Abstract
This 2005 Article IV Consultation highlights that economic activity in Germany is slowly picking up, and there is scope for some further firming of growth in the course of 2006. The recovery, however, remains unbalanced, and strong exports have yet to feed through into higher household spending. Although the risks to the outlook are broadly neutral, an unwinding of global imbalances and higher oil prices could yet provide headwinds for the recovery. On balance, headline growth is forecast at 1 percent in 2005 and 1.5 percent in 2006, implying a gradual recovery in working-day-adjusted terms.
1. After a close election in September, a “grand coalition” government took office on November 22, 2005. The government comprises the Christian parties (Christian Democratic Union and Christian Social Union) and the Social Democratic Party, and is headed by Mrs. Merkel (CDU). Mr. Müntefering (SPD) is Vice-Chancellor and Minister of Labor and Social Security.
2. As envisaged in the staff report for the 2005 Article IV consultation with Germany (September 20, 2005), a second round of discussions was held with the new authorities and staff at the Bundesbank.1 This supplement reports on these discussions, which centered around the coalition agreement issued by government partners on November 12, 2005.2 An updated staff appraisal based on these discussions is included in this supplement.
I. The Coalition Agreement
3. The coalition agreement sets out the major policy objectives for the government’s four-year term, although in many areas detailed policies and the interlinkages between various aspects still need to be crystallized. The key economic elements of the agreement include:
Fiscal consolidation: reducing the deficit below the Maastricht criterion in 2007, with an increase in the VAT rate from 16 to 19 percent in January 2007 as the main adjustment measure. A package of new expenditure initiatives equivalent to about 1 percent of GDP distributed over four years (with some backloading) is to provide support for selected activities. (See Box 1 for additional information.)
Labor markets: reducing nonwage labor costs by cutting unemployment insurance contributions (financed in part by one-third of the receipts from the VAT increase) and extending the probationary employment period—i.e., with unrestricted dismissal rights—in new labor contracts from 6 to 24 months.
Product and service markets: implementing further reform in network industries; tightening licensing requirements for some crafts; and renegotiating the EU Services Directive.
Entitlement reforms: increasing the statutory retirement age from 65 to 67 years at a pace of one month a year starting in 2012; freezing pension benefits for the foreseeable future; and increasing the pension contribution rate from 19.5 to 19.9 percent effective January 2007.
Federalism reforms: reducing complexity and improving political and financial governance.
Financial sector: implementing the Basel II capital adequacy accord “in a Mittelstand friendly way;” reviewing governance aspects of the Federal Office of Financial Supervision (BaFin), including “reducing supervisory regulation to an appropriate level” to facilitate the extension of credit; and enhancing the role of the National Development Bank (KfW) to support investment and the market for venture capital.
II. Report on the Discussions
4. As the government took office only recently, converting the coalition agreement into an operational implementation plan is still in its early stages. The authorities observed that the agreement is the result of difficult negotiations between two parties that had spent 30 years opposing each other in government. Fiscal consolidation is the fundamental goal and the area where the strategy is most fleshed out; accordingly, this was the focus of the staff visit. There is also agreement between the coalition partners that the financing of the health insurance system and corporate income tax regime need major reform, but, given their complexity, decisions on these two reforms have been scheduled for 2006 and 2007, respectively. In other structural reform areas, such as labor, product, and service markets, where the initial plans are modest, the mission’s interlocutors noted that the coalition partners would need more time to learn how best to work together and make further progress, and hence the coalition agreement should be viewed as a stepping stone to further initiatives.
A. Fiscal Policy
5. The coalition agreement articulates specific policies to reduce the fiscal deficit to below 3 percent of GDP in 2007. The authorities noted that the general government deficit, which is projected to remain around 3¾ percent of GDP in 2005, had been too high for too long. A new budget for 2006 will be presented in February 2006 and will aim to lower the deficit by about ¼ percent of GDP (in both nominal and structural terms). Moreover, the authorities will prepare the ground for additional durable adjustment measures totaling at least ¾ percent of GDP in 2007, centered around the VAT hike on January 1, 2007. The intention is to continue with further deficit reduction in later years (the precise objectives will be spelled out in an updated Stability Program to be submitted to the European Commission in February 2006), but the detailed policies to achieve this were not available at the time of the discussions. The authorities noted that the grand coalition has broad support in both chambers of parliament and felt that using this opportunity to make a determined effort to reduce the fiscal deficit was already strengthening confidence and improving sentiment.
Germany: Preliminary Staff Estimates of Fiscal Measures in the Coalition Agreement
The projections in the staff report were premised on policy plans prior to the elections.
Projected cumulative impact in billions of euros, a negative number widens the deficit.
Also reflects small data revisions since issuing the staff report.
