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Norway—2001 Article IV Consultation
December 6, 2001
1. The Norwegian economic policy landscape has undergone significant shifts during the course of 2001. The economy continued its long expansion of recent years, retaining its remarkable record of high employment and low inflation. The policy of reinvesting abroad a large part of oil revenues has continued to underpin stability by insulating the economy from the fluctuating fortunes of the oil sector and has helped build the foundation for an equitable sharing of oil wealth with future generations of Norwegians. The year has also seen important changes in the economic policy framework—the adoption of an inflation targeting regime and a new long-term fiscal program in the spring. Moreover, a new government took office and set in train a policy redirection, auguring well for a long overdue reduction in the high tax burden. As Norway nears its peak petroleum output and faces a demographic transition, this is an opportune time to design and implement an economic policy agenda to ensure high living standards over the long run.
2. The global economic slowdown under way is bound to have ripple effects on Norway, intensifying existing sectoral imbalances. The most likely channel of transmission is the export sector—already feeling the impact of softer demand and slumping prices. Set against this is the strong rise in household disposable income expected next year, which should sustain private consumption despite high real interest rates. Under the present expectation that a recovery in the world economy will take hold by the middle of 2002 and gather pace in the second half of the year, mainland growth is projected to be around 1¼ percent in 2002. The exposed sector is likely to slow down, while sheltered sectors continue to grow and experience constraints on capacity and labor supply, intensified by the planned fiscal stimulus. Transitory effects of tax changes and energy prices should help keep headline inflation below 2 percent. A caveat to this broadly benign scenario is in order. The recent pattern of repeated downward revisions to global growth projections and the steep loss in consumer and business confidence that followed the tragic events in the United States suggest that the risk of even weaker world growth in 2002 than is now projected should not be discounted—nor should the possibility of a stronger adverse impact on the Norwegian economy than is visible in current indicators, particularly if oil prices were to weaken even more sharply.
3. The economic slowdown and downside risks to growth justify a moderate policy stimulus for 2002. The fiscal stimulus of around half a percent of GDP in the budget for 2002 approved by parliament last week is appropriate, given the expected cyclical slowdown. However, it does diminish the scope for alleviating the burden of high interest rates. Some of the fiscal stimulus will take effect late in 2002 and into 2003 due to the timing of tax cuts. Such carryover of the stimulus, combined with continued fiscal expansion in 2003 could contribute to excess demand pressures as activity gathers speed. Furthermore, the fiscal stance at the general government level has tended to be more expansionary than the state budget in recent years and this trend is projected to continue next year.
4. The adoption of an inflation targeting framework is a welcome affirmation of the authorities' commitment to low and stable inflation. By setting the inflation target at 2½ percent, the government has rightfully indicated its preferred balance between inflation and nominal appreciation. Adherence to the inflation targeting framework will contribute to nominal exchange rate stability in the medium term, provided that fiscal policy does not lead to excessive real appreciation, which monetary policy would be powerless to counteract. However, it will be important for Norges Bank, especially in the early stages of the new regime, to react to movements in the exchange rate only to the extent that they affect its inflation forecast over the two-year horizon. Any attempt—actual or perceived—to attain two separate and sometimes conflicting objectives could confuse the markets and thereby undermine the credibility and coherence of the regime. The decision to exclude temporary influences from the price index to prevent a volatile interest rate path is appropriate, as is the publication of the underlying index by Statistics Norway. However, Norges Bank should abstain from frequent changes to its definition of the underlying price index so as to avoid any perception that attempts were being made to justify deviations of inflation from its target level.
5. With inflation at the two-year horizon likely to be below target, some room for interest rate cuts has emerged. During the course of 2001, even as interest rates abroad have fallen, Norges Bank has held a steady hand, reflecting Norway's tight labor market and cyclical divergence from its trading partners. Indeed, with inflation running significantly above target in the first half of the year and strong domestic inflationary impulses, Norges Bank is to be commended for its commitment to bringing inflation back to its target path. The success in dampening underlying inflation, combined with the subdued outlook for growth in the near future and the expected increase in real interest rates next year as headline inflation declines sharply, has provided some room for monetary easing. However, as the negative impulses and downside risks associated with the global outlook recede and the stimulus from fiscal policy begins to add to demand pressures from late 2002 on, renewed monetary tightening would likely be required. A more enduring relaxation of the current high interest rates would be possible only if the social partners are able to ensure wage moderation in the upcoming bargaining round.
