Growth
prospects remain strong but are subject to increasing downside risks
from weakening international activity and stress in financial markets.
Implementation of the international tax transparency agenda, which
Luxembourg has embraced, could weigh on economic activity and tax
revenue.
At the same time, various other competitive advantages, such as
Luxembourg’s triple-AAA rating and its qualified labor force, would
continue to benefit the country. Against this backdrop, the fiscal
stance should remain prudent and contingency measures should be prepared
for the event negative shocks occur. The limited
fiscal space should be used to bolster growth prospects, while adapting
the tax regime to the changing international environment and ensuring
the long-term viability of the pension system. Implementation of the
Banking Union will help to increase the stability and resilience of the
banking system. Financial sector risks need to be monitored closely and,
where necessary, Luxembourg should advocate appropriate international
regulation. Building on past experience, active labor market policies
should focus on integrating refugees in the labor market and further
reducing unemployment.
Fiscal Policy
The revenue
risks of the international tax transparency initiatives and volatile
financial flows make it appropriate for Luxembourg to keep the public
debt ratio on a slightly declining path, in order to maintain
sufficient buffers in case of need. This requires targeting a small
fiscal surplus of around ½ percent of GDP in 2016 and over the medium
term.
Vigorous economic activity has opened some fiscal space, which should be used to bolster long-term economic growth.
In 2015, buoyant tax revenues and lower-than-expected capital outlays
have contributed to a significant improvement in the fiscal balance
compared to budget. Under unchanged policies, including full
implementation of the Zukunftspak, the fiscal position is expected to remain in surplus over the medium term. Available fiscal space of almost ½ percent of GDP should be used for growth-friendly measures such as infrastructure investments.
The tax reform
proposals unveiled at end-February contain a significant reduction in
personal taxation and also in the corporate income tax starting in 2017.
Preliminary estimates indicate that these measures would reduce total
fiscal revenue by up to 1 percent of GDP, fully using up the projected
fiscal surpluses. It is advisable to limit the size of the tax reduction
to the available fiscal space. While some of the tax measures aim to
increase housing supply, the envisaged tax relief for home buyers would
aggravate existing imbalances given that demand for real estate
structurally outstrips supply.
The ongoing tax
reform is an opportunity to solidify the tax base in a revenue neutral
way and adjust to the changing international taxation environment.
The international tax transparency initiatives—including those
spearheaded by Luxembourg during its EU presidency in the second half of
2015—call for closing loopholes used for tax avoidance. The tax reform
should aim at widening the corporate tax base and eliminating special
tax regimes while lowering statutory tax rates. The decision to phase
out the IP Box tax regime from mid-2016 is a step in this direction.
Moreover, the government should develop contingency measures, including
revisiting the low real estate taxes, in case negative revenue risks
materialize.
Continued reform of the pension system is advisable. The
pension system is currently generating surpluses due to advantageous
demographics. However, population ageing is expected to put significant
pressure on the system in the future, especially when cross-border
workers begin to retire. Accordingly, the upcoming 2016 pension review
should propose additional parametric reforms of the pension system—such
as of the minimum contributions period and conditions for early
retirement—to safeguard its long-term sustainability and promote
fairness across generations.
Financial Sector Policy...
Luxembourg’s
world-class financial sector benefits from a stable regulatory and
fiscal environment, prudent oversight, and a skilled workforce. The
expansion of the investment funds industry, the second largest in the
world, has benefited from the EU passport. Since end-2008, about 1/5
of all worldwide net inflows into mutual funds came to Luxembourg. The
mostly outward oriented banking system, well-capitalized and with very
low non-performing loans, is characterized by a high level of
intra-group flows and the collection of corporate and high net-wealth
clients’ deposits.
The high
interconnections of Luxembourg’s financial system with the rest of the
world make it a recipient and conduit of global financial volatility. Investment
funds, which have benefited from a search for yield, comprise diverse
asset classes spread across many countries. Cross-border and interbank
claims account for more than half of banking assets. Value-added in the
financial sector, which accounts for ¼ of GDP, fluctuates with global
market developments.
The Banking Union is particularly beneficial to Luxembourg’s banking system. The
Single Supervisory Mechanism (SSM) is an improvement in supervision,
especially of cross-border banks, and establishes a consistent and high
level of oversight. The significant enlargement of the resources of the Commission de Surveillance du Secteur Financier
in recent years is welcome and should remain commensurate with the
increasing size and complexity of the financial sector. Likewise, the
Single Resolution Mechanism will ensure swift intervention ahead of
insolvency, with financial support from the industry pooled in the
Single Resolution Fund. The recent transposition of the Deposit
Guarantee Scheme Directive and of the Bank Recovery and Resolution
Directive completes the legal implementation of the Single Rule Book in
Luxembourg. The authorities should also advocate for better oversight at
the European level of holding companies that include banks to improve
risk monitoring.
Strong oversight
of investment funds and their management companies is necessary, in
line with evolving international standards. The relevant EU
directives have strengthened the framework for risk monitoring,
liquidity management, and supervision of investment funds. The use of
derivatives that boost leverage, liquidity mismatches between assets and
redemption terms, and the use of securities lending to improve cash
returns should be more specifically scrutinized. The data reporting
should allow identifying funds’ sensitivity to interest rates and credit
market movements.
Linkages between banks and investment funds are an important trait of the financial system. Depository
banks of investment funds are all located in Luxembourg and banks
provide administrative, pricing, brokerage, and accounting services to
funds. Investment funds hold sizable deposits in their depository banks,
which may channel the liquidity to the parent, as well as significant
amounts of financial bonds while banks act as counterparties in
derivative contracts. There are also ownership links between Luxembourg
fund management companies and large banking groups.
Risk monitoring and regulatory frameworks should take into account the linkages between banks and investment funds. Luxembourg
should propose to discuss these linkages in the SSM and include them in
the design of joint fund-bank stress test scenarios. Risks should be
assessed not only at the investment fund level but also from a financial
stability perspective. The Comité de Risque Systémique has added
the analysis of these linkages to its work program at the national
level and it should also ensure that the linkages are examined at the EU
level in the European Systemic Risk Board.
Risks in the real estate market should be closely monitored.
Steadily rising house prices appear to mainly reflect supply
bottlenecks against a growing demand. The authorities should explore
whether further macro-prudential measures such as limits to
loan-to-value ratios are appropriate.
Policies for Growth and Employment
The government is taking steps to diversify the economy.
Expanding activity beyond the financial sector is important to enhance
the resilience of the economy and should be supported with measures to
better align workers’ skills with the economy’s demands. Structural
reforms addressing supply-side constraints, such as easing zoning
requirements for real estate construction, could also help.
Strong growth and active labor market policies have reduced the unemployment rate. Innovative
measures by the public employment service (ADEM), vocational training
and apprenticeship programs, and the Youth Guarantee scheme have helped
to create job opportunities and to increase youth and women’s labor
market participation. Additional steps are needed to reduce inactivity
traps while ensuring that real wages remain in line with productivity.
Luxembourg is well-equipped to cope with elevated refugee inflows. Building
on its past experience, the country facilitates enrollment of the
newcomers into language classes, schools, and other training programs.
For faster integration of refugees in the labor market, the time to
obtain a temporary employment authorization could be further reduced to
less than 6 months after the asylum application. In addition, it would
be helpful to extend to refugees who have been granted asylum the
employment promotion programs currently available for the long-term
unemployed.
The mission thanks the Luxembourg authorities and
representatives from the private sector for the open and constructive
discussions.
