Abstract
In this study, during 2008, the financial crisis lead Iceland’s public debt to soar from under 30 percent of GDP to more than 100 percent of GDP, and while underlying external debt came down sharply, it remains elevated at close to 300 percent of GDP. First, external sustainability is overviewed, and second, growth of Iceland’s economy has been challenged, and finally, fiscal adjustments and its macroeconomic impacts are overviewed. Traditional external debt sustainability analysis (DSA) suggests that Iceland’s external debt is sustainable but is vulnerable to depreciation shock.
IV. Fiscal Consolidation Options1
A. Introduction
1. Iceland’s financial crisis burdened the country with very high public debt. Business cycle-related deficits, the need to recapitalize the banking system, crisis-related central bank losses, and foreign deposit insurance requirements combined to push the debt to 105 percent of GDP by end-2009 (Figure 1).2 Since the debt overhang puts fiscal sustainability at risk,3 an ambitious fiscal consolidation program is needed to set the debt ratio on a declining path.
Fiscal Consequences of the 2008 Crisis
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Sources: Ministry of Finance of Iceland; Statistics Iceland; and IMF staff calculations.Notes: Write-offs include costs of central bank recapitalization, failed securities lending to commercial banks, NPV of the cost of Icesave depositor guarantees, and retroactive interest paid to new banks to compensate for late capitalization.2. The first stage of the consolidation program is already in place. The government of Iceland took some 2 percent of GDP in policy measures during 2009, and over 5 percent of GDP in measures in 2010. All told, the primary balance has improved by about 5 percent of GDP. Revenue measures have included increases in VAT rates, excise rates, and social security contributions. On the expenditures side, transfers and capital spending have been reduced the most, but operating expenditures have also been curtailed to bring total central government spending down by about 3 percent of GDP. Also, local governments have cut expenditure by almost ½ percent of GDP.
3. The need for fiscal adjustment has stirred up public debate about the most appropriate course ahead. A medium-term consolidation strategy, published in July 2009, established a baseline plan.1 However, both the pace of fiscal consolidation (which is programmed to be in line with experience in other Nordic countries) and the composition of the adjustment remain under close scrutiny. Considerations affecting the choice of a fiscal adjustment mix include the desire to maintain the Nordic-type welfare state and to balance the need for public debt reductions against the need to support the economic recovery.
4. This paper sheds light on the macroeconomic effects of different fiscal adjustment options. We use the Global Integrated Monetary and Fiscal Framework (GIMF), calibrated to Iceland, to model fiscal consolidation under different scenarios for expenditure and revenue adjustment. The model suggests that an expenditure-oriented fiscal adjustment, especially if associated with reductions in transfers, would be modestly less detrimental to growth than a tax-based adjustment. If a more revenue-oriented consolidation is selected, a mix including a VAT increase would give room for a more export-oriented growth. As for the overall pace of fiscal consolidation, the pace now planned will protect the downward path of public debt from leveling off due to external shocks or realized contingent liabilities.
B. Background: fiscal consolidation objectives and options
5. The medium-term fiscal consolidation plan that the authorities presented to Parliament in July 2009 is appropriately ambitious. It aims to achieve: (i) a primary central government surplus by 2011; (ii) an overall central government surplus by 2013; and (iii) public debt of 60 percent in the long run. It also commits to a balanced use of revenue and expenditure measures, and a separate understanding reached with social partners suggest that revenue measures should amount to 45 percent of the needed adjustment. Creating conditions for stronger economic activity is an overarching theme of the plan. Finally, the authorities are committed to maintaining quality welfare services, including by protecting healthcare, social services, and public education.
6. Potential areas for expenditure rationalization have been identified in OECD reports, and the authorities have advanced in their implementation:2 The OECD has pointed to health care and education as areas where public spending is high by OECD and Nordic standards and cost-cutting could be implemented (Table 1).
Potential Areas of Expenditure Rationalization
Potential Areas of Expenditure Rationalization
| Recommendation | In ISK billions | In Percent of 2009 GDP |
|---|---|---|
| Reduce public-sector wage bill by 5% | 10 | 0.5 |
| Reduce public investment to 1% of GDP | 15 | 1 |
| Introduce cost-cutting reforms in health care to raise spending efficiency to the level of the first quartile OECD-member country | 20-25 | 1.5 |
| Introduce cost-cutting reforms in education to raise spending efficiency to the level of the OECD average | 20-25 | 1.5 |
| Eliminate agricultural subsidies | 10 | 0.75 |
Potential Areas of Expenditure Rationalization
| Recommendation | In ISK billions | In Percent of 2009 GDP |
|---|---|---|
| Reduce public-sector wage bill by 5% | 10 | 0.5 |
| Reduce public investment to 1% of GDP | 15 | 1 |
| Introduce cost-cutting reforms in health care to raise spending efficiency to the level of the first quartile OECD-member country | 20-25 | 1.5 |
| Introduce cost-cutting reforms in education to raise spending efficiency to the level of the OECD average | 20-25 | 1.5 |
| Eliminate agricultural subsidies | 10 | 0.75 |
In particular, OECD calculations have shown that input efficiency of the Icelandic health system is in the third quartile among all OECD countries. Should it be increased to the level of Spain—which is in the first quartile—health care spending could be reduced by 17.5 percent without compromising quality. Measures to cut expenditure by 13.2 percent have already been implemented since 2009, and with additional measures in 2011 to cut current expenses of 4.7 percent, the recommended reforms are expected to be near completion and total 1.5 percent of projected 2011 GDP.
