Austria -- 2004 IMF Article IV Consultation, Preliminary Conclusions

May 11, 2004

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.

Preliminary Conclusions

Vienna, 11 May 2004

Since the turn of the decade, a strategic policy shift has made Austria a showcase of reforms and placed it at the forefront of the European Union. Austria restored discipline to its public finances, balancing the budget over the cycle; implemented a courageous pension reform that strengthened significantly the long-term sustainability of the system; started a major tax reform, with the ambitious objective of reducing the tax burden to 40 percent of GDP by 2010; unified financial sector supervision under a new Financial Market Authority; modernized the legal and institutional framework of competition policy; and took measures to make the labor market more flexible, stimulate research & development, and encourage entrepreneurship. These achievements have placed Austria among the top three EU countries in terms of implementing the Lisbon Agenda.

This policy shift was necessary to address long-standing imbalances and future challenges and will improve the long-term growth potential of the economy. Increasing product and labor market flexibility, encouraging innovation, and maintaining macroeconomic stability while lowering the tax burden will boost competitiveness and economic efficiency.

The short-term outlook is also strengthening, although considerable uncertainties remain. The recovery has started but remains tentative in most euro area economies. Austria has continued to outperform its major EU partners in terms of growth and employment, and we expect this to continue this year and next. After the long-anticipated rebound of investment in the second half of last year-helped in part by the private sector's response to the incentives for investment and new business-the short-term outlook is positive: we expect growth to average 1.6 percent this year and 2½ percent in 2005. But questions about the underlying strength of consumption and, above all, the risks still surrounding the outlook for the euro area, especially Germany, imply a significant margin of uncertainty around these projections.

The main challenge now, other than completing the unfinished reform agenda, is to manage the fiscal implications of recent and future reforms, especially of the tax system. To manage these so as to maintain a balanced budget over the cycle, the government will need to show the same determination it has shown in implementing its ambitious structural reform agenda since 2000. The strengthening recovery, however, should make this task a little easier in the coming years.

The unfinished reform agenda

Although the government's ambitious reform program is well advanced, certain key steps remain.

· Harmonizing the various pension systems should be the highest priority. This would reduce inequities between future pensioners and have positive effects on the labor market by enhancing mobility and removing the distortions generated by the different contribution rates and benefit levels across the various schemes. More broadly, delivering on this major commitment would underscore the government's credibility and cement the gains from last year's pension reform.

· The ongoing rationalization of invalidity pensions should be continued. The measures in 2000 have reduced the number of new claimants; this number, however, remains large, suggesting that invalidity pensions are used to some extent as an early retirement vehicle. Measures here should focus on targeting invalidity pensions to those truly unable to work and meriting state assistance.

· The quality of health care in Austria is high but the health system is fragmented. There is scope for efficiency gains and savings, including through harmonizing the various plans, improving hospital management, and raising co-payments.

· The major progress achieved in market reforms should be followed up by efforts to reduce red tape further; continue to liberalize services (including railways, in line with EU initiatives in this area); and privatize the remaining state holdings in ÖIAG.

· Last but not least, tax reform should not stop in 2005. The measures planned for next year will reduce further the overall tax burden, make Austria more attractive as a business location, and boost growth in the long run. But still more will need to be done in the medium term to achieve the government's objective to lower the tax burden to 40 percent of GDP by 2010. Future reforms should focus on reducing the tax burden on labor through cutting personal income tax and nonwage labor costs, and simplifying the complex and unfriendly tax system.

Tax reform, government size, and growth

While many studies, as well as the experience of several countries, confirm that reducing the fiscal deficit through expenditure consolidation benefits growth, the literature examining the economic impact of reducing both taxes and spending simultaneously is not extensive. Our own empirical study, based on the experience of 18 OECD countries and presented at a seminar in Vienna on May 7, suggests the following.

    · Reducing government size (both revenues and expenditures) by 5 percentage points of GDP would increase

    the long-term growth rate by about 0.2 of a percentage point per year.

    · This impact could be even higher if tax reductions focus on direct, rather than indirect taxes, because the

    former are more distortionary.

