OREANDA-NEWS. November 12, 2015. A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

Now that the recovery is taking hold, the authorities should turn their attention to structural reforms.

Outlook—A Strengthening Recovery but not Without Risks

1. The recovery is strengthening, but growth is moderate. We expect growth to be roughly 2 percent in both 2015 and 2016. Over the rest of the decade, we expect continued growth, a decline in unemployment, and a gradual reduction in the current account surplus as domestic investment and consumption take over from net exports as the main drivers of growth. Corporate savings are high, reflected in the high current account surplus. There is scope for firms to use these savings for new investment or increased wages and hiring, which would further boost domestic demand and reduce the current account surplus.

2. The risks to the macroeconomic outlook are mixed, but skewed to the downside. Weaker-than-expected growth in the euro area or emerging markets could slow the Dutch economy given its high dependence on exports. While the housing market seems to have turned the corner, a reversal of the recent recovery in house prices could weaken household balance sheets and dampen domestic demand. Fiscal risks are mixed; while a slowdown in overall growth would negatively affect revenues, a continued rebalancing of growth from external to domestic components would, other things being equal, improve the tax composition of growth, leading to stronger structural consolidation and debt reduction. Furthermore, the Netherlands is also a target country for many refugees and economic migrants. Costs associated with refugees and economic migrants are not known given the rapidly changing developments in migrant flows, but they are expected to be substantial. In the longer term, there may be demographic and growth dividends to the extent that the migrants can be effectively integrated.

3. ECB quantitative easing has increased liquidity, but it has not yet spurred lending. Credit has continued to decline, although credit to households appears to have bottomed out in early 2015. Weak demand for credit appears to be a more important factor than either liquidity or capital constraints. However, this may be turning around; lending surveys have been reporting increased demand from households and large enterprises since early 2014, while the most recent lending survey reported stable rather than declining credit demand from SMEs for the first time since early 2009.

4. The Dutch banking system is gradually emerging from its restructuring. Dutch banks continue to adjust to tightening capital and liquidity requirements. Banks’ capital levels are well above minimum requirements now, and comfortably on track to meet the Basel III requirements.

Fiscal Policy – Making Use of Fiscal Space

5. Fiscal policy was supportive in 2015 and is expected to be roughly neutral in 2016. The recovery helped keep the headline deficit relatively stable in the 2.1–2.3 percent of GDP range in 2013-15, even as the structural balance eased by half a percentage point. The draft 2016 budget reduces labor and income taxes by € 5 billion (about 0.7 percent of GDP) while pursuing the expenditure-based path of fiscal consolidation. On current staff projections, general government debt will decline from 69 percent to 67 percent of GDP. Both the headline deficit and the pace of debt reduction are comfortably within the Stability and Growth Pact (SGP) limits.

6. There is fiscal space in economic terms, but perhaps less in SGP terms. Staff calculations show a structural balance that is well within the medium-term objective (MTO) of -0.5. However, we note that the authorities find that the space vis-?-vis the MTO is fully used under the European Commission approach. Should this change or if there is still a significant output or employment gap in 2017, we would urge the authorities to make use of this space to support the recovery. In the medium- and long-term and as the output gap closes, consolidation should resume to rebuild buffers, including by reducing public debt to below 60 percent of GDP.

Structural Policies—Important Reforms Implemented, but a Large Outstanding Agenda

7. An interrelated set of policies has given rise to an overly leveraged Dutch economy over time. The tax system has a bias toward debt rather than equity for both households and firms. The high pension savings of most workers promote security in old age, but the associated high contributions together with the high labor tax wedge can leave younger households cash-constrained. These constraints, together with the tax incentives for home ownership and mortgage debt and the absence of a well-functioning private rental market, promote premature home ownership and high household leverage. This in turn leaves the real economy vulnerable to shocks. There are also issues in the pension system that need to be addressed for their own sake, and the rapid rise in the share of the self employed suggests tensions in labor market policies that need to be addressed. The government has taken important steps to address the inefficiencies in the housing market, support indebted households, address financial sector problems, and implement pension and labor reforms. However, there is more to be done, and because of the interrelated nature of the policies and their economic impact, there is merit in pursuing the reforms in tandem.

