Concluding Remarks of the 2000 Article IV Consultation -- Finland
June 12, 2000
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June 12, 2000
1. Thanks to sound macroeconomic policies, Finland has fully recovered from the depression of the early 1990s, and is engaged in a new phase of economic growth. Real GDP increased at an average annual rate of 4½ percent over the past three years; inflationary pressures have remained largely absent; the public finances are back into a comfortable surplus; and the viability of the banking sector has been restored. In addition, a very dynamic "high tech" sector has emerged, which, while still accounting for only 3 percent of employment, is generating nearly a third of the growth in real GDP.
2. Nonetheless, serious problems remain. If not tackled promptly, these problems could undermine the prospects for robust longer-run economic growth and hinder Finland's adjustment to the impending demographic shock facing all of Europe: an insufficient number of workers to support a growing population of pensioners. In particular, (1) outside the high tech sector productivity growth is rather low - labor productivity increased at an average annual rate of only 1.3 percent over the past three years; and (2) a high rate of structural unemployment and a low average retirement age limit the effective labor supply. In the traditional sectors much of the economic growth of recent years has been based on the re-absorption of the large pool of cyclical unemployment. As this process will soon come to an end, the growth potential of the economy could be sharply curtailed. These problems are not unrelated to the high tax burden and to persistent rigidities in the product and labor markets.
3. The government's policy strategy is rightly aimed at tackling these problems, but, while some measures have been taken, much remains to be done. With currently strong economic activity and Finland's cyclical position already somewhat ahead of the euro-area average, the continuous restraint on the growth of public expenditures is welcome. The resulting surpluses will provide room for the use of automatic stabilizers in periods of weak economic activity and help cushion some of the fiscal impact of population aging. However, this policy needs to be complemented by: (1) a significant reduction in the heavy tax burden on labor income to strengthen labor market incentives, (2) elimination of the various subsidies and other incentives for early retirement to increase the effective retirement age, and, (3) further reforms of labor and product markets to improve the flexibility and supply response of the economy. These three dimensions of reforms should be viewed as mutually reinforcing each other.
Economic Environment and Outlook
4. Finland weathered the emerging market crisis with only a mild slowdown in economic activity, and the near-term outlook is favorable. After a temporary slowdown in activity in the first half of 1999, economic growth picked up toward the end of the year, driven by a sharp recovery in exports. This expansion in exports should continue in 2000-01 as the country's external competitiveness remains strong and domestic demand growth accelerates in the rest of the euro area. Domestic demand should also increase rapidly in Finland as both consumer and business confidence is bolstered by favorable employment and profit developments. Thus, the mission concurs with the authorities' projections of strong economic growth of the order of 5 percent in 2000 and 4 percent in 2001.
5. While there is no clear evidence of overheating so far, in the absence of further reforms, labor market tensions and capacity constraints may well emerge in 2001. Currently there is still some economic slack. The economy-wide vacancy rate remains below 1 percent of the labor force, and there are no generalized cost-push pressures. Capacity utilization remains below previous cycle peaks, and the shift in activity toward the high tech sector—where capacity is fully used but also expanding rapidly—may well result in higher average utilization rates without implying a constraint on production. Nonetheless, warning signs are emerging. Labor shortages are becoming more pressing in certain sectors, including information technology and construction. Wage negotiations for 2000 have been more difficult than those for previous years. Consumer price inflation has hovered around 2¾ percent in recent months, and core inflation (excluding energy and seasonal food) has risen to 1¾ percent—some ¾ percentage points above both the 1999 rate and the euro-area average. Housing prices are rising at an annual rate in excess of 20 percent. Even with wage moderation, the mission believes that there is some risk that the core rate of inflation could move above 2 percent in 2001.
