Mission Concluding Statement 

Austria-2001 Article IV Consultation Discussions

Preliminary Conclusions

April 2, 2001

Recent economic performance and near-term outlook

The Austrian economy performed well in 2000: real GDP grew by 3.2 percent, and inflationary pressures remained low despite higher oil prices and a lower euro. Helped by strong external demand and the lagged effects of real effective exchange rate depreciation, economic growth exceeded 4 percent in the first half of the year, before abating to some 2¼-2½ percent in the second half. The unemployment rate declined to 3.7 percent, with disproportionate improvements among older, long-term unemployed and female workers. The sharp increase in oil prices and tax increases pushed headline inflation, as measured by the harmonized consumer price index, to 2.0 percent in 2000. However, wage moderation and increased competition in newly liberalized markets kept core inflation to a little more than 1 percent.

Despite weakening external demand, the near-term outlook remains favorable: real GDP is expected to grow by 2.2 percent in 2001 and 2.6 percent in 2002, while headline inflation is likely to subside. Although fiscal consolidation will be a drag on growth, lower household savings are likely to support private consumption and exports will be bolstered by a continued increase in competitiveness in the weaker external environment. Employment gains will be smaller and the already low unemployment rate is likely to decline only moderately. Headline inflation is projected to decline to some 1½ percent as the effects of recent oil price increases dissipate, the euro ceases to depreciate, and the base effects of last year's tax increases disappear in mid-2001. The risks to this forecast are broadly balanced: a sharper U.S. downturn or a steep appreciation of the euro could dampen external demand and domestic confidence more than envisaged, while domestic demand could be strengthened over time in the event of monetary easing by the European Central Bank (ECB).

Monetary conditions and macroeconomic policy mix

Against the backdrop of an expected decline in GDP growth to just below its potential rate, a modest easing of the macroeconomic policy stance would not be inappropriate in 2001-02. With a broadly neutral fiscal impulse and tighter monetary conditions, the macroeconomic policy mix was slightly contractionary in 2000. The social partners supported this contractionary stance by maintaining a prudent incomes policy. To encourage the further expansion of employment and preserve the improvements in relative unit labor costs achieved in recent years, restrained wage settlements continue to be needed in 2001-02. Consequently, as the urgently needed fiscal consolidation heralded by the budgets for 2001 and 2002 implies some fiscal withdrawal at a time when economic growth is slowing below potential, a measured easing of monetary conditions would be welcome in 2001-02. If the ECB decided to reduce its repo rate, this action would be helpful in Austria's current and prospective macroeconomic circumstances.

Fiscal policy

Stronger economic growth and one-off events helped reduce the general government deficit faster than budgeted in 2000. Stripping away cyclical and transitory factors, however, it becomes clear that the primary structural fiscal balance did not improve last year.¹ While an unchanged fiscal stance for the third consecutive year is disappointing, a worse outcome was avoided as the new government, faced with the need to prepare the 2000 budget under great time pressure, had to adopt measures to neutralize the effects of a generous tax and family support package legislated by its predecessor.

The government's revised Stability and Growth Program for 2001-04 is an important step toward fiscal consolidation. The budgets for 2001 and 2002 hold out the prospect of establishing overall fiscal balance, even under the reduced economic growth projections. The government deserves praise for having recognized the urgent need for fiscal consolidation and for having rallied popular support behind the idea of a "zero deficit". Its moves to translate this vision into concrete action have indeed been fast and decisive. A few critical observations are, however, in order. First, it is regrettable-although unavoidable, given the need for speed and the comparative slowness of expenditure restraint in producing results-that the fiscal adjustment is primarily based on revenue increases in 2001-02, with expenditure reductions becoming substantial only during 2002-03. Thus, the cumulative effect of expenditure reductions to revenue increases will reach the ratio of 2:1 only in 2003. On the positive side, the tax measures have simplified the tax system by broadening its base and closing loopholes. Second, the adjustment effort relies heavily on an increased surplus of the lower levels of government. Any shortfalls in their performance-and some slippage might occur simply if Eurostat disallowed the changed modalities of housing support-would need to be promptly offset by adjustments in the federal budget. Third, while the budgets seem to have been drawn up conservatively, the fiscal cost of the planned further enhancement of child benefits is as yet unclear. The authorities must carefully estimate the cost of current plans in order to avoid a repetition of the fiscally disastrous consequences of the introduction of elderly care in 1993. Fourth, care must be taken to avoid revenue reductions in 2003 that exceed the margin provided by expenditure restraint. The intention to focus on reducing nonwage labor costs is welcome, but the relief granted should not be so large as to necessitate the adoption of another "savings package" after the election. Fifth, should economic activity weaken unexpectedly in 2001-02, the government should rely on the automatic stabilizers and accept weaker than budgeted fiscal outcomes. Adhering to announced budget targets in such circumstances would entail procyclical measures that would further depress economic growth.

