1. Fiscal policy in Iceland and the challenges of globalisation Central Bank of Iceland & IMF conference on “The Challenges of Globalisation for Small Open Economies with Independent Currencies” Thorsteinn Thorgeirsson, Director-General Economics Department Reykjavík, 31 May 2007

2. Overview i)Economic policy framework ii)Structural reforms and results iii)Fiscal policy outcomes iv)Closing remarks

3. Economic policy framework A. To effect short- to medium-term demand management i)Monetary policy: counter-cyclical impact through interest rate setting in order to reach inflation target ii)Fiscal policy: counter-cyclical impact through a) operation of automatic stabilisers, b) attainment of a fiscal rule and c) the use of discretionary measures B. To increase sustainable growth rate of the economy i)Monetary policy: a stable and low inflation rate reduces uncertainty and enhances efficiency and growth ii)Fiscal policy: counter-cyclical policy and strong Treasury position reduce uncertainty and enhance efficiency and growth iii)Structural policy: reforms increase efficiency, flexibility and motivation of participants in an increasingly open economy Main challenge Policy challenged to manage the substantial impact of structural reforms on demand in a rapidly globalising economy

4. Structural reforms A.Opening up of economy i)EFTA membership in 1971: liberalisation of merchandise trade, with also Third Countries due to Free Trade Agreements ii)EEA membership in 1994: liberalisation of Goods, Services, Labour and Capital flows on Single Market B.Seperate reforms i)Private Pension Funds created in 1960s ii)Labour market liberal by standards of mainland Europe iii) Benefit dependency not yet a problem C. Privatisation and corporate governance i)Privatisation of firms in banking and communication sectors ii)Publicly owned energy companies made more independent. iii)Energy co’s recently moved under Finance Ministry jurisdiction iv)Similar move being considered for Housing financing fund

5. Fiscal policy reforms Revenues: Significant reforms of tax system in past decades with aim to a)enhance the automatic stabilisation properties of the tax system for short-term demand management b)make it simple, transparent and motivating for economic activity Key tax reforms Capital: Corporate income taxes reduced from 50% in 1989 to 18% in 2003. Net wealth tax abolished, inheritance taxes reduced and simplified, capital income tax and capital gains tax reduced to 10% Labour: High income surcharge phased out from 2003 and abolished in 2006. Personal income taxes reduced in stages from 25.75% in 2004 to 22.75% in 2007 with also personal tax excemption raised Goods and services: VAT system simplified and rate reduced in 2007 for food and various other items to 7% from 14% or 24.5%

6. Fiscal policy reforms Expenditure: Wide ranging reforms to contain public spending pressures: a)Frame budgeting adopted in 1992 b)Accruals accounting in 1998 increased transparency of new liabilities c)Program to enhance public sector efficiency from 1991 d)Public sector wage reform in 1998 with more flexibility and budget amounts based on output, not number of employees e)Medium term plan adopted in 2003 f)Fiscal rules an integral part of medium term plan i)real growth of public consumption not to exceed 2.0% ii)real growth of transfers not to exceed 2.5% iii)Budget in balance, but preferably a surplus g)Outsourcing policy for public services introduced in 2006 h)Ministries/agencies increasingly respecting frame budgeting process i)Parlimentary culture evolving from “advocacy” to “enforcement” j)Fiscal rules to be extended to municipal government sector

7. Channels for globalisation to impact fiscal policy A. Capital market Corporate income tax receipts surged in recent years, but could decline in downswing Easier access to foreign financing increases exposure to exchange rate and foreign interest rate risk B. Labour market Direct and indirect tax receipts increased with labour inflows, whereas unemployment benefits could increase in downswing C. Goods and services Surge in VAT receipts due to foreign investment related imports, to contract as projects end Implications of globalisation for fiscal policy i)Treasury revenues and expenditures more volatile ii)Automatic stabilisation properties more pronounced iii)Fiscal sustainability: stronger fiscal position but more macro risk

8. Corporate income tax revenues and the tax rate 1994–2006

9. Corporate income tax revenues by sector (at constant prices) 1999–2006

10. Personal income tax elasticity estimated at 1.0-1.3

11. No “Twin deficit” problem in Iceland

12. Results of extensive structural reforms The results have exceeded expectations i)Economic growth and disposable growth averaged 4% in real terms since mid 1990s ii)Potential growth rate of economy estimated at 3.5% iii)Corporate sector dynamic iv)Work force well trained and fully employed v)Economy is resilient vi)Demographics of young and fast growing population vii)Pension system fully funded viii)Fiscal policy is counter-cyclical ix)Net treasury debt reduced from 35% of GDP in mid 1990s to 4% of GDP in 2006 x)Fiscal sustainability for the longer term looks promising

13. Public consumption 1999–2009

14. Public investment 1998-2009

15. General government revenue balance 1998–2009

16. Gen. gov. cyclically adjusted revenue balance 2000–2009

17. Cyclical adjustment in OECD-countries 1997-2006

18. Closing remarks Fiscal policy i)Counter-cyclical impact ii)Strengthend Treasury position iii)To continue emphasising spending containment Globalisation i)Positive effect on welfare ii)Temporary domestic and external imbalances iii)Resilience of economy and strong government finances offset risk to macroeconomic stability Policy debate i)Sufficiency of fiscal restriction in upswing ii)Efficacy of domestic monetary policy in a globalising economy

19. Thank you