52004DC0020

COMMUNICATION FROM THE COMMISSION ON THE IMPLEMENTATION OF THE 2003-05 BROAD ECONOMIC POLICY GUIDELINES (presented in accordance with Article 99 (3) of the EC Treaty) {SEC(2004) 44}

PART I

General Assessment(1)

1) Commission Communication

// EXECUTIVE SUMMARY

The BEPGs outline the medium-term economic policy strategy...

... on how to reach the Lisbon goal. // This Communication presents a first assessment of the follow-up given to the general guidelines in the 2003-05 Broad Economic Policy Guidelines (BEPGs). An assessment on the implementation of the country-specific recommendations is given in the accompanying working document of the Commission services. Together, they constitute the first Implementation Report (IR) following the move to multi-annual guidelines in 2003. The 2003-05 BEPGs laid down the EU's medium-term economic policy strategy with particular attention to the contribution economic policies can make to reach the Lisbon strategic goal. The three key elements of this strategy are:

* growth- and stability-oriented macroeconomic policies;

* economic reforms to raise Europe's growth potential; and

* strengthening sustainability.

Implementation assessment will be stepped up gradually.

// Following the move to a better streamlined policy coordination cycle, this Implementation Report is presented as part of the "Implementation Package" together with the draft Joint Employment Report and the Implementation Report on the Internal Market Strategy. Furthermore, as a consequence of the clearer medium-term focus of the policy strategy, this first Implementation Report can only provide a preliminary assessment. It concentrates on policy measures taken and/or envisaged in 2003 in response to the 2003-05 BEPGs. Specific attention is given to the three priority areas highlighted by the Council. The implementation assessment will be stepped up the closer we get to the full review of the BEPGs planned for 2006.

Stagnation in the first half of 2003.

// The economic background to this IR is that of a stagnation in the first half of 2003. Despite a clear improvement in economic activity in the third quarter, growth over the year as a whole is expected to have been a modest 0.8 per cent in the EU (and a mere 0.4 per cent in the euro area). The protracted period of low growth has started to take its toll on the labour market. Employment growth came to a halt and unemployment rose to 8.1 per cent in the Union. Headline inflation has been slow to come down, partly due to price increases for oil and fresh food, and rises in indirect taxes. A lack of response of wages to the cyclical slowdown in labour productivity also implied continued pressures on nominal unit labour costs.

// On the basis of this first implementation assessment, the following key messages emerge.

Macroeconomic policies supported growth.

// Macroeconomic policy was accommodative in 2003. Both the ECB and the national central banks in Denmark, Sweden, and the United Kingdom lowered further their key interest rates, thereby supporting domestic demand. Despite the appreciation of the euro, overall monetary conditions remained accommodative. The free play of automatic stabilisers helped to stabilise the economy. The EU's cyclically-adjusted primary balance remained broadly unchanged, indicating an overall neutral fiscal stance in 2003.

Budgets continued to deteriorate...

...but five Member States managed to maintain budget positions close to balance or in surplus in 2003... // The economic slowdown continued to weigh on public finances and progress seems mixed as regards reaching or maintaining a sound budgetary position. The average nominal budget deficit worsened further in 2003 to 2.7 per cent of GDP. However, differences are sizeable across Member States. Belgium, Denmark, Spain, Austria, Finland and Sweden had a cyclically-adjusted budgetary position close to balance or in surplus in 2002. With the exception of Austria, the other five Member States maintained such a budgetary position in 2003. Nominal deficits deteriorated sharply in several other Member States, with two countries (Germany and France) expected to have deficits exceeding the 3 per cent of GDP limit by a wide margin in 2003. While the economic slowdown is the main factor behind the recent deterioration in the public finances, part of the slippage in 2003 also stems from discretionary measures in some Member States (notably Greece, Austria, and the United Kingdom).

...and a further three markedly improved their CAB...

...while the excessive deficit situation seems likely to persist for three others.

// In 2003, only Ireland, the Netherlands and Portugal showed a marked improvement (of more than 0.5 per cent of GDP) of their cyclically-adjusted budget balance (CAB). In the case of Portugal, this is due to substantial one-off measures, which also resulted in keeping the nominal deficit just below the 3 per cent limit in 2003. However, the deficit is expected to deteriorate in 2004 in the absence of further measures, thereby going above the ceiling again. The other two countries with an excessive deficit, Germany and France, made little, if any, progress. Notwithstanding the consolidation measures taken in Germany of about 1 per cent of GDP, the lower-than-expected-growth makes them inadequate to bring the excessive deficit situation to an end in 2004. France has not taken effective action to redress the budgetary imbalances to bring the excessive deficit situation to an end this year.

Wages put pressure on profitability. // Nominal wages continued to grow by about 3 per cent in 2003 in the EU (2 ¾ per cent in the euro area), despite the continued slowdown in economic activity. This has put further pressure on profitability and job-creating investment. However, seen in a medium-term perspective, wage trends appear still broadly compatible with price stability.

Labour market reforms have been stepped up in some areas, but appear insufficient to reach the Lisbon targets.

// The labour market performed quite well in the beginning of this economic downturn, reaping the benefits of earlier reforms but also reflecting labour hoarding. The effect of the slowdown started to be felt more strongly in 2003 with employment growth stagnating and a continued rise in unemployment. The increase in the pace of labour market reforms in 2003 appears encouraging, but it needs to accelerate further. In particular, efforts have been made by most Member States to make work pay, even if reforms remain focused on the tax side. Some Member States have taken action to address incentive effects in the benefit systems (Denmark, Germany, France, the Netherlands, and the United Kingdom), which contribute most to the risk of unemployment- and inactivity traps. Several Member States have taken further measures to make the work organisation more adaptable (notably Denmark, Spain, France, Italy, the Netherlands and Sweden) and most Member States aim to foster occupational mobility through lifelong learning initiatives. Active labour market policies have also become better in responding to the individual needs of the unemployed. However and despite some improvements noted or planned in Denmark, Ireland, and the Netherlands, progress appears limited as regards improving the efficiency of ALMPs: e.g. evaluations are not systematically carried out or reported. Progress also appears limited in promoting wage differentiation or addressing the regulatory burden in the labour market. Despite the progress noted with some types of labour market reforms, the Lisbon- and Stockholm employment rate targets risk being missed, unless further and comprehensive reforms are undertaken without delay.

Disappointing labour productivity growth... // Labour productivity growth continued to disappoint and the gap with the USA widened. Lower labour productivity per hour worked now represents 40 per cent of the difference in GDP per capita between the EU and the USA. The gradual deterioration in labour productivity growth since the mid-1990s can be explained in equal parts by the slowdown in investment and in total factor productivity (which generally include effects from more efficient resource utilisation, technological progress and the natural catching-up process of lesser developed EU countries). ICT and their adoption are a key driver of productivity growth and the differentials between the EU and US productivity trends are strongly influenced by differences in the extent to which ICTs have penetrated the respective economies. This illustrates the need to stimulate market integration, business dynamism, and investment, particularly in knowledge.

...partly due to slow progress on the Internal Market.

// Economic reforms are essential to enhance the EU's growth potential, which is necessary to achieve the 'Lisbon targets'. Progress in implementing the guidelines aimed at increasing productivity and business dynamism seems mixed. The functioning of the Internal Market is still hampered by the absence of proper regulation in the areas covered by proposals pending before the Council and the European Parliament (including directives on professional qualifications and on intellectual property rights). The average transposition rate by Member States also deteriorated somewhat in 2003.

Better progress on competition policies and the liberalisation of network industries. // Progress has been better in improving the effectiveness of competition policies, where e.g. Belgium, Austria, and the United Kingdom have acted to ensure the effective independence and capabilities of their competition authorities. Market opening in network industries also continues to progress both at EU level (with e.g. the directive laying down common rules for the electricity and gas market and an agreement on the trans-European networks) and at national level, even if the market share of the incumbent often remains very high after liberalisation.

Measures taken to improve the business environment...

// The business environment continues to be hampered by some weaknesses, such as relatively high administrative burdens and the difficulties to find financing (notably venture capital). Nevertheless, several countries (e.g. Belgium, Germany, Greece, Spain, France, Luxembourg, and Austria) took measures to facilitate business start-ups in 2003.

...while investment in knowledge and innovation is still insufficient.

// The transition to the knowledge based economy is progressing, albeit slowly, and differences between Member States remain important. The Commission put forward an Action Plan aimed at promoting R&D investments (to 3 per cent of GDP by 2010) where two-thirds are to be financed by the private sector. So far, evolutions remain far from satisfactory with declining R&D spending (as a share of GDP) in e.g. Ireland, the Netherlands, and the United Kingdom. It is also worrying that Member States failed so far to substantially raise investment in human resources, which was also addressed in a Communication from the Commission in November 2003. On the positive side, several Member States are trying to improve the quality and efficiency of their education systems, where e.g. Spain adopted a law on quality in education and Sweden introduced a new system of vocational training.

Good progress in implementing the RCAP and the FSAP, but a final effort is needed.

// As regards capital markets, the Risk Capital Action Plan is almost completely implemented. The Financial Services Action Plan is well on the way to full implementation and transposition of the adopted legislative measures into national law has begun. However, a final effort is required to meet the 2005 deadline. Integration of clearing and settlement arrangements has become a clear priority for action at both the EU and the Member State level in 2003. Following corporate scandals in recent years, several Member States have strengthened corporate governance arrangements at the national level, while the Commission has adopted an Action Plan on company law and corporate governance in May 2003. Financial supervision arrangements are being streamlined, both at Member State- and EU level.

Long-term sustainability of public finances is not yet secured in about half of the Member States.

// Long-term sustainability of public finances, particularly in view of the ageing population, is not yet secured in about half of the Member States, notably Belgium, Germany, Greece, Spain, France, Italy, and Portugal. While significant progress has been made through pension reform measures in some Member States in 2003, in particular in France and Austria, less progress was made in bringing the public debt down. Public debt remained above 60 per cent of GDP in 2003 in six Member States, including in Belgium, Greece, and Italy where it continued to exceed 100 per cent of GDP.

Limited progress on social sustainability, despite some measures taken.

// The progress in improving social sustainability is hampered by the deteriorating labour market situation, since jobs play an important role in lifting people out of poverty and social exclusion. Some measures have been undertaken to tackle regional differences in unemployment, and above all, to enhance the efficiency of investments financed by the Structural Funds.

Environmental sustainability remains a major challenge

// Some progress has been made towards improving environmental sustainability in 2003. At the EU level, the Council extended the coverage of Community legislation in energy taxation (on e.g. minimum taxation levels). Several Member States (e.g. Belgium, the Netherlands, and Sweden) took further measures to promote the use of renewable energy. Other Member States (notably Germany and Austria) took measures in the area of transport pricing. In the United Kingdom, congestion charges were introduced in London, causing a marked change in behaviour. In contrast, and despite the good progress made at the end of the 1990s, no progress was noted as regards reduction of greenhouse gas emissions.

Mixed progress so far in the euro area, where more action is needed on the budgetary side...

... and as regards the euro area's external representation.

// Progress in response to the guidelines for the euro area is mixed. The macroeconomic policy mix appeared broadly compatible with price stability and continued to be supportive to growth. However, the implementation of the budgetary guidelines is worrisome. Only three Member States maintained budgetary positions close to balance or in surplus in 2003 (namely Belgium, Spain and Finland), and three others recorded an improvement in the cyclically-adjusted budget balance of at least 0.5 per cent of GDP (Ireland, the Netherlands and Portugal). Half of the euro area Member States made insufficient progress towards sound public finances in 2003. Finally, progress appears very limited in improving the external representation of the euro area in international fora.

Despite important progress noted in some areas, the overall pace of reform has not been stepped up.

// Recognising that this is only the first year in a multi-annual setting, the overall picture that emerges from this review is mixed. The pace of reform (incl. both measures taken and/or envisaged) appears to have improved somewhat as regards the labour market, policies affecting competition, the business environment and the use of new technologies, education, and pensions. Progress is more limited in market integration, investment in knowledge and research, social- and environmental sustainability. The rapid deterioration in budgetary positions in several Member States and the lack of resolve to address the (excessive deficit) situation is a source of great concern. Taken together, it does not appear as if the overall pace of reforms has been stepped up as requested by the Council. There is a clear risk that with the current reform pace, full implementation of the BEPGs can not be secured by 2006, thereby putting the fulfilment of the Lisbon targets by 2010 at risk. The slowdown and the need to consolidate public finances cannot be an excuse for postponing necessary reforms further. Indeed, both fiscal consolidation and structural reforms can be growth supportive even in the short run through positive effects on confidence. Their longer-term positive impact on growth is undisputed.

1. Introduction

This Communication aims to assess the action taken or envisaged in response to the EU's medium-term economic policy strategy as laid down in the 2003-05 Broad Economic Policy Guidelines (BEPGs) [1]. The BEPGs provide the overarching instrument for economic policy co-ordination in the European Union. Following streamlining of the Union's policy co-ordination processes, the BEPGs focus on key economic policy issues and the measures to be taken over the medium term to effectively address them. Other processes (such as the Internal Market Strategy and the European Employment Strategy) deal with their issues in greater detail. This Implementation Report is presented as a part of an "Implementation Package" with the draft Joint Employment Report and the Implementation Report on the Internal Market Strategy. Together they support the Commission's 2004 Spring Report. It has taken due account of the recent report of the European Employment Taskforce.

[1] See Council recommendation of 26 June 2003 on the BEPGs (2003/555/EC), published in the Offical Journal No. L 195/1 of 1 August 2003.

The EU's medium-term economic policy strategy is concentrated around:

" growth- and stability-oriented macroeconomic policies;

" economic reforms to raise Europe's growth potential; and

" strengthening sustainability.

The BEPGs concentrate on the contribution that economic policies can make in the medium term to the fulfilment of the strategic goal set in Lisbon in 2000: "to become the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion". An environmental dimension was added to the Lisbon Agenda in 2001.

The Implementation Report provides a key input for the multilateral surveillance of the economic policies of the Member States and the Union as envisaged by the Treaty Article 99 (3). This Implementation Report is the first one following the move to multi-annual guidelines. Recognising that Member States now have three years to address the general guidelines and country-specific recommendations in the BEPGs, an incremental approach will be followed where the implementation assessment becomes gradually more thorough the closer we get to the full review of the BEPGs planned for 2006. This implies that the implementation assessment of this first intermediate year is less detailed and conclusive, and concentrates on policy intentions to a greater extent than future assessments.

Box 1: Follow-up given to the Council's three main priorities

In a cover note to the 2003-05 Broad Economic Policy Guidelines (BEPGs) the Ecofin Council highlighted three main priorities for policy action in the coming year:

1. promoting growth;

2. increasing flexibility in our labour markets; and

3. ensuring sustainability of our public finances.

The Council also stated that the pace of reform must be stepped up and that a timely and effective implementation of the BEPGs is of crucial importance for confidence and growth. Moreover, it indicated that it had a vital role to play, together with the Eurogroup, to jointly monitor and encourage implementation by all policy actors.

Thereafter, the Italian Presidency indicated that the Council will start holding regular implementation discussions throughout the year. A working breakfast was devoted to the follow-up given to the 2003-05 BEPGs so far, notably with regard to the sustainability of public finances on 4 Nov. 2003. Adopting conclusions on this report will be the next opportunity for the Council to return to implementation discussions.

It is not easy to briefly summarise the actual follow-up given to the three priority areas highlighted by the Council, given their very broad nature. For instance, all general guidelines under "growth- and stability-oriented macroeconomic policies" and "economic reforms to raise Europe's growth potential" are more or less directly aimed at improving Europe's growth- performance and potential. The presentation below should therefore not be seen as replacing the more in-depth assessment carried out in the full report.

As regards "giving priority to growth in Europe" and the need to find an appropriate balance of macroeconomic policies, this Implementation Report concludes that such policies have been accommodative to growth. The monetary policy stance was loosened as the ECB cut interest rates by 75 basis points in total in 2003. The budgetary stance remained neutral given the broadly unchanged cyclically-adjusted budget deficit, although the play of automatic stabilisers helped to stabilise the economy.

In addition to sound macroeconomic policies, the Council highlighted the need to step up investments in human and physical capital and to complete the Internal Market. Progress appears mixed. Total investments are expected to have declined in 2003 (by 0.4 per cent in EU15 and 1 per cent in the euro area), albeit at a lower rate than in 2002, and in line with the adverse cyclical conditions. Investment in knowledge and innovation continues to lag behind that of the USA. Moreover, progress in creating a better functioning Internal Market has slowed down. However, the European initiative for growth, which was launched in October 2003, aims to encourage certain trans-European network infrastructure and R&D projects where funding can be provided from the EU budget. The contribution from the Community for trans-frontiers infrastructure investments is limited to 20 per cent of the project's cost. These projects will also benefit from an enhanced co-ordination in respect of planning, environmental impact assessment and financing.

As regards "increasing flexibility in our labour markets", it appears as if the pace of labour market reforms slightly improved in 2003, but needs to be stepped up further if the Lisbon targets are to be met. Efforts have been made in several Member States to make work pay, even if reforms remain focused on the tax side. Several Member States have also taken further measures to make the work organisation more adaptable and to foster occupational mobility. Active labour market policies (ALMPs) have also become better in responding to the individual needs of the unemployed. In contrast, few measures have been proposed to address incentive effects in benefit schemes, promote wage differentiation, enhance the efficiency of ALMPs in line with evaluations, or address the regulatory burden (e.g. the employment protection legislation).

As regards "ensuring sustainability of our public finances" progress seems to be mixed. Since 2000, the public debt level is increasing in both the EU and in the euro area, and remains well above the reference value of 60 per cent of GDP for the latter. Important pension reforms, on the other hand, were adopted in some Member States in 2003, notably in France and Austria. Several Member States have also tried to improve the interaction between the pension system and the labour market performance, but the employment rate of older workers amounted to only 40 per cent in 2002, with sizeable differences across Member States.

This Communication (Part I of the Implementation Report) is complemented by a working document of the Commission services that provides a first assessment of the implementation of the recommendations given to Member States to address their individual challenges on a country-by-country basis (Part II). As for the general guidelines, the implementation assessment will be stepped up gradually in the coming years.

2. Strengthening the EU's Economy

2.1 Growth- and stability-oriented macroeconomic policies

2.1.1 Economic background: lowest economic growth since 1993

Economic growth has turned out to be markedly weaker than anticipated. Following a poor performance at the end of 2002, the EU economy stagnated in the first half of 2003. Even if activity clearly improved in the third quarter, the average growth rate is expected to have been a modest 0.8 per cent in 2003 (0.4 per cent in the euro area), see Graph 1. This is the lowest growth rate since 1993. There are several factors behind the disappointing economic performance and the delay in the expected recovery. Firstly, confidence was generally undermined by the geopolitical tensions linked to the Iraq war. Secondly, uncertainties related to future labour and pension income and the adverse wealth effects of the prolonged stock market decline dampened consumers confidence in the euro area. Thirdly, weak profitability in the corporate sector following e.g. the on-going balance sheet adjustment and the increased costs for external funding is likely to have reduced or postponed investments. Finally, structural rigidities remain substantial. Market segmentation and inflexibility caused e.g. real unit labour costs and consumer price inflation to adjust only sluggishly to weak economic growth and deteriorating labour market conditions.

The protracted period of sluggish growth has started to take its toll on the performance of the labour market. In 2003, some 200.000 jobs are expected to have been lost in net terms in the euro area (thereby recording the first decline since 1994). The unemployment rate is forecasted to have increased to 8.1 per cent in the EU (8.9 per cent in the euro area).

Inflation, estimated at 2 per cent in the EU in 2003 (2.1 per cent in the euro area), has been relatively slow to come down despite weak growth. This is partly due to temporary factors such as the pass-through of oil price increases, weather-induced food prices hikes and rises in indirect taxes. But core inflation has also been sticky, because of upward pressures on unit labour costs from steady nominal wage growth in combination with a cyclically induced slowdown in productivity growth, and a slow pass-through of the euro appreciation into consumer prices.

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Macroeconomic policy conditions remained accommodative

Macroeconomic policies have been accommodative in view of the weak growth conditions.

The ECB cut interest rates two times in 2003, by a cumulative 75 basis points to 2 per cent for the minimum bid rate, in connection with decelerating cyclical conditions, see Graph 2. Its supportive effect on growth, and above all on domestic demand, was partly counteracted by the recent strengthening of the euro that hampered net export somewhat. Overall, the monetary policy stance continued to be accommodative. Even though inflation has remained above 2 per cent and monetary aggregates have grown strongly, inflation expectations remained low and stable.

Outside the euro area, central banks lowered policy rates in several steps in the first half of the year. The Bank of England cut the repo rate, the main policy rate, twice by 0.25 percentage points to 3.5 per cent by mid-July. Subsequently, amid signs of strengthening economic activity and strong credit growth, it raised the repo rate in November by 0.25 percentage points. In Sweden, the Riksbank cut the policy rate three times in the period between January and early July, by 1.0 percentage point in total. The repo rate has subsequently been kept unchanged and currently stands at 2.75 per cent, its lowest level ever.

Graph 2: Short-term and long-term interest rates

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The overall fiscal policy stance remained neutral in the EU, where the primary cyclically-adjusted budget balance was broadly unchanged, see Graph 3. Nominal budgetary positions deteriorated, as automatic stabilisers acted to cushion the effects of the protracted slowdown. The lack of a budgetary consolidation in some Member States during the previous up-turn has limited the current room of manoeuvre. This has put the overall EU fiscal framework under pressure, see also Section 2.1.2 below.

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Wage growth remained unchanged at around 3 per cent in EU-15 in 2003 (2 ¾ per cent in the euro area). The continued rise in nominal wages coupled with a slight decline in inflation has allowed real wage growth to edge higher, thereby benefiting households' purchasing power. Against a background of a cyclical reduction in labour productivity growth, unit labour cost growth remained above 2 per cent last year. Wage trends still appear broadly in line with price stability, provided that the expected cyclical recovery in labour productivity is not translated into higher wage growth.

2.1.2 Budgetary developments: fiscal policy framework under pressure

Further deterioration in budgetary positions

The impact of the economic slowdown on EU public finances became clearly visible after 2000. Both automatic stabilisers and discretionary policies exerted pressures on the budget balances, and the nominal surplus of 1.0 per cent of GDP in 2000 [2] for EU-15 turned into a deficit of 1.9 per cent in 2002. The average nominal budget position worsened further in 2003 to -2.7 per cent of GDP in the EU, with sizeable differences across Member States. Despite the general worsening, four Member States managed to maintain a nominal budget position in balance or in surplus during the whole period 2000-2003 (BE, DK, FI and SE). A substantial deterioration can be noted for several other Member States, where two countries (DE and FR) are expected to have deficits exceeding the 3 per cent of GDP reference value by a large margin in 2003.

[2] The EU-15 net lending figure included one-off proceeds for telephone licences (UMTS) of 1.2 per cent of GDP in 2000.

For the EU as a whole, the economic slowdown is the main factor responsible for the deterioration in public finances in recent years, through the working of the automatic stabilisers. An important part of the deterioration stems from discretionary deficit-increasing measures. The cyclically-adjusted budget deficit rose from -1.2 per cent of GDP in 2000 to -2.2 per cent in 2003. At Member State level, the development has been quite diverse (see also Graph 4). Of all the Member States that had a cyclically-adjusted budget deficit in 2000, the situation worsened in the case of Germany, Greece, France, and the Netherlands, while it improved in Belgium, Spain, Italy, Austria, and Portugal.

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Against this background, the 2003-05 BEPGs recommended Member States to:

1. reach or maintain budgetary positions of close to balance or in surplus throughout the economic cycle*; to correct excessive deficits in line with the Stability and Growth Pact;

2. subject to (1), avoid pro-cyclical policies, in particular in economic upturns.

* Euro area Member States were recommended to improve their cyclically-adjusted balance by at least 0.5 per cent of GDP annually in case the medium-term objective had not yet been achieved.

Implementation of the guideline on fiscal policies is worrisome

According to the Commission's economic forecasts (autumn 2003) five Member States maintained a budget position of close to balance or in surplus in 2003 (in cyclically-adjusted terms), namely Belgium, Denmark Spain, Finland and Sweden (see Table 1). These Member States seem likely to maintain sound positions over the coming years. In the case of Austria and according to the recent Stability programme, the budgetary situation weakened in 2003 to a degree that it no longer complies with this guideline. On the assumption of unchanged polices, the autumn forecasts imply that two more Member States (IE and AT) could achieve a sound position by 2005. However as regards Austria, it now appears unlikely that the forthcoming tax cuts (amounting to 1 per cent of GDP) will be accompanied by corresponding expenditure restraint; thereby causing the cyclically-adjusted balance to deteriorate considerably in 2005.

Member States that had not reached the above mentioned objective are recommended to improve their cyclically-adjusted budget balance (and the adjustment should amount to at least 0.5 per cent of GDP per year for euro area countries with deficits below the 3 per cent of GDP ceiling whereas bigger improvements are expected from those with a deficit in excess of that limit, see also Section 3). In 2003, only Ireland, the Netherlands, and Portugal showed a more marked improvement (of more than 0.5 per cent of GDP) of their cyclically-adjusted budget balance. In 2004, an improvement is also expected in Germany and France, while the cyclically-adjusted budgetary deficits in Greece, Italy, Luxembourg, and Portugal could sharply deteriorate in 2004 and/or 2005 (but it should be noted that the forecasts for 2005 are based on a no-policy change scenario for all Member States).

In 2002, the Council identified an excessive deficit in Portugal, followed by Germany and France in 2003. Both Germany and Portugal have made considerable efforts in response to the recommendation to bring this situation to an end. According to the forecasts and following substantial one-off measures, the nominal deficit in Portugal is expected to stay below 3 per cent of GDP in 2003, but risks exceeding the limit again in 2004. In the German case, measures amounting to about 1 per cent of GDP have been taken in 2003, thereby fulfilling that part of the Council recommendation of January 2003. However, given the adverse cyclical conditions, the measures taken now appear inadequate in order to bring the excessive deficit situation to an end in 2004. France does not appear to have taken effective action to redress the budgetary imbalances, and given the current economic outlook, the excessive deficit situation is likely to persist with a continuation of a deficit well above 3 per cent of GDP in 2004.

In view of the developments outlined above, the Commission adopted recommendations to Germany and France in accordance with Treaty Articles 104 (8) and 104 (9) that no effective action has been taken (FR) or was inadequate (DE), and that both Member States should take measures to remedy the excessive deficit situation. However, in light of the weak economy, the Commission recommended to allow both Member States one additional year to bring down the deficit below 3 per cent of GDP, i.e. by 2005. On 25 November 2003, the Council rejected the Commission's recommendations and found an agreement outside the Treaty, de facto suspending its application for these articles. The Council took note of the commitments made by Germany and France to reduce their deficits to below 3 per cent of GDP by 2005.

Graph 5 examines the fiscal stance (approximated by the changes in the cyclically-adjusted primary balance (CAPB)) in relation to cyclical conditions which is approximated by the size of the output gap. The overall fiscal stance for the EU is expected to be broadly neutral in 2003. However, the aggregate fiscal stance results from quite diverse fiscal stances across Member States, despite fairly similar cyclical developments. Some Member States are expected to run somewhat pro-cyclical policies, reflecting consolidation efforts needed to abide by Guideline no. 1 on sound budgetary positions (e.g. NL and PT), which takes precedence over the Guideline on avoiding pro-cyclical policies. The pro-cyclical fiscal stance in Greece, however, can not be explained by a need to consolidate public finances.

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2.1.3 Wage developments: wage growth too high to be conducive to employment creation

Wage growth declined less than the drop in productivity growth...

Wages have responded only modestly to the worsened economic situation, partly reflecting a greater resilience initially shown in the labour market in the current slowdown. Nominal wage growth has fallen gradually from 3½ per cent in 2000 to around 3 per cent in 2003 in the EU, while it remained relatively stable around 2¾ per cent in the euro area during the same period. Unit labour costs increased, in contrast, as labour productivity growth declined sharply early in the slowdown reflecting labour hoarding in several Member States.

Against this background, the 2003-05 BEPGs recommended to:

3. ensure that nominal wage increases are consistent with price stability and productivity gains; and foster the macroeconomic dialogue.

...but wages appear broadly compatible with price stability in the medium-term

Overall, the 2003 nominal wage increases of around 3 per cent in the EU and 2¾ per cent in the euro area are broadly in line with medium-term price stability. However, the cyclical slowdown in labour productivity growth has kept the rise in nominal unit labour costs above 2 per cent for the third year in a row. This still relatively high pace has contributed to the very gradual retreat in inflation. In addition, small advances in productivity have just been sufficient to keep real unit labour costs in check, see Table 2 below.

Wage increases appear relatively high, given the weak demand for labour. A number of institutional features contribute to explain a certain lack of nominal- and real wage flexibility (such as union power, co-ordination/centralisation of bargaining, bargaining coverage, the use of wage rules in collective bargaining, and not least various insider-outsider mechanisms). No major changes have been observed as regards the framework of wage formation in general in 2003, or the linking of wages to prices by means of indexation more specifically.

At a country level, nominal wage increases were comparatively high in Greece, Spain, Ireland, the Netherlands, and the United Kingdom [3], i.e. all countries with relatively tight labour markets and/or high inflation. Real unit labour costs rose particularly in Ireland, Luxembourg, and the Netherlands.

[3] The increase in nominal compensation per employee in the United Kingdom in 2003 is partly explained by a raise in the employers' National Insurance Contribution (NIC), which contributed to the apparent wage increase by around 1.5 percentage points.

The macroeconomic dialogue fosters a common understanding among policy actors

Over the last few years, the Macroeconomic Dialogue has developed into a useful forum at EU level for the regular exchange of views between all policy actors, including the social partners. It fosters a common understanding of the economic situation and can thereby help to prevent tensions that could lead to an unbalanced macroeconomic policy mix.

2.2 Economic reforms to raise Europe's growth potential

The EU needs higher and sustainable economic growth for the rest of this decade to achieve the Lisbon objectives. Structural reforms are necessary to increase Europe's growth potential. They are best implemented in a comprehensive and coordinated way. The 2003-05 BEPGs therefore focused on the need to both improve the functioning of the labour market, the quality of human resources, and to increase productivity and business dynamism.

2.2.1 The Lisbon employment targets are in serious jeopardy of being missed

Progress towards the Lisbon and Stockholm employment targets is too slow

After several years of strong job creation, the impact of the economic slowdown on employment has started to be felt more strongly. Following a deceleration in 2002, job creation in the EU came to a standstill in 2003, and employment contracted slightly in the euro area. As firms accelerated labour cutbacks, unemployment started increasing more rapidly. From 7.3 per cent in early 2001, the (seasonally adjusted) unemployment rate increased to 8.0 per cent in October 2003. Differences across Member States are sizeable. Unemployment remains below 5 per cent in Luxembourg, the Netherlands, Austria, and Ireland, while it is above 9 per cent in Spain, Germany, and France.

The total employment rate stood at 64.3 per cent in the EU in 2002 (varying from 55.5 per cent in IT to 75.9 per cent in DK). Graph 6 illustrates the different starting points in 1999 and developments across Member States. Following a certain catching-up during the past three years, the difference between the highest and the lowest national employment rate was reduced from 23.3 to 20.4 percentage points.

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The employment rate for older workers was only 40.1 per cent in 2002, leaving the greatest distance to cover towards the target for 2010 (of 50 per cent for the average EU employment rate). The differences across Member States are particularly large - only 26.7 per cent of those aged 55 to 64 work in Belgium, while it is 68.0 per cent in Sweden (see Graph 7). Moreover, progress in recent years is slowest in some of the Member States with the lowest starting levels. It is important that the errors of the past must not be repeated, i.e. the recourse to early retirement as a seemingly convenient solution for corporate restructuring has to be avoided.

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Women benefited particularly from employment growth in the recent past. The female employment rate reached 55.6 per cent in 2002 (see Graph 8). Although cohort effects will continue to push the female employment rate up, since the propensity to work is higher among younger generations of women, specific barriers to female labour market participation (such as the lack of childcare and opportunities for part-time employment) remain a major impediment in some Member States.

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Kok report calls for wide-ranging reforms

Given the lack of employment growth in 2003 and a modest acceleration forecast for 2004 and 2005, the EU is likely to miss the intermediate employment rate target of 67 per cent by the end of 2005, and does not appear on course to meet 2010 targets. The risk of missing the Lisbon- and Stockholm employment targets should not be attributed to the cyclical slowdown. The problems are of a structural nature and to come anywhere close to meeting the employment targets, the swift implementation of comprehensive labour market reforms is urgently needed.

