Реферат: Transitional Success: USSR to EU

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<span Times New Roman",«serif»">The Czech Republic

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<span Times New Roman",«serif»">TransitionalSuccess:

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<span Times New Roman",«serif»">Publicfinance policy issues during the political

<span Times New Roman",«serif»">economictransition from centrally planned socialist

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<span Times New Roman",«serif»">V550 Dr. Mikesell

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<span Times New Roman",«serif»">November 20, 1996

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<span Times New Roman",«serif»">RickFerguson rfergus@indiana.edu

<span Times New Roman",«serif»">EricMartin emartin@indiana.edu

<span Times New Roman",«serif»">DmitriMaslitchenko dmitri@mailroom.com

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<span Times New Roman",«serif»">Tableof Contents

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<span Times New Roman",«serif»">I.

<span Times New Roman",«serif»">         Introduction

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<span Times New Roman",«serif»">II.

<span Times New Roman",«serif»">       PoliticalSummary: Restructuring for Transition

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<span Times New Roman",«serif»">III.

<span Times New Roman",«serif»">      Transition to Market Economy: 1990 — 1991

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<span Times New Roman",«serif»">IV.

<span Times New Roman",«serif»">      Problems of Transitional MonetaryPolicy and the Financial Sector: An Overview

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<span Times New Roman",«serif»">V.

<span Times New Roman",«serif»">       Macro Economic Stability: 1993 — present

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<span Times New Roman",«serif»">VI.

<span Times New Roman",«serif»">      MonetaryPolicy: 1993

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<span Times New Roman",«serif»">VII.

<span Times New Roman",«serif»">    IntergovernmentalFinancial Relations

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<span Times New Roman",«serif»">VIII.

<span Times New Roman",«serif»">   Budgetary Overview: 1993 — present

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<span Times New Roman",«serif»">IX.

<span Times New Roman",«serif»">      Tax Reform

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<span Times New Roman",«serif»">X.

<span Times New Roman",«serif»">       Current Political EconomicConsiderations: 1996

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<span Times New Roman",«serif»">XI.

<span Times New Roman",«serif»">       The EU and NATO

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<span Times New Roman",«serif»">XII.

<span Times New Roman",«serif»">    Conclusions

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<span Times New Roman",«serif»">XIII.

<span Times New Roman",«serif»">   References

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<span Times New Roman",«serif»">Introduction

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<span Times New Roman",«serif»">In1989, after nearly 40 years of Soviet control, Czechoslovakia once again becamean independent nation, the Czech and Slovak Federalist Republic. Thistransition from Soviet socialism to democracy culminated throughout Central andEastern Europe with the literal collapse of the Berlin Wall in East Germany,the heroic Gdansk Shipyard Strikes in Poland. The student and worker protestsin Prague and Budapest were no less important.

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<span Times New Roman",«serif»">TheCzechoslovakian revolution took place peacefully and over a much longer periodof time than events in other former Soviet Union or Warsaw Pact nations. Hintsof major reform in Czechoslovakia began as early as 1968. Czechoslovakianofficials, under Soviet power, moved incrementally to begin the long roadtowards decentralization and independent Czechoslovakian rule. Theirincreasingly effective efforts became known as the Prague Spring, a time ofgrowth, change and development.

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<span Times New Roman",«serif»">Successwas, of course, neither immediate nor easy to achieve. The Cold War reached apinnacle in the Eighties and the winds of change began to blow in Central andEastern Europe. The CEE nations endured many hardships. Soviet oppression,though waning by this time, became largely unbearable. Change in Czechoslovakiacame from the ground up; dissidents quietly began to return to popular power.The revolution gained momentum by 1989. ‘Revolutionists’ began to demand sweeping economic and political reform.They were backed by well organized and very timely strikes and protests. Aftera two hour general strike on November 27, 1989, proving the immediate andwidespread power and cohesion of the revolution, the Soviet controlledauthorities finally agreed to negotiate.

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<span Times New Roman",«serif»">Throughthe negotiation process and threat of further massive general strikes, formerdissidents assumed officially sanctioned ‘concessional’ positions. Withinmonths, they gained near complete (and very real) control of the FederalAssembly. On December 29, 1989, Mr. Havel, a very famous and popular Czechdissident, became President of Czechoslovakia (renamed the Czech and SlovakFederalist Republic).

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<span Times New Roman",«serif»">Thisinitial political victory represents only half of the nation’s success. Withinthe first three years of self rule, harsh economic (and subsequent political)realities forced the nation to divide once again. The nation as a whole wasunable to accommodate the vast discrepancies between the western Czech andeastern Slovak regions. Massive economic reforms brought this to the popularagenda as Slovakia suffered greatly while their Czech counterparts seemed tobenefit from reform.

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<span Times New Roman",«serif»">Thegovernment in Prague wished to move swiftly to further reform efforts. Slovakiahindered Czech success and in turn suffered greatly by this Czech-led reform.Slovakia simply could not move as rapidly toward a market economy due to theeconomic configuration left to them by years of Soviet planned economics.

