Austria -- 2002 Article IV Consultation, Preliminary Conclusions of the Mission
May 6, 2002
1. In the last two years, a fresh approach to economic policy has taken shape in Austria. This approach builds on the strengths of the past, notably a tradition of price stability and wage moderation, and focuses on reducing the burden of the state, ensuring healthy public finances, liberalizing markets, and supporting enterpreneurship. Progress so far has been uneven, and it is too early to judge to what extent these goals will be reached. Nevertheless, this new approach has already delivered some notable successes.
2. This new approach to economic policy will now meet its first major tests. First, the current economic slowdown, albeit mild by historical standards, will make it more difficult to maintain the balanced budget. The recovery is projected to start in 2002, but its timing is uncertain. In the best case, the rate of growth in 2002 as a whole will be slightly above the rate of last year and reach 2½-2¾ percent in 2003, while unemployment is likely to rise further before beginning to decline. But if the recovery is delayed, growth this year could be somewhat lower than in 2001 and remain below 2½ percent on average in 2003. Second, the forthcoming elections may create pressures to abandon the responsible fiscal management of the last two years and stop key structural reforms.
3. Looking ahead, the Austrian economy will need to adapt to a new environment: (1) the aging population will force far-reaching adjustments to the traditional pay-as-you-go pension system, as in many other European countries; (2) intensifying competition within the expanding European Union will require lowering Austria's high tax burden; and (3) continued success in the globalized knowledge economy will necessitate more flexible institutions and attitudes.
4. To pass these short-term tests, as well as ensure continued success in the future, policy-makers and the social partners should recognize the need for change and bring long-term considerations to bear on today's economic policy decisions. In what follows, we outline our preliminary recommendations in some key areas.
5. The balanced budget should be maintained in 2002. Although this will require continued fiscal restraint in a period of slow growth, it is critical for policy credibility. Because the "zero deficit" was achieved in 2001 partly thanks to one-off advance payments of income taxes, abandoning it just one year later would raise doubts about the sustainability of this target and the government's commitment to it.
6. In 2003 and beyond, policy should be oriented toward maintaining a balanced budget over the economic cycle, consistent with Austria's Stability Program. There are good arguments for a tax reform in 2003: it would undo some of the tax hikes on which the consolidation of 2001-02 was based, and set the stage for further tax reductions over the medium term. But tax reform should not take place at the expense of fiscal discipline, and must be accompanied by spending cuts. Furthermore, the quality of the tax and expenditure measures is as important as the quantity: tax reductions should be consistent with an appropriate medium-term tax strategy (see below), and spending cuts should be permanent. These considerations should guide the formulation of the 2003 budget that will begin this summer.
7. We support the goal of reducing significantly the tax burden over the medium term, provided this is done in a way that promotes sustainable growth. The government taxes away almost 46 cents out of every euro of value added generated in the Austrian economy. Not only is this share high, but the difference between Austria and its peers is bound to grow as other countries reduce their tax burden. Therefore, the objective of lowering the tax burden to about 40 percent of GDP by 2010 points in the right direction. But not all tax cuts are the same. As the government starts to prepare its medium-term tax strategy, it should aim at (1) reducing the burden on labor and capital, especially since these are becoming increasingly mobile across borders; (2) maximizing incentives to work; and (3) minimizing distortions in the treatment of various types of assets.
8. Achieving lasting tax reductions of this magnitude will require a new medium-term fiscal policy framework based on multi-year expenditure targets. Given the Stability Program's objective of a balanced budget over the cycle, reaching a 40 percent tax-to-GDP ratio implies a corresponding reduction in government expenditure. This is ambitious, but the experience of other European countries shows that it can be done. However, the present Stability Program would need to be supplemented by a new fiscal policy framework. Its core would be annual expenditure targets for the medium term, broken down by major spending categories, and accompanied by a set of specific policies to achieve them. Such a coherent and transparent framework would provide the basis for making the necessary political choices between competing spending priorities in an informed and rational manner. Targeting the expenditure path while allowing the automatic stabilizers on the revenue side to operate freely would also shift the focus to the cyclically-adjusted fiscal balance. The new budget framework law, currently under preparation, could provide the appropriate vehicle for introducing such a medium-term fiscal policy framework.
9. Redefining the fiscal relations between the federal, state, and local governments is an important condition for the success of the medium-term budgetary plans. The present system of fiscal relations between the various levels of government is rooted in tradition. As the recent Internal Stability Pact between the federal, provincial, and local governments demonstrates, the system can still be used to support a common goal. However, it also has serious shortcomings and may not be adequate to deliver a medium-term adjustment effort of the magnitude contemplated by the government. The next Finanzausgleich in 2004 will provide an opportunity to simplify the system, enhance its transparency, and ensure that the burden of adjustment be spread fairly among the various levels.
