Selected Issues Paper

Abstract

Selected Issues Paper

Status of Fiscal Adjustment and Challenges Ahead1

Questions, Answers, and Possible Objections

What are the specific questions this chapter tries to answer? How was the fiscal adjustment under the program designed and implemented? How could a more growth-friendly debt reduction be achieved, providing fiscal space for targeted fiscal measures to support growth? Is additional public investment spending warranted to support growth? How can fiscal policy contribute to corporate deleveraging, higher employment, and improving the skills composition of the labor force?

Why is answering these questions important for this Article IV consultation? High public indebtedness remains a significant vulnerability, with only a gradual decline projected over the medium-term under staff’s baseline scenario. Further fiscal adjustment is essential to accelerate the downward trajectory of public debt, and minimize scope for a significant worsening of debt dynamics, should downside risks materialize. While growth has resumed, the recovery is projected to be modest, creating a challenge for policymakers to balance the need for further fiscal adjustment with the potentially negative implications for growth.

What are the main answers to these questions? Fiscal consolidation achievements were substantial, but largely relied on revenue measures and capital spending reductions (¶6 to ¶10). Spending growth has proven difficult to contain across levels of government, and the adoption of expenditure targets and institutional reforms would help underpin spending rationalization (¶11 to ¶15). Identifying specific policy measures to rein in spending will be critical, with a focus on public sector wages and pensions (¶16 to ¶26). Targeted tax policy measures could help to address bottlenecks to growth created by high corporate indebtedness and labor slack (¶27 to ¶33). While there is little fiscal space for scaling up public investment to support growth, education reform can have a positive impact on the skills composition of the labor force (¶34 to ¶39). In order to sustain reform momentum, the authorities need to institutionalize fiscal reform management and move toward a more policy-oriented approach (¶40 to ¶42).

What could be possible objections to these answers? The government faces significant legal constraints to implementing a more expenditure-oriented fiscal adjustment. While further expenditure rationalization is needed, defining adjustment in structural terms would not provide a useful operational target given considerable uncertainty in estimating potential output. Expenditure rationalization should better account for generational equity issues; the burden of adjustment so far has been heavily oriented toward the current workforce.

Portugal has made significant progress in its fiscal consolidation, overcoming structural and legal challenges, in the context of a sharp fall in output. Still, the debt-to-GDP ratio remains high (130.2 percent of GDP at the end of 2014), with the pace of economic recovery projected to be modest. Over the medium-term, the authorities face the challenge of balancing the need for further fiscal adjustment to reduce debt vulnerability, with the potentially negative implications for growth.

This SIP takes stock of fiscal consolidation under the Fund-supported Extended Arrangement from 2011–14, and proposes measures to increase the productivity of spending and make space for targeted reforms aimed at promoting higher competitiveness and growth. Institutional processes to manage the implementation of fiscal reforms should also be enhanced to deliver more efficient spending going forward.,

Status of Fiscal Adjustment

A. Build-up of Imbalances Prior to the Crisis

1. An expansionary fiscal policy and the materialization of fiscal risks led to a rapid run-up in Portugal’s public debt since 2007. Gross public debt nearly doubled from 2006 to 2014, when it reached 130 percent of GDP. About two-thirds of this increase has been due to fiscal deficits—the result of loose fiscal policies since euro adoption, and adverse interest rate differentials. The global financial crisis aggravated the fiscal position, as stimulus policies led the deficit to reach 11.2 percent of GDP in 2010 in the context of low growth.

2. A significant expansion of social spending over the last decade was at the root of the fiscal deterioration. The fiscal space created by the decrease in sovereign yields as Portugal moved into the euro area was more than offset by permanent spending increases; public expenditure increased by more than 9 percentage points of GDP over the period from 2000–2010. In particular, spending on social benefits rose sharply, reaching 20.3 percent of GDP in 2012, up from 12.2 percent of GDP in 1995.2

3. The deterioration of the fiscal position was accompanied by aggressive off-budget spending, leading to a buildup of substantial contingent liabilities. Portugal adopted one of the largest PPP programs in the world, with cumulative investment of 15 percent of GDP; on average, this implied higher fiscal deficits by roughly 1 percent of GDP over the period in which these concessions were granted (1995–2010). Similarly, the state-owned-enterprise (SOE) sector expanded greatly, often to circumvent stricter policies applied to the general government entities, minimizing the short-term impact on the deficit and debt indicators. In the aftermath of the global financial crisis, the financial imbalances accumulated in SOEs and PPPs led to the reclassification of a number of these entities within the general government, adding over 10 percent of GDP to the stock of public debt.

