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EUROPEAN SEMESTER THEMATIC FACTSHEET

SUSTAINABILITY OF PUBLIC FINANCES

1. INTRODUCTION healthy initial fiscal positions are reasons


for precautionary policies1.
The sustainability public finances also
referred to as fiscal sustainability, is Against this background, the
the ability of a government to sustain its deterioration in fiscal positions and
current spending, tax and other policies increases in government debt in the EU
in the long run without threatening the since 2008, together with the budgetary
government's solvency or without pressures posed by, among others,
defaulting on some of the government's population ageing, compound each other
liabilities or promised expenditures. and make fiscal sustainability an acute
policy challenge.
That fiscal sustainability is crucial has
become more evident in the context of Analysing prospective government debt
the recent crisis. Yet, sustainability of developments and risks to fiscal
public finances is not a circumstantial sustainability is crucial at the current
concern, it affects essentially juncture for euro-area countries and for
intergenerational fairness and it sets the EU as a whole to be able to
forth principles that are useful at all formulate appropriate policy responses
times and to all governments, and restore credibility and confidence.
irrespective of their current leverage. Developments in the recent past, in
Keeping the government debt in check particular the sovereign debt crisis
and maintaining the ability to issue debt leading to conditions under which some
when needed is essential for the smooth Member States faced difficulties in
functioning of the economy. Member accessing the market, have confirmed
States need to be able to adjust to that fiscal sustainability challenges are
unforeseen circumstances beyond the not only of a longer-term nature.
control of the government, such as large
swings in the business cycle or economic In the euro area and the EU the overall
crises. fiscal outlook continues to improve2, with

Moreover, limited capacity to extract


taxation from the economy, political 1
Obstfeld, M. (2013), "On Keeping Your
economy reasons complicating Powder Dry: Fiscal Foundations of Financial
consolidation, as well as evidence that and Price Stability", IMES institute for
structural reforms are implemented monetary and economic studies, Bank of
more successfully in countries with Japan, Discussion Paper No. 2013-E-8,
Fournier. M., and F. Fall (2015) "Government
Debt and Fiscal Frameworks" OECD Working
Paper, ECO/CPE/WP1(2015)7/ANN2; Eyraud,
L and Wu, T (2015), "Playing by the Rules:
Reforming Fiscal Governance in Europe" IMF
Working Paper WP/15/67.

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the deficit-to-GDP ratio3 projected to outlines the challenges associated with
decline, respectively, to 1.8% and 2.0% public finance sustainability; section
in 2016 and to continue that trend, with three looks into the policy levers; section
this ratio reaching 1.5% in the euro area four examines the policy state of play.
and 1.6% in the EU in 20184.
2. CHALLENGES
With lower deficits, the debt-to-GDP ratio
in the euro area and the EU is forecast to When assessing fiscal sustainability, due
continue to decline from its 2014 peak, attention needs to be paid to the current
to reach, respectively, 91.6% and 86.0% and prospective level of outstanding
in 2016, and, respectively, 89.4% and government debt. High-debt countries
83.9% in 2018. are more vulnerable to negative growth
rate/interest rate shocks. In the absence
Despite considerable progress in fiscal of a sufficiently high primary surplus,
consolidation, the main causes of fiscal which might be difficult to maintain over
sustainability challenges and the time, public debt might be unsustainable
economic and budgetary situations and even before considering the challenge
prospects vary widely across EU posed by an ageing population. Hence, a
countries at the current juncture. high level of outstanding government
debt can put fiscal sustainability at risk
The appropriate combination of policies even before considering the long-term
needed to ensure fiscal sustainability is expenditure trends influenced by
therefore also idiosyncratic, depending population ageing.
on the challenges faced by each Member
State5. In 2016 most EU Member States have a
government debt-to-GDP ratio above the
Finally, the sustainability of public 60% of GDP Treaty threshold. However,
finances in the EU is closely linked to assuming that the SGP fiscal rules are
principles enshrined in the Treaties, to fully respected, i.e. the SGP scenario,
the Stability and Growth Pact (SGP), and the large majority of countries would be
to the process of multilateral surveillance expected to have a lower ratio in 2027
carried out through the European compared to a no fiscal policy change
Semester, i.e. it is part of a framework scenario (Figure 1). Moreover, assuming
whereby the Commission acts together full respect of the SGP fiscal rules, no
with Member States. Member State would have an increasing
debt-to-GDP ratio by 2027.
The remainder of this thematic factsheet
is organised as follows: section two

2
See European Commission (2016b),
"Autumn 2016 European Economic Forecast"
3
This represents the headline balance, not
cyclically-adjusted and not net of one off and
other temporary measures.
4
For more information on the fiscal position
of the euro area and the EU see European
Commission (2016a), "Annual Growth Survey
2017".
5
Greece, a country implementing an
adjustment programme is not covered by this
fiche. The macroeconomic and budgetary
prospects for 'programme' countries are
assessed more frequently than for the other
Member States. The time horizon covered by
the forecasts for these countries is also
different than for the other Member States
and assume full implementation of the
adjustment programme.

