Norges Bank


Norges Bank's submission on economic policy for 2001

The following document was submitted to the Ministry of Finance on 19 October 2000

The implementation of monetary policy

There is a close relationship between the implementation of monetary policy and the formulation of fiscal policy. Against this background, Norges Bank presents its views on the overall economic programme for 2001. Norges Bank also refers to its submission of 21 October 1999 to the Ministry of Finance where it provided its views on the interplay between economic policy components and its interpretation of the mandate for the conduct of monetary policy. Norges Bank reaffirms its views and its interpretation as the basis for the implementation of monetary policy. The best way for Norges Bank to contribute to an appropriate policy mix is probably to be transparent, both as regards its economic analyses and its pattern of reactions.

The political authorities formulate Norges Bank's mandate for the conduct of monetary policy. The mandate is laid down in the Exchange Rate Regulation, adopted by Royal Decree, of 6 May 1994. Section 2 of the Regulation states:

"The monetary policy to be conducted by Norges Bank shall be aimed at maintaining a stable krone exchange rate against European currencies, based on the range of the exchange rate maintained since the krone was floated on 10 December 1992. In the event of significant changes in the exchange rate, monetary policy instruments will be oriented with a view to returning the exchange rate over time to its initial range. No fluctuation margins are established, nor is there an appurtenant obligation on Norges Bank to intervene in the foreign exchange market".

Since 1 January 1999, Norges Bank has chosen to define the reference "European currencies" as the euro. In its submission of 21 October 1999, the Bank wrote:

"In order to achieve exchange rate stability against the euro, monetary policy instruments must be oriented in such a way that price and cost inflation is brought down towards the corresponding aim for inflation for the European Central Bank (ECB). At the same time, monetary policy must not in itself contribute to deflationary recessions, as this would undermine confidence in the krone".

The krone exchange rate will fluctuate in the short term. Attempts to fine-tune the exchange rate may undermine the credibility of monetary policy, and hence exchange rate stability, over time. If the exchange rate changes, it is necessary to evaluate the interest rate in the light of exchange rate movements over a longer period so that the fundamental preconditions for exchange rate stability are fulfilled. In general, the background for exchange rate developments must be assessed carefully before Norges Bank adopts monetary policy measures.

In the National Budget for 2001, the Government writes (chapter 1 and in section 3.4.1):

"Balanced economic growth, with low price and cost inflation, is a precondition for achieving exchange rate stability over time. Monetary policy instruments must thus be oriented, together with the other instruments of economic policy, towards fulfilling this precondition. With this aim, Norges Bank must assess the use of instruments in light of developments in the foreign exchange market and the situation in the Norwegian economy".

This assessment is consistent with the evaluations presented in Norges Bank's submission of 21 October 1999. The best contribution monetary policy can make to overall economic policy is to lay the basis for nominal stability. The Bank cannot with open eyes orient monetary policy instruments towards triggering inflation or a deflationary recession. This would result in an unstable krone. Hence, there is initially no conflict between orienting monetary policy instruments towards low and stable inflation and the objective of exchange rate stability.

In Norway, fiscal policy has had an important role in stabilisation policy. However, developments in the real economy are also of importance to price and cost inflation, and hence for Norges Bank's setting of interest rates. At the same time, changes in the interest rate and exchange rate will influence developments in the real economy in the short run. This means that fiscal and monetary policy have a combined effect on the overall level of activity in the economy. With large and to some extent varying budget revenues, the basis for determining central government expenditure and taxes from one year to the next may easily be impaired. If budget expenditure is allowed to fluctuate in step with oil prices, the result may be abrupt shifts and instability in the Norwegian economy. Changes in oil prices may then quickly influence wage and price expectations, the exchange rate and long-term rates. In that case it will be very demanding to achieve nominal stability. Short-term interest rates would have to be changed frequently and sharply and will generally reflect a high risk premium for the Norwegian krone. It is therefore important that the annual budgets are anchored in a long-term strategy that takes into account that oil revenues can fluctuate from one year to the next. In addition, it is advantageous if fiscal policy can be used to counter fluctuations in demand and production.

In the National Budget, the Government states (section 3.4.1):

"Higher interest rates alleviate the onus on fiscal policy with regard to stabilising the Norwegian economy, but caution should be exercised in imposing an excessive burden on monetary policy. …In any event, the amounts channelled through the central government budget account for such a large proportion of the overall Norwegian economy that in practice it is not possible to achieve stable economic growth without fiscal policy assuming a main responsibility".

Norges Bank concurs with this statement. It is essential that there is a sound interplay between fiscal and monetary policy to achieve stable economic growth.

In the interest of financial stability, it is also important that fiscal policy is anchored in a long-term strategy. A high debt burden increases the vulnerability of households and enterprises to a rise in interest rates, and thus also the vulnerability of the financial sector. If household and enterprise debt grows sharply and the responsibility for demand management primarily rests with monetary policy, with an associated high level of interest rates, this may increase the risk of financial instability.