B. Program Intervention and Implementation to Date

4. The strategy under the Fund-supported Extended Arrangement envisaged a sharp fiscal consolidation. This was primarily designed to restore market confidence through a credible front-loading of measures. The fiscal path was built on the SGP objectives of stabilizing debt through a sharp improvement in the primary balance, and achieving a fiscal deficit of 3 percent of GDP by 2013, compared to 9.1 percent of GDP in 2010 (according to ESA95).

5. An ambitious fiscal structural program was also adopted to support the consolidation efforts. Reforms aimed at streamlining the functioning of the public sector in order to reduce fiscal risks. Priority was given to: (i) better monitor and reduce arrears, and strengthen commitment controls to prevent expenditure overruns; (ii) design sub-national government financial arrangements; (iii) enhance the management and reporting of fiscal risks arising from PPPs and SOEs, and; (iv) reinforce tax compliance and modernize tax and customs administration.

6. Portugal made significant progress in its fiscal consolidation efforts over the period of the program. The government has achieved primary structural adjustment of about 8.7 percent of GDP since 2010, despite weaker-than-expected economic activity and less favorable tax and social contribution bases - which were partly accommodated through recalibrations of the program targets. As a result, Portugal has achieved a significant structural primary surplus since 2012, and a significant reduction in the overall fiscal deficit. However, this was still short of original program objectives.

uA03fig01

Fiscal Balances

(percent of GDP)

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Sources: INE and IMF staff estimates.
uA03fig02

Overall Fiscal Balance

(percent of GDP)

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Sources: INE and IMF staff estimates.

7. The fiscal adjustment effort has relied to a larger extent on revenue measures than originally planned. The original program request in 2011 focused on the unsustainable level of expenditure and envisaged an adjustment based primarily on expenditure consolidation; three-fourths of the planned fiscal consolidation from 2011–2013 was expected to come through an across-the-board spending adjustment. However, efforts to reduce the public wage bill and rein in pension expenditures have been hindered by recurrent adverse rulings by the Constitutional Court (CC). As a result, the authorities relied to a larger extent on revenue-based measures to achieve program targets, with nearly half of the 8.7 percent of GDP structural primary adjustment achieved from 2011–2014 coming from higher revenue.

8. The bulk of the spending consolidation came from capital spending, while current spending proved more difficult to reduce (Table 1). General government capital spending was reduced by about 3 percent of GDP under the adjustment program (2010–2013), while current spending continued to increase (1.4 percent of GDP). Non-interest current spending declined by 0.7 percent of GDP from 2010–13 thanks to reductions in public sector wages and intermediate consumption. However, these savings were partially offset by further increases in social benefits, which rose by 1.7 percent of GDP.

Table 1.

General Government Spending by Economic and Functional Classifications

article image
Sources: Eurostat (ESA 2010) and IMF staff calculations

9. From a functional perspective, the reduction in spending was concentrated in the economic and security sectors (Table 1). Between 2010 and 2013, savings in the security sector and economic sector (driven by a sharp decline in transport spending) exceeded total expenditure reduction. Cuts in health (mainly on medical products and outpatient services) and education (particularly on primary and secondary education) were fully offset by higher social protection spending, driven by public pension outlays. General public services outlays significantly increased on the back of higher debt service payments.

10. Debt sustainability considerations remain a significant constraint on fiscal policy. On current policies, assuming limited structural adjustment after 2015, gross public debt would remain at 121 percent of GDP by 2020; even assuming a structural adjustment of ½ percent of GDP per year, in line with the European Treaty on Stability, Coordination, and Governance (SGP) framework, public debt would still remain about 112 percent of GDP. The associated sizable gross financing needs and continued substantial macro-fiscal risks will require further consolidation and limit the scope for active fiscal policies to support growth.

11. However, there is considerable scope to re-orient the composition of spending to be more supportive of growth. Despite the large fiscal adjustment achieved in recent years, spending consolidation has been uneven across levels of government. Real primary spending growth has outpaced real output growth for all levels of government since 2000, particularly in the social security sector (Table 2), highlighting the role of weak expenditure control in the build-up of fiscal imbalances prior to the crisis. By comparison, real growth in primary spending in euro area countries has been broadly in line with real output growth over the same period.

Table 2.

Primary Spending in Portugal and the Euro Area by Levels of Government

(percent of GDP)

article image
Sources: Eurostat and IMF staff estimates.Note: Spending by levels of government includes transfers across levels of government, which are netted in general government data.

