Iceland had to deeply reshape the public finances after the 2008 crisis, through both spending cuts and tax increases. The need to act swiftly and boldly left little room for appropriate design in the various spending areas. As a result, the quality of public spending – i.e. the contribution of spending to growth and less inequality - has declined. In particular, public investment remains weak, weighing on productivity, while the disability benefit system is generous, weighing on employment. Effectiveness of government spending is low, especially in education, with PISA results declining despite rising spending. This chapter identifies main challenges in spending for education, health, infrastructure, social security and other areas. Overall the authorities should strengthen the link between spending and objectives in the various policy areas, i.e. by broadening spending reviews. In particular, investment for transport, energy and digital infrastructure should be increased; in education, teacher salaries should be more differentiated and partially linked to performance; in health care, general care should be favoured against specialised care and co-payments for hospital care introduced; the disability system should more strongly aim at labour market integration of claimants; and high implicit tax rates in the tax-benefit system should be reduced, e.g. by abandoning means-testing of child benefits.
OECD Economic Surveys: Iceland 2019
Chapter 2. Improving public spending to maintain inclusive growth
Abstract
Iceland had to reshape public finances dramatically after the 2008 crisis. During the consolidation period, which started as early as 2009, the government reduced spending in main policy areas such as health care and education on a wide scale, mainly by cutting wages and reducing public employment. Social spending, which had jumped after the crisis, was partly spared and declined only gradually thereafter. The area most affected by cuts was public investment, which was below the OECD average even before the crisis, with capacity limits becoming ever more constraining. Consolidation was successful as the country soon emerged from the ruins of its financial sector crisis to a new boom. While public spending rose across the OECD after the crisis, including in the Nordic countries, Iceland’s spending to GDP ratio today is precisely where it was before the crisis hit.
The need to react swiftly and boldly to the crisis left little time to design appropriate public sector reforms. The quality of public spending – i.e. its contribution to inclusive growth – deteriorated during both fiscal expansion and consolidation and is now clearly below pre-crisis levels. Indicators of government effectiveness also declined and remain below the OECD average. Despite high and rising education spending, educational outcomes are relatively weak. Problems also loom in other sectors where outcomes are often not commensurate with what is being spent.
Against this background, the current pick-up of the economy is an opportunity to look at the drivers of public sector efficiency. This chapter identifies the main challenges related to the public finances and their contribution to inclusive and sustainable growth, calling for comprehensive structural reform. The chapter evaluates public spending reform from both an overall budget perspective as well as for individual policy areas such as education, health care, infrastructure or social security. Rather than determining whether “more” or “less” overall spending is needed, the chapter recommends policies that make current spending levels as growth-friendly as possible while sustaining Iceland’s inclusive economy.
The quality of public spending has deteriorated
The quality of public spending – i.e. its contribution to growth and a more equal income distribution - has been continuously declining even before the 2008 crisis with some improvements lately (Figure 2.1). Currently spending quality is around OECD average. Below-average pension spending following a high retirement age is conducive to employment and growth, while a large disability benefit system and low public investment put a drag on growth (Bloch & Fournier, 2018). Government effectiveness has declined and is now at around the OECD average, thereby exacerbating low spending quality (WorldBank, 2019).
Figure 2.1. The quality of public spending has declined
Note: The three spending quality indicators measure the contribution of the public spending mix to growth (“growth”); to growth and equality (“inclusive growth”); and to growth taken government size and effectiveness into account (“effectiveness”). Indicators are derived from a set of regressions linking public spending and other determinants to long-term growth of around 30 OECD economies. All indicators measure spending quality relative to the OECD average.
Source: Preliminary OECD Public Finance database; (Bloch & Fournier, 2018)
Making the composition of public spending more growth-friendly while maintaining its redistributive traits can be achieved mainly by reforms in two spending items: 1) public investment and 2) sickness and disability benefits. According to OECD calculations, increasing the share of capital spending by 0.5 percentage points, bringing it up to 2.0% of GDP, while lowering the share of sickness and disability benefits by 0.5% points of GDP, to bring it halfway back to the share reached in the year 2000, could altogether raise GDP per capita by around 3.5% in ten years and 7% in the long run. Moreover simulations suggest that such reform would benefit all households, therefore involving few efficiency-inequality trade-offs (Cournède, Fournier, & Hoeller, 2018). However and as will be shown, the impact of the compositional change hinges on reform design.
Performance budgeting should be strengthened
In 2016 Iceland adopted a new budget law improving governance of the public finances. Budgeting now largely follows the principles set out for European Union countries, pioneered by Sweden, in particular by introducing numerical fiscal rules, setting up an independent fiscal council, establishing multi-annual budgeting and strengthening the top-down approach to budgeting (Downes, Moretti, & Shaw, 2017). The thrust of Iceland’s budget reforms were:
Setting up a five-year fiscal policy plan describing the priorities during the legislature each time a new government is elected.
