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Austria -- 2003 IMF Article IV Consultation, Preliminary Conclusions of the Mission
September 8, 2003
This year's annual consultation took place against the background of a weak economic situation. The global slump has lasted longer than most analysts expected and there are still no clear signs that a recovery has started, at least in Europe.
Austria has weathered the slump relatively well. The economy has continued to grow, albeit at a slow pace, and the unemployment rate rose only slightly and remains one of the lowest in Europe. This resilience largely reflects the benefits of globalization. The opening up of the economies of Central & Eastern Europe and their increasing integration with the market economies of the west provided the opportunity to Austrian business to take advantage of geographic proximity and historic links, capture market share, and create exports and jobs.
Nevertheless, the short-term outlook is subject to considerable uncertainty. While the international environment appears to be improving and some indicators suggest that economic activity in Austria has bottomed out, it is very difficult to forecast the timing and speed of the recovery. As a result, the short-term projections of the Oesterreichische Nationalbank (OeNB), leading research institutes, and private sector forecasters vary widely. Our own estimates are tilted to the conservative side: economic growth in Austria is expected to accelerate slowly from about 0.7 percent this year to 1½ percent in 2004 and reach its potential rate only in early 2005, driven primarily by a pick-up in investment and consumption. A better international environment and a more optimistic outlook for business could result in faster growth in 2004 and beyond.
Although short-term prospects are improving, it is important to keep in mind that the fundamental long-term challenges facing the Austrian economy have not gone away. The ageing population will depress potential growth and put increasing pressure on the pay-as-you-go pension system. Intensifying competition within the expanding EU will make Austria's high tax rates unsustainable. And continued success in the globalized knowledge economy will require more flexible institutions and attitudes.
The government's broad economic policy strategy is right on target; what is needed now is persistent and balanced implementation. Reducing the burden of the state, ensuring healthy public finances, liberalizing markets, and encouraging entrepreneurship will help maintain stability in the short and medium term and competitiveness and growth in the long term. Since our last visit to Austria, the government has taken some very significant steps to turn this strategy into reality, notably a major pension reform, continued liberalization and structural reform, and specific plans for tax reductions in 2004-05. The government must now maintain this momentum and, in particular, strike the right balance between tax and structural reforms that will enhance Austria's growth potential on one hand, and expenditure discipline that will maintain credibility and stability on the other.
Tax reform and fiscal policy
We support the plans for tax reform in 2004-05 and the goal of reducing significantly the tax burden over the medium term as long as they are designed to promote sustainable growth. The case for tax reform is compelling: the high tax burden on labor and profits dampens incentives to work and makes Austria less attractive as a business location. These disadvantages loom even larger in the context of an expanding EU, where tax rates are generally on a downward trend. But Austria needs tax reform—not just tax cuts—aiming not only at lowering the burden on labor and capital but also at simplifying the system and minimizing distortions in the treatment of various forms of assets. These should be the guiding principles of tax reform in 2005 and beyond.
The government's ambitious tax reform plans will be successful only if accompanied by an equally far-reaching expenditure policy reform. As we have argued in the past, the Stability Program should be supplemented by a new medium-term policy framework, with annual expenditure targets broken down by major program, and accompanied by a set of specific policies to achieve them. Such a framework, as the experience of other European countries shows, would illustrate policy tradeoffs, help reconcile conflicting objectives and generate broad-based consensus over policy choices, and enhance transparency and credibility. We are disappointed to see that the work started last year on such a framework in the context of a new budget framework law was interrupted by the elections, and urge the government to resume it as quickly as possible.
Without a credible medium-term expenditure policy framework, tax reform might weaken fiscal discipline and undermine policy credibility. As plans stand today, the second phase of tax reform in 2005 is not fully matched by expenditure cuts and would thus lead to a sizeable increase in the deficit at a time when the economy will be growing rapidly. Although the latest Stability Program targets expenditure reductions in 2006-07 that would return the deficit to a downward trend, these are not sufficiently specific. We recognize that tax reform generates long-term benefits and that tax and expenditure cuts cannot be perfectly synchronized. But the procyclical relaxation of fiscal policy now planned for 2005—a pre-election year—cannot but raise concerns in the absence of a concrete and credible medium-term expenditure framework.
What are the policy options now? Designing and implementing such an expenditure framework would take time—all the more reason to resume work on it quickly. In the meantime, the government should consider phasing in the 2005 tax reform more gradually: the entire package could be decided in the context of the next budget but some of the measures could take effect in later years. Bringing tax reform forward to 2004, as some advocate, should be avoided. It would lengthen the lag between revenue losses and expenditure reductions and thus undermine the credibility of the government's medium-term fiscal consolidation program. In addition, it might not provide sufficient time to design a proper tax reform and result in partial changes in an already complicated system.
