Finland -- 2002 Article IV Consultation Concluding Remarks
June 10, 2002
INTERNATIONAL MONETARY FUND
Finland--2002 Article IV Consultation
Helsinki, June 10, 2002
1. Finland's remarkable recovery from the crisis of the early 1990s is one of Europe's success stories. Reflecting sound policy choices and increasing economic openness, real GDP growth averaged close to 5 percent during 1994-2000, inflation was 1-3 percent, and the general government balance moved from large deficits to sizable surpluses. Moreover, improved market flexibility and external competitiveness were evident in the favorable performance of Finland's export industries, including both traditional industries and the dynamic ICT sector. When combined with fiscal surpluses, structural reforms-including measures to improve labor market performance and to increase the effective retirement age-helped to make important headway in preparing for the impact of population aging.
2. In the face of a worsening external environment, the pace of economic activity slowed sharply in 2001. The sudden turnaround of the ICT market contributed significantly to a decline in both export volume growth and real growth overall. However, the spillover effects on employment and the domestic economy were nevertheless limited. Thus, the growth of real GDP remained positive at about ¾ percent and employment increased by almost 1½ percent. Meanwhile, year-on-year inflation fell to below 2½ percent during the course of the year-close to the EU average.
3. Certain structural rigidities, likely to hamper Finland's future economic well being if left unattended, were in evidence. The official unemployment rate remained excessive at about 9 percent and a broader measure-which takes into account individuals such as unemployed workers who left the labor force early, discouraged workers, and those in active labor market programs-could be as much as double. Among the contributing factors to high unemployment were insufficient wage differentiation across different skill levels; a number of disincentives to seek work, stay in the labor force, and hire labor; and an underdeveloped market for lower-skilled private services in the non-business sector.
4. The period ahead is a critical one, in which preparing for population aging should be an overarching goal of policy. In the mission's view, the key elements for achieving this goal must include:
· Increasing the rate of employment. Failure to raise the rate of employment would greatly exacerbate demographic pressures-with too few workers to support a growing number of pensioners-and soon curtail growth as the working population shrinks in the years ahead. This would place large strains on the public finances, making it increasingly difficult to maintain social expenditures without burdening future generations with even higher taxes. Measures to lower unemployment, enhance employment creation, and thereby generate economic growth should include pension, labor and, product market reforms, in addition to significant further tax cuts on labor in the context of expenditure restraint.
· Maintaining general government surpluses over the medium-term. As the demographic shock sets in, health and pension expenditures will surely rise and the balance of the general government will worsen significantly as a result. As a consequence, it is important to secure fiscal surpluses and pay down public debt beforehand to avoid large deficits after the demographic shock sets in. The goal, expressed in the 2000 Stability Program, of a central government surplus of at least 1½-2 percent of GDP-in line with a general government surplus of 4½ percent of GDP or more-remains appropriate.
· Adhering to strict expenditure limits and rationalizing spending. This would leave room for additional tax cuts on labor, while avoiding fiscal deficits over the medium- and long-term (also in line with Finland's commitment under the EU's Stability and Growth Pact). The alternative to this strategy is to shift the burden of population aging on to future generations in the form of higher taxes, fewer resources to provide public services, or both.
5. In all, reform measures should be taken without delay, taking advantage of the demographic window of opportunity that is closing quickly. Otherwise, rapid population aging will complicate the prospects for an alleviation of the heavy burden of taxes on labor, and for a significant and lasting improvement in employment growth. But with a determined effort, public expenditure limits, coupled with wide-ranging structural reforms and tax cuts, could trigger a virtuous circle of strong employment creation, solid economic growth, and fiscal savings-without which Finland would find it ever so difficult to meet its social welfare objectives.
Near-Term Economic Environment and Policy Stance
6. Economic growth may remain somewhat lackluster in 2002 but pick up in 2003-while continued economic slack should curb inflation. The mission projects real GDP growth of roughly 1 percent for this year. Based on foreign demand accelerating, and domestic demand gathering pace as private investment recovers, projected growth rises to about 3 percent next year. There is, however, considerable uncertainty about the demand for mobile communication equipment, and the associated impact on Finland's ICT-sector and prospects for investment. At the moment, downside risks would seem to predominate this year and next. Meanwhile, headline inflation is expected to edge down to about 2 percent. Monetary conditions, based on market expectations of interest and exchange rates over the next 12 months, are likely to turn toward restraint.
