I



[pic] |World Bank EU-8

Quarterly Economic Report

April 2005[1]

Part I |EU-8 | |

Highlights of the Report

The Political Economy Background

• Government reshuffles and/or prospective early elections in the Czech Republic, Poland, and Estonia, as well as regular elections in several other countries looming on the horizon, generally slowed reform momentum across the region. Economic policy discussions have generally focused on further tax cuts with a clear pre-electoral flavor in many countries. There was also further progress on privatization in the Czech Republic with the sale of the main state-owned telecommunications company.

• While Euro adoption plans constrain the room for discretionary fiscal expansion, the recent revision of the Stability and Growth Pact (SGP) may affect the credibility of the pact and risk undermining the resolve for fiscal discipline also in EU8 countries.

Macroeconomic Policies and Developments

• Output growth in most EU8 countries slowed toward the end of 2004, and early indicators for 2005 suggest that this slowdown is persisting and likely to lower growth rates this year relative to last. Growth has generally become more balanced with domestic demand recovering in countries with strong external current accounts and net exports improving in countries with weaker external positions. Meanwhile, employment remains sluggish and unemployment stubbornly high in some countries.

• Foreign trade in the EU8 received a strong boost with EU accession as remaining technical and administrative barriers were eliminated (including among the EU8 countries themselves) and agriculture was liberalized within the larger EU. A stellar export performance, including of more traditional exports, in most countries bore witness of strong competitive positions in the EU8. Unit labor costs have grown only slowly if at all, and levels appear to be well below those prevailing in Western Europe. Despite strong export performance, current account deficits as a share of GDP remained close to double digits in Hungary and even higher in Estonia and Latvia. At the same time, FDI inflows rebounded in most countries after the slump in 2003.

• EU-accession related inflationary pressures were successfully contained in the Visegrad countries as monetary conditions tightened, while the Baltic countries (notably Latvia) and to a lesser extent Slovenia with their fixed exchange rates have had more of a problem. In these countries, fiscal and wage policy will need to do more than otherwise necessary to contain demand pressures.

• Fiscal policies were eased in some countries in 2004 (notably Estonia, Lithuania, and Poland) and tightened in others. In most cases (with Hungary the notable exception), fiscal outcomes were significantly better than planned on the back of stronger output and revenue growth and in a few cases tighter spending. Fiscal plans for 2005 have not yet been revised. With the revised SGP, including the decision to accept pension reform costs (albeit on a declining scale and phased out over 5 years), all Visegrad countries could comply with the key 3% of GDP fiscal deficit criterion for Euro adoption by 2007—if they follow through on their Convergence Programs from late 2004—thus potentially enabling them to adopt the Euro in 2009.

Special Topic: Tax Wedge In EU8 and its Link to Employment

Labor taxation is high in the EU8 countries, not least for low-income earners, even compared to EU15 countries. While many other factors affect labor market outcomes and the relationship between labor taxes and employment, both theory and evidence from OECD countries point to a negative association between the two, not least at the lower end of the income distribution. Further, many of the factors underlying such a relationship are likely to be particularly strong in the EU8 countries, where lower-skilled and paid workers form a larger share of the working population and where minimum or reservation wages (the latter depending on non-working sources of income, including social transfers) are likely to be more binding.

Results of our preliminary empirical analysis for the EU8 countries indeed suggests a strong and significantly negative relationship between the tax wedge and employment dynamics in these countries. In particular, other things equal, each percentage point of the tax wedge increase is found to be associated with a decline in employment growth of 0.5 - 0.7 percentage points.

While further work is needed to underpin these tentative findings, they nevertheless suggest that lowering labor taxation, not least for low-income earners, would be desirable to boost employment and output growth. Given fiscal constraints, this would need to be done in a budget neutral manner. While lowering the tax wedge might partly finance itself through higher employment and output, additional revenue measures or preferably expenditure cuts would likely be required, not least in view of emerging demographic pressures on social spending. In most countries, there is considerably room to streamline subsidies and rationalize social transfers, including through better targeting of these.

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WORLD BANK

Warsaw Office

53 Emilii Plater St, 00-113 Warsaw

Tel (+48 22) 520 8000, Fax (+48 22) 520 8001, .pl

Daniella Gressani, Country Director, Central Europe and Baltic countries

Thomas Laursen, Lead Economist, Central Europe and Baltic countries

Marcin Sasin, Country Economist (Poland)

Emilia Skrok, Country Economist (Czech Republic, Hungary)

| | | |

|Bratislava Office |Vilnius Office |Riga Office |

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|Fax (+421 2) 5752 6701 |Mantas Nocius, Country Manager |.lv |

|worldbank.sk |Jekaterina Rojaka, Country Economist |Dina Grube, Manager |

|Ingrid Brockova, Country Manager |(Lithuania) |Andrejs Jakobsons, Country Economist |

|Anton Marcincin, Country Economist | |(Latvia, Estonia) |

|(Slovakia, Slovenia) | | |

|[pic] |External Environment |

The external environment has turned more adverse with weaker growth prospects in main markets and what appears to be an extended period of high oil prices. While low interest rates in the Euro-zone had been putting undue upward pressure on real exchange rates in the EU8, the gradual tightening of monetary policy in the U.S. has provided some relief through a diversion of speculative capital inflows away from emerging markets.

Oil prices

With a secular increase in demand not least from Asia and limited spare production capacity, oil prices have surged to above US$50 per barrel compared to around US$30 one year ago. Nevertheless, prices for crude oil remain below historical peaks in real terms. Higher oil prices are putting a damper on growth in industrial countries, including the main EU8 export markets in Western Europe.

EU15 growth

Output growth in Western Europe slowed markedly in the second half of 2004 on the back of rising oil prices and appreciation of the Euro vis-à-vis the U.S. dollar. Signs of a pick-up in activity in early 2005 remain mixed and growth forecasts for the year have generally been revised down somewhat.

