Selected Background Issues

This Selected Background Issues paper examines the process of international financial integration in Germany, focusing on both banking and securities markets. The examination is useful both because of the size and importance of Germany’s economy and because of the structure of its financial markets, which rely on bank-based finance as opposed to securities-based finance to a greater extent than most other major industrial countries. The paper examines the data demonstrating the increased internationalization of German financial markets. It also considers measures taken by authorities to facilitate the internationalization process.


This Selected Background Issues paper examines the process of international financial integration in Germany, focusing on both banking and securities markets. The examination is useful both because of the size and importance of Germany’s economy and because of the structure of its financial markets, which rely on bank-based finance as opposed to securities-based finance to a greater extent than most other major industrial countries. The paper examines the data demonstrating the increased internationalization of German financial markets. It also considers measures taken by authorities to facilitate the internationalization process.

The Internationalization of German Financial Markets 1/

This chapter examines the process of international financial integration in Germany, focusing on both banking and securities markets. The examination is useful both because of the size and importance of Germany’s economy and because of the structure of its financial markets, which rely on bank-based finance as opposed to securities-based finance to a greater extent than most other major industrial countries. 2/ By understanding how the German authorities have addressed the challenges and opportunities of increased internationalization, while seeking to maintain the positive attributes of their financial system, insight into the process of adapting domestic financial markets to international standards can be gained.

The chapter is structured as follows. A01lev1sec1 Section examines the data demonstrating the increased internationalization of German financial markets. Section 2 considers measures taken by authorities to facilitate the internationalization process. Section 3 discusses current outstanding issues related to the internationalization of German markets and the structural change it has entailed. Section 4 offers a brief conclusion.

1. Trends in internationalization of German financial markets

Data from Germany point to an increased involvement both of foreign residents in the German financial market and of domestic German residents in foreign markets. Bundesbank figures show a sharp increase in the proportion of German public debt held by foreigners. This rose from only 3 percent at end-1974 to 15 percent at end-1984 and 32 percent at end-1994. Turnover by nonresidents of debt securities in Germany increased sixfold between 1990 and 1994 to DM 3.6 trillion (Bundesbank (April 1995)). 3/ Foreign interest in German futures and options has been strong too. The German futures exchange, the Deutsche Terminbörse (DTB), reports strong participation by foreign residents, while it has moved in the past year to establish direct trading links with several other European countries and has obtained permission to have its products sold in the United States (Franke (1995)). In addition, the contract in the Bund (the German ten-year government bond) on the London International Financial Futures Exchange (LIFFE) remains one of that exchange’s most heavily traded products, despite heavy trading in a similar product on the DTB. 4/

Foreign use of deutsche mark securities markets has also expanded rapidly in recent years. In the wake of substantial liberalization of this sector (see below), the total amount of foreign deutsche mark debt securities outstanding rose from DM 96 billion in 1984 to DM 341 billion in 1994. Issuance of these securities reached a peak of DM 87 billion in 1993.

In recent years, German banks have expanded their foreign operations at a fast rate. Assets of foreign branches and subsidiaries of these banks rose from 12 percent of their domestic assets in 1984 to 20 percent in 1994. 1/ In the past year, publicity has focused on the expansion by several large German banks of their presence in the London financial market. In 1994, Deutsche Bank announced plans to consolidate some of its international securities operations in its Morgan Grenfell subsidiary in London. In June 1995, Dresdner Bank announced that it would acquire the British investment bank Kleinwort Benson, and in July 1995 takeover talks between the third largest German bank, Commerzbank, and another U.K. investment bank were reported, but were subsequently aborted.

The presence of foreign banks in Germany, however, has not seen a similar expansion. Branches of foreign banks had assets totaling 2 percent of total German bank assets in both 1974 and 1984, but only 1 percent in 1994. Assets of German subsidiaries of foreign banks grew from 2 percent of total German bank assets at end-1985, the first year for which data are available, to 3 percent at end-1994.

Since unification in 1990, Germany has seen large net capital inflows after many years as a capital exporter. Over 1991–94, Germany had an average annual current account deficit of DM 31 billion, after an average surplus of DM 89 billion in the preceding five years. 2/ The current account deficits increased the trend toward internationalization of the German financial market. Germany has seen consistent outflows of direct investment in recent years, due to sustained investment by German enterprises abroad. Therefore, the current account deficits have been financed through net inflows of portfolio investment and credit transactions. The balances in these two categories have fluctuated substantially from year to year, and were supplemented in some years (especially 1992) by reserve accumulation by the Bundesbank. According to the capital finance accounts, foreign holdings of German securities rose from DM 252 billion in 1989 to DM 824 billion in 1994 (Table I-1). The increasing involvement of foreign capital suppliers in Germany can in turn be seen as a force for structural change in German financial markets, as foreign investors tend to demand markets that they perceive as fair, liquid, and transparent.

Table I-1.

Foreign Holdings of German Financial Assets

(In billions of deutsche mark)

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Source: Bundesbank (May 1985, p. 47; May 1990, p. 55; May 1995, p. 39). Bond and share data for 1984 and 1989 include investment company certificates, which are a separate category in 1994 (DM 16.0 billion). For 1984 and 1989, East Germany is part of the rest of the world; for 1994, eastern Germany is part of Germany.

Despite the trend toward greater capital inflows into Germany, German residents also have increased their investment abroad. To a large extent this has been due to the imposition of a withholding tax on interest income in Germany, which will be discussed in greater detail in section 3. Residents have increased their investment in Luxembourg-based investment funds and in Euro-deposits (Bundesbank (January 1994 and May 1995)). Most of these funds have reportedly been reinvested in the German market.

2. Recent policy measures

The trends toward internationalization outlined in the preceding section have been accompanied by many policy measures that have brought the structure of German financial markets closer to international norms. 1/ These measures have focused on expanding international access to German securities markets and formalizing the regulatory structure of these markets. While increased foreign presence and need for foreign capital may have created pressure for these measures, the measures have in turn created an environment that is more attractive to foreign investment. With ongoing European financial integration and with the possibility of European monetary union on the horizon, German authorities have expressed their desire to establish Frankfurt as a European financial center. European integration has also required a number of specific adaptations of German banking and financial law in compliance with EU single market directives.

a. The introduction of international standards in German securities and derivatives markets

In January 1990, Germany moved to catch up with other European countries, notably France and the United Kingdom, by opening a financial futures and options exchange, the DTB. Contracts on the Government’s five-year bond (Bobl) and ten-year bond (Bund) and on the DAX stock market index currently dominate futures trading on the DTB. There is also substantial trading volume in options on these futures contracts and in options on individual German stocks (IMF (1995)). Despite the activity in the Bund futures contract, a similar contract continues to trade on LIFFE in the United Kingdom, and trading volume on LIFFE’s contracts is more than twice as high as on the DTB’s. In contrast to LIFFE and other major international futures exchanges, which have open-outcry floor trading, DTB has fully electronic screen-trading. 1/

In 1990 and 1991, the authorities took three measures to open German securities markets to greater activity: (1) at the end of 1990 the Government terminated an issue authorization procedure that had required an issuer of a deutsche mark fixed-income security to obtain approval from the Ministry of Finance; (2) at the same time a 0.10–0.25 percent tax on securities transfers was repealed; and (3) a year later a tax on new securities issues was removed. The authorization procedure had been made unnecessary by changes in disclosure, in part due to the EU Listing Particulars Directive (Bundesbank (May 1993)). The securities transfer tax was a tax on securities transactions and may in part have been responsible for the large amount of trading in German securities conducted in London (see discussion of activity in London in section 3).

The first two of these measures paved the way for the development of a commercial paper market in Germany. Until the beginning of 1991, the authorization procedure had prevented such issues, while the tax on securities transfers had had a proportionately large effect on short-term instruments. In the first years of its existence, the German commercial paper market grew rapidly. It peaked in October 1992, when DM 19 ½ billion was outstanding. Since then the market has declined, owing in part to the termination of the Treuhand agency’s commercial paper program.

Convergence of the German and foreign markets was aided by the Bundesbank when it lowered reserve requirements on savings and time deposits on March 1, 1993 from 4.15 and 4.95 percent, respectively, to a uniform 2 percent. A year later, the Bundesbank lowered requirements on sight deposits to 5 percent from a progressive scale of 6.6 to 12.1 percent. 1/ Among the reasons given by the Bundesbank for this move was increased competition from other European financial centers with lower reserve requirements and an increasing outflow of deposits from Germany to the Euromarket (Hausler (1994)). In July 1995, the Bundesbank announced that it would lower the ratios on sight and savings deposits further, to 2 percent and 1.5 percent, respectively, from August 1, 1995; the ratio on term deposits would not change.

The Bundesbank has also taken steps to open the deutsche mark bond market to foreign issuers and foreign intermediaries. A series of liberalization measures were announced in 1992, and as described in Section 1, bond issues surged in the wake of these measures. These measures allow German branches and subsidiaries of foreign banks to act as lead managers of deutsche mark issues, which the Bundesbank continues to require be lead-managed in Germany. Previously only subsidiaries of these banks had been permitted to lead-manage deutsche mark issues, with permission only applying to foreign issues (i.e., issues by entities not resident in Germany). The measures also allowed short-term issues by foreign nonbanks, who thus were allowed to join the growing deutsche mark commercial paper market. For monetary policy reasons, however, foreign credit institutions were not permitted to issue deutsche mark debt securities of less than two years of maturity.

The most significant recent measure concerning German financial markets was the passage in July 1994 of the Second Financial Markets Promotion Act (SFMPA). This act combined a variety of measures that may be interpreted as bringing the German market closer to international standards. These measures included ending the prohibition of money market mutual funds, founding the Federal Securities Supervisory Office, making insider trading a crime, and increasing disclosure requirements for securities positions and for information relevant for the value of a security.

The introduction of money market funds had long been opposed by the Bundesbank because of concern that such funds would make the conduct of monetary policy more difficult. Nonetheless, the Bundesbank dropped its objections in May, and the SFMPA then allowed banks to offer these funds to their customers, effective August 1, 1994. The first such funds to be marketed to German residents were incorporated in Luxembourg in August, and the first German-based funds were authorized in September. The funds were managed by banks, as is the case with all investment funds in Germany. Initial growth of these funds was slow, however; net inflows over September-November 1994 into German-based money market funds were DM 8.2 billion. In December, these funds saw a sharp increase in inflows, with DM 23.0 billion worth of fund shares bought, in advance of wealth tax assessments at the end of the year. 1/ Because the tax rate on equity shares (including all shares in investment companies) was not scheduled to increase as of that date, in contrast to the rate on debt holdings (including deposits), individuals were induced to transfer funds from direct debt holdings to fund shares. Despite the existence of these funds, the Bundesbank continues to discourage their use. In September 1994, it discontinued a short-term debt instrument, known as the Buli, that it had first issued in 1992 to mop up excess liquidity after ERM intervention. The Bundesbank continues to oppose the issue of short-term debt by the Federal Government that funds might purchase, because government exposure to short-term interest rate fluctuations might constrain monetary policy (International Securities Regulation Report (1994)). 2/

An important provision in the SFMPA was the creation of the Federal Securities Supervisory Office (Bundesaufsichtsamt fur den Wertpapierhandel). Before this, securities market supervision had been handled by the Laender, especially those that played host to one of the eight stock exchanges. The states shared this supervisory responsibility with the individual exchanges. The Federal Securities Supervisory Office (FSSO) began operations on January 1, 1995. It is charged with monitoring compliance with other aspects of the SFMPA, notably the insider trading and disclosure provisions. It also serves a key role in representing German interests in international fora, including the International Organization of Securities Commissions and also facilitates coordination with foreign supervisors. It was, for example, a prerequisite for the approval recently obtained by the DTB to market its DAX futures contract in the United States (Franke (1995)).

Another key provision of the SFMPA was a change in the German approach to insider trading. Germany had been plagued in recent years by scandals involving insider trading, despite the existence of a voluntary code of conduct (Waller (1994b)). There was no statutory proscription of insider trading before the SFMPA. The existence of dealing on inside information may have created a perception of unfairness by those likely to be less informed—including small domestic individual investors and foreign investors—especially in a system where the major players in the stock market—the banks—are also heavily involved in the supervisory boards of major corporations. The new law made insider trading a criminal offense, in compliance with the EU directive on insider trading, effective in 1992 (European Commission (1994)). The FSSO was given the responsibility for investigating suspected insider trading, and then turning over the results to public prosecutors.

Finally, the SFMPA mandated numerous new disclosure provisions and a code of conduct for stock market participants. The provisions cover two main aspects of disclosure. First, companies are now required to publish information relevant to the value of their securities. Second, in compliance with an EU directive, changes in major positions in a firm’s shares must be disclosed. Like the insider trading provisions, these disclosure measures make the securities market more transparent for outside participants. Finally, a code of conduct for firms engaging in securities business has been instituted; this requires participants to have adequate expertise and to deal carefully and honestly with their customers. The FSSO is charged with monitoring compliance with the code, which is a prerequisite for German compliance with the EU Investment Services Directive. All these measures align German securities market practice with practice in other major markets, especially the Anglo-American markets, and therefore facilitate capital flows into Germany.

Very recently, the DTB has intensified its trading links with other countries. In 1993, it concluded an agreement with the MATIF futures exchange in France, which allowed screen-trading of each exchange’s products by the other’s members. The DTB set up a similar link with the Netherlands in 1994 and with Switzerland this year (Franke (1995)). With the implementation of the EU Investment Services Directive, due by the end of 1995, the DTB and other EU exchanges will be permitted to put their screens in other EU countries, without the approval of host-country authorities that is currently needed.

b. Aligning the banking system with EU and Basle requirements

Rules coordinating German bank regulation and supervision with international standards date to the Basle Concordat and the EU First Banking Coordination Directive in the 1970s. This process of international coordination has greatly intensified in the 1990s, as a set of EU directives implementing the single market in financial services has come into effect. Some of these directives closely parallel rules for internationally active banks agreed by the Basle Committee on Banking Supervision, of which Germany, along with other Group of Ten countries, is a member. The recent EU directives have required significant changes in German banking law. By creating a “single passport” for banks and later for nonbank securities firms, the directives also are likely to lead to changes in the structure of German financial markets, as competition from foreign financial institutions increases and as German banks increase their international ties, especially within the EU.

An important set of EU directives covering banks and similar credit institutions came into effect on January 1, 1993 (Fraser and Mortimer-Lee (1993); European Commission (1994); and Goldstein, Folkerts-Landau, and others (1993)). The Second Banking Coordination Directive created a single passport for a bank operating in one EU-member state to conduct business in other member states, either through a branch or on a cross-border basis. To complement the single passport, the directive also specified certain minimum regulatory standards for banks chartered in member states. The Own Funds Directive and the Solvency Ratio Directive introduced a system of minimum ratios of bank capital to risk-weighted assets, with the weights defined (at least in broad terms) by the level of credit risk inherent in different categories of assets. These two directives corresponded closely to capital rules developed by the Basle Committee on Banking Supervision, which came into effect at the same time as the EU directives.

