Sweden publishes IMF statement

The IMF’s appraisal of the Swedish economy is contained in the statement, which
is attached. The IMF’s statement will also be accessible on the Riksbank’s website: www.riksbank.se.

Mr Jacques Artus, who heads the delegation, will be available for questions
at 2 p.m. today, Wednesday, at the Riksbank. Admission by press card from
no. 11 Brunkebergstorg .

For further information, please contact the International Department:
Maria Götherström, telephone no. +46 8 787 04 95.

International Monetary Fund

Sweden – 2000 Article IV Consultation

Concluding Statement

June 21, 2000

Overview

Sweden is currently enjoying the fruits of its financial adjustment efforts during the mid- and late 1990s, centered on inflation targeting and a strong fiscal consolidation program. The success of these policies is evident: a robust economic recovery, low inflation, fiscal surpluses, and a profitable and sound banking sector. Indeed, the elimination of the long-term interest rate differential vis-à-vis Germany from a peak exceeding 500 basis points in 1994 is a clear sign that Swedish macroeconomic policy is now fully credible.

In 2000 and 2001, the rate of economic growth is expected to remain firm with subdued inflationary pressures. The mission projects that economic growth could be close to 4½ percent this year, and 3½ percent in 2001, with all components of demand making contributions. Employment growth should sustain its recent momentum, with the open unemployment rate dropping below 4 percent in 2001. The core inflation rate (which excludes the effects of interest rate changes, indirect taxes, and changes in the price of oil) should rise only gradually, from less than 1 percent currently to 1½ percent in 2001.
The challenge is now to secure the longer-run sustainability of the expansion. This is a battle that has not yet been won. Notwithstanding the sharp reduction in the ratio of government expenditures to GDP in recent years, the role of the government remains large in comparison with other industrial countries. This level of government is financed by numerous taxes, which, piled on top of each other, considerably weaken and distort the incentives to work, save, and invest. Other prominent rigidities include the limited amount of wage differentiation and weak job search incentives. These rigidities may explain why, despite Sweden’s dynamic telecommunications industry, the benefits of new technologies in terms of higher productivity growth are yet to be evident elsewhere in the economy.

Fiscal Policy

Sustaining the expansion will, first and foremost, require the firm implementation of Sweden’s medium term fiscal strategy of lowering the ratio of government expenditures to GDP to provide room for additional tax cuts. In the Spring budget the Swedish authorities stressed their commitment to adhere to budgetary ceilings for the central government that would contribute to an average increase in real general government expenditure (net of interest payments) of 1.3 percent per annum from 2000 to 2003. This is not an ambitious effort. Cyclically sensitive expenditures such as unemployment compensation are declining rapidly because of the improved economic situation, so that the fiscal restraint in other categories is quite limited. At a minimum, the authorities should take these cyclical effects into account and lower the expenditure target by a corresponding amount below the ceiling. Measures should also be taken to resorb policy slippages, including those currently taking place in sickness and disability benefits. Net budgeting (the practice of recording expenditures as negative revenues) masks the problems rather than solving them and it should be stopped. At the local government level there is a risk that buoyant revenues resulting from strong economic activity will lead to an undue expansion of expenditures. Such a development would call for a reduction in transfers from the central government or a cut in local taxes.

The mission strongly recommends that all the room for tax cuts be used. Provided that the existing expenditure ceilings are respected, it would estimate this room for tax cuts at about 4 percent of GDP over the 2001-03 period. Even with such tax cuts, the structural fiscal surplus would be maintained at 2 percent of GDP, in line with the authorities’ objective. Taking into account the receipts from privatization — which should be used for debt reduction, as the authorities intend — the gross public debt to GDP ratio could be cut from 66 percent at end-1999 to probably less than 47 percent by end-2003. There is really no need to reduce the debt burden any faster than this.

Indeed, there is a real risk that if not fully used for tax cuts, the initial gains from expenditure restraint would soon lead to policy slippages on current expenditure and possibly to political pressures for new expenditure programs. Sweden would then have wasted a golden opportunity to make some progress in reducing the tax burden, without any benefit in terms of lower public debt.

