Kingdom of the Netherlands--The Netherlands 2001 Article IV Consultation Discussions Preliminary Conclusions
March 12, 2001
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.
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INTERNATIONAL MONETARY FUND
1. After several years of strong output growth, increased labor force participation, and falling unemployment rates, the Netherlands is clearly in the front rank of economic performers among industrial countries. Long-term growth has been underpinned by supply-side factors, notably wage moderation and structural reform, and by sustained reductions in both the tax burden and the fiscal deficit. There has also been an important cyclical component in recent years. As a result, labor market tensions are now clearly evident, labor compensation growth is rising, unit labor costs are creeping up, and profits and international competitiveness are being squeezed. These developments will tend to slow the economy to a more sustainable pace, thereby promoting the equilibration of a cyclically advanced country in a monetary union.
2. In 2001, real GDP growth is expected to moderate to about 3 percent. This reflects in part weaker private investment due to these equilibrating forces, but it is mainly the result of the slowdown in the United States, which is affecting the Dutch economy through direct and indirect trade channels, and through repercussions on financial markets and confidence. These factors are being partly offset by the substantial fiscal impulse associated with the long-planned tax reform. The projected decline in aggregate demand growth would be welcome from a cyclical perspective, although it is relatively modest and thus unlikely to materially ease the inflationary tensions that have built up over the past few years. We expect further gradual deterioration of competitiveness and profit margins to reduce growth in 2002 and beyond, resulting in an orderly unwinding of the macroeconomic imbalances in the Dutch economy.
3. There are, of course, risks to this scenario. On the downside, the slowdown in the United States may be more pronounced than is now projected, or its effects on the world economy may be larger than anticipated. Domestically, house prices-which rose strongly again last year but have recently flattened out-may decline sharply, reducing household wealth and consumption. On the other hand, the upside risk of a further period of high and ultimately unsustainable growth may prove to be a more significant threat. The U.S. economy is widely expected to recover later this year, which could reinvigorate Dutch exports. Increased confidence, further rises in asset values, and a possible easing of monetary conditions associated with developments in the euro area as a whole could boost domestic demand. The resulting acceleration of labor costs could put excessive pressure on profits and international competitiveness. In the worst case, these tensions would lead eventually to a steep decline in economic activity and a rise in unemployment.
4. If such risks were to materialize, economic performance would depend critically on the financial sector. The Dutch banking system is well positioned to weather a hard landing, since the major institutions are large and highly diversified. Nevertheless, risk-adjusted capital-asset ratios, while still well in excess of requirements, have been eroded somewhat, and some banks are undertaking significant and costly restructuring. In addition, risks have risen in the mortgage market, as lending standards have been relaxed and households have extended their borrowing to finance increasingly expensive houses and to take advantage of the deductibility of mortgage interest payments. This advantage has already been curtailed somewhat by the 2001 tax reform, but further reduction over the longer run would encourage households to return to a more balanced financial position. Supervisors must ensure the soundness of the financial system even in the event of a sharp cyclical downturn. In this regard, they will face the challenge of keeping pace with financial innovation, including new technologies of risk management, and with the increasing complexity of financial institutions.
5. Fiscal policy has a crucial role to play in containing the risks associated with the current cyclical situation. Until demand pressures are relieved, avoiding fiscal stimulus is the clear priority. In particular, next year it will be important to adhere strictly to the expenditure ceiling in the coalition agreement, and to meet demands for additional outlays in areas such as health care and education by reallocating resources within the ceiling. Likewise, taxes should not be lowered, even though the coalition agreement permits cuts in the event of windfalls. Holding the line on both spending and taxes would result in a surplus of about 1¼ percent of GDP in 2002, and in a fiscal balance once the effects of the business cycle are removed. Viewed in a longer-term perspective, this outcome would position the next government to move quickly to a structural surplus of 1 to 2 percent of GDP, which is needed to meet the fiscal demands of population aging.
6. The experience of the last seven years has demonstrated the benefits of using multi-year rules to shape fiscal policy, and argues for retaining the broad contours of the current framework. We would particularly highlight the critical role of the real expenditure ceiling and the associated separation of expenditures from revenue developments. It is only through spending control that room can be created over time for the required larger structural surplus and for reductions in the tax burden.
7. The same experience also points to areas for improvement. The rules for dealing with windfall revenues have been problematic, and they should be replaced by the full use of automatic stabilizers; that is, devoting all growth-related windfalls and shortfalls to the budget balance. Within the multi-year framework, this policy would be facilitated by a realistic assumption about underlying economic growth. Because of the large uncertainties involved, we would recommend a prudent approach in estimating the evolution of trend output in the years ahead; certainly, the recent growth rates of well over 3 percent a year should not be taken as an indication of sustainable growth.
8. Turning to the labor market, steady gains and international comparisons testify to the considerable achievements of the past several years. Yet, the situation of some groups (especially the unskilled, minorities, and those in the 55-65 age bracket), though improved, remains unsatisfactory. In addition, although overall dependence on public transfer programs is not particularly high in the Netherlands, the number of people on disability benefits continues to grow and may exceed one million this year or shortly thereafter. That these problems persist after several years of very high growth demonstrates the need for further structural reform.
9. The very buoyant economic climate provides a unique opportunity to enhance the supply-side of the economy further by sharpening work incentives. The 2001 tax reform contains welcome measures to encourage labor market participation. Tax rates were reduced and tax deductions were replaced by credits, including the labor tax credit (LTC). There has also been increased use of actuarially fair early retirement benefit schemes, which should raise participation among older people; and the elimination of the exemption from job search for older unemployment benefit recipients, as proposed, would be welcome. Also, we are encouraged by the widespread recognition that the disability program must be reformed, although progress in this area will depend on addressing its two weakest points: very high replacement rates in the first two years of sickness/disability, and the ease of entry into the program. Finally, although it is too early to judge performance, the reorganization of the welfare administration holds the promise of increasing the effectiveness of reintegration efforts.
10. Key areas for action are poverty and unemployment traps, which have had particularly adverse effects on the low-skilled and minorities. Accounting for the withdrawal of benefits, the implicit tax rate can exceed 100 percent at low earnings, implying that taking a job or increasing hours worked would result in a loss of income. Raising the LTC could significantly reduce these disincentives. Considerable resources would be freed for this purpose by phasing out the credit, as is done in similar schemes in the United Kingdom and the United States. This would raise marginal tax rates higher up the earnings schedule, but if done gradually these rates would still be well below those now faced by lower-income workers. Moreover, the scale of the poverty trap and the problems it creates would become much more transparent if the relevant benefit schemes were integrated into the tax system; doing so would imply significant changes, including introducing negative income taxes.
11. There has been continued progress in liberalization of product markets, placing the Netherlands at the forefront of EU countries in this respect. It appears, however, that the momentum for reform may be waning. This development could reflect fatigue-much has already been done and the benefits of additional measures, while real, seem less obvious, especially in light of recent prominent examples around the world of apparently unsuccessful attempts at deregulation. Clearly, however, the process remains incomplete, and efforts must be made to ensure that the next set of measures is successful, and is seen to be successful. The authorities have also taken steps to alleviate the administrative burden of government, although it is widely accepted that progress has been insufficient. The independent review body (Actal) should mitigate the burden imposed by new legislation, but it may take a broader, more central political effort to effectively address the problem.
12. We commend the high level of development assistance, which remains above the United Nations target of 0.7 percent of GDP.