Conversation with Muriel Bouchet

“On the face of it, the signals are reassuring” 

Climate risks, a factor to be taken into account for future budgets, suggests Idea Foundation director Muriel Bouchet. (Photo: Guy Wolff/Maison Moderne)

Climate risks, a factor to be taken into account for future budgets, suggests Idea Foundation director Muriel Bouchet. (Photo: Guy Wolff/Maison Moderne)

The draft State budget for 2022 shows a return to normal growth, which is essential to ensure, among other things, social spending and a continued investment to prepare the country for the challenges ahead. Muriel Bouchet of the Idea Foundation takes stock of the situation.

On 13 October, Finance Minister Pierre Gramegna (DP) presented the draft 2022 state budget as a normalisation budget. What does this 'normalisation' mean?

Muriel Bouchet - After the extraordinary events we experienced in 2020, and even in 2021 - we are not yet out of the health crisis--2022 is a year of budgetary normalisation. We only experienced a reduction in GDP of 1.8% in 2020, which reflects the good resilience of our economy compared to our neighbouring countries (a 6.5% reduction in GDP in the euro zone, editor's note), before rebounding in 2021 towards 6% growth, according to the Statec estimate, which seems to me to be entirely credible. That said, a form of normalisation had already appeared at the end of 2020, when the level of GDP had returned to that of the pre-crisis period.

For 2022, we should return--even if we have to remain prudent--to what we might call 'normal' growth, at around 3.5%. This is the basis for the 2022 budget. If we look at the growth over 2019-2020-2021, we end up with an average growth of around 2.5%. This is rather a surprise, given the enormous shock caused by the health crisis on our societies and the economy. This is the macroeconomic framework in which the 2022 budget project is set, also characterised by a gradual return to balance.

We can say "thank you" to teleworking and to the very structure of the country's economy, which relies on a financial centre whose activities have not been affected by the pandemic?

The large number of 'teleworkable' jobs, the continuity of the financial sector and the fact that the health crisis did not turn into a financial crisis saved us, but what is perhaps less emphasised is the dynamism of the ICT sector in 2020, which is much more evident in Luxembourg than in neighbouring countries. The responsiveness of the authorities in setting up emergency aid has also proved decisive. Without this intervention, we would probably have seen many SME bankruptcies, particularly in the hotel and catering sector.

Is this recently returned economic normality already reflected in public finances?

The economic slump experienced in 2020 has largely been compensated for, and even exceeded, since the beginning of 2021. One could speak of 'symmetry' in the evolution of public finances, but their dynamics are even more pronounced. Central government revenue fell--like GDP--by some 2% in 2020, but in 2021 there is a rebound of 12.7% rather than 6% like GDP, mainly due to the tax on salaries and wages, which remains very sensitive to economic growth. The subscription tax also generated additional revenue under the effect of the recovery of the financial markets, as did the tax on capital income. VAT also brought in additional revenue due to a recovery in consumption.

A small economy is always volatile, if we think of the Irish example during the 2008 crisis, where the situation deteriorated very quickly. It all depends on the nature of the shock.
Muriel Bouchet

Muriel BouchetDirector of the Idea Foundation

Public revenues are therefore returning to normality, with the budget forecasting growth of around 4% for 2022. The central government deficit was 5% in 2020 and will be only 2% in 2021 and 1.7% in 2022. For the general government as a whole--the criterion that counts for compliance with the Maastricht rule--we would be almost in balance in 2022, which would be a great performance. This is also a return to normal and to a situation that is enviable compared to our neighbours.

Cyclical elements are playing in favour of the country after this extraordinary year of 2020, but are there structural elements that explain this capacity to rebound faster than others?

I don't know if we can point to any particular structural aspect. As everyone knows, our economy's size is relative--even if it is very large compared to the size of the country--and very open, which makes it more exposed than others to external shocks. This was already the case in 2008, during the previous financial crisis. Even then, we were relatively resilient, also thanks to government and central bank intervention.