Structuring the budget process into two distinct phases, with a rolling fiscal strategy plan in the spring setting down broad aggregates for fiscal policy for the next five years, and a government budget bill in the autumn specifying spending items for the coming budget year.
Establishing a budget balance rule - requiring the annual deficit to remain below 2.5% of GDP and the budget to be balanced over a five-year period - and a debt rule requiring gross debt (national definition) to remain below 30%. Debt exceeding the 30% threshold must be reduced annually by 1/20 (correction rule) over three years.
Providing more strategic oversight to the minister of finance and the government cabinet in the budgeting process, while increasing flexibility of line ministries in fund allocation.
Strengthening the link between spending and outcomes (performance orientation).
Establishing an independent fiscal council, which surveys whether fiscal policy is in line with the organic budget law.
The new framework has proven successful in maintaining budget discipline, although this was facilitated by the favourable economic situation. The “whole of year” approach streamlined budget deliberations. The authorities consider that the new budget law improved ownership of and responsibility for the budget. The finance ministry is exerting more control over the budget submitted to the cabinet, while the line ministries are more flexible in disbursing allocated funds. Iceland is now one of the few countries using accrual accounting. Given the short period the framework is in place, the multi-year budgeting framework has yet to mature, and it remains to be seen whether the new budget institutions and frameworks will have a significant impact on spending quality (Pina, 2016).
The fiscal council, established concomitantly with the new budget law, has a limited role (Figure 2.2). It has few resources and lacks operational independence. In some instances it seems to be ignored such as in 2018 when the fiscal strategy plan was passed even before the deadline set for the fiscal council to comment on the plan. The fiscal council has so far focussed on the budget process, namely by recommending better budget transparency, a stronger link between budgeting and outcomes, and by clarifying individual budget items. Given the small size of the country and potential overlap of their areas of work, the government might consider a stronger collaboration between the national audit office and the fiscal council, or even merging the two agencies under a joint roof. This is what Lithuania did in 2015 when creating its own fiscal council, building on the high reputation of the national audit office (OECD, 2018).
Figure 2.2. The fiscal council is relatively weak
Independence of fiscal councils in the OECD, 2017
Source: von Trapp and Nicoll (2017)
Spending reviews could further help improve the efficiency and impact of public spending. Spending reviews provide a link between financial accounting and performance budgeting, obliging ministries and agencies to set priorities, as required by the new organic budget law. The government started spending reviews on small budget items in the ministry of justice and the ministry of industry and innovation. Against this background, spending reviews should be extended to areas such as education, health care or social welfare, which make up a large part of public spending. Also, peer-review exercises with other countries such as the United Kingdom, the Netherlands or the Nordic countries, could speed up knowledge transfer and implementation of best practices (Box 2.1). As pointed out in earlier Surveys and suggested by the national audit office, the government should carry out spending reviews as follows (OECD, 2013):
A permanent expert unit in the MOF should undertake spending reviews.
The MOF should decide on the areas to investigate without the need for line ministry approval, with line ministries providing inputs as required.
The MOF should run a multi-year cycle of spending reviews so that all major spending programmes have been reviewed by the year before elections.
Decisions on strategic-spending review recommendations – programme expansions or cuts - need to be made at the cabinet level as they are highly political.
Box 2.1. Spending review: budgeting for performance
Spending reviews are a budgeting tool used in all but six OECD countries, serving to identify areas for potential savings and to improve alignment of public expenditure with strategic and political priorities. A key characteristic of most spending reviews, which differentiates them from other budgeting tools, is that they systematically analyse baseline expenditures to assess scope for savings. This contrasts with the normal focus in the budget on competing demands for incremental increases in spending, as pointed out in a Survey carried out by the OECD Senior Budget Officials (SBO) in 2018. Against this background, spending reviews are politically sensitive.
Spending reviews are resource-intensive and so are not typically applied to all expenditures annually. Denmark, the Netherlands and Germany conduct limited spending reviews of selected spending programmes each year, to improve spending and administrative efficiency and reprioritise spending within a limited area. In contrast the UK applies comprehensive spending reviews, carried out every few years, to identify savings across the whole of government and align the budget to policy priorities. More recently Ireland went from periodic “comprehensive reviews of expenditure” towards a rolling series of reviews that can feed into the budgetary process each year.
The main challenges in implementing spending reviews are the lack of performance data or their poor quality. Information on performance are crucial in enabling budget analysts to make informed decisions about the effectiveness of different types of expenditure. The 2018 SBO Survey also points at the need to strengthen follow up on implementation of spending review recommendations. Notable innovations include Canada’s Policy on Results, which looks at spending across all of government and applies a results-driven, rather than a fiscally-driven, approach to spending assessment. In 2017 the UK introduced the concept of a “Public Value Framework”, which focuses not only on the potential for value creation, but also whether the conditions to realise that value are met.
