Finland: Staff Report for the 2004 Article IV Consultation
Author: International Monetary Fund
Publication Date:
07 Feb 2005
eISBN:
9781451813234
ISBN:
9781451813234
Language:
English
Keywords:
ISCR; CR; government; surplus; policy agenda; economy; euro; public spending; GDP deflator; real interest rate; current account; wage accord; Employment; Labor taxes; Global; output gap
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The staff report for the 2004 Article IV Consultation on Finland highlights economic background and policy discussions. Sustained economic growth, among the highest in the industrialized world, has been underpinned by productivity gains led by the high technology electronics sector. The medium-term fiscal prospects are shaped by the strengthening recovery and the planned tax cuts. Reducing taxation of labor has been a key element of the authorities’ efforts to promote employment. The structural unemployment remains high, and Finland faces a rapidly changing global and domestic environment that calls for hard policy choices.

Abstract

The staff report for the 2004 Article IV Consultation on Finland highlights economic background and policy discussions. Sustained economic growth, among the highest in the industrialized world, has been underpinned by productivity gains led by the high technology electronics sector. The medium-term fiscal prospects are shaped by the strengthening recovery and the planned tax cuts. Reducing taxation of labor has been a key element of the authorities’ efforts to promote employment. The structural unemployment remains high, and Finland faces a rapidly changing global and domestic environment that calls for hard policy choices.

I. Economic Background

1. The Finnish economy has made impressive strides in recent years, but faces earlier than any other country in the EU the challenge of population aging. Sustained economic growth over the past decade, among the highest in the industrialized world, has been underpinned by productivity gains led by the high technology electronics sector. A stable macroeconomic policy framework with low inflation and sizeable fiscal surpluses has supported investor confidence. However, employment has been stagnant since 2002 and unemployment has remained stubbornly high. The longer-term outlook is clouded by imminent aging of the population, with old-age dependency set to rise most rapidly among EU countries.

2. Recent Fund advice has underlined the need for sizeable fiscal surpluses and further structural reforms to address the aging shock. The authorities broadly share the Fund’s assessment that large fiscal surpluses are needed over the coming decade and beyond to cope with the expected long-term fiscal pressures and ensure sustainability. The goals of the pension reforms recently initiated by the authorities are in line with Fund advice, although the authorities do not envisage further measures in the near future. The authorities share the Fund view that greater labor market flexibility and a shift to a more decentralized wage-setting system are desirable, but they regard these as medium-term goals that can only be achieved gradually, in view of the long tradition of solidaristic wage bargaining.

3. The economy weathered the global slowdown relatively well. The robust pace of domestic demand, stimulated by an expansionary fiscal policy, helped sustain GDP growth at 2 percent in 2003, well above the euro area average of 1/2 percent (Table 1). Domestic demand, especially private consumption, has continued to drive growth in 2004 as well, as disposable income was further boosted by exceptionally low inflation and sizeable tax cuts (Figure 1). While housing investment has been strong, business fixed investment has shown only tentative signs of a durable pick-up, after declining in 2002—03. Reflecting the initial slow pace of the global recovery and the loss of market share suffered by Nokia—Finland’s flagship technology company—the contribution of the technology and export sectors to growth has been muted in comparison with the late 1990s.

Table 1.

Finland: Main Economic Indicators, 2000—07 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.

Using weights for real short- and long-term interest rates and the real effective exchange rate (ULC) of 1/3 each.

On ESA95 basis.

The fall in revenues in 2003 reflects, in part, planned cuts in some indirect taxes as well as the fading out of one-off factors related to exceptional tax revenues due to income from stock options in earlier years.

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

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

One-off factors include exceptional tax revenues due to income from stock options.

Includes stock-flow adjustements reflecting changes in the portfolio allocation of Finnish pension funds.

For 2004—06, staff expects a current account balance that stays above 7 percent of GDP.

Based on relative normalized unit labor costs.

Table 2.

Finland and Selected Countries: Expenditure Structure, 2002 1/

(In percent of GDP)

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Sources: Eurostat Chronos database.

Definition differs slightly from Table 1. Data for the EU15 are for 2001.

Figure 1.
Figure 1.

Finland: Growth, Demand and Employment, 2000-04

Citation: IMF Staff Country Reports 2005, 035; 10.5089/9781451813234.002.A001

Sources: Statistics Finland; ETLA; WEO; and Fund staff calculations.

GDP and Demand

(percent change)

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Sources: Statistics Finland; and staff projections.

Contribution to growth.

4.The cyclical recovery has failed to revive the labor market in the face of persistent structural rigidities. The unemployment rate has remained at 9 percent since 2000, slightly above the estimated NAIRU of about 8 1/2 percent (Figure 2).1 A centralized wage-setting regime has fostered wage compression and led to growing mismatch in the labor market. At the same time, high taxes on labor and multiple possibilities for early exit from the labor force have tended to reduce labor supply. With recent employment gains confined largely to the financial services and local government sectors, the authorities’ goal of raising the employment rate from the current 67 percent to 70 percent by the end of the current electoral cycle in 2007—and to 75 percent by 2011—appears increasingly beyond reach under present policies.

