For more than a decade, growth in Germany has been subdued and uneven. This paper introduces the stylized facts pertaining to the strength in exports, the weakness in domestic demand, and the surge in the current account. It discusses the adjustment undertaken in the private sector and its impact on exports and domestic demand, followed by fiscal and monetary policies and their macroeconomic impact. Finally, structural impediments accelerating capital exports and the rising current account surplus are outlined.

Abstract

For more than a decade, growth in Germany has been subdued and uneven. This paper introduces the stylized facts pertaining to the strength in exports, the weakness in domestic demand, and the surge in the current account. It discusses the adjustment undertaken in the private sector and its impact on exports and domestic demand, followed by fiscal and monetary policies and their macroeconomic impact. Finally, structural impediments accelerating capital exports and the rising current account surplus are outlined.

II. Tax Reform and Debt Sustainability in Germany: An Assessment Using the Global Fiscal Model 25

There is considerable uncertainty about the growth and spillover effects of the tax reform proposals contained in the coalition agreement, namely an increase in the VAT rate, a reduction in payroll taxes, and a corporate income tax reform. We use the IMF’s Global Fiscal Model (GFM) to analyze the macroeconomic and fiscal effects of the coalition package and explore various options for addressing fiscal pressures from population aging and their implications for debt sustainability. The main findings are that the growth dampening impact of the VAT increase is likely to be modest, largely owing to the stimulating effect of other tax reductions. Overall the reform achieves a more efficient tax system and improves the debt outlook. However, to put debt on a sustainable trajectory it is necessary to achieve structural balance over the medium term. To meet this goal, a package of expenditure restraint, entitlement reform, and tax base broadening compares favorably to other adjustment options. Spillover effects to trading partners of these policies are anticipated to be modest.

A. Introduction

39. Chronic fiscal deficits and rising aging-related future liabilities pose a serious threat to the German welfare system. In 2005 Germany violated the Maastricht deficit ceiling for the fourth consecutive year and public debt grew to almost 70 percent of GDP. International competition and domestic adjustment have kept employment and income growth low and eroded the main taxes bases. Fiscal pressures from population aging are mounting and have not been sufficiently anticipated. Even after far-reaching reforms (Agenda 2010 and Hartz-reforms), aging related expenditures are projected to increase by up to 4 percent of GDP by 2050.26

A02ufig01

Fiscal Developments

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

40. Germany’s coalition government reached an agreement on three tax reform initiatives aimed at reducing the fiscal deficit and strengthening potential growth: (i) a VAT increase from 16 to 19 percent partly offset by (ii) a reduction in payroll taxes for unemployment insurance, both effective in 2007; and (iii) a reduction in corporate income tax rates (CIT) to become effective in 2008.27

41. This chapter investigates the implications of these tax reform plans and Germany’s medium-term fiscal pressures for long-run debt sustainability. Specifically, the paper asks the following questions:

  • What are the growth and fiscal effects of the VAT hike and the proposed relief in payroll and corporate income taxation?

  • Which (combination of) tax and expenditure measures are most efficient to achieve structural balance over the medium-term?

  • What is the trade-off between upfront, delayed, and gradual deficit reduction?

  • What are the international spillovers of fiscal reform in Germany, especially on the Euro area and new EU member states?

In addition, we consider whether the results are robust to alternative assumptions about consumer and producer behavior and different degrees of Germany’s integration with international capital markets.

B. Analytical Framework and Calibration

42. The framework used is a four-country version of the IMF’s Global Fiscal Model (GFM) calibrated to the German economy. GFM is a macroeconomic model developed to examine a broad range of fiscal issues.28 GFM analyzes the impact of fiscal policy on real activity through both aggregate demand and supply channels. Aggregate demand responses result from the absence of debt neutrality and consumers’ impatience. Aggregate supply responses arise from the distortionary effects of taxation. Compared to earlier applications of the model, the current version features marginal payroll taxes on workers that exceed the average rate, which allows for the consideration of the effects of tax base broadening. The calibration reflects the trading patterns between Germany, the Euro area excluding Germany, new EU member states and accession countries, and the rest of the world (Table 1).

Table 1.

Germany: Key Macroeconomic Variables in the Initial Steady State

article image
Source: IMF staff estimates.

Euro area without Germany.

10 new EU member states and Bulgaria, Croatia, and Romania.

