Chapter

6 Iceland

Author(s):
International Monetary Fund
Published Date:
March 1986
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Iceland’s growth performance depends largely on unstable fish catches and world market prices for fish products, which are subject to sharp fluctuations. Despite substantial diversification of export production over the last decade and a half, fish products still account for 75 percent of total exports, which, in turn, amounts to one third of GDP. The impact of the two oil crises on the highly open economy was mitigated by the country’s rich hydro and geothermal energy sources, which were developed rapidly over the period. Real GDP growth, albeit uneven, averaged almost 4 percent a year during 1972–82, although it actually fell in two of those years, owing to reduced fish catches. Due to the instability of export prices and the impact of oil price increases on the country’s terms of trade, national income has undergone substantially greater fluctuations than GDP.

Full employment was an overriding aim of economic policy during the period. As a result of a high level of investment and accommodating exchange rate and financial policies, the rate of unemployment was kept at or below 0.5 percent in all years except 1982 when it reached a peak of 0.7 percent. This is the second lowest level of unemployment achieved in the smaller industrial countries—only Luxembourg had a lower rate.

By contrast, Iceland suffered the highest inflation rate of any industrial country over the period, with rates ranging in most years between 30 percent and nearly 60 percent. Sharp increases in fishermen’s incomes in individual years, the working of a demonstration effect throughout the rest of the economy, and widespread indexation mechanisms constituted a vicious circle that sustained these high rates of inflation, which at times were further fueled by external price shocks. In all years except 1978, the external current account was in deficit, peaking at 11 percent of GDP in 1974 and 1975. After a marked improvement in 1978 and a satisfactory outcome in the following year, the deficit widened sharply and by 1982 amounted to 9½ percent of GDP.

Iceland: Selected Economic Indicators, 1972–82
19721973197419751976197719781979198019811982
Real GDP, percentage changes6.57.94.0–0.53.55.83.94.14.12.2–1.3
Rate of unemployment0.50.40.40.50.50.30.30.30.30.40.7
Consumer prices, percentage changes9.720.642.949.133.029.944.944.157.551.649.1
External current account balance as percentage of GDP–2.6–2.8–10.9–10.9–1.7–2.51.3–0.8–2.3–4.9–9.6
Sources: Organization for Economic Cooperation and Development, Economic Outlook, December 1984; for rates of unemployment: Central Bank of Iceland, Economic Statistics Quarterly, November 1983.
Sources: Organization for Economic Cooperation and Development, Economic Outlook, December 1984; for rates of unemployment: Central Bank of Iceland, Economic Statistics Quarterly, November 1983.
Iceland: Consolidated Central Government Finances, 1972–82(Year ended December 31)
19721973197419751976197719781979198019811982
Total Revenue
(as a percentage of GDP)27.929.229.229.728.327.429.030.229.631.132.9
Percentages of total revenue100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0
Income taxes17.317.212.28.89.38.09.812.310.710.611.1
Social security contributions4.83.53.54.03.03.84.84.54.22.72.3
Payroll (manpower) taxes3.83.53.94.64.84.34.74.64.44.54.5
Property taxes2.92.82.42.32.82.82.93.93.94.13.9
Taxes on goods and services34.332.040.346.448.147.944.843.246.947.547.1
Taxes on international trade28.927.727.421.920.621.621.619.718.219.117.6
Other taxes0.10.10.10.2
Nontax revenue and grants7.913.210.311.811.411.112.011.811.711.413.3
Total Expenditure
(as a percentage of GDP)30.532.333.835.930.831.931.632.430.931.935.9
Percentages of total expenditure100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0
Expenditure on goods and services30.729.330.228.332.432.034.834.136.335.833.4
Of which:
Wages and salaries20.219.820.318.620.521.423.623.024.023.521.9
Interest payments2.63.13.25.65.05.26.97.45.76.26.6
Subsidies and other current transfers39.734.637.736.133.232.134.837.937.136.636.9
Of which:
Social security funds24.022.021.220.319.920.422.922.723.624.522.9
Capital expenditure16.323.722.219.917.417.915.214.214.615.312.2
Lending minus repayments10.69.36.710.111.912.88.36.46.36.110.9
Surplus/Deficit
(as a percentage of GDP)–2.6–3.1–4.6–6.2–2.5–4.4–2.6–2.2–1.4–0.8–2.9
Financing:
Abroad2.81.61.21.92.03.10.71.70.80.93.1
Domestic–0.31.53.44.20.51.31.90.50.5–0.1–0.2
Monetary authorities–0.91.02.93.00.40.9–0.7–0.3–0.8–0.7
Deposit money banks0.10.10.1–0.10.20.20.1–0.10.1
Other10.60.50.51.20.51.10.81.00.80.90.4
Memorandum Items:
General government expenditure and net lending/GDP37.438.540.644.037.738.8
Central government debt outstanding/GDP15.812.513.418.118.920.722.423.926.423.631.4
Source: International Monetary Fund, Government Finance Statistics Yearbook, 1983 and 1984.

