Iceland: Recent Economic Developments

This paper reviews economic developments in Iceland during 1990–96. It analyzes the origins of the current economic expansion associated with a swing in the current account and in emerging inflation pressure. Three driving forces are emphasized: the positive supply shock affecting the fisheries; the expansion of the power intensive industry; and brisk increases in real wages over the past two years (1995–96). The paper highlights that the main sources of upside risks comprise the likely construction of a new aluminum smelter.

Abstract

This paper reviews economic developments in Iceland during 1990–96. It analyzes the origins of the current economic expansion associated with a swing in the current account and in emerging inflation pressure. Three driving forces are emphasized: the positive supply shock affecting the fisheries; the expansion of the power intensive industry; and brisk increases in real wages over the past two years (1995–96). The paper highlights that the main sources of upside risks comprise the likely construction of a new aluminum smelter.

IV. FISCAL POLICY AND ISSUES 35

101. This chapter analyses recent fiscal developments, policies and issues. Section A presents an assessment of Iceland’s fiscal performance in recent years with an emphasis on policies and the budgetary outcome for 1996. Section B presents the 1997 budget bill, recent reforms in the public sector, and a brief account of the medium-term fiscal outlook. Section C reviews the characteristics and problems raised by Iceland’s personal income tax system, and options for reform. Finally, an annex describes Iceland’s system of taxation of marine resources, reviewing arguments for and against reform.

A. Recent Fiscal Developments

Background

102. With its emphasis since 1991 on containing public expenditures, correcting fiscal imbalances and reducing the government’s involvement in the economy, Iceland’s recent fiscal performance has been favorable by international standards. With stagnating activity in the early 1990s, Iceland’s general government deficit averaged 3.6 percent of GDP over 1990-1995, in line with the OECD average and well below the European Union average of 5 percent.36 The sharp deterioration in Iceland’s public finances during the 1980s, however, contrasted with a history of relative fiscal restraint and contributed to a rapid rise in the traditionally low net public debt, from about 5 percent of GDP in the mid-1980s up to 35 percent in recent years (Chart 1).

Chart 1.
Chart 1.

ICELAND: GENERAL GOVERNMENT FINANCES, 1980-1996

(In percent of GDP)

Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A004

Sources: National Economic Institute; and staff calculations.1/ Accrual basis, including imputed contributions to unfunded pensions to government employees.2/ Staff estimates.3/ Excluding imputed pension liabilities to government employees.

103. As well as being hampered by the economic downturn from 1987 to 1993, recent fiscal consolidation efforts were insufficient to contain growth in health and social security outlays and were also frustrated by fiscal concessions granted in connection with wage agreements. As a result, the deficit proved recurrently larger than targeted by the authorities (Chart 2).37 In addition, progress towards fiscal adjustment was also achieved partly through a reduction in capital expenditures—which had been increased temporary by both central and local governments to stimulate activity during the downturn—and through cuts in net capital transfers, rather than through measures to boost public savings. General government investment was brought down to 2.7 percent of GDP by 1996, one percentage point below its average over the 1980s, but gross public savings remained at a low 1.5 percent of GDP over 1993-1995 (see also Chapter III).

Chart 2.
Chart 2.

ICELAND: TREASURY FINANCES, 1987-1997

(In percent of GDP, cas basis)

Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A004

Sources: Ministry of Finance of Iceland.1/ Treasury revenue and expenditure for 1997 are expected to decrease by ISK 5.9 billion and ISK 5.2 billion due to the transfer of the primary school system from central to local government.

104. Estimates of structural balances and fiscal impulse provide further information needed to assess the stance of fiscal policy in recent years (see Chart 1 and Table 1).38 39 The estimated elasticities suggest that the cyclical sensitivity of Iceland’s public finances has increased significantly in recent years as a result of major tax reforms—which were intended in part to reinforce built–in stabilizers (Bollason, 1996)—and the increased size of government: a 1 percentage point increase in the output gap would now raise the general government budget balance by about 0.4 to 0.5 percent of GDP, a cyclical response still relatively modest by international standards, but higher than the 0.3 percent estimated for the 1980s.40 The resulting estimates of the government structural balance also highlight that Iceland’s public finances deteriorated largely because of unsustainable policies pursued during the upswing of the mid–1980s. But they also suggest that recent discretionary policy actions towards fiscal consolidation have been limited, as the general government’s structural position was allowed to deteriorate again in 1993-1994 and the subsequent improvement in 1995 largely reflected a remarkable strengthening of local government finances—after an exceptional deterioration triggered by an erosion of their tax base and later exacerbated by measures to boost activity during the downturn.41 42

Table 1

Iceland: General Government Finances and Debt, 1990-1996

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Source: National Economic Institute; and staff calculations.

Preliminary estimates.

Including imputed contributions to unfunded pensions for government employees.

Based on a simple cyclical adjustment of tax revenues and unemployment compensation (see for instance Giorno et al, 1995); tax elasticities with regard to nominal GDP are assumed to be 1.35 and 0.90 for direct and indirect taxes, in accordance with past observations; and unemployment compensation is assumed to be proportional to the actual unemployment rate and computations are based on the NAWRU estimates presented in chapter III.

Standard fiscal impulse indicator based on total revenues and expenditures net of unemployment insurance payments (see Heller et al, 1986), with 1986 as the base year with an estimated output gap close to zero.

Fiscal impulse indicator based on primary revenues and expenditures net of unemployment insurance payments only (see 4/).

Including accrued undue interests, and excluding imputed pension liabilities to government employees.

Staff estimates based on the HP filter with a detrending parameter equal to 25 and medium-term growth projections.

Table 2

Iceland: Treasury Finances and Debt, 1990-1996

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Source: Ministry of Finance of Iceland.

Preliminary estimates.

Excluding the early redemption of Treasury bonds in July 1996.

Including accrued undue interests, and excluding imputed pension liabilities to government employees.

Staff estimates based on the HP filter with a detrending parameter equal to 25 and medium-term growth projections.

