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### 1. The Current Account, Recovery, and Near-term Outlook
- After nine quarters of negative growth, growth returned in the second half of 2013.
- Key drivers of the recovery:
  - Exports are performing well; exports gaining market share and tourism booming.
  - Financial conditions improved: sovereign yields at record lows; banks halved reliance on ECB funding.
  - Domestic demand rebounding: business investment picking up; private consumption recovering.
  - Labor market turning around: unemployment and employment both improving.
  - Fiscal consolidation continues: structural primary balance strengthened by 1½ percent of GDP in 2013.
- Growth expectations:
  - Growth is expected to increase to around 1¼ percent in 2014.
  - Over the medium term, growth is expected to remain around 1½–2 percent.
  - Unemployment projected to decline significantly but remain above 18 percent by 2019.
- Risks and contingencies:
  - Upside: stronger consumer and business confidence; ECB monetary easing (e.g., TLTROs); successful European AQR/ST.
  - Downside: protracted private deleveraging; very low or negative inflation; weaker external demand; re-emergence of Euro-area financial stress.

### 2. Magnitude and Nature of External Adjustment
- Current account adjustment:
  - During the last 5 years the current account improved by 11 percent of GDP, from a deficit of 10 percent in 2007 to a 1 percent surplus in 2013.
  - Only one other advanced large non-commodity exporting country had a similar improvement: South Korea in 1997–98.
- Exchange rate and REER:
  - Improvement achieved without nominal exchange rate depreciation; REER based on unit labor costs depreciated significantly largely due to labor shedding; CPI-based REER has not depreciated much.
  - Model-based and historical REER analysis suggests the REER is some 5–15 percent above the level consistent with medium-term fundamentals and desirable policies.
- Staff assessment of cyclically-adjusted current account:
  - Staff assesses the 2013 cyclically-adjusted current account balance was 1–3 percent of GDP weaker than desirable.
  - Staff projections envisage the current account surplus will rise by close to this amount over the medium term; such surpluses will need to be maintained until the external position is stronger.

### 3. Legacy from the Boom/Bust and Key Vulnerabilities
- Labor market and social outcomes:
  - Unemployment at 26 percent; the majority of unemployed have been without a job for at least a year—about 3½ million people (15 percent of the labor force).
  - Youth unemployment at 55 percent.
  - Large share of workers on temporary and involuntary part-time jobs; sharp decline in labor force (partly via net emigration).
  - Median income fell substantially; about four million who became unemployed since 2007 suffered large falls in income (about half on average).
- Public and private indebtedness:
  - Fiscal deficit was 6½ percent of GDP in 2013.
  - Public debt jumped from 36 percent of GDP in 2007 to 94 percent of GDP in 2013.
  - Households’ net wealth has fallen by about 124 percent of GDP since end-2007.
  - Corporate debt well over historical and international averages.
- External position:
  - Net international investment position (NIIP) deteriorated further in 2013 to reach almost 100 percent of GDP.
  - Despite a current account surplus, net external liabilities remain high.

### 4. Structural Constraints and Growth Prospects
- Key impediments to faster recovery:
  - Need for further internal devaluation amid wage and price rigidities and low global inflation.
  - High corporate debt and tight financing conditions limiting firms’ (especially SMEs’) capacity to borrow and expand.
  - Household balance sheets constrained by high debt, low savings rate, high unemployment, and modest wage growth.
  - Housing sector unlikely to contribute meaningfully to growth for some time due to high stock of vacant new houses and few transactions.
  - Ongoing fiscal consolidation weighing on demand.
- Longer-term prospects:
  - Potential growth may only be around 1 percent over the medium term absent stronger productivity gains and demographic reversal.

### 5. Spain’s Overarching Macro Policy: Objectives and Priorities
- Policy objectives:
  - Ensure the recovery is strong and long-lasting and inclusive, especially so that the unemployed benefit from more job opportunities.
- Policy elements:
  - Help firms expand, hire, and invest: reduce firms’ debt burden via creditors restructuring excessive debt of operationally-viable firms; continue efforts to bolster banks’ ability to support the economy.
  - Lower regulatory barriers: lower regulatory barriers that constrain Spain’s businesses; combine with continued wage moderation and more ambitious policies to improve skills and reduce the high tax cost of employing the low-paid.
  - Pursue growth- and job-friendly fiscal consolidation: continue gradual consolidation to get debt to trend down while minimizing drag on growth and employment and complement with reforms that boost growth and employment.
  - More support from Europe: action to address low inflation and financial fragmentation in the Euro area would help the recovery.

### 6. Private Debt — Reducing Debt Overhang (Context and Staff Recommendations)
- Context and findings:
  - Private sector debt, while falling, remains very high.
  - Firms have been reducing debt faster than households, mainly via a sharp fall in net borrowing driven by sharply lower investment and rising profit margins.
  - Decline concentrated in construction/real estate sector and SMEs.
  - Government measures for out-of-court debt restructuring: mediation for smaller firms; legal/regulatory incentives for debt-to-equity swaps for larger firms.
  - Recently announced plans include:
    1. Strengthen the in-court debt restructuring process along the lines of enhancements in out-of-court mechanisms.
    2. Foster liquidation as a going concern instead of piecemeal liquidation.
    3. Introduce a code of good practice to facilitate debt restructuring for SMEs and the self-employed.
    4. Create an inter-ministerial committee to monitor the debt restructuring process.
- Staff recommendations:
  - Adopt a comprehensive, pro-active strategy catalyzed by the official sector, aligning incentives of all stakeholders, potentially overseen by an independent oversight body reporting restructuring statistics.
  - Tools to evaluate:
    1. Increase effectiveness of in-court and out-of-court workouts by providing more tools to public creditors; facilitate going-concern sales; speed up procedures; introduce a personal insolvency regime to help entrepreneurs.
    2. For larger firms, issue centralized guidelines for voluntary out-of-court workouts with independent mediation.
    3. For SMEs, develop a menu of standardized voluntary workouts with harmonized restructuring terms and indicative targets for financial institutions.

### 7. Banking Sector — Achievements, Challenges, and Staff Recommendations
- Achievements during ESM-supported program:
  - Core Tier 1 ratio reached 11.8 percent at end-2013, compared with 9.6 percent at the start of the financial sector program.
  - Coverage ratio (specific reserves to NPLs) rose to 46 percent at end-2013, up from 36 percent at the start of the program.
  - Deposit and wholesale funding rates fell substantially; reliance on debt issuance and ECB borrowing fell.
  - Banks’ equity prices have risen strongly—price to book ratios are above unity for the system and above European peers.
- Remaining challenges:
  - Bank credit to firms declining by about 11 percent in March — one of the fastest among advanced economies.
  - Deposit rates have declined by nearly 160 bps since 2012, but lending rates for firms have only fallen by around 40 bps.
  - Net pre-provision income from core banking activities fell compared to 2012.
  - NPL ratio is high at 13½ percent, though it has started falling slightly.
  - Comparison: average core Tier 1 ratio for the largest 150 European banks (excluding the 11 Spanish banks) was 14.2 percent; for the largest 11 Spanish banks it was 11.9 percent at end-2013.
- Staff recommendations:
  - Support the recovery while continuing to raise capital ratios over the medium term, preferably by increasing nominal capital rather than contracting credit.
  - Restrain cash dividends and bonuses; issue equity (or similar instruments); dispose of/restructure distressed assets; continue to reduce costs and improve efficiency.
  - Prepare for the Comprehensive Assessment; note remaining uncertainties from haircuts to sovereign bonds and foreign loan portfolio reviews.

### 8. Labor Market — Findings and Staff Recommendations
- Findings:
  - The 2012 labor reform and wage agreements appear to be moderating wage increases and creating jobs.
  - Reform may have lowered the growth threshold for generating positive net employment (previously the economy needed to grow close to 2 percent).
  - Temporary reduction in employer’s social security contributions for new (net) hiring on permanent contracts in 2014.
  - Reform of active labor market policies launched in 2013 with greater focus on results.
  - New initiative for youth employment to improve training/subsidies, job quality, and promote entrepreneurship.
  - Structural unemployment estimated at very high levels by OECD and EC (above 20 percent).
  - Government projections envisage unemployment above 19 percent by 2017.
  - High degree of labor market duality between protected “insiders” and precarious “outsiders.”
- Staff recommendations:
  - Further decentralize wage setting: enhance ability of individual firms to adapt wages and hours; consider facilitating opt-outs and extending collective agreement coverage rules.
  - Cut employer social security contributions for the low paid; fiscal cost could be offset by broader tax reform.
  - Reduce duality by making hiring on permanent contracts more attractive: increase dismissal costs for new permanent contracts gradually with tenure and from a lower initial level.
  - Improve active labor market policies: implement the new employment strategy aggressively, widen use of private job placement agencies, improve training services and establish a single portal for job vacancies.

### 9. Market Unity, Business Environment, and Structural Reform Priorities
- Market Unity law:
  - Objective: reduce barriers to trade across Spain’s regions by rationalizing regulatory framework, reinforcing cooperation among administrations, and encouraging smart regulation.
  - Ambitious screening identified about 2,700 regulatory barriers (mainly at subnational level) that contradict the new law and need elimination.
  - New expeditious appeal process via the Secretary of Market Unity; early successful cases include barriers in agricultural and pharmaceutical product sales across regions.
  - Success conditions: strong central and subnational government cooperation; swift alignment of existing regulations; adequate resources.
- Business environment findings:
  - Total factor productivity (TFP) growth has been on a declining trend since the 1990s; Spain and Italy had the worst productivity performance among OECD economies pre-crisis.
  - Doing Business ranking has deteriorated and remains far from best performers, especially in protecting investors, getting credit, and paying taxes; also weak in starting a business and dealing with construction permits.
- Staff recommendations:
  - Appoint an independent agency on growth and jobs to establish priorities, garner public support, and monitor progress.
  - Complement labor reform with product and service market liberalization to lower mark-ups and increase purchasing power.
  - Ambitious liberalization of professional services; improve training for the unemployed; fully implement energy reform to eliminate the electricity tariff deficit.

