INTERNATIONAL MONETARY FUND

Finland-2001 Article IV Consultation

June 7-18, 2001

Concluding Remarks

1. Sound macroeconomic policies and growing economic openness have been at the root of Finland's remarkable recovery from the recession of the early 1990s. Since 1994, real GDP growth has averaged almost 5 percent, inflation has been in the range of 1 to 3 percent, and the general government balance has shifted from a large deficit to a sizeable surplus. Meanwhile, the economy has become increasingly open, driven by a dynamic export-oriented ICT sector, which has overtaken the traditional forest industry in terms of both exports and value added. While these structural changes have generated large benefits to the economy, Finland's export base is concentrated in a few key industries. As such, economic growth is susceptible to significant fluctuations. Maintaining fiscal surpluses is, therefore, prudent during good times.

2. Key structural reforms, building on past efforts, would contribute to making the Finnish success story a lasting one. If anything, the impressive handling of the crisis during the early 1990s has demonstrated the ability of policy makers, social partners, and the society at large to work together for a common goal. This ability is being tested again, as society is now faced with challenges of a different nature. Finland's population will be aging rapidly over the coming years. Without raising significantly the rate of employment, economic growth would be sharply curtailed in the face of a rapidly shrinking labor force, and there would be too few workers to support a growing number of pensioners. This would place large strains on the public finances, making it increasingly difficult for society to support its more vulnerable members without burdening future generations with excessive taxes. Thus, further cooperative action to raise employment growth is needed. In particular, it is important to broaden the participation of various segments of the population in gainful employment, including those with lower skills, through further tax cuts on labor and other efforts to improve incentives to work. Equally crucial are deeper pension reforms that encourage and reward a longer working life and bring the average age of retirement (currently 59) closer to the statutory age of 65. The time to act is now, even more so with the "baby-boom" generation close to the age of potential early retirement.

3. The economic expansion is expected to continue in 2001 and 2002, albeit at a more moderate pace, while inflation should fall. With the growth of demand weakening in Finland's trading partners, the mission projects real GDP growth to slow to near 3¾ percent this year and about 3½ percent in 2002. At this juncture, downside risks predominate, reflecting the possibility of a more prolonged slowdown in global activity than now envisaged, related uncertainties in the ICT sector, and potential spill-over effects on domestic demand. Inflation can be expected to decelerate to about 2½ percent in 2001, falling to a somewhat slower pace in 2002, thanks mainly to lower energy prices, and slower wage growth next year. However, risks of higher inflation arise from the possibility that unit labor costs could develop unfavorably in low-productivity sectors and that wage drift could accelerate in the high-skill segment of the labor market.

4. In this setting of lower expected inflation and moderating growth, the macroeconomic policy stance seems broadly appropriate. The ECB's recent interest rate cut and a competitive exchange rate provide stimulus. While markets are expecting another rate cut later in the year, monetary conditions would otherwise tighten if the long-expected appreciation of the euro were to materialize. Indeed, as much of Finland's trade is with countries outside the euro area, monetary conditions could even turn contractionary in the course of 2002, depending on exchange rate developments. In these circumstances, and with risks to growth on the downside, moderate fiscal stimulus would not seem unwarranted. The general government surplus is set to fall in 2001 by 1¾ percentage points to 5 percent of GDP, reflecting in part the unwinding of exceptional factors unrelated to fiscal policy measures that have been boosting revenues and the surplus. Correcting for these factors, the underlying fiscal stimulus is estimated to be slightly less than ½ percentage point of GDP. Fiscal policy would be similarly stimulative next year, on the basis of the government's current plans.

Fiscal Strategy

5. Medium- and long-term issues-most notably, the impact of population aging-have important implications for how fiscal policy should be formulated now. As the population ages, there will be a natural tendency for health and pension expenditures to rise, and the balances of the general government to worsen significantly as a result. It is, therefore, important that the general government balances are sufficiently in surplus beforehand to avoid large fiscal deficits after the demographic shock sets in. By running surpluses, the government can pay down debt, generating interest savings over time. This would enhance equity between current and future generations by reducing the future need for tax increases, while safeguarding spending in priority areas. However, expenditure restraint in the coming years is crucial to leave room for needed meaningful cuts in taxes on labor income. In this way, it is possible to support strong employment and high economic growth, while maintaining the desired fiscal surpluses.

6. Against this background, the mission agrees with the broad outlines of the government's strategy. This strategy, as described in the government's September 2000 Stability Program, holds central government expenditure broadly constant in real terms. It also provides for a moderate reduction in direct taxes (mostly on labor, by 1 percentage point of GDP) and in indirect taxes (by ½ percentage point of GDP) over the 2002-04 period. However, perhaps in response to the unexpectedly strong revenue outcome in 2000, expenditure pressures have risen since the Stability Program was formulated. The recent budget proposal implies an increase in real central government spending of about 1¼ percent in 2002. While not excessive, the government should resist any further temptation to use revenue windfalls to raise spending, particularly if of a recurring nature. The mission projects, assuming no additional spending, that the central government surplus on a structural basis (i.e., adjusted for cyclical fluctuations) would remain at about 2 percent of GDP in 2002, increasing gradually to 2½ percent of GDP in 2004. Taking into account the local governments and social security funds, this corresponds to a structural general government surplus in the range of about 5-5¼ percent of GDP in 2002-04.