105. General government gross debt has nearly doubled since the mid-1980s, from about 30 percent of GDP in 1987 to close to 60 percent in 1995, reflecting persistent deficits and stagnating activity; the devaluations of 1992 and 1993 also substantially raised its foreign-currency–denominated component (see Chart 1). Extensive recourse to foreign financing in 1994-95, consistent with the government’s policy of maintaining low domestic interest rates at that time, contributed to raising its foreign component further, to 29 percent at the end of 1995, one half of the total outstanding debt. The fact that most of the domestic debt is inflation–indexed, the size of the foreign-currency denominated debt and the risks associated with its future servicing place additional demands on present and future fiscal and monetary policies.

Fiscal policy in 1996 and the medium-term consolidation plan

106. In 1995, the new government made the strengthening of public finances one of its priorities and adopted an ambitious medium–term fiscal consolidation plan. At that time, modest prospects for growth, strong pressures for social expenditures, and high borrowing costs were contributing to a disquieting medium-term fiscal outlook. A baseline scenario prepared by the Ministry of Finance on the basis of unchanged laws and regulations as of 1995 projected increased Treasury revenue deficits. This was mainly due to strong anticipated growth in expenditures for health, social security and other social affairs (3 percent per year in real terms) due to ageing population and trend increases in supply and demand of health care services, and the rising needs of the public education system.43 Treasury gross debt was projected to increase to 52 percent of GDP by the end of the century, reflecting the widening of the deficit compounded by resulting adverse effects on interest rates, private investment and GDP growth (Table 3).

Table 3

Iceland: The 1996 Treasury Budget Proposal and the 1995 Medium-Term Consolidation Plan 1/

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Sources: Ministry of Finance of Iceland; and National Economic Institute.

Medium-term scenarios prepared with the 1996 Budget Proposal (Ministry of Finance, October 1995)

Assuming no changes in the laws or regulations of 1995.

Target medium-term fiscal consolidation scenario adopted by the Government.

Includes operational, maintenance, and sickness insurance costs.

Excluding sickness insurance costs.

107. Aimed at restoring medium-term fiscal sustainability and paving the way to lower interest rates and stronger growth, the government’s medium-term fiscal consolidation plan targeted a halving of the Treasury deficit in 1996 (to 0.8 percent of GDP), achieving a balanced budget in 1997 and a small surplus in later years. Assuming no tax changes other than those in the 1996 Budget Proposal (see below), the consolidation plan emphasized expenditure restraint and structural changes, with various measures aimed at reducing transfer payments and capital expenditures in 1996, and plans to curb public consumption and transfers in 1997 and beyond. The plan was thus aiming at a reduction of Treasury expenditure by 3.0 percentage points of GDP from 1995 to 1999 (then projected at 24 percent of GDP), allowing a gradual decline of central government debt to 40 percent of GDP by the end of the century. Measures contemplated to contain expenditure in 1997 and beyond focussed on the health sector and public administration reform—with general savings on wage costs, supplemented by framework budgeting, further recourse to open tender and contracting-out, increased service charges, the merging of public institutions and a revaluation of the sickness insurance system—and also on a more rational division of responsibilities between central and local governments and between the social security system and private pension funds.

108. As the first step toward balancing the budget, the 1996 budget proposal aimed at reducing the Treasury revenue deficit to ISK 3.9 billion (0.8 percent of GDP down from 2.0 percent in 1995), through cuts in expenditures by about 3 percent in real terms, reflecting the emphasis on reducing capital expenditures and curtailing transfer payments (Table 4). Capital and maintenance expenditures were thus projected to decline by 0.6 percent of GDP in 1996 with the expiry of job-creation projects undertaken during the economic downturn, reduced expenditures on road construction, and postponement of construction of all new public buildings (in particular for health institutions). Transfer payments were projected to decrease by 0.5 percent of GDP, mainly by reducing pension and health insurance outlays. For pensions, savings were to be generated through the removal of all automatic links of transfer payments to wage or price indices, as well as by taking into account capital income when calculating means-tested benefits, and imposing stricter regulations on supplementary benefits. For health insurance, planned saving measures included a reduction in pharmaceutical expenses through price reference methods together with efforts toward promoting increased competition in supply. Other net operational expenses were also projected to be contained through across-the-board restraint helped by a decentralization of decision making and increased financial responsibility of managers. In addition to increased user charges for outpatient services in the health sector, there were also measures aimed at reducing budget caps for some major urban hospitals through rationalization and by curtailing appropriations for primary health care institutions.

Table 4

Iceland: Treasury Finances, 1995-1997

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Source: Ministry of Finance of Iceland.

Treasury revenue and expenditure for 1997 are expected to decrease by ISK 5.9 billion and ISK 5.2 billion due to the transfer of the primary school system from the central to local government.

Preliminary estimates.

Additional interest costs, on a cash basis, due to the early redemption of Treasury bonds in July 1996.

109. The actual budget for 1996, passed in December 1995, maintained the deficit target of ISK 3.9 billion expressed in the budget proposal: increased projected revenue resulting from better growth prospects was offset by the cost of new fiscal concessions granted in connection with the November review of the general wage agreement and by some additional expenditures, for agriculture and the health sector in particular (ISK 450 million). The fiscal concessions amounted to a total of ISK 1.0 billion for 1996, as the government moved forward tax exemptions on contributions to pension funds and rescinded plans to remove indexation of pension and unemployment benefits to wages, thus lowering Treasury revenue by ISK 400 million and increasing expenditure by ISK 600 million. Their effects on Treasury finances were, however, partially offset by a combination of new saving measures projected to yield additional revenue of ISK 250 to 300 million; these measures included further cuts in public investment (ISK 450 million) and the early removal (as from January 1996) of tax deductions for pension payments.

The budgetary outturn in 1996

110. Preliminary figures indicate that the Treasury deficit was actually reduced to ISK 2.7 billion, i.e., 0.5 percent of GDP instead of the 0.8 percent of GDP budgeted (excluding a major extraordinary expenditure item associated with an early redemption of bonds, discussed below). Although this performance was slightly better than expected, it proved disappointing in view of the strength of the economy, with notable expenditure slippages particularly in the areas of health and social security. Combined with a further improvement in local government finances from a deficit of 0.5 percent of GDP in 1995 to 0.2 percent in 1996, this budgetary outcome allowed a reduction in the general government deficit from 3.1 percent of GDP in 1995 to an estimated 1.7 percent of GDP in 1996. With actual output estimated at 1 percent above its potential in 1996 after having been 2 percent below it in 1995, the government deficit is estimated to have fallen marginally from 2.1 percent to 2.0 percent of GDP in structural terms. On the whole, it appears that, along with some revenue shortfalls, strong growth was mainly used to cover expenditure slippages at the Treasury level.