Interest rates

While interest rates in the Euro-zone kept on hold and hikes in interest rates in several EU8 countries around mid-2004 in response to the temporary EU-related spike in inflation, currencies in the region generally came under strong upward pressures through early 2005. However, with concern about rising inflation in the U.S., interest rates there have been raised rapidly, which—along with heightened political uncertainty in the EU8 region—has taken some of this pressure off over the last month or so. Nevertheless, emerging market spreads remain record-low.

|Chart 1. LIBOR, 6M. |Chart 2. JPM EMBI+ spread. |Chart 3. Exchange rate, USD/EUR. |

|[pic] |[pic] |[pic] |

|Source: BBA. |Source: CbondS. |Source: ECB. |

|Chart 4. Brent Crude Oil, US/BBL. |Chart 5. EU15 growth, y/y. | |

|[pic] |[pic] |

|Source: Reuters. |Source: EUROSTAT. | |

|[pic] |Overview of EU8 |

Political economy background

The prospects of early elections and/or new governments in several countries and regular elections looming ahead in some other countries have slowed down reform momentum and may weaken fiscal discipline in these countries (see Box 1).

Early elections and/or new government are likely in Poland, the Czech Republic and Estonia.

• In Poland, political positioning and reshuffles have started as parliamentary elections, scheduled in September, approach. Prime Minister Belka announced that he would resign on May 5 and join the newly established opposition Democratic Party (this would follow the defection of Minister of Economy and Labor Hausner in March). President Kwaśniewski has indicated that he would not accept the PM’s resignation, at least not immediately. In the meantime, PM Belka’s government of experts is becoming increasingly separated from its weak parliamentary support base. Overall, given the segmentation of the political scene, the biggest uncertainty is whether the post-election governing coalition would be strong enough to form a stable and effective government.

• In the Czech Republic, the Christian Democrat coalition party withdrew from government owing to lack of confidence in Social Democratic Prime Minister Gross, and although the now minority government survived a no confidence vote in the parliament with the abstention of the Communist Party, it is uncertain if it will get through another confidence vote planned in the near future. The most likely outcomes of the political crisis appear to be either reunification of the coalition under a new PM or early elections.

• In Estonia, the Government of Prime Minister Parts (Res Publica) resigned on March 24 following a vote of non-confidence in the Minister of Justice (from the same party as the PM). A new government headed by Prime Minister Ansip (chairman of the Reform Party) and including the Center Party and Peoples' Union (with the coalition holding 52 out of 101 seats in Parliament) was confirmed appointed on April 12.

Elsewhere, the political situation in Slovakia and Hungary is already heavily influenced by upcoming regular parliamentary elections in 2006 (nevertheless, it was noteworthy that the Slovak parliament passed in its first reading new legislation on tertiary education which would introduce tuition fees). In Lithuania, the new government is proving more effective than initially expected.

At the EU level, the revision of the Stability and Growth Pact risks undermining fiscal discipline also in the new member countries. While the decision to allow for costs of pension reform (albeit only for a period of five years and according to a declining scale) would facilitate meeting the fiscal criteria for Euro adoption, the general weakening of the pact erodes its credibility and may weaken the resolve for fiscal consolidation also of new member countries striving to adopt the Euro (although they remain strictly subject to the 3% of GDP deficit criterion, at least for now). The push back on the Services Directive, which would extend the benefits of the common market to not only new but all EU members, was also disappointing. Further, the uncertainty regarding early approval of the next Financial Framework (2007-13) complicates the ongoing strategic and financial planning in the new member countries, of which regional aid is an important element.

|Box 1. Electoral budget cycles. |

| |Chart 6. Electoral budget cycles in the Baltic countries. |

|Drawing on previous experiences there is a risk that the combination|[pic] |

|of a recent cyclical upturn and prospective elections may strengthen|Source: AMECO. |

|the temptation to run pro- cyclical expansionary policies in some | |

|EU8 countries. The findings of the theoretical literature on | |

|electoral budget cycles indicate that uncertainty about the | |

|electoral result and the degree of polarisation encourages | |

|governments to undertake short-sighted, discretionary policies. Most| |

|models predict tax cuts in the run up to elections and expenditure | |

|increase in pre-election years (except if the elections are not | |

|anticipated) and/or in election years. The relative size of tax cuts| |

|versus expenditure boosts may change according to the type of | |

|electoral calendar. Recent empirical work has found support, though | |

|not unequivocal, for these predictions (see e.g. Persson and | |

|Tabellini 2002a and 2002b, Milesi Ferretti, Perotti and Rostagno | |

|2002, and Buti and de Noord 2003). Analysis of fiscal policy in | |

|relation to election in the EU8 countries provides some evidence on | |

|incentives for politically motivated fiscal policies (e.g. Baltic | |

|countries 1992-2003 and Hungary; in other EU8 countries no such | |

|pattern was discernible. | |

|Source: WB staff |

Macroeconomic policies and developments

Macroeconomic developments over the last six months were characterized by a continued slowdown in activity and easing of inflationary pressures on the back of weakness in main export markets and appreciation of currencies (although partly reversed toward the end of the period as interest differentials vis-à-vis the U.S. narrowed). Meanwhile, the policy mix tended to be skewed toward relatively firm monetary policies and loose fiscal policies.

Output growth accelerated and became more balanced across the region in 2004. Output growth almost doubled in Slovenia, while Lithuania was the only country to see its growth rate reduced but from a very high level (Chart 7). At the same time, the pattern of growth became more balanced (Chart 8). In the Czech Republic and Hungary, fixed investment picked up while consumption growth slowed and the negative contribution of net exports from previous years was largely eliminated. In contrast, higher growth in Poland and Slovakia was led mostly by stronger consumption and inventory accumulation (along with a slight recovery in fixed investment), while the positive contribution of net exports declined. In Slovenia and Estonia, higher growth resulted from an improvement in all components of demand, while the opposite was true in Lithuania where output growth slowed despite strong inventory build-up.

|Chart 7. Real GDP growth 2002-04, y/y (%). |Chart 8. Contributions to GDP growth in 2003 and 2004 (% points of GDP). |

|[pic] |[pic] |

|Source: CSOs. |Source: CSOs, staff calculations. |

Economic activity generally weakened in the last quarter of 2004. While real GDP growth continued rising in Slovakia and the Czech Republic, it stagnated or slowed down in other countries in the region mainly as a result of an easing in consumption growth (Chart 9).