Germany: Preliminary Staff Estimates of Fiscal Measures in the Coalition Agreement
| 2005 | 2006 | 2007 | ||
|---|---|---|---|---|
| (In billions of euros) | ||||
| General government balance projected in the staff report 1/ | -86.5 | -85.1 | -87.6 | |
| Cumulative measures in the coalition agreement 2/ | ||||
| VAT increase | … | … | 21.1 | |
| Reducing tax expenditures and subsidies | … | 1.2 | 7.6 | |
| Cost cutting in Hartz IV program | … | 5.0 | 6.0 | |
| Increase in pension contribution rate | … | … | 3.8 | |
| Reduction in the unemployment contribution rate | … | … | -13.0 | |
| Support package over four years | … | -2.9 | -5.5 | |
| Discretionary spending cuts and other | … | 1.3 | 0.2 to 9.9 | |
| General government balance after measures 3/ | -86.2 | -80.5 | -67.3 to -57.6 | |
| (In percent of GDP) | ||||
| General government balance projected in the staff report | -3.9 | -3.7 | -3.7 | |
| Cumulative measures in the coalition agreement | … | 0.2 | ¾ to 1¼ | |
| General government balance after measures | -3.8 | -3.6 | -3 to -2½ | |
The projections in the staff report were premised on policy plans prior to the elections.
Projected cumulative impact in billions of euros, a negative number widens the deficit.
Also reflects small data revisions since issuing the staff report.
Germany: Preliminary Staff Estimates of Fiscal Measures in the Coalition Agreement
| 2005 | 2006 | 2007 | ||
|---|---|---|---|---|
| (In billions of euros) | ||||
| General government balance projected in the staff report 1/ | -86.5 | -85.1 | -87.6 | |
| Cumulative measures in the coalition agreement 2/ | ||||
| VAT increase | … | … | 21.1 | |
| Reducing tax expenditures and subsidies | … | 1.2 | 7.6 | |
| Cost cutting in Hartz IV program | … | 5.0 | 6.0 | |
| Increase in pension contribution rate | … | … | 3.8 | |
| Reduction in the unemployment contribution rate | … | … | -13.0 | |
| Support package over four years | … | -2.9 | -5.5 | |
| Discretionary spending cuts and other | … | 1.3 | 0.2 to 9.9 | |
| General government balance after measures 3/ | -86.2 | -80.5 | -67.3 to -57.6 | |
| (In percent of GDP) | ||||
| General government balance projected in the staff report | -3.9 | -3.7 | -3.7 | |
| Cumulative measures in the coalition agreement | … | 0.2 | ¾ to 1¼ | |
| General government balance after measures | -3.8 | -3.6 | -3 to -2½ | |
The projections in the staff report were premised on policy plans prior to the elections.
Projected cumulative impact in billions of euros, a negative number widens the deficit.
Also reflects small data revisions since issuing the staff report.
6. The mission welcomed the authorities’ commitment to reduce the fiscal deficit, but also expressed reservations about the fiscal consolidation strategy. Specifically:
The consolidation effort in 2006 is insufficient and the mission argued that a small additional effort to achieve structural adjustment of ½ percent of GDP would not pinch off growth (see section D on the updated macroeconomic outlook). This would require adjustment of ¼ percentage points more than planned, which could be achieved by curtailing new expenditures or advancing the VAT increase by three to six months. In addition to showing more distinct progress in 2006, this would also allow a more even consolidation path into 2007. The authorities were mindful of the lumpy adjustment path, but they felt that the expansion was still fragile and that the planned approach would provide “backwind” to the recovery, thus placing the economy in a better position to absorb the large deficit reduction in 2007. They also noted that in any event the new government had been in office too briefly to be able to prepare and get approval for major adjustment measures for 2006.
The preannounced VAT increase introduces a time inconsistency risk. If the recovery is seen as too fragile to tolerate a large VAT increase in 2006, the same could be true in 2007 if the economy does not pick up significantly. Alternatively, if the economy is strong at the end of 2006, consolidation measures will appear less necessary and there will be pressure to scale back the VAT increase. The authorities recognize this risk and intend to contain it by seeking early legislative commitment to the VAT increase in 2007 (possibly in a by-law to the 2006 budget) to strengthen the credibility of the adjustment effort. They felt that the coalition could not afford to reconsider this key measure as the resources were needed in any event to help comply with the constitutionally-mandated golden rule (discussed in ¶17 of the staff report). Further, they view the VAT increase as central to the strategy of putting greater reliance on indirect rather than direct and payroll taxes.
The deficit reduction effort puts more emphasis on increases in tax rates as opposed to durable expenditure cuts. The authorities explained, however, that the fiscal challenge could not be tackled with expenditure cuts alone. This would imply cutting pensions and other entitlements for which there was little political support. Moreover, they pointed out that the adjustment strategy does contain cuts in tax expenditures and subsidies that will cumulate to 0.6 percent of GDP a year by 2009—more in these areas was not politically feasible—and that a sizeable decline in spending on active labor market policies is also underway. The authorities also stressed that substantial spending associated with reunification limits the fiscal room for maneuver.
The package of new expenditures offsets the other efforts to cut spending and some elements could become permanent and introduce new distortions. These distortions include accelerated depreciation for new investment and new subsidies (via the tax system) for spending on household services. The authorities explained that the accelerated depreciation rules would be valid only in 2006 and 2007, after which the planned corporate income tax reform would go into effect and lower overall distortions.
