Finland: Staff Report for the 1999 Article IV Consultation

This 1999 Article IV Consultation highlights that Finland’s economy has made a strong recovery from the deep recession that began in the early 1990s. Spurred by a devaluation of the markka, growth was predominantly export driven, and the external current account shifted from a deficit of more than 5 percent in the early 1990s to a surplus of the same magnitude in 1997/98. In this setting, prudent macroeconomic policies brought public finances from a deficit of 7 percent of GDP in 1993 to a surplus in 1998.

Abstract

This 1999 Article IV Consultation highlights that Finland’s economy has made a strong recovery from the deep recession that began in the early 1990s. Spurred by a devaluation of the markka, growth was predominantly export driven, and the external current account shifted from a deficit of more than 5 percent in the early 1990s to a surplus of the same magnitude in 1997/98. In this setting, prudent macroeconomic policies brought public finances from a deficit of 7 percent of GDP in 1993 to a surplus in 1998.

I. Background

1. Finland’s economy has recovered strongly from the deep recession that began in the early 1990s, and over the past few years it has experienced growth well above the EU average.1 Spurred by a devaluation of the markka, exports of goods and services drove the recovery—rising from under 25 percent of GDP at the start of the decade to 40 percent of GDP currently. Economic growth averaged some 5 percent over the past three years, while inflation fell to a low level (Figure 1 and Appendix III). The external current account shifted from a deficit of over 5 percent of GDP in 1991 to a surplus of the same magnitude—by far the largest adjustment among advanced economies over that period.

Figure 1.
Figure 1.

Finland: Selected Economic Indicators, 1990-2000

Citation: IMF Staff Country Reports 1999, 121; 10.5089/9781451813142.002.A001

Sources: World Economic Outlook, European Central Bank; and staff estimates.

2. Firm restraint over expenditure, in a setting of economic recovery, brought the public finances from a deficit of 7 percent of GDP in 1993 to a surplus in 1998, and reduced the public debt ratio to less than 50 percent of GDP. Primary spending fell by 10 percentage points of GDP between 1992 and 1998—the strongest performance in the European Union.2 With the fruits of restraint dedicated to deficit reduction, taxes remained high. Together with a firm monetary policy, this cleared the way to membership in the euro area. Finland’s impressive macroeconomic record was not matched in structural policies, though some labor market and pension reforms have been carried out since 1995. The unemployment rate is still some 10 percent, and in some regions is on the order of 20 percent.

3. The last Article IV consultation was concluded on August 28,1998 (SUR/98/106). Directors commended the authorities’ prudent macroeconomic policies, which had led to strong output growth in a setting of low inflation, a large external surplus, and a strengthened fiscal position. They advised that fiscal consolidation be continued, given the sizeable demographic shock ahead. To offset the loss of monetary independence under EMU, they urged increasing the flexibility of fiscal policy, and pursuing comprehensive structural reforms to improve the working of the labor market and reduce unemployment.

II. Recent Developments and Short-term Prospects

4. Since mid-1998, activity has been underpinned by robust domestic demand Private consumption has expanded strongly, supported by rapid employment growth, while fixed investment has decelerated only slightly. The services and construction sectors have maintained a pace of strong expansion. In manufacturing, capacity utilization declined significantly in late 1998 from historically high levels (Figure 2). However, after slowing somewhat toward the end of 1998, industrial output accelerated in the first quarter of 1999, and was some 6 percent higher than a year earlier—spurred by the excellent performance of the electronics industry. Wage rates rose by an average of 3½ percent in 1998, broadly in line with an expected drift of 1 percent above the economy-wide pay increase agreed in the 1997 wage pact. The unemployment rate is currently about 10 percent. Twelve-month CPI inflation is running at 1¼ percent (after falling briefly to ½ percent at the beginning of the year).

Figure 2.
Figure 2.

Finland: Cyclical Indicators, 1995-99 1/

Citation: IMF Staff Country Reports 1999, 121; 10.5089/9781451813142.002.A001

Sources: ETLA and staff estimates.1/ Seasonally adjusted.2/ Included in metal industry.

5. Despite a weakening of exports toward the end of 1998—with the impact of the emerging market crisis being felt both directly and through weaker EU activity—the current account surplus remains above 5 percent of GDP. The high surplus reflects, in part, longer-run influences on saving and investment—namely, the prospective rapid aging of Finland’s population, and a trend reduction of external indebtedness from the high levels accumulated by the private and public sectors in the late 1980s and early 1990s. In addition, competitiveness is currently strong—with some unwinding to be expected over the medium term, through a nominal appreciation of the euro and/or higher inflation in Finland than in its trading partners.3

6. Monetary and financial conditions are currently fairly accommodative (Figure 3). By mid-1999, nominal short-term interest rates were some 100 basis points lower than a year earlier. Adjusted for 12-month CPI inflation, bank lending rates touched new lows in recent months, and the volume of lending accelerated sharply over the past year. Long-term real rates extended their downward trend in 1998 and early 1999. Finland’s real effective exchange rate appreciated somewhat in late 1998, but with the weakening of the euro in the first half of 1999 this has been reversed. Real estate prices continued to rise, with wealth effects supporting consumption and residential investment. Stock prices have more than tripled since 1996, although the related wealth effects may be less pronounced, given high non-resident ownership (equivalent to some 60 percent of total market capitalization).4 Overall, monetary and financial conditions were supportive of activity in 1998, and have remained so in early 1999, with Finland’s cyclical position being more advanced than the euro-area average.

Figure 3.
Figure 3.