43. In GFM, fiscal policy matters because of the following departures from Ricardian equivalence:

  • Consumers have finite horizons. As a result, even temporary changes in fiscal policy may affect consumption because any offsetting action required by the government’s intertemporal budget constraint is (perceived to be) borne by future generations and there is no bequest motive.

  • A fraction of consumers are liquidity constrained. Liquidity constrained consumers do not save and cannot borrow, and therefore any change in fiscal policy that affects their disposable income immediately changes their consumption as well.

  • Taxes are distortionary, affecting labor supply and saving-investment patterns.

44. The model is parameterized to reflect key macroeconomic features of Germany (Table 1). In particular, the ratios of consumption, investment, government spending, wage income, and income from capital relative to GDP are set to their values in 2005. Similarly, key fiscal variables—revenue to GDP ratios from taxation of corporate, labor, and personal income and consumption tax, as well as government debt and current government spending—have been calibrated to Germany’s fiscal structure.

45. Key behavioral parameters are based on microeconomic evidence. These include parameters characterizing real rigidities in investment, markups for firms and workers, the elasticity of labor supply to after tax wages, the elasticity of substitution between labor and capital, the elasticity of intertemporal substitution, and the rate of time preference. Simulations examine the impact of changing the values of the following key parameters: 29

  • The sensitivity of labor supply to the real after-tax wage (Frisch elasticity): The baseline value (−0.08) is at the low-end of those found by micro-economic studies given that German specific micro-evidence points to a more inelastic relationship (Evers et al 2005). Alternative simulations assume almost completely inelastic labor supply (−0.01).

  • The elasticity of substitution between labor and capital in the production function: The baseline value is −0.75, with alternative simulations using a value of −0.6.

  • The elasticity of intertemporal substitution: The baseline value for this parameter that describes the sensitivity of consumption to changes in the real interest rate is −0.33. The parameter value in the alternative simulation (−0.25) is consistent with the lower end of microeconomic estimates.

  • The wedge between the rate of time preference and the yield on government bonds: This parameter, which determines consumers’ degree of impatience, has not been subject to extensive microeconomic analysis. We set the baseline value of the wedge to 4 percent (corresponding to a planning horizon of 25 years), with an alternative simulation using 1 percent.

  • The fraction of consumers that is liquidity constrained: The baseline assumes that 40 percent of consumers is liquidity constraint. As these consumers have no wealth, this implies that these individuals consume a quarter of aggregate consumption. An alternative simulation assumes that 20 percent of individuals are excluded from participating in financial markets.

  • Price markups: The baseline assumes that the markup over marginal cost in the tradables sector in Germany is equal to 14 percent and in the nontradables sector is equal to 27 percent. An alternative simulation lowers these values by 25 percent to 10.5 and 20.25 percent.

46. Other main aspects of the model are:

  • Consumption and production are characterized by constant elasticity of substitution functions. Firms and workers have some market power, so that prices and wages are above their perfectly competitive levels.

  • There are traded and non-traded goods that allow for a bias toward domestic goods in private or government consumption.

  • There are two factors of production—capital and labor—which are used to produce traded and non-traded goods. Capital and labor can move freely between sectors, but are not mobile internationally.

  • Investment is driven by Tobin’s Q with adjustment costs. Firms respond sluggishly to differences between the discounted value of future profits and the market value of the capital stock.

  • Wages and prices are fully flexible. As a result, monetary policy is ineffective.

  • There are two kinds of financial assets, government debt (traded internationally) and equity (held domestically). In the standard version of GFM, international trade in government debt implies the equalization of nominal interest rates across countries as capital markets are fully integrated. Alternatively, however, the model can be specified such that it contains a risk premium which depends on the level of public debt.

47. GFM provides a good platform for discussing the relative merits of alternative fiscal consolidation measures and has been applied to several countries.30 The nonricardian structure of the model implies empirically plausible responses of key macroeconomic variables to changes in fiscal policy. The wide ranging menu of taxes allows for a detailed analysis of the composition of adjustment while the strong microfoundations allows to consider the fundamental determinants of the effects of fiscal policy, such as the response of consumers and producers to changes in fiscal policy as well as the sensitivity to the structure of the economy. Finally, as GFM is an open economy model, it allows for the study of fiscal interdependence.

C. Assessing Tax Policy Proposals

48. The baseline projection assumes aging-related expenditure pressures of 4 percent of GDP by 2050 (Scenario A). It does not include the approved VAT increase and reductions in payroll and corporate income taxation so that these can be evaluated separately. Responses of the economy to these spending pressures and changes in tax policy—for example on revenue, real interest rates, and growth—are then determined endogenously within the GFM.

