## _cr0535

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### Executive Summary — Background and Outlook
- Economy weathered the global slowdown relatively well.
- Growth expected to pick up to about 3 percent in 2004–05, with a closing of the small output gap.
- Employment has stagnated; unemployment remains stuck at about 9 percent since 2001.
- HICP inflation fell to 0.2 percent in 2004, the lowest level in the euro area in 2004, reflecting large cuts in indirect taxation; expected to gradually revert to close to the euro area average.
- A 2½ year wage accord is moderate, accompanied by sizable (about 1 percent of GDP) cuts in income taxation over 2005–07.
- General government fiscal surplus at about 2 percent of GDP appears comfortable in a comparative EU context but is inadequate given rapid population aging which sets in earlier than any other EU country.

### Key Recent Performance Indicators (as reported)
- Real GDP (percent change): 2002: 2.3; 2003: 2.0; 2004 est.: 3.1; 2005 proj.: 2.9.
- Domestic demand (percent change): 2002: 1.3; 2003: 2.1; 2004 est.: 2.6; 2005 proj.: 2.2.
- Consumption (percent change): 2002: 2.2; 2003: 3.5; 2004 est.: 2.6; 2005 proj.: 2.0.
  - Private consumption (percent change): 2002: 1.5; 2003: 4.3; 2004 est.: 3.1; 2005 proj.: 2.1.
- Gross fixed capital formation (percent change): 2002: -2.0; 2003: -2.9; 2004 est.: 2.3; 2005 proj.: 3.1.
  - Residential investment (percent change): 2002: 2.1; 2003: 9.0; 2004 est.: 7.5; 2005 proj.: 2.1.
- Net exports (contribution to growth): 2002: 2.0; 2003: -0.5; 2004 est.: 1.3; 2005 proj.: 1.3.
- HICP inflation (percent): 2002: 2.0; 2003: 1.3; 2004 est.: 0.2; 2005 proj.: 1.5.
- GDP deflator (percent): 2002: 0.9; 2003: -0.1; 2004 est.: 0.2; 2005 proj.: 1.0.
- Employment (percent): 2002: 0.2; 2003: -0.3; 2004 est.: -0.3; 2005 proj.: 0.5.
- Unemployment rate (percent of labor force): 2002: 9.1; 2003: 9.0; 2004 est.: 8.8; 2005 proj.: 8.3.
- Labor compensation (percent change economy-wide): 2002: 3.0; 2003: 3.2; 2004 est.: 3.1; 2005 proj.: 2.9.
- Unit labor costs (percent change economy-wide): 2002: 0.9; 2003: 0.6; 2004 est.: 0.5; 2005 proj.: 1.1.
- Output gap (percent of potential output): 2002: -0.7; 2003: -1.2; 2004 est.: -0.7; 2005 proj.: -0.1.

### Economic Structure and Risks
- Productivity gains concentrated in the Nokia-led electronics sector and financial services, with limited diffusion across the rest of the economy.
- Finland has the highest degree of export specialization among advanced economies; ICT exports in 2002 amounted to almost 22 percent of exports of goods.
- Investment ratio has been below the euro area average for the past ten years; current account surpluses in the range of 5 to 8 percent of GDP since the mid-1990s and expected to sustain similar surpluses over the medium-term.
- Imminent aging: old-age dependency is set to rise most rapidly among EU countries; demographic transition will begin to impact labor market as early as 2006 with a steep rise in the old-age dependency ratio between 2010 and 2025.
- Competitiveness concerns: perception as “a small, expensive, rapidly aging and remote country,” rising propensity of Finnish companies to invest abroad, secular decline in terms of trade, persistence of high structural unemployment.

### Budget for 2005 — Stance and Measures
- 2005 budget described as expansionary despite projected economic rebound.
- Tax measures enacted:
  - Corporate tax rate cut of 3 percentage points (to 26 percent).
  - Personal capital income tax rate cut of 1 percentage point (to 28 percent).
  - Cuts in income taxes of 0.2 percent of GDP in the context of the incomes policy accord aimed at stimulating employment.
- Projected fiscal balances:
  - General government surplus projected to decline to about 1¾ percent of GDP.
  - Deficit of the central and local government sector likely to exceed ¾ percent of GDP.
- Authorities view 2005 stimulus as appropriate given commitments in the centralized wage accord and the objective of raising employment.

### Tax Burden and Labor Taxation
- Finland’s tax burden among the highest in the world, exceeded only by Sweden and Denmark; about 5 percentage points of GDP higher than the EU average.
- Marginal tax wedges on labor remain well above the OECD average; high marginal tax rates set in at comparatively low income levels.
- Policy emphasis:
  - Target tax reductions at low-income earners to address high tax wedge at the low end.
  - Consider targeted reductions in social insurance contributions by employers of the low skilled (and low paid).
  - Officials plan to reduce payroll taxes for the low-paid in 2006.
  - Across-the-board tax cuts should ideally be offset by expenditure cuts.

### Pension Reform and Labor Supply Measures
- Tripartite pension reform phased in beginning 2005:
  - Replace standard retirement age of 65 with flexible retirement age ranging from 62 to 68.
  - Introduce an accrual rate rising with age for older workers.
  - Automatic link of pensions to life expectancy; nexus of benefits to lifetime earnings replacing the earlier "ten-year rule."
- Reform expected to raise the effective retirement age by almost two years; staff note it will take years before effective retirement age rises from present 59 years to 62 years.
- Remaining early-exit avenues identified (e.g., "unemployment pipeline" allowing unemployed aged over 57 to claim benefits to age 65); staff recommend closing the "unemployment pipeline" to maximize participation effects.

### Labor Market Institutions and Wage-Setting
- Centralized wage determination has moderated inflation but “solidified wage rigidities” unfavorable to the young and unskilled.
- Recent wage accord (December 2004) covers two and a half years to September 2007; including local-level increases and wage drift, expected to result in a rise in annual wages of about 3½ percent over this period.
- In the context of the agreement, the government announced intention to reduce income taxes by over 1 percent of GDP over 2005–07.
- Staff recommendation: shift toward more decentralized wage bargaining to ease compressed wage structure, align wages with productivity differentials, and reduce structural unemployment.

### Fiscal Sustainability Assessments and Scenarios
- Staff analysis on present policies:
  - General government (excluding social security surpluses of about 2½ percent of GDP) would need to sustain annual surpluses of 1½ percent of GDP through the end of the decade to ensure sustainability, compared with a present deficit of about ¾ percent of GDP.
  - Staff’s baseline projections suggest a permanent fiscal adjustment of about 2 percent of GDP is required to ensure sustainability.
- OECD study: assuming no further pension reforms, potential output growth of 2¼ percent and some increase in employment, a permanent fiscal adjustment of 1 percent of GDP would be needed to avoid sharp deterioration of government net asset position by 2050.
- GEM model structural reform scenario (Fund-calibrated):
  - Combination of product and labor market reforms simulated to raise employment and output by around 3 percentage points each.
  - The need for fiscal adjustment is reduced by about 1 percent of GDP versus the baseline.
  - Reforms plus additional pension or other expenditure measures would create room for growth-enhancing tax cuts.
- Caveat: estimates likely understate required fiscal adjustment because they do not allow for rises in health care spending due to new treatment methods or rising wage and non-wage costs of local governments.

### Public Spending Pressures and Local Government Finances
- Narrowing margins under expenditure ceilings; pressures from demographically driven increases in transfers to local authorities and initiation of new infrastructure investments without explicit allocations inside the spending ceiling.
- Local sector: rapid growth in consumption; provides large share of education and social services; accounts for bulk of public employment.
- Declining efficiency and reliance on volatile corporate profit tax bases forced local governments to raise income tax rates, partially offsetting central government tax reductions.
- Authorities plan limited reforms to municipal finances, including abolition of automatic adjustment of state grants when local spending exceeds plans.
- Longer-term option of shifting from cyclical tax bases to property taxes noted but regarded as politically infeasible given widespread home ownership.