Finland: Monetary Indicators, 1991-99

Citation: IMF Staff Country Reports 1999, 121; 10.5089/9781451813142.002.A001

Sources: ETLA, Bank of Finland; and staff estimates.1/ Only available since November 1992.2/ Derived on the basis of consumer price index through 1995 and core inflation (CPI net of the effects of indirect taxes, subsidies, and housing related capital costs) thereafter.

7. The 1999 budget extended the process of fiscal consolidation, while providing for some reduction in taxes on labor income. With activity stronger than projected, and profit taxes buoyant, the general government surplus appears set to reach some 3 percent of GDP. The fiscal impulse (measured as the change in the cyclically-adjusted primary balance) is estimated to be contractionary to the tune of 1 percent of GDP. With Finland’s economy very open, and revenue performance boosted by electronics—where non-resident ownership is extensive—the domestic demand impact of fiscal withdrawal should not be overplayed. The regime shift implied by the adoption of the euro further complicates the assessment of the relative impact of fiscal and monetary policies. Nonetheless, weighing this fiscal withdrawal against the relative ease of monetary conditions, the overall stance of macroeconomic policies in 1999 appears broadly neutral.5

8. Structural reforms have been getting underway, and internal regional mobility has been relatively high, but serious problems remain in the labor market (Figure 4). In recent years, measures to strengthen incentives included some tightening of unemployment benefit eligibility, notably for the young; enhancement of training programs; and improvements in the flexibility of working-time arrangements, especially for small and medium-sized enterprises. Moreover, inflation indexation for unemployment benefits was suspended, and personal income taxes were lowered—reforms which together cut markedly the “threshold wage” (the gross wage equal to an unemployed person’s replacement income), albeit from a high base.6 Labor union density, at 80 percent, is among the highest in Europe: recently, centralized bargaining has favored moderate overall settlements, but wage differentiation remains limited. While economic recovery has cut the unemployment rate from 18 percent in early 1994 to some 10 percent now, there is high structural unemployment among the low-skilled, and in the northern and eastern regions. Broad unemployment (including participants in training programs, subsidized employment schemes, and early retirement) is estimated by the OECD at some 20 percent of the labor force. The employment ratio is not impressive by international standards (Figure 5). Part-time work and self-employment are notably low, reflecting fiscal and other regulations, and the fact that social benefits—despite reforms—are still not strongly conditioned on readiness to seek work or training.

Figure 4.
Figure 4.

Finland: Labor Market Characteristics, 1987-98

Citation: IMF Staff Country Reports 1999, 121; 10.5089/9781451813142.002.A001

Sources: Finnish Labor Market Review; and staff estimates.1/ Lappi and Kainuu are regions in the Northern part of the country; Uusimaa and Varsinais-Suomi are in the South.
Figure 5.
Figure 5.

Finland: Labor Market Indicators in Selected Countries

Citation: IMF Staff Country Reports 1999, 121; 10.5089/9781451813142.002.A001

Source: OECD, Employment Outlook, June 1999.1/ Data for Ireland refers to 1997; data for United States is estimate for wage and salary workers only.2/ Defined as unemployment rate of people with less than upper secondary education. Data for New Zealand refers to 1997.3/ Defined as 12 months and longer. Data for Ireland refers to 1997.Countries are: DMK=Denmark, FIN=Finland, FRA=France, GER=Germany, IRE=Ireland, ITA=Italy, NLD=Netherlands, NZL=New Zealand, ESP=Spain, SWE=Sweden, and UK=United Kingdom.

9. With world trade projected to accelerate later this year, and the macroeconomic policy stance broadly neutral, solid economic growth should continue. The latest surveys confirm that corporations are now expecting somewhat stronger export growth, after the sluggish performance of the first quarter. Consumer sentiment has remained buoyant, and stronger domestic demand has continued to fuel a virtuous circle of employment growth and rising output, with the service sector expanding strongly. Overall, GDP growth should be in excess of 3½ percent in 1999, and close to 4 percent in 2000. The current account surplus is expected to fall somewhat below 5½ percent of GDP in 1999 and 2000.

10. The risks to output in 1999 and 2000 appear balanced. Downside risks remain in the global setting—but the most recent developments in Finland’s export markets suggest these risks are diminishing. Domestically, risks are on the upside: consumption and residential investment may be stronger than projected, reflecting robust job creation, low interest rates, and wealth effects.

III. Policy Discussions

11. The discussions focused on two main issues: policy responses to the short-term outlook; and the authorities’ medium- and long-term goals of raising employment and preparing for the impact of population aging.

A. The Short-Term Outlook and Policy Stance

12. The authorities judged the economy to be operating quite close to capacity, though the degree of tightness in the labor market was uneven. At the time of the discussions, official and private forecasts for 1999 and 2000 were being revised upward. They now show an acceleration of growth from the dip in late 1998 toward an annual rate of some 4 percent over this period. The authorities confirmed that in the labor market, some pressures had emerged in the course of 1998 in the Helsinki area and a few other centers, but mainly in the high technology and construction sectors. These pressures were eased to some degree by internal migration and higher participation. While electronics was still expanding strongly through early 1999, recent months had seen a decline in vacancies economy-wide.

13. The centralized wage system had delivered moderation in recent years, but prospects for an accord for 2000-01 were uncertain, given wide sectoral variations in profitability and pressure on resources. The authorities saw a need for greater wage dispersion, to help spread job creation more broadly and ease bottlenecks. The dilemma was how to achieve this without triggering a generalized acceleration of wages (in 1993 a breakdown in central negotiations and pattern-bargaining across sectors led to inflationary increases at a time when unemployment was much higher than now).