C. Creating Fiscal Space for Growth-Enhancing Measures

General Government Expenditure Targets

12. The introduction of multi-year real primary expenditure targets would help to underpin a fiscal adjustment based on spending rationalization. Empirical evidence suggests that spending rules are associated with expenditure containment, higher primary balances and have a higher likelihood of compliance than other fiscal rules.3 This would help mitigate spending pressures, and ensure that future adjustment focuses on spending reform rather than further revenue measures, given that Portugal’s tax burden has risen at twice the pace of the euro area, and significantly faster than other large southern European countries.4 In addition, excluding interest payments from the expenditure rule would neutralize the impact of shifts in financial market conditions on interest costs and help to ensure that savings from favorable current market conditions are applied to debt reduction.

uA03fig03

General Government Revenue

(percent of GDP)

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Sources: Eurostat and IMF staff estimates.

13. Portugal has experience with spending rules at the national level, but has not yet implemented the expenditure benchmark of the Fiscal Compact. Since 2012, Portugal’s medium-term budget framework (MTBF) has set spending ceilings for 10 high level programs for the budget year plus one, and a binding overall spending limit for budget years plus two and three. Portugal has also integrated the “expenditure benchmark” of the SGP in its national legal framework, which requires real growth in primary expenditure to remain below the medium-term growth rate of potential GDP (for countries which have not yet reached their Medium Term Objectives). However, this has yet to be implemented.5

14. Real primary expenditure targets should preferably be set to achieve the annual structural adjustment called for under the SGP. This would provide a tool for implementing an expenditure-based structural adjustment.6 Estimates show that keeping real primary expenditures unchanged in real terms from 2016–20 would be consistent with the annual structural adjustment objective of 0.5 percent of GDP (Table 3). It would reduce primary spending by 2.7 percent of GDP over 2016–2020, compared to a projected stabilization in the passive scenario. This is actually slightly lower than the adjustment called for in the authorities’ April 2015 Stability Program (SP), which targets a reduction in primary spending of 3.3 percent of GDP from 2015–19.7 Public debt to GDP ratio would be reduced by more than 14 percent of GDP over the same period, about 9 percentage points below the level in the passive scenario.

Table 3.

Primary Expenditure Growth Under Passive and Adjustment Scenarios

article image
Sources: INE and IMF staff calculations.

15. Institutional changes would be required to ensure that a spending rule could be operational and sufficiently binding. While the current medium-term fiscal strategy sets a nominal target for general government expenditure, it does not provide a breakdown by levels of government. Expenditure ceilings currently set in the MTBF only cover central government, and exclude expenditure financed by own-source revenues.8 In order to ensure their effectiveness, real primary expenditure objectives should cover all general government expenditure, and be sufficiently binding to anchor fiscal policy at all levels of government. This would require setting indicative aggregate spending targets for local governments9 and social security funds either in the medium-term fiscal strategy or a specific fiscal law, with the recently created intergovernmental coordination council being responsible for monitoring local government outturns. Mechanisms to monitor and adjust spending should be designed, such as incentives for local governments (linking the level of central government transfers to achieving the expenditure target),10 or alert mechanisms for health spending, with the obligation to adopt in-year corrective actions in case of spending slippages. An extension of the MTBF would also be needed to better capture central government spending, in particular spending financed by their own revenue sources.

16. Specific policy measures to contain spending should be identified to enforce the expenditure targets, with a focus on public sector wages and pensions11. Public sector wages and pensions account for nearly 25 percent of GDP and more than half of non-interest government spending. Wage bill expenditure has been significantly reduced in Portugal under the program, and is now below the euro area average, as well as most southern European countries. Reduction in public sector employment was sizable across levels of government and SOEs from 2011–2014 (Table 4). However, the sustainability of these savings is uncertain, as many of the public sector wage cuts introduced under the program are set to be reversed by 2016, in line with the CC rulings (see below). Public spending on pensions has continued to increase, although at a slower pace since 2010, and remains significantly above the euro area average.

Table 4.

Public Sector Employment (2011–14)

(number of employees)

article image

Some SOEs were reclassified in the general government in line with ESA2010, and are not excluded consistently over the 2011-September 2014 period.

Source: Authorities (DGAEP).
uA03fig04

Compensation of Public Employees

(percent of GDP)

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Sources: Eurostat and IMF staff estimates.
uA03fig05

Public Pension Expenditure

(percent of GDP)

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Sources: OECD and IMF staff estimates.

