Austria -- 2005 Article IV Consultation, Preliminary Conclusions of the Mission
May 2, 2005
1. Austria's economy performed well in 2004. Growth of real GDP gathered speed on the back of strong exports, inflation remained low, and unemployment was one of the lowest in the EU. Moreover, company profitability rebounded and the Vienna stock exchange staged an impressive rally. Much of this favorable performance can be traced to sound economic policies, the diversification of the Austrian economy into the Central and Eastern European countries (CEECs), and a social partnership that has delivered wage moderation, thereby maintaining a strong competitiveness position. However, despite a resumption of employment growth, the unemployment rate remains persistent.
2. The short-term growth outlook is relatively favorable, although the pace of expansion is likely to be gradual. We expect growth to rise from 2.1 percent this year to 2.3 percent in 2006. Robust underlying growth in productivity and the fiscal stimulus in the 2005-06 budgets will provide ongoing support to economic activity. Nevertheless, downside risks warrant close monitoring. Domestic demand has yet to take off decisively in this recovery, and the baseline outlook hinges on a rebound of private consumption. In addition, higher oil prices and concerns about the strength of activity in the euro area-despite weaker links to the German economy-could weigh on short-term prospects.
3. A track record of policy implementation has placed Austria ahead of its peers. A policy shift since 2000 has oriented Austria's economic policies toward fiscal consolidation and liberalization. The main economic policy objectives have been to balance the budget over the cycle, reduce the tax burden by 4 percentage points to 40 percent of GDP by the end of this decade, and increase Austria's growth potential. Notable achievements so far include a marked reduction in the size of government during 2000-04; a major pension reform in 2003 and harmonization of the main pension systems effective 2005; privatization and deregulation in product and labor markets over the past five years; and tax reform in 2004-05.
4. The credibility and success of these policies face a critical test. There is a tension between the objective of lowering the tax burden and balancing the budget over the cycle. As a result, larger deficits will emerge in 2005-06. These are to be erased by 2008 as spending cuts required to return to a budget balance are envisaged to come on stream gradually. Further tax cuts are planned before the end of the decade. The challenge to fiscal policy is evident. Unless the government succeeds in balancing the budget as planned, efforts for further tax reform would be complicated. Our preliminary recommendations below focus on the fiscal plans for 2005-06 and beyond, and on the outstanding steps to boost Austria's potential growth.
The Fiscal Challenges Ahead
5. The temporary widening of the deficit resulting from the tax reform does not threaten macroeconomic stability or raise sustainability issues. Even though we would have preferred more ambitious deficit targets in 2005-06, we recognize that the benefits of tax reform outweigh the concerns about the temporary widening of the deficit. We also recognize that expenditure cuts require broad consensus and thus take longer to design and implement. Therefore, we accept the fiscal plans for 2005-06. Nevertheless, these plans should be seen as the minimum that is required. It will thus be important to resist the temptation to spend any unanticipated windfalls, especially if the economy turns out to be stronger than anticipated.
6. We support the government's objectives to balance the budget over the cycle and lower the tax burden further. The latest Stability Program has set out an ambitious consolidation goal for 2007-08, aiming for a structural adjustment of 1¾ percent of GDP. Further modest tax cuts are envisaged for 2007-08, that would allow the government to meet its target of a 40 percent of GDP tax burden as early as 2008, two years ahead of schedule. We are pleased to observe a broad political acceptance of the policy of a balanced budget over the cycle. While the fiscal policy priorities within a balanced-budget objective may differ across the political spectrum, the general recognition that such a policy is good for Austria is commendable.
7. But the policies to achieve these objectives during 2007-08 are not well defined. The identified areas at the federal government level-chiefly further reform of public administration-are insufficient to deliver the required expenditure savings. As for the subnational governments, the initiatives underway aimed at generating sustainable savings-notably reform of public administration and the health sector-are expected to help them achieve the agreed targets of the Austrian Stability Pact, but not contribute to a further improvement of the general government balance.
8. Now is the time to design and set in motion the expenditure cuts that would enable the government to return to a budget balance by 2008. In view of the upcoming elections, it is conceivable that the budget for 2007 will become law only within 2007, which will make it difficult to achieve the ambitious general government deficit target for that year set out in the Stability Program. Unless the government identifies the areas where expenditure savings can be implemented and proceeds expeditiously to mobilize the necessary consensus, the prospects for reaching the budget targets in 2007-08 will diminish. With this urgency in mind, a key priority for the authorities is to design expenditure measures that are both durable and target the least productive areas of government spending.
9. There remains a great need to redress federal-provincial fiscal relations, and to increase the contribution of subnational governments to the fiscal reform effort. So far, the bulk of this effort has been made by the federal government. The Finanzausgleich and the Österreich-Konvent had the potential to increase efficiency, streamline the functions of various levels of government, generate savings, and improve the incentive structure by realigning spending responsibilities and revenue-raising powers. However, neither seized the opportunity to address the efficiency of subnational governments. We nevertheless hope that the required broad political consensus will emerge to provide impetus to what seems to be a stalled constitutional reform process. Austria needs a modern, efficient framework guiding relations between the various layers of government.