OECD estimates have also shown that there is scope for rationalizing education spending. The input efficiency of Iceland’s education system has been assessed as lower than the OECD average, and increasing it to that level would allow reducing education spending by about 21 percent without compromising outcomes. Reductions in school costs of 1.6 percent in 2009 and 7 percent in 2010 have already been implemented, and a further reduction of 5 percent in upper secondary school costs and 7.5 percent in university costs will be implemented in 2011.
7. Other areas of expenditure rationalization identified by the OECD are public sector wages, investment, and agricultural subsidies. The wage bill was reduced by 0.5 percent of GDP in 2010 and will undergo a further cut of 0.5 percent of GDP in 2011. Investment was reduced by 0.5 percent of GDP in 2010 and will be further reduced by 0.2 percent of GDP in 2011.
8. There is also scope for raising tax revenues. A recent IMF technical assistance mission has found that, while Iceland’s tax system already yields high revenue, there is some room for greater collection.1 Iceland’s tax system features relatively low rates, broad tax bases, limited cases of favorable treatment, and small opportunities for arbitrage—all contributing to high revenue yield and low distortionary impact. Consequently, at 34 percent of GDP, general government tax revenue is among the highest among OECD countries—as is required to fund relatively high expenditure levels. Nonetheless, there are a few areas in which improving tax efficiency could also help raise additional revenues: (i) raising or eliminating the reduced VAT rate and eliminating non-standard VAT exemptions (1.1-1.5 percent of GDP); (ii) improving the progressivity of the personal income tax and increasing the personal capital income tax to 20 percent (0.6-0.7 percent of GDP); (iii) increasing the fuel excise (0.3-0.5 percent of GDP); and (iv) increasing the corporate income tax (0.1 percent of GDP).
C. The model
9. The macroeconomic implications of the size and mix of fiscal adjustment can be considered using the IMF’s Global Integrated Monetary and Fiscal Model (the GIMF). The GIMF is a calibrated model commonly used to assess the implications of fiscal measures on the real economy.1 The main advantage of this analysis is the granularity with which different fiscal policy instruments can be examined compared to analysis based on empirical estimations. This allows realistic fiscal policy scenarios to be modeled.
10. The GIMF model contains three channels through which fiscal adjustment affects the economy:
Government spending affects aggregate demand both directly and through multiplier effects due to its effect on output and income. In addition, changes in government investment affect the productivity of private capital and labor, and magnify output responses.
Taxes create distortions that affect the supply of factors of production, which in turn affects output. Changes in the level of taxation also affect aggregate demand. They have strong income and wealth effects due to consumers’ finite work life and planning horizon; agents experience real and permanent wealth/income losses.
Transfers generate wealth and income effects similar to changes in lump-sum taxes. In addition, the existence of liquidity constrained consumers who do not have means to smooth lifetime consumption, amplifies the impact of transfer cuts on aggregate consumption.
11. The model for Iceland is calibrated to produce a steady state similar to the present economic structure, and to generate reasonable dynamic responses to shocks:
The steady-state is calibrated at the expected 2010 public debt value of 118 percent of GDP (Appendix 1). Calibrating steady-state debt at this value allows us to simulate a realistic public debt path in the following 10 years. Similarly, government expenditures on consumption and investment are calibrated to be, respectively, at 24½ percent and 2½ percent of GDP, corresponding to projected 2010 ratios according to national accounts definitions (Box 1).
The model is calibrated to broadly match the impulse responses to shocks generated by the central bank’s QMM model2. Thus, a 100 bps increase in monetary policy rate for one year reduces annual inflation by around 0.3 percentage point and GDP growth by 0.4 percent within the first year, mainly through the exchange rate channel. The effects of government expenditure shocks are also close to those in the central bank model—the short-run multiplier is relatively low (at 0.6 percent) because of the leakage effect through imports. Similarly, a depreciation shock (1 percent drop in exchange rate) generates a substantial increase in inflation in the first year (with the implied pass-through coefficient of about 0.2 in line with the QMM model), but also a real exchange rate depreciation leading to improvements in the trade balance. The implied imports (0.3) and exports (-0.3) elasticities with respect to real exchange changes are again close to those found in the QMM model.
Model definitions
Government primary expenditures: The national accounts definition is used; thus, government consumption and investment are included, but not transfers to consumers.
Government primary revenues. To simplify the modeling these are taken to include interest revenues.
Government is general government (i.e. the consolidation of central and local governments). It is assumed that policy measures taken by the central government are used to achieve the targeted general government primary balance, while local government balances are unchanged.
12. The steady state model is simulated forward to establish a baseline against which to investigate alternative scenarios. Key assumptions underlying this baseline include:
The fiscal consolidation entails a frontloaded 8¾ percent of GDP primary balance improvement in 2011–13, a positive primary balance in 2011, and a positive overall balance in 2013. The 2013 primary balance—at 6 percent of GDP—is then maintained for 5 years to sustain the downward trend of the debt to GDP ratio to reach a long-term target of 60 percent of GDP in a 10-year horizon.