Figure 2.
Figure 2.

Finland: Labor Market Characteristics, 1991—2004

Citation: IMF Staff Country Reports 2005, 035; 10.5089/9781451813234.002.A001

Sources: Finnish Labor Review; OECD Employment Outlook 2004; and Fund staff calculations.1/Income tax plus employee and employer contributions (as a percentage of labor costs); single person without children.2/ Defined as the unemployment rate of persons with less than upper secondary education.3/ 2004 data are for second quarter.

Inflation, Labor Market and Output Gap Indicators

(percent change)

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Sources: Statistics Finland; and staff projections.

Percent of labor force.

Economy-wide.

In percent of potential ouput.

5. inflation has fallen to the lowest level in the euro area. The HICP measure of inflation declined to 1.3 percent in 2003 and fell even further in 2004, reflecting large cuts in indirect taxation, especially on alcohol and cars, low import prices, the weak labor market and growing competition in services such as retailing, telecom, and air transport. As the impact of one-off factors such as the tax cuts recedes, inflation is gradually expected to revert close to the average prevailing in the euro area. The pace of house price inflation rose to 8 percent in 2003 from the recent annual average of 5 percent, mainly reflecting the rising cost of building land, especially in the Helsinki region.

6. Strong productivity gains have helped contain unit labor costs despite a faster rise in wages than the EU average. Recent high productivity growth has, however, been concentrated in a few sectors such as the Nokia-led electronics sector and financial services, without significant diffusion across the rest of the economy. The lack of large spillover effects may reflect the relative inflexibility of labor and product markets (Box 1).

Finland—How Durable Is the Nokia Effect?

The emergence of the high-technology sector led by Nokia has played a key role in altering the structure of the Finnish economy over the past decade. The industrial structure and the profile of exports, traditionally dominated by forestry products—Finland is the world’s leading exporter of paper—have become oriented towards the telecommunications industry. In 2002, information and communication technology (ICT) exports amounted to almost 22 percent of exports of goods—triple their share in the early 1990s and twice the EU average. Finland stands out as having the highest degree of specialization in exports among the advanced economies, making it more susceptible to sector-specific shocks such as the global downturn in the ICT industry.

uA01fig01

Export specialization relative to OECD

(average index 1998—2002)

Citation: IMF Staff Country Reports 2005, 035; 10.5089/9781451813234.002.A001

The acceleration in productivity growth since the mid-1990s primarily reflects the productivity gains in the ICT sector, without significant diffusion across the rest of the economy. Nokia accounts for almost half of the Finnish ICT cluster’s sales and its network includes a large number of suppliers and subcontractors (Paija, 2001).1 However, productivity gains outside the Nokia cluster have been relatively small and temporary.2 With weak inter-industry linkages between the Nokia cluster and the rest of the economy, the ICT diffusion and spillover effects in the form of research and development (R&D) and knowledge sharing appear to have been small, unlike in the United States and to a lesser extent in Sweden.

The relative inflexibility of the labor and product markets may have prevented stronger diffusion of productivity gains throughout the economy. A tentative conclusion from the Finnish experience seems to be that ICT diffusion can lead to economy-wide productivity gains only if accompanied by flexible labor and product markets. The period of Nokia’s rise coincided with the global ICT sector boom and liberalization of telecom equipment and service markets. In the past two years, the global ICT downturn and increasingly stiffer competition have already had an adverse impact on Nokia’s prospects. While Nokia’s impact on Finland’s exports, growth, and R&D spending continues to be substantial, steps to enhance the economy’s competitiveness through deeper structural reforms would seem imperative to meet the coming challenges from globalization and demography.

1 Paija, L. (2001) The ICT Cluster in Finland—Can We Explain It? In Paija L. (ed.) Finnish ICT Cluster in the Digital Economy, ETLA, Helsinki: 11—70.2 Daveri, F., and O. Silva (2004) Not Only Nokia: What Finland Tells Us About New Economy Growth, Economic Policy 38: 117—163.

7. The wage accord concluded in December 2004 represents a continuation of efforts to ensure wage moderation in return for cuts in income taxation. The accord, to be ratified in union-level negotiations, covers a period of two and a half years to September 2007, and, including local-level increases and wage drift, is expected to result in a rise in annual wages of about 3 1/2 percent over this period, broadly in line with recent years. In the context of the agreement, the government announced its intention to reduce income taxes by over 1 percent of GDP over the 2005—07 period. The accord retains the essentially centralized framework of Finland’s wage bargaining regime, in contrast to the recent Nordic trend towards firm-level bargaining.

8. The large current account surpluses partly reflect low domestic investment.

Finland has recorded surpluses in the range of 5 to 8 percent of GDP since the mid-1990s and is expected to sustain similar surpluses over the medium-term (Table 3). While in the late 1990s, they flowed partly from the thriving exports, more recently, they are largely a counterpart of the low level of corporate investment and higher net factor incomes. Finland’s investment ratio has been below the euro area average for the past ten years. The net international investment position (excluding equities) has turned positive.

