CZK 1.2 to 1.5 bn. per year. In case of the statutory cities Brno, Pilsen, České Budějovice, and others, the local coefficient increase of up to 2 may be considered – leading to an increase in their annual municipal budget revenue of about CZK 200, 100, and 50 million, respectively.

With regard to government institutions in charge of the tax system effectiveness in the Czech Republic (as a whole), it is necessary to assess the current configuration of all property taxes, including real estate tax, in connection with the findings of the performed comparative study.

Although these taxes show certain positive aspects (low distortive effects on labor, support of efficient property management, and redistribution effect), it is also necessary to keep in mind their controversial nature, particularly relating to the double taxation effect (i.e. taxation of income and subsequent taxation of property), relatively low importance in terms of the overall tax revenue and thus relatively high cost of their administration and management, relatively high complexity of the tax for taxpayers, etc. (also see, for example, Kubátová, 2015).

If the government intends to preserve property taxes, mainly to support the application of the subsidiarity and fiscal federalism principles (e.g. see Maaytová, Ochrana & Pavel et al., 2015), rigorous application of all three components of the widely known and commonly applied 3E principle (Effectiveness, Efficiency, Economy) (Ochrana & Půček, 2012) must be ensured.

5.3 Existing Limitations and Suggestions for Future Research

The exclusive use of publicly available sources of information and data is somewhat limiting for this paper, as it was not possible to collect certain data – such as median gross monthly income for individual municipalities of the Czech Republic. The aforementioned fact distorts the comparative study results to a certain extent, particularly to those municipalities of the analyzed set that are not a natural center of the relevant region (Příbram is a typical example; the real local figure for the median gross monthly income will be lower than the one presented in the study).

Another limitation of the study is the fact that, due to the scope of the paper, research could only be conducted for a single budget period and limited set of analyzed entities; similar

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comparison for a number of consecutive years would also be very interesting, similarly as a comparison of other differently structured sets of individual municipalities.

At the same time, the above mentioned limitations represent recommendations for the focus of any future research in the given area.

Conclusion

Property taxes, frequently used in the past, represent only a supplementary form of direct taxation for individuals in most economies today, with relatively low shares in total public budget revenue. These are often entrusted/mandated (with tax revenue being revenue of local governments in full) and local taxes (local authorities may influence imposed taxes through their own autonomous decision-making process).

In the Czech Republic, property taxes include a road tax, real estate acquisition tax, and finally a real estate tax (referred to as tax on real property until the end of 2013); real estate tax is the only tax that can be characterized as an entrusted/mandated and local tax. The question is how Czech municipalities capitalize on various opportunities available to them under the applicable real estate tax legislation.

In this connection, research has focused on the comparison of the budget revenue originating from the real estate tax revenue collected by Czech municipalities with more than 25,000 inhabitants, not only in terms of their size, but also in terms of their socioeconomic status and stability, expressed as the median gross monthly income and the share of unemployed. The research objective was to identify inappropriate disparities relating to the approach of the municipalities to using the real estate tax potential as it currently is the only tax in the Czech Republic, where the revenue may be influenced by autonomous decision-making process of individual municipalities.

Municipalities with more than 25,000 inhabitants were deliberately selected as research entities – due to the generally applicable reliability and objectivity requirements, as we can assume considerably lower probability of pragmatic conduct by local authorities with a view to collect high real estate tax revenue as a result of specific local factors.

The following claims were formulated as the initial hypotheses: In most cases, the municipalities under review use the opportunity to affect the real estate tax revenue through their own decision-making process (H0). The total real estate tax revenue per capita reflects the socioeconomic reality of the municipalities under review – i.e. municipalities with lower share of unemployed and higher gross monthly income would also feature higher real estate tax revenue per capita and vice versa (H1).

Data relating to all entities under review have been collected from publicly available sources, particularly the website and databases of the Czech Statistical Office, MONITOR information portal of the Ministry of Finance of the Czech Republic, and the Tax Portal of the Financial Administration of the Czech Republic.

The comparative study results confirm the first of the initial hypotheses concerning the active approach of municipalities to influencing the real estate tax revenue; however, the second hypothesis claiming the relation of the total real estate tax revenue per capita and the socioeconomic status of the relevant municipalities has not been confirmed.

It is absolutely clear from the graphical presentation of the study results that some municipalities imposed very ambitious real estate taxes on their taxpayers; at the same time, this mainly concerns municipalities from structurally affected regions, specifically Karviná,

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Most, Ústí nad Labem, Chomutov or even Znojmo. In this case, the question is whether the given tax rates would not be a factor hindering future socioeconomic development of the given locations, discouraging people from living and/or carrying out business activities within the municipalities, etc., and whether such municipalities should not actually consider future reduction of either the coefficient pursuant to Section 11 for residential buildings or the local coefficient pursuant to Section 12 of the Real Estate Tax Act.

However, the number of municipalities under review that do not adequately capitalize on the available economic potential of real estate tax is considerably higher. These municipalities can be found within the category of highly developed large cities (Prague, Pilsen, Brno), as well as within the category of municipalities with low share of unemployed and lower level of median gross monthly income (Písek, České Budějovice, Zlín, Prostějov, Jablonec nad Nisou, etc.). In case of these municipalities – namely in case of the largest cities – it is absolutely recommended to increase the relevant coefficients, particularly the local coefficient pursuant to Section 12 of the Real Estate Tax Act.

Further research in the given area depends on the availability and quality of input data (e.g. absence of data on the median gross monthly income for individual municipalities of the Czech Republic is a significant limitation of this study). On the other hand, a comparison of a longer period of several consecutive years and a comparison of other differently structured sets of individual municipalities are absolutely feasible.

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15. Czech Republic Act No. 243/2000 Coll., on budget allocation of revenue of certain taxes to territorial self-government units and to certain state funds (the Act on Budget Allocation of Taxes), as amended. Available at: http://www.zakonyprolidi.cz/cs/2000-243

16. Czech Republic Senate Ordinance No. 340/2013 Coll., on real estate transfer tax, as amended. Available at: http://www.zakonyprolidi.cz/cs/2013-340

17. Czech Republic Senate Ordinance No. 344/2013 Coll., on the amendment of tax legislation with respect to the recodification of private law and on amendments to some other acts. Available at: http://www.zakonyprolidi.cz/cs/2013-344

Data Sources

18. Czech Statistical Office (CZSO) (2014). Information on selected indicators for the needs of spatial analytical data. Available at: https://www.czso.cz/documents/10180/23192368/metodika_ukaz_uap_16102014.pdf/ d98df9df-25a2-479f-8530-4de5baeddc85?version=1.0

19. Czech Statistical Office (CZSO) (2015) [1]. Czech Republic in Figures – 2015. Municipalities and regions of the Czech Republic. Available at: https://www.czso.cz/csu/czso/ceska-republika-v-cislech-2015

20. Czech Statistical Office (CZSO) (2015) [2]. Structure of average gross monthly earnings in regions - 2015. Available at: https://www.czso.cz/csu/czso/struktura-mezd-zamestnancu-2015

21. Czech Statistical Office (CZSO) (2015) [3]. Employment, unemployment: Unemployment in the municipalities of the selected administrative district of municipality with extended powers (MEP). Available at: https://www.czso.cz/csu/czso/zamestnanost_nezamestnanost_prace

22. Financial Administration of the Czech Republic (FACR) (2016). Tax Portal of the FACR. DNE – Search Coefficients. Available at: http://adisreg.mfcr.cz/adistc/adis/idpr_reg/dne/koef/vyhledani.faces

23. Ministry of Finance of the Czech Republic (MFCR) (2016). Information portal MONITOR. Available at: http://monitor.statnipokladna.cz/

24. Podnikatel.cz (2016). Tax Portal. Real Estate Tax Coefficients. Available at: http://www.podnikatel.cz/danovy-portal/dan-z-nemovitych-veci/seznam-mistnich-koeficientu/

Contact information

Milan Lindner NEWTON College, a.s. Václavské náměstí 11, Prague 1, Czech Republic [email protected]

84

FISCAL ASPECTS OF COHESION POLICY IN HUNGARY

Klára Major

Abstract

This research focused on the issue to what extent have cohesion funds contributed to the recovery of the Hungarian economy after 2008. The results of the model simulation show that cohesion funds presented a large stimulus to the economy, without it the decline in GDP could even be 2%pont larger. However the GDP impact is less than proportional that comes from a very strong crowding out effect, that mainly works through the decline in export and an increase in import.

Keywords: cohesion funds, crowding-out effect, Hungary, CGE model

JEL Classification: O290, O520, O220, E650

Introduction

Hungary is a small open economy with strong dependence on what happens in the rest of the world. This dependence is remarkably indicated by the fact that its openness (the ratio of export plus import to GDP) is very close to 2 and is amongst the top 10 values in the world. The decline in GDP after 2008 has been large, but it is even more important that the pre-crisis real GDP level has just been reached again by the end of 2015 (see Figure 1).

Figure 1 - Real GDP, Hungary, 2000-2014

Source: Hungarian Central Statistical Office

At the same time Hungary is part of the EU and after joining it in 2004 it has started to receive cohesion funds to develop the economy and catch up with developed countries. After 2010, and especially in the recent years the incoming income transfer reached approximately 5% of GDP (see Figure 2 below). Our research focused on the issue to what extent have this money contributed to the recovery of the Hungarian economy. The research results stem from a recent

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project with a much broader focus with general evaluation of cohesion funds in Hungary. This paper summarizes some of the results of that have been published recently, see Balás et al (2015).

Figure 2 - GDP and EU funds in Hungary, 2009-2013

Source: Hungarian Central Statistical Office and “EMIR” (szechenyiterv.gov.hu)

Due to cohesion funds a large amount of subsidy flowed out to the participants of the economy, in most cases (but not exclusively) they supported investment, research and development and innovation activities. These activities aim at developing the economy with hopefully influencing the long-term growth potential as well. From all this reasoning the expressions: “cohesion funds” and “development policy” are used interchangeably as both referring to the subsidies given by the Hungarian government and mostly financed by the EU. However, in the short run they meant a large demand stimulus to the suppliers of the subsidized agents, therefore cohesion funds had a remarkable impact on the level of income immediately.

In our research we applied Hétfa-CGE model to understand the role EU funds played in the macroeconomic path of the Hungarian economy after 2008. By simulating the path of the main macroeconomic variables we made an estimation on how the economy would have evolved without the existence of cohesion funds. The results of the model simulation show that cohesion funds presented a large stimulus to the economy, without it the decline in GDP could even be 2%pont larger.

The results show that export has been crowded out, without this support the export could have been 0,5-3% higher. The larger demand for domestic goods has led to real appreciation that can be an explanation for this simulation result. At the same time the impact on the primary balance of the budget is less understood, its sign changes year to year. This is partly because incoming

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EU funds and outgoing domestic support has a certain delay and different time pattern. The difference between time pattern of the incoming funds and the outgoing domestic support in itself leads to hectic impact on the primary balance of the budget. Nonetheless the implied impact on the revenue side of the government is shown to be positive and increasing. The simulation results show that the magnitude of the impact on the budget balance could be around 0,1-2% of GDP.

This paper is organized as follows. The next chapter gives a short description of the Hétfa-CGE model, it is followed by a chapter on how the cohesion funds have been included into the model. The simulation results are presented in the final chapter.

1. HÉTFA-CGE MODEL OF THE HUNGARIAN ECONOMY

We apply a dynamic CGE model for estimating the impact of EU funds to the Hungarian economy. The core of the model is a standard, static CGE model which has been modified for the purpose of this analysis. The applied CGE model follows the tradition of the single country CGE models, a great survey can be found for example in Dixon et al (2013). However in the current application certain differencies have been made, namely the followings:

1. Firms utilize three primary factors in production, namely skilled and unskilled labour and capital. However, unlike in a standard CGE model, in our application capital is not mobile across sectors. Capital is given by past investment and depreciation in each sector, only labour inputs are free to adjust to the shocks.

2. Market for skilled labour is modelled following efficiency wage theories, which make it possible to simulate the impact on (involuntary) unemployment, as well. At the same time in case of unskilled labour it is assumed that there is an (effective) real wage minimum that leads to conditioning on the market for unskilled labour.

3. Recursive dynamics has been added to follow how investment decisions influence the path of capital.

In the followings we introduce the building blocks of the model. The data consideration and parametrization is briefly summarized. The EU funds interpreted in the model as an additional shock to either the elements of macroeconomic demand or supply.

The core of the CGE model is a set of static equations describing the behaviour of the agents, their decisions about consuming, producing goods and services. As a result of their decision, the flows are completely determined and influence the time path of the stock variables as it is shown in the section on dynamics.

1.1 Households

The representative household shares its income between savings and consumption. The primary income of the household equals the income generated in production, since the household is the only owner of factors of production. It pays tax on the income of primary factors of production, and furthermore, it receives a transfer from the government. In the static CGE framework savings are exogenous; however, in our application the savings rate is driven by the past real interest rate. Disposable income of the household is therefore given as the difference of primary income and savings, transfers and taxes. The household decision is related to the composition of consumption goods (labour supply is by assumption exogenous). The utility level of aggregate consumption is a CES aggregate of consumption of all other goods.

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1.2 Production

The relationships between factors of production and the goods produced follow the structure of the standard CGE models. The production decision is modelled in a nested structure (see Figure 3). Firms take the prices of inputs and the prices of their products as given at every decision level. At the first level firms use primary factors of production to obtain the composite factor. The technology of production is described by Cobb-Douglas production function. The demand of the different sectors for primary inputs can be derived from the profit maximization of the firms. At the second level firms produce their goods from the composite factor of production and intermediate inputs. At this level aggregation is modelled by Leontief technology, assuming that the composite factor and the intermediate inputs are used at fixed ratios in production. The demand function of factors and the supply function of products are derived from the profit maximization decisions.

Domestic output is sold both at home and abroad. The usual transformation function is used to split domestic production between domestic sale and export. The transformation function utilizes the price differences between domestic sale and foreign sale, and it assumes final elasticity of substitution, thus avoiding perfect specialization (thus reaching a “corner solution”) in the production of the goods.

The goods finally consumed are either produced domestically or imported. Goods for final use are aggregated by Armington’s aggregation functions from domestic goods and import goods. This method is similar to the transformation function approach: by introducing final price elasticities, domestic and foreign goods are considered as not perfect substitute to each other. The composition of domestic demand is the following: private consumption, government expenditure, investment demand and intermediate inputs.

Figure 3 - Production and use of goods in the tradeable industries

Source: own edition

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We assumed that the amount of capital is given by past decisions on investment and depreciation (however, the whole process is completely exogenous). Therefore, there is no market for capital in the model. The income share of the capital is modelled as gross operating profit and is given to the households, it forms part of their primary income.

Foreign trade is modelled assuming that Hungary is a small, open economy. Therefore, by assumption the world price of export and import goods are exogenous and given in foreign currency. The real exchange rate is applied to calculate the price of export and import goods in terms of domestic currency. The foreign savings is also expressed in foreign currency.

Goods produced domestically and imported goods are not perfect substitutes; therefore, it is important to define composite goods that express the relationship between domestic and imported goods. Therefore, for tradable goods the so-called Armington aggregation functions are used, where a parameter shows the substitutability of foreign and domestic goods. From these functions demand for domestic and imported goods can be derived.

Domestic goods are either consumed in the country or are exported. These two types of use are expressed by a transformation aggregation function where the elasticity of substitution is described by a parameter. The domestic supply and the supply for exports can be derived from this function.

1.3 Government

The incomes of the government are determined endogenously, while the expenditures are exogenous. The income of the government comes from two parts: indirect taxes stemming from the use of products and direct taxes levied on the primary factors of production. Expenditures of the government are governmental consumption and transfers paid to households. The primary balance of the budget is the difference of the incomes and expenditures that is expressed as a percentage of GDP, as well.

1.4 Labour Market

In standard CGE models labour market as well as the other markets clear due to the adjustment of the real wage, and thus unemployment occurs only voluntarily. However, in the last decades several ways of modelling labour market rigidities were implemented in CGE framework; for an excellent summary of these methods see Boeters & Savard (2012). In the present model Küster et al. (2007) has been followed in general.

In case of the market for skilled labour, efficiency wage model has been applied. In this approach the equilibrium wage is determined as the intersection of the labour demand curve and the wage curve. Since this wage level is not necessarily the one where labour supply and demand are equal, there is an oversupply of labour in the market; thus, there is unemployment. The wage curve is the result of an incentive situation stemming from the information asymmetry between employers and employees. The firm wants to determine a wage by which workers are incentivized to work hard; therefore, the utilities of workers from working must be at least the utility from shirking. The parameterization of the labour market follows Boeters & Savard (2012).

However following Küster et al. (2007) in case of the market for unskilled labour we assumed that minimum wage regulation is effective, therefore wage equals its officially set value and employment is completely determined by the demand for unskilled labour. Any increase in the

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demand for the unskilled labour will lead to higher employment and leaves wages of unskilled labour unchanged as long as there is a remaining pool of unemployed workers.

1.5 Market Equilibrium

As the present model has a general equilibrium framework, equilibrium must hold in all markets; therefore, total consumption of every tradable good must be equal to the sum of the supplies of the import and domestic production. As for non-tradable goods, domestic supply must equal to domestic demand. Trade balance and the balance of the capital account add up to determine savings of the rest of the world. The investment-savings balance holds as domestic investment can only be financed from domestic savings and foreign savings.

Equilibrium must hold in the market of production factors, as well. However, in the labour market it means that the difference between labour demand (as is defined by the sum of sectorial labour demand) and the labour supply (from household utility maximization problem) defines unemployment. However, this unemployment rate must be consistent with the wage specified by the wage curve.

1.6 Closure Rule

The macroeconomic aggregates of a static CGE model are not fully determined. As it is usual in this modelling environment, a so-called “closure rule” is applied. Closure rule means to identify which macroeconomic variable is considered as being exogenous in order to fully specify the macro level of the model. In our application the investment-driven closure rule is applied. We assume that the model simulations aim at measuring the impact of a short-run event without having any significant impact on future plans, including investment. Therefore, (sectorial) investment demands are taken as exogenous.

1.7 Dynamics

The characteristics of the system described above determine the static equilibrium of the model. However, for describing the time path of the economy dynamics should be added. Dynamics of a model can either be forward-looking or backward-looking. In the present model recursive dynamic relationships are used; therefore, past and present values determine the initial values of the next period.

These recursive relationships are the following: (1) capital stock increases with investments and decreases due to depreciation. (2) Net foreign debt of the country is the debt of the previous period increased by payable interests and decreased by redemption, which is expressed by the balance of trade of the country. Real interest rates are determined by the foreign real interest rate. Risk premium related to the debt of the country is a nonlinear function of the indebtedness of the country, and is modelled by a so called linex function that punishes high indebtedness strongly. The savings rate of the household is exogenous; however, it may change in time due to the changes in the real interest rate. In this model it is assumed that the lagged value of the real interest rate affects the savings rate of the household.

1.8 Data

The parameterization of any CGE model requires enormous effort from the model builder. The core data source of the parameterization is the published input-output tables that are estimated

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by the Central Statistical Office of Hungary. The estimation has been based on the input-output table of 2008 and collected other statistical information of this year to finalize parameterization. In some cases missing information were utilized from other sources; however, in each cases we aimed to avoid using data of different years.

There are 18 industries in the current application, from which “construcion” and “public services” are treated as non-tradeable, the other are all tradables. The list of industries is presented in Table 1.

Table 1 - The list of industries in the model simulations

No. Industry NACE Rev. 2.0 No. Industry NACE Rev. 2.0

1 Agriculture 01-03 10 Water 36-39

2 Mining and oil 05-09, 19 11 Construction 41-43

3 Food 10-12 12 Trade and logistics

45-53

4 Light industry 13-18, 31-32 13 Tourism 55-56, 79

5 Chemistry 20-23 14 ICT 62-63

6 Electronics 26-27 15 RDI 72

7 Vehicles 29-30 16 Financial services

64-66

8 Machinery 24-25, 28, 33: 17 Public Services 84-94:

9 Energy 35 18 Business Services

58-61, 68-71, 73-78, 80-82, 95-98

Source: own edition

The input-output data has been completed with data on income flows between different agents of the economy by creating a consistent social accounting matrix (SAM). The SAM in our application follows the standard structure (see Table 2). The published data needed some small corrections as it had to fit to the model requirements. These changes have been described in detail in Drucker-Major (2015).

The “upper right” and “bottom left” blocks of the SAM (as denoted by different shading) are also part of the published input-output tables; however, we needed to make small data corrections (these are described in detail below). The “bottom right” block of the SAM contains some non-market income flows (transfers and taxes) between the different agents that are not part of the input-output tables, so these cells have been filled with additional information from the national account statistics that are published by the CSO. From these statistics we utilized information on how much tax has been paid by the households, these were interpreted as taxes on labour. The taxes paid by the firms were interpreted as taxes on gross operating profit. The transfers from government to households have been added to the model. By the addition of these statistics we could model the change in the primary budget balance of the government and the overall sum of private savings, which now has been assigned to the household sector.

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Table 2 - Social Accounting Matrix

Sectors Factors Taxes Final consumption

CAP LAB DTX IDT HOH GOV S-I RoW

Sectors

CAP

LAB w

DTX

IDT

HOH w

GOV

S-I

RoW

The accounts of the SAM are indicated as follows: CAP = capital, LAB = labour, DTX = direct taxes, IDT = indirect taxes, HOH = households, GOV = government, S-I = savings-investment balance, RoW = rest of the world. Income flows are indicated in the cells of the tables. Any cell without a variable in it indicates zero income flows. The notations are the following: X: intermediate and final consumption, GOP = gross operating profit, w: real wage, L:

employment, Tz: indirect taxes, Td: direct taxes, M: import, E: export, S: savings, e: real exchange rate. Sectors are indicated by i and j.

Source: own edition

2. COHESION FUNDS IN THE HETFA-CGE MODEL

Cohesion funds are meant to develop the Hungarian economy, which basically means that the financial support is given for specific goals and activities. Therefore, even though in practive they apprear as money transfers, their implementation in a macroeconomic model requires a lot of consideration. As in a CGE model all agents behave optimally without formal restricitons on how to use their resources, if money is given for certain purposes we need to find a suitable compromise between optimizing behaviour and the goal-oriented aspects of cohesion funds. The usual approach is to shock directly those macroeconomic (often aggregated) variables that are aimed by the development policy.

This approach has been followed in this research project. The financial support is given to mainly investment activities, which include purchase of tangible assets or initiating research and development projects. These supported projects will lead to an immediate increase in the investment demand of certain industries. Large part of cohesion funds presented a new investment demand for the products of construction industry, but other industries have also been influenced. Certain supporting activities, like project-preparation, technical assistance, etc, are implemented as direct increase in the government pruchases, in most cases for “public administration” industry, in other cases for industries of market participants (councelling, etc.). Therefore cohesion funds have been added to the model as an exogenous increase in either

investment demand or government purchases. This is called as “demand side impact of the funds”.

Purchasing tangible or intangible assets increases the productive capital of firms therefore lead to higher income in the long run. Also in most cases the newly bought capital assets represent better technology than the older one, therefore not only productive capacity but also

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productivity is increased by these projects. Research and development may lead to new products, lower costs or better organizational structure, each will manifest itself in larger productivity. These are very important channels of economic development that needed to be captured in every macroeconomic model that are to measure impacts. In the present application these channels are modelled as follows.

It has been assumed that new investment demand increases capital stock in the industry of the subsidized agent with certain delay. Without precise information on the exact timing of the investment projects, moreover because of the large heterogenity of such projects with respect of their duration, it is assumed that the appropriate delay is one year. Next by this channel it has been assumed that investment activity will lead to higher productivity in the industry of the subsidized agent. These two channels are called “supply side impact of the funds”.

The parametrization of the supply side impact of the funds is remarkably challenging. As there are very few impact studies on how the value added of subsidized firms changed, the appropriate coefficient took on a very low value to reach rather conservative estimation of the supply side impact. Further progress is needed to be done in this area.

The overall impact of the funds are just the sum of the demand side impact and the supply side impact (however the nonlinearity of the model leads to a small deviation from this relationship). Simulation techniques make it possible to measure these impacts separately, even if they are hard to interpret without each other. For example, the demand side impact in itself means that there are new demand for investment but there will be no increase in the stock of capital. The supply side impact means that the stock of capital increase even if there are no assumed change in the investment demand. It is important to keep in mind that the division of demand and supply side impact are rather artificial. Nonetheless the decomposition of the total impact into demand and supply side impact help us in interpreting the simulation results.

3. SIMULATION RESULTS

Simulation results are summarized in Table 3. As the results show, the funds have stimulated the economy, as both GDP and employment increased (see Figure 4). The impact on GDP is less than proportional which is a result of the remarkably strong crowding out effect. This effect works mainly through the export: the relatively more expensive domestic goods leads to higher import and lower export which, in sum, decreases the value of net export. The amount of investment demand and government purchases are exogenous in this model, the crowding out of these demand components are not directly taken into account. Households consumption changes procyclically with GDP, however its size is smaller.

There are basically two different channels of adjustment, through which crowding out effect takes into action. First, as financial support stimulates demand, it increases the relative price of domestic goods over foreign goods. This is the real appreciation channel, its size could be about 2,5% by the end of 2014. The real appreciation leads to a small decline in competitiveness of exporting firms, thus leading to a decline in export. Summarizing, the extra demand generated

by development policy leads to real appreciation that will harm export.

Second, extra demand generated by the development policy is not sector-neutral. As only certain kind of activities are supported, certain sectors face with larger shock than others. For example, most of the support increases demand for construction services, which leads to a large increase for factors of production in the construction industry. As construction is non-tradeable, this extra demand can only be satisfied from domestic production. As the labour force is given, the extra demand for labour can only be met by (1) either increasing the real wage thus leading to a decline in unemployment, (2) or inter-sectoral flow of labour. The construction industry is

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basically unskilled labour intensive, therefore an extra demand for its services leads to a large increase in the demand for unskilled labour. However, because of its real wage is given by the effective minimum wage, the abovementioned first way of adjustment is just kicked off. The only way to increase production in this sector is to inflow unskilled labour from other industries. The result will be a “shortage” of unskilled labour in other industries, also in exporting industries. Generally, the extra demand generated by the development policy will rearrange

factors of production between sectors and it seems that largely at the costs of the exporting

sectors.

Figure 4 - The impacts of EU funds on the path of GDP, 2008-2014


The total impact of development policy has been decomposed into demand side impact and supply side impact. There are important differencies between them. Supply side impact are cumulative in their nature, as larger capital stock will increase production until it is completely depreciated (which takes years or even decades). Also, the productivity impact of a better technology is assumed to be permanent. However, based on our existing calibration, the magniute of the demand side impact is much larger than that of the supply side impact. The relative size of these channels are important, because demand side impact basically influences the level of GDP, while supply side influences more the persistence of the impacts and thus leading to certain growth characteristics. Given our current parametrization, the impacts are mainly driven by the demand side impacts of the shock. Therefore any fluctuation in the size of the cohesion funds might lead to a similar fluctuation in the Hungarian GDP in the upcoming years. Also further research should be done in order to (1) better calibrate these channels, (2) understanding how supply side impacts could be targeted better.

The sign of the demand side impact and the supply side impact is the same for almost all variables (see Table 3). Nonetheless there are some interesting exceptions. As we have seen already, export might decrease due to the abovementioned adjustment channels. Nonetheless, supply side impacts are positive and only demand side impact is negative in the case of export. The reason is related to what have said above. The extra demand generated by the development policy leads to a real appreciation that harms competitiveness of export. Nonetheless the supply side impact (through the improvement of productivity and an increase in the capital stock) itself means an increase in the competitiveness of the exporting sectors. Thus the decomposition showed us that the decline of export can be explained by the fact that the increase in productivity

of exporting sectors could not compensate for the strong crowding out effects of the

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development policy. This in turns shows us the importance of understanding better how the productivity itself is influenced by the funds.

Table 3 - Simulation results

2009 2010 2011 2012 2013 2014

GDP (%) 0,32 0,58 0,85 1,19 1,05 1,95

From this: demand side impact 0,32 0,49 0,62 0,77 0,39 1,06

supply side impact 0,00 0,09 0,23 0,43 0,67 0,92

Employment (ths persons) 20,7 30,4 39,1 46,0 38,1 81,7

From this: demand side impact 20,7 28,8 35,1 38,8 26,9 67,1


Export (%) -1,48 -1,88 -2,13 -1,77 -0,41 -3,09

From this: demand side impact -1,48 -2,19 -2,81 -3,02 -2,44 -5,91


Real exchange rate (%) -0,56 -0,84 -1,09 -1,19 -0,94 -2,44

From this: demand side impact -0,56 -0,84 -1,07 -1,16 -0,88 -2,25

supply side impact 0,00 -0,01 -0,03 -0,05 -0,09 -0,25

Primary balance of the budget (change in % of GDP) 0,48 0,35 -0,23 -0,12 1,95 -0,93

From this: demand side impact 0,48 0,32 -0,32 -0,28 1,71 -1,27



References:

1. Balás G. & – Csite, A. & Kiss, G. & Major, K. & Németh, N. & Piross, A. (2015). Growth and development impacts of EU funds [Az EU források gazdaságfejlesztési és növekedési hatásai], only in Hungarian, Hétfa Research Institute, research report. Available: http://hetfa.hu/wp-content/uploads/Fejlpolhatasok-HETFA_151130.pdf

2. Boeters S. & Savard, L. (2012). The Labor Market in Computable General Equilibrium Models’. In P. Dixon & D. Jorgenson (eds.), Handbook of Computable General Equilibrium Modeling, chap. 26, pp. 1645–1718. Elsevier

3. Dixon, P. B. & Koopman, R. B. & Rimmer, M. T., 2013. The MONASH Style of Computable General Equilibrium Modeling: A Framework for Practical Policy Analysis, Handbook of Computable General Equilibrium Modeling, Elsevier.

4. Drucker, L. & Major, K. (2015). Macroeconomic impact of electric power outage: simulation results from a CGE modelling experiment for Hungary, Hétfa Working Paper Series, 2015/12, available: http://hetfa.eu/wp-content/uploads/2016/01/HETFA_WP_impact_of_power_outage.pdf.

5. Küster, R. & Ellersdorfer, I. & Fahl, U. (2007): A CGE-Analysis of Energy Policies

Considering Labor Market Imperfections and Technology Specifications. Working Papers 2007.7, Fondazione Eni Enrico Mattei.

Contact information

Klára Major Hétfa Research Institute Október 6. u. 19, Budapest, Hungary [email protected]

95

TO THE FISCAL DIMENSION OF HEALTH CARE FINANCING

Jan Mertl

Abstract

Presented paper focuses on the fiscal aspects of health care financing within the paradigms of recent socioeconomic development. This is justified by the size of health budget in current economies and the importance of health care for economic performance and social well-being. The models of health care financing are discussed and the characteristics of health care are described. Then the situation in the Czech Republic is assessed and the system of multiple health insurance companies is analyzed. An overview of fiscal aspects that influence health care system is made and possible configurations are discussed.

Keywords: health insurance, health budget, government expenditure, fiscal policy

JEL Classification: I13, I18, H51

Introduction

Health care systems became in the 20th century the significant part of public budgets, in developed countries utilizing approximately 6 – 9 % of GDP for public expenditure on health (and additional private resources, too). This is connected with the character of health care as a mixed good, whose majority of consumption is universal by decision of public choice and thus the techniques of public financing are used in this area. In this sense, a big new element of public finance emerged with certain level of autonomy on the expenditure side and this has its consequences in behavior of fiscal policy.

Sometimes, we see fiscal approaches that treat health care equally to the other significant public sectors like army, police, justice, education etc. While this corresponds to the general theory of public finance and fiscal policy, because theoretically there is no or little reason to give “preference” to health care before other (also important) sectors, we can also discuss the characteristics of health care and its position in national economy and seek for approaches that justify some special treatment (OECD, 2015).

The last economic crisis, as measured by the slowdown in the key macroeconomic indicator of GDP and in parallel with the increase in unemployment, caught the Czech health sector in a difficult situation. Before it occurred in 2008 the first phase of an ambitious unpopular reform was implemented, on simple calculations based (30-60-90 CZK) implemented regulatory fees. This should have created space for the next phase of reform, involving the introduction of regulated competition in the private health insurance companies based on their economic performance as an incentive to save resources. This did not occur, for two reasons. The first of these was a political unwillingness to continue the reforms in the spirit proposed and their inner conflict with some health economics knowledge.