Includes adjustments.

Source: International Monetary Fund, Government Finance Statistics Yearbook, 1983 and 1984.

Includes adjustments.

Expenditure

Between 1972 and 1982 the ratio of government expenditure to GDP rose by 5½ percentage points to 36 percent. An especially sharp expansion occurred in 1982 when lending operations soared and real GDP fell. This expansion of the government sector is nonetheless one of the smallest recorded in this group of countries. The growth pattern was highly irregular; during 1972–75, for example, the ratio to GDP increased from 30½ percent to 36 percent, reflecting outlays in connection with a natural disaster (volcanic eruption) in 1973 and a transfer of functions from local to central government in 1974. A more relaxed attitude to government spending by a government that took office in 1971 contributed further to this rise in government expenditure. Following two years of large current external deficits, measures were taken in 1975 and 1976 to reduce the fiscal imbalance; as a result, the expenditure/GDP ratio shrank by 5 percentage points in 1976 to 31 percent. The measures taken included substantial expenditure cuts that were legislated in 1975 and incorporated in the 1976 budget, and a special 2 percent additional sales tax earmarked for a special fund that financed natural disaster expenditure and later became a permanent part of the general sales tax. General expenditure restraint was subsequently exercised and the ratio was kept relatively stable through 1981.

The share of expenditure on goods and services in total expenditure rose from 30½ percent to 33½ percent during the period, and within this category wages and salaries rose from 20 percent to 22 percent of the total. While some of the increase stems from the transfer of functions from local government, it also reflects growing public sector employment and higher wages and salaries in that sector; a further contributor to this increase was a change in the definition of outlays for the operation of state hospitals, which had previously been treated as transfers, but were increasingly being incorporated in the budget as final expenditure. Interest payments increased from 2½ percent of total expenditure in 1972 to 6½ percent in 1982, despite a rapid erosion of the nonindexed component of domestic debt, which is mostly with the central bank. Subsidies and other current transfers declined as a proportion of total expenditure from almost 39½ percent to 36½ percent over the period. Although the change in definition mentioned above explains some of this unusual decline, the main reason is negligible expenditure on unemployment benefits. Capital expenditure was kept at a relatively high, if unstable, level throughout the period, ranging from 12 percent to 24 percent of total expenditure. Net lending, which ranged between 6 percent and 13 percent of the total, represents in large measure relending by the Central Government for investment in domestic energy sources.

Revenue

Total revenue of the Central Government expressed as a ratio to GDP rose by 5 percentage points between 1972 and 1982 to 33 percent. The importance of income taxes relative to other revenue sources declined sharply over the period from over 17½ percent of total revenue in 1972 to 11 percent in 1982. This decline reflects annual adjustments in tax scales to reduce or eliminate fiscal drag and periodic cuts in rates in an effort to moderate wage settlements. Income taxes in Iceland are substantially lower than in other industrial countries. The major revenue source of the Central Government is domestic taxes on goods and services, mainly a general sales tax at the retail stage and profits of the liquor and tobacco monopoly. Taxes in this category rose as a proportion of total revenue from 34½ percent to 47 percent between 1972 and 1982. Taxes on international trade, on the other hand, dropped from 29 percent in 1972 to 17½ percent in 1982, partly as a result of tariff reductions under the European Free Trade Association (EFTA) and EC agreements.

Social security contributions ranged between 2½ percent and 5 percent of total revenue during the period. These are borne entirely by employers and the self-employed, since contributions by employees, levied on a per capita basis, were abolished in 1971. Other tax revenue comprises payroll taxes earmarked to the State Housing Fund and property taxes, which, taken together, increased slightly from 7 percent to 8½ percent of total revenue over the period. Nontax revenue, which is mostly interest income and administrative fees and charges, accounted in most years for 10½ percent to 12 percent of total revenue.