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Figure 1 – Gross government debt projections under the SGP scenario vs. the baseline
no-fiscal policy change scenario (% of GDP)
SGP Scenario

Baseline no-fiscal policy change scenario

Source: Commission services


Notes: based on Commission Autumn 2016 forecast data; Gross debt projections under different scenarios are
available in the Commission's assessment of each Members State's Stability Programme at
http://ec.europa.eu/economy_finance/economic_governance/sgp/convergence/index_en.htm

The Commission's multidimensional assessment of more immediate


approach for assessing fiscal sustaina- challenges and risks; both long and
bility integrates the longer term with an short term analysis are underpinned by

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appropriate indicators which can point to shows the upfront adjustment effort
the scale and the scope of the required, in terms of a cumulated
sustainability challenges, as follows6: gradual improvement in the
structural primary balance over 5
 Short-term fiscal challenges are years (starting from the year after
captured in the S0 indicator: as a the forecasts, currently 2019), and
weighted set of fiscal, financial and then sustained, to bring the debt – to-
competitiveness indicators, the S0 GDP ratio back to 60% in 2031,
indicator aims at an early detection of including financing for any additional
fiscal stress stemming from risks within expenditure arising from an ageing
a one-year horizon, making use of the population8.
signalling power of its components7.  Long-term fiscal challenges are
 Medium-term fiscal challenges are assessed by the S2 indicator: this
described by the S1 indicator: The indicator shows the adjustment to the
medium term sustainability indicator S1 current structural primary balance
required to fulfil the infinite horizon
inter-temporal budget constraint,
6
The below indicators are described in more including paying for any additional
technical detail in the most recent Fiscal expenditure arising from an ageing
Sustainability Report of the European population9.
Commission: see European Commission
(2016c), "Fiscal Sustainability Report 2015", This battery of indicators is used as part of the
Directorate-General for Economic and Commission evaluation of Member States
European Economy Institutional Paper budgetary plans in the context of the Stability
018/2016.
http://ec.europa.eu/economy_finance/publica
and Growth Pact10. They enable to assess the
tions/eeip/pdf/ip018_en.pdf extent to which there is a need for large
7
A whole set of economic variables are policy adjustment now or in the future
weighted in the composite indicator S0. There and the kind of policy adjustment required (of
are fourteen variables in each of the two sub-
indexes composing S0. The variables used fiscal or structural nature or a
are: On the fiscal side: budget balance, combination of the two). In a medium- to
primary budget balance, cyclically adjusted long-term perspective, it is necessary to
budget balance, stabilising primary budget
analyse how the sustainability challenge
balance, government gross debt (level and
change), government short term debt, should be addressed. This can be is carried
government net debt, gross financing needs, out in two steps:
change in government expenditure, change in
government final consumption expenditure
(all as % GDP) plus the differential between
the interest rate and growth rate, old age
dependency ratio 20 years ahead and 8
On the latest estimates of the fiscal costs of
projected age-related public expenditure
ageing, see European Commission (2015),
(average yearly change over the next 5years
"The 2015 Ageing Report. Economic and
as % GDP); On the macro-financial and
budgetary projections for the EU 28 Member
competitiveness side: net international
States (2013-2060)", Directorate-General for
investment position, net savings of
Economic and Financial Affairs, European
households, private sector debt, private
Economy 3/2015.
sector credit flow, short term debt of non- 9
financial corporations, short term debt The adjustment implied by the S2 indicator
households, current account 3year backward might lead to debt stabilising at relatively
moving average (all as % GDP), plus the high levels, thus the indicator has to be taken
leverage of financial corporations, with some caution for high debt countries in
construction (as % of value added), real view of the SGP requirements.
10
effective exchange rate vs. 35 trading See the Commission's assessment of
partners and based on the exports deflator Stability or Convergence Programmes – DG-
(% change over 3years), nominal unit labour ECFIN Staff working documents available at
cost (% change over 3years), yield curve, http://ec.europa.eu/economy_finance/econo
read GDP growth, and GDP per capita in PPP mic_governance/sgp/convergence/index_en.
as % of US level. htm

