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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.

San Marino -- 2001 IMF Article IV Consultation

Preliminary Conclusions of the Mission

September 23, 2001

1. San Marino has enjoyed an extended period of remarkably strong economic performance, posting real GDP growth well above the levels recorded in neighboring regions or in the euro-area, low unemployment, and declining inflation. At the same time, the country has become increasingly integrated with the world economy, as evidenced by trade and tourism, the rapid increase in the share of Italian commuters in the workforce, and a rising intermediation of foreign savings by the Sammarinese banks. The challenge at hand is to sustain this performance in an increasingly competitive international environment.

2. The discussions focused on the policy changes needed to secure strong growth over the medium term. Various factors have contributed to San Marino's outstanding performance, including a low tax burden together with a labor cost advantage over surrounding regions that have helped in attracting businesses and jobs. However, despite the positive economic developments, the central government budgetary balance has moved into a substantial deficit on an accruals basis--estimated at about 2¾ percent of GDP in 2000--because of rapidly rising outlays on generous entitlement programs and tax collection difficulties. This fiscal performance compares unfavorably against that of euro-area countries, particularly the small, rapidly growing economies. Nevertheless, San Marino's public sector still has a comparatively favorable net asset position.

3. The government's new economic program recognizes that public policies need adjustment to maintain the virtuous circle of high economic growth and low taxation. A key priority to avoid a further deterioration of the public finances is to tame the growth of public expenditure--including through reforms to the pensions and health care programs--and to sustain tax revenue. The program also underscores the need to improve the public administration and to further deregulate economic activity.

4. The economic environment to implement these reforms remains positive but the downside risks to activity are growing, as global activity is slowing and asset markets are weakening. Few indicators are available on current economic developments in San Marino--an issue that needs to be addressed--but employment growth appears to remain robust and economic activity should benefit from relatively low real interest rates and continued growth in Italy. However, San Marino's labor cost advantage over neighboring regions has gradually declined and this poses risks for the medium term, even if it has not yet seriously affected the inflow of business. Moreover, the decline in tax pressure, the improvement in public administration, and the liberalization of labor and product markets planned by the Italian government could further increase competition.

5. Against this background, fiscal policy must play a key role in maintaining San Marino's attractiveness as a place to do business. With foreign commuters accounting for over 45 percent of the private sector workforce and a banking system tending to a large foreign clientele, San Marino's tax base is potentially highly mobile. Sizable tax increases to finance generous expenditure policies are thus not advisable. Similarly, contracting public debt--even to fund public investment--carries risks, as the returns on such investment crucially hinge on the presence of mobile factors of production. By contrast, an explicit commitment by the government to a sound fiscal policy--spelt out in the budget documents--would provide an important assurance to investors and workers on the evolution of fiscal policy over the medium term. Covering the current legislature, such a commitment should be (i) to submit to parliament central government budgets that are balanced or in surplus and, if necessary, to explain--in a report to parliament--ex-post deficits, including plans for remedial measures; and (ii) to maintain or improve the central government's net asset position on a cash basis.

6. Through the Stability and Growth Pact, Italy and other euro-area countries are already committed to at least budget balance over the economic cycle. But the case for maintaining balance or a surplus is actually stronger for San Marino because of the mobile tax base.

7. Unless public expenditure is slowed, the objectives to at least balance the central government budget and improve net assets will be difficult to achieve over the medium term without a major increase in taxation. We recognize that this may require measures that are politically difficult--all the more reason, in our view, to move decisively in the early years of the new government. Action should focus on current expenditure, while concentrating capital expenditure on the provision of public goods. In particular:

    · The public sector and public employment should be reformed. The government's objectives in this domain are commendable and important progress has already been made as a result of the hiring freeze. Staffing resources should be reallocated to areas of greatest need, building on a reform plan and taking advantage of the envisaged increase in the staff mobility. Moreover, a sizable annual turnover should permit some reduction in staffing without seriously compromising the provision of public services, including through the adoption of new technologies and the elimination of red tape.

    · Tax expenditures and subsidies should be curtailed. The imminent suspension of tax relief for producers is welcome as are the plans to reassess the subsidies policy. Considering the remarkable performance of the Sammarinese business sector and the strain on the public finances, rapidly ending corporate welfare should be a top priority.

