Hansjörg Blöchliger
OECD Economic Surveys: Iceland 2025
Abstract
Iceland’s economy has slowed over the past two years, but growth appears to have bottomed out. The labour market remains tight, while falling inflation and the 2024 wage agreements have brought the decline in real wages to a halt. However, inflation remains well above target, driven by housing costs. The central bank started to cut the policy rate last October but monetary policy is still restrictive. The fiscal stance is slightly contractionary. Skills mismatch remains high especially among immigrants, and qualified labour is lacking in the technical sectors and in health care. Introducing an expenditure rule should help address spending excesses and reduce pro-cyclicality of fiscal policy. Fewer reduced rates in the VAT system, notably for tourism, would correct distortions and improve tax collection. Simplifying and accelerating the permit process and reforming land-use would help boost investment in housing. The new government in power since late 2024 has promised swift action in various policy areas.
Iceland’s economy has slowed, inflation has fallen, and the output gap turned negative in the second half of 2024 (Figure 1.1). The labour market remains tight and real wages have stabilized. The central bank has started to cut the policy rate, while fiscal policy remains slightly contractionary. Following volcanic eruptions on the Reykjanes peninsula around 1% of Iceland’s population had to relocate, and disaster relief put some strain on public finances and the housing market, yet the economy was little affected overall. The economy is diversifying, with rapid expansion in various non-traditional export sectors. Several indicators point to a positive near-term growth outlook despite the challenging global environment. The new government, in power since end 2024, has placed economic stability, low interest rates, and robust public finances at the heart of its policy agenda (Box 1.1).
Note: Panel B, national consumer price indices.
Source: OECD, Economic Outlook database; and OECD, Prices database.
Iceland enjoys strong fundamentals, which help it to combine high income per capita and low income inequality (Figure 1.2). Competitiveness is bolstered by a sound macroeconomic framework; a skilled and productive workforce; and an innovative business environment. A strong international net creditor position, substantial pension funds and low levels of corporate and household debt provide significant resilience. Iceland boasts one of the youngest populations and the lowest old-age dependency ratio in Europe. It is also among the most egalitarian economies in the OECD, thanks to high labour force participation, a compressed wage distribution, and a well-targeted tax and social benefit system. Access to education and healthcare is universal, and socio-economic status has less influence on educational and health outcomes than in most other OECD countries. On top of that, Icelanders benefit from pristine wilderness and excellent air and water quality.
Even so, Iceland is facing several fiscal and structural policy challenges. The fiscal rules framework, established in 2016, has been suspended since 2019. Despite a buoyant economy in recent years, budget deficits have persisted, with spending prone to procyclicality and gross debt remaining high. Over the past two decades, spending on disability benefits has surged, exerting pressure on the public finances and potentially reducing labour force participation and employment. Foundational skills as measured by scores in the Programme for International Student Assessment (PISA) have declined to a worrying extent, with the performance gap between native and immigrant students among the widest in the OECD. Furthermore, Iceland, once known for abundant and affordable electricity, now faces power supply constraints and rising prices. Finally, business regulation is stringent, impeding efficient resource allocation and the expansion of productive firms.
Note: In Panel A, weighted average of GDP per capita for the upper half of the OECD countries. Upper half of OECD countries is determined each year by the level of GDP per capita and varies across years. In Panel B, the Gini coefficient of income distribution ranges between 0 (perfect equality, everyone gets the same share of income), and 1 (perfect inequality, all income goes to one person). Data for Iceland are sourced from Statistics Iceland.
Source: OECD, National Accounts database; OECD, Income Distribution Database; Statistics Iceland.
The snap election of November 2024, prompted by the collapse of the previous coalition government, brought a new government coalition comprising the Social Democratic Alliance, the Reform Party, and the People’s Party, which unveiled their policy reform programme at the end of 2024. The new government prioritizes economic stability, lower interest rates, and a tighter grip on the public finances, with a commitment to swift action. By policy area, their intended actions are as follows:
Fiscal policy: Adopting an expenditure rule, increasing spending efficiency and making the tax system more effective by closing loopholes. Formulating a policy for natural resources and resource rents, and their division between central and local government. Introducing visitor fees at selected spots.
Regulation: Enforcing competition rules and ensuring robust consumer protection and a favourable business climate for enterprises.
Housing: Fostering the supply of housing by simplifying the permit process, enabling the pension funds to increase housing investment, supporting housing associations, and facilitating the construction of new residential areas through agreements with municipalities.
Public investment: Boosting investment in public and private transport and in communication networks, partly financed through road pricing/tolls.
Education: Fostering education, with an emphasis on Icelandic language teaching, literacy, and access to diverse learning materials.
Energy policy: Fostering energy generation and transmission by simplifying the licensing process and by establishing a legal framework for wind energy.
Social policy: Raising disability and retirement pensions each year in line with the increase in the wage index, and never by less than inflation. Increasing allowances in the maternity/paternity leave system. Establishing a more stable framework for child benefits.
Immigration: Strengthening immigrants’ capacity to learn Icelandic and participate in economy and society. Maintaining consistency with other countries in receiving asylum applicants.
The government also plans to hold a referendum on resuming accession negotiations with the European Union by 2027; and an independent foreign experts’ group will be tasked to evaluate Iceland’s monetary options, including adopting the euro. Many reform priorities of the new government reflect recommendations in earlier OECD Economic Surveys of Iceland.
1.1.1. Growth has likely bottomed out
Economic growth has slowed against the backdrop of tight monetary policy and shocks to exports of seafood and energy-intensive goods but seems to have passed its low point (Figure 1.3). Household consumption is gradually expanding, driven by growing real wages and rising consumer confidence. Business investment has begun to recover from its downturn in the second half of 2024 as financial conditions eased. Despite slowing population growth, investment in housing remains substantial, supported by declining interest rates. The unemployment rate has seen an uptick from around 3.5% at the end of 2024, and while labour shortages are easing, the labour market remains tight in specific segments. Volcanic activity on the Reykjanes peninsula has had minimal impact over the past six months. Since April, all goods imports from Iceland to the United States are subject to a 10% tariff except pharmaceuticals, which are exempt and make up around 30% of Icelandic goods exports to the United States.
The central bank began easing monetary policy in early autumn 2024 and has cut the key interest rate in five steps from 9.25% to 7.5% by May 2025. Various measures of inflation declined sharply, with headline inflation down to around 4% year-on-year in early 2025 but remain above the target of 2.5%. As both the key policy rate and inflation decrease at a similar pace, the central bank’s real rate remains steady at around 4%. Although slowing, housing costs continue to be a significant driver of inflation, as housing demand remains robust due to rapid population growth and rising incomes. Fiscal policy is slightly contractionary, but the budget remains in deficit. Gross public debt, as measured by the national accounts, has declined following the privatisation of ĺslandsbanki and the winding down of the Housing Financing Fund, a government-owned agency.
