Czech Republic: 2024 budget bill attempts to put public finances on a consolidation path
Metodi Tzanov
Helping finance professionals understand what is going on in Emerging and Frontier Markets
The 2024 budget bill is the first time when the government is going to attempt to bring public finances back to sustainability. The five-party coalition forming the current government came to power at the very tail end of 2021 with a promise of considerable fiscal consolidation after the pandemic crisis. However, it already faced rising energy costs and soon after a war in Ukraine, which led to commodity prices exploding. This made fiscal consolidation plans in 2022 and 2023 untenable, leaving a narrow window of opportunity for the ruling coalition to deliver on its manifesto.
The challenge is considerable, as record-high inflation has stretched public finances to the limit. Pension expenses soared as prices kept rising, boosted by generous indexation rules. The government is yet to deliver on a comprehensive pension reform, limiting itself only to some initial steps, which deal with pension indexation and early retirement rules. Yet, it is not going to be enough to make public finances sustainable in the long run, according to?a recent study of the Czech Fiscal Council. The cornerstone of the 2024 budget bill is?a fiscal consolidation package, which should provide a fiscal consolidation effort at 1.3% of GDP in 2024. However, total fiscal improvement will likely be hindered by fiscal performance in 2023, when the state budget deficit target of CZK 295bn looks like it will be missed by a noticeable margin.
As a side note, the government had not adopted the 2024 budget bill at the time this report was written. However, the 2024 budget bill was presented to social partners, which is why we assumed that no major changes, if any at all, will be applied. This report will be updated in case there are any major adjustments, but we doubt there will be any.
Macroeconomic framework appears realistic, with only a handful of weak points
Macroeconomic assumptions are essentially taken from?the latest finance ministry forecast, published in August. The framework envisages moderate recovery in 2024, based on the assumption that private consumption will fully recover to 2022 levels, after the heavy price shocks seen in 2022 and 2023. Investment should maintain a very modest growth, and the contribution of net exports is expected to remain positive, albeit with a smaller contribution than in 2023, as there will be no longer a favourable base effect related to energy prices in play. CPI inflation should ease to an average of 2.8% in 2024, downf rom 10.9% in 2023, which implies a worse development than?the latest CNB staff forecast. Still, deviations are relatively small, and we see only a few places where projections may fail to materialise.
One is the EUR/CZK exchange rate, which we expect to be weaker than anticipated, as the odds are the CNB will start easing monetary conditions much sooner than the ECB, thus leading to a very narrow interest rate differential. We also see risks related to oil prices, which appear to be rising again, and it may take some time before they moderate. On the positive side, private consumption may recover faster than projected, as it has developed somewhat better than expected in H1 2023 so far. The headline inflation projection appears realistic, though core inflation is likely to be visibly higher.
Thus, while we see some downside risks to the macroeconomic framework, we expect them to be relatively modest and manageable. At this point, unexpected events have the potential to affect public finances much more than the economic cycle, so we don't see it as a source for major concern.
General government deficit to narrow due to fiscal consolidation, debt to remain high
The 2024 budget bill assumes a noticeable improvement in the general government balance, from 3.6% of GDP in 2023 to 2.1% of GDP in 2024. A big part of this is due to the fiscal consolidation effort of CZK 97.7bn (1.3% of GDP) planned in 2024. This does imply a much worse performance of the state government budget, which is planned to report a deficit of CZK 295bn (4% of GDP) in 2023. Based on the fiscal consolidation effort and the expected improvement in the general government budget, however, the state budget defiicit may reach as much as CZK 350bn (4.7% of GDP). The budget bill puts the state government budget at a still high deficit of CZK 252bn (3.3% of GDP) in 2024, expecting strong performance of local government budgets and a close-to-neutral performance of social security funds.
All this doesn't bode well for general government debt, which is expected to end 2023 at 44.7% of GDP, and 2024 - at 45.3% of GDP. This is still far from the debt brake threshold, at 55% of GDP, which, if breached, will require immediate and mandatory fiscal consolidation measures. Current projections do not envisage an improvement at least until at least the first phase of fiscal consolidation takes effect, but if public finances keep improving, government debt could peak in 2024. This comes despite the expectations of a rising tax burden, as the government will be withdrawing some tax breaks and raising social contributions, bringing the tax burden to 33.7% in 2024, higher by 1.1pps. Windfall tax is expected to be maintained in 2024, though it will bring a much lower revenue than in 2023.