Germany implemented these directives with the Fourth Act Amending the Banking Act. 1/ This act included several regulatory changes to comply with the Second Banking Coordination Directive. Major shareholders of German banks were made subject to checks by the Federal Banking Supervisory Office, whereas only managers had previously been subject to such checks. The act also mandated tighter restrictions than previously on banks’ shareholdings in nonfinancial enterprises, with the total of stakes limited to 60 percent of a bank’s capital and each stake limited to 15 percent of capital.2/

As in other countries, the implementation of the Own Funds Directive created two categories of capital, core capital and additional capital (known as Tier I and Tier II under Basle rules). An important issue in Germany was the extent to which hidden reserves of German banks should be counted in additional capital. These hidden reserves consist of unrealized—and previously unreported—gains on the value of assets held by banks. The decision was reached that hidden reserves up to 1.4 percent of risk-weighted assets could be counted as additional capital, provided core capital was at least 4.4 percent of risk-weighted assets. The types of hidden reserves eligible for such capital were limited to unrealized gains on real property, listed securities, and—for savings banks and credit cooperatives—holdings in affiliated enterprises and in investment funds. Critics of this decision, including the Bundesbank, argued that hidden reserves should not be included in own funds because capital based on these unrealized gains was unreliable and dependent on volatile market values. On the other hand, such hidden reserves are widely known to exist on the books of German banks, and any move to a more explicit recognition of such reserves may increase the transparency of German bank accounts, in turn making it easier for international investors to assess the creditworthiness of the banks and to provide funds to the banks.

Bank financial statements for the year 1993 marked the beginning of German compliance with the EU Directive on Bank Accounts of 1986. Compliance entailed changes in German bank accounting law that, among other adjustments, required banks to provide a more accurate disclosure than previously of their provisions against loan losses. These provisions were thenceforth required to be included as deductions from banks’ operating profits (IBCA Ltd. (1993)). This is likely to make reported bank earnings more variable while making bank accounts more transparent (Waller (1993)). 1/

The Fifth Act Amending the Banking Act was passed in 1994, to go into effect at the end of 1995 (Bundesbank (November 1994)). This act implemented two more EU banking directives in Germany, the Large Exposures Directive and the Consolidation Directive. The Large Exposures Directive tightened restrictions on the exposure of German banks to individual counterparties. In keeping with the expanded participation of German banks in the international derivatives market, one of the provisions of the act was to extend existing German large exposure restrictions from loan exposures to credit risks on all exposures, including derivatives. The Consolidation Directive, as applied in Germany, expanded the range of subsidiaries that are required to be combined into the parent bank’s financial statements for purposes of supervision, and also prescribed similar consolidation for financial holding companies. The directive harmonized the nature of this consolidation across the EU. The issue of consolidated supervision, which a series of agreements by the Basle Committee on Banking Supervision have also addressed (Goldstein, Folkerts-Landau, and others (1993)), has become more important internationally in recent years, especially in the wake of the collapse of the Bank of Credit and Commerce International in 1991.

The implementation of the EU Capital Adequacy Directive (CAD) and Investment Services Directive (ISD) in Germany is still in progress. These directives are scheduled to be effective at the end of 1995, but they will require additional changes in German law that have not yet been formally proposed by the Government. The ISD will establish a single passport for firms involved in a range of investment businesses and permit these firms to join local exchanges. This directive will thus allow foreign securities firms to operate in Germany to a much greater extent than before. With the exception of certain brokers, foreign securities firms carrying out securities activities in Germany must currently establish a German subsidiary licensed as a credit institution.

The CAD creates rules governing capital that both banks and nonbank investment firms must allocate to cover market risks on trading assets. It requires that banks separate their assets into trading assets, governed by the CAD, and banking assets, governed by the Solvency Ratio and Own Funds Directives. Such a split would be new for German banks. In March 1995, the Basle Committee on Banking Supervision proposed a set of rules covering the same types of market risk as the CAD; these rules would apply to internationally active banks in Germany and other Group of Ten countries. If the Basle proposal is finalized, the rules will become effective at the end of 1997. The Basle rules differ from the CAD in allowing considerably greater use of banks’ own risk management models in calculating required capital for different types of market risk, while the CAD takes a less flexible approach that divides market risks into an intricate set of building blocks. The differences between Basle and the CAD are discussed in IMF (1995).

c. Greater liquidity and flexibility in markets

In the past five years, the German authorities and market officials have introduced measures to increase, at least potentially, the flexibility and liquidity of German financial markets. One such set of measures involves the restructuring of the stock exchanges. A central corporation, the Deutsche Börse AG, was created in 1992 out of the Frankfurt Stock Exchange, which became a subsidiary. The new corporation also took over the DTB and the securities clearing agency (the Deutscher Kassenverein) as subsidiaries. The seven regional stock exchanges took a minority stake in the Bdrse, but most of it is owned by banks, which collectively hold an 80 percent stake. The supervisory board of the Bdrse is dominated by large universal banks, which at its inception were expected to use the new corporation as a vehicle to modernize German securities markets (Saunderson (1993)). The creation of the corporation represented an initial step toward centralizing German securities trading in Frankfurt. Observers have frequently claimed that the diffuseness of trading on eight separate exchanges reduces the liquidity of German markets, as quotes for the same security can differ between exchanges.

This trend toward the centralization of German stock exchanges was recently accelerated. The three largest exchanges, Dusseldorf, Frankfurt, and Munich, agreed in May 1995 to merge much of their operations, including share pricing, supervision, and share registration, although the ownership structure of the three exchanges will remain separate. The exchanges agreed to have major German equities (the components of the DAX 100 index) trade jointly on the three exchanges, but to divide trading in smaller equities, which will be traded on only one of the three exchanges. These three exchanges together account for 90 percent of German trading volume, with 75 percent on the Frankfurt exchange alone. It is possible that other exchanges will also join in this venture. Also in May, the Deutsche Bdrse announced plans to move to completely electronic trading by 2000. The Bdrse is planning to develop a new system that will replace its current IBIS system for trading thirty major issues and then to move trading in other issues from the current manual system to the new electronic system. To the extent that these changes lower costs and centralize trading, they may increase liquidity in the stock exchange and possibly attract trading in German securities back from London.

Several regulatory changes in recent years have also increased liquidity and flexibility. In 1990, the first Financial Markets Promotion Act increased the range of investments open to German investment funds. This law allowed funds to invest in derivatives and money market instruments to a limited extent (Bundesbank (March 1992)). In addition, the regulatory regime for special investment funds, which are funds not open to the general public, was liberalized (Bundesbank (October 1994)). The creation of the German commercial paper market in 1991 (discussed above) can also be seen as an increase in flexibility of German markets.

The Second Financial Markets Promotion Act last year further increased flexibility and liquidity. The green light for full money market investment funds (discussed above) increased flexibility, as did the act’s expansion of the range of derivatives in which investment companies may transact. Other provisions of the act may help increase liquidity in German equity markets. The act reduced the minimum par value of German shares from DM 25 to DM 5, which will permit German companies to divide their shares into smaller, lower-priced units to appeal to retail investors (Waller (1994b)). The lack of interest of German individual investors in equity investment has been a source of concern (see Section 3.c below). The act also included provisions to boost the liquidity of German securities markets by making it easier to borrow and lend securities. This will permit securities dealers to manage their inventory more efficiently and will therefore reduce the cost of acting as a dealer and providing liquidity to the market. Another important tool for securities market liquidity, the repurchase agreement, remains inhibited in Germany, because bank borrowing through repurchase agreements is subject to reserve requirements. 1/ This has meant that repurchase agreements in German government bonds are transacted in the international market, chiefly in London, instead of in the domestic German market (Goldstein, Folkerts-Landau, and others (1994)).

3. Issues related to the internationalization of German financial markets

As discussed in the previous section, Germany has made considerable changes to its banking and financial system. Despite these changes, however, serious issues remain open. While additional foreign presence in German markets may promote competition and therefore efficiency, these competitive pressures may also threaten German financial structure. German economic achievement has relied on a bank-dominated system of finance without a high degree of transparency. While in some ways such a system may inhibit competition and therefore efficiency, the close relationships between banks and corporations in this system arguably can enhance economic efficiency, by facilitating monitoring and control of corporate managers. The structure of the German financial system also may promote financial stability, both through the stabilizing effect of house banks on corporate financial conditions and through the macroeconomic stabilization of the German monetary structure. The recent policy measures discussed above, along with the trends toward greater internationalization discussed in section 1, have clearly produced pressure for change on many aspects of the German financial system and have raised potential tradeoffs between stability and efficiency. 1/ This section discusses several important topics in German finance related to this issue, in order to assess the effects of recent changes and to discuss both the choices facing the authorities and the extent to which additional changes are needed.

a. Competition in German banking

It is often asserted—though quantitative evidence seems to be lacking—that the German banking sector is less than fully competitive. The degree of competition in the banking system matters for two reasons. First, a competitive banking sector will price loanable funds near the marginal cost of those funds for savers, so that savings and investment will be allocated efficiently in the economy. Competition will also improve the allocation of other products offered by banks, including payment services and risk management products such as derivatives. Second, less competitive banks may be able to engage in behavior to keep out potential competitors, especially foreign banks, so that the full benefits of internationalization may not be realized. This second factor is, however, sensitive to the exact market structure of banking, and may be counterbalanced by the attractiveness to foreign firms of the excess profits to be made in German banking. Some areas of banking, notably retail deposit-taking and lending to small and medium-sized businesses, may be particularly resistant to new entrants, because of the strength of bank-customer relationships. 2/

These issues are of particular importance in Germany because of the dominant role played by banks in the financial system. According to the Bundesbank (April 1995), the share of “bank borrowing in domestic producing enterprises’ borrowing in the market has amounted to about 80 percent for a long time,” while at end-1994, “bank deposits accounted for about 40 percent of households’ financial assets,” although this number had declined from 55 percent at end-1970. Both Edwards and Fischer (1991) and Prowse (1994) note the reliance of enterprises on banks for external finance, although they also observe that enterprises obtain most of their finance from their own retained earnings.

In 1992, the Federal Cartel Office began an investigation of how large German banks set interest rates on savings accounts. The Office’s attention was drawn by the relatively low interest rates on savings accounts in the Berlin area, relative to money market and other interest rates, and also by comments by the head of Deutsche Bank that the bank would raise interest rates if public sector savings banks did so. The office discontinued its action against the banks in early 1993, after declining money market interest rates narrowed the gap between these rates and rates on savings accounts.

Evidence on the degree of competition is incomplete. One line of argument, sometimes taken by the authorities, is that the number of German banks is too high for imperfect competition or collusion to be possible. In March 1995, there were 3,696 credit institutions in Germany, including 336 commercial banks, 631 savings banks, and 2,660 credit cooperatives. 1/ It could be argued, however, that for many bank products, the relevant market definition is not national, but rather regional or local. Such issues are explicitly considered by the banking authorities in the United States, for example, who consider the degree of concentration of local banking markets in deciding whether to approve mergers. It could also be argued that the markets for particular banking services are more concentrated than the number of banks would indicate.

Another line of argument, also difficult to interpret, focuses on the reaction of bank lending and deposit rates to change in German money market rates. It has been noted that as money market rates fell in 1993, lending rates charged by banks fell more slowly than deposit rates, with the spread consequently widening (Bundesbank (October 1994)). Some observers have suggested that this behavior is indicative of imperfect competition in German banking. While this may be so, the behavior may instead be due to other factors, including the increased riskiness of loans during the recession. The data may also not accurately capture banks’ marginal lending and deposit-taking rates, although it can be argued that the extent to which rates charged some customers differ from marginal rates indicates the degree to which banks have the market power to charge different customers different (risk-adjusted) rates. 2/

It appears that the issue of bank competition has not received the degree of attention in Germany that may be warranted, especially given the international implications of the issue. On the other hand, incomplete competition in banking might be tolerated because it is possible that less competitive banking systems are more stable, in that banks may be more profitable and therefore may be less inclined to enter more marginal and unfamiliar businesses. However, enhanced supervision of banks could also prevent banks from entering such businesses without sacrificing the economic benefits of competition.

b. Transparency and openness of corporate finance

As German financial markets become more internationalized, the issue of the transparency and openness of German corporate finance is likely to grow in importance. The traditional dependence of German enterprises on their house banks may be attenuated as banks come under more competition for funds. Firms may also begin to perceive opportunities for less costly finance on international capital markets than offered by banks. There is evidence that large German enterprises are already moving to decrease their dependence on banks and have increased their reliance on capital market finance (Bundesbank (October 1992); Haas (1994, Chapter 3)). However, for enterprises to fully access finance from international capital markets, the financial conditions of enterprises must be readily understandable by international investors. Current disclosure and accounting norms may not be sufficient.

An example is provided by the experience of Daimler-Benz, which in October 1993 became the first German corporation to obtain a listing for its shares on the New York Stock Exchange. In doing so, Daimler-Benz agreed to abide by U.S. listing and accounting standards; the company has issued separate accounting statements according to German and U.S. standards since this agreement. Since U.S. accounting standards require significantly more disclosure than German accounting, no other enterprises have followed Daimler-Benz’s lead. However, some German firms are beginning to shift their accounting practices toward International Accounting Standards (IAS), making international listings more likely, especially with indications that the U.S. Securities and Exchange Commission may accept such standards to satisfy some U.S. listing requirements (Merrill Lynch (1995)). These standards are viewed as providing more precise information than German financial accounting provides on the results of different business segments of enterprises (Steinmetz (1995)). In May 1995, the German Ministry of Justice proposed permitting German companies to use IAS for their consolidated accounts, although the unconsolidated statements of the parent company would continue to have to follow German standards. These moves are likely to increase the ability of German enterprises to obtain international funding.

The barriers may be greater for medium-sized German firms, which typically are not incorporated as limited corporations (AGs or GmBHs). Instead these firms often are run as partnerships or sole proprietorships, and as a result, the disclosure requirements for these firms are minimal. Accessing international finance, or capital market finance in general, requires that these firms begin to disclose much more than is customary. 1/

German corporate finance clearly is evolving toward a more open and transparent system. The Government has announced its intention to eliminate the requirement that existing shareholders be given preemptive rights to all new share issues. Such a system makes it difficult for firms to expand their shareholder base, especially internationally. The enhanced disclosure requirements for listed firms in the Second Financial Markets Promotion Act (discussed in Section 2) should also improve openness. Nonetheless, Germany continues to lag behind international standards on these issues. As Germany expands its reliance on international capital markets, greater transparency in corporate finance could increase the stability of international financial flows to Germany, as investors can be better assured of having an accurate picture of the financial condition of enterprises.

c. Size and liquidity of securities markets

In liquid securities markets, issuers and investors can sell securities at a price close to their expected long-term value. If a market is liquid, prices are more likely to reflect values and therefore provide proper signals to guide savings and investment. Liquidity is difficult to measure, however, so proxies such as turnover volume are often used. Table I-2 provides a comparison of stock market turnover and market capitalization across the major industrialized countries. Germany ranks fifth of these seven countries in terms of turnover as a percentage of GDP.

