THE QUEST FOR EQUITABLE GROWTH IN THE SLOVAK REPUBLIC

Transcription

1 1 Report No SK THE QUEST FOR EQUITABLE GROWTH IN THE SLOVAK REPUBLIC A World Bank Living Standards Assessment: Policy Note 2 Earning Your Way Out of Poverty: Assessing the Distributional Effects of Recent Slovak Reforms of the Tax and Benefit Systems September 19, 2005 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank

2 2 The Quest for Equitable Growth in the Slovak Republic CURRENCY AND EQUIVALENT UNITS (Exchange Rate Effective) Currency Unit =Slovak Koruna US$1.00 = SKK FISCAL YEAR January 1 December 31 Acronyms and Abbreviations AAA ALMP ALMP CE CIS EU EUROSTAT FD FDI FGT GA GDP HBS ISAE JIM LFS LSA LTU MICS MOE MoLSAF MSL NAPE NAPSI NBS NMS OECD OMS PD PIT PPP PSIA SIA SILC SOSR SR STU UNDP VAT Analytic and Advisory Activities Active Labor Market Policies Active Labor Market Program Central European Commonwealth of Independent States European Union European Commission Statistics Family Diary Foreign Direct Investment Foster-Greer-Thorbecke Guaranteed Amount Gross Domestic Product Household Budget Survey Information System on Average Earnings Joint Inclusion Memorandum Labor Force Survey Living Standards Assessment Long-Term Unemployment Multiple Indicator Cluster Survey Ministry of Education Ministry of Labor, Social Affairs and Family Minimum Subsistence Level National Action Plan for Employment National Action Plan for Social Inclusion National Bank of Slovakia New Member States Organization for Economic Cooperation and Development Old Member States Personal Diary Personal Income Tax Purchasing Power Parity Poverty and Social Impact Analysis Social Insurance Agency Survey of Income and Living Conditions Statistical Office of the Slovak Republic Slovak Republic Short-Term Unemployment United Nations Development Programme Value Added Tax Vice President: Shigeo Katsu Country Director: Daniela Gressani Sector Director: Cheryl Gray Sector Leader: Asad Alam Team Leader: Pierella Paci

3 3 TABLE OF CONTENTS 1. INTRODUCTION...1 THE OBJECTIVE OF THE REPORT AND ITS STRUCTURE...1 THE BACKGROUND...1 THE REFORM WAS LONG OVERDUE PERSONAL INCOME TAX AND SOCIAL BENEFIT REFORMS...9 PERSONAL INCOME TAX REFORM SOCIAL BENEFITS REFORM...13 Unemployment insurance...14 Social assistance benefits...16 Family Benefits...23 Child Benefit...24 Sickness Benefit ASSESSING THE DISTRIBUTIONAL IMPACT OF THE REFORM...27 IMPACT ON DIFFERENT HOUSEHOLD TYPOLOGIES...28 EVALUATING THE DISTRIBUTIONAL EFFECTS OF THE REFORM...34 Model Description...35 Data and Empirical Specifications...37 Income Distribution and Poverty in Impact of Reforms on the Progressivity of the Tax System...44 Impact of Reforms on Poverty and on the Progressivity of the Net Fiscal System CONCLUSIONS...50 ANNEX 1: Detailed Description of Sites Visited for Qualitative Analysis...51 ANNEX 2: Active Labor Market Policies...52 ANNEX 3: Details of Pensions and Contributions Systems...56 ANNEX 4: Household Simulations...64 ANNEX 5: Miscellaneous Tables and Figures...72 ANNEX 6: Model Specification...77 ANNEX 7: Details of Micro-simulation Model...78 REFERENCES...82 List of Tables Table 1.1: Main Macroeconomic Indicators, Table 1.2: Economic Activity and Selected Characteristics of the Unemployed, Table 1.3: Risk of Long-term Unemployment, Table 2.1: Personal Income Tax in 2004 and Table 2.2: Unemployment Benefits in 2004 and Table 2.3: Minimum Subsistence Level in 2004 and Table 2.4: Social Assistance Benefits and Family Benefits in 2004 and Table 2.5: Social Benefits in 2004 and Table 2.6: Multiple Birth Benefits in 2004 and

4 4 The Quest for Equitable Growth in the Slovak Republic Table 2.7: Child Benefits in 2004 and Table 2.8: Foster Care Payments in 2004 and Table 2.9: Sickness Cash Benefits in 2004 and Table 3.1: Assumptions of the Social Impact Model...29 Table 3.2: Income Variables from Microcensus 2003 (yearly SKK)...37 Table 3.3: Main Poverty Indicators...40 Table 3.4: S80/S20 Income Quintile Ratio and Gini Coefficient in New Member States and Candidate Countries, Table 3.5: Poverty Profile (headcount ratio percent)...42 Table 3.6: Poverty by Age Group (headcount ratio percent)...43 Table 3.7: Poverty Incidence by Different Transfer Components...43 Table 3.8: Different Equivalized Income Typologies by Gross Income Deciles (yearly - SKK)...44 Table 3.9: Simulated Personal Income Tax by Income Deciles, 2002 and 2004 (yearly - SKK)...44 Table 3.10: Progressivity and Redistributive Impact of the Tax System, 2002 and Table 3.11: Progressivity and Redistributive Impact of Tax System, Isolating the Tax Rates Effect and the Deductions Effect...45 Table 3.12: Benefits by Income Deciles, 2002 and 2004 (yearly - SKK)...46 Table 3.13: Impact of Benefits on Income Inequality, 2002 and 2004 ( percent)...46 Table 3.14: Regressivity and Redistributive Impact of Benefits Simulated, 2002 and Table 3.15: Impact of Reforms on Poverty Indicators (percent difference)...47 Table 3.16: Decomposing the Poverty Impact of the Changes to Social Benefits, 2002 and Table 3.17: Poverty Measures, List of Figures Figure 1.1: Risk of Unemployment by Education, Age and Region...6 Figure 1.2: The Poverty Trap for Different Family Typologies under the 2002 Benefits System...8 Figure 2.1: Effective Personal Income Tax Rates in 2004 and 2002 for a Single Wage-earner...12 Figure 2.2: Social Expenditures in the Slovak Republic, Figure 3.1: Distribution of Gross Wage in 2002, in 2004 Prices...30 Figure 3.2: Examples of Results of Simulations, 2004 versus 2002: In Poverty for Subjective Reasons...33 Figure 3.3: Examples of Results of Simulations 2004 versus 2002: In Poverty for Objective Reasons...34 List of Boxes Box 2.1: The Milestones of the Reform: Action Plans and New Legislation...10 Box 2.2: Arguments for and Against Flat Taxes Box 2.3: Other Employment-Related Insurance...15