The fiscal strategy includes measures that require counterpart efforts that have not yet been fully specified. For instance, it is assumed that subnational governments will save all proceeds from the higher tax revenue transfers following the VAT hike, without specifying a mechanism to ensure that this takes place. Also, as unemployment insurance contribution rates are being reduced, the labor office will need to find offsetting savings to avoid the need for new subsidies. The authorities deemed the risk of such leakage to be small. Many subnational governments are suffering from excessive deficits themselves and need the additional revenue transfers to bring these down. Further, the coalition partners have broad representation in the Länder, which will strengthen fiscal coordination. Finally, the authorities said that the labor office had been lowering costs already and improving its performance, and they will implement new efficiency measures in 2006 to help offset the revenue cuts.
7. The authorities recognize that the small deficit reduction planned for 2006 will have implications under the revised Stability and Growth Pact rules. They pointed, however, to their concrete plan to bring the deficit into compliance with the Maastricht criterion in 2007, which they believe sets them apart from other countries with excessive deficits. At the same time they emphasized that Germany does not want to be seen as the country that does damage to the revised Pact, and they are engaged in a dialogue with the European Commission to reach satisfactory understandings. The mission stressed the importance of accepting the consequences (primarily intensified fiscal surveillance by the Commission) under the SGP, noting that resistance would have grave implications for the credibility of both Germany and the Pact. Instead, Germany could exert much-needed leadership by accepting the consequences of its policy plans, and then overcome these difficulties in 2007 with the already-agreed deficit reduction package.
B. Structural Issues
8. Although the emphasis is on fiscal matters, the authorities stressed that the coalition agreement also makes important headway on structural issues. In some areas, they felt that the agreement was farther reaching than appreciated by most observers. In other areas, it sets out principles of understanding, which now needed to be translated into policy plans. The discussions focused on the following issues:
Increasing the retirement age was seen as one of the grand coalition’s major achievements. This issue had been taboo, but was now accepted to help bring the pension finances under control and increase labor participation. The mission agreed that it is an important step, but recommended that its implementation be accelerated as the 24-year time span to achieve the two year increase was excessively gradual, especially keeping in mind that the age limit will likely need to be increased further in the future in line with life expectancy.
Coalition discussions on labor market reforms had been particularly difficult. The main accomplishments in this area will be the reduction in the wage wedge by cutting contribution rates for unemployment insurance from 6.5 to 4.5 percent, and the loosening of employment protection legislation by lengthening probation periods for new labor contracts. In addition, the authorities noted that drawing on the experience gained under the Hartz IV reforms, improvements in this important program are underway, notably in the design of the Unemployment Benefit II program.3 The mission welcomed these initiatives and appreciated that more time may be needed to bring the coalition partners together on other essential aspects of labor market reform, especially to revitalize labor demand (see ¶27 and ¶52 of the staff report).
Proposals in product and services markets reforms fall short of what is needed and in some aspects go in the wrong direction. Specifically, the mission reiterated the views laid out in the staff report (see ¶29-32 and ¶53), emphasizing the important complementarities between labor market and product and services market reforms.4 The authorities are still formulating their views on these matters and their immediate priority is to continue with reforms of network industries, where they see scope to partially privatize the national railroad and to reform the postal services when its monopoly status for letter delivery expires in 2007. At the same time, they believe that adequate licensing requirements are necessary to assure workmanship of high quality, and that the EU Services Directive as presently formulated raises concerns about a race to the bottom in labor conditions and quality of service in some areas.
The planned federalism reforms focus on reducing the number of laws that require upper house approval, and clarifying the responsibilities of different levels of government (such as environmental policy for the federal government and education policy for the Länder). The mission welcomed these efforts, but noted that they should be augmented by deeper second stage reforms as outlined in the staff report (see ¶23 and ¶50). In this second stage, the authorities should seek possibilities for small revenue surcharges and independent expenditure decisions at the Länder level, and a strengthening of the Internal Stability Pact (ISP) with quantitative targets for different levels of government and penalties for noncompliance. The authorities responded that there was no support for more competitive federalism at this time, mainly because of the concerns of the poorer Länder. Options to strengthen the ISP, however, are being discussed but are still at an early stage.
The authorities stressed their commitment to reform the health insurance system and the corporate income tax regime even though these are areas where the coalition partners had taken opposing positions in the past. The coalition needed more time to discuss these reforms and develop a common approach. The health care reform will be formulated in the course of 2006, and a CIT reform is envisaged to go into effect in 2008. The mission agreed that these reforms are complex and should not be rushed. It recommended that the health care reform should seek financing models that do not increase the burden on payrolls (see ¶20 in the staff report), and that the CIT reform should endeavor to be revenue neutral with base broadening and a lowering of tax rates (see ¶21).
