VZCZCXYZ0036
RR RUEHWEB

DE RUEHPG #0057/01 0201307
ZNR UUUUU ZZH
R 201307Z JAN 06
FM AMEMBASSY PRAGUE
TO RUEHC/SECSTATE WASHDC 6852
INFO RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/DEPT OF COMMERCE WASHDC

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