The authorities use a balanced mix of revenue and expenditure measures (as agreed with social partners). Policy measures taken by 2013 are assumed permanent, and in the outer years transfers adjust automatically and remain contained to preserve the primary balance at 6 percent. Revenues are assumed to be raised through PIT in 2011, and through VAT (or other consumption taxes) in 2012–13, as these are the highest yielding potential tax policy measures. Public consumption and transfers are reduced in equal amounts in 2011–13. Public investment is reduced only temporarily in 2011 (which prevents a long-term deterioration in private sector productivity).
To capture “post-crisis”-like effects, liquidity constrained consumers are assumed to comprise 50 percent of the population.3 These are consumers whose credit score prohibits borrowing and whose level of income prevents them from holding financial instruments.
13. Four main alterative scenarios are used to evaluate the effect of the composition and pace of fiscal consolidation (Appendix 2 and Table 2). The first two capture the impact of a more expenditure oriented fiscal adjustment (Scenario 1) and a more revenue-oriented fiscal adjustment (Scenario 2). A second set of scenarios analyses the size and speed of fiscal adjustment by assuming a smaller primary balance adjustment than in the baseline (Scenario 3) and a more back loaded fiscal adjustment that in the baseline (Scenario 4). All other assumptions remain as in the baseline.
Fiscal Adjustment Scenarios
(Cumulative change in 2011-13 in percent of GDP)
Fiscal Adjustment Scenarios
(Cumulative change in 2011-13 in percent of GDP)
| Composition of the Fiscal Adjustment | Pace of the Fiscal Adjustment | ||||
|---|---|---|---|---|---|
| Baseline | Scenario 1 Expenditure-Oriented | Scenario 2 Revenue-Oriented | Scenario 3 Smaller | Scenario 4 Delayed | |
| Primary Balance | 8.7 | 8.7 | 8.7 | 8.1 | 8.7 |
| Revenues | 2.2 | 0.7 | 4.2 | 1.9 | 3 |
| Expenditures | 6.5 | 8.0 | 4.5 | 6.2 | 5.7 |
Fiscal Adjustment Scenarios
(Cumulative change in 2011-13 in percent of GDP)
| Composition of the Fiscal Adjustment | Pace of the Fiscal Adjustment | ||||
|---|---|---|---|---|---|
| Baseline | Scenario 1 Expenditure-Oriented | Scenario 2 Revenue-Oriented | Scenario 3 Smaller | Scenario 4 Delayed | |
| Primary Balance | 8.7 | 8.7 | 8.7 | 8.1 | 8.7 |
| Revenues | 2.2 | 0.7 | 4.2 | 1.9 | 3 |
| Expenditures | 6.5 | 8.0 | 4.5 | 6.2 | 5.7 |
D. Results
The fiscal adjustment mix
14. Model simulations suggest that an expenditure-oriented adjustment would have a modestly less negative impact on aggregate demand than a revenue-oriented one (Figure 2):
Under an expenditure-based consolidation, the additional cut in public consumption and transfers of 1.5 percent of GDP in 2011-13 relative to the baseline reduces tax-induced distortions, raising potential output. As a result, cumulative GDP growth is about one-third of a percentage point higher compared to the baseline by 2014 and inflation is lower by about ¾ percent in 2011-15, which allows for lower real interest rates. The higher permanent income and lower interest rates open room for private demand (Figure 3). Private consumption is expected to be about 1 percent of GDP higher by 2015, and under perfect foresight, firms raise investment already in 2011-13. However, a somewhat more appreciated real effective exchange rate, results in a slightly more negative trade balance compared to the baseline (by about ½ percent of GDP).
Under a revenue-oriented consolidation tax distortions reduce growth prospects. Cumulative GDP growth is about ½ percent lower than under the baseline by 2014 and about ¾ percent lower than under a more expenditure-oriented consolidation. Meanwhile, the inflation rate is nearly 1 percentage point higher than under the baseline and more than 1½ percentage points higher than under an expenditure-oriented consolidation in 2011-15, leading to higher real interest rates.4 Weaker growth prospects and higher interest rates reverberate into slightly lower consumption and investment, which is partly offset by an improved trade balance by about 0.2-0.4 percentage points of GDP by 2015 relative to the baseline.
Fiscal Adjustment Mix and Aggregate Demand
(Deviation from the baseline in percent of GDP)
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Source: IMF staff calculations.Effect of the Fiscal Adjustment Mix on Growth and Inflation
(Percent)
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Source: IMF staff calculations.Note: Real GDP growth and the inflation rate are calculated by adding the difference between each scenario and the baseline to the rates projected by IMF staff under the baseline.Sensitivity to the fiscal adjustment mix
15. Does the precise adjustment mix matter? For the case of a more expenditure-oriented adjustment, possible scenarios include: (i) a greater reduction in general transfers; and (ii) a greater reduction in public consumption than in the baseline, where transfers and public consumption are reduced by the same amount. For the case of a more revenue-oriented adjustment, possible scenarios include: (i) increases in the VAT or other consumption taxes in 2011-13; (ii) increases in capital and/or the corporate income tax rate in 2011, and VAT or other consumption taxes in 2012-13; (iii) increases in PIT only in 2011-13; and (iv) increases in capital and/or the corporate income tax rate in 2011 and PIT in 2012-13.
