EUROPEAN COMMISSION Brussels, 22.2.2017 SWD(2017) 74 final COMMISSION STAFF WORKING DOCUMENT Country Report Spain 2017

Including an In-Depth Review on the prevention and correction of macroeconomic

imbalances Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2017 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under

Regulation (EU) No 1176/2011



{COM(2017) 90 final}

{SWD(2017) 67 final to SWD(2017) 93 final}



Contents Executive summary1 1.Economic situation and outlook4 2.Progress with country-specific recommendations9 3.Summary of the main findings from the MIP in-depth review12 4.Reform priorities20 4.1.Public finances and taxation20 4.2.Financial sector and private sector deleveraging31 4.3.Labour market, education and social policies36 4.4.Investment45 4.5.Sectoral policies52 4.6.Public administration56 A.Overview table59 B.MIP Scoreboard64 C.Standard tables65 References70



LIST OF Tables 1.1.Key economic, financial and social indicators — Spain8

2.1.Summary table on 2016 CSR assessment10 3.1.Current account and net international investment position sensitivity analysis15 3.2.MIP assessment matrix — Spain16 4.1.1.Correlation between (1) changes in regional revenues and (2) changes in expenditure with changes in regions' deficits30 B.1.The MIP Scoreboard for Spain64 C.1.Financial market indicators65 C.2.Labour market and social indicators66 C.3.Labour market and social indicators (continued)67 C.4.Product market performance and policy indicators68 C.5.Green growth69 LIST OF Graphs 1.1.Contributions to GDP growth4 1.2.Net lending/borrowing by sector5 1.3.Breakdown of unit labour costs (ULC)6 1.4.Employment, unemployment and long-term unemployment6 3.1.Non-cyclical current account and NIIP13 3.2.Breakdown of rate of change of net international investment position13 4.1.1.Evolution of expenditure ratios for various categories24 4.1.2.General government revenue, expenditure and balance by subsector25

4.1.3.Expenditure structure of regional governments, 201425 4.1.4.Revenue structure of regional governments, 201526 4.1.5.Evolution of the Regional Authority Index since 1980 and level in 201027 4.1.6.Taxing power of the regional government sector (as % of general government tax revenue)27 4.1.7.Regional governments: real expenditure in EUR per capita by COFOG function. Differences 2015-200630 4.2.1.Non-performing loans31 4.2.2.Financing the Spanish economy31 4.2.3.Bank loans to the private sector32 4.2.4.Indebtedness by sector32 4.2.5.Breakdown of y-o-y changes in households’ debt-to-GDP ratio33 4.2.6.Households’ financial assets acquisition33 4.2.7.Breakdown of y-o-y changes in NFCs’ debt-to-GDP ratio33 4.2.8.NFCs’ balance sheet and financial position34 4.2.9.The interest coverage ratio for Spanish construction SMEs34 4.2.10.The interest coverage ratio for Spanish manufacturing SMEs35 4.3.1.Share of temporary employees, transition rates from temporary to permanent, wage premium for permanent and full-time temporary employed at risk of not being entitled to unemployment benefits.37 4.3.2.Shares of temporary employees by age and education level (2015)38 4.3.3.In-work-poverty rate, groups, Spain42 4.3.4.Changes in social protection expenditure in real terms, and contributions by function42 4.4.1.Breakdown of external position45

4.4.2.Trade balance of goods (Jan-Nov), total and non-energy products45 4.4.3.Density function of Spanish export value per quality rank46 4.4.4.Breakdown of rate of change of unit labour costs47 4.4.5.Total factor productivity of small firms for selected sectors in Spain, France and Italy47 4.4.6.Allocative efficiency in selected sectors in Spain, France, Germany and Italy 201348 LIST OF Boxes 2.1.Contribution of the EU budget to structural change in Spain11 3.1.Euro area spillovers18 4.1.1.Long-term projections of general government debt21 4.1.2.EUROMOD simulations for narrowing of the actionable policy gap in VAT23 4.4.1.Investment challenges and reforms in Spain51 4.6.1.Selected highlights58 Executive summary This report assesses Spain’s economy in light of the European Commission’s Annual Growth Survey published on 16 November 2016. In the survey, the Commission calls on EU Member States to redouble their efforts on the three elements of the virtuous triangle of economic policy — boosting investment, pursuing structural reforms and ensuring responsible fiscal policies. In so doing, Member States should focus on enhancing social fairness in order to deliver more inclusive growth. The Commission also published the Alert Mechanism Report (AMR) that initiated the sixth round of the macroeconomic imbalance procedure. The in-depth review, which the 2017 AMR concluded should be undertaken for the Spanish economy, is presented in this report. The Spanish economy continues to enjoy a strong recovery and is moving towards a more balanced composition of growth than before the crisis. In its third year of expansion, Spanish real GDP is almost back to its 2008 pre-crisis peak. The recovery was initially led by exports, helped by a reversal of the cost-competitiveness losses accumulated in the pre-crisis years. It then gradually broadened to the domestic sector. Since 2015, high job creation, low oil prices and improving financing conditions have boosted consumer spending. Investment in equipment has also been growing strongly, while investment in construction has started to recover. The current-account balance maintains a surplus position. Growth is expected to slow, but remain robust. Spain’s ambitious structural reforms in recent years laid the ground for the strong economic recovery, but favourable conditions also helped. As oil prices pick up, and assuming geopolitical tensions in competing tourist destinations subside, Spain's external balance may worsen. Furthermore, no further significant cost-competitiveness gains are expected as productivity growth remains modest and wage growth resumes. Domestic demand is set to lose vigour as falling prices, the tax cuts implemented in 2015-2016, and the improvement in financing conditions no longer provide a boost. Overall, real GDP growth is expected to moderate but remain robust, at 2.3 % in 2017 and 2.1 % in 2018. The legacy of the crisis has not yet been fully overcome, and significant challenges remain. Spain has undertaken a substantial economic adjustment, but the stock of imbalances leaves the economy vulnerable. Private sector debt continued to decrease, supported by a healthier financial sector, but public sector debt has not been reduced, resulting in a slow reduction of the very high level of external debt. Although unemployment has been falling rapidly, it remains very high, and both poverty and income inequality are among the highest in the EU. Spain represents a source of moderate spillovers to other euro area countries. Simulations show that an increase in government expenditure (e.g. for higher education and R&D support), financed by a value-added tax rise would have limited impact on the growth of other euro area countries, except Portugal, for which Spain is the main export market.

