a. Fiscal policy

Reducing debt levels and building up fiscal buffers are key priorities, as shared by staff´s assessment; the authorities are thus targeting a structural adjustment in 2019. Discretionary efforts and the growth momentum should mutually reinforce each other to reduce the government debt-to-GDP ratio and deficit levels. In this respect, the authorities are strongly committed to reversing the procyclicality exhibited by the fiscal stance in the past few years, which has widened the structural deficit by around 1 percentage points of GDP since 2015. The 2019 Draft Budgetary Plan targets a general government deficit of 1.8 percent of GDP in 2019, including a 0.4 structural adjustment effort. This path would imply attaining a primary surplus for the first time since 2007 (of 0.6 percent of GDP). Furthermore, it would bring forward an acceleration in the pace of debt reduction, which is projected to fall from 97.0 percent of GDP in 2018 to 95.5 percent in 2019, the biggest decline since 2014.

The 2019 Draft Budgetary Plan (DBP) is compliant with the requirements under the Stability and Growth Pact (SGP) of the EU and has been broadly endorsed by the Independent Fiscal Authority (AIRef). The authorities share staff´s view that the structural adjustment is a fundamental objective and take note of its word of caution in the design of the budget, in order not to deviate from fiscal targets. Spain will exit the Excessive Deficit Procedure and the corrective arm of the SGP with a deficit below 3 percent of GDP in 2018. For 2019, notwithstanding the EU Council recommendation of a 0.65 percent of GDP structural adjustment, the targeted 0.4 adjustment is compliant with the Stability and Growth Pact, considering the flexibility embedded therein. AIReF has endorsed the macroeconomic scenario underpinning the 2019 DBP, and considers the budgetary provisions feasible, albeit its central scenario estimates point at a slightly higher deficit for 2019 of 1.9 percent of GDP. The authorities will closely monitor budgetary execution throughout 2019 to avoid target deviations. The 2019 draft budget law is scheduled to be brought forward for Parliamentary discussion in December and the authorities are working to obtain the required parliamentary support. It should be noted the Spanish budgetary provisions contemplate the extension of the 2018 budget into 2019 until a new budget is approved, preventing any paralysis or gridlock in public administration.

The fiscal strategy is based both on increasing revenues and better-targeted social and growth-friendly spending. There is room to increase general government revenues considering that the revenue-to-GDP ratio in Spain is estimated to be at 38.5 percent of GDP in 2018, well below the euro area average (46.2). Furthermore, the taxation system is partly outdated, with the bases of some taxes having been considerably eroded over the past few years and new forms of economic activity not contributing according to their revenue-generating capacity. The 2019 DBP projects this ratio to go up to 39.1 percent, because of both cyclical factors and an estimated €5.7 billion in new discretional measures, which have been designed considering their revenue stream, progressivity, and environmental impact. They include, among others: a reform of the corporate income tax to ensure a minimum effective rate of 15 percent, increases in personal income and wealth taxes for the higher brackets, new taxes on financial transactions and certain digital services, increased taxation on diesel (environmental tax), and legal reforms to reduce tax fraud and tax evasion. The expenditure-to-GDP ratio is expected to go down to 40.9 (from 41.2 in 2018), as expenditures will grow at a slower pace than nominal GDP. The budget includes a reorganization of expenditures and a new package of up to €4.3 billion tailored to enhance social cohesion and productivity growth, including: an increase in long-term care expenditures, the reinstatement of the unemployment subsidy for workers over the age of 52, the progressive equalization of paternity leave to current maternity leave, or increases for scholarships and R&D&I expenditures.