Fiscal consolidation package to mark a path towards stabilisation
The fiscal consolidation package?is the biggest package of discretionary measures seen in recent years. Almost all the discretionary measures listed below are the product of a fiscal consolidation effort, the first since ANO entered government a decade ago. The only remnant from measures related to the energy crisis is windfall tax, which will be applied in 2024 as well. The government has been mulling to abolish windfall tax early, but given the latest fiscal developments, such plans must have been dropped.
You will probably wonder why you don't see the corporate income tax hike of 2pps here, but the reason is that it will have an effect on cash balances only in 2025, as the government is not allowed to collect higher taxes immediately. Thus, what will happen in 2024 is that the government will keep collecting advance tax payments under the current corporate tax rate, but it will balance it out in Q1 2025, when the intake from corporate income tax will be much higher.
Along with fiscal consolidation measures, we will likely see some windfalls from not fully implemented measures in 2023, related to the energy crisis. The most likely one is the energy price cap, as energy prices eased faster than originally expected. Still, we are yet to see the full impact, because at the time this analysis was being written, budget execution data were available only for January-August, and results have been inconclusive thus far. We expect savings of at least CZK 5bn in 2023, but they may prove bigger were electricity prices to remain stable or even ease some more.
We should underline that a part of the fiscal consolidation effort has been eaten away by rising social expenses, as pension costs increased by almost 19% y/y in January-August, and their increase may reach about 20% in the entire 2023, fuelled by a few inflation-triggered indexations. This is going to ease as of 2024, as the government amended pension indexation rules to reduce the fiscal burden. Yet, the sheer increase of pensions in 2022 and 2023 will keep social spending high for some time. Another big spending increase is the defence budget, which the government mandated to be at least 2% of GDP, given the much higher threat from Russia. Thus, while the fiscal consolidation package will push down spending by a non-negligible amount, there are a lot of new expenses that were not envisaged before, leading to a smaller immediate impact at state government level.
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State government budget to see a smaller improvement due to slippage in 2023
At first glance, the state government budget is seeing a relatively small improvement in 2024, at only CZK 43bn. This is mostly due to comparisons being based on adopted budget laws, rather than on actual budget execution. As we inferred above, we expect that budget performance will be worse than anticipated, and the budget deficit could reach as much as CZK 350bn, much above the CZK 295bn target. Under such an assumption, the improvement matches the fiscal consolidation effort in the government's package. Our own expectations are for a slightly more benign performance, mostly due to underspending on some of the energy crisis measures, and we expect a deficit of around CZK 330bn (you can see our reasoning in more detail?here). This would imply a better-than-planned performance in 2024 as well, provided that the fiscal consolidation package is fully implemented.
In all fairness, tax revenues are indeed expected to rise considerably, in line with fiscal consolidation measures. The big decline in corporate income tax is mostly due to emergency taxes, like windfall tax and the revenue cap on energy companies, the latter expiring at the end of 2023. These are expected to bring CZK 100bn in 2023 (out of which CZK 85bn for windfall tax), while the intake is expected to be only CZK 17bn in 2024 (windfall tax only). It would imply a much higher corporate income tax revenue outside emergency taxes, higher by 26%. Social security contributions will rise steeply because the government is raising employee-paid health insurance by 0.6pps, and it is withdrawing tax breaks on non-cash benefits, which will expand the social contribution base. In addition, a tight domestic labour market is keeping unemployment very low, even during stagnation. The decline in non-tax revenue is primarily due to a much lower intake expected from state property, mostly related to lower dividend payouts expected in 2024. We should note that dividend payouts are likely to remain considerable when compared to 2022 or earlier, just not as high as in 2023.
Expenditure is expected to fall by 2.2%, with the biggest decline coming through transfers, a decline of 11.1%. These feature both a withdrawal of energy crisis measures, and a drastic cut of corporate subsidies, as per the fiscal consolidation package. The latter is already putting the government at odds with big business, but it is a policy the government is willing to uphold, despite the potential political cost. It also explains the 11.1% decline of capital expenses, as it includes investment subsidies as well. On the other end, social expenses will rise by 3.9%, mostly driven by pension expenses, but there will be also a big increase in maintenance costs, almost exclusively due to higher debt service costs, which will rise by 36.1%. The government has been borrowing at much higher costs in 2023, which will have a negative impact on expenses in the next few years.
You will probably notice a big increase in mandatory expenses. It is a one-off occurrence, mostly because of defence spending. The government fixed the defence budget at least at 2% of GDP, and in order to set that in stone, it made defence spending mandatory. Based on the GDP forecast for 2024, it implies CZK 155bn of additional mandatory expenses, which is the bulk of the increase. The rest comes mostly from pensions and other social subsidies, which are arranged by separate legislation and cannot be ignored.
