The Minister of Finance and Economic Affairs will introduce a proposal for a parliamentary resolution on the fiscal policy statement for 2022-2026 before Parliament today. According to the Act on Public Finances, the strategy must be introduced no later than at the time the new Government’s fiscal budget proposal is introduced.
The guiding principle underlying the fiscal strategy is to halt the rise in the debt-to-GDP ratio no later than 2026. Public debt is positioned to be far lower by the end of the fiscal policy horizon than was feared at the beginning of the COVID-19 pandemic. This significantly improved debt position, which is due to the strong rebound in the economy and the sale of Government holdings in Íslandsbanki, provides the scope needed to achieve the objective of halting debt accumulation one year later than originally planned.
The aim is to ensure the financial resilience of the public sector and shore up the Government’s ability to mitigate the impact of economic shocks on households and businesses while simultaneously safeguarding public services and transfer systems. This also builds up the flexibility to meet increased expenditures due to the foreseen aging of the population. In the short term, the goal will be to support the economy until it has regained a strong footing.
Fiscal response capacity increasingly important
The objective of halting public debt accumulation supports short-term economic stability and better enables the Government to respond to shocks further ahead. For this reason, it is clear that although the numerical fiscal rules provided for in the Act on Public Finances will not take effect again until 2026, the fundamental principles underlying the Act – sustainability, prudence, and stability – require that the fiscal strategy take account of the business cycle position and rebuild the capacity of public finances to respond to economic shocks.
Public sector outcome improves year by year
In order to achieve the objective of halting the rise in the debt-to-GDP ratio, the public sector net lending balance will improve each year until the goal is reached. The estimated public sector outcome will improve from a deficit of ISK 200bn, or just under 6% of GDP in 2022, to a deficit of no more than ISK 50bn, or just over 1% of GDP by the end of the period. This represents an improvement of 5 percentage points of GDP over the next five years.
According to the updated outlook, public debt as measured by the debt rule in the Act on Public Finances will total 40% in 2021 and an estimated 41% of GDP by the end of 2022. Based on the assumptions underlying macroeconomic forecasts of GDP and interest rates in coming years, together with given assumptions on the sale of State assets, public debt is projected at about 46% of GDP by the end of the period. Furthermore, the primary balance – i.e., the overall outcome net of the interest balance – will be positive in the final years of the strategy.
It should be noted that the objectives presented here are based on projected developments in underlying performance and debt but also allow for given deviations until the target in the final year of the strategy.
Total public revenues are projected to average 38.5% of GDP in 2021 and 2022. Revenues are expected to rise by nearly 2 percentage points as a share of GDP, to 40.5% of GDP by the end of the period.
Public expenditures are projected to equal 48.5% of GDP in 2021 and fall to 44.5% of GDP in 2022, in tandem with strong GDP growth, a turnaround in the labour market and the associated reduction in unemployment-related expenditures, and the expiry of most of the temporary measures to mitigate the impact of the COVID-19 pandemic. By the end of the period, expenditures are projected at 41.5% of GDP, which is consistent with the average from 2018 and 2019. Expenditures as a share of GDP will therefore decline relative to the current position. This entails that spending growth must be contained so that expenditures do not rise faster than GDP. Real growth in Treasury expenditure must therefore be modest over the period, or less than 1% per year.
The outlook for local governments’ outcome as a share of GDP is broadly unchanged from the approved fiscal plan. Local government debt will increase relative to the fiscal plan currently in effect, partly because the outcome for 2020 was weaker than previously projected. As a share of GDP, local government debt will increase somewhat over the horizon of the fiscal plan.
Slack in output to close in 2022
GDP will return to its pre-pandemic level as soon as 2022, according to the Statistics Iceland forecast on which the fiscal policy statement is based. Despite relatively strong GDP growth in 2021-2023, it is assumed that annual GDP will be 3-4% lower than was expected before the pandemic. Because of the erosion of potential output and the rapid turnaround, official forecasts assume that output will be close to potential from 2022 onwards.