### 10. Fiscal Policy, Projections, and Debt Sustainability
- Fiscal context:
  - Fiscal consolidation continued in 2013, but public debt is still rising.
  - Debt is rapidly approaching 100 percent of GDP and is already above the Euro area average.
  - Putting debt onto a firmly-declining path requires maintaining a primary surplus of at least 2 percent of GDP—implying improving the primary balance by some 6 percent of GDP compared with 2013.
- Government strategy and Stability Program Update (percent of GDP):
  - Authorities' Stability Program Update (2014–2017):
    - Revenue: 38.5, 38.8, 38.9, 39.0
    - Expenditure: 44.0, 43.0, 41.7, 40.1
    - Fiscal balance: -5.5, -4.2, -2.8, -1.1
    - Primary balance: -2.0, -0.6, 0.9, 2.7
    - Change in cyclically adjusted primary: 0.6, 0.6, 0.6, 0.7
    - Gross public debt: 99.5, 101.7, 101.5, 98.5
  - IMF staff projections (2014–2017):
    - Revenue: 38.1, 38.1, 38.4, 38.6
    - Expenditure: 43.9, 42.8, 42.2, 41.6
    - Fiscal balance: -5.7, -4.7, -3.8, -2.9
    - Primary balance: -2.2, -1.2, -0.2, 0.6
    - Change in cyclically adjusted primary: 0.6, 0.6, 0.6, 0.5
    - Gross public debt: 98.5, 100.9, 102.0, 102.1
  - Note: 2014 forecast based on 2014 budget; medium term forecast assumes annual improvement of 0.6 % of GDP in the cyclically adjusted primary balance.
- Staff views and recommendations:
  - Continue gradual, steady consolidation at about ½-¾ percent a year of structural consolidation.
  - Strengthen medium-term strategy; revise targets if nominal GDP growth disappoints.
  - Improve spending efficiency via public expenditure review (CORA) and better targeting of social spending.
  - Use forthcoming tax reform to enhance revenue and be growth- and job-friendly: rely more on indirect taxes (raise excise duties and environmental levies, gradually reduce preferential VAT treatments) while protecting the most vulnerable through transfers and tax credits.
  - Sharply cut taxes on employing the low paid by cutting employer social security contributions, structured as tax credits financed by transfers from the budget to protect the social security system.
  - Broaden the base of direct taxes by cutting exemptions and special treatments to allow cutting the top corporate rate to 25 percent while maintaining revenue.
- Authorities’ stance:
  - Confident ambitious fiscal targets will be met within envisaged recovery; expect public debt-to-GDP ratio will start declining after 2015.
  - Supportive of broadening income tax bases and reducing tax evasion; cautious about increasing preferential VAT rates.

### 11. Box 3 — How Euro Area Policies Could Help Spain’s Adjustment
- Supportive monetary policy to achieve inflation targets would:
  - Enable greater competitiveness gains for a given level of Spanish inflation, or the same competitiveness gains with a higher level of Spanish inflation, aiding recovery by:
    - Lowering real labor costs given nominal wage rigidity.
    - Lowering the real burden of Spain’s high private debt and lending rates.
    - Easing fiscal consolidation via higher inflation reducing real cost of interest payments and lowering debt ratio.
- Reducing fragmentation to improve monetary transmission:
  - The ECB policy rate is described as already too tight for Spain; transmission to lending rates for SMEs is impaired.
  - European banks reduced exposure to Spain by about half since 2007.
  - Staff estimates: substantially reducing the spread compared to Germany of the Spanish sovereign and banks could narrow, by up to 40 percent, the gap between Spanish and German short-term interest rates on lending to small firms.
- Key staff responses and concerns:
  - Wage moderation: staff argues for gradual nominal wage moderation to reduce real employment costs and support hiring while opening protected nontradeable sectors to competition.
  - Output gap uncertainty: staff notes output gap estimates are especially uncertain and warns against assuming quick closure that could delay necessary reforms.
  - Fresh start in insolvency: design could allow benefit after monitored good-faith efforts and surrender of non-exempt assets; Germany example cited (initially after 7 years).
  - Deflation risks: protracted very low or negative inflation would be harmful given high indebtedness; ECB actions to address undershooting are warranted.

### 12. Macroeconomic Projections and Selected Key Statistics (exact figures preserved)
- Real GDP growth (percent change): 2013: -1.2; 2014: 1.2; 2015: 1.6; 2016: 1.7; 2017: 1.8; 2018: 1.9; 2019: 2.0.
- Current account balance projections (percent of GDP): 2014: 0.6; 2015: 0.7; 2016: 1.1; 2017: 1.2; 2018: 1.5; 2019: 1.7.
- Unemployment rate (percent): 2013: 26.1; 2014: 24.9; 2015: 23.8; 2016: 22.6; 2017: 21.4; 2018: 20.1; 2019: 18.7.
- HICP (average) projection: 2014: 0.1; 2015: 0.8; 2016: 1.0; 2017: 1.1; 2018: 1.3; 2019: 1.4.
- General government balance (percent of GDP): 2013: -6.6; 2014: -5.7; 2015: -4.7; 2016: -3.8; 2017: -2.9; 2018: -2.2; 2019: -1.8.
- Primary balance (percent of GDP): 2013: -4.1; 2014: -2.7; 2015: -1.6; 2016: -0.7; 2017: 0.2; 2018: 0.9; 2019: 1.3.
- General government gross debt (Maastricht, percent of GDP): 2013: 99; 2014: 101; 2015: 102; 2016: 102; 2017: 101; 2018: 100; 2019: 100.
- Private sector debt (percent of GDP): 295, 282, 270, 255, 243, 238, 235, 231, 227, 223 (historical series).
- Net international investment position (percent of GDP): -89, -91, -93, -98, -96, -92, -88, -83, -79, -73 (historical series).
- House prices dropped by a third.

### 13. Appendix I — Public Debt Sustainability Analysis (selected findings)
- Baseline debt path:
  - Debt is projected to peak at 102 percent of GDP in 2017, before declining to 100 percent by 2019.
- Gross financing needs:
  - Expected to remain around 17 percent of GDP during the medium term.
- Baseline macro-fiscal assumptions (selected):
  - Real GDP growth: 2014: 1.2; 2015: 1.6; 2016: 1.7; 2017: 1.8; 2018: 1.9; 2019: 2.0.
  - Inflation (GDP deflator): 2014: -0.1; 2015: 0.8; 2016: 1.0; 2017: 1.1; 2018: 1.4; 2019: 1.4.
  - Primary Balance: 2014: -2.2; 2015: -1.2; 2016: -0.2; 2017: 0.6; 2018: 1.4; 2019: 1.8.
  - Effective interest rate (percent): 2014: 3.8; 2015: 3.7; 2016: 3.6; 2017: 3.6; 2018: 3.6; 2019: 3.7.
- Stress test results (selected):
  - Primary balance shock (2015–16 hit by 2.7 percent of GDP): debt-to-GDP about 6 percentage points higher than baseline by 2019.
  - Growth shock (real GDP growth 1.3 percent lower in 2015–16): debt-to-GDP reaches 111 percent by 2019 (11 percentage points higher).
  - Interest rate shock (nominal rates +200 bps 2015–19): debt-to-GDP reaches 102 percent in 2019 (2 percentage points higher).
  - Combined shock: debt-to-GDP reaches 115 percent in 2019 (15 percentage points higher).
  - Contingent liability shock (one-time 10 percent of GDP in 2015 combined with lower growth/inflation): debt-to-GDP reaches 119 percent in 2019 (19 percentage points higher).
- Policy implications:
  - Debt dynamics are sensitive to fiscal slippage, weaker growth, higher interest rates, and contingent liabilities.
  - Importance of maintaining fiscal consolidation, bolstering growth, and containing contingent liabilities.

### 14. Appendix II — Independent Tax Reform Committee Recommendations (selected)
- Strategy:
  - Revenue-neutral shift from direct taxes to indirect taxes; additional cut in employer’s social security contribution for the low-paid; broaden the tax base; reduce tax fraud.
- Personal Income Taxes (PIT):
  - Reduce number of brackets to four; cap top rate at 50 percent; reduce bottom and top rates; harmonize treatment of capital income.
- Corporate Income Taxes (CIT):
  - Cut the top corporate income tax rate first to 25 percent, then to 20 percent; broaden the base; reduce debt bias.
- Social Security Contributions:
  - Modernize then cut: transform contributions into a payroll tax; merge administrations; only then reduce employer social security contributions.
- VAT and excise:
  - Mobilize revenues by broadening standard rate base; increase excises and environmental levies to EU averages; remove exemptions.
- Tax decentralization and fraud:
  - Empower Fiscal and Financial Policy Council; eliminate simplified regimes that enable abuse.

### 15. Shortcomings Noted by Staff on the Proposed Reform
- The proposed reform (June 20, 2014 government proposal) is revenue-losing rather than revenue-neutral or revenue-enhancing; will require offsetting measures to achieve envisaged consolidation.
- Strategy to boost employment could be better targeted: staff favors targeted cut in employer’s social security contributions for low-skilled workers rather than relying mostly on PIT and CIT cuts.
- Net impact on base broadening unclear: some deductions eliminated while new ones created; special SME regimes strengthened, suggesting need for further base broadening.

### 16. Risk Assessment Matrix — Selected Risks and Policy Responses
- Risk 1: Advanced economies’ lower-than-anticipated potential growth and persistently low inflation
  - Relative Likelihood: High
  - Impact if Realized: High
  - Policy response: ECB should loosen monetary policy further; revise fiscal targets if needed; deepen and accelerate structural reforms.
- Risk 2: Surges in global financial market volatility
  - Relative Likelihood: High
  - Impact if Realized: Medium
  - Policy response: ECB actions to reduce volatility; increase reforms to support investor confidence.
- Risk 3: Euro area sovereign stress re-emerges
  - Relative Likelihood: Low
  - Impact if Realized: Medium
  - Policy response: Strengthen banking union; credible AQR/stress test; further monetary easing; banks build capital buffers.
- Risk 4: Structural reform slippage amid political/social difficulty
  - Relative Likelihood: Medium
  - Impact if Realized: High
  - Policy response: Set clear reform timetable; foster independent agencies; enhance communication of reform benefits.

*Italic: IMF staff report content as provided in the source PDF.*

### 1. The Current Account Has Improved Significantly, but Vulnerabilities Remain High ______________ 8

### 1. The Current Account Has Improved Significantly, but Vulnerabilities Remain High

### Recovery and near-term outlook
- After nine quarters of negative growth, growth returned in the second half of 2013.
- Key drivers of the recovery:
  - Exports are performing well; exports gaining market share and tourism booming.
  - Financial conditions improved: sovereign yields at record lows; banks halved reliance on ECB funding.
  - Domestic demand rebounding: business investment picking up; private consumption recovering.
  - Labor market turning around: unemployment and employment both improving.
  - Fiscal consolidation continues: structural primary balance strengthened by 1½ percent of GDP in 2013.
- Growth expectations:
  - Growth is expected to increase to around 1¼ percent in 2014.
  - Over the medium term, growth is expected to remain around 1½–2 percent.
  - Unemployment projected to decline significantly but remain above 18 percent by 2019.
- Risks and contingencies:
  - Upside: stronger consumer and business confidence; ECB monetary easing (e.g., TLTROs); successful European AQR/ST.
  - Downside: protracted private deleveraging; very low or negative inflation; weaker external demand; re-emergence of Euro-area financial stress.