### Policies to Raise Employment and Labor Supply
- Official employment targets: raise employment rate from current 67 percent to 70 percent by end of electoral cycle in 2007, and to 75 percent by 2011—targets appear increasingly beyond reach under present policies.
- Policy measures discussed:
  - Reduce taxation of labor, emphasizing low-paid and targeted employer social contribution cuts for low-skilled workers.
  - Shorten average time in tertiary education by introducing a two-tier university degree structure in 2005.
  - Consider use of study loans rather than grants.
  - Improve active labor market policies and secure moderate wage accords to allow greater flexibility in wage-setting.
  - Recognize role of immigration; share of foreign-born population in Finland in 2002 was less than 3 percent.

### Financial Sector and EMU Experience
- Over five years in EMU viewed with satisfaction; entry at beginning of 1999 met expectations of monetary stability and lower interest rates.
- Financial sector soundness:
  - Bank profitability healthy; proportion of non-performing loans extremely low.
  - Stress tests suggest banks could withstand extended economic stagnation and a significant fall in asset prices.
  - Household debt as proportion of disposable income has risen but remains low internationally; little concern about servicing ability.
- Cross-border integration calls for close cooperation among Nordic-Baltic supervisors and coordinated supervisory mechanisms.

### Staff Appraisal — Recommendations (selected)
- Fiscal policy:
  - Maintain awareness that the current fiscal surplus of about 2 percent of GDP is inadequate to meet long-term aging-related fiscal pressures.
  - If income tax cuts proceed, offset them with spending cuts to avoid increasing the long-term fiscal adjustment burden.
  - Achieve expenditure restraint and raise efficiency in delivery of social services, especially at the local level.
- Structural reforms:
  - Pursue mutually reinforcing labor and product market reforms to boost employment and productivity and reduce required fiscal adjustment over time.
  - Adopt measures to enhance employment at both ends of the age spectrum, address labor market mismatches, and increase job search incentives.
  - Strengthen competition in sheltered sectors and consider a smaller role for the state to boost productivity diffusion outside the high-technology sector.
- Pensions and aging:
  - Recent pension reform is an important step but is insufficient by itself to ensure sustainability; early consideration of further measures warranted given rapid population aging and adverse electoral arithmetic.
- Specific fiscal targets and actions:
  - Offset proposed tax cuts in the 2005 budget (and those announced in the recent wage round) with spending cuts; the fiscal stimulus implied by the 2005 budget "is no longer necessary."
  - Create room for durable reductions in labor taxation by pruning public spending; achieve central government balance by 2007 by offsetting any new tax cuts or spending initiatives with spending cuts and observing expenditure ceilings.
  - Reduce social transfers that deter labor utilization, focusing on limiting incentives for early retirement.
  - Reassess municipal revenue sources, considering greater reliance on alternative sources such as property taxes.

### IMF Executive Board Conclusions (selected)
- Directors commended productivity gains, stable macro framework, low inflation, and sizeable fiscal surpluses.
- Employment stagnant and structural unemployment high; Finland faces population aging earlier than any EU country.
- 2005 budget expansionary with cuts in corporate and capital taxes and start of a three-year labor income tax cut following the wage agreement; Directors recommended offsetting planned income tax cuts over 2005–07 by reductions in public spending, preferably via improved efficiency in social and welfare services.
- Directors recommended targeting tax cuts toward the lower end of the income scale, reducing employers’ social security contributions for low-income workers, a gradual shift to more decentralized wage bargaining, closing early-exit avenues (e.g., "unemployment pipeline"), and strengthening competition in product markets including reducing farm subsidies.

### Selected Projections and Indicators (selected)
- GDP growth (percent): 2004: 3.1; 2005: 2.9; 2006: 2.4; 2007 (Proj.): 2.2.
- Consumer price inflation (harmonized, percent): 2004: 0.2; 2005: 1.5; 2006: 1.8; 2007 (Proj.): 1.8.
- Unemployment rate (percent): 2004: 8.8; 2005: 8.3; 2006: 8.0; 2007 (Proj.): 7.8.
- Current account balance (percent of GDP): 2004: 5.8; 2005: 6.0; 2006: 6.2; 2007 (Proj.): 6.3.
- General government balance (percent of GDP): 2004: 2.1; 2005: 1.9; 2006: 2.1; 2007 (Proj.): 2.1.
- General government debt (EMU definition, percent of GDP): 2004: 45.0; 2005: 44.2; 2006: 43.3; 2007 (Proj.): 42.4.
- Public sector debt baseline (percent of GDP): 2005: 44.2; 2006: 43.3; 2007: 42.4; 2008 (Proj.): 41.3; 2009 (Proj.): 40.1.

*Source: Executive Summary and selected sections, _cr0535.*

### Executive Summary ......................................................................................................

### Executive Summary

### Background and Outlook

- The economy weathered the global slowdown relatively well.
- Growth is expected to pick up to about 3 percent in 2004–05, with a closing of the small output gap.
- Employment has stagnated, and unemployment remains stuck at about 9 percent since 2001.
- Inflation fell to the lowest level in the euro area in 2004, reflecting large cuts in indirect taxation, but is expected to gradually revert to close to the euro area average.
- A recently concluded 2½ year wage accord is moderate, accompanied by sizable (about 1 percent of GDP) cuts in income taxation over 2005–07.
- The fiscal surplus at about 2 percent of GDP appears comfortable in a comparative EU context, but is inadequate given rapid population aging which sets in earlier than any other EU country.

### Economic Background

- Sustained economic growth over the past decade has been among the highest in the industrialized world, underpinned by productivity gains led by the high technology electronics sector.
- Employment has been stagnant since 2002 and unemployment has remained stubbornly high.
- Imminent aging of the population: old-age dependency is set to rise most rapidly among EU countries.
- Recent Fund advice has emphasized the need for sizeable fiscal surpluses and further structural reforms to address the aging shock.
- Authorities broadly share the Fund’s assessment that large fiscal surpluses are needed over the coming decade and beyond to cope with expected long-term fiscal pressures and ensure sustainability.
- Authorities view greater labor market flexibility and a shift to a more decentralized wage-setting system as desirable but regard them as medium-term goals to be achieved gradually.

Key recent performance indicators (as reported)
- Real GDP: 2002: 2.3; 2003: 2.0; 2004 est.: 3.1; 2005 proj.: 2.9 (percent change)
- Domestic demand: 2002: 1.3; 2003: 2.1; 2004 est.: 2.6; 2005 proj.: 2.2 (percent change)
- Consumption: 2002: 2.2; 2003: 3.5; 2004 est.: 2.6; 2005 proj.: 2.0 (percent change)
  - Private consumption: 2002: 1.5; 2003: 4.3; 2004 est.: 3.1; 2005 proj.: 2.1 (percent change)
- Gross fixed capital formation: 2002: -2.0; 2003: -2.9; 2004 est.: 2.3; 2005 proj.: 3.1 (percent change)
  - Residential investment: 2002: 2.1; 2003: 9.0; 2004 est.: 7.5; 2005 proj.: 2.1 (percent change)
- Net exports (contribution to growth): 2002: 2.0; 2003: -0.5; 2004 est.: 1.3; 2005 proj.: 1.3 (percent contribution)
- HICP inflation: 2002: 2.0; 2003: 1.3; 2004 est.: 0.2; 2005 proj.: 1.5 (percent)
- GDP deflator: 2002: 0.9; 2003: -0.1; 2004 est.: 0.2; 2005 proj.: 1.0 (percent)
- Employment: 2002: 0.2; 2003: -0.3; 2004 est.: -0.3; 2005 proj.: 0.5 (percent)
- Unemployment rate: 2002: 9.1; 2003: 9.0; 2004 est.: 8.8; 2005 proj.: 8.3 (percent of labor force)
- Labor compensation: 2002: 3.0; 2003: 3.2; 2004 est.: 3.1; 2005 proj.: 2.9 (percent change economy-wide)
- Unit labor costs: 2002: 0.9; 2003: 0.6; 2004 est.: 0.5; 2005 proj.: 1.1 (percent change economy-wide)
- Output gap: 2002: -0.7; 2003: -1.2; 2004 est.: -0.7; 2005 proj.: -0.1 (in percent of potential output)

Additional economic characteristics and concerns
- Strong productivity gains concentrated in the Nokia-led electronics sector and financial services, with limited diffusion across the rest of the economy.
- The centralized wage-setting regime has fostered wage compression and growing mismatch in the labor market.
- High taxes on labor and multiple possibilities for early exit from the labor force have tended to reduce labor supply.
- Authorities’ employment targets: raise employment rate from current 67 percent to 70 percent by end of current electoral cycle in 2007, and to 75 percent by 2011—targets appear increasingly beyond reach under present policies.
- Household real disposable income growth has been buoyed by tax cuts.
- House price inflation rose to 8 percent in 2003 from the recent annual average of 5 percent, mainly reflecting rising cost of building land, especially in the Helsinki region.

