Is it possible to adjust with a human face? Lessons from Iceland

21 July 2015

During the recent economic crisis, governments in European countries have implemented plans to reduce debt and improve fiscal conditions through a combination of tax increases and spending cuts. A growing number of studies depict that restrictive policies have negative consequences for growth and for the fiscal consolidation process, which has a high probability of failing in times of deteriorating macroeconomic conditions. Further, the experiences of Mediterranean countries and especially Greece have shown that the negative consequences of changes in distribution – such as rising inequalities - have in many cases been accepted as a collateral effect of such processes.

However, the case of Iceland highlights that it is possible to ‘adjust with a human face’. In particular, this country implemented a stabilization package that was completely different from that undertaken by Greece or other European countries. It was promoted via a set of heterodox policies such as capital controls, debt repudiation and a severe devaluation of the national currency. In addition, a multi-year fiscal consolidation plan was implemented in order to pursue macroeconomic stabilization and to promote economic activity as well as to protect households (especially those with lower- and middle-incomes). Indeed, Iceland’s government preserved its social protection system even though public spending cuts were introduced as in other countries.

Moreover – contrary to the norm during the recent crisis - the government made extensive use of direct taxation by reintroducing taxes on net wealth and increasing those on capital income, inheritance and social security. However, the most emblematic reform was related to the taxation of personal income. In particular, the government implemented a progressive tax scheme replacing the previous flat rate, which sought to reflect the idea that there was a necessity for contributions to the adjustment process to be set according to the ‘ability to pay’.

As a result, Iceland fully met the objectives of the International Monetory Fund’s (IMF) programme and improved its fiscal indicators, while many European economies are still failing. It is worth noting that the success of its fiscal consolidation process was also related to the capacity to reduce costs for the most vulnerable groups. Indeed, while inequality remained stable, on average, in European countries or increased in countries that introduced more restrictive policy measures, the overall Gini index dropped by about six points in Iceland.

What can we learn from Iceland’s experience?

Admittedly, it is difficult to compare the experience of Iceland to other European countries due to dissimilarities in their initial conditions, the nature of the shocks they encounter, EU membership, etc. However, these differences are not sufficient to prevent us to extract useful policy lessons:

First, the Icelandic case highlights the central role of fiscal policy in macroeconomic stabilization, especially in a situation such as that experienced by rich countries during the Great Recession.

Second, the success of a fiscal consolidation programme is strictly related to the implementation of credible and sustainable measures.

Third, policies should be designed by not only taking account of their economic effects but also their distributional consequences. Participation in the adjustment process should be progressive, reflecting the ability-to-pay rule. In other words, it is difficult to ask people who received less during the good times to participate more in the bad times.

Finally, an important point is related to democracy and the policy making process. In Iceland, the crash of the banking sector led to strong protests against the conservative government and to a steady shift in preferences towards the left wing coalition consisting of the Social Democratic Alliance and the Left- Green Movement. As in the recent Greek referendum, there was a strong call for equity and a clear mandate to break with the past. Thus, the preservation of the social protection system, the re-introduction of taxes on wealth, the increase in the flat tax rate on capital income and the switch from a linear to a progressive income tax scheme was motivated by the necessity to assure a fair adjustment process. In this way, the government reshaped the cost of the crisis ensuring that the ‘social contract’ could be respected and that confidence in institutions could be restored.

Opening the doors for more inclusive decision making

As highlighted by Sir Richard Jolly in a recent blog, adjustment and austerity programmes ‘were [usually] negotiated behind closed doors by financial officials of the government with visiting bureaucrats of the International Monetary Fund (IMF) and the World Bank, often in secret from other ministers of the government and elected parliamentarians’.

In Greece, the Referendum has represented a good occasion to directly involve people in the decision making process and to make a good progress toward a better future. Now - if the government and European Institutions keep on ignoring the voice of people - it is a complex challenge to think positively about the future of Greece and the European Union as well.

Bruno Martorano is an IDS Research Fellow and author of “Is it possible to adjust ‘with a human face’? Differences in fiscal consolidation strategies in Hungary versus Iceland”, Comparative Economic Studies, 2015, Palgrave Macmillan: London. 

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