### Legacy from the boom/bust and key vulnerabilities
- Labor market and social outcomes:
  - Unemployment at 26 percent; the majority of unemployed have been without a job for at least a year—about 3½ million people (15 percent of the labor force).
  - Youth unemployment at 55 percent.
  - Large share of workers on temporary and involuntary part-time jobs; sharp decline in labor force (partly via net emigration).
  - Median income fell substantially; about four million who became unemployed since 2007 suffered large falls in income (about half on average).
- Public and private indebtedness:
  - Fiscal deficit was 6½ percent of GDP in 2013.
  - Public debt jumped from 36 percent of GDP in 2007 to 94 percent of GDP in 2013.
  - Households’ net wealth has fallen by about 124 percent of GDP since end-2007.
  - Corporate debt well over historical and international averages.
- External position:
  - Net international investment position (NIIP) deteriorated further in 2013 to reach almost 100 percent of GDP.
  - Despite a current account surplus, net external liabilities remain high.

### Current account adjustment (Box 1 findings)
- Magnitude of improvement:
  - During the last 5 years the current account improved by 11 percent of GDP, from a deficit of 10 percent in 2007 to a 1 percent surplus in 2013.
  - Only one other advanced large non-commodity exporting country had a similar improvement: South Korea in 1997–98.
- Nature of adjustment:
  - Improvement achieved without nominal exchange rate depreciation; REER based on unit labor costs depreciated significantly largely due to labor shedding; CPI-based REER has not depreciated much.
- Remaining vulnerabilities and model-based assessments:
  - With a still very negative NIIP, the external position appears significantly weaker than consistent with medium-term fundamentals.
  - Model-based and historical REER analysis suggests the REER is some 5–15 percent above the level consistent with medium-term fundamentals and desirable policies.
  - Staff assesses the 2013 cyclically-adjusted current account balance was 1–3 percent of GDP weaker than desirable.
  - Staff projections envisage the current account surplus will rise by close to this amount over the medium term; such surpluses will need to be maintained until the external position is stronger.

### Structural constraints to stronger growth
- Key impediments to a faster recovery:
  - Need for further internal devaluation amid wage and price rigidities and low global inflation.
  - High corporate debt and tight financing conditions limiting firms’ (especially SMEs’) capacity to borrow and expand.
  - Household balance sheets constrained by high debt, low savings rate, high unemployment, and modest wage growth.
  - Housing sector unlikely to contribute meaningfully to growth for some time due to high stock of vacant new houses and few transactions.
  - Ongoing fiscal consolidation weighing on demand.
- Longer-term prospects:
  - Potential growth may only be around 1 percent over the medium term absent stronger productivity gains and demographic reversal.

### Policy implications highlighted by staff and authorities
- Maintain and deepen structural reforms to raise productivity and competitiveness (product and service market reforms, active labor market policies, insolvency framework improvements).
- Continue measures that support financial system repair, bank restructuring, and access to finance for SMEs.
- Sustain current account surpluses over the medium term to repair the NIIP; acknowledge that achieving a stronger NIIP and much lower unemployment may require a substantially weaker REER and several years of larger current account surpluses.
- Monitor and manage downside risks from protracted deleveraging, very low inflation, and external shocks; leverage European support measures (monetary easing, banking union progress, Comprehensive Assessment) where possible.
- Authorities’ perspective: they note substantial regained competitiveness based on unit labor costs, emphasize the improvement in the current account, and question the precision of staff REER overvaluation estimates while agreeing on the need to further strengthen the current account.

*Source: 1. The Current Account Has Improved Significantly, but Vulnerabilities Remain High (IMF).*

### 10.      Spain’s overarching macro policy

### 10.      Spain’s overarching macro policy

### Overarching macro policy: objectives and priorities
- Priority is to ensure the recovery is strong and long-lasting and inclusive, especially so that the unemployed benefit from more job opportunities.
- Policy elements to achieve this:
  - Helping firms expand, hire, and invest:
    - Reduce firms’ debt burden via creditors restructuring excessive debt of operationally-viable firms.
    - Continue efforts to bolster banks’ ability to support the economy.
  - Lowering regulatory barriers:
    - Lower regulatory barriers that constrain Spain’s businesses to increase efficiency and employment.
    - Combine with continued wage moderation and more ambitious policies to improve skills for the low-skilled and reduce the high tax cost of employing them.
  - Pursuing growth- and job-friendly fiscal consolidation:
    - Spain has made strong progress cutting its deficit in the last two years, but the deficit is still very large and debt is rapidly approaching 100 percent of GDP.
    - Getting debt to trend down requires further efforts to reduce the deficit; efforts need to be gradual and well-designed to minimize drag on growth and employment and complemented by reforms that boost growth and employment.
  - More support from Europe:
    - Action to address low inflation and financial fragmentation in the Euro area would help the recovery in both the Euro area and in Spain.

### Longer-term approach and structural reforms
- A comprehensive, multi-year approach is required:
  - Implementing recommended reforms should make the recovery stronger and more job-rich but may not be sufficient to generate the high and sustained growth rates Spain needs to reduce unemployment to international norms and catch up with higher income peers.
  - More fundamental and wide-ranging reforms may be needed in education, institutions, barriers keeping firms small, and cross-party determination over many years.
  - Clear and ambitious goals (e.g. getting to the Top 10 in the Doing Business Indicators) could help define a roadmap and build national consensus.

### Private Debt — Reducing Debt Overhang (Context)
- Private sector debt, while falling, remains very high.
  - Firms have been reducing debt faster than households, mainly via a sharp fall in net borrowing driven by sharply lower investment and rising profit margins (partly via a reduction in employment).
  - Decline in debt, investment, and employment has been more acute in sectors that were more leveraged before the crisis: the construction/real estate sector and SMEs.
- The steadily-rising share of firms under financial distress undermines the recovery:
  - Some firms may be operationally viable but hampered by excessive debt.
  - Government measures introduced to facilitate out-of-court debt restructuring for viable firms under financial stress include:
    - A mediation process for smaller firms.
    - For larger firms, legal and regulatory incentives for debt-to-equity swaps.
  - Recently announced plans include:
    1. Strengthen the in-court debt restructuring process along the lines of enhancements in out-of-court mechanisms.
    2. Foster liquidation as a going concern (transferring the business as a whole) instead of piecemeal liquidation.
    3. Introduce a code of good practice to facilitate debt restructuring for SMEs and the self-employed.
    4. Create an inter-ministerial committee to monitor the debt restructuring process.

### Private Debt — Staff views and recommendations
- A more comprehensive, pro-active strategy would help address private, especially SME, debt overhang:
  - In-court restructuring options are too limited; processes are too expensive and slow.
  - Public creditors (tax agency, social security) have little flexibility for out-of-court restructuring and are not brought to the negotiating table with other creditors, particularly problematic for SMEs.
  - A comprehensive and voluntary strategy, catalyzed by the official sector and aligning incentives of all stakeholders, could accelerate restructuring and enhance growth prospects (example cited: Korea in the late 1990s).
  - An oversight body with public and private participation could oversee, coordinate, and drive the process, including reporting qualitative and quantitative debt restructuring statistics.
- Authorities could evaluate “all the tools of the trade” to support corporate restructuring, including:
  1. Increase the effectiveness of in-court and out-of-court workouts by providing more tools to public creditors to fully engage (to maximize tax collection from a forward-looking perspective), facilitating going concern sales, speeding up procedures, and introducing a personal insolvency regime to help individual entrepreneurs.
  2. For larger firms, issue centralized guidelines for voluntary out-of-court workouts, coupled with independent mediation by a centralized body.
  3. For SMEs, develop a menu of standardized voluntary workouts for operationally viable firms, including harmonized restructuring terms, and indicative targets for financial institutions to offer/agree to restructurings.
- Authorities’ stance:
  - Open to further measures to grease the corporate restructuring machinery and saw merit in a coordinating body and a possible code of good practices.
  - Cautious about further reforms to the insolvency regime; consider increasing scope/flexibility of in-court restructuring, speeding up procedures, and harmonizing out-of-court mechanisms including for SMEs.
  - Skeptical about involving public creditors more fully at this juncture due to concerns about undermining Spain’s payment culture and financial stability.
  - Introducing a personal insolvency framework with a possibility of a fresh start may warrant consideration in the medium term but should be carefully studied.

### Banks — Encouraging Lending (Context and achievements)
- ESM-supported program was successfully completed in January 2014.
- Achievements during the program:
  - Capital has been bolstered:
    - The Core Tier 1 ratio reached 11.8 percent at end-2013, compared with 9.6 percent at the start of the financial sector program.
  - Provisioning has increased:
    - Coverage ratio (specific reserves to NPLs) rose to 46 percent at end-2013, up from 36 percent at the start of the program.
  - Funding has become cheaper and more stable:
    - Deposit and wholesale funding rates fell substantially; deposit volumes stabilized with fewer non-resident deposits; reliance on debt issuance and ECB borrowing fell.
  - Market confidence has returned:
    - Banks’ equity prices have risen strongly—price to book ratios are above unity for the system and above European peers; bank risk premia (CDS spreads) are much lower.
  - Some upside surprises in sale prices of public stakes in state-intervened institutions; banks sold some problem loan portfolios to foreign investors.

### Banks — Remaining challenges (findings)
- Credit is contracting rapidly:
  - Bank credit to firms declining by about 11 percent in March — one of the fastest among advanced economies and only marginally reflects contraction of the real estate sector.
  - Rapid credit contraction may be faster than optimal given the wide output gap and high unemployment.
- Lower funding costs have not translated into significantly lower corporate lending rates:
  - Deposit rates have declined by nearly 160 bps since 2012, and cost of market funding has come down, but lending rates for firms have only fallen by around 40 bps.
- Core profitability remains weak:
  - Net pre-provision income from core banking activities fell compared to 2012, reflecting lower margins on variable-rate loans and lower loan volumes.
  - Public ownership remains significant; NPL ratio is high at 13½ percent, though it has started falling slightly.
- Core capital comparison:
  - At end-2013, average core Tier 1 ratio for the largest 150 European banks (excluding the 11 Spanish banks) was 14.2 percent of risk-weighted assets; for the largest 11 Spanish banks it was 11.9 percent.
  - Spanish banks are less levered by leverage measures.

### Banks — Staff views and policy recommendations
- Focus on supporting the recovery while continuing to raise capital ratios over the medium term, preferably by increasing nominal capital rather than contracting credit.
- Recommended actions:
  - Restrain cash dividends (recent guidance from the Bank of Spain is welcome) and bonuses.
  - Issue equity (or similar instruments).
  - Dispose of/restructure distressed assets.
  - Continue to reduce costs and improve efficiency.
- Comprehensive Assessment preparedness:
  - Reforms have helped prepare the system for the Comprehensive Assessment; the system underwent a similar independent asset quality review and stress test.
  - Uncertainties remain: the Comprehensive Assessment applies haircuts to sovereign bonds and reviews samples of banks’ foreign loan portfolios.

