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