World Bank EU-8 Quarterly Economic Report October 2004 Thomas Laursen Lead Economist World Bank October 15, 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 Slovakia Voter preference for government has improved since start of year; Government was able to push through controversial but much needed health care reform; Also approval of new system of revenue sharing with local governments; Slovakia leading global reformer in 2003 (World Bank Doing Business 2005) and now in world Top-20 (only Lithuania in the region shares this achievement); First multi-year budget — fiscal deficit to reach 3% of GDP in 2006/07 consistent with Euro adoption (depending on final verdict on pension funds).

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 – Slovakia Robust output growth continued;Robust output growth continued; Real GDP growth steady at 5 ½ % y/y in Q2-2004;Real GDP growth steady at 5 ½ % y/y in Q2-2004; Growth driven by investment and consumption while net exports contribute negatively;Growth driven by investment and consumption while net exports contribute negatively; Agriculture and industry most dynamic sectors;Agriculture and industry most dynamic sectors; Unemployment declining slowly, but remains high (18.5% in Q according to LFS);Unemployment declining slowly, but remains high (18.5% in Q according to LFS); Significant uncertainty about poverty dataSignificant uncertainty about poverty data

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 – Slovakia Headline inflation stabilized (6.7% in September);Headline inflation stabilized (6.7% in September); Core inflation moderate at less than 3%Core inflation moderate at less than 3%

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 – Slovakia Budget implementation in 2004 on track— higher revenues mostly committed to increased spending;Budget implementation in 2004 on track— higher revenues mostly committed to increased spending; Corporate tax revenues as a share of GDP unchanged from 2003 but lower than in 2002 (when adjusted for extra payments this year on 2003 profits);Corporate tax revenues as a share of GDP unchanged from 2003 but lower than in 2002 (when adjusted for extra payments this year on 2003 profits); General government deficit for the year expected at 3.9 % of GDP (ESA95) compared to 3.6% of GDP in 2003;General government deficit for the year expected at 3.9 % of GDP (ESA95) compared to 3.6% of GDP in 2003;

Macroeconomic Policies and Developments Fiscal performance – Slovakia (2) 2005 budget targets a general government deficit of 3.8% of GDP;2005 budget targets a general government deficit of 3.8% of GDP; No improvement envisaged in fiscal position (but losses from pension reform offset through savings);No improvement envisaged in fiscal position (but losses from pension reform offset through savings); New budget emphasized increased spending on social programs and highways.New budget emphasized increased spending on social programs and highways.

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.

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 and FDI in Slovakia Tax burden in Slovakia smaller than EU average;Tax burden in Slovakia smaller than EU average; but share of CIT in GDP similar (about 3% of GDP before latest rate cuts); Nominal CIT rate reduced to 19% in 2004 (compared to average of 31% in EU-15);Nominal CIT rate reduced to 19% in 2004 (compared to average of 31% in EU-15); Effective tax rate around 20% before latest reduction in nominal rate. Lower than in EU-15, but around average in the region;Effective tax rate around 20% before latest reduction in nominal rate. Lower than in EU-15, but around average in the region; Some tax holidays remain for enterprises with foreign capital.Some tax holidays remain for enterprises with foreign capital.