6. The new Long-Term Programme, calling for spending more of the oil revenues over the next decade, reinforces concerns about long-term fiscal sustainability. The choice about when and how to use the resource wealth rightfully occupies a central position in the policy debate. The new fiscal rule, which allows the use of the expected real return on the Government Petroleum Fund to increase nonoil fiscal deficits, formalizes the decision to spend more of the oil wealth and seems appealing on account of its simplicity. However, it is critical for the public to appreciate some hard facts about the current use of the oil wealth and its implications for the future. The bulk of the cash flow from past petroleum extraction has already been used in the past three decades to finance a large rise in public employment. Looking ahead, the impending demographic transition will impose escalating demands on fiscal resources to provide for public pensions and health care services, and will result in a shrinking pool of effective labor to generate those resources. Indeed—without a substantive reform of the pension regime and under plausible assumptions underlying the Programme itself—the policy of using the return on the oil fund indefinitely implies a drastic squeeze on non-pension public spending in the future. Absent an early pension reform, a desire to maintain the current share of non-pension public spending in GDP in the future—let alone to allow it to rise in line with the demands of demography—would force Norway to violate the fiscal rule and could thus result in the exhaustion of the fund before mid-century.
7. Exhaustion of oil wealth would violate the admirable Norwegian principle of solidarity across generations. Indeed, if this implication were to be fully recognized, many Norwegians would find it unsettling that their children and grandchildren would not benefit much from the oil windfall. This analysis points to the need for a balanced strategy of public finance that stimulates potential growth through tax reform, frees up additional resources by improving labor market incentives and public sector efficiency, and designs a long-term plan to address the variety of needs of an ageing population while preserving a fair share of the oil wealth for future generations. An early reform of the public pension system would have to be a key component of such a strategy (see 10).
8. Tax cuts to raise growth and efficiency could help mitigate the detrimental impact of the new fiscal rule on the private economy. In this context, the new government's decision to shift the balance toward larger tax cuts rather than higher spending and to aim at a medium-term reduction in the public spending ratio is in the right direction. Abolishing the investment tax and removing last year's temporary tax on dividend income are welcome measures to enhance tax neutrality and efficiency, as would be measures to reduce tax loopholes and end the extensive tax preferences that benefit primarily the energy—intensive and shipping industries. The plan to increase the standard income tax allowance and the threshold for the surtax would help reduce marginal tax rates for some income groups. To reduce loopholes associated with the dual income tax regime, the differential between the top marginal tax rates on capital and labor income should be reduced. While some reductions in rates may be necessary due to international tax competition, changes that narrow the tax base should be avoided. In the same vein, the VAT base should be expanded to cover most of the remaining services. It will also be important to reduce the discrimination currently in favor of wealth held in the form of real estate and against financial assets, especially since Norway's tax burden on real estate is relatively low in an international context. Such a change would reduce incentives for overinvestment in property, help develop Norwegian financial markets and channel more savings to risk capital.
9. The emphasis of the strategy towards public spending should be on increasing the efficiency of spending rather than its level. Announced intentions to reform the public sector are welcome. These reforms will require stronger incentives and substantial market elements, including improved pricing mechanisms, more extensive privatization, result-based financial management and salary structures, and better intra-governmental transfer mechanisms. Further growth in public employment should be reined in by reducing excessive bureaucracy and reallocating labor to its most efficient uses. Much of the discontent with the current health care system can be traced to rationing of services through queuing and rent-seeking supply restrictions. The authorities also need to act quickly to restrain the rapid rise in costs in some social insurance programs, especially in sickness leave and early retirement.