16. Model simulations suggest that for expenditure-oriented adjustments a greater emphasis on transfer cuts modestly boosts output. If 75 percent of the expenditure measures involve transfer cuts, cumulative GDP growth is more than ¾ percentage points higher than under the baseline by 2014, tripling the impact of scenario 1, and 1 percentage point higher than under a consolidation with a greater cut of consumption spending. The intuition is that government investment and consumption impact aggregate demand directly, while reduction in transfers operate mainly through their effects on personal disposable incomes, with is widely accepted in the literature to have smaller multipliers. (Figure 4). The overall inflation rate and the debt reduction path remain similar under all expenditure-oriented scenarios, although the better growth under a consolidation with greater transfer cuts reduces the debt ratio by an additional percentage point to a consolidation with greater cut in government consumption (Figure 5).
Aggregate Demand under Expenditure-Oriented Fiscal Adjustment Scenarios
(Deviation from the baseline in percent of GDP)
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Source: IMF staff calculations.Growth and Inflation under Expenditure-Oriented Fiscal Adjustment Scenarios
(Percent)
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Source: IMF staff calculations.17. Revenue-oriented scenarios keep GDP subdued, with some nuances. All scenarios which more heavily tax consumption reduce consumption by at least 0.8 percent of GDP by 2015 and tend to discourage investment (Figure 6). Under consolidation using only consumption taxes instead of income taxes, this effect is amplified by a higher inflation rate (1¼ percentage points in 2011-15) and the associated higher real interest rate due to the response of monetary policy (Figure 7). While consumption taxes allow the trade balance to improve, it is not sufficient to offset the decline in domestic demand: by 2014 consolidations relying on consumption taxes generate lower cumulative GDP growth than alternative revenue-based scenarios. Nonetheless, a fiscal adjustment plan that raises consumption tax revenues generates fewer distortions and redirects the economy toward export-led growth, and after 2015 cumulative GDP is higher than under consolidations relying on taxes on factor inputs. The debt ratio follows a similar path under all revenue-oriented scenarios, although an adjustment that relies exclusively on consumption tax revenues leads to a slightly higher debt ratio (by ¾ percent of GDP) in 2015.
Aggregate Demand under Revenue-Oriented Fiscal Adjustment Scenarios
(Deviation from the baseline in percent of GDP)
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Source: IMF staff calculations.Growth and Inflation under Revenue-Oriented Fiscal Adjustment Scenarios
(Percent)
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Source: IMF staff calculations.The Fiscal adjustment pace
18. Model simulations suggest that small variations in the total amount of fiscal adjustment have no major impact. An adjustment in the primary balance that is about ½ percentage point lower than in the baseline would be less restraining on consumption despite inducing a trade balance deterioration (Figure 8), and allows GDP to temporarily stay slightly above the baseline (Figure 9).5
Fiscal Adjustment Pace and Aggregate Demand
(Deviation from the baseline in percent of GDP)
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Source: IMF staff calculations.Fiscal Adjustment Pace and Growth and Inflation
(Percent)
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Source: IMF staff calculations.19. However, the pace of fiscal adjustment is of more importance. A delayed consolidation—assuming a primary balance 2 percentage points lower in 2011 offset by later surpluses—worsens borrowing conditions for the private sector by keeping pressure on the inflation rate and putting growing pressure on interest rates. It also leads to real appreciation in 2011-15 and deterioration of the trade balance. Private investment and aggregate demand are relatively subdued throughout the coming decade under delayed consolidation, and cumulative GDP growth is about 1 percent lower by 2014.
20. The simulations suggest that the pace of fiscal consolidation has an important bearing on debt reduction. Public debt declines steadily and in 2020 is at or under 60 percent of GDP under all scenarios except delayed consolidation. Due to the more sluggish growth, a delayed consolidation leaves the public debt at a level almost 5 percent of GDP higher than the baseline (Figure 10). A ½ percentage point of GDP smaller adjustment modestly elevates debt in the long-run (by 3¼ percent of GDP), but entails much lower interest costs, especially in 2011-15.
Fiscal Adjustment Pace and Aggregate Demand and Public Debt
(Deviation from the baseline in percent of GDP)
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Source: IMF staff calculations.Public Debt to GDP
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Sensitivity analysis and the fiscal adjustment pace
21. How robust are results on the pace of adjustment to underlying assumptions? Two scenarios are considered. First, a higher risk premium, perhaps due to premature or missequenced capital control liberalization (a model-based estimation6 suggests that under normal market conditions and given Iceland’s public debt level, Iceland’s long-term government bond yields would be about 200 basis points higher than observed). Second, materializing contingent liabilities (commercial bank losses may call for a new round of bank recapitalization, amounting to as much as 10 percent of GDP, and separately litigation risks remain) would increase public debt.