Table 3.

Finland: Balance of Payments, 1999—2009

(in billions of euros)

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Sources: Bank of Finland; and staff projections.

9. The fiscal surplus has rapidly eroded in recent years. Although the general government surplus, at around 2 percent of GDP in 2003, remained among the highest in the advanced world, it was more than accounted for by the surplus of the social security funds, with the central and local government sector in a small deficit. The dwindling of the surplus since its record level of 7 percent of GDP in 2000 is partly cyclical, reflecting the end of the technology-sector-driven boom; however, it is also a consequence of a sharp discretionary policy shift as the structural surplus fell by 3 1/4 percent of GDP over the period (Figure 3). The strong fiscal expansion—second only to that observed in the United States and the United Kingdom in the OECD area—was largely brought about by increased public spending in 2002 and tax cuts in 2003, the latter amounting to about 1 1/2 percent of GDP.

Figure 3.
Figure 3.

Finland: Selected Indicators, 2000—04

Citation: IMF Staff Country Reports 2005, 035; 10.5089/9781451813234.002.A001

Sources: Statistics Finland; ETLA; WEO; and Fund staff calculations.

General Government Overall Balances

(percent of GDP)

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Sources: Statistics Finland; Ministry of Finance; and staff projections.

10. Strong growth helped maintain the fiscal surplus at 2 percent of GDP in 2004, although the structural balance weakened further. With growth about % percent above that estimated in the budget, revenues were buoyant, despite cuts in income taxes and alcohol excises, totaling some 1 percent of GDP. The revised four-year expenditure rule with a 1—year legal and a 3—year indicative ceiling—covering about three-fourths of central government spending, but excluding cyclical, interest, and other volatile expenditures—was observed, although the margin remaining over the 2005—08 horizon is limited. The structural surplus is estimated to have worsened by about 1/2 percent of GDP.

11. The budget for 2005 is expansionary despite the projected economic rebound. A cut in the corporate tax rate of 3 percentage points (to 26 percent) and in the personal capital income tax rate by 1 percentage point (to 28 percent) is designed to stimulate investment. In the context of the incomes policy accord, the authorities have also announced cuts in income taxes of 0.2 percent of GDP, aimed at stimulating employment. The general government surplus is projected to decline to about 1 3/4 percent of GDP, with the deficit of the central and local government sector likely to exceed 3/4 percent of GDP.

12. Despite recent tax cuts, the tax burden and tax wedges continue to be high.

Finland’s tax burden is among the highest in the world, exceeded only by Sweden and Denmark, and is about 5 percentage points of GDP higher than the EU average. Moreover, marginal tax wedges on labor, despite a decline in recent years, remain well above the OECD average (Figure 2), and high marginal tax rates set in at comparatively low income levels.

uA01fig02

Tax revenues

(as percentage of GDP)

Citation: IMF Staff Country Reports 2005, 035; 10.5089/9781451813234.002.A001

13. A significant reform of the public pension system is underway. The reform, to be phased in over an extended period beginning 2005, aims to raise the effective retirement age, currently 59 years. A key element of the reform is the replacement of the standard retirement age of 65 with a flexible retirement age ranging from 62 to 68, and an accrual rate rising with age for older workers. The inactivity rates in Finland among males aged 50 and over from sickness and disability are among the highest in the industrialized world.

II. The Policy Setting and The Outlook

14. The longer-term outlook is clouded by rapid population aging and the economy’s vulnerability to shocks due to its relatively undiversified structure. The lackluster productivity record of the sheltered sectors is likely to hold back growth as the contribution from the high technology sector, facing falling prices and stiffer competition in world markets, becomes less significant. The challenge for policy is to raise the utilization of labor in the face of low participation rates at both ends of the age spectrum. Labor resources are set to decline even more rapidly than in other European economies, constraining the fiscal room for maneuver. Indeed, the changing population age structure will begin to impact the labor market as early as 2006. The economy’s greater vulnerability to shocks in light of its specialization in telecom and forestry products also argues for reforms to raise the flexibility of product and labor markets (Box 1).

15. Despite Finland’s top position in competitiveness rankings, there is fairly widespread anxiety about the economy’s ability to compete in a rapidly globalizing world. The unease stems from a perception that “a small, expensive, rapidly aging and remote country”2 would be unattractive to global investors. A variety of trends—Finnish companies’ rising propensity to invest abroad; shrinking net capital stock as the investment ratio remains below that of the euro area; the secular decline in the terms of trade as export prices fall; and persistence of high structural unemployment—all tend to feed a climate of pessimism about the economy’s long-term prospects. The authorities have been trying to raise public awareness of the coming demographic transition and of the need to persevere with structural reforms if Finland is to capitalize on its strengths: a highly educated labor force, a culture of innovation, a consensual social climate, and strong macroeconomic fundamentals.3

16. In the near-term, an improved domestic and external climate is set to strengthen growth. Domestic demand is projected to accelerate to 2 1/2 percent in 2004, as tax cuts stimulate consumption and investment stages a tentative recovery. Although monetary conditions have tightened, reflecting the euro appreciation, they are not expected to hold back the recovery of demand (Figure 4). Staffs forecast, based on assumptions underlying the ongoing WEO exercise, is for GDP to grow by around 3 percent in both 2004 and 2005 and for the small output gap to close. However, unemployment is expected to decline only slightly. The latest official projections, assuming an oil price of about US$45 in 2005 and US$40 in 2006, and an average euro exchange rate of $1.24, are broadly similar.

