Council opinion of 10 March 2009 on the updated stability programme of Luxembourg, 2008-2010
Date: 2009-03-10
Institutions: Council of the European Union
Subjects: Luxembourg, budget estimate, economic forecasting, public finance, stability programme

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COUNCIL OPINION

of 10 March 2009

on the updated stability programme of Luxembourg, 2008-2010

(2009/C 70/03)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

Having regard to Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveil-
lance of budgetary positions and the surveillance and coordination of economic policies (1), and in particular
Article 5(3) thereof,

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1)

(2)

(3)

(4)

On 10 March 2009, the Council examined the updated stability programme of Luxembourg, which
covers the period 2008 to 2010 (2).

Economic activity slowed down considerably as a result of the global economic downturn and the
financial crisis, with real GDP growth falling from 5,2 % in 2007 to about 1 % in 2008. In 2009,
economic activity is expected to contract by 0,9 % according to the Commission services' January
2009 interim forecast: the Luxembourg economy, which is both very open and dependant on the
performances of its financial sector, will be seriously hit by the projected fall in world trade and the
financial crisis, while government spending and, to some extent, private consumption are expected to
constitute the only support to growth. The main policy challenges in the downturn are related to the
financial sector, whose activity is highly internationalised, and to the support of domestic demand.
The downturn will have a significant impact on public finances as the large surplus projected for
2008 is expected to turn in 2009 into a deficit which will widen in 2010. This deterioration in the
government balance also takes into account the effect of the support measures decided in recent
months, which essentially include important tax cuts, especially in personal income tax, as well as a
significant acceleration in the implementation of government investment projects. In view of the
favourable budgetary starting position and the very low level of the public debt, these measures are
appropriate and welcome.

The macro-economic scenario underlying the programme, as amended by the addendum, projects
real GDP, after decelerating from 5,2 % in 2007 to 1,0 % in 2008, to contract by 0,9 % in 2009
before recovering somewhat and rising by 1,4 % in 2010. Assessed against currently available infor-
mation (3), this scenario appears to be based on plausible growth assumptions for 2008 to 2010. It is
fully in line with the Commission services' January 2009 interim forecast. The programme's projec-
tions for inflation and wage developments also appear realistic.

For 2008, the general government surplus is estimated at 2,0 % of GDP in the programme's
addendum, which compares with a target of 0,8 % of GDP set in the previous update of the stability
programme. This much better than expected outcome compared with the previous update is for a
large part due to the base effect associated with a revision of the general government surplus in 2007
from a previous estimate of 1 % of GDP to 3,2 %, mainly on account of revenue surprises.

(1) OJ L 209, 2.8.1997, p. 1. The documents referred to in this text can be found at the following website:

http://ec.europa.eu/economy_finance/about/activities/sgp/main_en.htm

(2) The original October 2008 programme covered the period 2008-2011. However, the Luxembourg authorities submitted
on 2 February an addendum replacing the original macro-economic and budgetary scenario by a fundamentally different
one, but which only covers the period 2008-2010. The Commission services could therefore not assess the
macro-economic scenario and the budgetary targets in 2011.

(3) The assessment notably takes into account the Commission services' January 2009 forecast, but also other information

that has become available since then.

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For 2008, this better than expected starting position was partly offset by higher-than-anticipated
expenditure growth, in particular in government consumption and investment as well as social trans-
fers. The faster-than-expected increase in government consumption is partly explained by the hiring
of new staff required by the development of the University of Luxembourg and other public research
centres.

