Germany
Recent Economic Developments and Selected Issues

This Recent Economic Developments and Selected Issues paper highlights that Germany’s recovery from the 1993 recession, which had already been weaker than the previous three recoveries, stalled in the third quarter of 1995; output subsequently contracted in the fourth quarter of 1995 and first quarter of 1996. After rising by almost 3 percent in 1994 and at an annual rate of 2½ percent (seasonally adjusted) during the first half of 1995, real GDP stagnated in the third quarter and fell by 0.6 percent (seasonally adjusted, annual rate) in the fourth quarter of 1995.

Abstract

This Recent Economic Developments and Selected Issues paper highlights that Germany’s recovery from the 1993 recession, which had already been weaker than the previous three recoveries, stalled in the third quarter of 1995; output subsequently contracted in the fourth quarter of 1995 and first quarter of 1996. After rising by almost 3 percent in 1994 and at an annual rate of 2½ percent (seasonally adjusted) during the first half of 1995, real GDP stagnated in the third quarter and fell by 0.6 percent (seasonally adjusted, annual rate) in the fourth quarter of 1995.

I. Output, Employment, and Inflation 1/

1. Output

a. Overview

Germany’s recovery from the 1993 recession, which had already been weaker than the previous three recoveries, stalled in the third quarter of 1995; output subsequently contracted in the fourth quarter of 1995 and first quarter of 1996 (Chart I-1). The recovery faltered under the cumulative weight of high long-term interest rates, a sudden appreciation of the deutsche mark and an overly generous wage round in early 1995. Extremely cold winter weather, which limited construction activity, exacerbated the downturn in output. After rising by almost 3 percent in 1994 and at an annual rate of 2½ percent (seasonally adjusted) during the first half of 1995, real GDP stagnated in the third quarter and fell by 0.6 percent (seasonally adjusted, annual rate) in the fourth quarter as a result of an inventory correction and a decline in fixed investment; for the year as a whole real GDP grew by only 1.9 percent in 1995 (Chart I-2). 2/ In both west and east Germany, economic growth in 1995 (at 5.6 percent and 1.6 percent, respectively) was slower than in the previous year. 3/ During the first quarter of 1996—the only quarter for which national accounts data are currently available—real GDP declined by 1.5 percent (seasonally adjusted, annual rate). According to staff estimates, the output gap widened to some 3¼ percent of GDP in 1995. 4/

CHART I-1
CHART I-1

Germany Recoveries 1/2/

(Trough=100)

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Source: Deutsche Bundesbank.1/ The troughs are as follows: 1967Q2 for the 1967-68 recovery; 1975Q2 for the 1975-76 recovery; 1982Q4 for the 1983-84 recovery; 1993Q1 for the 1993-94 recovery.2/ Data prior to 1991 are for West Germany only.
CHART I-2
CHART I-2

Germany Recent Developments

(Percent change from previous year)

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Source: Deutsche Bundesbank.1/ Contribution to GDP growth.2/ As a percent of disposable income.3/ As a percent of the labor force (seasonally adjusted).

Like the pattern of previous recoveries, the recovery from the 1992-93 recession started in exports and spread to investment; it was expected to continue on to private consumption. Economic growth in 1994, however, had a narrow base, with inventory accumulation and construction contributing about three quarters of GDP growth. A sharp inventory accumulation pushed the ratio of inventories to final demand to a five-year high, as business confidence soared to unsustainable heights (Chart I-3). 1/ Meanwhile, a construction boom—in public projects, particularly in the new Under, and in residential housing, which was partly motivated by expiring tax breaks—was about over.

CHART I-3
CHART I-3

Germany Confidence, Orders, Inventory-Sales Ratio, and Production

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Sources: Deutsche Bundesbank; Bundesministerium fuer Wirtschaft; IFO Institute; IMF, International Financial Statistics and staff calculations.1/ Data prior to 1991 are for West Germany only.2/ Percentage of those surveyed expecting an improvement in their situation, less percentage expecting a deterioration.

If this recovery had followed the course of earlier ones, business investment would have picked up in 1995 as capacity utilization rose and prospects for demand and profits appeared bright. However, the economy did not make the customary transition to investment-led growth in 1995. The main reasons were the high wage settlements (led by the metal and engineering unions) and a sudden appreciation of the deutsche mark, which dimmed the profit outlook (although not actual profits in 1995) by threatening export competitiveness and dampened business confidence. Despite an expansionary fiscal impulse and an acceleration in private consumption, the other components of demand weakened, especially stockbuilding and construction, which had been strong in 1994.

The cyclically sensitive manufacturing sector continued to mirror in 1995 the broader trends in the economy (Table I-1). Output in the manufacturing sector peaked in mid-year and fell by about 3½ percent during the remainder of 1995; capacity utilization in manufacturing also declined markedly (by 2 percentage points from the second to the fourth quarter), but it was still above its long-term average of 83.3 percent. A milestone was reached in the structural transformation of Germany in 1995; in the fourth quarter of 1995, value-added in the service sector pulled even with the value-added in the industrial sector. To place this development in perspective, it should be remembered that the service sector in the United States and the United Kingdom account for twice the value added of manufacturing. Still, this transformation has been fast paced; in the first half of 1991, value-added in industry was 30 percent higher than in the service sector.

Table I-1.

Output in Manufacturing and Construction

(Percentage changes at 1991 prices) 1/

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Source: Deutsche Bundesbank.

Data are adjusted for the number of working days in each quarter.

In 1995, data for the manufacturing sector were aligned with EU classification standards. This change impairs comparability with previous years. Similarly, in 1996 data for the construction sector are being compiled for the first time according to EU classifications.

Percentage change over 1995 Q1.

In the first quarter of 1996, real GDP continued to contract, declining by 0.4 percent from the fourth quarter of 1995; however, compared with the first quarter of 1995, real GDP was higher by about 0.3 percent. The main factor underlying this development was a 7.7 percent drop in construction activity from the previous quarter because of the unusually harsh winter weather. All other domestic demand components moved upward, suggesting that a platform for renewed recovery may be in place. In west Germany, real GDP fell slightly (0.1 percent, quarter to quarter, s.a.), while in east Germany, economic activity dropped (by 2.6 percent on the same basis) in the wake of the collapse in construction, which constitutes a much bigger share of GDP in the new Länder than in the old Länder.

Recent indicators are consistent with a moderate recovery in output growth that was initially stimulated by factory orders for export goods and has since been augmented by rising domestic demand. In June, industrial production for united Germany rose by 5.6 percent compared to its low in February, spurred mainly by a weather-related rebound in construction activity. With the reversal of much of the nominal appreciation experienced in 1995, export orders—especially for capital goods—have revived; in the second quarter of 1996, export orders exceed their level in the third quarter of 1995 by almost 5 percent. Domestic orders have also rebounded, increasing by 4½ percent in the second quarter, after a 3 percent drop in the first three months of 1996. Building permits for residential housing have also been trending up since the fall of 1995. Even with these positive indicators, there are still signs of weakness, especially in confidence surveys for businesses and consumers.

b. Aggregate demand

Growth in domestic demand slowed to 1.7 percent in 1995 from 2.8 percent in 1994, accounting for the entire reduction in real GDP growth between the two years. (Table I-2) This slowdown in domestic demand stemmed mostly from weaker fixed investment and the absence of a contribution from stockbuilding (unlike in 1994). Both public and private consumption rose more rapidly in 1995 than in 1994.

Table I-2.

Main Expenditure Components of Real GDP

(Percentage changes from previous period)

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Source: Statistisches Bundesamt.

Seasonally and calendar adjusted quarterly change at annual rate.

Contribution to the growth of GDP.

Fixed investment increased by only 1½ percent in 1995 compared with over 4¼ percent in 1994. The increase in fixed investment from the year before steadily declined during the course of the year and became negative in the final quarter. This development was mirrored in the trends observed for both machinery and equipment investment, and construction. Developments in construction, however, played a more dominant role owing to its large share in fixed investment (62 percent). It is also the case that on an annual basis, investment in machinery and equipment rose by 2 percent in 1995 after declining by 1¼ percent in 1994, while construction increased by about 1¼ percent in 1995 compared with a little over 7¾ percent in 1994.

The boom in construction activity of 1994 turned to bust in 1995. The contribution of construction to the growth in real GDP fell to 10 percent in 1995 from about 33 percent in 1994. The eight-year housing construction boom came to an end: residential construction decelerated from 13.1 percent in 1994 to 3.0 percent in 1995. Substantial excess demand in west Germany, largely due to an earlier wave of immigration, had produced a prolonged period of high activity in housing construction. The imbalance in the west German housing market was largely eliminated in 1995, although pockets of excess demand may persist in individual regions or market niches.1/ In east Germany, construction was sustained largely by public infrastructure projects. However, as finances of the territorial authorities came under increased strain, they began to extend construction schedules; public construction investment consequently dropped by 2.7 percent in 1995. Growth in commercial construction declined from 3.0 percent in 1994 to 0.4 percent in 1995. An even sharper drop in construction (7.7 percent) was recorded in the first quarter of 1996, mainly because of exceptionally harsh winter weather.

Business investment, following a hesitant pickup in the second half of 1994, virtually leveled off in absolute real terms (s.a.) in 1995 as demand prospects became clouded. Nonetheless, machinery and equipment investment rose modestly (2 percent) on an annual basis. With a decline in capacity utilization in the manufacturing sector, firms had little need to invest to expand capacity and instead they focused on modernizing production, including the adoption of labor-saving technologies. There is some evidence to suggest that in the new Länder enterprise investment rose in 1995 (with the continued help of government subsidies) but less rapidly than in 1994. More broadly, business fixed investment has yet to recover from the decline that occurred during the 1992-93 recession, which may presage a return to the lower investment ratios prevalent before unification rather than the higher ratios recorded during 1991-92.

Both private and public consumption grew at a much faster pace in 1995 than in 1994. Private consumption rose by 1.7 percent in 1995, or almost twice the rate as in 1994. Private consumption showed considerable strength particularly in the first half of 1995 despite tax increases and higher social security contribution rates (including the reimposition of the 7.5 percent solidarity surcharge on income taxes and the new nursing care insurance). Household disposable income rose by almost 2 percent, more rapidly than private consumption. After several years of decline, the household saving rate stabilized in 1994 and 1995 around 11 ½ percent. Public consumption increased by 2.1 percent in 1995 compared with 0.7 percent in 1994, in part, due to sharply higher health care spending.

Growth in exports of goods and services was almost halved from 7.5 percent in 1994 to 3.8 percent in 1995. The main reasons for this slowdown were the appreciation of the deutsche mark recorded over the past several years, the comparatively high wage increases in 1995, and weaker foreign demand in major trading partners in 1995. Despite a substantial order book to draw upon and the normal lagged response to a real appreciation, growth in merchandise exports experienced an even faster slowdown—from 9.2 percent in 1994 to 4.1 percent in 1995. As domestic demand sputtered in the second half of 1995 and exports slowed, import expansion moderated. Thus, growth in imports of goods and services dropped to below 3 percent in 1995 from above 7 percent in 1994. As a result, the contribution to GDP growth coming from net exports actually rose slightly to 0.2 percentage points in 1995.

2. Employment and unemployment

Since unification, the German economy has been engaged in a major restructuring effort—not only in the new Länder but also in the manufacturing sector of the old Länder—aimed at productivity improvements. As a result, unemployment in the western Länder hardly fell at all during the recovery from the 1992-93 recession, while in the eastern Länder, employment began to rise in late 1993 following the earlier collapse of output and employment. On average in 1995, employment in the whole of Germany declined once again, albeit marginally (0.3 percent), to 34.9 million (Chart I-2). The cumulative decline in employment since 1991 has increased to 4.5 percent or 1.6 million people. The unemployment rate also declined to 9.4 percent of the labor force in 1995 from 9.6 percent in 1994.

As output growth stalled and then fell during the second half of 1995, the situation in the labor market deteriorated and the unemployment rate rose to 9.9 percent (s.a.) by end year. Unemployment rates in both the eastern and western Länder reached their troughs (at 13.6 percent and 8.2 percent (s.a.), respectively) during the second quarter of 1995 and proceeded to rise thereafter. By end 1995, the unemployment rate in the eastern Länder reached 15.3 percent (s.a.) compared with 8.6 percent (s.a.) in the western Länder. The rise in unemployment was mainly a consequence of the sharp currency appreciation and the higher-than-expected wage increases in early 1995. This is consistent with the relatively large employment decline in the production sector (a fall of 2.8 percent from first quarter 1995 to first quarter 1996 compared with an overall decline of 1 percent in the same period) which has a higher concentration of tradable goods and thus had a greater need to adjust to changes in relative unit labor costs.

