Mission Concluding Statement 

France: 2004 IMF Article IV Consultation, Concluding Statement of the Mission

July 6, 2004

1. France's economic landscape today presents several positive features that provide encouragement for an unwavering pursuit of the government's reformist strategy and for strengthened fiscal adjustment. The cyclical upswing appears well established and economic reforms are making headway in tackling obstacles to higher long-term growth. Following last year's milestone pension reform, health care reform—another important step toward fiscal sustainability—is being undertaken. Product markets are receiving a boost from the simplification of administrative procedures and the opening up of the energy market. And labor markets stand to benefit from the increased scope given to social partners to negotiate the modalities governing their relations, including at the enterprise level. Nonetheless, serious challenges persist to maintain France's attractiveness for investment and secure long-term fiscal viability. Indeed, a high tax burden and low employment rates, together with a large deficit, and an impending demographic shock cast a shadow over long-term growth prospects. The solution lies in an improvement of labor market institutions to raise labor utilization, a steadfast reduction in public spending to eliminate budget deficits and make room for growth-enhancing tax cuts, and an acceleration of product market reforms to increase competition.

2. The issue that has now clearly come to a head is the pernicious nexus between labor market policies and the budget. This nexus needs to be untangled. True, cuts in social security contributions have been promoting labor demand, the earned income tax credit (PPE) is helping to overcome inactivity traps, and other administrative actions are assisting people in returning to activity, but all these measures are weighing heavily on the budget. They were instituted to offset the adverse consequences on competitiveness and employment of institutions that adversely impact labor market performance, such as the minimum wage (SMIC), the mandatory 35-hour workweek, and high marginal tax and replacement rates. This circle has been taking a series of vicious turns with the convergence of the SMICs, and another large step is in the offing for 2005. The ensuing increase in labor costs is likely to price more young and unskilled workers out of market jobs and reduce the tax base or, alternatively, require further cuts in social security contributions that will burden the budget. Only changes in labor market institutions can reverse this spiral. Extending the planned real SMIC increase over time and narrowing the salary range over which reductions in social security contributions are granted may offer interim relief but leave the fundamental problem unaltered.

3. Recent labor market initiatives will need follow-up to induce higher employment levels. Particularly, social partners should use the invitation extended by the plan de cohésion sociale to clarify and limit the role of the judiciary in labor relations and modify the employment protection regime with the aim of raising hiring rates. Should social partners fail to reach agreement on these areas, the government will need to step in.

4. Improving labor market performance further requires a fundamental rethinking of the minimum wage and benefit systems. The high level of the SMIC and its continuing real increase—be it in the context of the convergence or through discretionary changes (coups de pouce)—simply exclude a large and increasing number of possible workers from activity. It is necessary to avoid further real increases in the SMIC. Returning people to activity will be helped by shifting from income support to work-fare arrangements. The plan de cohésion sociale invokes this principle but falls back into the trap of using fiscal resources to promote employment outside the private sector. It should be modified to focus on market jobs, strengthen obligations as well as rights of participants, and be funded by a redeployment of resources from existing labor market and welfare programs.

5. We strongly welcome the presentation of a comprehensive health care reform within the deadline set by the government. The reform is well-designed to establish control over the budget of the health care system but its effectiveness will depend crucially on the firmness of its implementation. The reform appropriately focuses on strengthening incentives of patients, health care providers and insurance agencies to behave in a more cost-conscious manner. It is precisely in this sphere that strict application of sanctions, the effective working of the early warning system, and execution of all other measures aiming at behavioral change will be vital. It will also be necessary to apply incentives (e.g., the franchise) uniformly to avoid substitution among services. In the event of insufficient expenditure control, measures will need to be strengthened, e.g., by raising and possibly extending the scope of application of co-payments. To increase support for spending limits, the visibility to households of the overall cost of the health care system should be heightened.

6. The pursuit of reforms is taking place in a propitious economic environment. Economic growth has surprised on the upside: initiated by a rebound in exports, private domestic demand has taken over as the driving force. The outlook is positive: the financial sector is highly profitable; corporate indebtedness is declining; and rising house prices and higher equity valuations are supporting household consumption. The recovery is set to continue in 2004 and beyond, though not at the brisk pace of the first quarter, and we expect growth to average about 2½ percent in 2004 and 2005. Downside risks include oil prices, external demand, and competitiveness—following the recent decline in export market shares. Conversely, domestic demand has clear upside potential. Inflation is likely to remain persistent for some time, buffeted by increases in oil prices, tobacco excises, and the SMIC.

