## _cr14140

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---

### Smoothing parameter choice and implications
- Purpose: Assess how choice of smoothing parameter (λ) in filtering methods affects estimates of Finland’s potential output and output gap.
- Main conclusion: Estimated potential output growth is low across methods; results are highly sensitive to the choice of smoothing parameter, implying large uncertainty for policy decisions.
- Common λ values and cycle implications:
  - Hodrick and Prescott (1997) recommend λ = 100 for annual data and λ = 1600 for quarterly.
  - Ravn and Uhlig (2002) derive λ = 6.25 for annual data (and 1600 for quarterly consistent with HP).
  - Paper uses λ = 6.25 and 100 for annual data and correspondingly 1600 and 25,199 for quarterly data.
  - λ = 6.25 implies a cycle length of around 9.8 years (lower smoothing).
  - λ = 100 implies a cycle length of approximately 19.8 years (higher smoothing).
- Key implication: Estimates produced by the models are remarkably sensitive to λ; sensitivity affects potential output levels, potential growth, and output gap estimates.

### Methodologies reviewed
- Hodrick-Prescott (HP) Filter (Univariate)
  - Decomposes log growth into trend and cyclical components using penalty λ on trend variability.
  - Annual data; λ = 100 and λ = 6.25 used. GDP projected to 2030 with constant growth after 2019 to alleviate endpoint bias.
- Production Function Approach (PFA)
  - Cobb-Douglas production function: potential output from θ (TFP), smoothed real capital stock, smoothed labor volume, and factor intensity α.
  - Employment smoothed assuming NAIRU-based employment; TFP underlying growth estimated by applying an HP filter to the Solow residual. Two calibrations for λ: 100 and 6.25. Inputs projected to 2030.
- Multivariate Filter (MV) — Kalman State Space
  - Augmented HP in state-space adding covariates (GDP, real Nokia stock price, real short-term interest rate, real bank external assets, capacity utilization). Time series demeaned and differenced. AR(1) parameter ρ estimated from HP output gap, then substituted and estimated by MLE.
- Augmented Phillips Curve (APC) Approach
  - System linking core inflation to output gap, unemployment to output gap (Okun’s law), and manufacturing capacity utilization to output gap. Quarterly data through 2013Q3. Estimated by Bayesian Regularized Maximum Likelihood with priors. Based on 1990–2013, steady state growth estimated at about 1.7 percent.

### Estimates of potential output and sensitivity (selected figures preserved exactly)
- Point estimates of potential growth (2013 and 2009–13 average):
  - HP filter: potential growth in 2013 around 0.4 percent.
  - Production function approach: potential growth in 2013 around 0.5 percent.
  - Multivariate approach: potential output growth in 2013 at -0.4 percent.
  - All approaches: average potential output growth about 0.3–0.4 percent over 2009–13.
  - APC approach: suggests potential GDP grew by about 0.4 percent over 2009–13 and in 2013.
- Sensitivity to λ (selected illustrations):
  - HP filter:
    - Under low smoothing (λ = 6.25), potential growth changes from 0.2 to 1.9 (percentage points) over a given period.
    - Under high smoothing (λ = 100), potential growth increases from 0.6 to 0.9 (percentage points).
    - Output gap: currently negative; expected to close under both scenarios in the medium term (2017-18).
  - Production function approach:
    - Under low smoothing (λ = 6.25), potential growth falls into negative territory from 2009–2013.
    - Under high smoothing (λ = 100), potential growth remains positive though slowing over the same period.
    - Output gap closure: low smoothing closes in 2014; high smoothing closes in 2016.
  - Multivariate approach:
    - Identifies much pre-Great Recession ICT-sector growth as transitory, producing a low 2013 potential growth estimate.
    - Model sensitivity: in the period 2007-2009 varies by almost 2.5 percentage points depending on smoothing.

### Implications for policy and analysis (uncertainty and recommendations)
- Robustness and uncertainty:
  - The assumed smoothness of potential output is a key determinant of estimated potential growth, output gaps, structural balance, and fiscal impulse estimates.
  - High variability around estimates implies policies that rely on a single potential estimate should proceed with appropriate discretion.
- Structural reform emphasis:
  - Given consistently low potential growth estimates (around 0.3–0.5 percent in many specifications, and negative in some MV estimates), analysis supports structural reforms to boost TFP and address persistent weakness in GDP recovery.

### Structural drivers of weak growth and productivity (diagnosis)
- Main factors holding back growth:
  - Declining Total Factor Productivity (TFP) growth.
  - High Unit Labor Costs (ULC) growth — driven by high wage growth and declining labor productivity.
  - Loss of export market share, notably in electronics associated with Nokia's fading fortunes and a global shift from paper to electronic media.
  - Weak fixed investment as corporations postpone projects amid a dim growth outlook.
  - Low labor market participation, population aging, weak competitive environment in services, and fragmentation in local public service provision.
- Labor market features relevant for adjustment:
  - Strong collective bargaining system needing sufficient firm-level wage flexibility in sectors facing structural change.
  - Relatively high Unemployment Insurance (UI) replacement rates that "are likely to reduce the incentives for unemployed workers to search for and accept jobs."
  - A relatively high share of workers on temporary contracts, creating duality and reducing incentives to invest in temporary employees' human capital.
  - Low participation rates for older workers: employment rate for those aged 60-64 is "about 40 percent"; only "about 12 percent of the population aged 65-69 is working, compared to the OECD average of about 23 percent (numbers as of 2011)."

### Recent wage and labor cost dynamics (selected exact figures)
- Unemployment has "remained elevated at around 8 percent since 2009."
- Contractual wage and index projections/levels:
  - "Contractual wages will rise by 0.7 percent in 2014 and 0.5 percent in 2015, compared to 1.4 percent in 2013."
  - "The index of wage and salary earning will rise by 1.3 percent in 2014 and 1.2 percent in 2015, compared to 2 percent in 2013."
- Historical productivity:
  - Between 1991 and 2008, Finland "closed the gap to the best performing OECD countries" driven by strong TFP and a shift in investment toward R&D tied to ICT and Nokia.

### R&D, innovation, and sectoral adjustment
- R&D and innovation performance:
  - Aggregate R&D spending of about 4 percent of GDP in 2010.
  - Measurable innovation performance in line with peers despite high R&D intensity; indicators of weakening innovation include declining production/process innovation, contracting patent grants since 2008, and SME innovation declines (about 5 percent fewer innovating in-house from 2012 to 2013; about 8 percent fewer innovating in collaboration).
  - Nokia’s market share in the global mobile handset market fell from 36 to 17 percent between the third quarters of 2010 and 2011 (Gartner, 2011).
- Sectoral productivity issues:
  - Retail: regulatory barriers among the highest in the EU; restrictive legislation on opening hours; market concentration remains high.
  - Public services: efficiency deteriorated since 2000; fragmentation of municipalities limits economies of scale and hiring of qualified staff.
  - Network industries: productivity low in electricity, gas, water distribution, and transport, storage and communication; further opening to private provision and competition could yield gains.
- Adjustment scale:
  - Nokia's peak contribution: nearly 4 percent of Finnish GDP.
  - ICT sector employed roughly 2.3 percent of the labor force in 2010.
  - Sale of Nokia’s mobile business could affect 4,700 ex-Nokia employees in Finland, about 0.2 percent of the labor force.

