World Bank EU-8 Quarterly Economic Report October 2004 Thomas Laursen Lead Economist World Bank October 18, 2004

The Political Economy Background Changes in the political landscape continued: New government in Poland and the Czech Republic, new Prime Minister in Hungary;New government in Poland and the Czech Republic, new Prime Minister in Hungary; Parliamentary elections in Slovenia - shift from the incumbent center-left government toward the center- right;Parliamentary elections in Slovenia - shift from the incumbent center-left government toward the center- right; In Lithuania the ruling coalition lost to the Labor Party in the first round of elections;In Lithuania the ruling coalition lost to the Labor Party in the first round of elections; Governments busy preparing 2005 budgets little further progress on broader reforms, with exception of Poland, Slovakia and Czech Republic.

The Political Economy Background Latvia Minority government of Indulis Emsis survived confidence vote in September

Macroeconomic Policies and Developments Output growth – EU-8 Output growth remain robust through the second quarter of 2004 on the back of the ongoing recovery in Europe and improved competitiveness.Output growth remain robust through the second quarter of 2004 on the back of the ongoing recovery in Europe and improved competitiveness. But dynamics this year affected by stock- building in relation to EU accession, some signs that activity is becoming somewhat less buoyantBut dynamics this year affected by stock- building in relation to EU accession, some signs that activity is becoming somewhat less buoyant.

Macroeconomic Policies and Developments Output growth – Latvia Strong output growth continued;Strong output growth continued; Real GDP growth of 8.2% y/y in H1-2004;Real GDP growth of 8.2% y/y in H1-2004; Growth driven by investment and consumption while net exports contribute negatively;Growth driven by investment and consumption while net exports contribute negatively; Construction, wholesale/retail trade, and transportation/communication most dynamic sectors.Construction, wholesale/retail trade, and transportation/communication most dynamic sectors.

Macroeconomic Policies and Developments Inflation – EU 8 S tabilizes following the jump in the level related to EU accession. Should ease as the impact of one-off factors fades, and tighter monetary conditions feed through.S tabilizes following the jump in the level related to EU accession. Should ease as the impact of one-off factors fades, and tighter monetary conditions feed through. Unemployment high in several countries in the region, wage pressures moderate - rapid closing of output gaps, emerging bottlenecks in some labor markets, and risks of further increases in oil and other commodity prices suggests that monetary authorities need to remain vigilant.Unemployment high in several countries in the region, wage pressures moderate - rapid closing of output gaps, emerging bottlenecks in some labor markets, and risks of further increases in oil and other commodity prices suggests that monetary authorities need to remain vigilant.

Macroeconomic Policies and Developments Inflation – Latvia Further acceleration of inflation to nearly 8% (y/y) in August-September;Further acceleration of inflation to nearly 8% (y/y) in August-September; Rapidly rising food prices main contributor to inflation;Rapidly rising food prices main contributor to inflation; Surge in inflation may jeopardize plans for early ERM-2 entry and Euro adoption.Surge in inflation may jeopardize plans for early ERM-2 entry and Euro adoption.

Macroeconomic Policies and Developments External imbalances – EU 8 Remain worrisome in Hungary, but also sizeable in the Baltic countries and the Czech Republic although with a higher coverage by FDI;Remain worrisome in Hungary, but also sizeable in the Baltic countries and the Czech Republic although with a higher coverage by FDI; Meanwhile, current account positions remain strong in the other EU-8 countries as exports are booming.Meanwhile, current account positions remain strong in the other EU-8 countries as exports are booming.

Macroeconomic Policies and Developments External imbalances–Latvia Current account deficit widened further to over 17% of GDP in Q (11.5% of GDP in H1);Current account deficit widened further to over 17% of GDP in Q (11.5% of GDP in H1); Reflects in large part booming imports (some EU accession- related);Reflects in large part booming imports (some EU accession- related); Only around one-half covered by FDI.Only around one-half covered by FDI.

Macroeconomic Policies and Developments Fiscal performance – EU 8 oB etter than expected, on the back of strong output and revenue growth; oHungary stands out negatively; oBudget plans for next year point to some further consolidation where most needed (Poland and to a lesser extent Hungary); oLittle further progress in the Czech and Slovak Republics, budgets eased in the Baltic countries; oIn view of the cyclical upturn in the region, stronger fiscal consolidation would have been warranted.

Macroeconomic Policies and Developments Fiscal performance – Latvia Budget implementation in 2004 better than planned reflecting strong revenue growth;Budget implementation in 2004 better than planned reflecting strong revenue growth; But expenditure pressures growing;But expenditure pressures growing; Budget 2005 targets deficit of 2% of GDPBudget 2005 targets deficit of 2% of GDP Fiscal expansion not conducive to reducing macroeconomic imbalances.Fiscal expansion not conducive to reducing macroeconomic imbalances.

Special Topic Corporate Taxation and FDI in the EU-8 Unfair tax competition concerns in the wake of sizeable CIT cuts in the new member states;Unfair tax competition concerns in the wake of sizeable CIT cuts in the new member states; Tax bases largely harmonized with many incentive schemes abandoned in the new member countries, several old members also moved to cut rates, effective tax rates remain significantly lower in the EU-8 countries;Tax bases largely harmonized with many incentive schemes abandoned in the new member countries, several old members also moved to cut rates, effective tax rates remain significantly lower in the EU-8 countries; But large differences between very low rates in the Baltic countries and Slovenia and moderate rates in the other countries in the region;But large differences between very low rates in the Baltic countries and Slovenia and moderate rates in the other countries in the region;

Special Topic Corporate Taxation and FDI in the EU-8 (2) Lower effective corporate tax rates attract FDI, but other factors more important (i.e. labor and other production costs, overall investment climate);Lower effective corporate tax rates attract FDI, but other factors more important (i.e. labor and other production costs, overall investment climate); Meanwhile, flow of capital from old to new member states is a natural part of the income convergence process, including because of low labor mobility from new to old member states;Meanwhile, flow of capital from old to new member states is a natural part of the income convergence process, including because of low labor mobility from new to old member states; EU-8 countries in particular those that have already reduced statutory CIT rates to relatively low levels may well be better off easing very high taxes on labor than lowering further CIT rates. This should go along with rationalizing social spending.EU-8 countries in particular those that have already reduced statutory CIT rates to relatively low levels may well be better off easing very high taxes on labor than lowering further CIT rates. This should go along with rationalizing social spending.

Special Topic Corporate Taxation in Latvia Overall tax burden in Latvia among lowest in the EU (only Lithuania and Ireland lower);Overall tax burden in Latvia among lowest in the EU (only Lithuania and Ireland lower); Share of CIT revenues in GDP also relatively low (about 2% of GDP before latest rate cuts);Share of CIT revenues in GDP also relatively low (about 2% of GDP before latest rate cuts); Nominal CIT rate reduced to 15% in 2004 and plans for further cut to 12.5% in 2005 (compared to average of 31% in EU-15);Nominal CIT rate reduced to 15% in 2004 and plans for further cut to 12.5% in 2005 (compared to average of 31% in EU-15); Effective tax rate around 12% in 2003 among the lowest in the EU.Effective tax rate around 12% in 2003 among the lowest in the EU. Tax incentives in SEZs.Tax incentives in SEZs.