Mission Concluding Statement 

May 31, 2007

1. In many respects, Finland's economic situation is enviable. Growth continues to outpace the euro area average, inflation is among the lowest in the EU, and the government budget and external current account are both comfortably in surplus. Finland is also near the top of rankings for research and development, innovation, and competitiveness.

2. Yet, it also faces considerable challenges. Although the recent increase in employment is welcome, a tightening labor market threatens a building up of wage pressures. Export growth has been sizable, but it is vulnerable to a relatively heavy concentration in a few sectors. Demographic pressures are soon to be felt, and, despite substantial reforms to the pension system in recent years, and the unexpectedly large surplus last year, the fiscal position remains unsustainable, as acknowledged in the most recent update to the authorities' Stability Program. Fast-paced technological and organizational changes in the financial sector, together with increasing international integration, open opportunities, but also raise risk and test supervisory capabilities.

3. While growth is set to slow this year, prospects remain good and risks broadly balanced. The economy is likely to expand by around 3 percent, with rising interest rates and growing household debt anticipated to slow consumption. Net exports are expected to make again a positive contribution to activity owing to continued buoyancy of neighboring economies, although to a lesser degree than in 2006. Employment should continue to rise, but a tightening labor market will likely slow its pace. With the economy estimated to operate still above potential and the ebbing of favorable one-off factors, inflation is expected to edge up slightly, although recent euro strength may have a cooling effect. The risks to the outlook appear to be balanced. Stronger-than-anticipated growth among trading partners and higher-than-expected labor force participation or immigration could boost real output further. On the other hand, wage increases not justified by productivity gains would erode competitiveness, and a possible sharp tariff increase on unprocessed Russian wood exports could pose significant risks to Finnish paper production and exports.

4. However, rapid aging, a relatively undiversified economy, and lackluster gains of productivity in sheltered sectors hamper long-term growth and fiscal sustainability. With a working-age population expected to begin declining by the end of the decade, policies aimed at enhancing the utilization of the economy's labor resources are crucial. Raising resource mobility to respond to the challenges of globalization and shifting comparative advantages will also become increasingly necessary, as will efforts to improve productivity in the economy's "sheltered" sectors (agriculture, trade, utilities). Success in these areas will strengthen fiscal prospects, thereby allowing for additional labor taxation reductions-with due consideration for cyclical factors. Nevertheless, budgetary measures will still be necessary to place the public purse on a sound long-term footing.

5. The mission recommends greater fiscal prudence, on account of both long- and short-term considerations. The authorities' recently adopted budget framework for 2008-11 implies a worrisome deterioration of the fiscal position. Based on current macroeconomic projections, the general government surplus would decline by about 2 percent of GDP over four years. The central government balance would worsen by 1¼  percent of GDP and turn a deficit already by 2010, mainly owing to a front-loaded rise in expenditure. The authorities hope that stronger-than-projected growth of about 3½ percent, aided by as yet unspecified structural measures, could help maintain fiscal surpluses approximately at the current level—1 percent of GDP for the central government. While the authorities' commitment to the latter target goes in the right direction, relying on the assumption of a sizable pick-up in future growth is risky, in the absence of stronger measures to boost productivity and employment.

6. The fiscal position is not sustainable in the long term, thereby requiring adjustment efforts, in particular to reduce spending growth. Despite the current sizable surplus, in the long run the fiscal accounts will weaken, reflecting not only the new government's program but also population aging costs estimated at 5-6 percent of GDP. In order to maintain an adequate net asset position of the general government at least through 2050, the noninterest balance must improve by about 2 percent of GDP relative to the authorities' projected path. Taxes and expenditures are high in international comparison. Therefore, fiscal adjustment should focus on spending restraint. Indeed, tax cuts, albeit justified on efficiency or equity grounds, would require additional expenditure reductions in order not to undermine sustainability. If enacted, tax cuts should concentrate on labor taxes, which significantly distort the labor market because of their relatively burdensome rates.

7. Fiscal expansion is also not advisable from a cyclical perspective. With economic activity somewhat above potential, and a tight labor market, some withdrawal of fiscal stimulus is appropriate, although the ongoing tightening of financial conditions—with rising interest rates and an appreciating euro—reduces the amount of necessary fiscal correction. A general government surplus of about 4 percent of GDP, only slightly above the 2006 level, would be an appropriate target in both 2007 and 2008. Otherwise, excess demand could translate into inflationary pressures, raising concerns about competitiveness.

8. Multi-year expenditure ceilings have contributed to strengthen central government budget outcomes, but additional improvements could be considered. The system is not preventing a sizable step increase in outlays following the entry into office of a new government and before the new ceilings become effective. Moreover, while the ceilings are specified in "real" terms, the public spending deflators, which passively accommodate increases in wages and other government costs, have been rising more rapidly than broader-based price indices (such as the GDP deflator or the CPI). Shifting to a broader-based price index would impose more stringent ceilings, thereby providing incentives to raise productivity and reduce costs. As importantly, spending ceilings could be extended to local governments, perhaps through an appropriate strengthening of the "Basic Services Program."

