«Kiel Working Paper No. 1196 Germany’s Fiscal Policy Stance by Horst Siebert January 2004 The responsibility for the contents of the working papers ...»
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Kiel Working Paper No. 1196
Germany’s Fiscal Policy Stance
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Germany’s Fiscal Policy Stance Abstract: This paper analyzes Germany’s fiscal policy position. Half of GDP passes through the hands of government, a high debt to GDP ratio limits the maneuvering, and the revenue sharing mechanism prevents a competitive federalism. Most importantly for the future, the federal finance minister has to pick up the deficits that the social security systems leave behind. Transfers from the public budget to the social security systems are large, and since 1998 the elasticity of transfers to nominal GDP is 4. This trend will intensify in an aging society. All these factors weaken the prospects for reform that Germany must undertake in its taxation and expenditure system in view of the changed international conditions.
Keywords: Fiscal Policy, Subsidies, German Unification, Debt, Revenue Sharing, Social Policy JEL classification: E12, E13, H20,I 00 Horst Siebert Kiel Institute for World Economics 24100 Kiel, Germany Telephone: +49/431/8814-567 Fax: +49/431/8814-568 E-mail: firstname.lastname@example.org Germany’s Fiscal Policy Stance Germany’s fiscal policy condition has deteriorated since 2001. From 2002 to 2004, the budget deficit has exceeded the Maastricht limit of three per cent of GDP in three years in a row. Tax revenue remains way below expectations, the strategy of budget consolidation has been abandoned, and the public’s confidence in the government’s fiscal policy is in jeopardy. As in other policy areas, to effectively institute the structural features requires major reforms. The high debt to GDP ratio limits the maneuvering space of government, the revenue sharing mechanism prevents a competitive federalism and the finance minister has to pick the deficits that social policy leave behind. These factors not only weaken the prospects for reform, but they also make a steady fiscal policy nearly impossible and even put its sustainability into question. The already high annual transfers to the social security system and its implicit debt will be a topic that 1 will occupy German economic policy for the next two decades.
The Role of Government Spending in the Economy In Germany, the public sector absorbs half of GDP. The state’s share in GDP currently amounts to 49.2 per cent (2003), and 48.5 is forecasted for 2004. This includes the federal level, the Länder, the municipalities and the social security system. The share has increased by nearly twenty percentage points since 1950 when it was 31.6 per cent (Table A1 in the appendix). It was 32.9 per cent in 1960 and rose by six percentage points in the 1960s. In the 1970s, it then grew from 39.1 per cent by nine percentage points. In the recessions of 1975 and 1982
it stood at 49.9 and 48.9 per cent, respectively. Having been reduced to 44.0 per cent in 1989, it went up to a maximum of 50.3 per cent in 1996.
In the consolidated budget of the state, i.e. of the public sector, consisting of the three layers of government and the social security system, 24.5 per cent is spent for wages and intermediate goods, 3.3 per cent on investment, 6.3 per cent on interest, 3.0 per cent on subsidies and 55.7 per cent on social benefits and social 2 purposes (according to the macroeconomic accounts of 2002). The spending on social benefits and social purposes represents to an overwhelming part the expenditures of the social security system.
Germany is a federal state. Federalism is an approach to assign tasks to those layers of government that are best fit to solve. Issues of a local nature are to be handled at the local level. There information on the issue at hand is most likely to be available and local preferences can be voiced. Thus, municipalities should be involved in shaping local public goods and addressing local problems. This means, for instance, that they are responsible for the local infrastructure and for administering social welfare. Issues with a larger, but intermediate dimension are allocated to the federal states, the Länder. Problems where the benefits or costs affect the country as a whole are to be dealt with at the national level. Note that the spatial dimension of public goods is also discussed under the heading of the spatial extent of technological externalities or spillover effects. To start in the assignment of tasks with the lowest level and then to assign tasks that cannot be solved there to the higher levels of government is called the subsidiarity principle in the continental European tradition. This principle is at the heart of federalism. Assigning public goods of different spatial dimensions to different levels of governments provides the guideline for the allocation of expenditures
and revenues to the different levels of government (fiscal equivalence, Olson 1969).
The expenditures of government, i.e. of the three organizational layers of the state, the federal level, the Länder and the municipalities, excluding the social security system, account for about three-fifths of the state’s spending. The social security system makes up about two-fifths. The federal layer comprises about 40 per cent of the spending of the government (Table 1). Note that there are many cross flows between the different layers; therefore the sum of the gross expenditures is not identical to consolidated spending of either the government 3 or the state. For instance, the federal government provides transfers to the Länder and the Länder allocate funds to the municipalities. Moreover, the social security systems receive transfers from the federal level.
Table 1: Structure of the State’s Budget, bill euro, 2002 a
a Unconsolidated flows, therefore not addable vertically. b Figure rounded downward..
Source: Federal Statistical Office, Macroeconomic Accounts.
3 Not all transfers are calculated identically. Thus, at the federal level supplementary transfers of the federal layer to the Länder are netted with tax receipts so that they appear as a lowering of tax revenue, whereas financial transfers represent expenditures and are itemized on the expenditure side.
6 It can be expected that Germany’s high share of government spending in GDP has a negative impact on the economy, especially on the growth rate. With the German government controlling aggregate spending equalling nearly half the GDP, it is likely that Germany is on the right hand slope of a bell-shaped curve representing the growth rate versus the share of governmental spending. A reduction of the government’s expenditures will set free resources and create more maneuvering space for the private sector, and it will stimulate new initiatives by firms and entice effort of market participants. This prescription applies particularly to the overwhelming part of consumptive expenditures of the government; governmental expenditures for investment stood only at 1.6 per cent of GDP in 2002, having fallen to one third from its 1970 level. The task of German economic policy must be to find the optimal size of governmental activity and to rethink and reduce the role of government spending in the market economy.
