Output growth will slow down on account of labour supply constraints, but will remain above the Czech Republic’s 3% potential growth rate in 2018 and 2019. Increasing wages and employment will keep household consumption and internal demand high. Private investment will remain strong thanks to favourable credit conditions. Exports will stay high. Growing wages and strong household consumption are expected to keep annual inflation slightly above the 2% Central Bank’s target in 2018 (Figure A). The Czech National Bank (CNB) has started raising its policy interest rate in August 2017 to stabilise inflation at its target level over a medium-term horizon.

Risks stem equally from internal and external factors. Labour shortages could hamper growth. At around 2.4%, the unemployment rate is hitting a floor. Also, there are signs of overheating as the economy is growing above potential, therefore the rise in inflation and wages may lead to a normalisation of interest rates more rapidly than anticipated. This may create a gap with the rates in the euro area, and therefore further appreciations of the exchange rate. On the external side, the Czech economy is particularly exposed to trade disruptions. Exports in terms of value added contribute to around 45% of GDP. Housing market developments are of rising concern. The loans for house purchase have accelerated in the last two years and are reaching high levels. Price growth in the housing sector was the highest among EU countries in 2017. Therefore, household indebtedness is increasing and banks are exposed to a reversal in household income growth.

The Czech Republic’s growth model of low wage and high reliance on FDI has been successful in increasing GDP per capita but convergence towards OECD living standards is slow (Figure B). Even though wages have accelerated recently, their level remains low in international comparison. Low labour shares are influenced by the gap between GDP per capita and gross national income, which is among the highest in OECD countries (Figure C). Foreign direct investments have benefited the economy through its increasing participation in global value chains. However, there is room to better share the benefits of growth to support inclusive development.

Better skilling is necessary to increase labour productivity and innovation to maintain the price competitiveness and to favour upgrading in value chains. The Czech labour market is shifting towards higher-skilled employment. Since the 1990s, the service sector has expanded and manufacturing has become tightly integrated into global value chains; employment shifted from medium-skilled towards high-skilled jobs (Figure D). Sectors such as manufacturing, IT and business services are expected to continue expanding. Providing workers with the right skill set and training to adapt to a changing environment will increase the resilience towards automation. For instance, the demand for a highly skilled labour force, especially the technically educated one, will increase.

Preparing the labour market for technological change is high on the political agenda. Policy actions that foster productivity and innovation as highlighted in the last survey (OECD, 2016[1]) should be accelerated.

The skill mismatch is still important. Graduates are lacking in the fields of mathematics, science, statistics, and health and welfare studies. Current developments suggest that the stock of skills in the labour force may not suffice to address emerging shortages in certain sectors, such as health and IT. Providing effective, up-to-date and tailored information, advice and guidance are crucial to address emerging skills gaps. Vocational education should be further developed to play a significant role in overcoming skill mismatch through the involvement of employers in the design of curricula and in developing internships.

Increasing labour force participation of women with young children would limit labour shortages.

Available skills of women are not fully utilised in the labour market. Female graduates form the majority in mathematics and natural sciences (59.6%) and health and welfare studies (83.5%). These skills are often not available to the labour market as one out of three women aged 25 to 34 that graduated in a STEM (Science, Technology, Engineering, and Mathematics) field with a tertiary degree reported being inactive in 2016. Despite recent efforts, female labour force participation tends to fall with childbirth, contributing to gender inequality.

The long break in young mothers’ employment is partly due to long parental leave rules. Spending on maternity and parental leave is the highest among OECD countries, reflecting a preference for home care over formal childcare. Conditional on the expansion of affordable and quality childcare, the maximum duration of parental leave should be reduced. Child care facilities should be further developed by redirecting funds from cash transfers and parental leave. Increasing the flexibility of jobs by better enforcement of rights for part-time work, flexible teleworking arrangements and shared jobs can support the re-entering of female labour into the market.

Ageing will weigh on public finances. The Czech population is ageing more rapidly than in most European countries; the dependency ratio will rise from 28.1% in 2016 to 49.7% in 2070 with a peak at 56.1% in 2058.

Pension spending as share of GDP should be stable up to 2030, but will then rise steeply by more than 2.5 percentage points of GDP over 20 years. In 2017, the Czech government withdrew the perpetual increasing of the statutory retirement age and instead put a ceiling at the age of 65. However, the retirement age ceiling is worsening the effect of pension spending on public finances (Table B).

Also, the recent changes in the pension indexation rule are pushing up pension spending by approximately 0.3 percentage points over the projection horizon.

Health care and long-term care expenditures are also projected to rise in the upcoming decades. In comparison with other countries, the Czech Republic is going to face one of the biggest spending increases as share of GDP.

Financing of pensions, health care and long-term care currently requires more than 43% of the government budget. Assuming that the size of the budget in relation to GDP remains constant (at around 35%), the projected social expenditures in 2060 would take more than 75% of the budget (Table B). As in many OECD countries, the Czech Republic could consider linking retirement age tightly with life expectancy. Improving the efficiency of health care delivery could help cushion the impact of ageing on health spending.

The Czech health care system performs well along several dimensions but can be improved. Life expectancy rose by 2.6 years to 78.7 years between 2005 and 2015, just below the average of 80.6 years in the OECD. Spending on health care at 7.2% of GDP in 2016 is relatively low compared with OECD peers. However use of health services is among the highest in the OECD (Figure E).

Indicators for the quality of care and outcome performance are missing in the management and regulation of the health care system. Moreover, the health system is heavily regulated by the government through the Reimbursement Decree which sets most prices and volume limitations of activities of health providers. Having a genuine negotiation process between health care providers and insurance funds would help reduce some of the inefficiencies in service delivery.

Overall, there is a need to rebalance the system towards more competition between health providers and insurance funds and private funding to improve quality, efficiency and reduce the reliance on public funding.

The delivery of health care could be improved through better management of hospitals; and putting more incentives in the remuneration scheme of health providers. In hospitals, optimising outpatient care and day surgery should reduce the length of stay and lower spending. The new diagnostic related group (DRG) system should be used for setting the prices of health services but also to incentivise or reform underperforming hospitals. The DRG system should be based on a group of best-performing hospitals.

The efficiency of the delivery of primary care is suffering from lack of co-ordination. Patients’ ability to access specialist care without a prior general practitioner (GP) consultation, poorly defined mutual responsibilities of outpatient specialists and GPs and current payment systems mean that primary care’s potential to lead for instance chronic disease management is not being fulfilled. GPs should be entrusted with a greater gate-keeping and co-ordination role to ensure that patients are better directed to the most appropriate place for their treatments, which also allows diminishing the overuse of hospital facilities.

Ageing will account for roughly half of the future rise in health-care spending and pushes for broadening the financing of the health system. While total health spending is low, the share of public spending in total spending at 82.4% is among the highest in the OECD. The heavy reliance on public financing is a weakness in the context of an ageing society. Over the last 15 years, voluntary and out-of-pocket payments increased, reaching 17.6% of health care expenditure in 2016, remaining below the OECD average of about 20%. The main sources of revenue for the health insurance system are compulsory contributions that are levied primarily on wages. To increase revenues and allow more spending on health care in the future, the tax base needs to be broadened. Within the current scheme, contributions by the self-employed could be increased gradually. More generally, all kinds of income sources could be taxed to contribute to social security financing. Moreover, introducing smart cost sharing can steer patients’ behaviour and promote cost-efficient consumption of health care.