OECD Economic Surveys: Iceland 2021

Executive summary

Iceland stands up after a deep fall

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.

Figure 1. The economy plunged

GDP decline in 2020

Source: OECD, National Accounts database.

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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.

Figure 2. Border restrictions hit the tourism sector hard

Note: Passengers who go through security at Keflavík Airport.

Source: Statistics Iceland.

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Table 1. The economy is projected to accelerate

	2019	2020	2021	2022
			Projections
	Percentage changes, volume (2005 prices)
GDP at market prices	2.6	- 6.6	2.8	4.7
Private consumption	1.9	- 3.3	2.1	4.9
Gross fixed capital formation	- 3.7	- 6.8	8.0	3.4
Exports	- 4.6	- 30.5	6.5	12.0
Imports	- 9.3	- 22.0	8.2	8.2
Consumer price index	3.0	2.8	4.1	2.5
Unemployment rate	3.9	6.4	8.0	7.6
Budget balance (% of GDP)	- 1.5	- 7.3	- 10.3	- 7.1
Current account (% of GDP)	6.4	1.0	-1.0	0.0

Source: OECD, Economic Outlook No. 109.

Monetary and fiscal policies are accommodative

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.

Regulation should be eased and skills improved

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.

Figure 3. Barriers to entry are high

PMR gap with OECD average, 2018

Note: Positive values mean more stringent regulation than the OECD average, negative values less stringent regulation.

Source: OECD, Product Market Regulation database.

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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.

Figure 4. Innovation lags behind

Innovation outcomes in international comparison

Note: Higher values reflect better outcomes. More information is given in chapter 2.

Source: World Bank, World Development Indicators; OECD, Main Science and Technology Indicators; OECD, Information and Communication Technology; OECD, Education at a Glance database; and Global Innovation Index 2020.

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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.

Figure 5. PISA scores have trended down

Source: OECD, PISA 2018 database.

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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.

Addressing climate change

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.

Figure 6. Carbon emissions exceed the OECD average

Total greenhouse gas emissions per capita

Source: OECD Green Growth Indicators.

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MAIN FINDINGS	KEY RECOMMENDATIONS
Policies to support the recovery
Inflation and short-term inflation expectations are above target.	Keep monetary policy accommodative, but stand ready to tighten further if long-term inflation expectations risk becoming unanchored.
The merger of the Central Bank and Financial Supervisory Authority is expected to strengthen the overall surveillance of the financial system.	Remain vigilant to maintain a sound and resilient financial system.
Fiscal policy is supporting the economy.	Continue supporting the economy and start fiscal consolidation as planned once the recovery is firmly established.
Barriers to the entry of new firms are high.	Reduce barriers to sound competition in the tourism and construction sectors. Facilitate access to professions by easing stringent occupational licensing.
Skills mismatch is high. Labour shortages have intensified in some sectors, slowing reallocation.	Continue and extend the training programme for professions in short supply. Strengthen vocational education and training (VET) by extending work-based learning and by facilitating access to tertiary education for VET graduates. Strengthen the link between tertiary education and the labour market, by linking part of university funding to labour market needs.
Promoting innovation
Business R&D intensity does not match the rapid increase in tax support for R&D in recent years and innovation outcomes of smaller firms, which are the main beneficiaries of such support, are relatively weak.	Ensure that R&D tax-incentives better target smaller innovative firms.
Venture capital, an important source of financing for young and innovative firms without collateral, is not yet well developed.	Ensure that the new publicly-owned venture capital fund invests in privately-owned venture capital funds with large potential to promote start-ups and innovation companies.
The tertiary system does not provide sufficiently broad skills.	Increase the provision of vocational education programmes at the tertiary level and of entrepreneurship programmes.
Collaboration between research institutions and the business sector is weak, limiting knowledge transfer.	Introduce carefully-designed policy initiatives to encourage business-research collaboration on innovation, including specific programmes that connect smaller firms with researchers.
Addressing climate change
Climate policies lack prioritisation and sequencing and rely mostly on technical measures.	Develop a consistent climate policy framework to guide scope, priorities, and sequencing of actions and measures.
Geothermal energy, waste management and agriculture are not subject to carbon pricing.	Submit all sectors to carbon pricing, taking into account interactions between carbon taxes and emissions trading systems.
There is room for further investment in low-carbon infrastructure.	Step up spending on low-carbon transport infrastructure, energy transition and the digital transformation.