[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 21.6.2006

SEC(2006) 786 final

COMMUNICATION FROM THE COMMISSION TO THE COUNCIL

Assessment of the action taken by Portugal in response to the Council Recommendation of 20 September 2005 with a view to bringing an end to the situation of excessive government deficit

1. The excessive deficit procedure for Portugal

Over the 1990s, Portugal was successful in improving its budgetary situation. Against a backdrop of buoyant economic growth as from the middle of the decade, the general government deficit was gradually reduced to below 3% of GDP and the government debt ratio was put onto a downward path approaching 50% of GDP towards the end of the 1990s.

From the year 2000, however, the Portuguese economic and fiscal situations started to deteriorate. The economic growth rate declined significantly reflecting adverse cyclical conditions as well as a more permanent structural weakness of the economy. Such slowdown was accompanied by a rapid structural deterioration of public finances and in 2001 the general government deficit exceeded 4% of GDP. On 5 November 2002, the Council decided that an excessive deficit existed[1] and, pursuant to Article 104(7) of the Treaty, addressed a recommendation to Portugal with a view to bringing that situation to an end by 2003 at the latest[2]. In the following year, fiscal policy tightened and the general government deficit was reduced to marginally below 3% of GDP, albeit with recourse to sizeable one-off operations. In May 2004, the Council considered that Portugal had complied with its recommendation and decided to abrogate its decision of November 2002, thereby closing the excessive deficit procedure[3]. When deciding to abrogate the 2002 decision, the Council took into consideration the commitment by the Portuguese authorities to implement the necessary measures to keep the deficit below the reference value in 2004 and beyond.

Despite these consolidation efforts, public finances remained extremely fragile and plans for keeping the deficit below 3% of GDP reference value kept relying on large one-off measures.

In June 2005 – after the general elections of spring 2005 and subsequent change in government – Portugal submitted an update of its stability programme, which announced a change in fiscal strategy and revealed the plans to bring the general government deficit below 3% of GDP in 2008. The deficit would remain in excess of 3% of GDP for the years from 2005 to 2007, largely due to a discontinuation of reliance on one-off measures and a reassessment of government expenditure growth. Over that period, the government debt was projected to be in excess of 60% of GDP and to continue increasing until 2007. The Council, upon the corresponding Commission recommendation, placed Portugal in excessive deficit on 20 September 2005[4] and, in accordance with Article 104(7) of the Treaty, addressed a recommendation to Portugal with a view to bringing the deficit below 3% of GDP in a credible and sustainable manner by 2008 at the latest, by taking action in a medium-term framework[5].

The Council established a deadline of 19 March 2006 for Portugal to take effective action to reduce the general government deficit. Specifically, the Council requested Portugal to: " limit the deterioration of the fiscal position in 2005, by ensuring a rigorous implementation of the announced corrective measures "; to " thoroughly implement the necessary measures to ensure a sustained and marked correction of the cyclically-adjusted deficit, excluding one-off and other temporary measures, by taking a very substantial step of a reduction of 1.5% of GDP in 2006 from 2005, followed by a further significant decrease of, at least, ¾% of GDP in each of the two subsequent years " and to " rapidly implement reforms to contain and reduce expenditure over the coming years; seize any opportunity to accelerate the reduction of the budget deficit, and stand ready to adopt the additional measures which may be necessary to achieve the correction of the excessive deficit by 2008 " . At the same time, Portugal was invited to " consider more ambitious corrective measures, if it appears necessary to ensure the fulfilment of the targets defined for the correction of the excessive deficit ". In addition, the Portuguese authorities were requested to " ensure that the government gross debt ratio is brought onto a firm downward path and approaches the reference value at a satisfactory pace by ensuring that debt developments reflect progress in the reduction of the deficit, by avoiding debt-increasing financial transactions, and by considering carefully the possible impact on debt of major public investment projects, including those in partnership with the private sector. " The Council also invited the Portuguese authorities to " further improve the collection and processing of general government data ". Finally, the Portuguese authorities were urged to " ensure that budgetary consolidation towards the medium term position of government finances close to balance or in surplus is sustained through a reduction in the cyclically-adjusted deficit, net of one-offs and other temporary measures, by at least 0.5% of GDP per year after the excessive deficit has been corrected. "

In accordance with Article 9(3) of Council Regulation 1467/97, as amended by Council Regulation 1056/2005[6], which states that, following the expiry of the deadline for a Member State to take measures following a 104(7) recommendation, "… the Commission shall inform the Council if it considers that the measures taken seem sufficient to ensure adequate progress towards the correction of the excessive deficit within the time limits set by the Council, provided that they are fully implemented and that economic developments are in line with forecasts ", this communication assesses the action taken by Portugal in response to the Council recommendation.

