Executive summary
June 2025
• A bold reform programme will sustain Iceland’s high living standards
• The economy has slowed, and fiscal policy needs an overhaul
• Improving foundational skills would lift Iceland’s growth potential
• Electricity generation needs to be expanded
• Reforming regulatory frameworks would boost business dynamism
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A BOLD REFORM PROGRAMME WILL SUSTAIN ICELAND’S HIGH LIVING STANDARDS
Supported by a strong policy framework and innovative businesses, Iceland has become one of the wealthiest and most egalitarian economies of the OECD. Large macroeconomic buffers ensure resilience against shocks. The coalition government that came to power end 2024 has committed to comprehensive structural reform, and a referendum on accession to the European Union.
Iceland’s economy is weathering global headwinds thanks to strong fundamentals. Competitiveness is underpinned by sound policy frameworks, innovative businesses and a skilled and productive workforce. Iceland is also among the most egalitarian economies in the OECD, thanks to high labour force participation, a compressed wage distribution, and a well-targeted tax and social benefit system.
Long-term growth is hindered by excessive regulation and declining foundational skills. Trade openness is low in view of Iceland being such a small country. The electricity sector, for long the mainstay
in Iceland’s economic growth model, struggles to meet demand from the green transition. Scores in the programme for international student assessment (PISA) have declined alarmingly.
The government plans a series of structural reforms to ensure sustained growth and high living standards. These include various fiscal policy initiatives such as an overhaul of the fiscal rules, the introduction of natural resource taxes and a boost to public investment. Easing business regulation, improving education and expanding electricity generation to address climate change are also on the agenda.
THE ECONOMY HAS SLOWED, AND FISCAL POLICY NEEDS AN OVERHAUL
Growth is set to recover but the outlook is surrounded by considerable risks. Addressing labour market mismatches, notably by better integrating immigrants, and enhancing tax and public spending efficiency, are critical to sustain the recovery.
The economy has slowed sharply, with a 0.7% decline of real GDP in 2024 (Figure 1). High interest rates have held back business investment, although housing
construction remained strong due to high population growth and the release of pent-up demand. Modest real wage growth has constrained consumption.
A weak fishing season and a slowdown in foreign tourism, partly because of a stronger króna and seismic activity, have slowed exports.
Growth is set to recover. The economy is projected to grow by 2.7% in 2025 and 3.0% in 2026, driven by continued easing of monetary policy and a rebound in exports (Table 1). Private consumption is expected to expand more robustly, bolstered by the pay rises following the 2024 wage agreements. Business investment will increase as confidence grows and financial conditions become less restrictive, particularly in 2026.
Uncertainty is high. Iceland’s small economy is volatile and prone to shocks. Goods and services exports, particularly tourism, could be impacted by sluggish demand in major partner countries. Tariffs could weigh on goods exports to key destinations. A violent volcanic eruption or a large cyberattack could disrupt the economy.
Despite easing a bit, the labour market remains tight. The unemployment rate is low trending around 3.5% but creeping up. Labour market shortages could be addressed by easing access to the professions and faster recognition of immigrants’ diplomas.
Inflation continues falling. It came down to around 4% in spring 2025, from a peak of 10% two years before. Core inflation remains close to headline inflation. Most inflation measures still exceed the central bank’s 2.5% target. Housing now accounts for more than half of consumer price inflation.
Monetary policy should remain vigilant. In May 2025, the central bank reduced the key policy rate to 7.5%, the fifth cut since monetary policy began to loosen in October 2024. The stance should remain restrictive until inflation and inflation expectations have settled around the target.
The housing market is stabilising following the transmission of interest rate hikes to mortgages but remains tight. Real house prices rose more over the past decade than in other Nordic countries. Land use reform and faster permitting could help investment in the housing stock to keep pace with Iceland’s economic and population growth.
The fiscal framework needs an overhaul. Fiscal policy is often procyclical, amplifying economic volatility. The fiscal rules, introduced in 2016, have been suspended since 2019. The government plans to introduce an expenditure rule to curb spending excesses, which will contribute to ensure fiscal sustainability.
Figure 1. Iceland’s economy has cooled
Table 1. The economy will recover
Annual growth rates, %, unless specified
Note: 1. Includes unfunded liabilities of government employee pension plans.
Annual growth rates are based on the aggregation of quarterly data and might differ from values published by national authorities.
Source: Updated OECD Economic Outlook No. 117, includes Q1 2025 National Accounts provisional estimates and 2024 benchmark revision.
An ageing society will put pressure on the public finances. Despite a low old-age dependency ratio and a well-funded private pension system, the fiscal costs of ageing will go up by almost 2% of GDP by 2050, mostly because of rising long-term care needs. Despite recent reforms, spending on disability benefits exceeds the OECD average.
The tax system should be improved. Lower valueadded tax rates on tourism reduce tax revenues and distort economic activity. The taxation of joint rather than individual income (“tax bracket sharing”) puts high marginal tax rates on some second earners, mostly women.
