Tuesday, December 12, 2006

SLOVAKIA - MONACO UPON DANUBE

"I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it's possible. The reason I am is because I believe the big problem is not taxes, the big problem is spending. The question is, how do you hold down government spending? Government spending now amounts close to 40% of national income not counting indirect spending through regulation and the like. If you include that, you get up to roughly half. The real danger we face is that number will creep up and up and up. The only effective way I think to hold it down, is to hold down the amount of income the government has. The way to do that is to cut taxes. "
- Milton Friedman

Roughly a decade ago,
Slovakia could be described in the following words. According to a vast majority of economic indicators, Slovakia was on the edge of existence and macroeconomic stability among the nations in transit. It was governed by Vladimir Meciar, an iron-fist nationalist dictator, and by the post-communist coalition. This coalition isolated Slovakia from the international community politically as well as economically. This enormously devastating stituation came to conclusion when Madleine Albright regarded Slovakia as the black hole in the heart of Europe
. After the independence, Slovakian GDP cumulatively fell by 24,7 percent (Fisher, Saray 2000) taking into account the level of Slovakian GDP before the shift to transition began (1989 = 100). The program of macroeconomic and monetary stabilization lacked behind the very much needed pace. Until 1998, the inflow of foreign direct investment was the lowest among transition countries (Damijan, Polanec 2003). As a matter of fact, the household rate of internet connections was constantly below 15 percent (Eurostat, 2001) which the lowest internet connection rate among households in the entire European Union.

At this state of misery, a new Slovakian Prime Minister Mikulas Dzurinda began his mandate with a bulk of economic reforms which included the education reform, health sector reform, tax reform, social security reform, labor market reform as well as the entire reconstruction of public administration. A youthful team of reformers included experts who graduated from Harvard,
Princeton and Stanford. Martin Bruncko, one of the foremost reformers, received an honorable reward from Harvard University for his thesis on the implications of the flat tax. As a result of fast, seriously and transparently imposed economic reforms, the Slovakian economy skyrocketed. In 2003, economic growth rate peaked at 4,2 percent, in 2004 it equaled 4,9 percent and in 2005 it reached its peak at an incredible 5,6 percent. In that year, Slovakian economy was the third fastest growing tiger in Europe (OECD, Economic Outlook, 2005). In 2006 OECD estimated the annual economic growth rate of Slovakia at 6,2 percent. In 2004, Slovakia adopted a single flat tax on both personal and corporate income. This easy, simple and pro-growth system replaced the previous one which included five different tax rates, ranging up to 38 percent. After the first package of tax reforms was introduced in 2003, tax burden rapidly decreased to 13,7 percent so that economic analysits from OECD noted Slovakia as "tax heaven of Europe". Giving the economy very much needed boost, the unemployment declined sharply. It went from 20 percent in 2001 to 15 percent in 2004 and 11 percent in 2005. As a result of radical and unabating structural reforms, the quality of business environment improved dramatically. Foreign direct investment (FDI), one of the most powerful engines of economic growth, grew robustly. Automobile industry found a bulk of incentives in Slovakia. Equipped with low labor costs, shining geographical location and incredible opportunities offered stimultaneously, Slovakia became a host for automobile enterprises such as Volkswagen, Pegueot, Citroen and KIA Motors. The latter will start pushing its production in a small town of Zilina
in the North of Slovakia. On the other, a stimultaneous tax system and a flexible labor market did very much to attract foreign direct investment from the automobile sector. Increased volumes of capital inflows are a result of stimulating business climate which banished restrictions on ownership participation so that only minimal restraints remain in action.

"The country's low-cost yet skilled labor force, low taxes, liberal labor code and favorable geographic location have helped it become one of Europe's favorite investment markets."
-
US Department of Commerce


According to numerous reports,
Slovakia
is the leading innovator in making investment climate furtherly favorable. Minimal barriers to capital transaction also present an important feature by which Slovakian policymakers let the system of business and capital transactions running freely, without burdensome restrictions and bureaucratic regulation.

A group of youthful and enthusiastic economists under the leadership of Ivan Miklos was aware of the importance of the privatization of banking and financial sector. Previously restricted financial system under the possession of the government did not offer credible enhancement mechanisms to entrepreneurs and individuals. A quick, transparent and relatively fast privatization of almost entire financial sector included the undergoing series of structural changes, financially weak banks were eliminated and three largest state-owned banks were immediately privatized. Today, the financial sector consists of 18 commercial banks and three largest banks are 100 percent under the ownership of foreign investors. Interest rates were liberalized without the preliminary enforcment of Maastricht conditions (within ER mechanism) needed for a country if it wants to enter the European Monetary Union as well as credit condtions were reset and credit limits eliminated. Slovakian financial sector is small but far most efficient than most of
Slovakia's counterparts. Financial system offers incredible opportunities to foreign and domestic investors, there're numerous investment incentives which stimulate investors to rely on pro-market behavior. On the other side, financial sector in Slovakia had been reformed to change its behavior in order to transform it into pro-growth pillar of stimulations to businesses and individuals. The dynamics of the financial sector also applies to the business investment climate which is known after its transparency, tax and entrepreneurially-friendly attitudes (Heritage, 2006) and non-discriminatory treatment of investors regardless of their national origin. World Bank (2006) named Slovakia the top reformer in improving the climate of its investment environment. As to another importatn characteristic of the banking sector, credit limits are among the least restrictive in Europe
(IMF, 2005).