The second one was the “W” character of GDP trend, which brought a deterioration in key macroeconomic parameters and effectively blew a pillow that was created for the reform of health insurance companies on the basis of increased payments for state insured persons and favorable macroeconomic developments in the pre-crisis period. The overall balance of health insurance budget was surplus 17,2 billion CZK in 2007 and 10,7 billion CZK in 2008 (MF ČR, 2009). For health economics and health policy, however, this brought an interesting study

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material, because for the first time in the history of Czech health insurance system, the system was exposed to a massive decline in employment and thus incomes and the analysis shows that, if this pillow had not been accumulated before, the situation would have been significantly worse. In addition, some of the general crisis-induced and anti-crisis economic policies influenced health system, too.

In this sense, this paper aims to cover important aspects of health care’s fiscal dimension, which have been triggered by the recent socioeconomic development. To achieve this it is strongly rooted in knowledge of health economics and experiences from health policy in the Czech Republic.

Scientific methods used to write this paper include macroeconomic analysis of health expenditure, public policy evaluation of health resources’ settings in the Czech Republic and synthesis of observed trends from the health policy point of view.

1. THE SCHEMES OF HEALTH FINANCING

Generally, several possibilities how to allocate resources for universal health care exist. First, we can treat health care system equally to education, police, army and other “traditional” public finance areas. In this approach, the health system is just one of the important economic sectors and the level of health care expenditure is determined centrally by public choice and fiscal priorities. Hence, the position, power and governance quality (European Comission, 2001) of the Ministry of Health is crucial, because the fiscal process is mainly determined by the government legislation procedures and respected negotiations. The risks of this approach include poor public governance practices and health budget being under threat, especially at times when the whole government budget is tight.

Second, we can establish one or more independent health insurance companies, which operate on social health insurance principle – solidarity according to health status and usually wealth (income). This creates a parafiscal payment usually defined as a payroll tax, which is an income of those health insurance companies (company). They then have their own balance and budget, usually supervised by the public policy. When there are more insurance companies, the question of risk selection and the issue of character of competition between them appear (Choné, Grignon, & Mahieu, 2001).

Third, we can do a strict regulation of commercial subjects selling private health insurance on the market and provide a government subsidy for the citizens so that everyone can afford that product, at least on the universal (standard) level. This approach emerged from the private health insurance markets and their failures, when the public choice decided to keep its principles as viable, and simultaneously wanted to achieve also goals that social health systems achieved. Still the questions about effectiveness of those (usually large) subsidies appear, and in some countries, the government enters the market by creating programs for the poorer or sicker social groups (USA: Medicare, Medicaid).

Those are model approaches; in many countries, they slightly overlap or a big main system of one character is created, simultaneously a small “side” system is run on different principle – e.g. the case of Germany and social (90 % of people) and private (10 % of people) health insurance there. The reasons for this approach are different characteristics and performance of the means of financing in the social groups’ spectrum. If well organized, it does not have to possess a significant threat as every citizen can choose the subsystem, which he will participate in, however from the theoretical point of view some systems look like a mess. It is sometimes difficult to make theoretically perfect classification of real health care system. To achieve this,

97

we can usually identify the main, dominant or original health care financing approach for that country and then the supplemental ones used.

From the fiscal policy point of view, those possibilities imply the following budget schemes

1) A government expenditure program for health care – allocation within a health budget as a part of central public finance schemes. When allocating resources on the central level, supported by respected legislation determining the price level and amount of health care provided, the health sector is financed at the “pure” principles of public sector financing and allocation. In this scheme the majority of health expenditure can be seen as more discrete, because the government can decide about them individually and annually, although it does not have direct control of some variables that influence their need (e.g. drug prices etc.)

2) An independent institutional framework for financing health care, where the public governance and central government role is limited and the principal fiscal goal is to collect and allocate the agreed amount of money to specialized institutions (health insurance companies). In this scheme the public finance flows can be seen as more mandatory, since they are based on simple allocation of public resources defined by law (OECD, 2015).

3) A subsidy scheme, when the people receive support based on their social status so that they are able to buy a regulated health insurance product commercially. In this scheme the income differentiation and level of regulation is important for the government position and fiscal volume of health expenditure.

It is worth noting, that selection of those schemes is a result of the health financing system selection and configuration, fiscal policy alone cannot select a particular scheme on its own.

2. THE CHARACTERISTICS OF HEALTH CARE

Many times the importance of health care system has been assessed and defined (Suhrcke, et al, 2005), (Žáček, 1984), (Arrow, 1963). There is no doubt about its specific characteristics, however to discuss its position in fiscal policy in this paper, it is useful to stress out particular aspects that seem to be crucial for its assessment.

Health care expenditure is counter-cyclical by nature, because the volume of health care consumption does not depend of economic cycle and can even increase in economic downturns because of the socioeconomic problems that increase in those times.

The demand for health care is highly inelastic and is driven by determinants of health, thus the incomes of population not being a dominant factor. The volume of health expenditure is largely proportional to the volume of real health care demanded, e.g. the variable costs are significant share of health budget (Mooney, 1992).

In guaranteed health care systems, the government takes over a responsibility for the availability and accessibility of health care to the population. If this cannot be achieved, the guaranteed health care becomes merely “written on the paper”, causing vast problems in accessibility and rapidly decreasing the responsiveness of health system to the health issues of the citizen.

Since people are born with “full stock of health” (not considering inborn defects) and then the determinants of health imply how this stock of health is maintained and consumed, the possible failures of health policy and/or financing usually emerge in longer perspective. In this sense if we miss the health care goals and the health status of the people decreases, within a given population this cannot be in many cases “repaired” later. The population health status is overall crucial for the economic performance and the social well-being of the people.

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Social dimension and addressing of health inequality is important, it is actually one of the achievements of developed countries. We cannot put those goals aside for fiscal reasons because it directly undermines the health status, quality of living and social harmony, which we consider as key aspects of dignified life.

In this sense, the sustainability, predictability and accountability of health expenditure on health care is important (European Commission, 2013). Since we deal with social and human capital, the only similarly important sector of national economy is education.

3. MACROECONOMIC ASPECTS OF CZECH HEALTH INSURANCE

Following the theoretical outline, we can now analyze important characteristics of the Czech health insurance system. As for the basic macroeconomic indicators, the values for last 5 years are the following.

Table 1 – Total expenditure on health care 2010–2014 (mil. CZK)

Expenditure items 2010 2011 2012 2013 2014 1)

Public expenditure 243 281 242 410 246 918 246 562 254 699

In: Direct expenditure from

government budget 20 781 16 863 15 648 16 657 15 671

In: Health insurance

companies 222 500 225 547 231 270 229 905 239 028

Private expenditure 45 754 45 358 46 388 44 381 45 224

Total expenditure 289 035 287 768 293 306 290 943 299 923

GDP share in % 7,3 7,2 7,3 7,1 7,0

Source: (ÚZIS, 2015), 1) preliminary data

In the Czech Republic, kind of hybrid health system is running, and this has consequences in the measures taken. This hybrid character is rooted in the income structure of health insurance companies, their count and position and by different groups of the insured, although the coverage is universal by law.

99

Figure 1 – Shares of insured citizens in health insurance companies, 2014

Source: (MZ ČR, 2015)

This figure shows that the General Health Insurance Company (VZP, 111) retains dominant position on the market, all other companies having much smaller share of the insured. From micro economical perspective, this can be classified as an oligopoly with dominant firm. Behind this is also the issue on so-called state insured persons, which do not have taxable income and are not supposed to work (e.g. pensioners, students, unemployed, parents caring for children). Even if they can now choose a health insurance company freely, they originally were placed to GHIC by default and the incentives to change insurance company are rather small and not price-based. Thus still, this company has largest share of state insured. By the way, this has significant solidarity implications, as there is a very high degree of solidarity within GHIC’s insured. Whereas the employees have paid, in 2014, 61 billion CZK annually and consumed 18,3 billion CZK, the state insured persons have in the same year paid just 26 billion CZK and consumed 94 billion CZK (MZ ČR, 2016).

Všeobecná zdravotní pojišťovna ČR (111)

57%

Vojenská zdravotní pojišťovna ČR (201)

7%

Česká průmyslová zdravotní pojišťovna

(205)

12%

Oborová zdravotní poj. zam. bank, poj. a stav.

(207)

7%

Zaměstnanecká pojišťovna Škoda (209)

1%

Zdravotní pojišťovna ministerstva vnitra ČR

(211)

12%

Revírní bratrská pokladna, zdrav. pojišťovna (213)

4%

100

Figure 2 – Balances on basic and reserve health insurance fund, 09/2015, thousands CZK

Source: MZ ČR, 2015

This figure shows the real balances on the basic and reserve fund of health insurance – e.g. “reserves” of the public health insurance system. We can notice, that some smaller companies have the reserves half as high as GHIC (VZP, 111), which has the largest number of insured, 5-6 times more than e.g. ZPMV (211). Theoretically we can even sum up those balances and say that the system has “operating” reserve at about 11,2 billion CZK, but since the companies operate independently of each other, this is a purely theoretical calculation, and can be modified further through (annually returnable) government pre-payment, which was about 4,8 billion CZK in 2014. Moreover, the balance of health insurance companies is not determined solely by their operation (payments to health providers), by also by the government decision how to finance them and set the insurance redistribution scheme. This is necessary, because health costs highly differ between the insured, and thus the issue of “cream-skimming” has to be addressed. These aspects mean that analyzing the performance of health insurance companies has several important factors to consider and they represent to some degree independent institutional framework for health financing.

Simultaneously, fiscal policy determines the overall balance of the health insurance companies significantly through the following measures.

· The health insurance rate, which is fixed at 13,5 % by law and was not changed since its introduction

· The health insurance base and respective payment for so-called “state insured persons”, changed arbitrarily (more on this later)

· Government pre-payments to health insurance (§12, Act No. 89/2012 Coll.) and subsidies to the health system or to big health providers (e.g. public health projects, hospitals)

· Changes in general taxation influencing health system inputs and outputs (VAT, income taxes)

In this paper, we can discuss in more detail the payment for state insured persons. Its development is documented in the following table. Now no automatic changes take place so it depends on the public choice when and how much it is changed.

0

500000

1000000

1500000

2000000

2500000

3000000

3500000

4000000

Všeobecnázdravotní

pojišťovna ČR(111)

Vojenskázdravotní

pojišťovna ČR(201)

Českáprůmyslová

zdravotnípojišťovna

(205)

Oborovázdravotní poj.

zam. bank, poj.

a stav. (207)

Zaměstnaneckápojišťovna

Škoda (209)

Zdravotnípojišťovna

ministerstva

vnitra ČR (211)

Revírní bratrskápokladna,

zdrav.

pojišťovna(213)

Basic fund Reserve fund

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Table 2 – Changes in the base and premiums (amounts) for stated insured persons, 1993-2016, Czech Rep., CZK

Time Base Premium/amount

1. 1. 1993 - 31. 12. 1993 1 694 229

1. 1. 1994 - 31. 12. 1995 1 430 194

1. 1. 1996 - 30. 06. 1996 1 625 220

1. 7. 1996 - 31. 12. 1997 2 000 270

1. 1. 1998 - 30. 06. 1998 2 120 287

1. 7. 1998 - 30. 06. 2001 2 900 392

1. 7. 2001 - 31. 12. 2002 3 250 439

1. 1. 2003 - 31. 12. 2003 3 458 467

1. 1. 2004 - 31. 12. 2004 3 520 476

1. 1. 2005 - 31. 12. 2005 3 556 481

1. 1. 2006 - 31. 01. 2006 3 798 513

1. 2. 2006 - 31. 03. 2006 4 144 560

1. 4. 2006 - 31. 12. 2006 4 709 636

1. 1. 2007 - 31. 12. 2007 5 035 680

1. 1. 2008 - 31. 12. 2009 5 013 677

1. 1. 2010 - 31. 10. 2013 5 355 723

1. 11. 2013 - 30. 06. 2014 5 829 787

1. 7. 2014 - 31. 12. 2015 6 259 845

Since 1. 1. 2016 6 444 870

Source: VZP, 2016

Considering the structure of insureds and their burden, the indirect labour costs, including health insurance ones, are especially in the case of employees perceived as being high enough to stop any ceteris paribus changes (especially increases) of the current rate 13,5 %. In addition, the discrepancy between average amount of employee and state insured person is frequently stated and thus, when the overall balance of the system is challenged, there is an expressed demand for changing the amount paid for state insured persons (Tempus Medicorum, 2015). Within this outline we can see the second important role of this amount: actually it works as a part of health care financing that can in the described environment as a certain stabilizer of the health system overall balance. Generally said: although it is a controversial concept, the public policy and the stakeholders currently do not seem to have an intention to abandon it, actually the opposite is true and we can discuss the possible variants further.

The first aspect is how to set the base for the stated insured persons so that it is not dependent on public choice in the sense that if the public policy forgets about it, it is not changed and with the ongoing macroeconomic development is gets out-of-date; e.g. suggest some methods of its update (valorization). In this sense, the following possibilities exist (Zdravotnický deník, 2016):

1. Make relationship to general average income base (used also for pensions valorization), or simply to the average wage in the national economy.

2. Administratively valorize the base regularly, e.g. by 5 % annually (percentage estimated from the average of growth of payments at other insured persons).

3. Unify the base with the base for persons without taxable incomes, which is currently the minimum wage.

Fiscally the third possibility is the most extensive, according to calculations done by the Ministry of Health (MZ ČR, 2016) it would increase the resources by 30 billion CZK, in addition minimum wage is now set by discrete economic policy which compromises the rationality of related values. The second one, costing about 3 billion CZK is rather theoretical

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as it does not relate directly to the macroeconomic reality and thus is probably even more prone to being inadequate in time than the current scheme. The first one (currently being preferred at the stage of proposal) has fiscal dimension around 5 billion CZK in the first year and when utilizing similar schemes as pension base, also the average values cover longer term.

Within this first aspect, primarily the issue of changing the government expenditure for health care is resolved, in the conditions when we do not want to change the payments of other social groups. In addition, as we have discussed the second aspect exists and this is the reaction to the economic cycle, which causes lowering absolute incomes of health insurance funds through macroeconomic channel as a whole.

This second aspects leads to the discussion about the anti-cyclical measures in health insurance. It is clear, macro economically, that with rising unemployment the number of state insured persons will also rise. Thus, the health insurance budget will lose its payment and in addition, the government will have to pay its amount for such a person. Actually it is theoretically interesting, that from the pure fiscal principle the decrease of public revenue from health insurance, similarly to the decrease from tax income, could be seen as an automatic macroeconomic stabilizer, however, in the current environment it causes deficits in health insurance budgets and creates additional expenditure pressure for the government budget. Therefore, the guardian of health budgets, or so called stewardship maker (WHO, 2000) Ministry of Health, to protect the interest of the health budget, discusses currently the introduction of weighted state insured person coefficient.

This coefficient measures the deviation of the actual number of state insureds from the average number of them during a selected period (seven years – approximately one economic cycle). It is computed as a linear share of the actual number of the state insureds to the average; when this number is equal to the average the coefficient is 1.

To simplify actual calculations and prevent constant changes its “resolution” is in current proposals set for every 2000 persons by 0,001, this number can be adjusted to the sensitivity desired. By this coefficient will be reduced/increased the total amount of money paid for the state insured persons, calculated with one of the valorization mechanisms described above. One of the discussed variants works with creating an lower and upper limit (0,95-1,05) for this coefficient to limit the extent of consequences for the government budget during large or sudden fluctuations of employment. This limits automatic fiscal dimension of the proposed anti-cyclical measure at the sudden big fluctuations of unemployment, which could be unsustainable for the government budget.

Conclusion

Health care system characteristics justify the need of careful treatment of this sector at the level of public finance and fiscal policy. While many of them are similar to other sectors that have significant share of their budget filled from public resources, the degree of autonomy, strong presence of market imperfections and big significance for social and human capital formation are an inevitable property of health systems.

Macro economically, the health expenditure is anti-cyclically based and keeps its volume mainly based on health determinants’ development. That is why the health budget and resources must be adjusted to those real needs and the macroeconomic fluctuations.

We identified three different basic approaches to the general fiscal position of the government. A government expenditure program (budget) for health care, an independent institutional framework for financing universally available health care and a subsidy scheme in highly

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regulated competition of health insurance companies, when the people receive support based on their social status.

Considering the position of central government, the degree of autonomy of other subjects (stakeholders) is important. This also influences where the government position is seen as more discrete or mandatory in the relation to the health system. This is important for practice, because although the government with more mandatory position to the health financing can “simply engage the Parliament more frequently”, changes of those mandatory budget agencies usually are more difficult to achieve (OECD, 2015).

A system of multiple health insurance companies is running in the Czech Republic since 1990s. It is clear that it is a “practical compromise” between the theoretical models of health care organization and financing, struggling to fit them and therefore showing low adherence to pure public finance principles in some areas. It also requires big fiscal subsidy for people who are not supposed to work (state insured persons) and well-adjusted central redistribution of insurance payments.

Many aspects of fiscal policy influence health care systems. We have been focusing on the amount paid for state insured persons, which emerged in Czech health care system in the 1990s as a fiscal supplement to the payments of employed and self-employed persons. Although theoretically debatable and having direct connection to the government expenditure side, which leads to approaches that ask for its abandoning or minimizing in favour of the more standard solutions based on general taxation, its position in the health care system remains active.

Actually, when the public choice and public policy do not seem to make a health system reform fundamentally changing the categories of the insured, and when the burden of health costs spreading between them seems to be fixed in the last decade or so, the fiscal subsidy representing the amount paid for the state insured becomes one of the tools of optimizing the public expenditure to health budgets.

This is supported by recent public discourse about the methods of this amount determination. Recent proposals include its linking to the standard valorization procedure used for public pensions and introducing anti-cyclical measure which is sensitive to the number of state insured citizens and thus indirectly to the employment rate. Whether they are accepted or not of course remains a task of public choice but in the given environment, technically they strive for better automatic determination of the government payments fairly well.

For the future, the question of which health resources’ allocation scheme will be the primary one in the Czech health system remains. This will determine also the fiscal schemes that are used. However, any such schemes will have to adjust to and deal with the macro economic development and actual characteristics and importance of health care, so the challenges for fiscal policy will, probably, be very similar further.

Acknowledgements

The paper has been prepared within the project "Current trends in development of financial markets", supported by the Institutional support for long-term strategic development of research organization University of Finance and Administration in 2016.

References:

1. Arrow, K. (1963). Uncertainty and the Welfare Economics of Medical Care. American Economic Review, 53(5), pp. 941-973.

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2. European Comission. (2001). European Governance: A white paper. Brusel: Evropská komise.

3. European Commission. (2013). Investing in Health. Brussels. Retrieved 21. 3. 2016, from http://ec.europa.eu/health/strategy/docs/swd_investing_in_health.pdf

4. Choné, P., Grignon, M., & Mahieu, R. (2001). Quelles fonctions économiques pour des opérateurs de soins dans le système de santé français? Revue française d'économie, 16(1), pp. 169-214.

5. Mooney, G. (1992). Economics, Medicine and Health Care. Second edition. Essex: Prentice Hall.

6. MF ČR (2009). Státní závěrečný účet 2008. Výsledky hospodaření zdravotních pojišťoven. Retrieved 21. 3. 2016, from http://www.mfcr.cz/cs/verejny-sektor/statni-rozpocet/plneni-statniho-rozpoctu/2008/statni-zaverecny-ucet-za-rok-2008-2030#IIIF

7. MZ ČR. (2015). Zůstatky na fondech zdravotních pojišťoven. Retrieved 21. 3. 2016, from MZ ČR: http://www.mzcr.cz/obsah/zustatky-na-fondech-zdravotnich-pojistoven_2952_1.html

8. MZ ČR. (2016). Návrh zákona, kterým se mění zákon č. 592/1992 Sb., o pojistném na veřejné zdravotní pojištění, ve znění pozdějších předpisů. Verze do připomínkového řízení. Retrieved 8. 2. 2016, from OdOK - materiály v připomínkovém řízení: https://apps.odok.cz/kpl-detail?pid=KORNA6LHS2PA

9. OECD. (2015). Fiscal Sustainability of Health Systems: Bridging Health and Finance Perspectives. Paris: OECD.

10. Suhrcke, M., McKee, M., Sauto Arce, R., Tsolova, S., & Mortensen, J. (2005). The contribution of health to the economy in the European Union. Brussels: European Communities.

11. Tempus Medicorum. (2015). Valorizace platby za státní pojištěnce: finance versus zdravotnictví (5), pp. 3-8.

12. ÚZIS. (2015). Výdaje na zdravotnictví 2010-2014. Retrieved 21. 3. 2016, from http://www.uzis.cz/rychle-informace/vydaje-na-zdravotnictvi-2010-2014

13. VZP. (2016). Vyměřovací základ státu. Retrieved 1. 2. 2016, from https://www.vzp.cz/platci/informace/povinnosti-platcu-metodika/stat/vymerovaci-zaklad-stat

14. WHO. (2000). World health report 2000. Geneve: WHO. 15. Zdravotnický deník. (2016). Ministerstvo navrhuje pro valorizaci plateb za státní

pojištěnce zlatou střední cestu. Zdravotnický deník. Retrieved 1. 2. 2016, from http://www.zdravotnickydenik.cz/2016/01/ministerstvo-navrhuje-pro-valorizaci-plateb-za-statni-pojistence-zlatou-stredni-cestu/

16. Žáček, A. (1984). Metody studia zdraví a nemoci v populaci. Praha: Avicenum.

Contact information

Jan Mertl University of Finance and Administration Estonská 500, Prague 10, Czech Republic [email protected]

105

ASSURANCE – A VITAL TOOL OF GUIDING THE INTERNAL AUDIT

Martina Muchová, Maria Klimiková

Abstract

Corporate governance failure, especially within financial institutions, has been at the core of many of the problems during the global financial crises and numerous corporate and organizational scandals and failures. Many subjects have responded by issuing louder calls for increased regulation and by rethinking of guiding tools of internal audit processes like assurance.1

It is no coincidence that regulatory change in the past decade has focused on the quality of discussion and challenge in the boardroom. We need to understand what drives the organization, what could break it, and what will keep it on track to deliver its goals sustainably. This, in turn, requires an understanding of the assurance – the connection between those who seek assurance and those who provide it. The board is at the top of the network, seeking the assurance to discharge its accountabilities to the organization’s external stakeholders “Assurance maps are a vital tool that guide internal audits and give audit committees peace of mind.”2 In this paper we draw on an attention of key tools in corporate governance practices, especially tool guiding of internal audit.

Keywords: assurance, assurance map, internal audit, financial crisis, corporate governance

JEL Classification: G01, G31, G34, M42

Introduction

For board members, as representatives of good governance, it is important to rethink assurance as the sleepwalking into a disaster is likely to be every company board’s nightmare. Reliable assurance cannot be taken for granted. Blind trust at the top is no excuse for not ensuring that the organization’s core values and proper conduct are maintained.

Examples ranging from the collapse of Enron to phone hacking at News Corporation and the 2008 financial crisis make it clear that corporate governance has been ineffective when it counted. The assurance given in those boardrooms can only be described as empty. In case of Enron there was considered the board’s failure to challenge and seek appropriate assurances from management to have transformed Enron from a well-respected and award-winning company to a disgraced and bankrupt enterprise in less than three months. This was the consequence of not taking steps to become fully informed of the phone-hacking issues and exhibiting willful blindness to what was going on. The culture permeates from the top and reflects the overall lack of effective governance. If boards do not consciously seek assurance, surprises in the boardroom are more likely.

1 MUCHOVA M., Basel Committee 2015 Corporate Governance Principles for banks, Proceedings of Scientific

Conference for Doctoral Students and Post-Doctoral Scholarship EDAMBA 2015, pp. 645-653, 2015. 2 http://auditandrisk.org.uk/features/mapping-the-road-to-assurance-

106

1. INTERNAL AUDIT AND ASSURANCE

The value of internal auditing can be described by these three very important words: assurance, insight and objectivity. Management and governing bodies can look to their internal auditors to provide assurance on whether policies are being followed, controls are effective, and the organization is operating as management intends. Internal auditors have unique insight on which risks might lead to disaster; how to improve controls, processes, procedures, performance, and risk management; and ways to reduce costs, enhance revenues, and increase profits. Internal auditors view the organization with the strictest sense of objectivity that separates them from - but makes them integral to - the business.3

Internal audit is a key source of independent assurance, so it is no coincidence that in the last days the financial services regulators exerted great influence in the development of the IIA’s code for effective internal audit in financial services (July 2013). For the code to be implemented effectively, we need to appreciate the assurance network, so that stakeholders work collaboratively across all lines of defense and optimize collective risk intelligence. The code reinforces the link between risk management and risk assurance, and requires a more conscious approach to seeking and providing assurance across the risk spectrum. This link is consistent with the drive in corporate governance to align risk management and assurance across boundaries, and these expectations are found in the emerging practices of integrated assurance. Whether these help to minimize gaps and duplication in assurance plans or facilitate discussions about risks and the control environment, integrated assurance is encouraging a more conscious approach – and internal auditors have an opportunity to be the guiding light.

1.1 Quality Management in Internal Audit

Internal audit should employ both internal and external quality assurance tools in order to ensure that it is delivering an adequate level of quality. A feedback procedure should be implemented within the auditing organization in order to establish an open dialog with managers in audited units. Quality self-assessment processes ensure that every member of the audit organization is involved in the quality assurance process.4

The assurance is one of the trends in processes of internal audit. In fact, the lines that such a process should follow have not yet been clearly established because the responsibility of the internal auditor shifts from the verification of purely quantitative data after the fact to providing assurance on the management and disclosure processes that the organization has followed with regard to the issue of materiality. In future the abilities and experience of internal auditors shall be called on to make a contribution and provide support for issuing assurances on social and environmental aspects as well.5

2. ASSURANCE MAPPING

Internal audit functions work within organizations to support the improvement of governance, risk management, and control processes. Achieving success requires collaboration between internal audit and management, as well as other internal and external assurance providers. It is unlikely that the internal audit function would have sufficient resources to provide assurance

3 https://na.theiia.org/about-ia/PublicDocuments/PR-Value_Prop_Bro-FNL-Lo.pdf) 4 European Confederatin of Institutes of Internal Auditing, The Role of Internal Audit in Corporate Governance

in Europe, E.Schmidt Verlad. GmbH & Co.,pp. 36-37, ISBN: 978 3 503 10056 9, Berlin, 2007 5 European Governance, 2014, The Official Magazine of the ECIIA, May 24, 2014, Issue 26, http://www.interniaudit.cz/download/ECIIA/ECIIA-Magazine-May-2014.pdf

107

over the entire organization. Regardless, there are efficiencies to be achieved in coordinating assurance. Assurance mapping can help joint the dots between the activities of each of the different assurance providers, avoiding duplication while maximizing the use of organizational resources.6

Internal auditors need to embrace and effectively utilize the valuable data they spend their time producing. This data can be used to draw up maps that guide audits and give management and committees’ clear insight into what controls are being overseen and to what extent. The internal audit team can all use an assurance map for both individual audit planning and to inform the overall audit plan. Use the required level of assurance from the audit committee as a starting point. Either use existing planning methodologies to devise the internal audit plan, map the plan to the assurance map’s required coverage levels for Level 1 and Level 2 Risks, produce a gap analysis and update the internal audit plan accordingly; or produce the internal audit plan directly from the assurance map’s required coverage levels. In the second method, caution is advised to continually update both the assurance map and internal audit plan to take into account emerging risks. To inform individual audits use the relevant Level 3 Risks around which to plan testing.

Assurance maps could work in different forms. In recent years they have developed as audit committees seek to gain assurance that key risks facing the business today and tomorrow are being sufficiently assessed by its assurance providers. For those who are unfamiliar, an assurance map essentially consolidates information from assurance providers and shows how much coverage they are providing over the risks faced by an organization. The assurance map concept transcends industries, institutions, banks and sectors and is a useful tool that can be integrated into internal audit methodologies. The term of “assurance map” is familiar to many, the information they contain differs and some may be easier to use than others.

With the use of big data ever expanding, an assurance map can be a way of utilizing the valuable information created by internal audit and other assurance providers. It presents information in a way that is quick to understand and provides a basis on which to formulate good quality questions from its readers. The answers to those questions can then be used to direct resource to optimum effect, provide more targeted assurance and add long-term value to an organization. Table 1 shows an assurance map with ratings associated with the level of coverage provided; black signifies coverage above the required level defined.7

Table 1 – Assurance map: Coverage

Source: Dawson, S. (2016)

6 PITT S.-A., Internal audit quality – Developing a Quality Assurance and Improvement Program, John Wiley & Sons, Inc., Hoboken, pp. 97-103&213-215, ISBN 978-1-118-71551-2(hardback), New Jersey, 2014 7 This contribution is the result of the project VEGA 1/0124/14 „The Role of financial institutions and capital market in solving problems of debt crisis in Europe”.

L3 Risk

Delays are

sustained in

resorcing

Projects

Strategic Projects are not delivered to

budget

Targed service

levels are not

achieved

Targed cost savings

are not achieved

Strategic Projects do not deliver

required outcomes

L1 Risk

L2 Risk

Delays are

sustained in

obtaining required

technology

Delays are

sustained in

developing

required

technology

Strategic Projects are not delivered on time

Strategic Objectives are not met

Coverage

Table 1 - Assurance map: Coverage

Delays result in cost

overruns

Costs per unit is

greater than

forecast

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In risk mature organizations where assurance maps have been widely used to show coverage they can be further developed to show results, as shown in Table 2.8

Table 2 – Assurance map: Results

Source: Dawson, S. (2016)

2.1 Developing an assurance map

To develop a comprehensive assurance map we will need to have an understanding of and liaise with our organization’s other assurance providers. This will include designated first line control functions and second line functions such as risk management and regulatory compliance. Also we will need to agree upon the framework to use to structure the assurance map information – the risk universe, audit universe or something new. The most appropriate choice will likely depend upon the organization’s risk maturity. This will be used as our basis for assessing coverage.

Using output from all assurance providers, ascertain which controls have been tested and to what extent. Doing this for each and every risk/control will take some time and, depending upon your methodology, may involve going through individual test programs.

The ratings are an effective way of giving your assurance map the most visual impact; these are generally widely used, familiar and easily understood. Perhaps add an additional color (grey as an example) for coverage beyond that desired - this is potentially wasted resource that could be better utilized elsewhere. Our black areas could help address our red ones.

Decide how much assurance coverage we or the audit committee require over each risk. For risks with a lower risk appetite we may choose to require 100 per cent - for example there may be low (or more likely any) risk appetite for regulatory or legal breach. Conversely, for risks with a higher risk appetite we may say that 20 per cent is sufficient.

3. VALUE-ADDED ASSURANCE

An assurance map can provide a basis on which to communicate with stakeholders and begin quality conversations. An assurance map can help risk committees and audit committees understand current assurance positions, highlighting areas of low coverage, extensive or over coverage and gaps in understanding. One example of this would be an assurance map showing a huge amount of coverage by internal audit, but none from the second line, which leads to the

8 This contribution is the result of the project VEGA 1/0124/14 „The Role of financial institutions and capital market in solving problems of debt crisis in Europe”.

L3 Risk

Delays are

sustained in

resorcing

Projects

Targed cost savings

are not achieved

Results

L1 RiskStrategic Objectives are not met

Table 2 - Assurance map: Results

L2 Risk Strategic Projects are not delivered on timeStrategic Projects are not delivered to

budget

Strategic Projects do not deliver

required outcomes

Delays are

sustained in

obtaining required

technology

Delays are

sustained in

developing

required

technology

Delays result in cost

overruns

Costs per unit is

greater than

forecast

Targed service

levels are not

achieved

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question: why? There may be valid reasons for this and some qualitative commentary will be required.

If we are able to cross-reference the assurance map results to the risk events log this could reveal that one of the causes for a greater concentration of risk events in one area has been a historic lack of assurance coverage. In which case a higher level of coverage could be beneficial or this could direct the audit committee to consider whether first line management are effectively taking second and third line recommendations on board. On the other hand if an area with recent risk events is shown to have a significant amount of coverage, then the audit committee may want to initiate a deeper investigation into the cause of this. We can provide the first line management with an assurance map specific to their area to allow them to see the results of assurance providers’ testing and compare it to their own results. It will help them to see pictorially the results of second and third line assurance activity and can help them direct their resources to areas of concern. Regardless of the types of assurance engagements undertaken by the internal audit function, value is achieved when assurance moves beyond the adequacy of individual controls to the overall adequacy of systems and processes.9

Conclusions

Finding the right balance between the internal audit function assurance services and consulting engagements requires an explicit strategy that should be determined by the audit committee or equivalent on behalf of the organization. The audit committee determines how much assurance is needed in each engagement, plans it appropriately, and finds the right resources to complete the task. Consulting and assurance engagements of internal audit functions are important and valuable to an organization.10

The conclusion of studies on corporate failures has been consistent. Unfortunately, the failure has to learn from these. It is time to rethink assurance in the governance process – from being intuitive to being conscious. This rethink is particularly pertinent as organizations experience greater change and complexity in their structures and business models.