|Chart 9. Real GDP growth by quarters in 2004, y/y (%). |

|[pic] |

|Source: CSOs. |

The slower pace of output growth is likely to continue in 2005 on the back of real currency appreciation, weaker market demand, and subdued investor confidence. The nascent recovery in Western Europe has suffered a setback and output growth is expected to weaken relative to 2003, the recent strong appreciation of real exchange rates along with stiffer competition from non-EU countries is likely to dampen export growth, and increased political uncertainty in the region will probably keep investors cautious. The slowdown is projected to be most pronounced in Latvia, Poland, Slovakia, and Slovenia, where it could amount to around 1 percentage point relative to 2004. These prospects are supported by weak industrial production (but still robust retail sales that may be related to improved consumer confidence) in early 2005 (Chart 10-14).

|Chart 10. Industrial production, y/y (%). Czech Republic, Hungary, |Chart 11. Industrial production, y/y (%). Estonia, Latvia and Slovenia. |

|Poland and Slovakia. | |

|[pic] |[pic] |

|Source: CSOs. |Source: CSOs. |

|Chart 12. Retail sales, y/y (%). Czech Republic, Hungary, Poland and |Chart 13. Retail sales, y/y (%). Estonia, Latvia, Lithuania and Slovenia. |

|Slovakia. | |

|[pic] |[pic] |

|Source: CSOs. |Source: CSOs. |

|Chart 14. Consumer confidence on rise. | |

|[pic] |[pic] |

|Source: Eurostat. | |

Employment has remained broadly unchanged despite the rapid GDP growth. Slovenia appears to be an exception as the employment rate increased significantly in 2004, but this may in part reflect a sampling problem (Chart 15). In Hungary, employment fell significantly in the second half of 2004 as a result of public sector downsizing as well as employment reduction in some sectors of the economy (e.g. textiles and the leather industry) vulnerable to currency appreciation. Employment rates in Poland and Hungary are particularly low but in all EU8 countries remain well below the Lisbon target of 70% (EU average) by 2010. Slovakia has taken a number of steps in 2003-2004 to boost employment (including adoption of a new, more flexible labor code, and an overhaul of the social benefit systems) but the results remain to be seen.

|Chart 15. Employment rates (%). |

|[pic] |

|LFS statistics. Source: Eurostat. |

Meanwhile, unemployment rates eased somewhat in most EU8 countries, notably in Lithuania, although they rose further in Slovakia, the Czech Republic, and Hungary (Chart 16). Unemployment rates in Slovakia and Poland are more than twice the EU15 average, and the Baltic countries also continue to experience relatively high unemployment. Much of the unemployment is structural, with more than 50% unemployed for more than one year in all countries except in Latvia and Hungary—in Hungary the long-term unemployed tend to withdraw from the labor force relatively quickly and become inactive (Chart 17). This reflects a combination of skills mismatches, insufficient labor market flexibility, relatively high labor taxes, and generous non-working social benefits for some groups.

|Chart 16. Unemployment rates (%). |Chart 17. Duration of unemployment (3q04 LFS). |

|[pic] |[pic] |

|LFS statistics. Source: Eurostat. |LFS statistics. Source: Eurostat. |

Despite high GDP growth, wage dynamics decelerated in 2004 in most EU8 countries. Growth of real wages was lower compared to 2003 throughout the region, with the exception of Slovakia where wage growth picked up after a 2003 depression (Chart 18). Given the moderate growth of employment (or a slight decline in Lithuania, Hungary and the Czech Republic) this situation has translated into higher productivity gains (real GDP-per-hour worked) and an improvement in unit labor cost. Moreover, evidence suggests that wage pressures remained muted in the first quarter of 2005.

|Chart 18. Wages, productivity and unit labor cost. |

|[pic] |

|Note: GDP deflator used. |

|Source: CSOs, staff calculations. |

The year 2004 witnessed an astonishing export boom across most of the region reflecting strong competitiveness and improved market conditions, not least easier access. Exports grew by some 25% y/y in Poland, the Czech Republic and Latvia, by some 16% in Estonia, Lithuania and Hungary, and by 12% in Slovenia (Chart 19). Meanwhile, Slovakia—a top performer in 2003—saw its export growth slow mainly because of a gap in production of VW Slovakia ahead of its launching of new car models (given Slovakia’s larger share of exports in GDP relative to other countries in the region, not least Poland, there may also be an underlying tendency for slower export growth from Slovakia). At the same time, import growth accelerated reflecting both the pick-up in domestic demand and large import content of exports (Chart 20). On the whole, the accession of Central European and Baltic countries to the EU in 2004 was associated with a marked expansion of trade, but in part a one-time effect reflecting the dismantling of remaining real and technical trade barriers (including among the EU8 countries themselves).

|Chart 19. Export growth, EUR nominal, y/y (%). |Chart 20. Import growth, EUR nominal, y/y (%). |

|[pic] |[pic] |

|Source: WIIW, CSOs, staff calculations. |Source: WIIW, CSOs, staff calculations. |

The stellar export performance was broad based. Manufacturing (notably machinery and transport equipment) exports surged (except in Slovakia for the reasons mentioned above), but there was also a dramatic expansion in agricultural exports (from a low base) as the EU market was opened to the new member countries and these were included in the Common Agricultural Policy (albeit in a regrettably phased manner). Indeed, exports of food and live animals rose by some 30% y/y in the Czech Republic, Poland and Slovakia (Chart 21 and Chart 22). Meanwhile, both higher output and prices boosted agricultural incomes, which more than doubled in the Czech Republic and rose by three-fourths in Poland (followed by 56% in Estonia, 47% in Lithuania, 42% in Latvia, 29% in Slovakia, 28% in Hungary, and 14% in Slovenia; see Eurostat, December 2004). Perhaps more surprisingly, food imports also expanded rapidly.

|Chart 21. Export of food, EUR nominal, y/y (%). |Chart 22. Product composition of export growth (%). |

|[pic] |[pic] |

|Source: CSOs, staff calculations. |Source: CSOs, staff calculations. |

The regional composition of EU8 trade in 2004 reveals strong gains in intra-EU25 trade, and particularly in intra-EU8 trade. In all Visegrad countries and Slovenia the y/y gain in EU8 markets was higher than in EU15 markets, with the Czech Republic, Poland and Slovakia achieving the largest gains in regional market shares (Chart 23 and Chart 24). This is because the implementation of EU trade rules and full liberalization of intra-EU trade improved EU8 access not only to the EU15 market, but also to that of their peers further supporting trade creation. At the same time, there was no clear evidence of trade diversion away from non-EU25 countries.