Can we say that we are structurally more resilient than others? A small economy is always volatile, if you think of the Irish example during the 2008 crisis, when the situation deteriorated very quickly. It all depends on the nature of the shock. The fact that we had a lot of jobs that could be transferred to telework also helped us a lot in the covid-19 crisis. Finally, the public authorities are undoubtedly closer to the ground in Luxembourg than elsewhere, and we benefited from a more comfortable starting position in terms of budget.

What about the ICT sector in 2020, which you referenced? What concrete contribution has it made to the economy's resilience?

There is not much information available at the microeconomic level, but we must be cautious here too, because we are dependent on a small number of large companies in this sector that operate internationally. An accounting change in one of them can have a potentially large impact on the national accounts.

Not to mention Amazon and its European base in Luxembourg, the recent OECD agreement targets digital multinationals by providing for a minimum tax rate of 15% on the profits of companies with a turnover of more than €750m and allowing states in which they make excess profits to tax them. Could this agreement have consequences for Luxembourg's public finances?

It is still relatively difficult to assess the impact. If we tighten the tax rules, we can mechanically increase revenue, but what about the volume effect? Will we be able to attract as much business as in the past? Will some relocate? This issue must be closely monitored to ensure that Luxembourg remains attractive from a tax point of view. This evolution of the global tax context should lead to a new reflection at the national level, in particular on the subscription tax which concerns investment funds and on the wealth tax which concerns companies.

In the current context, it is difficult to imagine a drastic tax cut in the short term, but announcing a 10-year roadmap, for example, towards a gradual tax cut would send a signal to investors. A targeted reduction might not cost much to the public finances, and the possible cost would be counterbalanced by a favourable volume effect thanks to the attraction of additional activities. This roadmap would allow Luxembourg to reposition itself in relation to other countries, including Ireland, which remains the major European competitor in investment funds.

The cost of the dual transition from climate change to digital technology, which are linked, should be carefully considered in future budgets.
Muriel Bouchet

Muriel Bouchet

So the absence of any major tax reform for the moment, given the context, is not harmful?

The context remains very uncertain, and I understand that the time is not right for a profound tax reform. Cutting taxes would be tricky, and austerity is not an option at the moment either. Given the budgetary situation and Luxembourg's ability to continue to respect European rules (public debt below 60% of GDP, editor's note), the fiscal status quo is understandable. Even if, as I said, we should consider, outside the context of the budget presentation, a fiscal roadmap for the coming years.

The government has stated that it wants to achieve property tax reform within the next 12 months. Could this reformed tax have a tangible impact on the rise in property prices, which rose by 13.6% in the second quarter of 2021, compared to the same period in 2020, according to Eurostat?

This is indeed the main fiscal intention of the prime minister's State of the Nation address (delivered on 12 October, the day before the budget was tabled). At present, property tax represents 0.1% of GDP, compared to 1% in European Union countries. This reform should make it possible to curb the rise in property prices somewhat, especially if empty land and housing are targeted. However, everything will depend on its design and application, and therefore on the future law.

The minister of finance has stated that "the construction of affordable housing is a government priority", with appropriations for the Special Fund to Support Housing Development, set up in April 2020, at €228m in 2022, an increase of 77% compared to 2021. Is this really enough, given that the supply of housing from public developers remains limited?

It is indeed an effort made through this fund, but we cannot deny the insufficiency of the overall supply of housing, given that net immigration remains significant and necessary. The indispensable and structural increase in supply will only be achieved through new mechanisms involving the private sector. In addition to property tax, fiscal expenditure in terms of housing should also be the subject of a multidisciplinary analysis to find out whether it does not contribute, indirectly, to fuelling the demand for housing, and therefore the rise in selling prices.

The economy has been resilient during the crisis, but how can we ensure that the state budget is resilient on a multi-annual basis to support generous social spending?

On the face of it, the signals are reassuring. But, as we said, no one is ever safe from a potential shock. That said, future budgets will have to take into account the cost of the dual transition from climate change to digital technology, as the two are linked. The risks linked to climate change will probably prove very costly, and factors specific to a small territory like ours will have to lead to in-depth budgetary reflection, including the difficulty of producing enough renewable energy to meet needs. Not to mention the cost of an ageing population.

