SEC(2005) 723

COMMISSION STAFF WORKING DOCUMENT

PUBLIC FINANCES IN EMU2005(The complete and definitiveversion will be published asEuropean Economy n° 3/2005){COM(2005) 231}

[pic]

EUROPEAN

COMMISSION

DIRECTORATE-GENERAL FOR

Economic and Financial affairs

DRAFT

23.05.2005

PUBLIC FINANCES IN EMU2005

(The complete and definitiveversion will be published asEuropean Economy n° 3/2005)

Contents

Part I: Current developments and prospects 17

1. Budgetary developments in the euro area and EU Member States 20

1.1 Short-term developments and prospects for the budget balance and public debt 20

1.2 Government revenue and expenditure 23

1.3 The fiscal stance and policy mix 25

1.3.1 The fiscal stance and policy mix in the euro area 25

1.3.2 The fiscal stance and policy mix at the national level 26

2. Implementing the Stability and Growth Pact 28

2.1 Introduction 28

2.2 The enforcement mechanisms of the Stability and Growth Pact 28

2.3 The surveillance mechanisms since Spring 2004 30

2.3.1 The surveillance mechanisms in the euro area countries 30

2.3.2 The surveillance mechanisms in the non euro area Member States 34

3. Overview of the 2004 updates of the stability and convergence programmes 38

3.1 The medium-term budgetary targets 38

3.1.1 Growth projections 38

3.1.2 Debt projections 45

4. The sustainability of public finances based on the 2004 updates of stability and convergence programmes 49

4.1 Introduction 49

4.2 The assessment of sustainability of public finances based on the 2004 updates 50

4.2.1 Quantitative indicators 50

4.2.2 Comparison with last year’s results 56

4.2.3 Qualitative considerations 56

4.3 Policy conclusions per Member State 58

4.4 Conclusions 59

Part II: Evolving budgetary surveillance 65

1. The debate on the EU fiscal framework 69

1.1 Introduction 69

1.2 The architecture of the existing EU fiscal framework 70

1.3 Improving the implementation of the SGP – the 2005 reform package 71

1.3.1 Changes in the preventive arm 72

1.3.2 Changes in the corrective arm 76

1.3.3 Improving governance 78

1.4 An assessment of the 2005 SGP Reform according to criteria for an optimal fiscal policy rule 81

1.5 The road to the 2005 SGP reform 84

1.5.1 Early stages of the reform debate 84

1.5.2 The launch of the review 85

1.5.3 The 2005 Council agreement on the reform of the SGP and follow-up 86

2. Developments in EU budgetary surveillance 87

2.1 The stability and convergence programmes: a retrospective overview of plans, outcomes and assessments 1998-2005 87

2.1.1 Introduction 87

2.1.2 The stability and convergence programmes: plans and outcomes 87

2.1.3 Evolving budgetary surveillance: the Commission assessment of stability and convergence programmes 90

2.1.4 Conclusions 92

2.2 The dynamics of government debt: decomposing the stock-flow adjustment 94

2.2.1 Introduction 94

2.2.2 SFAs: main data and concerns 94

2.2.3 The main components of the SFA 94

2.2.4 Cash vs. accruals: the time of recording of transactions in the deficit and the debt 95

2.2.5 Net vs. gross: accounting for financial assets in the deficit and the debt 97

2.2.6 Valuation effects and residual adjustments 98

2.2.7 Conclusions 100

2.3 The role of budgetary institutions in shaping budgetary outcomes 101

2.3.1 Introduction 101

2.3.2 Conceptual framework 101

2.3.3 Empirical evidence 102

2.3.4 Explaining budgetary slippages: the role of optimistic forecasts and creative accounting 103

2.3.5 Performance of EU Member States under the SGP: commitment versus delegation as the key variable? 104

2.3.6 Expenditure rules and expenditure outcomes 105

2.3.7 Explaining budgetary outcomes: the role of macroeconomic forecasts 107

2.3.8 Conclusion 110

3. Sustainability analysis in EU multilateral surveillance: what has been done, what should be done? 111

3.1 Introduction 111

3.2 The current assessment of sustainability of public finances in the stability and convergence programmes 112

3.2.1 The cooperation with EU Member States 113

3.2.2 The annual assessment 113

3.2.3 The input data 113

3.2.4 Debt projections 115

3.3 An EU wide perspective of long-term sustainability of public finances 121

3.4 Are the results stable? 125

3.5 Possible avenues for improving the assessment of long-term public finance sustainability 127

3.5.1 Comparable budgetary projections 127

3.5.2 A comprehensive assessment of possible risks to sustainability 128

3.5.3 Assessing the impact of structural reforms 128

3.5.4 Sustainability considerations in the definition of budgetary medium-term objectives 129

3.6 Conclusions 129

Part III: Structural reforms and budgetary objectives 131

1. Introduction 134

2. Is there a trade-off between structural reforms and budgetary objectives? 135

2.1 Defining reforms 135

2.2 Why is there resistance to structural reforms? 136

2.3 The long-term effects of economic reforms on public finances 138

2.4 Economic reforms and government balances in the short run: is there a trade-off? 141

3. The short-term link between structural reforms and public budgets: a close look at the EU data 145

3.1 Introduction 145

3.2 The measurement of structural reforms 145

3.3 Do reforms worsen government budgets in the short run? 147

3.3.1 Labour and product market reforms 147

3.3.2 Pension reforms 148

3.3.3 Do fiscal consolidations hamper the adoption of reforms? 152

3.4 Summary of findings 155

Part IV: Fiscal challenges during convergence in the Recently Acceded Member States 159

1. Introduction 162

2. Macroeconomic and financial background 163

2.1 Key macroeconomic developments 163

2.2 Macroeconomic volatility: recent experience 164

2.3 Main financial sector characteristics 166

3. Recent developments in the public finances 168

3.1 Fiscal deficits and public debt 168

3.2 Composition of public revenues and expenditures 169

3.3 Volatility in the public finances: recent experience 169

4. Financial challenges during convergence 172

4.1 Introduction 172

4.2 Credit booms and private sector imbalances 172

4.3 Potential sources of financial risk 173

4.4 Quantifying risks to public debt sustainability 176

4.4.1 Volatility and public finances 176

4.4.2 Contingent liabilities in the recently acceded Member States 180

5. Fiscal policies for stable convergence 182

5.1 Introduction 182

5.2 Tax and expenditure strategies consistent with stable convergence 182

5.3 Debt sustainability and ageing 185

5.4 Stabilizers and credit cycles 185

5.5 Interactions with other policies 188

5.6 Risks, safety margins and fiscal institutions 189

5.7 Fiscal challenges and country situations 190

Part V: Member States developments 193

1. Belgium 194

2. Czech Republic 198

3. Denmark 201

4. Germany 204

5. Estonia 208

6. Greece 211

7. Spain 213

8. France 217

9. Ireland 221

10. Italy 224

11. Cyprus 228

12. Latvia 230

13. Lithuania 234

14. Luxembourg 237

15. Hungary 241

16. Malta 243

17. Netherlands 246

18. Austria 250

19. Poland 253

20. Portugal 256

21. Slovenia 258

22. Slovakia 261

23. Finland 264

24. Sweden 267

25. United Kingdom 271

Part VI: Resources 275

1. Glossary 277

2. References 282

Index of Tables

Table I.1. General government budgetary position - Euro area, 2001-2006 (% of GDP) 21

Table I.2. Budget balances in EU Member States, 2003-2006 (% of GDP) 22

Table I.3. Composition of changes in government debt ratio in EU Member States, 2003-2006 (% of GDP) 23

Table I.4. Euro area government revenue and expenditure, 2002-2006 (% of GDP) 24

Table I.5. Total revenue and expenditure in EU Member States, 2003-2006 (% of GDP) 24

Table I.6. Main components of the revision in the Greek data (1997-2003) (% of GDP) 31

Table I.7. Overview of ongoing excessive deficit procedures 37

Table I.8. Euro area - Growth projections and macroeconomic developments in the 2004 updates (% change on preceding year), and comparison with the Commission forecasts and the 2003 updates (in percentage points) 39

Table I.9. Projections of real growth in the 2004 updates (% change on preceding year) 39

Table I.10. Nominal budget balances in the 2004 updates and the Commission services autumn 2004 and spring 2005 forecasts* 40

Table I.11. Cyclically-adjusted budget balances in the 2004 updates and the Commission services autumn 2004 forecasts on the basis of the production function method (in % of GDP) 41

Table I.12. Euro area: Net lending by sub-sectors in the 2004 updates 42

Table I.13. Revenue and expenditure ratios in the 2004 updates 43

Table I.14. Euro area – Budgetary developments within the general government 44

Table I.15. Euro area – Gross debt level and changes in the 2004 updates 45

Table I.16. Debt levels in the 2004 updates (as % of GDP)* 46

Table I.17. Council examinations of the updated SCPs 2004 47

Table I.18. Data used to run the sustainability indicators (in % of GDP) 50

Table I.19. Projected changes in the expenditure and revenues between the first year of projections and 2050 (in percentage points) 52

Table I.20. Projected evolution of debt levels up to 2050 (in % of GDP) 54

Table I.21. Results of the sustainability gap indicators 55

Table I.22. The 2004 projections compared to the 2003 projections (EU-15) 57

Table I.23. Policy conclusions on the sustainability of public finances 60

Table II.1. Main changes to the Stability and Growth Pact following the Council agreement of 20 March 2005 74

Table II.2. Trade-offs according to good fiscal policy rule criteria 83

Table II.3. Assessments of stability and convergence programmes: 2000 versus 2005 92

Table II.4. Expenditure plans and outcomes: 2000-2003 107

Table II.5. Characteristics of forecasting institutions in EU Member States. 109

Table II.6. The source of pension expenditure projections in the sustainability analysis 115

Table II.7. Change of government expenditure on pensions over the period 2005-2050 (change in % of GDP) 117

Table II.8. The evolution of the indicators in the Commission’s sustainability analysis 121

Table II.9. Qualitative factors taken on board by the Commission in reaching policy recommendations on the sustainability of public finances. 122

Table II.10: Assessment of the sustainability of public finances across the period 2001-2004. 124

Table II.11. Assessing sustainability according to the S2 indicator, 2004 assessment round 125

Table II.12. Projection of the debt level in 2050 in EU-15 across the long-term projection exercises on the basis of the programme scenario 126

Table II.13. Comparison of 2050 pension and health care expenditure according to 2002 and 2004 update of the Stability and Convergence programme 128

Table III.1. Source and coverage of data on structural reforms 146

Table III.2. Frequency of different types of reforms in different time periods (EU-14) 147

Table III.3. Average changes in budgetary variables during reform periods and periods where no reforms took place: labour and product market reforms (EU-14 except EL, 1976-1998) 147

