Finland: Staff Report for the 2003 Article IV Consultation
Author: International Monetary Fund
Publication Date:
16 Oct 2003
eISBN:
9781451813180
ISBN:
9781451813180
Language:
English
Keywords:
ISCR; CR; surplus; budget proposal; government; consumer confidence; expenditure ceiling; fund staff calculation; output gap; retirement age; labor market; Employment; banking sector
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The economic restructuring and expansion after the crisis reflected a combination of private sector initiative, solid macroeconomic management, including the shift from large deficits to significant surpluses of the general government, and structural reforms. High unemployment is one indication that structural rigidities continue to hamper Finland's output potential. In the face of high unemployment and rapid population aging, the discussions focused on supporting medium-term growth while securing long-term fiscal sustainability. Reflecting concerns about slowing growth, front-loaded expenditure increases, and tax cuts were at the center of the fiscal policy debate.

Abstract

The economic restructuring and expansion after the crisis reflected a combination of private sector initiative, solid macroeconomic management, including the shift from large deficits to significant surpluses of the general government, and structural reforms. High unemployment is one indication that structural rigidities continue to hamper Finland's output potential. In the face of high unemployment and rapid population aging, the discussions focused on supporting medium-term growth while securing long-term fiscal sustainability. Reflecting concerns about slowing growth, front-loaded expenditure increases, and tax cuts were at the center of the fiscal policy debate.

I. Background

1. The Finnish economy has made enormous strides since the severe recession and banking crisis of the early 1990s. The economic restructuring and expansion after the crisis reflected a combination of private sector initiative, solid macroeconomic management—including the shift from large deficits to significant surpluses of the general government—and structural reforms. This, against the background of excellent physical and social infrastructure, allowed Finland to converge successfully to the euro, and to outperform euro-area partners in the recent past in terms of economic growth and the public finances. Based on prudent policy choices, increased external competitiveness, and favorable export performance, including both traditional industries and the dynamic information and communications technologies (ICT) sector, real GDP growth averaged almost 5 percent during 1994–2000; inflation was 1–3 percent.

2. Finland has generally responded appropriately to many policy challenges identified in previous Article IV consultations, though expenditure control has been elusive and further structural reforms remain needed. The Fund has long supported Finland’s goal of accumulating large general government surpluses in light of imminent pressures from population aging. It has also supported the goal of curbing spending in order to make room for much-needed tax cuts, especially on labor, with a view to raising employment. However, departures have been evident, particularly with regard to spending, leaving little or no scope for credible, growth-enhancing tax cuts, and the fiscal surplus has narrowed significantly since 2000. For their part, structural reforms have contributed to a strengthened economy. Among the reforms implemented were the bank restructurings and the widespread adoption of new banking technologies in the 1990s, the liberalization of markets, reforms to improve labor market performance, and pension reform. Financial supervision in the banking sector has also been improved along the lines recommended in the 2001 FSAP. However, further structural reforms—many of which were recommended in past consultations and discussed in this report—are needed to raise both actual and potential growth, as well as to support the public finances.

3. The economy, under difficult circumstances, performed reasonably well during 2001–02—though the pace of activity slowed considerably and remains subject to volatility. Real GDP growth slowed to 0.7 percent in 2001, before rising to 1.6 percent in 2002 (Figure 1 and Table 1).1 Growth in 2002 was bolstered by robust private consumption and a rebound in exports. Notably, ICT exports played a prominent role in the export recovery, contradicting some of the global pessimism surrounding this sector as Finland gained market share. Meanwhile, output has recently been below potential, contributing to a decline in inflation.

Figure 1.
Figure 1.
Figure 1.

Finland: Selected Indicators, 1990-2002

Citation: IMF Staff Country Reports 2003, 325; 10.5089/9781451813180.002.A001

Sources: Statistics Finland; ETLA; and Fund staff calculations.
Table 1.

Finland: Main Economic Indicators, 1999-2006 1/

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

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

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

As discussed in an accompanying selected issues paper, there is considerable uncertainty about the size of potential output growth and the output gap, partly reflecting that the volatility of GDP growth—not least due to the development and swings in the performance of the 1CT sector—has tended to be higher than in other euro-area countries. The figures reported in this table are based on a standard production function approach, using staff estimates of the future growth of investment, labor force, and TFP (with the behavior of the ICT sector heightening the uncertainly of the TFP estimates).

For 2003, based on data for April, annualized.

For 2003, latest available data (June).

Using weights for real short- and long-term interest rates and the real effective exchange rate (ULC) of one-third each. For 2003, latest available data (May).

On ESA95 basis. 2002 data preliminary.

Defined as noninterest (structural) revenue minus noninterest (structural) expenditure.

Corrected for the influence of the business cycle as measured by the output gap.

Adjusted for one-off factors, mostly exceptional tax revenues due to income from stock options.

Reflects stock-flow adjustments, including changes in the portfolio allocation of Finnish pension funds. Also note that the pension funds, which generate much of the general government surpluses, are accumulating assets rather than reducing debt. In addition, the 2003 data reflects a one-off change in the methodology of computing the fiscal accounts in line with national legal requirements.

Over the medium term, through 2008, staff expects the current account balance to stay above 5 percent of GDP.

Based on relative normalized unit labor costs.

