Finland: Selected Issues

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Abstract

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Fiscal Policy: Promoting Growth and Ensuring Sustainability1

Finland’s public finances are facing pressure from two related problems: slowing trend growth and a rapidly aging population. The need for adjustment is complicated by a weak economy, which would be further harmed by a rapid tightening. Simulations suggest that structural reforms could offset the fiscal adjustment’s drag on growth, especially product market reforms. Pension reforms would also be beneficial on both the fiscal sustainability and growth fronts.

A. Introduction

1. Finland’s public finances are facing pressure from two related problems: slowing trend growth and a rapidly aging population. Low productivity growth and structural change (e.g., Nokia’s break-up) are contributing to the recent decline in trend growth, but the rapid aging of the population is compounding the problem, as a growing share of the population joins the ranks of the retired. The fiscal pressure comes on two fronts. First slower trend growth means that nominal revenue will grow more slowly than in the past, necessitating that expenditure growth be reined in accordingly. At the same time, the demographic trends are starting to put pressure on age-related spending such as pensions and healthcare and long-term care for the elderly, which are set to rise substantially as a share of GDP over the next few decades—from 20.6 percent of GDP in 2010 to 26.2 percent in 2030 (EC, 2012). Age related spending pressures combined with a rapid and sustained increase in spending since 2007, driven mainly by local government and social security spending, have given rise to a sustainability gap estimated at roughly 4.7 percent of GDP. This means the government needs to implement a structural fiscal adjustment worth 4.7 percent of GDP over a 10-year period in order to maintain public debt sustainability over the long run (see Box 1). Delaying the start of the adjustment by 10 years would raise the size of the total adjustment needed by about ½ percentage point of GDP.

A04ufig01

Rise in Spending due to Aging, 2010–60

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 140; 10.5089/9781498331333.002.A004

Sources: DG ECFIN 2012 Aging Report (EC, 2012) and Fund staff calculations.
A04ufig02

Rise in General Government Spending, 2007–14

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 140; 10.5089/9781498331333.002.A004

Sources: Finnish authorities and Fund staff calculations.

2. The need for adjustment creates a growth trade-off in the short term. The sustainability gap needs to be addressed. At the same time, the economy has been in recession for two years and additional fiscal adjustment efforts beyond those already planned could undermine the modest recovery forecast for 2014. This is further complicated by the EU fiscal rules (incorporated in national legislation) that Finland is obliged to satisfy. In particular, there is a risk that the European Commission will call for further fiscal adjustment this year. This is based on its estimates of a deteriorating structural fiscal balance, for which the EU’s Fiscal Compact sets a medium term objective of −0.5 percent of potential GDP, and that the public debt-to-GDP is projected to approach the 60 percent level in 2014 (see Box 2).

3. The correct timing and composition of fiscal adjustment will be critical to both a successful economic recovery today and a sustainable fiscal position in the long run. To sustain the recovery, in the short run the government should avoid enacting additional fiscal adjustment measures. A credible medium-term adjustment plan that ramps up the pace of adjustment only after the economy’s return to growth is firmly entrenched would provide the right balance between shot-run growth concerns and longer-run fiscal sustainability concerns. Other policy measures could buttress the fiscal adjustment plans and offset the declining trend growth and labor force participation of older workers, particularly structural reforms that raise productivity and employment over the medium-term.

4. Simulations illustrate how a balanced approach might look, but also indicates the inherent uncertainty in such exercises. In the fiscal adjustment scenario, this stems from uncertainty regarding the size of the fiscal multiplier. In the structural reforms simulations, it stems from uncertainty about both the structural policy gap and how quickly the economy will react to key reforms. In addition, the potential policy options are outlined and compared to the government’s current plans.

B. Fiscal Adjustment Simulations

5. The baseline projections do not reflect the recently announced government spending limits decision. As a result, the baseline public debt-to-GDP ratio is projected to continue rising through 2019. The authorities recognize the need for fiscal adjustment over the medium term to put the public debt ratio on a downward trajectory and to close the fiscal sustainability gap, which their spending limits decision is geared towards.

6. We simulate six scenarios to illustrate the impact of a faster or slower fiscal adjustment. In each scenario, by 2019 there is a cumulative structural reduction in primary expenditures of 1.25 percent of GDP relative to the baseline, which is broadly similar in size to the government’s recently announced adjustment plan.2 Focusing the adjustment scenarios on primary expenditure reductions is consistent with the expenditure ceiling based fiscal framework in Finland. The simulations compare two adjustment paths, a “frontloaded” path and a “phased-in” path, by which the total adjustment can be achieved. The frontloaded adjustment path implements a 0.4 percent of GDP structural spending cut in 2015, with the size of cuts declining each year to a 0.1 percent of GDP spending cut in 2019.3 The phased-in adjustment path implements smaller spending cuts in 2015–16 and gradually ramps up the cuts, with a 0.25 percent of GDP reduction in 2017, followed by a 0.3 percent of GDP cut in both 2018 and 2019.

Primary Expenditure Reduction Paths

(in percent of GDP)

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7. The impacts of each adjustment path are simulated for different sets of fiscal multipliers that vary with the state of the economy. Estimates of spending multipliers for Finland are generally between 0.5 and 0.7 (OECD, 2010a, Barrell and others, 2012), based on pre-crisis data and reflecting, among other things (see text table), the fact that Finland is a small open economy, which tends to lower the impact of fiscal expansion or contraction through the trade channel. However, multipliers are likely to be larger than normal in the current context (IMF, 2013a; IMF, 2013b), as nominal monetary policy interest rates are at the zero lower bound (ZLB) and multipliers tend to be larger when the output gap is large and negative (Auerbach and Gorodnichenko, 2012, Battini and others, 2012, Baum and others, 2012), as is the case in Finland. These offsetting factors create uncertainty about the size of the multiplier. Given that, we simulate the two adjustment paths with a range of multipliers:

Multiplier Uncertainty

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Sources: IMF (2013a)
  • The “central” multiplier M is set at 1, 0.75, and 0.5, in the high, medium, and low multiplier scenarios, respectively.

