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Box 6. Recommendations concerning public-spending management

Box 6. Recommendations concerning public-spending management

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OECD Economic Surveys: Iceland

with a process that clearly defines political priorities and the means to achieve

them, and relies on multi-year spending targets rather than ad hoc decisions. There

is also room for enhancing near-term spending discipline. Although the introduction of “frame-budgeting” has improved planning and decision-making, its effectiveness has been undermined by the fact that expenditure targets have tended

to be modified in the parliamentary phase of the budget process. Moreover, fiscal

slippage has continued, with overspending (typically in the areas of compensation

and health care) systematically sanctioned by supplementary budgets.

With respect to the efficiency of public spending, much remains to be done

in the area of performance management. Most ministries have still to adopt performance-based budgeting. Moreover, managerial accountability has lagged the devolution of management authority to government agencies. This has contributed to

large wage increases following the introduction of a new decentralised public-sector

pay system. The devolution of responsibilities to local authorities has also not been

without problems, since they seem to have had greater difficulties in containing

costs than the central government, as it is harder for them to resist claims for more

public services and higher pay. And they have been even slower than the central

government in introducing performance management and other reforms. This is in

part due to their often microscopic size, highlighting the need for further amalgamation. Finally, there is scope for greater reliance on market mechanisms and signals,

such as outsourcing, user charges and client choice, in order to improve allocative

efficiency. Box 6 sets out some recommendations as to what could be the most

promising avenues of further reform in the area of public-spending management.

© OECD 2003


Structural policy developments

The 2001-02 recession was widely expected to lead to some deterioration

in the stability of the financial sector, reflecting both normal cyclical forces and the

rapid expansion in foreign-currency-denominated debt through 2000. However,

the 2001 depreciation in the krona and weakening in business activity did not

bring with them a pronounced reversal in the health of the financial system. In

part, this stems from the fact that the krona recovered before defaults on foreigncurrency debt began to accumulate. However, good policies also played a role, as

financial supervision has been strengthened since 2000, and banks have taken

action to improve their capital positions. More broadly, the long trend away from

government interference in the sector since the early 1990s has led to a more stable

environment. The sale last year of nearly all of the state’s shares in two commercial

banks ended the last major direct government ownership in the industry. However,

government programmes continue to distort financial decisions, particularly the

support of housing through the Housing Financing Fund, the tax system and social

policies. Policies should be changed to remove the advantages held by residential

investment, thereby placing business investment on a more equal footing.

While privatisation of the commercial banks was successful last year, the

government was forced to abandon its efforts to privatise Iceland Telecom by the

depressed global market for telecommunications, though it remains committed to

its sale over the medium term. A more difficult task will be deregulation and privatisation in the energy sector. Iceland has substantial energy resources in the form

of hydroelectric and geothermal energy potential. The current regime is heavily

regulated and does not distinguish between natural monopoly and competitive

areas. Proposals for deregulation have taken into account calls for a separation of

such activities and the need for incentives for efficient production and use. Nonetheless, deregulation has proceeded slowly, and the expansion of power-intensive

industry (a topic of macroeconomic importance – see Chapter I) will likely complicate matters further. The current system provides subsidies through government

backing of the National Power Company’s debt and does not adequately account

for the environmental costs of power generation. It also blocks foreign equity

investment in power generation (which could result in a better diversification of

the risks associated with large projects across interested parties).

© OECD 2003


OECD Economic Surveys: Iceland

The proposals for building a power plant and smelter in eastern Iceland

are in part related to regional development goals: the population has become

increasingly concentrated in the capital region, and the government hopes to

increase the attractiveness of other areas. A range of other policies, including support to agriculture, also have important regional motivations. Agricultural distortions remain very large in Iceland, with producer support at the upper range of

OECD experience and consumer prices for agricultural products substantially

above world levels. Lower support would raise consumer welfare and contribute

to better land management. It is also notable that agricultural policies contrast so

sharply with the liberal and largely effective management of Iceland’s fish resources.

Finally, despite its small isolated population, Iceland does have a role to play in

limiting its emissions of greenhouse gases and conventional pollutants, with care

taken to ensure that improvements be made at minimum cost. Table 14 provides a

summary and assessment of previous and new structural policy recommendations.

