Recommendation for a COUNCIL DECISION abrogating the decision on the existence of an excessive deficit in Portugal - Application of Article 104(12) of the Treaty establishing the European Community -

(presented by the Commission)

EXPLANATORY MEMORANDUM

1. INTRODUCTION

On 25 July 2002, the Commission received official confirmation from the Portuguese authorities that the general government deficit in 2001 amounted to 4.1% of GDP [1], therefore exceeding the reference value of the Treaty. Based on this evidence, the Commission initiated the Excessive Deficit Procedure for Portugal on 24 September 2002, with the adoption of the report foreseen in Article 104(3) of the Treaty. On 16 October 2002, the Commission adopted an Opinion stating that an excessive deficit existed in Portugal. On 5 November 2002, the Council adopted a Decision [2] to that effect, in conformity with Article 104(6).

[1] Later revised to 4.4% of GDP.

[2] OJ L 322, 27.11.2002.

At the same time, the Council adopted a Recommendation addressed to Portugal, in conformity with Article 104(7) of the Treaty, with a view to bringing the situation of an excessive government deficit to an end. Specifically, the Council recommended:

"the Portuguese government to put an end to the present excessive deficit situation as rapidly as possible in accordance with Article 3(4) of Regulation (EC) No 1467/97;

the Portuguese authorities to implement with resolve their budgetary plans for 2002, which aim at reducing the deficit in 2002 to 2.8% of GDP. The Council establishes a deadline of 31 December 2002 for the Portuguese government to take all the necessary measures to bring the excessive deficit to an end;

the Portuguese authorities to adopt and implement the necessary measures to ensure that the government deficit in 2003 is further reduced clearly below 3% of GDP and that the government debt ratio is kept below the 60% of GDP reference value."

In addition to the recommendations addressed under Article 104(7) of the Treaty, the Council welcomed a number of commitments undertaken by the Portuguese authorities, notably (i) to update the stability programme by end-2002, including adjustment measures for the achievement of the medium-term objective of a budgetary position close to balance or in surplus and to secure that the debt ratio is brought back to a declining path; (ii) to continue to improve the collecting and processing of general government data; and (iii) to reinforce the coordination mechanisms of budgetary policy.

2. COMPLIANCE WITH THE COUNCIL RECOMMENDATION

2a. General government balance in 2002-2003

In 2001, the government deficit exceeded the reference value of the Treaty by a significant margin. Although the exact magnitude of the slippage was only disclosed in July of 2002 [3], a rectifying budget was presented to parliament by the newly elected government already in April 2002, which included consolidation measures totalling about 0.6% of GDP. However, the extent of the budgetary imbalance carried over from 2001, together with weaker activity than initially expected led the Portuguese authorities to adopt a number of one-off measures at the end of 2002 [4], totalling 1.5% of GDP in additional revenue, in order to secure a government deficit below the 3% of GDP threshold already in 2002. As a result, the actual general government deficit turned out at 2.7% of GDP. In 2002, the cyclically-adjusted balance (CAB) improved by 2.3 percentage point of GDP, reaching -2.6% of GDP, or excluding one-off measures by 0.8 percentage point, attaining -4.1% of GDP in 2002.

[3] With the publication of a report of an ad-hoc Task Force entrusted by the newly elected government with the analysis of public accounts. This Task-Force was made up of representatives from the Ministry of Finance, the Bank of Portugal and the National Institute of Statistics. It was under the direct supervision of the governor of the Bank of Portugal.

[4] In particular, a tax amnesty for interest surcharges on all tax and social security contributions arrears, which brought alone in additional revenue a total amount of 1.0% of GDP.

According to the first 2004 Excessive Deficit Procedure (EDP) notification, validated by Eurostat, the general government deficit for 2003 is estimated at 2.8% of GDP. This compares with a targeted deficit of 2.4% of GDP set in the January 2003 update of the stability programme. The deviation from target is due to a massive tax shortfall [5], linked to the unanticipated decline of GDP in 2003 by an estimated 1.3% (compared with an initial GDP growth projection of +1.3%) and the revealed low tax intensity of economic activity in the current recession. Excluding the sale of tax arrears, the economic recession led to a decline in total tax revenue by an estimated 2.4% in 2003, compared with an initial budgetary target of +4%. On the expenditure side, by contrast, the government has been broadly successfully in securing the planned restraint. Growth of total current primary expenditure continued to decelerate from 8.9% in 2001 to 7.8% in 2002 and 4.1% in 2003. This basically reflects the sharp slowdown in government consumption due to the quasi-freeze of employment and nominal wages in 2003. All considered, these revenue and expenditure developments would have led to a government deficit clearly above 3% of GDP in 2003. In order to prevent this, the Portuguese authorities relied on two one-off measures, together worth 2.1% of GDP, namely a lump-sum payment from a public enterprise to the government in exchange of the transfer to the latter of the responsibility for paying pensions, and the sale to a financial institution of the right to the amounts collected in future concerning tax and social security contributions arrears. In 2003, the CAB improved by 0.9 percentage point of GDP, reaching -1.7% of GDP, or excluding one-off measures by 0.3 percentage point, attaining -3.8% of GDP in 2003.

