Front Matter Page

© 1997 International Monetary Fund

October 1997

IMF Staff Country Report No. 97/101

Germany—Selected Issues

This selected issues report on Germany was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with this member country. As such, the views expressed in this document are those of the staff team and do not necessarily reflect the views of the Government of Germany or the Executive Board of the IMF.

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Front Matter Page

INTERNATIONAL MONETARY FUND

GERMANY

Selected Issues

Prepared by G. Russell Kincaid, William Lee, Albert Jaeger, Burkhard Drees, Wolfgang Merz, Victor Valdivia (all EU1), and Hamid Faruqee (RES)

Approved by European I Department

August 8, 1997

Contents

• Basic Data

• Introduction

• I. Labor Market Asymmetries and Macroeconomic Adjustment

  • A. Introduction and Overview

  • B. Unemployment Developments and Alternative Explanations

  • C. Analytical Framework: The Wage-Price Mechanism

  • D. Estimation

  • E. Dynamic Simulations and Policy Scenarios

  • F. Multi-Country Simulations

  • Annex: Illustrative Model

• Text Tables

• I-1. (Convex) Phillips Curve Estimates, 1970-95

• I-2. (Convex) Phillips Curve Estimates, 1970-95

• I-3. Germany: Asymmetric Effects of a Change in Money Supply

• I-4. Germany: Comparative Effects of a Demand Disturbance under Alternative Policy Regimes

• Annex Tables

• I-A1. Summary Statistics 1970-95

• I-A2. Alternative (Convex) Phillips Curve Estimates

• Charts

• I-1. West Germany: Unemployment Rate

• 1-2. Germany: Convex Phillips Curve

• 1-3. Germany: Linear versus Convex Model

• 1-4. Germany: Unemployment Developments, 1960-95

• 1-5. Germany: Phillips Curve Estimates, 1995

• 1-6. Germany: Phillips Curve Estimates, 1995

• Annex Charts

• I-A1. Germany: Alternative Convex Models

APPENDIX I Germany: Basic Data

^1/Change as percent of previous year’s GDP.

^2/Deflated by the national accounts deflator for private consumption.

Area and population
Total area			357,041 square kilometers
Total population (1996)			82.3 million
GDP per capita (US dollar)			30.1 thousand
Germany			1993	1994	1995	1996
			(Percentage changes at 1991 prices)
Demand and supply
Private consumption			0.3	1.0	1.8	1.3
Public consumption			-0.0	1.3	2.0	2.4
Gross fixed investment			-5.6	4.2	1.5	-0.8
	Construction		0.9	7.7	1.2	-2.7
	Machinery and equipment		-14.1	-1.2	2.0	2.4
Inventory accumulation 1/			-0.2	1.0	0.3	-0.3
Total domestic demand			-1.3	2.8	2.1	0.8
Exports of goods and
	nonfactor services		-4.9	8.0	5.9	4.9
Imports of goods and
	nonfactor services		-5.7	7.6	6.4	2.6
		Foreign balance 1/	0.2	0.1	-0.1	0.6
GDP			-1.1	2.9	1.9	1.4
	Western		-1.9	2.2	1.6	1.3
	Eastern		8.9	9.9	5.3	2.0
			(In millions)
Employment and unemployment
Labor force			38.6	38.7	38.5	38.5
Employment			35.2	35.0	34.9	34.6
Unemployed			3.4	3.7	3.6	4.0
In percent of labor force			8.9	9.6	9.4	10.3
	Western		7.4	8.2	8.3	9.1
	Eastern		15.1	15.1	14.1	16.5
			(Percentage change)
Prices and incomes
GDP deflator			3.9	2.2	2.2	1.0
Consumer price index			4.5	2.7	1.8	1.5
	Western		3.6	2.6	1.8	1.4
	Eastern		10.5	3.6	2.1	2.3
Average hourly earnings (industry)			6.6	1.8	4.2	4.5
Unit labor costs (total economy)			3.6	-0.1	1.3	-0.0
Real disposable income 2/			-0.5	0.4	1.7	1.4
Personal saving ratio (In percent)			12.2	11.7	11.6	11.6

^1/Change as percent of previous year’s GDP.

^2/Deflated by the national accounts deflator for private consumption.