Financing needs to narrow down quickly, but base in 2023 will remain very high
While the official number for financing needs will be published in the first week of 2024, we do have something to work with, in order to make an unofficial estimate. To do that, we have made several assumptions, such as that the finance ministry will no longer rely on short-term loan faciltiies (mostly depo loans), as per Table 4 above. In addition, we assume that not a lot of debt buyback will occur for debt instruments maturing in 2024 in the rest of 2023. While some debt operations may take place this year, we don't expect them to have an impact bigger than around 0.1% of GDP, based on what the finance ministry has been doing thus far. Thus, we assume that the biggest change to financing needs will come from the state govermment budget, while the rest will remain similar to what is stated in the update to?the 2023 debt and funding strategy.
The big unknown is what actual financing needs will be in 2023. This is due to uncertainty around budget performance, as it appears increasingly likely that the deficit target of CZK 295bn will not be met. As we mentioned above, we assume a budget deficit of around CZK 330bn (more details about our reasoning can be seen?here), which would put financing needs at about CZK 680bn (9.2% of GDP), up from officially expected CZK 645.7bn (8.7% of GDP). Based on the assumptions above, financing needs will add up to CZK 436bn (5.6% of GDP) in 2024. It is likely to be a temproary respite, however, as 2024 happens to be a year with slightly lower debt amortisation payments than the years after it.
As far as financing sources are concerned, the finance ministry will likely continue to resort to domestic debt instruments, as it has stated more than once a preference to issue debt under Czech law. While the 2024 budget bill indicates external financing of CZK 71bn, we doubt this is going to be a new Eurobond. Instead, we expect said external financing to be coming from the EU, which is likely to be at much better borrowing terms. Information regarding a possible loan from the EU, likely under the NRRP, has not been consistent, as the latest rumour suggests the government has decided to seek only a CZK 19.4bn loan. Earlier, there were speculations about the government seeking a CZK 137.4bn loan (about EUR 5.8bn), so it appears the government has been pondering about this a lot. We remind that the Czech Republic can draw loans for up to EUR 14.3bn under the NRRP, so there is a relatively big leeway. Given that the ruling coalition has not been able to agree to spending cuts in 2023, and the deficit target in 2024 remains high, we believe the odds are in favour of seeking EU financing rather than relying on debt markets, especially given the big increase in debt service costs expected in 2024 (up 36%, see the state government budget section).
Final funding under 2014-2020 MFF to be used, absorptin of 2021-2027 MFF planned to accelerate
Projected EU-related spending is planned to decrease in 2024, mostly because of the expiration of the 2014-2020 MFF. The reason for bigger flows in recent years has been that this is a transitional budgetary period, when both MFFs are in place, though absorption under the 2021-2027 one is very slow for now, according to regional development ministry data. In any case, the goverment intends to boost financing from the 2021-2027 MFF, which will include the Recovery and Resilience Facility. The latter has been the source of most EU flows in 2023 so far, and is expected to be a major source of EU flows in 2024.
The biggest decline in revenue will be felt in cohesion policy, where the last absorption of operational programme funding from the 2014-2020 MFF is being done in 2023, withe some residual payments due in 2024. We remind that budget bills are being prepared under national methodology, which uses a cash-based approach, explaining why you are seeing residual flows from the 2014-2020 MFF paid out in 2024.
Conclusion
In the end, the 2024 budget may appear somewhat disappointing, given the much bigger hopes invested earlier this year, when fiscal consolidation measures were first revealed. One could argue that this is the government's own undoing, as it severely underestimated expenditure and tax collection in 2023, and is now paying the price for it. Still, we should note that this is the first real attempt to bring public finances in order, which we consider better than nothing. Much more will be required in order to return to pre-crisis levels, though the window of opportunity remains narrow.
Realistically, we don't see this coalition remaining in power if it decides to continue with massive spending cuts in 2025, an election year. The government is already quite unpopular, so we doubt it will risk angering voters further. This puts a considerable election risk to fiscal consolidation in the medium term, as ANO, the leading opposition party, has been claiming it will roll back most, if not all of the current fiscal consolidation measures. We are sceptical ANO will actually do go on such a promise, as government debt is already very high, and it may risk finding itself in a position where the 55%-of-GDP debt brake is activated. Yet, we see fiscal consolidation efforts being much weaker from 2026 onward, in case the current ruling coalition loses power, which is a fairly realistic scenario.
Thus, we welcome any fiscal consolidation we can see, as the Czech Republic's fiscal situation may prove to be much worse in several years if populist policies return. It doesn't take away medium-term fiscal risks, however, so we expect this to be reflect in sovereign ratings, where the best the Czech Republic can hope is a return to a stable rating outlook.
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