6. The government's medium-term fiscal framework presented in its 1999 update of the Stability Program incorporates the right elements, with expenditure restraint generating strong surpluses and providing scope for needed tax cuts on labor income. The government's expenditure plans through 2003 feature tight ceilings on central government outlays, broadly freezing real spending at the level budgeted in 1999. This would reduce the expenditure ratio by some 3½ percentage points of GDP in 2003 relative to 1999, which would be sufficient to bring the share of public spending in GDP down below pre-crisis levels. The budget of the central government would be in structural surplus throughout the 2000-03 period, notwithstanding tax cuts of FIM 10-11 billion (some 1½ percent of 1999 GDP), of which FIM 2.5 billion (0.3 percent of GDP) was included in the 2000 budget. The social security funds' surplus would continue to exceed 3 percent of GDP. Encouraged by strong economic growth and buoyant revenues, the government has recently announced its intention to increase the size of tax cuts, while stressing the need for continued wage moderation. The mission welcomes this decision. Indeed, it would urge the authorities to be bold in their tax-cutting endeavor, as the current very heavy tax burden on labor income impedes employment incentives by keeping labor input expensive for firms and rewards low for employees. With the favorable outlook in public finances, an overall reduction in income taxes and social security contributions of about 2¼ percentage points of GDP should be feasible over the 2001-03 period (with about FIM 7.5-8.5 billion remaining from the FIM 10-11 billion, and an additional FIM 11 billion). Assuming average GDP growth of about 3½ percent, this would still be consistent with keeping a surplus in the central government finances throughout this period, albeit a smaller one than foreseen in the 1999 Stability Program.
7. As to the composition of tax cuts, the current policy of combining targeted relief for lower income groups with across-the-board reductions provides an appropriate balance between the two goals of reducing high unemployment among the low-skilled and affecting work decisions (including the choice of residence) on a wider scale. Targeted tax cuts can be an effective tool in stimulating employment creation at the low-skill level. Past reforms in this area, such as increases in the threshold level for local income taxation, have already contributed to a substantial removal of unemployment traps, by lowering the "threshold wage" at which work becomes financially attractive. As a result, taxes paid by low-income workers have fallen substantially, making further actions in this direction less effective. Measures that are likely to be more effective would be those that directly reduce the non-wage cost for low-skilled workers, for example, through reductions in social security contributions for low-paid jobs, compensated by transfers from the central government. Alternatively, there may be a case for using tax revenues to finance a larger proportion of services that are granted to the entire population, rather than relying on social security contributions that add to labor costs. In addition, there is also a need to reduce the high marginal income tax rates across the pay scale, which tend to undermine efforts to improve work performance and skills, as a substantial part of the additional reward is "taxed away". Finally, with increased globalization and international mobility, tax decisions also need to be seen from the perspective of discouraging tax-induced emigration of high-skilled employees, who are needed to continue Finland's outstanding performance in the high tech industry.
8. Regarding the timing of these tax cuts, the mission recommends that they be spread uniformly over the 2001-03 period. For 2001, this would translate into a discretionary reduction in the tax ratio by some ¾ percent of GDP, and the projected surplus in the central government would be about 1 percent of GDP, versus 1½ percent in 2000. Overall, the fiscal stance would be somewhat stimulative in 2001, but not by much, because the impact of tax cuts on aggregate demand is, in the short run, proportionately smaller than that of expenditure cuts. At the same time, monetary conditions in the euro area are likely to tighten, owing to interest rate hikes and an expected recovery of the euro. Similarly, the tax cuts envisaged for 2002-03 would lead to a slightly expansionary fiscal stance, while monetary conditions would likely tighten further. To avoid an emergence of inflationary pressures, this macroeconomic policy stance would have to be complemented by both wage moderation and other measures on the structural front to expand the effective labor supply. Given that structural measures take time to have effect, prompt action is needed.
Extending the Span of Workers' Employment Years
9. Strengthening incentives for a long active working life must be an absolute policy priority, not only to cushion the fiscal impact of the demographic shock, but also to foster intergenerational fairness and social cohesion, by allowing the age group of 55-65 to play its rightful role in the productive labor force. The existing schemes for subsidized early retirement, such as the unemployment and part-time pensions, were established during the depression period and may well have played a valuable role in lessening the dramatic financial and social impact of the crisis on the older part of the population. However, with the economy having fully recovered and the demographic shock looming, there is no rationale for maintaining a system which, by ameliorating somewhat the financial conditions of early retirees, provides an excuse for employers to push older workers out the door. Currently, fewer than half of the people in the age group 55-65 are employed, and the effective retirement age is 59—six years lower than the statutory retirement age. The increase in the number of pensioners relative to the working-age population is projected to rise sharply over the coming decades, and this rise would be magnified, if early retirement remained the norm, rather than being the exception it used to be. With the "baby-boom" generation already past middle age, the time to reform the system is now. The key measures should include: (i) closing the "unemployment pipeline" to early retirement, by removing the requalification exemption for unemployment benefits of the unemployed aged 55 and over; (ii) discontinuing the unemployment pension scheme and eliminating the subsidy element in the part-time pension scheme, with grandfathering of current beneficiaries; (iii) enforcing strictly the eligibility requirements for disability pensions; (iv) removing existing disincentives for firms to retain older employees, such as those stemming from having the employer directly responsible for part of the cost of disability of his employees; and (v) moving toward a closer relationship between pension benefits and life-time contributions, rather than the current practice of basing pensions on only the last ten years of contribution, if only to avoid an unduly large penalty for taking on a lower paid job at later stages of the working life. Such a strategy would be a key component of an effective solution to the demographic shock, and could help set in motion a virtuous circle of higher employment, stronger output, and improved public finances over the longer term.
