Finland: Selected Issues

Abstract

Finland: Selected Issues

Reducing the Negative Growth Impact of Fiscal Consolidation: A Modeling Excercise Using GIMF1

The Finnish government has announced a set of fiscal consolidation measures worth about 1.7 percent of GDP on net basis over the next four years. Our analysis indicates that the implementation of these fiscal consolidation measures would affect output negatively in the short run. However, it also suggests that the negative effect on growth could be mitigated by changing the composition of revenue and expenditure measures. Furthermore, the envisaged growth package could also help to offset some of the negative effects on output.

A. Introduction

1. In this chapter we examine policy challenges related to the government’s planned fiscal consolidation. The consolidation is needed to address aging related spending pressures and ensure long term fiscal sustainability as well as compliance with the SGP. However, in the short-term, the consolidation can threaten the already fragile growth. Weaker growth could have a direct negative effect on fiscal outcomes and further present a less conducive environment for the government’s structural reforms to take hold. Therefore, the fiscal policy challenge is to ensure long-term sustainability while at the same time promoting a growth-friendly adjustment in the short run.

2. The analysis confirms that the fiscal consolidation package could be structured to have a smaller negative impact on output. We use the IMF’s Global Integrated Monetary and Fiscal Model (GIMF) to quantify the real impact of the government’s consolidation package as well as with alternative compositions. First, we analyze the potential macroeconomic impact of the envisaged fiscal consolidation, based on our current understanding of the government’s plans. As a second step, for illustrative purposes, we seek to improve the growth-friendliness of the fiscal package, using an expenditure and revenue neutral shift in measures. We also discuss the effect on output of the envisaged growth package.

3. The chapter is organized as follows. Section B describes the GIMF model and its calibration. Section C presents the analysis of the fiscal consolidation package and the alternative scenarios. Section D presents Finland specific considerations and Section F concludes.

B. The GIMF Model and Simulation Design

4. The impact of fiscal consolidation and structural reforms is simulated using the IMF’s GIMF model. 2 GIMF is a general equilibrium model that features nominal and real adjustment costs and incomplete asset markets. The model allows simulations to incorporate the effect of the monetary policy regime in evaluating the impact of fiscal policy. It features forward-looking households and firms optimizing their objective functions subject to given constraints. The model also includes frictions such as sticky prices and wages, real adjustment costs, and liquidity constrained households with finite planning horizons, leading to an important role for monetary and fiscal policy in affecting macroeconomic conditions.

5. GIMF is well suited to analyze fiscal policy questions. The non-Ricardian features of the model provide non-neutrality of both spending-based and revenue-based fiscal measures: contractionary fiscal policy dampens the level of economic activity in the short run while lower government expenditure encourages higher private investment in the longer term. Fiscal policy is modeled using seven tax and expenditure categories, while imposing that the government respects its long-term inter-temporal budget constraint. Specifically, government spending can take the form of consumption, investment expenditure or lump-sum transfers, to either all (general) households or targeted towards liquidity-constrained households. Government investment spending augments public infrastructure, which depreciates at a constant rate over time. Taxation includes labor and corporate income taxes as well as consumption (VAT) taxes.

6. The standard calibration of the model is augmented with additional information for Finland. The share of non-tradable sector accounts for roughly 60 percent of the economy. Markups are calibrated such that the non-tradable sector price markup is 20 percent versus 35 percent for the rest of the euro area. The calibration is consistent with a value added of 40 percent for the tradable sector price markup. 3 In addition, we consider a 4-region version of the GIMF model, based on Finland, the Nordic region, the euro area, and the rest of the world.

C. Fiscal Consolidation in Finland

7. Based on the government’s announced consolidation measures, we assume a fiscal adjustment worth about 1.7 percent of GDP on a net basis over four years. The fiscal consolidation measures announced by the government amount to about 2 percent of GDP. However, some planned tax reductions, starting next year, will effectively spend some of the gains. In addition, consolidation measures pertaining to foreign aid are not expected to impact Finnish economic performance. Taking account of these factors, we assume the net cutbacks to amount to 1.7 percent of GDP over a four year period.

  • Expenditure reductions account for about ¾ of the planned consolidation measures, where education, foreign aid, and social benefits are targeted for some of the most substantial cuts. Specifically, some of the areas where cuts are planned include: compensation for consultation with private doctor and dentist, child allowance, adult education allowances, financial aid for students, ending of job alternation leave, and abolition of parental leave holiday accrual. Furthermore, the government is planning cuts to unemployment benefits as well as reducing public investment in new projects and in particular transport infrastructure projects.