2. Action taken by Portugal in response to the Council recommendation

2.1 Government budget balance and expenditure reform

Budget balance in 2005

The 2005 budget law adopted in December 2004 targeted a general government deficit of 2.8% of GDP in 2005, based on real GDP growth projected at 2.4%. To achieve the target, the 2005 budget envisaged, inter alia, the implementation of one-off measures worth 1.4% of GDP. After the general elections of spring 2005 and the subsequent change in government, this target was revised to 6.2% of GDP, as revealed in the June 2005 update of the Portuguese stability programme and confirmed in a supplementary budget adopted by parliament in July 2005. The scale of the revision was due to reassessment of government expenditure growth and the adoption of a new fiscal strategy, one pillar of which was the non-recourse to sizeable one-off measures. The revised deficit target already reflected a corrective package worth some 0.6% of GDP adopted in mid-2005, the most sizeable measures of which were an increase in the standard VAT rate from 19 to 21% and a freeze on automatic promotions for government staff. The December 2005 stability programme update targeted a government deficit of 6.0% of GDP[7].

Budget balance in 2006

The 2006 budget law was approved by the Portuguese parliament on 30 November 2005 with a target for the general government deficit of 4.6% of GDP. The budget builds upon the fiscal strategy outlined in the June 2005 update of the stability programme and the achievement of the deficit target relies on a large number of corrective measures on both the expenditure and the revenue side. In terms of fiscal effort, the 2006 budget projects a reduction in the government structural balance (that is, the cyclically-adjusted balance, excluding one-off and other temporary measures) by 1.6% of GDP.

In 2006, most of the targeted fiscal consolidation comes from additional tax proceeds. The tax-to-GDP ratio is projected to increase by some 1 percentage point compared with the 2005 outturn. These additional proceeds come from the increase in VAT enacted in July 2005 and increases in taxes on petroleum and tobacco products. The 2006 budget law also created an additional personal income tax bracket with a higher marginal tax rate for annual incomes over €60 000, while tax deductions for pensioners were lowered. Curbs on tax benefits – some of which were implemented by the 2005 budget – and improved revenue collection are also expected to bolster revenues. The minimum tax base for social contributions by the self-employed was also increased in 2005 from 1 to 1.5 times the minimum wage.

On the expenditure side, the budget law aims to stabilise current expenditure in real terms, with the containment spread across the different areas and sub-sectors of the general government. Examples of important measures enacted by the budget law are a freeze on nominal transfers from central to regional and local governments, which also cannot increase their indebtedness from the end-2005 levels, and the obligation for local governments to hold personnel expenditure constant at its 2005 nominal level. At the same time, stricter hiring rules have been enacted, namely only partial replacement (on average only 50%) of workers leaving the civil service in central government[8], and an obligation to seek the Finance Minister’s approval for the hiring of government employees. At the same time, the temporary freeze on automatic promotions enacted in mid-2005 has been extended. In all, according to the budget, the primary-expenditure-to-GDP ratio is cut by 0.5 percentage points relative to the 2005 outturn. With a view to overseeing budgetary execution in such a way as to prevent deviations from the targets, financial controllers have been installed in each Ministry since last February and the 2006 budget includes expenditure-reporting mechanisms for sub-sectors of the general government, non-compliance with which can be penalised.