References:

1. Dawson, S. Mapping the road to assurance. Audit&Risk. Insight from the Chartered Institute of Internal Auditors. 2016. http://auditandrisk.org.uk/features/mapping-the-road-to-assurance-

2. European Confederation of Institutes of Internal Auditing, The Role of Internal Audit in Corporate Governance in Europe, E.Schmidt Verlad GmbH & Co.,pp. 36-37, ISBN: 978 3 503 10056 9, Berlin, 2007

3. Muchová M., Basel Committee 2015 Corporate Governance Principles for banks, Proceedings of Scientific Conference for Doctoral Students and Post-Doctoral Scholarship EDAMBA 2015, pp. 645-653, 2015

4. Pitt S.-A., Internal audit quality – Developing a Quality Assurance and Improvement Program, John Wiley & Sons, Inc., Hoboken, pp. 97-103&213-215, ISBN 978-1-118-71551-2(hardback), New Jersey, 2014

9 PITT S.-A., Internal audit quality – Developing a Quality Assurance and Improvement Program, John Wiley & Sons, Inc., Hoboken, pp. 97-103&213-215, ISBN 978-1-118-71551-2(hardback), New Jersey, 2014 10 The Institute of Internal Auditors Research Foundation, Common Body of knowledge Survey data, 247 Mainland Avenue, Altamonte Springs Florida 32701- 4201, http://www.interniaudit.cz/download/CBOK/1582416_5010.1- Characteristics-of-an-IA-activity.pdf, ISBN 978-0-89413-695-5

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5. European Governance, 2014, The Official Magazine of the ECIIA, May 24, 2014, Issue 26, http://www.interniaudit.cz/download/ECIIA/ECIIA-Magazine-May-2014.pdf

6. http://auditandrisk.org.uk/features/mapping-the-road-to-assurance- 7. https://na.theiia.org/about-ia/PublicDocuments/PR-Value_Prop_Bro-FNL-Lo.pdf) 8. The Institute of Internal Auditors Research Foundation, Common Body of knowledge

Survey data, 247 Mainland Avenue, Altamonte Springs Florida 32701- 4201, http://www.interniaudit.cz/download/CBOK/1582416_5010.1- Characteristics-of-an-IA-activity.pdf, ISBN 978-0-89413-695-5

9. This contribution is the result of the project VEGA 1/0124/14 „The Role of financial institutions and capital market in solving problems of debt crisis in Europe”.

Contact information

Martina Muchová University of Economics in Bratislava Dolnozemska cesta 1, Bratislava, Slovakia [email protected] Maria Klimiková University of Economics in Bratislava Dolnozemska cesta 1, Bratislava, Slovakia [email protected]

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THE GROWING ROLE OF THE CENTRAL BANKER

Marta Orviská, John Hudson

Abstract

Fiscal policy is in decline, although in part at least this may be temporary. But at the moment there are limitations on its use in many countries both in terms of financing government spending and as a tool of macroeconomic policy. Monetary policy has to an extent filled this gap, with the use in particular of unconventional monetary policy, particularly quantitative easing (QE), and low interest rates. This is being used not only in an attempt to stimulate the economy, but to finance government expenditure, although the latter has been less commented upon. Whilst being necessary short term measures, they bring potential dangers to the future not least with respect to inflation. All of this has propelled central banks, and central bankers to the forefront of economic policy making, so much so that there may be a case for regarding them as an emerging fourth branch of government. But this raises questions of legitimacy. In addition putting the central banker into this prominent position is not without risks to the central bank itself.

Keywords: central banks, fiscal limits, quantitative easing, institutional trust

JEL Classification: E31, E50, E62

1. THE DECLINE OF FISCAL POLICY

Fiscal policy is in a state of, perhaps temporary, decline. As Figure 1 shows the economic crisis has led to a considerable increase in government debt. The crisis began with the government having to rescue parts of the financial sector. This added considerably to what was in many cases an already high debt. This fuelled the initial rise in debt in the post 2008 period, but subsequently the debt also grew as a consequence of a severe economic downturn in many countries. This debt is now forecast to come down in Europe, but not in the USA and forecasts are often too optimistic and always tend to be based on a ‘no adverse shocks scenario’. Brexit, at least, illustrates that this may be somewhat optimistic. This is not the case in all countries. It is so for Japan, the UK, the USA and several of the Eurozone countries. But in countries such as Sweden and Estonia, the debt is not yet so large and fiscal policy is still a viable option.

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Figure 1 – Gross government debt

Source: IMF Fiscal Monitor 2015

Figure 2 – Gross government debt

Source: IMF Fiscal Monitor 2015

Quite apart from the debt, political intolerance of high tax rates also constrains taxation, which is of course an important part of fiscal policy. In many countries this is reflected in significant tax changes or reforms in countries such as the United States, the United Kingdom, Sweden and elsewhere in recent decades. These reforms have seen substantially lowered marginal tax rates. International tax competition also limits a country’s ability to raise taxes, particularly on the business sector. Countries are reluctant to raise taxes, and in some cases even to keep them

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were they are, because of a fear that the large multinationals will shift the base of their activity. Elections too are often accompanied by promises not to increase taxes and in many cases to cut them.

Taxpayers, both individuals and businesses, can not only voice their disapproval of taxes via the ballot box, they can also choose to either avoid or evade paying them. Figure 3 shows estimates of the size of the shadow economy in several countries, countries which are not traditionally thought of as having a large shadow economy. It appears to be steadily falling – albeit with a blip after 2008. But nonetheless the amount lost to taxation is still high and if France or the UK could halve its size, this would make possible a reduction to the debt whilst at the same time maintaining, or even increasing, public sector expenditure. In other countries the problems and potential gains are far more substantial as Figure 4 shows. Tax avoidance is also a substantial problem and is estimated to cost EU countries €50-70 billion a year1. Tax avoidance is the legal use of various means not to pay taxes, often by exploiting loopholes in the law. Policy action on these areas has been limited, indeed disappointingly so, although the EU is beginning to make proposals to deal with the problem as are some individual countries. We will have to wait to see how successful they prove and how serious the various governments are.

Figure 3 – Estimated shadow economy (% GDP)

Source: Schneider et al.

1 http://europa.eu/rapid/press-release_IP-16-1349_en.htm

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Figure 4 – Estimated shadow economy (% GDP)

Source: Schneider et al.

All of this is constraining governments not just in their ability to use fiscal policy as a macroeconomic tool, but in the purely simple terms of raising sufficient revenue to cover their normal spending. This has led to both upward pressure on the debt and declining public sector services. This at a time when there are many pressures on government to increase such spending. These pressures come from an increasingly elderly population. This impacts on both pensions and health care, whilst reducing the proportion of people working and hence can be taxed. But there are other pressures. Climate change is leading to increasing weather volatility which is inflicting damage across much of the world, including Europe and North America. In some cases this is flood damage and in others damage due to forest fires. It can have adverse impacts on agriculture and tourism. The number of extreme weather events are increasing and this puts pressure on government spending not just in reacting to environmental damage, but for example on expenditure to prevent flooding and coastal erosion.

Fiscal Policy is thus challenged in raising the revenue to meet all the competing demands for government expenditure. It is also being challenged in terms of its ability to impact on demand (GDP) in a Keynesian manner. Many countries, for example Spain and Greece are experiencing very high unemployment, but are prevented from attempting to boost demand by running a still larger deficit. One of the few exceptions to this is the USA, largely because they are choosing not to pursue policies to cut the deficit, although for how long is questionable.

2. THE DECLINE OF ‘TRADITIONAL MONETARY POLICY’

Henning (2016) has argued that prior to the crisis central banking concentrated on targeting inflation and was correspondingly restricted in its mandate and operations. It also had varying degrees of responsibility for micro-control of the financial institutions such as the banks, although this was in a world which had been substantially deregulated. After the crisis the attention has been on financial stabilization as well as price stability. Even more stark has been the change in the instruments of monetary policy. Interest rates in many countries are at or near their zero lower bound and hence could not be reduced more, or at least much more. Traditional

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IS/LM analysis, which we still teach in postgraduate macro courses, has also lost, perhaps temporarily, its relevance. In the place of interest rates and conventional open market operations, central banks have turned to a range of tools within the general umbrella of ‘unconventional monetary policy’.

This is a reflection that along with the decline of fiscal policy, there has also been a decline in conventional monetary policy, working primarily through interest rates per se and targeting inflation as in the Taylor rule. Because the interest is at or near its lower minimum bound2, it cannot be used to target inflation and in this sense the Taylor rule is in abeyance until such time as interest rates move upwards into fully adjustable regions. Because of this it has been argued that central banks are losing power, rather than gaining it due to this demise of traditional monetary policy. In absolute terms this may be so, at least with respect to monetary policy aimed at price stabilisation. But relative to fiscal policy and national governments, they have gained in power as effectively at this time of austerity they are the only ones who can act to at least try and stimulate the economy through QE and keeping interest rates at their lower bound. They have also been able to help finance government expenditure at a time when fiscal policy has had difficulties in this respect. But to do so they are having to move to this unconventional monetary policy, often in the form of quantitative easing (QE), but also perhaps ‘forward guidance’, together with a constant search for new ways to create this stimulus.

3. THE GROWTH OF QUANTITATIVE EASING

This section builds upon Hudson and Orviska (2016). Japan saw the first example of QE in 2001, with the Bank of Japan’s announcement that it would target holding a high level of bank reserves. This was partly to be achieved by purchasing government bonds. But it was after the economic crisis that QE really became a major innovation in macroeconomic policy. In the USA, QE began at the end of 2008, shortly after Lehman Brothers demise. It involved in excess of US$ 1.3 trillion, despite lasting for just a few weeks. It was very much a short and sharp reaction to a financial system on the edge of disaster. The focus, unlike many other QE programs, was not so much on government bonds, but on troubled security purchases, loans, and other credit facilities. Subsequently a second round, QE2, was announced in November 2010, with the Fed’s (Federal Reserve) bond-buying programme reaching $85bn a month. The latest round of QE finished in 2014. Many appear to regard this process as having finished, with it being time to begin at least thinking about ‘the exit strategy’. This may or may not be the case, with Janet Yellen recently hinting at further rounds, but whilst in progress it was a very substantial programme. Thus the Fed purchased 60.2% of the total net Treasury issuance (difference between new loans raised and old ones paid back) in 2011. In the UK, the first period of QE was between March 2009 and January 2010 when £200 billion was spent on purchasing assets. The focus here was on government bonds, although some corporate bonds were also purchased. Further rounds followed in In October 2011 and February 2012. There is also the distinct possibility that it will be resorted to again as the UK attempts to steer a course in a post-Brexit era.

It was not until 22 January, 2015 that the European central Bank (ECB) announced its first specific QE programme, with a view of targeting 2% inflation. The total assets purchased would increase, under the Public Sector Purchase Programme (PSPP), to €60bn per month between March 2015 and September 2016. This sums to a total €1.1 trillion or 9% of the stock of Eurozone central and other government debt of the Eurozone nations. The initial impact on

2 It is often referred to in this manner, although it is a bound which is being broken, but there are limits as to how far this can go.

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inflation has been limited and partly as a consequence the programme has been extended. It is now set to finish in March 2017 at the earliest (Claeys and Leandro, 2016). There are other changes with local and regional government bonds now included in the range of eligible assets. The ECB appears to have been somewhat late in using QE. But this is somewhat misleading as prior to this the ECB had engaged in other, related, forms of unconventional monetary policy. Thus the ECB’s long-term refinancing operations (LTROs) amounted to almost a trillion euros, comparable with the current QE. LTRO finance was provided to Eurozone banks. They were largely 3-year long term loan provisions which were exchanged for collateral, including bank loans and government bonds.

There seems a general consensus, amongst central banks in particular, that QE is temporary and there is a lot of talk of exit strategies. Equally the view is that these exit strategies will be challenging to implement (Putnam, 2013). It must involve both the selling of bonds to the private market and a move to higher interest rates. The latter has begun to happen with the Fed raising its benchmark interest rate to 0.25% at the end of 2015. However, this is only a small increase and it is difficult to judge the impact of more substantial increases. The economies of the QE countries have become used to low interest rates. Many householders have bought houses on the basis of this and the banks have adapted to the changed nature of bond markets and the low interest environment. It may take several years of slowly increasing interest rates, before a return to ‘normality’ can be countenanced. Even then the new normality may be different to the pre-2008 normality. One key difference is the size of government debt and thus the amount the private sector will be required to hold in bonds once we have reached this new normality.

4. THE ACCRETION OF OTHER POWERS

The use of QE to stimulate the economy in the absence of effective fiscal action is not the only gain in powers that have occurred with respect to central banks. The twin roles of macro and micro prudential stability have in many cases seen the central bank’s powers and responsibilities increase. Prior to the crisis, although central banks issued financial stability reports, they often had little authority to take action on the weaknesses they identified (Kohn, 2014). Kohn argued that in the U.S., the Fed had some responsibility for overall financial stability, but this was more implicit than explicit, with its powers limited to banks and bank holding companies, and any regulatory actions needed to be agreed upon with several other agencies. Since the crisis there has been considerable focus on creating and strengthening institutions responsible for macro and micro prudential supervision. In many cases the central banks have emerged as the leading player in macro-prudential supervision (Masciandaro and Volpicella, 2016). One reason for this is that the central bank has access to considerable information to help with the regulation.

In general, microprudential policies examine the responses of an individual bank to exogenous risks and do not incorporate endogenous risk and the interconnectedness with the rest of the system. (Osinski et al., 2013). In some jurisdictions, the banking supervisor is explicitly tasked with the responsibility for financial stability or for contributing to financial stability—a responsibility that is usually implicitly or explicitly part of the central bank’s mandate. In the UK responsibility for micro and macro-prudential regulation is in the hands of three bodies: The Financial Policy Committee (FPC); the Financial Conduct Authority (FCA), with responsibility for consumer protection, market functioning and the supervision of some financial firms, such as asset managers; and the Prudential Regulatory Authority (PRA), the microprudential regulator and supervisor for banks, other depository institutions, insurance companies, and major investment firms. The Bank of England helps with housing and staffing

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the FPC and PRA and also with broad responsibility for analysis and policy to promote stability. In the USA power is much more diverse. Nonetheless, the Fed was given broad new responsibility focused mainly on systemically important bank holding companies and financial market utilities, with the addition of, so far a few, nonbank companies designated as systemically important by the Financial Stability Oversight Council. In many other countries, the central bank is the institution performing both macro and micro prudential roles, e.g., Brazil, Bulgaria, Malaysia, Singapore, and Thailand (Osinski et al., 2013)

Given increased globalisation, there is also need for a co-ordination of economic policies. Once more this tends to fall to central banks, as, for example, occasions when co-ordinated interest rate changes have been announced. Engel (2015) has argued that such co-ordination is at least credible for central banks, but much less so with respect to fiscal policy which in all countries is the product of complex and cumbersome negotiations at the political level. Hence this too is an area when central banks powers have increased and probably would have done so regardless of the crisis. This co-operation is reflected in their close links with the Bank of International Settlements3 and central banks, and their governors, were closely associated with the specification of Basel III.

5. THE SPECIAL CASE OF THE ECB

Nowhere is the enhanced role of the central bank more apparent than in the Eurozone. This in part is due to the fiscal and the power vacuum left by the absence of an effective federal fiscal authority. This changing role includes the use of various unconventional monetary policies, but has also led to the ECB playing a leading role in negotiations with various debtor nations such as Greece. In filling this vacuum, the ECB has had to circumvent all sorts of problems including Article 103 of the Treaty establishing the European Community, which specifically prohibits the ECB from bailing out member states in case of default, or the threat of default. Yet this appears to many to be what the ECB has done4. A condition of such a bailout is that the ECB sets conditions for national governments of troubled countries to meet which extend well into the field of fiscal policy. This has happened not just in Greece, but also Spain and Italy.

As with other banks the ECB has also acquired powers in the area of micro-macro prudential supervision. For example, the ECB is now the single supervisor for the 130 largest banks in the Eurozone, a power transferred from national governments. The emergence of the European banking union between 2012 and 2014 thus represented a significant transfer of national sovereignty from the Eurozone’s member states to the ECB.

6. THE POLITICAL DANGERS TO THE ECB

This growth in power comes with potential dangers to central banks. It brings them into the political sphere and yet they lack democratic accountability. We illustrate dangers these with respect to the ECB, but they apply to other central banks too. Figure 5 shows the difference between those who trust and those who do not trust the ECB in a series of Eurobarometer surveys. For the EU as a whole people were increasingly positive until the crisis of 2008. The subsequent decline has affected all the countries shown, including Germany. But the collapse in trust is particularly severe in Greece. This is the case for other countries which have been struggling with the crisis and had demands placed upon them by the ECB. The decline in trust

3 See: https://www.bis.org/cbgov/index.htm?m=2%7C293 4 This has led to a series of court cases, instigated primarily from Germany, to determine the legality of various ECB actions. http://www.bbc.co.uk/news/world-europe-35586118

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has also characterised the Slovak and Czech Republics, although they tend to be more trusting than the EU as a whole.

Figure 5 - The Difference between Trust and Distrust of the ECB

Source: Eurobarometer 83.3

We now turn to examine the diversity of attitudes to fiscal and monetary policy issues. A diversity which emphasises how difficult agreeing a common position or set of policies will be. In Figure 6 we show the distribution of trust in the ECB across the EU in May of 2015. It shows the substantial degree of hostility to the ECB in some, but not in all countries.

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Figure 6 - The Distribution of Trust in the ECB across EU Countries


The next two diagrams relate to aspects of fiscal policy. Firstly attitudes to Eurobonds are shown in Figure 7. In many cases the dominant response is one of ignorance. But in general the troubled nations of Greece, Portugal, Italy, Ireland and Spain tend to be more favourable than others whilst Austria and Germany are particularly hostile to the idea.

Austria Belgium Bulgaria Croatia Cyprus Czech R.

Denmark Estonia Finland France Germany Greece

Hungary Ireland Italy Latvia Lithuania Luxembourg

Malta Netherlands Poland Portugal Romania Slovakia

Slovenia Spain Sweden UK

From left to right: trust, do not trust and finally don’t know From left to right: trust, do not trust and finally don’t kn Source: Derived from Eurobarometer survey 83.3

Belgium Bulgaria Croatia

Trust in the ECB in May 2015

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Figure 7 - Attitudes to Eurobonds across EU countries


Finally we turn to attitudes of tougher rules to deal with tax evasion and avoidance, which links in with our earlier discussion on the demise of fiscal policy. In most countries there is almost overwhelming support for this policy. But there are exceptions. Croatia, Estonia, Latvia, Lithuania, Luxembourg, Malta and Poland, although tending to be in favour are a little less so and one wonders why this should be? But equally one wonders why governments have not done more, given the large degree of public support and their debt problems, to take stronger steps to deal with these problems?






From left to right: strongly in favour to strongly against and finally don’t know Source: Derived from Eurobarometer survey 83.3

Attitudes to Introduction of Eurobonds in May 2015

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Figure 8: Attitudes to Tougher Rules on Tax Evasion/Avoidance across EU countries


Table 1 summarises the various attitudes across different socio-economic characteristics. Trust of both the EU Commission and the ECB is low throughout all sectors of society. It is likely that they both suffer from a general anti-EU sentiment, in part linked to the crisis, but it is also likely that they contribute to that sentiment. Trust is lower in the Eurozone countries which may be a debtor country effect. ECB Trust is also lower than for the Commission. Trust is highest amongst the better educated and in general mistrust characterises the ‘have nots’. Strong support for tax measures against avoidance also varies substantially. It is lowest amongst the young, professionals, and skilled and unskilled labour, arguably the groups most likely to be engaged in tax evasion. Compared to the other variables there is much less variation in attitudes to Eurobonds.






From left to right: strongly agree to strongly disagree and finally don’t know Source: Derived from Eurobarometer survey 83.3

Attitudes to Introducing Tougher Tax Rules in May 2015

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Table 1 - May 2015, Attitudes to and Knowledge of:

Commission ECB Tax measures

Euro- bond Know Trust Know Trust

All 89.97 55.41 89.8 50.9 65.45 55.87

Eurozone 90.82 52.7 92.11 47.98 65.17 55.12

Young 89.25 58.33 88.81 52.16 58.91 57.83

Old 90.76 53.89 90.61 50.03 68.75 54.83

Highly educated 96.23 66.31 96.07 60.73 69.5 58.68

Medium education 91.53 56.4 91.06 52.21 63.73 56.31

Low education 83.63 46.14 83.89 41.94 65.17 53.15

Prosperity (ability to pay bills)

91.67 61.32 91.87 56.94 67.75 55.12

Village 88.46 53.21 88.34 49.25 65.21 56.31

Town 90.09 56.2 90.12 51.84 65.18 54.59

City 91.53 56.65 91 51.31 66.14 57.29

Professional/ 96.51 65 96.08 61.74 60.68 59.18

Senior manager

Skilled manual 89.91 53.76 88.63 49.15 61.53 58.72

Unskilled manual 84.7 49.01 83.31 45.35 59.27 51.46

Unemployed 85.29 42.51 85.4 36.16 62.71 54

Retired 88.82 52.83 88.59 49.09 71.45 51.56

Student 85.7 65.6 87.15 58.7 56.2 58.72

House person 83.13 48.61 83.67 44.21 62.33 60.45

Male 92.26 55.33 92.49 51.87 67.36 58.55

Female 88.07 55.48 87.58 50.03 63.84 53.32

Notes: Shows proportions knowing of and trusting the EU Commission and the ECB, those strongly in favour of tax measures and those in favour of Eurobonds.


In Table 2 we present regression results relating to trust in the ECB, the difference in trust between the ECB and the Commission - what we term the trust gap - support for tax evasion and avoidance measures and support for Eurobonds. Focusing on ECB trust, this declines with age until the individual is about 48 years after which it starts increasing again. Apart from that, trust is greater amongst those who prosper, i.e. can pay their bills, are well educated, own or are buying their own house and have a good job. There are substantial differences between countries, not shown in the Table, with Greece, Spain and Cyprus being the least trusting and Denmark, Estonia, Lithuania and Malta the most trusting. Turning to the trust gap, a value of 1(-1)indicates that the individual trusts the commission more(less) than the ECB. In terms of the coefficients, the gap increases with education and is greater for women. It is highest for Hungary and Germany - i.e. these are the countries whose trust for the ECB is lowest in comparison to their trust for the Commission, and lowest for Denmark and the Czech Republic.

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Table 2 - Regression results

Trust ECB

ECB-Commi- Ssion Trust Gap

Tax Measures

Eurobonds

Unemployed -0.2417** 0.01292 -0.01119 -0.08576**

(7.12) (0.36) (0.38) (2.74)

Age -0.009435** 0.004885 0.02192** 0.001916

(2.72) (1.24) (7.16) (0.61)

Age2 0.00997** -0.005968 -0.01684** -0.002983

(2.93) (1.54) (5.52) (0.95)

Male 0.04575* -0.05945** 0.05293** 0.1265**

(2.49) (2.80) (3.19) (7.73)

Village -0.04125 -0.02435 -0.03348 -0.0811**

(1.66) (0.85) (1.49) (3.66)

Town -0.02388 -0.003781 -0.04784* -0.06559**

(1.03) (0.14) (2.29) (3.18)

Retired -0.1236** 0.04213 0.08203** -0.05882*

(4.09) (1.22) (2.99) (2.09)

Manager 0.116* -0.107 -0.2775** 0.046

(2.34) (1.66) (6.10) (1.10)

Log education 0.4939** 0.2355** 0.1932** 0.2725**

(10.07) (4.11) (4.21) (6.15)

Prosperity (ability to pay bills)

0.2613** 0.02392 0.07917** 0.032

(12.19) (0.99) (4.20) (1.67)

Own House 0.07759** -0.04796 0.136** 0.04058

(3.08) (1.64) (6.12) (1.83)

Buying own house

0.1608** -0.03335 0.1158** 0.02458

(5.90) (1.01) (4.75) (1.03)

Statistics

Observations 20442 19431 23508 17752

Log Likelihood -12965 -8613 -19260 -22554

X2 2215 271.9 1998 1793

Notes: Estimated using ordered probit apart from trust ECB which was estimated by probit. Variables are as defined in Figures 6-8 apart from the trust gap which is coded 1(-1) if the

individual trusts the commission more(less) than the ECB, if trust the same then zero.

Source for data: Eurobarometer 83.3

Conclusions

The role of central banks has changed dramatically since the crisis of 2008. They have in many cases been given greater responsibilities for macro and micro prudential regulation and again in many countries they are the only policy maker attempting to increase demand in the economy. In the UK this has happened as the UK government struggles to get debt down and rejects attempts to boost demand by fiscal policy. In the USA there is less aversion to running a deficit in the Executive, but the breakdown in relationships between the Executive and Legislature, i.e. the Democrats and the Republicans, in recent years has marginalised fiscal policy. The growth of power of the ECB is arguably greater than any other central bank, as they try to fill the vacuum left by their being no fiscal authority covering the whole of the Eurozone and political decision making in the area being hampered by the need for the agreement of so

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many member states. This has led the ECB, for example, to be at the forefront of negotiations with Greece and, with slightly less publicity, the other troubled Eurozone nations.

The question arises as to whether this has promoted the importance of the central bank sufficiently for it to be regarded as a fourth branch of government along with the Executive, Legislative and Judiciary? This may seem to exaggerate the situation, but is consistent with a literature which has argued, within a European context, that the significant growth of supranational regulatory agencies represent new modes of governance (Borras et al, 2007). Keleman (2003) has actually argued that these regulatory agencies compromise an emerging “fourth branch” in the EU’s institutional structure to complement the other three branches. Whilst Majone (1996) argues that the EU is primarily a regulatory state and issuing rules is its most important vehicle for shaping public policy in Europe. The ECB fits in with this general theme of leaving to experts decisions the politicians are reluctant to make.

Whether this is the case or not it is certainly the case that the central bank is a much more critical player than when the Fed was set up in 1913, when it was initially regarded as not being that important, with President Wilson observing that the USA had several more powerful federal agencies. It is also true that central bankers are getting involved in areas far removed from monetary and financial policies. For example, Mario Draghi has argued that the ECB’s efforts will be diluted if not accompanied by structural reforms, including investment in skills training and encouraging worker mobility. In the UK, Mark Carney has, slightly controversially, become involved in recent debates about Scottish independence and whether the UK should remain in the EU. In the USA Janet Yellen has recently called for an “investment oriented fiscal policy” as monetary policy struggles to boost demand in the absence of “a lot of help from fiscal policy”5. Prior to that in the early stage of the crisis, by December of 2008, the Fed lent almost $600 billion to foreign central banks from Brazil to Singapore6. Clearly this goes well beyond the remit of maintaining domestic price stability.

But this increased power is coming at a cost to central banks, as we have seen most clearly with the decline in support for the ECB. And this matters, for if the central bank loses the trust of the people it regulates then such regulation becomes more problematic, not least because a central bank’s effectiveness depends upon its credibility, part of which is based on people’s trust in it. There is a further question linked to the democratic accountability of the central bank. Its powers have increased and yet the governors are appointed by governments rather than elected and in addition they have a degree of independence from government which allows them to pursue their own policies. It is possible that the cost of making the central bank more democratically accountable, would be a reduction in its effectiveness, in its ability to act quickly and decisively, and in its ability to act in a coordinated manner with other central banks. There is a consensus in the literature that central bank independence increases policy credibility and improves economic outcomes (Dzigbede, 2016). In addition the judiciary give another example of a recognised branch of government with little democratic accountability. In the USA, e.g., the nine members of the Supreme Court are appointed by the President, confirmed by Congress and then have a lifetime tenure. We tend to trust the judiciary in this sense. Can we not also trust central bankers? Indeed one could reverse the question. Given the failures of and limitations to fiscal policy is there not a case for pursuing a central bank approach to fiscal policy, removing it from the political arena (Fernández-Albertos, 2015)?

Meanwhile it is clear that the future evolution of monetary and fiscal policy is uncertain. But in our view, as recently indicated by both Draghi and Yellen, monetary policy alone is not sufficient to steer economies back to health, and once there maintain equilibrium with a

5 https://mninews.marketnews.com/content/fed-chair-yellen-qa-transcript-part-2-text 6 http://www.thenation.com/article/the-federal-reserves-growing-power/

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properly funded public sector. So first there needs to be steps to tackle tax evasion and avoidance. Such are the amounts involved that a serious reduction in such activities could lead on its own to both sufficient funds to finance the public sector in a manner to what people had become used to prior to 2008 and simultaneously reduce the debt. Governments’ inaction in this respect is inexcusable, not least because of the large measure of public support for such action as revealed in our analysis. Secondly, supply side policy reforms need to be enacted. In each country this means different things. For example, Europe arguably needs a more competitive labour market and a greater emphasis on innovation as opposed to, e.g., agriculture. Thirdly, there are governance problems in many countries. In the USA, the ongoing conflict between the legislature and executive which have severely constrained policy making needs resolution. In the Eurozone, there is a need for a degree of fiscal union at the Eurozone level with the authority to issue bonds. None of this will be easy to achieve and, e.g. despite the obvious need fiscal union has been called “pie in the sky” by Eichengreen (2015). The diversity of views between the citizens of EU countries with respect to tax measures, Eurobonds and trust in the ECB emphasise how difficult agreeing a common position will be for governments trying to reflect the wishes of their electorates.

The alternative is that economies continue with current policies, with increasing, and ever more imaginative, recourse to unconventional monetary policy, until eventually they become partially responsible for the next crisis. In any case, regardless of whether this happens or not, it seems probable that there is no going back to the world before 2008. The role of the central bank has changed. They may well gain still further in power and importance. However, other reforms may mean they may lose some of its current prominence and pre-eminence in economic policy making. But the new insights into the need for macro and micro-prudential regulation, the new tools they have acquired have changed central banks, and probably for ever.

References:

1. Borras, S., Koutalakis, C. and Wendler, F. (2007). European agencies and input legitimacy: EFSA, EMeA and EPO in the post-delegation phase, Journal of European Integration, 5, 583-600.

2. Claeys, G., and Leandro, A. (2016). The European Central Bank’s quantitative easing programme: Limits and risks, Bruegel Policy Contribution, 2016/04.

3. Dzigbede, K. D. (2016). Whither are we bound? New insights on American economic policymaking, Policy Studies Journal, 44, S14-S27.

4. Eichengreen, B. (2015). How the euro crisis ends: Not with a bang but a whimper, Journal of Policy Modeling, 37, 415-422.

5. Engel, C. (2015). International coordination of central bank policy, Journal of International Money and Finance.

6. Fernández-Albertos, J. (2015). The politics of central bank independence, Annual Review of Political Science, 18, 217-237.

7. Henning, C. R. (2016). The ECB as a strategic actor: Central banking in a politically fragmented monetary union. in Europe's crises: Economic and political challenges of the monetary union, edited by J. A. Caporaso and M. Rhodes, New York: Oxford University Press.

8. Keleman, R.D. (2003). The structure and dynamics of EU federalism, Comparative Political Studies, 36, 184-208.

9. Kohn, D. (2014). Institutions for macroprudential regulation: The UK and the US, speech delivered at the Kennedy School of Government, Harvard University, Cambridge, Mass., April 17

10. Majone, G. (1996). Regulating Europe, London: Routledge.

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11. Masciandaro, D and Volpicella, A. (2016). Macro prudential governance and central banks: Facts and drivers, Journal of International Money and Finance, 61, 101-119

12. Orviska, M. and Hudson, J. (2016) Quantitative easing in the Eurozone. 13. Osinski, J., Seal, K. and Hoogduin, M. L. (2013). Macroprudential and microprudential

policies: toward cohabitation, International Monetary Fund. 14. Putnam, B. H. (2013). Essential concepts necessary to consider when evaluating the

efficacy of quantitative easing, Review of Financial Economics, 22, 1-7.

Contact information

Marta Orviská Matej Bel University Tajovskeho 10, Banska Bystrica, Slovak Republic [email protected] John Hudson University of Bath Bath, BA2 7AY, United Kingdom [email protected]

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THE CHALLENGING FIELD OF BUDGET TRANSPARENCY

RESEARCH1

Katarina Ott, Mihaela Bronić

Abstract

The goal of this brief is to wrap up the current state of global budget transparency and the needs for further research. With budgetary problems common in numerous countries, poor and even decreasing citizen trust in democratic institutions and, on average, the unsatisfactory state of global budget transparency, numerous international initiatives have arisen, a body of academic literature has developed. Accordingly, the Institute of Public Finance (IPF) in Croatia has joined the club with its own researches and initiatives related to budget transparency. The challenging field is open to all those who are interested in digging deeper into the possibilities of budget transparency as well as to public participation research aimed at improving fiscal policies and outcomes.

