[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 13.6.2007

SEC(2007) 776

COMMISSION STAFF WORKING DOCUMENT

Public finances in EMU - 2007

Accompanying document to the: COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE, THE COMMITTEE OF THE REGIONS AND THE EUROPEAN CENTRAL BANK Public Finances in EMU - 2007 Ensuring the effectiveness of the preventive arm of the SGP {COM(2007) 316 final}

Member States

BE Belgium

BG Bulgaria

CZ Czech Republic

DK Denmark

DE Germany

EE Estonia

EI Ireland

EL Greece

ES Spain

FR France

IT Italy

CY Cyprus

LV Latvia

LT Lithuania

LU Luxembourg

HU Hungary

MT Malta

NL The Netherlands

AT Austria

PL Poland

PT Portugal

RO Romania

SI Slovenia

SK Slovak Republic

FI Finland

SE Sweden

UK United Kingdom

EUR-13 European Union Member States having adopted the single currency (BE, DE, EL, ES, FR, IE, IT, LU, NL, AT, PT, SI, FI), i.e. countries participating in the Economic and Monetary Union.

EU-25 European Union, 25 Member States (excl. BG and RO)

EU-27 European Union, 27 Member States

EU-15 European Union, 15 Member States before 1 May 2004

EU-10 European Union, 10 Member States that joined the EU on 1 May 2004 (CZ, EE, CY, LV, LH, HU, MT, PL, SI, SK)

Currencies

EUR euro

ECU European currency unit

DKK Danish krone

GBP Pound sterling

SEK Swedish krona

CAD Canadian dollar

CHF Swiss franc

JPY Japanese yen

SUR Russian rouble

USD US dollar

Other

SCPs Stability and Convergence Programmes

EFC Economic Financial Committee: is a Council Committee set up by Article 114 of the Treaty and which based on the preventive arm of the SGP, and within the framework of multilateral surveillance under Article 99 of the Treaty, together with the Commission examines the budgetary targets presented by the Member States in the Stability and Convergence Programmes.

EPC Economic Policy Committee is a Committee set up by a Council decision on 18 February 1974 (74/122/EEC), revised in 2003 (2003/475/EC). The aim of the EPC is to contribute to the preparation of the work of the Council (Ecofin) in co-ordinating the economic policies of the Member States and the Community, and to provide advice to the Commission and the Council. The focus is on structural policies for improving growth potential and employment in the Community in line with the Lisbon strategy.

This report was prepared in the Directorate-General of Economic and Financial Affairs under the direction of Klaus Regling, Director-General, and Servaas Deroose, Director of the Directorate for the Macroeconomy of the euro area and the EU.

The main contributors were Elena Flores, Joaquim Ayuso Casals, Antoine Deruennes, Per Eckefeldt, Roland Eisenberg, Martin Larch, Laurent Moulin, Marko Mršnik, Doris Prammer, Vegard Sørebø and Alessandro Turrini.

Specific contributions were provided by Kieran Mc Morrow, João Nogueira Martins and Charlotte Van Hooydonk.

The country chapters in Part V were prepared in the Directorates for the Economies of the Member States under the responsibility of Jürgen Kröger. The contributors were Orlando Abreu, Jean-Luc Annaert, Laura Bardone, Gerrit Bethuyne, Bouke Buitenkamp, Georg M. Busch, Mateo Capó Servera, Pedro Cardoso, Ivan Ebejer, Polyvios Eliofotou, Laszlo Jankovics, Heinz Jansen, Anton Jevcak, Barbara Kauffmann, Filip Keereman, Mart Maiväli, Carlos Martinez Mongay, , Michal Narozny, Lucia Piana, Hervé Piffeteau, Lucio R. Pench, Stéphanie Riso, Peer Ritter, José Luis Robledo Fraga, Aleksander Rutkowski, Michael Stierle, Pietro Toigo, Charlotte Van Hooydonk, Javier Yaniz Igal, Ann Westman, Stefan Kuhnert, Norbert Wunner, George Moschovis, Luis Angel Maza Lasierra, Jan Komarek, Arlette Motte, Jakob Wegener Friis, Marco Cacciotti, Balazs Forgo, Ralph Wilkinson, Carl Scerri, Ingrid Toming, Julda Kielyte, Baudouin Lamine, Elena Reitano, Julia Lendvai, Siegfried Steinlein, Neil Kay, Stefaan Pauwels, Lorena Ionita, Andreas Trokkos.

Elena Flores and Martin Larch coordinated and supervised the production of the report. Ilona Löser was responsible for statistical and editorial work.

Comments and suggestions by colleagues in the Directorate-General for Economic and Financial Affairs as well as by other services of the Commission are gratefully acknowledged.

Secretarial support was provided by Maria Davi-Pilato and Dominique Prins.

Comments on the report would be gratefully received and should be sent to:

Directorate-General for Economic and Financial Affairs

Unit C2: Public Finances in the euro zone and the EU

European Commission

B-1049 Brussels

or by e-mail to Elena.Flores@ec.europa.eu or martin.larch@.ec.europa.eu

Summary and main conclusions 1

Part I: Current developments and prospects 9

Summary 11

1. Budgetary developments in the euro area and the EU Member States 13

1.1. Short-term developments and prospects for the budget balance and public debt 13

1.2. Government revenue and expenditure 16

2. Implementing the Stability and Growth Pact 20

2.1. Introduction 20

2.2. The excessive deficit procedure since spring 2006 20

3. Overview of the 2006 updates of the Stability and Convergence Programmes 36

3.1. Introduction 36

3.2. Country-specific medium-term budgetary objectives 36

3.3. The adjustment path over the programme period 37

3.4. Debt projections 43

3.5. Macroeconomic assumptions and risks to the budgetary projections 44

4. The long-term sustainability of public finances based on the 2006 updates of the stability and convergence programmes 51

4.1. Introduction 51

4.2. The update of the long-term sustainability analysis 51

4.3. Overall assessment of the sustainability challenge in the Member States 52

Part II: Evolving budgetary surveillance 52

Summary 52

1. Ensuring the effectiveness of the preventive arm of the Stability and Growth Pact 52

1.1. Introduction 52

1.2. Strengthening the link between the Stability and Convergence Programmes and national budgetary plans 52

1.3. A stronger role for the Mid-Term Budgetary Review in the euro area 52

1.4. Placing the assessment of stability and convergence programmes into a broader economic perspective 52

1.5. The Commission Policy Advice 52

1.6. Implicit government liabilities and medium-term budgetary objectives 52

2. Measurement and statistical issues 52

2.1. The assessment of tax revenues in the EU fiscal surveillance framework 52

2.2. New methodology for computing minimum benchmarks 52

2.3. Accounting for pension-related liabilities 52

2.4. Quarterly Government Accounts and Fiscal Surveillance 52

3. Advances in the assessment of the long-term sustainability of public finances 52

3.1. Introduction 52

3.2. Envisaged improvements of the long-term budgetary projections 52

3.3. Improving the assessment of public finance sustainability 52

4. Systemic pension reforms in the revised Stability and Growth Pact 52

4.1. Introduction 52

4.2. Pension reforms in the excessive deficit procedure 52

4.3. Numerical examples 52

4.4. Conclusion 52

5. Strengthening budgetary procedures 52

5.1. Introduction 52

5.2. Basic features of budget procedures 52

5.3. Descriptive analysis of the budget procedures 52

Part III: How to stick to medium-term budgetary plans? 52

Summary 52

1. Introduction 52

2. The functions of medium-term budgetary frameworks 52

2.1. Introduction 52

2.2. Functions of medium-term budgetary frameworks 52

2.3. What types of medium-term budgetary frameworks in the EU? 52

2.4. Conclusions 52

3. Experience with Stability and Convergence Programmes under the preventive arm of the Stability and Growth Pact 52

3.1. Introduction 52

3.2. Stylised facts about a typical Stability/Convergence Programme 52

3.3. Comparing plans to outcomes 52

3.4. Conclusions 52

4. Which factors help stick to budgetary plans? 52

4.1. Introduction 52

4.2. Which factors explain the difficulties in respecting expenditure plans 52

4.3. Real GDP growth forecasts: the role of institutions 52

4.4. Conclusions 52

Part IV: Lessons from successful fiscal consolidations 52

Summary 52

1. Introduction 52

2. Basic features of successful fiscal consolidations 52

2.1. Introduction 52

2.2. Defining episodes of successful fiscal consolidation 52

2.3. Findings from existing literature 52

2.4. Basic features of successful fiscal consolidations in the EU 52

3. The determinants of fiscal consolidation 52

3.1. Introduction 52

3.2. How do episodes of consolidation in the EU compare to 'normal' times and what triggers them? 52

3.3. What explains the difference between 'cold shower' and 'gradual' consolidations? 52

4. The determinants of success 52

4.1. Introduction 52

4.2. The typical profile of successful consolidations 52

4.3. The likelihood of success 52

4.4. Why do consolidations fail? 52

5. Conclusions 52

A. Annex: Country Cases 52

A.1. Introduction 52

A.2. Spain 52

A.3. Italy 52

A.4. The Netherlands 52

A.5. Hungary 52

Part V: Member State developments 52

1. Belgium 52

2. Bulgaria 52

3. The Czech Republic 52

4. Denmark 52

5. Germany 52

6. Estonia 52

7. Ireland 52

8. Greece 52

9. Spain 52

10. France 52

11. Italy 52

12. Cyprus 52

13. Latvia 52

14. Lithuania 52

15. Luxembourg 52

16. Hungary 52

17. Malta 52

18. Netherlands 52

19. Austria 52

20. Poland 52

21. Portugal 52

22. Romania 52

23. Slovenia 52

24. Slovakia 52

25. Finland 52

26. Sweden 52

27. United Kingdom 52

Part VI: Resources 52

1. Common methodology for calculating potential output - Overview of key features and recent modifications 52

1.1. Introduction 52

1.2. Basic features of the method 52

1.3. Recent modifications to the methodology 52

1.4. Technical specification of the model 52

2. Glossary 52

3. References 52

4. Useful Internet Links 52

Tables

I.1.1. Euro area - The General government budget balance (% of GDP) 14

I.1.2. Budget balances in EU Member States (% of GDP) 15

I.1.3. Composition of changes in the government debt ratio in EU Member States (% of GDP) 16

I.1.4. Euro area - Government revenue and expenditures (% of GDP) 17

I.2.1. Overview EDP-steps since spring 2006 – EU-15 Member States (planned dates in italics) 33

I.2.2. Overview EDP-steps since spring 2006 – Recently acceeded Member States (planned dates in italics) 35

I.3.1. MTO, minimum benchmark, debt and potential growth 37

I.3.2. Nominal budget balances in the 2006/07 Stablity and Convergence Programme updates and the Commission services' autumn 2006 and spring 2007 forecasts (% of GDP) 38