4. High unemployment is one indication that structural rigidities continue to hamper Finland’s output potential. The official unemployment rate (seasonally adjusted) has hovered somewhat above 9 percent so far this year and may have been higher except for labor hoarding. Broader measures, which take into account individuals who left the labor force early and participants in active labor market programs, put the unemployment rate around 16½ percent. High labor taxes (Figure 2) and the lack of wage differentiation have made much of the unemployment structural. This is reflected in its persistence across time and regions, as well as the lack of jobs for low-skilled labor (Figure 3) and the high number of long-term unemployed. At the same time, a low effective retirement age (now about 59½ years—among the lowest within OECD countries) has been one of the factors depressing the supply of labor.

Figure 2.
Figure 2.

Finland and the EU: Tax Wedge, 1993-2001 1/

(In percent of labor costs)

Citation: IMF Staff Country Reports 2003, 325; 10.5089/9781451813180.002.A001

Sources: OECD; and Fund staff calculations.1/ Income tax plus employee and employer contributions (as a percentage of labor costs); single persons without children.
Figure 3.
Figure 3.

Finland: Labor Market Characteristics, 1990-2003

Citation: IMF Staff Country Reports 2003, 325; 10.5089/9781451813180.002.A001

Sources: Finnish Labor Review, OECD Employment Outlook 2002; and Fund staff calculations.1/ Lappi and Kainuu are regions in the Northern part of the country; Uusimaa and Varsinais-Suomi are in the South.2/ Defined as unemployment rate of people with less than upper secondary education.3/ 2003 data are for first quarter only.4/ 2003 data are annual growth rate for the first quarter.

5. The Finnish population is also aging rapidly, exerting downward pressure on the labor force, with adverse implications for potential economic growth and the public finances. The old-age dependency ratio will rise to 40 percent in 2020 and 50 percent in 2030. This is almost double the ratio today and among the highest in the EU during that time.

6. Fiscal discipline has slipped in recent years. In 2002, the general government surplus was still high at 4.6 percent of GDP, compared with 7 percent in 2000. However, one-off factors were an important but fading contributor.2 Moreover, while the public finances are in considerably better shape than in many other euro area countries, slippages have been evident. For example, with the election year approaching, overruns occurred across all spending categories in 2002, raising real central government expenditures to an estimated 4 percent above the original target. Figure 4 illustrates, more generally, the weakening trend in expenditure discipline as spending, especially in the form of higher social benefits and increasing transfers to local governments (which shoulder the majority of health and education expenses), has ratcheted up.3 While staff had successively supported the expenditure ceilings and stability program targets set in 2000–01, policies have clearly drifted in the opposite direction. Based on Finance Ministry estimates for the 2003 supplementary budget, staff expects that the general government surplus will decline further, to about 2 percent of GDP, as the central government balance swings to a small deficit of 0.3 percent of GDP. In addition to a budgeted increase in expenditure of about 4 percent in real terms, this deficit also reflects tax cuts of a half percentage point of GDP.

Figure 4.
Figure 4.

Finland: Central Government Expenditure Ceilings and Actual Expenditure, 2000-07 1/

(In millions of euros, constant 2000 prices)

Citation: IMF Staff Country Reports 2003, 325; 10.5089/9781451813180.002.A001

Sources: Ministry of Finance; and Fund staff calculations.1/ In line with the authorities’ definitions. Actual expenditure for 2003 preliminary.2/ The government’s original benchmark established under its 1999 stability program aimed at constant real expenditure relative to the 1999 budget, but this was relaxed somewhat in the 2000 update.3/ These are the ceilings set by the old government. The expenditure ceilings of the new government exclude cyclical components and interest payments and are therefore not comparable. However, total expenditure in the government’s supplementary budget for 2003 is above the earlier ceiling.

II. Policy Discussions

7. In the face of high unemployment and rapid population aging, the discussions focused on supporting medium-term growth while securing long-run fiscal sustainability. It was recognized that the boom years were exceptional, and that various policy actions must be taken to keep the economy growing, create new jobs, and sustain Finland’s well-developed welfare system. In this context, the discussion took up several interrelated elements, comprising the need to: (i) raise the employment rate by increasing work incentives for all age and skill groups; (ii) establish and maintain a record of expenditure discipline to make room for credible tax cuts without compromising the public finances; (iii) on this basis, reduce taxes, notably on labor, as an important component of raising employment, safeguarding competitiveness, and enhancing growth; (iv) implement further pension reform to make a longer working life more attractive and thereby increase the effective retirement age; and (v) reform the product market to enhance the economy’s efficiency and generate employment. Most of these elements are contained in the government’s economic program, although, in the short term, more immediate concerns about slowing growth are dominating the policy agenda. How the various elements come together, in terms of the timing and ambition of their implementation, has important implications for economic performance and the health of the public finances.