During early 1996, unemployment reached a post World War II record high of 4.0 million people (s.a., in March) or 10.4 percent (s.a.) of the labor force. This increase was ascribed to the downturn in activity which was exacerbated by the unusually harsh winter. The latter was a particularly important factor for the rise in unemployment in the construction sector. However despite the apparent recovery in the second quarter of 1996, the unemployment rate only inched downward to 10.2 percent (s.a.) in July. This slow unemployment decline is consistent with past tendencies for the unemployment rate to rise in a downturn but retreat only slowly during the upswing. In the past, this has led to a ratcheting up of the unemployment rate. 1/ After dipping in the second half of 1995 to 306,000 positions (s.a.), vacancies climbed to 339,000 positions (s.a.) in May 1996.

Both eastern and west Germany posted record unemployment rates during the winter of 1996. In March, the unemployment rate peaked at 16.4 percent (s.a.) in the eastern Länder and 9.0 percent (s.a.) in the western Länder. For the new Länder, the unemployment rate topped the level reached in early 1994 in the depths of the post-unification recession. The old Länder experienced only a very modest decline in the unemployment rate during the brief 1994 recovery. In the early summer of 1996, the labor market developments were somewhat more encouraging in the new Länder than in the old: unemployment in east Germany had fallen to 15.4 percent (s.a.) by July, whereas the rate was stuck at 9.0 percent (s.a.) in west Germany.

The composition of unemployment has changed during 1995-96. As newcomers on the German labor market, foreigners are harder hit by downsizing than domestic residents and unemployment among foreigners has increased more than among Germans over the last year. In west Germany where data are available, the unemployment rate among foreigners increased from 16.8 percent in April 1995 to 19.1 percent in April 1996 when they constituted 17.5 percent of all the unemployed. Long-term unemployment normally increases in conjunction with high and rising overall unemployment, but increased use of early retirement has lessened this phenomenon. Unemployment related early retirements rose from about 50,000 people in 1993 to 200,000 people in 1994 and reached 300,000 people in 1995. Long-term unemployment increased marginally (by only 20,000) from March 1995 to March 1996 to a total of almost 1.2 million people. Nonetheless, the long-term unemployed accounted for more than one quarter of total unemployment.

Active labor market policies slowed the rise in unemployment in late 1995 and early 1996 but less so than in other recent episodes of rising unemployment. Persons benefiting from active labor market policies (including short-time workers) comprised 3.4 percent of the labor force in April 1996 up from 3.1 percent a year ago. Nonetheless, the number of persons employed under employment promotion schemes declined by more than 40,000 (almost exclusively in the new Länder) over the twelve months to April 1996.

3. Wages and prices

a. Wages

After the wage restraint exhibited in 1994, wage increases jumped sharply in 1995, particularly in the old Länder where negotiated hourly wage increases for the whole economy averaged 4.3 percent in 1995 compared with 2.1 percent in 1994. (Inflation was 1.8 percent in 1995 and 2.7 percent in 1994 (Chart I-4).) The process of wage convergence between the new and the old Länder continued in 1995 as negotiated hourly wages across all sectors increased by 8.8 percent in east Germany or slightly less than the previous year (9.3 percent).

CHART I-4
CHART I-4

Germany Inflation and Wages

(Percentage change from previous year)

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Sources: Deutsche Bundesbank; and IMF staff estimates.

In the old Länder negotiated hourly wage increases in the producing sector rose by 5.3 percent and outstripped the wage increases for all sectors. This development reflected the exceptional two-year agreement reached in the metal-working industry; in the first year, wages rose 4 percent and the work week was reduced to 35 hours effective in October, yielding an average increase in hourly wages of 4¾ percent for 1995. Wage increases in the producing sector of the new Länder exceeded those for all other sectors (as was the case in 1994); this reflected a continuation of the wage convergence process.

In the wake of the downturn in activity and rising unemployment in late 1995, the metal workers’ union took an initiative to secure employment in exchange for wage moderation—the so-called “Alliance for Jobs.” New wage settlements in the private sector moderated significantly in 1996; new hourly wage increases ranged from 1½ percent (the textile industry) to 2 percent (the chemical industry). 1/ This limited differentiation—notwithstanding the substantially different profiles for profitability—illustrates one of the drawbacks of pattern bargaining. Under the second year of their two-year contract, the metal workers would receive a substantial wage increase for 1996—about 4½ percent on an hourly basis, partly owing to the aforementioned reduction in the work week. Outside of the chemical sector, job guarantees were generally not a feature of these new wage settlements.

In the public sector, a 20-month agreement was reached in June that provided for a smaller wage increase than the new private sector settlements. Public employees will receive a one-off payment of DM 300 in 1996—equivalent to a 0.8 percent wage increase—and effective January 1, 1997, a wage increase of 1.3 percent from the 1995 base; that is excluding the one-off payment in 1996. This implies an average annual wage increase over the life of the agreement of 0.7 percent. No significant changes in working conditions wore included in this agreement.

One positive aspect of wage agreements reached in 1996 was increased flexibility in work rules. For example in the textile industry, individual firms were allowed to opt out of the industry-wide agreement warranted by economic conditions at the firm level. Several other agreements also contain enhanced flexibility in work time arrangements and overtime pay. Also noteworthy was the failed attempt to extend to foreign construction firms and foreign workers on construction sites in Germany minimum wages in the construction sector negotiated by the trade unions and employers associations (DM 18.60 per hour in the western Länder and DM 17.11 in the eastern Länder). 1/

In the new Länder, the process of wage convergence with the old Länder continued. Tariff wages in the east reached on average 87 percent of the western level at end-1995—up from 60 percent at end-1991. In a few industries full wage equalization was reached in 1995, while in some other industries—most importantly, metal-working, construction and banking—full wage equalization was to be achieved in 1996. On the other hand, in the textile and chemical industries, tariff wages in the east were 75 percent of those in the west at end-1995. Wage convergence within the public sector has been somewhat slower than the average convergence in the private sector, reaching 84 percent in 1995 and increasing to 85 percent in 1997 under the new agreement.

The rapid wage growth in the tariff agreements, in spite of a persistent high unemployment rate, has weakened the efficacy of the wage negotiation process, particularly in the new Länder. The coverage of tariff agreements has continued to decline which has helped effective wages to converge more slowly than tariff wages. Moreover, reportedly about one third of employers in the east were reported to pay below tariff wages; unlike in west Germany, where most firms pay above-tariff wages, only 6 percent of east German firms do so. Consequently, labor income per employee in the eastern Länder was only 75.3 percent of that in the western Länder, displaying less convergence than tariff wages (Table I-3).

Table I-3.

Wages in East Germany Relative to West Germany

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Source: Data supplied by the Ministry of Labor.

End of period.

Gross salaries and wages per employee, annual averages.

b. Prices

Consumer price inflation receded sharply in 1995 owing to the weaker economy (which expanded the output gap) and to the dampening effects of the currency appreciation. For unified Germany, inflation dropped to 1.8 percent in 1995 from 2.7 percent in 1994. This downward trend continued during the first half of 1996 (Table I-3); the 12 month increase in consumer prices for unified Germany averaged 1.5 percent in the second quarter of 1996. Consumer price inflation in east Germany in 1995 continued to converge toward consumer price inflation in west Germany; in 1995, inflation was 2.1 percent for the new Länder compared with 1.7 percent for the old Länder. However, these data mask a divergence in inflation rates that has taken place since mid-1995. In east Germany, because of higher legal rent ceilings in mid-1995, rental inflation jumped form 2½ percent (12-month rate) during the first half of 1995 to 9½ percent in August 1995 and has remained at that level. Consumer price inflation in east Germany, thus, accelerated by almost 1 percentage point to 2½ percent in the second half of 1995 and to nearly 2¾ percent in the second quarter of 1996. In west Germany, price pressures lessened for all CPI components during 1995 with particularly sharp declines for foodstuffs. Price increases for services, reflecting their large labor component, slowed only moderately and remained relatively high in 1995. As the excess demand situation in the housing market in west Germany has eased, growth in rental prices also slowed but has remained by far the CPI component with the highest inflation rate. During the first half of 1996, all components, except for foodstuffs, continued to display a downward drift in their 12 month rate of change.

Table I-4.

Inflation

(Percentage change from a year ago)

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Source: Deutsche Bundesbank.

In 1995, the index of prices for raw materials (HWWA Index) dropped—in deutsche mark terms—by 2½ percent compared with an increase of ¼ percent in 1994. Reflecting, in part, the depreciation vis-à-vis the US dollar, in the three-month period March to May 1996, the price index was about 9½ percent higher than one year earlier. Import price inflation was halved in 1995 to 0.4 percent, with import prices at the end of the year almost 1 percent lower than 12 months earlier. Import prices contributed to subdued producer prices—both directly due to lower intermediate input prices and indirectly through greater price competition from abroad. Producer price inflation declined throughout the year to 1.3 percent in the fourth quarter of 1995. In early 1996, following the elimination of the “coal penny” surcharge on electricity, producer prices dropped below their level in early 1995. In June 1996, the producer price index was 0.8 percent below its level of June 1995 but was unchanged from its level in December 1995.

II. Public Finances 1/

During 1992-94, Germany made considerable progress in reducing the public sector borrowing requirement that had ballooned as a consequence of unification. 2/ The deficit of the general government (on a national accounts basis) was reduced to 2½ percent of GDP in 1994 and off-budget borrowing was trimmed substantially. 3/ For 1995, the deficit of the general government was budgeted to remain around 2½ percent of GDP—comfortably below the Maastricht reference value of 3 percent, but the outturn placed the deficit at 3.5 percent of GDP. This unexpected rise stemmed about equally from higher deficits of the territorial authorities and of social security funds. Only to a small extent was the wider deficit a by-product of the slower economy; the measured structural balance thus weakened following several consecutive years of improvement. The measured structural balance, however, overstates the expansionary fiscal impulse in 1995, because of technical difficulties consolidating the accounts of the Treuhand and its successor agencies into the public sector on a consistent basis in 1994 and 1995, and because part of the significant tax shortfall in 1995 was related to the 1992/93 recession and should thus not be considered structural.

Notwithstanding this setback on the macroeconomic front, progress was made in 1995 on institutional reforms as two temporary fiscal arrangements since unification were put on a more permanent footing. First, the new Länder were fully integrated into the revenue sharing arrangement between the federal government and the old Länder (Finanzausgleich). As part of the new arrangement, all Länder receive a 7 percentage point higher share of value added tax (VAT) receipts, and the western Länder make a net transfer to the eastern Länder of about DM 9½ billion. As a second measure, the federal government assumed responsibility for servicing Treuhandanstalt debt (DM 204 billion) and debts of east German housing agencies (DM 30 billion), which had previously been outside of the general government sector. Further improving the transparency of the fiscal accounts, other unification-related debt—including DM 102 billion of the Credit Fund (Kreditabwicklungsfonds) that mainly contained equalization claims from the 1990 currency conversion-was also combined into the new Inherited Debt Fund (Erblastentilgungsfonds).

With the economy weaker than projected when the 1996 budgets were approved, cyclical pressures to widen the deficit of the general government are intense. New official estimates indicate tax revenues in 1996 will be DM 20 billion (or 0.6 percent of GDP) lower than budgeted and expenditure overruns—particularly labor market spending—are likely. The cyclical impact on the deficit is estimated at about 1 percentage point of GDP, but would be partly offset by a budgeted improvement in the structural balance of about ½ percentage point of GDP stemming mainly from higher social security contributions. As a result, the general government deficit could widen to 4 percent of GDP in 1996.1/

The authorities’ fiscal objectives for 1997 include significant deficit reduction, that avoids an increase in the sum of tax and contribution rates. Achieving these objectives—even as official projections for revenue were scaled back by 1.8 percent of GDP in May 1996—would represent an important step along the authorities’ medium-term fiscal path and would allow Germany to meet the Maastricht fiscal deficit criterion in 1997. The Government has formulated a fiscal package for 1997 directed toward cutting expenditures of territorial authorities by DM 50 billion (about 1 ½ percent of GDP), lowering taxes by about DM 11 billion (not quite ½ percent of GDP), and restraining spending on pensions and health care by DM 20 billion (about ¾ percent of GDP) to prevent further increases in social security contribution rates. The authorities have estimated that full implementation of these measures would lower the deficit of the general government to about 2½ percent of GDP in 1997 or below the Maastricht fiscal deficit criterion.

Fiscal policy retains its medium-term focus to lower the deficit of the general government to 1 percent of GDP in 2000 and to return the ratio of expenditure to GDP to its pre-unification level (Chart II-1). Beyond this horizon, Germany is expected to face considerable pressures on social spending associated with an ageing population. 2/ To address the implications for the pension system, the Government has appointed a commission, chaired by Labor Minister Blüm. Similarly, a commission headed by Finance Minister Waigel is working on proposals for a comprehensive reform of the income tax system with the aim of broadening the tax base and reducing tax rates.

