Spain: Selected Issues
Author: International Monetary Fund
Publication Date:
29 Jul 2011
eISBN:
9781462340545
ISBN:
9781462340545
Language:
English
Keywords:
ISCR; CR; Spain; savings bank; deficit; GDP; GDP adjustment; retirement age; General government debt; IMF staff projection; Spain's public finances; Pension reform; Pension spending; Aging; Pensions; Global
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Rebalancing in Spain’s private sector is under way, but with more modest progress on reducing stocks. Spain is subject to significant spending pressures, reflecting unfavorable demographic trends and subdued growth prospects, and will require substantial structural reform. Priority reforms are needed to strengthen its fiscal framework. The study tries to infer the potential impact of the ongoing integration process on bank efficiency based on preconsolidation bank data. The reforms, such as those recently implemented, of employment protection and collective bargaining could help improve Spain’s inflation performance.

Abstract

Rebalancing in Spain’s private sector is under way, but with more modest progress on reducing stocks. Spain is subject to significant spending pressures, reflecting unfavorable demographic trends and subdued growth prospects, and will require substantial structural reform. Priority reforms are needed to strengthen its fiscal framework. The study tries to infer the potential impact of the ongoing integration process on bank efficiency based on preconsolidation bank data. The reforms, such as those recently implemented, of employment protection and collective bargaining could help improve Spain’s inflation performance.

II. Re-Assessing Spain’s Fiscal Sustainability: 3 percent and Beyond1

In the medium term, Spain’s fiscal deficit is projected to fall and government debt to remain relatively low compared to euro area peers. However, in the longer term, Spain is subject to significant spending pressures, like most advanced countries, arising from age-related spending, reflecting unfavorable demographic trends and subdued growth prospects. The full implementation of the draft pension reform combined with substantial medium-term consolidation to reach the Medium-Term Objective of a balanced budget by 2016 (the MTO) would be needed to ensure that the debt ratio would remain below 60 percent by 2060. This, however, critically assumes that economic growth strengthens in the longer-term, which will likely require substantial structural reform.

A. Introduction

1. At first glance, Spain’s public finances over the medium term do not present a particularly worrying picture. Although the deficit hit 11.1 percent of GDP in 2009, it is on course to fall to about 6 percent in 2011 and the government is targeting 2.1 percent of GDP by 2014. General government debt is also likely to remain below 85 percent of GDP over the medium-term -lower than projections for the euro area as a whole -even if allowance were to be made for full utilization of the €99 billion allotted to Spain’s Fund for Orderly Restructuring of the Banking Sector (FROB). However, in the longer term, Spain’s public finances, like most advanced countries, face serious challenges arising mainly from age-related spending, especially pensions, reflecting unfavorable demographic trends, and subdued growth prospects. To help contain the pressure from aging and ensure the sustainability of its public finances, in January 2011, Spain has proposed a pension reform, and in February, it enacted “the Sustainable Economy Law” to set the foundation for a more solid recovery in economic growth.

A02ufig01

Fiscal Position 2016 1/

(percent of GDP)

Citation: IMF Staff Country Reports 2011, 216; 10.5089/9781462340545.002.A002

Sources: WEO; and IMF staff projections.1/ ESP_BK when assuming full utilization of the €99 billionallotted to Spain’s FROB.

2. The objective of this note is to assess Spain’s long-term fiscal sustainability taking into account the impact of recent developments. By exploring alternative scenarios, it illustrates the important effects that recently implemented policies and reforms may have, and also highlights the need for fiscal consolidation to go beyond the 3 percent target in 2013 to achieve the MTO quickly thereafter.

B. Spain’s Current Fiscal Position

3. The global financial crisis exposed the underlying structural weakness of Spain’s public finances that had been masked by the credit and housing market boom. During 1995-2007, the fiscal position shifted from a deficit of 6½ percent of GDP to a surplus of about 2 percent, and public debt was nearly halved to 36.1 percent of GDP. The large improvement reflected lower interest payments associated with euro adoption and strong increases in tax revenues on the back of the housing boom and strong employment growth. With the collapse of the housing market in the wake of the global financial crisis, the substantial contribution of the construction sector to the tax base was substantially, and probably permanently, reduced. Combined with the effects of a large fiscal stimulus to assist the economy through the downturn, Spain’s fiscal position deteriorated sharply, with the deficit peaking at 11.1 percent of GDP in 2009. Measures adopted by the government brought the deficit down to 9.2 percent of GDP in 2010, and the government has committed to reducing the deficit further to 2.1 percent by 2014.