Note: The network of Senior Budget Officials shares experience and best practice in the area of budget performance and results.
Source: (OECD, 2019)
Comprehensive cost-benefit analysis for large infrastructure projects could help prioritise projects, keep cost under control and avoid supplementary budgets. Strengthening institutional and individual responsibility – a ministry or senior official held responsible for project costs and outcomes – could also improve project implementation and help avoid cost overruns. An additional measure would be to require qualified majority in parliament for supplementary bills.
Decentralisation should be modernised
Despite its small size, Iceland is quite decentralised. Municipalities account for more than a third of total government spending, with responsibilities ranging from education and social welfare to infrastructure and transport. Following the crisis-related deterioration of municipal finances, the government in 2011 tightened the intergovernmental fiscal framework by imposing a budget balance rule – municipal operating budgets must be balanced over three years – and a debt rule, with debt required to be kept below 150% of own revenue. After a painful consolidation episode for some municipalities, most now remain within the limits of the local fiscal rules.
The effectiveness of the decentralised set-up could be improved by addressing two issues:
Minimum size in rural areas. 25 out of a total of 72 municipalities – down from 225 three decades ago - have less than 500 inhabitants. This implies high per-capita service cost and may prevent sufficient scale for investment projects. For instance, small schools are more expensive to run, although some small municipalities mitigate size effects through service agreements with larger municipalities (OECD, 2019). The government is currently contemplating further mergers. While geographical service concentration may help raise service quality or decrease cost, it might reduce access for citizens in remote areas. Financial incentives for voluntary mergers may offer an alternative to reach spending effectiveness. Finally, size-independent equalisation grants, which undermine municipal reform, should be abolished.
A fragmented metropolitan area. The capital area of Reykjavik extends over seven municipalities, and according to many observers policymaking is fragmented. The regional body covering the area has little regulatory and no financial power. Fragmentation and coordination failure could imply underinvestment at the metropolitan scale. Indeed metropolitan areas tend to exhibit faster growth and higher productivity if policy is coordinated, in particular for transport infrastructure and land use (Ahrend, Farchy, Kaplanis, & Lembcke, 2014). The government should hence consider different variants for better policy coordination at the metropolitan level, for instance by assigning the capital region a stronger role or by creating special bodies in individual policy areas.
While the current spending assignment between central and local government seems adequate, some long-term scenario analysis points at growing structural imbalances for the municipal sector. For example spending on services for the disabled are projected to grow at more than 10% annually, above average public spending growth (Analytica, 2018). Such growth rates require a deeper look into the mechanism of disability spending and might require a redesign of the intergovernmental fiscal framework if they persist.
Education spending needs better impact
Icelanders are well educated but there are signs that the education system could deliver more for what is spent. While the share of spending on primary and secondary education in GDP is among the highest in the OECD and rising further, PISA test results have been gradually declining over the past 15 years. And while spending on tertiary education is rising even more rapidly, the quality of tertiary education has not followed suit (see chapter 1). Policy research suggests that the quality of education and the efficient use of the resources dedicated to education is key in ensuring high education outcomes (Hanushek & Wössmann, 2010). This section deals with structural spending reforms in education.
From childhood to PISA
PISA, the international test for 15-years old students, suggests that the quality of compulsory education in Iceland has deteriorated over the past 15 years (see chapter 1). While outcomes were around the OECD average in the first decade of the millennium, the country now is below the OECD average and clearly below the other Nordic countries (Figure 2.3). Boys fare worse than girls in languages, and immigrant children fare worse than those born in Iceland (see chapter 1). Yet the system is very egalitarian as disparities across schools and between high- and low achievers are small, and parent’s economic background plays a smaller role for student outcomes than in other OECD countries (Dagsson, Karlsson, & Zoega, 2018).
Figure 2.3. Performance of compulsory education is low despite high spending
Spending per student and overall PISA results, 2015
Source: Education at a glance.
Making up around 90% of total education spending, the payroll for teachers is by far the most important spending item. This is why the best-performing countries in PISA are strongly focusing on teachers, with a wide range of career and compensation structures (OECD, 2018). Iceland’s current teacher compensation structure stands out by three factors (chapter 1):
Teacher’s wages in primary and lower secondary education are relatively low compared to other professions
Wage progression is lower than in most other OECD countries and strictly based on seniority rather than performance
Wages vary little between school levels, disregarding that complexity and challenges are rising from per-primary to primary and secondary school.
The compensation structure partially reflects Iceland’s low wage distribution (Key Policy Insights and chapter 1). Against this background, the compensation system should attract high quality teachers and reward them better for their contribution to educate the young. If needed, additional spending on teachers should be financed by reducing spending on non-teaching staff which is much above OECD average.