In 2003, Slovakian government undertook serious steps in reforming a very rigid labor market. Renovated Comprehensive Labor Code was legislated. It allowed greater flexibility at hiring and firing workers. The flexibility of labor market essentially contributed to the Slovakian shift to freer economy (CATO, 2003). The labor market is among the least regulated in
Europe
. In 2004 the costs of labor per unit of GDP equaled 0,2 percent.

Slovakia also has incredibly transparent, pro-choice and activity-based pension system. Many analysts from Ernst&Young and Dun&Bradstreet are putting Slovakian transparent and long-term sustainable pension system as an example to Western governments in France, Germany and Italy. New system enables more free choice. The individuals can therefore choose between the old 'pay-as-you-go' system and new system which is based upon individual contributions to personal (private) retirement accounts. Individuals can also put their away in various investment and private funds in order to keep their money safe from political expropriation. Current social security contribution rate is equal to 29 percent of the gross salary. 9 percent of this amount goes to the old system while 9 percent goes to the new system. This particular ratio also covers other types of insurances. More than 50 percent of all contributions is invested in various private investment funds which yields a lot more than the old system and also offers incredible opportunities to control long-term and short-term risk. Thus 8,5 billion SKK is saved in 8 various investment funds. Their job is the management of pension savings. There are numerous opportunities let to individuals. Every investment fund consists of 3 additional funds - growth fund, balance fund and conservative fund. 80 percent of all portfolio growth funds can be constructed in exactly the same way as asset management funds. Younger individuals can choose between all 3 funds while older generations can vary between balance fund and conservative fund. Businesses whose mission is the management of pension savings can accomplish their investment anywhere abroad but 30 percent of all investments is required to be based in Slovakia
. Pension reform was enforced quickly, within the period of one year. Personal retirment accounts (PRA), where individuals and businesses can put their savings, have two increasingly important characteristics - (i) they don't violate the principle of private property and (ii) they are safe from political abuse (Tupy, 2006).

According to international research studies,
Slovakia
undertook pro-growth steps to make macroeconomic stabily sounder and business environment less wedged. For example, there are minimal barriers to the process of company registration. It only takes 3 steps to register the company which means 17 days until the company is established and ready to operate. The costs of establishing the company amount 0,1 percent of total property value (WB, Doing Business 2006).

Slovakia passed a long period of economic changed. From financially devastated economy, it stepped at the top of economic miracles under the leadership of Mikulas Dzurinda and Ivan Miklos. A group of serious economists and reformers, including Ivan Miklos and Martin Bruncko, made Slovakia the first serious reformist country in Eastern Europe after Estonia. In 2006, the World Bank ranked Slovakia among top 20 countries with the most business-friendly investment environment and entrepreneurial climate. There had been a particular emphasis on undertaking economic reforms in order to stimulate productive behavior which was generated by pro-growth tax legislation embodied in the imposition of the flat tax of 19 percent on both personal and corporate income. This particular type of tax system is far away from being complicated. It is far more efficient, transparent and pro-growth. The flat tax replaced the old system which was known after its enormously grown progressivity, ranging from 16 to 35 percent. According to analytical studies, tax reform stimulated the growth of the economy. It also improved the investment climate and removed heavy burden which had been caused through highly progressive system of income taxation. Tax reform resulted in both, greater freedom and greater equality. According to some econometric estimate, structural reform of the tax system empowered the economy which resulted in 2,5 percent increase of the economic growth on the annual basis. In the past period, Slovakia had significantly improved the state of macroeconomic stability. In fact, Slovakia was the foremost macroeconomic reformer in the region (see: Macroeconomic Environment Index). In 2004, the country scaled up and came among 50 most transparent, firm and efficient macroeconomic environments (WEF Global Competitiveness Report 2004, McKinsey&Company 2004).

The privatization of government enterprises and state assets was fast, non-troubled and transparent. In 2001, Austrian Erste Bank and Italian Banca Intesa acquisted the package of governmental stakes in the following banks; Slovensky Sportelna and VUB Banka. In 2002, the government sold the stakes of gas distrubtion company Slovensky Plynarenski Priemysel to EDF, RWE and Ruhrgas. The infrastructural change was accompanied together with rapid economic transformation (IMD, 2006).

The main features of labor market reform had been the shift towards greater flexibility of labor market itself. This particular objective was reached through (a) more flexible labor contracts, (b) stimulating working extra-hours and (c) less complicated hiring and firing of workers. According to data from TREND, approximately 80 000 graduates left
Slovakia
between 1994 and 2002 which equals nearly 7000 to 10 000 graduates a year. The so-called "brain-drain" effects reflect in 0,6 percent decrease in annual economic growth (McKinsey&Company, 2005).