4. The government’s ability to reach this near-term objective is subject to significant risks. The outlook for revenue is particularly uncertain given weak growth prospects reflecting a protracted recovery in the housing market and the pressures on households and corporations to deleverage and restore their balance sheets. Continued reliance on spending restraints also poses a significant challenge given Spain’s high degree of government decentralization and the structural nature of regional governments’ expenditure (especially health and education).

5. And over the long run, the European Commission (2009) classified Spain as one of the few countries subject to high long-term sustainability risks reflecting population aging and a slowdown in population growth coupled with a weak initial budgetary position. Costs associated with aging were projected to rise by 9 percent of GDP through 2060 in Spain, compared with about 5 percent in the euro area, mainly reflecting a substantial increase in pension expenditure.

Age-related Spending Projections

(Percent of GDP)

article image
Source: European Commission 2009 Ageing Report.

Pension reform

6. At about 9 percent of GDP in 2010, some 2 percentage points of GDP lower than the euro area average, public pension expenditure is not yet a key source of budgetary concern in Spain. However, it is projected to surge in the coming years reflecting population aging and relatively generous benefits (Box 1). The dependency ratio of the pension system is projected to nearly double from 37 percent in 2010 to 77 percent in 2060 as the impact of retiring baby boomers kicks in, especially after 2030. Compounding these pressures is the relative generosity of Spain’s current pension system with a net replacement ratio of 85 percent (compared to 76 percent for the euro area average). In addition, the system gives incentives for early and partial retirement.

Spain: Pension System Characteristics

article image
Source: European Commission 2009 Ageing Report OECD Pensions at a Glance 2011.

For average earner, in percent of earnings.

Used for benefit calculation.

Number of pensioners relative to the number of contributors in public pension schemes.

Key Aspects of the Pension System in Spain Prior to the Reform

The Spanish public pension system consists of a single, earnings-related, system covering old-age, disability and survivors’ pensions, financed through contributions with a means-tested minimum pension. It is mandatory for all employees and the self-employed and provides pension entitlements after a minimum contribution period of 15 years. There is also a non-contribution means-tested level, financed solely by tax revenues, granted to persons aged 65 and older, who have not acquired enough pension contributions or are not entitled to a contributory old-age pension. Pensioners can also benefit from additional services including healthcare and social services. Supplementary private pension schemes are voluntary.

Benefit calculation: The system is financed as a PAYG, with a defined benefit formula. Benefits are calculated as a percentage of a “base pension”—an average of the contributions during the last 15 years before retirement (up to a ceiling of about 160 percent of the average wage). 35 years of contribution is required to receive a full pension (100 percent of the “base pension”) at the retirement age of 65.

Early-retirement is available from the age of 61 for those who entered the system after 1967 with 30 years of contribution (age of 60 for those entered before). Pension benefits are reduced by 6 to 7.5 percent per year depending on the numbers of years of contributions (reduction of 8 percent for those before 1967).

7. To reduce future pension liabilities and strengthen the sustainability of the pension system, a draft pension reform was agreed with social partners, which has recently been approved by the Lower House. The reform would increase the statutory retirement age from 65 to 67, to be phased in gradually over the period from 2013 to 2027. On the benefits side, the numbers of years to calculate the earnings base (reference period) will be gradually raised from 15 to 25 years, as well as the required contribution to qualify for the full pension from 35 to 38.5 years. In addition, eligibility criteria for early retirement will be tightened as the minimum retirement age will be raised from 61 to 63 years with at least 33 years of contribution. This is combined with an increase in the penalty rate (reduction in pension) to be raised to 7½ percent per year of retirement before the statutory age. Finally, a “sustainability factor” was included aiming (although no detailed and automatic formula has been identified) at reassessing the parameters of the system every 5 years starting in 2027 to factor in any impact of any further increases in life expectancy.

A02ufig02

Pension Expenditure

(percent of GDP)

Citation: IMF Staff Country Reports 2011, 216; 10.5089/9781462340545.002.A002

Sources: Ministry of Finance; and IMF staff estimates.

8. Staff estimates the reform would reduce pension expenditure by 2-3½ percent of GDP by 2050. Applying further increase in retirement age beyond 2027 to take into account the impact of the sustainability factor, the savings could be considerably higher, amounting to about 3½ percent of GDP. The implementation of the pension reform would imply an important reduction of the projected age-related spending, limiting the level of total aging-related spending to below 25 percent of GDP in 2016, nearly 5 percentage points of GDP lower than that of the euro area average.