C. Financial Sector Policies
9. The mission expressed concern that the financial sector initiatives described in the coalition agreement could be taken to imply a relaxation of supervision, including possibly a reduction in the independence of BaFin. This would be ill-advised, not least because of the high level of impaired loans in the banking system, low overall profitability, and some isolated signs of stress as evidenced by the recent difficulties in a large mortgage bank and a real estate investment fund. The authorities explained that it is not their intention to weaken financial sector supervision or regulation. Rather, the intention is to implement the objectives in the coalition agreement in a way that strengthens the financial sector and makes it more efficient. They also reiterated their commitment to the independence and autonomy of BaFin, but wanted to review its governance structure and learn from the experience gained in the three and a half years since the agency was established. On Basel II, they noted that although the potential burden for smaller banks and companies (which in Germany rely on bank financing to a greater extent than in other countries) is of concern, good progress has been made by bank federations to develop centralized risk models and that Mittelstand companies need to accept that they will be rated. They also saw the KfW as a useful institution with its own niche in the German capital market, and would explore options to stimulate investment in smaller enterprises, including through the development of a more active venture capital market.
D. The Updated Macroeconomic Outlook
10. Lack of clarity about the timing and size of some of the coalition’s policy measures adds uncertainty to the economic outlook. The coalition agreement does not provide a macroeconomic framework and many of the economic policies are not quantified. Further, the implementation timetable for some of the policy proposals has not been specified and the impact of the preannounced VAT increase on consumer and business behavior is difficult to quantify precisely. Nevertheless, common views are emerging that the fiscal strategy and structural policy mix will likely be about neutral on growth and inflation in 2006, but will result in a slowing of growth and a temporary uptick in inflation in 2007. (See Box 2 for the experience with large increases with consumption taxes in Japan and the U.K.)
Germany: Revised Macroeconomic Outlook 2005-2007 1/
“Staff report” refers to figures reported in the staff report; “Supplement” presents revised outlook that takes account both the policy package and revisions to the baseline that are unrelated to the package.
Mid-point projection. Depending on the consumer response to the VAT increase and the final package of fiscal measures, the staff projects growth in 2007 to be in a range of ¾ to 1¼ percent.
Contribution to growth.
Also reflects data revisions for 2005 since the staff report was issued.
Germany: Revised Macroeconomic Outlook 2005-2007 1/
| 2005 | 2006 | 2007 | 2005 | 2006 | 2007 | ||
|---|---|---|---|---|---|---|---|
| (Percentage change) | |||||||
| Staff Report | Supplement | ||||||
| Real GDP | 0.8 | 1.2 | 1.6 | 1.0 | 1.5 | 1.02/ | |
| Final domestic demand | -0.4 | 0.8 | 1.8 | -0.1 | 1.2 | 0.7 | |
| Private consumption | -0.3 | 0.3 | 0.7 | -0.3 | 0.6 | 0.1 | |
| Gross fixed investment | -0.8 | 2.8 | 3.5 | 0.2 | 3.7 | 3.2 | |
| Foreign balance 3/ | 0.7 | 0.3 | -0.2 | 1.1 | 0.3 | 0.4 | |
| CPI inflation | 1.7 | 1.7 | 1.5 | 1.9 | 1.9 | 2.5 | |
| Unemployment rate (ILO) 4/ | 9.5 | 9.3 | 9.0 | 9.1 | 8.8 | 8.9 | |
“Staff report” refers to figures reported in the staff report; “Supplement” presents revised outlook that takes account both the policy package and revisions to the baseline that are unrelated to the package.
Mid-point projection. Depending on the consumer response to the VAT increase and the final package of fiscal measures, the staff projects growth in 2007 to be in a range of ¾ to 1¼ percent.
Contribution to growth.
Also reflects data revisions for 2005 since the staff report was issued.
Germany: Revised Macroeconomic Outlook 2005-2007 1/
| 2005 | 2006 | 2007 | 2005 | 2006 | 2007 | ||
|---|---|---|---|---|---|---|---|
| (Percentage change) | |||||||
| Staff Report | Supplement | ||||||
| Real GDP | 0.8 | 1.2 | 1.6 | 1.0 | 1.5 | 1.02/ | |
| Final domestic demand | -0.4 | 0.8 | 1.8 | -0.1 | 1.2 | 0.7 | |
| Private consumption | -0.3 | 0.3 | 0.7 | -0.3 | 0.6 | 0.1 | |
| Gross fixed investment | -0.8 | 2.8 | 3.5 | 0.2 | 3.7 | 3.2 | |
| Foreign balance 3/ | 0.7 | 0.3 | -0.2 | 1.1 | 0.3 | 0.4 | |
| CPI inflation | 1.7 | 1.7 | 1.5 | 1.9 | 1.9 | 2.5 | |
| Unemployment rate (ILO) 4/ | 9.5 | 9.3 | 9.0 | 9.1 | 8.8 | 8.9 | |
“Staff report” refers to figures reported in the staff report; “Supplement” presents revised outlook that takes account both the policy package and revisions to the baseline that are unrelated to the package.
Mid-point projection. Depending on the consumer response to the VAT increase and the final package of fiscal measures, the staff projects growth in 2007 to be in a range of ¾ to 1¼ percent.
