Iceland fully recovered from the 2008 financial crisis. The country is rapidly catching up with the richest OECD economies but is now slowing.
The economy is strong. Favourable external conditions and good macroeconomic policies helped create high growth, low unemployment, low inflation, sustainable public finances and a positive external balance over the past years. Living standards are among the highest in the OECD.
GDP per capita, difference to OECD upper half
Source: OECD National Accounts database
Slower growth is projected. Growth is now turning around sharply. Tourism, the most important export sector, is declining because of supply constraints following the insolvency of one of Iceland’s airlines. Marine exports also contracted. Consumption growth has eased despite considerable wage increases. The economy is expected to grow by 0.2% only in 2019 and to rebound to 2.2% in 2020, and unemployment will rise.
Inequality is low. Iceland is also one of the most egalitarian economies in the OECD thanks to high employment, little wage inequality, and low pay and employment gaps, suggesting that high economic performance and an egalitarian society can co-exist. A well- targeted tax-benefit system supports equality further.
Growth is green. Thanks to extensive use of renewable energy, Iceland’s environmental impact remains low overall, although greenhouse gas emissions remain elevated. The government plans to make the economy largely carbon-neutral by 2040.
There are risks and vulnerabilities. A marked downturn in global growth could severely affect revenues from tourism. A hard Brexit could dent exports to the United Kingdom. A bad fishing season would reduce exports further.
Monetary policy has eased and fiscal policy remains expansionary. Capital controls have been largely withdrawn.
Monetary policy has eased. After several years of undershooting the target, inflation has started to rise again, pushed by the depreciation of the króna in late 2018 coupled with strong domestic wage growth. The central bank increased the interest rate to 4.5% in November 2018 but lowered it to 4% in May, to 3.75% in June and to 3.5% in August 2019 as inflation expectations declined. Rates remain at a historical low, though significantly higher than in most OECD countries.
Capital controls are largely dismantled. Further capital controls have been lifted and are now virtually non-existent. Capital flow management is now in line with international agreements. Financial market developments have been inconspicuous. House price inflation has slowed, following the recent construction wave, easing immigration and a decline in Airbnb demand. The planned merger of the Central Bank with the Financial Supervisory Authority would strengthen financial sector oversight.
Fiscal policy is expansionary. Fiscal policy has been prudent in recent years, helping to achieve a budget surplus and lower debt. The fiscal plan for 2020 is expansionary, reflecting an increase in infrastructure and social spending and tax cuts.
Competitiveness is on a long-term decline as wages are rising faster than productivity. Competitiveness gains, achieved after the 2008 crisis thanks to the devaluation of the króna and cuts to real wages, are exhausted by now. A focus on both productivity and wages is needed.
Productivity and compensation rate, total economy
Source: Economic Outlook database
A more open economy would help raise productivity. Better integration into the world economy could help raise productivity. Openness remains below its potential. The productivity gap between the export and domestic sectors is wide. Further growth of exports on the back of efficiency gains in the domestic sector could raise overall productivity and help share them more widely. Stronger integration into the world economy would also raise competition and encourage businesses in the domestic economy to become more innovative.
Share of goods and services exports plus imports in GDP, 2018
Source: OECD Analytical database.
Regulatory barriers are high. Regulation should be more commensurate with the needs of a small open economy. Product market regulation is stringent and the administrative burden for start-ups is high, holding back investment and innovation. Restrictions to foreign direct investment are among the highest of the OECD, dampening employment and productivity gains through international knowledge transfer. The government should set up a comprehensive action plan for regulatory reform, prioritising reforms that foster competition, level the playing field between domestic and foreign firms and attract international investment. In early 2019 the government tasked the OECD to carry out competition reviews in two sectors.
Wages should better reflect productivity developments. Improved labour relations could also help maintain competitiveness. The wage structure is compressed; contributing to income equality, yet the wage bargaining process often leads to wage drift and creates inflationary pressures. The April 2019 wage agreements provide a welcome novelty by linking future wage developments to growth of GDP per capita. Further steps should include: link wages more closely to productivity growth; provide reliable and relevant economic information; allow for better wage coordination; and increase power for the state mediator to delay industrial action.
Stronger skills should respond to labour market needs. Boosting skills would help Iceland to raise productivity and prepare for rapid technological change. This would require a comprehensive strategy with a high quality education system that builds strong foundation skills and provides the right skill mix. Moreover, effective lifelong learning strategies and well-designed policies should help to make the most of existing skills, including those of immigrants. Developing rigorous skill assessment and anticipation tools is essential to inform policy decisions.
Barriers to domestic and foreign entry (0 least strict, 6 most strict), 2018
Source: OECD 2018 Product market regulation database.
The contribution of public spending to inclusive growth has declined. The tax system relies too much on income taxation.
Spending effectiveness could be better. The quality of public spending has declined since the 2008 crisis. In particular, public investment is too weak, weighing on productivity, while the disability benefit system is generous, weighing on employment. Effectiveness of government spending also weakened, especially in education, with declining PISA results despite high and rising spending. Providing a better nexus between spending and performance targets in various policy areas could help increase public sector effectiveness.
The tax system. Although below the level of other Nordic countries, taxation is skewed towards income taxation. In 2019 the government reduced income tax rates for low-income earners, and a reform is planned to reduce the tax burden further. The VAT system could be improved, mainly by reducing the gap between the two VAT rates.
The planned sovereign wealth fund should be built up gradually. The planned sovereign wealth fund, to be sourced by dividends of the national power company, could help diversify risks, mitigate revenue volatility, and prevent Dutch disease. It can also help avoid fiscal slippage. The pace of asset build up should be gradual and in line with prudent fiscal policy objectives and priorities. An alternative to the fund can be winding down debt more rapidly, investing more in infrastructure or education, or reduce taxes, to boost potential growth.
Contribution of public spending to growth and inclusiveness
Source: Preliminary OECD Public Finance database.