Medium-term expenditure policy reform should concentrate primarily on entitlements and subsidies. Ongoing efforts to reduce staffing and operational outlays, while necessary, will not be sufficient to generate the savings necessary over the medium term. The solution should be sought in restructuring entitlements, where the pension reform and ongoing health system reform will soon start having an impact. Moreover, while social spending in Austria ranks among the highest in the EU, absorbing over 50 cents of every taxpayer's euro, virtually none of it is means-tested. Rationalizing the multitude of subsidies and transfers, notably for housing and families, and targeting them to those truly in need would generate savings for the public purse without compromising social solidarity.
This will require re-thinking the role and functions of the state in a modern economy and re-defining the fiscal relations between the federal, state, and local governments. We hope that the work of the Österreich-Konvent will result in concrete proposals for fundamental state reform along these lines and for improving efficiency in state administration. The negotiation of a new Finanzausgleich in 2004 will also provide the opportunity to simplify the current system of fiscal relations between levels of government, align spending authority with taxing responsibility at each level, and ensure that the burden of adjustment is equally distributed between them.
Pension reform
The recent pension reform was a major and courageous step that will strengthen significantly the long-term sustainability of the public pension system. The effective reduction in benefits to a more realistic level and the lengthening of working life will generate considerable savings, which we estimate at around 1½ percentage points of GDP annually in the long run. Although the impact on labor force participation of the elderly is somewhat uncertain, it should also help expand the contribution base and thus lower the fiscal burden of the pension system even further. Demographic trends will still push pension spending to a peak of about 16 percent of GDP in 2030-35, but this reform dampens considerably its path over time and makes fiscal pressures more manageable.
While we strongly support this reform overall, certain aspects are questionable. In particular, the 10 percent cap on benefit cuts, introduced as a last-minute political compromise, has a number of undesirable effects. First, it severs the notional link between contributions and benefits, one of the major guiding principles of this reform: once the cap is effective for most new pensioners (which will happen in very few years), benefits will essentially be determined by the old formula reduced by 10 percent regardless of the new accrual rate and assessment period. Second, since it is essentially a quick fix but has no expiration date, it introduces uncertainty about the long-term impact of the reform. And third, it reduces savings in the long run. A cap on benefit cuts may indeed have been a necessary compromise, without which the pension reform would not have taken place. But we believe it could have been designed to be phased out gradually in the long run while, at the same time, providing a cushion especially for low-income pensioners.
More importantly, there is still unfinished business. First and foremost, most measures so far have affected only the ASVG: harmonization of the various pension schemes—notably for civil servants—is still pending. We welcome the government's strong commitment, reiterated several times during our discussions, to carry out this important measure. We believe that harmonization should primarily aim at reducing inequities and distortions between pension schemes; generating additional savings should be a secondary objective, to be achieved only in the medium-to-long term. In addition to harmonization, the planned introduction of personal pension accounts would enhance the transparency of the system (although this is compromised by the 10 percent cap). The gradual development of the second and third tiers would reduce the reliance on the public pension system. And the ongoing rationalization of invalidity pensions would prevent the abuse of this benefit as an early retirement vehicle.
Financial sector
The creation of the Financial Market Authority (FMA) was a major step toward strengthening financial sector supervision. A state-of-the-art legal framework, capable and committed staff, and financial and operational independence enable the FMA, in cooperation with the OeNB and foreign supervisors, to safeguard the soundness of the Austrian financial sector at a time of increasing sophistication and cross-border expansion. The forthcoming Financial Sector Assessment Program, whose conclusions and recommendations will be discussed during the 2004 Article IV consultation, will provide an opportunity to assess the effectiveness of supervision in greater depth.
Foreign currency loans to households should come under closer scrutiny. While they are unlikely to jeopardize the stability of the financial sector, these loans, which have been rising for some time now, are extended to customers who by and large do not have a foreign exchange hedge. They thus represent a higher default risk for the banks, which is only partly covered by the usual collateral and redemption fund accounts. In addition, in the event of customer default due to exchange rate fluctuations, they may expose banks to litigation. Finally, in extreme cases, they could represent a systemic risk if, in the event of widespread defaults, banks' efforts to realize the value of collateral were to depress real estate prices. The supervisory authorities should therefore step up their efforts to make customers aware of the risks and ensure that banks are better protected against these through improved risk management.
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