[5] Excluding the one-off operation on the sale of tax and social security contributions arrears.

>TABLE POSITION>

2b. Debt ratio in 2002-2003

In the period from 2001 to 2003, the gross government debt-to-GDP ratio increased due basically to low economic growth and a significant amount of financial operations. These financial operations [6] reflect to a large extent the regularisation of expenditure arrears, and the transformation of a significant number of public hospitals into publicly owned corporations.

[6] ACCOUNTED UNDER THE "STOCK-FLOW ADJUSTMENT" HEADING.

3. FOLLOW-UP OF THE COMMITMENTS IN THE COUNCIL RECOMMENDATION

In relation to the commitments of the Portuguese authorities made at the time of the Council Recommendation issued under Article 104(7), substantial progress has been achieved in the strengthening of the coordination mechanisms of budgetary policy, with the adoption in 2002 of a Budgetary Framework Law ("Lei de Estabilidade Orçamental"), and in the collecting and processing of general government data. The Budgetary Framework Law takes precedence over all legislation concerning budgetary matters, allowing the government to set zero net borrowing requirements in 2004 for local authorities and regional governments; non-compliance with the zero net borrowing requirements could trigger cuts in central government transfers in the following year.

However, two caveats should be mentioned: first, the effectiveness of the strengthening of coordination mechanisms will only be tested in the run-up to the next local elections, scheduled to take place in the Autumn of 2005, due to the usual political cycle of local (investment) expenditure; and second, lack of quarterly data for local authorities have hindered the scheduled production of quarterly general government accounts, although significant progress has already been accomplished in the treatment of data, on a quarterly basis, for the other levels of government.

4. BUDGETARY PROSPECTS

According to the Commission services' 2004 Spring forecast, the government deficit for 2004 is projected at 3.4% of GDP. This compares with the official target set in the latest stability programme and confirmed in the first 2004 EDP notification of 2.8%. The difference can basically be accounted for by three elements: (i) projected growth of GDP is ¼ percentage point lower in the Commission forecast; (ii) base effects due to the significant amount of one-off measures carried out at the end of 2003, affecting the revenue side; and (iii) the partial replacement of such one-off measures, i.e. from 2.1% of GDP in 2003 to a value of 0.7% of GDP in 2004, according to the government plans known so far. For 2005, the Commission's 2004 Spring forecast, which is based upon the customary "no-policy-change" assumption, projects the government deficit to rise to 3.8% of GDP, reflecting the persistence of a sizeable negative output gap and the phasing out of all one-off measures.

According to the Commission services' 2004 Spring forecast, the CAB is projected to deteriorate by 0.3 percentage point of GDP in 2004, reaching -2.0% of GDP, although this result is entirely due to a decline in the amount of one-off measures from 2.1% of GDP in 2003 to a planned value so far of 0.7% of GDP. Therefore, excluding one-off measures, the CAB is projected to improve by 1.1 percentage point in 2004, attaining -2.7% of GDP (-3.8% in 2003). In the latest stability programme update of December 2003, the Portuguese authorities planned a reduction in the CAB of 0.6 percentage point of GDP in 2004, reaching -1.1% of GDP in that year.

>TABLE POSITION>

5. CONCLUSIONS

The Portuguese authorities have complied with the Council recommendation issued under Article 104(7). Specifically, they complied with the recommendation to put an end to the excessive deficit situation as rapidly as possible in accordance with Article 3(4) of Regulation (EC) No 1467/97, which in the present case meant 2003 at the latest. Further, they reduced the deficit below 3% in 2002 and took measures before December 2002, the deadline set by the Council, to take measures to bring the existence of an excessive deficit to an end. In 2003, the deficit remained below 3% of GDP. Finally, according to the values reported in the first EDP notification of 2004, the debt ratio reached 59.4% of GDP in 2003 up from 58.1% in 2002 and 55.6% in 2001. Hence, from an overall assessment it follows that the Portuguese authorities completed the correction of the excessive deficit situation in 2003 under the terms of the Council Recommendation of 5 November 2002. Therefore, the Commission recommends the Council to abrogate the decision on the existence of an excessive deficit in Portugal.

However, additional measures are needed in order to prevent the general government deficit from exceeding the 3% of GDP reference value again as of 2004. According to the Commission services, the risk of breaching the 3% of GDP threshold in 2004 would be reduced by additional measures amounting to at least ½% of GDP. Budgetary plans drawn up last Autumn (for the 2004 budget) already included provisions for one-off measures (sales of real estate) that could be activated to offset any gap in the budget. Moreover, after the cut-off-date for the Commission Spring 2004 forecast, the Portuguese authorities made public their intention to carry out further (real estate related) operations to allow the deficit to stay below 3% of GDP in the current year. Going forward, the government should make every effort to gradually replace all one-off measures by measures of a more permanent nature, thereby putting consolidation on a more lasting basis in line with the broad economic policy guidelines.