  • Revenue raising measures include unemployment insurance taxes which will increase by 0.1 percent of GDP per year in 2016–17. Fees and fines on several health and social services will also be raised. Other revenue measures include phasing out the tax deducibility of mortgage interest more rapidly than previously planned and gradually increasing excise taxes on alcohol, tobacco, and sweets. In addition, with the goal to increase tax revenues, a tightening of the corporate tax base is planned together with active efforts to combat the shadow economy. These revenue raising measures will be largely offset by tax reductions, including on the earned income deduction, capital, and corporate taxes. The car tax will also be lowered in favor of low-emission cars.

8. The impact of the proposed fiscal consolidation can be simulated with GIMF. The fiscal measures envisaged by the authorities, as described above, are mapped to the seven fiscal instruments available in GIMF. The numbers in each column of the Table 1 below represent the fiscal consolidation effort for each of the instruments made every year as percent of GDP.4 E.g., on the basis of the current government plans, consumption tax revenues are expected to increase 0.05 percent of GDP in 2016, 0.12 percent of GDP the following year, etcetera.

Table 1.

Fiscal Consolidation Effort, Percent of GDP

article image
Source: Fund staff estimated calculations.

9. The planned fiscal consolidation has a negative effect on output in the short run. The combination of revenue and expenditure measures would have a cumulative negative effect on output of about 1.4 percent relative to the baseline of unchanged policies (Figure 1).5 It is assumed that the government’s fiscal consolidation is perceived by economic agents to be fully credible, where households and firms believe policies to be immediate and permanent. Therefore, firms and households are adjusting their behavior as expected, starting in the first year of the fiscal consolidation package. Output would revert to positive territory in the medium term.

Figure 1.
Figure 1.

Fiscal Consolidation

Citation: IMF Staff Country Reports 2015, 312; 10.5089/9781513517162.002.A003

Source: Fund Staff Calculations

10. Revenue neutral shifting of taxation from direct to indirect taxes could increase the incentives to work and invest and thus output. The balance of the literature suggests that corporate income taxes have the most negative effect on growth, followed by labor income taxes, than consumption taxes, and finally property taxes.6 High tax wedges are found to increase aggregate unemployment and associated with lower employment prospects.7 Thus, shifting taxes away from the labor factor and toward consumption offers strong potential for growth gains. Indeed, Bouis and Duval (2011) find that reducing labor tax wedges has the potential to deliver sizeable employment gains in many OECD countries. Allard and others (2010) show that transferring the tax burden from labor-related tax to VAT in the euro area would increase the incentive to work and hire labor, which would consequently increase the labor supply and real GDP. Shifting the tax burden from corporate taxes to VAT would similarly increase the return on capital and thus investment and real GDP.

11. In addition, a “fiscal devaluation” achieved through tax switching could help competitiveness. Moving from the taxation of final goods according to where they are produced to their taxation according to where they are consumed is essentially equivalent to an exchange rate devaluation because such a shift effectively brings imports into tax and takes exports out. Thus the essence of a “fiscal devaluation” lies in the shift away from production-based taxes and towards destination-based ones. Specifically, this shift would offset the revenue loss by increasing broad-based destination-based taxes, such as the VAT. The most common form of “fiscal devaluation” mentioned in the literature comprises a combination of a reduction in the social contributions paid by employer and an increase in VAT. The literature also shows that “fiscal devaluation” with a revenue-neutral shift from employer’s social contributions towards value added tax increases output and employment.8

12. Shifting expenditure from transfers to investment could also raise output. Expenditure measures, particularly changes in government investment, tend to have higher multipliers than revenue measures. Empirical literature such as Spilimbergo and others (2009) suggest that in advanced economies, as a rule of thumb, government consumption multipliers are 0.5 or less in small open economies, with smaller values for revenue and transfers and slightly larger ones for investment.

13. A stylized simulation for Finland confirms the positive effect on output of revenue neutral tax switching. A tax reform to shift taxation from direct to indirect taxes could promote growth by about 0.8 percent. This effect could be achieved with a tax reform package which lowers labor and corporate tax rates by 0.75 and 0.25 percent respectively and is offset by a 1 percent increase of the consumption tax (VAT) rate. On one hand, the consumption tax increases would affect negatively the consumers’ marginal propensity to consume immediately. On the other hand, the direct tax cuts would not have as large an offsetting effect on the behavior of households and firms. Therefore, consumption would fall initially but would increase in the medium and long run as the direct tax cuts boost employment and raise total consumption, which would eventually more than offset the increase in VAT. Employment would increase by 0.3 percent while real wages would decrease in the medium term but increase in the long run. Despite the real wage increase, unit labor cost would fall slightly. Competitiveness would improve since the tax cuts would affect directly the cost of capital and labor. Real exports would rise by almost 1 percent in the long run while the real exchange rate would depreciate by less than a half percent.

