Реферат: Transitional Success: USSR to EU

The CzechRepublic

TransitionalSuccess:

USSRto EU

Public financepolicy issues during the political

economictransition from centrally planned socialist

economics tofree market democratic capitalism.

V550 Dr.Mikesell

November 20,1996

Rick Fergusonrfergus@indiana.edu

Eric Martinemartin@indiana.edu

DmitriMaslitchenko dmitri@mailroom.com

Table of Contents

I.          Introduction

II.        Political Summary:Restructuring for Transition

III.       Transition to MarketEconomy: 1990 — 1991

IV.       Problems of TransitionalMonetary Policy and the Financial Sector: An Overview

V.        Macro Economic Stability: 1993 — present

VI.       Monetary Policy: 1993

VII.     Intergovernmental FinancialRelations

VIII.    Budgetary Overview: 1993 — present

IX.       Tax Reform

X.        Current Political EconomicConsiderations: 1996

XI.       The EU and NATO

XII.     Conclusions

XIII.    References

Introduction

In 1989, afternearly 40 years of Soviet control, Czechoslovakia once again became an independentnation, the Czech and Slovak Federalist Republic. This transition from Sovietsocialism to democracy culminated throughout Central and Eastern Europe withthe literal collapse of the Berlin Wall in East Germany, the heroic GdanskShipyard Strikes in Poland. The student and worker protests in Prague andBudapest were no less important.

TheCzechoslovakian revolution took place peacefully and over a much longer periodof time than events in other former Soviet Union or Warsaw Pact nations. Hintsof major reform in Czechoslovakia began as early as 1968. Czechoslovakianofficials, under Soviet power, moved incrementally to begin the long roadtowards decentralization and independent Czechoslovakian rule. Theirincreasingly effective efforts became known as the Prague Spring, a time ofgrowth, change and development.

Success was, ofcourse, neither immediate nor easy to achieve. The Cold War reached a pinnaclein the Eighties and the winds of change began to blow in Central and EasternEurope. The CEE nations endured many hardships. Soviet oppression, thoughwaning by this time, became largely unbearable. Change in Czechoslovakia camefrom the ground up; dissidents quietly began to return to popular power. Therevolution gained momentum by 1989.  ‘Revolutionists’ began to demand sweepingeconomic and political reform. They were backed by well organized and verytimely strikes and protests. After a two hour general strike on November 27,1989, proving the immediate and widespread power and cohesion of the revolution,the Soviet controlled authorities finally agreed to negotiate.

Through thenegotiation process and threat of further massive general strikes, formerdissidents assumed officially sanctioned ‘concessional’ positions. Withinmonths, they gained near complete (and very real) control of the FederalAssembly. On December 29, 1989, Mr. Havel, a very famous and popular Czechdissident, became President of Czechoslovakia (renamed the Czech and SlovakFederalist Republic).

This initialpolitical victory represents only half of the nation’s success. Within thefirst three years of self rule, harsh economic (and subsequent political)realities forced the nation to divide once again. The nation as a whole wasunable to accommodate the vast discrepancies between the western Czech andeastern Slovak regions. Massive economic reforms brought this to the popularagenda as Slovakia suffered greatly while their Czech counterparts seemed tobenefit from reform.

The governmentin Prague wished to move swiftly to further reform efforts. Slovakia hinderedCzech success and in turn suffered greatly by this Czech-led reform. Slovakiasimply could not move as rapidly toward a market economy due to the economicconfiguration left to them by years of Soviet planned economics.

Political Overview: Restructuring for Transition

In 1992,Vladimir Meciar, a very strong nationalist was elected prime minister of theSlovak Republic, while Vaclav Klaus, a moderate federalist, was elected in theCzech Republic. Unfortunately, these two leaders were unable to agree on commoneconomic and political strategies to govern the CSFR. Klaus’s reform plans, nowlegendary, were simply inappropriate for the fledgling Slovak regions.Slovakians felt alienated from the government reform in Prague. Within a shorttime it was very clear that the Czech regions could not completely supporttheir Slovak countrymen through the transition. The two leaders agreed todivide the Czech and Slovak Federalist Republic (CSFR) into the Czech andSlovak Republics on January 1, 1993.