(5)

(6)

(7)

(8)

The programme projects the general government balance to deteriorate from a surplus of 2 % of
GDP in 2008 to a deficit of 0,6 % of GDP in 2009. This can be explained in part by the impact of
the economic slowdown and the associated normal functioning of automatic stabilisers, especially
concerning tax revenue from the financial sector. The 2009 deficit will also result from discretionary
measures adopted in the 2009 budget including those decided in response to the economic downturn
and in line with the European Economic Recovery Plan, amounting to 1,75 % of GDP. The 2009
budget foresees important tax cuts, especially in personal income tax, amounting ex ante to about
1,25 % of GDP, while some government investment projects initially scheduled for 2010 are planned
to be brought forward. Revenues are projected to decline by about 0,5 percentage point of GDP in
2009. This comprises a decrease by 1 percentage point of GDP in direct taxes resulting from the tax
cuts and from the impact of the crisis, while social contributions and property income would increase
by around 0,25 percentage point of GDP each, thanks to the carry-over resulting from still buoyant
employment growth until the end of 2008 and to the interests received on the loans granted in
support of the financial sector. Simultaneously, in 2009 general government expenditure is planned
to rise by 2,25 percentage point of GDP, mainly as a result of significant increases in government
consumption and investment as well as in social transfers, the latter being partly the result of the
replacement of the tax reduction for children by a system of tax credit and also of the increase in
unemployment forecast for this year.

The programme projects the general government headline deficit to deteriorate further from 0,6 % of
GDP in 2009 to 1,5 % of GDP in 2010, while the primary deficit would increase from 0,3 % of GDP
to 1,2 %. Luxembourg's medium-term budgetary objective is a structural (that is cyclically-adjusted
and net of one-off and other temporary measures) deficit of 0,75 % of GDP. Based on the pro-
this medium-term objective is
gramme's macro-economic scenario and budgetary projections,
planned to be fully respected throughout the period covered: the structural balance recalculated
according to the commonly agreed methodology based on the information in the programme is
projected to remain positive, slightly declining from a surplus of 0,6 % of GDP in 2009 to a surplus
of 0,4 % of GDP in 2010. The gross public debt, which doubled from 7 % of GDP in 2007 to 14,4 %
of GDP in 2008 as a result of the financing of the supporting loans to the Luxembourg subsidiaries
of systemically relevant foreign banks, is projected to increase to 15 % of GDP in 2009 and to 17 %
in 2010. However, despite its doubling in 2008, it will remain by far the lowest inside the euro area.

The risks to the budgetary projections in the programme appear broadly balanced. On the one hand,
In particular, private
some downside risks to the macro-economic scenario could materialise.
consumption might prove less resilient than forecast. Moreover, the impact of the crisis on tax
revenue, especially those from the financial sector, could be even larger than currently expected. On
the other hand, the 2008 outcome might be better than projected in the programme (as was already
the case in 2007) since budgetary projections in Luxembourg are traditionally renowned for being
cautious.

The main concern for Luxembourg's public finances remains their long-term sustainability in view of
the very large projected increase in age-related public expenditure and the fact that no measures have
been taken to date in order to address this issue: the long-term budgetary impact of ageing is among
the highest in the EU, influenced notably by a very considerable projected increase in pension expen-
diture. The budgetary position in 2008 as estimated in the programme, which is better than the
starting position of the previous programme, the low debt ratio, the significant assets accumulated in
social security, and a structural primary surplus contribute to offsetting the projected long-term
budgetary impact of ageing populations. However, this is not sufficient to cover the sizeable increase

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implementing measures aimed at curbing the substantial

in age-related expenditure. Achieving high primary surpluses over the medium term and, as recog-
nised by the authorities,
increase in
age-related expenditures, including by increasing the effective pension age, would contribute to redu-
cing the medium risk to the sustainability of public finances. The risks to sustainability stemming
from the financial sector support operations performed in recent months do not seem considerable
at the moment, despite the sizeable increase in public debt that these operations required, even
though potential liabilities could be comparatively important due to the very large size of the finan-
cial sector. Moreover, a large part of the costs (or even all of them) generated by these support opera-
tions could be recouped in the future.

(9)

The structure of public finance seems comparatively favourable in Luxembourg: government expendi-
ture and the tax burden are relatively low and expenditure as well as revenue systems seem relatively
efficient, compared with other Member States. In particular, government consumption and taxation
of
labour income are comparatively low while public investment is one of the highest in the
whole EU.