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<span Times New Roman",«serif»">PoliticalOverview: Restructuring for Transition

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<span Times New Roman",«serif»">In1992, Vladimir Meciar, a very strong nationalist was elected prime minister ofthe Slovak Republic, while Vaclav Klaus, a moderate federalist, was elected inthe Czech Republic. Unfortunately, these two leaders were unable to agree oncommon economic and political strategies to govern the CSFR. Klaus’s reformplans, now legendary, were simply inappropriate for the fledgling Slovakregions. Slovakians felt alienated from the government reform in Prague. Withina short time it was very clear that the Czech regions could not completelysupport their Slovak countrymen through the transition. The two leaders agreedto divide the Czech and Slovak Federalist Republic (CSFR) into the Czech andSlovak Republics on January 1, 1993.

<span Times New Roman",«serif»">Federalassets and liabilities were split between the two nations in a two to oneratio. The Czech Republic received the larger portions reflecting both size andpopulation. Again, the split was achieved peacefully, without massive debate.The two countries agreed to form a customs union. They implemented identicalforeign policies with respect to third countries, and forbid tariffs or ‘bans’between themselves. They also formed a temporary monetary union, whichcollapsed within months as both countries unexpectedly experienced a massivedrain on foreign reserves during this time. To more fully understand thecurrent developments in the Czech Republic, one must examine the historicaleconomic decisions made before the break-up in 1993 as outlined below.

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<span Times New Roman",«serif»">Transitionto Market Economy Overview: 1990-1991

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<span Times New Roman",«serif»">CSFReconomic reformers went to work immediately following the collapse of Sovietrule. The reform package included near complete liberalization of prices, acomplete reversal of former exchange and trade systems and an impressivepreparation for massive and rapid privatization. These efforts were supportedby financial policies including a “pegged” exchange rate, currencydevaluations, and restrictive fiscal, monetary and wage policies.

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<span Times New Roman",«serif»">Monetary Policy

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<span Times New Roman",«serif»">Althoughmonetary policy is discussed in a separate section, it needs to be brieflyaddressed here to understand the conditions in which the transition occurred.Monetary policy in the initial stages of transition ensured that inflation remainedin control throughout currency devaluations and price liberalizations. The CSFRdevalued its currency by 20 percent in 1991 after several smaller devaluationsbefore hand. Taken as a whole, these devaluations reduced the value of thecurrency by half within six months. Generally, monetary policy remained tightthroughout the entire period.

<span Times New Roman",«serif»">Fiscal Policy

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<span Times New Roman",«serif»">Undoubtably,the goals of the CSFR economic reformers were to drastically reduce governmentspending. The former centrally-planned, output-driven economic policies were nolonger effective for the new capitalist democracy. Restructuring governmentexpenditures was a key component of reform. The main changes, aside frommassive privatization discussed below, forced reduced subsidies wherever possible.Every sector of society, with the exception of health, welfare and education,saw an abrupt end to government subsidies. In 1991 alone, for example,officials reduced government spending by 12 percent to reach 47 percent of GDP.This trend continued throughout the transition. Massive government spending, ahallmark of socialism, ended virtually overnight.

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<span Times New Roman",«serif»">Areaswhere government spending remained high would remain so throughout the reformprocess. Health and welfare for poor, elderly, unemployed and children is avery difficult situation in any government, especially one in transition.Reformers focused primarily on industry and energy in the initial stages,leaving the areas of greater uncertainty to be dealt with in a more stablepolitical environment.

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<span Times New Roman",«serif»">Price Liberalization

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<span Times New Roman",«serif»">Asan almost immediate measure, subsidies to foodstuffs and energy were reduced bynearly 50 percent. Retail prices for most household items increased by nearly25 percent literally overnight.  By theend of 1991, the Czech government controlled only 6 percent of prices in thecountry as compared with 85 percent in early 1990. Only basic necessities, oil,and agricultural products remained under state control. To offset some of theseshocks, wages increased, though only slightly and not nearly enough to meet theincreased cost of living. Politically powerful trade unions prevented thepassage of even more drastic reform measures. Plans in 1991 to increase theprice of electricity, heating oil and coal by nearly 400 percent and rent by 300percent were delayed until 1992 and 1993.

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<span Times New Roman",«serif»">Foreign Trade and Investment

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<span Times New Roman",«serif»">Afteran initial currency devaluation of nearly 50 percent, the government adopted anadjusted exchange rate connected to a “basket” of convertible hard currencies.Internal convertibility of hard currencies was established in 1991. These twomeasures combined to foster trade and investment. Initially, the CSFR set a 20percent surcharge on imports coupled with a 5 percent tariff. These obstaclessoon ended as major provisions were passed to more actively encourage trade andinvestment. Initial steps toward private property rights and the disseminationof publicly owned lands further enhanced the investment environment.

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<span Times New Roman",«serif»">Privatization

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<span Times New Roman",«serif»">Privatizationis by far the most critical and complicated development the CSFR had toaddress. Speed was critical. The ‘default mechanism’ ensured that currentmanagers and persons of powers would assume control and create their own jointventure agreements with foreign entities.

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<span Times New Roman",«serif»">Statefirms that were nearly completely vertically integrated needed to bedesegregated by form and function. And the process had to be done well, forflailing industries would simply increase state expenditures. Failures did notdecrease expenditures in compliance with the transitional reform strategy. TheCSFR privatization plan was threefold. Small-scale privatization was theeasiest. Retail stores, restaurants and small service or industrial workshopswere sold to the highest bidders in weekly public auctions. Where no CSFRbuyers were found, a second round of auctions allowed foreigners to bid.