Table III.4. Budget balances and labour and product market reforms: estimating fiscal rules (EU-14 except EL, 1976-1998) 148

Table III.5. Average changes in budgetary variables during reform periods and periods where no reforms took place: pension reforms (EU-14, 1986-2001) 149

Table III.6. Budgetary variables evolution during structural pension reforms, EU-15, 1986-1999, (% GDP) 150

Table III.7. Budget balances and pension reforms: results from the estimation of fiscal rules (EU-14, 1986-2001) 151

Table III.8. General government budget and funded DC pension scheme balance, Sweden (% of GDP) 152

Table III.9. Public budgets and the probability of reforms: probit regressions 154

Table IV.1: Selected macroeconomic indicators 164

Table IV.2: Selected external indicators 165

Table IV.3: Financial intermediation 166

Table IV.4: Selected fiscal indicators 168

Table IV.5: Government debt composition (2003) 169

Table IV.6: Volatility in fiscal variables (1997-2004) 171

Table IV.7: Macroeconomic and public finance performance and volatility in the recently acceded Member States 177

Table IV.8. Contigent liabilities in the RAMS 181

Table IV.9. Average budgetary elasticities and sensitivities in the EU10 and EU15 – Preliminary estimates based on OECD methodology as described in van den Noord (2000) 188

Table V.1. Budgetary developments 2002-2007, Belgium (% of GDP) 194

Table V.2. Main measures in the budget for 2005, Belgium 195

Table V.3. Financing sources of the ageing fund until 2004 (in million EUR) 196

Table V.4. Budgetary developments 2003-2006, Czech Republic (% of GDP) 198

Table V.5. Main measures in the budget for 2005, Czech Republic 199

Table V.6. Budgetary developments 2003-2010, Denmark (% of GDP) 201

Table V.7. Main measures in the budget for 2005, Denmark 202

Table V.8. Budgetary developments 2003-2008, Germany (% of GDP) 204

Table V.9. Main measures in the budget for 2005, Germany 205

Table V.10. Budgetary developments 2003-2008, Estonia (% of GDP) 208

Table V.11. Main measures in the budget for 2005, Estonia 209

Table V.12. Budgetary developments 2003-2007, Greece (% of GDP) 211

Table V.13. Main measures in the budget for 2005, Greece 212

Table V.14. Budgetary developments 2003-2008, Spain (% of GDP 213

Table V.15. Main measures in the budget for 2005, Spain 214

Table V.16. Budgetary developments 2003-2008, France (% of GDP) 217

Table V.17. Main measures in the budget for 2005, France 218

Table V.18. Projected budgetary impact of ageing on public expenditures between 2009 and 2050 (as a % of GDP) 220

Table V.19. Budgetary developments 2003-2007, Ireland (% of GDP) 221

Table V.20. Main measures in the budget for 2005, Ireland 222

Table V.21. Budgetary developments 2003-2008, Italy (% of GDP) 224

Table V.22. Main measures in the budget for 2005, Italy 225

Table V.23. Budgetary developments 2003-2008, Cyprus (% of GDP) 228

Table V.24. Main measures in the budget for 2005, Cyprus 229

Table V.25. Budgetary developments 2003-2007, Latvia (% of GDP) 230

Table V.26. Main measures in the budget for 2005, Latvia 231

Table V.27. General Government expenditure by function Latvia 2003, EU-15 2002 232

Table V.28. General government expenditure by national account categories in 2003 Latvia and EU-15 233

Table V.29: Budgetary developments 2003-2007, Lithuania (% of GDP) 234

Table V.30. Main measures in the budget for 2005, Lithuania 235

Table V.31. Budgetary developments 2003-2007, Luxembourg (% of GDP) 237

Table V.32. Main measures in the budget for 2005, Luxembourg 238

Table V.33. Main categories of government expenditure 1990-2004, Luxembourg 240

Table V.34. Budgetary developments 2003-2008, Hungary (% of GDP) 241

Table V.35. Main measures in the budget for 2005, Hungary 242

Table V.36. Budgetary developments 2003-2007, Malta (% of GDP) 243

Table V.37. Main measures in the budget for 2005, Malta 244

Table V.38. Budgetary developments 2003-2007, Netherlands (% of GDP) 246

Table V.39. Main measures in the budget for 2005, the Netherlands 247

Table V.40. Deductions of mortgage interest and exemption of pension premia (% of GDP) 248

Table V.41. Budgetary developments 2003-2008, Austria (% of GDP) 250

Table V.42. Main measures in the budget for 2005, Austria 251

Table V.43. National Stability Pact 2001-2004, budgetary targets and results, % of GDP 252

Table V.44. Budgetary developments 2003-2007, Poland (% of GDP) 253

Table V.45. Main measures in the budget for 2005, Poland 254

Table V.46. Share of non-flexible (legally determined) expenditure in the general government budget 255

Table V.47. Budgetary developments 2003-2007, Portugal (% of GDP) 256

Table V.48. Main measures in the budget for 2005, Portugal 257

Table V.49. Budgetary developments 2003-2007, Slovenia (% of GDP) 258

Table V.50. Main measures in the budget for 2005, Slovenia 259

Table V.51. The general government deficit initial targets, revisions and the outcome 260

Table V.52. Budgetary developments 2003-2007, Slovakia (% of GDP) 261

Table V.53. Main measures in the budget for 2005, Slovakia 262

Table V.54. Budgetary developments 2003-2008, Finland (% of GDP) 264

Table V.55. Main measures in the budget for 2005, Finland 265

Table V.56. Budgetary developments 2003-2007, Sweden (% of GDP) 267

Table V.57. Main measures in the budget for 2005, Sweden 268

Table V.58. Local government finances 1997-2004, Sweden (% of GDP) 269

Table V.59. Budgetary developments 2003-2008/2009, United Kingdom (% of GDP) 271

Table V.60. Main measures in the budget for 2005, United Kingdom 272

Table V.61. Annual public service efficiency savings expected or achieved in the UK since July 2004 273

Index of Graphs

Graph I.1. Euro-area fiscal stance and cyclical conditions, 2000-2006 25

Graph I.2. Euro-area policy-mix, 2000-2004 25

Graph I.3. Fiscal stance and cyclical conditions in the EU-15 Member States, 2004 26

Graph I.4. Policy-mix in the euro-area Member States, 2004 27

Graph I.5. Fiscal stance and cyclical conditions in the EU-15 Member States, 2005 27

Graph I.6. Budgetary plans, forecasts and outcomes in Greece 32

Graph I.7. Budgetary plans, forecasts and outcomes in Germany 33

Graph I.8. Budgetary plans, forecasts and outcomes in France 33

Graph I.9. Budgetary plans, forecasts and outcomes in the Netherlands 34

Graph I.10. Budgetary plans, forecasts and outcomes in the Italy 34

Graph I.11. Budgetary plans, forecasts and outcomes in Hungary 35

Graph I.12. Nominal budget balances in the euro area: evolution in projections from the 2000 - 2004 updates of the stability programmes (% of GDP) 41

Graph I.13. The fiscal stance and cyclical conditions in the euro area, 2004-2007 42

Graph I.14. Contributions to change in budgetary position 2004-2007 (in percentage points) 44

Graph I.15. Debt to GDP ratio in the euro area: evolution in projections from the 2000 updates to the 2004 updates of the stability programmes (% of GDP) 46

Graph I.16. Debt development in EU 55

Graph II.1. Extended deadlines for the steps in the EDP 78

Graph II.2. General government budget balances. Projections from different programmes. Weighted averages EU-121 88

Graph II.3. Budget balance slippages. Various time horizons. Weighted averages EU-121 89

Graph II.4. Expenditure slippages. Projections from different programmes. Weighted averages EU-121 89

Graph II.5. Revenue slippages. Projections from different programmes. Weighted averages EU-121 89

Graph II.6. Growth rates forecasts from Stability and Convergence Programmes. Projections from different programmes. Weighted averages EU-121 90

Graph II.7. Budget balance slippages, uncorrected for growth surprises. Projections from different programmes. Weighted averages EU-121 90

Graph II.8. Budget balance slippages, corrected for growth surprises. Projections from different programmes. Weighted averages EU-121 90

Graph II.9. Stock-flow adjustment – 2000-2004 (in % of GDP) 95

Graph II.10. Time of recording: cash and accruals – average 2000-2004 (in % of GDP) 96

Graph II.11. Accumulation of financial assets – average 2004-2004 (in % of GDP) 98

Graph II.12. Valuation effect and residual adjustments – average 2000-2004 (in % of GDP) 99

Graph II.13. Centralisation of budget process and average deficits, 1981-1995 102

Graph II.14. Centralisation of budget process and average deficits in central and eastern European countries, 1994-1998 103

Graph II.15. Degree of optimism in growth forecasts and budget deficits (averages 1991-2002) 104

Graph II.16. Degree of optimism in budgetary projections and budget deficits (averages, 1991-2002) 104

Graph II.17. Incidence of one-off measures and creative accounting and budget balances (averages, 1993-2003) 104

Graph II.18. Expenditure developments: effects of expenditure rules? 106

Graph II.19. Maastricht gross debt and adjusted gross debt in 2004 119

Graph II.20. Old age dependency ratio against different waves of assessments 123

Graph II.21. Analysis of the source of the difference in long-term debt dynamic indicator 127

Graph II.22. Graphic illustration of the difference in the debt ratio in 2050 across waves of assessment 128

Graph III.1: Assessing the long-term effects of labour market reforms on debt: simulation with the Quest model 141

Graph III.2: Debt dynamics with and without pension reform: simulations with the QUEST ageing model 144

Graph III.3: Frequency of reforms during years of consolidations and years where primary cyclically-adjusted budget balances worsened 153

Graph III.4: Frequency of reforms before and after phase II of EMU 153

Graph IV.1: Real convergence 163

Graph IV.2: Unemployment and inflation 163

Graph IV.3: External current account and FDI 165

Graph IV.4: GDP growth and growth volatility 165

Graph IV.5: Openness and growth volatility 165

Graph IV.6: Basic characteristics of the RAMS' banking sector 167

Graph IV.7: Basic character-risitics of the RAMS' bond markets 167

Graph IV.8: Basic characterisitics of the RAMS' stock markets 167

Graph IV.9: Composition of general government revenues (as % of GDP) 170

Graph IV.10: Composition of general government expenditure (as % of GDP) 170

Graph IV.11: Expenditure and revenue dynamics in the RAMS and the euro area 170

Graph IV.12: Competitiveness and external balance 176

Graph IV.13: Cyclically-adjusted primary balance (% of GDP) 176

Graph IV.14: Private saving and net 176

Graph IV.15: Stress tests for the recently acceded Member States 179

Graph IV.16: Budgetary pressures in the RAMS arising from the population ageing 187