  • We vary the multiplier in each year with the output gap, using the “central” multiplier if the output gap is between −1 and −2 percent of potential GDP, set it 0.25 lower if the output gap is greater than −1 percent, or set it 0.25 higher if the output gap is below −2 percent.

Multipliers Vary with Output Gap

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8. We use a modified version of the framework developed by Abbas and others (2013) to simulate the effects of the two adjustment paths on output and public debt dynamics.4 In the framework, fiscal adjustment efforts (in percent of GDP) have an impact on growth, with the size of the growth impact depending on the size of the expenditure reduction, the size of the multiplier, and the multiplier’s persistence (an exogenous parameter than determines how long it takes output to return to potential). Thus, the total impact on growth in year t includes the impact of current fiscal adjustment efforts, as well as past fiscal adjustment efforts and their marginal multipliers in period t. Hence, the size and phasing of fiscal adjustment efforts (i.e. the change in the structural primary balance) matter for determining the size of deviations in output from the baseline. This in turn affects the degree of actual improvement in the headline primary balance and debt-to-GDP ratio. The improvement in the structural primary balance will not be fully reflected in the headline primary balance, as nominal revenue levels will fall when expenditure cuts have a negative growth impact.

9. The latest (April 2014) WEO projections for Finland are set as the baseline for the simulations. This includes values for nominal and potential GDP, the output gap, real GDP growth, inflation, interest rates, and fiscal variables (revenue, primary expenditures, interest expense, and debt levels). One point to note is that by assuming that the path of potential output is consistent with the latest WEO projections, the simulations will abstract from any longer-run effects of fiscal consolidation on potential growth.

10. Given Finland’s strong fiscal track record, we abstract from any effects of the debt level (or its change) on the risk premium on new government borrowing. Abbas and others (2013) simulate a response in the risk premium on interest rates to changes in debt levels, based on the idea that as a country’s fiscal space is eroded the risk premium on its debt will rise (see, for example, Ostry and others (2010)). However, Finland’s strong track record and the moderate projected rise in the baseline debt-to-GDP ratio over the forecast horizon suggest this dynamic is not pertinent here.5

Simulation Results

11. Both frontloaded and phased-in adjustments can cause the debt ratio to temporarily rise relative to the baseline. As the adjustment is implemented, it slows GDP growth (i.e. the “multiplier effect”), reducing the denominator of the debt-to-GDP ratio relative to the baseline. The initial improvement in the headline primary balance is not sufficient to reduce the nominal debt level by enough to offset the growth impact on the debt-to-GDP ratio. Hence, under the frontloaded adjustment scenarios the debt ratio increases faster than the baseline ratio in the first year. The debt ratio response under the phased-in scenarios is similar, with the adjustment starting in 2015, but slightly less pronounced as the initial fiscal effort is lower.6

12. The simulation results show that both adjustment path put the public debt-to-GDP ratio on a downward trajectory after 2015 (Figure 1). For a given set of multipliers, both the frontloaded and phased-in adjustment paths can achieve nearly the same primary balance by the end of the projection period. However, the sums of the primary surpluses over the projection period are larger under the frontloaded adjustment paths than in the respective phased-in adjustments. The primary balance will not improve by as much as the adjustment effort initially due to the impact of slower growth on revenue. However, since the structural fiscal adjustment takes place sooner, even with the largest multipliers we use, a primary surplus is achieved more quickly under the frontloaded scenarios. This is the main reason the public debt ratio falls more in the frontloaded scenarios than in the phased-in ones, though the difference (for a given multiplier assumption) is less than 1 percentage point of GDP by 2019.

Figure 1.
Figure 1.

Simulations for Frontloaded and Phased-in Fiscal Adjustment Paths

(Percent and percent of GDP, respectively)

Citation: IMF Staff Country Reports 2014, 140; 10.5089/9781498331333.002.A004

Sources: Abbas and others (2013) and Fund staff calculations.Notes: The panels show the deviation of output from the “Baseline – WEO” forecast, the primary balance, and the public debt ratio, along with their respective “Baseline – WEO” forecasts, under six adjustment scenarios. The frontloaded adjustment path (red) is simulated with high, medium, or low fiscal multipliers. Similarly, the phased-in adjustment path (blue) is simulated for the three different multipliers.

13. However, the frontloaded adjustment path generally has a more deleterious impact on output than the phased-in adjustment. The phased-in adjustment path reduces the adjustment efforts in 2015 and then it ramps up the adjustment over time. The phased-in path gives the economy more time to recover, which shrinks the output gap and generally results in smaller multipliers being applied in the outer years (relative to the frontloaded adjustment scenarios) when the bulk of the adjustment occurs. The deviations from the baseline output level and the cumulative output losses relative to the baseline are much larger for the frontloaded adjustment scenarios.

14. While the simulations abstract from any longer-term impact on potential growth, fiscal consolidation could lower potential growth through hysteresis effects, for example.7 Dell’Erba, Koloskova, and Poplawski-Ribeiro (2014) find support for this, showing that fiscal consolidations during prolonged economic downturns have a persistent impact on output growth, primarily explained by hysteresis in the labor market. This illustrates the importance of implementing structural reforms that can help offset any persistent impact fiscal consolidation may have on the economy’s growth potential. For instance, active labor market policies such as retraining for unemployed workers and job search assistance may help prevent or reverse hysteresis in the labor market (see below).

