Mission Concluding Statement 

Portugal: 2007 Article IV Consultation, Preliminary Conclusions of the Mission, Lisbon

June 28, 2007

Decisive action is being taken to correct the imbalances accumulated during the 1990s, and the results are beginning to be seen. But the economic situation remains challenging and more is needed to increase the economy's long-term growth potential. This means making the most of the current favorable economic setting to further streamline the public sector and to boost productivity and competitiveness. In particular, expenditure plans should be adhered to, the revenue overperformance locked-in, and the labor market made more flexible.

1. Decisive action is being taken to correct the imbalances accumulated during the 1990s, and the results are beginning to be seen. Major achievements include reducing the fiscal deficit by two percentage points of GDP in 2006 without one-off measures, embarking on an ambitious strategy to streamline the public administration, reforming the general and civil service social security schemes, and improving the business environment.

2. The economy is finally picking up. A modest, and cyclical, recovery is underway, led by strong external demand, which is driving a notable rebound in export growth. In response, corporate investment shows signs of strengthening, but overall domestic demand remains weak as the anticipated retrenchment of households unfolds, and construction activity continues to decline. And while employment and participation rates have risen, so too has unemployment. We project a growth rate close to 2 percent in 2007, increasing to about 2½ percent by 2009, as external demand is forecast to remain robust and corporate investment to recover.

3. But the underlying economic situation remains challenging. Although progress is being made, productivity growth continues to lag, the loss of competitiveness has not been regained, and the income convergence process with the EU is still in reverse. At root, Portugal's challenges can be traced to low levels of human capital, investment in R&D, and ICT penetration, but also to shortcomings in the business environment, insufficient competition in domestic markets, and labor market rigidities.

4. Raising the economy's long-term growth potential requires maintaining the reform momentum, building on the gains already made. The current favorable economic setting should be used, in particular, to further streamline the public sector and to boost productivity and competitiveness. Greater competitiveness will spur growth and employment, easing fiscal adjustment. And further streamlining the public sector will help regain competitiveness by moderating wage growth, enhancing credibility, and improving the efficiency of the public services. In contrast, letting the reform effort slip would increase the duration and costs of adjustment.

Further streamlining the public sector

5. The ambitious deficit reduction target for 2006 was surpassed. The fiscal deficit was budgeted to be brought down from 6 percent of GDP in 2005 to 4.6 percent of GDP - a target that many (including the IMF) thought demanding. The outcome of 3.9 percent of GDP is thus a major achievement. This improvement was mainly driven by expenditure reduction, especially of the wage bill, and to a lesser extent by unexpected revenue strength in the latter part of the year. This strong performance reflects determination to stick to tight expenditure targets and to strictly enforce the new local and regional government financing framework. And while such revenue strength is being seen elsewhere in the euro area, in Portugal's case, the marked improvement in tax administration is clearly a contributing factor.

6. Notwithstanding the significant progress made in 2006, substantial further fiscal adjustment is still required. Portugal's deficit is projected to remain above 3 percent of GDP this year and far from the government's Medium-term Objective (MTO) of half a percentage point of GDP in 2010, public debt is above 60 percent of GDP, and the public sector remains oversized. While the reform of the social security schemes significantly improved long-term fiscal sustainability, the projected increase in age-related spending remains substantial.

7. The revenue overperformance is continuing in 2007 and should be saved. Data through May suggest that revenues remain strong, driven by buoyant corporation tax receipts. The government's intention to save the revenue overperformance is thus welcome. This would imply a deficit for 2007 slightly below the revised government target of 3.3 percent of GDP. In this regard, the government should be vigilant to ensure expenditure plans are adhered to; in particular, there appears risk of spending overruns on social transfers, health, and transfers to the public roads company (Estradas de Portugal). The new mechanism in place to better monitor budget execution of local government should flag any signs of potential slippages; any further large shortfalls of local government capital spending compared to budget should be carefully monitored.

8. The 2008 budget should consolidate recent faster progress towards achieving the MTO. Locking-in the continued revenue strength and keeping the real primary spending reduction as envisaged for 2008 should translate into a deficit slightly below the revised government target of 2.4 percent of GDP. Any tendency to loosen spending should be avoided—attaining the MTO still relies on future spending reduction measures, whose yield are particularly uncertain given their nature, and 2009 is an election year. International experience also indicates that adjustments are more durable and effective when front-loaded and expenditure-based. Consolidating the recent adjustment gains in 2008 would then make the remaining adjustment in 2009 and 2010 to achieve the MTO more credible, and would bring the public debt ratio down to close to 60 percent of GDP.

9. The restructuring of the central administration is making good progress and is entering a critical phase. The number of central administration structures has been cut by a quarter, the new public employment framework has been submitted to parliament, and recruitment has been kept to less than half of departures. The process is now entering a critical and challenging phase of moving significant numbers of civil servants into the special mobility pool.

10. With fiscal consolidation performing better than expected, the government has faced pressure to reduce the tax burden—it should be resisted. Given Portugal's fiscal situation, there is no room for a discretionary reduction in the tax burden in the near term, nor could it be expected to produce a quick growth response. And despite the recent increase in the tax-to-GDP ratio, it is still below the euro area average. Nevertheless, there is scope for further simplifying some tax laws and procedures, which could have a significant impact on competitiveness, especially for small and medium-sized firms.