17. The risks to the forecast are evenly balanced. A faster pace of global recovery than assumed and a turnaround in Nokia’s market share could strengthen exports further. The present projection assumes a continued loss in Finland’s overall market share. Measures of competitiveness have remained broadly stable over the past two years despite the appreciation of the euro. However, high oil prices and further appreciation of the euro could worsen prospects in the euro area as a whole, while continued adverse employment trends could damage consumer confidence.

Figure 4.
Figure 4.

Finland: Interest Rates and the Real Effective Exchange Rates, 1996—2004

Citation: IMF Staff Country Reports 2005, 035; 10.5089/9781451813234.002.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. An increase in the index represents a tightening of conditions.

III. The Policy Discussions

18. Against the backdrop of a nascent recovery and the demographic transition, the discussions centered on three key issues.

  • Ensuring fiscal sustainability: With a recovery underway and rapidly approaching demographic pressures, how to place the fiscal position on a stronger footing through additional pension reforms and expenditure restraint, which would also allow for further reductions in the high taxation of labor;

  • Enhancing employment at both ends of the age spectrum: How to calibrate policies to boost employment among the young and older workers, address labor market mismatches by reducing wage compression, boosting the demand for unskilled labor, and increasing incentives for job search;

  • Broadening productivity gains: Strengthening competition, especially in sheltered sectors (utilities, transport and retail services, and agriculture), and reducing public ownership.

A. Fiscal Policy Issues

19. The medium-term fiscal prospects are shaped by the strengthening recovery and the planned tax cuts. The authorities noted that following the strong stimulus of 2001—03, fiscal policy had returned closer to a neutral stance in 2004. The stimulus implied in the budget for 2005, although no longer needed from a cyclical perspective, was considered appropriate since it flowed largely from the authorities’ commitment to tax cuts in the context of the centralized wage accord and the critical importance of the objective of raising employment. Officials shared the mission’s concern over the composition of the public sector surplus, with the central government balance expected to move into a sizeable deficit in 2005. The authorities were candid in acknowledging the difficulties in meeting the official objective of a balance in central government finances by 2007, but they remained committed to achieving it. The medium-term fiscal outlook is not regarded as a cause for concern, although longer-term prospects are less reassuring (Table 4).

Table 4.

Finland: Public Sector Debt Sustainability Framework, 1999—2009

(In percent of GDP, unless otherwise indicated)

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Indicate coverage of public sector, e.g., general government or nonfmancial public sector. Also whether net or gross debt is used.

Derived as [(r−π(1+g)−g+αε(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r−π(1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(1+r).

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last proj ection year.

20. The authorities and the staff concur that mutually reinforcing labor and product market reforms would obviate the need for larger fiscal adjustment over the long-term (Box 2). Absent such reforms, assessments of fiscal sustainability, employing broadly similar frameworks—those by the staff, the authorities, and the OECD—conclude that, despite starting from a net asset position, sizeable fiscal surpluses will be needed over the coming decade. The staff analysis suggests that, on present policies, the general government (excluding the social security surpluses of about 2 1/2 percent of GDP) would need to sustain annual surpluses of 1 1/2 percent of GDP through the end of the decade to ensure sustainability, compared with a present deficit of about 3/4 percent of GDP. A more ambitious set of structural reforms, spanning the fiscal and pension fronts as well as labor and product markets, would reduce the need for fiscal adjustment, creating much-needed room for tax cuts (Figure 5). The staff and the officials agreed that these estimates were likely to understate the required fiscal adjustment since they did not allow for factors such as the likely rise in health care spending due to new expensive treatment methods, and a rise in wage and non-wage costs of local governments.

Figure 5.
Figure 5.

Finland: Baseline and Structural Reform Scenarios, 2005—50

(Percent of GDP)

Citation: IMF Staff Country Reports 2005, 035; 10.5089/9781451813234.002.A001

Sources: Finnish authorities; and staff projections.

Structural Reforms and Fiscal Sustainability

The long-term fiscal outlook is less comfortable than it appears at first glance. With the impact of aging occurring about a decade earlier than in many other European countries—between 2010 and 2025, the rise in the old-age dependency ratio is the steepest in the EU—and the stronger response of age-related spending, reflecting Finland’s comprehensive public welfare provision, leaves it little fiscal leeway.

uA01fig03

Old-Age Dependency Ratio

Citation: IMF Staff Country Reports 2005, 035; 10.5089/9781451813234.002.A001

Staff analysis suggests that, in the absence of further structural reforms, sizeable fiscal surpluses would be required over the coming decade to meet the demographic shock.