A02ufig03

Total Age-related Spending in 2060

(percent of GDP)

Citation: IMF Staff Country Reports 2011, 216; 10.5089/9781462340545.002.A002

Source: European Commission “The 2009 Ageing Report”.

C. Illustrative Scenario Analysis

9. To assess Spain’s long-term fiscal sustainability taking into account the latest fiscal developments and the impact of the recent pension reform proposal, a scenario analysis was used to evaluate the state of public finances in 2060. A baseline, no-reform scenario, was constructed based on staff’s projections until 2016, reflecting its assessment of the authorities’ existing policies (excluding pension reform), and the staff’s macroeconomic projections. Alternative scenarios were then constructed to illustrate the importance of pension reform and of early fiscal consolidation (a reform and adjustment scenario). A lower productivity growth scenario shows how ensuring sustainability would be complicated by a failure to achieve the higher projected longer-term economic growth.

The baseline (no-reform) scenario

10. Staff projects the deficit to decline to about 3.8 percent of GDP in 2016, corresponding to a small primary deficit of 0.3 percent of GDP and the government debt ratio to reach 76 percent of GDP. Beyond 2016, revenue is projected to remain unchanged at the 2016 level in percent of GDP—about 4 percentage points of GDP lower than the cyclical peak in 2006-07. Non-aging primary spending is also kept constant relative to GDP from 2017 onward, so that the variation in overall primary expenditures is governed by aging costs. Projections beyond 2016 are based on the macroeconomic and demographic assumptions used in the European Commission’s Ageing Report. In particular, aging costs are assumed to unfold as envisaged in the report through 2060.

11. The “no reform” scenario would not be sustainable in the long run. The primary balance deteriorates gradually to a deficit of about 2½ percent of GDP by 2030. Subsequently, this deterioration accelerates as the pressures from aging increases, with the deficit reaching over 8 percent of GDP by 2060. The debt ratio would rise to about 400 percent of GDP.

A02ufig04

Spain: No-Reform Scenario

Citation: IMF Staff Country Reports 2011, 216; 10.5089/9781462340545.002.A002

Sources: IGAE; Stability Report 2011-14;and IMF staff projections.

12. The required adjustment to ensure sustainability would be substantial. The improvement in the structural primary balance needed in 2017 to reach a target debt of 60 percent of GDP in 2060 (S1 indicator) amounts to 5.8 percent of GDP, while the adjustment to fulfill the infinite horizon inter-temporal budget constraint reaches 7.6 percentage points (S2 indicator). The decomposition of the gap suggests aging accounts for a lion’s share of the needed adjustment. While the weak initial budgetary position (2017) accounts for a smaller share of the gap, this owes to a large fiscal consolidation projected in the baseline with nearly 7 percent of GDP adjustment in the primary balance by 2016.

Sustainability Indicators: Illustrative Scenarios

(Percent of GDP)

article image
Sources: European Commission Ageing Report 2009; IGAE; and IMF staff estimates.

Based on staff projections until 2016. Productivity growth of 1.7 percent in the long-run.

Additional fiscal measures to achieve 2.1 percent of GDP by 2014 or MTO by 2016.

Assuming productivity growth of 1 percent from 2017.

Assuming full utilization of the €99 billion allotted to Spain’s FROB.

Pension reform including the sustainability factor from 2027.

S2=Permanent budgetary adjustment need to fulfil the intertemporal budget constraint.

S1=Permanent budgetary adjustment need for debt to reach 60% of GDP in 2060.

Reform and adjustment scenario

13. By directly tackling the spending pressure from aging, the pension reform would significantly reduce the debt build-up over the long-run. In particular, with the sustainability factor, the pension reform is projected to lower the debt ratio by 120 percent of GDP compared with the baseline. However, because of the gradual implementation of the pension reform, the projected debt ratio would remain above 270 percent of GDP, requiring 3.7 percentage points of GDP adjustment in the primary fiscal balance in 2017 if the 60 percent of GDP debt threshold is to be met in 2060.

