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«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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Nevertheless, transfers still flow to East Germany. These include transfers from government to the enterprise sector, from the federal government to the public 21 budgets of the federal states in Eastern Germany (vertical revenue sharing), within the revenue sharing among the federal states (horizontal revenue sharing), and within the social security system. There are two major types of investment aid to firms: a tax subsidy (Investionszuschuss) with a volume of 2.3 bill euro in 2002, and an investment support in the context of regional policy with a volume of 1.9 bill euro in 2002 (Gemeinschaftsaufgabe regionale Wirtschaftsförderung). Whereas an investor in the producing sector and the production-related service sector is entitled to the tax subsidy of 12.5 per cent of the investment outlay (25 per cent for small and medium sized firms) according to federal law, the investment support, which can go up to 50 per cent of the investment for small firms in structurally weak areas, is granted upon a filed application and subject to the financial means available. It is administered by the Länder. The tax subsidy was supposed to stop at the end of 2004 but will be extended to 2006. The investment support is a normal policy instrument in regional policy and therefore will continue. With respect to the flows within the governmental system, the federal provides supplementary transfer payments (Bundesergänzungszuweisungen) in a vertical revenue sharing. In addition, a scheme to be effective until 2019 has been agreed upon for the flows between the federal layer of government and the East German Länder (Solidarpakt Ost).

These flows with an annual volume of 3.4 bill euro are intended to finance infrastructure projects (Sonderbedarfs-Bundesergänzungszwuweisungen).

Together these vertical flows add up to the five states in East Germany amounted to 10.2 bill euro. Adding up the federal supplementary transfer payments with the horizontal flows from the other Länder, the East German federal states received a total of 13.4 bill euro in 2002 (see Table 6 below). The horizontal transfers between the Länder are the implication of the institutional set-up of Germany’s revenue sharing (see below). With respect to the flows within the social budget, the West-East transfers are estimated 27.9 bill euro for 2001 (Federal Ministry of Health and Social Affairs 2002, Table 43). This is the 22 upper bound for flows within the social security system for which there are no data. All amounts sum up to about 45 bill euro, which is about 2 per cent of GDP.

It is apparent that these transfers have affected Germany’s fiscal position negatively. Transfers were partly financed by higher taxes, though admittedly only to a minor extent. Nevertheless, taxes had to be raised, and they could not be reduced as in other countries. A larger part of the transfers was financed through credits leading to a doubling of government debt from 0.46 trillion euro (1989) or 42 per cent of GDP to 1.35 trillion euro in 2003 (64.2 per cent of GDP). A debt of 1.42 trillion euro is forecasted for 2004. Transfers and debt have repercussions on the maneuvering space of government in many ways. One aspect is that the interest load is high with 15.2 per cent of the tax revenue being spent to pay interest on public debt. Another consequence is that the option to reduce taxes is severely limited by the interest load for new debt. Thus, even after the 2000-tax reform with its final stage being implemented in 2005, the effective tax rates for German firms are still high relative to the other EU countries. All of this had a negative impact on growth, or, to put it differently, a potential stimulus for economic growth was not available.

There are additional consequences for Germany’s economic position. Transfers were organized within the social security system. The share of contributions to social security increased from 15.0 per cent of GDP in 1990 (West Germany) to 9

17.5 per cent in 2001. It is not clear to what extent this increase can be traced exclusively to the transfers within the system or whether it reflects a general expansion of the welfare state. As an example, nursing care insurance was introduced in 1995 requiring additional contributions amounting to 1.7 per cent of the gross wage or 0.8 per cent of GDP. But even if only part of the higher

9 German Council of Economic Advisers, Annual Report 2002/03, Table 34* 23

contributions within the social systems is due to unification, it means that the tax on labor has been raised in Western Germany, with a negative impact on employment there. Another effect of the consumptive transfers is that domestic demand increased leading to a real appreciation of the deutsche mark that affected Germany’s competitive position until 1995. It seems that West Germany has been partly inhibited by financing the transfers, but it also seems that West Germany was not able to unfold enough economic dynamics for a strong carry-over to East Germany.

The political demand for transfers can be considered as an Achilles heels of German fiscal policy. This demand would be reduced if the catch up process would pick up in Eastern Germany which now stands at 66.2 per cent of the West German GDP per capita of the population including Berlin (2002); it is

71.2 per cent of the German level. Unfortunately, the convergence process has come to a halt since 1997. An important prerequisite for strong regional growth is that initiative and an optimistic mood prevail as the rare examples for a successful regional restructuring and for a successful quick convergence process in Ireland and, on the municipal level, of Pittsburgh show. I hesitate to mention the coastal regions of mainland China as another example. Whereas the majority of people in Eastern Germany seem to have a somewhat optimistic outlook, the PDS, the Party of Democratic Socialism and the political successor of the previous communist SED, appeals to people’s feeling of being deprived and still collects up to 20 per cent of the votes in the regional elections. In such an environment, optimism is constrained.

The demand for transfers would also weaken if East Germans were prepared to give up their 100 per cent mentality and if they would accept that the same conditions cannot prevail everywhere in the federal republic and that neither the same income per capita can be reached in each locality of the country, nor the 24 same public infrastructure can be provided everywhere. The policy issue for Germany then is to get more economic dynamics into East Germany.

Debt Tax revenue has not been sufficient to finance the expenditures of the state.

Since 1990, the deficit of the state budget has been 3.0 per cent on average per year. To finance government expenditures through credit seems to have become a normal business practise. Only in the years prior to the establishment of the European Monetary Union with its entry criteria on the budget deficit and the debt levels was there some restraint on deficit financing. When we look at the 1990s in more detail, the only annual positive balance in the state’s budget in the year 2000 is due to the special circumstance of auctioning the licenses for the Universal Telecommunication Systems; without these receipts, there would have been a deficit in that year as well, in the magnitude of 1.2 per cent. The peak in the deficit in 1995 was caused by integrating the debt from the shadow budget of the East German privatisation agency (Treuhandanstalt).