14. The present uncertainty about wage trends led to some divergence in assessments of the NAIRU and the output gap, but within a fairly narrow range.7 Some policy-makers saw imminent risks of overheating, but most thought that a safety margin was still present in the labor market—with the discipline of monetary union helping tip the balance in favor of relatively moderate settlements. Wholesale prices had been falling through most of 1998 and early 1999, contributing to well-contained inflationary expectations for the remainder of the year. Overall, most officials considered that the cyclical position was more advanced than the euro area average; that growth prospects remained strong, with risks to activity balanced; and that concern about overheating was warranted, but probably over a two-year time horizon.

15. The authorities shared the staff’ assessment that monetary conditions in the euro area were easy in relation to the domestic economic position. The situation, they noted, was not as novel as sometimes portrayed, however, since domestic monetary conditions had never matched perfectly with the economic position in all of Finland’s varied regions. Also, the mismatch in Finland was considered to be smaller than in some euro-area economies that had been growing rapidly. The key to successful policy management was to take due account of monetary conditions in framing fiscal policy and, more fundamentally, to enhance the flexibility of the economy.

16. The near-term stance of fiscal policy was expected to be somewhat restrictive. The authorities anticipated some budgetary overperformance in 1999, and their latest projections confirmed that there was likely to be a significant withdrawal of fiscal stimulus. For 2000, the outlook depended on budgetary decisions still to be taken. Initial projections suggest a further withdrawal of perhaps ½ percent of GDP, provided expenditure levels are consistent with the agreed medium-term ceilings. On the other hand, the authorities have indicated that they would delay income tax cuts, if they were dissatisfied with the outcome of wage negotiations, in which case the fiscal withdrawal would be larger. Staff broadly supported the authorities’ near-term fiscal plans, endorsing the case for continued fiscal withdrawal to help offset expansionary monetary conditions. Staff noted, however, that the fiscal stance should not be tightened indefinitely to address overheating, but that deeper labor and product market reforms were needed to improve the supply side of the economy (see Box 1 for a discussion of when and how to respond to potential cost and price pressures).

17. The authorities have further enhanced the scope for automatic stabilizers with the introduction of “EMU buffer funds”, but the operation of stabilizers on the expenditure side is somewhat restricted by the comprehensive coverage of the medium-term expenditure ceilings. Staff welcomed the constitution of the buffer funds in the social security system, which should avoid repeating the past experience of pro-cyclical rises in unemployment contributions (see SM/98/190). However, on the expenditure side, cyclically-induced fluctuations in basic unemployment benefits and some other transfers do require offsets within the central government expenditure ceilings.8 A full and balanced play of both revenue and expenditure stabilizers would be desirable, and the authorities are encouraged to explore ways to achieve this without undermining the spending ceilings.

When and How should Cost Pressures be Resisted?

ECB policy aims for price stability in the euro area. For Finland, as an open and relatively small economy within the area, how far are there dangers of cost/price developments that could pose problems for policy makers? In interpreting cost and price developments, it is important to distinguish between several phenomena in the Finnish economy:

  • The competitiveness of the economy (judged on relative unit labor costs, or the staffs macroeconomic balance approach) suggests a significant margin for real appreciation—via nominal appreciation of the euro, and/or higher inflation than in Finland’s trading partners.

  • Productivity growth in manufacturing, at 5½ percent annually, exceeds that in the non-traded sector by slightly more than in most other euro-area countries: Balassa-Samuelson effects are expected to cause CPI increases in Finland that are somewhat higher than the euro-area average (but to a lesser extent than competitiveness influences).

  • Generalized cost-push pressures could emerge in the labor market and depress employment, but recent trends in labor costs and aggregate employment do not indicate this as yet.

  • Low-skilled unemployment is already high, given compressed labor cost differentials, and this problem could become more serious as the median wage rises, if there is no increase in dispersion.

  • Price bubbles or overshooting may occur in asset markets—but thus far the rise in real estate prices (particularly when assessed against household income) appears more consistent with a recovery from depressed levels; stock prices are high, but exposure to wealth effects and vulnerability to losses affect non-residents more than residents on present ownership patterns.

  • Price rises reflecting the first two factors above represent a move toward equilibrium, and over the medium term a modestly higher rate of CPI inflation in Finland, compared with the euro-area average, is to be expected on these grounds. By contrast policy needs to address risks of cost-push pressures, of damage to low-skill employment, or of asset price inflation:

  • With the cyclical position more advanced than the euro-area average, and monetary conditions thus relatively expansionary, it is prudent for fiscal policy to withdraw stimulus, in order to lessen risks of a destabilizing cycle in prices; and this strategy coincides benignly with the need to complete structural fiscal consolidation.

  • More fundamentally, forestalling such problems requires structural reforms—for example, addressing poorly designed social benefits, problems in wage formation, or distortions in the tax regime for housing finance. Near-term fiscal tightening, by mitigating excess demand pressures, at most helps to buy time for such adjustments.

18. In the present macroeconomic policy setting, with competitiveness favorable and some cushion in internal migration and rising participation, the staff did not see immediate risks of overheating. Staff stressed, however, the case for a wage agreement with scope for flexibility. While upward flexibility was increasingly prevalent through bonuses and profit-sharing arrangements, downward flexibility was needed to allow exceptional cost containment in firms and localities with low productivity and weak employment growth, fostering job creation both at the low-skill level and in regions with high unemployment. Without such reforms there were risks of further damaging low-skill employment and, over a longer time horizon, of eroding competitiveness to an undue degree. The staff suggested that the authorities’ plan to condition tax relief on a moderate wage settlement should take into account also the need for such downward flexibility. Though overheating might not be imminent, policy measures to improve labor market incentives should be implemented without delay, because they would inevitably take time to bear fruit. Such measures might help to foster greater wage dispersion, and minimize the risks involved in any future shift to more decentralized bargaining (see section B for specific measures).