CHART II-1
CHART II-1

Germany General Government Revenue and Expenditure 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Source: Statistisches Bundesamt; and data provided by the authorities.1/ Data for western Germany only before 1991.

1. Developments in 1995

Fiscal consolidation experienced a setback in 1995. Following improvements in the structural deficit that averaged over 1 percentage point of GDP in 1993-94, the primary structural deficit worsened by 0.8 percentage points of GDP in 1995 (Table II-1, and Chart II-2). The fiscal impulse was, however, much less expansionary than indicated by the change in the structural deficit because in 1995 debt servicing costs of unification related debts were incorporated into the fiscal accounts and the Treuhand deficit, which had been off-budget in 1994, was eliminated. The actual deficit of the general government (on a national accounts basis) increased to 3.5 percent of GDP compared with 2.5 percent of GDP in 1994 (Table A6). The deficit of the federal government rose to 1.6 percent of GDP in 1995 from 1.2 percent in 1994, while the combined deficits of the Länder and local governments (1.5 percent of GDP) were roughly unchanged in 1995 from 1994. The social security funds, however, swung from a small surplus in 1994 to a deficit of 0.4 percent of GDP in 1995. The transfer of Treuhand and east German housing debt (6.8 percent of GDP), together with the deficit of the general government, increased gross public debt from 50.2 percent of GDP at end-1994 to 58.1 percent of GDP at end-1995.

Table II-1.

General Government Accounts, 1993-95

(In percent of GDP: national accounts basis)

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Sources: Data provided by the German authorities; and staff calculations.

Balances for 1995 have been affected by the incorporation of previously off-budget expenditures, chiefly interest on debt taken over by the Federal Government. Thus changes in the primary structural balance give a better, albeit still imperfect, measure of the fiscal impulse.

The increase from 1994 stems largely from the assumption by the Federal Government of Treuhandanstalt debt.

CHART II-2
CHART II-2

Germany General Government: Deficits and Debt 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Sources: Data provided by the authorities; and IMF staff estimates.1/ Data before 1991 are for western Germany only.

The improvement in the combined deficits of the territorial authorities (on an administrative basis) from 3.5 percent of GDP in 1994 to 3.2 percent of GDP in 1995 fell short of the deficit projection of the Financial Planning Council in mid-1995 (2.9 percent of GDP) even though expenditures were DM 32 billion (or 0.9 percent of GDP) lower (Table A7). 1/ Despite tax increases at the beginning of 1995, notably the new solidarity surcharge and higher insurance and wealth taxes, tax revenues of the territorial authorities were lower than expected (about 1 percent of GDP). 2/ Cyclical factors—according to official estimates—accounted for only about one quarter of this tax shortfall. More important were non-cyclical factors, such as more extensive utilization than had been projected of tax breaks on housing and investment, particularly for eastern Germany, and the unusually large income tax refund for the recession year 1993. 3/

Notwithstanding a DM 16.6 billion (or 1/2 percent of GDP) shortfall in tax revenues, the federal government was able to contain its budget deficit overrun to DM 1 billion. The deficit (on an administrative basis) at DM 50.5 billion (or 1.5 percent of GDP) was virtually unchanged from 1994 (Table A8).1/2/ Federal expenditures—adjusted for changes in spending categories—declined by 0.6 percent in 1995 compared with 1994 and were DM 13 billion below budget. Several factors kept expenditures lower than projected: (1) the delayed approval of the budget in mid-year restrained spending in the first half of the year; (2) an expenditure freeze was imposed from October to December, which reduced expenditures by an estimated DM 2 billion; (3) interest payments were DM 4½ billion below budget; (4) expenditures of the successor agency of the Treuhand were DM 4 billion lower; (5) the transfer to the Federal Labor Office was DM 1 billion smaller (largely due to fewer short-time workers and participants in training programs); and (6) federal investment spending was DM 5 billion below budget. A few spending items, however, were higher than budgeted, most prominently spending on unemployment assistance (DM 2.5 billion).

The Länder were also confronted with sizable tax shortfalls and exercised expenditure restraint to keep spending below their budgets. Nonetheless, the combined deficits of the Länder reached DM 46.7 billion (1.3 percent of GDP, on an administrative basis) in 1995 and exceeded official projections made in mid-1995 by DM 12 billion (or 0.3 percent of GDP) (Table A9). The deficit of the western Länder (DM 30.0 billion) exceeded the projections by DM 8.0 billion as tax revenue shortfalls of DM 11 billion were only partially offset through expenditure restraint. 1/ In the eastern Länder, tax revenues rose by 50 percent as a result of the Finanzausgleich but fell DM 3 billion short of their projected amount. Overall, despite expenditure restraint, the deficit in the east (DM 16.7 billion) was DM 4 billion higher than anticipated, even though it was down from DM 19.8 billion in 1994. The fiscal situation was particularly severe in the State of Berlin, where the deficit surged to DM 10.1 billion, some DM 2.7 billion higher than budgeted.

The aggregate deficits of local governments at DM 13.9 billion (0.4 percent of GDP) increased only slightly in 1995 from 1994, although the deficits of the local governments in the west more than doubled to DM 12.1 billion (or 0.3 percent of GDP) in 1995 while local governments in the east reduced their deficits to DM 1.8 billion in 1995 from DM 6.0 billion in 1994 (Table A10). The sharply higher deficits of local governments in the west, were mainly due to lower-than-expected tax revenues (DM 3 billion). Cuts in investment and modest increases in personnel spending kept the expenditure increase to a mere 1.1 percent, despite much higher social spending. 1/ The deficit of the local governments in the east dropped sharply—despite 13 percent higher social expenditures–as a result of larger transfers from the old Länder (17 percent), higher tax revenues (15 percent), and lower investment spending (11 percent).

The social security funds reported a combined deficit of DM 13.6 billion (0.4 percent of GDP) in 1995 compared with a surplus of DM 4.3 billion (0.1 percent of GDP) in 1994; most of the turnaround was due to the pension funds (Table A12). Greater-than-projected utilization of unemployment-related early retirement provisions in combination with adverse cyclical effects on revenues widened the deficit of the pension funds from DM 1.0 billion in 1994 to DM 12.7 billion in 1995. 2/ The finances of health care funds also deteriorated sharply-from a DM 3 billion surplus in 1994 to a deficit of DM 7 billion in 1995. In the wake of the 1992 Pension Reform, new rules lowered health insurance contributions for pensioners and the unemployed in 1995, and increased health care expenditures by an estimated DM 5 billion. Overall, disbursements per member grew by 4½ percent in the west and twice as fast in the east. 3/ The new nursing care insurance fund reported a surplus of DM 4.3 billion largely because contributions were collected from the beginning of 1995 whereas benefits started in the second quarter.

2. Developments in 1996

The 1996 Annual Tax Act for the territorial authorities had to accommodate the significant revenue losses resulting from two rulings by the Constitutional Court. The first Court ruling exempted subsistence income from taxation at a cost of DM 14 billion. The second Court ruling eliminated the “coal penny” (Kohlepfennig), an electricity surcharge benefitting coal mining (DM 7 billion). 4/ In addition, the authorities decided to raise child benefits by DM 9 billion. Moreover, various tax loopholes were closed and tax incentives for east Germany were streamlined and extended; in total, about DM 2 billion in additional revenues were found. Complicating matters, tax estimates in October 1995 indicated much lower revenues (DM 30 billion), prompting budget plans to be revised to meet the deficit target for 1996.

The 1996 federal budget that was adopted in November 1995, closed a financial gap of almost DM 20 billion that had emerged in October. The budget envisaged a 5.4 percent decline in expenditures; this was equivalent to a 1.3 percent decline, if expenditures are adjusted for the new treatment of child benefits, which henceforth will be netted against personal income tax liabilities. Measures to restrain expenditures included: reducing personnel by 1 percent; maintaining vacant personnel positions from 1995; and cutting investment. Additional privatization receipts (DM 9 billion) were added to the budget, and some expenditure items such as interest expenses and spending on successor agencies of the Treuhand were cut. Transfers to the Federal Labor Office were raised to DM 4.3 billion, and DM 2.2 billion was added for unemployment assistance (Arbeitslosenhilfe). 1/ The federal budget deficit was estimated to rise to DM 60 billion (1.7 percent of GDP) in 1996. However, this increase reflected the federal take-over of the Railway Fund (about DM 10 billion), which had previously been off-budget.

As the economy continued to weaken, the goal of limiting the federal deficit to DM 60 billion has come under increased strain. According to official estimates in May 1996, tax revenues would be DM 8½ billion below the level estimated in October 1995, and additional expenditures, mainly on transfers to the Federal Labor Office and on unemployment assistance, may be needed. 2/ In response to lower revenues, a freeze on discretionary expenditures was put in place in March 1996 for the Federal Government (and several Länder). It has been officially estimated that this freeze at the federal level could produce some DM 7 billion in savings in 1996.

Expenditures of the Länder are projected by the Financial Planning Council to increase by 3½ percent in the west and 2½ percent in the east. 3/ Overall, the deficit of the Länder is officially projected to decline in 1996; in the west from DM 30.0 billion to DM 27.0 billion and in the east from 16.7 billion to DM 14.5 billion. Western municipalities have projected their deficits to decline by almost DM 2 billion to DM 10.5 billion in 1996; revenues would rise by 2 percent and expenditure increases would be contained to 0.3 percent. The latter reflects modest increases for personnel expenditures and reduced investment spending. Eastern municipalities have projected slightly smaller deficits than in 1995. Revenues are expected to rise by 5 percent in 1996, while expenditures would grow by merely 2 percent, owing to unchanged investment spending and only slightly higher personnel expenditures-though these expenditures would remain, on a per capita basis, well above west German levels.

A deficit of the social security funds in 1996 has been officially estimated at about DM 9 billion, down from DM 13.5 billion in 1995. The pension funds would again run a deficit mainly as a result of cyclically smaller revenues, despite a 0.6 percentage point increase in the contribution rate (to 19.2 percent). The deficit of health care funds has been projected to narrow. Contribution rates were raised in 1996 and measures to restrain expenditure growth were implemented (e.g., hospital budgeting). The new nursing care insurance, which was introduced in 1995, was extended to cover in-patient care as of mid-1996; at the same time, the contribution rate was increased to 1.7 percent from 1 percent. The increases in social security contribution rates have been projected to yield an estimated 0.5 percent of GDP.

3. Budget plans for 1997

Full implementation of the Government’s savings package of DM 50 billion for the territorial authorities—half at the federal level and half at the level of the Länder and local governments—is officially projected to keep expenditures of territorial authorities unchanged in 1997 compared to 1996. Taking account of proposed tax relief measures, the net deficit reduction for the territorial authorities would amount to about DM 40 billion. Proposed measures for the social security funds amount to DM 20 billion and are designed to keep contribution rates from rising further. 1/ In total, the deficit of the general government was estimated by the Financial Planning Council in mid-1996 to decline to 2½ percent of GDP in 1997.

Expenditure savings by the territorial authorities have been proposed in five main areas.

  • ▸ Savings on personnel costs would amount to DM 18 billion. The recently agreed wage settlement for the public sector yields about DM 14 billion in savings, with the remainder to be achieved through personnel reduction. 1/

  • ▸ DM 7 billion in spending cuts have been agreed with individual federal ministries, whereas DM 8 billion cuts at the Länder level remain as yet unspecified.

  • ▸ Postponement of an increase in the basic income tax deduction and of child benefits would save DM 5.3 billion.

  • ▸ A lower transfer to the Federal Labor Office (DM 8 billion) would be achieved partly through tower spending on active labor market measures in east Germany (DM 1.7 billion), other budget cuts in the Labor Office (DM 1.8 billion), and lower administrative expenses (DM 0.9 billion). The annual increase in individual unemployment benefits would be omitted in 1997, and handicapped unemployed would not automatically be entitled to active labor market benefits (DM 0.8 billion). The modified early retirement scheme for long-term unemployed would save DM 0.7 billion. Earlier contribution payments, improved collections, and the sale of loan claims would yield DM 2.1 billion as one-off revenue.

  • ▸ Cuts in pension expenditures would reduce the federal transfer to the pension funds by DM 2.3 billion. Spending on unemployment assistance (which is paid directly from the federal budget) would be cut by DM 0.6 billion.

