Concluding Remarks of 1999 Article IV Consultation -- Finland

June 7, 1999

At the conclusion of annual Article IV bilateral discussions with the authorities, and prior to the preparation of the staff's report to the Executive Board, the IMF mission often provides the authorities with a statement of its preliminary findings.
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Finland - 1999 Article IV Consultation, May 28-June 7, 1999
Concluding Remarks

June 7, 1999

Overview of key issues

1. The conduct of macroeconomic policies in Finland since the early 1990s has been impressive by any standard. Firm monetary policy and public spending control—buttressed by wage moderation—have transformed the public finances and cut consumer price inflation from over 6 to some 1 percent. With an export-led recovery, private sector balance sheets have been rebuilt; the current account has swung from a deficit of more than 5 percent of GDP to a surplus of the same magnitude; growth, over the past three years, has averaged close to 5 percent; and unemployment has fallen markedly. In sum, a decade that began with the steepest recession among the advanced economies is ending with the public finances in balance, activity strong, and founder membership of the euro zone secured.

2. This macroeconomic progress notwithstanding, major structural challenges remain in the public finances and the labor market, posing risks to economic performance. Despite recent pension reforms, intergenerational equity remains elusive; and the impact of demographic pressures threatens to trigger a rise in the burden of social contributions over the coming decades—just when broad participation in the labor force will be crucial because the population of working age will be shrinking. In the labor market, job creation has yet to reach large groups in society; regional imbalances have widened; and pressures are appearing in some areas and sectors, with national unemployment still in double digits. There is a risk that overheating could re-emerge in real and financial markets over the next two years—with no independent monetary policy on hand to address such pressures. Under monetary union, moreover, without deeper reforms to improve the flexibility of the real economy, fiscal stabilizers alone will not suffice to safeguard stability.

3. These challenges are pressing, but—with the crisis of the early 1990s receding—action will require strong resolve among policy makers and the social partners. EMU offers major opportunities, if the flexibility of the economy is enhanced when conditions are favorable. Risks of overheating can be forestalled, if reforms are adopted and given time to work. The next decade offers a window to lower the heavy tax burden before demographic pressures limit the room for maneuver—with this shock occurring particularly early in Finland. The current setting is thus ideal to deepen reforms, and action is needed now.

4. The government program focuses rightly on raising employment, as well as holding to a firm fiscal stance: this goal now needs to be translated into concrete measures. Raising employment substantially, while preserving core social protection, will require well-targeted structural reforms. Strong domestic and external demand will not do the trick. The key lies in sufficient spending restraint to cut taxes on labor sizably, without jeopardizing fiscal consolidation; stronger incentives to encourage work and training; and action to stem the loss from the work-force of those aged 55 to 65—which will enhance both growth and the public finances. To address the risk of adverse shocks or overheating under monetary union, further action is needed to reform the labor and product markets—measures that typically take some time to have their full effect on employment.

Recent developments, prospects, and the near-term stance of policy

5. Since mid-1998, activity has been driven increasingly by strong domestic demand. Private consumption has expanded robustly, underpinned by employment growth, while fixed investment has slowed only modestly. The external contribution to growth has been declining, with the emerging market crisis influencing exports directly, through EU activity, and through world market prices. While electronics has grown rapidly, other manufacturing output has weakened over the past year. Growth in services and construction, however, has substantially offset this weakness, and these sectors remain buoyant. Labor market conditions have thus become more uneven, with incipient labor shortages in some localities and for selected skills. There are no signs of generalized overheating, and competitiveness is comfortable; but, overall, the cyclical position is more advanced than the euro zone average.

6. Monetary and financial conditions are currently fairly easy. By end-May 1999, nominal short-term interest rates were some 1 percentage point lower than in early 1998, while even in real terms bank lending rates have touched a new low in recent months. Long-term real rates have extended their downward trend. Finland's competitiveness deteriorated somewhat in late 1998, but with the recent weakness of the euro that has now been reversed. Overall, monetary conditions were supportive of activity in 1998, while the impact of favorable interest and exchange rate shifts in recent months has yet to be felt. Reflecting these conditions, bank lending accelerated substantially over the past year, although household and business balance sheets remain sound. Real estate prices have continued to recover, with wealth effects underpinning consumption and residential investment. Market indicators do not signal expectations of any marked tightening of monetary conditions in the period ahead.

