Overview

1. The German economy is experiencing a robust upswing this year, growing at its fastest pace since 2000. While exports remain very strong, the main contribution to output growth is expected to come from accelerating domestic demand. The upswing is driven by solid profit expectations and increased capacity utilization, alongside the ongoing improvement in the labor market.

2. Being well aware of the cyclical factors supporting the recovery, the German government strongly believes that the various reforms since the Agenda 2010 of 2003 (in particular labor market reforms Hartz I–IV, as well as pension, health care, federalism, and capital market reforms) are beginning to show a positive impact on the economy. In addition, the carefully designed fiscal strategy, enacted by the Grand Coalition upon assuming office, is now supporting the upswing. The strategy rests on two pillars: the investment stimulating package Impuls and the gradually phased consolidation of the general government budget. This phased approach is now meeting its objective, which is to help the economy embark on a self-sustained growth path strong enough to endure the necessary fiscal consolidation.

3. However, the German economy is not yet out of the woods. Continued fiscal prudence and structural reforms are essential to address the challenges presented by globalization and population aging. My authorities are therefore continuing the reform process, labeled as path breaking in earlier staff reports. The reforms underway, while intensely debated within government and society, will eventually help ensure medium and long-term fiscal sustainability, promote employment, and further improve the environment for investment and job creation.

Economic Outlook

4. My authorities and the staff broadly agree on the economic outlook for this and next year. For 2006, the government projects real GDP growth of 2.3 percent, which it considers to be a conservative projection. Strong private investment and construction activity are the main drivers of growth. Importantly, the construction sector has started to expand again after many years of negative growth. The situation in the labor market has improved considerably and is bolstering the beginning recovery of private consumption. Export growth remains brisk reflecting a competitive manufacturing sector. Net exports are nonetheless contributing a smaller share towards output growth due to the acceleration of imports.

5. After benefiting from one-time effects this year, the economy will likely slow down somewhat at the beginning of 2007 due to the fiscal consolidation package. However, given the strong underlying momentum of the economy, my authorities share the staff’s confidence that the slowdown will only be temporary—an expectation that is supported by current high-frequency indicators. Overall, my authorities expect real GDP to expand by 1.4 percent in 2007 and the labor market to show further improvement. Inflation, which has been well below the eurozone average, will likely move up due to the forthcoming VAT increase, though only on a temporary basis.

Advancing Fiscal Consolidation

6. Continued expenditure restraint and accelerating economic activity will pave the way for a significant improvement in public finances this year. The general government deficit is now expected to be at 2.1 percent of GDP, as compared to a projection of 3 ½ percent of GDP at the time of the last Article IV consultation. As a result, the Maastricht deficit criterion will be met one year earlier than expected.

7. In 2007, the bulk of the windfall revenues will be used for reducing the general government deficit, which is projected to be at 1 ½ percent of GDP. Nevertheless, my authorities remain convinced that further structural adjustment of the budget is essential. They will therefore proceed as planned to implement their fiscal consolidation package, a key element of which is the increase of the VAT rate by three percentage points. This increase will still leave the German VAT rate below the EU average. One percentage point of VAT is earmarked to help fund the forthcoming reduction of unemployment insurance contribution rates by one third. More generally, the tax increase reflects a deliberate shift from direct to indirect taxes aimed to enhance economic efficiency. It is worth noting that despite the VAT increase, the revenue to GDP ratio will remain largely unchanged in 2007.

8. The structural fiscal improvement this year and next will in total be well above one percent of GDP, in line with staff recommendations. Beyond 2007, my authorities remain committed to continued structural fiscal adjustment over the medium-term. Annual growth of general government spending will be limited to 1 percent in nominal terms over the period of 2006 to 2010. At the end of this period, my authorities expect a budget deficit of close to balance.

9. The staff’s long-run fiscal projections and indicative public sector balance sheet are welcome analytical tools as they heighten awareness for the pressing issue of fiscal sustainability. While further adjustment measures will be required to ensure long-term fiscal sustainability, it should be noted that a number of actions are forthcoming or have already been implemented. These include inter alia the gradual increase of the retirement age and the phasing out of the homeowner subsidy. These measures will generate increasing expenditure savings over the longer term.

10. Entitlement reforms are progressing with a view to improving the long-term fiscal outlook. Further to the pension reforms of recent years, the cabinet recently decided to gradually raise the statutory retirement age from 65 to 67 years from 2012 onwards, as mentioned above. After intense debate on health care reform, the coalition government has been able to reach agreement on a substantive proposal. While stopping short of some more radical blueprints, the reform will instill more competition and transparency into the system through a broad array of measures to be phased in from April 2007. It will thus increase cost efficiency, while preserving the high quality of the German health care system. Furthermore, a reform proposal to strengthen the financial viability of long-term care insurance will be put forward in 2007.

11. The fiscal framework has been improved considerably by the federalism reform enacted earlier this year. Competencies of the federal government and the Länder have been disentangled. Fiscal discipline has been supported by clarifying the respective responsibilities of the federal government and the Länder in the context of the European Stability and Growth Pact. A second round of reforms focusing on the overhaul of financial relations between the various government entities will be launched in the near future.

Supporting Investment and Growth

12. As also acknowledged in earlier Article IV reports, since the 1990s Germany has made significant strides in liberalizing product markets and rolling back public ownership. Looking ahead, the government is determined to further improve the business climate, inter alia by reforming the corporate income tax (CIT), ensuring free and competitive product markets, and reducing the administrative burden. Alongside labor market reforms and improved conditions for research, development, and innovation, these actions should gradually feed into a pick-up in potential growth.

