Labour markets, human capital and inequality

Economic Survey of Luxembourg 2010

 

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 Chapter 1. Recovering from the crisis

Luxembourg has experienced a severe recession as the result of the international financial crisis. Output contracted sharply and unemployment has risen. Luxembourg’s economy was heavily exposed to the downturn in world trade and the financial centre has been strongly affected. However, policy support from accommodative euro area monetary policy and a fiscal stimulus package helped stabilise the economy. While recovery is now underway, demand is likely to be held back by a weakness in competitiveness, necessary fiscal consolidation and lower potential output. Growth in the coming years is likely to be lower than before the crisis, although living standards will remain high. The fiscal position has deteriorated rapidly due to a sharp fall in tax receipts from the financial sector, substantial fiscal stimulus measures and rising spending. A consolidation plan has been outlined. This should be implemented and could even be more ambitious, given long–run spending pressures.

The consolidation effort would be enhanced by a more detailed, multi–year plan based on limiting current expenditures. Strengthening the budgetary and fiscal institutions would also help. The main challenge for fiscal sustainability is very large future pension costs, with the effects of population ageing amplified by the age profile of cross–border workers. While substantial reserves are being accumulated, the high level of pension benefits needs to be contained through a comprehensive reform of the pension system. The required fiscal consolidation provides an opportunity to improve public sector efficiency, modernise public management and increase value for money. Improving the control of costs in the health system would increase efficiency.

Chapter 2. Achieving sustainable improvements in living standards

Luxembourg has achieved rapid and sustained growth over the past 25 years and living standards are the highest in the OECD. However, following the crisis, it now faces the possibility of weaker performance in the years to come even if living standards will remain high. This underlines the importance of structural policies to help boost growth and sustain high incomes. Apart from measures to improve the functioning of the labour market and raise public sector efficiency, there are a number of policy priorities. Education performance is relatively weak: it does not match the demand for high–skilled workers and makes it harder for residents to find jobs. Major reforms now underway to improve the education system are welcome. Product market regulations are highly restrictive of competition, particularly for professional services and in the retail sector. This leads to high prices and inefficiency. The weak enforcement of competition policy is due to inadequate resources and the fragmented structure of the competition authorities. Housing costs are high by comparison with the surrounding region and other financial centres. This contributes to large flows of commuters. While increasing housing supply is recognised goal, this has been frustrated by policy barriers that restrict house building. At the same time, housing demand is boosted by tax subsidies. The transport infrastructure is being upgraded and extended. However, the existing network could be used more efficiently through user charges. Luxembourg has the highest per capita CO2 emissions in the OECD. It is committed to making large reductions, and measures to increase energy efficiency are being put in place. The key problem, however, is large sales of motor fuels to people who live in the surrounding countries. Car taxes and fuel duties have increased but there is scope to go further.

 Chapter 3. Making the labour market work better

Rapid economic growth over the past two decades has substantially increased employment in Luxembourg, which has largely been met by in–flows of cross–border workers and, to a lesser extent, immigration. Unemployment has remained low compared to other European countries. These significant social changes have been absorbed without substantially widening income disparities, facilitated by the generous welfare system made affordable by the strong economy. However, this favourable overall picture masks weaknesses in the design of labour market institutions and social transfers that reduce incentives to work for resident workers. Despite the strong economy, this has resulted in lower employment rates for certain groups of residents, notably those who are second–earners, younger or older, or from poorer socioeconomic backgrounds.  Furthermore, the incentives provided by existing labour market institutions could make adjustment to changed economic prospects more difficult. The functioning and adaptability of the labour market could be improved without undermining social cohesion through a range of related measures. This could include aligning minimum wage adjustments more closely with economic conditions, which could be achieved through a Minimum Wage Council, and softening employment protection legislation. To raise incentives of residents, social benefits should be decoupled from average wages, and social transfers could be reoriented towards in–work social benefits.

 Chapter 4. The Luxembourg financial centre and the international financial crisis

Over past decades, Luxembourg has emerged as a major international financial centre. This has been crucial to the development of its economy and the financial sector has come to play a large role in economic activity, employment and government revenues. The financial centre is specialised in the management of interbank liquidity for international cross–border banks and asset management activities. The global financial crisis has had a strong impact on the financial sector with a substantial contraction of banks’ balance sheets, mostly related to lower interbank lending, and a fall in the value of assets under management due to the drop in equity prices. Two large cross–border banks came under severe pressure and were supported by the authorities in Luxembourg and their home countries, while three small subsidiaries of foreign banks were put into administration. However, the impact on the wider Luxembourg economy may be more limited than anticipated. The crisis had a big direct impact on financial activity and tax receipts, but the fall in financial sector employment has been modest so far. The scale of support to the banking sector has been manageable. Despite a very large financial sector in relation to the overall economy, the wider effect has been muted by the limited links between financial centre activities and provision of credit to the local economy, the role of the banking centre in managing liquidity rather than extending credit to the non–financial sector, and high foreign ownership of the main institutions. Nevertheless, the crisis has underlined some of the inherent risks associated with activities in the financial sector. In particular, it is important that the regulation of liquidity is effective and cross–border supervision works well. The resolution mechanism for banks appears to have worked effectively, although there is scope to strengthen the deposit guarantee scheme. In the aftermath of the financial crisis, there will be significant changes in the financial industry and the international regulatory environment. In addition, a new EU directive on investment funds (UCITS IV) is likely to lead to some restructuring of asset management activities. It will be a significant challenge for Luxembourg to adapt to these changes and ensure that its financial sector remains a success and continues to develop. 

How to obtain this publication

 The complete edition of the Economic Survey of Luxembourg is available from:

 

Additional information

For further information please contact the Luxembourg Desk at the OECD Economics Department at eco.survey@oecd.org.

The OECD Secretariat's report was prepared by Sebastian Barnes, Artur Radziwill and Jeremy Lawson under the supervision of Piritta Sorsa. Research and editorial assistance were provided by Agnès Cavaciuti, Ane Kathrine Christensen and Isabelle Duong.

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