|Chart 23. Export of selected EU8 countries by regions, % of GDP. |Chart 24. Import of selected EU8 countries by regions, % of GDP. |

|[pic] |[pic] |

|Source: Eurostat, staff calculations. |Source: Eurostat, staff calculations. |

|Box 2. EU8 competitiveness |

|Economy-wide unit labor costs relative to trading partners (ULCs, PPP adjusted) have remained relatively stable in most EU8 countries|

|over the last four years. Hungary is a notable exception, although the situation improved in 2004, and there has also been some |

|erosion of competitiveness in the Czech Republic, Slovakia, and Estonia (Chart 25 and Chart 26). The situation has been even better |

|in industry, where the changes in unit labor costs in absolute terms have fluctuated around zero in most countries, and generally |

|been negative in Poland (Chart 27). In 2004, rapid wage growth led to a rise in ULC in Slovakia, Lithuania, Estonia, and the Czech |

|Republic (Chart 28). Only in the Czech Republic and Hungary, was the improvement in productivity in 2004 associated with continued |

|labor shedding (decline in employment |

|Chart 25. ULC PPP (2000=100). Latvia, Poland, Hungary and Slovenia. |Chart 26. ULC PPP (2000=100). Lithuania, Estonia, Slovakia and |

| |Czech Republic). |

|[pic] |[pic] |

|Source: WIIW, CSOs, World Bank, staff calculations. |Source: WIIW, CSOs, World Bank, staff calculations. |

|Chart 27. ULC in industry, EUR-adj, %, y/y*. |Chart 28. ULC growth rate and contributions in 2004. |

|[pic] |[pic] |

|* 6-month rolling average. |Source: WIIW, CSOs, World Bank, staff calculations. |

|Source: WIIW, staff calculations. | |

|Cost competitiveness remains strong. While there are significant problems in comparing ULC levels across countries, studies suggest |

|that they generally remain below one-half of the average level in Western Europe. The highest relative levels prevail in Slovenia |

|(around 60% of the level in Austria in 2004) and Poland (around 45% of the level in Austria) according to WIIW 2005. |

External current account balances generally changed little in the first year of EU membership. The current account deficit in Latvia increased significantly in 2004, and the country now shares with Estonia the un-envious position of having the highest deficits in Europe at over 12% of GDP (Table 1). External deficits also remain high in Hungary and to a lesser extent Lithuania, while current account imbalances are moderate or small in all other EU8 countries (there was a notable improvement in the Czech Republic in 2004).

|Table 1. External indicators in 2003 and 2004, in % of GDP. |

| |Current account |FDI gross |FDI net |Portfolio investment |

| |deficit | | | |

| |2003 |2004 |2003 |2004 |2003 |2004 |2003 |2004 |

|Czech Republic |-6.3 |-5.2 |2.3 |4.2 |2.1 |3.7 |-1.4 |2.3 |

|Estonia |-13.2 |-12.6 |9.9 |8.3 |8.3 |6.0 |1.9 |6.4 |

|Hungary |-8.7 |-8.8 |2.6 |4.2 |0.6 |3.6 |3.6 |7.0 |

|Latvia |-8.2 |-12.3 |2.7 |4.8 |2.4 |4.0 |-2.0 |2.0 |

|Lithuania |-6.9 |-7.2 |1.0 |3.5 |0.8 |2.3 |1.5 |0.9 |

|Poland |-2.2 |-1.6 |2.0 |2.5 |1.9 |2.2 |1.2 |4.0 |

|Slovakia |-0.8 |-3.5 |2.2 |2.7 |2.1 |3.1 |-1.7 |2.1 |

|Slovenia |-0.4 |-0.7 |1.2 |1.6 |-0.5 |0.2 |-0.9 |-2.4 |

|Source: NCBs, CSOs, staff calculations. |

FDI inflows recovered somewhat in 2004 but generally remained well below the levels recorded in 2001-02 (Chart 29). Two of the Baltic countries—Estonia and Latvia—and two of the Central European countries (the Czech Republic and Hungary) did well in terms of attracting FDI inflows in 2004, with Poland perhaps the most disappointing case although one of the only countries in the region to fully cover its current account deficit through net FDI (in other cases the coverage ranged from one-half to two-thirds). Net portfolio investment surged across the region (with the exception of Lithuania and Slovenia) in 2004 attracted by relatively high interest rates and stronger currencies.

|Chart 29. Net FDI in EU8 countries (EUR per capita). |

|[pic] |

|Source: NCBs, CSOs, staff calculations. |

Inflationary pressures in the aftermath of EU accession were successfully contained in the larger EU8 countries. Core inflation has been gradually receding in the Visegrad countries after the EU accession-related spike around mid-2004 as higher interest rates and not least appreciating currencies led to a significant tightening of monetary conditions while wage pressures were held in check owing to the relatively weak labor market conditions (Chart 30-31). While the disinflation process was facilitated by declining food and in some countries transport prices, and supported by enhanced competition in the single market, it is remarkable in view of the strong upward trend in oil prices since early 2004.

|Chart 30. Monetary conditions index - 2000/01=0%. |Chart 31. Core inflation, y/y (%). |

|[pic] |[pic] |

|Source: NCBs, CSOs, staff calculations. |Source: NBP, MNB, SO SR. |

In contrast, the Baltic countries—especially Latvia—are struggling with strong price pressures (Charts 32-33) The currency pegs in these countries do not allow for the exchange rate to take off some of the pressures, and real appreciation necessarily has to occur through inflation. Nevertheless, the pace of real appreciation is a source of concern in view of the large current account deficits, and fiscal policy may need to play a larger role in cooling the economies than would otherwise be the case. These challenges are exacerbated by signs of emerging bottlenecks in the labor markets (such as shortages of skilled labor in certain sectors) and accelerating wage growth.

|Chart 32. HICP, y/y (%). |Chart 33. PPI, y/y (%). |

|[pic] |[pic] |

|Source: Eurostat. |Source: Eurostat. |

Fiscal performance varied considerably in the EU8 in 2004. While fiscal deficits were reduced in the Czech Republic, Hungary, Latvia, and Slovakia, fiscal policies were eased in Estonia (although a surplus was retained), Lithuania, and Poland (Table 2). The deficit has remained stable at around 2% of GDP in Slovenia in recent years. In Lithuania, the higher deficit reflected mainly the effect of the pension reform introduced from 2004, while in Estonia and Poland fiscal expansion was behind the worse outcomes. The change in fiscal balances compared to 2003 was also affected by increased EU contributions and transfers including associated co-financing (although only part of the funds allocated for 2004 were absorbed). Public debt levels edged higher in Hungary and Slovakia (and in the former case is rapidly approaching 60% of GDP), but declined in Poland on account of currency appreciation and the Czech Republic due to significant decline in government deficit.

