Abstract
This paper examines Iceland's expenditure policy, especially five expenditure pressure points, as well as capital flows and monetary policy effectiveness in small open economies. The postcrisis fiscal adjustment demanded painful choices, with spending on healthcare, education, and investment suffering cuts in real terms. While expenditures in these areas have rebounded more recently, there is a room for further decompression. Using quarterly panel data for 18 advanced and emerging small open economies during 2002-15, it finds that monetary policy is focused on inflation developments, but also that domestic interest rates affect capital flows, raising concerns about a reinforcing loop between monetary policy and capital flows.
Expenditure Policy in Iceland: Moving Beyond the Crisis1
This chapter examines Iceland’s medium-term public expenditure challenges. The post crisis fiscal adjustment demanded painful choices, with spending on healthcare, education, and investment suffering cuts in real terms. While expenditures in these areas have rebounded more recently, there is room for further decompression. Disability and pension spending also pose challenges, although these are related to longer-term demographic and labor market issues. With the public debt ratio falling rapidly, the budget will record significant interest savings going forward. This will permit a reconsideration of expenditure priorities.
A. Context
1. Iceland’s financial crisis severely disrupted its public finances. On the expenditure side, the human impact demanded a substantial increase in social benefits even as the state incurred large debts recapitalizing the central bank and various financial institutions; interest costs rose accordingly. On the revenue side, all main revenue categories suffered significant declines.
2. The fiscal consolidation that had to follow achieved results. The general government’s overall deficit was cut from more than 12 percent of GDP in 2008 to ½ percent in 2015. The gross debt ratio has fallen by almost 30 percentage points from its peak of 95 percent of GDP in 2011.
3. There was a mix of revenue and expenditure measures, some of which were painful and unpopular. On the revenue side, the authorities introduced a series of temporary tax measures including a wealth tax and a levy on bank liabilities as well as permanent increases in corporate and value added tax rates. On the expenditure side, spending on healthcare, education, and investment were reduced in real terms, while spending on social benefits increased.
4. Iceland is now in the latter stages of unwinding its fiscal response to the crisis. Some temporary revenue measures, such as the wealth tax, have been removed. The improving economic situation has allowed important tax reforms to go ahead, including steps to improve the efficiency of the value added tax system and simplify the personal income tax regime. Expenditures on social benefits have receded as the economy has returned to growth and job creation. Temporary government programs to reduce household indebtedness are drawing to a close.
5. The prospect of significant interest savings opens up an opportunity for Iceland to reconsider its spending priorities. Thanks to the windfall receipts from the old bank estates and continued prudent fiscal policies, Iceland is on track to achieve its statutory objective of reducing the net debt ratio to 30 percent of GDP or less. The lighter debt load will generate interest savings of some 2 percent of GDP. At the same time, the recently passed Organic Budget Law requires the government to submit to parliament a Statement of Fiscal Policies outlining its medium-term strategy. This provides a rallying point for the requisite public dialogue.
B. Five Expenditure Pressure Points
6. This chapter examines five expenditure pressure points that Iceland needs to address over the medium term. The first three of these are health, education, and public investment, which bore the brunt of the post crisis consolidation; there is a need to transition them out of crisis mode and arrive at medium-term expenditure plans more consistent with a stable resource envelope. The fourth pressure point is disability spending, which did not experience any step change with the crisis; it has been increasing steadily for a number of decades. The fifth pressure point is pensions.
Healthcare
7. Public expenditure in the healthcare system has become a charged topic. There is concern about growing waiting lists, the centralization of care facilities, and recruitment difficulties. Industrial relations in the sector have been turbulent, with a pay dispute in 2015 leading to strikes by medical staff followed by a wage agreement that spilled over into large nationwide awards. The European Social Survey suggests people’s subjective assessment of their own health and mobility as of 2012 had deteriorated relative to 2004. Over the same period, subjective assessments of happiness also deteriorated, marginally, suggesting deteriorating perceptions on health could be linked to wider dissatisfaction.
Subjective Assessment of Happiness and Wellbeing 1/
(Index)
Higher scores = better.
Scores are normalized on 100.