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<span Times New Roman",«serif»">Propertyrestitution was more difficult. The government needed to equitably redistributeland that had been taken nearly 40 years earlier. This is a difficult andinvolved issue. CSFR citizens are allowed to claim land taken from them, thoughthe burden of proof is on them. Where no proof exists, special arrangements canbe made for state assistance. In areas of conflict, the issue will be broughtto the courts. A large part of the country was not in private hands beforeSoviet rule. Some of this land can be used as an offering to parties wheredisputes over ownership exist. Also, lands that have been improved (shops,developments, houses, etc.) are sold at specially determined rates to theformer property owners. Prices and possible alternative compensation for thoseowners who do not wish to purchase these ‘improvements’ are again settled by aspecial court arrangement.

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<span Times New Roman",«serif»">Large-scaleprivatization progressed swiftly. Some state-owned firms were sold outright toprivate interests while others remained under indirect state control untilbuyers were found, legal or economic concerns settled, or parliamentary debateresolved.

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<span Times New Roman",«serif»">Social Policy

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<span Times New Roman",«serif»">Thestrong tradition of labor unions and their political strength proved crucial tosocial security reforms throughout CEE. The CSFR was no exception. Labor unionswere instrumental in keeping CSFR unemployment at very low levels and socialsafety net benefits quite high. Essentially the state guaranteed incomes at aminimal level to meet the ‘cost of living’ for the unemployed or theunder-employed. Pensioners and parents of children received benefits adequatelycovering bare essentials. Further benefits for health care were distributed atthe local level as the health system still remained under state control.

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<span Times New Roman",«serif»">Problemsof Transitional Monetary Policy and the Financial Sector

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<span Times New Roman",«serif»">Sincethe introduction of reforms, monetary policy played a key role in the economicstability of the Czech Republic throughout the transition. Inflation remainedsurprisingly low (though relatively high in 1989 and 1990), exchange rates wererelatively stable (after initial fluctuations), and external reserves stayedstrong throughout the period (spurred by unusual and unexpected outsideinterest in the Czech Republic as the first reformer to prove its success).

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<span Times New Roman",«serif»">Whatis perhaps most impressive are the obstacles Czech officials overcame indeveloping an effective monetary policy. First, the entire CMEA trading blockwas virtually dismantled. Reform and transition would be difficult even withstable trading partners. In the CMEA, all of the countries were experimentingwith and adjusting prices, exchange rates and policies. It was very difficultto set monetary conditions correctly, in real or absolute terms.

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<span Times New Roman",«serif»">Second,within just a few short years, the CSFR itself broke apart for economic andpolitical reasons. This was largely unexpected and proved difficult in thepolicy making arena. As the break-up drew near, officials had a difficult timedetermining which policies should be enacted based upon which of many scenariosmight occur in the CSFR.

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<span Times New Roman",«serif»">Third,after finally establishing the terms of the CSFR split and negotiating aseemingly effective customs and monetary union between the two new countries,the monetary union failed miserably. Within a few months, the union causedsignificant drains on much needed foreign reserves in both countries and had tobe abandoned.

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<span Times New Roman",«serif»">Finally,the Czech tax system had to be completely overhauled. Additionally, the bankingsystem needed massive reform. Large spreads in interest rates were common andoverall the banks were simply reluctant to lend on any long term basis, a majorimpediment to domestic investment and growth.

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<span Times New Roman",«serif»"> All of these massive changes occurred withinjust a few years. Throughout these developments, monetary policy remainedextremely tight. At the onset of the reform period, it was at its tightest,with a minor break late in 1991, once the political economic dust had settled.Otherwise, the next monetary reprieve didn’t occur until the second half of1993.  By 1994, broad money grew at 30percent compared with growth of 15 percent a year earlier. More important thandoubling growth figures is that the economy was able to withstand this growthby 1994!

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<span Times New Roman",«serif»">Interestrates were high throughout the period, and continue to remain high by mostwestern standards (over 9 percent). Interest rates were not directly controlledbut were subject to central bank reserve requirements and discount rateannouncements. Liquidity was further controlled through regular auctions oftreasury bills.

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<span Times New Roman",«serif»">Bankreform focused primarily on establishing the legal framework for transactionsbetween the central bank and newly established commercial banks. Weaknesses stillremain in reporting and accounting and the reluctancy for banks to lend.Several commercial banks have had to come back under government control toprevent major economic problems.

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<span Times New Roman",«serif»">MacroEconomic Stability 1992 — present

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<span Times New Roman",«serif»">By1992, the CSFR began to show significant signs of success. Though they were infact more disadvantaged than many other countries in the CEE, they fared well.Their export market consisted almost entirely of former members of the Councilfor Mutual Economic Assistance (CMEA) who were in the same transitionalposition as the CSFR, impeding efficient trade. Fortunately, inflation on thewhole in the CSFR remained remarkably low when compared to the rest of theCMEA, as did external debt. Inflation did jump just before the CSFR breakupinto the Czech and Slovak Republics. Experts suggest this occurred in part dueto the fear of instability during the breakup and in part due to an anticipatedVAT. As expected, in 1993 (in the Czech Republic), inflation rose again afterintroduction of the VAT.