Federal assetsand liabilities were split between the two nations in a two to one ratio. TheCzech Republic received the larger portions reflecting both size andpopulation. Again, the split was achieved peacefully, without massive debate.The two countries agreed to form a customs union. They implemented identicalforeign policies with respect to third countries, and forbid tariffs or ‘bans’between themselves. They also formed a temporary monetary union, whichcollapsed within months as both countries unexpectedly experienced a massivedrain on foreign reserves during this time. To more fully understand thecurrent developments in the Czech Republic, one must examine the historicaleconomic decisions made before the break-up in 1993 as outlined below.

Transition to Market Economy Overview: 1990-1991

CSFR economicreformers went to work immediately following the collapse of Soviet rule. Thereform package included near complete liberalization of prices, a completereversal of former exchange and trade systems and an impressive preparation formassive and rapid privatization. These efforts were supported by financialpolicies including a “pegged” exchange rate, currency devaluations, andrestrictive fiscal, monetary and wage policies.

Monetary Policy

Althoughmonetary policy is discussed in a separate section, it needs to be brieflyaddressed here to understand the conditions in which the transition occurred.Monetary policy in the initial stages of transition ensured that inflation remainedin control throughout currency devaluations and price liberalizations. The CSFRdevalued its currency by 20 percent in 1991 after several smaller devaluationsbefore hand. Taken as a whole, these devaluations reduced the value of thecurrency by half within six months. Generally, monetary policy remained tightthroughout the entire period.

Fiscal Policy

Undoubtably, thegoals of the CSFR economic reformers were to drastically reduce governmentspending. The former centrally-planned, output-driven economic policies were nolonger effective for the new capitalist democracy. Restructuring governmentexpenditures was a key component of reform. The main changes, aside frommassive privatization discussed below, forced reduced subsidies wherever possible.Every sector of society, with the exception of health, welfare and education,saw an abrupt end to government subsidies. In 1991 alone, for example,officials reduced government spending by 12 percent to reach 47 percent of GDP.This trend continued throughout the transition. Massive government spending, ahallmark of socialism, ended virtually overnight.

Areas wheregovernment spending remained high would remain so throughout the reformprocess. Health and welfare for poor, elderly, unemployed and children is avery difficult situation in any government, especially one in transition.Reformers focused primarily on industry and energy in the initial stages,leaving the areas of greater uncertainty to be dealt with in a more stablepolitical environment.

PriceLiberalization

As an almostimmediate measure, subsidies to foodstuffs and energy were reduced by nearly 50percent. Retail prices for most household items increased by nearly 25 percentliterally overnight.  By the end of 1991, the Czech government controlled only6 percent of prices in the country as compared with 85 percent in early 1990.Only basic necessities, oil, and agricultural products remained under statecontrol. To offset some of these shocks, wages increased, though only slightlyand not nearly enough to meet the increased cost of living. Politicallypowerful trade unions prevented the passage of even more drastic reformmeasures. Plans in 1991 to increase the price of electricity, heating oil andcoal by nearly 400 percent and rent by 300 percent were delayed until 1992 and1993.

Foreign Tradeand Investment

After an initialcurrency devaluation of nearly 50 percent, the government adopted an adjustedexchange rate connected to a “basket” of convertible hard currencies. Internalconvertibility of hard currencies was established in 1991. These two measurescombined to foster trade and investment. Initially, the CSFR set a 20 percentsurcharge on imports coupled with a 5 percent tariff. These obstacles soonended as major provisions were passed to more actively encourage trade andinvestment. Initial steps toward private property rights and the disseminationof publicly owned lands further enhanced the investment environment.

Privatization

Privatization isby far the most critical and complicated development the CSFR had to address.Speed was critical. The ‘default mechanism’ ensured that current managers andpersons of powers would assume control and create their own joint ventureagreements with foreign entities.

State firms thatwere nearly completely vertically integrated needed to be desegregated by formand function. And the process had to be done well, for flailing industrieswould simply increase state expenditures. Failures did not decreaseexpenditures in compliance with the transitional reform strategy. The CSFRprivatization plan was threefold. Small-scale privatization was the easiest.Retail stores, restaurants and small service or industrial workshops were soldto the highest bidders in weekly public auctions. Where no CSFR buyers werefound, a second round of auctions allowed foreigners to bid.