I.3.3. Euro area - Decomposition of the planned change in government balance-to-GDP ratio 42

I.3.4. EU - Decomposition of the planned change in government balance-to-GDP ratio 42

I.3.5. Euro area - Gross debt level and changes in the 2006 updates 43

I.3.6. Real GDP growth projections (percentage change on preceding year) 44

I.3.7. Projections of real growth projections in the 2006 updates (% change from the previous year) 45

I.3.8. General government gross debt (% of GDP) 46

I.3.9. Council examinations of the 2006/07 updates of Stability and Convergence Programmes 47

I.3.10. Council examinations of the 2006/07 updates of SCP's 49

I.4.1. Projected changes according to the common projections in age-related public expenditure between 2004 and 2030/50 (% of GDP) 52

I.4.2. Government balances in 2005 and 2006 compared (% of GDP) 52

I.4.3. Sustainability gaps in the '2006' scenario (% GDP) 52

I.4.4. Required primary balance (% of GDP) 52

I.4.5. Sustainability gaps of the 'programme' scenario (% GDP) 52

I.4.6. Projected debt developments in the EU Member States (% of GDP) 52

I.4.7. Overall classification of risks to the sustainability of public finances 52

I.4.8. Policy invitations by the Council on the sustainability of public finances on the 2006/07 SCPs 52

I.4.9. Policy conclusions by the Council on the sustainability of public finances on the 2006/07 SCPs 52

I.4.10. Policy conclusions by the Council on the sustainability of public finances on the 2006/07 SCPs 52

I.4.11. Policy conclusions by the Council on the sustainability of public finances on the 2006/07 SCPs 52

I.4.12. Policy conclusions by the Council on the sustainability of public finances on the 2006/07 SCPs 52

I.4.13. Policy conclusions by the Council on the sustainability of public finances on the 2006/07 SCPs 52

II.1.1. Calendar for budgets and Stability and Convergence Programmess preparation in Member States 52

II.2.1. Tax elasticities of Member States 52

II.2.2. New minimum benchmarks 52

II.2.3. Availability of quarterly government accounts 52

II.4.1. Estimated budgetary impact of systemic pension reforms (in % of GDP) 52

II.4.2. Numerical example on the implementation of the Pact provision on systemic pension reforms, when considering an abrogation of the procedure (Case 1) 52

II.4.3. Numerical example on the implementation of the Pact provision on systemic pension reforms, when considering an abrogation of the procedure (Case 2) 52

II.5.1. Correlation coefficients between the indices reflecting feautres of the budget procedures 52

III.2.1. Medium-term budgetary frameworks - a typology 52

III.3.1. Medium-term budgetary plans formulated by Member States in their Stability and Convergence Programmes over the period 1998-2006 52

III.3.2. Medium-term budgetary plans formulated by Member States in the successive Stability and Convergence Programme updates over the period 1998-2006 (change over three years, cimple averages) 52

III.3.3. Medium-term macroeconomic projections in the Stability and Convergence Programmes 52

III.3.4. Planned and observed changes in the government balance ratio 52

III.3.5. Planned and observed changes in GDP growth 52

III.3.6. Planned and observed changes in the government revenue ratio 52

III.3.7. Planned and observed changes in the government expenditure ratio 52

III.3.8. Consistency of general government expenditure plans over time (EU-15 Member States) - 2000-2006 52

III.4.1. Dependant variable: difference between the observed and planned increase in real primary expenditure 52

IV.2.1. Overview of episodes of fiscal consolidation in the EU 52

IV.2.2. Successful and unsuccessful fiscal consolidations - fiscal conditions and composition of adjustment 52

IV.2.3. Successful and unsuccessful fiscal consolidations - macroeconomic performance 52

IV.3.1. Fiscal consolidation in normal times - Mean comparisons 52

IV.3.2. Probability of starting a fiscal consolidation 52

IV.3.3. Probability of a gradual fiscal consolidation 52

IV.4.1. Episodes of fiscal consolidation - Mean comparisons 52

IV.4.2. Probability of a successful fiscal consolidation 52

IV.4.3. Backtracking of unsuccessful fiscal consolidations: 52

V.1.1. Budgetary developments 2005-2010, Belgium (% of GDP) (1) 52

V.1.2. Main measures in the budget for 2007, Belgium 52

V.2.1. Budgetary developments 2005-2009, Bulgaria (% of GDP) (1) 52

V.2.2. Main measures in the budget for 2007, Bulgaria 52

V.2.3. EU budget allocations to Bulgaria 2007-2013 (in current prices) 52

V.2.4. Budgetary effect of transfers between the EU and Bulgaria in 2007 (share of GDP) 52

V.3.1. Budgetary developments 2005-2009, Czech Republic (% of GDP) (1) 52

V.3.2. Main measures in the budget for 2007, CZ 52

V.4.1. Budgetary developments 2005-2010, Denmark (% of GDP) (1) 52

V.4.2. Main measures in the budget for 2007, Denmark 52

V.5.1. Budgetary developments 2005-2010, DE (% of GDP) (1) 52

V.5.2. Main measures in the budget for 2007, Germany 52

V.5.3. Agreements on expenditure growth for sub-sectors of government in % 52

V.6.1. Budgetary developments 2005-2010, Estonia (% of GDP) (1) 52

V.6.2. Main measures in the budget for 2007, Estonia 52

V.7.1. Budgetary developments 2005-2009, Ireland (% of GDP) (1) 52

V.7.2. Main measures in the budget for 2007, Ireland 52

V.8.1. Budgetary developments 2005-2009, Greece (% of GDP) (1) 52

V.8.2. Main measures in the budget for 2007, Greece 52

V.9.1. Budgetary developments 2005-2010, Spain (% of GDP) (1) 52

V.9.2. Main measures in the budget for 2007, Spain 52

V.9.3. Tax revenues in Spain. 1995-2006 52

V.10.1. Main measures in the budget for 2007, France 52

V.10.2. Main measures in the budget for 2007, France 52

V.10.3. Impact of discretionary measures 52

V.11.1. Budgetary developments 2005-2011, Italy (% of GDP) (1) 52

V.11.2. Main measures in the budget for 2007, Italy 52

V.12.1. Budgetary developments 2005-2010, Cyprus (% of GDP) (1) 52

V.12.2. Main measures in the budget for 2007, Cyprus 52

V.12.3. Composition of the Fiscal Adjustment in Cyprus 52

V.13.1. Budgetary developments 2005-2009, Latvia (% of GDP) (1) 52

V.13.2. Main measures in the budget for 2007, Latvia 52

V.14.1. Budgetary developments 2005-2009, Lithuania (% of GDP) (1) 52

V.14.2. Main measures in the budget for 2007, Lithuania 52

V.15.1. Budgetary developments 2005-2009,Luxembourg (% of GDP) (1) 52

V.15.2. Main measures in the budget for 2007, Luxembourg 52

V.16.1. Budgetary developments 2005-2010, Hungary (% of GDP) (1) 52

V.16.2. Main measures in the budget for 2007, Hungary 52

V.17.1. Budgetary developments 2005-2010, Malta (% of GDP) (1) 52

V.17.2. Main measures in the budget for 2007, Malta 52

V.18.1. Budgetary developments 2005-2009, the Netherlands (% of GDP) (1) 52

V.18.2. Main measures in the budget for 2007, the Netherlands 52

V.19.1. Budgetary developments 2005-2010, AT (% of GDP) (1) 52

V.19.2. Main measures in the budget for 2007, Austria 52

V.20.1. Budgetary developments 2005-2009, Poland (% of GDP) (1) 52

V.20.2. Main measures in the budget for 2007, Poland 52

V.21.1. Budgetary developments 2005-2010, Portugal (% of GDP) (1) 52

V.21.2. Main measures in the budget for 2007, Portugal 52

V.22.1. Budgetary developments 2005-2009, Romania (% of GDP) (1) 52

V.22.2. Main measures in the budget for 2007, Romania 52

V.22.3. EU transfers available to Romania 2007-2013 52

V.23.1. Budgetary developments 2005-209, Slovenia (% of GDP) (1) 52

V.23.2. Main measures in the budget for 2007, Slovenia 52

V.24.1. Budgetary developments 2005-2009, Slovakia (% of GDP) (1) 52

V.24.2. Main measures in the budget for 2007, Slovakia 52

V.24.3. Comparision of General Government revenue and expenditure projections and outcomes 52

V.24.4. General government deficits with May 2004 Convergence Programme ceilings 52

V.25.1. Budgetary developments 2005-2010, Finland (% of GDP) (1) 52

V.25.2. Main measures in the budget for 2007, Finland 52

V.26.1. Budgetary developments 2005-2009, Sweden (% of GDP) (1) 52

V.26.2. Main measures in the budget for 2007, Sweden 52

V.27.1. Budgetary developments 2005/06-2010/11, United Kingdom (% of GDP) (1) 52

V.27.2. Main measures in the 2006 Pre-Budget Report and the 2007 Budget, United Kingdom 52

Graphs

I.1.1. Euro area fiscal stance and cyclical conditions 18

I.1.2. Euro area fiscal stance and cyclical conditions 18

I.1.3. Policy-mix in the euro area 19

I.2.1. Budgetary plans, forecasts and outcomes in Germany 21

I.2.2. Budgetary plans, forecasts and outcomes in France 22

I.2.3. Budgetary plans, forecasts and outcomes in Portugal 22

I.2.4. Budgetary plans, forecasts and outcomes in Greece 24

I.2.5. Budgetary plans, forecasts and outcomes in Italy 24

I.2.6. Budgetary plans, forecasts and outcomes in the United Kingdom 27

I.2.7. Budgetary plans, forecasts and outcomes in Hungary 28

I.2.8. Budgetary plans, forecasts and outcomes in Czech Republic 29

I.2.9. Budgetary plans, forecasts and outcomes in Cyprus 29

I.2.10. Budgetary plans, forecasts and outcomes in Malta 30

I.2.11. Budgetary plans, forecasts and outcomes in Poland 31

I.2.12. Budgetary plans, forecasts and outcomes in Slovakia 32

I.3.1. Structural budget balances in the EU Member States and planned changes, 2006 - 2008 40

I.3.2. Structural balance and planned changes in Member States in EDP end 2006 with deadlines for their correction 40

I.3.3. Headline deficit of the euro area: projections in the successive updates of the Stability Programmes (% of GDP) 41

I.3.4. Composition of the variation in the budget position 2006-2009 (% of GDP) 43

I.3.5. Debt to GDP ratio of the euro area: projections in successive updates of stability programmes (% of GDP) 43

I.4.1. Debt developments in the EU, 2005-2050 52

I.4.2. Overall risk classification and the sustainability gap (S2 in the 2006 scenario) 52