This was also highlighted in the recent report of the European Employment Taskforce (EETF), which was chaired by former Dutch Prime Minister Mr. Wim Kok, and released in November 2003. It makes an important contribution to the debate on how the EU can renew making progress towards the Lisbon employment targets. The policy recommendations are broad ranging, and underline the need for a consistent set of policy measures. The report outlined the following four key requirements to boost employment and productivity - increasing adaptability of workers and enterprises, attaching more people to the labour market, investing more and more effectively in human capital, and ensuring effective implementation of reforms through better governance. Overall, the policy recommendations are in line with the 2003-05 BEPGs. For example, the EETF report underlines the need for employees and employers to be able choose from a variety of contractual employment relations, and that business regulation needs to be simplified. It acknowledges the contribution that temporary work agencies can play in increasing the adaptability of the labor market, while providing employees with a well-defined framework. The EETF calls for a reconsideration of the concept of security for employees by simultaneously considering the contractual framework and adequate protection in the case of job loss through more dynamic forms of social protection "job-to-job insurance" and active measures. In addition, the EETF calls for renewed impetus in tax/benefit reform, and agrees that in-work benefits can be a powerful tool for alleviating unemployment traps, but that they need to be designed carefully in order to avoid poverty traps or excessive overall costs. It supports further reform of means-tested benefits and the individualisation of income taxation in order to remove inherent disincentives. Finally, the EETF recognises the importance for wage differentiation to reflect productivity and the sectoral and regional labour market situation.

Against this background, the 2003-05 BEPGs recommended Member States to:

4. improve the combined incentive effects of taxes and benefits and reduce high marginal effective tax rates;

5. ensure that wage bargaining systems allow wages to reflect productivity differences;

6. review labour market regulation and promote more adaptable and innovative work organisation;

7. facilitate labour mobility;

8. ensure efficient active labour market policies.

Overall, the pace of labour market reforms has become more encouraging, but it needs to accelerate further

In general, the pace of reforms on the labour market has slightly improved in 2003. Significant reforms have been adopted in several Member States, see Box 3. However, their impact is still to be seen as reforms are still in the process of being adopted and/or implemented in several Member States.

Tax/benefit reforms contribute to improving incentives, but so far they remain piecemeal and too much focused on the tax side

Improving incentives to work remains a serious challenge in most Member States. Indeed, all Member States but three (ES, IE and PT) received recommendations to address disincentives to work generated by the combined effect of taxes and benefits.

In general, measures implemented and announced in 2003 continue to be concentrated on the tax side, introducing or increasing work-related tax credits (BE, FR, IE and NL) and reducing the marginal tax rates at the lower end of the wage scale (in particular in DE, FR and IT). Others Member States, like Belgium, Austria, Denmark, and Finland, envisage further steps in this direction in the coming years. However, although the focus of measures on the tax side may be understandable from a political perspective, it is problematic as public finances are under pressure in several Member States, further limiting the room for manoeuvre.

Few steps have been taken (or announced) to reform benefit systems, which contribute most to the risk of unemployment- and inactivity traps. Eligibility criteria, duration of benefits, enforcement of job-search and availability-to-work requirements have changed only little. Nevertheless, Germany envisages important steps in this direction and is going to implement a reform of the unemployment benefit scheme in the coming months. A review of the unemployment insurance has been undertaken in the Netherlands in 2003, markedly tightening eligibility requirements. Some measures have also been undertaken in Denmark. Although Member States are increasingly developing activation measures related to the granting of welfare benefits, much more needs to be done in terms of closer interactions between passive and active labour market programmes.

Childcare provision has improved only slightly, even though it is recognised as a priority in most Member States. More efforts by Member States are needed to ensure adequate and affordable childcare for children in line with the Barcelona targets of childcare coverage.

Few concrete measures to foster wage differentiation can be noted so far

Unemployment differentials remain important across regions and skills levels. Seven Member States (DE, GR, ES, IE, IT, PT, FI) received a specific recommendation to allow for stronger wage differentiation, reflecting productivity ratios and local labour market conditions. Although discussions have started in some Member States, few concrete measures towards wage differentiation can be noted so far.

In 2003, concrete initiatives remained at early stages of discussion or were piecemeal. Wage differentiation in public sector collective agreements is being discussed in the UK. In Germany, public employers have been trying to reduce personnel costs, e.g. by negotiating working time reductions without compensating payments for overstaffed services or by cutting additional benefits for employees and officials. A relaxation of the "favourability principle" is under discussion in Germany and France, where lower-level agreements can only be more favourable than sectoral agreements. This notwithstanding, an informal trend towards more flexibility at the firm level continues while respecting the role of social partners according to national practices.

In most Member States, work organisation is becoming more adaptable, but there are only few recent initiatives to address employment protection legislation

A move towards full employment will require rapid net employment growth and high labour turnover. This needs to be supported by a flexible regulatory framework and work organisation. Excessively rigid labour market regulations discourage hiring and slow down adjustment. Country-specific recommendations were issued to Germany, Greece, Spain, and Italy to this end. Flexibility has been improved in most Member States, through e.g. enhanced rights to flexible working to improve reconciliation of work and family life. Security has also been strengthened, particularly the health and safety aspects in work organisation. However, not enough has been done to tackle employment protection legislation (EPL), or to render non standard contracts more

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attractive to employees.

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The promotion of adaptable work organisation has mostly been taken up in social dialogues at the national level. In 2003, agreements were reached on flexibility of working time (DK, NL, and SE) and modernisation of public sector work organisation (ES). Legislative reviews are planned in France, Ireland, the Netherlands, and Portugal. The UK has introduced principles to improve the quality of future regulations. France has introduced legislation to make the 35-hour week more flexible. Several Member States (e.g. IE and NL) are also looking at how to adapt to future changes in working practices, such as how best to take advantage of e working opportunities. Many countries (e.g. IE, NL, and UK) have taken measures to improve reconciliation of work and family life through increased rights to parental- and/or care leave.

Employment contracts and EPL were only addressed in a few countries in 2003. The new labour code in Portugal includes an increase in fixed-term contract duration, working hours flexibility, devices to control unjustified absenteeism and encouragement of occupational mobility. Portugal and Spain have continued efforts to reduce their high share of fixed-term contracts. In Italy, a decree on labour market reform has just entered into force. It includes new forms of 'flexible' contracts, but the EPL was not addressed. In Germany, a relaxation in the social criteria have been put forward determining which employees are laid off first in redundancies, including also a relaxation of the EPL for small firms.

Some Member States are encouraging geographical mobility, and a majority is addressing occupational mobility

Regional disparities, often with simultaneous unemployment and skills shortages, continue to point to the need to foster geographical and occupational mobility. A recommendation to eliminate barriers to geographical mobility was addressed to Spain.

Some Member States have taken measures to encourage geographical mobility. The dissemination of information on vacancies is improving through the cooperation of Member States and the use of information technology. Some Member States have introduced changes in the tax/benefit system in 2003, in order to improve incentives to mobility (DE, EL, ES, FR, and SE). Belgium and Spain have started addressing rigidities in the housing market.

Most Member States continued to take initiatives to promote lifelong learning to foster occupational mobility. Some Member States have recently adopted, or are planning to adopt, measures to facilitate the recognition of informal skills. Denmark has introduced new training measures to address foreseen shortages of skilled labour. Belgium has stepped up efforts to overcome linguistic barriers.

Individualised approaches are spreading, but the redesign of ALMPs in the light of evaluations remains exceptional

Active labour market policies (ALMPs) are an important instrument to open a path back to employment and to prevent long-term unemployment. However, they need to focus on "the right measure to the right person at the right time". Germany received a specific recommendation to increase the efficiency of ALMPs. While individualised approaches are becoming more widespread, evaluations are not systematically carried out, nor used to critically assess and redesign programmes.

Despite growing awareness of shortcomings in their efficiency following rigorous assessments, only a few Member States adapted ALMPs in 2003, or announced plans for doing so. For instance in Denmark, the former high activation target was abandoned in order to focus more strongly on job placement activities, and it is planned to streamline the tools available to the employment service. Sweden has looked at simplifying the structure of programmes. In Ireland, there has been a shift from employment schemes towards measures focusing on employability, while in the Netherlands "reintegration agencies" are paid depending on the integration results achieved.

More progress is made concerning the targeting of measures towards those hardest to place. The early identification of jobseekers' needs and, where required, a tailor-made offer of an active programme are being implemented or on the agenda in a majority of Member States. In this context, the role of job placement activities is being strengthened. Unemployed with good employment prospects are increasingly channelled to self-service facilities. In Germany, the government proposed a simplification of benefit administration. It will free additional resources for placement activities. It is also likely to enhance efficiency e.g. by removing incentives for municipalities to provide an active measure with the main goal of re-qualifying a participant for unemployment benefits. Most Member States are planning to enhance the cooperation of different actors involved in job-placement, training, and benefit administration, in some cases by bringing the different providers together in a "one stop shop".

2.2.2 Economic reforms not reflected in productivity growth figures

The economic reform effort recommended by the 2003-05 BEPGs is aimed at increasing the long-term growth potential of the EU economy. This should be seen within the context of a divergence in EU employment and productivity growth patterns in recent years. Compared with the first half of the 1990s, the period 1996-2002 witnessed a significant increase in the contribution of labour to GDP growth in the EU, but this has been partly offset by a reduction in the contribution from labour productivity. By comparison, the USA has been able to combine a strong employment performance with accelerating labour productivity growth, resulting in GDP growth that was more than a full percentage point higher than in the EU over the period 1996-2003.

The labour productivity gap has widened between the EU and the USA...

The growth rate of labour productivity per person employed in the EU slowed down from 1.9 per cent in the first half of the 1990s to 1.3 per cent in the second half. Since then, annual labour productivity growth has fluctuated between 0.5 per cent and 1 per cent, reflecting initially a greater resilience in the labour market to the economic slowdown with continued (albeit modest) employment growth. The experience in the EU was quite different from that in the US, where labour productivity growth rates have recovered to levels of 2 per cent or more. As a consequence, the productivity gap with the USA has widened, with EU productivity per hour worked being 12 per cent below that in the US. This productivity gap is now responsible for 40 per cent of the difference in GDP per capita between the EU and the USA (where the European GDP per capita amounted to 72 per cent of the level in the USA in 2003), see Graph 9.

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...but the EU average hides significant differences between Member States

Differences are wide in hourly productivity levels and growth rates between Member States (see Graph 10). Starting from a good position, hourly labour productivity continued to increase relatively rapidly in Denmark, Ireland, and France. In France this may be associated with the introduction of the 35-hour working week as labour productivity growth per person employed was below the EU average. Productivity levels in Greece and the UK continued to catch-up with the EU average. In Spain and Portugal, on the other hand, productivity fell even further behind. Drops in relative productivity levels were observed as well in Italy and the Benelux countries.

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The deterioration in EU labour productivity growth may be explained in equal parts by slow-downs in investment and technological progress...

The productivity challenge is clear, with the EU's long-established superiority in terms of labour productivity growth having disappeared since the mid 1990s. Half of the decline in labour productivity growth since the first half of the 1990s can be attributed to a reduction in the contribution from capital deepening, while the other half emanates from a deterioration in total factor productivity. Whilst investment in ICT was contributing positively, its contribution to labour productivity growth was only half of that in the United States. The main reason for this was a lesser use and slower diffusion of these technologies in certain services sectors, including in particular the financial services and distribution sectors. This illustrates the need to raise business dynamism and investment, particularly in ICT. That can only be achieved through a reform strategy aimed at improving the regulatory environment, promoting market integration and efficiency, stimulating the diffusion of ICT, and boosting investments in human capital and R&D.

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...and recent developments in business investment and spending on IT, R&D, and education are not very promising.

Due to business cycle effects, business investment as a percentage of GDP in the EU declined from 18.3 per cent in 2000 to 17.2 per cent in 2002, see Table 3. This produced a reduction in total gross fixed capital formation (from 20.6 per cent in 2000 to 19.1 per cent in 2003) in spite of the fact that public investment has been quite stable (at 2.2-2.4 per cent of GDP) over recent years. Expenditure ratios on IT, R&D, and education showed little movement. According to the Commission's economic forecast (autumn 2003), business investment should recover in 2004 and 2005, provided that the economic framework conditions that encourage businesses to invest and grow have been put in place. Recent efforts to ease the regulatory burden on business should be helpful in that respect. Spending on IT should benefit as well from regulatory reform. A cross-country analysis of investment rates [4] reveals that countries with low levels of regulation have in general been more successful in adopting new technologies in the form of ICT investment.

[4] European Commission (2003), "Drivers of productivity growth: an economy-wide and sectoral perspective", Chapter 2 in the EU Economy 2003 Review.

Despite its many successes, the Internal Market is still not functioning as it should. After years of steady progress throughout the 1990s, some key indicators of Internal Market integration are now pointing in the wrong direction. Growth in trade amongst the EU Member States has almost stalled, growing by less than 3 per cent annually over the past three years, and the dispersion of price levels between Member States in 2001 did not differ from that observed in 1998 or 1999.

Against this background, the 2003-05 BEPGs recommended Member States to:

9. foster competition in goods and services markets;

10. accelerate the integration of EU capital markets and ensure consistent enforcement of EU rules and removing barriers to efficient cross border clearing and settlement;

11. generate a supportive environment for entrepreneurship and for SMEs to start-up and grow;

12. agree on and implement measures to strengthen corporate governance and further improve arrangements at national and Community level to deliver efficient cross-sector and cross-border cooperation in financial supervision and financial crisis management;

13. take active steps to promote investment in knowledge, new technologies and innovation and make progress towards the 3 per cent of GDP objective of total R&D investment;

14. enhance the contribution of the public sector to growth.

Mixed progress in fostering competition in goods and services markets...

A regulatory environment that is conducive to investment is essential to make the EU economy more competitive and dynamic. Creating a well-functioning Internal Market with an effective competition policy is essential. Since the launch of the Lisbon Strategy more than 25 legislative measures have been adopted to extend the reforms in these areas (including the tax package aimed at curbing harmful tax competition), but a number of proposals (including directives on professional qualifications and intellectual property rights) remain pending before the Council and the European Parliament. The Commission issued new proposals for directives to eliminate further obstacles to the Internal Market found in the tax regimes applicable to associated companies located in different Member States; to further simplify and streamline VAT; and to update guidelines and financing rules for trans-European networks. It has adopted a proposal for the establishment of a legal framework for providing cross border services between Member States.

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...particularly due to a lack of implementation of measures agreed

The average rate of transposition by Member States of Internal Market directives deteriorated from 97.9 per cent in 2002 to 97.7 per cent in November 2003, putting the target of 98.5 per cent (which is already overdue) further out of reach. Only five Member States, Denmark, Spain, Ireland, Finland, and the United Kingdom actually met the agreed target, while in five other Member States - Belgium, Germany, Greece, France, and Luxembourg -the transposition rate even dropped below 97 per cent. Moreover, the number of infringement cases related to the non-conformity or incorrect application of Internal Market law declined only slightly. France and Italy have particularly bad records in this respect. Finally, the amount of cross border public procurement remains very low, even if the share of call for tenders published in the Official Journal has been rising. Germany continued to lag behind the other Member States. Nevertheless, public procurement legislation appears to have a positive effect on cross border transactions. [5]

[5] European Commission services working paper, Internal Market DG (forthcoming): A report on the functioning of public procurement markets in the EU: benefits from the application of EU directives and challenges for the future. Almost half of firms seeking a public procurement contracts did so across borders, most of them via subsidiaries located in the Member State publishing the call for tender. Moreover, the probability, that a bid was successful was similar for domestic firms and foreign subsidiaries (30 per cent and 35 per cent respectively).

Measures have been taken to improve the effectiveness of competition policies. At the Community level, the most notable step has been the adoption by the Council of the new regulation on implementing the anti-trust rules. This regulation will streamline the procedures, improve the co-ordination between competition authorities and enhance the Commission's powers of investigation. Some Member States (incl. BE, AT, and the UK) have taken action to enhance the effective independence and capabilities of their competition or regulatory authorities. The level of sectoral and ad-hoc state aid in the EU appears to have stabilised at around 0.7 per cent of GDP.

Market opening in the network industries continues to progress, but does not necessarily guarantee effective competition. Even in liberalised markets, the market share of the incumbent often remains very high. In fixed telephony, for example, its market share was 81 per cent for local calls and 70 per cent for long distance and 62 per cent for international calls in 2002. In this latter market segment, the market shares of incumbents were relatively high in Greece, Luxembourg, and Portugal. Nevertheless, prices of long distance and international calls continued to decline slowly. The new regulatory framework for electronic communications, in force at the EU level since July 2003, aims at enhancing competition and improving legal certainty.

Contrary to telecommunications prices, electricity and gas prices show no clear downward trend. Electricity prices have experienced a general increase in 2003 due to low rainfall reducing hydro-electric output and extreme weather conditions. However, even in these circumstances, prices are still no higher than pre-liberalisation levels in nominal terms and much lower in real terms. Nevertheless, in Belgium, Greece, France, and Ireland, the market share of the largest electricity generator was still at 90 per cent or above in 2001. Meanwhile, gas prices are, on average, some 10 per cent lower than January 2001. The Council adopted a number of pieces of legislation in 2003 that should contribute to the completion of market opening in these sectors. The Barcelona European Council fixed in March 2002 the target of reaching by 2005 10 per cent electricity interconnection capacity for each member state compared to the domestic installed production capacity. The progress towards this target has been very slow, as there have been only minor capacity additions in the recent years.

There was progress at Community level in liberalising rail transport. The Transport Council reached an agreement in March on the "2nd railways package", opening the international freight market by January 2006, and the cabotage market by January 2008. A further opening of the international passenger market is still being debated between the Parliament and the Council.

The RCAP is almost, but not completely implemented as the deadline approached...

As the 2003 deadline for implementation of the Risk Capital Action Plan (RCAP) approached, considerable progress can be reported. Most of the RCAP measures have been completed. Member States have also taken steps in providing an environment - in terms of administrative/legal, regulatory, and fiscal aspects - which is more conducive to developing the risk capital industry.

Several Member States have undertaken reforms which facilitate institutional investment in risk capital. They include: (i) the creation of a new category of closed-end collective investment undertakings dedicated to investment in non-quoted SMEs (BE and LU); (ii) some facilitating of the setting up or functioning of venture capital companies (ES and PT); (iii) the easing of quantitative constraints on pension funds and insurance company investments (DK and PT). Some further types of distortions have been removed (e.g. minimum funding requirements in the UK), while others may still impede institutional investment in risk capital (e.g. liquidity requirements in BE, EL and AT).

Insolvency and bankruptcy rules are being adjusted in some of the Member States (e.g. BE, FI, and the UK), with a view to minimise the disincentives to entrepreneurial risk taking, but with a varying outcome regarding the remaining level of disincentives. In other Member States, however, it appears difficult to actually finalise reforms underway (e.g. DK, IT, and the NL). Most of the Member States are making further improvements in their fiscal frameworks for risk capital investment, whether by reducing corporate tax rates (e.g. BE and DE), by reducing VAT compliance costs for SMEs (e.g. the UK), or by introducing tax relief for venture capital investment (e.g. DE, ES, FR, IT, PT, SE, and the UK). However, further progress seems necessary, most notably in reducing the often substantial differences in national fiscal frameworks that are faced by pan-EU operators.

...and good progress is made so far with the FSAP...

The end of the legislative phase of the Financial Services Action Plan (FSAP) is in sight. 36 of the 42 original measures are now finalised. Progress continues to be made on the few remaining proposals. An agreement has been struck between Council and Parliament on the text of a new take-overs directive. Following Council agreement on the investment services directive, it now remains to forge consensus with the European Parliament on a handful of substantive issues. On the transparency directive, political settlement has been reached in the Council. The EP is working on the basis of the Council text so as to ensure final adoption in the first half of 2004. 3 FSAP measures must await the reformation of the EP before the legislative process can be brought to a conclusion. Amongst these is the proposal for a new directive on capital adequacy. This is linked to the finalisation of Basel II Accord, now scheduled for mid-2004.

Alongside conclusion of the FSAP agenda, the Commission will launch work on initiatives foreseen in the Communication on company law and corporate governance (including a proposal for the modernisation of EU legislation on statutory audit). Elsewhere, the Commission will take forward work on important prudential legislation relating to reinsurance and insurance solvency.

A key adjunct to the FSAP has been the creation of structured arrangements for national regulatory and supervisory authorities to participate in the formulation and consistent implementation of EU financial legislation ("Lamfalussy" approach). This approach has been successfully road-tested in the securities sector. The Commission has recently proposed to extend this approach to the banking, insurance and UCITS fields. The increased transparency and greater collective dimension in performance of supervision is the key to more consistent and effective enforcement of financial regulation in an enlarged EU financial marketplace.

As the legislative phase of the FSAP draws to a close, the Commission has launched a comprehensive assessment of the state of integration of EU financial markets. This is not a prelude to a comprehensive new legislative programme. It is an attempt to identify successes and failures of the evolving EU legislative framework and to draw lessons from the FSAP experience. As a first step, four expert groups in the fields of banking, insurance, asset management, and securities will assess the extent to which the EU legislative framework enables financial institutions to organise their business on a pan-European basis. The output from these groups will be submitted to public scrutiny and high-level public debate before being consolidated in late 2004.

Elsewhere, a sub-group of the newly created Financial Services Committee has been tasked with establishing a shared assessment of Member States of remaining priorities for financial integration. They will report to European Finance Ministers in mid-2004.

...while the cross-border clearing and settlement is still to become more integrated

The Commission is also anxious to take forward the policy debate on the value of / need for collective EU-level action in the areas of clearing and settlement - but also for cash transfers and payment systems (the Commission has recently launched a Consultation Communication on cross-boarders payments with an end-January 2004 deadline). Integration of clearing and settlement arrangements has become a clear priority for action at both the EU and national levels. Following up on the second report of the Giovannini Group of financial market experts from April 2003, the Commission will shortly come forward with a Communication formulating a strategy for removing barriers to an integrated EU clearing and settlement system.

Restructuring and consolidation in the EU clearing and settlement infrastructure has also continued in 2003 at the national level (DE, EL, and IT). The process of consolidation and restructuring within EU stock exchanges accelerated. An integrated Nordic-Baltic market for trading, clearing and settlement of securities was created by the merger of the Stockholm and Helsinki stock exchanges, with the merged entity maintaining a strategic co-operation with the Copenhagen, Oslo and Iceland stock exchanges within NOREX. Italy's MTS continued to expand internationally, providing a widely accepted infrastructure for bond trading. In 2003, Euronext (comprising the Belgian, French, Netherlands and Portuguese stock exchanges together with the UK-based Liffe derivatives market) expanded further via an agreement with the Warsaw stock exchange.

In spite of recent improvements, the business environment in the EU continues to be hampered by some weaknesses

Businesses' perceptions of the administrative burden in 2003 remained quite negative in many Member States and particularly so in Belgium, Germany, France and the Netherlands. [6] Also, the percentage of 18-64 year-olds involved in entrepreneurial activity remains below that in the United States. According to this measure, entrepreneurial activity is particularly weak in Belgium and France. The rate of enterprise creation is relatively low in Belgium, Finland, and Sweden (see Graph 11).

[6] European Commission (2003): survey reported in the Enterprise Policy Scoreboard 2003, ENSR (European Network for SME

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Research).

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Differences in entrepreneurship between countries may be explained by many factors. An often-mentioned factor is ease of access to finance. The most commonly used indicators of access to finance - equity finance, venture capital and initial public offerings - tend to be strongly influenced by the business cycle. Venture capital, in particular, has suffered greatly from the slowdown in economic growth. In spite of the different measures taken to encourage investment in risk capital (see Section on the RCAP), early-stage venture capital investment levels in 2002 were only half or less of their 2000 levels in many Member States. Greece, Finland, and Sweden were exceptions. Moreover, investment shifted from the seed segment to more mature investments.

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However, many other business framework conditions have shown a gradual improvement (time and costs of setting up a company, internet penetration, e-government, corporate tax system, etc.), and progress towards meeting the recommendations of the European Charter for Small Enterprises is encouraging. Several Member States have taken or implemented new measures aimed at reducing red tape and easing business start-ups (notably BE, DE, EL, ES, FR, LU, and AT). In addition, governments are increasingly turning their attention to shaping tomorrow's entrepreneurs and have stepped up efforts to develop entrepreneurial skills in education. Member States with programmes that support the teaching of entrepreneurial skills in primary schools now include Ireland, Luxembourg, Finland, Sweden, and the UK.

Investment in knowledge and innovation is lagging, even if...

There remains a substantial gap between the EU and the USA in terms of innovative capacity as measured by the availability of venture capital, R&D intensity, the number of patent applications and IT expenditures (see Graph 12). Nevertheless, the formation of the European Research Area will create an internal market for research which should contribute to achieving the Lisbon Strategy Goals. Moreover, Member States have unanimously endorsed the Barcelona target of increasing investment in R&D to approach 3 per cent of GDP by 2010, and a vast majority of them have defined national targets. In April 2003, the Commission put forward an Action Plan aimed at achieving the Barcelona target, taking into account that two thirds of the additional investment is supposed to be financed by the private sector; this in light of the fact that the bulk of the R&D gap, and most of its increase in recent years, is due to lower funding by the private sector. In Sweden and Finland, however, R&D expenditures as a percentage of GDP are above that in the USA and rising rapidly. Greece, Ireland, the Netherlands, and the UK, on the other hand, have witnessed a decline in R&D spending as a percentage of GDP in recent years. Even more worrying is the observation that companies in certain high-technology and research-intensive sectors such as pharmaceuticals or biotechnology are conducting a growing share of their research outside Europe, especially in the US, in order to take advantage of more favourable regulatory or other framework conditions. Still pending decisions on intellectual property rights, including a legally secure and affordable Community patent are just an example of what appears to be missing.

All Member States have decided to take an active part in applying the open method of coordination in support of the Barcelona targets. Various measures have been taken to stimulate R&D and innovation. For example, Belgium, Portugal, and the UK have extended tax credits for R&D and innovation expenditures and Ireland has introduced them in the budget for 2004; Belgium, Germany, Ireland, and Italy have opened up new sources of funding for R&D and innovation; Ireland and the Netherlands have taken measures to improve the cooperation between research and business; Greece is supporting university spin-offs; and Denmark and the Netherlands are making an effort to raise the number of university graduates in science and technology.

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...the development and use of key technologies in Europe is progressing

The fact that there are large differences between the research efforts of EU Member States may not be a problem as such, as long as the results of the R&D efforts are spread widely and knowledge is transferred into innovation across Europe. Knowledge diffusion is as important an element of the EU innovative capacity as is investment in research and development. Studies indicate that only 15 per cent of knowledge is gathered outside the region of origin and only 9 per cent outside the country of origin in North America and Western Europe. In its Action Plan "Investing in research" the Commission supported public-private partnerships and introduced the concept of European Technology Platforms, which are aimed at furthering the development and use of key technologies in Europe through improved science-industry links. In addition, the Commission intends to propose a directive permitting entry and stay of third country researchers, which should help facilitate researcher mobility.

Deployment of the Galileo satellite navigation system is now planned for 2006-2007 with a start of operations in 2008. The Galileo joint undertaking has started operation in June 2003 and international commercial interest has fully consolidated it as a global project. Moreover, the eEurope Action Plan has been instrumental in raising Internet access and use. The percentage of EU households with internet access at home rose to 50 per cent in 2003. In addition, 84 per cent of enterprises with more than 9 employees had internet access in 2003, which was a five percentage point increase over the previous year. In comparison with the year before, the broadband internet access rate per 100 EU inhabitants in October 2003 almost doubled to 5.2 per cent, but this was still less than the level reached by the US (8.1 per cent) in July 2003. The highest broadband access rates in the EU can be found in Denmark (11.2 per cent), Belgium (11.1 per cent), the Netherlands (10.1 per cent) and Sweden (9.0 per cent).

Corporate governance strengthened at national and at community level...

A series of high-profile corporate scandals in both the United States and Europe undermined investor confidence in the integrity of financial markets. It focused the attention of policymakers on the need to reinforce existing corporate governance arrangements. The Commission presented two Communications on company law and corporate governance in May 2003. These Communications provide an Action Plan, comprising a balanced mix of legislative and non-legislative initiatives and combining harmonisation of a few essential rules with closer co-ordination between national codes.

Several Member States have proceeded with strengthening corporate governance arrangements at the national level also, either by establishing a voluntary self-regulatory corporate governance code (e.g. AT and the UK), by introducing in company laws measures to improve corporate governance (e.g. EL, IE, IT, and NL), or by strengthening auditors' independence (e.g. FR).

...and financial supervision strengthened

In September 2003, the Ecofin Council reviewed the implementation on financial supervision and on financial crisis management. The Council concluded that further progress has been made in improving the institutional arrangements for cross-border supervision, notably through enhanced procedures for information exchange. A further review will be carried out in September 2004. Meanwhile, the extension of the Lamfalussy arrangements should further encourage cross-border co-operation in financial supervision and crisis management, as well as facilitating convergence in supervisory practices between the Member States.

At the national level, several Member States carried on the restructuring of supervisory structures in 2003. In France, supervisory authorities for securities have finally been regrouped, insurance and banking authorities have been streamlined, and the law on financial safety has been modernised. In other Member States, reforms of the national regulatory and supervisory authorities included various measures. They include the establishment of new supervisory boards for the integrated institutions (BE), the transfer of capital market regulatory authority from the exchanges and the Ministry of Economy and Finance to the supervisory authority: Hellenic Capital Market Commission (EL), legislation affording the Government emergency powers to regulate the financial sector in exceptional circumstances (FI), regulatory measures to strengthen financial supervision of the insurance industry (PT), consolidating financial regulation into a uniform cross-sector law for financial services (DK), and adjusting the legislation to the new functional approach of supervision (NL).

Member States are making an effort to improve the quality and efficiency of their education and training systems

There are clear signs of efforts to improve quality and efficiency in education and training in several countries (e.g. BE, DK, ES, IT, PT, FI and SE). In Spain, for example, a basic law on the quality of education has been adopted, while in Sweden a new vocational training system has been put into place. While some Member States are concentrating on in-company lifelong learning, others are more focused on improving basic skills and second chance schemes for adult education. Nevertheless, the lack of quality and attractiveness of vocational training remains a serious cause for concern. Moreover, there is a risk of a serious shortage of teachers and a need for an increase in the supply of scientists, technicians, engineers and business graduates. Finally, the level of private funding of higher education is only a small fraction of the level attained in the US. To address these problems, the Commission proposes a series of measures that are described in its November 2003 Communication entitled "Education and training 2010, the success of the Lisbon strategy hinges on urgent reforms".

Initiatives have been taken to enhance the contribution of the public sector to growth

The European initiative for growth, which was launched in October 2003 and endorsed by the European Council in December, aims to mobilise public and private funds to finance certain infrastructure and R&D projects that have a truly European scale. The Council reached a political agreement that up to 20 per cent of the trans-frontier infrastructure projects' costs could come from the EU budget. Despite the economic slowdown, public investment expenditures have been stable around 2.3 per cent of GDP. However, differences are noticeable across Member States, where the investment ratios vary from around 1½ per cent of GDP (in BE, DK, DE, AT and the UK) to 3 per cent or more (in EL, ES, FR, IE, LU, NL, PT, and SE). In general, public expenditures on education as a share of GDP declined slightly in recent years, in part due to demographic factors, while public spending on R&D has been stable around 0.7 per cent of GDP. Member States have taken various measures to encourage the development of public-private partnerships, the adoption of new technologies in government and competition in public procurement, particularly through an increased use of ICT tools. In addition, statutory corporate tax rates have been sharply reduced in many Member States over the past couple of years, accompanied by measures that broadened the tax base leading to less dispersion in the tax burden on corporations between Member States.

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Another way of strengthening the contribution of the public sector to growth is through redirecting spending towards growth-enhancing cost-effective investments in physical and human capital. As a share of total public expenditure, public investment is expected to increase modestly by 0.3 percentage points in the EU in 2003. More marked increases can be noted for Spain, Italy [7] and the UK, while the share is expected to decline by 0.6 percentage points or more in Ireland [8] and Finland. The expected increase in the share of the EU's public spending on investments is a positive step towards improving its growth capacity and securing "value for tax payers' money". Not least, since interest payments are expected to increase in some Member States as a consequence of the deterioration of budgetary positions (in e.g. DE and FR) thereby crowding out other expenditures.

[7] The increase in public investments in Italy is mostly an accounting effect, resulting from the marked decrease in sales of public-owned real assets compared to the previous year.

[8] Despite the recent reduction, Irish public investment still corresponded to around 4 per cent of GDP in 2003, thereby remaining one of the highest investment ratios in the EU.

Social transfers will continue to represent by far the largest share of public expenditure in the EU (see Table 4). However, levels and developments differ across Member States (where they are likely to increase by more than 1 percentage point in BE, NL, PT and SE, while they will decline in the UK by almost as much).

Although additional steps have been taken, enforcement of budgetary rules and procedures could be enhanced at the national level

In 2003 Member States continued to apply national budgetary rules and procedures in order to improve efficiency and control. However, as shown by the Commission Report "Public Finances in EMU - 2003" there are large variations in the kind of fiscal rules adopted and implemented across EU Member States. All countries have targets for the upcoming and subsequent years in so-called multi-annual budget plans. Some Member States target the budget balance, while others set expenditure limits. Nevertheless, the deterioration of budgetary positions in respect to targets indicates that the enforcement of the rules in many cases is weak. The mechanism to control public spending at sub-national level also remains a key issue for some Member States.