Contribution to growth.
Also reflects data revisions for 2005 since the staff report was issued.
11. Economic growth strengthened somewhat in the second half of 2005, and is expected to continue firming in 2006. However, growth remains unbalanced with the expansion still largely based on external demand. Investment in machinery and equipment is picking up, while construction and consumption have remained weak. Overall, the staff projects output to expand by 1 percent in 2005 and by about 1½ percent in 2006. (These are headline growth figures; the corresponding figures adjusted for working days are approximately 0.1-0.2 percentage points higher.)
12. The projection for 2007 is subject to more uncertainty, with some advance of consumer purchases likely at end-2006, in anticipation of the VAT hike, followed by a drop in consumption in the first half of 2007. Spending is expected to begin normalizing in the second half of 2007. The fiscal impulse is projected to be negative by at least ¾ percent of GDP. As a result, output growth is likely to slow, to between ¾-1¼ percent. Consumer price inflation is expected to remain steady at 1¾ percent in 2006, followed by a one-off increase to about 2½ percent in 2007 because of the VAT hike.5 On these prospects, employment is not expected to strengthen significantly and unemployment is expected to remain comparatively high. The staff’s revised outlook is broadly consistent with the views of the authorities and most other analysts.
III. Staff Appraisal
13. The coalition agreement contains several economic measures and objectives that are featured in the comprehensive strategy advocated in the main staff report. At the core is the vital commitment to reduce significantly the fiscal deficit in 2007, while reducing the cost of employment and shifting some fiscal revenue from direct to indirect taxes. The planned increase in the statutory pension age and the move toward reforming the federal fiscal structure are also important steps in the right direction. Many of the details in the agreement, however, still need to be worked out. Careful and steadfast implementation of intended policies, in a way that avoids introducing new distortions, will ultimately determine their success. In this connection, the short delay in implementing the difficult but needed reforms in the areas of health care financing and the corporate income tax system is appropriate, and the time should be used to design bold policies that reduce distortions and are revenue neutral.
14. The objective of fiscal consolidation by 2007 is welcome but the path to get there is too backloaded and there are drawbacks related to the composition of the package. The consolidation planned for 2006 is insufficient. In addition, the deficit reduction strategy is heavily weighted toward increases in tax rates rather than expenditure cuts, and a deeper and broader-based approach to reducing tax expenditures and subsidies would be preferable. The delayed VAT increase also gives rise to time inconsistency concerns. Further, the new spending initiatives could lead to permanent costs and distortions and are unlikely to be effective. To meet the previously recommended target of annual structural adjustment of at least ½ percent of GDP, adjustment amounting to ¼ percent of GDP would need to be brought forward from 2007 to 2006. This could be done by curtailing new expenditures and dropping those that may create new distortions, or bringing forward somewhat the VAT increase. Cyclical conditions do not preclude this small additional adjustment in 2006.
15. More generally, the coalition agreement needs to be used as a stepping stone for much bolder structural reform and continued fiscal consolidation. The policy measures on labor, product and services reforms are not strong enough to significantly bolster competition in the economy and strengthen employment and long-run growth. This partial approach will limit the full benefits of the policy package in the agreement. Every effort should therefore be made to augment the coalition agreement in these areas to improve efficiency and take advantage of the critical synergies between labor, product, and services market reforms and structural fiscal adjustment. Moreover, the fiscal consolidation package in the agreement should be considered as a first step toward regaining control over public finances, and policies should aim to eliminate the structural deficit by the turn of the decade and reduce the public debt-to-GDP ratio. Various welfare programs also need to be put on a sound intertemporal footing. In the financial sector, the coalition agreement should be implemented in a way that does not infringe on the independence of BaFin or weaken prudential oversight.
16. In sum, although valuable initiatives have been developed, Germany still has some way to go in framing a cohesive policy strategy to raise economic performance in a durable way. The staff report offered a vision for such a strategy with mutually-reinforcing elements. The strategy should be decisive, with firm implementation and a clear explanation of the policy steps, their quantification, and timing. A good start has been made in putting together such a framework, but it will need to be augmented and cast in a quantified long-run outlook that takes account of looming demographic changes. The grand coalition government offers a unique opportunity to address these challenges with determination.
Key Fiscal Policy Steps of the Coalition Agreement
Many of the measures in the coalition agreement described below have not been fully quantified and also some (small) components may already be in the fiscal baseline and would not affect the deficit path in net terms.
Measures to increase revenue:
Increase VAT rate in January 2007 from 16 to 19 percent, yielding about 1 percent of GDP.1
Cut tax expenditure and subsidies with savings accumulating to 0.6 percent of GDP by 2009.2
Increase pension contribution rate in January 2007 from 19.5 to 19.9 percent, yielding about 0.2 percent of GDP.
Increase top marginal income tax from 42 to 45 percent for individuals earning over €250,000 or couples earning over €500,000 a year (small yield from 2007).
Measures that reduce revenue:
Cut the unemployment contribution rate in January 2007 from 6.5 to 4.5 percent of gross taxable wages, costing about 0.5 percent of GDP.
