Chapter

XI The System of Public Finance in the German Democratic Republic and the Challenges of Fiscal Reform

Author(s):
International Monetary Fund
Published Date:
December 1990
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Günther Thumann

Despite some similarities reflecting common historical roots, in many respects the fiscal system of the German Democratic Republic (GDR) differed fundamentally from that of the Federal Republic of Germany (FRG), both in role and in scope. In the FRG, fiscal policy is geared toward supporting market processes within a social market economy. It is democratically controlled with a federative structure that offers considerable fiscal autonomy to the lower levels of government. In the former GDR, fiscal planning played a pervasive role in the context of a command economy, essentially uncontrolled by the people and burdened with complex and at times conflicting political objectives. It was highly centralized, granting little if any fiscal autonomy to the lower levels of government.

Unification of the two German economies required, among a host of other tasks, a fundamental reform of the fiscal system, involving the adoption in east Germany of the fiscal system of the FRG. Details of fiscal reform were spelled out in the State Treaty, which constituted the legal basis for German economic, monetary, and social union (GEMSU). The Unification Treaty (which dealt with political union) had further consequences for the fiscal system in east Germany, the most obvious of which was the elimination of a separate central government.

This chapter describes the major features of the fiscal system of the GDR prior to GEMSU, identifies the crucial elements of the reform process, and discusses some implications for budgetary developments.

Outline of the Fiscal System in the GDR Prior to GEMSU

Institutional Framework

Fiscal planning was regarded as an integral part of central planning. In combination with banking it formed the sphere of financial planning, the counterpart of material planning, and was assessed by the success with which it steered decisions toward those prescribed by the central economic plan, the Volkswirtschaftsplan. The fiscal plan in the form of the state budget comprised the central government, the governments of the counties (Bezirke) and the local authorities (Kreise and Gemeinden), and the social insurance system. In addition, the state enterprise sector, although not itself part of the budget, had a major influence on the size and the structure of revenue and expenditure.

In line with the principle of “democratic centralism,” budgetary planning and control were carried out “topdown.” The Ministry of Finance, backed by the Ministerial Council, issued plans to all levels of government. The county and local authorities had little autonomy in raising revenue and were dependent on revenue-sharing arrangements over which they had hardly any influence. Although the People’s Chamber formally voted each year on the budget law, the budget was in essence determined by the executive. Any broader political discussion was effectively prevented, partly because of the lack of transparency in the way the state budget was presented.

Fiscal Structure

Overview

Both general government revenue and expenditure tended over time to rise faster than net material product (NMP), bringing the shares of revenue and expenditure to 99 percent each in 1988, from 91 percent in 1983. Revenue, which, according to published data, usually exceeded expenditure by a small margin, relied heavily on receipts from the state-owned enterprises; in 1988, these receipts accounted for more than three fourths of state revenue. Taxes on wages and social security contributions amounted to less than 4 percent and 7 percent, respectively, of total revenue. About 5 percent of revenue was recorded as “other revenue,” with no identification as to its source. The expenditure accounts also lacked transparency. The lion’s share of expenditure appears to have been allocated to social welfare and “economic development,” the latter principally in the form of subsidies and transfers to state-owned enterprises (Table 1).

Table 1.German Democratic Republic: State Budget(In billions of marks)
19871988
Revenue260.4269.7
Levies and taxes from stale-owned enterprises202.1205.9
Wage tax and other direct taxes
Of which:20.120.8
Wage tax9.610.0
Private business taxes4.04.2
Social security contributions, fees, and other tax-like revenue29.430.3
Of which:
Social security contributions18.318.8
Other revenue8.912.6
Expenditure260.2269.5
“Economic development”85.394.0
Research and development, investment, and transport17.220.0
Social policy150.3155.1
Housing29.130.2
Price subsidies49.349.8
Education14.915.5
Health16.317.8
Social security35.236.3
Other5.55.6
Other expenditure7.40.4
Balance0.30.2
Source: Staatliche Zentralverwaltung für Statistik der DDR, Statistisches Jahrbuch der DDR, 1989.
Source: Staatliche Zentralverwaltung für Statistik der DDR, Statistisches Jahrbuch der DDR, 1989.

In 1988, revenue from the state-owned enterprises fell below the budgeted figure but, owing to unplanned receipts in the category of other revenue, overall revenue exceeded target. Expenditure also rose faster than expected, yet a small surplus was recorded as usual. The 1989 budget was set up in accordance with earlier practice. Not least because of the mass exodus of people during the second half of 1989, the reported budgetary results deviated from the plan to a larger extent than had been typical. The Annual Report of the Staatsbank (State Bank) for 1989 noted a deficit of M 6 billion, equivalent to about 2 percent of NMP. No budget for 1990 was prepared prior to GEMSU. In the first half of 1990, government institutions were instructed to follow the plan laid out for 1989. With higher expenditure, for example, on the recently introduced unemployment benefits, and lower revenue, because of the decline in output, the deficit in the first half of 1990 is believed to have amounted to at least M 20 billion.