|Table 2. Fiscal developments. |

| |2003 |2004 |2003 |2004 |

| |Actual |CP May |CP Nov |Actual |Actual |CP May |CP Nov |Actual |

| |GG Balance |GG Debt |

|CZ 1/ |-11.7 |-5.3* |-5.2 |-3.0 |38.3 |38.4* |38.6 |37.4 |

|EE |3.1 |0.7 |1.0 |1.8 |5.3 |5.4 |4.8 |4.9 |

|HU 2/ |-5.5 |-4.6 |-4.5 |-4.5 |56.9 |56.3 |57.3 |57.6 |

|LV |-1.5 |-2.1 |-1.7 |-0.8 |14.4 |16.2 |14.2 |14.4 |

|LT |-1.9 |-2.7 |-2.5 |-2.5 |21.4 |22.4 |20.1 |19.7 |

|PL 2/ |-3.9 |-5.7 |-5.4 |-4.8 |45.4 |49.0 |45.9 |43.6 |

|SK |-3.7 |-4.0 |-3.8 |-3.3 |42.6 |45.1 |43.0 |43.6 |

|SI |-2.0 |-1.9 |-2.1 |-1.9 |29.4 |29.1 |30.2 |29.4 |

|1/Including one-off expenditures of around 6% of GDP in 2003. |

|2/Excluding effect of pension reform. |

|* actualization of Ministry of Finance. |

|Source: Eurostat. |

Fiscal outcomes in 2004 were better than planned and expected in several countries. This was particularly the case in the Czech Republic, but also in Poland, Slovakia, and the Baltic countries. The better outcomes reflect partly higher than expected growth rates and revenue collection (Latvia, Poland and the Czech Republic), structural expenditure cuts (Slovakia and the Czech Republic), revenue carry overs (Czech Republic), delays in EU fund disbursement (all countries), and introduction of multi-annual budgeting which allows chapters to defer their capital funds (Slovakia).

Despite the better results in 2004, no country has yet revised its fiscal plans for 2005. In Poland, the Ministry of Finance announced a new, more ambitious medium-term fiscal strategy aimed at reducing the deficit to 2.8% of GDP in 2007 (including the full cost of pension reform). The strategy envisages three areas of action: (1) cutting expenditures; (2) harmonizing tax rates; and (3) improving expenditure management (including a 3-year expenditure framework, program budgeting, outcome and efficiency measurement, and computerizing budget and cash management). However, given the prospective elections it is not clear what the significance of this new strategy is. In Hungary, the government has accepted to follow the EC recommendation to raise budget reserves from 0.5% to 0.8% of GDP in 2005, but risks of fiscal slippage remain. The 2006 fiscal target will be even more difficult to meet due to expected lower revenues (termination of the lump sum health care contribution in 2006 and proposed tax cuts), additional spending (payment of the full 13th-month pension), and election-related spending pressures (especially in local governments). In the Czech Republic, the fiscal deficit in 2005 is likely to increase by 1.5-2.0% of GDP and might be even higher than targeted in the latest Convergence Program (much depends on how government agencies will spend last years’ reserves—a Ministry of Finance resolution from March 2005 seeks to limit the carry-overs by imposing restrictions or thresholds on specific type of spending that might be financed from last year’s budget allocations.

With the revised SGP, Hungary, Poland and Slovakia would fulfill the Maastricht fiscal deficit criterion in 2007 (Table 3). According to revised pact, countries can exclude 100% of the cost of pension reform in 2005, declining by 20% each year so that the full cost of the reform would need to be included by 2010. This would allow these countries to adopt the Euro in 2009 consistent with government targets (Hungary, however, has not yet advanced its 2010 target).

|Table 3. Revised SGP allows earlier adoption of EURO. |

| |2003 |2004 |2005 |2006 |2007 |

|Hungary | | | | | |

|GG Deficit |-5.5 |-4.5 |-3.8 |-3.1 |-2.4 |

|Gap due to pension reform |-0.7 |-0.8 |-0.9 |-1.0 |-1.0 |

|GG total deficit (old Pact) |-6.2 |-5.3 |-4.7 |-4.1 |-3.4 |

|GG total deficit (new Pact) |-6.2 |-5.3 |-3.8 |-3.3 |-2.8 |

|Poland | | | | | |

|GG deficit |-3.9 |-4.8 |-3.9 |-3.2 |-2.2 |

|Gap due to pension reform |-1.6 |-1.6 |-1.8 |-1.7 |-1.7 |

|GG total deficit (old Pact) |-5.5 |-6.4 |-5.7 |-4.9 |-3.9 |

|GG total deficit (new Pact) |-5.5 |-6.4 |-3.9 |-3.5 |-2.9 |

|Slovakia | | | | | |

|GG deficit |-3.7 |-3.3 |-3.4 |-2.9 |-1.9 |

|Gap due to pension reform |0.0 |0.0 |-0.4 |-1.0 |-1.1 |

|GG total deficit (old Pact) |-3.7 |-3.3 |-3.8 |-3.9 |-3.0 |

|GG total deficit (new Pact) |-3.7 |-3.3 |-3.4 |-3.1 |-2.3 |

|Note: General Government deficit in % of GDP. |

|Source: Convergence programs, and staff calculations based on first use of new SGP in 2005. |

Structural issues and reform developments

With a few exceptions, there was little progress on broader structural reforms in recent months while there was widespread, pre-electoral talk of further tax cuts.

Several EU8 countries are contemplating further tax reforms. Tax reforms the EU8 in recent years—mainly corporate income tax cuts—have been driven by a desire to improve the business environment and enhance competitiveness. Discussions on further tax reforms are centered on harmonizing tax rates across main tax categories and lowering the high taxation of labor. In Lithuania and Slovenia, governments are pursuing their pre-election promises of tax cuts, while in the Czech Republic, Hungary, and Poland taxation has become a key battleground issue ahead of elections. In Estonia, on the other hand, income tax cuts planned by the previous government are being resisted by most parties.