Recommendation for a COUNCIL DECISION abrogating the decision on the existence of an excessive deficit in Portugal

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community, and in particular Article 104(12) thereof,

Having regard to the recommendation from the Commission,

(1) By Council Decision 2002/923/EC [7] following a recommendation from the Commission in accordance with Article 104(6) of the Treaty, it was decided that an excessive deficit existed in Portugal.

[7] OJ L322, 27.11.2002, p. 30.

(2) In accordance with Article 104(7) of the Treaty, the Council made a Recommendation addressed to Portugal with a view to bringing the excessive deficit situation to an end [8]. That Recommendation, in conjunction with Article 3(4) of Council Regulation (EC) No 1467/97 of 7 July 1997 on speeding up and clarifying the implementation of the excessive deficit procedure [9], established a deadline for the correction of the excessive deficit which should be completed in the year following its identification, i.e. 2003 at the latest.

[8] Council Recommendation of 5 November 2002.

[9] OJ L209, 2.8.1997, p.6.

(3) In accordance with Article 104 (12) of the Treaty, a Council Decision on the existence of an excessive deficit is to be abrogated, when the excessive deficit in the Member State concerned has, in the view of the Council, been corrected.

(4) The definitions of "government" and "deficit" are laid down in the Protocol on the excessive deficit procedure by reference to the European System of Integrated Economic Accounts (ESA), second edition. The data for the excessive deficit procedure are provided by the Commission.

(5) Based on the data provided by the Commission after reporting by Portugal before 1 March 2004 in accordance with Council Regulation (EC) No 3605/93 of 22 November 1993 on the application of the Protocol on the excessive deficit procedure annexed to the Treaty establishing the European Community [10], as amended by Council Regulation (EC) No 475/2000 [11], and on the Commission services Spring 2004 forecast, the following conclusions are warranted:

[10] OJ L332, 31.12.1993, p. 7. Regulation as last amended by Commission Regulation (EC) No 351/2002 (OJ L55, 26.2.2002, p. 23).

[11] OJ L 58, 3.3.2000, p. 1.

- The general government deficit is estimated at 2.8% of GDP in 2003, compared with 2.7% in 2002 and 4.4% in 2001. The outcome for 2003 complied with the Council recommendation issued under Article 104(7), particularly as regards the reduction of the government deficit below the reference value of 3% of GDP by 2003 at the latest. Fiscal adjustment was pursued in 2003 on the back of a sustained deceleration in the pace of total current primary expenditure growth from 8.9% in 2001 to 7.8% in 2002 and 4.1% in 2003. However, the current cyclical downturn, which ended in a recession in 2003, led to a significant deviation of 2.6 percentage point between the GDP growth outcome for the year and the initial budgetary projection. As a result, a massive shortfall in tax revenue developed during 2003, which had to be offset by the adoption of two one-off measures, together worth 2.1% of GDP.

- The Commission services' 2004 Spring forecast projects a general government deficit of 3.4% of GDP for 2004, thereby significantly above the official target of a deficit of 2.8% of GDP. The difference can basically be accounted for by: (i) somewhat lower growth than assumed in the budget; (ii) base effects associated with the one-off measures taken in 2003; and (iii) the planned partial replacement so far of such one-off measures. Therefore, additional measures are needed in order to prevent the government deficit from rising above the 3% of GDP reference value in 2004 and following years.

- After the cut-off-date for the Commission Spring 2004 forecast, the Portuguese authorities made public their intention to carry out further (real estate related) operations to allow the deficit to stay below 3% of GDP in the current year.

- According to the values reported in the first 2004 EDP notification, the government debt ratio was kept below the 60% of GDP reference value in 2003, thereby in accordance with the Council recommendation issued under Article 104(7), although it has steadily increased since 2001, and according to the Commission services' 2004 Spring forecast, is projected to exceed that value in 2004.

(6) Decision 2002/923/EC should therefore be repealed, while in the light of the risks to the budgetary position highlighted by the Spring forecast, it is of the utmost importance that the Portuguese authorities take the appropriate measures to ensure that the general government deficit remains below 3% of GDP.

(7) For the consolidation to be sustained and in order to eventually achieve the medium-term objective of a budgetary position of close to balance or in surplus, in line with the broad economic policy guidelines, all one-off measures should be gradually replaced by measures of a more permanent nature, while the cyclically-adjusted budgetary position should improve by at least 0.5 percentage point of GDP per year.

HAS ADOPTED THIS DECISION:

Article 1

From an overall assessment it follows that the correction of the excessive deficit situation in Portugal was completed in 2003, under the terms of the recommendation addressed to Portugal on 5 November 2002 in accordance with Article 104(7) of the Treaty.

Article 2

Decision 2002/923/EC is abrogated.

This Decision is addressed to the Portuguese Republic.

Done at Brussels, [...]

For the Council

The President [...]