The major items of the fiscal accounts are described in some detail below, looking first at revenue and expenditure of the territorial authorities and then at the social insurance system.

Revenue of the Territorial Authorities

Political considerations dominated revenue policy in the GDR. Levies and taxes were aimed at a politically ordained allocation of resources and distribution of income. The fiscal burden on business was high, whereas households were taxed comparatively lightly. Business taxes were negotiable, which introduced an element of arbitrariness into the tax system. Indirect taxes played a limited role in financing expenditure; this was, however, more a reflection of the size of the state budget in relation to economic activity than an indication of the level of tax rates. The major components of revenue are presented in Table 2.

Table 2.German Democratic Republic: Revenue of the Territorial Authorities
19871988
In billions of marksIn percent of totalIn billions of marksIn percent of total
Levies on the state-owned companies202.183.5205.982.1
Industry and service sectors188.377.8193.577.1
Of which:
Production and trade fund levies28.411.730.012.0
Net profit levy39.216.243.617.4
Contribution to social funds34.114.135.214.0
Product-specific levies43.017.743.117.2
Agriculture and food13.85.712.55.0
Taxes and levies paid by cooperatives and private businesses8.93.79.23.7
Cooperatives and craftsmen2.71.12.81.1
Consumer cooperatives2.20.92.10.9
Private craftsmen anti other private business4.01.64.21.7
Wage tax9.64.010.14.0
Other taxes1.60.71.70.7
Car tax0.50.20.50.2
Local authority taxes0.40.211.40.2
Inheritance, land purchase, and other taxes0.70.30.70.3
Contributions to the social welfare system11.14.611.54.6
Other receipts18.93.712.65.0
Total revenue242.1100.0250.9100.0
Source: Staatliche Zentralverwaltung für Statistik der DDR, Statistisches Jahrbuch der DDR, 1989.

Mostly unidentified.

Source: Staatliche Zentralverwaltung für Statistik der DDR, Statistisches Jahrbuch der DDR, 1989.

Mostly unidentified.

There were four main categories of receipts from state-owned enterprises:

  • The net profit levy was determined by the Government in the context of the central plan.1 In an accounting sense, it represented dividends paid by the enterprises to their shareholder, the State, and in 1988 accounted for 17 percent of revenue.2
  • The production fund and trade fund levies represented taxes on capital at a rate normally of 6 percent. Reduced rates could be stipulated by the Ministerial Council. In 1988, these levies made up 12 percent of revenue.
  • The so-called contribution to social funds, introduced in 1984, was in effect a tax on labor inputs at a rate of up to 70 percent of wages and salaries and represented 14 percent of revenue in 1988. Its use was not restricted to social purposes.
  • Product-specific levies were turnover taxes on consumption goods, with rates varying by product; the average rate exceeded 50 percent.3 “Luxury” items carried a particularly high tax burden, while basic goods were practically exempt. These levies amounted to 17 percent of revenue in 1988.

Business outside the state sector, which included cooperatives, the self-employed, and small-scale private companies, was subject to a complicated system of taxation with regulations varying by the type of business. The cooperatives and some of the professions were treated favorably but private companies faced prohibitively high average tax rates, with marginal rates up to almost 100 percent. Although an onerous burden on individual businesses, revenue from nonstate-owned business was of limited budgetary importance,4 reflecting the small size of this sector following the nationalizations of 1972.

The system of wage taxation in the GDR was structurally similar to that in the FRG, although average tax rates were much lower. Rates differed according to family status and specific circumstances. For a married income earner with two children, wage income below M 332 a month was exempt from wage tax. On incomes between M 332 and M 1,400, the marginal tax rate increased up to 20 percent and remained at this level for higher incomes. The structure of tax allowances and exemptions was complex, and reduced rates applied to certain types of income (for example, overtime pay, premiums, and shift and weekend work). The average tax rate on gross wage and salary income was 8½ percent in 1988, compared with 18 percent in the FRG.5 Taxes on wages and salaries accounted for 4 percent of total revenue in 1988, compared with 27½ percent in the FRG.

Other taxes, which made a relatively minor contribution to revenue, included a wealth tax, an inheritance tax, a land purchase tax, a lottery tax, a car tax, and a number of taxes levied by the local authorities (e.g., a land tax, dog license fees, and a tax on leisure and cultural activities).6 Revenue of the territorial authorities also included contributions and fees for various goods and services provided by the state welfare system, which accounted for about 5 percent of revenue in 1988.

Expenditure of the Territorial Authorities

The classification of spending in the budget rendered its analysis even more difficult than in the case of revenue. The largest category of expenditure was transfers and subsidies to nonagricultural state-owned enterprises, which accounted for over 36 percent of total expenditure in 1988 (Table 3). It included contributions to finance research and development and investment projects, and subsidies for intermediate inputs, but no quantitative breakdown was published. Setting-off the levies and taxes paid by the enterprises against the transfers they received, they were substantial net contributors to the budget. State-owned agricultural enterprises received even higher transfers per employee than the other state-owned enterprises,7 with, in 1988, about half of the total amount of M 9½ billion used to subsidize intermediate inputs for agricultural production. On balance, however, agricultural enterprises made a net contribution to the budget.