Public Sector Employment and Compensation

17. The CC decisions create significant legal obstacles to reining in the public sector wage bill. In particular, the CC requires: (i) the fiscal consolidation burden to be shared between civil servants and the rest of the population; and (ii) wage bill consolidation to take place through structural reforms of public employment, rather than nominal cuts in wages. As a consequence, the public sector wage cuts introduced under the program will be partially reversed in 2015, and are expected to be fully cancelled by 2016, at a cost of 0.3 percent of GDP. These legal restrictions necessitate a more strategic approach to restraining the wage bill over the medium term. The main challenge for Portugal will be to build a more competent public administration, while reducing both public employment and the wage premium relative to the private sector.

18. There is considerable scope for rationalization of the public sector to reduce duplication and streamline public interventions. The public sector in Portugal is highly fragmented, with 6,095 separate institutional units.12 This is particularly the case for central government, which comprises 331 units, including 298 autonomous funds and services (SFAs) that carry out policy and operational functions. In the absence of strong control to ensure compliance with budgetary and financial regulations, this fragmentation was one of the root causes of fiscal slippages prior to the financial crisis. There has been some progress on consolidating financial reporting of these various entities under the program, including reclassification of 141 SOEs within the general government,13 the privatization or dissolution of about half of local SOEs, and a reduction by nearly one third in the number of parishes responsible for administration of the municipal level. However, Portugal still counts a very large number of SOEs outside the general government, and a reflection is needed on the role and functions of the various levels of government in Portugal going forward.14 In this regard, the authorities should prepare a comprehensive strategy to modernize the public sector, building on an in-depth assessment of the appropriate level of employment needed to deliver public services.

19. A further reduction in public employment, particularly in overstaffed sectors, is needed over the medium term. Increasing the rate of natural attrition would provide a gradual approach to rationalizing public employment, and would generate savings in both the short and medium term. While across-the-board attrition would be easier to implement, it may have an adverse impact on service provision in certain sectors. As a result, the authorities should target overstaffed sectors, including the education sector, where staffing needs will fall in line with the declining school-age population (see paragraph 42). This should be complemented by enhancing the requalification pool and scaling up the scheme for termination by mutual agreement, which has resulted in fewer departures than expected thus far. In addition, the increase in required working hours (to 40 hours week) should be forcefully enforced across the public sector, in particular in local governments.

20. A key objective should be to reduce the disparity between public and private sector wages. 15 At present, lesser qualified workers receive relatively high pay in the public sector compared to both peers in the private sector and more highly skilled civil servants. In addition, the wage grid is relatively flat and depends mostly on years of experience, rather than performance. This makes it difficult to attract highly qualified staff, as private sector opportunities (with lower entry salaries but steeper increases for performance) are considerably more attractive.16 In order to become more attractive for highly-skilled workers and benefit from ongoing improvements in the quality of tertiary education,17 the civil service should identify specific skills that are needed in the public sector, and revised the relatively flat wage structure that proves costly and impairs talent attraction in these areas.18

21. Further measures are also needed to containing the wage drift embedded in the current system.19 When progression is automatic, average wage levels rise as the public sector workforce becomes more experienced, even in the absence of wage and employment increases.20 In past years, Portugal has been characterized by a powerful automatic progression system, which has translated into an early attainment of a high level wage in most occupational careers, and particularly for high-skilled workers.21 The authorities have already replaced the automatic progression mechanism with a system in which promotions and salary increases are now linked to the results of the staff appraisals, and subject to budget constraints. To prevent any relaxation of these changes, the authorities could further slow down automatic progression by lengthening the maximum duration for a civil servant in each scale level. This could be anchored on the successive extensions of the retirement age decided over the recent period (see below), and would make career progression more gradual to avoid an early attainment of high level wages.

Pension System

22. Portugal has implemented a number of reforms to the pension system in recent years. These measures include: (i) the introduction of a “sustainability factor” in 2007 linking initial benefits with improvements in life expectancy at retirement; (ii) the increase in the legal retirement age to 66 years, with further automatic increases linked to the evolution of life expectancy; (iii) the suspension of pension indexation (excluding the minimum pensions); and (iv) the creation of a solidarity surcharge levied on higher pensions. For the public sector, a “convergence law” entered into force in March 2014, aligning the rules for the public sector pension scheme (CGA) with the changes for new entrants to the general social security system.