Keywords: local governments, budgets, transparency

JEL Classification: H70, H72, H83

With growth prospects anaemic in many countries, expected public revenues, in spite of high taxation, are often insufficient to cover the growing costs of the public services associated with an ageing population and the needs for improving the quality of public infrastructure, pensions, health, education and R&D. Numerous governments are confronted with low and even decreasing citizen trust in the fundamental democratic institutions. The results of Eurobarometer

(2015) – the survey of citizens’ opinions regularly conducted by the European Commission – are worrying. If one looks at the EU-28 average, only 15% of citizens tend to trust political parties, 27% government, 28% parliament, 32% the EU with 42% tending to trust regional/local public authorities.

1. THE CURRENT STATE OF BUDGET TRANSPARENCY

One would expect that governments would do their best to increase the trust of citizens and how better than by being transparent in their fiscal policies, budgets and budgetary processes? Budget transparency – the focus of this brief – means that the public can obtain complete, accurate, timely and understandable information on the budget.

The International Budget Partnership (IBP), a Washington-based think-tank, has been measuring the budget transparency of numerous countries since the mid-nineties. According to the most recent Open Budget Survey – OBS (IBP, 2015), the large majority of the 102 countries surveyed provide insufficient budgetary information. The OBS average score of these countries is 45 (out of a possible 100), meaning that governments are making available to the public only 45% of budgetary information. Almost 70% of the population covered by OBS live in countries the governments of which provide insufficient budget information. The best scoring countries, offering extensive information (scores over 81) are New Zealand, Sweden, South Africa,

1 This work has been supported in part by Croatian Science Foundation under the project IP-2014-09-3008.

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Norway and USA and the worst countries, offering scant or no information (scores below 21) are Saudi Arabia, Qatar, Myanmar, Lebanon and Iraq.

Of 15 EU countries covered by the OBS, only Sweden offers extensive information (score 88); France, United Kingdom, Romania, Italy, Germany, Czech Republic, Slovenia, Bulgaria, Portugal and Poland offer substantial information (scores 76 to 64). However, Spain, Slovakia, Croatia and Hungary provide only limited information (scores 58 to 49). Although the average scores of EU countries (67) as well as those of all European countries (EU members and non-members2) (62) are higher than the world average (45), there is no place for complacency. As the OBS covers a large number of really poor and non-democratic countries one would expect the European continent to excel in such measurements. The fact that e.g. Hungarian citizens are provided with only 49%, Croatian only 53% and Spanish only 58% of budget information should worry us all.

2. INTERNATIONAL INITIATIVES FOR IMPROVEMENTS

Awareness of the necessity of budget transparency, which might contribute to governments’ struggles with overstretched budgets and difficulties in satisfying ever greater budgetary needs, has been emerging slowly since the mid-1990s. Consequently, some important international initiatives were launched. In addition to the IBP, which has been active in the field for years, there are now the Open Government Partnership (OGP), Global Initiative for Fiscal Transparency (GIFT) and the Global Civil Society Movement for Budget Transparency, Accountability and Participation (BTAP). OGP consists of committed governments, GIFT of governments, international organizations and civil society organizations, and BTAP of civil society organizations.

All these initiatives are doing a great job, e.g. establishing high level principles, guides, best practices and so on. Additionally, the IMF provides a Fiscal Transparency Code, the OECD Best Practices for Budget Transparency, GIFT has already provided its High Level Principles of Fiscal Transparency and is in the final stages of providing Principles of Public Participation in Fiscal Policies. The EU also has requirements and transparency initiatives for its citizens, member states and candidates.

A consensus has been established that transparency in government financial reports is a basic prerequisite for public participation and government accountability. International good practices and demands from civil society organizations, international financial institutions and in some countries donors have resulted in more and more countries producing eight key budget documents.3

3. GROWING INTEREST OF THE ACADEMIC COMMUNITY

Numerous excellent experts have been involved in the above mentioned initiatives, but more from international organizations and civil society organizations than from academic circles. However, there has been more and more interest of researchers and the body of literature has been growing too. Appended here are tables of only some examples of literature, e.g. focusing on budget transparency measurements on national and local level (table A1 and A2), using

2 EU non-member states covered by the OBS are Norway (extensive information); Russia and Georgia (substantial information); Azerbaijan, Serbia, Ukraine and Bosnia and Herzegovina (limited information); Albania and Macedonia (minimal information). 3 Eight key budget documents being: pre-budget statement, executive's budget proposal, enacted budget, citizen budget, in-year reports, mid-year review, year-end report and audit report.

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economic variables for determining relationship with transparency (table A3) as well as voluntary internet financial reporting (table A4). As the pace of researches has been increasing, looking for the literature for our current research of local budget transparency in Croatia, we found numerous very recent articles.4 However, probably the best starting article could be de Renzio and Wehner (2015) which provides a structured review of the impacts of fiscal openness interventions based on a database of 38 empirical studies and sets out questions for future research.

4. IPF RESEARCHES INTO LOCAL BUDGET TRANSPARENCY

The IPF has been active in the field since the late 1990s, promoting budget transparency, government accountability and public participation. It all started with our cooperation with the IBP, but later we became involved with BTAP, GIFT and OGP and focused more and more on measuring and analysing budget transparency. Since its very beginning we have been analysing Croatian national budget transparency for the Open Budget Survey5, then more and more the budget transparency of Croatian sub-national levels6 and public participation in fiscal and budgetary processes7.

In the period 2015-2019 IPF is running the research “Understanding, monitoring and analysing local government budget transparency: Case study of Croatia and Slovenia – Open local budget index (OLBI)”, funded by the Croatian Science Foundation. The starting point was the consideration that local government budget transparency (LBT) is of extreme importance as local authorities’ decisions upon spending public money have an impact on each and every citizen. LBT refers to how easily and to what extent citizens can access information on local government revenues and expenditures and it is a first step toward democratizing the budget process and giving citizens a say in policy formulation and resource allocation. A non-transparent budget cannot be properly analysed, its implementation cannot be thoroughly monitored and its outcomes cannot be evaluated.

LBT is especially important because local budgets deal with expenditures that are for citizens particularly visible and tangible. In this sense, LBT has the potential to provide answers to basic questions such as whether plans to build a new neighbourhood school or carry out local road works have actually been implemented. Despite the importance of LBT, research into its measures, causes and consequences is rather thin. Our aim is to complement the literature and investigate: LBT in Croatia and Slovenia, how it changes over time; why some local budgets are more transparent than others; whether LBT affects budget outcomes in election years; whether it affects election outcomes and whether changes in it over time influence incumbents' and voters’ preferences regarding budget outcomes.

Building upon the existing literature and our previous works, we first harmonized and adapted the already existing Croatian OLBI methodology (previously mentioned works by Ott, Bronić and Petrušić) so that it can be further continually, annually applied in the same way in Croatia and Slovenia. Our OLBI offers numerous opportunities to analyse the extent of LBT in different countries and the differences between them, its causes and consequences and its policy implications and it should result in articles relevant to researchers, policy-makers and

4 E.g. Canares and Shekhar (2015); De Renzio and Wehner (2015); Frans (2015); OECD (2015); Tehou and Sharaf (2015); Turley, Robbins and McNena (2015); Williams (2015). 5 Bronić and Urban (2013; 2015); Ott (2014); IPF (2011); Bađun and Urban (2009; 2010). 6 Ott, Bronić and Petrušić (2013; 2014; 2015); Bronić, Ott and Urban (2012); Ott, Bronić, Petrušić and Stanić (2016) 7 Ott and Bronić (2015; 2015a).

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consequently the end-users, i.e., citizens. The results of the first round measurements in Croatia and Slovenia will be released in July 2016.

Since LBT will be empirically measured and monitored for a fairly long period of time in the two countries, we hope that our continuous research will contribute to the existing literature. We also hope that our results will enable better policy-making and greater public participation in local budget deliberations. In some further stages we would like to apply our OLBI to a greater number of countries.

Conclusion

Access to information, meaningful public participation and government accountability might enhance the integrity, quality and implementation of fiscal policy, increase the legitimacy of and trust in government and improve access to revenue and financing. In this way budget transparency might increase the efficiency, equity, effectiveness, stability and sustainability of fiscal policies and have a major positive impact on economic, social and environmental outcomes. Also, at international levels, it can be beneficial for improving global financial stability, reduction of poverty and corruption, more equitable economic growth, environmental protection and global welfare. It is citizens that provide the resources and the public must have the right to information and participation.

In conclusion, budget transparency is an open and challenging field for various kinds of researches, from basic measurements at various levels of government in particular countries or for groups of countries, to trying to establish its causes and consequences and its relationship with various economic, political and socio-cultural variables. Even more open and even more challenging is the field of public participation in budgetary processes; however, both budget transparency and public participation are essential for government accountability, trust of citizens and a more democratic governing of countries’ public finances and their overall public sectors.

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Appendix

Table A1 - Measures of fiscal/budget transparency on national level

Authors Index of Sample Method

Alesina et al., (1999)

budget institutions

20 Latin American and Caribbean countries

two questionnaires covering ten characteristics of the budget procedures

Bastida and Benito (2007; 2009)

budget transparency

41 countries questionnaire based on OECD's Best

Practices

Hameed (2005) fiscal transparency

57 countries assigning numbers to practices following IMF' Code

IBP (2002) budget transparency

5 Latin American countries

survey

IBP (2006) open budget over 80 countries questionnaire

Jarmuzek et al. (2006)

fiscal transparency

27 transition economies

survey of relevant websites based on a questionnaire following IMF's Code

von Hagen (1992) fiscal transparency

8 European countries questionnaire

Source: Bronić, Ott and Urban, 2012.

Table A2 - Attempts to measure local fiscal/budget transparency

Authors Index Sample Method

Beales and Thompson (2010)

fiscal transparency

134 local government units in Virginia, US

availability of information on local government units websites using 16 criteria on a 100-point scale

Boubeta, Santias and Alegre (2010)

fiscal transparency

33 Galician municipalities, Spain

questionnaire based on the three pillars of the IMF's Code and authors' knowledge about budgetary processes and municipalities’ realities

Caamano-Allegre et al. (2011)

budget transparency

33 Galician municipalities, Spain

questionnaire based on the three pillars of the IMF's Code and authors' knowledge about budgetary processes and municipalities’ realities

Alton, Agarwal and Songwe (2013)

local budget transparency

all local councils in two regions of Cameroon

adapted versions of the IBP´s national OBS questions

Korth (2012) subnational budget transparency

ten different pilot studies for Argentina, Brazil, Bolivia, Croatia*, Ecuador, India, Indonesia, Mali, Mongolia, and Peru

generally all pilot studies adopted the IBP´s national OBS methodology; most studies first investigated the online availability of budget documents and then analysed the budgetary process in the chosen units

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Lawson and Alvarez (2013)

subnational open budget

44 subnational governments in Brazil, Indonesia, and Tanzania

adapted versions of the IBP´s national OBS questions, as well as wholly new questions covering intergovernmental transfers, service delivery, and procurement

Ott, Bronić and Petrušić (2013; 2014)

local budget transparency

All counties (20), all cities (128), and a sample of 100 municipalities

availability of key budget documents on local government units websites

* Bronić, Ott and Urban (2012) investigate LBT for 33 Croatian cities.

Source: Ott [et al.], 2016

Table A3 - Literature trying to establish the relationship with some economic variables


Authors Variable Level of

research

Relationship with the variable

(positive or negative)

Hameed (2005) fiscal transparency

national GDP p.c. (positive)

Alt, Lassen and Rose (2006)

transparency of the budget procedure

National (American states)

both higher surpluses and deficits p.c. (positive);higher level of debt p.c. (negative)

Alt and Lessen (2006)

fiscal transparency

National (19 OECD countries)

higher general government debt as % of GDP (negative):higher deficits (negative)

IBP (2009)

budget transparency (open budget index - OBI)

national

lower level of income - GDP p.c. (worst performers); dependency on revenues from foreign aid and natural resources (worst performers)

Ross (2011) fiscal transparency

national (autocracies)

greater oil wealth, but only among autocracies (negative); nonfuel mineral wealth (positive)

Wehner and de Renzio (2013)

budget/fiscal transparency

national GDP p.c. (positive)

Caamano-Allegre et al. (2011)

budget transparency

33 Galician municipalities

debt p.c. (positive)

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Table A4 -Literature looking at the relationships between voluntary Internet financial reporting practices of local government units and other variables


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Authors Variable Level of research Relationship with the variable

(positive or negative)

Laswad, Fisher and Oyelere (2005)

voluntary internet financial reporting of local government units

86 local government units, New Zealand

financial leverage (long-term liabilities/total assets) (positive); p.c. income level (positive)

Styles and Tennyson (2007)

accessibility of municipalities’ financial reports on the Internet

sample of 300 US municipalities

number of inhabitants (positive); p.c. income (positive); level of debt (positive); better financial situation for the municipality (positive)

Serrano et al. (2008)

voluntary online financial reporting (e-disclosure) by local public administrations

92 provincial capitals and municipalities with more than 70,000 inhabitants, Spain

p.c. income (positive); number of inhabitants (positive)

Cárcaba and Garcia (2008)

voluntary financial disclosure on the Internet

334 Spanish municipalities

number of inhabitants (positive);the level of capital investment (positive)

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39. Islam, R., 2006. Does More Transparency Go Along with Better Governance? Economics and Politics, 18(2), 121-167. doi: 10.1111/j.1468-0343.2006.00166.x

40. Jarmuzek, M. [et al.], 2006. Fiscal Transparency in Transition Economies. CASE Studies and Analyses, No. 328.

41. Jarmuzek, M. 2006. Does Fiscal Transparency Matter? The Evidence from Transition Economies. Available at: http://www.cerge-ei.cz/pdf/gdn/RRCV_77_paper_03.pdf

42. Kaufmann, D., Mehrez, G. and Gurgur, T., 2002. Voice or Public Sector Management? An Empirical Investigation of Determinants of Public Sector Performance based on a Survey of Public Officials. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=316865

43. Laswad, F., Fisher, R. and Oyelere, P., 2005. Determinants of voluntary Internet financial reporting by local government authorities. Journal of Accounting and Public Policy, 24(2), 101-121. doi: 10.1016/j.jaccpubpol.2004.12.006

44. Lourenço, R. P. [et al.], 2013. Online transparency for accountability: one assessing model and two applications. The Electronic Journal of e-Government, 11(1), 280-292.

45. Ma, L. and Wu, J., 2011. What Drives Fiscal Transparency? Evidence from Provincial Governments in China. doi: 10.2139/ssrn.1807767

46. Milesi-Ferretti, G. M., 2003. Good, Bad or Ugly? On The Effects of Fiscal Rules with Creative Accounting. IMF Working Paper. Available at: http://ssrn.com/abstract=880217

47. OECD, 2015. Tax Administration 2015-Comparative Information on OECD and Other Advanced and Emerging Economies. Paris: OECD.

48. Piotrowski, S. J. and Van Ryzin, G.G., 2007. Citizen attitudes toward transparency in local government. The American Review of Public Administration, 37(3), 306-323 doi: 10.1177/0275074006296777

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49. Reinikka, R. and Svensson, J., 2011. The power of information in public services: Evidence from education in Uganda. Journal of Public Economics, 95(7-8), 956-966. doi: 10.1016/j.jpubeco.2011.02.006

50. Ríos, A. M., Bastida, F. and Benito, B., 2014. Budget Transparency and Legislative Budgetary Oversight: an International Approach. The American Review of Public Administration. doi: 10.1177/0275074014565020

51. Rodríguez Bolívar, M. P, Caba, P. and López Hernández, A. M., 2013. Online Budget Transparency in OECD Member Countries and Administrative Culture. Administration & Society, 20(10) 1–40

52. Rodríguez Bolívar, M. P, Pérez, C. C. and López Hernández, A. M., 2007. E-Government and Public Financial Reporting the Case of Spanish Regional Governments MPR The American review of public administration, 37 (2), 142-177. doi: 10.1177/0275074006293193

53. Rodríguez Bolívar, M. P. [et al,], 2016. Risk Factors and Drivers of Financial Sustainability in Local Government: An Empirical Study. Local Government Studies, 42(1), 29-51. doi: 10.1080/03003930.2015.1061506

54. Ross, M. L., 2011. Mineral Wealth and Budget Transparency. doi: 10.2139/ssrn.2334583 55. Sebola, M. P., 2016. Public Participation in South Africa’s Policy Decision-Making

Process: The Mass and the Elite Choices. International Public Administration Review, 14(1), 55–73. doi: 10.17573/ipar.2016.1.03

56. Sedmihradská, L. and Haas, J. 2013. Budget Transparency and Fiscal Performance: Do Open Budgets Matter? ACTA VSFS, 7(2), 109-122. Available at: http://www.vsfs.cz/periodika/acta-2013-02.pdf

57. Serrano-Cinca, C., Rueda-Tomás, M. and Portillo-Tarragona, P., 2008. Factors influencing e-disclosure in local public administrations. Environment and Planning C: Government & Policy, 27(2), 355-378

58. Simone, D. S, 2009. The Concept of Budget Transparency: Between Democracy and Fiscal Illusion. Available at: http://www-3.unipv.it/websiep/2009/200931.pdf

59. Stein, E., Talvi, E. and Grisanti, A., 1999. Institutional Arrangements and Fiscal Performance: The Latin American Experience. NBER Working Papers, 6358. Available at: http://www.nber.org/papers/w6358.pdf

60. Styles, A. K. and Tennyson, M., 2007. The accessibility of financial reporting of US municipalities on the internet. Journal of Public Budgeting, Accounting and Financial Management, 19(1), 56-92.

61. Tehou, Y. and Sharaf, M., 2015. Fiscal Transparency, Measurement and Determinants: Evidence from 27 Developing Countries. University of Alberta Working Paper, No. 2015-02. Available at: http://www.ualberta.ca/~econwps/2015/wp2015-02.pdf

62. Turley, G., Robbins, R. and McNena, S., 2015. Framework to Measure the Financial Performance of Local Governments. Local Government Studies, 41(3), 401-420. doi: 10.1080/03003930.2014.991865

63. Vishwanath, T. and Kaufmann, D., 1999. Towards Transparency in Finance and Governance. Policy Research Working Paper. Available at: http://siteresources.worldbank.org/INTWBIGOVANTCOR/Resources/tarawish.pdf

64. Wang, T., Shields, P. And Wang, Y., 2014. The Effects of Fiscal Transparency on Municipal Bond Issuances. Municipal Finance Journal, 35(1), 25-44.

65. Weber, A., 2012. Stock-Flow Adjustments and Fiscal Transparency: A Cross-Country Comparison. IMF Working Papers, WP/12/39.

66. Wehner, J. and de Renzio, P., 2012. Citizens, Legislators, and Executive Disclosure: The Political Determinants of Fiscal Transparency. World Development, 41, 96-108. doi: 10.1016/j.worlddev.2012.06.005

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67. Williams, A., 2009. On the release of information by governments: Causes and consequences. Journal of Development Economics, 89(1), 124-138. doi: 10.1016/j.jdeveco.2008.08.001

68. Williams, A., 2015. A global index of information transparency and accountability. Journal of Comparative Economics, 43(3), 804-824. doi: 10.1016/j.jce.2014.10.004

Some IPF references

69. Bađun, M. and Urban, I., 2009. Open Budget Index 2008 - Small Advances Made in the Accessibility of Information about Croatian Public Finance. Press Release, No. 8. Available at: http://www.ijf.hr/eng/releases/8.pdf

70. Bađun, M. and Urban, I., 2010. Croatia's Score on Open Budget Index 2010. Press Release, No. 26. Available at: http://www.ijf.hr/eng/releases/26.pdf

71. Bronić, M. and Urban, I., 2013. Croatia's score on the Open Budget Index 2012 - a slight improvement in the quality and comprehensiveness of budget information. Press Release, No. 47. Available at: http://www.ijf.hr/upload/files/file/ENG/releases/47.pdf

72. Bronić, M. and Urban, I., 2015. National budget transparency - a deterioration in the quality and comprehensiveness of government revenue and expenditure information. Press Releases, No. 85. Available at: http://www.ijf.hr/upload/files/file/ENG/releases/85.pdf

73. Bronić, M., Ott, K. and Urban, I., 2012. Local budget transparency: the case of 33 Croatian cities. Financial theory and Practice, 36(4), 355-371. doi: 10.3326/fintp.36.4.2

74. IPF, 2011. Citizens and Civil Society Demand Open Budgets. Press Releases, No. 33. Available at: http://www.ijf.hr/upload/files/file/ENG/releases/33.pdf

75. IPF, 2016. Understanding, monitoring and analysing local government budget transparency: Case study of Croatia and Slovenia – Open local budget index (OLBI). Available at: http://www.ijf.hr/eng/research/croatian-science-foundation-projects/1053/olbi/1064/

76. Ott, K. [et al.], 2016. Measuring online local budget transparency in Croatia – A way to enhance efficiency and accountability. (forthcoming)

77. Ott, K. and Bronić, M., 2015. Citizen Participation in Fiscal Policy and Budgetary Processes in Croatia. Newsletter, No. 96. doi: 10.3326/nle.2015.96

78. Ott, K. and Bronić, M., 2015a. Public participation in fiscal policy and budget processes in Croatia. Available at: http://www.fiscaltransparency.net/resourcesfiles/files/20150706114.pdf

79. Ott, K., 2014. New IMF Code of Fiscal Transparency: Citizens should be involved in fiscal decision-making. Press Release, No. 67. doi: 10.3326/pr.2014.67

80. Ott, K., Bronić, M. and Petrušić, M., 2013. Budget transparency of Croatian counties, cities and municipalities. Newsletter, No. 81. doi: 10.3326/nle.2013.81

81. Ott, K., Bronić, M. and Petrušić, M., 2014. Budget transparency of Croatian counties, cities and municipalities in 2013/2014. Newsletter, No. 87. doi: 10.3326/pr.2014.87

82. Ott, K., Bronić, M. and Petrušić, M., 2015. Budget transparency in Croatian counties, cities and municipalities (November 2014 – March 2015). Newsletter, No. 97. doi: 10.3326/nle.2015.97

83. Ott, K., Bronić, M., Petrušić M. and Stanić, B., 2016. Budget transparency in Croatian counties, cities and municipalities (November 2015 – March 2016). Newsletter, No. 107. doi: 10.3326/nle.2016.107

Some useful web sites

84. European Commission - Public opinion. http://ec.europa.eu/COMMFrontOffice/PublicOpinion/index.cfm/Survey/getSurveyDetail/instruments/STANDARD/surveyKy/2098

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85. Global civil society movement for budget transparency, accountability, and participation. http://www.internationalbudget.org/opening-budgets/international-advocacy/global-budget-movement/

86. High Principles on Fiscal Transparency. http://www.fiscaltransparency.net/eng/principles.php

87. IMF - Fiscal transparency. http://www.imf.org/external/np/fad/trans/ 88. International Budget Partnership. http://www.internationalbudget.org/ 89. OECD Best Practices for Budget Transparency. http://www.oecd.org/gov/budgeting/best-

practices-budget-transparency.htm 90. Open Budget Survey. http://www.internationalbudget.org/opening-budgets/open-budget-

initiative/open-budget-survey/ 91. Open Government Partnership. http://www.opengovpartnership.org/ 92. Principles of Public Participation in Fiscal Policy.

http://fiscaltransparency.net/PP_Approved_in_General_13Dec15.pdf 93. The Global Initiative for Fiscal Transparency (GIFT) http://www.fiscaltransparency.net/

Contact information

Katarina Ott Institute of Public Finance Smičiklasova 21, Zagreb, Croatia [email protected] Mihaela Bronić Institute of Public Finance Smičiklasova 21, Zagreb, Croatia [email protected]

139

INTERACTION OF FISCAL AND MONETARY POLICY IN CROATIA: BETWEEN

SCYLLA AND CHARYBDIS

Hrvoje Šimović

Abstract

In the last decade Croatia has experienced a dynamic economic and political path during which Croatia struggled with six years of recession and joined the EU. The observed period was characterized by uncoordinated economic policies and the lack of consistent fiscal policy partially due to the political instability, but also because of the lack of government’s efforts to implement substantial fiscal consolidation. This paper analyzes institutional characteristics and limitations of interaction of monetary and fiscal policy in Croatia, with special emphasis on future policy mix implications.

Keywords: fiscal policy, monetary policy, Croatia

JEL Classification: E63

Introduction

The aim of this paper is to analyze institutional characteristics and limitations of interaction of monetary and fiscal policy in Croatia. Focus and criteria for analysis of such interaction will be based on achieving economic policy goals. Regarding monetary policy, price stability is the main and only goal, while the main goals of fiscal policy are determined annually by Government’s Guidelines for Economic and Fiscal Policy. In Croatian Government’s Guidelines for Economic and Fiscal Policy 2016-2018 macroeconomic and economic stability are specified as main goals of economic policy, which primarily involve low inflation, economic growth and low unemployment (Ministry of Finance, 2015).

Economic characteristics are very important in the context of interaction of monetary and fiscal policy as they determine the maneuvering space and possibilities of policy makers to achieve before mentioned goals. Croatia is a small and open economy, so for theoretical framework of such analysis a Mundell-Fleming model can be consulted. First of all, the impossible trinity or trilemma should be mentioned in case of monetary policy. Generally, in international economics which states that it is impossible to have all three of the following at the same time: (i) a stable foreign exchange rate, (ii) free capital movement, and (iii) an independent monetary policy. In Croatian case it is obvious that there is no independent monetary policy, while hard peg and free capital movement exists. Further characteristic are complementary like highly eurised economy, dominant foreign ownership of the banking sector, no key rate channel and weak transmission mechanism. Such characteristics leave week maneuvering space for efficient interaction of fiscal and monetary policy.

In order to achieve the aim of this paper, after Introduction main monetary and fiscal policy developments are discussed. Fourth part of paper discusses fiscal and monetary policy interaction implications, such as recession, expectations and future focus. The final part is conclusion.

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1. MONETARY REGIME DEVELOPMENTS

Effects of monetary policy in Croatia can be analyzed only when bearing before mentioned circumstances in which domestic monetary system was built. The problem of high, chronicle inflation in ex-Yugoslavia and hyperinflation in 1992 and 1993 required strong anti-inflationary program that was implemented in 1994, with exchange rate as a monetary policy anchor (Ćorić et al., 2015).

Exchange rate stability is also important given the high degree of euroization and the banking sector that induced the introduction of the currency clause. This is a quasi-forward contract in the loan agreement which says that the exchange rate risk within the credit relationship is fully borne by the borrower. This runaway of savings into the foreign currency justifies a psychological phenomenon: the permanent fear of inflation and devaluation based on the experience from two or more decades ago (Ćorić, 2015 et al. 2015). Further, currency structure of broad money (M4) currently indicates (period after recession) that the share of foreign currency deposits is around 80%.

Figure 1 presents exchange rate stability and moderate inflation in Croatia in period 1995-2015. Basically, figure show that main and only goal of monetary policy – price stability, is achieved successfully via exchange rate anchor.

Figure 1 – Exchange rate stability and moderate inflation in Croatia 1995-2015

Source: CNB (2016)

Significant impact on the development of the system had the fact that domestic banking sector in late 90s was privatized and sold to foreign owners. In the conditions of weak local liquidity and the effort of the central bank to control money supply, local banks turned to foreign sources of resources. Such circumstances contributed to high level of external (and public) debt (see Figure 2). In circumstances of constant cheap cash inflows from abroad, central bank was completely ignored as a "lender of last resort". Its interest rates where and remained non-referent. Its money issuing function was reduced to an instrument of foreign exchange auctions, while the operations on open market as the main instrument of modern monetary policy were and are of secondary importance (for more details see Ćorić et al., 2015).

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2. FISCAL POLICY DEVELOPMENTS

On the other hand, fiscal policy plays a major role in the creation of the fiscal position and has a direct effect on economic activity. However, many indicators show that fiscal policy was not led in a prudent way as Croatia recorded constant fiscal deficits regardless of the positive GDP growth rate before the crisis (see Figure 2 and 3). Figures 2 and 3 present basic macroeconomic imbalances that were contributed by current policy mix.

The real need for fiscal consolidation after the outburst of recession and joining the EU has additionally caused (social) resistance to the changes and also provoked the instability of the government. Two governments and even 3 prime ministers and 4 ministers of finance have changed in Croatia in period from 2008 till 2015. Excessive deficit procedure (EDP) and Macroeconomics imbalances procedure (MIP) additionally contributed to political instability and repulse of general population regarding major structural reforms.

It is necessary to point out that during that whole period, the stability of Croatian financial system was preserved, mostly due to countercyclical macro-prudential policy of central bank and the fact that there were no unforeseen budget costs required to restructure the banking sector, as it was the case in many EU countries, resulting in rising pressures on public sector budgets. Discretionary fiscal policy and economic policies were mainly conducted by increasing taxes in order to reduce budget deficit, while government spending was led by “policy of doing nothing” which resulted in absence of structural reforms that are necessary to support long-term sustainable economic growth. Moreover, the announcement of politically unpopular fiscal measures regarding the fiscal consolidation, whether they were actually implemented or not, has had a negative impact on economic activity and investment climate.

Figure 2 – External and public debt

Source: CNB (2016)

Without reforms and fiscal consolidation, public deficit, financing needs and public debt significantly increased, with the latter moving above 60% of the GDP, thus breaking both fiscal rules from the Maastricht agreement and putting Croatian credit rating in speculative grade. In such conditions, maneuvering space of fiscal policy was significantly reduced.

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Figure 3 – GDP growth rate and fiscal deficit

Source: CNB (2016)

3. POLICY INTERACTION IMPLICATIONS: RECESSION, EXPECTATIONS AND

FUTURE FOCUS

Global financial and economic crisis revealed the weaknesses of Croatian economic model and policy mix. Croatian economic model is based on capital inflows, credit and construction boom and expansionary fiscal policy. The problems with the liquidity and lower demand followed by the economic downturn in the European Union (EU) very quickly turned into a multi-year recession, with which Croatia is still faced. Croatia was only EU member state that was 6 years (2009-14) continuously in recession (Figure 3).

Monetary conditions tightened but were accompanied by lower demand in private sector as both, corporate and households, started to deleverage. Unfortunately, the contribution of the central bank to prevent negative trends is more than limited, because it is almost impossible to significantly change the existing conditions in the monetary sphere of the economy. Transmission channel is limited by the ownership structure of the banking sector and low demand for loans and if the central bank decides to abandon the exchange rate anchor that would inevitably lead to strong depreciation and would directly affect most of the debtors who are bound by the foreign currency clause (Ćorić et al., 2015).

Similar can be applied to public debt which is mostly financed from abroad, i.e., with currency clause in the domestic financial market. The possible positive effect of depreciation on the export sector and on the increase of competitiveness could be offset by above mentioned effects on debts and the increase of energy and intermediate products. On the other hand, the abolition of the currency clause would lead to significant imbalance in the balance sheets of the banks (Ćorić et al., 2015).

Neither monetary nor fiscal policy could contribute much for some kind of expansive policy mix. Like the title of paper Croatia was between Scylla and Charybdis. Eric Leeper (2010) suggested another interesting title “Monetary Science, Fiscal Alchemy”. Same applies to Croatia where “monetary policy decisions tend to be based on systematic analysis of alternative

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policy choices and their associated macroeconomic impacts: this is science. While fiscal policy choices, in contrast, spring from unsystematic speculation, grounded more in politics than economics: this is alchemy” (Leeper, 2010).

If the monetary policy and price stability have no alternative, Croatia has to accomplish reliable fiscal position as soon as possible. This implies a number of reforms within the public sector which will contribute fiscal consolidation. It implies serious long-term budget planning and adequate public debt management, thereby insuring the fiscal sustainability and return of confidence within the domestic and international financial market.

Table 1 – Croatia credit rating and outlook

Year Moody's Investors Service Standard & Poors Fitch Ratings

2008 Baa3/posit. BBB/stab. BBB-/stab.

2009 Baa3/stab. BBB/stab. BBB-/neg.

2010 Baa3/stab. BBB-/neg. BBB-/neg.

2011 Baa3/stab. BBB-/neg. BBB-/neg.

2012 Baa3/neg. BB+ BBB-

2013 Ba1/neg. BB+ BB+ /stab.

2014 Ba1/neg. BB/stab. BB+/neg.

2015 Ba1/neg. BB/stab. BB/stab.

Source: web pages of Moody’s, S&P and Fitch

Figure 4 – Coupon interest rates CEE (Eurobonds)

Source: Bloomberg

Such task is rather difficulty regarding Croatia has to refinance its debt, and at the same time having credit ratings downgraded continuously for several years with mostly negative outlook (Table 1). Financial markets respond to such macroeconomic imbalances and also political (in)stability. If there will be no insurance of fiscal sustainability and credible fiscal policy, cost of refinancing public debt will continue to be rather high, compared to other CEE countries. Croatia currently has one of the highest risk premiums compared to CEE countries (Figure 4).