Overall, Spain has made limited progress in addressing the 2016 country-specific recommendations (CSRs). It should be borne in mind when assessing progress towards implementing the CSRs that, since the publication of the CSRs and until early November 2016, Spain had a caretaker government without full legislative powers. On the fiscal CSR, in November 2016 the Commission concluded that the excessive deficit procedure could be kept on hold. However, limited progress was achieved in strengthening public procurement policy frameworks, and some progress in implementing the fiscal framework law. Some progress was achieved in the provision of individualised support by the regional employment services. However, limited progress was made in improving coordination between employment and social services, addressing gaps in social benefits and improving family support, including the provision of child-care services. Some progress was made in the provision of long-term care services. Progress was limited in improving the labour market relevance of tertiary education and in fostering university-business cooperation, as well as in increasing performance-based funding for public research bodies and private sector investment in research and innovation. In goods and services markets, limited progress was made in implementing the 2014 retail reform, and some progress in implementing the market unity law at regional level. No progress was made in the regulation of professional services. Regarding progress in reaching the national targets under the Europe 2020 strategy, Spain is performing well in reducing greenhouse gas emissions and is also on track to achieve the agreed renewable energy share. The tertiary education attainment target is within close reach. While the country is still far from the targets for the employment rate and early school leaving, the gaps were reduced substantially in 2015 and 2016. By contrast, there was little progress towards the targets for R&D investment, energy efficiency, and reducing poverty risk. The main findings of the in-depth review contained in this report, and the related policy challenges, are as follows: Current account surpluses are translating into a slow reduction of Spain's net external liabilities. The current account adjustment since the aftermath of the crisis has been largely due to structural improvements in export performance, supported by sustained cost competitiveness gains. However, recently it has also been driven by temporary factors, such as the low oil prices, which are gradually abating. Moreover, the still sizeable amount of external liabilities exposes the country to shifts in market sentiment. In order to bring them to prudential levels, Spain needs to maintain current account surpluses over a sustained period of time. Private sector debt reduction has continued, but indebtedness remains high, especially for households. The total stock of private sector debt has continued to fall, although the pace of reduction has slowed as new credit has started to flow again. Economic growth has become, and is expected to remain, the main driver of debt reduction in the medium term, also facilitated by the expected rebound in inflation. Debt reduction needs have significantly declined for the corporate sector, but remain relatively high for households. The financial sector has continued to show a high degree of stability, supported by its ongoing restructuring, low funding costs and the economic recovery. The banking system further strengthened its capital buffers and the six largest Spanish banks comfortably met their capital requirements in the EBA stress tests of July 2016. The aggregate non-performing loan ratio fell to just above 9% in November 2016. As elsewhere in Europe, squeezed profitability, against the background of low interest rates and remaining scope to further improve the sector's business model, is the main challenge. The outstanding volume of credit is still falling, but bank lending to firms, in particular small and mediumsized enterprises, and consumer credit have resumed, supporting economic activity. Fiscal sustainability risks remain high in the medium term. Spain's general government debt ratio remains high, at just below 100 % of GDP in 2016. While in the long term the projected savings in age-related expenditure would significantly mitigate risks to fiscal sustainability, the public debt ratio is expected to continue rising in the medium term. On the revenue side, fiscal adjustment is not sufficiently supported by consumption taxes, mainly due to a large policy gap in VAT, and environmental taxes. On the expenditure side, some ongoing and planned policy initiatives aim to increase efficiency of spending at all government levels, though weaknesses in public procurement remain an obstacle. Job creation has been strong in recent years and unemployment decreased rapidly, but remains very high. Labour market reforms are credited to have cushioned the fall in employment during the later stages of the crisis and increased the responsiveness of employment to growth. Wage moderation has also been an important driver of strong job creation and competitiveness gains in recent years. The unemployment rate has been declining rapidly in the past three years, but remains among the highest in the EU, especially among young and lowskilled workers. Almost half of the unemployed have been without a job for more than a year. Spain is taking measures to strengthen individual support to the long-term unemployed, but their effectiveness depends on the capacity of the regional public employment services. Other key economic issues analysed in this report pointing to particular challenges for Spain’s economy are: The cooperation of regional governments is critical for Spain to reach its fiscal targets. Over 2013-2015, regional governments were responsible for around one third of the average annual general government deficit. While enjoying a high degree of tax autonomy, the extent to which it has been used to finance increases in spending has varied across taxes and regional governments. Limited use of the preventive and corrective tools established in domestic legislation and other policy settings have not provided sufficient incentives for fiscal discipline. The widespread use of temporary contracts may impact negatively on the social situation and hinder productivity growth. Spain has one of the highest shares of employees on temporary contracts in total employment in the EU. Many of these contracts are of very short duration. The widespread use of temporary contracts may harm productivity growth, including through lower on-the-job training opportunities. Too often, temporary jobs fail to be a stepping stone into stable careers and might be associated with poorer working conditions and higher poverty risks. The recent labour market reforms seem to have a mildly positive effect in reducing segmentation between permanent and temporary contracts, but some aspects of the labour law may still create an incentive to hire on temporary contracts. Weaknesses in activation and social policies hinder a fast reduction in poverty. The risk of poverty or social exclusion started to decline in 2015. However, it remained very high, especially for children, and in-work poverty was still on the rise. Limited coverage of social benefits other than pensions, and lack of coordination between employment and social services leave many jobless people without support in their efforts to (re)enter the labour market. Support to families is low and poorly targeted to low-income families. Gaps in education outcomes are set to hamper future productivity growth. The average students' performance remains stable and Spain still has the highest share of early school leavers and low basic skills among adults in the EU, despite measures to improve the attractiveness of vocational education and training. Wide regional disparities in the performance of students remain. The employability of university graduates is relatively low. Innovation performance remains weak, despite some modest improvements. Expenditure for research and development as a share of GDP and innovation performance have both continued to decline. A complex governance framework and lack of an evaluation culture weigh on the effectiveness of R&I support. Despite some bright spots, coordination of regional and national innovation policy is still limited. Obstacles to cooperation between universities and businesses remain, in particular regarding technology transfer and the inter-sectoral mobility of researchers. The business environment hampers efficient resource allocation and productivity growth. The average cost of starting a business is higher than in most Member States and varies substantially across regions. Shortages of digitally skilled labour slow down the integration of digital technologies into the economy. The implementation of the market unity law only made minor advances in 2016 and regulation of professional services remains restrictive and the corresponding mark-ups high. Venture capital remains underdeveloped, even though public support instruments contributed to stimulating its supply. The public procurement policy framework does not foster efficiency and legal compliance. Spain lacks a nation-wide public procurement policy that ensures efficiency and legal compliance and a high level of competition across the country. Some measures have been taken recently to improve public procurement practices, but weaknesses remain, including low coordination across general government levels, insufficient control mechanisms, gaps in transparency and a relatively low use of centralised purchasing. 1. Economic situation and outlook Economic growth The Spanish economy expanded by 3.2 % in 2016, well above the euro area average. On its third year of expansion, GDP growth has continued to outpace the euro area average, and the level of output has almost reached its pre-crisis level. Growth has continued to surprise on the upside in recent quarters, and GDP expanded by 3.2% in 2016, the same rate as in 2015 (European Commission 2017a). The composition of growth is expected to have been more balanced in 2016 than in previous years. Growth is projected to have been driven by private consumption and investment, but the external sector is expected to have had a positive contribution to growth in 2016 for the first year since the recovery started (see Graph 1.1). Graph 1.1:Contributions to GDP growth Source: European Commission

As favourable tailwinds gradually subside, growth is expected to decelerate but remain robust. Real GDP growth is projected at 2.3 % in 2017 and 2.1 % in 2018, mainly driven by domestic demand. Private consumption is expected to slow down as job creation decelerates, and other factors that supported the growth of disposable income in recent years - i.e. declining oil prices, tax cuts and improving financing conditions - gradually abate. However, private consumption is projected to remain the main contributor to growth until 2018. Investment is expected to be affected by two opposing trends, with growth in residential and non-residential construction investment gradually recovering, while equipment investment growth is expected to moderate in line with final demand. This is likely to lead total investment growth to ease slightly in 2017, before picking up modestly again in 2018. External position The contribution of the external sector to growth is expected to remain positive until 2018. Export growth is expected to have slowed down slightly in 2016 and ease a bit further in 2017, before picking up in 2018 as Spain's trading partners recover, also reflecting structural improvements in export performance (see Section 4.4.1). Import growth is projected to follow a similar pattern, slowing down in 2016 and 2017, and accelerating in 2018, in line with the evolution of final demand. However, as growth of imports is expected to remain below that of exports until 2018, net trade is set to give a positive contribution to growth throughout the period. However, after a projected increase in 2016, Spain’s current account surplus is forecast to decline somewhat in 2017 and 2018, mainly reflecting the impact of the expected deterioration in the terms of trade. Net external lending is similarly expected to gradually decline in until 2018. The current account surpluses recorded in recent years are finally translating into a reduction of Spain's external liabilities. The net international investment position (NIIP) has been improving since 2015, but remains sizeable at -88.7 % of GDP in Q3-2016. At the same time, the composition of external liabilities has been gradually shifting from the private to the public sector. The expected continued strong growth, pickup in inflation and net external surpluses projected until 2018 should facilitate the further improvement of the NIIP. However, the current external dynamics do not seem sufficient to decisively bring down the NIIP over the medium term (See section 3.2). Private indebtedness Private sector deleveraging is progressing, but the level of debt is still high. Private sector debt stood at nearly 167.5 % of GDP in Q3-2016, a decrease of about 50 % of GDP since its peak (see Section 4.2). A large part of this reduction — about 30 pps. — has been due to the fall in debt of non-financial companies (NFCs), but progress in household deleveraging was also quite remarkable (see Graph 1.2). Real growth has now become the main driver of the reduction in debt ratios, as new credit to households and SMEs has continued to grow, supported by a healthier financial sector. However, deleveraging needs are still sizeable, especially for households. Graph 1.2:Net lending/borrowing by sector Source: AMECO Public finance The general government deficit is declining, but the debt ratio has not been put on a declining path. The general government debt ratio is expected to stabilise at around 100 % of GDP, as strong nominal GDP growth largely offsets the still large, though declining, deficit expected until 2018. The deficit in 2015 was 5.1 % of GDP and recent data indicate that Spain’s general government deficit only narrowed by 0.3% in the first three quarters of 2016. Whereas expenditure has grown in line with expectations, significant shortfalls in income tax revenue have weighed on revenue growth. According to the Commission 2017 winter forecast, this should lead to a deficit of 4.7 % of GDP in 2016. At unchanged policies, the deficit is expected to narrow to 3.5 % and 2.9 % of GDP in 2017 and 2018. Inflation Inflation is expected to pick up, as oil prices increase and core inflation recovers. The projected oil price increases are set to continue dominating inflation developments in the short term. Headline inflation is forecast to rise from −0.3 % in 2016 to 1.9 % in 2017, before decreasing slightly to 1.7 % in 2018 as the effect of energy price increases fades away. At the same time, core inflation is expected to gradually increase over the next two years, as wages pick up, the output gap closes, and the energy price increases pass-through into consumer prices. Labour market Strong job creation has continued throughout 2016, and it is expected to moderate but remain robust until 2018. The employment rate increased again in 2016 on the back of sustained economic growth but is still well below the pre-crisis level (64.5 % in Q3-2016, compared to 69.7 % in 2007) and the EU average (71.5 % in Q3-2016). Robust job creation has been underpinned by ongoing wage moderation and the labour market reforms implemented in previous years. Full-time equivalent employment is expected to have expanded by 2.9 % in 2016, and is expected to grow further by 2.0% and 1.7% in 2017 and 2018 respectively. Wage moderation has also been facilitated by very low inflation. However, as inflation gradually picks up, wages are projected to increase. This, together with very low productivity growth, is likely to result in increasing unit labour costs (see Graph 1.3). Graph 1.3:Breakdown of unit labour costs (ULC) Source: AMECO Social developments The improvement in the labour market translated into a small decline in poverty and social exclusion rates. Despite having fallen rapidly, the unemployment rate and the share of long-term unemployment remain very high (18.6 % and 45.9 % in Q4-2016 respectively, see Graph 1.4 and Section 4.3.1). Improved labour market conditions led to a decline in poverty and social exclusion rates in 2015 ( ). However, they remained at very high levels, affecting people in working age and children in particular. In addition, the regional variation in employment rates increased significantly during the crisis and is the second highest in the EU ( ). Graph 1.4:Employment, unemployment and long-term unemployment Source: Instituto Nacional de Estadistica, Eurostat Income inequality, as measured by the income quintile ratio ( ), widened during the crisis, and is one of the highest in the EU. This trend was largely due to soaring unemployment and persistent segmentation ( ), which mainly increased inequalities at the bottom of the income distribution (OECD 2015). The polarisation of skills between a high share of low-skilled and rather high share of tertiary educated is another important factor (Eurofound 2014). In 2014, the overall inequality reduction impact of the tax and benefit system — as measured by the difference between the Gini coefficients ( ) before and after taxes and transfers — remained below the EU average despite an increase recorded since 2007 (European Commission 2016a, Chapter 1). Efforts to improve the progressivity of the system in the context of the reforms implemented since 2008 (De Agostini et al. 2016) have been weakened by the pressure on expenditure (and lower revenues). Inequality in net wealth ( ) was within the range observed in other EU countries for which data were collected in 2013-2014 (ECB 2016). Inequalities in access to healthcare have also risen significantly from low levels during the crisis ( ). Table 1.1:Key economic, financial and social indicators — Spain Source: European Commission, European Central Bank