    · Lowering corporate taxes, in particular, is an effective tool to stimulate private investment.

Managing the fiscal implications of reforms

Adjusting public expenditures in order to return to a balanced budget over the cycle will be the major policy challenge in the coming years. We estimate that the general government deficit would approach 2 percent of GDP next year and, without implementing the planned savings measures, might rise even higher in 2006. A temporary deficit of this magnitude would not undermine macroeconomic stability or fiscal sustainability, but would represent a substantial deviation from the government program targets, raising questions about the government's medium-term intentions. More importantly, unless this widening of the deficit is reversed, further tax reform will not be feasible.

· In the short term, this requires renewed efforts to generate savings at both the federal and the provincial and local government levels, with a view to keeping the deficit in 2005-06 as close as possible to the Stability Program targets.

    · At the federal level, it is imperative to continue the reform of public administration as planned and seek additional savings in health spending and other transfers.

    · The new Finanzausgleich should ensure that subnational levels of government continue to contribute to the overall adjustment effort.

· In the medium term, restoring a structural budget balance and reducing the tax burden to 40 percent of GDP by 2010 would require cumulative savings of about 4 percentage points of GDP.

    · Incremental or piecemeal efforts will not be sufficient to deliver this adjustment: a fundamental re-thinking of the role of the state would be needed. The Österreich-Konvent provides an excellent opportunity for this. The Konvent should aim not only at streamlining relations between the various levels of government and aligning spending authority with taxing responsibility, but also at re-defining the essential functions of the government in a modern market economy and improving efficiency in the delivery of public services.

    · Planning and implementing the measures that would generate these savings over a period of time would require a comprehensive medium-term expenditure framework, with multi-year targets broken down by major program. We were encouraged to learn that work on such a framework has advanced since last year, and would urge the Ministry of Finance to carry this agenda forward to the cabinet and, eventually, parliament. Such a framework would illustrate tradeoffs, enhance transparency, facilitate rational policy choices, and strengthen credibility.

The financial sector

An in-depth Financial Sector Assessment Program, for which Austria volunteered last year, has concluded that the financial system is generally sound, well supervised, and resilient to shocks. The banking system is profitable and well-capitalized and, in recent years, has seen major restructuring, consolidation, and a successful expansion abroad. The large banks have made major strides in implementing best practices in risk management. These features helped the system weather the recent slowdown relatively well.

Austria enjoys a high standard of financial supervision, based on strong institutions and a modern legal framework. The consolidation of supervision in the new Financial Market Authority (FMA) in 2002 was smooth; cooperation among the FMA, OeNB, and Ministry of Finance is good; and the FMA's capacity to discharge its mandate is being built quickly and effectively. This is confirmed by Austria's high level of compliance with the internationally accepted standards in the areas of banking, insurance, securities, and anti-money laundering.

Looking forward, the Financial Sector Assessment Program identified the following medium-term challenges and areas of potential risk.

· The successful expansion in the CEECs has helped boost the performance of banks, offsetting chronically low profitability in the home market. But growing exposure to local clients there implies new risks and requires continued monitoring and vigilance.

· Despite progress in recent years, bank and branch density in Austria remains high by international standards, creating room for further restructuring and consolidation. Banks should avoid complacency arising from high profitability in the CEECs and persevere in their efforts to improve their cost structure.

· The continued growth in foreign currency lending, particularly to households that do not have a foreign currency hedge, is a source of concern. We welcome the recent measures and urge the authorities to continue educating customers about the risks and helping banks-particularly the smaller ones-improve their risk management.

· The sectoral deposit insurance system has worked well and incorporates multiple lines of defense. But the restructuring underway in the banking industry argues in favor of taking a fresh look at the system in the medium term to reduce the likelihood of recourse to public funds.

· Financial supervision should be strengthened further. While ongoing reforms and EU directives in the pipeline will address most of the identified gaps, the authorities need to resolve the outstanding legal issues, in particular the public liability of supervisors, so that the latter can carry out their mandate effectively.


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