The draft of the 1997 Annual Tax Act envisages a net loss of tax revenues of DM 5.3 billion, with the federal budget and local authorities gaining DM 2.5 billion and DM 0.7 billion respectively, while the Länder would forgo DM 8.5 billion. The wealth tax, which accrues exclusively to the Länder, would be eliminated in reaction to a Constitutional Court ruling that found the valuation of assets uneven (DM 8.0 billion). The revenue loss would only be partially offset by an increase in the inheritance and gift taxes (DM 1.6 billion). The federal solidarity surcharge on income tax would be lowered from 7.5 percent to 6.5 percent in 1997 (and to 5.5 percent in 1998) at a loss of DM 4.0 billion in 1997. By contrast, two measures (both part of the fiscal package described above) would raise tax receipts: the postponed increase in child allowances (DM 3.8 billion), and the delayed increase in the basic income tax allowance (DM 1.5 billion). These extra revenues would be shared about equally by the federal and state budgets. In connection with the reduction of the solidarity surcharge and the omission of the hike in child allowances, the draft act also envisages that the Länder relinquish VAT receipts of DM 4.1 billion to the federal government. In addition to the 1997 Tax Act, the local trading tax on capital would be eliminated and the local tax on profit would be reduced, with cuts in depreciation allowances as a revenue offset.

The draft federal budget for 1997, which fully implements the federal measures of the savings package, projects a deficit by DM 56.5 billion (1.5 percent of GDP). Total expenditure would decline by 2.5 percent; non-interest expenditures would fall by 4 percent. Subsidies, in particular for coal mining and agriculture, would be scaled back, and the budgets of the Ministries of Transport and Defense trimmed (DM 5.8 billion). Investment spending is envisaged to drop by some 10 percent but would be kept close to the average ratio vis-à-vis total spending observed during the past five years. The proposed labor market measures are expected to reduce federal spending by DM 9.5 billion, and the proposed savings measures in the pension funds would reduce the federal transfers by DM 2.3 billion. For 1998-2000, the medium-term finance plan, in which the 1997 budget is embedded, envisages expenditure growth of merely 2 percent annually compared with nominal GDP growth of 4 percent. The federal deficit is officially projected to drop to around 1 percent of GDP by the year 2000.

In the Länder, expenditures are officially projected to rise modestly-in the west by about 2 percent and in the east by 1½ percent—with subdued increases in personnel expenditures. The combined deficit of the western Länder would decline from DM 27 billion to DM 23 billion, while the deficit in the east would remain unchanged at DM 14.5 billion. Subdued increases in personnel expenditures are also projected to restrain spending at the local level to about 2 percent. With more buoyant revenues, the deficit of local governments in the west is officially projected to drop in 1997 from DM 10.5 billion to DM 6.5 billion and in the east from DM 1.5 billion to DM 0.5 billion.

The social security funds are officially projected to move to a surplus of DM 5½ billion. The proposed measures would improve the finances of the pension funds by DM 11.3 billion in 1997. Lower expenditures (DM 3.7 billion) and one-off revenue measures (DM 7.8 billion) would keep the contribution rate, which otherwise would increase by an additional 0.6 percentage points, below 20 percent of gross wages. Spending on spa visits would be cut by DM 2.1 billion, pension benefits for immigrants and due to illness would be curtailed (DM 0.7 billion), and the accrual of pension rights during times of schooling reduced (DM 0.2 billion). The sale of real estate would yield one-time revenues of DM 2.0 billion, and illiquid assets would be included in the legally mandated one-month liquidity reserve (DM 1.9 billion). Health care spending is proposed to be reduced by DM 6.3 billion and earlier payment of contributions would yield one-time revenues of DM 1.3 billion. These savings are designed to permit a reduction in the average health care contribution rate from 13.4 percent to 13.0 percent of gross wages in 1997. Sick pay covered by the health funds after the initial six weeks, which are paid by employers, would be lowered from 80 percent to 70 percent of income (DM 1.9 billion), promotional spending by health care funds ahead of increased health care competition would be limited (DM 1.2 billion), and health care benefits for spa visits, medication and dental coverage would be reduced (DM 2.3 billion).

ANNEX Prospective tax reform

In early 1996, the Government announced its intention to address structural shortcomings in the tax code and—over the longer term—to reduce the tax burden, particularly on personal income. Currently, reforms in three areas are under consideration: (1) income taxation; (2) wealth, inheritance, and gift taxation; and (3) local trading taxes.

a. Income taxation

Problems with the current income tax system include a tax base that is too narrow, tax rates that are too high, and tax breaks that are too numerous. These factors are generally considered to create an unfair distribution of the tax burden, cause severe economic distortions, and undermine transparency. The Government—under its “Tax Reform 2000” to be implemented in 1999—aims to simplify the income tax rules, broaden the tax base, reduce rates, and to reestablish a linear-progressive tax schedule. To identify politically viable options to meet these objectives, a commission chaired by Finance Minister Waigel has been appointed. The Waigel Commission is scheduled to report on its proposals by the end of 1996.

Under the tax code, not all types of income are treated equally. While the top marginal income tax rate on ordinary income remained at 53 percent (above DM 120 thousand), in 1993 the tax rate on business income (gewerbliche Einkünfie) was lowered to 47 percent and that on retained earnings (Thesaurienmgssatz) was reduced to 45 percent. Income from agriculture and forestry is also treated favorably. Moreover, capital gains on non-business assets are tax-exempt if held beyond a minimum span of time (e.g., six months for financial assets and 10 years for real estate). Furthermore there are income-specific tax allowances and deductions, such as exemptions for overtime premia for work on Sundays, holidays, and at night. Unemployment benefits and social assistance income are also not taxed-though they are considered in determining the tax rate (Progressionsvorbehalt). Pension income is taxed only to the extent that it derives from capital gains.

The tax code is characterized by a large number of tax breaks, most designed to promote non-fiscal objectives. These range from tax allowances for outlays necessary to secure taxable income (Werbungskosten) (including commuting costs), premia for insurance and pensions, and special expenses, which include expenses for hiring domestic help. 1/ To promote home ownership, tax payers can claim an annual depreciation allowance of 6 percent of the purchase price (maximum DM 19,800) in the first four years and 4 percent (maximum DM 16,500) in the second four years. 2/ In the wake of unification, special depriciation allowances (Sonderabschreibungen) have expanded opportunities for tax writeoffs significantly (see section V.4). Investment in shipbuilding and rental property also offers extensive possibilities for tax shelters. Moreover, any loss can be used to offset any other taxable income with unlimited carry forward into the future.

The schedule of income tax rates currently contains some shortcomings. Whereas the tax reform of the late 1980s established a linear-progressive schedule by 1990, the 1996 Tax Law, which increased the basic tax exemption from DM 5,616 to the subsistence income (DM 12,042), has created a hurdle at the lower end of the tax schedule by raising the entry marginal tax rate from 19.0 percent to 25.9 percent. As a result, tax traps in conjunction with the withdrawal of social assistance benefits were deepened.

Many of the income tax rules, primarily those motivated by special economic objectives, have severely reduced the transparency of the tax system and have made it difficult to assess the implicit subsidy component in most policy-oriented tax breaks. A number of tax rules also tend to violate both horizontal fairness (mainly due to the unequal treatment of different sources of income) and vertical tax fairness (in part because the benefits of tax breaks typically increase with the marginal tax rate). 3/ Moreover, the interplay of overly generous write-offs, unlimited loss carry forward, and tax-exempt capital gains permit substantial tax arbitrage by channelling normal—i.e., taxable—income into tax-exempt capital gains. 4/

In the absence of conclusive survey data, an indication of taxpayers’ ability to shelter their income from taxation may be gleaned from the sharp decline in revenues from the income tax on high-income earners and the self-employed (veranlagte Einkommensteuer). It dropped from 20.6 percent of wage tax revenues (Lohnsteuer) in 1990 to 6.7 percent in 1995. Moreover, large parts of income are not reported to the authorities. Survey data for 1983 (more recent data are not available) indicate that only 64 percent of national income was declared, of which an additional 22 percent was tax-exempt. 1/ As a result, barely half of national income was taxed. Similar conclusions are supported by Council of Experts (Sachverständigenrat) calculations that indicate that in 1989 just 57.4 percent of national income was subject to taxation. 2/ Furthermore, despite a top marginal rate of 56 percent in 1983, the estimated effective marginal tax rate peaked at 34 percent at an annual income of about DM 80,000 and then declined toward 30 percent for higher income levels. 3/

Against this background, an Income Tax Commission (Bareis Commission), appointed by the Ministry of Finance, proposed a far-reaching streamlining of income tax rules to improve fairness and transparency. 4/ In particular, fiscal incentives that are deemed worth relating as instruments of economic policy (such as special depreciation allowances, promotion of home ownership, and tax breaks for agriculture) should be converted from tax allowances to explicit transfers. The Commission also urged that all forms of income be treated equally, that types of income that are currently tax-exempt (including capital gains) be made subject to taxation, that the number of tax exemptions be cut; and that the deductibility of expenses that are largely determined by the taxpayer, such as expenses tied to commuting distance, be severely limited. 5/ The Bareis Commission calculated that the proposed measures aimed at broadening the tax base would yield about DM 34 billion (almost 1 percent of GDP) in additional income tax revenue annually. It is expected that the Waigel Commission will adopt some of the analysis done by the earlier Bareis Commission into its legislative action plan.

b. Wealth, inheritance and gift taxes

A second area of problematic taxation concerns taxes that are assessed based on so-called unified values (Einheitswerte). 1/ In this area the Government has already proposed action, although more changes may be warranted over time. The taxes involved include the wealth tax and the inheritance and gift taxes (Vermögens-, Erbschqfts- und Schenkungssteuer), which accrue exclusively to the states. 2/ Although the level of the unified values, has been adjusted from time to time, the values diverge greatly from market values. In particular, the valuation of real estate is far below market. As a result, tax liabilities can be vastly different depending whether wealth is held in the form of financial assets, which are assessed at their market value, or in the form of real estate.

In June 1995, the Constitutional Court ruled that this valuation method created unfair distortions in the assessment of the wealth tax, inheritance and gift taxes. 3/ The Court called for a uniform taxation of all types of wealth and stated that the total tax burden on the return from wealth should be below 50 percent. In response to the Court ruling, the Government proposed abolishing the wealth tax in 1997. It is not yet clear how the states would adjust to—or would be compensated for—their revenue losses. To offset about one fifth of the loss, the Government envisaged raising inheritance taxation by DM 1.6 billion. Inheritance taxes and gift taxes would be assessed on a case-by-case basis closer to market values. 4/

c. Local trading taxes

The Government has also targeted the local trading taxes for reform; these taxes consist of a tax on capital (Gewerbekapitalsteuer) and a tax on profits (Gewerbeertragssteuer).1/2/ These taxes have traditionally been among the most important local taxes; municipalities have even some autonomy in setting tax rates. 3/ According to government plans, the trading tax on capital, which—together with the corporate wealth tax—has not been assessed in east Germany, would be abolished in 1997. The tax is levied independent of the firm’s profitability and is therefore thought to create an adverse distortion. At the same time, the local trading tax that is tied to profitability would be lowered. To ensure that the reform of corporate taxation is revenue-neutral overall, depreciation allowances are planned to be curtailed.

To offset the revenue loss at the local level, the Government plans to assign municipalities a share of VAT receipts (only the federal government and Länder currently share VAT receipts). This, however, would make municipalities more dependent on transfers beyond their control. More importantly, it would weaken the incentive of municipalities to attract businesses. 4/ Even if a distribution formula based on an indicator of local production is conceivable, autonomy over the tax rate would still be lacking. Therefore, the 1995 report of the Council of Exports (Sachverständigenrat) recommended replacing local trading taxes with a local tax on the value-added (Wemchöpfungssteuer) and retaining local discretion over tax rates.

III. Monetary Policy and Developments 1/

In setting monetary policy, the Bundesbank has adhered to its traditional objective of achieving and maintaining price stability. For this purpose, an intermediate targeting framework, centered on the annual growth of broad money (M3), has served as the primary guidepost for setting interest rate policy. 2/ After interest rates, were increased to counter the inflationary impact of unification they have been on a gradual downward trajectory since September 1992. After a pause for most of 1994, the discount rate and the Lombard rate were reduced by 150 and 125 basis points, respectively, during 1995 as M3 growth decelerated and even fell in absolute terms. During 1995, M3 growth was below its (4-6 percent) target corridor (for the first time since monetary targeting was adopted in 1975), and reached only 2.0 percent from the fourth quarter of 1994 to the fourth quarter of 1995. As a consequence, M3 declined by an average of 0.1 percent in 1995 compared with its 9.0 percent growth in 1994.