A02ufig02

Primary Expenditure

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

49. The choice of the baseline is critical to interpret the costs and benefits of different reform strategies. The focus of this study is to analyze the implications of various fiscal adjustment scenarios for debt sustainability in order to highlight implications of aging on the public sector balance sheet. As a result, the baseline investigates the dynamics in debt as an endogenous variable without any particular government response to what might become a very rapid debt buildup.31

50. The simulations understate the long-term growth effect of population aging. An alternative modeling strategy might constrain debt accumulation to a ceiling, which triggers endogenous (payroll) tax increases. In other words, rather than adjusting now or never, the baseline could be constructed to compare adjusting now or later. This other formulation of the baseline would highlight the growth effect—rather than the debt effects—of fiscal adjustment strategies. For this reason, the simulations in this study underplay long-term growth effects, since they use an unrealistic, unchanged- policies scenario as a counterfactual. This implication of the model simulations needs to be kept in mind when interpreting the long-term growth effects presented in this study.

51. The analysis of tax reforms in 2007–08 distinguishes three policy experiments and contrasts them with the baseline projection.

  • Scenario B extends the baseline by adding the effects of the three-percentage point increase in the standard VAT rate of 16 percent in 2007—estimated to generate additional revenue of 1 percent of GDP. Since GFM does not incorporate VAT exemptions, we have mapped this policy into a corresponding “effective VAT rate” of 10.1 percent of total consumption in 2006, which increases by 1.9 percentage point from 2007 onwards.

  • Scenario C adds to scenario B the payroll-tax relief equivalent of 0.4 percent of GDP effective January 2007.

  • Scenario D is the full scenario and adds to scenario C a reduction in the corporate income tax rate at a revenue loss of 0.25 percent of GDP from 2008 onward. The proposed reform would reduce the marginal CIT rate from an average of 39 percent to less than 30 percent, partly financed through base broadening measures. As the coalition’s intentions with the corporate income tax reform are evolving, the experiment simulates an equivalent tax relief through a CIT rate reduction only, yielding a revenue loss of ¼ percent of GDP without offsetting base broadening. Hence, the simulated CIT rate cut is hence smaller than the announced statutory rate cut.

52. GFM suggests that the tax measures in 2007–08 will improve the long-term debt outlook, but are not enough to secure fiscal sustainability (Figure 1). The baseline simulation shows unsustainable debt dynamics with the debt-to-GDP ratio rising to over 300 percent of GDP in the long-run. The planned (permanent) VAT hike in isolation (Scenario B) could lower the debt ratio by about 100 percentage points of GDP a result of a lower interest burden and a less distortionary tax base. The cuts in social security payroll taxes and the CIT (Scenarios C and D) each offset part of the VAT revenue gains and result in debt of between 230–250 percent of GDP by 2050. Hence, while the combined tax measures lower the debt buildup, the fiscal improvement would not be sufficient to stabilize the debt ratio.

Figure 1.
Figure 1.

Germany: Debt Path and Tax Reform Proposals

(In Percent of GDP)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.

53. The VAT tax hike temporarily dampens growth in 2007, but lower payroll taxation and anticipatory effects of the CIT cut in 2008 substantially reduce the magnitude of this effect (Figure 2). The model suggests that the 2007 tax relief package would reduce growth by 0.2 percent. The main channel would be a weakening of consumption by about ¾ percentage point.32 Since investment decisions of firms are forward-looking and firms prefer to smooth investment over time the CIT would also have an additional offsetting effect in 2007 of 0.1 percent. The extent to which a reduction in corporate income taxation increases growth in 2007 needs to be interpreted with caution, however. On the one hand, the benefits of CIT reform on incentives to save and invest will be considerably larger, since the announced cut in statutory CIT rates is larger than simulated.33 On the other hand, it is unclear what type of base broadening measures will be implemented to compensate for the revenue loss and hence what their impact on investment activity may be.

Figure 2.
Figure 2.

Germany: Economic Impact of Tax Reform Proposals 1/

(Deviations from baseline in percentage points)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.1/ Baseline includes effects of population aging on government spending. Scenario B includes increase in VAT by 3 percentage points in early 2007. Scenario C adds a reduction in social security contributions by workers equal to 0.4 percent of GDP to Scenario B. Scenario D adds a reduction in corporate income taxation equivalent to 0.25 percent of GDP to scenario C.