7. The economic recovery is now reasonably self-sustained and not in need of policy stimulus. Monetary conditions in France are accommodative, with declining domestic real interest rates offsetting most of the impact of the euro's appreciation. In 2003, fiscal policy has been supportive too, with automatic fiscal stabilizers playing fully, while the primary fiscal deficit widened. However, the deteriorating budgetary situation might have had a negative impact on confidence, partly offsetting the supportive role of fiscal policy. For 2004-05, given the expected strength of private demand, the envisaged fiscal consolidation is unlikely to create a risk to the recovery.

8. Against this backdrop and impending demographic pressures, delivering on the commitment to medium-term fiscal consolidation is a priority. While pension and health care reforms constitute progress and labor and product market reforms should be pursued to boost growth, they cannot be counted upon to bring about all of the required fiscal adjustment. Therefore, to complement these efforts, the structural fiscal position should be brought into balance or a small surplus as soon as possible. Annual structural adjustment by somewhat more than 0.5 percentage point of GDP would strike an appropriate balance between credibility and feasibility. Once a reasonable fiscal downpayment is in place, and reform efforts are paying off in terms of higher growth, consideration can be given to allocating a larger share of spending restraint to growth-enhancing tax cuts. In this approach, there is a need to clarify France's medium-term budgetary objectives and demonstrate that they are consistent with addressing the aging problem, especially as the operation of the SGP is likely to become more country specific. Finally, medium-term budget objectives should not be seen as a floor, but as an average over the business cycle, thus implying appreciable surpluses in good times.

9. The present fiscal framework has failed to deliver on overall objectives and needs to be strengthened in several directions:

· The ongoing implementation of the organic budget law (LOLF) is key: it provides an improved framework to control spending, including output-oriented, zero-base budgeting. In addition, inter-ministerial concertation will be helpful to overcome an ingrained spending culture.

· Proposals to supplement the framework with multi-annual social security budgets and an internal stability pact with local authorities should be implemented. We recommend that multi-year spending ceilings be set for the general government in terms of the level of spending to ensure transparency and the correction of past overruns.

· The political cost of deviating from commitments needs to be raised by strengthening accountability and democratic checks. Consideration should be given to establishing an independent agency to conduct forward-looking budget assessments. Quarterly publication of social security, local authority, and consolidated general government accounts would also be helpful to enhance public scrutiny.

· A rule determining ex ante the allocation of revenue windfalls will ensure that improvements in weak underlying fiscal positions are sustained. Broadly symmetrical policy behavior over the cycle is essential for any rational fiscal policy rule, especially in a monetary union. A partial allocation of windfalls to deficit reduction does not satisfy this criterion. On the other hand, a simple rule that prevents discretionary changes in revenues in the course of the execution of a given budget does so, and is economically sensible (it would also preempt another "cagnotte" episode). Such a rule could usefully be enshrined in the organic budget law, as in some other countries.

10. The 2004 general government deficit objectives are likely to be overshot, despite welcome efforts at the central government level to contain spending within the amount approved in the initial loi de finances. Revenue windfalls from higher-than-expected growth stand to be more than offset by expenditure overruns and the planned large structural adjustment will not be achieved. Additional funds are needed to reintegrate the recalculés and health care spending is growing faster than anticipated. Consequently, health care reform measures, including those already in the pipeline (e.g., the second wave of déremboursement), should be advanced to the greatest possible degree.

11. For 2005, the commitment of reducing the general government deficit to below 3 percent of GDP is, on present growth forecasts, consistent with structural adjustment of somewhat more than 0.5 percentage points of GDP. Its achievement should, however, not rely on one-off measures. We support the intention to restrain spending growth in the central government but are concerned that the planned reduction in the social security deficit may not materialize. Cuts in social security contributions linked to the SMIC convergence, new measures aimed at social inclusion, and start-up costs of the health care reform will weigh on the budget, while expenditure savings will take time to accrue. Though not a source of immediate savings, the ongoing wave of retirements from the civil service-thus far used only symbolically-needs to be tapped in earnest to secure long-term fiscal adjustment. While across-the-board cuts are unwarranted, productivity gains should make it possible to meet the "reference value" of replacing only one out of two retirees. Without prior savings on spending there is no margin for tax cuts.

