Cut labour costs, says World Bank

A NEW World Bank report recommends that Slovakia cut labour-related taxes and reduce social spending instead of trying to lower income tax rates below 19 percent.
The Labour Ministry defended its position, pointing to recent reductions in payroll taxes, while financial analysts generally supported the World Bank's recommendation.

A NEW World Bank report recommends that Slovakia cut labour-related taxes and reduce social spending instead of trying to lower income tax rates below 19 percent.

The Labour Ministry defended its position, pointing to recent reductions in payroll taxes, while financial analysts generally supported the World Bank's recommendation.

The report, which evaluates the economic and reform developments of the eight new EU members in Central Europe and the Baltic region, comes on the heels of an earlier World Bank report that ranks Slovakia as first among those nations implementing successful reforms in 2003.

While the new report does not diminish Slovakia's achievements, it does suggest that the country take a slightly different tack going forward.

"The new EU member countries - in particular those that have already reduced statutory corporate income tax rates to relatively low levels on their part - may well be better off easing very high taxes on labour than further lowering CIT [corporate income tax] rates," reads the World Bank's quarterly economic report.

In Slovakia, the CIT is at 19 percent, one of the lowest rates in Europe.

However, 37 percent of an employee's salary goes to pay for social services, and employers carry 28 percent of the burden. Employees contribute 9 percent of their salary to social services, which includes disability and pension insurance.

According to Thomas Laursen, the World Bank's chief economist for Central Europe and Baltic countries, easing payroll taxes and rationalising social spending would likely result in a business climate more conducive to investment and increased hiring. It would also boost employment and reduce poverty in the country.

Laursen told the press that low corporate income taxes represent only a "marginal temptation" for foreign investors.

"Other factors are more important. Mainly, it is the investment climate as a whole that attracts investors," he said.

Slovakia's Labour Ministry acknowledged the World Bank's opinion and defended its position.

Martin Danko, a ministry spokesman, told The Slovak Spectator, "The Labour Ministry considers cutting the compulsory payments to social funds [payroll taxes] a key issue. Since January 1, 2004, we have cut the payroll tax burden by 3.25 percent."

According to the Labour Ministry, the main obstacle to further cuts is the long-standing deficit of social security insurer, Sociálna poisťovňa. Until pension and disability funds stabilize, not much can be done.

"The ministry carefully monitors the developments of these funds and will immediately propose further cuts once positive impacts of the Slovak government's social reforms can be felt," Danko told The Spectator.

High payroll taxes hit Slovak businesses hard. In a survey conducted by the daily SME, the weekly publication Trend and the polling agency Focus, companies that do business in Slovakia consider the high taxes on labour their greatest obstacle.

Slovak financial analysts tend to see the issue of payroll taxes through the same prism as the World Bank.

"Considering that higher [economic] growth has not fully translated into higher employment rates, it seems that lowering tax rates on labour could increase employment, particularly among unskilled labour," a bank analyst from ING, Ján Tóth, told The Slovak Spectator.

Tóth confirmed what the Labour Ministry said, that tax rates on labour remain high because social reforms, such as the government's healthcare package, have not had a chance to work. Nevertheless, Tóth thinks it makes sense to lower taxes on labour first.

"I would cut compulsory social contribution first. I would also support further lowering corporate income taxes to 15 percent, with a possible hike of VAT rate to 20 percent. And I would cut subsidies to agriculture and building savings companies," he said.

Cutting personal and corporate income tax to 15 percent would deepen the tax deficit by Sk13 billion (€320 million).

Mária Valachyová, a research analyst with the VÚB bank, agrees with Tóth that the Slovak government should focus on decreasing the taxes paid by employers to support social services. Like Tóth, she believes that lower labour costs would create more jobs, especially lower paid ones, as well as increase the country's business competitiveness and attract new inflows of foreign direct investment.

According to Valachyová, cutting social welfare expenditures would be essential to reducing compulsory social contributions.

However, she doubts that a decisive political will exists to reduce social expenditures, even if reductions "would improve the budget balance sustainability" in the long term.

"Though the government claims it wants to bring the budget deficit to the 3-percent level in 2006, doing so would require a strong desire on the part of the ruling coalition to cut the deficit by cutting spending, and we don't see that as realistic at the moment," Valachyová told The Spectator.

The World Bank report comes at a time in Slovakia when some voices are calling for further tax cuts while others, primarily old EU members, are complaining that Slovakia's flat income tax rate of 19 percent that took effect January 1, 2004, is too low already.

Tax experts say evaluating the situation is tricky. They agree that separating the influence of lower income taxes on foreign investments from other factors is difficult.

"Structural reforms happened so fast in Slovakia that we need time to define the influence of taxes," Anton Marcincin, a World Bank economist for Slovakia, Slovenia and the Czech Republic, told the TASR news wire.

According to Marcincin, the growing automobile industry in Slovakia will impact other sectors as well. He says it will be important to invest tax revenues from new industries properly, for example, in education.

However, a World Bank study on factors in eight new EU member states that attracted foreign direct investment showed that corporate tax rates, labour costs, reform progress and the openness of economy impacted on foreign investment in the following ratio: 1:2, 5:3, and 2:1.7.

"Results suggest that in terms of attracting foreign direct investment, the most important factors are labour costs and the reform progress of the country, and then corporate income tax. As you can see, lower income tax rates (corporate or personal) are not the only, and certainly not the most important, factor in attracting foreign capital," VUB's Valachyová said.

The World Bank's report also claims that political instability continues to characterise the EU-8 region (Central Europe and Baltic EU states).

"With more or less well-established EU-8 governments scrambling to prepare 2005 budgets, there was little further progress on broader reforms with the notable exception of some further advances on social spending reforms in Poland and the Slovak Republic, and on privatisation in Poland and the Czech Republic," said the World Bank report.

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