### Labor Market — Spurring Employment (Context and findings)
- The 2012 labor reform and wage agreements appear to be moderating wage increases and creating jobs:
  - Reform may have lowered the growth threshold for generating positive net employment (previously the economy needed to grow close to 2 percent).
  - Firm surveys suggest firms with more wage moderation are most likely to maintain or expand employment.
- Government measures to foster employment:
  - Temporary reduction in employer’s social security contributions for new (net) hiring on permanent contracts in 2014.
  - Reform of active labor market policies launched in 2013 with greater focus on results.
  - New initiative for youth employment to improve training/subsidies, job quality, and promote entrepreneurship.
- Employment outlook and structural challenges:
  - Structural unemployment estimated at very high levels by OECD and EC (above 20 percent).
  - Government projections envisage unemployment above 19 percent by 2017.
  - Over six years of the crisis, wages have been slow to respond, placing burden of adjustment on employment.
  - High degree of labor market duality: segmentation between well-protected “insiders” on permanent contracts and precarious “outsiders” who cycle between temporary jobs and unemployment.
  - Low representativeness of collective bargaining combined with broad coverage of collective agreements may bias protection towards “insiders” at the expense of the unemployed and temporary workers.

### Labor Market — Staff recommendations
- Further actions needed to boost employment and reduce duality:
  - Further decentralize wage setting:
    - Enhance ability of individual firms to adapt working conditions (wages and hours) to their specific conditions.
    - Options include facilitating opt-outs by firms (similar to Germany in the 1990s) and extending collective agreements only where unions/business associations represent a majority of workers and/or increasing the number of employees for automatic coverage (examples: Finland, Italy).
  - Cut employer social security contributions for the low paid:
    - These taxes are among the highest in Europe and could constrain labor demand, especially for the low skilled.
    - Fiscal cost could be offset by broader tax reform (see Section F).
  - Reduce duality by making hiring on permanent contracts more attractive:
    - Increase dismissal costs for new permanent contracts gradually with tenure and from a lower initial level (severance payments for permanent contracts remain above the OECD average).
    - This would be less costly to the budget than subsidizing permanent contracts.
  - Improve active labor market policies to improve skills and job matching:
    - Implement aggressively the new employment strategy (including for youth unemployment), especially by regions.
    - Measures include wider use of private job placement agencies, improving training services including opening them up to competition, and establishing a single portal for job vacancies throughout Spain.

*Source: _cr14192 - 10.      Spain’s overarching macro policy*

### 26.      The authorities noted the increasing success of the labor reform and argued the focus

### _cr14192 - 26.      The authorities noted the increasing success of the labor reform and argued the focus

### Labor reform and active employment policies
- The 2012 labor reform has helped achieve wage moderation, greater internal flexibility for firms, and create jobs early in the recovery.
- Current focus: implementation of active employment policies, especially implementing the new strategy based on results and public-private partnerships.
- Authorities' view on staff proposal to reduce social security contributions for the low skilled:
  - Saw some merit in principle.
  - Stressed that similar benefits may arise from the recent flat rate for permanent contracts and that these effects need to be assessed before changes.
  - Highlighted the fiscal cost of staff’s proposal.

### Improving the business environment — context and findings
- Requirement: Spain must significantly raise productivity to sustain high growth; pre-crisis growth relied on large accumulation of capital and labor.
- Total factor productivity (TFP) growth:
  - Has been on a declining trend since the 1990s.
  - Spain and Italy had the worst productivity performance among OECD economies in the years preceding the crisis.
  - TFP rebounded somewhat recently, but improvement partially reflects temporary factors (e.g. large labor shedding in the construction sector); TFP growth remains low.
- Business environment progress:
  - Reforms introduced or in the pipeline, but actual progress in improving the business environment has been modest.
  - Causes: complex, duplicated, and burdensome regulatory framework across different levels of government.
  - Spain’s Doing Business ranking has deteriorated somewhat and remains far from best performers, especially in protecting investors, getting credit, and paying taxes; also ranks low in starting a business and dealing with construction permits.
  - Education outcome indicators remain less strong than many European peers.

### Improving the business environment — staff recommendations
- A concerted national effort is needed to press ahead with a reform agenda to promote a new growth model; top priorities: reducing structural unemployment and substantially raising productivity.
- Appointing an independent agency on growth and jobs could:
  - Help establish priorities.
  - Garner public support.
  - Monitor progress.
- Complementary reforms:
  - Labor market reform should be accompanied by product and service market liberalization to maximize gains to growth and jobs; improve competition to lower mark-ups and increase purchasing power.
  - Lower entry barriers in services industries to enhance productivity and job creation.
  - OECD analysis suggests Spain could raise yearly growth by about ½ percentage point were it to improve its index of product market regulation to that of the best performers.
- Specific areas to advance without slippage:
  - Ambitious liberalization of professional services.
  - Improve training for the unemployed.
  - Fully implement an energy reform that eliminates the electricity tariff deficit and contains costs while promoting a stable business environment and appropriate levels of investment.
- Role of regions: Given many regulations at all government levels, regions play a critical role; planned introduction of regional World Bank “Doing Business” indicators is positive.

### Market Unity reform (Box 2) — key points
- Objective: reduce barriers to trade across Spain’s regions by rationalizing regulatory framework, reinforcing cooperation among administrations, and encouraging smart regulation.
- Law on the Market Unity:
  - Defines principles, operational framework, appeal process, resolution procedures, and cooperation and supervision networks.
  - Ambitious screening process identified about 2,700 regulatory barriers (mainly at the subnational level) that contradict the new law and need elimination.
- New expeditious appeal process:
  - Firms can enter an expeditious appeal process when public action contradicts market unity and creates barriers to trade across regions.
  - Appeal process done through the Secretary of Market Unity assisting the Council of Market Unity.
  - Early successful cases include barriers to sell agricultural and pharmaceutical products across different regions.
- Success conditions:
  - Strong commitment and cooperation by central and subnational governments.
  - Swift alignment of existing regulations to the new legal framework.
  - Adequate resources to ensure the appeal process is effective.

### Fiscal policy — context and key statistics
- Fiscal consolidation continued in 2013, but public debt is still rising.
- Debt is rapidly approaching 100 percent of GDP and is already above the Euro area average.
- Requirement: Putting debt onto a firmly-declining path requires maintaining a primary surplus of at least 2 percent of GDP.
- Implication: This entails improving the primary balance by some 6 percent of GDP compared with 2013.
- Quality of fiscal consolidation is improving with institutional and policy changes:
  - Strong pension reform passed to ensure sustainability.
  - Public administration reform (CORA) to reduce wasteful spending by eliminating duplication and overlapping functions across government levels.
  - Fiscal council (AIReF) created to improve credibility and design of consolidation by monitoring and evaluating policies.
  - Planned tax reform with independent committee recommendations; government indicated likely measures include:
    - Unifying the corporate income tax rate at 25 percent (currently 20/25/30 percent depending on turnover).
    - Lowering the number of personal income tax brackets, increasing the threshold for the lowest rate, and reducing the top rate.
    - Preferential treatments under the VAT would not be altered (government indication).

### Fiscal policy — government strategy and projections (selected figures)
- Government strategy: reduce the deficit to below 3 percent of GDP by 2016, mainly by containing spending.
- Revenue-to-GDP ratio projected to remain broadly constant around 39 percent of GDP in the medium term.
- Planned substantial decline in public consumption of 3 percent of GDP; public investment remaining low.
- Staff projections and Stability Program Update (percent of GDP) — selected lines:
  - Authorities' Stability Program Update (2014–2017):
    - Revenue: 38.5, 38.8, 38.9, 39.0
    - Expenditure: 44.0, 43.0, 41.7, 40.1
    - Fiscal balance: -5.5, -4.2, -2.8, -1.1
    - Primary balance: -2.0, -0.6, 0.9, 2.7
    - Change in cyclically adjusted primary: 0.6, 0.6, 0.6, 0.7
    - Gross public debt: 99.5, 101.7, 101.5, 98.5
  - IMF staff projections (2014–2017):
    - Revenue: 38.1, 38.1, 38.4, 38.6
    - Expenditure: 43.9, 42.8, 42.2, 41.6
    - Fiscal balance: -5.7, -4.7, -3.8, -2.9
    - Primary balance: -2.2, -1.2, -0.2, 0.6
    - Change in cyclically adjusted primary: 0.6, 0.6, 0.6, 0.5
    - Gross public debt: 98.5, 100.9, 102.0, 102.1
  - Note: 2014 forecast based on 2014 budget; medium term forecast assumes annual improvement of 0.6 % of GDP in the cyclically adjusted primary balance.

### Fiscal policy — staff views and recommendations
- Pace of consolidation: continue gradual, but steady. Recommended structural consolidation pace of about ½-¾ percent a year.
- Need for a more fully fleshed out medium-term strategy; targets for 2015–17 may need revision if nominal GDP growth disappoints.
- Further scope for improving spending efficiency, and case for revenue to play a larger role:
  - Complement CORA with a public expenditure review across all government levels of key functions.
  - Improve targeting of social spending to protect the most vulnerable and generate efficiency savings.
  - Given required adjustment size and Spain’s relatively low revenue ratio, rely more on revenue to achieve consolidation.
- Forthcoming tax reform as a critical opportunity to support consolidation with a more growth- and job-friendly tax system; main elements suggested:
  - Enhance overall revenue ratio by relying more on indirect taxes (raise excise duties and environmental levies, gradually reduce preferential VAT treatments) while explicitly protecting the most vulnerable through transfers and tax credits (e.g., income tax credits for the low paid, enhancing regional minimum income programs).
  - Sharply cut taxes on employing the low paid: sharply and permanently cut social security contributions paid by employers on the low paid; recommend reductions be structured as tax credits financed by transfers from the budget to protect the social security system.
  - Broaden the base of direct taxes by cutting exemptions and special treatments to allow cutting the top corporate rate to 25 percent while maintaining the effective rate and revenue; limited scope to significantly cut top personal income tax rates due to need to protect revenue and progressivity.
  - Additional measures to enhance revenue and progressivity: lower the threshold for the top personal income tax rate, more fully use recurrent property and inheritance taxes, and reduce tax fraud.

### Authorities’ views on fiscal policy
- Authorities are confident the ambitious fiscal targets will be met in the context of the envisaged strong recovery.
- Emphasized the high fiscal effort in recent years among advanced economies and commitment to public finance sustainability.
- Noted high procyclicality of tax revenue bases explains why tax revenue-to-GDP ratios and the cyclical balance are likely to increase more in a sustained domestic-demand-led recovery.
- Support for a growth- and job-friendly consolidation relying on both revenues and high-quality spending; see scope for additional spending savings via streamlining public administration.
- Support broadening income tax bases and reducing tax evasion; cautious about increasing preferential VAT rates as it could stifle recovery.
- Expect public debt-to-GDP ratio will start declining after 2015.

### Fiscal risks and vulnerabilities (Figure 5 findings)
- Tax shortfalls in 2013 were compensated by other revenue over-performance.
- Public debt has been rising fast and vulnerabilities remain high.
- Interest-growth differential is still negative despite recent declines in yields.
- Subnational levels (Social Security, Municipalities, Regions, Central Government) have driven consolidation efforts.
- Scenarios shown: baseline, contingent liabilities shock, growth shock, constant primary balance, no inflation — illustrating sensitivity of gross public debt projections.

