Kingdom of the Netherlands - The Netherlands -- IMF 2005 Article IV Consultations, Preliminary Conclusions

April 11, 2005

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

April 11, 2005

1. The Netherlands hit a difficult stretch going into the new millennium. After a long period of comparatively strong economic performance, growth was relatively poor during 2000-03. It turned negative on a year-average basis in 2003 for the first time in twenty years. A weakening external environment contributed to the sharp slowdown of activity, as did deteriorating competitiveness on the heels of an appreciating euro and a significant bout of wage inflation. Wage pressures reflected tightness in the labor market that had built up in the second half of the 1990s. Although the Netherlands still had a considerable labor reserve, it went untapped for lack of reform. This was especially the case with respect to disability, a long-acknowledged haven of hidden unemployment. Wealth effects amplified the cycle, which was accentuated further by changes in pension fund contributions.

2. The challenge ahead is to support and sustain economic recovery. It is reasonable to expect that growth will accelerate significantly by next year—though economic prospects in a broader perspective will depend on confidence in policies. This underscores, after the marked deterioration in the public finances during 2000-03, the benefits of ensuring significant fiscal consolidation during an economic upturn. It also underscores the advantages of making further quick advances on the structural front. A key goal of various structural reforms is to stimulate high employment and growth, and thereby generate the resources without which it would be virtually impossible to keep the public finances sound while maintaining social expenditures in the face of population aging. In addition, while the recent moderation in wage increases has been helping to restore the external competitiveness of the Dutch economy, such moderation must continue if, as in past recoveries, exports are to remain a driver of growth.

3. The prospect of growth picking up is reflected in the mission's projections. Although there is major uncertainty over confidence and its effect on private consumption, fundamentals have improved in several respects. Corporate debt has been paid down and profits margins are up, boding well for investment. Growth in trading partners, though slowing, should still be strong. Exports should therefore contribute positively to the outlook as the deterioration in competitiveness comes to an end. In all, while growth in 2005 is likely to be close to the rate of last year, it should accelerate to over 2 percent in 2006. Higher-than-expected oil prices, a significant further appreciation of the euro, and slower-than-expected growth in the euro area and other trading partners are factors that could dampen the strength of the upswing. In addition, a possible interest rate led house price decline, given high household debt, could have a negative effect on consumption. On the upside, more forward-looking consumers might see through any short-term soft patch in the economy, prompting above-baseline consumption. Meanwhile, with economic slack still present, inflation should continue to be subdued. Separately, as a statistical matter, the impact of institutional changes (especially to health care) on economic data must be effectively communicated to avoid misunderstandings. For example, while the statistical adjustments required to reflect these changes will produce significant movements in expenditure components, it must be made clear that overall GDP growth will not be affected.

4. Recent developments give reason for optimism on the fiscal front. After breaching the Maastricht deficit ceiling by a small margin in 2003, the deficit was reduced to 2.3 percent of GDP in 2004. The original target from the 2004 budget memorandum was therefore met, even under more difficult economic conditions than originally envisaged. This impressive fiscal effort resulted in a structural narrowing of the deficit by about 1¼ percentage points of GDP—a major accomplishment. Supplemental measures, implemented in a timely way, were important in reversing the unexpected and sharp deterioration in the preceding year. Unexpected windfalls from tax and gas revenues and social security spending, and a somewhat lower-than-expected deficit of local governments contributed as well. It was also important that government departments did not exhaust their budget ceilings.

5. Building on this success, continued vigilance is needed in consolidating the public finances to ensure sustainability, and resilience to population aging. Fiscal adjustment in structural terms of at least ½ percentage point of GDP per year, on average, during the government's term (which would leave at least ¾ percentage point of GDP of adjustment for 2005-07) would have considerable benefits. One key aspect is that it would provide some needed impetus for a return to a sustainable path for public finances, in line with the CPB's work on aging. In doing so, it would help the Netherlands prepare for the fiscal pressures that will arise as the baby boom generation retires. New measures should preferably exploit the synergies between fiscal consolidation and structural reforms helping to raise employment rates and potential growth—for example, by rationalizing and restraining unemployment benefits and rent subsidies (see below). The prospect of elections in 2007 further underscores the merits of early action to secure the recommended adjustment. Importantly, any windfalls should go to deficit reduction. The earlier fiscal problems in the Netherlands reflected, in part, insufficient adjustment in the previous upturn. Against this background, it is important that the authorities try to take full advantage of the economic upturn, also with a view to building a buffer to shield the fiscal balance against unanticipated shocks and in light of the continuing uncertainty and risks in containing the costs of health care.

