Economic surveys and country surveillance

Economic Survey of Luxembourg 2006: Public finances: adjusting to lower growth

 

Contents | Executive Summary | How to obtain this publication |  Additional Information

The following OECD assessment and recommendations summarise Chapter 2 of the Economic Survey of Luxembourg 2006 published on 5 July 2006.

Contents                                                                                                                           

This chapter addresses these short-term and long-term challenges consecutively. The first part provides a brief overview of the structure of public finances and then discusses what could be done to rein in the growth of public spending and reform the budgetary framework. The second part reviews the structure of the pension system, summarises the upcoming difficulties and presents some possible solutions.
Despite recent difficulties, Luxembourg's public finances retain many enviable features. On the revenue side of the general government budget, tax rates are generally lower than in other OECD countries. The total of income tax and social security contributions paid on labour income (12.2% of labour costs for a married average one-earner couple with two children) is well below the OECD average (27.7%) and particularly advantageous compared to the tax wedges prevailing in the three neighbouring countries. This reflects the low levels of both personal income tax rates and social security contributions. The corporate income tax is also relatively low by international standards, although not among the lowest in the OECD: companies pay a tax to the central government representing 22% of earnings (impôt sur le revenu des collectivités or IRC), a 4% (to be raised to 5% from 1 January 2006) “solidarity” levy on the IRC that helps to finance measures to reduce unemployment and a tax to local governments of 6.5-10% of earnings (impôt commercial communal).  As for indirect taxes, the standard rate of value added taxes (VAT) has remained fixed at 15%, i.e., at the lower end of VAT rates foreseen by EU law, and excise taxes on road fuels and tobacco are lower than in other countries. The authorities abolished the wealth tax (impôt sur la fortune) on private persons (personnes physiques) in 2006 but introduced a withholding tax of 10% on interest income of residents in excess of € 250 per year. Since 1 July 2005, a withholding tax has been applied to the interest income of non-residents from other EU states (in accordance with the EU Directive on the taxation of savings income in the form of interest payments). This tax rate will remain at 15% during the first three years, then increase to 20% during the following three years and finally will be kept at 35%. Three quarters of the proceeds of this tax are transferred to the fiscal authorities of the country in which the holder of the saving account resides.
Even though tax rates are low by international standards, general government receipts are comparable as a share of GDP to those in neighbouring countries. This is in part explained by the concentration of economic activity in sectors, such as financial services, which have an above-average level of productivity, remunerate employees at high wage rates and generate sizeable profits. It has been estimated that the financial sector contributes directly and indirectly 27% of central government receipts, even though it only accounts for 17% of employment (Comité de Développement de la Place Financière, 2005). In addition, there are significant excise tax receipts from the purchase of petrol and tobacco by non-residents. With tax receipts accounting for a relatively high proportion of GDP, and economic growth sustained at a rapid pace, the general government has been able to generate sizeable budgetary surpluses during most of the past decade, even though total expenditure has been growing at a fast pace. This virtuous circle of low tax rates, buoyant revenues and large budget surpluses worked to the country’s advantage for many years.
The fiscal situation has, however, come under strain since 2001. The slowdown of activity, especially in the financial sector, has weighed on fiscal revenue. Even though activity has bounced back since then, growth has been less buoyant than in the late 1990s and growth in government revenues has slowed down considerably relative to past trends. The increase in general government receipts has dropped from an annual average of 8% during the 1990s to 4.8% during 2000-05. This would not have been a problem if public outlays had decelerated concomitantly. However, the pace of growth in public expenditure accelerated to reach 9.1% annually on average during 2000-05, compared with 7.5% in the 1990s. This divergence in the trends of government receipts and expenditure has resulted in a sharp turnaround in public finances. A deficit emerged for the first time in 2004 and the budgetary position deteriorated further in 2005, when the general government deficit is estimated to have reached 1.9% of GDP, by far the largest deficit on record in Luxembourg (general government budget data are only available from 1990 onwards). If unchecked, these trends would imply growing deficits.
The 2006 budget targets a general government deficit of 1.5%-1.8% of GDP. Little consolidation is expected to come from the revenue side of the budget, reflecting the modesty of tax measures.  However, owing to the improvement of cyclical conditions, corporate and personal income tax receipts are projected to increase, as are revenues more closely related to activities in the financial sector, notably the subscription tax (taxe d’abonnement). Notwithstanding potentially favourable trends on the revenue side, significant adjustment is also intended to take place on the expenditure side. The growth of total expenditure is assumed to fall to 5.2% in 2006, after having expanded at the annual pace of 9.1% during the previous five years. In addition to keeping a tight rein on central government consumption expenditures, the costs linked to Luxembourg holding the Presidency of the Council of the European Union during the first half of 2005 will not recur, reducing spending by about 0.2% of GDP. Measures introduced since 2000 to curtail medical spending notably the tighter control of sick leave, promotion of generic drugs, measures to facilitate the labour market participation of partially disabled workers, lower reimbursement of doctors’ fees    are projected to have a downward effect on spending. Furthermore, growth in expenditure on public investment is to slow, albeit with such expenditure remaining high as a share of GDP (about 3.7%). The authorities remain committed to expanding the road and railroad infrastructure as well as to building a new air terminal, constructing new schools and long-term care institutions and investing in new information and telecommunication equipment used by public administrations. The better than expected budgetary outcome for 2005 (the general government deficit was revised downwards from 2.3% of GDP to 1.9% of GDP), robust revenue growth during the first quarter of 2006 and the authorities known propensity to overestimate investment expenditure in the budget suggest that the public deficit in 2006 could turn out to be smaller than projected.
Irrespective of the exact outcome of the 2006 budget, there is a need to strengthen the budgetary framework to achieve a long-lasting reduction in expenditure growth. Reducing expenditure growth will not be an easy task, given its present dynamism. The approach needs to be comprehensive because all categories of spending have strong dynamism, and laws will need to be amended to achieve the intended results, notably to curb the growth of automatic entitlements. The following paragraphs discuss measures that have already been decided, and what else could be done.

General government expenditure, receipts and financial balance
(As a percent of nominal GDP)

1. Includes social benefit in kind.
Source: Economic Outlook No. 79 database.

Evolution of the financial balance and net assets of the pension system, 2005-2050
In per cent of GDP

Source: IGSS (2006).

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 the Luxembourg 2006 is available from:

 

Additional information                                                                                                  

For further information please contact the Luxembourg Desk at the OECD Economics Department at webmaster@oecd.org. The OECD Secretariat's report was prepared by David Carey, Ekkehard Ernst and Stefaan Ide under the supervision of Patrick Lenain.

 

 

 

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