II.1.1. Department in charge of budget and Stability and Convergence Programmes preparation and accounting rules 52

II.1.2. Stability and Convergence Programmes annexed to the budgets and targest for t+1 52

II.2.1. Euro-area tax elasticity with respect to GDP 52

II.2.2. Revisions of the output gap estimate for 2000 in sucessive Commission services' forecasts 52

II.2.3. Revisions of the cyclically-adjusted budget balance (CAB) for 2000 following revisions of the output gap estimates of successive Commission services' forecasts 52

II.2.4. Euro area- projection of real GDP growth of the last year of stability programme period 52

II.2.5. Minimum benchmark: an illustration 52

II.2.6. Alternative definitions of implicit liabilities 52

II.2.7. Quarterly government deficit (euro area) 52

II.2.8. Government expenditure and revenue (euro area) (% of GDP) 52

II.2.9. Quarterly government debt (euro area) 52

II.2.10. Revisions in quarterly government deficit figures (euro area) 52

II.5.1. Budget transparency index 52

II.5.2. Multi-annual planning horizon index 52

II.5.3. Centralisation of the budget process index 52

II.5.4. Centralisation during execution index 52

II.5.5. Top-down budgeting index 52

II.5.6. Prudent economic assumptions and reserves index 52

II.5.7. Performance budgeting index 52

II.5.8. Overall quality index 52

II.5.9. Overall centralisation index 52

II.5.10. Budgetary procedures 52

II.5.11. The index of budget procedures and range of subindices 52

II.5.12. Budgetary procedures and country-specific features 52

II.5.13. Budgetary procedures and political variables 52

II.5.14. 'Contract' vs. 'delegation' and budgetary procedures 52

II.5.15. Budgetary procedures and budget outcome 52

III.2.1. Features of national Medium-Term Budgetary Frameworks 52

III.2.2. Features of national Medium-Term Budegetary Frameworks 52

III.2.3. Preparation of the Stability and Convergence Programme 52

III.2.4. Involvement of national parliament in the preparation of the Stability and Convergence Programmes and status of the Council Opinion 52

III.3.1. Initial fiscal position and planned consolidation over a three-year horizon (simple average of EU-15 Member States) 52

III.3.2. Composition of the consolidation planned in the programme (EU-15 Member States) 52

III.3.3. Contemporaneous growth conditions and macroeconomic forecasts (simple average of EU-15 countries) 52

III.3.4. Budget balance ratio - Successive plans in the Stability and Convergence Programmes and outcomes (% of GDP) - Simple average of EU-15 countries 52

III.3.5. Plans vs. Outcomes - General Government balance (ratio) - EU-15 Member States 52

III.3.6. Plans vs. Outcomes - real GDP growth - EU-15 Member States 52

III.3.7. Plans vs. Outcomes - nominal GDP growth - EU-15 Member States 52

III.3.8. Plans vs. Outcomes - Nominal revenue - EU-15 Member States 52

III.3.9. Plans vs. Outcomes - Nominal expenditure - EU-15 Member States 52

III.3.10. Plans vs. Outcomes - Real primary expenditure - EU-15 Member States 52

III.4.1. Plans vs. Outcomes - Expenditure overruns and planned change in the expenditure ratio - EU-15 52

III.4.2. Plans vs. Outcomes - Expenditure overruns and size of general government - EU-15 52

III.4.3. Plans vs. Outcomes - expenditure overruns and real GDP growth surprises - EU-15 Member States 52

III.4.4. Planned and observed increases in real primary expenditure in groups of countries - EU-15 - simple averages 52

III.4.5. Planned and observed increase in real primary expenditure in groups of countries EU-15 - simple averages 52

III.4.6. Planned and observed budgetary developments in different groups of countries - EU-15 - simple averages 52

III.4.7. Real GDP growth developments in the period considered by the study and in the two decades preceding it 52

III.4.8. Real GDP growth projections in different groups of countries 52

IV.2.1. Stylised fiscal consolidation episode: 'cold shower' adjustment 52

IV.2.2. Stylised fiscal consolidation episode: 'gradual' adjustment 52

IV.2.3. Frequency distribution of the annual improvement in the cyclically-adjusted budget balance (CAPB) during consolidation years 52

IV.2.4. Frequency distribution of annual improvement in the cyclically-adjusted budget balance (CAPB) during consolidation episodes in EU-15 52

IV.2.5. Frequency distribution of consolidation episodes 52

IV.2.6. Frequency of at least 0.5 % of GDP improvements of the cyclically-adjusted primary budget balance (CAPB) over consecutive years 52

IV.A.1. Spain - composition of fiscal consolidation 52

IV.A.2. Italy - composition of fiscal consolidation 52

IV.A.3. The Netherlands - composition of fiscal consolidation 52

IV.A.4. Hungary - composition of fiscal consolidation 52

V.9.1. Developments in selected tax bases 1970-2006 52

V.9.2. Total tax burden: breakdown by types of taxes 1970-2006 52

V.10.1. Corporate tax (CT) revenues 52

V.10.2. Apparent elasticity of the corporate tax with respect to GDP 52

V.10.3. Apparent elasticity of CT to GOS 52

V.10.4. Quarterly profile of CT payments 52

V.10.5. Apparent elasticity of CT to GOS taking into account discretionary measures 52

V.11.1. Severance payment by the General Government 52

V.18.1. Breakdown of total government revenue into its main categories 52

V.18.2. Elasticity of total tax revenues to GDP 52

V.18.3. Elasticity of indirect taxes to GDP 52

V.18.4. Development of two tax bases for indirect taxes 52

V.18.5. Policy-adjusted elasticity to GDP of the main direct taxes categories 52

V.21.1. Tax burden in Portugal (annual change) 52

V.21.2. Tax elasticities and the GDP growth pattern 52

V.21.3. Behaviour of different tax categories 52

V.21.4. Drivers of tax revenue 52

V.22.1. Per capita GDP and net EU transfers to Member States 52

V.27.1. Developments in ratio of taxes to GDP 52

V.27.2. VAT 52

V.27.3. Personal income tax 52

V.27.4. Social security contributions 52

V.27.5. Corporation tax 52

Boxes

I.2.1. EU budgetary surveillance 26

I.2.2. Classification of pension schemes 32

I.4.1. Sustainability indicators 52

II.1.1. Main points covered by the Commission services' technical analysis of stability and convergence programme. 52

II.2.1. The cyclical-adjustment of the budget balances in the EU budgetary surveillance: caveats linked to the assessment of tax revenues 52

II.2.1. Narrow and broad definitions of implicit liabilities 52

II.4.1. Pension reforms in the preventive arm of the SGP 52

II.5.1. Construction of indices based on information from the OECD/World Bank Budget Practices and Procedures Database 52

III.2.1. The medium-term budgetary framework in the Netherlands 52

III.2.2. Empirical studies on the effectiveness of MTBFs 52

III.2.2. The medium-term budgetary framework in Sweden 52

III.3.1. The database comparing multiannual budgetary plans and outcomes 52

III.3.2. Situation in groups of Member States 52

III.4.1. Construction of an index on the quality of institutions for medium-term budgetary planning 52

IV.2.1. Main determinants of successful fiscal consolidations: A synthetic overview of the evidence from previous empirical studies 52

IV.3.1. Indicators of determinates of fiscal consolidation 52

VI.1.1. Cobb-Douglas production function scheme 52

Recent budgetary developments

Public finances in the euro area and the EU posted a significant improvement in 2006. In the group of thirteen countries adopting the single currency the headline deficit declined to 1.6% of GDP, down from 2.5% of GDP in 2005. Progress was slightly lower but still significant in the EU as a whole, including the two new Member States Bulgaria and Romania. Taken at face value the improvement of the headline deficit was matched by an identical change in the budget net of cyclical factors and one-off and other temporary measures suggesting that the improvement was completely structural. However, the estimates of the structural deficit are likely to be affected by specific features of the prevailing economic and fiscal conditions. In 2006, the improvement of government budget balances took place against the background of a broad-based economic recovery over the course of which the inflow of tax revenues went clearly beyond normal rates. Since the buoyancy of tax revenues may reflect both temporary and permanent elements, the verdict is still out on the actual determinants of the estimated improvement of the structural budget balance and an additional degree of caution is warranted in reading the available estimates.

The projections for 2007 and 2008 remain favourable. The euro area deficit is expected to drop to 1% of GDP this year and, based on the customary no-policy-change assumption, to post a further slight decline the year after. A similar though slightly flatter profile is projected in the EU as a whole. Taking into account that economic conditions in 2007 are forecast to remain favourable the estimated budgetary adjustment in structural terms of 0.3% of GDP in the euro area and of 0.2% of GDP in the EU as a whole falls short of the provisions of the reformed Stability and Growth Pact which asks Member States to do more than the 0.5% of GDP benchmark during economic 'good' times.

Since spring 2006, the Commission and the Council took action on eight Member States concerning the Excessive Deficit Procedure. The Commission and the Council considered that Cyprus, France, Germany, Greece and Malta had corrected their excessive deficits. The excessive deficit procedure for Cyprus was abrogated in July 2006, for France in January 2007, and for Germany, Greece and Malta in May 2007, respectively. Furthermore, the Commission and the Council considered that Poland had not respected the recommendations formulated in line with the 104(7) recommendation. As Poland is a Member State with derogation, the Council issued another recommendation based on Article 104(7) in February 2007. Similarly, in May 2007 the Commission recommended the Council to decide that the Czech Republic had not taken adequate actions in response to the Council recommendation under Article 104(7) of the Treaty and to address a new recommendation under the same article. Having already decided that Hungary had not respected its recommendations in 2005, the Council addressed the third recommendation based on Article 104(7) to Hungary in October 2006. Currently, seven EU countries are still subject to an excessive deficit procedure: two euro area Member States – Portugal, and Italy – the UK, and four new Member States – the Czech Republic, Hungary, Poland, and Slovakia. Based on the Commission services' spring 2007 forecast and the April 2007 notification by the government, Romania plans a deficit of slightly above 3% in 2007 and 2008. Developments are being monitored and the Commission will take appropriate measures in the coming weeks.

In the context of the EU budgetary surveillance, the Commission assessed the 2006/07 updates of the Stability and Convergence Programmes submitted by the 27 Member States and proposed Council opinions on these documents. The picture emerging from the Commission assessment and Council opinion highlights two distinct trends. The first and encouraging trend relates to the budgetary plans of countries currently in excessive deficit. If they are fully implemented all but two countries currently in excessive deficit will have a budgetary position breaching the the 3% of GDP threshold of the Treaty by 2008. The second and less encouraging trend refers to Member States where the deficit is below the 3% of GDP threshold. They do not seem to fully size the opportunity provided by the favourable economic outlook. The overall adjustment effort targeted in 2006-2009 is somewhat back-loaded with larger adjustments planned for the outer years. In 2007, countries already at the medium-term budgetary objective are estimated to loosen their fiscal stance by on average ¾ of a percentage point. In the same year, while planning a fiscal adjustment, Member States which are not yet at the medium-term objective are on average estimated to target an improvement in the structural budget balance of less than the 0.5% of GDP benchmark indicated by the reformed Stability and Growth Pact.