• In the Czech Republic, the Finance Ministry has proposed reductions in the lowest PIT rate from 15% to 12% (while raising the income threshold by 10%) and in the second lowest rate from 20% to 19%. Further, tax deductibles would be streamlined. Similar tax relief would be introduced for dependent spouses, students, and handicapped. The proposal is estimated to reduce the tax burden for 70-90% of taxpayers, with the largest reduction applying to persons with gross incomes under Kc35,000 (Table 4). The tax cuts would reduce general government budget revenues by about Kc14bn in 2006 and Kc18bn in 2007, with the shortfall expected to be made up by faster output growth and higher revenue from indirect taxes.

|Table 4. Proposed changes in PIT in Czech Republic. |

|Rate (%) |Annual income (in Kc) |

|12 |up to 121,200 |

|19 |from 121,200 to 218,400 |

|25 |from 218,401 to 331,200 |

|32 |from 331,200 |

|Estimated impact of proposed tax changes on personal revenues (Kc) |

|Gross wage |Monthly saving |Annual saving |

|10,000 |387 |4,644 |

|15,000 |349 |4,188 |

|20,000 |393 |4,716 |

|25,000 |240 |2,880 |

|30,000 |241 |2,892 |

|35,000 |30 |360 |

|60,000 |20 |240 |

|Source: Finance Ministry, CR |

• In Estonia, the PIT rate was reduced from 26% to 24% in 2005, and the plan of the previous government to gradually lower the rate to 20% seems to be accepted by key parties.

• In Hungary, the government has accepted the “Streamlining Act” on taxation, and parliament approval is expected in April. This act proposes some 60 amendments to the current tax system and aims to streamline administrative barriers which have complicated the start-up and operation of SMEs. Among others, it provides for faster depreciation rules for SMEs, a simplified system for applying for government support, and simplified reporting requirements. The second phase of tax reform is still under discussion, but plans include: (i) reducing the local business tax from 2% to 0.5% by 2008 (perhaps by one percentage point already next year) while introducing a two-tier corporate tax system with a 10% rate up to the first HUF 5mn profit and over that limit with 16% rate. The complementary corporate tax with 3% rate can be a temporary solution to cover revenue losses from the lower local business tax (further, a property tax could be introduced on vehicles, buildings, and plots); (ii) raising the income threshold for the lower 18% PIT rate from the current HUF 1.5mn to HUF 2.5mn in 2007; and (iii) a gradual unification of VAT rates with the existing 3-tier (5%, 15% and 25% rates) progressively converted to a two-tier system with a 5% preferential rate and a 20% regular rate. These tax changes would reportedly be consistent with the revenue/GDP ratio in 2006-2007 assumed in latest Convergence Program.

• The Lithuanian government has agreed to cut personal income taxes by 6 percentage points in 2006 and a further 3 percentage points in the following two years, which would reduce the flat PIT rate to 24% in 2008. In order to compensate for the associated decline in budget revenues, the Government has proposed to introduce additional taxes, mainly a provisional solidarity tax (which would replace the road tax from July 1 2005) and a tax on real estate used for commercial purposes (1% of its value) to take effect from 2006. This tax will be introduced only for individuals as legal entities are already subject to the real estate tax.

• In Poland, within its 2005-2008 Fiscal Management Strategy, the Ministry of Finance proposes to unify VAT, PIT and CIT rates at 18% along with a 50% tax break for investors. The Civic Platform, leading opinion polls ahead of upcoming elections also wants to introduce a general flat tax system from 2007 (unifying VAT, PIT, and CIT rates at 15%) while withdrawing most deductions and allowances.

• Slovenia recently introduced changes to the PIT focused at reducing the tax burden on lower income groups and elderly workers: in September 2004, the general taxable minimum increased from 11% to 17.2% of the average salary, and from January 2005 tax rates of five tax brackets (reduced from six) vary from 16% to 50% (Table 5). However, overall taxes on labor remain high not only reflecting PIT and social contribution rates but also a 14.8% payroll tax charged on all salaries higher than 62% of the average (49% before reform). The effective tax rate on corporate profits is expected to increase from 12% to 17% (nominal rate is 25%) as the CIT act expanded the tax base through a more precise definition of taxpayers and fewer exemptions.

|Table 5. New PIT in Slovenia. |

|Tax brackets (%) | |

|Before reform |17 35 37 40 45 50 |

|After reform |16 33 37 41 50 |

|Allowances (in % of average gross wage) |

| |Before reform |After reform |

|General allowance |11 |17.2 |

|For disabled |100 |100 |

|For students |40 |34.9 |

|Seniority |8 |8 |

|For one child |10 |13.8 |

|For two children |25 |28.8 |

|For three children |45 |48.8 |

|For disabled child |50 |50 |

|For other dependent family member|10 |13.8 |

|Payroll tax |

|Monthly gross wage (SIT) |Tax rate |

|Before reform |After reform | |

|0-130,000 |0-165,000 |0% |

|130,001-400,000 |165,001-400,000 |3.8% |

|400,001-750,000 |400,001-750,000 |7.8% |

|750,000+ |750,000+ |14.8% |

|Source: Finance Ministry, Slovenia |

Slovakia implemented its 2nd pension pillar from January 1, 2005 thus following the example of Hungary and Poland in the late 1990s and more recently Latvia and Estonia. Participation in the new mixed pension system is mandatory for new workers, but voluntary for the existing work force (Table 6). In the mixed system pension contributions are divided equally between the first PAYG and second private savings pillars. So far, about one-third of eligible workers have switched to the new system and more are expected to follow by the June 2006 deadline. Like in other countries that have implemented such pension reforms, more people than expected have switched to the new system reflecting widespread distrust in the state pension system because of the unsatisfactory standard of living of pensioners and expectations of higher yields in the private pension funds.[2]

|Table 6. Pension contribution rates. |

|Country |Total Contributions |First pillar |Funded |Starting date |Type of pension |