Graph V.1. General government total expenditure and government consumption as % of GDP 215

Graph V.2. Comparison between real GDP, domestic demand and government consumption growth 215

Graph V.3. Private and public consumption. Contribution to domestic demand growth at 1995 constant prices 216

Graph V.4. Ireland - outturn vs. target for discretionary spending and taxes 223

Graph V.5. Comparison of different definitions of deficit 227

Graph V.6. Total healthcare expenditure in 2001 as % of GDP 232

Graph V.7. General government expenditure and revenues 1990-2004 (as % of GDP) 239

Graph V.8. Sustainability 245

Graph V.9. Adequacy 245

Graph V.10. Budgetary effects of the pensions reform 263

Graph V.11. Budget and spending limits for the electoral period of 2003-2007, at the 2006 price level, € billion and as percentage of GDP. 266

Index of Boxes

Box I.1. The revision in the Greek deficit and debt (1) 31

Box II.1. Why fiscal rules? 71

Box II.2. Strengthening the governance of budgetary statistics 80

Box II.3. The European Court of Justice’s decision on the EDP for France and Germany of 13 July 2004 86

Box II.4. Sustainability analysis carried out by the IMF 114

Box III.1. Assessing ex-ante the long-term impact of reforms on public finances: methodological issues 140

Box III.2. Systemic pension reforms and the trade off between the short-term and the long-term impact on public finances: an illustration via simulations with the QUEST ageing model 143

Box III.3. The multi-pillar pension reform in Sweden: main characteristics, statistical classification issues and its impact on the government budget 151

Box III.4. Estimating the impact of fiscal consolidation on reforms 154

Box IV.1. Financial imbalances on the road to EMU: lessons from Portugal and Spain 175

Box IV.2. Determinants of the debt/GDP ratio 178

Box IV.3. The Stability and Growth Pact – 2005 reform package and its Consequences for RAMS 184

Box IV.4. Slovakia: fiscal reforms, strong growth, and a declining deficit 191

Abbreviations and symbols used

Member States

BE Belgium

CZ Czech republic

DK Denmark

DE Germany

EE Estonia

EL Greece

ES Spain

FR France

IE Ireland

IT Italy

CY Cyprus

LV Latvia

LT Lithuania

LU Luxembourg

HU Hungary

MT Malta

NL The Netherlands

AT Austria

PL Poland

PT Portugal

SI Slovenia

SK Slovak Republic

FI Finland

SE Sweden

UK United Kingdom

EUR-12 European Union Member States having adopted the single currency (BE, DE, EL, ES, FR, IE, IT, LU, NL, AU, PT, FI), i.e. countries participating in the economic and monetary union without a derogation

EU-25 European Union, 25 Member States

EU-15 European Union, 15 Member States before 1. May 2004 (EUR-12 plus DK, SE and UK)

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

SCP Stability and Convergence Programmes

PEP Pre-accession Economic Programmes

RAMS Recently Acceded Member State

Acknowledgements

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 for the Economy of the Euro Area and the Union.

The main contributors were Servaas Deroose, Per Eckefeldt, Reinhard Felke, Sven Langedijk, Fabrizio Melcarne, Laurent Moulin, Marko Mršnik, Andrea Montanino, Alessandro Turrini, Maxwell Watson, Peter Wierts and Ingvild Stromsheim Wold.

Specific contributions were provided by Sean Berrigan, Albero Cabrero Bravo, Pedro Cardoso, Nathalie Darnaut, Christine Gerstberger, Adam Jaworski, Filip Keereman, Martin Larch, Joao Nogueira Martins, Jiri Plecity, Peer Ritter, Werner Roeger, Sari Sontag Siegfried Steinlein, Massimo Suardi, and Jan in’t Veld.

The country chapters in Part V were prepared in the Directorate for the Economies of the Member States under the responsibility of Marco Buti. The contributors were Ronald Albers, Jean-Luc Annaert, Gerrit Bethuyne, Georg Busch, Alberto Cabrero Bravo, Juan Ramon Calaf Sole, Pedro Cardoso, Zdeněk Čech, Nikolaos Chryssanthou, Nathalie Darnaut, Luis Fau Sebastian, Jonas Fischer, Timo Hirvonen, Heinz Jansen, Barbara Kauffmann, Filip Keereman, Viktoria Kovacs, Martin Larch, Carlos Martinez Mongay, Jens Matthiessen, Marek Mora, Willem Noë, Lucio R. Pench, Mateja Peternelj, Lucia Piana, Hervé Piffeteau, Stéphanie Riso, Peer Ritter, José Luis Robledo Fraga, Richard Salt, John Sheehy, Monika Sherwood, Agnieszka Skuratowicz, Siegfried Steinlein, Charlotte Van Hooydonk, Kristine Vlagsma, Helga Vogelmann, Javier Yaniz Igal.

Alessandro Turrini coordinated and supervised the production of the report. Fabrizio Melcarne 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, Aliki Drossou and Dominique Prins.

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

Directorate-General for Economic and Financial Affairs

Public Finance Unit, with particular reference to the euro zone

European Commission

B-1049 Brussels

or by e-mail to Elena.Flores@cec.eu.int

Part I

Current developments and prospects

Summary

After having deteriorated for three consecutive years, the euro-area general government deficit improved marginally in 2004 to 2.7% of GDP, from 2.8% of GDP in 2003. The nominal deficit of the EU fell from 2.9% of GDP in 2003 to 2.6% of GDP in 2004. The larger improvement in the EU deficit is due to a significant reduction of deficits in a number of the recently acceded Member States (RAMS). According to the Spring 2005 forecasts of the Commission services, the euro area and EU deficits would remain roughly stable in 2005 and 2006, based on the assumption of unchanged policy. Past and projected developments in the EU and euro area deficits result from diverse budgetary performances across Member States. In 2004, only three euro-area countries and six EU countries had budget positions in balance or in surplus, both in nominal and cyclically-adjusted terms. In contrast, in four euro-area Member States (Germany, France, Greece, Italy) and seven non-euro-area countries (UK, Cyprus, Hungary, Malta, Poland, Czech Republic and Slovakia) deficits reached or breached the 3% of GDP reference value in 2004. The deficit is projected to be reduced to or below 3% of GDP in 2005 in France, albeit temporarily, and in the UK and in Cyprus. The deficit would be brought below 3% in 2006 in Germany and Malta. After having kept their deficit at or just below 3% of GDP in 2004, Portugal and Italy could breach the 3% of GDP ceiling significantly in 2005, on the basis of the current policies.

In cyclically-adjusted terms, the euro-area deficit remained unchanged in 2004, at 2.4% of GDP. Across the EU-15, the cyclically-adjusted deficit was particularly high in Germany, France, Greece, Italy and the UK. It deteriorated significantly in Greece, Spain and Luxemburg. According to the latest Commission forecasts, the cyclically-adjusted balance (CABs) in the euro-area and EU-15 should improve by ¼ percentage point of GDP in 2005 and remain constant in 2006, despite the projected improvement in the macroeconomic situation. Efforts to improve the underlying budget positions should be made as economic conditions recover in order to ensure sufficient room for the automatic stabilisers to operate when necessary.

One of the consequences of the lack of substantial adjustment in the underlying fiscal position is that the debt-to-GDP ratio continues increasing. After having stood at 70.8% in 2003 and 71.3% in 2004, the euro-area debt ratio is projected to reach 71.7% in 2005 and 71.9% in 2006. In the EU, the debt-to-GDP ratio would increase from 63.8% in 2004 to 64.2% in 2006. The debt ratio would remain particularly high in Belgium, Greece, and in Italy (106.3% of GDP). In the latter, the debt ratio would continue increasing over the projection period. The debt ratio is also projected to increase over the next two years from a relatively high level in Germany, France, Portugal and Malta.

Budgetary developments in 2004 triggered further actions by the Commission and the Council in the context of the implementation of the SGP. Since Summer 2004, ten EU countries are subject to the excessive deficit procedure: four euro-area Member States, and six RAMS. For the first time, the Council decided to issue a notice under Article 104(9), the last step before sanctions. This recommendation was addressed to Greece, which has to correct its excessive deficit in 2006. In December 2004, the Commission, and subsequently the Council, clarified their position regarding the excessive deficit procedure for Germany and France, after the events of November 2003 and the ruling of the Court of Justice of 13 July 2004. Considering that these two countries had taken measures that make plausible a correction of the excessive deficit in 2005, the Commission decided that no further actions were necessary in the context of the excessive deficit procedure. Finally, the Commission considered that the Netherlands had taken effective action to correct its excessive deficit. Concerning non euro-area Member States, the Council decided on 5 July 2004 that an excessive deficit existed in Hungary, Czech Republic, Cyprus, Malta, Poland and Slovakia and at the same time issued recommendations to each country for its correction. Except for Hungary, the Commission considered on 22 December 2004 that all countries had taken effective action in response to the Council recommendation, in particular to respect the 2005 deficits targets set in the May 2004 convergence programmes. Accordingly, the Commission concluded that no further steps were necessary for Czech Republic, Cyprus, Malta, Poland and Slovakia under the excessive deficit procedure. In March 2005, the Council addressed a new recommendation to Hungary.

In the context of budgetary surveillance, the Commission also assessed the 2004 updates of the stability and convergence programmes submitted by the 25 Member States and proposed Council opinions on these documents. For the euro-area countries, macroeconomic and budgetary projections included in the programmes are consistent with an annual improvement in the CAB of 0.3 to 0.4 percentage point over the coming years. This implies a tightening of the fiscal stance in the euro area compared to the current situation. A close-to-balance position in cyclically-adjusted terms would then almost be reached by 2008 (-0.7% of GDP). However, for several Member States, the projected budgetary adjustment would remain insufficient to ensure that a sufficient safety margin to prevent a breach of the 3% of GDP reference value would be reached over the time span covered by the programmes. In addition, the budgetary targets of some Member States are based on growth assumptions and government expenditure projections which appear to be overly optimistic. This is a source of concern since the implementation record of the programmes has, in several cases, been characterised by a repeated postponement of the achievement of the close-to-balance or in surplus objective. Concerning the medium-term plans of the RAMS, the expected budgetary development in the projection period indicates a substantial consolidation of public finances for all of them. By 2007, only the Czech Republic foresees the general government deficit still above the 3% of GDP reference value. Large deficit reductions are expected in countries with initially high deficits, such as Cyprus, Malta, Poland and Hungary. All the non-euro area Member States are expected to improve their CABs by the end of the programme period, except from Estonia and Sweden, where they are projected to be broadly unchanged at a sound level.