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<span Times New Roman",«serif»">In1993, free from its less advantaged Slovak counterpart, the Czech Republicbetter targeted its economic recovery plan. The plan encompassed three mainelements:

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<span Times New Roman",«serif»">1)  A balanced state budget that encompassedsweeping tax reform;

<span Times New Roman",«serif»">2)A tight monetary policy to reduce the inflation caused by VAT and other lessereffects (which             also improvedits external position for trade and investment); and

<span Times New Roman",«serif»">3)  Moderate wage increases (adjusted toinflation) and a stable exchange rate.

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<span Times New Roman",«serif»">Thisreform policy was backed by an IMF “stand by” arrangement as a precautionarymeasure. The IMF would assist if the Czech Republic needed financialassistance. This happened once early in 1993 and Czech officials repaid theloan before it came due (much to the delight of the IMF).

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<span Times New Roman",«serif»">Unemploymentremained remarkably low in the Czech Republic at 3 percent in 1993, whilePoland’s figures (another major success story in CEE) still remain in double digits. Low, virtually non-existentunemployment certainly contributes to greater political and popular acceptanceof the above fiscal and monetary policies.

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<span Times New Roman",«serif»">Manyattribute a major setback in the Polish “Shock Therapy” reform efforts to thepolitical demands of the labor unions. The Polish President, Lech Walesa,understood the need to keep wages low to implement the reform. But he fearedfor his political power and caved in to labor pressures by granting wageincreases. By doing so he nearly destroyed the entire economic reform process.He claimed that had he not, the entire political reform process would havecrumbled.

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<span Times New Roman",«serif»">Czechofficials didn’t face this obstacle as unemployment throughout the transitionremained low. The political reform process was slightly segregated from theeconomic reform process. The small Czech population (roughly 10 million) waseasier to organize than Poland’s 40 million. Regional differences were less andpolitical factions less pronounced. Regardless, by 1993, the Czech Republic hada very cohesive popular political support base which facilitated the economic reforms.

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<span Times New Roman",«serif»">By1994, foreign trade increased substantially, with much of the growth occurringbetween EU member nations. Tourism in Prague, now a “must see” on any Europeanvacation, contributed to increased trade to maintain a strong balance ofpayments and a surplus in the current account. Though FDI by 1994 had decreased(after very high initial investments in 1992 and 1993), the

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<span Times New Roman",«serif»">capitalaccount maintained high inputs due to the rise in borrowing of Czech firms(which proved even better for Czech long term economic success).

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<span Times New Roman",«serif»">GDPbegan to rise slightly after a period of decline from 1991-1993 of nearly 20percent. Privatization entered its second round in 1994 for enterprises beingprivatized through voucher programs. The first wave of privatization is considereda remarkable success (a model to be used farther east). As this first waveended in 1993, the Prague stock exchange began trading and the banking systemwent though increased and improved reforms. The Czech Republic was a leader inthe CEE in trade and investment. Economic reform efforts, coupled with theabove mentioned political support, put the Czechs at the forefront of CEEsuccess.

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<span Times New Roman",«serif»">Industry

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<span Times New Roman",«serif»">Industrialoutput by 1993 declined by nearly 21 percent compared with 1991 figures. Thiscan partially be explained by increases in the service sector, as investmentsoared in service sectors and dropped dramatically in the industrial sector.Also, the industrial sector was the most inefficient sector in the formercentrally planned economy and much of those inefficiencies were corrected withthe introduction of market reform. Most industries produced less as consumptiondropped. And they did so more efficiently as output based economic plans wereno longer used.

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<span Times New Roman",«serif»">Itis significant to note that the Czech Republic does not have an industrialpolicy. They feel the state does not have enough information or resources andthus it is most efficient to allow the private sector complete control.Government could assist with exemptions and subventions, but the market shoulddetermine winners and losers.

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<span Times New Roman",«serif»">However,the Czech government continued, through 1994, to bail out state-ownedenterprises, mostly due to their economic (employment) and political leverage.In essence, this hurts struggling smaller, private, firms that are unable tocompete with giants, let alone subsidized giants. These large industrialsubsidies are all but gone in most industries today, however they still existfor politically sensitive or economically vital industries. In some cases thegovernment reluctantly returned to subsidies as not all of the initialprivatization efforts proved successful. Some large enterprises were noteffectively dismantled and the resulting giant enterprises were simply toolarge and inefficient for the new market economy. It took several years, insome cases, to learn this lesson.

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<span Times New Roman",«serif»">Prices

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<span Times New Roman",«serif»">Consumerprice inflation by 1993, after the initial shocks of the VAT, stabilized at 18percent. Experts estimate the VAT added 7 percent to inflation during 1993 andan additional 2 percent can be attributed to government administered priceregulations. Price regulations remained mostly in the utilities sector.Adjustments from 1994-1995 increased prices in several key areas including gas,oil, transportation, medicine and telecommunication tariffs.

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<span Times New Roman",«serif»">Wages

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<span Times New Roman",«serif»">Wagerestraints through a “tax based income policy” was an important feature of theCSFR. Wage restraints ended in 1993, but had to be brought back by the end ofthe year by the Czech government. The rational behind bringing the restraintsback was that market forces were not yet adequate to control wage increases.Wage increases had to remain close to increases in consumer prices to avoidinflationary difficulties. Therefore, as late as 1995, up to 100 percent taxrates were applied to wage increases over allowable limits, effectively keepingwages at desired rates.