The economy is projected to grow by 2.7% in 2025 and 3.0% in 2026. Private consumption will expand, driven by real wage increases. Residential investment will remain robust, supported by improving financial conditions and sustained housing demand (Table 1.1). Business investment is projected to grow as confidence rises and financial conditions continue to ease. Export growth will recover on a broad base. Imports are set to record strong growth in 2025, partly due to the carry-over of purchases of equipment for data centres in late 2024. Trend unemployment will rise to above 4% in 2025 and stabilise thereafter. Inflation is expected to continue to decline in the face of still tight macroeconomic policies but to stay above target until mid-2026. The budget deficit will shrink, while the debt ratio will decline.
Source: OECD, National Accounts database; OECD, Consumer Price Indices database; Eurostat; Statistics Iceland; CEIC.
1. Contributions to changes in real GDP, actual amount in the first column.
2. Consumer prices index excluding food, energy, alcohol and tobacco.
3. Includes unfunded liabilities of government employee pension plans.
Note: Annual growth rates are based on the aggregation of quarterly data and might differ from values published by national authorities.
Source: Updated OECD Economic Outlook No. 117, includes Q1 2025 national accounts provisional estimates and 2024 benchmark revision.
The projections continue to be surrounded by considerable risks and uncertainty. The small size of Iceland’s economy makes it volatile and prone to shocks. Goods and services exports, particularly tourism, could be adversely affected by a sluggish recovery in major origin countries, potentially exacerbated by financial sector stress. A poor fishing season could negatively impact exports. Tariffs could reduce exports of goods and services to key trading partners. Inflation could exceed expectations if wages rise faster than stipulated in the 2024 wage agreements or if import prices, especially for food and oil, begin to increase again. Low-probability, high-impact events include violent volcanic eruptions close to settlements, notably the capital area; an escalating tariff war; and a large and successful cyber-attack (Table 1.2).
1.1.2. Productivity growth remains sluggish in the domestic sector
Competitiveness, as measured by unit labour costs (the ratio of wages to productivity), has declined (Figure 1.4). Over the past decade, wages generally outpaced productivity, except for a few years before the pandemic. Labour productivity has rebounded from several supply shocks and accelerated post-pandemic, driven by economic diversification and innovation in traditional sectors like fishing and tourism. However, productivity growth in the domestic goods and services sector remains sluggish due to stringent regulations and various entry barriers (OECD, 2023). Despite some actions in tourism and construction, broader business climate reforms have been limited over the past decade. Stepping up regulatory reform efforts could attract new and innovative firms, diversify the economy, and boost productivity to sustain high wages, as detailed in the in-depth thematic chapter on business regulation. Structural reforms more generally could increase GDP per capita in ten years by around 10% (Box 1.2). Past reform actions are listed in Table 1.4.
Note: Panel B, Nordics exclude Iceland. Panel B: relative unit labour costs (ULC) are measured economy-wide and trade-weighted, and show the evolution of competitiveness over time, with a rise in ULC reflecting declining competitiveness.
Source: OECD, Economic Outlook No. 117 database; OECD, Competitiveness Indicators.
Selected reforms proposed in this Survey are quantified in Table 1.3 below, using simple and illustrative policy changes and based on both cross-country and single-country regression analysis. Some reforms are not quantifiable under available information or given the shape of the policy design. Most estimates rely on empirical relationships between past structural reforms and productivity, employment, and investment, assuming swift and full implementation. They do not reflect specific settings in Iceland. Hence, the estimates are merely illustrative, and results should be interpreted with care.
Note: The effects of a PISA scores improvement is taken from Figure 6 in (Egert, de la Maisonneuve and Turner, 2023).
Source: OECD calculations based on (Saia, Andrews and Albrizio, 2015), (Égert and Gal, 2017), (Cournède, Fournier and Hoeller, 2018), (Egert, de la Maisonneuve and Turner, 2023) (Blöchliger, Johannesson and Gestsson, 2022) and (Benz et al., 2023).
The new government plans to strengthen analysis and policy advice on productivity and growth drivers. Many OECD countries have created independent institutions to address productivity slowdowns, offering valuable lessons for Iceland (Cavassini et al., 2022). Key factors for success include the analytical independence of these institutions and access to reliable micro-level data on firms and workers. Given Iceland's small size and limited resources, it may be beneficial to closely link the new productivity institution with existing bodies like the Fiscal or Climate Council, and indeed the government plans to extend the remit of the Fiscal Council. Denmark's model of housing multiple independent economic and fiscal institutions under a joint roof, promoting economies of scope and cross-fertilisation, could provide further inspiration for the set-up of the new institution (Box 1.3).
Denmark exemplifies how a small country with limited resources can maximize the benefits of well-integrated independent economic and fiscal institutions. Established in 1962, the Danish Economic Councils (De Økonomiske Råd) is an independent public institution tasked with assessing and advising on economic and fiscal policy. The Chairmanship, composed of distinguished economics academics, oversees four distinct branches. It reports to the Councils, which include high-level representatives from the Government, Central Bank, social partners, NGOs, and academic experts. A relatively small secretariat supports the Councils (Figure 1.5).
Source: (OECD, 2019).
The Economic Council monitors the economy, analyses long-term trends, makes projections, and provides recommendations on macroeconomic and structural policies.
The Independent Fiscal Institution assesses public finance soundness and budget law compliance. Its strong credibility and a comply-or-explain requirement on the government ensure adherence to recommendations without formal power.
The National Productivity Board surveys productivity trends and drivers, advises on productivity-enhancing policies, and assesses their impact.
The Environmental Economic Council examines the interaction between the environment and the economy and evaluates the efficiency of environmental policies.
Integrating various policy areas under one roof facilitates independent policy advice, creates synergies, and ensures consistency across different domains, including productivity. The institution has developed a strong independent voice on economic policy, garnering significant media coverage and political attention.
Source: (OECD, 2019) (Cavassini et al., 2022).
Note: other past recommendations and actions related to the business climate can be found in the in-depth chapter.
1.1.3. Institutional quality is high
The quality of institutions is a key determinant of productivity. This includes the rule of law, government accountability and effectiveness, political stability, trust in government, regulatory quality, corruption control, and transparency. Well-functioning public institutions gain higher public trust, enhancing their effectiveness. Corruption undermines institutional quality, erodes trust, increases costs and risks for businesses, and reduces productivity (Acemoglu and Robinson, 2010). Iceland boasts some of the highest quality institutions in the OECD, though still below other Nordic countries. Trust in national and local governments, and other private and public institutions, is below the OECD average, except for public services and administration, which are among the most trustworthy in the OECD (OECD, 2024).
