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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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According to his consolidation plan, the federal budget was to be balanced in 2004, this then was shifted to 2006 and eventually given up. Surprisingly, it was after the election in the fall of 2002 that the dire situation of the budget became known to the public. Eichel at first had introduced a new principle into fiscal policy, that of sustainability, a concept stressed by the German Council of Economic Advisers in its Annual Reports in the 1990s. According to this concept, popular from environmental economics, the long-run effects of fiscal policy, i.e. the opportunity costs for future generations, are to be taken into account. Most importantly this relates to the long-run effects of increased government debt. However, Germany’s budget deficit increased from 1.5 per cent to GDP in 1999 and 1.2 per cent in 2000 (if one excludes the receipts from the sale of licenses for the Universal Mobile Telecommunication Systems (UMTS) to 3.5 per cent in 2002 and an (expected) 4.1 per cent in 2003. These figures apply to the state in total, including the social security system and all layers of government. It is the unpleasant job of the finance minister to be held responsible not only for the federal government’s actions but also for the expenditures and revenue of the state as a whole. This accountability relates not only to the social security systems, where the federal layer (together with the Länder) has the authority to set the laws, but also to the Länder and 38 municipalities, where the federal minister has no direct control over their budgets. Nevertheless, spending by the Bund creates the overwhelming part of the budget deficit, which equals roughly two thirds, though varying through the years. Moreover, the federal government has the responsibility to define the institutional setting for fiscal policy, including the taxation system.

The increased budget deficit is only one of the indicators of Germany’s disappointing fiscal policy situation. Thus, it now has become almost customary that a budget, which has been passed in parliament, will not live through the year. The budget does not cover all the expenditures that arise unexpectedly, and it is too optimistic with respect to expected revenue so that a revised budget, then with a much higher deficit, becomes necessary in autumn to have a formal financing for the year’s expenditures. It is fair to say that the budget deficits are not caused by a spending spree. Expenditures of the federal level increased by

2.3 per year from 1999 to 2003 in nominal value, and those of all three layers of government together rose by 2.1 per cent. A major factor in the budget deficits is the poor showing of tax revenue. Total tax revenue has declined by 22 bill euro from 2000 to 2001, i.e. by 4.4 per cent. It remained at about that lower level in 2002 and increased slightly in 2003 by 1.1 per cent according to the taxation forecast of the German Council of Economic Advisers. In the past, the recessions of 1975, 1982 and 1992 did not lead to reduction of tax revenue, only in 1975 revenue more or less stagnated. Thus, one must look for one-time causes or for structural factors to explain the recent decline. One possible explanation is that the fall in revenue in 2001 simply is the effect of the tax reform. Thus, firms were allowed to apply (unused) depreciation allowances of periods prior to the tax reform, and the revenue of the corporate income tax fell by 20 per cent. But other taxes also brought a lower revenue, namely the income tax including the tax on wage income, the value added tax and the local business tax. It remains to 39 be seen whether structural issues are behind the fall in tax revenue. This would have long-run implications for Germany’s fiscal policy position.

A specific issue, also showing the actual strains of Germany’s fiscal policy stance, is the reduction of total revenue of the municipalities since the mid 1990s relative to nominal GPD by about one percentage point. One aspect is that the revenue of the local business tax has fallen by from two to one per cent of nominal GDP in the last three decades. Another aspect is that the revenue of municipalities relies to a large part on transfers (more than one third); only one third of the revenue comes from taxes. The problem is that municipalities do not have their own tax base and that a reform is needed in which their will receive more taxation autonomy. This, however, can only be achieved in a major restructuring of Germany’s fiscal federalism.

Fiscal Policy – The libero of social policy

A major problem of German fiscal policy is that it has to step into the breach when the social security systems creates a deficit. Fiscal policy thus is like the libero in soccer, representing the last resort. The finance minister has to help out when the rising expenditures of the social security system can no longer be financed from contributions. It is remarkable that the elasticity of transfers with respect to nominal gross domestic product is surprisingly high. In the period 1998 – 2002 it amounted to 4; an increase of nominal GDP in the whole period of 9 per cent was accompanied by an increase in transfers of 39 per cent. Indeed, transfers to the social security systems have risen considerably in that period (Table 7). In addition, the social security system has developed a sizable deficit amounting to 6.6 bill euro or 1.4 per cent of its expenditures. Part of this high elasticity can be explained by the automatic stabilizers operating when nominal 40 economic growth was low, only at around two per cent. That part of the high elasticity is not disturbing because in periods of higher nominal, and of course more importantly of higher real growth, transfers would increase less. It is, however, a different story that a large part of the increase is structural so that the higher elasticity expresses a new long-run relationship, i.e. an increased absorption of transfers by the social security system. Unfortunately, with the expansion of the welfare state the calculation of elasticities of previous periods as points of orientation would not be too helpful because the structural relationship has changed. Thus, the transfers from the federal budget to the social security system account for 25 per cent of the federal expenditures. This proportion has doubled since the 1980s; it was 15 per cent in 1995 (German Council of Economic Advisers 2003: 257).

Table 7: Received Transfers of the social security systems, bill euro

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a Forecast of the German Council of Economic Advisers.

Source: Federal Statistical Office, Macroeconomic Accounts.