A. Short-Term Outlook

8 Real growth is likely to be moderate in 2003, but should gather pace in 2004. Staff projects real GDP growth of 1.3 percent in 2003, driven by private consumption (with recent data showing continued strong consumer confidence)4 and some, albeit moderate, growth in exports. While investment is projected to decline in 2003, the projection incorporates a modest pick-up in the second half of the year, reflecting the postponement of earlier planned investments. Higher investment and accelerating export growth (which contributes to investment activity) lie behind staff’s projection of 2.6 percent growth in 2004. Monetary conditions are estimated to remain largely unchanged, with the lagged effects of the decline in interest rates being offset by the strengthening of the real effective exchange rate (Figure 5). While Finland’s external competitiveness nevertheless remains solid,5 downside risks still stem mainly from the external environment—with questions hanging on the upswing in the euro area and possible further euro strength against the U.S. dollar and other currencies.6 The possibility of continued business investment weakness, and of a softening of strong consumer confidence should significant layoffs occur, would also affect domestic demand. By the same token, while there are major uncertainties about the prospects for the ICT sector, upside surprises are not out of the question.7 The projections by the authorities were somewhat higher, but the authorities put the staffs projection well within their confidence interval, and stressed that the existing differences would not affect policy conclusions.8

Figure 5.
Figure 5.

Finland: Monetary Conditions, 1995-2003

Citation: IMF Staff Country Reports 2003, 325; 10.5089/9781451813180.002.A001

Sources: ETLA; IFS; Bank of Finland; and Fund staff calculations.1/ Using weights for real short-term and long-term interest rates and the real effective exchange rate (ULC based) of one-third each.

9. Inflation is expected to be subdued. The authorities and staff agreed that consumer prices were likely to increase by less than 2 percent during 2003–04, reflecting moderate wage growth and a persistent output gap. The likelihood of a broad-based decline in prices seemed remote, however. And while the authorities, like staff, saw the possibility of deflation as deserving of careful monitoring, they viewed the risks as low. The disinflation visible in headline figures partly originated outside of Finland (e.g., a decline in the prices of oil and other tradables in euro), could be temporary, and should boost real demand. At the same time, certain domestic components of the CPI, notably services prices, were showing increasing rates of growth. Finally, despite excess capacity and a significant drop in equity prices in the recent past, other characteristics often associated with more imminent deflationary pressures were absent: there was no sign of a slowdown in domestic credit growth and, after a moderate decline in 2000–01, real housing prices have more recently rebounded (Tables 1 and 3).

B. Fiscal Policy and Pensions

10. Reflecting concerns about slowing growth, frontloaded expenditure increases and tax cuts were at the center of the fiscal policy debate. While the authorities’ fiscal program was still being fleshed out, it included expenditure ceilings for 2004–07, which allowed for rapid expenditure growth in 2004, and a focus on reducing the tax burden, particularly on labor, as an essential element for raising the employment rate.

  • The new expenditure ceilings—which, in contrast to the previous ones exclude cyclical components and interest rate payments—imply real expenditure growth for the items covered of 1.3 percent per year on average over the period, and 3.2 percent in 2004. Taking into account government projections of the spending items that are excluded from the new ceilings, overall expenditure would be looser than under the previous ceilings.

  • On revenues, preliminary budgetary plans for 2004 envisaged significant tax cuts, equivalent to 0.6 percent of GDP—on labor to a significant degree, though the exact size of the cuts was still under discussion. In addition, mainly as a result of Finnish adjustments to EU regulation, indirect tax receipts (notably from revenues on alcohol, tobacco, and cars) will decline.

  • The Finance Ministry envisaged that the central government will be in balance in 2007 if 100,000 new jobs can be created. Meeting this ambitious target would add to revenues and lower spending, leaving, according to Finance Ministry estimates, the general government in surplus by about 3½ percent of GDP in 2007. However, the specific measures to meet this target for jobs were not explicitly identified and matched to estimates of their impact on job growth, or costed out in terms of their impact on the fiscal accounts.9 Thus, achieving the job target lacked a well-specified strategy.

  • Substantial job creation is crucial: in its absence, the Finance Ministry’s projection (assuming moderate job growth of 25,000 jobs) foresaw central government deficits of 1.1 to 1.3 percent of GDP in 2004–07, corresponding to a surplus for the general government of only 1.7 percent in the latter year. This projection, which is based in the staffs view on conservative estimates of revenue, implies fiscal stimulus, measured by the change in the primary structural balance, of about 1.2 percent of GDP in 2004 according to staff calculations, and little change in this balance afterward.

11. The discussions reviewed the choices facing the authorities between accumulating substantial fiscal surpluses now or, in the absence of reform, imposing higher taxes and contribution rates in the future. Recent studies by the Bank of Finland and the Ministry of Finance were revealing on this score (Box 1). In the scenarios in both studies, the general government runs a surplus of about 4 percent of GDP on average over the 2003–10 period (broadly consistent with the targets of the previous government, and a half percentage point of GDP above the surplus envisaged by the new government by 2007 under its rapid job growth scenario). In the Ministry of Finance study, taking into account the effects of various recent reforms (including to pensions, agreed in 2002),10 gross public debt would double between 2020 and 2050, rising to almost 80 percent of GDP, because of population aging. The Bank of Finland study, which also takes into account the 2002 pension reform, suggests that the ratio of both pension contributions to wages and the tax-to-GDP ratio would each have to be increased by about 4 percentage points over the next two decades to cover higher age-related spending while keeping the central government balance out of deficit and securing a surplus in the social security funds of around 2–3 percent of GDP.11 Simulations by staff reached broadly similar conclusions, illustrating the advantages of raising the fiscal surplus to 4 percent of GDP or more to end up in a sound fiscal position in the long-term after the full effects of population aging are realized.12 The simulations also showed that tax cuts (relative to baseline) can improve economic performance over time, with positive feedback effects on the fiscal position. However, staff noted, expenditure restraint is essential, to make room for tax cuts, avoid that they lead to unwanted deterioration of the fiscal position, and to enhance their credibility and hence their economic effectiveness.

