Public Information Notice No. 00/68

Public Information Notice: IMF Concludes Article IV Consultation with Finland

August 31, 2000

On August 22, 2000, the Executive Board concluded the Article IV consultation with Finland.¹

Background

Finland has completed its recovery from the severe recession of the early 1990s with the help of sound macroeconomic policies, and economic growth is now increasingly sustained by the sectors of the “new economy”. Real GDP increased at an average annual rate of 4½ percent over the past three years, while inflationary pressures have remained largely absent. Fiscal policies anchored on firm expenditure restraint have moved the public finances back into a sizeable surplus, and the viability of the banking sector has been restored. The expansion has been led by a very dynamic “high tech” sector, which, while still accounting for only 3 percent of employment, is generating nearly a third of the growth in real GDP.

The Finnish economy weathered the 1998-99 emerging market crisis with only a mild slowdown in economic growth, and the near-term outlook for economic activity is favorable. After a temporary slowdown in the first half of 1999, economic growth picked up toward the end of the year, driven by a sharp recovery in exports. This expansion in exports should continue in 2000-2001, as external competitiveness remains strong and the growth of domestic demand accelerates in the rest of the euro area. Domestic demand should also expand rapidly in Finland, with consumer and business confidence comforted by favorable employment and profit developments. Both the authorities and the staff project solid economic growth of the order of 5 percent in 2000 and 4 percent in 2001, with risks assessed to be larger on the upside. Consumer price inflation has picked up in the first half of 2000 to an average of around 2¾ percent, with higher oil prices and housing costs accounting for some 1 and ½ percentage points, respectively. The latter have also contributed to a rise in core inflation (excluding energy and seasonal food) from a low rate of just above 1 percent in 1999 to slightly below 2 percent in May 2000—some ¾ percentage points above the euro-area average.

The main challenges for economic policy are now predominantly of a structural nature. In particular, (i) labor productivity is well below the euro-area average, and outside the high tech sector, productivity has increased at an annual rate of only 1.3 percent over the past three years; (ii) despite a significant fall in recent years, the unemployment rate at around 10 percent is high, even by European standards, and particularly excessive among the low-skilled; and (iii) the effective labor supply is limited by a low average retirement age of 59 years, which if not tackled, will significantly exacerbate the impending demographic shock, facing all of Europe: an insufficient number of workers to support a growing population of pensioners.

Executive Board Assessment

Executive Directors endorsed the thrust of the staff appraisal, acknowledging the important role of sound macroeconomic policies for Finland’s impressive recovery from the depression of the early 1990s. The economy was now engaged in a new phase of economic expansion, and rapid growth over the past years was set to continue in 2000-01, supported by a very dynamic high tech sector. The public finances were back in surplus; the viability of the banking sector had been restored; and so far, inflationary pressures had been subdued, notwithstanding accommodative monetary conditions, supported by a very competitive exchange rate.

Nonetheless, serious problems remained on the structural front, that if not tackled promptly, could undermine the prospects for robust long-term growth and hinder Finland’s adjustment to the impending demographic shock. Symptoms could be found in low productivity growth outside the high tech sector and a high rate of structural unemployment, which, combined with a low average retirement age, was limiting the effective labor supply. These problems were not unrelated to the heavy tax burden and to persistent rigidities in product and labor markets. Moreover, while overheating was not an imminent risk, price and wage pressures could emerge over the coming years. With a shrinking pool of cyclical unemployment to be absorbed, the growth potential of the economy could be sharply curtailed, unless labor market tensions and capacity constraints were alleviated by decisive measures to improve the flexibility and the supply response of the economy.

On the fiscal front, continued restraint on the growth of public expenditures was crucial, but needed to be complemented by a significant reduction in the heavy tax burden on labor income. The government’s medium-term expenditure plans continued the process of fiscal consolidation, with sizeable surpluses cushioning the fiscal impact of growing demographic pressures, while providing scope for reductions in income taxes and social security contributions. With the favorable outlook in public finances, the government’s intention of augmenting earlier announced tax cuts was welcome, and an overall reduction in the tax wedge of about 2¼ percentage points of GDP appeared feasible over the 2001-03 period. This would be consistent with maintaining a sizeable structural surplus and imply an almost neutral fiscal stance at a time when monetary conditions in the euro area were likely to tighten. As to the composition of tax cuts, a mixed approach, combining targeted relief for low-income groups with across-the-board reductions in marginal rates, was regarded most effective in encouraging job creation at the low-skill level, while affecting performance incentives and residence decisions on a wider scale.

To avoid an emergence of inflationary pressures and adjust to the demographic challenges, the macroeconomic policy stance needed to be complemented by other measures on the structural front that would help expand the effective labor supply and enhance the supply response of the economy. In particular, the existing schemes for subsidized early retirement, which were established during the depression period of the early 1990s, needed to be abolished to promote the reintegration of the age group of 55-65 years into the active labor force. Also, a closer link between pension benefits and life-contributions was seen as crucial to foster both work incentives and intergenerational fairness. In the labor market, social partners needed to allow for greater wage differentiation, commensurate with diverse productivity developments, in order to strengthen the demand for low-skilled labor. At the same time, the unemployment benefits system needed to be redesigned to enhance incentives for a quick reintegration into the active workforce. Finally, to dampen inflationary risks and foster economy-wide productivity growth, further reforms of product markets were crucial, including the removal of rigidities in land and housing markets, in order to promote labor mobility.