2. Progress with country-specific recommendations Progress with the implementation of the recommendations addressed to Spain in 2016( ) has to be seen in a longer term perspective since the introduction of the European Semester in 2011. Spain has a comparatively good record of Country Specific Recommendations (CSRs) implementation since 2011, which has however weakened since 2014, as the recovery gathered strength and reform fatigue set in. The Spanish economy has experienced a significant turnaround in recent years, also thanks to reforms undertaken in a challenging economic environment that partially addressed some of the rigidities in labour, product and financial markets. Progress has been visible in the policy areas of financial sector, labour market and the long term sustainability of the public finances. Over the past few years, Spain has made substantial progress in restructuring the financial sector. The law on savings banks to strengthen their governance and reduce controlling stakes held by banking foundations has been applied. The implementation of plans for restructuring State-aided banks is well advanced. The labour market reforms undertaken in recent years have made employment more responsive to growth and job creation has resumed, supported by increased flexibility and continued wage moderation. Spain has also made progress in ensuring long-term sustainability of public finances also thanks to the 2011 and 2013 pension reforms. Spain has also improved its fiscal framework. The 2012 Stability Law, as amended, the creation of an independent fiscal institution in 2013 and improvements made in the reporting of budgetary execution are cases in point. However, the assessments accompanying the Country Specific Recommendations have frequently noted that there is scope for a more automatic implementation of the Stability Law's preventive and corrective mechanisms. Progress made in implementing product market reform CSRs has been mixed. Over the past few years the CSRs have called on the Spanish government to address regulatory fragmentation in Spain's internal market. The law on the guarantee of market unity has been in force more than three years. However, its implementation has visibly slowed down since the last quarter of 2015, judging from the limited progress made in adapting sector specific legislation to the principles of the law. The Council has also recommended Spain to reform professional services. However, since 2010, no horizontal reform of regulated professions has been adopted other than in the area of professional board certification of projects. Likewise, the benefits of the 2014 retail sector reform adopted by Spain's central government still depend on regional governments adopting the necessary implementing acts. On a more positive side, the Spanish government has reformed the corporate and personal insolvency policy frameworks and has taken measures to ease business licencing procedures. Overall, Spain has made limited ( ) progress in addressing the 2016 country-specific recommendations. This has taken place against the backdrop of a government without full legislative powers until November 2016. On CSR1, there has been some progress in implementing Spain's Stability Law at all government levels but limited progress on strengthening Spain's public procurement policy framework. The Commission finds that Spain has made some progress in implementing CSR2, following the adoption of a three-year action plan to strengthen the employment services' capacity to provide individualised support for long-term unemployed and the evaluation made of the regional employment services. On CSR3, progress is limited, as only small steps have been taken to increase performance-based funding of public research organisations and universities and to combine vocational training with higher education. On CSR4, Spain has made limited progress, judging from the slow pace of implementation of the law on market unity and the 2014 retail reform at regional level and as the reform of professional services has not yet been adopted.

Table 2.1:Summary table on 2016 CSR assessment Source: European Commission 3. Summary of the main findings from the MIP in-depth review 3.1.Introduction The 2017 Alert Mechanism Report called for further in-depth analysis to monitor progress in the unwinding of the imbalances identified in the 2016 MIP cycle. The selection was motivated by the fact that Spain was identified to have imbalances in spring 2016 after the last In-Depth Review (IDR) analysis, so that a new IDR is needed to assess how these imbalances evolve. The identified imbalances related to the high levels of external and internal debt, both private and public, in a context of high unemployment. This Country Report provides an In-Depth Review into how the identified imbalances have developed. In particular IDR relevant analysis is found in the following sections: high government debt is analysed in Section 4.1.1; private sector indebtedness and its links with the financial sector are discussed in Sections 4.2.1 and 4.2.2; and external adjustment and competitiveness is assessed in section 4.4.1. An additional IDR relevant topic through its links to external sustainability and growth is that of productivity, also analysed in Sections 4.4.1 and 4.4.2. Labour market adjustment related aspects are dealt with in Section 4.3.1. Potential spillovers to the rest of the euro area are discussed in Box 3.1. 3.2.Imbalances and their gravity Spain's net international investment position remains very negative, and is mostly composed of debt. The large stock of net external liabilities (-88.7 % of GDP in Q3-2016) is mainly composed of net marketable debt (about 80% of GDP) ( ), leaving the country highly exposed to adverse shocks or shifts in market confidence. Equity instruments (foreign direct investment / portfolio equity) do not imply the same risks as debt for external sustainability given that dividend payments can be adjusted during economic downturns, whereas servicing costs related to fixed-income liabilities are less sensitive to the cycle. Although much of the debt has long-term maturity and does not pose an immediate risk in terms of liquidity, it may pose a risk in terms of sustainability. Private sector indebtedness is still high, but low interest rates reduce the associated financial burden. Private sector debt amounted to 167.5 % of GDP in Q3-2016 (65.2 % of GDP as household debt and 102.3 % of GDP as non-financial corporation debt, hereafter, NFC). A high level of debt increases vulnerability to interest rate shocks, and its associated financial burden constrains domestic demand. The financial position of Spanish households has strengthened thanks to improvements in the labour market and growing real disposable income, partly due to low or negative inflation and lower income taxes. Furthermore, the financial burden of household debt has been reduced by the prevailing low interest rates. However, indebted Spanish households are among the most vulnerable in the euro area to interest rate increases (Ampudia et al., 2014). On the corporate side, the net financial wealth of firms improved in 2015 for a third consecutive year, but is still negative. Spain’s general government debt ratio remains high, and fiscal sustainability risks are high in the medium term. The general government debt ratio peaked at slightly above 100 % of GDP in 2014, a sharp increase of about 65 percentage points above its trough of 2007. Under normal economic conditions and with no change of fiscal policy after the last Commission forecast year (2018), the Spanish general government debt would rise to almost 108 % of GDP by 2027 (see Section 4.1). The unemployment rate is still very high (18.9 % in Q3-2016), particularly among young and low-skilled people. Besides, almost half of the unemployed have been without a job for more than one year, indicating a high risk of long-term unemployment becoming entrenched and human capital depreciation. This in turn constrains potential growth and productivity. 3.3.Evolution, prospects, and policy responses