In addition to the corrective measures enacted by the 2006 budget law itself, structural measures aiming to contain and reduce expenditure more permanently, and which thus have a deficit-reducing impact in subsequent years and support fiscal consolidation over the medium term, have been launched since mid-2005 (see Table 1), some of them before the Council recommendation of September 2005 under Article 104(7) of the Treaty. Most notably, changes to old-age pension schemes have been introduced: the phasing-out of the civil servant's old-age pension scheme and its integration into the (less generous) general pension scheme has been accelerated by stepwise increases, from 2006 until 2015, in the statutory retirement age and eligibility periods, as well as a change to the benefit formula; in addition, the retirement rules for some categories of government employees have been tightened, in particular by tightening pension eligibility for shorter working careers; and finally, in the general pension scheme, conditions for early retirement have been made less favourable. Expenditure-reducing measures in the area of health care have also been introduced. In particular, reimbursement rates for medicines were lowered in August 2005; rules of specific health assistance schemes for some groups of government employees have been tightened; a revision of agreements for the purchase of services by the National Health Service from private suppliers has been launched; and in late 2005, more government hospitals were transformed into government-owned corporations, with a heightened degree of entrepreneurial autonomy. A reorganisation of health services is also under way, with a number of services being closed.

With a view to assessing the compatibility of major public investment projects with fiscal consolidation objectives, a framework for inter-ministerial monitoring of financial implications of investments projects that exceed a threshold of € 250 million (about 0.2% of GDP) was adopted in 2005.

Table 1: Budgetary impact of the main policy changes

according to the December 2005 stability programme

Cumulative values, % of GDP, 2005 prices | 2005 | 2006 | 2007 | 2008 | 2009 |

Measures to increase revenue |

Income and wealth tax | 0.1 | 0.4 | 0.5 | 0.6 | 0.6 |

VAT | 0.4 | 0.8 | 0.8 | 0.8 | 0.8 |

Tax on petroleum products | - | 0.1 | 0.3 | 0.4 | 0.4 |

Excises on tobacco | - | 0.1 | 0.2 | 0.3 | 0.4 |

Social contributions | 0.1 | 0.2 | 0.3 | 0.3 | 0.3 |

Total revenue | 0.6 | 1.6 | 2.1 | 2.3 | 2.4 |

Measures to decrease expenditure |

Public administration reform (including personnel) | 0.1 | 0.3 | 0.7 | 1.1 | 1.4 |

Social security and Health |

Private sector workers | - | 0.1 | 0.2 | 0.2 | 0.2 |

Government employees | - | 0.2 | 0.3 | 0.5 | 0.6 |

Payment of medicines | - | 0.1 | 0.1 | 0.1 | 0.1 |

Total expenditure | 0.1 | 0.6 | 1.3 | 1.8 | 2.3 |

Total impact on general government balance | 0.6 | 2.3 | 3.3 | 4.1 | 4.7 |

Note: values may not add up due to rounding Source: December 2005 stability programme (SP); Commission services calculations |

Budget balance in 2007 and beyond

According to the December 2005 update of its stability programme, Portugal is aiming for a general government deficit of 3.7% of GDP for 2007 and to reduce the deficit below 3% of GDP by 2008. It also envisages pursuing fiscal consolidation in subsequent years towards a medium-term objective (MTO) for the budgetary position of a balanced budget in structural terms, as specified in the Stability and Growth Pact.

For the years 2007-2009, fiscal consolidation is to rely increasingly on primary expenditure restraint, along with a gradually declining, but still positive, contribution from tax revenues (see Table 1). The latter will be achieved through further annual increases in taxes on oil and tobacco products. The expenditure containment over these years will come from the corrective measures in the health and pensions schemes described above. Furthermore, savings are to be realised in the area of public administration, as the combined result of a central administration reform, the introduction of new career and wage scales as from January 2007, and an increase in the intra-government reassignment of staff according to need with a view to improving human resource management. According to the Portuguese authorities' announcements, these measures will be adopted in the course of 2006 and implemented soon thereafter.[9]

