France: Selected Issues Paper

International Monetary Fund

doi:10.5089/9781462338528.002.A001

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France

Selected Issues Paper

Author: International Monetary Fund

Publication Date:: 27 Jul 2011

eISBN:: 9781462338528

Language:: English

Keywords:: ISCR; CR; France; staff calculation; financial crisis; labor force; output gap; labor force participation; further labor market; production function; spur TFP; Potential output; Total factor productivity; Production growth

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This note estimates potential output for France during 1980–2010, using three distinct approaches, and discusses long-term growth prospects. The focus on capital taxation highlights the need for a broader reform of the French tax system to address the features that hamper job growth, investment, and productivity growth. This paper analyzes the impact of Basel III capital requirements on French banks and the French economy, and proposes policy recommendations. French banks should be able to meet the new requirements through earnings retention.

Abstract

I. France’s Potential Output during the Crisis and Recovery¹

Using three distinct approaches—statistical filtering, production function, and multivariate model—this note estimates potential output for France during 1980–2010 and discusses long-term growth prospects. The main findings include: (i) prior to the crisis, France’s potential output growth had already been on a declining trend, reflecting a slowing TFP growth and falling average working hours per worker; (ii) potential output losses due to the financial crisis are estimated to be between 1 percent and 3 percent, somewhere between the losses of Germany and the U.S.; (iii) demographic factors would likely shave 0.2 percent from potential growth over the next two decades; and (iv) boosting potential growth in the period ahead would require structural reforms to increase the participation rate, reduce structural unemployment, raise working hours, encourage capital accumulation and utilization, as well as spur TFP.

A. Introduction

1. An important economic issue facing France today is the rate of its future potential output growth. Indeed, potential growth determines the extent to which a country can attain a higher living standard while providing social security and jobs for its citizens. Furthermore, given that potential output is an indicator of the level of economic activity consistent with price stability, an accurate measure of the corresponding output gap—the deviation of actual from potential output—provide a key barometer of an economy’s cyclical position. This would in turn enable policy makers to evaluate inflationary and structural fiscal pressures, and adopt appropriate economic policies to achieve balanced growth.

2. This note aims to shed light on France’s potential output. Given that potential output is unobservable and different measures could yield different results, this note uses three distinct approaches—the commonly used statistical filtering technique invented by Hodrick and Prescott (1999), an enhanced production function developed by Barrera et al. (2009), and a multivariate model developed by Benes et al. (2010)—to cross check each other and ensure robustness of the findings.

3. The remainder of the note is organized as follows: section B discusses important stylized facts; section C presents the models and discusses the results; finally, section D considers long-term growth prospects and concludes with some policy implications.

B. Stylized Facts

4. While the recent financial crisis has done comparatively less damage to the French economy than to other countries, from a historical perspective, the impact on actual output has been more severe both in terms of magnitude and duration. Compared to other countries, France had suffered less during the recent financial crisis—with a maxium output decline of less than 4 percent and a relatively shorter duration of the downturn. However, from a historical perpective, the recent crisis has done greater damage—in terms of output loss—to the French economy than the past three recessions during the last four decades.

5. France’s domestic sectors had borne the bulk of output losses during the crisis and the recovery had been more sluggish. Partly reflecting the fact that France, like the United States, is a less open economy, the decline in domestic demand accounted for most losses in output during the crisis. This is in sharp contrast to the case of Germany where the fall in net exports accounted for the bulk of output losses, suggesting that the crisis-related damage is likely to have been entirely demand-driven for Germany. Moreover, while France suffered a more moderate decline in output during the trough of the crisis, its recovery has also been more tepid. Indeed, while both output in Germany and the U.S. had surpassed their pre-crisis levels by 2011 Q1, France still had not by then fully recuperated its output losses associated with the crisis and the recession. The fact that France experienced larger domestic output losses due to the crisis for a more prolonged period leaves open the possibility that the crisis has damaged the fabric of the economy.