Table I-2.

Stock Market Turnover and Capitalization, 1994 1/

(Ratios to GDP. in percent)

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Sources: Turnover and capitalization from IFC, Emerging Stock Markets Factbook 1995, May 1995; GOP from IMF, International Financial Statistics, July 1995.

Turnover and capitalization are for listed domestic company shares.

The size of a securities market—market value, number of issues quoted—may also provide a rough indicator of liquidity. Larger markets have more buyers to provide liquidity, while more liquid markets are likely to attract more issuers and so become larger. German securities markets are small relative to the size of the German economy. German stock market capitalization at the end of 1994 was about 25 percent of GDP (Table I-2). This compares with approximately 75 percent in Japan and the United States and 115 percent in the United Kingdom, and is the second smallest ratio in the major industrialized countries. The number of listed companies is also small by international standards. The German corporate debt securities market is small, and the bond market is dominated by public and bank issuers. Corporate debt constitutes only 1 percent of corporate funding; along with France, this is the smallest figure of the major industrial countries, while U.S. firms obtain 16 percent of their funding through debt securities (Bundesbank (April 1995)).

The small size of German corporate securities markets is due in part to supply and demand constraints. The supply of corporate debt and equity securities is limited by the dominant role of banks in corporate finance and by the disclosure hurdles for firms discussed in the previous subsection. Enterprises have also been able to finance themselves through provisions for pensions, taxes, and other items. The German pension structure limits demand for equity. This structure consists of public pensions financed on a pay-as-you-go basis and pensions offered by enterprises. Enterprise pension reserves are generally kept on the books of the enterprise offering the pension. Partly for this reason, institutional investors play a small role in German securities markets relative to international standards.

Demand from German individual investors, at least for equities, is rather limited; only 6 percent of German households reportedly own shares, compared with more than 20 percent in the United Kingdom and the United States (Waller (1994a)). In recent years, additional demand has come from international investors; for example, the turnover by nonresidents of German debt securities sextupled between 1990 and 1994 (Bundesbank (April 1995)). The coming DM 15–25 billion privatization of Deutsche Telekom, scheduled to begin in 1996, will increase the supply of equity to the German market.

Despite these supply and demand factors limiting the size of German securities markets, the German authorities have undertaken many initiatives to increase the efficiency of German securities markets. The most important of these measures were discussed above in section 2. Additional measures may need to be taken. The fragmented structure of the stock market, with eight different exchanges, is frequently cited as contributing to an inefficient market, in which prices differ from exchange to exchange. Last year, one large German firm, BASF, attempted to delist itself from the regional exchanges and have its shares quoted only in Frankfurt, but this effort was rejected by the regional exchanges. Further efforts to reduce this fragmentation could increase the liquidity of markets. 1/

d. Role of the London and Luxembourg markets

A substantial portion of financial transactions involving German assets takes place outside of Germany, mostly in London and in Luxembourg. A large share of German securities and derivatives business is transacted in London. By one estimate, 10 percent of the trading in leading German shares takes place on London’s international share market (Waller (1994a)). A considerable share of the trading of German government bonds also takes place in London (Goldstein, Folkerts-Landau, and others (1994)). In the futures market, as noted in section 1, LIFFE has the dominant share in trading on the futures contract for the German ten-year government bond. In addition to its role in trading in German assets, the London market has also proved vital for German financial institutions pursuing international capital markets business, with Germany’s two largest banks, first Deutsche Bank and now Dresdner Bank, having moved to concentrate their international securities operations in the London market (see section 1 above).

Luxembourg serves as a focus for much German banking business, through branches and subsidiaries of German banks located there. In large part, this activity is due to tax and regulatory differences between Germany and Luxembourg, notably the absence in Luxembourg of reserve requirements and of an interest withholding tax. 2/ The most recent German withholding tax was imposed in January 1993, at a rate of 30 percent on interest paid in Germany to German residents, and caused a massive shift of assets by German residents into Luxembourg-based bank deposits (Eurodeposits) and investment funds. In late 1993 and early 1994, some of these funds were shifted back to Germany after the tax was extended to income from Luxembourg investment funds paid in Germany. In large part, the funds invested by German residents in Luxembourg are believed to be recycled back to Germany as purchases of German assets by the investment funds. The attractiveness of Luxembourg as a conduit for these funds, instead of other EU centers, is due to Luxembourg’s having the most flexible rules in the EU for mutual funds, which may be marketed in Germany in accordance with the EU directive on collective investment undertakings. 1/

The location of German financial activity abroad raises a number of issues. The location of activity in Luxembourg and other centers to avoid German taxes clearly erodes the German tax base and therefore has distributional consequences within Germany. Similarly, the location of deutsche mark assets in these centers, particularly deutsche mark bank deposits, distorts monetary aggregates, as these Eurodeposits are not subject to Bundesbank reserve requirements. To the extent that these centers are under different regulatory regimes, issues of the protection of German investors might also be raised. Finally, the loss of financial business to foreign centers is an issue relating to trade in financial services. To the extent that the movement of transactions abroad reflects the relative competitiveness and comparative advantages of the German and foreign centers, welfare may be enhanced, but if the moves are driven by other factors, such as regulatory and tax differences, then the moves may not be economically desirable. It is plausible that the concentration of financial activity in London is due to natural economic effects, especially those of agglomeration, rather than mere tax or regulatory arbitrage, while for Luxembourg, tax and regulatory considerations appear to be dominant.

e. Monetary policy and EMU

Recent policy measures have complicated the conduct of monetary policy in Germany. An example is the surge of deposits in early 1994, as funds were repatriated from Luxembourg after the German tax treatment of Luxembourg mutual funds was changed. This surge caused a rapid rise in M3. Another example is the creation in 1994 of money market funds. Investment in these funds surged in December in advance of wealth tax assessments that treated these funds as equity shares, taxed at a lower rate than bank deposits (see section 2). The Bundesbank has noted that these funds also have led to more market-oriented rates for bank time and savings deposits (Bundesbank (January 1995)), which may in turn decrease the size of the (negative) interest elasticity of money demand. This has furthered recent trends to more market-oriented deposit rates.

These changes are forcing the German monetary authorities to adopt a more flexible approach, while preserving their primary focus on annual M3 targets. Their decisions to lower interest rates in early 1994, despite the surge in M3, demonstrate this flexibility. In addition, in addressing the issue of money market funds, the Bundesbank has announced that it will monitor M3-extended as a supplementary indicator. This aggregate now includes assets of these funds.

A more serious concern of the German monetary authorities has been the widening of short-term assets available to savers beyond the banking system. In particular, the Bundesbank has opposed the issue of short-term paper by the Federal Government and has withdrawn its own short-term paper from the market. It has argued that the existence of such short-term paper could create political opposition to monetary tightening as the Government itself would quickly bear higher interest costs (Hausler (1994, p. 50)). Similar pressures might also arise if there were an expansion in short-term borrowing by enterprises and individuals, which might be encouraged by increased short-term borrowing by the Government (Bundesbank, Annual Report 1994, p. 89). These concerns suggest a tension between the benefits of a German money market developed to international standards, as a part of the promotion of a financial center in Germany, and the benefits of monetary stability, which might be more easily obtained if the development of such a money market is restrained. 1/ The existence of such a money market might force a change in Bundesbank operating procedures from its current weekly operations with a large number of banks to more frequent interventions with a smaller group of core money market players, as for example is done by the Bank of England and the U.S. Federal Reserve System.

The Bundesbank has advocated such a system of infrequent, decentralized interventions if European Monetary Union (EMU) occurs (Hausler (1994)). This system would entail binding reserve requirements, so that reserve demand would be predictable and stable. If EMU occurs, Europe will therefore face the same tradeoffs that Germany now faces. The presumed benefits of a fully developed money market will have to be weighed against the benefits of what may be a more decentralized and possibly a more stable system, although evidence will certainly have to be gathered on these issues. 2/

f. Tax impediments

Policy measures of the past five years have removed many significant structural impediments from the German financial markets and have fostered their further integration into international markets. Nevertheless, impediments remain. Many of these, such as the current pension system and concerns related to the conduct of monetary policy, have already been discussed. Another area of continued impediments is the structure of taxation. The effects of the interest withholding tax were described above. Another impediment is posed by the German business capital tax (Gewerbe-kapitalsteuer), which is a tax on the net worth of an enterprise. The tax covers not only equity capital of an enterprise, normally considered the net worth of the firm, but also its long-term borrowing, although such borrowing is taxed at a lower rate than equity capital. 1/ This tax therefore provides an incentive for a company to obtain debt financing rather than equity financing, and short-term debt (such as from a bank) rather than long-term debt (such as through a bond issue). The 1996 draft tax law proposed repealing this tax, although a final decision has not yet been reached.

Like most national income tax systems, German income taxes favor debt finance over equity finance. However, the German system compensates for the deductibility of interest payments on corporate income taxes by providing a tax credit to domestic taxpayers receiving dividend income, to compensate these taxpayers for the income taxes paid by the corporation paying the dividends. While eliminating one impediment, the existence of this credit creates another impediment. Foreign recipients of dividends do not receive this credit, because they do not pay German income taxes, and therefore dividend income accrues to foreigners at a lower rate than it accrues to domestic residents, which creates a disincentive for foreign holdings of German equities. 2/

4. Conclusion

In the past five years the process of the internationalization of German financial markets has accelerated. The authorities have taken a host of initiatives aimed at harmonizing the banking system with those in the EU and the Group of Ten countries, while restructuring securities markets to make them more attractive to international investors. In addition to the direct benefits of internationalization, these changes are also likely to benefit domestic residents, as yields on savings become more market determined, the range of savings vehicles widens, and the securities markets become more transparent and more liquid.

This chapter has noted that despite these impressive changes, continued attention may yield benefits in a number of areas. In particular, competition might be improved in the banking system, liquidity in the securities markets might be enhanced, corporate finance might be made more open and transparent, and certain tax distortions in financial markets might be eliminated. In addition, as internationalization and structural change continue, vigilance to the changing environment for the implementation of monetary policy will be required. Competition from other international financial centers, including others within the EU, is only likely to increase, and the authorities will remain under pressure to sustain progress toward the internationalization of the German financial markets.

II. Adjustment Dynamics in the German Labor Market 1/

As in other European countries, unemployment in Germany (including in western Germany) has risen considerably since the 1970s, as employment growth has failed to keep pace with a steady rise in the labor force (Chart II-l). Much of the literature has focused on the possible rise in the “equilibrium” rate of unemployment that may underlie this increase. This chapter takes a rather different approach, focusing instead on adjustment dynamics in the labor market. Slow adjustment of the labor market means that the effects of temporary shocks will be persistent, and the effects of permanent shocks will be delayed. An understanding of why adjustment is slow should point to policies that could speed it up—a particularly important question in Germany in light of the danger of persistent high unemployment in the new Laender.


Western Germany: Unemployment and Employment

(In thousands)

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Source: Statistisches Bundesamt, Volkswirtschoftliche Gesamtrechnungen; and Deutsche Bundesbank, Monthly Report.

The chapter reports the results of a set of estimates based upon data on the west German labor market, for the period 1970–94. 2/ Broadly following the methodology in Karanassou and Snower (1994), a system of labor demand, labor supply, and wage determination equations is estimated, using current and—most importantly—lagged aggregate variables such as employment, labor force, and wages, as well as policy indicators. The novelty of the present approach lies not so much in the specification of this system: simple labor market models including lagged variables have been built before, and like them the present system admits in principle of a long-run equilibrium rate of unemployment. The present study, however, singles out the effects of lagged variables—including the ways in which they may have changed over the last two and a half decades—as objects of attention in themselves. A number of sources of adjustment lags are identified, and related to specific features of labor market institutions and policies. In addition, the study pays particular attention to the way the effects of different lagged variables interact, and the response of the system to various types of shocks is simulated over time. As will be seen, the results—tentative as they are—suggest that unemployment may remain far from its long-run equilibrium for a very long time, so that the long-run equilibrium itself may lose much of its relevance over any time horizon of practical significance.

The chapter is structured as follows. The conclusions of the paper are stated in summary form in Section 1, in an attempt to provide a framework for the rest of the paper. Section 2 provides a broad overview of developments in the German labor market since 1970. Section 3 describes the model and the methodology used to estimate it. Section 4 describes the results and draws out their implications for policies.

1. Executive summary

  • The paper finds that the German labor market exhibits considerable sluggishness in adjustment. The specific numerical results should be treated with caution, but it is at least suggestive that, in the present model, it takes one to two decades for the effects of a temporary shock to employment demand to disappear, and for employment to adjust to its new equilibrium level following a permanent shock. It may thus be that unemployment at any given point in time is determined much more by its own history than by its “long-run equilibrium.” Such slow adjustment—as in other European countries—may help to explain the rise in unemployment since the early 1980s, and does not bode well for the path of unemployment in the future, including in eastern Germany.

  • There is tentative evidence from this and companion studies that the German labor market adjusts more slowly than those of other European countries. Thus, even though the (west) German unemployment rate is relatively low by European standards, structural reform of the labor market may be no less necessary in Germany than elsewhere in Europe.

  • Strong persistence in unemployment strengthens the presumption that macroeconomic policies should be stability-oriented. If inflation is allowed to get out of hand, the rise in unemployment necessary to get it back to acceptable levels may turn out to be very long-lived.

  • The study finds that there is substantial persistence in employment in Germany, perhaps related to relatively strict employment protection and to the fact that the courts have considerable discretion in the area of dismissals. Even so, there is no evidence of reduced persistence in employment around the time of the Employment Promotion Act of 1985, which somewhat loosened the restrictions on dismissals.

  • Another factor underlying high persistence in employment and unemployment is a weak effect of unemployment on wage growth. This result may be related to Germany’s labor market institutions (widespread collective bargaining, industrial democracy, and generous social protection), which—for all their strengths in other dimensions—would be expected to prevent outsiders from exerting a major influence on wages. The indefinite duration of unemployment assistance, which distinguishes the German unemployment insurance system from that of most other countries, probably plays an important part in this respect.

  • The fact that collective bargaining is in practice highly centralized may also contribute to the weak effect of unemployment on wage growth, as it reduces the likelihood that wages will adjust to clear segments of the labor market (e.g., in particular regions or sectors) that are subject to particularly high unemployment. While centralized bargaining need not produce a relatively undifferentiated structure of wages across skill levels, in practice it tends to do so, reflecting unions’ objectives; thus high unemployment among particular skill groups may also exert only weak downward pressure on wages overall.

