Fiscal consolidation driven by EU fiscal rules and the national debt brake poses significant risks for Finland

Executive summary

Finland’s national debt brake is stricter than the EU fiscal framework. Last year, the Finnish Parliament adopted legislation establishing a national debt brake. This mechanism requires the ratio of general government gross debt to GDP to decline by an average of 0.75 percentage points per year until it falls below 40% of GDP. In addition, it mandates that the general government deficit must not exceed 2.5% of GDP. The rules and targets embedded in the debt brake are therefore more stringent than those of the European Union’s fiscal framework, which sets a 60% debt threshold and a 3.0% deficit limit.

UTAK report estimates the macroeconomic impacts of Finland’s new fiscal rules. The report written by UTAK’s Chief Economist, Otto Kyyrönen, provides the first comprehensive assessment of the macroeconomic implications of the fiscal adjustment requirements arising from these rules in Finland. It also evaluates which combinations of policy measures could be pursued by the next government to meet the debt and deficit targets over the period 2032–2039. The simulations are based on the European Commission’s debt sustainability analysis model, further developed by Kyyrönen to incorporate potential hysteresis effects.

The Ministry of Finance’s assumptions imply an adjustment of €9.7 billion. Under the assumptions of the Ministry of Finance, achieving the required debt reduction path would necessitate a nominal fiscal adjustment of €9.7 billion during the next parliamentary term (reaching its full annual level in 2031). This would ensure that the debt-to-GDP ratio declines by an average of 0.75 percentage points per year over 2032–2039. This estimate falls within the €8–11 billion adjustment range proposed by the Finnish parliamentary fiscal policy working group.

Public expenditure cuts could fail to reduce the debt ratio. The Ministry of Finance’s estimates entail considerable risks, as their calculations appear systematically to underestimate the adverse economic effects of public expenditure cuts. Specifically, they do not account for the state of the economic cycle, employ a fiscal multiplier that is too low for current economic conditions in Finland, and omit potential hysteresis effects. When more realistic assumptions grounded in the research literature are applied, a reduction in public expenditure of €9.7 billion could weaken economic growth to such an extent that the debt ratio would fail to enter a declining trajectory.

Policy recommendations

1. Tax increases could achieve the required debt reduction. The calculations of the report suggest that the debt ratio could be reduced in line with fiscal rules through tax increases. A nominal increase in taxation of €8.4 billion during the next parliamentary term would be sufficient to achieve the targeted annual reduction of 0.75 percentage points in the debt ratio over 2032–2039.
2. Combining taxation and investment could support both debt reduction and growth. An alternative strategy would combine tax increases with higher public investment. Increasing taxes by €8.1 billion alongside a €5.1 billion rise in annual public investment would likewise place the debt ratio on the required downward path. Assuming the presence of positive hysteresis effects, such investment would raise GDP by €21.9 billion (7.5%) by 2039, thereby enhancing living standards.
3. Fiscal adjustment models should better reflect real economic conditions. Looking ahead, the Ministry of Finance should recalibrate its fiscal adjustment models. Key parameters should more accurately reflect the chosen fiscal measures, prevailing cyclical conditions, and the composition of aggregate demand. Without such refinements, fiscal policy recommendations risk undermining economic growth and weakening Finland’s public finances.