Luxembourg OECD Economic Survey 2022-Brochure

OECD Economic Surveys

LUXEMBOURG

OECD Economic Surveys Luxembourg

Executive Summary November 2022

NOVEMBER 2022

• Russia’s war of aggression against Ukraine is weighing on the recovery • Enhancing resilience to risks

• Raising labour supply and productivity to sustain long-term growth • Securing a sustainable green transition for the long term requires a comprehensive policy toolkit

Key recommendations

Enhancing resilience to risks

• Make income support to households more targeted to the most vulnerable and limited in time, whilst avoiding accelerating domestic demand pressures.

• Reform the wage indexation system in consultation with social partners to take better account of the productivity, employment, and investment effects.

• Expand and publish regular monitoring of all loan types by household characteristics to understand emerging pockets of vulnerability, and be prepared to implement additional macroprudential policies if necessary.

• Put in place a more performance-oriented budgeting framework, incorporating spending reviews, to make spending more effective.

• Link increases in the statutory retirement age to increases in life expectancy.

• Phase out incentives for early retirement, while providing for more flexible working arrangements for older workers.

Improving labour market outcomes and productivity for sustained growth

• Subsidise active on-the-job training schemes targeted to the over-45-year-olds.

• Expand access to training to help early-school leavers enter the workforce, alongside school system reforms.

• Increase public spending on R&D to match private R&D funding and encourage greater investment by firms.

• Increase funding to targeted projects by reducing the funds spent on administration.

• Reduce administrative burdens on small firms, notably by streamlining procedures for starting a business.

Improving resilience through the transition to green growth

• Introduce scenario and sensitivity analysis to estimate the long-term cost of the green transition, including the impact on different households and firms.

• Set a rising carbon tax trajectory over the medium and long term, while redistributing revenues to minimise the burden on the most vulnerable.

• Introduce and gradually increase road use charges in conjunction with tighter parking policies.

• Use tax credits and municipal funding incentives to encourage higher urban density, with green homes built in accordance with the Master Programme for Spatial Planning.

• Strengthen regulations on fertiliser and pesticide use.

• Make national agricultural subsidies contingent on the adoption of sustainable farming practices that protect the environment.

Russia’s war of aggression against Ukraine is weighing on the recovery

The economic recovery from COVID has slowed due to war-related uncertainty and inflationary pressures. Public support can help vulnerable households cope with the higher cost of living but should be well targeted and time-bound, and maintain incentives for energy savings.

Economic growth recovered strongly in 2021 (Figure 1). Owing to decisive economic support, the economy escaped the worst impacts of the COVID pandemic, with GDP already reaching pre-pandemic levels by the third quarter of 2020. Post-COVID support measures helped ensure most sectors recovered strongly in 2021.

Figure 1. The economy rebounded quickly

Real GDP, Index 2019Q1=100

Source: OECD Economic Outlook (database).

The war in Ukraine is worsening the economic outlook (Table 1). Headline inflation reached 8.8% in October, due to high energy prices, rising core inflation, and automatic wage indexation, which tends to push up wage inflation in an already-tight labour market. In the short term, growth is expected to slow, on the back of higher global interest rates, and plummeting confidence. Whilst direct exposure to Russia is low, the economy will be negatively affected through a slowdown in activity in European partners. The EU embargo on Russian oil imports, supply chain disruptions related to the war and China’s COVID-related shutdowns will further dampen activity.

Policies to mitigate inflation impacts on incomes should be better targeted, time-bound and maintain energy savings incentives. Generous fiscal policy support of about 3.3% of GDP is weighted towards price support. Such measures may blunt incentives to reduce energy consumption, especially if energy prices remain high over the medium term. Policy should focus more on temporary, targeted income support.