54. Overall, however, the reforms are likely to achieve a more efficient tax system by shifting from direct to indirect taxation. Over the long run, shifting revenue from direct taxation to less distortionary indirect taxes increases growth through higher employment and investment growth. This is relevant in an aging society where the direct tax base could contract, while the indirect tax base is more stable.

D. Achieving Long-Term Sustainability

55. Achieving fiscal sustainability requires additional efforts beyond those in the coalition’s tax reform package. As set out in its February 2006 Stability Program, the government aims to move towards structural balance over the medium-term. In practical terms, this would require about a ½ percentage point of GDP reduction in the deficit per year during 2008–11 (some 2 percent of GDP in total). The following subsections assess various strategies to achieve structural balance and the effects of a different timing and phasing of adjustment.

Ranking different adjustment strategies

56. Structural balance by 2011 could be attained through various combinations of expenditure and revenue measures (Table 2). GFM can be used to analyze the effects of different consolidation methods: (i) lower government consumption; (ii) lower government transfers; (iii) higher worker social security contributions; (iv) higher employer social security contributions; (v) higher personal income tax rates; (vi) a higher VAT; (vii) labor income tax base broadening measures; (viii) higher corporate income tax rates, or (ix) a combination of these measures.

Table 2.

Germany: Eight Illustrative Adjustment Strategies: 2006–11 1/

article image
Source: IMF staff estimates.

Adjustment of ½ percent of GDP between 2007–11 in addition to the coalition agreement.

Fraction of average labor income that is tax exempt.

Aging costs are projected to decline between 2007–11.

57. The GFM model suggests that the short-run growth slowdown of achieving structural balance varies with the type of consolidation measure. The impact on short run growth varies between −0.1 and −0.4 percent a year between 2007–11, depending on the specific measures, their distortionary effect, and the impact on domestic demand:

  • Expenditure cuts. Lowering social security transfers has the smallest growth impact per year (−0.1) percent until 2011. This modest growth effect occurs when the benefits that are reduced are distributed in a lump sum manner—reducing transfers that cause economic distortions (such as unemployment benefits) would imply even smaller growth losses. Part of the decline in consumption demand is absorbed by trading partners via reduced import demand. In contrast, reductions in other government consumption in contrast would lead to a larger slowing in growth, which reflects the fact that current government spending in the model is heavily biased towards nontradables (“home bias”).

  • Revenue increases. The negative growth impact of the different tax measures ranges from −0.1 to −0.3 percent. The VAT is less distortionary than payroll taxes, because it also taxes accumulated savings (i.e. reaches a broader base) and hence does not solely affect the labor-leisure choice. Increasing payroll taxes on workers is more distortionary than reducing tax exemptions (base broadening) or raising social security contributions on employers owing to marginal tax rates on workers (but not employers) exceeding the average rate. Raising corporate or personal income taxes is roughly equally distortionary in terms of output loss. That payroll taxes are less distortionary than taxation of capital is a result found in other studies as well (Baylor, 2005), and reflects generally inelastic labor supply in Germany.

58. If no specific strategy is proposed, rising aging-related expenditure pressures would likely result in higher direct taxation. German law stipulates that the social security accounts have to maintain balance and as a result, under current rules, growing expenditures must be met with equivalent social security contributions. While this prevents runaway fiscal deficits and a buildup of debt, it implies higher payroll taxes as the default policy response.

59. Expenditure cuts and entitlement reform, in combination with base broadening and raising indirect taxes, compares favorably to raising direct taxes. Achieving the 2 percent of GDP adjustment between 2008–11 by relying exclusively on just one of the eight adjustment measures appears difficult, and the government likely will need to choose a combination of measures. For instance, reducing government spending—whether on goods and services or social security transfers—by 2 percentage points of GDP by 2011 implies unrealistically large cuts in discretionary spending. Similarly, further increases in the VAT revenue are also limited (including through EU regulations), although further base broadening would be possible by placing fewer items under the lower (7 percent) VAT rate. Raising direct taxation is distortionary and runs counter to the coalition’s intentions to increase incentives for labor participation and investment. The fiscal impulse of a mixed policy package is outlined in Figure 3 comprising lower government spending, lower social security transfers, reductions of payroll tax exemptions (base broadening), and a small further increase in the effective VAT.34 Eliminating the structural deficit by 2011 through such a package lowers medium-run growth by about 0.2 percent per year (Figure 4).

