Slovakia Out of the Black Hole: Tax and Pension Reforms

By Rastislav Kacer, Marian Tupy

[Wall Street Journal Europe, February 17, 2005]

Next week, President George W. Bush will visit Slovakia to meet Slovak officials and hold a summit with Russian President Vladimir Putin. Though Mr. Bush's trip will likely be dominated by foreign policy, his travel destination should also be seen as an acknowledgment of the changes that Slovakia has undergone the past few years. Once politically authoritarian and economically unfree, Slovakia has made considerable progress toward democracy and the free market. Moreover, some of the economic reforms that Slovakia recently undertook are relevant to Mr. Bush's ambitious second-term domestic agenda.

The last visit by a U.S. president to Slovakia dates back to November 1990, when George H. W. Bush was in the White House and Slovakia was still part of the Czech and Slovak Federal Republic. On Jan. 1, 1993, this federation ceased to exist and Slovakia became independent. Slovakia's early years were not easy, however. The government of nationalist Prime Minister Vladimir Meciar became increasingly authoritarian and attempted to silence its political opponents. The privatization of state enterprises was deeply corrupt, with many companies "sold" to government supporters at fire-sale prices. Worries about Slovakia's political system delayed the country's entry to NATO and the EU. Western leaders shunned the country. Madeleine Albright, the U.S. secretary of state under President Clinton, went as far as to call Slovakia a "black hole in the heart of Europe."

Much has changed since then. Mr. Meciar was ousted in 1998 by a coalition led by Mikulas Dzurinda. But Mr. Dzurinda presided over an ideologically disparate government and was thus unable to push through economic liberalization. That changed after Mr. Dzurinda's re-election in 2002 and the formation of Slovakia's first market-friendly government. The government proceeded to improve Slovakia's microeconomic environment by eliminating unnecessary business regulation. In recognition of these improvements, the World Bank's "Doing Business in 2005" report declared Slovakia the world's leading reformer and ranked it among the top 20 countries with the best business conditions.

As a consequence of economic liberalization, Slovak macroeconomic performance improved as well. Between January 2000 and June 2004, cumulative foreign direct investment to Slovakia rose five-fold. The list of foreign investors included a number of American blue chips such as Citibank, Ford, Motorola, U.S. Steel and Whirpool. Economic growth accelerated to 4.9% last year from a low of 1.5% in 1999. According to the Ministry of Labor, the Slovak unemployment rate fell from 19.8% in January 2001 to 13.1% in December 2004. In addition, Slovak foreign-policy objectives were met in 2004 when the country joined both NATO and the EU. Steve Forbes, who visited Slovakia in 2003, wrote in Forbes Magazine: "The Slovak Republic is set to become the world's next Hong Kong or Ireland, i.e., a small place that's an economic powerhouse."

But it is Slovakia's reform of its tax and pension systems that may be of particular interest to Mr. Bush. On Jan 1, 2004, Slovakia adopted a 19% flat income and corporate tax rate. The dividend tax and a plethora of tax exemptions were eliminated. The tax reform has resulted in an increase of tax revenues from SK 200 billion in 2003 to SK 209 billion in 2004 -- some 30% above government expectations. This tax reform is part of a regional trend. Flat tax rates in Estonia, Latvia, Russia and Ukraine have also proved successful. More recently, the flat-tax club grew to include Georgia, Romania and Serbia. As Alvin Rabushka of the Hoover Institution argues, "President Bush's most effective way to promote tax reform [in the United States] is to showcase the experiences of Eastern and Central Europe."

Like Social Security in the U.S., the Slovak pay-as-you-go retirement scheme faced adverse demographic trends and, consequently, long-term financial shortfalls. The Cato Institute's Jose Piñera, who as the former Chilean minister of labor and social security presided over the original social security privatization in Chile, helped Slovak reformers design legislation that allows Slovak workers to invest half of their social security contributions into private accounts. The legislation went into effect this year. Already more than one-third of eligible workers have switched to private accounts. Other European countries, including Hungary, Poland and Sweden, also allow their workers to save privately.

Of course, much work still remains to be done in Slovakia. Government spending as a percentage of gross domestic product and payroll taxes continue to be high, impeding additional investment and growth. Although Slovak parents already have an unrestricted choice of schools -- state, private or parochial -- for their children, reform of higher education needs to be accelerated. Initial steps toward liberalization of the health-care sector will need to be followed up by a more wide-ranging reform.

Still, the tax and pension reforms in Slovakia and other countries of Central and Eastern Europe represent a liberalizing trend that other countries would find to their advantage to follow. Mr. Bush can see so for himself next week.

-------------------------------------------------------------

Mr. Kacer is the ambassador of the Slovak Republic in the United States and Mr. Tupy is the assistant director of the Project on Global Economic Liberty at the Cato Institute.