In April 1996, official interest rates were reduced again—to levels that matched their historical low points in 1987—in recognition of the continued favorable inflation outlook and despite a strong bounce back in the growth of M3 to a rate above the 1996 target range (4-7 percent). The repurchase rate, which had declined by nearly 60 basis points from its December level, was left unchanged at 3.3 percent from April to July.

1. The framework for monetary targeting and its implementation

The Bundesbank set its 1996 annual target growth range to provide for growth in its key intermediate target, M3, of 4 to 7 percent between the fourth quarter of 1995 and the fourth quarter of 1996 (Chart III-1). 3/ The target corridor was widened by one percentage point, compared with the 1995 target range (4 to 6 percent growth), by raising the upper corridor limit in recognition of increased short-term monetary volatility. As in previous years, the Bundesbank’s presentation of the new target range de-emphasized comparisons with actual M3 growth in the early part of the year owing to “major random fluctuations around the turn of the year.” 1/2/ During its mid-year reassessment in July, the Bundesbank reaffirmed its annual growth target for M3 despite M3 growth of 9½ percent (annual rate) during the first half of 1996. This excessive money growth, which the Bundesbank maintained would slow over the course of the year, was an important factor underlying its decision to leave short-term interest rates unchanged.

CHART III-1
CHART III-1

Germany Money and Credit 1/

(In percent)

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Source: Deutsche Bundesbank.1/ Monthly average data.2/ Logarithmic scale.

The Bundesbank has noted the advantages of using its monetary targeting framework (they include sustaining credibility and transparency) and declared that its use has successfully produced a stable price environment; the framework served to “tame inflationary expectations…and to overcome the risk of domestic and foreign investors losing confidence in the deutsche mark.” 3/ By contrast, the Bundesbank has maintained that the use of inflation targeting as an alternative strategy is regarded as a “stopgap solution in the event of the collapse of the traditional underlying monetary relations” and would typically be adopted by those countries where there have been disruptive financial changes. Moreover, the Bundesbank has claimed that direct inflation targets make the central bank’s performance “less verifiable” and transparent because of the large number of potential price indicators and the long and variable lags for monetary policy actions to take effect. 4/

Nonetheless, the Bundesbank acknowledged limitations of its monetary framework as a guide to setting interest rate policy in the near term because of the increased volatility in M3 since unification. However, during the last twenty one years, the monetary aggregate (M3 or its predecessor, central bank money) has often (48 percent of the time) missed its target range; for nine of the twenty one years, actual money growth exceeded its target, while in only one year (1995) did growth fall short of its target range (Table III-1). Indeed the Bundesbank have advocated flexibility in determining tactical changes in interest rate policy:

Table III-1.

Monetary Targets and their Implementation 1/

(In percent)

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Source: Deutsche Bundesbank, Annual Report, 1996.

From 1991 for united Germany.

From 1988 money stock M3.

Between the fourth quarter of the previous year and the fourth quarter of the current year; 1975: December 1974 to December 1975.

Initially set at 4-6 percent but an adjustment of the monetary target corridor was made in July 1991.

“In the short run, the Bundesbank has never regarded the annual targets as the sole guideline for its liquidity and interest rate policy actions, but has also taken domestic and external underlying conditions into account. This does not mean, however, that, by doing so, it has relinquished its medium-term objectives for appropriate monetary growth.” 1/

Because of difficulties in assessing actual M3 developments in 1995 and early 1996, owing to increased short-term volatility, the Bundesbank stressed the need to adopt a “medium-term perspective”—a concept that the Bundesbank has made operational by comparing M3 not only to the 1996 annual target range but also to the extended target range created by continuing the upper and lower growth limits for 1995 into 1996. But the Bundesbank has also warned that multi-year targets can jeopardize the credibility of the central bank by reducing the disciplining effects and transparency of policy from the use of annual targets. In addition, the Bundesbank has, for the first time, explicitly acknowledged that a wide range of indicators are used along with M3 to reach its policy decisions:

“…[T]he Bundesbank continues to adhere to its annual monetary targets which, however, must be seen and assessed even more than before in a medium-term perspective. …Finally, it bases its assessments on a wide range of financial and real indicators.” 2/

Consulting other indicators during periods when M3 has become more volatile in the short run would help to identify the underlying causes for questionable near-term changes in M3 and appropriately respond to either portfolio shifts between M3 and other assets, or changes in transactions demand that foreshadow increased real activity. Shifting interest rates, guided strictly by movements in M3, could lead to shifts in the yield curve and in exchange rates that further reinforce destabilizing portfolio shifts. 3/ Indeed, there is evidence that the weight given by the Bundesbank to achieving steady M3 growth has diminished during the time since unification. 4/

Nonetheless, the Bundesbank has maintained that despite the short-term volatility in M3, there is no need to change this intermediate target variable. The Bundesbank has often noted numerous studies, including those done by the Fund staff, the Federal Reserve and the OECD, that show the demand for M3 is stable in the long run and, compared with other money aggregates, it performs best in terms of controllability and in providing guidance for achieving good price performance. By adopting a longer-term perspective for M3 growth rates and using a broader range of indicators the Bundesbank has adjusted its monetary framework to allow for the higher M3 volatility.

2. Interest rate developments

After a pause during the last half of 1994, the Bundesbank continued to reduce official and market short-term interest rates in 1995 (when M3 growth dropped precipitously) and in early 1996 (in light of favorable price developments and despite a strong rebound in M3). From the start of 1995 until the latest decrease in official interest rates in April 1996, the discount rate has dropped by two percentage points to its current level of 2½ percent (matching its historical low reached in the fall of 1987 following the stock market crash) and the Lombard rate has declined by 1½ percentage points to 4½ percent (Chart III-2).

CHART III-2
CHART III-2

Germany Interest Rates 1/

(In percent)

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Source: Deutsche Bundesbank.1/ Monthly average data.2/ Daily data.Shaded areas show periods of recession.

During 1995 and the first two months of 1996, the interest rate for 14-day repurchase agreements (the principal interest rate with which monetary policy affects market expectations and other market interest rates) eased by 155 basis points and has been fixed at its current level of 3.3 percent since February 1996 (just below the midpoint between the Lombard and discount rates following the April reductions). In implementing this policy shift to stimulate M3 growth during 1995, the Bundesbank also used the margin between the repurchase rate and the discount rate to promote the expectation of declining interest rates. Operationally, this was accomplished with the switch in April 1995 from volume tenders (at a fixed interest rate) to variable rate tenders with which the Bundesbank managed a steady decline of the repurchase rate in the second half of 1995.1/ Although M3 growth had rebounded strongly during the first half of 1996, by allowing the repurchase rate to remain at the midpoint of its interest rate corridor following the reductions in official interest rates in April, the Bundesbank created room to allow interest rates to decline further once M3 growth slowed:

“In this way the Bundesbank created new scope for its open market operations … which it will conduct, above all, in the light of future trends in monetary growth.” 1/

In addition, Bundesbank officials have consistently noted their expectation that M3 growth would slow during the course of 1996.

Long-term interest rates (yields on 10-year government bonds) rose during most of 1994 in concert with the rise in long-term interest rates abroad, particularly in the United States (Chart III-3). Although German long-term rates had averaged about 60 basis points above U.S. rates during the 1990-1993 period, this spread closed and even reversed during 1994 as the rise in German rates lagged those in the United States. During 1995, long-term interest rates declined by 1¾ percentage points and the yield curve flattened slightly during the course of the year; but the spread over U.S. rates widened to about 30 basis points.

CHART III-3
CHART III-3

Germany Monetary Conditions Indices and Interest Rate Developments

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Sources: Deutsche Bundesbank and IMF staff calculations.1/ The MCIs are constructed with a relative weighting of 1:2.5 between the interest rate and the effective exchange rate — a one percentage point change in the interest rate is equivalent to a 2.5 percentage point change in the exchange rate. The MCI is scaled to equal zero in January 1991 and upward movements in the index denote tighter monetary conditions.

However, despite favorable price developments and weak economic growth, long-term interest rates rebounded in February 1996, and by mid-year stood about ½ percentage point higher than their December 1995 level. This recent rise reflects several considerations: a tighter coupling with U.S. long-term interest rates (evidence for which is presented in Appendix III); uncertainties regarding the course of domestic short-term interest rates in light of the conflict between the persistent rapid growth in M3 and other indicators; and fiscal uncertainties particularly in light of the poor outturn for the fiscal deficit for 1995 which was first disclosed in January 1996. The Bundesbank has also expressed concern regarding prospects for the European Monetary Union (EMU), and called for measures to address any incipient EMU-premium (for which there is admittedly little solid statistical evidence); especially if such premia signaled doubts about the future anti-inflationary stance of the European Central Bank or about arrangements to ensure fiscal discipline after the start of EMU. 2/ From October 1995 through July 1996, the yield spread on long-term securities narrowed vis-à-vis other European securities of comparable maturity (Chart III-4).

CHART III-4
CHART III-4

Germany Long-Term Interest Rates and Spreads

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

As a consequence of the jump in long-term interest rates during the first three months of 1996, the spread between long and short-term interest rates (three-month rates), which since mid-1994 had been already wide by historical standards, expanded further in March 1996 to its widest level in over 20 years (see Chart III-3). Moreover, on an inflation-adjusted basis, (ex-post real) long-term interest rates have risen to levels in excess of their (1980-1995) historical average despite low real short-term interest rates.

Offsetting the contractionary financial influence of the rise in long-term interest rates has been the correction in the exchange rate from its sharp rise at the beginning of 1995. In nominal effective terms, the exchange rate depreciated by 3½ percent between December 1995 and June 1996 (4½ percent when measured against the currencies of the G-7 countries). Taken together with the change in interest rates, monetary conditions (broadly defined as an average of interest rate and exchange rate changes) around mid-1996 have eased compared with conditions a year ago but in real terms are, to varying degrees, tighter (depending on the measure used for the real effective exchange rate) than at the bottom of the last recession in 1992 (see Chart III-3). 1/

3. Money and credit market developments

Monetary growth stalled in the last quarter of 1994 and during the first half of 1995 and M3 remained below the level prescribed by its 1995 target growth path. This slowdown reflected a shift out of short-term time deposits (which fell by 14.8 percent during 1995) into longer-term assets (consistent with the sharp rise in long-term interest rates and the steep yield curve) that are included in monetary capital but not M3 (see Chart III-1). 2/ In addition to the influence of relative yields, additional impetus to shift out of time deposits and into money market fund certificates was created by the preferential property tax treatment accorded such certificates. 3/ M3 growth did not pick up until the second half of 1995 when the rise in long-term interest rates paused and began to retreat slightly and the growth in monetary capital slowed (Table III-2).

Table III-2.

Growth in Monetary Aggregates and Main Counterparts 1/

(In percent)

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Source: Deutsche Bundesbank, Monthly Report and Saisonbereinigte Wirtschaftszahlen.

Growth rates are adjusted to correct for changes in statistical coverage.

End-month data for M1 and M2. Monthly average data for M3 and M3- extended, where the latter are calculated from end-month levels. M1 consists of currency in circulation plus domestic non-bank sight deposits. M2 consists of M1 plus domestic non-bank time deposits for less than four years. M3 consists of M2 plus domestic non-bank savings deposits at three month’s notice. M3-extended consists of M3 plus short-term bank debt and deposits in domestic and foreign money market funds

Excluding Bundesbank lending. Including lending in the form of securities.

The expansion of M3 accelerated at the end of 1995 and during the first half of 1996. The level of M3 in June 1996 breached the upper limit of its 1996 target range by a wide margin despite signs of an incipient deceleration; measured from the fourth quarter of 1995, M3 grew by 9.6 percent (annual rate) through June. The prime reason for the vigorous monetary growth was the slowdown in monetary capital formation and the sharp rise in saving deposits at three months notice owing to the transfer of funds from maturing long-term assets. 1/ The Bundesbank has noted that changes in saving deposits and the growth of special saving facilities (that offer a rate of interest more closely related to market conditions) have been special factors contributing to the volatility of M3 in the short run.

Liability management among financial institutions has been made easier with the completion in August 1995 of the last phase of the Bundesbank’s revision of minimum reserve regulations initiated in March 1993. Minimum reserves were lowered from 5 percent to 2 percent for sight deposits, and from 2 percent to 1.5 percent for saving deposits (requirements on time deposits were left unchanged at 2 percent). The revisions were intended to lower the cost of maintaining the various categories of bank liabilities and thus lessen banks’ incentives to circumvent the reserve requirements (which would also increase the short-term volatility of M3). However, compared with other large industrial countries with developed but more liberalized financial markets, the burden on financial institutions from maintaining reserve requirements is still relatively high in Germany; in the United States, reserves (equal to 3 percent) are only required on transactions balances (which constitute only 21 percent of broad money, M2) and in the United Kingdom, required reserve balances are not required at all, although some reserves (0.4 percent of bank liabilities) are deposited with the Bank of England for clearing and other operational purposes. Therefore, in competing with banks based in these countries, German banks could have a cost disadvantage.

