The recovery will be slow. GDP will grow modestly in 2021. Continued restrictions in some sectors, low sentiment and elevated uncertainty will hold back demand, notably investment. Withdrawal, albeit gradual, of government income and liquidity support will give way to increased bankruptcies and unemployment. Inflation will moderate towards the 2% target level in 2021. Slack in the labour market and slower wage growth will hinder growth in private consumption. In 2022, economic growth is expected to pick up slightly, on the back of sustained rises in sentiment and domestic demand, once the pandemic is better controlled in the Czech Republic and globally.

The Czech National Bank (CNB) moved quickly to ease the monetary policy stance. It reduced policy rates from 2.25% to 0.25% between March and May 2020. It also reduced the counter-cyclical capital buffer to support bank credit to the economy. The Act on the CNB was amended to pave the way for quantitative easing. The CNB took additional measures to support liquidity by broadening the range of eligible collateral and introducing liquidity-providing operations with longer maturities.

The government introduced broad emergency fiscal measures to support the economy. Low public debt before the crisis gave ample fiscal space to extend assistance. The government introduced job retention schemes, benefit payments to the self-employed, income support for workers caring for children and tax deferrals. Moreover, a COVID loan and guarantee programme was launched to boost firm liquidity, notably for SMEs. Deferrals of rent and loan repayments have also been offered. The duration and scope of many of these programmes have been extended following the resurgence of cases and reintroduction of containment measures.

There remains room for continued fiscal policy support, if needed. The medium-term expenditure framework has been amended to allow for extensive fiscal support. After 2021, however, the framework requires a gradual fiscal consolidation by 2028. The plan for medium-term consolidation is appropriate, but it could be adjusted if the crisis lingers longer than expected.

Policy focus will need to shift towards facilitating workers’ retraining and job search. Some sectors and firms will adapt rapidly to the new economic reality, while for others, restrictions and low demand may persist for longer. A key challenge will be to keep supporting viable firms and jobs, while allowing for necessary resource reallocation across sectors. The coronavirus job retention schemes are effective in preserving existing jobs, but cannot replace active labour market programmes and retraining for job seekers. These programmes currently receive little fiscal support and should be boosted to facilitate job reallocation. Effective insolvency procedures will also be crucial to minimise barriers to corporate restructuring and spur productivity-enhancing capital reallocation.

The Czech Republic faces challenges from population ageing. Ageing-related costs will weigh heavily on public finances in the medium to long term. There is no automatic link between retirement age and life expectancy. Moreover, recent changes in the pension indexation rules and discretionary measures are pushing pension spending up further. Once the economic recovery is well established, addressing the challenges of the pension system’s sustainability will become more important.

The Czech tax system can be reformed to become more growth-friendly. A heavy tax burden on labour - high social security contributions in particular - is not optimal. On the other hand, the use of environmental and real estate taxes, that are less distortive to growth, is low. There is also too much use of reduced VAT rates, which are shown to be poorly targeted to fight poverty.

Lower taxes and social contributions for the self-employed reduce public revenues and adequacy of safety nets. Taxes and contributions of the self-employed remain lower than for employees, driving the high incidence of self-employment. The lower assessment base for social contributions creates issues of fairness, adequacy and sustainability. While enjoying the same rights from the health care system as employees, the self-employed contribute significantly less. Lower contributions to pensions, on the other hand, result in lower pension rights, leading to poverty in old age.

Strong economic performance before the crisis spurred convergence in incomes and living standards, but productivity still lags markedly behind the OECD average. Czech companies, particularly SMEs, invest comparatively less in R&D, and innovation activity is moderate. Much of the R&D activity is done by foreign multinationals. There is scope to make R&D support better targeted to young dynamic firms.

The burdensome aspects of the business environment impede investment and creation of new firms. The process of obtaining construction permits is one of the lengthiest in the OECD, slowing investment and construction. Also, opening a company is more cumbersome than in most OECD countries. Reducing red tape would help restart investment after the crisis and help unleash the entrepreneurial potential.

Resources and investment should shift to less polluting and more energy-efficient activities. Energy and carbon dependence are high. Certain areas suffer from high air pollution. The Czech Republic does not have a carbon tax and there are numerous exemptions for excise taxes applied to different uses of fuel. In the road sector, tax on diesel is lower than on gasoline, sending mixed signals to the market. Investment support should target transport and energy projects that help improve energy efficiency and reduce carbon emissions and air pollution.

Strengthening governance and public integrity will improve the effectiveness of government spending. While the Czech Republic has made progress, further strengthening public integrity of members of Parliament and government officials will improve transparency and prevent mismanagement of funds. In addition, The Czech Republic is highly export-oriented and its exports include high-risk sectors for foreign bribery. In light of this, efforts to guarantee greater independence to prosecutors in foreign bribery investigations and prosecutions should be continued.

The small size of municipalities and the highly fragmented local government impede effective provision of public services and investment. The Czech Republic exhibits significant regional variation in incomes and poverty, and the gaps have grown over time. This is not helped by the fact that the Czech Republic suffers from a highly fragmented subnational government with the highest number of municipalities per capita in the OECD, making coordination difficult. The resulting lack of capacity at the local level and the lack of economies of scale compromise service quality.

Municipal cooperation is common, but lacks stability in administration and funding. Inter-municipal associations depend heavily on the willingness of the existing municipal administration to cooperate, and they primarily rely on external sources of funding. Mandating inter-municipal co-operation over a legally defined set of public services can be an effective way of improving efficiency and the quality of service delivery. Furthermore, small municipalities should be incentivised to merge.

Low labour market participation of mothers constrains growth, incomes and equity. Childbirth has a large impact on labour market participation of women, with consequences for later careers. The gender pay gap is relatively high, and the risk of poverty in old age is higher for women than for men.

Generous cash benefits and limited childcare places discourage mothers’ return to work. Family benefits are generous, mostly in the form of cash benefits to families with young children, and parental leave lasts until the child’s age of three. At the same time, childcare availability, while growing in recent years, is limited.

Socio-economic factors and variation in school quality play a strong role in student performance and educational attainment. Small schools in remote and disadvantaged areas can find it challenging to provide high quality education. A recent funding reform has partly addressed the problem of lack of resources for these schools, but disadvantage could be more explicitly targeted. Further efforts to consolidate the school network and incentives for highly competent teachers to work in remote areas could raise quality.

Lifelong learning should be better targeted to the low skilled. The Czech Republic has already experienced a rise in the share of high-skilled jobs. These trends are set to continue and may be accelerated by the distancing requirements during the coronavirus outbreak. Low-skilled workers rarely take part in adult education programmes and the VET sector should be better adapted to delivering education to adults, by developing short and flexible courses.