The improvement in the current account has been due to structural, cyclical, and transitory factors (see Section 4.4.1). Spain has undergone a substantial current account adjustment in recent years, amounting to 11 pps. of GDP between 2007 and 2015. Much of this adjustment was due to an improvement in the trade balance of goods (about 6 pps. of GDP), initially driven by a collapse of domestic demand, but increasingly reflecting a structural improvement in export performance, such as the expansion in the number of regular exporters and cost competitiveness gains. Some of the improvement in the current account was also been driven by non-cyclical, transitory factors, such as low oil prices, low interest rates, or the depreciation of the euro (See Section 4.4.1). In cyclically adjusted terms, the current account has continued to improve (see Graph 3.1). However, the elasticity of imports with respect to final demand remains high, and no significant changes in import substitution are detected yet at the aggregate level. In addition, after years of cost-competitiveness gains, unit labour costs (ULC) have started to increase again and converge to the euro area average. Graph 3.1:Non-cyclical current account and NIIP Source: AMECO, European Commission Current account surpluses are finally translating into a slow reduction of Spain's net external liabilities (see Graph 3.2). The external surpluses registered since 2013 and, as of 2014, high nominal growth, have started to translate into a slow reduction of Spain's net international investment position (NIIP) – Graph 3.2. Valuation effects, which played a strong role in the deterioration of net external liabilities in 2013 and 2014, have been broadly neutral since 2015. As a consequence, the NIIP has been improving since 2015, but at -88.7 % of GDP in the third quarter of 2016 it remains sizeable. In the short term, net external surpluses, strong real growth, and the pickup in inflation projected until 2018 should facilitate the further improvement of the NIIP. Graph 3.2:Breakdown of rate of change of net international investment position Source: Eurostat Spain would need to maintain the current account surpluses over sustained periods of time in order to decisively reduce its net external liabilities. Even under relatively benign growth and inflation scenarios, Spain would need to maintain current account surpluses over a long period of time in order to bring down decisively its NIIP (See Table 3.1). In this context, the current account surpluses projected over the next two years continue to be partly driven by transitory factors. Maintaining these surpluses over sustained periods of time may therefore be challenging. This underscores the importance of safeguarding cost competitiveness, given that Spain is specialised in price-sensitive market segments. While cost-competitiveness gains in recent years have been largely achieved through wage moderation, supporting productivity growth is a key challenge going forward. Higher productivity growth could also attract foreign direct investment (FDI) and reduce import dependence, thereby supporting external sustainability. Private sector deleveraging is increasingly driven by GDP growth, while new credit continues to grow. Private sector debt has been reduced by more than 50 pps. of GDP since its peak in 2010. A large part of this reduction has been due to a decline in NFC debt (about 30 pps. of GDP), but progress in households deleveraging (20 pps. of GDP) was also remarkable. Even so, deleveraging needs remain sizeable, mainly for households. Although the outstanding volume of credit to the private sector is still shrinking, new bank lending to households and SMEs continues to grow. As new credit increases, debt reduction is now being supported by real GDP growth, especially for households (see section 4.2.2). Although NFC deleveraging has been mainly driven by negative credit flows, it is also now increasingly driven by real GDP growth. The projected pickup in inflation should further facilitate deleveraging in the private sector, even though consumption and investment are forecast to keep registering robust growth rates. In 2016, Spanish banks furthered the process of balance sheet clean-up through the reduction in the crisis legacy of non-performing loans (NPLs). The banking system has ample access to liquidity and can comfortably meet the regulatory capital requirements. Solvency levels are resilient to a stress scenario, and the quality of banks' assets has further strengthened. The stock of NPLs went further down to 9.4 % as of July 2016, and is now close to the euro area average. After a sharp adjustment since the crisis, the housing market and the construction sector have bottomed out, and housing prices have been rising for almost three years in a row. Despite these positive signs, there is still a large stock of unsold houses, especially in some areas. The evolution of the real estate market remains important for banks’ future profitability. Reforms undertaken in 2014/2015 made corporate and personal insolvency and out-of-court procedures more flexible. Although the number of insolvency cases has continued declining, especially for corporate insolvencies, this has been to a large extent due to the improvement in economic conditions. Public sector debt is not being reduced. The deficit in 2015 was 5.1 % of GDP. According to the Commission 2017 winter forecast, the deficit should decline to 4.7 % of GDP in 2016. It is then expected to narrow to 3.5 % and 2.9 % of GDP in 2017 and 2018. Since 2014, the slow reduction of the deficit has been relying to a large extent on the positive macroeconomic outlook and the improving financing conditions. Public sector debt is expected to remain stable at around 100 % of GDP, as strong nominal GDP growth largely offsets the still large, though declining, deficit expected until 2018. Thanks to the relatively benign macro-financial situation, there is no immediate risk of fiscal stress. However, risks to fiscal sustainability remain significant in the medium term (See Section 4.1.1). The labour market has kept improving, but high levels of long-term unemployment increase the risk of human capital depreciation. Strong job creation has continued throughout 2016, and is expected to slow but remain robust until 2018. Robust job creation has been underpinned by ongoing wage moderation and the labour market reforms implemented in previous years. These include a reform of the wage bargaining system to promote more wage bargaining decentralization. Despite this, evidence shows that firm level bargaining is not picking up. The minimum wage has increased by 8% in 2017, but the immediate impact on job creation and the overall wage distribution is likely to be modest (see section 4.3.1). There is however a risk that high unemployment becomes entrenched. Spain is taking measures to strengthen individual support to the long-term unemployed, but their impact relies on the capacity of the regional public employment services, which so far has been limited. In addition, addressing the education gaps is critical to reduce structural unemployment and support the reallocation of resources towards more productive activities. Table 3.1:Current account and net international investment position sensitivity analysis Source: European Commission calculations The share of temporary work is very high, with negative impact on productivity growth and social cohesion. There is evidence that labour market segmentation negatively affects productivity through various channels (see section 4.3.1). The impact of the labour market reforms in reducing segmentation has been mildly positive. 3.4.Overall assessment Spain has undertaken a substantial adjustment in terms of flows, but significant vulnerabilities remain in terms of stocks. Private sector deleveraging has continued to advance. However, public sector debt has not been reduced on account of large but declining deficits, resulting in a slow reduction of the very high level of net external debt. In order to bring down decisively its stock of external liabilities, Spain would have to record large current account surpluses over a long period of time. Based on current external dynamics, this appears challenging. Low productivity growth makes competitiveness gains hinge on cost advantages, also affecting working conditions. Besides, some of the factors behind the improvement in the external balance have been of a transitory nature. Although unemployment has been declining rapidly, it remains very high, especially for the young and long-term unemployed, and risks becoming entrenched. Measures have been taken to maintain cost competitiveness, but continued efforts are needed to further strengthen the resilience of the banking sector, ensure a durable reduction of the general government deficit and resume structural growth. Table 3.2:MIP assessment matrix — Spain (Continued on the next page) Table (continued) Source: European Commission (Continued on the next page)

Box (continued) 4. Reform priorities 4.1. Public finances and taxation 4.1.1.Public Sector Debt Spainʼs general government debt ratio remains high and is not yet on a clear declining path. After rising sharply in the years following the financial crisis, the general government debt ratio peaked at slightly over 100 % of GDP in 2014, about 65 percentage points above its trough of 2007. The Commission 2016 winter forecast projects the debt ratio to stabilise at just below that peak level over 2016-18, as relatively strong nominal GDP growth largely offsets the still large, though declining, expected deficit. As the private debt ratio has declined from its peak levels, general government debt now makes up a much larger share of the total indebtedness of the economy – at around 40% in 2015 relative to around 20% in 2010, the year in which private debt peaked (See Graph 4.2.4). Spain does not appear to face immediate risks of fiscal stress. ( ) This is mainly thanks to the improved macro-financial situation, in particular strong real GDP growth, a positive current account balance and regained cost competitiveness, as well as the low proportion of short-term debt among non-financial corporations and households. In an assessment of the balance of risks stemming from the macro-financial situation, these favourable features more than offset Spainʼs still sizeable negative net international investment position and low household savings rate. Short-term risks related to the still high general government deficit and the financing structure of public debt are mitigated by improved investor confidence (as measured by the decline in yield spreads since 2012). Nevertheless, the still high general government deficit and debt ratios remain a source of vulnerability to changes in market sentiment, also given the proportion of total public debt that is of a short-term nature (8.0 %) or held by non-resident creditors (43.3%). Spain faces high fiscal sustainability risks in the medium term. Under normal economic conditions and with no change of fiscal policy after the last Commission forecast year (2018), the Spanish general government debt would rise to around 108 % of GDP by 2027 (last projection year). The increase of around 8 pp over a 10-year horizon is driven by the persistent primary deficit throughout the projection period and a growing interest rate-growth differential, especially in the latter part of the projection period (see Box 4.1.1 for further details and for alternative debt projection scenarios). Furthermore, Spain's structural primary balance would need to improve by as much as 4.6 % of GDP in cumulated terms over a five-year horizon (from 2018 until 2023) relative to the baseline no-fiscal policy change scenario to reach the 60 % public debt-to-GDP ratio reference value by 2031( ). In the longer term, risks to fiscal sustainability are significantly mitigated by savings in age-related expenditure. These correspond to savings in non-health ageing related spending (pensions, education and unemployment benefits), also due to the recent pension reform. By contrast, public expenditure on health care and long term care is projected to increase slightly above the average increase for the EU over the horizon till 2060 (by 1.1 pp against 0.9 pp, respectively). The projection is based on current expenditure trends and the expected demographic changes. The persistent deficit of the social security system is receiving policy attention. Two successive reforms of the pension system, in 2011 and 2013, will help contain the increase in pension expenditure in the long term, while also resulting in lower income replacement rates at retirement. However, despite these reforms social security sector has been running widening deficits since 2011. Behind this development lies the loss of revenues as employment fell in the wake of the crisis while pension expenditure continued to increase, driven by demographic trends and the fact that new entrants have higher pensions than those who exit the system. More recently, the rebound in employment is supporting contributions paid into the system, but the 0.25% minimum annual revaluation of pensions in a context of low or even negative inflation, and the various employment incentive schemes in the form of contributions' rebates, have weighed on social contributions' revenues. To strengthen revenues, in December 2016 the government raised the maximum contributory base by 3%. ( ) This is expected to bring in EUR 300 million in additional revenues in 2017. On 22 November 2016, the Toledo Pact parliamentary committee ( ) launched a discussion on the possible further revisions of Spain's pension system, in the light of the persistent social security deficit but also as part of a regular review of the sustainability and sufficiency of the pension system against the backdrop of the increase in life expectancy and low fertility rates. The Committee will look into measures to be adopted in the short term to reduce that deficit (e.g., through the allocation of existing tax revenues to the funding of social security rebates and/or survivors' pensions). 4.1.2.Tax and Government Spending Structure Spain raises less tax revenue as a share of GDP than the EU or euro area average. In 2015, Spain's tax burden accounted for 34.6% of GDP in 2015 compared to an EU average of about 40% and euro area average of 41.4%. Spain raises roughly equal shares of revenues from indirect taxes, direct taxes and social contributions (see 2016 country report for details). Measured by the implicit tax rates on labour or the tax wedge on the average wage, Spain ranks low in the league table of EU countries. The scope for higher taxation on labour income is however limited, given the need to bring down the high unemployment rate. The low share of consumption tax revenues is linked to a relatively high policy gap in VAT ( ). At 21 %, Spain's standard VAT rate was in line with the EU median in 2014. However, Spain has relatively low VAT revenues. This is mainly due to Spain extensively applying exemptions or reduced rates ( ) on various goods and services. As a result, Spain recorded the largest policy gap in the EU in 2014 (59 % compared to the EU average of about 44 %), up from 53.9 % in 2013. In contrast, the VAT compliance gap ̶ the difference between the theoretical VAT liability and the revenue actually received ̶ continued to decrease and amounted to 9 % in 2014 (down from a peak of 14 % in 2011), significantly below the EU average of about 14 % (see 2016 country report for a more detailed discussion of measures against fraud). A reduction of the policy gap in VAT is likely to bring in higher tax revenues. Simulations conducted by the European Commission Joint Research Centre based on the EUROMOD model (See Box 4.1.2) show that reducing the actionable VAT policy gap would increase revenues by 0.2-1.4 % of GDP, depending on the scope and extent of the reduction. Any negative distributional effects can be reduced or avoided by giving priority to items with little or no regressive effects or compensated through other means, such as social transfers. Environmental taxes are still below the EU average, despite increases in recent years. Environmental taxes in Spain amounted to about 1.8 % of GDP in 2014, compared to an EU average of about 2.5 % of GDP. In particular, taxes on transportation only yield half as much revenue in Spain as the EU average, reflecting a relatively low level of excise duties on both unleaded petrol and diesel. As a share of total tax revenues, Spain also relies less on environmental taxes than its EU peers (5.5 % vs 6.3 %). In property taxation, Spain relies to a relatively low extent on recurrent taxes. While overall revenues from property taxation in Spain are close to the EU average, the recurrent element is below the EU average (1.3 % of GDP v 1.6 % in 2014). No major policy changes have been introduced in the area of property taxation in recent years, except for the gradual phasing out of mortgage deductibility. From a theoretical point of view, recurrent property taxes are considered among the taxes least detrimental to growth and preferable to transaction taxes, as the former allow a more efficient allocation of assets, as well as higher labour mobility. On the expenditure side, the crisis-induced rise in the expenditure ratio has been partly reversed. General government expenditure reached 43.8% of GDP in 2015, compared with an EU average of 48.8% and a euro area average of 49.6%. In the years following the crisis, the expenditure ratio rose sharply, as GDP fell, unemployment benefits rose sharply and other government expenditure continued to rise, but it has subsequently declined as economic growth has resumed, the interest burden has decreased and investment been reduced. However, some expenditure ratios are expected to be at higher levels in 2018 than during the years prior to the crisis, also when measured against potential GDP. Graph 4.1.1 shows the evolution of the main expenditure items from 2000 to 2018 (with 2016-2018 based on the Commission 2016 autumn forecast). Compared to the average for 2000-2007, total expenditure is expected to be about 1.9 % of potential GDP higher in 2018, despite a halving of gross fixed capital formation as a percentage of potential GDP during the crisis. Although there might have been some excessive investment in the years leading up to the crisis, the subsequent steep decline has left the former at historically low levels. Both compensation of employees and intermediate consumption have ratios above the pre-crisis period and this is expected to remain the case in 2018 (at 15.6 % of potential GDP, their aggregate ratio is expected to be 1.0 % of potential GDP higher in 2018 than the average for 2000-2007. Graph 4.1.1:Evolution of expenditure ratios for various categories Source: European Economic Forecast - Autumn 2016