5 Box 2.4: Poverty for Subjective or Objective Reasons: The Rules...19 Box 2.5. Average Social Assistance Benefits and Number of Recipients...21 Box 2.6: Reduction in the Number of Recipients of the Social Assistance Benefits Between January 2001 and December Box 3.1: Evaluating Perceptions...27 Box 3.2: Assumptions of the Tax-Benefit Model...35 Box 3.3: Issues in Micro-simulation Modeling...36 Box 3.4: Value of MSL Compared to Relative Poverty Line...38 Box 3.5: Short-Run Summary Conclusions

6 6 The Quest for Equitable Growth in the Slovak Republic ACKNOWLEDGMENTS This policy note is part of the Living Standards Assessment (LSA) for the Slovak Republic produced by the World Bank in collaboration with the Slovak Ministry of Labor, Social Affairs and Family (MoLSAF), and with Slovak and international experts. The World Bank team working on this policy note included Pierella Paci (Task Team Leader), Anton Marcincin, Helen Shariari, Bilal Erdogan, Manuela Coromaldi and Katarina Kotovova (consultants), Helena Makarenko, Elena Markova and Emily Evershed. Stefano Paternostro and Anis Dani have acted as informal advisors. The LSA was undertaken under the guidance of Mr. Roger Grawe and Ms. Daniela Gressani, Country Directors, Ms. Cheryl Gray, Sector Director, and Mr. Asad Alam, Sector Manager. The team is grateful to Mr. Miroslav Beblavy (State Secretary of the MoLSAF, Government of the Slovak Republic) for his through comments and many suggestions on the report, Mr. Ludovit Odor (of the Financial Policy Institute, Ministry of Finance) for comments on and suggestions for an earlier version of this report, Michal Horvath (former Advisor to the Minister, MoLSAF), all government and non-government officials who provided technical support to the team and commented on different versions of this report and, in particular, the participants in the consultative workshop held in April The team is also particularly grateful to the Statistical Office of the Slovak Republic for permission to use the Microcensus 2003 and to the entire Bratislava office for their support and advice at various stages of the project.

7 1. Introduction 1 1. INTRODUCTION 1.1 In 2002 the Slovak Republic s newly elected government initiated a broad reform program aimed at bettering the country s economic performance by improving the investment climate and eliminating the disincentives to work that were provided by the post-socialist benefits system. The reform has been praised by many, both within the country and internationally. Among other sources, the World Bank s Doing Business in 2005 ranked the Slovak Republic as the best reformer in 2004 and number seven out of 145 countries surveyed in terms of its investment climate. At the same time, the reform package met with vigorous opposition in some parts of the country and among some groups. The main concern was that, while promoting economic growth and increasing the returns from employment, the reform deepened the gap between those who could benefit fully from better economic opportunities and the rest, who risked a considerable reduction in their income. THE OBJECTIVE OF THE REPORT AND ITS STRUCTURE 1.2 The objective of this study is to assess the impacts of the new social policies and the personal income tax (PIT) reform introduced between the autumn of 2002 and the autumn of 2004 using the poverty and social impact analysis (PSIA) approach. For this purpose, the report first provides the macroeconomic context in which the reforms have been implemented and the rationale behind the reforms in light of the literature on unemployment insurance (Chapter 1) and then describes the key elements of the reforms for the tax and benefit systems (Chapter 2). This is followed by an attempt to quantify the impacts (Chapter 3) using two different approaches: one focusing on the impacts on different household typologies, and the other using the tax-benefit model. Finally, Chapter 4 concludes by presenting the challenges still to be faced and by providing recommendations. THE BACKGROUND 1.3 By most indicators the Slovak Republic (SR) has achieved a high level of human and social development. The UNDP s Human Development Report 2004 ranked the country forty-second among all countries in its level of human development in accordance with its ranking according to per capita GDP. 1 However, deep pockets of poverty remain in the midst of a relatively well-off population. The World Bank s Living Standards Assessment 2 found that using a US$2.15 threshold the incidence of extreme poverty among individuals was 2.6 percent, twice as high as in the neighboring countries. However, the SR scored relatively well when the poverty line was increased to US$4.30 PPP per 1 The ranking was two points higher than that, according to the human development index. The Slovak Republic s ranking in this latter index was somewhat lower than those of Slovenia, the Czech Republic, Estonia, Poland, Hungary and Lithuania, although Estonia, Poland and Lithuania had a lower GDP per capita (in PPP US). See UNDP, Human Development Report World Bank, 2002, Slovak Republic: Living Standards, Employment and Labor Market Study. World Bank Country Study No More current data on absolute poverty rates are not available.