Table 3.German Democratic Republic: Expenditure of the Territorial Authorities1
19871988
In

billions

of marks
In

percent

of total
In

billions

of marks
In

percent

of total
Subsidies and transfers to state-owned enterprises85.337.994.040.3
Agriculture and food10.84.89.44.0
Of which:
Investment0.20.10.30.1
Interest subsidies0.20.10.20.1
Price subsidies3.81.74.62.0
Product development1.00.40.80.4
Other sectors74.533.184.536.3
Consumer price subsidies49.321.949.821.4
Other welfare expenditure69.230.872.631.1
Housing29.112.930.212.9
Health care16.37.217.87.6
Education18.48.219.08.2
Cultural activities5.52.45.62.4
Investment and maintenance expenditure13.86.116.57.1
Investment8.13.610.44.5
Maintenance of roads, railways, etc.5.72.56.12.6
Other expenditure7.43.30.30.1
Total expenditure225.0100.0233.2100.0
Source: Staatliche Zentralverwaltung für Statistik der DDR, Statistisches Jahrbuch der DDR, 1989.

Excluding transfer payments to the social security system of M 16.9 billion in 1987 and M 17.5 billion in 1988.

Source: Staatliche Zentralverwaltung für Statistik der DDR, Statistisches Jahrbuch der DDR, 1989.

Excluding transfer payments to the social security system of M 16.9 billion in 1987 and M 17.5 billion in 1988.

Subsidies on consumer goods amounted to M 50 billion in 1988, or 21 percent of expenditure. These subsidies aimed at stabilizing prices for basic consumer goods and services.8 As basic consumer goods were also largely exempt from product-specific taxes, their prices could be kept unrealistically low.9 Public investment (excluding housing) accounted for a comparatively small share of expenditure as did the maintenance of roads, railways, and waterways. The current inadequate state of public infrastructure indicates the low priority that was given to this category of expenditure. Public housing, on the other hand, was a high-priority area, with budgetary expenditure amounting to 11 percent of NMP. At the end of 1989, the housing sector (including privately owned housing) carried a debt of M 108 billion.10

Social Insurance

The social insurance system in the GDR was monolithic, in contrast to the complex structure found in the FRG. More than 90 percent of the population was organized in an institution known as the “Social Insurance of Blue and White Collar Workers at the Free German Trade Union (FDGB).” The remainder, mostly professionals, self-employed, and farmers were organized in the “State Insurance of the GDR.” Both institutions ran a mandatory insurance system and a voluntary supplementary system.11

As in the FRG, the social security system in the GDR was unfunded. Contributions to the system, which were not distinguished by type of insurance, were mandatory and paid by both employees and employers. In addition, a voluntary system was introduced in 1971, which provided supplementary benefits. In 1988, the social security contributions of employees amounted to about 6 percent of gross income from employment and those of the employers to about 7½ percent.12 Contribution rates and income limits above which earnings were not subject to taxation had remained more or less unchanged since the 1950s, except for the introduction of the voluntary system in 1971;13 with benefits rising much faster than contributions, the deficit of the social insurance system widened markedly. In 1988, about half of expenditure was financed out of transfers from the territorial authorities (Table 4).

Table 4.German Democratic Republic: Revenue of the Social Insurance System
19871988
In

billions

of marks
In

percent

of total
In

billions

of marks
In

percent

of total
Contributions18.352.118.851.9
Employees8.123.18.323.0
Employers10.229.010.528.9
Transfers from the territorial authorities16.947.917.548.1
Total revenue35.2100.036.3100.0
Source: Staatliche Zentralverwaltung für Statistik der DDR, Statistisches Jahrbuch der DDR, 1989.
Source: Staatliche Zentralverwaltung für Statistik der DDR, Statistisches Jahrbuch der DDR, 1989.

Benefits of the GDR social insurance system fell into four categories: pensions, health care, family-related benefits, and poverty assistance. Pensions were by far the most important category, accounting for more than half of total expenditure. Unlike in the FRG, pensions in the GDR were not adjusted annually to keep them in line with wage and salary developments. Instead, discretionary adjustments were made at intervals of several years. The increase in pensions in December 1989 raised the monthly statutory old age pension from M 378 to M 447 and the disability pension from M 404 to M 482.14 The maximum monthly old age pension amounted to M 510 under the mandatory system; those who participated in the voluntary system (about one third of old age pensioners) received on average an additional M 60 a month. The minimum pension was M 330 a month. Taking into account the December 1989 increase, the average old age pension was equivalent to about 45 percent of net wages in the GDR, compared with about 50 percent in the FRG.15

Health care expenditure covered benefits in kind (mostly medical services), medicines, and transfer payments. The latter consisted of sick pay, which was granted for up to 78 weeks at a rate of 90 percent of previous earnings. Medical services and medicines were provided free to the user; in 1988, they accounted for 30 percent of social insurance expenditure (Table 5). Family benefits included transfers to mothers, allowances for childbirth, benefits for children, and interest-free credit to young families.16 Poverty assistance, which—as in the FRG—was subject to a means test, played only a minor role according to official data. Poverty assistance was lower than the minimum pension; as virtually all old people received at least the minimum pension and as open unemployment was practically nonexistent, demand for regular poverty assistance was limited.