External sector and investment
- Finland recorded current account surpluses in the range of 5 to 8 percent of GDP since the mid-1990s and is expected to sustain similar surpluses over the medium-term.
- Recent surpluses reflect low domestic investment and higher net factor incomes; Finland’s investment ratio has been below the euro area average for the past ten years.
- The net international investment position (excluding equities) has turned positive.

Fiscal developments
- General government surplus around 2 percent of GDP in 2003, among the highest in the advanced world, but largely accounted for by the surplus of the social security funds; central and local government sector in a small deficit.
- The surplus declined from a record level of 7 percent of GDP in 2000, with the structural surplus falling by 3¼ percent of GDP over the period.
- The strong fiscal expansion was largely due to increased public spending in 2002 and tax cuts in 2003 amounting to about 1½ percent of GDP.
- General government overall balances (percent of GDP): Central and local governments: 2002: 1.3; 2003: -0.3; 2004 est.: -0.4; 2005 proj.: -0.9. Social security: 2002: 3.0; 2003: 2.4; 2004 est.: 2.4; 2005 proj.: 2.7. General government: 2002: 4.3; 2003: 2.1; 2004 est.: 2.0; 2005 proj.: 1.8. General government (structural): 2002: 4.5; 2003: 2.8; 2004 est.: 2.4; 2005 proj.: 2.0.
- In 2004, growth about ½ percent above that estimated in the budget helped maintain the fiscal surplus at 2 percent of GDP despite cuts in income taxes and alcohol excises totaling some 1 percent of GDP.
- The revised four-year expenditure rule (1-year legal and 3-year indicative ceiling) covers about three-fourths of central government spending, excluding cyclical, interest, and other volatile expenditures; the margin remaining over the 2005–08 horizon is limited.
- The structural surplus is estimated to have worsened by about ½ percent of GDP.

### Policy Discussions

Key issues addressed
- The stance of short-term fiscal policy in light of the need to cut labor taxes to boost employment prospects, and the coming aging-related fiscal pressures.
  - Authorities view the income tax cuts as appropriate in the context of a moderate wage agreement and to achieve a critically needed increase in employment, even though no longer necessary from a cyclical perspective.
  - Staff recommendation: planned tax cuts should be offset by cuts in spending in order not to add to the long-term burden of fiscal adjustment.
- Benefits of mutually reinforcing labor and product market reforms to reduce the need for larger fiscal adjustment over the long-term.
  - Staff and authorities concurred on benefits of reforms; urged adoption of measures to enhance employment at both ends of the age spectrum, address labor market mismatches, and increase job search incentives.
  - Productivity gains, relatively low outside the high technology sector, could be boosted through strengthened competition, especially in sheltered sectors, and through a smaller role for the state.
- Imminent aging of the population will lead to rising expenditure pressures.
  - To further reduce high levels of labor taxation, focus needs to be placed on expenditure restraint, including raising efficiency in delivery of social services, especially at the local level.
  - The mission noted that while the recent pension reform is an important step, it is, in itself, insufficient to ensure sustainability of the system.
  - Given worsening electoral arithmetic as the median age of the average voter rises rapidly, the mission called for early consideration of further measures.

Labor market and wage-setting
- The wage accord concluded in December 2004 covers a period of two and a half years to September 2007; including local-level increases and wage drift, expected to result in a rise in annual wages of about 3½ percent over this period.
- In the context of the agreement, the government announced its intention to reduce income taxes by over 1 percent of GDP over the 2005–07 period.
- The accord retains Finland’s essentially centralized wage bargaining framework, in contrast to the recent Nordic trend towards firm-level bargaining.

Structural issues highlighted
- The emergence of the high-technology sector led by Nokia has reoriented the industrial structure and exports toward telecommunications; in 2002, ICT exports amounted to almost 22 percent of exports of goods—triple their share in the early 1990s and twice the EU average.
- Finland has the highest degree of export specialization among advanced economies, making it more susceptible to sector-specific shocks.
- Productivity acceleration since the mid-1990s primarily reflects gains in the ICT sector, with limited spillovers to the rest of the economy; Nokia accounts for almost half of the Finnish ICT cluster’s sales.
- Relative inflexibility of labor and product markets may have prevented stronger diffusion of productivity gains throughout the economy.

### Staff Appraisal and Recommendations

- Fiscal policy:
  - Maintain awareness that the current fiscal surplus of about 2 percent of GDP is inadequate to meet long-term aging-related fiscal pressures.
  - If income tax cuts proceed, offset them with spending cuts to avoid increasing the long-term fiscal adjustment burden.
  - Achieve expenditure restraint and raise efficiency in delivery of social services, especially at the local level.
- Structural reforms:
  - Pursue mutually reinforcing labor and product market reforms to boost employment and productivity and reduce required fiscal adjustment over time.
  - Adopt measures to enhance employment at both ends of the age spectrum, address labor market mismatches, and increase job search incentives.
  - Strengthen competition in sheltered sectors and consider a smaller role for the state to boost productivity diffusion outside the high-technology sector.
- Pensions and aging:
  - Recent pension reform is an important step but is insufficient by itself to ensure sustainability; early consideration of further measures is warranted given rapid population aging and adverse electoral arithmetic.

*Source: Executive Summary, _cr0535.*

### 11.      The budget for 2005 is expansionary despite the projected economic rebound. A

### _cr0535 - 11.      The budget for 2005 is expansionary despite the projected economic rebound. A

### Budget stance and near-term policies
- The budget for 2005 is described as expansionary despite a projected economic rebound.
- Tax cuts enacted to stimulate investment and employment:
  - Corporate tax rate cut of 3 percentage points (to 26 percent).
  - Personal capital income tax rate cut of 1 percentage point (to 28 percent).
  - Cuts in income taxes of 0.2 percent of GDP (in the context of the incomes policy accord) aimed at stimulating employment.
- Projected fiscal balances:
  - General government surplus projected to decline to about 1¾ percent of GDP.
  - Deficit of the central and local government sector likely to exceed ¾ percent of GDP.
- Authorities view the 2005 stimulus as appropriate given commitments in the centralized wage accord and the objective of raising employment, despite no cyclical need.

### Tax burden and labor taxation
- Finland’s tax burden:
  - Among the highest in the world, exceeded only by Sweden and Denmark.
  - About 5 percentage points of GDP higher than the EU average.
- Marginal tax wedges on labor:
  - Despite declines in recent years, remain well above the OECD average (Figure 2 referenced).
  - High marginal tax rates set in at comparatively low income levels.
- Policy emphasis:
  - Targeting tax reductions at low-income earners to address high tax wedge at the low end of the wage distribution.
  - Consideration of targeted reductions in social insurance contributions by employers of the low skilled (and low paid) as more effective than across-the-board cuts.
  - Officials plan to reduce payroll taxes for the low-paid in 2006.
  - Caution that across-the-board tax cuts should ideally be offset by expenditure cuts.