12. Against this background, staff concluded that a general government surplus of at least 4 percent of GDP would constitute a useful medium-term norm, which was, however, not at hand on current policies. The authorities’ fiscal strategy—notably the level at which the expenditure ceilings are set and the lowering of taxes—implied surpluses below this norm for a number of years. Indeed, in the baseline scenario in Figure 6, the general government surplus would not exceed 2 percent of GDP during 2003–07. With the output gap not yet closed, staff suggested a phased-in approach to meeting the medium-term norm, targeting an adjustment in the structural primary balance of ½ percent of GDP per year, while allowing the automatic stabilizers to play around the consolidation path.13 Given staff’ projection for output—which sees growth broadly constant during 2004–06 as export performance remains solid, investment continues to take hold, but imports also increase—this would imply raising the actual general government surplus in broadly equal increments from its estimated 2003 level (2 percent of GDP) to reach 4 percent of GDP by 2006.14

Figure 6.
Figure 6.

Finland: The General Government Balance Under Alternative Fiscal Scenarios, 2000-07

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 325; 10.5089/9781451813180.002.A001

Sources: Ministry of Finance; and Fund staff calculations.1/ The baseline scenario is in line with the authorities’ central government expenditure ceilings, and staff projections for revenue.2/ Alternative A holds real central government expenditure constant at its 2001 level.3/ In alternative B an adjustment in the structural primary balance of 1/2 percent of GDP per year is achieved through further expenditure consolidation.

Aging and the Finnish Public Finances in the Long Run

Two recent studies by the Ministry of Finance and the Bank of Finland discuss the implication of aging. The scenarios in both studies are broadly compatible with a general government surplus of about 4 percent of GDP on average over the 2003–10 period. Nevertheless, an increase in taxes and contribution rates or, alternatively, in public debt is needed to cope with the demographic shock. The results also suggest that the recent pension reform is insufficient.

The baseline scenario in the Finance Ministry study finds that public spending on pensions and aging-related health costs could increase by as much as 8 percentage points of GDP by 2050. In this scenario, holding other expenditures as well as taxes and social security contributions constant as a share of GDP, the general government surplus would steadily decline, falling below 4 percent of GDP after 2010 and turning negative by 2035. As a consequence, gross public debt would double between 2020 and 2050, rising to almost 80 percent of GDP. This is despite taking into account the effects of various reforms (including to pensions in 2002), estimated to increase the average effective retirement age by about 3 years, and increases in labor market participation through linking pensions rights more closely to career earnings.

The Bank of Finland study is similar in nature, but assumes that tax and social security contribution rates would be adjusted to keep the central government balance out of deficit and to secure a surplus in the social security funds of around 2–3 percent of GDP. The results suggest that the ratio of pension contributions to wages would have to be increased by an additional 4 percentage points over the next two decades while the tax-to-GDP ratio would be increasing by about 4 percent of GDP to cover higher age-related spending. Without the 2002 pension reform the estimated increases in the former would have been 7 and 6 percent, respectively. But even after the reform, the tax and social security contribution increases required to keep the public finances in balance remain high.

The Bank of Finland study is also helpful in gauging the sensitivity of these results to changes in the underlying assumptions on GDP. A gradual increase in the employment rate by about 3½ percentage points during 2010–50 would, all else equal, increase the end-period level of GDP by about 3 percent compared to the baseline. This would allow a reduction in the ratios of contributions to wages and of taxes to GDP by 1 percentage point—suggesting that a formidable effort would still be needed to keep the public finances healthy.

13. The authorities were not in disagreement with the benefits of higher fiscal surpluses in the medium term, but more immediate concerns tended to dominate the policy agenda. In particular, with boosting employment so important, tax rates high by international standards, and tax competition increasing, the government felt that early tax cuts were crucial. At the same time, expenditure increases were in line with election commitments. Moreover, it was felt that the previous expenditure ceilings had been too tight and were particularly difficult to adhere to politically in the face of the slowdown in growth and large fiscal surpluses. With inflation low and external demand weak, the authorities felt that the cyclical outlook mitigated any near-term problems associated with the fiscal stimulus resulting from running down the fiscal surplus. They nevertheless also recognized the adverse consequences of future expenditure slippages and stressed the seriousness with which they intended to hold to the spending ceilings. Staff emphasized the importance of further structural measures (both in labor markets and pensions as discussed below) as quickly as possible to make the targeted increase in employment a more realistic prospect. On the latter, the authorities—though perhaps to varying degrees—agreed, seeing merit in such reforms, while cautioning that it would take time to muster the necessary political support for any additional reforms.

14. Various actions to more decisively approach the medium-term norm were discussed

  • Revenues: with revenue estimates by the Ministry of Finance possibly on the conservative side, staff urged the authorities to use higher-than-projected revenues to raise the general government surplus and lower debt (projections by the Bank of Finland as well as staff suggest that revenues could be higher than projected by the Finance Ministry). In light of the overruns to past expenditure ceilings, staff also advised that tax cuts be put on hold until the authorities were convinced that expenditure (and the fiscal balance) was well under control.