8 2 The Quest for Equitable Growth in the Slovak Republic person per day. At 6.3 percent among households and 8.6 percent among individuals, the incidence of poverty as opposed to extreme poverty was one of the lowest poverty rates in the Europe and Central Asia Region. 1.4 These findings appear to be confirmed by the data from the 2003 Microcensus, which show an increase of only 27 percent in the incidence of poverty among households when the poverty line is doubled to US$4.30 PPP. This suggests that, with the exception of the extremely poor, the population tends to cluster around values of income that exceed the line used to define the poor. 1.5 Moreover, the living standards of the average household have been improving rapidly since 2002, which signaled the return to a growth performance comparable to those prior to the financial crisis of 1998 (see Table 1.1). 3 The economy has been gathering strength over recent years. Real GDP rose risen to 5.5 percent in The high inflation of 7.5 percent in 2004 was caused by the last major round of de-regulation of the administrative process, and core inflation remained low at 2.6 percent. Although the current account deficit increased to 3.5 percent of GDP in 2004, it remains within comfortable margins. Foreign direct investments have regained their upward movement, with many new contracts in the automotive, electronics and engineering sectors, although the levels are still lower than in Supported by strong revenue performance, the fiscal outcome for 2004 was better than expected. The 2004 consolidated budget deficit (including local budgets and off-budget costs) was 3.3 percent of GDP and the budget framework for the coming years is consistent with the adoption of the euro in High unemployment remains a concern, however, particularly among low-skilled labor. 3 See also World Bank, 2002, Slovak Republic - Joining the EU: A Development Policy Review.

9 1. Introduction 3 Table 1.1: Main Macroeconomic Indicators, GDP, real growth Private consumption, real growth Gross fixed investment, real growth Unemployment rate, registered, percent Unemployment rate, LFS, percent GG expenditures, percent of GDP (ESA95) GG budget deficit, percent of GDP (ESA95) 1/ Real wage growth, percent, y/y Consumer price inflation, percent, y/y NBS refinancing rate (end-year) Current account balance, percent of GDP Foreign direct investment, percent of GDP External debt, percent of GDP Exchange rate SKK/USD (average) / Large deficit figures between 1998 and 2002 reflect costs of bank restructuring. Sources: Statistical Office of SR, Labor Office, Ministry of Finance, NBS and EUROSTAT. 1.6 However, the slowdown of brought lower employment and higher unemployment rates, which were not reversed by a strong economic recovery until the third quarter of 2004 (see Table 1.2 and Figure 1.2; for quarterly data for , see Annex 5). 4 The average unemployment rate of 12.5 percent in increased to 16.2 percent in 1999 and since 2000 has remained at around 18.4 percent. Although the economic activity rate declined after 2001 (although very slightly), and GDP growth increased substantially in , 5 the employment rate settled at around 57 percent, down three percentage points from the pre-1998 rate of 61 percent. 4 The employment rate is a ratio between the number of employed and the population either above 15 years old (here denoted 15 years+), or 15 to 64 years old. The economic activity rate is a ratio between the persons who have a job or search for a job and the population above 15 years old. 5 There is high positive correlation between GDP growth and employment rate growth (0.75), and a negative correlation between GDP growth and unemployment rate growth (-0.87), annual data

10 4 The Quest for Equitable Growth in the Slovak Republic Table 1.2: Economic Activity and Selected Characteristics of the Unemployed, Economic activity rate ( percent) Employment rate (15 years+, percent) Employment rate (15-64 years old, percent) Working age population growth (15-64) Risk of unemployment by age years old years old years old years and older years old Risk of unemployment by education Elementary Apprenticeship Secondary Tertiary Sources: Labor Force Survey, Statistical Office of SR, and authors calculations. 1.7 As Table 1.2 and Figure 1.1 show, the risk of unemployment was twice as high for youth as for adults, but it declined over the last two years at the expense of the adult population. 6 The risk of unemployment for those with only elementary education reached 51 percent in 2004, and almost doubled over the period While those with an apprenticeship type of education also face a higher risk of unemployment, this risk is only slightly above the national rate. On the other hand, those with a full secondary or tertiary type of education face an unemployment risk of only 13 percent and 6 percent, respectively. 1.8 The number of long-term unemployed increased significantly to almost two-thirds of the unemployed in Again, the highest but declining - risk of long-term unemployment was faced by youth (16 percent in 2004, although declining) (see Table 1.3) and by those with only an elementary education (39 percent in 2004). 6 Youth is defined as the age group

11 1. Introduction 5 Table 1.3: Risk of Long-term Unemployment, (in percent) Risk of long-term unemployment by age years old years old years old years and older years old Risk of long-term unemployment by education elementary apprenticeship secondary tertiary Sources: Labor Force Survey, Statistical Office of SR and authors calculations. 1.9 The cross-regional variation in unemployment rates is very high by international comparisons. The unemployment rate is directly related to a region s distance from the capital city of Bratislava, which is the westernmost region of the Slovak Republic and the main growth pole (Figure 1.1). Bratislava is very close to the Austrian capital of Vienna and the Hungarian capital of Budapest and also has good access to Czech markets. On the other hand, the eastern regions of the Slovak Republic (Presov and Kosice) are surrounded by the less prosperous regions of Ukraine, Poland and Hungary. The central region of the Slovak Republic (Banska Bystrica) appears to suffer from inadequate access to transport infrastructure, which places it further from markets than it is geographically. Thus, the regions could be divided into three groups: (i) the Bratislava, Trencin and Trnava regions with relatively low unemployment rates; (ii) the Zilina and Nitra regions with high, but falling, unemployment rates; and (iii) the Presov, Kosice and Banska Bystrica regions with high and rising unemployment rates.