6. While recognizing the many strengths of the Dutch fiscal framework, some refinements are worth considering. The strengths include multi-year real expenditure ceilings along with specified structural measures to achieve them, at the same time that the framework allows for the operation of automatic stabilizers on the revenue side. However, the recent experience has highlighted a few areas to strengthen:

• The local governments compile their accounts on a different basis than the central government and this allows for relatively wide fluctuations in their fiscal balances when put in EMU-consistent terms. The authorities' trial with a "national stability pact" in 2005 should be used to pave the way for a durable solution. Indeed, ensuring timely information sharing and close coordination between central and local government is essential for avoiding the adverse fiscal surprises of the past.

• A stronger wording of the rule on the allocation of expenditure windfalls would help prevent the use of temporary windfalls to fund structural spending, fostering fiscal discipline.

• Enhancing the transparency of the expenditure ceilings would facilitate their accessibility to a broader audience. In this regard, the mission recommends aligning the ceilings more closely with national accounts concepts, while focusing strictly on spending by ending the practice of treating non-tax revenue as negative expenditures. Consideration could also be given to referencing the nominal budget ceilings in the monthly reports on the "EMU balance" on the website of the Ministry of Finance, with a view to allowing direct and continuous comparison between actual developments and the pre-set ceilings.

7. Over the medium and long term, it is important to boost the economy's growth potential—both for its own sake and because it would reduce pressures on public finances, including those arising from population aging. In this connection, structural reforms that alleviate inactivity and boost productivity would not only help generate output growth, but also, if sufficiently ambitious, resources to deal with population aging. As a result, such reforms would avoid having to resort to undesirable tax increases or unduly sacrificing public services. The authorities' efforts to reform disability and sickness benefits, early retirement schemes, and unemployment benefits are important steps towards these objectives. However, it remains important to take further measures to increase incentives for labor market participation. Moreover, while the overall level of productivity is high, accelerating its growth is also needed to raise the economy's potential. This would be facilitated by increased product market competition and greater labor market flexibility.

8. It is encouraging to see that reform of the disability scheme is having favorable effects. First, inflows into disability fell in 2002 and 2003 and declined still further in 2004. These results reflected the introduction of a more effective "gate-keeper" and the significant impact of firm-level experience rating in premiums (PEMBA). Second, the extension of the duration of sickness benefits from one to two years in 2004 extended employers' reintegration responsibilities. Third, as a consequence of the application of a stricter definition of full disability, ongoing reassessments have frequently resulted in a reduction or elimination of benefits. Finally, the new benefit scheme appropriately creates incentives for the partially disabled to return to work. To be successful looking forward, it remains crucial that the stringent gate-keeper and assessment processes not be relaxed. In addition, resisting hikes in replacement ratios might lessen the pressure on medical examiners. In view of its documented success, a continuation of PEMBA would discourage disability scheme misuse.

9. Removal of the fiscal incentives for early retirement is another step in the right direction. The effects in the near term depend on the extent to which the social partners offset the reform's impact in new collective agreements. However, over time, moving to actuarially neutral pension arrangements would boost participation because pension entitlements would fairly reflect each additional year of work. The impact of the new "life-course scheme" on labor force participation and hours worked is, at present, unclear. Careful monitoring of its uptake and usage will be essential, both to ensure that it is not solely used as a route into early retirement, and that its broader objectives of increasing personal and career flexibility and creating opportunities for training in mid-career advance economic objectives—an outcome that cannot be taken for granted. More broadly, changes in life expectancy should be taken into account in determining the official retirement age.

10. High replacement rates, means-tested benefits, and subsidies with sharp income- related withdrawal rates continue to create significant poverty and inactivity traps. Further increases in the earned income tax credit could offset many of these concerns. At the same time, however, ending the abrupt withdrawal of subsidies through better phasing, and abolishing schemes that significantly distort labor market incentives still need to be considered. In this context, recent changes to the OZB real estate tax and the proposed amendments to the child credit, due to come into effect in 2006, should reduce spikes in marginal effective tax rates. Reform of rent subsidy arrangements, if undertaken, could have a particularly large effect in making work pay for lower-income earners. To balance housing market benefits across income groups, this could be combined with a withdrawal of mortgage interest tax relief, implemented in a way that avoids disruptive effects.