7. The 1999 budget has extended a record of consolidation that brought the general government finances from a deficit of 8 percent of GDP in 1993 to a small surplus in 1998. The budget also provided for a welcome reduction in taxes on labor income. With activity somewhat stronger than projected a few months ago, and profit taxes buoyant, the general government surplus is set to reach some 3 percent of GDP. Given a significant rise in the structural primary surplus, the fiscal impulse is contractionary—offsetting the ease of monetary conditions. The overall macroeconomic policy stance in 1999 is broadly neutral.

8. With world trade projected to accelerate later this year, solid economic growth should be combined with relatively low inflation. Consumer sentiment remains strong, and business confidence has rebounded significantly over the past few months. The shift of activity toward domestic demand is now fuelling a virtuous circle of employment growth and rising output. Economic growth should exceed 3½ percent in both 1999 and 2000. Undeniably, downside risks remain in the global setting—but recent interest and exchange rate changes in the euro zone, and an up-tick in emerging markets, suggest that near-term risks are diminishing. Domestically, risks are on the upside: consumption and residential investment may be stronger than projected, reflecting strong job creation, low interest rates, and wealth effects from real estate gains. The major concern is that present pockets of tightness in the labor supply could broaden. While competitiveness is currently very favorable, the development of a strong momentum in wage costs could—within the framework of monetary union—eventually trigger an extended downturn in employment.

9. In this setting, public expenditure restraint in 2000 needs to be sufficiently firm to ensure at least some fiscal offset to the ease of monetary conditions. On the assumptions that income taxes are cut in response to wage moderation, and profit taxes remain strong, present spending plans for 2000 should result in a fiscal tightening of perhaps ½ percent of GDP (in terms of the cyclically-adjusted primary balance). This degree of tightening would appear prudent to partially counterbalance easy monetary conditions. At least as importantly, to forestall risks of overheating, it is crucial to proceed now with further labor and product market and pension reforms (discussed below) to improve the supply side of the economy.

10. Membership of the euro zone requires a continuing improvement in the flexibility of the economy. This is intuitively clear in the case of external shocks, given Finland's export composition and exposure to economies outside the zone. But equally important risks arise from domestic overheating. Under EMU, wholesale and producer prices are likely to move in step across the zone, but major scope exists for labor costs to move out of line—triggering serious damage to employment. Equally, asset price inflation could take root at times when, as now, monetary conditions are easy relative to the cyclical position. In one sense this is not new: domestic monetary conditions were never "right" for each region of the economy. But under EMU, these effects could prove more acute and longer-lived, with less mobility of labor to mitigate their impact.

Medium-term policy objectives

11. The key priorities for policy over the medium term are to address the demographic shock, while enhancing the flexibility of the economy. On present projections, population aging would raise public expenditure on pensions and health care substantially relative to GDP over the coming decades. Without further reforms, this would imply a sizable rise in taxes and contributions on labor income, compounding the problem of a shrinking working age population. The strategy to address this should be front-loaded, and incorporate pension, labor market, and other structural reforms—including a brisk pace of privatization to further reduce the public debt. These approaches, by contrast with an exclusive reliance on fiscal consolidation, can set in motion a virtuous circle of declining taxes and rising employment.