19. This cyclical setting prompted a discussion about asset market and financial sector risks—updating the broad review in the 1998 consultation. The staff questioned, in particular, whether asset price inflation might take root at a time, such as the present, when monetary conditions were easy relative to Finland’s cyclical position; and whether the banks might not begin to engage in riskier lending under the pressure of European, and broader global, competition. Three main points emerged:

  • The authorities did not see grounds for concern, as yet, about banks’ risk exposure. Corporate and household balance sheets had been rebuilt in recent years; the average capital-adequacy ratio was 11½ percent in 1998; and direct exposure of Finnish banks to the Russian and Asian markets was low. Major progress had been made in enhancing the banking system’s efficiency: banks’ cost-earnings ratio was below 60 percent in 1997, compared with a euro-area average of 68 percent. Managements, generally, were prudent—quite well-prepared, for example, for Y2K, with the supervisory authority expected to complete a review of banks’ contingency plans by the fall.

  • The rise in house prices thus far was viewed by some officials, and the staff, as a recovery from depressed post-crisis levels, and banks’ memories of the early 1990s real-estate crisis were fresh—with some institutions still working out property loans from that period. Nonetheless, the monetary authorities noted potential risks of a renewed real estate price cycle and overexposure by banks and households, if the increasing pressure on the residential and commercial real estate markets of the south—fueled by internal migration and low interest rates—persisted. There was already a considerable shortage of rental and lower income accommodation, contributing to rising prices. A number of reforms had been undertaken since 1993 to foster the development of the rental market by reducing the bias for owner-occupied housing, resulting from different tax treatments and regulations. Staff suggested continuing these reforms by eliminating the partial tax deductibility of mortgage interest payments, and reviewing the functioning of the land market—addressing any distortions that may reduce the availability of land for construction in municipalities with large inward migration.

  • Domestic financial markets would face increasing competition from other euro zone banks and the securities markets, and further international consolidation appeared likely. The mission welcomed the authorities’ intention to discontinue the distortive tax-free status of low-interest deposit accounts, and the way in which supervisory practices in Finland had evolved.9 Staff agreed with the authorities that the extent of future challenges, particularly in international coordination, should not be underestimated. More broadly, the health of the financial system would depend on a stable and balanced medium-term course for the economy.

B. Medium-Term Policy Issues

20. The authorities confirmed that their strategic priorities were to strengthen further the public finances—ahead of the impact of population aging—and to foster a higher level of employment. Discussions focused on broad approaches to achieving these complementary goals, and also on the design of specific measures.

Broad Policy Objectives

21. The authorities saw fiscal consolidation as the cornerstone of their approach to the demographic shock. With this shock occurring earlier in Finland than other EU economies, the authorities viewed the attainment of a significant general government surplus over the medium term as essential. This would facilitate a decisive decline in the public debt ratio, unlocking interest savings that would partially offset the impact of population aging. In line with this, the government program envisages a sharp drop in public debt—by more than 10 percent of GDP, on a consolidated (EMU) basis, over the coming four years. To this end, the government’s medium-term fiscal plans featured a continuing freeze on the real level of central government expenditure. This degree of spending restraint appears consistent with achieving a general government surplus of over 4 percent of GDP by 2000.

22. A key question in the discussions was the respective roles of high fiscal surpluses and structural reforms in efficiently addressing the demographic shock. The authorities stressed, first, that in dealing with population aging they followed a broad strategy—incorporating tax cuts, structural reforms, and fiscal consolidation; and second, that they traditionally viewed the pension component of the surpluses as more akin to private saving:

  • One goal of the government’s program was to cut taxes on labor income by some 1½ percent of GDP through 2003, combining across-the-board with targeted cuts benefiting low-income groups. Room for this would be created by a combination of spending restraint, a rise in corporation and capital gains taxes from 28 percent to 29 percent, and an increase in environmental—and possibly local property—taxes.

  • Regarding structural reforms, a central objective of the government was to raise employment from currently some 65 percent of the working-age population to a level approaching 70 percent. In addition to tax cuts, there were commitments to enhance further the targeting of active labor market programs, and to improve vocational training.

  • The authorities highlighted that sizeable fiscal surpluses would arise primarily within the employment pension funds, and were a key component in addressing the demographic shock, based on present entitlements and retirement projections. Such funds, which are partly funded and are managed by private firms, had traditionally been viewed by the authorities as vehicles for private savings and were classified outside the public sector until 1993. However, in line with OECD and Eurostat norms, they were now classified as part of the general government, largely reflecting their mandatory and comprehensive nature—and there is no plan to change these characteristics.10

23. These medium- and longer-term fiscal priorities also conditioned the authorities’ objectives under the EU Stability and Growth Pact. Finland’s 1998 Stability and Growth program envisaged, as a separate constraint, balancing the central government budget. With local authorities traditionally maintaining a position of balance over time, this would ensure sufficient room for automatic stabilizers to operate without taking into account the pension fund surplus—which would be the authorities’ strong preference in a medium-term perspective.11 The EU Council of Ministers endorsed Finland’s medium-term fiscal plans, urging the authorities to press ahead with fiscal consolidation at the central government level.

24. The staff welcomed the authorities’ overall fiscal strategy—including notably the strong commitment to spending restraint—but laid added emphasis on the contribution that deeper structural reforms could make. Illustratively, the staff contrasted two longer-run economic strategies (Box 2 and Figure 6):

Figure 6.
Figure 6.

