Finland—2004 Article IV Consultation Concluding Statement of the IMF Mission
October 28, 2004
INTERNATIONAL MONETARY FUND
Finland—2004 Article IV Consultation
Concluding Statement of the Mission
October 28, 2004
1. Finland has made impressive economic strides in recent years, but major challenges lie ahead. A high rate of productivity growth, driven by a world-class technology sector, has helped drive a strong economic expansion. The economy has weathered the global downturn relatively well, with strong fiscal stimulus helping to support economic growth. Inflation is low, the external position is comfortable, and the public finances have recorded surpluses that remain among the largest in the European Union. Thus, there is much to be satisfied with. However, these successes risk breeding complacency and reinforcing a natural tendency to postpone difficult decisions. Indeed, looking ahead to the rest of this decade and beyond, Finland faces major economic challenges in a rapidly changing global and domestic environment that call for hard policy choices to ensure that Finnish citizens continue to maintain and enhance their living standards in the years ahead.
2. An improved external climate is expected to sustain economic growth in the near-term. Private consumption and domestic demand are projected to grow at a steady pace in 2005 and private fixed investment to continue a gradual recovery that began this year after two years of decline. Although monetary conditions have tightened somewhat due to the appreciation of the euro, they remain accommodating and are not expected to hold back the recovery of demand. With a projected pick up in export markets and assuming a turnaround in Nokia's market share, GDP growth in 2005 is likely to be sustained at about 3 percent, narrowing the output gap further. With continued productivity gains, inflation is projected to remain low, barring sustained high oil prices. Growth, however, has failed to generate significant gains in employment and Finland continues to be haunted by the specter of high structural unemployment. Moreover, the risks to this scenario are tilted to the downside, as persistently high oil prices could dampen demand at home and in Finland's markets abroad, especially in the euro area, and, combined with adverse employment trends, could dent consumer confidence.
3. The longer term outlook is clouded by imminent aging of the population, and rigidities in institutions and attitudes that impede adaptation to change. With the adverse effects of aging impacting Finland earlier than any other country in EU, the window for an effective policy response will close rapidly. As aging accelerates over the coming decade, the electoral arithmetic will begin to shift soon against the constituency for reforms, with voters 50 years or older set to form a majority by 2010. While Finland enjoys the advantage of a favorable initial position, with the public sector holding sizeable net assets and a significant pension reform in train, much remains to be done to put the Finnish welfare state on a sustainable long-term path. The authorities should therefore aim at a consensus behind a holistic approach to structural reforms that could initiate a virtuous circle of higher employment and growth and stronger public finances. Indeed, the current interlude of growth should be used to galvanize efforts to build such a consensus.
4. The fiscal surplus appears comforting, particularly in a comparative EU context, but is less reassuring from Finland's own longer-term perspective. The surplus of the general government is projected to be around 2¼ percent of GDP this year and next. However, the surplus will be more than accounted for by the surpluses of the social security funds, with the combined central and local governments in deficit. The authorities' objective to balance the central government accounts by 2007 would be assured only if any new tax cuts or spending initiatives were offset by spending cuts elsewhere and ceilings on expenditures observed scrupulously. In this context, the experience of the new medium-term spending rule appears encouraging. It would be important to resist new spending pressures, given the very narrow margins remaining under the expenditure ceilings. In any case, with a recovery under way, there is no need for a fiscal stimulus in 2005.
5. Recent tax cuts are desirable and welcome, but the overall tax burden continues to be onerous and the labor tax wedge remains high. The cuts in income taxation this year and corporate and capital income taxation proposed in the budget for 2005 will be conducive to growth. The government's announced readiness to implement further reductions in income taxes in the framework of a moderate general wage increase in the forthcoming wage round suggests its awareness of the imperative of reducing the tax burden. Over time, the beneficial effects on employment will be enhanced by tax cuts targeted at the lower end of the income scale. The government's intention to reduce employers' social security contributions for low-income workers in 2006 is an important step in this direction.
6. The room for a durable reduction in the taxation of labor should be created by pruning public spending. Social transfers that deter the effective utilization of labor should be reduced, with a focus on limiting unemployment traps and incentives for early retirement. A key avenue to easing pressures on public spending is to raise the efficiency in the provision of social and welfare services. These pressures are especially evident in the rising strains on the municipal finances which are projected to be in deficit for the fourth consecutive year in 2005. In the face of new spending mandates, municipal governments have resorted to income tax increases, offsetting cuts in central government taxes. In order to place municipal finances on a sound footing, a reassessment of their revenue sources may be necessary, with consideration given to greater reliance on alternative sources such as property taxes. Mechanisms are also needed to provide incentives for municipal authorities to raise efficiency in the provision of public services, especially as they face rising demands for age-related services and, concurrently, an accelerating pace of staff retirement.