Indicators of public integrity and control of corruption suggest that Iceland performs above the OECD average but below its Nordic peers. Perceived control of corruption has gradually declined since the global financial crisis (Figure 1.6, Panels A to D). Iceland has responded to demands for improved anti-corruption measures by strengthening its framework for investigating and prosecuting foreign bribery. Several amendments to the penal code have clarified issues of bribery by foreign public officials, as recommended by the OECD’s Working Group on Bribery. However, the low number of detected cases could be a concern. Iceland’s only foreign bribery investigation reported in 2020 is still ongoing, with no completed cases since the Convention's entry into force (OECD Working Group on Bribery, 2023). Iceland is largely compliant with respect to the exchange of information for tax purposes, while the effectiveness of anti-money laundering measures is below the OECD average (Panels E and F).
Note: Panel B, point estimate and margin of error. Panel D, no data on anti-corruption strategy and risk management and audit available for Iceland. Panel E, overall assessment on the exchange of information in practice from peer reviews by the Global Forum on Transparency and Exchange of Information for Tax Purposes. Panel F, ratings from peer reviews to assess implementation of the FATF Recommendations. “Investigation and prosecution ML” refers to money laundering. “Investigation and prosecution TF” refers to terrorist financing.
Source: Panel A: Transparency International; Panels B and C: World Bank, Worldwide Governance Indicators; Panel D: OECD, Anti-Corruption and Integrity Outlook; Panels E and F: OECD calculation based on the materials from the Global Forum on Transparency and Exchange of Information for Tax Purposes; OECD, Financial Action Task Force (FATF).
1.1.4. Structural factors make for a tight labour market
The labour market remains tight (Figure 1.7). The unemployment rate oscillates around a low 3.5% despite a cooling economy. Differences in unemployment rates between men and women are negligible, while the gap between youth and overall unemployment rates has widened slightly, indicating certain imbalances in the labour market, notably a lack of skills (chapter 2). Employment has expanded most in some service sectors, especially tourism, as well as in construction and IT-related activities. Labour force participation, traditionally high in international comparison, is climbing further, exceeding 87% at the end of 2024, driven by high labour immigration, flexible labour market regulations (notably flexible hire-and-fire and wage-setting rules), and a high retirement age. While participation and employment are expanding (more people are in work), the number of working hours per worker is declining, as seen in most wealthier OECD countries (Bick et al., 2021).
Note: Panels A, B and C are based on Labour Force Survey. Panel A, participation rate is smoothed as a 4-quarter trailing average and refers to the population aged 16-64. Panel C, due to missing estimates for individuals born abroad, certain data points have been interpolated.
Source: Statistics Iceland; Eurostat.
Labour market shortages are easing but could remain more pronounced than on the eve of the pandemic (Figure 1.8). The share of firms reporting labour shortages has decreased to the average of 2010-24. The Beveridge curve, which depicts the relationship between the unemployment rate and the vacancy rate over time, suggests that labour market mismatch is decreasing, though it is likely higher than pre-pandemic. The outward shift in the curve, indicating less efficient labour matching post-pandemic, has not been fully reversed, though this finding should be interpreted cautiously as the curve starts in 2019. As such, persistent labour market mismatch could be driven by structural factors. Cross-country analysis suggests that long-term trends such as globalisation, as well as the green and digital transitions, could be at the origin of labour market mismatch, while pressure from an ageing population seems less of an issue in Iceland (Dorville, Filippucci and Marcolin, forthcoming). Additionally, geographical concentration of activity and employment in the capital area, along with a lack of affordable housing, could hinder individuals - especially immigrants - from relocating to where jobs are available, keeping labour mismatch elevated (OECD, 2024).
Note: Panel A unemployment data are sourced from Labour Force Survey.
Source: Statistics Iceland, CEIC.
Labour market shortages are strongly linked to skills mismatch, with Iceland facing a rapidly changing employment structure and rising demand for high skills (Figure 1.9, Panel A). Skills mismatch is considerably above the OECD average and higher than in other Nordic countries (Panel B). Overqualification is frequent, mostly because immigrants often work below the qualification obtained in their origin countries (see below). Technical fields like information and communication as well as health care face considerable shortages. The digital and green transitions including the rapid integration of artificial intelligence across a wide range of sectors will further increase demand for skilled technical workers (Filippucci, Gal and Schief, 2024). As noted in earlier Surveys, addressing skills mismatch requires labour market and education policy reforms, including adapting education to the rising skill and upskilling needs, removing barriers to the professions, and recognizing foreign qualifications (see below).
The share of the immigrant population has more than doubled over the past decade, although net immigration eased over the past two years as the economy slowed. The proportion of foreigners in the workforce reached around 24% in 2024, with a particularly high share of foreign workers in construction, tourism and fishing (Figure 1.10, Panel A). As such, immigration enhances labour market flexibility and helps fill important niches. Contrary to perceptions, many immigrants settle for an extended period, with the average stay of a migrant in Iceland being longer than in the OECD on average (OECD, 2024). Yet immigrants account for more than half of the unemployed, up from 15% a decade ago. The unemployment ratio between immigrants from a European Economic Area (EEA) country and the native born is among the highest in OECD Europe, suggesting that immigrants witness specific obstacles in Iceland’s labour market (OECD, 2024). In this context, Iceland faces the distinctive challenge of developing integration measures specifically for labour migrants who benefit from free movement within the EEA and a relatively generous unemployment benefit system.
Note: Panel A: high-skill occupations are managers, professionals, and technicians and associate professionals; medium-skill occupations are clerical support workers, skilled agricultural workers, craft and related trades workers and plant and machine operators and assemblers; low-skill occupations are service and sales workers, and elementary occupations. The armed forces and non-responses are not shown.
Source: Eurostat, Labour Force Survey; OECD, Skills for Jobs database.
Note: Note: In Panel A, data come from the Labour Force Register. The over-qualification rate is the share of the highly educated (ISCED Levels 5-8), who work in a job that is ISCO-classified as low- or medium-skilled (levels 4-9).
Source: Statistics Iceland; OECD, “Settling In 2023: Indicators of Immigrant Integration”.