7. Unfortunately, fiscal policy is veering off course. While announced cuts in taxes on labor are welcome, central government expenditure in real terms, based on the 2002 budget and current plans for 2003, is set to grow by about 5 percent this year and 1½ percent next year, implying a surplus of about 1 percent of GDP in 2002 and balance in 2003, according to the mission's estimates. This falls significantly short of the 2000 Stability Program targets for the central government surplus, and real expenditure growth of no more than ½ percent per annum over its 2000 level (and no real growth over the 1999 level in the government's original plans). For the general government, the mission foresees the fiscal surplus falling from just under 5 percent of GDP in 2001, to about 3¼ percent in 2002, and to around 2¼ percent in 2003. This deterioration in the public finances goes well beyond the effects of tax cuts (including ¾ percentage point of GDP on income taxes and social security contributions in 2002) and allowing the automatic stabilizers to operate.
Fiscal Strategy and Pension Reform
8. With taxes on labor still very high, the composition of fiscal policy needs to be better balanced. Thus, a reorientation of policy away from expenditure increases and toward lower tax cuts on labor (i.e., income and social security contributions) merits serious consideration. Without further tax cuts, Finland would be less attractive as a destination for foreign capital and internationally mobile high-skilled labor, including Finnish citizens. And even after the recent labor tax cuts, the labor tax wedge in Finland remains well above the EU average, impeding employment incentives by keeping labor input expensive for firms and rewards low for employees.
9. But the current overshooting of the expenditure ceilings has forced a difficult tradeoff between the government's two goals of lowering the tax burden on labor and achieving targeted fiscal surpluses. Holding to the original expenditure targets would have been preferable to address the aging problem forcefully now-at a time when the first "baby-boomers" are nearing retirement. However, this may not be feasible in light of the election cycle and other political pressures. One pragmatic approach might be to hold central government primary real spending (i.e., excluding interest payments) constant at the level in the 2002 budget for the coming years. The mission estimates it would then be possible to cut labor taxes by about 1 percent of GDP over the 2003-04 period while keeping the central government balance from moving into deficit. The risks from any resulting fiscal stimulus would be mitigated by the anticipated economic slack, possible downside risks to growth, and the likely contractionary shift in monetary conditions. And even though the central government's balance during this period would be well below the government's target of a surplus of at least 1½ percent of GDP, the central government surplus would be expected to converge back to the target by 2006, though assuming no further reduction in labor taxes. Further tax reductions would require offsetting expenditure cuts, while higher-than-expected but one-time increases in revenue should be used for debt reduction.
10. The tax strategy should now have two dimensions: not only tax cuts on labor for employment leverage, but also finding ways to generate new sources of revenue to help ease fiscal pressures. Tax competition precludes raising taxes on the corporate sector, while tax revenues from tobacco and alcohol are likely to fall in line with EU requirements. Ideally, then, measures that both raise revenues while potentially keeping public spending in check-such as user fees-deserve serious consideration. This is particularly the case where valued services are priced at zero and create overspending in the public domain. A recent study by the Ministry of Finance noted that the average time taken to complete a degree in higher education is among in the highest in the world in Finland and referenced the experience in the Netherlands, where a redesign of higher education financing-by introducing tuition fees and converting student grants into repayable loans if studies are not completed within a set time-clearly increased the pace of graduation. Aside from user fees, other sources of revenue could include raising the lower VAT rate and property taxes (Finland is among the lowest in the OECD in term of property taxes as a percent of GDP).
