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The following is the Chapter 1 of the OECD assessment and recommendations, taken from the Economic Survey of Denmark 2006 published on 9 May 2006.
Contents
Economic performance is impressive …
The Danish economy is performing very well, reaping the benefits of 25 years of well-managed economic reform that have produced sound macroeconomic policies, a flexible labour market and a competition-friendly regulatory environment. Temporary factors such as revenue from oil exploration have also contributed to strong public finances. After some years of slow growth, the economy started to recover in late 2003, and accelerated to a GDP growth rate of 3% in 2005. Private consumption, exports and investment are all expanding. Consumer confidence is close to its highest level since records began three decades ago. Unemployment is historically low, and firms still expect to hire more people in most sectors of the economy. So far, wage inflation has been remarkably subdued, but that could change rapidly as labour shortages are now very clear in construction and seem likely to spread to other sectors.
… but overheating is a near-term risk
While the Danish economy is in good shape, GDP growing much faster than its potential rate in 2005 and a closed output gap pose the immediate challenge to be vigilant in the face of an overheating risk. House prices have grown strongly and added about half a percentage point to consumption growth each year via wealth effects and mortgage equity withdrawal. With the recent acceleration of house price increases, private consumption and housing construction could have plenty of steam well into 2007. And neither world trade nor investment show signs of weakening. Wages seem set to rise somewhat faster than productivity next year, and experience from other small open economies shows that an overheating scenario can then set in very quickly. Monetary policy cannot be tightened autonomously because with the fixed exchange rate regime it is de facto set by the ECB, and it will most likely continue to add stimulus. In this context, policy makers must be very attentive to how the economy evolves, and stand ready to take swift measures to mitigate the risk of overheating. The following areas should receive particular attention:
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In general, automatic stabilisers function well and the cyclical response of the fiscal balance is the strongest among OECD countries, but recently the real estate tax has been frozen in nominal terms for each dwelling. Now only the smaller land tax follows increased valuations, putting only a weak check on the house price boom.
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Some oil exporting countries like Norway smooth their oil related revenues in funds, which establish a firewall between the economy and fluctuations in oil prices. Denmark does not have such a fund and keeps all oil-related revenues in the budget, leading to large swings in the budget balance. Such temporary revenues should be used to reduce public debt, as excessive public spending growth should be avoided not least in municipalities.
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The labour market is more flexible than in most OECD countries, but a number of factors still hinder adjustments. Administrative procedures for firms to employ foreigners from the new EU member states have been relaxed somewhat, but rules remain cumbersome. High marginal taxes on labour set in already from average incomes and reduce the incentive to work more hours when wages increase. Long duration of unemployment benefits, in particular for seniors, may reduce the intensity of job search.
Speed of house price increases raises concerns
1. Actual and fundamental house price-to-rent ratios have been set equal to 100 in the most recent year when the actual price-to-rent ratio was close to its 35-year-average.
2. Simulation assuming an interest rate increase by 1 percentage point from the end-of-2006Q1 level.
There are also challenges ahead in the long term
Looking further ahead, ageing would reduce growth in GDP per capita to below 1% a year from an average 1¾ per cent during the two decades to 2005. Over the coming three decades, the labour force is projected to contract by 10%, if participation rates remain unchanged, bringing the economy into a regime quite different from the steady labour force growth of the recent decades. The number of children and over-65's will increase by a quarter relative to those in working age. Under current policies, the primary budget balance would deteriorate by 4% of GDP over the coming three decades. In this context three medium-term challenges need to be addressed to circumvent the slow-growth scenario:
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It will be difficult to sustain today's welfare society unless there are profound reforms to raise labour supply. More people working gives an especially large fiscal gain in countries with high taxes and generous social benefits.
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To boost living standards, it is vital that Denmark continues reaping the full benefits of globalisation, with human capital and innovation being the key issues.
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Reforms are necessary also in areas that are sheltered from international competition, but where inefficiencies nevertheless put a drag on development, create unnecessary costs for public budgets and restrict mobility and flexibility. One such policy area is housing - the in-depth chapter topic in this Survey - which, despite some progress, still needs less subsidy and regulation.
