November 24, 2003

The Austrian authorities appreciate the consultations with the Fund and the high quality of the staff report, including the focus on the 2003 pension reform and the analysis of fiscal sustainability. They broadly agree with the staff’s assessment of Austria’s economic situation and its general recommendations on economic and financial policy.

The staff report highlights that in comparison to many EU-member states Austria has weathered the recent economic slump relatively well. Indeed, headline indicators on inflation, unemployment, the balanced external position and the continuing stable fiscal position bode well also for the upswing which is gathering strength.

The new government, which was sworn in in February 2003, followed up on many recommendations Directors made at the last Article IV discussion in 2002:

• Despite lower growth, the budget remained in broad balance in 2002

• The commitment to the European Stability and Growth Pact was reaffirmed

• The reforms on the expenditure side concentrate on pension and health care systems and public administration. The latter aims at a fundamental overhaul of the relations between the different layers of government, a reform of the federal railways and the privatization of the remaining shares of public enterprises. In many of these areas substantial reforms have been implemented within the first six months, despite considerable political opposition and the emergence of strikes, a phenomenon not observed in Austria for decades. All reforms have been based on vetting expenditure trends until 2010 and partly also beyond.

Since the issuance of the staff report, the government has initiated a third stimulus package (“Wachstums- und Standortpaket”) on November 11. This package is a follow-up to the EU’s Lisbon-agenda and the current EU growth initiative. Its main measures are to implement the one-stop principle also for public aid to R&D, including a higher tax premium of 8 percent (instead of 5 percent) for R&D expenditures and other measures, including more flexibility in the labor market. Thus it has a clear focus on fostering the knowledge-based economy and to improve productivity. This package does not jeopardize the fiscal indicators listed in the staff report, as it is financed by a shift in priorities within the budget.

1. Fiscal Policy

The government undertook a sharp fiscal adjustment of close to 2 percent of GDP in 2001, resulting in a small budget surplus (0.3 percent in Maastricht definition). But due to lower than anticipated GDP growth, in 2002 a small deficit (-0.1 percent) was recorded. The continuation of a balanced budget in 2002 is proof that fiscal consolidation has been largely driven by expenditure cuts. Also, the tax burden has been on a declining path since its peak in 2002.

For 2003, the budget which was adopted only later in the year due to delays in forming the new coalition government foresees a fiscal deficit of 1.3 percent at most. Continued low growth (3 of the 4 most important trading partners will record GDP growth of below or at zero) deferred both the fiscal effects of two stimulus packages in 2002 and the flood-related expenditure effects on the 2003 fiscal accounts.

In 2004, the underlying fiscal balance is expected to improve by at least 0.5 percent of GDP. When assessing Austrian fiscal policy, one has to keep in mind that traditionally Austrian budget presentations to parliament and the public are based on rather conservative assumptions. As a result, the actual budget outcomes tend to be better than forecast. Not surprisingly, recent data and forecasts by the EC/OECD/IMF confirm that the assumed economic framework for the 2004 budget (adopted already in June) is plausible.

For 2005, the government reaffirmed its intention to undertake a major tax reform in order to lower the high tax burden in Austria as a step towards the 40 percent (of GDP) ratio to be achieved by 2010. The tax reduction of 1.3 percentage points of GDP will not immediately be matched by expenditure cuts. My authorities argue that:

• the incurred temporary public deficit is limited (-1.5 percent) and well below the safety margin of the European Stability and Growth Pact (which is 2.1 percent in the case of Austria)

• current forecasts show a negative output gap for 2005, and thus the cyclically-adjusted balance will be closer to 1 percent, and pro-cyclical effects, if any, would be clearly contained

• many EU-accession countries have recently significantly reduced their corporate taxes, giving rise to location shifts of enterprises

• some major EU-member states have lowered or are continuing to cut direct taxes despite a much worse fiscal position, prompting tax competition among Member States.

• the measures envisaged in the government’s program for 2005 (i.e. on health care and federal railways) recently have become more concrete. As a result, the risks of fiscal slippage will be limited.

2. Pension Reform

With the extension of the effective retirement age of currently 59 years to 65 years, the lowering of the replacement ratio and savings of some 1½ percent of GDP, the 2003 pension reform was certainly the biggest in Europe this year. At the same time, one feature of the reform, the 10 percent cap on benefit losses, has been criticized. My authorities argue however, that the cap has a natural expiration date, and that the cap will not give rise to social hardship as it does not affect the minimum pension in Austria. They also note that the first pillar reform (PAYG-system) was supplemented by a new funded third pillar, which is promoted by preferential tax treatment.

The Austrian authorities are very much aware of the equity issue in the pension reform and are committed to resolve this issue in a balanced way.

The authorities are also mindful of the staff’s advice about the desirability of a medium-term fiscal framework. Achieving the 40 percent target for the tax burden will require such a framework to help policymakers through the necessary steps. The authorities are presently working on such a framework. Part of it is a macro-econometric model, capable of taking into account the impact of demographic changes on macro-economic variables. Moreover, a study on an appropriate expenditure rules has been commissioned.

3. Structural Reforms

As mentioned in the staff report, the government sold its stake in the former flagship of the state-owned industries, i.e. the “VOESTALPINE AG” on the stock exchange in September. This prompted considerable protests by workers and parts of the population (in the run-up to regional elections). Furthermore, the holding company OIAG decided last weak to sell its 25 percent stake in Boehler-Uddeholm also via the stock exchange in November 2003.

The government has also addressed another long-standing controversial problem of public ownership: Currently 7 percent of federal expenditures are spent on the federal railways. The government’s intention is to reduce spending by 1 billion Euros (0.45 percent of GDP) until 2010 in the course of a substantial reform. In November the government proposed measures, which include a significant reduction of staff, changes in the economic governance and aligning the work statutes to private sector rules. Trade unions went on the longest recorded strike so far in a major Austrian company. On November 14, the government and the trade unions agreed to continue negotiations until end April, 2004. If no agreement is reached among social partners by then, the government will enact a law.

On shop-opening hours, it is to be recognized that the additional room for liberalization provided by the recent reform was not used by the provinces (though it is likely that overtime economics will prevail over the Austrian public’s preference for more family time).

The new Austrian Financial Market Authority (FMA) has worked with a Fund team on the first phase of the FSAP. The first preliminary results confirm the effectiveness of the reform of financial market supervision and have led to interesting discussions on the changes in the Austrian financial system.

Finally, Austria might reach the EU target of 0.33 percent (of GDP) ODA already in 2004, i.e. two years ahead of the EU-agreed schedule.