12 6 The Quest for Equitable Growth in the Slovak Republic Figure 1.1: Risk of Unemployment by Education, Age and Region Risk of unemployment by age, % Risk of unemployment by education, % years years years years 65 years and older elementary apprenticeship secondary tertiary Y94 Y95 Y96 Y97 Y98 Y99 Y00 Y01 Y02 Y03 Y04 0 Y94 Y95 Y96 Y97 Y98 Y99 Y00 Y01 Y02 Y03 Y04 Risk of long-term unemployment by age, % Risk of long-term unemployment by education, % years years years years 65 years and older Y94 Y95 Y96 Y97 Y98 Y99 Y00 Y01 Y02 Y03 Y elementary apprenticeship secondary tertiary Y94 Y95 Y96 Y97 Y98 Y99 Y00 Y01 Y02 Y03 Y04 Unemployment rate by regions, % SR Bratislava Trnava Trencin 30 Nitra Zilina Banska Bystrica Presov 25 Kosice Y97 Y98 Y99 Y00 Y01 Y02 Y03 Y04 Unemployment rate by regions, % deviations from SR rate SR=0 (100%) Bratislava Trnava Trencin 70 Nitra Banska Bystrica Zilina Presov Kosice Y97 Y98 Y99 Y00 Y01 Y02 Y03 Y Sources: Statistical Office of SR, LFS, and authors calculations. THE REFORM WAS LONG OVERDUE 1.10 There was broad agreement among both Slovak and international observers that the social benefits system in operation in the SR over the 1990s acted as a reasonably effective safety net mechanism, but also that (i) it was fiscally unsustainable; (ii) it provided a financial disincentive for individuals with low earning potential to actively seek employment; and (iii) the high tax wedge that it generated resulted in considerable barriers to job creation The need for far-reaching reforms had been argued convincingly in the previous World Bank Living Standards Assessment (World Bank, 2002), which had reached the following conclusions:

13 1. Introduction 7 The pre-2002 social benefits system was an effective safety-net mechanism. However, its generosity generated both a poverty trap and an unemployment trap which removed the financial incentive for some groups of workers to actively seek employment. This was because the value of the benefits received by workers with low earning potentials when out of work (and in poverty) was higher than the amount that they could have received in employment i.e., the replacement ratio was close to one. 7 This is clear when looking at Figure 1.2, which plots total income (including benefits) against gross wage for selected groups of households under the two different social benefit regimes that were in operation before the reform. 8 The last two graphs in particular show clearly the lack of incentive generated by the old benefit system for the second adult to work in a low-income two-adult household with children. The high rates of unemployment and inactivity were associated with low job creation (especially in some regions) and with the existence of severe mismatches between the labor supplied and that demanded. Among the main reasons for low job creation was the comparatively high tax wedge on wages required to finance the generous benefits system. This was particularly biting for the lower level of wages and in lowproductivity/low-employment regions In response to the weaknesses of the system, the New Social Policy of the government elected in the autumn of 2002 focused on employment creation, poverty reduction, and the improvement of the fiscal sustainability of the benefits system. The reform addressed three interrelated sectors: (i) social assistance and family policy; (ii) the labor market and active labor market policy; and (iii) the pension and social insurance system. It had three guiding principles: (i) clear and simple rules, (i) active individuals, and (iii) making work pay. 9 7 The replacement ratio is the ratio of income out of work to potential work income. 8 Under the old system individuals in material need were divided into two distinct groups (for objective reasons and for subjective reasons) depending on their recent job search history. Those that were in material need for subjective reasons i.e, were able to work but were not looking for a job, had been deleted from the unemployment registry, or were not paying alimony received lower benefits than the rest (generally, the elderly and the sick). It is worth noting that the total number of beneficiaries under the two regimes was approximately equal. For details see Box See Concept of Pension Insurance, approved by the government on April 2, 2003; Strategy of Labor Market Reform to Generate Growth in Employment, approved on April 30, 2003; and Strategy of Public Sector Employment, approved on June 11, 2003.