Eliminate inheritance tax for qualifying small firms (no yield or timing available).
Measures that increase expenditure:
Support package to be implemented over four years from 2006 to fund higher R&D spending, transportation infrastructure, accelerated depreciation for investments in machinery and equipment, family assistance, and building renovation and household services, totaling about 1.1 percent of 2005 GDP.
Measures to reduce expenditure:
Rationalize active labor market programs from 2006.
Cut Hartz IV costs through improved design and administration from 2006.
Cut pension contributions on behalf of unemployment benefit recipients from 2006.
Cuts in public administration and other from 2006.
Cut federal subsidies to health insurance funds from 2007.
Extend pensionable age from 65 to 67 at a pace of 1 month a year from 2012.
Large Increases in Consumption Taxes – The Experience of Japan and the United Kingdom
The April 1997 hike in Japan’s consumption tax rate from 3 to 5 percent has been blamed for the subsequent economic downturn, but a number of other factors were also important in triggering the recession. Consumption fell sharply in the second quarter of 1997. Some consumer purchases were brought forward to the first quarter, prior to the increase in the consumption tax, and spending resumed in the third quarter. The weakness in domestic demand in 1997 and 1998, however, was caused primarily by a large contraction in business investment that has been ascribed to domestic financial stress associated with the failure of several large financial institutions. In addition, the Asian crisis contributed to a stall in export growth. Moreover, the consumption tax hike was part of a broader program of fiscal consolidation that included the withdrawal of temporary tax cuts, an increase in medical insurance copayments, and continued cuts in public investment, which together resulted in a structural fiscal contraction of slightly more than 1 percent of GDP in fiscal year 1997. Inflation increased temporarily to 1.7 percent in 1997, falling back to 0.6 percent in 1998 as there were no second-round increases because of slack in the economy.
Japan: Growth in Real Private Consumption Expenditure
(Percentage change, quarter on quarter)
Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A002
Source: WEO.Japan: Growth in Real Private Consumption Expenditure
(Percentage change, quarter on quarter)
Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A002
Source: WEO.Japan: Growth in Real Private Consumption Expenditure
(Percentage change, quarter on quarter)
Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A002
Source: WEO.In the United Kingdom, the increase in VAT from 15 to 17½ percent in 1991 was part of a broader reorientation of fiscal policy. The VAT increase helped finance a decrease in the corporate income tax rate and the elimination of the “poll” tax. Other fiscal measures in the budget, together with a privatization program, were designed to balance the budget over the cycle. In addition to the fiscal consolidation, there was significant monetary tightening in 1990 to slow an overheating economy. Thus, while consumption fell, several factors alongside the VAT increase contributed to this result. As in Japan, second-round inflation effects were small.
United Kingdom: Growth in Real Private Consumption Expenditure
(Percentage change, quarter on quarter)
Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A002
Source: WEO.United Kingdom: Growth in Real Private Consumption Expenditure
(Percentage change, quarter on quarter)
Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A002
Source: WEO.United Kingdom: Growth in Real Private Consumption Expenditure
(Percentage change, quarter on quarter)
Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A002
Source: WEO.The Japan and U.K. episodes point to some cyclical impact of a VAT increase, but the influence on growth is also determined by accompanying policies and circumstances. Currently, consumer confidence in Germany remains subdued with growth still driven primarily by external demand, and a VAT increase in this environment could slow the momentum of economic recovery. Effects of the VAT increase in Germany may, however, be less severe than either the 1997 increase in Japan or the 1991 increase in the UK because (i) the fiscal shock is smaller than that in Japan in 1997 and it is not accompanied by the same degree of financial sector difficulties as in Japan; (ii) fiscal multipliers in Germany have been estimated to be smaller than in Japan; and (iii) even though the European Central Bank recently raised its policy rate, the extent of ECB cumulative tightening is envisaged to be much lower than the doubling of interest rates in the UK in 1990. As in Japan and the UK, second round effects on inflation in Germany are expected to be small, especially with continued high unemployment.
Selected Economic and Social Indicators
Staff estimates and projections, if not otherwise indicated.
From 1999 onward data reflect Germany’s contribution to M3 of the euro area. Data not shown for 2002 because of a series break (from January 2002 M3 excludes currency in circulation).
Data for 2005 refer to the change from Oct 2004 to Oct 2005.
Data for 2005 refer to December 14, 2005.
Data for 2005 refer to November 2005.
Based on relative normalized unit labor cost in manufacturing.
At risk of poverty rate: cut-off point: 50% of median equivalised income.