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4. INSTEAD OF CONCLUSION

Aforementioned fiscal and monetary policies resulted in public debt explosion which increased from 36% of GDP in 2008 to 85% of GDP in 2015. In meanwhile, European commission activated Excessive deficit procedure (EDP) and Macroeconomic imbalances procedure (MIP) for Croatia. Combined with recessionary trends, this resulted in downgraded credit-rating with a negative outlook ranked by the „Big Three“ credit rating agencies. Moreover, the risk premium increased significantly in comparison with other Central and Eastern European (CEE) countries alike and conditions of financing and refinancing worsened sharply, in both public and private sector. In the post-recession period from 2015 onwards, forecasts predict small real GDP growth rates in the next several years that should not surpass 2%. Apart from GDP and employment growth, main objectives of economic policy-makers will be sustainability of public debt due to risks of high debt-to-GDP ratio and its growth in the previous years. The need for fiscal consolidation in periods of slow economic growth and the fact that interest expenses amount to 3.5% of GDP will make policy-maker's jobs even more difficult. Furthermore, Croatia's economic and political plans include (obligatory) joining the Euro area, i.e., adopting the Euro. It is for certain that Croatia in medium-term period won't be able to fulfill all the convergence criteria due to its high debt-to-GDP ratio. However, there is definitely space in the future to secure fiscal stability and membership in The Exchange Rate Mechanism (ERM II) in order to establish conditions for adopting of the Euro.

Acknowledgements

This work was supported by the Croatian Science Foundation under Grant IP-2013-11-8174.

References:

1. CNB (2016), Croatian National Bank – Statistics. Available at: http://www.hnb.hr/en/statistics

2. Ćorić, T., Šimović, H. & Deskar-Škrbić, M. (2015). Monetary and fiscal policy mix in a small open economy: the case of Croatia, Economic research-Ekonomska istraživanja, 28(1), 407-421.

3. Deskar-Škrbić, M., Šimović, H. & Ćorić, T. (2014), The Effects of Fiscal Policy in a Small Open Transition Economy: The Case of Croatia, Acta Oeconomica, 64(S1), 133-152.

4. Law on Croatian National Bank; National Gazette, no. 75/2008. and 54/2013 5. Leeper, E.M. (2010). Monetary Science, Fiscal Alchemy. NBER Working paper No.

16510). Retrieved from: http://www.nber.org/papers/w16510.pdf 6. Ministry of Finance (2015), Guidelines for Economic and Fiscal Policy 2016-2018.

Zagreb: Ministry of Finance.

Contact information

Hrvoje Šimović University of Zagreb J.F. Kennedy 6, Zagreb, Croatia [email protected]

145

PENSION SYSTEM BALANCE SHEET DEVELOPMENT MODEL UNTIL

2066

Petra Škarýdová

Abstract

In this paper, three scenarios of the development of old-age pension expenditures (positive, realistic and negative) are simulated in correlation to the development of the average gross wage, average old-age pension, population ageing, employment rate and population in retirement age. On the basis of these data since 1990 and their simulation using statistical analysis models and visualisation, a future expected income estimate and pension system expenditures are calculated.

The hypothesis is either to confirm or disprove the sustainability of the current pension system. The amount of the replacement rate that will reach nearly 57% in 2066, being the current average for ECD countries, is one of the assumptions of the analysis. Another assumption is that the current level of payments in the pension system will be maintained.

Keywords: average gross wage, average old-age pension, economically active population,

demographic development

JEL Classifiaction: H68, H55

Introduction

The population development not only in the Czech Republic is characterized by the process of demographic ageing which, according to the data available, will become even more intensive in the coming years. In addition, according to the data of the Czech Statistical Office, we can expect population decline from 2014 onwards.

In connection with adverse prospects in the population age structure, the debate regarding the unsustainability of the current pay-as-you-go system is quite relevant. So far, the government has implemented some parametric changes and the pension reform, which was not well received. At present, there are even discussions in the expert committee to cancel the second pillar entirely. It appears that the parametric changes do not resolve the sustainability issue from the long-term perspective. Today, it is obvious that the second pillar was not well received by the general public. The number of participant is very low and currently all pension companies together have approx. 89,000 participants (in the first two years, each company should have recruited at least 50,000 participants). Due to the current situation, this analysis does not take into account the existence of the second pillar.

In this paper, three scenarios of the development of old-age pension expenditures (positive, realistic and negative) are simulated in correlation to the development of the average gross wage, average old-age pension, population ageing, employment rate and population in retirement age. On the basis of historical data from the ČSÚ and MoLSA, the future until 2066 was modelled using the program for statistical analysis and data visualisation. All models used in this paper have been test at the 95% significance level.

The hypothesis in this paper is to establish whether or not the current pension system is sustainable in the future. To facilitate the calculation, the future pension is calculated from the historical relation of the average gross wage and old-age pension, population, and number of the employed.

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Based on these data, the expected future income and pension system expenditures are calculated (only old-pension expenditures are taken into account as expenditures).

1. AVERAGE QUANTITIES DEVELOPMENT MODEL

To calculate the average quantities, the data from the Czech Statistical Office from 1990 to 2014 were used. This period was chosen deliberately, as it covers the entire economic cycle.

The estimate of the average gross wage was calculated using the quadratic function allowing to estimate the gradual slowdown of the wage growth-rate.

To calculate the future development of the average old-age pension, the ratio of the average pension to the average gross wage was used. The share of the quantities addresses the valorization of old-age pensions. To model the trend, Holt’s Linear Exponecial Smoothing which fared best in all tests for excessive oscillation, excessive deviation over and under median, excessive autocorrelation, difference in variance and at the same time having the lowest value of a potential error was used.

The values were verified at 95% significance level, with P-value being lower than 5% for all values , therefore statistical significance of this research is expected.

1.1 Average Gross Wage Development

In recent years, wages in the Czech Republic have grown very slowly compared to the wage growth in 1990s and in fact posted a real decline due to inflation. What is the reason behind it? "Because we are a country of employees. Standard economy is based on small and medium-sized

enterprises financed by domestic capital. However, here, the foreign capital subsidized directly

or indirectly to the detriment of local business dominates.”1 says the economist Pavel Kohout. The revenues and dividends derived from them disappear abroad which has an impact in the Czech Republic.

High unemployment rate and very low creation of new jobs is responsible for the stagnation of wages. This July, the unemployment reached 7.4 % .2 From the long-term perspective, based on the data 3 from ČSÚ the unemployment rate can be considered as high for the Czech Republic, even though in the EU, the Czech Republic was one among the countries with the lowest unemployment rates in 2013.4 The crisis is the most persistent in the fields employing less qualified workforce and thus the lower income groups have the least wage increases.

On the basis of historical data, the following chart shows three alternatives of the potential development of AGW from 2015 to2066. The extreme values for each alternative for 2015/2066 are the following:

- optimistic alternative AWG CZK 29,152/76,015.1, - realistic alternative CZK 27,934.9/57,076,

- pessimistic alternative CZK 26,717.9/38,136.8.

1 O2ACTIVE. Half of the Czechs earn less than CZK 111 per hour. The Polish are wealthier. (2014-04-02). Available at://zpravy.o2active.cz/detail.aspx?id=179620 2 ČSÚ. Latest economic data. (2014-08-26) Available at: http://www.czso.cz/csu/csu.nsf/aktualniinformace 3 ČSÚ. (2014-08-26) Available at: http://vdb.czso.cz/vdbvo/tabparam.jsp?voa=tabulka&cislotab=PRA1010CU&&kapitola_id=3 4 NOVINKY. The unemployment in the Czech Republic is the sixth lowest in EU. (2014-08-26) Available at: http://www.novinky.cz/ekonomika/333667-nezamestnanost-v-cesku-je-sesta-nejnizsi-v-eu.html

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These values will further be reflected in other calculations.

Figure 1 - Forecast of the development of average gross wage in 2015 – 2066

Source: Finance5, own calculations

1.2 Average old-age pension development

The average old-age pension amount is influenced by the increase of the old-age pension paid, and their growth is mostly influenced by the so-called generation exchange. This exchange means that the average amount of the old-age pensions paid would grow even if they were not valorized as the claims to old-age pensions by older pensioners that are lower on average than the newly awarded pensions expire.6 Since 2003 according to the law, all pensions (not only the old-age ones) have been regularly increased as of January of each year, the new law specifies the minimum increase, being 100 % of the price growth and 1/3 of the real wages growth. The increases of the provided pensions made in 2006 and 2007 exceeded the minimum amount specified by the law by 1.9 percentage point. Other increases from 2003 to 2008 exceeded the minimum amount specified by the law by 0.1 - 0.3 percentage point. As a response to the increased valued added tax, the pensioners continued to receive an extra contribution of CZK 1,000. However, this contribution is not included in the pension expenditures.7 In 2009, the expenditure started to exceed the income significantly. The drop in the income from premiums to 96,8% against 2008 and significant growth of expenditures arising from the pension valorization contributed greatly to the increase. In 2010, the valorization of pensions was not made, as the statutory condition was not complied with. The expenditures in 2011 were influenced by the valorization of pensions and response by the policy holders to changes in the pension calculation method. The deficit in 2011 posted a record of CZK 39.5 billion.8 In 2012 and 2013, there valorization of pensions was made, while in 2013 it was lower than expected due to savings. Since January 2015, the pensions will grow on average by

5 FINANCE. Pensions and benefits. Available at: http://www.finance.cz/duchody-a-davky/duchody-v-cislech/vyvoj-starobnich-duchodu/ 6 THE MINISTRY OF LABOUR AND SOCIAL AFFAIRS. Actuarial Report on Pension Insurance 2012. (2014-04-02). Available at: http://www.mpsv.cz/files/clanky/13783/PMZ-2012.pdf 7 THE MINISTRY OF LABOUR AND SOCIAL AFFAIRS. Actuarial Report on Pension Insurance 2008. (2014-04-02). Available at: http://www.mpsv.cz/files/clanky/5886/zprava_2008_cz.pdf 8 THE MINISTRY OF LABOUR AND SOCIAL AFFAIRS. Actuarial Report on Pension Insurance 2012. (30/08/2014). Available at: http://www.mpsv.cz/files/clanky/13783/PMZ-2012.pdf

0

10000

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Optimistic AWG forecast Realistic AWG forecast Pessimistic AWG forecast

148

1.8%, i.e. CZK 250. Therefore, from the next year the valorization will return to the inflation growth and 1/3 of the real wages growth model. The pensions are to grow by the said 1.8 % should the calculation specified in the law be lower. The limitations by enforced the previous government will thus be terminated earlier. Since 2013 the pensions were to be valorized by 1/3 of inflation and 1/3 of the real wages growth.9

The calculation will reflect the replacement rate which is being steadily increased to reach nearly 57% in 2066 which is the current average of OECD countries.10 Such high replacement rate is taken into account deliberately due to the fact that in OECD countries, the Czech Republic is among the countries with lowest replacement rates. In the future, there is an assumption that the Czech Republic will try to match the more developed countries with regard to this indicator. At the same time, it is expected that the average of OECD countries would move significantly upwards, with the reason being that the population ageing will impact globally all states. The pensions systems across the OECD and EU countries will face the problem of sustainability and the government try to bring forward reforms.

The following Table No. 1 and Chart No. 2 show possible forecasts of the average old-age pension development for optimistic, realistic and pessimistic alternatives in 2020 – 2066.

Table 1 - Forecast of average old-age pensions amounts in CZK in 2020 – 2066

Year

Optimistic alternative of the old-age pension amount

Realistic alternative of the old-age pension amount

Pessimistic alternative of the old-age pension amount

2020 15,426 14,632 13,836

2025 18,004 16,795 15,585

2030 20,979 19,179 17,377

2035 23,754 21,232 18,709

2040 26,670 23,267 19,862

2045 29,798 25,333 20,867

2050 32,859 27,185 21,510

2055 36,037 28,971 21,905

2060 39,395 30,731 22,066

2066 43,423 32,605 21,785

Source: ČSÚ11, own calculations

9AKTUÁLNĚ.CZ. The pensions will grow faster. The senate confirmed the end of budget cuts. (30/08/2014). Available at: http://zpravy.aktualne.cz/finance/duchody-porostou-rychleji-senat-potvrdil-konec-skrtu/r~07b3a2ba130811e489070025900fea04/ 10 TÝDEN.CZ. Pension vs. average wage ratio? The Czech Republic falls behind its neighbours. (17/08/2014). Available at: http://www.tyden.cz/rubriky/byznys/cesko/pomer-duchod-v-prumerny-plat-cesko-kulha-za-sousedy_228503.html#.U_MFEpBIvmg 11 CZECH STATISTICAL OFFICE. Average monthly pension amount by the type. (12/04/2014). Available at: http://www.czso.cz/cz/cr_1989_ts/1304.xls

149

Figure 2 - Forecast of average old-age pensions amounts in 2020 – 2066


2. DEMOGRAPHIC DEVELOPMENT

For the final balance sheet of the system, the population, number of the employed and old-age pensioners until 2066 must be established. The demographic data were obtained from ČSÚ. They are sorted by gender and date of birth, and based on these data the numbers of old-age pensioners in individual years were calculated.

2.1 Development of the number of the employed and old-age pensioners until 2066

Due to the fact that until 2066 the population will dramatically decline and the number of old-age pensioners will increase according to the available data, we base our conclusions on the fact that both economically active population and the number of the employed contributing in the pension system will decline. The Czech Statistical Office even anticipates that there will be approx. 37.8% of the employed from the total population in 2050.13 The following chart shows the number of the old-age pensioners and the employed in1993 – 2066.

12 CZECH STATISTICAL OFFICE. Average monthly pension amount by the type. (12/04/2014). Available at: http://www.czso.cz/cz/cr_1989_ts/1304.xls 13 CZECH STATISTICAL OFFICE. Models of the expected development on the labour market in the Czech Republic

until 2050. (12/04/2014). Available at: http://www.czso.cz/csu/tz.nsf/i/modely_predpokladaneho_vyvoje_trhu_prace_v_cr_do_roku_2050_20121115

0

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2020 2025 2030 2035 2040 2045 2050 2055 2060 2066

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Pessimistic alternative of the old-age pension amount

150

Figure 3 - Forecast of the number of the old-age pensioners and the employed in 1993 – 2066


It is clear from the chart that the number of the employed will rapidly decline in the economy and the number of old-age pensioners will slowly grow .

3. PENSION SYSTEM BALANCE SHEET DEVELOPMENT

According to the last study of Allianz, the Czech Republic is among the countries with an increasing risk level with regard to the unsustainability of the pension system.15 Over the last three years, the Czech Republic lost three position, with population ageing and rapidly growing state debt being responsible for the drop. In 2010, the expenditures to all pensions amount to approx. 9% of GDP. The experts from Allianz agree that "Due to the increasing number of pensioners in

relation to the people in productive age it is now clear that the private insurance or pension

savings will play an ever increasing role.“16 Today, the private insurance model works very well e.g. in Australia which is at the same time positioned on the top of the said ranking.

The income of the pension system and expected expenditures on old-age pension in three alternatives data were calculated using the data above. According to Chart No. 4, it is clear that all are deficit ones. Table No. 2 demonstrates the forecast deficit amount.

When the calculations were made, the assumptions that the payments in the pension system will remain at the current level and 80% of income of the pension system will continue to be released for old-age pensions, and the remaining 20% will be released for other types of pensions, was taken into account. Should the same level of payments be maintained, it will not be sufficient to cover the old-age pensions and these expenditures will increase the deficit of the state budget. At present, the state old-age pension constitutes 95% of the income of pensioners which is very unusual compared to other countries.

14 CZECH STATISTICAL OFFICE. Selected demographic data in the Czech Republic. (12/04/2014). Available at: http://www.czso.cz/cz/cr_1989_ts/0101.xls 15ALLIANZ. Allianz Sustainability Study. (28/08/2014). Available at: http://www.allianz.cz/vse-o-allianz/tiskove-centrum/tiskove-zpravy/studie-allianz-o-udrzitelnosti.html 16 POJIŠTĚNÍ V PRAXI. The Czech Republic lost position in the pension system sustainability level ranking. (01/05/2014). Available at: http://www.pojistenivpraxi.cz/cesko-si-pohorsilo-v-zebricku-miry-udrzitelnosti-duchodoveho-systemu/

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Conclusion

In this paper, an estimate of the pension system deficit is calculated on the basis of historical data and using statistical models, as well as on the basis of the average wage development, the growth rate of which has been on steady decline since 1990s, in three alternatives (optimistic, realistic and pessimistic) and the average old-age pension.

For the purposes of the calculation, the expected pension system balance sheet, the share of the employed and old-age pensioners was calculated in individual years. The calculation takes into account an assumption of the Czech Statistical Office that there will be approx. 37.8% of the employed from the total population in 2050. According to the calculations from the available data, the number of the employed will decline rapidly in the economy, while the number of old-age pensioners will grow at slow rate.

The income of pension system, assuming that the payments in the pension system will remain at the current level and 80% of income of the pension system will be released for old-age pensions, was calculated. The replacement rate that increases steadily in the model and which will reach nearly 57% - the current average of OECD countries - in 2066, was another important assumption.

On the basis of the assumptions made, the paper confirms the hypothesis that the current pension system is not sustainable in the future in the existing form and must be modified.

The main benefit of this paper is that future demands of the current pension system were put under scrutiny.

Acknowledgement

The paper was conceived as part of the "Financing the Field of Productive Services" project supported from the specific university research at the University of Finance and Administration.

References:

1. AKTUÁLNĚ.CZ. The pensions will grow faster. The senate confirmed the end of budget

cuts. (30/08/2014). Available at: http://zpravy.aktualne.cz/finance/duchody-porostou-rychleji-senat-potvrdil-konec-skrtu/r~07b3a2ba130811e489070025900fea04/

2. ALLIANZ. Allianz Sustainability Study. (28/08/2014). Available at: http://www.allianz.cz/vse-o-allianz/tiskove-centrum/tiskove-zpravy/studie-allianz-o-udrzitelnosti.html

3. CZECH STATISTICAL OFFICE. Average monthly pension amount by the type. (12/04/2014). Available at: http://www.czso.cz/cz/cr_1989_ts/1304.xls

4. CZECH STATISTICAL OFFICE. Models of the expected development on the labour market in the Czech Republic until 2050. (12/04/2014). Available at: http://www.czso.cz/csu/tz.nsf/i/modely_predpokladaneho_vyvoje_trhu_prace_v_cr_do_roku_2050_20121115

5. CZECH STATISTICAL OFFICE. Selected demographic data in the Czech Republic. (12/04/2014). Available at: http://www.czso.cz/cz/cr_1989_ts/0101.xls

6. CZECH STATISTICAL OFFICE. Employment and unemployment since 1993. (12/04/2014). Available at: http://vdb.czso.cz/vdbvo/tabparam.jsp?voa=tabulka&cislotab=PRA1010CU&&kapitola_id=3

154

7. CZECH STATISTICAL OFFICE. Latest economic data. (2014-08-26) Available at: http://www.czso.cz/csu/csu.nsf/aktualniinformace

8. CZECH STATISTICAL OFFICE. (2014-08-26) Available at: http://vdb.czso.cz/vdbvo/tabparam.jsp?voa=tabulka&cislotab=PRA1010CU&&kapitola_id=3

9. EUROPEAN COMMISSION. 2010. Joint Report on Pensions. Brussel: 2010 10. EUROPEAN COMMISSION. 2012. The 2012 Ageing Report Economic and budgetary

projections for the 27 EU Member States (2010-2060). European Union, 2012. ISBN 978-92-79-22850-6.

11. FINANCE. Pensions and benefits. Available at: http://www.finance.cz/duchody-a-davky/duchody-v-cislech/vyvoj-starobnich-duchodu/

12. THE MINISTRY OF LABOUR AND SOCIAL AFFAIRS. Actuarial Report on Pension Insurance 2012. (2014-04-02). Available at: http://www.mpsv.cz/files/clanky/13783/PMZ-2012.pdf

13. THE MINISTRY OF LABOUR AND SOCIAL AFFAIRS. Actuarial Report on Pension Insurance 2008. (2014-04-02). Available at: http://www.mpsv.cz/files/clanky/5886/zprava_2008_cz.pdf

14. THE MINISTRY OF INTERIOR OF THE CZECH REPUBLIC. Future of European pensioners. (2014-08-37). Available at: http://www.mvcr.cz/clanek/evropska-unie-2010-budoucnost-evropskych-duchodu.aspx

15. NOVINKY. The unemployment in the Czech Republic is the sixth lowest in EU. (2014-08-26) Available at: http://www.novinky.cz/ekonomika/333667-nezamestnanost-v-cesku-je-sesta-nejnizsi-v-eu.html

16. OECD. 2012. Pensions Outlook 2012. OECD Publishing, 2012. ISBN 978-92-64-16940-1 17. OECD. 2011. Pensions at a Glance 2011 Retirement-income systems in OECD and G20

countries. OECD, 2011. ISBN 978-92-64-09628-8 18. O2ACTIVE. Half of the Czechs earn less than CZK 111 per hour. The Polish are wealthier.

(2014-04-02). Available at://zpravy.o2active.cz/detail.aspx?id=179620 19. POJIŠTĚNÍ V PRAXI. The Czech Republic lost position in the pension system

sustainability level ranking. (01/05/2014). Available at: http://www.pojistenivpraxi.cz/cesko-si-pohorsilo-v-zebricku-miry-udrzitelnosti-duchodoveho-systemu/

20. TÝDEN. CZ. Pension vs. average wage ratio? The Czech Republic falls behind it neighbours. (17/08/2014). Available at: http://www.tyden.cz/rubriky/byznys/cesko/pomer-duchod-v-prumerny-plat-cesko-kulha-za-sousedy_228503.html#.U_MFEpBIvmg

Contact information

Petra Škarýdová University of Finance and Administration Estonská 500, Prague 10, Czech Republic [email protected]

155

NEGATIVE INTEREST RATES: IMPACTS ON BANKING SECTOR

Pavel Štěpánek, Eva Zamrazilová

Abstract

Basic interest rates set by central banks have been extremely low for historically long period of time. Temporary measures have become a new normal of monetary policy. Zero has proved not to be a lower bound for central bank policy rates. While the expected positive outcomes for real economy have not proved to be strongly convincing, potentially dangerous side effects of negative interest rates have been rather downplayed by policy makers. In particular, the negative interest rates have started to undermine the roots of traditional banking business models. Moreover, asset price inflation, incentives for excessive financial risk-taking and deficits in pension schemes seem to threaten financial stability in the future.

Keywords: monetary policy, interest rates, central banks, banking sector

JEL Classification: E43, E44, E58, G21

1. NEGATIVE INTEREST RATES: INTRODUCTION AND GOALS

Monetary policy has remained extremely accommodative during a historically longest period of time with extremely low interest rates in recent years. Traditional views saw zero as a lower bound for interest rates of central banks. This barrier was first broken by European Central Bank (ECB) on June 11th 2014, when the ECB decided to cut the deposit rate to -10 basis points. Second in a row was the Denmark Nationalbank (DN) which cut the rate on certificates of deposit to – 5 basis points on September 5th 2014. Swiss National Bank (SNB) followed on December 18th 2014 setting the interests on big sight deposit into the negative territory of – 25 basis points (effective 5 weeks later, ie., as of 22nd January , 2015). Swedish Riksbank (RIX) announced the cut of basic repo rate to -10 pb on 18th February 2015. The fifth central bank broking the zero threshold was Bank of Japan (BOJ) on January 29th 2016 when the rate of -10 basis points was introduced to part of the balances of current accounts.

Later on, the ECB lowered its deposit rate to -20 bp in September 2014, to -30 bp in December 2015 and further to -40 bp in March 2016. SNB announced further cuts of 50 bp in January 2015 along with the abandoning of FX floor to EUR. Strong pressures on appreciation of the Danish currency following the Swiss exit led the DN to four further cuts (in January to February 2015) which placed the rate on certificates on deposits into negative territory of -75 basis points. In early 2016 a slight reversal to -65 bp was realized. As for the RIX, three cuts were made in the course of one year, pressing the basic reporate to – 50 bp valid from February 2016. Figure 1 presents the developments of average remunerations of liabilities of those five central banks.

156

Figure 1 - Average remuneration of central bank liabilities, in basis points

Source: BIS (2016)

2. LOOSE MONETARY POLICY AND REAL ECONOMY

The narrative behind introduction of negative policy rates was primarily the fulfilling of inflation targets. However, policy rates have also been affecting the developments of the currency. Therefore, preventing the currency against appreciation or trying to support economic growth by depreciation has always been a part of the story. Negative rates should have boosted both main channels of domestic demand – consumer demand and investments. Customers were expected to benefit from lower mortgage rates and businesses by easier access to loans. At the same time, banks were expected to profit from lower funding costs. These scenarios, however, turned out into a little bit different reality. Loosening of monetary policy has not pushed many consumers to spending. Low or zero interest rates on deposits, in particular in ageing societies may paradoxically increase precautionary savings and weaken consumption. Many savers that were historically accustomed to annual non-risk yields amounting to 3-4 % increased the volume of savings to guarantee the formerly expected targeted volume. Simply put, at very low rates the need to save more for retirement becomes more evident.

The demographic structure plays role - elder cohorts are prone to more savings while the younger generation tend to loans taking. Monetary policy should adjust the theoretical background for this important factor. At the same time, households' confidence may be shaken by the prospect of negative nominal interest rates. A recent survey (see BIS, 2016) finds that only a small percentage of households would spend more if faced with negative rates, while a similar percentage would actually spend less.

This obstacle to transmission from low rates to spending has been amplified by large underfunding of pension funds. Pension schemes have been under stronger and stronger pressures as it is almost impossible to find yields with acceptable balance of risk and yield. At the same time, funding deficits in corporate pension plans may constrain companies' capacity to make new investments. Generally, the easy monetary policy itself cannot support investment demand. As Borio (2016) states: “easy monetary policy cannot and in fact it should not – bring idle cranes back to life when there is an oversupply of buildings“.

157

Table 1 - Economic growth and inflation

2014 2015 H1 2016

GDP, y/y, % HICP, y/y, % GDP, y/y, % HICP, y/y, % GDP, y/y, % HICP, y/y, %

Euroarea 0.9 0.4 1.7 0.0 1.6 0.1

Denmark 1.3 0.4 1.0 0.2 0.3 0.1

Sweden 2.3 0.2 4.2 0.7 3.6 0.8

Switzerland 1.9 0.0 0.8 -0.8 0.7 -0.4

Japan -0.1 2.7 0.6 0.8 0.4 -0.4

Source: OECD

The years of ultra –loose monetary policy have not brought any convincing results as for fulfilling the inflation targets. Inflation seems to be stubbornly low and most probably will continue to be below the targets in the foreseeable future (unless some unexpected increase of oil price occurs). The goal of price stability objective thus seems to be equally far away like before the introduction of negative rates. On the other hand, economic activity has been recovering in Euroarea, while Sweden has been witnessing robust economic growth. Therefore, it is evident that the relationship between inflation (measured by standard HICP) and economic growth does not hold to an extent that is built in the models of central banks.

The lower were the basic interest rates pushed down the lower seem to be the efficiency of monetary transmission mechanism. A good example is the development of mortgage rates in Denmark and Switzerland – Figure 2. Obviously, the introduction of negative rates did not lead to appropriate decline in mortgage rates and thus to expected benefits for customers in these two countries. The monetary transmission mechanism is most probably impaired especially by the fact that retail bank deposit rates remain sticky. In Q2/2016, Danish mortgage rates were roughly the same like two years ago, a very moderate decline is visible for Switzerland. It is contrasting with increasing negative remunerations that declined to -28.5 basis points and to -18 basis points for Swiss and Danish banks respectively.

Figure 2 - Mortgage rates in Denmark and Switzerland

Source: BIS, 2016

0,00

0,50

1,00

1,50

2,00

2,50

3,00

3,50

4,00

Mortgage rate: Switzerland Mortgage rate: Denmark

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3. NEGATIVE INTEREST RATES: THE IMPACT ON BANKING SECTOR

Banks need reasonable profits to carry out their intermediation function – transformation of short-term deposits into long-term loans. The main source of revenue for most banks is net interest margin. Borio at al. (2015) find that the correlation between the level of interest rates and the steepness of the yield curve, on the one hand, and ROA, on the other, is positive: higher rates and a steeper yield curve boost profitability of banks. On the other hand, declining spreads between bank lending and deposit rate have been pressing the profitability of banks down.

Interest revenue has been generally pressed by weak credit demand combined with declining interest rates. Pressures on net interest margins are particularly pronounced among banks from countries where negative rates were introduced. The policy makers expected that the banks would profit from lower funding costs after the introduction of negative monetary policy rates on deposits. However, many banks in Denmark, Sweden and Switzerland, for example, have experienced declining net interest margins over recent years, with the compression in interest income often outpacing the reduction in interest expenses. Banks have until now refrained from cutting retail deposit rates below zero in order to retain customers. Banks that rely heavily on retail deposits have seen their interest expenses decline less than their more wholesale-funded peers. It is well visible on the comparison between different banking models in Denmark, Switzerland and Sweden.

Table 2 - Sensitivity of interest expenses to funding models

Customer deposits/total assets (%) Change in interest expenses/total assets (percentage points)

Switzerland (34) Denmark Sweden Switzerland (34) Denmark Sweden

64.79 61.42 27.76 -1.45 -2.44 -2.99

Source: BIS, 2016

Table 2 indicates that the more is the banking model based on retail funding, the smaller are benefits from declining interest rates expenses. Swiss banks are the most retail funded ones with the ratio between customer deposits and total assets at 65 % on average. The decline in interest rate expenses (to total assets) amounted to mere 1.45 percentage points. Swiss banks registered decline in gross interest income by 1.81 % on average and by net interest income by 0.44 on average. The impact of low and negative interest rates on the basic source of banking income is thus evidently adverse. On the opposite side is Sweden where the ratio of deposit/assets is only at 28 % and the impact of interest expenses was more profound at -3 percentage points.

The risks to the banking system due to low yields environment may lead to a change in the business model of banks from interest rate profits towards fee-based approach. This means the transfer of costs to the clients more or less indirectly. This is the case particularly in Denmark, where the change in net income from fees (in % of total assets) increased by 0.9 percentage points – see BIS (2016)

Another risk stemming from artificially low interest rates may be masking of credit risks by compressing borrowers’ debt service burdens. They also provide incentives for banks to postpone write-offs and thus prevent restructuring. It is well visible in some euro area countries, where the legacy of non-performing loans (NPL) seems to be still unresolved. Even though some progress has been made to address NPLs, recent data from the European Banking Authority (EBA, 2016a) indicate that the overall level of NPLs remains high by historical standards. In March 2016, the volume of non-performing loans amounted to around 1 billion EUR and represented 5.7 % of loans on average in EU. The share of NPLs differs considerably

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across the EU and Eurozone. The improvements have also been very uneven across various countries. Therefore, in many countries high share of NPLs in balance sheets restrain lending activities of the banks as well as hurt their profitability. Obviously, there are no “one size fits all” solutions. Past experience shows that authorities can help improve banks’ incentives via changes to the tax code, by lowering obstacles to collateral sales, as well as addressing obstacles to debt restructuring.

Figure 3 - Ratio of non-performing loans, (%), selected countries

Source: EBA

Not only the ratio of non-performing loans differs across various jurisdictions, but also the pace of credit restoration has been very uneven as indicated in Table 3. As for the Eurozone as a whole, the average of 5.7 % of non- performing loans does not seem to be hindering the banking sector from fulfilling its basic intermediary function. Credit activity in euro area as a whole seems to be recovering both in the sector of households and corporate – see Table 3.

However, the figures vary strongly across the euro area. It seems to be in line with basic intuition that in countries with lowest NPLs like Germany, the Netherlands, Belgium and Austria, loans have been growing above average. However, the countries suffering by high NPLs, in particular Ireland, Italy, Portugal, Slovenia and Spain have not witnessed the recovery of banking intermediation function yet. The exception is consumer credit in Italy, Spain and Portugal. However, this cannot be perceived as a sign of balanced economic recovery, the corporate sector has been still reporting declines of loans in these countries. This may be a result both of low supply capacities of banking sector to offer loans and/or weak demand from the part of the corporate sector. In the countries with pre-crisis legacy of massive credit misallocation leading to present high volumes of NPLs, monetary policy itself is not able to “clean the post crisis mess” in spite of historically low interest rates and massive quantitative easing.