C. Fiscal Adjustment, Structural Reforms, and Growth

15. Should Finland be resigned to accepting the drag on growth from fiscal adjustment? As the above analysis indicates, the impact of fiscal adjustment on output varies with the phasing and the size of multipliers. In all cases though, it has a negative impact on growth. In the context of Finland, the scope for more accommodative monetary policy to offset the growth impact of fiscal adjustment is limited. The ECB is operating close to the ZLB. Even to the extent that further monetary expansion is possible, the potential impact of lower growth on expected inflation in Finland would have little weight in the overall euro area inflation targeted by the ECB’s monetary policy. This suggests that other policy tools will have a larger role to play.

16. One policy approach to boost growth would be to adjust the composition of taxes, though we do not model this in the simulations below. Several recent empirical studies suggest that the composition of taxes can have long run effects on growth (Arnold and others, 2011, Gemmel, Kneller, and Sanz, 2011, Acosta Ormaechea and Yoo, 2012). For a given level of taxation, shifting the composition away from direct (i.e. income) taxes and towards property and indirect (i.e. consumption) taxes is associated with faster growth. Acosta Ormaechea and Yoo (2012) also find that for the different types of direct taxes, labor income taxes like social security taxes (SST) and personal income taxes (PIT) have a stronger negative association with growth than corporate income taxes (CIT). A high labor tax wedge, the difference between the total cost of employing a worker and the pay they receive, can reduce employment through both the supply and demand for labor. Simulations by Bouis and Duval (2011), for example, suggest that if Finland gradually reduced its labor tax wedge to the average of the of the six OECD countries with the highest employment rates in 2007, it would raise the employment rate by more than 1 percentage point over 5 years.

17. Structural reforms will make a difference. An extensive literature examines the impact of different structural reforms of growth, employment, and productivity, suggesting that structural reforms can boost an economy’s growth potential over the medium-term (see, for example, Bouis and Duval, 2011, Barnes and others, 2013). The impact depends, in part, on the economic (e.g., global demand) and institutional environment. For instance, Lama and Medina (2014) look at the experience of Sweden. They find that following the financial crisis in the early 1990s, Sweden’s economy grew strongly, even in the face of a substantial fiscal consolidation. The authors show that this is largely explained by the growth in TFP during that period, which the authors attribute to a series of substantial structural reforms enacted in the aftermath of the early 1990s crisis (see Box 3).

18. Several recent papers simulate the impact of structural reforms on growth in models based on the IMF’s Global Integrated Monetary and Fiscal (GIMF) model.8 Anderson, Hunt, and Snudden (2013) and Anderson and others (2013a) start with estimates of structural indicator gaps from the OECD (see OECD, 2013a)—the distance between a country’s structural indicators and those of countries with the “best practice,” as measured by their structural indicators—to determine a country’s distance to the “frontier.” They then combined these structural indicator gaps with empirical estimates of the impact of the structural reforms—such as changes to unemployment benefits, pensions, and product market regulations—on productivity, employment, and labor participation (see Bouis and Duval, 2011, and references therein). Together the structural indicator gaps and the estimated impacts of reforms are then translated into country (or region) specific changes in firms’ mark-ups, productivity, and labor supply in the GIMF model.

19. The different reforms works through a number of channels. For example, product market reforms that increase competition and lower mark-ups would reduce the costs of goods and services for consumers, which would boost consumption and investment, as well as employment despite a rise in real wages. Similarly, lowering employment protection legislation (EPL) would reduce the cost of adjusting employment, making it easier to reallocate labor across firms and sectors. By increasing the efficiency of firm-employee matches and increasing productivity, such reforms have a positive impact on the economy.

20. The structural indicator gaps are typically measured as the distance of a given country’s indicator from the average of the “best” countries. This is typically based on specific structural indicators, such as an index of retail trade regulations or spending on active labor market policies (ALMP). However, various reforms can be combined into more comprehensive measures of structural gaps to reflect the broader status of product and labor markets (see OECD, 2013a). Intuitively, countries with larger structural policy gaps can make larger strides in terms of productivity, growth, and employment if they reform their policies to match “best practices.” The growth impact also depends on the pace of implementation of reforms, and, potentially, on how credible the reforms are (i.e. how quickly people believe the reforms are permanent and change their behavior).

21. There is substantial uncertainty surrounding the average impact of reforms. For one, there is the usual statistical uncertainty around point estimates from empirical models used to calibrate the model-based simulations. As noted above, the effects also depend on the economic context. Anderson and others (2013a) experiment with several variations of assumptions and factors that could change the impact of structural reforms (e.g., the state of the economy, the credibility of reform efforts). They simulate the model focusing on two regions calibrated to the euro area core and periphery to illustrate the larger output effects of reforms for countries farther from the frontier.

D. Reforms and Growth: An Illustration for Finland

22. To approximate the effects of structural reforms for Finland, we use the results from Anderson and others (2013a) to derive elasticities of output to structural reform efforts. Their simulations show how the output of “core euro area” (core EA)9 countries reacts to structural reforms that close half the gap with the average of the best performing OECD countries over a period of 13 years. This allows us to extract the elasticity of output to a change in a structural indicator index that combines key labor and product market characteristics over the period of simulation.10 For example, if the deviation of output increases from t to t+1 by 0.5 percentage points and the structural indicator index improves by 2 units, the approximated elasticity is 0.25.

