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New cabinet needs to continue with reforms rather than reverse the reforms that have been implemented

Economic Quarterly Report

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  • At present, the Dutch economy is doing well (see ‘Economic Update’ chapter)
  • The next cabinet should however not be unduly optimistic: the current growth figures signify a temporary revival and growth is expected to drop back again in 2018
  • Reforms and investments designed to structurally bolster growth are therefore needed. At the same time, the new cabinet must not reverse economically sensible reforms that have already been implemented
  • We see five themes as crucial: visionary investment in innovation and education; reforms to the tax system; curbing health costs; not reducing the state pension (AOW) retirement age; and limiting macroeconomic instability.

The Dutch economy will prosper in the short term with GDP growth of 2 per cent or more in 2017 and 2018 (see ‘Economic Update’ chapter). However economic growth in the Netherlands is likely to be significantly lower in the longer term, after 2018. This is related to developments in the two fundamental drivers of growth: the labour supply and productivity. In the years ahead, the supply of labour will not be a source of growth (contributing only 0.2 per cent per annum between 2018 and 2023, see table 1), despite the increase in the AOW retirement age and in the participation of women. The level of productivity is very high in the Netherlands but growth in productivity is under pressure and will be only 1 per cent per annum between 2018 and 2023 (see table 1).

A look at the structural trends in employment and productivity shows that potential annual average growth in the Netherlands in the period to 2023 is around 1.2 per cent (see Rabobank, 2016 and table 1). After the crisis, the economy grew at a rate below its potential for a number of years, with an output gap building up as a result. Indeed, the current growth figures should be seen as catch-up growth, making up for the economic lost ground since the crisis in 2008. However, with the current high growth figures we expect the output gap to be virtually closed by the end of 2018, and unemployment to be around our estimated equilibrium unemployment rate of 4.5 per cent. This makes it likely that economic growth will drop back in the years that follow to a lower trend growth rate. The basic assumption here is that there will be hardly any structural increase in purchasing power. This may change if a new cabinet pursues a different policy.

This does not take into account any negative consequences of Brexit, which will probably take place after 2018, or a potential trade war started by Trump. In an earlier scenario, we calculated that a decline in global trade would have a marked negative effect on Dutch growth: in that scenario, average economic growth would probably fall to 0.3 per cent per annum (see Rabobank, 2016).

Table 1: Components of structural growth 2018-2023
Table 1: Components of structural growth 2018-2023Source: Rabobank’s own calculations

In short, there is no reason for the next cabinet to lean back, relax and trust that the economic upturn will continue for the next four years. Additional measures are needed to structurally bolster growth. The mantra is and remains: “Make hay while the sun shines”. Unfortunately, recent decades have taught us that a crisis is needed to provoke action. However, many people have experienced first-hand that action during a crisis period is particularly costly. It is to be hoped that this realisation will prompt the next cabinet to work on structural improvements to the foundations of the Dutch economy.

At the same time, it would be foolish from an economic perspective to reverse the reforms that the current cabinet has introduced. We therefore consider five themes below that we see as crucial economic issues for the next cabinet. Sensible choices in these areas would strengthen the fundamentals of the Dutch economy and make it less vulnerable to headwinds and tailwinds. This would enable structural increases in household purchasing power beyond 2018 and would improve the business climate.

Visionary policy in R&D, innovation and human capital would be very welcome

The next cabinet should make visionary investments in R&D, innovation and human capital in order to increase structural labour productivity in the Netherlands (see also Rabobank, 2016 (only in Dutch)). There are still plenty of regulations hampering entrepreneurship, for instance, while the average number of years children spend in education in the Netherlands is relatively low from an international perspective. It would be a good idea if the next cabinet were to consider what has been written on this subject in studies by the Netherlands Bureau for Economic Policy Analysis (CPB), such as ‘Kansrijk Innovatiebeleid’ (promising innovation policy) and ‘Kansrijk Onderwijsbeleid’ (promising education policy), and then produce a clear-cut vision for the years ahead.

In areas where lifelong learning has not really got off the ground yet, despite the many commissions, reports and grant schemes, it is essential that the cabinet should take serious action on investing in the long-term employability of workers. Human capital should be much higher up the policy agenda, especially now that the labour market is becoming ever more flexible and technological developments are causing knowledge and skills to quickly become outdated.

Thorough reform of the tax system would be good for the economy

The tax system has many distorting economic effects that diminish prosperity in the Netherlands. That is why thorough reform of the tax system is required. Figure 1 gives a rough sketch of the prerequisites for a properly functioning tax system. In view of the fragmented political landscape, it is important to stress that a revised tax system must put an end to the jumble of allowances and tax-deductible items and should be as simple as possible. The current tax system is so complex mainly because allowances and new taxes have been added year in, year out, principally for short-term political ends (see Box 1).