### Pension reform and demographic pressures
- Pension reform underway, phased in beginning 2005:
  - Aim to raise the effective retirement age, currently 59 years.
  - Replace standard retirement age of 65 with a flexible retirement age ranging from 62 to 68.
  - Introduce an accrual rate rising with age for older workers.
- Context and concerns:
  - Inactivity rates among males aged 50 and over from sickness and disability are among the highest in the industrialized world.
  - The demographic transition will begin to impact the labor market as early as 2006.
  - Rapid population aging and a steep rise in the old-age dependency ratio between 2010 and 2025 create significant fiscal challenges.

### Outlook, growth, and risks
- Near-term growth projections and assumptions:
  - Domestic demand projected to accelerate to 2½ percent in 2004.
  - Staff forecast for GDP growth of around 3 percent in both 2004 and 2005; the small output gap is expected to close.
  - Unemployment expected to decline only slightly.
  - Latest official projections assume an oil price of about US$45 in 2005 and US$40 in 2006, and an average euro exchange rate of $1.24.
- Risks to the forecast:
  - Upside: faster global recovery and a turnaround in Nokia’s market share could strengthen exports.
  - Downside: continued loss in Finland’s overall market share, high oil prices, further appreciation of the euro, and adverse employment trends that could damage consumer confidence.
- Competitiveness concerns:
  - Despite top competitiveness rankings, anxiety exists about attractiveness to global investors due to being perceived as “a small, expensive, rapidly aging and remote country.”
  - Trends feeding pessimism: rising propensity of Finnish companies to invest abroad, shrinking net capital stock (investment ratio below euro area), secular decline in the terms of trade, persistence of high structural unemployment.

### Fiscal sustainability and structural reform scenarios
- Fiscal sustainability assessments and required adjustments:
  - Staff analysis: on present policies, general government (excluding social security surpluses of about 2½ percent of GDP) would need to sustain annual surpluses of 1½ percent of GDP through the end of the decade to ensure sustainability, compared with a present deficit of about ¾ percent of GDP.
  - Staff’s baseline projections suggest a permanent fiscal adjustment of about 2 percent of GDP is required to ensure sustainability (Figure 5).
  - OECD study: assuming no further pension reforms, potential output growth of 2¼ percent and some increase in employment, a permanent fiscal adjustment of 1 percent of GDP would be needed to avoid sharp deterioration of government net asset position by 2050.
- Structural reform scenario (Fund’s GEM model calibrated to Finland):
  - Combination of product and labor market reforms leads to sizeable economic gains.
  - Simulated impacts: higher employment and output—around 3 percentage points each (Figure 6).
  - The need for fiscal adjustment is reduced by about 1 percent of GDP versus the baseline.
  - Reforms plus additional pension or other expenditure measures would create room for growth-enhancing tax cuts.
- Caveats:
  - Staff and officials agreed these estimates likely understate required fiscal adjustment because they do not allow for rises in health care spending due to new treatment methods or rising wage and non-wage costs of local governments.

### Public spending pressures and local government finances
- Pressures on public spending:
  - Narrowing margins under expenditure ceilings.
  - Two main sources of pressure: demographically driven increases in transfers to local authorities; initiation of new infrastructure investments without explicit allocations inside the spending ceiling.
  - Medium-term savings potential: education subsidies, public pensions, improved efficiency in provision of public services (particularly at local level).
- Local government concerns:
  - Local sector has experienced rapid growth in consumption; provides large share of education and social services and accounts for bulk of public employment.
  - Declining efficiency and excessive reliance on volatile corporate profit tax bases have forced local governments to raise income tax rates, partially offsetting central government tax reductions.
  - Authorities plan limited reforms to municipal finances, including abolition of automatic adjustment of state grants when local spending exceeds plans.
  - A longer-term option of shifting from cyclical tax bases to property taxes was noted but regarded as politically infeasible given widespread home ownership.

### Labor market policies and other measures to raise employment
- Employment objectives and constraints:
  - Official objective to raise employment to 70 percent; employment rate expected to decline to 67 percent in 2004, underlining difficulty of the target.
  - Incentives still exist for workers to leave the labor force early and enter late, given almost free education and generous subsidies.
- Policy measures discussed:
  - Reduce taxation of labor, with emphasis on the low-paid and targeted employer social contribution cuts for low-skilled workers.
  - Shorten average time in tertiary education by introducing a two-tier university degree structure in 2005.
  - Consider use of study loans rather than grants.
  - Improve active labor market policies and secure moderate wage accords to allow greater flexibility in wage-setting.
  - Recognize the role of immigration: Finland has generally attracted lower immigration (share of foreign-born population in Finland in 2002 was less than 3 percent) compared with several peers.
- Immigration and labor supply:
  - Studies of migration from the Baltics suggest no significant rise in labor inflows into the Nordic countries.
  - Finland, like most EU countries, introduced special transition rules governing access to its labor market for citizens from the new EU member states.

*Italic: Source—Content unit _cr0535 - 11. The budget for 2005 is expansionary despite the projected economic rebound. A (PDF).*

### 27.      The authorities recognize that changes in the institutional arrangements of the

### The authorities recognize that changes in the institutional arrangements of the labor market are highly desirable

### Labor market institutions and wages
- Centralized wage determination moderated inflation but "solidified wage rigidities" unfavorable to the young and unskilled.
- Finnish trade unions favor a "solidaristic" framework emphasizing job security and effective "job-to-job" training.
- Recent wage accord viewed by officials as "a first step in the direction of more decentralized wage formation."
- Staff view: a shift toward more decentralized wage bargaining would
  - ease the compressed wage structure,
  - allow greater correspondence between wage and productivity differentials,
  - help reduce structural unemployment.

### Pension reform and labor supply
- Tripartite pension reform package contains three critical elements:
  - automatic link of pensions to life expectancy;
  - nexus of benefits to lifetime earnings replacing the earlier "ten-year rule";
  - introduction of a flexible retirement age.
- The reform is expected to raise the effective retirement age by almost two years.
- The reform to be phased in beginning next year.
- Remaining concerns:
  - important avenues to early exit remain, notably the "unemployment pipeline" whereby the unemployed aged over 57 can continuously claim benefits to age 65;
  - officials note political difficulty of further reforms in the near term, but staff argue for early consideration given long phase-in periods required.
- Recommendation: close the "unemployment pipeline" to maximize the reform’s impact on participation.

### Product markets, competition, and trade policy
- Lack of competition evident in Finland’s high price level relative to the EU average.
- Sheltered sectors characterized by high market concentration, high prices, lagging productivity, and significant state ownership.
- Public enterprise sector remains larger than in most Nordic countries; privatization likely to proceed only gradually.
- Finland ranks high on "soft" measures of competitiveness (e.g., perceptions of corruption, supportive legal environment, good educational system) but lags on "hard" measures (e.g., high tax rates, high compensation levels, high management remuneration), potentially explaining comparatively low inward foreign direct investment.
- Competitive pressures increasing:
  - competition in retail rose since EU accession and has led to fall in food prices;
  - rising tax competition and revived regulatory authorities in sheltered sectors, including network industries, have had salutary impact;
  - Competition Authority legislation aligned with EU competition law and should allow effective action against cartels;
  - planned reform of shop opening hours expected to enhance retail competition.
- Trade policy:
  - Finland supports the Doha Development Agenda but retains heavy farm subsidization—subsidies are higher than the EU average.
  - Officials favor multilateral trading framework and expect only gradual reduction in farm subsidies for political reasons.
  - Official development assistance budgeted to rise to almost 0.4 percent of GDP in 2005 from around 0.35 percent in recent years.

### EMU experience and financial sector
- Over five years in the EMU viewed with considerable satisfaction; entry at beginning of 1999 met expectations of monetary stability and lower interest rates.
- Post-entry outcomes: growth faster than the euro area due to high-technology sector boom; economy opened up and large current account surpluses emerged after decades of deficits.
- Financial sector soundness:
  - bank profitability healthy; proportion of non-performing loans extremely low;
  - stress tests suggest banks could withstand extended economic stagnation and a significant fall in asset prices.
  - household debt as proportion of disposable income has risen but remains low internationally with little concern about servicing ability.
- Cross-border integration issues:
  - increased cross-border activities and the merger of the Swedish and Finnish stock exchanges call for close cooperation among Nordic-Baltic supervisors and new coordinated supervisory mechanisms;
  - cross-border transactions raise EU-wide policy questions on deposit insurance and lender of last resort.