Propertyrestitution was more difficult. The government needed to equitably redistributeland that had been taken nearly 40 years earlier. This is a difficult andinvolved issue. CSFR citizens are allowed to claim land taken from them, thoughthe burden of proof is on them. Where no proof exists, special arrangements canbe made for state assistance. In areas of conflict, the issue will be broughtto the courts. A large part of the country was not in private hands beforeSoviet rule. Some of this land can be used as an offering to parties wheredisputes over ownership exist. Also, lands that have been improved (shops,developments, houses, etc.) are sold at specially determined rates to theformer property owners. Prices and possible alternative compensation for thoseowners who do not wish to purchase these ‘improvements’ are again settled by aspecial court arrangement.

Large-scaleprivatization progressed swiftly. Some state-owned firms were sold outright toprivate interests while others remained under indirect state control untilbuyers were found, legal or economic concerns settled, or parliamentary debateresolved.

Social Policy

The strongtradition of labor unions and their political strength proved crucial to socialsecurity reforms throughout CEE. The CSFR was no exception. Labor unions wereinstrumental in keeping CSFR unemployment at very low levels and social safetynet benefits quite high. Essentially the state guaranteed incomes at a minimallevel to meet the ‘cost of living’ for the unemployed or the under-employed.Pensioners and parents of children received benefits adequately covering bareessentials. Further benefits for health care were distributed at the locallevel as the health system still remained under state control.

Problems of Transitional Monetary Policy and theFinancial Sector

Since theintroduction of reforms, monetary policy played a key role in the economicstability of the Czech Republic throughout the transition. Inflation remainedsurprisingly low (though relatively high in 1989 and 1990), exchange rates wererelatively stable (after initial fluctuations), and external reserves stayedstrong throughout the period (spurred by unusual and unexpected outsideinterest in the Czech Republic as the first reformer to prove its success).

What is perhapsmost impressive are the obstacles Czech officials overcame in developing aneffective monetary policy. First, the entire CMEA trading block was virtuallydismantled. Reform and transition would be difficult even with stable tradingpartners. In the CMEA, all of the countries were experimenting with andadjusting prices, exchange rates and policies. It was very difficult to setmonetary conditions correctly, in real or absolute terms.

Second, withinjust a few short years, the CSFR itself broke apart for economic and politicalreasons. This was largely unexpected and proved difficult in the policy makingarena. As the break-up drew near, officials had a difficult time determiningwhich policies should be enacted based upon which of many scenarios might occurin the CSFR.

Third, afterfinally establishing the terms of the CSFR split and negotiating a seeminglyeffective customs and monetary union between the two new countries, themonetary union failed miserably. Within a few months, the union causedsignificant drains on much needed foreign reserves in both countries and had tobe abandoned.

Finally, theCzech tax system had to be completely overhauled. Additionally, the bankingsystem needed massive reform. Large spreads in interest rates were common andoverall the banks were simply reluctant to lend on any long term basis, a majorimpediment to domestic investment and growth.

 All of thesemassive changes occurred within just a few years. Throughout thesedevelopments, monetary policy remained extremely tight. At the onset of thereform period, it was at its tightest, with a minor break late in 1991, oncethe political economic dust had settled. Otherwise, the next monetary reprievedidn’t occur until the second half of 1993.  By 1994, broad money grew at 30percent compared with growth of 15 percent a year earlier. More important thandoubling growth figures is that the economy was able to withstand this growthby 1994!

Interest rateswere high throughout the period, and continue to remain high by most westernstandards (over 9 percent). Interest rates were not directly controlled butwere subject to central bank reserve requirements and discount rateannouncements. Liquidity was further controlled through regular auctions oftreasury bills.

Bank reformfocused primarily on establishing the legal framework for transactions betweenthe central bank and newly established commercial banks. Weaknesses stillremain in reporting and accounting and the reluctancy for banks to lend.Several commercial banks have had to come back under government control toprevent major economic problems.

Macro Economic Stability 1992 — present

By 1992, theCSFR began to show significant signs of success. Though they were in fact moredisadvantaged than many other countries in the CEE, they fared well. Theirexport market consisted almost entirely of former members of the Council forMutual Economic Assistance (CMEA) who were in the same transitional position asthe CSFR, impeding efficient trade. Fortunately, inflation on the whole in theCSFR remained remarkably low when compared to the rest of the CMEA, as didexternal debt. Inflation did jump just before the CSFR breakup into the Czechand Slovak Republics. Experts suggest this occurred in part due to the fear ofinstability during the breakup and in part due to an anticipated VAT. Asexpected, in 1993 (in the Czech Republic), inflation rose again afterintroduction of the VAT.