25 Figure 2: Budget Deficits and Debt, 1970-2004

-10 10 70

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4 40

-4 2 30

-2 0 20 0

-2 10 2 1970 1975 1980 1985 1990 1995 2000 2004.

Germany has seen quite an increase in debt relative to GDP (Figure 2, Table A 1). This ratio has more than doubled from 1970 to 1990 from 18.6 per cent in 1970 to 41.8 per cent in 1989. Since then it rose again by twenty percentage points to 64.2 per cent in 2003. The absolute amount of debt doubled in the 1990s. Only in the 1980s was the budget deficit reduced, and debt increased more slowly in this period. The 1970s and the 1990s were decades in which debt was on a stark rise. Germany has violated the 3 per cent debt to GDP criterion of the Stability Pact for the European Monetary Union in the years 2002, 2003 and

2004. The deficit of 2.8 per cent of GDP in the year 2001 hardly upheld the spirit of the treaty either. Apparently, an international treaty on the important issue of a common European money does not represent a sufficient constraint for government spending.

26 National institutional arrangements have also not succeeded in restraining the increase in public debt. Thus, article 115 of Germany’s Constitution limits the issuing of new debt to the amount of public investments. This requirement has been violated quite often in the last twenty years, because there is a clause in article 115 specifying that if the macroeconomic equilibrium is disturbed, the government may take measures and thus incur new debt, i.e. finance expenditures out of credits or reduce taxes, if these expenditures will lead back to an equilibrium. It has become almost a routine that the government simply proclaims a macroeconomic disturbance once its budget shows a deficit.

Governments have not been very choosy in explaining and defining the type of disturbance. For instance, they regularly have pointed to the high rate of unemployment. But this is a phenomenon that has existed for more than two decades, and it has been well known when budgets were passed in parliament.

The government also does not take care to prove, as required by the Constitution, that the measures will be appropriate to restore equilibrium. The political process, the public and the press all have become accustomed to not taking the constitutional constraint seriously. Those in charge of the budget violate well established practices and well founded norms. Another institutional feature, that the finance minister has a veto right against expenditures, has not succeeded in restraining debt either. The consequence of using the veto right would only be credible if in the end one is willing to resign, and ministers are reluctant to do that. This instrument was only used twice, by the social democratic ministers Alex Möller in 1971 and Karl Schiller in 1972. Moreover, the ability of the Chancellor to dismiss the minister is simply too strong so that a finance minister is disinclined to use his veto.

A specific concern is the implicit debt of the public insurance systems. This amount equals the sums of deficits that will arise in the social security systems over the next decades being discounted to its present value. In these calculations 27 it is assumed that the benefits continue to be paid according to the actual legal stipulations and contribution rates remain at their actual level. The aging of the population is taken into account. Assuming a GDP growth rate of 1.5 per cent and calculating the present value with an interest rate of 3 percent, the German Council of Economic Advisers (2003/04: 420) estimates the implicit value of debt of the social security system ( including the pension system for government officials and deficits in the deficit of the government) of the period up to 2050 at 270 per cent of the GDP of 2002. This figure indicates the adjustment needs of society if such a debt is to be prevented. According to previous OECD studies, Italy and France have markedly higher implicit debt than Germany (OECD 1997, Table 2).

Distributive federalism

A specific feature of Germany’s fiscal policy is its federal structure. Fiscal federalism is rooted in German history, where for centuries people lived in an environment of many principalities without a unified state. Unification only then occurred in 1871, however the regional level continued to play an important role in economic decisions. With this historical background and with the experience of a centralized state under the Nazis, a federal structure was attractive when the new constitution was developed, first to guarantee that regions could voice their preferences and second as a check on excessive power.

As already discussed, according to fiscal federalism and fiscal equivalence the federal governmental level should be in charge of public goods with a spatial dimension extending over the whole political area and that lower levels should be responsible for those public goods that are spatially less extended. Fiscal equivalence, the subsidiarity principle and fiscal federalism are allocation 28 concepts. They define organizational layers of governments that are consistent with a hierarchy of public goods in their spatial dimension. These concepts thus belong to Musgrave’s (1959) allocation branch. Germany has supplemented this allocation concept by equity considerations, i.e. with the distributive branch.

Article 72 of the German Constitution expressly contains the target of having similar living conditions in the area of the Federal Republic.

The term living conditions is vague. Looking at economic conditions in terms of productive capacity, measured by GDP per capita of the population, there are differences between the states of Germany. Of course, these are especially strong between states in Western and states in Eastern Germany. In the new Länder (except Berlin), GDP per capita was at about 66 per cent of the German level in 2002; it was a little bit higher in Saxony. Berlin including East Berlin reached 89.0 per cent, Eastern Germany including Berlin was at 71.2 per cent.

West Germany with 107.5 per cent was above the German average. Even without the strong differences between Eastern and Western Germany, it is quite normal to have a variance in the economic situation of the Länder. Some of the Länder with greater territory in the West are below average in their GDP per capita. For example, Lower Saxony and the Rhineland-Palatinate reached 84 per cent of the average West German level, with Schleswig-Holstein and the Saarland being one or two percentage points higher. In contrast, the city-states of Hamburg with 170.4 per cent and Bremen with 136.0 per cent were above average. Hessen (123.2), Bavaria (116.8) and Baden-Württemberg (113.1) were 10 also above average.

The requirement of similar living conditions does not, however, refer to GDP per capita. Indeed it could not, since GDP per capita is the result of market

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