12. Changes in the tax structure can contribute to a better resource allocation and reduce disincentives to supply labor and invest. Following its recent, temporary suspension for new investments, the fate of the taxe professionnelle (TP)—a highly distortionary tax on capital—is under discussion. Given its large yield and its importance as a source of revenue for local governments, its replacement by other taxes is problematic, as it would lead to significant shifts in the tax burden and complicate the devolution of responsibilities to local authorities. In the context of already high taxes, the best solution would consist of additional cuts in overall expenditures (including subsidies to industry) over time to fund a concurrent phasing out of the TP. Alternatively, room could be found in a combination of increased reliance on user fees at the local level, higher real estate tax revenues, the closure of existing tax niches, and the abolition of preferential VAT rates.

13. Decentralization provides an opportunity to better tailor services to local needs and improve the efficiency of public services. Its effectiveness will depend crucially on the design of the associated incentives. For example, the devolution of income support programs (RMI/RMA) will be beneficial only if the local authorities can reallocate any budgetary savings in these programs to other uses. Similarly, the scope for modulating tax revenues should be significant and impact local constituents (i.e., the dégrèvement of the taxe d'habitation and the taxe professionelle should be abandoned).

14. In product markets, we welcome the ongoing efforts to reduce the regulatory burden, simplify administrative procedures to create companies, and promote divestiture. The reform of the EDF/GDF statute marks a major change in this area. More broadly, the government's intention to withdraw from commercial activities should proceed resolutely as market conditions permit. The reform of the corporate bankruptcy legislation will help clarify and limit the liability of creditors, while at the same time enhancing the survival chances of troubled companies. However, more needs to be done to strengthen competition, e.g., by loosening restrictions on the right of establishment and on price setting in the distribution sector, improving price transparency in financial services, and closing the significant transposition gap of EU directives.

15. The attractiveness of France as a place to produce and invest is best defended by structural reforms in goods and labor markets, aiming at higher productivity growth, more flexibility, and lower production costs, supplemented by investment in infrastructure and human capital. Emphasis on "national champions" and state intervention against relocation go against the grain of such reforms. Indeed, they risk ultimate defeat as vested interests may take the state hostage.

16. France concluded a Financial Sector Assessment Program (FSAP) this year, an international initiative that aims to promote the soundness of countries' financial systems. The FSAP confirms the sound state of France's financial system and the high quality of oversight and prudential supervision, finding a strong conformity to international standards. The stress tests point to a resilient system and no weaknesses that could cause immediate systemic risks were identified. Nonetheless, the FSAP recommends continuing vigilance on banks' potentially risky expansions, strengthening cooperation among the supervisory agencies, and addressing certain weaknesses identified in the system for countering money laundering and the financing of terrorism (AML/CFT) and in the payment systems area.

17. There are still a number of idiosyncracies in the French financial system which adversely affect efficient resource allocation and the economy's dynamism. First, the administrative savings schemes are not well-targeted to achieve their intended social goals and hamper the transmission of monetary policy. As recommended in the FSAP, the system should be phased out. In the mean time, the change initiated last year should be pursued further, tying the adjustment mechanism for the livret A and other schemes (such as the plan épargne logement) more closely to changes in market rates. Second, despite the strong growth in mortgage lending, mortgage markets could be further developed by addressing high refinancing costs and the absence of home equity loans. Third, both the ni-ni rule and usury rate could be usefully abolished.

18. In the trade area, the Doha round is at a crucial juncture, and the EU's new efforts to relaunch the round are welcome. We would encourage France to associate itself fully with these efforts, and to support the offer to phase out all farm export subsidies and further limit negotiations on Singapore issues. We also look forward to France's implementation of the June 2003 reform of the Common Agricultural Policy. France's contribution to development through its relatively high level of ODA and its intention to broadly double it to reach the UN target by 2012 are most welcome.