Executive summary

After a deep contraction, the economy is recovering from the COVID-19 pandemic on the back of robust export growth.

The health situation is under control, and new infections are rare. All domestic restrictions were lifted end of June. Vaccination is progressing rapidly.

The government extended most support programmes until end-2021. It also set up a five-year programme to invest in infrastructure, digitalisation and research and innovation accounting for 0.5% of GDP per year.

Following a 6.6% contraction in 2020, the economy is expected to grow by 2.8% in 2021 and 4.5% in 2022 (Figure 1,Table 1), driven by a rebound of tourism, a successful vaccination programme and the lifting of restrictions. Unemployment will edge down to around 7% in 2022 on the back of accelerating growth.

Non-tourism exports are on the rise. Intellectual property services now account for around 15% of service exports. Data processing and storage are growing rapidly, attracted by low energy prices and a cool and windy climate.

Domestic tourism has only partly replaced foreign travellers. In 2020, pandemic-related travel restrictions reduced foreign arrivals to around a fourth of the previous year (Figure 2). To a limited extent, this sharp decline was offset by Icelanders travelling in their own country.

Notwithstanding the recent interest rate hike, monetary policy remains accommodative. Fiscal policy continues to support households and firms.

Monetary policy has been eased in response to the crisis and remains appropriately accommodative. Between March and November 2020 the central bank reduced its key interest rate by 2 percentage points to 0.75%. As inflation and short-term inflation expectations have risen above the target, the bank raised the interest rate again to 1% in May.

The easing monetary conditions have helped households more than firms. Mortgage credit rose in 2020, and real estate market activity and house prices rose. Yet corporate lending stagnated, despite measures to ease access to credit, with liquidity constraints a concern especially for the tourism sector.

Fiscal policy is supporting the economy. The budget deficit widened to 7.3% of GDP in 2020. Parliament suspended the fiscal rule and the rolling five-year fiscal plan it approved in late 2020 as well as the one it endorsed in Spring 2021 aim to support the economy in the short term and to reach a positive primary balance by 2025, when gross public debt according to the National Accounts is set to stabilise at 100% of GDP.

Tax reforms help low-income households and the environment. The third and last stage of an income tax reform reduced tax rates by up to 8 percentage points. Environmentally-friendly transport modes receive temporary VAT reliefs.

Regulatory barriers are stringent, slowing innovation and the entry of new firms. At the same time, skills gaps need to be addressed.

Productivity has recently accelerated but has overall remained sluggish over the past decade. The competitiveness gains built up shortly after the 2008/09 crisis were exhausted by the late 2010s.

Stringent regulation stifles competition. The state sector is small and well run, but barriers to entry facing domestic and foreign firms are high (Figure 3), hampering competition. Administrative burdens and an extensive licensing and permit system protect incumbents and slow new and innovative start-ups.

Iceland has untapped innovation potential (Figure 4). More effective support for business R&D would unlock private investment and improve the ability of smaller firms to innovate. Encouraging firms to adopt digital technologies would help Iceland to make the most of innovation niches, with productivity gains. The public sector too could become more digitalised with positive societal impact. Skills for the digital era and strong knowledge exchange through closer business-research collaboration on innovation and international cooperation in research are essential for stronger innovation.

The quality of primary and secondary education is declining, although the system is remarkably equitable. PISA scores are trending down (Figure 5), as teacher qualifications fail to keep up with requirements, and teacher salaries provide few rewards for experience and excellence.

Tertiary education induces skills mismatch. Links between universities and the labour market are weak. Funding levers make it attractive for universities to focus on enrolment rather than performance. Collaboration between research institutions and firms is improving, however.

Vocational education and training is underdeveloped. Participation is lower than in any European country and limited to traditional technical and crafts professions. School-based and work-based learning are weakly integrated, and there are only few pathways to higher education.

Iceland has committed to reduce carbon emissions substantially over the coming decade. It should do so in a sustainable, cost-efficient and inclusive manner.

Iceland’s per capita carbon emissions exceed the OECD average, partly because of industry’s reliance on low energy generation cost (Figure 6). The government committed to reduce emissions from their 2005 level by at least 40% by 2030.

Iceland’s climate policy should rely on effective carbon pricing, complemented by investment in low-carbon infrastructure, targeted spending on green research and development, and well-designed environmental regulation. To ease the transition, the country should remove barriers for new and innovative firms and foster the creation of green jobs and skills.

To garner political support and make the low-carbon transition beneficial for all, proceeds from carbon pricing could be redistributed to households and firms, at least partly.


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