Recent forecasts from the international institutes predict that advanced countries will see hardly any growth at all in 2023, but that activity will bounce back in 2024. The main reasons for this pause in growth for the current year are: the lag in the effects of soaring energy prices, which have eroded household purchasing power and corporate profitability; and the impact of rising interest rates, which have reduced household consumer spending and investment.
In the current tense and unpredictable geopolitical situation, Luxembourg is also expected to see a similar scenario: a slowdown in activity in 2023, a rebound in 2024, and then a stabilisation of the rate of expansion at around 3%, according to STATEC[1]. Unemployment is forecast to increase slightly over the entire period, while inflation would only return to normal levels from 2025. Moreover, if policy remains unchanged, public finances would be marked by an unprecedented deficit, estimated at -2.2% of GDP in 2023. In the run-up to the tripartite committee meeting on 3 March, a few months before the general election, political measures with a significant impact on public spending can be anticipated. If these measures prove unselective, their effects would be inefficient and their costs to the community and future generations would be extremely high, putting additional pressure on State finances.
Among the indiscriminate measures that are widely discussed in the public debate is the indexation of tax brackets. It would ensure the neutrality of the tax system with respect to inflation, as the fixed brackets currently lead to a progressive shift of the whole income structure towards the highest marginal tax rates. But as the IDEA Foundation[2] recently stated: “While the very principle of indexation of tax brackets (and other tax thresholds) therefore appears to be amply justified on a philosophical level, its degree of urgency is far from obvious. A simple numerical examination highlights the poor social targeting of such a measure, which goes hand in hand with a high budgetary cost that is rather unfortunate in the present context” and therefore:
“Ultimately, the question of indexation (or not) of tax brackets boils down to a trade-off between, on the one hand, a measure that automatically favours certain households (compared with the current situation of frozen brackets, in any case) and, on the other hand, the formation of some discretionary budgetary leeway that may allow the authorities to better address certain fundamental structural problems, or provide them with a “kitty” to enable them to respond quickly and flexibly to sudden crises (such as the health crisis and the aftermath of events in Ukraine), to support businesses and households, for example.”
The question of indexation of tax brackets is in fact only a side issue. What is central and what our sense of responsibility should lead us to raise in the public debate in this period of high inflation, is the automatic and full indexation of wages.
High inflation at least until 2025
Although consumer prices have been slowing down since October 2022 as a result of the measures included in the second tripartite agreement, STATEC[3] maintains its inflation forecast of 3.4% for 2023. It foresees an additional indexation round in the last quarter of 2023. This would be the third of the year after the one introduced on 1 February and the forthcoming one on 1 April (which will be an adjustment of the increase initially planned for July 2022). Over the next few days, the Government is to present its proposals to compensate for this third round so as to protect businesses from its adverse effects, in accordance with the most recent tripartite agreement.
The increase in the application rate would thus total 5.3% in 2023, which should be the peak in the trend. Without the tripartite measures, the rate would have been nearly 8% in 2023, after +5% in 2022.
Energy prices are still the main agents driving inflationary fever. STATEC is predicting that the lifting of the tariff shield on 1 January 2024 is expected to push inflation to 4.8% in 2024. By that date, if no new protection mechanism has been adopted, gas and electricity tariffs would once again reflect actual purchase prices on the wholesale markets. This is inducing STATEC to already anticipate an additional indexation in the second quarter of 2024. If policy remains unchanged, it would take until 2025 for prices to rise close to long-term averages. Over the 2022-2024 period, Luxembourg should therefore experience higher nominal wage increases than its trading partners, which would severely impact the competitiveness of our companies.
A system revealing major weaknesses
Given the negative impact of the indexation system on a large majority of the country’s companies in a context of high inflation, it seems important to remember the fundamental problems inherent in the system.
First of all, the indexation system as it exists today is particularly costly for companies. According to STATEC calculations, based on the 2022 wage bill, each round of indexation would cost public and private employers EUR 965 million. Of these EUR 965 million, about EUR 200 million would be paid by the State and the municipalities, EUR 175 million by the financial sector and the rest (EUR 590 million) by other sectors. The resulting loss of competitiveness is significant, especially in labour-intensive sectors that face foreign competition.
In a highly competitive environment, in order not to lose their market share, Luxembourg companies are often forced to reduce their margins and therefore their profitability, which has already been severely affected in recent months. According to the annual report of the Observatory of Competitiveness[4], Luxembourg ranks last in Europe in terms of profitability for non-financial companies. This poses a real obstacle to achieving our national objectives for economic diversification.
In order not to erode their margins and thus preserve their profitability, some companies that are not exposed to international competition pass on these indexations in their prices. This is the perverse effect of the current system: by a process of self-ignition, whenever a round of indexation is triggered, the resulting price increases in products and services on the domestic market in turn feed inflation. The price-wage spiral then becomes very difficult to break. In its latest economic survey of the country, the OECD[5] warns the government: “The current period of high inflation has highlighted the potential risks stemming from the automatic wage indexation system. Wage indexation can induce a price-wage spiral, particularly in the current context of high inflation and tight labour markets.”
Wage indexation as practised in Luxembourg is a system that is rarely used elsewhere in Europe. Only Malta and Belgium have a similar mechanism. But Belgian indexation does not apply to all employees: it is adjusted according to business sector. In addition, some consumer products, such as tobacco and fuel, are excluded from the consumer price index. Other countries, such as France, have preferred to introduce automatic indexation of the minimum wage, in order to give preferential protection to the lowest paid.
