Kingdom of the Netherlands—Netherlands: Selected Issues and Analytical Notes

Important issues of the Netherlands are discussed. Openness to trade has benefited the Netherlands before the crisis and has supported the recent recovery process. However, both financial openness and trade linkages have also been a transmission channel for the financial crisis. Synchronized fiscal tightening across Europe has important spillover effects for GDP growth. The improvement on the supply side of credit has contributed to a normalization of the credit market. However, the recent increase in the financial stress index indicates that the situation is still fragile.

Abstract

Important issues of the Netherlands are discussed. Openness to trade has benefited the Netherlands before the crisis and has supported the recent recovery process. However, both financial openness and trade linkages have also been a transmission channel for the financial crisis. Synchronized fiscal tightening across Europe has important spillover effects for GDP growth. The improvement on the supply side of credit has contributed to a normalization of the credit market. However, the recent increase in the financial stress index indicates that the situation is still fragile.

Analytical Note 7: Fiscal Sustainability and Optimal Consolidation Paths in the Netherlands1

1. This note provides an assessment of fiscal sustainability in the Netherlands, and also examines the optimal pace of consolidation under quadratic preferences. The estimates of aging pressures from the European Commission’s Stability Report 2009 are incorporated in the analysis, as well as the implications of the recent weakening in the fiscal position. The sustainability gap is evaluated from a starting point of 2012, and thus incorporates only those consolidation measures that are anticipated for 2011. We conclude that the sustainability gap as of 2012 is moderately smaller than that estimated for 2011 in the 2009 Staff Report, reflecting the strong consolidation plans for 2011. Measures to help erase the sustainability gap are briefly discussed. In addition, we develop a model to shed light on optimal fiscal consolidation paths under quadratic preferences concerning the sustainability and output gaps.

A. Recent Fiscal Developments and Outlook

2. The headline fiscal balance deteriorated sharply in 2009. This was largely driven by the sharp decline in economic activity—which drove revenues down while at the same time raising expenditure-GDP ratios—as well as discretionary stimulus. Revenues fell by one percent of GDP, led by social contributions, while expenditures rose by almost 5 percent of GDP with almost half of the increase due to social benefits. As a result the headline balance fell from a surplus of ½ percent of GDP in 2008 to a deficit of 5½ percent of GDP in 2009. Staff estimates that structural worsening accounted for half of this deterioration, with the robust deficit (i.e. the structural primary deficit excluding property income) rising from 2¼ percent of GDP in 2008 to 5¼ percent of GDP in 2009. Alongside, public debt rose 2½ percentage points to 60¾ percent of GDP, breaching the SGP debt limits.

3. But improved in 2010. The headline fiscal deficit declined modestly to 5¼ percent of GDP in 2010, with a revenue decline of ¼ percent of GDP more than offset by a decline of ½ percent of GDP in expenditure. The revenue decline was concentrated in non tax revenues, whereas the expenditure reduction broad based. Alongside, the robust deficit improved by ¼ percentage point to 5 percent of GDP, while public debt rose to 63¾ percent of GDP.

4. And substantial consolidation is planned for 2011. The headline deficit is expected to contract by 1½ percent of GDP, primarily as a result of consolidation efforts that reduce the robust deficit by almost 1 percent of GDP. In this regard, revenues are expected to increase by ¾ percent of GDP, with a significant increase in social contributions partly offset by reduced taxes. Expenditures are also expected to decline by ½ percent of GDP, with the cuts led by the wage bill but spread in a broadly uniform fashion across most expenditure categories. Notwithstanding this consolidation, public debt continues to grow, reaching 65½ percent of GDP, as the deficit remains substantial.

5. The year for the calculation of the sustainability gap is taken to be 2012, one year later than that in the 2009 Staff Report. This implies that the impact of the strong consolidation in 2011 is taken into account in the calculation, unlike the case of the 2009 staff report, which will reduce the size of the sustainability gap in comparison with the estimate of 8 percent of GDP estimated in the 2009 Staff Report.

