France: 2002 IMF Article IV Consultation, Concluding Statement of the Mission

July 15, 2002

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

International Monetary Fund
France: 2002 Article IV Consultation
Concluding Statement of the Mission
July 15, 2002

1. The newly-elected government of France takes charge of a country tha

t has notable strengths, including high per capita income and business sector productivity, but also certain weaknesses, such as low activity rates, an onerous tax burden, and one of the largest fiscal deficits in the euro area. In this setting, the government is faced with the formidable challenge of the demographic turnaround—an enduring decline in active population for the first time in recent history—that will mark its mandate and require a resolute and broad-ranging reform effort.

2. The economic recovery now under way and the favorable prospects for growth and inflation provide a supportive environment for policy action. The strength of the underlying expansion remains to be established, though, especially in light of recent financial market turbulence and less-than-buoyant short-term indicators. Still, we project the economy to grow by 2.6 percent on average in 2003, after 1.3 percent in 2002. So far, underlying inflation has been sustained by one-off price shocks, the euro changeover, and cost pressures in the service sector (in part due to the reduction of the workweek). Looking forward, with slack having returned to product and labor markets, the appreciation of the euro, and no other signs of wage pressures, underlying inflation is expected to fall below 2 percent by early 2003.

3. In a longer-term perspective, the economic outlook is clouded by demographic developments. The decline in the active population as from 2007 will reduce annual per-capita-GDP growth by about ½ of one percentage point during the next few decades. At the same time, population ageing will add over 5 percentage points of GDP to budgetary outlays by 2040—when the age structure of the population will stabilize—with much of the impact occurring within the next ten years, reflecting the large wave of civil servant retirements.

4. In the face of these prospects, policies need to be geared decisively and unequivocally toward strengthening public finances and boosting the growth potential of the economy, two objectives that are mutually reinforcing. With relatively high unemployment and low participation rates, there is ample scope for improving France's economic performance. Well-designed tax reduction, tax-benefit, pension, labor, and product market reforms could increase employment significantly. Together with policies to enhance public sector efficiency they would relieve part of the budgetary burden of ageing and contribute to sustainable expenditure reduction. Such sustainable reduction is key to ensuring that any tax cuts are credible and will not be reversed, thereby avoiding raising the burden on future generations.

5. The economic policy priorities announced in the Prime Minister's recent general policy speech appear to be oriented in this direction, though specific proposals remain to be worked out. It should be emphasized that their design and implementation will need to be ambitious in both substance and timing. Indeed, the window of opportunity to enact required reforms at reasonable social and economic cost is closing rapidly.

6. Among the areas of needed action, pension reform has been long outstanding and must now be a priority. Thus, we welcome the establishment of a deadline (mid-2003) to define essential changes. Reforming pensions is key for long-term fiscal sustainability, and equally important for improving labor-market functioning and ensuring intergenerational equity. Among the various options to improve the sustainability of the pension system, linking the length of the contribution period to evolving life expectancy is a promising avenue. Its success will rest on additional efforts on training and continuing education. Making pensions portable and actuarially fair within and across different regimes—while technically complex—will be essential to raise activity rates and stay abreast of the direction of reform in other European countries. Labor market participants should neither be induced or compelled to retire early, nor penalized for deciding to work longer.

7. The adverse budgetary consequences of ageing can be mitigated but not eliminated by pension reform alone. Further fiscal consolidation is thus imperative. Against this background, the increase in the 2002 general government deficit—possibly to 2.6 percent of GDP as indicated in the public finance audit—represents a setback and a structural deterioration. The maturing of a host of labor market and social assistance programs, whose high fiscal costs were masked by the strong cyclical upswing in 1999-2000, appears to be an important contributing factor. Of particular concern are also the sharp overrun of expenditures by the central government—breaking with its record of exemplary restraint—and persistent difficulties in controlling public health care spending.

8. At the central government level, the supplementary budget for 2002 opens new credits to meet the expenditure requirements revealed by the audit without however any compensation by restraint in other areas. Nor is the income tax rebate fully offset by savings measures elsewhere. As a result, the central government deficit is now set to rise slightly above even the upper end of the range estimated by the audit. Public spending on health care has also been increased. These choices—while partly due to the electoral context—convey an improper signal about budgetary discipline. In the execution of this year's budget, every effort should therefore be made to curb expenditure so that the central government deficit remains below the level indicated in the supplementary budget and the general government deficit below 2.6 percent of GDP. Better-than-expected revenue performance—which depends largely on difficult-to-predict corporate income tax receipts—should not be used as an opportunity to relax such efforts.

9. Beyond 2002, fiscal consolidation needs to be pursued at a steady pace, using structural reforms to yield durable expenditure reduction—a necessary precondition for sustainable tax cuts, which will thus initially need to be put on hold. The long-term effects of ageing require that the general government balance move into a small surplus as soon as possible. By restricting real spending growth of the general government to about 1 percent per year—a demanding but feasible restraint that will necessitate discipline on social security spending, and in particular health care—the underlying general government balance should be improved by about ¾ percentage points of GDP annually until the required surplus is reached. In this context, the 0.2 percent real growth target for central government spending in 2003 is a good start as it reflects the authorities' intention to accommodate shifts in spending priorities within a tight budget envelope—though it does not correct slippage incurred in 2002. Around the path of fiscal consolidation, automatic stabilizers should be allowed to operate freely. Improvements in the budget balance due to above-trend growth, whether projected or actual, should not be seen as an underlying strengthening of the fiscal position. From this perspective, it would be prudent to base the 2003 budget on a realistic growth assumption and not to rely on higher-than-trend growth for the purpose of medium-term budgeting.