Staff’s baseline projections suggest that, on present policies, a permanent fiscal adjustment of about 2 percent of GDP is required to ensure sustainability (Figure 5).1 The conclusion of this scenario mirrors that of the authorities’ own assessment, which suggests that the currently envisaged general government surpluses of about 2 percent of GDP for the rest of the decade will eventually result in accelerating public debt, as the fiscal costs of aging materialize. In the same vein, a recent OECD study suggests that—assuming no further pension reforms, potential output growth of 2 1/4 percent and even some increase in employment—a permanent fiscal adjustment of 1 percent of GDP would be needed to avoid a sharp deterioration of the government net asset position by 2050.2 A significant fiscal tightening would be needed under the authorities’ present program to achieve the required adjustment.

A more ambitious set of structural reforms would reduce the need for large fiscal surpluses, creating room for tax cuts. Staff’s analysis on the basis of the Fund’s GEM model, calibrated to the Finnish economy, shows that a combination of product and labor market reforms would help initiate a virtuous circle that would substantially reduce the required fiscal adjustment. In the “structural reforms” scenario, greater product and labor market efficiency leads to sizeable economic gains, resulting in higher employment and output—around 3 percentage points each (Figure 6). The need for fiscal adjustment is, accordingly, substantially lower than in the baseline scenario, by about 1 percent of GDP. These reforms, combined with additional pension or other expenditure measures, would make room for growth-enhancing tax cuts.

1 See the Selected Issues Paper.2 See OECD, “2004 Economic Review—Finland.”
Figure 6.
Figure 6.

Finland: Simulated Impact of Labor and Product Market Reforms 1/

(Percent deviation from baseline)

Citation: IMF Staff Country Reports 2005, 035; 10.5089/9781451813234.002.A001

1/ Number of quarters on horizontal axis.Source: Fund staff calculation based on the IMF’s Global Economy Model.

21. The mood of popular complacency about the challenge of aging has complicated policymaking. The Finnish ethos of consensus had in the past served to mobilize popular support behind difficult decisions at times of crises. However, with Finland’s recent record of strong growth and fiscal surpluses, officials expressed frustration at the task of overcoming the public’s “information deficit.” They intended to continue their efforts to raise public awareness of the issues at stake. The mission underscored, especially in its public statements, that as aging accelerated, the electoral arithmetic would begin rapidly shifting against the constituency for structural reforms. Further reform of the pension system, combined with addressing labor and product market rigidities, would provide scope for tax cuts.

uA01fig04

Voters Age 50 and Older Exceed 50 percent of All Voters

Citation: IMF Staff Country Reports 2005, 035; 10.5089/9781451813234.002.A001

22. Pressures on public spending are unlikely to abate in the next few years.

Officials noted the narrowing margins under the expenditure ceilings and pointed to two main sources of pressure in the coming years. Demographically driven increases in spending were likely to result in rising transfers to local authorities. In addition, the decision to initiate new infrastructure investments without explicit allocations inside the spending ceiling was adding to spending pressures. Over the medium term, areas that offered scope for savings included education subsidies, public pensions and improved efficiency in the provision of public services—particularly those provided at the local level.

23. The authorities agreed that local government finances are increasingly a cause for concern. The local sector, providing a large share of the education and social services and accounting for the bulk of public employment, has experienced rapid growth in consumption in recent years. Declining efficiency of spending, combined with excessive reliance on volatile corporate profit tax bases, has obliged local governments to raise income tax rates, partially offsetting central government efforts to reduce taxation. The authorities planned limited reforms to municipal finances including abolition of the automatic adjustment of state grants when local spending exceeds plans. The mission argued that, over the longer term, a shift from relatively cyclical tax bases to property taxes may be needed. This option was, however, regarded as politically infeasible, in view of the widespread home ownership.

B. Labor Market Policies and Pension Reforms

24. Reducing taxation of labor has been a key element of the authorities’ efforts to promote employment. In view of the particularly high tax wedge at the low end of the wage distribution, the authorities have tried to target tax reductions at the low-income earners. Considerable evidence suggested that targeted reductions in social insurance contributions by employers of the low skilled (and low paid) was a more effective policy to promote employment than across-the-board tax cuts.4 While noting that tax cuts implemented in the context of incomes policy accords tended to be more of the latter variety, officials pointed to their efforts to tilt tax cuts towards the low-paid and the decision to reduce their payroll taxes in 2006. There was also a case to reduce high marginal tax rates at the upper end of the wage distribution to attract and retain skilled labor. The recent report of the Globalization Committee had recommended across-the board tax cuts to encourage work effort. The mission argued that, while a more substantial reduction in overall labor taxation was clearly desirable, it should occur only when offsetting expenditure cuts are secured.

