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Ministry of Finance and Economic Affairs

The 2002 fiscal budget speech by the Minister of Finance, Mr. Geir H. Haarde, presented to the Althingi, October 4, 2001

The 2002 fiscal budget.

Speech by the Minister of Finance, Mr. Geir H. Haarde to the Althingi, October 4, 2001

Mr. Speaker

I hereby present the 2002 fiscal budget to the Althingi. My speech will concentrate upon the main points of the Government’s economic and fiscal policy as they appear in the budget. I shall also introduce the main elements of the budget and the premises on which it is based. I shall not deal with individual appropriations as proposed in the budget.

Fiscal policy will be tight

In many respects, the 2002 fiscal budget reflects the recently changed economic conditions. Following a vigorous upswing in recent years, the economy is again moving towards equilibrium. Domestic demand has abated and the current account deficit is being reduced. Inflation is also expected to decline in the near future. As a result, economic growth is now lower, which in turn will inevitably lead to a lower increase in Treasury revenue. Given these circumstances it is not unreasonable that the Treasury surplus will be lower than in recent years. Nonetheless, it will be very important to pursue a tight fiscal policy in the coming year. The 2002 fiscal budget projects a revenue surplus of 18.6 billion krónur, equivalent to 2 ½ per cent of GDP. The net financial balance is substantially higher, more than 41 billion krónur. This result is indicative of the success achieved with the Government’s economic policy in recent years and is fully in line with the Government’s policy goal of maintaining stability, strengthening the foundations of economic activity and to ensure a continued rise in the standard of living. The net debt of the Treasury is estimated to decline to 14 per cent of GDP towards the end of next year. This means that the Treasury will become a net lender, not a net debtor, in the foreseeable future, although the Treasury will certainly continue to perform its role as a provider of government securities in the market.

Room for tax reductions

Under these circumstances there are important arguments for reducing taxes, both on enterprises and individuals. By applying prudent tax measures, a downward spiral in the economy can be averted and the Government can act as a catalyst in the positive response of the economy to the downswing. The Government has therefore decided to propose significant tax reductions that will come into effect over the next two years. These measures were introduced by four ministers of the Government yesterday, and I shall present a bill to the Althingi to that effect in the near future. Amongst the changes proposed is that the corporate income tax will be cut by nearly a half. The net wealth surtax on corporations and individuals will be abolished and the general net wealth tax will be reduced by half. The stamp duty will be reduced. Inflation accounting will be abolished and corporations will be allowed to keep their books and draw up their account in foreign currency. The tax-free threshold for the net wealth tax will be substantially increased next year in order to prevent the recent general revision of real property values from leading to increased net wealth taxation. The general income tax rate on individuals will be reduced by 0.33 per cent and the taxation of rent subsidies will be abolished. These reductions will be partially offset by a small increase in the social security tax which enables larger tax reductions than otherwise would have been possible. The purpose of these tax reductions is to stimulate economic activity, thereby creating new and larger resources for the economy.

The Treasury is prepared

These measures are possible thanks to the reforms achieved in the Treasury’s operations in recent years. The Government is now prepared to respond to the changed economic circumstances in a positive and constructive manner, instead of resorting to such haphazard manual economic measures as we Icelanders are all too familiar with. The role of government as a cycle-mitigating agent has been strengthened and it is fully in accordance with prudent economic management to facilitate the economic environment for business and individuals in times of economic uncertainty.

Further tax reforms are being prepared

Furthermore, the Government has decided to present legislation to prevent the substantial increase in assessed property values from increasing net wealth taxation next year. At the beginning of next year, the last phase but one of the transferability of the personal tax exemption between spouses will become effective. Next year, 95 per cent of the personal tax exemption will be transferable between spouses as against 90 per cent this year, and in 2003 the exemption will be fully transferable.

The measures will strengthen the economy and stimulate saving

The measures announced yesterday will improve the competitiveness of Icelandic companies and create a more favourable domestic tax environment in an international context. It would thus create opportunities for attracting foreign companies to Iceland and reduce the likelihood of Icelandic companies emigrating for tax reasons. All these factors will have a positive impact and strengthen the Icelandic economy. A reduction in the net wealth tax is also logical in the present circumstances in this country and would encourage national saving.