23. The next step is to construct an indicator capturing the structural characteristics of Finland and calibrate the pace of reform. We construct summary indices of structural characteristics along the lines for the core EA, but adjust the speed at which reforms will close the gap with the frontier to mirror the likely progress on structural reforms proposed in the government’s current plans. For one, we assume that pension reforms only become effective in 2017, consistent with the government’s reform plan. Also, the pace of reform for ALMPs, unemployment benefits’ average replacement rate (ARR), and changes to EPL is initially modest, but increases over the forecast horizon until they achieve a constant rate of reform from 2019 onwards. This implies that over 13 years the overall structural index closes about 44 percent of the gap instead of closing half the gap as is done for the core EA countries in Anderson and others (2013a).

Structural Reform Gaps for “Core Euro Area” and Finland

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Sources: OECD and Fund staff calculations.Notes: OECD structural indicators are converted to indexes with the OECD frontier normalized to 100. Gaps are calculated as the difference between the country’s (or weighted average of countries for the Core EA group) index value for an indicator and the OECD frontier. Core euro area (EA) includes: Austria, Belgium, Estonia, Finland, France, Germany, Luxembourg, the Netherlands, the Slovak Republic, and Slovenia.

24. The overall product and labor market reform index and the output elasticities to structural reform efforts are then combined to simulate the impact of key reforms in Finland. The output deviation elasticity to changes in the structural reform index derived from the results for the core EA countries in Anderson and others (2013a) are multiplied by the change in the Finnish overall structural reform index for each year. This gives the deviation of output (relative to the baseline) due to structural reforms for Finland in each year of the projection period (see Figure 2). Under our benchmark structural reform scenario, output would be about 2½ percent higher by the end of the forecast period (2019). Also, as discussed above, the full impact of most labor market reforms is explicitly set so that the pace of reforms builds up over time, rather than immediately proceed to close the gap at a constant rate. In comparison, in the “accelerated” case, where reforms are implemented steadily from the beginning (i.e. in line with the assumptions in Anderson and others, 2013a), the impact on output over the forecast horizon is stronger, with output 3.2 percent higher than the baseline by 2019. Unsurprisingly, in all scenarios, the higher output leads to better primary balances and public debt-to-GDP ratios than in the baseline WEO forecast (see Figure 2).

Figure 2.
Figure 2.

Structural Reform Simulations

(Percent and percent of GDP, respectively)

Citation: IMF Staff Country Reports 2014, 140; 10.5089/9781498331333.002.A004

Sources: Abbas and others (2013) and Fund staff calculations.Notes: The panels show the deviation of output from the “Baseline – WEO” forecast, the primary balance, and the public debt ratio, along with their respective “Baseline – WEO” forecasts for the bench mark and high and low impact scenarios for structural reforms.
A04ufig03

Deviations from Baseline Output Levels

(Percent)

Citation: IMF Staff Country Reports 2014, 140; 10.5089/9781498331333.002.A004

Sources: OECD, Anderson and others (2013), and Fund staff

25. The effects of structural reforms are rather uncertain though. In particular, as Anderson and others (2013a) show, the impact can vary with the demand environment—for example, in a scenario with strong (weak) global demand, the effects of supply side reforms are likely to be larger (smaller), as any additional capacity will be utilized more (less) quickly.11 Following their example, we construct high and low impact scenarios for the effect of structural reforms in Finland. The implied range in terms of the output deviation from the baseline at the end of the forecast period in 2019 is between 1.1 and 3.3 percent (Figure 2).

The results from combining structural reform and fiscal adjustment simulations suggest that reforms can significantly mitigate the drag on growth from consolidation. Comparing the WEO baseline with a combined simulation scenario–assuming phased-in consolidation, medium-sized multipliers, and benchmark structural reforms—results in output levels more than 1 percent higher than the baseline (Figure 3). This contrasts with output levels more than 1 percent lower than the reforms results in output levels more than 1 percent higher than the baseline (Figure 3). This contrasts with output levels more than 1 percent lower than the results in output levels more than 1 percent higher than the baseline (Figure 3). This contrasts with output levels more than 1 percent lower than the baseline in the simulation with fiscal adjustment and no reforms. However, as Figure 3 illustrates, the uncertainty around these point estimates is sizable.

Figure 3.
Figure 3.

Simulations for Combined Fiscal Adjustment and Structural Reform Scenario

(Percent and percent of GDP, respectively)

Citation: IMF Staff Country Reports 2014, 140; 10.5089/9781498331333.002.A004

Sources: Abbas and others (2013) and Fund staff calculations.Notes: The panels show the deviation of output from the “April 2014 WEO” forecast, the primary balance, and the public debt ratio, along with their respective “April 2014 WEO” forecasts, under scenarios illustrating fiscal adjustment only, structural reform only, and a “combined” scenario with simultaneous fiscal adjustment and structural reforms. “Fiscal adjustment only” (red) is the phasedin path from Figure 1 simulated with high, medium, or low fiscal multipliers. “Structural reform only” (green) is the results from Figure 2. The “combined” scenario uses the structural reforms impact simulated in the benchmark scenario in Figure 2 and applies the phased-in fiscal adjustment path with the medium sized multiplier.

E. Policy Discussion

26. A combination of a phased medium-term fiscal adjustment and structural reforms can raise growth and address the fiscal sustainability gap. The results of the fiscal adjustment simulations point to the advantages of addressing the sustainability gap over the medium term, delaying further tightening until the recovery is more firmly entrenched. However, even with adjustment gradually ramped up over the medium-term, it will still be a drag on growth. Structural reforms can provide critical support in this regard. Indeed, at first approximation, embarking on a reform path that would close between 40 and 50 percent of Finland’s existing reform gaps with the OECD’s best performers over a 13 year period could potentially more than offset the effects of an adjustment plan that closes half of the fiscal sustainability gap by 2019.