Table 5.German Democratic Republic: Expenditure of the Social Insurance System
19871988
In

billions

of marks
In

percent

of total
In

billions

of marks
In

percent

of total
Pensions17.148.517.247.4
Medical care15.042.715.843.6
Medical services7.220.47.520.5
Sick pay4.412.64.612.8
Medicines3.49.73.710.3
Family assistance2.16.02.26.2
Maternity benefits0.92.40.92.4
Infant care0.82.20.82.3
Child sickness0.51.4O.61.5
Other benefits10.82.40.92.4
Administrative0.10.40.10.4
Total expenditure35.2100.036.3100.0
Source: Staatliche Zentralverwaltung für Statistik der DDR,Statistisches Jahrbuch der DDR, 1989.

Including poverty assistance.

Source: Staatliche Zentralverwaltung für Statistik der DDR,Statistisches Jahrbuch der DDR, 1989.

Including poverty assistance.

Structural Aspects of Fiscal Reform

Institutional Changes

Plans for the reform of the system of public finance in the GDR were worked out by a joint commission of experts established by the Governments of the FRG and the GDR; these plans became a central part of the State Treaty on GEMSU. The new fiscal system that emerged in the GDR after July 1, 1990, was, except for certain transitional arrangements, practically identical to that of the FRG.17 This implied a fundamental change in the role of government in the GDR. Most importantly, the state-owned company sector was removed from the system of government finances and was to be restructured and privatized as quickly as possible.18 The monolithic social insurance system of the GDR was also separated from the state budget and broken up into its component parts, essentially the pension, health insurance, and accident insurance funds. The remaining elements of the government finances initially were left with the GDR Government and the local authorities. At the time of political unification, central government functions in east Germany were merged with those of the Federal Government of the FRG. The newly formed Länder19 and the local authorities would perform the same functions as their counterparts in west Germany. They would not, however, participate in the revenue-sharing arrangements that exist between the Federal Government and the Länder of west Germany. These arrangements would have to be renegotiated.20

Revenue and Expenditure Reform

Territorial Authorities

On the revenue side, probably the most pressing task was the reform of the tax system in east Germany, not least because of the immense burden that it imposed on the enterprise sector under the former system. Besides the need for generating revenue, other important goals were to create a stable tax structure and to establish a system of uniform tax treatment across individuals and enterprises. The task of reforming the tax system was resolved pragmatically. The State Treaty on GEMSU stipulated that, from July 1, 1990, essentially all FRG tax laws would be applied in the GDR21 with the temporary exception of the income tax and certain business taxes, which would be governed by simplified schemes until the end of 1990.22 Customs duties would be regulated in line with the customs law and the Common Customs Tariff of the European Community (EC).23 Contributions and fees for public services would be harmonized with the system in the FRG.24

Given that in the early stages of GEMSU, incomes in east Germany were likely to be much smaller than in the west, it was expected that the yield (relative to GDP) of direct taxes would be low, reflecting the interaction of a progressive income tax system with exemption levels attuned to conditions in west Germany. Initially, the main source of revenue was likely to be indirect taxes; indeed, in view of the high share of consumption in GDP that was expected for a number of years, the potential yield (relative to GDP) would be higher than in west Germany. Tax collections related to the expenditure of east German residents in west Germany would, of course, not be registered as revenue in east Germany; this, however, would be of little material interest in the context of the government finances of Germany as a whole. Collections in east Germany might also be affected by administrative difficulties during the early stages of GEMSU.

The level and structure of government expenditure in east Germany have also changed radically. Expenditure of the social insurance system, the state-owned enterprises, the public railways, the postal system, and the public housing corporation has been removed from the budget.25 Subsidies have been largely abolished or have been earmarked for reduction.26 The need for substantial cuts in personnel expenditure in the public services has also been identified; reportedly public service in the GDR was about twice as labor-intensive as its counterpart in the FRG.27 On the other hand, given that infrastructural needs were severely neglected in the past, these are likely to become a major priority for expenditure in the years ahead.

Social Insurance

The State Treaty on GEMSU envisaged a social security system in east Germany corresponding to the west German system, that is, the establishment of separate pension, health, unemployment, and accident insurance institutions.28 With political unification, the systems in the two parts of Germany will be merged but a date for this has not yet been set. In the interim, the four constituent parts of the social insurance system in east Germany are being administered by a single institution, but with separate revenue and expenditure accounts maintained for each type of insurance. Benefits are linked to insured earnings, and primarily financed by contributions, paid half by the employee and half by the employer.29 Contribution rates and the income ceilings for compulsory insurance cover are the same as in west Germany.30 Those with incomes in excess of the ceilings may join professional schemes outside the compulsory system.

