IMF Urges VAT Restraint In Finland

by Ulrika Lomas, Tax-News.com, Brussels

05 November 2008

The International Monetary Fund (IMF) on Monday released the conclusions of its Article IV consultation with Finland.

Although the IMF stressed that the country was among the best EU performers, it nevertheless observed that "the Finnish economy faces the headwind of the international crisis and important structural challenges. Finnish financial markets and banks have been remarkably resilient to the global turmoil so far, but the spillovers from the persistent upheaval will take a severe toll on 2009 growth. Looking forward, rapid population aging and slowing productivity threaten longer-term growth, competitiveness and fiscal sustainability".

Commenting on economic growth and inflation, the IMF revealed that:

"After expanding by a strong 4.5% last year, GDP slowed considerably in the first half of 2008 amid sharply falling consumer and business confidence. Employment growth has also all but vanished in recent months, though labor shortages and mismatches in some sectors remain a problem...Growth is likely to slow further in 2008-09 amid dwindling domestic demand and a flagging external environment. The mission projects it to dip to about 2% this year and 0.5% next year."

However, it suggested that:

"Inflation should peak at about 4% in 2008, before falling back in 2009, as the pass-through of earlier food and fuel price surges fades, aided by a late-2009 cut in food VAT."

On fiscal policy, the IMF mission report observed that:

"From a cyclical perspective a modest fiscal loosening is possible. Current policies, including a cut in labor taxes and in the VAT on food, would result in a fiscal stimulus of about 1 percent of GDP. The mission recognizes that, in the short-term, with negative output gaps envisaged for 2009-11, there is scope for a discretionary budgetary impulse. Nevertheless, a somewhat smaller relaxation than envisaged by the authorities might be appropriate."

The Fund went on to explain that, putting aside questions of the magnitude of the stimulus, it should be designed to minimize the negative impact on the long-term budget position:

"The mission backs actions that reduce economic distortions or can be implemented swiftly and clawed back quickly once growth prospects improve and room for loosening fades. Specifically, rapidly implementable infrastructure projects, e.g. supporting liquidity-constrained firms in housing construction and earned-income tax cuts to promote labor force participation, seem preferable. On the other hand, the cut in the VAT rate on food is not advisable."

Going on to explain its reasoning, the IMF suggested that:

"Lower labor taxes can promote higher labor force participation, and possibly aid fiscal sustainability, if accompanied by a broadening of the bases of less distortionary levies. In this context, the mission does not consider advisable the planned cut of the VAT rate on food, since the VAT is among the least distortionary taxes and revenue losses must be minimized for sustainability's sake. Indeed, the Finnish VAT base should be expanded, considering that its effectiveness is barely at the OECD average, owing to special treatments for a relatively large share of goods and services. At the same time, it would be useful to increase property taxation, low in international comparison."

Turning to financial sector oversight, the IMF mission welcomed the fact that Finland's banks have been largely sheltered from the turmoil so far, but suggested that profitability, liquidity, and mortgage lending require attention.

It stated that:

"The authorities' measures to buttress the financial sector are opportune. In keeping with euro area agreements, Finland raised deposit insurance to EUR50,000, announced a EUR50 billion to guarantee the rollover of term debt issued by banks (subject to compensation on commercial terms and with maximum maturity of five years), and proposed a bank recapitalization fund of EUR4 billion. The mission supports prompt passage of the related legislation and regulations. The mission also endorses the authorities' intention to implement these measures without distorting competition among Finnish banks."

"Rapid changes in the financial landscape will continue to challenge supervision. Financial market supervision is good in Finland, and the prospective merger of the Financial Supervisory Authority and the Insurance Supervisory Authority should further improve efficiency and effectiveness."

In conclusion, the IMF report observed that:

"Initiatives to stanch the financial crisis and stimulate activity must not impede efforts to boost long-term growth and attain fiscal sustainability. Given Finland's strong initial position, prudent and foresighted policies should allow the economy to respond to the present shocks better than most other countries."

"In particular, continued steps are required to maintain financial stability, consolidate fiscal resilience to population aging, and stimulate labor force participation and productivity. This will ensure preservation of the current social model -- embracing the benefits of globalization, while supporting those who face difficult adjustments -- which has served Finland well."

The Finnish government pledged following the 2007 election to cut Finnish taxes by EUR1bn over the course of its term, which ends in 2011.

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