In the coming decades, ageing populations is projected to have a significant budgetary impact on public finances in the EU challenging the long-term sustainability of public finances. The assessment of the 2006/07 updates of the Stability and Convergence Programmes coupled with the common long-term budgetary projections shows that the fiscal efforts made by a number of Member States are bearing fruit; the improved structural budgetary position in 2006 in the EU as a whole contributes to a reduction in the sustainability gap. Nevertheless, a significant sustainability gap remains. In the euro area and the EU structural budget balance would have to be permanently improved by 3% of GDP so as to ensure the sustainability of public finances in the long term. For a large majority of countries, achieving the budgetary targets set down in the 2006/07 updates of the Stability and Convergence Programmes would significantly reduce yet not close the sustainability gap. Hence, to ensure progress towards more sustainable public finances, structural reform measures, notably in the field of pensions and health care are required. As regards the degree of risks to public finance sustainability by country, the assessment of the 2006/07 updates of the Stability and Convergence Programmes confirms the findings of the previous year. Six Member States (the Czech Republic, Greece, Cyprus, Hungary, Portugal and Slovenia), face a high risk with regard to the long-term sustainability of public finances in view of the budgetary impact of ageing populations. Ten Member States (Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, Malta, Slovakia and the UK) are at medium risk and another nine countries (Denmark, Estonia, Latvia, Lithuania, the Netherlands, Austria, Poland, Finland and Sweden) are at low risk.

Evolving budgetary surveillance

Following years in which budgetary surveillance largely focused attention on the correction of excessive deficits, public finances in the EU are clearly improving. On the back of both a broad-based economic recovery and significant adjustments of the underlying budgetary positions, the upward trend of the government debt ratio has been reversed and, based on current plans, most excessive deficits are going to be corrected in the coming years.

In spite of these encouraging developments, the recent experience also highlights a number of issues that need to be addressed in order to secure current accomplishments and in particular to make sure that Member States make rapid progress towards achieving sustainable budgetary positions in order to be prepared for the budgetary impact of ageing population. In a number of countries the decline of the structural budget deficit recorded in 2006 significantly benefited from better-than-expected tax revenues, which were partly used to offset slippages on the expenditure side of the budget. Hence, revenue windfalls have not been fully used for budgetary adjustment; a part has been spent. A similar pattern is projected to prevail in 2007, when as mentioned before the projected improvement in the structural budget balance for the euro area and the EU as a whole fall short of the benchmark of 0.5% of GDP required by the reformed Stability and Growth Pact.

With a view to avoiding mistakes of the past, the challenge ahead is to ensure an effective functioning of the preventive arm of the Stability and Growth Pact. As regards coordination, one important element consists in discussing and assessing at an early stage national fiscal policy intentions at the EU level so as to possibly shape the national debate before budget plans are fixed. One way to make progress towards this objective is to strengthen the Mid-Term Budgetary Review along the lines indicated by the Eurogroup in November 2006. The idea is to transform the Mid-term Budgetary Review, which takes place each year after the presentation of the updated Stability Programmes and programmes ahead of the next round of budgetary planning, into a more effective strategic policy debate. The main innovations of the ongoing revamp refer to the timing of the procedure and the level of commitment by the Member States. The review is re-designed to better fit the national budgetary calendars and Member States are invited to forward any information on their main plans for fiscal for the coming year. With a view to strengthening the results and the impact of the review the Eurogroup also plans to endorse policy conclusions which should serve as guidance for the national fiscal policy making.

A second major avenue to be pursued in the future consists in strengthening national budgetary procedures and to better link them to the EU budgetary surveillance framework. The focus on budgetary procedures complements the work on national fiscal rules and institutions which was at the centre of last year's Public Finance Report and which echoed the Council report of March 2005 underpinning the reformed Stability and Growth Pact stating that 'domestic governance arrangements should complement the EU framework'. Based on past experience, the failure to achieve medium-term budgetary objectives can also be related to weak arrangements ensuring the effective preparation, legislation and the implementation of budgetary targets that go beyond the annual budget cycle. The range of national practices is very broad. In some countries, developed national medium-term frameworks where introduced in the past and are working well; in others the 'only' instrument placing fiscal policy into a multi-annual context is the stability and convergence programme, where the latter is not necessarily well integrated with national procedure. In a bid to highlight the importance of the quality of budgetary procedures for the functioning of the preventive arm of the Pact this year's report attempts a first panoramic overview of the prevailing landscape of budgetary procedures in the EU Member States. It also touches upon some specific elements such as medium-term budgetary frameworks showing that well-defined arrangements embedding budgetary planning in a multi-annual context are a promising way forward to ensure compliance with medium-term budgetary targets.

One of the distinctive features of the reformed Stability and Growth Pact is its enhanced economic rationale. In the preventive arm of the Pact this is reflected in requirements for fiscal adjustment that explicitly take into account economic conditions as well as other factors. In the past two years, work was carried out to find operational definitions of a number of concepts such as economic 'good times' and one-off measures that play a key role in the EU budgetary surveillance. On top of this, the current juncture underlines the scope for improving the current toolset for measuring the underlying fiscal position of Member States. In many EU Member States the present economic recovery goes along with higher-than-expected revenue inflows and calls for improved indicators that allow for a clearer view about which part of the budget balances can be considered purely temporary and whether higher tax-to-GDP ratios are purely temporary and more permanent. The structural budget balance, i.e. the budget balance net of cyclical factors and one-off and other temporary measures, which is the main indicator to assess the underlying budgetary position in the EU budgetary framework, has proved its usefulness over the years but needs to be upgraded or complemented to safeguard its effectiveness also in specific economic circumstances. Two interlinked issues are of particular importance: the appraisal of cyclical conditions in real time and the assessment of tax revenues. Work is ongoing on both issues and possible ways to overcome current limitations on both counts have been identified. The next step consists in translating current findings and insights in practical improvements of the current toolset used in the EU budgetary surveillance.

The benefits of sound fiscal policy could be better communicated if fiscal surveillance was placed into a broader economic perspective, including the context of the renewed strategy of Lisbon for Growth and Jobs. The assessment of fiscal policy developments could notably take greater account of the overall macroeconomic situation in the Member States. Particular attention could be given to internal and external imbalances which may mask potential risks to sustainable economic development and in turn to sustainable public finances.

Giving more attention in the surveillance of budgetary positions to debt and long-term sustainability of public finances was one of the main areas for improvement identified in the 2005 Council report underpinning the reform of the Stability and growth Pact. Since then a number of important steps have been taken. The work on common long-term budgetary projections carried out jointly by the Member States and the Commission services and, based on those projections, the first sustainability report adopted by the Commission at the end of 2006 are cases in point. The next major update of the common long-term projections and in turn of the sustainability report is planned for 2009. In that context a number of potential improvements are envisaged so as to provide further insight in the budgetary impact of ageing.

Analytical sections

How to stick to medium-term budgetary plans

One of the key goals of the Stability and Growth Pact is to place fiscal policy into a multi-annual framework by requiring Member States to aim for a sound budgetary position in the medium term. So far the track record of a number of Member States in achieving medium-term targets has been mixed. In many cases, medium-term plans rather than acting as a point of reference across years turned into moving targets. Slippages from short-term objectives were followed by a revision of the entire adjustment path, in particular of the year in which the medium-term objective was expected to be achieved. The issue of why Member States conspicuously missed their medium-term objectives in the past has been addressed from many different angles, especially ahead of the reform of the Stability and Growth Pact in March 2005. The debate is gaining renewed importance because, as mentioned before, the focus is shifting from the corrective to the preventive arm of the Pact. After the correction of most excessive deficits, the main challenge for fiscal policy in the EU now consists in ensuring a rapid and consistent progress towards sound budgetary positions in the medium term.

Part III of this report focuses on the question of why some EU Member States were more successful in achieving medium-term budgetary targets than others. The main aim is to identify the elements in the set up of national fiscal policy making that allow Member States to stick to a predefined course of action over a number of years. Particular attention is given to the role played by well-defined medium-term budgetary frameworks. The basis of the analysis is a comprehensive review of past experience, which highlights the reasons for the difficulties to respect medium-term budgetary targets. The comparison of plans versus outcomes points to a number of revealing patterns. The typical adjustment path laid out in the Stability and Convergence Programmes was expenditure based which on top of an improvement of the budget balance aimed at reducing the revenue-to-GDP ratio. In about two thirds of the cases, the planned improvement in the budget balance was missed mostly because of expenditure overruns, and to a lesser extent due to negative growth surprises. As regards the factors explaining the size of the expenditure overruns the main results of the analysis refers to the institutions for medium-term budgetary planning. In particular, the capacity to achieve multi-annual expenditure targets turns out to be systematically linked to the quality of such institutions.

In the light of these findings the implementation or strengthening of adequate Medium-term budgetary frameworks in the EU Member States seems to be a promising avenue towards a better compliance with medium-term budgetary targets. As a sort of guidance, the key conditions for the effectiveness of Medium-term budgetary framework are discussed, notably cautious macroeconomic assumptions and the credibility of budgetary objectives.

Lessons from successful fiscal consolidations

The correction of strained fiscal positions is a recurring feature of public finances, where, by experience, some types of adjustment give rise to a more lasting correction than others. The second analytical section of this report presents the results of a comprehensive review of the episode of fiscal consolidation carried out in the EU since 1970. The main aim of the review is to re-examine the factors that lead to a more lasting improvement of the underlying budgetary position.

The findings established in the literature have so far been relatively clear: expenditure-based adjustments, in particular those involving cuts in the government wage bill, were found to be more likely to be successful than corrections relying on higher revenues or cuts in investment expenditure. Our analysis substantiates this 'received wisdom' for the entire sample period 1970 and 2006, but points to some qualifications as regards the 1990s and beyond. In the latter period, cutting primary expenditure is still found to have had a positive impact on the likelihood of success however the link has grown weaker. Successful corrections were increasingly characterised by across-the-board savings of primary expenditure while unsuccessful episodes became somewhat more expenditure based than in the 1970s and 1980s. As a result, the likelihood of success was somewhat less determined by the composition of adjustment per se. Other factors that helped safeguard expenditure cuts or revenue increases are likely to have gained importance.