The pension system reform needs a comprehensive approach. The authorities share the staff’s view on the importance of a pension system that is both financially and socially sustainable. Last May, due to strong social demand, the previous government decided upon an increase in pensions in line with inflation for 2018 and 2019, above the legal provision of a 0.25 percent annual increase. This decision has later been endorsed by all political parties at the “Pacto de Toledo” (the Parliamentary committee dedicated to the pension system) with the aim of recovering pensioners’ purchasing power. The authorities are well-aware of the budgetary implications that this measure would potentially have in the long-run and are approaching the necessary pension reform from the comprehensive perspective embedded in the Pacto de Toledo’s twenty-one policy recommendations (sources of finance, contribution rate, non-contributive pensions, pensionable earnings) with a view to attaining a sustainable system in the long run.

Further steps to strengthen regional finances have been adopted and gender budgeting has been introduced. The government has set up a decision group to advance in the reform of regional financing and to reinforce regional compliance with deficit targets. New measures include establishing the procedure for a gradual return to market financing of financially-sound regions, the long-term refinancing of short-term, and better incentivizing compliance with a new spending rule that allows investment of regional surpluses, but only in financially sustainable investments. The 2019 DBP plan introduces gender budgeting which evaluates the gender impact of the different budget items and reinforces those with larger potential to reduce gender inequality.

b. Labor market policy

Labor market policies seek to continue reducing unemployment as well as addressing problems of labor market duality or in-work poverty, among others. Unemployment remains well-above euro area average, not only in aggregate ratios (14.9 percent vs 6.7 percent) but also for youth (33 percent vs 14.6 percent) and long-term unemployment (6.6 percent vs 3 percent). The rate of temporary contracts at 26.8 percent remains the highest in the EU. In parallel, productivity gains have not been fully translated into wage increases. Furthermore, the share of workers at risk of poverty is the second highest in the euro area. Addressing these labor market deficiencies is crucial to the objectives of productivity growth and reducing inequality.

These objectives require a multifaceted approach. The authorities share staff´s view that a comprehensive approach should be pursued when addressing labor market reform including, for instance, the reinforcement of the education system and active labor market policies to increase human capital and address skill mismatches—here, the Government has announced new legislation to develop a dual vocational training model and to enhance the digital and language skills of the youth, while employment subsidies will be revised and reduced to focus only on the most vulnerable groups.

There is also a need to fine-tune labor market regulation to promote better-quality employment, including through increasing the minimum wage. The last reform dates back to 2012 and was designed in a context of recession. New measures will include streamlining the number of contractual modalities, as well as new requirements to register working time to avoid an inadequate use of part-time contracts. The authorities are also assessing collective bargaining taking into account its impact in a wide range of labor market outcomes, such as wages, employment, productivity or job environment, and have already introduced some measures such as the increase of the minimum wage to €12,600 in 2019, as well as measures to fight against excessive rotation in the workplace (the so-called “Master Plan for Decent Work,” launched in July 2018 with significant effects already in the very short-term). The authorities take note of the staff´s caveats with respect to the increase in the minimum wage, that said:

§ The minimum wage is currently very low in Spain and previous experience suggests that raising it will likely have no substantial impact on job creation. The minimum wage remained flat during the period 2010–2016 and the proportion of the minimum wage over the mean wage, at only 33 percent, is among the lowest within the OECD. The announced increase would raise this ratio to around 40 percent, in line with the OECD average. There is no consensus in the literature on the employment effects of the minimum wage. While, on average, studies tend to show small negative effects on employment, these are often not significant, and the results are not robust to alternative specifications. In this respect, the experience in Spain shows a large absorption capacity of increases in minimum wages, especially in high growth periods: the increases of 2004 (11 percent) and 2017 (8 percent) were consistent with an acceleration of job creation in the following years, particularly significant in the case of youth employment. In parallel, the empirical evidence suggests a positive impact on domestic demand stemming from the increased consumption of minimum wage workers, as well as a reduction in poverty rates.

c. Structural reforms

The root causes of low productivity growth in Spain are multifaceted, including deficiencies in education, the prevalence of micro and small firms, or an insufficient investment in R&D. In Spain the share of young adults (25–34 years old) below upper secondary education is 33 percent, way beyond the OECD average of 14 percent, which partially explains the high share of low-skilled workers in the labor force. R&D investment is comparatively low, since 2000 the ratio of R&D spending over GDP has averaged 1.2 percent of GDP, which is well below its European peers. Additionally, the contribution of micro and small-sized enterprises (with lower average productivity levels) to employment in the non-financial business sector in Spain was 59.5 percent, almost 10 pp above the EU average.