2.2 Government debt

The government debt amounted to 63.9% of GDP at the end of 2005, and the December 2005 update of the Portuguese stability programme envisages that the debt-to-GDP ratio will further increase in 2006 and 2007. Overall, this indicates a continuation of the upward trend which has been observed since 2001 and has been rooted in high primary deficits, low nominal GDP growth and sizeable debt-increasing stock-flow adjustments. The debt ratio is projected to peak at slightly over 69% of GDP in 2007 and to decline thereafter, driven by the return to primary budgetary surpluses, the acceleration of nominal GDP growth and the end of debt-increasing stock-flow adjustments. The latter will be helped notably by privatisation proceeds amounting to 1.1% of GDP in 2006 and some ½% of GDP in both 2007 and 2008. The impact of debt-increasing financial transactions (excluding privatisation proceeds) was 1.2% of GDP in 2005 and, according to the December 2005 update of the Portuguese stability programme, in 2006 is planned to be about ½% of GDP and to further decline to some ¼% of GDP in 2007-2008, presumably in connection with a reduction of capital injection in government-owned companies. In addition, the impact on debt of the difference between the cash- and accrual-based deficits is expected to go down from around 1% of GDP in 2006 (after 0.7% of GDP in 2005) to less than ¼% of GDP in 2007-2009.

2.3 Collection and processing of government data

Portugal has recently taken measures concerning the collection and processing of general government data. A protocol was signed in January 2006 between the national statistical institute (INE), the Ministry of Finance and the Banco de Portugal with a view to clarifying the responsibilities of the different institutions in compiling public finance statistics and stepping up cooperation between them. As a way to support collection of government data, the 2006 budget foresees penalties for delays in data reporting on expenditure for sub-sectors of the general government and the human resources database of the public administration. At the same time, the financial controllers that are being installed in each ministry are responsible for consolidating information and improving the quality of financial information and accounting transparency.

3. ASSESSMENT OF THE ACTION TAKEN BY PORTUGAL IN RESPONSE TO THE COUNCIL RECOMMENDATION

The assessment of compliance of the above measures with the Council recommendation under Article 104(7) is carried out on the basis of the Commission services' spring 2006 economic forecast, the 2006 budget law and the December 2005 update of the Portuguese stability programme.

Following real GDP growth of 0.3% in 2005, the macroeconomic scenario underlying the update of the stability programme projects GDP growth to increase to 1.1% in 2006, 1.8% in 2007, 2.4% in 2008 and eventually 3% in 2009. This scenario is more cautious than the one underlying the September 2005 Council recommendation in accordance with Article 104(7). In the light of a further weakening of economic prospects, the Commission services' spring 2006 forecast projects GDP growth rates of 0.9% for 2006 and 1.1% for 2007.

3.1 Government budget balance and expenditure reform

Budget balance in 2005

The Council recommendation under Article 104(7) required a limitation of the deterioration of the fiscal position in 2005 by ensuring a rigorous implementation of the announced corrective measures. And indeed on 1 April, the Portuguese authorities reported a general government deficit of 6.0% of GDP for 2005 – less than the deficit target of 6.2% of GDP pledged in the June 2005 update of the Portuguese stability programme, which was implicitly retained for the Council recommendation under Article 104(7), and in line with the target of 6.0% of GDP presented in the December 2005 update of the stability programme[10]. The deficit target was met in spite of the higher-than-projected expenditure level since it was fully compensated by higher revenues[11].

Budget balance in 2006

A full implementation of the 2006 budget would be consistent with the 1.5% of GDP improvement in the structural government balance (i.e., the change in the cyclically-adjusted balance, excluding one-off and other temporary measures) required by the Council for 2006, assuming that real GDP growth unfolds broadly in line with plans.

Based on a cautious assessment of those measures that were announced in the 2006 budget and in the December 2005 stability programme update with a sufficient degree of detail for them to be properly assessed, the Commission services’ spring 2006 economic forecast projected a deficit of 5% of GDP for 2006, higher than the official target of 4.6% of GDP. According to the Commission’s calculations, the structural deficit correction between 2005 and 2006 implied by the Commission services’ spring 2006 economic forecast, at slightly over 1% of GDP, would still fall short of the minimum recommended by the Council.

The difference between the Commission forecast and the official target reflects a number of uncertainties regarding the 2006 budgetary outturn in relation both to the various measures aiming at expenditure containment and the effectiveness of mechanisms to enforce expenditure control is not yet tested[12]. It is true that preliminary data on budgetary execution on a cash basis for the early part of 2006 suggest that, overall, the budgetary plans have been broadly observed during the first few months of 2006, in particular for the State sub-sector. However, uncertainties persist, particularly as to whether it will be possible to achieve all the planned containment of expenditure, notably as regards expenditure on social transfers other than in kind, whose 2005 outturn was above the forecast underlying the 2006 budget plans[13], as well as health and regional and local government expenditure. Moreover, other measures aiming at expenditure restraint may take longer than expected to become effective. Expenditure slippages in the areas mentioned above, possibly coupled with some other minor slippages, could lead to a deficit closer to 5% of GDP than to the 4.6%-of-GDP official target. At the same time, on the revenue side, while some downward risks to economic activity might materialise, it is possible that the improvement in tax collection observed in 2004 and 2005 may carry through into the current year. Preliminary data suggest this may indeed be the case, for instance, for social contributions.