The rationale for making these changes is substantial

There are a number of economic reasons for these changes. Nearly a decade has passed since a substantial reduction in corporate taxes took place in order to bring the economy out of several years of recession. Most important was the reduction in the corporate income tax and the abolishment of the municipal situation impost. The corporate tax environment thus created was among the best in our customer countries. Icelandic enterprises are in certain respects at a disadvantage due to the small size of the market, their distance from foreign markets and substantial transport costs. It is therefore even more important for Iceland than many other countries to create not just comparable but more favourable circumstances for Icelandic enterprises than prevail in competitor countries.

The tax advantage of earlier years has disappeared

On the other hand, there are clear signs that Icelandic enterprises no longer enjoy the tax advantage over competitor countries that was evident a few years ago. This applies to the income tax ratio, which today is about average for the OECD as a whole, but was well below average nearly a decade ago. It should also be remembered that when the corporate income tax was reduced, the tax base was broadened by eliminating a large number of previously permitted deductions. This makes the tax base considerably broader in this country than in most others. The recommendations of the OECD in its recent examination of the Icelandic tax system go along the same lines.

The situation of enterprises is more difficult than often before

The income of enterprises has declined in recent months due to declining demand at home and abroad. This is partially due to the fact that nearly all major countries of the world are experiencing an economic slowdown and the terrorist atrocities in the United States have exacerbated that situation. Economic growth has slowed down in the United States and Europe, and Japan’s economic difficulties are continuing. The same may be said for many developing countries and countries in Asia and Latin America. The impact is felt in this country since many of these countries are important trading partners of Iceland. Domestic demand has also slowed down after a major expansion in recent years in concert with a rise in household and business expenditures. Both have eventually led to reduced income for enterprises and some staff layoffs.

A tax reduction will quickly be felt by households and enterprises

All told, there are important economic reasons for resorting to such measures at this time. This would include a corporate tax reduction for all enterprises engaged in normal operations. A personal income tax reduction would also have a positive economic effect. The initial impact of such measures would quickly be transposed into increased economic activity, for example through increased investment, which, in turn, would increase employment, personal income and corporate earnings. Improved economic growth and increased economic activity will in turn increase Treasury revenue.

Continued economic growth is encouraged

It is therefore a pleasure that the Government is in these circumstances able to continue in its endeavour to strengthen the foundations of the economy. It will steadfastly continue to adhere to the policy pursued in the past decade of creating an environment for enterprises and individuals for continued economic growth. I believe in the wisdom of creating wealth first, before spending it, not spending first and then hope for the best. We Icelanders are quite familiar with such methods and know full well to what consequences they may lead.

Important steps in sales of Government enterprises will soon take place

Important sales of government assets are taking place this year and next, as major stakes of the central government in Landssíminn, the telephone company, as well as in Landsbanki and Búnaðarbanki, the two majority-government-owned commercial banks, will be sold. These sales are expected to yield substantial revenue to the Treasury and make it possible to reduce Treasury debt by a considerable margin.

These sales will markedly reduce the central government’s involvement in economic activity and strengthen the ability of the private sector to compete in international markets. They would also tend to renew activity in the stock market, thus encouraging economic activity and the economy in general.

A turning point for the economy

The economy has reached a turning point in recent months. Economic growth and domestic demand is slower, following a sharp expansion in recent years. This slowdown means that the economy is in many respects moving to a better equilibrium. The current account deficit that emerged in the expansion years is declining rapidly and the latest forecast indicates that it will be considerably lower in 2001 and 2002 and should be under 3 per cent of GDP in 2003-2004. Inflation is also expected to decline sharply over the next several months and should be back on par with neighbouring countries in the near future.

Certain warning signs lie ahead

Although decelerating inflation and a decreasing current account deficit are a welcome result of slower economic activity, there is good reason to watch out for signs of a possible recession. If the economy cools too quickly, it could lead to a recession that will be difficult to reverse in the short run. Recent economic indicators show that economic growth has slowed down considerably. The role of the Government in these circumstances is to mitigate the business cycle with appropriate measures to strengthen the economy.

The main emphasis of economic policy will be to ensure continued growth

Under these circumstances, the main emphasis of economic policy, both fiscal and monetary, must be on improving the competitiveness of enterprises, reducing inflation and thereby fostering economic growth. The measures outlined in this fiscal budget are based on this view. A reduction in taxes and the Government’s emphasis on privatisation constitute an important contribution towards strengthening the economy and ensuring full employment and a good standard of living, which is the main goal of the fiscal budget.

Mr. Speaker

Let me now turn to the main elements of the fiscal budget, both as regards individual aspects of revenue and expenditure as well as to the economic premises on which the budget is based.

