Introductory remarks

1. “Portugal: Coping with Fiscal Policy Challenges in the 21st Century Peter S. Heller International Monetary Fund December 13, 2004(Presentation to the Budget Control Committee of the Portuguese Parliament) This Presentation should not be reported as representing the views of the IMF. The views expressed in this presentation are those of the speaker and do not necessarily represent those of the IMF or IMF policy. .

2. Introductory remarks • This conference is noteworthy, reflecting recognition by the Parliament of the need to take account of long-term issues in budget formulation. • Critical that such a perspective is shared both by executive and legislative branches.

3. Principal Messages • As with most other industrial countries, Portugal needs to take account of potential long term structural developments and risks. • There are fiscal dimensions to many of these risks. • Dealing with problems for which there are fundamental uncertainties • A multi-pronged approach is necessary to deal with issues of the long-run, involving strengthened policy analysis, reforms of the budget process, sustained fiscal consolidation, and sectoral policy reforms.

4. Motivation for considering LT fiscal risk issues: what are some of the key long-term challenges confronting Portugal? 1. Demographic factors • Fertility rate low (at 1.53); Eurostat projections suggest a rise to only 1.6 by mid-century. • Increasing life expectancy by 2050: males 72 to 78; females: 79 to 84. • Dependency rate will double by 2050: from 23 percent to 46 percent. • Population will peak in 2040.

6. Potential fiscal impact of aging population well-recognized General system pension (GSP) costs will rise, even under new 2000 Framework law: • From 6% of GDP in 2000 to 8% in 2075; • GSP revenue to decline: by 1.5% of GDP in same period; system in deficit by 2016; zero balance in reserve fund by 2029. • Civil Service Pension scheme: costs projected to rise from 3.6% to 5.0% during same period.

8. Medical care: impact of aging population • Caldes and Rodriguez: aging alone will lead to increase in spending from 5.3% of GDP in 2000 to 6.4 to 7.2% by 2050. • Bronchi (OECD, 2003) suggests even larger increase of about 3% of GDP by 2030. • With increasing elderly dependency rates, long-term care will also be a challenge, with Portugal now poorly positioned relative to other European countries.

9. 2. Medical costs may increase further due to technology-induced cost pressures Between 1970 and 2000/01, health care costs in Portugal rose from 2.7% of GDP to over 6%, independent of aging-related pressures; parallel experience to US; Note: standard of technological equipment in Portugal still much below OECD average ; high cost equipment (e.g., imaging devices) still in short supply.

10. 3. Global Climate Change For Portugal, most Global Climate Change Models (GCMs) project a temperature increase in interval 4-7º C by 2100 (SIAM Model). Climate change will also be reflected in: • Increased frequency and intensity of extreme weather events. • Reduced precipitation in many regions: substantial declines in spring (by 30%) and autumn (35-60%); an increase in winter months. • Increased probability of flooding episodes with accumulated precipitation in heavy rainy periods.

11. Alternative GCM Model Projections of Climate Change in Portugal through 2100

12. Potential impact of Climate Change • Agricultural sector: net adverse effects • Negative impact of temperature change and from pressures on available water supply; positive impact from CO2 change; • Differential impact across regions, with shifting to different crops in different zones • Coastal zones: increase in sea level—need for protective actions to minimize impact, particularly in regions of high development and high population density • Increasing energy demands in summer months • No estimates made by SIAM GCM of impact on insurance or tourism sectors, urban centres, or soil and land resources.

13. 4. Supply-side challenges Pressure to upgrade human capital skills • Portugal suffers from competitive disadvantage in terms of quality of its human capital, its investment in R&D, and ICT penetration. • Portugal will need to increase investments and quality of spending in education and bolster spending on R&D.

14. 5. Contingent Risks associated with commitments on PPPs (in transport, water, energy, hospital sector): akin to debt, but not reflected in budget. 6. Globalization: tax competition pressures; fiscal policy constraints associated with membership in Eurozone. 7. Global pressures on energy supplies and prices. 8. Other potential risk factors: terrorism, WMD, possible global systemic “viruses.”

15. 9. Risks associated with present fiscal position • Portugal’s current debt to GDP ratio—close to 60 percent. • Present fiscal position, while consistent with Stability and Growth Programme, still too reliant on one-off measures and imbalanced in terms of share of wages and salaries; • Failure to bring down primary deficit in line with SGP and sustain it at lower level (exclusive of aging-related fiscal pressures) would put Portugal on unsustainable fiscal track in terms of its projected debt growth. • Sensitivity to adverse interest rate scenarios. • Scale of continued EU assistance through Community Support Framework. Presently about 3% of GDP.

