CZECH REPUBLIC: 2006 BUDGET IMPLIES INCREASE IN

UNCLAS PRAGUE 000057 SIPDIS SIPDIS STATE FOR EUR/NCE, EUR/ERA, EB/IFD/OMA TREASURY FOR OASIA ANNE ALIKONIS STATE PLEASE PASS USTR LISA ERRION COMMERCE FOR ITA/MAC/EUR MIKE ROGERS E.O. 12958: N/A TAGS: ECON EFIN EZ SUBJECT: CZECH REPUBLIC: 2006 BUDGET IMPLIES INCREASE IN STRUCTURAL DEFICIT REF: 05 PRAGUE 1686 ¶1. SUMMARY: Thanks to higher than expected tax revenues and better than forecasted economic growth (reftel),GOCR statistics show the 2005 budget deficit was 2.8 percent/GDP, slightly lower than the Parliament-approved 2.9 percent/GDP deficit ceiling and much lower than the 4.7 percent/GDP deficit target under the Czech Republic's Convergence Program. Despite the overperformance in 2005, the approved 2006 budget deficit target is 3.8 percent/GDP, the same as the convergence program target. The Czech National Bank and private economists have resoundingly criticized the 2006 budget for failing to build upon the strong budgetary and macroeconomic performance of 2005. The IMF cautioned that the 2005 budget performance masks underlying risks, which could reverse the real economic gains from 2005. END SUMMARY. ¶2. EU CONVERGENCE PROGRAM: A key element of the Czech Republic's May 2004 EU Convergence Program is gradual fiscal adjustment, with a government deficit target of 3.8 percent/GDP in 2006, 3.3 percent/GDP in 2007, and reaching the 3 percent/GDP Maastricht Criteria deficit ceiling in ¶2008. While in 2005 the Parliament-approved budget deficit ceiling of 2.9 percent/GDP was significantly lower than the EU convergence program target of 4.7 percent/GDP, the 2006 approved target of 3.8 percent/GDP equals the convergence program target. The GOCR's fiscal adjustment strategy is based on two pillars of the budgetary process: legally binding medium-term nominal expenditure ceilings for central government and the policy of earmarking any higher-than-budgeted revenues for swifter deficit reduction. It is the weakening of the latter pillar that is drawing criticism. ¶3. 2005 OVERPERFORMANCE: According to the Czech Ministry of Finance, the 2005 budget ended with a deficit of CZK 56.4 billion or 2.8 percent/GDP, compared to the target of 4.7 percent/GDP. The IMF commended GOCR authorities for its 2005 budgetary performance, but noted key underlying risks since 2005 budgetary underspending will be transferred into reserves for 2006. According to IMF estimates, full implementation of the 2006 budget and spending authorizations from reserves could imply an increase in the structural deficit of around 2.5 percent/GDP. The IMF also noted that a part of the reason for overperformance in recent years is related to systematic overbudgeting of expenditures. ¶4. 2006 EXPANSIONARY RISKS: The approved 2006 budget deficit target is 3.8 percent/GDP deficit (CZK 884.4 billion in revenues, CZK 958.8 billion in expenditures, resulting in a CZK 74.4 billion deficit). The IMF assessed that the 2006 budget represents a missed opportunity to advance consolidation and raises implementation risks for the medium-term fiscal plans, noting that "less conservative revenue assumptions and backloading of consolidation makes the fiscal position more vulnerable in the run-up to euro adoption." Key elements of the 2006 budget break down as follows: Ministry of Labor CZK 357.2 bn (7 percent over 2005) Ministry of Education CZK 108.9 bn (51 percent over 2005) Ministry of Defense CZK 55.7 bn (5 percent over 2005) Ministry of Justice CZK 18.5 bn (less than 1 percent over 2005) Ministry of Environment CZK 14 bn (240 percent over 2005) ¶5. TYPICAL ELECTION YEAR BUDGET: With general elections expected in June 2006, the biggest spending seems to be going where potential voters will be able to appreciate it most: Social benefits spending will rise CZK 27 billion or 5 percent, wages of the 750,000 state officials will increase on average 5 percent, pension benefits will increase by CZK 12 billion to CZK 380/month. In addition, the government has promised higher parental allowances and child and sickness benefits in the future, which would cost around CZK 42 billion if it goes in to effect in 2007 as initially indicated. However, this promise is being criticized and reconsidered due to its fiscal impact. According to Finance Ministry analysts, if all the promises are kept, the state budget in 2007 would exceed the 3.3 percent/GDP deficit target under the Convergence Program. ¶6. EXTRA BUDGETARY FUNDS: Subsequent to its approval of the 2006 budget, Parliament approved seven extra-budgetary funds totaling CZK 94 billion, compared to CZK 55.5 billion in ¶2005. Transportation infrastructue CZK 55.5 bn Agriculture Fund CZK 27.8 bn Housing CZK 6.4 bn Environmental Fund CZK 4.1 bn Sate Fund of Czech Cinematography CZK 83 mn Cultral Fund CZK 44.7 mn State Fund or Soil Reclamation CZK 1.9 mn Extra-budgetry funds are treated as "reports," which get approved upon recommendation by the relevant parliamentry committee after just one hearing, as opposed o the three readings required for the regular buget bill. The IMF has noted that extrabudgetaryspending has contributed to the variability in fical performance and that transparency is hindere by delays in fiscal reporting on extrabudgetaryfunds. ¶7. COMMENT: At the end of December, CNBGovernor Zdenek Tuma called the government spendng plans "undisciplined and unreasonable," notingthe budget is being stabilized primarily by highr tax revenues, not by lower spending, and that here is a risk of strong fiscal expansion n the future. With the current dynamic economic development, the CNB believes the budget gap should move somewhere around one pecent/GDP in 2006. Tuma's statement was not surpriing given the widely shared view among economists What was surprising, however, was PM Paroubek' over-the-top public lashing out against Tuma, clling him a puppet of the opposition party and qestioning the independence of the CNB. There s little doubt the projected 2006 budget deficit ould be much lower if there were no elections hld next year. But the real story is that despite the Czech Republic's strong macroeconomic performance, fiscal discipline remains a key vulnerability of the Czech government as it prepares to join the eurozone in 2010. CABANISS