In 1993, freefrom its less advantaged Slovak counterpart, the Czech Republic better targetedits economic recovery plan. The plan encompassed three main elements:

1)  A balancedstate budget that encompassed sweeping tax reform;

2) A tight monetarypolicy to reduce the inflation caused by VAT and other lesser effects (which             alsoimproved its external position for trade and investment); and

3)  Moderatewage increases (adjusted to inflation) and a stable exchange rate.

This reformpolicy was backed by an IMF “stand by” arrangement as a precautionary measure.The IMF would assist if the Czech Republic needed financial assistance. Thishappened once early in 1993 and Czech officials repaid the loan before it camedue (much to the delight of the IMF).

Unemploymentremained remarkably low in the Czech Republic at 3 percent in 1993, whilePoland’s figures (another major success story in CEE) still remain indouble digits. Low, virtually non-existent unemployment certainly contributesto greater political and popular acceptance of the above fiscal and monetarypolicies.

Many attribute amajor setback in the Polish “Shock Therapy” reform efforts to the politicaldemands of the labor unions. The Polish President, Lech Walesa, understood theneed to keep wages low to implement the reform. But he feared for his politicalpower and caved in to labor pressures by granting wage increases. By doing sohe nearly destroyed the entire economic reform process. He claimed that had henot, the entire political reform process would have crumbled.

Czech officialsdidn’t face this obstacle as unemployment throughout the transition remainedlow. The political reform process was slightly segregated from the economicreform process. The small Czech population (roughly 10 million) was easier toorganize than Poland’s 40 million. Regional differences were less and politicalfactions less pronounced. Regardless, by 1993, the Czech Republic had a verycohesive popular political support base which facilitated the economic reforms.

By 1994, foreigntrade increased substantially, with much of the growth occurring between EUmember nations. Tourism in Prague, now a “must see” on any European vacation,contributed to increased trade to maintain a strong balance of payments and asurplus in the current account. Though FDI by 1994 had decreased (after veryhigh initial investments in 1992 and 1993), the

capital accountmaintained high inputs due to the rise in borrowing of Czech firms (whichproved even better for Czech long term economic success).

GDP began torise slightly after a period of decline from 1991-1993 of nearly 20 percent.Privatization entered its second round in 1994 for enterprises being privatizedthrough voucher programs. The first wave of privatization is considered aremarkable success (a model to be used farther east). As this first wave endedin 1993, the Prague stock exchange began trading and the banking system wentthough increased and improved reforms. The Czech Republic was a leader in theCEE in trade and investment. Economic reform efforts, coupled with the abovementioned political support, put the Czechs at the forefront of CEE success.

Industry

Industrialoutput by 1993 declined by nearly 21 percent compared with 1991 figures. Thiscan partially be explained by increases in the service sector, as investmentsoared in service sectors and dropped dramatically in the industrial sector.Also, the industrial sector was the most inefficient sector in the formercentrally planned economy and much of those inefficiencies were corrected withthe introduction of market reform. Most industries produced less as consumptiondropped. And they did so more efficiently as output based economic plans wereno longer used.

It issignificant to note that the Czech Republic does not have an industrial policy.They feel the state does not have enough information or resources and thus itis most efficient to allow the private sector complete control. Governmentcould assist with exemptions and subventions, but the market should determinewinners and losers.

However, theCzech government continued, through 1994, to bail out state-owned enterprises,mostly due to their economic (employment) and political leverage. In essence,this hurts struggling smaller, private, firms that are unable to compete withgiants, let alone subsidized giants. These large industrial subsidies are allbut gone in most industries today, however they still exist for politicallysensitive or economically vital industries. In some cases the government reluctantlyreturned to subsidies as not all of the initial privatization efforts provedsuccessful. Some large enterprises were not effectively dismantled and theresulting giant enterprises were simply too large and inefficient for the newmarket economy. It took several years, in some cases, to learn this lesson.

Prices

Consumer priceinflation by 1993, after the initial shocks of the VAT, stabilized at 18percent. Experts estimate the VAT added 7 percent to inflation during 1993 andan additional 2 percent can be attributed to government administered priceregulations. Price regulations remained mostly in the utilities sector.Adjustments from 1994-1995 increased prices in several key areas including gas,oil, transportation, medicine and telecommunication tariffs.