Overall bank lending slowed but remained robust during 1995 with a slowdown in private sector borrowing in the second half of the year; lending to enterprises and individuals rose by 7.1 percent during 1995 compared with 8.6 percent during 1994. Over half of the lending to private borrowers in 1995 was for housing loans, the demand for which eased in 1995 because of the phasing out of tax incentives. In addition, consumer credit demand also slackened owing to a gloomier consumption climate. By contrast, the pace of corporate lending nearly doubled, growing by 6 percent during 1995 as more firms resorted to borrowing to finance investment needs because of the limited growth in corporate cash flow. Public borrowing grew at a rapid pace during 1995 (9.5 percent), spurred by Länder government borrowing because of their strained budgetary situation.

During the first quarter of 1996, private sector credit growth has remained strong, with a pickup from domestic enterprises (excluding housing)—8 percent (annual rate) compared with 4 percent during the last quarter of 1995; demand for housing-related loans dropped. Public borrowing also expanded at a considerably faster pace during the January-April period (16 percent at a seasonally adjusted annual rate) compared with 1995.

In a related development concerning government borrowing, on July 17, 1996, the Government issued its first zero-coupon six-month Treasury bill (called Bubills). The issue of Bubills was announced in June as part of a package to enhance Germany’s attractiveness as a financial center (Finanzplatz Deutschland). 1/ Because of past concerns by the Bundesbank regarding the potential conflict between monetary policy actions (that could raise short-term interest rates) and the financing costs of the Government, the total issuance of Bubills will be limited to DM 20 billion, to be issued in quarterly auctions of DM 10 billion. The Government has estimated that even this limited volume of Bubills could save around DM 200 million in annual interest payments (based on interest rates over the past 20 years). 2/ Financial market observers welcomed this move and noted the high demand for government debt in the short-term maturity ranges below four years. However, they have also noted that the small volume of Bubills could work against the creation of a secondary market for Bubills because it was likely that most of the issue would be purchased by central banks and held until maturity.

IV. The Balance of Payments and Trade Policy 1/

During 1995, external developments in Germany were affected by a pronounced appreciation of the nominal effective exchange rate and an economic downturn in many export markets. The long-standing surplus in the trade balance continued to improve, despite a slowdown in export growth, as even weaker import growth resulted from sluggish domestic demand. Moreover, the appreciation in the exchange rate in late 1994 and early 1995 (coupled in 1995 with substantial wage settlements) exacerbated concerns regarding Germany’s competitiveness in its traditional export product markets. Because of the improvement in the trade balance, the current account deficit reduced further in 1995 even though the balance on net investment income deteriorated significantly. The composition of the capital account reflected large net equity outflows, that were more than offset by inflows related to debt transactions.

1. The exchange rate and the current account 2/

Owing in part to unification-related pressures that spilled onto the foreign exchange market, the nominal effective exchange rate appreciated by 5.2 percent between the end of 1990 and the end of 1992. Because Germany’s labor costs were also rising faster than those of its trading partner countries, the real effective exchange rate, based on relative unit labor costs (ULC) in manufacturing, appreciated by 8.6 percent during the same period. However, other indices with a broader coverage of the business sector or based on more general inflation indicators exhibited a smaller loss of competitiveness (about half as large) (Chart IV-1). 1/

CHART IV-1
CHART IV-1

Germany Exchange Rates

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Source: IMF, International Financial Statistics.1/ Shaded area denotes a one standard deviation band for the real effective exchange rate(ulc) from the (1989-95) period averages. The relative weights for the countries shown are: France (.17), the US(.13), Italy (.12), the UK (.11), and Spain (.02).

After a volatile period during 1993 and 1994 which left the nominal effective exchange rate unchanged on average, the deutsche mark rose sharply in value against the major currencies between December 1994 and its peak in April 1995, largely stemming from the weakening of the U.S. dollar from concerns after the collapse of the Mexican peso. During the period December 1994 to April 1995, the deutsche mark appreciated by 5.5 percent in nominal effective terms and by even more against many of the major currencies (14 percent against the U.S. dollar, 20 percent against the Italian lira, and 10 percent against the British pound). 2/ Aided by the lowering of domestic short-term interest rates during 1995 and in early 1996, the deutsche mark has since reversed much of its appreciation during the first half of 1995 (Table IV-1). More generally, despite the nominal depreciation during the first half of 1996, the real effective exchange rate (ULC-based) in June 1996 was still 19 percent above its pre-unification level at the end of December 1989.

Table IV-1.

Recent Exchange Rate Changes with Respect to Germany’s Most Important Trading Partners

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Sources: IMF Information Notice System (INS), IMF International Financial Statistics, and IMF staff calculations.

Competitiveness weights used in INS, and based on Wickham, A Revised Weighting Scheme for Indicators of Effective Exchange Rates, IMF Working Paper WP/87/87, (December 1987). The weights capture the relative importance in German trade of the respective country, as a destination market or supplier, in trade in manufactures and in non-oil primary commodities.

The emergence of current account deficits following unification reflected the diversion of some of west Germany’s net savings to the eastern Länder, increased investment demand in the eastern Länder, and the appreciation of the exchange rate since unification. The large current account surpluses prior to unification (about 4 percent of GDP) precipitously shifted to annual deficits (about 1 percent of GDP) in the post unification period, with small cyclical improvements in 1993 and 1995 (Table IV-2). The main counterparts of the widening current account deficit were sharply higher investment, a deterioration in the public finances, and a steady decline in the household saving rate (from 13.8 percent in 1990 to 11.5 percent in 1995) (Chart IV-2). Continued high investment demands (particularly from east Germany), reduced national savings and the appreciated real exchange rate are the main factors that have thus far impeded the return of Germany to its historical role as a capital exporter.

Table IV-2.

Balance of Payments

(In billions of deutsche mark)

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Source: Deutsche Bundesbank, Monthly Report, Supplement 3.

Merchandise trade data for 1996 are quarterly flows at seasonally adjusted annual rates. Seasonally adjusted data are not available for the other categories.

CHART IV-2
CHART IV-2

Germany Saving-Investment Balance 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Sources: Deutsche Bundesbank and IMF WEO database.1/ Data prior to 1991 are for West Germany only.2/ Current account minus public saving-investment balance.3/ General government balance including Treuhandanstalt borrowing.

Even though a large share of Germany’s exports are specialized capital goods that, in the short run, are less price sensitive than consumption goods, the deterioration in Germany’s competitiveness contributed to the weakening of German export growth in 1995 (export volume growth fell to 3.8 percent in 1995 from 7.5 percent in 1994). 1/ Moreover, preliminary national accounts data for the first quarter indicated real exports declined by 1.7 percent (quarterly rate) and monthly data through March 1996 also show a decline in value terms. On a geographical basis, cyclical slowdowns in Germany’s main export partners may explain some of the decline in export growth in 1995 and the first quarter of 1996; exports to the EU countries (which comprise 57.3 percent of total exports) slowed to 3.3 percent from 9.0 percent in 1994. Export growth to the European countries in transition in 1995 remained as buoyant as in 1994 (about 12 percent), but export growth to the newly industrializing countries in south-east Asia (where German market share is small but growing) fell from 23 percent in 1994 to 13 percent in 1995 owing, in part, to a small reversal in 1995 of the trend depreciation of the deutsche mark against the Japanese yen. Indeed, because the bulk of German exports are capital goods, the strong investment demand in Asia and central and eastern Europe helped keep total exports in 1995 buoyant even as German exports of consumer goods flagged.

Import growth in 1995 and the first quarter of 1996 slowed reflecting the more subdued expansion of domestic demand; real import growth was 2.7 percent in 1995 compared with 7.1 percent in 1994 and import growth was almost nil in the first quarter of 1996. The appreciation of the deutsche mark allowed some foreign suppliers to make inroads into the German market (especially exporters in central and eastern Europe). The slowdown in imports was, however, dominated by the decreased demand for imported raw materials and other intermediate inputs owing to the drop in export volume and in domestic demand.

Continuing the trend since 1991, Germany’s trade surplus has improved steadily; in 1995 the trade surplus was 3.0 percent of GDP, an improvement of ½ percent of GDP from 1994. However, the deficit on nonfactor services was little changed, rising by DM 1 billion to DM 50.3 billion (1.5 percent of GDP) with German travel abroad accounting for almost all of the deficit. 1/ The dwindling surplus on net factor income (comprised of both cross-border labor and investment income) turned into a small deficit (DM 2 billion) in 1995 compared with the DM 8.2 billion surplus in 1994 mainly because of a drop in investment income from abroad (from DM 12.9 billion in 1994 to DM 2.4 billion in 1995). Germany’s positive net financial asset position has eroded in the face of the successive current account deficits since unification. Moreover, the appreciation of the deutsche mark against the U.S. dollar has resulted in revaluation losses (DM 2.6 billion) to the holdings of foreign assets denominated in dollars.

2. Capital account

Despite a resurgence of direct investment inflows, a surge in outflows in 1995 increased the net outflow to DM 37.1 from DM 25.9 billion in 1994. 2/ Net direct investment outflows have taken place for some time and most of the investment outflows have gone to other EU countries (62 percent in 1995) and other industrial countries (22 percent in 1995). The Bundesbank has noted that increased investment abroad occurs for various reasons (including opening new markets and maintaining market share abroad by increasing local representation of German firms) and has been regarded as a natural consequence of increased economic integration. 3/ At the same time, it was noted that the decline in direct investment into Germany has been viewed with some concern to the extent it signals that Germany has less attractive location for production which in turn jeopardizes Germany’s export potential. Export performance in recent years may have been sustained by a squeeze on profit margins in the traded goods sector compared with the non-traded goods sector (Chart IV-3). One consequence of the widening gap between profit margins in the traded and non-traded goods sector is a shift of resources away from traded goods-investment in the traded goods sectors would therefore be diverted abroad. 1/

CHART IV-3
CHART IV-3

Germany Profit Ratios in the Tradeable and Non-Tradeable Sectors

(Index 1991=100)

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Source: Stotistisches Bundesamt, National Income Accounts.1/ Tradeable sector is proxied by the goods producing industries from the national accounts; non-tradeable by the service sector. For each sector the profit ratio is the sector deflator devided by unit labor costs. The latter is gross compensation of employees in the sector divided by gross value added at constant prices.

In contrast with the DM 43.9 billion net outflow of portfolio investments in 1994, there was a net inflow of DM 41.8 billion in 1995. The inflows mainly related to strong demand for German bonds and notes and reflected the strength of the currency despite the decline in long-term interest rates and the elimination of the premium over U.S. securities of comparable maturities that had prevailed since unification. There was also a sizable drop (from DM 22.4 billion to DM 0.8 billion) in German residents’ (purchases of investment fund certificates from) money market funds in Luxembourg as favorable property tax treatment ended for such assets. Other capital flows in 1995 amounted to a DM 51.2 billion inflow or less than half of the amount in 1994. The inflows in 1995 consisted mainly of long-term bank borrowing through foreign offices which contrasted with the predominantly short-term bank credit inflows in 1994. The Bundesbank’s net external position increased by DM 15.0 billion, reflecting mainly U.S. dollar receipts from foreign military agencies and interest earnings on dollar asset holdings. Foreign exchange market intervention in 1995 was relatively minor compared with 1992 and 1993 when foreign exchange markets were more turbulent.

3. Trade policy

The completion of the Uruguay Round and creation of the World Trade Organization (WTO) was welcomed by the German government as the basis for a transparent, open, and comprehensive world trade system and the start of a far-reaching liberalization process. The arrangements achieved included the lowering of tariffs for industrial goods by one third; the German government supported the accelerated implementation of tariff reductions but noted that substantial tariffs still remained for some sectors and suggested that negotiations for further reductions be started. The proposed Singapore conference was viewed as a potential forum for further negotiations in government procurement, accelerated implementation of TRIPS in developing countries, and mutual acceptance of test and certification methods (with attempts to reach multilateral agreements). There would also be opportunities to include new topics in areas where trade policy overlapped with matters related to the environment, investment, and competition.

The German Government acknowledged the benefits of enlarged markets for member countries of the increasing number of regional groupings but considered it essential that these arrangements remain compatible with the multilateral WTO trade system. Regarding the dialogue based on the action plan approved at the U.S.-EU summit in December 1995 in Madrid, negotiations have begun on continued trade liberalization in the following areas: the mutual recognition of standards, tests, and conformity certificates; the reduction of market access barriers in the information technology and telecommunications sector; and a simplification of customs procedures.