The pension law that applied in the GDR has been adapted to the pension insurance law of the FRG.31 The supplementary and special pension schemes of the GDR were discontinued on July 1, 1990, with accrued claims transferred to the new system. Initial pension levels and Because of income differentials between east and west Germany, this acts as a disincentive to westward migration. future adjustments are linked to the development of net wages and salaries in east Germany.

Introduction of the health insurance law of the FRG implies that the institutional diversity found in west Germany will develop in east Germany over time. Medical expenses and sick pay of the insured are funded by the medical insurance system in line with the present FRG legislation. The health insurance contributions of pensioners are covered by the pension insurance fund. Outlays for investment in inpatient and outpatient facilities in the health service are financed from the budgets of the territorial authorities.

The unemployment insurance system in east Germany has been required, since July 1, 1990, to abide by the Employment Promotions Act of the FRG. In addition to paying unemployment benefits and assistance, the system is also responsible for conducting an active labor market policy, including vocational training and retraining. The State Treaty on GEMSU stipulated that in the transitional phase, the special labor market situation in east Germany would be taken into account.32 For instance, regulations with regard to short-time work are being applied more liberally than in west Germany until mid-1991.

Social assistance is now provided in line with the Social Assistance Act of the FRG, with the cost borne by the east German local authorities. The amounts involved are expected to be small initially, since practically all the unemployed will be covered for some time under the unemployment insurance system and pensions will in most cases be above the level provided by social assistance, which is based on a means test.

Financial Framework for the Fiscal Reforms

Besides stipulating how the revenue and expenditure systems of east Germany were to be reformed, the State Treaty on GEMSU provided a financial framework for the management of the public finances in east Germany. In particular, borrowing by the territorial authorities of the GDR would be limited to DM 10 billion in the second half of 1990 and DM 14 billion in 1991. They would receive additional financing from the German Unity Fund amounting to DM 22 billion in the second half of 1990 and DM 35 billion in 1991. The Federal Government would also provide DM 3 billion to the GDR Government in the second half of 1990 and a further DM 3 billion in 1991 to cover initial imbalances in the social security funds. The state budget for the second half of 1990, which was passed by the GDR parliament on July 22, 1990, was consistent with these financing constraints (Table 6). The budget projected revenue of DM 29½ billion. DM 25 billion would be in the form of taxes, of which two thirds would be generated by value-added and excise taxes. Expenditure was budgeted at DM 64 billion. On an annual basis, this represented only about half of expenditure prior to GEMSU; the separation of social security and public enterprises from the state budget, as well as expenditure cuts, accounted for the reduction in expenditure.

Table 6.East Germany: Central Government Budget in the Second Half of 1990(In billions of deutsche mark)
Original Budget1Revised Estimates1
Total expenditure64.281.8
Public services9.8
Education, science, and research4.0
Social welfare6.4
Of which:
Child benefits2.5
Housing1.3
Food, agriculture, and forestry4.4
Energy, water, and mining1.1
Transportation and communications4.9
Transfers26.1
To other levels of government19.5
To pension fund3.6
To unemployment insurance2.0
To health insurance0.9
Subsidies (excluding agriculture)6.2
Export subsidies (CMEA)2.0
Public transport1.3
Energy2.9
Interest2.9
Across-the-board expenditure cut−3.4
Other (including contingency reserves)1.7
Total revenue29.422.8
Taxes24.817.7
Value-added tax10.2
Excise taxes5.5
Lump-sum company tax6.0
Wage tax2.1
Other1.0
Other revenue4.75.2
Financial balance−34.8−59.0
Financing34.8−59.0
Transfers from German Unity Fund22.0
Transfers from Federal Government for start-up financing of:2.8
Pensions0.8
Unemployment insurance2.0
Borrowing by GDR Government10.0
Source: Bundesministerium der Finanzen.

Passed by the parliament of the GDR on July 22, 1990.

2 As estimated in the proposals for the third supplementary budget for the FRG, September 1990.
Source: Bundesministerium der Finanzen.

Passed by the parliament of the GDR on July 22, 1990.

2 As estimated in the proposals for the third supplementary budget for the FRG, September 1990.

Establishing a budget for the immediate post-GEMSU period was severely hampered by many uncertainties. On the revenue side, it was difficult to project economic developments in east Germany and there were questions about how efficiently the tax collection system would work. On the expenditure side, the lack of transparency in the old accounting system was a major problem. Moreover, the likely financial needs of the social insurance funds were difficult to anticipate.