Wages

Wage restraintsthrough a “tax based income policy” was an important feature of the CSFR. Wagerestraints ended in 1993, but had to be brought back by the end of the year bythe Czech government. The rational behind bringing the restraints back was thatmarket forces were not yet adequate to control wage increases. Wage increaseshad to remain close to increases in consumer prices to avoid inflationarydifficulties. Therefore, as late as 1995, up to 100 percent tax rates wereapplied to wage increases over allowable limits, effectively keeping wages atdesired rates.

Monetary Policy:1993

By 1993, Czechmonetary policy began to stabilize in conjunction with political and economicindications of success. The basic aims of monetary policy at this point weresimply to maintain internal and external currency stability. Officials kept theCzech crown pegged to stable European currencies and prevented inflation fromrising above 10 percent. In a somewhat disguised blessing, foreign capital flowedinto the Czech Republic at high rates in 1994 causing officials to raisereserve requirements from 9 to 12 percent to insure inflationary stability. Thebanking system, though still flawed, was able to withstand the pressures. Theeconomy certainly welcomed the increased capital.

By 1993 and evenmore so by 1994, monetary policy was less of a political tool in the reformprocess. Stability in many respects had been achieved. The nature of furtherreform and continued stability relied almost entirely upon fiscaldecision-making. To fully understand and appreciate the political economics ofreform from 1993 onward, both fiscal and monetary, an examination of the Czechbudget is helpful. Defining the role of the state in the new market orientedeconomy is critical. Two main issues must be examined, the resources andinformational capabilities of the state. Both are limited and both are notindependently effective. The budget and the political issues surrounding itspassage are important in understanding the Czech approach to stability now thatmuch of the transition has been rather successfully completed.

IntergovernmentalFinancial Relations

Before thebudget analysis, a brief overview of intergovernmental financial relations maybe helpful.  The Department of Finance makes budgetary estimates for theMinistry of Economy. They regulate spending and essentially decide whichorganizations and institutions receive the much sought after governmentsubsidies. They are also responsible for government accounting, financialmanagement and regulation of wages. The Department of Finance is classifiedunder the Ministry’s “Administration and Finance” section.

The ForeignEconomic Relations Department, the European Affairs Department and the Economicand Social Policy Department are all included under the Ministry’s “EconomicPolicy.” They all report to the Ministry and are essentially charged with thedifficult task of improving and encouraging economic development both home andabroad. The Ministry also supports a wide variety of business developmentdepartments; Small Business, Business Promotions, Tourism, etc. Though theirinteractions, cooperation and communication are limited, they all followsomewhat coordinated general policy initiatives of the Ministry.

The 1993 Budget

The followingbudget summary is based on the 1993 budget because that was the first budgetelaborated as the independent Czech Republic. Before the transition, Czech hadone of the more state dominated economies in the CEE. The state controlledalmost all economic activity with government expenditures reaching as high as65 percent of GDP in 1989.

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

Revenues

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

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

Expenditures

A large part ofthe expenditures for the Republic encompassed transfers to the people. Thelargest programs are pensions, family allowances and sickness insurance. Socialtransfers were increased in 1993 to create reserves for expected increases inunemployment. Expenditures on branches of government like health care, forexample, increased by 50 percent in 1993, simply responding to demand. A moveto create the National Health Fund was instituted out of a revamped payroll taxand transfers from the central budget to care for the non-working public. Thehealth fund reduced local spending on health care thereby reducing localtransfers. Expenditures on education and culture also increased by a third over1992 levels. These additional expenditures were partially offset by a new wagetax targeting employers and a combination of the following:

1) Savings incompensatory income support and sickness benefits by a new means tested model;

2) A freeze onsubsidies to agriculture, transportation and mining; and

3) Largecutbacks in real investment, including a public housing plan begun in 1992.

Transfers fromfederal accounts to the Czech government totaled 90 billion crowns, one fifthconnected with expiring credits granted abroad and debts owed by the formerCzechoslovakian and CSFR government. Debt service is a major component of the1993 budget. The debt reached 115 billion crowns by 1993. 40 billion crownswere transferred liabilities of the Czechoslovakian Commercial Bank fromoperations of the so-called ‘central foreign currency resources’. Totalexpenditures on debt service reached 23 billion crowns in 1993. Due to its sizeand proportion of the entire budget, some of those payments were deferred.Eight billion crowns, the total Czech share of the 1992 debt, was financedthrough state bonds and money from the national property fund. Old debtprincipals were deferred for a year until 1994.