6. There are a few channels in which a financial crisis can affect an economy’s potential output and growth:

By directly destroying a certain segment of an economy—Financial crises could often cause permanent damage to certain segments of the economy and the literature suggests that the finance, insurance, and real estate (FIRE) sectors tend to suffer most losses during a supply-driven shock. In some instances, the damage can be so large that a sector is entirely wiped out, particularly in case of a severe asset bubble burst. As a consequence, the potential output otherwise generated by these sectors is permanently lost.
By distorting the efficient allocation of capital—During a financial crisis, banks and other financial institution might become more reluctant to lend and entrepreneurs may be more risk averse to embark on an investment. This would in turn slow capital accumulation and distort the efficient allocation of capital. Furthermore, lower investment in finance research and development could also hamper technological progress and thus depress total factor productivity growth going forward.
By lifting structural unemployment—A long and deep recession caused by a financial crisis could reduce the potential labor force by discouraging labor participation and perpetuating unemployment. In fact, if a worker is unemployed for a protracted period, he could lose his skills and become unemployable even after the recession is over.

7. Unlike some other countries with severe permanent losses in certain sectors, no sector in the French economy has suffered such a loss by the financial tsunami. Like Germany, the real value-added of FIRE—the sector that was most directly impacted by the financial crisis in many countries—suffered relatively little destruction during the financial crisis and has already attained the pre-crisis output levels by end-2010. For comparison, the U.S. saw a maximum decline of the FIRE by almost 8 percent during the crisis and has thus far not recuperated the losses.

8. The crisis left some adverse impact on capital accumulation in France. On the one hand, the evolution of credit to household and companies in France was somewhat similar to that in Germany and was much less severe than the decline in U.S. credit. On the other hand, the crisis did depress investment in France, which has not yet recovered its decline since the crisis. Compared to Germany, the plummet in French investment was somewhat faster and larger during the crisis while the recovery was more sluggish. That said, compared to the U.S., the magnitude of decline is milder in France.

9. In terms of employment, France’s experience during the crisis was somewhat in between those of the Germany and the U.S. Unlike Germany, which saw a decline in its unemployment rate and an increase in total employment—partly reflecting labor hoarding supported by policy measures—France saw an increase of over 2 percent in its unemployment rate and has not yet recuperated the employment loss since the onset of the crisis. However, compared to the U.S. which saw an increase of over 4 percent in its unemployment rate during the course of the crisis, France’s experience seems rather mild.

C. Estimating Potential Output

Methods to estimate potential growth

10. One method widely used to estimate potential output is a univariate statistical filter technique developed by Hodrick and Prescott (1997). An important advantage of this approach—as known as the HP filter—is that it is simple, transparent, and well known. On the other hand, as a purely statistical technique, the HP filter estimates potential output without a firm basis in economic theory and disregards important economic relationships—such as the Phillips curve and Okun’s law². Nevertheless, this simple approach is used as a benchmark to cross-check results from the other two approaches.

11. The second approach is based on a production function Following Barrera et al. (2009), this approach is estimated in two steps³: first, using a Cobb-Douglas production function, actual total factor productivity (TFP) is calculated as a residual after controlling for total hours worked, capital utilization, and capital stock. Second, potential output is then calculated as a sum of six components (i) capital stock; (ii) equilibrium capital utilization; (iii) trend working hours of workers; (iv) natural rate of unemployment (NAIRU); (v) trend of the labor force⁴ (population active); and (vi) trend of TFP. An advantage of this approach, apart from being very transparent, is that not only can it estimate potential growth, it also explains it by decomposing potential growth into different components.

12. The third approach uses a macroeconomic model-based multi-filter method. Developed by the Research Department in the Fund, this approach brings consistency between potential output and other key macroeconomic variables, including inflation, NAIRU, and the capital utilization rate. In addition, using the Bayesian estimation method, the approach allows the data to “speak for themselves.” A disadvantage of this approach is that it is not transparent and not straightforward enough for a user to immediately dissect the inter-relation among various factors and potential output. In addition, while incorporating complicated short-term time-series dynamics, this method is not suited for estimating long-term potential growth, which is an input, rather than output of the model.

Results

13. Results suggest that potential output in France had been on a declining trend even before the onset of the crisis. The three different approaches—in terms of period averages over a decade—yield very similar estimates for potential growth during 1981–2016, although on an annual basis, results could differ more markedly. Broadly speaking, potential output grew at an average rate of over 2 percent during the 1980s and 1990s, but decelerated to around 1.7–1.8 percent in the 2000s before the crisis. During the crisis, potential output fell to below one percent.⁵

Potential Growth, 1981–2010

Source: Staff calculations.

