OREANDA-NEWS. A year in office, the new government has taken important steps to support job creation and address the cost of ageing—notably through wage moderation, pension reform, and the tax shift. These efforts need to be sustained and expanded, even more so as growth remains lackluster and downside risks have risen. The central task is now to lay the foundations for a lasting reduction in public debt, as a buffer against future shocks, while nurturing the recovery and supporting social cohesion.

• To address the debt problem, it will be critical to balance the budget across all levels of government—this requires not only additional revenue efforts but also deep reforms to make public spending more efficient.

• To unlock Belgium’s full growth potential, there is an urgent need to tackle the very high unemployment among some groups and localities—this calls for a comprehensive strategy on education, training, work incentives, and mobility.

1. The economy showed resilience during the crisis years, but growth prospects remain mediocre and downside risks loom. Real GDP has recovered and is now well above the pre-crisis level. Growth has been supported by household consumption and government spending, and unemployment is below the euro area average. Looking ahead, growth is expected to remain modest in the context of subdued demand in the euro area. Downside risks have risen significantly, notably related to the slowdown in emerging markets, geopolitical tensions, and the immediate challenges arising from the European refugee crisis.

2. A year in office, the government has made important progress in delivering on its economic reform agenda. At the center of the program are steps to improve external competitiveness and address the country’s fiscal challenges, with a view to supporting private sector growth and employment.

• Wage moderation and the tax shift will support job creation. The suspension of the automatic indexation mechanism (“saut d’index”), building on earlier wage moderation efforts, has further narrowed the wage gap with neighboring countries. The reduction in the labor tax wedge through targeted cuts in social security contributions and income taxes under the tax shift should support job creation over the medium run, even if the measures needed to fully finance the tax cuts will dampen the growth impact.

• The 2015 pension reform was a major step toward addressing the cost of ageing. Building on the 2012 reforms, it phases in an increase in the legal retirement age to 67 by 2030, and tightens conditions for early retirement. This will raise employment rates and significantly reduce the projected long-term increase in the cost of ageing.

3. However, major challenges continue to weigh on Belgium’s economic prospects—including high public debt and severe labor market fragmentation. The fiscal gains made in previous decades have been reversed since the crisis, and the public debt-to-GDP ratio has returned to triple digits. The pace of consolidation since 2010 has been much slower than in other euro area countries, as public spending continued to grow rapidly. With the deficit hovering around three percent of GDP, fiscal sustainability is tenuous and highly sensitive to potential macroeconomic shocks. While private sector employment is beginning to recover, there is entrenched high unemployment and inactivity among certain groups, including the youth, the low-skilled, and non-EU immigrants. This has not only considerable human and social costs, but also detracts from Belgium’s longer-term economic potential.

4. Belgium now has an opportunity to lay the foundations for higher growth, job creation, and debt reduction. The crisis has shown how hard it can be to manage bad times with high debt. The current favorable external conditions—including low interest rates, a depreciated euro, and low oil prices—may not last. To build buffers against future shocks, it is imperative to achieve a lasting reduction in public debt. The central challenge is therefore to bring down the deficit while also nurturing the recovery and supporting social cohesion. To square this circle, Belgium needs more efficient tax and expenditure policies, accompanied by growth-oriented reforms.

5. To address the debt problem, it will be critical to balance the budget. The government’s objective is to achieve structural fiscal balance at all levels of government by 2018. This is ambitious—we estimate that budgetary measures of close to two percent of GDP would need to be realized over the coming three years. This would have to involve substantial additional measures beyond what is already envisaged in the 2016 budget. Given the potential adverse impact of fiscal adjustment on aggregate demand, the challenge will be to identify policies that also support job creation and inclusive growth.

6. The efficiency and fairness of the tax system can still be improved. The reduction in social security contributions and income taxes under the tax shift could be partly financed through more efficient taxation of wealth, including by introducing a capital gains tax, shifting real estate taxes from transactions to recurring charges, and limiting the favorable tax treatment of rental income. Further strengthening environmental charges and eliminating the tax incentives for company cars would have both environmental and fiscal benefits. There is also scope for improving VAT efficiency. Building on the tax shift, regions could use their new fiscal responsibilities for further targeting the income tax cuts toward the lower wage ranges.

7. The bulk of adjustment will have to come from making public spending more efficient—this requires deep reforms at all levels of government. At around 55 percent of GDP, Belgium’s level of government spending is among the highest in the EU, and this does not appear to translate fully into better economic and social outcomes. While spending is projected to decline gradually under current policies, there is significant scope for securing additional adjustment through spending reform.

• To make public administration more efficient, procurement could be centralized and tightened, tax collection could be strengthened, and the state’s management of its real estate holdings could be reviewed. Public capital spending should be reoriented toward more productive investments. There is also scope for faster attrition-based and well-targeted reductions in public employment. Education spending, which has increased sharply without apparent improvements in test scores, could be reviewed and refocused on the areas with the biggest education gaps. Belgium’s high level of business subsidies could be rationalized as well. To improve budgetary control, it will be critical to strengthen and integrate intra-year monitoring of budget execution across all levels of government, especially as the Sixth Reform of the State entails a further devolution of spending competencies.

• If the efficiency of social benefits was raised to the EU average, spending could be reduced by an estimated three percent of GDP without worsening inequality. Enhanced means-testing of benefits would help to better target the most vulnerable. Health spending, which is a significant factor in the cost of ageing, could be made much more efficient, including by further reducing medication and hospitalization costs, and better enforcing budget ceilings. The unemployment benefit system could be improved by further linking benefits to job search and accelerating the phase-out of benefits with employer top-up that act as an early retirement scheme.

8. To unlock Belgium’s full economic potential, there is an urgent need to address the severe fragmentation of the labor market. In addition to regional differences, unemployment and inactivity rates among vulnerable groups—in particular the young, the low-skilled, and non-EU immigrants—are far above the national average. For instance, only about half of non-EU immigrants aged 25-55 are employed, compared to over 80 percent for Belgian-born residents. These problems are particularly severe in larger population centers.

9. This requires a comprehensive and inclusive jobs strategy. To maintain the benefits from recent wage moderation, the wage formation process should take into account not only price developments but also broader labor market and economic conditions. Additional targeted reductions in the labor tax wedge could support job creation for the low-skilled. A central component is education and training, in particular given the need for competency in multiple languages and demand for certain technical skills—this will require better coordination between schools and employers, e.g., in the context of apprenticeship programs. Activation policies and work incentives for the unemployed should be strengthened, combined with well-targeted training efforts. But employment policies alone will not suffice. Barriers to geographical mobility should be reduced, including by addressing the severe traffic congestion in some large urban centers, e.g., through road pricing schemes, elimination of company car subsidies, and well-targeted public transport projects. Structural reforms to remove growth bottlenecks, such as the administrative burden on smaller companies and barriers to competition in some service sectors, would help support employment growth.

10. The soundness of the financial sector will need to be maintained to support the recovery and ensure resilience against shocks. The banking sector has transformed itself since the crisis, and is now much smaller and focused on the Belgian market. It has returned to profitability, but banks’ business models must continue to adapt. The protracted low-interest environment and regulatory uncertainties weigh on medium-term prospects of both banks and insurance companies. Credit growth is positive but driven primarily by mortgage lending. Building on the recent extension of higher capital requirements for mortgages, the authorities could consider more targeted measures to limit overexposures of vulnerable groups (for example, additional risk weights or caps on loan-to-value ratios or limits on debt-service-to-income ratios).