25. The authorities are mindful of the necessity for a broader structural agenda to achieve their ambitious employment target. The expected further decline in the employment rate to 67 percent in 2004 underlined the demanding nature of the official objective of raising it to 70 percent. While reducing the tax wedge on labor would help stimulate employment,5 officials agreed that incentives remained for workers to leave the labor force too early and enter it quite late, given the almost free education and generous subsidies. The authorities planned to shorten further the average time spent in tertiary education, by putting in place a two-tier university degree structure in 2005. The use of study loans rather than grants is also under consideration. However, since unemployment primarily afflicted the unskilled, both young and old, the authorities’ approach focused on easing labor taxation, improving active labor market policies and securing a moderate wage accords that would gradually allow for greater flexibility in wage-setting.

26. Finland has generally attracted lower immigration than the other Nordic or the larger EU countries. For instance, the share of foreign-born population in Finland in 2002 was less than 3 percent, compared with 6—7 percent in Denmark and Norway and almost 12 percent in Sweden. Officials noted that recent studies of migration from the Baltics suggested no significant actual or prospective rise in labor inflows into the Nordic countries. Nevertheless, Finland, along with most EU countries, has opted to introduce special transition rules governing the right of access to its labor market for citizens from the new EU member states.

27. The authorities recognize that changes in the institutional arrangements of the labor market are highly desirable. While the centralized wage determination had served to moderate inflation, it had solidified wage rigidities that are unfavorable to the young and unskilled workers. Globalization, with the attendant greater competition in product and labor markets, had tended to alter the premises of centralized systems, as was evident in the trends in the rest of the Nordic world. The Finnish trade unions, wedded to the traditional “solidaristic” framework of wage bargaining, continued to place emphasis on job security and effective “job-to-job” training. Nevertheless, officials viewed the recent wage accord as marking a first step in the direction of more decentralized wage formation.

28. The pension reform is expected to improve incentives for older workers to delay exit from the labor force. The authorities believed that the tripartite agreement on the reform package was a major achievement and stressed the critical importance of three elements of the reforms in train: the automatic link of pensions to life expectancy; the nexus of benefits to lifetime earnings in place of the earlier “ten-year rule” and introduction of a flexible retirement age. Officials argued that the impact of the changes already initiated needed to be assessed before contemplating further measures. Officials did not dispute that additional reforms such as further limiting the avenues to early retirement by closing the so-called “unemployment pipeline”—whereby the unemployed aged over 57 can continuously claim benefits to age 65—were needed, but stressed the political difficulty of “selling” any new reforms in the near term. The mission argued for early consideration of further reforms, given the long phase-in periods required.

C. Product Markets and Trade

29. The authorities concurred that labor market reforms would yield positive synergies if they were complemented with product market reforms. Lack of competition was evident in Finland’s high price level in relation to the EU average. The relative size of the public enterprise sector remained larger than in most Nordic

uA01fig05

Relative Size of the Public Enterprise Sector in OECD

Citation: IMF Staff Country Reports 2005, 035; 10.5089/9781451813234.002.A001

countries. The sheltered sectors were characterized by relatively high market concentration, high prices, lagging productivity, and significant state ownership. Officials believed that privatization was likely to proceed only gradually. They agreed that despite Finland’s high ranking in relatively “soft” measures of competitiveness (e.g., perceptions of corruption, supportive legal environment, good educational system), it lagged behind in “hard” measures (e.g., high tax rates, high compensation levels, high management remuneration). This divergence might explain comparatively low levels of inward foreign direct investment.

30. The authorities noted that competitive pressures were gradually increasing.

Competition in the retail sector had risen somewhat since EU accession, and although still limited, had more recently led to a fall in food prices. Similarly, rising tax competition and the revived role of regulatory authorities in sheltered sectors, including network industries, also had a salutary impact. The Competition Authority’s legislation had been brought into alignment with the EU competition law. The new legislation in place should allow the Competition Authority to deal effectively with cartels. The planned reform of shop opening hours is expected to enhance competition in the retail sector.

31. Finland remains a strong supporter of the Doha Development Agenda, but retains its heavy farm subsidization. Officials generally favored a multilateral trading framework as superior to a series of bilateral agreements. While agreeing that a reduction in Finland’s farm subsidies—even higher than the EU average—would raise efficiency and consumer welfare, officials regretted that political difficulties would allow only a gradual progress in this area. Finland’s official development assistance remained notable, budgeted to rise to almost 0.4 percent of GDP in 2005 from around 0.35 percent in recent years.

D. The EMU Experience and the Financial Sector

32. The authorities looked back on the experience of over five years in the EMU with considerable satisfaction. Expectations at the time of entry into the euro area at the beginning of 1999 had generally been met, while some of the concerns prevalent at the time of entry had been belied. As expected, Finland had benefited from monetary stability and lower interest rates. Officials noted that the effects of EMU entry were not easy to isolate from other influences, especially since the economy had just recovered from a period of severe recession and financial crisis at the time of entry. Despite initial concerns centered on the risk of unfavorable asymmetric shocks, growth had been more rapid than in the euro area, thanks to the boom in the high technology sector. The economy’s openness had increased and, after several decades of deficits, large current account surpluses had emerged, even during periods of robust growth. Looking ahead, as EU enlargement intensified competition for placement of production and jobs, the challenge of adaptation for a country like Finland with high tax rates and a large welfare state was clear.

