However, slower growth is projected (Table A), and there are downside risks. In case of a slowdown, the authorities should allow automatic stabilisers to operate. A fiscal stimulus could be envisaged in case of a severe downturn, which might result from rising trade tensions and financial volatility. Building on recent measures, one option to stimulate the economy could be to further reduce taxes on low wages, which would have the side-benefit of making the labour market more inclusive by favouring job insertion of low-skilled workers.

Rising household indebtedness creates vulnerabilities for some families and some banks. Mortgage debt has continuously increased in line with rising house prices (Figure B), creating a high debt service burden for a larger share of households than in most other countries. Though the regulator has imposed higher capital buffers, domestic banks have large exposures to the residential real estate market, which is a source of risk. Introducing borrower-based macroprudential instruments, such as caps to loan-to-value or debt service-to-income ratios, as envisaged in draft legislation, would help avoid the further build-up of vulnerabilities.

Reinforced supervision and regulation can further enhance financial sector resilience and foster the transition to a low-carbon economy. The large investment fund industry is sensitive to external risks, and sizeable intra-group exposures of international banks likewise call for close monitoring. The financial sector is globally exposed to climate-related risks, inter alia through holdings of high-carbon assets which are likely to lose value when policies are implemented to meet international climate change mitigation targets. Building on Luxembourg’s leading role in green bonds, strengthening climate-related disclosure requirements for financial intermediaries will increase transparency and thus the allocative efficiency of financial markets.

The fiscal position is very strong, but ageing creates a long-term fiscal challenge. The 2018 budget surplus exceeded 2% of GDP, and gross public debt is low and far outweighed by financial assets. However, under unchanged policies, ageing-related costs are projected to rise substantially, posing a long-run fiscal sustainability challenge. Taking steps to increase the retirement age with life expectancy and/or reduce the generosity of pensions would help address this challenge. Options outlined in the 2012 pension reform should be discussed in this context.

The composition of revenues should be also revised to support more sustainable growth (Figure C). Increasing environmental taxes, such as those on transport fuel or on motor vehicles, would reduce CO2 emissions and pollution. More reliance on recurrent real estate taxes would also be desirable. This would allow less reliance on base-narrowing tax arrangements that in the past attracted multinationals to Luxembourg and thus helped increase corporate tax revenues. Those provisions are being gradually phased out as part of Luxembourg’s engagement in international efforts towards tax transparency, which should continue.

Productivity growth has disappointed, especially in services. The level of productivity is high, but its growth has been subpar for two decades (Figure D). Weak growth can largely be traced to services, where often the most productive firms have failed to pull ahead and weaker firms have fallen further behind. Within services, the financial sector has remained the main area of activity, despite declining productivity growth. Policy initiatives to diversify the economy need to be further pursued, with systematic monitoring and evaluation.

Firms that are not top-performers, but viable, need to catch up. Firms often face skill shortages, inter alia in digital technologies, which weighs on productivity outcomes. Market congestion by inefficient firms compounds the problem. Training offers should be stepped up and need to be better informed by regular skill foresight exercises. Restrictive regulations in professional services hamper productivity in that sector but also in downstream production. A more efficient insolvency regime would foster entrepreneurship and help struggling firms to either restructure or exit.

Top-performing firms could still become more innovative. This can take place through more widespread adoption of cutting-edge technologies, such as artificial intelligence or blockchain applications, where public sector use can have a valuable demonstration effect. R&D investment is low by international standards, and the share financed by firms has been declining. Income-based R&D tax incentives have been recently made more targeted, but remain likely to benefit large firms disproportionately. Introducing expenditure-based tax incentives could thus be considered.

Housing supply has not kept pace with growing demand. Strong demographic growth, coupled with a trend towards smaller households, have fuelled housing demand, while structural constraints have hampered supply (Figure E). Limited use of land available for construction and cumbersome zoning restrictions have made land prices soar. In turn, this has worsened land hoarding, left unchecked by the low opportunity cost of vacant constructible land, but also by weak incentives of municipalities to enforce an obligation to build on private landowners. Complex construction norms set by municipalities have made building costs rise further.

High urban sprawl weighs on housing affordability and on the environment. Single-family houses still account for half of the housing stock, which contributes to high urban sprawl in international comparison. This private preference for low-density housing entails major social costs in terms of pollution, traffic congestion (not least due to massive cross-border commuting) and more expensive public infrastructure. Enhanced incentives for densification are hence called for. As with other supply constraints, better coordination between central and local government, as well as across different municipalities, is key.

Tax provisions hamper housing supply, fuel mortgage indebtedness and harm equity. Recurrent real estate taxes are very low, partly because they are based on outdated cadastral valuations. Besides raising little revenue, these taxes hardly provide any incentives for socially efficient land use and territorial development. For instance, unused constructible land is seldom taxed, thus encouraging land hoarding. Rising house prices are also due to the favourable income tax treatment of owner-occupied housing, inter alia through mortgage interest deductibility, which tends to be regressive.

Equitable access to housing is also made difficult by a small social rental sector. The stock of social rental housing is very low (Figure F), partly reflecting the past practice of re-sale of subsidised housing on the unregulated market. Social rental agencies can alleviate this shortage by acting as intermediaries between landlords and vulnerable tenants, providing rent payment guarantees and maintenance services to the owners and supporting tenants in their future transition to unsubsidised housing. Financial support for these agencies should be stepped up and municipalities could provide up-to-date information on unoccupied dwellings.

Social housing allocation can be improved. Social rental housing should be targeted at those households most in need, to provide them with an affordable dwelling and prevent socio-economic segregation. However, the admission criteria for social housing are often flexible and with low transparency. Moreover, partly due to unlimited tenure contracts, many tenants come from the two top income quintiles. Recurrent means-testing should be combined with tailored plans for re-entering the private rental sector, similar to those used by social rental agencies. Rents in the social housing sector should also increase more steeply with tenant income.