Finland: Long-Term Fiscal Scenarios, 1998-2030

Citation: IMF Staff Country Reports 1999, 121; 10.5089/9781451813142.002.A001

Source: Staff estimates.
  • The first strategy would be based on modest structural reforms, combined with large general government surpluses over the medium term. Under such a strategy, even with surpluses of 5 percent to 6 percent of GDP during the next few years, it would be difficult to meet the fiscal costs of population aging without some increase in the burden of taxes and social contributions on labor income over the coming decades. Such a rise in contributions would likely be perceived as an intergenerational transfer, driving up the labor market tax wedge at a time when it would be critically important to foster higher participation in order to mitigate the demographic shock. More generally, the opportunity costs of running high surpluses with a largely unchanged tax burden, in lieu of addressing pension and labor market reforms, would be high.

  • The second strategy would incorporate deeper structural reforms to curtail early retirement and raise employment levels, allowing somewhat lower surpluses and a substantial reduction in tax rates on labor income over time. In addition, changes could be made in the employment pension scheme to render pension contributions less like a tax by making them more transparent and linking them more closely to benefits. This approach could help to set in motion a virtuous circle, enhancing output, employment, and the public finances. But, with large cohorts (the “baby-boom” generation) at risk of exiting prematurely from the labor force over the next five to ten years, prompt action to shift the incentives for early retirement was urgent for such a strategy to work.12

Medium- and Long-Term Fiscal Challenges and Policy Trade-Offs

In a nutshell, the Finnish authorities are faced with three key medium- and long-term fiscal challenges: (i) to prepare for anticipated expenditure pressures posed by a rapidly aging population; (ii) to maintain a fiscal position that can accommodate cyclical fluctuations within the 3 percent of GDP deficit limit of the EU Stability and Growth Pact; and (iii) to allow for indirect tax cuts, agreed in the context of EU tax harmonization, and to create scope for further cuts in the tax wedge on labor income.

To illustrate the trade-offs between alternative policy strategies, the staff has developed two long-term scenarios:

The current policy scenario incorporates the government’s projections of real expenditures for 1999/2000, and announced tax cuts on labor income, as well as reductions in indirect taxes in line with agreed EU policies. Subsequently, revenues are assumed to grow in line with GDP, and current expenditures are linked to demographic developments and labor productivity growth (as a gauge for real wage increases, developments in nonwage outlays, and the indexation of transfer payments). Capital expenditures, after increasing only moderately over the medium-term, grow in line with GDP over the long run. Importantly, it is further assumed that the effective retirement age remains at 59 years.

This policy strategy implies that (i) the unemployment rate falls just below 8 percent, and the employment rate peaks at under 68 percent, with both ratios deteriorating toward the end of the projection period, in response to a rise in the tax wedge; (ii) the surplus in the general government swells to 5¾ percent of GDP in 2005 and is gradually eliminated in the long run; and (iii) social security contributions and direct taxes have to be increased significantly by the end of the projection period to maintain fiscal balance.

The high employment scenario, in contrast, combines further moderate expenditure restraint with significant and front-loaded pension and labor market reforms, resulting in a gradual increase of the effective retirement age by three years. Under these assumptions, greater scope is opened up for tax cuts (with a lower peak in the general government surplus), and the combined effect of the reforms sets off a virtuous circle of strong employment generation, higher economic growth, and fiscal savings. As a result, the unemployment rate falls to 5½ percent and the employment ratio rises from about 65 percent to almost 75 percent of the working-age population—nearly 9 percentage points higher than in the current policy scenario. While not explicitly modeled, the removal of labor market rigidities, together with improved incentives, would also lower the risk of cyclical unemployment (in the event of economic downturns) becoming a long-term structural problem.

25. The authorities viewed this emphasis on the potential contribution of structural reforms as a helpful input to the domestic policy debate. But this should not detract, they stressed, from the priority of proceeding with fiscal consolidation at the present time—both to balance the central government budget and to ensure policy credibility until the scope and -impact of such structural reforms could be evaluated. The staff agreed.

The Design of Measures to Support Medium-Term Policy Goals

26. Against this background, the discussions went on to explore specific reform measures relating to public expenditure as well as the labor and product markets:

  • Regarding the substance of their public expenditure plans, the authorities confirmed that medium-term ceilings—set by the cabinet, and covering spending by individual ministries, including transfers to local authorities and social security funds—had proved an effective control system in the past. Such ceilings were now agreed for 2000-2003. The discussions illustrated, though, the challenges for implementation that would arise as this strategy was pressed forward, if bottlenecks for growth were to be avoided. For example, with some municipalities experiencing heavy inward (and outward) migration, continuing restraint in transfers to municipalities would only work effectively if they achieved fuller cost recovery, raised property taxes, and were more selective in spending—while making their operations more efficient by enhancing cooperation with other municipalities through joint projects.13 Another challenge was to assure adequate infrastructure spending, which had been pared back in recent years.14 The staff suggested that there was some scope for additional savings, for example, by targeting more tightly transfers to households, which together with social security benefits account for some 20 percent of GDP; but politically this remains an uphill task.15 In the field of official development assistance, the authorities confirmed that they would like to raise this above the current level of 0.34 percent of GDP once their situation permits.

