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Luxembourg—2000 Article IV Consultation Discussions
February 29, 2000
1. Luxembourg's economic performance has remained impressive. Since our last visit, economic activity has continued to expand vigorously, with both real GDP and employment growth exceeding the respective EU averages by large margins; unemployment has remained low and stable at a rate of about 3 percent, less than one third of the EU-wide unemployment rate. At the same time, price and wage pressures have been subdued; CPI inflation excluding energy has stayed close to 1 percent. Finally, Luxembourg's fiscal performance is unmatched within the EU; the overall government has continued to register sizeable surpluses, and the public sector's net financial assets exceeded 30 percent of GDP at the end of 1999.
2. What are the sources of Luxembourg's excellent economic performance? Economic activity has been driven by a virtuous circle between skillful policies, social consensus, and locational external economies. We would particularly highlight the importance of locational external economies—knowledge spillovers between related activities; thick labor markets in specialized skills; and the ability of producers to share specialized providers of inputs—in underpinning the rapidly growing cluster of specialized service industries, particularly financial services. At the same time, Luxembourg's economy is able to draw on a highly elastic supply of labor from the surrounding regions. As a consequence, the pace of growth in Luxembourg can change for prolonged periods of time without triggering wage and price pressures—labor mobility acts as the primary adjustment mechanism to shocks. Finally, fiscal policy has largely resisted the temptations to fiscal profligacy in the face of a swelling tide of budget revenues. Instead, a large share of the additional fiscal resources went to accumulating financial assets, to cutting taxes, and to spending on public infrastructure—further bolstering Luxembourg's already formidable locational advantages.
3. Economic prospects for the next few years are bright. However, we see substantial downside risks to mechanically extrapolating Luxembourg's status-quo growth to the longer run. The experience of regions in other integrated economic areas shows that specialization allows clusters of activity to expand rapidly in an environment with high labor mobility—in line with Luxembourg's own record. But the growth dividend from regional specialization accrues at the cost of increased variability of growth—largely idiosyncratic and unpredictable shocks to preferences or technology can drastically change a region's growth outlook. In the particular case of Luxembourg, more tangible risks to long-term prospects include: ongoing European integration, in particular in areas such as regulatory structures and taxation, could eat into Luxembourg's locational advantages; greater integration of financial markets, both within and outside EMU, could stiffen competitive pressures for the financial center; and environmental constraints could eventually act as brakes to fast-paced growth.
4. In this setting, we believe that the challenge to policy makers will be to resist complacency and to adopt proactive policies to bolster the robustness of Luxembourg's economic and fiscal system in case of economic reversals. Four main priorities call for proactive policies: (i) diversifying the financing risks of the social insurance system, particularly the large-scale pay-as-you-go (PAYG) pension scheme; (ii) reforming the income tax system; (iii) improving the management of the public sector's financial assets; and (iv) mitigating labor market rigidities. The alternative to a proactive approach in these areas—wait-and-see and muddle-through when an economic reversal occurs—while perhaps more attractive from some perspectives, is likely to prove costlier in the longer run. Moreover, the benefits of acting early are illustrated by Luxembourg's tradition of proactive policies in the financial market area.
5. It is important to put our call for proactive policies into the context of an exceptionally favorable fiscal outlook over the next few years. Assuming continued spending restraint and unchanged tax policies, we project the general government's fiscal surplus to rise to about 5 percent of GDP by 2003, while the level of the public sector's net financial assets could climb to over 40 percent of GDP. This favorable fiscal outlook opens a wide window of opportunity for high-quality social insurance, income tax, and labor market reforms—even if these reforms would carry fiscally expensive price tags in the short run.
6. Luxembourg's public pension system—as well as other parts of the social insurance system—faces the longer-term risk of large declines in the pensioner support ratio (the number of contributing workers per pensioner). This risk is particularly pronounced in Luxembourg's case because of its very small, open, and highly specialized economy. Indeed, our stress testing simulations suggest that the pensioner support ratio would decline precipitously after 2010 if population aging were to combine with an abrupt reversal in cross-border worker flows.
7. In this context, we welcome the previous government's civil service pension reform—a proactive policy that put an effective ceiling on the pension replacement rate of an already generous system. But we would also advocate an early shift to a much more diversified pension system, perhaps benchmarked on Switzerland's long-standing multipillar approach to old-age income provision. Indeed, Luxembourg has already expended substantial efforts to establish a comprehensive legal framework for funded pension schemes. Besides spreading financing risks for future generations of workers and pensioners, a shift to a genuine multipillar structure would have additional longer-term benefits: required social contribution rates in a diversified system would be lower than otherwise, reducing labor cost; the fiscal system would be less sensitive to large adverse shocks; the likelihood of higher rates of return of funded schemes (relative to rates of return of PAYG schemes) would add to Luxembourg's locational advantages in terms of labor mobility; and Luxembourg would be able to draw on extensive local expertise to develop funded pension schemes.
8. Further income tax reforms would also be desirable—a lower tax burden would boost competitiveness and a more neutral tax system would improve the overall functioning of the economy. We therefore welcome the Government's plans to implement a significant income tax reform by 2002. These plans are still at a preliminary stage and, at this point, we would stress that reforms should be guided by the following broad efficiency principles: lower marginal tax rates; broaden the tax base; level the playing field across different sources of incomes; and resist the introduction of new special tax incentives.