12. A key component in demographic strategy must be to avoid a premature withdrawal of the "baby-boom generation" from the labor force, which would damage both the public finances and the labor market. In pension policy, it will be crucial to build further on the important reforms already made to retirement ages and pension indexation. In particular, with recession of the 1990s over, policy on early retirement needs to be tightened swiftly. With the "baby-boomers" approaching qualifying ages for early retirement, an urgent priority is to ensure that, from 2000, they do not face artificial incentives to withdraw their skills from the labor force—and that firms do not face incentives to avoid employing them. This is justified in terms of equity and efficiency, and implies raising the effective retirement age by: (1) closing the "unemployment pipeline" to the pension system through removing the requalification exemption for the unemployed aged 55 and over, and discontinuing the unemployment-pension for future claimants; (2) improving the financing of disability pensions to avoid encouraging the shedding of employees aged 55 and over; (3) increasing the flexibility of the official retirement age; and (4) relating pension entitlements to contributions over an individual's entire working life, ending distortions that discourage taking a new job late in an employee's career; and, correspondingly, increasing the after-tax penalty for early retirement.

13. Over time, changes should also be made in the design of earnings-related pensions so that these are clearly perceived as a form of saving rather than a tax. This implies moving progressively in the direction of defined contributions rather than defined benefits, tailoring options to individual needs, and making transparent the link between individual contributions, benefits, and investment returns. Further key reforms are to: increase competition among pension companies; end lending to associated companies; and raise minimum yields before rebates of contributions are made. These changes, by relating pension entitlements closely to preferences, and making them more transparent and credible, should improve incentives to work—and reduce the risk that government and private sector both save for the same goal.

14. For medium-term fiscal policy also, the overarching challenge is to address demographic pressures efficiently through several channels. A first priority, clearly, is adequate fiscal consolidation. The need for this is widely accepted. Over and above this, however, and with a general government surplus now on the order of 3 percent of GDP, the time has come for the pendulum to swing toward cutting taxes on labor income—subject to the important proviso of eliminating the structural deficit in the central government finances, which has persisted despite strong economic growth. In these regards, the government's expenditure plans for 2000-2003 are welcome, since they provide room for a cut in income taxes without undermining fiscal consolidation. Indeed, the goals for tax reduction in this program should be viewed as a minimum. If economic conditions are favorable and revenues buoyant—or if greater selectivity can be exercised in expenditure—then a more decisive cut in taxes should be possible. In designing tax relief, the government is right to emphasize earned income, with both across-the-board reductions and targeted cuts on lower incomes. The plan to eliminate tax-free bank deposits is also very welcome.

15. Hard budget constraints set by the central government have been effective, and should be continuedbut translated into reforms that address bottlenecks for growth. An example of the need for well-balanced reforms is the challenge for municipalities experiencing heavy inward and outward migration. The strategy of continuing restraint in transfers to municipalities will only work effectively if they can achieve fuller cost recovery, raise property taxes, and be more selective in spending—and if resources are streamlined by further sharing of facilities. Another challenge is to ensure adequate infrastructure spending, which has been pared back in recent years (and where private capital is tapped, to cut public borrowing needs, then the framework must avoid the state incurring large contingent liabilities if returns on projects are less than projected). To strengthen restraint, more savings could be found by a tighter targeting of transfers to households and enterprises, and phasing down tax relief on mortgage interest. The authorities are encouraged to maintain development assistance at as high a level as feasible.

16. An additional challenge for fiscal policy is to ensure ample room for stabilizers, thus moderating swings in the economic cycle. Several actions in recent years should indeed enhance automatic stabilizers: the avoidance of social contribution hikes in recessions and the related build-up of EMU buffer funds; and the cut in profit tax collection lags. The general government surplus is now adequate to allow automatic stabilizers to operate freely, and to use discretionary measures in the event of a serious negative shock. A consideration for the future, however, is that the burden of stabilization may in practice fall mainly on the central government. Municipalities tend to pursue balanced budget goals, thus acting pro-cyclically. And the pension system—on the recommendations above—should be increasingly separated as a saving vehicle for the public. On this scenario, the central government needs to ensure that its track record of consolidation remains impeccable—aiming for balance in its accounts, or a modest surplus at times when economic activity is strong.