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 Identifying the extent to which there reach the Treaty's 60% threshold for
is an important fiscal sustainability government debt fifteen years ahead (by
challenge; 2031)12 - Figure 3 shows the S1 indicator
 Establishing the nature of the in the no-policy-change scenario taking
challenge so as to devise appropriate the budgetary position in 2018 (the last
policies to remedy the situation. This year of the autumn 2016 Commission
is done by looking at the relative forecast) as a starting point.
importance of the fiscal positions
(current and prospective deficit and 2.3. The long term fiscal challenges
debt levels) and of future age-related (S2 indicator)
spending pressures in the EU
countries, notably in the fields of The S2 sustainability indicator provides
pensions, health care and long-term quantification of the size of current and
care11. future budgetary imbalances and,
therefore, of the size of the challenge
Fiscal sustainability is assessed placed on public finances. The higher the
separately and non-mechanically over values of the S2 sustainability indicator,
each time horizon. At the level of each the greater the fiscal sustainability risk
horizon additional factors and qualifiers and thus the required fiscal adjustment.
are taken into account in a process History provides several examples of
involving economic judgement. periods when a lasting improvement in
the fiscal position (primary balance) of
Moreover, country-specific situations
up to 2 percentage points of GDP has
need to be taken into account.
occurred. However, there have been
very few periods of lasting improvements
2.1. Short term fiscal challenges (S0 of 6 percentage points or more. In cases
indicator) where the sustainability gap is large due
to high ageing costs, structural reforms
Values of the S0 indicator beyond the geared towards curbing the long-term
threshold indicate potential short-term age-related expenditure trends are
risks for fiscal stress. necessary parts of the policy adjustment.
As was the case in the 2012
A more precise identification of the
Sustainability Report, the following
specific sources of short-term fiscal risks
indicative thresholds for the S2 indicator
at country level is made possible by the
have been retained: (i) if the value of S2
analysis of the individual variables, and
is lower than 2, the country is assigned
the values they take relative to their own
low risk; (ii) if it is between 2 and 6, it is
thresholds. Countries with a value for the
assigned medium risk; and, (iii) if it is
overall indicator above the threshold
greater than 6, it is assigned high risk.
(0.46) in 2016 are at risk for fiscal stress
in the year ahead (Figure 2). The results for the S2 sustainability
indicator or sustainability gap can be
2.2. Medium term fiscal challenges broken down into two elements:
(S1 indicator)
 The initial budgetary position (level
As regards the medium-term challenges of debt and initial structural primary
– quantifying the required steady fiscal balance): some Member States
adjustment over the five years after the currently have too large a deficit
period covered by the forecast (2018) to given the level of their debt and long-
term growth potential, which would

11
See European Commission (2014), 12
The fiscal gap is captured by the S1
"Identifying fiscal sustainability challenges in 60%
the areas of pension, health care and long- indicator ( S12031 ), where the end-point is set
term care policies" European Economy, to 60% of GDP in fifteen years' time (by
Occasional Papers No 201|2014. 2031).

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imply an explosive debt even without increase of expenditure than others,
taking into account the impact of the driving factors being mainly
ageing; demographics and features of the
 The "cost of ageing", i.e. the pensions systems, but also other
discounted change in age-related expenditure categories such as
expenditure over the long-term. Here health care and long-term care.
Member States also show large
differences: some face much larger

Figure 2 – S0 Indicator split into its two sub-indexes: the fiscal index and the financial-
competitiveness index

Source: Commission services


Note: based on Commission Spring 2016 forecast data

Figure 3 – S1 indicator (pps of GDP)

Source: Commission services


Note: based on Commission Autumn 2016 forecast data

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Figure 4 shows the initial budgetary The further a country is positioned
position (IBP) on the horizontal axis towards the upper-right corner, the
and the long-term change in the higher is the sustainability gap. The
budgetary position (LTC) on the vertical diagonal trapezoidal lines indicate the
axis. A country positioned to the left size of the sustainability gap. For
has a favourable IBP; if it is below zero, example, the EU a whole has a S2
it means that the budgetary position sustainability gap of 1.7 pp. of GDP.
contributes positively to fiscal
sustainability. A country positioned Figure 5 shows in more detail the
towards the bottom of the axis has a components of the cost of ageing. For
low long-term 'cost of ageing'. the EU as a whole, the contribution
from health care spending and long-
Countries in the upper area can term care spending13 is larger than that
improve their fiscal sustainability of pension spending. There is however
position by curbing the projected a large variation across countries. In
increase in age-related expenditure, some Member States, the fiscal
such as implementing pension reforms. sustainability challenge is mostly
Countries to the right can improve their affected by pension spending trends
fiscal sustainability position by and in others by trends in health care
consolidating their public finances. and long-term care spending.