7. In the mission's view, serious consideration must be given to a larger reduction in the heavy tax burden on labor. Doubling the magnitude of labor tax cuts to 2 percentage points of GDP over the 2002-04 period would add further impetus to much needed employment creation and economic growth. As a result, some of the direct impact of labor tax cuts on reducing the fiscal surplus would be offset by higher revenues from faster economic growth, and lower expenditures in support of the unemployed. Provided further increases in real spending are resisted, this would keep the medium-term structural surpluses in the central government, on average, above 1½ percent of GDP. Surpluses of this magnitude would allow a further reduction in public debt, and provide sufficient room for the operation of automatic stabilizers in the event of an economic downturn.

8. The mission advocates frontloading the labor tax cuts: 1 percentage point of GDP in 2002 and ½ percentage point of GDP in each of the subsequent two years. When judged against their lasting benefits, any risks from tax cuts of this size providing additional fiscal stimulus are well worth taking. Moreover, these risks, in the event of stronger-than-expected output growth, are mitigated by a shrinking fiscal multiplier in Finland's increasingly open economy. In addition, the fiscal stimulus resulting from tax cuts is smaller than the full extent of the cuts, as part of it is absorbed by higher savings.

9. The mission sees merit in continuing the policy of across-the-board reductions in the tax wedge on labor income-but with additional targeted tax relief for low-income workers. By international standards, Finland's tax rates on labor, including social security contributions, are still high across all income levels. Tax relief for low-income groups, particularly if accompanied by changes in the benefits system, could potentially generate the strongest employment leverage by removing so-called income traps that exist when high taxation of wages contributes to the unattractiveness of work relative to unemployment. However, incentive problems also exist for middle-income groups-and particularly families-who face high marginal tax rates and the threat of lower income-related support as a discouragement for additional work efforts and the acquisition of additional skills. This is a serious problem in Finland's dynamic economic environment, where the skills demanded on the labor market are constantly evolving. Finally, with increasing international competition for, and mobility of, high-skilled workers, Finland cannot afford to defy the international trend toward lower tax rates at the high-income level.

Pension Reform

10. Several features of the pension system discourage employment of the working-age population and, if left unchanged, would seriously aggravate the impact of the demographic shock. While the existing schemes for early retirement may have lessened the social impact of the depression, if early retirement remains the norm rather than the exception it used to be, both current and future generations have to pay the price. The government and the social partners have acknowledged this in past reform efforts and ongoing discussions to further improve the pension system. Nevertheless, the system contains a number of characteristics, introduced with good intentions, that effectively defeat their purpose. For example, part-time pensions were introduced to keep people in the work force who otherwise would have taken early retirement. However, by enabling these "pensioners" to work part-time without losing much of their earnings and none of their pension rights, part-time pensions provide strong incentives to lower, rather than increase, working hours. The so-called unemployment pipeline to retirement-by providing benefits at little loss to income and a ready path to the unemployment pension at age 60-too often serves as a blanket discouragement to job search, irrespective of a person's skills and chances to become reemployed. It also provides a ready excuse for employers to lay off older workers. Indeed, under the current system of financing unemployment pensions, larger firms face rising contributions as the age of their employees increases, and also bear part of the direct cost of unemployment and disability. This provides a strong disincentive for keeping or hiring older workers. The same holds for disability pensions, traditionally the primary channel into early retirement. The sheer number of disability pensioners suggests that the eligibility requirements may have been interpreted too generously.

11. Three other features of the pension system dramatically weaken incentives to join the labor force early or participate in it until the statutory retirement age of 65-further diminishing the attractiveness of a longer working life. These features also imply that the benefits to those with shorter working lives are comparatively high at the expense of those who work longer. First, pension rights accumulate only from the age of 23, irrespective of when a person starts working, making early participation in the labor force financially less attractive. Second, pension benefits are linked to earnings over the last ten years of employment, implying an unduly large penalty for taking on a lower paid job at later stages of the working life, while favoring people-often with better jobs and education-who have a steeper pay scale due to promotions later in their career. Third, the cap on pension benefits at 60 percent of the so-called pensionable wage can further diminish the attractiveness of a longer working life. This effect is accentuated by a higher rate of pension accumulation rights from the age of 60, implying that a person with an uninterrupted working life, starting at or before age 23, accrues no further pension rights after the age of 61.

12. Particularly when the population is aging so rapidly, these incentive problems are acute, prompting the mission to recommend urgent reforms. These reforms-many of which are currently under active discussion between the government and the social partners-focus on strengthening the link between pension benefits and life-time contributions and on removing the various elements of the system that push older people out of gainful employment. To this end, a number of measures, taken in combination, would seem to be most effective: (i) allowing the accumulation of pension rights from the beginning of each person's working life; (ii) abolishing the cap of 60 percent on pension rights along with the higher old-age accumulation rate; (iii) introducing a more flexible retirement age within a reasonable range, taking into account changes in life expectancy when determining pension benefits; (iv) discontinuing the various subsidized schemes, such as part-time and unemployment pensions, together with the "unemployment pipeline"; (v) enforcing strictly the eligibility requirements for disability pensions; and (vi) reforming the financing system for unemployment and disability pensions to eliminate the bias against hiring and keeping older workers. The mission strongly encourages the swift adoption of these reforms in time to influence the decisions of the aging "baby boomers."