A number of Member States have recently improved the budgetary process somewhat. In Spain the General Law on Budgetary Stability, which came into force in 2003, requires that all the general government sub-sectors should show a surplus or balanced budget in nominal terms every year. In Portugal the Budgetary Stability Law, which is effective from 2003, sets more stringent, although temporary limits to net borrowing across all levels of general government. Austria adopted this year a budget law which implies a cut in the ministries' budgetary envelops by 5 per cent across-the board compared with the budget 2002. Also, Finland has reformed its spending limits. A multi-annual budget plan covering the election period has been introduced. The spending limits cover ¾ of the central government's budget expenditure, including supplementary budgets. Budgetary items sensitive to the business cycle and interest payments on the general government debt are, however, excluded.

Full assessment of efficiency in public sector not yet possible

The composition of public expenditure does not change much from one year to another. In particular, it takes time for public consumption to adapt to new legislation, changes in the demographic structure of the population, or changes in welfare functions. For this reason, it is difficult to assess progress in the composition of public spending. In addition, the lack of timely and comprehensive data hampers a thorough assessment of the quality of public expenditure. Moreover, the impact of public expenditure on economic and social goals is difficult to assess. Expenditure efficiency relates to the links between inputs (mainly money, but not solely) and output. A proper assessment would require better information, notably on measures of the input (policies and expenditure) and output (objectives met), and a detailed microeconomic assessment of specific policies.

National fiscal rules can also contribute to enhance the quality of public spending and to the compliance with the EU fiscal framework. Again, a proper evaluation requires a longer observations period. Nevertheless, in many cases it would be useful to strengthen the enforcement mechanisms: experiences with fiscal policy rules in different countries indicate that, without an effective enforcement and sanction system, rules often turn out to be ineffective in term of ex-post outcome.

2.3 Strengthening sustainability

2.3.1 Economic sustainability: ensuring the long-run sustainability of public finances

Since 2000, the average public debt ratio in the EU has not declined

The sustainability of public finances in view of the ageing population is far from secured in about half of the Member States (notably BE, DE, EL, ES, FR, IT, and PT) [9]. As a whole, the average government debt to GDP ratio in the EU has not declined between 2000 and 2003 and thus remains at 64.1 per cent of GDP (70.4 per cent of GDP in the euro area). However, the situation differs substantially across Member States (see Graph 14). The debt ratio declined in most Member States during the period 2000-2003, in particular in Belgium, Greece, and Spain, while it rose in Germany, France, and Portugal. Despite recent improvements, the debt ratios continue to be above 60 per cent in six Member States (BE, DE, EL, FR, IT and AT), where it is very high or above 100 per cent of GDP in Belgium, Greece, and Italy.

[9] This is based on the sustainability assessment of the 2003 updated programmes, except for Germany and Spain where the assessments should be considered as provisional since they are still ongoing.

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Both the size and age structure of the EU's population will undergo dramatic changes over the coming decades. Its working-age population is projected to decline very significantly, from 243 million in 2000 to 203 million in 2050, a drop of 40 million persons or 18 per cent. At the same time, the population of older persons above 65 years will increase by 40 million persons to 103 million in 2050, an increase of over 60 per cent.

The demographic developments have a significant impact on two important elements. First, most Member States project the long-term rate of economic growth to be lower than 2 per cent, also due to the contraction of the number of active people. Second, there will be a pressure for higher public expenditure due to ageing population over the next 15 to 20 years.

Against this background, the 2003-05 BEPGs recommended Member States to:

15. ensure a further decline in government debt ratios;

16. design, introduce and effectively implement reforms of pension systems.

A stronger commitment to reduce debt ratios needed in several Member States

The Commission's economic forecast (autumn 2003) show that the debt ratio declined in most Member States in 2003. Six Member States, namely Belgium, Germany, Greece, France, Italy and Austria, are expected to have a debt ratio above 60 per cent of GDP in 2003 and 2004. The debt ratio is expected to continue to decline in Belgium, Greece, and Austria, to stabilise in Italy, while it continues to increase in Germany and France in the coming two years.

There would appear to be a need for stronger commitment to reduce debt ratios in several Member States, not least those with very high government debt ratios. The current trends do not show a satisfactory rate of reduction that could bring debt ratios below the 60 per cent of GDP reference value before the full impact of ageing takes place in 15 to 20 years. In addition, the unfavourable development noted in some Member States where debt ratios are raising in recent years is a source of concern.

The pace of pension reform has accelerated in the EU and important pension reform measures have been adopted in some Member States

Eight Member States received country specific recommendations concerning the reform of their pension systems (BE, DE, EL, ES, FR, IT, AT, and PT). Significant progress has been made in several Member States. France and Austria adopted major reforms in 2003 that are an important step towards securing more sustainable pension systems. Germany and Portugal introduced some changes aiming at improving the financial balance of their public pension schemes and facilitating the development of supplementary private pension schemes. Greece put in place the operational reorganisation of social security funds enacted in 2002. In Germany the public debate has continued on the basis of a report of the 'Commission for Sustainability in Financing the German Social Insurance System', and the Italian government tabled a reform proposal.

Some progress towards tackling the budgetary consequences of ageing populations on public pension schemes

France enacted a gradual increase in the number of contribution years entitling to a full pension and modified the indexation mechanism from wages to consumer prices to tackle budgetary consequences. Moreover, private sector employees will have to pay higher social contributions, compensated by a symmetric decrease in unemployment contributions. Austria has enacted the gradual extension of the reference period for calculating pension benefits and will also gradually lower the yearly accumulation rate for pension rights. Portugal extended the contribution period, increased the basic pension calculation period, and linked the benefits growth to the rate of growth of wages net of contributions. According to the Italian government's proposal, eligibility conditions are to be tightened and the minimum retirement age is to be increased.

Both France and Germany have initiated reforms that address demographic risks. France has implemented a rule linking the contribution period required for entitlement to a full pension to the increase in life expectancy. In Germany , the gradual raising of the retirement age and the link between benefits and the system dependency ratio through an indexation rule have been proposed.

Reforms address interaction of pension systems with labour market performance

More transparency and better incentives to take up work have been sought in several Member States to improve the interaction between the pension system and labour market performance in several respects. As part of efforts to strengthen the link between contributions and entitlements, the Austrian government intends to harmonise all pension insurance systems and establish an integrated uniform pension system: it is also considering establishing individual retirement accounts. In Italy, the government plans to reduce the contribution rate to the public pension scheme for newly hired employees. Greece proceeds with moves towards a uniform social security system with the single managing body, where uniform terms, conditions of entitlement and method of pension calculation for all wage-earners is going to be introduced.

Raising the employment rates of older workers will require removing incentives to withdraw early from the labour market and providing incentives to prolong working lives. In Austria, early retirement schemes will be gradually abolished. Both French and Austrian reforms have strengthened financial incentives for the employees to remain active after having obtained the right to retire. In France, incentives have been offered to the employers to hire elderly workers as well as to discourage employers from dismissing them or obliging them to retire. The French reform made it easier to receive both a pension and a supplementary income from employment. An increase in the statutory retirement age has been proposed in Germany, while the Italian and Portuguese governments have proposed methods to calculate seniority pensions which penalise early retirees.

But more analysis required on long-term impact of the reforms

The long-term impact of reforms, including the financial impact, depends notably on the length of the transition periods, which are necessary in order to ensure a smooth adjustment process and in view of the legitimate expectations of people planning for their own retirement. The downside of this is that, as in the case of the Austrian and French reforms, a long time will be needed before they produce a full positive impact on public finances and labour market performance. Lower benefits from public pension schemes imply a rebalancing between different pillars of the pension system. A key consideration in this context is whether an appropriate fiscal and regulatory regime has been put in place to develop supplementary retirement schemes through occupational pension schemes and/or third pillar schemes so that citizens have alternative means to save for retirement income. Italy, Germany, and Austria have proposed to establish or further develop private, fully funded schemes. The proposed changes deserve a more thorough analysis.

2.3.2 Social sustainability: Contributing to economic and social cohesion

The lack of up-to-date data continues to hamper the assessment of progress in improving social sustainability. The weakened labour market situation lately is a source of concern as regards social sustainability, since jobs play an important role in lifting people out of poverty and social exclusion. While the long-term unemployment rate continued to decline in 2002 (to 3.0 per cent down from 3.5 per cent in 2000), more recent developments are likely to have been less promising as e.g. the overall unemployment rate started to increase. For instance, the share of jobless households has not declined in 2002 (unchanged at 12.2 per cent).

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Against this background, the 2003-05 BEPGs recommended Member States to:

17. take steps to modernise social protection systems and to fight poverty and exclusion with a view to supporting the broad Lisbon objectives;

18. improve the functioning of markets so that they are conducive to private investment in regions lagging behind, particularly by allowing wages to reflect productivity differences;

19. ensure that public support in regions lagging behind is focused on investment in human and knowledge capital, as well as adequate infrastructure, and that investment programmes are designed and administered efficiently.

Increased efforts needed in modernising the social protection system

Efforts concentrate more on the tax side than on benefit reforms. In 2003, only Denmark, Germany, France, the Netherlands, and the United Kingdom appear to have taken further steps to reform benefit systems (see also the follow-up to Guideline 4). Several Member States introduced measures to facilitate the access to the labour market of those at a disadvantage. Promoting their employment opportunities is key to social inclusion. Thus, recruitment incentives targeting disabled persons are being introduced in Belgium and increased in Austria, while Denmark targets newly qualified disabled. New financial incentives to encourage people with disabilities to seek and take up work and to make work attractive are also implemented in Ireland and the UK. Newly introduced employment subsidies target the long-term unemployed (in the NL, FR and the eastern Länder in DE), the disabled (FR and the eastern Länder) or the unskilled youth (the eastern Länder).

With no major initiative to enhance wage differentiation, regional differences in unemployment remain wide

In spite of significant employment growth in the second half of the 1990s, in particular in lagging regions, regional differences in both employment and unemployment rates remain substantial. High unemployment is generally concentrated in poorer regions, with a low GDP per capita. While unemployment rates were below 3 per cent in 27 regions in 2002 mostly in the Netherlands and the UK, they exceeded 20 per cent in ten regions in the south of Spain and Italy and the French overseas territories. Regional differences remain wide within some Member States, e.g. in Italy where the difference between the highest unemployment rate (in Calabria) and the lowest (in Trentino-Alto Adige) exceeds 21 percentage points.

Such differences in unemployment point to the need for additional policy steps, in particular with a view to enhancing human capital investments in disadvantaged regions and wage differentiation. In 2003, no major comprehensive initiative has been taken in the Member States most concerned to allow wages to reflect differences in skills and in local labour market conditions (see also the follow up to Guideline 5 on wage differentiation). Nevertheless, wage differentiation under the form of performance-related pay is gaining ground. Elements of flexibility based on company/sector situation are either possible in e.g. Spain (in the interconfederal agreement for 2003) or due for discussion in Germany and France where a relaxation of the "favourability principle" (by which lower level agreements can only be more favourable than sectoral ones) is being considered.

Measures taken to ensure efficiency of investments made

The lack of timely and sufficiently disaggregated data hampers a thorough assessment of the types of investments that are the focus of public support. In three cohesion countries (ES, IE, and PT) data on national public structural support in lagging regions are available from the ex-post and mid-term additionality assessments for 1994/1999 and 2000/2002. There is some evidence of an increased emphasis on human resources, in particular on qualifications related to RTD, where their shares in national public spending have increased in 2000/2002. The importance of infrastructure has declined somewhat, but still represents a major share of structural public spending.

The Commission has recently taken steps to increase the efficiency of investment programmes supported by the EU. The management of the 2000-2006 structural funds programmes will be simplified and made more flexible. As a result of the mid-term evaluation which is due to take place in 2004, the Commission and the Member States will decide to reallocate resources from ineffective measures to more effective measures, with a view to increasing their contribution to Lisbon objectives, notably investment into knowledge and innovation. The achievement of the targets on effectiveness, management, and financial implementation, which are set out in each programme, will also be assessed before 31 March 2004. The results will be decisive for the allocation of the performance reserve (that was introduced in 2000). Cooperation with the EIB has also been enhanced, notably to strike an adequate balance between loans and grants co-financing. The Bank has stepped up its advisory work on the appraisal of the technical and economic soundness of a number of ERDF, Cohesion fund and Ispa projects. From 2000, a hundred projects have been reviewed.

2.3.3 Environmental sustainability: promoting efficient management of natural resources

Maintaining a high level of environmental quality is not only an end in itself but may have wider benefits

Reforms such as removing subsidies and introducing taxes and charges that internalise external costs of pollution not only yield environmental benefits, they also enhance the effects of structural reforms in other areas by helping to "get prices right". This is particularly so if revenue from environmentally-motivated reforms is used to reduce other, distortionary taxes. Alternatively, although revenue raising is not the primary purpose of these measures, they can contribute towards fiscal consolidation, or the provision of other public goods.

Against this background, the 2003-05 BEPGs recommended Member States to:

20. reduce sectoral subsidies, tax exemptions and other incentives that have a negative environmental impact and are harmful for sustainable development. Ensure, inter alia through the use of taxes and charges, that pricing of the extraction, the use and, if applicable, the discharge of natural resources, such as water, adequately reflects their scarcity and all resulting environmental damage;

21. reduce subsidies to non-renewable energy and promote market instruments, further broaden the coverage, and ensure appropriate differentiation of energy taxation;

22. adjust the system of transport taxes, charges and subsidies to better reflect environmental damage and social costs due to transport, and increase competition in transport modes;

23. renew efforts to meet commitments under the Kyoto protocol and implement the EC greenhouse gas emissions trading scheme and set up systems to report on those policies and measures and their prospective effects on emissions. Take measures to reach the targets set by subsequent European Councils, notably on energy efficiency, renewable energy and bio fuels.

Progress towards environmental sustainability in 2003 was disappointing

Given the economic slowdown, more attention was paid to boosting growth in the short-term rather than to securing medium- and longer-term sustainability. However, some events served as reminders of the need for action in this area. Whether or not it can be attributed to human-induced climate change, the long hot summer of 2003 stretched electricity supplies to capacity. This, together with (unrelated) power cuts in some Member States, stresses the importance of removing distortions in energy prices and ensuring that all actors - generators, suppliers and consumers - face appropriate incentives.

The Council adopted a number of pieces of legislation in 2003 that should contribute to this: directives concerning common rules for the electricity and gas markets aimed at making these markets competitive, secure, and environmentally sustainable, and a regulation setting fair rules for cross-border electricity exchanges. The latter has been complemented by a decision of EU electricity regulators to make no additional charges for cross-border electricity transactions in the internal market. The Council also adopted the directive restructuring the Community framework for taxing energy products. Although this will have little effect on energy prices in the short run, the directive will have a more substantial impact over time, in particular in the new Member States. It extends the Community framework to include the use of coal and natural gas as heating fuels, so that the Community is moving towards a framework that could enable appropriate differentiation of energy taxation.

At Member State level, there have been a number of changes relating to support for different energy sources. 2003 has been the year for the implementation of the directive on electricity from renewable energy sources. Results in terms of generation of green electricity are far from impressive except for wind energy mainly in three Member States: Germany, Spain and Denmark (23 GW were installed in Europe at the end of 2002). Although it is premature to make a detailed analysis, it is already clear that the Community target of 22 per cent electricity share from renewable energies in 2010 will not be achieved unless Member States take additional action. The Commission will report to the Council and to the European Parliament in May 2004 assessing to what extent Member States have made progress towards their national indicative targets and consistency with the 22 per cent Community target of renewable electricity contribution to the European gross electricity consumption in 2010.

Belgium (Wallonia) and Sweden introduced "green certificates", requiring electricity suppliers to source a minimum percentage of their output from renewable energy sources. Sweden also continued its policy of switching taxation from labour to pollution. The Netherlands now uses its tax on electricity from renewable sources to fund differentiated feed-in tariffs for these energies. While Germany reduced the overall level of state aid to the coal industry, operating aid was increased.

Congestion charges in London led to marked changes in behaviour

In the area of transport pricing, Austria plans to introduce a kilometre-based charge for commercial vehicles from 2004; delays in the start of a similar scheme in Germany highlight the importance of ensuring that transport charging schemes will work in practice and do not entail excessive transaction costs. In the United Kingdom, London launched a congestion charge in February 2003. This scheme has been highly successful in terms of its objective of reducing traffic congestion, without giving rise to significant negative side-effects, while it has yielded significantly less revenue than expected. Other cities, such as Rome, Bristol or Edinburgh, have been experimenting with road pricing in order to reduce car traffic in city centres. Some of these schemes are still at a preliminary stage; however, the automated control system in place in Rome since 2001 has already restricted access to the historic city centre. One may tentatively conclude that changes in urban transport prices can lead to greater changes in behaviour than is generally believed, which has as a consequence that one should not necessarily look to transport charging schemes as major revenue sources.

There was progress at Community level in liberalising rail transport. The Transport Council reached an agreement in March on the "2nd railways package", opening the international freight market by January 2006, and the cabotage market by January 2008. A further opening of the international passenger market is still being debated between the Parliament and the Council. At Member State level, the existing legislation (the first rail legislative "package" introducing competition to the market for international freight services) has been implemented slowly and/or ineffectively, discouraging private investment in the sector.

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Greenhouse gas emissions are rising - not falling in the EU

As regards climate change, the European Environment Agency reported that EU greenhouse gas emissions rose in 2001 for the second year in succession, moving the Union away from its target under the Kyoto Protocol, despite the slowdown in economic growth. Indeed, only five Member States (DE, FR, LU, SE and the UK) are currently on track or close to their specific targets, while ten Member States are well above their target paths (ES, IE, AT and PT are 15 percentage points or more off track), see Graph 16.

All Member States are preparing to implement the EU emissions trading scheme, which became law in October. However, projections by Member States show that even with this and other existing and planned policies and measures, most will not reach their targets unless they aim higher. This points to the need for additional action on their part, for example by setting more ambitious objectives for the sectors covered by the emissions trading scheme in their forthcoming national allocation plans, or by introducing cost-effective measures to tackle emissions in sectors outside the scheme. Several Member States have already decided or declared their intention to use the flexible mechanism of the Kyoto protocol in addition to domestic and European policies and measure to achieve their targets. Still only a few have explicitly foreseen the budgetary resources to be used to this end.

As regards compliance with legal reporting requirements and the evaluation of actual and projected progress, some Member States were several months late with the submission of inventory data, others did not deliver all the data required or the required level of detail (by gas and by sector) for their inventories as well as for their projections (in particular Germany, Greece, Italy, Luxembourg, the Netherlands, Portugal and Spain). Additional efforts will be required by all Member States to improve the situation.

3. Euro area specific challenges.

In 2003 the euro area recorded subdued growth for the third year in a row.

For a third consecutive year, economic performance disappointed. Average GDP growth declined gradually to a mere 0.4 per cent in 2003, the rate of unemployment increased by about half a percentage point to 8.9 per cent, while public finances deteriorated further. At the same time, inflation came down only sluggishly, fluctuating around 2 per cent in the course of 2003. However, survey indicators paint an increasingly optimistic picture and the recovery is likely to gain pace in 2004.

Against this background, the 2003-05 BEPGs recommended policy actors at national level to:

24. Contribute to a policy-mix that is compatible with price stability;

25. maintain budgetary positions of close to balance or in surplus throughout the economic cycle in cyclically-adjusted terms, and if needed, take all the necessary measures to ensure an annual improvement of at least 0.5 per cent of GDP. Countries with excessive deficits need to correct them;

26. analyse the causes of inflation differences to identify instances when they are undesirable;

27. deepen the analysis of economic developments and policy requirements, focus more on implementation, and strengthen the external representation of the euro area;

28. improve the efficiency of the existing co-ordination procedures in the area of structural reforms.

Policy mix appears supportive to growth

Macroeconomic policy was accommodative in 2003. The ECB cut interest rates two times in 2003, by a cumulative 75 basis points to a level of 2 per cent for the minimum bid rate. When assessed against the so-called Taylor rule [10], short-term interest rates have been accommodative to economic activity during the slowdown. The fiscal policy in the euro area was broadly neutral as the cyclically-adjusted primary balance remained unchanged. However, it can not be excluded that the public debate on the sustainability of public finances and an apparent reduced resolve to abide by the SGP has weighed on consumer confidence. The strong co-movement of the households' savings ratio with the budget deficit would appear to be a clear indication of that, and rising public consumption in the euro area went alongside weaker private spending. During 2003, the euro exchange rate appreciated by 8 per cent in nominal effective terms. This contributed to some losses in market shares of euro-area exporters on the world market, while the positive disinflationary impulse has not yet visibly fed through to consumer price inflation.

[10] According to the so-called Taylor rule, the appropriate short-term interest rate is conditional on two variables, the actual rate of inflation and the size of the output gap. Any deviation of both variables from their target value should lead to adjustments of the short-term interest rate according to the weights of both variables in the Taylor rule.

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Implementation of the guideline on fiscal policies is worrisome

In recent years the fiscal position in the euro area has deteriorated. The annual nominal budget deficit has increased by 3 percentage points of GDP since 2000 [11] to a deficit of -2.8 per cent of GDP in 2003. The working of the automatic stabilisers explains most of this development. Another part of the slippage results from discretionary deficit-increasing measures. Overall, the cyclically-adjusted budget balance worsened by 0.4 percentage points between 2000 and 2003.

[11] The euro area net lending figure included one-off proceeds for telephone licences (UMTS) of 1.1 per cent of GDP in 2000.

According to the Commission's economic forecast (autumn 2003) three of the four euro area Member States that had a cyclically-adjusted budget position of close to balance or in surplus in 2002, namely Belgium, Spain, and Finland, managed to maintain those in 2003 and will continue to do so in 2004. In view of the national budgets and on the assumption of unchanged polices in 2005, Ireland and Austria could achieve a sound position by 2005. However as regards Austria, it now appears unlikely that the forthcoming tax cuts (amounting to 1 per cent of GDP) will be accompanied by corresponding expenditure restraints, thereby causing the cyclically-adjusted balance to deteriorate considerably in 2005.

Among those euro area Member States that had not reached the above mentioned objective, only Ireland, the Netherlands, and Portugal are expected to have improved their cyclically-adjusted budget balance by at least 0.5 per cent of GDP in 2003. In 2004, France and the Netherlands would, according to the forecast, be able to comply with this Guideline. Although a certain improvement in the cyclically-adjusted deficit is expected for Germany, it would, just as the remaining Member States (EL, IT, LU, and PT), not achieve the required improvement in 2004. However, on the basis of the no-policy-change assumption, the cyclically-adjusted budgetary positions in Greece, Italy, Luxembourg and Portugal would seem to sharply deteriorate in 2004 and/or 2005. This clearly indicates the need for further policy measures in 2004.

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The three countries in an excessive deficit situation are having difficulties correcting it. Both Germany and Portugal have made considerable efforts in response to the recommendation to bring this situation to an end. According to the forecasts and following substantial one-off measures, the nominal deficit in Portugal is expected to stay below 3 per cent of GDP in 2003, but risks exceeding the limit again in 2004. In the German case, measures amounting to about 1 per cent of GDP have been taken in 2003, thereby fulfilling that part of the Council recommendation of January 2003. However, given the adverse cyclical conditions the measures taken appear inadequate in order to bring the excessive deficit situation to an end in 2004. France does not appear to have taken effective action to redress the budgetary imbalances, and given the current economic outlook, the excessive deficit situation is likely to persist with a continuation of a deficit well above 3 per cent of GDP in 2004.

In view of the developments outlined above, the Commission adopted recommendations to Germany and France in accordance with Treaty Articles 104 (8) and 104 (9) that no effective action has been taken (FR) or was inadequate (DE), and that both Member States should take measures to remedy the excessive deficit situation. However, in light of the weak economy, the Commission recommended to allow both Member States one additional year to bring down the deficit below 3 per cent of GDP, i.e. by 2005. On 25 November 2003, the Council rejected the Commission's recommendations and found an agreement outside the Treaty, de facto suspending its application for these articles. The Council took note of the commitments made by Germany and France to reduce their deficits to below 3 per cent of GDP by 2005.

Inflation differences remain wide

Over the first three quarters of 2003, inflation differences in the euro area, as measured by the difference between the Member State with the highest and the one with the lowest HICP inflation rates or by the unweighted standard deviation, have narrowed slightly compared to the situation last year, but they remain wider compared to the first year of EMU.

At the euro area level, the extent of inflation dispersion observed since the introduction of the euro does not appear to be significantly higher than that of other monetary unions. It is roughly comparable to that of cities in the USA, while it is somewhat above that of regions in the USA or that within some Member States. From a historical perspective, the inflation dispersion in the euro area seems low. The sui generis (or special) character of the euro area and the relatively short experience with it, however, call for a degree of caution in interpreting results from such comparisons.

Graph 20: Inflation differences and dispersion, euro area

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At the national level, it should be noted that since the start of Stage Three of EMU, some countries have registered persistent differentials relative to the euro area average, particularly in the main sectors that make up core inflation (HICP excluding energy and unprocessed food). On the one hand, inflation differences can be considered a normal adjustment mechanism in a monetary union. Given that, by definition, the nominal exchange rate instrument is no longer available for national purposes, required national adjustments in a monetary union fall on relative price and wage movements. On the other hand, the persistence of inflation differentials could indicate that structural rigidities are impeding a smooth adjustment, requiring policy action at the national level to prevent an unwarranted deterioration in competitiveness. The fact that the single monetary policy is geared to safeguarding price stability for the euro area as a whole, and hence cannot address country specific inflation differentials, underscores the importance of continuing with structural reforms. They raise growth potential, safeguard long-term competitiveness at the national level, and will also increase the flexibility of national economies thereby easing the adjustment process to common or country specific shocks and reducing the scope for protracted inflation differentials. However, it should be recognised that in the short-term, differences in the speed and magnitude of implementation of structural reforms may temporarily accentuate inflation dispersion among Member States.

The external representation of the euro area needs to be strengthened

Economic policy co-ordination has proven increasingly beneficial in e.g. the spring 2003 when the increased economic uncertainty related to the Iraq conflict demanded for a coherent policy approach. In contrast to the oil price hike in 2000, Member States abstained from isolated national measures and agreed on a common line in international fora. Also the discussions on the impact of the sizeable euro appreciation witnessed in 2003 took place in a more orderly form than when the euro depreciated, which has supported the credibility of EMU's policy framework.

Although the start of EMU constituted a major change for the international monetary system, this has, however, yet to result in a complementary upgrade of the international role of the euro area. The need to strengthen the external representation of the euro area in the relevant international institutions and fora was fully recognised by the Convention, in order to ensure that the area's political importance becomes commensurate to its economic weight. While the issue was discussed in several working groups, no clear conclusion has been reached and the text of the draft Constitution basically leaves the matter unchanged. Apart from the debate in the Convention, no actual and tangible improvements can be reported in respect of the euro area's representation on the international scene. Nevertheless, the preparations of euro area positions in e.g. the IMF has improved somewhat, at least as regards issues where a consensus can be reached and 'common understandings' adopted.

The Lisbon Strategy has reinforced the awareness of and interest in structural reforms

The Lisbon Strategy, which is at the centre of the structural reform process, has increased the awareness of, and interest in, medium term policies that simultaneously promote potential growth; full employment; improvements in the European social model; and a sustainable development. That has called for a 'streamlining' of the policy co-ordination processes, with a view to increase the coherence and complementarity between the various processes. The Broad Economic Policy Guidelines were thus adopted as a part of a "Guidelines Package" together with the Employment Guidelines and the Internal Market Strategy for the first time in 2003. A greater emphasis has also been given to the follow-up in terms of implementation, when the Council adopted conclusions on the 2003 Implementation Report for the first time, stating inter alia that it was a useful tool to monitor progress and give guidance for areas where further progress is particularly needed. The Italian Presidency has indicated that the Council will start holding regular implementation discussions throughout the year. A first working breakfast in November 2003 was devoted to the follow-up given to the 2003-05 BEPGs so far, notably with regard to the sustainability of public finances. While it appears too early for any firm conclusions on the efficiency of the existing co-ordination processes, the streamlining ought to have improved the consistency between the different sets of guidelines and should limit the reporting burden for Member States.

Looking ahead, the Lisbon Strategy will be subject to a mid-term review in 2005 with an eye to making it a more effective tool for achieving the objectives set out at the Lisbon and Gothenburg European Councils. In addition, decisions on the financial perspectives post-2006 will be taken on the basis of policy priorities and objectives identified within the context of the Lisbon strategy. The Open Method of Co-ordination (OMC), which was conceived with the launch of the Lisbon strategy, is increasingly being used to co-ordinate Member States' and Community policies in a number of areas, including R&D, education and social protection policies.

4. Implementation by the Member States: A preliminary assessment.

In the accompanying working document of the Commission Services more detailed information can be found on how economic policies in the Member States so far have responded to the identified challenges and the country-specific recommendations in the 2003-05 BEPGs. As this Communication provides a first, intermediate, look at the progress made and Member States have two more years to complete their follow up on the challenge and recommendations, a full assessment can only be made in two years time i.e. in the Implementation Report 2006. Nevertheless, a preliminary assessment of the degree of implementation at this moment can give a useful overview of which Member States have taken steps in the right direction towards adequately addressing the policy challenges. In a number of cases reforms undertaken or envisaged allow already a more in-depth assessment.

Since the number and the nature of challenges differ among Member States, a comparison of the follow-up between Member States is difficult. Some challenges are more demanding and often more difficult to fulfil than others. In the following summary of the progress made in the individual Member States, the indication 'fully addressed' is used when policy actions in response to a challenge going in the right direction have been adopted or proposed. The indication 'largely addressed' is used when actions have been taken but do not yet cover the whole challenge and all specific recommendations. The indication 'partially addressed' is used when policy actions have been adopted or proposed only relating to a small part of the challenge and the recommendations. When no follow-up has yet been given to the challenge and recommendations, the indication 'not yet started' is used.

It must be stressed that from the assessments on how well Member States responded to these recommendations, it cannot be inferred how Member States compare in terms of absolute performance and improvements therein. From this follows that a Member State can be performing relatively well compared to other Member States, but nevertheless has not implemented or planned measures to tackle the policy challenges and the country-specific recommendations. An indication of the absolute performance (both in terms of progress and in terms of level) of Member States on the basis of the shortlist of structural indicators can be found in the Commission's Spring Report 2004, see Annex 1 therein.

On the basis of the detailed information of the individual countries it appears that all Member States have started to address their challenges. While Belgium, Denmark, Germany, Ireland, the Netherlands, Austria, Portugal, Finland and the UK seem to be addressing, overall, the identified challenges in a satisfactory way, there seems, however, to be scope for improvement in the other Member States.

4.1 Belgium

Overall, Belgium seems to be addressing the three identified policy challenges. The challenge and the recommendations regarding public finance in the 2003-05 BEPGs appear largely addressed. The high debt ratio continues to decline steadily and primary surpluses, although decreasing, remain sizeable. Measures have been taken to limit the growth of real expenditure but the increase is still higher than recommended. Preparations for the budgetary implications of ageing continued in 2003, notably via stimulating employment, but more needs to be done to ensure long term sustainability.

Also the challenge and the recommendations on the labour market seem to be largely addressed. Some action has been taken to address the low employment rate among older workers. Progress is made on reducing distortions to work incentives in tax-benefit systems with a strong focus on the tax-side.

Finally, the challenge and recommendations on competition, public administration and the business environment appear partially addressed. Improvements were made in the regulatory framework in telecommunications, postal services and railways, and energy markets have been opened to competition in Flanders. However, no progress has been registered in stimulating competition in local services and the reform of the public administration has been suspended.

4.2 Denmark

Overall, Denmark seems to be addressing the two identified policy challenges. The challenge and recommendations regarding long term fiscal sustainability appear fully addressed. The tax reform, aimed at increasing labour supply, will be implemented in 2004. Regarding labour market reform some measures have been adopted to tighten eligibility rules. Achieving the targets for the growth of public consumption will require discipline in adhering to the budget agreements across all government levels, including the tax freeze.

The challenge and recommendations on enhancing competition and improving efficiency in the public sector seem largely addressed. Some measures have been taken in 2003 to increase competition and the regulatory barriers to competition are being identified, but weak competition persists in many sectors. Reforms in welfare services have increased competition and the government has presented plans to make further use of benchmarking and reduce administrative burdens.

4.3 Germany

Overall, Germany seems to be addressing the four identified policy challenges. Based on the measures adopted in parliament, the challenge and recommendations regarding the labour market appear largely addressed. Measures have been implemented and proposed to reform the tax-benefit system including a reduced eligibility of unemployment benefits and promotion of low-wage jobs. Some progress has been made in a more flexible system of wage formation but the authorities should go further to promote wage flexibility across skills and regions. Efforts to enhance the efficiency of active labour market policies have started, but there remains room for improvement.