Some ongoing and planned policy initiatives aim to increase efficiency of spending, but weaknesses in public procurement remain an obstacle. Efforts to implement the CORA reform continued, a programme for administrative reform launched in 2012 including a broad set of measures to enhance efficiency and effectiveness in the public sector at all general government levels. According to the latest implementation report, 87 % of the 222 concrete measures included in the reform had been implemented by June 2016( ). These measures include i) reducing duplicated administrative structures within the central government and between central and regional governments; ii). reducing administrative burdens; iii) streamlining overheads; and iv) rationalising the central government’s ‘institutional’ administration. The government has also announced that it will ask the independent fiscal body, AIReF, to undertake a general spending review to identify further areas of potential efficiency gains. Inefficiencies in public procurement policies (see Section 4.5) limit the potential efficiency gains from some of these measures. 4.1.3.Fiscal Frameworks Spain is a highly decentralised country. In 2015, consolidated regional and local government expenditure (as percent of total general government spending) stood at a level comparable to that in federal Belgium, at around 42%. Decentralisation is also considerable on the revenue side, although as in other countries, less intense than on the expenditure side: the share of total general government revenues owned by sub-central governments amounted to around 27%. In 2015, the sub-central government subsector in Spain recorded a higher share in the general government deficit than in other countries with a regional dimension and in the EU28 (Graph 4.1.2). Graph 4.1.2:General government revenue, expenditure and balance by subsector Source: Eurostat, own calculations. Graph 4.1.3:Expenditure structure of regional governments, 2014 Source: Eurostat. Cofog data Despite not being de iure a federal country, Spain has a strong regional dimension. Regional governments in Spain are responsible for a variety of expenditure functions, mostly geared towards the provision of public services such as healthcare, education, and social protection policies. Spain stands out together with Italy for the importance of the healthcare function relative to Austria and Switzerland, and above all, to Germany and Belgium, where healthcare spending is to a large extent centralised (Graph 4.1.3). Over time, the share of taxes in Spain's regional revenue has become more important than the share of transfers from other government levels, namely the central government. In 2015 the share of own taxes – excluding shared taxes on which regional governments have no normative powers, which are treated as transfers in revenue statistics - was slightly smaller than in Germany and Switzerland (Graph 4.1.4). Regional governments play an important role in shaping policies in Spain. There is more to the role of government than managing resources and providing services. The regional authority index (Hooghe et al., 2016), a composite indicator measuring the powers of regional governments across ten dimensions, including law making and policy scope (see Graph 4.1.5), also place Spain in the group of most decentralised countries in the world. The graph also shows that over the past few decades, Spain has reached comparable levels of decentralisation than long-established federal countries. The regional financing system is based on the constitutional principles of autonomy, solidarity and coordination with the government's fiscal policy. There are two regional financing systems in Spain: the common and the foral system. The former, which is the object of this section, applies to all regions other than Navarre and the Basque Country. It is regulated via Organic Law 8/1980 and ordinary law 22/2009 (as amended). In addition to the above-mentioned principles, it is based on the principle of sufficiency. It aims at ensuring sufficient homogeneity in the provision of essential public services throughout Spain while allowing for different spending patterns across regions. The latter, applies to the Basque Country and Navarre. Under this system, both regions enjoy a considerably higher level of revenues per capita than the common financing system regions, thus creating a visible asymmetry in funding.( ) Graph 4.1.4:Revenue structure of regional governments, 2015 Source: OECD. Fiscal Federalism database. To implement the principle of co-responsibility, the tax autonomy of regions has increased over time. Spanish regions have considerable discretion over their own taxes (De la Fuente et al., 2016). Their tax autonomy, as measured by the OECD taxing power index,( ) is the highest among the relevant EU countries and among the highest in the group of OECD federal countries (see Graph 4.1.6), even though tax sharing agreements in which regions have no normative powers account for a considerable part of regional tax revenue. In 2011, the share of regional tax revenues with full or partial discretion amounted to around 23% of total general government tax revenues. Regions' tax autonomy allows them to make spending decisions in the margin through increases in the taxes they control. Graph 4.1.5:Evolution of the Regional Authority Index since 1980 and level in 2010 Source: European Commission based on the Regional Authority Index. Hooghe et al. (2016). Differences in regions' initial tax capacity call for equalisation transfers under the solidarity principle. There are considerable differences in various economic indicators across regions. Disparities in income per head across regions translate into differences in regions' tax capacity, a measure of the tax revenues regions would get if they applied the same tax rates and were all equally efficient in the taxes they collect. Equalisation transfers are carried out namely through the Guarantee Fund, which aims to ensure that each region receives the same resources relative to its population (adjusted for differences in relevant demand and cost factors) to finance the basic public welfare services (i.e., education, healthcare and social services), as well as through the Convergence Funds, which redistribute resources based on regions' ranking in variables such as income per head, population density and population growth. Graph 4.1.6:Taxing power of the regional government sector (as % of general government tax revenue) Source: OECD. Fiscal Federalism database. The regional financing system is also based on the principle of sufficiency of resources. This principle, however, does not give right of an unlimited coverage of regions' spending needs by the system. Rather, it aims at ensuring that all regions have sufficient resources to provide services that have been transferred to them by the central government at a minimum level of quality - it therefore does not apply to quality improvements in the provision of those services or to new services by regions, whose funding would have to rely on the use of the regions' tax autonomy (Herrero Alcalde et al., 2011). Moreover, it implies that the allocation across regions of the total amount of available resources at each point in time should be done with respect of the principles of solidarity and coordination (Constitutional Court Judgement, 2016). This puts this principle in relation with the fairness dimension and the financing needs of the general government. Ultimately, sufficiency of resources is measured against the level of taxation the society is willing to support to cover spending needs. The financial autonomy of regions is carried out within the framework of the government's fiscal policy. To that end, the reforms to the regional financing systems have been accompanied with reforms to Spain's fiscal framework. The adoption in 2001 of the first Stability Law and its amendment in 2012 is a case in point, to ensure that the increasing tax and spending autonomy of sub central governments is carried out consistently with the annual general government fiscal targets. The use of the tax autonomy has varied across taxes and regional governments. Over 2003-2014, regions have made low use, in aggregate terms, of their normative powers to raise personal income tax. They have relied more on other taxes, such as stamp duty tax, to get additional resources during the crises years. There are also considerable differences across regions in the use of their tax powers (AIReF 2016b). Several elements have weakened regions' incentives to use their tax autonomy, thus reducing fiscal co-responsibility. Firstly, to date, each revision of the financing system has been carried out under the premise that no regional government would lose revenues relative to the status quo and has been accompanied by additional monetary transfers from the central government, thus reducing the need for regions to use their taxing powers. Secondly, while the Regional Liquidity Fund (RLF),( ) as amended in 2014, further reduces the cost of debt for regional governments, it could weaken incentives to keep borrowing in check. And while access to the RLF is subject to conditionality, the regions' adjustment plans under the RLF are subject to less strict requirements than the economic and financial plans required by the Stability law in case of non-compliance with the fiscal targets.( ). A gradual return of region's financing schemes to market conditions can therefore contribute to reduce moral hazard and increase fiscal prudence at the regional level.