6. Recent ECFIN baseline estimates of aging pressures for the Netherlands are in the relatively high range in comparison with other European countries (Figures 7-1 and 7-2). From 2007 to 2060, aging pressures are estimated to add 9.4 percent of GDP to fiscal expenditures in the Netherlands, well above the median of 5.3 percent of GDP across the European Union. The increase for the Netherlands is composed of increased pension expenditure of 4 percent of GDP, larger long-term care expenditure of 4.7 percent of GDP, higher health-care expenditure of one percent of GDP, and reduced education and unemployment-benefit expenditures of 0.2 and 0.1 percent of GDP, respectively.

Figure 7-1.
Figure 7-1.

Change in Expenditure Due to Aging, 2007-60

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A007

Source: DG ECFIN, The 2009 Ageing Report, and IMF staff calculations.
Figure 7-2.
Figure 7-2.

Aging-Related Expenditure Under Different Scenarios, 2007-60

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A007

Sources: DG ECFIN; The 2009 Ageing Report; and IMF staff estimates.
uA07fig01

Net Immigration

(Thousands of persons)

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A007

7. These baseline estimates are sensitive to the underlying assumptions used. In particular, the assumptions on immigration have a significant influence on the projections. The baseline scenario assumes that average annual net immigration over 2010–60 is about 9,500 persons, which is among the lowest in share of population (0.06 percent) in the EU27, and also below inflows in recent years. In comparison, an alternative scenario with zero immigration is projected to add 1.4 percent of GDP to the increase in aging related spending over 2011–60. Roughly speaking, therefore, an increase in annual immigration flows by 1,000 would reduce the buildup of aging pressures by about 0.15 percent of GDP. In contrast, however, an analysis of the benefits of immigration carried out by the CPB in 2003 is more pessimistic, finding little or even negative fiscal benefits to the Netherlands from recent immigration, given that immigrants often have different labor market characteristics than the native population and will also ultimately add to the number of the aged.2

B. Estimating the Fiscal Sustainability Gap

8. The sustainability indicator used is based on the general government intertemporal budget constraint. This is consistent with the approach used by the Dutch authorities and the S2 sustainability indicator used in the EC’s sustainability reports.3 The starting point for this analysis is the equation defining the evolution of public debt:

Bt=Bt1(1+r)Pt1(1)

Where Bt, r, and Pt, represent the debt stock at the beginning of period t, the discount rate, and the primary surplus in period t, respectively. Dividing equation (1) by GDP gives the following equation:

bt=bt1(1+r1+g)pt1(11+g)(2)

Where bt and pt represent the debt to GDP ratio at the beginning of period t and the primary surplus to GDP ratio in period t, respectively, and g represents the growth rate of GDP, assumed to be constant for algebraic simplicity. Solving equation (2) forward and imposing the no-Ponzi-scheme condition yields the government intertemporal budget constraint:

bt=(11+r)Σj=0(1+g1+r)jpt+j(3)

For any given fiscal stance (e.g. the current structural primary fiscal balance) and given the outlook for growth and other expected exogenous changes such as demographic change and depletion of natural resources, a “passive” path for the primary surplus over an infinite horizon can be estimated, and on that basis the sustainability gap in stock terms (which is the total intertemporal debt in present value terms) is then given by:

Vt=bt(11+r)Σj=0(1+g1+r)jpt+j(4)

And the sustainability gap in flow terms—hereafter simply called the sustainability gap—which is defined as the constant change to the primary balance in percent of GDP such that the sustainability gap in stock terms is zero is thus derived as:

St=(rg)[bt(11+r)Σj=0(1+g1+r)jpt+j](5)

9. Staff’s updated estimate of the sustainability gap is about ½ percent of GDP lower than that in the 2009 Staff Report. Taking into account the consolidation of almost 1 percent of GDP in 2011 (bearing in mind that we now calculate the sustainability gap as of 2012, in contrast to the last staff report where it was calculated as of 2011), slightly offset by the impact of the one-year delay on the accumulation of debt and a somewhat lower projection for medium term growth of nominal GDP, we find that the estimate of the sustainability gap has declined to 7½ percent of GDP.4,5 While higher pension payments would also increase tax receipts on pension income, this offers only a small offset to the increase in the sustainability gap. However, the sustainability gap could turn out to be less than 7½ percent of GDP if the large external current account surplus unwinds as a rising number of retirees draw down their accumulated pensions, raising consumption-based tax revenues over the long run as share of output. The authorities’ estimates (also published by Bettendorf et al, 2011) indicate that this effect is substantial.6 However, we have not taken this into account in our calculations because the size of this effect is quite uncertain.

