The war in Ukraine is worsening the economic outlook (Table 1). Headline inflation reached 8.8% in October, due to high energy prices, rising core inflation, and automatic wage indexation, which tends to push up wage inflation in an already-tight labour market. In the short term, growth is expected to slow, on the back of higher global interest rates, and plummeting confidence. Whilst direct exposure to Russia is low, the economy will be negatively affected through a slowdown in activity in European partners. The EU embargo on Russian oil imports, supply chain disruptions related to the war and China’s COVID-related shutdowns will further dampen activity.

Policies to mitigate inflation impacts on incomes should be better targeted, time-bound and maintain energy savings incentives. Generous fiscal policy support of about 3.3% of GDP is weighted towards price support. Such measures may blunt incentives to reduce energy consumption, especially if energy prices remain high over the medium term. Policy should focus more on temporary, targeted income support.

The wage indexation system risks adding to already high inflation in periods of unprecedented price shocks, potentially harming longer-term competitiveness. General wage increases result in proportionately higher monetary gains for wealthier earners. Agreements by the social partners to moderate wage indexation may not be sufficient if energy prices remain elevated for a prolonged period. The government should reform the wage indexation system in consultation with social partners to better safeguard against risks to productivity, employment and inflation.

Higher global interest rates will raise risks in the financial sector and housing markets over the short and medium term. Pensions spending represents a large fiscal risk over the long term.

The overheating housing market poses risks for some categories of borrowers. House price inflation has outstripped most OECD countries (Figure 2), worsening affordability and raising household debt levels to 180% of net disposable income in the first quarter of 2022. Macroprudential policy measures have been taken to lower risks for borrowers, and loan-to-value limits introduced in January 2021. Nonetheless, higher interest rates will put some categories of borrowers on variable rates under strain, particularly those with lower incomes. In addition to maintaining heightened vigilance of banks and household indebtedness, the authorities should stand ready to apply a broad range of macroprudential policy instruments.

The fiscal system’s resilience to shocks is high but can improve further. High growth, resilient tax bases and a strong commitment to low public debt have been important safeguards, particularly given how small and open the economy is. However, over time, spending pressures are set to increase. Pension expenditure will rise sharply under unchanged policies whilst macroeconomic shocks, linked to climate change, could increase in frequency. Developing a more systematic framework to assess and prioritise spending policies could further increase fiscal resilience.

The current pension review is an opportunity to tackle projected increases in annual pension expenditures of up to 9% points of GDP by 2070 (Figure 3). Debt sustainability projections show that in the worst-case scenarios, this would raise the public debt to GDP ratio to over 140% by 2060, after fully drawing down pension asset reserves. Raising effective retirement ages and introducing actuarially fair adjustments for early retirement would improve the affordability of the pensions system and enhance intergenerational equity.

Potential growth is set to slow as the population ages. Labour participation of young and older workers should increase while higher private sector investment, including in R&D, would boost productivity growth.

A number of young workers are at high risk of being excluded from the job market. High dropout rates are concentrated amongst the most vulnerable students, who are less equipped to cope with uneven schooling quality and rigid educational pathways. Any reforms to the schooling system will take time to be effective and need to be accompanied in parallel by a sharp expansion in vocational training for unemployed youth. Programmes should promote in particular highly demanded skills for technical professions.

The current high barriers to employing older workers should be removed. Participation rates of over 55-year-olds are amongst the lowest in the OECD. Generous pension benefits and existing work practices reduce incentives to remain in the workforce. The pensions system could be reformed to allow a phased entry into retirement, including more flexible use of part-time contracts. The existing incentives to hire older workers should be enhanced, including via targeted training to overcome skills gaps, notably in digitalisation. A strengthened system of adult learning, with a focus on life-long learning, would ensure the existing workforce is not left behind in the transition to a green economy.

Private investment levels of 8.5% of GDP and 0.6% of GDP for R&D are amongst the lowest in the OECD. The government provides significant support to R&D investment, but total private investment, including for R&D, continues to fall as a share of GDP. SMEs’ digital investments also lag peers. Public investment support for R&D is highly dispersed with overlapping structures. Streamlined administration could improve the use of available funds, which could be redirected from a narrow focus on high-tech sectors to the manufacturing sector. Increasing the share of funds deployed to match private funding of R&D could support more investment by firms.

Administrative burdens are high, representing an obstacle to firm dynamism. Professional licensing rules are amongst the most restrictive in the OECD. Starting a business, whilst possible to do online, remains a cumbersome procedure.

Luxembourg has ambitious climate goals, but deep changes are needed to meet them. Higher carbon prices reinforced by transport and housing policies can improve household choices on where to live and how to move.

The price of carbon must increase in the long term for the green transition to succeed (Figure 4). Energy prices paid by consumers have increased significantly recently but may need to rise even further in the long term to reach net-zero emissions. Low carbon prices have encouraged residents’ high levels of car usage and residential heating consumption, and provided little incentive to undertake large behavioural changes or expensive energy efficiency investments. Cross-border fuel sales have also been significant as prices in Luxembourg have been historically lower than in neighbouring countries.

The current carbon tax lacks the long-term time horizon needed to create clear incentives for the green transition. A rising carbon tax, with a clearly defined trajectory over the long term, will incentivise required investments in energy efficiency. This needs to be accompanied by a clearly communicated policy as to how any additional revenues from environmental taxes may be used. Policies that explicitly tackle distributional concerns tend to increase the political support and sustainability of transition policies.

Ambitious policy targets for the transition need to be accompanied by estimates of the costs of the green transition. The costs of the transition will change over time, and across groups of households and firms. These costs, and how they are affected by policies, need to be carefully monitored. Costing the transition will enable prioritising competing long-term fiscal demands, including for pensions.

High house prices, significant benefits for car usage and planning co-ordination challenges have resulted in urban sprawl and high car dependence. Luxembourg has one of the highest rates of urban sprawl in the OECD. Tax benefits for travel distances and company cars should be removed and gradually replaced with road-use tolls and parking restrictions to encourage more people to use the free, expanded public transport services. Housing supply incentives for municipalities and households should be aligned to encourage building in accordance with the Master Programme for Spatial Planning. Increasing the benefits for households that undertake densification and energy efficiency renovations simultaneously could encourage deeper renovations and improve the alignment between housing and climate objectives.

Biodiversity and the quality of water and soil are under significant threat. The number of endangered species is amongst the highest in the European Union. Intensive cattle farming and fertilizer use are harming biodiversity with very limited attention to environmental impacts in the design of agricultural policy. Regulation of the agricultural sector’s use of fertilisers and pesticides must be urgently strengthened. Existing subsidies to the sector must be re-shaped to support green farming.