14 8 The Quest for Equitable Growth in the Slovak Republic Figure 1.2: The Poverty Trap for Different Family Typologies under the 2002 Benefits System 225, , , , , ,000 Single household, with job 1 child 3 children 225, , , , , , ,000 85,000 65,000 Net Inco m e 2002 obj Net Inco m e 2002 subj 105,000 85,000 65,000 Net Incom e 2002 o bj Net Incom e 2002 subj 45, ,000 96, , , , , , ,000 A nnual Gro ss W ag e 45, ,000 96, , , , , , ,000 A nnual Gro ss W ag e 285, , , , , , , , , , ,000 65, , , , , ,000 A couple, both with job 1 child 3 children Net Incom e 2002 obj Net Incom e 2002 subj 0 144, , , , ,000264, , ,000 A nnual Gro ss W ag e 285, , , , , , , , , , ,000 65,000 Net Incom e 2002 obj Net Incom e 2002 subj 0 144, , , , ,000264, , ,000 A nnual Gro ss W ag e A couple, one with job, other long-term unemployed 1 child 3 children 225, , , , , , ,000 Net Inco m e 2002 o bj 12 5, ,0 0 0 Net Inco m e 2002 o bj 85,000 Net Inco m e 2002 subj 85,000 Net Income 2002 subj 65, ,000 96, , , , , , ,000 A nnual Gross Wage 65, ,000 96, , , , , , ,000 A nnual Gro ss W ag e Note: When there is zero gross wage, net income of the unemployed person (couple) is considered with the same number of children. A gross wage of 72,000 roughly reflects the minimum wage in 2002 (in 2004 prices). Total gross wage of the working couple assumes that one of the partners receives only the minimum wage. Source: Authors On the other hand, skeptics of the reform are concerned about its possible negative effect on poverty, arguing that the main barrier to increased employment in the SR, especially for the most vulnerable groups, is not lack of incentives but lack of employment opportunities. They claim that, given the strong links between high structural and long-term unemployment and low skills and geographic location, lack of employment and vulnerability to poverty cannot be tackled simply by cutting social assistance. In their views, the poor, the vulnerable and the excluded are the groups least able to take advantage of the incentives offered by the changes.

15 2. Personal Income Tax and Social Benefit Reforms 9 2. PERSONAL INCOME TAX AND SOCIAL BENEFIT REFORMS 2.1 The post-2002 reforms were implemented in two stages. The first stage was intended predominantly to reduce fiscal pressure while a more comprehensive reform package was being prepared. It consisted of a cut in child benefits (from Sk 480-1,290 per month to Sk per month) and a cut in social benefits (by cutting the amount and, especially, by introducing a cap of total monthly social benefits per household at Sk 10,500) In the meantime, the New Social Policy was developed in two concept papers: (i) one on pensions approved by the government on April 2, 2003 reforming the first pillar (pay-as-you-go) and introducing the second pillar (funded scheme); and (ii) a strategy of growth in employment based on the labor market reform, approved by the government on April 30, The cornerstones of the latter were the principles of (i) making work pay; (ii) considering any work as being better than no activity and reliance on benefits; (iii) focusing on job creation; and (iv) providing new benefits for those who really need them. This is the focus of this analysis. 2.3 The concept papers were then developed into new legislation (see Box 2.1 for a list and descriptions) which introduced a single rate personal income tax ( flat-tax ); a single value added tax; substantial changes to the social assistance benefits (lower base benefit, supplemented by conditional allowances); a changed composition of child benefits (from means tested to a flat benefit and tax credit); more pro-active labor market policies (including changes in the institutional setup and the remuneration; and more transparent social insurance. 10 Acts No.658/2002 and No.281/2002 introduced a temporary minimum benefit of Sk 480 for a child under 6 years; the maximum was Sk 1,290 for a student in secondary school when the household income was below 1.37 times the minimum subsistence level. Through Acts No.724/2002 and No.195/1998: monthly benefits to an adult who was in poverty for objective reasons (definition, see Box 2.4) were changed from Sk 1,375-1,965 to 1,450; benefits to an adult or a working minor who was in poverty for subjective reasons were reduced from Sk 2,440-3,490 to Sk 1,000-2,900; and benefits to a dependent child were changed only slightly from Sk 1,580 to Sk 1,600.

16 10 The Quest for Equitable Growth in the Slovak Republic Box 2.1: The Milestones of the Reform: Action Plans and New Legislation The concept papers were elaborated into two action plans and a joint inclusion memorandum: The National Action Plan on Social Inclusion was adopted by the Government of the Slovak Republic on July 14, The National Action Plan for Employment was adopted by Government of the Slovak Republic on September 22, The Joint inclusion memorandum was prepared with help of the European Commission, Directorate-General for Employment and Social Affairs. The memorandum has the purpose of preparing the country for full participation in the open method of coordination on social inclusion upon accession. It outlines the principal challenges in relation to tackling poverty and social exclusion, presents the major policy measures taken by the Slovak Republic in the light of the agreement to start translating the EU s common objectives into national policies and identifies the key policy issues for future monitoring and policy review. Action plans served as background materials for designing ten new legislative pieces, which reformed the social system and labor market from January These are: Flat personal income tax at 19 percent, and corporate income tax at 19 percent. The Act on Physical and Corporate Income Taxes introduced a more simple and transparent tax framework. Single value added tax at 19 percent. The Act on Value Added Tax replaced two existing rates (23 percent and 13 percent) by a single 19 percent tax rate. New composition of social assistance benefits. The Act on Social Assistance brought a single basic benefit for the poor, allowances for health care and housing, and activation and protection benefits. It also strengthened the role of the municipalities and civil society. New child benefit. The Act on Child Benefits defined a single child benefit for all parents paid in cash and as a tax credit. Simplified calculation of the base for social benefits. The Act on the Minimum Living Standard simplified the payment of social benefits and increased benefits for families with children. New active labor market policies. The Act on Employment Services (valid since February 2004) made active labor market policy more transparent and appropriate to fit the individual needs of job-seekers. The registered unemployed visit the Labor Office every two weeks, the long-term unemployed every seven days, and activation workers once a month. New instruments were introduced to cover training, services for families with children, the activation allowance, the mobility allowance and allowances for disabled workers. New institutional structure to merge social and labor agendas. The Act on State Administration in Social Affairs, Family and Employment Services merged labor and social offices into Offices of Labor, Social Affairs and Family (Labor Offices). This made it possible to merge previously separated social and labor agendas. More transparent social insurance. The act on social insurance made social insurance more transparent, reduced certain contributions, re-defined sickness and unemployment benefits and prepared the conditions for pension reform. During 2004, several amendments to the existing legislation increased the amounts of the social benefits, housing allowance, child benefit, child birth grant and multiple birth benefit, foster care benefits and funeral allowance (government decrees nos from August 18, 2004). Sources: Ministry of Labor, Ministry of Finance, and authors.