10. Absent corrective measures, public debt is projected to exceed 500 percent of GDP by 2060 in view of the large sustainability gap (Figures 7-3 and 7-4). Alongside, the robust deficit is projected to increase by 6¼ percentage points to 10½ percent of GDP, while the overall fiscal deficit deteriorates by 30 percentage points to 34 percent of GDP as interest payments consume an ever-increasing share of fiscal expenditure. In contrast, immediate full adjustment implies that gross debt is driven to zero by 2026, with a notable buildup of government assets thereafter to help defray the long-run costs of aging.

Figure 7-3.
Figure 7-3.

Netherlands: Fiscal Sustainability, 2012–60 1/

(in percent of GDP)

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A007

Sources: CPB: Ageing and the Sustainability of Dutch Public Finances (2006), ECFIN: The 2009 Ageing Report, and Staff calculations.1/ Plausible adjustment path 1 is somewhat less ambitious than authorities’ adjustment path in the short run, but envisages stronger consolidation thereafter such that the sustainability gap is closed in 2021. This also corresponds to the variable weights scenario in Table 7-1. Plausible adjustment path 2 is consistent with the authorities’ adjustment path up to 2015, and further assumes that consolidation continues at a pace of ½ percent of GDP until the sustainability gap is closed in 2025.
Figure 7-4.
Figure 7-4.

Netherlands: Fiscal Sustainability Excluding No Measures Path, 2012-60 1/2/

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A007

Source: CPB: Ageing and the Sustainability of Dutch Public Finances (2006), ECFIN: The 2009 Ageing Report, and Staff calculations.1/ Same data as immediately preceding panel chart, but excluding no-measures path in order to highlight constrasts between the various sustainable paths.2/ Plausible adjustment path 1 is somewhat less ambitious than authorities’ adjustment path in the short run, but envisages stronger consolidation thereafter such that the sustainability gap is closed in 2021. This also corresponds to the variable weights scenario in Table 7-1. Plausible adjustment path 2 is consistent with the authorities’ adjustment path up to 2015, and further assumes that consolidation continues at a pace of ½ percent of GDP until the sustainability gap is closed in 2025.

11. Other commonly-used sustainability indicators generally show smaller gaps, but do not satisfy the intertemporal budget constraint. In particular, the European Commission defines another indicator, S1 as the constant change to the primary balance in percent of GDP such that the public debt to GDP ratio is 60 percent of GDP in 2060, and the IMF’s Fiscal Affairs Department sometimes uses an indicator (which we will call S3 here for brevity) defined similarly as the constant change to the primary balance in percent of GDP such that the public debt to GDP ratio is 60 percent of GDP in 2030. S1 and S3 however generally do not satisfy the intertemporal budget constraint, as they do not address what happens beyond the respectively envisaged time horizons. For Netherlands, we estimate S1 and S3 to be 6½ percent of GDP and 4 percent of GDP, respectively. In both cases our estimates indicate that debt is on a strongly rising path beyond the respective time horizons used. Thus, we do not focus on these indicators beyond this point.

C. Measures to Achieve Sustainability

12. The authorities plan significant consolidation in 2011 and beyond. Deep cuts in expenditure are envisaged over 2011–15, with a view to reduce the headline deficit to less than one percent of GDP by 2015. The cuts are broad-ranging, and will include reducing public administration costs, restraining growth of public wages, efficiencies in health care, and reductions in grants and transfers. However, the new government stepped back from some key structural measures announced by the previous government: in particular, the retirement age is now to be increased by one year to 66 rather than 67 announced previously. Also, there is to be no action to modify the generous regime for mortgage interest deductibility. Cuts to unemployment benefits are also off the table. While the fiscal measures for the medium term are ambitious, the total from these efforts falls short of the size of the sustainability gap, so more measures will need to be identified over the longer horizon to close the sustainability gap.