In this context, the authorities are committed to devising a comprehensive strategy cutting across different policy dimensions and with an adequate sequencing. In this vein, we thank staff for providing particularly useful regional analysis in the areas of labor mobility and productivity, with some interesting policy implications in the fields of education, labor mobility, R&D spending, and ALMPs. The 2019 DBP aims to increase outlays on education and R&D spending. Additionally, the authorities are considering measures to improve the business environment (by removing obstacles to business growth and start-up creation) and to enhance the application of the Market Unity Law, strengthening the degree of coordination among regions. Other measures include the deployment of the 5G National Plan and regulatory changes in the pipeline to improve the functioning of some network industries, such as railways or energy.

Environmental and gender policy issues also rank high in the Government’s agenda; staff’s insights on these policy areas would be welcomed. These policies are not only key for achieving an equitable society from an intergenerational and a gender point of view and are also instrumental to improving productivity and long-term potential growth. The authorities are drafting a new comprehensive Law on Climate Change and Energy Transition to steer the transition towards a low-carbon economy. This could lead to higher growth given Spain´s competitive edge on renewable energies. On gender policy, the gender perspective of the 2019 DBP aims for greater gender inclusion. Furthermore, eliminating gender pay gaps also has a high potential growth impact by raising women’s participation rates. For future Article IV reports authorities would welcome further staff analysis on these areas profiting from their comparative advantage in drawing from international practices.

d. Financial sector

Spanish banks are steadily increasing their resilience. The Spanish banking system has made important efforts for reducing the volume of impaired assets in the last few years. Thus, non-performing loans have diminished by 60 percent compared to 2013, when they reached a peak, and foreclosed asset have been cut by 40 percent since its ceiling in mid-2012. This adjustment has been a crucial contributor to the recovery of profitability, that now is above the European average, although it is still reduced form a historical perspective. In this context, solvency ratios are well above the regulatory standards; in fact, compared to December 2014 (the first full year of application of Basel III prudential standards), in 2017 capital ratios had increased by almost 2 pp for total capital (up to 15.4 percent), and by roughly 1 pp in highest quality CET1 capital (up to 12.7 percent). The recently released 2018 EU-wide stress tests produced by the European Banking Authority (EBA) reflect this resilience and capacity to withstand tail risk scenarios. The authorities share staff´s view on the importance of continuing to strengthen bank capitalization to close the remaining gap with European peers. They also share staff´s views on the need for continued vigilance of growth in consumption credit and property prices, which nonetheless remain contained. On the exposure to emerging markets, as highlighted by staff, Spanish banks operate with an autonomous subsidiary model, whereby subsidiaries are self-financed and do not receive intragroup support. Moreover, parent banks hedge against most exchange rate risks.

The authorities are stepping up the reform of the institutional set-up of surveillance, including through the creation of a national macroprudential authority and a fintech regulatory sandbox. The government has announced the creation of a national financial stability authority (ANESFI), which complies with the 2011 ESRB recommendation to create a macroprudential authority. The projected new authority will be comprised of representatives from the Ministry of Economy and Business, Banco de España and CNMV, and it will be empowered to issue opinions, warnings and recommendations. Macroprudential tools will remain under the responsibility of the sectoral supervisors while, following the recommendations under the 2017 FSAP, the toolkit of Banco de España will be expanded to include borrower-based measures, sectoral countercyclical buffers and limits to sector credit concentration. The government has already closed a public consultation on a draft Law to establish a Regulatory sandbox to allow FinTech startups and other financial entities to conduct live experiments in a controlled environment under regulatory supervision.