Selected Economic and Social Indicators
| 2002 | 2003 | 2004 | 2005 1/ | 2006 1/ | 2007 1/ | ||||
|---|---|---|---|---|---|---|---|---|---|
| Real economy (change in percent) | |||||||||
| Real GDP | 0.1 | -0.2 | 1.6 | 1.0 | 1.5 | ¾ to 1¼ | |||
| Total domestic demand | -1.9 | 0.6 | 0.5 | -0.2 | 1.3 | 0.6 | |||
| CPI (average) | 1.3 | 1.0 | 1.8 | 1.9 | 1.9 | 2.5 | |||
| Standardized unemployment rate (in percent) | 7.7 | 8.8 | 9.2 | 9.1 | 8.8 | 8.9 | |||
| Gross national saving (percent of GDP) | 20.6 | 19.9 | 21.2 | 21.8 | 22.0 | 22.2 | |||
| Gross domestic investment (percent of GDP) | 18.3 | 17.8 | 17.4 | 17.1 | 17.4 | 17.4 | |||
| Public finance (percent of GDP) | |||||||||
| General government balance | -3.7 | -4.0 | -3.7 | -3.8 | -3.6 | -3 to -2½ | |||
| General government structural balance | -3.5 | -3.4 | -3.2 | -3.4 | -3.2 | -2¾ to -2¼ | |||
| General government debt | 59.6 | 62.8 | 64.5 | 66.9 | 68.9 | 70.9 | |||
| Money and credit (end of year, percent change) 2/ | |||||||||
| Credit to private sector 3/ | 0.9 | 0.0 | -0.2 | 2.4 | … | … | |||
| M3 3/ | … | 3.5 | 2.2 | 4.7 | … | … | |||
| Interest rates (percent) | |||||||||
| Money market rate 4/ | 3.3 | 2.3 | 2.1 | 2.5 | … | … | |||
| Government bond yield 4/ | 4.8 | 4.1 | 4.2 | 3.4 | … | … | |||
| Balance of payments (percent of GDP) | |||||||||
| Current account balance | 2.2 | 2.1 | 3.8 | 4.7 | 4.6 | 4.8 | |||
| Trade balance | 5.9 | 5.6 | 6.5 | 7.3 | 7.2 | 7.4 | |||
| Exports | 30.4 | 30.8 | 33.0 | 34.7 | 36.2 | 37.4 | |||
| volume (annual percent change) | 3.5 | 3.0 | 10.0 | 7.4 | 6.5 | 5.1 | |||
| Imports | 24.5 | 25.1 | 26.6 | 27.4 | 29.0 | 30.0 | |||
| volume (annual percent change) | -0.3 | 6.6 | 8.2 | 5.3 | 7.1 | 4.9 | |||
| Net oil imports (billions of US$) | 30.6 | 32.0 | 33.0 | 50.7 | 59.4 | 57.6 | |||
| FDI balance | 1.8 | 1.3 | -1.0 | -1.0 | -0.8 | -0.8 | |||
| Official reserves minus gold (billions of US$) 5/ | 51.2 | 50.7 | 48.8 | 39.9 | … | … | |||
| Fund position (as of October 31, 2005) | |||||||||
| Holdings of currency (percent of quota) | 78.4 | ||||||||
| Holdings of SDRs (percent of allocation) | 109.5 | ||||||||
| Quota (millions of SDRs) | 13008 | ||||||||
| Exchange rate | |||||||||
| Exchange rate regime | Participant in euro zone | ||||||||
| Present rate (Dec 14, 2005) | Euro 0.84 per US$ | ||||||||
| Nominal effective rate (2000=100) 5/ | 102.0 | 107.2 | 109.0 | 108.1 | … | … | |||
| Real effective rate (2000=100) 5/6/ | 99.4 | 103.4 | 102.4 | 98.1 | … | … | |||
| Social indicators: GDP per capita (2004): US$33,279; income distribution (ratio of income received by top and bottom quintiles, 2001): 3.7; at-risk-of-poverty rate 7/ (2003; percent): 10; life expectancy at birth (2003; years): 75.5 (male), 81.3 (female). | |||||||||
Staff estimates and projections, if not otherwise indicated.
From 1999 onward data reflect Germany’s contribution to M3 of the euro area. Data not shown for 2002 because of a series break (from January 2002 M3 excludes currency in circulation).
Data for 2005 refer to the change from Oct 2004 to Oct 2005.
Data for 2005 refer to December 14, 2005.
Data for 2005 refer to November 2005.
Based on relative normalized unit labor cost in manufacturing.
At risk of poverty rate: cut-off point: 50% of median equivalised income.