The increased focus on long-term sustainability in the EU has resulted in reforms in several countries, leading to some further improvement to cope with the budgetary impact of ageing populations. Several countries, including the larger ones, have implemented reforms with a view to strengthening sustainability; for example, Germany and Italy reformed their pension systems and France reformed its health-care system. The RAMS have been fully included in the analysis for the first time. The situation for these countries is generally positive; a majority have recently implemented major reforms of their pension systems and they generally have a relatively low debt-to-GDP ratio, which contribute to a more sustainable position over the long run.

However, the analysis also shows that the planned budgetary consolidation in the medium-term is a very important factor to achieve a more sustainable position for most Member States, as was the case in previous years. The results show that there are risks to long term sustainability in ten countries (Belgium, Czech Republic, Germany, Greece, France, Italy, Cyprus, Hungary, Malta and Slovenia). In seven other countries (Poland, Slovakia, Spain, Netherlands, the UK, Latvia, Lithuania) there could be some risks due to the projected medium-term budgetary developments, the budgetary impact of enacted reforms or, as is the case for Spain and Poland, due to the considerable uncertainties over the long-term age-related expenditure trends. Finally, seven countries (Ireland, Denmark, Finland, Austria, Luxembourg, Sweden and Estonia) at present appear to face only limited risks in view of the budgetary costs of an ageing society.

Budgetary developments in the euro area and EU Member States

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

In 2004, the budgetary position in the euro area improved slightly after having deteriorated for three consecutive years (see Table I.1). Compared to 2003, the nominal deficit fell by 0.1 percentage point and reached 2.7% of GDP. The aggregate nominal deficit of the entire EU also improved, by 0.3 percentage points and reached 2.6% of GDP in 2004 (see Table I.2).

The aggregate outcome for the euro area as a whole results from diverse budgetary performances across Member States. In the case of Germany, France, Greece, Italy, the Netherlands and Portugal the budgetary positions in 2004 remained weak with nominal deficits ranging from 2.5% of GDP in the Netherlands to 6.1% of GDP in Greece. Germany, France and Greece have remained in excessive deficit positions, while in the Netherlands, the deficit has been under the 3% of GDP reference value. In Italy and Portugal, the budgetary situation remained weak in 2004 as deficits reached respectively 3.0% and 2.9% of GDP. In 2004, the nominal deficit has also significantly deteriorated in Spain and Luxembourg. Outside the euro-area, a large majority of Member States improved their budgetary situation, apart from Estonia, Lithuania and Poland. Given the protracted period of low growth, only Belgium, Ireland and Finland had nominal budget positions in balance or in surplus in the euro area. Overall, the nominal budget balances in 2004 did not worsen (or did so only marginally) compared to the previous year in the case of Belgium, Germany, France, Ireland, Italy, the Netherlands, Austria, Portugal and Finland.

Certainly, the budgetary performance also differed across the Member States outside the euro area. Nominal budget balances in 2004 varied from a deficit of 5.2% of GDP in Malta to a surplus of 2.8% of GDP in Denmark. In the case of Cyprus, Hungary, Malta, Poland, Slovakia and the UK, the nominal deficit in 2003 was above the reference value of 3% of GDP, and only Denmark, Estonia and Sweden had a surplus budgetary position. Relative to 2003, the budget position remained roughly unchanged or improved in ten countries, while it deteriorated in Estonia, Lithuania and Poland. The improvement was particularly important in the Czech Republic and Malta.

Looking ahead to 2005 and 2006, the Commission Spring 2005 forecasts project that economic growth in the euro area as a whole will hover around 2%, decreasing to 1.6% in 2005 in order to rise to 2.1% in 2006. The nominal budget balance is expected to improve slightly, to 2.6% of GDP in 2005 and deteriorate again in 2006 (2.7% of GDP). In the light of the scarcely resilient economic situation coupled with difficulties in pursuing budgetary consolidation in some member states, the aggregate nominal deficit for the entire EU is foreseen to hold stable at 2.6% of GDP in 2005 and decline only slightly to 2.5% of GDP in 2006.

At the Member State level, the surplus budgetary positions in the case of Belgium and Ireland are expected to deteriorate into deficit positions in 2005. Under a no-policy-change assumption, the deficits in Belgium would continue to worsen in 2006, while in Ireland will hold stable. In contrast, Spain and Finland are expected to maintain their budgetary positions in balance or in surplus throughout the forecast period. Among the Member States outside the euro area, this is also the case of Denmark, Estonia and Sweden.

On the basis of current policies, the Commission forecast projects that the nominal deficits in Germany, Greece, Italy and Portugal will be exceeding the 3% of GDP reference value in 2005 and, except Germany, also in 2006, when France is expected to breach the reference value again. In Germany, the nominal deficit is projected to remain above 3% of GDP in 2005 and move slightly below the reference value in 2006. In Greece, the nominal deficit is expected to stay at higher levels than 3% of GDP in 2005 and slightly improve in 2006. The period of weak budgetary situation in France is being prolonged, since the nominal deficit is expected to remain around the 3% of GDP threshold also in 2005 and breach the reference value again in 2006. Although the excessive deficit procedure for Portugal was abrogated in 2004, the nominal deficit is foreseen to exceed 3% of GDP again in both 2005 and 2006. In Italy, although the nominal deficit is expected to hover around the reference value in 2004, it is projected beyond the threshold in 2005 and will deteriorate further in 2006.

The nominal deficit is projected to be high also in other Member States. In the UK, it is foreseen to remain well above 2% of GDP during the forecast period and in Austria, the nominal deficit would be around 2% of GDP. In the RAMS, the nominal deficit is expected to decline or remain unchanged in more than half of the countries. In the case of Latvia, a significant deterioration is projected for 2005, while the surplus in Estonia is expected to be reduced over the forecast period.

In cyclically-adjusted terms, relative to 2003, the deficit in the euro area remained unchanged in 2004, at 2.3% of GDP. According to the Commission Spring 2005 forecasts, the cyclically adjusted budget balance is projected to decrease in 2005 and deteriorate again slightly in 2006, reflecting the weak resilience of the budgetary consolidation process which has stalled in the recent couple of years. Among the euro-area countries with higher cyclically-adjusted deficits, deterioration over the entire projection period is expected in Italy. In Portugal, after a pronounced deterioration expected to occur in 2005, it is projected to slightly improve in 2006. Improvements over the whole period are foreseen in Germany, Greece, and the Netherlands, while in France the improvement will fade out in 2006, when the cyclically adjusted deficit is planned to be above 3% of GDP. Despite the expected improvement in Greece, the cyclically adjusted deficit is projected to remain above 5% of GDP over the whole period.

Table I.1. General government budgetary position - Euro area, 2001-2006 (% of GDP)

2001(1) | 2002(1) | 2003 | 2004 | 2005 | 2006 |

Total revenue (1) | 46.5 | 46.1 | 46.3 | 45.7 | 45.6 | 45.4 |

Note: differences are due to rounding.

(1) Including UMTS receipts. UMTS receipts as a % of GDP would be equal in 2001 to 0.2 for BE, 0.2 for DK, 0.5 for EL, 0.1 for FR, and 0 for the Euro area and the EU-15. In 2002 they would be equal to 0.2 for IE and 0 for the euro area and EU-15.

Source: Commission Spring 2005 forecasts .

Table I.2. Budget balances in EU Member States, 2003-2006 (% of GDP)

Budget balance | Cyclically-adjusted budget balance | Cyclically-adjusted primary balance |

Total revenue | 46.1 | 46.3 | 45.7 | 45.6 | 45.4 |

- Cyclically-adjusted | 46.0 | 46.7 | 46.1 | 46.1 | 45.8 |

Taxes on imports and production | 13.4 | 13.4 | 13.6 | 13.6 | 13.6 |

Current taxes on income and wealth | 12.2 | 11.8 | 11.7 | 11.6 | 11.5 |

Social contributions | 16.0 | 16.2 | 15.9 | 15.9 | 15.9 |

of which actual social contributions | 14.9 | 15.0 | 14.9 | 14.8 | 14.8 |

Other revenue | 4.6 | 4.9 | 4.5 | 4.5 | 4.3 |

Total expenditure | 48.6 | 49.1 | 48.5 | 48.2 | 48.0 |

- Cyclically-adjusted | 48.6 | 49.0 | 48.4 | 48.1 | 47.9 |

Collective consumption | 8.3 | 8.4 | 8.3 | 8.2 | 8.1 |

Social benefits in kind | 12.1 | 12.3 | 12.2 | 12.2 | 12.2 |

Social benefits other than in kind | 16.9 | 17.2 | 17.1 | 17.1 | 16.9 |

Interest | 3.7 | 3.5 | 3.3 | 3.3 | 3.3 |

Subsidies | 1.4 | 1.3 | 1.3 | 1.2 | 1.2 |

Gross fixed capital formation | 2.5 | 2.6 | 2.6 | 2.6 | 2.7 |

Other expenditures | 3.7 | 3.8 | 3.7 | 3.7 | 3.7 |

Note : Including UMTS receipts, see footnote to Table I.1.

Source : Commission Spring 2005 forecasts.

Table I.5. Total revenue and expenditure in EU Member States, 2003-2006 (% of GDP)

Revenue | Expenditure |

2003 | 2004 | 2005 | 2006 | 2003 | 2004 | 2005 | 2006 |

BE | 51.3 | 49.6 | 49.1 | 48.5 | 50.9 | 49.5 | 49.3 | 49.0 |

Note : Including UMTS receipts, see footnote to Table I.1.

Source: Commission Spring 2005 forecasts.

The fiscal stance and policy mix

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 ECB when setting the monetary policy. Analogously, the policy mix for the euro-area will have an impact on the national policy mix via the common interest rates.

Graph I.1 examines the fiscal stance (approximated by the changes in the cyclically-adjusted primary balance, CAPB) in relation to cyclical conditions (approximated by the size of 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. Thus, changes in the output gap would not imply movements in the CAPB. However, as long as a Member State has not yet reached the medium-term target of the SGP, a restrictive fiscal stance – that is a positive change in CAPB – would be needed.

According to the Commission Spring 2005 forecasts, the euro-area fiscal stance in 2004 was slightly on the side of counter-cyclical fiscal loosening, although still broadly neutral. Looking ahead to 2005 and 2006, the euro area fiscal stance is projected to remain broadly neutral. Lessons from the past show, however, that efforts to improve the underlying budget positions should be made as economic conditions improve, in order to ensure sufficient room for the automatic stabilisers to operate in the next downturn.

Graph I.2 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 a protracted slowdown in economic activity, the monetary stance tightened somewhat and became more neutral, after three consecutive years of loosening. Overall, in 2004, the euro-area fiscal stance could be still seen as neutral, coupled with a growth-supportive monetary stance, despite tightening respect to 2003, thus contributing to a recovery of economic activity and closing of the output gap. The policy mix in the early years of EMU has therefore been broadly appropriate to support growth enhancing economic condition and macroeconomic stability.