Iceland could benefit more from immigrants’ skills. Approximately one-third of immigrants are overqualified for their jobs, while only about 10% of native workers face the same issue. This indicates that many workers are not employed in positions that match their qualifications (Figure 1.10, Panel B). The main contributing factor appears to be labour market opportunities, with many immigrants pulled into lower-skill sectors such as tourism and construction. While a digital portal for applications has been set up, simplifying the formal recognition of qualifications earned abroad could also help reduce labour mismatch (OECD, 2024). Given the key role of language skills for labour market success, the scale, scope, and quality of language training should be enhanced for immigrants who are both in need and show prospects for settlement (chapter 2). A parliamentary resolution passed in 2024 aims to improve the integration of immigrants, particularly by fostering Icelandic language training and simplifying the recognition of foreign qualifications, as recommended in the previous Survey (OECD, 2023). Easing entry to the professions could also help reduce labour shortages (chapter 4). Past recommendations and actions taken on immigration are shown in Table 1.5.
1.1.5. The government should avoid fiscal inducements in wage negotiations
The 2024 four-year wage agreement, replacing the 2022 short-term settlement, sets a milestone in Icelandic labour relations. As a novelty, negotiations relied on economy-wide productivity rather than GDP, strengthening the link between wage and productivity growth, thereby supporting competitiveness. Average wages are expected to grow by 4% annually, matching productivity growth plus targeted inflation, although wage drift is expected to add another 2% at least. Additionally, shifting from absolute wage increases (a fixed pay rise in króna terms regardless of the wage level) to percentage increases, albeit with a nominal minimum, aims to better anchor wages across the salary scale, reducing wage drift and macroeconomic risks. Iceland’s wage structure remains one of the most compressed of the OECD, contributing to low income inequality (Figure 1.2).
As in previous bargaining rounds, the government committed to increasing social spending for families with children, low-income households, and renters. These commitments facilitated smooth negotiations and were deemed necessary for a sustainable agreement. However, the tendency to offer additional public spending in the context of the wage bargaining process leads to higher structural expenditures not necessarily accounted for in the fiscal plan, worsening the budget balance. More broadly, Icelandic wage agreements often result in fiscal lock-in effects, where social partners conclude agreements at the expense of the public finances. The government should clearly separate fiscal policy from wage negotiations to maintain credible budget targets. Instead, it should limit its role to that of a mediator during the negotiation process, as recommended in the 2019 OECD Economic Survey of Iceland (OECD, 2019).
The gap in paid hours worked between men and women is the widest in the OECD, despite a gradual decline over the past two decades and high female labour participation (Figure 1.11). During Iceland’s decades-long catch-up with the OECD’s wealthier countries, households followed a traditional labour division; men often had several jobs and worked long hours to compensate for low hourly earnings, while women took care of household work (OECD, 2023). Women are more likely to work part-time than men (23.5% vs. 10.5% in the OECD on average) and often work in the public sector or social services, which tend to offer more flexible hours. They are less represented in STEM positions, with a larger gap to men than OECD-wide (OECD, 2021).
Note: Percentage point difference in hours worked between men and women in full-time dependent employment, weighted average for OECD.
Source: OECD, Labour Force Statistics database.
Some persistence of the gap in hours worked may be policy-related: marginal tax rates for low- and middle-income earners are among the highest in the OECD, discouraging second earners - often women - from moving from part-time to full-time work. Consequently, despite a relatively compressed wage structure, the wage gap between men and women is around the OECD average. Against this background, the government is considering reducing high tax rates on second earners, notably by amending the system of “tax bracket sharing”, a specific form of joint rather than individual income taxation (see fiscal section). Moreover, access of women to education in the STEM areas should be fostered, as recommended in the previous OECD Economic Survey (OECD, 2023).
1.1.6. Foreign trade is becoming more diversified
The current account balance has again turned negative in 2024 reflecting a failure to catch capelin, weaker-than expected foreign tourism, easing export revenues from energy-intensive goods and services (chapter 3) and strong imports of capital goods, notably computers for data centres (Central Bank of Iceland, 2025). However, strong growth in the pharmaceutical and biotechnology sectors is supporting foreign trade. Net foreign assets, i.e., the difference between Icelanders’ investments abroad and foreigners’ investments in Iceland, amounted to 43% of GDP end 2023. Having long been significantly negative, the net foreign asset position now serves as a welcome macroeconomic buffer. Inward foreign direct investment remains low compared to most other OECD countries, pointing to regulatory barriers (chapter 4). Additionally, openness remains comparatively low and trending down (chapter 4), although it has returned to pre-pandemic levels (Figure 1.12, Panel B). Against this background, Iceland should ease restrictions on foreign investment to help fund investments in new sectors.
Note: Panel B, trade openness is measured as the average of goods and services imports and exports divided by GDP. Panel C, weighted average for OECD, GDP weights were used. Panel D, both aluminium and seafood price indexes are based on nominal ISK prices.
Source: OECD, Balance of Payments statistics; OECD, National Accounts database; OECD, International Investment position; Statistics Iceland.
Iceland is gradually diversifying its exports portfolio (Figure 1.13 Panels B and D). The share of fish in total goods exports is declining. Non-traditional exports, such as high-value services and medical products, have recently driven export growth. Since the success of Game of Thrones, parts of which were filmed in Iceland’s dramatic landscape in the 2010s, the film industry has become one of the fast-growing service sectors in the country (Tomas, 2023). However, the share of R&D-intensive exports remains low, as traditional fisheries, aluminium, and tourism still dominate overall export revenues. Aluminium remains key, with the three smelters currently operating at full capacity, benefiting from reliable domestic energy and low (but rising) energy prices (chapter 3). Tourism remains the most important service export. Exports to the United States have been increasing rapidly over the past decade, primarily due to a surge in American tourists visiting Iceland. The share of goods exported to the United States in total goods exports is around 6%, and the effective tariff applied by the United States on Iceland is around 7%, below most other European countries (OECD Economic Outlook 117). US tariffs on aluminium, at 10% since 2018, were increased to 25% in March 2025, but Iceland exports no aluminium to the United States.
Note: Provisional 2024 data in Panels A, B and C.
Source: Statistics Iceland; Ministry of Finance and Economic Affairs.
Tourism activity has recovered to pre-pandemic levels and is now stabilising (Figure 1.14). Overnight stays per visitor are decreasing, indicating shorter visits to Iceland. Real exchange rate appreciation is affecting the sector’s competitive position, making Iceland a more expensive destination than before the pandemic, and more expensive than most neighbouring countries. While the share of tourism in GDP is back to around 8%, the share in employment has fallen below pre-pandemic levels, suggesting significant labour productivity gains over the past few years. For the common traveller, this is noticeable in the rapid rise of self-check-in accommodations, for instance. In 2024, Parliament legislated an action plan on tourism, with a focus on increasing productivity and sustainability.
Note: Panel A, monthly number of passengers (12-month moving average) who go through security at Keflavík Airport, including foreigners residing in Iceland, foreign labour leaving the country and transit passengers.
Source: Statistics Iceland.
