Summary: KEY ISSUES Context. With a strong policy framework, Luxembourg has weathered the crisis well, and the economy is rebounding. The fiscal position remains sound, and the large financial sector has been resilient. But trend growth has slowed substantially. The financial sector will have to adjust to a changing external landscape, public finances will come under strain from losses in e-VAT revenue and strong expenditure growth, and Luxembourg’s cost competitiveness is being eroded. A new government took office in December 2013. Fiscal policy. A moderate but sustained fiscal consolidation is essential to preserve the current healthy fiscal position, stabilize debt below 30 percent of GDP—a commitment of the new government—and strongly anchor the AAA rating. Given current low rates, the planned VAT hike is appropriate, and consideration should be given to increasing the yield of property taxes. But even after implementing revenue measures, it will remain critical to curb public spending growth; the expenditure review underway will be a useful tool to identify savings. A thorough assessment of social benefits should receive special focus and would also help boost growth potential through greater labor participation. Financial sector policy. Banks’ capitalization and liquidity remain high, the investment fund industry continues to grow, and financial sector oversight has been strengthened. Faced with lower growth in euro area activities, and the switch to automatic exchange of information, banks are diversifying businesses and retooling private banking activities. The decision to front-load the implementation of Basel III capital requirements will help safeguard the resilience of the financial sector. But consideration should be given to supplement it with additional measures for systemic banks over time and within the European framework. Supervisors need to continue to closely monitor domestic real estate exposures, interconnections in the domestic financial sector and new emerging risks from financial diversification. Structural policies. Despite a strong external position, the country might be pricing itself out of some activities, following substantial labor cost increases since the crisis. The expiration of the temporary agreement on wage indexation offers an opportunity to adjust the mechanism in a way that better aligns wages and productivity movements. Measures to strengthen labor skills and the business environment would further support the authorities’ strategy to diversify beyond the financial sector.

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