11. The recent improvement in the efficiency and effectiveness of the tax administration should be built upon. Impressive achievements of the tax administration are reflected in the enhanced registers, more use of electronic filing and accounting, improved audit results, more reliable databases and wide-scale information cross-checks. These measures have helped bring the Portuguese tax administration more in line with international best practice. But there is scope for further strengthening to support growth through greater focus on taxpayer services and non-compliance. Specific measures, which go in the direction being pursued by the tax administration, could include establishing a taxpayer assistance function, implementing a full functional Large Taxpayer Office, adopting risk management systems for audit selection, and continuing debt collection enforcement. In this context, improving the effectiveness of the special judicial system for tax issues is key.

12. Fundamental reforms to substantially enhance the budgetary process are envisaged. The interim report of the program budgeting committee approved by the government this month envisages moving to performance-based, medium-term, budgeting with expenditure ceilings. Such a reform would greatly enhance the efficiency and quality of public spending and would make government fiscal programs more transparent and credible. International experience suggests that this fundamental reform takes considerable time and patience to be effectively implemented, and requires broad political consensus and has substantial human resource implications. The phased approach envisaged is thus welcome, especially the use of pilots, though while the political commitment embodied in the target of 2010 for a full roll-out is vital, the timeline may be unduly demanding. The establishment in November 2006 of the Budget Technical Support Unit is also a step forward, and should enhance Parliament's budgetary oversight capacity, especially in tandem with the envisaged budgetary process reform.

Boosting competitiveness and productivity

13. The government's comprehensive reform strategy could be strengthened by more fully addressing the labor market. As is well understood, a flexible labor market is central to regaining competitiveness. It would also boost social cohesion by reducing the pernicious effects of the growing duality of the labor market, help further raise participation and employment growth rates, reduce the amount and duration of unemployment, and increase investment in human capital. Without labor market reform, the benefits of other reforms would also be dampened.

14. The labor market should be made more flexible. Real wages unresponsive to the sizeable output gap, high long-term unemployment, heavy reliance on fixed term-contracts, all suggest significant labor market rigidities, as do standardized international measures of employment protection. The government's intention to consider reforming the labor market in setting up a commission to study the issue is thus encouraging, and should be quickly followed up by concrete measures. In particular, it will be important to ease employment protection legislation (especially for individuals), end the automatic extension of collectively-agreed contracts to firms not part of the agreement, and make procedures less cumbersome. In this context, the impact on labor market functioning of the recent decision to sharply increase the minimum wage in coming years should be carefully monitored.

15. Progress is being made to support labor market participation and skill upgrading. Recent changes to the unemployment benefit system to broaden the definition of "acceptable" employment and to promote more active job-seeking should encourage more rapid reintegration by the jobless into employment. The simultaneous effort to boost training in the "New Opportunities" program is also positive, as is the extent of the initial take-up, though care should be taken to ensure that the quality of the training does not deteriorate as numbers increase.

16. Strengthening ongoing product and service market reform could appreciably boost competitiveness and consumer welfare, lending support for reform in general. Important progress has been made with the SIMPLEX program which, for example, greatly eased procedures to create companies, and initiatives to simplify the permit system, especially at the local level, should further enhance the business environment. Continued progress on increasing competition in domestic markets, especially in network industries and some service sectors, will also be important. In this context, the Competition Authority should continue to play a key role in advocating and enforcing competition, as done recently in the pharmaceutical and telecommunication sectors. The planned spin-off of the cable network operator from Portugal Telecom in September is thus welcome, though its effectiveness may be determined by whether its ownership structure becomes significantly different. Among other areas, improving the working of the judicial system should be a priority, and the reinvigoration of the privatization process is welcome.

17. Progress continues to be made on increasing competition in the energy sector and integration with Spain is accelerating. Electricity consumers have been able to choose their suppliers since September and the electrical and gas grid company is about to be privatized. But their immediate impact on electricity prices will be muted by the decision to pass on to consumers the costs arising from existing electricity supply contracts, the policy to increase the share of renewables in generation, and the limited interconnectivity between Portugal and Spain. Promoting competition is thus critical and actions, such as the recent capping of regulated price increases, should be avoided. In the gas sector, meeting the target of end-2008 for full liberalization will be important.

18. The financial system remains sound and well supervised. Since last year's Financial Sector Assessment Program (FSAP) exercise, somewhat faster loan growth, continued cost-cutting efforts, and higher interest rates have boosted bank profitability. Banks are also moving to more advanced risk management systems in preparation for Basel II. The Bank of Portugal is further strengthening its supervision, for example, by adopting a new risk rating system. A new household wealth survey has also recently been completed and a better index of housing prices has been developed.

19. Close monitoring of key risk areas, as being exercised by the Bank of Portugal, should help ensure the continued health of the financial system. The trend in recent years of rising unemployment and household and corporate debt is continuing. Bank lending concentrates on the real estate sector and on a limited number of large corporates, and banks' employee pension schemes are exposed to stock market fluctuations. Intensified competition has resulted in some loosening of lending criteria in some loans, and banks' liquidity ratios have deteriorated slightly. While the FSAP finds that risks are well controlled and the capacity of the financial system to absorb even severe macroeconomic disturbances is strong, regular stress tests are called for. In this regard, the bottom-up stress tests now planned for every other year, with the next round due early 2008, are welcome. The forthcoming results of the wealth survey will also help risk management by identifying key vulnerable subgroups of households.

The mission would like to thank its counterparts for their time and the high quality of the discussions. We also thank the authorities for their skillful handling of the administrative aspects of the mission.