11. Reducing the generosity of unemployment benefits is essential and would help avoid a shift from one category of inactivity to another. It is therefore encouraging that the social partners recognize the need to reduce the duration of the unemployment scheme. While high replacement rates can be justified in the initial months of unemployment, over time benefits should decline quickly to encourage a rapid return to employment and to avoid benefit dependency. In addition, a maximum period much shorter than three years would seem sufficient for unemployment benefits to serve their purpose from the standpoint of job search. As the continuing success of the transfer of responsibility for social assistance to municipalities shows, improving incentives, both financial and individual, can quickly lead to significant improvements in labor market attachment and participation, while at the same time reducing fiscal outlays.

12. To help raise productivity growth, labor market reforms will need to go beyond the narrow focus of raising participation and aim at facilitating the reallocation of labor. Productivity depends, in part, on innovation, which in turn is related to the ease in undertaking experimentation and exiting when appropriate. This is a process that works best when resources can be reallocated quickly and smoothly to the most productive firms. While the Innovation Platform rightly emphasizes the need to improve innovation, the agenda could usefully include an assessment of employment protection legislation. This is because the extent of this legislation, considered among the most restrictive in Europe, acts as a tax on new hiring and can stand in the way of the reallocation process and entrepreneurial activity. There are also benefits from greater wage differentiation. Greater differentiation would be helpful in attracting labor to higher productivity companies and sectors, while strengthening the incentives for human capital investment.

13. Reducing the administrative burden also has an important role to play in fostering entrepreneurial activity and augmenting productivity. Having recognized that the cost of red tape is comparatively high—including by discouraging entry by both domestic and foreign firms—the government has instigated reforms with the aim of reducing the burden by 25 percent. This ambitious goal, which aims in part at reducing unnecessary bureaucracy, is likely to be reached, aided by estimates of the size of the administrative costs from which reductions would take place. The introduction of a "one-stop shop" for high-wage immigrants should facilitate the entry of high-skilled workers.

14. Product market reform can also contribute to productivity growth. Although the Netherlands has made significant progress in improving the functioning of product markets—including through the liberalization of network industries—the benefits of enhanced competition have not yet reached all markets. In particular, the productivity record of some sectors where competition has been lacking has been particularly weak. In this context, the increasingly effective enforcement efforts of the competition agency (the NMa) are most welcome. Nonetheless, entrepreneurial attitudes take time to change and reinforcing the powers of the NMa, as envisaged, is therefore important.

15. The financial system continues to be sound, resilient to potential adverse shocks, and well supervised. Despite reduced interest margins, banks' returns improved last year as the demand for credit (especially mortgages) increased. Insurance firms and pension funds, like banks, also benefited from higher security prices, though the current low-yield environment, especially if prolonged, poses challenges. However, the quality of supervision is high and stress tests under the FSAP have demonstrated the resiliency of the financial system. The new supervisory arrangements for pensions improve transparency, and the flexibility in the timeframe for making up shortfalls in the coverage ratio is welcome. This timeframe rightly tries to balance the goal of avoiding procyclical effects without unduly prolonging adjustment. Supervisors and policymakers will, nevertheless, have to monitor the macroeconomic implications of pension reform and the risks taken by banks and insurance companies in a low-yield environment. In addition, it is important that the solvency requirements for health insurance funds after the reforms in 2006 are set at an appropriate level.

16. The mission welcomes the authorities' efforts to help preserve financial stability in the medium and long term. These include enhanced transparency of the boundaries of responsibility of the various supervisory authorities; cooperation with international securities' supervisors; participation in multilateral improvements in security settlement arrangements; the upcoming pensions fund act; a restructuring of the crisis management framework; analytical work aimed at partial ex-ante funding and risk sharing in the deposit guarantee scheme; and a strengthening of macro prudential supervision, with a view to early identification of risks and vulnerabilities. In addition, the authorities' desire to move to a risk-based solvency framework for the insurance sector seems sensible.

17. The authorities' coherent and enthusiastic support of multilateral trade liberalization and overseas development assistance is commendable. Even under budgetary pressure, the Netherlands has still exceeded the United Nations' ODA target.

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The mission is truly grateful to the authorities and other participants for the frank, high quality, and stimulating discussions, in addition to the warm hospitality.


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