27. Given Finland’s already high tax levels, fiscal adjustment will have to focus mostly on expenditures. Some measures, such as pension reforms that gradually increase the retirement age and reduce the implicit tax on working at older ages, would benefit both the growth and fiscal agenda. Similarly, product market reforms that boost competition and productivity can complement reforms aimed increasing the cost effectiveness of the provision of public services through lower prices for goods and services purchased by the government. Beyond expenditure reductions, there may be room to tweak the tax structure to promote labor force participation and economic activity.

Revenue

28. The room to raise substantial new tax revenues may be limited, but there is scope to make the structure of taxes more growth friendly. As noted earlier, fiscally neutral shifts of some of the tax burden from labor income taxes to less distortionary consumption and property taxes can support employment and growth. Following the one percentage point increase of the standard VAT rate to 24 percent in early 2013—similar to other Nordic countries—the VAT revenue-to-GDP ratio of more than 9 percent is in the top quintile of OECD countries. In contrast, total property tax revenue is only 1.1 percent of GDP, which is less than 60 percent of the OECD average (IMF, 2013c).

  • VAT: There is some scope to enhance VAT revenues by reducing the number of items subject to special VAT rates that are lower than the standard rate (e.g., 14 percent rate of food and restaurants, 10 percent rate on books, hotels, and pharmaceuticals). IMF (2013c) estimates that eliminating half of the “policy gap” (i.e. applying the standard VAT rate to more goods) could generate up to 2.4 percent of GDP in additional revenue. However, offsetting some of the regressive effects of such a measure, which tends to hurt the poor and vulnerable the most, would reduce its net-impact on the budget.

  • Property tax: Raising the property tax revenue-to-GDP ratio to the OECD average could generate additional revenue of about 1 percent of GDP. In addition, property tax revenue tends to vary less with the business cycle than other tax revenue, so shifting the tax base of municipalities away from corporate income taxes towards property taxes could contribute to making local public finances less procyclical overall.

  • Other measures: Consideration could also be given to budget-neutral changes in R&D support. A shift from larger-scale direct support focused on large firms to tax-based schemes with the potential to benefit younger and smaller firms could boost innovative activity and growth.

29. Changes in the allocation of the portfolio of public financial assets may also have the potential to lift revenue. The stock of public financial assets is worth nearly 100 percent of GDP. As noted in the 2012 Article IV, this portfolio is invested relatively conservatively, resulting in low returns. Exploring options of shifting the portfolio allocation towards assets with higher returns could increase investment income, while the making sure to invest such that the reallocation limits any rise in revenue volatility.

Expenditure

30. Expenditure measures will be essential to ensuring Finland’s fiscal position is sustainable in the long-run though. Central government spending has remained fairly contained under Finland’s spending limits system. But the rapid growth in local government and social security spending since 2007 indicates there is scope for reforms to ensure fiscal sustainability.

31. Improving the cost-effectiveness of the public sector is critical, and the government is taking steps in this direction. The productivity of government-provided services has declined more than 10 percent over the past decade, suggesting substantial room for improvement.12 Consequently, a central goal of the government’s structural reform program agreed in November 2013 is to improve public sector efficiency at all levels of government. The government foresees savings coming from a significant reduction in the government workforce compared to the baseline—the expected increase in the public workforce would shrink from an estimated 3,000 workers per year (or about 1.5 percent of the current workforce) to about 1,000 workers per year over the medium term.

  • Municipalities reform: One pillar of the government’s plan is to reduce the tasks and responsibilities of local governments and merge municipalities (or some of their functions) to reap the benefits of economies of scale, such as in procurement for health and long-term care (LTC). This should also assist with the recruitment and retention of qualified personnel, especially in regions outside of the Helsinki Metropolitan Area (OECD, 2013b).

  • Central government reform: The Central Government Productivity Program 2005–2015 sought to improve public sector efficiency by reducing government employment levels and other measures to curb expenditure growth. However, as the OECD (2013b) observes, without changes See the Selected Issues Paper, Chapter II, Finland: Structural Health Check. in practices to improve productivity and align staffing with capacity needs based on the demand for services, staff reductions may just increase the workload for remaining workers. This may have a demoralizing impact on public servants and make retention of key personnel more difficult. Hence, reforms require regular assessments of how performance management mechanisms affect productivity and how the implementation of reforms is managed.

  • Electronic service delivery and data provision: Developing new technologies to improve the delivery of services, including in health and social benefits, can increase the efficiency of the public sector. The government plans to increase investment in ICT to better coordinate and deliver services online. It also plans to broaden the public provision of data collected by the government over 2015–18, which could both help with monitoring public sector efficiency, as well as stimulate innovative new private sector ventures.

32. Measures to contain local government spending involve reforms in areas such as healthcare, long-term old-age care, social services, and education. The government’s structural reform program agreed in November 2013 aims to achieve savings in local government spending of around €1.3 billion (0.6 percent of GDP) by 2017 relative to the baseline with no policy change. However, some of the underlying details have yet to be presented.

  • Healthcare: Savings are projected to total roughly €180 million (0.1 percent of GDP), mostly due to discontinuing archiving of paper records for patients (€94 million) and reforms of the emergency system (€60 million). The merger of smaller municipalities could rein in costs by improving their bargaining power with providers and achieving greater economies of scale. Finally, measures to reduce the reliance on hospitals and specialists, shifting the provision of healthcare towards outpatient general care, could also generate savings (OECD, 2012).

  • Long-term care: Plans to tighten eligibility for long-term care (LTC) of the elderly are projected to save €300 million (0.14 percent of GDP), by reducing, relative to current rules, the facilities required to provide long-term care. However, LTC spending is still projected to rise by 1.4 percent of GDP by 2030 (EC, 2012). Reform efforts in LTC provision over the last few years should be continued and expanded, including measures: (i) to increase competition amongst providers of LTC services, (ii) to promote the use of remote technologies and assistive devices, and (iii) other measures to help the elderly remain healthy and at home as long as possible (e.g., in home assistance) (OECD, 2012).

