Increasing trust gap

There is only about 5 to 10% of the Czech population that belongs to the European middle class

Aleš Chmelař
1 June 2017

The prosperity index is higher in countries where the GDP growth matches a more cohesive society. How can we encourage social trust in Central European countries in order to meet the demands of economic growth and build-up their prosperity further?

We have worked on creating a picture of what can be done since 2014; I will jump directly to the conclusion and only then explain how we got there. We found out that the Czech economy has a dualistic corporate sector that leads to the middle-income trap. That is, there is a large sector of finalizing companies with foreign direct investment (FDI) and rather high added value and apart from that there is another sector of domestically owned companies that are in most part subcontractors in the middle of the production chain, with significantly less assets. The thing is that when you have only one labour market it tends to level the wages to the point that the wages in the latter sector drag down the wages in the former. Therefore, the way to get out of this stagnant situation is through focusing on the subcontracting sector, and particularly on certain parts of the research and innovation sector. This can be done through structured support of applied research in the companies, basically creating an offer targeted at small and medium enterprises in cooperation with a development bank. It should lead to a higher retention of the value from the FDI companies and increased competitiveness. Hopefully, what we will end up with are higher wages distributed evenly across the economy.

As to social cohesion, we have visited many countries in Central Europe to offer tax policy recommendations for less progressive systems. Now we can witness a worrying divide in the Czech Republic, there is only about 5 to 10% of the Czech population that belongs to the European middle class, and the rest can at best be ascribed to the Czech middle class and those are two strata of society that diverge. There are real problems with communication between those groups, and social media has only made it worse, which has led to a growth of distrust. It was particularly visible in the last presidential election when the two camps were basically Prague’s elite vs. the rest of country. And one of the effective ways to fight such dangerous stratification is a very old one, i.e. work on progressive taxation. One of the paradoxes of the Czech tax system is that there is a limit for social contributions and thus the effective tax rate starts dropping when your income reaches four times the average salary. I think it is high time for Central Europe to drop the flat rate experiment and develop a standard progressive taxation system.

Despite good economic indicators, Visegrad societies have voiced dissatisfaction with their economic standing. What can we do about it?

There is also this proposal of one of the coalition parties to additionally raise the banking tax, which is partly relevant to the issue of the increasing wage gap. The main goal of this measure, for better or worse, would be limiting the possible outflow of capital from the country which in the Czech Republic can climb as high as 8% of its GDP. In other countries, this rate is usually counterbalanced by the freedom of movement, people going abroad and bringing back money for consumption. But Czechs are not that mobile compared to other EU countries; they rarely decide to go work abroad, and thus cannot easily alleviate this income outflow.

Also, the FDI return in the Czech Republic is, depending on the model, from 2 to 3 times higher than in other European Union countries on average. It is disheartening for people to see themselves generate value and receive no real compensation. This corresponds to a feeling common among the general public that a portion of the wealth generated in the country is vanishing abroad. Usually globalisation takes the blame and, by ricochet, the EU; this has led to more and more of the Czech population becoming sceptical towards the union.

Central Europe has built up its prosperity by moving from low-skilled jobs to more complex services. But today, it is facing the problem of brain drain. How can we address this issue?

Tax rates will not affect the phenomenon of brain-drain. The first thing to consider is that even after proposed tax changes, the Czech Republic would still suffer from this tendency when compared to neighbouring countries, especially so when compared against the Western countries. Also, I do not believe that taxation is usually a motivating factor for leaving a country unless it goes absurdly out of proportion. The motivation for leaving the country is not that the tax rate is one or two percentage points lower than in the country of origin, but rather that the wages are two or three times higher where one is headed. We ran a study on the divergence of wages in particular sectors and professions, and we saw that the difference in earnings of the managers between European countries are larger than in professions which traditionally earn less. This points to a broader problem, not limited to just specific parts of the economy.

Brain-drain, however, does not affect Czechs that much as they are not a very mobile nation. There are instances of course, like in the medical profession, but it is a marginal phenomenon, unlike Poland, the East Balkans or Bulgaria where virtually anyone who has any chance of succeeding abroad either thinks about or decides to leave the country.

As to the risk of companies fleeing abroad in the aftermath of introducing a more progressive taxation, I would not fear that. When a country has this high return on investment it means the value is not generated in manufacturing or other traditional industries, it is in the local consumption-based sectors, like energy or banking, and those cannot move away because the clients are there and there only. And we are not a country of traders and stock exchanges, we do not provide international financial services. Our financial sector is inward looking, focused on local companies and households, and thus ready to comply. Companies leaving because of slightly higher taxes is, therefore, unlikely.

Aleš Chmelař – The chief EU analyst at the Czech Government Office and a Head of its EU Strategy and Trends Unit

Read more in Visegrad Insight 1 (10) 2017 ‘From golden hands to golden heads’.