Also the challenge and recommendations on increasing productivity and the efficiency of the education system appear largely addressed. An initiative to improve the business environment, through the reduction of red tape and overregulation was launched. In addition, the competition law will be brought in line with EU-rules and the law on unfair competition will be relaxed. Measures also have been proposed to improve primary and secondary education, but success hinges upon effective follow-up by the Länder.

The challenge and recommendations on public finances in the 2003-05 BEPGs seem only partially addressed. Despite the implementation of compensatory measures amounting to about 1 per cent of GDP, the government deficit is expected to have exceeded 4 per cent of GDP in 2003. Following the confirmation of the German authorities that the 2004 deficit will exceed the 3 per cent ceiling, the Commission made recommendations to decide that inadequate action has been taken and to allow, in light of the weak economy, to bring the government deficit below 3 per cent of GDP in 2005, which were rejected by the Council. The Council took note of the commitments made by Germany on 25 November 2003 to reduce the cyclically-adjusted deficit by 0.6 per cent in 2004 and at least 0.5 per cent of GDP in 2005 to ensure that the general government deficit is brought below 3 per cent of GDP in 2005.

Finally, the challenge and recommendations on long term sustainability appear being largely addressed. Measures have been proposed to address the ageing challenge notably the introduction of a sustainability factor in order to contain the increase in pension payments. Changes in the supervision of private pension schemes and adjustments to increases in pensions need however to be complemented with a structural reform of the pension system.

4.4 Greece

Overall, Greece does not yet seem to be addressing sufficiently all three identified policy challenges. The challenge and recommendations regarding public finance in the 2003-05 BEPGs appear partially addressed. As primary surpluses are decreasing, the reduction of the high debt ratio as requested depends to a great extent on the success of the announced privatisation programme. So far no sufficient measures have been implemented to effectively control government spending and no follow-up has been made or planned to continue reforms in the social security system.

The challenge and recommendations on increasing productivity seem largely addressed. The government has launched several initiatives to accelerate the transition towards the knowledge-based economy, to improve the business environment and to simplify the tax system. In the area of competition in the energy sectors, steps were taken in the right direction but still need to be strengthened in order to ensure effective competition.

Finally, the challenge and the recommendations on the labour market appear partially addressed. Some measures to improve work incentives have been implemented, in particular for women and low wage workers, but no progress is made in reducing non-wage costs as requested. No action has yet been taken to changing the wage bargaining process.

4.5 Spain

Overall, Spain does not yet seem to be addressing sufficiently all three identified policy challenges. The challenge and recommendations regarding the labour market appear being partially addressed. Measures have been implemented to increase female participation through tax incentives and a higher provision of care facilities. In addition, some progress has so far been made in the removal of fiscal distortions hampering the geographical mobility of workers. Nevertheless, no changes were made to the wage bargaining system including the use of indexation clauses whereas the requested reform of employment protection legislation to reduce the labour market segmentation is still pending.

The challenge and recommendations on raising the low level of productivity seem largely addressed. Several initiatives have been launched to strengthen the knowledge-based economy. Progress was also made in improving the business environment by tax incentives and a reduction of red tape. As regards competition, some progress has been made in the electricity market while effective competition in retail distribution has not been addressed.

Finally, the challenge and recommendation on the long term sustainability of public finances seem partially addressed. Some measures have been implemented so as to tackle the budgetary impact of ageing, namely actions to increase the employment rate while continuing to reduce public debt. In addition the Pension Reserve fund is planned to be further increased to 1.6 per cent of GDP. However, no measures strengthening the link between contributory effort and pension benefits have been adopted, which appears indispensable to ensure the long term sustainability.

4.6 France

Overall, France does not yet seem to be addressing sufficiently the four identified policy challenges. The challenge and recommendations regarding public finance in the 2003-05 BEPGs seem only partially addressed. Insufficient measures were taken to respect the recommendation issued by the Council in June in the context of the Excessive Deficit Procedure. Therefore the Commission made recommendations to decide that no effective action has been taken and to allow, in light of the weak economy, to bring the government deficit below 3 per cent of GDP in 2005, which were rejected by the Council. The Council took note of the commitments made by France on 25 November 2003 to reduce the cyclically-adjusted deficit by 0.8 per cent of GDP in 2004, and by 0.6 per cent of GDP or a larger amount in 2005 so as to ensure that the general government deficit is brought below 3 per cent of GDP in 2005.

By contrast, the challenge and recommendations on the long term sustainability of public finances appear largely addressed. A comprehensive reform of the pension system has been adopted increasing the contribution period entitling to a full pension and strengthening the financial incentives to remain active. The reform represents a major improvement of long run fiscal sustainability. Some measures have been introduced to control health spending, but a more comprehensive reform of the health insurance system is to be implemented in 2004.

The challenge and recommendations on the labour market appear partially addressed. In particular, specific measures were taken to encourage participation of older workers and to make work pay.

Finally, the challenge and recommendations on the business environment and competition seem partially addressed. Measures have been taken to reduce and simplify business regulations. Competition in energy markets has improved but the market is still dominated by incumbents. While the transposition rate of internal market directives (one of the lowest in the EU) has increased, the number of infringement increased too.

4.7 Ireland

Ireland seems to be addressing the single identified policy challenge. The challenge and recommendations regarding the management of the transition to lower, sustainable growth appear largely addressed. Efforts are being made to enhance the efficiency of public expenditure, notably by extending multi-annual budgeting and reorganising the health sector. Various measures are taken to improve capital spending and to increase the level of R&D. As regards competition, measures for several sectors are under review including full liberalisation of gas and electricity markets.

4.8 Italy

Overall, Italy does not yet seem to be addressing sufficiently all five identified policy challenges. The challenge and recommendations regarding public finance in the 2003-05 BEPGs appear partially addressed. Little progress has been made in achieving lasting budgetary consolidation and the Italian government has continued to rely on one-off measures. Primary expenditures continue to show a strong downward rigidity constraining the room for implementation of the tax reform.

The challenge and recommendations regarding the long term sustainability of public finance seem only partially addressed. An acceleration of the planned reduction of the high debt ratio would be warranted in the light of ageing. Proposals to reduce pension expenditures as of 2008 were presented to parliament.

Also the challenge and recommendations regarding the labour market seem partially addressed. Reform measures have been taken but important elements of labour market reform are either still pending in parliament (employment protection legislation) or were not tackled (wage differentiation).

The challenge and recommendations regarding the knowledge-based economy are being fully addressed. In particular, the primary and secondary education level system has been reformed and several measures have been taken to stimulate R&D and innovation.

The challenge and recommendations regarding the business environment and competition seem largely addressed. Administrative burdens on start ups and red tape affecting businesses have become less onerous. However, the liberalisation of the service and energy sector proceeds at a slow pace and the rate of transposition of internal market directives has further decreased.

4.9 Luxembourg

Overall, Luxembourg does not yet seem to be addressing sufficiently both identified policy challenges. The challenge and recommendations on the labour market seem partially addressed. No action has so far been taken to reduce incentives for early retirement. Some progress has been made to reduce the inflow in disability pension schemes by tightening eligibility.

Also the challenge and recommendations concerning the business environment and entrepreneurship seem partially addressed. Little progress has been made regarding the reform of the competition law but some measures have been taken to encourage entrepreneurship.

4.10 Netherlands

Overall, the Netherlands seem to be addressing the three identified policy challenges. The challenge and recommendation regarding public finance in the 2003-05 BEPGs appear fully addressed. The new government continued to limit expenditure growth under multi-annual ceilings defined in real terms. Additional efforts may be required to ensure that expenditure plans remain consistent with a budgetary position of close to balance or in surplus.

The challenge and recommendation on the labour market seem largely addressed. Whereas the envisaged reform to reduce the flow into the disability scheme seems adequate, additional efforts are needed to activate people that are already in this scheme. Progress has been made in reforming other benefit systems with the aim of enhancing incentives to work.

Finally, the challenge and recommendations on productivity growth seem fully addressed. The government plans to make improvements in the regulatory framework for competition by increasing the powers of the competition authority. Also progress is made in promoting a stronger technology oriented education and in improving the co-operation between research institutions and business.

4.11 Austria

Overall, Austria seems to be addressing the three identified policy challenges. The challenge and recommendations regarding public finance in the 2003-05 BEPGs appear largely addressed. Action to achieve structural expenditure savings has been taken but was partly offset by increases in discretionary expenditure. Most notable in Austria is the comprehensive overhaul of the pension system which leads to significant savings in the long run and should raise the participation rate of older workers.

The challenge and recommendation regarding the weak technology base appear largely addressed. Several measures have been implemented to increase and rationalise R&D and innovation support.

Finally, the challenges and recommendation regarding competition appear partially addressed. Although steps have been made to enhance effective competition in the retail sector, no measures have been made to address high concentration in some other sectors. The resources of the competition authority remain inadequate and the power of the telecom regulator continues to be insufficient.

4.12 Portugal

Overall, Portugal seems to be addressing the three identified policy challenges. The challenge and recommendations regarding public finance in the 2003-05 BEPGs seem largely addressed. Although the general government deficit rose in 2003 but stayed just below 3 per cent due to the effect of sizeable one-off measures, progress was made in curbing expenditure growth notably through a strong deceleration of public consumption outlays. Portugal has continued to implement reforms in several areas such as health-care and education with a direct impact on budgetary consolidation as requested.

The challenge and recommendations on productivity and business dynamism seem largely addressed. Measures have been taken to stimulate innovation and R&D, to improve the quality of education and to reduce the number of early school leavers. Steps in the right direction have been taken to enhance competition in the gas sector, but in the electricity sector effective competition is not yet secured. Finally, the transposition rate of internal market directives improved in 2003 but stays below the set target of 98.5 per cent. A quasi-wage freeze in the government sector has contributed strongly to overall wage moderation, possibly bringing to a halt the deterioration in price-competitiveness registered in recent years.

Finally, the challenge and recommendations on long term sustainability appear fully addressed. A comprehensive reform of the health-sector is proceeding at a rapid pace but it is yet too early to assess its impact. Reforms of the pension system for workers in the general government sector have so far only partly been implemented, but the government plans to introduce additional measures.

4.13 Finland

Overall, Finland seems to be addressing the two identified policy challenges. The challenge and recommendations regarding the labour market seem partially addressed. Tax reductions implemented and intended will lead to a reduction of the tax wedge for a low wage earner by 1 percentage point. Reform of eligibility criteria to improve work incentives are however lacking. There is little progress in allowing wages to reflect productivity differences.

The challenge and recommendations on competition and public sector efficiency appear largely addressed. Some steps toward improved competition in network industries and non-tradable services have been launched. Further efforts have been made to improve the efficiency of the public sector. The new government has introduced multi-annual spending limits for the period 2003-2007 in order to improve spending control, in line with the request in the recommendation.

4.14 Sweden

Overall, Sweden does not yet seem to be addressing sufficiently the two identified policy challenges. The challenge and recommendations regarding labour supply appear partially addressed. On the one hand, measures have been undertaken to retain older workers and to promote the participation of immigrants and young in the labour force. On the other hand, some planned measures could have a negative impact on labour supply. Furthermore, there are no detailed plans as to when the last step of the income tax reform will be implemented.

The challenge and recommendations on competition and public sector efficiency appear partially addressed. Efforts have been made to improve competition in some sectors, such as construction and food retail, but no further measures have been taken to open up the rental housing market. Steps have been taken to increase the efficiency of the public sector by increasing the use of benchmarking, but no major initiatives have been taken to improve framework conditions for increased competition for public services.

4.15 United Kingdom

Overall, the United Kingdom seems to be addressing the three identified policy challenges. The challenge and recommendations regarding productivity seem fully addressed. The competition authority is progressing in further improving competition in specific sectors such as professional bodies, although the government is taking a cautious line on the deregulation of pharmacies and the liberalisation of postal services. Furthermore a long term strategy has been set out to improve the basic skills in the work force containing clear quantitative targets.

The challenge and recommendation on the labour market also seem fully addressed. Pilot projects have been launched to address the issue of high sickness and disability benefits (Pathways to Work) and financial incentives (Working Tax Credit) have been improved. A growing number of workers is being targeted by the above policies.

Finally, the challenge and recommendation on quality and efficiency of public services appear fully addressed. Reforms have been made to ensure that increased public spending is allocated efficiently and effectively. The authorities plan to make an Efficiency Review and further improvements are made in the use of Public Service Agreements, which are considered central in the strategy for public sector reform and improved delivery.

COMMISSION STAFF WORKING PAPER - Annex to the COMMUNICATION FROM THE COMMISSION ON THE IMPLEMENTATION OF THE 2003-05 BROAD ECONOMIC POLICY GUIDELINES - PART II - Country notes {COM(2004) 20 final}

1. Belgium

Like its neighbouring countries, Belgium has experienced a prolonged slowdown in economic activity, expected real GDP growth not exceeding 1% for a third consecutive year in 2003. Most demand components, have been weak during these years; in the first half of 2003, Belgium saw a significant drop in external demand but private consumption was relatively strong. Following the weak economic developments, labour market conditions have deteriorated. Initially, 2003 showed a further decrease in employment and a further increase in the unemployment rate, but there are indications of a strengthening in labour demand. Despite this unfavourable economic environment, Belgium has succeeded in attaining slight surpluses in the general government budget since 2000 and at continuously reducing the gross debt to GDP ratio, that still remains above 100% of GDP. Productivity in Belgium has remained high and tops EU-15 rankings in various sectors such as the industry, the construction and the financial sectors. In recent years, the business environment and the competitive framework have improved. Reforms aimed at simplifying corporate taxation and at cutting red tape for companies have been initiated. Together, these should consolidate high openness to trade in goods and services in Belgium and above-the-EU-average FDI inflows. Nevertheless, key network industries and the provision of local services still lack effective competition and the breadth and scope of the recent reforms aimed at liberalising further need to be sustained to deliver their full effects.

Key challenges in the light of recent developments

In Belgium the government has taken a number of measures, covering most challenges, notably as regards increasing labour demand and supply and improving the business environment. However, positive results are only partly visible in some cases, due largely to the cyclical downturn or because the effects of some measures have yet not materialised. Not all challenges have been properly tackled, for instance as regards the increase in real expenditures in Entity I (the Federal Government and the Social Security Sector) and as regards effective competition in local services. A more detailed assessment of recent developments in addressing key policy challenges in Belgium is presented in the following sections.

1. Long-term sustainability of public finances

Ensure the continuation of the budgetary adjustment in the forthcoming years, in particular in view of ensuring the long-term sustainability of public finances in the face of population ageing.

Under this challenge, Belgium was requested to:

1. ensure that the government debt ratio is kept on a sustained declining trend at a satisfactory pace by maintaining high primary surpluses (GL 15);

2. limit the real expenditure increase in Entity I (Federal Government and social security) to 1,5 % and allocate proceeds stemming from higher than expected economic growth to improve the budgetary position as a matter of priority; and

3. strengthen the existing strategy in order to prepare for the budgetary implications of population ageing: in particular by reducing the debt level, better addressing the low effective retirement age, pursuing the reform of the pension systems, and strengthening efforts to finance the Ageing Fund (GL 16 and E-REC 2).

Debt ratio remains on a downward trend supported by lower interest payments.

Despite the unfavourable economic climate in the last few years, the general government balance has been in surplus and the government gross debt ratio has remained on a downward trend. Primary balances have been decreasing in the last two years, but this development seems to be largely related to the cycle, as the cyclically-adjusted primary balance has remained fairly stable. The impact of lower primary surpluses on the government balance has been balanced to a large extent by favourable developments in interest payments, a budgetary structure which does not improve the sustainability of government finances. Furthermore, the levels of the budget balance and the debt in 2003 and in 2004 are influenced by a one-off measure, the transfer of the Belgacom pension fund for the government area and the respective payments which immediately accrue to the public finances. This measure is still under scrutiny by Eurostat. Without this one-off measure, Belgium would show a general government deficit of around 1% of GDP in 2003.

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Still some difficulties in curbing real expenditures

The government seems to have been successful in limiting real expenditures in several areas. Real expenditures in the Federal Government are expected to increase by around 1½ % in 2003. However, deterioration in the economic environment and the increase in unemployment, has forced increases in social expenditures beyond the target. It is currently estimated that the growth of real expenditures of Entity I (Federal Government and social security) will exceed the 1.5% limit. In the 2004 budget, expenditures have been allowed to increase only in a few areas, including health, justice and investment. On the other hand, health expenditures are planned to increase by 4.5% annually in real terms for the next four following years. All in all, according to the 2004 budget, primary expenditures in Entity I will increase by close to 4% in nominal terms, which amounts to about 2.4% in real terms and is accordingly above the recommended maximum growth rate of 1.5%.

To meet the challenge of an ageing population, emphasis is put on increasing employment.

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The employment rate is well below the EU average, particularly for older workers. In order to tackle this problem, employment promoting measures have been given highest priority. Social security contributions were reduced in 2003 and further reductions are announced in the 2004 budget for targeted groups. The size of the reductions is estimated to be around 0.2% of GDP in both 2004 and 2005. Several other measures have also been taken in order to increase demand and supply of labour. Some of these measures have a negative short term budgetary impact, making the objective of maintaining high primary surpluses harder. However, they are expected to have a positive impact on employment, productivity and the budget in the medium term.

Further measures to meet the challenge of an ageing population include the reduction of the debt, the creation of the Ageing fund, as well as further reforms in the pension system. The Ageing Fund is meant to be used during the period 2010-2030 and is projected to raise about 10 billion euro in 2007. In order to strengthen the fund, the assets of the Belgacom pension fund have been allocated to finance the Fund. However, this transfer of the Belgacom pension fund to the public sector does not only imply assets but also government liabilities in a medium-long term perspective.

Some measures have been taken as regards the pension system. It has been decided to gradually extent the definition of a complete working career for women, from 40 to 45 years, and to gradually raise the minimum age within the GRAPA (garantie de revenues aux personnes agées) system. These measures should strengthen the sustainability of the pension system. In addition, steps have been taken in order to increase the number of participants within the second pillar in the pension system and the minimum pension levels for employees and employers and in the GRAPA system were raised as from April 2003.

2. Labour market and regional development

Increase the low participation and employment rates, especially for older workers and women, and improve incentives to work.

Under this challenge, Belgium was requested to:

4. take further steps to reinforce measures to postpone retirement from the labour force, in particular by combining a removal of incentives to early retirement (GL 16) with enhanced prevention and activation measures for older workers; and

5. continue progress in making work pay by eliminating the major distortions to work incentives arising from the interaction of the tax and benefit systems (GL 4 and E-REC 3).

Some measures have been taken to address the low employment rate.

The employment rate is relatively low in Belgium, 59.9% in 2002 as compared to 64.3% in the EU 15. Among older workers, 55-64 years, the rate was the lowest within the EU15, 26.7%, much lower than the 40.1% EU15 average. With employment falling, the situation has been worsening in 2003. This problem is widely recognised and measures have been taken in order to improve the situation. Besides those measures aimed at raising the overall employment rate, some others are directed towards older people. In January 2002, a system facilitating the access to part-time work for older workers was introduced; the aim being to prevent people from taking early retirement at the end of their careers by allowing them to work part-time while receiving full pension. In addition, the 2004 budget includes a reduction in social security contributions for workers above 58. It also includes an increase by 25% in the maximum amount of work allowed for pensioners who have reached pension age. These measures should have a positive influence on the employment rate among older workers.

Measures to encourage active job search have been adopted or are planned.

To encourage unemployed to look actively for work, the government has announced some measures. Firstly, the tax reform includes a reduction in the personal income tax, directed in particular towards lower wages. It is introduced gradually and is to be fully applied as from January 2004. Secondly, social security contributions paid by the employees have been reduced for lowest wages workers. Finally, co-operation between different social inspection services will be increased in order to prevent fraud and abuse of the system. These measures go in the right direction but results tend to take time to show up.

3. Productivity and business dynamism

Enhance competition in certain services sectors and continue to increase the efficiency of the public administration and to improve the business environment.

Under this challenge, Belgium was requested to:

6. take measures to enhance effective competition in network industries and in local services (in line with GL 9); and

7. improve public administration in the context of the ongoing reform and pursue the reduction of administrative burden for companies (GL 11).

Improvements made in the competitive and regulatory framework in network industries although effective competition has not yet appeared in some of these key sectors.

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Important steps have been taken to grant more independence to the regulator in the telecommunications and postal services sectors and to establish such a regulatory body in railways. In addition, the activities of the energy regulator for the non-eligible part of the market have been taken over by the regulator for the eligible part of the market, which is seen as more independent from operators. In full conformity with EU requirements, the reserved area in postal services was reduced and international rail freight services were opened to competition. Legal unbundling of transport and distribution systems operators in electricity and gas has been fully completed at the federal level and in Flanders but not yet in the two other regions. Likewise, full market opening of energy markets in Flanders has not been matched yet by the two other regions, which still officially stick to the timetable set in the EU directives. Despite these positive legal developments, effective competition in railways and in energy sectors remains low with high market shares for incumbents, low rates of consumer switching and high prices. No tangible progress has been made in clarifying the role of association of municipalities in the provision of local economic services and to solve the competition problems that could arise when private suppliers are competing for the provision of such services.

Reforms to encourage entrepreneurship and to ameliorate the business environment have been initiated....

The new government declared its commitment to reduce the administrative burden for citizens and businesses. Its top priority is to decrease the time and costs of administrative obligations for companies and to simplify the procedures to start a new company. It should translate into a single form to be filled at an accredited one-stop-shop that would provide the necessary accreditation within three days by 2005. These reforms should help to enhance the current position of Belgium as second-worst in terms of time and cost for starting-up a company and to improve its very poor performance in company's creation. Several initiatives have been achieved or initiated in 2003 at both federal and regional levels, among which the setting up of a crossroads bank for enterprises to simplify and centralise information on companies, the provision of guarantees to loans to SMEs, the extension of electronic interactive applications in the field of VAT returns and social security obligations, or the streamlining and acceleration of administrative procedures. However, most plans are in an early phase and have still to be fully completed within the deadline of 2005 set by the government.

...but the reform to modernise public administration has been suspended.

Although the new Federal government has declared its commitment to continue the modernisation of its administration, important aspects of the reform that started under the previous legislature (Copernicus) have so far been put to a halt. Specifically, the procedures to hire top managers for public administrations have been suspended and so is the modernisation of the status of civil servants with a university degree.

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2. Denmark

After the robust GDP growth in 2002, economic activity was more subdued in 2003, mainly due to weak domestic demand. The slowdown has opened a negative output gap which has eased inflationary pressures but resulted in an increased unemployment, albeit from a relatively low level. Against this backdrop, a moderately expansionary fiscal policy stance is foreseen in the draft Budget Bill for 2004. Overall, economic policy remains focused on medium-term objectives. The challenge of securing longer-term sustainability of public finances is addressed through the target of reducing the public debt ratio substantially by 2010, by running general government surpluses of on average 1½-2½% of GDP until 2010. This will finance the expected future increase in net public expenditures due to ageing, without triggering a need for fiscal tightening at some later point . To this end, however, it is essential that the growth of public consumption expenditure is brought in line with targets and that further measures are taken to ensure the assumed increase in effective labour supply in addition to the measures already implemented. Measures going in the right direction have been taken in the context of the 2004 tax reform, as well as in the 2002 labour market reform. Recent Danish productivity performance has been above the EU average, which could result from the advanced stage in the transition to a knowledge-based economy. However, competition is weak in a number of sectors, which contributes to Denmark having the highest price level in the EU, when including indirect taxes. Reform measures in 2003 included fully liberalising the electricity market and the launching of an action plan to increase public sector efficiency. However, further measures may be needed in order to increase public sector efficiency, which could contribute to increase competition and to reduce the price level relative to the EU15.

Key challenges in the light of recent developments

Denmark's economic policy agenda keeps its medium-term focus on macroeconomic stability and debt reduction. The moderate fiscal expansion for 2004 reflects mostly the structurally motivated reductions of income taxes and a general government surplus in 2004 of 1.3% of GDP is envisaged for 2004. Reforms addressing the 2003-05 BEPG recommendations to enhance labour supply are being implemented, but it is still early to evaluate their effects. To underpin the medium-term fiscal strategy, targets for the growth of public consumption expenditure should be achieved through discipline at all levels of government. High prices and weak competition persist in many sectors, but measures have been taken to strengthen competition and increase efficiency in the public sector. The following sections present and assess in more detail recent developments in addressing the key economic policy challenges.

1. Long-term sustainability of public finances

Ensure an adequate labour supply in view of the ageing of the population

Under this challenge, Denmark was requested to:

1. continue efforts to increase labour supply notably by efforts to make work pay by increasing incentives to join and remain in the labour force and to postpone retirement, in particular by ensuring the implementation of the tax reform and by considering additional steps to tighten eligibility rules and reduce marginal taxes within a framework of sound public finances (GL 4 and ERECs 1 and 3); and

2. ensure expenditure control at all levels of government so that the multi-annual targets for public consumption growth are respected (GL 14).

Measures to enhance labour supply have been implemented...

Denmark ranks among the EU Member States with the best labour market performance and the Lisbon targets are fulfilled by a wide margin. Nevertheless, further increasing labour supply over the medium-term is essential to meet the future demographic challenge taking into account present and projected fiscal policies. In addressing this challenge, the employment rates will need to be raised, in particular among older persons and immigrants. Denmark's recent reform efforts include measures to increase labour supply and lower unemployment. The 1999 reform of the voluntary early retirement benefit is having some positive effects on the labour supply of persons aged 60-62 years. However, the scheme remains an obstacle to raising labour market participation for older persons overall. The 2002 "More people into employment" initiative includes a range of measures. In addition to simplifying the labour-market administration and introducing more results-oriented activation measures, the initiative addresses unemployment traps for specific groups benefiting from the social assistance system by strengthening economic incentives. The scope to keep earned income without losing means-tested benefits is increased and there is a reduction in the cash benefit after six months. Rules governing availability and willingness-to-work criteria have been tightened. The main objective of the 2004 tax reform is to stimulate effective labour supply through lower marginal rates by a rise in the threshold for the intermediate tax bracket and introducing an earned income tax credit in the form of an employment allowance.

... but it is early to assess their effects.

With already high employment rates as a starting point, Denmark is facing a challenging task financing its public sector commitments at the time of worsening demographic conditions. In addition, the present downturn is having a negative short-term effect on the labour market. The measures in the "More people into employment" and the lowering of tax rates on labour should have a positive effect on labour supply. However, as the effects of the measures take time to come through, it is still too early to evaluate their effects. Nevertheless, as recognised by the authorities, further efforts will be needed to reach Denmark's medium-term targets for increased labour supply.

Targets for public expenditure growth need to be achieved

In spite of some weakening of the general government surplus due to the economic slowdown, Denmark's public finances remain overall sound. Potential fiscal leeway for reducing taxes has been created by lowering the future growth of real public consumption expenditure. It is therefore essential that these lower growth rates are achieved. However, over the last decade, the average growth of public consumption expenditure in real terms has been 2-2½ %. In 2002, it was 2.1%, clearly above the target of 1%. Achieving the national target of ½% as from 2005 is therefore ambitious. As the largest share of public consumption is the responsibility of the counties and municipalities, fulfilling the targets for general government will require discipline in adhering to the agreements across all government levels. In addition to the budget agreements (between central and local governments), the tax freeze is key in this respect- as local governments are severely restricted in raising capital via loans- and it should prevent local governments from raising taxes to finance increased spending. The tax freeze did not fully constrain local government spending in 2002, which was the first year of its implementation. In 2003, compliance of local governments with the tax freeze and with the budgeted expenditure has been overall good. However, if a pattern of not living up to the budget agreements on expenditure persists, it should be considered to re-evaluate the instruments for assuring the necessary budgetary discipline.

2. Productivity and business dynamism

Enhance competition in certain sectors and improve the efficiency of the public sector

Under this challenge, Denmark was requested to:

3. step up efforts to enforce competition in sectors where competition is inadequate (GL 9); and

4. continue efforts to increase the efficiency of the public sector, inter alia by improving framework conditions for increased competition, promoting the benchmarking of public sector efficiency, and by increasing public tendering (GL 11).

Some measures have been taken to increase competition although high prices and weak competition persist in many sectors ....

Danish prices, including indirect taxes, remain the highest in the EU and weak competition in many sectors could be a contributing factor. There are so far no signs that prices measured relative to EU15 have decreased. The changes in the competition law in 2002 should enhance competition, but it is still too early to evaluate its effects. Some further measures have been taken in 2003 to increase competition. The electricity market was fully liberalised on 1 January 2003 and during the first six months 64.000 customers have changed suppliers, corresponding to a third of the total electricity consumption. Further changes made to the legal framework in some sectors such as payment services and regarding drinking cans may increase competition. However, there is no information on any recent measures taken to increase competition in the rental housing sector. The Competition Authority in co-operation with relevant Ministries has started a project to identify regulatory barriers to competition and will present the results in the first half of 2004.

... but some signs of increasing efficiency in the public sector.

The Danish public sector is among the largest in the EU and substantial efforts are made to improve its efficiency. During the last two years reforms in welfare services have increased competition and some measures have been taken to promote the benchmarking of public sector efficiency and increasing public tendering. The number of businesses for care for the elderly has increased after the opening of the market in 2003. Furthermore, the government has extended the free choice of hospital, in cases where patients have to wait more than two months, to include private hospitals and hospitals abroad, which is expected to increase the efficiency of (public) hospitals. The government launched a knowledge strategy in 2003 with inter alia the aim to increase the efficiency of the higher education system. A primary school reform, which came into effect in 2003, and a secondary school reform, which will come into effect in 2005, could increase the quality and efficiency in education. In August 2003 the government presented an action plan to increase the efficiency of the public sector by benchmarking it with the private sector, reducing administrative burdens and improving communication to the public. If the expected results of the reforms materialise, Denmark has prospects of increased efficiency in the public sector.

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3. Germany

Recent developments confirm the structural weakness of the German economy as identified in the country-specific challenges. Continued sluggish activity in 2003 was accompanied by a significant fall in employment, underlining the key importance of labour market reforms for stronger growth and job creation. There is a notable drive to reform: however, labour market rigidities remain a paramount problem. Public finances deteriorated, with the general government deficit exceeding 4% of GDP. Budget consolidation measures taken earlier this year were either undermined by unfavourable economic developments or proved inadequate. Prompted also by the ongoing excessive deficit procedure, the government has presented a package that would bring the deficit down by a significant amount, but not enough as to ensure that the deficit will be below the 3% of GDP by 2004 or even 2005. In order to raise the growth potential of the economy, the Government has launched the "Agenda 2010", which is a comprehensive project for restructuring Germany's expensive social security system and has major consequences for labour and product markets. On 14 December 2003, the governing coalition and the opposition reached a compromise deal, allowing large parts of "Agenda 2010"to come into effect. These measures should improve cost competitiveness by reducing non-wage labour costs and boosting productivity.

Key challenges in the light of recent developments

Germany's policy agenda has made some progress in the last year. The most remarkable aspect is a broad-based debate on structural reform, which has spawned already a number of promising legislative proposals and other policy initiatives, notably in the field of labour market reform, tax reform, education and health care. Most prominent here are the proposals under the heading of the Agenda 2010 and the "Hartz" labour market reforms. It is, however, at this stage too early to say whether these proposals will actually result in noticeable progress, because many proposals have only recently been passed into law and have not yet had the time to be fully effective. An agreement has been reached between the government coalition and the opposition on a health care reform. Furthermore, in order to contain the rise in retirement costs, pensions will be frozen next year and rise at a lower rate thereafter. Finally, a number of measures were taken to encourage enterprise creation and improve public service provision. A more detailed assessment of recent developments in addressing Germany's key policy challenges is presented in the following sections.

1. Labour market and regional development

Promote job creation and adaptability and mobilise the unutilised employment potential,

Under this challenge, Germany was requested to:

1. continue to reform the tax-benefit system (GL 4 and E-REC 6), in order to ensure sufficient incentives to take up work or to move into a higher income bracket, and firmly enforce the conditionality of benefits upon active job search;

2. take measures to ensure that wages reflect better productivity differences across skills and regions (GL 5), notably by reviewing the Günstigkeitsprinzip, allowing temporarily lower payments for job starters; and

3. carry forward the reforms to improve the efficiency of ALMPs, in particular of job search assistance. Further reform ALMPs according to cost-effectiveness criteria and target them better towards those persons most prone to the risk of long-term unemployment (GL 8, 13 iv and E-REC 1).

Efforts are under way to enhance work incentives provided by the tax-benefit-system...

Germany made noticeable progress in implementing the 2003 labour market recommendations. On 1 January 2003 and 1 April 2003, the first two of the four "Laws for modern services in the labour market" (Hartz I to IV) came into effect, while government and opposition agreed on the remaining "Hartz" proposals along with the bulk of Agenda 2010 on 14 December 2003.