10. There is considerable scope for rationalizing expenditures in a number of areas. The size of public administration-especially at the subnational level-remains large. The Finanzausgleich included measures in the health sector, but there is still considerable room for savings. It is possible to improve the efficiency of the health sector through rationalization of services-including through cooperation of subnational governments-without materially affecting the quality of services. In addition, the authorities should reexamine the size and role of subsidies. The housing subsidy, in particular, is costly and not well targeted. Moreover, better means-testing of social transfers would be desirable.
11. We are encouraged by the progress made in designing a medium-term expenditure framework, and look forward to legislative approval that will enable it to become operational by 2007. We agree with the authorities that this framework will help improve the transparency and operation of fiscal policy, strengthen the budgetary process, and achieve medium-term fiscal goals.
12. The tax reform agenda is not yet complete. Recent measures have mainly targeted taxes on profits and capital. These measures will enable Austria to attract business as well as boost employment, investment, and growth in the medium term and beyond. However, little has been done to reduce the burden on labor, which remains high by international standards. Wages are encumbered by various charges that raise labor costs, reduce take-home pay, and ultimately stifle employment growth. Moreover, tax allowances and preferential tax treatments run counter to the need to widen the tax base. Tax reform should aim not only at lowering the tax burden, but also at simplifying the system, increasing its transparency, and minimizing distortions. We are pleased to see that these are the broad areas the authorities consider addressing in future tax reforms.
Structural Policies for Growth
13. Building on considerable progress since 2000, the momentum of structural reforms needs to be reinvigorated. It is important to take advantage of the current cyclical upturn to complete the outstanding reform agenda in order to tap the dynamism of the private sector and help unleash the full growth potential of the Austrian economy. In this connection, the government's emphasis on public and private R&D spending in the context of the Lisbon Agenda is well placed. But the full impact of structural reforms on employment and growth would only be felt in the medium term.
14. Key tasks remain in a number of areas. The authorities are advised to proceed with their remaining privatization plans, taking advantage of the favorable conditions in equity markets. The Austrian labor market is quite flexible, but labor force participation of older workers remains among the lowest in the EU. Pension reform is expected to help raise participation rates, but the government needs to do more in the area of labor market policy to facilitate the integration of older workers. The deregulation of product markets is well advanced, but services (including free professions) are heavily regulated. More flexible shop opening hours have been legislated, but implementation by provinces has stalled. The discussions among social partners to institute more flexible work hours is a welcome step that could lead to lower overtime costs. We expect the authorities to continue cutting red tape further as well as strengthening the role of the Federal Competition Authority.
15. The recent harmonization of pension schemes has been a major step in reducing inequities. In addition, the harmonization will generate savings in the long run, and will help labor mobility by facilitating transferability of pension claims. This as well as the 2003 pension reform are major accomplishments. Austria is now better prepared than many advanced economies to face the demographic challenges of the future. However, the lowering of the cap on pension benefit losses surrenders some of the long-term savings achieved with the 2003 reform. While the fiscal loss is limited until 2024-a period during which the pension system is not expected to face large demographic pressures-it nonetheless puts pressure on public finances.
16. Further work is needed on the pension front. First, pensions of most civil servants at the subnational level remain outside the unified pension system. The completion of harmonization is an issue of equity, and would also generate additional savings. We call on the authorities-particularly the provinces and municipalities-to work toward a solution that would bring these groups within the unified system. Second, despite the ongoing rationalization of disability pensions, the number of new claimants remains high. The government should continue its efforts to ensure that access is restricted only to those who need this pension. Successful reform of the disability pension would bolster the long-term sustainability of the system, and raise labor force participation of the older cohorts and thus the growth potential of the economy.
17. Following a favorable assessment by the Financial Sector Assessment Program (FSAP) last year, the performance of the financial system has strengthened further. The financial system continues to be generally sound and resilient to potential adverse shocks. Capital ratios are more than adequate and bank profitability has improved owing largely to rapidly expanding activities in the CEECs. Moreover, cost-cutting efforts on the domestic front have continued, albeit slowly. We commend the authorities for taking measures in the areas identified by the FSAP and encourage them to make further progress.
18. The continuing growth of foreign currency loans to households remains an area of concern in the financial system. These loans (mainly in Swiss francs) could be a source of vulnerability. We support the public information campaign launched by the OeNB as well as the measures the Financial Market Authority (FMA) has taken to improve risk management of banks. That said, we urge the authorities to continue informing consumers about the risks involved, address consumer protection aspects, and monitor developments closely.
19. Supervision is being strengthened further and adapted to the changes in financial markets. Recent developments in asset markets are being monitored closely, and we encourage the financial sector authorities to remain vigilant. The expansion in the CEECs, while beneficial overall, has brought new risks. The FMA has developed further its strategy to improve the supervision of Austrian financial institutions in the region. Furthermore, EU enlargement has enhanced cooperation of supervisors with the new member states. As regards the issue of the liability of supervisors, we hope that the amendment currently in Parliament will muster a strong majority, enabling supervisors to carry out their mandate effectively.