13. Measures to directly contain the impact of aging on the public finances should be a key plank of efforts to secure sustainability. In this regard, pension reform is critical. The OECD notes that the state pension has not been changed since it was set up in 1957, even as life expectancy has increased by more than 6 years and a strong second-pillar pension system has been built up. Also, it is relatively generous by international standards, at about 31 percent of average earnings compared to an average 22 percent for neighboring countries. The decomposition of the projected buildup in pension pressures indicates that the increase arises from a pronounced increase in the old-age dependency ratio, which is projected to be partly offset by tightening of eligibility rules (Figure 7-5). However, more could be done, including by gradual reduction of benefits as well as improvements in the employment ratio. In addition, the rise in the old-age dependency ratio could be limited by increasing the retirement age.

Figure 7-5.
Figure 7-5.

Netherlands: Decomposition of Pension Expenditure Projections, 2007-60

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A007

Sources: DG ECFIN; The 2009 Ageing Report; and IMF staff estimates.

14. The authorities do not dispute the need for such measures. Indeed, they have already moved in this direction by abolishing tax incentives for early retirement. And while the previous government’s intention to raise the retirement age from 65 to 67 by 2025 has been scaled back, there is still time to reconsider this position as the measure takes place over a long horizon. These measures could also be supported by intensified efforts to increase labor participation rates and immigration in order to increase the base for funding pensions. Consideration could also be given to reducing or means-testing the generosity of pensions, while strengthening dependence on the second pillar pension.

15. Major health sector reform in 2006 has increased competition in the sector, but more is needed to contain the rise in health-care expenditures. The reforms harmonized the basic health insurance package, increased consumer information on premiums, facilitated the switching of insurance providers, blocked insurance companies from refusing coverage on the basis of pre-existing conditions, and mandated that all acquire insurance. This has intensified competition amongst insurers, leading to increased mergers and some downward pressure on premiums. However, expenditure pressures are still significant, and the new government is rightly seeking efficiencies in this area. There are also concerns that mergers of insurance companies will ultimately reduce competition. Thus sustained vigilance will be needed to keep a lid on health costs.

16. Moreover, eligibility, entitlements, and arrangements for old-age care will also need reform, as this is an area where aging pressures will be substantial. The projected increase in long-term care spending for the Netherlands is by far the highest in the EU, which suggests that reforms drawing on lessons from other EU countries could yield substantial savings.

D. Optimal Fiscal Consolidation Paths

17. The pace of consolidation will reflect the balancing of the government’s twin stated objectives of reducing both the output and the fiscal sustainability gaps. We construct a model to assess the optimal pace of consolidation as follows: the authorities are assumed to care about both the sustainability and output gaps, and to prefer that both be zero. However, these objectives are conflicting, in that action to close the sustainability gap (fiscal tightening) comes at the expense of widening the output gap, while on the other hand, action to close the output gap (fiscal loosening) increases the sustainability gap. Thus, over an infinite horizon, the authorities’ problem can be characterized as choosing a path for the fiscal stance that minimizes the following quadratic objective function.

Σt=0βt(αOt2+γSt2)(6)

Where Ot, α γ and β, represent the output gap in percent of GDP in period t, the weight placed by the authorities on closing the output gap, the weight placed by the authorities on closing the sustainability gap, and the authorities’ rate of time preference, respectively, with β = 1/(1 + r).

18. The output gap is assumed to evolve according to the following equation:

Ot=λOt1ξ(ftft1))(7)

Where ft, λ and ξ, represent, respectively, discretionary fiscal measures taken (in percent of GDP) in period t, an autoregressive parameter on the output gap which determines how long it would take for the output gap to be eliminated through self-repair of the economy rather than fiscal action, and the fiscal multiplier.