Successful implementation of the government's fiscal plans for 2001-03 would still leave a number of fiscal problems. First, fiscal balance (or a small surplus, as suggested by EMU rules) should not be aimed at on a strict year-to-year basis, but rather on average over the economic cycle. Strict observance of annual balance would require the frequent adoption of ad hoc measures. Instead, the government should aim at structural balance (or a small structural surplus).² Second, it is not clear whether the planned fiscal adjustment is sustainable, given the reliance on expenditure restraint within existing structures. Sustained compression of expenditure will create pressures to increase spending in subsequent years. Third, even with the full implementation of the government's fiscal plans, the size of government remains too large. The revenue and expenditure ratios would still be one half the size of GDP in 2003 and, without further reductions from privatization receipts, government debt would still amount to some 57½ percent of GDP by the end of that year. Thus, expenditure cuts and further privatization would be needed to increase economic efficiency and growth and create room for anticyclical discretionary measures. Fourth, adverse demographic trends will put substantial pressure on the public finances in the medium and long run. Hence, pension and health care reform are urgently needed. Without such reforms, fiscal surpluses would be needed now as a second-best solution to accumulate the financial assets required to finance the future deficits of the pension and health care systems.

With the 2001 and 2002 budgets a fait accompli, the fiscal policy debate should focus on the budget for 2003 and the fiscal policy requirements in the post-electoral period. The absence of elections until some time in 2003 also makes this an ideal time for finalizing the intergovernmental agreement on revenue sharing and the financial responsibility for observing agreed fiscal deficits as well as for deciding on civil service, administrative, health and pension reforms. With the just submitted report on administrative reform, the government would seem to have all the technical and factual background information necessary to formulate its proposals in all these areas. As the budgets for 2001 and 2002 appear to have exhausted the savings that can be achieved by paring expenditure within the existing structure, durable expenditure reductions must be sought for 2004 and beyond. These reductions must be large enough to ensure attainment of the structural fiscal objective (i.e., balance or a small surplus), allow further tax reductions, and perhaps make room for an increase in capital investment. To determine cutbacks on a rational basis and make progress with civil service and administrative reform, the government should subject the spending programs at all three levels of government to a number of tests to ascertain: (i) that the programs continue to be in the public interest; (ii) that their delivery by the government remains justified; (iii) whether they could alternatively be delivered by the Länder or municipalities or by the private sector; (iv) how they could be redesigned for greater efficiency; (v) whether they are affordable given the fiscal constraints. The results of this review of spending programs should be made public.

The choice of which fiscal measures to adopt is political, but a few of the many measures identified by various experts are the following. Using international benchmarking as a point of departure, permanent cuts could be sought in housing subsidies (the public policy need seems to have disappeared and the subsidies appear to miss their intended beneficiaries); family and child benefits (child care centers would provide incentives for parents to work); pensions (see below); health care services (higher copayments would reduce demand for services); agricultural subsidies (shifting from price to income support); and civil service reform (including teachers). In addition, social transfers should be targeted, preferably by making them taxable, thereby raising revenue; income tax rates could be lowered in a revenue-neutral fashion by eliminating the preferential treatment of the 13th and 14th monthly salaries and by withdrawing other exemptions such as the commuting allowance for pensioners; and nonwage labor costs could be lowered through a revenue-neutral replacement of the municipal payroll tax by increased real estate taxes. Savings can also be achieved by adopting the recommendations of the administrative reform commission, including the closure of government offices and agencies, the transfer of indirect federal administration to the Länder (with appropriate own resources), and a thorough overhaul of the system of intergovernmental transfers.

Further reforms of the pension system are required to ensure its long-run sustainability. To contain the primary deficit of the public pension system at its current level of about 4½ percent of GDP over the next 30 years, measures are required to lower the replacement rates for new retirees, reduce indexation of existing pensions, tax benefits, raise the retirement age in line with longevity, and harmonize civil service pensions with the private sector pension plans. In addition, the implementation of the already legislated equalization of retirement ages for men and women should be accelerated. As a particularly urgent measure in light of the recent EU decision at the Stockholm Summit to raise the labor force participation rate of older workers, the remaining incentives for early retirement should be abolished and perhaps be replaced with a bonus/malus system that penalizes early and rewards late retirement.

The government's privatization program should be reinvigorated. As the primary purpose of privatization is improved efficiency, the current stockmarket situation should not be allowed to delay further privatization. The government should therefore complete the first stage of its privatization program and proceed to the second stage. In addition, all three levels of government should follow the suggestions of the administrative reform commission and privatize their holdings of real estate (forests and apartments). The lower levels of government should also privatize their holdings in banks, utilities, and other productive enterprises. All proceeds should be used to reduce the public debt.

Structural Policies

Recent progress with structural reform has not been satisfactory. The labor market has performed well, with solid employment growth helping to reduce unemployment among most target groups (especially older, long-term unemployed and female workers), and reforms have continued in the energy and telecommunication markets. However, the elderly participation rate is low and the government has not yet succeeded in its attempts to extend shop opening hours, create a one-stop shop for obtaining business licenses and investment approvals, reform competition law, and liberalize the trades and professions. Although agreement on such reforms is difficult in Austria's consensus-based federal system, improvements in the flexibility and efficiency of the Austrian labor, capital and product markets are crucial in the absence of an independent monetary policy to face the challenges of increasing competition from abroad, including from future EU enlargement.