10. An overhaul of the pension system as part of an adequate response to the demographic transition is long overdue. Many advanced countries have initiated reforms of their unsustainable social insurance systems. The present Norwegian public pension system is also financially unviable, and oil wealth alone cannot cover the surge in public pension liabilities expected over the next decades. Yet, the popular perception of large oil wealth has regrettably delayed a serious consideration of this issue. While oil wealth will play a role in easing the cost of the demographic transition, a policy change that ignores the need for substantive pension reform and relies solely on renaming the Government Petroleum Fund should be avoided. The recently appointed high-powered commission should aim at a comprehensive reform that ensures financial viability of the pension system, reduces the major disincentive effects of the current regime on labor supply, and addresses future health care needs. First, a closer link between benefits and contributions should be established and a sense of ownership in the system should be fostered. For example, Norway could consider creating an automatic adjustment mechanism that would balance the present value of the pension system's liabilities with its contributions and assets. To provide for private choice and help develop Norwegian financial markets, a small defined contribution element could be accumulated gradually through annual savings. Second, the acute decline in labor supply expected from an ageing population will need to be stemmed. Therefore, people who want to work longer should not be discouraged by the pension and tax systems. Indeed, some groups earn less by working than by retiring. In addition, liberal access to disability pensions also contributes to a rapid exit from the labor force. Finally, the reform should address the increased health care costs resulting from the demographic transition.
11. The coming wage bargaining round will test the Solidarity Alternative framework. The unbalanced labor market expected by spring—with job losses in the exposed sector combined with continued labor shortages in service industries—will put additional strains on the resolve of the social partners to maintain competitiveness by letting the exposed sector take its traditional lead role in wage setting. An excessive rise in public sector wages could fracture the social consensus for maintaining competitiveness and would not be consistent with productivity differentials.
12. Structural measures are needed to raise effective labor supply and labor market flexibility. Despite Norway's high labor participation rate, hours worked remain the lowest among the advanced countries. Furthermore, effective labor supply has become more limited by restrictive labor regulations, a surge in sickness absence and the increased take-up of disability and early retirement pensions—trends that are likely to become even more pronounced over time. The authorities should implement the Sandman commission's recommendations, including the reduction of the replacement ratio for extended sickness absence. Labor supply constraints could be eased by reforming the unemployment benefit structure, and by measures to increase employment flexibility through easing rules on fixed-term contracts, working hours, and hiring and dismissals, and focusing active labor market programs on acquiring job-related skills. The government's intention to liberalize the inflow of immigrant labor is a welcome step toward easing labor shortages. Allowing increased wage flexibility would reward investment in education and in productive industries, and ensure that the young and low-skilled are not crowded out of employment.
13. The economic restructuring associated with increased spending of oil wealth creates an urgent need for structural measures to improve microeconomic efficiency and the viability of the nonoil export sector. Economic costs implied by the long-term fiscal expansion, especially if it takes the form of higher public spending, will likely begin surfacing soon in the form of a further real appreciation and pressures on the nonoil exposed sector. Structural reform, including privatization and deregulation, will be required to counter these forces and ensure viable industries. Efforts to foster competition throughout the economy and to extend privatization in competitive sectors are therefore essential.
14. The financial system remains stable, but the outlook has become more uncertain. Although rapid domestic credit growth is currently leveling off, it has led to high indebtedness both in the enterprise and household sectors. While credit risk in the household sector is still relatively low, enterprises have become more vulnerable to a possible economic downturn. Declining earnings have added to risks involved in lending to mainland export enterprises. The credit quality of some industries may also be affected by structural changes associated with the transfer of resources to the public and other sheltered sectors. While banks' financial strength is still satisfactory, risks could also be amplified in Norway's concentrated financial system, with its increasingly important international linkages. The recent Financial Stability Report indicates that the financial supervisors are actively monitoring these risks.
15. Norway should complement its generous aid to the developing world with reduced budgetary and trade protection of agriculture. The intention to raise official development assistance as percent of GNP is commendable. However, the subsidy to agriculture, which itself costs around one percent of output and has failed to achieve the objective of preventing the depopulation of rural areas, is damaging to the exports of developing countries. Direct budget transfers that are not linked to output or trade would be a more appropriate means of supporting rural communities.
16. In sum, the macroeconomic performance and policies of recent years remain admirable. Looking ahead, as Norway faces the challenge of designing and implementing structural reforms to secure long-term economic welfare, the oil windfall, while comforting, should not become a cause for complacency.