19. Discretionary fiscal measures are assumed to have no effect on potential growth. In effect, discretionary measures only affect GDP growth temporarily, with corresponding changes to the output gap. The constant growth rate assumed in the derivation of the sustainability gap is best interpreted as the average of the annual growth rates that obtain over the infinite horizon. With the underlying potential growth path unchanged, temporary deviations of annual growth rates have a negligible impact on the average calculated over the infinite horizon. Moreover, since the output gap closes, temporarily low growth rates must be offset by temporarily higher growth rates. Thus, notwithstanding some variation in growth rates, equation 5 would still give a close approximation to the sustainability gap.

20. It is necessary to adjust the sustainability gap formula to reflect discretionary actions. If we adjust equation 5 to take account of discretionary fiscal measures taken in time t, in addition to the “passive” evolution of the primary surplus, this yields:

St=(rg)[bt(11+r)Σj=0(1+g1+r)jpt+j(1rg)ft](8)

And some algebraic manipulations reveal that the sustainability gap evolves as follows:

St=(1+r1+g)St1(ftft1)(9)

21. Equation 9 reveals that in the normal case where the discount rate exceeds the GDP growth rate, delaying actions to ensure sustainability is costly. The magnitude of the sustainability gap increases over time absent discretionary measures to close it, since the discount rate (which governs the pace of debt accumulation) exceeds the GDP growth rate (which governs the burden of debt relative to GDP). We estimate in the Netherlands case that whereas immediate full adjustment to sustainability requires measures totaling 7½ percent of GDP, phasing in the adjustment over a 10 year period requires measures totaling about 8 percent of GDP for sustainability.

22. The authorities’ problem is to choose the size of fiscal measures in time t to minimize the objective function (6) subject to equations (7) and (9). Given the quadratic preferences and linear constraints, we know that the optimal fiscal tightening in any time period is a linear function. We therefore speculate that the fiscal consolidation pace is governed by the following equation:

ftft1=AOt1+BSt1(10)

Where A > 0 and B > 0. Substituting equation (10) into the first order condition of the authorities’ problem, and solving for A and B yields:

A=αξλ(αξ2+γ)(11)
B=γ(1+r)(αξ2+γ)(1+g)(12)

23. Thus, the optimal path for fiscal consolidation depends on the starting values for the output and sustainability gaps, the fiscal multiplier, the speed of self-correction of output gaps, the discount and GDP growth rates, and the authorities’ preferences. For Netherlands, starting in year 2012, the initial sustainability gap is calculated above at 7½ percent of GDP, while it is estimated that the (negative) output gap in 2011 was one percent of GDP. λ is calibrated to equal 0.5, implying that the Dutch output gap would be essentially eliminated by 2016. The fiscal multiplier is taken to be 0.6. The discount rate and GDP growth rate are taken to be 5 percent and 3.4 percent respectively, consistent with the EC Sustainability Report 2009. On this basis, we then zero-in on the impact of the authorities’ preferences on the optimal consolidation path.

24. In general, the optimal consolidation path includes some front-loading of adjustment, but also envisages that full elimination of the sustainability gap takes place over a long horizon. Quadratic preferences mean that the pressure to act to reduce any of the two gaps under consideration increases in nonlinear fashion with the size of that gap. Thus, if the sustainability gap is large enough relative to the output gap, the optimal immediate fiscal tightening would be one that trades a substantial reduction the sustainability gap for some increase in the output gap. Therefore (subject to the weights in the authorities’ preferences) the larger the sustainability gap, the more optimal it is to front-load adjustment. Also, the authorities have a very long horizon over which to consider and implement adjustment, and under quadratic preferences they would tend to select a path in which both the output and sustainability gaps trend toward zero, which then pushes back the timing for full sustainability to be achieved.