Figure 3.
Figure 3.

Germany: Composition of Mixed Policy Fiscal Adjustment Package 1/

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.1/ Adjustment package of ½ percent of GDP per year between 2008–11 comprising revenue and expenditure measures.2/ Change in fiscal deficit between two years.
Figure 4.
Figure 4.

Germany: Growth Effects of Medium-Term Fiscal Adjustment Strategies 1/

(Average annual deviation in real GDP growth by adjustment method)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.1/ Fiscal adjustment of ½ percent of GDP per year between 2008–11.

60. Achieving structural balance by 2011 lowers the debt-to-GDP ratio significantly until 2030. Thereafter debt will start to increase above the Maastricht threshold of 60 percent of GDP at the height of aging pressures (Figure 5). Focusing on a limited set of feasible adjustment strategies, debt ratios range between 90 and 120 percent of GDP by 2050, depending on how the adjustment method interacts with the direct and indirect tax base—the fiscal pressures from aging imply a relative expansion of the latter. Essentially, achieving structural balance by 2011 amounts to prefunding a substantial part of aging-related liabilities, but it would not resolve the long-run financing problem in its entirety.

Figure 5.
Figure 5.

Germany: Debt Dynamics of Selected Medium-Term Fiscal Adjustment Strategies

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.

Phasing of the adjustment

61. Political as well as technical reasons may prevent a front-loading of fiscal adjustment. After the significant tax increases in 2007, the political room for further adjustment on the revenue side may be limited. Furthermore, designing a package of high-quality expenditure-saving measures may require significant lead time and implementation may need to be phased in. GFM allows to quantify the implied economic and fiscal trade-offs between an immediate, delayed, and gradual adjustment. Two alternative scenarios to the ½ percent adjustment package are considered: (i) a more gradual ¼ percentage point adjustment completed only by 2015, and (ii) a delayed implementation of ½ percent adjustment until 2011–15.

62. Delaying adjustment or more gradualism increases the medium and long-term debt burden only modestly (Figure 6). As deficits remain higher under more gradual or delayed adjustment, debt dynamics will be slightly less favorable. As long as the adjustment strategy is credible and convincingly completed before aging pressures peak, the negative spiral of rising interest rates, debt, and declining investment would be manageable, even with a more gradual path of adjustment.

Figure 6.
Figure 6.

Germany: Fiscal Adjustment Package: Delayed or Gradual Implementation 1/

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.1/ Gradual adjustment is defined as a ¼ percent of GDP fiscal adjustment for eight consecutive years between 2008–15; delayed adjustment defined as a ½ percent of GDP adjustment between 2011–15; mixed policy defined as package of revenue and expenditure measures with ½ percent of GDP adjustment between 2007–11.

63. Delaying or slowing down fiscal adjustment shifts the negative effects on growth to the medium term. The benefits of delaying action for a few years in terms of avoiding further contractionary impulses are limited. However, postponing reform even further, beyond the medium term, would have significant negative real effects. By delaying adjustment until a time when debt levels are accelerating together with aging pressures—e.g. beyond 2020—the government would have to engage in repeated and sizeable adjustments of the fiscal balance that lead to large output losses. This implies that the long-run aging problem needs to be substantially anticipated and resolved in the next decade before drastic measures will become necessary to secure solvency of the welfare state.

E. Spillover Effects

64. As Germany is an open economy, and well integrated with international capital markets, spillover effects of its policies are of interest. In GFM, spillover effects occur through trade and financial channels. Because Germany’s fiscal policies in isolation35 have only a small effect on the global pool of savings and investment, financial spillover effects in real interest rates will be relatively modest. Spillover effects through trade channels could be more substantial, although any change in import demand will also affect international relative prices.

65. The planned tax policy measures for 2007–08 have limited spillover effects for trading partners (Figure 7). Germany’s current account surplus improves further as a result of increasing the VAT. However, the effects on partner countries’—accession countries, euro-zone partners, and the rest-of-the-world (ROW)—growth and current account balances are modest because the VAT increase will have only temporary and small effects on German consumption and import demand. Furthermore, as Germany is well integrated with international capital markets, there is an offsetting effect on partner country growth through lower real interest rates—albeit this effect is small as Germany is a relatively small open economy. These spillover effects are even smaller when the increase in the VAT is combined with lower labor income taxes and CIT, as foreseen in the government’s plans as it reduces the impact on German consumption.