Table 2: Budget balances and debt

In % of GDP | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 |

Budget balance in 2007 and beyond

Assuming that all the plans outlined in the December 2005 update of the Portuguese stability programme materialise, the achievement of the 2007 deficit target at 3.7% of GDP would imply a reduction of the cyclically-adjusted deficit, net of one-off and temporary measures, by some ¾% of GDP (see Table 2). With further fiscal efforts of some ¾% of GDP, a deficit below 3% of GDP would be achieved in 2008, which would be in line with the Council recommendation. Beyond 2008, the pace of the adjustment towards the MTO implied by the programme is in line with the minimum annual improvement in the structural balance of 0.5% of GDP requested by the Council, though the MTO will not be achieved by 2009.

Under the customary no-policy-change assumption, the Commission services' spring 2006 economic forecast projects the general government deficit at 4.9% of GDP in 2007, based upon a growth rate for GDP of 1.1%. This would suggest that fiscal consolidation will nearly come to a standstill due to the unabated upward pressure on expenditure. However, this outlook factors in the possibility of (i) economic growth being weaker than anticipated, and, (ii) the fact that although a number of additional measures to control expenditure have been announced, in particular in the area of public administration, they still await legislation in the further course of the current year[14]. For instance, according to the December 2005 stability programme update, changes in government organisation should yield savings of some ½% of GDP in 2007 compared with 2006[15]. In all, attainment of the deficit targets hinges upon a full implementation of the measures outlined in the stability programme, which will have to be appropriately reinforced or complemented by additional measures if any shortfalls occur.

3.2 Government debt

The planned reduction in the debt-to-GDP ratio after 2007, if achieved, would also be consistent with the Council recommendations in the sense that debt developments are expected to reflect progress in reducing the deficit and a decrease in debt-increasing financial operations. According to the Commission services spring 2006 economic forecast, the government debt ratio is projected at 68.4% of GDP in 2006 and 70.6% of GDP in 2007. There are significant uncertainties concerning the debt reduction path as it is conditional on the achievement of the ambitious deficit reduction targets, the realisation of large privatisation plans and the effective scaling back of debt-increasing financial operations – notably capital injections into government-owned non-financial corporations – which would represent a break with the recent past. Downward risks to the profile of GDP growth heighten the uncertainty.

3.3 Collection and processing of government data

The quality of general government data has improved. In particular, the availability of infra-annual accounts, on a cash basis, for the different sub-sectors of the general government has increased in scope. On 24 April 2006, following the 1 April reporting of government deficit and debt levels, Eurostat withdrew its reservations vis-à-vis the Portuguese data[16]. Nevertheless, the revisions of government deficit figures since mid-2005 – partly related to the efforts to improve the quality of statistics – have been relatively large[17]; moreover, the nature of those revisions, still point to deficiencies in the collection of data on expenditure pending payment.

4. CONCLUSIONS

On current information, it appears that Portugal has taken action representing adequate progress towards the correction of the excessive deficit within the time limits set by the Council. In particular, Portugal:

- has achieved a general government deficit outturn in 2005 in line with plans;

- has adopted a comprehensive package of corrective measures since mid-2005, including in the 2006 budget law, which, if fully implemented and effective, would achieve a reduction in 2006 of the cyclically-adjusted deficit, excluding one-off and other temporary measures, that is in line with the Council recommendation;

- has set a nominal government deficit target of below 3% for 2008 and plans to gradually decrease the cyclically-adjusted deficit for the years 2007-2008, excluding one-off and other temporary measures, in line with the Council recommendation;

- has implemented or initiated a number of measures of a permanent nature aiming to contain and reduce expenditure, and has kept the announced fiscal targets despite a more cautious re-assessment of GDP growth prospects;

- plans to bring the government gross debt ratio onto a declining path as from 2008 by means of the envisaged return to primary surpluses, the inflow of large proceeds from privatisation and the scaling back of debt-increasing financial operations;

- has improved the quality of general government data.

