VZCZCXRO4581
OO RUEHAG RUEHAST RUEHDA RUEHDBU RUEHDF RUEHFL RUEHIK RUEHKW RUEHLA
RUEHLN RUEHLZ RUEHPOD RUEHROV RUEHSR RUEHVK RUEHYG
DE RUEHPG #0359/01 0941457
ZNR UUUUU ZZH
O 041457Z APR 07
FM AMEMBASSY PRAGUE
TO RUEHC/SECSTATE WASHDC IMMEDIATE 8845
INFO RUEHZL/EUROPEAN POLITICAL COLLECTIVE
RUCPDOC/DEPT OF COMMERCE WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
RUEAIIA/CIA WASHDC

UNCLAS SECTION 01 OF 03 PRAGUE 000359 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
STATE FOR EUR/NCE, EUR/ERA, EB/IFD/OMA, E STAFF DAN MORRISON 
TREASURY FOR OASIA ANNE ALIKONIS 
STATE PLEASE PASS USTR WENDY MOORE 
COMMERCE FOR ITA/MAC/EUR MIKE ROGERS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PGOV EZ
SUBJECT: CZECH REPUBLIC: PUBLIC FINANCE REFORM BILL IS 
FIRST TEST FOR NEW GOVERNMENT 
 
REF: A. 06 PRAGUE 1239 
 
     ¶B. 06 PRAGUE 1173 
     ¶C. 06 PRAGUE 534 
 
¶1. (U) SUMMARY AND COMMENT:  The Topolanek cabinet on April 3 
announced its long-anticipated economic and social reform 
package, and said it intends to link the bill to a vote of 
confidence in Parliament.  The reform package falls short of 
simplifying the tax system but does undo many of the popular 
social spending bills passed in the run-up to the 2006 
general elections that derailed the Czech Republic from its 
euro-adoption timeline.  Preliminary reaction from economists 
has been relatively positive.  A proposed cap on social 
security is a welcome development for U.S. businesses and 
Americans working in the Czech Republic. 
 
¶2. (SBU) Politically, the proposed reforms are being 
criticized by the left for going too far and by some on the 
right for not going far enough.  Not surprisingly, the 
opposition Social Democrats complain that many subsidies will 
be eliminated and pensioners, in particular, will face higher 
prices for necessities; they promise to oppose such "asocial 
reforms."  More troubling, some within the ruling coalition 
have also announced they are not yet ready to support the 
package.  With the parliament evenly split, and the coalition 
reliant on the votes of two opposition rebels for support, 
the fate of the package in parliament is not certain.  If the 
government continues to insist that it will link the program 
to a confidence vote, it may need to consider restoring some 
of the more popular subsidies the bill intends to eliminate 
in order to ensure passage.  END SUMMARY AND COMMENT 
 
--------------------- 
MACROECONOMIC CONTEXT 
--------------------- 
¶3. (U) The Czech economy has been growing at a record pace of 
over 6 percent for the last two years (fifth fastest in the 
EU behind Slovakia and the Baltic states). 2007 expected GDP 
growth is 5.8%.  Exports (automobiles & machinery) and 
export-oriented foreign direct investments continue to drive 
this growth, although in the last two years, consumer 
spending has been increasingly contributing to GDP growth 
(over 5% in 2006).  The increase in domestic consumption is 
attributed to income tax cuts, increased social transfers, a 
recent boom in consumer mortgage and other loans, as well as 
growth in housing construction and wages.  Per capital GDP 
(ppp) reached 76% of the EU average in 2006, up from 73.7% in 
2005  Newly-released Ministry of Finance statistics show 
foreign direct investment (FDI) inflows went from USD 11.7 in 
2005 to USD 6 billion 2006; increased exports led to 
continued improvements in the trade balance from USD 1.6 
billion to USD 1.97 billion.  According to the IMF, inflation 
remains low and stable around 3% while  core inflation is 
around 1%, reflecting strong central bank credibility. 
 
------------------------------------- 
IS THE ECONOMY HEADED FOR A DOWNTURN? 
------------------------------------- 
¶4. (U) While entrepreneurs are generally of the opinion that 
the Czech Republic has the potential to reach GDP growth 
levels beyond 6%, they see red tape, high taxes, high social 
and healthcare contributions, and over-regulation as key 
obstacles.  Economists believe growth has already reached its 
peak and the first signs of a moderate slow-down are evident. 
 They argue that the automotive industry has reached its 
maximum capacity and would not repeat the massive growth of 
the past two years until after 2009 when a new Hyundai plant 
becomes operational as the third major carmaker after Skoda 
Auto (owned by Volkswagen) and Toyota-Peugeot-Citroen Auto 
(TPCA). 
 