### Staff appraisal — outlook, risks, and policy recommendations
- Recent record: impressive recovery with low inflation, comfortable external position, and public finance surpluses among the largest in the European Union.
- Main challenges:
  - structural unemployment remains high;
  - imminent population aging; Finland will face aging earlier than any other EU country;
  - institutional rigidities impede adaptation to change.
- Fiscal sustainability:
  - In absence of wide-ranging structural reforms, central and local governments would need to run a combined annual surplus of the order of 1½ percent of GDP, compared with a projected deficit of over ¾ percent of GDP in 2005.
  - The pension reform contributes but is insufficient alone; closing early-exit avenues (e.g., the "unemployment pipeline") is necessary.
- Policy recommendations:
  - Pursue early, wide-ranging structural reforms to raise employment and growth and strengthen public finances.
  - Raise employment rates via reforms across tax-benefit, product, and labor market arrangements; recent tax cuts help low-skilled employment but are insufficient alone.
  - Target tax cuts toward the lower end of the income scale to enhance employment effects.
  - Offset proposed tax cuts in the 2005 budget (and those announced in the recent wage round) with spending cuts; the fiscal stimulus implied by the 2005 budget "is no longer necessary."
  - Create room for durable reductions in labor taxation by pruning public spending; achieve central government balance by 2007 by offsetting any new tax cuts or spending initiatives with spending cuts and observing expenditure ceilings.
  - Reduce social transfers that deter labor utilization, focusing on limiting incentives for early retirement.
  - Improve efficiency in provision of social and welfare services and reassess municipal revenue sources, considering greater reliance on alternative sources such as property taxes.
  - Enhance productivity by promoting investment in equipment and technology and increasing flexibility in labor and product markets, especially in sheltered sectors.
  - Strengthen competition in product markets, including reducing farm subsidies (high even by EU standards) to improve efficiency and consumer welfare.
  - Strengthen cooperation among Nordic-Baltic supervisors and develop coordinated supervisory mechanisms to manage cross-border financial integration.
- Positive notes:
  - Finland’s high level of official development assistance is commendable.
  - Finland’s provision of economic statistics is adequate for Fund surveillance.

*Source: IMF staff report content provided in the supplied PDF excerpt.*

### 46.      It is recommended that the next Article IV consultation with Finland remain on the

### _cr0535 - 46.      It is recommended that the next Article IV consultation with Finland remain on the

### Recommendation
- It is recommended that the next Article IV consultation with Finland remain on the 12-month cycle.

### Output, demand, prices, labor, and monetary indicators (selected)
- GDP (growth, percent): 2000: 5.1; 2001: 1.1; 2002: 2.3; 2003: 2.0; 2004: 3.1; 2005: 2.9; 2006: 2.4; 2007 (Proj.): 2.2
- Domestic demand (volumes, percent): 2000: 3.6; 2001: 1.7; 2002: 1.3; 2003: 2.1; 2004: 2.4; 2005: 2.5; 2006: 2.1; 2007 (Proj.): 1.9
- Consumer price inflation (harmonized, percent): 2000: 3.0; 2001: 2.7; 2002: 2.0; 2003: 1.3; 2004: 0.2; 2005: 1.5; 2006: 1.8; 2007 (Proj.): 1.8
- Core inflation (excluding energy and seasonal food, percent): 2000: 3.0; 2001: 2.6; 2002: 1.9; 2003: 1.2; 2004: 0.0; 2005: 1.5; 2006: 1.3; 2007 (Proj.): 1.5
- Unemployment rate (percent): 2000: 9.8; 2001: 9.1; 2002: 9.1; 2003: 8.9; 2004: 8.8; 2005: 8.3; 2006: 8.0; 2007 (Proj.): 7.8
- Output gap (percent of potential output): 2000: 2.4; 2001: -0.1; 2002: -0.7; 2003: -1.2; 2004: -0.7; 2005: -0.1; 2006: 0.0; 2007 (Proj.): 0.0
- Growth in potential output (percent): 2000: 6.6; 2001: 3.6; 2002: 2.9; 2003: 2.6; 2004: 2.6; 2005: 2.3; 2006: 2.3; 2007 (Proj.): 2.2
- NAIRU (percent): 2000: 9.7; 2001: 9.2; 2002: 9.2; 2003: 8.5; 2004: 8.2; 2005: 7.9; 2006: 7.7; 2007 (Proj.): 7.5
- 3-month money market rate (percent): 2000: 4.4; 2001: 4.3; 2002: 3.3; 2003: 2.3; 2004: 3.7; 2005: 3.9; 2006: 4.2; 2007 (Proj.): 4.3
- 10-year government bonds yield (percent): 2000: 5.5; 2001: 5.0; 2002: 5.0; 2003: 4.1; 2004: 4.2; 2005: 4.4; 2006: 4.6; 2007 (Proj.): 4.8

### External sector and balance of payments (selected)
- Current account balance (percent of GDP): 2000: 7.7; 2001: 7.1; 2002: 6.8; 2003: 5.7; 2004: 5.8; 2005: 6.0; 2006: 6.2; 2007 (Proj.): 6.3
- Trade balance (percent of GDP): 2000: 11.4; 2001: 10.4; 2002: 9.7; 2003: 9.2; 2004: 9.4; 2005: 8.5; 2006: 8.6; 2007 (Proj.): 8.6
- Exports of goods and services (percent of GDP): 1999: 45.3; 2000: 55.9; 2001: 54.1; 2002: 54.1; 2003: 53.1; 2004: 55.0; 2005: 57.1; 2006: 59.9; 2007: 62.8; 2008: 65.3; 2009: 68.0 (Proj.)
- Imports of goods and services (percent of GDP): 1999: -35.1; 2000: -43.9; 2001: -42.8; 2002: -42.4; 2003: -43.8; 2004: -45.2; 2005: -46.9; 2006: -49.2; 2007: -51.7; 2008: -54.4; 2009: -57.2 (Proj.)
- Net external debt (excluding equity FDI and shares, percent of GDP): 1999: 13.8; 2000: 5.5; 2001: 2.2; 2002: -3.5; 2003: -9.2; 2004: -14.9; 2005: -20.6; 2006: -26.2

### Public finances (selected, percent of GDP)
- General government: Revenues: 2000: 51.2; 2001: 49.5; 2002: 49.3; 2003: 48.0; 2004: 48.2; 2005: 47.9; 2006: 48.0; 2007 (Proj.): 48.0
- General government: Expenditure: 2000: 44.1; 2001: 44.3; 2002: 45.0; 2003: 45.8; 2004: 46.0; 2005: 46.0; 2006: 45.9; 2007 (Proj.): 45.9
- General Government balance (percent of GDP): 2000: 7.1; 2001: 5.2; 2002: 4.3; 2003: 2.1; 2004: 2.1; 2005: 1.9; 2006: 2.1; 2007 (Proj.): 2.1
- Primary balance (percent of GDP): 2000: 8.1; 2001: 5.9; 2002: 4.5; 2003: 2.4; 2004: 2.1; 2005: 1.8; 2006: 1.9; 2007 (Proj.): 1.8
- Debt (EMU definition, percent of GDP): 2000: 44.6; 2001: 43.9; 2002: 42.6; 2003: 45.5; 2004: 45.0; 2005: 44.2; 2006: 43.3; 2007 (Proj.): 42.4
- Central government balance (percent of GDP): 2000: 3.4; 2001: 2.0; 2002: 1.4; 2003: 0.3; 2004: 0.1; 2005: -0.5; 2006: -0.5; 2007 (Proj.): -0.4
- Central government debt (percent of GDP): 2000: 49.3; 2001: 45.9; 2002: 42.9; 2003: 45.0; 2004: 43.7; 2005: 42.8; 2006: 41.8; 2007 (Proj.): 40.9