22. Model simulations suggest that results are sensitive to the behavior of the risk premium on Iceland’s debt. A 200-basis point increase in the foreign currency premium in 2011 slows down growth and slows the reduction of public debt (Table 3 and Figure 11). The initial real effective exchange rate depreciation—which could give a cumulative boost to growth by about ¾ percentage points in 2011-15—wears off in the long-run, while the inflation rate remains elevated for most of the decade. The rise in the foreign currency risk premium burdens the government with additional interest payments of more than 1½ percent of GDP by 2013, which in combination with the sharply declining GDP growth, levels off the long-term public debt path. In sum, an increase in the foreign currency premium would keep the 2020 public debt level more than 15 percent of GDP higher than under the main scenarios if the fiscal consolidation is delayed. This points to a need to carefully coordinate the fiscal adjustment path with the capital control liberalization path.
Impact of a 200 Basis Point Increase in the FX Premium on Public Debt Dynamics
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Real Growth and Public Debt under FX Premium Shock
Real Growth and Public Debt under FX Premium Shock
| Real GDP Growth | Public Debt in Percent of GDP | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Main Scenarios | 200 Basis Point Increase in the FX Risk Premium | Main Scenarios | 200 Basis Point Increase in the FX Risk Premium | |||||||||
| Year | Baseline | Smaller | Delayed | Baseline | Smaller | Delayed | Baseline | Smaller | Delayed | Baseline | Smaller | Delayed |
| 2011 | 3.0 | 2.9 | 3.2 | 2.7 | 2.6 | 3.2 | 115 | 115 | 116 | 115 | 115 | 116 |
| 2012 | 2.4 | 2.7 | 2.2 | 3.1 | 3.4 | 2.7 | 110 | 110 | 113 | 111 | 111 | 115 |
| 2013 | 1.9 | 1.9 | 1.1 | 2.3 | 2.3 | 1.4 | 102 | 103 | 106 | 103 | 104 | 110 |
| 2014 | 3.1 | 3.1 | 3.0 | 3.2 | 3.2 | 2.9 | 93 | 94 | 98 | 94 | 96 | 104 |
| 2015 | 3.1 | 3.1 | 3.2 | 2.9 | 2.9 | 3.0 | 84 | 86 | 89 | 85 | 87 | 97 |
| 2016 | 74 | 77 | 79 | 76 | 79 | 90 | ||||||
| 2017 | 65 | 68 | 70 | 67 | 70 | 83 | ||||||
| 2018 | 61 | 65 | 66 | 64 | 68 | 81 | ||||||
| 2019 | 59 | 62 | 64 | 62 | 65 | 79 | ||||||
| 2020 | 56 | 59 | 61 | 59 | 63 | 77 | ||||||
Real Growth and Public Debt under FX Premium Shock
| Real GDP Growth | Public Debt in Percent of GDP | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Main Scenarios | 200 Basis Point Increase in the FX Risk Premium | Main Scenarios | 200 Basis Point Increase in the FX Risk Premium | |||||||||
| Year | Baseline | Smaller | Delayed | Baseline | Smaller | Delayed | Baseline | Smaller | Delayed | Baseline | Smaller | Delayed |
| 2011 | 3.0 | 2.9 | 3.2 | 2.7 | 2.6 | 3.2 | 115 | 115 | 116 | 115 | 115 | 116 |
| 2012 | 2.4 | 2.7 | 2.2 | 3.1 | 3.4 | 2.7 | 110 | 110 | 113 | 111 | 111 | 115 |
| 2013 | 1.9 | 1.9 | 1.1 | 2.3 | 2.3 | 1.4 | 102 | 103 | 106 | 103 | 104 | 110 |
| 2014 | 3.1 | 3.1 | 3.0 | 3.2 | 3.2 | 2.9 | 93 | 94 | 98 | 94 | 96 | 104 |
| 2015 | 3.1 | 3.1 | 3.2 | 2.9 | 2.9 | 3.0 | 84 | 86 | 89 | 85 | 87 | 97 |
| 2016 | 74 | 77 | 79 | 76 | 79 | 90 | ||||||
| 2017 | 65 | 68 | 70 | 67 | 70 | 83 | ||||||
| 2018 | 61 | 65 | 66 | 64 | 68 | 81 | ||||||
| 2019 | 59 | 62 | 64 | 62 | 65 | 79 | ||||||
| 2020 | 56 | 59 | 61 | 59 | 63 | 77 | ||||||
Impact of a 200 Basis Point Increase in the FX Risk Premium in 2011
(Deviation from Main Scenarios)
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
Source: IMF staff calculations.23. Results are also sensitive to public debt shocks. A 10 percent of GDP shock to public debt increases the real interest rate and amplifies the effect of the private sector’s net worth reduction in 2011, subsequently reducing investment. The shock also triggers further fiscal consolidation through reduction in household transfers, amplifying the negative GDP growth effect on the debt path.
Impact of a 10 Percentage Point Increase in Public Debt in 2010 on Public Debt Dynamics
Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A004
24. The simulations suggest that a debt shock will delay achieving the authorities’ objective of maintaining debt to GDP ratio of 60 percent. This is particularly the case for delayed consolidation, and the total impact on public debt 15 percent of GDP higher than if contingent liabilities were not assumed by the government. In sum, given a targeted path of debt reduction, variations in the fiscal adjustment path should only be considered once there is greater clarity about contingent fiscal liabilities.
