Public Information Notice No. 02/91

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Finland

August 15, 2002

On August 13, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Finland.¹

Background

Finland's recovery from the crisis of the early 1990s is a European success story. Based on prudent policy choices and an increasingly open economy, real GDP growth averaged about 5 percent during 1994-2000, inflation was 1-3 percent, and the general government balance moved from large deficits to sizable surpluses. Moreover, increased external competitiveness and market flexibility contributed to Finland's favorable export performance, including both traditional industries and the dynamic information and communications technologies (ICT) sector. The combination of fiscal surpluses and structural reforms—including improvements in labor market performance and increases in the effective retirement age—were important first steps in preparing for the impact of population aging.

In the face of a deteriorating external environment, economic growth slowed sharply in 2001, but is expected to pick up significantly by 2003 after staying somewhat lackluster this year. The abrupt contraction of the ICT market, as well as a decline in traditional exports, contributed to a significant decline in both export volume growth and real growth overall in 2001. However, due to the dual economy nature of the Finnish economy—characterized by only limited spillovers from the dynamic but volatile ICT sector to the rest of the economy—the repercussions of ICT developments for employment and the domestic economy were limited. On balance, real GDP growth stayed positive at about ¾ percent, and employment increased by almost 1½ percent. While considerable uncertainties remain, in particular with regard to the ICT sector and prospects for investment, Fund staff expects real GDP growth to increase gradually to about 1 percent in 2002 and about 3 percent in 2003—somewhat less than the authorities' projections. With a significant output gap, headline inflation is expected to moderate to 2 percent or less during 2002-2003.

Certain structural rigidities—likely to hamper Finland's future economic well being if left unattended—have been in evidence. The official unemployment rate remained excessive at about 9 percent. Broader measures—which take into account such categories as individuals who left the labor force early, discouraged workers, and others participating in active labor market programs—could be as much as double. Among the factors contributing to high unemployment were inadequate wage differentiation across different skill levels; disincentives to seek work, stay in the labor force, and hire labor, including high taxes on labor; and an underdeveloped market for private services in the non-business, lower-skill sector. While past reforms have made some headway in reducing the tax wedge on labor (i.e. taxes on labor income and social security contributions), the wedge is still high compared with the EU average and even higher when compared to the OECD average.

The main challenges for economic policy are interrelated: to deal with high unemployment and the impact of a rapidly aging population. Finland's population is aging faster than any other EU country. Against this background, without actions to significantly raise the employment rate and productivity, economic growth would be reduced drastically as the number of workers declines. This would accentuate the significant pressures on the public finances from the demographic shock. All this has important implications for fiscal policy and structural policies to broaden labor market participation, including reforms in the areas of pensions, the labor market, and the product market.

Executive Board Assessment

Executive Directors endorsed the thrust of the staff appraisal. They commended the Finnish authorities for their successes following the severe recession in the early 1990s. This included sound policy choices, including the shift from large fiscal deficits to sizable surpluses, and strong economic performance, reflecting increasing economic openness, improved market flexibility, and enhanced external competitiveness. Directors emphasized that, while the pace of economic activity slowed in 2001 and output is expected to be below potential in the period ahead, policy needs to be strongly attuned to Finland's long-term challenges.

In view of rapid population aging, Directors stressed that the period ahead is a critical one, in which preparing for the demographic shock should be an overarching goal of policy. This requires a concerted effort on a number of fronts to increase the rate of employment; maintain sufficiently large general government surpluses over the medium-term to avoid structural deficits after the demographic shock sets in; find ways to generate new sources of revenue, including through user fees to also help rationalize public expenditure; and adherence to strict public expenditure limits, with a view to leaving room for additional tax cuts on labor without jeopardizing the public finances. In this context, Directors viewed it as essential to reverse the recent expenditure overruns and urged the authorities to strengthen the institutional backing to adhering to medium-term expenditure ceilings. At a minimum, they urged the authorities to hold primary real spending constant at the budgeted 2002 level, with a view to cutting labor taxes by 1 percentage point of GDP over the 2003-05 period. But, considering the near-term cyclical outlook and the longer-term potential benefits to employment and growth, they advocated even larger, frontloaded labor tax cuts—financed to the extent possible by further expenditure restraint, embedded in a long-term strategy to ensure fiscal discipline.

Directors underlined that pension reform had an important role to play, as an integral part of the strategy to raise the low average retirement age and the effective supply of labor, and keep social security spending in check. They recommended that recently proposed reforms to make a longer working life more attractive should be implemented as quickly as possible, while urging the authorities to reconsider the proposal to soften the eligibility criteria for disability pensions. To further support the goals of raising potential GDP growth and strengthening the public finances, Directors also stressed that additional measures must be contemplated, for example: eliminating the subsidized component of the part-time pension scheme as well as disincentives for hiring older workers; basing the pensionable wage on lifetime earnings; and calibrating the statutory retirement age to take into account changes in life expectancy.

To further foster employment creation and the functioning of the economy, Directors saw other measures in the labor and product markets as beneficial. They stressed that one key aspect is for the social partners to find ways to introduce greater wage differentiation commensurate with diverse productivity developments and labor demand, which could be achieved by allowing greater room for setting wages at the firm level. In a related vein, this would also enhance the effectiveness of tax-based labor supply incentives, such as the earned-income tax allowance, by ensuring sufficient demand. Directors noted that other reforms aimed at rewarding work would improve the flexibility and supply response of the economy. In addition to tax cuts on labor, these include modifications to the unemployment and benefits systems to avoid penalizing taking a job by making work financially more attractive relative to unemployment (and early retirement for that matter). Finally, Directors saw reinvigorating privatization efforts—and using the proceeds to pay down public debt—increasing private sector involvement in the provision of public services, and strengthening the degree of competition in product markets as key policy objectives.

Directors emphasized that the demographic window of opportunity is closing rapidly. Thus reform measures should be taken without delay. Otherwise rapid population aging will complicate the prospects for an alleviation of the heavy burden of taxes on labor, and for a significant and lasting improvement in employment growth. But, in the view of Directors, with a determined effort, public expenditure limits, coupled with wide-ranging structural reforms and tax cuts, could trigger a virtuous circle of strong employment creation, solid economic growth, and fiscal savings—without which Finland would find it difficult to meet its social welfare objectives.

Notwithstanding the financial system's current soundness, Directors highlighted that further strengthening of regulatory and supervisory arrangements would help mitigate future risks. In particular, efforts toward harmonizing the cross-border and the cross-discipline regulatory and supervisory arrangements should be a priority. At the same time, to underpin the effective functioning of the Financial Supervisory Authority (FSA) and avoid obfuscating lines of competence and accountability, Directors emphasized the importance of ensuring that decisions on licensing and imposition of sanctions are made at the operational level of the FSA and not at the policy-making level of the new FSA Board.

Directors commended the authorities for further strengthening of legislation on anti-money laundering and terrorist financing, and for the conformity of Finland's legislation to the standards of the OECD Anti-Bribery Convention, to which Finland is a signatory. They also praised the generally high quality, comprehensiveness, and timeliness of Finland's economic statistics.