### Public debt sustainability framework (selected)
Baseline projections and key assumptions:
- Public sector debt (percent of GDP): 1999: 47.4; 2000: 44.6; 2001: 43.9; 2002: 42.6; 2003: 45.5; 2004: 45.0; 2005: 44.2; 2006: 43.3; 2007: 42.4; 2008 (Proj.): 41.3; 2009 (Proj.): 40.1
- Change in public sector debt (percent of GDP): 1999: -1.2; 2000: -2.9; 2001: -0.7; 2002: -1.3; 2003: 2.9; 2004: -0.5; 2005: -0.8; 2006: -0.9; 2007: -0.9; 2008 (Proj.): -1.1; 2009 (Proj.): -1.2
- Identified debt-creating flows (percent of GDP): 1999: -2.6; 2000: -9.4; 2001: -6.7; 2002: -6.0; 2003: -3.9; 2004: -3.3; 2005: -3.6; 2006: -3.6; 2007: -3.4; 2008 (Proj.): -3.6; 2009 (Proj.): -3.5
- Primary deficit (percent of GDP): 1999: -5.3; 2000: -10.0; 2001: -7.9; 2002: -6.5; 2003: -4.2; 2004: -3.7; 2005: -3.4; 2006: -3.5; 2007: -3.5; 2008 (Proj.): -3.4; 2009 (Proj.): -3.3
Key macro-fiscal assumptions:
- Real GDP growth (percent): historical averages and projections show values including 3.4, 5.1, 1.1, 2.3, 2.0, 3.6, 1.6, 3.1, 2.9, 2.4, 2.2, 2.2, 2.2, 2.5 (various years as tabulated)
- Average nominal interest rate on public debt (percent): 6.6; 6.5; 6.4; 5.2; 4.8; 6.8; 1.1; 3.8; 3.6; 3.5; 3.4; 3.2; 3.1; 3.4 (historical and projected entries)
- Inflation rate (GDP deflator, percent): -0.2; 3.2; 3.0; 0.9; -0.1; 1.9; 1.8; -0.2; 1.0; 1.1; 1.1; 1.5; 1.5; 1.0 (historical and projected entries)

Stress tests and alternative scenarios (selected outcomes for public sector debt percent of GDP)
- Baseline: 2005: 44.2; 2006: 43.3; 2007: 42.4; 2008: 41.3; 2009: 40.1
- A1. Key variables at historical averages in 2005-09: 2005: 45.0; 2006: 44.1; 2007: 43.0; 2008: 41.8; 2009: 40.4; debt-stabilizing primary balance: 38.9
- A2. No policy change (constant primary balance) in 2005-09: 2005: 45.0; 2006: 43.9; 2007: 42.9; 2008: 41.7; 2009: 40.3; debt-stabilizing primary balance: 38.7
- B1. Real interest rate shock (historical average + 2 s.d.) in 2005 and 2006: 2005: 45.0; 2006: 46.7; 2007: 48.5; 2008: 47.7; 2009: 46.5; debt-stabilizing primary balance: 45.3
- B2. Real GDP growth shock (historical average - 2 s.d.) in 2005 and 2006: 2005: 45.0; 2006: 46.4; 2007: 48.3; 2008: 49.5; 2009: 50.4; debt-stabilizing primary balance: 51.2
- B3. Primary balance shock (historical average - 2 s.d.) in 2005 and 2006: 2005: 45.0; 2006: 50.5; 2007: 56.0; 2008: 55.2; 2009: 54.0; debt-stabilizing primary balance: 52.7
- B5. One time 30 percent real depreciation in 2005: 2005: 45.0; 2006: 44.5; 2007: 43.5; 2008: 42.6; 2009: 41.5; debt-stabilizing primary balance: 40.3
- B6. 10 percent of GDP increase in other debt-creating flows in 2005: 2005: 45.0; 2006: 54.2; 2007: 53.3; 2008: 52.4; 2009: 51.2; debt-stabilizing primary balance: 50.0

### Financial sector vulnerability indicators (selected)
Households:
- Total household debt (percent of GDP): 1998: 30.5; 1999: 31.5; 2000: 30.2; 2001: 31.8; 2002: 33.7; 2003: 37.3
- Debt-to-income ratio: 1998: 58.5; 1999: 61.2; 2000: 63.7; 2001: 65.3; 2002: 70.7; 2003: 74.6

Non-financial corporations:
- Gross debt (percent of GDP): 1998: 46.2; 1999: 48.2; 2000: 52.8; 2001: 53.0; 2002: 51.1; 2003: 53.1

Government:
- General government debt (EMU definition, percent of GDP): 1998: 48.8; 1999: 47.4; 2000: 44.6; 2001: 43.9; 2002: 42.6; 2003: 45.5

Banking sector:
- Outstanding credit to nonfinancial private sector (percent change, e.o.p.): 1998: 12.1; 1999: 14.2; 2000: 6.4; 2001: 6.9; 2002: 8.6; 2003: 11.2
- Housing loans (percent change, e.o.p.): 1998: 13.1; 1999: 15.8; 2000: 10.6; 2001: 11.5; 2002: 13.3; 2003: 15.6
- Housing loans as percent of total lending to nonfinancial private sector: 1998: 36.5; 1999: 37.0; 2000: 38.5; 2001: 40.1; 2002: 40.0; 2003: 41.6
- Non-performing loans/total loans (percent): 1998: 1.2; 1999: 1.0; 2000: 0.6; 2001: 0.6; 2002: 0.5; 2003: 0.4
- BIS capital asset ratio: 1998: 11.5; 1999: 11.9; 2000: 11.6; 2001: 10.5; 2002: 11.7; 2003: 19.3
- Return on equity (percent): 1998: 25.8; 1999: 20.1; 2000: 22.4; 2001: 13.5; 2002: 10.7; 2003: 10.1
- Return on assets (percent): 1998: 1.2; 1999: 1.0; 2000: 1.2; 2001: 0.7; 2002: 0.5; 2003: 0.7
- Liquid assets/total assets (percent): 1998: 19.3; 1999: 19.6; 2000: 15.2; 2001: 14.0; 2002: 10.7; 2003: 12.0

Stock market and housing:
- Change in stock market index (percent, e.o.p.): 1999: 68.5; 2000: 162.0; 2001: -10.6; 2002: -32.4; 2003: -34.4; 2004: 4.4
- Change in housing price index (percent, e.o.p.): 1999: 9.6; 2000: 10.5; 2001: -0.2; 2002: 1.4; 2003: 8.8; 2004: 7.4

### Fund relations and administrative facts (selected)
- Membership Status: Joined January 14, 1948; Article VIII.
- Quota (SDR Million / Percent of Quota): Quota: 1,263.80 / 100.00; Fund holdings of currency: 833.94 / 65.99; Reserve position in Fund: 429.94 / 34.02
- SDR Department: Net cumulative allocation: 142.69 / 100.00; Holdings: 125.42 / 87.89
- Outstanding Purchases and Loans: None
- Latest Financial Arrangements: None
- Projected Payments to Fund (Charges/Interest, SDR million): 2004: 0.39; 2005: 0.39; 2006: 0.39; 2007: 0.39; 2008: 0.39
- Exchange arrangements: Finland is a founding member of EMU, with a euro conversion rate of Finnish markka (Fmk) 5.94573.
- Article IV consultation: 2003 Article IV consultation discussions held in Helsinki during June 9–18, 2003; Executive Board concluded consultation on October 8, 2003. Staff Report (IMF Country Report No. 03/325, 09/05/03) and a PIN (PIN/03/124) were published.

