Mission Concluding Statement 

France -- 2005 Article IV Consultation, Concluding Statement of the Mission

July 11, 2005

1. France has been implementing important reforms, which strengthen its ability to respond to the challenges posed by aging and changes in the global economy. The pension and health care reforms of the past two years have substantially improved the prospects for fiscal sustainability. The recently-announced Plan d'urgence pour l'emploi has added impetus and new direction to labor market reforms, much needed to reduce high unemployment. In addition, the focus of the authorities on consumer welfare is a constructive approach to motivate product, services, and financial market deregulation. While the authorities' determination to proceed with reforms is courageous, particularly in the difficult context in which they are being undertaken, it will be essential to build further reform momentum. Otherwise, benefits in terms of growth and job creation may remain limited or take a long time to accrue.

2. The near-term outlook has improved following the soft spot in the first half of 2005, when unexpected external weakness dampened growth. With the clarification of the direction of economic policies and their emphasis on job creation, consumers should take heart and continue to carry growth in the remainder of the year. At the same time, improvements in the business environment will help sustain investment, and the weakening of the euro should draw in additional external demand. GDP growth is projected to average about 1¾ percent in 2005 and rise to an annual pace of slightly more than 2 percent in 2006, though important downside risks remain. Oil prices and possible lackluster domestic demand in European trade partners are key ones. Headline inflation is expected to average about 2 percent in the 12 months ahead, with oil prices and health care reforms constituting upward risk and the reform in the distribution sector downward risk.

3. The long-term growth outlook is an important input in policymaking. Over the past 15 years, growth has averaged just below 2 percent. Without reform, demographics, though favorable compared to many other European countries, are likely to dampen potential growth. With the pursuit of structural reforms, growth will be higher, at least during the period in which reforms take hold. Nonetheless, to secure fiscal consolidation, the general government's real spending growth—which in any case needs to be lowered to well below current potential growth—should not be permitted to move up with increases in potential growth until consolidation objectives are met. Revenues should be allowed to fluctuate in line with actual growth, with all windfalls going toward deficit reduction, thus helping to bring about fiscal consolidation.

4. It is imperative to pursue fiscal adjustment with the aim of achieving a structural surplus and reducing the burden of public debt on the next generation. In this respect, the execution of the 2004 budget was exemplary. By projecting growth realistically, keeping central government spending constant in real terms, and allocating all higher-than-expected revenues to deficit reduction, considerable structural adjustment was achieved. Nonetheless, the deficit, at 3.6 percent of GDP, remained high. In 2005, the execution of the budget on the expenditure side is once again commendable, especially because successful implementation of health care reform is keeping spending in line with the targeted deceleration, for the first time in several years. However, underlying structural adjustment is modest, in part because initial plans were unambitious, which leaves the risk that the general government deficit could exceed 3 percent of GDP this year. In addition, the inclusion of the EDF soulte in the 2005 budget masks the lack of underlying adjustment as it is matched by future budgetary liabilities. For the remainder of the year, it will be essential to avoid any overruns on spending at all levels of the government. In this context, the freeze of some spending at the central government level and of unemployment benefits by the UNEDIC are highly appropriate.

5. In 2006, policies need to deliver a general government budget deficit of less than 3 percent of GDP, based on structural spending restraint. Some key elements to achieve this objective are already in place: the announced freeze in real spending of the central government (for the fourth consecutive year), the postponement of promised income tax cuts, and the pursuit of a nominal target for health care spending in line with trend GDP growth. Further measures are likely to be required to ensure that the structural deficit is reduced in line with this objective and put on a downward path, yielding an annual adjustment of at least ½ of one percentage point of GDP. The forthcoming renegotiation of the UNEDIC convention provides an opportunity to eliminate the deficit of the unemployment insurance system, while concurrently strengthening labor market performance. Streamlining active labor market policies and improving procurement could also contribute to deficit reduction. While short-term benefits of civil service reform are limited and an across-the-board approach to nonreplacement of retirees is undesirable, more efforts should be made to utilize the ongoing sizeable wave of retirements to help with medium-term consolidation.

6. The framework for fiscal governance has been strengthened considerably, but some weak points remain to be addressed. The implementation of the loi organique for the central government and the attendant use of performance indicators should raise the efficiency and quality of public services. In the health care sector, the Comité d'Alerte should keep spending on track, but a mechanism to rapidly return to budget balance and maintain it should be established, in particular as recent estimates indicate that the target of balance in 2007 may be difficult to reach. In this respect, the loi organique for social security, which should be adopted imminently, will be helpful, as is the increased role of the Cour des Comptes in informing parliament about budget execution and perspectives. Consideration should be given to strengthening the mandate and role of this or a similar body in providing forward-looking budget assessments at the time budgets are presented to parliament. Finally, local authorities should be made to share responsibility for achieving overall budgetary objectives.

