OECD Economic Surveys: Luxembourg 2022

Executive summary

Russia’s war of aggression against Ukraine is weighing on the recovery

The economic recovery from COVID has slowed due to war-related uncertainty and inflationary pressures. Public support can help vulnerable households cope with the higher cost of living but should be well targeted and time-bound, and maintain incentives for energy savings.

Economic growth recovered strongly in 2021 (Figure 1). Owing to decisive economic support, the economy escaped the worst impacts of the COVID pandemic, with GDP already reaching pre-pandemic levels by the third quarter of 2020. Post-COVID support measures helped ensure most sectors recovered strongly in 2021.

Figure 1. The economy rebounded quickly

Real GDP, Index 2019Q1=100

Source: OECD Economic Outlook (database).

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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.

Table 1. Growth is weakening

% change unless noted	2021	2022	2023
Gross domestic product	5.1	1.7	1.5
Private consumption	9.4	2.8	2.0
Unemployment rate	5.7	4.8	5.0
Consumer price index (HICP)	3.5	8.2	4.0
Fiscal balance (% of GDP)	0.8	-0.2	-2.2
Gross public debt (% of GDP)	24.6	27.0	30.5

Source: OECD Economic Outlook 111 and updates (database); debt: Maastricht.

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.

Enhancing resilience to risks

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.

Figure 2. House price inflation has been very high

Index 2017=100

Source: OECD House Prices (database).

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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.

Raising labour supply and productivity to sustain long-term growth

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.

Figure 3. Pension spending is set to rise rapidly

Difference between 2070 and 2019

Source: European Commission, The 2021 Ageing Report.

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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.

Securing a sustainable green transition for the long term requires a comprehensive policy toolkit

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.

Figure 4. Fuel prices have been below those in neighbouring countries

Fuel prices, USD/unit, 2021 average

Note: Average of diesel and petrol prices.

Source: IEA energy prices (database).

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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.

Main findings and key recommendations

MAIN FINDINGS	KEY RECOMMENDATIONS
Enhancing resilience to risks
Inflation pressures have been broadening. Measures to mitigate the impact from rising energy prices and high inflation have been adopted. In addition, wages and benefits are indexed to inflation. Automatic wage indexation can increase inflationary pressure and benefits the wealthiest the most.	Make income support to households more targeted to the most vulnerable and limited in time, whilst avoiding accelerating domestic demand pressures. Reform the wage indexation system in consultation with social partners to take better account of the productivity, employment, and investment effects.
Macroprudential policy has tightened borrower requirements to reduce tail risks. Rising house prices, high debt-service ratios and variable mortgages could raise some borrowers’ vulnerability to higher interest rates.	Expand and publish regular monitoring of all loan types by household characteristics to understand emerging pockets of vulnerability, and be prepared to implement additional macroprudential policies if necessary.
The current fiscal position is strong. However, shocks can affect the composition of spending. Current spending decisions are only weakly linked to evaluation mechanisms. Pensions spending is projected to rise to 18% of GDP in 2070 from 9% in 2022. The effective retirement age is low, and not linked to life expectancy. Participation rates of older workers are very low, depriving the economy of an important source of skills and expertise.	Put in place a more performance-oriented budgeting framework, incorporating spending reviews, to make spending more effective. Link increases in the statutory retirement age to increases in life expectancy. Phase out incentives for early retirement, while providing for more flexible working arrangements for older workers.
Improving labour market outcomes and productivity for sustained growth
Workers will need higher skills over the medium and long term. There is a higher concentration of low skills among the older workers. School dropout rates are high, and young people face high unemployment rates, excluding them from the workforce and depriving the economy of valuable skills.	Subsidise active on-the-job training schemes targeted to the over-45-year-olds. Expand access to training to help early-school leavers enter the workforce, alongside school system reforms.
Productivity levels are high, but growth has been low and overall investment has declined. Public investment support schemes have overlapping structures. The current incentive scheme design has not had an appreciable impact on business investment, which including R&D, is very low as a share of GDP.	Increase public spending on R&D to match private R&D funding and encourage greater investment by firms. Increase funding to targeted projects by reducing the funds spent on administration.
The business regulatory environment is restrictive, notably for new firms, and for small traders.	Reduce administrative burdens on small firms, notably by streamlining procedures for starting a business.
Improving resilience through the transition to green growth
The households and firms negatively impacted by the transition will change over time, which needs to be carefully monitored, alongside the revenues and spending implications for the government.	Introduce scenario and sensitivity analysis to estimate the long-term cost of the green transition, including the impact on different households and firms.
A carbon tax was introduced in 2021 and will rise to EUR 30 in 2023. Low carbon prices stimulate cross border sales of fuel and weaken energy efficiency incentives. The speed and scope of changes required to meet targets, particularly households, could increase resistance to change.	Set a rising carbon tax trajectory over the medium and long term, while redistributing revenues to minimise the burden on the most vulnerable.
Public transport use is a low proportion of total trips and car usage costs are very low, due to tax incentives for travel and company car fleets. Urban development and transport infrastructure, alongside housing prices, have reinforced one another to lock in high car usage and urban sprawl in Luxembourg and the greater region.	Introduce and gradually increase road use charges in conjunction with tighter parking policies. Use tax credits and municipal funding incentives to encourage higher urban density, with green homes built in accordance with the Master Programme for Spatial Planning.
Current regulations have failed to keep up with the negative environmental impacts of increased livestock farming and intensive fertiliser use.	Strengthen regulations on fertiliser and pesticide use. Make national agricultural subsidies contingent on the adoption of sustainable farming practices that protect the environment.