Mission Concluding Statement 

Slovak Republic -- Concluding Statement of an IMF Staff Visit

October 15, 2003

1. An IMF mission has conducted discussions with the authorities focusing on fiscal policy for this year and the next. This note presents the mission's assessment of the current economic situation and lays out policy recommendations.

Macroeconomic Background

2. Recent economic indicators suggest that strong growth is continuing, macroeconomic imbalances are narrowing, unemployment is declining, and core inflation remains low. Real GDP growth eased to 3.9 percent in the first half of 2003, driven by exports. The volume of exports grew by an impressive 37 percent in the first half of 2003 despite weak economic growth in Europe, and contributed to a trade surplus in May-August for the first time in three years. The external current account deficit thus fell from 8.6 percent of GDP in the twelve months to June 2002 to under 5 percent of GDP in the twelve months to June 2003. Private consumption has slowed substantially, though, reflecting the impact of price deregulation and indirect tax hikes on real disposable income. Investment has also been sluggish. The price and tax increases have led to a jump in headline inflation this year but apparently not to any significant second-round inflationary effects, and real wages have declined moderately.

3. The short-term outlook remains favorable. Our baseline projection is for real GDP to grow by 3.9 percent this year and 4 percent in 2004, with downside risks arising from uncertainties about the timing of the recovery of consumption and investment. On present expectations of moderate wage increases and continuing fiscal consolidation, both the external current account and the inflation outlook are likely to continue improving. The external current account deficit is projected to narrow to under 4 percent of GDP in 2003 and 2004, based on very robust export growth. Utility price increases will continue in 2004—but to a lesser extent than in 2003—and VAT rates will be unified at a higher average level in January 2004. On this basis, and assuming that wage increases and second-round price effects remain moderate, staff and the authorities project headline inflation to fall slightly next year, and to decline towards Maastricht levels by 2006 as targeted.

Fiscal Policy in 2003

4. Despite a projected shortfall in tax revenues, the 2003 ESA 95 deficit target of 5 percent of GDP should be within reach assuming continued expenditure containment. Achievement of the deficit target would represent a needed and welcome reduction from the 7.2 percent of GDP registered in 2002. Although the authorities have responded to a projected revenue shortfall by bringing forward excise tax increases previously planned for January 2004, both the authorities and the mission expect a total revenue shortfall (compared to budget) of about Sk 7 billion on an ESA 95 basis. Nearly half of this shortfall is to be covered by a lower-than-budgeted interest bill and the rest by savings in primary spending. These savings in primary spending include welcome savings of about Sk 500 million in social allowances and benefits, an area where the norm was spending overruns in the past. Substantial savings are also expected, however, from lower co-financing of EU projects which are expected to be delayed to next year. This may reflect slow implementation of quality projects—and thus affect the quality of spending this year—and the authorities should strengthen their efforts to implement spending that will be supportive of long-term growth, and aim to concentrate spending savings on other items.

5. Nonetheless, there remain risks for slippages outside the state budget. First, municipal budgets were assumed to be balanced on a cash basis in 2003; the mission has made a substantial effort to assess the financial position of municipalities but given data limitations this position remains unclear. However, in light of the devolution of responsibilities to lower levels of government spending slippages remain a possibility. Second, the general government budget assumed a halving of the accumulation of health sector arrears in 2003. While budget execution data for health insurance companies through August appear in line with this objective, the picture on arrears accumulation in other parts of the health sector remains uncertain. Therefore, the authorities should continue their efforts to get a better handle on the finances of municipalities and the health sector. On municipalities, in particular, two issues relevant to this year's budget are important more generally for future fiscal policy: (i) better reporting may be needed for enhanced control by the Ministry of Finance, and (ii) if slippages do eventuate, financing rules for municipalities may need to be tightened to contain spending at the municipal level.

The 2004 Budget

6. The 2004 budget represents a decisive and welcome step toward further fiscal consolidation, as the government has approved an appropriate deficit target of 3.9 percent of GDP. The budget is based on a realistic growth assumption of 4.1 percent, although the average inflation assumption, at 8.1 percent, is half a percentage point higher than the updated IMF staff projections. The 2004 fiscal objectives are appropriate both from a cyclical and a medium-term perspective, and envisage ambitious tax and spending reforms. In particular, the spending reduction represents a substantial installment toward the strategy underlying the Pre-accession Economic Program, which depends on a reduction of expenditure as a share of GDP.

7. While revenues in 2004 are budgeted to remain practically flat as a share of GDP, this conceals a change in the composition of revenues. Reforms are projected to reduce taxes (including social security contributions) as a share of GDP by 2 percentage points—but this should be largely offset by EU transfers (1.4 percent of GDP), and an increase in nontax revenues by about ⅓ percentage point of GDP reflecting primarily increased dividend payments from the gas company. Although the contribution rates for social insurance will be reduced in 2004, the lower revenues are budgeted to be offset by savings from reforms to the social insurance system. The mission believes that revenue projections are realistic, with the main caveat referring to the personal income tax. Forecasting the revenue impact of the tax reform on the collection of this tax involves major uncertainties and therefore there remain risks that revenue losses from the tax reform could be larger than projected. However, this uncertainty will only be resolved as 2004 unfolds.