Two prominent examples of such other factors are fiscal governance and structural reforms. Starting with fiscal governance, our analysis indicates that the likelihood of success significantly increases with the strength and coverage of fiscal rules; the same hold for the effectiveness of budgetary procedures. While the exact mechanisms still need to be determined, the link between fiscal governance and lasting fiscal corrections is likely to work via at least two different channels. Firstly, comprehensive and strong fiscal rules favour discipline-oriented budgets. They provide incentives to draw up adjustments that stand a larger chance to be sustainable, not least in view of the possible costs associated with the risk of running afoul of the rules. Secondly, effective budgetary procedures favour good planning, a balanced composition and an effective implementation of consolidation measures as opposed to a situation in which measures are planned over a short period of time and in an uncoordinated way.

The EU experience also supports the conclusion that the success of fiscal consolidation increases significantly if they are coupled with structural reforms. We find a significant link for different types of reforms including those focusing on product and labour markets. This result points to potential complementarities between the Stability and Growth Pact and the Lisbon process for Growth and Jobs. Our analysis does not detail the precise channels through which structural reforms help fiscal consolidation. Further work is needed to clarify the relationship. However, the favourable impact of structural reforms on the success rate of fiscal consolidation, especially of labour market reforms, does not come as a complete surprise. The empirical literature on fiscal consolidation includes many references to potentially beneficial feedback mechanisms between reforms that contribute to wage moderation and fiscal adjustment.

In 2006, the budgetary position in the euro area and the EU improved significantly compared to the previous year. The headline deficit declined to 1.6 % of GDP in the euro area, down from 2.5% of GDP, and to 1.7% of GDP in the EU as a whole, down from 2.4% of GDP. The budgetary improvement took place against a better-than-expected economic growth performance and higher- than-expected revenues.

Taken at face value, the improvement in the headline deficit was matched by an equal improvement in the budget balance net of cyclical factors and one-off and other temporary measures suggesting that the improvement was completely structural.

However, the estimates of the structural deficit are likely to be affected by the exceptionally high tax content of economic activity. In 2006 the current tax burden posted the strongest annual increase in ten years. Since the buoyancy of tax revenues may reflect both permanent and temporary factors, the verdict is still out on the actual determinants of the estimated improvement of the structural budget balance in 2006.

In the euro area, the largest improvements in both, nominal and structural terms were recorded in Germany, Greece and Portugal. The headline deficit increased in Italy, mainly on the back of temporary effects. Net of one-offs the deficit remains on a downward path. Outside the euro area three out of six excessive deficit countries, notably the Czech Republic, Malta and the UK brought the budget deficits below the 3% of GDP reference value of the Treaty. In the case of the Czech Republic the decline is forecast to be only temporary.

According to the Commission services' spring 2007 forecast, the deficit of the euro area and EU are expected to decline further in 2007 and, based on the no-policy assumption, also 2008. Compared to 2006, the composition of adjustment is projected to shift from the revenue to the expenditure side of the budget. In 2007, the estimated improvement of the structural balance falls short of the 0.5% of GDP benchmark of the reformed SGP. As regards the countries in excessive deficit, Italy and Slovakia are forecast to bring the headline deficit below the 3% of GDP reference value in 2007. In the same year, the nominal deficit is expected to return above the 3% of GDP reference value in the Czech Republic, and to stay above the reference value in 2008, unless further measures are taken. The deficit is forecast to decline but to stay above 3% of GDP in Hungary, Poland and Portugal in 2007-08. The forecast for 2008 is on the consumary no-policy-change assumption.

Among the euro-area countries with relatively high structural deficits, improvements are expected in Greece, France and Portugal over the forecast period. Outside the euro area, most of the countries are foreseen to see a worsening or no changes in the structural balance. The most significant worsening is expected in the Czech Republic and Romania. The countries where the structural balance is expected to improve over the forecast period are Cyprus, Hungary, Latvia, Lithuania, Poland and Slovakia.

In 2006, the debt-to-GDP ratio in the euro area and the EU remained on a declining path. Further declines are expected in 2007 and 2008 on the back of sustained economic growth and an expected improvement in the primary budget balance. The debt ratio of the euro area is projected to fall from 69.0 % of GDP in 2006 to 65.0 % of GDP in 2008. In the EU as a whole, the debt-to-GDP ratio is forecast to fall from 61.7 % of GDP in 2006 to 58.3 % of GDP in 2008. As regards the high debt countries, the GDP debt ratio is expected to decline but to remain well above 60% of GDP in Belgium, Greece, and in Italy. As of 2008, Italy is projected to be the only Member State with a debt-to-GDP ratio above 100 % of GDP. In Austria, the debt ratio is forecast to fall below the 60 % of GDP reference in 2008.

Since spring 2006, the Commission and the Council took action on eight Member States concerning the Excessive Deficit Procedure (EDP). The Commission and the Council considered that Cyprus, France, Germany, Greece and Malta had corrected their excessive deficits. The excessive deficit procedure for Cyprus was abrogated in July 2006, for France in January 2007, and for Germany, Greece and Malta in June 2007, respectively. Furthermore, the Commission and the Council considered that Poland had not respected the recommendations formulated in line with the 104(7) recommendation and issued another recommendation based on Article 104(7) in February 2007. Similarly, in May 2007 the Commission recommended the Council to decide that the Czech Republic had not taken adequate actions in response to the Council recommendation under Article 104(7) of the Treaty and to address a new recommendation under the same article. Having already decided that Hungary had not respected its recommendations in 2005, the Council addressed the third recommendation based on Article 104(7) to Hungary in October 2006. Currently, seven EU countries are subject to an excessive deficit procedure: two euro area Member States – Portugal, and Italy – the UK, and four recently acceded Member States – the Czech Republic, Hungary, Poland, and Slovakia. Following information that Romania is planning a deficit of more than 3% of GDP in 2007 and beyond, the Commission will take the appropriate steps in the coming weeks.

In the context of the EU budgetary surveillance, the Commission assessed the 2006/07 updates of the Stability and Convergence Programmes submitted by the 27 Member States and proposed Council opinions on these documents. The picture emerging from the Commission assessment and Council opinion highlights two distinct trends. The first and encouraging trend relates to the budgetary plans of countries the deficit of which still exceeds the 3% of GDP threshold of the Treaty. If budgetary targets are fully implemented, all but the Czech Republic and Hungary, will have corrected excessive deficit by 2008.

The second and less encouraging trend refers to countries with deficits below the 3% of GDP threshold, which do not seem to size the opportunity provided by the currently favourable economic outlook. The overall adjustment effort targeted in 2006-2009 is somewhat back-loaded with larger adjustments planned in the outer years. In 2007, countries already at the medium-term budgetary objective (MTO) are projected to loosen their fiscal stance by on average ¾ of a percentage point. In the same year, while planning a fiscal adjustment, Member States which are not yet at the MTO are on average estimated to target an improvement in the structural budget balance of less than the 0.5% of GDP benchmark indicated by the reformed Stability and Growth Pact.

Compared to the previous rounds of programme updates, according to the 2006/07 vintage, most Member States plan faster reduction in government debt-to-GDP ratio over the programme period. A number of countries plan their debt ratios to decline below the 60% of GDP reference value over the programme period: in the euro area, France and Austria and, outside the euro area, Cyprus and Malta. In Belgium, Germany, Greece, Italy, Portugal and Hungary the debt ratios are expected to stay above the 60 % of GDP reference value. In Hungary, the debt ratio is planned to be above its current level at the end of the programme period.

In the coming decades, ageing populations will have a significant budgetary impact on public finances in the EU, challenging the long-term sustainability of public finances. The assessment of the 2006/07 updates of the Stability and Convergence Programmes coupled with the long-term budgetary projections produced jointly by the Commission and the Economic Policy Committee of the Council shows that the fiscal efforts made by a number of Member States are bearing fruits. The improved structural budgetary position in 2006 in the EU as a whole contributes to a reduction in the sustainability gap. Nevertheless, a significant sustainability gap remains. In the euro area and the EU the structural budget balance would have to be permanently improved by 3% of GDP to ensure the sustainability of public finances in the long term. For a large majority of countries, achieving the budgetary targets set in the 2006/07 updates of the Stability and Convergence Programmes would significantly reduce but not close the sustainability gap. Hence, to ensure progress towards more sustainable public finances, structural reform measures, notably in the field of pensions and health care are required. As regards the degree of risks to public finance sustainability by country, the assessment of the 2006/07 updates of the Stability and Convergence Programmes confirms the findings of the previous year. Six Member States (the Czech Republic, Greece, Cyprus, Hungary, Portugal and Slovenia), face a high risk with regard to the long-term sustainability of public finances in view of the budgetary impact of ageing populations. Ten Member States (Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, Malta, Slovakia and the UK) are at medium risk and another nine countries (Denmark, Estonia, Latvia, Lithuania, the Netherlands, Austria, Poland, Finland and Sweden) are at low risk.

1.1. Short-term developments and prospects for the budget balance and public debt

In 2006, the budgetary position of the euro area improved for the third year running, recording a particularly significant progress compared to 2005. The nominal deficit reached 1.6% of GDP, down from 2.5% of GDP in 2005. A slightly more moderate, but still sizeable improvement took place in the EU as a whole, where the headline deficit declined by 0.7 percentage point reaching 1.7% of GDP in 2006.

In both the euro area and the EU the improvement in the headline deficit was matched by an equal improvement of the structural budget balance, i.e. the budget balance net of cyclical factors and one-off and other temporary measures. Taken at face value this result would seem to suggest that the improvement in the headline deficit was fully structural or permanent. However, at the current juncture the estimates of the structural budget balance are likely to be affected by the exceptional buoyancy of tax revenues. In 2006, the current tax burden measuring the incidence of current taxes on GDP was 0.8 percentage point higher than in the year before in both the euro area and the EU, posting the strongest annual increase in ten years. The increase in the tax burden in 2006 surpassed the readings observed at the end of the 1990s when tax revenues benefited from a number of positive developments such as strong consumption growth and an asset price boom. In the light of this, and taking into account that few countries implemented discretionary revenue increasing measures in the 2006 budget, it is likely that at least part of the estimated structural improvement is temporary.

The decline of the headline deficit in the euro area in 2006 reflects a broad based trend across countries. All Member States recorded a more or less significant improvement in the budget balance. Starting with countries where the budget balance is in the red, progress was particularly sizable in Greece, where the deficit fell by 2.9 percentage point including 0.6 percentage point of one-off measures, as well as in Portugal and Germany. Greece and Germany succeeded in bringing the deficit below the 3% of GDP reference value of the Treaty in 2006 and joined France which had achieved it the year before.

In Belgium, Luxemburg and the Netherlands, the deficit turned into a small surplus. In the case of Belgium this was achieved thanks to sizeable temporary measures. The only euro-area country with a government deficit where the budgetary situation worsened is Italy. However, excluding the impact of deficit-increasing one-offs worth around 1.2 percentage points of GDP the deficit remained on a downward path.