Graph I.1. Euro-area fiscal stance and cyclical conditions, 2000-2006

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Source : Commission Spring 2005 forecasts.

Graph I.2. Euro-area policy-mix, 2000-2004

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Source : Commission Spring 2005 forecasts.

The fiscal stance and policy mix at the national level

The aggregate fiscal stance for the euro-area results from a variety of diverse fiscal stances across Member States, despite fairly similar cyclical developments. Graph I.3 shows that most EU-15 countries recorded a negative output gap in 2004, with the exception of Greece.

In 2004, several EU countries ran moderately broadly neutral fiscal policies in a context of negative output gaps. Policies were, however, clearly countercyclical in the case of Luxemburg, Spain and Belgium. It is worth mentioning that the nominal budget balances in these countries markedly worsened in the course of 2004. Finland, which was benefiting from past consolidation efforts and therefore had a large safety margin, was also somewhat easing the fiscal stance.

The Netherlands ran pro-cyclical policy in 2004, reflecting consolidation efforts in order to keep the nominal deficits below the 3% of GDP reference value. At the same time Denmark and Ireland tightened their fiscal stance, while in the latter the output gap deteriorated quickly. Greece stands out for loosening the fiscal stance in spite of a large positive output gap.

As pointed out above, the overall policy-mix in the euro-area has been still accommodative in 2004 with most Member States experiencing a broadly neutral fiscal stance despite increasing real interest rates (see Graph I.4). The real interest rates raised in half of the euro-area MS, in particular in Ireland, the Netherlands and Portugal.

While Graph I.4 refers to the changes in the real short-term interest rates, their level is equally important when assessing the policy-mix. After the reductions in the nominal interest rate decided by the ECB in the course of 2003, the real interest rate for the euro area (i.e. the short-term interest rate corrected by private consumption inflation) amounted to 0.2% in 2004. However, this aggregate figure for the euro-area conceals significant differences across Member States due to disparities in inflation rates across countries. The highest real interest rates were in Finland and the Netherlands (1.2% and 0.2%, respectively), whereas in a number of countries (Belgium, Greece, Spain, Ireland, Luxembourg and Portugal) the real interest rates were negative.

Regarding 2005, the overall fiscal stance of the euro area is expected to be broadly neutral (see Graph I.5), although some pro-cyclical fiscal tightening is expected, particularly in France, Germany and the Netherlands. Greece is projected to considerably tighten its fiscal stance, even though the output gap is expected to be positive. Portugal, Ireland and Austria, on the other hand, are, however, projected to loosen their fiscal stance.

Graph I.3. Fiscal stance and cyclical conditions in the EU-15 Member States, 2004

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Source: Commission Spring 2005 forecasts .

Graph I.4. Policy-mix in the euro-area Member States, 2004

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Source : Commission Spring 2005 forecasts .

Graph I.5. Fiscal stance and cyclical conditions in the EU-15 Member States, 2005

[pic]

Source : Commission Spring 2005 forecasts .

Implementing the Stability and Growth Pact

Introduction

The fiscal framework of EMU aims at ensuring budgetary discipline through two main requirements. These are 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 of the SGP to achieve and maintain a budgetary position ‘close to balance or in surplus’ over the cycle. Compliance with the ‘close to balance or in surplus’ requirement 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 SGP consists of both preventive and dissuasive elements, both of which are backed up with enforcement procedures. Section 2 of this chapter makes a short description of these procedures, namely the excessive deficit procedure and the early warning mechanism. This section is entirely based on the provisions in force, and does not discuss the recent reform proposals agreed in the Council.

During 2004 and the early part of 2005, the deterioration in the budget positions has required the Commission and Council to apply the various enforcement mechanisms of the Stability and Growth Pact (SGP) against several Member States. Section 3 of this chapter reviews the implementation of these mechanisms since spring 2004 in the EU countries. It examines the developments concerning the Member States which have been subject to an excessive deficit procedure and other countries which have been the object of Council recommendations giving early warning.

The enforcement mechanisms of the Stability and Growth Pact

This section provides a description of the enforcement mechanisms at the disposal of the Commission and the Council to ensure budgetary discipline in the EU. It explains the different steps of the excessive deficit procedure, which are codified in Article 104 of the Treaty and Council Regulation 1467/97, and when these steps need to be activated. This description puts a particular emphasis on the consequences of euro-area membership on the procedure. In a second step, a short description of the mechanism of early warning is provided. This mechanism is codified in Article 99(4) of the Treaty and Articles 6(2) and 10(2) of Council Regulation 1466/97.

The excessive deficit procedure

Article 104 of the Treaty states that Member States shall avoid excessive government deficits. In particular Member States shall comply with budgetary discipline by respecting two criteria: a deficit ratio and a debt ratio not exceeding reference values of respectively 3% and 60% of GDP. A few exceptions are specified in the Treaty. Article 104 also sets out the procedure to be followed to identify and correct situations of excessive deficit, and voting modalities in the course of the procedure. The Regulation 1467/97 of the Stability and Growth Pact (SGP) clarifies the procedure.

The first four steps of the procedure, corresponding to provisions of paragraphs 3 to 6 of Article 104, concern the identification of situations of excessive deficit. The excessive deficit procedure is triggered if the deficit of a Member State exceeds 3% of GDP.[2] In such a situation, the Commission adopts a report, in accordance with Article 104(3), reviewing in detail the economic and budgetary situation the Member State considered. As foreseen in Article 104(4) and Regulation 1467/97, the Economic and Financial Committee formulates an opinion on this report within two weeks. The Commission takes this opinion into account and, if it considers that an excessive deficit exists, addresses an opinion under Article 104(5) to the Council. On the basis of the Commission opinion, the Council itself decides on the existence of an excessive deficit under Article 104(6).

The subsequent steps of the procedure are dedicated to the correction of excessive deficits. When it decides that an excessive deficit exists, the Council addresses a recommendation to the Member State concerned in accordance with Article 104(7). In this recommendation, the Council sets two deadlines: one for the Member State to take effective action to correct the excessive deficit, and one for the correction of the excessive deficit itself.[3] Regulation 1467(97) specifies that the latter deadline shall be the year following the identification of an excessive deficit, unless there are special circumstances.

In case action by the Member State concerned leads to the correction of the excessive deficit, the Council shall decide, in accordance with Article 104(12), to abrogate its decisions under the excessive deficit procedure. In other words, the procedure is closed. In the event the Council considers that no effective action has been taken, it may decide, as stated in Article 104(8) of the Treaty, to make public its recommendation according to 104(7).

The steps described above apply to all EU countries. The further steps of the procedure depend on whether the Member State is a euro-area Member State.

The excessive deficit procedure applies in full to euro-area Member States. For these countries, Article 104(9) stipulates that, provided the Council adopts a decision under article 104(8), it may decide to give notice to the member state concerned to take the necessary measures to reduce the deficit. The recommendations under article 104(9) of the Treaty shall include a deadline for the correction of the excessive deficit, and Regulation 1467/97 specifies that measures for the deficit reduction that the Council judges necessary have to be taken by the Member State concerned within two months at the most from the adoption of the notice under 104(9).

This step constitutes a move towards even closer surveillance, and is the ultimate step before the possible imposition of sanctions. If the Member State fails to comply with the recommendations, the Council may decide to impose sanctions no later than two months after notice has been given. In case of compliance with the recommendations formulated in the notice under article 104(9), the decisions taken under articles 104(6) to 104(9) are abrogated with a Council decision in accordance with article 104(12), and the procedure is closed.

As already mentioned, non-euro-area Member States are not exempt from the obligation to avoid excessive deficits, but the later steps of the EDP do not apply for them. When a Member States outside the euro area in a situation of an excessive deficit fails to respect the recommendations addressed under Article 104(7), it cannot be submitted to the last two steps of the excessive deficit procedure, namely notice foreseen in Article 104(9) and the imposition of sanctions foreseen in Article 104(11).[4] Non-compliance with a recommendation under 104(7) may lead to a renewed recommendation according to Article 104(7).

The UK, Sweden, Denmark and the RAMS are in such a situation. The specific situation of the RAMS, which have the status of ‘Member States with a derogation’, in the sense of article 122 of the Treaty, was detailed in the 2004 edition of this report. This report also underlined that, in addition to Council recommendations, other channels may act as complementary discipline mechanisms for these countries.

The early warning mechanism

In complement to the Excessive Deficit Procedure, the Treaty foresees in its Article 99(4) the possibility for the Council to make recommendations to Member States in case their economic policies ‘are not consistent with the broad guidelines or risk jeopardising the proper functioning of EMU’. Based on this Article, Regulation 1466/97, which constitutes the preventive arm of the SGP, provides the Council with the possibility to issue “early warnings” to Member States in order to prevent the occurrence of an excessive deficit.

Early warnings are issued by the Council, upon recommendation of the Commission, in the event that the Council identifies significant divergence of the budgetary position from the medium-term budgetary objective of ‘close to balance or in surplus’, or the adjustment path towards it.

The surveillance mechanisms since Spring 2004

Since Summer 2004, ten EU countries are subject to an excessive deficit procedure: four euro-area Member States and six RAMS.[5] In addition, in 2004 the Commission recommended to the Council that an early warning be issued to Italy to prevent the occurrence of an excessive deficit. Below is a presentation of the ongoing procedures concerning the various countries.

The surveillance mechanisms in the euro area countries

Since spring 2004, the Commission and the Council took action or clarified their positions concerning four euro-area Member States in EDP. The Council decided to address a 104(9) recommendation, the latest step of the procedure before sanctions, to Greece, which has to correct its excessive deficit in 2006. The Commission clarified its position for the excessive deficit procedure for Germany and France, after the events of November 2003 and the ruling of the court of Justice of 13 July 2004. Finally, the Commission and the Council considered that the Netherlands had taken effective action to correct its excessive deficit and the Commission proposed on 18 May 2005 to abrogate the EDP.

Greece

On 4 May 2004, the Greek authorities submitted a revised EDP notification showing a 2003 deficit of 3.2% of GDP. This provided prima facie evidence for the existence of an excessive deficit. The Council decided that an excessive deficit exists in Greece and addressed on 5 July 2004 a recommendation 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 its autumn 2004 forecast incorporating the data revisions of 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 104(7) recommendation. 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) of the Treaty, to take the necessary measures to remedy its excessive deficit situation.

The Commission recommended extending the deadline for bringing the deficit below the 3.0% reference value by one year to 2006. When taking this decision, the Commission took into account the fact that the deficit would likely be substantially higher than expected (the 2003 deficit was revised to 5.2% in March 2005, up from an estimated 4.6% of GDP in September 2004 and 1.7% of GDP in March 2004), due to statistical revisions and to expenditure overruns associated notably with the organisation of the Olympic games. In addition, the Commission considered that GDP 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) of the EC Treaty, 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 its 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.[6] The Council decided that Greece had to submit, by 21 March 2005 at the latest, a report outlining the decisions to respect these recommendations.