Economic conditions have changed

As I noted earlier, there has been a significant change in the economy in the course of this year. Demand pressures have been succeeded by a slowdown and even a contraction in some sectors. These important changes followed considerable turbulence in foreign exchange markets in the spring where the króna exchange rate declined considerably, following the abolishment of the exchange rate bands. The reaction of the economy was predictable under the circumstances. Import prices rose, which in turn fuelled inflation. Imports declined at the same time and the economy’s external position improved. The lower exchange rate served to encourage the export sector and, as could be expected, improved their competitive position.

No ground for a substantial devaluation

In my view there were no economic grounds for such a large devaluation as took place last summer, irrespective of whether one looks at the real exchange rate in an historical context or at the general state of the economy. Similar opinions have been voiced by the Central Bank and financial institutions. It has been pointed out that the turbulence and uncertainty in the financial markets has had a substantial impact and even exacerbated the devaluation beyond what could have been justifiable on economic grounds.

The changing role of fiscal policy

The role of fiscal policy in overall economic policy has changed in view of the changes that have taken place in the Icelandic financial market in recent years and the increased independence of the Central Bank in shaping monetary policy. Fiscal policy can thus no longer be applied to change economic fundamentals in a rapid manner. The role of fiscal policy has shifted towards creating conditions for economic stability in the longer term. This will best be done by ensuring an adequate Treasury surplus and by creating an efficient economic environment for households and business.

Fiscal policy has supported monetary policy

Fiscal policy is not only a matter of longer-term considerations. It plays an important role in supporting monetary policy. The Treasury has yielded an impressive surplus in recent years, both on a cyclical and structural basis. The structural (i.e. cyclically adjusted) surplus amounted to nearly 3½ per cent of GDP in 1999-2000. This year, however, it is estimated to amount to 1 per cent of GDP. This is attributable to several costly expenditure items, particularly in the area of welfare and social security. The 2002 fiscal budget, however, projects a 2½ per cent structural surplus for the year. This clearly shows that fiscal finances have done much to support monetary policy in recent years and thus mitigate the unfavourable effects of the business cycle.

Interest rates and inflation

The high rate of interest in this country has been the subject of considerable discussion recently. Those who think the time has come for the Central Bank to reduce interest rates are being increasingly heard. It is clear that the spurt in inflation following the devaluation earlier this year has led to the increased determination of the Central Bank to adhere to a high base rate, even if there are signs of a recession in evidence. The Bank has argued that there are not clear enough signs yet that the economic expansion is abating in order to justify a reduction in interest rates. In this connection it has referred to the state of the labour market.

A reduction in interest rates should be approaching

All told, it appears that the time is rapidly approaching when interest rates will be reduced. On one hand, the rate of inflation is declining rapidly following the temporary spurt this summer and autumn. On the other hand, it is evident that the economy is unable in the long run to live with the present level of interest rates. This may have serious consequences and even lead to increased inflation in the end.

The economic assumptions of the fiscal budget

The present adjustment of the economy will have a substantial impact upon the economic environment for the coming year. The room for economic growth will be limited and there is every likelihood that enterprises and households will have to prepare for changed economic conditions in relation to recent years.

In this connection I would like to comment upon the economic assumptions behind the budget and the difference between them and the latest forecast of the National Economic Institute that has been subject to considerable discussion for the past several days. Let me observe first that this debate has been full of declarations with limited substance, which shows that commentators have not been able to fully apprise themselves of the facts. The final revenue and expenditure projections of the budget are concluded with due regard to the latest forecasts of the National Economic Institute as prescribed by law. The law is deliberately phrased in this manner, since the situation may well arise where the forecast may have to be differed with in certain respects, often because the final forecast of the National Economic Institute is not available by the closing date for the fiscal budget. What should then be the reference point? The difference between the forecast of the Ministry of Finance and the National Economic Institute lies mainly in different assessments of economic developments in the course of 2001. In view of the development of tax receipts so far this year, we in the Ministry of Finance are of the opinion that the contraction in domestic demand is greater than shown in the NEI national budget. It also appears to us that the NEI export forecast is somewhat on the optimistic side. We conclude that GDP growth in 2001 will be of the order of 1½ per cent, ½ per cent below the NEI forecast. As for next year, the main difference lies in different assessments of inflation prospects. The Ministry estimates year-on-year inflation at 5 per cent, which is similar to the latest Central Bank forecast, but close to 1 per cent less than in the national budget. Consequently, private consumption is estimated to hold unchanged, whereas the national budget forecasts a ½ per cent decline. We have also permitted ourselves to be more optimistic as regards investment because the tax reductions announced by the Government will have a positive effect on business and personal expectations next year. In addition, the tax reductions may have a considerable impact upon the sale of the government enterprises that now has been decided.