### Labor market matching, ALMPs, and skills
- Business environment and financing:
  - World Bank Doing Business: Finland ranked 12th out of 189 economies in 2014.
  - World Economic Forum Global Competitiveness Index: Finland ranked 3rd.
  - Lower rankings in adjustment-relevant areas: Doing Business ranks Finland 55th on starting a business and 42nd on getting credit.
- ALMPs and activation timing:
  - Referral to an active labor market program in Finland takes place after 100 weeks.
  - Mandatory referral occurs after 60 weeks in Sweden and 40 weeks in Denmark (OECD, 2010b).
  - Authorities took steps in 2010 toward earlier activation (removing age limit on compulsory activation, individualized work plans, guarantees for young workers after three months).
- Skills and education:
  - About 87 percent of the population has completed education that exceeds upper secondary level.
  - Only about 45 percent of students complete their degrees in the targeted time (OECD, 2012).
  - Historical redeployment: share of Nokia leavers joining start-ups fell from about 64 percent (1989–1994) to about 15 percent (2008–2010); close to 48 percent of Nokia leavers joined firms >11 years old in 2008–2010.

### Policy recommendations (prioritized actions)
- Strengthen labor market performance:
  - Ensure wage growth in line with productivity; provide sufficient firm-level wage flexibility.
  - Increase labor market participation via improved monitoring, earlier phase-out of UI benefits and/or reduction in replacement rates, effectiveness-tested ALMPs, and measures to improve participation of older workers (e.g., further pension reform).
- Improve TFP growth and productivity:
  - Adjust R&D policies to the post-Nokia era; consider shifting to tax incentives from large-scale direct support.
  - Regulatory reform to facilitate start-ups; service sector reforms—especially retail.
  - Municipality reforms to enable economies of scale in healthcare and other services.
- Facilitate adjustment:
  - Measures to facilitate job change, improve search incentives and training.
  - Shorten duration of higher education to allow quicker labor supply adjustment.
  - Ensure employment protection does not impede adjustment.
- Fiscal and revenue measures:
  - Focus fiscal adjustment mostly on expenditures given high tax levels, but make tax structure more growth friendly.
  - VAT: Eliminating half of the “policy gap” could generate up to 2.4 percent of GDP in additional revenue (offsetting regressive effects would reduce net budget impact).
  - Property tax: Raising property tax revenue-to-GDP ratio to the OECD average could generate about 1 percent of GDP.
  - Public financial assets: stock nearly 100 percent of GDP; portfolio more conservative—reallocation to higher-return assets could increase investment income.

### Government reform program and fiscal sustainability (figures preserved)
- Government “Decision on Implementing the Structural Policy Program” (November 2013) includes labor market, service and product market, and municipalities reform measures; some elements await specification.
- Government estimates a fiscal sustainability gap of 4.7 percent of GDP with possible impacts by reform area:
  - Management of local govt. finances: Possible Sustainability Gap Impact -1.0 percentage points — Preliminary Staff View: Feasible if further measures taken beyond 2017.
  - Productivity of public services: Possible Sustainability Gap Impact -1.4 percentage points — Preliminary Staff View: More details needed.
  - Working careers and labor supply: Possible Sustainability Gap Impact -1.4 percentage points — Preliminary Staff View: More details needed, depends largely on pension reforms TBD in 2015.
  - Structural unemployment: Possible Sustainability Gap Impact -0.3 percentage points — Preliminary Staff View: More details needed.
  - Output potential of the economy: Possible Sustainability Gap Impact -0.6 percentage points — Preliminary Staff View: Feasible if reforms are implemented expeditiously & followed by more reforms.
  - Total: -4.7 percentage points — Preliminary Staff View: Current plans are vague on many measures and leave many details TBD.
- IMF simulation results suggest vigorous implementation of reforms, starting with those in the current government program and going further, could feasibly close the sustainability gap through direct fiscal savings and indirectly through higher medium-term growth relative to the baseline.

### Fiscal consolidation trade-offs and simulations
- Short-run guidance:
  - Avoid enacting additional fiscal adjustment measures that could undermine the modest recovery forecast for 2014.
  - Adopt a credible medium-term adjustment plan that ramps up adjustment only after growth is firmly entrenched.
- Simulation setup and scenarios:
  - By 2019 there is a cumulative structural reduction in primary expenditures of 1.25 percent of GDP relative to the baseline.
  - Two adjustment paths:
    - Frontloaded: 0.4 percent of GDP in 2015, then 0.3, 0.25, 0.2, and 0.1 percent of GDP in 2016–2019.
    - Phased-in: 0.2, 0.2, 0.25, 0.3, 0.3 percent of GDP in 2015–2019.
- Fiscal multiplier assumptions:
  - Empirical estimates generally between 0.5 and 0.7 (OECD, 2010a; Barrell and others, 2012).
  - Central multiplier (M) values used:
    - High multiplier scenario: M = 1
    - Medium multiplier scenario: M = 0.75
    - Low multiplier scenario: M = 0.5
  - Multipliers vary with the output gap (OG):
    - If OG < -2: use M + 0.25
    - If -2 < OG < -1: use M
    - If OG > -1: use M - 0.25
- Key simulation results:
  - Both frontloaded and phased-in adjustments can cause the debt-to-GDP ratio to temporarily rise relative to the baseline because growth slows while initial balance improvements take time to affect nominal debt.
  - Frontloaded path achieves primary surplus more quickly and results in larger cumulative surpluses; public debt falls more under frontloaded scenarios than phased-in ones, but the difference is less than 1 percentage point of GDP by 2019 for a given multiplier.
  - Output impact: frontloaded adjustment has a more deleterious impact on output; phased-in path results in smaller cumulative output losses.
- Hysteresis and role of reforms:
  - Fiscal consolidation during prolonged downturns can have persistent negative effects on potential growth through labor market hysteresis (Dell’Erba, Koloskova, and Poplawski-Ribeiro (2014)).
  - Structural reforms can offset persistent negative effects and boost growth potential over the medium term.

### Structural reform indicator, calibration, and simulated impacts
- Indicator construction and calibration:
  - Structural indices follow Anderson and others (2013a) but assume slower pace for Finland: over 13 years the overall structural index closes about 44 percent of the gap (instead of 50 percent for core EA).
  - Reforms assumed: pension reforms effective in 2017; modest initial pace for ALMPs, ARR, and EPL changes, increasing through the forecast horizon and constant from 2019 onward.
  - Structural indicators: OECD’s ALMP measure; ARR; EPL index; public childcare spending; implicit tax on continued work at older ages.
- Simulation outcomes:
  - Benchmark structural reform scenario: output about 2½ percent higher by end-2019.
  - Accelerated reform scenario: output 3.2 percent higher than baseline by 2019.
  - High and low impact scenarios: output deviation range from baseline at end-2019 between 1.1 and 3.3 percent.
  - Reforms’ impact depends on demand environment: strong global demand increases short-term utilization and output gains.
- Interaction with fiscal adjustment:
  - Combining phased-in consolidation, medium-sized multipliers, and benchmark structural reforms yields output levels more than 1 percent higher than the baseline.
  - Fiscal adjustment with no reforms yields output more than 1 percent lower than baseline.
  - Point estimate uncertainty around these simulations is sizable.

### Revenue and expenditure policy levers (exact figures)
- Revenue-side:
  - After a one percentage point increase of the standard VAT rate to 24 percent in early 2013, VAT revenue-to-GDP ratio is more than 9 percent (top quintile of OECD countries).
  - Total property tax revenue is only 1.1 percent of GDP, less than 60 percent of the OECD average.
  - VAT policy gap: eliminating half could generate up to 2.4 percent of GDP in additional revenue.
  - Combined capital of growth funding programs may increase to around EUR 1 billion (or about 0.5 percent of GDP) according to the 2014 Spring Budget Review.
  - Public financial assets: stock nearly 100 percent of GDP.
- Expenditure-side:
  - Public sector productivity declined more than 10 percent over the past decade.
  - Projected local government savings by 2017: around €1.3 billion (0.6 percent of GDP).
  - Healthcare savings roughly €180 million (0.1 percent of GDP) by 2017.
  - Long-term care tightening projected to save €300 million (0.14 percent of GDP) by 2017; LTC spending projected to rise by 1.4 percent of GDP by 2030 (EC, 2012).
  - Social services savings projected: €125 million (0.05 percent of GDP).
  - Education reforms expected to save nearly €300 million (0.14 percent of GDP) by 2017—€195 million from provider network/funding reforms and €65 million from funding only attainment of qualifications.
- Pensions and labor-force participation:
  - Pension costs expected to rise by 3.5 percent of GDP by 2030.
  - Government aims to raise average effective retirement age from 60 years old to above 62 years old by 2025 via reforms effective in 2017.
  - Share of population aged 15-64 receiving disability benefits is nearly 9 percent (OCED, 2010a).