33. The financial sector appears ready for greater European market integration.

Officials noted that bank profitability remained healthy, the proportion of non-performing loans extremely low, and stress tests suggested that banks could withstand extended economic stagnation and a significant fall in asset prices (Table 5). Although household debt as a proportion of disposable income had risen, it was still low in an international perspective and there was little concern about the ability of households to service their debts. Increased cross-border financial activities by systemically important institutions and the merger of the Swedish and Finnish stock exchanges called for close cooperation among Nordic-Baltic supervisors and new coordinated supervisory mechanisms. The authorities noted that cross-border financial transactions raised important policy questions for the EU as a whole, not least regarding deposit insurance and the role of the lender of last resort.

Table 5.

Finland: Indicators of Financial Vulnerability, 1998—2003

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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.

Banking sector is defined here consists of all Finnish banks, including the Nordea Bank Finland Group (the Finnish subsidiary of Nordea Bank AB (Sweden); Merita Bank until 2000). Due to frequent restructurin within the Nordea group, the data are not directly comparable over time.

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

Average lending rate minus average deposit rate.

Data for 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 entire country.

IV. Staff Appraisal

34. Finland’s recent economic record has been impressive, but major challenges lie ahead. The economy has weathered the global slowdown relatively well, with strong fiscal stimulus helping to support economic growth. Inflation is low, the external position is comfortable, and the public finances have recorded surpluses that remain among the largest in the European Union. However, structural unemployment remains high, and looking ahead, Finland faces a rapidly changing global and domestic environment that call for hard policy choices.

35. The longer term outlook is clouded by imminent population aging, and rigidities in institutions that impede adaptation to change. With the adverse effects of aging impacting Finland earlier than any other country in EU, the electoral arithmetic will begin to shift soon against the constituency for reforms. While Finland enjoys the advantage of a favorable initial position, with the public sector holding sizeable net assets and a significant pension reform under way, the window for an effective and politically feasible policy response is likely to close rapidly. An early pursuit of wide-ranging structural reforms would help set in train a virtuous circle of higher employment and growth and stronger public finances.

36. Policy initiatives are needed to raise the employment rate—a precondition to achieving fiscal sustainability. Given the incentives embedded in the current labor market and education arrangements for workers to enter the labor market rather late and leave it too early, achieving the authorities’ ambitious employment target would call for major policy changes. Recent tax policy measures that reduce the burden of labor taxation will help promote employment, particularly of the low-skilled, but are unlikely to be effective on their own. Policies encompassing the tax-benefit system as well as product and labor market arrangements are required to raise utilization of labor at both ends of the age spectrum. A shift towards a more decentralized wage bargaining arrangement would ease the compressed wage structure, allowing a greater correspondence between wage and productivity differentials, and help reduce structural unemployment.

37. In the absence of wide-ranging structural reforms, ensuring fiscal sustainability would require sizeable general government surpluses for the rest of the decade. With the stronger expected rise in age-related spending than elsewhere, reflecting the rapidity of aging as well as Finland’s comprehensive welfare state, fiscal surpluses would provide a cushion to absorb the coming demographic shock. Staffs assessment suggests that the central and local governments would need to run a combined annual surplus of the order of 1 1/2 percent of GDP, as compared with a projected deficit of over 3/4 percent of GDP in 2005.

38. With solid growth in prospect, the fiscal stimulus implied by the 2005 budget is no longer necessary. The proposed cuts in taxation, including those announced in the context of the recent wage round, should be offset by cuts in spending as the full tax package is implemented. Over time, the beneficial effects on employment will be enhanced by tax cuts targeted at the lower end of the income scale. The government’s intention to reduce employers’ social security contributions for low-income workers in 2006 is an important step in this direction.

39. The room for a durable reduction in the taxation of labor should be created by pruning public spending. The authorities’ objective to attain central government balance by 2007 will be feasible only if any new tax cuts or spending initiatives are offset by spending cuts elsewhere and ceilings on expenditures observed scrupulously. Social transfers that deter the effective utilization of labor could be reduced, with a focus on limiting incentives for early retirement. A key avenue to easing pressures on public spending is to raise the efficiency in the provision of social and welfare services. In order to place municipal finances on a sound footing, a reassessment of their revenue sources may be necessary, with consideration given to greater reliance on alternative sources such as property taxes.

40. The pension reform to be phased in beginning next year is an important step towards ensuring fiscal sustainability, but is, by itself, insufficient. The reform—with commendable features such as an automatic adjustment for rising life expectancy, link of benefits to life-time earnings, and sharply rising accrual rates at age 63—is expected to raise the effective retirement age by almost two years. While the reform goes some way towards promoting higher labor participation by limiting the avenues for leaving the labor market early, important avenues to early exit from the labor force remain. To maximize the beneficial impact of the reform on participation, the so-called “unemployment pipeline” should be closed.