Figure 7.
Figure 7.

Germany: Spillover Effects of Tax Reform Proposals

(Difference from baseline in percentage points)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.1/ 10 new EU member states and Bulgaria, Croatia, and Romania.

66. Additional adjustment to achieve structural balance has limited supplemental spillover effects to other economic regions (Figure 8). Germany’s current account position will improve somewhat further because of the greater overall adjustment effort.36

Figure 8.
Figure 8.

Germany: Spillover Effects of Medium-Term Adjustment

(Difference from baseline in percentage points)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.1/ 10 new EU member states and Bulgaria, Croatia, and Romania.

F. Sensitivity Analysis

67. Sensitivity analysis indicates that the results outlined above are robust to changes in the behavioral assumptions and structural parameters of the model.

  • The relative impact of fiscal consolidation on economic growth does not vary much with different model parameters (Figure 9). The largest change in the results can be observed for a parameterization extending the planning horizon. More forward looking behavior would limit the crowding out effects of government debt, but would also reduce the impact on consumption of increasing the VAT. Less elastic labor supply would reduce the benefit of cutting payroll taxes, while higher price markups reduce the benefit of cutting corporate income taxes as more of the tax burden would fall on monopolistic rents rather than the return to capital.

  • The impact of the timing and the pace of consolidation depend on the planning horizon of consumers and their sensitivity to changes in interest rates (Figure 10). Implementing the adjustment to achieve structural balance is less costly if consumers are more forward looking, but overall the results are robust to changes in modeling assumptions.

  • If Germany is less well integrated in international capital markets, the debt-GDP ratio will increase faster. With perfectly integrated capital markets, real interest rate increase by only 20–30 basis points under the coalition’s proposals by 2050 (Figure 11). Introducing imperfectly integrated capital markets—by specifying a risk premium in relation to the change in the current account deficit to GDP—amplifies the increase in real interest rate in the long term to between 40 and 70 basis points. Government debt increases more quickly because interest payments rise more quickly, unless structural balance is achieved (Figure 12). The short-term costs of fiscal adjustment are also smaller, since interest rates decline more (Figure 13).37 These long-term beneficial effects of fiscal adjustment would be larger if the interest rate would be even more sensitive to the debt profile.

Figure 9.
Figure 9.

Germany: Sensitivity Analysis: Effects of Coalition Agreement on German Real GDP Growth 1/

(Deviation from baseline in percentage points)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.1/ Alternative simulations consider a longer planning horizon (100 versus 25 years in the baseline); less elastic labor supply (absolute elasticity of labor supply equal to −0.01 rather than −0.08 in the baseline); a smaller share of rule-of-thumb consumers (20 percent of consumers compared with 40 percent in the baseline); lower price markups (a reduction of 25 percent relative to the baseline), and less substitutability between capital and labor (0.60 rather than 0.75 in the baseline; with a value of unity indicating the Cobb-Douglas case).
Figure 10.
Figure 10.

Germany Sensitivity Analysis: Effects of Mixed Policy, Gradual, and Delayed Adjustment on Real GDP Growth 1/

(Deviation from scenario D in percentage points)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.1/ Alternative simulations consider a longer planning horizon (100 versus 25 years in the baseline); less elastic labor supply (absolute elasticity of labor supply equal to −0.01 rather than −0.08 in the baseline), a smaller share of rule-of-thumb consumers (20 percent of consumers compared with 40 percent in the baseline); lower price markups (a reduction of 25 percent relative to the baseline), and less substitutability between capital and labor (0.60 rather than 0.75 in the baseline; with a value of unity indicating the Cobb-Douglas case).
Figure 11.
Figure 11.

Germany: Sensitivity Analysis: Effect on Real Interest Rate

(Deviation from 2006 projection in basis points)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.
Figure 12.
Figure 12.

Germany: Debt Ratio with Imperfect Capital Market Integration

(Difference in debt relative to no-risk premium in percent of GDP)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.
Figure 13.
Figure 13.

Germany: GDP Growth Effects of Varying Risk Premia

(Deviation from baseline in percentage points)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

Source: GFM simulations.

68. The debt profile is highly sensitive to alternative assumptions about the cost of an aging population. Estimates for aging related spending pressures range from 2¾ percent of GDP to 7¾ percent. The debt dynamics after 2025 are highly sensitive to the size of these costs implying that, to help guide policies, the authorities should convene a group of independent experts to estimate aging costs as is done for the preparation of joint tax estimates.

