Luxembourg: Concluding Statement of the 2016 Article IV Consultation Mission
March 1, 2016
Growth prospects remain strong but are subject to increasing downside risks from weakening international activity and stress in financial markets. Implementation of the international tax transparency agenda, which Luxembourg has embraced, could weigh on economic activity and tax revenue. At the same time, various other competitive advantages, such as Luxembourg’s triple-AAA rating and its qualified labor force, would continue to benefit the country. Against this backdrop, the fiscal stance should remain prudent and contingency measures should be prepared for the event negative shocks occur. The limited fiscal space should be used to bolster growth prospects, while adapting the tax regime to the changing international environment and ensuring the long-term viability of the pension system. Implementation of the Banking Union will help to increase the stability and resilience of the banking system. Financial sector risks need to be monitored closely and, where necessary, Luxembourg should advocate appropriate international regulation. Building on past experience, active labor market policies should focus on integrating refugees in the labor market and further reducing unemployment.
The revenue risks of the international tax transparency initiatives and volatile financial flows make it appropriate for Luxembourg to keep the public debt ratio on a slightly declining path, in order to maintain sufficient buffers in case of need. This requires targeting a small fiscal surplus of around ½ percent of GDP in 2016 and over the medium term.
Vigorous economic activity has opened some fiscal space, which should be used to bolster long-term economic growth. In 2015, buoyant tax revenues and lower-than-expected capital outlays have contributed to a significant improvement in the fiscal balance compared to budget. Under unchanged policies, including full implementation of the Zukunftspak, the fiscal position is expected to remain in surplus over the medium term. Available fiscal space of almost ½ percent of GDP should be used for growth-friendly measures such as infrastructure investments.
The tax reform proposals unveiled at end-February contain a significant reduction in personal taxation and also in the corporate income tax starting in 2017. Preliminary estimates indicate that these measures would reduce total fiscal revenue by up to 1 percent of GDP, fully using up the projected fiscal surpluses. It is advisable to limit the size of the tax reduction to the available fiscal space. While some of the tax measures aim to increase housing supply, the envisaged tax relief for home buyers would aggravate existing imbalances given that demand for real estate structurally outstrips supply.
The ongoing tax reform is an opportunity to solidify the tax base in a revenue neutral way and adjust to the changing international taxation environment. The international tax transparency initiatives—including those spearheaded by Luxembourg during its EU presidency in the second half of 2015—call for closing loopholes used for tax avoidance. The tax reform should aim at widening the corporate tax base and eliminating special tax regimes while lowering statutory tax rates. The decision to phase out the IP Box tax regime from mid-2016 is a step in this direction. Moreover, the government should develop contingency measures, including revisiting the low real estate taxes, in case negative revenue risks materialize.
Continued reform of the pension system is advisable. The pension system is currently generating surpluses due to advantageous demographics. However, population ageing is expected to put significant pressure on the system in the future, especially when cross-border workers begin to retire. Accordingly, the upcoming 2016 pension review should propose additional parametric reforms of the pension system—such as of the minimum contributions period and conditions for early retirement—to safeguard its long-term sustainability and promote fairness across generations.
Financial Sector Policy
Luxembourg’s world-class financial sector benefits from a stable regulatory and fiscal environment, prudent oversight, and a skilled workforce. The expansion of the investment funds industry, the second largest in the world, has benefited from the EU passport. Since end-2008, about 1/5 of all worldwide net inflows into mutual funds came to Luxembourg. The mostly outward oriented banking system, well-capitalized and with very low non-performing loans, is characterized by a high level of intra-group flows and the collection of corporate and high net-wealth clients’ deposits.
The high interconnections of Luxembourg’s financial system with the rest of the world make it a recipient and conduit of global financial volatility. Investment funds, which have benefited from a search for yield, comprise diverse asset classes spread across many countries. Cross-border and interbank claims account for more than half of banking assets. Value-added in the financial sector, which accounts for ¼ of GDP, fluctuates with global market developments.
The Banking Union is particularly beneficial to Luxembourg’s banking system. The Single Supervisory Mechanism (SSM) is an improvement in supervision, especially of cross-border banks, and establishes a consistent and high level of oversight. The significant enlargement of the resources of the Commission de Surveillance du Secteur Financier in recent years is welcome and should remain commensurate with the increasing size and complexity of the financial sector. Likewise, the Single Resolution Mechanism will ensure swift intervention ahead of insolvency, with financial support from the industry pooled in the Single Resolution Fund. The recent transposition of the Deposit Guarantee Scheme Directive and of the Bank Recovery and Resolution Directive completes the legal implementation of the Single Rule Book in Luxembourg. The authorities should also advocate for better oversight at the European level of holding companies that include banks to improve risk monitoring.
Strong oversight of investment funds and their management companies is necessary, in line with evolving international standards. The relevant EU directives have strengthened the framework for risk monitoring, liquidity management, and supervision of investment funds. The use of derivatives that boost leverage, liquidity mismatches between assets and redemption terms, and the use of securities lending to improve cash returns should be more specifically scrutinized. The data reporting should allow identifying funds’ sensitivity to interest rates and credit market movements.
Linkages between banks and investment funds are an important trait of the financial system. Depository banks of investment funds are all located in Luxembourg and banks provide administrative, pricing, brokerage, and accounting services to funds. Investment funds hold sizable deposits in their depository banks, which may channel the liquidity to the parent, as well as significant amounts of financial bonds while banks act as counterparties in derivative contracts. There are also ownership links between Luxembourg fund management companies and large banking groups.
Risk monitoring and regulatory frameworks should take into account the linkages between banks and investment funds. Luxembourg should propose to discuss these linkages in the SSM and include them in the design of joint fund-bank stress test scenarios. Risks should be assessed not only at the investment fund level but also from a financial stability perspective. The Comité de Risque Systémique has added the analysis of these linkages to its work program at the national level and it should also ensure that the linkages are examined at the EU level in the European Systemic Risk Board.
Risks in the real estate market should be closely monitored. Steadily rising house prices appear to mainly reflect supply bottlenecks against a growing demand. The authorities should explore whether further macro-prudential measures such as limits to loan-to-value ratios are appropriate.
Policies for Growth and Employment
The government is taking steps to diversify the economy. Expanding activity beyond the financial sector is important to enhance the resilience of the economy and should be supported with measures to better align workers’ skills with the economy’s demands. Structural reforms addressing supply-side constraints, such as easing zoning requirements for real estate construction, could also help.
Strong growth and active labor market policies have reduced the unemployment rate. Innovative measures by the public employment service (ADEM), vocational training and apprenticeship programs, and the Youth Guarantee scheme have helped to create job opportunities and to increase youth and women’s labor market participation. Additional steps are needed to reduce inactivity traps while ensuring that real wages remain in line with productivity.
Luxembourg is well-equipped to cope with elevated refugee inflows. Building on its past experience, the country facilitates enrollment of the newcomers into language classes, schools, and other training programs. For faster integration of refugees in the labor market, the time to obtain a temporary employment authorization could be further reduced to less than 6 months after the asylum application. In addition, it would be helpful to extend to refugees who have been granted asylum the employment promotion programs currently available for the long-term unemployed.
The mission thanks the Luxembourg authorities and representatives from the private sector for the open and constructive discussions.