### Europe and ECB policy — context and views
- Decisive European actions (ECB LTROs and OMTs) have supported Spain’s recovery and improved sovereign yields.
- ECB policy transmission remains impaired; lower policy rates since 2011 have not transmitted into lower lending rates for Spanish SMEs (which account for almost two thirds of total employment).
- On June 5, the ECB announced actions including: lower policy rates; targeted credit easing (TLTROs); and extension of fixed rate full allotment.
- Staff view: Euro Area policies could help Spain by lowering borrowing costs for firms and households, reducing risk of protracted very low or negative inflation, and increasing demand for Spanish exports.
  - Recommend more monetary easing by the ECB to achieve price stability and support Euro area demand while reducing financial fragmentation.
  - Reducing fragmentation requires completing the banking union, including a common fiscal backstop, and a sound and credible Comprehensive Assessment.
  - If Euro area inflation remains too low, the ECB should consider more substantial balance sheet expansion, including asset purchases.
- Authorities agree further European actions are warranted:
  - Monetary transmission mechanism remains impaired and financial fragmentation drives higher Spanish borrowing rates for SMEs.
  - Recent ECB actions to repair transmission and achieve inflation target are warranted and will help Europe’s recovery.
  - A weaker Euro and stronger domestic demand by other Euro area countries would help rebalancing.
  - Authorities emphasize support for the recent banking union agreement.

*Source: _cr14192 - 26.      The authorities noted the increasing success of the labor reform and argued the focus*

### Box 3. How Policies in the Euro Area Could Help Spain’s Ongoing Adjustment

### Box 3. How Policies in the Euro Area Could Help Spain’s Ongoing Adjustment

### Supportive monetary policy to achieve inflation targets
- Higher Euro area inflation consistent with the ECB target would support Spain’s recovery by enabling either:
  - (1) greater competitiveness gains for a given level of Spanish inflation, or
  - (2) the same competitiveness gains with a higher level of Spanish inflation, which would aid recovery through three channels:
    - Lowering real labor costs would become easier given nominal wage rigidity, supporting employment growth
    - Lowering the real burden of Spain’s high private debt and lending rates
    - Easing fiscal consolidation efforts—higher inflation increases the real gain from nominal primary expenditure restraint, lowers the real cost of interest payments, and lowers the debt ratio

### Reducing fragmentation to improve monetary policy transmission
- The ECB’s policy rate is described as already too tight for Spain and is not being fully transmitted into lower lending rates for Spanish firms, especially SMEs.
- Contributing factor: fragmentation of the European banking system; European banks reduced their exposure to Spain by about half since 2007.
- Staff estimates: substantially reducing the spread compared to Germany of the Spanish sovereign and banks could narrow, by up to 40 percent, the gap between Spanish and German short-term interest rates on lending to small firms.

### Key Q&A points on staff analysis (selected)
- On wage moderation:
  - Concern: lower wages might exacerbate aggregate demand weakness and increase profits without creating jobs.
  - Staff response: real wages remain above 2007 levels despite large job losses; recommended wage moderation means nominal wage increases that gradually reduce the real cost of employing people until unemployment is at a more acceptable level. Expected outcomes include more hiring, greater job security, higher private consumption, greater investment, and boosted net exports. Staff also argue for opening protected nontradeable sectors to competition to reduce excessive profit margins.
- On the output gap:
  - Acknowledgement: output gap estimates are especially uncertain; staff increased its estimate of the negative output gap relative to the April WEO reflecting revisions and model estimates.
  - Two observations:
    - Even assuming a higher output gap, unemployment in Spain has a large structural component and, without stronger structural reforms, is expected to persist for a very long time. Authorities’ projections (which assume a much higher output gap) still have unemployment around 20 percent by 2017.
    - Assuming a larger output gap that would close quickly could lead to misleading policy implications—potentially delaying needed labor market improvements or fiscal consolidation and casting doubt on the sustainability of current account improvements.
- On a “fresh start” in insolvency:
  - Experience from many EU countries (e.g., Germany) shows fresh start can be introduced without undermining payment culture or increasing cost of credit.
  - Proposed design: benefit only after a period of good faith monitored efforts, repayment of what is reasonably possible, and surrender of non-exempt assets (e.g., house). The number of years until fresh start could be set where expected payments (net of collection costs) are nil for creditors (Germany example: fresh start initially granted after 7 years).
  - Expected societal benefits: encourage entrepreneurship, preserve human capital, and increase participation in the formal economy.
  - High reliance on mortgages argues for caution but also action to ensure bankruptcy regime is sound.
- On deflation risks:
  - Low or slightly negative inflation in Spain is helpful for competitiveness, but protracted very low or negative inflation in the Euro area could eliminate gains from Spanish disinflation and risk persistent deflation, which would be particularly harmful given high public, corporate, and household indebtedness.
  - Factors limiting deflation risk:
    - There has been only one month of negative core inflation since mid-2010.
    - Part of CPI fall reflects declining import prices, which should reverse.
    - The share of the CPI basket with negative inflation has declined recently.
    - Private consumption is rebounding and wage growth trends remain positive (although low).
    - The ECB is acting to address the risk of persistent undershooting of region-wide inflation.
- On tax reform and VAT:
  - Raising VAT on food would affect the poor and vulnerable and therefore compensation (e.g., increased social transfers or tax credits financed by extra VAT revenue) is critical.
  - Raising VAT on restaurants and hotels would affect tourism but could be offset by lower wage costs if social security contributions are cut for the low paid, financed by higher VAT revenue.
  - Advice should be seen as part of a package of measures, not in isolation.

### Output gap and VAT numerical highlights (preserve source figures exactly)
- Spain: Output Gap Estimates (as percent of potential output) 2014
  - April WEO-3.1
  - OEC D (Economic Outlook, May 2014)-5.0
  - Current staff report-5.1
  - European Commission-6.7
  - Authorities (Stability program update)-8.3
- Spain vs. EU: Super-Reduced and Reduced VAT Rates, Selected Goods and Services (percent)
  - CategoryS
  - pain                         EU                         average 
  - 1/ Foodstuff4,1013.2
  - Construction work on new buildin
  - gs  4,1019.1
  - Hotel accom odation1011.1
  - Restaurants1015.7
  - Bars and cafes1018.3

### Staff appraisal and policy recommendations
- Recovery status and challenges:
  - Spain has turned the corner; recovery is underway and labor market trends are improving.
  - Persisting problems: 5.9 million people are unemployed, more than half of them for more than a year; average household income remains below pre-crisis levels; households, firms, and the government still face heavy debt burdens.
- Recommended continuing efforts:
  - Continue measures across fiscal, banking, and labor market fronts to ensure recovery is strong, long-lasting, and inclusive so the unemployed benefit from more job opportunities.
  - Reduce financial stress of operationally-viable firms through a comprehensive, coordinated strategy; government participation is appropriate given public interest.
  - Implement a personal insolvency framework allowing an eventual fresh start while preserving payment culture.
  - Bolster banks’ ability to support the economy:
    - Banks should continue to raise capital levels over time, including by limiting cash dividends and bonuses, and reducing costs.
  - Lower regulatory barriers to increase business efficiency and employment, including implementing the Market Unity law and opening up professional services.
  - Make the labor market more inclusive and responsive:
    - Help the unemployed improve skills and find work.
    - Strike a better balance between highly-protected permanent contracts and precarious temporary contracts to increase permanent hiring.
    - Enhance firms’ ability to adapt remuneration to specific conditions to better align productivity to wages.
  - Use forthcoming tax reform to:
    - Protect public services by raising revenues.
    - Create jobs for the low skilled by cutting social security contributions firms pay when employing them, financed by higher revenue.
    - Promote inclusive growth by broadening the base of income taxes while preserving progressivity.
- Expected macro benefits:
  - These reforms would help reduce Spain’s external vulnerabilities by increasing competitiveness, supporting continued fiscal consolidation, strengthening the current account surplus, and helping bring Spain’s highly negative international investment position to safer levels.
  - Stronger policies by Spain’s European partners would also help by lowering borrowing costs for Spanish firms and households, reducing the risk of protracted very low or negative Euro area inflation, and increasing demand across the Euro area.

*Source: Box 3, "How Policies in the Euro Area Could Help Spain’s Ongoing Adjustment."*

### 62.      It is proposed that Spain remain on the regular 12-month Article IV cycle.

### _cr14192 - 62.      It is proposed that Spain remain on the regular 12-month Article IV cycle.

### Overview / Executive summary
- Imbalances built up during the boom years are being gradually addressed.
- The current account has swung into surplus.
- Net international investment position (Net IIP) is stabilizing, but remains very negative.
- Private sector debt is declining, though household debt-to-GDP is only slowly falling due to falling nominal income.
- Spain's competitiveness is improving and house prices dropped by a third; construction's share of GDP has fallen to historical norms.
- Financial market indicators show declining sovereign risk premia since the OMT announcements in mid-2012; bank risk has fallen and equity prices rose sharply in 2013.

### External sector and imbalances
- Current account:
  - Turned into a surplus; current account balance projections: 2014: 0.6, 2015: 0.7, 2016: 1.1, 2017: 1.2, 2018: 1.5, 2019: 1.7 (percent of GDP).  (Table 5)
  - Change in current account 2008-2013 (change in balances, % GDP) shown by components: Income, Goods and services, Transfers.
- Net IIP:
  - Net international investment position levels: -89, -91, -93, -98, -96, -92, -88, -83, -79, -73 (series across years; percent of GDP). (Table 5 / Table 6)
  - Net IIP (billions of euro): -823, -863, -982, -931, -956, -955, -1,004 (2007–2013). (Table 6)
  - Net IIP deterioration in part due to valuation effects despite current account surplus.
- Portfolio and other flows:
  - Portfolio investments (billions of euro) show volatile inflows/outflows across 2007–2013; notable portfolio investment liabilities: 1,086.9, 958.0, 1,068.1, 946.2, 842.3, 790.2, 903.0 (assets/liabilities series). (Table 6)
- TARGET2 claims and other indicators have declined as funding market access improved.

