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What should be done to put public finances on a sound footing?

Because the cyclically-adjusted budget position was allowed to deteriorate during the late 1990s upturn, Portugal was confronted with the need to undertake fiscal retrenchment in the downturn, after the deficit exceeded the 3 per cent limit by a wide margin. Reducing the budget deficit and ensuring sustainability of public finances over the longer-term has been the overriding policy priority since 2002, despite a weak external and domestic economic environment. The government’s strategy over the past two years has included spending cuts and freezes and sizeable one-off operations, in combination with more in-depth reforms to put public finances on a sustainable basis over the longer run. The areas for reform include: public administration, the health care sector and education services and rules governing fiscal relations with sub-central governments (and autonomous funds). The government’s two-pronged strategy seems appropriate. The deficit was maintained below 3 per cent in 2002 and 2003 despite the cyclical weakness. Achieving quick results through emergency cuts and one-off measures with limited demand effects has given more time for the implementation of necessary in-depth measures and for reaping the results in terms of spending control.

Fiscal consolidation efforts
Per cent of GDP

1. General government financial balance. National accounts basis.
2. Excludes the cyclical effect and the impact of the non-cyclical factors that reduce the budget deficit, occurring only once in time (e.g. the UMTS sales in 2000).
3. Data for 2004 are OECD estimates, under the assumption that one-off measures are not higher than those budgeted.
Source: OECD, Economic Outlook 75 (May 2004); Ministry of Finance.

The authorities’ 2004-07 Stability Programme foresees an average annual reduction of the structural budget deficit of about ½ percentage point of GDP per year, mainly achieved through expenditure side adjustments, while the corporate income tax rate is cut by 5 percentage points in 2004 and again in 2006. This approach is in line with earlier OECD recommendations. The groundwork has been laid for long-lasting reforms with the approval of important legislation: closing down government agencies, re-allocating civil servants; rationalising the school network; raising private tuition fees in universities; promoting the use of generic pharmaceuticals; incorporating some hospitals and creating public-private partnerships in others. However, meeting the medium-term targets will not be an easy task.

• First, achieving the 2004 deficit target of 2.9 per cent of GDP is likely to require more one- off measures than budgeted. The macroeconomic scenario underlying the budget is prudent, but revenue projections that assume increased compliance appear rather optimistic. According to OECD estimates, which also envisage some slippage in current expenditure, the deficit could be about 1 percentage point higher than budgeted.
• Second, achieving a steady reduction of the structural deficit implies forceful implementation of the approved structural reforms. But there seems to have been delays in the implementation of the reforms, judging from the heavy reliance of the 2004 budget on spending freezes and one-off measures.

Is enough being done to reform the public administration and the pension system?

Implementation needs to be accelerated, especially in some areas of public administration reform. Most of the legislation to improve human resource management has already been approved: a new organisational model for central administration, a new framework for public institutes, a new status for managers imposing performance requirements and reinforcing managerial autonomy and accountability. There have already been some achievements in terms of closure or merger of public institutes and schools and restructuring has started in two ministries. However, implementation needs to be stepped up as enhanced effectiveness of the public administration would be a key factor in achieving the intended results in many other reform areas. The “employment pool”, created to encourage mobility of civil servants, has yet to be used on a significant scale. The legislation introducing individual contracts in the public sector, to give more flexibility to human resource management, has been approved. It is too early to judge the eventual success of these reforms, but success is crucial because public sector employment is recognised as being excessively large relative to the services provided in many areas, while staff mobility is very low.

Once fully and effectively implemented, in-depth reforms in education, health care and the public administration are likely to improve cost effectiveness in the public sector and spending control. However they will be insufficient to meet ageing-related pressures on public finances in the longer run.

• Official simulations suggest that the expected population ageing will increase public expenditure on pensions by 2.6 percentage points of GDP by 2020, . The pension system for private workers will be in deficit by 2015, thereafter financed for a further 10-15 years by the pension trust fund. The generous public sector pension regime is already in deficit.
• The pension reform initiated a few years ago with the definition of a new benefit formula for disability and old-age pensions for private sector workers will have only a minor impact on spending.
• The legislation on a second-pillar complementary regime envisaged in the framework law is still in preparation.
• Regarding the public sector regime, the changes introduced to the benefit formula in 2004 will not suffice to cope with pressures coming from the ageing population.

Therefore, a more radical reform of both the public and private employees’ pension schemes is imperative. A number of options could be considered, including: incentives to raise the effective age of retirement; reducing the annual accrual rate; limiting indexation of standard pensions to inflation rather than wage developments; increasing the (low) effective rate of taxation of pension incomes; and adjusting replacement rates for changes in life expectancy [of pension cohorts]. Several of these options would probably need to be combined to significantly improve the sustainability of the pension systems.
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The full edition of the OECD Economic Survey for Portugal is available from:

• SourceOECD for subscribing institutions and many libraries
• Government officials with OLISnet accounts
• OECD Online Bookshop for non subscribers
• Password-protected web site for accredited journalists

Return to the OECD Economic Survey - Portugal 2004 homepage

A printer-friendly Policy Brief (pdf format) may also be downloaded. The Policy Brief contains the OECD assessment and recommendations, but does not include all of the charts available from the above pages