14. The impact of the financial crisis on France’s potential output is somewhat moderate. Compared with a counter-factual level—calculated by assuming potential output during 2007–14 would grow at the same rate average rate observed during 2004–07 while converging to the same rate as the average estimated potential growth rate under the baseline—the output loss due to the financial crisis is estimated to be between 1 percent and 3 percent by 2015, depending on the estimating methods used. By comparison, France’s output loss induced by the crisis is more than that of Germany (which is estimated to be almost nil), but less than that for the U.S. (which is estimated to be over 5 percent).

15. The size of potential output losses due to the crisis relative those of Germany and U.S. concurs with economic intuition. The more significant loss relative to Germany reflects three factors: first, unlike Germany, where losses entirely reflected temporary lower foreign demand, losses in France occurred in domestic sectors for a more prolonged period. Second, capital accumulation endured greater losses for a more prolonged period in France than in Germany. Third, while Germany suffered no employment losses, France suffered significant employment losses. That said, France’s losses should be less significant than those of the U.S. on account of the fact that, being the epicenter of the crisis, the latter suffered far greater losses in FIRE, employment losses, and declines in capital formation.

16. The choice of the counterfactual growth rate, however, is crucial to the estimated output losses. Since potential output was on a declining trend, if the counterfactual growth rate were assumed to be the same as an moving average over a longer period (such as 1980–2007), the output loss would have been bigger. On the contrary, if the counterfactual was based on a more recent historical rate (such as 2006–07), the loss would have been smaller. However, given the fact that potential output had been on a declining trend prior to the crisis, it would be unreasonable to assume that it would have grown at a rate similar to the average of the last two decades if the crisis had not occurred.

17. Over the medium term, potential growth should gradually recover. Staff estimates that with a number of appropriate structural reforms already in place or in the pipeline, potential growth should increase from about 1 percent during 2010–11 to 1.7 percent by 2020. In this connection, the output gap should narrow gradually and close by 2016.

Potential Growth During 2010–11

Source: Staff calculations.

Potential Growth During 2010–11

	HP Filter	Production Function	Model-Based	Average
2011	1.3	1.1	0.9	1.1
2012	1.3	1.3	1.2	1.3
2013	1.4	1.4	1.4	1.4
2014	1.5	1.5	1.5	1.5
2015	1.5	1.5	1.6	1.5
2016	1.5	1.6	1.6	1.6
2017	1.6	1.6	1.7	1.6
2018	1.6	1.6	1.7	1.6
2019	1.6	1.7	1.7	1.7
2020	1.7	1.7	1.7	1.7
Period Average	1.5	1.5	1.5	1.5

Source: Staff calculations.

Potential Growth During 2010–11

	HP Filter	Production Function	Model-Based	Average
2011	1.3	1.1	0.9	1.1
2012	1.3	1.3	1.2	1.3
2013	1.4	1.4	1.4	1.4
2014	1.5	1.5	1.5	1.5
2015	1.5	1.5	1.6	1.5
2016	1.5	1.6	1.6	1.6
2017	1.6	1.6	1.7	1.6
2018	1.6	1.6	1.7	1.6
2019	1.6	1.7	1.7	1.7
2020	1.7	1.7	1.7	1.7
Period Average	1.5	1.5	1.5	1.5

Source: Staff calculations.

D. Long-Term Growth Prospects and Policy Implications

18. A growth accounting exercise suggests that the declining trend of potential growth during the past three decades reflects a confluence of factors. First and foremost, TFP growth has been on a declining trend since the 1980s. Second, declining average working hours per worker has also contributed to lower potential growth. Third, capital utilization has played an important role in lowering potential output growth during the crisis. Finally, the increase in NAIRU in the 1980s had reduced potential growth then, while the decline in the NAIRU in the 2000s has had the opposite effect.

Contribution to Potential Growth 1981–2010

Source: Staff calculations.