Choosing the right taxes to cut is key to the success of the strategy. The main objective should be to allocate the overall tax burden fairly among social groups and foster incentives to work, save, and invest to expand the supply of resources. This will require a well-articulated, comprehensive program of tax reforms. The main components should encompass the following: (i) increase further tax credits to offset the fees paid by employees to the pension fund to stimulate work incentives at the lower end of the income scale; (ii) replace the two state income tax rates of 20 and 25 percent with a single rate of 15 percent to lower marginal tax rates at higher incomes and help Sweden to better reward investments in education and skills; and (iii) lower the capital income tax rate and raise the threshold on wealth taxation to stimulate entrepreneurship, saving, and investment. On the other hand, the authorities should strongly resist maintaining the freeze on the tax valuation of housing or offsetting the effects of lifting the freeze through other tax concessions: this sector is already heavily favored from a fiscal standpoint.

Tax cuts should be spread uniformly over 2001-03. The mission projects that, in the absence of policy slippages, the general government surplus should already reach about 4 percent of GDP before tax cuts in 2001. As economic activity could be viewed as broadly cyclically neutral (i.e., without much economic slack or overheating), the structural surplus would also be 4 percent and the room for tax cuts would be 2 percentage points of GDP. However, the mission would recommend a cautious approach of smoothing the tax cuts over time — with a first installment of only about 1 1/3 percent of GDP (some Skr 30 billion) in 2001 — to take into account the uncertainty of the estimates of the current cyclical position of the economy and the size of the structural fiscal surplus. The precise size of the tax cuts for 2002 and 2003 could then be determined after reviewing the economic and fiscal developments in 2001.

Several factors will contribute to limit the effects of the tax cuts on aggregate demand. First, the ongoing parallel reduction of revenue and expenditure implies some restraint in aggregate demand because the stimulative effect of revenue reductions is less than the contractionary effect of corresponding cuts in expenditure. Second, the automatic stabilizers are extremely powerful in Sweden, and in 2001 — as in 2000 — they will provide considerable restraint on aggregate demand. Appropriately chosen tax cuts would also have a stimulating effect on the supply side. In any case, monetary policy could easily adjust to compensate for some small expansionary effects from fiscal policy if they did emerge.

Monetary Policy

The Riksbank is to be congratulated for not having raised interest rates too aggressively early in the business cycle. However, a less accommodative stance will likely be required in the not too distant future. After some modest hikes in the repo rate in late 1999-early 2000, it was quite appropriate for the Riksbank to refrain from further increases, given that: (i) the core rate of inflation was less than 1 percent and falling, and (ii) there was no serious risk of inflationary pressures in the foreseeable future. Looking ahead, however, it is likely that the robust momentum of the economy will require some increase in interest rates by Fall 2000 to keep inflation on target through at least 2002. As long as moderation persists in the coming wage round, and even with the suggested tax cut, a gradual return to a cyclically neutral level of interest rates in the first half of 2001 should probably be sufficient to keep inflation prospects for the next two years in line with the 2 percent target. If this gradual tightening were to lead to some moderate appreciation of the exchange rate, this should not be viewed with concern, given the healthy current account surpluses and the favorable external competitiveness of the Swedish economy. As to the inflation targeting framework itself, it seems to work well and our only suggestion would be to extend the forecast horizon for inflation beyond two years to provide the financial market with a clearer picture of the likely future path of the repo rate.

Structural Reforms in Labor Markets

The wage formation process is changing but the implications are uncertain and will be tested during the new wage round set to commence next Spring against the backdrop of a low unemployment rate. The establishment by the government of a new Mediation Authority, as well as the agreements in the industrial and government sectors to set up their own mediation procedures, may help to foster a continuation of wage moderation. However, this remains to be seen as the authority of the mediators does not go much beyond "moral suasion". As Sweden cannot afford a return to the wage inflation of the 1970s and 1980s, or the economic recession that would result from a clash between unduly high wage increases and the Riksbank’s inflation target, the authorities will have to remain vigilant and, if necessary, strengthen the recent reforms by implementing more fully the recommendations of the Öberg Commission.