Structural and financial sector policies
10. Austria's demographic trends represent the most serious threat for the long-term sustainability of the public pension system and, more broadly, of the public finances. The ratio of the elderly (over 64 years) to the total working age population is projected to double in the next thirty years. Without corrective measures, total age-related spending (pensions, health, and long-term care) would rise by 5-6 percentage points of GDP, according to the government's estimates. Under slightly less optimistic assumptions, age-related spending could rise by 9-10 percentage points of GDP, making not only the pension system but the finances of the public sector as a whole unsustainable. This is not a problem unique to Austria: other European countries are faced with similar demographic trends. But each country must solve the problem on its own.
11. What can be done? Fundamentally, there are only two viable options for the current system: lengthen working life, so as to increase the number of contributors and reduce the number of pensioners; or cut pension benefits. Since Austria has one of the lowest participation rates for older workers (55-64 years) among developed countries, it makes sense to concentrate on the first option. Some measures have already been taken in this direction-notably increasing retirement age by 18 months. But much more will need to be done. The menu of possible measures includes, among others, restricting early retirement (the effective average retirement age in Austria is 58 years, one of the lowest in the world); accelerating the equalization of female and male retirement ages; harmonizing the different pension schemes, notably in the public and private sectors; adjusting pension benefits to life expectancy; and indexing pensions to prices rather than wages. In addition to this menu of reforms, a supplementary funded system could also be developed. But this by itself would not address the fundamental imbalances of the current system.
12. The biggest risk is doing nothing. The demographic trends are deteriorating only gradually until 2010 and take a rapid turn for the worse after that. There is thus the temptation to delay decisions until age-related spending begins to rise and the magnitude of the problem becomes clearer. This is a myopic view: postponing the solution would actually make it costlier. Another temptation is to avoid the necessary reforms, hoping that changes in family policy to slow the decline in the birth rate, improvements in education and training, and active labor market policies would be sufficient. These measures are useful and could indeed supplement pension reform. But they will not solve the underlying problem and, in addition, are not always cost effective. These temptations should be resisted. Instead, the government, political parties, and social partners should work together to educate Austrians about the problem and the available options, and act decisively while spending pressures are still modest. We hope that the work of the pension reform expert group currently underway would provide the basis for consensus and action.
13. Microeconomic reforms are key for increasing efficiency and raising the growth potential of the economy. A number of steps have been taken to deregulate product and labor markets and increase their flexibility. Some, like the liberalization of the telecommunications and electricity sectors, have already brought significant benefits. Others will bear fruit only over time. These efforts should be continued, with the planned reform of the severance pay system, further reduction of the administrative burden on business, and liberalization of Austria's anachronistic shop opening hours regulation. Moreover, the details of the "Austrian solution" to the electricity sector should be designed carefully so as not to hinder competition. And the recommendations of the Expenditure Reform Commission, particularly in the areas of education, hospital management, and housing policy, should gradually be translated into concrete measures. All these microeconomic reforms will help maintain Austria's position in an increasingly competitive world and raise the economy's long-run potential growth. In this way, they will also contribute to some extent toward accommodating the growing burden of age-related spending on the public purse.
14. Like the rest of Austria's economy, the financial sector has benefited from globalization. Significant benefits have derived, in particular, from the opening up of Central and Eastern European countries and their preparation for EU accession. This process has created jobs, profits, and opportunity for growth. It has also brought new risks, and the supervisory structures are evolving to address these. The most recent revisions in the banking law, the National Bank's Financial Stability Reports, and the creation of the Financial Market Authority (FMA) are all welcome steps in the right direction. Building on the new legal framework, the FMA now has to grow into an efficient and effective supervisory body. Additional skilled staff need to be recruited and trained to enhance the oversight of the financial sector. While independent, the FMA has to cooperate both in policy development and implementation with the National Bank and the Ministry of Finance. This is essential to ensure there are no gaps in the supervision of the financial sector. Cooperation is equally important for avoiding duplication and an unnecessary regulatory burden that would impose needless costs on consumers and handicap Austrian financial institutions competing internationally. Laws and regulations will need to continue adapting to international best practices, such as establishing the framework for supervision of the financial conglomerates growing within Austria and throughout Europe.
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Austrians enjoy the benefits of a strong and affluent market economy. The increasing integration into the European and world economy over the last decade and, more recently, the successful introduction of the euro will provide the basis for continued growth. To keep pace with the changing global economy and maintain its relative position in the future, Austria must embrace the opportunities-and risks-that the global economy offers, and choose policies that are rooted in its long-term goals and take into account the interests of future generations.
Vienna, 6 May 2002