E. Conclusions
25. GIMF simulations underscore that the depth, composition and timing of the fiscal adjustment have macroeconomic consequences. Domestic demand and growth would be modestly stronger under an expenditure-oriented adjustment than under a revenue-oriented one. The small differences resulting from fiscal adjustment options with different compositions show that the authorities’ aspiration to reduce the ratio of long-term debt to GDP to 60 percent can be achieved with any policy mix. However, attention must be paid to the pace of consolidation: delay could stall debt reduction at above 75 percent of GDP. Finally, the pace of adjustment provides protection against debt shocks and an increase in the foreign currency risk premium, opening up greater room for other policies (e.g. capital control liberalization).
References
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Appendix I. Model Assumptions
| Variable | Iceland | Rest of the World | ||
|---|---|---|---|---|
| GDP (percent share of world nominal GDP) | 0.12 | 99.88 | ||
| National Expenditure Accounts(percent share of GDP) | ||||
| Consumption | 53.21 | 64.60 | ||
| Liquidity-constrained agents | 25.47 | 7.44 | ||
| Overlapping generation agents | 34.44 | 53.16 | ||
| Investment | 13.00 | 15.90 | ||
| Government spending | 27.00 | 23.50 | ||
| On consumption | 24.50 | 20.50 | ||
| On investment | 2.50 | 3.00 | ||
| Exports | 44.21 | 0.05 | ||
| Of final goods | 26.87 | 0.03 | ||
| Of intermediate goods | 17.34 | 0.02 | ||
| Imports | -44.13 | -0.42 | ||
| Of final goods | -29.86 | -0.03 | ||
| consumption goods | -23.55 | -0.03 | ||
| investment goods | -6.31 | 0.00 | ||
| Of intermediate goods | -14.27 | -0.02 | ||
| National income accounts (percent share of GDP) | ||||
| Wages and dividends | 59.54 | 59.70 | ||
| Capital income | 23.52 | 28.15 | ||
| Taxes on wages | 16.94 | 12.15 | ||
| Taxes on capital | 4.62 | 4.05 | ||
| Government revenue | 30.50 | 26.50 | ||
| Assets and Debt | ||||
| Government debt (percent share of GDP) | 118.00 | 60.00 | ||
| government deficit | 6.80 | 3.18 | ||
| primary balance | 1.39 | 0.01 | ||
| interest payments | 8.19 | 3.19 | ||
| Structural Parameters | ||||
| Population growth, percent p.a. | 1.00 | 1.00 | ||
| Intertemporal elasticity of substitution | 2.00 | 0.20 | ||
| Probability of survival (20 year planning horizon) | 0.95 | 0.95 | ||
| Income decline rate (20 year remaining working life) | 0.95 | 0.95 | ||
| Share of liquidity-constrained agents | 0.50 | 0.15 | ||
| Elasticities of substitution | ||||
| Home/foreign final goods | 1.50 | 1.50 | ||
| Home/foreign intermediate goods | 1.50 | 1.50 | ||
| Tradable/nontradable | 0.80 | 0.80 | ||
| Commodities | ||||
| Capital/Labor | 0.99 | 0.99 | ||
| Depreciation rate of private capital, percent p.a. | 9.00 | 9.00 | ||
| Depreciation rate of public capital, percent p.a. | 4.00 | 4.00 | ||
| Variable | Iceland | Rest of the World | ||
|---|---|---|---|---|
| GDP (percent share of world nominal GDP) | 0.12 | 99.88 | ||
| National Expenditure Accounts(percent share of GDP) | ||||
| Consumption | 53.21 | 64.60 | ||
| Liquidity-constrained agents | 25.47 | 7.44 | ||
| Overlapping generation agents | 34.44 | 53.16 | ||
| Investment | 13.00 | 15.90 | ||
| Government spending | 27.00 | 23.50 | ||
| On consumption | 24.50 | 20.50 | ||
| On investment | 2.50 | 3.00 | ||
| Exports | 44.21 | 0.05 | ||
| Of final goods | 26.87 | 0.03 | ||
| Of intermediate goods | 17.34 | 0.02 | ||
