Luxembourg: staying on top in a changing environment
Luxembourg continued to show robust growth in 2015. New fiscal and financial regulation is heading towards Luxembourg, challenging its financial sector-driven growth model.
Strengths (+) and weaknesses (-)
(+) Solid fiscal position
Modest budget surpluses and deficits have kept the public debt very low (23% of GDP in 2015), while the government holds a net asset position. This gives the government room to adopt an expansionary stance when needed.
(+) Strong external position
Luxembourg runs structural current account surpluses and, in 2014, has a net international investment position of 33% of GDP.
(+) Attractive business environment
A favourable regulatory environment, a highly skilled workforce and a high level of regional integration make Luxembourg an attractive destination for investments.
(-) Small and open economy, highly dependent on the financial sector
The economy of Luxembourg is very open and therefore very vulnerable to external shocks. Since the financial sector accounts for 27% of GDP, around (excluding income tax paid on wages by the financial sector) 13% of tax revenue, and 12% of employment, the economy is highly susceptible to negative developments in this sector.
1. Economic growth remains robust despite adverse developments
The economy of Luxembourg grew by 4.8% in 2015, marking 3 years of growth above 4% (Figure 1). Growth in 2015 was mainly driven by strong exports of financial and non-financial services. In 2016, growth is expected to remain robust by, again, a large contribution of net exports with on top increased domestic demand on the back of low energy prices, favourable financing conditions and positive employment prospects. Employment is still growing by more than 2% a year even though unemployment (at 6.9% in 2015) is only falling slowly, reflecting rigidities outside the competitive financial sector. Implementation of the European VAT directive in 2015, leading to a sharp drop in VAT revenues from non-resident e-commerce, was compensated by raising all VAT rates and levying an additional tax on income. These interventions seem to have had no impact on economic growth, further underlining Luxembourg’s economic resilience. Growth prospects continue to be strong, but there are downward risks such as stress in financial markets and (further) harmonisation of tax structures that could harm prospects of Luxembourg’s financial sector, in turn weighing on economic activity and tax revenues.
2. Pro-active government measures keep fiscal balances in check
Thanks to prudent fiscal behaviour, Luxembourg has one of the lowest public debt ratios in the euro area, at 23% of GDP in 2015, in combination with continued modest budgetary surpluses (Figure 2). This fiscal stance is appropriate for Luxembourg as international tax transparency initiatives and volatile financial markets create risks to fiscal revenue. The aforementioned 2015 VAT reforms contributed to a significant improvement in the structural balance compared to the headline budget. Luxembourg could use its fiscal space to increase growth prospects by investing in lower productivity sectors. Announced tax reform proposals in February 2016, to the contrary, propose to significantly reduce personal and corporate taxes from 2017 onwards, consuming all available fiscal space instead of investing. In addition, other challenges also remain substantial: the current pension system is not sufficiently equipped to deal with the increasing costs of ageing.
3. Productivity gains in the non-financial sector remain limited
Despite efforts to diversify the Luxembourg economy, a heavy reliance on the financial sector persists. Due to inflation-linked wage indexation, many sectors continue to face losses in cost competitiveness. While this is no real issue at the current junction, with low current and expected inflation, this could change once inflation starts to accelerate. Luxembourg did not make progress on reforming the wage setting mechanism in the private sector. In contrast, reforms of the wage setting mechanism in the public sector have been implemented. These include longer training periods, phasing in of public servants’ starting salary, a scaling back of automatic career progressivity and a shift towards more performance-based promotions. The government could also promote diversification by using more active labour market policies.
Luxembourg is a small, open economy and one of the wealthiest countries in the world. Infrastructure, institutions and industrial relations are of the highest standard. Luxembourg hosts a large financial sector, built upon a favourable tax regime and regulation. The main activities in the sector are insurance, fund management and banking. The fund management industry is the second largest in the world and the banking sector is colossal – bank assets were 20 times GDP in 2013, the largest ratio in Europe. However, banking is dominated by foreign-owned banks, which serve as foreign investment vehicles for their parent companies and have few ties to the local economy. Hence, the contingent liabilities for the sovereign are estimated to be low, while the sector’s good health makes such claims unlikely. EU regulatory harmonisation could hurt the banking sector, but thanks to the highly skilled financial workforce, the sophisticated and adaptive regulatory system Luxembourg’s attractiveness as a financial centre is likely to remain. Besides, diversification towards fund and wealth management and insurance services, which account for 80% of total assets in the financial sector, reduces vulnerability. Luxembourg has been a front runner in regional cooperation, driven by its small size and central location in Western Europe. It set up a customs and currency union with Belgium in as early as 1922. Later on, it was one of the founding members of the EU, NATO and WTO. Consequently, Luxembourg hosts important EU institutions and a pan-European not-for-profit sector. Foreign residents account for 45% of the population and, together with cross border workers, account for the lion’s share of the private sector workforce.