The Fiscal Balance and ITS Financing

According to GFS data,1 a fiscal deficit occurred every year of the period. As a percentage of GDP, the deficit widened from 2½ percent in 1972 until it peaked at over 6 percent in 1975, as a result of tax concessions and increases in consumer subsidies to facilitate wage negotiations, a sharp increase in loan-financed energy investment, and some relaxation in fiscal discipline. In subsequent years, general expenditure restraint and increases in indirect taxes reduced the deficit substantially. The lowest deficit of the period, less than 1 percent of GDP, occurred in 1981. Attitudes of policymakers to deficit financing have differed according to whether the Treasury proper or the investment and credit budget (see below) was involved. For the ordinary central government operations that exclude relending to autonomous public enterprises, recourse has been had to the central bank in the form of overdrafts on the treasury main account. Also, the sale of government savings certificates, which are price-indexed and carry tax privileges, has financed certain ordinary investments. But the largest financing requirement has arisen in connection with projects included in the investment and credit budget, chiefly investments for exploiting the country’s rich hydro and geothermal energy sources. Foreign borrowing, with the Treasury acting as an intermediary, has been used entirely to finance these and other investments by public enterprises that are expected to service the debt out of own revenue. Financing of these projects has also been in the form of sale of government savings certificates to the general public and to financial institutions. Between 1972 and 1982, total debt of the Central Government expressed as a ratio to GDP rose from 16 percent to 31½ percent, and the foreign component of the debt rose from 10½ percent to 20½ percent of GDP.

Fiscal Policy

The framework. The Central Government dominates public sector activity in Iceland. A fiscal reform in 1972 centralized public revenue and expenditure to a considerable degree, and in recent years, about four fifths of total public expenditure and revenue is accounted for at the central level. Thus, based on 1977 data, the size of general and central government expenditure relative to GDP was 39 percent and 32 percent, respectively. The main source of revenue of local governments is a flat-rate income tax; local governments are free to vary the rate of the tax within a range of zero to 10 percent, and may also raise it to 11 percent with the consent of the Central Government. Owing to cost-sharing arrangements and restricted borrowing authority, local government investment is in large measure determined in the central government budget and in the public investment and credit budget.

Annual budgeting is based on a forecast of the national economy for the upcoming fiscal year. In recent years, the national economic forecasts have been presented to Parliament along with the central government budget, but as a separate document in which the Government states its economic policy. Owing to inherently unstable economic conditions, measures that may significantly affect the budget plan are frequently introduced in the course of the fiscal year. Despite recent legislation that provides for multiyear budgeting as a means of facilitating fiscal decision making, such exercises have not been performed so far. However, four-year plans for the communications sector have been prepared for a number of years. From the mid-1970s, public investment and credit budgets were prepared annually and presented to Parliament, first separately, and then, after the budget was passed; in later years, emphasis was placed on finalizing the two together to facilitate coordinated decision making in the relevant areas. The investment and credit budgets, which cover one year, include total public investment and its financing, as well as forecasts of available public funds for certain private investment, such as housing. The purpose is to coordinate investment and credit policies in the framework of specified price and balance of payments objectives, and generally to ensure consistency between the financial and real sides of the economy.

While inflation automatically influenced revenue more than expenditure in the early part of the period, due to a responsive tax system that relied heavily on ad valorem indirect taxes, this stabilizing property of the fiscal system has eroded in recent years. The reason is a proliferation of indexation mechanisms on the expenditure side and a growing tendency to enact legislation that provides for present and future spending commitments. It is estimated that about 70 percent of total expenditure is “uncontrollable,” in the sense that this portion of expenditure at the central level cannot be affected except by amending laws and contracts. Flexibility in fiscal policy is further restricted by the link between the cost of living index, which reflects increases in indirect taxes, and wages and salaries and social security benefits, and also by the practice of earmarking certain tax proceeds.

Aims and measures. Traditional fiscal policy attitudes in Iceland are characterized by a strong urge to balance the budget.2 Present-day concerns over the persistent inflation have added support to the traditional view that fiscal policy should be defensive, geared toward preventing fiscal deficits, rather than restrictive, in pursuit of substantial surpluses. A manifestation of this attitude is the positive balance3 that budgets, as approved by Parliament, invariably show, although the intended balance often turns into a deficit during the fiscal year. The fiscal objective of price stabilization tends to be pursued by selective measures designed to affect the outcome of general wage negotiations.

The balanced budget approach, although not successful in preventing deficits in actual outturns, contributed significantly to expenditure restraint. For most of the period, this restraint took account of the expenditure/GDP ratio, although the Government did not announce a specific target until 1979, namely, to prevent the ratio from exceeding 30 percent in 1979 and 1980; this target was reached if relending operations are not counted on the expenditure side. Within the constraints imposed by efforts to prevent the budget from imparting undue stimulus to demand and adding to inflationary pressures, fiscal policy has aimed at improving social security benefits and redistributing income in favor of low- and middle-income earners.