11. The recent experience points to areas in which the fiscal framework might be strengthened. Broader-based commitment, on the part of parliament as well as the government, is a key consideration for ensuring the success of medium-term expenditure ceilings. Enhancing commitment could be achieved, for example, by including multiyear expenditure ceilings, along with a description of the strategy that lies behind them, when the annual budget is presented to parliament-with a view to generating endorsement of the ceilings (and monitorable commitments), their underlying rationale, and the strategy to achieve them. There should also be the presumption that the subsequent year's ceiling will be a starting point for next year's budget discussions. In addition, switching from real to nominal ceilings has advantages, not least by improving the transparency of the expenditure ceiling framework through publishing targets that will facilitate monitoring by the public of actual expenditure behavior. These ceilings might also exclude interest payments, to strengthen the commitment to expenditure limits on other items, and spending restraint generally. Finally, mechanisms to correct deviations from expenditure targets would clearly be beneficial, for instance by requiring that supplementary expenditure increases outside the regular budget process be accompanied by expenditure cuts elsewhere-a process that could be facilitated by stronger budgeting by objective.
12. To further prepare for the impact of population aging, pension reforms already in the pipeline should be implemented swiftly-but also selectively. The reforms proposed in November 2001 generally move in the right direction. Among them: (i) the introduction of a flexible retirement age of 63 to 68, with the possibility of early retirement at 62; (ii) changes in accrual rates and the abolition of the 60 percent accruals ceiling to make a longer working life more financially attractive; (iii) a lowering of the minimum age to 18 to start accruing pension rights; (iv) a uniform approach to indexation across all forms of pensions; (v) the decision to raise the minimum age for part-time pensions to 58; and (vi) eliminating the individual early-retirement pension scheme and the so-called unemployment pipeline to an old-age pension. However, most of these recommended measures will not become effective until 2005, and other reforms, in the mission's view, run against the idea of extending the average work life. In particular, a softening of the eligibility criteria for disability pensions, already a well-used path into early retirement, has been proposed to offset the elimination of the individual early retirement scheme. The net impact of the proposed reforms on the pension system is highly uncertain and, depending on the final decisions that are yet to be made, may be less than hoped for. Nevertheless, to the extent that the effective retirement age increases, the proposed reforms should raise potential GDP growth and strengthen the public finances. To further support these goals, the mission would recommend further reform efforts, including eliminating the subsidized component of the part-time pension scheme; ensuring that the financing of early retirement schemes does not penalize the hiring of older workers; basing the pensionable wage on lifetime earnings to enhance actuarial fairness; calibrating the statutory retirement age to take into account changes in life expectancy; and a strict enforcement of the current eligibility requirements for disability pensions.
Labor Market Reform
13. Labor market reforms could usefully complement other efforts to increase labor supply. While past efforts to strengthen labor market performance have helped to increase overall labor market flexibility, the combination of high taxes and income-related social benefits continues to give rise to incentive traps, especially at the lower end of the skill-scale. In addition to reducing the tax wedge, reforms in several areas should be considered, with a view to rewarding work and boosting the supply of labor. These include: encouraging job search by tapering off unemployment benefits over time, rather than raising benefits as decided recently; modifying the benefit system to avoid penalizing taking a job; stricter enforcement of job acceptance requirements, possibly to include part-time work; and continued monitoring of the effectiveness of various active labor market programs, phasing down or ending those that are less successful while not hesitating to increase the funds for those that are effective. Serious efforts are also required to reduce the continuing stark differences in the labor market performance across Finnish regions, among them incentives for greater labor mobility and related housing concerns. In this regard, it might be worthwhile to reexamine the financial relationships between central and local governments with regard to encouraging residential housing development and to extend favorable tax treatment to developers of rental housing projects.
14. But a fundamental mismatch between the labor supply and labor demand, particularly for lower-skilled labor, needs to be addressed. While the centralized wage bargaining process has helped to deliver moderate wage increases, on average, the loss of competitiveness for low-productivity workers tends to aggravate rather than alleviate the employment problem for the less skilled. Indeed, attempts to increase post-tax income and labor market participation of low-skilled labor, through, for example, the earned-income tax allowance, have had only a limited impact on employment due to the compression of wages inherent in the collective wage bargaining system. Thus, even if the earned-income tax allowance succeeds in raising the supply of labor on offer, low demand for low-skilled labor renders it largely ineffective. At the same time, the fading out of the earned-income tax allowance at higher income levels increases effective marginal tax rates for higher-skilled workers, further limiting the overall employment effect of the tax allowance. To raise employment rates for lower-skilled labor, there is an urgent need for the social partners to find ways to introduce greater wage differentiation commensurate with diverse productivity developments and labor demand, and allow greater room for setting wages at the firm level. In the meantime, consideration should be given to reducing the generosity of the earned-income tax allowance while cutting statutory marginal tax rates so as not to penalize higher-skilled workers. In addition, it would be worth exploring ways to lower the costs for low-skilled workers on the employer's side-for example, by reducing social security contributions, compensated by transfers from the central government. This would be all the more effective if the social partners could agree not to raise wages in response to such an initiative.