### Key statistics and stylized facts (preserved exactly)
- TFP contribution share: 81.9 percent (average annual growth, 1985-2010).
- Decline in reported innovation activity relative to 2006: about 5 percentage points (manufacturing and services).
- Nokia’s share of Finnish patent applications in 2011: 27 percent.
- Age-related spending: 20.6 percent of GDP in 2010; 26.2 percent of GDP in 2030.
- Sustainability gap: roughly 4.7 percent of GDP.
- Impact of delay: Delaying adjustment start by 10 years would raise the size of the total adjustment needed by about ½ percentage point of GDP.
- Employment and sectoral contributions:
  - ICT sector employed roughly 2.3 percent of the Finnish labor force in 2010.
  - Potential effect of Nokia mobile business sale: potentially affect 4,700 ex-Nokia employees in Finland, about 0.2 percent of the labor force.

*Source: IMF staff text (chapter excerpts provided in content unit _cr14140).*

### 1. Smoothing Parameter Choice and Implication __________________________________________ 6

### 1. Smoothing Parameter Choice and Implication

### Overview
- Purpose: Assess how choice of smoothing parameter (λ) in filtering methods affects estimates of Finland’s potential output and output gap.
- Key conclusion: Estimated potential output growth is low across methods; results are highly sensitive to the choice of smoothing parameter, implying large uncertainty for policy decisions.

### Methodologies Reviewed
- Hodrick-Prescott (HP) Filter (Univariate)
  - Principle: Decomposes log growth into trend and cyclical components using penalty λ on trend variability.
  - Application: Annual data; two λ values used: λ = 100 (Hodrick and Prescott, 1997) and λ = 6.25 (Ravn and Uhlig, 2002). GDP projected to 2030 with constant growth after 2019 to alleviate endpoint bias.

- Production Function Approach (PFA)
  - Principle: Cobb-Douglas production function with potential output determined by θ (TFP), smoothed real capital stock, smoothed labor volume, and factor intensity α.
  - Application: Annual data; employment smoothed assuming NAIRU-based employment, net capital stock, and TFP. Underlying TFP growth estimated by applying an HP filter to the Solow residual. Two calibrations for λ used: 100 and 6.25. Inputs projected to 2030.

- Multivariate Filter (MV) — Kalman State Space
  - Principle: Augmented HP in state-space adding covariates to help identify transitory part of GDP; follows Borio and others (2012) framework but estimated by MLE.
  - Application: Inputs include GDP in constant prices, real Nokia stock price, real short-term interest rate, real bank external assets, and capacity utilization. Time series demeaned and differenced. AR(1) parameter ρ estimated from HP output gap, then substituted and estimated by MLE.

- Augmented Phillips Curve (APC) Approach (Box 2)
  - Principle: Follows Benes and others (2010); system of equations linking core inflation to output gap, unemployment to output gap (Okun’s law), and manufacturing capacity utilization to output gap.
  - Application: Quarterly data through 2013Q3; inputs: GDP, CPI, core CPI, unemployment, capacity utilization, long-term inflation expectations (German 10-year Consensus Forecasts used). Estimated by Bayesian Regularized Maximum Likelihood with priors. Based on 1990–2013, steady state growth estimated at about 1.7 percent.

### Box 1 — Smoothing Parameter Choice and Implication (key points)
- Common λ values:
  - Hodrick and Prescott (1997) recommend λ = 100 for annual data and λ = 1600 for quarterly.
  - Ravn and Uhlig (2002) derive λ = 6.25 for annual data (and 1600 for quarterly consistent with HP).
  - Paper uses λ = 6.25 and 100 for annual data and correspondingly 1600 and 25,199 for quarterly data.
- Cycle length implications:
  - λ = 6.25 implies a cycle length of around 9.8 years (lower smoothing).
  - λ = 100 implies a cycle length of approximately 19.8 years (higher smoothing).
- Main message: Estimates produced by the models are remarkably sensitive to λ; this affects potential output levels, potential growth, and output gap estimates.

### Results (estimates and sensitivities)
- Point estimates of potential growth (2013 and 2009–13 average):
  - HP filter: potential growth in 2013 around 0.4 percent.
  - Production function approach: potential growth in 2013 around 0.5 percent.
  - Multivariate approach: potential output growth in 2013 at -0.4 percent.
  - All approaches: average potential output growth about 0.3–0.4 percent over 2009–13.
  - APC approach: point estimates broadly comparable, suggesting potential GDP grew by about 0.4 percent over 2009–13 and in 2013.

- Sensitivity to smoothness (selected illustrations from text):
  - HP filter:
    - Under low smoothing (λ = 6.25), potential growth changes from 0.2 to 1.9 (percentage points) over a given period.
    - Under high smoothing (λ = 100), potential growth increases from 0.6 to 0.9 (percentage points).
    - Output gap: currently negative; expected to close under both scenarios in the medium term (2017-18).
  - Production function approach:
    - Under low smoothing (λ = 6.25), potential growth falls into negative territory from 2009–2013.
    - Under high smoothing (λ = 100), potential growth remains positive though slowing over the same period.
    - Output gap closure: low smoothing closes in 2014; high smoothing closes in 2016.
  - Multivariate approach:
    - Identifies much pre-Great Recession ICT-sector growth as transitory, producing a low 2013 potential growth estimate.
    - Model sensitivity: in the period 2007-2009 varies by almost 2.5 percentage points depending on smoothing.

### Implications for Policy and Analysis
- Robustness and uncertainty:
  - The assumed smoothness of potential output is a key determinant of estimated potential growth, output gaps, and thus structural balance and fiscal impulse estimates.
  - High variability around estimates implies policies that rely on a single potential estimate should proceed with appropriate discretion.
- Structural reform emphasis:
  - Given consistently low potential growth estimates (around 0.3–0.5 percent in many specifications, and negative in some MV estimates), the analysis supports the need for structural reforms to boost TFP and address persistent weakness in GDP recovery.

*Source: IMF staff text, April 30, 2014.*

### 11.      Estimates of potential output for Finland are an important part of the toolkit for

### _cr14140 - 11.      Estimates of potential output for Finland are an important part of the toolkit for

### Uncertainty in potential output estimation
- Different methodologies and assumptions (HP, PFA, multivariate, multivariate APC) yield materially different potential output and output gap estimates.
- Under the HP, PFA, and multivariate approaches, the choice of smoothing "can just as reasonably produce a negative growth rate as well as a positive one."
- Output gap estimates, which are critical for fiscal policy, "should also be carefully considered."

### Evidence that potential output growth is low
- Historical and recent comparisons:
  - From 1997-2007, potential growth averages 3.2 percent per year (independent of the choice of smoothing).
  - In 2013, that average has dropped to 0.2 (several models produce negative growth).
- Interpretation:
  - The lack of a recovery in Finland is "largely structural in nature."
  - Any indication that the output gap is closing is "due to falling potential rather than a pickup in growth."