The three euro-area members with a surplus in 2005, notably Ireland, Spain and Finland, managed to further improve the budget position in 2006.

Favourable growth conditions coupled with buoyant taxes revenues had a positive impact also outside the euro area. Relative to 2005, the budgetary position weakened in just four out of fourteen Member States that do not adopt the single currency. The most serious deterioration was recorded in Hungary where the deficit widened from 7.8% of GDP in 2005 to 9.2% of GDP in 2006. In Slovakia, the deficit returned above the 3% of GDP threshold of the Treaty in 2006 after it had edged below the threshold the year before. By contrast, there are three non euro-area countries, the Czech Republic, Malta and the United Kingdom where the budget deficit dropped below the 3% of GDP reference value. In the case of the Czech Republic the progress is expected to be temporary.

Looking ahead to 2007 and 2008, public finance developments in the euro area and the EU are expected to fall in a period of marginally slowing but still sustained economic growth. The Commission services' spring 2007 forecast projects real GDP to expand by 2.6% in 2007, compared to 2.7% in 2006, and to stage a further increase of 2.5% in 2008.

Against this favourable backdrop, the public finance situation in the euro area is expected to further improve this year and the next, yet at a slower pace compared to 2006. The aggregate deficit of the thirteen Member States adopting the single currency is expected to reach 1.0% of GDP in 2007, 0.6 percentage point lower than the year before. Based on the customary no-policy-change assumption a further rather marginal improvement to 0.8% of GDP is projected in 2008. Broadly the same profile is projected for the EU as a whole. The deficit is forecast to decline to 1.2% of GDP in 2007, from 2.4% in 2006, and to 1.0% of GDP in 2008.

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In structural terms, i.e. net of cyclical factors and one-off and other temporary measures, the projected improvement in both the euro area and the EU in 2007 is somewhat lower than that of the headline figure in view of the expected narrowing of the output gap. In particular, the structural balance is estimates to improve by only 0.3% of GDP in the euro area and by 0.2% of GDP in the EU as a whole. This is less than the 0.5% of GDP benchmark required by the reformed Stability and Growth Pact.

As regards individual euro-area countries, Italy is forecast to reduce the headline deficit below the 3% of GDP reference value in 2007, whereas further measures are required to achieve the same results by 2008 in Portugal.

A relatively mixed pattern is forecast for the other euro-area countries. Further significant progress is expected in Germany where the deficit is likely to decline to 0.6 % of GDP in 2007, and, at unchanged policies, to 0.3 % of GDP in 2008. A significantly flatter downward trend is projected in France. The budgetary position is expected to weaken somewhat in Belgium, where the balance is forecast to move back into the red, as well as in Ireland, Spain and Finland which are forecast to reduce their budgetary surplus.

The group of euro-area countries that have already achieved their medium-term budgetary objective (MTO), notably Ireland, the Netherlands, Spain, Luxembourg and Finland, is expected to remain unchanged over the period covered by the Commission services' spring 2007 forecast.

Among the Member States outside the euro area, the nominal deficit is projected to stay or return above the 3% of GDP reference value in Hungary, the Czech Republic and Poland. The budget deficit in Hungary is projected to improve over the forecast horizon but to stay well above the 3% of GDP threshold by the end of 2008. Similarly, in Poland, the deficit is forecast to ease from 3.9% of GDP in 2006 to 3.3% of GDP in 2008. Following an improvement in 2006, the deficit in the Czech Republic is expected to return above the 3% of GDP reference value throughout the forecast period. Slovakia is the only non-euro area country with an excessive deficit where the budget balance is expected to drop just below the 3% of GDP reference value in 2007 and to essentially stabilise, at unchanged policies, in 2008. Based on the information available at the cut-off date of this report, Romania is forecast to breach the 3% of GDP deficit threshold in 2007 and 2008.

Among the remaining Member States outside the euro area, relatively comfortable surpluses are expected to be maintained throughout the forecast period in Bulgaria, Denmark, Estonia, Latvia and Sweden. As regards the position vis-à-vis the MTOs the Commission services' spring 2007 forecast implies no change in the number of non euro-area countries in 2007.

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Bulgaria, Denmark, Latvia, Lithuania and Sweden are all expected to keep their budgetary positions in line with or above the MTO, in some cases despite a projected deterioration in the structural balance. Unless further measures are taken, the compliance with the MTOs is likely to remain unchanged also in 2008.

Turning to government debt, in the euro area the ratio with respect to GDP declined to 69.0% in 2006. According to the Commission services' spring 2007 forecasts, the debt ratio is projected to decline to 65.0% of GDP in 2008. Primary surpluses coupled with a positive contribution from interest expenditure and economic growth are expected to more than offset the effect of debt-increasing stock-flow adjustments.

In the EU as a whole, the debt ratio stood at 61.7% of GDP in 2006 and is projected to decline to 58.3% of GDP in 2008. As in the case of the euro area, the overall positive contribution from the primary balance and the contribution from interest expenditure and economic growth will more than offset the effect of debt-increasing stock-flow adjustments.

Aggregate figures tend to mask diverging developments at the country level. In 2006, Greece and Italy continued to have debt ratios above 100% of GDP, however by 2008 Greece is expected to reduce its debt ratio to below 100% of GDP. In Belgium the government debt remained on a steady downward path. It fell below 90% of GDP in 2006 and is expected to be at 82% of GDP by 2008. Among the other countries with current debt ratios above the 60% of GDP threshold, notably Germany, France, Austria, Portugal, Cyprus, Hungary and Malta, only Austria and Cyprus are forecast to reduce their debt ratios below the debt reference value by 2008 without additional measures. In Portugal and Hungary the debt ratio is projected on an upward path over the forecast period.

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1.2. Government revenue and expenditure

In 2006, the observed improvement in budgetary positions was chiefly the result of higher revenues. The overall decline in the headline deficit of 0.9 % of GDP in the euro area and of 0.7% in the EU as a whole was two-thirds revenue and only one-third expenditure based ( see Table I.1.4). At the level of individual revenue items, the single most important contribution came from taxes on income and wealth which compared to 2005 increased by 0.6% of GDP in both the euro area and the EU, thanks to a particularly buoyant inflow of corporate income taxes. The decline in the expenditure ratio was due to slightly lower social transfers other than in kind and collective consumption.

According to the Commission services' spring 2007 forecast, the composition of adjustment is expected to shift towards the expenditure side of the budget in 2007-2008. In the euro area, a projected decline in the revenue ratio of 0.4 percentage point of GDP is forecast to be more than offset by a reduction in the expenditure ratio of more than one percentage point of GDP. The brunt of the adjustment is expected to be borne by collective consumption and social transfers other than in kind, while other expenditure items are foreseen to remain broadly unchanged in percent of GDP.

At the level of the Member States, the patterns are generally similar. Only in Belgium, Ireland, and, outside the euro area, in the UK, expenditure ratios are projected to increase in 2007-2008.

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Conversely, large declines are expected in Italy, Luxembourg, Slovenia, Hungary, Poland and Sweden. The revenue ratios are set to increase in 2007-08 in Italy, and, outside the euro area in Cyprus, Lithuania, Hungary, Romania and the UK, whereas important reductions are foreseen in Belgium, Luxembourg, Slovenia, Finland, Denmark and Sweden.

In the euro-area, as well as in the EU, the projected decrease in social contributions and other resources is expected to be offset by a decline in expenditure on collective consumption, social benefits in kind and transfers other than in kind. These plans seems to reflect lessons from the past according to which tax cuts should be accompanied by expenditure restraints to avoid the worsening of the general government balances.

The projected budgetary adjustment in the euro area and the EU does not seem to weigh on growth enhancing spending items such as public investment, education and R&D. Gross fixed capital formation in the euro area is projected broadly stable at around 2½% of GDP at annual level, while in the EU as a whole a slight increase is expected. The reduction in interest expenditure that has contributed to a better allocation of available resources in past years will slowly continue.

1.2.1. The fiscal stance and policy mix in the euro area

An appropriate policy mix can be defined as a combination of monetary and fiscal policies that ensures price stability and keeps economic activity close to its potential level. In the euro area, given that monetary policy is centralised and fiscal policies decentralised, it is of a particular importance to assess both the aggregate fiscal stance at the euro area level and national fiscal stances. Namely, the aggregate fiscal stance affects the policy mix at the euro area level and is, therefore, one of the elements to be considered by the monetary policy authority.

Graph I.1.1 displays the fiscal stance approximated by the change in the cyclically-adjusted primary budget balance (Δ CAPB) in comparison with the change in the cyclical conditions estimated by the output gap.([1]) In this graph, fiscal behaviour in accordance with the SGP would be represented by movements along the horizontal axis. In other words, countries would achieve and maintain broadly balanced budgets over the economic cycle. However, as long as a Member State has not yet reached the medium-term budgetary objective in line with provisions of the SGP, a restrictive fiscal stance – that is a positive change in the CAPB – would be needed.

On the face of it, in 2006 the fiscal stance in the euro would seem to have been clearly pro-cyclical as the budget balance net of cyclical factors markedly improved against a background of an output gap that is estimated to have been still negative. This conclusion needs to be qualified in two respects. Firstly, and not surprisingly the fiscal tightening largely reflects the fiscal adjustment undertaken in countries with an excessive deficit. Secondly, although negative, the output gap narrowed significantly in 2006 reflecting the ongoing brisk economic recovery (see Graph I.1.2). ([2]) Taking into account the lessons from the past, it is crucial not to relax adjustment efforts when growth prospects are favourable.

[pic] Looking ahead, a further yet somewhat milder fiscal tightening is expected in 2007 when cyclical conditions are expected to continue improving. In 2008, the no-policy-change assumption underlying the Commission services' forecast implies a broadly neutral fiscal stance when actual output is estimated to approach potential.

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Graph I.1.3 illustrates the euro area policy-mix, by plotting the fiscal stance on the vertical axis and the monetary stance (approximated by the change in the short-term real interest rates) on the horizontal axis. Against the background of brisk economic growth and fiscal tightening the monetary stance remained broadly neutral in 2006. In 2007, the gradual increases in the ECB's policy rate at the end of 2006 and at the beginning of this year plus those assumed in the Commission services' spring 2007 forecast are expected give rise to a policy mix where both monetary and fiscal instruments bridle aggregate demand.

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2.1. Introduction

The fiscal framework of EMU aims at ensuring budgetary discipline through two main requirements: the Treaty requirement to avoid excessive deficit positions, measured against reference values for deficits and debt of 3% and 60% of GDP respectively, and the requirement for Member States to achieve and maintain their medium-term budgetary objective (MTO). Compliance with the MTO secures fiscal discipline and the sustainability of public finances, and thus contributes to maintaining an economic environment in which monetary policy can effectively pursue price stability. It also provides the necessary room for manoeuvre to allow the automatic stabilisers to play freely without breaching the 3% reference value of the Treaty.