  • To the extent that any effects of unemployment on wage growth are found, there is evidence that they weakened during the 1980s. An increase in government involvement in the labor market may have contributed to this, as may an increase in the duration of unemployment benefits for older workers (which represent a large, and growing, fraction of the unemployed). The finding is also consistent with the observed growing segmentation of the German labor market—between regions, ages, and skill levels—during the 1980s.

  • There is also persistence in wages, which depend strongly on their own past values, implying slow adjustment to labor market disequilibria. Germany’s system of pattern bargaining, whereby the first wage contracts signed each year become the standard for subsequent ones, may contribute to this, as there is little opportunity for changed labor market conditions to be reflected after the first agreements have been concluded.

  • Rises in measured unemployment tend to be mitigated by declines in the labor force: there is evidence that the labor force responds negatively to unemployment, suggesting that discouraged workers leave the labor force. Thus the detrimental effects of unemployment may be underestimated if one looks only at the unemployment rate, without considering the loss of the productive potential of discouraged workers. Measures to keep the long-term unemployed in touch with the labor market may be especially important in this respect.

  • As a by-product of the study, some evidence was found that increases in the tax wedge between total labor costs and take-home pay fall partly on employers, and therefore have a significant effect on employment. The continuous rise in the tax wedge over the last two decades may help to explain relatively slow growth in employment.

2. Developments in German labor market institutions and policies since 1970 1/

The German labor market is characterized by a centralized system of collective bargaining and by rather extensive social protection. Its institutions and policies have remained relatively stable throughout the post-war period, although some trend toward greater government activism in labor market matters can be discerned after 1970, when the government proclaimed an unconditional “full employment guarantee” (Soltwedel (1988)).

The following paragraphs describe a number of important labor market institutions and policies as they stand at present, and note changes since 1970 where there have been significant ones. In each case an attempt is also made to identify the ways in which the institutions and policies described may affect, respectively, the equilibrium rate of unemployment and the speed with which unemployment moves to its equilibrium.

The basic principles governing wage bargaining in Germany date back to the 1920s. The partners to the negotiations are industry-wide employers’ federations and trade unions. Negotiations take place at the regional level, but national demands are publicized in advance of the wage round, and wage contracts are typically identical nation-wide within a sector. Wage agreements specify a set of tariff (minimum) wages; there are no minimum wages established by law. The coverage of collective bargaining is very wide. Although the unionization rate is only about 40 percent (up only a little from about 35 percent in 1970), a large majority of west German employers belong to employers’ federations, and are obliged to pay at least the union-negotiated wage. 1/ Individual firms are free to pay wages higher than the tariff, and most do. However, in practice, perhaps in part because industrial action is prohibited in firm-level negotiations, increases in actual wages tend to follow the increase in the tariff, and “wage drift” from year to year is small.

In practice, the system operates more like a centralized one than these bare facts would suggest. Not only is there little regional differentiation between wage contracts within sectors, but coordination mechanisms between sectors include the employers’ and unions’ umbrella organizations, and a system of “pattern bargaining” whereby certain sectors (metal-working in particular, followed by construction and the public sector) set the standard for each wage round.

There has been no significant change in the way the bargaining system has operated, nor in its coverage, since 1970. Something of a watershed was reached in 1984, with a nine-week strike by the metal-workers’ union, affecting about half a million workers by the end—the biggest and arguably most embittered strike in the history of western Germany (Streeck (1988)). Remarkably, the traditional cooperative pattern of west German industrial relations survived this strike, and unlike in other countries in the 1980s there was no determined effort by employers or the Government to roll back union power. The only legislative change—much debated but, in the final analysis, rather minor—was the passage of “Section 116” in 1986. Section 116 made workers ineligible for unemployment benefit if they are laid off because a strike elsewhere has cut off a firm’s supplies, and if they stand to benefit directly from the industrial agreement at stake in the strike. 1/

The generally cooperative patterns evident in collective bargaining also prevail at firm and plant level. “Industrial democracy” in Germany has a long history, but was strengthened significantly with the 1972 Works Constitution Act (Betriebsverfassungsgesetz) and the 1976 Code termination Act. These laws established the rights of Works Councils (Betriebsrate, representing the workforce) to approve decisions on most aspects of working practices, and to be consulted or at least informed on other matters. They also strengthened worker representation on supervisory boards (Aufsichtsrãte), which guide long-term company strategy.

The very high degree of coverage of collective bargaining, and the influence of employees over firm-level working practices, suggest a potential role for “insider-outsider” effects in German labor markets. 2/ Both the unions and firms’ own workforces represent primarily the interests of the employed, so that high unemployment may have only a weak tendency to correct itself by means of wage restraint. This effect may be magnified by centralized bargaining, which will tend to make all wages in the economy move together, and hence may prevent wages in particularly weak segments of the labor market from adjusting to eliminate unemployment. 3/ “Pattern bargaining” in Germany may introduce a further element of persistence in the form of wage staggering: adjustment to a labor market shock may be delayed by the heavy influence exerted on contracts concluded later in the wage round by contracts concluded earlier in the round. 4/

A unique feature of the German labor market is the prominence of apprenticeship programs. Which provide employment for over half of all 16 to 19-year-olds, and which combine practical training with compulsory part-time education at vocational schools. Practical training has long been provided in private firms, but since 1969 it has been regulated by the Vocational Training Act (Berufsbildungsgesetz). In 1976, fears of free-rider problems led the Government to introduce fines for employers for a collective failure to create enough apprenticeships to absorb all school-leavers, but the relevant law was struck down as unconstitutional in 1980. Nevertheless, apprenticeship programs expanded considerably during the 1970s and 1980s.

Germany places considerable emphasis on active labor market policies—an emphasis which has increased since 1970. The precursor of the Federal Labor Office was created as early as in 1927, with responsibilities for job placement as well as the compulsory unemployment insurance system, but the Labor Promotion Act (Arbeitsförderungsgesetz) of 1969 set the stage for an expansion of vocational training and counseling and job creation programs.

To the extent that the expansion of both apprenticeship programs and active labor market policies has mitigated skill mismatches, it would be expected to have reduced equilibrium unemployment (at least compared with what it might have been otherwise). At the same time, retraining and job creation programs may help smooth adjustment by ensuring that the unemployed remain in touch with the labor market.

Income maintenance for the unemployed is provided under the headings of unemployment benefit (Arbeitslosengeld, typically for the first year of unemployment), unemployment assistance (Arbeitslosenhilfe, thereafter and indefinitely, subject to means-testing), and social assistance (Sozialhilfe, available to all whose income is inadequate). 1/ Replacement ratios rose in 1975, but were reduced in 1984 and again in 1994 (Table II-l). At the same time, from the beginning of the 1980s, eligibility requirements for unemployment insurance payments—in particular the minimum contribution period and the penalties for turning down job offers—were gradually tightened.

Table II-1.

Unemployment Insurance Statutory Replacement Ratios 1/

(In percent)

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Source: Data provided by the German authorities.

Statutory replacement ratios were constant over the periods indicated. Replacement ratios apply to previous after-tax earnings, excluding the typical 13th month wage; thus as a proportion of total annual earnings replacement ratios are a little lower.

An exception to the trend of decreasing generosity of benefits from the mid-1980s occurred in 1986, with an extension of the period of eligibility of older workers for unemployment benefits, from one year to, depending on age and tenure, up to 32 months. Because—in contrast to many other European countries—unemployment in Germany is disproportionately concentrated among older workers, the significance of this change should not be underestimated: in 1994, 40 percent of the unemployed in western Germany were 45 or older (up from about 30 percent in the early 1980s), compared with 30 percent of those in dependent employment.

From an international perspective, Germany’s replacement ratios for unemployment insurance are not unusually high, at least in the first few years of unemployment. However, Germany is unusual in that it provides unemployment insurance benefits (albeit at a slightly reduced level, in the form of unemployment assistance) indefinitely.

From a theoretical point of view, the more generous unemployment insurance, the lesser will be the intensity of job search by the unemployed and the downward pressure unemployment puts on wages. The result could be not only higher equilibrium unemployment, but also higher persistence in unemployment following adverse macroeconomic shocks.

The growing cost of both active labor market policies and income support for the unemployed, together with a more general expansion of government activities, has been reflected in rising taxation of labor. Not unlike other major industrial countries, Germany has experienced an enormous rise in the “tax wedge” between net take-home pay and the total cost of labor to employers (Charts II-2 and II-3). The overall wedge has risen from just over 50 percent (of take-home pay) in 1970 to close to 90 percent in 1994.


Western Germany: Labor Costs and Take-Home Pay

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Source: Statistisches Bundesamt, Volkswirtschaftliche Gesamtrechnungen.

Germany: Labor Taxes 1/

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Source: Mendoza at el. (1993).1/ All taxes on labor as a percentage of all payments for labor (both including social security contributions and payroll taxes).

Rising taxation of labor would be expected—for given take-home pay—to raise labor costs, reduce employment demand, and hence raise the equilibrium rate of unemployment. Of course, if rising taxation of labor is instead absorbed through a decline in take-home pay, employment demand would be unaffected, and measured unemployment might even fall to the extent that labor supply contracts in response to falling net wages. In either case, however, it is difficult to see how the taxation of labor would have an important impact on the dynamics of unemployment, as distinct from its long-run equilibrium.

Employment protection in Germany is fairly severe. This may be one reason why the German economy operates with large amounts of overtime even in periods of recession (Franz and Konig (1986)), and why, as shown by Abraham and Houseman (1993), shocks to labor demand tend to result in changes in the number of hours worked rather than in the number of employees.

For strictness of protection against individual dismissals, Grubb and Wells (1993) rank Germany fifth among 11 OECD countries, directly behind four southern European countries (Portugal, Spain, Italy, and Greece). Perhaps even more importantly, much is left to the discretion of the courts, creating uncertainty for employers. Individual dismissals have to be “fair,” but criteria for fairness are only partly laid down in legislation. Similarly, individual redundancies can only be implemented if alternatives are “intolerable,” and the choice of redundant workers is subject to “social criteria,” but the definition of both these requirements has in practice been left up to the courts. In addition, large-scale dismissals must be accompanied by “social plans,” under which compensation is negotiated. 1/

Although there were no basic legal changes in employment protection during the 1970s and early 1980s, labor courts over this period increasingly developed the idea of employees’ “social property rights” in their jobs. There is some evidence that in practice average dismissal compensation payments rose considerably over the period (Soltwedel (1988)). Employment protection legislation was relaxed a little in 1985, with the passage of the Employment Promotion Act (Beschäftigungsförderungsgesetz). This law expanded the possibilities for fixed-term contracts, increased their maximum duration from six to 18–24 months, and exempted new firms from the social plan requirement. Due to expire in 1995, its validity was recently extended to the year 2000.

While the effects of employment protection are the object of debate, the high costs and uncertainty involved in the process of making workers redundant in Germany may affect both the dynamics of adjustment in the labor market and the equilibrium level of unemployment. Employment protection may delay the upward adjustment of employment in a recovery, as firms may be reluctant to hire workers who might later be difficult to fire should product demand decline. 2/ Blanchard and Summers (1988) and more recently Saint-Paul (1995) have also shown that employment protection may cause unemployment to react especially strongly to adverse shocks to employment demand. When employment protection is high, firms are more likely to rely on voluntary quits than on firings and they will therefore be more willing to hire new workers when the voluntary quit rate is high. In that case, a rise in unemployment, which may be expected to reduce the voluntary quit rate (as new jobs are harder to find), would be exacerbated by a decline in firms’ propensity to hire. Far from reducing the impact of adverse shocks on employment, high firing costs may thus be associated with large rises in unemployment in recessions. Saint-Paul (1995) shows that this mechanism may even lead to high-unemployment “trap” equilibria.

Aside from their direct effects on the speed of adjustment of employment, hiring and firing costs also strengthen the hand of insiders in wage negotiations, and would thereby be expected to delay the adjustment of wages to weak labor market conditions, and to result in higher equilibrium unemployment rates overall.

The details of housing policy are beyond the scope of this paper, but the potential effects of such policy on the speed of labor market adjustment to geographically localized shocks must be mentioned. The sharp increase in unemployment in Germany between the 1970s and the 1980s coincided with the structural decline of the coal, shipbuilding, and metallurgy industries located in the North of the country, and these areas remain characterized by especially high unemployment rates. Anecdotal evidence suggests that the relatively high proportion of owner-occupancy in Germany, together with an underdeveloped market in second-hand houses (due in part to tax preferences for new housing), may contribute to slow adjustment of regional labor markets. 1/

In sum, German labor market policies and institutions exhibit a number of features that would be expected to affect, respectively, equilibrium unemployment and the speed with which unemployment responds to changing conditions. High and rising labor taxation stands out among factors tending to raise equilibrium unemployment, while training policies would tend to lower equilibrium unemployment. Among influences on the speed of adjustment of unemployment, three should be noted in particular. The widespread and centralized collective bargaining system has changed little over the last two and a half decades, but may contribute to persistence in unemployment through “insider-outsider” effects. The generous unemployment insurance system may weaken the downward pressure the unemployed exert on wages, and hence may slow the adjustment of unemployment. The level of benefits was reduced during the 1980s, which would have been expected to raise the responsiveness of wages to unemployment; but the duration of benefits for older workers was increased, which would have had the opposite effect. Finally, relatively strict employment protection, subject also to considerable uncertainty, may slow not only the adjustment of employment itself, but also the adjustment of wages, by further strengthening the hand of insiders in the wage determination process.

3. The labor market model

a. Description of the model

The system of equations was specified as follows: a labor demand equation, with employment as a function of total labor costs to the employer and gross domestic product (the latter as a proxy for product demand); a wage bargaining equation, with real take-home pay as a function of productivity and the wedge between real total labor cost to employers and real take-home pay for employees (which consists of the tax and social security wedge between total labor costs and take-home pay, and of the discrepancy between consumer and producer prices); and a labor force equation, with labor force as a function of working age population and unemployment (the latter as a proxy for the “discouraged worker” effect). A number of other independent variables were tried in each equation, but proved insignificant.

Potential effects of labor market policies and institutions were analyzed in several ways in this model. First, policy variables were included in the system as exogenous, explanatory variables. Second, the stability of the relationships was analyzed by exploring potential changes in the estimated coefficients for different sample periods, corresponding to changes in labor market policies and institutions. The relative stability of these policies and institutions in Germany over the past twenty-five years sets limits on what either method can achieve. Nevertheless, it is possible to identify important ways in which labor market behavior has changed, ways which in themselves suggest possible policy responses. Finally, the equations themselves, and their lag structures in particular, point to various possible sources of sluggish adjustment, some of which may be amenable to policy changes.

b. Estimation

In order to analyze the robustness of the results to different approaches, two estimating strategies were adopted. The first strategy (hereafter called the error-correction model, or ECM, strategy) was to estimate long-run, cointegrating relationships and to construct error-correction models based upon them. The second (hereafter called the autoregressive distributed lag, or ADL, strategy) was to estimate equations including a number of lags of the independent and dependent variables and to infer the long-run relationships implied by them. The ECM model is a restricted form of the ADL model, with the restrictions reflecting a priori judgments about the form adjustment dynamics are likely to take.