111. Treasury revenues are estimated to amount to ISK 126.0 billion, exceeding budget projections by ISK 5.1 billion and reflecting stronger–than–expected growth, as real GDP and total domestic demand grew by 5.5 percent and 6.9 percent in 1996, instead of 3.2 percent and 5.6 percent assumed in the budget (Table 4). Based on these preliminary figures, personal income taxes exceeded the budget by ISK 3.1 billion, as a result of higher income and improved tax collection resulting from the cyclical upswing, and payroll taxes also yielded ISK 0.3 billion more than budgeted, due to higher wages and lower unemployment. On the opposite, corporate tax revenues fell short of budget projections—despite higher business profits—as a consequence of increased utilization of old losses against current profits. Moreover, with only ISK 0.2 billion above their budget estimates, despite real private consumption growth 1½ higher than assumed, VAT collections stood out as particularly disappointing. While VAT collections on imported goods were broadly in line with registered imports, VAT revenues from domestic activities turned out much smaller than expected (12 percent below budget projections), and even somewhat lower than their 1995 level. Potential explanations mentioned by the Ministry of Finance include: (i) increased weight of lightly taxed capital goods in value added; (ii) intensified competition, reducing profit margins and prices in retailing; and (iii) increased tax refunds in the fisheries. However, this shortfall remains largely a puzzle at this time, perhaps also reflecting increased tax evasion and avoidance. Finally, actual revenues from excise taxes were also lower than budgeted, due to an extensive revision of the system during 1996 (see below).

112. On the expenditure side, Treasury outlays exceeded budget projections by an estimated ISK 3.9 billion (0.8 percent of GDP). The largest overruns were in the areas of health and social security, for a total amount of ISK 1.3 billion (Tables 4 and 5), partly due to delays and a failure to implement some key cost-saving measures. Total operating expenditures turned ISK 1.2 billion higher than budgeted, reflecting large overruns for the hospitals in Reykjavik (ISK 430 million), increased expenditure for the primary school system (ISK 240 million) and higher wage costs resulting from some agreements made after the budget was passed (ISK 250 million). Meanwhile, the largest part of the ISK 1.2 billion overrun in transfer payments was in health insurance (ISK 830 million), as a consequence of higher outlays on pharmaceutical and medical expenses—in part reflecting an insufficient increase in co-payments, and insufficient progress towards the adoption of generic drugs and improved competition among suppliers. Transfers also increased due to the effects of devastating snow avalanches in late 1995 and higher-than-projected agricultural subsidies.44 Finally, additional interest payments (ISK 700 million, excluding accrued interest on callable bonds redeemed early—see below) and increased investment outlays (ISK 600 million), in road construction in particular, accounted for most other expenditure overruns.

Table 5

Iceland: Treasury Expenditure by Ministry, 1996-1997

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Source: Ministry of Finance of Iceland.

113. An additional development influencing the 1996 budgetary outturn was the early redemption in July of Treasury savings bonds, issued in 1984 and 1986 and maturing in 2000, for a total amount of ISK 17 billion (3½ percent of GDP). As these callable bonds carried high interest rates, the operation was expected to reduce debt servicing costs by ISK 2.0 billion in present value terms over the remaining life of the bonds; the initial impact on the Treasury budget expressed in cash terms was, however, to bring forward spending due to the payment of accrued interest of ISK 10.1 billion (2 percent of GDP). This operation also inflated the Treasury net borrowing requirement from an underlying ISK 5.1 billion (3.1 percent of GDP after 4.1 percent in 1995); the borrowing requirement was also increased by the extension of a ISK 2.3 billion loan to the State Housing Board.45 More than half of the total ISK 14.5 Treasury borrowing was met by foreign borrowing in 1996, albeit down from a share of about nine tenths in 1995.46

B. Fiscal Policy and Outlook

The 1997 budget bill

114. The 1997 budget proposal aimed at recovering a large part of the 1996 expenditure overruns, resulting in a projected decline of total expenditure by 1.0 percent of GDP from 1996 to 1997 (correcting for the interest payment related to the bond redemption in 1996 and the transfer of the primary school system from central to local governments—Table 6). With no major change in tax incidence for 1997 (see section C), this was expected to turn the Treasury revenue balance into a small surplus—the first in years—of 0.2 percent of GDP, after a deficit of 0.5 percent in 1996. Combined with stable local government finances, this would contribute to halving the general government deficit to about 1 percent of GDP in 1997.47 With a net lending capacity of ISK 2.3 billion (0.4 percent of GDP), the budget proposal also envisaged a further reduction of Treasury gross debt from 51 percent of GDP in 1995 to 46 percent in 1997.

Table 6

Iceland: Effects on Treasury Expenditure of the Transfer of the Primary School System to Local Government Transfer

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Sources: Ministry of Finance; and staff calculations.

Excluding interest payments due to the early redemption of Treasury bonds in July 1996.

Expenditures in 1996 are adjusted for the effects of the transfer of the primary school system in order to make them comparable to expenditures in 1997.

Deflated by implicit GDP deflator.

115. In the budget proposal, continued growth was expected to yield an increase in revenue of about ISK 5½ billion in 1997. With Treasury income tax revenues projected to fall by ISK 5.9 billion due to the transfer of the primary school system, total revenue would thus amount to ISK 125.4 billion, slightly below the ISK 126.0 billion estimated for 1996 (Table 4). These projections, however, reflect cautious macroeconomic assumptions—with real GDP growth decreasing from 5.5 percent to 2.5 percent in 1997 and consumer price inflation moderating to 2.0 percent from 2.3 percent in 1996—and conservative projections for VAT collections after the unexplained 1996 shortfall.48 As for personal income tax, the budget proposal incorporated a further extension of 5 percent surcharge for higher incomes introduced as a temporary measure in 1993.

