Executive Summary

Growth strong in post-crisis era
Luxembourg’s economy weathered the financial crisis quite well, and is continuing to show growth. The country experienced real GDP growth of 4.8% in 2015, which is higher than the euro-area average. This was up from -0.8% in 2012. In 2015, a 2% increase in VAT rates was implemented to compensate for the decline in e-commerce revenues. Since 2012, the return to growth has been accompanied by a sustained workforce-expansion rate of approximately 2.5% per year.
Prosperity enables robust welfare system
Luxembourg’s strong economic performance over the last three decades has given authorities the means to build an outstanding welfare system, with generous insurance plans, benefit programs and services, as seen within the recently expanded health care sector. Replacement-revenue levels exceed Scandinavian standards. The welfare state has consequently expanded since 1970, even as neighboring countries have cut benefits. In this sector, Luxembourg has not yet enacted a rigorous austerity policy, but has adopted some changes to the country’s pension regime and general employment rules. With an eye to ensuring the long-term sustainability of this system, the OECD and the European Commission have urged radical pension-system reform. However, poverty levels are quite high before social transfers. Luxembourg performs better after transfers; however, Scandinavian countries demonstrate a more egalitarian post-social-transfer performance in terms of Gini index scores despite Luxembourg’s strong welfare system.
Open economy faces external threats
Despite the still-formidable economic climate and the resilience of public finances, some clouds are appearing on the horizon. Luxembourg’s extremely open economy is strongly affected by uncertainty within the global economic outlook (regarding monetary policy, emerging economies’ performance, geopolitical upheavals, etc.), being essentially driven by the international market. Therefore, caution and long-term budgeting is necessary, because e-commerce revenues and excise duties fell sharply during the first six months of 2015, with the impact of lower revenues from fuel sales also having an effect. The population increase and rise in the number of jobs mean that investments need to be strengthened. Major public investments are expected in the coming years, particularly in the areas of infrastructure, environment and housing; indeed, an increase of 18% in public-investment spending is planned for 2016 alone.
Tax-shelter policies in global spotlight
The LuxLeaks tax-shelter scandal, a dominant topic during the period under review, threw Luxembourg into the international news. Multinational companies had negotiated low tax rates (often less than 2% instead of an average of 29.22%) in return for locating premises in Luxembourg. Luxembourg is not unique in Europe for offering such preferential treatment, but had relied to a great extent on exceptional tax incentives to attract major companies. The scandal came at an inopportune time, as Luxembourg took over the presidency of the EU Council during the Commission’s investigation into the issue. European Commission President Jean-Claude Juncker, Luxembourg’s former prime minister, came under tremendous pressure as a result. After careful consideration, the European Commission ruled in October 2015, that Luxembourg (along with other countries with preferential tax regimes) had granted selective tax advantages to Fiat Finance Europe.
EU orders harmonization of tax systems
Marking a turning point, the European Commission requested that national tax authorities harmonize their taxation systems, and mounted further investigations into national tax policies, seeking to prevent conditions of unfair competition, or what is externally regarded as illegal state aid. The investigation has now been expanded to include many EU countries, with worldwide calls for the creation of common rules and the closure of tax loopholes intensifying. However, Luxembourg has played an unambiguously leading role in providing tax such advantages. According to some estimates, more than 50,000 companies have reduced their global tax bills by channeling profits through Luxembourg in return for favorable tax deals. Curiously, the landmark conviction of Fiat Finance Europe has proved beneficial for Luxembourg, as the penalty payment (€20 million – €30 million) goes to the state treasury. In sum, the restructuring of Luxembourg’s fiscal landscape can no longer rely on these opportunities for tax minimization. In the opinion of experts, the effects of these proceedings and ongoing audits within the new framework will have a long term impact on state revenues. Another fiscal issue emerges from the fact that 30% of the country’s tax revenue comes from indirect taxes (especially VAT receipts).
E-commerce tax changes curtail state revenues
In 2015, Luxembourg was affected by an EU-level change in e-commerce taxation regimes, which again had a structurally negative impact on public revenues. Policymakers have sought to compensate for this loss, which amounted to an annual €800 million, through an increase in VAT rates. In general, Luxembourg is known for its expertise in exploiting the full available spectrum of financing instruments, as well as for the rapid application of EU directives through the smart adjustment of national regulations.
Overreliance on financial sector remains a risk
The LuxLeaks scandal once again demonstrated how vulnerable Luxembourg’s economy has become as a result of its focus on the financial sector. The country’s substantial fiscal imbalances also imply potential risks to long-term macroeconomic solidity. For Luxembourg, financial services have been strategically significant revenue sources and a key pillar of economic growth, investment and stability. For this reason, Luxembourg will continue to pursue every niche possible. Yet structural reforms must be pursued; for example, the welfare system must be reformed in order to address the impact of aging populations, and the economy must be further diversified (with a particular focus on innovative industries) given the new volatility of tax revenue deriving from the financial sector.
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