23. However, the impact of these changes on pension expenditure has been limited by legal roadblocks and an excessive backloading of savings. The CC rulings have ruled out a number of changes to the pension system implemented under the program, imposing a requirement that reforms must be structural, with due consideration to equity and intergenerational solidarity, and without affecting acquired rights.22 In addition, the design of the reform would generate savings only over the longer term due to extensive grandfathering rules that protect current retirees; public pension spending is expected to stabilize only after 2020 and at a relatively high level (13.5 percent of GDP).23

24. In addition, Portugal’s public pension system remains inequitable, and will face major adverse demographic changes in the long run. After accounting for social transfers and pension outlays, the risk of poverty for the population over 65 years of age in Portugal is broadly in line with the rest of the EU. However, the risk of poverty faced by the share of the population under the age of 65 in Portugal is much higher, which threatens to increase non-contributory pension spending in the long term. In addition, demographic trends are unfavorable, with the dependency ratio in Portugal expected to more than double by 2050 to become the highest in the EU.

uA03fig06

At Risk of Poverty Rate after Social Transfers and Pensions in EU countries, 2012

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Source: Eurostat.Note: Dashed lines represent EU medians.
uA03fig07

Projected Old Dependency Ratio in EU Countries

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Source: Eurostat and IMF staff estimates.

25. Further pension reforms should aim to limit indexation and shorten the transition period. First, indexation mechanisms (based on GDP growth and CPI) that were suspended during the adjustment program should be revisited (except for minimum pensions). While low growth and inflation are expected to contain pension dynamics in the near term, a more sustainable formula is need to prevent a pro-cyclical increase in pension spending going forward. Second, the authorities should reduce grandfathering for those who are not yet retired, and tighten some of the pension eligibility rules, particularly for those who would receive pensions from the CGA (the pension scheme for civil servants hired until December 2005). Reinstating the suspension of early retirements in the private sector (which was introduced in 2012 and lifted in 2015) could also be considered. Finally, employees’ contribution to CGA could increase over time to improve the financial sustainability of the scheme; for example, an increase by one point of employees’ CGA contribution would provide about 0.1 percent of GDP of additional revenues annually.

26. A more systemic reform could further strengthen automatic adjustment mechanisms of pensions. In addition to the adjustment of benefits to account for improvements in life expectancy introduced under the program, an economic adjustment factor could be implemented. This could be applied to pension bonuses that were reinstated by the CC, conditioning the payment of these bonuses on achievement of a certain level of GDP growth, as in Hungary. Pensions could also be adjusted to ensure the financial sustainability of the system as in Sweden, by estimating the actuarial balance for the overall pension system and adjusting benefits in line with any deterioration of this balance.

D. Supporting Growth Through Targeted Fiscal Measures

Growth-Friendly Tax Policy

27. Growth-friendly tax policy recommendations typically consist of corporate tax reform and increased incentives for labor force participation. Corporate income taxes are generally considered to be the most harmful type of tax for economic growth, followed by personal income taxes and then consumption taxes. 24 Corporate taxes are deemed to discourage capital accumulation and productivity improvement, and often introduce a bias toward the use of debt finance.25 Therefore, a shift from direct income tax to indirect consumption tax is usually considered to be supportive of growth, as consumption taxes create less of a distortion on saving and investment decisions. In addition, increasing tax incentives for private research and development spending is often recommended as way to support innovation and boost productivity growth. This section will review recent developments with regard to tax policy in Portugal, and consider possible reforms to support long-term growth.

28. The implicit tax rate on labor is favorable in Portugal, while capital taxation is comparatively high. In 2012, labor taxation in Portugal was significantly lower than both the euro area average and other southern European countries, while the implicit taxation of capital was significantly higher. Recent developments have been positive, moreover, with a decline in the implicit taxation on capital and an increase in the share of indirect taxation, in particular VAT. However, the implicit taxation of labor increased during the program period, primarily through higher personal income tax (PIT).

uA03fig08

Implicit Tax Rates by Functional Classification

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

* Excluding Greece, Luxembourg, and Malta.Sources: European Commission, IMF staff estimates.
uA03fig09

Change in Implicit Tax Rate by Functional Classification (2009–2012)

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

* Excluding Greece, Luxembourg, and Malta.Sources: European Commission, IMF staff estimates.

29. Recent CIT reform should help create a business environment that is conducive to higher investment. In 2013, Portugal adopted a comprehensive reform package to address deficiencies in the corporate income tax (CIT) regime. The comparatively high CIT rate was reduced from 25 percent in 2013 to 21 percent in 2015, while the reform of tax provisions applicable to holding corporations should help to attract and retain large multinational companies in Portugal. In addition, several previously ineffective investment tax incentives were revised in 2014, to offer higher CIT credits, particularly for investment in poor regions, information and communication technologies, and SMEs.

