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  Assessment and Recommendations

  After seven years of strong growth that culminated in a surge in output of almost 6 per cent in 2000, the Finnish economy was working close to capacity, bottlenecks had emerged and first signs of overheating had appeared. However, since late 2000 activity has turned around sharply. On the basis of monthly figures, output has been lower than a year earlier since June 2001 and year-on-year growth in 2001 is estimated at a meagre ½ per cent. This rupture was largely caused by external factors. The economic slowdown in the United States and Europe led to a sharp contraction in paper exports and weighed heavily on exports of the electronic equipment industry, which also suffered from demand saturation and disappointing sales of new products.

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  Macroeconomic Developments, Prospects and Policy Challenges

  Since the end of 2000, activity has turned around sharply and the economy was technically in recession in the first two quarters of 2001. After seven years of strong growth that culminated in a rise of gross domestic product (GDP) of 5.7 per cent in 2000, year-on-year expansion is estimated to have come down to a meagre ½ per cent in 2001, with the monthly figures showing output lower than a year earlier since June 2001 (Figure 1). In the manufacturing sector, the rupture was extremely steep. In the final quarter of 2000, manufacturing production peaked at a level 14 per cent higher than a year earlier, but in the third quarter of 2001 production had fallen back by 6 per cent from that peak. The factors behind this sharp turnaround are largely external. The economic slowdown in the United States and Europe led to a sharp contraction in exports of the paper industry. It weighed heavily too on exports of the electronic equipment industry, which also suffered from demand saturation and disappointing purchases of new products. Feedthrough effects of falling exports on private consumption were small, however, as the initial impact on employment was limited and plummeting industrial output mainly showed up in lower productivity. Hence, despite the output collapse, unemployment edged down at the same moderate pace in the first half of 2001 as in the previous year. However, it remained high in an international and historical perspective (Figure 2) and the deterioration in economic conditions led to a rise in unemployment and a fall in vacancies in the third quarter. As a consequence, labour shortages are no longer a bottleneck for production.

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  Policies to Boost Potential Output Growth

  Prior to the recent slump, the growth performance of the Finnish economy had been among the best in the OECD in recent years. At the same time, the economy has undergone fundamental changes. Partly as a result of its EU membership since 1995, it has become more integrated with the rest of the world, increasing the need to adjust quickly to developments abroad. Liberalisation and privatisation have facilitated adjustment, with market mechanisms now operating to a greater extent. Furthermore, the sectoral composition of output has changed significantly, with a diminished role for the traditional metal and forest industries, while the electronic equipment industry has become the most important export sector. This change in composition made the Finnish economy less capital intensive and more knowledge-based. Finally, economic activity has become more concentrated in the Helsinki region and other growth centres. Helsinki is one of the fastest growing cities in Europe whereas eastern and northern Finland are among the EU regions with the strongest migration outflow.

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  Options for Reforming the Finnish Tax System

  Finland is among of the most egalitarian countries in the OECD. Generous welfare services and large transfers aim at a high degree of income redistribution, but a high tax burden is required to finance the associated public spending. The tax system has also been designed to compress the already rather flat primary income distribution further. However, like the other Nordic countries, to stem tax base erosion, Finland radically reformed the taxation of the most mobile tax bases in the early 1990s. Capital and corporate income taxation has been streamlined, through significant rate cuts cum base broadening measures. However, high taxes, especially on labour income, still hamper growth potential, give rise to tax arbitrage and distort economic behaviour. In this respect, the poor performance of the Finnish labour market is revealing. The tax system, and its interaction with social transfers, has undermined work incentives and contributed to the emergence of serious labour shortages for highly qualified workers. At the same time, high non-wage labour costs have hindered employment creation. Pockets of very high unemployment still exist, even though activity has been very strong for several years, while some companies have moved part of their business to countries where costs are lower partly because of taxes. Addressing concerns about the increasing cross-border mobility of tax bases while keeping high quality public services and a fair amount of income redistribution will thus be key issues in reforming the Finnish tax system.

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  Annexes
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