Iceland’s education system is highly decentralised. In 1996 the government moved responsibility for funding primary and lower secondary education from the central to the local level and to the schools, with a concomitant shift of the income tax. An equalisation fund helps poorer and high-cost municipalities. Some observers argue that decentralisation set the stage for the decline of education quality, as municipalities were neither willing nor able to maintain education standards, sometimes citing the Swedish case (OECD, 2019). However recent research suggests that decentralised school systems perform better overall (Box 2.1). Against this background and to get the most out of Iceland’s decentralised school system, school funding should be linked to performance indicators such as test results at school or municipal level. Also, performance monitoring by central government should be strengthened.
Box 2.2. Decentralised education performs better
In the 1990s and early 2000s many countries devolved primary and lower secondary education to state and local governments in an attempt to bring it closer to the citizens and to raise effectiveness of the education system (Figure 2.4). While the curriculum usually remained under the responsibility of higher government, the power to fund and manage schools and teachers was assigned to lower government levels. Governments also handed over more autonomy to schools in terms of internal organisation, finances and teaching material and methods.
Figure 2.4. Education has become more devolved
Share of state and local education spending in overall education spending, 1995 and 2017.
Source: OECD National Accounts, government expenditure by function. Data are non-consolidated across government levels, explaining that some shares exceed 100%.
In an attempt to assess the role of the institutional set-up for education performance, the OECD carried out a multivariate econometric analysis. In a panel estimation, different measures of fiscal and administrative decentralisation as well as of school autonomy were linked to the international PISA test outcomes. While educational outcomes naturally depend on country-specific policy design, overall results suggest that handing over more power to bodies more directly involved with educating the young has overall positive effects for education outcomes.
In particular:
The relationship between decentralisation and PISA scores is consistently positive, regardless of whether one looks at the sub-central revenue share, tax share, spending share, tax autonomy or decision-making power. For instance, a 10 percent point increase in the subnational revenue share is associated with a 6 point increase in PISA scores.
The relationship between school autonomy and PISA scores is also positive. When including school autonomy in the same estimations, the effects of administrative and fiscal decentralisation become stronger.
These results are stronger and more consistent for unitary countries than for federal countries, probably as a result of more comprehensive reform.
Administrative decentralisation slightly increases the gap between high- and low-achievers, while fiscal decentralisation has no distributional effects
Results for individual countries largely confirm the cross-country findings. Still the estimations, especially those for fiscal decentralisation, are not significant for up to half the countries, including Iceland.
More decentralisation of taxation and decision-making is associated with higher education spending. However, the size of the effect is small.
The empirical analysis covers the period since the year 2000 so captures the long-term rather than the immediate effects of the decentralisation reforms implemented in the mid- and late 1990s.
Tertiary education
Spending on tertiary education has grown rapidly, as has enrolment, reflecting the education offensive after the crisis. Tertiary education is almost entirely funded by public sources, while tuition fees provide very little additional resources, similar to most Nordic countries (Figure 2.5). The corporate sector also contributes little to research and development, making Iceland’s tertiary education one of the most government-dependent of all OECD countries.
Figure 2.5. Private funding of tertiary education is almost inexistent
Share of public, individual and corporate funding
Source: OECD EAG 2018, figure C3.2.
A few peculiarities distinguish Iceland’s tertiary education system. With seven universities for a country of 350 000 inhabitants, the system has a hard time reaching sufficient scale, while generating overlap and duplication across study fields. Given Iceland’s size and geography, the country would probably be well-served with fewer universities, with smaller ones becoming potential subsidiaries of the University of Iceland. Competition between universities plays on attracting a high number of students rather than on quality of the curriculum. Moreover, supply of study fields grew mainly in the social sciences, humanities and law, while the STEM curricula grew relatively little, likely contributing to study field mismatch observed in chapter 1.
The funding of universities could better support educational quality and performance. The current funding formula allocates around 2/3 of university revenues on a per student basis, while the remaining 1/3 is based on historical spending (chapter 1, box 1.1), prompting a bias towards inexpensive courses and popular studies. Moreover, universities tend to focus on study areas with relatively low investment cost, namely social sciences and humanities, while the technical study fields with lower student numbers and higher fixed cost risk producing deficits for the university. Against this background, funding should be more tightly linked to performance, labour market and future skill needs, as in Denmark following the reform of higher education (OECD, 2019). Taking labour market needs better into consideration could also help reduce high drop-out rates. Finally, linking funding to accreditation of study fields could also help improve educational quality.
Study or tuition fees could provide additional resources and help improve quality of universities. In all OECD countries for which data are available, the wage premium derived from tertiary education is considerable, justifying the introduction of moderate tuition fees (OECD, 2017). In addition, fees may enhance the quality of education by encouraging timely completion of studies, raising student expectations for value for money and increasing the responsiveness of universities to labour market demands (chapter 1). In Iceland, as in other countries, tuition fees face opposition, for fear of socio-economic segregation and barriers to higher education. Indeed, students from poorer backgrounds tend to invest less in risky assets such as tertiary education, resulting in higher wage inequality across generations (Cox, Kreisman, & Dynarski, 2018). To avoid that credit constraints harm equal opportunity, higher tuition fees should be combined with a generous system of grants or income-contingent loans to at-risk students, as in Australia, the Netherlands, New Zealand and the United Kingdom (OECD, 2017).
