Euro Watch – Finally a new Dutch government

by: Philip Bokeloh , Nico Klene , Kim Liu

  • After almost seven months, four parties have reached an agreement to form a new government
  • The new government will implement new measures to the tune of EUR 14.5 bn (1.8% of GDP) by 2021
  • Expenditures will be raised by EUR 7.9 bn (1% GDP). Social security, defense and education will benefit most from the spending impulse
  • Total taxes will be cut by on balance EUR 6.4 bn. This is mainly due to lower taxes on labour and income. Taxes on profits and wealth will be cut as well, but the low VAT rate will be raised
  • Both corporate tax rates will be cut by 4 percentage points
  • The maximum tax rate against which mortgage-interest payments can be deducted from taxes will be lowered more quickly
  • The proposed measures will boost average economic growth in 2018-2021 by 0.2% points per year, according to the CPB
  • The budget surplus will not improve any further but will remain on balance roughly stable between 2017 and 2021
  • EMU debt will continue to drop, but less than initially expected
  • In 2018, the government’s funding need wil be slightly higher than we initially had calculated
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Introduction

Today, the centre-right liberals (VVD), Christian Democrats (CDA), left-wing liberals of D66 and the social Christian Union (CU) presented their coalition agreement “Trust in the future”. This followed a record long formation process of almost seven months after the general elections of 15 March. The new cabinet is expected to be inaugurated in about two weeks.

There are significant (political) differences between these four parties. These are reflected in the coalition agreement, which shows many compromises. It is a package of measures with give and take.

Stable public finances

In the initial baseline scenario, the Dutch EMU surplus was expected to improve significantly. As a result of the planned measures, however, the surplus will roughly remain stable around 0.5% of GDP between 2017 and 2021. This will be the result of net spending increases and a lower tax burden.

Additional expenditures

The new coalition plans to raise net spending by EUR 7.9 bn (1% GDP) during 2018-2021. This will be the result of extra spending particularly in social security, defense and education (totalling EUR 4.5 bn), which will be partly offset by cuts in health care .

Lower tax burden

The tax burden will be significantly lowered by on balance by EUR 6.4 bn by 2021. Households with pay over EUR 5 bn less taxes and socal premiums. The lower taxes for households will be mainly realized by the introduction of a new tax system with only two tax brackets. Working people (with middle or high income) and households with children will benefit most from the new measures.

In addition, taxes on wealth and profits will be lowered, mainly via a 4% points cut in both corporate tax rates and via the abolition of the dividend tax.

Environmental taxes, however, will increase (by EUR 1.4 bn). In addition, several other taxes will be raised too (by EUR 2.8 bn). This is mainly due to the rise in the low VAT rate from 6 to 9%. Moreover, the mortgage-interest rate deductibility will be further curtailed (see below).

Government steps up structural reform of the housing market

The new government will quicken the pace at which it will reduce the maximum tax rate against which mortgage interest rates can be deducted from taxes. Originally, the plan was to reduce the maximum rate by 0.5% per year, from 52% in 2014 to 38% in 2042. The current proposal is to reduce the maximum tax rate against which mortgages interest payments can be deducted from taxes by 3% in 2020, 2021, 2022, and 2023 (and keeping the 0.5% reduction in 2018 and 2019). This would reduce the tax rate to 37% in 2024.

The decline in purchasing power will be partly compensated by lowering the lump sum tax on houses from 0.75% to 0.6% and lower marginal income tax tariffs. In addition, the government decided to gradually phase out the so called Hillen-ruling over 20 years. This ruling compensates households with low debts for the lump sum house tax.

The measures are well timed. The current low mortgage interest rates dampen the effect on housing costs. Yet, a future increase in mortgage interest rates might give rise to higher housing costs. In addition, the measures might dampen the strong housing price increases in the popular regions.

With these measures the government concedes to the requests previously made by the IMF, the OECD and the European Commission. All insisted on further structural reform of the housing market. However, the government refrained from further lowering the LTV-ratio from 100% to 90% as this would impede first time buyers from entering the market.

Macro economic impact

The Netherlands Bureau for Economic Policy analysis (CPB) has calculated the impact of the planned measures for the period 2018-2021. According to the CPB, economic growth, on average, will be 0.2% percentage points per year higher than in the intial baseline scenario . This stems mainly from stronger household and government consumption. As a consequence, GDP may rise by 2% annually in 2018-2021.

The unemployment rate is expected to drop to 4.1% in 2021 (instead of the 4.6% expected previously), on the back of the stronger expansion in employment.

The increases in the low VAT rate and in other indirect taxes cause inflation to increase. And via negotiations this will lead to stronger wage rises. In addition, the government’s spending impulse and lower taxes lead to lower unemployment and to upward pressure on wages and inflation. This in turn, will raise the wage share in GDP (from a macro perspective).

Higher prices put a brake on exports, which are expected to expand less than in the baseline scenario. But imports will see more growth due to stronger domestic demand.

Impact on the budget balance

The announced measures will affect public finances. On balance, the budget surplus (or EMU surplus) is calculated to decline fractionally to 0.5% of GDP in 2021, instead of improving to 1.6% of GDP according to the baseline scenario. Hence a difference of 1.2% points. On the one hand, the new measures depress the government surplus by 1.8% points. On the other hand, the surplus improves by 0.6% points on the back of stronger economic growth.

The new measures will also affect the structural budget balance. Moreover, the effect of stronger growth is partially cyclical. Nevertheless, the structural budget surplus is slightly positive in most years.

The EMU debt ratio will decline to slightly below 46% in 2021, which is only modestly higher than in the baseline scenario.

  

Overall, the measures will hurt the long-term sustainability of public finances according to the CPB. The socalled ‘sustainable balance’ will become negative again. This is attributable to a stronger rise in spending in the next decades than in government income. This can be interpreted that spending cuts or higher taxes may be necessary in the future to keep the government’s finances sustainable.

Funding need will increase slightly in 2018

Due to the timing of the implementation of the measures, the 2018 budget surplus will be noticeably lower than the CPB initially had estimated (0.5% of GDP instead of 0.9%; see left graph). As a result, the government financing need will be somewhat larger in 2018 than our earlier estimate. Hence, we expect no significant change in the borrowing requirement and funding composition in 2018.