Table 1. Growth is weakening

% change unless noted 2021 2022 2023

Gross domestic product 5.1 1.7 1.5

Private consumption 9.4 2.8 2.0

Unemployment rate 5.7 4.8 5.0

Consumer price index (HICP) 3.5 8.2 4.0 Fiscal balance (% of GDP) 0.8 -0.2 -2.2 Gross public debt (% of GDP) 24.6 27.0 30.5

Source: OECD Economic Outlook 111 and updates (database); debt: Maastricht.

The wage indexation system risks adding to already high inflation in periods of unprecedented price shocks, potentially harming longer-term competitiveness. General wage increases result in proportionately higher monetary gains for wealthier earners. Agreements by the social partners to moderate wage indexation may not be sufficient if energy prices remain elevated for a prolonged period. The government should reform the wage indexation system in consultation with social partners to better safeguard against risks to productivity, employment and inflation.

Enhancing resilience to risks

Higher global interest rates will raise risks in the financial sector and housing markets over the short and medium term. Pensions spending represents a large fiscal risk over the long term.

The overheating housing market poses risks for some categories of borrowers. House price inflation has outstripped most OECD countries (Figure 2), worsening affordability and raising household debt levels to 180% of net disposable income in the first quarter of 2022. Macroprudential policy measures have been taken to lower risks for borrowers, and loan-to-value limits introduced in January 2021. Nonetheless, higher interest rates will put some categories of borrowers on variable rates under strain, particularly those with lower incomes. In addition to maintaining heightened vigilance of banks and household indebtedness, the authorities should stand ready to apply a broad range of macroprudential policy instruments.

The fiscal system’s resilience to shocks is high but can improve further. High growth, resilient tax bases and a strong commitment to low public debt have been important safeguards, particularly given how small and open the economy is. However, over time, spending pressures are set to increase. Pension expenditure will rise sharply under unchanged policies whilst macroeconomic shocks, linked to climate change, could increase in frequency. Developing a more systematic framework to assess and prioritise spending policies could further increase fiscal resilience.

Figure 2. House price inflation has been very high Index 2017=100

90 100 110 120 130 140 150 160 170

LUX FRA

DEU OECD

2017 2018 2019 2020 2021 2022

Source: OECD House Prices (database).

The current pension review is an opportunity to tackle projected increases in annual pension expenditures of up to 9% points of GDP by 2070 (Figure 3). Debt sustainability projections show that in the worst-case scenarios, this would raise the public debt to GDP ratio to over 140% by 2060, after fully drawing down pension asset reserves. Raising effective retirement ages and introducing actuarially fair adjustments for early retirement would improve the affordability of the pensions system and enhance intergenerational equity.

Raising labour supply and productivity to sustain long-term growth

Potential growth is set to slow as the population ages. Labour participation of young and older workers should increase while higher private sector investment, including in R&D, would boost productivity growth.

A number of young workers are at high risk of being excluded from the job market. High dropout rates are concentrated amongst the most vulnerable students, who are less equipped to cope with uneven schooling quality and rigid educational pathways. Any reforms to the schooling system will take time to be effective and need to be accompanied in parallel by a sharp expansion in vocational training for unemployed youth. Programmes should promote in particular highly demanded skills for technical professions.

Figure 3. Pension spending is set to rise rapidly

Difference between 2070 and 2019

Source: European Commission, The 2021 Ageing Report.

The current high barriers to employing older workers should be removed. Participation rates of over 55-year-olds are amongst the lowest in the OECD. Generous pension benefits and existing work practices reduce incentives to remain in the workforce. The pensions system could be reformed to allow a phased entry into retirement, including more flexible use of part-time contracts. The existing incentives to hire older workers should be enhanced, including via targeted training to overcome skills gaps, notably in digitalisation. A strengthened system of adult learning, with a focus on life-long learning, would ensure the existing workforce is not left behind in the transition to a green economy.

Private investment levels of 8.5% of GDP and 0.6% of GDP for R&D are amongst the lowest in the OECD. The government provides significant support to R&D investment, but total private investment, including for R&D, continues to fall as a share of GDP. SMEs’ digital investments also lag peers. Public investment support for R&D is highly dispersed with overlapping structures. Streamlined administration could improve the use of available funds, which could be redirected from a narrow focus on high-tech sectors to the manufacturing sector. Increasing the share of funds deployed to match private funding of R&D could support more investment by firms.