Problems in these and other areas substantially affected budgetary developments in the second half of 1990. It was officially recognized in August that fiscal imbalances in east Germany would not be contained within the limits prescribed by the State Treaty. In September 1990, revised estimates were published along with the proposals for the third supplementary budget of the FRG. In the revised estimates, expenditure was 28 percent higher than budgeted earlier and revenue about 22 percent lower. These adjustments resulted in a projected deficit of DM 59 billion, compared with DM 35 billion in the original budget. On the expenditure side, about half of the increase was accounted for by transfers to the social insurance funds (Table 7). The budget had assumed that some 430,000 people would be receiving unemployment benefits on average in the second half of 1990, of which 270,000 would be fully unemployed; in September, however, the number of unemployed and part-time workers totaled 2.2 million, with 20 percent of these fully unemployed.33 Moreover, benefits were larger than expected, owing to the size of wage increases in east Germany. In the area of health expenditure, costs had risen because of higher salaries and because of a shift in the use of medicines away from those produced in east Germany toward more expensive west German products. Pension expenditure was also higher, since a decision to increase benefits was reached after the budget had been formulated. On the other hand, the income of the social security funds had been lower than anticipated, as firms with liquidity problems had been unable to remit payroll taxes. Lower employment had also reduced receipts, though this had been offset by higher wages.

Table 7.East Germany: Sources of Expenditure Overruns in the Budget for the Second Half of 1990(In billions of deutsche mark)
Original

Budget
ChangeNew

Estimate
Total expenditure64.217.781.8
Principal factors increasing expenditure
Transfers to social security5.18.914.0
Transfers to local government19.53.122.6
Agriculture
Market regulation1.51.22.7
Structural adjustment2.00.82.8
Subsidies
Energy2.91.24.1
Rents0.61.11.7
CMEA trade2.00.62.6
Early retirement benefits0.10.30.4
Wages and salaries0.80.8
Defense3.80.44.2
Transport investment2.10.52.6
Principal factors reducing expenditure
General contingency1.4−1.0−0.4
Interest2.9−0.52.5
Source: Bundesministerium der Finanzen, Pressemitteilung, September 28, 1990.
Source: Bundesministerium der Finanzen, Pressemitteilung, September 28, 1990.

Expenditure on subsidies was also expected to be greater than in the budget. Energy and transportation subsidies had increased, in part because of the rise in oil prices but also because of higher consumption than anticipated: for example, large purchases of consumer durables had boosted demand for electricity. Subsidies to agriculture would exceed the budgeted amount, as a result of the difficulties being experienced in this sector following the lifting of restrictions on imports; moreover, the estimate of subsidies related to supporting exports to member countries of the Council for Mutual Economic Assistance (CMEA) had also been increased. Of the other components of expenditure, the biggest overrun would be in transfers to local governments.

The financial framework set by the State Treaty also covered the operations of the public Trust Fund. In particular, the treaty limited borrowing by the Trust Fund to DM 7 billion in the second half of 1990 and a further DM 10 billion in 1991, these funds were to be used in the restructuring of the enterprise sector. In addition, the Trust Fund was authorized to guarantee liquidity loans to enterprises.

In the first months of GEMSU, the Trust Fund focused on the severe liquidity crunch being faced by enterprises. With questions of property rights unresolved, the initial balance sheets of enterprises yet to be finalized, and great uncertainty about the underlying competitive position of firms, banks were reluctant to take lending risks. Against this background, the Trust Fund guaranteed working capital loans to firms; in July, these guarantees, which amounted to about DM 10 billion, were granted across the board at a rate of about 40 percent of the requests from enterprises. Additional guarantees of some DM 20 billion were provided in August and September and authorization was given to extend liquidity guarantees until March 1991. In August- September the Trust Fund began to scrutinize liquidity requests to ensure that guarantees were more closely related to the needs of firms and their longer-term prospects.

Thus, in the early months of GEMSU, the efforts to keep enterprises operational diverted the attention of the Trust Fund, to some extent, from its work related to rationalization, restructuring, and privatization. Decisions on the disposition of publicly owned enterprises were made on a case-by-case basis and concerns about employment and the social impact were weighed, along with financial and efficiency considerations. Thus, in the case of privatization, not only financial offers but also the investment and employment intentions of the purchasing firms were taken into account. In the case of liquidation, action was delayed until the social consequences of closing the firms concerned had been evaluated. Through mid-August, 12 companies had been privatized, which yielded total receipts of some DM 70 million. Since then the pace of privatization has quickened. By early October, 30 firms had been privatized, yielding DM 1 billion; 80 percent of these receipts arose from the privatization of the electricity generating companies.

Implications of GEMSU for the Course of Public Finances in East Germany

With political unification, the scope of separate fiscal institutions in east Germany has been greatly reduced; for example, a separate central government budget for east Germany will not be produced in 1991. However, assuming a separate fiscal sector (including central government functions) is a useful analytical tool as it enables us to examine how the fiscal situation in Germany might be influenced by unification.