  • Expenditures: a freeze on real spending at its 2003 level would move part of the way in the direction advocated by staff. Moreover, such a move would be less stringent than might appear at face value, because of recent expenditure overruns. Staff estimated that this action would raise the fiscal surplus relative to GDP by about 1.1 percentage points in 2004 and by 1.3 percentage points by 2007, ultimately implying (assuming moderate job creation) that the 4 percent of GDP norm would be achieved by 2008.

  • To achieve the norm by 2006, some combination of even greater spending restraint, frontloaded structural reforms to make the target of creating 100,000 new jobs as realistic as possible, or other measures on the revenue side would need to be considered. In particular, in cases in which the fact that services are free creates overspending in the public domain, measures that raise revenues while potentially keeping public spending in check—such as user fees—deserved careful evaluation. Other sources of revenue could include raising property taxes; Finland ranks among the lowest in the OECD in terms of property taxes as a percent of GDP.

15. Areas where spending can be scaled back are being identified. Finland’s level of expenditure is lower than the high level of other Nordic countries, but a comparison with the EU average suggests room to reduce across spending categories, particularly on social protection (also with a view to making work more attractive), and on education (Table 2). While the authorities stressed that education was key to Finland’s innovative role in the ICT market, they also indicated that there was room for efficiency gains, including at the university level, where the average time taken to complete a degree in higher education is among the longest in the world. Moreover, a significant share of public employees at all levels of government will be retiring in the coming years. This should provide a catalyst for restructuring the public sector. And the evidence suggests, according to the discussions with the Ministry of Finance, that if all municipalities were to provide services as efficiently as the best one, cost reductions of 20–30 percent appear possible. Better use of economies of scale through enhanced local cooperation (e.g., in health, which more generally is an area for lowering expenditure) is one way for local governments to achieve fiscal savings. Another way is by encouraging greater use of procurement and tenders for the private provision of public services, in addition to providing municipalities with greater know-how to undertake such tasks. A working group has started to make initial recommendations on how to improve the efficiency of the public sector and is moving forward in developing specific recommendations.

Table 2.

Finland and Selected Countries: Expenditure Structure, 2001 1/

(In percent of GDP)

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Sources: Eurostat; and Fund staff calculations.

Definition differs slightly from Table 1. Data for Sweden is for 2000.

Unweighted average, excluding the Nordic countries.

16. With respect to the expenditure framework, there was consensus on the advantages of expenditure ceilings in general, but staff noted the need to increase their effectiveness. The positive features of the government’s new ceilings were recognized: they extend over the government’s term in office; they exclude cyclical components and interest payments so the expenditures covered by the ceiling are controllable; and they have been well publicized. However, staff suggested ways to strengthen their effectiveness and garner broader political commitment, including by submitting them to parliament as part of the regular budgetary process along with a description of the underlying rationale and the strategy to achieve them. Staff also suggested expressing the ceilings in nominal, rather than real, terms. This approach would avoid the complications that have arisen in monitoring ceilings because of difficulties in translating nominal into real spending, and enjoyed some support in the discussions. However, the authorities noted that real ceilings were more flexible in determining actual spending, which could reduce the potential for losing credibility from overruns.

17. More ambitious pension reform would be an extremely helpful addition to the policy agenda. The 2002 pension reform significantly enhanced sustainability. It comprised: an increase in the effective retirement age through raising the legal retirement age to 68 and sharply increasing the accrual rate after 62; better incentives to enter the workforce early by allowing an earlier start of earnings-related pension accrual; a reduction in pension benefits through changing indexing mechanisms and factoring in increasing life expectancy (i.e., reducing the annual flow of benefits so that lifetime receipts are not increased by longer life expectancy); and measures to curtail existing options for early retirement, in particular through changes in the unemployment and disability pensions. However, the “baby-boom” cohorts are largely shielded from the effects of the reform. To further raise the effective retirement age, staff proposed: (i) eliminating the subsidized component of the part-time pension scheme; (ii) tightening eligibility criteria for disability pensions; and (iii) reducing disincentives to hire older workers. The latter would require limiting the extent to which larger firms face both rising contributions and increasing payments for the direct cost of unemployment and disability as the age of their employees’ increases. Consideration could also be given to shortening the transition periods that shield large parts of the “baby-boomer” generation from the 2002 reform. The authorities acknowledged that the 2002 pension reform would not solve all the tensions from population aging. However, some aspects of the pension system, such as the factoring in of changes in life expectancy and the indexation mechanisms for benefits, would allow for adjustments to benefits in the years to come if needed. The point that any additional reform would take time to muster the necessary political support was reinforced by union representatives who felt that the 2002 pension reform package, agreed by social partners, was a major effort, and that further reforms would have to await a thorough assessment of the 2002 package.

C. Labor and Product Markets

18. While many of the problems are not new, there was agreement that tackling unemployment and raising the employment rate has become especially pressing against the background of slower potential growth. Indeed, the ICT sector made a substantial contribution to growth over the 1990s, but a repeat on that scale is unlikely. In addition to reducing the tax wedge and incentive traps at the lower end of the skill scale, the discussions took up several other important reforms.

  • The first relates to the centralized wage bargaining system. Staff noted that, while it has helped to deliver moderate average wage increases, greater wage differentiation, so that wages would be more in line with the differences in the demand for labor across regions and in productivity developments across skills, remained crucial. It would help create conditions that would tend to reduce regional and skill mismatches, enhance the attractiveness of hiring lower-skilled workers, provide the opportunity to gain greater work experience to enhance future employability, and improve the chances for increasing living standards through own efforts. The discussions suggested that one way to achieve greater wage differentiation within the existing wage bargaining framework might be to agree on lower base wage increases, while accepting greater wage drift at the firm level.