Finally, rather than investing in universities at home, the government could invest in Icelandic students abroad. Iceland’s tertiary education is constrained by minimum size requirements, with some potential study areas attracting too few people to offer education at reasonable cost or sufficient quality. As a result, around 13% of Icelandic students are already studying in foreign countries, more than in most other OECD countries (OECD, 2017). While subsidised loans are available to students studying abroad, funding could be strengthened further. Students abroad should get equal financial support to those studying at home. Improving support for studying abroad could also help strengthen international networks of Icelandic students and finally Iceland’s integration in the world economy.
Private funding of universities should be strengthened
More funding from the private sector, including from abroad, could further foster tertiary education and strengthen ties between research institutions and the business sector. With one of the smallest private spending shares, Iceland forgoes a financial source which is important in other countries (Figure 2.5). Some technology-intensive sectors such as energy production or data processing could lend themselves to private sector involvement. Reykjavik University recently set up a technology transfer office. A stronger role of the private sector could help establish revolving doors for researchers between education and R&D-intensive companies and foster entrepreneurship at the universities. Strengthening private funding would require governance reforms, to ensure research institutes’ appropriate participation in the revenues from commercial activities.
A similar private involvement could also help establish a stronger tertiary vocational education and training (VET) system, as described in chapter 1. Public funding of tertiary VET programmes could be partially linked to universities’ capacity to attract private resources for applied research and development, with students moving between research institutes and firms.
Health care could be made more cost-effective
Health care works well but is expensive
The health status of Iceland’s population is very good, helped by a comprehensive and expensive health care system (Figure 2.6). Life expectancy is among the highest in the OECD for both men and women. Access to health care is almost universal irrespective of income or place of residence. Indeed the relationship between socio-economic and health status seems to be weak, suggesting that health care reaches out to the entire population and that health issues are not concentrated in specific income groups (Olafsdottir, 2007). Lifestyle is generally healthy, except with a propensity for overweight, which requires comprehensive strategies beyond health care (Griffith, 2019). Icelanders are generally satisfied with their health system. Health spending is hovering around 8.5% of GDP, yet spending on long-term care is above the OECD average, partly reflecting a high share of people above 80 years, the biggest recipients of health and long-term care (de la Maisonneuve, Moreno-Serra, Murtin, & Oliveira Martins, 2016).
Figure 2.6. Iceland spends a lot on health yet also gets a lot out
Healthy life expectancy against spending per capita
Source: OECD health database, and WHO Global Health Observatory data repository.
Health reforms should help contain unnecessary spending
Iceland’s health-care is integrated, centralised, publicly funded and offers universal coverage to all residents (Box 2.3). With relatively few levers for cost containment in place, the system is largely supply-driven and overconsumption of health care has become an issue. A core challenge is to steer the use of health services away from expensive specialist care towards more cost-efficient and effective primary care (Sigurgeirsdóttir, Waagfjörð, & Maresso, 2014). The government’s health care strategy, published in February 2019, addresses financial sustainability and proposes several cost containment measures, among them a stronger gatekeeping role for general practitioners, yet incentives for spending restraints in specialist care should be strengthened further (OECD, 2017).
Box 2.3. The Icelandic health funding system and the new health care strategy
Health care is funded by the National Health Fund (IHI) which covers all residents. The IHI is funded jointly by the central government budget (around 60%) and the social security fund (around 40%). Responsibility for services for people with mental health conditions or disabilities lies with the municipalities. Unlike all other OECD countries, there is no private health care insurance. While general hospitals and primary care centres are public, the number and scope of private providers, such as specialised clinics, has increased over the past two decades, with services contracted out. The IHI pays part or all costs, with co-payments applying to primary care visits, outpatient care and pharmaceuticals. Vulnerable groups have to pay smaller co-payments or are exempt altogether. Hospital care is free of charge.
Stronger financial oversight, especially on specialist care, has been a major policy issue for at least a decade, but reforms have been small and piecemeal so far. The government’s new health care strategy, presented to parliament in February 2019, is an attempt to set objectives more clearly and to define the resources needed to achieve them. Potential policies include: an enhanced role for general practitioners and the introduction of a risk-adjusted capitation system; better regulation of access to specialist care; activity-based payment for hospitals (diagnosis-related groups) and measures to contain pharmaceutical spending. Finally, spending on public health and prevention will be increased. Evidence from OECD countries suggests that health care reform as planned by the government can curb health spending while maintaining the health status of the population.