  • The government has already set out the guiding principle for further labor market reforms: a focus on reducing disincentives to taking up a job. One measure planned to achieve this is further cuts in the taxation of earned income, to widen the gap between the net unemployment benefit and net labor income. There is also an intention to further retarget active labor market policies toward key groups, shifting civil service staff to assure effective interviewing and guidance of benefit recipients (800 staff were reassigned to these functions during the 1990s). The staff suggested shortening the comparatively long duration of the unemployment benefit, and tapering it off more strongly over time; a stricter enforcement of requalification requirements for this benefit; and action to address the disincentives to job-search and mobility that result from the way cash benefits such as housing and child care allowances are withdrawn. This would also foster continued mobility across Finnish regions.16

  • The government agreed that a broad priority, affecting a range of public programs, was further action to reduce early retirement. They had already undertaken a number of reforms during 1993-97 to cut future pension expenditures and raise incentives for longer participation in the labor force. There was a range of views about the time-horizon for further reforms, and staff strongly stressed the case for taking measures urgently, so that members of the “baby-boom” generation no longer faced artificial incentives to withdraw from the labor force—and that firms no longer faced incentives against employing them (Box 3).17 This was consistent with considerations of intergenerational equity as well as efficiency.

  • The discussion further focused on specific reforms to strengthen the perception of employment pensions as savings rather than taxes, including enhanced competition and transparency (Box 3). A guiding principle, which officials thought deserved support, would be to move in the direction of making transparent the link between individual contributions, investment returns, and benefits. The authorities confirmed that a number of changes in the pension framework were under discussion with the social partners, but the scope of reforms remained to be seen.

  • In the product markets, finally, further reforms are needed. Staff urged pressing ahead rapidly with privatizations mandated by parliament—which would make a significant contribution to reducing the public debt—and seeking a widening of this mandate in the case of commercial enterprises. There is also a case for simplifying tax and social security procedures, and cutting red tape, which may limit the growth of small enterprises and self-employment, including notably in personal services. Also, as part of a broad strengthening of the competitive environment, including in energy, domestic telecommunications, and other services, there is a case for reviewing possible distortions in wholesale distribution and in construction.

How to Change Incentives in the Pension System1

In the field of pension policy, there was broad agreement on the priority of curtailing early retirement, and support for moving in the direction of making transparent the link between individual contributions, benefits, and investment returns. Based on these principles, staff highlighted a number of features it considered worth addressing:

A first operational priority should be to limit early retirement before the “baby-boom” generation reaches eligible ages. Some measures in this direction have already been taken. A number of complementary actions are called for now, including:

  • closing the so-called “unemployment benefit pipeline” to early retirement, by removing the requalification exemption for the unemployed aged 55 and over;

  • discontinuing the “unemployment-pension” for future claimants;

  • alleviating firms’ liability for disability pensions, to avoid encouraging the shedding of employees aged 55 and over;

  • ensuring that new entrants to the disability pension scheme are, in fact, disabled according to reasonable criteria;

  • increasing the after-tax penalty for early retirement;

  • increasing the flexibility of the official retirement age;

  • relating pension entitlements to contributions over an entire working life, ending distortions that discourage taking a new job late in an employee’s career; and

  • shifting ultimately to a system based on defined contributions rather than benefits.

The last two measures above should be part of a broader strategy to mitigate the “tax” aspects of employment pension contributions. Further changes in that direction could also be made on the investment side. Key reforms would be: to increase competition among pension management companies; to end direct lending by funds to corporations who pay contributions to them; and to raise minimum yields on pension fund portfolios before rebates of contributions are made. These changes, by making pension entitlements more transparent and credible, should both improve incentives to work and reduce the risk of the government and private sector saving for the same goal. Of course, greater competition would imply stronger supervision—and in this connection, the creation this year of a separate insurance and pension supervisory agency, with close links to the banking and securities supervisor, is very welcome. Finally, there is scope for an increased role of private pensions, which have been growing quite strongly over the past few years.

1 For a further discussion of the Finnish pension system, see Selected Issues Paper.

27. On the broad thrust of structural reforms, there was a fair measure of agreement between the authorities and the staff—but further changes in the social benefit system, in particular, will be difficult to press through. The question remains whether a critical mass of measures to improve labor market performance can be put in place while cyclical pressures are still well-contained, and the window of opportunity, demographically, is still ajar. Success in this will depend in no small measure on the authorities’ skill in conveying the message that equity is well-served by such reforms; that they will focus protection on those most in need; and that they will avoid exclusion and foster social cohesion through reintegration in the work force, not just income support.

28. The authorities considered that greater transparency should enhance the quality of domestic debate on economic policy issues. They published the mission’s concluding remarks for the first time, and are participating in the pilot project for staff report release. The authorities are also considering performing a self-assessment under the IMF’s Code of Good Practices on Fiscal Transparency.

IV. Staff Appraisal

29. The conduct of macroeconomic policy in Finland since the early 1990s has been impressive. Firm monetary policy and public spending restraint, buttressed by wage moderation, have transformed the public finances and reduced inflation to a low level. Private sector balance sheets have been rebuilt; the external current account has swung from deficit to sizeable surplus; growth has become stronger than in neighboring countries; and unemployment has fallen markedly. In sum, a decade that began with the steepest recession among the advanced economies is ending with the public finances in surplus, activity strong, and founder membership of the euro zone.

30. This macroeconomic progress notwithstanding, important structural challenges remain in the public finances and the labor market, posing risks to economic performance in the medium to longer term. In the public finances, population aging will soon begin to exert major pressures, despite recent pension reforms. In the labor market, the employment ratio is still unsatisfactory, and pressures have appeared in some areas and sectors at a time when unemployment nationwide remains high. It is crucial to enhance the flexibility of the economy under monetary union—forestalling domestically-generated cost pressures, and improving resilience to shocks. But with the economy performing well, and memories of crisis receding, it will take continuing foresight and strong resolve among policy makers and the social partners to put these reforms in place in a timely fashion.