12 2 2

3 3 34 4 4 4

5 56

7 7

1415

17

1920

5,7

0

5

10

15

20

25

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Table 3 - Loans to households and corporates, selected euro area countries, y/y in %

Households -total Households –housing loans

Households-consumer loans

Corporates

2014 2015 2016 2014 2015 2016 2014 2015 2016 2014 2015 2016

Germany 1.5 2.8 3.1 2.4 3.5 3.8 -0.1 3.6 4.2 1.4 1.6 3.2

Netherlands 0.5 4.8 3.5 1.3 5.4 4.0 -7.1 -5.7 -4.5 -3.9 -10.5 -4.2

Belgium 16.2 10.4 5.9 19.5 12.1 6.5 -2.8 -3.8 2.8 -0.4 4.4 3.3

France -1.7 2.8 2.7 -2.8 3.2 3.4 2.5 1.9 -0.2 2.9 3.3 4.8

Austria

Spain -3.6 -2.8 -2.1 -3.7 -4.2 -3.7 -2.3 9.1 11.0 -7.1 -0.9 -1.0

Ireland -4.9 -2.4 -4.1 -3.9 -1.2 -4.1 -6.3 -2.4 1.1 -10.3 -10.1 -4.2

Italy -0.9 1.6 1.0 -0.9 0.4 1.0 -2.9 14.6 6.3 -2.6 -1.4 -1.5

Portugal -3.6 -3.1 -2.3 -3.8 -3.8 -3.4 -2.3 2.9 7.3 -7.6 -2.0 -2.4

Slovenia -1.5 0.6 2.4 0.2 1.8 3.6 -4.5 -2.6 1.8 -13.9 -7.6 -8.0

Euroarea -0.3 1.9 1.9 -0.1 2.1 2.1 -0.5 3.8 3.2 -1.4 -0.4 1.2

Source: ECB

Conclusions

There has been recently a debate among policy makers and academicians about the monetary policy strategies and toolkit in the pre-crisis time, during the crisis and in the present and possibly future circumstances (see for example the proceedings of the recent 2016 Jacson Hole symposium). Opinions differ, however strong arguments are made that we have transitioned into a new world, a new normal, where central banks will no longer be able (or willing) to return to the old policy model, based in the first place on the use of interest rates. Negative interest rates were not there since the outset of the crisis, however when they appeared, they got almost a feature of an act of desperation, a signal that traditional policy options have proved ineffective. At present, proposals are being made that the zero lower bound is dropped as a concept altogether and even that negative rates should not be bound to policy size or time limits.

Watching the statistical evidence, it is clear, however, that negative interest rates have not brought in the expected or desired effects (despite the fact, that counterfactual evidence does not exist). Indeed, return to growth and full employment in economies has not taken place (as demonstrated by central banks themselves as they kept and still keep in place unorthodox policy tools), inflation is out of sight and – last but not least – the pumping of liquidity into banking systems has not cured the lack of confidence between market players and restored full speed lending by banks to the economy.

Low interest rates may paradoxically increase savings and weaken consumption. Or, alternatively, they may stimulate firms in investing in capital intensive technologies, resulting in lower demand for labour and push to increase unemployment. Thirdly, future pensioners in ageing societies may worry more about their retirement and make more precautionary savings. Last but not least, low/negative interest rates also reduce motivations for necessary efforts to consolidate public finance and to implement desperately needed structural reforms.

Our concern is that the longer the “new normal” lasts, the higher is and will be the threat that banking systems will no longer be able to sustain the costs of this situation. Indeed, banks have their own mental problem or dilemma how much of this unusual set-up they can afford to shift on their clients. For the time being the choice for most of them was to absorb the negative rates themselves at the cost of squeezing profit margins between their lending and deposit rates, reducing their capacity to expand their lending activities while maintaining the (ever increasing) regulatory capital adequacy.

At the same time, there is an inconsistency between the two mandates of central banks which

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makes the situation of commercial banks extremely difficult: on the one hand, banks are pressed to “more lending” by monetary policy, on the other one they have to cope with new and more prudent regulation. In fact, negative rates represent a new form of taxation which further hits the situation of banks. It is also probable that the banks that will be most hardly hit as for their profits may be the ones least able to bear it.

Consequently, there are natural limits to the process - to how far interest rates can be pushed into negative territory, central bank balance sheets expanded, spreads compressed and asset prices boosted. And there are limits to how far spending can be brought forward from the future. The effectiveness of monetary easing declines while unintended consequences are becoming more visible.

References:

1. Bank for International Settlements (2015): 85 th. Annual Report, Basel June 2015. 2. Bank for International Settlements (2016): 86 th. Annual Report, Basel June 2016. 3. Bertelsen, S.H.- Stenbaek, N.S. (2015): Low interest rates challenge the business model of

Danish banks. Bančni vestnik The Journal of Money and Banking, Vol 64, No. 11, November 2015, pp. 15-20.

4. Bech,M.- Malkhozov, A.: (2016) .: How have central banks implemented negative policy rates. BIS Quarterly Review, March 2016, pp. 31-44.

5. Borio,C (2015).: Persistently ultra-low interest rates: causes and consequences. Bančni vestnik The Journal of Money and Banking, Vol 64, No. 11 November 2015., pp. 6-14.

6. Borio,C.- Gambacorta,L.- Hofmann, B.: (2015) : The influence of monetary policy on bank profitability. BIS Working Paper, No.514 October 2015.

7. EBA (2016a): Report on the dynamics and drivers of non-performing exposures in the EU banking sector, London, July 2016.

8. EBA (2016b): 2016 EU-wide stress tests, London, July 2016.

Contact information

Pavel Štěpánek Czech Banking Association Vodičkova 30, Prague 1, Czech Republic

Eva Zamrazilová Czech Banking Association Vodičkova 30, Prague 1, Czech Republic [email protected]

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CALCULATION OF ECONOMICALLY JUSTIFIED COSTS AND

CALCULATION OF SOCIAL SERVICES RATES IN SOCIAL

SERVICES IN SLOVAK REPUBLIC

Jana Štrangfeldová, Zuzana Sojaková, Štefan Hronec

Abstract

In our research based on the philosophy that the purpose of the inevitable transformation of existing social facilities can be changed when the object becomes the subject, which processes the integration and makes the most of their human potential. At the same time, it must be kept in mind that the process of transformation and de-institutionalization is indeed a universal aim, but in the Slovak socio-economic conditions, particularly in the area of income testing affected citizens in need of assistance, it is extremely important to know the risks of this process. Some areas of risk, we have tried to identify. This paper is a partial result of the project VEGA no. 1/0405/15 entitled: Program budgeting as a tool of New Public Management. The principal investigator is doc. Ing. Hronec Štefan, PhD.

Keywords: social services, economically justified costs

JEL Classification: H55

Introduction

In this scientific study we will try to outline how social services work, respectively, how they should operate with economic determinants. Priority will be focus on the residential provision of social services, as it is currently a highly disputed area, causing additional costs to public finance, municipal budgets, budgets of providers, and the clients themselves.

For an analysis of the provision of modern social services at the European level, we focused on the social systems of Great Britain, Sweden, and Germany. These states are the basic representatives according to Esping-Andersen welfare state model. Based chiefly on the work of Bjalkovski, Fruhbauer (2000), Matousek (2011) and Prusa (2003) and our own research.

1. CALCULATION OF ECONOMICALLY JUSTIFIED COSTS (EJC) IN SOCIAL

SERVICES

The actual current expenses of social service facilities are considered to be budgeted current expenditure and real incomes are actually achieved revenues.

Actual current expenditure and actual revenue from payment for social services in general and the higher territorial unit are identifies by the different types of social services. When it comes to social services that are provided in facilities, it is worth exploring the different forms of social services, i.e. whether providing year-round, weekly residential care, or outpatient services, and consequently the capacity of the facility (comparable type and form of social services).

For each comparable type of social services, which shows the actual current expenditure and actual revenue from payment for social services, are calculated the average actual current expenditure and average real income of the consideration paid to recipients of social services for the financial year.

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For the period concerned and for the purposes of determining the amount of the financial contribution to the operation of the provision of social services, the time duration of the provider must be considered; and for this period, it is the fiscal year. If the duration of the provision of social services is less than the fiscal year, the determined amount of financial contribution is considered to function fairly.

The economically justified costs (EJC), expenditure on:

- wages, salaries, and other personal remunerations is in the amount corresponding to the amount of salary and other personal settlements,

- contributions to social insurance, public health insurance, and contributions to retirement savings,

- travel expenses (excluding foreign business trips), and transportation,

- energy (Gas, Electricity, solid fuel), water and communications;

- material (except representational equipment of new interiors);

- routine and standard maintenance (excluding one-off maintenance and dealing with emergency situations),

- rents from occupation of the property, which is adequate for the amount of rent in the surrounding area and time,

- services,

- current transfers (only pocket money, severance pay, retirement benefits, reimbursement for temporary incapacity for work),

- depreciation of tangible and intangible assets provider.

EJC specification also governs § 72, para. 5-6 of the Act on Social Services.

A deduction of the average amount is used to determining the amount of reimbursement from the economically justified costs (determined as the sum of the amounts of the financial contribution, corresponding to the form of the provision of social services, the degree of dependence of individual beneficiaries for assistance of another person and the number of beneficiaries of social services). This does not apply to non-public service provider by which the municipality or higher territorial units, does not apply.

If the provider of social services is requested by the municipality or higher territorial units, the recipient / client social services can apply for payment of assistance for individuals dependent on the assistance of another person for acts of self-service, interpretation services, crisis assistance provided through telecommunications technology, implementation: social counseling, assistance in the application of rights and legitimate interests, social rehabilitation, occupational therapy.

Legal claim to contracts financed from public social services budgets are only those entities that apply to the production of services on a non-profit basis, i.e. active in the area of social entrepreneurship. Any gains must be invested into the main objectives. In Table 1 we compare eligibility and the methodology for calculating financial contributions.

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Table 1 - Payments for social services from public budgets

Public providers Non-public providers 1 Non-public providers 2

- the amount of consideration in accordance with generally binding regulations of the village, higher territorial unit

- most of the economically justified costs

- the amount, method of determining payment is under contract

- most of the economically justified costs

- the aim is not to make a profit

- the amount, method of determining payment is under contract

- imposed maximum limit payments

- the objective of making a profit

Source: own conception

The Public provider determines the amount of payment, the method of determining a payment agreement and in accordance with generally binding ordinance of the municipality or higher territorial units, most of the economically justified costs. Non-public provider determines the amount of payment for social services, the methods of how it is determined, paying the contract, and also most of the economically justified costs. This limited amount of economically justified costs does not apply to non-public provider, which provides social services to make a profit.

The beneficiary/client of the social services is required to pay compensation for social services in the amount determined by the provider, but with regard to the amount of his income and assets. In the case of low income, it is the legal obligation of parents and children, to pay the amount of the fee specified by the provider.

Table 2 - Payments for public provider according to income and assets.

Public provider

Service Payments for the beneficiary of 1 month

income for service

nursing, transportation service and help with personal care for a child

payment for service cannot be more than 1.4 times the subsistence minimum for one adult person

year-round residential service payment for service cannot be more than 25% of the subsistence minimum for one adult person

Year-round residential service without board From the reception of at least 75% of the subsistence minimum for one adult person

weekly residential care payment for service cannot be more than 50% of the subsistence minimum for one adult person

outpatient social service facilities in the provision of catering

payment for service cannot be more than 70% of the subsistence minimum for one adult person

outpatient social service facilities without providing catering

payment for service cannot be more than 1.4 times the subsistence minimum for one adult person


Privacy minimum financial balance for the client and the criteria for calculating the payments for social services as well as other legislative secured (Table 3).

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Table 3 - Other cases payment recipient provider for social services

Recipient of social services Fee

no payment for social service if the income ≤ value that should remain after payment

pays part of the fee if income> the minimum balance, but not enough to cover cost

assessed together with other persons

after payment recipient must be able to keep a minimum balance of jointly assessed persons for 1 month of at least 1.6 times the subsistence level

no income or insufficient income can be paid by another person if, however, it doesn’t apply to the outstanding amount claimed as inheritance


The Beneficiary/client do not pay for social services, even if their income is less than or equal to the value they would have after making the payment. The only part of the payment for social service is applied to income that is higher than the stated minimum. In other words, payment for service cannot leave the beneficiary with less money than the stated minimum.

If the income of the recipient / client social services assessed, together with the income of others, after paying for the social service, the recipient must be able to maintain a minimum amount for himself and the total assessed persons must be able to maintain a monthly income of at least 1.3 times the subsistence minimum.

If the recipient does not receive social services or has insufficient income to make a payment, another person, or parents, or their children may cover part or all of the fee. This person enters into a contract with the provider of the payment settlement. If the parents or children voluntarily agree on payment of charges, in this case, it may be ordered by the municipality or higher territorial units in its scope.

In the event of non-payment, the beneficiary / client or his parents, or children, or the recipient dies, the claim of the unpaid balance of the provider, can be applied to probate proceedings.

This does not apply to social services unsolicited by municipality or higher territorial units as well as non-public provider whose goal is to make a profit.

Of the social services provided in a hostel facilities, shelter, halfway houses, low-threshold day center, emergency housing facilities, facilities temporary child care, day center and integration center, these payments do not apply.

If the expected revenues from the charges, or actual revenue from the charges for the relevant period, the social services provided by non-public providers of social services are higher than the standard income for the relevant period, the financial contribution to the operation shall be reduced by the difference between the actual revenues from the charges and the relevant period and standard income for the relevant period.

If the expected revenues from the charges, or actual revenue from the charges for the relevant period for social services provided by non-public providers are lower than the standard income for the relevant period, the financial contribution to the operation will be increased by the difference between the standard income for the relevant period and the actual income from payment for the relevant period.

If a non-public provider of social services, which cannot determine the amount of financial contribution to the operation of that using a comparison type of social services, the amount of that allowance shall be determined for the financial year based on the difference of the estimated

166

current expenditure, the estimated revenues from paying for the social service, and the estimated amount of financial contribution of the individual dependent on the assistance of another person. This depends on their degree of dependence on others, calculated according to the type of social services (the number of beneficiaries of social services, the number of kilometers of transport services, the number of hours of interpretation, the number of hours social counseling, the number of hours for reading services, etc.).

When a private providers of social services provided by a financial contribution to the operation of the provision of that service and the cash benefits for the individual is dependent on the assistance of another person in the act of providing that service for the financial year, the municipality or higher territorial unit can provide the subsidies by prepayment and the first advance will be provided no later than the end of February of the financial year.

If financial contributions starts to be provided to private providers of social services to an operation of social services and cash benefits for the individual dependent on the assistance of another person for that service during the financial year, the municipality or higher territorial unit, will provided these financial contributions as a prepayment, firstly, from the first day of the calendar month in which the entitlement to the subsidies is created and no later than the last day of the calendar month following the month in which they qualify for the subsidies.

If a non-public provider of social services will end the provision of that services during the financial year, then a settlement of the provided financial contributions to the operation of the provision of social services and financial contribution in reliance on assistance of another person providing the service will be made at the end of the provision of social services.

2. CALCULATION OF SOCIAL SERVICES RATES

One of the indicators for determining the quality standards for services should be economic efficiency of the social service facilities. In this context, the pricing of social services will be analyzed following a valid nationwide funding formulas from public sources.

Price for a well-functioning market economy must have the financial expression values (objective evaluation of quality level) of goods (products / results, services), that the customer is willing to pay. If prices are formed differently, the very method of pricing conditions could produces significant inflation, unfair conditions for remuneration or prevent the optimization of costs (the cost pricing).

General approaches to pricing include cost, profit, and customer access. The output cost approach to price formation can be extremely low price, the minimum possible price, respectively, the cost price. For the profit pricing approach, there may be several options where competitive pricing is equal to the selling price, or less, or greater than the selling price. When the customer has access to price formation, it can result in exclusive, prestigious, penetrative, or fractional pricing.

The pricing of service generally has its own specifics that distinguish it from normal pricing for goods that have a tangible substance. It is difficult to provide a direct cost to performance of one service and it is also difficult to determine overhead costs, and profit levels. Recommendation in determining the gross profit is divided by net overhead working hours laid down in calendar working hours minus the hours for holidays, vacations, and sick leave. The hours spent is then multiplied by the gross profit. There is a second method for determining the gross profit in the service of the sum of overhead costs and the share of gross profit and net working hours.

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Social services has a very specific price formation. The price of social services should cover normal operating and labor costs. Optimal price allows for the receiving of a sufficient amount of money to pay all the economically eligible costs for which are identified as those that would be impossible without defined performance and quality to the provided the time and place in which it is required. The prices of basic functions in social services are measuring inputs and outputs, control demand, informing participants of the needs, available resources, and the provision of social services providers benefit as motivation and motivation of clients to secure access to social services.

Figure 1 - Flowchart for calculating the price of social services

,

Source: own conception according to Majerníka, 2004

For social service facilities, the apply accounting standards was established by Act no. 431/2002 statue code on accounting and was altered amended. The act establishes the obligation and a method of accounting for legal and natural persons for tax purposes of demonstrating their spending to achieve and maintain revenue. Subject to accounting under the act are, inter alia, costs (double entry) and expenditure (in a simple accounting). Accounting is therefore the main source of costs and expenses. The full use of data accounting system pricing for the introduction of such a structure monitoring costs, which allows for the sharing of costs and their use in the formula to calculate price.

Indirect

(overhead) costs

Staff cost Fund for working time

(active performance)

Calculation of overheads

for 1 hour / minute

activities of the facility

Calculate personnel costs

per 1 hour / minute activity

Calculating overhead

costs for social service

Time for Social

Service Calculation of personnel

costs for social service

Overhead costs for social service

Personnel costs for social service

Cost price of

social services

Materials consumed

in social service

The cost of the technique

used for social service

Calculate the cost of

technology to the service

through depreciation

Procurement price of

technology

The number of services per year (month)

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The flowchart for calculating the price of social services clearly illustrate the calculation of the cost price, which includes all current costs and expenses broken down into direct and overhead, material, personnel and technology costs.

The economic legitimacy for the operating costs in the provision of social services is the most important criterion for cost analysis. Legitimacy of costs shall be assessed according to whether the reason for incurring the operation of the activity in the provision of care is the subject of prices, whether their amount was proportionate to the amount and quality of the activities carried out, whether they were actually spent on the activity, was it not possible to ensure the provision of activities in a given quantity, quality, and time without incurring these costs, respectively, at a lower price. The costs shall be assessed not only in terms of the past, but also in terms of present and future. The aim is to quantify the optimal costs that will be needed at the time the application fees are incurred.

The normative based on the sum of direct and indirect cost of a specific social service is according to the degree of reliance and because of this reason it is not possible to change the direct costs for the same kind of social services. The direct costs means an increases with the number of clients in the degree of reliance. Indirect costs means that inversely develops (decreasing or increasing) the movement of the clients.

Direct costs can be determined with one unit of output (the client) in a given type of social services.

Indirect costs are determined as a proportion of total indirect costs and fund working time multiplied by the time required for the provision of specific social services in the degree of reliance.

To calculate the price, expenses cannot be used as they were taken from the books, but they need to be customized for timing differences between their acquisition and use, expenses, which, according to the general rules do not belong to the economically justified costs (penalties and fines), in terms of applying the rules of price regulation and in terms of irregular and rare expenses. When correction is necessary to determine the costs according to the accounts, adjustment to their amounts are according to the above principles, to find out information about changing conditions and spending costs a reasonable estimate of future costs is made.

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Table 4 - Calculation scheme for the cost price (economically justifiable costs - EJC) social services broken down by accounting

1 Raw material - direct costs 1 Raw material - indirect costs

fuel for transport to a specific service fuel, propellants and lubricants

special material for specific service literature and magazines

other material intended for a specific service

conventional supplies, bedding

depreciable equipment and instruments for a specific service

personal protective equipment, small tangible fixed assets

2 Energy consumption - direct costs 2. Energy consumption - indirect costs

electricity for a specific service electric energy

water for a specific service water

heat for space heating separately from the specific service

heat, gas

3 Services - direct costs 3. Service- Indirect costs

repair and maintenance services of a specific service

repairs and maintenance, asset protection, security, revision

purpose software for a specific service

travel, training, software

rent for technology in a specific service

representation, organizational, advisory and brokerage services

transportation and communication

laundry, cleaning, waste removal, disinfection, sterilization, disinfestation

administration, economics, and legal fees

rent, management fees, insurance

4 Staff costs - direct 4 Staff costs - indirect

gross wages of professional staff to a particular service

gross wages of other employees

employer's personnel for a specific service (professional staff)

employer contributions for employees and other insurance for employees

Other insurance professional staff to a particular service

the cost of safety and health (preventive. inspections beyond health insurance, external trainer, ...)

5 Depreciation - direct 5 Depreciation - indirect

equipment for a specific service intangible and tangible fixed assets

6 Other direct costs 6 Other indirect costs

the review and certification facilities for specific service

costs of inspection and certification of other facilities

fees for membership in professional societies

financial costs, fines and penalties


The cost price of a service is the sum of direct and indirect cost applied per service rendered.

The reimbursement mechanisms for implemented services are an essential element of motivation for the effective operation of any social service facilities. The reimbursement

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mechanisms for different categories of social services may vary significantly, and therefore in terms of efficiency it makes sense to focus on priority categories of disability according to the clients.

Table 5 - Economically justified costs of social services facilities

The general calculation

formula

Costs according to

accounting

Type of costs

direct material raw material for 1 client variable

direct wages staff cost for social worker variable

other direct costs depreciation of facility for 1 client

fixed

Performance output energy consumption repair and maintenance travel outputs of communication

variable fixed variable fixed/variable

administrative expenses raw material personnel costs of administrative and managerial workers

fixed fixed fixed fixed fixed

price of performance total costs x


The amount of each type of cost can vary depending on the degree of reliance of the individual clients on specific facilities and social services especially in material, energy, wages, social workers, respectively, of the treatment of staff, etc.. Ultimately, they are a reflection of the policy of quality of social services, educational, and obligatory norm of the provider that wants to compete with other providers and producers in the region.

Summary

In this paper we have attempted to outline the basic determinants of economic development and sustainability of modern social services and show the importance of standardization of economic and non-economic effects.

A prerequisite for the development and quality of social services are clearly defined standards. It creates a national platform acceptance of quality of service for different types of social services (mandatory standards) and to give space for the provider to determine their own strategy for managing and financing their goals and to be in the area of social entrepreneurship, capable of competition.

This is a partial result from projects that are part of a comprehensive examination of the issue of financial management in the public sector. The wider debate will be subject to further output on the domestic and international scientific forum

References:

1. BJALKOVSKI, CH., FRÜHBAUER, O. 2000. Sociální služby v zemích Evropské unie. Praha : VÚPSV, 2000. 37 s. ISBN 9788023871166.

2. MAJERNÍK, K. 2004. Tvorba cien v súkromnej ambulancii. Bratislava : Dr. Josef Raabe, In Medicínsky monitor. - Bratislava : BONUS . - Č. 1 (2004), s. 40. - ISSN 1335-0951.

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3. KOLDINSKÁ, K., MATOUŠEK, O. Trendy v historickém vývoji sociálních služeb. In MATOUŠEK, O. a kol. Sociálni služby. Praha : Portál, 2011 ISBN 978-80-262-0041-3.

4. PRUŠA, L. 2003. Ekonomie sociálních služeb. Praha : ASPI Publishing, 2003. 152 s. ISBN:80-86395-69-3.

5. Zákon č. 100/1988 Zb. o sociálnom zabezpečení 6. Zákon č. 180/1990 o zmenách predpisov v nemocenskom a sociálnom zabezpečení a

materskom príspevku a niektorých ďalších predpisov 7. Zákon NR SR č. 195/1998 Z. z. o sociálnej pomoci 8. Zákon NR SR č. 416/2001 Z. z. o prechode niektorých pôsobností z orgánov štátnej

správy na obce a na vyššie územné celky 9. Zákon NR SR č. 448/2008 Z. z. o sociálnych službách a o zmene a doplnení zákona č.

455/1991 Zb. o živnostenskom podnikaní v znení neskorších predpisov 10. Zákon NR SR č. 50/2012 Z. z. ktorým sa mení a dopĺňa zákon č. 488/2008 Z. z. o

sociálnych službách a o zmene a doplnení zákona č. 455/1991 Zb. o živnostenskom podnikaní (živnostenský zákon) v znení neskorších predpisov.

Contact information

Jana Štrangfeldová Matej Bel University Tajovskeho 10, Banska Bystrica, Slovakia [email protected] Zuzana Sojaková Matej Bel University Tajovskeho 10, Banska Bystrica, Slovakia Štefan Hronec Matej Bel University Tajovskeho 10, Banska Bystrica, Slovakia

172

EXCHANGE RATE COMMITMENT, NEGATIVE INTEREST RATES

AND CURRENT MONETARY AND FISCAL POLICY MIX IN THE

CZECH REPUBLIC

Dana Viktorová, Vladimír Tomšík1

Abstract

The paper discusses interaction of fiscal and monetary policy and their roles promoting real economic growth and smoothing business cycle fluctuations. Using recent macroeconomic developments in advanced countries it shows that monetary policy is able effectively smooth business cycle fluctuations but it is a blunt tool promoting the long-term growth. Fiscal and structural policies are more efficient promoting the long-term growth. Furthermore, the paper discusses unconventional monetary policy measures as the CNB’s exchange rate commitment and negative interest rates.

Keywords: exchange rate commitment, economic growth, monetary and fiscal policy, interest

rate, inflation, monetary trilemma

JEL Classification: E52, E58, E62

1. MONETARY AND FISCAL POLICY AND REAL GROWTH

Low Economic Growth since the Crisis

Real economic growth in developed countries has remained subdued since the world financial crisis, staying well below the pre-crisis average, Figure 1. It has been so despite loose monetary policy, as central banks in developed countries lowered policy interest rates towards zero. On the top of that, many central banks in these countries also resorted to “unconventional” monetary policy instruments such as quantitative easing, forward guidance, and exchange rate commitments.2 As an “unconventional” policy tool we consider any instrument different from the short-term (policy) rate, which is considered as the benchmark instrument in normal times. Several central banks also move their policy interest rate to negative levels in order to to further ease monetary conditions.

Real growth below the pre-crisis average gives rise to concerns that the world economy is reaching a period of a low potential product growth. This concern echoes for examplein International Monetary Fund’s World Economic Outlook (April 2016) – “Too Slow for Too Long”.

1The views expressed in the paper are those of authors and do not necessarily represent the views of NEWTON College and/or the Czech National Bank. 2 The Czech National Bank started to cut down the policy interest rate in August 2008, reaching the zero level in December 2012.

173

Figure 1 - Real GDP Growth Rate (y/y change in percent)

Source: IMF WEO database

Monetary and Fiscal Policy and the Business Cycle

As discussed in the previous part, accommodative monetary policy was able only partly recover the real economic growth in advanced countries but the pre-crisis level is far from being restored. This point to a couple of lessons learned from the recent developments. First, monetary policy is able to smooth the business cycle to only some extend and the space for monetary policy accommodation through interest rates faces limits given by the liquidity trap. Second, monetary policy is not able to increase long-term sustainable, potential growth. There have been no doubts, even prior to the crisis, that monetary policy is neutral with respect to real variables in the long-run – so called long-term neutrality of monetary policy. Both lessons give a rise to question whether other macroeconomic policies, fiscal policy in particular, can aim to smooth the business cycle. Or does the fiscal policy do more harm than good?

Fiscal Policy and the Business Cycle

There were two different opinions before the world financial crisis. The first stream claims that fiscal policy can effectively moderate economic fluctuations. While its opponents argued that fiscal policy is inefficient in moderating business cycle fluctuations because of problems with synchronization of policy actions and due to a limited impact of discretionary interventions. Furthermore, potential distortions caused by discretionary fiscal policy were highlighted.

A new consensus about the fiscal policy starts to emerge during the crisis and based on recently learned lessons. It stays that smoothing of business cycles should be ideally done automatically through the built-in stabilizers, such as taxes, mandatory expenditures or fiscal rules. This is labeled as “passive” anti-cyclical fiscal policy. As Frankel et al. (2013) state, the number of countries with a negative correlation between fiscal quantities (government expenditures, taxes etc.) and business cycle is increasing. Anti-cycle fiscal policy can be observed mainly in countries that demonstrate an institutional quality.

-5

-4

-3

-2

-1

0

1

2

3

4

5

Advanced economies Euro area

174

On the contrary, the importance of discretionary fiscal policy actions is considered as declining. Beside timing and target issues, they lead to a “debt curse” and reduce the space for possible future accommodation. The narrowing of potential accommodative space of fiscal policy can be viewed from the share of government debt on GDP. Figure 2 shows that the debt nowadays is snout three times higher compared to 1975 and it is constantly growing last 30 years.

Figure 2 - Government Debt as a Percentage of the GDP (Average of 13 Developed Countries Weighted according to GDP)

Source: Mandel and Tomšík (Bankovnictví 2015)

Fiscal Policy and the Economic Development in the Czech Republic

How did fiscal policy contributed to the real economic growth in the Czech Republic? Based on decomposition of real GDP growth to factors, government expenditures including structural funds resources helped with the economic recovery in the Czech Republic, Table 1.

Table 1 - Fiscal Impulse (Decomposition of the Real Economic Growth in the Czech Republic)

2013 2014 2015

GDP -0.5% 2.0% 4.3%

Gross Value Added -0.5% 2.7% 3.7%

Contributions (in. p.p.)

Fiscal Stimulus -1.0 0.3 0.7

Growth in Effective Eurozone 0.6 1.1 1.9

Oil Prices 0.0 0.1 0.7

Taxes (cigarettes) 0.0 -0.7 0.5

Monetary policy and sentiment -0.1 1.2 0.5 Source: CNB and CNB’s computations

0,0

20,0

40,0

60,0

80,0

100,0

120,0

140,0

160,0

180,0

200,0

19

00

19

04

19

08

19

12

19

16

19

20

19

24

19

28

19

32

19

36

19

40

19

44

19

48

19

52

19

56

19

60

19

64

19

68

19

72

19

76

19

80

19

84

19

88

19

92

19

96

20

00

20

04

20

08

175

The real economy growth about 4 percent in 2015 made the Czech Republic one of the fastest growing countries. However, such a growth rate is exceptional. It has benefited from the recovery of external demand and easy monetary policy on the back of fiscal stimulus, mainly related to the European Union Financial Framework 2007 – 2013 and structural investment, along with an oil prices decrease, constituting a positive supply shock. Such conditions would not probably repeat any sooner and the Czech economy cannot growth fast without boosting the long term sustainable economic growth in the future. Monetary policy is able to stabilize the economy within the business cycle; however, it is not able to shift the economic potential due to long term neutrality. Fiscal policy needs to provide the additional help boosting the business cycle by means of automatic stabilizers and discretion measures. However, fiscal policy should primarily aim at long-term growth using its structural and infrastructure policies.

Unconventional Monetary Policy and Negative Interest Rates

Negative Interest Rates in the World

Reaching the zero level of nominal interest rates, several central banks cut their policy rates to the negative territory. Since 2012 with a short break in 2014, there has been implemented a negative key interest rate on certificate of deposits in Denmark, Figure 3. Negative key interest rates were also introduced by other central banks recently. Namely, the ECB shifted the marginal deposit facility rate to the negative territory in the mid of 2014, the Riskbank introduced a negative repo rate in early 2015, the Swiss National Bank has experienced a negative SARON rate since the end of 2014. Japan introduced the negative interest rate in 2016.

Figure 3 - Monetary policy rates (percent p.a.)

Source: Central bank web pages and monetary policy reports

-2

-1

0

1

2

3

4

5

6

20

08

M0

1

20

09

M0

1

20

10

M0

1

20

11

M0

1

20

12

M0

1

20

13

M0

1

20

14

M0

1

20

15

M0

1

20

16

M0

1

Czech Rep.

Denmark

Euro area

Japan

Sweden

Switzerland

176

CNB’s Exchange Rate Commitment and Its Effects

Czech National Bank (CNB) also reached the zero level in November 2012, Figure 3. However, the policy easing through interest rates was not sufficient and deflationary risks emerged during 2013. In response to rising deflationary risks, the CNB had to further ease monetary policy. Reflecting the fact that the Czech economy is very open and there is a structural surplus of liquidity, the CNB resorted to the nominal exchange rate as an extra monetary policy instrument once interest rates reached the zero level. Following this strategy the CNB announced the exchange rate commitment in November 2013. The FX commitment is one side commitment as the central bank prevents appreciation of the koruna below 27 CZK per EUR but let the exchange rate depreciate freely.