The estimation strategies differ for the two modelling approaches. For the ECM, the long-run (cointegrating) relationship is estimated first and then used as an input in an equation capturing the short-run dynamics. 1/ By contrast, the long-run relationship in the ADL model drops out of a general dynamic specification, which is estimated directly using a “general to specific” specification search to simplify the lag structure. In each case, the coefficients on the lagged variables—and in the ECM model, in particular the coefficient on the lagged error correction term, which captures the deviation from the long-run equilibrium in the previous period—provide key information on the speed with which the system adjusts.

The models were estimated by a variety of econometric techniques to counter potential problems, such as simultaneous equation bias, using quarterly data for the period 1970–1994. 2/ The results presented here are based on Ordinary Least Squares, as more sophisticated methods produced very similar results. Lags of up to eight quarters were used in light of the strong autocorrelation of many of the data series, not only at the first but also at the higher orders. 3/

4. Results and implications

Tables II-2, II-3, and II-4 below report the individual-equation estimates for the employment, wage, and labor force equations, respectively.

Table II-2.

Employment Equation 1/

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All variables are in logarithms, t-statistics are in brackets. The serial correlation statistic is a Lagrange multiplier statistic of the null hypothesis that the residuals are serially uncorrelated (up to the fourth order) and is distributed as a chi-square with A degrees of freedom; the rejection level is reported in square brackets. DF and ADF are the Dickey-Fuller and augmented Dickey-Fuller statistics of the null that the residuals are non-stationary, with the 95 percent critical values in parentheses.

Table II-3.a.

Wage Bargaining Equation 1/

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All variables are in logarithms. t-statistics are in brackets. The serial correlation statistic is a Lagrange multiplier statistic of the null hypothesis that the residuals are serially uncorrelated (up to the fourth order) and is distributed as a chi-square with 4 degrees of freedom; the rejection level is reported in square brackets. DF and ADF are the Dickey-Fuller and augmented Dickey-Fuller statistics of the null that the residuals are non-stationary, with the 95 percent critical values in parentheses.

Table II-3.b.

Wage Bargaining Equation, Levels Regression, Unrestricted 1/

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All variables are in logarithms. t-statistics are in brackets. The serial correlation statistic is a Lagrange multiplier statistic of the null hypothesis that the residuals are serially uncorrelated (up to the fourth order) and is distributed as a chi-square with 4 degrees of freedom; the rejection level is reported in square brackets. DF and ADF are the Dickey-Fuller and augmented Dickey-Fuller statistics of the null that the residuals are non-stationary, with the 95 percent critical values in brackets.

Table II-4.

Labor Force Equation 1/

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All variables are in logarithms, t-statistics are in brackets. The serial correlation statistic is a Lagrange multiplier statistic of the null hypothesis that the residuals are serially uncorrelated (up to the fourth order) and is distributed as a chi-square with 4 degrees of freedom; the rejection level is reported in square brackets. DF and ADF are the Dickey-Fuller and augmented Dickey-Fuller statistics of the null that the residuals are non-stationary, with the 95 percent critical values in brackets.

a. The employment equation

Employment (E) is modelled as a function of total labor costs to the employer (w6) and gross domestic product (y) (the latter as a proxy for product demand): 4/


The results for the employment equation are reported in Table II-2. 1/ The signs of the coefficients are as expected, if the equation represents a labor demand function: high labor costs reduce employment, while high output demand raises it. The long-run elasticity of employment with respect to the real total labor cost is estimated to be -0.4 using the levels regression model, and -0.2 using the implied long-run relationship from the distributed lag model. The error-correction equation also displays the expected negative association with wages and positive association with GDP.

The results of both models suggest that there is considerable persistence in employment. The coefficient on the error correction term is negative and significant, suggesting that the system does tend to return to its long-run equilibrium, but it does so rather slowly, as indicated by the small magnitude of the coefficient. Similarly, the sum of the coefficients on lagged values of employment in the distributed lag form of the employment equation is very high (0.92), so that employment depends very strongly on its own past values. Strong persistence in employment may be related to the presence of considerable hiring and firing costs in Germany, as described in Section 2.

Recursive estimation of the short-run employment equations (for both the ECM and ADL forms) yields no evidence of changes in the coefficients on the individual lagged employment terms, nor in their sum, so that there is no evidence of changing persistence in employment. In particular, there is no sign of reduced persistence in employment around 1985, the date of the Employment Promotion Act. This finding accords with that of Abraham and Houseman (1993), who analyze the responsiveness of employment to output changes and find no evidence of instability in this relationship around 1985.

b. The wage bargaining equation

Real take-home pay (wn) is modelled as a function of productivity (g) and the wedge between real total labor cost to employers and real take-home pay for employees (rtw) (which is equal to the ratio of nominal total labor cost to nominal take-home pay divided by the ratio of the GDP deflator to the CPI): 2/


The results for the wage bargaining equation are reported in Table II-3.a. A levels regression in which the “tax wedge” (tw, defined as the ratio of nominal total labor cost to nominal take-home pay) and the “price wedge” (pw, defined as the ratio of the CPI to the GDP deflator) were used as separate regressors showed that the coefficients on these two wedges were not significantly different (Table II-3.b). The preferred specification therefore aggregates the two wedges into a single “real tax wedge” (rtw).

The coefficients on both the wedge and productivity display the expected signs in the long-run relationship of the ECM. Real take-home pay responds negatively to the real tax wedge, and positively to productivity. It is easy to show in this model that when the tax wedge rises, the additional burden is divided about equally between employers and employees in the long-run. 1/ However, the long-run relationship implicit in the ADL model casts some doubt on this conclusion. In the latter model, employees bear the whole (indeed, more than the whole) increase in the tax wedge. Anecdotal evidence suggests that the trade unions have not recently sought to “shift forward” increases in the personal income tax burden, although they did in the early 1970s; and that increases in social security contributions tend to be accepted by employers and employees at the statutory levels, that is, 50 percent each.

Surprisingly, although real take-home pay is positively associated with productivity in the long-run, the elasticity is estimated to be below one in both specifications, implying that increases in productivity have not been fully reflected in increases in real take-home pay over the sample period considered. 2/ The same finding is evident in Chart II-4, which shows net wages declining as a proportion of GDP. However, the same is not true of gross wages, which rose as a proportion of GDP from 1970 to 1981, and then fell back to their earlier level by the early 1990s. Chart II-4 suggests a possible interpretation of the coefficients on productivity and the tax wedge in the wage equation as capturing one and the same bargain between employers and employees: workers may have been willing to sacrifice some of the potential gains from productivity growth if employers bore some of the burden of tax increases.


Western Germany: Labor Share 1/

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Source: Stotistisches Bundesamt, Volkswirtschaftliche Gesamtrechnungen.1/ Labor shares calculated as percent of GDP at factor cost.

The unexpected magnitudes of some of these coefficients dictate a need for caution in interpreting some of the long-run results—which are in any case not the prime focus of this study. Nevertheless, it is worth highlighting the sharing of the tax burden between employers and employees implicit in the ECM model. A possible interpretation of this result is that the increase in taxes and social security payments—by raising labor costs—may have contributed to the relatively slow growth of employment. If the government raises taxes on employment in the ECM model, labor costs rise and employment declines: a 1 percentage point increase in the tax wedge from its current level of 90 percent would reduce employment by a little under 0.1 percent, or about 25,000 people—and vice versa for a reduction in the tax wedge.

Perhaps the most important result from the long-run relationships, and one which significantly affects the dynamics of the system, is the small role played by unemployment in wage bargaining. A priori, one would expect unemployment to feature prominently in the wage equation: higher unemployment should dampen wage claims, both by raising fears of unemployment among “insiders,” and by increasing competition for jobs from “outsiders.” It is, however, difficult to find evidence of such an effect in these regressions. In particular, the unemployment rate (or its change) does not enter significantly into the “levels” form of the wage bargaining equation. The first lag of unemployment was found to be marginally significant in the ADL specification, but recursive estimation of this coefficient (Chart II-5) suggests that the effect of unemployment on wage settlements diminished in the 1980s.


Western Germany: Sensitivity of Wages to Unemployment 1/

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Source: Staff estimates.1/ Coefficient on the unemployment rate lagged one quarter, and its two standard error bands, based on recursive regressions of wages on unemployment.

Since the restraining effect of (current and lagged) unemployment on wages is an important channel by which labor markets normally equilibrate, the weakness, and increasing weakness, of this effect in Germany are important findings. They point to hysteresis as a major danger, and to (increasing) insider power as a possible explanation. Certainly centralized bargaining, strong worker influence over firms’ working practices, and generous social protection—for all the other advantages that these institutions bring with them—must help to entrench insider power. With few marked changes in labor market policies and institutions during the period under consideration, it is difficult to pinpoint the sources of an increase in insider power. However, the general direction of policy changes toward more government involvement in the labor market may be relevant to this result, as may be the increased duration of unemployment benefits for older workers. Both of these would tend to strengthen insider power by both reducing the search intensity of the unemployed and tempering insiders’ own fear of unemployment.

In addition, the finding of increasing insider power is consistent with the observed growing segmentation of the labor market between the high- and low-skilled in particular, with the latter increasingly marginalized. 1/ While this segmentation cannot be traced to any clear institutional change, it is likely to be the natural result of centralized collective bargaining at a time when technological change and growing competition from developing countries in labor-intensive sectors would dictate a widening of wage differentials.

The overall fit of the error-correction model for wages is less satisfactory than that of other equations, and still shows some evidence of higher-order serial correlation. 2/ There is only tentative evidence of the role of productivity and the real tax wedge in determining changes in wages.

High persistence in wages is suggested both by a relatively low coefficient on the error term in the error-correction specification, and by the relatively high (0.75) sum of the coefficients on lagged wages in the distributed lag form of the wage equation. High persistence in wages may reflect in part staggered wage setting, which will tend to make current wages depend on past wages. Such staggering may be particularly prevalent in Germany, with its systems of pattern bargaining.

c. The labor force equation

The labor force is modelled as a function of working age population (N), unemployment (U), and real take-home pay (wn):


In both the ADL and ECM specifications, the labor force is positively and significantly associated with working-age population, with an elasticity slightly above one (Table II-4). The labor force is also negatively associated with the unemployment rate, perhaps owing to a “discouraged worker” effect. While the elasticity is rather small, it is statistically significant at the conventional levels. There is no significant evidence of any effect of real take-home pay on the labor force. It is possible to speculate that the decision of whether to enter the labor force is determined by other factors, while there may be a role for wages in determining effort and the number of hours worked.

The error-correction model fits relatively well and there is no evidence of residual autocorrelation. Labor supply displays considerable persistence and there is significant evidence that—holding working-age population and other factors constant—past increases in unemployment are negatively associated with increases in the labor force. There is also tentative evidence that changes in working-age population are associated with labor supply changes, though the elasticity is relatively low. Again there is no evidence that wage changes play a part in changes in the labor force.

The labor force exhibits high persistence. The error correction term in the ECM model is significant only at the 10 percent level and the elasticity is relatively low; and the sum of the coefficients in the distributed-lag form of the labor force equation is 0.88. This suggests that there are large adjustment costs involved in entering and leaving the labor force.

The lasting “discouraged worker” effects found in these equations suggest that unemployment will be associated not only with lower output today, but also with lower potential output tomorrow, and points to the risk that measured unemployment may not capture anything like total welfare costs. Measures to keep the long-term unemployed in touch with the labor market may be particularly important in this respect.

d. Labor market dynamics

The sections above have highlighted the importance of lagged effects in the individual equations of the labor market model. These lags, in addition, interact to create more complex dynamics in the system as a whole. In order to investigate these dynamics, the labor market system (in the form of the ADL model) was simulated in the presence and absence of, first, a temporary adverse shock to labor demand, and second, a permanent adverse shock to labor demand. Slow adjustment is manifested in the former case in the form of a slow return of unemployment to what its level would have been in the absence of a shock (following Karanassou and Snower (1994), we call this “persistence” of unemployment), and in the latter case in the form of a slow adjustment of unemployment to its new equilibrium level (we call this “imperfect responsiveness” of unemployment).

The simulations show that the effects of a temporary shock are very persistent, and that it takes considerable time to reach a new long-run equilibrium following a permanent shock. Each case is analyzed in turn below.

Following a 1 percent temporary shock to employment demand, it takes six years for the unemployment rate to return to its initial value for the first time, and 20 years for the unemployment rate to stabilize within the vicinity of equilibrium (defined as a distance equivalent to one quarter of the initial shock) (Charts II-6 and II-7). The results reflect strong and mutually reinforcing persistence in employment, wages, and the labor force. When the negative shock is applied to employment demand, employment falls, thus raising productivity. The rise in productivity raises wages, and this in turn reinforces the initial fall in employment. Also, as employment falls, unemployment rises, and in subsequent periods this puts downward pressure on the labor force, via the “discouraged worker” effect. This mechanism slightly mitigates the effects of the fall in employment on the (measured) unemployment rate. The lag structure produces over adjustment and unemployment oscillates toward its equilibrium level.


Germany: Temporary Shock Difference in the Unemployment Rate with and without the Shock

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Source: IMF staff estimates.

Germany: Temporary Shock Difference in Each Series with and without the Shock

(Percentage points)

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Source: IMF staff estimates.

Following a permanent shock to employment demand, it takes about five years for the unemployment rate to reach its new long-run equilibrium value for the first time. However, unemployment then overshoots substantially, and it takes 12 years for it to return to and stabilize in the vicinity of the new equilibrium (Charts II-8 and II-9). Following the permanent rise in the growth rate of employment demand, the same mechanisms as described in the case of a temporary shock raise productivity and wages, and reduce the labor force, with the overall effect being a rise in unemployment.


Germany: Permanent Shock Difference in the Unemployment Rate with and without the Shock

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Source: IMF staff estimates.1/ Dotted line is the difference in long run equilibrium with and without the shock.

Germany: Permanent Shock Difference in Each Series with and without the Shock

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Source: IMF staff estimates.1/ Dotted line is the difference in long run equilibrium with and without the shock.

Overall, the model suggests that there is considerable sluggishness in German labor markets. This conclusion is further supported by the international comparisons reported in Henry and Snower (1995). Based on the simulations reported above for Germany and similar ones for three other European countries (France, Italy, and the United Kingdom), Henry and Snower present the time taken to recover after temporary and permanent shocks, as well as aggregate measures of persistence and imperfect responsiveness. 1/ Table II-5 shows the results. The time to recover following either a temporary or a permanent shock is longer in Germany than in any of the other countries. Similarly, the measure of persistence is higher in Germany than anywhere else, and the measure of imperfect responsiveness indicates inertia exceeded only in the United Kingdom.