The reform of the European agricultural policy in 1992, which provided for a reduction in price subsidies in some product areas and the introduction of direct compensation payments, was regarded by the German Government as a step in the right direction to improve the international competitiveness of European agriculture but further progress is needed. The German Government has not yet arrived at a final position regarding concrete steps for further development of the European agricultural policy, but favors further efforts to improve price competitiveness in world markets without resorting to additional export subsidies. The agreed tariff equivalents for some agricultural sector products are higher than the variable agricultural levies prior to the effective date of the agreements reached by the Uruguay Round, because of the method used to determine the tariff equivalents. 1/

4. Official development assistance and aid to transition economies

Official development assistance (ODA) by Germany totaled DM 10.7 billion in 1995; 3 percent lower than in 1994 (Table IV-3). The ratio of ODA to GNP has declined during the past decade from a high of 0.47 percent in 1985 to 0.31 percent in 1995. Most of this decline took place from the beginning of the 1990s and can be attributed in large part to budgetary pressures related to unification and the increased assistance provided to transition economies, especially Russia. The share of multilateral assistance in total ODA fell to 36 percent in 1995 from 39 percent in 1994, but the grant component in both bilateral and multilateral assistance rose from 77 percent in 1994 to almost 84 percent in 1995.

Table IV-3.

Aid and Other Resource Flows to Developing Countries and Multilateral Agencies 1/

(Net disbursements in millions of DM)

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Source: OECD Development Assistance Committee; Federal Ministry of Finance.

Prior to October 1990, data refer to western Germany only. GDP used for 1990 is a weighted average of western and united German GDP.

From 1989 onward, DAC figures, excluding grants to churches and private agencies.

Primarily grants for financial cooperation, food aid, and humanitarian aid.

Grants given by non-governmental organizations (e.g., churches, societies) from their own funds or donations.

German development assistance is directed toward poverty alleviation, sustainable development (with protection of the environment), and education (particularly basic eduction). However, the primary objective remains poverty alleviation, which is broadly defined and includes the protection of human rights. German development policy recognizes the importance of the development of market-oriented structures, an efficient financial system, and support for entrepreneurial activities in small businesses for promoting economic efficiency.

Germany also continues to provide generous assistance to economies in transition. From 1990 to 1995, the cumulative value of financial support—one third of which was provided in the form of grants—reached DM 159.3 billion (including the German share of assistance provided by the EU) (Table IV-4). About one third of the total was furnished to countries in central and eastern Europe.

Table IV-4.

Support for Economies in Transition, 1990-95

(In billions of DM)

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Source: Data provided by the German authorities.

End-1989 to 1995.

V. Structural Issues

1. The labor market

To further address the problem of high and rising unemployment and to respond to the “Alliance for Jobs” initiative from the metal workers’ union, the Government launched its “Action program for Investment and Growth”—also called the 50-Point Plan—early in 1996.1/ This program is aimed at lowering non-wage labor costs, removing rigidities in the labor market, strengthening job search incentives, and promoting self-employment and innovation. 2/ The basic thrust of these proposed measures is to reform Germany’s Social Market Economy (Soziak Marktwirtschaft) rather than to restructure it radically. A few of the proposals have already been implemented, such as the cuts in unemployment assistance while others are still under consideration in the legislative process and the subject of intense political debate. As of August some of the proposed measures were approved by the Bundestag but rejected by the Bundesrat; the Bundestag can, however, overrule the Bundesrat veto on a number of measures. Other proposals, as the reform of the Employment Promotion Act, have not yet been approved by the Bundestag.

In order to lower non-wage labor costs, the Government has proposed to scale back sick pay paid by the employer and to change the incentive structure. Sick pay adds to relative labor costs because German workers in industry were out sick more days (5½ percent of the work year) than in all other industrial countries accept the Netherlands, partly because of generous benefits. For the first six weeks of sick leave, benefits would be reduced to 80 percent of base salary from the current practice that includes 100 percent of actual pay (including bonuses and overtime). 3/ Furthermore, workers would become eligible for full sick pay only after four weeks of employment compared with immediate eligibility at present. These changes would not initially affect those workers who are covered by collective bargaining agreements, since existing provisions for sick pay will continue to apply. However, such provisions would likely be changed over time to conform with the standard established in the law. Beyond these changes to sick pay, the maximum frequency of spa/sanatorium visits would be reduced to every fourth year from every third year and their length would be shortened from four weeks to three weeks. The costs of the spa visits are paid by health insurance and pension funds while the worker continues to receive normal wages. 1/

Relatively extensive legal employment protection and uncertainties regarding the courts’ interpretation of the relevant legislation have raised the costs of firing workers and contributed to heavy use of overtime. To encourage new hiring, the Government has proposed to extend the maximum duration of fixed-term job contracts from 18 months (24 months in small new enterprises) to a uniform 24 months with the possibility of three renewals. Employees over age 60 would be exempted from any duration limit. Furthermore, companies with fewer than 10 employees (previously 5 employees) would be exempted from dismissal rules with a three year transition period for workers currently employed. The criteria for interpreting social responsibility provisions in mass layoffs would be made more specific and limited to tenure, age and family income and size, thus narrowing the courts’ discretion in interpreting the criteria. 2/

Some proposals, that have not yet been approved by the Bundestag, seek to facilitate part-time work and to promote the hiring of the unemployed, particularly the long-term unemployed; regulations would be simplified and tax incentives would be enhanced, For example, the maximum deduction from taxable income for employment in two-earner private households would be doubled to DM 24,000 to encourage (part-time) employment in private households. 3/ To mate part-time work more attractive, the threshold for coverage of the unemployment insurance system would be changed from 18 hours of work per week (Kurzzeitigkeitsgrenze) to the minimum income level of DM 590 per month (Geringfügigkeitsgrenze) applied by other social security funds. To promote hiring of unemployed persons, a firm would not be obliged to pay sick pay and a previously longterm unemployed person would not be covered by the dismissal protection law for the first six months of a job contract. Furthermore, public support for those unemployed who become self-employed and for newly established firms that hire unemployed workers will increase.

Previous reports have pointed to weak incentives for job search as a serious problem in the German labor market. 4/ A proposal to shorten the indefinite duration of unemployment assistance to two years failed in Parliament in 1995; no limitation on duration was proposed in 1996. However, to strengthen incentives for job search, other changes have already been implemented. The income base (after indexation) for calculating unemployment assistance will be reduced by 3 percent every year. 1/ Social assistance benefits will be lowered to ease unemployment traps and reduced by 25 percent in cases where acceptable work is rejected. In addition, to strengthen job search incentives, the Government lias proposed—but it has not yet been discussed in the Bundestag—that severance pay be credited against half of unemployment compensation after exclusion of 25 percent of the severance pay; the excluded share would increase by age and tenure.

The Government has also proposed measures to combat abuse. Training measures would be introduced to make it easier to test the recipients’ ability and willingness to work. Internal reviews in the employment offices would examine in detail whether benefits should be granted or whether benefits could have been utilized more effectively. To reduce the potential for manipulating the earnings base, the calculation of unemployment compensation would henceforth be based on earnings received during the preceding 12 months (up from six months). The criteria for acceptability of a job offer by a recipient of unemployment benefits would be tightened. A job offer could no longer be rejected without a loss of unemployment compensation if the distance to the workplace is less than three hours (currently 2½ hours), and over-qualification would no longer be accepted as a reason for job rejection. The income thresholds for acceptable jobs also would be lowered.

The Government has proposed some tightening of the eligibility criteria for unemployment benefits. The minimum age for receiving unemployment benefits for more than one year would be raised from 42 years to 45 years. The sliding benefit duration scale would be shifted accordingly such that a 45-year-old would receive unemployment benefits for 18 months increasing to 32 months for a 57-year-old; the length of previous work is also taken into consideration. Unemployed persons would no longer be able to qualify for successive periods of unemployment benefits by participating in active labor market programs within their own profession.

As regards active labor market policies (ALMP), the Government has proposed to put more emphasis on job brokering and reintegration of the unemployed into the labor market. This increased emphasis is needed because only 28 percent of all hires in west Germany were arranged by the Labor Office (44 percent in east Germany). Active labor market policies in Germany have also been relatively expensive; outlays per person for ALMPs has been above the level of unemployment benefits. Moreover, ALMPs seem to be relatively unsuccessful in achieving a lasting reduction in unemployment and reintegration into the labor market. Most studies indicate that only about 30 percent of participants in these ALMP programs found regular work at the end of their course because these programs are not well tuned to the interests and skills of the participants and the needs of employers. Thus, spending decisions within the Federal Labor Office (FLO) would be decentralized, enabling local labor offices to respond more effectively to local needs. To improve job prospects and to lessen long-term unemployment, the FLO would be obliged, within the first six months of unemployment to offer the recipient job counseling. Since 1994, the job brokering monopoly of the FLO was terminated and other firms have entered into operation. It is now proposed that the remaining FLO monopoly on placement in occupational training come to an end.

2. Deregulation

In conjunction with reforms to the labor market, liberalization in product markets has been undertaken as part of the “Standort Deutschland” initiative to enhance the attractiveness of Germany as a place of business. 1/ The 50-Point Plan also contains proposals to address structural weaknesses in the German economy and enhance its adaptability to the globalization of trade and production and increased competition from emerging economies. Some, albeit insufficient, progress was made in these areas during the past year. In June, the Bundestag approved a controversial extension of shop opening hours, allowing retail shops to remain open an additional 8½ hours per week beginning in November. A report by the Ifo Institute, commissioned by the Government, indicated that retail turnover and employment would increase by 2-3 percent and about 50,000 persons respectively. 2/ This change has been considered a litmus test for Germany’s willingness to liberalize its economy.

New simplified procedures to accelerate the planning and authorization process for construction and related activities were implemented in 1996. 3/ The new procedures among other things allows enterprises to proceed with projects after a shortened approval process, but some legal uncertainties remain. Companies still complained about the nine to fifteen months necessary to obtain a building permit and the strenuous building codes; a number of studies have shown that changes in these areas could reduce building costs in Germany by up to 40 percent. 4/

The Government is working on new cartel legislation to harmonize national cartel laws with EU directives. Under the new legislation the energy, telecommunications, transport, banking, and insurance sectors would lose their present protection from competition from other suppliers and new entrants. The recent EU agreement on a liberalization of cross border electricity markets within Europe also clears the way for domestic reforms to enhance competition within Germany, which up until now has been limited. Electric companies, and more broadly public utilities, have been protected from competition by local exclusivity clauses and the regional segmentation between electricity producers. 1/ Concession fees have been an important revenue source for some local governments, therefore, prices for electricity and natural gas in Germany have been above the EU average and much higher than in the United States and Canada. Such practices will be made illegal.

Further progress was also made toward opening up the market for telecommunication services and preparing for the partial privatization of Deutsche Telekom AG. In July 1996, the Parliament passed a law ending—effective January 1, 1998—the current monopoly on telecommunications services, liberalizing service and allowing foreign access. Some issues related to supervision and anti-monopoly control remain unresolved, particularly at the local level.

Regarding financial markets, the Government has unveiled plans to promote their efficiency and competitiveness, with the objective of enhancing Germany’s attractiveness as a financial center (Finanzplatz Deutschland). 2/ The Third Financial Markets Promotion Law, which was expected by the authorities to be approved by Parliament in 1996, is aimed at further encouraging equity investment in Germany, particularly venture capital, and reforming the stock market in order to invite broader participation of institutional shareholders. Publicly quoted companies would be allowed to buy back up to 10 percent of their capital. Insurance companies would be allowed to invest more in the stock market, and mutual funds and investment holding companies would be granted more investment opportunities.

3. Privatization

The authorities regard privatization as a key element in their strategy to reduce the role of the state and to enhance economic efficiency. In principle, the Government aims at a wide political consensus and considers a policy of gradual privatization as advantageous both for the private investors and current stake holders, including employees. Privatization is also seen as strengthening Germany as a financial center (Finanzplatz Deutschland). But unlike the 1960s, when share issues in government-owned companies were used to actively promote share ownership by private households (as by the Volksaktie programs), recent privatizations have been conducted on the open market without special incentives to spread household share ownership. Nonetheless it is expected that in particular the equity issue by Deutsche Telekom will stir interest by the general public.

During the second phase of privatization (1982-95), the Federal Government withdrew from all of its industrial holdings, with the exception of Saarbergwerke AG (mining), and privatized fully a number of banks (Berliner Industriebank AG, Deutsche Pfandbrief- und Hypothekenbank AG, and Staatsbank Berlin). 1/ Privatizations that were concluded in 1995 include Bayerischer Lloyd (insurance), Rhein-Main-Donau AG and Neckar AG (companies to improve the waterways). As a result, the number of firms (fully or partially) owned by the federal government dropped from 956 in 1982 to about 400 in 1995 and privatization receipts amounted to DM 13.2 billion.