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<span Times New Roman",«serif»">Monetary Policy: 1993

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<span Times New Roman",«serif»">By1993, Czech monetary policy began to stabilize in conjunction with politicaland economic indications of success. The basic aims of monetary policy at thispoint were simply to maintain internal and external currency stability.Officials kept the Czech crown pegged to stable European currencies andprevented inflation from rising above 10 percent. In a somewhat disguisedblessing, foreign capital flowed into the Czech Republic at high rates in 1994causing officials to raise reserve requirements from 9 to 12 percent to insureinflationary stability. The banking system, though still flawed, was able towithstand the pressures. The economy certainly welcomed the increased capital.

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<span Times New Roman",«serif»">By1993 and even more so by 1994, monetary policy was less of a political tool inthe reform process. Stability in many respects had been achieved. The nature offurther reform and continued stability relied almost entirely upon fiscaldecision-making. To fully understand and appreciate the political economics ofreform from 1993 onward, both fiscal and monetary, an examination of the Czechbudget is helpful. Defining the role of the state in the new market orientedeconomy is critical. Two main issues must be examined, the resources andinformational capabilities of the state. Both are limited and both are notindependently effective. The budget and the political issues surrounding itspassage are important in understanding the Czech approach to stability now thatmuch of the transition has been rather successfully completed.

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<span Times New Roman",«serif»">Intergovernmental Financial Relations

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<span Times New Roman",«serif»">Beforethe budget analysis, a brief overview of intergovernmental financial relationsmay be helpful.  The Department ofFinance makes budgetary estimates for the Ministry of Economy. They regulatespending and essentially decide which organizations and institutions receivethe much sought after government subsidies. They are also responsible forgovernment accounting, financial management and regulation of wages. TheDepartment of Finance is classified under the Ministry’s “Administration andFinance” section.

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<span Times New Roman",«serif»">TheForeign Economic Relations Department, the European Affairs Department and theEconomic and Social Policy Department are all included under the Ministry’s“Economic Policy.” They all report to the Ministry and are essentially chargedwith the difficult task of improving and encouraging economic development bothhome and abroad. The Ministry also supports a wide variety of businessdevelopment departments; Small Business, Business Promotions, Tourism, etc.Though their interactions, cooperation and communication are limited, they allfollow somewhat coordinated general policy initiatives of the Ministry.

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<span Times New Roman",«serif»">The1993 Budget

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<span Times New Roman",«serif»">Thefollowing budget summary is based on the 1993 budget because that was the firstbudget elaborated as the independent Czech Republic. Before the transition,Czech had one of the more state dominated economies in the CEE. The state controlledalmost all economic activity with government expenditures reaching as high as65 percent of GDP in 1989.

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<span Times New Roman",«serif»">The1993 budget focused on a more developed private sector. The budget isfundamentally influenced by tax reform which will be discussed in the followingchapter.

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<span Times New Roman",«serif»">Revenues

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<span Times New Roman",«serif»">The1993 budget is based on three main revenues: the value added and excise taxes(36.9 percent), income tax from legal entities (25 percent) and socialinsurance (28.5 percent). The new tax system (and total restructuring of publicfinance to benefit local budgets) reshaped the revenue system and forced budgetdevelopers to complete more in-depth estimates of revenue flows. They wereforced to make more accurate revenue predictions.

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<span Times New Roman",«serif»">Totalrevenues in 1993 reached 419 billion crowns (26 Kc per $1USD), of which 343billion went to the state, 41 billion to local districts and 35 billion tohealth insurance. Revenue growth was 13.4 percent and local budgets rose 35.2percent in 1993

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<span Times New Roman",«serif»">Expenditures

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<span Times New Roman",«serif»">Alarge part of the expenditures for the Republic encompassed transfers to thepeople. The largest programs are pensions, family allowances and sicknessinsurance. Social transfers were increased in 1993 to create reserves forexpected increases in unemployment. Expenditures on branches of government likehealth care, for example, increased by 50 percent in 1993, simply responding todemand. A move to create the National Health Fund was instituted out of arevamped payroll tax and transfers from the central budget to care for the non-workingpublic. The health fund reduced local spending on health care thereby reducinglocal transfers. Expenditures on education and culture also increased by athird over 1992 levels. These additional expenditures were partially offset bya new wage tax targeting employers and a combination of the following:

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<span Times New Roman",«serif»">1)Savings in compensatory income support and sickness benefits by a new meanstested model;

<span Times New Roman",«serif»">2)A freeze on subsidies to agriculture, transportation and mining; and

<span Times New Roman",«serif»">3)Large cutbacks in real investment, including a public housing plan begun in1992.

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<span Times New Roman",«serif»">Transfersfrom federal accounts to the Czech government totaled 90 billion crowns, onefifth connected with expiring credits granted abroad and debts owed by theformer Czechoslovakian and CSFR government. Debt service is a major componentof the 1993 budget. The debt reached 115 billion crowns by 1993. 40 billioncrowns were transferred liabilities of the Czechoslovakian Commercial Bank fromoperations of the so-called ‘central foreign currency resources’. Totalexpenditures on debt service reached 23 billion crowns in 1993. Due to its sizeand proportion of the entire budget, some of those payments were deferred.Eight billion crowns, the total Czech share of the 1992 debt, was financedthrough state bonds and money from the national property fund. Old debtprincipals were deferred for a year until 1994.