  • Social services: A plethora of measures to more efficiently deliver social services, including closer integration of health care and social services provision are projected to yield savings of €125 million (0.05 percent of GDP). Measures to increase competition in service provision and greater electronic delivery of services will assist in this effort, but how much savings these reforms may generate remains to be determined.

  • Education: Reforms are expected to save nearly €300 million (0.14 percent of GDP) by 2017, mainly through education provider network and funding system reforms (€195 million) and a shift to only funding the attainment of qualifications (i.e. degree or certification granting upper secondary level programs) (€65 million). Other planned reforms include: (i) streamlining the application procedures and qualification system for vocational programs, (ii) changes to financial aid to incentivize students to finish the studies at the tertiary level in a timely manner, and (iii) a temporary increase in the intake rate in higher education. These reforms may help to support post-education employment prospects, but their fiscal impact is unclear at this time.13

33. Further pension reforms will also be critical to ensuring long-run fiscal sustainability. Pension costs are expected to rise by 3.5 percent of GDP by 2030 and are a key contributor to the sustainability gap. Reform efforts over the last few years have raised the effective retirement age and introduce an adjustment for longevity to new pensions. The government’s current reform plan includes the negotiation of additional pension reforms by autumn 2014 that would come into force in 2017. The aim of these reforms would be to gradually raise the average effective retirement age from 60 years old to above 62 years old by 2025, as well as change the contribution and benefits formulas to strengthen the public finances. However, there are other measures the authorities could pursue to narrow the channels to early retirement.

  • Disability benefits: Though it has fallen by over a percentage point since the mid-1990s and is lower than in Sweden and Norway, the share of the population aged 15–64 years old receiving disability benefits still appears high at nearly 9 percent (OCED, 2010a). Hence, tightening eligibility for disability benefits, while also providing adequate support for such workers in terms of ALMPs, could provide fiscal savings while supporting the structural reform goal of increasing the labor market participation of older workers.

  • Statutory retirement age: The statutory retirement age was lowered from 65 to 63 as part of the 2005 pension reform. Additionally, as the implicit tax on working beyond age 63 is high, there is a little incentive to work longer, resulting in a significant decline since 2005 of individuals working to age 65 (OECD, 2010b). The simulations of the impact of structural reforms on growth suggest that pension reforms to increase the effective retirement age would boost growth. Hence, returning to a statutory retirement age of 65 and providing an actuarial adjustment for income from work beyond age 63–to reduce the implicit tax on working beyond that age–would have a positive impact on both growth and fiscal sustainability.

34. While Finland’s current fiscal framework and rules can help anchor medium-term adjustment plans, its coverage could be expanded. Currently the central government’s spending limits framework only covers 80 percent of budgeted spending by the central government and excludes local governments, which account for roughly one third of general government spending. A more comprehensive framework, covering more of the general government spending, would improve expenditure control. However, there may be legal difficulties in terms of enforcing such a rule at the local government level. A new steering system for local government finances is being established (work has begun and related legislation will come into force in 2015). Similar to the central government spending limits system, the new steering system aims to include binding medium-term limits on local government finances. This could potentially offer a solution to the expenditure control dilemma. However, it is still too early in its development to evaluate its impact on local government spending growth. Bolstering the role and capacity of Finland’s de facto fiscal council, the National Audit Office, would also help to ensure fiscal discipline and to meet fiscal targets in the future (see also, IMF, 2012a).

Structural reform

35. Structural reforms can enhance growth, mitigating the impact of fiscal consolidation, and Finland’s structural reform gaps point to several critical areas that are ripe for reform. Finland’s reform gaps are somewhat larger, though of the same order of magnitude, as other core euro area economies. The reform potential is particularly high in the labor market area (ALMP, ARR of unemployment benefits) and for pension reforms. While the structural reform gaps in the overall product market reform indicator is lower than for labor market indicators, the output elasticity of product market reforms is higher, which suggests a comprehensive approach. In particular:

  • Pensionreforms: Pension reforms have both growth and fiscal benefits that accrue over time, suggesting that quickly implementing reforms is particularly helpful. This points to the advantage of starting the necessary dialogue between all stakeholders soon, including social partners, to avoid unnecessary delay in terms of legislation and implementation.

  • Activelabormarketpolicies: Increasing spending on ALMP can boost output, and can complement pension reforms if some ALMP spending is targeted towards older people to encourage them to stay in the labor force. While this may have some fiscal cost, it could be offset by savings from reforms of pension and unemployment benefits.

  • Unemploymentbenefitsaveragereplacementrate: Gradually reducing the generosity of unemployment benefits over time could raise employment and help reduce long-term unemployment, which could increase the labor supply. It would be particularly effective if the measure comes into effect during a period of strong demand (and is accompanied by effective ALMP). Otherwise, a gradual phasing-in, commensurate with economic conditions, would maximize the impact over the medium-term.

  • Employmentprotectionlegislation: The direct growth impact of reducing EPL tends to be smaller than other labor market reforms, but a policy that protects workers rather than jobs has potentially strong benefits in a period of rapid structural change, such as the one Finland finds itself in after the end of the ICT boom.14

36. Product market reforms are also critical to improving productivity and countering the decline in trend TFP growth. While Finland’s overall product market reform gap is not terribly large, in certain sectors the gaps are substantially worse than the overall indicator suggests. As the Structural Health Check SIP describes, Finland’s retail sector regulatory barriers among the highest out of OECD countries, with its retail sector regulation indicator (lower is better) in the top quintile. Reforms here would help boost service sector productivity. Increased productivity and competition lead to lower prices for consumers and could have positive spillovers to other sectors, including domestically oriented non-tradable sectors (e.g., construction, public sector). Similarly, reforms in network sectors such as rail and utilities could have beneficial cost and productivity effects.