Iceland remains the most visited country of the OECD on a per-resident basis, entailing pressure on infrastructure and the environment. Tourism remains concentrated in the Southwest region and along the South coast, partly because getting to regions beyond Reykjavik from abroad is slow and cumbersome. Iceland should continue to build on its 2019 policy framework for productive and sustainable tourism. A balanced tourism strategy should harness the economic benefits of tourism for the whole country while addressing potential negative impacts (OECD, 2024). A tourism tax was reinstated in 2024 and extended to cruise ships, and the government plans to introduce user fees at specific tourist sites. Moreover, tourism services should be subjected to the standard VAT rate (see section 1.4).
In May 2025, the central bank reduced the key policy rate to 7.5%, the fifth cut since monetary policy began to loosen in October 2024 (Figure 1.15, Panel A). Interest rates are now 1.75 percentage points lower than in August 2023, when the tightening cycle peaked, but remain very high in international comparison. Both short- and long-term market interest rates are declining in the wake of the policy rate cuts. Real interest rates, calculated from various measures of inflation and one-year inflation expectations, have risen sharply over the past two years to around 4%, although this increase appears to have levelled off in late 2024. The central bank estimates the natural real interest rate - corresponding to a zero-output gap, inflation at target, and neutral monetary policy - at around 2¼ per cent, albeit with considerable uncertainty (Central Bank of Iceland, 2025). The trade-weighted real exchange rate of the króna appreciated in the course of 2024, against the backdrop of a widening interest rate differential with trading partners, an upgrade of Iceland’s credit rating in September and the merger between an Icelandic food processing company and an international competitor (Panel B).
Note: Panel B, the real effective exchange rate is CPI-deflated, with rising values reflecting declining price competitiveness.
Source: Central Bank of Iceland; US Federal Reserve; European Central Bank; Bank of England; OECD, Competitiveness Indicators.
Inflation is falling, with headline inflation at 3.8% in May, down from 10% in early 2023 (Figure 1.16). Core inflation remains close to headline inflation, both exceeding the central bank's 2.5% target. Housing now accounts for over half of inflationary pressures. A modified method by Statistics Iceland applied since mid-2024, using rental equivalence, smooths the housing component of inflation. Moreover, mortgage interest payments are henceforth excluded, avoiding higher measured inflation when monetary policy tightens (Statistics Iceland, 2024). Services price inflation remains sticky due to significant wage increases in 2024, though the pace has slowed. Domestic goods inflation has eased, thanks in part to the entry of a new competitor in the grocery market. International electricity price fluctuations have a minimal impact as the country relies almost entirely on domestic electricity generation. The decline in inflation lags other countries partly because Iceland’s post-pandemic growth, especially business investment, had been underestimated for some time, and because wage hikes and domestic demand were larger than expected.
Inflation expectations are becoming better anchored. The central bank anticipates further disinflation throughout 2025, with risks to the inflation outlook broadly balanced (Central Bank of Iceland, 2025). The target is expected to be reached in the second half of 2026. Businesses and households are more cautious, expecting inflation to be at 4% and 5% respectively by the end of 2026. Domestic inflation pressures are expected to remain persistent due to wage drift as the labour market stays tight. Energy prices are trending upward (chapter 3). In this context, the central bank should maintain a restrictive monetary stance until inflation and inflation expectations have settled durably around the target. Finally, structural reforms such as strengthening competition-friendly regulations or easing conditions for foreign direct investment could help tame inflation and improve monetary policy transmission (chapter 4).
In late 2024, the government announced its intention to hold a referendum on resuming EU accession negotiations by 2027 and to commission an international expert group to assess the potential benefits of reforming Iceland’s monetary policy regime (Box 1.1). Historically, the idea of abandoning the króna and joining a larger currency area or establishing a currency peg has been regularly discussed. Debates on monetary policy independence intensified following the 2008/09 financial, economic and currency crisis. In 2012, the government started accession negotiations with the European Union (Ministry of Economic Affairs, 2012) but it called them off rather abruptly in 2013. In 2016, one reform option considered was to forgo monetary autonomy and peg the króna to another currency (OECD, 2017). However, it was ultimately concluded that a currency board would entail significant costs with limited benefits (Box 1.4).
Note: In Panels A and B, inflation refers to the national CPI. Panel B shows the weighted contribution of each spending item to overall inflation.
Source: Statistics Iceland; OECD, Prices database; Central Bank of Iceland.
Iceland has the smallest currency area among advanced economies, prompting regular discussions on potential changes to its monetary policy regime. Following a government initiative, the 2017 Economic Survey examined the benefits and costs of a unilateral currency peg. The main conclusion was that, should the monetary framework be reformed, membership in the European Union and adoption of the euro would be preferable to a peg.
The benefits of pegging the krona were found to include:
Enhanced currency predictability, reducing the tension between capital mobility management and monetary autonomy.
Serving as an anchor to contain domestic inflation pressures and promote price stability.
Lowering the costs of foreign exchange transactions, enabling firms to benefit from economies of scale and specialisation.
The costs could be as follows:
The loss of monetary independence would require more reliance on other policy levers, notably active counter-cyclical fiscal policy in pursuit of macroeconomic stability. Historically, Icelandic fiscal policy has often been inadequate to stabilise the economy (see fiscal section).
The capacity to cope with adverse external shocks would be reduced and the real exchange rate would still undergo fluctuations. Economic adjustment would need to occur through domestic wage and price adjustments.
Identifying a suitable currency to peg against is challenging given Iceland’s resource-based trade composition and high exposure to idiosyncratic shocks. Export destinations and import providers differ, making an obvious currency peg elusive.
Rather than pegging the currency, joining a larger monetary union through a bilateral agreement was deemed more beneficial. By adopting the euro, Iceland would benefit from the credibility of euro-area monetary policy, which could have a stabilising influence.
Source: (OECD, 2017).
1.3.1. Financial activity is picking up
Iceland’s financial system appears resilient and stable. With declining interest rates and gradually rising confidence, corporate credit growth remains robust, while demand from households is weak (Figure 1.17). Although the debt of both households and companies has slightly increased, it remains close to historical lows. Banks appear solid, comfortably meeting capital and liquidity requirements. Commercial property firms remain liquid, and risk premia have decreased since 2023. As property prices rise, households’ equity positions are improving (see below).
Note: Companies excluding financial institutions (which includes holding companies). GDP is the sum of the last four quarters. Annual and quarterly data.
Source: Central Bank of Iceland; Statistics Iceland.
Against this backdrop, the central bank reduced the capital buffer for systemic risk from 3% to 2% in December 2024, while raising it for other systemically important financial institutions from 2% to 3%. The central bank should remain vigilant and monitor the potential build-up of new imbalances as the policy interest rate is cut.