Complementary Reforms of Labor and Product Markets

13. If complemented by further labor market reforms, the virtuous circle of employment creation, growth, and fiscal savings could be deepened significantly. Past reforms to strengthen labor market performance included enhanced training programs, more flexible working-time arrangements, and various measures to improve work incentives. However, at present, the combination of high taxes and income-related social benefits-such as child-care and housing allowances-means that the additional financial benefits of taking a job are often modest, and in some cases nonexistent. These incentive traps discourage entry into the labor market, particularly for those with little experience and skill, thereby diminishing their chances for raising, in a durable way, their living standards through their own efforts. Hence, in addition to tax cuts, the mission sees considerable merit in returning to a system of gradually declining unemployment benefits over the duration of the unemployment period to encourage swift job search before skills erode; and redesigning other social benefits to reduce disincentives to seek employment because of an unduly high replacement income. The potential for employment creation through benefit reforms is particularly large among the young and unskilled, whose unemployment rate is excessive, including in comparison with other advanced economies. To maximize their effects, such reforms could be combined with enhanced training and counseling, and stricter mobility requirements across regions and occupations. Finally, to reduce the regional and skill mismatches in the labor market, an increase in wage flexibility, more commensurate with differences in the demand for labor across regions and in productivity developments across skills, seems crucial. These measures taken in combination-by encouraging and enabling people of working age to play an active role in the working society-would not only raise living standards and safeguard the resources needed in the future to support the more vulnerable members of the society, but also foster the confidence and skills of its individual members.

14. The private services sector, which is underdeveloped in Finland, has strong potential for employment creation and growth. In view of the aging population and rising incomes, the demand for personal and other services should increase. Prospects for employment of low-skilled workers would improve if the private market for these services were to develop. This would be facilitated by opening up the publicly-dominated market for social services to private competition. Experience so far has shown that this could also have a positive effect on the quality of these services. However, the combination of the high tax wedge, the benefits structure, and insufficiently flexible wages, in addition to complicated labor market regulations, impede the creation of new firms. Here again, reducing high labor taxes and redesigning the benefits system would go a long way.

15. The Finnish economy would also benefit from further improvements in the functioning of product markets. Finland was among the frontrunners in the EU in opening its markets for telecommunication, and has fully liberalized its electricity markets. However, the pace of privatization has been considerably slower, and the mission would encourage the government to implement the privatization program mandated by parliament as quickly as possible, and seek a new mandate to sell most of its remaining equity investments on a timely basis. In addition, while there is no easy solution, the mission would urge the government to continue its search for ways to alleviate the shortage of affordable housing in high-growth urban centers, with a view to enabling lower-income workers to move to where labor demand is greatest. Importantly, the government should focus on municipalities' zoning decisions that tend to favor corporate real estate at the expense of housing, and also examine whether there are tax or regulatory disincentives to the private provision of rental housing.

Financial Sector Stability

16. Finland's financial system has been assessed to be very sound, with the risks to the economy from adverse financial sector developments low in current circumstances. This was a main finding of a review conducted as part of the IMF/World Bank Financial Sector Assessment Program. The banking system and the insurance and pension industries are well capitalized, and profitability of the banking system is good. Finland's strong macroeconomic performance has strengthened balance sheets across sectors, and loan losses are very low. As a member of the euro zone, Finland benefits from integration in the system of euro-wide bond and money markets and reduced currency risks. Stress tests of the resilience of the financial system to export, stock market, and real estate price shocks suggest that the financial system is fairly robust to sizeable asset price fluctuations.

17. Finland is nevertheless at the forefront of financial innovation, and mitigating potential vulnerabilities in a more demanding financial market environment will require strengthening regulatory and supervisory arrangements. The financial system is reorganizing with the creation of complex cross-product and cross-border financial conglomerates, and is now very concentrated with three large financial institutions. At the same time, competition is increasing. In this environment, supervisory arrangements will need to meet and even exceed international standards. Priority should be placed on strengthening the independence, accountability and early intervention powers of the Financial Supervisory Agency (FSA). Preventing regulatory loopholes will increasingly require harmonization of regulatory and supervisory arrangements across different regulatory jurisdictions, both within Finland and more broadly in the Nordic and euro area. This will call for the speedy enactment of new legislation on the FSA and on financial conglomerates, as well as for enhancing the existing cross-discipline and cross-border cooperation among supervisors.

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18. The mission would like to thank the authorities, as well as the social partners and other participants in its meetings, for the fruitful and open discussions. It warmly welcomes the government's commitment to transparency, demonstrated again in its decision to share these concluding remarks with the public.

Helsinki, June 18, 2001.