Following Finland’s application in May 2022 to join NATO, Russia terminated gas and electricity exports to Finland. While most gas was imported from Russia, gas only represents 5% of total energy consumption and plans are advanced for sourcing most of it elsewhere, in LNG form. Nevertheless, replacing gas in industrial uses is proving more difficult. The new nuclear power plant will supply 14% of Finland’s electricity when it reaches normal production this winter, more than compensating for lost Russian electricity imports.

Russia’s war of aggression against Ukraine accentuated increases in energy prices that began in late 2021, pushing up inflation to 8.2% by the third quarter both directly and indirectly as higher energy and food prices fed into core inflation (Figure 1). Wage increases have lagged far behind inflation, reducing household real disposable income and portending future weakness in private consumption expenditure.

Finland enjoyed a strong labour market recovery from the COVID-19 shock until the second quarter of 2022. The employment and unemployment rates regained pre-pandemic levels by mid-2021 and early 2022, respectively, and have now posted their best performances since 1987 and 2008, respectively. Labour market tightness has increased markedly and the job vacancy rate is now higher for any given unemployment rate than in the past. Given the fast recovery and rapid increase in employment, part of the mismatch may be temporary, reflecting rigidities in filling jobs. Nevertheless, shortages in non-cyclical professions, such as healthcare and long-term care, are the most pronounced and are likely to persist. Reducing such mismatches requires training of workers and/or relaxation of skill requirements in jobs as well as stronger incentives for workers, unions and firms to compromise to improve match acceptance rates.

To rein in inflation, the European Central Bank has begun tightening monetary policy and is expected to continue doing so through 2023. Fiscal policy in Finland became expansionary in 2022 largely owing to expenditures related to Russia’s war in Ukraine and will be again in 2023 but will be neutral in 2024.

The economy will stall in 2023 but growth will recover to 1.1% in 2024. Consumption will weaken in response to falling real wages but subsequently recover as wages rise. Export growth will decline with export markets, which are being hit by the reduction in gas supplies from Russia, but will pick up as alternative energy sources are found. Business investment will remain weak through 2023 owing to the economic downturn and more uncertain economic outlook caused by Russia’s war in Ukraine but strengthen in 2024 as the global outlook improves. The unemployment rate should peak at around 8% and only fall slightly by end-2024. Inflation will fall to 3.1% in 2024, when the energy shock will have passed.

The downturn would be deeper if Russia were soon to cut off gas supplies to more EU countries, thereby preventing the rebuilding of gas stocks during summer 2023. Another downside risk is that tightening global financial conditions could affect the housing market and consumption and investment more than foreseen.

Finnish financial institutions’ greatest vulnerability is too high household debt. The authorities have taken steps to limit the risk it poses to financial institutions but more needs to be done. Exposures to Russia are minor.

Household debt is 150% of disposable income, mostly for housing loans. Households are vulnerable to rising housing loan interest rates as they are typically revised annually.

To curb rising household indebtedness, the Board of the Finnish Financial Supervisory Authority (FIN-FSA) has returned loan-to-value restrictions to the pre-pandemic level and issued a recommendation on a debt servicing-to-income limit for mortgage lending. The Government has put forward a proposal to limit the maximum maturity of housing loans and housing company loans to 30 years, reduce the maximum amount housing companies can borrow for new construction and require amortisation of such loans to begin during the first five years. However, it has not given the FIN-FSA power to impose debt-servicing-to-income restrictions, out of concern about the effects on first-home buyers.

On current policies, the structural budget balance would need to rise by 2.5% of GDP for the debt-to-GDP ratio to stabilise. Age-related expenditures are projected to rise by 4.5% of GDP by 2070, driven by health and long-term care. Pension- and labour market reforms limit the projected increase in pension expenditures.

The government is committed to reducing the structural budget deficit mainly by increasing employment. The Ministry of Finance estimates that the employment measures taken to date or at an advanced stage could increase employment by 40 000 and reduce the structural deficit by 0.2% of GDP, far short of what is needed to stabilise the debt-to-GDP ratio. Closing the unemployment tunnel route to early retirement makes a large contribution to these gains but there is a risk of leakages into the disability benefit route.