¶5. (U) In this context, the traditionally business-friendly 
Civic Democrats (ODS) that now head the three-party coalition 
government with the Christian Democrats (KDU-CSL) and the 
Greens (SZ), have an opportunity to implement changes they 
talked about for eight years in opposition.  ODS' focus is 
the "misused social state" based on the principal that it 
should be more advantageous to work than to be on social 
welfare.  The current system, according to ODS, 
disincentivizes some income groups from seeking employment. 
The IMF has also concluded that a high tax wedge and generous 
entitlements discourage job search. 
 
 
PRAGUE 00000359  002 OF 003 
 
 
---------------------- 
IT'S THE BUDGET, DUMMY 
---------------------- 
¶6. (U) In terms of the EU Maastricht Convergence Criteria, 
the Czech Republic's one glaring weakness is its lack of 
fiscal discipline.  Despite the robust GDP growth, the 
general government budget deficit stood at 2% in 2005 but 
ballooned to 3.7% (estimated) in 2006.  The 2007 budget 
deficit is estimated at 4.4% (CZK 122 million). The main 
culprits are the tax cuts and the significant increase in 
mandatory social spending in the run-up to the June 2006 
general elections.  The new public finance reform package 
seeks to reinstate fiscal discipline and push the deficit 
down to 2.6% by 2009, as reflected in the latest update to 
the Czech-EU convergence program completed in March. 
 
---------------------- 
REFORM PACKAGE DETAILS 
---------------------- 
¶7. (U) On April 3, the Czech government publicly released 
details of the long-anticipated economic reform package. 
Income tax rates would be cut to 15% for all income levels; 
the lower of the two VAT brackets (e.g. for food) would be 
increased from 5% to 9%; the standard VAT rate would remain 
19%.  In terms of social reforms: 
 
EFFECTIVE 2008 
-- a cap on social taxes will be put in place at a salary of 
CZK 80,000 (USD 4,000) per month, but deductions for mortgage 
interest, construction savings, and add-on pension insurance 
will decrease significantly for income groups that earn more 
than this figure. 
-- retirement age will be raised to 65, and 35 years of 
service would be required to qualify for a state pension. 
-- birth allowances will be reduced from CZK 17,760 to CZK 
15,000 for the first child and CZK 13,000 for each additional 
child. 
-- maternity allowances will decrease after two years (CZK 
11,400 up to two years, CZK 7,600 up to 3 years, and CZK 
3,800 up to four years) to motivate parents to return to work 
more quickly.  Currently, the standard maternity leave is 
three years. 
-- parental allowances will be limited only to those with 
household incomes up to 2.4 times the "living minimum" (less 
than CZK 22,560/month).  This will reduce the percentage of 
families receiving child subsidies from 73% to 43%. 
-- elimination of the one-time CZK 1,000 benefit introduced 
by the Social Democrats for familles with children entering 
first grade. 
 
EFFECTIVE 2009 
-- first three days of sick leave will not be paid at all, 
from day 4 - 30 benefits will be at 60% of wages, day 31 - 60 
at 66% of wages, and 60  days at 72% of wages. The current 
rate is 25% of the wage for the first three days and 69% for 
any days beyond. The Czech Republic currently has one of the 
highest number of sick leave days taken among EU countries. 
 
¶8. (SBU) Ministry of Finance Director of the EU and 
International Relations Department Eva Anderova told econoff 
April 2 that public finance reform should be discussed in 
Parliament this month, followed by separate tax reform 
package.  She described the reforms as "not so revolutionary" 
that the opposition CSSD could not support it.  In fact, she 
noted that much of the reforms were based on ideas CSSD put 
forth in its own reform agenda.  Despite the political limbo 
in an evenly divided Parliament, Anderova believes the reform 
package will ultimately be supported by Parliament, if for no 
other reason than that the Czech Republic must adhere to EU 
convergence criteria. 
 
--------------------- 
EURO ADOPTION in 2012 
--------------------- 
¶9. (SBU) On March 13, the Czech government adopted an updated 
Czech EU convergence program aimed at adopting the euro in 
2012, although it does not spell out the interim steps needed 
in public finance reform to reach that target date.  The 
report is expected to be much criticized by the European 
Commission, but the government hopes that the EC will take 
the longer view on its ambitious reform targets. Anderova 
said it would be announced after the public finance reforms, 
and that Finance Minster Kalousek remains personally 
 
PRAGUE 00000359  003 OF 003 
 
 
committed to the 2012 goal.  She admitted that the general 
public did not see euro adoption as either a goal or a 
motivator for economic reforms.  She largely attributed that 
to the government not adequately explaining the benefits of 
euro adoption to the general public.  The new Advisor to the 
Finance Minister Oldrich Dedek (former central bank 
vice-governor and now at the Charles University) is in charge 
of the government euro adoption strategy. 
GRABER