8. As noted during the 2003 Article IV consultation, the tax reform appropriately aims to provide better incentives to work and save. The reform features a more transparent and simpler tax law, a shift in the tax burden from direct to indirect taxes, and a flat income tax rate. The measures sought are likely to improve economic performance. Removal of exemptions, deductions, and exclusions should lead to fewer distortions in income and consumption taxation, and help finance lower rates of direct taxation. The uniform rate of VAT should improve administration and compliance, while leading to a more neutral taxation of goods and services. Lower direct taxation should encourage both the legalization of firms operating in the grey economy, and foreign and domestic investment. We welcome the sequencing of introduction of the tax legislation, with the more politically difficult items, particularly unification of the VAT, already passed by the parliament.

9. The budget implies a reduction in primary spending of nearly 1 percentage point of GDP, reflecting largely the implementation of planned reforms to social legislation and health care reform. This reduction in primary spending is all the more notable in light of additional EU-related spending in 2004. Despite the across-the-board reduction in primary spending as a share of GDP, subsidies to agriculture are budgeted to increase by 0.4 percentage points of GDP. An estimated 4 percent increase in the general government wage bill reflects wage policy for 2004 (increase of 5 percent in wages to state and public service as of July) and a reduction by 2,700 employees in the state sphere. Turning to social spending: sickness, unemployment, and social welfare benefits should be reduced significantly as a proportion of GDP through a combination of measures to control abuse and tighten eligibility criteria for access to unemployment benefits, lower unemployment, and a more targeted social aid system. On health care, the ongoing reform of the system that started earlier this year is ambitious, and goes beyond containing health spending by including the rationalization of hospitals and reduction of employment in the sector. As regards pensions, the government should obtain savings in spending as a ratio to GDP through the recently approved increase of the retirement age by 9 months in 2004. The most important savings from the reform of the first pillar pension system should be realized longer term.

10. The mission has the following views on the 2004 budget:

· We welcome the fact that the ambitious tax reform is being done in conjunction with continued fiscal consolidation. Moreover, on the spending side, the consolidation is not at the expense of capital spending, which will be required to sustain long-term growth.

· We are encouraged by the strong government efforts under way to improve fiscal transparency—most importantly, the recent ending of the practice of using government guarantees to provide implicit subsidies.

· We also welcome the intention to limit the growth of most items of state spending substantially below the increase in headline CPI. The increase in the wage bill represents a significant reduction of the public payroll's share in GDP. The growth in spending on goods and services in the state budget is projected to be contained to 3-4 percent, and should also result in a decline of this item's share in GDP. The authorities should encourage the adoption of this policy in other areas of the general government.

· However, the mission regrets the increase in subsidies in the 2004 budget (all of it going to the agricultural sector), which seem unlikely to enhance the growth potential of the Slovak economy.

· The very ambitious reform agenda underlying the 2004 budget still requires the approval of important legislation. As noted, on taxation the most difficult reforms—unification of VAT and increases in excises—have already been passed. However, substantial legislation in the areas of health care, benefits, labor, and civil service reform still requires parliamentary approval. In the event that parliament does not approve these reforms, or reforms are otherwise delayed, the government would need to review the parameters underlying the 2004 budget to achieve the general government deficit target of 3.9 percent of GDP.

· On health care, the introduction of co-payments together with a reduction of the free healthcare package available universally should increase income and reduce abuse of the health care system, while the rationalization of supply should make the overall health care system more efficient in providing needed services. The mission shares the authorities' hope that this will virtually eliminate the accumulation of debts in the health care system in 2004.

· The continued reduction in interest rates should result in a further decrease of the interest bill in proportion to GDP, but going forward permanent deficit reduction should rely mainly on reducing primary spending as a share of GDP.

· We note that achieving the 2004 fiscal objectives requires parallel efforts by the state budget and by areas outside it (primarily the Social Insurance Agency, the health insurance companies, and municipalities). The Ministry of Finance will need to remain vigilant that efforts outside the state budget are implemented as planned.

· Given that the uncertainties surrounding expenditure and the effects of the tax reform, in particular, are larger than usual, the 2004 budget may need a substantial cushion (perhaps as part of a reserve fund) within the government-approved expenditure envelope to prepare for the event of slippages.

Monetary Policy

11. The NBS reduced policy interest rates by 25 basis points on September 25, primarily reflecting evidence that domestic demand was very sluggish—despite overall good developments in GDP—and that inflation remained contained. The mission concurs that domestic demand is weak—although this reflects to a large extent a desirable adjustment from the excessive pace of the second half of last year—and inflation is subdued. Thus the reduction in interest rates reflected appropriately the balance of risks facing the economy. Domestic demand could contract too much—and thus slow growth by more than would be desirable—core inflation remains low and is expected to fall in 2004, and headline CPI is expected to fall but still reflect further adjustments to utility prices and indirect taxes. In these circumstances, we believe that the current monetary policy stance should be adequate to contain inflationary pressures and achieve the authorities' inflation objectives. However, the authorities should maintain a cautious approach in the period ahead. Any further easing of monetary policy should await evidence of wage increases remaining moderate, of no substantial second-round increases from forthcoming administered price and tax increases, and of continued subdued domestic demand. The mission welcomes the planned move by the NBS to quarterly inflation projections (compared with the current twice-yearly monetary program). This should provide better guidance to the market on the stance of monetary policy, help the NBS board discussions, and provide the basis for a needed improvement in communications to the public.

We thank the authorities for their usual close cooperation with the mission, their generous hospitality, and for the interesting and constructive discussions.