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The Luxembourg economy has regained its footing after the sharp slowdown at the start of the decade and is now growing at around its trend rate of 4-4½ per cent. The financial-services sector, which accounts for nearly one-third of economic activity, has benefited from the return of confidence in capital markets. Nonetheless, there are signs that the conditions for long-term economic growth are becoming less favourable. Output growth has not returned to the extraordinarily fast rates of the 1980s and 1990s, the dynamism of real incomes has declined, productivity growth has slowed, the fiscal situation has deteriorated and inflation has remained higher than in the main trading partners. This Survey analyses these challenges and outlines measures to prepare for changing times.
A worrying sign of strain is the deterioration of the fiscal position, caused by the rapid growth in public expenditure. The authorities have rightly announced that they will bring the budget back to balance by the end of the current legislature, i.e., in 2009 at the latest. To achieve this goal, it will be important to rein in the growth of public salaries and social benefits. This should start in earnest in the 2007 budget.
Another source of concern is the weakening of the pension system, which appears unsustainable under present rules. This results from the maturing of the system as well as the forthcoming increase in average effective replacement rates. The government should undertake reforms to put the pension system back on a sustainable path. These include indexing the age of retirement to life expectancy, reducing incentives for early retirement and pre-funding future pension promises by accumulating a large, actively-managed pension reserve.
Despite strong employment growth, unemployment is rising. Employers prefer to recruit cross-border workers, who accept lower salaries than residents. To reverse these trends, labour market institutions that drive up reservation wages should be reformed, in particular high unemployment