In June 2024, Parliament legislated the privatisation of the remaining 42.5% state ownership in ĺslandsbanki. The third and final tranche was sold in May 2025 to the Icelandic public, with institutional investors receiving a small share only. The presence of foreign banks remains very small, and so does the size of the fintech sector.
Icelandic pension funds, among the largest in the OECD as a share of GDP, account for over 40% of total financial assets (Figure 1.18). They provide a substantial macroeconomic buffer and, as noted, through their foreign investment holdings, improve the net investment position (Central Bank of Iceland, 2024). A 2022 reform allows these funds to gradually increase foreign currency asset holdings from below 50% to up to 65%, reducing their exposure to Iceland's volatile economy and countering the negative impact of “common ownership” (chapter 4). However, the share of housing and real estate in total assets is much lower than in similar pension systems such as those in Canada, the Netherlands or Switzerland (OECD, 2023). In June 2024, Parliament approved amendments to the pension funds’ investment authorisations. This will foster investment in real estate, notably the rental housing market (see below); help diversify the funds’ portfolio; and reduce mutual dependencies between banks and funds.
Note: Panel A: includes parent companies only. Panel B: covers assets that are earmarked for retirement under private pension plans.
Source: Central Bank of Iceland; OECD, Pensions at a Glance 2023.
The financial market infrastructure remains vulnerable to cyber-attacks. The number of incident reports surged from 700 in 2022 to over 1 200 in 2023, with several large-scale attacks targeting companies and government institutions (Central Bank of Iceland, 2024). In response, Iceland is enhancing cybersecurity measures. Since 2021, the central bank has operated a cooperation forum on financial market infrastructure security, modelled after similar bodies established by other Nordic central banks, and is working with deposit institutions to establish a domestic retail payment solution. In summer 2024, Parliament strengthened the central bank's authority over payment intermediation, allowing it to set operational security rules for digital retail payment intermediation, cross-border payment intermediation, and banknotes and coins, among others. Additionally, the Ministry of Finance is drafting a bill to implement the EU 2022 DORA directive on digital operational resilience for the financial sector.
1.3.2. The housing market is stabilising
The housing market is stabilising following the transmission of interest rate hikes to mortgages, but it remains tight (Central Bank of Iceland, 2024). Real house prices in Iceland have risen considerably more than in other Nordic countries and more than across the OECD (Figure 1.19, Panel A). Rising disposable incomes and population growth continue to sustain strong housing demand, preventing house prices from declining (Panel B). Short-term factors, such as the volcano-related evacuation and re-housing of several thousand inhabitants on the Reykjanes peninsula, added pressure to the market, but this effect tapered off in the second half of 2024. Resilience of households remains high as the household equity ratio (equity to assets) has gradually risen from around 45% in 2012 to 75% in 2023. In June 2022 the central bank lowered the maximum loan-to-value ratio from 90% to 85% for first-time buyers and in June 2021 from 85% to 80% for all others. Debt-service-to-income rules were introduced in December 2021 and tightened in June 2022.
Note: Panel B, real estate values according to the Housing and Construction Authority's official properties valuation for 2023.
Source: OECD, Analytical House Prices indicators; Central Bank of Iceland, Financial Stability Report 2025/1.
Along with strong demand, the tightness of the housing market could reflect undersupply of new housing, notwithstanding the dynamism of the construction sector in recent years. While the Icelandic housing market tends to react normally over the cycle - when prices and demand rise, supply responds, albeit with a lag - the housing stock has not kept pace with Iceland’s economic and population growth (Box 1.5). Construction, which increased moderately with the post-pandemic recovery, is levelling off (Figure 1.20, Panel A). Indicators such as the rent burden or overcrowding are above the OECD average (Panel B). Several obstacles could prevent more investment in housing. The issuance of municipal building permits can be cumbersome and slow at times, as noted in the previous OECD Economic Survey (OECD, 2023). Construction is essentially confined to the metropolitan arc around Reykjavik, while it is more limited beyond. Moreover, Reykjavik is advancing the "15-minute city" initiative, which aims to foster neighbourhood services close to residential areas and reduce traffic (City of Reykjavik, 2022). While this initiative is highly welcome, minimum service requirements should ensure that development projects are economically viable.
The government, as part of its coalition platform, pledges to foster housing supply by simplifying the permit process, enabling pension funds to increase housing investment, supporting housing associations, and facilitating the construction of new residential areas through agreements with municipalities (Box 1.1). This broad-ranging supply-side initiative is welcome. Land-use reforms, particularly the expansion of buildable land and densification, could stimulate investment in housing. Appropriate long-term planning should prevent the build-up of imbalances and oversupply. Simplifying and clarifying planning regulations and easing the administrative burden of obtaining building permits will help reduce construction time and costs. On the demand side, the government should better target housing allowances at low-income households and ensure appropriate investment in affordable housing, as recommended in the previous OECD Economic Survey (OECD, 2023).
Note: Panel A, fully finished housing units. Central Bank estimations for 2025. Panel B, median rent payments as a share of disposable income. Private market and subsidised rent are included.
Source: Central Bank of Iceland; OECD, Affordable Housing Indicators.
Over the past decade, housing demand in Iceland, particularly in the greater Reykjavík area, has surged due to a rapid rise in disposable income, significant inward immigration, and declining interest rates. The residential housing stock has not expanded proportionately to rapidly rising demand. This raises the question of whether Iceland’s housing market is in disequilibrium and whether stronger expansion through new investment could alleviate housing pressures. Conversely, there is a concern that such expansion could heighten financial market risks, particularly if new construction is debt-financed.
In the run-up to the global financial crisis, the housing stock had grown very rapidly. Housing investment, mostly debt-financed, was at its peak when the financial sector collapsed in 2008, leaving a significant property and debt overhang. After the crisis, Iceland experienced an extended housing trough. House prices began to rise again only from 2015 onwards, while the annual construction of new apartments resumed around 2018. An analysis conducted by the central bank for the years 1972 to 2023 suggests that supply responded appropriately to rising demand, albeit with considerable lags, meaning that construction took some time to increase when house prices rose, including in recent years. However, the analysis also indicates that investment had always been weaker than expected and never fully caught up during an upswing with the territory it had lost during a downswing.
The question of whether Iceland’s housing market functions well must be examined from different perspectives. From a financial market or cyclical viewpoint, the market operates appropriately, with supply responding to changes in demand, albeit slowly, and currently stabilising with declining risks. From a structural and long-term perspective and seen in an international context however, Iceland’s housing market has significantly tightened, with housing options gradually becoming more limited over the past 15 years. In this context, improving the conditions for building more houses without creating the risk of a future supply overhang could help alleviate the tightness in Iceland’s housing market.