View Table

Area and population
Total area			357,041 square kilometers
Total population (1996)			82.3 million
GDP per capita (US dollar)			30.1 thousand
Germany			1993	1994	1995	1996
			(Percentage changes at 1991 prices)
Demand and supply
Private consumption			0.3	1.0	1.8	1.3
Public consumption			-0.0	1.3	2.0	2.4
Gross fixed investment			-5.6	4.2	1.5	-0.8
	Construction		0.9	7.7	1.2	-2.7
	Machinery and equipment		-14.1	-1.2	2.0	2.4
Inventory accumulation 1/			-0.2	1.0	0.3	-0.3
Total domestic demand			-1.3	2.8	2.1	0.8
Exports of goods and
	nonfactor services		-4.9	8.0	5.9	4.9
Imports of goods and
	nonfactor services		-5.7	7.6	6.4	2.6
		Foreign balance 1/	0.2	0.1	-0.1	0.6
GDP			-1.1	2.9	1.9	1.4
	Western		-1.9	2.2	1.6	1.3
	Eastern		8.9	9.9	5.3	2.0
			(In millions)
Employment and unemployment
Labor force			38.6	38.7	38.5	38.5
Employment			35.2	35.0	34.9	34.6
Unemployed			3.4	3.7	3.6	4.0
In percent of labor force			8.9	9.6	9.4	10.3
	Western		7.4	8.2	8.3	9.1
	Eastern		15.1	15.1	14.1	16.5
			(Percentage change)
Prices and incomes
GDP deflator			3.9	2.2	2.2	1.0
Consumer price index			4.5	2.7	1.8	1.5
	Western		3.6	2.6	1.8	1.4
	Eastern		10.5	3.6	2.1	2.3
Average hourly earnings (industry)			6.6	1.8	4.2	4.5
Unit labor costs (total economy)			3.6	-0.1	1.3	-0.0
Real disposable income 2/			-0.5	0.4	1.7	1.4
Personal saving ratio (In percent)			12.2	11.7	11.6	11.6

^1/Change as percent of previous year’s GDP.

^2/Deflated by the national accounts deflator for private consumption.

Germany: Basic Data (concluded)

^1/Data for the federal government and the territorial authorities are on an administrative basis. Data for the general government are on a national accounts basis. In recent years, a persistent difference between the general government deficit on a national accounts and on an administrative basis has mainly reflected sizable net lending to support reconstruction in eastern Germany. Debt data are end-of-year data for the territorial authorities, including the German Unity Fund and eastern Germany from 1990.

^2/Including supplementary trade items.

Germany: Basic Data (concluded)

Germany				1993	1994	1995	1996
				(In billions of deutsche marks)
Public finances 1/
General government
	Expenditure			1,599	1,662	1,751	1,770
	Revenue			1,489	1,582	1,628	1,644
		Financial balance		-110	-81	-123	-126
			(In percent of GDP)	-3.5	-2.4	-3.5	-3.6
Deficit of the territorial authorities				-138	-116	-111	-120
			(In percent of GDP)	-4.4	-3.5	-3.2	-3.4
Borrowing requirement of the Treuhand				38.0	37.0	--	--
Federal government
	Financial balance			-67	-51	-51	-79
		(In percent of GDP)		-2.1	-1.5	-1.5	-2.2
General government debt				1,522	1,675	2,008	2,149
	(In percent of GDP)			48.2	50.4	58.1	60.7
Balance of payments
Trade balance (f.o.b./f.o.b.) 2/				65.7	81.4	105.0	123.8
Services balance				-52.1	-62.9	-69.8	-70.2
Net private transfers				-42.8	-46.4	-42.1	-37.8
Net official transfers				-42.8	-46.4	-42.1	-37.8
	Current account			-22.4	-31.9	-30.1	-26.5
		(In percent of GDP)		-0.7	-1.0	-0.9	-0.7
Foreign exchange reserves (e.o.p)				120.1	113.6	121.3	119.5
				(Percentage changes in annual averages)
Monetary data
Money and quasi-money (M3)				8.2	8.5	0.1	7.3
Domestic bank lending				9.8	9.5	7.3	7.8
	Of which lending to:
		Public authorities		18.6	10.9	15.7	10.7
		Private nonbanks		7.5	9.1	4.9	7.0
				(Period averages in percent)
Interest rates
Three-month interbank rate				7.2	5.3	4.5	3.3
Yield on ten-year government bonds				6.5	6.8	6.8	6.2
				(Levels)
Exchange rates
DM per US$ (end of period)				1.73	1.55	1.43	1.55
DM per US$ (annual average)				1.65	1.62	1.43	1.50
Nominal effective rate (1990=100)				106.2	106.4	112.2	108.7
Real effective rate (ULC) (1990=100)				109.3	111.9	120.9	119.4

^1/Data for the federal government and the territorial authorities are on an administrative basis. Data for the general government are on a national accounts basis. In recent years, a persistent difference between the general government deficit on a national accounts and on an administrative basis has mainly reflected sizable net lending to support reconstruction in eastern Germany. Debt data are end-of-year data for the territorial authorities, including the German Unity Fund and eastern Germany from 1990.