The rules-based framework of the Treaty and Stability and Growth Pact (SGP) consists of both preventive and dissuasive elements, both of which are backed up with enforcement procedures. Box I.2.1 contains a brief description of these procedures. In 2006 and the early part of 2007, the Commission and Council applied the various enforcement mechanisms of the SGP to several Member States. This section reviews the implementation of these mechanisms since spring 2006.

2.2. The excessive deficit procedure since spring 2006

Since spring 2006, the Commission and the Council took action on eight Member States subject to an Excessive Deficit Procedure (EDP). The Commission and the Council considered that Cyprus, France, Germany, Greece and Malta had corrected their excessive deficits. The Council decided to abrogate the excessive deficit procedure for Cyprus in July 2006, for France in January 2007, and for Germany, Greece and Malta in June 2007, respectively. Furthermore, in November 2006 the Commission and the Council considered that Poland has not respected the recommendations formulated under Article 104(7) of the Treaty. As Poland is a Member State with derogation the Council issued another recommendation based on Article 104(7) in February 2007.([3]) Similarly, on 30 May 2007 the Commission recommended the Council to decide that the Czech Republic had not taken adequate actions in response to the Council recommendation under Article 104(7) of the Treaty and to address a new recommendation under the same article. Having already decided that Hungary has not respected its recommendations in 2005, the Council addressed the third recommendation based on Article 104(7) to Hungary in October 2006.

Currently, seven EU countries are still subject to an excessive deficit procedure: two euro-area Member States, namely Portugal and Italy, the UK and four recently acceded Member States, namely the Czech Republic, Hungary, Poland and Slovakia. ([4])

2.2.1. The surveillance mechanisms in the euro-area countries

Germany and France: Summary of past events

Following evidence of government deficits above 3% of GDP in 2002, the Council decided in spring 2003 that excessive deficits existed in Germany and in France and adopted recommendations under Article 104(7) with a view to bringing this situation to an end by 2004. In autumn 2003, the Commission considered that the actions implemented were inadequate and recommended the Council to adopt decisions giving notice to these two countries to correct the excessive deficit by 2005.

On 25 November 2003, the Council voted on the recommended decisions but did not achieve the required majority. Instead the Council adopted conclusions addressing recommendations to Germany and France for the correction of the excessive deficit by 2005 and stating that the excessive deficit procedure was held in abeyance. The Commission brought the case before the Court of Justice of the European Communities. On 13 July 2004, the Court annulled the Council conclusions in so far as they aimed at formally suspending the procedure and modifying the existing recommendations.

On 14 December 2004, the Commission adopted a Communication clarifying the situation of Germany and France in relation to the excessive deficit procedure. The Commission recognised that the actions of the two Member States concerned taken in the aftermath of the Council conclusions of 25 November 2003 and up to their annulment by the Court on 13 July 2004 were based on the notion that the deadline for the correction of the deficit had been effectively moved to 2005. The Commission considered that the assessment of the actions taken to correct the excessive deficit situation should refer to 2005 as the relevant deadline. In the Communication, the Commission stated that the actions taken by the German and French authorities were broadly consistent with a correction of the excessive deficit by 2005 and that no further steps were necessary under the excessive deficit procedure. The Council agreed with this position.

Germany

The German statistics office announced on 22 February 2006 that the public deficit in 2005 was 3.3% of GDP, following 3.7% of GDP in 2004. In addition, the deficit was expected by the German authorities to remain above the 3% of GDP threshold in 2006. On 1 March 2006, the Commission recommended to the Council to give notice to Germany, according to Article 104(9) of the Treaty, to correct its excessive deficit by 2007. Such a notice was adopted by the Council on 14 March 2006. In this notice, the Council acknowledged that the German government had adopted a comprehensive budgetary consolidation strategy in a context of still fragile economic recovery to bring the deficit below the 3% reference value by 2007.

The Council recommended in the notice that Germany corrects the excessive deficit by 2007 at the latest and ensures that the budget balance in structural terms improves by at least one percentage point cumulatively in 2006 and 2007. The Council decided that Germany had to submit, by 14 July 2006 at the latest, a report outlining the measures taken to comply with the notice.

Based on the German implementation report submitted on 5 July 2006, the action taken by Germany to correct its excessive deficit was assessed in the Commission communication of 19 July 2006. The Commission considered that Germany was on track to correct its excessive deficit by 2007 at the latest, as requested by the Council, provided it fully implemented the 2006 and 2007 budgets. The Commission considered that no further steps were needed at present under the excessive deficit procedure. On 10 October 2006, the Council agreed with this position welcoming the commitment of the German authorities to address the budget deficit on a structural basis.

In 2006, the German deficit was reduced to 1.7% of GDP, well below the reference value of the Treaty, one year earlier than recommended by the Council. The Commission services' spring 2007 forecast shows a further reduction of the deficit to 0.6% of GDP in 2007 and – on a no-policy change basis – to about 0.3% in 2008. The cumulative structural improvement in 2006-07 is estimated to be some 1 ½ percentage points of GDP. With the correction of the excessive deficit confirmed, the Council, following a recommendation of the Commission, abrogated the EDP for Germany in June 2007.

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France

The French deficit was reduced to 2.9% of GDP in 2005 from 3.7% in 2004, partly thanks to substantial one-off revenues. The structural adjustment (i.e. the improvement in the cyclically-adjusted balance net of one-off and other temporary measures) in 2005 amounted to 0.6% of GDP. In autumn 2006, both the French authorities and the Commission expected the deficit to fall further – to 2.7% of GDP in 2006, 2.6% in 2007 and about 2% by 2008 – with the recourse to one-offs limited in 2006 (¼% of GDP) and negligible or non-existent thereafter. As this deficit reduction was expected to be driven by a better expenditure control at the State and health-care sector levels, the improvement in the structural balance was estimated at 0.5%, 0.3% and 0.6% of GDP in 2006, 2007 and 2008, respectively. This suggested that the deficit has been brought below the Treaty reference value in a credible and sustainable manner. According to the Commission services' 2006 autumn forecast, the debt increase trend has also been inverted.

Based on these projections, the Commission concluded that the excessive deficit situation in France has been corrected and recommended on 29 November 2006 to the Council to abrogate its decisions under paragraph (6) of Article 104 of the Treaty. On 30 January 2007, the Council abrogated its decision on the existence of an excessive deficit in France.

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Portugal

The update of the Stability Programme submitted on 9 June 2005 by the Portuguese authorities revealed the plans for a general government deficit in excess of the 3% of GDP reference value of the Treaty for the years from 2005 to 2007. More specifically, after a reported deficit outturn of 2.9% of GDP in 2004, Portugal planned a government deficit of 6.2% of GDP for 2005, 4.8% in 2006, 3.9% in 2007 and 2.8% of GDP in 2008. Over the same years, the debt-to-GDP ratio was projected to increase from 61.9% in 2004 to a peak of 67.8% of GDP in 2007. On this basis, the Council decided on 20 September 2005 that Portugal has an excessive deficit.

On the same date, the Council addressed a recommendation under Article 104(7) specifying that the excessive deficit had to be corrected by 2008. Specifically, Portugal was recommended to limit the deterioration of the fiscal position in 2005 and to ensure a narrowing of the structural deficit of 1.5% of GDP in 2006 from 2005, followed by a further decrease of, at least, ¾ % of GDP in each of the two subsequent years. At the same time, Portugal was invited to rapidly implement reforms to contain and reduce expenditure and to stand ready to adopt the additional measures which may be necessary to achieve the correction of the excessive deficit by 2008. In addition, the Portuguese authorities were recommended to ensure that the government gross debt ratio is brought onto a downward path also by avoiding debt-increasing financial transactions, and by considering carefully the possible impact on debt of major public investment projects.

The Council established the deadline of 19 March 2006 for the Portuguese government to take effective action in order to achieve the 2006 deficit target. The Commission communication of 21 June 2006 considered that the action taken by Portugal in response to the Council recommendation represented adequate progress towards the correction of the excessive deficit within the set time limit. In particular, Portugal (i) achieved a 2005 deficit in line with plans; (ii) adopted a comprehensive package of corrective measures which, if fully implemented and effective should deliver the required structural adjustment in 2006; (iii) confirmed the deficit target for 2008 below 3% of GDP and a structural adjustment path in line with the Council recommendation; (iv) implemented or initiated expenditure-containing measures and kept fiscal targets in spite of a more cautious re-assessment of GDP growth prospects; (v) planned to return government debt to a declining path as from 2008; and (vi) has taken action to improve statistics.

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Greece

On 4 May 2004, the Greek authorities submitted a revised EDP notification showing a 2003 deficit of 3.2% of GDP. The Council, also taking into account developments in the debt ratio, decided that an excessive deficit existed in Greece and addressed on 5 July 2004 recommendation under Article 104(7) to Greece with a view to bringing the excessive deficit situation to an end by 2005. The Council established the deadline of 5 November 2004 for Greece to take appropriate measures to this end.

Based on the Commission services' 2004 autumn forecast incorporating the data revisions of the September 2004 notification and projecting the 2005 deficit at 3.6% of GDP, on 22 December 2004 the Commission recommended to the Council to decide under Article 104(8) that no effective action had been taken in response to its recommendation under Article 104(7). The Council decided accordingly on 18 January 2005. On 9 February 2005, the Commission recommended to the Council to give notice to Greece, in accordance with Article 104(9), to take the necessary measures to remedy its excessive deficit situation. The Commission recommended extending the deadline for correcting the excessive deficit by one year to 2006. When taking this decision, the Commission took into account the fact that the 2004 deficit would likely be substantially higher than expected, due to statistical revisions and to expenditure overruns associated notably with the organisation of the Olympic Games. In addition, the Commission considered that economic growth prospects for 2005 and 2006 had become less favourable, making the reduction of the deficit more difficult.

On 17 February 2005, the Council adopted a decision giving notice to Greece, in accordance with Article 104(9), to take measures to remedy the situation of excessive deficit as rapidly as possible and at the latest by 2006 through (i) a rigorous implementation of the 2005 budget as approved by the Parliament; (ii) implementing in 2006 adjustment measures of a permanent nature leading to a correction in the deficit of at least 0.6 percentage point of GDP. ([5]) The Council decided that Greece had to submit, by 21 March 2005 at the latest, a report outlining the decisions to respect these recommendations.

Following the submission of the report, the Commission communication of 6 April, the Commission concluded in its communication of 6 April 2005 that the Greek government had taken effective action so that no further steps under the EDP were needed at that stage.