### Financial sector and markets
- Sovereign spreads and CDS:
  - 10-Year Government Bonds vis-à-vis Germany and Sovereign CDS (USD 5 Year Senior) show declining premia since OMT announcements (mid-2012).
- Banks' risk and market prices:
  - Banks' CDS EUR 5 Year Senior and stock prices (Jan. 1, 2010 = 100) rose/fell reflecting improved sentiment in 2013.
  - Liquidity pressure described as limited; use of ECB refinancing peaked: Use of ECB refinancing (billions of euro) series includes 21.2, 52.3, 92.8, 1.4, 69.7, 132.8, 357.3, 206.8, 185.0 (table entries).
- Financial soundness indicators (selected):
  - Regulatory capital to risk-weighted assets: 11.9, 11.4, 11.3, 12.2, 11.9, 12.2, 11.6, 13.3 (2006–2013 series). (Table 2)
  - Tier 1 capital to risk-weighted assets: 7.5, 7.9, 8.2, 9.4, 9.7, 10.3, 10.0, 11.8 (2006–2013 series). (Table 2)
  - Non-performing loans (billions of euro): 10.9, 16.3, 63.1, 93.3, 107.2, 139.8, 167.5, 197.2, 195.1 (2006–2013 series). (Table 2)
  - Non-performing to total loans (percent): 0.7, 0.9, 3.4, 5.1, 5.8, 7.8, 10.4, 13.6, 13.4 (2006–2013 series). (Table 2)
  - Exposure to construction sector (billions of euro): 378.4, 457.0, 469.9, 453.4, 430.3, 396.9, 300.4, 237.0, 237.0 (2006–2013 series). (Table 2)

### Credit conditions and households
- Credit dynamics:
  - Private sector debt (percent of GDP): 295, 282, 270, 255, 243, 238, 235, 231, 227, 223 (series in Table 1).
  - Corporate debt: 203, 192, 182, 172, 170, 168, 166, 164, 161, 158 (percent of GDP). (Table 1)
  - Household debt: 92, 90, 88, 83, 73, 71, 69, 68, 66, 65 (percent of GDP). (Table 1)
  - Credit to private sector growth: 0.8, -3.2, -9.9, -10.2, -1.3, -0.8, 1.3, 1.3, 1.0, 1.0 (percent change series). (Table 1)
- Interest rates and credit standards:
  - Short-term interest rates on small loans to NFCs and on large loans remain elevated relative to peers; fragmentation of lending rates to businesses remains high, reflecting incomplete banking union.
  - Interest rates on new mortgages (fixed up to 1 year) for Italy, Spain, Euro Area, Germany series indicate mortgage rates broadly similar to euro area average.
  - Credit standards have not eased in general, but have improved slightly for SMEs; change in credit standards (net percentage balance) shows tightening historically with slight recent improvement for SMEs. (Figure 8)
- Household finances:
  - Household saving rate (gross saving rate except for Germany, %): series show falling disposable income pushed saving rate back to pre-crisis levels; specific series for countries are depicted in Figure 9.
  - Household interest burden (percent of household gross disposable income) rose; interest burden series across 1999–2013 shown in Figure 9.
  - Household NPLs: consumer loans and mortgages show rising NPL shares; household NPLs (percent total loans in each category) series shown in Figure 9.
  - Household wealth (percent of GDP): total wealth, real-estate wealth, net financial wealth series declined during the crisis (Figure 9).

### Macroeconomic projections and public finances
- Real GDP growth (projections, percent change):
  - 2013: -1.2; 2014: 1.2; 2015: 1.6; 2016: 1.7; 2017: 1.8; 2018: 1.9; 2019: 2.0 (Table 1, row "Gross domestic product").
- Demand components (percent change):
  - Private consumption 2013: -2.1; 2014: 1.6; 2015: 1.3; 2016: 1.3; 2017: 1.6; 2018: 1.6; 2019: 1.7.
  - Gross fixed investment 2013: -5.1; 2014: -0.5; 2015: 2.1; 2016: 2.1; 2017: 2.3; 2018: 2.3; 2019: 2.4.
  - Construction investment 2013: -9.6; 2014: -5.9; 2015: -0.3; 2016: 0.8; 2017: 1.4; 2018: 1.8; 2019: 2.2.
- Labor market and prices:
  - Unemployment rate (percent): 2013: 26.1; 2014: 24.9; 2015: 23.8; 2016: 22.6; 2017: 21.4; 2018: 20.1; 2019: 18.7. (Table 1)
  - HICP (average) projection: 2014: 0.1; 2015: 0.8; 2016: 1.0; 2017: 1.1; 2018: 1.3; 2019: 1.4. (Table 1)
- Public finances:
  - General government balance (percent of GDP): 2013: -6.6; 2014: -5.7; 2015: -4.7; 2016: -3.8; 2017: -2.9; 2018: -2.2; 2019: -1.8. (Table 1 / Table 3)
  - Primary balance: 2013: -4.1; 2014: -2.7; 2015: -1.6; 2016: -0.7; 2017: 0.2; 2018: 0.9; 2019: 1.3.
  - Structural balance: 2013: -4.0; 2014: -3.5; 2015: -2.9; 2016: -2.3; 2017: -1.8; 2018: -1.5; 2019: -1.4.
  - General government gross debt (Maastricht): 2013: 99; 2014: 101; 2015: 102; 2016: 102; 2017: 101; 2018: 100; 2019: 100 (percent of GDP). (Table 3)
- Savings and investment (percent of GDP):
  - Gross domestic investment: 2013: 17.7; 2014: 17.3; 2015: 17.3; 2016: 17.4; 2017: 17.4; 2018: 17.5; 2019: 17.5.
  - National savings: 2013: 18.4; 2014: 18.6; 2015: 19.0; 2016: 19.0; 2017: 19.2; 2018: 19.2; 2019: 19.2.
- Memorandum and fiscal notes:
  - The headline deficit for Spain excludes financial sector support measures equal to 0.5 percent of GDP for 2011 and 2013, and 3 ¾ percent of GDP for 2012. (Table 1 note)

### Key statistics (selected exact figures preserved from source)
- House prices dropped by a third (Figure 6 caption).
- Investment in Construction (percent of GDP) historical series and projections shown; construction share fell to historical norms (Figure 6).
- House Price-to-Income Ratio (1990-2013 = 100) comparative series for UK, Spain, US, Ireland (Figure 6).
- Private sector debt (percent of GDP): 295, 282, 270, 255, 243, 238, 235, 231, 227, 223. (Table 1)
- Net international investment position (percent of GDP): -89, -91, -93, -98, -96, -92, -88, -83, -79, -73. (Table 5 / Table 6)
- Unemployment rate (percent): 19.9, 21.4, 24.8, 26.1, 24.9, 23.8, 22.6, 21.4, 20.1, 18.7 (2010–2019 series). (Table 1)
- General government gross debt (Maastricht): 70, 86, 94, 99, 101, 102, 102, 101, 100, 100 (2009–2019 series). (Table 3)

_Italic: IMF staff report content as provided in the source PDF._

### Appendix I. Public Debt Sustainability Analysis

### Appendix I. Public Debt Sustainability Analysis

### Summary findings
- Public debt sustainability risks remain significant although mitigated by strong policy commitment and favorable market sentiment.
- Under the baseline scenario, public debt is projected to peak at 102 percent of GDP before declining to 100 percent in 2019 as the fiscal imbalances are reduced and economic recovery gains traction.
- Gross financing needs are expected to remain around 17 percent of GDP during the medium term which is above early warning benchmarks.
- Debt dynamics is highly vulnerable to fiscal adjustment, growth, and contingent liabilities shocks.

### Background
- Public debt comprises Excessive Deficit Procedure (EDP) debt in hands of the General Government.
- The General Government includes the Central Government, Regional Governments, Local Government, and Social Security Funds. It does not include public enterprises.
- EDP debt is a subset of General Government consolidated debt (i.e., it does not include trade credits and other accounts payable) and the stocks are recorded at their nominal value.
- The public debt-to-GDP ratio increased from 36 percent of GDP in 2007 to 94 percent in 2013, driven by large fiscal deficits.
- The composition of public debt is tilted towards long-term debt (89 percent of the total), similar to the pre-crisis ratio. The fraction of public debt in hands of domestic residents increased from 52 percent in 2007 to 64 in 2013.

### Baseline projections and underlying assumptions
- Debt path:
  - Debt is projected to continue increasing and peak at 102 percent of GDP in 2017, before declining to 100 percent by 2019.
- Main baseline assumptions:
  - i) a gradual and steady fiscal consolidation until the fiscal deficit is below 3 percent of GDP; and
  - ii) gradual acceleration in real GDP growth over the medium term.
- Reasons staff considers gradual and steady fiscal consolidation the most likely scenario:
  - i) the authorities have shown strong commitment to fiscal consolidation by substantially reducing the primary deficit during 2012–13, in the middle of a recession;
  - ii) the Stability Program Update 2014–17 envisages such a fiscal consolidation plan;
  - iii) the Spanish Constitution was amended in 2011 to include the limits to fiscal deficits and public debt set in the Stability and Growth Pact;
  - iv) the fiscal framework was strengthened further with the new Budget Stability Law approved in 2012, including new tools to enforce fiscal discipline and an explicit target of structural fiscal balance by 2020;
  - v) fiscal transparency was significantly enhanced with monthly reporting of fiscal outturns for the General Government except Local Governments;
  - vi) there is broad consensus on the need to reduce fiscal imbalances and contain fiscal vulnerabilities.
- Baseline macro-fiscal paths (selected series, in percent):
  - Real GDP growth: 2014: 1.2; 2015: 1.6; 2016: 1.7; 2017: 1.8; 2018: 1.9; 2019: 2.0.
  - Inflation (GDP deflator): 2014: -0.1; 2015: 0.8; 2016: 1.0; 2017: 1.1; 2018: 1.4; 2019: 1.4.
  - Primary Balance: 2014: -2.2; 2015: -1.2; 2016: -0.2; 2017: 0.6; 2018: 1.4; 2019: 1.8.
  - Effective interest rate (in percent): 2014: 3.8; 2015: 3.7; 2016: 3.6; 2017: 3.6; 2018: 3.6; 2019: 3.7.
- Historical note: growth outcomes in Spain have tended to be worse than projected during the financial crisis; current near-term growth projections are somewhat below consensus and staff believes that risks are broadly balanced.

### Stress tests and scenarios (selected results)
- Primary balance shock:
  - The primary balance in 2015–16 is hit by a shock equal to 2.7 percent of GDP (50 percent of the 10-year historical standard deviation of the primary balance-to-GDP ratio).
  - This shock results in a debt-to-GDP ratio about 6 percentage points higher than the baseline by 2019.
- Growth shock:
  - Real GDP growth rates are 1.3 percent lower in 2015–16.
  - The debt-to-GDP ratio reaches 111 percent by 2019 (11 percentage points higher than the baseline).
- Interest rate shock:
  - Nominal interest rates increase by 200 basis points during 2015–19.
  - The effective interest rate increases to 4.5 percent by 2019 compared to 3.7 percent in the baseline.
  - The debt-to-GDP ratio reaches 102 percent in 2019 (2 percentage points higher than the baseline).
- Combined shock:
  - A simultaneous combination of the previous three shocks would result in an increasing debt-to-GDP ratio that reaches 115 percent in 2019 (15 percentage points higher than the baseline).
- Contingent liability shock:
  - A one-time increase in non-interest expenditures equivalent in 2015 to 10% of GDP (e.g., via private debt migrating to public debt) combined with lower growth and lower inflation in 2015–16 (i.e., growth is reduced by 1 standard deviation) results in an increasing debt-to-GDP ratio that reaches 119 percent in 2019 (19 percentage points higher than the baseline).