30. Tax incentives for research and development in Portugal comparable favorably with peer countries, with little need to expand the current framework. The Portuguese tax system appears supportive in this regard, both for large firms and SMEs, as well as for profit-making and loss-making companies. The 2013 CIT reform also introduced intellectual property incentives for income derived from patents, and extended the carry-forward period for R&D spending.

uA03fig10

Tax Subsidy of R&D Expenditures, 2013

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Sources: OECD Science, Technology and Industry Outlook 2014.
uA03fig11

Tax Subsidy of R&D Expenditures, 2013

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Sources: OECD Science, Technology and Industry Outlook 2014.

31. Going forward, reforms should focus on eliminating capital tax-induced distortions to growth, and reducing informality and tax avoidance. The authorities have committed to further reductions in the standard CIT rate. However, priority should be given to elimination of the state CIT surcharge, as its progressive rates create distortions in investment decisions. To partially finance these tax cuts, the authorities could remove tax incentives for investment in the medium-term, as removing the preferential tax treatment created by the surcharge should help to improve the quality of investment.26 An increase in the standard VAT rate could also partially offset the CIT reform fiscal costs, and would further shift the tax burden from income to consumption (an additional 0.5 percentage point would increase revenue by about 0.2 percent of GDP). Revenue administration reforms could also support growth by further lowering compliance costs, and reducing tax avoidance; the authorities have launched a major campaign to improve tax compliance in 2015.

32. The introduction of a deduction for corporate equity would reinforce recent changes to reduce corporate debt bias and help bring down corporate indebtedness. Tax systems typically favor corporate debt over equity, as interest payments are deductible for CIT purposes while dividend payments to shareholders are not.27 The large debt burden in Portugal continues to have a significant adverse impact on both corporate investment and bank balance sheets. Portugal has progressively limited the deductibility of interest for companies in order to reduce the debt bias and prevent multinational debt shifting practices, line with common practice in the EU.28 This could be complemented by introducing an allowance for corporate equity (ACE) providing a deduction for the normal return on equity, equivalent to the rate of government bonds (a proxy for risk-free rate of return on capital). Estimates for selected advanced countries suggest that an ACE would have a significant impact on both corporate deleveraging, and output gains.29 Tentative calculations indicate that an ACE for advanced countries would involve an average budgetary cost of 0.5 percent of GDP. Revenue cost can be significantly mitigated through adequate design, by applying the ACE only to new investment, as recently implemented in Italy.

33. Other tax policy reforms can complement labor market reform. Disincentives to labor participation in the current system are particularly high for low-income families that may lose social benefits if a second earner enters the labor force. Possible reforms include the introduction of an earned-income tax credit that would separate employers’ labor cost from workers’ take-home pay.

More Productive Public Expenditure to Support Growth

34. The need to scale up investment spending is limited following a significant increase in public investment in Portugal in the two decades before the crisis. Public infrastructure investment is typically considered to have a positive impact on output growth, in the short term through demand effects and the crowding in of private investment, and in the long term by raising productive capacity.30 In addition, debt-financed projects could have large output effects without increasing the debt-to-GDP ratio, if clearly identified infrastructure needs are met through efficient investment. However, these arguments appear less applicable in the case of Portugal. First, the high level of public debt limits the scope to increase borrowing for further investment without a potentially large adverse impact on financing costs. Second, public investment in Portugal has been significantly higher than in the euro area for a long period of time before the crisis, resulting in a large and high quality public capital stock. Moreover, the level of the public capital stock is likely underestimated due to the large role of public-private partnerships (PPPs) and SOEs reported outside the general government (Figure 12) in public investment.31

Figure 1.
Figure 1.

Public Investment

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Sources: Sources: Center for International Comparisons (2013); OECD; WEO; and IMF staff estimates.1/ Data include PPPs managed by the central government, and not local governments.

35. Priority should be given to maintaining the quality of capital stock. If Portugal and other euro area countries were to maintain their current level of public investment in the long term, estimates show that Portugal’s capital stock would converge to the euro area level by 2022 (even with the drop in public investment in Portugal in 2013–14). However, in the absence of increased spending on maintenance, Portugal’s public capital stock would significantly deplete afterward and return to its 1993 level by 2030. The near-term priority, therefore, should be to ensure that maintenance spending is sufficient to prevent rapid deterioration in the quality of infrastructure, particularly in the transport sector where private and public maintenance spending have been low in comparison to other advanced economies.

uA03fig12

Transport Maintenance

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Sources: OECD International Transport Forum, and IMF staff estimates.