    · Health care spending needs to be controlled so that the ISS needs less state transfers. The health care system performs well but expenditure has rapidly accelerated. The planned separation of health care management within the ISS and the tightening of budget constraints should help to contain expenditure pressures. However, preserving free access to essential health care over the medium term will require further action. In particular, (i) the list of health care services and products that are provided free of charge should be reviewed and be limited to strictly essential items; (ii) the introduction of copayments on selected services and pharmaceutical products should be considered, possibly combining them with some transfers to limit the adverse consequences for the poorest segments of society; and (iii) whenever possible, pharmacies should dispense generic products. These measures could also help to reduce any scope for abuse that may derive from differences between cost and access to pharmaceuticals under the Sammarinese and Italian health care systems.

    · The pension system should be put on a financial footing that is sustainable over the long term to allow a reduction in state support for the ISS. Pension benefits in San Marino are among the most generous when compared with systems in other European countries, in terms of a low average retirement age, high statutory and average replacement rates, and a short required contribution period. Thus, despite a 4:1 worker-retiree ratio--one of the highest in Europe--the ISS requires sizable transfers from the state budget to finance its expenditure on pensions. These transfers would have to increase significantly in the near term to avoid widening ISS budgetary deficits. The planned improvement in the management of the pension fund and the proposed increase in the retirement age to 65 years for new workforce entrants are commendable measures but they will not be sufficient to remedy the problems. Building on the consensual approach to policymaking that has served San Marino so well, additional measures should be considered, including (i) strengthening the link between lifetime contributions and benefits by increasing the length of the period over which the qualifying wage is calculated, scaling down the weighing parameters for the calculation of the entitlement, and lengthening the required minimum contribution period to qualify for a worker pension; (ii) harmonizing the rules governing the pension system of public employees with those of the private sector; and (iii) introducing a fully-funded private component.

8. Action should also be taken to sustain fiscal revenue. First and foremost, tax administration should be improved, particularly the monitoring of compliance by the self-employed and corporations, whose tax payments have recently declined despite a strong economy. To facilitate tax administration, exemptions and deductions for businesses should be reviewed and existing loopholes should be closed. The planned introduction of taxes on the transaction of leasing contracts, the tax on revalued assets, and the sale of government property appear well targeted. But a large proportion of the revenue--which needs to be realistically projected--flowing from these measures will be temporary. Accordingly, the mission recommends that all the proceeds from asset sales be used to build up government deposits. Further tax policy changes should be undertaken only after a careful assessment of their incidence, bearing in mind the high mobility of factors of production.

9. The foundation for a move toward a balanced central government budget should already be laid during the remainder of 2001, through firm budget execution. Preliminary data suggest that without any policy change the central government budgetary deficit may not narrow relative to 2000, thus further weakening the government's financial position. Accordingly, the mission advises that at least part of the reforms--specifically those regarding public sector wages and tax administration--start now, rather than on January 1, 2002. In addition, further expenditure measures are needed to allow the presentation of balanced budgets for 2002-03 to parliament, as the planned tax measures will not yield a sufficient, sustainable increase in revenue.

10. The current medium-term central government budgets for 2002-03--which were presented with the 2001 Budget--program large borrowing requirements (mutui a pareggio di bilancio) and thus are not consistent with budgetary balance. We note that, as in the past, this reflects prudent revenue projections; that the mutui a pareggio di bilancio have not been drawn recently; and that the government has no intention to increase net borrowing to the indicated levels. Nonetheless, the large and widening borrowing requirements send a wrong message to agents and markets about the government's intentions for fiscal policy. And the practice undermines the role of the budget as a tool to manage resources, thereby reducing the benefits from the commendable reform of budget accounting. A preferred approach would be to realistically project fiscal revenue with the help of a medium-term macroeconomic framework and to prudently budget expenditure by allocating a substantial proportion of projected revenue to a contingency reserve. This approach would also be in the spirit of the recommendations in the IMF's new Manual on Fiscal Transparency.