A02ufig03

Government Debt Dynamics For Alternative Aging-Related Spending Projections

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A002

G. Conclusions

69. The coalition’s planned tax policy measures for 2007–08 significantly improve the debt outlook, achieve a more efficient tax system, but do not secure fiscal sustainability. GFM simulations suggest that the coalition’s tax reforms increase labor demand and incentives to save and invest by moving from direct to indirect taxation. As the reforms lower the deficit path, the outlook for debt improves, by about 60 percentage points of GDP, but not yet to long-run sustainability.

70. Fiscal adjustment leads to some sacrifice in growth and consumption in 2007, as necessary to address aging related spending pressures. Real GDP growth following the increase in the VAT is estimated to slow by about ½ percentage point upon implementation, with small effects on growth afterwards. The proposed reduction in payroll taxes in 2007 would reduce this impact on growth by half, while the planned reduction in corporate income taxation appears to be broadly neutral on growth.

71. Beyond the tax reforms in 2007–08, achieving structural balance over the medium term would further significantly improve the debt dynamics and set aside resources for aging-related liabilities. Model simulations suggest that ½ percent of GDP adjustment each year in the structural balance from 2008–11 would lead to a further significant reduction in government debt over the medium term. However, from 2030 onwards, debt would start to increase again, still resulting in a debt-to-GDP ratio of around 100 percent by 2050. Achieving structural balance by 2011, therefore, is no panacea.

72. Expenditure cuts and entitlement reform, in combination with base broadening and raising indirect taxes, compare favorably to raising direct taxes. Achieving structural balance through increasing payroll taxation—whether on workers or through social security contributions by employers—or taxation of corporate or personal income taxation implies the largest efficiency losses. At the same time, relying on cuts in government spending or social security transfers alone would require large cuts that may be politically difficult. Eliminating the structural deficit by 2011 through such a mix of expenditure and revenue measures lowers growth by about 0.2 percent per year.

73. Debt would be higher and adverse growth effects would occur later if achieving structural balance is delayed or occurs more gradually over time. Delaying adjustment to 2011–15 or phasing in adjustment more gradually to beyond 2011 would increase the debt ratio by 10 and 20 percent of GDP in the long run, respectively, while adverse growth effects are broadly the same in magnitude although occurring later. Postponing reform to the longer run, however, (say, waiting until 2020) would have significant adverse growth effects, as the government would be forced eventually to apply much larger and hence more distortionary adjustment measures.

74. International spillover effects on growth and current account imbalances are moderate. Under the assumption that Germany is well-integrated with international capital markets, the coalition’s reforms will have only a moderate impact on international saving-investment balances. As consumption declines in Germany in 2007 following the higher VAT, demand for imports falls. At the same time, by strengthening government saving, the international financing environment would improve somewhat (less crowding out of saving). Over the longer run, less pressure from government debt supports more private sector investment and growth.

75. These results are robust to alternative assumptions about the structure of the economy and the sensitivity of consumers and producers to changes in tax and expenditure policy. However, the debt profile is highly sensitive to alternative estimates of the cost of an aging population. The simulations indicated moderate effects of reducing the elasticity of labor supply to after-tax real wage, lengthening the planning horizon of consumers, reducing the faction of consumers that is excluded from financial markets, the sensitivity of consumers to changes in the real interest rate, reducing price markups, or lowering the substitutability between capital and labor. The introduction of country specific risk premia makes consolidation less costly and reduces the direct output costs of achieving structural balance, but makes the debt dynamics worse because of higher debt servicing costs.

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  • Botman, Dennis and Manmohan Kumar, 2006, Fundamental Determinants of the Effects of Fiscal Policy, IMF Working Paper 06/208 (Washington, D.C.: International Monetary Fund).

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  • Botman, Dennis, Doug Laxton, D. Muir, and Alexander. Romanov, 2006, A New Open Economy Macromodel for Fiscal Policy Evaluation, IMF Working Paper 06/45 (Washington, D.C.: International Monetary Fund).

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  • Botman, Dennis, Hali Edison, and Papa N’Diaye. Strategies for Fiscal Consolidation in Japan Japan-Selected Issues, IMF Country Report No. 06/276 (Washington, D.C.: International Monetary Fund).

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  • Evers M, Ruud A. de Mooij and Daniel J. van Vuuren, 2005. What explains the Variation in Estimates of Labour Supply Elasticities?, CesIFO Paper 1633.