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<span Times New Roman",«serif»">TaxReform

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<span Times New Roman",«serif»">Themain elements of the systems prior to 1993 included taxes on enterprisesurpluses, payroll and turnover. Wage or income taxes existed but were largelyinsignificant. The main function of the taxes were to transfer enterprisesurpluses to the state budget and to sustain the administratively determinedprice structures. Tax incentives played no role in the economic system.

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<span Times New Roman",«serif»">Sweepingtax reforms dominated the budget for the 1993 year. They included new indirect,direct and property taxes and modification to the payroll tax including a shiftin the tax burden from corporate incomes to wage incomes. From 1992 to 1994,relative to GDP, the share of wage based taxes rose while the share ofcorporate income tax fell and indirect taxes remained unchanged.

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<span Times New Roman",«serif»">Thesenew direct taxes eliminated earlier distinctions for taxation of businessesbased on forms of ownership and employment status. The new system of VAT andexcise taxes expanded the coverage of indirect taxes to services. It alsomitigated the falling implicit rate in the earlier turnover tax and condensedthe range of standard tax rates.

<span Times New Roman",«serif»">Thereforms promoted investment by lowering the cost of capital to businesses. Thisreform featured a significant reduction in the statutory rate of taxation,standardization and acceleration of allowed depreciation and a 10 percentcredit on investment in selected equipment which reduced the dispersion in effectivetaxes on investment activities. This is how the cost of capital was lowered.The tax allowed the rate of taxation on enterprise profits to drop from 55 to45 percent.

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<span Times New Roman",«serif»">Apersonal income tax was also introduced to replace the previous network (maze?)of taxes on wages of large enterprises, the incomes of artists and authors, andthe various forms of income derived from the emerging private sector. The newtax had all wage and self employed income taxes on a progressive scale withmarginal rates from 15 to 47 percent, standard deductions and additionaldeductions allowed for social insurance contributions, children, transportationto work, etc. Interest, dividends and capital gains were subjected to 15 to 25percent, encouraging investment only slightly. Social security and health taxeson wages of 36 percent from the employer and 13.5 percent employee replaced theold payroll tax of differential rates. Net taxes on gifts, inheritance andmotor vehicles were implemented and the import surcharge was eliminated.Although the system went through amazing changes as outlined above, much ofthese changes were to no avail.

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<span Times New Roman",«serif»">Tax evasion and avoidance

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<span Times New Roman",«serif»">Theproblem with this system is that these any tax structures are still relativelyeasy to get around if one is willing to operate in the shadows. In the firstquarter of 1994, the (23% rate) VAT yield was 30 percent below initialexpectations. The corporate and VAT combined barely yield 80 percent oforiginal estimations (one suspects that estimate is high...). Overall, Czechshadow economic activity, though low, is still significant. Estimate suggestanywhere between 15 and 25 percent of the economy works in the shadows.

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<span Times New Roman",«serif»">Policeclaim it is almost impossible to investigate and prosecute tax violations. Thecriminal codes do not allow for them to effectively investigate suchactivities, and no other effective mechanisms yet exist. Change in codes andregulations are too complex and far too frequent. The Ministry of Financeclaims that between 1993 and 1994 there was a change in the tax codes at leastevery 4 days. An example is the modification in 1994 of the corporate incometax from 45 percent to 42 percent, a reduction in the highest marginal personalincome tax rates from 47 to 44, and an increase in allowable expenses. Thesesimple changes required major modification in software and procedure for theMinistry’s clerks to keep up with the changes. The Ministry coordinates 12,000employees in hundreds of local offices that constantly need to register andupdate databases with the latest tax changes.

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<span Times New Roman",«serif»">Dueto all the confusion, police estimate they can only catch roughly 10 percent oftax related crimes. A 1994 law adds to the difficulties by allowing businessesto keep their records secret. Employees can be sworn to secrecy regardingcertain administrative procedures in firms, like tax issues. The criminal codestates that banks can only be forced to reveal tax information after initial evidence from a formalinvestigation. With no information to go on, investigations rarely reach formalstatus. Additionally, a great deal of business transactions are still conductedon cash basis due to the ease and tradition. This opens very easy avenues fortax evasion and avoidance as cash is barely trackable.

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<span Times New Roman",«serif»">Manyof these tax reforms will become obsolete as the Czech Republic bids for EUmembership. Czech will have to compete with EU tax codes, one example entailssmall breweries. Parliament passed a law on EU guidelines that allows a largerconsumption tax on alcoholic beverages to be granted only to small, independentbreweries. Breweries producing less than 200,000 hectoliters per year will beeligible for consumer tax cuts of up to 50 percent. The law sets a progressiverate up to the minimum margin limit.

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<span Times New Roman",«serif»">Thoughit may seem straight forward, experts are unsure whether this brings the taxcode closer to EU standards or drives them farther away. Are they protectingsmall business, providing tax shelters to favored companies, or preparing forentrance into the EU? Currently no one knows. The tax reform process is slow.Though much has been accomplished on the books, no one is really sure what thefinal outcomes will be. One suspects, as with many recent development in theCzech Republic, change will gravitate toward EU standards wherever possible. Asthe potential for EU membership draws near, one can expect many of theseseemingly confusing tax issues to be clarified immediately as the CzechRepublic attempts to do business with one of the most developed and powerfuleconomic forces in the world.