|Hungary |28 |22 (PAYG) |6 |1998 |Mandatory |

|Poland |19.5 |12.2 (NDCS) |7.3 |1999 |Mandatory (< 30) |

|Latvia 1/ |20 |18 (NDCS) |2 |2001 |Mandatory (< 30) |

|Estonia |22 |16 (PAYG) |6 |2002 |Mandatory (< 18)l |

|Lithuania 2/ |26 |22.5 (PAYG) |3.5 |2004 |Optional 2. pillar |

|Slovakia |18 |9 (PAYG) |9 |2005 |Mandatory (< 18) |

|1/ Contribution rate for the funded pillar increases gradually to reach 10% in 2010 (equal to PAYG). |

|2/ Contribution rate for the funded pillar increases gradually to reach 5.5% in 2006. |

|Source: World Bank, ILO, Jurzyca and Golias (2004)[3] |

There was some sporadic progress in advancing the remaining privatization agenda in some EU8 countries. In 2004, Poland sold a minority share in the biggest public retail bank PKO PB, while Slovakia privatized its state-owned power plants and airline. In April 2005, the Czech government sold its main state-owned telecommunications company Cesky Telecom to Spanish Telefonica for EUR 2.9 billion after long delays, receiving a price twice as high as when the company was first offered for sale a couple of years ago. Further privatization plans include the PKN Orlen oil refinery company (Poland), the Vitkovice steel mill, Czech Airlines and Volan (the Czech Republic), the MAV railway company and Malev airlines (Hungary), Lietuvos Avialinijos (Lithuania), and freight rail and heating companies (Slovakia). At least in Poland, reinvigoration of the privatization agenda has been driven more by the budget concerns than downsizing the state and enhancing efficiency and competition.

EU8 countries are also busy preparing their National Development Plans which will form the foundation for EU financial support in 2007-13. These plans are being developed in parallel with new strategic guidelines for regional policy under discussion at the EU level but continue to suffer from the uncertainty regarding the next EU budget. Contrary to most NDPs prepared for the remainder of the current EU budget period, which were largely about the allocation of EU funds, the new NDPs are likely to provide a much broader strategic framework for the longer-term development of the different countries. Key issues concern not only the allocation of public resources among key objectives and expenditure priorities, but also the level of decentralization in the decision making process and the need to strengthen technical and administrative capacity to make full and efficient use of the large EU aid funds.

• Poland has perhaps advanced the furthest in its preparations with the launch of its draft NDP for public consultation in January (expected to end in April). A fundamental principle in the new Polish NDP is the allocation of structural funds equally between the state and regions, with each of the 16 regions preparing their own development strategies and operational programs. The work will of course have to be finalized by the next government.

The OECD published an interesting report—“Going for Growth”—on structural policy priorities in its member countries, including in the EU8 the Czech Republic, Hungary, Poland, and the Slovak Republic. Measures were focused on labor utilization and productivity and generally included lowering of tax wedges on low-income workers, enhancing labor market mobility, revisiting disability pensions, and enhancing competition not least in network industries (Table 7).

|Table 7. Structural policy priorities in EU8 OECD countries. |

| |Labor utilization |Labor productivity |

|Czech Republic|Stimulate employment by cutting the costs of employment |Implement intended reform of bankruptcy laws and simplify |

| |protection legislation for regular workers. |business registration. |

| |Strengthen work incentives of low-income workers by reducing |Reform system of taxes and benefits to reduce poverty traps |

| |tax wedge imposed on them. |for non-employed households. |

| |Increase labor mobility by further liberalizing the rental | |

| |housing market. | |

|Hungary |Strengthen incentives of low-income workers to work in formal|Reduce state control on the operations of network industries |

| |economy by reducing tax wedge imposed on them. |to allow prices to better reflect market signals and to |

| |Encourage those with substantial work capacity to enter the |facilitate entry. |

| |labor market by refocusing disability benefit schemes. |Promote greater domestic competition by reducing |

| |Facilitate labor mobility by downsizing the housing loan |administrative costs for start-ups. |

| |subsidy program and thus reducing housing market distortions.| |

|Poland |Stimulate hiring for youth and low-skilled by allowing for a |Intensify competitive pressures in a number of sectors by |

| |relative decline in the minimum cost of labor. |strengthening the privatization program. |

| |Encourage those with substantial work capacity to enter the |Reduce barriers to foreign ownership to enhance technological|

| |labor market by refocusing disability benefit schemes. |transfers from abroad. |

| |Increase labor mobility by improving transport and housing | |

| |infrastructure. | |

|Slovak |Strengthen incentives of low-income workers to work in formal|Reduce state control in certain network industries to promote|

|Republic |economy by reducing tax wedge imposed on them. |effective competition. |

| |Promote a rules-based business environment by |Raise overall level of human capital by improving secondary |

| |strengthening the governance of the judicial and |education achievements and access to tertiary education. |

| |enforcement systems law. | |

| |Reduce future pension contributions by raising standard | |

| |retirement age. | |

|Source: OECD (2005). |

World Bank activities

Technical assistance credit line of US$100m opened to the EU8 countries. On January 25, 2005, the World Bank approved a new Social and Institutional Development and Economic Management (SIDEM) technical assistance facility for EU8 countries with an aggregate lending limit of US$100 million. Examples of activities that could be financed through loans under SIDEM include support for the formulation of National Development Plans, creation of knowledge-based economies, reform of judicial systems, modernization of health and education sectors, and effective utilization of EU assistance. The World Bank has approved the first loan under SIDEM—a Human Capital Technical Assistance Project for the Slovak Republic in the amount of €5 million.

In Poland, the World Bank in March finalized a new Country Partnership Strategy (CPS) outlining the framework for the Bank’s operations in Poland in the coming years. The CPS was consulted with the government and civil society between November 2004 and February 2005. The new Partnership Strategy envisages a flexible framework for supporting the Government’s reform efforts through selected lending operations and analytical and advisory activities (AAA).

• In March, the World Bank also approved a new Euro100mn loan to Poland for Roads rehabilitation and maintenance as well as modernization of the national road agency (GDDKiA). This is a follow-up to a similar operation approved last year and now under implementation.

• The Bank’s portfolio in Poland now includes a total of eleven loans, supporting reform efforts in the coal mining and railway sectors, strengthening and modernization of the ports and roads agency, and programs for road maintenance, rural development, energy efficiency, regional development, and flood reconstruction and prevention.

• Two new projects are under preparation: Odra River Basin Flood Prevention and Post-Accession Rural Support. The first project would finance—together with other development partners—construction of infrastructure in Racibórz and around Wroclaw to protect against future floods. The second project would support activities to strengthen the administrative and analytic capacity of KRUS during its reform process and to enhance the capacity of local governments to identify, plan and execute social inclusion strategies.