The Sustainability Gap

The sustainability gap indicator is the structural fiscal adjustment (i.e. total change in structural primary balance) needed to ensure the government’s intertemporal budget constraint is satisfied.1 The first step to estimate the sustainability gap is to calculate the public debt-to-GDP ratio at time t (bt) minus the present value of all future primary balances (PtPV) for a given fiscal stance (usually measured as the structural primary balance path).2 If this is positive using the baseline long-run forecast for structural primary balances (SPB), then the government’s intertemporal budget constraint (IBC) is not satisfied. Next, one needs to define a fiscal adjustment path that generates an alternative SPB path, such that the government’s IBC is satisfied (i.e. btptPV=0). Given the starting point of the current (time t) SPB and an adjustment path (and corresponding SPB path) that satisfies the IBC, the total adjustment (change in SPB) needed over the specified time period gives us the sustainability gap.

This suggests that the sustainability gap will depend, in part, on the timing of the adjustment path. Any delay in adjustment will increase the sustainability gap, since higher surpluses will be needed in the longrun to offset the lower present value of the SPBs expected in the future. That said, the increase may not be very large—for example, if the envisaged shift is small and if the spending pressures forecast to lead to declining SPBs in the long-run will not be realized for several decades.

1 This is consistent with the Europe Commission’s S2 indicator. For a more technical exposition of how the sustainability gap is defined and derived, see Analytical Note 6 in IMF (2012b).2 Note that this involves making very long-run forecasts on a number of variables (e.g., growth, interest rates, demographics), making the sustainability gap sensitive to the underlying assumptions of these forecasts.

Potential Output Uncertainty and Structural Balance Estimates

The structural fiscal balance can be a useful tool for trying to ascertain the underlying fiscal stance. The structural fiscal balance attempts to measure the underlying fiscal position by adjusting the headline balance for cyclical and one-off factors. Accounting for the elasticities of revenue and expenditure to the business cycle (i.e. the output gap)—as well as asset and commodity price cycles and other one-off items, where applicable—allows for the calculation of the cyclical component of the headline balance. Subtracting this cyclical component from the headline balance gives us the structural balance. This can help policymakers “see through” the fluctuations in the headline balance due to cyclical factors, which, in turn, can help reduce the procyclicality of fiscal policy.1

However, measuring the cyclical position of the economy depends on estimating potential output, which is subject to substantial uncertainty. As the Selected Issues Paper (Chapter I) on potential GDP illustrates, potential GDP can be estimated with a number of different approaches and these estimates can have sizable confidence bands around them. Forecasts of potential output and its growth rate (and, consequently, the output gap) are also subject to as much (if not more) uncertainty as forecasts of real GDP and its growth rate. Recent work by Fund staff looks at revisions to European Commission (EC) estimates of the output gap and the cyclically-adjusted primary balance (CAPB), comparing forecasts at the time of budget preparation to the latest available estimates. They find that for 2003–2012 the average size of (absolute) revisions of the output gap and CAPB estimates are around 2.5 percent and 1.1 percent of potential GDP, respectively, with a higher average size of (absolute) revisions for 2007–2009. To be sure, such revisions are not unique, but the example illustrates the underlying measurement issue.

Large shocks and structural changes in the economy can compound the uncertainty surrounding any potential output estimate. The global financial crisis hit Finland particularly hard, with real GDP falling more than 8 percent in 2009. At the same time, Finland’s ICT sector continues to lose steam and other traditional export industries, such as pulp and paper manufacturing, have been in decline, while services have grown as a share of the economy. These compositional changes in the economy have probably contributed to the slowdown in Finland’s potential TFP and output growth rates (see, Chapters I, II, and III, above). However, the extent of that contribution is difficult to determine due the simultaneity of cyclical and structural developments.

Structural fiscal balance estimates may also change if there are fundamental shifts in the way revenue and expenditure components change with the business cycle. Sizable downturns may have stronger effects than more mild recessions, while rapid structural changes in the economy may fundamentally change the cyclical behavior of various revenue and expenditure components. In such cases, revenue and expenditure elasticities estimated on historical data may not accurately capture the cyclical component of the fiscal balance. Thus, beyond uncertainty related to estimating potential output and the output gap, if revenue and expenditure elasticities are changing, it can introduce additional uncertainty when measuring the structural fiscal balance (see, for example, Kiss and Vadas, 2005).

1 See Larch and Turrini (2009) for a discussion of the cyclically-adjusted balance and its use in EU fiscal policy making over time.

The Role of Structural Reforms and Productivity in Fiscal Consolidations: The Swedish Experience1

Fiscal consolidations tend to have a depressing effect on aggregate demand and employment.2 However, the Swedish fiscal consolidation episode in the 1990’s provides an interesting case study of a fiscal adjustment implemented in a context of high economic growth and a declining unemployment rate. Lama and Medina (2014) argue that this scenario was possible, primarily, as a result of the implementation of productivity-enhancing structural reforms.