A special situation arises if fiscal policy stimulates higher growth in demand for goods and services from sheltered industries while there are still considerable pressures in the economy. In this situation, the contest for economic resources must inevitably result in deteriorating competitiveness and a reduction in value added in the internationally exposed sector. If there is little confidence in Norwegian economy policy, this may result in expectations of higher inflation and an unstable exchange rate. Norges Bank must counter any developments that in this way would erode the fundamental preconditions for exchange rate stability. If, on the other hand, there is confidence that monetary policy is geared towards fulfilling these fundamental preconditions, ie that monetary policy will not inflate the economy, market agents might expect a deterioration of cost competitiveness through an appreciation of the krone. Norges Bank would not be able to counter such an appreciation without generating inflation. Norges Bank's first response when it sees such pressures building up would be to recommend changes in the government budget. However, if an appreciation of the krone should reflect a political desire to expand public sector activity, and this is assigned higher priority than continued growth in activities exposed to international competition, it would also be appropriate to consider a revision of the guidelines for monetary policy, as communicated in Norges Bank's budget submission of 21 October 1999.

Incomes policy cooperation is also important for economic developments, including the total level of employment over time. In this connection Norges Bank would refer to NOU 2000:21 "A strategy for employment and value added", which states (section 1.5.4):

"Incomes policy cooperation has been a key component of economic policy in Norway throughout the post-war period. The purpose of this cooperation is to contribute to smoothly functioning wage determination that combines adequate real wages with moderate nominal wage growth, thereby laying the basis for sustained high employment. If wage growth in Norway is higher than among our trading partners, without this reflecting higher productivity growth, and the exchange rate remains stable, cost competitiveness will deteriorate. Such developments will over time undermine the possibilities for maintaining high employment. Investment and market shares in internationally exposed activities will be reduced, and monetary and fiscal policy would have to be tightened to restore balance in the economy. Experience shows that in this situation unemployment may rise rapidly".

Norges Bank refers to its consultative statement regarding NOU 2000:21 in which the Bank supports the main features of the Commission's recommendations.

The 2001 budget bill

The central government budget proposal for 2001 implies an approximately neutral fiscal stance, as measured by the non-oil, cyclically adjusted surplus net of interest payments. Underlying real growth in central government budget expenditure is estimated at 2½ per cent, compared with estimates from the accounts for 2000. This is somewhat higher than trend growth in mainland GDP. Public consumption is also estimated to expand by close to 2½ per cent. The programme for local government finances entails a real increase in local government revenues of about 1¾ per cent, or a good NOK 4 billion, from 2000 to 2001. As a result of strong growth in hourly wage costs, public expenditure's share of mainland GDP shows an increase that is greater than underlying real expenditure growth would imply. The Government is proposing an increase in the tax level that is equivalent to a net increase in tax payments in the order of NOK 6.4 billion, or a good ½ per cent of mainland GDP.

The estimates for the accounts for 2000 show real underlying expenditure growth in the central government budget of about 2¼ per cent, which is somewhat higher than estimated in the Revised National Budget, but somewhat lower than estimated in the National Budget for 2000 which was presented in autumn 1999. Over the last five years average underlying spending growth in the central government budget has been ¾ percentage point higher than estimated in the National Budget for the fiscal year in question.

The increase in public expenditure, particularly local government expenditure, will have a direct impact on labour market conditions. The public sector will probably account for the bulk of the estimated increase of about 14 000 in employment in 2001. When the economy is already operating at full capacity utilisation, an expansion in the public sector in excess of the level implied by underlying growth in the economy will normally involve a transfer of real resources from the business sector to the public sector. The tax programme, which also includes the introduction of a supplementary payroll tax and the taxation of share dividends, will contribute to this transfer of resources.

The challenges in the labour market are further amplified by limitations in the supply of labour. In the National Budget (section 3.6.1), the Government writes:

"The sharp rise in sickness absence and in the number of new disability pensioners in recent years resulted in the appointment of an official commission (the Sandman Commission) by the Bondevik Government in order to evaluate developments in the National Insurance Scheme's sickness-related benefits. The Commission, which submitted its report on 15 September 2000 made a number of proposals, cf Box 3.6. The Commission's report is further discussed in Proposition no. 1 to the Storting (2000-2001). The report will be circulated for comment and the Government intends to present the matter to the Storting during the spring session of 2001".