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  • Werding, Martin and Anita Kaltschütz, IFO, Munich, 2005, IFO Beiträge zur Wirtschaftsforschung—Modellrechnungen zur Langfristigen Tragfähigkeit der Öffentlichen Finanzen.

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25

Prepared by Dennis Botman (FAD) and Stephan Danninger (EUR).

26

The fiscal aging cost profile is taken from a long-term fiscal scenario developed IMF Country Report 06/17, and is in between a more optimistic scenario by the authorities (Federal Ministry of Finance 2005, Werding and Kaltschütz 2005) and the EU’s Aging Working Group (2¾ percent), and a more pessimistic view expressed by the IFO institute (7¾ percent): although 4 percent of GDP is used as the baseline projection of aging costs, the sensitivity to alternative estimates is also analyzed.

27

In addition, the authorities’ are considering health care reform with potential fiscal implications.

28

See Botman and others (2006) for the micro-foundations of the model.

29

Other structural parameters have been calibrated using evidence from Laxton and Pesenti (2003) and Batini and others (2005).

30

The model has been applied by IMF staff for background work on recent Article IV consultations with Canada, Japan, the United Kingdom, and the United States.

31

The GFM imposes a fiscal reaction function that re-establishes debt sustainability only in the very long run. The simulations in this paper focus on benefits over a shorter policy horizon (until 2050).

32

Negative consumption growth effects in 2007 could be larger than indicated in the model, as GFM does not include anticipation effects in consumption ahead of the VAT hike (no consumer durables in the model).

33

The model also understates the sensitivity of investment to taxation as capital is not internationally mobile.

34

This policy package assumes a combination of the following measures in percent of GDP: 2008 ½ percent reduction in government consumption, 2009 ½ percent of labor income tax base broadening, 2010 ½ percent of reduction in government transfers, and 2011 ½ percent from a combination of cuts in transfers and raising the effective VAT rate.

35

Abstracting from the fact that other countries also face aging problems fiscal difficulties are set to compound on a global scale.

36

Again, this assumes that Germany is the tackling aging pressures in isolation. In reality, other countries may also be expected to reduce aging costs. To the extent that this induces global fiscal adjustment, global growth could slow, and the external current account of countries could swing either way, depending on their relative adjustment effort. At the same time, interest rate in Germany and other countries would be expected to decline by more.

37

The long-term debt projections in GFM are by 20–30 percentage points of GDP lower than long-term fiscal projections obtained reported in the accompanying Staff Report (Figure 12). Most of this discrepancy can be explained by the larger, endogenous, decline in the real interest rate in GFM following lower debt.

Germany: Selected Issues
Author: International Monetary Fund
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    Fiscal Developments

    (In percent of GDP)

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    Primary Expenditure

    (In percent of GDP)

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    Germany: Debt Path and Tax Reform Proposals

    (In Percent of GDP)

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    Germany: Economic Impact of Tax Reform Proposals 1/

    (Deviations from baseline in percentage points)

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    Germany: Composition of Mixed Policy Fiscal Adjustment Package 1/

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    Germany: Growth Effects of Medium-Term Fiscal Adjustment Strategies 1/

    (Average annual deviation in real GDP growth by adjustment method)

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    Germany: Debt Dynamics of Selected Medium-Term Fiscal Adjustment Strategies

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    Germany: Fiscal Adjustment Package: Delayed or Gradual Implementation 1/

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    Germany: Spillover Effects of Tax Reform Proposals

    (Difference from baseline in percentage points)

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    Germany: Spillover Effects of Medium-Term Adjustment

    (Difference from baseline in percentage points)

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    Germany: Sensitivity Analysis: Effects of Coalition Agreement on German Real GDP Growth 1/

    (Deviation from baseline in percentage points)

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    Germany Sensitivity Analysis: Effects of Mixed Policy, Gradual, and Delayed Adjustment on Real GDP Growth 1/

    (Deviation from scenario D in percentage points)

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    Germany: Sensitivity Analysis: Effect on Real Interest Rate

    (Deviation from 2006 projection in basis points)

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    Germany: Debt Ratio with Imperfect Capital Market Integration

    (Difference in debt relative to no-risk premium in percent of GDP)

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    Germany: GDP Growth Effects of Varying Risk Premia

    (Deviation from baseline in percentage points)

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    Government Debt Dynamics For Alternative Aging-Related Spending Projections

    (In percent of GDP)