Measures toward the above objectives have affected both sides of the budget. Reductions in the personal income tax have typically been introduced to ensure moderation in wage settlements. In 1974 a particularly sharp reduction caused the share of income taxes in total revenue to fall by 5 percentage points. To partially compensate for the revenue loss, the general sales tax was raised by 4 percentage points. A series of reductions in the personal income tax and increases in indirect taxes was implemented in subsequent years.

Consumer subsidies were also typically used to facilitate wage negotiations or generally constrain price increases. In the short run, these subsidies dampened the rise in the cost of living index to which wages and salaries and social security benefits were linked, as did increases in family allowances in the years when these allowances were incorporated in the index base. While social security benefits are indexed, additional measures to extend their coverage and increase benefits in real terms were frequently taken over the period, sometimes in the context of incomes policy and sometimes separately. One such measure, which particularly burdened the budget, was the introduction in the mid-1970s of guaranteed and indexed minimum income limits for old-age and disabled pensioners.

Implementation of the measures noted above was not a continuous process, however. In 1976, for example, a mounting current external deficit induced the authorities to reduce the expansionary impact of the budget and both consumer subsidies and social security benefits were curtailed. Apart from frequent increases in indirect taxes to counteract deterioration in the fiscal position, legal authorizations to cut expenditure in the existing budget were granted occasionally, although the full extent of the authorized cuts was generally not realized. To reinforce the general effort at expenditure restraint, a month-to-month fiscal reporting and expenditure control system was introduced in the mid-1970s and was further developed in subsequent years.

Overview and implications for future policy. The overall impression that emerges from the events during 1972–82 is that the application of fiscal policy for stabilization purposes was quite limited. The balanced budget approach was narrowly applied and did not prevent deficits, which, according to the GFS definition, were substantial in some years. This fiscal practice nonetheless made a major contribution to the general expenditure restraint that was exercised for most of the period under review. Within the constraints implicit in the general political preference for balanced budgets, selective measures to combat inflation and reduce external imbalances were taken, largely in the context of incomes policy through reductions in direct taxes and increases in consumer subsidies and social security expenditure. The effectiveness of this approach was diluted by the weakening of the fiscal position that resulted from these measures, as accompanying increases in indirect taxes usually were only partially compensating. A widespread indexation of significant expenditure categories and de facto indexation of income tax scales greatly eroded the automatic stabilization properties of the fiscal system. Moreover, increased reliance on indirect taxes that are included in the price index used for compensation purposes implied growing rigidities and narrowed the scope for fiscal policy action.

Despite the limited use of fiscal instruments for demand management, progress was nonetheless made in the pursuit of other fiscal objectives. In a situation of full employment, a virtual absence of unemployment benefits and a general expenditure restraint that was reinforced by the balanced budget attitude prevented the expenditure/GDP ratio from rising appreciably and kept down the tax burden. Investment policy that emphasized exploitation of domestic energy sources greatly reduced the country’s dependence on imported oil. However, much of the fiscal deficit as defined here stems from this policy, and the liquidity impact of foreign borrowing attached to energy projects aggravated the problem of monetary management.

If future fiscal policy is to be more instrumental in combating inflation, which is Iceland’s main economic problem, a reversal of past tendencies toward indexation and rigidities in the fiscal system would seem to be required. An attempt in this direction was made in 1983 when a new government, facing a sharp acceleration of inflation and mounting external imbalance, suspended indexation of wages and salaries and social security benefits and imposed a statutory wage ceiling for two years. Further measures in this direction, such as the exclusion of indirect taxes from the price compensation index, could substantially enhance the effectiveness of fiscal policy in this regard. Decisions on such rearrangements are essentially political in nature, however, and would require a steadfast, long-run course of policy—unfortunately a rarity in a country subject to unstable economic conditions and frequent changes of government. A departure from the balanced budget approach in order to relate fiscal policy more closely to the cyclical position of the economy, although attractive from a theoretical viewpoint, would entail a substantial risk. The increased flexibility such a reorientation might permit would have to be weighed against an eventual loss of fiscal discipline that appears to have been instrumental in stabilizing the relative size of the government sector in the economy.

1

Owing to different treatment of relending operations of the Central Government, data on the fiscal balance differ substantially from national sources. The latter treat borrowing and relending as offsetting items that do not affect the balance, whereas in GFS relending is entered on the expenditure side (lending minus repayments), and borrowing in this context is treated as a financing item. As a result, the data presented here (GFS) exhibit a deficit for each year, which in most instances is, as a ratio to GDP, 2 to 3 percentage points larger than data from national sources indicate. Thus, according to the national sources, there were surpluses in 1972, 1981, and 1982.

2

Blöndal, pp. 56–58.

3

According to the operational concept as distinct from the GFS definition (see footnote, pp. 144–45).

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