14. It also shows that shifting expenditures from transfers to investment would raise GDP. In our stylized model simulation, shifting government expenditure from transfers towards investment by 1 percent of GDP would have a positive effect of 2 percent on output in the long run. The highest return can be achieved by a shift toward spending on productive, well-targeted infrastructure. Improving the stock of infrastructure can make all sectors more productive as a whole. Therefore, an increase in the government investment in infrastructure could lead to long-lived and persistent gains in the productivity of the whole economy. To make the spending increase neutral, general lump-sum transfers, which have a smaller negative multiplier, are cut.

15. An alternative fiscal consolidation package could decrease the negative effect on output (Figure 1). Building on the theoretical simulations presented in paragraphs 13 and 14, an alternative fiscal consolidation package comprising tax and expenditure switching, as outlined in Table 2 below, would have a smaller negative effect on output. Under this scenario, consumption taxes are increased by 1/8 percent of GDP every year while labor taxes are cut correspondingly. On the expenditure side, the envisioned cuts to investment are applied as additional cuts to consumption. Similarly, the planned cuts to targeted transfers are added towards the general transfer cuts. Subsequently, the effect of the consolidation on output is less negative for three main reasons: (i) there are no direct cuts to investment; (ii) because of the exclusion of cuts to targeted transfers, the consumption behavior of liquidity constrained households would not be affected as much; and (iii) the direct tax cuts increase consumption in the medium and long run. As a result, overall consumption and investment are dampened less and so is output.

Table 2.

Alternative Fiscal Consolidation, Percent of GDP

article image
Source: Fund staff estimated calculations.
uA03fig01

Fiscal Consolidation Scenarios

Citation: IMF Staff Country Reports 2015, 312; 10.5089/9781513517162.002.A003

Source: IMF Staff Calculations

16. Implementing the planned fiscal consolidation in Finland together with the government’s growth package would yield a more growth friendly result. In this scenario, it is assumed that the fiscal consolidation is undertaken as described in paragraph 9 and Table 1 and is complimented by the government’s growth package as outlined in Table 3. The growth package is envisaged to account for about 0.7 percent of GDP over a three year period. However, as specific details are yet to be fleshed out, the growth package is simulated as an increase in public investment and consumption spread over three years. The results indicate that the implementation of the growth package would mitigate the initial negative effect of the fiscal consolidation and boost growth by more than 1 percent in the long run. Overall, this scenario yields more growth friendly results compared to the fiscal consolidation scenario with tax and expenditure switching. Only the effect on consumption is slightly more negative in the long run, compared to the previous scenario. This is because the government’s fiscal consolidation includes cuts to targeted transfers, which leads to a decrease in the consumption for liquidity constrained households.

Table 3.

Growth Package

article image
Source: Fund staff estimated calculations.

17. The most growth-friendly scenario comprises tax and expenditure switching together with an implementation of the growth package. An implementation of the alternative fiscal consolidation package with tax and expenditure switching as described in paragraph 15 and Table 2 together with the growth grogram, as outlined in Table 3, would have only a very small initial negative effect on output. Moreover, in the long run, this composition of measures would boost growth by more than 2 percent. This positive outcome is driven by two components. First, consumption is dampened only slightly by the consolidation as cuts are made only to general transfers and not to targeted ones. Therefore, liquidity constrained households are less affected by the consolidation. Second, investment is not affected by the consolidation and boosted by the growth package.

D. Some Finland Specific Considerations

18. The high tax wedge in Finland indicates room for improvement. The tax wedge in Finland measures above the OECD average as well as Nordic peers. In addition, all of the increase in the tax wedge between 2013 and 2014 can be attributed to higher social security contributions. In particular, increasing employer social security contributions have the largest part in the rise in the tax wedge in Finland, 0.53 percent.9 Reducing the tax wedge by shifting taxation from direct to indirect taxes could boost employment, growth, and competitiveness.

uA03fig02

Tax wedge

(Indicator, Total percent of labor cost, 2014)

Citation: IMF Staff Country Reports 2015, 312; 10.5089/9781513517162.002.A003

Sources: OECD and Fund Staff Calculations

19. How can the revenue gaps be closed in a growth friendly fashion? VAT has been the focus of most research in this area partially because its potential base is relatively easy to quantify. In addition, on average, VAT accounts for about one third of revenue in advanced economies. The standard rate is one of the revenue factors that policymakers can control. The second factor is the C-efficiency, which represents the revenue from VAT divided by the product of the standard rate and aggregate private consumption.10 For example, the C-efficiency would be 100 percent for a VAT with no exemptions, a single rate and full compliance. The C-efficiency in advanced economies is at only about 60 percent.

uA03fig03

Standard Rates of VAT

(2014)