116. The 1997 budget proposal planned a reduction in expenditures by 1½ percent in real terms, excluding extraordinary items (Table 6), somewhat more broadly spread than in the 1996 budget. Cuts in health and social security expenditure were largely intended to reverse the 1996 slippages by carrying out measures that had been delayed or not fully implemented. Compared to estimated outlays for 1996, appropriations for the hospitals in Reykjavik and outside the capital area were planned to be reduced by ISK 450 million and ISK 160 million respectively; for the former, a plan for rationalization and restructuring had been agreed upon. The government also envisaged a reduction of ISK 650 million in outlays for health insurance, achieved through extended copayments as well as various other measures potentially including agreements towards expenditure restraint with medical doctors’ unions, increased recourse to contracting–out for research work, and lower reimbursements for dental claims. Outlays for pension insurance would be lowered by ISK 200 million, as the base for the means–tested component of basic public pensions was broadened to total income (including capital) instead of wage income only. Along with reduced appropriations for secondary schools (ISK 200 million), saving measures in other areas would result from increased efficiency of public services and a further reduction in capital expenditure (by about ISK 300 million, despite a special appropriation of ISK 265 million granted to municipalities for the construction of primary school buildings). The budget proposal also projected a reduction in interest payments by ISK 250 million compared to 1996, reflecting in part the overall surplus budgeted.

117. Responsibility for the primary school system was transferred from central to local governments in August 1996. This shift was designed to be neutral on both Treasury and municipalities’ finances, as a tax reallocation accompanied the reshuffling of responsibilities. As from 1997, the central government’s share of the personal income tax was thus lowered by 2.65 percent (of gross earnings) to allow municipalities to meet their new education expenditures. Treasury revenues would thus fall by ISK 5.9 billion in cash terms, but taking into account a one-month collection lag, the total effect of the shift would amount to ISK 7.2 billion per year. Local governments are to be compensated for this lag in 1997 through a direct transfer payment of ISK 1.2 billion by the Treasury, which is also committed to finance part of the additional capital expenditures foreseen, providing a fixed payment over the next five years (see below).

118. The final 1997 budget (adopted by parliament on December 20, 1996) reduced the small Treasury revenue surplus projected by the budget proposal to balance (more precisely, a surplus of ISK 124 million, i.e., 0.02 percent of GDP); this was a consequence of both higher revenue and expenditure. Despite unchanged macroeconomic assumptions, Treasury revenue projections for 1997 were revised upward by ISK 800 million in light of favorable developments in late 1996. The personal income tax was expected to yield an additional ISK 975 million, which, along with higher revenues from payroll taxes and import duties, largely exceeded downward revisions in corporate tax and VAT revenues, reflecting in turn several tax modifications (see below) and still lower-than-expected VAT collections in 1996. Increased expenditures compared to the budget proposal amounting to ISK 1.8 billion (0.3 percent of GDP) were partially due to additional cash payments (ISK 600 million) associated with a newly announced reform in public pensions (discussed below), but were also due to the abandonment of some saving plans, in the health sector in particular. Total appropriations for hospitals were increased by ISK 481 million, following a reassessment of their financial needs and the postponement or phasing of some of the cost-saving measures envisaged. Other additional expenditures were rather widespread, including increased payments to the Student Loan Fund and the costs of repairs to roads and bridges damaged by the flooding associated with the Vatnajökull volcanic eruption (each about ISK 100 million).

119. On the financing side, as new lending to other public institutions is expected to fall short of repayments by ISK 1.7 billion (with no further plans for borrowing and relending to the State Housing Board), the Treasury is expected to show a total net lending capacity of 0.3 percent of GDP this year. Including the financial needs of partly state-owned enterprises and public financial institutions such as the mortgage bond system and investment credit funds, the public sector borrowing requirement (PSBR) is, however, projected to decline only moderately, because of higher borrowing and lower repayments for public institutions other than the Treasury (Table 7).49 Although indicative of the large role played by Iceland’s public sector in the credit markets, the PSBR cannot be used to assess the borrowing pressure resulting from direct government intervention in the economy, given its coverage of various institutions whose purpose is purely commercial.

Table 7

Iceland: Net Public Sector Borrowing Requirement, 1990-1997

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Source: Ministry of Finance of Iceland.

Preliminary estimates.

Projections by the Ministry of Finance based on the 1997 Budget.

Includes borrowing by the Workers’s Building Fund, the State Housing Fund and the Housing Bond system.

Includes borrowing by partially public enterprises and investment credit funds other than housing funds.

Modifications planned in the tax system

120. Substantial changes in the personal income tax system, aiming at improving work incentives by reducing the marginal effects of both the income tax and related benefit payments, are presently under consideration (see Section C). But the tax modifications planned for 1997 are modest, intended mainly to move towards greater harmonization with other OECD and EEA countries and to strengthen the competitive position of Icelandic companies. These modifications include a gradual merging of the present two-tier social security into one and various changes in the corporate income tax system in order to make it more flexible. In addition, further steps are planned to lower excise taxes and consolidate the rate structure, and a new consolidated capital income tax is to become effective in 1997. While intended to be revenue neutral in the medium-term, these tax changes could result in some revenue loss in 1997.

121. The social security tax is presently levied at two different rates, with the lower rate of 3.55 percent applied to agriculture, fisheries, manufacturing, hotels and restaurants, car rental and computer services and the higher rate of 6.85 percent applied to other sectors.50 With a view to complying with EEA standards and improving efficiency, the government has decided on a gradual harmonization, phased over 1997-2000. The final unified rate would be equal to the present average rate of 5½ percent, so that ultimately the reform should be roughly revenue neutral.

