The impact of the recession on public finances in the Czech Republic

Czech public finances have come under significant pressure as a consequence of the ongoing economic crisis. Public budgets have not been affected by bail-out operations in the banking sector, as domestic financial institutions did not get involved in toxic asset operations. However, several anti-crisis budget measures have been adopted in order to mitigate the impacts of the economic crisis. These measures are largely focused on bolstering aggregate supply (a reduction in employers’ social security contributions, accelerated depreciation, etc.) and – together with measures adopted previously as part of a public finance reform – will ultimately lead to a decline in budget revenues (i.e. to wider public finance deficits). The global financial and economic crisis has also led to a rise in risk premia on financial markets, including in the Czech Republic. This has resulted in an increase in budget expenditure on interest paid on government bonds. Moreover, during economic downturns, public finances are also significantly affected by the action of built-in stabilisers, which automatically reduce tax revenues and simultaneously increase certain budget expenditures. While the figures for actively planned anti-crisis measures are known in advance, the magnitude of the impact of the decline in economic activity on public finances needs to be quantified ex post using the cyclical component of the budget balance.

Numerous international institutions (European Commission, OECD, IMF) use a traditional approach to determining the cyclical component based on identifying the gap between actual and potential output (the output gap) and then measuring the sensitivity of public finances to the change in the output gap identified. However, the ECB has introduced a different method for the calculation of the cyclical component at the European System of Central Banks (ESCB). This is because public budget items are in fact linked to specific components of GDP (e.g. consumption) rather than to GDP as a whole. The ECB therefore uses a methodology in which key budget items affected by the economic cycle are always related to specific indicators of economic activity and the labour market known as bases. The cyclical component of public budgets in a given year is then determined as the difference between the sum of the partial cyclical components of four key tax revenues (personal income tax, corporate income tax, indirect taxes and social security contributions) and one expenditure item sensitive to the economic cycle (unemployment benefits).

The ESCB’s method has the undeniable analytical advantage that it reflects the actual determinants of public finances and enables further analysis of those determinants. By contrast, the method based on estimating the output gap is able to capture the change in the evolution of the economy in the form of a cyclical component usually faster than the approach used by the ESCB banks, since its calculation is based directly on the change in output not in labour market variables, which respond to fluctuations in economic activity with a lag. The results of the two methods naturally differ over time and from each other. Bear in mind that both methods are by their very nature mere approximations of two unobserved components of the budget balance (the cyclical component and the cyclically adjusted balance) and their main objective is to determine the position and the underlying trend in their development.

As part of its regular reporting to the ECB, the Czech National Bank calculates the impact of the economic cycle on public finances using the ESCB approach. For its own use, the CNB also calculates the cyclical component of the public budget balance using the output gap approach. To compare the two methodologies, Charts 1 and 2 show their results calculated on the basis of the CNB’s macroeconomic forecast contained in this Inflation Report. The results of both approaches point to a deterioration in the cyclically adjusted deficit in the coming years. The output gap approach more strongly reflects the economic decline this year (see the negative cyclical component of the budget balance in 2009).