Thirdly, until recently, Spain has made little use of the corrective and preventive tools in Spain's fiscal framework to ensure fiscal discipline at all government levels. However, in 2016, the Ministry of Finance activated for the first time some such provisions, such as the requirement for several regional governments to adopt spending cuts (acuerdos de no disponibilidad) to reach the regional 2016 deficit target, although the actual response by regional governments (EUR 40 million; AIReF, 2016a) was considerably below what the Ministry of Finance called for. There are limits to further devolving tax powers to regions. Further increases in regions' tax autonomy would have to rely on the devolution of powers over the large taxes and / or the creation of new taxes. In practice, some taxes are ill-suited to be shared with regional governments. For example, the high sensitivity to the economic cycle of corporate income tax would not ensure stability of financing sources for the regions, and in addition it would be difficult to allocate revenues from this tax to each region. There are also limits to further increasing the share of personal income taxes devolved to regions, as this could impair the central government's ability to carry out its stabilisation and redistribution functions. Moreover, EU law does not allow for differentiated regional VAT rates. Lastly, on the expenditure side, higher co-responsibility could be achieved through increases in the powers of regional governments over the setting of co-payments (Tax experts' report, 2014), with due consideration to their distributional impact, in terms of access by low income households to the services subject to co-payment. Equalisation transfers go some way in reducing dispersion in revenue per head across regions, but raise issues of fairness. This is because they result in a final distribution of revenues that does not preserve the ranking of regions in terms of tax capacity. Specifically, the Guarantee Fund reduces the dispersion in regions' revenues per head, while keeping the initial ordering of regions in terms of capacity. However, three other funds - i.e., the Sufficiency, ( ) Competitiveness and Cooperation funds - come into action after the redistribution made by the Guarantee Fund. The end result is an increased dispersion of revenues per head across regions relative to the distribution post-Guarantee Fund (although a decrease compared with the initial one) and, above all, a ranking of regions' revenues per head that is uncorrelated with the initial ranking based on the tax capacity (de la Fuente, 2016; Zubiri, 2016). Thus, regions with comparable tax capacity per head may end up having different revenues per head as a result of the operation of the above-mentioned three funds; similarly, regions with relatively low tax capacity may end up getting higher revenues per head than regions with a higher tax capacity. Regions with higher revenues from the financing system are not necessarily the ones with lower deficits. There are differences in revenues from the financing system across regions. In 2016, there was a difference of 36%, between the region with highest and lowest revenues per head from the financing system, measured in terms of EUR per head. A priory, regions with higher revenues from the regional financing system should record, all other things equal, lower deficits compared with regions with lower revenues. However, the deficit is a matter of revenues and expenditure and while variations in revenues show some correlation with variations in the deficit, over time the change in primary expenditure shows a higher degree of correlation with the change in the deficit than the change in the level of revenues (Table 4.1.1). The cooperation of regional governments is crucial for Spain to reach its fiscal consolidation targets. Over 2003-2015, the average deviation of regional governments from their deficit target (0.7 % of GDP) has been close to the central government's (0.8 % of GDP). Over the past few years, regional governments have contributed to fiscal consolidation. The regional deficit peaked at 5.1% of GDP in 2011, was more than halved in 2012 and has been hovering around 1.6% of GDP since then. However, the pace of consolidation went down considerably in 2015, at both central and regional level, despite a pick-up in revenues from the financing system and a considerable reduction in regions' interest expenditure. This slowdown has hampered Spain's deficit reduction in 2015. Regional expenditure is regaining its pre-crisis levels. Graph 4.1.7 shows that in 2015, the total level of regional expenditure per capita in real terms was very close to the 2006 level. While some expenditure categories, such as economic affairs, were considerably lower (on account of the fall in gross fixed capital formation, investment aid and subsidies to production) others, namely healthcare and spending on social protection, were above. The application of the Stability Law's expenditure rule, whose implementation details are still not sufficiently specified (European Commission, 2016d), can help underpin the sustainability of expenditure growth, especially for regions for which the annual headline deficit target may not be overly demanding. A reform of the regional financing system is scheduled for 2017. A revised regional financing system along the principles of co-responsibility, solidarity and coordination with the central government's fiscal policy could increase incentives for fiscal compliance at regional level. Other policy settings, which are related to this reform, are also believed to play a role in fostering fiscal discipline at this government level. For example, regions have received so far uniform public deficit and debt targets, regardless of their initial budgetary position, with the exception of 2013. It has been suggested that differentiated deficit and debt targets would help regions to increase the likelihood of reaching their fiscal targets, as it would allow keeping a better balance between their ambition and realism (AIReF, 2016b). Moreover, it has been noted that the current system of periodic payments from the central to regional governments of shared taxes and equalisation transfers (whereby payments are made in year t on account of the final settlement of those taxes and transfers in year t+2), reduces the sensitivity to the cycle of regions' revenues. This lowers in turn, regions' incentives to adjust in bad economic times and makes it more difficult for regions to comply with deficit targets in good times, as revenue slowdowns / recoveries are felt with a two year lag (Hernández de Cos, 2015). Furthermore, the setting up of rainy day fund (i.e., a fund made of contributions from regions to help them deal with revenue shortfalls in slowdowns) could also enhance the contribution of regional governments to the stabilisation of the economy (Hernández de Cos, 2015). Lastly, the spending review announced in the 2017 DBP, to be carried out by AIReF, is a step in the right direction, as it can help identify areas where spending needs can be met with a more efficient use of resources. Table 4.1.1:Correlation between (1) changes in regional revenues and (2) changes in expenditure with changes in regions' deficits Source: European Commission Graph 4.1.7:Regional governments: real expenditure in EUR per capita by COFOG function. Differences 2015-2006 Source: European Commission from IGAE and INE (padrón continuo) 4.2. Financial sector and private sector deleveraging 4.2.1.Financial Sector The Spanish financial sector has continued to show a high degree of stability, supported by its ongoing restructuring, low funding costs and the strength of the economic recovery ( ). The banking system further strengthened its capital buffers and all six Spanish banking groups that were subject to the EBA stress tests of July 2016 comfortably met capital requirements under this exercise. As elsewhere in Europe, sustaining profitability over the medium term, against the background of low interest rates and still negative growth of business volumes, remains the main challenge ( ). Graph 4.2.1:Non-performing loans Source: BdE, own calculations. In 2016, Spanish banks continued to clean up their balance sheets and reduce the share of crisis legacy loans. Amid robust economic growth over the past two years, the stock of non-performing-loans (NPLs) further dropped in September 2016. The overall NPL ratio (share in total loans) went down to 9.23 % as of November 2016, from 10.12 % at the end of 2015 (see Graph 4.2.1). However, the share of legacy assets is not uniform across banks. For Q1-2016, the aggregate NPL ratio_( ) of Spanish banks remained only just above the euro area average (EBA, 2016). The divestment of SAREB's portfolio has been progressing, even though SAREB has continued to post consistent negative financial results before tax since its start of operations. Graph 4.2.2:Financing the Spanish economy Source: European Commission, own calculations based on AMECO, ECB and Invest Europe. The outstanding volume of credit is still decreasing, but new bank lending to firms and households has been growing. The Spanish economy still relies heavily on the banking sector. In 2015, bank loans represented 50 % of GDP vs. a EU average of around 36 % (see Graph 4.2.2), while non-bank financial intermediation via equity markets, debt issuance and venture capital is below the EU average (see Section 4.5). Credit standards for approving loans were further relaxed in Q1-2016 for households, while the average terms and conditions for loans continued to ease for both households and non-financial corporations (NFCs) (Banco de España, 2016). Also supported by the robust economic recovery, new bank lending to firms and households, in particular to small and medium enterprises (SMEs) and households for other than real estate purposes, continues to grow, in turn supporting economic activity (see Graph 4.2.3). Graph 4.2.3:Bank loans to the private sector Source: BdE, own calculations. 4.2.2. Private Sector Deleveraging Although declining since mid-2014, the indebtedness of the Spanish economy remains high, the stock of private non-financial sector debt amounting to 167.5 % of GDP, Q3-2016. Mirroring the net external liabilities, the high level of debt remains a macroeconomic imbalance, the associated financial burden constraining domestic demand and increasing vulnerability to interest rate shocks. In the wake of the crisis, the debt-to-GDP ratio significantly increased, but, since then, its composition has been shifting from the private to the public sector, in line with the deleveraging process undertaken in the former (see Graph 4.2.4).