8. Grumblings are rooted in the fiscal consolidation. The national hospital was a major target for cost containment. Efforts were made to shift patient volumes from inpatient to outpatient care. The number of doctors on call was reduced, which limited overtime payments. Diagnostic testing was scaled back, the number of hospital beds cut, and some support services downsized. Iceland also introduced measures to increase copayments while ensuring that low income and vulnerable households were exempt. Between 2009 and 2011, health expenditures fell by around 8 percent in real terms. The reductions in pharmaceuticals and specialized hospital services were particularly significant. More recently, health spending has recovered somewhat in real terms.
Government Health Expenditure
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: Statistics Iceland.Government Health Expenditure
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: Statistics Iceland.Government Health Expenditure
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: Statistics Iceland.9. Notwithstanding the dissatisfaction, Iceland continues to have one of the most impressive public healthcare systems in the world. The legislative framework guarantees universal access to mental, physical, and social healthcare irrespective of ability to pay. Life expectancy stands at 83 years, the highest in Iceland’s Nordic and North Atlantic peer group. Infant mortality is just 1.5 per thousand, which is also the lowest in the peer group. Other headline health outcome indicators, such as the incidence of tuberculosis, HIV, cancer, and heart disease, and alcohol and cigarette consumption, all compare favorably with Iceland’s peer group.
General Health Information 1/
(Per 100,000 unless otherwise indicated)
Latest available data.
General Health Information 1/
(Per 100,000 unless otherwise indicated)
| Belgium | Finland | Iceland | Ireland | Netherland | Norway | Sweden | UK | Peers | EU | |
|---|---|---|---|---|---|---|---|---|---|---|
| Crude Death Rate (per 1,000 people) | 9.8 | 9.5 | 6.7 | 6.5 | 8.4 | 8.1 | 9.4 | 9.0 | 8.7 | 10.1 |
| Per Capita Health Expenditure | 4526.1 | 3604.1 | 3645.8 | 3867.1 | 5601.1 | 6307.8 | 4243.8 | 3310.7 | 4494.4 | 3009.5 |
| Public Health Expenditure (percent of GDP) | 8.5 | 7.1 | 7.3 | 6.0 | 10.3 | 8.2 | 7.9 | 7.6 | 7.9 | 6.4 |
| Total Health expenditure (percent of GDP) | 11.2 | 9.4 | 9.1 | 8.9 | 12.9 | 9.6 | 9.7 | 9.1 | 10.1 | 8.7 |
| Life Expectancy at Birth (years) | 80.4 | 80.8 | 83.1 | 81.0 | 81.1 | 81.5 | 81.7 | 81.0 | 81.1 | 79.1 |
| Maternal Mortality Ratio | … | 5.5 | … | 6.0 | 7.0 | 6.0 | 4.5 | 7.0 | 6.0 | 7.2 |
| Infant Mortality Rate (per 1,000 live births) | 3.3 | 1.9 | 1.6 | 3.0 | 3.2 | 2.0 | 2.4 | 3.5 | 2.8 | 3.8 |
Latest available data.
General Health Information 1/
(Per 100,000 unless otherwise indicated)
| Belgium | Finland | Iceland | Ireland | Netherland | Norway | Sweden | UK | Peers | EU | |
|---|---|---|---|---|---|---|---|---|---|---|
| Crude Death Rate (per 1,000 people) | 9.8 | 9.5 | 6.7 | 6.5 | 8.4 | 8.1 | 9.4 | 9.0 | 8.7 | 10.1 |
| Per Capita Health Expenditure | 4526.1 | 3604.1 | 3645.8 | 3867.1 | 5601.1 | 6307.8 | 4243.8 | 3310.7 | 4494.4 | 3009.5 |
| Public Health Expenditure (percent of GDP) | 8.5 | 7.1 | 7.3 | 6.0 | 10.3 | 8.2 | 7.9 | 7.6 | 7.9 | 6.4 |
| Total Health expenditure (percent of GDP) | 11.2 | 9.4 | 9.1 | 8.9 | 12.9 | 9.6 | 9.7 | 9.1 | 10.1 | 8.7 |
| Life Expectancy at Birth (years) | 80.4 | 80.8 | 83.1 | 81.0 | 81.1 | 81.5 | 81.7 | 81.0 | 81.1 | 79.1 |
| Maternal Mortality Ratio | … | 5.5 | … | 6.0 | 7.0 | 6.0 | 4.5 | 7.0 | 6.0 | 7.2 |
| Infant Mortality Rate (per 1,000 live births) | 3.3 | 1.9 | 1.6 | 3.0 | 3.2 | 2.0 | 2.4 | 3.5 | 2.8 | 3.8 |
Latest available data.