17 2. Personal Income Tax and Social Benefit Reforms 11 PERSONAL INCOME TAX REFORM 2.4 Following what is becoming an established trend among countries in the EU-8 and the CIS, the Slovak Republic introduced a flat-rate PIT by replacing the pre-existing five brackets and the corresponding rates of 10 percent to 38 percent with a 19 percent flat rate. The pros and cons of the introduction of a flat-rate tax are summarized in Box 2.2. One of its strongest points is that its simplicity appears to encourage compliance. However, usually there is a concern that the single tax bracket can reduce the progressivity of the tax system and can penalize low-income individuals and households. Box 2.2: Arguments for and Against Flat Taxes The concept of flat taxes has been gaining prominence following seemingly successful implementations in Eastern European countries. Although countries have adopted varying percentage rates, the main advantages have been the simplification of the tax system and the higher compliance rates. Following is the timeline of the flat tax phenomenon over the last decade. Flat tax rates on personal income, percent Country Rate Year introduced Estonia Lithuania Latvia Russia Serbia Ukraine Slovak Republic Georgia Romania Arguments for and against the adoption of flat taxes can be summarized as follows: Arguments in favor simplifies the lives of smallbusiness owners does away with complexity in the tax laws slashes red tape improves incentives leads to higher compliance rates Arguments against lower progressivity lower tax revenues possible Source: The Economist, March 3 and April 14, However, this does not appear to have happened in the Slovak Republic, thanks to a successful package of deductions and tax credits combined with a reduction in the average tax rate. The deductible items more than doubled for the taxpayer and for his/her spouse. The tax credit for a dependent child was introduced (see Table 2.5). Disabled persons and old-age pensioners receive the same treatment as any other taxpayers except that the oldage pensioners have zero tax deductible items. The deductible item for a dependent child was replaced by a much lower tax credit (however, family and social benefits for dependent children increased). The details of the changes are presented in Table 2.1.

18 12 The Quest for Equitable Growth in the Slovak Republic Table 2.1: Personal Income Tax in 2004 and Income range, rate on the rate + fixed amount Sk 0-Sk 90, percent + Sk 0 Tax rate 19 percent flat Sk 90-Sk 180, percent + Sk 9,000 Sk 180,000-Sk 396, percent + Sk 27,000 Sk 396,000-Sk 564, percent + Sk 87,480 Sk 564,000 and more 38 percent + Sk 146,280 Taxpayer Sk 80,832 * Sk 38,760 (Sk 48,000 if handicapped) Spouse MAX (Sk 80,832 minus spouse s income, 0) Sk 12,000 if had no income Old-age pensioners Sk 0 Sk 0 (Sk 8,400 if partially disabled; Sk 16,800 if disabled) Dependent child Sk 0 Sk 16,800 (Sk 22,800 if handicapped) Dependent child Sk 4,800 only if parent s annual gross income exceeds 6 x minimum wage, i.e., Sk 36,480 Sk 0 * The amount is set at 19.2 times the minimum subsistence level as of January every year (see Act No. 601/ 2003). Source: Act on Income Tax Nos. 595/2003 and 366/ Figure 2.1 presents the effective tax payments for different levels of gross wage for a single wage-earner for 2004 and It is clear from the figure that in this particular case the tax burden is lower for everyone except for a small range of middle income levels, which suggests that the shift to a flat-rate tax has not unduly harmed the poorest households. 11 A more detailed analysis of the changes in the progressively of the tax follows in the next section. Figure 2.1: Effective Personal Income Tax Rates in 2004 and 2002 for a Single Wage-earner Effective tax rate (%) Y2002 Y , , , , , , , ,000 Annual gross w age (Sk) Effective tax calculated as a ratio of tax paid to gross income. Source: Authors calculations. 11 It is worth noting that the representation in Figure 2.1 is somewhat imprecise, as the PIT reform has altered the link between taxable income and benefits and this is not taken into account in this graph. However, it provides an important representation of the changes that have taken place.