17. “Uncertain” Certainties • Most of these structural developments will happen; most likely concurrently. • But stillmuch uncertainty: nature of change; degree of predictability; size of potential impact. • Different processes; different time paths. • On demography: will fertility rise? Greater improvement in life expectancy? What migration level?; Impact of HIV/AIDS? • Still a wide band of uncertainty on the amount of possible climate change. • Obvious uncertainties on security risks, etc. • “Inevitable surprise” factor: shocks that are difficult to predict for which fiscal leeway required.

18. Many issues pose fiscal risks. Why? • Explicit, legislated, government commitments-- some linked to demographic variables • Pre-commitment of budgetary resources: in pensions, medical care; welfare assistance; education. • On political economy grounds, hard to change these commitments now; even harder in future, with prospect of rising share of elderly in electorate. • Implicit fiscal commitments? flowing from perceived role of government (e.g. Gov’t backup for failure of private occupational pension schemes? dealing with effects of sea level rise? sectoral adjustments in agriculture; flooding, etc.)?

19. Should one tighten the fiscal policy framework further to take account of these long-term issues? Arguments Con: • Unpredictability of future events. • Poor past records of forecasting. • Future generations likely to be better off. • Costs of addressing these long-term issues prematurely: • Higher taxes in the short term. • Additional burden on households in responding to reduced long-term promises. • Higher costs of adapting to uncertain climate change.

20. Arguments Pro: • Pressure for increased fiscal outlays will rise over time: could lead to politically unfeasible tax burden, even with higher per capita income. • Deferring action may increase cost of solutions (e.g., higher cost of tax smoothing or policy reform costs). • Unfair burdens shifted to future generations. • High potential welfare costs if abrupt benefit cuts. • Reduced capacity of government to respond to new challenges.

21. Arguments Pro • Failure to address LT risk factors may also constrain short/medium-term policy options • Markets may require higher risk premia on government borrowing; may constrain capacity for appropriate macro- economic policy stance. Recent S&P study (Kremer, 2004) suggests that Portugal’s rating could deteriorate substantially, even as early as 2010. • May induce Ricardian effects, as private sector agents respond to perceived failure of governments to act—reducing potential impact of countercyclical fiscal policy measures.

22. What to do? Not easy issues • Dealing with problems for which there are fundamental uncertainties; policies imply significant short-run costs to taxpayers with uncertain scale of actions required and uncertain benefits to future generations. Climate change as example. • Need to decide how much risk aversion is acceptable in judging sustainability of policies? What probability of LT fiscal sustainability desirable? What are losses if action not taken? • Social time preference rates matter: intergenerational welfare choices: defining generations. • There are allocative efficiency costs associated with tax smoothing.

23. What to do? A “multi-pronged” strategy is required to take LT fiscal concerns into account in short to medium-term • A budget process and framework more clearly recognizing LT fiscal risks—building on existing work. • Strengthened analytic approaches. • A blend of • aggregate fiscal policy consolidation. • accompanied by further sectoral policy reforms.

24. Need for strengthened analytic approaches • Formalize periodic long-term projections & sustainability indicators: scenario analyses; tax or primary gap analyses. • Alternative demographic scenarios. • Carry out demographic-based stochastic forecasts: taking multiple risk factors into account.

25. Possible sensitivity analyses • Alternative non-aging cost pressures in medical care (e.g., US Long Term Budget Outlook, Dec. 2003) • In assessing future cost burden of pension system, examine alternative assumptions: suppose less optimistic productivity assumptions (e.g. lower than 2.5% p.a.); lower labor force participation rates. • Risks of any failure to meet the SGP adjustment path. • Indexation assumptions for civil service pension scheme. • Potential costs of climate change—sea level rise, higher flooding levels. • Alternative demographic assumptions (fertility; LE).

26. Recognize limits on relevance of formal Government balance sheet or measures of Government debt • Excludes significant potential implicit commitments and risk exposures. • Hard to determine how to treat constructive budget obligations. • Excludes potential revenue assets • What is politically viable revenue share in future? • Suggests there is a spectrum of Government debt and risk exposure.

27. Chart 1: Illustrative spectrum of Government debt and risk exposures Off-Balance Sheet On Balance Sheet (As Liability or Provision) Other types of Guarantees Risk exposures derived from Role of Gov’t Constructive Budget Obligations Explicit Debt Public Guarantees (provisioned) Public Guarantees (not provisioned) Implicit Contingent obligations Hard Soft costs of climate change adaptation Contractual Noncontractual—medical care ---long term care ---strengthening educational system PPPs Explicit contingent liabilities

28. Spectrum of debt and risk Exposures • The softer the risk exposure, the: • Greater the potential flexibility of government in meeting an obligation; • Political economy factors weigh more heavily; • Greater indeterminacy on nature of government’s commitment; and • The more relevant moral hazard considerations.