Contribution to Potential Growth 1981–2010

		Growth	NAIRU	Population	Average Hour	K Utilitzation	K Stock	TFP
1981–2007		2.0	−0.1	0.4	−0.2	−0.1	0.9	1.1
	1981–1990	2.2	−0.2	0.3	−0.3	0.0	1.0	1.5
	1991–2000	2.0	0.0	0.4	−0.2	0.0	0.8	1.1
	2001–2007	1.7	0.1	0.5	−0.2	−0.2	0.8	0.8
2008–2010		0.9	−0.1	0.5	−0.1	−0.6	0.5	0.6

Source: Staff calculations.

Contribution to Potential Growth 1981–2010

		Growth	NAIRU	Population	Average Hour	K Utilitzation	K Stock	TFP
1981–2007		2.0	−0.1	0.4	−0.2	−0.1	0.9	1.1
	1981–1990	2.2	−0.2	0.3	−0.3	0.0	1.0	1.5
	1991–2000	2.0	0.0	0.4	−0.2	0.0	0.8	1.1
	2001–2007	1.7	0.1	0.5	−0.2	−0.2	0.8	0.8
2008–2010		0.9	−0.1	0.5	−0.1	−0.6	0.5	0.6

Source: Staff calculations.

19. While the recent pension reform is expected to raise labor force participation and thus potential growth over the long run, France’s potential growth will still be adversely affected by its demographic dynamics. Thanks to the recent pension reform, the labor force participation rate by the seniors is expected to increase. Indeed, INSEE has recently revised its projection of the labor force (population active) in the long run. Compared to its projection in 2006 that envisaged a flat labor force dynamics during 2010–50, under the new projection, the labor force will increase significantly over the next four decades. That said, in terms of the growth rate of its labor force, France will still face a less favorable demographic structure in the next 50 years relative to the past few decades. According to INSEE’s 2011 projection, the labor force annual growth rate would decline from 0.8 percent during 2001–10 to below 0.2 percent during 2021–30 and hover around 0.1 percent during 2031–50. Assuming a labor income share of 0.65, this would imply a reduction in annual potential growth of about 0.2 percent per decade during 2001–30.

INSEE’s 2011 Projection of Active Population

Sources: INSEE; and IMF staff calculations.

INSEE’s 2011 Projection of Active Population

	Average Annual Growth Rate	Contribution to Potential Growth
1991–2000	0.5	0.4
2001–2010	0.8	0.5
2011–2020	0.5	0.3
2021–2030	0.2	0.1
2031–2040	0.1	0.1
2041–2050	0.1	0.1

Sources: INSEE; and IMF staff calculations.

INSEE’s 2011 Projection of Active Population

	Average Annual Growth Rate	Contribution to Potential Growth
1991–2000	0.5	0.4
2001–2010	0.8	0.5
2011–2020	0.5	0.3
2021–2030	0.2	0.1
2031–2040	0.1	0.1
2041–2050	0.1	0.1

Sources: INSEE; and IMF staff calculations.

20. Staff estimates that potential output growth in the long run to be 1.7 percent per year. This projection corresponds to a scenario where sound structural reforms would reverse some of the negative trends in key determinants of potential growth. More specifically, the following assumptions are made:

Successful implementation of current macroeconomic and structural policies—such as the ongoing fiscal consolidation, labor and product market reforms, and the measures to increase investment in research and development—will stop the downward trend of TFP growth observed during the past three decades and annual TFP growth in the long run remains at 0.8 percent, the rate observed during 2000–07;
The baseline demographic structure projected by INSEE in 2011 would prevail over the next few decades. While INSEE has already incorporated a higher participation rate (relative to its 2006 projection), partly reflecting the pension reform in 2010, slowing population growth would remain a drag on potential output growth. Indeed, had the demographic structure over 2021–40 been the same as that during the 2000s, potential growth would be 0.4 percentage point higher;
Sensible labor market and tax policies amid a growth-conducive environment will halt the declining trend in average working hours per worker and this, together with the NAIRU, would remain constant in the period ahead;
The capital stock would increase at the same rates observed during 2000–07.

Potential Output Growth Projection for 2011–40

Source: Staff calculations.

Potential Output Growth Projection for 2011–40

	Potential Growth	Active Population	K Stock	TFP
2011–2020	1.5	0.3	0.6	0.7
2021–2030	1.7	0.1	0.8	0.8
2030–2040	1.7	0.1	0.8	0.8

Source: Staff calculations.