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The measures taken focus on improving the efficiency of job placement services and on the creation of new employment opportunities. Tighter eligibility criteria have caused unemployment to edge down even though overall employment has not increased (see chart). As of 2006, a general limitation of the entitlement to unemployment benefit to 12 months (older persons to 18 months) will come into effect. "Personal Service Agencies" (PSAs) have been created as public temporary work agencies, which effectively subsidise wages during a training period. Furthermore, self-employment and low-wage jobs are being promoted by offering favourable tax rates and social security contributions. While the promotion of self-employment has slightly increased employment, PSAs and the "Capital for Labour" scheme, which subsidises the recruitment of long-term unemployed, have met with only faint response so far. However, it is too early to judge the success of these measures.

Additional measures that were adopted in December 2003 include the reorganisation of Germany's Federal Employment Office into a more efficient service facility, the merger of social assistance with unemployment benefits and a tightening of rules for receiving unemployment benefits. Moreover, protection against dismissal will be eased for newly hired employees of small firms with up to 10 workers, and by lowering the threshold for which jobs are deemed acceptable, unemployed persons are expected to take employment more rapidly. However, the legal underpinnings of the wage bargaining systems remain as they were. In particular, no attempt has been made to alter the legal basis of the "Günstigkeitsprinzip", which allows for enterprise-level deviations from industry-wide tariff agreements only if the new contract is not unfavourable to employees on any aspect contained in the collective agreement.

The four Hartz laws and important parts of Agenda 2010 constitute significant progress in making the labour market more flexible. Considerable steps have therefore been undertaken or proposed by the German authorities to comply with GL 4. The framework conditions for job creation are also being improved through liberalisation of shop opening hours and reductions in the administrative burden on business. However, labour market participation of women is still negatively influenced by the continuing lack of care facilities.

...and some progress is being accomplished to make wages better reflect productivity differences.

Economic disparities have insufficiently narrowed since unification, with the East German unemployment rate still more than twice the national average. In dealing with these disparities, policy has to respect the autonomy of social partners. Some tentative progress can be observed, as collective wage agreements are more and more flexible by including opening clauses or are simply not applied, particularly in eastern Germany.

But active labour market measures still need to be improved

Active labour market measures (ALMPs) play an important role in the prevention of long-term unemployment, especially in eastern Germany. However, while being costly, public employment programs do not seem to have raised the probability of re-employment. On the contrary, ALMPs may have crowded out private sector activity. In order to improve the efficiency of ALMPs, German authorities thus called for more impact research and a comprehensive evaluation is currently being drawn up. The German vocational training system is also in the process of being modernised. Since August 2003, tests for on-the-job trainers are no longer obligatory, which facilitates training in new and small firms. Germany has thus made some progress in implementing the 2003 recommendations with respect to active labour market measures.

2. Productivity and business dynamism

Increase productivity through improvements in the business environment and the efficiency of the education system

Under this challenge, Germany was requested to:

4. encourage businesses to invest and grow by creating a more competitive environment (GL 9) and by further reducing the regulatory and administrative burden (GL 11), inter alia, by lowering the effective degree of employment protection (GL 6); and

5. carry out further reforms contributing to improved educational achievements and the elimination of persistent skill shortages (GL 13).

The German government has taken a number of new initiatives.

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The German Government has put forward proposals to bring German competition policies fully in line with EU competition law. In addition, the decision-making process in merger control will be speeded up. The new competition law should enter into force on 1 May 2004. The Government has also proposed to relax the law on unfair competition, lifting the prohibition of special sales. This reform should become effective at the beginning of 2004. Proposals to bring forward the third stage of the tax reform should contribute to a lowering of the tax burden on business in 2004. Sectoral and ad hoc State aids continued their slow decline, but the value of public procurement published in the Official Journal as a percentage of GDP remains the lowest of all Member states. The Government has included the simplification of public procurement rules as a priority in its initiative to reduce bureaucracy and over-regulation. This initiative, which was adopted on July 2003, aims to increase the attractiveness of Germany as a location for business and to improve public service provision through a series of measures in five domains: labour market and the self-employed; economy and 'Mittelstand'; research and technology; civil society and honorary posts; and services for the citizen. A number of measures were taken to encourage enterprise creation, which has recently been declining. These measures include the provision of low-interest loans, an easing of entry into the handicraft trades, and a lowering of the degree of employment protection in new and small firms.

Success of federal education initiative depends on the follow-up by the Länder

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In order to improve the achievements of its students in primary and secondary education, Germany intends to boost the supply of all-day schools (i.a. federal program of EUR 4 billion in the years 2004 to 2007); develop national standards (including the creation of an independent Agency for Standards and Evaluation); establish a committee of experts to report on development in the educational field; and take a number of measures aimed at improving the teaching quality. In spite of the continued decline in the number of tertiary graduates in science and technology, no new reforms at the university level are foreseen. Initiatives taken to improve the quality of vocational training are mentioned when discussing the follow-up to the recommendation on ALMPs.

3. Public finances

Reduce rapidly the general government deficit to below 3 % of GDP and keep government finances on a steady consolidation path

Under this challenge, Germany was requested to:

6. ensure a rigorous budget execution and implement the announced or compensatory measures for 2003 amounting to 1 % of GDP and put an end to the present excessive deficit situation by 2004 at the latest (GL 1); and

7. lower the cyclically-adjusted deficit by at least one percentage point of GDP between the end of 2003 and 2005.

Despite efforts, 2003 budget deficit deteriorates vis-à-vis 2002...

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Following a recommendation of the Council for Germany, according to Article 104.7 of the Treaty, to carry out budget consolidation measures amounting to 1% of GDP in 2003, the German government implemented measures in the order of over EUR 20 billion. The actual budgetary outcome for 2003, however, turned out to be worse than expected, with the Commission forecasting a general government deficit of 4.2% of GDP in 2003, which marks a deterioration vis-à-vis the 2002 deficit by 0.7 percentage points in nominal terms and by 0.1% in cyclically adjusted terms. Although there is no evidence of significant budgetary slippage compared with plans, apart from expenditures related to the labour market, the consolidation results so far show that additional efforts are needed [12].

[12] The fact that, despite the measures taken by the government, the cyclically-adjusted balance nevertheless deteriorated slightly can be attributed in particular to a downward revision of potential growth, as well as to a budgetary impact of the measures taken being lower than anticipated and a higher trend deficit due to the fact that growth turned out lower than expected in the Stability Programme on which expenditure plans were based.

...requiring additional efforts in 2004 and 2005...

In the light of the unforeseen deterioration of the budget balance, the need for achieving substantial improvement in 2004 and 2005 has become more pressing. On the basis of a projected deficit of 4.2% of GDP in 2003 and the confirmation by German authorities that the 2004 deficit will exceed 3% of GDP, the Commission adopted on 18 November a Recommendation for the Council to decide that action taken by Germany is inadequate to bring the excessive deficit to an end, in accordance with Article 104.8 of the Treaty. At the same time, the Commission adopted a recommendation to the Council to take a decision pursuant Article 104.9. In light of the weak economy, the Commission recommended to the Council to allow Germany an additional year (i.e. until 2005) to bring the government deficit below 3% of GDP and to require Germany to reduce the cyclically-adjusted deficit by a total of 1.3% of GDP, of which 0.8% in 2004.

...to which Germany committed itself while the Council found an agreement outside the Treaty.

On 25 November, the Council rejected the two Commission recommendations. Germany committed itself to a reduction of the cyclically-adjusted deficit by 0.6% and at least 0.5% of GDP in 2004 and 2005, respectively. This commitment was repeated in the 2003 update of the Stability Programme. However, it is less than the consolidation effort recommended by the Commission. Any higher than expected revenue is to be used for additional deficit reduction. Based on the Commission Autumn 2003 forecast an achievement of this consolidation path would result in a deficit minimally below 3% of GDP in 2005, leaving a substantial risk that it might actually be above that threshold for a fourth year in a row.

4. Long-term sustainability of public finances

Secure the long-term viability of pension and health-care systems.

Under this challenge, Germany was requested to:

8. promote the take-up of supplementary pension schemes and strengthen incentives for later retirement, (GL 16); and

9. increase the efficiency in the health care sector by introducing economic incentives for health care providers and recipients.

Reforms to address short-term pension financing problems and proposals for long-term sustainability

In the so-called Pension Summit of 18/19 October, German cabinet ministers and government coalition leaders decided on a number of measures, which would improve to some extent the sustainability of public finances. The decision to gradually increase the mandatory retirement age from 65 to 67 years has been postponed until the end of the decade.

The decisions will also lead to some further progress in the take-up of supplementary pension schemes, by simplifying the supervision of private pension schemes. In addition, the take-up of private pension schemes will be promoted indirectly by the introduction of a "sustainability factor" into the pension formula, which effectively lowers future increases in pensions. While the proposals of the Pension summit will bring some short-term relief for pensions financing, it needs to be complemented with a more structured reform of the pension system.

Health care reforms shift costs to patients

The health care compromise, which has been passed by the Bundesrat and will be effective as from 1 January 2004 foresees savings of EUR 10 billion in 2004 (2007: EUR 23 billion) allowing for a reduction of the joint employer/employee health care contribution by 0.7 percentage points in 2004 (1.3 percentage points in 2007). In turn, patients will have to pay a higher share of the direct costs themselves, regarding for example items such as dental care and sickness benefit. Much of the reform does not actually provide cost-savings but consists in removing components from the regular health insurance. De facto, the burden of health insurance will not be reduced, apart from having a somewhat increased incentive for patients to save costs, for instance, in dental care and medication. There are further efforts needed to contain upward pressure on health insurance contribution rates in the long term. Particularly, reductions in the costs of medical treatment and better incentives for a rational use of health care services are warranted.

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4. Greece

Economic activity in Greece remains strong as the economy is benefiting from a series of factors which have boosted domestic demand. Specifically, high wage increases and tax reductions introduced by the tax reform of last year combined with low cost of borrowing, as a result of easy monetary conditions, have boosted private consumption. Moreover, public spending on projects linked to the Olympics and the financial flows from the EU Structural Funds have supported public investment. However, despite these favourable domestic conditions the Greek economy has not made sufficient progress to deal effectively with its two basic structural problems, namely weak international competitiveness and fiscal imbalances. The need to control on a more permanent basis fiscal imbalances is of primary importance all the more that Greece has made little progress in reducing the high government debt. The situation in the labour markets has lately been improving. Unemployment has been following a declining trend much supported by employment creation in the buoyant construction activity. However, despite some attempts made for implementing measures aiming to render employment conditions more flexible, the structural problems in the labour market are not being eliminated at a satisfactory pace. Nevertheless, some improvement with respect to the employment participation rate, the long run unemployment, and the unemployment rate of the youth has recently become clearer. Progress with respect to the employment participation and the unemployment rate of women remains limited. Although strongly rising in recent years, Greek labour productivity remains the second lowest in the EU. This is partly due to low levels of investment in R&D, the still low -albeit growing- level of ICT diffusion, and low levels of educational attainment of the population. But still limited competition in certain network industries and a lack of business dynamism, due to complex regulation and administrative systems, can also be part of the explanation.

Key challenges in the light of recent developments

Despite continued strong economic growth, the Greek government has not resolutely tackled all identified challenges notably in the area of the increasing budgetary imbalances. A series of unforeseen factors, the higher than initially projected costs for the Olympic Games, as well as new social measures aimed at supporting low incomes will further increase the pressures on the State budget. Nevertheless, the privatisation plans which are in progress are expected to provide some relief by reducing the high government debt. Several measures have been taken in order to encourage the transition towards a knowledge-based economy but effective competition in the electricity market needs to be strengthened. A more detailed account of recent developments in relation to key policy challenges in Greece is provided in the following sections.

1. Long-term sustainability

Ensure the long-term sustainability of public finances in the face of population ageing, in particular in view of the high government debt ratio,

Under this challenge, Greece was requested to:

1. ensure that the government debt ratio is kept on a sustained declining trend at a satisfactory pace by maintaining high primary surpluses (GL 15);

2. ensure effective control of government current primary spending by addressing resolutely the problem of the inelastic elements of expenditures (GL 14), e.g. the wage bill;

3. use public resources more effectively with the aim of improving labour productivity and enhancing working capacity of the unemployed (GL 14); and

4. continue reforms of the social security system, and in particular the pension system (GL 16), in order to avoid budgetary strains in the future due to the problem of the ageing population.

Slow decline in the government debt ratio

The government debt ratio in Greece is among the highest in the EU. So far progress made in its reduction has been limited in the face of the buoyant nominal GDP growth. In fact, in 2001 and 2002 when the rate of increase of nominal GDP was around 8%, the government consolidated gross debt rose, after the corrections in the treatment of some financial operations requested by Eurostat. In 2002, the government debt was reduced by only 2 percentage points while, according to the Greek authorities, in 2003 and 2004, the debt ratio is expected to decline by 3 percentage point each year. On the other hand, the general government primary surplus particularly in cyclically adjusted terms followed a declining trend over the last four years. As the reduction in the primary surplus is expected to continue further in 2004, the effort in reducing the government debt seems to be resting mostly on the success of the announced privatisation programme. The expected revenues from privatisation amounted to EUR 3 billion (or 2% of GDP) in 2003.

Lack of effective control of government primary spending

According to the estimates provided in the draft State budget for 2004, primary current expenditure in 2003 should record an overrun equal to EUR 475 million (or 0.3% of GDP). Preliminary data on the budgetary implementation suggest that primary spending increased by 6.2% from January to September over the same period in 2002, while the State budget projects an annual increase of 6%. Although this additional primary spending is expected to burden the 2003 budget, a more permanent effect on primary spending should not be excluded. Moreover, as the cost of the new social measures announced by the Greek government will fall mostly on the expenditure side, risks of an increasing trend in primary spending cannot be ruled out. With respect to both the estimated outcome of the 2003 budget and the projections of the 2004 budget, spending on wages in the public sector and on social protection continue to be quite inelastic and constantly overshooting budget projections. However, after the Olympic Games in 2004, the government can save up to 1% of GDP in expenditures which should be used for deficit reduction.

Some progress in productivity and working capacity of the unemployed

Labour productivity was on an increasing trend in the last years reaching almost 85% of the EU average. A series of measures aiming at increasing the incentives to work for specific categories of the working age population, as well as measures for improving the skills of the unemployed, are being implemented with the financial support of government agencies. The government wishes currently to replace unemployment subsidies with employment subsidies. The tax reform may also be considered as a means to promote job creation. Since this is an ongoing process, there is yet no clear evidence as to the effectiveness of these measures. It seems that some progress has been achieved in the front of the long-term unemployment and the unemployment of the youth. However, although the employment participation rate of women has been improving, the differences in the participation rate and the unemployment rate between men and women remain significant.

No follow-up foreseen on reforms in the social security system

The reforms in the social security and pension systems introduced by the Greek government in 2002 emphasised the introduction of instruments that would add credibility and flexibility to the system. They may, nonetheless, be considered as not having sufficiently taken into account the current trends in public finances and especially the high level of the government debt. As the costs from the ageing population are expected to significantly rise in the future, the sustainability of the Greek public finances will be at high risk if no further measures are taken. However, no additional measures are foreseen for the moment in order to streamline and therefore reduce the future costs of the social security and pension systems.

2. Business dynamism and labour market

Increase the low level of productivity, which is associated with problems in the functioning of the labour and product markets, low investment in human capital, and the late development of the knowledge-based society.

Under this challenge, Greece was requested to:

5. step up efforts to increase the availability of skilled human capital, and continue to promote business involvement in R&D and innovation, and to improve ICT diffusion (GL 13 and E-REC 2);

6. enhance particularly competition in the energy sectors (GL 9);

7. continue to simplify the business and taxation environment and raise the transposition rate of internal market directives (GL 9 and 11).

Several initiatives have been launched to encourage the transition towards a knowledge based society

Several initiatives have been launched in 2003 to improve the availability of skilled human capital and to promote R&D and innovation and ICT diffusion. First, measures towards the development of information technology in schooling and professional training have been taken to upgrade human capital. Second, the links between universities and enterprises through initiatives supporting the establishment of spin-off-firms have been strengthened. Third, a programme which promotes technology cooperation among companies has been initiated. Fourth, a wide-range educational reform programme with various measures specifically targeted at tailoring education and training to the labour market needs has been implemented.

Despite steps in the right direction, effective competition in the electricity market still needs to be strengthened

On July 2003, the Greek Parliament amended the law transposing the EU directive on the liberalization of the electricity market. The amendments introduce a wholesale market and remove some administrative barriers to entry aiming at a more competitive market. Nevertheless as the incumbent is vertically integrated and its share of the generation market is 98%, entry of new firms is very difficult. The Commission has opened an infringement procedure relating to the unbundling of the incumbent company PPC.

Efforts have been made to simplify the business environment

Measures to reduce bureaucratic and legal obstacles to set up a new company have been implemented. As far as taxation is concerned, the Ministry of Finance has recently published one bill intended to further simplify the tax system and particularly the tax audit procedures. For example new practice for calculating taxable profits for businesses with inaccurate or inadequate accounting books should be implemented. Finally while Greece's transposition rate of internal market directives has increased from 96.7 to 96.9, it is still behind both the EU average and the target of 98.5% of Internal Market directives.

3. Labour market

Reduce the high rate of structural unemployment, and increase employment rates, particularly for women.

Under this challenge, Greece was requested to:

8. improve work incentives, particularly by reducing non-wage costs and improving transferability of pensions rights, in order to encourage increased employment in the formal sector, including parttime work (GL 4 and 16 and E-REC 4);

9. promote changes to the wage bargaining process to ensure that wages reflect productivity differentials (GL 5); and

10. implement the labour reform package to improve the balance between flexibility and security by ensuring effective implementation of reforms aiming to modernise work organisation and by reviewing unduly restrictive labour market regulations (GL 6 and E-REC 1).

Efforts to promote part-time work continue but without impact on non-wage costs

Despite some improvement and efforts undertaken in the past to promote part-time work, its share has stagnated at low levels. Incentives, in the form of subsidising social security contributions, are being introduced for certain categories of the working force (unemployed, women) and for specific sectors but as yet the reaction of the private sector has not been very encouraging. Furthermore, there seems to be no focus on the reduction of non-wage costs. A new law aims at strengthening the incentives for part-time work, providing the recruitment of 25.000 part-time employees in the public sector in the area of services of social interest. Finally, the government intends to introduce changes to legislation in order to ensure social security rights when moving from one fund to another.

Social dialogue is put forward but wage bargaining is hardly modified

Enhancing the social dialogue has been among the priorities of the government in recent years, with wage bargaining being among the core issues. The private sector is bound by 2-year wage agreements setting the minimum wage on which several sectoral and regional agreements are decided; the benchmark wage in the private sector is linked rather to the announced incomes policy in the public sector and to inflation prospects than to productivity differentials. The last agreement, signed in 2002, managed to promote social peace until end of 2003 while limiting the impact of higher than expected inflation in wage formation. A new agreement should be signed in the first half of 2004 but in view of the forthcoming general elections, it is unlikely that the overall framework of wage bargaining will be substantially modified.

New institutions to promote flexibility and to better match demand and supply

The restructuring of the institutional setting in the labour market has not yet enough maturity to tackle both employment and unemployment issues; the regulatory framework has not yet delivered fully satisfactory results. Under a new law "on the social dialogue for the promotion of employment and social protection" a National Employment Committee and a National Social Protection Committee was created and the role of the Temporary Employment Agencies in better matching demand and supply was strengthened. Emphasis is placed on offering personalised services to the unemployed through the creation of a Job Centres network and the restructuring of the Public Employment System. Nonetheless, barriers to entry in the labour market and supply side rigidities still constitute bold characteristics of the situation in the Greek labour market.

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5. Spain

Spain's continuing positive and even increasing growth differential over most Member States (almost 2 percentage points in 2003 vis à vis the EU) stems from a relatively buoyant domestic demand, notably private consumption and investment in dwellings, whereas the external sector has been a drag on GDP growth. Behind the resilience of domestic demand are supportive monetary conditions coupled with the prudent fiscal stance and rapid employment growth. Impressive employment creation has largely benefited from ongoing wage moderation and the labour market reforms implemented in recent years, as well as high net immigration. While the differential has progressively been reduced in 2003, inflation has remained significantly above the EU average, raising concerns on the competitiveness of the Spanish economy in the medium term. In this connection, the insufficient competition in certain sectors such as retail distribution is also cause for concern. Despite GDP growth decelerating from 2001, Spain was successful in keeping fiscal consolidation on course by achieving a close-to-balance position for a third year in a row as a result of the reduction of interest payments, current spending control and positive evolution of tax revenues linked to fast employment growth. However, the government has taken no steps to reform the public pension system which is of key importance in order to guarantee the future viability of the system and ensure a gradual implementation avoiding disruptions of expectations. While allowing for a steady reduction in structural unemployment, the labour market remains segmented between permanent and temporary workers and the participation rate, though on the increase, remains among the lowest in the EU. Finally, poor labour productivity growth, also linked to the relatively low educational levels of the population and the slow transition to a knowledge-based economy, raises concerns about the long-term performance of the economy.

Key challenges in the light of recent developments

Reflecting the approaching of the general elections in March 2004, most important policy measures implemented in 2003 had been previously approved in 2002. Budgetary consolidation has remained on track. However, to face the budgetary impact of an ageing population, the current policy of public debt reduction and raising participation and employment rates, should be complemented by parametric reforms in the pension system where pending the result of political negotiation, no significant measures have been taken to reform the public pension system, which is key for coping with the budgetary consequences of ageing population. Conversely, in line with the Lisbon agenda, the new income tax and the reform of social benefits and employment protection legislation approved in 2002 entered in force in 2003. Additionally, measures specifically targeted at increasing female employability and facilitating geographical mobility were approved in April 2003. Further measures affecting the current wage bargaining system or the labour market segmentation remain to be taken. Actions have been engaged to further liberalise the electricity market, to strengthen the knowledge-based economy and to further improve the business environment, but little progress was made in the field of the development of effective competition in retail distribution. The following sections present a more detailed assessment of recent developments in addressing Spain's key policy challenges.

1. Labour market

Raise the low employment rates, especially among women, and reduce wide regional labour market disparities,

Under this challenge, Spain was requested to:

1. continue to encourage increased labour market participation, especially among women, including through higher provision of childcare facilities and the promotion of greater use of part-time contracts (E-REC 2);

2. encourage a reform of wage setting in order to better reflect productivity taking into account productivity differences across skills, local labour market conditions and economic circumstances at the firm level, as well as phasing-out indexation provisions in collective agreements (GL 5);

3. further reform of employment protection legislation so as to reduce segmentation of the labour market across different types of contracts (GL 6 and E-REC 1); and

4. continue to facilitate the geographical mobility of workers by removing fiscal and other distortions, including by promoting the rental market for housing and removing rigidities in the availability of land for development (GL 7 and E-REC 3).

Employment rate differentials stem from significantly lower female participation

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Both the employment rate and labour participation are on an upward trend in Spain, but remain significantly below the EU average and the Lisbon target of 70%. The unemployment rate, although on a downward trend, remains, at 11.3%, the highest in the EU.

Whilst male employment rates are at around the EU average, female employment and participation rates, though rapidly increasing, remain well below the European standards. In order to boost convergence of female employment rates some measures have been identified.

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Firstly, increased female employability through tax incentives. The 2003 personal income tax reform has introduced a tax credit for women working with children under the age of 3. Furthermore, in April 2003 a set of new reductions of social contributions have been introduced for women joining the labour market within the 24 months after having given birth as well as for women with disabilities.

Secondly, a higher provision of child-care facilities is likely to encourage women attachment to the labour market, thus complementing the above mentioned initiatives. Despite recent efforts, the share in GDP of total expenditure on social protection benefits to family and children is well below the EU average. From 2003 onwards, in addition to standard tax deductions for parents established by both central and regional governments, companies can benefit from a 10% tax credit for creating new places in firms' nurseries. While in line with the specific recommendations in the BEPGs, these recent initiatives probably need to be complemented by further steps, mainly on child-care facilities.

Finally, the current limited use of part-time contracts in Spain contrasts sharply with that observed in other EU-countries: part-time employment in the EU is twice as high as in Spain. On the one hand, this type of contract is less attractive for workers in that the distribution of the working time is not clearly stipulated. In this respect, a new regulation might be desirable. On the other hand, the diffusion of the part-time contracts is hampered by the disproportionate use of fixed-term contracts.

Wage bargaining system remains unchanged along with the use of indexation clauses

Most of the collective agreements are at a sectoral and provincial level. Given the fact that around 75% of Spanish firms have 10 workers or less, and thus do not have union elections, a fully decentralised system would be difficult to implement. Rather, it would seem desirable to increase coordination among the different levels of bargaining by more clearly delimiting the areas to be covered at each level. This should give room to better reflect local labour market conditions as well as specific circumstances at the firm level. So far no steps in this direction have been taken. In addition, indexation clauses allowing for recovery of the excess of actual inflation over the official forecast are still in force, although their use is not currently creating significant inflationary distortions. In particular, indexation clauses in collective agreements allow for lower wage claims than in sectors where they are not present. Their phasing-out would still appear desirable possibly in connection with the use of realistic inflation forecast in settling wage claims.

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Labour market segmentation remains acute

No new significant labour regulatory measures have been adopted. In spite of the successful introduction in 1997 of a new permanent contract with lower dismissal costs and a number of fiscal incentives, the share of fixed-term contracts over total employment remains, at around 30%, far above the EU level (14%). Despite the introduction of some mechanism of control, fixed-term contracts are often used beyond their legal purpose of covering temporary needs of firms. While allowing for a quick allocation of labour in the face of changing economic conditions, excessive use of fixed-term contracts may deter investment in human capital and even reduce fertility rates while possibly hampering other elements of flexibility such as labour mobility. Further steps in the direction of the 1997 reform of permanent contracts, coupled with a closer monitoring of the use of fixed-term contracts, appear advisable.

Geographical mobility is deterred by rigidities in the housing market

The 2003 reform of the personal income tax introduced a higher tax relief for unemployed workers who accepted job implying change of residence. In addition, further fiscal incentives were set up for house owners putting their houses on the rental market along with fiscal advantages for firms operating in the rental sector. Although these are welcome, their effect might be rather limited since the main factors preventing mobility is the narrow supply of rental housing. In this respect, while the authorities have taken measures to enhance the legal security of the rental market, no major initiative has been adopted in order to increase the availability of land for development.

2. Productivity and business dynamism

Increase the low level of productivity, including by strengthening the knowledge-based economy in terms of educational attainment and skill levels, investment in IT, R&D and innovation performance,

Under this challenge, Spain was requested to:

5. step up efforts to increase skilled human capital, investments in R&D and innovation, and ICT diffusion (GL 13);

6. continue to take measures to further enforce effective competition in certain sectors, such as retail distribution (GL 9), pursue ongoing efforts to reduce the administrative burden on business and monitor closely the developments on the electricity market (GL 11).

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Several initiatives have been launched to strengthen the knowledge-based economy

The educational attainment of the population, as measured by the number of 18-24 years old with only lower education, is relatively low and spending in education as a percentage of GDP remains among the lowest in the EU. The development of the knowledge-based society still lags behind the EU average in terms of business R&D, patents and take-up of ICT. Several measures have been taken in 2003 with the view of promoting the development of human capital and life-long learning, such as several legislative measures to further adequate the educational system and the curriculum to labour market needs, the reform of continuous training which aims at making it available to all workers, especially SMEs and the promotion of vocational training. In addition, the plan "España.es 2004-2005" enacted in July 2003 contains a package of measures for the promotion and the development of the information society. It foresees the development of the e-government and a more intensive use of ICT in the education system. This plan is complemented by horizontal measures such as the promotion of internet access for all citizens and SMEs. Finally, a number of measures have been implemented to stimulate business R&D+i expenditure, and the new 2004-2007 R&D+i National Plan aims for expenditure on R&D to reach 1.4% of GDP in 2007, while business innovation will be promoted through tax rebates.

The business environment has improved and some progress has been made in terms of liberalisation of the electricity market, but effective competition in retail distribution remains insufficient.

In April 2003, the New Limited Company Act was adopted. It creates a new simplified legal framework for SMEs and cut the paperwork and procedures required to set up a small company. The necessary administrative formalities for registering a new company could be completed within 48 hours, mainly through the introduction of the Single Electronic Document (DUE), and a series of tax incentives aimed at encouraging new business creations have been implemented, such as the postponement of the taxes to be paid on company establishment, on corporate profit and on personal income. In addition, Spain has extended the advantages of the law on inheritance and gift taxes in order to facilitate business transmission Moreover, 11 new "one-stop-shops" providing business support services have been established in the period July 2002-July 2003 and the setting up of 80 new "one-stop-shops" is planned over the two coming years.

As of January 2003, domestic customers are free to choose their electricity supplier, which should contribute to increase effective competition. However, the Spanish government has mandated that all utilities must charge the same price per Kwh to consumers which have not opted for a free provider, and that for these consumers prices can only rise by a maximum of 2% a year between 2003-2010. In addition, legal framework to put into place a forward market for electricity has been adopted in November. The completion of the integration of the Spanish and Portuguese electricity markets has been postponed to 2004, instead of 2003 as initially planned. Finally, the competitive situation in retail distribution remains unsatisfactory since market entry is still inhibited by the multiplicity of requirements to grant opening licences. It may be partly as a consequence of the low level of competitive pressures that prices in this sector, and particularly in food distribution, have substantially increased in 2003.

3. Long-term sustainability of public finances

Ensure the long-run sustainability of public finances in the face of population ageing.

Under this challenge, Spain was requested to:

7. complement recent initiatives by taking the appropriate steps to implement a major reform of the pension system, so as to strengthen the link between contributions and benefits and control the long-term increases in pension expenditure linked to the foreseen demographic changes (GL 16).

No new major measures regarding reforms in the public pension system

Major concerns for the sustainability of the Spanish public finances stem from the ageing population and its likely budgetary impact in the long-term. Despite a more favourable scenario than previously estimated in the light of recent net immigration flows, the older people dependency ratio should increase sharply between 2020 and 2030. Therefore, a large increase in the GDP share of age-related expenditure can be expected. Thus, the current policy of public debt reduction, including the pension reserve fund created in 2000 (1.6% of GDP in 2003) and raising participation and employment rates, comprising recent measures to encourage workers to postpone retirement, must be supplemented by a reform of the public pension system coupled with a strategy to promote the second and third pillars. Regarding the latter, some partial measures have been recently introduced, in particular, the setting up of a Pension Fund by the general government to complement public servants' pensions.

As to the reform of the public pension system, it is envisaged that it should affect the key parameters, such as the number of contributory years, the retirement age and the replacement ratio. Recently, the Parliament endorsed a new version of a politically broad-based agreement ("Pacto de Toledo", agreed first in 1995), which aims at ensuring the viability of the public pension system. The recommendations in the agreement, to be discussed in the coming months, are consistent with the 2003-05 BEPGs, in that they aim at prolonging working life and raising employment rates (especially that of women) while advocating strengthening the relationship between the contributory effort and benefits. The latter would in fact involve the implementation of a parametric reform of the system. However, no agenda has been provided so far and one is unlikely to be released before the general elections in March 2004.

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6. France

The French economy has decelerated markedly in 2003 and real GDP growth is estimated to have been only 0.1%. The economy was strongly affected by the deceleration in global demand and the appreciation of the exchange rate of the euro. On the domestic side, private consumption remained relatively resilient but companies low profit margins and cash problems continued weighing on firms' investment. In the context of a cyclical slowdown, the absence of budgetary adjustment in 2003, following the large deterioration occurred in 2002, led to a general government deficit of more than 4% of GDP in 2003. While not respecting the nominal objectives in the area of government finances, the French authorities have taken relevant measures and implemented structural reforms. A major progress made is the implementation of a comprehensive reform of the pension system. The reform represents a major improvement of long-run fiscal sustainability, but does not address all the foreseeable financing challenges. Although reducing significantly the financial requirement of the system in the medium term, the reform is not yet sufficient to secure the long term sustainability of public finances. In order to foster the potential growth of the economy, further reforms will be necessary to address the structural problems of the labour market: despite recent progress, labour market participation is still relatively low and the structural unemployment rate remains at a relatively high level. Moreover, even if productivity per employee is relatively high, it has grown at a slower pace than the EU average over the recent years, probably as a result of the 35 hours work week. But hourly productivity has increased at a stronger pace in the period 1999-2002. In the same vein, reforms aimed at improving the functioning of the product market should be accelerated, even if the decrease of the relative price level below the EU average provides evidence of an increase in competitive pressure. Indeed, the liberalisation in the energy sector is implemented slowly and, despite recent progress, administrative burdens are still perceived as a major constraint by businesses.