17. In such an open economy, fiscal stabilizers alone cannot adequately safeguard stability under monetary union: to improve the flexibility of the economy, further reforms are needed to enhance the working of the labor market. In several respects the labor market has operated quite flexibly: mobility, for example, is high by EU standards; and progress has been made in integrating the young in work and training. A number of important reforms have been implemented, including an improvement in the design of the unemployment benefit in order to promote reintegration in the work force; and a start in reorienting active labor market programs. Nonetheless, together with the pension reforms discussed above, further measures in two areas are needed to improve the outlook for employment:

    · Microeconomic reforms to the tax and benefit system so that no individuals face financial disincentives to taking up a job. In addition to higher earned income tax relief, to widen the gap between net benefit and net labor income, the main priorities include limiting the legal and actual duration of the unemployment benefit, and tapering it off more strongly over time; a stricter enforcement of requalification requirements for the unemployment benefit; and action to address the disincentives to employment and mobility that result from the way cash benefits such as housing and child care allowances are withdrawn on taking up employment.

    · A further reorientation of benefit administration to emphasize job search and training. A main goal should be to continue retargeting active labor market policies toward key groups, by shifting staff to assure interviewing and guidance of benefit recipients. It will also be crucial to continue to work with enterprises in enhancing vocational training.

18. A major question at the present time is the future impact of the wage formation process on employment. The centralization of wage bargaining should continue to assist in preserving wage moderation; at the same time, there is now also a clear need for some greater wage dispersion—so that job creation is spread more broadly to all groups and regions, and to improve the matching of skills to jobs. The dilemma is how to move in this direction without triggering a generalized acceleration of wages that would be a disaster for employment. A prudent course could be to reach an agreement among the social partners that preserves reasonable moderation, while building in scope for greater flexibility for bonuses and profit-sharing in firms. In addition, it is worth studying sectors and localities with low employment growth, to determine whether exceptions are needed to bring pay more in line with productivity. The government's plan to condition tax relief on an appropriate wage settlement needs to take account of how far it is friendly to job creation in such respects.

19. In the product markets, scope remains to foster employment, and also to mitigate pressures that could contribute to asset price inflation. There is a case for (1) reviewing competition in wholesale distribution and in construction; (2) addressing tax and social contribution complications, and red tape, that may limit the growth of small enterprises and self-employment—including in personal services; and (3) assessing municipalities' approach to land development, while encouraging higher taxes on land that is ready for development but left vacant for speculative reasons. A further key priority is to press ahead rapidly with the privatization mandated by parliament—making a significant contribution to cutting the debt burden—and to seek a widening of this mandate in the case of commercial enterprises.

20. In the financial sector, major progress has been made in enhancing the efficiency of the banking system, but globalized markets and monetary union will sow winds of change that pose new challenges for financial institutions and supervisors alike. Competition under EMU is likely to be intense—whether from other euro zone banks or from securities markets (Finnish banks' loan and deposit intermediation remains very high). The lead supervisor arrangements recently reached with Sweden are very welcome, as is the creation this year of a separate insurance and pension supervisory agency, with close links to the banking and securities supervisor. Continuing consolidation within and across borders will pose challenges—which need to be addressed, of course, in a framework of international coordination. And in pensions, greater competition implies stronger supervision. In the financial sector, as elsewhere, progress has been made in addressing the Y2K issue; a priority economy-wide is to ensure that comprehensive contingency plans are well-advanced.

21. In the field of transparency, the mission welcomes the authorities' plans to publish these concluding remarks for the first time, and to participate in the pilot project for the publication of staff reports; and it encourages them to proceed with a self-assessment under the Fund's code for fiscal transparency. In this context, the mission strongly appreciated the continuing candour of the Article IV policy discussions—which was in no way diminished by the greater transparency now planned.

22. In international relations, Finland's profile in facilitating cooperative strategies in European affairs has never been higher. With the EU presidency from July 1, 1999, there will be scope to press firmly Finland's support for enlargement of the Union, as well as for outward-looking EU policies, which will contribute to a stable and growing global economy.

Helsinki, June 7, 1999.