Greater wage differentiation is beginning to appear in some sectors of the economy, but it needs to become more widespread. The high-tech sector presents the clearest example of increased wage differentiation taking place in Sweden, but even more differentiation will be required in the future to enable Sweden to maintain and attract highly skilled individuals to this sector. This development should help to bring about changes in other sectors where wage differentiation is much less pronounced. In particular, little wage differentiation occurs in response to different profit developments within industrial sectors, and investments in further education and training are not rewarded adequately. According to the OECD, only Australia, Denmark, Norway, and the Netherlands have lower wage premiums for university education. Increased wage flexibility could be accomplished without jeopardizing a moderate aggregate outcome through offering more wage variation within sectors and across skill levels while maintaining an aggregate ceiling for the wage bill.

The rationale for reforming the unemployment insurance system is commendable but the specific measures envisaged are unlikely to be sufficient to achieve the desired results. The reform intends to stimulate search behavior through tightening the relationship between the level of benefits and the intensity of job search. However, the current system already has a fairly strict search clause; the problem with this clause is that it is not implemented properly, partly because it is difficult to assess whether an individual is actively searching. Increased emphasis is being placed on maintaining the unemployed as active members of the labor force through mandatory full-time training or other full-time activities. This policy should be complemented by having a relatively generous level of unemployment benefit for the first few months of unemployment but significant cuts later on, say after 6 months and again after 12 months, regardless of whether an individual is in an active labor market program or not. This measure, by itself, would force the unemployed to search more intensively for work. For the long-term unemployed, the activation guarantee should help in maintaining the attachment of this group to the labor market, but the authorities must ensure that the activities under the program are truly full-time productive activities.

Active labor market programs have played a prominent role in Sweden’s macroeconomic strategy but so far the net benefit of these programs is uncertain. Notwithstanding the preference for active versus passive measures, Sweden’s generous spending on active programs stands out internationally. Moreover, recent research on the ability of various Swedish programs to reintegrate individuals into durable employment is disappointing. The majority of those on wage subsidies return to unemployment soon after the subsidies expire and those on youth programs have a lower probability of becoming employed relative to a control group with similar characteristics. On the other hand, the studies were carried out over a period when economic activity was low in Sweden and it is unclear whether similar results would hold true in the current strong upswing. Clearly, more resources need to be devoted to evaluating the cost effectiveness of these programs.

The authorities should be commended for their pension reform — which is one of the best in Europe — but much more needs to be done to increase the effective retirement age. Like most other industrial countries, Sweden will soon be faced by a major demographic shock: an insufficient number of workers to support a growing population of pensioners. Reducing the public debt ahead of the shock will help somewhat to blunt this effect. However, the only effective ways to adjust to the demographic shock are pension reform and increasing the effective retirement age. In the first case, Sweden is making progress. The new pension reform has strengthened the relationship between pension contributions and benefits and individuals can choose to retire between 61 and 70 years of age. In the other area, progress is less evident. While the decision to restrict combining part-time work with an early retirement pension will help somewhat, the current statutory retirement age at 65 is inconsistent with the enhanced freedom of choice embodied in the new pension scheme and should be raised or eliminated. More fundamentally, there is need to strengthen the legal protection against age-based discrimination in hiring, dismissal, and access to training. If there is one area where the social partners could play a more active and positive role, this is it.
* * *

Sound macroeconomic management over the past few years has made significant contributions to the strong rebound in the Swedish economy from the deep recession of the early 1990s. However, the sustainability of the rebound will depend on the success of the structural reform program under consideration. The authorities have a rare opportunity to tackle Sweden’s structural impediments head on to help reverse its decline into the lower half of the income-per-capita league among advanced economies over the past quarter century. This is an opportunity that should not be missed.