Healthcare Expenditure
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Healthcare Expenditure
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Healthcare Expenditure
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
10. Iceland has a good track record of containing healthcare costs. Since 1998, public expenditure on healthcare has remained broadly stable at around 7–8 percent of percent of GDP. This ratio compares well with Iceland’s peer group, a doubly impressive result given that Iceland’s dispersed population is a challenge to keeping costs down. The health sector maintains two university hospitals (one in Reykjavík, the other in Akureyri). These hospitals provide services to a lower population density than in most of Europe.
11. Nonetheless, going forward, Iceland needs to address growing demographic challenges confronting its healthcare system. Long-term expenditure projections suggest healthcare costs could rise by around 4 percent of GDP. Demographic pressures are already evident in recent expenditure patterns. Despite strong cost containment efforts, expenditures on nursing homes have increased substantially in recent years.
Education
12. As in healthcare, cost containment in education also played a major role in the fiscal consolidation. Between 2009 and 2013, annual education expenditure fell by about ½ percent of GDP, although it has recovered somewhat subsequently. The education system is a shared responsibility between the central and municipal governments, with the municipalities responsible for the operation of preschools and primary and lower secondary schools, and the central government for upper secondary schools and universities.
Education Expenditure
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: Statistics Iceland.Education Expenditure
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: Statistics Iceland.Education Expenditure
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: Statistics Iceland.13. Iceland’s education system has scored important achievements in terms of equity. Within the OECD, it has one of the lowest achievement gaps across schools (Ministry of Education, 2015) and one of the lowest percentages of students in low performing, socio economically disadvantaged schools (OECD, 2016). Enrollment in early childhood programs is almost universal.
14. Nonetheless, there are some grounds for concern. There is evidence that educational attainment has weakened slightly in recent years (OECD, 2016):
Iceland’s 2012 mathematics scores for 15 year olds under the OECD’s Programme for International Student Assessment (PISA) system are broadly in line with the OECD average but considerably lower than the Nordic and North Atlantic peer group.
Iceland’s PISA scores for reading and the sciences are considerably lower than both the OECD and peer group averages.
In all three subject areas—mathematics, reading, and the sciences—Iceland’s PISA scores in 2012 were weaker than in 2009.
15. Iceland is also struggling with educational standards within its upper secondary education and vocational training systems (OECD, 2016). Many attainment indicators are below the relevant OECD averages. A major challenge is the drop out rate. Many students fail to complete their courses, citing the structure and quality of upper secondary education as reasons for their decision to leave education. The proportion of adults who have not completed an upper secondary education stands at 30 percent, one of the highest ratios in the OECD.
Comparative Performance of Iceland’s Education System
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: OECD.Comparative Performance of Iceland’s Education System
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: OECD.Comparative Performance of Iceland’s Education System
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: OECD.16. The sector is also experiencing human resource management difficulties. According to the OECD (2014 and 2016), salaries for teachers fell in real terms over 2006–12. The teaching profession is also aging: in 2012, almost half of all secondary school teachers were over 50 years old.
17. The authorities are seeking to address these issues. In 2015, the Ministry of Education published a White Paper on education reform. It set out two goals to be achieved by 2018: (i) at least 90 percent of students should meet the minimum reading standards, up from 79 percent; and (ii) at least 60 percent of upper secondary students should graduate on time, up from 44 percent.
Public Investment
18. Public investment fell particularly sharply in the post crisis period. In 2015, public investment was 2.9 percent of GDP; in the two decades prior to the crisis, it averaged 4.7 percent of GDP. The data do not support suggestions of a pre crisis public investment boom: public investment rates prior to the crisis were close to their long-run historical averages.
