Mission Concluding Statement 

Luxembourg, March 17, 2015

An International Monetary Fund (IMF) mission ¹visited Luxembourg during March 4–17 for the 2015 Article IV consultation discussions, part of the IMF’s regular surveillance of all member countries. At the end of the visit, IMF Mission Chief Ashok Bhatia thanked the Luxembourg authorities for the candid and constructive discussions, and issued the following statement:

The main challenge Luxembourg faces today is to strengthen a business model that has served it well. This model emphasizes responding to investor needs, maintaining fiscal stability, and practicing conservative prudential oversight. It is good that the authorities are adjusting fiscal policy for lower revenues from e-commerce and embracing the global tax transparency agenda. They should pursue further reforms to make the pension system more resilient to population aging, and explore options to make the tax system more robust. Steps are also needed to uphold Luxembourg’s strong reputation in finance, including faster passage of banking union laws, ensuring a strong systemic risk committee, and being a voice for effective regulation internationally.

1. Luxembourg has tended to grow faster than its neighbors, but its business model is facing important challenges. Typically for a small open country, growth has been uneven and projections are uncertain, where the current baseline settles at around 2¼ percent over the medium term. Risks around this baseline seem balanced, with some positive signs from the euro area lately. A larger challenge arises from the various international tax initiatives underway, which could erode the revenue base. Equally, rising complexity in the financial sector calls for skillful management.

Fiscal Policy

2. It is appropriate that Luxembourg, as a small open economy, should target a budget surplus and low debt over the medium term. Periods of strong growth should be used fully to increase buffers, where eliminating the central government deficit is important. Openness is high, with even labor flowing across borders daily, leaving the economy exposed to a range of shocks. Targeting a surplus at the general government level also allows for some additional pre-funding of the large pension burden.

3. Budget 2015 and the medium-term fiscal plan belatedly address falling e-VAT revenues. After a surplus tentatively estimated at a half percent of GDP in 2014, the budget targets a general government deficit of 0.2 percent this year, reflecting a large reduction in VAT from electronic commerce. Retained e-VAT is projected to fall by more than half in 2015, to about one percent of GDP, and to less thereafter. Despite this, surpluses are to be restored from 2016. Key measures this year include a VAT rate hike, a new temporary personal income tax to balance the budget, and many small spending cuts drawing on an expenditure review last year. Commitment to these spending cuts is underscored by the government’s Zukunftspak, which details the legislative agenda. The package responds to the EU VAT Directive of 2008.

4. The budget package also sets up the Fonds Souverain Intergénérationnel, which should ideally be larger. The fund will collect some remaining e-VAT and some fuel duties, adding up to 0.1 percent of GDP per year, with a target size of €1 billion by 2035. This is too small to exert a meaningful impact. Options should be considered, therefore, to transfer some portion of central government financial assets to the fund, which would increase overall returns on public assets and help reinforce fiscal discipline. In addition, all future extraordinary receipts should flow into the fund.

5. Although the government enjoys a large net asset position, further reforms are needed to address future pension deficits. Currently, financial assets excluding social security stand at about 50 percent of GDP, comfortably exceeding gross debt of 23 percent of GDP. Social security assets amount to another 30 percent of GDP, pre-financing only part of the future increase in pension and other age related spending. Eurostat now projects very strong population growth, which sharply reduces estimates of pension deficits over the long run. These should be treated with caution. Deeper pension reforms remain essential, including for reasons of fairness across generations, and should not be deferred.

6. The authorities should assess the possible revenue impact of evolving global tax initiatives, and remain active in the discussions. Taxes on the financial and corporate sectors and on cross border retail trade yield sizable revenues. Some of these could prove susceptible to changes in EU and OECD tax standards and any U.S. moves to tax U.S. firms’ profits held abroad. The tax challenge should be quantified as details become clearer, where updates will be needed as standards evolve, and Luxembourg should continue to engage fully in the debate.

7. Options should be explored to make the revenue system more robust and achieve additional expenditure savings. The upcoming tax policy review is a good opportunity to develop revenue options. These could include adjusting property related taxes, tax exemptions including for corporations, and selected financial sector levies while preserving Luxembourg’s appeal internationally. Advance tax rulings should avoid encouraging undue complexity in ownership structures and instruments. Further expenditure savings should also be sought while protecting high quality public service provision, informed by regular expenditure reviews. On both the revenue and expenditure sides, the effort should be to identify measures that are equitable and durable and minimize the drag on growth.