Tax Reform – Promoting Growth and Employment

8. Tax reforms could increase potential growth, enhance fairness, and improve efficiency.  Despite progress in recent years, the Dutch tax and benefit system remains unbalanced; large efficiency gains could be achieved by shifting the tax burden away from labor, and towards consumption and capital income, in particular on residential property ownership. This makes some sense on distributional grounds as well; Dutch households have high net wealth (excluding pension entitlements) on average, but it is unevenly distributed and most of the assets are in illiquid real estate and pension accounts. The authorities have recently taken a number of steps in the right direction. For example, it has been decided to gradually phase out the large subsidies on housing investment and pension savings and to roll back some of the regressive features of the taxation of capital income. Also, next year’s €5 billion labor tax cut package is mainly targeted at female workers and low-wage earners – the most responsive groups – which should help create new jobs and increase hours worked. But more could be done and faster. The large subsidies on home ownership and pension income could be phased out more quickly than currently envisaged, allowing a budget-neutral and growth-enhancing rapid reduction of the labor tax wedge. Moreover, important tax revenue and efficiency gains would result from harmonizing the currently fragmented capital income and value-added tax schemes. Revenue shortfalls from corporate tax reforms could be offset through broadening the VAT base and unifying VAT rates.

9. The tax system favors debt and has contributed to overly-leveraged households and firms. Interest deductibility has favored debt over equity financing, resulting in excessive leverage, exacerbating business cycles and potentially threatening financial and fiscal sustainability. Future tax reforms should minimize the so-called debt bias. The Dutch authorities have already taken some measures to foster a gradual deleveraging in the housing sector (e.g., decreasing loan-to-value (LTV) ratios and mortgage interest deductibility). Similar measures should be taken in the corporate sector. For example, an allowance for corporate equity (ACE) could be introduced and calibrated so that equity and debt finance become fiscally neutral to encourage equity building. A similar type of allowance could in principle also be introduced in the housing sector.

The Second Pillar Pension System

10. The Dutch pension system has many virtues. The first pillar ensures a basic retirement income for all citizens and a very low rate of old-age poverty. The fully-funded, mostly defined-benefit, second pillar plans ensure a high replacement rate while pooling longevity risk. Finally, the Financial Assessment Framework ensures the soundness of these plans by requiring adjustments in contributions and benefits whenever the solvency ratio threatens to fall below full funding.

11. However, the second pillar plans are coming under stress. They are increasingly combining the disadvantages of both defined benefit and defined contribution schemes while failing to capture many of the virtues of either. While in principle defined benefit plans, they are increasingly behaving as de facto collective defined contribution plans. Preserving their solvency has necessitated frequent ad hoc adjustments in contribution rates, benefit accrual rates, indexation mechanisms, and even nominal benefit reductions. As a result, the predictability that should be associated with defined benefit plans for both contributors and beneficiaries has been lost. Furthermore, the adjustments to contributions and benefits tend to be procyclical in that they reduce disposable income at times when the economy is already weak. Finally, the absence of individual accounts, and opaque redistribution mechanisms between age cohorts make them non-transparent.

12. The government’s reform proposals are welcome in this context. Individual accounts could improve transparency and provide greater choice.

• Even a shift to a full, defined contribution system would not preclude collective asset management by the social partners. Doing so would also allow greater individual choice in contributions and investment options, and ensure sustainability by definition. The investment options could be constrained to protect future retirees from poor investment choices and insure them against longevity risk; the social partners could continue to negotiate terms for annuities, pension-related insurance, and investment management services collectively. The problems of procyclicality, portability, actuarial fairness in intergenerational transfers, and non-transparency would go away.