^2/Including supplementary trade items.

View Table

Germany: Basic Data (concluded)

Germany				1993	1994	1995	1996
				(In billions of deutsche marks)
Public finances 1/
General government
	Expenditure			1,599	1,662	1,751	1,770
	Revenue			1,489	1,582	1,628	1,644
		Financial balance		-110	-81	-123	-126
			(In percent of GDP)	-3.5	-2.4	-3.5	-3.6
Deficit of the territorial authorities				-138	-116	-111	-120
			(In percent of GDP)	-4.4	-3.5	-3.2	-3.4
Borrowing requirement of the Treuhand				38.0	37.0	--	--
Federal government
	Financial balance			-67	-51	-51	-79
		(In percent of GDP)		-2.1	-1.5	-1.5	-2.2
General government debt				1,522	1,675	2,008	2,149
	(In percent of GDP)			48.2	50.4	58.1	60.7
Balance of payments
Trade balance (f.o.b./f.o.b.) 2/				65.7	81.4	105.0	123.8
Services balance				-52.1	-62.9	-69.8	-70.2
Net private transfers				-42.8	-46.4	-42.1	-37.8
Net official transfers				-42.8	-46.4	-42.1	-37.8
	Current account			-22.4	-31.9	-30.1	-26.5
		(In percent of GDP)		-0.7	-1.0	-0.9	-0.7
Foreign exchange reserves (e.o.p)				120.1	113.6	121.3	119.5
				(Percentage changes in annual averages)
Monetary data
Money and quasi-money (M3)				8.2	8.5	0.1	7.3
Domestic bank lending				9.8	9.5	7.3	7.8
	Of which lending to:
		Public authorities		18.6	10.9	15.7	10.7
		Private nonbanks		7.5	9.1	4.9	7.0
				(Period averages in percent)
Interest rates
Three-month interbank rate				7.2	5.3	4.5	3.3
Yield on ten-year government bonds				6.5	6.8	6.8	6.2
				(Levels)
Exchange rates
DM per US$ (end of period)				1.73	1.55	1.43	1.55
DM per US$ (annual average)				1.65	1.62	1.43	1.50
Nominal effective rate (1990=100)				106.2	106.4	112.2	108.7
Real effective rate (ULC) (1990=100)				109.3	111.9	120.9	119.4

^1/Data for the federal government and the territorial authorities are on an administrative basis. Data for the general government are on a national accounts basis. In recent years, a persistent difference between the general government deficit on a national accounts and on an administrative basis has mainly reflected sizable net lending to support reconstruction in eastern Germany. Debt data are end-of-year data for the territorial authorities, including the German Unity Fund and eastern Germany from 1990.

^2/Including supplementary trade items.

Introduction

1. Economic recoveries in Germany have become less robust in the postwar period, owing to structural rigidities. The effect of these rigidities has been slower real growth and higher rates of unemployment.¹ In the 1990s, a phenomenon of “jobless” growth has emerged that has yielded record unemployment rates in 1996-97. From 1991 to mid-1997, the cumulative employment decline in Germany was about 6 percent even though output expanded by about 8½ percent. Relatively high labor costs in Germany—due to both high wages and the tax wedge (i.e., income taxes and contribution rates)—coupled with strong trade unions that largely shifted these costs to producers, have caused real growth to become less employment intensive.²

2. The very high tax and contribution rates have not only reduced real growth but they have also worsened fiscal performance and thereby jeopardized the achievement of the Government’s fiscal objectives. In particular, the resulting high level of unemployment has increased public spending on unemployment benefits and eroded general government revenues by weakening wage income growth. The following chapters examine the economic and policy implications of these structural problems.

3. Labor market rigidities, including the wage and price setting process, are at the root of Germany’s most pressing problem—the high level of unemployment. Empirical work reported in Chapter I shows that in Germany, negative demand shocks increase the unemployment rate by more than the decrease in the unemployment rate caused by a comparable-sized positive demand shock; this phenomenon is attributed to the operation of an asymmetric wage-price mechanism (or convex Phillips curve). Over the business cycle, the average rate of unemployment would be higher in the presence of these asymmetries. Based on international comparisons, Germany has the highest degree of asymmetry and also had the largest increase in the structural rate of unemployment over the past quarter century. These asymmetries also hamper the economy’s ability to respond flexibly to shocks and thus increase the burden on stabilization policies. Moreover, the relatively unfavorable wage-price tradeoff in Germany implies that demand shocks common to all ERM/EMU participants would have more adverse unemployment consequences for Germany than for its partner countries.