### Statistical and reporting notes (selected)
- Sources cited in the material: Ministry of Finance, Bank of Finland; Bank of Finland; Statistics Finland; Eurostat Chronos database; The Finnish Bankers' Association; Financial Supervision Authority; and staff projections/estimates.
- Projections are staff estimates based on the authorities' current policy indications.
- Table and footnote highlights include: ESA95 basis for government data; one-off factors related to exceptional tax revenues due to income from stock options; stock-flow adjustments reflecting changes in the portfolio allocation of Finnish pension funds; note that for 2004-06 staff expects a current account balance that stays above 7 percent of GDP.

*Source: IMF staff report content provided in the supplied document.*

### 1. Recent economic developments and short-term prospects

### 1. Recent economic developments and short-term prospects

### Recent growth and outlook
- Finland's GDP growth has exceeded the euro area average rate of growth by a good margin in recent years.
- According to the latest estimates, GDP growth was slightly above 3 percent in 2004.
- Last year, growth was sustained by stronger-than-expected domestic demand and an uptick in the pace of global economic growth.
- For 2005:
  - Consumption is projected to slow down.
  - Revival of exports coupled with strengthening corporate investment is expected to support growth.
  - In the recently updated Stability Program, the growth projection for 2005 has been revised upwards to 2.8 percent.
- On balance, the economic outlook for 2005 is comparatively good, though the risks of a slowdown in growth have increased, particularly as regards raw material prices.

### External position and inflation
- The current account surplus has amounted to 5 - 8 percent of GDP for a number of years reflecting relatively low investment activity.
- Finland's investment ratio has remained below the euro area average for a long time.
- In 2005, the current account is projected to remain at 8 percent of GDP.
- Over the medium term, the current account is projected to decline while still remaining in substantial surplus.
- Inflation developments:
  - The pace of the rise in consumer prices has been clearly lower than was anticipated in the previous Stability Program.
  - In 2004 inflation stood at 0.2 percent.
  - Inflation, which has been at very low levels partly because of exceptional factors (tax cuts of alcoholic beverages and automobiles), is expected to accelerate somewhat.

### Labor market, incomes, and household balance sheets
- Unemployment:
  - Unemployment has remained "stubbornly high" to quote the staff.
  - The unemployment rate has stayed at near 9 percent.
  - The economy suffered substantial job losses in industry during 2004.
  - The fall in the number of employed has stabilized, and the most recent data show an increase in the number of employed.
  - The employment rate, which has been approaching 68 percent, will likely remain below the 70 percent target that was set by the government in 2003 during this and next year.
- Household incomes and indebtedness:
  - Household real incomes have risen on average by 4 percent in 2004.
  - Household real incomes are forecast to grow by nearly 2 percent both in 2005 and 2006.
  - Household indebtedness has risen, boosted by rapid mortgage borrowing.
  - Authorities do not see a real cause for concern yet because loan maturities have become longer, mortgage rates are at historically low levels, and housing prices continue to rise.

---

### 2. Fiscal policy

### Current fiscal position and projections
- General government financial balance is currently in a strong position.
- In the updated Stability Program:
  - The projection for the general government surplus in 2004 has been revised upwards by 0.3 percent to 2 percent.
  - The general government surplus will be somewhat weaker in 2005 (estimated at 1.8 percent before the recently agreed tax cuts).
- Central government finances will be in balance in 2004 showing a stronger fiscal position than was envisaged in the previous Stability Program.
- General government debt levels have been revised downwards to 44.8 percent of GDP in 2004 and to 43.5 percent in 2005.
- The government's target is to balance central government finances by 2007.
- Fiscal stance:
  - The fiscal policy stance has shifted from a very expansionary phase in 2003 to a nearly neutral gear in 2004 and continues as neutral in 2005 and 2006.
  - The government is committed to keeping central government expenditure within the spending limits for 2004-2007 that were approved in May 2003.

### Policy trade-offs and sustainability concerns
- Authorities and staff agree on streamlining public expenditures in exchange for further tax cuts, which are necessary for raising employment as targeted in the government program.
- Authorities emphasize raising efficiency in the provision of public services, particularly at the local level, and keeping increases in local taxes from offsetting government efforts to lower overall taxation.
- Long-run fiscal sustainability:
  - Discussions centered on maintaining fiscal sustainability in view of diminishing labor input and rapidly aging population.
  - Longer term outlook is of concern once the costs of aging start to materialize around 2010.
  - Authorities share staff's view on the necessity of maintaining general government surpluses to meet rising costs of pension and health care services for the elderly.
  - Authorities consider staff's suggestion to run a 4 percent general government surplus (including the social security funds) for the rest of the decade unrealistic.
  - Government recognizes risks and stresses that positive outcomes depend on rigorous budget discipline and an appropriate combination of reforms (labor market, pension and health care systems) and measures to speed up productivity and employment growth.

### Labor supply and pension reform
- Raising labor supply and the employment rate are important policy objectives.
- Staff notes diminished labor supply at the young end due to late graduation from higher education and early departure into retirement at the other end.
- Authorities are implementing measures to speed up graduation from universities.
- Enacted pension reform allows actual retirement to be phased between the ages from 63 until 68.
- It will take years before the effective retirement age would rise from the present age of 59 years to 62 years.
- Before assessing the need for further reforms, it is important to observe the effect of the current changes in the pension system.

---

### 3. Labor market policies

### Wage agreements and tax policies
- Wage negotiations were conducted at the centralized level and agreed at the union level late last year.
- The government finalized its tax package with an elimination of the wealth tax to take effect in 2006.
- The income agreement signed by the Social Partners in November will run from March 1, 2005 until end September 2007.
- On an annual basis:
  - Negotiated wages will rise on average by 2.1 % in 2005 and 1.6 % in 2006.
  - The estimated annual increases on earnings are 3.5 % in 2005 and 2.5 % in 2006.
- By now about 90 percent of employees are covered by the new accord.

### Assessment of bargaining structure and local bargaining
- Staff's assessment leans toward a decentralized wage settlement that would better reflect labor productivity differentials and likely reduce wage compression, a characteristic feature of the Finnish wage structure.
- The relative wage increases at various wage levels are much more even than during the last few years and thus support good employment development better than before.
- While the Employment Contract Act and union-level agreements set rather tight limits to local bargaining, the new agreement includes an understanding on improving the local bargaining system to better meet the needs of both employers and the workforce.
- The local bargaining package is a new feature in Finnish incomes policy settlements but does not necessarily imply a rapid shift from a centralized to a decentralized wage bargaining regime.
- Possibilities for local bargaining vary significantly from branch to branch.
- The present more centralized system has worked well in Finland during the difficult times in the 1990s and until now.
- The long wage accord together with cuts in income taxation will provide a stable and predictable environment to pursue further reforms, as suggested by staff.

### Policies to raise employment
- Raising the employment rate is high on the government’s policy agenda.
- Reducing taxation of labor is a key element:
  - The government will be cutting labor taxes by a total of EUR 1.7 billion in gross terms between 2005 and 2007 with the tax cuts weighted towards the lower end of the income scale.
- In addition to lowering labor taxation, the government has focused on improving active labor market policies.

---

### 4. Long-term challenges

### Structural risks and preparedness
- Major challenges: globalization, aging, and persistently high structural unemployment.
- Relative strengths:
  - Fiscal stimulus has helped support growth during the global slowdown.
  - Inflation is low.
  - External position is comfortable.
  - Public finances are in surplus.
- Finland is relatively well prepared for aging:
  - Pension liabilities have been partly pre-funded.
  - Implementation of a major pension reform has begun.
- Additional preparatory measures include tighter central government expenditure control, reduction of indebtness, and fostering growth potential.

### Productivity, competition, and diversification
- Authorities emphasize the importance of raising productivity in the sheltered sectors of the economy.
- Staff has earlier advised strengthening competition in product markets, promoting flexibility in labor markets, and diversifying the structure of the Finnish economy to create a virtuous circle of higher growth and stronger public finances.