15. Reinvigorating privatization and liberalization efforts could help to improve the functioning of the economy and to foster employment creation. Finland has been among the frontrunners within the EU in opening its electricity and telecommunications markets, and past privatization and liberalization measures more generally have helped to increase the efficiency of private markets. But the pace of reform has slowed. Privatization efforts-negligible in 2001, when capital injections into state-owned companies widely exceeded revenues from privatization, and revived only recently-should be brought back on a fast-track. The proceeds from privatization should be used to pay down public debt. In addition, increasing private sector involvement in the provision of publicly-provided services-for example, by making wider use of public procurement and information systems-could improve the efficiency and quality of such services. At the same time, this would support the development of the private services sector, where the potential for employment creation, including for low-skill labor, is substantial.
16. Competition in some markets could be improved. Market concentration in many sectors-including construction, energy, telecommunications, and retail-is high, with a small number of suppliers dominating. In this regard, recent steps to better inform possible new entrants about the procurement for public construction projects are welcome, but further efforts seem to be called for. In particular, market concentration is strongly evident in the local telecommunications sector, effectively constraining competition on a broad range of telecom services at the consumer level. Thus, making the implementation of the existing competition law more effective in the local telecommunications market should be one area of focus for improving competition.
Financial Sector Stability
17. Finland's financial system remains very sound. The 2001 Financial Sector Stability Assessment (FSSA) found the banking system and the insurance and pension industries well capitalized, profitability of the banking system high, and loan losses very low. The robustness of the financial system has been well demonstrated over the past year. These positive findings have continued to hold, even as some of the worst-case stress test scenarios largely materialized amid the sharp economic slowdown. In light of the downside risk clouding the current economic horizon, the mission welcomes the authorities' continued monitoring of the financial system's stability, and encourages them to continue to update their stress testing of the system's resilience to export, stock market, and real estate price shocks.
18. Notwithstanding these findings, further strengthening of regulatory and supervisory arrangements would help mitigate any future risks. Finland's financial market is highly concentrated and increasingly dominated by cross-border financial conglomerates. Under these circumstances, the recent progress in tightening Nordic supervisory cooperation is welcome, and could be built on by further harmonization of the regulatory and supervisory arrangements-across both the Nordic and euro areas-and more fully developing a crisis management framework. The new law on financial conglomerates is also a welcome development, but unifying the supervision authority for financial markets-including for banks, insurance companies, and securities markets-merits further consideration. In addition, while the draft act on the Financial Supervisory Agency (FSA) is a step forward in addressing the independence, accountability, and early intervention powers of the FSA, the proposed arrangements for the new FSA Board has the potential to obfuscate the lines of competence and accountability and undermine the effectiveness of the FSA in some respects. In this connection, consideration should be given to at least moving the licensing and imposition of sanctions to the operational level of the FSA from the policy-making level of the Board. Finally, the mission welcomes the further strengthening of legislation on anti-money laundering and terrorist financing.
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The ability of policymakers, social partners, and the society at large to work together for a common goal was amply demonstrated by the impressive handling of the crisis during the early 1990s. While this ability is being tested again, in the form of a rapidly aging population, the mission is confident that a determined and cooperative effort by all involved can bring about the desired outcome of economic growth, prosperity, and social protection.
The mission would like to thank the authorities, as well as the social partners and other participants in its meetings, for open, informative, and fruitful discussions. Many of the suggested measures covered in this statement had already been identified and discussed by this policy-making community. The decision to share these concluding remarks with the public is very much welcome, and demonstrates once again the commitment to transparency in Finland.