122. The main changes envisaged in the corporate tax system concern the treatment of trading losses and depreciation rules. First, the period over which firms are allowed to carry losses forward will be extended from 5 years to 8 years. Second, the government has decided to increase the flexibility of depreciation rules, by changing the present rates on machinery from 9-12 percent to 5-15 percent (straight line method), and with similar adjustments for other items. The government also plans to pass legislation to abolish the deductibility of dividend payments from the corporate income tax (currently a maximum of 7 percent of the total value of shares): this deductibility together with the new capital income tax system (see below) could introduce a bias towards the payment of dividends against retained earnings. The government also intends to lower the net wealth tax on corporations, which is relatively high compared to other countries (1.45 percent with no a tax-free limit).

123. Various changes were made to the excise duties system in the Spring of 1996, as a formal charge from the EFTA Surveillance Office against Iceland highlighted the fact that the system did not fully comply with the EEA requirements. The 25 percent estimated mark-up on wholesale prices of imported goods was abolished and the collection rules were further harmonized between imported and domestic goods. These changes led to revenue losses of about ISK 300 to 400 million, which were temporarily offset by lowering VAT reimbursements for owner-occupied residential costs from 100 to 60 percent. Further adjustments in the excise system planned for 1997 could cause additional revenue losses of about ISK 350 billion; the government plans to meet these costs through a reallocation of the revenues raised by the social security tax, with lower payments to the Unemployment Insurance Fund resulting from lower benefit claims.

124. A new consolidated tax on capital income, passed in 1996, is also to become effective at the beginning of 1997, introducing a uniform 10 percent withholding tax on interests, dividends, capital gains and rents. This major overhaul was intended to eliminate the existing large discrepancies in the taxation of different forms of savings: interest income had previously been tax exempt while other sources of capital income were subject to personal income tax at rates of up to 47 percent and this discrepancy tended to distort savers’ choices. The new system was thus proposed on the basis of simplicity, transparency and equity, as well as efficiency. The revenue consequences of the reform are somewhat uncertain for the short term, but the new tax is expected to yield around ISK 1 billion per year when fully in force. The government has, however, stated that the total tax burden will not increase accordingly in the medium-term as the revenue gains should be used to reduce other taxes.

Other reforms in the public sector

125. Recent structural reforms in the non-financial public sector have focussed on the civil service status and improving the public pension system. Together with recent changes in the labor market legislation for the private sector (see Chapter I), amendments in the Act on Rights and Obligations of State Employees were also passed in May 1996, restricting public workers’ rights and benefits: in particular (i) guaranteed lifetime employment for civil servants was replaced by a system of renewable five-year contracts; (ii) new limits were imposed on overtime and severance pay; and (iii) directors of state institutions were given increased flexibility to differentiate employees’ remuneration.

126. New legislation aimed at reforming the public pension system was also passed in December 1996 with a view to simplifying it and bringing it closer to the largely-funded pension system of the private sector.51 In contrast to the latter, the old public pension scheme was a mixture of pay-as-you-go and personal saving, for which government contributions covered only about one half of the pension rights acquired by employees. As a result, the Treasury’s unfunded pension liabilities had gradually increased to an estimated ISK 81 billion (18 percent of GDP) at the end of 1995. The new system introduces increased contributions for both employees and the state, and stricter entitlement rules for retirement benefits (although remaining overall more favorable than those for private sector employees). First, public employees and the government’s pension contributions will now be equal to 4 percent and 11.5 percent of total earnings respectively, compared with 4 and 6 percent of day-time earnings. Second, pension benefits will be now be based on lifetime earnings (indexed to the private consumption deflator) instead of terminal earnings; and entitlement rules for late and advanced retirement benefits and for pensions for surviving spouses have also been tightened. Through greater alignment with the private system, this reform should also help remove obstacles to labor mobility and to structural reform (e.g. privatization of state–owned financial institutions would now raise fewer issues with regard to employees’ pensions). Its costs to the Treasury should be fairly small: although annual government pension payments are projected to increase by about ISK 600 million on a cash basis, payments should be largely unchanged on an accrual basis.

The medium-term fiscal outlook

127. Official projections, based on policies announced in the 1997 budget proposal, show that the medium-term fiscal outlook has improved, with small Treasury surpluses of about ½ percent of GDP (on a cash basis) projected over 1998-2000 (Table 8). As noted by the Ministry of Finance and despite a significant reduction in the Treasury’s debt ratio, these projections also emphasize the need for further fiscal consolidation in the coming years, as current policies would only allow a gradual restoration of the economy’s saving-investment balance and the central government would continue to accumulate small deficits on a full accrual basis.52 Without the construction of a second aluminum smelter in 1997, these official projections assume a moderation of growth to a trend 2-2½ percent per year. With no major tax reform envisaged, the projections also take into account fast inherent growth in transfers after 1997 (3½ percent per year in real terms for pensions and 3 percent for health insurance), and assume that growth in operating costs will be limited (to 1 percent in real terms) through general restraint, especially in the health sector.

Table 8

Iceland: Medium-term Fiscal Outlook, 1997-2000 1/

(In percent of GDP)

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Sources: Ministry of Finance; National Economic Institute; and staff calculations.

Baseline projections based on current and announced policies.

Offical projections consistent with the 1997 Budget Proposal.

Staff projections for 1997 based on measures included in the 1997 Budget.

Cash basis.

Excluding the early redemption of July 1996.

Accrual basis, including imputed contributions to unfunded pensions for government employees.

128. Staff projections, based on measures included in the final 1997 budget and announced policies for later years, give a broadly similar picture. With higher growth in 1997 (3.0 percent instead of 2.5 percent) and higher inflation, but similar growth projections thereafter, the staff would envisage somewhat higher revenues in the medium term, especially from VAT. In light of past slippages, however, difficulties in meeting expenditure reduction targets could lead to higher operating costs and transfer payments. This, combined with a less optimistic view on the authorities’ ability to contain maintenance and investment expenditures at their current low level, would result in a somewhat lower Treasury surplus of about 0.2-0.3 percent of GDP in the medium-term. With no further fiscal consolidation at the municipal level, the general government deficit would remain higher than ½ percent of GDP (accrual basis) in the later years. Meanwhile, public savings would not significantly improve after 1997 and the present current account deficit would only gradually disappear over the medium term (Table 9).

Table 9

Iceland: Medium-Term Outlook for Saving and Investment Balances

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Sources: National Economic Institute; and staff calculations.

Staff projections.