Reforms of Labor, Land, and Product Markets
10. While increases in average wages have been moderate in recent years, the wage bargaining process does not seem able to deliver the appropriate differentiation among regions, sectors, and job skills. Minimum increases in wages tend to be uniform across the economy, based on the average economy-wide rate of productivity growth and the targeted rate of inflation at the euro-area level. The risk inherent in this approach is that while sectors with high productivity growth can adjust through additional wage increases and various bonus schemes, sectors with low productivity are liable to suffer a gradual loss of competitiveness. As the economic slack disappears, such a system could be inflationary. Even more importantly, it tends to aggravate rather than alleviate the employment problem for the unskilled, because the low productivity sectors are often those with a high proportion of unskilled workers. The current dichotomy between the high tech sector—with extremely high rates of growth of productivity, largely passed on to consumers in the form of price cuts—and the rest of the economy, with far smaller rates of productivity growth, makes this approach particularly inappropriate. There is therefore an urgent need for the social partners to move to a much more flexible framework with greater wage differentiation.
11. On the labor supply side, there is need and scope to improve the balance between providing a safety net for the unemployed and encouraging greater individual job search initiative. In particular, gradually replacing the present flat rate of unemployment benefits by one in which benefits decline over time is essential for fostering re-employability, which tends to worsen with the duration of unemployment. To help increase labor mobility, it is also important to introduce a strong conditioning of unemployment benefits on job search and willingness to participate in training schemes, as well as stricter enforcement of job acceptance requirements across regions and occupations. The authorities should also continue to monitor the efficiency of the various active labor market programs. They should not hesitate to increase the funding of those that are effective, while downgrading or even terminating those that are found to be wasteful.
12. Structural reforms of product markets are also needed to strengthen the competitive environment. Considerable progress has been achieved in past years in deregulating and liberalizing key areas of the economy, including telecommunications and energy. Now, with early signs of cyclical tensions emerging, it is even more important to continue reforms of the product markets, in order to encourage competition and business creation and to dampen inflationary risk. The recent decision to reduce the state's holdings in telecommunications is welcome, and the government is strongly encouraged to implement speedily the privatization program mandated by parliament. Moreover, the government could seek to increase competition in some areas of retail trade where there is a high degree of concentration by promoting e-commerce through the adoption of supportive legislation. More generally, the authorities should ensure that the legal and regulatory framework contributes to the expansion of the internet-based "new economy" in Finland, so as to boost overall economic productivity. There is also scope to increase private sector involvement in the provision of public services, particularly at the municipal level, and to simplify administrative and tax procedures that currently obstruct the creation of small enterprises and self employment.
13. The inadequate supply of housing units in high growth areas has been hindering labor mobility and therefore contributing to high unemployment. Inappropriate incentives induce local governments to discriminate the granting of building permits in favor of corporate, rather than housing, units. Financial arrangements between the State and local governments could usefully be reassessed with a view to removing any disincentive for the building of residential developments. Similarly, the government could examine whether there are tax or regulatory disincentives to the private provision of rental housing, and consider extending favorable tax treatment to developers of rental housing projects.
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14. Faced by a truly major economic challenge at the beginning of the 1990s, Finland reacted with great courage and determination, and is now seeing the fruits of its adjustment efforts. Notwithstanding these achievements, important issues remain to be resolved, most notably an unemployment rate that remains much too high and a failure to provide the 55 to 65 age group with appropriate work opportunities. The mission is confident that the government, in collaboration with the social partners, will address these issues with the same resolve demonstrated in the past, and that this will ensure the continuation of Finland's success story.
Helsinki, June 12, 2000