### Structural drivers of weak growth and productivity
- Key factors holding back growth:
  - Declining Total Factor Productivity (TFP) growth.
  - High Unit Labor Costs (ULC) growth — driven by high wage growth and declining labor productivity.
  - Loss of export market share, notably in electronics associated with Nokia's fading fortunes and a global shift from paper to electronic media.
  - Weak fixed investment as corporations postpone projects amid a dim growth outlook.
  - Low labor market participation, population aging, weak competitive environment in services, and fragmentation in local public service provision.
- Labor market features relevant for adjustment:
  - Strong collective bargaining system that historically aligned wages with productivity but needs sufficient firm-level wage flexibility in sectors facing structural change.
  - Relatively high Unemployment Insurance (UI) replacement rates that "are likely to reduce the incentives for unemployed workers to search for and accept jobs."
  - A relatively high share of workers on temporary contracts, which provides flexibility but may create duality and reduce firm incentives to invest in temporary employees' human capital.
  - Low participation rates for older workers: employment rate for those aged 60-64 is "about 40 percent"; only "about 12 percent of the population aged 65-69 is working, compared to the OECD average of about 23 percent (numbers as of 2011)."

### Recent wage and labor cost dynamics (selected figures preserved exactly)
- Unemployment has "remained elevated at around 8 percent since 2009."
- Contractual wage and index projections/levels cited:
  - "Contractual wages will rise by 0.7 percent in 2014 and 0.5 percent in 2015, compared to 1.4 percent in 2013."
  - "The index of wage and salary earning will rise by 1.3 percent in 2014 and 1.2 percent in 2015, compared to 2 percent in 2013."
- Historical productivity and contributions:
  - Between 1991 and 2008, Finland "closed the gap to the best performing OECD countries" driven by strong TFP and a shift in investment toward R&D, tied to the ICT sector and Nokia.
  - Recent years: the Great Recession and declining ICT/Nokia importance "has significantly damped productivity growth."

### Policy implications and recommendations
- Priority: structural reforms to enhance Finland's long-term capacity and reverse falling potential.
- Targeted areas for reforms:
  - TFP-enhancing measures to support recovery despite implementation lags.
  - Adjust policies to encourage R&D and innovation "to the post-Nokia era."
  - Increase innovation and growth in smaller firms outside the existing ICT cluster.
  - Improve the provision and efficiency of public services, particularly at the municipality level.
  - Continue deregulation of the retail sector and strengthen labor market efficiency.
  - Ensure wages develop in line with labor productivity and provide sufficient firm-level wage flexibility in structurally affected sectors.
  - Review UI replacement rates and activation/monitoring to strengthen job search incentives.

### Methodological notes illustrated in the chapter (figures emphasized)
- Figures presented illustrate:
  - HP Filter approach with alternative smoothing (lambda=100 and lambda=6.25) for potential GDP, potential growth, and output gap.
  - Production Function Approach (PFA) with Augmented Phillips Curve NAIRU smoothed (lambda=100 and lambda=6.25) for potential GDP, potential GDP growth, employment at NAIRU, contributions of capital and TFP, and input growth.
  - Multivariate Filter Approach including a "Full Model (Nokia stock price, 3m money market rate, capacity utilization, external bank assets)" with lambda=1600 and lambda=25199 for potential GDP, potential growth, and output gap.
  - Multivariate Augmented Phillips Curve (APC) Approach with an APC estimated potential (SS=1) series for potential GDP, potential GDP growth, and the APC output gap.

_Italic: Prepared by Borislava Mircheva (content unit as supplied)._

### 10.      While R&D spending remains high, it may not be as effective as it could be. Finland

### 10.      While R&D spending remains high, it may not be as effective as it could be. Finland

### R&D spending and innovation performance
- Aggregate R&D spending of about 4 percent of GDP in 2010.
- Private and public R&D intensity remains relatively high compared to other OECD economies.
- Measurable innovation performance remains in line with peers despite high R&D intensity.
- Indicators of weakening innovation activity:
  - Production and process innovation activity has declined.
  - Number of patents granted to Finnish firms has been contracting since 2008.
  - Nokia’s market share in the global mobile handset market fell from 36 to 17 percent between the third quarters of 2010 and 2011 (Gartner, 2011).
  - The number of SMEs innovating in-house shrunk by about 5 percent from 2012 to 2013.
  - The number of SMEs innovating in collaboration with others shrunk by about 8 percent from 2012 to 2013.
- Possible causes of declining patent activity and weaker innovation:
  - Diminishing role of Finland’s ICT industry in recent years.
  - Lack of innovation and entrepreneurship outside the core ICT cluster and among SMEs.

### Productivity in the service and network sectors
- Retail sector:
  - Regulatory barriers remain among the highest in the EU, including zoning and planning restrictions that limit store size and expansion.
  - Passing of the 2011 Competition Act tightens merger control and is expected to lower market concentration, but market concentration remains high and likely curtails activity and contributes to higher prices.
  - Restrictive legislation on opening hours holds back retail productivity.
- Public services:
  - Efficiency of public services has deteriorated since 2000.
  - Fragmentation of municipalities and municipal services is a key factor; many municipalities are small and serve sparsely populated areas, preventing economies of scale and limiting ability to hire qualified staff.
  - Problem is particularly difficult in public healthcare, especially given an aging population and pressures to ensure equal, high-quality access to health and long-term care.
- Network industries:
  - Productivity remains low in sectors where the government is a dominant player: electricity, gas, and water distribution, and transport, storage and communication.
  - Further opening these sectors to private provision and competition could lead to significant productivity gains.

### Adjustment: labor reallocation and business environment
- Scale of ICT contraction and adjustment needs:
  - At the peak of the ICT boom, Nokia’s business accounted for nearly 4 percent of Finnish GDP.
  - ICT sector employed roughly 2.3 percent of the Finnish labor force in 2010.
  - The sale of Nokia’s mobile telecommunications business to Microsoft (to conclude in 2014) could potentially affect 4,700 ex-Nokia employees in Finland, or about 0.2 percent of the labor force.
  - Decline of the wood and pulp industry driven by contraction in global demand for paper presents additional structural challenges.
- Business environment indicators and impediments:
  - World Bank’s Doing Business Indicators ranks Finland 12th out of 189 economies in 2014.
  - World Economic Forum’s Global Competitiveness Index ranks Finland 3rd in overall competitiveness.
  - Lower rankings in adjustment-relevant areas:
    - Doing Business ranks Finland 55th on starting a business.
    - Doing Business ranks Finland 42nd on getting credit.
  - Access to financing and insufficient capacity to innovate are among the top most problematic factors for doing business in GCI survey responses.
- Labor market flexibility and matching:
  - No indications of decreasing matching efficiency; vacancy-unemployment movements largely along the Beveridge curve with no further structural shifts during the recent crisis episode.
  - Finland is farther from “flexicurity” than some peers (e.g., Ireland).
  - Unemployment insurance replacement rates are high and benefits are paid for relatively long periods: 550 days.
  - High levels of employment protection legislation (EPL) tend to slow structural adjustment.
- Active labor market policies (ALMP) and activation timing:
  - Referral to an active labor market program in Finland takes place after 100 weeks.
  - Mandatory referral occurs after 60 weeks in Sweden and 40 weeks in Denmark (OECD, 2010b).
  - Authorities took steps in 2010 toward earlier activation: removing age limit on compulsory activation requirement, demanding individualized work plans, and guaranteeing work or training for young workers after an unemployment spell of three months.
  - Evidence suggests training and matching programs are generally more effective than other ALMP measures, and continued monitoring of ALMP effectiveness is crucial.

### Skills, education, and labor supply
- Workforce skills and qualification matching:
  - About 87 percent of the population has completed education that exceeds upper secondary level.
  - Survey results point to a small shortage of low-skilled laborers and a small oversupply of laborers with upper-secondary qualification; jobs and skills requiring more than upper secondary education look on par.
- Education system performance and issues:
  - Finnish secondary school students score high and above the OECD average, but results have been deteriorating in recent years across reading, mathematics, and science.
  - Universities rank higher than the OECD along most dimensions, but lag behind Nordic neighbors and European top performers.
  - Relatively long time to enter the labor force linked to cumbersome entrance procedures and requirements.
  - Only about 45 percent of students complete their degrees in the targeted time (OECD, 2012).
- Potential for redeploying ICT-skilled labor:
  - Historically, many startups were founded by ex-Nokia staff.
  - Between 1989 and 1994, about two-thirds of employees leaving Nokia joined a start-up (firm less than two years old).
  - Between 2008 and 2010, this share dropped to about 15 percent; about half of ex-Nokia employees were moving to more established firms (11 years old or more), suggesting a slowdown in start-up formation by ex-Nokia staff.