14. The required adjustment to restore fiscal sustainability appears substantial but early consolidation, if sustained, can make a significant difference. A permanent reduction in the overall deficit to 2.1 percent of GDP by 2014 as envisaged by the government SGP plan and maintaining the deficit at that level throughout the projection period would reduce the debt ratio to about 306 percent of GDP. The impact of achieving the MTO of a balanced position over the cycle by 2016 is even stronger. By maintaining a nonaging primary surplus of 3 percent of GDP from 2017 onward, the debt ratio would only increase to about 178 percent of GDP by 2060. A combination of an early adjustment to the MTO and the full implementation of the pension reform would thus ensure maintaining the debt ratio consistently below the 60 percent threshold throughout the projection period.

A02ufig05

General Government Debt

(percent of GDP)

Citation: IMF Staff Country Reports 2011, 216; 10.5089/9781462340545.002.A002

A02ufig06

Primary Balance

(percent of GDP)

Citation: IMF Staff Country Reports 2011, 216; 10.5089/9781462340545.002.A002

Sources: IGAE; European Commission Ageing Report 2009; and IMF staff estimates.

Lower productivity scenario

15. While the combination of early fiscal consolidation and the implementation of pension reform especially with the sustainability factor is critical to ensuring fiscal sustainability, this may still not be sufficient. The 2009 Ageing Report assumes constant labor productivity growth of 1.7 percent over the projection period, which is substantially higher than the average growth of 0.5 percent recorded in Spain during 1995-2007. Between 2011 and 2016, staff projects labor productivity to rise to only 0.8 percent.

Key Macroeconomic Assumptions

(percent)

article image
Sources: 2009 Ageing Report; Eurostat; and IMF staff projections.

16. Higher productivity is a critical ingredient for fiscal sustainability. Assuming productivity growth of 1 percent after 2016 (instead of the 1.7 percent in the 2009 Ageing Report) suggests that even by achieving the MTO by 2016 and including the pension reform with the sustainability factor, the debt ratio could reach 250 percent of GDP, only somewhat lower than the projected level under the baseline with pension reform. The simple illustrative simulation suggests securing higher potential growth is essential for fiscal sustainability.2

A02ufig07

General Government Debt

(percent of GDP)

Citation: IMF Staff Country Reports 2011, 216; 10.5089/9781462340545.002.A002

A02ufig08

Primary Balance

(percent of GDP)

Citation: IMF Staff Country Reports 2011, 216; 10.5089/9781462340545.002.A002

Sources: IGAE; European Commission Ageing Report 2009; and IMF staff estimates.

17. To boost potential growth over the medium-term, Spain needs comprehensive structural reform. The pension reform would have a positive impact on the economy. Raising the retirement age would increase participation in the labor force and slow the increase in the pension system dependency ratio. In addition, reforms to promote greater competition especially in the labor market would help the Spanish economy to unlock growth potential by increasing employment and income levels.

18. To quantify the macroeconomic effects of the recent pension reform and potential payoff from labor market reforms, a six-region version of the IMF’s Global Integrated Monetary and Fiscal model (GIMF) is used.3 GIMF is a dynamic stochastic general equilibrium model with overlapping generations, well suited for conducting medium-to long-term policy analysis, as it incorporates rich layers of intra-regional trade, production, and demand that allow the transmission mechanism to be fully articulated.4

19. The simulations suggest that a gradual increase in the retirement age in the proposed pension reform can have an important positive effect on output especially in the long run (Figure 1).5 The increase in the retirement age boosts labor supply and labor income. Higher earning incomes over a longer working period reduce households’ saving while increasing consumption. In addition, increased fiscal saving (lower public debt) through lower pension expenditures would lower the cost of capital and boost investment. The simulations suggest that the proposed reform would increase output by about 10 percentage points, but over a long-term horizon.

Figure 1.
Figure 1.

Increase in the Retirement Age in Spain

(Percentage deviation from the baseline)

Citation: IMF Staff Country Reports 2011, 216; 10.5089/9781462340545.002.A002

20. While the impact of specific reforms is difficult to simulate because it depends critically on the design and implementation of the reform, and existing initial conditions, by varying the wage markups, the model can illustrate the macroeconomic implications of labor market reform. Using the OECD indicators of employment regulation and available estimates of markups in the literature6, the wage markup in Spain is set equal to 30 percent over the marginal cost, significantly larger than the average for the euro area. The simulations suggest that a reduction of the wage markup in Spain by 6 percentage points to the same level as the euro area average would increase output by about 2-3 percent in the medium-term, through higher with higher employment (hours worked) and a higher capital stock.

Wage Markups

article image
Source: IMF staff estimates.