36. There is considerable scope to improve both the efficiency of education outlays and education outcomes in Portugal. Education spending rose significantly before the adjustment program (+0.7 percent of GDP over 2000–2010), particularly on second and tertiary education. Despite a subsequent decrease, it remains above the EU average, and significantly higher than other southern European countries with higher GDP per capita. Average class size in Portugal was significantly below the 2012 EU average in primary education, with significantly lower student-teacher ratios at the secondary level. However, this has not been accompanied by a commensurate improvement in outcomes. Despite higher average growth in attainment rates in Portugal than the EU average over 2000–2012, education attainment remains lower, both for tertiary and non-tertiary educations. Portugal PISA scores significantly improved between 2003 and 2012, but remain below the EU average in mathematics and science.

Figure 2.
Figure 2.

Education Spending

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Sources: Eurostat, UNESCO, and OECD PISA.

37. Going forward, there is a need to better align the level of staffing with the shrinking school-age population. Teachers benefit from a significant wage premium compared to other workers with tertiary education, and significantly above the EU average. In addition, staff costs as a share of current spending (92.1 percent, for public institutions only) were the highest in the EU in 2011 (average of 77.2 percent).32 The overall number of students in the education system in Portugal fell by 2.4 percent between 1998 and 2012, meanwhile, and is projected to continue to decline. The number of students at the primary level is expected to shrink by 13 percent during 2010–20 and a further 9 percent during 2020–2030, with a commensurate decline in the number of secondary students as they move through the system.33 Further adjustment to the school network and the number of teacher will be needed as a result, particularly in rural areas where the pace of population decline is much more accelerated.

uA03fig13

Education Attainment

(Percent of population 25–34 age)

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Source: OECD PISA.
uA03fig14

Education Performance in 2012

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Source: OECD PISA.

38. Ambitious structural reforms have been launched to improve the quality of education services. Portugal has significantly stepped up its education reform agenda in recent years, including both the rationalization of the school network and a reduction in staffing. Future priorities include a new vocational training system to better match private sector needs,34 a program to reduce school early dropout and low rate of education attainment, and a transfer of decision making to the local level.35 Policy reforms could also include reducing grade repetition, better supporting disadvantaged students and schools, increasing family choices, strengthening teachers training and evaluation, and further decentralizing decision making.

39. Finally, pension reforms could contribute to higher labor force participation. Portugal has put in place bonuses to postponing retirement. The following reforms can also contribute to higher labor participation, particularly for low-skilled workers: (i) increasing the reward for additional years of contributions for low income workers by widening the range of minimum pensions by years of contribution; and (ii) the minimum pension could be set to increase in strict proportion to the number of years of contributions, hence eliminating the current steps increases (at 20 and 30 years of contributions) which create incentives for informality.

uA03fig15

Evolution of Student population in Portugal, 1998–2012

(Number of students by level of education)

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A003

Source: OECD PISA.

E. Improving Management and Implementation of Fiscal Reforms

40. The Fund-supported program provided institutional arrangements to discuss and monitor fiscal reforms, and offered leverage to ensure effective implementation. A reform unit (ESAME) was created within the Prime Minister’s office to centralize and manage policy discussions on structural reforms. Following the end of the Fund-supported program, this unit was dissolved, and its functions integrated in the Ministry of Finance. Various ad-hoc committees were also put in place to carry public policy evaluations, such as the expenditure review in 2012, and more recently on pension reforms. Finally, the program provided the authorities with a framework for monitoring and assessing the implementation of structural reforms, including in the fiscal sector.

41. Institutionalizing fiscal reforms management will be essential to maintain this momentum over the medium term. This would include establishing mechanisms whereby changes are anticipated and options for reforms evaluated on a daily basis36, helping to ensure appropriation by civil servants, and reinforcing a reform culture within the public administration. Reliance on ad-hoc and temporary commissions and working group to prepare policy reforms should be reduced, in order to ensure continuity in the reform agenda, and horizontal coordination between services on a routine basis. A reform unit within the Ministry of Finance, under the authority of the Minister, could coordinate the public sector reform agenda and provide regular reporting to the Prime Minister’s Office. This unit could usefully build on the current GPEARI structure and staff, and should heavily rely on the expertise and staff of core departments within the Ministry of Finance.