| Imports | -44.13 | -0.42 | ||
| Of final goods | -29.86 | -0.03 | ||
| consumption goods | -23.55 | -0.03 | ||
| investment goods | -6.31 | 0.00 | ||
| Of intermediate goods | -14.27 | -0.02 | ||
| National income accounts (percent share of GDP) | ||||
| Wages and dividends | 59.54 | 59.70 | ||
| Capital income | 23.52 | 28.15 | ||
| Taxes on wages | 16.94 | 12.15 | ||
| Taxes on capital | 4.62 | 4.05 | ||
| Government revenue | 30.50 | 26.50 | ||
| Assets and Debt | ||||
| Government debt (percent share of GDP) | 118.00 | 60.00 | ||
| government deficit | 6.80 | 3.18 | ||
| primary balance | 1.39 | 0.01 | ||
| interest payments | 8.19 | 3.19 | ||
| Structural Parameters | ||||
| Population growth, percent p.a. | 1.00 | 1.00 | ||
| Intertemporal elasticity of substitution | 2.00 | 0.20 | ||
| Probability of survival (20 year planning horizon) | 0.95 | 0.95 | ||
| Income decline rate (20 year remaining working life) | 0.95 | 0.95 | ||
| Share of liquidity-constrained agents | 0.50 | 0.15 | ||
| Elasticities of substitution | ||||
| Home/foreign final goods | 1.50 | 1.50 | ||
| Home/foreign intermediate goods | 1.50 | 1.50 | ||
| Tradable/nontradable | 0.80 | 0.80 | ||
| Commodities | ||||
| Capital/Labor | 0.99 | 0.99 | ||
| Depreciation rate of private capital, percent p.a. | 9.00 | 9.00 | ||
| Depreciation rate of public capital, percent p.a. | 4.00 | 4.00 | ||
Appendix 2. Main Fiscal Adjustment Scenarios
| Baseline | Scenario 1 | Scenario 2 | Scenario 3 | Scenario 4 | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Balanced Measures (45/55 Rule) | More Spending Cuts | Greater Tax Revenues | Smaller Consolidation Balanced Measures (45/55 Rule) | Delayed Consolidation Balanced Measures (45/55 Rule) | |||||||||||||||||||
| 2010 | 2011 | 2012 | 2013 | Cum. | 2011 | 2012 | 2013 | Cum. | 2011 | 2012 | 2013 | Cum. | 2011 | 2012 | 2013 | Cum. | 2011 | 2012 | 2013 | Cum. | |||
| Primary Balance | -2.7 | 0.6 | 3.8 | 6.0 | 0.6 | 3.8 | 6.0 | 0.6 | 3.8 | 6.0 | 0.8 | 3.3 | 5.4 | -1.2 | 2.0 | 6.0 | |||||||
| Change in the primary balance | 3.3 | 3.2 | 2.2 | 8.7 | 3.3 | 3.2 | 2.2 | 8.7 | 3.3 | 3.2 | 2.2 | 8.7 | 3.5 | 2.5 | 2.1 | 8.1 | 1.5 | 3.2 | 4.0 | 8.7 | |||
| Revenue Increasing | |||||||||||||||||||||||
| Measures | 0.1 | 1.0 | 1.0 | 2.2 | 0.1 | 0.4 | 0.3 | 0.7 | 0.4 | 2.3 | 1.5 | 4.2 | 0.1 | 0.8 | 1.0 | 1.9 | 0.0 | 1.0 | 1.9 | 3.0 | |||
| Increase in PIT | |||||||||||||||||||||||
| Revenues | 0.1 | 0.0 | 0.0 | 0.1 | 0.1 | 0.0 | 0.0 | 0.1 | 0.4 | 0.0 | 0.0 | 0.4 | 0.1 | 0.0 | 0.0 | 0.1 | 0.0 | 0.0 | 0.0 | 0.0 | |||
| Increase in VAT | |||||||||||||||||||||||
| Revenues | 0.0 | 1.0 | 1.0 | 2.1 | 0.0 | 0.4 | 0.3 | 0.7 | 0.0 | 2.3 | 1.5 | 3.8 | 0.0 | 0.8 | 1.0 | 1.8 | 0.0 | 1.0 | 1.9 | 3.0 | |||
| Expenditure Reducing | |||||||||||||||||||||||
| Measures | 3.2 | 2.2 | 1.2 | 6.5 | 3.2 | 2.8 | 1.9 | 8.0 | 2.9 | 0.9 | 0.7 | 4.5 | 3.4 | 1.7 | 1.1 | 6.2 | 1.5 | 2.2 | 2.1 | 5.7 | |||
| Reduction in Consumption | |||||||||||||||||||||||
| Spending | 1.3 | 1.1 | 0.6 | 2.9 | 1.3 | 1.4 | 1.0 | 3.7 | 1.2 | 0.5 | 0.3 | 1.9 | 1.4 | 0.8 | 0.5 | 2.7 | 0.6 | 1.1 | 1.0 | 2.7 | |||
| Reduction in Transfers | 1.3 | 1.1 | 0.6 | 2.9 | 1.3 | 1.4 | 1.0 | 3.7 | 1.2 | 0.5 | 0.3 | 1.9 | 1.4 | 0.8 | 0.5 | 2.7 | 0.6 | 1.1 | 1.0 | 2.7 | |||
| Reduction in Capital | |||||||||||||||||||||||
| Spending | 0.6 | 0.0 | 0.0 | 0.6 | 0.6 | 0.0 | 0.0 | 0.6 | 0.6 | 0.0 | 0.0 | 0.6 | 0.7 | 0.0 | 0.0 | 0.7 | 0.3 | 0.0 | 0.0 | 0.3 | |||