The exchange rate commitment has gained its credibility on the financial market quickly. After three days of FX interventions, the koruna depreciated above the commitment level without any central bank interventions, Figure 4. In summer 2015, the actual koruna exchange rate reached the commitment level and automatic intervention schedule has been activated.

Figure 4 - CZK per EUR exchange rate and CNB’s interventions

Source: CNB

Despite initial strong public doubts, the commitment has proven to be successful, preventing deflation and promoting real economy recovery. All real macroeconomic indicators improved, Table 2. However, despite the evident real economy recovery, inflation is still below the target and its tolerance band. Producer prices are even declining.

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Table 2 - Comparison of the Czech Economy Developments: Before (2013) and After (nowadays) the Exchange Rate Commitment

Source: CNB and CZSO

What is the current development and what is the projection?

Inflation

Figure 5 - Structure of Inflation (annual percentage changes; contributions in percentage points)

Source: CNB, Inflation Report II/2016

What are the causes of such low inflation? First of all, there is a slump in fuel prices, secondly, a decline in food prices, see Figure 5. Only a moderate increase in regulated prices was not able to offset effects of fuel and food prices on overall CPI inflation. Declining fuel prices reflect a drop in world oil prices from the level of around USD 110 per barrel in 2014 to about USD 40 in 2015.

Fuel and food prices are usually highly volatile and thus difficult to predict. Furthermore, their dynamics might not be closely related to business cycle. Therefore, central bank use so-called

Gross Domestic Product II/13 -1.3 IV/15 4.0

Household Consumption Expeditures II/13 0.0 IV/15 2.9

Gross Capital Formation II/13 -14.0 IV/15 4.9

Industrial Production 9/13 1.8 1/16 3.5

Construction 9/13 -12.7 1/16 -3.2

Retail Sales incl. Automotive Segment 9/13 0.3 1/16 6.7

Consumer Price Index 9/13 1.0 2/16 0.5

Producer Price Index 9/13 0.6 2/16 -4.0

General Unemploymnet Rate (%, CZSO) III/13 7.0 IV/15 4.6

Share of Unemploed Persons (%, MLSA) III/13 0.7 IV/15 1.2

Number of Vacancies (thousand of persons) 9/13 39.0 2/16 124.0

Average Nominal Wage II/13 1.2 IV/15 3.9

Gross Operating Surplus II/13 1.3 IV/15 3.6

Composite Confidence Indicator (index) 10/13 88.9 2/16 97.1

Available on Nov. 7, 2013 Available on March 16, 2016

Percent YoY (unless indicated otherwise)

-1

0

1

2

1/14 4 7 10 1/15 4 7 10 1/16

Indirect taxes in non-administered prices

Fuel prices

Food prices (including alcoholic beverages and tobacco)

Administered prices

Adjusted inflation excluding fuels and food

Annual consumer price inflation (in per cent)

178

core inflation measures, which exclude food and energy prices. The CNB uses adjusted inflation excluding fuel as a measure of inflation which is related to the business cycle position. When focusing on adjusted inflation excluding fuel, inflation has been positive and stable for almost two years, see red bars in Figure 5.

Inflation Forecast

Figure 6 - Inflation Forecast

Source: CNB, Inflation Report II/2016

Based on the CNB forecast from Inflation Report II/2016, headline inflation will remain low in 2016 on the back of low world oil and food prices. It starts to soar gradually back to the inflation target afterwards, as strong demand and real economic growth start to feed into prices. At the same time, strong disinflationary pressures from import prices will gradually fade out. The inflation rate shall increase according to the CNB’s forecast and the aim of 2 percentages would reach around mid-2017, Figure 6.

Economic Growth Prognosis

Figure 7 - GDP Growth Forecast

Source: CNB Inflation Report II/2016

-1

0

1

2

3

4

5

6

II/14 III IV I/15 II III IV I/16 II III IV I/17 II III IV

90% 70% 50% 30% confidence interval

Inflation target

Monetary policy horizon

-2

0

2

4

6

8

10

II/14 III IV I/15 II III IV I/16 II III IV I/17 II III IV

90% 70% 50% 30% confidence interval

179

The real economic growth is expected to slow down based on the CNB forecast due to a temporal decline in gross capital formation, Figure 7. The decline in gross capital formation arises mainly from a drop in government investment co-financed by structural EU funds. However, the economy will continue to benefit from easy monetary conditions, low oil prices, and recovering foreign demand.

Negative Interest rates in the Europe and Monetary Policy in the Czech Republic

Monetary Policy Trilemma

The impossible trinity stays that a country must pick two out of three choices – independent monetary policy, exchange rate stability, and financial market integration to the world financial market (free floats of capital). Namely, it can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows. Or, it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate. Finally, it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession. Maintaining all three is impossible over the extensive period of time.

Figure 8 - Impossible trinity

Source: authors’ scheme

The CNB does not face the full strength of the trilemma as its exchange rate commitment is one-sided not preventing depreciation of the koruna and it is possible to increase the foreign reserves unlimitedly. It means that the CNB is able to maintain the commitment, keeping free floats of capital and controlling liquidity on the domestic money market. Nevertheless, it is not wise to ignore the trilemma entirely, and it shall be considered, which means it is plausible to employ to prevent excessive speculative financial floats to the koruna.

International financial flows are driven by expected return on investment and the uncovered interest rate parity (UIP) is commonly used as an arbitrage free condition. The UIP says that

180

interest rate differential, as the difference between domestic and foreign rates, equals to expected depreciation of the currency adjusted by the country risk premium:

Where is the domestic interest rate, the foreign interest rate, is the nominal exchange rate

where upper script e denotes expectations, and is the country risk premium.

Given the negative interest rate in the euro area, the positive interest rate differential might create an arbitrage opportunity for koruna investment; see Table 3 for a list of countries with negative interest rates. In this regard it might be needed to remove the positive differential if speculative financial flows emerge. This is in-line with CNB’s communication which considers negative rates as a potential useful tool to mitigate speculative financial flows.3 At the same time the CNB consider negative interest rates as a blunt tool for further easing of monetary policy.

Justification for negative interest rate preventing speculative inflows of capital is provided by Danish experience. The Denmark National Bank cut the rate on certificate significantly below zero at the end of 2014, see Figure 9. As it can be seen from central bank reserve, Figure 10, pressures on accumulation of reserves due to financial inflows have eased with negative interest rates. Furthermore, negative policy rates do not necessarily imply negative client rates. In order to attenuate adverse effects of negative rates on bank profitability and financial stability, the negative rate are in many countries applied using a tier system with thresholds. In nutshell it means that only excessive reserves are penalized by the negative rate. Table 3 provides a brief overview of negative interest rate application schemes.

Table 3 - List of Countries with Negative Key Interest Rates

Country

Implementation

Date

Policy Interest Rate

Level as of January 2016

(percent p.a.) Application Scheme

Denmark September

2014 -0.65 (certificates of

deposits) Tier system, 0% up to Kr 32

billion threshold

Euro area June 2014 -0.4 (overnight deposit

rate) System wide

Hungary March 2016 -0.05 (deposit rate) Signaling (key 3M rate positive

and total amount unlimited)

Japan January 2016 -0.1 (rate on deposit account at the BoJ)

Tier system (three tiers with rates 0.1%, 0%, and -0.1%)

Norway September

2015 -0.5 (reserve rate)

Applied only on reserves above a threshold, market rates positive

Sweden February 2015 -0.5 (repo rate) System wide

Switzerland December

2014 -0.75 (deposit rate)

Tier system (applied only above threshold amounts -- 20 times

higher than reserve requirements but CHF 10 mil. at minimum)

Source: IMF Database

3 See e.g. https://www.cnb.cz/en/monetary_policy/bank_board_minutes/2016/160505_prohlaseni.html.

181

Figure 9 - DNB’s Interest Rates (percent p.a.).

Source: National Bank of Denmark Database

Figure 10 - DNB’s Foreign Reserves (Kr. In billions).

Source: National Bank of Denmark Database

Negative key interest rates in Denmark functioned as an efficient instrument in keeping pegged exchange rate, so it discouraged sort term speculative capital inflow more precisely.

Conclusion

Monetary policy is powerful, however it is not almighty. Monetary policy can smooth the business cycle; however it is not able to increase the long term sustainable potential growth rate. We can conclude the long term neutrality of the monetary policy, but automatic anti-cyclical fiscal policy might be the use promoting the long-term growth. We also discussed evidence on negative interest rates and their role mitigating financial flows through the interest rate differential.

Certificates of deposit rate Discount rate

Current-account rate Lending rate

2013 2014 2015 2016

-0.8

-1.0

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

0

100

200

300

400

500

600

700

800

Kr. billion

2013 2014 2015 2016

182

References:

1. Czech National Bank, 2016: Inflation Report II/2016. 2. Frankel, A. J., C. A. Végh and G. Vuletin, 2011.”On Graduation from Fiscal

Procyclicality" 3. NBER Working Papers 17619, National Bureau of Economic Research, Inc. 4. International Monetary Fund, 2016: World Economic Outlook (April 2016) – “Too Slow

for Too Long”. 5. Mandel, M. and V. Tomšík, 2015: “Dynamics and Balance of Savings, Investments, and

Credits in Business Cycle – The Case of the Czech Republic“, Politická ekonomie 1, pgs. 32-56. In Czech.

6. Mandel, M. and V. Tomšík, 2015: “Public Debt Development: Causes, Impacts, and Regulatory Treatments. Bankovnictví, No. 9, Vol. XXII (50), pgs. 24-27. In Czech.

Contact information

Dana Viktorová NEWTON College, a.s. Václavské náměstí 11, Prague 1, Czech Republic [email protected] Vladimír Tomšík NEWTON College, a.s. Václavské náměstí 11, Prague 1, Czech Republic [email protected] Czech National Bank Na Příkopě 28, Prague 1, Czech Republic

183

FINANCIAL (IL)LITERACY AND CZECH RETIREMENT POLICY

Jaroslav Vostatek

Abstract

The failure to respect recommendations of the relevant international institutions might be a token of financial illiteracy of the government. Even after the “small” pension reform, the Czech public pension pillar continues to lack transparency and is incomprehensible for its common participants, which may also have significant impact on public finance. In order to determine the potential effect of the lack of transparency and of the financial illiteracy, the paper analyses also the differences between the Czech and the U.S. public pension pillars, including the different statutory retirement ages.

Keywords: public pensions, financial literacy, statutory retirement age, pension insurance, flat-

rate pension

JEL Classification: H55, H53, J26

Introduction

“Consumers in most countries are generally not well informed about pensions. Both general facts about the structure of the pension system and specific data on their own pension entitlements are lacking. … many people form no expectations of their retirement income at all. These problems are probably general to pension systems of all types” (Whitehouse, 2000). The world literature addresses these problems, in particular, in relation to privately managed retirement savings accounts which place greater responsibility on individuals for planning their retirement income. At the very least, people must choose which of a range of competing funds should manage their pension assets.

With its ruling of 2010, the Constitutional Court of the Czech Republic has also marked a point in the history of the Czech pension policy. The applicable bend points provided for in Section 15 of the Pension Insurance Act were declared unconstitutional by the Court “because, in its consequences and in combination with other parameters and the existing structure of the pension system, [the provision] does not sufficiently warrant the constitutionally guaranteed right to adequate material security as provided in Article 30 (1) of the Charter of Fundamental Rights and Freedoms and results in an unacceptable inequalities between different groups of pension insurance beneficiaries” (Constitutional Court, 2010). In this connection, the Court also held in its ruling that “the entire complex structure of the pension system is lacking transparency to such an extent that it is de facto fully incomprehensible for its addressees; the calculated amount of pension benefits has become unverifiable for most beneficiaries”.

In principle, the Czech public pension pillar does not fall under any pension social model (Vostatek, 2015a). While public pension pillars in other countries also exhibit greater or smaller deviations from pension models (Vostatek, 2015b), it is the degree of such deviation that matters. This paper is primarily interested in the overall comprehensibility of our “pension insurance” and the potential impact of increased comprehensibility thereof on public finance in particular, as compared to the basic public pension system in the U.S., the concept of which is strikingly similar to the overall general structure of the Czech “pension insurance”. More specifically, the paper deals with the differences in the retirement age between the Czech Republic and the U.S. and strives to explain the different behaviour of participants in the two

184

countries in this regard. „Retirement age is the most visible parameter of the pension system and one which sets a clear signal for people in making economic decisions. As such, increases in pension age have often proved among the more contentious elements of pension reforms, compared with other changes to retirement-income provision” (OECD, 2014).

1. CZECH PENSION REFORMS

The basic structure of the present Czech system of public pensions dates back to the mid 1990’s. In the preceding, mostly uniform communistic system, pensions were largely dependent on the earnings, with the preferred “work categories” (mine workers, other hazardous professions) receiving preferential treatment and the nearly non-existent private farmers and self-employed being discriminated by the regime. With these exceptions, it was a universal defined benefit retirement system; pensions were calculated from the final wage (the average wage level of the top five years within the last ten years).

In 1989, an ordinary employee with a national average wage received, after 45 aggregated years taken into account, a relatively high pension amounting to 85-90% of net wage. After 20 retirement years, however, the employee could expect a minimum pension (“social pension”), which was nevertheless at a level corresponding nowadays to CZK 8,000. The ratios of the national average pension to the net pay and to the gross pay were then 64% and 50%, respectively. Insufficient indexation of pensions was a typical phenomenon; its insufficiency was effectively caused, in particular, by the so-called hidden price inflation (the long-term average of hidden retail price increase was approximately 2.5% per year); one-off campaign-based increases in pensions did not take this hidden price inflation into account. Bend points were used in the pension calculation to reduce higher earnings; the reduction coefficients (percentages) applied then were retained until 2010 (with a single minor derogation). In 1989, however, the first bend point corresponded to 92% of the median wage, which was significantly (by 78%) more than in 2010. The wage up to the first bend point was not and even today still is not reduced. Officially, this scheme constituted a national “pension security” rather than a social insurance system – it was a tax-financed public expenditure programme.

After the Velvet revolution, the discrimination of the private sector was abolished; the same was the case, in principle, for the preferred work categories. The real level of pensions paid out in relation to wages decreased, in spite of the introduction of periodic pension indexation. The social pension was not indexed at all until its abolition from 1996, and its level in real terms dropped to 16% of the average net nationwide wage during this period. After 1992, the universal pension security system was subject to targeted efforts to increase progressivity (solidarity) through a significant downward shift of the real bend points (to a level that is nearly comparable to the basic pension system in the U.S.). This can be put into context with the liberal tendencies which were then pushed forward and which could have gone as far in its results as to bring about a transformation of the “pension insurance” into a flat-rate, universal pension.

The “basic amount” of the pension is a constituent part of all current public pensions in the Czech Republic; it was developed through transformation of the state compensation allowance since 1996, which was introduced (“on a temporary basis”) in 1990 as a social compensation for the one-off abolition of negative sales tax that resulted in a single-time jump in retail prices, initially for all citizens. One year later, this cost-of-living allowance was already restricted to children and non-active pensioners while, just a few years later, it was fully “incorporated” into child allowances – and into pensions as their “basic amount”.

From the technical point of view, the “basic amount” of the pension is an analogy to the basic amounts of pensions in the historical workers’ social pension insurance schemes which were

185

characterized by an overall low level of pensions and the basic amount represented a sort of universal pension for all beneficiaries, indicating the preference for workers with lower earnings. It was thus a redistribution device within the blue-collar pension system. With the increased level of blue-collar pensions, the purpose of the basic pension amount got lost. In our country, the basic amount was last in existence under the 1948 national insurance act and was replaced by the introduction of bend points for higher earnings in the calculation of old-age pensions.

The second component of all Czech pensions is the “percentage amount” of the pension which is, as a rule, significantly higher than the basic amount; its minimum level is 770 CZK. The percentage amount in old-age pensions is calculated from average earnings (since 1986) indexed to the present wage level and then reduced by the reduction coefficients. The introduced system of indexations of paid pensions also enabled the governments to unilaterally reinforce or, vice-versa, weaken the role of the basic amount in pensions.

The ruling of the Czech Constitutional Court referred to above should be a major lesson for the Czech pension policy. It was initiated by a complaint filed by a disability pensioner concerning the low replacement rate, namely 19% of his personal assessment base – which, in his opinion, did not constitute adequate material security that is declared as a right in the Charter of Fundamental Rights and Freedoms. The complainant considered it an absolute inequality in a situation where the average replacement rate for all old-age and disability pensions was 44%. The Constitutional Court upheld the complainant’s view, basing its ruling on the fact that – in this area – we have had a “public social insurance” scheme since 1996.

The Constitutional Court derived the substance of the system, in fact, from the title of the Act – on “pension insurance”. In principle, the Court had no other option because there is no provision in the Act itself or elsewhere (e.g. in the Constitution) that would provide for a definition of “pension insurance”; we lack the characteristics of the entire social system – unlike Germany, for instance, which has a code of social laws including a comprehensive concept. We are also lacking, among other, one important “detail” in the title of the Act: one additional adjective that would distinguish the statutory “pension insurance” from the private pension insurance. In practice, this results in complex formulations such as “pension insurance covered by the Pension Insurance Act”.

The Constitutional Court did not reject the intra-generational redistribution associated with the existence of bend points and coefficients, although it had the option to do so, given the developments of the social pension insurance systems in Europe after WWII. In this regard, the Constitutional Court could have also rejected the existence of the basic amount of pensions or, possibly, “admit” it, but fully reject the reductions for the percentage amount of pensions. From the point of view of pension social models, the basic amount should be either abolished or replaced by a universal pension – for all residents rather than just for insured beneficiaries with insurance period above 30 years. Clearly, the Court did not dare to engage in such far-reaching “revolution” in the Czech “pension insurance”. The Constitutional Court “only” repealed Section 15 of the Pension Insurance Act, containing the valid bend points applied to determine the reduced personal assessment base for the calculation of the percentage amount of the pension, and forced the Government and the Parliament to act swiftly. A general lesson to be learnt from this case is that the title and contents of laws should always be consistent. If we want to have a social pension insurance scheme, our pensions should be predominantly or (even better) entirely dependent on the insurance contributions paid (or, as appropriate, on the earnings from which the insurance contributions were paid).

In the Czech “pension insurance” (under the Pension Insurance Act), redistribution of social nature prevails over the insurance components, which is also manifested in the so-called

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“progressivity index”, reaching a level of 62.2 – significantly higher compared to all other neighbouring countries: Germany with 26.8, Austria with 27.9, Poland with 1.0 and Slovakia with 13.9 (OECD, 2013a). The progressivity index of 100 belongs to universal pensions and, on contrary, the progressivity index of 0 goes hand in hand with a pension fully dependent on the earnings, i.e. an insurance system (whether social or private). In spite of that, employees and employers in our country pay, to the national budget, “insurance premiums” to the old-age “pension insurance” at a rate of roughly 20% of the wage (the theoretical old-age component of the total rate of 28%). If the current Czech old-age pensions would be divided into an insurance component and a solidarity component and if the insurance component would be financed from the insurance premiums, these premium rates would range at 7-8% of the wage – judging by the progressivity index referred to above. This, too, shows a considerable degree of deformation in the value relations in the Czech public “pension insurance” system and in the Czech tax system.

The Government and the Parliament had to respond quickly to the Constitutional Court because Section 15 was repealed with effect from 1 November 2011. The response was not as radical as would be appropriate for the Court ruling. The first bend point was newly just parameterized as 44% of the general assessment base (national average earnings, NAE); below that threshold, earnings continue to be exempt from reduction. The most significant change consisted in setting the second bend point at 400% of NAE instead of the previous ca. 114%, with a reduction rate of 26% newly applicable up to this substantially increased bend point (following a transition period) and 0% above that bend point. Figure 1 shows the group that benefited the most from the small pension reform – employees with earnings, say, above 150% of NAE. The disability pensioner, in whose favour the Constitutional Court ruled, would receive a significantly higher pension today. In the range of gross wages up to CZK 40,000 per month, the changes were relatively small, but affected rather a lot of beneficiaries – and a number of those opted for early retirement, under the influence of information provided in media, with the corresponding impact on the state budget as well.

Figure 1 - Dependence of net pension on gross wage in the Czech Republic before (2011) and after (2015) the small pension reform (45 years of insurance), in CZK

Source: author

When the Czech Government, in response to the ruling of the Constitutional Court, decided to retain the system of bend points and coefficients, it should have – from the systemic point of view – abolished the basic amount of the pension. Even in this case, however, it would be desirable to provide expert explanations as to why the bend points and coefficients are or should be set at the respective levels. In an evidence-based case, one can only rely on the existence of

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such a system in the U.S., which is very little from the perspective of pension theory and policy. We know how the bend points and coefficients came into existence – before the Velvet revolution, however, the key first bend point was set at 77% of NAE; since 1996, it decreased to approximately 52% of NAE, then it continued in the gradual decrease (with small fluctuations) down to 42% of NAE; since the small pension reform, it has been annually adjusted to remain at 44% of NAE or, to be more precise, of the general assessment base. In other words, we know how the bend points came into existence and how they developed, but nobody even tries to explain why the key bend point is set just at the level of 44% of NAE.

2. U.S. “SOCIAL SECURITY”

The 1935 U.S. “Social Security” Act was enacted in response to the Great Economic Crisis; its most important component is constituted by public old-age pensions “packaged” as social insurance. The primary aim of this mandatory “old-age insurance” was and is to prevent poverty by providing pensions at the level of subsistence minimum (Kinsella and Gist, 1995); nevertheless, the benefits should also reflect individual equity and the system is financed through “insurance contributions”, making the benefits an “earned right” – rather than social assistance or a tested benefit, as appropriate (Barr et al., 2014).

The insurance contribution rate is fixed at 12.4% of the wage, of which half is paid by the employer. This “contribution”, commonly referred to as payroll tax, is deducted from the wage up to an earnings ceiling, amounting to USD 118,500 in 2015 or approximately 290% of the average wage in the U.S.

The U.S. “pension insurance” system is (particularly for us) remarkable in that it applies bend points when calculating pensions from the previous average (indexed) monthly earnings (up to the earnings ceiling). In 2015, the following two bend points were applied: USD 826 and USD 4,980. As Figure 2 shows, 90% of earnings below the first bend point, 32% of earnings between the first and second bend points, and 15% of earnings above the second bend point are taken into account in the pension calculation. The maximum level of pension granted in 2015 was USD 2,663. The bend points and coefficients are reflected in the so-called progressivity of pensions, similarly to that in the Czech Republic.

Figure 2 - Bend points and coefficients in old-age pension calculation in the U.S. (2015)

Source: Meyerson (2015)

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The shapes of the curves in Figures 1 and 2 are very similar to each other, in particular when we compare the U.S. curve with the Czech curve before the “small” pension reform. The U.S. and the Czech reduction coefficients up to the first bend points were and still are today at 90% (U.S.) and 100% (Czechia). The same coefficients to take into account earnings between the first and second bend points were and are set at 32% in the U.S.; in Czechia, the reduction coefficient was 30% in 2010 and 26% today. Above the second bend point, a 15% coefficient was and is applied in the U.S. while, in Czechia, the same coefficient was previously set at 10% and today is zero. The earnings ceiling for pension calculation is set at 264% and 400% of the average nationwide wage in the U.S. and in Czechia, respectively. There is a greater difference between the relative level of the first bend point in the U.S. (22% NAE) and in Czechia (44% NAE). The second bend point in the U.S. is set at 133% of NAE; in our country, it amounted to 114% of NAE before the reform and now it is set at 400% of NAE.

To close the comparison of calculations of the reduced average earnings, we can conclude that the reduction structure is overall identical – and equally comprehensible. If the clients or experts or, as the case may be, politicians accept substantial reductions of higher employee earnings to be applied for the calculation of old-age pensions, it is a comprehensible structure – a structure which, however, has essentially nothing in common with the social insurance model as we know it in Europe, in particular thanks to the initial social pension insurance systems in Germany, Austria or Czechoslovakia. In any case, the figures specified above confirm that both the Czech and the U.S. “pension insurance” systems can be classified as Beveridge type rather than Bismarck type systems.

The basic modern Beveridge-type concept of old-age pensions, however, does not operate with bend points and coefficients. A modern liberal solution consists, in particular, in flat-rate pension provided at the level of the subsistence minimum, to be understood as including housing costs; 30% of NAE can be considered a benchmark (still reasonable upper limit) here (Mercer, 2015). By coincidence, it would be relatively easy in the current Czech earnings and pension circumstances – in the technical, redistribution-oriented terms – to implement a pension reform consisting in dividing the current Czech “pension insurance” into a flat-rate old-age pension at the level of 30% of NAE and a genuine (fully earnings-related) old-age insurance pension, with a premium rate at 9-10% of the wage. The corresponding political assignment aiming towards full transparency and comprehensibility of public pensions, however, is unavailable in our country at present – and it remains a question whether this situation cannot be easily explained by financial illiteracy or by simply different interests of the current pension experts in the political parties.

If we disregard the real possibility or the need to split the current Czech public pension pillar into two clear-cut public pillars (which was also recommended by the World Bank), we are left with the option of abolishing the existing basic amount of pensions with the rate set at 9% of the average wage. Flat-rate pension at this level makes no sense, as it is simply absolutely insufficient; if the party experts are not willing to triple this “amount”, they should eliminate it altogether – for the sake of the logic of the matter and, thus, for the sake of a greater comprehensibility that would result from the substantial simplification of the pension structure. At the same time, we assume also adjustments to the bend points and coefficients; this proposal is not aimed at decreasing or increasing the overall relative level of old-age pensions.

A higher comprehensibility of the U.S. system of public pensions is also determined by the simple calculation of the average earnings of the clients for the purpose of determining the reduced assessment base. In the U.S., the indexed average of earnings for the 35 best years is calculated. Unlike in Czechia, no substitute insurance periods (not even for children), excluded periods, etc. are used here. Here, too, a reform implemented according to the recommendations

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of the international institutions would significantly increase the transparency of the Czech system.

3. RETIREMENT AGE

In our country the National Insurance Act (1948) introduced dual retirement age depending on the insurance period: if the insurance period exceeded 20 years, it was possible to retire at the age of 60 years. The other option was a retirement age of 65 years requiring 5 years of insurance period. Since 1957, retirement age of 55 years was introduced for 1st category employees (underground mine workers and airmen) and for women. A worldwide rarity consisted in the retirement age of women being differentiated based on the number of children, which was introduced in Czechoslovakia in 1965 in the following form: 57 years for childless women, 56 years for women with 1 child, 55 years for women with 2 children, 54 years for women with 3-4 children, and 53 years for women with 5 and more children.

The statutory retirement age has been gradually rising in Czechia since the relevant 1995 act. In 2011, the Government decided to “accompany” the small pension reform with further raising of the basic retirement age, and this time for infinity. Based on this act, the retirement age in 2051 and in 2100 should be 68 years and 75 years, respectively. Starting from persons born in 1975, the retirement age of women and men should be fully unified. Men born in 1953 are subject to a retirement age of 63 years, which they will reach this year. Childless women born in the same year are subject to a retirement age of 62 years, which they reached in 2015.

A general comparison of the statutory retirement ages indicates that, in the U.S., the retirement age is 66 years (to be increased to 67 years between 2021 and 2027), while in the Czech Republic it ranges between 56 and 63 years. We must take into account the different life expectancy for seniors, for persons aged 65 years for instance; their life expectancy is 84.1 years in the U.S. and 82.8 years in Czechia (WorldLifeExpectancy, 2015) – this implies that the statutory retirement age in the U.S. is, in relative terms, roughly 3 years higher than in our country. The net replacement rate for earnings at the level of 100% of the average wage is (was) 62.4% in Czechia and 47.3% in the U.S. (OECD, 2013a) – in other words, we can indicatively state that state pensions are about 24% lower in the U.S. The pension insurance premium rate is 28% of the wage in the Czech Republic and 12.4% of the wage in the U.S., i.e. 56% lower. Although this is only a primitive comparison of public pensions in the U.S. and in Czechia, the figures roughly “fit together”, especially if we would also take into account the “premiums” for health insurance of Medicare senior employees, and show that a higher “full pension” (OECD model – life-long employment, no interruption) is reflected – together with the lower retirement age – in the higher insurance premium rate in our country.

It is an issue of public choice: on a model basis, we could have a higher retirement age with a higher replacement rate or, instead, a system with higher wages and a lower insurance premium rate. It is a trade-off, a give and take. Pension theorists use three interlinked variables insurance (premium rate, average length of pension benefits /period of retirement/ and level of pensions) for basic explanation: when two out of the three variables are determined, the third one is just computed. However, things do not work that way in public policy, in particular in a defined benefit pension system and especially in the conditions of the Czech non-transparent “pension insurance” system: the most transparent variable out of the three specified above is indeed the retirement age.

The EU Council has repeatedly recommended that our country should accelerate the increase in the retirement age: “the statutory retirement age is planned to increase over the long run but too slowly in the medium term” (EU Council, 2014). The Czech government refuses to do so,

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arguing that the current pace of increase of the retirement age corresponds to the life expectancy development; consequently, the average period spent in retirement is not higher than in most other member states (Government, 2015). Our analyses show that the Czech government could or, possibly, should be more open-minded. The statutory retirement age of men and its increase is adequate in relation to Germany, for instance; however, this is not the case with women – there is scope for acceleration of the extension of the retirement age – and, thus, for a fundamental simplification of the entire system of increasing the retirement age.

An accelerated increase of the retirement age for women in the upcoming period is, naturally, a politically very sensitive issue; in addition, the relevant point of the coalition agreement of Sobotka’s government is indirectly headed towards fixing a ceiling of the retirement age, which is interpreted as setting a ceiling at 65 years. Minister Marksová submitted a “legislative intent for an act to end the increase of the retirement age upon reaching 65 years of age and to implement a regular review mechanism for the fixing of the retirement age.” “The proposed review system for the fixing of the retirement age”, which was approved by the Potůček Pension Commission, does not foresee any changes in the level of the retirement age until 2044 when, under the applicable law, the statutory retirement age should increase to 67 years: with the rate of increase of the retirement age being set at 2 months per year after 2030. This is on the understanding that there will be no major changes, particular in the demographic developments. The head of the competent team, T. Kučera, expects the life expectancy of persons aged 65 years to be at 20 years in 2030. The period spent in retirement thus corresponds to 25% of the total lifetime of those persons. According to the Commission, this 25% share should be the crucial relevant value for further regular (possible) adjustments of the statutory retirement age; the final decision should still belong to politicians. The legislative intent of this act gives the impression that fixing a ceiling for the retirement age at the level of 65 years is somehow compatible with the review mechanism that should operate on a continuous, indefinite basis. A solution to this stalemate could be to guarantee the gradual increase of the retirement age until 2030, on the understanding that, in the upcoming period until 2044, the retirement age would increase by 2 months per year, unless decided otherwise by the Parliament. A correction of the existing tables for the increase of the retirement age is of pragmatic use only if it is accompanied by another amendment to the Pension Insurance Act.

Foreign and international research concluded that increasing the retirement age in a universal public pension system is not limited by health-related aspects. If, in certain professions, it is impossible to continue working after reaching the age of 60 or 65 years, for instance, it is a problem of that specific profession or the competent branch, which can be solved through occupational pensions. From the health perspective, the increase of the retirement age in a universal pension system can be accelerated so that life expectancy in retirement would decrease to 15 years, for example.

Setting the statutory retirement age at such a level so that the target life expectancy of the participants in the year when they reach the statutory age is at the level of 15 years, is still feasible today or even in the future, for that matter – also in the opinion of the World Bank experts (Schwarz and Arias, 2014). In 2050, the corresponding retirement age in Czechia and in Western Europe would be approximately 72 years and 74 years, respectively. It goes without saying that this would eliminate potential future problems with the financial sustainability of pension systems or possibly create scope for increasing pensions or reducing the premium rates. It is a challenge, but its acceptance by the politicians probably cannot be expected by anyone.

In the initial social insurance systems, the statutory retirement age was set relatively very “strictly” – there was no possibility for early retirement, and it was also not possible to benefit from a pension while being engaged in a gainful activity. This has changed significantly in most

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countries after WWII. A fixed retirement age is nowadays typical for flat-rate and means-tested pensions; in principle, it makes no sense here for anybody to retire early, as these are universal benefits. In countries with a social insurance system, early old-age retirement experienced a boom – this is a sign of flexibility on one hand (pension can be adjusted using actuarial methods), while also (partially) solving problems outside the pension system (unemployment) on the other hand and, last but not least, it is attractive also from a purely political perspective, especially if the funds are available in the system. Early retirement was used, for various reasons, even without cutting the level of pension or, as the case may be, on the condition of a long insurance period. Once the pension systems started facing strong financial pressures for different reasons, there was a strong turn in the policy in most countries and, for instance, early retirement started to be limited, including its increased sanctioning (high reductions for the earliness of the retirement compared to the common actuarial method). Any reform of review of the retirement age should also take into account the related pension issues, such as the minimum insurance period, reduction and bonuses for earlier or later entry in the system to benefit from pension.