Spending on hospital care has risen disproportionately, probably for different reasons (Figure 2.7). While the number of hospital beds is OECD average, some indicators point at overtreatment and unnecessary surgeries (OECD, 2017). Emergency rooms seem to be called upon excessively, suggesting a lack of generalist and primary care capacity. Also, since general practitioners’ gatekeeping role is limited, specialists extended their outreach, setting up private clinics or working in public hospitals on a fee base. Finally, financial oversight in hospitals is relatively backward: while activity-based costing such as diagnosis-related groups (DRG) has become the norm in many OECD countries, DRG in Iceland’s main hospital, the Landspitali, does not yet inform financial decisions. DRG could strengthen the effectiveness of hospital care, while global envelopes have to continue to ensure that activity is not artificially inflated (OECD, 2015). Given Landspitali’s monopolistic position, the authorities should strengthen cooperation and benchmarking with foreign hospitals of similar size and scope (Berenson, Ginsburg, Christianson, & Yee, 2012).
Figure 2.7. Hospital care is costly
Spending on health care components, percentage points difference to OECD average
Source: OECD health database.
Private cost participation could help reduce overconsumption
Private co-payments for publicly-financed health services make up slightly less than 20% of total health care spending, which is close to the OECD average but above European and especially Nordic countries. Co-payments apply to primary care visits, outpatient care and pharmaceuticals, with a number of exemptions limiting their impact for households with children, pensioners and the chronically-ill. The co-payment rate for prescribed drugs, the largest share in private health spending, amounts to around 40% of total pharmaceutical cost, with the rate decreasing with higher drug use.
Designed carefully, co-payments can be an effective policy to reduce overconsumption of health services, without affecting medium- and long-term health outcomes including for vulnerable groups such as children, as in Japan (Iizuka & Shigeoka, 2018). Some reforms to the co-payment system could induce households to become more cost-conscious while maintaining universal access to health care. The most important reform could be to level the financial playing field between outpatient and inpatient care. Introducing co-payments for inpatient care such as for pharmaceutics or nursing, while concomitantly lowering co-payments for outpatient services, could help reduce demand for hospital services and the associated costs.
Public infrastructure should be planned more rigorously
Public infrastructure was the spending item hit hardest when fiscal consolidation started after 2010. Public investment, at around 3% of GDP in the run up to the crisis, fell to 1.5% of GDP in 2018, below the OECD average. Infrastructure shortages have become apparent, especially in transport. Traffic on the ring road has increased by almost 50% since 2011, and investments needed to maintain the capital stock are estimated at 50bn króna or more than 3% of GDP (Icelandic Chamber of Commerce, 2018). The energy transition including the planned ban on new fossil-fuel cars by 2030 will also require investments in energy transmission. Finally, the growing data processing industry will require digital infrastructure, e.g. a new data cable to the United Kingdom or the European continent. The municipalities, which carry out around 40% of all public investment, face a backlog of investment projects. The government rightly plans to increase investment over the period 2019-2022, but the share in GDP will remain below the pre-crisis level.
While investing more would certainly be good, investing better could also help. According to the national construction agency, investment projects often fail to meet the timeframe as well as budget and service objectives (Framkvæmdasýsla ríkisins, 2019). According to the authorities, ongoing or recently finished infrastructure projects such as a road tunnel in Iceland’s North or the construction of the new national hospital (Landspitali) are incurring cost overruns. Cost-benefit analysis is still not commonly applied to infrastructure projects, and projects are often carried out on political rather than economic grounds.
An infrastructure planning framework should ensure that projects deliver on the expected economic gains (OECD, 2017). The core of such a framework is a rigorous quality assessment of all potential projects, with the ranking of projects based on comprehensive cost-benefit analysis. Increasingly, cost-benefit analysis will also have to include the environmental impact of new infrastructure. Moreover, according to the authorities, issues of coordination across jurisdictions are prominent in the capital region, especially in coordinating land use planning and transport. As such and since 40% of investment is carried out by the municipalities, the planning framework should include stronger vertical and horizontal coordination mechanisms (OECD and Committee of the Regions, 2015). Iceland could adapt elements of Norway’s transport infrastructure planning framework, including comprehensive cost-benefit analysis (Box 2.4).
Box 2.4. Norway’s comprehensive transport investment planning
Norway’s system of transport infrastructure planning follows a comprehensive and coordinated evaluation, discussion, selection, approval, implementation and assessment process. The relevant infrastructure agencies propose projects to be included in the national transport plan, after internal discussion and consultations with local and regional authorities. Large projects, exceeding around 75 million Euro, are put through a two-stage “quality assessment”, overseen by the Ministry of Finance and incorporating assessment by independent reviewers. The government then selects a shortlist of priority projects to become part of the national transport plan, which is submitted to parliament. After adoption, projects enter construction, and some are subject to ex post evaluation.