| Proportion of revenue measures | 3.1 | 32.8 | 47.7 | 2.2 | 12.2 | 12.2 | 12.8 | 71.8 | 68.7 | 3.1 | 32.8 | 47.7 | 3.1 | 32.8 | 47.7 | ||||||||
| Baseline | Scenario 1 | Scenario 2 | Scenario 3 | Scenario 4 | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Balanced Measures (45/55 Rule) | More Spending Cuts | Greater Tax Revenues | Smaller Consolidation Balanced Measures (45/55 Rule) | Delayed Consolidation Balanced Measures (45/55 Rule) | |||||||||||||||||||
| 2010 | 2011 | 2012 | 2013 | Cum. | 2011 | 2012 | 2013 | Cum. | 2011 | 2012 | 2013 | Cum. | 2011 | 2012 | 2013 | Cum. | 2011 | 2012 | 2013 | Cum. | |||
| Primary Balance | -2.7 | 0.6 | 3.8 | 6.0 | 0.6 | 3.8 | 6.0 | 0.6 | 3.8 | 6.0 | 0.8 | 3.3 | 5.4 | -1.2 | 2.0 | 6.0 | |||||||
| Change in the primary balance | 3.3 | 3.2 | 2.2 | 8.7 | 3.3 | 3.2 | 2.2 | 8.7 | 3.3 | 3.2 | 2.2 | 8.7 | 3.5 | 2.5 | 2.1 | 8.1 | 1.5 | 3.2 | 4.0 | 8.7 | |||
| Revenue Increasing | |||||||||||||||||||||||
| Measures | 0.1 | 1.0 | 1.0 | 2.2 | 0.1 | 0.4 | 0.3 | 0.7 | 0.4 | 2.3 | 1.5 | 4.2 | 0.1 | 0.8 | 1.0 | 1.9 | 0.0 | 1.0 | 1.9 | 3.0 | |||
| Increase in PIT | |||||||||||||||||||||||
| Revenues | 0.1 | 0.0 | 0.0 | 0.1 | 0.1 | 0.0 | 0.0 | 0.1 | 0.4 | 0.0 | 0.0 | 0.4 | 0.1 | 0.0 | 0.0 | 0.1 | 0.0 | 0.0 | 0.0 | 0.0 | |||
| Increase in VAT | |||||||||||||||||||||||
| Revenues | 0.0 | 1.0 | 1.0 | 2.1 | 0.0 | 0.4 | 0.3 | 0.7 | 0.0 | 2.3 | 1.5 | 3.8 | 0.0 | 0.8 | 1.0 | 1.8 | 0.0 | 1.0 | 1.9 | 3.0 | |||
| Expenditure Reducing | |||||||||||||||||||||||
| Measures | 3.2 | 2.2 | 1.2 | 6.5 | 3.2 | 2.8 | 1.9 | 8.0 | 2.9 | 0.9 | 0.7 | 4.5 | 3.4 | 1.7 | 1.1 | 6.2 | 1.5 | 2.2 | 2.1 | 5.7 | |||
| Reduction in Consumption | |||||||||||||||||||||||
| Spending | 1.3 | 1.1 | 0.6 | 2.9 | 1.3 | 1.4 | 1.0 | 3.7 | 1.2 | 0.5 | 0.3 | 1.9 | 1.4 | 0.8 | 0.5 | 2.7 | 0.6 | 1.1 | 1.0 | 2.7 | |||
| Reduction in Transfers | 1.3 | 1.1 | 0.6 | 2.9 | 1.3 | 1.4 | 1.0 | 3.7 | 1.2 | 0.5 | 0.3 | 1.9 | 1.4 | 0.8 | 0.5 | 2.7 | 0.6 | 1.1 | 1.0 | 2.7 | |||
| Reduction in Capital | |||||||||||||||||||||||
| Spending | 0.6 | 0.0 | 0.0 | 0.6 | 0.6 | 0.0 | 0.0 | 0.6 | 0.6 | 0.0 | 0.0 | 0.6 | 0.7 | 0.0 | 0.0 | 0.7 | 0.3 | 0.0 | 0.0 | 0.3 | |||
| Proportion of revenue measures | 3.1 | 32.8 | 47.7 | 2.2 | 12.2 | 12.2 | 12.8 | 71.8 | 68.7 | 3.1 | 32.8 | 47.7 | 3.1 | 32.8 | 47.7 | ||||||||
Prepared by Wojciech Maliszewski and Iva Petrova.
The general government debt includes the net present value of Icesave-related contingent liabilities.
See Ostry et al. (2010).
See OECD (2009).
See Freedman et al. (2009), Kumhof et al. (2009 and 2010) and Clinton et al. (2010).
See Danielsson et al. 2009 for details of the QMM.
A similar ratio of liquidity constraint consumers has been used in the case of upper income emerging European economies, see Allard and Muñoz (2008) and Allard et al. (2008)
The higher inflation would be particularly undesirable, given the large share of CPI- indexed loans, which constituted 19 percent of Icelandic banks’ loan portfolios at end-April 2010.
A smaller consolidation may also trigger a negative confidence effect, particularly if it involves a deviation from the previously announced path. A possibly non-linear effect of such a scenario on risk premium is difficult to model.
IMF staff calculations, based on a fixed effects panel data estimation, which covers 17 countries and the period from 1998-2008, without accounting for capital controls. According to this estimation Iceland’s projected 10-year government bond yield would average 9.8 percent of GDP compared to an IFS reported average of 7.6 percent.