### Debt dynamics, market and financing indicators
- Gross financing needs:
  - Public gross financing needs are presented as elevated; the report states: Gross financing needs are expected to remain around 17 percent of GDP during the medium term which is above early warning benchmarks.
- Debt composition vulnerabilities:
  - Long-term debt constitutes 89 percent of total public debt.
  - Public debt held by domestic residents increased to 64 percent in 2013.
- External debt and external financing (selected indicators):
  - External debt (baseline series) declines from 150.2 (2013) to 129.3 (2019) in projections.
  - Identified external debt-creating flows include current account deficits and net capital flows, with the current account deficit (excluding interest payments) projected to widen to -7.7 percent of GDP by 2019 under the baseline external-debt framework.
  - Gross external financing need (in percent of GDP) and gross financing needs in dollar terms are reported in the external DSA tables.

### Analysis and policy implications (as presented by staff)
- Debt dynamics are sensitive to slippages in fiscal consolidation, weaker-than-expected growth, increases in interest rates, and materialization of contingent liabilities.
- The baseline path relies on credible and sustained fiscal consolidation supported by institutional and legal reforms (Constitution amendment, Budget Stability Law), enhanced fiscal transparency, and broad political consensus.
- Stress tests indicate that sizeable shocks—particularly growth and contingent liability shocks—could lead to substantially higher debt ratios, underscoring the importance of:
  - maintaining fiscal consolidation to achieve the path toward a structural fiscal balance by 2020;
  - continuing reforms that bolster growth to reduce the vulnerability of debt dynamics;
  - containing and monitoring contingent liabilities to prevent large one-off fiscal costs.

*Source: IMF staff. As of June 15, 2014.*

### Appendix II. Key Recommendations—Independent Tax Reform Committee

### Appendix II. Key Recommendations—Independent Tax Reform Committee

### Strategy: broaden bases, shift from taxing labor to consumption, revenue neutrality
- Revenue-neutral shift from direct taxes (PIT, CIT, and wealth taxes, social contributions) to indirect taxes (VAT, excise duties and environmental levies) to support growth and efficiency
- Additional cut in employer’s social security contribution for the low-paid (fiscal devaluation), with timing left open
- Broaden the tax base by eliminating non-justified tax exemptions, allowances, and reducing statutory rates to simplify the tax system and improve its fairness
- Achieve greater neutrality, in particular by removing “debt bias”
- Reduce tax fraud

### Personal Income Taxes (PIT): Reduce progressivity, equalize tax treatment of assets
- Reduce number of brackets to four, cap top rate at 50 percent, and reduce bottom and top rates
- Harmonize tax treatment of capital income with respect to maturity, inflation-adjustment, gain-loss symmetry
- Tax property income under savings base not subject to progressive rates, as done with movable capital
- Modify the property income tax base to include inputted rent and, retroactively, mortgage interest payments
- Eliminate a number of partial exemptions, including on dividends and profit-sharing, employers’ fringe benefits

### Corporate Income Taxes (CIT): bring legal and effective rates closer, remove debt bias
- Cut the top corporate income tax rate first to 25 percent, then to 20 percent; broaden the base and unify the rates
- Reduce the debt bias by replacing current earning stripping rule with a standard thin capitalization rule
- Introduce a 10 percent levy on the (currently exempt) foreign sourced income of Spanish multinationals
- Remove tax credits on R&D, re-investment earnings, job creation for specific groups, environmental investments

### Social Security Contributions: modernize then cut
- Transform social security contributions into a payroll tax (harmonize labor income base under PIT)...
- ...merge social security administration into general tax administration...
- only then reduce employer social security contributions
- Restrict rebates (wage subsidies) to vulnerable groups not reachable by active labor market policies

### Property and wealth Taxes: simplify and streamline
- Eliminate wealth, transfer and stamp taxes
- Reduce exemptions under the inheritance and gift tax

### Value-Added Taxes (VAT): mobilize revenues by broadening base of standard rate
- Increase reduced rates to standard for all items except housing, transportation, and tourism
- Increase tourism rates subject to fiscal devaluation; increase super-reduced rates subject to compensation for the poor.
- Remove exemptions (e.g. postal services) not dependent on EC regulations.

### Excise and Environmental Taxes: align with EU practices and directives
- Increase excises in alcohol and tobacco to EU averages
- Split tax on hydrocarbons into taxes on energy and carbon emissions; increase rate on diesel towards gasoline first
- Switch electricity tax from ad-valorem to specific (kilowatt-hours)
- Eliminate environmental taxes imposed by regions

### Tax Decentralization: harmonize and devolve
- Empower the Fiscal and Financial Policy Council to set common nationwide limits on devolved taxes.
- Allow regions to establish co-payment schemes for public services under their remit.

### Tax Fraud: reduce scope for abuse
- Eliminate (simplified and beneficial) regimes (e.g. under VAT, PIT) for small taxpayers

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### Spain: Risk Assessment Matrix — Selected risks, likelihood, impact, and policy responses
- Risk 1: Advanced economies: Lower-than-anticipated potential growth and persistently low inflation
  - Relative Likelihood: High
  - Impact if Realized: High
    - Spanish exports could be hit, especially to Europe
    - Persistently low Euro area inflation makes adjustment for Spain more difficult
    - A weaker recovery would worsen private and public debt dynamics
  - Policy response:
    - The ECB should loosen monetary policy further
    - Fiscal targets may need to be revised
    - Deepen and accelerate structural reforms

- Risk 2: Surges in global financial market volatility
  - Relative Likelihood: High
  - Impact if Realized: Medium
    - Spain has so far seen limited impact from UMP volatility and partly benefitted from some EM debt outflows
    - While the subsidiary model is a mitigating factor, the profitability of Spanish banks’ EM exposure could be hit
    - Banks’ market funding could become more expensive
  - Policy response:
    - ECB policy actions could help reduce financial market volatility
    - Increase reforms that support investor confidence (e.g. credible medium-term fiscal plans)

- Risk 3: Euro area: Sovereign stress re-emerges
  - Relative Likelihood: Low
  - Impact if Realized: Medium
    - Potential market tension is mitigated by the availability of the OMT
    - The AQR/ stress test could lead to some additional capital and provisioning needs
    - Banks’ market funding could become more expensive
  - Policy response:
    - The banking union should be strengthened and completed; a credible AQR/ stress test is key
    - Further monetary easing. Apply for OMT if severe
    - Banks should further build capital buffers

- Risk 4: Structural reform slippage amid a more difficult political and social environment
  - Relative Likelihood: Medium
  - Impact if Realized: High
    - Slow structural adjustment especially in the labor market would undermine growth and employment
    - Fiscal sustainability may be questioned
    - Social support for reforms could weaken
  - Policy response:
    - Set clear reform timetable and keep to it
    - Reduce politicization of reform by fostering independent agencies, such as the fiscal council
    - Enhance communication of reform benefits

(Note: The Risk Assessment Matrix footnote defines “low” as a probability below 10 percent, “medium” as between 10 and 30 percent, and “high” as 30 percent or more.)

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### Supplementary information: June 20, 2014 government tax reform proposal (selected measures and numerical items)
- Context: On June 20, the government announced a tax reform proposal aiming to boost growth and employment mainly through reductions in personal and corporate income tax rates. After a public consultation, a revised draft will be submitted to the Council of Ministers by mid-July. A draft law needs to be submitted and approved by Parliament by end-November to be effective for 2015.
- Fiscal cost (authorities’ estimate): 0.9 percent of GDP through 2016 (0.6 percent of GDP after factoring in significant second-round effects).
- Personal Income Taxes (PIT) — Key proposal elements:
  - Phased reductions in all marginal tax rates. Number of brackets reduced.
  - Increase allowances for those with numerous, old, or disabled dependents
  - Limit deductions, including for (1) rental income (2) dividends (3) severance compensation, except for low-wage workers, and (4) multi-year/irregular income
  - Phased reductions in all marginal tax rates on savings and new savings vehicle created
  - Exempt income from bank deposits/life insurance up to €5,000 yearly for five years

- Corporate Income Tax (CIT) — Key proposal elements:
  - Phased unification of the standard rate to 25 percent in 2016
  - Restrict deductions for impairment and tax loss carry forward. Deduction for reinvestment replaced by 10 percent reduction in tax base for that purpose.
  - Preferential tax treatment for SMEs strengthened: 10 percent reduction of their tax base up to €1 million (in addition to other benefits under the existing special SME regime)

- Other proposed measures:
  - Increase VAT rates for certain healthcare products in line with EU law
  - Restrict eligibility to participate in the presumptive method of estimating income to activities with turnover and expenditure less than €150,000 (from €450,000/300,000, respectively)

- Presented Income Bracket examples (as shown in the proposal tables):
  - Previous and Current PIT brackets and marginal rates (partial listing):
    - 2011 2012-14: Below 17,700 -> 24
    - 17,700 - 33,000 -> 28
    - 33,000 - 53,400 -> 37
    - 53,400 - 120,000 -> 43
    - 120,000 - 175,000 -> 44
    - 175,000 - 300,000 -> 45
    - Above 300,000 -> 45
  - Proposed PIT brackets and marginal rates (selected years):
    - 2015: Below 12,450
    - 2016: 12,450 - 20,200 -> 25
    - 2019: 12,450 - 20,200 -> 25
    - 20,200 - 34,000/35,200 -> 31/30
    - 34,000/35,200 - 60,000 -> 39/37
    - Above 60,000 -> 47/45
    - Note: 1/ € 34,000 for 2015; € 35,2000 for 2016.

- Staff Appraisal (summary):
  - The thrust of the proposal is generally more growth-friendly, including lowering of PIT and CIT rates combined with some broadening of their bases.
  - Cuts in the top rates of CIT and PIT would bring them closer to EU peers, and the gradual application is prudent.
  - The overall growth impact will depend on how the loss of revenue is compensated.

*Source: Appendix II. Key Recommendations—Independent Tax Reform Committee; Supplementary information from the 2014 Article IV Consultation informational annex.*

### 3.      However, the proposed reform does not address some key issues cited in the staff

### _cr14192 - 3.      However, the proposed reform does not address some key issues cited in the staff

### Shortcomings of the proposed tax reform (from staff appraisal)
- The proposed reform is revenue-losing rather than revenue-neutral (the independent tax reform committee’s recommendation) or revenue-enhancing (staff’s recommendation). While broadly as envisaged in Spain’s Stability Program, the reform will require offsetting measures to achieve the envisaged consolidation path. As per the staff report, staff recommends raising excise duties and environmental levies, and gradually reducing preferential VAT treatments.
- The strategy to boost employment could be better targeted. The proposed reform aims to boost employment through PIT and CIT rate cuts rather than a targeted cut in employer’s social security contributions. The latter is likely to be more effective in boosting employment for the less skilled when the constraint is labor demand, rather than labor supply, as is the case in Spain.
- The net impact on base broadening is not clear. On one hand, the proposal would eliminate/limit a number of unwarranted tax deductions and allowances; on the other, it would create new ones. This seems to be particularly the case for the base of corporate taxes, where special SME regimes have been strengthened. Thus additional base broadening would be warranted.