Key challenges in the light of recent developments

Although the nominal objectives in the field of public finances were missed, clear progress was made to improve the long-term sustainability of public finances in the face of population ageing, through the implementation of a comprehensive reform of the pension system. As far as the two other challenges are concerned, any assessment remains at the current juncture very preliminary. Measures already taken and declared intentions go in the right direction, but it is still uncertain whether the reforms envisaged will allow compliance with the recommendations. A more detailed assessment of recent developments in addressing France's key policy challenges is presented in the following sections.

1. Public finances

Reduce rapidly the general government deficit to below 3% of GDP and keep government finances on a steady consolidation path

Under this challenge, France was requested to:

1. achieve a significantly larger improvement in the cyclically-adjusted deficit in 2003 than that currently planned.

2. implement measures ensuring that the cyclically-adjusted deficit is reduced in 2004 by 0.5% of GDP, or by a larger amount, so as to ensure that the cumulative improvement in 2003-2004 is enough to bring the nominal deficit below 3% in 2004 at the latest.

3. limit the increase in the general government gross debt to GDP ratio in 2003.

France did not respect the recommendations issued in June by the Council

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In the area of government finances, the country-specific recommendations addressed to France in June were very similar to those formulated three weeks earlier by the Council in the context of the excessive deficit procedure. Following the adoption of the 2003-05 BEPGs, the French authorities have taken a number of measures. However, these measures proved to be insufficient to respect the recommendations of the Council. According to the French authorities, the general government deficit will be reduced from 4.0% in 2003 to 3.55% of GDP in 2004; the Autumn 2003 Commission forecasts project a decline in the general government deficit from 4.2% of GDP in 2003 to 3.8% of GDP in 2004, under the assumption of real GDP-growth at 0.1% in 2003 and 1.7% in 2004. According to Commission calculations, no visible improvement in the cyclically-adjusted balance was achieved in 2003, both in absolute terms and compared to what was expected in June 2003. Moreover, even if the budgetary plans for 2004 include an improvement in the cyclically-adjusted balance larger than the minimum of 0.5 percentage point of GDP recommended by the Council in June, the cumulative improvement in the cyclically-adjusted balance in the years 2003 and 2004 will be insufficient to bring the nominal deficit below 3% of GDP in 2004. Finally, the French authorities did not take measures to limit the increase in the general government debt in 2003 as recommended by the Council in June. In view of these findings, it can be concluded that France did not respect the recommendations formulated.

While finding an agreement outside the Treaty, the Council decided to formulate new recommendations to France

On 8 October 2003, the Commission adopted a Recommendation to the Council to decide in accordance with Article 104.8 that no effective action has been taken by France in response to the Recommendation addressed under Article 104.7. The Commission also adopted on 21 October 2003 a Recommendation for a Council Decision giving notice to France, in accordance with Article 104.9 of the EC Treaty, to take measures for the deficit reduction judged necessary in order to remedy the situation of excessive deficit. In light of the severe economic slowdown, the Commission recommended the Council to allow France an additional year (i.e. until 2005) to bring the government deficit below 3% of GDP. The Commission also recommended the Council to request France to achieve a reduction in the cyclically-adjusted deficit by 1% of GDP in 2004. On 25 November 2003, the Council rejected the two Commission Recommendations finding an agreement outside the Treaty, de facto suspending its application. The Council recommended, in light of the commitments made by France, that France achieves a reduction in the cyclically-adjusted deficit by 0.8% of GDP in 2004 and by 0.6% or by a larger amount so as to ensure that the general government deficit is brought below 3% of GDP in 2005. This is less than the consolidation effort recommended by the Commission. In addition, should the recovery in economic activity be stronger than currently expected, the Council recommended France to allocate any higher-than-expected revenue to deficit reduction and to accelerate the reduction in the cyclically-adjusted deficit.

Ensure the long-term sustainability of public finances in the face of population ageing.

Under this challenge, France was requested to:

4. undertake with urgency a comprehensive reform of the pension system (GL 16), with the aim of ensuring its financial sustainability and increasing the effective retirement age, while adapting pension systems to more flexible employment and career patterns as well as to individual needs.

5. monitor closely the efficiency of the measures undertaken to curb the dynamics of spending in the health sector so as to reduce it to a sustainable level, and, if necessary, introduce new measures to achieve this objective in the context of the reforms envisaged.

Despite the clear improvement resulting from the implementation of the pension reform, long-term fiscal trends remain a cause of concern

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The French Parliament adopted in the Summer 2003 a comprehensive reform of the pension system. The reform foresees an increase in the number of contribution years entitling to a full pension in two steps: until 2008, this number will increase only in the public sector from 37.5 years to the level of 40 years currently prevailing in the private sector; in a second step starting in 2008, the contribution period is foreseen to increase for all workers to the level of 41 years in 2012 and proportionally with life expectancy, through a rule meant to keep constant the ratio between the number of contribution years and the number of years in pension [13]. The reform also raises significantly the financial incentives to remain active until and after the legal retirement age, and changes the reference for the indexation of pensions in the public sector from wages to prices.

[13] The application of this rule will however not be fully automatic, any increase in the number of contribution years being conditional upon the agreement of an independent Commission.

According to the French authorities, this reform, which has been completed in 6 months, will on its own cover around 40% of the financial needs of the pension system in 2020 and will increase potential growth. In the private sector, to finance the remaining part, pension scheme contributions will be modestly increased by 0.2% on January 1st 2006. Thereafter, the financial equilibrium should be ensured, by 2020 through a reallocation of unemployment contributions to pension scheme contributions, as the unemployment rate will decrease. In the public sector, the remaining financial needs, representing 0.7 percentage point of GDP, will be funded by an increase in government expenditures. Although the reform undeniably constitutes a large improvement compared to the initial situation, it is not sufficient on its own to secure the sustainability of public finances in the long run. Indeed, ageing population will continue impacting on the financial situation of the pension system after 2020, and until 2050. In addition, the impact of ageing population on public finances will also materialise through a large increase in health expenditures in the coming decades. This is becoming a source of serious concern for the French government.

The measures included in the budget for 2004 will only ensure a temporary deceleration in health expenditures

The deficit of the social security sector has increased continuously in the last few years, largely due to the rapid increase in health expenditures observed since 1998. Beyond its short term implications on the government deficit, the dynamism of health expenditures is a matter of concern for the long term sustainability of public finances. Particularly worrying is the systematic failure of the several attempts undertaken by the authorities to rein in expenditures in this sector. Indeed, on average since 1998, official targets for the yearly increase in health expenditures were overrun by roughly 2 percentage points.

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For 2004, the French authorities project a decrease in the deficit of the social security sector from 0.6 to 0.5% of GDP. Expenditure growth in the health sector is projected to decelerate to 4.0% in 2004, after 6.4% in 2003. Some measures were introduced to secure the deceleration, but, especially in the light of the past experience, their overall impact remains uncertain. Moreover, the measures taken so far will not - and are not intended to - ensure a lasting deceleration of health expenditures. This issue should be addressed in a comprehensive reform of the health insurance system that the government committed to implement in 2004. The aim of the reform will be to curb growth in health expenditures to a sustainable level, and to eliminate the deficit of the social security sector by 2007.

2. Labour market

Increase labour market participation and reduce structural unemployment.

Under this challenge, France was requested to:

6. ensure that the new unemployment insurance system is fully implemented, including appropriate requirements and effective incentives to search for a job.

Despite recent progress, labour market participation remains relatively low

Labour market participation has continually increased in France in the last 5 years. Despite this progress, the utilisation of human resources is lower than the European average. In 2003, a number of decisions were taken in order to increase labour market participation through reductions in high marginal tax rates (income tax cuts, re-evaluation of the income tax credit). Specific measures were also taken to encourage labour market participation of older workers. This is particularly urgent because in the next few years large cohorts will move from high participation rate categories to low participation rate ones [14]; such an evolution, if not compensated

[14] For instance, between 2000 and 2010, the share of people aged between 55 and 59 years in the total population will increase from 4.5% to almost 7%. The average participation rate for this age group is one third lower than for people aged between 50 and 54.

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by efficient structural measures, will weigh on the potential output growth of the economy. Some progresses were made in recent years, in particular through a significant decline in the flow of new entrants in existing early retirement schemes. The reduction in the duration of unemployment benefits for older workers decided in early 2003, and the implementation of the reform of the pension system, which increases significantly financial incentives to remain in work until and after the legal retirement age, should also produce positive effects in the next few years. Most of these measures go in the right direction, but it is too early to assess their efficiency.

Bolder labour market reforms will be necessary to achieve a significant reduction in the NAIRU

According to Commission estimates, the NAIRU has declined continuously in the last 5 years, to reach about 10% of the labour force in 2003. This indicator remains however well above the level projected for 2010 in the macroeconomic scenario underlying the reform of the pension system. While efforts should be strengthened to accelerate the decline in structural unemployment, it is a source of concern that the declining trend followed by labour cost of low paid workers for several years will probably come to an end in the next few years. Further cuts in social contributions will indeed continue to be implemented, as was the case in 2003, but these new cuts are designed to compensate for the labour cost impact of the increase in the minimum wage stemming from the phasing out of the multiple minimum wage system inherited from the implementation of the 35-hour working week. In order to achieve the large decline in the NAIRU projected by the French government, bolder labour market reforms will have to be implemented. As recommended in June, the authorities have in particular to ensure that the new unemployment insurance system is fully implemented, including appropriate requirements and effective incentives for job search. Moreover, the authorities should continue reducing the regulatory and administrative burden, particularly the effective degree of employment protection which is higher than in most EU countries.

3. Productivity and business dynamism

Ensure competition in the network industries and accelerate the adoption of internal-market measures, in order to create a level playing field.

Under this challenge, France was requested to:

7. pursue efforts to ensure competition in energy markets, namely in gas and electricity sectors (GL 9);

8. sustain the efforts to reduce and simplify business regulations (GL 11); and

9. raise the transposition rate of internal market directives and bring down the number of infringement proceedings (GL 9).

Slow opening to competition in the energy sector.

With a delay of two years, the gas directive has finally been transposed. As to electricity, the eligibility threshold has been reduced to 7 GWh allowing more eligible customers to choose their energy supplier. Both markets now fulfil the legal openness requirements of the EU directives. However, incumbents still retain a strong dominant position. Besides, the declared percentage market opening in gas and electricity remain, with values of respectively 30% and 37%, amongst the lowest of the EU. Moreover, in electricity the total network access cost is still high in comparison to the other Member States. Nevertheless, respectively 25% and 21% of electricity and gas customers have switched suppliers, whereas the electricity prices are low, and the gas prices on the European average. Finally, the unbundling of distribution activities in both sectors is still unachieved, but should be completed when the markets are fully opened (at the latest in 2007).

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Measures have been taken to reduce and simplify business regulations.

According to a 2003 survey conducted by the European Network for SME Research, the complexity of administrative rules was identified by 15% of the French SMEs as a major business constraint. However, an OECD study shows that France has made major progress between 1996 and 2002 in the reduction of administrative burdens faced by enterprises. Entrepreneurial activity, as measured by the percentage of 18-64 years old involved in entrepreneurship activity, was still one of the lowest in Europe in 2002. To improve this situation, an economic initiative law has been adopted by the French Parliament in July 2003. The law seeks to increase the birth and survival rates of enterprises and promotes entrepreneurship. It includes measures to reduce administrative burdens, to lower the time and cost necessary to start a new business and improve the access to capital. For instance, the minimal capital requirement to start a new business is freely chosen by the entrepreneur (it can even be fixed to one symbolic Euro) and one stop internet offices make it easier to register a new business. The law also includes the creation of local investment funds. Supposedly as a consequence of the 2003 reforms announcements, the number of created firms has increased during the first semester of 2003, but the survival rate of these newly borne firms still has to be assessed.

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Although the transposition rate of internal market directives increased, no progress made in bringing down the number of infringement proceedings

The transposition rate of internal market directives has increased from 96.2% in 2002 to 96.5% in November 2003. This is still one of the poorest records amongst EU Member States. However the trend is positive whereas, at the same time, the transposition rate has stagnated at EU level. Concerning infringements, France performance is still the worst amongst the EU Member States and the situation is deteriorating. The number of infringements cases open has slightly climbed again in 2003 to reach 220.

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7. Ireland

The Irish economy is undergoing a significant adjustment from double-digit growth in the second half of the previous decade to a lower pace of sustainable growth in the medium term of up to 5%. On account of its high degree of openness to trade and investment flows, Ireland's capacity to respond flexibly to economic shocks is fairly well-developed and the fact that a low unemployment rate has been preserved so far constitutes further evidence of its inherent flexibility. Additional measures to promote stable macroeconomic conditions, strengthen the supply-side and increase the degree of competition should facilitate a successful completion of Ireland's gradual transition towards its new pace of sustainable growth.

Key challenge in the light of recent developments

In the recent past, Ireland's economic policy agenda has built on and extended previous measures. Further, the government's response to the recommendations in several independent reviews published through 2003, in particular regarding the health care system and the National Development Plan for investment, is starting to take shape. The following sections present a more detailed assessment of recent developments in addressing Ireland's key policy challenge.

1. Macroeconomic conditions and supply-side measures

Achieve a smooth transition from double-digit economic growth in the late 1990s to lower, sustainable growth in the years ahead by ensuring stable macroeconomic conditions and by strengthening the supply-side of the economy.

Under this challenge, Ireland was requested to:

1. enhance the efficiency of public expenditure and improve revenue and expenditure planning in a stability-oriented medium-term framework building on the range of measures recently introduced to improve the planning, management and control of expenditure (GL 14);

2. encourage the social partners to adhere to a prudent and flexible wage norm to allow for adaptation to productivity and skill differentials and at the same time safeguard competitiveness (GL 3 and 5);

3. prioritise the roll-out of the infrastructural elements of the National Development Plan, while preserving budgetary stability, and pursue policy measures to raise the level of R&D (GL 13); and

4. increase competition in the network industries and in certain sectors of the economy, such as retail distribution (including the liquor trade), insurance and the professions (GL 9).

Some further measures to strengthen the budgetary framework are taken

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In view of the deviations from revenue and expenditure targets in recent years, tax forecasting procedures are being kept under review by the Department of Finance and the Revenue Commissioners. Two areas receiving particular attention are the full incorporation of structural changes in the tax system and the availability of more timely data. Work of this nature is expected to be ongoing for several years, potentially leading to modifications in forecasting procedures from 2004 onwards. As regards the development of the medium-term framework, an extension of multi-annual budgeting (rolling five-year envelopes) public transport capital projects to all areas of capital spending was announced with effect from 2004 (see also below).

Given the tighter budgetary situation, the government is stepping up its efforts to secure value for money, especially in high-priority areas which have received ample additional funds in recent years, such as health and infrastructure. As a follow-up to its Health Strategy 2001, the government commissioned more detailed reports on reform of the institutional structure of the health care system and of financial and accountability procedures. This led to the government's health reform programme announced in June 2003. Its main elements are: a rationalisation of the existing health service agencies, the establishment of a national health service executive, the decentralisation of budgetary responsibility and the modernisation of planning and reporting processes. Implementation is currently underway but will take several years to complete. Progress on value for money as part of the benchmarking process and the review of the National Development Plan are dealt with below.

Wage moderation required to protect competitiveness

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Higher inflation than in the main trading partners coupled with the recent appreciation of the euro have heightened competitiveness concerns. In response, wage growth eased markedly between early 2001 and end-2002, illustrating Ireland's capacity to respond flexibly to changing circumstances. However, the latest data show a gradual pick-up in compensation growth, especially in industry. This implies that competitiveness concerns, which resulted in relatively modest pay provisions for the private sector in the wage clause of the March 2003 national agreement, Sustaining Progress, are likely to feature prominently in the negotiations on a new pay deal, which are to start in Spring 2004.

In the public sector, Sustaining Progress provides for the gradual implementation by mid-2005 of an average 8.9% rise under "benchmarking", an exercise to better align pay scales with those in the private sector for comparable jobs. Payment of three-quarters of the increase is conditional on verifiable progress on modernisation and flexibility and maintenance of the industrial peace, in line with the government's drive to secure value for money. In the course of 2003, the necessary arrangements (action plans, performance verification groups) were put in place to monitor such progress and the first verification evaluations took place.

Various measures are planned to improve capital spending and to increase the level of R&D

The National Development Plan (NDP) 2000-2006 came up for a detailed mid-term evaluation in 2003. An independent review published in October 2003 concluded that the overall strategy underlying the NDP is as valid as in 1999, when it was drawn up. Regarding the infrastructural part of the NDP, the review argued that substantial progress has been made and that the returns to investment in physical infrastructure, especially roads, are very substantial. Hence, it advocated an increase in funding for the infrastructure programme of the NDP over the rest of the NDP period, primarily for the National Roads priority. In addition, the review made several recommendations to strengthen value for money and to address management weaknesses as manifested in cost overruns and delayed project delivery. For instance, it underlined the need to improve project selection, the desirability of multi-annual budgeting and the need to strengthen the capacity of implementing departments to manage large-scale projects.

The government agreed with the independent review's evaluation that infrastructure should be the key priority for investment over the remainder of the NDP period and the 2004 allocations for infrastructure are deemed to be broadly in line with the review's recommendations. In December 2003, the government published its first five-year envelopes for capital spending by department for the period 2004-2008, which aim at keeping public investment close to 4% of GDP, well above the EU average of around 2½% in 2003. The practice of multi-annual envelopes provides greater certainty for government departments and public bodies, which should enhance the efficiency of capital expenditure planning and management. In addition, the government intends to publish legislation to speed up the planning and environment impact assessment process and address issues arising from compulsory purchase orders and their cost. Finally, revised capital appraisal procedures to be introduced in 2004 should also help achieve better value for money.

In comparison with other EU countries, both business and total R&D spending are quite low in Ireland as a percentage of GDP. Although expenditure on R&D continued to increase in absolute terms between 1999 and 2001, the ratio of R&D expenditure to GDP levelled off at 1.2% because of the rapid growth in GDP. The number of Irish patents applied for at the EPO (per million inhabitants) is also below the EU average, although it has increased quite strongly in recent years. Funding for science, technology and innovation under the current NDP is on a larger scale than under the previous NDP. New research centres have been created and partnerships have been developed between Irish universities and companies. Naturally, the results of these efforts by the Irish authorities to improve the overall level of R&D will only be seen in the medium term. In addition, in the budget for 2004, it is proposed to introduce a tax credit for incremental R&D spending by companies.

Competition is increasing but at a variable speed depending on the sector

In the telecommunications sector, more competition has been introduced. In mobile telephony, three operators are currently operating on the market. In fixed telephony, the local loop is now unbundled and the market share of the incumbent is now 80% against 95% in 2000. Significant improvements have also been made in the telecommunications infrastructure and in broadband services, mainly for enterprises. In the gas and electricity markets, new competition rules have been introduced. 56 % of the electricity market and 85% of the gas market are now open. Additional measures are being introduced which will achieve full liberalisation in both sectors by early to mid-2005. In transport, new proposals have been made for reforming the aviation and bus sectors.

The Competition Authority is currently reviewing the medical and legal professions as well as engineers and architects and this work will be concluded by end-2004. As regards insurance, reform of motor insurance advances slowly with only 48% of the measures proposed by the Motor Insurance Advisory Board currently implemented. In the other insurance sectors, the authorities are analysing the degree of competition and barriers to entry. This work will be completed by end-2003 and a report on possible regulatory changes is expected for 2004. Finally, the retail sector, including retail in pharmacies, is also under review.

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8. Italy

In the context of a cyclical slowdown, Italy's recent economic performance has underlined some of the emblematic aspects of the country's economy. In 2003, the economy went into a slight recession in the first half of the year, recovering somewhat in the second. Inflation remained relatively high and sticky in the face of a negative output gap inter alia due to insufficient competition in services. On the external side, the economy continued to suffer from foreign sales concentrated towards markets growing less than world demand and from the comparatively high price sensitivity of its exports. Defying stagnant economic growth, the labour market continued to create new jobs, which, however, were not fully reflected in higher consumption expenditure. In this difficult context, authorities have chosen to rely on temporary measures to stave off the risk of breaching the 3% of GDP deficit threshold and avoid a restrictive fiscal stance, postponing the lasting consolidation of public finances warranted by the high debt ratio. As to the overall reform agenda, some progress has been made in the labour market and in education, while a proposal for pension reform to be implemented in the medium-term was presented in the Autumn. While the cycle is expected to have improved in the second half of 2003, no rapid improvement can be expected in the slow pace of underlying growth observed since the early 1990s. A series of structural weaknesses such as the slow transition to a knowledge-based economy, comparatively low expenditure on R&D and a relatively unfriendly business environment also weigh on economic growth. As a result, the government faces a difficult trade-off between improving the long-term growth perspective and obeying to short-term political constraints.

Key challenges in the light of recent developments

Last year, Italy's economic policy agenda largely reflected issues stemming from unfavourable short-term developments. In this context, the government has nonetheless progressed, albeit in a piecemeal way, in some areas of its more long-term reform agenda, most importantly labour market and education, while significant reform plans were put forward for pensions. Progress was made to accelerate the transition to the knowledge-based economy and to reduce the administrative burden for businesses, but measures undertaken to stimulate effective competition in services and energy markets are at this stage insufficient. In other areas, notably in the case of lasting adjustments in public finances, reforms were deferred. A more detailed assessment of recent developments in addressing Italy's key policy challenges is presented in the following sections.

1. Public finances

Rapidly consolidate public finances

Under this challenge, Italy was requested to:

1. until a medium-term budget position close to balance or in surplus is achieved, ensure a reduction in the cyclically-adjusted deficit of at least 0.5% of GDP per year, replacing one-off measures by measures of a more permanent character;

2. strengthen policy co-ordination between all levels of government, by ensuring adequate and transparent enforcement mechanisms for fiscal discipline, while providing for clear sources of financing regional spending; and

3. finance further reductions in the tax burden through structural cuts in current primary expenditure within a comprehensive reform plan on both the expenditure and the revenue side.

Budgetary consolidation slackens

In line with the experience of recent years, budgetary consolidation did not advance significantly in 2003. With a deficit in the region of 2.6 percentage points of GDP, the cyclically-adjusted primary surplus is estimated to have contracted, albeit slightly, and the cyclically-adjusted budget balance to have improved marginally compared to 2002. Also taking into account lower growth than had generally been expected, this contrasts with the recommendation to ensure a reduction in the cyclically-adjusted deficit of at least 0.5 percentage point of GDP per year until a medium-term budget position close to balance or in surplus is achieved. Moreover, the government continues to rely on one-off measures (sales of real assets and a series of tax amnesties), whose impact on the budget balance was in excess of 1 percentage point of GDP in 2002 and could be around 1.5 percentage points in 2003. The draft budget and fiscal measures adopted for 2004 do not foreshadow a significant turnaround in the fiscal stance. Temporary measures (including disposals of real assets and a fiscal amnesty for building regulation violations) once again feature prominently in the fiscal package. Taking into account receipts from sales of real assets already decided in the past, the full weight of the one-off measures may well be over 1 percentage point of GDP. On the whole, despite the perspective of an improving economic environment, the government's determination to implement a sizeable structural correction appears weakened, and there is a risk, after half the parliamentary term has elapsed, of further postponement in the coming years.

Sluggish current primary expenditure reduction constrains tax reform implementation...

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In 2003, the government implemented the first phase of the tax reform, hinging chiefly on a reduction in the personal income tax, which is to be followed in 2004 by a modification of corporate taxation. Given the goal of reducing the overall tax burden, fiscal consolidation implies lowering current primary expenditure in percentage of GDP, which has displayed a strong degree of downward rigidity in past years. Steps taken in late 2002 to tighten controls, implement more transparent spending procedures and set in place a system to collect timely information on the disbursements of public entities, all represent welcome progress. However, major difficulties persist in implementing structural expenditure cuts, and in perspective the process of decentralisation will continue to represent a key challenge, requiring a clear definition of means, instruments, competencies and objectives at all levels of government.

... and generates initiatives to promote public-private partnerships in infrastructure investment

The rigidity of current primary expenditure limits the possibility to expand capital expenditure, which so far has borne the major brunt of consolidation efforts. To overcome this constraint, in 2002 the government set up Infrastrutture S.p.A, a public company designed to finance infrastructure programmes by operating as a borrowing institution of the private sector and promoting public-private partnerships. It is expected to shortly embark on a first operation involving high-speed trains. The operations of Infrastrutture S.p.A. and their impact on the public debt will have to be closely monitored.

Ensure the long-term sustainability of public finances in the face of population ageing.

Under this challenge, Italy was requested to:

4. ensure that the debt ratio is diminishing at a satisfactory pace towards the 60% of GDP threshold; and

5. adopt further measures to address the critical issue in the public pension system, in particular the long transition period to the new contribution-based system. The new system has been designed just to deal with adverse demographic shocks and promote supplementary privately funded pension schemes.

Long-term fiscal trends continue to be a cause for concern...

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Italy's debt to GDP ratio remains very high. A marked slowdown in the process of disposal of financial assets and persisting high levels of the cash government borrowing requirement, which since 1999 has tended to exceed the Maastricht definition of general government deficit by about 1.5% of GDP on average, have weighed on the path of reduction of the debt ratio in recent years, while the dampening effect of low real GDP growth has been counterbalanced by a strong dynamics of the GDP deflator. In 2002 the reduction in the debt ratio of around 3 percentage points of GDP was achieved chiefly through an extraordinary debt conversion operation. In 2003, in a context of continued subdued real GDP growth, the debt ratio will decrease largely thanks to a resumption of privatisations (subject to Eurostat clearing the privatisation of the Casa Depositi e Prestiti, the formerly public deposits and loans fund), a sizeable reduction in cash assets held by the government with the Bank of Italy and a favourable exchange rate effect. The debt targets for the coming years are conditional upon achieving a progressive recovery in primary surpluses (increasing from the current expected 2.7% of GDP to above 5% in 2007) and on an estimate of privatisation operations of 1% of GDP per year on average, which appears ambitious even in comparison with the experience of 1995-2000. An acceleration of the reduction in the debt ratio compared to plans would be warranted in the light of the looming pressures from population ageing.

...despite plans to pursue reform in the pension system in the medium term.

The current draft framework law on the reform of the pension system appreciably dampens the projected increase in the ratio of pension expenditure to GDP over the next twenty years and advances on the implementation of the fully-funded second pillar. The government's plans envisage tightening conditions required to benefit from seniority pensions from 2008, in practice inducing the deferral of the age for retirement. Savings in pension expenditure, estimated by the Treasury at up to 0.7% of GDP per year compared to the present system, would gradually taper off after around 2030, as a longer contribution period will entail a higher average pension for workers falling under the full-contribution system. Yet the enabling legislation draft, subjects the proposal to non-negligible political risks, inter alia by deferring steps to curb pension expenditure trends to 2008. Moreover the proposal leaves open a number of critical issues such as the long interval between scheduled reviews of the parameters of the system.

2. Labour market and regional development

Raise the low employment rate, especially among women and older workers, and reduce the wide North-South economic disparities.

Under this challenge, Italy was requested to:

6. Further encourage increased labour force participation, especially among women, including by adequate provision of child-care facilities; and among older workers, stepping up and reinforcing measures targeted at postponing retirement from the labour force;

7. Further reform employment protection legislation, in order to facilitate job creation and adaptability and to reduce the segmentation of the labour market across type of contracts and firm size; and, at the same time, increase the resources and improve the efficiency of the unemployment benefit and social assistance system; and

8. Encourage social partners to move towards more decentralised wage setting mechanisms that allow wages to better reflect different productivity conditions and individual skill levels.

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Employment rate rises as job creation continues in the face of anaemic growth

The Italian labour market has continued to perform relatively well throughout the recent economic slowdown. Employment was still up, despite a slight contraction of real GDP in the first half of 2003. Thanks to this and a pro-cyclical labour force, the rate of unemployment in 2003 fell below the current estimate of the non-accelerating inflation rate of unemployment (NAIRU) of 9.1%, possibly reflecting the increasingly tight labour market conditions in the North of Italy. Italy's employment rate remained on an upward trend in 2003. Following the pattern of the recent past, including the demographic effect, i.e. the effect from an increasing share of age cohorts with high employment rates, the increase was mainly due to women. Older workers also posted a further rise in their very low rate of employment. However, despite the ongoing progress Italy's employment rate remains the lowest in the EU. Apart from marginal steps included in the 2004 draft budget, no significant measures have been taken to improve childcare facilities.

Labour market reform proceeds at variable pace...

Besides wage moderation and fiscal incentives, the positive performance of the Italian labour market is believed to reflect the impact of the successive stages of reform since the mid 1990s, chiefly by introducing new more flexible labour contracts. The most recent reform, the so called 'Biagi law', was approved by Parliament in February and entered effectively into force in October 2003. In the main, the new law further extends the range of existing, flexible labour contracts, attempts to tackle the issue of precarious work and sets out a reform of private and public employment services. While this may further increase the degree of flexibility of the labour market at the margin and improve its matching capacity, the issue of segmentation of the labour market across types of contract and firms remains to be addressed.

.....with important elements of the reform still pending.

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The original version of the draft 'Biagi law' also aimed at loosening employment protection legislation (EPL) and reforming the unemployment benefit system so as to mitigate the risk of a dual labour market. However, the proposals were removed from the law in the light of fierce trade union protest and wrapped in a separate draft law still pending in Parliament. While parts of the still outstanding reform agenda may currently be difficult to implement from a political point of view, the overall progress and impact of the labour market reform will crucially depend on the government's readiness to tackle the issue of tight EPL and the atypical structure of unemployment benefits system favouring mainly 'insiders' in the manufacturing sector. As regards the low participation of older workers, the government plans to offer a fiscal incentive to employees postponing their retirement decision. The effectiveness of that incentive remains subject of debate.

North-South economic disparity narrowing, although slowly

The regional income gap between the North and South of the county linked to large differences in the employment ratio and labour productivity remains high. The relative income level in the South has slowly improved in the second half of the 1990s returning to the levels observed in the late 1980s. In 2001, the latest year for which final regional data is available, GDP per capita in the South was at 68% of the country's average. Based on preliminary data the slow convergence is estimated to have continued in 2002. The relative improvement of the South since the mid-1990s chiefly resulted from somewhat higher productivity growth. However, the regional productivity differential remains high compared to a low regional wage dispersion. While the government acknowledges that a greater wage differentiation is needed to reduce the employment gap in the South it believes the issue should be dealt with by social partners.

The government's strategy for the South aims at increasing productivity

In view of the fact that the regional income gap intersects with regional employment disparities, progress in the labour market reform is clearly instrumental. More generally, the government's strategy for the South is to reduce the reliance on market-distorting subsidies and to improve the competitiveness of local firms by increasing the quantity and quality of local public goods and, therefore, productivity. The medium-term economic and financial plan (DPEF) for the period 2004-2007 released in July 2003 outlines the key points of that strategy, notably to accelerate public infrastructure programmes (inter alia by resorting to public-private-partnerships) and to strengthen local public administration. In terms of budgetary resources, the government aims at increasing the share of total public capital expenditure designated to the South to 45% in 2007, up from somewhat below 40% in 2002. It is also pursuing a plan of thorough institution building, especially in the Regional administrations. Moreover, the 2003 budget law introduced a single fund for lagging areas providing for more flexibility in the allocation of resources so as to faster react to changing requirements. While these elements clearly go into the right direction, their impact will depend on the improvement in the administrative capacity in Southern regions and the availability of funding for the implementation of infrastructure projects.

3. Knowledge-based economy

Strengthen the knowledge-based economy in terms of educational attainment and skill levels, investment in IT, R&D and innovation performance.

Under this challenge, Italy was requested to:

9. Pursue efforts undertaken to raise the overall education and skill base of the population, to further increase investment in R&D and innovation and to promote higher ICT take up, in particular through measures targeted at small and medium enterprises.

Efforts have been undertaken to accelerate the transition to a knowledge-based economy

Despite recent progress, Italy lags behind most of the other Member States in the field of the development of the knowledge-based economy. This is reflected by lower performances than the EU 15 average in the fields of IT expenditures as a percentage of GDP, of internet penetration and of e-commerce use. This slow transition to a knowledge-based economy can be explained by below EU average business R&D expenditure and patent applications and by a weak educational achievement of the population, as measured by the proportion of tertiary graduates. In March 2003, the Parliament approved a reform of the primary and secondary level education system which notably aims at reducing the still high drop out rates and at facilitating the school-to-work transition. In this respect, the compulsory schooling years have been increased from 10 to 12 years and a vocational education and training stream is proposed. Several measures have also been taken with the view of stimulating R&D and innovation. Actions have been engaged to simplify the public procedures aiming at supporting innovation in the private sector and to make the public aids system for innovation more efficient. Moreover, a new fund for technological innovation projects has been created. Specific actions have also been launched by the government to favour a more intensive use of ICT among companies and households and schools.

4. Productivity and business dynamism

Continue to improve the business environment and to enhance competition in the energy and service sectors.

Under this challenge, Italy was requested to:

10. Improve the business environment by reducing the administrative burden on businesses; and

11. Increase effective competition in the service sector, widen the opening of the energy markets, and improve the implementation of internal market directives.