Selected Economic and Social Indicators
| 2002 | 2003 | 2004 | 2005 1/ | 2006 1/ | 2007 1/ | ||||
|---|---|---|---|---|---|---|---|---|---|
| Real economy (change in percent) | |||||||||
| Real GDP | 0.1 | -0.2 | 1.6 | 1.0 | 1.5 | ¾ to 1¼ | |||
| Total domestic demand | -1.9 | 0.6 | 0.5 | -0.2 | 1.3 | 0.6 | |||
| CPI (average) | 1.3 | 1.0 | 1.8 | 1.9 | 1.9 | 2.5 | |||
| Standardized unemployment rate (in percent) | 7.7 | 8.8 | 9.2 | 9.1 | 8.8 | 8.9 | |||
| Gross national saving (percent of GDP) | 20.6 | 19.9 | 21.2 | 21.8 | 22.0 | 22.2 | |||
| Gross domestic investment (percent of GDP) | 18.3 | 17.8 | 17.4 | 17.1 | 17.4 | 17.4 | |||
| Public finance (percent of GDP) | |||||||||
| General government balance | -3.7 | -4.0 | -3.7 | -3.8 | -3.6 | -3 to -2½ | |||
| General government structural balance | -3.5 | -3.4 | -3.2 | -3.4 | -3.2 | -2¾ to -2¼ | |||
| General government debt | 59.6 | 62.8 | 64.5 | 66.9 | 68.9 | 70.9 | |||
| Money and credit (end of year, percent change) 2/ | |||||||||
| Credit to private sector 3/ | 0.9 | 0.0 | -0.2 | 2.4 | … | … | |||
| M3 3/ | … | 3.5 | 2.2 | 4.7 | … | … | |||
| Interest rates (percent) | |||||||||
| Money market rate 4/ | 3.3 | 2.3 | 2.1 | 2.5 | … | … | |||
| Government bond yield 4/ | 4.8 | 4.1 | 4.2 | 3.4 | … | … | |||
| Balance of payments (percent of GDP) | |||||||||
| Current account balance | 2.2 | 2.1 | 3.8 | 4.7 | 4.6 | 4.8 | |||
| Trade balance | 5.9 | 5.6 | 6.5 | 7.3 | 7.2 | 7.4 | |||
| Exports | 30.4 | 30.8 | 33.0 | 34.7 | 36.2 | 37.4 | |||
| volume (annual percent change) | 3.5 | 3.0 | 10.0 | 7.4 | 6.5 | 5.1 | |||
| Imports | 24.5 | 25.1 | 26.6 | 27.4 | 29.0 | 30.0 | |||
| volume (annual percent change) | -0.3 | 6.6 | 8.2 | 5.3 | 7.1 | 4.9 | |||
| Net oil imports (billions of US$) | 30.6 | 32.0 | 33.0 | 50.7 | 59.4 | 57.6 | |||
| FDI balance | 1.8 | 1.3 | -1.0 | -1.0 | -0.8 | -0.8 | |||
| Official reserves minus gold (billions of US$) 5/ | 51.2 | 50.7 | 48.8 | 39.9 | … | … | |||
| Fund position (as of October 31, 2005) | |||||||||
| Holdings of currency (percent of quota) | 78.4 | ||||||||
| Holdings of SDRs (percent of allocation) | 109.5 | ||||||||
| Quota (millions of SDRs) | 13008 | ||||||||
| Exchange rate | |||||||||
| Exchange rate regime | Participant in euro zone | ||||||||
| Present rate (Dec 14, 2005) | Euro 0.84 per US$ | ||||||||
| Nominal effective rate (2000=100) 5/ | 102.0 | 107.2 | 109.0 | 108.1 | … | … | |||
| Real effective rate (2000=100) 5/6/ | 99.4 | 103.4 | 102.4 | 98.1 | … | … | |||
| Social indicators: GDP per capita (2004): US$33,279; income distribution (ratio of income received by top and bottom quintiles, 2001): 3.7; at-risk-of-poverty rate 7/ (2003; percent): 10; life expectancy at birth (2003; years): 75.5 (male), 81.3 (female). | |||||||||
Staff estimates and projections, if not otherwise indicated.
From 1999 onward data reflect Germany’s contribution to M3 of the euro area. Data not shown for 2002 because of a series break (from January 2002 M3 excludes currency in circulation).
Data for 2005 refer to the change from Oct 2004 to Oct 2005.
Data for 2005 refer to December 14, 2005.
Data for 2005 refer to November 2005.
Based on relative normalized unit labor cost in manufacturing.
At risk of poverty rate: cut-off point: 50% of median equivalised income.
The discussions took place on December 12-14, 2005 in Berlin and Frankfurt. Meetings were held with Finance Minister Steinbrück, State Secretary of Finance Mirow, State Secretary of Labor and Social Security Anzinger, senior representatives at the Chancellery, the Ministries of Finance, Economy, and Labor and Social Security, parliamentarians from both major parties, and staff at the Bundesbank. The staff team comprised Mr. Chopra and Mr. Traa. Mr. Bischofberger, Germany’s Executive Director, attended the discussions.
In addition, on October 18, 2005, the authorities provided an updated Notification of Restrictions Under Executive Board Decision No. 144-(52/51) concerning certain payments restrictions.
A technical error in the design of the UB-II program had caused a sharp increase in the marginal tax rate for participants who were transitioning from welfare to work. This distortion had significantly weakened the effectiveness of the program and raised costs as participants did not make the transition. See also ¶28 of the staff report.
See also Berger and Danninger (2005), “Labor and Product Market Deregulation: Partial, Sequential, or Simultaneous Reform?” IMF Working Paper, WP/05/227, which was prepared as background for the Article IV consultation discussions with Germany.
The VAT increase is expected to be reflected only partially in headline inflation because categories subject to the reduced 7 percent rate are exempted, and with the wage wedge declining slightly, suppliers do not need to adjust output prices fully with the tax hike.