  • Greater wage flexibility and resulting differentiation, along with a greater effort by the public sector to promote private services, would also improve the prospects for developing the private market for personal services (including, for example, services to households). With an aging population, the demand for these services will increase and, with the right reforms, could contribute to alleviating unemployment at lower skill levels.15

  • Other measures discussed included encouraging job search by tapering off unemployment benefits; enforcing job acceptance requirements more strictly, possibly to include part-time work; and reducing the time spent before entering the labor market, for example by improving the efficiency of education so that students would leave university at an earlier age.

19. The authorities pointed to steps under way, especially in the education sector. Initial steps had been taken to streamline university entry exams (which have tended to delay the start of studies, shorten working lives, and add to fiscal pressures). Measures were also under consideration to reduce the duration of studies, including better counseling for long-time students and conditioning financial support on progress. The potential benefits of user fees were understood, but the authorities also stressed that the idea had very limited political support, especially with respect to education, with the principle of free education firmly implanted in the political consensus.

20. The authorities explained their efforts to increase privatization and enhance the functioning of product markets. Competition policy was key in liberalizing markets. In this regard, the authorities pointed to local telecommunication as an area in which intense activity to increase competition had most recently contributed to opening markets. Looking forward, strengthening the enforcement of existing laws and raising the prospect of higher sanctions would help to ensure an appropriately competitive market place. On privatization, the authorities noted that, after little activity in 2001, the pace increased significantly in 2002: privatization proceeds were about €1.5 billion (or 1.2 percent of GDP), mostly realized in the first half of the year when market conditions were perceived as favorable.

D. The Financial Sector

21. The discussions revealed that the Finnish financial system had weathered the slowdown in economic growth and decline in equity prices fairly well. The authorities noted that notwithstanding some decline in profitability in 2002 (Table 3) and the first quarter of 2003, bank balance sheets remained healthy. Looking ahead, while all agreed that bank profitability would be adversely affected by a serious economic downturn, stress tests conducted recently by the Bank of Finland suggested that the banking sector could withstand further distress. In response to questions on the insurance sector, the supervisory authority indicated that the decline in equity prices has had a stronger impact on the insurance sector than the banking sector, and the solvency ratios of some less-established companies are only at a satisfactory level. However, solvency ratios remained quite good in general, and the authorities stressed that, while cross-ownership links some banks to the insurance sector, the potential for systemic problems remains very limited. The authorities also envisaged future cooperation between various institutions involved in the supervision and regulation of financial markets generally to undertake comprehensive stress testing.

Table 3.

Finland: Indicators of Financial Vulnerability, 1997-2002

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Sources: Bank of Finland; The Finnish Bankers’ Association; Financial Supervision Authority; Statistics Finland; and Fund staff estimates.

Defined as total debt as a percentage of common equity. Data source is Worldscope database. Estimates are based on accounting or book value of equity.

Euro-denominated lending only, which accounted for about 98 percent of total lending in 1999 and 2000.

Loans are defined as the sum of claims on: credit institutions, the public, and public sector entities.

Average lending rate minus average deposit rate.

2001 adjusted for large intra financial conglomerate transactions.

Liquid assets are defined as the sum of bills discounted by the central bank, debt securities, and the balance sheet item “liquid assets”.

Housing price index has been changed. The new index more accurately reflects the price development of all dwellings in the whole country.

22. The Act on the Financial Supervisory Authority (FSA) has been revised and the authorities are working to strengthen cooperation among Nordic supervisors. In line with the recommendation from the last consultation, the institutional setup of the new FSA board and the FSA’s independence and powers to take prompt corrective actions were strengthened. The latter would be further enhanced by the adoption of the EU’s financial services directive and the Basel-2 accord, though the authorities explained the difficulties that arise in the legal implementation, including constitutional considerations. While the authorities also recognized the possible benefits from unifying supervisory authorities across the insurance and banking sectors, political obstacles existed. Finally, recent progress made in Nordic supervisory cooperation, both by financial supervisory authorities and central banks, was noted. It was also recognized that developing more fully a crisis management framework and further harmonizing regulatory and supervisory arrangements—not just across the Nordic countries but in the euro area too—are important items for the policy agenda.

23. Finland keeps its framework on combating money laundering and the financing of terrorism up to date. Finland has implemented all the relevant international directives and recommendations in this area, and has a good track record in investigating suspicious transactions. Its legislation is in line with the OECD’s anti-bribery initiatives. In addition, while the actual cases to test the effectiveness of implementation have been limited and there may be room for some improvement, the authorities noted that evaluations by the OECD indicate that Finland is doing well on implementation.