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<span Times New Roman",«serif»">CurrentPolitical Economic Considerations: 1996

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<span Times New Roman",«serif»">Perhapsthe most exciting chapter of the Czech political and economic transition isstill to come. In November 1995, the Czech Republic signed a membershipagreement with the Organization for Economic Cooperation and Development. TheCzech Republic is the first CEE country to enter the ‘rich boys club.’ TheCzechs furthered their status by recently declaring that they were nowconsidering themselves a ‘developed’ economy. Though perhaps a bit prematureand self-serving, OECD membership certainly entitles them to make such a claim.Many more economic issues still need to be addressed however, before transitioncan truly be considered complete.

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<span Times New Roman",«serif»">TheCzech Republic should reach growth levels of 7 percent this year. That growthneeds to be achieved for the next ten years to simply double their income, andeven then they will remain far behind their western neighbors. Current GDP inthe Czech Republic is only about $3500, which according to the World Bank,ranks them near Malaysia. Fortunately, unemployment is practically non-existentat about 3.2 percent, the lowest rate in all of Europe. And the Czech tradedeficit runs about 5-7 percent of GDP. Some experts suggest that rapidappreciation of the crown in recent times is to blame.

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<span Times New Roman",«serif»">Furthermore,wages are a problem. Though they remain low, they are rising very quickly evenwith governmental controls. To stay competitive Czech business must increaseproductivity. This tends to be very difficult without cheaper capital. Thoughtax designs are in place to ‘cheapen’ capital, it is not immediate nor aseffective as necessary. Finally, average savings rates throughout the CEE areabout 18 percent, which is just half of the very successful East Asian Tigers(and two to three times that of developed economies). Czech needs to decide howfast and how much more they will grow in the near future.  Regardless of some of these more negativeindicators, Czech has made a significant transition. The numbers above simplyindicate that their journey is not yet complete.

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<span Times New Roman",«serif»">OECDmembership is just a small step toward the Czech’s ultimate goal of EUmembership. The Czech Republic is revamping their policies in order to complywherever possible to EU regulations, guidelines and policies in order tofacilitate their membership bid. Some of these changes include a decrease inthe number of income tax brackets, decreases in the VAT from 22 percent tobelow 20, and the end to all tariffs with EU countries by 1997 (excluding“sensitive products”). These changes are helpful to the Czech economy butslightly premature. Experts claim they are done solely to impress the EUapplication reviewers.

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<span Times New Roman",«serif»">The EU and NATO

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<span Times New Roman",«serif»">EUmembership is inextricably tied to NATO membership. It is important tounderstand the similarities and differences between these two organizations,especially as they concern the Czech Republic and the continuation orcompletion of the transition. The transition is both economic and political andtherefore should be examined in terms of both EU and NATO powers. The EU andNATO are arguably the most advance powers economically and politically in theworld. NATO includes the US, while the EU, of course does not. It isinteresting, then, that many claim EU membership is virtually predicated onNATO membership. This creates an interesting foreign policy situation for theCzechs. It is not contradictory, but perhaps a bit dispersed in terms of goalsand objectives.

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<span Times New Roman",«serif»">Originally,NATO was created as a response to the communist threat. Recent discussionsbetween NATO and Russia suggest thisthreat no longer exists. So what is NATO’s role today? For the time being, NATOhas a very powerful, though perhaps indirect role in the continuation of EUexpansion. EU membership would bring long term economic and political stabilityto the CEE (a NATO objective as well). NATO must continue to work inassociation with the EU to bring stability throughout the region to insure thatthe “communist threat” is indeed diffused indefinitely. It is not out of thequestion that massive economic and political upheaval in the FSU could resultin some nationalist power rising up and posing a serious threat to Europeaninterests. It is in this sense that NATO and EU have a very common, and perhapsfinal goal.

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<span Times New Roman",«serif»">Recentlywhile in Detroit campaigning, President Clinton set a date for NATO expansion.He did not specifically mention which countries he was referring to, however,he did say that ‘their’ inclusion into NATO is expected by 1999 (by ‘their’most experts assume, Poland, Czech and Hungary). If the Czech Republic becomesa NATO member by the year 2000, EU membership could come as early as 2003 or2004.

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<span Times New Roman",«serif»">Therefore,politically, the Czech Republic needs to satisfy the goals of both EU and NATO.Economically, they need to address the EU a bit more thoroughly then the US asthe EU will be their main trading partner, but the US will remain a powerfulally, investor and trade partner. Although membership in either of theseprestigious world powers would be remarkable for a country just a decade aftersocialist rule, the Czechs need to proceed carefully.

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<span Times New Roman",«serif»">Injoining the EU, the Czech Republic will face a somewhat unpleasant reality.After years of being the political and economic leader of the transitional WarsawPact countries, they would be immediately subverted to the lowest status in EUmember countries, lower than Portugal. Though this would enable them to receiveEU assistance, both technical and financial, it would also require them toadapt possibly painful domestic policies involving increased environmentalstandards, increased costs and drastically high competition in terms of qualityand markets. It would also find them having to compete with Hungary and perhapsthe most important country from the EU perspective, Poland. If Czech is forcedto split benefits and favors with Poland and its huge 40 million personmarkets, they will indeed have their work cut out for them. Another majorproblem are the EU legal requirements for issues like consumer protection.

