Executive Summary
Russia’s war of aggression against Ukraine has derailed the Czech Republic’s post-pandemic recovery and further disrupted the impressive catch-up with OECD average incomes seen in the previous two decades. Steep rises in energy and commodity prices and disruptions in gas and oil imports from Russia triggered a cost-of-living crisis with a risk of broader energy shortages. Lower global growth, constraints in global supply chains and higher uncertainty have dampened activity.
Inflation has risen to high levels and become entrenched. Core inflation was persistently among the highest in the European Union throughout 2022. Inflation expectations have increased markedly, with corporates expecting around 7% inflation at a three-year horizon. The authorities had reacted swiftly and decisively to support the economy during the COVID-19 crisis. However, in hindsight, loose overall macroeconomic policy in 2020-21 contributed to high inflation by boosting demand over supply capacity.
The unemployment rate remains very low but rising prices have eroded domestic demand. High uncertainty and the looming energy crisis have resulted in large falls in consumer and business sentiment, lowering private consumption and investment. Real wages have fallen steeply.
Economic growth will be subdued in 2023 and pick up in 2024 amid reduced supply disruptions and resuming expansion in trading partners. High energy prices, tightened financing conditions and low sentiment will hold back private investment in 2023. Private consumption will be constrained by rising prices. Inflation will start falling from the currently very high levels but will only approach the 2% target towards the end of 2024.
Risks around the projections are considerable. Renewed rises in commodity and energy prices, a strong depreciation of the koruna and de-anchored inflation expectations could further feed inflation pressures and trigger a destabilising wage-price spiral. On the other hand, a deeper recession and lower confidence would lower inflation more quickly.
Monetary policy has rightly been tightened to counter rising prices and manage inflation expectations. Fiscal policy should avoid boosting aggregate demand, while providing support to cushion living standards.
The Czech National Bank (CNB) raised the policy interest rate from 0.25% to 7% between June 2021 and June 2022, after which it paused. The CNB has also intervened on the exchange rate market to prevent excessive fluctuation and stem depreciation pressures on the koruna.
Source: Czech Statistical Office.
Public spending pressures have intensified. The Czech Republic has welcomed the highest number of Ukrainian refugees per capita among European countries, providing basic services and income support. Countering the adverse impact of the energy crisis and rising prices of essential goods on the vulnerable has necessitated further public spending. Moreover, the need for defence spending has risen. Support measures provided to households and firms should be temporary and targeted at the most vulnerable to avoid fuelling inflation and designed to preserve incentives for energy savings.
The Czech Republic faces high fiscal pressures in the medium to long term that threaten fiscal sustainability. Action on both the expenditure and revenue sides should be considered to close expected future gaps in public budgets.
Recent expansionary fiscal policy helped preserve jobs and incomes, but it has led to a high deficit and increased public debt. Untargeted cash transfers and a permanent cut in tax revenues from late 2020, whereby fiscal revenues fell by roughly 2 percentage points of GDP in structural terms, aggravate the fiscal challenge. Fiscal rules have been loosened and there is no clear path towards fiscal consolidation. Looking ahead, population ageing will result in future steep rises in public spending on pensions, health, and long-term care, significantly pushing up the debt-to-GDP ratio. Without reform, a substantial increase in fiscal revenues would be required to counter the rise in expenditures. Raising the effectiveness in the public sector and continuing to fight corruption would also help curb increases in public spending.
There is scope to revise the tax system to better align economic, environmental and societal objectives. The tax burden on labour is high due to significant social security contributions. Personal income taxes remain low and are only weakly progressive. There is strong reliance on reduced VAT rates that have been shown to be poorly targeted to fight poverty. On the other hand, environmental and real estate taxes, which are less distortive to growth, are low.
Pensions are set to exert pressures on public spending. Pension spending is estimated to rise by 3.5 percentage points of GDP by 2060. Yet, Czech workers retire much earlier than in most OECD peers. The employment rate - while high overall - falls sharply after the age of 60. The current system of regularly reviewing the statutory retirement age relies too much on recurring government initiatives, raising the risk that the retirement age might not be increased in a timely and sufficient manner to curtail spending pressures. Moreover, under current provisions, early retirement age is set to remain at 60.
The Czech labour market is strong: the unemployment rate is very low, and the employment rate and job security are high. However, chronic labour shortages are a major obstacle to growth.
Mothers could be better integrated into the labour market. Female employment falls significantly and for a prolonged period after childbirth, adversely impacting women’s subsequent careers. The gender wage gap is sizeable. Very long parental leave and generous family cash benefits discourage mothers from returning to work. The lack of childcare capacity is another constraint and enrolment of children under three in early childhood education and care is among the lowest in the OECD.
Labour migration policy is not geared to attract skilled foreign workers. Labour shortages have prompted Czech employers to look for workers from abroad. Immigration has been rising steadily. Despite rising skills needs, close to 90% of foreign workers from non-EU countries work in low- to medium-skilled jobs. Conditions in terms of permit duration, family reunification and labour market mobility in the Czech Republic for highly skilled workers are less favourable than in peer countries.
The education sector could contribute more effectively to building skills in demand. Many jobs in the future will require high education and skills, and demand is growing for core and technical competences. Yet, tertiary educational attainment, despite progress in recent years, lags significantly behind OECD peers and skills shortages in growing sectors remain large. Despite workers’ good basic digital skills, the economy lacks specialists in information and communication technology. Modernised vocational education and training, better adapted to adult learning, can effectively build skills in demand and raise the economy’s adaptability to structural change.
Inequalities in education persist. Parents’ socio-economic status has a strong impact on performance in school. Drop-out rates vary widely across regions, and teacher quality in disadvantaged schools is low. Abolishing early tracking, reducing differences in school quality - including by closing small local schools - and attracting better teachers to disadvantaged schools would help raise equality of opportunity. Explicitly targeting disadvantage in school funding could help in this regard.
Note: A socio-economically disadvantaged student is from the bottom quarter of the PISA index of economic, social and cultural status. Source: OECD (2019), PISA 2018 Results (Volume II).
The Czech Republic has made significant headways in reducing greenhouse gas (GHG) emissions over the past three decades. Still, GHG-intensity remains high, largely driven by the extensive use of coal for electricity production and heat generation. Reliance on heavy industry coupled with older and poorly insulated dwellings make the Czech economy highly energy intensive. Major investments are needed to alter the energy mix and improve energy efficiency.
Current environmental policies are not stringent enough to effectively curb emissions. Effective carbon tax rates are among the lowest in the OECD. The Czech Republic does not have an explicit carbon price. Furthermore, tax exemptions are applied on various fuels, which decreases end-use prices and limits incentives to save energy or to switch to cleaner fuels.
Source: OECD Green Growth Indicators; IEA World Energy Statistics and Balances.
Low energy efficiency in buildings and use of coal in heating inhibit the green transition. Czech buildings have among the highest energy consumption per square meter in the EU and a large number of households still rely on coal for residential heating. Existing regulation and subsidies do not provide sufficient incentives to raise investment for boosting energy-efficiency. Permitting processes are complex, impeding spending on green technologies and infrastructure.
Inclusive labour policies can ease the green transition. On the path towards net zero the Czech economy will have to restructure. Relative prices will shift, jobs will be shed while others will be created. Some sectors and some groups of workers are more at risk and policy should ensure a fair green transition. Retraining and other active labour market policies can help displaced workers find jobs more quickly and effectively match jobseekers with emerging opportunities.