Public Investment
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: Investment and Capital Stock Dataset.Public Investment
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: Investment and Capital Stock Dataset.Public Investment
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: Investment and Capital Stock Dataset.19. The extended period of expenditure compression has started to reduce the public capital stock. In 2012, the capital stock reached a tipping point where capital depreciation rates were larger than gross investment rates.
20. Iceland is accumulating a growing list of public investment projects. The most urgent sector is healthcare, where there are widespread demands to replace the national hospital. A new hospital is planned, a public investment that could cost as much as 5 percent of GDP. Furthermore, municipal public investment, which accounts for around 40 percent of total general government public expenditure, has been low since the crisis.
Capital Stock
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: Investment and Capital Stock Dataset.Capital Stock
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: Investment and Capital Stock Dataset.Capital Stock
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: Investment and Capital Stock Dataset.Disability Benefits
21. For several decades, outlays on disability benefits have risen, as a percentage of both GDP and total revenues. Moreover, levels are high compared to other advanced economies. This trend of higher outlays runs counter to the general improvement of health sector indicators, where survey data on perceptions of personal health show the proportion of Icelanders reporting they are in “good” or “very good” health as higher than the OECD average (OECD, 2013).
22. The underlying causes of rising disability expenditures are complex. Like many OECD countries, Iceland has experienced a profound change in the composition of its disabled population with around one third of recipients suffering from mental health related problems. Extended periods of mental health related sick leave have led to high inflows into long-term disability benefits. Another one third suffers from musculoskeletal difficulties. Recent changes in the structure of economic activity toward lower skilled tourism related jobs have arguably reduced the options for disabled workers seeking to reintegrate into the labor force.
Disability Expenditure
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Sources: Eurostat; and Statistics Iceland.Disability Expenditure
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Sources: Eurostat; and Statistics Iceland.Disability Expenditure
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Sources: Eurostat; and Statistics Iceland.23. Measures to reintegrate recipients of disability benefits into the labor market have the potential to lift growth and create additional room for other public spending. Many disabled workers likely could reenter the labor force given active labor market policies, especially training and job search support. Conversely, with human capital deteriorating over long spells of disability, the probability of leaving the disability benefits regime falls with time. This can lead to marginalization, with its concomitant risks of poverty and exclusion.
Public Pensions
24. As a consequence of past reforms and prudent management, the Icelandic pension system provides high pension payments at a comparatively low cost to the public sector. As an early adopter of pension reform, Iceland had by the mid 1990s established a well funded three pillar system. A publicly financed first pillar offers a minimum level of income for retirees, which is withdrawn above a certain income level. A mandatory and private second pillar, as generous as it is well funded, requires pension funds to secure a minimum benefit of 56 percent of previous salary, provided the retiree has contributed for at least 40 years. A voluntary and private third pillar offers individuals the option of making tax exempt contributions.
Pensions
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: IMF staff calculations.Pensions
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: IMF staff calculations.Pensions
Citation: IMF Staff Country Reports 2016, 180; 10.5089/9781498313551.002.A001
Source: IMF staff calculations.25. There is, however, one segment with a funding shortfall: three public sector pension funds for workers who have chosen to remain in the pre reform system. Although these funds have accumulated sizable assets, they are unable to cover all of their future pension liabilities.
26. The Icelandic authorities provide transparent actuarial estimates of this shortfall, currently put at some 24 percent of GDP. These estimates are explicitly included in the general government balance sheet. Absent reforms to address this shortfall, projections suggest the government will have to inject around 1 percent of GDP annually into the funds starting in 2030 and continue to do so until 2060, although the precise timing of the public sector intervention will depend on future returns from the existing stock of assets.