IMPROVING FOUNDATIONAL SKILLS WOULD LIFT ICELAND’S
GROWTH POTENTIAL
Over the past two decades, the quality of compulsory education based on PISA results has declined markedly. The gap between native and immigrant students is wider than in most OECD countries, often due to the latter’s insufficient language skills. The school system lacks accountability.
The quality of foundational skills, as measured by the OECD’s Programme for International Student Assessment (PISA), has declined alarmingly (Figure 2). The more than 40-point decline in Iceland’s average PISA score between 2006 and 2022 could reduce productivity by over 5% in the long run.
The PISA score gap between native students and those with an immigrant background is among the largest in OECD countries. More than half of immigrant students lack the reading skills necessary for further education or work. Enhancing support for immigrant children, notably by expanding Icelandic language training, would help foster success in school and on the labour market.
Iceland’s highly decentralized school system has many advantages, but the central government lacks oversight on school and student performance.
2. Foundational skills are declining
Comparative data on policy implementation and student progress are missing. Introducing standardised tests, as planned, will help better assess effective student and school performance and support targeted interventions at schools.
The teacher competency framework could be strengthened, to help improve teaching quality. Higher salaries or granting allowances for challenging circumstances, against improved teacher appraisal, could help attract more quality teachers.
The curriculum is relatively broad and unspecific. It was streamlined to some extent in 2024 as part of the implementation of Iceland’s Education Policy 2030. Even so, a stronger focus on core subjects could help improve fundamental skills like literacy and numeracy. Moreover, the new framework of standardised testing and assessments should be well aligned with the curriculum.
ELECTRICITY GENERATION NEEDS TO BE EXPANDED
Abundant domestic electricity has long been a mainstay of economic development in Iceland. Growing demand, among others driven by decarbonisation efforts to address climate change, is now straining Iceland’s power system. Power shortages are becoming more frequent, and prices are rising.
Rising demand for electricity is closely linked to the green transition (Figure 3). The government plans to reduce carbon emissions from nonETS sectors by 41% by 2030 compared to 2005. The largest driver of rising power demand is the electrification of land transport. Plans to produce domestic e-fuels are also adding demand for power.
Power generation falls short of rising demand. Landuse disputes and a cumbersome licensing process are holding back new generation and transmission projects. Wind energy remains underdeveloped, partly due to the lack of compensatory hydro or geothermal generation. Accelerating and simplifying administrative procedures for politically agreed projects could help lift power generation.
Reforming the regulatory framework could promote more efficient electricity use. The market is dominated by a few large producers and consumers linked by confidential agreements. Gradually expanding the wholesale market would increase the efficiency of the electricity system. Introducing dynamic pricing would reduce pressure on generation and transmission during peak times, while safeguards for households in case of electricity cuts should be strengthened.
Figure 3. Demand for power is projected to outstrip planned supply
REFORMING REGULATORY FRAMEWORKS WOULD BOOST BUSINESS DYNAMISM
Over the past decade, productivity growth in Iceland has lost momentum. The country’s relatively stringent regulatory frameworks have hindered business dynamism. By reforming these frameworks, Iceland could strengthen market selection mechanisms and enhance competitive pressure, boosting productivity growth.
Overall, the business environment in Iceland is very good, but product market regulations remain more stringent than in many other OECD economies. While market distortions due to state involvement are minimal, barriers to market entry are among the highest in the OECD (Figure 4).
The significant administrative and regulatory burden to start a business can undermine entrepreneurship. Simplifying administrative procedures for business licensing, such as
establishing a one-stop-shop where entrepreneurs can apply for all necessary licenses in one place, would be beneficial. Moreover, the requirements to obtain business licenses should be reviewed, as some appear to be disproportionately restrictive, especially those related to heavy machinery operation. Similarly, the strict requirements for occupational licenses in certain professional and personal services hamper a better allocation of resources and should be systematically reviewed.
In some network sectors, effective barriers to entry exist, including limited access to key infrastructure. In freight transport, two large incumbents controlling important port facilities have sought to collude on the division of markets.
While tariff barriers in Iceland are generally very low, regulations on FDI and services trade are quite stringent in some areas. Certain sectors are subject to severe foreign equity restrictions. Moreover, according to current FDI law, the authorities can screen FDI on economic interest grounds in a discretionary manner across all sectors. In addition, further restrictions on FDI exist, including those related to cross-border mergers, the establishment of foreign branches, and residential requirements for board members and directors. These broad restrictions limit the effective market size and slow access to the global technological frontier. They should be reviewed and removed where appropriate.
Trade facilitation measures are not well developed. To further promote international trade, border procedures for imports and exports can be improved, particularly by establishing a one-stop-shop for all necessary procedures.
Insolvency proceedings appear to be efficient in practice, but upstream restructuring should be facilitated. Obstacles to initiating insolvency proceedings early on can reduce the chances of successfully restructuring viable firms and the liquidation value of failing firms. Therefore, creditors should be allowed to initiate restructuring proceedings in Iceland. Moreover, incentives for early debt resolution can be strengthened by establishing early warning systems and preinsolvency regimes that enable related parties to voluntarily reach agreements. Finally, insolvency proceedings are often long and costly, and therefore beyond the means of many SMEs, highlighting the need for a simplified insolvency regime for SMEs.