I therefore think it is absurd to kick up a fuss about the assumptions behind the budget just because they do not coincide with the national budget. The difference is insignificant, which best is seen by the fact that the assumption for the gross domestic product in nominal terms for 2002 in the fiscal budget is slightly lower than in the national budget. The Chairman of the Social Democratic Alliance is thrashing in the wind when he contends that the economic assumptions behind the fiscal budget constitute an attempt to beautify the Treasury outcome. If anything, the Treasury surplus would be larger under the assumptions of the national budget.

Economic growth expected to be slow next year

The assumptions behind the fiscal budget indicate that economic growth could reach 1½ per cent in 2001. This means that income per capita will be nearly constant in real terms. The assumption behind the fiscal budget is that growth will be slightly slower in 2002, close to 1 per cent. Economic growth should revive thereafter and be in the range of 2-3 per cent over the next several years and in fact higher if the plans for hydro-energy and aluminium investments materialise as now is being discussed.

The current account deficit should decline substantially

The prospects for the development of foreign trade, given the trends in the economy, are that the current account deficit will develop favourably in the near future. For this year it appears that the current account deficit will be considerably lower than earlier forecasts indicated. The assumption behind the fiscal budget is that the deficit will amount to 58 billion krónur this year and just over 40 billion krónur in 2002. This estimate is based on the expectation that imports will continue to decline as the economy adjusts to a new real exchange rate.

No recession expected

It is important to emphasise in this connection that national income is at an historical high at the present time. The change through which the economy is going is primarily one of readjustment to changed circumstances following an unusually sharp expansion. It should not be seen as an onset of a recession. It must be anticipated, however, that the atrocities in the United States will have a negative impact on economic developments in this country as they will elsewhere. It is difficult to predict the impact of these events or when it will emerge.

A solid Treasury surplus continues

As I noted earlier, the 2002 fiscal budget projects an 18.6 billion krónur surplus compared with a 21 billion krónur surplus this year. The decline is entirely due to reduced profits from asset sales. Since revenue from asset sales in 2001 is mostly expected to take place in next year’s cash flow, the net financial surplus for 2002 is expected to be unusually high, about 41 billion krónur, compared with a net financial deficit of 6 billion this year. It is therefore appropriate to view these two years together. They show a combined net financial surplus of 35 billion krónur, provided that plans for asset sales be realised. I believe that this is a quite satisfactory result and a welcome result for the central government, which thereby can continue to repay its debt, thereby strengthening the economy and improve conditions for future generations. Although the general tender of shares in Landssíminn was not successful in the first instance I am convinced that this is a temporary phenomenon. The initial response from base investors indicated that they consider Landssíminn to be an interesting investment opportunity. It is also likely that the coming tax environment that has been announced will increase the value of the company.

What is the best measure of the Treasury’s balance?

In this connection I would like to add a few words to the debate about the Treasury accounts for 2000 which seems to have come as a surprise to many. It is unfair to assert that the 2000 account results constitute a "major shock", as has been stated. The accounts do show however that the results have diverged significantly from the fiscal budget for that year and it is not unreasonable to demand that the special reasons for this divergence be reviewed. The explanations for this divergence should be clear to all and are not attributable to loose fiscal management, as is explained in the notes to the government accounts. The divergence is fully attributable to irregular expenditure items, including pension commitments and tax claims written off. When the accounts are adjusted for these irregular items it emerges that the revenue surplus actually increased between 1999 and 2000 but declines in 2001 and 2002 in concert with a slowdown in the economy. A similar result emerges when the revenue surplus is adjusted for a cyclical impact, as previously noted.

The trough of the recession is being reached

One of the main assumptions behind the 2002 budget is that the trough of the recession is presently being reached, and that economic growth will gradually resume in the course of the next several years. Inflation is expected to abate significantly in 2002, being close to 3 per cent from the beginning to the end of the year. Per capita purchasing power is expected to remain broadly unchanged. Private consumption per capita is, however, expected to contract slightly and household saving increase. All told, economic growth is forecast to be slightly below this year’s growth, around 1 per cent. The tax measures announced by the Government are expected to be of importance here since they can have a positive impact both on households as well as enterprises, including their investment decisions. It is also assumed that the exchange rate will slightly strengthen in 2002.