Including imputed contributions to unfunded pensions for government employees.

C. The Personal Income Tax System

Iceland’s tax structure and major recent reforms

129. Two characteristics of the Icelandic tax system stand out compared to other industrialized countries. First, at about 33 to 35 percent of GDP in recent years, the burden of taxation in Iceland is relatively modest, well below the European average of over 45 percent of GDP. Second, despite a declining role in the wake of major recent reforms, indirect taxes remain a major source of public income in Iceland, providing about one half of general government revenue compared with an average of 45 percent for other Nordic countries (Table 10).

Table 10

Iceland: General Government Revenue, 1990-1995

(In percent of GDP)

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Source: National Economic Institute.

130. In order to improve its efficiency as a stabilization policy instrument, reduce distortions and bring it more in line with that prevailing in other European countries, the Icelandic tax system has undergone a complete overhaul since the mid–1980s, with major changes in the personal income as well as in the corporate and indirect tax systems. One major goal of these reforms, initiated in 1987, was to make tax revenues more responsive to economic developments, strengthening built-in stabilizers through a move from indirect to direct taxation, and broadening the tax base which had been seriously narrowed by an accumulation of exemptions and deductions. These tax changes were motivated both by the need to strengthen Treasury finances, then impaired by stagnating activity and a growing structural deficit, and also by increased international cooperation and competition, for the corporate tax system in particular. Consequently, the extensive reforms which were then undertaken shared three basis characteristics with those implemented in the OECD at large: (i) the reduction and simplification of personal income tax via a reduction in the number of tax rates; (ii) the rationalization and broadening of the expenditure tax base, through a switch to a general expenditure tax; and (iii) a trend towards base-broadening and greater neutrality in the corporate tax system (Bollason, 1996).

131. As a first step, while personal income taxes were levied and collected on the basis of the previous year’s income and a range of six different effective rates, a new pay-as-you-earn (PAYE) system was introduced in 1988, with a single rate (initially put at 35.2 percent) together with the abolition of numerous exemptions and deduction. Further adjustments were made in later years, with a view to broadening the tax base and further reducing special credits and exemptions. At the same time, the corporate income tax system was reformed in similar ways: tax-free allocations to investment and general reserve funds, and some other tax-free allowances, were reduced in 1988-89; and the general tax rate was stepwise reduced from 50 percent in 1990 to 33 percent in 1994, together with further similar measures aimed at broadening the tax base.

132. As for indirect taxes, the sales tax system was thoroughly revised in 1988 with an important enlargement of its base, and then replaced by a simple value-added tax in 1990. Based initially on a single high rate of 24.5 percent with a relatively narrow base due to various exemptions and rebates, the VAT system was further overhauled in 1993: the tax base was broadened by introducing a second lower tax rate of 14 percent on various formerly exempted goods and services; the lower rate was then extended to food products as a result of fiscal concessions granted in early 1994. In addition, the entire system of excise and import duties was also subjected to a complete overhaul in 1988, with the aim of lowering general tariffs and abolishing various import levies; the import taxes were restructured further following Iceland’s 1994 accession to membership in the European Economic Area.

The personal income tax system

133. The main characteristics of the personal income tax introduced in 1988 are twofold. First, the system is based on a single and particularly high tax rate on gross earnings, which in recent years has gradually crept up to almost 42 percent (30.5 and 11.5 percent respectively for central and local governments), with a 5 percent surcharge on higher incomes since 1993. Second, the system is characterized by extensive tax credits and benefits (despite some reduction since 1988), resulting in a much lower average tax rate of about 17 percent (Table 11).

Table 11

Iceland: Structure of Personal Income Tax 1/

article image
Source: Ministry of Finance of Iceland.

Based on projections for 1997 by the Ministry of Finance, including the effects of the transfer of the primary school system and excluding the 5 percent surcharge on high income taxpayers (accrual basis).

Gross earnings.

Including seamen tax credits and tax relief for securities purchases.

134. There are three main types of credits. First and most important is the personal income tax credit, a fixed annual amount per taxpayer amounting at present to ISK 24,544 per month (transferable within couples up to a maximum of 80 percent). This credit is very important since it effectively exempts many people from tax: for instance, a standard one-earner couple with monthly earnings below ISK 105,000 (about 1560 US dollar) does not pay any personal income tax. All incomes above this threshold are taxed at the general 42 percent rate, which is a high marginal rate by international standards at least for the lower range of those incomes (see, in particular, OECD, 1993).

135. The other main tax credits consist of child benefits and mortgage interest rebates. Child benefits are awarded to families with children under 17 years old and consist of two components: the first is a lump sum payment which depends purely on the age and number of children: the benefit for the first child amounts to ISK 9,000 and ISK 27,000 for other children, with a supplementary allowance of ISK 30,000 for children under 7 years old and higher benefits for single-parent families. The second component is means–tested both to taxable income and net wealth (with one year lag and its rate varying with the number of children) and its maximum amount per child reaches ISK 93,000 per year. Mortgage interest rebates are granted to individuals purchasing owner–occupied housing. Their main component is means–tested, with a 6 percent deduction of actual income from the interest outlay, but their amount also depends on the taxpayer’s net wealth and interest burden. Altogether, the marginal effects of child benefits and interest rebates can be as high as some 20 percent. In addition, there are some other miscellaneous credits, including credits for seamen and credits related to the purchase of stocks (initially granted to help develop domestic financial markets).

Problems and policy options for reform

136. Due to this particularly generous use of tax credits and benefits, Iceland’s personal income tax system combines one of the highest standard marginal tax rates in the OECD (42 percent, and 47 percent for higher incomes), with one of the lowest revenue intakes in relation to GDP. In particular, due to these credits and benefits, the effective marginal tax rates can be as high as 60 to 70 percent for middle-income households with children and only about ⅓ of tax reporters actually pay the personal income tax. This feature is believed to seriously affect work incentives, especially in the middle range of the income distribution. The government has therefore set up a commission to evaluate possible reforms to both income tax and related benefits with the aim of reducing their marginal effects; its final recommendations are due by mid-1997.