31. The near-term outlook for the economy is in most aspects ideal for reform. Business confidence is recovering; consumer sentiment is strong; and solid employment growth is providing a strong undertone to demand, which should also benefit from wealth effects as real estate gains continue. Domestically, risks are on the upside, but they are counterbalanced by external downside risks. On balance, the economy is likely to operate at levels around potential—a cyclical position substantially ahead of the euro-zone average.

32. Accommodative monetary conditions relative to Finland’s cyclical position call for some fiscal tightening. Nominal and real interest rates are at record lows by the standards of recent decades; the real effective exchange rate is competitive; and asset markets are buoyant. Expanding money and credit aggregates, equally, portend high demand growth. Financial conditions are unduly accommodative for a country in an advanced cyclical position. Appropriately, the fiscal stance in 1999 is on the restrictive side, with a tightening of some 1 percent of GDP in prospect, thus providing a significant offset to monetary ease. In 2000, the government’s spending plans should result in at least a modestly restrictive stance, even after allowing for tax cuts.

33. The major medium- and long-term challenge for policy lies in the demographic outlook. On present projections, population aging would raise public expenditure on pensions and health care substantially over the coming decades. Disturbingly, this could trigger a rise in taxes and social contributions on labor income in the future—just when broad labor force participation will be crucial to offset a shrinking of the working-age population.

34. To meet this challenge, a first priority is adequate fiscal consolidation. The fiscal position is already sufficiently strong to allow automatic stabilizers to operate freely within the Stability and Growth Pact limits, as would be appropriate in future in the event of downside as well as upside developments. The authorities are right to take the opportunity presented by the current cyclical situation to move promptly toward their longer-run goal of eliminating the central government deficit—implying a significant surplus at the general government level. The expenditure plans for 2000-2003 should achieve this goal. There is a case, nonetheless, for tightening these plans somewhat, by targeting transfers to households more effectively to those in need, without undercutting core social assistance.

35. The government’s medium-term expenditure plans appropriately provide room for a cut in income taxes—of some 1½ percent of GDP through 2003—without undermining fiscal consolidation. The government has rightly emphasized a combination of across-the-board cuts and targeted reductions benefiting low-skilled and part-time employees. By widening the gap between the net unemployment benefit and net labor income, this should exert maximum leverage in raising employment. Provided additional structural reforms are undertaken to address the demographic shock directly, it should indeed be possible to step up the pace of tax cuts over the coming decade.

36. A key priority to buttress the long-run fiscal outlook is to avoid a premature withdrawal of the “baby-boom” generation from the labor force over the next 5 to 10 years. Currently, employees approaching the age of 55 face incentives to withdraw from the labor force, and firms are discouraged from employing them. Ending this situation will require a reform of unemployment and disability pensions. In addition, employment pension entitlements should relate clearly to life-time contributions, and the management of pension fund assets should be further strengthened. Together with improved transparency, this should mitigate the tax-like aspects of employment pensions—enhancing incentives to work. This overall strategy would both slow the demographic shift, by delaying retirement, and minimize perceptions that pension contributions are part of a steep and potentially rising tax wedge on labor income.

37. In the labor market, more broadly, the government’s emphasis on raising the employment ratio over the next four years is on the mark, as is the central message to reduce the disincentives to taking up a job. To this end, further efforts are needed to achieve a faster tapering of unemployment benefits, and a much stronger conditioning of benefits on efforts to find work or training—supported by enhanced active labor market policies and improved training. Generalized overheating is probably not imminent, but reforms to improve the flexibility of the labor market will take time to work, and should be initiated now. Finland’s centralized wage system has successfully contained the level of wage settlements—but in future the scope for differentiation should be increased, especially in firms, sectors, and regions were productivity is low and job creation slow.

38. Product market reforms could contribute to fostering employment and mitigating inflationary pressures in asset markets. Priorities are to press ahead with, and seek a widening of, the privatization mandated by parliament; to enhance competition in the economy, including in energy, domestic telecommunications, wholesale distribution, and construction; to address regulations that may limit the growth of small enterprises and self-employment; and to improve the working of the market in land in rapidly developing areas.

39. In the financial sector, major progress has been made in enhancing the efficiency of the banking system, but globalized markets and monetary union will pose growing challenges for financial institutions and supervisors alike. The recent establishment of an insurance and pension regulator—operating in coordination with the banking and securities regulator—and the lead supervisor understandings with Sweden, are examples of significant progress in this area. The goal of ending tax free deposit accounts is commendable, and action should also be taken to eliminate the tax deductibility of mortgage interest payments. In the financial sector, as elsewhere, good progress has been made in addressing the Y2K issue; a priority economy-wide is to ensure that comprehensive contingency plans are well-advanced.

40. Finland’s provision of high-quality data on a timely basis facilitates the conduct of effective surveillance.

41. It is proposed that the next consultation take place on the standard 12-month cycle.

APPENDIX I: Finland: Fund Relations

(As of July 31, 1999)

I. Membership Status: Joined 1/14/48; Article VIII.

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans: None

V. Financial Arrangements: None

VI. Projected Obligations to Fund (SDR Million; based on existing use of resources and present holdings of SDRs): None

VII. Exchange Rate Arrangements

1. Finland is a founding member of EMU, with a euro conversion rate of Finnish markka (Fmk) 5.94573. Finland has accepted the obligations of Article VIII and maintains an exchange system that is free of restrictions on payments and transfers of current international transactions. In accordance with Executive Board Decision No. 144-(52/51), Finland notified the Fund on September 5, 1990 and July 6, 1992 of exchange restrictions pursuant to UN Security Council Resolutions against Iraq and the Federal Republic of Yugoslavia (Serbia/Montenegro), respectively. On July 27, 1995, Finland also notified the Fund of exchange restrictions imposed against Libya, and of changes in the exchange restrictions pursuant to UN Security Council Resolutions on Iraq and the Federal Republic of Yugoslavia (Serbia/Montenegro) as well as on certain areas in Bosnia and Herzegovina. Finland has since removed restrictions imposed against certain areas of the Republic of Croatia, Bosnia and Herzegovina, and the Federal Republic of Yugoslavia (except for the prohibition on the satisfying of certain claims). The UN Security Council Resolution on food for oil (Iraq) was implemented in December 1996.