(10) With a view to stabilising the financial sector, the Luxembourg government decided in September and
October 2008 to grant a convertible loan to the local subsidiaries of two large foreign banks for a
total amount of EUR 2,776 billion (7,6 % of GDP). In order to improve its access to finance, it was
also decided to guarantee the new commitments contracted by one of these banks towards institu-
tional investors and with a maximum maturity of three years. Finally, in order to restore depositors'
confidence, the amount covered by the deposit guarantee scheme was raised from EUR 20 000 to
EUR 100 000 per deposit. It should be noted that the general government holds large financial
assets, accumulated from the recurrent surpluses recorded in the last decades and augmented by the
loans granted at the end of 2008 to the subsidiaries of these two foreign banks. These assets
amounted to about 32 % of GDP in 2008, of which about one third held by the central government
and two thirds by the social security system. Consequently, the net financial position of the general
government is widely positive.

(11)

Some fiscal support measures had already been decided in the 2009 budget, which was drafted
before the aggravation of the financial crisis. They consisted for the most part of cuts in income tax,
the cost of which is estimated by the programme at about 1,2 % of GDP. The budget also foresaw a
reduction of the corporate tax rate, which will affect revenues from 2010 onwards. In addition, in
line with the European Economic Recovery Plan agreed in December by the European Council,
Luxembourg has adopted other support measures, among which the most relevant refer to an
acceleration in government investment as well as subsidies for the purchase of energy-efficient
durables and for energy-saving investments. Furthermore, the employers' share of the unemployment
benefit in case of part-time unemployment will be reimbursed by the government until the end of
2009.
In total, these stimulus measures will amount to about 1,75 % of GDP. Thanks to the
non-negligible surplus recorded in 2008 and to the very low level of the public debt, the available
room for manoeuvre is especially large in Luxembourg. The fiscal stimulus package for 2009 and
2010 appears to constitute an adequate response to the current economic downturn, although a large
part of the stimulus measures is not supposed to be temporary, in particular the cuts in income tax,
which were primarily designed to compensate for the non-indexation of income tax brackets since
2001. Luxembourg also took several measures and will take additional ones in the coming years in
the energy and
order
climate-change package. These measures are related to the medium-term reform agenda proposed by
the Commission on 28 January 2009 under the Lisbon Strategy for Growth and Jobs.

to create a more attractive economic environment and to implement

(12)

The structural balance calculated according to the commonly agreed methodology is projected to
remain in surplus, declining from 1,5 % of GDP in 2008 to 0,6 % of GDP in 2009 and 0,4 % of
GDP in 2010. The overall fiscal stance is expansionary in 2009, reflecting the response of the
Luxembourg government to the downturn, and mildly expansionary in 2010, although the changes
in the structural balance are somewhat smaller than the stimulus measures taken. The MTO is
projected to be respected over the period covered.

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(13) As regards the data requirements specified in the code of conduct for stability and convergence
programmes, the programme has some gaps in the required and optional data (1). Moreover, the
addendum to the programme, which partly replaces the original macro-economic and budgetary
scenario, does not provide projections for 2011 (2).

The overall conclusion is that, in view of the sound budgetary starting position, the measures decided in
response to the downturn and presented in the addendum to the stability programme are appropriate and
should be welcomed. They are generally in line with the principles (timely, targeted and temporary) of the
European Economic Recovery Plan, even though the cuts in income tax, which were decided before the
aggravation of the crisis, are not planned to be temporary. Due to the projected sharp economic down-
turn and to the measures decided in response to the downturn, the government balance will turn into a
deficit in 2009, after several years in surplus, but it will remain far from the 3 % reference value and the
medium-term objective is planned to be respected throughout the programme period. Risks to the pro-
gramme's budgetary targets seem broadly balanced. However, concerns remain about the long-term sustain-
ability of public finance, which will have to bear a particularly heavy burden in the coming decades as the
increase in age-related public expenditure is projected to be among the strongest in the whole EU.