13. The proposed CIT reform will go a long way towards raising Germany’s attractiveness as a place to do business. The reform essentially involves a significant reduction of the composite corporate tax rate, which is currently among the highest in Europe, to just below 30 percent. This will be largely financed by broadening the tax base, although there will still be a reduction of the overall business tax burden by €5 billion. The thrust of the reform is thus in line with the international trend (tax-cut-cum-base-broadening policy). In the process, the tax system will be simplified, and various provisions will be introduced to reduce distortions in terms of tax treatment depending on the legal structure of the company, and to discourage profit shifting abroad.

14. The CIT reform is due for cabinet approval in March 2007 and for implementation in January 2008. It will be based on a recent proposal by a working group. This proposal differs in important respects from earlier deliberations that form the basis for the staff analysis. In particular, the initial proposal to limit interest deductibility, criticized by the staff and others, has now been largely abandoned. Also, accelerated depreciation provisions will be eliminated, as proposed by the staff.

15. On the electricity and gas industries, the new regulatory framework on access to networks and unbundling of services is currently being implemented. On liberal professions, bureaucratic hurdles are being lowered. On the guild system, while there are no plans for further reforms at this stage, several guilds have already been deregulated in recent years. Furthermore, in the first half of 2007, the government will conduct a review of the recommendations of the Monopolkommission, an independent advisory body dealing with issues of regulation and fair competition. Finally, we would note the ongoing comprehensive initiative aimed at lowering the overall administrative burden, as well as the plans of some Länder to further relax restrictions on shopping hours, some of which henceforth will be among the most liberal in Europe.

16. Raising Germany’s potential growth requires a substantial effort to boost research, development, and innovation. My authorities have made it a key priority to support this process. For example, from 2006 to 2009 the federal government will invest an additional €6 billion in R&D projects. This will contribute significantly to further increasing total R&D-investment (public and private) from currently 2.5 percent to 3 percent of GDP by 2010.

Fostering Employment

17. Unemployment has declined by more than half a million and the number of regular jobs subject to social security contributions has risen by more than 300,000 over the past year. Furthermore, the number of recipients of long-term unemployment assistance (UB-II) has declined markedly as of late. In particular, the latter shows that the labor market reforms of recent years are bearing fruit, even taking into account the support provided by the cyclical upswing.

18. Nevertheless, the still high unemployment is a matter of concern and its reduction remains high on the government’s agenda. At the same time, further reforms must strike a careful balance between flexibility and security, and it is of utmost importance that they have the necessary backing in the broader public. Against this background, and after the far-reaching changes already implemented in recent years, my authorities intend to proceed gradually with further reforms.

19. In August, legislative changes were enacted to address inefficiencies and cost overruns that have emerged under the new UB-II system. Furthermore, the provisions of means testing that have been adopted under the Hartz IV reforms will be implemented more rigorously. In addition, the cabinet intends to put forward proposals for further labor market reforms by the first quarter of next year, aimed at improving job incentives.

20. As regards active labor market policies (ALMPs), an evaluation including input from academia is currently being finalized. On this basis, a thorough overhaul of ALMPs is envisaged for 2007, aimed at eliminating those policies of limited effectiveness.

21. In order to strengthen incentives for labor demand and supply, the payroll tax wedge will be reduced considerably in 2007. The contribution rate for unemployment insurance will be lowered significantly, to be offset by a small increase of the contribution rate for pensions. This will result in a net reduction of non-wage labor costs by 1.9 percentage points.

Financial Sector

22. Numerous actions have been taken over the past years to improve the institutional framework governing financial markets. The German government is continuing along this path of swiftly and fully implementing agreed EU regulations while modernizing remaining national financial sector laws and regulations. This will ensure that the German financial system becomes even more effective in supporting economic growth, while maintaining strong prudential oversight.

23. Financial sector profitability has continued to rise this year and last, reflecting cost cutting, lower provisioning, and improved risk management, as well as cyclical factors. German banks are also increasingly tapping new sources of income generation. That said, profitability is not yet on par with international levels and innovation needs to advance further.

24. The restructuring of the Landesbanken (LBs) is making progress. Vertical integration of some LBs with regional savings banks (Sparkassen) is at an advanced stage. Others have been transformed into joint stock corporations operating under private law. This process will be continued.

25. That being said, my authorities consider that the staff’s findings on the LBs’ opportunity costs need to be qualified. First, caution should be used when extrapolating the results. The historic time period chosen for the analysis was one of unusually low profitability on the part of LBs. Also, the LBs face a changed regulatory environment following the recent withdrawal of government guarantees; they have reoriented towards new business models in recent years, and their performance has improved considerably. Second, the costs need to be contrasted with the LB’ benefits (including their role in promoting local economies), even if these are admittedly difficult to quantify.

26. Furthermore, conflicts of interest on the part of supervisory authorities are not an issue, contrary to staff suggestions. Owners and supervisors of the LBs are separate institutional entities, the former being the Länder and regional savings banks, the latter being federal agencies complying with the Basel Core Principles for Effective Banking Supervision. Indeed, the FSAP certified the supervisory authorities a high degree of independence and stated that political interference had not been considered to be an issue at any time. This continues to be the case.

27. The savings banks pillar of the German banking system continues to serve the economy well. The savings banks play a key role in the financing of small and medium-sized firms. This role continues to be usefully underpinned by the regional principle. In addition, the mostly long-term orientation of savings bank’ business relationships is beneficial from a stability perspective. Market trends with potentially procyclical effects have been followed only to a lesser extent.

28. The planned introduction of real estate investment trusts (REITs) in Germany will promote flexibility in property markets. It will also broaden the range of investment vehicles by complementing the existing open-ended real estate funds, given their different risk-return-profiles. While the recent draft bill proposes to largely exclude the existing stock of residential real estate, this restriction should not be overestimated. Experience elsewhere shows that, despite the eligibility of residential real estate, markets for REITs are effectively dominated by commercial property.