### Conclusion: growth potential and policy priorities
- Finland can grow faster than the current outlook indicates. Scope for action exists in several areas:
  - Strengthening labor market performance:
    - Wage growth in line with productivity to help exports regain competitiveness.
    - Increase labor market participation via improved monitoring of search and training requirements, earlier phase-out of UI benefits and/or reduction in replacement rates, effectiveness-tested ALMP, and measures to improve participation of older workers (e.g., further pension reform).
  - Improving TFP growth and productivity:
    - Adjust R&D policies to the post-Nokia era, where innovation and growth might be found in smaller firms outside the existing ICT cluster (possible consideration: strengthen tax incentives at the expense of R&D subsidies).
    - Regulatory reform to facilitate start-ups; service sector reforms—especially retail—would improve competitiveness and productivity.
    - Reverse negative productivity trend in the public sector via municipality reforms to enable economies of scale in healthcare and other services.
  - Facilitating adjustment:
    - Measures to facilitate job change, improve search incentives and training.
    - Shorten duration of higher education to allow quicker labor supply adjustment to changing sectoral demand.
    - Ensure employment protection does not impede adjustment, including in the context of local government reform.

### Government reform program and fiscal sustainability
- Government “Decision on Implementing the Structural Policy Program” from November 2013 includes labor market, service and product market, and municipalities reform measures; some elements await specification.
- Government estimates a fiscal sustainability gap of 4.7 percent of GDP and provides possible impacts by reform area (government nomenclature):
  - Management of local govt. finances: Possible Sustainability Gap Impact -1.0 percentage points — Preliminary Staff View: Feasible if further measures taken beyond 2017.
  - Productivity of public services: Possible Sustainability Gap Impact -1.4 percentage points — Preliminary Staff View: More details needed.
  - Working careers and labor supply: Possible Sustainability Gap Impact -1.4 percentage points — Preliminary Staff View: More details needed, depends largely on pension reforms TBD in 2015.
  - Structural unemployment: Possible Sustainability Gap Impact -0.3 percentage points — Preliminary Staff View: More details needed.
  - Output potential of the economy: Possible Sustainability Gap Impact -0.6 percentage points — Preliminary Staff View: Feasible if reforms are implemented expeditiously & followed by more reforms.
  - Total: -4.7 percentage points — Preliminary Staff View: Current plans are vague on many measures and leave many details TBD.
- IMF simulation results in Chapter IV suggest vigorous implementation of reforms, starting with those in the current government program and going further over time, could feasibly close the sustainability gap through direct fiscal savings and indirectly through higher medium-term growth relative to the baseline.

*Source: IMF staff assessment as presented in the provided chapter text.*

### References

### References

### Key findings on innovation and growth (Stylized facts)
- Total Factor Productivity (TFP) has been a prime driver of Finnish growth historically but has contracted recently.
- The share of TFP relative to average annual growth over the period 1985-2010 was 81.9 percent (highest in OECD).
- Low or negative TFP growth since the financial crisis coincided with a slowdown in innovation and patenting activity.
- TFP contraction in 2011-2012 occurred in several key industries: manufacturing, construction, information and communication, and real estate.
- Over the period 1977-2007, Finland experienced a negative contribution of TFP to value added growth only twice; recent negative contributions are unusual.

### Innovation activity and patenting
- Reported innovation activity declined since 2008 across industries (manufacturing and services) and across firm sizes.
  - Relative to 2006, reported innovation activity fell in both manufacturing and services firms by about 5 percentage points.
  - Small and medium sized firms were relatively more affected.
- Patent grants to Finnish innovators have been contracting since 2007, deviating from the European Union trend.
- Finland’s growth in patent grants at the U.S. Patent and Trademark Office (USPTO) tracked or outpaced the EU average since 2000, but since 2007 Finnish patent grants contracted faster than the EU average.
- Nokia’s importance:
  - In 2011 Nokia made 27 percent of Finnish patent applications.
  - The decline in Nokia’s global handset market share and the sell-off of its devices and services business to Microsoft may have contributed to the decline in Finnish patenting activity, though the relationship is not particularly strong.
- Recent patent data:
  - Enterprise patenting activity remains subdued.
  - Patenting activity has become less concentrated (ratio of patents granted to Finnish enterprises by USPTO divided by number of enterprises receiving patents has fallen), indicating less concentration in the hands of fewer enterprises.

### Outlook and implications for innovation policy
- The decline of a large R&D-intensive “anchor tenant” (Nokia) may reduce regional innovation externalities; Nokia served as an anchor tenant over the last two decades.
- With Nokia playing a less important future role, innovation activity is likely to come from younger and smaller firms.
  - Academic literature suggests larger firms often produce incremental innovations, while smaller and younger firms can be sources of disruptive innovation.
- Labor mobility evidence:
  - Using FLEED, Pajarinen and Rouvinen (2013) find about 15 percent of employees leaving Nokia joined a firm less than 2 years old (conditional on remaining in private sector employment) for 2008-2010, compared with close to 64 percent between 1989-1994.
  - In 2008-2010, close to 48 percent of employees leaving Nokia joined a firm greater than 11 years old.
  - These patterns suggest limited immediate startup formation from Nokia outflows; a reversal of trend since 2010 is possible but requires newer data to confirm.

### Policy recommendations and proposed measures
- A comprehensive set of policies is likely required to reverse TFP and innovation declines, for example:
  - Make more effective use of R&D tax credits.
  - Better align research grants with performance.
  - Improve the design of pre-seed and seed stage policy schemes.
- Government programs supporting early-stage technology companies:
  - The 2014 Spring Budget Review states combined capital of growth funding programs (government support plus private funding) may increase to around EUR 1 billion (or about 0.5 percent of GDP).
  - Streamlining these programs may prove fruitful given absence of strong startup and patenting activity.
- Opportunity to reduce reliance on the ICT sector and stimulate innovation in other sectors.
- Emphasis on refining both design and effective implementation of innovation policy programs.

### Fiscal policy context: promoting growth and ensuring sustainability
- Finland faces fiscal pressure from slowing trend growth and a rapidly aging population.
- Age-related spending projections and sustainability gap:
  - Age-related spending (healthcare and pensions) set to rise from 20.6 percent of GDP in 2010 to 26.2 percent in 2030 (EC, 2012).
  - A sustainability gap is estimated at roughly 4.7 percent of GDP; the government needs to implement a structural fiscal adjustment worth 4.7 percent of GDP over a 10-year period to maintain long-run public debt sustainability.
  - Delaying adjustment start by 10 years would raise the total adjustment needed by about ½ percentage point of GDP.
- Simulations suggest structural reforms could offset fiscal adjustment’s drag on growth, especially product market reforms; pension reforms would also be beneficial for fiscal sustainability and growth.
- Recent spending trends:
  - Rise in general government spending from 2007-2014 driven mainly by local government and social security spending (chart data referenced).