Better environment for business creation...

Regarding the time and costs necessary to set up a new company, Italy still needs to improve its performance, also in terms of enterprise creation. Administrative procedures for the setting up of new businesses have been lightened and all the relevant documents necessary for companies' registration can henceforth be send via electronic means. A wide reform of Italian bankruptcy law is currently under discussion. One of its major objectives is to make bankruptcy procedures less harsh towards debtors so to ensure that the consequences of business failures are not so severe as to discourage risk taking. However, administrative burden and red-tape associated with running a business in Italy are still high by international standards.

...but the liberalisation of the service sector and of the energy markets proceeds at a slow pace.

Professional services (such as liberal professions and services to households) are still highly regulated and characterised by measures restricting market entry. A number of proposals to reform professional services are being discussed before the Parliament. These proposals assign to the Professional Associations the task of establishing and enforcing appropriate quality standards. However, these proposals do not contain substantial changes in the regulation of entry and Italy still remains among the worst performers in term of strict regulation of professional services.

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As regards the energy sector, the gas market for final consumers has been fully liberalised but in many instances there is still one firm in the market. In electricity, recent developments are mixed. On the one hand, the Parliament is currently discussing a comprehensive energy sector reform, part of which has already been enacted. Some of the new measures could result in enhancing competition in the electricity sector, by accelerating investments in new capacity and by privatising the firms and allowing the Transmission System operator to own the facilities. Moreover, the law under discussion foresees the acceleration of the liberalisation of the market as requested by the EU Directive (full market liberalisation in 2004 for non-households users and 2007 for households). On the other hand, the measures designed to develop interconnections capacities also contain provisions that would allow the company investing in such capacities to be exempted from the "third party access" requirement for a limited period of time and only for a limited extent. In addition, in order to control inflation, the government has intervened recently by asking the energy regulator to modify the criteria for updating the part of the tariff linked to the fuel prices. A new proposal under discussion reorganises some aspects of the regulatory Authorities, assigning new regulatory competencies to the Ministries is being discussed. The introduction of a wholesale electricity pool has been postponed to 2004 and in the meantime a provisional system of exchanges, limited to captive market, has been set up.

Finally, the transposition rate of internal market directives (97.0%) has continued to decrease in 2003 and remains below the 98.5% target.

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9. Luxembourg

Following many years of real GDP growth well above the EU average, economic growth in Luxembourg slowed down sharply. Over the last decades, the sectors of financial intermediation, real estate and services to businesses have seen their share in gross value added increasing at the expense of the industry to reach about 47%, compared to an average of 27% in the EU-15 (see chart). Because of the importance of the financial sector to the economy of the Grand Duchy, the negative impact of the turmoil on financial markets on economic growth was more profound than in most other EU Member States. The resulting drag on activity and productivity growth continued into 2003, as firms adjusted to the shock. Weak profits and balance sheet restructuring held back investment. As the slowdown in economic activity spread to more sheltered sectors of the economy, the negative impact on employment was increasingly felt. Against the backdrop of weak economic growth, the labour market has weakened markedly in the course of 2002 and 2003. While economic growth is expected to pick up in 2004, there would be no improvement in the labour market in the near term. Its high openness and receptiveness to FDI inflows allows Luxembourg to benefit from competition from abroad whilst the reform of its own competition framework is dragging.

Key challenges in the light of recent developments

The weakened situation of the labour market makes the challenge to increase the domestic employment rates, especially for older workers, which is currently among the lowest in the EU, even more important. Strengthening competition and improving the business climate remain fundamental to boost the growth potential of the economy. In addition, the reform of the competition law is a long-awaited measure, which has not yet been implemented. The following sections present a more detailed assessment of recent developments in addressing key policy challenges identified for the Grand Duchy.

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1. Labour market

Increase the low national participation and employment rates, especially for older workers,

Under this challenge, Luxembourg was requested to:

1. review incentives for early and pre-retirement and ensure appropriate eligibility rules in the disability pension scheme (GL 16 and E-REC 2).

Continued weak growth takes its toll on employment

The substantial slowdown in employment growth in the course of 2003 (in response to sluggish real GDP growth) has led to a progressive increase in the domestic registered unemployment rate, which is forecast to increase from a low of 2.1% in 2001 to 4.2% in 2004. While in 2002 the overall employment rate in terms of full time equivalents still increased, the expected further deceleration in employment would lead to a decrease in the participation rate, even though this is likely to be cushioned somewhat by the specific employment schemes. In the public sector, employment would increase only slightly in 2004, in order to limit the increase in public expenditure.

In the limited time that elapsed since the adoption of the 2003-2005 BEPGs, to date, no concrete policy measures have been implemented to reduce incentives for early retirement. However, the government is considering abandoning legislation that prohibits people receiving pension benefits to take up salaried employment. In the public sector, a new measure allows officials to continue working beyond the age they are eligible for retirement. Some progress has been made to reduce the inflow in disability pension schemes by tightening eligibility. A specific measure aimed to promote the participation rate concerns the introduction of more flexible working schedules for workers in the public sector. An agreement has been reached on the right to vocational education. Because of the recent introduction of all these measures, it is too early to assess their impact on the participation rate.

2. Productivity and business dynamism

Improve the business environment and encourage entrepreneurship in order to achieve a more balanced economic structure.

Under this challenge, Luxembourg was requested to:

2. fully implement the reforms of competition law and to ensure that competition and regulatory authorities have sufficient independence, resources and power to fulfil their tasks (GL 9); and

3. take measures to encourage and facilitate the creation of SMEs and to help those to access venture capital (GL 11).

The reform of the competition law is slowly within sight...

The recommendation to reform the competition legislation dates from 2000. Original and amended draft legislations have been approved by the government respectively in September 2002 and in November 2003. The latter text should now go to the Parliament to be adopted, possibly before the end of the present legislature in mid-2004. It will abolish the present outdated legislation on fixed and monitored prices and install an independent Competition Council. New legislation has been adopted to set up a single legislative framework for public procurement, in order to align the national legislation with EU directives. No progress has been reported on the financial and human resources of the competition and regulatory authorities.

... and some measures have been taken to encourage entrepreneurship.

Luxembourg has traditionally been among Member States where a high share of SMEs identified the administrative burden as a major constraint for business performance. Typically, the thirty days necessary in 2002 to register a start-up and the associated cost of the procedure placed Luxembourg at the 11th position of the EU ranking. Legal initiatives have been taken in 2002 and 2003 to streamline the set of data requested to start up a business. A joint venture between the Public Company for Credit and Investment and some private banks has been created to help SMEs to access venture capital. In addition, actions to make pupils aware of entrepreneurship have been launched in schools with the help of Chambers of Commerce. These targeted schemes aim at removing cultural barriers to entrepreneurship, which Luxembourg claims to be the main problem in this field. It is too early to assess the effectiveness of the various programmes.

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10. Netherlands

In 2003 real GDP is expected to decline by 0.9% in the year as a whole, compared to a meagre positive growth rate of 0.2% in 2002, the weakest growth performance in the EU. In response, social partners agreed to freeze contractual wage increases in 2004 and 2005. Against the background of stronger and more protracted economic slowdown than in most other EU countries, the situation of public finances deteriorated markedly as surpluses turned into deficit. To reverse these adverse budgetary developments, the government adopted substantial fiscal consolidation measures in 2003 and 2004, in total equivalent to 2.5% of GDP. This substantial consolidation effort is an important step to meet the short-term objective in the field of public finances. Nevertheless, the weak economic prospects imply that the deficit would increase to 2.7% of GDP in 2004. Planned expenditure reductions are mostly of a structural nature and stem, inter alia, from reforms in social security, wage restraint in the public sector, measures to control health care spending, and a reduction of subsidies. The reforms of benefit systems should help to promote labour force participation in the medium term and thus go some way to meet the key challenges formulated for the labour market. Productivity growth has been relatively slow in the Netherlands over the recent years. Although this may be partly attributed to rapid employment growth, the low level of competition in some sectors as well as the declining specialisation in high-tech manufacturing sectors also contributed to this slowdown. Thus, reforms aimed at improving the functioning of product markets should be stepped up.

Key challenges in the light of recent developments

Shortly after adoption of the 2003-2005 BEPGs, the new Dutch government decided to pursue even more rigorous fiscal consolidation than previously envisaged in order to ensure that the deficit would not pass the 3% of GDP threshold. Some of the measures taken in order to meet the budgetary challenge posed by the severe economic slowdown are also aimed at increasing labour force participation. This constitutes progress with respect to labour market reforms, to the extent that these measures will be successful in promoting labour force participation in the medium term, even though the adverse economic situation hinders progress in the near term. However, some fundamental issues, specifically with respect to pensions, are still undecided. Productivity and innovation should be enhanced to boost potential growth, but while declared intentions go in the right direction recent progress in these areas has been slow. The following sections present a more detailed assessment of recent developments in addressing key policy challenges identified for the Dutch economy.

1. Long-term sustainability of public finances

Pursue budgetary adjustment in the coming years in the face of weaker potential growth, and the budgetary costs of ageing.

Under this challenge, The Netherlands was requested to:

1. continue to contain government expenditure within clearly defined ceilings set in real terms, consistent with a budgetary position close to balance or in surplus (GL 1 and 14).

Substantial budgetary consolidation despite economic headwind

Despite the strong and commendable fiscal consolidation effort, Dutch public finances have deteriorated very quickly and the deficit is expected to peak in 2004 just below 3% of GDP. Both the 2003 and 2004 budgets are very restrictive and contain ex-ante consolidation packages

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equivalent to 1.2% and 1.3% of GDP respectively [15]. In fact, over the summer the new government decided a package of additional measures in order to prevent the deficit from exceeding the 3% of GDP mark. For the whole cabinet period from 2003 to 2007, the budget contains ex-ante consolidation measures equivalent to a cumulative 3.9% of GDP. The consolidation effort relies to a large extent on expenditure reductions of a structural nature. As a consequence of tight budgetary policy, the cyclically adjusted deficit is forecast to improve markedly between 2002 and 2005. The budgetary consolidation effort is appropriate in view of the rather moderate growth rate of potential real GDP, which requires expenditure to move in line with the relatively modest increase in the revenue base in years ahead. In line with the recommendation in the 2003-05 BEPGs, the new government has decided to maintain the key elements of the budgetary strategy already used by previous governments. This encompasses limiting the growth of real government expenditure under ceilings defined in real terms and set in advance for the whole cabinet period up to 2007. The challenge for the Dutch authorities in the current adverse macro-economic environment is to ensure that actual expenditure remains consistent with achieving and maintaining a budgetary position close to balance or in surplus in the medium term. This may require additional consolidation efforts, should budgetary prospects worsen significantly compared to the targets set.

[15] Because of second-round effects on economic activity, the actual (ex-post) improvement of the government balance is less.

2. Labour market

Draw currently inactive people into the labour market.

Under this challenge, The Netherlands was requested to:

2. push forward with reforms of benefit systems in order to make work pay (GL 4 and E-REC 3). Concentrate, in particular, on benefit eligibility and conditionality. Legislate and implement the planned reform of the disability scheme, thereby paying attention to both the inflow and to the activation of those who already receive benefits.

Several measures aim to enhance incentives to work and discourage early retirement...

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The 2004 budget contains several measures to reform benefit systems with the aim of enhancing incentives to work. In addition, the government intends to promote the labour force participation of the elderly by removing fiscal incentives for private early retirement schemes. Measures decided upon include a limitation of the duration of unemployment benefits. In order to encourage the participation of older employees (of 57½ years and over), the obligation for unemployed elderly people on benefits to actively search for a job will be reintroduced. The municipalities will have full financial and administrative responsibility for those on welfare benefits (including both the payment of benefits and reintegration efforts) as of 2004. This decentralisation should save costs and enhance the efficiency of reintegration efforts. Measures taken to limit income-dependent subsidies would help to diminish the adverse cumulated effects of different benefit schemes. With respect to disability benefits, a reformed system will come into force in 2006. The period during which employers have to pay the sickness benefits of employees is extended from one to two years. Furthermore, criteria for the partly disabled to receive an income-related wage supplement will be limited. These measures are in line with the recommendation to reform benefit systems as they limit eligibility and enhance conditionality. The reforms of social security and pensions decided upon aim to reduce public expenditure and strengthen supply side conditions. At this juncture it is too early to assess to what extent they will actually affect the behaviour of economic agents.

...but some issues still pending in the aftermath of the wage moderation agreement.

However, some of the reforms of social security and pensions announced in the 2004 budget as presented to Parliament have been dropped or are still pending. This mainly reflects the outcome of a dialogue with social partners, which resulted in an agreement to freeze contractual wage increases new collective labour agreements in 2004 and to have these increases approach zero in 2005. Social benefits will be frozen in 2004 and 2005. The wage agreement is an important step marking efforts to improve external competitiveness, which had suffered substantially in recent years due to high wage and price increases. It is clear that the central wage agreement will have a beneficial impact on labour costs and external competitiveness in the near term. However, in the longer term more wage differentiation across sectors is called for, to promote innovation, competition, and an efficient distribution of production factors.

In response to the wage agreement, the government agreed to delay or modify some intended measures, especially concerning pre-pensions and early retirement and the disability benefit scheme. The planned measures to abolish tax-facilitation of early retirement and pre-pension schemes are put on hold. The cabinet and the Labour foundation have agreed to jointly propose a new arrangement to be introduced in 2006, including possible transitory arrangements. For the time being, the cabinet will put on hold some additional initiatives to tighten conditions to become eligible for unemployment benefits. As regards the disability scheme, proposed limitations on benefit payments related to family income and income suppletion of sickness benefits in the second year of illness have been dropped under the condition that social partners agree not to provide supplementary income. This has significant implications both for the recipients and for the costs of the system if the intended savings from this measure will occur. The new criteria for determining disability will be determined taking into account advice from the Social Economic Council. However, it is important not only to stem the inflow in disability schemes, but also to add further measures aimed at activating those currently on benefits to the extent possible. Apart from the introduction of medical re-examinations, this issue has not been sufficiently addressed so far.

3. Productivity and business dynamism

Tackle the relatively slow productivity growth, stemming, inter alia, from the low level of competition in some sectors, and insufficient business investment, particularly in R&D.

Under this challenge, The Netherlands was requested to:

3. improve the regulatory framework as well as its implementation (GL 11), especially in sectors where competition has been found to be inadequate, such as construction and professional services; and

4. promote a more technology oriented education and strengthen science-industry links with the aim of increasing business investment in R&D (GL 13).

Effective competition in a number of sectors remains limited

Until recently, the process of liberalisation in the network industries in the Netherlands was proceeding quite rapidly. However, as competition in the already liberalised markets remained rather limited, consumers benefited only little from the reform effort. This has negatively affected the public perception of liberalisation, which led the Dutch Government to delay further reforms (while opening up the electricity market for residential private customers was initially planned for January 2004, the government recently postponed the date to July 2004). In order to regain support for liberalisation, the government announced that further liberalisation will be accompanied with measures allowing to safeguard consumers' interests. This would imply a reinforcement of the regulatory regimes in the network industries.

The Dutch government intends to increase the powers of the Dutch Competition Authority, in order to better handle competition problems in sectors such as construction and professional services, where competition was found to be inadequate. In particular, the Competition Authority will have the power to enter the homes of suspected private individuals; to seal off business premises and objects (which would facilitate investigation procedures in the construction industry, for example); to give increased fines for failing to co-operate with an investigation; and to allow for penalties for directors as well as organisations.

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Objectives have been set to promote a more technology oriented education.

The Netherlands has an advanced R&D sector. However business R&D expenditure has been below the EU average during the last years. In order to stimulate private innovations an Innovation Council has been created recently which is headed by the Prime Minister. One specific problem is the low level of new science and technology graduates, which may create an obstacle for future innovation. The difference in the number of new Science and Technology PhDs between the Netherlands and the EU average has been growing over the recent period. There is a shortage in the labour market for highly qualified specialists and scientists. Therefore, the Ministry of Education, Culture and Science defined as a key objective increasing the intake into science and technology courses, bringing focus to scientific research, making vocational training more innovative and to improving the co-operation between research and educational institutions and business. In order to strengthen the Science-Industry links the Netherlands is currently reviewing all policy measures for innovative start-ups with the view of bringing all instruments under one initiative called "TechnoPartner".

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11. Austria

Against the background of subdued growth in a weak external environment, the Austrian government pressed forward with an extensive reform agenda, featuring most prominently a comprehensive reform of the public pension system and a sizeable tax relief. Budgetary negotiations and the simultaneous debate on the complete overhaul of the pension system accompanied by multi-sectoral strikes were at the centre stage in spring 2003. Against this background and despite increased uncertainty linked to the pension debate, consumer demand proved surprisingly resilient, although household disposable income was squeezed by weak employment growth and a further increase in unemployment. Notwithstanding a short-term economic outlook in line with international developments, potential growth in the medium term is projected to decrease. Measures aiming at raising participation rates are particularly welcome and represent the path to be followed with a view to reversing the projected trend in potential output growth. In this respect, however, the government's current policies send contrasting signals. Austria has benefited from reasonably high growth rates of labour productivity over the recent years. Increasing competition in product markets and intensive trade relations with the accession countries have been instrumental in this respect. However, some sectors still suffer from a lack of effective competition and the implementation deficit of the Internal Market directives should be further reduced. Due to a number of measures adopted, the conditions for a transition to the knowledge-based economy have improved but R&D expenditures remain slightly below the EU average.

Key challenges in the light of recent developments

In less than a year since having taken office, the Austrian government has implemented important economic reforms. Most importantly, it has enacted a comprehensive overhaul of the Austrian pension system. Moreover, a sizeable tax reform, to be implemented in two steps, is in the offing. The blueprint for the second, more substantial step of the tax reform 2005 is currently being drafted. Its implementation would require additional savings to return to a cyclically-adjusted budgetary position close to balance. Austria has continued building and streamlining the framework for support of R&D. Effective competition in some sectors has been promoted but significant weaknesses remain. A more detailed assessment of recent developments in addressing Austria's key policy challenges is presented in the following sections.

1. Long-term sustainability of public finances

Ensure the sustainability of public finances in the face of population ageing,

Under this challenge, Austria was requested to:

1. implement measures leading to structural expenditure savings, also at lower levels of government, so as to lower the high tax burden, while securing a cyclically-adjusted budgetary position close to balance (GL 1); and

2. reform the public pension system to ensure the sustainability of public finances (GL 16); in particular link more closely the level of pension benefits to life-long contributions; increase the low average effective retirement age and ensure in this context that incentives to work are enhanced (GL 4 and E-RECs 2 and 3), with a view to raising the labour market participation of older workers.

In 2003, deficit increase mainly induced by discretionary measures ...

The general government deficit in 2003, has widened to 1% of GDP according to preliminary official data. Apart from automatic stabilisers working fully, the deterioration of the budgetary balance vis-à-vis 2002 is mainly explained by discretionary measures. On the revenue side, the full impact of two economic stimulus packages is being felt, resulting in considerable permanent income shortfalls while on the expenditure side an increase in the family allowances and deferred, if small, one-off spending related to the flood disaster in summer 2002 led to rising discretionary expenditures. Structural savings have been implemented in the area of the ongoing administrative reform, consisting of staff reductions and cuts in current expenditure. As a result, the cyclically-adjusted deficit in 2003 is estimated to have widened by half of a percentage point to 0.7% of GDP.

In 2004, structural savings are expected to outpace additional increases in discretionary spending. Above all, spending should be curbed by beginning effects of the pension reform and related measures. Combined with a streamlining of health insurance funds and the administrative reform, the total impact of structural expenditure savings are estimated at some 0.6% of GDP in 2004. On the other hand, higher spending for R&D, universities, and family allowances is estimated to burden the budget by ¼% of GDP.

At the state level (Länder), structural savings measures have not been implemented (apart from a reduction in the number of school teachers).

Overall, noticeable progress with regard to structural savings is clearly being made, providing room for lowering the tax burden. However, due to an increase in discretionary spending and a sizeable tax relief planned for 2005, after a smaller one having become effective as of 2004, a cyclically-adjusted budgetary position close to balance is projected not to be maintained after 2004. Although planned to be of a temporary nature, this departure from the medium-term target may turn out to be persistent, if the expenditure savings announced in the stability programme update of November 2003 were only partly implemented or did not materialize as intended.

... but comprehensive overhaul of the Austrian pension system should rein in long-term spending increase with positive effects already in the short term.

The substantial modification of the pension system was for a long time the politically most sensitive and from a budgetary perspective most important issue. After long negotiations, the Austrian parliament on 11 June 2003 adopted a pension reform law, concerning both the public and the private sector pension regimes. The measures address the key problem areas and are fully in line with the respective recommendation:

* The actuarial fairness of the pay-as-you-go scheme should be enhanced. Starting from 2004, the reference period for calculating pension benefits will be extended by one additional year annually from currently 15/18 years with the highest income to ultimately - by as late as 2028 - a full 40-year earnings career. The same will apply to federal government officials, whose pension benefits have so far been based on their last salary.

* The effective retirement age as well as the labour force participation of older workers should be raised by a series of measures, mostly starting in 2004: (1) Early retirement will be abolished, but the effective retirement age should correspond to the statutory age only by 2017. In the private sector, unequal treatment of genders is planned to persist, as the early retirement age will be raised to 65 years for men and to only 60 years for women (from at present 61½/56½ years). As of 2019, however, due to the reform in 1997, the gender harmonisation of retirement ages will be phased in until 2033. For federal government officials, the retirement age will be raised likewise, with the same age limit of 65 years applying equally to men and women. (2) The retirement age for persons with particularly long contribution periods (men 45, women 40 years) will also be raised as of 2007. (3) Moreover, the gradual retirement scheme for older workers ("Altersteilzeit") is modified. Front-loading is prohibited, i.e. employees must actually work part-time for a period of 6½ years, instead of effectively retiring early. (4) In addition, incentives to stay in employment are strengthened. To this end, the so-called bonus/malus system is modified, increasing gains from remaining active or losses from retiring early. As a consequence, the Austrian authorities expect the overall participation rate to increase from 67% in 2000 to 76% by 2040 and the participation for workers aged 60-64 from 10% to 42% respectively.

* Upward pressure on budgetary spending shall be contained by lowering the annual accruals rate for pension benefits from 2 percentage points to 1.78 percentage points per contribution year, in five steps between 2004 and 2008. As a result, the maximum replacement ratio, remaining at 80%, will be attained after 45 instead of 40 contribution years.

Notwithstanding the overall merits of the reform, a few shortcomings remain: (1) A uniform 10 percent cap on benefit "losses" compromises guiding principles of this reform. New parameters become ineffective with benefits determined essentially by the old formula, reduced by 10%. Moreover, the notion of benefit "losses" is an artefact, misleadingly suggesting that benefit levels based on the old formula could have been maintained in the long run. (2) Long transition periods will delay the exonerating effect on public finances. In particular, the phasing-in period for early retirement, rather generous from the outset, should have been abolished by 2013, but was extended until 2017. (3) Early contribution years are not sufficiently re-valued in the framework of extending the reference period for calculating pension benefits. In practice, this implies that individuals with a flat earnings profile will receive lower benefits than persons with a steeper profile, even if in absolute terms their accumulated pension contributions are equivalent.

While the initial proposal was somewhat diluted in the parliamentary process, the pension reform should, nevertheless, be considered a major political success. Some measures are expected to have budgetary effects already in the short term, and further sizeable expenditure savings should materialise far beyond the current legislation period.

The Austrian authorities project the long-run upsurge in public pension spending to abate noticeably thanks to the recent reform. Expenditure for private sector pension schemes is forecast to be up by less than 2 instead of some 3 percentage points in 2050, rising from currently 10.5% of GDP to 12.3% in the year 2050, with a peak at 13.1% of GDP in 2035. In addition, savings in the civil servants' pension schemes are estimated at some 0.1 percentage point of GDP by 2010, rising to 0.3-0.4 percentage point by 2030. Clearly, even if these projections were subject to change, the pension reform 2003 represents a substantial, albeit not the last, step towards ensuring the long-term sustainability of public finances.

2. Productivity and business dynamism

Continue to improve the weak technology base, and encourage business R&D and innovation,

Under this challenge, Austria was requested to:

3. take measures to encourage business research and innovation, especially for SMEs, (GL 13).

Strengthening of weak technology base should continue to be a priority ...

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While an increasing trend of some indicators on innovation and research (e.g. number of patents, scientific publications) provide evidence of improvements, a strengthening of the weak technology base should continue to be a priority, especially given the slow increase in R&D expenditures which have kept Austria below the EU average. Moreover, the low participation of domestic companies in the financing and carrying-out of research activities has not significantly improved as the share of business financed R&D has stagnated at around 40%, as compared with around 55% at the EU level.

... but measures adopted promise future improvement.

Over the last year, Austria has taken several measures to increase and rationalise R&D and innovation support. On the one hand, the government adopted measures to stimulate R&D and innovation in the business sector. In this respect, the government has recently announced further extension for the next year of the tax allowance for innovation expenditures and pledged additional funds for R&D. In April 2003, a pilot project was launched with aim to step up the creation of technological axes between Austrian technology parks, research skills centres, technology-oriented clusters and cooperative research institutes, and their counterparts in Central and Eastern Europe. On the other hand, the government proceeded with rationalising the R&D support framework as a means of ensuring its efficiency. After creating the Austrian Business Service with focus on SMEs and start-ups by merging different promotion and financing bodies, a streamlining of the institutional framework for the administration of State aids to R&D is currently under examination. Since the recently adopted measures, coupled with sustained future efforts, might have the potential of generating benefits in the medium term, heightened attention should now be paid to introducing systematic monitoring and assessment of the programmes.

Strengthen the development of effective competition in some sectors.

Under this challenge, Austria was requested to:

4. increase the resources of the competition authority and to take measures to enhance effective enforcement of regulators' decisions in telecommunications (GL 9).

Effective competition increased in some sectors ...

Austria has made a step towards enhancing effective competition in the retail sector by partially liberalising the regulation on opening hours. Furthermore, a simplification of the regulatory framework has resulted in the decrease of start up costs and allowed for easier access to several professions. As a result, the share of SMEs considering administrative burdens as a major constraint has declined significantly in 2003. However, no measures to address high concentration in some other sectors (e.g. print media, health insurance, network industries, drugstores and furniture) have been reported.

... but resources of the Federal Competition Authority remain inadequate and the power of the telecom regulator continues to be insufficient.

During the first year of its existence the Federal Competition Authority started to build up the public record of its activities. Notwithstanding a slight increase in the number of the Authority's staff, insufficient resources remain a problem. The Authority has fewer resources than competition authorities in any of the other EU countries. The ability of the Authority to carry out thorough investigations, produce studies or get involved in competition advocacy is thus severely limited. No measures to enhance effective enforcement of the regulator's decisions in telecommunications were reported over the period under examination.

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12. Portugal

The impact of the economic slowdown in Europe is being accentuated by the ongoing adjustment of domestic demand such that economic growth is projected to stay below the EU average during the period 2002-05. Since the end of 2001, domestic demand has been receding on account of the continuous efforts of private sector agents to restore the sustainability of their balance sheets and of the tightening of fiscal policy. After the significant losses in price-competitiveness accumulated in recent years, cyclical conditions, together with the near-freeze in wages in the general government sector in 2003, are having a favourable impact on wage settlements for the private sector. As regards fiscal policy, in order to avoid having to adopt an overly restrictive stance, and to give extra-time for a broad-based programme of structural reform that is currently being carried through in order to yield the expected benefits in terms of expenditure savings, the Portuguese authorities have had to rely, for a second year running, on sizeable one-off measures in order to keep the budgetary deficit below the 3% of GDP ceiling. In order to strengthen the catching up process, the Portuguese authorities have taken a number of initiatives (or are planning to), notably to stimulate innovation and R&D activities, improve the education system, foster life-long learning, and enhance competitiveness, particularly in network industries.

Key challenges in the light of recent developments

In the present difficult circumstances, the Portuguese government has started to address the key challenges identified in the 2003-05 BEPGs. However, the budgetary plan for a further reduction of the general government deficit was severely hampered by the large (negative) output gap that induced a large revenue shortfall. However, considerable progress was made in slowing down the pace of total current primary expenditure on account basically of the rapid deceleration of public consumption, although this was partly offset by a strong dynamism of social benefits that is unsustainable over the medium-term. Progress was also made in the implementation of a number of reforms as recommended in the BEPGs, especially in the health-care sector and as regards incomes policy. Nevertheless, further efforts are needed to accelerate the transition towards a knowledge-based economy in order to increase productivity. A more detailed assessment of recent developments in addressing Portugal's key policy challenges is presented in the following sections.

1. Public finances

Accelerate the consolidation of public finances and address the strong dynamics of Government expenditure,

Under this challenge, Portugal was requested to:

5. ensure that the Government deficit is further reduced in 2003 as planned, and that the cyclically adjusted deficit is thereafter lowered by at least 0,5 % of GDP a year in order to reach a budget position that is close to balance (GL 1);

6. ensure that the deficit reduction is obtained mainly through the expenditure side by firmly executing budgetary plans for all sub-sectors of the general government (GL 14); and

7. undertake structural reforms in areas with a more direct impact on budgetary consolidation, notably in public administration, education, health-care, and social security.

The general government deficit in 2003 is expected to be below the 3% of GDP ceiling due to sizeable one-off measures.

As the general government deficit is estimated to amount to 2.9% of GDP in 2003 compared with 2.7% in 2002, Portugal did not meet the recommendation that called for a further reduction of the deficit, which was planned to be achieved against a much more favourable growth background. The strong deterioration of the cyclical position that has emerged together with the high sensitivity of the tax system to cyclical movements caused a massive shortfall in tax revenue. Government expenditure is expected to grow broadly in line with targeted values for 2003. These revenue and expenditure developments would lead to a government deficit above 3% of GDP in 2003. In order to prevent this, the Portuguese authorities have introduced two one-off measures, together worth more than 2% of GDP: (i) a lump-sum payment by the Post Office (CTT) to the government in exchange of the transfer to the government of CTT's unfunded pension obligations; (ii) the sale to a financial corporation of non-performing tax claims (i.e. tax arrears). Both operations have been cleared by Eurostat.

The cyclically adjusted deficit is expected to fall by more than ½ percentage point of GDP in 2003. This, however, is largely due to the impact of one-off measures.

Current primary expenditure is developing broadly in line with planned values.

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Total current primary expenditure is growing broadly in line with targeted values. This corresponds to a significant deceleration in the annual growth rate from 8.1% in 2002 to 5.1% in 2003. Despite the concerted efforts by the Portuguese authorities to rein in expenditure growth, the expenditure-to-GDP ratio increased further in 2003, basically because growth in nominal GDP decelerated by about 2½ percentage points. The progress made on curbing current primary expenditure growth in 2003 reflects basically the strong deceleration in public consumption growth from 6.9% in 2002 to an estimated 2.9% in 2003, to a large extent on account of a significant slowdown in the compensation of employees. Further moderation in current expenditure growth is expected for 2004, brought about both by budgetary measures and the efficiency gains associated with the ongoing implementation of a number of structural reforms.

The reforms programme is proceeding broadly as planned

The programme of structural reforms encompasses nearly all major policy areas, including those with a more direct impact on budgetary consolidation, notably public administration, the labour code, competition policy, the provision of education and health-care, and the reform of pension schemes. The main aims of the reforms are twofold: first to pursue the process of budgetary consolidation on a sustainable basis, therefore eventually dispensing with one-off operations, and second, to enhance the growth potential of the economy.

2. Productivity and business dynamism

Increase overall competitiveness which is at risk from the low efficiency of the education system, low R&D spending, a low degree of competition in certain sectors, and high nominal wage growth,

Under this challenge, Portugal was requested to:

8. promote the stronger involvement of the business sector in R&D spending and innovation (GL 13), together with higher ICT take-up;

9. improve the efficiency of spending in education with a view to, inter alia, raising the qualification of human resources (GL 13 and E-REC 1), and reducing substantially the number of early school leavers with insufficient levels of schooling or training;

10. enhance effective competition in liberalised utilities, especially in the energy sector, and create a better competitive environment by increasing the transposition rate of internal market directives (GL 9); and

11. encourage the social partners to secure wage moderation, while allowing wage increases to take into account productivity and skill differentials, with a view to improving competitiveness (GL 3 and 5).

Several initiatives have been launched to encourage the transition towards a knowledge based society

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The levels of R&D expenditure (as a percentage of GDP) particularly in the business sector are among the lowest in the EU. In addition, overall ICT diffusion remains below the EU level, while showing an improvement over the last decade. However, measures have recently been taken to spur innovation in enterprises and R&D activities. For example, in order to develop venture capital and risk capital funds, their legal framework is being revised. Tax deduction for investment in R&D is granted to firms that produce tradables. The "Quadros Programme" gives financial compensation to small and micro enterprises for hiring staff with university degree in technological areas. Moreover, within the framework of the Operational programme for information society, actions to promote the use of ICT within academic communities (the e-U programme) and by the public sector have been implemented. For example, the e-procurement Program is currently being developed in order to offer a unified platform for public tendering. Public access points have also been opened in municipalities and a tax incentive has been given to households for the acquisition of IT equipment.