On unchanged policies, the OECD projects that gross general government debt as a share of GDP will increase from 72% in 2021 to 131% in 2070. Reform fostering work-based immigration and improvements in the innovation system could limit the increase, with debt rising less, to 114% of GDP.

The health- and social-care reform, which transfers responsibilities for the delivery of health and social services from municipalities to counties, is expected to yield improvements in efficiency and slow growth in health and long-term care costs in the long run. However, there is a risk that the steering and financing model does not lead to more efficient outcomes as the new organisations have weak incentives to implement measures that would lead to efficiency gains.

Regular, comprehensive expenditure reviews, as in the Netherlands, could help to identify consolidation measures. In this context, there may well be scope to reduce aid and tax expenditures to companies that do not boost long-term productivity and to replace reduced VAT rates by more targeted measures.

Productivity slowed down considerably during the 2010s, due to weaker innovation, less efficient resource allocation and less capital deepening. Additional reforms are needed to reboot the innovation ecosystems and strengthen productivity growth.

The government aims to boost Finland’s gross domestic R&D spending to 4% of GDP by 2030 (Figure 2) and will introduce legislation that authorises an increase in government R&D spending to 1.2% of GDP by 2030. The revamped innovation support should continue to provide ample support to basic research while directing applied research toward solving the most pressing socio-economic challenges through a mission-oriented innovation policy framework. At present, innovation support lacks clear orientation and is spread across numerous measures. Coordination of innovation activities between public and private sectors as well as among various innovation actors has weakened, holding back more effective innovation collaborations between firms, higher education institutions and research institutions.

The government will introduce a new R&D tax allowance to stimulate stronger business-based R&D spending. Finland’s previous R&D tax incentives have not been taken up by many firms due to the narrow scope of eligible activities. They were also not well targeted to smaller firms that respond most to tax incentives.

Despite a favourable business environment, more can be done to enhance investment and improve resource allocation. For instance, stringent employment protection and wide coverage of collective wage agreements with limited opt-outs discourage innovative firms from scaling up by hiring more people and investing.

Severe skills shortages are a major bottleneck to more intensive investment and innovation activities. The government has implemented a university admission reform to improve the allocation of university places and accelerate the transition to tertiary education but has neither increased flexibility by field of study to address acute skills shortages nor committed to funding the increase in places needed to achieve its tertiary education attainment target.

Finland is broadly on track to meet its gross greenhouse gas abatement targets for 2030 and 2035 but not the forestry and other land-use targets. There is scope to increase the efficiency of abatement measures.

The marginal abatement cost of the national biofuel mandate, which contributes to meeting the EU effort-sharing target, is estimated to be EUR 500 per tonne of CO₂-eq. and the annual cost of the mandate to the national economy to be EUR 1.1 billion, rising to EUR 1.5 billion by 2030. The carbon price used to calculate carbon tax rates on heating fuels is lower than for transport fuels and peat is subject to a lower tax rate for heat production than other fossil fuels. Abatement costs could be reduced by eliminating these tax differences. Measures to reduce car dependency in cities, such as improving public transport in the capital region, and to support the diffusion of low-carbon vehicles in other localities would also contribute to cost-efficient abatement

Net emissions from the forestry and other land-use sector need to fall from 2 Mt CO₂-eq. currently to minus 17 Mt CO₂-eq. in 2030 and minus 21 Mt CO₂-eq. in 2035 to meet Finland’s share of the EU target for this sector and the net zero target stipulated in the Climate Change Act, respectively. There is considerable scope to increase this sector’s net sink role by reducing emissions from peatland cultivation (8Mt CO₂-eq.). This could be done by creating instruments to guide the cultivation of peatlands towards paludiculture (i.e., cultivation of wetted peatlands), as in Sweden, or allowing these lands to revert to a wooded state. Subjecting forestry to carbon pricing, as in New Zealand where the sector is included in the New Zealand Emissions Trading Scheme, would also help to increase the forestry and other land-use net sink.