9. The management of the public sector's financial assets—both at the social security and the central government levels—could be improved. Luxembourg's investment policies are excessively constrained by a host of extraneous considerations including social objectives and the dispersion of assets across a wide range of special funds, an arrangement prone to "honey pot" effects. A more professional asset management approach would aim at achieving a balanced profile of risk and return—and Luxembourg could draw on an abundance of local financial expertise for such a task. We welcome the authorities' intention to study this issue as regards the reserves of the social security system; but we would urge that similar attention be given to the management of the central government's financial assets.
10. Turning to Luxembourg's labor market performance, we note a seeming paradox. On the one hand, labor market institutions appear to be rife with rigidities, most of them also found in neighboring countries suffering from poor labor market performance—a high legal minimum wage; close-to-automatic wage indexation; collective bargaining at the sectoral level; administrative extension of sectoral wage agreements; a large-scale PAYG social insurance system; strict employment protection rules; and a generous social safety net for the long-term unemployed. On the other hand, the labor market has performed well, both in terms of the level of unemployment and, in particular, in terms of employment growth. In our assessment, the paradox can be resolved by noting that Luxembourg's exceptionally buoyant economic environment may have blunted the impact of rigidities. As a consequence, we suspect that Luxembourg's labor market would prove much less resilient in a less favorable economic environment—although we would acknowledge that both the steel crisis in the 1970s and the oil shock at the beginning of the 1980s illustrate the remarkable adaptability of Luxembourg's institutions and policies under circumstances of duress.
11. The National Action Plan for Employment contains many helpful elements including new tools to re-integrate the unemployed, cuts in red tape for small- and medium-sized companies, more flexible working time arrangements, and a new parental leave scheme. Nevertheless, we continue to see a solid case for more fundamental labor market reforms including promoting more flexible labor cost structures, particularly at the lower end of the labor market, and tightening eligibility criteria for social benefits, particularly as regards early retirement schemes. In this context, we note that other small continental European countries, in particular Denmark, the Netherlands, and Switzerland, while broadly sharing Luxembourg's objectives regarding distributional equity and social consensus have, at least in some areas, adopted labor market institutions markedly more flexible than Luxembourg.
12. Luxembourg has been relatively slow in transposing EU Single Market directives in the product market area, particularly in the energy and transportation sectors. We see considerable scope for going beyond a minimalistic approach in deregulating these sectors. As regards diversification policies that target particular companies or sectors, we would repeat the point that specialization is a key benefit of economic integration and this should not be artificially resisted through state interventions.
13. Luxembourg's large financial sector is evolving from an off-shore center (driven mainly by regulatory and tax advantages) to an on-shore center (driven mainly by specialized knowledge). Supporting this observation, the loss of what was once considered a key regulatory advantage—the absence of minimum reserve requirements in Luxembourg—hardly dented growth in the financial sector in 1999. The increased emphasis on financial sector activities related to specialized knowledge should also help diminish Luxembourg's vulnerability to the possible introduction of an EU-wide minimum withholding tax on interest income.
14. On joining the Eurosystem, the Institut Monétaire Luxembourgeois became the Banque centrale du Luxembourg (BCL) and took on the responsibilities of a fully-fledged independent central bank. Setting up a central bank is a complex undertaking—but the BCL has quickly acquired the necessary competencies to fulfill its functions. Moreover, the BCL's role in implementing the ECB's monetary policy and in operating a payments system has added new growth opportunities to the financial center.
15. In December 1998, a new and independent Commission de surveillance du secteur financier (CSSF) was set up to take charge of consolidated financial sector supervision. Consolidation, however, stopped short of integrating insurance supervision in the CSSF. This does not pose a serious threat to efficient supervision at this point—tie-ups between banks and insurance companies (bancassurance) are rare in Luxembourg. But we would nevertheless encourage complete integration of supervisory responsibilities. We fully expect that the CSSF will meet the challenges of supervising Luxembourg's large, evolving, and mostly foreign-owned financial sector.
16. Luxembourg's economic statistics have traditionally been weak. But more recently, considerable progress was made, in particular in compiling national accounts data. There remains, however, considerable room for further improvements in coverage, periodicity, timeliness, and quality of the data. We are encouraged by the Government's intention to provide adequate budgetary resources for implementing Luxembourg's undertakings in the statistical area. We would urge to expend the additional efforts needed to allow Luxembourg to subscribe to the Fund's Special Data Dissemination Standard.
17. Official development assistance (ODA) has increased sharply in recent years. In 2000, Luxembourg is likely to join the exclusive circle of countries whose ODA volume meets the United Nations' objective of 0.7 percent of GNP. Moreover, the Government has announced to aim at a further increase of ODA to 1 percent of GNP by 2004. We warmly welcome Luxembourg's determination to live up to and go well beyond international ODA commitments. We also appreciate Luxembourg's efforts at the EU level to further open up markets to all imports from the least developed countries.
18. We welcome Luxembourg's participation in the pilot project for publication of IMF Article IV staff reports.
19. In closing, we would like to express our appreciation for the warm hospitality and exemplary cooperation that has facilitated our work here.