42. The Ministry of Finance should continue moving toward a more policy-oriented approach, particularly with regard to budgeting. In many advanced countries, recent reforms have promoted a broader strategic perspective, with a medium-term approach that focuses on improving the efficiency of service delivery, assessing the impact of policies, and managing and mitigating risks.37 In Portugal, the budget function is currently geared toward detailed line-item budgeting and control, and lacks a more programmatic view of the budget and public sector reforms. Recent changes in fiscal reporting; fiscal forecasting and budgeting are in the right direction38, however, while the reorganization of the Portuguese Budget Office (DGO) should provide an institutional framework that is more conducive for analyzing drivers of public spending. The Ministry of Finance should aim to build on these changes by embedding its spending review into the annual budget process, and putting in place a performance-based budget framework to better evaluate the efficiency of spending.

References

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  • Cangiano, Marco, 2013, “Considerations on Public Sector Reforms in Portugal,” Bank of Portugal Seminar 2013.

  • European Commission, 2014, “The Economic Adjustment Program for Portugal 2011–2014,” Occasional Papers 202.

  • De Mooij, Ruud, 2011, Tax Biases to Debt Finance: Assessing the Problem, Finding Solutions,” Staff Discussion Note 11/11.

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1

Prepared by Maximilien Queyranne (FAD) and Matthew Gaertner (EUR). The authors would like to thank Marco Cangiano, David Coady, and Ruud de Mooij (all FAD) for helpful suggestions, and the authorities for useful comments.

2

Approximately 3 ppts of GDP is attributed to the reclassification of hospitals in the general government.

4

The increase in GG revenue as a share of GDP does not only reflects changes in tax policy and revenue administration performance (numerator), but also GDP changes (denominator)

5

As the expenditure benchmark does not apply to countries subject to the Excessive Deficit Procedure (EDP).

6

Evidence suggest that expenditure target defined in relationship with GDP are less binding, as GDP targets are often set too high for ensuring fiscal constraints. See IMF WP 15/29, 2015.

7

The SP targets a decrease in public debt to 107.6 percent of GDP by 2019. In addition to the larger reduction in primary spending, this also reflects a larger projected decline in interest spending and stronger medium growth than under staff’s baseline scenario. The SP assumes real GDP growth of 2.4 percent in 2019, compared to staff’s projection of 1.2 percent.

9

Local governments have been developing MTBFs, but there is no consolidation for the local government sector as the whole.

10

The 2013 Local Finance Law created an early warning mechanism for local governments that break the debt ceiling rule. This mechanism could also be used to monitor expenditure growth.

11

This also aligns with the fiscal plans outlined in the Stability Program, which target expenditure savings of 2.5 percent of GDP from 2015–19 from rationalization of the public sector wage bill and social security reform.

14

M. Cangiano, Bank of Portugal Seminar, “Considerations on Public Sector Reforms in Portugal”, 2013.

17

In 2012, 28 percent of the 25-34 year-olds had achieved tertiary education, compared to 11 percent of the 55–64 years-olds.

19

There are usually two components in the wage drift: a positive one which increases wage spending (impact of discretionary promotion, automatic progression, and promotion related to civil servants passing competitive exams), and a negative one which reduces wage spending (savings due to lower level of compensation for new employees compared to higher level of compensation for employees retiring).

22

The following measures were cancelled: (i) the suspension of the holiday and the Christmas allowances for public pensioners; (ii) the new calculation formula for surviving dependants’ pensions; (iii) the reduction in pension benefits granted within the pension scheme for the public sector; and (iv) the progressive sustainability contribution on pensions. As a result of the cancellation of the progressive sustainability contribution, increases in employee’s social security contributions and in the standard VAT rate were also cancelled. Source: European commission, Occasional Papers 202, 2014, “The Economic Adjustment Programme for Portugal 2011–2014.”

27

See IMF Staff Discussion Note 11/11, Tax Biases to Debt Finance: Assessing the Problem, Finding Solutions, 2011.

28

The cap has been set to €1 million in net interest payments, and has been limited to a percentage of the EBITDA (from 70 percent in 2013 to 30 percent in 2017). In addition, the CIT rate cuts adopted in 2014 will contribute to limit the bias toward debt as less tax is saved at lower rates.

30

See IMF, World Economic Outlook, Chapter 3, October 2014. Demand effects are usually expected to be stronger where accompanied by economic slack and monetary accommodation, as in Portugal.

31

Central government SOEs investment in fixed assets was about 0.4 percent in 2012 and 2013, net of government investment grants for private and public investment (0.3 percent of GDP).

34

European commission, Occasional Papers 202, “The Economic Adjustment Program for Portugal 2011– 2014, 2014.

37

R. Allen, and al., forthcoming IMF Working Paper, “The Evolving functions and Organization of Finance Ministries”.

Portugal: Selected Issues
Author: International Monetary Fund. European Dept.