### Key statistics and indices (preserved exactly as in source)
- TFP contribution share: 81.9 percent (average annual growth, 1985-2010).
- Decline in reported innovation activity relative to 2006: about 5 percentage points (manufacturing and services).
- Nokia’s share of Finnish patent applications in 2011: 27 percent.
- Combined capital for growth funding programs may increase to around EUR 1 billion (or about 0.5 percent of GDP).
- Age-related spending: 20.6 percent of GDP in 2010; 26.2 percent of GDP in 2030.
- Sustainability gap: roughly 4.7 percent of GDP.
- Impact of delay: Delaying adjustment start by 10 years would raise the size of the total adjustment needed by about ½ percentage point of GDP.
- Share of Nokia leavers joining firms <2 years old (1989-1994; 1995-2000; 2001-2007; 2008-2010): referenced chart intervals; specific values preserved in narrative where given (about 15 percent for 2008-2010; close to 64 percent for 1989-1994; close to 48 percent joining firms >11 years old for 2008-2010).
- ICT value added share charts referenced for 1995 and 2008 comparisons (country list and chart present in source).

### References list (selected items as in source)
- Aghion, Philippe, and Peter Howitt, 2006, “Appropriate Growth Policy: A Unifying Framework,” Journal of the European Economic Association, Vol. 4, 269–314.
- Agrawal, Ajay, and Iain Cockburn, 2003, "The anchor tenant hypothesis: exploring the role of large, local, R&D-intensive firms in regional innovation systems," International Journal of Industrial Organization, Vol. 21(9), pp. 1227-1253.
- Cincera, Michele, and Reinhilde Veugelers, 2013, “Young leading innovators and the EU's R&D intensity gap," Economics of Innovation and New Technology, Vol. 22(2).
- Lerner, Josh, 2009, “Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital have Failed—and What to Do About It,” Princeton University Press (Princeton, NJ).
- Luukkonen, Tertuu (2010). “The Effectiveness of the Finnish pre-seed and seed policy schemes to promote innovative high-growth entrepreneurial ventures,” Keskusteluaiheita Discussion Papers No. 1221.
- Pajarinen, Mika, and Petri Rouvinen, 2013, “Nokia’s Labor Inflows and Outflows in Finland: Observations from 1989 to 2010,” ETLA Reports No 10.
- Additional references cited in the source include EC (2012), OECD publications, World Economic Forum (2013), ILO (2013), Eurofound (2013), Gartner (2011), IFC/Doing Business (2014 Economy Profile: Finland), and Council of the European Union (2013).

*Source: _cr14140 - References (IMF staff papers and chapter excerpts provided in the PDF content unit).*

### 2.      The need for adjustment creates a growth trade-off in the short term. The sustainability

### _cr14140 - 2.      The need for adjustment creates a growth trade-off in the short term. The sustainability

### Short-term trade-off and sustainability gap
- The economy has been in recession for two years; additional fiscal adjustment beyond planned measures could undermine the modest recovery forecast for 2014.
- EU fiscal rules (incorporated in national legislation) oblige Finland to satisfy a medium term objective for the structural fiscal balance of -0.5 percent of potential GDP.
- Public debt-to-GDP is projected to approach the 60 percent level in 2014.
- There is a risk the European Commission will call for further fiscal adjustment in the year based on estimates of a deteriorating structural fiscal balance.

### Timing and composition of adjustment: policy guidance
- Short run: the government should avoid enacting additional fiscal adjustment measures to sustain the recovery.
- Medium term: adopt a credible medium-term adjustment plan that ramps up adjustment only after the economy’s return to growth is firmly entrenched.
- Complementary measures: structural reforms that raise productivity and employment over the medium-term can buttress fiscal plans and offset declining trend growth and labor force participation among older workers.
- Active labor market policies (retraining, job search assistance) can help prevent or reverse hysteresis in the labor market.

### Fiscal adjustment simulations: setup and scenarios
- Baseline: projections do not reflect the recently announced government spending limits decision; baseline public debt-to-GDP ratio projected to continue rising through 2019.
- Simulation objective: illustrate impact of faster or slower fiscal adjustment focused on primary expenditure reductions, consistent with Finland’s expenditure ceiling fiscal framework.
- By 2019 there is a cumulative structural reduction in primary expenditures of 1.25 percent of GDP relative to the baseline.
- Two adjustment paths simulated:
  - Frontloaded path: 0.4 percent of GDP structural spending cut in 2015, then 0.3, 0.25, 0.2, and 0.1 percent of GDP in subsequent years (2016–2019 respectively).
  - Phased-in path: 0.2, 0.2, 0.25, 0.3, 0.3 percent of GDP in 2015–2019 respectively.

### Fiscal multiplier assumptions and uncertainty
- Empirical estimates of Finland’s spending multipliers generally between 0.5 and 0.7 (OECD, 2010a; Barrell and others, 2012) based on pre-crisis data.
- Multipliers likely larger than normal in current context due to:
  - Zero lower bound (ZLB) on nominal interest rates,
  - Large negative output gap.
- Central multiplier (M) values set for scenarios:
  - High multiplier scenario: M = 1
  - Medium multiplier scenario: M = 0.75
  - Low multiplier scenario: M = 0.5
- Multipliers vary with the output gap (OG):
  - If OG < -2: use M + 0.25
  - If -2 < OG < -1: use M
  - If OG > -1: use M - 0.25
- Factors favoring a higher multiplier: Zero lower bound, Negative output gap, Expenditure based adjustment (in simulation).
- Factors favoring a lower multiplier: Small open economy, Sizable automatic stabilizers.

### Simulation framework and assumptions
- Modified Abbas and others (2013) framework used: fiscal adjustment (percent of GDP) impacts growth via the size of expenditure reduction, multiplier size, and multiplier persistence. Past fiscal efforts and their marginal multipliers affect current growth impacts.
- No revenue adjustment in simulations: revenue assumed to fluctuate with GDP (revenue elasticity of 1).
- Baseline set to April 2014 WEO projections for nominal and potential GDP, output gap, real GDP growth, inflation, interest rates, and fiscal variables.
- Simulations abstract from long-run effects of fiscal consolidation on potential growth (potential output path consistent with WEO).
- No risk premium response to debt level changes is modeled, given Finland’s strong fiscal track record and moderate projected rise in baseline debt-to-GDP.

### Key simulation results
- Both frontloaded and phased-in adjustments can cause the debt-to-GDP ratio to temporarily rise relative to the baseline because the growth slowdown reduces the denominator while the initial headline primary balance improvement does not immediately offset nominal debt.
- Under frontloaded scenarios, the debt ratio increases faster than baseline in the first year; phased-in scenarios show a similar but slightly less pronounced initial increase.
- Both adjustment paths put public debt-to-GDP on a downward trajectory after 2015 for a given set of multipliers.
- Frontloaded path achieves a primary surplus more quickly and results in larger sums of primary surpluses over the projection period than phased-in path; public debt ratio falls more under frontloaded scenarios than phased-in ones, but the difference (for a given multiplier assumption) is less than 1 percentage point of GDP by 2019.
- Output impact:
  - Frontloaded adjustment generally has a more deleterious impact on output than phased-in adjustment.
  - Phased-in path allows more time for recovery, shrinks the output gap, and results in smaller multipliers in outer years when the bulk of adjustment occurs.
  - Deviations from baseline output level and cumulative output losses are much larger for frontloaded scenarios.

### Risks of hysteresis and role of structural reforms
- Fiscal consolidation during prolonged downturns can have persistent negative effects on potential growth through hysteresis in the labor market.
- Evidence cited: Dell’Erba, Koloskova, and Poplawski-Ribeiro (2014) find fiscal consolidations during prolonged downturns have persistent impacts on output growth driven by labor market hysteresis.
- Structural reforms can offset persistent negative effects and boost growth potential over the medium term.
- Tax composition: shifting from direct (income) taxes toward property and indirect (consumption) taxes, for a given level of taxation, is associated with faster growth.
- Labor tax wedge reductions: simulations by Bouis and Duval (2011) suggest reducing Finland’s labor tax wedge to the average of the six OECD countries with the highest employment rates in 2007 would raise the employment rate by more than 1 percentage point over 5 years.