7. In the absence of wide-ranging structural reforms, ensuring fiscal sustainability would require sizeable general government surpluses for the rest of the decade. With the stronger expected rise in age-related spending than elsewhere, reflecting the rapidity of aging as well as Finland's comprehensive welfare state, these surpluses are a necessary cushion to absorb the coming demographic shock. Most estimates of the likely impact of changes in the demographic structure on employment and public finances, including our own, suggest that, with present policies, sizeable surpluses of the order of 4 percent of GDP would be required for the rest of this decade to prevent an unsustainable build-up of public debt in later years. This implies that the central and local governments would need to run a combined annual surplus of the order of 1 percent of GDP as compared with a projected deficit of about ½ percent of GDP in 2005. Moreover, it needs to be underlined that, while subject to considerable uncertainty, these estimates are likely to understate the required fiscal adjustment. This is because expenditures on major categories, such as health care, due to rising cost of new treatment methods, and local government wage and non-wage costs, are likely to exceed estimates.
8. Wide-ranging policy initiatives are needed to raise the employment rate which is a precondition to maintaining fiscal sustainability. Employment gains in the current cyclical recovery have been confined largely to the financial services and the local government sectors. Recent trends such as the continuing shift of investment abroad suggest that the prospect of achieving the authorities' target of raising the employment rate to 70 percent by 2007—and to 75 percent by 2011—are not promising under present policies. The incentives embedded in the current labor market and education arrangements are for workers to leave the labor market too early and enter it rather late. While tax policy changes that reduce the burden of labor taxation will help promote employment, particularly of the low-skilled, they are unlikely to be effective on their own. Policy measures encompassing the tax-benefit system as well as product and labor market arrangements are required to raise utilization of labor at both ends of the age spectrum.
9. The pension reform to be phased in beginning next year is an important step towards ensuring fiscal sustainability, but is, by itself, insufficient. The reform—with commendable features such as an automatic adjustment for rising life expectancy, link of benefits to life-time earnings, and sharply rising accrual rates after age 63—is expected to raise the effective retirement age by almost two years. While the reform goes some way towards promoting higher labor participation by limiting the avenues for leaving the labor market early, important pathways to early exit from the labor force remain. To maximize the beneficial impact of the reform on participation, the so-called "unemployment pipeline" should be closed.
10. A move towards a more decentralized wage bargaining arrangement is desirable. While the centralized wage determination regime has served to moderate inflation and preserve competitiveness, it has solidified wage rigidities that are unfavorable to the young and unskilled workers. A shift to a more decentralized system, in line with trend in the Nordic world, would ease the compressed wage structure, thereby allowing a greater correspondence between wage and productivity differentials, and help reduce structural unemployment. The coming wage round will be a test of the ability of social partners to move beyond the old "solidaristic" mindset to a broader concept of solidarity that would encompass all Finnish citizens and would be in consonance with Finland's future prosperity in a globalized world economy. A first step in this direction could be a centralized accord allowing for a very low general wage increase, to be supplemented by local level wage formation that reflect productivity and profit differentials across sectors. This step could be facilitated by targeted tax cuts at low-income workers.
11. The prospective shrinking of labor supply as the full impact of aging sets in by the end of the decade underlines the importance of enhancing productivity. Although the overall growth of labor productivity in recent years has exceeded the EU average, this record reflects primarily the performance of the electronics and financial sectors, with little spillover into other sectors of the economy. Closing this productivity gap will require investment in equipment and technology, in turn calling for a supportive economic and policy environment. Reforms to promote greater flexibility in labor and product markets are likely to have a large pay-off in terms of durable productivity gains throughout the economy.
12. Strengthening competition in product markets is a necessary complement to measures to improve the functioning of labor markets. Despite notable progress achieved in recent years, especially in communications, air transport and retail trade, the price level remains significantly above the EU average and scope exists to enhance competition. Reducing rigidities that continue to impair the functioning of product markets would raise consumer welfare and could have positive spillover effects on the labor market. The new legislation in place should be used to empower the Competition Authority to deal effectively with cartels. Competition between private and public sectors in the provision of services could also be encouraged. Last but not least, Finland's farm subsidies—high even by EU standards—should be reduced in the interest of greater efficiency and consumer welfare.
13. The Finnish financial system seems ready to face the challenges of European financial integration. Bank profitability remains healthy, the proportion of non-performing loans is very low, and stress tests suggest that banks can withstand an extended economic downturn and a significant fall in asset prices. However, growing cross-border financial activities by systemically important institutions and the recent merger of the Swedish and Finnish stock exchanges underline the importance of close cooperation among Nordic-Baltic supervisors and new coordinated supervisory mechanisms.
14. In sum, a new Finnish consensus to seize the opportunities offered by global integration and meet the challenges of demographic transition is desirable and feasible. A broad-ranging policy agenda of structural reforms should enable Finland to capitalize on its considerable strengths. However, this calls for shedding defensive mindsets and outdated notions of solidarity in favor of a new consensus for openness and dynamism.