In view of the above assessment and of the very strong increase in age-related expenditure forecast for the
coming decades, Luxembourg is invited to:

(i) implement the fiscal plans, including the stimulus measures in line with the EERP and within the frame-

work of the SGP;

(ii) improve the long-term sustainability of its public finances by implementing structural reform measures,

in particular in the area of pensions.

Comparison of key macro-economic and budgetary projections

Real GDP
(% change)

HICP inflation
(%)

SP Oct 2008

COM Jan 2009

SP Nov 2007

SP Oct 2008

COM Jan 2009

SP Nov 2007

Output gap (1)
(% of potential GDP)

SP Oct 2008

COM Jan 2009 (2)

SP Nov 2007

2007

5,2

2008

1,0

5,2

6,0

2,7

2,7

2,3

3,2

3,2

0,5

1,0

4,5

4,1

4,1

2,0

1,1

1,1

0,1

2009

– 0,9

– 0,9

5,0

0,6

0,6

2,1

2010

1,4

1,4

4,0

2,5

2,5

2,1

– 2,5

– 3,8

– 2,3

– 3,5

0,2

– 0,8

(1) In particular, there are no data on sectoral balances with the exception of the general government.
(2) Article 3(3) of Council Regulation (EC) No 1466/97 foresees that ‘The information about the paths for the general government
deficit ratio and debt ratio and the main economic assumptions (…) shall cover, as well as the current and the preceding year, at least the
following three years’.

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Net lending/borrowing
vis-à-vis the rest of the
world
(% of GDP)

SP Oct 2008

COM Jan 2009

SP Nov 2007

2007

n.a.

n.a.

n.a.

2008

n.a.

n.a.

n.a.

2009

n.a.

n.a.

n.a.

2010

n.a.

n.a.

n.a.

SP Oct 2008

41,0

43,2

42,8

42,8

COM Jan 2009

41,0

43,6

44,0

42,9

SP Nov 2007

38,5

37,8

37,9

37,8

SP Oct 2008

37,8

41,2

43,4

44,3

COM Jan 2009

37,8

40,6

43,5

44,3

SP Nov 2007

37,5

36,9

36,9

36,6

General government
revenue
(% of GDP)

General government
expenditure
(% of GDP)

General government
balance
(% of GDP)

Primary balance
(% of GDP)

Cyclically-adjusted
balance (1)
(% of GDP)

SP Oct 2008

COM Jan 2009

SP Nov 2007

SP Oct 2008

COM Jan 2009

SP Nov 2007

SP Oct 2008

COM Jan 2009

SP Nov 2007

Structural balance (3)
(% of GDP)

SP Oct 2008

COM Jan 2009

SP Nov 2007

3,2

3,2

1,0

3,5

3,5

1,2

1,6

1,6

0,7

1,6

1,6

0,7

2,0

3,0

0,8

2,3

3,3

1,1

1,5

2,4

0,8

1,5

2,4

0,8

– 0,6

– 1,5

0,4

1,0

– 1,4

1,2

– 0,3

– 1,2

1,0

1,2

0,6

1,6

0,9

0,6

1,6

0,9

– 0,9

1,5

0,4

0,3

1,6

0,4

0,3

1,6

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Government gross debt
(% of GDP)

SP Oct 2008

COM Jan 2009

SP Nov 2007

2007

7,0

7,0

6,9

2008

14,4

14,4

7,1

2009

14,9

15,0

7,2

2010

17,0

15,1

7,0

Notes:
(1) Output gaps and cyclically-adjusted balances according to the programmes as recalculated by Commission services on the basis of the

information in the programmes.

(2) Based on estimated potential growth of 4,2 %, 3,2 %, 2,7 % and 2,8 % respectively in the period 2007-2010.
(3) Cyclically-adjusted balance excluding one-off and other temporary measures. One-off and other temporary measures are 0 % of GDP in

2009, 2010 and 2011 according to the most recent programme and in the Commission services' January interim forecast.

Source:
Stability programme (SP), Commission services' January 2009 interim forecasts (COM); Commission services' calculations.