Table II-5.

Persistence and Imperfect Responsiveness in Various European Countries

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Source: Henry and Snower (1995).

These results are at variance with the traditional view of the German labor market as rather more “flexible” than those of other European countries—a view which is based on Germany’s relatively low unemployment rate. 2/ Although the results need to be treated with caution, it is possible that the traditional view does not distinguish sufficiently between equilibrium unemployment and speeds of adjustment: our results suggest that while equilibrium unemployment may be low in (western) Germany, adjustment to that equilibrium may be at least as slow as in the rest of Europe.

Of course, because the model is by its nature symmetric (responses to rises in employment demand are the exact opposite of responses to falls in employment demand), both persistence in the face of a temporary shock and overshooting in the face of a permanent shock will work to lower unemployment if a shock is favorable, just as they work to raise unemployment if a shock is adverse. In practice, many of the effects identified as sources of sluggish adjustment are likely to have asymmetric effects. An exploration of these asymmetries is beyond the scope of this study. Nonetheless, the presence of considerable sluggishness in German labor markets is sufficient to raise serious concerns about the likely path of unemployment in future. To the extent that west German labor market behavior is replicated in eastern Germany, slow adjustment is also likely to keep unemployment in eastern Germany higher than it would otherwise be.

III. Effective Taxation for Recipients of Social Assistance and the Consequences of the 1996 Tax Reform 1/

1. Introduction

The social income assistance program—a key plank in Germany’s comprehensive welfare system—has expanded rapidly over the past two decades, with expenditures overtaking the defense budget in size in 1993. Controlling the growth of social assistance spending would, as a consequence, contribute considerably to ongoing fiscal consolidation efforts. But perhaps more importantly, reform of social assistance could also contribute in a potentially significant way toward alleviating Germany’s most pressing economic problem: structural unemployment.

The root cause of rising expenditures on social assistance is an issue of much controversy. Certainly it is possible to argue that causation runs from rising structural unemployment to increasing demands on social assistance. From this perspective, a significant number of unemployed persons would have slipped into the social assistance bracket because relatively low unemployment benefits and a lack of job opportunities would have discouraged job search. However, this interpretation raises the question of what caused high and rising structural unemployment, and it is quite possible that relatively generous social assistance benefits have provided a considerable disincentive to job search and thereby contributed to the structural unemployment problem.

This chapter focuses on the question of whether benefits are so generous and their withdrawal in case of labor income so rapid as to act as a disincentive to work for those at the low end of the income scale. Considerable evidence is found that this is indeed the case. Moreover, the 1996 tax reform, despite eliminating income tax on the very low paid, will do little to reduce welfare traps because benefit withdrawal schedules will continue to impose high marginal effective tax rates. 2/

The chapter is organized as follows. Section 2 describes the structure and purpose of social assistance. Section 3 provides estimates of effective marginal tax rates for social assistance recipients and analyzes the impact of the 1996 tax reform. Section 4 examines the economic incentives to leave social assistance in order to take up regular employment. Section 5 discusses possible reforms to social assistance. Conclusions are presented in section 6.

2. Social assistance in Germany: purpose and development

Social assistance in Germany consists of two main programs: support for special circumstances, in particular for the re-integration of handicapped persons and for care (Hilfe in besonderen Lebenslagen), and support in case of temporary or permanent loss of income (Laufende Hilfe zum Lebensunterhalt). In the context of this chapter, only the second element is of interest and, unless otherwise mentioned, the term social assistance will refer to this element. According to the principle of subsidiarity, it is the ultimate means of support that everyone with insufficient resources to make a living in Germany is entitled to, including non-nationals. Social assistance is needs based and individuals have a legal claim to receive social assistance, independent of whether they work or not. Strictly speaking, however, it is meant to be “help to work” in the sense that it ought to provide a basis from which an individual can and should try to obtain employment. 1/

Benefits consist of a basic allowance (DM 520 per month in 1994/95), an allowance for housing (DM 370 on average) and possibly one-time benefits (DM 140 on average). The average regular monthly allowance for an adult is therefore DM 890 (US$640), or DM 1,030 (US$740) including one-time payments. This is the lower bound of benefits for an adult. Benefits are higher for senior citizens, persons with physical disabilities, and for expectant mothers. Depending on age, benefits for children are 50–90 percent of the basic allowance for an adult.

a. Expenditures on social assistance

Expenditures on social assistance have soared over the last two decades (Chart III-l, upper panel). While nominal GDP quadrupled from 1970 to 1990, total social assistance expenditures—including spending on those in special circumstances—went up by a factor of ten, and expenditure on social income maintenance alone went up by a factor of fifteen. Even though the basis for social assistance is a federal law (Bundessozialhilfegesetz, 1962), expenditures are borne by the Laender and local authorities. In total, the Laender spent 6 percent of their budgets on total social assistance in 1991 compared with 2 1/2 percent in 1970. 2/ The increase in expenditures is mainly due to a large increase in the number of recipients. However, increases in the real value of benefits per recipient have also contributed: deflated by the consumer price index, the basic allowance was in 1993 almost 50 percent higher than it was in 1970 and 20 percent higher than in 1983 when the present government coalition began its consolidation efforts. 1/


Western: Germany Social Assistance: Expenditure and Recipients

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Source: Statistisches Bundesamt, Fachserie 13.2, 1993; and Zeitreihen zur Sozialhilfe, September 1994; and IMF staff calculations.1/ Detailed categories for western Germany only.

Eastern Germany represents a source of potential future increases. In 1993 social assistance expenditure per inhabitant in eastern Germany was only 38 percent of that of western Germany, owing mainly to a lower level of benefits, but also to a relatively lower number of recipients. 2/ Should the structure of benefits and recipients in eastern Germany eventually adjust to that in western Germany, social assistance expenditures in all of Germany would be another DM 2.5 billion (14 percent) higher.

b. Development of number and age structure of social assistance recipients

The number of recipients of social income maintenance has increased strongly in the past two decades with the number of national recipients in western Germany rising by 4.5 percent per year on average from 1970 to 1993 (Chart III-1, lower panel). 3/ Thus, at end-1993 (latest available data), recipients (including foreigners) constituted by no means a small social group, comprising almost 2.5 million persons in Germany or roughly 3 percent of the population. Of these, 2.163 million recipients were in western Germany and 287,000 were in eastern Germany. The number of national recipients amounted to 1.76 million—1.5 million in western Germany and 260,000 in eastern Germany. All these figures refer to points in time (end of year). The total number of recipients throughout the year is substantially higher because of a high number of short-time recipients; during the course of 1993, for example, a total of 2.65 million nationals received social assistance.

One striking feature in the recipient structure is the decreasing age of recipients. For national recipients, the average age fell by eight years from 1972 to 1993: while in 1972 the average age of recipients was 41 years, it had fallen to 33 years by 1993 (Table III-1).

Table III-1.

Western Germany: Age Structure of National Recipients

(In percent, unless otherwise indicated)

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Sources: Federal Statistical Office; Erbe and Erbe (1993, p. 592), Klanberg and Prinz (1983, p. 292); and IMF staff calculations.

16–50 years.

Assuming “under 18” = 12 years, “over 65” = 70 years, otherwise mid-interval.

The share of recipients of working age is of particular importance in the context of this chapter. Almost one half of recipients at end-1993 (some 1 million nationals) were aged 16 to 50 years—itself a limited definition for working age—in contrast to only one quarter in 1972. Also the proportion of persons of retirement age has decreased sharply from almost 30 percent to 10 percent. The large and roughly unchanged proportion of under 18 year-olds reflects the fact that children of recipients are also counted in the statistics, and, indeed, receive a basic allowance of their own that is calculated as a fixed fraction of an adult’s basic allowance. The issue of child allowances is discussed in detail in section 5.

3. Incentives to take up employment within the system of social assistance

This section analyzes the incentives for social assistance recipients to take on work that does not pay enough for them to drop out of the social assistance system altogether (e.g., part-time or irregular work). In particular, it analyzes how the social assistance system interacts with the tax code; the results are high marginal effective tax rates. Effective marginal tax rates will remain high after the 1996 tax reform.

a. Explicit taxation from the tax code 1/

The most important event for tax policy in recent times has been a ruling by the Constitutional Court in 1992 that all income necessary as a subsistence minimum ought to be untaxed. As a consequence, the tax-free subsistence minimum of the tax code (previously DM 5,616) had to be brought in line with social law, according to which a level of around DM 12,000 was regarded as the subsistence minimum. The court allowed until 1996 to complete the necessary reform, but required that from 1993 onwards a preliminary solution be found that effectively left the social subsistence minimum untaxed. 2/

Therefore, three phases of taxation rules can be distinguished: the original tax code, effective until 1992; the interim stage, effective from 1993 to 1995; and the final reform stage, effective from 1996 onward. The original tax code of 1992 implied an initial marginal tax rate of 19 percent on annual taxable income from DM 5,616 to DM 8,100. From thereon, marginal tax rates rose linearly to the maximum rate of 53 percent at an income of DM 120,040. For the interim stage, all taxable income up to the social subsistence minimum was made tax exempt, but since the government sought to restrict the drop in tax liability to the lowest income group, income above the tax-free subsistence minimum had to be taxed at high rates in order to catch up with the former liability schedule (Chart III-2, upper panel). Accordingly, even though the overall level of tax liability was lowered at these income levels, very high marginal tax rates (up to 61 percent) applied to income just above the subsistence minimum (Chart III-2, lower panel).


Germany: Income Tax Schedules 1992 - 1996

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Sources: Bundesministerium der Finonzen; Steuertabellen fuer die Bundesrepublik Deutschiand; and IMF staff calculations.

At first sight, the pattern of marginal tax rates in the interim stage appears to constitute a classical tax trap, defined to exist where marginal tax rates are unusually high at a particular income level. This was certainly the case in Germany from 1993 to 1995 for the DM 11,100 to DM 13,600 range of taxable income (approximately DM 16,000 to DM 19,100 gross income for a single earner) since marginal tax rates of the order of 60 percent are unusually high for this group—and were three times higher than the marginal tax rates faced by this group under the original tax code. 1/ However, the empirical importance of this tax trap should not be overstated as it only applied to a rather small income group for a transitory period which might have been too short to have a substantial effect on labor supply decisions.

The 1996 tax reform proposal eliminates these tax traps by allowing for a more gradually increasing tax schedule above the subsistence minimum of DM 12,100 (Chart III-2, lower panel). 2/ The initial marginal tax rate is 25.9 percent. Thereafter, marginal rates increase at a relatively low rate (0.173 percentage points per DM 1,000 income) up to a taxable income of DM 55,700 at which point the marginal tax schedule kinks upwards and becomes identical to the former tax schedule (with marginal rates increasing by 0.304 percentage points per DM 1,000 income). 3/

b. Implicit taxation deriving from the withdrawal of benefits

The withdrawal of benefits as an individual earns outside income effectively represents a form of implicit taxation that is likely to affect labor supply decisions. Typically, withdrawal schedules consist of an earnings disregard that defines the maximum earnings allowed before benefits are reduced, a withdrawal rate at which benefits are withdrawn for incomes above the earnings disregard, and a maximum level of outside income at which benefits phase out entirely. The withdrawal schedule in Germany effectively—albeit in a more complex design—comes very close to this pattern.

As mentioned in section 2, social assistance receipts (R) consist of a basic allowance of DM 520 (B), support for housing expenses of DM 370 (H), and one-time payments which are, however, irrelevant for the marginal withdrawal schedule:

(1)R = B+H

The rules defining how benefits change in case of outside income are based on a rather complicated set of regulations laid down in an attachment to the social assistance law. 1/ There are four key intervals of net labor income, N, (i.e., gross income net of social security contributions, taxes, and expenses in employment):

  • For net labor income under DM 130 per month, no withdrawals are made: DM 130 (25 percent of the basic allowance, B) is the earnings disregard;

  • For net labor income between DM 130 and DM 1,000 (rounded), social assistance receipts are reduced by an “appropriately adjusted” net income N’, so that social assistance receipts are: 2/

(2)R = B+HN

To calculate the adjusted net income N’, the recipient may make a deduction for his or her work efforts consisting of a fixed component, equal to the earnings disregard, and a variable component of 15 percent of the amount by which net income exceeds the earnings disregard (0.25 B). Thus,


Inserting (3) into (2) yields the total receipts R as a function of net labor income:

(4)R = 1.2125B+H0.85N

Therefore, as can be seen from (4), the marginal rate of implicit taxation is 85 percent in this range; an increase of net earnings by DM 1 increases disposable income R+N by only DM 0.15;

  • For net labor income between DM 1,000 and DM 1,150, social assistance receipts are reduced by the full increase in net income and the implicit marginal tax rate is 100 percent;

  • If net labor income exceeds DM 1,150 per month, no social assistance is provided.

c. The welfare trap: explicit and implicit taxation combined

The rate of implicit taxation through welfare reductions can be combined with the explicit tax burden—which would also include social security contributions (pension, unemployment, medical, and, since January 1995, long-term nursing care insurance)—to arrive at the effective tax burden. It is this full burden that drives a wedge between gross and disposable income and that is therefore relevant for the individual decision of whether to supply an incremental amount of labor for a given gross wage.

The effective wedge must be defined for several intervals because, in addition to the net-income-dependent withdrawal schedule of social benefits, social security contributions and taxation begin at different levels of gross income. The order of calculation is as follows:

(1) Employees’ social security contributions at a fixed fraction of 19.5 percent (1995: 19.6 percent, 1996: 19.8 percent) of entire gross income are due on income above DM 560 (1996: DM 580) per month. 1/

  • (2) Taxation begins at an annual taxable income of DM 11,050 in 1994 and at DM 12,100 for 1996. An employee can deduct from gross income 18 percent for private provisions (life insurance, private pension provisions), a lump-sum allowance of DM 2,000 for expenses in employment, and an allowance of DM 108 for non-provision related expenses. 2/ Therefore, taxation begins at approximately DM 16,040 gross income in 1994 and at DM 17,320 in 1996. 3/

  • (3) The recipient may, if in work, deduct expenses in employment (for transportation, clothing, etc.) “up to a reasonable amount” from his net income for purposes of the withdrawal calculation. These deductions are made for actual expenses only and must be accepted on an individual basis by the local authority. It is important to account for them because the withdrawal schedule is based on net income after these expenses. There is no general rule for the “reasonable” volume of expenses in employment. Generally, the tax code allows a lump sum of DM 2,000 per year for expenses in employment, or roughly 10 percent of net income in the lower income groups, and in the following analysis, it is therefore assumed that the recipient can similarly deduct 10 percent of net earnings as expenses in employment. If the remaining income net of taxes, social security contributions, and expenses of employment exceeds DM 1,150 per month, the individual can file no claim for social assistance.

