Public Information Notice No. 05/14

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with Finland

February 7, 2005

On January 28, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Finland.¹

Background

The Finnish economy has performed admirably in recent years, but must confront earlier than any other country in the EU the pressures of population aging. The momentum of growth was maintained, despite the receding role of the export-intensive high-technology electronics sector, aided by a strong fiscal stimulus, although unemployment, largely structural, remains high. Nevertheless, inflation is low and the fiscal and external current account surpluses are comfortable. However, longer-term prospects are clouded by the imminent rise in old-age dependency—the most rapid in Europe.

The economy weathered the global downturn relatively well, and in the near-term an improved external climate is expected to strengthen growth. Strong domestic demand, especially private consumption and residential investment, has buoyed the economy, reflecting strong disposable income growth and low interest rates. Increased external demand is expected to make a larger contribution in the near term, with growth averaging 3 percent in 2004-05. Inflation was largely absent in 2004, following sizable excise cuts, and an appreciating euro which tempered the increase in oil prices, but is expected to revert closer to that in the euro area average in 2005. Strong productivity gains have helped contain unit labor costs and maintain competitiveness. A recent centralized wage accord covering a period of 2½ years is expected to ensure continued wage moderation. However, a compressed wage structure and increased labor market mismatches impede employment growth—despite significant cuts in labor taxation (which nevertheless remains comparatively high)—with relatively low labor contributions from both ends of the age spectrum, and from the less skilled. The unemployment rate has remained broadly at 9 percent since 2000.

The fiscal position has rapidly eroded in recent years, but is expected to remain in surplus over the medium term. While the decline in the surplus from 7 percent of GDP in 2000 is partly cyclical, it is also the consequence of a sharp discretionary policy shift, with the structural surplus declining by 3¼ percent of GDP by 2004. The 2005 budget is expansionary, with cuts in corporate and capital taxes, and the beginning of a three-year labor income tax cut following the wage agreement. Nevertheless, the general government fiscal balance is likely to remain at about 2 percent of GDP, as the output gap closes. The government's sizable net asset position, equivalent to some 15 percent of GDP at the end of 2004, is expected to increase further.

Despite the benign short-term outlook, Finland's long-term fiscal prospects are less comforting. Aging-related fiscal pressures are anticipated to occur earlier than in most other EU countries, and to be stronger, reflecting Finland's comprehensive public welfare system. A significant reform of the public pension system has been initiated, aiming to raise the effective retirement age by 3 years from its current level of 59 years. However, the reform, by itself, is insufficient to ensure fiscal sustainability.

Executive Board Assessment

Executive Directors commended the authorities for the impressive strides made by the Finnish economy in recent years, aided by strong productivity gains and a stable macroeconomic policy framework, with low inflation and sizeable fiscal surpluses. Directors noted, however, that employment has remained stagnant, and structural unemployment high. They also underlined that Finland will face the challenge of population aging earlier than any other country in the European Union.

Directors stressed that economic diversification will be important to reduce Finland's vulnerability to downturns in the information and technology sector. Nevertheless, they observed that the economy has weathered the global slowdown relatively well and that growth is set to remain robust in 2005. The recent tax cuts are expected to stimulate employment, and business investment is set to recover after a period of weakness. Although high oil prices and further appreciation of the euro could pose risks to growth, Directors considered these risks to be broadly offset by a likely faster pace of global recovery and strengthening export prospects. As the impact of cuts in indirect taxation and other one-off factors recedes, inflation is expected to revert to the average in the euro area.

Directors noted that while Finland's fiscal position remains comfortable from a comparative EU perspective, the general government surplus has eroded in recent years. They stressed that sizeable fiscal adjustment will be required in the coming years to ensure long-term fiscal sustainability, given the imminent demographic pressures on public finances. Directors therefore recommended that the planned cuts in income taxes over the period 2005-07 be offset by a reduction in public spending, preferably through improved efficiency in the provision of social and welfare services. Such efficiency gains rather than tax increases should be the preferred means of strengthening local government finances.

Directors argued that a holistic approach to structural reforms, setting in train a virtuous circle of stronger employment, growth, and public finances is necessary to address effectively the challenge of aging. Such comprehensive reforms would reduce the required fiscal adjustment. Absent such reforms, the general government would have to run sizable surpluses to ensure fiscal sustainability.

Directors called for policy initiatives to raise the employment rate, especially at both ends of the age spectrum where labor utilization is relatively low. The recent steps to reduce the burden of labor taxation will help promote employment, but may not be sufficient to attain the authorities' ambitious target for raising the employment rate. Welcoming the authorities' intention to reduce employers' social security contributions for low-income workers, Directors called for targeting tax cuts at the lower end of the income scale in order to maximize the beneficial effects on employment. A gradual shift to a more decentralized wage bargaining system would also help ease wage compression and reduce structural unemployment, as would improved training for low-skilled and older workers.

Directors welcomed the significant pension reform being phased in from the beginning of this year as an important step toward ensuring fiscal sustainability. The reform, with commendable features such as an automatic adjustment for rising life expectancy and sharply rising accrual rates, goes some way toward promoting higher labor participation. However, the reform will need to be followed up with further steps, such as closing the so-called "unemployment pipeline," whereby unemployed persons over 57 can claim benefits until age 65. Noting that a consensus for structural reform may become more difficult to achieve in future years, Directors called for early consideration of additional measures and for stepped-up efforts to raise public awareness of the need for faster reform.

In Directors' view, further strengthening competition in product markets would complement efforts to improve labor market efficiency and accelerate the diffusion of productivity gains from the technology sector to the rest of the economy. While commending the progress achieved in recent years in promoting greater competition in sheltered sectors such as communications and retail trade, Directors felt that considerable scope remains to enhance competition in the sheltered sectors, given that the price level is still significantly above the EU average. In this regard, a more proactive stance on foreign direct investment and privatization of public enterprises would be helpful. A reduction in Finland's farm subsidies, which are high by EU standards, would also contribute to raising competition and consumer welfare.

Directors viewed the financial system as sound and resilient to economic shocks, and considered that it is poised to gain from greater European market integration. They noted that growing cross-border financial activity would call for increasingly closer cooperation among Nordic-Baltic financial supervisors.

Directors expressed their appreciation for Finland's strong record of official development assistance (ODA) and the country's support for increased market access for developing countries' agricultural exports through multilateral trade initiatives. They welcomed the 2005 budgeted increase in ODA and the authorities' intention to continue to increase ODA as a percent of gross national income in the future.

It is expected that the next Article IV consultation with Finland will be held on the standard 12-month cycle.