Tax Reform

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

Sweeping tax reformsdominated the budget for the 1993 year. They included new indirect, direct andproperty taxes and modification to the payroll tax including a shift in the taxburden from corporate incomes to wage incomes. From 1992 to 1994, relative toGDP, the share of wage based taxes rose while the share of corporate income taxfell and indirect taxes remained unchanged.

These new directtaxes eliminated earlier distinctions for taxation of businesses based on formsof ownership and employment status. The new system of VAT and excise taxesexpanded the coverage of indirect taxes to services. It also mitigated thefalling implicit rate in the earlier turnover tax and condensed the range ofstandard tax rates.

The reformspromoted investment by lowering the cost of capital to businesses. This reformfeatured a significant reduction in the statutory rate of taxation,standardization and acceleration of allowed depreciation and a 10 percentcredit on investment in selected equipment which reduced the dispersion in effectivetaxes on investment activities. This is how the cost of capital was lowered.The tax allowed the rate of taxation on enterprise profits to drop from 55 to45 percent.

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

Tax evasion andavoidance

The problem withthis system is that these any tax structures are still relatively easy to getaround if one is willing to operate in the shadows. In the first quarter of1994, the (23% rate) VAT yield was 30 percent below initial expectations. Thecorporate and VAT combined barely yield 80 percent of original estimations (onesuspects that estimate is high...). Overall, Czech shadow economic activity,though low, is still significant. Estimate suggest anywhere between 15 and 25percent of the economy works in the shadows.

Police claim itis almost impossible to investigate and prosecute tax violations. The criminalcodes do not allow for them to effectively investigate such activities, and noother effective mechanisms yet exist. Change in codes and regulations are toocomplex and far too frequent. The Ministry of Finance claims that between 1993and 1994 there was a change in the tax codes at least every 4 days. An exampleis the modification in 1994 of the corporate income tax from 45 percent to 42percent, a reduction in the highest marginal personal income tax rates from 47to 44, and an increase in allowable expenses. These simple changes requiredmajor modification in software and procedure for the Ministry’s clerks to keepup with the changes. The Ministry coordinates 12,000 employees in hundreds oflocal offices that constantly need to register and update databases with thelatest tax changes.

Due to all theconfusion, police estimate they can only catch roughly 10 percent of taxrelated crimes. A 1994 law adds to the difficulties by allowing businesses tokeep their records secret. Employees can be sworn to secrecy regarding certainadministrative procedures in firms, like tax issues. The criminal code statesthat banks can only be forced to reveal tax information after initialevidence from a formal investigation. With no information to go on,investigations rarely reach formal status. Additionally, a great deal ofbusiness transactions are still conducted on cash basis due to the ease andtradition. This opens very easy avenues for tax evasion and avoidance as cashis barely trackable.

Many of thesetax reforms will become obsolete as the Czech Republic bids for EU membership.Czech will have to compete with EU tax codes, one example entails smallbreweries. Parliament passed a law on EU guidelines that allows a largerconsumption tax on alcoholic beverages to be granted only to small, independentbreweries. Breweries producing less than 200,000 hectoliters per year will beeligible for consumer tax cuts of up to 50 percent. The law sets a progressiverate up to the minimum margin limit.

Though it mayseem straight forward, experts are unsure whether this brings the tax codecloser to EU standards or drives them farther away. Are they protecting smallbusiness, providing tax shelters to favored companies, or preparing forentrance into the EU? Currently no one knows. The tax reform process is slow.Though much has been accomplished on the books, no one is really sure what thefinal outcomes will be. One suspects, as with many recent development in theCzech Republic, change will gravitate toward EU standards wherever possible. Asthe potential for EU membership draws near, one can expect many of theseseemingly confusing tax issues to be clarified immediately as the CzechRepublic attempts to do business with one of the most developed and powerfuleconomic forces in the world.

Current Political Economic Considerations: 1996

Perhaps the mostexciting chapter of the Czech political and economic transition is still tocome. In November 1995, the Czech Republic signed a membership agreement withthe Organization for Economic Cooperation and Development. The Czech Republicis the first CEE country to enter the ‘rich boys club.’ The Czechs furtheredtheir status by recently declaring that they were now considering themselves a‘developed’ economy. Though perhaps a bit premature and self-serving, OECDmembership certainly entitles them to make such a claim. Many more economicissues still need to be addressed however, before transition cantrulybe considered complete.