Cost-benefit analysis (CBA) is integral to Norwegian infrastructure planning. Most transport projects undergo a thorough assessment of their positive and negative impacts, both on transport users but also on the wider economy and society. CBA guidelines are embodied in an official document (“Circular R-109”), which is rich about how to measure the benefits of a project. This includes assumptions about future GDP growth, the lifetime of a project and discount rates, the value of work and leisure time, revenues from toll roads, or health and mortality impacts. The guidelines also require an analysis of the environmental impact. A common methodology for assessing the wider economic benefits (and costs) is currently being developed by the transport agencies.
Source: (OECD, 2017)
Public-private partnerships (PPP) could generate more value for money invested in public assets (World Bank, 2018). The potential increase in efficiency compared to traditional forms of procurement arises mainly from the (international) private sector’s expertise in combining the design and operation of such assets. Iceland currently makes little use of PPPs in infrastructure development. Endorsing them more widely could not only improve managerial efficiency but also raise investment rates in areas such as transport where (public) investment is currently lacking (Araújo, 2011). Yet, while PPPs better reflect the benefit stream of infrastructure projects in the public accounts, their explicit and implicit fiscal consequences - e.g. contingent liabilities - should be fully accounted for and well-monitored.
Road pricing could help manage transport demand, especially growing congestion in the capital area, and bring in additional financial resources for improvement (Icelandic Chamber of Commerce, 2018). Medium-sized cities such as Bergen or Trondheim in Norway introduced road pricing schemes as early as the 1980s, thereby improving traffic management and providing funds for new infrastructure (International Transport Forum, 2010). In Reykjavik, road-pricing could in addition support environmental policy, e.g. by charging more for polluting vehicles, or it could help fund public transport such as the planned urban express bus lanes. Given the political headwinds for road-pricing schemes, its benefits should be clearly and instantly visible, for instance in the form of better infrastructure both for public and private transport or higher environmental quality.
Social protection
The system is well-targeted but discourages low- and medium income earners
With around 18% of GDP, Iceland spends less on social protection than the average OECD country, although the share is small partly because the occupational second-pillar pension system is not accounted for in the public accounts. Despite being small, the system is quite redistributive. Most benefits, including first-pillar pay-as-you go pensions, are means-tested, resulting in relatively targeted support for low-income households (Figure 2.8). Strong targeting is partly the result of post-crisis fiscal consolidation which required savings while protecting the most vulnerable.
Figure 2.8. Social benefits are well-targeted
Source: OECD Social Protection and Wellbeing Database.
The flipside of such a targeted system is that it could discourage low-income earners. Marginal tax rates for those households are higher in Iceland than in most OECD countries, which is the combined result of a progressive tax system and the strong means-testing of benefits (Figure 2.9). METRs are particularly high for families where both parents work. Moreover, high marginal tax rates are not confined to low-income earners, but extend into the group of middle-income households (Hermansen, Ruiz, & Causa, 2016). For instance, child benefits are tapered gradually until around 130% of the average wage when they are withdrawn completely. Indeed and unlike for most other countries, progressivity in Iceland is generally declining with growing income. A similar pattern holds when moving from unemployment to work (see chapter 1)
The debate on social benefits versus work incentives has culminated in a proposal for a universal basic income, which is a financial support granted irrespective of market income and hence supposed to be largely incentive-neutral (Francese & Prady, 2018). All other social benefits would be removed. Model simulations for Finland suggest however that a universal basic income would either be too costly or would have to be cut to barely more than subsistence levels (Pareliussen & Hwang, 2018). Against this background, an option could be to abandon means-testing for child benefits – i.e. introducing a universal child benefit -, or else start tapering at considerably higher income levels than today. Such reform would improve work incentives for low- and middle-income families. Moreover it could increase birth rates and family size (Riphahn & Wiynck, 2017).
Figure 2.9. The tax-benefit system puts a high marginal burden on low-income earners
Marginal tax rates, from 10% to 200% of average wage for a married two-earner couple with two children, second earner at 67% of average wage
Note: Marginal effective tax rates (METR) show the share of additional earnings lost to either higher taxation or lower benefits. For instance, a household ranging between 30% and 70% of the average wage loses around 55 króna for 100 króna earned.
Source: OECD Tax Benefit Model
Disability benefits are rising
The most conspicuous increase in social protection spending relates to disability benefits. Since the early 1990s, the share of workers getting a disability benefit has more than doubled reaching almost 9% of the working-age population (Figure 2.10). In 2017, one-sixth of workers in the pre-retirement cohort received a disability benefit. The rise of spending on disability benefits is driven mainly by the rising incidence of mental health disorders among young claimants - around 38% of disability benefit recipients – and a growing share of muscosceletal diseases among the older. In addition, municipal spending on disability is projected to rise annually by around 10% (Analytica, 2018). As such, new types of disability prevention and management are needed to curb new caseloads (OECD, 2012).