Graph 4.2.4:Indebtedness by sector Source: Eurostat, own calculations. Real GDP growth has become the main driver of households’ deleveraging. As the household sector moved from a net borrowing to a net lending position in Q1-2011 (see Graph 4.2.6), it actively reduced its high debt, from 84.7 % of GDP in Q2-2010 to 65.2 % in Q3-2016. This trend was driven by the negative net credit flows. However, the decrease in household borrowing is currently decelerating. The household deleveraging process has been more gradual than for the corporate sector, as most household loans are long-term housing mortgage loans, which are written off by banks less often than corporate loans. With nominal growth gaining momentum, the deleveraging is likely to accelerate (see Graph 4.2.5), while sustainability analyses reveal persistent household deleveraging needs. Graph 4.2.5:Breakdown of y-o-y changes in households’ debt-to-GDP ratio Source: Eurostat, own calculations. The financial position of Spanish households continued to strengthen in 2016 (see Graph 4.2.6). With low interest rates and adjustable rate loans prevailing in the Spanish mortgage market, the financial burden borne by households has been falling rapidly. Together with labour market improvements and growing gross disposable incomes, the ratio of NPLs to households has been declining since the peak of 7.1 % in Q1-2014 to 5.3 % in Q3-2016 (see Graph 4.2.1). Graph 4.2.6:Households’ financial assets acquisition Source: Eurostat, own calculations. Graph 4.2.7:Breakdown of y-o-y changes in NFCs’ debt-to-GDP ratio Source: Eurostat, own calculations. Deleveraging in the corporate sector is being compatible with an increase in investment. In 2009, the corporate sector in Spain turned from a net borrower to a net lender position (see Graph 4.2.7), and, since 2012, negative credit flows have been the main driver of the fall in corporate debt-to-GDP ratio, clearing of debt occurring at a faster pace than new lending. However, the deleveraging process is now increasingly driven by real growth, as the improvement of economic conditions have gone hand-in-hand with an increase in new credit. As investment continues to grow, the corporate sector can be expected to move back to a net borrower position. The financial position of the corporate sector has been steadily improving since 2013. The net financial wealth of firms increased for a third consecutive year, although’ still remaining in the negative territory, from -133.4 % of GDP in 2013 to a forecast -108.6 % in 2016 (see Graph 4.2.8). The improvement, consistent with the sustained deleveraging process, was driven by the decreases on the liabilities side which countervailed the ones on the assets side. While the overall decrease on the assets side was reflected across almost all asset classes, the total drop in liabilities is, to a great extent, supported by reductions in corporate loans. Graph 4.2.8:NFCs’ balance sheet and financial position Source: Eurostat, own calculations. 4.2.3.Insolvency Reform The number of insolvencies has been decreasing since 2013, reflecting the ongoing economic recovery. Reforms undertaken in 2014/2015 made corporate insolvency and out-of-court procedures more flexible. The corporate insolvency law ( ), adopted in 2015, reformed the in-court debt restructuring by expanding the scope of agreements. Although the number of insolvency cases continued to fall ( ), the declining recourse to insolvency can be explained by the improving ability of Spanish firms to meet their interest payments. The ability of Spanish SMEs to meet their interest payments has improved. The ability to service debt is determined by the level of earnings and debt and by the paid interest. Improving earnings and lower interest rates made it easier for firms to service their debt. Since 2012, the interest coverage ratios ( ) have been increasing for SMEs operating in manufacturing or construction (see Graphs 4.2.9 & 4.2.10( )). The probability of bankruptcy remains higher for SMEs in construction, as compared to manufacturing or other sectors. In the period 2008-2014, between a quarter and a half of SMEs in construction had difficulties generating sufficient cash flow to pay their interest obligations. Graph 4.2.9:The interest coverage ratio for Spanish construction SMEs Source: BACH-ESD database, own calculations Graph 4.2.10:The interest coverage ratio for Spanish manufacturing SMEs Source: BACH-ESD database, own calculations The number of personal bankruptcy cases is increasing. The reform of the personal insolvency framework, adopted in 2015( ), set provisions for full debt relief for individuals and extended the number of beneficiaries entitled to mortgage debt restructuring. Although the new legislation came into force when the economy was experiencing a strong rebound, the number of personal bankruptcy cases started increasing at a fast pace in the course of 2016. 4.3. Labour market, education and social policies 4.3.1.Labour Market

The labour market keeps improving, but unemployment and segmentation remain important challenges. Previous labour market reforms, wage moderation and economic growth are supporting job creation and contribute to reducing the job destruction rate, leading to falling unemployment. Still, at 18.9 % in Q3-2016 unemployment remains very high, especially for the young (41.9 %, 15-24 years old) and low-skilled workers (27 %, ISCED levels 0-2). Almost half of the unemployed have been without a job for more than one year (2.1 million people or 9.1 % of the labour force) and 17.8 % for more than four years. Wages are expected to increase as inflation gradually picks up, which may affect job creation. Moreover, Spain has one of the highest shares of temporary employment in the EU. Unemployment and labour market segmentation, together with ageing and gaps in education, contribute to low potential growth and one of the highest levels of inequality in the EU. Measures to step up the specific support for young people are beginning to bear fruit. After a slow start, implementation of the Youth Guarantee (YG) improved in 2016, partly thanks to reinforced outreach mechanisms ( ). A reform adopted in December 2016 will significantly increase coverage as it envisages that all young people registered as unemployed with the Public Employment Services (PES) are automatically eligible for support from the YG as from 2017. The quality of the offers proposed to the YG beneficiaries will depend on the capacity of the PES to meet the increased demand for services resulting from this reform. Spain is taking measures to strengthen individual support for the long-term unemployed. Previously adopted measures (e.g. the PREPARA plan for professional reskilling and the employment activation programme, PAE) have not yet helped to significantly improve individual support for the long-term unemployed. In 2016, Spain allocated EUR 515 million over three years to a new joint action plan ( ) to support the employment services in providing assistance to one million long-term unemployed until 2018. The plan envisages profiling and individual integration pathways, for which a profiling tool is being developed, and an upper limit of 120 cases handled per counsellor. The success of the plan will depend on the capacity of the regional PES, as well as on the stability of funding. Indicators point to a still weak performance of the PES in providing services to both employers and jobseekers. The share of vacancies handled by the PES is very low, as well as their contribution to job placement (2 % of total vacancies against 10 % on average in the EU, based on Labour Force Survey data). The share of the unemployed having contacted the PES to seek work is the lowest in the EU (27.5 % in 2015 against 48.3 % in the EU-28). This is reflected in Spain's relatively low expenditure on active labour market policies (ALMPs) ( ). Moreover, a benchmarking evaluation of regional PES run by the Spanish authorities (EVADES) points to large differences in performance across regions linked, among other factors, to weak cooperation with national authorities and a focus on procedures rather than on results. There is also little progress on implementing single points of contact. The new government has announced further labour market measures. In particular, it intends to promote an integral agenda on employment quality. It has also announced an upcoming law to support the self-employed, including through the extension of the social contribution flat rate scheme (tarifa plana) of EUR 50 from six to twelve months. At the same time, the government has increased the upper threshold for income subject to social contributions by 3 % from 2017 (see section 4.1) ( ). This will contribute to reducing the deficit of the social security system, but might entail adverse employment effects. After years of almost complete freeze, the minimum wage has increased by 8 % in 2017. The new minimum wage is set at EUR 707.6 a month (14 payments a year). This comes after a very limited nominal increase (2.2 % in cumulated terms) between 2011 and 2016, below cumulated inflation (2.8 %) and productivity growth (5 %). The minimum wage in force until 2016 was one of the lowest in the EU ( ), although the share of employees receiving it was also low. This suggests that the immediate impact of the increase on in-work poverty, job creation and the overall wage distribution will be modest. In addition, the Parliament is due to discuss a proposal that would increase the minimum wage significantly and envisages full indexation to inflation. The share of temporary work, most of which of short duration, is still very high. The share of temporary employees of total employees dropped during the first years of the crisis, as they bore most of the adjustment, but increased after 2013 to reach 26.5 % in Q4-2016, still the second highest share in the EU (Graph 4.3.1). While temporary work is most frequent among the young (15-24 years old) and the low-skilled, it also affects medium- and high-educated workers more often than in the rest of the EU (Graph 4.3.2). This, together with very low yearly transition rates from temporary to permanent contracts (10.2 % in 2015 compared to an EU average of 23 % in 2014) suggests that temporary jobs are not a stepping stone to stable careers. In addition, around one third of temporary workers have contracts of up to three months. This is larger than the 20 % EU average and national data indicates that one fourth of the contracts signed in 2016 had a duration of up to seven days. Graph 4.3.1:Share of temporary employees, transition rates from temporary to permanent, wage premium for permanent and full-time temporary employed at risk of not being entitled to unemployment benefits. Source: Eurostat, Turrini and Dias da Silva (2015), Research note Non-standard employment and access to social security benefits (2015). The widespread use of temporary contracts might be explained by multiple factors. The use of temporary contracts allows companies to respond flexibly to fluctuations in demand, but the use of temporary contracts may reveal rigidities in wage structures or a too short trial period. Higher costs for permanent workers are related to higher dismissals costs, aggravated by uncertain and cumbersome dismissal procedures, and to less flexible working conditions. The last labour reforms addressed some of these issues. The sectoral composition of the economy, the dominance of small companies or uncertainty about future economic developments may also play a role. Several forms of atypical employment coexist in Spain. The most frequent types of fixed-term contracts are those used to respond to production needs or to carry out a specific task or service (45 % and 40 % of temporary contracts in 2016 respectively) ( ). Other forms of atypical work include discontinuous permanent contracts, which are frequent in seasonal jobs, as well as temporary agency contracts. There are also concerns about the use of ‘bogus’ self-employment as a replacement for standard employees. In addition, while part-time work is less widespread than in other Member States, a large share of it is involuntary (in 2015 more than 60 % of part-time workers could not find a full-time job and this percentage has almost doubled in the last ten years). Almost three quarters of part-time workers are women. Graph 4.3.2:Shares of temporary employees by age and education level (2015) Source: Eurostat The widespread use of temporary work may harm productivity growth. There is evidence that high shares of temporary work harms total factor productivity growth through various channels. These include limited incentives for workers to acquire firm-specific knowledge, lower on-the-job training opportunities (e.g. Cabrales et al, 2014), smaller workers’ effort (Dolado et al, 2011) and concentration of temporary jobs in production opportunities with short-expected durations (Cahuc et al, 2016). This may bias the production structure towards less productive activities. Moreover, short employment spells have negative fiscal implications due to lower contributions and higher expenditure on benefits. Segmentation also contributes to inequality and has significant social consequences. Many workers alternate fixed-term contracts with unemployment spells. The wage gap between permanent and temporary workers is estimated at between 10 % and 19 % (Dias da Silva, A. and A. Turrini, 2015 and OECD, 2015), and rises with age. Together with higher probabilities of repeated unemployment spells and of working part-time, this results in lower annual earnings and higher poverty risks among temporary workers (23.3 % against 5.9 % for permanent workers in 2015) ( ). The impact of recent reforms in reducing segmentation has been mildly positive. The 2010-2012 reforms increased firms’ internal flexibility and introduced a new permanent contract for full-time workers in small companies, with an extended probation period of 12 months (entrepreneurs’ contract). There are indications that the reforms have increased the probability of moving from unemployment into permanent employment from 1.7 % to 2.6 %, while the probability of moving from unemployment to temporary employment is still 4.6 times higher (it was seven times higher before the crisis), suggesting a positive but small effect in reducing segmentation (García Pérez and Mestres Domenech, 2016). A plan for fighting employment segmentation agreed upon in the tripartite agreement of 29 July 2014 has not been further developed (European Commission, 2016e). The remaining gap in firing costs between temporary and permanent contracts, and uncertainty in case of legal dispute may incentivise fixed-term hiring. The 2012 reform increased severance payments for temporary workers, while it reduced those for permanent contracts, namely in case of unfair dismissal (from 45 to 33 days’ pay per year of service, with a cap at 24 months instead of 42). According to OECD summary indicators on employment protection legislation ( ), the gap between overall protection of permanent and temporary workers has not changed significantly, and severance payments for permanent workers remain comparatively high in case of fair dismissals, at long tenures. The gap in severance payments between different types of contracts might limit the incentives for employers to hire on permanent contracts. Incentives may also be reduced by potentially higher costs in case of dispute (if the dismissal of a permanent employee is judged ‘unfair’ in court, the employer would need to pay a higher severance payment). According to Jimeno et al. (2015) during 1984-2010 about 70 % of dismissal cases resolved in court were declared ‘unfair’, and this percentage has increased after the crisis. Spain stands out for having a high number of labour law cases compared to the number of employees (European Commission, 2015a). The reinforcement of labour inspections is showing positive results in reducing the abuse of temporary contracts. Weak enforcement of regulations limiting the abuse of temporary contracts had been identified as an issue in Spain (e.g. Bentolila et al., 2012). In this regard, labour inspections have been improved by targeting action towards those areas where abuse appears to be more widespread and by increasing staff and improving their expertise regarding temporary work. Between 2012 and October 2016, the number of yearly inspections has increased by more than 60 % and 230 000 temporary contracts were transformed into permanent ones. In 2015, more than 20 % of inspections resulted in temporary contracts being transformed into permanent contracts. The Court of Justice of the EU (CJEU) in September 2016 issued three rulings related to the use of fixed-term contracts in Spain ( ). These judgments concerned the renewal of successive fixed-term contracts when needs were permanent ( ) and the payment of compensation for termination of a temporary replacement contract (contrato de interinidad). Following on from the latter CJEU judgment, the competent Spanish court ruled that the worker in question should receive compensation equivalent to that of a permanent worker. The Government has set up a panel of experts with government and social partner representatives to analyse the rulings and make a proposal to translate them into Spanish legislation. Hiring incentives aimed at reducing segmentation are not always well targeted. At the national level, there are a wide variety of incentives, including rebates in social contributions or lump-sum subsidies to hire on a permanent basis and to transform temporary into open-ended contracts. In 2015, 10.9 % of subsided contracts were to hire workers with permanent contracts (mainly for young or older workers in small firms). The groups of eligible workers are rather broad, suggesting that incentives are not sufficiently targeted towards those with greater difficulties to (re-)enter the labour market. Moreover, research shows that subsidies entailed deadweight and substitution effects, i.e. they either were not effective, or incentivised the replacement of non-subsidised workers. 4.3.2.Education High early school leaving (ESL) rates and a high share of low-skilled people among the adult population remain major challenges. The ESL rate ( ) further declined to reach 19 % in 2016, but remains among the highest in the EU. ESL rates vary greatly across regions, due to the high demand for low-skilled workers in given areas but also linked to students’ socio economic or migrant background. Spain also has the third highest share of low-skilled people (ISCED 0-2) in the adult population (42.6 % in 2015), which hardly declined in the last 10 years among the younger age group (25-29). This hampers productivity growth and fuels inequalities.