REFERENCES

  • Blanchard O.J., 1990, “Suggestions for a New Set of Fiscal Indicators”, OECD Economics and Statistics Department Working Paper No. 79, (Paris: Organization for Economic Cooperation and Development).

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  • Bollason B.T., 1996, “(Iceland’s) Public Finance”, in Iceland: The Republic (Handbook published by the Central Bank of Iceland), (Reykjavik: The Central Bank of Iceland).

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  • Chand S., 1993, “Fiscal Impulse Measures and their Fiscal Impact”, in How to Measure the Fiscal Deficit, M.I. Blejer and A. Cheaty eds., (Washington: International Monetary Fund).

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  • Giorno, C., P. Richardson, D. Roseveare, and P. van der Noord, 1995, “Estimating Potential Output, Output Gaps and Structural Budget Balances”, OECD Economic Department Working Paper No. 152, (Paris: Organization for Economic Cooperation and Development).

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  • Heller P.S., R. D. Haas, and A. S. Mansur, 1986, “A Review of the Fiscal Impulse Measure”, IMF Occasional Paper No. 44, (Washington: International Monetary Fund).

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  • IMF, 1995, Tax Policy Handbook, P. Shome ed., (Washington: International Monetary Fund, Fiscal Affairs Department).

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  • OECD, 1993, Taxation In OECD Countries (Paris: Organization for Economic Cooperation and Development).

  • Roseveare D., W. Leibfritz, D. Fore, and E. Wurze, 1996, “Ageing Populations, Pension Payments and Government Budgets Simulations for 20 OECD Countries”, OECD Economic Department Working Paper No. 168, (Paris: Organization for Economic Cooperation and Development).

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ANNEX II Issues in Fisheries Taxation53

137. Fisheries account for an important, albeit diminishing, share of economic activity in Iceland—recently some 15 percent of GDP, and over 70 percent of merchandise exports. This makes the taxation of fisheries an important structural issue, with significant fiscal and macroeconomic implications.54

138. The key aspect of the fisheries that warrants public policy involvement is the element of common property; if this element is not addressed, individual fishing firms would take account of the costs of catching the fish, but not the costs of the resulting depletion offish stocks. The common property problem is exacerbated when ownership offish stocks is not exclusive to one country. Iceland addressed this problem by establishing an exclusive fishing zone within a 200-mile limit of Iceland’s coastline in 1976, and enforcing quotas on fish catches within this limit.

139. Iceland’s fishing quotas are based on a total allowable catch (TAC) announced by the Ministry of Fisheries on the advice of the Marine Research Institute. The TAC is designed to overcome the common property problem by limiting fishing to a sustainable and economically efficient level. Individual fishing firms are then allocated shares in TAC, called individual transferable quotas (ITQs), on the basis of their catch in a base period 1981-83. The ITQ system was introduced at different times for different species (in 1984 for demersal species, the most important), with a uniform system in place for all species since 1990.55

140. One feature of Iceland’s ITQ system that is particularly conducive to economic efficiency is that shares in TAC are tradable, subject to certain restrictions. A fishing firm may either sell its share for a particular year, sell its entire stream of TAC shares into the future. This permits quota rights to pass into the hands of those for whom they have the highest value. It also helps reduce the problem of wastage (resulting from the fact that catches are uncertain and fishing nets, unlike TAC, are not species-specific): a fishing boat that catches above-quota amounts of a particular species can, in principle, purchase the needed quota before it reaches port.

141. The efficiency resulting from the TAC system is limited by some restrictions on who may purchase quota rights. In particular, the market is narrowed by a rule that quotas can only be purchased by Icelandic boat-owners. Moreover, a rule that if a quota is not used or sold it is forfeited may in principle induce firms to continue uneconomic fishing simply to preserve the option value of the quota. Transfers of quota among different ports are also subject to approval of the Ministry of Fisheries, although such approval is generally granted.

142. Excess capacity has been a persistent problem in Iceland’s fisheries, estimated at 30-40 percent. One reason has been the exemptions granted to small boats: small operators have been permitted instead to work under limitations on their number of days at sea—a form of restrictions that creates a large incentive to overinvest in small ships. Some observers have argued that the root of excess capacity is a more general problem: fishing firms distrust the permanence of the TAC system, and thus overinvest in capacity to be prepared in case of an easing of quotas or change in the allocation system. One response to excess capacity has been to levy contributions to a Fisheries Development Fund whose resources are used to finance the retirement of excess capacity and other conservation measures that are to the long-term benefit of the industry.

143. The most contentious aspect of current fisheries policy is the allocation of quota rights free of charge to existing boat owners, in proportion to their 1981-83 catch. This may be viewed as a transfer of the right to use resources which by law belong to all Icelanders. The market price of these resources, established in the over-the-counter market for TAC shares, provides a rough measure of resources transferred to boat owners, estimated at some 3 percent of GDP per year in 1990.56 Whether this transfer is equitable is, of course, to be decided by Icelanders and expressed through the political process. However, the implications for economic efficiency may also be important. The value of the right to participate in a catch that is limited by quota is an economic rent; in principle, economic rent can be taxed away, or equivalently a market price charged for the use of a publicly-owned resource, without distortionary effect, and the proceeds used either to improve long-run fiscal position or to reduce other distortionary taxes (such as the personal income tax).

144. These considerations have led many to argue that it would be desirable to modify the existing system by charging fees for the use of the fisheries resources. This could be done either by imposing a tax or fee up to the amount of the quota rent; or by selling the quota rights in an open auction. Such a fee or price, provided that it were less than or equal to the price that would emerge in an auction, would not affect fishing output, which would still be equal to TAC.57

145. There are some counter-arguments. One is that the present system of quota allocation creates a pool of funds to be invested in a range of activities, including fisheries-related industries, which adds to the productive capacity of the economy. A related argument is that if a resource tax were imposed, the additional revenues might be used to finance additional, socially wasteful government spending rather than to reduce the deficit or to lower other distortionary taxes. Similar arguments could equally be used, however, to support the continuation of any government entitlement that concentrates wealth, or to oppose any change in tax structure or broadening of the base.