However, the correction of the excessive deficit by the 2008 deadline and the reduction in the debt ratio are subject to significant risks and uncertainties. Particularly, as highlighted by the Commission services' spring 2006 forecast, the containment of expenditure in 2006 and the achievement of the deficit targets for 2007 and beyond crucially rely upon a quick translation into legislation and an effective implementation of all the announced corrective measures. If measures are not fully implemented or prove ineffective, or the downward risks to the projected economic scenario materialise, further corrective efforts would be needed in order to attain the fiscal targets, in line with the Council recommendation.

A strict implementation of the 2006 budget and a rigorous 2007 budget fully in compliance with the Council recommendation will be key to keep the correction of the excessive deficit on track.

In view of the above assessment, the Commission considers that no further steps in the excessive deficit procedure of Portugal are needed at present. The Commission will continue to closely monitor budgetary developments in Portugal in accordance with the Treaty and the SGP, in particular in the light of the fragile situation of public finances.

[1] OJ L 322, 27.11.2002, p. 30.

[2] http://register.consilium.eu.int/pdf/en/02/st13/13531-r2en2.pdf#page=2

[3] OJ L 47, 18.2.2005, p. 24.

[4] OJ L 274, 20.10.2005, p. 91.

[5] http://register.consilium.eu.int/pdf/en/05/st12/st12401.en05.pdf#page=2

[6] Respectively, OJ L 209 of 2.8.1997 and OJ L 174 of 7.7.2005.

[7] Compared with the June 2005 stability programme, the nominal general government balances were “mechanically” revised down by some ¼ percentage point of GDP entirely due to a significant upward revision of the GDP series, in the context of a benchmark revision of national accounts undertaken in many EU Member States, by about 4½% implemented in August 2005. The December 2005 targets were revised accordingly. A further revision in the GDP series in March 2006 resulted in an upward correction of its level by some 1½%. The latter revision arose due to a change in the accounting treatment of FISIM.

[8] On 3 May 2006, hiring at the central government level for the rest of the year was cut by half again.

[9] Additionally, last April, the Portuguese authorities submitted to parliament the principles for a reform of the general pension scheme. A detailed legislative proposal showing how the envisaged changes will be implemented is still pending.

[10] See footnote 7.

[11] The figure for total expenditure presented in the 2005 preliminary national accounts indicate that it overshot its level by some 2%, leading to a total-expenditure-to-GDP ratio of around ½ percentage point higher than the projections of the December 2005 update of the stability programme. However, part of that increase was due to a one-off contribution to the EU of some 0.15% of GDP following the upward revision of the Portuguese GNI series in August 2005.

[12] It should be noted also that the earmarking of part of VAT receipts to the civil servants’ pension scheme (CGA) as from July 2005 (1% out of a 21% standard tax rate) has led to the reduction in social contribution paid by the State to CGA. Without this earmarking, both the government expenditure and revenue ratios would be higher by almost 0.1% of GDP in 2005 and some 0.3% of GDP in 2006 (and thus would have no impact on the general government balance).

[13] In addition, apparent changes in retirement behaviour since the announcement of the changes to retirement rules, specifically an upsurge in retirement applications, compound the uncertainty.

[14] On the ground of the customary no-policy-change assumption, measures that have been outlined but not presented in sufficient detail for them to be properly assessed were not included in the Commission services forecast.

[15] The stability programme says nothing about what the expenditure growth pattern would be in a no-policy-change scenario.

[16] Eurostat News release N° 48/2006

[17] In the reporting of September 2005, the deficit figures for 2002 and 2004 were revised upwards by around 0.2% of GDP per year, to include expenditure arrears that had not been included in the previous reporting. In the reporting of April 2006, the 2004 deficit was further revised upward by some ¼% of GDP to 3.2% of GDP, largely on the basis of more complete information from local government and the reclassification of loans as capital expenditure. The impact on the deficit-to-GDP ratios of these revisions was actually slightly smaller than indicated, given the upward revision in the GDP series in the deficit figures (see footnote 7).