Economic survey of Luxembourg 2008: Adapting fiscal policies to slower tax revenues

 

Contents | Executive summary  | How to obtain this publication | Additional information

The following OECD assessment and recommendations summarise chapter 3 of the Economic survey of Luxembourg published on 1st July 2008.

 

Contents                                                                                                                             

Slower growth makes it important to strengthen the fiscal policy framework

Since 2005, the buoyancy of tax revenue has resulted in strong budgetary outcomes. Some of this buoyancy is unlikely to last, however, in particular if the financial sector does not return to its past brisk pace of expansion. Furthermore, some of the recent revenue surprises were of a temporary nature, such as the exceptional dividends and withholding tax on dividends which accrued to the budget in the process of the merger of Arcelor and Mittal. The budget has also benefitted from the location in Luxembourg of international internet services firms, which were attracted by agglomeration effects and the low value added tax of 15% on electronic services (the minimum EU standard rate), charged in the country of origin. This tax advantage is scheduled to become less advantageous in 2015 following a recent decision by EU finance ministers that internet services should be taxed in the country where they are consumed. Both the temporary nature and the high volatility of some tax revenues highlight the need for diversifying the tax structure. In this respect, higher taxes on fossil fuel energy may achieve the double dividend of abiding by post-Kyoto emission abatement targets and diversifying the tax structure. Moreover, such a tax increase is likely to be a more efficient abatement measure to meet post-Kyoto targets than investing in renewable energy.

 

The authorities have improved the fiscal policy framework in recent years: the parliamentary discussion of the budget has been moved closer to the start of the budget year; the time between the budget presentation and the publication of the stability programme has been reduced; and with the 2008 budget the presentation includes a version based on national account rules. Nevertheless, the budget process remains driven by a process of line-item discussion and input-based principles, with a strong focus on the allocation of resources among spending ministries. The fiscal framework should be reformed to establish multi-annual spending ceilings that link short-term fiscal objectives to a well-defined path towards securing fiscal sustainability. For example, in order to close the fiscal sustainability gap over a five-year period solely using prefunding, spending growth needs to be 1½ percentage points less than nominal GDP growth. As well, there should be a move from input-based budgeting to output-based budgeting, so as to emphasise the efficient provision of public services. To secure a broad political support for the strategy, transparency and credibility of the budgetary process should be enhanced by implementing a clearer separation of statistics compilation, macroeconomic projections and budget preparation. This separation could include having an independent institution providing macroeconomic projections and assessments of spending and revenue trends.

 

Ageing-related public spending will increase sharply

As already highlighted in the previous Survey, public finances will deteriorate significantly in the medium term. This reflects the maturing of a generous welfare system, which currently benefits from the large contributions made by prime-age cross-border workers. The demographic ageing of these workers, together with the retirement of persons with full-career working lives, will eventually imply a sharp increase in the level of pension benefits. The authorities (Inspection Générale de la Sécurité Sociale) project that public spending on pension benefits will possibly increase by 7 percentage points of GDP by 2050. In addition, updated projections prepared for the present Survey suggest that health and long-term care spending expenditures are also likely to increase by 7 percentage points of GDP by 2050. Under unchanged policies, these two sources of spending pressure will put a considerable burden on the public finances and could imply an exponential increase in public indebtedness.

 

The government seeks to prefund some of age-related spending

The authorities have prefunded only part of these future expenditures. A pension reserve fund established in the early 1980’s now holds assets in excess of 25% of GDP, consistent with the current strategy of securing the viability of the pension system within a seven year time horizon. However, the time horizon of the strategy should be extended to at least 2050 in order to deal early with the mounting age-related pressures on public pension expenditures. This implies that the budget should run structural surpluses in years to come and increase the pension reserves by three to four times, as argued in the previous Survey. Also, given the special circumstances with respect to the large number of cross-border workers who will become eligible for health insurance coverage during their retirement, there is a need to increase the health care reserve fund, which currently holds assets amounting to about 10% of annual expenditures, and to expand its role so as to prefund future health liabilities. Precise estimates of such health care prefunding are difficult to make, not least because of the issue of coverage of cross-border workers. Nevertheless the increase in health and long-term care spending could be of the same order of magnitude as the increase in pension spending, so that the required health care prefunding may be similar to that in the pension system. Overall, if the entire fiscal sustainability gap were to be closed solely through prefunding and the low public debt-to-GDP ratio was allowed to increase to 60%, then the structural balance would need to be improved by 2% of GDP to have a structural surplus of 4½ per cent of GDP. Thus, Luxembourg would have to make difficult choices between raising the tax burden and restraining public spending priorities.

 

Pension benefits should be reformed to eliminate early-retirement incentives

Prefunding can, however, only deal with the bunching of retiring baby-boomers, not the long-term increase in longevity; in addition, there is a political-economy problem with attempts to maintain large budget surpluses over a prolonged period of time. Thus, other measures could also be envisaged to secure fiscal sustainability. The contribution base could be expanded by raising the low effective retirement age by reducing access to early retirement, as argued in the previous Survey. Additional measures in this area should focus on moving the public pension system towards an actuarially-neutral basis by raising the retirement age and lowering the replacement rate. The official retirement age of 65 years should be increased by, for example, two years to partially reflect the 10-year increase in life-expectancy since 1960. Once such a one-off measure has been implemented, a more robust measure would be to link the official retirement age to developments in life expectancy. The generous replacement rate in the pension system should also be lowered, although over a sufficiently long time horizon to allow workers to adjust their working and savings decisions. This could be achieved by indexing pensions to price developments with some improvements in living standards then being implemented through a partial link to real wage developments.

 

How to obtain this publication                                                                                   

The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.The complete edition of the Economic survey of Luxembourg 2008 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 Jens Christian Høj, Ekkehard Ernst, Arnaud Bourgain and Patrice Pieretti under the supervision of Patrick Lenain. Research assistance was provided by Laure Meuro and secretarial assistance by Heloise Wickramanayake.

 

 

 

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