The following OECD assessment and recommendations summarise chapter 4 of the Economic Survey of the Euro Area published on 14 January 2009.
The recession and financial market turmoil will add to fiscal pressures
Fiscal performance improved in recent years. The overall euro area fiscal deficit shrank from 2.5% of GDP in 2005 to 0.6% in 2007 and the cyclically-adjusted fiscal deficit declined as well. Some countries achieved impressive fiscal positions but some high-debt countries made little effort to improve their fiscal position. The last economic expansion was particularly rich in revenue and generated strong growth in receipts from corporation tax and taxes related to capital gains and property, so that the measured improvement in the underlying fiscal position is likely to be overstated. The economic downturn, unfavourable developments in tax elasticities, and the actions being taken by governments to stabilise financial markets will add to fiscal pressures. The euro area actual fiscal deficit is expected to increase by 0.8% of GDP in both 2008 and 2009, reversing much of the decline in 2006-07. Government debt had fallen as a share of GDP, but is now set to rise again. The major challenge for long-run fiscal sustainability remains ageing and healthcare costs: the most recent estimate from the European Commission suggests an increase in the share of age-related spending of 4.4% of GDP between 2010 and 2050, bringing this share to about 28% of GDP but the actual costs could be much higher. Consideration should be given to how this challenge will be addressed through structural reforms and pre-funding.
The revised Stability and Growth Pact has yet to be tested in an economic downturn
The revised Stability and Growth Pact (SGP) agreed in 2005 has been successful up until recently, but has yet to be tested in an economic downturn, or a financial crisis. Euro area countries had emerged from Excessive Deficit Procedures under the “dissuasive arm” of the Pact in recent years. The greater discretion under the revised Pact has hardly been used so far and should be used only sparingly. In fact this is exactly what has happened since the 2005 reform of the Pact. The SGP’s “preventive arm” has continued to develop, with greater focus on the achievement of long-run fiscal sustainability. Nevertheless, the existing range of the country-specific medium-term budgetary objectives (MTOs) does not fully reflect the fiscal sustainability challenges facing different countries: the current proposals to take implicit liabilities into account when setting MTOs should be implemented. The objective of attaining the MTOs by improving the structural balance by 0.5% of GDP or more in “good times” has had mixed results. The definition of good and bad times and the calculation of their impact on budgetary balances could be refined further. There should be greater emphasis on asset prices and a disaggregated analysis of revenues in assessing structural balances.
Improving long-run fiscal sustainability should remain a priority, given the challenges stemming from ageing.
Fiscal policy in some euro area member states tightened as the economy expanded in recent years, but policy has remained pro-cyclical in others and a few were forced to tighten policy under adverse cyclical circumstances. In the context of the current economic slowdown and the exceptional measures being taken to support the financial system, discretionary fiscal policy may be appropriate where room for manoeuvre exists. Any discretionary easing should be timely, targeted and temporary and take into account specific challenges of the country concerned. The reformed Stability and Growth Pact provides sufficient flexibility to allow for fiscal policy to play its normal stabilisation function. The relatively large automatic stabilisers in Europe will help cushion the slowdown. The priority should remain improving long-run fiscal sustainability, given the challenges stemming from ageing. This is in line with the conclusions of the October 2008 ECOFIN Council. In addition, fiscal incentives to invest in housing exacerbate the housing cycle and should be phased out in the long run. Moreover, in some cases there is opportunity for property taxation to be designed more efficiently, allowing it to function as a built-in stabiliser. However, due account would need to be taken of the timing of these changes, especially with regard to the risk of exacerbating further the present difficulties in the housing market.
The quality of the public finances could be improved, which will contribute to improved living standards
The efficiency of government intervention is an important way in which fiscal policy can contribute to raising living standards, with key factors including the ways in which money is spent and the design of the tax system. This is a key issue for the euro area because public spending accounts for around 45% of GDP on average. Infrastructure investment can help to raise living standards, although it should be well-designed and policies such as user charges can contribute to its efficient use. The efficiency of public spending is hard to assess. But, there is some evidence that euro area countries could benefit from improving value for money: educational attainment could be raised by following international best practice or raising the efficiency within national systems towards those of the best performing schools; and health spending could be better used to improve outcomes. The design of the tax system should be improved by increasing the use and efficiency of consumption taxes, which would be less distorting than the current degree of reliance on personal income taxes, although in seeking such reform it is important to consider the effect on the distribution of real incomes. Moreover, strong fiscal governance frameworks can help to ensure sound budgetary positions and improve the efficiency of public spending.
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The OECD Secretariat's report was prepared by Nigel Pain, Jeremy Lawson, Sebastian Barnes and Marte Sollie under the supervision of Peter Hoeller. Research assistance was provided by Isabelle Duong.