### Macroeconomic context and outlook (highlights from the Article IV consultation)
- After a protracted double-dip recession, growth has resumed, and unemployment is falling.
- Unemployment remains high: cited as 26 percent in summary; seasonally adjusted unemployment recorded in March 2014 dropped 1 percent yoy, but total unemployment rate noted as 25.3 percent.
- Growth forecasts and recent performance:
  - Both government and staff forecast a 1.2 percent growth rate in 2014.
  - For 2015, the authorities estimate a 1.8 percent GDP increase while staff estimate 1.6 percent.
  - In Q1 2014, GDP accelerated to 0.4 percent qoq (0.5 yoy, 1.5 annualized) from 0.2 in Q4 2013.
- Inflation and labor costs:
  - HIPC annual rate hit -0.2 in March 2014 and stood at 0.1 in June.
  - Wages and labor costs remain moderate while productivity continues to increase, albeit at a subdued rate.
- External sector and investment:
  - Current account: a remarkable adjustment from a peak 10 percent deficit in 2007 to a 0.8 surplus in 2013.
  - Foreign direct investment increased by 52 percent in 2013, for a total of almost 40 billion US dollars.
- Financial conditions have improved sharply, with sovereign yields at record lows and spreads dropping to pre-crisis levels.

### Fiscal stance, reforms, and key fiscal numbers
- Recent fiscal outturns and targets:
  - The deficit of the General Government was reduced from 10.6 to 7.1 percent of GDP in 2013 (6.6 percent of GDP, net of the one-off financial support for the recapitalization of banks).
  - The primary deficit was reduced from 8.0 to 4.1 percent of GDP.
  - The deficit reduction in 2014 has been accelerated to 5.5 percent of GDP (instead of the previous 5.8 percent).
  - The Stability Program aims at bringing down the fiscal deficit below 3 percent of GDP in 2016 and reaching the medium-term objective (MTO) of a balanced budgetary position in structural terms in 2017.
- Structural and institutional reforms:
  - An independent fiscal institution (AIReF) has been created and steps to make it fully operational are being completed.
  - Mechanisms to prevent and combat tax fraud have been significantly enhanced.
  - A comprehensive review of expenditure bases at the Central Government level (CORA) has been undertaken; Regions and Local governments can adhere.
  - Measures have been taken to address commercial arrears to public sector suppliers, reduce contingent liabilities, and eliminate the electricity tariff deficit (as of 2014).
- Pension projections:
  - Public pension expenditure is expected to decline from 10 percent of GDP in 2010 to 9.6 percent in 2060.

### Executive Board and Directors’ policy recommendations
- Directors welcomed improving economic conditions but stressed that high unemployment and elevated public and private debt persist.
- Recommended policy actions include:
  - Continued decisive policy action, with support from European partners, to secure a sustainable, strong, and job-rich growth.
  - Further efforts to reduce the private sector’s debt overhang, especially for small and medium-sized enterprises; consideration of a personal insolvency framework that allows an eventual fresh start while preserving payment culture.
  - Additional reforms to improve skills of the unemployed, further decentralize wage setting mechanisms, and reduce labor market duality between temporary and permanent contracts.
  - Enhance the proposed tax reform to boost employment through cuts in social security contributions and increase indirect tax revenue while protecting the most vulnerable.
  - Continue product and service market liberalization, including implementation of the Market Unity Law and opening up professional services.
  - Continued progress in raising banking-sector capital levels over time, including limiting cash dividends and bonuses, to foster credit.

*Source: IMF Executive Board Concludes 2014 Article IV Consultation with Spain (Press Release No. 14/336, July 10, 2014) — content excerpt.*

### 12.9 percent of GDP), compared with a projected 13.7 percent of GDP in 2060 before the

### _cr14192 - 12.9 percent of GDP), compared with a projected 13.7 percent of GDP in 2060 before the

### Fiscal policy and tax reform
- Recent rebalancing of direct and indirect taxation has moved "in the direction of a fiscal devaluation."
- In 2010 and 2012, indirect taxation was "significantly strengthened."
- The 2012 VAT reform:
  - implemented to increase the standard and reduced rates,
  - broadened the tax base,
  - reduced goods subject to preferential treatment.
- New environmental taxes were introduced and some excise taxes increased.
- Reductions in social security contributions introduced in 2013 and 2014, including a temporary €100 flat rate contribution.
- A substantial tax reform was under preparation and envisaged to be in effect in 2015.
- Planned reform (unveiled on June 20, 2014) following a Committee of Experts report aims at:
  - boosting economic activity, corporate competitiveness and job creation;
  - gradual reductions in rates and a broadening of the bases for Personal Income Tax and Corporate Income Tax;
  - further strengthening tools to fight against fraud;
  - some increases in VAT rates in line with EU legislation.
- Fiscal effects of the planned reform were already incorporated into the Stability Program; "no significant additional fiscal costs can be expected."
- Authorities envisage additional reforms to certain indirect and environmental taxation in the near term.

### Financial sector and credit
- Financial sector program successfully completed in January 2014.
- Reforms and policy actions, with support of Euro Area partners, bolstered capital, liquidity and efficiency and enhanced governance, regulation and supervision.
- Banking sector downsized to a "more efficient size and structure."
- Post-recapitalisation actions:
  - deep cleaning up of troubled assets,
  - very demanding provisioning requirements,
  - accurate classification of refinanced/restructured loans;
  - balance sheets "are now sounder."
- Banks’ solvency:
  - Core Tier 1 ratio reached 11.8 percent at the end of 2013.
  - Quality of capital instruments improved with Tier 2 and additional Tier 1 instruments decreasing.
  - Forward-looking Bank of Spain evaluation in November 2013 confirmed "fairly comfortable solvency position" at an aggregated level under different macroeconomic scenarios.
- Profitability:
  - Spanish banks recorded positive results in 2013 ("more than €11 bn in profits").
  - Efficiency gains: "operating costs are now 24 percent the pre-crisis levels."
  - Earnings resilience supported by geographically diversified business models.
- Credit trends:
  - Credit to the private sector has been falling steadily since the crisis onset, but contraction is decelerating.
  - Flow of new credit has been growing yoy both for SMEs and households for eight and five months, respectively.
  - Credit recovery remains a challenge, particularly for SMEs.
- Measures to ease SME financing:
  - Development of non-banking financing alternatives;
  - MARF, the alternative bond market for SMEs, is operational;
  - Volume of ICO’s lending program for SMEs has "substantially increased";
  - A comprehensive package with additional measures to further ease financing to SMEs and non-financial corporations is in the pipeline.
- Supervisory and regulatory actions by Bank of Spain:
  - guidance to ensure reclassification of doubtful credit under uniform criteria;
  - recommendation of a conservative dividend policy to foster capital increases;
  - new supervisory tool to assess sensitivity of banks’ solvency to shocks.
- Market signals:
  - reduction of systemic risk indicators for Spain;
  - reduction in gross recourse to the Eurosystem by Spanish banks;
  - high and rising Spanish banks’ price-to-book values compared to European peers.
- Authorities confident Spanish financial system is well prepared for the ECB’s comprehensive assessment and to contribute to recovery.

### Corporate and personal debt management
- Authorities adopting measures to facilitate deleveraging while preserving financial stability and growth.
- ECB data: corporate and household debt in Spain dropped 4.6 and 4.4 percentage points respectively from 2012 Q4 to 2013 Q4; "in both cases, it has been the largest decline among the five largest European economies."
- Personal insolvency and corporate restructuring reforms:
  - 2013: significant steps to reinforce the personal insolvency framework.
  - 2014: Government approved and implemented a set of major changes enhancing corporate debt restructuring and insolvency frameworks.
  - March 2014 Royal Decree Law introduced:
    - new tools to foster restructuring, including new types of in and out-of-court refinancing agreements and debt for equity swaps usable by any type of company, including SMEs.
  - September 2013 law on entrepreneurship included measures to facilitate out-of-court insolvency agreements and promote a second chance.
- Further measures announced to reinforce corporate debt restructuring framework:
  - rebalancing of the in-court debt restructuring process;
  - fostering liquidation as a going concern;
  - expanding restructuring options for SMEs;
  - setting up a Code of Good Practices for SMEs and self-employed;
  - creating an inter-ministerial commission to monitor debt restructuring processes and foster institutional coordination.
- Authorities differ from staff on scope and timing for:
  - deeper involvement of public creditors in debt restructuring;
  - establishment of a new personal insolvency framework providing full discharge of debts.
- Authorities cite need for more study on fiscal and financial impact and reference "strong payment culture" in Spain with household NPL at relatively low levels, in a context where NPLs are starting to contract and recovery is at an early stage.

### Structural reforms and labor market
- Labor market reform outcomes:
  - increased labor market flexibility allowing firms to better adapt wages and labor conditions;
  - wages are moderating;
  - reform "has substantially reduced the job-creating GDP growth threshold."
  - Employment is being created "even with growth rates under 1 percent."
- Authorities launched an Activation for Employment Strategy 2014–16 in close coordination with the Youth Guarantee Implementation Plan.
  - Strategy includes a common framework with the regions setting common priorities, evaluations and monitoring of policies in a result-oriented manner.
  - Other measures: deep reform of vocational training system, close coordination with private job placement agencies, creation of a Single Portal with all job vacancies at the national level.
  - These measures align with staff recommendations.
- Labor market indicators:
  - Temporary employment fell from 31.5 percent in 2007 to 23.1 percent in 2013, "an 8.4 percent less."
- Social security contribution measures:
  - Reductions introduced in 2013 for hiring young people;
  - Temporary €100 flat rate contribution created in 2014 for new permanent contracts to support employment.
  - These measures align with fiscal devaluation suggestions; the latter will imply savings of 75 percent in the tax wedge for firms and help create more jobs, including among low-skilled workers.
- Corporate Income Tax cuts in the tax reform expected to foster investment and create employment.
- Product and services structural reforms:
  - Law on the guarantee of market unity (adopted December 2013) tackles fragmentation in more than 30 sectors, expected to impact productivity and growth and creates an open-ended process to address future regulatory barriers.
  - A "regional doing business indicator" prepared with the World Bank will help monitor and promote good regulation across regions.
  - Law on entrepreneurship (September 2013) reduces cost and time of company creation, supports growth and internationalization, and simplifies administrative burdens.
  - Reform of professional services and associations: draft bill with far-reaching liberalization measures (including strict limits on registration requirements and revision of membership fees) expected to be adopted this year.
  - Rental market reform (2013) expected to increase efficiency and reduce home-ownership bias, with positive effects on labor mobility.
  - Significant reforms adopted to enhance the R&I framework, retail market, transport, energy and telecommunications sectors.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14192.pdf*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14192.pdf_