Are climate issues sufficiently represented in the 2022 budget?

Green investments show strong growth from 2022 to 2025. The increase in the CO2 tax was already planned last year and will reach €25 on 1 January 2022. One might also ask whether the impact of global warming on the budget should not be modelled, following the example of this summer's floods, which were estimated to cost some €100m. As this type of phenomenon is likely to happen again in the future, should we not create a special fund that goes beyond the annual budgetary exercise?

In this respect, the European Commission's Ageing Working Group published new projections for the EU Member States last May. In this context, the National Council for Public Finance points out that expenditure linked to population ageing will rise from 16.1% of GDP in 2021 to 24.6% of GDP in 2070. While these estimates are subject to a number of variables, what do they tell you?

Luxembourg is one of the countries, if not the country, where the cost of ageing will increase the most in the European Union. Everything seems reassuring from a budgetary point of view in the short and medium term, but other challenges that are looming in the long term may have a greater impact here than abroad. This should encourage the pursuit of a serious budgetary policy, which has enabled us to face the pandemic in a more favourable starting position than our neighbouring countries.

Luxembourg needs a 5% growth rate to comfortably finance the pension system. A ‘normal' growth of around 3% would therefore not be enough. However, there are already bottlenecks that could prevent this continuous growth of 5%, or even 3%.
Muriel Bouchet

Muriel BouchetDirector of the Idea Foundation

Should we keep a form of fiscal orthodoxy in mind, given the major challenges ahead--climate, digital and demographic?

It all depends on what you mean by “fiscal orthodoxy”. Luxembourg needs 5% growth to comfortably finance the pension system. So a 'normal' growth of around 3% would not be enough. However, there are already bottlenecks that could prevent this continuous growth of 5%, or even 3%. I am thinking of the difficulty of attracting qualified workers, mobility problems and the lack of housing. It is therefore in our interest to specialise in economic sectors with high added value that can generate significant activity without consuming resources to the same extent. As for investments, the importance lies in their composition and their effective implementation.

To which sectors or investments should public spending be directed?

We need to invest massively in research, development and innovation, as well as in infrastructure. On this last point, Luxembourg remains well above 4% of GDP, even if the credits in the Rail Fund are relatively stagnant. If we look at aid to companies for R&D, the trend is also stagnant. The allocation for the University increases by an average of about 2% per year from 2022 to 2025, i.e. at the rate of inflation, but no more. Continuing education efforts must also be supported. However, according to the draft multi-annual budget, companies' contribution to training costs is expected to decrease by 2025. With regard to the sectors of activity, it is difficult to imagine being able to do without the financial sector, whose internal diversification must be continued. At the same time, care must be taken to promote high value-added sectors such as health and its economy, which have been crucial during the pandemic. I welcome the prime minister's idea of a health campus but this has not yet been translated into budgetary terms. The investments in ICT that have been made in recent years must also be maintained.

How do you look back on public investment in relation to GDP?

The best way to understand the effort in terms of public investment is to calculate the ratio between the investments of the public administrations on the one hand (the investments of the municipalities and the social security system are thus taken into account, together with those of the central administration) and the GDP on the other. According to the draft budget for 2022, this ratio would be 4.4% in 2022 and would hover around 4.7% of GDP from 2023 to 2025.

This is a significant effort, compared to investments made by neighbouring countries, for example. However, these orders of magnitude show only a measured increase compared to our past experience. As a reminder, from 2000 to 2019, public investment had already averaged 4.2% of GDP, with even peaks of over 5% of GDP from 2002 to 2005.

Finally, it remains to be seen whether the investment projects will be properly implemented in a country that is particularly in need of public investment due to the strong growth in its mobility and housing needs, in particular, and the very sustained trend in its population growth.

This article was written for the November issue of Paperjam magazine published on 28 October 2021.

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This story was first published in French on Paperjam. It has been translated and edited for Delano.