In March 2005, Greece submitted a report, which was assessed in the Commission Communication of 6 April. The Commission concluded that the Greek government is taking effective action so that no further steps under the EDP seem to be needed at this stage. Greece shall submit other reports by 31 October 2005, 30 April 2006 and 31 October 2006, examining progress made in respecting the recommendations of the notice issued under 104(9).

Box I.1. The revision in the Greek deficit and debt ( 1 )

In 2004, the Greek data on the government deficit and debt underwent a very large revision. The government deficit for 2003, which was initially reported at 1.7% of GDP, stood at 4.6% of GDP after the September 2004 notification. Following a further revision in March 2005, it stands at 5.2% of GDP. The deficit ratios over the period 1997 to 2003 were also quite significantly revised upwards by up to 2½% of GDP. A separate revision of the debt data led to increases between 5 to 8% of GDP. Moreover, if a revision which had already taken place in autumn 2002 is taken into account, the overall upward revision in the deficit and debt ratios reaches, for some years, 4 and 15 percentage points, respectively. Moreover, in March 2005, Eurostat did not validate the revised Greek data and highlighted inconsistencies in the recording of flows with the EU budget which could lead to further upward revisions in the deficit figures. |

The revision in the Greek accounts concerned several topics as summarised in the table. The most significant revisions – such as the revision in social security accounts and military expenditure – were in relation to difficulties in the compilation and estimation of basic data. Other revisions – such as debt assumptions, capital injections and interest – concerned an inappropriate application of accounting rules. |

Table I.6. Main components of the revision in the Greek data (1997-2003) (% of GDP) 1997 1998 1999 2000 2001 2002 2003 Deficit (as of March 2004) 4.0 2.5 1.8 2.0* 1.4* 1.4 1.7 Military expenditure 0.2 0.1 0.9 1.9 1.2 1.7 0.7 Interest 1.0 0.3 0.1 0.3 0.1 0.1 0.1 Social security accounts – – – – 1.0 0.4 0.6 Debt assumpt. / capital injections 1.0 1.1 0.8 – – – – Tax revenue – – – – – – 0.9 Other 0.4 0.4 -0.1 0.0 0.0 0.5 1.1 Deficit (as of March 2005) 6.6 4.3 3.4 4.1 3.6** 4.1** 5.2** Debt (as of March 2004) 108.2 105.8 105.2 106.1* 106.6* 104.6 102.6 Bonds with capitalised interest 4.9 4.7 4.5 4.5 4.2 3.9 3.4 Social security accounts 1.0 1.9 1.9 3.2 3.9 3.5 2.6 Other 0.0 0.0 0.7 0.1 0.1 0.2 0.1 Debt (as of March 2005) 114.0 112.4 112.3 114.0 114.8** 112.2** 109.3** * Data for 2000 and 2001 had already been significantly revised in autumn 2002. |

** Not validated by Eurostat and subject to further upward revision. |

Source: Eurostat. |

Revisions in statistics, and in particular in the government deficit and debt data, are not unusual. After the publication of the first outcomes in March, data are often revised because new information becomes available or because errors are corrected. However, “the scope and size of the past revisions in the Greek case are unprecedented and very serious, particularly as regards the overall credibility of the multilateral surveillance framework”. (2) |

The revision in the Greek accounts revealed “systemic weaknesses” in the statistical authorities of Greece: notably “lack of expertise” and “lack of reliable basic data needed to produce public accounts of good quality.”(3) However, this case also illustrated insufficiencies in the Commission services and of a more general nature. Notwithstanding a permanent dialogue between the national statistical authorities and Eurostat, the latter has neither the resources nor the legal means to countercheck the veracity and reliability of information provided by Member States. Moreover, in spite of the relevance of budgetary statistics for macroeconomic surveillance and for the decision on the participation on the monetary union, and the fact that most difficulties in the Greek statistical system had been identified in earlier years, the statistical issues used to be discussed among a restricted circle of statisticians without being raised to the public attention and the appropriate political level. In this respect, the ECOFIN Council of 7 December 2004 regarded as “serious cause for concern that (…) Eurostat validated the critical March 2000 EDP notification data of Greece [immediately before the decision on the participation of Greece in the euro], in spite of significant open issues related to the fiscal data” and that “the Commission's and the ECB’s Convergence Reports failed to emphasise to the Council potential problems with regard to Greek budgetary statistics”. |

The revision in the Greek accounts also brought the issue of professional independence of national statistical authorities to the fore. (See Box II.2 on the strengthening of budgetary statistics summarises recent developments and proposals to address these weaknesses.) |

(1) For more information on the revision of Greek government statistics, see the “Report by Eurostat on the revisions of the Greek government deficit and debt figures (1997-2003)”, SEC(2004) 1539 of 22 November 2004. |

(2) ECOFIN Council Conclusions of 7 December 2005. |

(3) Commission Communication “Report on the accountability issue related to the revision of Greek budgetary data”, COM (2004) 784 of 1 December 2004. |

Graph I.6. Budgetary plans, forecasts and outcomes in Greece

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Source: Commission services.

Germany and France

Summary of past events and consequences of the Court of Justice ruling of 13 July 2004

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 assessed the measures taken in both countries and considered that the actions implemented by Germany and France were inadequate to correct their excessive deficits and recommended the Council to decide accordingly. The Council also recommended the Council to adopt a decision giving notice to these two countries to take measures to remedy the situation. In the light of the weaker than expected economic situation, the Commission recommended that the deadline for correcting the deficit should be extended by one year to 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, in the light of the commitments by the two Member States, the excessive deficit procedure was held in abeyance. The Commission brought the case before the Court of Justice of the European Communities challenging certain elements of the Council conclusions of 25 November 2003. 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. However, the Court did not elaborate on the implications of its decision for the excessive deficit procedure for Germany and France.

On 14 December 2004, the Commission adopted a Communication clarifying the situation of Germany and France in relation to their obligations under the excessive deficit procedure following the judgement of the Court of Justice. The Commission considered that, in assessing the position of Germany and France, it is appropriate to take into account the consequences of the Council conclusions until their annulment by the Court, and notably the fact that these conclusions benefited from the presumption of validity that is attached in principle to every Community instrument.

Therefore, while maintaining its view on the inadequacy of the actions taken by Germany and France to correct the excessive deficit by 2004, 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. In light of these circumstances, the Commission considered that the assessment of the actions taken to correct the excessive deficit situation should refer to 2005 as the relevant deadline. The Council agreed with this position.

As detailed in the following two sub-sections, the Commission considered in its Communication that Germany and France were in a position that makes the correction of the excessive deficit still possible. The Commission noted however that if failures in implementing the envisaged correction measures should emerge at a later stage, it would have to recommend to the Council to enhance the budgetary surveillance and to take the necessary action within the provisions of the Treaty and the Stability and Growth Pact.

Germany

In the Autumn 2004 forecast, the Commission projected real GDP growth at 1.5% and the general government deficit at 3.4% of GDP in 2005 based on a no-policy change scenario with the reference date 18 October 2004. On 4 November, the federal government presented a savings package and, in the Fiscal Planning Council (Finanzplanungsrat) meeting of 18 November, the federal, state and local levels of government agreed to reduce the government deficit to 2.9% of GDP in 2005.

The Commission considered in its Communication of 14 December 2004 that measures taken as well as a subsidy repayment by the state banks (Landesbanken) would allow to reduce the 2005 deficit to 2.9% of GDP. Therefore, the Commission considered that the measures taken by the German authorities were consistent with a correction of the excessive deficit by 2005. Accordingly, the Commission concluded in its Communication of 14 December 2004 that no further steps were necessary under the excessive deficit procedure.

The Commission however noted that the budgetary situation of Germany remains vulnerable, that none of the additional measures constitutes a structural reforms with long-term benefits, and that the reduction of expenditure to the cash settlement office shifts an implicit liability to the future. In addition, the Commission noted that any unfavourable development on the macroeconomic or on the budgetary side could bring the deficit above 3% in 2005.

In Spring 2005, the Commission services revised their deficit forecast for 2005 up to 3.3% o GDP, due to economic developments in Germany less favourable than expected at the end of 2004. This suggests that additional measures may be needed to bring the deficit below 3% of GDP in 2005. However, in view of the uncertainties attached to the 2005 deficit outcome at this point in the year, the Commission considered that it would be premature to take further steps under the excessive deficit procedure. The Commission will continue monitoring the budgetary situation, which remains vulnerable, in the coming months.

Graph I.7. Budgetary plans, forecasts and outcomes in Germany

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Source: Commission services.

France

The Commission services’ Autumn 2004 forecasts projected the general government deficit at 3.7% of GDP in 2004 and 3.0% of GDP in 2005. The deficit reduction was projected to result from expenditure restraint and a significant increase in revenues, stemming notably from a large one-off payment (0.5% of GDP) linked to the transfer of the responsibility for the payment of pensions of the employees in public electricity and gas companies to the social security sector.[7] Based on this forecasts, the Commission considered that actions taken by the French authorities were broadly consistent with a correction of the excessive deficit by 2005. Accordingly, the Commission concluded in its Communication of 14 December 2004 that no further steps were necessary under the excessive deficit procedure.

Like in the case of Germany, the Commission noted that the budgetary situation of France remained vulnerable. The Commission noted that any unfavourable development on the macroeconomic or on the budgetary side could compromise the achievement of the objective of correcting the excessive deficit in 2005 at the latest. The Commission also underlined that the deficit reduction in 2005 largely relies on the favourable impact of a large one-off measure. This was reflected in the Autumn 2004 Commission deficit forecast, which projected an increase in the deficit to 3.3% of GDP in 2006 under the assumption of an unchanged policy.

In Spring 2005, the Commission services confirmed their forecast of a 2005 deficit of 3.0% of GDP, on a no policy change basis. The deficit forecast for 2006 was revised slightly upward, to 3.4% of GDP. Following this forecast, and considering the uncertainties attached to the 2005 deficit outcome, the Commission considered that it would be premature to take further steps under the excessive deficit procedure, and will continue monitoring budgetary developments, which remain vulnerable.

Graph I.8. Budgetary plans, forecasts and outcomes in France

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Source: Commission services.

The Netherlands

In light of a reported general government deficit of 3.2% of GDP in 2003 and considering the risk that the deficit might remain above 3% of GDP in 2004, the Council placed the Netherlands in excessive deficit on 2 June 2004 and at the same time issued an Art. 104(7) recommendation for its correction. The Dutch government was recommended to put an end by 2005 at the latest to the present excessive deficit. To that end, it was recommended to take action regarding corrective measures in 2005 amounting to at least half a percentage point of GDP by the deadline of 2 October 2004.