APPENDIX II: Finland: Core Statistical Indicators

(As of July 31, 1999)

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APPENDIX III: Finland: Basic Data

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Sources: Ministry of Finance, Bank of Finland; and staff projections.

Projections are staff estimates based on the authorities’ current policy indications.

Wages and salaries, plus employers’ social security contributions, divided by working hours of employees.

A negative value indicates a level of potential output that is larger than actual GDP.

On a national accounts basis.

Defined as noninterest revenue minus noninterest expenditure.

Projections are based on real effective exchange rate assumptions of the World Economic Outlook.

Based on relative normalized unit labor costs.

APPENDIX IV: Finland: Medium-Term Macroeconomic Scenario, 1998-2004 1/

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Sources: Ministry of Finance, Bank of Finland; and staff projections.

Projections are staff estimates based on the authorities’ current policy indications.

Wages and salaries, plus employers’ social security contributions, divided by working hours of employees.

A negative value indicates a level of potential output that is larger than actual GDP.

On a national accounts basis.

Defined as noninterest revenue minus noninterest expenditure.

Projections are based on real effective exchange rate assumptions of the World Economic Outlook.

1

The recession resulted from the effects of an overvalued currency, the collapse of trade with the former Soviet Union, a terms of trade shock, and the bursting of an asset price bubble.

2

The Selected Issues paper reviews experience and issues in the field of public expenditure.

3

Staff calculations based on the macroeconomic balance approach put the longer-run savings-investment surplus on the order of 3 to 4 percent of GDP; presently, the underlying current account, after allowing for the lagged effect of exchange rate changes and the closing of foreign and domestic output gaps, is estimated at over 6 percent of GDP (for a description of this approach, see IMF, Occasional Paper 167, 1998).

4

Stock market performance since 1997 has been dominated by the electronics industry—and in particular, by Nokia, the world’s largest supplier of mobile phones—with the industry-specific index rising more than four-fold over the two-year period. However, shares in a number of other sectors have also risen substantially. The sizeable market gains attributed to non-residents were reflected in a marked deterioration in Finland’s net international investment position in 1998.

5

It can be argued that Ricardian equivalence may offset part of the fiscal impulse (for an empirical analysis, which concludes that a high degree of Ricardian equivalence cannot be rejected in Finland, see Bank of Finland Discussion Papers, 28/96 and 6/97). On the other hand, with the advent of the euro, the impact of fiscal policy in Finland will not be weakened by country-specific interest and exchange rate responses. Based on past relationships, simulations by the Bank of Finland suggest that over a two year period, the impact on economic activity of a fiscal withdrawal of one percent of GDP is approximately equivalent to that of a one percentage point rise in real short-term interest rates, assuming rational expectations (see Bank of Finland Discussion Papers, 10/98).

6

Since 1996, cuts in the threshold wage have been in a range of 12 percent (for married couples with one child) to 35 percent (for single persons without children); but replacement rates, after taxes and benefits—such as child and housing allowances—are high and remain so for an extended period of unemployment.

7

The NAIRU was estimated by a range of official sources at some 10 percent in 1998. OECD, EU, national, and staff estimates cluster around a negligible output gap in 1998. See Selected Issues paper for a discussion of different measures of the output gap.

8

See Selected Issues paper.

9

A lead supervisor arrangement was recently reached with Sweden, and the coordination between bank and non-bank supervisors had been enhanced by shifting insurance and pension supervision from the Ministry of Social Affairs to an independent agency, with cross-membership between its board and that of the banking and securities regulator.

10

Finland has two parallel statutory pension systems, classified as part of the general government: the national pension scheme, based on residency; and the employment pension scheme, based on employment, partly funded, and largely managed by private institutions. While the role of supplementary employer-financed and private pensions has remained limited—likely reflecting the relatively high pension level and coverage of the statutory pension schemes—private pensions have been growing quite rapidly over the past years, and the authorities confirmed that they would retain a tax treatment compatible with the continuing growth of such private schemes. For key features of the pension system, see the Selected Issues paper.

11

The burden of fiscal stabilization may fall quite heavily on the central government, if local authorities in future act counter-cyclically by seeking to correct deficits swiftly.

12

A fuller exploration of these scenarios is presented in the Selected Issues paper.

13

The staff had detailed discussions with representatives of municipalities, which confirmed that—provided structural reforms moved forward at this level—the planned restraint in transfers was indeed realistic. An important area where efficiency will need to be improved is the management of health care costs, which is essentially a local government responsibility.

14

The authorities are exploring the scope for private financing of capital projects; the staff, citing other country experience, urged applying efficiency tests and avoiding risks of the state incurring contingent liabilities if project returns turned out to be lower than projected.

15

Potential areas for expenditure cuts include family allowances, agricultural and housing subsidies, educational grants via improved means-testing, and public sector employment.

16

The authorities’ approach to regional policy focuses on the development of a number of poles of growth across regions, with an emphasis on university towns.

17

Staff projections in the Selected Issues paper illustrate the powerful interaction between Finland’s unusually early demographic shock and the strong incentives for early retirement.

Finland: Staff Report for the 1999 Article IV Consultation
Author: International Monetary Fund