Sweden experienced a substantial acceleration in total factor productivity (TFP) growth after the early 1990s financial crisis due in large part to structural reforms. Between 1970 and 1990 Sweden’s TFP growth averaged 0.5 percent per year. However, during the 1993–2000 period, TFP increased at an annual rate of 2.7 percent. These productivity gains became possible after the implementation of a package of structural reforms. In 1993 the government enacted a new “Competition Act” in order to prevent the formation of cartels and the abuse of dominant market position. By joining the European Union in 1994, the government lowered trade barriers, which increased competition from abroad and encouraged firms to become more efficient. Several network industries were deregulated such as telecommunications, electricity and rail transport. Many state-owned enterprises were privatized. In addition, new planning regulations were enacted to encourage competition in the retail sector by granting licenses to new entrants. The model in Lama and Medina (2014) estimates that the Swedish GDP increased by 20 percent due to TFP gains after the implementation of structural reforms. Interestingly, this estimate is similar to the upper bound of the structural reform effects on output calculated by the OECD (2012) (see also Bouis and Duval, 2011).

Without structural reforms that boosted TFP growth, Sweden’s fiscal consolidation would have tanked the recovery after the financial crisis. Figure 1 shows the results of a simulation of the primary balance and GDP under alternative scenarios using a DSGE macroeconomic model. In the absence of a fiscal adjustment and productivity gains (red line), the primary balance would have remained in deficit and GDP would have remained stagnant. Once the discretionary measures were adopted (green and light blue lines), the primary balance improved by 5 percentage points of GDP, though at the cost of a declining GDP. Finally, once the observed gains in productivity are considered in the model (black line), the primary balance increases by 10 percentage points of GDP and the output increases by 6 percent above the trend by the year 2000.3 Higher productivity contributed to closing the primary deficit by expanding the tax base and fiscal revenues. The simulation illustrates that by implementing productivity-enhancing structural reforms it was possible to expand output and consolidate public finances simultaneously.

A04ufig04

Sweden: Contributions to Primary Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 140; 10.5089/9781498331333.002.A004

Source: Lama and Medina (2014) and Fund staff calculations.
1 Prepared by Ruy Lama.2 See Guajardo and others (2011).3 The simulation considering the productivity growth fits the actual data on GDP and the primary balance.

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1

Prepared by Nathaniel Arnold.

2

No revenue adjustment occurs, so revenue is assumed to fluctuate with GDP (i.e. revenue elasticity of 1). This differs from the government’s adjustment plans announced recently, which include a mix of tax hikes revenue and spending cuts. For the purposes of these illustrative simulations, this difference is not crucial, but in reality the composition of the adjustment may influence the impact on output.

3

The size and timing of the frontloaded path is roughly along the lines of the government’s recently announced spending limits decision that lays out their proposed medium term adjustment, but does not include any mitigating factors, such as how the composition affects output or the government’s proposed “growth package.”

4

See Appendix V of Abbas and others (2013) for a more detailed explanation of how their framework models the impact of fiscal consolidation on growth and public debt dynamics.

5

For example, Ostry and others (2010) estimate Finland’s hypothetical debt limit–the point at which the debt becomes unsustainable–between 167 and 200 percent of GDP, well above the baseline level projected in 2019.

6

As mentioned above, since Finland can borrow at exceptionally low rates already, there are no “credibility” effects of fiscal adjustment in our simulations. Such an effect would lower the risk premium on sovereign debt, thereby directly lowering the government’s interest expense and stimulating output by reducing private sector borrowing costs. Abbas and others (2013) discuss this in further detail.

7

Periods of prolonged high unemployment can cause hysteresis effects, as the long-term unemployed permanently drop out of the labor force and lower the potential labor supply (Blanchard and Summers, 1986).

8

See Kumhof and others (2010) and Anderson and others (2013b) for a description of the GIMF model and its properties.

9

Anderson and others (2013a) define the “core euro area” as including: Austria, Belgium, Estonia, Finland, France, Germany, Luxembourg, the Netherlands, the Slovak Republic, and Slovenia.

10

For the core EA, the individual indicator indexes (e.g., the index for EPL) are based on a GDP (in PPP terms) weighted average of the structural indicators of the countries that constitute the core EA group, which are then combined into an overall product and labor market reform index. We use the overall product market reform indicator. Five labor market indicators are combined into a single labor market index (the underlying labor market characteristics are the same indicators as Anderson and others (2013a)). We use the OECD’s ALMP measure, unemployment benefits’ average replacement rate (ARR) of income, the EPL index, public spending on childcare (as a proxy for policies that support female labor force participation), and the implicit tax on continued work at older ages (based on old-age pensions).

11

Anderson and others (2013a) show in simulations that mimic a weak economy (i.e. labor demand is inelastic) that reforms, such as reducing the ARR of unemployment benefits, may take time to improve employment. The rationale is that when the economy is in a slump, reductions in the reservation wage of unemployed workers may incentivize job search, but it might take time for labor demand to pick up. Moreover, cutting unemployment benefits in a downturn may reduce the income of households with a high marginal propensity to consume (hand-to-mouth consumers).

12

See the Selected Issues Paper, Chapter II, Finland: Structural Health Check.

13

See the Selected Issues Paper, Chapter II, Finland: Structural Health Check.

14

See the Selected Issues Paper, Chapter III, Finland: Stylized Facts on Innovation and Growth for more details.

Finland: Selected Issues
Author: International Monetary Fund. European Dept.
  • View in gallery

    Rise in Spending due to Aging, 2010–60

    (Percent of GDP)

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    Rise in General Government Spending, 2007–14

    (Percent of GDP)

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    Simulations for Frontloaded and Phased-in Fiscal Adjustment Paths

    (Percent and percent of GDP, respectively)

  • View in gallery

    Structural Reform Simulations

    (Percent and percent of GDP, respectively)

  • View in gallery

    Deviations from Baseline Output Levels

    (Percent)

  • View in gallery

    Simulations for Combined Fiscal Adjustment and Structural Reform Scenario

    (Percent and percent of GDP, respectively)

  • View in gallery

    Sweden: Contributions to Primary Balance

    (Percent of GDP)