Following this recommendation, the Dutch authorities implemented an additional savings package for 2004 equivalent to 0.6 percentage point of GDP on top of the savings measures that had already been included in the 2004 budget. The measures involved in particular higher premiums for health insurance, lower health expenditure and an end to subsidies on employing low-skilled workers. The budget for 2005 contained further deficit-reducing measures adding up to an adjustment of half a percent of GDP for 2005. The corrective measures were for the largest part of a structural nature, thus having a deficit-reducing impact also in subsequent years. On 6 October 2004, the Commission considered that the Netherlands had taken effective action to correct the excessive deficit by 2005. The Council concurred to this analysis in its conclusions of 21 October 2004.

On a no-policy change basis, the Commission services’ spring 2005 economic forecast projected the deficit at 2.0% in 2005, after 2.5% of GDP in 2004. Following this forecast, the Commission recommended on 18 May to the Council to abrogate its decisions under Article (6) and (7) of paragraph 104 of the Treaty.

Graph I.9. Budgetary plans, forecasts and outcomes in the Netherlands

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Source: Commission services.

Italy

In Spring 2004, the Commission projected for 2004 a budget deficit of 3.2% of GDP compared to a target of 2.2% of GDP in the 2003 update of the programme and of 0.6% of GDP in the 2002 update. The Commission, also considering that divergence from the objectives was almost entirely structural and the projected interruption of the reduction of the debt ratio, recommended, on the basis of Article 99(4) of the Treaty and Article 6(2) of Council Regulation 1466/97, that an early warning be issued to Italy to prevent the occurrence of an excessive deficit. In July 2004, in view of the announcement of further consolidation measures by the Italian authorities, the Council decided not to put to vote the Commission recommendation for an early warning to Italy.

In March 2005, the Italian authorities reported a 2004 deficit of 3.0% of GDP. Eurostat indicated that it was not in a position to validate the figures for Italy in view of pending statistical issues and that ‘the clarification of these issues could lead to an upward revision in the government deficit, most notably for 2003 and 2004’. This suggests a clear risk that the 2004 deficit was already above the reference value of 3% of GDP. On a no-policy change basis, the spring 2005 forecast of the Commission services project the 2005 deficit at 3.6% of GDP, followed by 4.6% of GDP.

Graph I.10. Budgetary plans, forecasts and outcomes in the Italy

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Source: Commission services.

The surveillance mechanisms in the non euro area Member States

After the publication of the Commission services’ Spring 2004 economic forecasts, which took into account data reported in March 2004, the Commission initiated the excessive deficit procedure for 6 RAMS: Hungary, Czech Republic, Cyprus, Malta, Poland and Slovakia. The Council decided on 5 July 2004 that an excessive deficit existed in these countries and at the same time issued an Article 104(7) recommendation to each of them for its correction. Different deadlines, from 2005 to 2008, were set for the correction of the excessive deficit, taking into account the deficit level, growth prospects, and the intentions of the authorities regarding the participation to EMU. Except for Hungary, the Commission considered on 22 December 2004 that all countries had taken effective action in response to the Council recommendation, in particular to respect the 2005 deficit target set in the May 2004 convergence programmes. Accordingly, the Commission concluded that no further steps were necessary for Czech Republic, Cyprus, Malta, Poland and Slovakia under the excessive deficit procedure.

Hungary

On 5 July 2004, the Council issued a recommendation to 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, the Council considered that Hungary had not taken effective action in response to its recommendation. The Council considered that the measures taken were not sufficient to avoid a sizeable deviation from the 2004 and 2005 deficit targets and from the adjustment path planned in the convergence programme. Having joined the Community on 1 May 2004, Hungary is a Member State with a derogation, which means that it is to avoid excessive deficits but that Articles 104(9) and Article 104(11) of the Treaty do not apply to it. The Council therefore issued another recommendation based on Article 104(7), taking into account information of Hungary’s convergence programme update submitted in December 2004.

This update foresees a decline in the general government deficit from 4.4% of GDP in 2004 to 2.4% of GDP in 2007 and 1.6% of GDP in 2008. These figures benefit from the decision by Eurostat of 23 September 2004 allowing that, for a transitory period, until the March 2007 fiscal notification, second pillar pension funds can be recorded inside the general government. This lowers the yearly deficit figures by 0.8-1 percentage point between 2004 and 2008. Including the impact of the pension reform of 1998, the projected deficit path would show a reduction from 5.3% of GDP in 2004 to 2.8% of GDP in 2008.

On 8 March 2005, the Council adopted a new recommendation under Article 104(7) recommending notably the Hungarian to: (i) put an end to the excessive deficit situation as rapidly as possible; (ii) 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; (iii) take effective action by 8 July 2005 regarding additional measures, as far as possible of a structural nature, in order to achieve the deficit target for 2005 as set in the December convergence programme. The action taken in response to the new 104(7) recommendation will be assessed by the Commission at the expiry of this deadline.

The Commission services’ spring 2005 forecast projected a deficit of 3.9% of GDP in 2005, followed by 4.1% of GDP in 2006, on a no-policy change basis. This is to be compared to the 3.6% and 2.9% of GDP respectively in the December 2004 update of the convergence programme, which constituted the basis for the multi-annual adjustment path recommended by the Council in March 2005.

Graph I.11. Budgetary plans, forecasts and outcomes in Hungary

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Source: Commission services.

Czech Republic

The Council recommendation under Article 104(7) recommended to the Czech authorities to correct the excessive deficit by 2008 and to take effective action by 5 November 2004 in order to achieve the 2005 deficit target, set in the May 2004 convergence programme at 4.7% of GDP.

In summer 2004, the Parliament passed a law on new budgetary rules, which introduced fiscal targeting based on medium-term expenditure ceilings for central government. Although the expenditure ceilings will become legally binding only in 2006, the government accepted them as voluntary guidelines already for the 2004 and 2005 budgets. The 2005 state budget largely respects the 2005 expenditure ceiling, leading to a sharp decline in the expenditure ratio, and includes revenue cuts worth 0.7% of GDP.

The spring 2005 forecast of Commission services of a deficit at 4.5% of GDP in 2005 confirm that the measures taken by the Czech authorities should be sufficient to achieve the 2005 deficit target. The Commission projects a further decline in the deficit in 2006, at 4.0% of GDP.

Cyprus

The Council recommended the Cypriot authorities to take effective action by 5 November 2004 in order to achieve their objective of bringing the deficit below 3% of GDP in 2005 in a credible and sustainable manner.

According to the projections in the 2005 budget, the deficit would decrease to 2.9% of GDP in 2005, i.e. just below the reference value of 3% of GDP. The deficit reduction in 2005 is projected to be achieved through revenue increases and expenditure cuts. The measures ensuring expenditure restraint appear to be mostly structural (cap on current expenditure, increase in the retirement age for public sector employees). Revenue measures are a mix of structural and one-offs measures (tax-amnesty, fees for issuance of title deeds for certain real estate).

In spring 2005, Commission services projected a decline in the deficit ratio to 2.9% of GDP in 2005 and, on a no-policy change basis, to 1.9% in 2006. This confirms that the consolidation impact of the envisaged measures should be sufficient to achieve the 2005 deficit target.

Malta

The Council recommended to the Maltese authorities to correct the excessive deficit by 2006 and to take action by 5 November 2004 regarding the measures envisaged to achieve the 2005 deficit target set in the May convergence programme at 3.7% of GDP.

The 2005 budget confirmed this projection, targeting a decline in the deficit ratio from 5.2% in 2004 to 3.7% in 2005. Two-thirds of the total deficit reduction would result from structural measures consisting mainly of tax increases (introduction of an excise duty on mobile telephony services, increase of the departure tax on airfares, imposition of VAT and excise duty on kerosene, the increase in excise duty on tobacco). The remaining third would be generated through one-off measures on the revenue side (sale of government property and from revenues to be raised from listed/unlisted companies).

The Commission services Spring 2005 forecast project the 2005 deficit at 3.9% of GDP, confirming that the budgetary target set in the budget for 2005 (3.7% of GDP) is plausible.

Poland

The Council recommended to the Polish authorities to correct the excessive deficit by 2007 and to take action by 5 November 2004 regarding the measures envisaged to achieve the 2005 deficit target of 4.2% of GDP set in the convergence programme of May 2004.

The budget for 2005 foresees a reduction of the government deficit from 5.6% of GDP in 2004 to 3.9% in 2005. The deficit would decrease further to 3.1% of GDP in 2006. Measures from the Hausner plan contained in the budget would have a deficit-reducing impact of 1.1 percentage points in 2005 and 0.8 percentage points in 2006. The authorities expect to achieve a further deficit reduction by up to 0.6% of GDP by implementing measures aiming at a widening of the tax base. The measures adopted and planned appear to be for the largest part of a structural nature, thus having a deficit reducing impact also in subsequent years.

The Commission services Spring 2005 economic forecasts confirm that the consolidation impact of the envisaged measures should be sufficient to achieve the 2005 deficit target in the budget. In particular, against the background of the projected strong growth and the corrective measures taken by the government, the projections by Commission services show a decline in the deficit to 3.8% of GDP in 2005 from the estimated 4.4% in 2004 and, on a no-policy change basis, further to 3.1% in 2006.

Slovakia

Concerning Slovakia, the Council recommended to correct the excessive deficit by 2007 and to take effective action by 5 November 2004 regarding the measures envisaged to achieve the 2005 deficit target set at 3.9% of GDP in the May convergence programme.

On 9 December 2004, the Slovak Parliament adopted the budget for 2005, setting the 2005 deficit target at 3.8% of GDP (3.4% of GDP without the revenue loss stemming from the introduction of a funded pension pillar). The budget incorporates: (i) a systemic pension reform, leading to a redirection of social security contributions to a newly introduced funded pension pillar; (ii) the last tranches of the current government’s health care reform agenda; and (iii) further public sector rationalisation. These reforms almost fully completed the current government’s reform agenda, most of which had already been implemented in the budget year 2004 and which encompassed in particular a comprehensive tax reform package.

In their Spring 2005 forecast, Commission services projected an increase in the general government deficit from 3.8% of GDP in 2005 to 4.0% in 2006, on a no-policy change basis. This confirms that the measures presented up to now are broadly sufficient to achieve the 2005 deficit target set in the May 2004 convergence programme.