Student’s performance at school is stable and around the EU average, but varies greatly across regions. According to the 2015 OECD Programme for International Student Assessment (PISA), pupils’ performance in Spain improved in reading and maths. The proportion of low achievers is lower than the EU average in all three tested fields. However, differences between well performing regions and low performing ones can exceed 40 points (equivalent to one school year) in the three fields, reflecting differences in the socio-economic conditions of their populations and gaps in the effectiveness of their education system. The impact of socio-economic status is close to the EU average ( ), while the performance gap between non-immigrants and first-generation immigrants is relatively small (OECD, 2016). The results of the 2015 Trends in International Mathematics and Science Study show that fourth grade students in Spain have improved their mathematics and science performance from 2011 to 2015. High rates of grade repetition increase inequality and education costs. In 2015, more than 31 % of pupils had repeated a grade during compulsory education in Spain, the second highest rate in the EU, even if slightly improved compared to 2012. Rates vary from 53 % among disadvantaged students to less than 9 % among advantaged ones (PISA 2016). Grade repetition increases the risk of school drop-out, lowers attainment expectations (OECD 2012) and increases education inequalities, affecting professional achievement and wages. The cost of grade repetition in Spain accounted for 8 % of the total education budget in 2012 (OECD 2013). Spain has taken measures to improve performance and basic skills with mixed results. Most of the measures set out in the Organic Law for Improvement of the Quality of Education (LOMCE) adopted in 2013 are now implemented, but their continuation depends on the outcome of the Pact for Education ( ) (currently under discussion). The planned yearly nation-wide students’ evaluations have been substituted by sample- based studies without academic effects. Several regions are also introducing bilingual teaching in primary and secondary schools. A first study related to science teaching conducted in one of the Spanish regions suggests that the lack of foreign language proficiency of teachers and parents may have a negative impact on students’ learning especially in science (Anghel, Cabrales, Carro 2016). Additional funding (EUR 11.7 million) has been earmarked to hire assistants and support teachers’ language courses, but its impact is not clear at this stage. It should be mentioned that the upcoming Pact for Education is expected to improve the initial training of teachers and include performance-based remuneration in their career paths to improve the quality of school education. Spain is making efforts to strengthen basic vocational education and training (VET) but enrolment rates are low so far. The strengthening of VET is intended to be the cornerstone of the national strategy to reduce ESL. The government approved 27 new qualifications of the basic VET ( ) in 2016, which should enrich the offer and increase its attractiveness. However, enrolment rates are low, which might be partly explained by the slow roll out of the programmes in some regions or the limited relevance of the degrees for the local economies. In several regions transitions from the first to the second year and promotions from basic to medium VET (upper secondary) are low, probably due to implementation flaws and lack of resources (European Commission, 2016). In addition, the number of students enrolled in medium VET programmes decreased in 2015-2016 for the first time since 1990. Reforms of vocational training for employment are being implemented. In 2015, Spain completed the reform of the training for employment subsystem (Subsistema de Formación para el Empleo) as part of the broader reform of the VET system to increase its attractiveness and improve young people’s skills. In the new governance model, the role of social partners focuses on strategic planning and monitoring while the PES manages the system through the new State Foundation for Training in Employment (Fundación Estatal para la Formación en el Empleo). The reform also introduced the right to a twenty-hour period of training leave for workers with at least one year of seniority and the option of introducing an individual training account for workers. This should contribute to improving participation in lifelong learning activities (9.9 % against 10.7 % in the EU). Employability of tertiary graduates remains an issue. Spain’s tertiary educational attainment rate is still above the EU average, but the employment rate of recent tertiary graduates ( ) is one of the lowest in Europe at 68.7 % in 2015, far below the EU average of 81.9 %. Spain also has the highest share (37 %) of tertiary graduates working in occupations considered as not requiring university education ( ). In 2015, a graduate tracking system was set-up to raise awareness about future employment prospects among university applicants. Spain is taking measures to foster cooperation between universities and business. Spain had the highest number of applications to the Knowledge Alliance EU grants in 2016, which shows the interest of education and research institutions for university-business cooperation. However, the reduced mobility of students and academic staff, lack of incentives to engage with businesses in teachers’ career progression schemes and the rigidity of university governance remain significant obstacles to cooperation and innovation. The government has approved a number of fiscal incentives to help businesses to expand their limited innovation capacity by encouraging them to hire research staff and to offer apprenticeships to university and VET students. The government envisages expanding the dual model to higher education and some universities have already signed agreements with companies to develop dual training in engineering programmes. 4.3.3.Social Policies In 2014, poverty started to decrease thanks to the emerging improvement in the labour market, but not all groups were benefiting. Based on 2015 SILC data( ), the share of people at risk of poverty or social exclusion declined slightly to 28.6 %, but remained far above the 2008 rate and the EU average. It was especially high for the working age population and children. The at-risk-of-poverty gap ( ) increased, reflecting the worsening situation of those who remain out of work, such as the long-term unemployed and their households. In-work poverty was still on the rise. In 2014, 13.1 % of Spanish employed people were at risk of poverty. In-work poverty was especially high and rising for people on temporary contracts or working part-time (Graph 4.3.3). Other drivers of in-work poverty in Spain were low hourly wages, and low work intensity at household level (European Commission, 2016b). Graph 4.3.3:In-work-poverty rate, groups, Spain Source: Eurostat, EU-SILC. Child poverty remained high mainly because of parents' labour market situation and weak family support. Though declining, a high share of children (12% in 2014) still lived in jobless households. Children whose parent(s) work faced the highest risk of poverty in the EU28 (22.6 %), in particular if living in single earner families (39.5 %). This also reflects the weakness of family support, in cash and in kind ( ). In 2013, family expenditure per child represented 7.6 % of GDP per head against 13 % on average in the EU (Chart 1.28 in European Commission, 2016b). Family benefits are also poorly targeted ( ) (European Commission, 2015) and when taking into account the impact of tax credits, the tax-benefit system is overall slightly regressive ( ) (Canto, 2012).The impact of social transfers on reducing child poverty further