Source: (Central Bank of Iceland, 2024); (OECD, 2021); (Elíasson, 2017).
1.4.1. Reforming the fiscal framework could improve spending control
The general government fiscal deficit has come down from 9% of GDP in 2020 to 2.2% in 2023 but widened in 2024 to 3.4% (Figure 1.21). Tax revenues have slowed as the economy decelerated, while disaster relief and reconstruction efforts on the volcano-stricken Reykjanes peninsula added around 0.3% of GDP to government spending. The fiscal stance remains contractionary, with the underlying primary balance improving by around 1% of GDP per year since 2021 on average, although the pace of consolidation has considerably slowed over time. Gross public debt, according to national accounts rules, went down from around 70% of GDP in 2020 to around 60% in 2024 as the Housing Financing Fund (HFF), a government-owned mortgage lender, was wound down and proceeds from the partial privatisation of Islandsbanki were used to repay liabilities. Net debt according to the Icelandic definition remains low at around 35% of GDP. The large gap between gross and net debt is due to substantial and liquid government financial assets held at the central bank and the HFF. Contingent liabilities have declined to 18% of GDP, and the government plans to issue new treasury debt to settle its remaining guarantees of HFF liabilities, which along with the sale of the government’s remaining shares in Íslandsbanki will reduce gross debt by around 6% of GDP in 2025.
Note: Panel B, national accounts statistics. These differ from Statistics Iceland measures of public debt, reflecting differences in the treatment of public entities, contingent liabilities and pension funds. Weighted average for OECD.
Source: OECD, Economic Outlook database.
According to the new government’s fiscal policy plan 2026-30, public finances will improve, to a surplus of 0.3% of GDP in 2030, implying strong consolidation efforts in 2025 and 2026. The planned overall 3½ percentage point reduction in the deficit is to be achieved through a combination of revenue and expenditure measures. On the revenue side, the government plans to reduce preferential tax treatments, better prevent tax evasion, and improve digital tax administration, without increasing the tax burden on individuals. It also plans to strengthen the taxation of natural resources, including tourism and fishing, notably and commendably through a more market-based valuation of the fish catch, which may bring in an extra 0.2% of GDP. On the spending side, outlays are to grow by less than GDP and priority will be given to the support of old and disabled people and additional spending on infrastructure including for defence (Iceland is a member of NATO but has no army).
The government is also about to amend the fiscal rules framework, replacing the current budget-balance rule by a new spending rule. The current rules create incentives to use cyclically-high revenues to finance new structural spending or reduce taxes, contributing to a pro-cyclical fiscal stance and amplifying economic cycles. Indeed, spending policy in Iceland has been pro-cyclical in more than two-thirds of the years since the turn of the millennium (OECD, 2023). Against this backdrop, the government has introduced legislation to Parliament proposing the replacement of the budget balance rule with a “stability rule” or structural spending rule. This new rule would cap the annual growth rate of real expenditure net of discretionary tax measures and some spending categories at 2%, taking into account the estimated longer-term growth rate while allowing for some cyclical variation, as recommended in past OECD Economic Surveys (OECD, 2019). The new rule should help to dampen pro-cyclical spending drift and maintain fiscal space. It should be carefully calibrated to ensure consistency with the debt rule, which is intended to remain basically unchanged, but with less mechanical provisions governing the return to under the 30% threshold in case of overshoot.
The position of the Fiscal Council within the fiscal framework remains relatively weak in international perspective, mainly because of its small size and a limited remit (von Trapp and Nicol, 2018). In particular, the Fiscal Council could be empowered and given the resources to assess revenue forecasts and revenue measures (as envisaged), and to evaluate the macroeconomic and fiscal projections underpinning medium-term budgeting, including the cost and revenue implications of new fiscal measures. Providing it with more resources and improving collaboration with other independent bodies could strengthen its role further. An option could be to integrate the Fiscal Council into a wider framework of independent institutions, to benefit from synergies and ensure consistency of policy advice across areas, as is done in Denmark (see above).
1.4.2. Spending on disability continues to rise
The share of public spending in GDP has not yet returned to pre-pandemic levels in Iceland (Figure 1.22, Panel A). The spending composition has evolved over the past decade: spending on health has considerably expanded, while property income paid (interest payments, rents, etc.) declined. Pension spending is below the OECD average thanks to a high retirement age and a small state pension system, while spending on disability benefits exceeds the OECD average. The share of public investment has considerably increased over the past decade. The government should carry out spending reviews, notably in large spending areas and building on earlier pilot projects, to prepare the ground for sustainable and efficient spending policy, as recommended in former Economic Surveys of Iceland (OECD, 2023) and (OECD, 2021)
Source: OECD, National Accounts database; (Pina, Hitschfeld and Miyahara, forthcoming)
Spending on disability benefits has significantly increased over the past two decades. The proportion of workers receiving disability benefits has almost doubled since 2000, reaching around 9% of the working-age population, while in several other countries, especially Sweden, the share has declined (Figure 1.23). Spending hikes were particularly significant in the years after the 2008-09 crisis. They span all age groups, with the most substantial increase among claimants aged 60 and older, suggesting that disability benefits are sometimes used as a pathway to early retirement. The system is complex, fragmented and opaque, offering various payments and supplements, and it provides relatively few incentives for disability claimants to return to work (Tryggingastofnun, 2024). Being on disability benefits increases the probability of being neither in employment, education, nor training from 8% to around 22%. The share of people receiving disability payments who are employed is below 20%, compared to an OECD average of 30% and even 50% in some OECD countries, including Sweden.
Share of disability benefit recipients in the population aged 20-64
Note: Disability benefit recipients over population aged 20-64. Disability benefits include contributory and non-contributory programmes specifically targeted to persons with disability. OECD is an unweighted average excluding Colombia and Costa Rica.
Source: OECD (2022), Disability, Work and Inclusion: Mainstreaming in All Policies and Practices, OECD Publishing, Paris, https://doi.org/10.1787/1eaa5e9c-en, Figure 4.1.
In 2024, Parliament adopted legislation to reform the disability system, effective September 2025 (Government of Iceland, 2024). The reform shifts from a purely medical to a comprehensive disability assessment, maintaining support for the disabled while encouraging work. It merges various disability-related payments into a single benefit, introduces a partial disability benefit, reduces adverse tapering when work is taken up, and improves coordination between service providers. This reform is welcome but incomplete. Health-related payments remain unreformed, potentially shifting pressure to the sickness benefit system. Additionally, the new benefit architecture, with a long rehabilitation payment (up to seven years) followed by a partial disability payment, provides few incentives for a successful return to work. International evidence suggests that the chances of returning to work and the effectiveness of rehabilitation measures decline steeply the longer individuals remain off work (OECD, 2022). Stronger disability prevention and management to curb new caseloads and further encouragement for returning to work might be needed. This includes strengthening early intervention, tightening eligibility criteria, and providing financial support when taking up part-time work, as in the Danish “Fleksjob” scheme (OECD, 2024).