Ivan Miklos and the group of economic reforms were the first serious signs of economic change in
Central Europe. Ther willingness to impose a bulk of structural reforms did not decrease even though trade unions and other signals of neosocialism furiously opposed economic reforms and refused the need to let the economy grow and make economic change happen. Today Slovakia is known as the European Detroit with a 19 percent flat tax rate on boh personal and corporate income which embodies all of the requirements for the country to become tax heavens. Foreign direct investment presented 18,4 percent of the GDP in 2000. In 2004 the amount of foreign direct investment presented incredible 35,3 percent of the GDP. In 2005 and 2006 the growth of Greenfield foreign direct investment showed positive signs of further investment growth. After the country enacted the flat tax in 2004, it joined the club of those economic miracles in Eastern Europe
who showed enough courage to enact the flat tax and thus insured them against possible economic downturn in the future. The phenomenon of eastern European tigers is coined as the flat tax revolution.

The efficiency of government policies increased dramatically under the mandated leadership of Mikulas Dzurinda and Ivan Miklos. In World Competitiveness Ranking of the IMD in 2006, Slovakian government was ranked 17th according to the factor of efficiency. In 2005, tax burden measured as the percentage of the GDP was among the lowest in the OECD group of countries. Tax burden did not reached 30 percent of the GDP. Government spending decreased from 50,5 percent of the GNP in 2002 to 40,5 percent of the GNP in 2004. However, some forecasts have been made and show continually-adjusted signs of decreasing governmental consumption. Between 2000 and 2005, only
Ireland, Estonia, Lithuania and Latvia had had higher rates of economic growth. Through the period of liberal economic reforms, the size of the budget deficit reduced from -13 percent to -3 percent. The latest research called Tax Misery & Index confirmed the simplicty of the tax system and its pro-growth nature. If you are a taxpayer working in Slovakia who earns 50 000 € gross annually, social security contributions transferred from your income will be equal to 1 736 €, 8 033 € will be taken away through the payment of an income tax. After other minimal obligatory contributions are taken into account, your net income will be equal to 40 231 € or 80,46 percent of the gross income. In Slovenia
, your net income would present only 55 percent of the gross income (50 000 €). Social security contributions would be equal to 10 050 €, personal income tax would be equal to 11 323 €, so that only 27 627 € remained left (see: Tax Misery & Reform Index, Forbes).

However, the whole picture of Slovakian economy is far from being an ideal fairytale. Several challenges are still to come ahead. A bulk of incentives in order to energize the economy has been recommended by McKinsey&Company. It recommends the following advice:

"As first,
Slovakia should face the problem of corruption and persistent inefficiency of the judicial system. The protection of private property rights should be enhanced immediately. The government should continue improving the infrastructure while it must avoid burdensome regulation of product markets. The liberalization of health-care sector and social security system should continue. Fighting against corruption will improved the efficiency of the judicial branch of government. Slovakia should avoid minimum wages and keep the labor market flexible. The government needs to furtherly privatize the rest of the its stakes in state enterprises whereas the elimination of various forms of ownership restrictions is vastly needed as well. The government should put more efforts to reduce the burden of bureaucracy. Those barriers reduce the dynamics of enterpreneurial prosperity. The government should not hesitate in making efforts to reduce brain-drain outflows. That is the way upon which economic growth will get very much needed boost. After a series of features stated above is to be enacted, Slovakia
economy will have more opportunities and engines to be a competitive country with high rates of economic growth and sufficient climate of the entrepreneurial environment."

Source: McKinsey&Company Report on Slovakia
(translated by Rok Spruk)

Economic reforms undertaken by Ivan Miklos and other younthful and enthusiastic group of economists made
Slovakia one of the friendliest places for portfolio and direct foreign investors. The tax system was redesigned completely and became one of the most competitive ones in the world. In many recent surveys, Slovakia was recognized as the most entrepreneurially innovative country in the region. The level of entrepreneurial innovation is stimulated through low taxes, lower regulation and lower rate of government spending. The government under the leadership of Mikulas Dzurinda was attacked by the trade unions and other rent-seeking interest groups. Those groups penetrated the media and sent waves of illusionary fears against the process of economic change. We especially admire the fact that the bulk of measure to increase economic freedom and let the passage of transition become a success story, was never in question of political popularity of the government. During the period of economic reforms, the rate of political popularity of the government fell below 5 percent. Ivan Miklos told that the imposition of reforms is very costly. Opposition parties are doing propaganda, people are not satisfied, and trade unions fear others while the results of economic reforms come later.

At the following elections, Slovakian voter chose extreme leftists to be in charge of the country. Those parties even formed coalition with the party whose leader is former dictator of Slovakia Vladimir Meciar. With the election of leftists, right-wing extremists and nationalists, Slovakian economic freedom is about to be in danger. However, the people of
Slovakia will soon feel the devastating impact of leftist government. It will surely be a colateral damage which puts the long-term competitiveness of Slovakia in a very fragile position.

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