19 2. Personal Income Tax and Social Benefit Reforms However, it is also important to note at this stage that the apparent increased progressivity of the PIT gives only a partial picture of the overall effect of the reform on the progressivity of the overall tax system. The reduction in the average PIT rate has resulted in an increase in the share of tax revenue that comes from sales taxes (VAT and excise taxes) from percent to percent. Sales taxes traditionally tend to be more regressive and are particularly likely to be regressive in the light of the introduction of a single rate VAT. Thus, the increase in their relative importance may have reduced the progressivity of the tax system despite the opposite effect of the introduction of the flat-rate PIT. SOCIAL BENEFITS REFORM 2.8 Social assistance reform is one of many elements in a package intended to reform the social system by decentralizing labor offices, implementing an active labor market policy, and reforming the social assistance system to decrease dependency on benefits. The aim of the larger strategy is to reduce benefits while implementing an active labor market strategy that would simultaneously increase employment and reduce benefit dependency. These social reforms are part of a broader strategy that includes pension reforms and economic reforms, including the tax code and public finances. 2.9 Social benefits are composed of social insurance and social assistance. There are three types of social insurance: unemployment benefits, pensions, and sickness benefits. 12 And there are two types of social assistance, family related and poverty related. Social reform has also brought about more active labor market policies and certain new instruments that increase the incentives to work (see detailed description in Annex 2; the terminology used in this paper and the Slovak synonyms are listed in Table A5.1 in Annex 5) The changes in social benefits, introduced in 2004, continued to guarantee the minimum social assistance to all in need but contained two new elements, namely: The difference between in material need for subjective reasons and for objective reasons was eliminated and entitlement to benefits became linked to the current rather than the past activities of the beneficiary, Disincentives to switch from the social safety net to employment were to be reduced According to the available annual data, the total amount of social benefits declined from about 11.5 percent of GDP in 2002 to 9.9 percent of GDP in 2004 (see Figure 2.2; for the number of beneficiaries, see also Table A5.2 in Annex 5). 13 The main reason for the decline lies in a more than 50 percent reduction in social assistance benefits and about a 50 percent reduction in sickness benefits. Spending on active labor market policies declined by twothirds. Benefits to the severely disabled were reduced by more than one-third. 12 The system is based on the following acts: Act on Family Benefits No. 600/2003, Act on Social Insurance No. 461/2003, Act on Social Benefits No. 599/2003. The Slovak legislation prefers a slightly different classification: social protection includes social assistance benefits; social security includes unemployment benefits, pension, sickness, injury and guarantee benefits; and state social assistance includes family benefits. 13 Source: Statistical Office of SR, Ministry of Labor and Social Insurance Agency.

20 14 The Quest for Equitable Growth in the Slovak Republic 2.12 However, quarterly data for 2004 and 2005 suggest that the main reason for this decline was a considerable drop in the first half of 2004, in the aftermath of the implementation of the 2004 reform and as the result of teething problems in the implementation of new types of benefits. As from the second half of 2004, social expenditure is on a nominal level similar to that in 2003 (see Figure 2.2, lower row). Similarly, after a radical decline in the first quarter of 2004, the number of recipients of different benefits soon returned close to the 2003 level (in Figure 2.2, figures for 2003 are underestimated see notes below the figure). Figure 2.2: Social Expenditures in the Slovak Republic, Social expenditures , percent of GDP Pensions Social assistance benefits Family benefits Sickness benefits Benefits to severely disabled Unemployment benefits Active labor market policies Y01 Y02 Y03 Y04 Social expenditures 1q2003-1q2005, SK million Social expenditures , total = 100 percent Pensions Family benefits Benefits to severely disabled Active labor market policies 100% 90% 80% 70% 60% 50% 40% 30% 20% 10 % 0% Social assistance benefits Sickness benefits Unemployment benefits Y01 Y02 Y03 Y04 Number of recipients 1q2003-1q2005, 000 persons 8,000 7, ,000 5, ,000 3,000 2,000 1,000 2,500 2,000 1,50 0 1, under-reported, see 1/, 2/ 0 1q03 2q03 3q03 4q03 1q04 2q04 3q04 4q04 1q05 Fam ily benefits Social assistance benefits Other Social State B enefits B enefits to severely disabled 0 1q03 2q03 3q03 4q03 1q04 2q04 3q04 4q04 1q05 Family benefits 1/ Social assistance benefits Other Social State B enefits B enefits to severely disabled 2/ 1/ Under-reported in 2003 because of unavailable number of recipients of child allowances. 2/ Under-reported in 2003 because of unavailable number of recipients of purpose benefits. Other Social State Benefits include allowance for families of soldiers, and burial and housing allowances. Sources: Statistical Office of SR, Ministry of Labor and Social Insurance Agency, Authors calculations. Unemployment insurance Unemployment benefit. This benefit is intended to secure income for the insured person during the period of the person s unemployment (see Table 2.2 for a basic description). The insured person is eligible for the benefit if the person contributed to the system for at least three years within last four years before the listing on the unemployment registry. If the insured person is withdrawn Act No. 461/2003 on Social Insurance. For different pension insurances, see Annex Several conditions are specified in Act No. 5/2004 (see Active Labor Market Policies in Annex 2) and include also frequency of visits to the Labor Office. The person can work for 16 hours a week for a maximum weekly income of Sk 800 and still be considered unemployed (Art.6). This allows the unemployed person to join Activation Fund programs.