25. Table 7-1 illustrates various consolidation paths, reflecting different preference weights of the authorities on the output and sustainability gaps. In the case where there are equal weights on the output and sustainability gaps, the optimal fiscal tightening for 2012 is 5¼ percent of GDP, which is rather large, and certainly well beyond what most advanced economies could contemplate. The next two cases deal with “corner” solutions where the authorities care only about the sustainability gap (and therefore eliminate it totally in one year) or care only about the output gap (and therefore eliminate it totally in one year by appropriate fiscal loosening). The case where alpha=0.9 and gamma=0.1 yields results that are quite plausible, with annual consolidation starting at about ¾ percent of GDP and declining gradually over time such that the sustainability gap is kept on a steady downward path. However, at that pace the sustainability gap is only eliminated over a very long horizon. As of 2021 the sustainability gap, though substantially reduced, is still at 3¼ percent of GDP.

Table 7-1.

Illustrative Optimal Annual Fiscal Adjustment Paths Under Quadratic Preferences 1/

article image
Source: IMF staff calculations.

Initial sustainability gap (given no consolidation from 2012 onward) = 7.5 percent of GDP; Initial output gap (in 2011) = -1.0 percent of GDP; fiscal multiplier is taken to be 0.6; autoregressive parameter for output gap (lambda) is taken to be 0.5; nominal interest rate = 5 percent; nominal GDP growth rate = 3.4 percent.

Alpha is the weight on the output gap, while gamma is the weight on the sustainability gap.

Alpha is assumed to decline over time from an initial value of 0.9 to zero over a 10-year period, while Beta rises at the same pace from an initial value of 0.1. This scenario corresponds to “Plausible adjustment path 1” in the Netherlands: Fiscal Sustainability, 2012-60 textchart.

The underlying output gap is not directly comparable with the output gap in staff’s WEO projections, as the WEO projections assume that other effects (including confidence e.t.c) will provide some offset to the negative impact of fiscal tightening, such that the output gap closes in 2016. These other effects could be modeled by introducing an exogenous term into the equation governing the evolution of the underlying output gap.

26. The last scenario (variable weights) considers the case where the authorities have a fixed time horizon (taken to be 10 years) to close the sustainability gap. This is modeled in a simple fashion by allowing the weights on the sustainability and output to vary, with alpha declining from 0.9 to zero over the 10 years while gamma rises at the same pace from a starting value of 0.1. Here we observe a relatively uniform but plausible pace of consolidation, with annual tightening averaging about ¾ percent of GDP. The “Plausible adjustment path 1” scenario shown in the text chart on fiscal sustainability corresponds to this scenario. In contrast, the “Plausible adjustment path 2” scenario in the same text chart is consistent with the authorities’ announced adjustment path up to 2015, and further assumes that consolidation is continued at a pace of ½ percent of GDP annually from 2016 onward, which leads to the sustainability gap being closed in 2025. It is thus a bit more frontloaded in the short run, but with the pace of consolidation declining more significantly than in “Plausible adjustment path 1” over the medium and long run.

1

Prepared by Daniel Kanda

2

Roodenberg, H., R. Euwals, and H. ter Rele, 2003, “Immigration and the Dutch Economy,” CPB Netherlands Bureau for Economic Analysis, The Hague.

3

See van Ewjik, C., N. Draper, H. ter Rele, and E. Westerhout, 2006, “Ageing and the Sustainability of Dutch Public Finances,” CPB Netherlands Bureau for Economic Analysis, The Hague; and European Commission, 2009, “Sustainability Report 2009.”

4

This assumes that the outlays for financial sector bailout—including any additional interest payments from the debt issued for this purpose—are fully recouped. With zero recoupment of these outlays the sustainability gap increases to 7¾ percent of GDP.

5

In comparison, ECFIN estimates the fiscal sustainability gap for the Netherlands in 2009 at 6.9 percent of GDP.

6

See Bettendorf, L., A. van der Horst, N. Draper, C. van Ewjik, R. de Mooij, and H. ter Rele, 2011, “Ageing and the Conflict of Interest Between Generations,” published online in De Economist, Springer. http://www.springerlink.com/content/l066481t43655j32/fulltext.pdf

Kingdom of Netherlands: Netherlands: Selected Issues and Analytical Notes
Author: International Monetary Fund