The calculated marginal effective tax rates are very high and begin at a gross wage as low as DM 145 per month (Table III-2). 1/ At that point, additional labor earnings are effectively taxed at 76.5 percent owing to the withdrawal of benefits: in other words, net income from an additional DM 100 gross income is only DM 23.50. 2/ Furthermore, the total marginal burden rises with outside wages and only at a level of DM 1,790, where the claim to file for social assistance expires (because this level represents a net income relevant for social assistance of DM 1,150), does the marginal burden fall to just above 40 percent. On average (weighted by the relative size of the different earnings intervals), recipients of social assistance face a marginal burden on outside earnings of 75 percent.

Table III-2.

Marginal Explicit (Column 3) and Implicit (Column 7) Taxation as a Function of Gross Wage Income per Month in 1994

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Sum of social security contribution, marginal tax rate, and social assistance reduction (of gross).

d. The effects of the 1996 tax reform on the “welfare trap”

The 1996 tax reform will not alleviate the problem of very high marginal burdens on labor earnings for recipients of social assistance (Table III-3). Even though the reform eliminates the tax traps above the subsistence minimum, it leaves the total marginal burden practically unchanged at almost 73 percent on average. 1/ This is because the reduced taxation in this income bracket leads to higher after-tax income, which in turn implies a higher withdrawal of benefits (compare columns 7 in Tables III-2 and III-3). As a consequence, the tax and benefit system will continue to offer similar disincentives for taking up part-time or irregularly paid jobs yielding a gross income of less than about DM 1,650 per month. 2/

Table III-3.

Marginal Explicit and Implicit Taxation as a Function of Gross Wage per Month in 1996

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Sum of social security contributions, marginal tax rate, and social assistance reduction (of gross).

4. Incentives to leave social assistance and the “Lohnabstandsgebot”

The previous section addressed the question of the incentives for a recipient of social assistance to supplement his or her income within the system of social assistance. By contrast, this section discusses the net benefits of switching from social assistance to a regular job. This question is implicitly recognized in the Lohnabstandsgebot—the principle that social assistance benefits must be at a certain “distance” below wages in the economy in keeping with the view that social assistance is meant to act as a “help to work.”

Of course, since there exists no measure of the average utility of leisure nor of the disutility of being dependent on social assistance (the “shame factor”), it is impossible to construct an “objective” measure of a sufficient gap between wages and social assistance. However, a comparison of total net incomes from work and from social assistance suggests that a social assistance recipient has to move quite far up the income scale before his or her net income lies considerably above the social assistance entitlement (Chart III-3). At a gross wage of DM 2,300 per month, for example, which would be an entry wage in the services sector (average for men and women), net income would be approximately DM 1,560 or just DM 470 above the social assistance entitlement, for a work effort of 170 hours. 1/


Germany: Disposable Income as a Function of Gross Wage Income (1994/95) 1/

(In DM per month)

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Sources: Bundesministerium fuer Arbeit und Sozialordnung (1994); and IMF staff estimates.1/ Disposable income includes social assistance up to a gross wage of approx. DM 1800 per month and church taxes and social security contributions.

a. The Lohnabstandsgebot

The Lohnabstandsgebot principle itself is simple and uncontroversial. Putting it into practice, however, is much more difficult. In its current version, the principle states that for “a family with three dependents social assistance entitlements, including housing benefits, may not lie above the net wage of a low-income group, including child allowance and housing allowance.” 2/ The principle therefore takes a five-person household as the reference group, but it is rather vague on which wage level to choose and does not state how large the benefit-wage wedge ought to be. This suggests that as long as there is some wedge, the principle is met. Current reform plans aim at establishing a minimum wedge of 15 percent. 3/

On a regular basis, a government commission assesses the size of this wedge by comparing the social assistance entitlement for different groups of recipients with two wage earnings positions: the average earnings of unskilled blue-collar workers in industry and the average earnings of low-skilled, white-collar employees (both net of tax and including benefits). For all groups (single earners, couples, and couples with up to three children) the average wage—even of the unskilled blue-collar worker, which is below the wage of low-skilled employees—lies above social assistance receipts each group is entitled to (the “official reference wage” in Chart III-4). The conclusion of the commission has therefore been: “The principle of a wedge between wages and social assistance benefits is generally met.” 4/


Western Germany: Social Assistance Entitlements and Potential Wage Earnings

(In DM per month)

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Source: Statistisches Bundesamt, Lohnstatistik; and IMF staff calculations.1/ First year earnings, net of taxes and social security contributions for:“A”: Apprentice in retail or crafts sector.“B”: Retail sector: unskilled employee.“C”: Services sector: low-skilled employee/crafts sector: unskilled worker.“Off.”: Official benchmark wage (unskilled worker, industry)The horizontal lines are the social assistance entitlements for the groups indicated in the chart.

Nevertheless, from an economic point of view, three questions remain: is the correct reference wage being used; is the “distance” sufficient; and has the correct reference group of recipients been identified?

b. Reference wage levels and recipient groups

In choosing the reference wage level, the commission rightly distinguishes between male and female earners because their actual earnings profiles differ greatly, and it takes a low-skill or unskilled wage level as the benchmark because the majority of social aid recipients have a lower education level and may have had their human capital depreciated during a possibly longer stay on social assistance. But other elements of the reference wage choice are more questionable—including the sector (industry), the number of years spent in the company (average for the economy), and the age (again, average for the economy)—and suggest the reference wage level may be substantially too high. 1/

  • Sector: The industrial sector is the sector with the highest labor productivity in the economy and the highest level of average wages. It is not, however, the sector with the greatest flexibility in taking up new workers. Furthermore, the high stress on productivity makes it not an easy sector to enter for persons with possibly long spells outside employment. Rather than the industrial sector, the services sector, the retail sector or the crafts sector would seem to be sectors which are easier to enter for former recipients of social assistance and therefore better benchmarks.

  • Age: Earnings are generally increasing in age. Since social assistance recipients are on average younger than those in employment (in particular the age group of 18–30 is relatively large) official reference wages may overstate the potential earnings of recipients.

  • Years within a firm: Earnings strongly increase with years spent in a given firm. This holds for blue-collar workers and—even more so—for white-collar employees. The most recent available, detailed wage statistics for the German economy show that for unskilled workers, the wages of the bracket with the greatest number of years within a given firm (more than 20 years) are almost 40 percent above entrance wages (less than one year within the firm); for white-collar employees they are 60 percent higher. 2/ Since, by definition, recipients of social assistance are new entrants to a firm, their wage receipts will be far overstated if an economy-wide average is used.

  • “Gradual” entry into the labor market: Taking up full employment is not the only, probably not even the most relevant, alternative for a person on social assistance. Rather, the recipient might seek a gradual entry on the labor market, be it in a part-time job or on a contractual basis. These forms of employment are most common in the crafts sector, the services sector and the construction sector.

The picture is very different if these factors are taken into account. The retail sector, for example, turns out to be a rather unattractive alternative to social assistance (Chart III-4). 1/ And a single young person who decides to switch from social assistance to an apprenticeship in the retail or crafts sector, which implies switching from zero to 170 hours of work per month, would improve his net income by only DM 230 per month.

Exiting from social assistance to a regular job—rather than an apprenticeship—is least attractive for female recipients. In a full-time regular work position in the retail sector, for example, monthly earnings would be only approximately DM 500 higher than on social assistance. If the recipient has a child, the wedge between social assistance and labor income narrows to only DM 300 per month because additional tax relief plus cash benefits for the child are much lower than the support received when on social assistance (this problem is discussed in detail below). With two children, taking up employment may even have a negative effect on disposable income.

In sum, the official benchmark for measuring the wage-benefits wedge is “insider” oriented. It reflects whether an incumbent of an average full-time job in the economy—an insider—has an incentive to quit his or her job voluntarily and file for social assistance. More relevant for the question of exiting social assistance, however, is the “outsider” perspective: what are the wage earnings that recipients of social assistance—people outside regular employment—can actually achieve? On this criterion, the wedge is substantially narrower and in many cases wages and benefits are so close that there is practically no incentive to take up employment. 2/

Moreover, focusing on the wage/benefit wedge for a family with three dependents, the Lohnabstandsgebot in its present form clouds the picture rather than clarifies it. The target group is practically irrelevant, accounting for merely 3 percent of recipients (Chart III-5). The three main groups are in fact single women (34 percent), single men (26 percent), and single women with one or two children (22 percent). At first sight this suggests that the actual gap is larger than the gap reported under the Lohnabstandsgebot. This, however, does not hold any more once an actually achievable wage level is taken as the reference: if one focuses on the relevant groups of single earners and single women with one or two children, and applies actually achievable reference wages, the following picture emerges.


Germany: Composition of Social Assistance Recipients (1993)

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

Note: Adult, national recipients only.Sources: Statistisches Bundesamt, “Statistik der Sozialhilfe 1993”. June 1995; and IMF staff calculations.

While single men have an incentive—albeit a small one with regard to some sectors—to take up employment, the incentive is narrower for female recipients given lower wage levels for women on average. For single women with one child, average earnings for new entrants in an unskilled job in the retail sector are (including child allowances) only DM 100–200 higher than social assistance entitlements (DM 1,700 per month), and only DM 300–400 higher for low-skilled employees in the services sector. For single women with two children the wedge reduces to DM 100–200 for service sector jobs and virtually vanishes or even becomes negative for retail sector jobs (Chart III-4). 1/

In conclusion, it is possible that the Lohnabs tandsfebot may not be satisfied for many recipients—particularly women with children. Moreover, for many others, the net pecuniary benefits of working may be small and thus provide little incentive for taking a job.

5. Reform

The system of social assistance has many parameters, and few which have not undergone changes since 1983 (Table III-4). All the changes, however, have not been sufficient to meet the aims of reform: to focus social assistance on the needy, to bring back into employment those who can work, and to keep the fiscal burden under control. 2/ Before turning to measures of reform, however, the constraints to reform need to be briefly discussed.

Table III-4.

Selected Reforms to Social Assistance Since 1983

article image
Source: BMA (1994, Chapter 19); BMG (1995); Handelsblatt (May 24, 1995, p. 2).

This is part of the draft on social assistance reform, which was approved by the Government on July 18, 1995, and which will go through the parliamentary process in fall 1995. See BMG (1995 p. 3); or Seehofer (1995, p. 233).

a. The constraints on reform

Reform of the system of social assistance is complicated by a number of constraints. Some of these constraints can be traced to the constitution and the principle of the “social state” (in particular (b) and (e) below), while others are necessary to make the system viable by restricting eligibility (in particular (a) and (c)). 1/ The constraints are:

  • (a) the system shall be need-based;

  • (b) it shall provide full support—meaning enough money to allow for a basic, “dignified” standard of living—for those who have no own resources or access to labor market income, and possibly their dependents; 2/

  • (c) it shall provide no support for those who can make their own living;

  • (d) it shall provide a basis for those recipients who are able to work to find their way (back) into employment;

  • (e) it shall provide time-unlimited support for those who do not find employment.

Constraints (a) and (c) militate against a system of negative income tax or Burgergeld which would be an integrated system of transfers and taxes. In such a system the status of individuals—whether net transfer recipients or net tax payers—would be determined by their income, not by their need. 3/ Also most proposals of a negative income tax foresee net transfers beyond the mere subsistence level, which would conflict with constraint (c). 4/

The constraints also have important implications for the withdrawal schedule, which are highlighted in Charts III-6 athrough III-6c. Constraint (b) implies that the social assistance schedule must be at a level sufficient for basic housing and living for net earned income of zero. This fixes point A (at a level of currently DM 890 per month for a single person) in Charts III-6a and III-6b. Constraint (c) implies that social assistance must be phased out for people who can make their own living. This fixes point D in Chart III-6b (at a level of net income of currently DM 1,150). In order to avoid administrative costs for the recalculation of receipts in case of small incomes an earnings disregard is introduced (currently DM 130 per month). This fixes point B in Chart III-6b. In order to avoid “perverse” incentive effects, the rate of withdrawal should at no point exceed 100 percent, which would make disposable income fall as net labor income rises. This fixes the upper bound for withdrawal rates at the 100 percent line in Chart III-6c and implies that the provision of social assistance in Chart III-6b should not decline at a rate steeper than -1. The fact that at an income of DM 1,150 all benefits must be withdrawn implies that the area under the withdrawal rate in Chart III-6c must equal the maximum amount of benefits, i.e. DM 890.


Germany: Provision and Withdrawal of Social Assistance

Citation: IMF Staff Country Reports 1995, 101; 10.5089/9781451810394.002.A001

The result is that the rate of withdrawal, given as the dashed lines in Charts III-6b and III-6c, will be 77.4 percent (=890/1,150) on average and, if it may not exceed 100 percent at any point, the room to lower it in any subinterval is also limited. Chart III-6c shows the current actual withdrawal schedule with zero withdrawal for a very small income range, 85 percent withdrawal for the largest part of the range, and 100 percent for incomes just under the eligibility maximum. Therefore, given the constraints above, a high marginal burden on labor income within social assistance is unavoidable. In order to increase the incentives to take up employment, either the support level A has to be lowered or the support range D has to be extended. Both options seem politically infeasible, the first because it could be regarded as undermining the idea of full support for the needy, and the second because it could be regarded as increasing eligibility beyond those immediately needy and thereby increasing the fiscal burden of social assistance.

Nevertheless, there might be two steps of reform that bring the system closer to its aim, while remaining within the given constraints.

b. Scope for reform

(1) Time-delayed withdrawal of benefits

The main incentive not to search for or take up employment is the small effect this will have on disposable income in many cases. What is more, there are search and setup costs, as well as possibly costly changes in daily habits connected with taking up employment. These costs, which in general will be higher the longer the spell outside employment has been, reduce the wedge between wages and benefits even further. What is even more detrimental for incentives is that these costs arise in many cases before the positive impact from employment on disposable income materializes. One way to alleviate this problem would be to withdraw parts of the social assistance benefits only after a delay—say, of three months—after employment is taken up. The main aim would be to help an individual to cover the transition costs and provide for, at least at the beginning, a very visible effect of employment on disposable income. Such a reform will decrease the social assistance burden in the long run to the extent that recipients will search for jobs who otherwise would not have done so, although for those recipients who would have taken up employment anyway, some benefits will be paid out longer than otherwise.