4. The contribution of labor costs to explaining the high level of unemployment, particularly since unification, is studied in Chapter II. Empirical estimates are obtained for the wage gap—the deviation of actual labor costs from warranted labor costs based on estimated production functions assuming competitive factor markets and full employment. Since unification, the “wage gap” for unified Germany is estimated to have risen to about 20 percent. Although the wage gap in the new Länder is very large, a wage gap in the old Länder of about 10 percent in 1994 also existed. A positive correlation was also detected between the rate of unemployment and the estimated wage gap, the output gap was negatively correlated with the unemployment rate. Based on these findings, closing the wage gap would reduce the unemployment rate by approximately 6½ percentage points; closing the output gap would decrease the unemployment rate by about 1¼ percentage points. These findings point to the critical importance of wage moderation and growth-oriented policies for reducing the high level of unemployment.

5. Chapter III examines the convergence process in the new Länder and the structural problems that have slowed that process almost to a standstill in recent years. The principal problem has been the rapid convergence of nominal wages in the east to the level in the west—driven mainly by social concerns and pressure from trade unions rather than by productivity gains. Consequently, unit labor costs in the east have been at least one third higher than those in the west during 1994-96. The resultant squeeze on profits of firms in the eastern Länder has constituted the major obstacle to self-sustaining growth and has tended to increase labor retrenchment to boost productivity. The registered unemployment rate in the new Länder was above 17 percent in mid-1997 with underemployment reaching close to 25 percent. Spending exceeded production in the new Länder—effectively a current account deficit—by more than 50 percent of eastern Germany’s GDP during 1994-96 and this deficit was financed mainly by official transfers. Simulations suggest that based on the pace experienced during 1991-96, output convergence would require at least an additional 20 years. Improving labor market flexibility and slowing the convergence of nominal wages would help foster self-sustained growth financed by the private sector and would avoid a protracted mezzogiorno problem.

6. The structural problems underlying the poor economic performance identified in the three previous chapters can be alleviated, inter alia, through tax policy and the reduction of pension contributions rates.³ Chapter IV examines the weaknesses in the German income tax code. By international standards, the tax burden on labor income in Germany is high and effective capital and corporate income tax rates are low, adding to the incentives to adopt labor-saving production processes. A myriad of exemptions and allowances (particularly in the post-unification period) has made the tax code less transparent and less equitable, eroded tax yields, and complicated the conduct of fiscal policy by making revenue projections less reliable. The Government’s proposed income tax reform—which would lower marginal tax rates for personal and corporate income and scale back allowances and exemptions to broaden the tax base—is described in detail and its implications analyzed. Overall, this proposal represents a step in the right direction.

7. A pension reform has also been put forward by the Government to slow the increase in pension contribution rates (largely by reducing benefits) and thereby enhance the cost competitiveness of German labor. The proposed piecemeal measures, which were designed within the framework of the existing PAYG system, are studied in Chapter V along with more systemic approaches to reform—including a shift of more of the pension provision to privately-funded occupational pension plans and the partial prefunding of the PAYG system. This chapter concludes that a pension reform strategy solely based on piecemeal adjustments to the PAYG system subjects pensioners and contributors to considerable long-run risks related to the rapidly ageing population. A prudent strategy would continue with piecemeal changes to the PAYG and would also move toward partial prefunding and enhance the role of private pension systems. This strategy would reduce distortions affecting the labor market and savings, and contribute to a deepening of financial markets, particularly the equity segment, in Germany.

Contents

• II. Real Wages, Unemployment, and Unification

  • A. The Theory

  • B. Wage Gap Estimation

  • C. The Unemployment Rate and the Real Wage Gap

• Text Tables

• II-1. Estimation Results for a CD Production Function

• II-2. Estimation Results for a CES Production Function

• II-3. Unemployment and the Wage Gap

• Charts

• II-1. Germany: Unemployment and Labor’s Share of Income

• II-2. Germany: Capital to Labor Ratio, Wages and Labor Productivity

• II-3. Germany: Wage Gap

• II-4. Germany: Labor’s Share of Income and Wage Gap

• II-5. Germany: Effect of Unification on Wage Gap

• II-6. West Germany: Wage Gap and Labor Productivity

• III. The Convergence Process in Eastern Germany

  • A. Convergence Developments

  • B. Unemployment

  • C. Official Transfers

  • D. Prospects

• Text Tables

• III-1. Germany: Eastern Germany—Convergence Indicators

• III-2. Germany: Eastern Germany—Sectoral Output Growth and Shares

• III-3. Germany: Eastern Germany—Sectoral Labor Cost Competitiveness Indicators

• III-4. Germany: Eastern Germany—Sectoral and Regional Wage Dispersion, 1995

• III-5. Germany: Eastern Germany—Hourly Compensation Costs in Manufacturing in East Germany and Selected Countries