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<span Times New Roman",«serif»">Thebenefits to EU membership, of course are many. The Czech Republic currentlymeets four of the five requirements for EU membership under the recentMaastricht Treaty. The Czechs reached EU membership levels for currencystability, interest rates, debt as a percentage of GDP and public expendituresas a GDP percentage. They still fall short on the inflation determinant. 1996inflation is still at 9.1 percent. This would have to be lowered to 3.8 percentto conform to EU standards, a daunting task. The country will continue toreduce taxes wherever possible to stimulate the economy, but this isincreasingly difficult as the Czechs are now in a relatively comfortableposition where increased reductions in taxes would seriously hurt socialbenefits.

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<span Times New Roman",«serif»">TheEU is currently in the process of implementing their monetary union. Thoughthis is a fantastic goal for the Czech Republic, they are not yet in a positionto completely abandon their own monetary policy and rely entirely on fiscalpolicy. Even though they could not be permitted to join the EMU upon their EUmembership (it has much stricter requirements than general membership), itwould be strange for the Czech Republic to enter the EU knowing that they are afar cry from EMU membership. This is not to say it is inadvisable. The Czechsmust join the EU at almost any cost. It is simply a concern worthy of mention.As the EU expands, the core states will be able to continue a favored status orelite power center, revolving around EMU involvement and not simply EUmembership.  This could be an importantstrategic leveraging issue for the core states (and a major point of contentionfor the Czech Republic as a new member).

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<span Times New Roman",«serif»">Thereare many concerns and areas for excitement both politically and economicallyfor the Czech Republic. They are in a very good position to come out far aheadof anyone’s expectations. Perhaps even their own. EU and NATO membership willboth be achieved within the next 5-10 years, no matter what difficulties arefaced along the way.

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<span Times New Roman",«serif»">Injust seven years, the Czech Republic transformed itself from a socialist,Soviet-controlled industrial-based economy to an increasingly service orientedOECD member and number one contender for the next wave of EU and NATO expansionin the region.

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<span Times New Roman",«serif»">TheCzech Republic’s success can be largely attributed to its small size andpopulation and its relative ethnic and religious homogeneity. More important,however, is the Czech determination and persistence in meeting the challengesof transition. The transition that began in 1989 entailed a great manyhardships. Not all of the CEE countries made it through the transition sosuccessfully. The Czechs succeeded because they were able to stick to theirplan when most other countries were forced to abandon for political reasons andpopular discontent.

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<span Times New Roman",«serif»">Whenthe reform package became difficult, the Czechs didn’t revolt, they didn’tstrike and they didn’t complain. They showed remarkable foresight in takingearly steps to revamp their tax system and banks, keep inflation andunemployment and wage increases low, and keep their currency at stable levels.These were not all easily accomplished. They survived the difficult times andcame out on top of the CEE as the only country to make it through the transitionvirtually unscathed. This smooth transition earned their revolt the nickname,“the Velvet Revolution.”

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<span Times New Roman",«serif»">TheCzech Republic is now poised to embark upon a greater challenge, that ofbecoming one of the world’s power core with EU and NATO membership. It willentail further difficulties, but compared with the accomplishments of the pastand their ability to overcome Soviet oppression and transition from centralplanning, there is little doubt that the Czech Republic will succeed in theirfinal step toward complete transition from the USSR to the EU.

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<span Times New Roman",«serif»">References

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<span Times New Roman",«serif»">Economist. Country Profile: Czech Republic. The Economist, London.1996.

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<span Times New Roman",«serif»">Economist. Saving Graces. The Economist November 9, 1996.

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<span Times New Roman",«serif»">Freiden Jeffrey. International Political Economy 3rd Edition.St. Martins Press, NY. 1995, Section IV.

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<span Times New Roman",«serif»">Heady, Christopher. Tax Reform and Economic Transition in theCzech Republic. Fiscal Studies, Feb. 1994.

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<span Times New Roman",«serif»">Heady, Christopher. Tax and Benefit Reform in the Czech andSlovak Republics. Center for Economics and Policy Research, DiscussionPaper Series No. 1151. March 1995.

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<span Times New Roman",«serif»">Klaus, Vaclav. The Ten Commandments of Systemic Reform.Occasional Paper 43, Group of Thirty, Washington, DC, 1993.

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<span Times New Roman",«serif»">Munk, Eva. Trouble Brews Over Tax Break. The Prague Post, January 18, 1995.

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<span Times New Roman",«serif»">Munk, Eva. 25 Year Old Sports Car Picking Up Speed. The Prague Post, January18, 1995.

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<span Times New Roman",«serif»">OECD Economic Surveys. Czech Republic. OECD, Paris, 1996.

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<span Times New Roman",«serif»">State Budgets and the 1993 FiscalPolicy. CTK Business News. May 4, 1993.

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<span Times New Roman",«serif»">Svejnar, Jan. The Czech Republic and Economic Transitionin Eastern Euro

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