11. The government's intention to publish soon--in addition to the avanzo d'esercizio required by Sammarinese laws and beginning with data for 2000--a central government budgetary balance on an accruals basis (drawn from the risultato d'esercizio in conto competenza) that follows the statistical requirements specified by EUROSTAT is commendable. Such a fiscal aggregate--which should not comprise various financing items presently included under the avanzo d'esercizio--will also facilitate international comparisons.

12. High employment growth has been a hallmark of the economy's outstanding performance. However, San Marino's labor cost advantage over the surrounding regions has diminished rapidly over the past decade. Such a development is partly a natural reflection of tight labor market conditions and could lead to a noticeable decline in growth. The intended reduction in public employment as well as in public sector wage increases--to levels in line with expected inflation of about 1½ percent per annum--are thus crucial to preserve the economy's competitiveness. Also, wages in the private sector need to be set bearing in mind the wage developments in surrounding regions, accounting for reductions in the length of annual working hours. Education and training--particularly to develop new economy skills--can make an important contribution to maintaining competitiveness. The government's plans in this domain are commendable and they should be implemented in close collaboration with private enterprises, which should contribute financial support for courses and scholarships.

13. The transformation of the AASS into a joint stock corporation should improve public services. For a successful transformation of the AASS, it is important that the new company be free in its management to achieve the objectives set by policymakers. Similarly, the setting of tariffs needs to be reformed: to that effect, the envisaged regulatory authority should design a price-cap mechanism that--based on the evolving cost of inputs--provides for frequent, automatic adjustments to tariffs, while providing an incentive for improving management.

14. The continued development of the financial system can play a key role in raising the economy's growth potential. According to market participants, this will require a legislative and regulatory framework permitting the establishment of insurance companies, mutual funds, securitization vehicles, and other financial institutions and instruments. The planned, cautious introduction of such activities and instruments will require important changes in supervisory policies and practices and a sizable increase in the staffing resources of the ICV. Such an increase in staffing will be necessary even if external auditors are to be increasingly relied upon for some supervisory activities, as is done already in other countries.

15. The mission strongly supports the planned introduction of Basel capital adequacy requirements and recommends that following their introduction, the ICV consider a self-assessment against the Basel Core Principles of Supervision. Also, in the spirit of the increased disclosure under the new Basel capital accords, the ICV should consider publishing its semi-annual and annual reports to the Credit and Saving Committee and the government. Moreover, it should move toward frequent and timely reporting of financial soundness indicators and require similar action by individual financial institutions. Regarding the ICS, the mission urges that its equity stakes in companies competing in the financial sector be immediately divested and their products and services no longer be marketed. Such practices are highly unusual among central banks of industrialized countries.

16. Major progress has been made in the fight against money laundering through the adoption of the law on money laundering, the ratification of the 1990 Council of Europe Convention, and the signing of the European Convention on Mutual Assistance in Criminal Matters and the European Convention on Extradition. The government's plan to better identify the stock holders of anonymous joint stock companies is another important step: at a minimum, the names of those individuals or entities holding at least 5 percent of a company's stocks should be disclosed, as is already done in the banking sector. In the operational sphere, the government must stand ready to meet any request by the ICV for additional resources to investigate money laundering.

17. The statistical base has greatly improved, notably through the reform of accounting in the public sector; the production--on a trial basis--of selected government finance statistics; the improvements in monetary statistics; the production of national accounts on an ESA95 basis; and the planned production of the Statistical Bulletin on a more timely basis as well as its release on the worldwide web. We welcome the determination to continually improve statistics and urge the collection and compilation of data that would allow San Marino to join the IMF's General Data Dissemination Standard or to prepare an International Financial Statistics data page, as is already done by almost all countries. Such data are crucial for an assessment of economic and financial developments in San Marino. However, producing them will require a considerable increase in resources devoted to statistics, including calling upon expert technical assistance.

18. The economic performance of the Sammarinese economy during the 1990s is commendable and the public sector's financial position--although less favorable than at the beginning of the last decade--is still sound. We have found a broad consensus that action is necessary to avoid a decline in the public sector's net assets and address the challenges raised by an aging population. Building on this consensus, a prudent policy strategy must seize the opportunities offered by the still favorable economic environment in San Marino and include decisive action across the spectrum of economic policies covered in our discussions, so as to safeguard the remarkable achievements in the domain of social policy and preserve the country's attractiveness for business.