Figure 4 – The S2 sustainability gap decomposed

Source: Commission services.


Note: based on Commission Autumn 2016 forecast data

13
Increases in health care expenditure reflect not only the impact of changes in the demographic
structure, but also take account of the fact that health care expenditure tend to rise faster than
GDP over time (reflecting e.g. improvements in health care quality).

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Figure 5 – S2 indicator and its components: initial budgetary position (IBP) and cost of
ageing (CoA) (pps of GDP)

Source: Commission services


Note: based on Commission Autumn 2016 forecast data

3. POLICY LEVERS measures, both in terms of averages per


EU Member State 2008-2012 and the
Several policy responses could be used Commission’s forecasts for 2018.
to address the challenges, including
fiscal consolidation and/or structural The first step for any country to address
reforms, especially those to curb the challenges of fiscal sustainability is to
long-term budgetary costs of ageing. fully adhere to the EU fiscal rules, the
Stability and Growth Pact14.
3.1. The starting point: the
Measures targeting a broadening of the
government's budgetary position
tax base also help to ensure sound
The government budgetary position is budgetary positions15.
the first key element of the sustainability
indicators.

Its assessment should not be influenced


by temporary factors: therefore a
correction for the impact of the business
cycle on the general government balance
14
and the impact of any one-off measure is Fiscal frameworks and fiscal policy are
due. discussed in a separate thematic factsheet
elaborating on the challenges addressed in
Figure 6 shows the structural primary the European Semester and possible policy
balances of EU Members States, that is, responses to them.
15
In this context see the thematic factsheet
the cyclically-adjusted primary balance
on undeclared work.
corrected for one-off and temporary

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Figure 6 – Structural primary balance 3.2. A long-term determinant of
(% of GDP, 2016 vs average over 2008- fiscal sustainability: the cost of
2012) ageing and its components

In a longer-term horizon, a key factor for


fiscal sustainability is the cost of ageing.
In the sustainability assessment, the
consideration of the cost of ageing
covers a longer time horizon, until
206016.

The largest expenditure item of these is


public pension spending, accounting for
about 11% of GDP in the EU as a whole.
There is considerable variation across
Member States in terms of both current
expenditure levels and in terms of
projected changes in pension spending,
reflecting the different pension systems
in place, and importantly, at which stage
of the pension reform process countries
find themselves in (see Figure 7).

The second largest public expenditure


item is expenditure on health care,
accounting for about 7% of GDP for the
EU as a whole.

In addition to health care, consideration


should be given to expenditure on long-
term care. Taken together, these items
represent almost 9% of GDP in the EU.

As it is the case for pensions, there is


considerable variation across Member
States in terms of both current
expenditure levels and in terms of
projected changes in pension spending,
reflecting the different health care and
long-term care systems and
arrangements in place (see Figure 8).

Source: Commission services


Note: based on Commission Autumn 2016 forecast
data

16
The age-related expenditure items
comprise public expenditure on pension,
health care, long-term care and education)
and unemployment benefits from the 2015
Ageing Report.

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Figure 7 – Public pension expenditure (% of GDP, 2018 vs 2060)

Figure 8 –Public health care and long-term care expenditure (% of GDP, 2018 vs 2060)

Source: Commission services

Reforms addressing the longer-term adjusting the size of the pension


drivers of risks to fiscal sustainability benefit17.
include those that try to contain the
costs of ageing and their components. In the first category reforms have a
decreasing impact on the coverage rate
In the area of pensions, potential reform of pension systems. They commonly
approaches include adjusting the age concern the abolishment or restriction of
eligibility for a pension benefit and early retirement schemes and other
early-exit pathways, the increase in
statutory retirement ages (also through

17
Pension policy is discussed in a separate
thematic factsheet elaborating on the
challenges addressed in the European
Semester and possible policy responses to
them.

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introducing automatic links to the largely expenditure. As two subsequent Ageing
known changes in longevity over the Reports published in 2012 and 2015
medium and long term) or the show, the total age-related expenditure
harmonisation of retirement ages has decreased from one projection to the
between men and women. next one, meaning that reforms in these
areas actually bear fruit.
The category of reforms adjusting the
size of the pension benefit offers an Amongst the most effective measures to
alternative to restrictions in the coverage tackle the cost of ageing are
of a pension system. Such reforms result mechanisms automatically linking
in a decrease in the pension benefit ratio retirement age or/and pension benefits
(defined as the average pension as a to life expectancy, recommended by the
share of the average economy-wide Commission in several Annual Growth
wage). Surveys19.