The CzechRepublic should reach growth levels of 7 percent this year. That growth needsto be achieved for the next ten years to simply double their income, and eventhen they will remain far behind their western neighbors. Current GDP in theCzech Republic is only about $3500, which according to the World Bank, ranksthem near Malaysia. Fortunately, unemployment is practically non-existent atabout 3.2 percent, the lowest rate in all of Europe. And the Czech tradedeficit runs about 5-7 percent of GDP. Some experts suggest that rapidappreciation of the crown in recent times is to blame.

Furthermore,wages are a problem. Though they remain low, they are rising very quickly evenwith governmental controls. To stay competitive Czech business must increaseproductivity. This tends to be very difficult without cheaper capital. Thoughtax designs are in place to ‘cheapen’ capital, it is not immediate nor aseffective as necessary. Finally, average savings rates throughout the CEE areabout 18 percent, which is just half of the very successful East Asian Tigers(and two to three times that of developed economies). Czech needs to decide howfast and how much more they will grow in the near future.  Regardless of someof these more negative indicators, Czech has made a significant transition. Thenumbers above simply indicate that their journey is not yet complete.

OECD membershipis just a small step toward the Czech’s ultimate goal of EU membership. TheCzech Republic is revamping their policies in order to comply wherever possibleto EU regulations, guidelines and policies in order to facilitate theirmembership bid. Some of these changes include a decrease in the number ofincome tax brackets, decreases in the VAT from 22 percent to below 20, and theend to all tariffs with EU countries by 1997 (excluding “sensitive products”).These changes are helpful to the Czech economy but slightly premature. Expertsclaim they are done solely to impress the EU application reviewers.

The EU and NATO

EU membership isinextricably tied to NATO membership. It is important to understand thesimilarities and differences between these two organizations, especially asthey concern the Czech Republic and the continuation or completion of thetransition. The transition is both economic and political and therefore shouldbe examined in terms of both EU and NATO powers. The EU and NATO are arguablythe most advance powers economically and politically in the world. NATOincludes the US, while the EU, of course does not. It is interesting, then,that many claim EU membership is virtually predicated on NATO membership. Thiscreates an interesting foreign policy situation for the Czechs. It is notcontradictory, but perhaps a bit dispersed in terms of goals and objectives.

Originally, NATOwas created as a response to the communist threat. Recent discussions betweenNATO and Russia suggest this threat no longer exists. So what is NATO’srole today? For the time being, NATO has a very powerful, though perhapsindirect role in the continuation of EU expansion. EU membership would bringlong term economic and political stability to the CEE (a NATO objective aswell). NATO must continue to work in association with the EU to bring stabilitythroughout the region to insure that the “communist threat” is indeed diffusedindefinitely. It is not out of the question that massive economic and politicalupheaval in the FSU could result in some nationalist power rising up and posinga serious threat to European interests. It is in this sense that NATO and EUhave a very common, and perhaps final goal.

Recently whilein Detroit campaigning, President Clinton set a date for NATO expansion. He didnot specifically mention which countries he was referring to, however, he didsay that ‘their’ inclusion into NATO is expected by 1999 (by ‘their’ most expertsassume, Poland, Czech and Hungary). If the Czech Republic becomes a NATO memberby the year 2000, EU membership could come as early as 2003 or 2004.

Therefore,politically, the Czech Republic needs to satisfy the goals of both EU and NATO.Economically, they need to address the EU a bit more thoroughly then the US asthe EU will be their main trading partner, but the US will remain a powerfulally, investor and trade partner. Although membership in either of theseprestigious world powers would be remarkable for a country just a decade aftersocialist rule, the Czechs need to proceed carefully.

In joining theEU, the Czech Republic will face a somewhat unpleasant reality. After years ofbeing the political and economic leader of the transitional Warsaw Pactcountries, they would be immediately subverted to the lowest status in EUmember countries, lower than Portugal. Though this would enable them to receiveEU assistance, both technical and financial, it would also require them toadapt possibly painful domestic policies involving increased environmentalstandards, increased costs and drastically high competition in terms of qualityand markets. It would also find them having to compete with Hungary and perhapsthe most important country from the EU perspective, Poland. If Czech is forcedto split benefits and favors with Poland and its huge 40 million personmarkets, they will indeed have their work cut out for them. Another majorproblem are the EU legal requirements for issues like consumer protection.