41. The prospective shrinking of labor supply underlines the importance of enhancing productivity. The high-technology sector has propelled the recent strong productivity growth. Raising productivity in the sheltered sectors will require investment in equipment and technology, in turn calling for a supportive economic and policy environment. Reforms to promote greater flexibility in labor and product markets are likely to have a large pay-off in terms of durable productivity gains throughout the economy.

42. Strengthening competition further in product markets would complement measures to improve the functioning of labor markets. Despite notable progress achieved in recent years, especially in communications, air transport and retail trade, the price level remains significantly above the EU average and scope exists to enhance competition. Reducing rigidities that impair the functioning of product markets could have positive spillover effects on the labor market. Competition between private and public sectors in the provision of services could also be encouraged. Last but not least, Finland’s farm subsidies—high even by EU standards—should be reduced in the interest of greater efficiency and consumer welfare.

43. The financial system is stable and is poised to benefit from increasing European financial integration. However, growing cross-border financial activities by systemically important institutions and the recent merger of the Swedish and Finnish stock exchanges underline the importance of close cooperation among Nordic-Baltic supervisors and new coordinated supervisory mechanisms.

44. Finland’s high level of official development assistance is commendable.

45. Finland’s provision of economic statistics is adequate for the purposes of Fund surveillance.

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

APPENDIX I: Finland: Fund Relations1

(As of November 30, 2004)

I. Membership Status: Joined January 14, 1948; Article VIII.

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans: none

V. Latest Financial Arrangements: none

VI. Projected Payments to Fund

(SDR million; based on existing use of resources and present holdings of SDRs):

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VII. Exchange 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 (Sections 2, 3, and 4) and maintains an exchange system that is free of restrictions on the making of payments and transfers for current international transactions, apart from those in accordance with: (i) IMF Executive Board Decision No. 144—(52/51) and the relevant UN Security Council resolutions—measures have been taken to freeze the accounts of the Taliban and of listed individuals and organizations associated with terrorism; (ii) EU regulations and the relevant UN Security Council resolutions—certain restrictions are maintained on the making of payments and transfers for current international transactions with respect to Myanmar, certain individuals associated with the previous governments of Iraq and the former Republic of Yugoslavia, and Zimbabwe; (iii) EU Regulation No. 147/2003, effective January 27,2003—financing of and financial assistance related to military activities in Somalia are prohibited. Restrictions also apply on transfers with respect to members of Al-Qaida and the Taliban, and individuals and organizations associated with terrorism.

VIII. Article IV Consultation:

Discussions for the 2003 Article IV consultation were held in Helsinki during June 9—18, 2003 and the Executive Board concluded the consultation on October 8, 2003. The Staff Report (IMF Country Report No. 03/325, 09/05/03), and a PIN (PIN/03/124) summarizing the views of the Executive Board, were published.

Core Statistical Indicators

Finland: Core Statistical Indicators

(As of December 20, 2004)

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Finnish contribution to euro area M3.

ETLA is the Research Institute of the Finnish Economy.

1

A broader measure of unemployment which tries to capture varieties of disguised unemployment, including participants in active labor market programs and those under unemployment pensions, is estimated to be as high as 16 1/2 percent. “How Many People in Finland Are Unemployed?” by Samu Kurri, Euro and Talous, No. 4, 2003.

2

Former Governor Mr. Vanhala’s characterization in a speech delivered on October 9, 2003.

3

Recent reports commissioned by the authorities include: “Strengthening Competence and Openness: Finland in the Global Economy,” Prime Minister’s Office, October 2004; and “Challenges For Growth in the 21st Century,” Ministry of Finance, 2003.

4

Such targeted cuts have shown positive effects in Belgium, France, the Netherlands, and Spain, and are in line with the thinking of a study group set up in the Finnish Prime Minister’s Office.

5

While the Finnish approach is in line with the EU’s Employment Guidelines of “making taxation employment friendly,” the recent tax cuts have been relatively modest and, unless supported by policies to reduce labor and product market rigidities, may fail to have a major impact on employment. In this context, a recent survey of international experience is suggestive. See Nickell, S. (2003), “Employment and Taxes,” CESifo Conference Paper, July 2003 www.bankofengland.co.uk/speeches/.

1

Updated information relating to members positions in the Fund can be found on the IMF web site (http://www.imf.org/external/np/tre/tad/index.htm). payments and transfers for current international transactions with respect to Myanmar, certain individuals associated with the previous governments of Iraq and the former Republic of Yugoslavia, and Zimbabwe; (iii) EU Regulation No. 147/2003, effective January 27, 2003—financing of and financial assistance related to military activities in Somalia are prohibited. Restrictions also apply on transfers with respect to members of Al-Qaida and the Taliban, and individuals and organizations associated with terrorism.