The new fiscal system in east Germany raises a number of important issues for the conduct of fiscal policy. First, the flexibility of government finances is quite limited, given the adoption in east Germany of the most important elements of the fiscal structures that govern taxation and social security in west Germany; this limits the extent to which policies can be adjusted to circumstances in the east. Second, the fiscal situation in east Germany is extremely difficult to project, owing in part to insufficient information on the starting conditions but even more to the uncertainties as to how economic conditions will evolve, particularly over the next few years. The inflexibility in the budget reinforces the vulnerability of the fiscal situation to macroeconomic developments.34 For example, the links with the economic and social system of west Germany place a floor on the provision of services. Infrastructure services will have to be improved rapidly, independent of economic developments in east Germany. Similarly, the cost of social benefits, in particular medical services, will be strongly influenced by the quality of services in the west. Moreover, if links with the labor market in west Germany develop rapidly and if wages rise at a fast pace as a result, expenditure on pensions and other social welfare programs will be higher at the same time that increased unemployment would reduce contributions relative to expenditure.

The links between labor markets in east and west Germany may also induce pressures for measures to boost wages in east Germany, for instance, through investment subsidies and other incentives for business. However, in this case the ability of the Government to resist should, in principle, be greater as there are good arguments for limiting the extent to which the Government tries directly to influence investment and employment decisions in the private sector.35 In other respects, too, one should not exaggerate the inflexibility of the budgetary situation. This is particularly the case if one takes as starting point the budgetary position in the second half of 1990, a period when expenditure was heavily influenced by pre-GEMSU budgetary policies. For example, while many subsidies have been abolished, important ones remain in the areas of energy, transportation, and housing. Eliminating these subsidies is a crucial step in bringing relative prices in line with the availability of resources. The Government intends to phase these out as quickly as possible. The main constraint is a concern for living standards of the less affluent, but such concerns can also be dealt with through direct income transfers. There is also room for economies in personnel expenditure; the public service of the former GDR was reportedly twice as labor-intensive as that in the FRG. Political unification will greatly reduce central government employment in the unified Germany, as the increased employment of the Federal Government will absorb only a limited number of former employees of the GDR central government. However, one should bear in mind that the scope of the central government of the GDR was much broader than that of the FRG. How much reduction in government employment takes place with unification will, thus, depend on the employment practices of the newly reconstituted Länder in east Germany. Over time, the speed with which employment is rationalized both at the Länder and municipality levels will influence not only the government finances but also the pace at which productivity rises toward west German levels.

A key feature of the fiscal reform has been the separation of various components of the state sector. When interpreting the macroeconomic effects of fiscal developments, one should bear in mind that this institutional change has had fundamental implications for government revenue, in view of the historical reliance of the government finances in the east on revenue from the state-owned enterprises. In particular, to the extent that larger government deficits in the east (compared with deficits that prevailed under the old system) are matched by an increase in retained earnings of the enterprises that no longer have to pass their profits on to the Government, the macroeconomic consequences are attenuated. The enterprises would be able to finance investment to a greater extent from internal resources, and government borrowing would take the place of borrowing previously carried out by the enterprises. Of course, the key question is enterprise profitability. It is likely that in the early stages of GEMSU, the labor share in income will be rather large, but, assuming that enterprises place emphasis on efficiency criteria, significant profits should in due course emerge at an aggregate level.

The extent to which publicly owned firms earn profits will also be important for the net worth of the public sector. It is likely that the highest profitability will be outside the state-owned sector, accruing to new private businesses and those public enterprises that are privatized early36 But, to the extent that the Trust Fund emphasizes efficiency, profits should also recover in the enterprises it oversees; this would boost future receipts from privatization and enable a reduction of part of the increases in public debt that occur in the interim. Nevertheless, questions remain about the financial prospects of the Trust Fund. The borrowing authority granted to the Trust Fund in the State Treaty on GEMSU (see above) was subsequently raised to DM 25 billion in the period to the end of 1991. It is also likely that, in the course of 1991, calls will be made on guarantees given by the Trust Fund to banks for liquidity credits extended to enterprises in the second half of 1990. Moreover, great uncertainty remains about the future proceeds from privatization, the costs of paying compensation to people whose assets were expropriated by the GDR Government, and the financial obligations that may result from the environmental cleanup and the resolution of the “old debt” of state-owned enterprises. There is a danger that overburdening the Trust Fund could endanger its core activities, that is, the restructuring and privatization of enterprises.

1

The profits of a state-owned enterprise did not reflect market conditions. Heavily influenced by the decisions of the central planners, the size of an enterprise’s profit was not an appropriate indicator of its competitiveness.

2

In the national accounts of the FRG, revenue of the territorial authorities from entrepreneurial activity and wealth amounted to 2½ percent of revenue in 1988.

3

A large number of individual tax rates existed but details were not made public.

4

Taxes from the nonstate-owned business sector amounted to only 3½ percent of revenue in 1988.

5

The FRG calculation is based on compensation of employees in the national accounts.

6

Similar taxes, though with a higher relative yield, exist in the FRG.

7

Agricultural state-owned enterprises included food processing enterprises.

8

The bulk of these subsidies—64 percent in 1988—related to food, and another 24 percent was for basic manufactured consumer goods. Subsidies on transportation (10 percent), drinking water (1 percent), and services (1 percent) accounted for the remainder.