Economic policy is affected strongly by the expectation that the slack in output will close in 2022. Although estimates of potential output are subject to considerable uncertainty, it is clear that the economy has rebounded strongly and that most indicators suggest increased resource utilisation. If the recovery proves as solid as forecasts indicate, the fundamental principles of prudence and stability underlying the Act on Public Finances require that the fiscal stance be tightened, both to prevent short-term overheating and to rebuild the public sector’s strength in the long run. This is consistent with economic policy for the years to come, where the public sector will focus on adapting to changed circumstances after having intervened decisively in 2020-2021 in order to mitigate the impact of the economic contraction on households and businesses.
Declining productivity growth and an aging population
As the impact of short-term factors tapers off in the latter half of the fiscal strategy horizon, the assessment of economic developments will increasingly entail extrapolation based on underlying drivers, chief among them the aging of the population and changes in productivity.
Owing to slow natural population growth combined with weaker productivity growth, the outlook is for the economy’s growth potential to decline, all else being equal.
In line with developments in the above-mentioned drivers of potential output, Statistics Iceland has revised its estimate of the economy’s annual growth potential downwards from 2.7% to 2.3%. This is consistent both with estimates from the Central Bank and the Ministry of Finance and Economic Affairs and with developments in the global economy. This is highly significant for the long-term outlook, as annual GDP will therefore be ISK 300bn less (at the 2021 price level) in 25 years’ time than it would have been otherwise.
Unless changes are made to the tax system, weaker output growth will reduce tax revenues and will therefore reduce the amount of spending the public sector can undertake in the long run. At the same time, weaker productivity growth and, in particular, an aging population call for increased spending.
Fiscal policy has a role to play in counteracting this trend and promoting increased long-term potential output throughout the economy. This can be seen in two ways in the fiscal strategy.
First, increased investment supports potential output, and second, the fiscal policy fosters economic stability by tightening the fiscal stance as the economic recovery gains ground.
Calculations due to uncertainty buffers developed further
The objectives of the fiscal strategy are based on the economic outlook as portrayed in Statistics Iceland’s most recent macroeconomic forecast. It is probable that at some point during the horizon of the strategy, economic developments will be less favourable than is now considered likely. Economic forecasts cannot predict unforeseeable external events that have a decisive impact on economic developments. The fiscal strategy must provide the latitude to promote economic stability under conditions where the economic outlook deviates from what is now considered most likely.
For the first time, the fiscal strategy for 2018-2022 introduced an uncertainty buffer into the assumptions concerning the outcome targets to be included in annual fiscal plans. The uncertainty buffer was based on the sensitivity of performance and debt to the business cycle and the size of deviations in ISK terms, but in other respects it was not based on direct calculations.
Now, however, calculations relating to uncertainty buffers have been developed further. In the new version, this entails determining the statistical probability that deviations from economic assumptions over the horizon of the strategy will lie within the historical bounds of the past 50 years. Because uncertainty increases over time, the statistical confidence interval grows accordingly wider. The uncertainty buffer should therefore be able to accommodate most setbacks and shocks to the public sector outcome. Only downturns of the magnitude of the 2008 financial crisis and the COVID-induced economic shock would fall outside the confidence interval as it is presented in the strategy. With this presentation of the confidence interval, plus the key feature of the strategy – i.e., the assumption that stronger GDP growth and derived revenues over and above targets will be used to improve the outcome – the fiscal strategy now incorporates greater flexibility vis-à-vis the business cycle than it did originally.
Fiscal rules and the Fiscal Council
In order to create the flexibility to apply fiscal policy to combat the economic repercussions of the pandemic, the numerical fiscal rules concerning performance and debt as provided for in the Act on Public Finances were set aside with special legislation passed in December 2020. This provided temporary scope for deficit operations and debt accumulation under these challenging circumstances, and it is in line with governmental responses all over the world. The fundamental principles of the Act on Public Finances – sustainability, prudence, stability, predictability, and transparency – are still fully in effect, and they serve as guideposts for Government policy formation. The numerical targets provided for in the Act will take effect again in 2026, and fiscal policy must ensure that this can happen successfully. According to provisions in the Act, the Fiscal Council is entrusted with assessing whether the Government’s declared fiscal objectives and their enforcement will make this possible. The Council has two weeks after the presentation of the fiscal strategy to complete its comments on the strategy and deliver them to Parliament.