By 1994, foreign trade increased substantially, with much of the growth occurring between EU member nations. Tourism in Prague, now a “must see” on any European vacation, contributed to increased trade to maintain a strong balance of payments and a surplus in the current account. Though FDI by 1994 had decreased (after very high initial investments in 1992 and 1993), the
capital account maintained high inputs due to the rise in borrowing of Czech firms (which proved even better for Czech long term economic success).
GDP began to rise slightly after a period of decline from 1991-1993 of nearly 20 percent. Privatization entered its second round in 1994 for enterprises being privatized through voucher programs. The first wave of privatization is considered a remarkable success (a model to be used farther east). As this first wave ended in 1993, the Prague stock exchange began trading and the banking system went though increased and improved reforms. The Czech Republic was a leader in the CEE in trade and investment. Economic reform efforts, coupled with the above mentioned political support, put the Czechs at the forefront of CEE success.
Industrial output by 1993 declined by nearly 21 percent compared with 1991 figures. This can partially be explained by increases in the service sector, as investment soared in service sectors and dropped dramatically in the industrial sector. Also, the industrial sector was the most inefficient sector in the former centrally planned economy and much of those inefficiencies were corrected with the introduction of market reform. Most industries produced less as consumption dropped. And they did so more efficiently as output based economic plans were no longer used.
It is significant 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 it is most efficient to allow the private sector complete control. Government could assist with exemptions and subventions, but the market should determine winners and losers.
However, the Czech 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 with giants, let alone subsidized giants. These large industrial subsidies are all but gone in most industries today, however they still exist for politically sensitive or economically vital industries. In some cases the government reluctantly returned to subsidies as not all of the initial privatization efforts proved successful. Some large enterprises were not effectively dismantled and the resulting giant enterprises were simply too large and inefficient for the new market economy. It took several years, in some cases, to learn this lesson.
Consumer price inflation by 1993, after the initial shocks of the VAT, stabilized at 18 percent. Experts estimate the VAT added 7 percent to inflation during 1993 and an additional 2 percent can be attributed to government administered price regulations. 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.
Wage restraints through a “tax based income policy” was an important feature of the CSFR. Wage restraints ended in 1993, but had to be brought back by the end of the year by the Czech government. The rational behind bringing the restraints back was that market forces were not yet adequate to control wage increases. Wage increases had to remain close to increases in consumer prices to avoid inflationary difficulties. Therefore, as late as 1995, up to 100 percent tax rates were applied to wage increases over allowable limits, effectively keeping wages at desired rates.
Monetary Policy: 1993
By 1993, Czech monetary policy began to stabilize in conjunction with political and economic indications of success. The basic aims of monetary policy at this point were simply to maintain internal and external currency stability. Officials kept the Czech crown pegged to stable European currencies and prevented inflation from rising above 10 percent. In a somewhat disguised blessing, foreign capital flowed into the Czech Republic at high rates in 1994 causing officials to raise reserve requirements from 9 to 12 percent to insure inflationary stability. The banking system, though still flawed, was able to withstand the pressures. The economy certainly welcomed the increased capital.
By 1993 and even more so by 1994, monetary policy was less of a political tool in the reform process. Stability in many respects had been achieved. The nature of further reform and continued stability relied almost entirely upon fiscal decision-making. To fully understand and appreciate the political economics of reform from 1993 onward, both fiscal and monetary, an examination of the Czech budget is helpful. Defining the role of the state in the new market oriented economy is critical. Two main issues must be examined, the resources and informational capabilities of the state. Both are limited and both are not independently effective. The budget and the political issues surrounding its passage are important in understanding the Czech approach to stability now that much of the transition has been rather successfully completed.
Intergovernmental Financial Relations
Before the budget analysis, a brief overview of intergovernmental financial relations may be helpful. The Department of Finance makes budgetary estimates for the Ministry of Economy. They regulate spending and essentially decide which organizations and institutions receive the much sought after government subsidies. They are also responsible for government accounting, financial management and regulation of wages. The Department of Finance is classified under the Ministrys “Administration and Finance” section.
The Foreign Economic Relations Department, the European Affairs Department and the Economic and Social Policy Department are all included under the Ministrys “Economic Policy.” They all report to the Ministry and are essentially charged with the difficult task of improving and encouraging economic development both home and abroad. The Ministry also supports a wide variety of business development departments; Small Business, Business Promotions, Tourism, etc. Though their interactions, cooperation and communication are limited, they all follow somewhat coordinated general policy initiatives of the Ministry.
The 1993 Budget
The following budget summary is based on the 1993 budget because that was the first budget elaborated as the independent Czech Republic. Before the transition, Czech had one of the more state dominated economies in the CEE. The state controlled almost all economic activity with government expenditures reaching as high as 65 percent of GDP in 1989.
The 1993 budget focused on a more developed private sector. The budget is fundamentally influenced by tax reform which will be discussed in the following chapter.
The 1993 budget is based on three main revenues: the value added and excise taxes (36.9 percent), income tax from legal entities (25 percent) and social insurance (28.5 percent). The new tax system (and total restructuring of public finance to benefit local budgets) reshaped the revenue system and forced budget developers to complete more in-depth estimates of revenue flows. They were forced to make more accurate revenue predictions.
Total revenues in 1993 reached 419 billion crowns (26 Kc per $1USD), of which 343 billion went to the state, 41 billion to local districts and 35 billion to health insurance. Revenue growth was 13.4 percent and local budgets rose 35.2 percent in 1993
A large part of the expenditures for the Republic encompassed transfers to the people. The largest programs are pensions, family allowances and sickness insurance. Social transfers were increased in 1993 to create reserves for expected increases in unemployment. Expenditures on branches of government like health care, for example, increased by 50 percent in 1993, simply responding to demand. A move to create the National Health Fund was instituted out of a revamped payroll tax and transfers from the central budget to care for the non-working public. The health fund reduced local spending on health care thereby reducing local transfers. Expenditures on education and culture also increased by a third over 1992 levels. These additional expenditures were partially offset by a new wage tax targeting employers and a combination of the following:
1) Savings in compensatory income support and sickness benefits by a new means tested model;
2) A freeze on subsidies to agriculture, transportation and mining; and
3) Large cutbacks in real