The most promising way to make spending on disability more effective and to curb unnecessary spending on benefits is likely to move the sickness and disability system from a medical-based passive benefit payer towards an active caretaker that fosters job retention and return to work (OECD, 2014). In particular, potential disability should be recognised early at the workplace while priority should be given to (financial) integration measures that help workers remain in employment. Tackling disability requires extensive collaboration among health care, social security, employers and educational institutions. The Swiss reforms, which took almost a decade to mature, might show a way forward in both improving integration at the workplace while keeping spending at bay, although mental illness still remains an issue (Box 2.5).
Figure 2.10. Disability has risen fast
Incidence of disability in the working age population
Source: Statistics Iceland.
Box 2.5. The decade-long reform of Switzerland’s disability insurance
Switzerland witnessed a rapid increase in the number of disability pension recipients since the mid-1990s, especially beneficiaries with mental health disorders. As the caseload went up, the financial situation of the disability insurance fund deteriorated, peaking in a cumulative deficit of more than 4% of GDP in 2005. At that time, around 6% of the working-age population was entitled to a disability pension. The disquieting increase of young claimants and those with mental disorders triggered an intense public debate about the fundamental role of the disability benefit system, about targeting justified claims and about the potential to get pension recipients back to employment. Some studies commissioned by the government altogether questioned disability pension for under 30-years old claimants with mental disorders.
Between 2003 and 2016 the government thoroughly reformed the disability insurance system in several steps, basically by trying to reduce the number of new claimants and by incentivising claimants to remain in or take up work. The main thrust consisted in moving disability insurance from a medical-based, passive and rather permissive benefit payer towards a system fostering return to work (“integration before pension”), in close collaboration with employers, health and educational institutions, employment services and other parts of the social security system. The government mustered support for reform by stressing both “fairness” and the ailing finances of the disability insurance fund. The resulting change of regulations was comprehensive despite various political economy obstacles. Overall, the reforms:
Clarified and tightened the criteria that give access to a disability pension
Introduced more fine-grained disability degrees and pensions, to better reflect actual disability (quarter, half and three-quarter pensions)
Reduced implicit tax rates by partially decoupling additional labour income from disability pensions
Improved the detection of people at risk of becoming disabled, including a new form of low-threshold application to disability insurance
Set up early intervention measures to secure job retention or to support job search, including vocational training and active job placement
Introduced substantial wage subsidies for employers hiring disability benefit claimants
The reforms were financially successful as the annual deficit turned to a (small) surplus, and debt of the disability insurance fund decreased to 2% of GDP and should reach zero by 2030. Since 2005 the overall number of benefit claimants declined slightly, while new caseloads fell by around 50%. In 2019 the government introduced a draft bill to better address and integrate claimants with mental health disorders, whose prevalence remains high, and to reduce benefits for children of pension recipients. The government plans to strengthen incentives to work further by reducing threshold effects and implicit tax rates on labour income, which were both rejected in a referendum in 2013.
Subsidies should become less damaging
Spending on subsidies to households and firms make up around 3.5% of GDP, down from 4.6% in 2000. While a few subsidies can be justified on grounds of market externalities, they tend to undermine competition and stifle innovation. However, cutting subsidies tends to widen income dispersion, arguably since they support mainly low-productivity and low-wage sectors (Cournède, Fournier, & Hoeller, 2018). Addressing subsidies thus often involves political trade-offs.
Agriculture is the most important recipient of subsidies, despite employing only 2% of the labour force. Although much support comes in through tariffs and border protection, various subsidies additionally help the meat, dairy and vegetable markets (OECD, 2018). Around 80% of subsidies are directly or indirectly coupled with production, i.e. they belong to the potentially most distorting forms of income support. By contrast, spending on agricultural innovation is declining. Support accounts for 58% of total farm receipts, more than in any other OECD country. Reforms over the past decade were limited, although the government plans to move partly away from production-related support in 2019.
Production-related subsidies are also among the most environmentally damaging, which is a particular concern for Iceland’s fragile environment (OECD, 2014). The current farm subsidies foster overgrazing, thereby exacerbating soil erosion - a lasting issue after the woods were cut in medieval times – and weakening flood prevention. Subsidies are only partly conditional on meeting environmental performance standards. The contribution of livestock to Iceland’s high CO2-per capita emissions is above-average, even if transport currently dominates overall emissions (see Key Policy Insights). As such, support should be moved from agricultural production towards less (economically) distorting and (environmentally) damaging forms, essentially by coupling subsidies to sustainable land management and to the production and preservation of amenities. More specific subsidies could foster agricultural innovation, especially digitalisation, and reforestation, which has a large CO2 mitigation potential (OECD, 2014).
Findings and recommendations to improve the public finances
Note: Key recommendations are in bold and can be found again in chapter “key policy insights”
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