Financial markets

The transition to a fully privatised banking system is now complete…

Iceland’s financial markets have undergone a revolution over the past

decade, as emphasised in previous Surveys. Until very recently, state-owned commercial banks dominated the market, but the government sold nearly its entire

70 per cent stake in two of the largest commercial banks, Landsbanki and

Bunadarbanki, in late 2002, effectively ending its participation in commercial

banking. This change should help spur increased efficiency: the governmentowned banks have experienced persistently higher costs and lower returns on

equity than the privately-held Islandsbanki, and competitive pressures should

lead to some improvement. The entry of Kaupthing, an investment bank, into

commercial banking activities at the beginning of 2002 has provided a further degree

of competition. This has been needed, as the small size of the market guarantees

some limitation on the number of banks with the potential to operate at minimum

efficient scale. Indeed, competition concerns had prevented the government’s plans

in 2000 to merge its two commercial banks prior to their eventual privatisation.

The rapid expansion of credit through the business cycle peak in 2000 was

accompanied by an improvement in the financial strength of the banking sector,

but it also led to some decline in capital adequacy and concerns that a slowing in

activity and/or a correction in the exchange rate could lead to a deterioration in

the financial system. In particular, both the June 2001 Financial Stability Assessment of the International Monetary Fund (IMF) and credit rating agencies had

voiced concerns regarding the sufficiency of bank capital, given the rapid increase

in debt levels, especially foreign-currency-denominated debt. Non-performing

loans and appropriated assets at the three major commercial banks edged up last

year (relative to the stock of loans, Figure 19, Upper panel), but remain below the

© OECD 2003


Financial markets

Speed up privatisation of the two commercial

banks that the government owns.

Consider a minimum capital ratio of 10 per cent.

Speed up consolidation of savings banks.

Public employee pensions

Move to a fully funded system as quickly

as feasible.

Housing sector

Transition away from government backing of

bonds issued by the Housing Financing Fund.

Eliminate tax benefit associated with mortgage

interest and replace with general means-tested


Eliminate rebate of value-added tax on wage

cost of new house construction.

Labour market

Shorten the time period unemployment

benefits are paid.

Move away from two-stage centralised

bargaining process.


Increase focus on foreign languages, sciences

and mathematics.

Boost fees for tertiary education.


Privatise Iceland Telecom.



Nearly all shares sold in 2002.

The programme is effectively complete.

Government is considering a range of changes in

response to IMF’s Financial Stability Assessment,

although not this specific action.

New law in 2001 allowed transition to corporate


Given the historical volatility of Iceland’s

economy and the high exposure to currency risk,

a prudent approach seems warranted.

None have incorporated; the incentives appear


Government has placed these liabilities

on its balance sheet.

Despite progress, a large part of the government

pension scheme remains unfunded.

No action.

Distorts choice between housing and other


Distorts choice between housing and other


No action.

No action.

Distorts choice between housing and other


No action.

Payments are unusually long-lived.

No action.

Government plays a role in private-sector pay

negotiations that results in excessive fiscal


Funding and teacher qualifications have been


No action.

Test scores have risen some, but it is too early

to declare victory.

While most of the returns are private, fees are

minimal, contributing to long completion times.

Attempted, but global telecoms bust thwarted Renewed efforts should soon be made.




Summary of structural policy recommendations

Structural policy developments

© OECD 2003

Table 14.

Summary of structural policy recommendations (cont.)





Implement electricity deregulation plan.

Proposals have been delayed.

Necessary to improve efficiency and comply

with EEA agreement.

Increased debt associated with major projects

will make privatisation more difficult.

Eliminate government backing of National

Power Company debt.


Reduce corporate tax rates.

No action.

Abolish net wealth tax.

Reduced from 30 per cent to 18 per cent

in 2001.

Lowered from 1.2 per cent to 0.6 per cent.

Index basic tax credit for individuals.

No action.


Table 14.

Increases efficient allocation of capital and

incentives for saving.

Increases efficient allocation of capital and

incentives for saving.

Would stop automatic rise in effective tax rates.


Reduce price supports.

Some progress, but abandoning administration Delay prevents an improvement in consumer

of milk prices delayed.


Open agriculture to foreign competition.

No action.

Unusually protective quotas and tariffs boost

domestic prices.

Eliminate lower VAT rate on food in conjunction No action.

Unnecessary once distortions boosting food

with other reforms to liberalise the agricultural

prices are eliminated.


Limits on annual changes in TAC for cod.

Small boats brought within the TAC.


Slows recovery to maximum economic stock.

Effort-based system is inefficient.

This distortion is no longer justified.


Introduce diesel fuel taxation on vehicles.


Use more cost-benefit analysis.


Current distance-based system has poor

incentives to reduce emissions.

Would improve policy effectiveness and


© OECD 2003



OECD Economic Surveys: Iceland


Expand use of automatic catch rules.

Eliminate small-boat exemption.

Abolish seamen’s tax credit.

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Box 6. Recommendations concerning public-spending management

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