Monetary policy may remain too expansionary in the near future
The fixed exchange rate regime which shadows the monetary policy stance of the European Central Bank continues to serve Denmark well. It is highly credible as indicated by only small fluctuations of the krone around its central parity vis-à-vis the euro and by a minimal interest-rate differential. One contributing factor has been that fiscal policy has held course so far, avoiding destabilising the economy. At the current juncture, with a strong boom in Denmark, and considerable slack in the euro area, ECB policy rates are well below the appropriate level for Denmark and are likely to remain so in the near future, adding stimulus that is not needed in the next couple of years. Moreover, over the recent decade, structural changes in the mortgage market have gradually changed how monetary policy functions. In particular, the transmission of short-term interest rates to the real economy has become stronger. This probably reflects the increased use of adjustable rate loans which have raised the exposure of households to changes in short-term interest rates, as well as mortgage equity withdrawal which has been facilitated by rising house prices in an environment of lower interest rates. The currently low level of interest rates is thus likely to have a larger effect on aggregate demand and economic activity than previously. Hence, an appropriate policy mix requires tighter fiscal policy and measures to increase the supply elasticity of the economy in order to balance the current excessive monetary stimulus.
The first priority is to establish fiscal sustainability and then create room for tax cuts
Denmark has achieved much in terms of bringing down debt and recorded a budget surplus of almost 4% of GDP in 2005. General government net debt has been reduced to just 10% of GDP by the end of 2005, down from about 30% of GDP a decade ago, and will probably be eliminated by 2010. Removing old debt has provided a strong position for tackling the ageing challenge. Looking ahead, policy should focus on genuine reforms to extend working lives. In an updated medium term fiscal strategy, it would be appropriate to aim for small budget surpluses, provided initiatives currently under way succeed in alleviating the longer-term budgetary pressures. This strategy needs to be implemented vigilantly. Room for tax cuts to make work pay better should then be created by further reforms. However, timing is important to avoid overheating the economy. Despite the present surplus there is no room for lax fiscal policy in the short run. The tax freeze has succeeded in ending the upward drift in municipal income tax rates, and it is important that municipal spending growth is kept modest to match this.
Although the aim of the tax-freeze - putting an end to an upward spiral of public expenditures and revenues - can be fully shared, its narrow interpretation will become more and more problematic as it precludes meaningful restructuring of the tax system as a whole. For instance, income taxation should be made less distorting by a revenue-neutral reform raising the real estate tax, while lowering the middle or top income tax rates. This could improve incentives to work considerably while changing the income distribution only negligibly. It should be considered in connection with a wider reform of capital taxation, where effective tax rates on real return vary from 25% to 100% for two identical bonds, the one being held in a pension scheme, the other being held as a liquid investment. In particular the gap between 33% interest deductibility (which is large compared to other countries) and 15% tax on pension returns seems to encourage tax planning. Sooner or later, tax reform will most likely be necessary to accommodate changes in mobility, financial markets and other factors. The current capping of the real estate tax for each home at the nominal level it had in 2001-02 cannot be an appropriate long run solution, as misalignment from neutrality gradually grows.
Denmark has benefited enormously from openness
Today's living standards could hardly have been achieved without taking advantage of the gains from new technologies and specialisation deriving from the country's openness and the resulting international division of labour. To continue reaping the full benefits of openness, Denmark needs to reinvigorate its education system and develop greater interaction between universities and firms on R&D. Other policies such as labour and product market regulations are already more adjustment-friendly than in most OECD countries so that the key requirement is to look for ways to improve human capital and raise the supply of skilled labour. Business sector R&D has trended up since the mid 1990s, reaching 2% of GDP in 2004, and special subsidies or tax credits are not warranted. According to recent government proposals public R&D should reach 1% of GDP in 2010, with additional grants provided on a competitive basis.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded. It contains the OECD assessment and recommendations, but not all of the charts included on the above pages.
The complete edition of the Economic Survey of Denmark 2006 is available from:
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SourceOECD for subscribing institutions and many libraries
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OLISnet, under "Publication Locator", for government officials with accounts (subscribe)
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Additional information
For further information please contact the Denmark Desk at the OECD Economics Department at webmaster@oecd.org . The OECD Secretariat's report was prepared by Jens Lundsgaard, Felix Hüfner and Espen Erlandsen under the supervision of Andreas Wörgötter.
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