• III-6. Germany: Eastern Germany—Labor Cost Competitiveness in Selected Industries

• III-7. Germany: Eastern Germany—Capital Investment and Capital-Labor Ratios

• III-8. Germany: Eastern Germany—Labor Market Developments

• III-9. Germany: East Germany—Average Monthly Unemployment Flows

• III-10. Germany: East Germany—Official Transfers

• III-11. Germany: East Germany—Sectoral Shares of GDP and Employment, 1995

• Charts

• III-1. Germany: Eastern Germany—Convergence of GDP and Absorption

• III-2. Germany: Eastern Germany—Convergence of Absorption Components

• III-3. Germany: Eastern Germany—Convergence of Wages, Labor Productivity, and Unit Labor Cost

• III-4. Germany: Eastern Germany—Convergence of Wages and Social Benefits

• III-5. Germany: Eastern Germany—Convergence of Capital Endowments

• III-6. Germany: Eastern Germany—Per Capital GDP in East Germany and in Selected Eastern European Countries (PPP Adjusted)

• III-7. Germany: Eastern Germany—Employment and Unemployment

• III-8. Germany: Eastern Germany—Marginal Implicit Tax Rates on Additional Labor Earnings in West and East Germany in 1996

• III-9. Germany: Eastern Germany—Catching-Up Scenarios for Capital-Labor Ratios

• III-10. Germany: Catch-Up Growth in Ireland

• IV. Tax Reform in Germany

  • A. Introduction and Overview

  • B. The Current Code of the German Income Tax

  • C. International Comparisons and Recent Trends in German Tax Yields

  • D. The Government’s Tax Reform Proposals

  • E. The Effects of the Tax Reform Proposals

  • Annex I: Effective Average Tax Rates Based on Macroeconomic Data

  • Annex II: Marginal Effective Tax Rates on Investment

• Text Box

  • Main Proposals on Income Tax Reform

• Text Tables

• IV-1. Germany: Marginal Effective Tax Rates

• IV-2. Germany: Revenue Effects of the Tax Reform Acts Passed by the Bundestag

• IV-3. Germany: Distribution of Tax Relief of the Proposed Tax Reform

• IV-4. Germany: Revenue Effects of the Proposed Tax Reform

• IV-5. Germany: Parameters for the Calculation of Effective Marginal Corporate Tax Rates

• IV-6. Germany: Effective Marginal Tax on Investment Under the Current Tax Code

• IV-7. Germany: Effective Marginal Tax on Investment Under the Government’s Tax Reform Proposal

• IV-8. Germany: Taxation of Distributed Profits to Foreign Parent Companies Under the Government’s Tax Reform Proposal

• Charts

• IV-1. Germany: Wage and Profit Tax Ratios

• IV-2. Germany: Personal Income Tax Schedules

• IV-3. Germany: Income Taxation

• IV-4. Germany: Statutory and Effective Average Personal Income Tax Rates

• IV-5. Germany: Statutory and Effective Corporate Tax Rates

• IV-6. Germany: Effective Average Tax Rates

• IV-7. Tax Rates on Distributed Profits to U.S. Parent Company

• V. Alternative Approaches to Pension Security in an Aging Society

  • A. Institutional Background and the Mechanics of PAYG Financing

  • B. The Piecemeal Approach to Pension Reform

  • C. Systemic Pension Reform Approaches

• Text Tables

• V-1. Germany: Public Pension Projections and Blüm Commission Reform Proposals, 1994-2030

• Charts

• V-1. Industrial Countries: Public Pension Expenditure as a Percent of GDP

• V-2. Germany: Demographic and System Dependency Ratios

• V-3. Germany: Intergenerational Equity Implications of Public Pension System

• V-4. Industrial Countries: Public Pension Expenditure and Labor Force Participation Rates of 55-64 Year Old Persons

• V-5. Industrial Countries: Public Pension Expenditure and Stock Market Capitalization as a Percent of GDP

• V-6. Germany: Partial Prefunding of Public Pension System