27. This high level of transparency has ensured that there is a widespread acknowledgement of the issue across civil society. Indeed, the problem is widely understood to be one of the main long-term fiscal challenges facing the country. However, the authorities are also concerned that the issue is poorly understood outside Iceland, given that the bulk of the pension system is well funded. While the headline figure of 24 percent of GDP seems large, this cost is spread over several decades and it is manageable,
28. The government has announced that commencing in 2017 it will inject about 0.3 percent of GDP annually into these pension funds. There is also a live debate about whether part of the failed bank estates’ stability contributions should be channeled toward this shortfall, with proponents arguing that such use of funds would be consistent with the statutory objective of paying down the public debt.
C. Conclusions
29. Iceland’s fiscal policy priorities are evolving. The crisis related necessities—in particular, fiscal consolidation and debt reduction—have subsided. The fiscal position has moved decisively into balance and the public debt ratio is now firmly on a downward trajectory.
30. With fiscal risks subsiding and substantial interest savings on the horizon, there is an opportunity to reexamine public expenditure priorities. Given the receipts from the bank estates and prudent fiscal management, interest costs are projected to fall by around 2 percent of GDP. This opens up choices on how best to use the additional room for maneuver. After several years of necessary but painful restraint, growth enhancing expenditures on education, health, and investment need to decompress. In recent budgets, health and education expenditures have started to recover. However, capital spending remains at historically low levels. There is also need to rationalize expenditures on social protection, which jumped during the crisis and stay elevated despite subsequent job creation, and disability outlays, which have grown steadily over the last two decades. Furthermore, there remains the public pensions shortfall, a legacy of an otherwise successful pension reform in the 1990s. This latter issue is manageable if a modest but steady annual stream of resources is allocated to ensure these pension funds are fully financed by 2030.
31. The new Organic Budget Law requires the authorities to provide a comprehensive statement of fiscal policies. This will provide an opportunity to identify a set of public expenditure priorities that could play a decisive role in promoting strong, sustainable, and equitable growth over the medium term without jeopardizing ongoing efforts to cement fiscal sustainability.
References
Ministry of Education, Science and Culture, 2015, “White Paper on Education Reform” Ministry of Education, Science and Culture, Reykjavik, http://eng.menntamalaraduneyti.is/media/frettir2015/Hvitbok_ENSKA04.pdf
Ministry of Education, Science and Culture, 2013, “OECD Health Data”, OECD Health Statistics (Database).
Ministry of Education, Science and Culture, 2014, “Education at a Glance 2014,” Country Note: Iceland, OECD Publishing, Paris, http://www.oecd.org/edu/Iceland-EAG2014-Country-Note.pdf.
Ministry of Education, Science and Culture, 2016, “Education Policy Outlook 2015: Making Reforms Happen,” OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264225442-en
Prepared by Jimmy McHugh and Mark Albertson (both FAD).
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Prepared by Marco Arena (EUR) and Tahsin Saadi Sedik (MCM).
Changes in international short-term interest rates need not feed one for one into domestic short-term interest rates, depending on the behavior of the exchange rate and the risk premium. But, given that sharp exchange rate changes may have effects on the domestic economy, central banks may intervene to dampen the effects on the exchange rate through sterilized foreign exchange intervention. The latter, however, may be limited in its effectiveness because it causes interest rates to increase and sucks in further inflows.
Among other papers, there are IMF (2012a), Bruno and Shin (2013a), Claessens et al. (2014), Cerutti et al. (2015), Bruno et al. (2015), and Akinci and Olmstead-Rumsey (2015).
For example, the fixed effect takes account of all time-invariant country specific factors, including geography, climate, ethno linguistic characteristics, and unchanging political and legal systems.
The ordering of GDP growth and inflation follows the one presented in the early empirical literature on monetary transmission mechanisms—e.g., Bernanke and Blinder (1992) and Eichenbaum and Evans (1995). An additional exercise was done reversing the order of the policy rate and capital flows (or real exchange rate) and the results were similar.
The credit growth variable is the quarterly growth rate of seasonally adjusted real credit to the private sector. Nominal credit is deflated by the country’s GDP deflator to calculate real credit. The data source of nominal credit is the International Monetary Statistics (IMF).
As discussed by Akinci and Olmstead-Rumsey (2015), the study uses cumulative indexes instead of quarterly changes because it is difficult to know when macroprudential regulations impose biding constraints on borrowers and lenders.