29. Need to obtain greater clarity on the risks to which the public sector is exposed • Clarifying potential costs of different risk factors: simple first step in process of judging when policy adjustment is necessary: • Aging-related costs (pensions, medical care, long-term care; cost of climate change vulnerabilities). • Carry out sensitivity analyses. • Becomes exercise in • analyzing prospects for fiscal sustainability. • considering scale of necessary policy actions. • Assessing which policy alternatives limit risk exposure.

30. Portugal is relatively advanced in considering long-term issues through its involvement in EU/OECD work programs on aging populations • Over time, Portugal should develop full-fledged medium term budget: • Incorporate into annual budget. • Provide long-term cost implications of policy measures. • But don’t extend detailed budget beyond medium-term. • Consider value of an additional fiscal rule on expenditure ceilings.

31. Long-term annexes to budget should be prepared: • Clarifying potential cost of: • contingent liabilities; • Implicit debt; • Risk exposures on extended balance sheet. • Providing long-term projections • Clarify when additional R&D needed before policy action. • Providing stochastic analyses. • Carrying out sensitivity analyses.

32. The political economy challenge of dealing with long-term fiscal policy issues:Need to provoke public debate on long-term fiscal challenges—implied intergenerational tradeoffs; degree of risk aversion • Consider legislative procedural rules: • Require executive to provide long-term risk assessments as part of budget submission; • Require debate by Parliament; • Call for hearings by Parliament. • Earmarking of social insurance funds could be considered? • Emphasis on providing transparency on long-term risk exposure.

33. A potential role for an autonomous agency charged with providing independent assessments of long-term fiscal risks • Scrutinize assumptions in budget. • Characterize adequacy of sensitivity assessments. • Comment on cost of implied policy tradeoffs. • Assess generational cost-sharing implications.

34. What policy changes required? Governments cannot wholly rely on an aggregative approach to meet higher prospective fiscal costs over long term;Requires sectoral reforms as well.

35. Three Types of Aggregate approach possible • Balancing budget, year by year, but not reducing debt/GDP ratio below present level. • SGP approach: rule which over time brings debt/GDP ratio to zero (EU-Portugal approach). • Primary Gap filling—or tax smoothing • But, there are limits to an aggregative approach.

36. Balanced Budget approach: responding annually to new expenditure pressures as they arise by reducing other expenditure or increasing aggregate tax burden; • But limits to increase in politically or economically feasible tax share • Limits to feasible expenditure rationalization—given Govt’s role in provision of public goods and other services and high share of wages and public transfers in total government expenditure.

37. Primary Gap Filling (or Prefunding) approach?Increase and sustain a higher tax share, implying decumulation of debt and possiblynet asset accumulation • How much net asset accumulation feasible? Political economy risks with increasing asset/GDP ratio (Norway case): • “Expenditure creep”; • Pressures for tax reduction. • Allocational efficiency costs of increased tax burden. • Ricardian effects of prefunding strategy. • Increases political economy costs of further Government policy changes.

38. As a minimum for Portugal, SGP implementation must be high priority • European Commission reports as well as S&P assessment highlight fiscal risks associated with not implementing Stability and Growth Programme in coming three years. • Requires sustaining that primary balance (independent of aging-related factors). • Sufficiency? Ignores other forms of fiscal risk exposure of Portugal. • Does not assess whether there is further revenue-raising potential.

39. Thus, need a balance between aggregate and sectoral policy reforms: • Commitment and regulatory reform must be a critical component of policy mix. • Requires commitment reform, affecting time path of pre-committed expenditures and reduced exposure by Govt to various fiscal risks. • Critical toensure adequate fiscal leeway is maintained. • Critical to consider when there are important windows of opportunity for action.

40. Portugal has made important start in recent years, with reform efforts in health and pension areas. Reforms in public administration and early efforts at developing a long-term care network. • Still, more effort needed in public pension reform • May require further extension in retirement age; • Possibly reduced accrual rate of pension benefits—lowering replacement rate. • More targeting. • Change in qualitative commitments: further forms of cost sharing; may require adopting Dutch type of limits on coverage for certain categories of medical care. • Promote greater clarity on who will bear given risks. • Government support for strengthening insurance markets. • Clarify government role in addressing issues of climate change: its adaptation role.

41. Commitment reform (continued) • Transparency necessary on implied intergenerational burden sharing. • Long lead time needed for some reforms. • Need to clarify macroeconomic effects of reliance on sectoral policy reforms. • Consider self-adjusting policy provisions—”built-in flexibility with uncertain outcomes.” • How much risk reinsurance coverage should be provided by Government?