Potential Output Growth Projection for 2011–40

	Potential Growth	Active Population	K Stock	TFP
2011–2020	1.5	0.3	0.6	0.7
2021–2030	1.7	0.1	0.8	0.8
2030–2040	1.7	0.1	0.8	0.8

Source: Staff calculations.

21. Looking forward, while appropriate structural reforms are expected to help France stop its declining TFP growth trend and mitigate the negative demographic impact on potential growth, further reforms can even raise potential growth back to the levels observed during earlier decades. Specifically, sensible policy measures in the following areas would further lift potential growth in the long run:

Increasing the labor force—Given the aging population, the labor force can still be increased by raising the participation rate. In this connection, the recent pension reform is a welcome step, but further increase in the effective retirement age would help. In addition, the participation rate can be further increased by reducing the labor-tax wedge to increase incentives for work.
Lowering equilibrium unemployment rate—Determined efforts to further strengthen activation policies would better support the unemployed in their job search and broaden training opportunities but should be accompanied by strict enforcement of job-search requirements. Consideration should be given to limit the duration of unemployment benefits, in order to increase job-search incentives and to reduce long-term unemployment. Furthermore, containment of the minimum wage would raise employment prospects for the low-skilled.
Raising working hours—Reduction in the labor-tax wedge would enhance work incentives and increase the opportunity cost of leisure.
Spurring capital accumulation and capital utilization—Improving the business environment, streamlining regulation, and a corporate tax reform would increase investment and thus potential growth.
Boosting TFP—Measures should be taken to encourage innovation, research, and development. In particular, effective implementation of current policy initiatives—such as tax credit for R&D activities, university reform, the Investissements pour l’avenir and Pôle Competitivités—should continue in an efficient manner. Further liberalizing the service sector would also increase efficiency and thus TFP.

22. In conclusion, with reforms to enhance incentives in the economy towards work, investment in more productive activities, and innovation, France could enjoy higher potential growth. Based on Everaert and Schule (2006), staff estimates suggest that further labor and product market reforms that would bring France in line with best practices could raise growth by about ¾ percent per year over the medium term. This would therefore translate into an increase in the potential growth rate from 1.7 percent to around 2½ percent over the medium term.⁶

References

Barrera, N., M. Estevão, and G. Keim (2009), “U.S. Potential Growth in the Aftermath of the Crisis,” IMF Country Report No. 09/229 (Washington).
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Benes, Jaromir, Kevin Clinton, Roberto Garcia-Saltos, Marianna Johnson, Douglas Laxton, Petar Manchev, and Troy Matheson, (2010), “Estimating Potential Output with a Multivariate Filter,” IMF Working Paper No. 10/285 (Washington).
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Bourlès, Renaud, Gilbert Cette, Jimmy Lopez, Jacques Mairesse, and Giuseppe Nicoletti, 2010, “The Impact of Growth of Easing Regulations in Upstream Sectors,” CESifo Dice Report, Journal for Institutional Comparisons, vol. 8, No.3 (Autumn).
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Bourlès, Renaud, Gilbert Cette, Jimmy Lopez, Jacques Mairesse, and Giuseppe Nicoletti, 2010, “Do Product Market Regulations in Upstream Sectors Curb Productivity Growth? Panel Data Evidence for OECD Countries”, National Bureau of Economic Research (November).
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Chetouane, Mabrouk, Matthieu Lemoine, and Marie-Elisabeth de la Serve, (2011), “Impact de la Crise sur la Croissance Potentielle,” Banque de France.
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Technical Appendix

Production Function-based approach

Following Barrera et al. (2009), potential output is discomposed into changes in (i) capital stock; (ii) equilibrium capital utilization; (iii) trend hours of work per employee (iv) the equilibrium rate of unemployment (or NAIRU); (v) trend labor force (population active); (vi) trend TFP.