### Modeling structural reforms for Finland
- Approach: use Anderson and others (2013a) results to derive elasticities of output to structural reform efforts by mapping the reaction of “core euro area” output to reforms that close half the gap with the average of best-performing OECD countries over 13 years.
- Elasticity illustration: if the deviation of output increases from t to t+1 by 0.5 percentage points and the structural indicator index improves by 2 units, the approximated elasticity is 0.25.
- Structural reforms work via multiple channels: lower mark-ups from product market reforms, lower adjustment costs from relaxing employment protection legislation (EPL), improved firm-employee matching, higher productivity, higher consumption and investment, and higher employment despite rising real wages.
- Uncertainty around reform impacts arises from statistical estimation error, the state of the economy, pace of implementation, and credibility of reforms.

*Source: _cr14140 - 2.      The need for adjustment creates a growth trade-off in the short term. The sustainability*

### 23.      The next step is to construct an indicator capturing the structural characteristics of

### 23.      The next step is to construct an indicator capturing the structural characteristics of

### Construction of structural reform indicator and calibration
- Summary indices of structural characteristics for Finland are constructed along the lines for the core EA, but the pace of reform closing the gap with the frontier is adjusted to mirror likely progress in the government’s current plans.
- Assumptions on timing and pace:
  - Pension reforms only become effective in 2017, consistent with the government’s reform plan.
  - The pace of reform for ALMPs, unemployment benefits’ average replacement rate (ARR), and changes to EPL is initially modest, but increases over the forecast horizon until they achieve a constant rate of reform from 2019 onwards.
  - Over 13 years the overall structural index closes about 44 percent of the gap instead of closing half the gap as is done for the core EA countries in Anderson and others (2013a).
- Structural indicators used (same underlying labor market characteristics as Anderson and others (2013a)):
  - OECD’s ALMP measure
  - Unemployment benefits’ average replacement rate (ARR)
  - EPL index
  - Public spending on childcare (proxy for policies that support female labor force participation)
  - Implicit tax on continued work at older ages (based on old-age pensions)
- OECD structural indicators are converted to indexes with the OECD frontier normalized to 100. Gaps are calculated as the difference between the country's (or weighted average of countries for the Core EA group) index value for an indicator and the OECD frontier.
- Core euro area (EA) includes: Austria, Belgium, Estonia, Finland, France, Germany, Luxembourg, the Netherlands, the Slovak Republic, and Slovenia.

### Simulation methodology and output effects
- The overall product and labor market reform index and the output elasticities to structural reform efforts (derived from core EA results in Anderson and others (2013a)) are combined to simulate impacts on Finland.
- Mechanic:
  - Output deviation elasticity to changes in the structural reform index (from core EA results) is multiplied by the annual change in Finland’s overall structural reform index to obtain yearly output deviations from the baseline.
- Benchmark structural reform scenario outcome:
  - Output would be about 2½ percent higher by the end of the forecast period (2019).
- Accelerated reform scenario (reforms implemented steadily from the beginning, in line with Anderson and others (2013a)):
  - Output 3.2 percent higher than the baseline by 2019.
- Uncertainty and demand-environment sensitivity:
  - High and low impact scenarios for Finland imply an output deviation range from the baseline at end-2019 between 1.1 and 3.3 percent.
  - Reforms’ impact varies with the demand environment: strong (weak) global demand leads to larger (smaller) effects because additional capacity is utilized more (less) quickly.

### Interaction of structural reforms with fiscal adjustment
- Combining structural reform and fiscal adjustment simulations:
  - Reforms can significantly mitigate the drag on growth from consolidation.
  - Comparing the WEO baseline with a combined simulation assuming phased-in consolidation, medium-sized multipliers, and benchmark structural reforms results in output levels more than 1 percent higher than the baseline.
  - In contrast, a simulation with fiscal adjustment and no reforms yields output levels more than 1 percent lower than the baseline.
- Point estimate uncertainty around these simulations is sizable.

### Policy discussion — overall conclusion
- A combination of a phased medium-term fiscal adjustment and structural reforms can raise growth and address the fiscal sustainability gap.
- Embarking on a reform path that would close between 40 and 50 percent of Finland’s existing reform gaps with the OECD’s best performers over a 13 year period could potentially more than offset the effects of an adjustment plan that closes half of the fiscal sustainability gap by 2019.

### Revenue-side recommendations and findings
- Given Finland’s already high tax levels, fiscal adjustment will have to focus mostly on expenditures; however, there is scope to make tax structure more growth friendly.
- Key numeric and policy points:
  - Following a one percentage point increase of the standard VAT rate to 24 percent in early 2013, the VAT revenue-to-GDP ratio is more than 9 percent (in the top quintile of OECD countries).
  - Total property tax revenue is only 1.1 percent of GDP, which is less than 60 percent of the OECD average (IMF, 2013c).
- Specific revenue measures:
  - VAT: Eliminating half of the “policy gap” (i.e. applying the standard VAT rate to more goods) could generate up to 2.4 percent of GDP in additional revenue (IMF (2013c)). Offsetting regressive effects would reduce net budget impact.
  - Property tax: Raising the property tax revenue-to-GDP ratio to the OECD average could generate additional revenue of about 1 percent of GDP. Property tax revenue tends to vary less with the business cycle.
  - Other: Budget-neutral changes in R&D support—shifting from larger-scale direct support focused on large firms to tax-based schemes that benefit younger and smaller firms—could boost innovative activity and growth.
- Public financial assets:
  - The stock of public financial assets is worth nearly 100 percent of GDP.
  - The portfolio is invested relatively conservatively, resulting in low returns; shifting allocation towards assets with higher returns could increase investment income while limiting any rise in revenue volatility.

### Expenditure-side recommendations and findings
- Expenditure measures are essential for long-run fiscal sustainability. Central government spending has remained fairly contained, but rapid growth in local government and social security spending since 2007 indicates scope for reform.
- Public sector productivity:
  - The productivity of government-provided services has declined more than 10 percent over the past decade.
  - Government’s structural reform program (agreed November 2013) aims to improve public sector efficiency at all levels and foresees savings from a significant reduction in the government workforce relative to the baseline: expected increase in the public workforce would shrink from an estimated 3,000 workers per year (about 1.5 percent of the current workforce) to about 1,000 workers per year over the medium term.
- Specific reform areas:
  - Municipalities reform: Reduce tasks/responsibilities of local governments and merge municipalities (or functions) to achieve economies of scale (e.g., procurement for health and long-term care).
  - Central government reform: Central Government Productivity Program 2005-2015 aimed to reduce employment and curb expenditure growth; reforms require regular assessments of performance management and implementation to avoid adverse impacts on staff morale and retention.
  - Electronic service delivery and data provision: Increase investment in ICT over 2015-18 to coordinate and deliver services online and broaden public provision of government-collected data.
- Measures to contain local government spending with projected savings by 2017 (relative to baseline):
  - Overall projected local government savings: around €1.3 billion (0.6 percent of GDP) by 2017.
  - Healthcare: Savings roughly €180 million (0.1 percent of GDP) largely from discontinuing archiving of paper records (€94 million) and emergency system reforms (€60 million).
  - Long-term care (LTC): Tightening eligibility projected to save €300 million (0.14 percent of GDP); nevertheless, LTC spending is projected to rise by 1.4 percent of GDP by 2030 (EC, 2012).
  - Social services: Measures projected to yield savings of €125 million (0.05 percent of GDP).
  - Education: Reforms expected to save nearly €300 million (0.14 percent of GDP) by 2017—€195 million from education provider network and funding system reforms and €65 million from funding only attainment of qualifications.
- Further LTC reforms recommended:
  - Increase competition among LTC providers.
  - Promote remote technologies and assistive devices.
  - Measures to help the elderly remain healthy and at home as long as possible (e.g., in-home assistance).

