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  Assessment and Recommendations

  The sharp slowdown in economic activity since 2000, which is mostly attributable to developments in the financial sector, appears to be partly structural. The exceptionally buoyant international equity market conditions that boosted growth in the 1990s are unlikely to return any time soon. Even so, trend growth is still likely to be high enough to require continued net inflows of foreign workers. This means that important issues related to high inflows of foreign labour remain in education, transport and housing policy while the authorities now also have the challenge of implementing policies that facilitate adjustment to lower growth than in the 1990s. In particular, growth in public expenditure needs to be reduced to stabilise it as a share of GDP and adjustments are required to the parameters of the pension scheme to make it sustainable. At the same time, a variety of reforms to increase participation rates and productivity growth are needed to attenuate the decline in national income growth.

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  Economic Developments and Policy Challenges

  Economic growth has crashed in Luxembourg in the past couple of years as its financial sector, along with the rest of the global financial industry, suffered the fall-out from the deflation of the international stock market bubble that developed during the late 1990s. While conditions in the financial sector, which directly accounts for about one third of GDP, are likely to improve, they are unlikely to return to those of the 1990s. Accordingly, Luxembourg must adjust to mediumterm growth that is likely to be lower than in the past, although still considerably higher than in other European countries. As in the past, most of the adjustment to changes in growth will entail variations in employment of foreign workers, notably cross-border workers. However, lower growth in the medium term also increases the likelihood that labour-market adjustment to adverse shocks will entail reductions in national employment because there will be less scope to absorb such indicators by reducing growth in cross-border employment. In these circumstances, adverse shocks could lead to higher structural unemployment given current labour-market institutions. This chapter discusses recent economic developments and prospects before turning to medium-term characteristics of the economy. Finally, the policy challenges that emerge from the medium-term outlook for the economy, bearing in mind its special features, are reviewed.

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  Fiscal Policy

  The budget surplus has fallen markedly during the current economic downturn, from 6 per cent of GDP in 2000 to 2½ per cent of GDP in 2002. This deterioration, which is mainly structural, is entirely attributable to continued rapid growth in government expenditure, the public expenditure ratio rising by 6 percentage points of GDP over 2000-02 to 45 per cent, just below the record registered in 1993 (Ministry of Finance, 2003a). Most of this increase is accounted for by high growth in social security and investment expenditures and can be attributed to economic growth turning out to be much lower than forecast when expenditure plans were finalised. Government revenues have increased as a share of GDP, despite tax cuts in 2001 and 2002, owing to a surge in back taxes from corporations and other lags in the effect of the downturn on tax revenues. Economic growth in 2003 is again likely to be much lower than when expenditure plans were finalised, resulting, according to the authorities, in another large deterioration in the budget balance (to a projected surplus of 0.2 per cent of GDP).

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  Policies to Strengthen Growth in National Income

  Luxembourg residents have benefited from high economic growth based on the intensive use of inputs of foreign capital and labour, which has generated tax receipts that have helped to finance very generous social benefits and an expansion in well-paid public sector jobs (see Chapter IV). In addition, high growth in cross-border employment has provided a buffer for the national (i.e. resident) labour market in the event of adverse economic shocks, helping to keep structural unemployment low despite labour-market institutions that in other OECD countries have contributed to large increases in structural unemployment. In the likely event that medium-term growth in the future is lower than in the past, reflecting a normalisation of prospects for the financial sector, growth in taxes will be less and a higher proportion of the burden of adjustment to adverse labour-market shocks will fall on residents. This chapter discusses policies that could help to attenuate the decline in growth in national income and facilitate national labour-market adjustment to adverse shocks. These focus on increasing the employment rate, improving the performance of the education system, increasing the efficiency with which government achieves its objectives, including sustainable development, and increasing competition in the provision of internet services.

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  The Economic Impact of Migration in Luxembourg

  Luxembourg stands out in international comparisons as having a much higher proportion of foreigners in its population than any other OECD country; about 37 per cent of its population and 65 per cent of employees are foreigners.92 This is partly a function of size, since Luxembourg is a small country located in a large economic area. Hence movement over relatively small distances that would be internal migration in Luxembourg’s much larger neighbours, France and Germany as well as Belgium, is recorded as international migration. Indeed, approximately the same number of people as there are foreigners resident in Luxembourg – about one-third of the labour force – cross from neighbouring countries to work in Luxembourg every day and are known as cross-border workers ("frontaliers").93 But most of Luxembourg’s foreign resident population comes from much further away – in particular Portugal and Italy – than its neighbouring "Grande région", so the phenomenon is not merely local. While frontaliers might not be strictly defined as a migration issue, in the case of Luxembourg it is very much part of the same set of economic phenomena: reducing labour market constraints and allowing the economy to grow independently of locally available skills.

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  Annexes
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