The Tax System
The two taxes with the highest revenue are the income tax and the value added tax (Table 2). The income tax has as its tax base individual income and income of the corporations. It includes seven income categories, among them the wage income of employees, the income of self-employed (assessed income tax) and income from capital. The corporate tax, a tax on the income of incorporated firms, normally provides a revenue of around 20 bill euro per year. It had low revenues of only 7.5 bill euro in 2003, 2.9 bill euro in 2002 and even a negative revenue of 0.4 bill euro in 2001 due to the tax reform of 2000. The value added tax is paid on the value added generated at each stage of production, but passed on to domestic final consumption demand. Investment and exports are exempt from it. A tax with an important revenue is the petroleum tax, which includes the 7 tax on gas for cars and heating oil; moreover, the local business tax is an important source of revenue for the municipalities.
Table 2: Tax revenue, bill euro, 2003a
a Preliminary Data. – b Tax on interest income, solidarity payment.
Source: German Council of Economic Advisers (2003: 266) The distribution of tax revenue also reflects the federal structure. Thus, the two taxes with the highest receipts are split between the federal, the states and the municipal level. The federal level and the Länder each receive, in broad interpretation, 42.5 per cent of the wage and assessed income tax revenue, with the remaining 15 per cent going to the municipalities. The corporate income tax is split half and half between the federal level and the Länder half and half. The revenue of the value added tax is divided between the federal government, the Länder and the municipalities in the proportions of 51.4 per cent, 46.5 per cent and 2.1 per cent, respectively. While the petroleum tax is purely a federal tax, the tax on property (real estate) is purely a local tax. At the moment, a wealth tax is not levied.
8 As of 2005, the income tax begins to be applied at a taxable income of 7 665 euro per year for a single individual with a tax rate of 15 per cent. Income below that threshold is not taxed. The tax rate then increases to a maximum of 42.0 per cent at an income of 52 152 euro and remains constant thereafter. These rates represent the marginal rates. In the income bracket up to 12 755 euro, the marginal rate increases steeply up to 25.97 per cent; it then rises more slowly up to 52 151 euro. For a married couple, total income is split in half and then taxed respectively (known as “splitting”). For each child, 5 808 euro can be deducted per year from the taxable income. Families who do not earn enough to benefit from this arrangement (taxable income less than 52 632 euro) receive a child allowance (Kindergeld) amounting to 154 euro for each of the first three children and 179 euro for each child thereafter.
Value added tax is paid on the additional value generated at each stage of production where value added means income paid to factors of production plus pure profits at each stage. The tax base is defined as sales minus costs for intermediate products bought from other suppliers minus investment expenditures. Each firm pays tax on its revenue and subtracts the value added tax paid by the previous suppliers in the vertical chain of production. There is no value added tax for exports; this also applies to exports to the other EU countries. Exporting firms can deduct the value added tax paid by the previous suppliers. Imports are taxed with the value added tax. This means that in the European Union the tax is paid in the country where the product is finally consumed carries the burden of the value added tax (so called principle of destination). Investment goods also are exempt from the value added tax. Thus, the value added tax is de facto a tax on consumption. Unlike a cumulative sales tax, the value added tax avoids accumulating the tax amount over the vertical chain of production. The rate of the value added tax in Germany is 16 per cent;
however, a reduced rate of 7 per cent applies to foodstuff, media products and some other goods. There is no value added tax on housing rents, unless it is done commercially.
Besides some changes in the years from 1998 to 2001, the tax reform decided by parliament in 2000 reduces the tax load in several consecutive steps in the years 2001-2005 (Table 3). Regarding the income tax for individuals, the threshold of taxable income at which the income tax starts has been raised. Moreover, the initial income tax rate has also been brought down so that people with lower incomes pay less taxes. The maximum income tax rate also has been lowered considerably coming down to 42 per cent from 53.0 in 1998. However, the threshold from which the maximum income tax rate applies has also been scaled down, implying that the maximum rate now refers to lower incomes. The 10 revenue elasticity of the reformed income tax is even higher than the elasticity for the 1998 tax according to a simulation, due to the steeper rise of the marginal tax rate over some income ranges (Boss and Elendner 2003).
Table 3: Tax base and tax rates of the income tax, 1998-2005
a A different rate applied to commercial income; maximal tax rate 47, 45 and 43 per cent, respectively.– bApplies also to the distribution of dividends.
For firms, the rate of the corporate income tax has been reduced from 45.0 per cent in 1998 to 25.0 per cent. This rate applies independently of whether the earnings are retained or whether they are paid out as dividends. Additionally, firms must pay the local business tax so that the tax rate from both taxes is estimated to equal 39 per cent for the larger corporations. The owners of small firms can deduct part of the local business tax from their income tax. The tax load for firms is still high compared to other countries. Thus, for incorporated firms the marginal tax rate is estimated at 40.7 per cent in 2003, the effective marginal rate at 31.1 per cent and the effective average rate at 37.2 per cent.
4 This is higher then in France with the exception of the effective marginal rate, in Italy, Ireland, the Netherlands and Sweden (Council of Economic Advisers 2003, Table 58).
For the capital owner, who supplies his savings, the tax rate is different from that of the firms because he must pay his personal income tax on his dividend or 5 interest income. There is no capital gains tax outside the speculation period.