Administrative burdens are high, representing an obstacle to firm dynamism. Professional licensing rules are amongst the most restrictive in the OECD. Starting a business, whilst possible to do online, remains a cumbersome procedure.

Securing a sustainable green transition for the long term requires a comprehensive policy toolkit

Luxembourg has ambitious climate goals, but deep changes are needed to meet them. Higher carbon prices reinforced by transport and housing policies can improve household choices on where to live and how to move.

The price of carbon must increase in the long term for the green transition to succeed (Figure 4). Energy prices paid by consumers have increased significantly recently but may need to rise even further in the long term to reach net-zero emissions. Low carbon prices have encouraged residents’ high levels of car usage and residential heating consumption, and provided little incentive to undertake large behavioural changes or expensive energy efficiency investments. Cross-border fuel sales have also been significant as prices in Luxembourg have been historically lower than in neighbouring countries.

The current carbon tax lacks the long-term time horizon needed to create clear incentives for the green transition. A rising carbon tax, with a clearly defined trajectory over the long term, will incentivise required investments in energy efficiency. This needs to be accompanied by a clearly communicated policy as to how any additional revenues from environmental taxes may be used. Policies that explicitly tackle distributional concerns tend to increase the political support and sustainability of transition policies.

Figure 4. Fuel prices have been below those in neighbouring countries

Fuel prices, USD/unit, 2021 average

Note: Average of diesel and petrol prices.

Source: IEA energy prices (database).

Ambitious policy targets for the transition need to be accompanied by estimates of the costs of the green transition. The costs of the transition will change over time, and across groups of households and firms. These costs, and how they are affected by policies, need to be carefully monitored. Costing the transition will enable prioritising competing long-term fiscal demands, including for pensions.

High house prices, significant benefits for car usage and planning co-ordination challenges have resulted in urban sprawl and high car dependence. Luxembourg has one of the highest rates of urban sprawl in the OECD. Tax benefits for travel distances and company cars should be removed and gradually replaced with road-use tolls and parking restrictions to encourage more people to use the free, expanded public transport services. Housing supply incentives for municipalities and households should be aligned to encourage building in accordance with the Master Programme for Spatial Planning. Increasing the benefits for households that undertake densification and energy efficiency renovations simultaneously could encourage deeper

renovations and improve the alignment between housing and climate objectives.

Biodiversity and the quality of water and soil are under significant threat. The number of endangered species is amongst the highest in the European Union. Intensive cattle farming and fertilizer use are harming biodiversity with very limited attention to environmental impacts in the design of agricultural policy. Regulation of the agricultural sector’s use of fertilisers and pesticides must be urgently strengthened. Existing subsidies to the sector must be re-shaped to support green farming.

OECD Economic Surveys LUXEMBOURG

Luxembourg recovered quickly from the COVID-19 pandemic thanks to extensive policy support. However, the impact of the war in Ukraine is exacerbating inflationary pressures, alongside labour market shortages. This highlights the importance of boosting the resilience of the Luxembourgish economy. Longer-term fiscal sustainability challenges should be addressed by improving the efficiency of public spending through regular spending reviews, limiting early exit from the labour market and undertaking much-needed pension reform. Removing disincentives to work and strengthening the effectiveness of active labour market policies, in particular for older workers and disadvantaged youth, would boost employment and lower skill mismatches. Digital skills need to improve and life-long learning should be strengthened. Increasing private R&D spending, improving diffusion of digitalisation, especially for small firms, and reducing the regulatory burden would support productivity growth and economic diversification. Reaching the climate objective of net zero emissions by 2050 will require bold policy action, requiring a clear carbon pricing path and adjustments to urbanisation and transport policies.

SPECIAL FEATURE: SECURING A DYNAMIC AND GREEN ECONOMY

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