E. Other Issues

24. While critical of the proposals for initial CAP reform, the authorities supported the agreement reached in Luxembourg in late June. From the Finnish perspective, the most important change to the original proposal was the softening of the decoupling principle with regard to cereals and beef. The compromise allows Finland to continue its practice of partly linking subsidies to the production of these products. The authorities also supported increasing market access for developing countries, including through the participation by developing countries in the setting of sanitary and phytosanitary standards, and through building their capacity to implement such standards.16

III. Staff Appraisal

25. Finland’s recovery from the severe difficulties of the early 1990s exemplifies the virtues of sound economic policies, which need to be safeguarded, including by avoiding recourse to short-term stimulus. At the heart of Finland’s successes were the consolidation of the public finances—which has been impressive, especially when compared with other euro area economies—and structural measures that fostered increased openness, competitiveness, and flexibility. While Finland has weathered the slowdown in the world economy well, growth in recent years has declined and output is below potential. In these circumstances, there is the temptation to use fiscal stimulus. However, the impact of such stimulus would be limited in a small and open economy and would run counter to the need to gear policy to the longer-term challenges related to a rapidly aging population.

26. Unemployment, which is high and largely structural, is a key concern. The persistence of unemployment reflects a number of factors, including, most importantly, the lack of wage differentiation across skill levels and high taxes on labor, as well as various other disincentives to work.

27 Against this background, several measures are essential to support growth over time while securing long-run fiscal sustainability. This entails a number of interrelated elements, centering on two key requirements. The first is the need to raise the employment rate, involving increasing work incentives, pension reform, and labor tax cuts. The second is the need to establish and maintain a record of expenditure discipline, to make room for credible tax cuts without compromising the public finances in light of the inevitable rise in age-related spending. How these elements come together has important implications for economic performance and fiscal sustainability.

28. A useful medium-term norm is a general government surplus of at least 4 percent of GDP—achieved through expenditure restraint. A surplus of this size would help to keep the public finances healthy after the demographic shock sets in. Credible tax cuts would be an important component of raising employment, safeguarding competitiveness in circumstances in which tax rates are already high by international standards and tax competition is increasing, and enhancing growth. This, in turn, would have positive feedback effects on the public finances. However, without sufficient expenditure restraint and confidence in the underlying fiscal position, tax cuts would be less credible and effective—and could, more generally, jeopardize Finland’s fiscal position.

29. To secure sufficiently large fiscal surpluses while leaving room for tax cuts, expenditures would need to be much more tightly contained than now planned under the new government’s spending ceilings. While the authorities’ strategy rightly emphasizes job creation, the approach of cutting taxes while also frontloading expenditure increases and letting the fiscal surplus fall needs to be reconsidered. This is especially the case in light of Finland’s mixed record on spending discipline, which also underscores the risks of greater fiscal deterioration than planned. Tax cuts should thus be put on hold until the authorities are convinced that expenditure is well under control. At the same time, higher-than-projected revenues, including any additional revenues from introducing new user fees or higher property taxes, should be used to strengthen the fiscal position. Combined with more decisive expenditure restraint, consistent with raising the primary structural balance by a half percentage point of GDP per year, a general government surplus of 4 percent of GDP is achievable by 2006 on staff projections—though the automatic stabilizers should be allowed to play around the consolidation path.

30. There are several areas that provide scope for expenditure savings, and a strengthened expenditure framework would also be beneficial. In this regard, social protection, education, and health are areas for savings that deserve attention, including by achieving greater economies of scale through enhanced cooperation at the local level. In addition, the operations of the most efficient municipalities suggest that more general cost saving can be achieved. In this connection, the contributions of a working group on how to improve the efficiency of the public sector are most welcome. However, it will take time to put reforms in place and realize fiscal savings. Thus, in the short-term, general cuts across spending categories may need to be considered. The expenditure framework could be strengthened by, for example, switching to nominal rather than real ceilings to improve transparency and monitoring; and by including the ceilings as part of the regular budgetary process.

31. Additional pension reforms would support efforts to raise the employment rate and reduce social security spending. The 2002 reform package was a significant step in the right direction. However, the “baby-boomers” were largely shielded, and further reforms are pressing to support employment growth, including by raising the effective retirement age, and to consolidate the public finances. Consideration will thus need to be given to: eliminating the subsidized component of part-time pensions and disincentives to hiring older workers; tightening eligibility criteria and enforcement for disability pensions; and shortening the transition periods for “baby-boomers.” Without an adequate accumulation of fiscal surpluses now, difficult choices on further reforming benefits—for example, by adjusting the parameters related directly to the benefits paid to pensioners—would ultimately be needed if large increases in taxes or debt are to be avoided.

32. The authorities’ ambitious target of creating 100,000 new jobs will likely remain beyond reach without commensurately ambitious labor market reform. In addition to reducing the tax wedge and incentive traps that make work unattractive, greater wage differentiation is essential. This, along with encouraging greater development of the private market for services, would also help enhance the working opportunities for lower-skilled workers. Encouraging job search by tapering off unemployment benefits, and stricter enforcement of job acceptance requirements, would further help to raise the employment rate.

33 The financial system, which is basically sound, has benefited from a strengthening of supervisory arrangements and further efforts would be helpful. Bank balance sheets are healthy, and stress tests indicate resilience if adverse shocks were to occur. Moreover, while some problems have arisen in the insurance sector, solvency ratios are quite good in general and the sector is monitored closely. Meanwhile, efforts to strengthen the financial supervisory authority and Nordic supervisory cooperation are welcome. Nevertheless, to the extent possible, the authorities are encouraged to find the legal means to adopt the EU’s directive on financial services, which would strengthen supervision further. Developing more fully a crisis management framework, across the Nordic countries and in the euro area too, is another important item on the policy agenda. With a view to comprehensive and coordinated oversight of financial markets, unification of the supervisory authorities across the banking and insurance sectors is also worthy of consideration. Finally, the efforts in Finland to combat money laundering and financing of terrorism are commendable.