In 1996, an ambitious privatization program is under way that is expected to yield about DM 9 billion. It includes some large-scale projects, such as the sale of the federal stakes in two housing companies (DM 4 billion), the partial privatization of the Postbank (DM 3.2 billion), and a further reduction in the government’s stake in Deutsche Lufthansa (DM 1.7 billion). 2/ The huge new share issue by Deutsche Telekom, which is scheduled for this fall and would be the largest equity issue on the German stock market, will not yield revenue for the budget, instead its proceeds will be used to augment Telekom’s equity base. 3/ Other projects slated for (partial) privatization in 1996 include Saarbergwerke AG (mining), the Bundesanzeiger Publishing Company, and the Autobahn Tank & Rast AG (autobahn rest stops).

In 1997, it is envisaged that the Lufthansa privatization will be completed and the sale of some smaller state holdings will be started. Over the medium term, the emphasis of privatization is expected to shift further to functions that have traditionally been in the public sector. These would include airport companies (in particular in Cologne and Hamburg) and the successor agencies of the Post Office (the Postbank and the Postal Service) as well as parts of the railways. 1/

The largest potential for privatization exists at the level of the Länder and local authorities. Länder ownership remains concentrated in regional utilities, housing, and hospitals, but also in banking and insurance. Some Länder have made significant progress in recent years; the State of Bavaria has obtained DM 5.3 billion from the privatization of companies such as Bayernwerk (utilities) and Dasa (aerospace). The potential for privatization at the local level lies mainly in utilities and local mass transport as well as in the savings bank sector. Initiatives by the federal government to coordinate privatization efforts at the federal, state, and local level have, however, stalled.

4. Developments in the new Länder

Some six years have passed since unification and despite considerable progress, self-sustaining growth in the new Länder has not been achieved. 2/ While nominal convergence has largely been completed—inflation in the new Länder was only slightly higher than that in the old Länder during 1995 and 1996, real convergence or the “catching-up” process with the western Länder has slowed considerably; real growth in the new and old Länder has become more synchronized and the cyclical sensitivity of the new Länder has apparently increased (see Chapter I for details). 3/ Nonetheless, the gap between east and west remains large; nominal GDP per capita in the new Länder was only 52 percent of that in the old Länder in 1995. Moreover, the new Länder remain highly dependent on transfers from the old Länder (see below).

The convergence of wages in the east to those in the west—driven by social concerns and pressure from labor unions—has far outstripped the convergence of productivity. Average unit labor costs in 1995 were significantly higher in the new Länder than in the old Länder and their convergence has stalled. The resultant pressure on profits of firms in east Germany has constituted the major obstacle to self-sustaining growth and has traded to increase layoffs. Although the difference between the annual average unemployment rates in the new and old Länder narrowed from 1991 to 1995, this differential widened in late 1995 and early 1996.

The industrial base in the east has also been eroded. The share of manufacturing in the gross value added of east Germany slipped to about 15 percent in 1995 from 18 percent in 1994 and 53 percent in 1989 (including mining) compared with nearly 27 percent in west Germany in 1995. The economic viability of these firms is also questionable owing to a lack of equity capital and competitive products; business insolvencies have risen continually since 1991 and jumped from 3900 in 1994 to almost 5900 in 1995. According to a survey conducted by the Deutsche Bundesbank (July 1995), the average ratio of equity to total liabilities was less than three quarters of that in the west. The export share of the manufacturing sector in east Germany in 1995 was only 40 percent of manufacturing’s export share in west Germany, indicating firms in the new Länder are not able to compete in terms of price and quality.

a. Wage developments and cost competitiveness

Negotiated hourly wages for the producing sector and the whole economy in the new Länder increased by 150 percent during 1991-94 compared with wage increases of just over 20 percent in the producing sector of the old Länder during the same period. As a result (see Chapter I), nominal tariff wages in the eastern Länder rose to about 15 percent below the level of wages in the western Länder in 1995.

Unit labor costs (ULC), measured as labor costs per employee divided by real GDP per employed person are normally used to assess cost competitiveness. In 1991 ULC in the new Länder were about 50 percent higher than ULC in the old Länder. Subsequently, as wage growth outstripped productivity growth, ULC in the new Länder increased faster than in the old Länder widening the gap to some 70 percent by early 1996. However, the Bundesbank has used an alternative measure of labor competitiveness which might be called “nominal ULC” to compare the new and the old Länders. It is defined as labor costs per employee divided by nominal GDP per employed person. In support of using this “nominal ULC” concept as a gauge for labor competitiveness, it has been argued that the distorted price structure in the east before unification included many below-market prices. Therefore, (with the equalization of prices in the east with those in the west subsequent to unification), firms in the east had scope to pass through increases in labor costs onto prices. In this case the use of the traditional ULC measure could overstate the loss in labor competitiveness. While this argument may be true for nontraded goods that had below-market prices, the “nominal ULC” measure would not apply for the traded-goods sectors. Moreover, it is questionable whether a ULC concept that uses nominal turnover or nominal GDP in place of a measure of output to scale labor costs has any relation to labor competitiveness: “nominal ULC” could increase or decrease because of changes in aggregate demand induced by changes in transfer payments, for example.

Even using the “nominal ULC” measure, labor costs were about 35 percent higher in the new Länder compared with the old Länder in early 1996. After some convergence during the first years following unification (largely because of the higher inflation in east Germany) the gap has widened again since 1994 as productivity gains in the new Länder declined to nearly the rate of increase in the old Länder while wage increases remained well above. For the producing sector, the differential was lower (below 20 percent) because of relatively stronger productivity growth in that sector in the east.

Associated with these rapid increases in wages and productivity was substantial employment shedding in the new Länder, particularly in the producing sector, and a sharp rise in the unemployment rate in the new Länder. Employment in east Germany fell by 37 percent from early 1989 to its trough in the first half of 1993 and the unemployment rate rose from near zero in 1989 to 15 percent in 1993 in spite of significant emigration and a decline in the labor force participation rate by 15 percentage points. Employment in the new Länder has increased since mid 1993 and the unemployment rate dipped before rising again (see Chapter I for details). The high unemployment rate is indicative of a nonmarket-clearing wage rate.

b. Capital formation

Public support of investment in east Germany in the form of direct subsidies and tax relief has been considerable. In addition to investment transfers, there has been a substantial program of publicly subsidized credit for financing investment. This investment support by the federal and local government expenditures has been a major factor behind the investment boom in east Germany. Tax expenditure (mainly through investment subsidies and special depreciation allowances), related to investment in east Germany amounted to DM 14 billion in 1995, an increase of 40 percent from the previous year. 1/

The Bundesbank has estimated that productive assets (excluding housing) in eastern Germany have grown at a rapid pace since unification: with the capital stock estimated to be DM 855 billion (in constant 1991 prices) in 1995, these assets rose at three times the pace of the capital stock in west Germany. However, much of the capital stock in east Germany inherited from the pre-unification period proved to be obsolete and was scrapped (Chart V-1). The Bundesbank has estimated that real gross capital formation since unification has replaced more than half of the productive assets in the corporate sector in east Germany (the comparable replacement ratio in west Germany was about one-quarter). 2/ Thus, the productive assets in the new Länder are significantly more modern than their counterparts in the old Länder.

CHART V-1
CHART V-1

East Germany Gross Capital Stock 1/

Citation: IMF Staff Country Reports 1996, 111; 10.5089/9781451810301.002.A001

Source: Deutsche Bundesbank, Annual Report 1995.1/ Enterprises excluding housing.

The capital-labor ratio in the new Länder increased sharply from 1990 to 1995, owing almost equally to the higher capital stock and the decline in employment (of more than 25 percent). Capital par worker in the enterprise sector of east Germany increased by almost two thirds from 1991 to 1995, thereby climbing from 48 to 67 percent of the level in west Germany. Consequently, the amount of capital needed to create one job is estimated to have almost doubled since 1991 to DM 200 thousand in current prices in 1995. This increase in capital intensity reflected, in part, substitution of capital for labor stemming from a rise in relative unit labor costs and the subsidies given for investment. 1/

These developments have given rise to fears that the Mezzogiorno problem of Italy might take root in Germany. Many observers have focused on the adverse implications of extending to the eastern Länder the wage bargaining and social benefit system of the western Länder. 2/ In negotiating industry-wide wage rates unions have pushed up wages in the east closer to those in the west, fostering more unemployment in the east. Moreover, with unemployment compensation and assistance practices of the western Länder applied to the east (added to attractive early retirement provisions for the public pension system), the state provided generous income support, which maintained a high reservation wage in the east. In addition, to spur the integration of the new Länder and increase output in the east, labor productivity was raised by promoting investment through capital subsidies. This succeeded in achieving a rapid increase in the capital stock, but since the subsidies supported the use of capital (and wages were high relative to productivity), capital was also substituted for labor in production processes. Thus factor price distortions must be seen as fundamental to the slow convergence process, the high level of structural unemployment, and the enormous fiscal costs associated with integration of the new Länder.

c. Official transfers to cast Germany

In 1995, net official transfers to the eastern Länder (DM 148 billion) represented almost 5 percent of west German GDP and 40 percent of east German GDP (Table V-1). Indeed, total net transfers were substantially higher, because a significant part of private investment flows were induced by tax incentives. 1/ As a share of GDP, net official transfers have dropped significantly in recent years. This trend is expected to continue as government policy is aimed at reducing official transfers to prevent them from becoming entrenched in the new Länder. Although it is difficult to separate those transfers that are geared solely to supporting the economic integration of the eastern Länder and those that stem from the application of uniform rules and regulations in all of Germany, at least DM 60 billion (or one third of gross official transfers, excluding transport and housing investment) appear to be due to special rules that apply to the new Länder only.

Table V-1.

Official Transfers to the New Länder

(In billions of DM)

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Source: Federal Ministry of Economics, Wirtschaftsdaten Neue Länder, April 1996.

Official projections.

The downward trend in total net transfers since 1993, which reflects declining gross transfers and higher tax revenues in the eastern Länder (up almost 8 percent in 1995) from the secular improvement in economic conditions, masks some divergent developments among the individual components. While net transfers by the Federal Labor Office have been roughly steady as unemployment has remained high, net pension expenditures have expanded rapidly as pension benefits converged to levels in west Germany. More importantly, whereas Treuhandanstalt transfers were eliminated in 1995, transfers from the federal budget have risen sharply because of the new revenue sharing and financial equalization scheme (Finanzausgleich) among the various levels of government. In 1995, total transfers from the federal government to the new Länder budgets surged by DM 22 billion. In 1994, the eastern Länder had received transfers of DM 24.5 billion from the German Unity Fund (which ceased operation at end-1994) in addition to direct transfers from the western Länder of DM 14 billion. As part of the new financial equalization scheme, in 1995 the new Länder received slightly lower transfers from the old Länder (DM 10 billion), but benefitted from special transfers from the federal government (DM 18.4 billion). Together with their VAT share, the new Länder received revenue transfers of about DM 44.9 billion in 1995, or almost 6½ billion more than in 1994. 2/

About one third of gross transfers to the new Länder in 1995 supported investment. The main instruments to promote private investment in eastern Germany were set to expire in 1996, but the 1996 Annual Tax Act contained provisions that extended most of them until 1998—albeit in modified and in most cases reduced form (Table V-2). The modifications to the most important incentives—special depreciation allowances and investment subsidies—were designed to refocus the investment incentives on small and medium-size firms mainly in manufacturing to build up the still-small industrial base in the new Under. Specifically, the special depreciation allowances (Sonderabschreibungen), which grant a 50 percent write-off in addition to the linear depreciation in the first five years, will be reduced from 1997 onward to 40 percent in manufacturing (both on machinery and equipment as well as building investment), while in other sectors a 20 percent rate would apply to commercial buildings, and 25 percent rate to private rental units. The basic investment subsidy (Investitionszulage) was also extended through 1998 but was reduced from 10 percent to 5 percent and restricted to manufacturing. Small and medium-size firms, continue to be eligible for a 10 percent subsidy. In 1996, both the special depreciation allowances and the basic investment subsidy were extended to small and medium-size manufacturing firms in west Berlin. As a new measure, inner-city retail and wholesale businesses with fewer man 50 employees can receive a 10 percent investment subsidy. Concerning tax changes, the wealth tax will continue not to be levied in the new Länder through 1998, while the exemption from the local trading tax was extended through 1996.

Table V-2.

Official Transfers to Enterprises in the New Länder

(In billions of DM)

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Source: Federal Ministry of Economics, Aufbau Ost, September 1995.