Growth in social security expenditure and other rule-based benefit schemes accounts for about half of the real growth in central government spending. Should these expenditures continue to increase at the same pace, the question of further tax increases may arise. Measures to curb expenditure growth will affect the internationally exposed sector's willingness to invest in Norway because expectations concerning the tax level influence the estimated rate of return on this investment. At the same time, increased use of these schemes contributes to a substantial reduction in the growth of the labour force. In the National Budget, the Government points out that the annual increase in sickness absence has been equivalent to about 10 000 person-years in recent years. If this continues, the increase in sickness absence will correspond to about the entire growth in the labour force next year. Such developments will have very serious consequences for the growth potential of the Norwegian economy and the scope for improving public welfare benefits. If, for example, sickness absence had been at the same level in 2001 as in 1996, sick pay expenditure in the budget proposal for 2001 would have been NOK 8 billion lower (National Budget, section 3.6.1). This approximately corresponds to the estimated revenues from the proposed supplementary payroll tax. The increase in vacation days, the introduction of cash grants for families with small children and the increase in sickness absence, in the number of disability pensioners and in early retirement pensioners have the effect of reducing the supply of labour in Norway as measured by the number of person-hours. Productivity growth in the Norwegian economy has also been disturbingly low in recent years. Against this background, it is essential that the authorities as soon as possible take measures which may stimulate labour force growth and boost productivity growth.

The Government has proposed a supplementary payroll tax of 1½ per cent of wage and salary payments and self-employment income. Furthermore, the Government proposes an increase in the electricity tax paid by households and enterprises and a reduction in the petrol tax from 1 January 2001. In addition, a revision of the VAT system from 1 July and changes in some excise rates have been proposed. According to the National Budget, the revision of the VAT system and reduction in excise duties will have an approximately neutral impact on consumer price inflation. However, the payroll tax will influence the business sector's labour costs, and the Ministry of Finance estimates that labour costs will increase by about 6 per cent next year.

On the basis of the estimate for real underlying expenditure growth in the central government budget and the proposed tax programme, Norges Bank assumes that consumer price inflation will be somewhat higher in 2001 and 2002 than previously projected by the Bank. In the longer term, this effect may be curbed as higher labour costs will contribute to lower employment in the business sector.

The Government is proposing a tax of 14 per cent on share dividends for personal taxpayers to enhance the distributional effects of the tax system and contribute to more equal tax treatment of employment income and share dividends. The Government has also proposed a tightening of business taxation and an increase in the minimum income deduction. Norges Bank would underline the importance of maintaining a coherent tax system based on the fundamental principles underlying the tax reform of 1992. In this connection, it is of paramount importance to emphasise the need for a set of rules that ensures consistency over time, neutrality in the choice between various forms of investment and funding and corporate structures, and which from an international perspective does not reduce to an excessive extent the business sector's willingness to invest in Norway. In conjunction with moderate growth in public expenditure and labour costs, the tax reform of 1992 appears to have made a substantial contribution to laying the basis for growth in the business sector through the 1990s.

Norges Bank would emphasise that important elements of a sound tax system are broad tax bases, effective resource rent taxation and excise duties that compensate for market failure. The Bank takes note of the proposals relating to the auctioning of licences. It is the Bank's view that this would be in keeping with these principles.

It is the Government's intention that the increase in the dividend tax from 2002 shall be replaced by a system where only the return in excess of a further specified share of the company's capital shall be subject to higher taxation. Norges Bank would point out that the tax on share dividends for the recipient will make it relatively less profitable for Norwegian investors to invest in shares rather than in other forms of investment. This may lead to an increase in foreign ownership of Norwegian companies. A dividend tax will, in isolation, contribute to increasing retained profits, and thereby the equity of companies. At the same time, this tax increase will increase the required rate of return on equity funding. The companies and their owners will therefore find it more profitable to raise loans rather than increase their equity capital. In isolation, this will weaken the financial strength of enterprises and increase the risk of financial instability. Furthermore, it is questionable whether the authorities will achieve the intended distributional effects. The scale of public services probably has stronger distributional effects, while an effective tax system is a precondition for being able to finance these services without giving rise to excessive economic costs. An important reason for the tax reform in 1992 was that a system with a broad tax base, fewer deductions and lower tax rates would provide a better, more equitable and effective tax system than that which applied at the time. The starting point for the reform was that different and conflicting considerations had resulted in a highly eroded tax system where high formal tax rates did not have the desired distributional effects.

Norges Bank refers to the Government's evaluations concerning business taxation in the National Budget (section 4.3), and will emphasise the need for introducing a more coherent system for the taxation of capital income and the return on capital as soon as possible. Norges Bank would emphasise that a new model should safeguard the principle of tax neutrality.

Executive Board member Kostøl is of the view that Norges Bank provides a description of the proposal concerning the tax on share dividends that places sole emphasis on some uncertain analyses of its possible harmful effects. This member cannot support a groundless assertion that the intended distributional effects of the proposals can be better achieved through an increase in the scale of public services, particularly because this in turn will require a higher tax level or an increased use of oil revenues. It has been demonstrated that those engaged in business exploit an increasingly eroded split-income model by converting income from employment into capital income to save taxes, and this does not contribute to more effective taxation. This member views the proposal as a contribution to remedying distortions and to a more equitable distribution of the tax burden.

Svein Gjedrem

Amund Holmsen
Published 19 October 2000 09:13