Box 1: Logical tax reforms from an economic perspective

Three rules of thumb for a sound tax system (Mirrlees Review)
• Neutrality (tax similar elements the same -> minimise distortions)
• Simplicity (more transparent, lower administrative costs)
• Stability (constant change leads to uncertainty and higher costs of adaptation)

Tax on labour
• Tax on labour is economically distorting
> Generic reduction in tax for households is not very effective
> Targeted reduction in tax for employees and employers is effective
- Labour participation
- Employment

Consumption
• Exemptions and multiple VAT rates are economically inefficient
> Introduce a single uniform VAT rate
> Need to do this in a European perspective

Wealth
• Tax on deemed investment income is economically illogical
> Tax actual income from capital (investigate option for dual system)
• Many tax benefits for home ownership and pensions
> Tax all forms of capital the same (including homes and pensions)
• Little economic distortion from municipal property tax and inheritance tax
> But they are politically very unpopular

Corporate income tax
• Economically distorting and difficult to increase because businesses can easily move elsewhere
> International cooperation desirable in tackling avoidance

Increasing healthcare costs are putting pressure on disposable income

Disposable income has barely risen since the turn of the century despite the fact that GDP per capita is significantly higher. In a recent study (only available in Dutch), we showed that the sharp rise in healthcare costs is a key factor explaining why disposable income has barely increased.

Figure 2: Health costs will rise again in the future
Figure 2: Health costs will rise again in the futureSource: MEV 2017

In recent years, the cabinet has managed to curb healthcare costs by implementing reforms in long-term care, among other things. However, if current policy continues unchanged, healthcare costs will rise again substantially over the next few years in part because of the ageing population, according to the Netherlands Bureau for Economic Policy Analysis (figure 2). Now that the economy is performing better and the government is expected to have a budget surplus in 2017, there is a danger of losing a sense of urgency about the need to keep health costs under control. The debate about abolishing the insurance deductible is one example of this. Of course, ultimately the decision on how much money to spend on healthcare is a political choice. However if healthcare costs spiral out of control again, households’ disposable income will probably barely rise in the decade to come either, as taxes and health insurance premiums will need to be increased to cover the costs.

Reducing the AOW retirement age to 65 will harm both government finances and the economy

In accordance with government policy, the retirement age is being increased gradually, to 67 years in 2021. Thereafter, the retirement age will be linked to future life expectancy. This reform is a significant step towards sustainable government finances in the longer term.

Figure 3: Potential labour force will decrease in size if the retirement age is reduced
Figure 3: Potential labour force will decrease in size if the retirement age is reducedSource: Statistics Netherlands, Rabobank

Another important benefit from the reform is that it increases the size of the potential labour force. If the retirement age had remained fixed at 65 years, the potential labour force would already have almost stopped expanding due to the ageing population and would even start to fall in 2019 (figure 3)[1]. However, the increases in the AOW retirement age will ensure that the potential labour force continues to expand in the next few years and will remain more or less constant after that. Based on the current policy, the potential labour force is expected to include 700,000 more people in 2030 than would have been the case if the AOW retirement age had remained at 65. The current planned increases in the AOW retirement age are therefore a significant boost to the Netherlands’ potential growth rate, especially if the labour participation of older cohorts can be improved.

A reduction in the state retirement age to 65 would ultimately come at a considerable cost, both for government finances and for the growth potential of the Dutch economy.

Footnote
[1]These calculations make use of the Statistics Netherlands population forecasts per year, broken down by age. The additional effect of the policy on the potential labour force compared with a retirement age of 65 can be calculated by linking the current proposals for the increases in the retirement age to the number of persons per age cohort as forecast by Statistics Netherlands.

Limiting the Netherlands’ macroeconomic instability

The Dutch economy suffers more than its neighbours when there is a headwind but also experiences more of an upturn when there is a tailwind. This degree of volatility is undesirable, if only because it leads to uncertainty and undermines confidence. The next cabinet can tackle this by dismantling the barriers that currently exist, for example between pensions and the housing market.

Employees have to borrow relatively large amounts to buy a house because they have to save a great deal for their pension. If we were to add up those assets and liabilities for all households, we would see that over the years household balance sheets have become increasingly large. That makes them much more vulnerable to economic headwinds. During the crisis, we saw that unrest in the financial markets put considerable pressure on pension assets: pension contributions increased, pension benefits were cut and there was more uncertainty concerning pensions.

At the same time house prices fell substantially and many households ended up with negative equity: they were unable to sell their homes, or if they did they were left with a large residual loan. The consequence was that households used a larger portion of their income to pay off their mortgage or increase their financial buffers. Household expenditure collapsed and that had a negative impact on growth in the Netherlands for several years running. Reducing households’ balance sheets is therefore the fifth item on the reforming agenda for the new cabinet. Much has already been written on this subject, starting with the Social and Economic Council (see SER, 2013 (only in Dutch)). One way of increasing the resilience of Dutch households is to reduce the barriers between different kinds of assets. In this way, households would be able to use part of the money they have saved for their pension to reduce their debt on their own home, especially if the mortgage is being repaid in regular instalments anyway. They should also be able to use their pension capital or their capital in their own home to finance lifelong learning in order to maintain their level of education.

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