Citation: IMF Staff Country Reports 2015, 312; 10.5089/9781513517162.002.A003

Sources: OECD and Fund Staff Calculations

20. Room for raising the VAT rate may be limited in Finland. The standard VAT rate was increased to 24 percent (from 23 percent), effective January 1st, 2013. At the same time, the reduced rate for food stuff and animal feed as well as restaurant and catering service was raised by 1 percent to 14 percent. Similarly, the remaining reduced rates were also raised by 1 percent to 10 percent.11 The VAT rate in Finland is above the OECD average but slightly lower compared to Nordic peers. However, further increases in the standard VAT rate may be problematic for Finland, as there is a general agreement between EU member states (although not a legally binding one) not to go beyond a maximum of 25 percent.12

21. However, improving the VAT C-efficiency could be an option. The C-efficiency can be decomposed into a policy gap where a 0 is applied at a single rate to all consumption and a compliance gap where a 0 indicates that the implementation of the VAT is perfect. Data indicates that the VAT rate in Finland accounts for 8.7 percent of GDP and the C-efficiency is measured at 61 with a compliance gap of 5 and a policy gap of 36. The policy gap is comparable to neighbouring peers and reflects extensive exemptions and a frequent use of multiple rates.13 Closing half of the policy gap in Finland, all else equal, would raise a very substantial 2.4 percent of GDP in revenue. A simultaneous increase in social transfers to protect the poor from the subsequent price increases would reduce the revenue gain somewhat but not eliminate it completely. 14

22. Property taxation could also help achieve a more growth friendly fiscal consolidation. Although VAT has been the focus of debate, it is not the only way in which revenue can be recouped and mitigate the negative impact of a fiscal consolidation. Taxes on residential property would have the same effect. The appeal of residential property taxation is that it has very little direct impact on production costs and thus a relatively growth friendly source of finance with untapped revenue potential. For example, Arnold (2008) concludes that property taxes, and particularly recurrent taxes on immovable property, seem to be the most growth-friendly form of revenue generation. In this analysis, the coefficient on recurrent taxes on immovable property is highly positive, demonstrating that these taxes are significantly better for growth.

23. Property taxation in Finland allows room for additional revenue generation. Property taxes, as percent of GDP, are below the OECD average in Finland and present a potential growth-friendly revenue generating option. Real estate taxes are paid annually to the municipalities, which set the tax percentage.15

uA03fig04

Tax on Property

(Total, percent of GDP, 2013)

Citation: IMF Staff Country Reports 2015, 312; 10.5089/9781513517162.002.A003

Sources: OECD and Fund Staff Calculations

E. Concluding Remarks

24. In recent years, the Finnish government has been implementing growth friendly measures. Specifically, over the past few years, steps to increase the progressiveness of the tax system and shift taxation towards indirect taxes, have been adopted. For example, the government has lowered the tax burden on low and medium-level incomes, increased VAT, adopted large reductions in mortgage interest deductibility, as well as raised environmental taxes and lowered environmentally harmful subsidies. Furthermore, the current government is considering a reduction in employer social security contributions as well as rising VAT further if needed.

25. The analysis in this chapter suggests that further revenue and expenditure shifting would help support growth. As illustrated in this chapter, the negative effect of the planned fiscal consolidation could be mitigated by a tax and expenditure switching. The growth friendliness of the fiscal consolidation could be increased further with a simultaneous implementation of the growth package. Furthermore, a more limited use of reduced VAT rates and exemptions would increase the efficiency of the VAT system, while further changes in property taxation could provide a potential source of additional government revenue.

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1

Prepared by Borislava Mircheva.

2

For a detailed discussion on the theoretical foundation and properties of GIMF see Kumhof and others (2010) and Anderson and others (2013).

4

It is assumed that cuts to investments are related to unproductive infrastructure. Cuts to targeted transfers include social assistance grants, social benefits in kind, and unemployment benefits. Cuts to general transfers comprise cuts to subsidies, partial cuts to social security benefits, and cuts to other transfers to domestic sectors.

5

The implied fiscal multiplier from this GIMF simulation is relatively large compared to the empirical fiscal multiplier estimates for Finland. While empirical fiscal multiplier estimates are more appropriate for macroeconomic forecasting purposes, the GIMF simulations have an illustrative purpose.

6

While many studies suggest the above ranking of tax instruments, the literature is not unanimous. E.g., Acosta-Ormaechea and Yoo (2012) find that a revenue neutral rebalancing from income taxes to consumption and property taxes is associated with faster long-term growth, but do not find that the corporate income tax is more harmful to growth than the personal income tax. In addition, Xing (2012) argues that the ranking of instruments is not robust to different specifications. For example, a corporate tax that falls only on rents would have quite a different effect on growth from a corporate tax falling on total returns.

8

See for example IMF Country Report 12/168 as well as Mooij and Keen (2012).

10

For a discussion on the issues regarding the measurement and interpretation of C-efficiency see Keen (2013).

13

The policy gaps for Denmark, Netherland, and Sweden are 33, 38, and 42 respectively.

14

IMF Fiscal Monitor, October 2013.

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