• If reforms are more limited and retain defined benefit system elements such as predefined accrual rates, the question of actuarial fairness between age cohorts would still arise. The government proposal has a level contribution rate with age, but a decreasing accrual rate as retirement age approaches. We have argued for addressing intergenerational fairness issues by keeping a constant accrual rate with escalating contribution rates with age. Each has its problems. The former approach would place a high premium on the youngest workers to have regular and stable employment at a stage in life when they are least likely to be in that situation. The latter has the advantage giving younger households more disposable income to save up for down payments or build up home equity, but it might discourage the hiring of older workers. Modifications would also need to take into account the need for greater transparency, although individual accounts would facilitate this.

• Under any approach, transition issues will be complicated. They are technically easier to solve the closer to a defined contribution system the authorities go, but real and perceived issues of fairness will arise with any transition scheme.

• The current pillar II system is fragmented, penalizing occupation mobility. Any redesign should increase rather than reduce labor market flexibility through pension portability.

Housing Market Policies

13. Housing policies and housing finance need to be addressed in tandem with tax reform. The policies of gradually reducing the LTVs ratios on new mortgages to 100 percent by 2018 and allowing mortgage interest deductibility only for new fully amortizing loans are appropriate to mitigate housing risks. The prospective reinstatement of the higher gift tax exemption is also welcome for reducing mortgage debt. However, the Netherlands LTV limit is high even at 100 percent, and the recent recommendation of the Financial Stability Committee to continue the annual reduction in LTV limits between 2019 and 2028 to reach 90 percent should be adopted. A faster pace would be welcome for both LTV and mortgage interest deductibility reduction. This would ensure that households have greater financial buffers and limit macroeconomic volatility in the event of a housing shock. However, this should be complemented by an accelerated reform of social housing to make it more market oriented and other polices to promote a larger and more robust private rental market (e.g., deregulation of rents on small apartments). These policies would give younger households an alternative to premature home ownership and promote geographic labor mobility both directly and by helping to avoiding underwater mortgages. Clarifying the LTV path after 2018 sooner rather than later would also provide buyers more time to build savings and for all participants in the housing market to plan appropriately.

The Rapid Rise of the Self Employed

14. The rapid rise in self-employment reveals tensions in the labor market. These developments have increased the flexibility of the Dutch labor market and have probably helped contain unemployment. The rapid increase in the self employed is also suggestive of an overly rigid regulatory regime for regular employment. The self employed receive large tax exemptions and tend to pay lower social contributions, resulting in lower labor costs than for regular labor. These factors entail costs, including to the budget and potentially to the viability of the pension schemes and are an institutional incentive for self employment. Also, not all of the self employed are in that status voluntarily, and many work under conditions that resemble employment relationships. Tighter enforcement of existing regulations as envisaged under new legislation that went into effect at the beginning of 2015 and perhaps new criteria (e.g., when hours and work location are set by the entity paying for the services, there would be a presumption that this is an employment relationship) could also help.

15. The lack of retirement benefits and sickness and disability insurance for the self employed need to be addressed. The low levels of participation in Pillar II and Pillar III pension schemes and sickness and disability insurance exposes many of the self employed to low income in retirement. This could be addressed through a collectively-managed pillar III system with contributions roughly equivalent to average Pillar II plans for employees. The self employed could be enrolled by default but opt out of part of the pension contributions down to some minimum level. Sickness and disability insurance could also be made obligatory, and a collectively managed insurance pool could be used to control costs to beneficiaries. At the same time, the authorities should consider liberalizing the regulatory regime for employees and move toward more equal tax treatment between employees and the self employed.

The mission team would like to thank the authorities and other colleagues for their frank discussion, support, and warm hospitality.

1 An IMF team visited The Netherlands from October 29 – November 10, 2015, for the 2015 Article IV consultation. This statement describes the preliminary findings of the staff.