Table I.7. Overview of ongoing excessive deficit procedures

2004 updates of the Stability Programmes |

Real GDP growth GDP deflator | 0.6 2.0 | 2.1 2.0 | 2.3 1.9 | 2.4 1.8 | 2.5 1.7 |

HICP change | 2.1 | 2.1 | 1.8 | 1.6 | 1.5 |

Employment growth | 0.1 | 0.5 | 0.9 | 1.1 | 1.2 |

Labour productivity growth | 0.8 | 2.2 | 1.4 | 1.3 |

2003 updates of the Stability Programmes |

Real GDP growth | 0.6 | 2.0 | 2.5 | 2.6 | 2.5 |

Difference with 2004 updates | 0.0 | 0.1 | -0.2 | -0.2 | -0.1 |

Commission services autumn 2004 forecasts |

Real GDP growth | 0.6 | 2.1 | 2.0 | 2.2 |

Difference with 2004 updates | 0.0 | 0.0 | 0.3 | 0.2 |

Commission services spring 2005 forecasts |

Real GDP growth | 0.6 | 2.0 | 1.6 | 2.1 |

Difference with 2004 updates | 0.0 | 0.1 | 0.7 | 0.3 |

- Note: Commission services calculations. Discrepancies are due to rounding. The Commission services autumn 2004 forecasts were used to obtain a representative aggregate by replacing the missing information on HICP in the German programme and for Greece and Portugal (both 2004-2006). For Spain and France, the private consumption index was used instead of the HICP. The missing information on employment growth for France was replaced by reported information on dependent employment growth in market sector.

The excessive deficits in Germany and France are foreseen to be corrected in 2005 according to the respective stability programme. However, there are risks for the deficits in both countries to remain above the 3% of GDP reference value also in 2005, in particular as growth may be lower than expected. In Greece, the expected deficit is projected to be corrected in 2006.

Table I.9. Projections of real growth in the 2004 updates (% change on preceding year)

2003 | 2004 | 2005 | 2006 | 2007 | 2008 |

BE | 1.3 | 2.4 | 2.5 | 2.5 | 2.1 | 2.0 |

Note: * In the calculation of the euro-area and the EU averages for the year 2003, data from the Commission services autumn 2004 forecast were used for France and Cyprus. Same source was used for Portugal for the period 2004-2006 to get a representative aggregate.

** Financial years ending in following March.

Table I.10. Nominal budget balances in the 2004 updates and the Commission services autumn 2004 and spring 2005 forecasts*

2004 updates of the stability and convergence programmes | Commission services autumn 2004 forecasts | Commission services spring 2005 forecasts |

General government | -2.7 | -2.8 | -2.3 | -1.8 | -1.3 |

Central government | -1.7 | -2.3 | -2.0 | -1.9 | -1.7 |

State plus local governments | -0.8 | -0.4 | -0.3 | -0.2 | -0.1 |

Social security funds | 0.1 | 0.0 | 0.1 | 0.2 | 0.4 |

Note: Commission services calculations. Discrepancies are due to rounding or inconsistencies in the data provided in the programmes.

Graph I.13. The fiscal stance and cyclical conditions in the euro area, 2004-2007

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Note: The changes in the cyclically-adjusted primary balance are used as a proxy of the fiscal stance, while the size of the output gap is used as a proxy of the cyclical conditions. A positive value for the fiscal stance represents a tightening of discretionary fiscal policies.

Source: Commission services calculations based on the 2004 updates of the Stability programmes.

The updates of the programmes show that both revenue and expenditure ratios are expected to decline over the programme period (see Table I.13 ) . In the euro area total receipts are expected to fall by 0.6 percentage point between 2004 and 2007, to below 45% of GDP by the end of the programme period. This is more than compensated by reductions in the expenditure ratio which, over the same period, are expected to amount to almost 2 percentage points of GDP. Revenue ratios are projected to decline in all Member States with the exception of Spain, Greece and France, where they are expected to increase. Contrary to this, outside the euro area, total receipts are foreseen to rise in all countries except for the Czech Republic, Denmark, Estonia, Hungary, Malta and Sweden, where they are set to decrease. Particularly strong reductions in revenue are projected in Estonia, Ireland and Austria. Almost all Member States are set to decrease the expenditure ratio, with the exception of Latvia, Lithuania, Luxemburg and the UK. Particularly strong reductions are planned by the Czech Republic, Germany, Hungary, Malta and Austria. For the two Member States, the size of projected adjustments in the updates is very much in line with that calculated by the Commission services (based on the updates) and for Germany also in line with the Commission services autumn 2004 forecast.

Table I.13. Revenue and expenditure ratios in the 2004 updates

Total revenue | Total expenditures |

2004 | 2007 | 2004-07 | 2004 | 2007 | 2004-07 |

BE | 49.6 | 49.1 | -0.5 | 49.6 | 48.8 | -0.8 |

Note: Commission services calculations. Discrepancies are due to rounding or inconsistencies in the data provided in the programmes. Therefore, the net lending implied by this table may be different from the one in Table I.10.

* For Portugal (2004-2006), the Commission services autumn 2004 forecast have been used to have a representative aggregate for the 2004 updates and the Commission services calculations.

** See Note ** in Table I.10.

*** Financial years ending in following March. Concerns total current revenue.

Table I.14. Euro area – Budgetary developments within the general government

% of GDP | 2003 | 2004 | 2005 | 2006 | 2007 | 2004-2007 |

Components of revenue |

Taxes | 25.6 | 26.8 | 26.7 | 26.7 | 26.8 | 0.0 |

Social contributions | 15.6 | 15.3 | 15.2 | 14.9 | 14.9 | -0.4 |

Other revenue | 4.4 | 4.0 | 3.7 | 3.7 | 3.7 | -0.3 |

Total revenue | 46.2 | 45.5 | 45.2 | 45.0 | 44.8 | -0.7 |

Components of expenditure |

Collective consumption |

Social transfers in kind | 14.8 | 14.6 | 14.2 | 14.1 | 13.8 | -0.8 |

Social transfers other than in kind | 17.7 | 17.6 | 17.2 | 16.9 | 16.6 | -1.0 |

Interest expenditure | 3.5 | 3.4 | 3.3 | 3.3 | 3.3 | -0.1 |

Subsidies | 1.4 | 1.3 | 1.3 | 1.3 | 1.2 | -0.1 |

Gross fixed capital formation | 2.5 | 2.5 | 2.4 | 2.5 | 2.2 | -0.3 |

Other | 3.3 | 3.1 | 3.1 | 3.1 | 3.0 | -0.1 |

Total expenditure | 48.9 | 48.3 | 47.5 | 47.1 | 46.4 | -1.9 |

Note: Commission services calculations. Discrepancies are due to rounding, lack of data or inconsistencies in the data provided in the programmes.

Graph I.14. Contributions to change in budgetary position 2004-2007 (in percentage points)

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Note: A positive value indicates a positive contribution to the change in budgetary position. A positive value in total variation of budgetary position (value is presented on top of columns) implies an improvement of the balance. For UK data refer to 2004-2006. For Portugal data refer to the period 2004-2006 from the Commission services autumn 2004 forecast. For Hungary, Poland and Slovakia see Note ** in Table I.10.

Source: 2004 updates of the Stability and Convergence programmes.

A closer look at the euro-area budgetary developments for the general government over the programme period reveals that the above mentioned reduction of total receipts can be ascribed to a planned fall in social contributions and other revenues. As to the components of public expenditures, very limited data are provided for collective consumption. According to the updates, most of the planned reduction in total expenditure is due to a decrease in social transfers in the euro area, both in kind and other than in kind, as they are projected to fall by 1.8 percentage points over the programme period. The rest is due to lower gross fixed capital formation, planned cuts in subsidies as well as slightly reduced interest and other expenditures.

Graph I.14 presents the contribution to the change in the budget balances from four budget components, namely primary current expenditures, interest expenditure, gross fixed capital formation and total revenues. A number of remarks can be made.

Table I.15. Euro area – Gross debt level and changes in the 2004 updates

2004 | 2005 | 2006 | 2007 |

Gross debt level | 71.1 | 70.7 | 69.7 | 68.3** |

Change in gross debt | 0.4 | -0.4 | -1.0 | -1.4 |

Previous updates of the programmes | 70.0 | 69.4 | 68.4 | 67.6 |

Difference | 1.1 | 1.3 | 1.3 | -0.7 |

Contributions to change in gross debt |

Primary balance | -0.6 | -1.0 | -1.5 | -2.1 |

Interest expenditure | 3.4 | 3.3 | 3.3 | 3.3 |

Nominal GDP growth | -2.7 | -2.8 | -2.8 | -2.8 |

Stock – flow adjustment* | 0.3 | 0.2 | 0.1 | 0.2 |

Note: Commission services calculations. Discrepancies are due to rounding or inconsistencies in the data provided in the programmes.

* The programmes do not always contain enough information to identify directly the contribution from different factors to the development of the euro area debt ratio. Therefore, it has been necessary in some cases to derive the contribution from nominal GDP growth (GDP deflator plus real GDP growth multiplied by the debt ratio). In this way, the stock-flow adjustment is derived as a residual.

** For Portugal (2004-2006), the Commission services autumn 2004 forecast have been used to have a representative aggregate for the 2004 updates and the Commission services calculations. Therefore, the 2007 projection of the aggregate gross debt level does not include information on projected debt in these two countries.

Firstly, Member States that have been under the excessive deficit procedure project to improve budget balances substantially via cuts in primary current expenditures. However, excluding France, Greece, Cyprus, Slovakia and Poland further tax cuts are also foreseen. In the case of Hungary, the Netherlands, Poland and Slovakia, the budgetary adjustment involves a decline in public investments.[10] The decline in the RAMS implies that the budgetary adjustment arising from this item is coming to an end, particularly given their substantial investment needs to improve the infrastructure. In Hungary, a significant fall in interest expenditure over the programme period is expected to contribute to an improvement in budget balance. Secondly, Latvia, Lithuania, Luxembourg and the UK plan to increase the expenditure ratio (notably public investments). This is financed by an increase in the revenue ratio, which should help reducing the deficit to closer to balance. Thirdly, several Member States with budget close-to-balance or in surplus in 2004 (Belgium, Denmark and Sweden) foresee cuts in primary current expenditures as well as in taxes, thereby reducing the size of the public sector while maintaining sound budgetary positions. Finally, deterioration in the budget balance over the period is expected in Estonia and Ireland, albeit from a position of budgetary surpluses. The reduction in revenues in both countries is partially compensated by cuts in primary current expenditures, and in public investments.

Debt projections

The gross debt to GDP ratio in the euro area is expected to have increased to 71.1% of GDP in 2004 (see Table I.15). As it was the case in the previous vintages of updates, most Member States revised their debt level upwards but project a gradual improvement in the debt ratio over the programme period. However, the adjustment path is slower and the debt ratio for 2006 is projected to be 1.3 percentage point higher than the figure projected in the 2003 updates (see Graph I.15) and even higher compared to the previous updates. This is mainly due to smaller primary surpluses, while the contribution from the increasing nominal GDP growth is projected to remain broadly unchanged.

Table I.15 also shows that the estimated stock-flow component on average increases the debt ratio over the programme period. This could stem from plans to build