34. It is recommended that the next Article IV consultation with Finland remain on the 12-month cycle.

APPENDIX I Finland: Fund Relations

(As of June 30, 2003)

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: None

VII. Exchange Rate Arrangements

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 the Republic of Bosnia and Herzegovina. Finland has since removed restrictions imposed against certain areas of the Republic of Croatia, the Republic of 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.

VIII Last Article IV Consultation

Discussions for the 2002 Article IV consultation were held in Helsinki during May 30–June 10, 2002 and the Executive Board concluded the consultation on August 13, 2002. The Staff Report (SM/02/245, 7/30/02), and a PIN (PIN/02/91) summarizing the views of the Executive Board, were published.

Appendix II Core Statistical Indicators

Finland: Core Statistical Indicators

(As of August 19, 2003)

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Finnish contribution to euro area M3.

ETLA is the Research Institute of the Finnish Economy.

1

The national income accounts are currently being revised back to the mid-1990s and there are preliminary indications that the growth rates for these two years may have been higher.

2

These largely reflected (lagged) exceptional tax revenues due to income from stock options from the asset boom ending in 2000.

3

On average, real spending on social security benefits and other transfers to households increased by 4 and close to 8 percent annually during the 2000–03 period, respectively. Central government transfers to other government sectors, mostly local governments, increased by an average of 10 percent annually in real terms during this period.

4

Private consumption is holding up despite the recent sharp decline in equity prices during 2000–02, which have yet to recover (Table 3). This decline largely reflects a pronounced drop in the ICT sector, which dominates the Finnish stock market. However, the impact of equity price changes on Finnish households is limited, as about two-thirds of the ICT sector’s total market capitalization is held abroad, and domestic holdings are highly concentrated.

5

This view is buttressed by Finland’s continued strong showing in international competitiveness comparisons. For instance, the World Economic Forum ranked Finland second in its 2002–03 competitiveness survey, reflecting, inter alia, the high quality of public institutions, an innovative research environment, and good ICT infrastructure.

6

About two-thirds of Finnish goods exports go outside the euro area.

7

The export-oriented ICT sector, which generated about one-third of the exceptional real GDP growth during the late 1990s, remains important for Finland’s economic performance. On the one hand, for example, a further deterioration in demand for network equipment, as (especially European) network operators continue to struggle under the debt accumulated before the burst of the telecommunications bubble in 2001, would reduce prospects for growth. On the other, higher-than-expected demand for communication equipment—namely for third-generation mobile telephones—and further significant gains in market share could boost demand for Finnish exports beyond staffs baseline projection.

8

The authorities’ projections were made before the release of preliminary, and weaker-than- expected, real GDP data for the first quarter. It showed a 1.3 percent decline (seasonally adjusted) from the previous quarter, mostly reflecting a drop in both investment (of 1.5 percent) and exports (of 1 percent); consumption was broadly constant (rising by 0.1 percent). Subsequent to the Article IV discussions, the Ministry of Finance revised its projection to 1.2 percent for 2003 (from 1.8 percent in the spring), and 2.4 percent for 2004 (from 2.9 percent).

9

The government had also adopted a limit of 2¾. percent of GDP for the central government deficit. However, the expenditure ceilings were expected to be the binding constraint, and balance for the central government was expected to be achieved “under normal circumstances,” assuming 100,000 new jobs would be created.

10

The 2002 pension reform is described in more detail in paragraph 17.

11

With Finland being a small and open economy with volatile growth, the EC estimated that a minimum general government surplus of 0.8 percent of GDP is called for to ensure compliance with the Stability and Growth Pact.

12

These simulations are in IMF Country Report No. 02/186. Though not necessarily as large as 4 percent of GDP in all cases, other Nordic countries have chosen to run substantial fiscal surpluses to address population aging—for example, Denmark, Norway (also to prepare for falling oil revenues), and Sweden.

13

An accompanying Selected Issues paper analyzes the impact of fiscal policy changes on growth.

14

As discussed in another accompanying Selected Issues paper, there is considerable uncertainty about the size of the output gap. While this makes it difficult to set the target in terms of the structural surplus, targeting an adjustment in the structural balance is much less sensitive to the size of the output gap.

15

See Labor Market Challenges: Job Creation in the Services Sector (IMF Country Report No. 01/215).

16

Sanitary standards relate to human and animal health; phytosanitary standards to plants.

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Finland: Staff Report for the 2003 Article IV Consultation
Author: International Monetary Fund
Volume/Issue:
Volume 2003: Issue 325
Publisher:
International Monetary Fund
ISBN:
9781451813180
ISSN:
1934-7685
Pages:
43
DOI:
https://doi.org/10.5089/9781451813180.002

Finland: Selected Indicators, 1990-2002

Finland: Selected Indicators, 1990-2002

Finland and the EU: Tax Wedge, 1993-2001 1/

(In percent of labor costs)

Finland: Labor Market Characteristics, 1990-2003

Finland: Central Government Expenditure Ceilings and Actual Expenditure, 2000-07 1/

(In millions of euros, constant 2000 prices)

Finland: Monetary Conditions, 1995-2003

Finland: The General Government Balance Under Alternative Fiscal Scenarios, 2000-07

(In percent of GDP)