10. Further strengthening the medium-term fiscal framework will be essential for successful fiscal consolidation. The forthcoming joint presentation of the 2003 budget and the next Stability Program to Parliament is a welcome step toward an improved integration of annual budgets and the medium-term fiscal framework, remedying a key shortcoming of the experience to date. We would also recommend that multi-year expenditure norms be defined in terms of the level of expenditure rather than its growth rate to ensure that overruns are corrected. Improving transparency by institutionalizing independent public finance audits and reducing the number of special funds, regimes, and accounting constructions in the sphere of social security is also desirable. To anchor medium-term fiscal policy, consideration should be given to setting long-term targets for the debt-to-GDP ratio.

11. An important aspect of the government's program concerns decentralization. The devolution of a number of responsibilities and means to the local level can lead to more effective and responsive government—the objectives that are indeed being sought—but decentralization is not without economic and budgetary risks. Attention will need to be paid that tax, transfer, and labor market programs at the local level are mindful of the need to continue to improve the functioning of the labor market. At the same time, devolution of fiscal autonomy will need to be done in a framework that clearly establishes roles, responsibilities and related accountability. Decentralization should also provide an opportunity for rationalizing the various levels of government.

12. We are in full agreement that a reduction in France's high tax burden will benefit potential growth. Nonetheless, to this end, the reduction will have to be well designed within a broad package of tax measures aimed at raising activity rates and strengthening competitiveness, rather than merely directed at boosting disposable income. Reducing high effective marginal tax rates for the low skilled will be essential and require coordination with social benefits reform. In this context, the PPE is a useful instrument and the planned removal of its bias against part-time work is welcome. To improve the environment for business and high-skilled labor, lowering marginal taxes on corporate and high labor income will also be important. Finally, a number of costly-to-collect taxes with low yields should be phased out.

13. On the expenditure side, reforms to raise productivity in the public sector, stem the rapid rise of health care spending, and scale back entitlement programs are essential. With the new law on budget procedures and the forward-looking personnel management system—both important and welcome innovations—the authorities have the instruments at hand to meet the first challenge. Part of this process will have to consist of reducing the size of the civil service in the context of the ongoing wave of retirements, within a broader process of redeployment and redefinition of the role of the state. A reduction in France's very high public employment is also needed to avoid crowding out the private sector in some skill segments of the labor market as the labor force diminishes. In the health care sector, the need to establish effective budgetary control is widely recognized. Proposals to reduce wasteful spending, e.g., by reimbursing drugs on the basis of the cost of their generic equivalent, need to be enacted and supplemented by other measures to curtail spending growth. In the context of tax-benefit reform, social entitlement programs should be trimmed, for example by reintroducing the phasing out (degressivité) of unemployment benefits.

14. In the labor market, the first priority is to address the threat looming over the employment prospects of low-skilled workers from the prospective unification of the SMIC and monthly income guarantees. Raising the SMIC faster than the average wage will price the low-skilled out of work and push them into costly labor market or income support programs. Further, competitiveness will be reduced—at a time when demographics are set to lower growth. These wide-ranging adverse consequences should be minimized to the fullest extent possible. In this context, the recent decision not to boost the SMIC in a discretionary manner is welcome. It should become standard practice.

15. Further promotion of labor market flexibility is desirable. Programs to increase labor demand have already been used extensively and may be running into limits in terms of their budgetary cost. Still, the proposed "Jeunes en Entreprise" program fills a gap in the coverage of existing active labor market policies, but its likely success is not easy to gauge ex ante and there are appreciable risks of large windfall benefits (effets d'aubaine). Further, a cost-benefit analysis of the multitude of existing programs would be desirable as a basis for their streamlining and simplification. To mitigate the adverse effects of the reduced workweek on effective labor supply, social partners should be allowed to determine overtime limits and modalities. Softening restrictions on part-time work and simplifying the dismissal procedures of the loi de modernisation sociale would also be helpful.

16. More product market reform and financial sector deregulation will help foster economic efficiency. Divestiture of commercial enterprises, including in the financial sector, should be completed and competition policy further strengthened. The system of administrative regulation of some interest rates, the prohibition to remunerate sight deposits, and the requirement to provide checks free of charge should be removed as they no longer fit in the context of European financial market integration and reduce economic efficiency.

17. While the financial sector appears to have weathered the economic slowdown and the September 11 events well, the recent world-wide equity market losses and ongoing corporate accounting troubles represent new adverse developments. They call for intensified supervision, especially of insurance companies that are particularly sensitive to equity market valuations. It will be important to make further progress on several ongoing initiatives, some of which anticipated in the recently announced loi de securité financière: the changes in securities market regulation and supervision, the reflections on corporate governance and accounting practices (that will need to be coordinated internationally), and the strengthening of efforts to combat money laundering and terrorist financing.

18. France's support for development through an appreciable level of ODA is welcome. Global prosperity would further benefit from raising ODA to the level of the U.N. target, promoting trade liberalization, and dropping objections to early reform of the Common Agricultural Policy.

July 15, 2002


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