In Luxembourg, advocates of indexation applaud its universality. The system may be universal, but it is not egalitarian. It plays a part in exacerbating the wage gap. Every time a round of indexation is triggered, an employee on EUR 3,000 per month will earn an additional EUR 900 over 12 months, while an employee on EUR 10,000 will earn EUR 3,000 more each year. Rather than a general indexation of salaries, targeted measures to deal with shocks are therefore preferable. In 2022, the introduction of an energy tax credit was a much fairer and more effective policy response to help households cope with soaring energy prices, as has been demonstrated by the IDEA Foundation[6].
In short, indexation, as it now works, no longer meets the challenges of our society. The energy and environmental transition in which we are immersed cannot succeed without a profound change in our patterns of consumption. Nationally or throughout Europe, public policies are therefore being implemented to encourage citizens to reduce their consumption of fossil fuels. In Luxembourg, every increase in the price of fuel, heating oil or gas is one of the factors triggering wage indexation. Indexation therefore appears to be a disincentive. The same applies to products that are contrary to public health objectives, such as tobacco. Consumers of these products have no incentive to change their behaviour, since every price increase helps to trigger an increase in purchasing power.
In this period of high inflation, in order to limit the great difficulties caused by each triggering of an indexation increase, the salary indexation system must therefore be reformed. This is how the Chamber of Commerce proposes to do it: based both on its historical positions and on a new element, degressivity, introduced as one of the 30 key measures formulated in the run-up to the 2023 general elections[7].
The Chamber of Commerce proposes changes in the wage indexation system according to the three cumulative pillars of sustainable development.
Pillar 1: Economic Pillar
Maximum one indexation per year. In this period of high inflation, this is the most important pillar for ensuring predictability. It would greatly reassure companies by giving them visibility on the evolution of labour costs.
Pillar 2: Social Pillar
Full indexation up to 1.5 times median monthly income, then capped indexation up to 4 times median income, and finally degressive indexation from this threshold (and no indexation from 5 times median income). This measure aims to increase the social and selective aspects of the current model and to reduce the resulting wage differentials.
Thus:
- All employees earning up to 1.5 times the median income (EUR 5,310 per month gross) would have their wages indexed by 2.5% as at present. In this way, the purchasing power of the poorest households would be preserved.
- All employees earning between 1.5 times the median income (EUR 5,310) and 4 times the median income (EUR 14,140) would have their monthly salaries increased by a lump sum of EUR 133, corresponding to a 2.5% increase for 1.5 times the median income. These employees would thus see their salaries increase, without this increase being too heavy a burden on their companies’ costs.
- All employees earning between 4 times (EUR 14,140) and 5 times the median income (EUR 17,700) would receive a degressive increase from EUR 133 to EUR 0. This would reduce the wage gap.
- There would be no indexation for employees earning more than 5 times the median income (EUR 17,700). This would protect companies from the most costly automatic indexation: for an employee earning 5 times the median salary (EUR 17,700), each indexation round currently costs the company EUR 5,310 over 12 months.
Pillar 3: Environmental Pillar
Indexation based on a sustainable basket. The aim is to adapt the indexation system to global challenges and to the necessary evolution in patterns of consumption. How can consumers be encouraged to reduce their consumption of fossil fuels if the slightest increase in the price of these fuels is compensated by an increase in wages? And the same goes for tobacco, alcohol, etc.
Wage indexation has long been considered a “sacred cow” in our country; it takes a certain amount of courage to tackle it. But the times we are living in force us to do so. At a time when inflation is soaring, when our companies face more competition than ever on international markets, when we are going to have to rethink our production models to meet environmental challenges, we cannot remain hostages to such a rigid system. Competitiveness, and therefore our country’s long-term prosperity, now depends on our ability to re-examine the relevance of this mechanism.
[1] Statec, Projections à moyen terme 2023-2027 (Medium-term projections 2023-2027), https://statistiques.public.lu/dam-assets/actualite/2023/stn12-projections-moyen-terme/stn-12-projections-moyen-terme.pdf
[2] Décryptage No.27: Mettre fin à la « Kal Progressioun », une réelle urgence, (Putting an end to the “Kal Progressioun”, a real urgency) Idea, https://www.fondation-idea.lu/2023/02/23/decryptage-n27-mettre-fin-a-la-kal-progressioun-une-reelle-urgence/
[3] STATEC, Projections à moyen terme 2023-2027 (Medium-term projections 2023-2027), https://statistiques.public.lu/dam-assets/actualite/2023/stn12-projections-moyen-terme/stn-12-projections-moyen-terme.pdf
[4] The National Indicator System, 2022 edition, Observatory of Competitiveness, https://gouvernement.lu/dam-assets/documents/actualites/2022/12-decembre/19-systeme-indicateurs-national/perspectives-de-politique-economique-n38-le-systeme-dindicateurs-national-edition-2022.pdf
[5] OECD, November 2022
[6] IDEA, Décryptage No. 23: Inflation énergétique, quel impact sur le budget des ménages en 2022 ? (Energy inflation, what impact on household budgets in 2022?), 2022
[7] Elections 2023 – Quel avenir pour les entreprises ? Les 30 propositions phares. (2023 Elections – What does the future hold for businesses? The 30 key proposals). https://www.cc.lu/fileadmin/user_upload/Elections_2023_-_30_Propositions_phares.pdf