Financial Sector Policies

8. Luxembourg’s complex financial sector is the beating heart of its economy and a hub for European finance. Bank balance sheets of €770 billion reflect intragroup activity, corporate deposits, high net worth clients, and more. The shift to automatic information exchange is being managed smoothly. Investment fund products worth €3¼ trillion enjoy the strong Luxembourg brand name. Clearstream Banking S.A. is critical in global securities settlement and custody, collateral management including triparty repo and securities lending, and eurobond issuance services. The financial sector generates one-fourth of GDP, one-sixth of fiscal revenues, and one-tenth of jobs, and gives rise to extensive legal, accounting, and ICT services.

9. Strong oversight is de rigueur. Bank capital ratios are high, as is capital quality. Exempting banks’ claims on their parents from large exposure limits facilitates intragroup activity, most of which is cross border, reflecting centralized liquidity and group treasury management. Supervisors recognize tradeoffs between bank capital and profitability, where low interest rates will continue to hurt net interest income. These conditions also encourage a search for yield by investors, seen in strong flows into investment funds. The fund industry is adapting to new EU rules, including for alternative investment fund managers. Fund related services are an important income source for banks, partly offsetting narrowing net interest margins.

10. The banking union is especially positive for Luxembourg, and the related EU directives should be transposed swiftly. By taking an integrated approach across countries, the Single Supervisory Mechanism is better able to shine light on important cross border risks. To benefit fully from the banking union, Luxembourg should speed up adoption of the EU directives governing bank capital requirements, bank recovery and resolution, and the deposit guarantee scheme. The delays are counterproductive, and no effort should be spared to return to the tradition of prompt implementation of EU financial market directives.

11. The revised proposal for a systemic risk committee provides for appropriately broad reach, going well beyond banking. The committee’s recommendations will not be binding, underscoring the need for a consensual approach. Duties should include not only risk monitoring but also identification of regulatory issues. Macroprudential tools should be readied for use if needed, with the choice of tools informed by relevant data and analysis. One focus for the committee could be the housing market, where there seems no urgent cause for concern but pockets of risk are possible. Rising housing prices span decades, reflecting population and job growth combined with zoning and other rules that constrain supply.

12. Lastly, it is good that Luxembourg intends to advocate for better oversight arrangements for groups that include banks. Such groups are difficult to supervise effectively, especially when they mix banking and commerce. As the events last year show, the EU framework can allow holding companies that exert dominant influence over banks to slip through the supervisory net. Even where these firms are correctly identified, they cannot be directly subjected to capital rules to ensure they are able to support their bank subsidiaries. As a welcome first step, Luxembourg supervisors have proposed strictures on the use of a bank’s franchise name by nonbanks claiming no affiliation, to cut reputational links. Befitting its position as a financial hub for Europe, Luxembourg also intends to discuss changes at the EU level, placing itself at the forefront of the wider debate.

Policies for Growth

13. Diversification efforts should go together with steps to equip workers with relevant skills. Seeking to develop opportunities outside finance, the government is promoting logistics, biotechnology, ICT, and green technology, most of which require advanced skills. Math and science scores are below OECD averages, however, despite high education spending per student relative to neighboring countries. Vocational training in particular should be more nimble, to keep up with the economy’s needs.

14. Job creation is strong, yet unemployment remains elevated by historical standards. More than half of new jobs go to cross border commuters, while joblessness among residents reflects skills mismatches and, potentially, incentives reflecting aspects of the benefits system. Efforts to tackle this situation include continuing to modernize the employment agency. Steps are also being taken to lift youth and women’s participation in the labor force. Maintaining the tradition of dialogue between government, employers, and employees, the authorities should assess whether other features of the benefits system can be reformed to boost jobs.

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¹ As part of its mandate to oversee the international monetary system, the IMF periodically has an in-depth discussion with each of its member countries about their economic policies. This exercise, known as an Article IV consultation, involves an examination of fiscal, financial sector, and other key policies from a medium-term perspective. The IMF’s last Article IV consultation with Luxembourg concluded in May 2014.