Estimation is done in two steps. In the first step, actual TFP level is calculated by using the following equation:

tfp=y-α ks- α ku-(1-α) hour;

where y is actual output; ks is capital stock; ku is capital utilization; hour is total hours worked, which equals average hour of work per worker* (1-uemployment rate)* labor force; and tfp is total factor productivity. All variables are in logarithm

Once actual TFP level is obtained, potential output is calculated as:

y* = α ks α ku* + (1-α) h*+(1-α)(1-u*)+(1-α)labor*+tfp*

where h is average hours of work per worker, u is the unemployment rate, labor is the labor force. Variables with a ^* are trend values obtained using an HP filter for all series a smoothness parameter of 100—the traditional value for annual-frequency data. The income share of capital used in the Cobb-Douglas production function, α, is assumed to be 0.35.

Multi-Filter Model-based Approach

Based on the model developed by Benes et al. (2010), this approach is underpinned by equations revolving three gaps—the output gap (y), the unemployment gap (u), and the capacity utilization gap (c):

The inflation equation relates the level and the change of the output gap to core inflation:

π 4_{t} = π 4_{t - 1} + β y_{t} + Ω (y_{t} - y_{t - 1}) + ɛ_{t}^{π 4} .

The dynamic Okun’s law defines the relationship between the current unemployment rate and the output gap. Based on Okun’s law, an unemployment equation links the unemployment gap to the output gap:

u_{t} = Ø_{1} u_{t - 1} + Ø_{2} y_{t} + ɛ_{t}^{u} .

Finally, the model also relies on a capacity utilization equation, on the assumption that capacity utilization contains important information that can help improve the potential output and output gap estimates. The equation takes the following form:

c_{t} = K_{1} c_{t - 1} + K_{2} y_{t} + ɛ_{t}^{c} .

Given the three identifying equations, the equilibrium variables are assumed to evolve dynamically as follows. A stochastic process including transitory (level) shocks and more persistent shocks guides the evolution of equilibrium unemployment (Ū_t) (the NAIRU equation):

{\bar{U}}_{t} = {\bar{U}}_{t - 1} + G_{t}^{\bar{U}} - \frac{ω}{100} y_{t - 1} - \frac{λ}{100} ({\bar{U}}_{t - 1} - U^{s s}) + ɛ_{t}^{\bar{U}}

Persistent shocks to the NAIRU $(G_{t}^{\bar{U}})$ follow an autoregressive process:

G_{t}^{\bar{U}} = (1 - α) G_{t - 1}^{\bar{U}} + ɛ_{t}^{G^{\bar{U}}}

And potential output (Ῡ_t) is modeled to be a function of the underlying trend growth rate of potential output ( $G_{t}^{\bar{Y}}$ ) and changes in the NAIRU. Specifically:

{\bar{Y}}_{t} = {\bar{Y}}_{t - 1} - θ ({\bar{U}}_{t} - {\bar{U}}_{t - 1}) - (1 - θ) ({\bar{U}}_{t - 1} - {\bar{U}}_{t - 20}) / 19 + G_{t}^{\bar{Y}} / 4 + ɛ_{t}^{\bar{Y}}

where θ is the labor share in a Cobb-Douglas production function. This specification allows for short- and medium-term growth of potential to differ from trend growth. Note that $G_{t}^{\bar{Y}}$ is not constant, but follows serially correlated deviations (long waves) from the steady-state growth rate $G_{s s}^{\bar{Y}}$ . Similar dynamic equations are specified for equilibrium capacity utilization.

The full model is estimated by regularized maximum likelihood (Ljung, 1999), a Bayesian methodology. This method requires the user to define prior distributions of the parameters. This approach would improve the estimation procedure by ensuring economically sensible results.

Prepared by Kevin C. Cheng.

As discussed in Benes et al (2010), the HP filter approach could introduce biases. For example, by ignoring the fact that central banks made good progress in fighting inflation over the past few decades, the HP filter would understate potential GDP.

For a detailed discussion of these methodologies, see the Technical Appendix.

Alternatively, active population can be further decomposed into the participation rate and the working-age population.

The HP filter method is estimated with IMF forecast as the “actual” growth rates during 2011–16.

This estimate involves both increased factor usage (both labor and capital) and higher productivity. Bourlès et al (2010) estimate that if France aligned its regulation to best practices in the OECD, the long-run employment rate would increase by 1.2 percentage point and multifactor productivity would increase by between 0.2 and 0.6 percent per year over the medium term.

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