The benefits toEU membership, of course are many. The Czech Republic currently meets four ofthe five requirements for EU membership under the recent Maastricht Treaty. TheCzechs reached EU membership levels for currency stability, interest rates, debtas a percentage of GDP and public expenditures as a GDP percentage. They stillfall short on the inflation determinant. 1996 inflation is still at 9.1percent. This would have to be lowered to 3.8 percent to conform to EUstandards, a daunting task. The country will continue to reduce taxes whereverpossible to stimulate the economy, but this is increasingly difficult as theCzechs are now in a relatively comfortable position where increased reductionsin taxes would seriously hurt social benefits.

The EU iscurrently in the process of implementing their monetary union. Though this is afantastic goal for the Czech Republic, they are not yet in a position tocompletely abandon their own monetary policy and rely entirely on fiscalpolicy. Even though they could not be permitted to join the EMU upon their EUmembership (it has much stricter requirements than general membership), itwould be strange for the Czech Republic to enter the EU knowing that they are afar cry from EMU membership. This is not to say it is inadvisable. The Czechsmust join the EU at almost any cost. It is simply a concern worthy of mention.As the EU expands, the core states will be able to continue a favored status orelite power center, revolving around EMU involvement and not simply EUmembership.  This could be an important strategic leveraging issue for the corestates (and a major point of contention for the Czech Republic as a newmember).

There are manyconcerns and areas for excitement both politically and economically for theCzech Republic. They are in a very good position to come out far ahead ofanyone’s expectations. Perhaps even their own. EU and NATO membership will bothbe achieved within the next 5-10 years, no matter what difficulties are facedalong the way.

Conclusions

In just sevenyears, the Czech Republic transformed itself from a socialist,Soviet-controlled industrial-based economy to an increasingly service orientedOECD member and number one contender for the next wave of EU and NATO expansionin the region.

The CzechRepublic’s success can be largely attributed to its small size and populationand its relative ethnic and religious homogeneity. More important, however, isthe Czech determination and persistence in meeting the challenges of transition.The transition that began in 1989 entailed a great many hardships. Not all ofthe CEE countries made it through the transition so successfully. The Czechssucceeded because they were able to stick to their plan when most othercountries were forced to abandon for political reasons and popular discontent.

When the reformpackage became difficult, the Czechs didn’t revolt, they didn’t strike and theydidn’t complain. They showed remarkable foresight in taking early steps torevamp their tax system and banks, keep inflation and unemployment and wageincreases low, and keep their currency at stable levels. These were not alleasily accomplished. They survived the difficult times and came out on top ofthe CEE as the only country to make it through the transition virtuallyunscathed. This smooth transition earned their revolt the nickname, “the VelvetRevolution.”

The CzechRepublic is now poised to embark upon a greater challenge, that of becoming oneof the world’s power core with EU and NATO membership. It will entail furtherdifficulties, but compared with the accomplishments of the past and theirability to overcome Soviet oppression and transition from central planning,there is little doubt that the Czech Republic will succeed in their final steptoward complete transition from the USSR to the EU.

References

Economist.Country Profile: Czech Republic. The Economist, London. 1996.

Economist.Saving Graces. The Economist November 9, 1996.

FreidenJeffrey. International Political Economy 3rd Edition. St. Martins Press,NY. 1995, Section IV.

Heady,Christopher. Tax Reform and Economic Transition in the Czech Republic.Fiscal Studies, Feb. 1994.

Heady,Christopher. Tax and Benefit Reform in the Czech and Slovak Republics.Center for Economics and Policy Research, Discussion Paper Series No. 1151.March 1995.

Klaus,Vaclav. The Ten Commandments of Systemic Reform. Occasional Paper 43,Group of Thirty, Washington, DC, 1993.

Munk,Eva. Trouble Brews Over Tax Break. The Prague Post, January 18, 1995.

Munk,Eva. 25 Year Old Sports Car Picking Up Speed. The Prague Post, January18, 1995.

OECDEconomic Surveys. Czech Republic. OECD, Paris, 1996.

StateBudgets and the 1993 Fiscal Policy. CTK Business News. May 4, 1993.

Svejnar,Jan. The Czech Republic and Economic Transition in Eastern Europe.CERGE-EI, Prague, Academic Press, NY, 1995.

Untitled.CTK National News Wire. December 11, 1992.

WebSites:       www.cerg.cuni.cz

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                        alta vista.digital.com — simple query cz repub, transitional economies

                        www.lbs.lon.ac.uk/school/wpaps

                        www.ssc.upenn.edu/east/spring95/janusz

                        www.hiid.harvard.edu/pub