146. Two further arguments for the existing allocation of quota rights are based on other objectives. One pertains to the distribution of coastal population: the fishing rights were allocated on a regional basis, corresponding to fish catch in the base period, and rights can only be transferred across regions with government permission. Moreover, the transferability of quotas implies that those in outlying regions get the benefits of the quota rights even if they do not continue to fish these quotas. In this case, the quota allocation is in large measure a regional transfer in pursuit of a national objective.

147. Another consideration is banking system soundness. In 1995, loans outstanding to fishing companies were some 15 percent of total bank credit and 38 percent of the credit of the investment credit funds (excluding housing funds). Charging a substantial fishing fee could reduce the net worth of fishing companies, considerably endangering their loans and thus the solvency of the banking system and investment credit funds. For this reason, in effect the additional revenues from a fishing fee could be absorbed by a reduction in the net worth of the (mainly state-owned) financial system or in transfers to recapitalize insolvent institutions. To the extent that this situation was pervasive, it would create difficulties in implementing a fishing fee. In this case, the allocation of quota rights to fisheries is an implicit subsidy to the financial system, whose removal could cause transitional strains.

148. However, in both of these cases, the issues of fiscal transparency and targeting of expenditure remain. Subsidies—either to outlying regions or to the financial system—could, if they are justified, be made explicitly through the budget and targeted to their desired purpose. Allocating the quota rights free of charge may be, in effect, an attempt to accomplish national objectives through off-budget transfers; replacing it with equivalent on-budget taxes and transfers would clarify the use that is being made of public resources.

REFERENCES

  • Arnason, Ragnar, 1993, The Icelandic Individual Transferable Quota System: A Descriptive Account. Marine Resource Economics Vol. 8, pp. 201-218.

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  • Gylfason, Thorvaldur, 1991, Iceland on the Outskirts of Europe: The Common Property Resource Problem. EFTA Bulletin Volume 2, pp. 23-28.

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  • Gylfason, Thorvaldur, 1992, The Pros and Cons of Fishing Fees: The Case of Iceland. EFTA Bulletin Vol. 3-4, pp 6-9.

35

Prepared by Antoine Magnier.

36

Iceland’s general government financial accounts and those of its components (central and local government, and social security) are reported on an accrual basis, and include imputed contributions to unfunded pension to public employees. The Treasury finances (consistent with the national accounts definition of the central government), as presented in the budget documents used for policy discussions in parliament are, however, on a cash basis.

37

In 1995, in particular, fiscal concessions in order to expedite the two-year general wage agreement amounted to ISK 2.7 billion (0.6 percent of GDP), with higher expenditure and lower revenue resulting from the decision to gradually exempt the employees’ compulsory contributions to pension funds from income tax.

38

See, for instance, Giorno et al. (1995) and Heller et al. (1986) for the methods used.

39

Elasticities of general government total revenues to nominal GDP are assumed to be 1.35 and 0.90 respectively for direct and indirect taxes—in line with recent observations—and unemployment compensation is assumed to be proportional to the actual unemployment rate. The measures of output gap and the NAWRU used here are from chapter II.

40

Given recent overhauls of the tax system, with the introduction of a pay-as-you-earn income tax and a broad-based VAT, our approach only yields tentative estimates for the earlier years. Additional adjustments for inflation could also help to better assess the fiscal policy stance in this period, but debt indexation, along with the treatment of the inflation-linked component of interest costs on indexed securities as repayments of principal, would limit their scope.

41

Estimates of structural balances are particular uncertain given the uncertainty surrounding output gap measures for Iceland. They however provide a useful benchmark which can help to assess the scope of past policy discretionary actions (see, for instance, Blanchard 1990).

42

Computations at the Treasury level yield similar conclusions. Their implementation and interpretation are, however, further complicated by recent tax reforms and reshuffling of responsibilities between central and local governments.

43

See Annex II of Iceland - Staff Report for the 1996 Article IV Consultation (SM/95/311).

44

An agreement, signed in October 1995, raised agricultural transfer payments by ISK 200 million in 1996, while reducing them in the following years.

45

The Treasury borrowed ISK 7.5 billion and ISK 8.0 billion in 1994 and 1995 for relending to the State Housing Board, due to the institution’s difficulties in raising funds directly on the market, and consistent with the government’s policy of maintaining low domestic interest rates at that time.

46

The monetary impact of the operation is discussed in Chapter V.

47

Prospects for municipalities were rather unclear at the time of the budget proposal, since they were still in the first phase of preparing their budget plan for 1997. There were, however, converging indications that the consolidation undertaken in 1995-1996 would come to an end this year; the last NEI projections envisaged a slight deterioration in their deficit from 0.2 percent of GDP in 1996 to 0.3 percent in 1997.

48

In advance of the general wage negotiations to be held in early 1996, the budget proposal assumed wage increases in 1997 to be similar to those in neighboring countries at 3.6 percent.

49

A large borrowing increase is projected by the National Power Company, for investments required by the (now likely) construction of a second aluminum smelter.

50

The social security tax, which is levied on employers’ wage payments, was raised by 0.5 percent in 1995, to compensate partly for the fiscal concessions granted in connection to the wage negotiations in early 1995, and a larger share of it was directed to the Unemployment Insurance Fund in view of its rising needs.

51

Long-term simulations by Roseveare et al. (1996), assessing the future negative impact of ageing population on public finances and national savings, suggest that Iceland’s difficulties should remain relatively mild compared to most other industrial countries, due to its largely-funded private pension system, together with a relatively high retirement age and moderate retirement benefits.

52

The main difference in Treasury accounts between cash and accrual basis stems from future pension payments and interest outlays that accrue, but are not paid during the year.

53

Prepared by Tim Lane.

54

A more general discussion of fisheries management is contained in Iceland - Recent Economic Developments (SM/94/7, January 10, 1994), Annex IV.

55

The ITQ system is described in Arnason (1993).

56

See Arnason (1993). The author notes that the market valuation of the quota may be biased upward as a measure of economic rents. However, rents may have increased with the replenishment offish stocks during the 1990s.

57

The case for fishing fees is made, for instance, by Gylfason (1991, 1992).

Iceland: Recent Economic Developments
Author: International Monetary Fund