OECD Product Market Regulation indicator – barriers to domestic and foreign entry, 2023
Figure 4. Market regulation is relatively stringent
■ Main findings | ● Key recommendations
MACROECONOMIC DEVELOPMENTS AND POLICY CHALLENGES
■ Inflation is declining but remains above the target.
● Maintain a restrictive monetary stance until inflation and inflation expectations have settled around the target.
■ Fiscal policy has been pro-cyclical for around two-thirds of the time over the past two decades. The budget balance rule provides incentives for structural spending increases when tax revenue is cyclically high.
● Complement or replace the existing budget balance rule by a structural spending rule, as planned, and stick to it.
■ The share of spending in GDP is higher than before the pandemic. No spending reviews were carried out over the past few years.
● Carry out spending reviews, building on experience gained in earlier years.
■ The VAT revenue ratio edged up from 50% in 2019 to 52% in 2023 but remains below the OECD average.
● Reduce remaining exemptions in the VAT system further, notably by subjecting tourism services to the standard VAT rate.
■ As in former agreements, the 2024 wage settlements were underpinned by the government committing to permanent social spending increases that were not foreseen in the fiscal plan.
● Refrain from abetting wage agreements with public spending promises.
■ Perception of corruption remains at average levels. Iceland is largely compliant on exchange of information for tax purposes. Effectiveness of anti-money laundering measures is below the OECD average.
● Continue the implementation of legislation to promote public integrity and improve the effectiveness of anti-money-laundering measures.
RAISING FOUNDATIONAL SKILLS AND EDUCATION QUALITY
■ PISA results have declined sharply. While across-school variation is very low, reflecting Iceland’s universal and comprehensive school system, within-school variation in PISA performance is among the highest in the OECD.
● Step up national education reform as outlined in the “Education Policy 2030” framework, focusing on teaching quality, the curriculum and student and school assessment.
■ Standardised national testing has been abandoned, leaving central authorities with little information about performance of schools and students and the factors affecting it.
● Set up a framework for standardized testing, to inform student outcomes and teaching practices, and strengthen central monitoring of school performance.
■ Immigrant students fare worse than native ones, and the difference is larger than in most OECD countries.
● Integrate and support immigrant students, especially by funding well-targeted and systematic language training.
■ Teacher quality in the classroom as measured by the PISA framework seems low.
● Improve and adapt the teacher competency framework.
■ Main findings | ● Key recommendations
POWERING THE ELECTRICITY SECTOR
■ Carbon emissions are above the OECD average, and they are declining only gradually.
● Broaden and increase carbon taxation and consider taxing methane and nitrous oxide.
■ The transmission network is ageing and at capacity limits.
● Invest in additional transmission capacity based on comprehensive cost-benefit analysis and wellcoordinated with generation projects.
■ Competing interests and land-use conflicts slow new power projects. Veto power of stakeholders is strong all along the planning phase.
● Establish a ‘fast track’ administrative framework for power projects that have been prioritised by parliament.
REFORMING REGULATORY FRAMEWORKS TO BOOST BUSINESS DYNAMISM
■ The procedures to obtain business licences are often cumbersome, involving multiple authorities and sometimes leading to inconsistent decisions.
● Establish a single point of contact where the entrepreneur can apply for the required business licences, while enhancing coordination among licence issuers.
■ In some cases, the policy objectives motivating the requirements to obtain business and occupational licences are not clear or these requirements are disproportionately strong.
● Review the policy objectives for the existing business and occupational licences and investigate whether the requirements to obtain them are proportionate to their policy objectives.
■ In the freight transport sector, large incumbents controlling important port facilities have engaged in collusion.
A government-owned company manages all airports and has possibly discriminated against small flight handling operators.
● Ensure a level playing field in the freight and air transport sectors.
■ The authorities retain discretionary power to screen FDI on economic interest grounds. In some countries the criteria to screen FDI on these grounds are more specific and clearer than in Iceland.
● Specify the criteria against which FDI undertakings are evaluated and limit the discretionary power to screen FDI.
■ Trade facilitation measures are not well developed, mainly due to a lack of coordination among the authorities involved in customs proceedings.
● Set up a single window where traders can complete all the necessary procedures while strengthening coordination among the authorities involved in customs proceedings.
■ Pre-insolvency proceedings where the debtor and creditors voluntarily reach an agreement before formal insolvency proceedings do not exist.
● Introduce pre-insolvency proceedings specifying their modalities. Encourage the use of such proceedings by allowing the debtor to stay in management.
■ There are no favourable treatments for SMEs in insolvency proceedings, which are often long and costly, possibly beyond the means of SMEs.
● Introduce a simplified insolvency regime for SMEs to alleviate their cost burden, including fiscal incentives for firm restructuring.
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