If benefit ratios are very high both in Currently, almost half of EU Members
comparison to the reference wage and in States have such a mechanism in place
comparison to other Member States, this (see Figure 9) and all euro area
could hint to the fact that a pension countries supported this principle in a
system is rather generous. Reducing the recent statement adopted on 16 June
benefit ratio, i.e. the generosity of 201620.
pension entitlements, can thus have a
This wide recognition reflects the double
substantial decreasing or at least
dividend paid by these mechanisms –
stabilising impact on public pension
automatic links strengthen pension
expenditure.
system sustainability at the same time
In the area of health care and long term as they improve the adequacy of the
care challenges are more Member State pension systems since by accumulating
specific and solutions to improving cost higher contributions throughout
effectiveness and governance are extended working lives people secure
generally sought on a case-by-case higher pensions.
basis18.

4. CROSS-EXAMINATION OF THE
POLICY STATE OF PLAY

Graphics in this factsheet have so far


provided a cross-country perspective of
both the challenges and policy levers.

While population ageing puts upward


pressure on public spending with large
differences across the EU, Member
States have become increasingly aware
of these risks and have taken policy 19
See European Commission (2016a),
action. Accordingly, progress with "Annual Growth Survey 2017".
20
reforms is visible in terms of the Eurogroup 2016 "Common principles for
projected increase of age-related strengthening pension sustainability"
expenditure and in particular pension Statement 16 June 2016.
http://www.consilium.europa.eu/en/press/pr
ess-releases/2016/06/16-eurogroup-pension-
sustainability/ These principles are the
following: i) Safeguard against demographic
18
Health care policy is discussed in a and macroeconomic risks: ii) Flanking
separate thematic factsheet elaborating on policies; iii) Broader reforms to strengthen
the challenges addressed in the European growth and employment; iv) Anchoring
Semester and possible policy responses to political and societal support.
them.

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Figure 9 – Measures effective in strengthening pension sustainability

Source: Commission services


Note: subject to parliamentarian decision

Date: 16.12.2016

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5. REFERENCES

 Eyraud, L., and T. Wu (2015),"Playing by the rules: Reforming fiscal governance in


Europe". IMF Working Paper No. 15/67.
 Eurogroup (2016), "Common principles for strengthening pension sustainability"
Statement of 16 June 2016.
http://www.consilium.europa.eu/en/press/press-releases/2016/06/16-eurogroup-
pension-sustainability/
 European Commission (2016a), "Annual Growth Survey 2017", Communication from
the Commission to the European Parliament, the Council, the European Central Bank,
the European Economic and Social Committee, the Committee of the Regions and the
European Investment Bank
 European Commission (2016b), "Autumn 2016 European Economic Forecast"
Directorate-General for Economic and Financial Affairs, European Economy,
Institutional Paper 038 | 2016
 European Commission (2016c), "Fiscal Sustainability Report 2015", Directorate-
General for Economic and Financial Affairs, European Economy, Institutional Paper
018/2016
http://ec.europa.eu/economy_finance/publications/eeip/pdf/ip018_en.pdf
 European Commission (2015), "The 2015 Ageing Report. Economic and budgetary
projections for the EU 28 Member States (2013-2060)", Directorate-General for
Economic and Financial Affairs, European Economy 3/2015.
 European Commission (2014), "Identifying fiscal sustainability challenges in the
areas of pension, health care and long-term care policies", Directorate-General for
Economic and Financial Affairs, European Economy, Occasional Papers No 201|2014
 European Commission (2012), "The 2012 Ageing Report. Economic and budgetary
projections for the EU 28 Member States (2013-2060)", Directorate-General for
Economic and Financial Affairs, European Economy 2|2012
http://ec.europa.eu/economy_finance/publications/european_economy/2012/pdf/ee-
2012-2_en.pdf
 Fournier, J. M., and F. Fall (2015), "Government debt and fiscal frameworks, Annex 2
The government debt limit", OECD Working Paper, ECO/CPE/WP1(2015)7/ANN2.
 Obstfeld, M. (2013), "On keeping your powder dry: Fiscal foundations of financial
and price stability", IMES institute for monetary and economic studies, Bank of Japan
Discussion Paper No. 2013-E-8.

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