• On AAA, the Bank—in collaboration with the NBP—is preparing a set of policy notes on development of financial services and a study assessing how the functioning of the legal system influences the situation on financial markets. Further, the Bank is in the final stages of providing support for the development of a Computable General Equilibrium Model for Poland that would strengthen the tools available for analyzing key public finance and labor market reform ideas.

In Slovakia, the World Bank portfolio includes a total of five loans supporting the Government’s reform agenda in the areas of public finance, health sector modernization, pension reform and capacity building in public administration. In addition, the Bank’s operational involvement includes implementation of four active grants supporting legal and judicial reform, accounting and auditing reform, enhancement of regulatory reforms in infrastructure and strengthening the communication efforts of the Government.

• The new Human Capital Technical Assistance Project will assist the Government in modernizing its systems for employment, education and social cohesion by enhancing the institutional capacity to implement, manage and evaluate reforms in these sectors in the Ministry of Labor, Social Affairs and Family and in the Ministry of Education.

• On AAA, the Bank has been actively engaged in Higher Education Reform, including support to the newly established Ranking and Rating Agency for HEIs. The Bank has also facilitated discussion on international experiences in the implementation of life-long learning programs. In agriculture and rural development, the Bank has prepared a study on market linkages in the Slovak agriculture sector (“Vertical Coordination in the Marketing Chain”) to be finalized in April. In addition, an analysis of reform options for the Common Agriculture Policy (CAP) will be prepared. Further, as a follow-up to the Bank’s work on knowledge economy undertaken in late 2004, the Bank is commenting on the “Competitiveness Strategy for Slovakia until 2010” (launched in January 2005) and assisting with the design and implementation of a comprehensive e-government strategy that would lead to the formulation of a national innovation policy (particular attention would be given to legislative issues, the institutional framework for effective public support of research and development, and development of a venture capital industry).

• The World Bank also has a Small Grants Program, jointly managed by the Open Society Foundation (OSF) of Slovakia, which in 2005 will support the efforts of civil society organizations to better monitor, evaluate and/or implement the “Decade of Roma Inclusion 2005-2015” initiative.

In Lithuania, the Bank’s work is focused on AAA and implementation of ongoing lending projects. The active lending program includes five projects dealing with social policy community services, municipal development, Klaipeda Port, and health and education reforms. All projects are scheduled for completion by June 2006. The Bank’s non-lending assistance includes a recent Investment Climate Assessment as well as TA and analytical work in telecommunications/rural internet access, transport, education and health.

In Latvia, the Bank is continuing a dialogue with the Ministry of Health on cooperation in the area of health reform. Discussions have also been initiated on providing support for the preparation of the National Development Plan. Further, the Bank continues a dialogue with the Ministry of Economy and Ministry of Education and Science on cooperation in building a knowledge-based economy.

• A “Cities Alliance” grant program is supporting the 8 biggest Latvian cities in preparation of their development strategies. This program will feed into the overall urban development strategy being drawn up. There is also a Small Grants program for which projects for 2005 are being identified.

In the Czech Republic, the Bank is assisting the Czech National Bank in evaluating governance and failure resolution mechanisms in the banking Industry. Four financial institution governance assessments are under way (banks, insurance companies, mutual funds, and pension funds). The Bank has also undertaken an Insolvency Study.

In Hungary, a Black Sea Nutrient Reduction Project financed by the Global Environment Facility is under preparation.

At the regional level, the World Bank in cooperation with the Polish Ministry of Economy and Labor hosted a conference in Warsaw April 6-7 on the experience with NDP preparation in both the new member countries and some of the earlier member countries. All EU8 countries participated, along with representatives from Bulgaria, Romania, and Croatia and government officials and experts from Poland, Ireland and Italy. The main conclusions that emerged from the conference were (i) NDPs should provide a broad, strategic framework for countries’ longer term development; (ii) NDPs should include an explicit discussion of key economic and social objectives, technical, administrative, and financial constraints, alternative policy levers (including regional, fiscal and labor market policies); (iii) key investment priorities should be well-supported by underlying analysis and clear criteria established for project selection; (iv) NDPs should be closely linked to medium-term budget planning; (v) early political buy-in, open and transparent consultations, and independent assessments were important; and (vi) strengthening technical and administrative capacity to better prepare, select, implement, and evaluate projects was essential.

Work is also under way on an EU8 cross-country public finance reform study, focusing on selected issues (this year health care financing, higher education financing, pension reform, decentralization, and fiscal risks from PPPs). Further, a regional labor market study focusing on constraints to geographical labor mobility is in progress.

Statistical Annex

|  |

|Czech Republic |

|Czech Republic |

|Czech Republic |

|Czech Republic |

|Czech Republic |

|Czech Republic |13.0 |4.9 |7.9 |18.5 |11.3 |27.0 |19.9 |15.8 |  |

| | | | | | | | | | |

|  |

|Czech Republic |

|Czech Republic |

|Czech Republic |

|Czech Republic |

|Czech Republic |

|Czech Republic |34.05 |30.82 |31.85 |31.90 |32.85 |32.04 |31.59 |

| | | | | | | | |

| | | | | | | | |

| | | | | | | | |

|  |

|Czech Republic |

|Czech Republic * |

|Czech Republic |

|Czech Republic |

|Czech Republic |

|Czech Republic |

|** LCU/EUR |

|*** quarterly figures: cumulative 4 quarters |

| |

|Czech Republic |

|Czech Republic |

|Czech Republic |

|Czech Republic |

|**** General government budget |

|***** State and municipality budget |

| |

|Source: Eurostat, WIIW, CSOs, NCBs, World Bank, staff calculations. |

Forecasts

|  |2005 |2006 |

|  |EC |GOV |

|  |EC |GOV |IMF |OECD |

|Source: EC: Spring 2005 Economic Forecasts; GOV: Convergence Programs December 2004; IMF: IMF: World Economic Outlook, April 2005; |

|OECD: OECD Economic Outlook November 2004; WB: latest country economist forecast. |

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[6] Real returns so far in private pension funds in Poland have exceeded 10% per year on average, but administration fees have been sizeable which could potentially point to insufficient competition among pension companies.

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