This reform would create potential moral hazard risks whereby recipients take up and quit employment on a cyclical basis. 1/ However, such risks are perhaps small. Experience shows that there are high hurdles for workers to quit and enter the social assistance system: they lose social status, reduce their net earnings, and also forego potential earnings increases. In fact, people mostly enter social assistance because of adverse circumstances (unemployment, long illness, etc.); 2/ then, habits and consumption patterns adapt to social assistance levels and exiting becomes more difficult. Thus possible reforms need worry less about more people entering the system and more about how to make more recipients exit it. The time-delayed withdrawal of benefits may be one possibility to enhance exiting rates. In fact the bill which is to go through Parliament in fall 1995 foresees cutting benefits but providing a time-degressive special allowance (Zuschuss) to cover adjustment costs. 3/ In essence this would be equivalent to the time-delayed withdrawal discussed here.

(2) Consistency of child allowances in tax and social law for low incomes

The tax reform for 1996 makes the full subsistence minimum for children defined in the social law (roughly DM 6,000 or half the subsistence level of an adult) tax free. 4/ It recognizes, however, that the cash value of this allowance—the allowance multiplied by the marginal tax rate—is low for low and middle income earners. Therefore, the reform includes the option for households to receive either the tax allowance or a direct cash benefit. This cash benefit would be DM 200 per month for the first and second child, DM 300 for the third, and DM 350 for each thereafter; the opposition had counter-proposed a flat cash benefit of DM 250 per child. All low income households (up to a marginal tax rate of 40 percent or an annual taxable income of roughly DM 60,000 in case of one child) would be better off opting for the cash allowance.

Even so, the allowance would be considerably lower than the allowance in the social assistance system, which ranges from DM 260 to DM 468 depending on the age of the child (Table III-5). For example, the head of an average low income household with two children would receive an allowance of between DM 520 and DM 936 for the children, depending on their age, if claiming social assistance compared with a cash benefit under the tax reform of DM 400 (and only DM 210 under present law) if working. The social assistance allowance is thus between 30 percent and 134 percent higher, depending on the children’s age. In absolute terms the difference lies between DM 1,440 and DM 6,430 per year; the latter may well be more than 20 percent of the net income of a family in the low income bracket. What is more, the child allowances under social assistance, being calculated as fixed fractions of an adult’s basic allowance, are indexed (to inflation or net wage increases) so they at least stay constant and may even increase in real terms. The allowances in the tax code, by contrast, are in general nominally fixed and therefore bound to decline in real terms. Even though a nominal increase is foreseen for 1997, any further increase will require discretionary policy action and is therefore less of a commitment than explicit indexation.

Table III-5.

Child Benefits Under Social Assistance and Under the Tax Reform

(In deutsche mark per month)

article image
Sources: BMA (1994, p. 628); BMF, Pressemitteilung zum Jahressteuergesetz, August 1, 1995.

The idea behind these substantial differences in child benefits is clear: the recipient of social assistance is assumed to have no resources at all for his or her dependent(s) and therefore receives a full cash benefit for them. The regular earner, by contrast, is assumed to have, in principle, sufficient resources for him- or herself and dependents, so that the tax allowance is merely meant as a supplementary means of support. But given the rather low wages for women who enter, for example, the services or retail sectors this must not always hold true: the amount of resources necessary for the child which are not covered by the cash benefit may well absorb a large portion of the amount by which the single mother’s net income exceeds her own social assistance entitlement, i.e. of her pecuniary benefit of working. This considerably reduces her work incentives if she has a job, or her search incentives if not.

Furthermore, while the social law takes into account the fact that the costs of raising a child increase with age (from 50 percent of an adult’s allowance to almost a full adult’s allowance for 15–18 year-olds), the cash allowance for regular earners is not related to child age. Again, the incentive effects work against employment and in favor of social assistance. Moreover, the difference—up to DM 268 per child and month—is not a negligible amount, in particular for (young) female earners.

Reconciling these differences in child benefits between social and tax law (for example by increasing the tax allowance/cash benefits for single parents, in particular, with older children), will increase the gap between the net position of a family or a single earner with children and a recipient of social assistance. This may equally be a way to enhance horizontal equity between low income earners and social assistance recipients.

6. Conclusion

The fact that the social assistance system has failed to meet its aim of being a “help to work” can be attributed to the low incentives it provides for recipients to take up employment. For one thing, the level of benefits is close to feasible labor earnings for this group—particularly for female recipients and single mothers, but also for men if the alternative to social assistance is an apprenticeship or a job in the retail or crafts sector, where earnings for work beginners are relatively low. In addition, the high marginal rates of effective taxation on minor labor market earnings—due to withdrawal of benefits—imply that part-time jobs or irregular jobs are practically crowded out by social assistance.

In principle, the 1996 tax reform, with its generous tax cuts at the lower end of the income range, could have substantial positive employment effects for regular earners because it increases the net return of working. However, this is unlikely to be the case for a large group of social assistance recipients whose high effective marginal tax burdens will be little affected. If positive employment effects are to materialize for this group, reforms to the system of social assistance itself will be unavoidable.

Given the tight constraints on reform, which inhibit any step that might undermine the principle of full support for the needy, and given the difficulty of filtering out the needy from those who voluntarily stay out of work, reform should focus on increasing the incentives for voluntary exits from social assistance to employment. The introduction of time-delayed withdrawals in case of employment and of greater consistency between child allowances in social law and the tax code, at least for very low incomes, may be two possible routes for reform.


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This chapter was prepared by John Montgomery (RES).


Frankel and Montgomery (1991) discuss some of the differences between the German and Japanese financial systems and those of the U.K. and U.S. Allen and Gale (1994) compare the welfare attributes of stylized German and U.S. financial systems.


Unless otherwise indicated, references to Bundesbank publications are to the Bundesbank Monthly Report.


Excluding assets of Luxembourg subsidiaries, which tend to be particularly close extensions of German banks’ domestic business, the proportion rose from 7 percent in 1984 to 16 percent in 1994.


Data include external transactions of eastern Germany from July 1990.


In many respects German financial markets have long been open to foreign activity. Most capital controls were removed in the 1950s, with the remaining restrictions on nonresident purchases of bonds and short-term paper eliminated in 1981 (OECD (1986)).


In addition to their participation in the DTB and other derivatives exchanges, German banks have become active participants in over-the-counter derivatives markets. At the end of 1994, German credit institutions had written a notional value outstanding of DM 2,008 billion in interest rate and currency swaps, compared with DM 922 billion two years earlier (Bundesbank (May 1995, Table IV.17)). While notional values greatly overstate the market value of these transactions, the trend over time indicates the rapid expansion of German participation in this market.


See SM/94/213, pp. 34–35.


Bundesbank, Kapitalmarktstatistik. March 1995, Table VI.1.


This issue is discussed in greater detail in Section 3.


Bundesbank (January 1993) describes this law in detail.


German banks were given a transitional period to 2002 to comply with the new rule on shareholdings. The previous rule limited “a credit institution’s investments in land, buildings, furniture and equipment, and other enterprises to the amount of the liable capital” (Bundesbank (January 1993)).


Other effects of the bank accounting changes are discussed in Bundesbank (May 1992).


A reserve requirement applies to repurchase agreements undertaken by German banks with nonbanks and with non-German banks, at the rate applicable to sight deposits (Hypo-Bank (1995)). This rate will be lowered from 5 percent to 2 percent on August 1, 1995, thus reducing the costs of undertaking such operations.


An aspect of this tradeoff is noted by Gaddum (1992), who raises the concern that minimum standards should be kept for financial institutions in order to guarantee “stability of the financial system as a whole,” while the authorities are promoting competition in the financial system.


These issues in the context of European integration are discussed in Montgomery (1991).


Bundesbank (May 1995, Table IV.3).


In a related study, Borio and Fritz (1995) examine the response of short-term interest rates on bank loans to changes in monetary policy rates in twelve countries. They found that the response of interest rates in Germany after one year was smaller than all but three other countries and in recent years was smaller than all countries except France. Among the reasons they suggest for their cross-country results are differences in bank market power and differences in the response of average bank funding costs to market rates.


A law passed in 1994 will permit smaller companies to become joint-stock companies (AGs) under less stringent restrictions than faced by larger companies. These smaller companies will not be required to have worker representatives on their supervisory boards or to hold annual meetings. This action increases incentives for enterprises to issues shares.


If such efforts are undertaken, however, the contributions of the regional exchanges in bringing smaller enterprises to the stock market (Wegen (1992)) may need to be replaced by other mechanisms, such as a separate stock market for shares of smaller firms.


Recent reductions in reserve requirements have reduced the advantage of Eurodeposits in Luxembourg relative to deposits in Germany (Bundesbank (February 1994)). With the reserve ratio on sight deposits being lowered from a maximum of 12.1 percent before March 1, 1994, to 5 percent and now to 2 percent from August 1, 1995, the additional interest cost for domestic deposits over Eurodeposits at an assumed 6 percent interest rate has fallen from 0.83 percentage points to 0.32 percentage points and now to 0.12 percentage points.


Bundesbank (January 1994) describes the structure and effects of the tax in detail, and Bundesbank (October 1994) discusses the interaction of the tax with investment funds.


The restriction on repurchase agreements discussed above in section 2.c is another example of this tradeoff.


Häusler (1995) observes that differing national financial structures under EMU, including differences in reliance on short-term financing, might cause some national economies to react more quickly to changes in monetary policy.


The first DM 50,000 of long-term debt is taxed at the same rate as equity, but any long-term debt above this level is taxed at half this rate. The tax rate varies according to municipality. In 1993 the average rate was 0.742 percent.


Another tax issue is uncertainty over the tax status of warrant investments (Reed (1995)).


This chapter was prepared by Paolo Mauro (EP, PDR) and Tessa van der Willigen (EU1). It is part of a cross-country study on labor market adjustment dynamics coordinated by the European I Department of the International Monetary Fund. Companion studies have been undertaken on France, Italy, Spain, and the United Kingdom.


Insufficient data preclude the inclusion of eastern Germany; but the wholesale extension of west German labor market institutions to eastern Germany means the results should also be relevant to the new Laender.


For a detailed discussion of three key features of the German labor market—the wage bargaining system, income support for the unemployed, and employment protection—see SM/94/213, Chapter V.


The Minister of Labor has the authority, under certain conditions, to extend the validity of collective agreements to employers who are not members of employers’ federations, through a “declaration of general validity.” However, these declarations involve a minority of contracts, usually relating to working conditions rather than wages.


Previously, and particularly in the metal-workers’ strike of 1984, unions had been able to conserve strike funds by striking only at selected firms and counting on other firms in the sector having to shut down for lack of supplies: employees laid off in these other firms would receive unemployment benefit.


This is not to deny the benefits of centralized bargaining, which many authors have theorized include greater overall wage restraint. See SM/94/213, Chapter V, for a detailed discussion of the advantages and disadvantages of the German system of collective bargaining.


This is true whether the labor market is broken down by region, sector, or skill level. In the last case, it is the usually egalitarian objectives of the unions that make all wages tend to move together. See SM/94/213, Chapter V, for a detailed discussion of wage differentiation in Germany.


An interesting example is provided by the 1995 wage round. The key metal-workers’ agreement was signed just prior to a sharp appreciation of the deutsche mark. Commentators generally agree that wage increases in the (export-oriented) metal-working sector would probably have been lower had the appreciation occurred before the agreement was concluded, but these wage increases nevertheless set the standard for other sectoral agreements, concluded subsequent to the appreciation.


A government proposal to limit the duration of unemployment assistance to two years was recently rejected by the Parliament.


For a detailed description of employment protection in Germany, see SM/94/213, pp. 113–114.


Of course, employment protection may also, symmetrically, delay the downward adjustment of employment in a recession. Indeed, the model investigated in sections 3 and 4 does not distinguish between the speed of adjustment to positive and negative shocks to employment demand.


See Decressin (1994) for a thorough analysis of the determinants of internal migration flows in western Germany, including a discussion of the housing market.


In all cases, there is tentative evidence that long-run relationships exist among the variables of interest. For the most part, the Dickey-Fuller and augmented Dickey-Fuller statistics are not far from rejecting the null of no cointegration at the conventional levels. In all cases, the Johansen procedure yields a strictly positive set of cointegrating vectors, which typically do not significantly differ from those of the long-run relationships estimated using both approaches adopted in this chapter.


The data are drawn from German official sources and the International Financial Statistics of the International Monetary Fund. All series refer to western Germany. All variables are in logarithms. Employment includes both dependent employment and self-employment. While formal Dickey-Fuller and augmented Dickey-Fuller unit root tests yield ambiguous results for some of the series, it seems safe to assume that all variables included in the levels regressions are integrated of order 1.


The fact that eight lags are required when quarterly data are used is consistent with the findings that two lags are needed when annual data are used, as in Karanassou and Snower (1994).


The potential role of a number of other explanatory variables—including real interest rates, competitiveness indicators (the ratio of import prices to the GDP deflator), and (changes in) the real oil price—was explored, with no significant and robust relationship being identified, so that they are not included in the preferred specification.


Little evidence was found of endogeneity bias, related to the two-way causation between (demand for) output and labor input, as two-stage least squares estimation yielded results very similar to the OLS estimates.


Because much of the impact of unemployment insurance in Germany is thought to come through the intermediary of duration of benefits, rather than their level, statutory replacement ratios were not included in the wage equation. No suitable data could be found for aggregate replacement ratios.


Over the range spanned by the tax wedge over the period 1970–94, the amount of an increase in the wedge falling on employees ranges from 40 percent to 46 percent, and the amount falling on employers from 54 percent to 60 percent. Similarly, workers are only partially compensated for an increase in the consumer price index relative to the price deflator which is relevant to employers, and an increase in the GDP deflator by more than the CPI may yield higher real take-home pay (and lower real total labor costs) as a result of the bargaining process.


However, the coefficient on g(-4) could be omitted from the ADL specification, as it is not significantly different from zero. In that case, the long-run elasticity of real wages with respect to productivity would be close to one.


While the apprenticeship system in Germany ensures that the majority of people have a qualification, the unemployment rate for the unskilled is still generally at least twice as high as for those with a qualification. In addition, the “low-skilled” should be taken to include those whose specific skills have been devalued by structural change, helping to explain the concentration of unemployment in the heavily industrial northern regions of western Germany and among older people. See SM/94/213, Chapter V.


Standard errors for this regression are corrected using the Newey-West procedure.


The measure of persistence is defined as the sum of deviations of unemployment from its baseline path in response to the temporary shock, and the measure of imperfect responsiveness as the sum of deviations of unemployment from the new long-run equilibrium resulting from the permanent shock.


Layard, Nickell, and Jackman (1991), however, also find more rigidity—in this case, real wage rigidity, interpreted as the extent to which real shocks translate into unemployment at constant inflation rates—in Germany than in France or Italy.


This chapter was prepared by Christian Thimann (EP, EU1).


The “1996 tax reform” refers to the resolution of the parliamentary mediation committee of July 31, 1995, which is expected to go forward to both houses of Parliament on August 21–22, 1995.


See BMA (1994, Chapters 19 and 20) for a comprehensive overview of the characteristics of social assistance.


BMA (1994, p. 626).