Initiatives have been taken to improve the quality of education and to promote life-long learning

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Despite spending on education (as percentage of GDP) above the EU average, the level of educational attainment of the population remains comparatively low. For example, in 2002 the percentage of early school-leavers in the population aged 18-24, with at most lower secondary education and not in further education training, was the highest in the EU. In addition, the fraction of the active population involved in life-long learning is one of the lowest in the EU. In order to increase the quality of education, a law has been recently approved, setting a comprehensive system of evaluation for all non-tertiary schools. In secondary education, the range of courses offered has also been broadened and modernised with the objective of reducing dropout rates. The creation of a general and independent system of evaluation and certification of university courses has been announced by the Portuguese government. Finally a law which aims to promote life-long learning is currently being discussed between the government and social partners.

In the gas sector, steps in the right direction are being taken, but effective competition in the electricity market is not yet secured

Portuguese electricity and gas prices for households and, albeit to a lesser extent, for large users rank amongst the highest in the EU. In 2001 the market share of the largest generator in the electricity market was higher than the EU average. Despite a derogation on the gas market, the Portuguese government approved a plan to restructure this sector. The severing between the oil and gas businesses and the unbundling between the generation and the transporter should contribute to more competition in this sector. On the electricity market, the elimination of long term purchase agreements between generators and the transmitter may lead to more competitive prices. The implementation of the Iberian Electricity market will improve capacity and efficiency in this sector. In addition, Portugal plans to open its retail market by 2004. However, the government intends to merge the ownership of the gas and electricity transmission networks. This new structure added to the common ownership of transmission and generation of electricity are likely to raise competitive concerns at the generation level.

The transposition rate of internal market directives has improved but remains insufficient.

Although the transposition rate of internal market directives in Portugal has increased from 96.9% to 97.8%, it is still lower than the target set in Internal Market directives of 98.5%.

Major steps towards improving competitiveness and enhancing the flexibility of the labour market

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In 2003, wage settlements in the private sector decelerated significantly compared with 2002 on the back of the cyclical weakness and the leadership role played by the general government sector that adopted a quasi-wage-freeze, following a number of years of both buoyant wage and employment growth. According to the Commission Autumn 2003 forecast, the slowdown in the growth rate of wages (per employee) is projected to bring to a halt the trend decline of price-competitiveness registered in recent years. In 2003, a new labour code (Código do Trabalho) was approved, replacing most current individual and collective labour legislation with a unified text. Some of the areas that were amended in the new code, notably the introduction of expiry clauses in collective agreements and the possibility of compulsory arbitration being determined by the Ministry of Social Security and Labour if a collective agreement expires without being replaced by another are likely to enhance the responsiveness of wage settlements to productivity and skill differentials across economic sectors.

3. Long-term sustainability of public finances

Ensure the long-term sustainability of public finances in the face of population ageing.

Under this challenge, Portugal was requested to:

12. increase the efficiency of the health-care system by introducing a wide range of measures that strengthen market mechanisms and rationalise demand (GL 14); and

13. adopt further reforms to the pension system for workers in the general government sector to secure its long-term sustainability and in order to progressively align it with the pension regime for private sector workers (GL 16).

A comprehensive reform of the health-care system is proceeding at a rapid pace.

A thorough reform in health-care is underway of which the major elements are: (i) a significant number of public hospitals have been transformed into publicly owned corporations, with an enhanced degree of entrepreneurial autonomy; (ii) medical services will be charged for in future according to a price list established for services/techniques and not as in the past as part of an overall budgetary envelope based on historical data; (iii) the setting-up of a regulatory agency for the health-care sector that will address, among other things, the problem of adverse selection, (iv) the implementation of a comprehensive policy for the consumption of medicines, involving the promotion of generic drugs and the setting of ceilings for the reimbursement of drugs according to reference prices; and (v) an increase in user fees for medical treatment.

At this stage, it is too early to assess of the impact of these ambitious reforms on either efficiency or equity grounds.

The reforms of the pension scheme for the general government sector have not yet been fully implemented

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Since 2001, the pension schemes (both the general social security and the public employee scheme to be gradually phased out) are being reformed in order to strengthen their long-term sustainability. As regards the former, the formula used to calculate pension benefits was modified in 2001: benefits will eventually be based on the entire working career and no longer on the best 10 out of the last 15 contribution years. However, given the long transition period to the new formula, it is projected that only pensioners retiring after 2016 will have a lower pension compared with the pension that would have resulted from using the previous formula. In 2004, the government projects to introduce legislation allowing for contributions in excess of a relatively high threshold to be channelled into individual pension funds. As regards the public employee scheme, the government introduced a number of reforms in 2003, which are expected to come fully into force at the beginning of 2004, in order to reduce the generosity of this scheme when compared with the general pension scheme [16].

[16] Entry to this regime was closed in 1 September 1993. After that date, the pension rights of new general government employees follow the same rules of the general social security pension scheme. The changes to be implemented in January 2004 include: the calculation of new pensions based of the last net wage (instead of the last gross wage) and penalties for retirement before 60 years of age even for pensioners that have the full contributory career of 35 years.

However, on account of a constitutional court ruling, these reforms were only partly carried through in 2003. Both pension schemes have not yet reached their maturity. In the coming years, new pensioners are going to retire with longer contribution records, thereby increasing the average replacement ratio even after consideration of the reform of 2001 to the pension formula and the measures introduced or planned to be for the public sector scheme. In addition, the government has decided to secure, by 2006 at the latest, the convergence of minimum pensions to certain pre-determined fractions of the statutory minimum wage net of the worker's social contributions. Combined with the imminent demographic shock, the planned convergence of minimum pensions, as well as the envisaged setting of ceilings for the contributions to the general social security scheme will put additional pressure on pension expenditure, requiring offsetting measures in order to secure the long-term sustainability of the social security system.

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13. Finland

Although Finland was also affected by the cyclical slowdown, economic performance in 2003 remained clearly above the euro area average. While sluggish external demand and further declining business investment weighed on activity, private consumption, fuelled by rising real disposable income, provided firm support. The new government, appointed in June, responded to the slowdown by easing the fiscal stance and introduced measures to stimulate growth. Employment has been surprisingly resilient, falling only marginally. The situation of public finances is expected to remain favourable, even though the general government surplus is projected to moderate in 2004. The new government has put forward measures that respond to the recommendations of the 2003-05 BEPGs, inter alia, by introducing multi-annual spending limits for the entire election period and tax cuts on labour. Regarding productivity and business dynamism, Finland has maintained its leading position in the transition to the knowledge-based economy, even though the benefits have not yet been fully materialised into higher hourly productivity, which remains around the EU average. Contributing factors could be weak competition in some sectors of the economy and inefficiencies in the large public sector. Enhancing competition could also help to lower the price level, which is one of the highest in the EU. Some initiatives have been taken to improve competition and to enhance the efficiency of the large public sector.

Key challenges in the light of recent developments

In 2003, Finland's economic policy has addressed concerns arising from the unfavourable short-term development and medium-term challenges facing the economy. The new government decided as one of its first steps to lower taxes on earned income and step up measures to support employment growth. Further tax cuts could be envisaged, as lowering the tax burden on labour is one the key priorities in the Government Programme. While fostering job creation, the government also seeks to ensure the sustainability of public finances. Furthermore, important adjustments have been made to improve the efficiency of the public sector, notably the introduction of multi-year spending limits and the envisaged reform of local government finances. Measures have also been taken to increase competition in network industries. A more detailed assessment of recent developments in addressing Finland's key policy challenges is presented in the following sections.

1. Labour market

Reduce the high level of structural unemployment and increase the employment rate of older workers,

Under this challenge, Finland was requested to:

1. improve incentives in tax and benefit systems further to make work pay, in particular by addressing their combined effects on older workers, continue to reform the eligibility criteria, improve the administration of benefit systems and target the tax measures on low-paid labour (GL 4 and EREC 2); and

2. seek possibilities to ensure that wage bargaining systems allow wages to better reflect productivity differences across skills in order to improve the job prospects of low-skilled unemployed (GL 5).

The new government is proposing steps to reduce structural unemployment and promote labour supply

The government has decided to cut taxes on labour by at least EUR 1.12 billion i.e. 0.8% of GDP over the electoral period 2003-07. In the first 2003 supplementary budget, taxes on labour were reduced by EUR 295 million. Taking earlier decisions into account, including an increase in tax deductions for household service work, tax cuts in 2003 will total EUR 792 million. These tax cuts have been distributed fairly evenly among all income levels. For 2004, the government has put forward the following proposals: cuts in earned income taxation worth of EUR 775 million, by lowering marginal tax rates in state income tax schedules, increasing work-related deductions and earned income deductions in municipal taxation. Even though the tax cuts on income will apply to all income levels fairly evenly, the increase in deductions of work-related expenses and an earned income is targeted towards low and medium-income wage-earners. Furthermore, the government decided to reform the capital and corporate income taxation as from 2005. The corporate income tax rate will be reduced by 3 percentage points to 26 per cent and the capital tax rate will also be reduced by one percentage point to 28 per cent, yielding a decline in tax receipts from business and capital taxation by EUR 500 million i.e. 0.3% of GDP.

These tax reliefs will narrow the tax wedge (i.e. the ratio between take-home pay and total labour costs to the employer) for a low-income wage earner by about one percentage point to 50% in 2004. The tax wedge on labour has narrowed by 5.5 percentage points since the mid-1990s. The government is also planning to improve incentives for offering and accepting work, particularly in low-productivity sectors.

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The government has introduced an intersectoral employment programme to raise the employment rate and prevent social exclusion. The emphasis of the programme is to reduce the high level of structural unemployment and boost labour supply. Some of the key measures to achieve these targets include reforming public employment services, raising the participation of job-seekers in active labour market policy measures to 30%, shifting the emphasis from passive to active labour market support and improving the effectiveness of active labour market programmes. While these measures represent a step in the right direction, it remains to be seen how effective they will be. The previous government had launched similar programmes to combat the high level of structural unemployment, but their effects have been marginal with the NAIRU estimated being around 8-9%. Admittedly, the proposed measures appear to be on a larger scale and may potentially be more effective than the previous ones. The present government is also setting up rather ambitious employment targets; creating 100 000 new jobs by the end of election term in 2007 and raising the employment rate to 75% by 2011.

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The employment rate of older workers has been rising markedly over the last few years and this is expected to continue when the 2002 pension reform is implemented in 2005. Consequently, the Lisbon target of 50% employment rate for older workers is achievable. Concerning the further tightening of the eligibility criteria and improvement of the administration of benefit systems, no progress has been made so far.

Some progress in allowing wages to better reflect productivity differences

In previous wage agreements, pay rises have been based on the average productivity increase with the result that in low-productivity sectors unit labour costs have risen significantly. In the current two-year collective bargaining agreement that was settled in December 2002, this factor was taken into account and the cost effect of the pay rises is now somewhat less biased against the low-wage sectors than previously. Still, progress on this issue is small and tangible outcomes will likely be limited in 2003-04 as multi-annual centralised wage agreement is binding until January 2005.

2. Productivity and business dynamism

Enhance competition in certain sectors and improve the efficiency of the public sector.

Under this challenge, Finland was requested to:

3. step up efforts to enforce competition in network industries and non-tradable services (GL 9);

4. make further efforts to increase the efficiency of the public sector, inter alia by improving the framework conditions for increased competition, promoting the benchmarking of public sector efficiency and by increasing public tendering (GL 11); and

5. improve mechanisms to help control spending and ensuring compliance with rules on expenditure (GL 14).

Steps towards improved competition ...

Prices remain among the highest in the EU, including indirect taxes, and competition in sectors such as network industries and non-tradable services is still weak. However, there are some planned measures to strengthen competition in general. The Competition Restrictions Act is currently subject to a reform aligning it with EU competition rules and introducing a leniency programme in the case of revealing cartel agreements. In order to get better information on competition and market efficiency, the Competition Institute will be established. Some measures have been taken to enhance competition in network industries such as mobile number portability and amending the Electricity Market Act to make it easier to change suppliers. However, the government is concerned about excessive market concentration in the electricity sector and a government working group has presented proposals in November 2003 on how to reform the network pricing in the energy markets. In 2003 a government working group presented proposals to enhance competition in the financial sector and some steps have been taken to strengthen competition in the real estate sector and construction.

... and initiatives have been launched and pursued to improve the efficiency of the public sector.

Some encouraging measures have been taken to improve the efficiency of the large public sector. In 2003, the Ministry of Finance has launched a Productivity Action Programme to enforce reforms in the public administration with the aim to increase public sector productivity. Other government programmes pursued during 2003 aim at increasing the public sector efficiency through more advanced use of information technology. Work is continuing on reforming the National Procurements Act and special attention will be devoted to procurement below the EU threshold value. There are plans to set up an advisory service point for public procurement to promote the use of the private sector in the provision of public services. In September 2003, the government submitted a bill to parliament regarding service vouchers. The objective is to open up the possibility to use service vouchers for social and health care services.

Multi-annual spending limits introduced to improve spending control

After repeated overruns of spending targets during the previous government, the new government has redesigned politically binding spending ceilings, first introduced in 1991. In the new type of ceilings about ¾ of budget appropriations are designed to fall within the spending limits. Excluded from the ceilings are expenditures like housing subsidies and unemployment benefits, which are typically vehicles for automatic stabilisers. Furthermore, interest expenditures and financial investment expenditures are excluded as well as compensations of tax losses of other levels of government due to tax reforms. A further change to previous spending limits is that supplementary budgets are included in the ceilings. In its new budget rules the government aims at balance in central government finances at the end of its term and introduces a central government deficit ceiling of 2.75% of GDP in national account terms, even in times of weak economic development. Furthermore, the government has made a commitment to take expenditure-reducing measures and other remedial action if the deficit limit on central government finances threatens to be breached. However, the update of the 2003 stability programme envisages that the government will fall short of target of balancing central government finances, as the deficit in central government finances is expected to widen from 0.1% of GDP in 2003 to 0.9% in 2007.

The 2004 budget proposal provides for expenditure of EUR 316 million or 0.2% of GDP below the spending limit. This leeway will be used to cover the supplementary budgets. In the light of the experience with the supplementary budgets over the recent years, the proposed leeway is somewhat small.

On intra-government financial relations, a basic service programme between the central government and municipalities will improve the balance and predictability of municipalities' responsibilities, obligations and financing. A working group, assessing the local government financing and the central government transfer systems to municipalities, has been set up with the objective of reforming the transfer system. The reform is aiming to improve the stability of local government finances and provide incentives to carry out reforms with a view to improve service efficiency. This is envisaged to take effect from the beginning of 2005.

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14. Sweden

While Sweden's economic performance has been affected by the global downturn, the economy has held up relatively well supported by a stability-oriented macro-economic framework. Steady private consumption growth contributed to growth in 2003 and a recovery is expected in 2004 and beyond, benefiting from a revival in export markets and business activity. Inflation should remain in line with the Riksbank's 2% inflation target, underpinned by a negative output gap and moderate wage increases. In 2003, the situation on the labour market deteriorated with negative employment growth and a significant rise in unemployment. While addressed by the Swedish authorities, a strengthening of the incentives to work by means of further reducing negative effects on labour supply and employment stemming from the interaction of tax and benefit systems and by completing the tax reform, should result in higher labour force participation and a better labour market performance. The government surplus is expected to be low in 2003, in response to relatively weak economic growth. The Swedish fiscal policy framework and plans - with a strong emphasis on sound public finances - suggests that fiscal stance will be tight in 2004-05. Whereas Sweden had maintained its lead in R&D and innovation, the effects of the advanced stage of the transition to the knowledge-based economy does not yet seem to have fully materialised into higher productivity. Both the hourly productivity trend growth 2000-2002 and the hourly productivity level in 2002 are below the EU average. Contributing factors could be weak competition in several sectors of the economy and possible inefficiencies in the large public sector. Enhancing competition could also help to lower the Swedish price level, being one of the highest in the EU.

Key challenges in the light of recent developments

Sweden has made some progress in several key areas in implementing the 2003-05 BEPGs. However, the relatively weak cyclical position of the economy has impacted negatively on the room for fiscal manoeuvre and has been a constraint on some reforms, e.g. to complete the tax reform. Nonetheless, some steps towards strengthening the work incentives have been taken and additional measures are expected in 2004. Some initiatives have been taken with a view to strengthen competition and to increase efficiency in the public sector. The following sections present a more detailed assessment of recent developments in addressing Sweden's key policy challenges.

1. Labour market

Ensure an adequate labour supply in view of the ageing of the population,

Under this challenge, Sweden was requested to:

1. pursue further the reforms of tax and benefit systems to improve work incentives, in particular for those groups with high marginal effective taxes (GL 4 and E-REC 3), and complete the tax reform on labour income while maintaining sound public finances.

Some progress has been made, but several important issues are pending

Employment rates, while remaining very high and well beyond the Lisbon targets, have fallen during 2003, as economic activity has been subdued. The Swedish authorities have undertaken several steps with a view to improve work incentives. Efforts have been made to retain older workers in the labour force, to integrate immigrants into the labour market and to strengthen prospects for the young to find employment. However, there are also some elements that may have an adverse impact on labour supply. Preparations are underway to extend the 'free-year' initiative (an employee can, while paid a salary-linked benefit, take up to one year off under certain conditions) throughout the country, aimed at taking effect in 2005. Another measure having that could have a negative impact on supply are the plans tp reduce working time, for which a pilot is starting in 2004. On the tax side, there has been some easing of labour taxation in the framework of the 'green tax swap' strategy. However, local government tax rates were increased in 2003 and further increases have been announced for 2004. The Swedish government intends to complete the tax reform - the fourth and final step - during the present term in office (until 2006). However, this hinges upon the government finances being 'sufficiently sound'. There would appear to be little room for going through with the reform unless it is offset in the Budget, keeping in mind the Swedish surplus target for the public finances of 2% of GDP on average over the cycle. There are no detailed plans as to when this reform will be implemented. On the benefit side, the authorities introduced a cut in the sickness insurance with the 2003 Spring Fiscal Policy Bill, which should strengthen the financial incentives to work. Other measures for this insurance have also been introduced, intended to curb the rising costs in this area e.g. the employers' financial responsibility for the sickness leave period has been extended from two to three weeks and the sickness benefit for unemployed persons can no longer exceed the highest unemployment benefit. In order to achieve the nationally set target of halving the number of sick days until 2008, additional measures are foreseen in 2004. Increasing labour market participation and employment further remains crucial, not least as the Swedish authorities do not expect to reach the nationally set target of raising employment by 2004, according to the latest Budget Bill. As noted above, Sweden has an ambitious surplus target, intended to ensure the long-term sustainability of the public finances with regard to the ageing of the population. While according to the Commission services estimates in the years to 2005 this target is not fully reached, Sweden is nevertheless expected to continue to show a sound fiscal position during this period, therefore continuing to respect the Stability and Growth Pact's requirement of a fiscal position 'close to balance or in surplus'.

2. Productivity and business dynamism

Enhance competition in certain sectors and improve the efficiency of the public sector.

Under this challenge, Sweden was requested to:

2. step up efforts to enforce competition in sectors where competition is inadequate (GL 9); and

3. make further efforts to increase the efficiency of the public sector, inter alia by improving framework conditions for increased competition, promoting the benchmarking of public sector efficiency, and by increasing public tendering (GL 11).

Some steps towards increased competition taken....

Prices in Sweden, including indirect taxes, remain among the highest in the EU, with very high price levels in sectors such as retailing, housing, construction and non-tradable services, and there are so far few signs of increased competition. Laws which came into effect in August 2002 have increased the effectiveness of competition policy, enabling the discovery and prosecution of several cartels during 2003. In September 2003 the government presented a proposal for a new law on price information, which is expected to increase price transparency in general and especially for the energy market and financial services. At the sectoral level the government has acknowledged that competition is weak in the food industry and construction. The establishment of a foreign food discount chain in 2003 may put pressure on food prices. A parliamentary committee will further investigate whether the local application of zoning and building legislation constitutes an entry barrier for competitors. Regarding the construction sector, proposals from a committee with the aim to increase competition are currently reviewed by the government. A project to increase competition and trade in the construction sector involving the Nordic and Baltic countries and Poland has started during 2003. The National Board of Trade will present a report on how to tackle and solve problems common to a number of service sectors. Regarding the rental housing sector no further measures have been taken to open-up the market, but there is evidence of greater influence of location factors as well as of production costs for new rental housing. Sweden is a pioneering country as regards efforts to simplify rules and reduce administrative burdens to enterprises. However, according to representatives of the private sector there is still a lot to be done.

... but further room to increase public sector efficiency.

There is little evidence of increased efficiency in the public sector. Competition for public sector welfare services remains limited with private operators having less than ten percent of the market for schools and care for the elderly. There has been a long-term trend towards a slightly larger share of privately provided welfare services, but no further measures to increase the share of private operators in welfare services have been reported. In 2003 the Council for Municipal Analyses made publicly accessible a municipal benchmarking database containing more than 100 indicators covering mainly public services.

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15. United Kingdom

The UK's macro-economic performance continues to combine low inflation, low unemployment and steady growth, and is now recovering from the relatively slow growth rate as the global economy situation improves in a framework of supportive, stability-oriented macro-economic policy. For 2003 as a whole, growth is expected to be some way below trend growth as a result of a less strong private consumption, but a recovery in fixed investment and export growth. Actual and prospective inflation is subdued, as an output gap persists, although it is narrowing. The easy monetary stance of the recent past, together with large rises in government expenditure, has helped maintain domestic demand growth in 2003. Employment growth remained healthy and unemployment stabilised on a low level. To sustain labour supply in the longer term, as well as address social concerns, the UK authorities have announced some new initiatives for the disabled, but the number helped by such policies is small. Recent revisions of national accounts data give an improved picture of UK productivity growth. Nevertheless, the level of productivity remains well below the EU average. The reforms undertaken to tackle this problem will take some time to produce their effects. Among these reforms are many initiatives to boost training and basic skills. The UK authorities have also made some progress in opening up certain protected sectors, such as professional bodies, pharmacies and postal services. While the UK is below the EU average in terms of R&D expenditure as a percentage of GDP, a mechanism has now been put in place for evaluating the science and technology strategy. To help ensure that the large rises in public expenditure are as effective as possible, the government launched a consultation process for an efficiency review.

Key challenges in the light of recent developments

The key challenges for the United Kingdom as identified in the 2003-05 BEPGs include the need to improve the relatively low level of productivity, to address the high numbers of working-age people claiming sickness and disability benefits and sustain labour supply in the longer term, and to improve the quality and efficiency of public services. This is particularly important given that there is a widening general government deficit. This was 1.4% of GDP in 2002, and is expected to widen further. The Commission is projecting deficits of around 2¾% of GDP in 2003 and 2004. A more detailed assessment of recent developments in addressing the UK's key policy challenges is presented in the following sections.

1. Productivity and business dynamism

Improve the relatively low level of productivity,

Under this challenge, United Kingdom was requested to:

1. continue to improve competition in sectors like the professions, postal services and pharmacies (GL 9);

2. monitor closely existing measures to promote R&D (GL 13); and

3. review and strengthen, where appropriate, policies aimed at improving basic skills in the work force (GL 13).

Although a revision of the national accounts has improved the picture of UK productivity growth, the relatively low level of productivity remains a key challenge for the UK. Productivity per person employed was still well below the EU average in 2002 although the gap has been declining in recent years. While the UK did embark on reforms, their effect will take time to feed through into increases in productivity. The government itself has identified five priority areas for further action to improve productivity: strengthening competition to promote greater business efficiency and consumer choice, promoting enterprise by removing market barriers to entrepreneurship, improving the skills base, encouraging investment through stronger local and national capital markets, and supporting science and innovation to harness the potential of new technologies.

Some progress in opening up protected sectors

The Enterprise Act 2002 increased the powers of the competition authorities. Amongst other things, it is no longer possible for the government to exclude the rules of professional associations from control by the competition authorities. The Office of Fair Trading has made some progress in persuading professional bodies, particularly in accountancy, to amend anti-competitive rules. The government has announced a slight relaxation of the restrictions on the location of pharmacies. On the other hand, full opening of the postal markets is not foreseen until 2007, although this deadline is to be reviewed in 2005.

A mechanism is in place for evaluating the science and technology strategy

A wide range of measures for promoting research and innovation is in place. Nevertheless, the U.K. is below the EU average in terms of the percentage of GDP spent on R&D, both by businesses and by government. The Department of Trade and Industry has a long-established mechanism for evaluating initiatives in this field but the published reports are limited in scope. The most important recent initiative in this field was the extension of tax credit for R&D to large companies. Since this measure only applies to expenditure incurred since April 2002, it is clearly too early to assess its impact.

Many initiatives to boost training and basic skills

As was mentioned above, the UK government has identified five priority areas for increasing productivity. One of these concerns improving the skills base. The UK authorities thus consider improving skills among young people and the adult workforce to be one of the key drivers of productivity performance.

The 2003 Budget included a number of measures to boost training and basic skills as a direct policy response to improving productivity. Further, in July 2003, the authorities presented a White Paper on Skills Strategy in which additional initiatives have been announced. It outlines an agenda for sustained effort over the long term, through to 2010 and beyond. As for basic skills, the government's target is to raising the literacy and numeracy skills of 750,000 adults by 2004 and those of 1.5 million adults by 2007. It is as yet too early to assess the impact of these measures, especially since a number of them take the form of pilot schemes.

The 2003 Budget announced measures including pilots for improving access to training such as extending the Employer Training Pilots which were launched in September 2002, and introducing a new form of adult learning grant. The government also announced the creation of a Sector Skills Council network. Sector Skills Councils are independent, UK-wide organisations who are licensed to tackle the skills and productivity needs of their sector throughout the UK. The first full five year licences were issued in April 2003. The UK authorities claim to be on track to establish 23 Sector Skills Councils by summer 2004. In their approach to apprenticeships, the UK authorities intend to meet a target that, by 2004, 28% of 22 year-olds will have entered an apprenticeship. The plan is to have 320,000 young people will be participating in an MA by 2006. The Budget also enhanced MAs by lifting the current age cap, so adults can benefit.

Although the medium-to-long term perspective encouraged by the White Paper on Skills Strategy, and the initiatives to strengthen apprenticeships and facilitate adult learning are steps in the right direction, it is premature to judge whether the many different initiatives will work together, as a set, to raise productivity by boosting basic skills in the UK.

2. Labour market

Address the high numbers of working-age people claiming sickness and disability benefits and sustain labour supply in the longer term,

Under this challenge, United Kingdom was requested to:

4. ensure that all those who are able to work have the opportunities and incentives to do so, in particular by examining and reforming as necessary sickness and disability benefit schemes (GL 4 and E-REC 3).

New initiatives for the sick and disabled

While unemployment has fallen to around 5%, the number of people claiming incapacity benefit and severe disability allowance was 2.7 million in 2003Q2, slightly more than the trough value at the beginning of 2000. Survey evidence suggests that many of these people - the Labour Force Survey suggests over a quarter - would like to work if they could find suitable employment and obstacles to accessing work could be overcome. Finding ways to encourage all these people to find work will sustain labour supply in the longer term and address social concerns.

In its 2003 Budget, the government announced further pilot projects to provide claimants with better advice (the extension to the New Deal for Disabled People), new programmes which aim to provide recipients of incapacity-related benefits with greater support and improved financial incentives (such as the Pathways to work programme, launched in October 2003, and the newWorking Tax Credit). Also mentioned in the Budget in this context was the National Minimum Wage. In March 2003, the Fourth Report from the Low Pay Commission (LPC) found that the National Minimum Wage had also benefited disabled workers. In particular, the LPC found that when the National Minimum Wage was increased in October 2001, it specially benefited working disabled people and women. It is estimated that 70% of employees benefiting from the increase were women, 13% were disabled, and two-thirds worked part-time. As a result of these findings, the government has announced an increase to the National Minimum Wage as of October 2003 and, subject to consideration of the LPC's review early next year, again as of October 2004. However, any beneficial effects on the supply of disabled workers may be counteracted by the impact on employers' demand for labour of the increased National Insurance Contributions (NICs) which came into effect in April 2003. It is as yet premature to assess the impact, if any, of the NICs changes on labour demand. More analysis by the authorities on the combined impact of changes in the National Minimum Wage and in the the tax and social insurance regime would give a more complete picture of the work opportunities facing the disabled.

In 2003 the Government introduced regulations, which implement the disability provisions of the EU Article 13 Employment Directive and come into force in October 2004. Existing anti-discrimination legislation is affected, such as the Disability Discrimination Act (DDA). In this context, a draft Disability Discrimination Bill was proposed on 3 December 2003. The current DDA exemption of small employers (i.e. those with fewer than 15 employees) will be ended together with a wide range of occupational exclusions, bringing within the scope of the DDA occupations like the police, fire-fighters, barristers in chambers and partners in business partnerships. The authorities estimate that these changes will extend the DDA's coverage to over 1 million additional employers, 7 million further jobs and 600,000 disabled people already working in those jobs.

The number helped by policies specifically targeted at the disabled so far was relatively small compared to the 2.7 million claiming incapacity benefit and severe disability allowances. The new policy initiatives would appear to be addressing this weakness.

Improve the quality and efficiency of public services.

Under this challenge, United Kingdom was requested to:

5. ensure that the public services associated with the announced increases in public expenditure (including investment in the transport infrastructure) are delivered efficiently and with a view to ensuring cost-effectiveness (GL 11 and 14).

Consultation process for an efficiency review underway

The government has budgeted for a large increase in expenditure on public services. As a result of decisions taken in the 2002 Spending Review, public sector net investment is projected to rise steadily to 2¼% of GDP in 2007-08 from around 1.0% of GDP in 2002-03. Current expenditure is set to rise by 2.6% a year in real terms in 2004-05 and 3.7% in 2005-06. NHS healthcare spending is planned to grow by 7.2% per year in real terms over the same period. Planned spending on education is set to grow by 6.0% a year and on transport by 8.3%. These increases are affecting the public finances. There was a general government deficit of 1.4% of GDP in 2002, and it is expected to widen further in 2003 as some tax revenues, notably income and corporation tax, are weak, while discretionary expenditure growth is forecast to rise strongly as planned. The Commission Autumn 2003 forecast projects deficits of around 2¾% of GDP in 2003 and 2004. The ratio of gross debt to GDP, though increasing slightly, is forecast to be close to 40% by the end of 2005.

The UK government has recognised the need to accompany the increases in expenditure with reforms designed to ensure that these resources are used and allocated efficiently and effectively, that consumers receive high quality public services and that both consumers and taxpayers receive best value for money. Some may argue that the significant increases in general government consumption and investment expenditures in real terms (at 2.4% and 10.8% respectively in 2002) are a testimony to the beneficial impact of this efficiency drive. However, a note of caution is sounded by the noticeable rise in the value of the public expenditure deflators in recent years. For example, the general government consumption deflator was a robust 6.8% in 2002.

To further address this issue, the Chancellor announced an Efficiency Review in his Budget speech in the Spring. The Review seeks to maximise the effectiveness of investment going into public services by assessing measures to strengthen the transfer of best practice and support the devolution of funds to local bodies. A consultation process was launched in October 2003, with views sought by 21st November 2003. No conclusions on the effectiveness of this measure can therefore be drawn yet.

A well-established policy cornerstone for public expenditure reform is the use of Public Service Agreements (PSAs). These were first introduced in the 1998 Comprehensive Spending Review and are central to the Government's strategy for public service reform and improved delivery. PSAs set targets for the outcomes that each department is committed to achieving, so they form an integral part of the Government's public spending framework. Government departments now publish details of progress against their targets twice a year, in their Autumn and Spring departmental reports. As of April 2003, the government introduced an innovation in this area in the form of regular web-based reporting against all the new PSA targets, making all the latest performance information accessible to the public in a single place, the website of HM Treasury. Alongside these developments in public accountability, HM Treasury and the Cabinet Office have worked closely with departments to improve departmental capacity to manage performance to deliver the public service improvements outlined in PSAs. This includes improving work on active performance management and use of the evidence base in developing policies. The 2003 Budget specifically stated that "targets set out in PSAs have contributed to a genuine shift in departmental culture away from inputs and processes and towards the delivery of outputs and results." In addition, following a public consultation, in January 2003 the Treasury issued a new edition of its long-standing guide to appraisal and evaluation - the 'Green Book'. This guidance is binding on all government departments, their agencies and Non-Departmental Public Bodies. Departments are required to follow the principles and practice set out in the Green Book, requiring them to justify departures from the guidance when circumstances dictate. The principles of appraisal and evaluation in the Green Book help ensure that lessons from the delivery of outputs and results are widely learned, communicated and applied when assessing new proposals.

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