### Long-term sustainability scenarios
- Authorities have produced sustainability scenarios for public finances extending up to 2050 using national population estimates with higher life expectancy estimates than the Eurostat 1999 population estimates, leading to higher estimates of public spending pressures.
- Although long-term projections are uncertain, baseline and alternative scenarios demonstrate the effect structural reforms can have.
- Ministry of Finance calculations indicate:
  - Under the baseline scenario, central and local governments will not be on a sustainable basis without adaptive measures.
  - Changing the assumption regarding productivity of social and healthcare services from assuming no increase in productivity to assuming an annual increase of 0.5 percent leads to a substantial improvement in general government finances with the deficit at no stage exceeding the 3 percent limit.

### International development policy
- Finland, in principle, favors easing access of developing countries' agricultural products to industrial countries' markets and supports efforts to address this issue in multilateral trade negotiations.
- The government will increase funds for development cooperation in accordance with its program so that based on the present estimation of national income growth the ODA will be at the level of about 0.44 % of GNI in

*IMF staff report: "1. Recent economic developments and short-term prospects" (content unit _cr0535).*

### 2007. In the 2005 budget, the ODA share is estimated to account for 0.39 percent of GNI.

### IMF Executive Board Concludes 2004 Article IV Consultation with Finland

### Background
- Finnish economy performed admirably in recent years but faces early and rapid population aging.
- Growth momentum maintained despite receding role of export-intensive high-technology electronics sector, aided by strong fiscal stimulus.
- Unemployment has remained broadly at 9 percent since 2000 and is largely structural.
- Inflation was largely absent in 2004 following sizable excise cuts and an appreciating euro, but is expected to revert closer to the euro area average in 2005.
- Growth averaged 3 percent in 2004-05 (staff expectation).
- Strong productivity gains helped contain unit labor costs and maintain competitiveness.
- Recent centralized wage accord covering 2½ years expected to ensure continued wage moderation; compressed wage structure and labor market mismatches impede employment growth.
- Significant cuts in labor taxation implemented, though labor taxation remains comparatively high.

### Executive Board Assessment — Key Findings
- Directors commended strong productivity gains, stable macroeconomic framework, low inflation, and sizeable fiscal surpluses.
- Employment stagnant and structural unemployment high; Finland faces population aging earlier than any EU country.
- Economy weathered global slowdown relatively well; growth set to remain robust in 2005.
- Tax cuts expected to stimulate employment; business investment set to recover after weakness.
- Risks to growth: high oil prices and further appreciation of the euro, broadly offset by likely faster global recovery and strengthening export prospects.
- Inflation expected to revert to the euro area average as impact of cuts in indirect taxation and one-off factors recedes.
- Financial system viewed as sound and resilient; poised to gain from greater European market integration; growing cross-border activity calls for closer Nordic-Baltic supervisory cooperation.

### Fiscal Position and Long-Term Sustainability
- Fiscal position has rapidly eroded in recent years but expected to remain in surplus over the medium term.
- Decline in the surplus from 7 percent of GDP in 2000 reflects cyclical factors and a sharp discretionary policy shift; structural surplus declined by 3¼ percent of GDP by 2004.
- 2005 budget is expansionary with cuts in corporate and capital taxes and start of a three-year labor income tax cut following the wage agreement.
- General government fiscal balance likely to remain at about 2 percent of GDP as the output gap closes.
- Government’s net asset position equivalent to some 15 percent of GDP at end-2004, expected to increase further.
- Directors stressed that sizeable fiscal adjustment will be required in coming years to ensure long-term fiscal sustainability given imminent demographic pressures.
- Pension reform initiated aiming to raise effective retirement age by 3 years from current level of 59 years; reform is important but insufficient alone to ensure sustainability.
- Directors recommended offsetting planned income tax cuts over 2005–07 by reductions in public spending, preferably through improved efficiency in social and welfare services rather than tax increases.
- Holistic structural reforms required to raise employment, growth, and public finances; absent reforms, general government would have to run sizable surpluses.

### Labor Market and Structural Reform Recommendations
- Call for policy initiatives to raise employment rates, especially at both ends of age spectrum where labor utilization is low.
- Recent reductions in labor taxation will help but may not be sufficient to meet employment targets.
- Directors welcomed intention to reduce employers’ social security contributions for low-income workers and called for tax cuts to be targeted at the lower end of the income scale.
- Recommended a gradual shift to more decentralized wage bargaining to ease wage compression and reduce structural unemployment.
- Recommended improved training for low-skilled and older workers.
- Pension reform should be followed up with measures to close the “unemployment pipeline” allowing unemployed persons over 57 to claim benefits until age 65.
- Early consideration of additional measures and stepped-up public awareness urged due to possible future difficulty in achieving reform consensus.

### Competition, Trade, and Other Structural Issues
- Further strengthening competition in product markets would complement labor market reforms and help diffuse productivity gains from technology sector.
- Progress noted in communications and retail trade, but price level remains significantly above EU average.
- Directors recommended a more proactive stance on foreign direct investment and privatization of public enterprises.
- Reduction in Finland’s farm subsidies, high by EU standards, would raise competition and consumer welfare.

### Official Development Assistance (ODA)
- Directors expressed appreciation for Finland’s strong record of ODA and support for increased market access for developing-country agricultural exports.
- Directors welcomed the 2005 budgeted increase in ODA and the authorities’ intention to continue to increase ODA as a percent of gross national income in the future.
- In the 2005 budget, the ODA share is estimated to account for 0.39 percent of GNI.

### Selected Economic Indicators (as reported)
- Real economy:
  - GDP (change in percent): 2001: 1.1; 2002: 2.3; 2003: 2.0; 2004: 3.1
  - Domestic Demand (change in percent): 2001: 1.7; 2002: 1.3; 2003: 2.1; 2004: 2.4
  - Harmonized CPI (change in percent) 2/: 2001: 2.7; 2002: 2.0; 2003: 1.3; 2004: 0.2
  - Unemployment rate (in percent) 2/: 2001: 9.1; 2002: 9.1; 2003: 9.0; 2004: 8.8
  - Gross national saving (in percent of GDP): 2001: 27.7; 2002: 25.8; 2003: 24.2; 2004: 24.3
  - Gross domestic investment (in percent of GDP): 2001: 20.6; 2002: 19.0; 2003: 18.5; 2004: 18.6
- Public finances (general government, in percent of GDP):
  - Overall balance: 2001: 5.2; 2002: 4.3; 2003: 2.1; 2004: 2.1
  - Primary balance 3/: 2001: 5.9; 2002: 4.5; 2003: 2.4; 2004: 2.1
  - Gross debt (Maastricht definition): 2001: 43.9; 2002: 42.6; 2003: 45.5; 2004: 45.0
- Money and credit (end of year, percentage change):
  - M3 (Finnish contribution to euro area) 4/: 2001: 7.7; 2002: 4.9; 2003: 7.4; 2004: 7.3
  - Total domestic credit 4/: 2001: 6.5; 2002: 9.1; 2003: 11.2; 2004: 11.7
- Interest rates (year average):
  - Three-month money market 5/: 2001: 4.1; 2002: 3.5; 2003: 2.3; 2004: 2.3
  - Ten-year government bonds 5/: 2001: 5.0; 2002: 4.9; 2003: 4.2; 2004: 4.0
- Balance of payments (in percent of GDP):
  - Trade balance: 2001: 10.4; 2002: 9.7; 2003: 9.2; 2004: 9.4
  - Current account: 2001: 7.1; 2002: 6.8; 2003: 5.7; 2004: 5.8
- Fund position (as of end-November, 2004):
  - Fund holding of currency (in percent of quota): 65.99
  - Holdings of SDRs (in percent of allocation): 87.89
  - Quota (in millions of SDRs): 1,263.80
- Exchange rate:
  - Exchange rate regime: Euro
  - Present rate (December 29, 2004): US$ 1.3608 per euro
  - Nominal effective exchange rate (increase in percent) 6/: 2001: 1.9; 2002: 1.3; 2003: 4.4; 2004: 1.7
  - Real effective exchange rate (increase in percent) 7/: 2001: 0.8; 2002: -0.9; 2003: 2.0; 2004: -0.3

*Public Information Notice (PIN) No. 05/14 — February 7, 2005.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr0535.pdf_