9

Subsidies on consumer goods rose significantly, from about 13 percent of retail turnover in 1980 to almost 35 percent in 1988. On the other hand, product-specific taxes declined in relative terms—from about 38 percent of retail turnover in 1980 to 34 percent in 1988. As a result, the net revenue yield fell quite sharply and was negative in 1988.

10

Part of the interest and amortization payments on this debt was financed by the state budget (M 4 billion in 1988).

11

Starting in 1971, individuals could—on a voluntary basis—make an additional contribution to the social security system that entitled them to higher pension benefits (retirement, survivors’, disability, and orphans’ pensions).

12

See “Quantitative Aspects of Economic and Financial Reform in the GDR,” Deutsches Institut für Wirtschaftsforschung, Economic Bulletin (Berlin), vol. 27(5), July 1990.

13

In the case of the mandatory system, employees paid a rate of 10 percent and employers a rate of 12.5 percent on monthly incomes of up to M 600. Contributions to the voluntary system were 10 percent of the monthly income in excess of M 600 for both employees and employers. There was no upper income limit for contributions to the voluntary system from blue collar and white collar workers but for the self-employed the limit was M 1,200.

14

Individuals who had earned the average wage and had contributed for a specified number of years were eligible for the statutory pension.

15

The FRG system guarantees a worker about 70 percent of his or her previous net earnings after 45 years of employment. The average is significantly lower than 70 percent, mainly because women typically accumulate lower claims on the pension insurance system and receive smaller pensions.

16

Allowances for childbirth were M 1,000 for each child and children’s benefits were between M 50 and M 150 a year. The interest-free credits were often later converted into grants.

17

See, in particular, Articles 1, 11, 18, 26 and Annexes II-IV of the State Treaty on GEMSU.

18

In addition, the State Treaty stipulated that the railways (Deutsche Reichsbahn) and post and telecommunications (Deutsche Post) would be operated as special funds.

19

The five Länder that existed prior to 1952—Brandenburg, Mecklenburg-West Pomerania, Saxony, Saxony-Anhalt, and Thuringia.

20

Initially, 85 percent of the resources of the German Unity Fund would be directed to the Länder of east Germany. See the discussion in Chapter II, section on “Fiscal Implications of GEMSU.”

21

See Articles 30 and 31 and Annex IV (III) of the State Treaty. The possibility of deviating from FRG tax regulations in certain cases was provided if such deviations could be justified by circumstances (see Annex IV (II-(2) of the Treaty). Although perhaps attractive from a theoretical perspective, it would not have been feasible to introduce a tax system in the east that was significantly different from that in the FRG, particularly in view of the impending political unification.

22

Until the end of 1990, the individual income tax would be paid solely according to Class I (single taxpayers) of the FRG wage tax code, including a child allowance. Given the comparatively low incomes in the GDR, the full application of the FRG wage tax code would have yielded very little revenue. To give companies time to adjust, corporation, trade and wealth taxes would be paid under the tax rules that had been introduced by the Modrow Government in March 1990. The tax bases, however, would be calculated to conform with FRG accounting rules. From January 1, 1991 all income and profit taxes would be levied in accordance with FRG regulations.

23

See Article 30 of the State Treaty.

24

See Article 26(3) of the State Treaty.

25

See Article 26(2) of the State Treaty.

26

For instance, subsidies for industrial goods, agricultural products, and food were eliminated, except where they were in line with EC regulations. Subsidies on transportation, energy for private households, and housing were to be phased out progressively as incomes rose.

27

Information on the size of the civil service was not published in the GDR. The number of employees in the so-called nonproducing sector was reported to be 1.8 million in 1988, a large part of which probably worked in the government sector. According to the Deutsches Institut für wirtschaftsforschung, over 1.1 million workers were employed in public sector jobs, excluding the army and the security forces and the health service. See “Quantitative Aspects of Economic and Financial Reform in the GDR,” Deutsches Institut für Wirtschaftsforschung, Economic Bulletin (Berlin), Vol. 27(5), July 1990.

28

See Article 18(2) of the State Treaty.

29

See Article 18(1) of the State Treaty. Accident insurance contributions are paid by the employer only.

30

Contribution rates for both employers and employees in the FRG in 1990 are 9.35 percent of gross wage and salary income for pension insurance, 2.15 percent for unemployment insurance, and 6.45 percent for health insurance.

31

In contrast to arrangements prior to May 18, 1990, entitlements earned in east Germany will not be changed when a person transfers his or her residence to west Germany (Article 20(7) of the State Treaty). Because of income differentials between east and west Germany, this acts as a disincentive to westward migration.

32

See Article 19 of the State Treaty.

33

The cost of an additional 100,000 fully unemployed people has been estimated at DM ½ billion in the second half of 1990.

34

Compare, for example, the fiscal outcomes in scenarios A and B in Chapter V.

35

See the discussion in Chapter XII.

36

Most of the enterprises privatized at an early stage are likely to be already in a position to compete effectively with foreign producers.

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