Treasury revenue expected to remain unchanged in real terms

Based on these assumptions, Treasury tax revenue is projected to amount to 222 billion and total revenue to 258 billion. These projections indicate that tax revenue will remain nearly unchanged in real terms whereas total revenue will decline by close to 8 billion. The main change is that the 2002 budget projects lower revenue from asset sales than this year. Revenue from the personal income tax is expected to rise in concert with personal income. Value added tax receipts are expected to remain unchanged in real terms, whereas the corporate income tax and the capital income tax are expected to yield less than this year due to reduced profits and less turnover in the capital markets.

The second stage of increasing child benefits comes into effect

The second stage of three of increasing child benefits takes place at the beginning of next year. This is in accordance with the Government’s Policy Statement and its statement of 27 October, 2000 which stated that child benefits would increase by more than a third in the years 2001-2003, or by some 2 billion krónur. The first stage took effect in 2001. The main element of the changes is that child benefits not tied to income have been reintroduced, the curtailment of child benefits with rising income was reduced and the curtailment due to net wealth was abolished. These changes will lead to a considerable increase in the disposable income of families with children, particularly those with low incomes.

Expenditure expected to decline in real terms

Total Treasury expenditure is estimated at 239 billion in 2002, increasing by 3.1 per cent from the 2001 estimate. In real terms, total expenditure is forecast to decline from the 2001 estimate, after having been adjusted for prepayments of pension fund commitments. Measured as a proportion of GDP, expenditure is projected to decline by 1 per cent from the 2001 estimate, in line with the Government’s economic policy. I wish to call special attention to the fact that operational expenditure is expected to decline in real terms, whereas transfer payments are projected to increase as I shall discuss further later on. I would also like to point out further that total expenditure by the Treasury in relation to GDP has declined in recent years and is expected to amount to 30.7 per cent of GDP in 2002.

Operational expenditure is being cut

Following expenditure increases due to higher wage costs and prices in 2001 in excess of budget, the Government decided that operational expenditure in budget frames should be reduced by 2 per cent from baseline levels. This has been carried out in the budget. Taking into account new operational tasks, such as the new Sóltún nursing home, the operational expenditure is budgeted to decline by 0.6 per cent from the 2001-level. The budget implementation process will be strengthened on the basis of a new Regulation to that effect, and new expenditures will be met by efforts to reduce existing ones as much as possible.

Social security benefits increase

Transfer payments to households are expected to increase in real terms from the estimate for 2001. First, there is an increase in social security benefits. The increase is twofold; general benefits are projected to increase by more than 7 per cent and benefits for the lowest paid will increase in accordance with proposals by a committee appointed to review such benefits. Second, child benefits will rise by 0.5 billion in line with the Government’s decision as I noted earlier. Third, the Childbirth Leave Fund will be operating for a full year for the first time, and one month will be added to the right of fathers to take leave on account of childbirth.

Closing comments

Mr. Speaker

Changed economic circumstances

This fiscal budget is presented under somewhat unusual circumstances. On one hand, economic conditions are quite different from those prevailing a year ago. The economy has slowed down and signs of contraction have emerged. Although this course of events was in part foreseeable, the devaluation of the króna exacerbated it. International developments have, on the other hand, deteriorated and the atrocities in the United States have not helped the situation. All these factor have had an impact on Treasury finances, especially the revenue side, since incoming revenue has slowed down considerably. The expenditure side is not as sensitive to these contractionary impulses, which means that the finances of the Treasury are bound to deteriorate.

We now enjoy the prudence of earlier years

Under these circumstances we now can enjoy the fiscal prudence of recent years where we have built up a substantial surplus and reduced debt. We are therefore better prepared to meet the challenge of the downturn without endangering fiscal finances. The repayment of debt in earlier years has meant that the interest cost of the Treasury has been reduced in real terms. It can be conservatively estimated that the interest saving from having repaid 100 billion krónur of Treasury debt in the past five years comes to 5 billion krónur a year. I believe that this saving should be used to reduce taxes on individuals and enterprises. I am convinced that such measures are in full accordance with continued sound economic management. They will in the end lead to a broader tax base, which will offset a possible reduction in Treasury revenue.

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