9. A reduction of public spending would be facilitated by enhancing its efficiency, especially at the local level. Most recent studies suggest that expenditures could be more efficient, particularly in healthcare and higher education. Thus, sizable savings should be feasible without jeopardizing the quality of services. While due consideration must be given to the role of a relatively small population dispersed over a large geographic area in limiting economies of scale, recourse to domestic or international benchmarking could identify best practices. Efficiency may also be stimulated through measures affecting both the supply and demand for public services. Thus, greater use of contracting out, outsourcing, and well-designed public-private partnerships may help moderate cost inflation. In addition, more frequent resort to—and a rebalancing of—user charges would strengthen market incentives for consumers and suppliers. Providing greater incentives for local governments to be more efficient may also require rethinking intergovernmental arrangements and the devolution of tasks and tax bases. Indeed, local spending has increased as a share of output in recent years, and, given the types of activities municipalities are responsible for (including primary healthcare and other social services), expenditure pressures are anticipated only to intensify.

10. With the working-age population soon set to decline, future growth demands improved utilization of labor resources. While Finnish employment rates are slightly above OECD averages, they are lagging those of Nordic peers. Rates have increased for all major age groups since the mid-1990s, especially for older workers, reflecting earlier reforms of unemployment insurance and early retirement schemes, but considerable scope remains to increase activity rates, notably for older workers and the youth.

11. Youth employment rates in particular are comparatively low and can be raised through reforms to the wage setting, tax, benefit, and education systems. While the economy-wide wage agreements have served to maintain overall wage moderation, they have also resulted in wage compression, with high effective minimum wages "pricing out" the young and low skilled. Increased wage differentiation, obtained either directly or through tax policies, could help "price-in" those with low initial or permanent productivity. Greater geographical wage flexibility can boost employment and offset low labor mobility. Low youth employment also reflects extended periods spent in tertiary education, the result in part of under-priced education services and generous student allowances. An increase in fees, along with financial aid to the truly needy, while limiting the amount and duration of grants with greater reliance on guaranteed loans, could reduce tertiary study periods and promote earlier labor force entry.

12. The share of beneficiaries of passive unemployment and disability programs remains disproportionately large, while active programs are scarce. Although the unemployment rate has fallen considerably, it exceeds levels in other Nordic countries, as generally do youth and long-term unemployment rates. The population on disability benefits is high compared to many OECD countries, and the share of recipients claiming benefits on grounds that were in the past compatible with some work has increased over time. Both unemployment and disability programs are used as "pipelines" to early retirement. With relatively generous out-of-employment benefits, especially for those previously in low-paying jobs, many find themselves in "poverty traps," whereby re-employment would entail punishing implicit tax rates through the loss of benefits. It would be advisable to reduce further the scope of early retirement "pipelines," by tightening access to disability pensions, strengthening early medical and vocational rehabilitation, and envisaging broader recourse to activation requirements for both unemployment and disability beneficiaries. Tax and benefit policies ought to be revised to increase the relative benefits from employment.

13. Improving product market performance can also help boost living standards. Although product market rigidities have been substantially reduced in the last decade, OECD rankings show that Finland has still significant room for improvement. Productivity can be enhanced, especially in the sheltered sectors, through further privatization, restraining local monopolies, and strengthening non-discriminatory third party access to network industries. In addition, liberalizing shop opening hours and more flexible zoning laws could promote competition in wholesale and retail trade, while reforming agricultural support should increase efficiency and lower food prices.

14. In the financial sector, rapid structural changes are generating internal risks, while regulation and supervision of cross-border institutions pose increasing challenges. The Finnish financial system appears sound and well supervised. Banks are profitable, well capitalized, and stable, and low cost ratios are generating generally high returns on equity. Stress tests confirm that the system can withstand considerable disruptions. However, increasing foreign ownership in the banking sector poses considerable challenges for regulation and supervision, highlighting the urgency to nurture cooperation between home and host supervisors, especially to minimize the potential for conflicting interests in case of financial crises. Furthermore, the widespread adoption of new technologies and instruments to enhance the financial system's efficiency may threaten its reliability. Cross-border supervision issues relating to infrastructure (payment systems, stock exchanges, security depositories) are also growing. Supervisors will need to work closely with market participants and foreign supervisors to take full advantage of new technologies while minimizing systemic risks.

15. The economic and political conjunctures are propitious for wide-ranging reforms to address the structural challenges facing the Finnish economy. The policy framework set by the new government for the next four years could usefully incorporate a more ambitious set of reforms and more prudent fiscal targets. With the opportunity to boost the economy's growth potential and place the fiscal accounts on a long-term sustainable path, it is no time for complacency.