Jan Cienski in Prague -

Mirek Topolanek, the Czech prime minister, arguably leads one of the weakest governments in Europe, a fractious coalition with only 100 votes in a 200-member parliament, but he has managed to push through one package of economic reforms and is bracing to fight for two more. The next steps will be politically harder to pull off, however.

"These reforms were very urgent and they could not be delayed further," Topolanek told bne in a recent interview. "We managed to stop the increase in the deficit and we also managed to decrease the tax burden at the same time."

This summer, Topolanek, leader of the centre-right Civic Democrats (ODS), squeezed through a reform package by 101-99 of the vote thanks to the help of two independent MPs, former members of the opposition Social Democrats. That legislation cut corporate taxes from 24% to 21%, set the ground for a flat 15% income tax to go into force next year and cut some social benefits including sick pay, long-term unemployment benefits and baby bonuses, while VAT rates were raised.

However, those steps won't be enough by themselves to solidify the Czech Republic's fiscal future. "The first phase of reforms was successful, but it needs to be stabilized by further reforms, especially in the areas of health care, and the social and pension systems," Topolanek said. "Every issue requires very difficult negotiations in parliament in order to be approved. The fact that each of the three coalition parties has its own internal problems doesn't make it any easier."

Topolanek heads a coalition of the ODS, Greens and Christian Democrats - one of whose MPs voted in August against the first round of reforms. The three parties differ on issues such as the US missile defence shield, part of which is to be based in the Czech Republic, as well as having their own internal difficulties.

At first glance, Topolanek's call for further reform doesn't seem all that urgent, given the Czech Republic's strong economic statistics. The economy is expected to grow at about 6% this year, and per capita income has overtaken that of Portugal, one of the old EU's poorest members. Unemployment is about 6%, much lower than in other post-Communist countries like Poland. But there remain many problems to be addressed and growing signs of danger on the horizon.

Slowing growth

The tax reforms set for 2008 aren't expected to change the terrible situation that Czech Republic is regarded as having the most time-consuming tax compliance system in the EU, according to a report released on November 24 by the World Bank and PricewaterhouseCoopers. "[The study] demonstrates that one of the weakest points of doing business in the country is in particular the administrative burden of paying taxes," says PricewaterhouseCoopers Czech Republic tax manager Petr Hajek. "Unfortunately, the upcoming tax reform will not change much about it. Therefore, this issue must be a priority when preparing further changes to the Czech tax system."

The International Monetary Fund also expects growth to slow to about 4.5% next year, and inflation, stoked by steeply rising wages and commodity prices, is picking up, forcing the central bank to raise interest rates three times this year, with more increases likely.

Without additional reforms, the Czech Republic won't be able to maintain its growth rate and has little hope of meeting the Maastricht criteria needed for adoption of the euro, Zdenek Tuma, the country's central bank governor, has said. "If there is a slowdown at this time, we would be in deep trouble," said Tuma.

Government spending rose steeply before last year's election and the deficit is expected to come in at about 3.4% of gross domestic product this year. Tuma said that such a deficit is "inappropriate" during a time of strong economic growth.

The first package passed this year was "a step in the right direction," says Kamil Janacek, chief economist for Komercni Banka, the Czech affiliate of France's Societe Generale, who has consulted with Topolanek over the direction of future reform. "Now we have to start with pension reforms."

Czechs currently retire at 62, but for the pension system to remain solvent that will have to be raised to 65, he reckons. The number of years that wage earners have to pay into the system before collecting their pensions will also have to be increased.

In recent weeks, the government has also begun to discuss the shape of healthcare reforms. The healthcare system has been running a deficit since 1992, and there is a broad consensus that a way has to be found to make Czechs pay for a larger proportion of their healthcare. Currently, the government pays about 92% of those costs, while Czechs cover the rest. In France, the state pays just three-quarters and the rest is paid directly by users. "The Czech system is nonsense from an economic point of view," says Janacek.

While the first round of reforms managed to squeak through parliament, the next rounds are much more contentious - even within the ruling coalition. That makes the next steps politically much trickier. "I can't imagine pension reform could be made in the same way as the earlier reform package," says Pavel Sobisek, chief economic for UniCredit's Czech subsidiary. "A broader consensus needs to be built."

Although he is no advocate of rapidly adopting the euro, Topolanek recognizes that without further reforms, there is no way the Czech Republic will be ready to join the common currency. His government has set no target date for entry, but the prospect of neighbouring Slovakia entering the Eurozone by 2009 could shift public perceptions in Prague. "Without implementing all the necessary reforms, any kind of debate on adopting the euro doesn't make much sense," said the Czech prime minister.

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