### Pensions and labor-force participation
- Pension-related fiscal pressure:
  - Pension costs are expected to rise by 3.5 percent of GDP by 2030 and are a key contributor to the sustainability gap.
- Recent and planned pension reforms:
  - Past reforms raised the effective retirement age and introduced a longevity adjustment to new pensions.
  - Government’s plan includes negotiating additional pension reforms by autumn 2014 that would come into force in 2017, aiming to gradually raise the average effective retirement age from 60 years old to above 62 years old by 2025 and change contribution and benefits formulas.
- Additional measures to narrow early retirement channels:
  - Disability benefits: Share of population aged 15-64 receiving disability benefits is nearly 9 percent (OCED, 2010a); tightening eligibility while providing ALMP support could yield savings and raise older-worker participation.
  - Statutory retirement age: The statutory retirement age was lowered from 65 to 63 as part of the 2005 reform. High implicit tax on working beyond age 63 reduces incentives to work longer and led to a decline in individuals working to age 65 (OECD, 2010b). Returning to a statutory retirement age of 65 and providing an actuarial adjustment for income from work beyond age 63 would reduce the implicit tax on working beyond that age and positively impact growth and fiscal sustainability.

### Fiscal framework and governance
- Current framework coverage and limits:
  - The central government’s spending limits framework covers only 80 percent of budgeted spending by the central government and excludes local governments, which account for roughly one third of general government spending.
  - A more comprehensive framework covering more of general government spending would improve expenditure control, though legal difficulties may arise for enforcing rules at the local level.
- New initiatives:
  - A new steering system for local government finances is being established; related legislation will come into force in 2015. The system aims to include binding medium-term limits on local government finances, but it is too early to evaluate its impact.
  - Bolstering the role and capacity of Finland’s de facto fiscal council, the National Audit Office, would help ensure fiscal discipline and meet fiscal targets in the future.

*International Monetary Fund — FINLAND (Selected chapter content).*

### 35.      Structural reforms can enhance growth, mitigating the impact of fiscal consolidation,

### 35.      Structural reforms can enhance growth, mitigating the impact of fiscal consolidation,

### Key findings on Finland’s reform gaps and priorities
- Finland’s structural reform gaps are somewhat larger, though of the same order of magnitude, as other core euro area economies.
- Reform potential is particularly high in the labor market area (ALMP, ARR of unemployment benefits) and for pension reforms.
- The overall product market reform gap is lower than for labor market indicators, but the output elasticity of product market reforms is higher, suggesting a comprehensive approach.
- Sectoral product market gaps can be substantially worse than the overall indicator suggests, notably:
  - Retail sector regulatory barriers are among the highest out of OECD countries (retail sector regulation indicator in the top quintile; lower is better).
  - Network sectors such as rail and utilities show reform scope with potential cost and productivity benefits.

### Policy recommendations (labor market and pensions)
- Pension reforms:
  - Pension reforms have both growth and fiscal benefits that accrue over time, suggesting that quickly implementing reforms is particularly helpful.
  - Start the necessary dialogue between all stakeholders, including social partners, soon to avoid unnecessary delay in legislation and implementation.
- Active labor market policies (ALMP):
  - Increasing spending on ALMP can boost output.
  - ALMP can complement pension reforms if some ALMP spending is targeted towards older people to encourage them to stay in the labor force.
  - Some fiscal cost of increased ALMP could be offset by savings from reforms of pension and unemployment benefits.
- Unemployment benefits average replacement rate (ARR):
  - Gradually reducing the generosity of unemployment benefits over time could raise employment and help reduce long-term unemployment, increasing labor supply.
  - More effective if phased in during a period of strong demand and accompanied by effective ALMP.
  - Otherwise, a gradual phasing-in commensurate with economic conditions would maximize the impact over the medium-term.
- Employment protection legislation (EPL):
  - The direct growth impact of reducing EPL tends to be smaller than other labor market reforms.
  - Policies that protect workers rather than jobs have potentially strong benefits in a period of rapid structural change (e.g., post-ICT boom).

### Box 1 — The Sustainability Gap (definition and implications)
- The sustainability gap indicator: the structural fiscal adjustment (i.e. total change in structural primary balance) needed to ensure the government’s intertemporal budget constraint is satisfied.
- Estimation steps:
  - Calculate public debt-to-GDP ratio at time t (b_t) minus the present value of all future primary balances (p_tPV) for a given structural primary balance path (SPB).
  - If b_t – p_tPV is positive using the baseline long-run SPB forecast, the government’s intertemporal budget constraint (IBC) is not satisfied.
  - Define an adjustment path that generates an alternative SPB path such that b_t – p_tPV = 0.
  - The total adjustment (change in SPB) needed over the specified time period gives the sustainability gap.
- Timing matters:
  - Any delay in adjustment will increase the sustainability gap, since higher surpluses will be needed in the long-run to offset the lower present value of future SPBs.
  - The increase in the gap from delays may not be very large if the envisaged shift is small and spending pressures are many decades away.
- Sensitivity:
  - The sustainability gap is sensitive to long-run forecasts on variables such as growth, interest rates, and demographics.

### Box 2 — Potential Output Uncertainty and Structural Balance Estimates
- The structural fiscal balance adjusts the headline balance for cyclical and one-off factors (e.g., output gap, asset and commodity price cycles).
- Measuring the cyclical position requires estimating potential output, which is subject to substantial uncertainty:
  - Fund staff found average absolute revisions (2003–2012) of the output gap and CAPB estimates are around 2.5 percent and 1.1 percent of potential GDP, respectively, with higher revisions for 2007–2009.
- Large shocks and structural changes compound uncertainty (example: Finland’s real GDP fell more than 8 percent in 2009).
- Structural shifts in revenue/expenditure elasticities can introduce additional uncertainty when measuring the structural fiscal balance.

### Box 3 — The Role of Structural Reforms and Productivity in Fiscal Consolidations: The Swedish Experience
- Fiscal consolidations tend to depress aggregate demand and employment; Sweden’s 1990s episode shows simultaneous consolidation and high growth was possible due to productivity-enhancing structural reforms.
- Sweden’s TFP growth:
  - Between 1970 and 1990, TFP growth averaged 0.5 percent per year.
  - During 1993–2000, TFP increased at an annual rate of 2.7 percent.
- Policy actions in Sweden included: a new “Competition Act” (1993), EU accession (1994), deregulation of network industries (telecommunications, electricity, rail), privatizations, and planning regulation changes to encourage retail competition.
- Estimated impacts:
  - The model in Lama and Medina (2014) estimates that Swedish GDP increased by 20 percent due to TFP gains after structural reforms.
  - In simulations, discretionary measures improved the primary balance by 5 percentage points of GDP but at the cost of declining GDP; including observed productivity gains increased the primary balance by 10 percentage points of GDP and output increased by 6 percent above trend by the year 2000.
- Conclusion: Implementing productivity-enhancing structural reforms can allow output expansion while consolidating public finances.

### Simulation results and scenarios (summary of figures and implications)
- Figure summaries illustrate alternative scenarios for fiscal adjustment (frontloaded vs. phased-in) under high, medium, and low fiscal multipliers:
  - Panels show deviations of output from the “Baseline – WEO” forecast, the primary balance, and the public debt ratio under six adjustment scenarios.
- Structural reform simulations show benchmark, low-impact, and high-impact scenarios:
  - Panels show deviations from baseline output levels (percent), primary balances (percent of GDP), and debt (percent of GDP) for 2013–2019 horizons.
- Combined scenario simulations compare:
  - “Fiscal adjustment only” (phased-in path), “Structural reform only,” and a “combined” scenario (structural reform impact in benchmark plus phased-in fiscal adjustment with medium multiplier).
  - Panels show deviations from the “April 2014 WEO” forecast for output, primary balance, and public debt ratio, indicating complementary gains from simultaneous structural reforms and fiscal consolidation.

*International Monetary Fund — Finland: Selected chapter on structural reforms and fiscal consolidation*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14140.pdf_