Labor market

An increase in the labor force participation rate is needed to ease both impediments to growth and pressure on the public finances. The participation rate of younger cohorts could be raised by streamlining academic curricula and training programs and providing financial incentives for the timely completion of degree programs at universities. The participation rate of older workers could be raised by penalizing early retirement and rewarding late retirement, promoting flexible work arrangements for older people, and eliminating seniority bonuses that discourage the retention of long-serving older workers. The participation rate of parents (in particular, women) could be raised by shifting family support from cash payment to the provision of affordable child-care facilities. Other measures to raise the participation rate and improve the functioning of the labor market in general include the following:

• Sectors with high seasonal fluctuation of employment could be encouraged to adapt their work time arrangements further to reduce the duration of seasonal unemployment.
• Collective agreements could allow for genuine opening clauses to permit greater wage flexibility at the enterprise level.
• Active labor market policies could be stepped up in an effort to upgrade the employability of female, older and low skilled workers.
• Educational and training programs could increasingly be directed at skills demanded in the private sector and thereby help overcome bottlenecks in the labor market.
• Access to the trades and professions could be liberalized and regulations eased, e.g., by switching from a list of permitted activities to a list of regulated ones.
• Employer contributions to the family support, work accident insurance and insolvency funds and the municipal payroll tax could be reduced or eliminated.
• Private placement services could be encouraged by easing staff qualification requirements, reporting responsibilities, and the restriction that fees can be levied only on employers.

Capital markets

The reform of financial sector supervision should focus on strengthening regulatory capacity rather than on the structure of the regulatory body. It is important to raise the effectiveness of supervision by providing adequate resources and legal protection to the supervisors in the exercise of their duties. The institutional structure of supervision needs to reflect the structure of the markets that are to be regulated and supervised. And perhaps most importantly, the supervisory agency needs to be fully independent in its operations, have sufficient authority to exercise its mandate, and be accountable for this authority. If full independence cannot be achieved in the current political setting, it would be better to continue with the status quo until the necessary two thirds parliamentary majority can be secured.³ Recent international trends toward greater financial sector integration have generally strengthened the case for unified supervision. However, the decision to introduce such supervision should be based primarily on the prospect of reaping tangible economies of scope and other synergies from the presence of financial conglomerates in the domestic market. The changeover to a unified system would need to be carefully managed so as not to weaken regulatory capacity in the transition process. This would seem to be particularly important at this juncture as banking supervisors are gearing up for the implementation of the Basel II accord.

The savings bank law should be amended so as to remove domestic savings banks' right of first refusal in acquiring stakes in other savings banks that are offered for sale.

The new capital markets law (KMOG) should be reviewed to ensure that its tax provisions do not discriminate between Austrian and foreign mutual funds or between equity and bond financing.

Product markets

Liberalization, regulation (where needed) and privatization are required to improve the functioning of product markets. The government is to be commended for adhering to its timetable for the complete opening of the electricity market and for appointing a regulator for that market. It should now proceed with its plans to regulate and liberalize the gas market by October 2002. An independent competition agency should be created with powers to initiate investigations and adjudicate cases without interference from the social partners and the government. Financial and administrative barriers to entrepreneurship should be lowered, the time-bound one-stop approval of investment projects should be legislated, and shopping hours and worktime arrangements should be made more flexible. An auction-based public procurement system should be introduced to reduce discretionary power, thereby contributing to equal treatment of potential suppliers. To foster research and development, the cooperation between universities and businesses should be strengthened. As noted, privatization should proceed at all three levels of government, with proceeds earmarked for debt reduction.

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Austria should reverse the decline in its overseas development assistance and strive to raise it to the internationally recommended benchmark of 0.7 percent of GNP. It should use its influence in the EU to (i) speed up the phase-out of remaining import restrictions on three sensitive items from the least developed countries and extend the EU's import concessions to these countries to all developing countries; (ii) promote agricultural reform in the EU; and (iii) liberalize world trade in agricultural products and services under the auspices of the WTO. As a major prospective beneficiary of EU enlargement, Austria should strive for the flexible application of any transitional restrictions on the free movement of labor and services after accession.

¹ The primary structural position indicates the underlying stance of fiscal policy and can be calculated by removing cyclical effects (e.g., the increases in tax collections and decreases in unemployment benefit payments associated with a cyclical expansion), one-off or temporary measures, and net interest payments, whose level the government cannot affect in the short run.

² The structural balance, which is equal to the primary structural balance plus net interest payments, can be maintained indefinitely without discretionary fiscal measures when the economy operates at capacity (i.e., when the output gap is closed).

³ The formulation of a unified supervisory board could perhaps provide an alternative interim solution.