21. There are substantial uncertainties surrounding the impact of aging on public finances. Healthcare costs are projected to increase only by 1.7 percent of GDP by 2060 merely on demographic factors. Recent literature suggests, however, that demographic changes may not be the key driver of future health care expenditure. Taking account of the potential impact of demand and if medical costs continue to rise significantly more rapidly than overall inflation, health spending would be substantially higher than assumed in the scenarios, requiring further adjustments to ensure sustainability of public finances.

D. Policy Implications

  • In the long term, Spain’s public finances face significant challenges arising from age-related spending, reflecting unfavorable demographic trends and weak growth prospects. The draft pension reform, if fully implemented especially with the sustainability factor, would significantly improve sustainability, but would not be enough by itself. Achieving the 2.1 percent budget deficit target by 2014 helps but without the pension reform or other reforms combined does not ensure sustainability. But the full pension reform combined with achieving the MTO by 2016 would keep the debt ratio below 60 percent of GDP by 2060.

  • However, this assumes labor productivity increases substantially in the longer run. If it does not, the debt ratio could again grow unsustainably. Securing higher potential growth is thus essential for fiscal sustainability. Undertaking substantial structural reform could indeed deliver the needed increase in economic growth.

References

  • Almeida, V., Castro, G. and R.M. Félix, 2008, “Improving Competition in the Non-tradable Goods and Labor Markets: The Portuguese Case”, Bank of Portugal Working Papers 16/2008.

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  • Bayoumi, T., Laxton, D. and P. Pesenti, 2004, “Benefits and Spillovers of Greater Competition in the Europe: A Macroeconomic Assessment”, Working Paper 341, European Central Bank.

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    • Export Citation

  • European Commission (EC), 2009a, “Sustainability Report 2009.”

  • European Commission (EC), 2009b, “2009 Ageing Report: Economic and Budgetary Projections for the EU-27 member States (2008-2060).”

  • Girouard, N., and C. André, 2005, “Measuring Cyclically-adjusted Budget Balances for OECD Countries,” OECD Working Paper No. 434

  • Hyatti. H., and M. Valaste, 2009, “The Average Length of Working Life in the European Union,” Kela/Fpa working papers 1/2009.

  • Karam, P., D. Muir, J. Pereira, and A. Tuladhar, 2010, “Macroeconomic Effects of Public Pension Reforms,” IMF Working Paper 10/297

  • Kumhof, M., D. Laxton, and S. Mursula, 2010, “The Global Integrated Monetary and Fiscal Model (GIMF)—Theoretical Structure,” IMF Working Paper 10/34

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1

Prepared by Keiko Honjo.

2

Assuming wages are linked to productivity, lower productivity reduces both wages and future pensions but given that the current pensions are linked to past productivity, the impact of lower productivity would be only neutral in the long run.

3

Six regions are Spain, Italy, Portugal, rest of the Euro area, United States, and the rest of the world.

4

Fiscal policy aims at stabilizing the government debt-to-GDP ratio over the long term by adjusting expenditure or taxes. Public investment is productive, enhancing private sector productivity. Governments levy lump-sum taxes, a consumption tax, a labor income tax, and a capital income tax. In addition, the model incorporates a wide range of rigidities in labor and product markets, reflecting, in part, barriers to competition. Monopolistic competition in labor and goods markets implies that wages and prices are higher than they would be under a more competitive environment; wages can contain a markup over the marginal rate of substitution between consumption and leisure; and prices can contain a markup over the marginal cost of production. For a complete description of the model, see Kumhof et al. (2010).

5

An increase in retirement age in GIMF is introduced by modifying two parameters, agents’ income profile over their average working life, and the population size. For more detail, see Karam et al. (2010).

6

For example see Bayoumi et al. (2004).

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Cover IMF Staff Country Reports
Spain: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2011: Issue 216
Publisher:
International Monetary Fund
ISBN:
9781462340545
ISSN:
1934-7685
Pages:
113
DOI:
https://doi.org/10.5089/9781462340545.002

Fiscal Position 2016 1/

(percent of GDP)

Pension Expenditure

(percent of GDP)

Total Age-related Spending in 2060

(percent of GDP)

Spain: No-Reform Scenario

General Government Debt

(percent of GDP)

Primary Balance

(percent of GDP)

General Government Debt

(percent of GDP)

Primary Balance

(percent of GDP)

Increase in the Retirement Age in Spain

(Percentage deviation from the baseline)