1.4.3. Ageing costs will increase
Ageing and the associated fiscal costs are currently less of an issue in Iceland than in almost any other OECD country. Iceland’s population is young and growing fast, largely due to considerable labour immigration. The old-age dependency ratio is the lowest in Europe. Healthy life expectancy is one of the highest in the OECD, both for men and women. The work life is long with the statutory retirement age at 67 years and many people working even beyond, although the share of older workers receiving disability benefits has been rising considerably over the past ten years, suggesting disability is becoming a pathway to earlier retirement (see above). The pension system is sustainable, well-funded and diversified, comprising means-tested pay-as-you go state pensions, statutory private pension funds (see above) and tax-favoured individual savings. Consequently, public spending on pensions as a share of GDP is currently the lowest in the OECD (Figure 1.24, Panel A).
Note: Panel A, the old age dependency ratio is the number of individuals aged 65 and more to the population aged between 15 and 64. Panel B, public pension spending is total public cash benefits spent on old age and survivors.
Source: OECD, Historical population database; OECD, Population Projections database; OECD, Social expenditure database.
Even so, Iceland will face the economic and fiscal impact of ageing. The old-age dependency ratio is expected to rise as immigration and employment growth slow (Figure 1.24, Panel B). The government projects the fiscal cost of ageing to increase by almost 2 percentage points of GDP by 2050, primarily due to higher spending on health and long-term care (Ministry of Finance and Economic Affairs, 2025). The costs of generalist and hospital care tend to expand less because people are both getting older and healthier, largely cancelling each other out (Kallestrup-Lamb et al., 2024). The most significant cost increase comes from the rising need for long-term care (LTC), especially due to the increasing prevalence of dementia with age (Kollerup et al., 2022). As such, the cost of LTC will rise considerably over the coming decades in Iceland (Hashiguchi and Llena-Nozal, 2020), requiring a more detailed analysis of future public funding levels and composition, a potential reshuffle of funding across government levels (LTC in Iceland is largely under municipal responsibility today), and – if appropriate - the extension of care insurance (Koutsogeorgopoulou, Morgavi and Unsal, forthcoming). Additionally, there is scope to make service provision more resilient, efficient, and affordable, especially for low-income earners (OECD, 2023).
The private funded pension system is largely immune to ageing pressures as it relies on defined benefits adjusted for each age cohort, ensuring overall system sustainability despite declining participation. The government also anticipates that the spending share of the state pension system will remain stable - and even decline from around 2035 - despite nearly doubling from 1.5% to 3% of GDP since 2010, partly due to a 2016-18 revision, negotiated in collective wage agreements and later legislated, that increased replacement rates. Even so, it could be prudent to link the retirement age to life expectancy and allow for small incremental increases every year, as more and more OECD countries are doing (OECD, 2023) and as recommended in the previous OECD Economic Survey (OECD, 2023).
Overall, Iceland’s long-term debt profile depends importantly on the implementation of structural reform (Figure 1.25). In a baseline scenario with no reforms to address rising ageing costs, gross government debt would start rising in the 2040s to around 60% of GDP by 2060. In a fiscal consolidation scenario following reforms described in Table 1.7, debt would fall to around 26% by 2060. In the full reform scenario, with implementation of all growth-enhancing structural reforms recommended in Table 1.3, debt would decline further to around 22% of GDP. Debt developments will also be shaped by the evolution of long-term interest rates (Panel B). Reform progress with respect to monetary, financial and fiscal policy is shown in Table 1.6.
Note: Debt projections until 2030 follow the government’s proposed fiscal plan. The baseline reflects rising current tax and spending with a build-up of ageing costs stemming from state pensions, public health and long-term care spending, assuming an unchanged replacement rate for state pensions. The “fiscal consolidation” scenario shows the effect of the fiscal package listed in Table 1.7 within the next 10 years, while the “all reforms scenario” shows the effect of the fiscal package shown in Table 1.7 plus the growth effect of reforms listed in Table 1.3.
Source: OECD Economic Outlook database; OECD, Long-term model; OECD calculations.
1.4.4. Taxation should become less distorting
After major reforms between 2017 and 2021, the government has made minor tax changes in the past two years. Key changes include partly repealing the VAT refund on the labour share in housing construction (reduced from 60% to 35%), reinstating the full VAT for electric cars, higher carbon taxes, an airport tax, and reinstating the hotel accommodation tax, suspended during COVID-19. A distance-based car tax for fossil-fuel-propelled cars is to be introduced in the second half of 2025. The VAT revenue ratio - the share of actual VAT collection relative to the maximum if all consumption was taxed at the standard rate - edged up from 50% in 2019 to 52% in 2023, still below the OECD average. The overall tax burden is around 35% of GDP, with a heavy reliance on income taxes as in other Nordic countries (Figure 1.26). The government should continue reducing exemptions and closing loopholes to enhance tax system efficiency and fairness.
Note: Panel A, the spike in 2016 reflects revenues from the “exit tax” levied on creditors reclaiming assets from banks that had defaulted in the 2008/09 crisis.
Source: OECD, Global Revenue Statistics database.
Marginal tax rates for low- and middle-income earners remain relatively high, a result of the progressive tax system and strong means-testing of social benefits, particularly for child and family support, as noted in previous Economic Surveys (OECD, 2023). The system of “tax bracket sharing” (a specific Icelandic method of reducing the additional burden resulting from taxing family or joint rather than individual income), results in Iceland having the highest marginal income tax rates for second earners in the OECD, predominantly affecting women. Tax bracket sharing could partly explain why Iceland has the largest gap in hours of paid work between men and women, and why this gap is only slowly closing towards the OECD average or other Nordic countries (see section on the labour market and Figure 1.11). In this context, and as planned, the government should abolish “tax bracket sharing” to increase women’s participation. Overall, the fiscal recommendations, including those from chapter 2, would improve the budget balance by 1.0% of GDP (Box 1.6).
The estimates in Table 1.7 below roughly quantify the fiscal impact of selected recommendations within a 5 to 10-year horizon, using simple and illustrative policy changes. The reported effects do not include behavioural responses and growth effects.
Note: The recommendations related to improving the business climate (in-depth thematic chapter) are included in the growth impact quantification, but their fiscal impact cannot be quantified.
Source: OECD own calculations.
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