21 2. Personal Income Tax and Social Benefit Reforms 15 from the registry or the person reaches the pension age, eligibility for the unemployment benefit disappears. (Other benefits linked to unemployment insurance are shown in Box 2.3.). Table 2.2: Unemployment Benefits in 2004 and Formula Minimum daily amount Maximum daily amount Duration 50 percent of CA Sk202 Sk283 6 months 50 percent of CA first 3 months, then 45 percent of CA Sk97 Sk275 6 or 9 months Note: CA stands for calculation basis, which was different for 2004 and Source: Social Insurance Agency The amount of the monthly benefit is calculated as 50 percent of the calculation basis 16 up to a maximum monthly benefit of Sk 8,785. The minimum benefit is calculated from the minimum monthly wage. 17 The duration of the payment is six months. Accumulation with health or maternity benefits, the child-raising allowance, or a pension is not permitted. Box 2.3: Other Employment-Related Insurance Guarantee benefit. The employee is eligible for the guarantee benefit if his/her employer becomes insolvent and is unable to pay wages. The benefit is paid in the amount of the employee s wage minus the employee s social contributions. A similar scheme was in place in Injury benefits. 1 These benefits, depending on the injury and its consequences, take different forms: injury surcharge, injury rent, one-off settlement, death injury rent, one-off compensation, work rehabilitation, re-qualification, pain compensation, compensation for the costs of medical treatment and compensation for funeral costs. 1 Act No. 461/2003 on Social Insurance, Art In 2002, for those with more than six months of paying contributions, the amount was calculated from the average gross wage over the period of the last six months. For those with less than six months of paying contributions, the amount was calculated from the gross monthly wage of Sk 3,000. The ceiling was 1.5 times the adult minimum subsistence level. For the first three months 50 percent of the relevant gross wage was paid, and for the remaining period 45 percent was paid. The duration of payment varied according to years of paid contributions: 6 months for up to 15 years of paying contributions, or 9 months for over 15 years of paying contributions. 16 Here, the daily calculation basis is a sum of all of the bases used in the previous three years to calculate unemployment contributions, divided by the number of respective working days. The maximum benefits are limited at 20 percent of the daily calculation basis. 17 In September 2004, the minimum monthly wage was Sk 6,080. Daily benefits for two groups of disabled persons are lower and correspond to their minimum contribution ceilings.

22 16 The Quest for Equitable Growth in the Slovak Republic Social assistance benefits Social assistance benefits are provided to all those in material need i.e., those below the minimum level of subsistence (see Table 2.3) 19 in order to ensure basic living standards. After the reform of 2004 the social assistance benefits came to include a social benefit, an activation allowance, a health care allowance, a housing allowance, a protection allowance, a lump-sum benefit, a subsidy for catering, a school needs subsidy and scholarships. In 2002 they included only a social benefit and a lump-sum benefit (see Table 2.4). The benefit amount in 2004 was calculated as a difference between the sum of a social benefit, an activation allowance, a health care allowance, a housing allowance and a protection allowance, for which the household was eligible, and the income of the household. This was different from 2002, when the benefit was calculated as a difference between the social benefit for which the household was eligible and the household income (however, reduced by the housing benefit). Table 2.3: Minimum Subsistence Level in 2004 and 2002 July 2004, monthly amounts Minimum subsistence head of household other adults dependent or child under 18 Sk 4,580 Sk 3,200 Sk 2,080 Minimum subsistence head of household other adult and working minor 1/ dependent or child under 18 July 2002, monthly amounts in 2002 prices Sk 3,930 Sk 2,750 Sk 1,780 in 2004 prices Sk 4,260 Sk 2,980 Sk 1,930 Source: 2004: Law no. 601/2003, 599/ : law no.125/1998 and 195/1998. Authors calculations. 1/ Working minor is an employee under the age of Acts on Social Assistance No. 599/2003 and No. 195/1998. It should be noted that social assistance is within the competency of municipalities and the Labor Office. 19 Acts No.601/2003 and 125/1998 on Minimum Subsistence Level. Amounts are increased every year from July 1.

23 2. Personal Income Tax and Social Benefit Reforms 17 Table 2.4: Social Assistance Benefits and Family Benefits in 2004 and 2002 Description /Income related (in 2004 prices) Social assistance Social benefit monthly / Yes Sk4,850 or less depends on past behavior and family size, no cap Housing allowance monthly / Yes Sk1,670 or less N.A. Lump-sum benefit annual, no entitlement / Yes Sk13,740 or less.. Scholarships for pupils monthly, depends on grades / Yes Sk500 or less N/A Scholarships for students monthly, depends on grades / Yes Sk1,200 or less N/A Health-care allowance monthly / Yes Sk50 N/A Activation allowance monthly during activation works / Yes Sk1,500 N/A Back-to-work allowance monthly / Yes special formula N/A Protection allowance monthly, exceptional / Yes Sk1,500 N/A Subsidy for catering and Subsidy for school needs daily and annual, respectively, paid to school / Yes Sk25 catering, Sk1,000 school needs Housing benefit monthly/yes special formula special formula Family Childbirth grant 1/ one-off payment / No Sk4,320 or less Sk3,370 or less Multiple birth benefit annual / No Sk2,340-Sk3,070 Sk2,340-Sk3,080 Child benefit monthly / 2004 No, 2002 Yes Sk540 Sk520-Sk970 Parental allowance monthly / 2004 No, 2002 Yes Sk4,110 or less Sk2,970 Foster care allowances three allowances / No.... 1/ Payments per child - lower amount paid for second and consequent children. Sources: Law No. 235/1998 and authors calculations The social benefits are paid to households in material need whose net income is lower than the maximum level of benefits. Material need is the status in which the household income is lower than the minimum subsistence level. The household income consists of all incomes as defined by the Tax Law minus contributions and taxes, plus nontaxable income such as some sales of tangibles and intangibles, sickness benefits, parental allowance, pension benefits and job-related benefits (guarantee and unemployment benefits). 20 In 2004, there were two types of exceptions: some incomes were not considered, and in other cases only 75 percent of the income was considered. The former type consisted of child benefits, occasional income, and scholarships. The latter type consisted of wages, pensions and maternity benefits. The discounts were intended to increase job incentives for those who appeared at the margin of social benefits. In 2002, the child benefit (as well as the housing benefit) was also considered part of the income and there was no discount on any income. N/A 20 See Tax Law No.595/2003, Act on Social Assistance No. 599/2003 and Act on Social Insurance No. 461/2003.