7. Tax reforms could significantly improve economic efficiency, but should be revenue-neutral unless accompanied by additional spending restraint. With targeted reductions in social security contributions being made permanent, the stability of the tax system is being enhanced and a signal sent that this avenue for cuts has been exhausted. As recognized by the authorities, the taxe professionnelle (a highly distortionary tax on capital) should be reconsidered, ideally in the context of a broader reform, which includes its elimination together with the establishment of alternative sources of taxation for local authorities. In the interim, the base of the taxe professionelle should be broadened and the transfers from the central government to local authorities associated with its dégrèvement capped. In the area of savings, exemptions and tax credits should be phased out, except for pension savings, and the proceeds applied to lower overall tax rates on savings, the budgetary situation permitting. Ad hoc modifications of taxes, e.g., targeted VAT rate reductions, should be avoided.

8. We fully support the authorities' renewed emphasis on tackling unemployment and welcome the plan d'urgence pour l'emploi. This plan builds on existing reforms, such as the easing of work week restrictions (loi Fillon), the plan de cohésion sociale, the promotion of personal services, and the adoption of an enabling framework for life-long learning. It recognizes the need to improve labor market institutions and, in a breakthrough, to avoid excessive reliance on budgetary resources in solving labor market problems. In our view, the extent to which the plan will promote job creation depends on the modalities of its implementation and the adoption of supporting reforms:

• The contrat nouvelle embauche (CNE), of which several parameters remain to be defined, supported by administrative simplifications and the phasing of threshold effects (lissage des seuils), will facilitate hiring by small enterprises. The CNE's effectiveness in reducing unemployment will be the larger the less limitations it has in duration and scope, and the sooner it leads to the adoption of recent proposals to integrate all existing contracts into a single one, with internalization of the social costs of layoffs and as little legal uncertainty as possible (e.g., as suggested by Cahuc-Kramarz).

• As recognized by the authorities, strengthening employment services and job search incentives is key to success in reducing unemployment. Measures in these areas foreseen in the plan de cohésion sociale need to be accelerated and supported by reforms of the UNEDIC convention to promote better job search. Unemployment benefits should be capped and their phasing out (dégressivité) could be reintroduced. At the same time, sanctions (possibly graduated) for noncompliance with job search requirements and duration limits should be strictly enforced.

• With minimum income guarantees and the minimum wage (SMIC) unified, the mechanism of minimum wage adjustments should be reconsidered. Further increases in the SMIC will reduce the employability of low-skilled workers and contribute to the ongoing, demotivating compression of wages at the low end of the pay scale. In this way, such increases constrain the effectiveness of the measures of the plan d'urgence pour l'emploi. Against this background, future increases in the minimum wage should be limited to at most changes in underlying consumer price inflation.

• Even though good progress has been made in reducing inactivity traps, in some cases high benefits will need to be lowered to make the return to work pay. Similarly, incentives that promote premature exit from the workforce, such as special early retirement regimes, should be phased out. In this context, we welcome the intent to remove the tax on the dismissal of older workers (contribution Delalande), which is a source of exclusion.

With ample analysis available on ways to promote employment, it will be important to mandate the soon-to-be-established Conseil d'orientation de l'emploi with the task of building consensus for reform, as was done successfully in the context of the pension and health care reforms.

9. Ongoing and planned reforms in product markets are likely to boost consumer welfare appreciably, in turn generating support for further reform. The impending modification of rules governing margins in the distribution sector (loi Galland), the successful public flotation of Gaz de France, and the planned opening of the capital of the electricity utility will be helpful. At the same time, it is important to increase the autonomy of regulatory agencies in setting tariffs and combating abuse of market power. The recent focus of the authorities on increasing the transparency of switching costs in the utilities, financial services and telecommunications sectors will foster competition at the benefit of the consumer. Important strides are being made in reducing the administrative burden on businesses, and similar determined efforts in economic deregulation would be welcome. Opening up the services markets to orderly competition, both domestically and within the EU context, is likely to generate appreciable efficiency gains. Finally, it will be necessary to reinforce incentives for research and innovation, not so much through increased public funding but through a better exploitation of synergies between public and private sectors.

10. The financial sector has been performing well, though part of the increase in its profitability stems from a transitory reduction in provisioning as risk declined. Some institutions incurred losses in derivatives, though without raising systemic concerns. Market participants still need to come fully to grips with the implications of the new accounting standards and the globally low price of risk. Exposure to household mortgages has increased in the context of a buoyant residential real estate market. Further sustained housing price increases at rates observed during the last few years would increase the risk of an abrupt slowing or even a turnaround. The focus of the supervisory authorities on these developments is appropriate, and this vigilance should be continued.

11. Reforms to improve the efficiency of the financial system should be complemented by the removal of some idiosyncrasies. The end to the prohibition to remunerate sight deposits and the planned creation of the postal bank will promote competition, as care is being taken to ensure a level playing field. Long-standing administered savings schemes should be phased out, however, as the objectives of these schemes are no longer relevant today. This is particularly the case for the subsidized mortgage-related savings and loan scheme, whose credit rates have been well above market rates. As planned, mortgage markets should be further developed by permitting home equity withdrawal and reducing legal and regulatory transaction costs and procedures.

12. We encourage France to assist in securing a successful completion of the Doha round, to which it is committed, and support comprehensive liberalization of agricultural markets, in particular of market access. In this context, rapid progress with the implementation of the CAP reform would be helpful. France's contribution to development through its relatively high and steadily increasing level of ODA is commendable, as is its intention to reach the UN target by 2012.

July 11, 2005