In 2006, the deficit fell below the reference value, to 2.6% of GDP, inter alia thanks to one-off measures worth around 0.6% of GDP. Including the impact of recently announced new measures, the Commission services' spring 2007 forecast projects the deficit to narrow slightly to 2.4% of GDP in 2007; excluding one-offs, it would be 2.9% of GDP. On a no-policy change basis and without further one-offs, the deficit would increase to 2.7% of GDP in 2008. The fiscal effort, measured by the improvement in the structural budget balance, is estimated at more than 2 percentage points of GDP in both 2005 and 2006. The projected evolution of the debt ratio, which stood at 108 ½ % of GDP in 2004 and should fall below 100% of GDP in 2008, can be considered to be in line with the Council's recommendations. The spring forecast thus supports the conclusion that the deficit has been brought below the reference value in sustainable manner and, on this basis, the Council, following a recommendation of the Commission, abrogated the excessive deficit procedure for Greece in June 2007.

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Italy

On 23 May 2005, Eurostat released revised figures on Italian government data, showing a general government deficit of 3.1% of GDP in both 2003 and 2004. Over the same two years, the debt-to-GDP ratio was reported to have remained broadly stable at around 106-107% of GDP. On 24 May the Italian institute of statistics (ISTAT) released new public finances data for the period 2000-2004. The deficit was reported at 3.2% of GDP in 2003 and 2004. Given that the deficit ratio had been above but close to 3% of GDP in 2003 and 2004 and that the breach of the reference value could not be considered temporary because the Commission projected the deficit to exceed 3% in 2005 and 2006, and taking into account developments in the debt ratio, the Council decided that Italy has an excessive deficit on 28 July 2005. At the same time, the Council addressed a recommendation under Article 104(7) specifying that the excessive deficit had to be corrected by 2007.

In particular, Italy was recommended to implement with rigour the 2005 budget; reduce the structural deficit by a minimum 1.6% of GDP by 2007 relative to its level in 2005, with at least half of this correction taking place in 2006; and ensure that the debt-to-GDP ratio diminishes and approaches the reference value at a satisfactory pace.

On 22 February 2006, the Commission adopted a communication concluding that the actions taken by Italy, if fully implemented and effective, would be consistent with the Council recommendation. The Commission communication highlighted that implementation uncertainties persisted, requiring continuous monitoring. On 14 March 2006, the Council agreed with this analysis, stressing the utmost importance of the execution of the 2006 budget and the likely need to identify and implement substantial additional corrective measures for 2007.

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2.2.2. The surveillance mechanisms in the non euro-area Member States

United Kingdom

According to the data notified by the United Kingdom in August 2005, the general government deficit amounted to 3.2% of GDP in the 2004/05 financial year. ([6]) The Commission services' 2005 autumn forecasts projected that on the basis of unchanged policies the general government deficit would rise further in the financial 2005/06 to 3.4% of GDP, before declining to 3.2% in 2006/07 and 3.0% in 2007/08. Output in the Commission services' 2005 autumn forecasts was projected to be strengthening from late 2005, with approximately trend-level growth from 2006. Based on these projections, the excess over the reference value could not be considered exceptional or temporary within the meaning of the Treaty and the Stability and Growth Pact although the deficit was close to the reference value.

After the Commission services' 2005 autumn forecasts had been published, the United Kingdom announced policy decisions in the Pre-Budget Report presented to Parliament on 5 December. In net terms, these measures represented an easing of policy by 0.1% of GDP in the 2005/06 financial year and a tightening of policy by 0.1% of GDP in 2006/07. Compared to an unchanged policy scenario, the Pre-Budget Report foresaw a tightening of 0.2% of GDP in 2007/08. Taking into consideration these measures, the Commission's assessment nevertheless remained that the deficit through to 2006/07, was expected to exceed 3% of GDP. On this basis, the Council decided on 24 January 2006 that the UK had an excessive deficit.

At the same time, the Council addressed a recommendation under Article 104(7) specifying that that the United Kingdom authorities should put an end to the excessive deficit situation as soon as possible and by the financial year 2006/07 at the latest. To bring the general government deficit below 3% of GDP in a credible and sustainable manner the United Kingdom was required to ensure an improvement of the structural balance by at least 0.5 percentage points of GDP between the 2005/06 and 2006/07 financial years.

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Box (continued) [pic] |

On 20 September 2006, the Commission adopted a communication concluding that the United Kingdom was just on track to correct its excessive deficit by the end of the 2006/2007 financial year. According to the Commission fiscal consolidation was supported by better GDP growth than originally envisaged and the tax base was strengthened by good performance of the financial sector and oil prices. Nevertheless, the Commission communication noted that the deficit correction remained vulnerable to negative surprises, given the lack of a safety margin against exceeding the 3% reference value again and the likely shortfall of the structural improvement recommended under Article 104(7). On 10 October 2006, the Council agreed with this view.

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Hungary

According to the fiscal notification of March 2004, Hungary had a general government deficit above the 3% of GDP reference value. On the basis of these notifications and following a recommendation by the Commission the Council decided that an excessive deficit existed in Hungary and addressed a recommendation under Article 104(7) to Hungary on 5 July 2004. The recommendation invited the Hungarian authorities to implement the measures envisaged in the May 2004 convergence programme aiming at a correction of the excessive deficit by 2008. The Hungarian authorities were recommended to stand ready to introduce additional measures, if necessary, with a view to achieving the deficit targets for 2004 and 2005.

On 18 January 2005, in accordance with 104(8) the Council considered that Hungary had not taken effective action in response to its recommendation. Since Hungary is a Member State with derogation, the Council issued on 8 March 2005 another recommendation based on Article 104(7), taking into account the information of Hungary’s convergence programme update submitted in December 2004. ([7]) The Council recommended the Hungarian authorities to "take action in a medium-term framework in order to bring the deficit below 3% of GDP by 2008 in a credible and sustainable manner, in accordance with the path for deficit reduction as specified in the Council Opinion of 8 March 2005 on the on the convergence programme update submitted in December 2004.

In light of a substantial deterioration of the budgetary outlook in Hungary, based on a Commission recommendation the Council decided on 8 November 2005 acting pursuant to Article 104(8) for the second time that Hungary did not comply with the new recommendations under 104(7).

The Council addressed a third recommendation under Article 104(7) to Hungary on 10 October 2006, postponing the deadline for the correction of the excessive deficit by one year, to 2009. The Hungarian authorities were recommended to limit the deterioration of the fiscal position in 2006, which was estimated as a deficit of 10% of GDP (including pension reform costs) ([8]), ensure a frontloaded and sustained substantial correction of the structural deficit and adopt and implement wide-ranging structural reforms aimed at containing public expenditure. Furthermore, Hungary was requested to stand ready to improve expenditure control and ensure the gross debt ratio is brought onto a firm downward trajectory, preferably before 2009.

The Council established the deadline of 10 April 2007 for Hungary to take effective action in order to achieve the deficit targets for 2006 and 2007, and welcomed the commitment of the Hungarian authorities to submit reports on a six-monthly basis to the Commission and the Council examining progress made in complying with the Council recommendation.

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Czech Republic

On 5 July 2004 the Council decided that the Czech Republic had an excessive deficit. At the same time, the Council addressed a recommendation under Article 104(7) specifying that the excessive deficit had to be corrected by 2008 in a credible and sustainable manner. In particular, the Czech Republic was recommended to take effective action regarding the measures envisaged to achieve the 2005 deficit target by the deadline of 5 November 2004 and to implement with vigour the measures envisaged in the May 2004 convergence programme, in particular to cut the wage bill of central government and to reduce spending of individual ministries. Furthermore, the Czech Republic was invited to allocate higher-than-budgeted revenues to deficit reduction, to introduce fiscal targeting based on medium-term expenditure ceilings, to design effective rules to reduce the risk of increasing indebtedness of regions and municipalities, to undertake the reform of the pension and healthcare systems so as to improve the long-term sustainability of the public finances and to minimise the negative budgetary impact of the operations of the Czech Consolidation Agency.

On 22 December 2004, the Commission concluded that the Czech government had taken effective action regarding the measures envisaged to achieve the 2005 deficit target in response to the Council recommendation, and that no further steps were necessary under the excessive deficit procedure.

In 2006, the deficit fell just below the reference value of the Treaty, to 2.9% of GDP, in spite of some deficit-increasing one-off measures. The Commission services' spring 2007 forecast projects the deficit to widen significantly in 2007 to close to 4% of GDP, on the back of higher social spending. Under the no-policy-change assumption, it would decline to 3.6% of GDP in 2008. The structural position is estimated to have widened in both 2005 and 2006 and to widen even more significantly in 2007. Accordingly, on 30 May the Commission recommended to the Council to decide that the Czech Republic has not taken adequate action in response to the Council recommendation under Article 104(7) and to address a new recommendation under the same article.

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Cyprus

On 5 July 2004, the Council decided that an excessive deficit existed in Cyprus. At the same time, the Council addressed a recommendation to Cyprus under Article 104(7), requesting Cyprus to take effective action by 5 November 2004 in order to bring the deficit below 3% of GDP by 2005 in a credible and sustainable manner and to implement with vigour the measures envisaged in the May 2004 programme. Cyprus was also requested to ensure that the rise in the debt ratio was brought to a halt in 2004 and reversed thereafter as specified in the Council opinion on the convergence programme.

A Commission communication of 22 December 2004 concluded that, on then available information and on the basis of the measures detailed in the 2005 budget, it appeared that the Cypriot government had taken effective action to achieve the 2005 deficit target, in compliance with the Council recommendation under Article 104(7). Accordingly, the Commission concluded that no further steps were necessary at that point under the excessive deficit procedure.

On 21 June 2006, the Commission recommended that the Council abrogates the excessive deficit procedure for Cyprus. The deficit had fallen to 2.4% of GDP in 2005 and the government debt-to-GDP ratio had also decreased. According to the Commission services' spring 2006 forecast, the deficit was expected to fall further in 2006 and 2007, thus staying well below the 3% reference value, while the debt ratio would diminish sufficiently towards the 60% of GDP reference value. Although some one-off measures helped reduce the deficit in 2005, the budgetary consolidation in Cyprus was achieved mainly through structural measures. The structural deficit fell to 3 % of GDP, compared to almost 5 % and 8 % of GDP in 2004 and 2003 respectively. On this basis, the Council abrogated its decision on the existence of an excessive deficit in Cyprus on 11 July 2006.

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Malta

On 5 July 2004 the Council decided that Malta had an excessive deficit. At the same time, the Council addressed a recommendation under Article 104(7) specifying that the excessive deficit had to be corrected by 2006. Malta was recommended to implement with vigour measures, particularly those of a structural nature, aimed at rationalising and reducing expenditure. The Council also recommended that the rise in the debt ratio is brought to a halt