Early and later retirement – compared to the statutory retirement age – is or might be, as appropriate, also an essential modification of this retirement age as well as of the computations of the pension level in relation to the previous earnings. There are significant differences between various countries, for that matter. Sweden, for example, has two differently designed retirement ages (without the possibility for early retirement): one for the NDC system (61 years, with actuarial incentives to continue working) and one for tested (“guaranteed”) pension (65 years, no incentives). The Swedish retirement age concept is highly reasonable – in most other countries, this is a product of political mechanisms where problems are often not solved systematically from the model perspective.

In our country, the possibilities for early retirement have been relatively limited following the small pension reform. At present, early retirement is only possible at the age of 60 at the earliest, which means that women with more children are not able to retire early at all. In 2013, nearly all early old-age pensions were granted no longer than one year prior to the statutory retirement age, while in the period 2009-2011, there was a large majority of pensions granted 2-3 years before the statutory retirement age. The small pension reform caused a flow of early retirements, under the influence of information provided in the media. The reform increased the reduction rate for the assessment of early old-age pension where the period between the pension being granted and the person reaching the retirement age is longer than 360 days. The reduction rates for the calculation base are now scaled by 90 days (also commenced) as follows:

· 0.9% for the period of the first 360 days;

· 1.2% for the period of the next 360 days;

· 1.5% starting from the 721st day.

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Figure 3 - Reduction of old-age pensions for early retirement (in % per year, 2% discount rate)

Source: Queisser and Whitehouse (2006)

Increased reduction rate for early retirement more than 2 years before the retirement age to 6% per year is certainly commendable; nevertheless, the reduction rate should also be increased for the first two years and, in addition, 6% per year is not a sufficient reduction in actuarial terms, also because the reductions do not affect the basic amounts of the pensions. A fundamental reform of early old-age retirements is a must in our country. The actuarially neutral level of reduction rate for early old-age retirement is roughly 7-8% per year (Queisser and Whitehouse, 2006); based on the 2002 mortality data, the necessary neutral reduction rate for Czechia might be approximately 7.4% per year – see Figure 3.

In practice, the system of reductions and bonuses for early or later retirement represents (so far) a significant correction of the statutory age in the defined benefit system of social old-age insurance, although this did not have to be (and initially was not) the case. In an NDC (notional defined contribution) system, statutory retirement age works as a minimum value which one cannot fall below; in theory, this is considered to a major advantage – the signal role of the retirement age and the continuation of gainful activity is more accentuated and transparent here. In an NDC model, mortality tables are reviewed automatically and, in this manner, the conversion rates used to transform balance of the NDC personal account to lifelong old-age pension are also continuously adapted. In the respective countries, these issues appear (at least until now) to be somehow out of the (undesired) reach of politicians. In countries with a defined benefit system, on contrary, the statutory retirement age and early retirements are still significant (purely) political issues, in spite of the strong efforts of the pension theory to eliminate early retirement. If one or other retirement age “review mechanism” is to operate successfully, it must also include the issue of early retirement – especially in our country, because, under the applicable Pension Insurance Act in force, the gradual increase of the retirement age will extend the scope for early retirement, underlined by the failure to respect the actuarial equivalence.

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Pokorná (2016) carried out a lay advantage test of early retirement for a man born on 5 January 1953, without taking into account the time factor (interest) and pension indexation, and concluded that this man (with average nationwide earnings and life expectancy of 20.4 years after reaching the age of 63 years, with 46 years of insurance period) will receive, in total, 425 CZK more in the form of old-age pension if he retires one year before reaching the statutory retirement age. A more accurate calculation would have to take the time factor into account, and one can expect the conclusion that the most favourable option is to opt for early retirement as soon as possible, i.e. now after reaching the age of 60 years in Czechia.

At present, Czech insureds are not informed about the advantages of the early retirement; the lack of information in this regard actually causes financial “illiteracy” of the clients. In the U.S., the general level of awareness in this respect is apparently much higher. Upon early retirement (at the age of 62 years at the earliest), the pension is permanently reduced by 5/9% for each month (ca 6.7% per year) up to 36 months, increased by further 5/12% per month (ca 5% per year) for an even earlier retirement. Bonus rate for pensions for longer gainful activity is set at 8% per year, up to the age of 70 years.

Altogether, our retirement age for men and the increase thereof is set at a level comparable to Germany and other Western European countries. This does not exclude its correction in case of a more significant change in policy or in the economic or other circumstances. Changes of such type take place also in occupational and personal retirement schemes. The increasing of the statutory retirement age for women, where we still apply an unfounded differentiation based on the number of children brought up, is a highly topical issue and this problem can also be addressed in the context of a broader or narrower pension reform and family policy. Increased retirement age will also result in increased levels of pensions paid to women – thus reducing the gender gap in this regard. Strong motivation for early retirement caused by the low reduction rates for early retirement is a crucial weakness of the Czech pension legislation. Transition to an NDC system would increase motivation for a later retirement, given the actuarial equivalence typically applied in this system (Chłoń-Domińczak and Mora, 2007).

Conclusions

The complexity, lack of transparency and incomprehensibility of the Czech “pension insurance” scheme for its clients is not determined primarily by their financial illiteracy (in this regard), but by the quality (literacy) of the Czech pension policy. A major fault of the Czech “pension insurance” consists already in the actual combination of the universal basic amount of pensions and the percentage amount of old-age pension, the calculation of which reduces significantly any earnings above 44% of the national average wage. Compared to the U.S., we have “in addition” not only the basic amount of pensions, but also –– the substitute insurance periods and excluded insurance periods. At the same time, there is scope for a very efficient, fundamental pension reform which would not modify the current level of redistribution (progressivity index) and would respect the today’s modern pension policy requiring a strict separation of the social pension insurance (with the pension fully dependent on the insurance premium contributions paid) from the tax-financed flat-rate pension.

In our country, the statutory retirement age plays a crucial role in the decision-making of the clients about the starting date of old-age pension payments, also due to the fact that the clients are not informed (by the state or by the media) about the advantages of early retirement. Increased literacy of the clients in this regard may easily bring about serious fiscal impact. Also this perspective makes the transition to an actuarially neutral scheme of early and delayed old-age retirement sensible. Modern pension policy goes hand in hand with the elimination of early

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retirements and their replacement – solely in a modern social old-age insurance system – by a lower statutory retirement age with adequate incentives to continue gainful activity.

Acknowledgement

The paper has been elaborated within the project "Current trends in development of financial markets", with the Institutional support for long-term strategic development of research organization University of Finance and Administration in 2016.

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Contact information

Jaroslav Vostatek University of Finance and Administration Estonská 500, Prague 10, Czech Republic [email protected]

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TOXIC ASSETS OF THE FISCAL POLICY OF THE CZECH REPUBLIC

Karel Zeman

Abstract

The fundamental premise for the regular performance of economic policy, fulfilment of the revenues of the state budget and thus creating optimal conditions for efficient fiscal policy realization, is to minimize state receivables after maturity, as the theoretical planning of the revenue side of the state budget is irrelevant considering that tax payers and other entities fail to fulfil their liabilities towards the state, or more precisely the state budget, and conversely the state is not able to provide the approved income in the state budget.

The text is structured in the following way. First, the author took into consideration the theories which are connected with surveyed matters, followed by the characteristics and causes of state receivable development for the period of 1991 to 2014. The economic testing of dependence comes after. The next chapter characterizes the development of two experimental models for the management process of recovery of state receivables after maturity, research results included. The last chapter provides all the research results, evaluates the economic policy significance of the toxic assets of fiscal policy and suggests some solutions.

Keywords: economic and fiscal policy, taxes, receivables, unpaid balances, econometric testing,

regression analysis, transaction cost, implementation

JEL Classification: C35, D23, D78, H20, H30, H63

Introduction

By way of introduction to this contribution, the author allows himself to voice the question: what is actually the national economic significance of managing the state receivable recovery process, especially in relation to fiscal policy? The author looks for the answer mainly in the econometric testing of the dependency of the origin of state receivables and in the analysis of the current development of receivables, but also in the research of expert articles in renowned and impactive magazines, etc.

Until the transformation of the national economy of the Czech Republic began, the state was completely unprepared to deal with the failure to fulfil obligations on the part of domestic legal and natural persons, as well as foreign subjects. In a centrally-managed economy this area was practically not dealt with at all, because most obligations towards the state budget arose for state organizations.

At the start of the transformation period, this unpreparedness manifested itself most distinctly in the progressively growing volume of state receivables against debtors who failed to pay for assets acquired during the privatization process. This completely new situation called for the adoption of very fast measures consisting of the creation of a new system of managing the receivable recovery process in the National Property Fund of the Czech Republic (hereinafter NPF CR) with a certain subsequent time delay in the Land Fund of the Czech Republic (hereinafter LF CR). Similarly, the management of the process of recovering underpayments on taxes, customs duties and similar items was completely inefficient, because neither a legal environment, nor the institutional state facilities necessary for the completely new conditions of a liberal market economy, had been created.

197

1. ANALYSIS OF THE DEVELOPMENT OF STATE RECEIVABLES FROM THE

YEAR 2001 TO THE YEAR 2014 IN THE CZECH REPUBLIC

The examination of this issue commenced with an analysis of the development of state receivables arising from underpayments on taxes, customs duties and social security payments, i.e. receivables against private law subjects, not receivables against other states (governments) whereby statistical developmental series from the year 2001 to the year 2014 were examined. The statistical analysis of the development of state receivables1 set forth below created the basic files, which were subsequently used for the econometric regression analysis models.

Graph 1 shows the overall development of underpayments on taxes and social security payments in the Czech Republic. The periodicity of the data is on a biannual basis, from the second half of the year 2001 to the year 2014. The radical reduction in the volume of underpayments in the year 2014 was not caused by a more efficient recovery of receivables, but rather by an administrative intervention by the state, i.e. a write-off of a portion of allegedly irrecoverable receivables. Most likely, the reason for this administrative intervention by the state can be identified as the achievement of significantly better results in this area for political presentation. From graph 1 it's evident that the greatest volume for the entire monitored period is take up by underpayments on social security payments, at a relatively stable level for the entire monitored period. The second largest item are receivables from VAT, which however have a slightly progressive character from the year 2001 to the year 2008, and show a significantly progressive growth from the year 2009 to the year 2013.

Figure 1 - Overall development of the structure of underpayments (expressed absolutely in mil. CZK)

Source: Ministry of Finance of the Czech Republic (2002 – 2014), own adaptation

1 From a legal and accounting perspective, the correct name for the investigated state activities is “overdue receivables”. For better traceability of sources in the graphic and econometric section of the article, the not completely correct or fitting term “underpayments” which is used in publicly accessible sources by the Ministry of Finance of the Czech Republic, the Ministry of Labour and Social Affairs of the Czech Republic, etc., is used. The term “receivable overdue” covers all types of unpaid obligations by the state's counter-parties, as opposed to the term “underpayments”, which is very narrow.

-

25 000

50 000

75 000

100 000

125 000

150 000

175 000

200 000

225 000

Other Tax on the income of natural persons Tax on the income of legal personsSocial insurance Road tax Excise taxVAT

198

2. TESTING THE DEPENDENCY OF THE ORIGIN OF STATE OVERDUE RECEIVABLES ON THE ECONOMIC CYCLE, CHANGES IN THE TAX RATE AND THE ENTRY OF THE CZECH REPUBLIC INTO THE EU

Graph 2 compares the year-on-year growth rate of actual underpayments in the given six-month period with the year-on-year growth rate of actual GDP in the given six-month period. This data is the source for the first set of regression analyses – Regression I.

Regression model no. 1 analyses the growth rate of actual tax underpayments dependent on the growth rate of actual GDP, where the explained variable is the “year-on-year growth rate of actual underpayments for the six-month period” (seasonally adjusted - SA) and the explanatory variable is the “year-on-year growth rate of actual GDP for the six-month period”.

Figure 2 - Year-on-year growth rate of actual underpayments in the relevant six-month period, and the year-on-year growth rate of actual GDP in the relevant six-month period


The regression analysis (1) in regression block I examines whether the growth rate of actual tax underpayments depends on the growth rate of GDP in the same period (the variable g GDP t), in the previous six-month period (g GDP t-1), and two six-month periods ago (g GDP t-2), i.e. a year ago.

Only the response with a year's delay is proven to be statistically significant. The regression analysis (5) includes only the GDP growth rate delayed by two periods (i.e. by a year; g GDP t-2), which is statistically significant. At the same time, it includes the delayed growth rate of actual underpayments (i.e. the delayed endogenous variable Underpayments t-1), whose statistical significance indicates that the underpayments show a strong persistence. On the other hand, the entry of the Czech Republic into the EU did not prove to be statistically significant.

Regression block I, testing the dependency of the growth rate, documents that a significant delay exists between the change in the GDP growth rate and the subsequent response of actual tax underpayments. We can also note that the write-off of irrecoverable receivables in the year 2014 was evaluated as statistically significant. Dummy variables for this unsystematic state intervention in the year 2014 (i.e. the I. six-month period of 2014 and the II. six-month period of 2014) were

-10

-5

0

5

10

Year-on-year growth rate of underpayments for the six-month period

Year-on-year growth rate of GDP for the six-month period

II. 2014 -19,4

199

added to the regression analysis, so that the change in policy does not skew the estimates – results of key parameters. The examination also showed that results similar to those in regression block I may be obtained from the regression of simple differences and logarithmic differences which approximate the biannual growth rate. Graph 3 attempts to capture the cyclical component of GDP and the actual underpayments with the help of the Hodrick Prescott (HP) filter. For the biannual data, it is stated that the parameter λ = 100. The anti-cyclicity of actual underpayments is evident from the graphic analysis. In other words, if the economy finds itself in a boom (measured by the positive gap in the output calculated by the HP filter), actual underpayments have a tendency to fall, and vice versa. An oddity is the behaviour during the recession in the years 2008-2009, which was “imported from abroad”, when underpayments only begin to grow after a considerable delay. Table 1 - Regression I: Year-on-year growth rate of seasonally adjusted actual underpayments in

the given six-month period

VARIABLES (1) (2) (3) (4) (5)

g GDP t -0,637 -0,216

- - - (0,540) (0,264)

g GDP t-1 1,017

- -0,413 -0,400

- (0.677) (0,254) (0,257)

g GDP t-2 -1,499***

- - - -0,690**

(0,451) (0,255)

Underpayments t-1 - 0,596*** 0,551*** 0,545*** 0,431**

(0,190) (0,181) (0,183) (0,176)

Entry into the EU - - - -2,956 -3,372

(4,006) (3,656) I. six-month period of 2014

-9,146*** -7,831* -8,329* -8,403* -9,986**

(1,772) (4,253) (4,052) (4,103) (3,822) II. six-month period of 2014

-23,37*** -17,82*** -18,04*** -18,20*** -19,99***

(1,569) (4,224) (4,019) (4,073) (3,813)

Constant 3,916** 1,022 1,580 1,684 2,615**

(1,374) (1,129) (1,087) (1,110) (1,109) Number of observations

23 24 24 24 23

R2 0,704 0,668 0,698 0,707 0,766

DW 1,6 2,23 2,3 2,4 2,5

AIC 130,19 139,50 137,19 145,54 128,73 BIC 134,73 145,39 143,08 138,47 135.54

F stat (p-value) - 0,0002 0,0001 0,0002 0,0001

Robust (only in 1) standard errors reported in brackets, *** p<0,01, ** p<0,05, * p<0,1

Source: own

200

Figure 3 - Comparison of the development of the production gap and actual seasonally adjusted (SA) underpayments with the HP filter, biannual data, HP filter λ = 100


Regression model no. II analyses the cyclical behaviour of actual tax underpayments dependent on the cyclical behaviour of actual GDP using the HP filter, where the explained variable is the “actual logarithmized underpayments (SA) with the HP filter” and the explanatory variable is the “total actual GDP (SA) logarithmized with the HP filter”.

Table 2 - Regression II: Actual seasonally adjusted logarithmized underpayments, deviation from filtered values with the help of the HP filter

VARIABLES (1) (2) (3) (4) (5)

GDP t HP -0,253 _ _ _ -0,183

(0,382) (0,328)

GDP t-1 HP _ -0,599 _ _ _

(0,433)

GDP t-2 HP _ _ -0,842** -0,565** _

(0,393) (0,263)

Underpayments t-1 _ _ _ 0,669*** 0,766***

(0,219) (0,194)

I. six-month period of 2014 -0,0181** -0,0230** -0,0364*** -0,101*** -0,0996**

(0,00780) (0,00972) (0,0126) (0,0261) (0,0374)

II. six-month period of 2014 -0,123*** -0,125*** -0,133*** -0,121*** -0,113***

(0,00709) (0,00765) (0,00917) (0,00647) (0,0316)

Constant 0,00521 0,00634 0,00827 0,00668 0,00537

(0,00801) (0,00797) (0,00795) (0,00621) (0,00627) Number of observations 27 26 25 25 26

R2 0,313 0,375 0,447 0,653 0,607

DW 0,95 1,01 1,02 2,3 2,4

AIC -98,99 -96,93 -95,45 -105,09 -103

BIC -96,40 -94,42 -93,01 -101,44 -96,70

F stat (p-value) - - - - 0,0004

Robust (in 1, 2, 3 and 4) standard errors reported in brackets, *** p<0,01, ** p<0,05, * p<0,1

Source: own

2,1

0,2

-0,9 -1,4 -1,9 -2,3-1,7

-0,9 -0,6

1,11,9

2,73,7 3,9

2,9

-2,6 -2,7-1,7

-0,5

0,5 0,5 0,0-1,0

-1,8-0,6

0,11,0

-2,2

-2,4

1,31,9 1,9

0,20,0

5,6

0,71,3

3,0

-2,5

-1,2-2,5

-3,8

-4,8 -5,7

-4,6

-1,5

3,3

1,2

3,1

6,6

3,8

10,6

-1,3

-12,0

-15,0

-10,0

-5,0

0,0

5,0

10,0

15,0

Production gap (%) Total actual underpayments (SA) with HP filter (%)

201

Regression block II works with deviations from the filtered values of seasonally adjusted actual tax underpayments. It uses a similar method for actual GDP. The HP filter is used. Thus, it represents econometric support for graph 3. The regression analysis (3) in regression block II documents that, using the HP filter, it is possible to detect the anti-cyclical development of actual tax underpayments. This relationship manifests itself with a delay of one year (the statistical significance of the variable GDP t-2 HP). The strong persistence of actual underpayments from the high statistical significance of the delayed endogenous variable Underpayments t-1 is again evident from regression analyses (4) and (5). According to regression analyses (1) and (2), the effect of the economic cycle will not manifest itself in a delay of less than one year, i.e. one six-month period (variable GDP t-1 HP), or concurrently (variable GDP t HP). Furthermore, expanded research has shown that a similar conclusion can be drawn from regressions which test the dependency of the absolute amount of actual underpayments on the economic cycle, which is detected with the help of the HP filter. A statistically significant response is noted only after a year's delay. In other words, if the economy begins to overheat and show a positive production gap, actual underpayments will fall in absolute terms only after a year's delay. Graph 4, for the identification of the economic cycle, uses the seasonal adjustment of logarithmized values by a linear trend. Thus, the explanatory variable “ln GDP LT“ in the regressions below represents a deviation by the logarithmized GDP from the linear trend. If the given quantity (e.g. GDP) grew at a constant rate, the deviations in this type of analysis would be zero. The anti-cyclical behaviour of the underpayments is clearly evident in this illustration. The econometric support is captured in regression blocks III and IV.

Figure 4 - Total actual underpayments (seasonally adjusted (SA)) in logarithmic form, a deviation from the linear trend, and the total actual GDP (SA) in logarithmic form, a deviation from the

linear trend


Regression model no. III analyses the cyclical behaviour of logarithmized actual tax underpayments, dependent on the cyclical behaviour of the logarithmized actual GDP, using the linear trend, where the explained variable is the “total actual logarithmized underpayments (SA) + filter – linear trend” and the explanatory variable is the “total actual logarithmized GDP (SA), filter – linear trend”.

0,03

0,03

0,060,05

0,02

0,01

0,06

-0,01

-0,01

-0,07

-0,07

-0,09-0,10

-0,11

-0,11 -0,09

-0,05

0,02

0,05

0,10

0,08

0,16

0,05

-0,06-0,052

-0,059

-0,059

-0,052

-0,044-0,035

-0,015 0,006

0,050

0,0670,082

0,0940,096

0,082

0,0220,012

0,013

0,015

0,004

-0,012

-0,034

-0,053

-0,052

-0,15

-0,10

-0,05

0,00

0,05

0,10

0,15

0,20

CRN_ln_lin HDP_ln_lin

202

Table 3 - Regression III: Logarithmized seasonally adjusted actual tax underpayments, a deviation from filtered values with the help of a linear trend

VARIABLES (1) (2) (3) (4) (5) (6)

ln GDP t LT -1,051*** _

_

-0,427** _

-0,404

(0,151) (0,179) (0,548)

ln GDP t-1 LT _

-1,144*** _

_

-0,460** -0,0270

(0,144) (0,201) (0,927)

ln GDP t-2 LT _

_

-1,181*** _ _

-0,112

(0,145) (0,596) Underpayments t-1

_

_

_

0,764*** 0,719*** 0,707***

(0,139) (0,156) (0,185) I. six-month period of 2014

-0,0179 -0,0205 -0,0256 -0,106** -0,0991** -0,105**

(0,0144) (0,0151) (0,0170) (0,0378) (0,0386) (0,0405) II. six-month period of 2014

-0,122*** -0,127*** -0,126*** -0,122*** -0,121*** -0,128***

(0,0147) (0,0155) (0,0168) (0,0345) (0,0348) (0,0366)

Constant 0,00519 0,00689 0,00902 0,00667 0,00662 0,00870

(0,0103) (0,0101) (0,0109) (0,00674) (0,00680) (0,00734) Number of observations

27 26 25 26 26 25

R2 0,571 0,641 0,644 0,825 0,821 0,834

DW 0,79 0,83 0,75 2,18 1,9 2,1

AIC -86,42 -86,99217 -82,9 -99,60 -99,15 -92,01 BIC -83,83 -84,48 -80,46 -93,32 -92,86 -83,48

F stat (p-value) - - - 0 0 0

Robust (in 1, 2 and 3) standard errors reported in brackets, *** p<0,01, ** p<0,05, * p<0,1

Source: own

The graphic analysis about the significance of the economic cycle is confirmed by regression block III – a concurrent effect exists (the statistically significant variable ln GDP t LT in regression analysis (1)), delayed by a six-month period (the variable ln GDP t-1 LT in regression analysis (2)) or even by one year (the variable ln GDP t-2 LT in regression analysis (3)). Again, the significance of the persistence of the underpayments is evident, as documented by regression analysis (4). At the same time, regression analysis (4) takes the form of a Koyck transformation, from which it follows that 50% of the effect of GDP manifests itself during 0.764/(1-0.764) = 3.23 of the period, i.e. during approximately one and a half years. Regression (6) is consistent with this. It can be shown that the common restriction on the GDP parameters in various delays is statistically significant. Regression analysis (4) also implies that a positive deviation of 1% from the GDP trend results in a 0.4% fall in underpayments below the trend. Similar results were also obtained for unlogarithmized GDP and tax underpayments.

Regression model no. IV analyses the cyclical behaviour of logarithmized actual tax underpayments, dependent on the cyclical behaviour of logarithmized actual GDP, using a linear trend. The effect of entry into the EU and changes in VAT, where the explained variable is the “total actual logarithmized underpayments (SA) + filter – linear trend” and the explanatory variable is the “total actual logarithmized GDP (SA), filter – linear trend; entry into the EU, change in VAT.”

Neither entry into the EU nor changes in VAT were shown to be statistically significant, as is documented by regression block IV. Changes in VAT were tested for two reasons. Firstly, VAT underpayments form a significant part of total underpayments. And secondly, during the course of the monitored period, changes occurred in this tax (unlike the rate of social security payments), as the table 5 below documents.

203

Table 4 - Regression IV: Logarithmized seasonally adjusted actual tax underpayments, deviation from filtered values with the help of a linear trend

VARIABLES (1) (2) (3) (4)

ln GDP t LT -0,443** -0,451** _

_

(0,179) (0,212)

ln GDP t-1 LT _

_ -0,490** -0,522*

(0,200) (0,249)

Underpayments t-1 0,777*** 0,799*** 0,725*** 0,700***

(0,138) (0,173) (0,154) (0,207)

Entry into the EU -0,0389 _

-0,0423 _

(0,0338) (0,0341)

VAT change 2004 _ -0,0408 _ -0,0422

(0,0369) (0,0371)

VAT change 2008 _ 0,00193 _ 0,00149

(0,0389) (0,0390)

VAT change 2010 _ -0,00300 _ -0,0129

(0,0402) (0,0419)

VAT change 2012 _ 0,0227 _ 0,0326

(0,0362) (0,0364)

VAT change 2013 _ -0,0295 _ -0,0128

(0,0388) (0,0394) I. six-month period of 2014

-0,111*** -0,115** -0,104** -0,101**

(0,0377) (0,0426) (0,0383) (0,0440) II. six-month period of 2014

-0,126*** -0,128*** -0,125*** -0,126***

(0,0344) (0,0377) (0,0345) (0,0376)

Constant 0,00849 0,00908 0,00864 0,00835

(0,00687) (0,00817) (0,00691) (0,00816) Number of observations 26 26 26 26

R2 0,835 0,846 0,834 0,845

DW 2,36 2,2 2,16 2,17

AIC -99,27 -92,97 -99,09 -92,81 BIC -91,72 -80,39 -91,54 -80,23

F stat (p-value) 0 0,0001 0 0,0001

Standard errors reported in brackets, *** p<0,01, ** p<0,05, * p<0,1

Source: own

Table 5 - Changes in VAT rates

Basic rate Reduced rate

1. 1. 1993 – 31. 12. 1994 23 % 5 %

1. 1. 1995 – 30. 4. 2004 22 % 5 %

1. 5. 2004 – 31. 12. 2007 19 % 5 %

1. 1. 2008 – 31. 12. 2009 19 % 9 %

1. 1. 2010 – 31. 12. 2011 20 % 10 %

1. 1. 2012 – 31. 12. 2012 20 % 14 %

1. 1. 2013 – 31. 12. 2014 21 % 15 %

1. 1. 2015 – 21 % 15 % 10 %

Source: ucetni-portal.cz, 2014

Regression model no. V analyses the behaviour of logarithmized actual tax underpayments,

204

dependent on the cyclical behaviour of logarithmized actual GDP, using a linear trend, where the explained variable is the “total actual logarithmized underpayments (SA)” and the explanatory variable is the “total actual logarithmized GDP (SA), linear trend”.

Regression block V provides conclusions similar to regression blocks III and IV, whereby, even in the delays, the analysis can be confirmed. Compared to regression blocks III and IV, the last block does not examine deviations by underpayments from the trend, but studies the dependency of the total underpayments on the course of the economic cycle, which is identified by deviations in the logarithmized GDP from the linear trend. The reason is that the underpayments do not show a significant trend. This problem can also be viewed from the perspective that that as long as GDP grows at a certain rate, the total amount of the actual underpayments does not change. If the GDP accelerates above its trend, the amount of the actual underpayments will fall in absolute terms.

Table 6 - Regression V: Logarithmized seasonally adjusted actual tax underpayments

VARIABLES (1) (2) (3) (4)

ln GDPt LT -1,043*** -0,416** -0,434**

(0,180) -0,438* (0,213) (0,199) (0,181)

Underpayments t-1 _

0,776*** (0,141)

0,788*** 0,814***

(0,140) (0,176)

Entry into the EU _ _ -0,0395 _

(0,0340)

VAT change 2004 _ _

_ -0,0414

(0,0372)

VAT change 2008 _

_ _

0,00182

(0,0391)

VAT change 2010 _

_ _

-0,00113

(0,0405)

VAT change 2012 _

_ _

0,0232

(0,0365)

VAT change 2013 _

_ _

-0,0297

(0,0393) I. six-month period of 2014

-0,0135 -0,107** -0,111*** -0,116**

(0,0520) (0,0383) (00382) (0,0434) II. six-month period of 2014

-0,118** -0,121*** -0,125*** -0,127***

(0,0522) (0,0348) (0,0346) (0,0379)

Constant 12,01*** 2,699 2,556 2,244

(0,00997) (1,689) (1,680) (2,110) Number of observations 27 26 26 26

R2 0,562 0,823 0,834 0,844

DW 0,78 2,16 2,35 2,19

AIC -81,84 -99,23 -98,93 -92,62 BIC -76,66 -92,94 -91.38 -80,04

F stat (p-value) 0,0002 0 0 0,0001

Standard errors reported in brackets, *** p<0,01, ** p<0,05, * p<0,1

Source: own

205

Conclusion

Alarming national economic conclusions have emerged from the economic, econometric, statistical and legal analysis, which have fundamental negative consequences for the fiscal policy of the Czech Republic:

o The absolute volume of underpayments expressed in CZK has a growing character whereby, through state intervention in the year 2014 – the write-off of receivables – the total amount was reduced by approximately 40 billion CZK.

o By comparing the development of nominal underpayments in relation to the amount of the GDP amount, it was discovered that this trend, since the year 2001 when it reached 13 % of the amount of GDP, was reduced to just 8% in the year 2008. From the year 2009 to the year 2013 the trend developed negatively, reaching 11%.

o The structure of underpayments shows a very stable character in the area of social security, tax on the income of legal persons, tax on the income of natural persons, excise tax, road tax and other taxes. The only tax which shows a negative development is VAT, because between the years 2001-2013 the growth index is approximately 150 %. This quite logically also manifests itself in the percentage representation of individual types of taxes. First and foremost, we must draw attention to the highly negative development of state receivables between the years 2009 and 2013, when the growth index is approximately 30 %, as a result of which the total volume of overdue receivables reached a record amount of approximately 225 billion on 31/12/2013. In the year 2013, total income into the state budget amounted to 1,091.86 billion CZK (Ministry of Finance of the Czech Republic, 2013). In relation to the income side of the state budget, the volume of overdue receivables amounted to approximately 20.5%.

o The current unsystematic and inefficient method of managing the receivable recovery process in the Czech Republic is caused by legislative-legal and institutional deficiencies, different methods of procedure by individual state institutions, the non-existence of a single central register of the state's debtors, and more than 20 years' lack of interest on the government's part in resolving the toxic assets of fiscal policy.

o Econometric analysis led to the following most interest national economic results: § The entry of the Czech Republic into the EU was not demonstrated to be statistically

significant. § The effect of the recession imported from abroad at the turn of the years 2008-2009 on the

immediate increase in underpayments was not proven; on the contrary, this growth only manifested itself after a considerable delay.

References: 1. Ministry of Finance of the Czech Republic (2002 – 2014). Report on the fulfilment of the state

budget of the Czech Republic. http://www.cnb.cz/docs/ARADY/HTML/index.htm 2. Ministry of Finance of the Czech Republic (2010). Final state accounts of the Czech Republic

for the year 2010. http://www.mfcr.cz/cs/verejny-sektor/monitoring/plneni-statniho-rozpoctu/2010/statni-zaverecny-ucet-za-rok-2010-2059

3. Ministry of Finance of the Czech Republic (2013). Final state accounts of the Czech Republic for the year 2013. http://www.mfcr.cz/cs/verejny-sektor/monitoring/plneni-statniho-rozpoctu/2013/statni-zaverecny-ucet-za-rok-2013-17756

4. Ucetni-portal.cz. Changes in the rates of VAT. 2014. 5. Zeman, K. (2016). State receivables – the destructive factor of the fiscal policy of the Czech

Republic. Journal of Political Economy, 2016(3), 264-292, DOI: 10.18267/j.polek.1070 6. Zeman, K. (2015). Analysis of privatization process of the Czech Republic. Prague: Karolinum

2015. 303 s. ISBN 978-80-246-2939-1. 7. Zeman, K. (2013). Development of ownership to land and related processes in the Czech

Republic from 1918 until now. Prague: Oeconomica 2013. 316 s. ISBN 978-80-245-1915-9.

206

Contact information

Karel Zeman University of Economics in Prague W. Churchill Sq. 4, Prague 3, Czech Republic [email protected]