In the last thirty years politics has done away with some of the buffers that existed between the deficit of the social security system and fiscal policy. Thus, the precautionary mechanism of the pay-as-you-go system such as reserves of one year’s expenditures in the pension system was given up. In recent years, the 41 Schröder government even reduced the required reserve of the pension system from one month’s expenditure to those of 0.8 month, then to 0.5 month and now to 0.2 month in order to gain a short-term interim tiny source of finance. This implies that fiscal policy has to take over the deficit of the social security system as it arises, making governmental expenditures more volatile. Another repercussion would be that the responsibility for welfare recipients capable of working will be transferred from the municipalities to the federal level. This means that a decentralized institutional buffer between social policy and fiscal policy will be abolished.

Taking the future aging of the population into account, the opposite development would have resulted, namely to introduce additional buffers between the two areas of policy so that fiscal policy can follow a steady course and so that declining revenue in the social security systems in a recession is cushioned by the sufficient reserves of these systems. Moreover such a buffer is needed to offer protection when the implicit debt of the social security system becomes explicit. Thus, the simple concept of the elasticity of transfers to the social security system from tax revenue in relation to nominal growth can be used to express the knot between the policy issues facing Germany. At the same time it shows, how important the reform of the social welfare systems is for fiscal policy to become credible again.

Fiscal policy under new international constraints Although stepping into the breach as a financier of last resort for the different branches of the social security system is one of the new job requirements for a finance minister, fiscal policy also faces a new international environment.

42 An international restraint for German fiscal policy arises in the context of the stability pact in the European Monetary Union. If this pact would be taken seriously, which does not seem to be the case, Germany still has to allocate the responsibility to the three layers of government. The federal layer should be responsible to control the deficit of the social security systems, but it cannot directly influence the expenditures and the budget of the Länder with their municipalities. So far, there is only an agreement that the layers of government take into account the implications of their behavior with respect to deficits in their medium-term financial planning.

The solution must exist in a binding agreement between the federal layer and the Länder in which they split their responsibility to prevent excessive deficits. In such an internal stability pact, the obligations of the European Monetary Union’s stability pact would have to be broken down for the three layers of government, while taking into account such factors as sensitivity of expenditures at these levels with respect to the cycle and, of course, the structure of the expenditures.

Thus, the permissible deficit of 3 per cent could be allocated in accordance with the proportions of the expenditures of the federal level and the Länder level if one excludes the municipalities. This would be half and half.

A much more important change in the international environment is that most factors of production, capital, technology and also highly-qualified labor, as well as portfolio capital have become more mobile. These factors of production have an exit option, i.e. they can avoid national taxation if they simply move to another place abroad or into the shadow economy at home. According to the concept of locational competition, the maneuvering space of national states and fiscal policy is reduced (Siebert 2000). Consequently, it becomes harder to tax these mobile factors of production. In the future, this change will also apply, at least to some extent to the choice of residence of pensioners in Europe and 43 especially in the euro area. Of equal importance is that national policy has to react to tax reductions elsewhere. This environment will not make it easier for German fiscal policy to solve the structural issues it faces, including high debt, large transfers to the social security systems, a sizable implicit debt and a distributive federalism.

The attempts to restrain this tendency of locational competition by international macroeconomic cooperation are not too promising, even within the European Union. Some of the EU member states are not prepared to cede their national sovereignty in these matters; they are not willing to renounce their own options in this competitive game in order to make it easier for the finance minister of another country. Thus, it can be expected that the European Union will not go beyond some agreements of minimum standards in taxation as we already know them for the minimum rates for the value added tax. For instance, some of the distortionary business taxes representing strong location incentives for production or holding companies may be prevented in the future.

Macroeconomic coordination in this area beyond the European Union is a fruitless attempt, anyhow. Fiscal policy will have to live with the exit-option of the mobile factors of production.

44 Appendix Table A 1: Different Shares of the state in per cent of GDP a

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a All shares in current prices according to the Macroeconomic Accounts, European System of Macroeconomic Accounting, basis 1995. - b Until 1990 West Germany, since 1991 Germany.

- c For West Germany until 1989 according to ESMA 1979. - d Interest payments for public debt in relation to tax revenue. - e Excluding the Saar and West Berlin. - f Tax revenue is reduced since 1996 by the child allowances which are considered as a negative tax and which are netted out.- g Including the revenue from auctioning the licenses for the Universal Mobile Telecommunication Systems (UMTS), amounting to 2.5 per cent of GDP. – h Forecast of the Kiel Institute. – i Council of Economic Advisers Annual Report 2003/2004.

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a Per Inhabitant, in current prices. – b Including Berlin Source: Arbeitskreis Volkswirtschaftliche Gesamtrechnungen der Länder (http://www.statistik-bw.de/Arbeitskreis_VGR/) 47 References Boss, Alfred, and Astrid Rosenschon. 1996. Öffentliche Transferleistungen zur Finanzierung der deutschen Einheit: eine Bestandsaufnahme. Kiel Discussion Papers 269. Kiel: Institute for World Economics.

Boss, Alfred, and Astrid Rosenschon. 2002. Subventionen in Deutschland:

Quantifizierung und finanzpolitische Bewertung. Kiel Discussion Papers 392/93. Kiel: Kiel Institute for World Economics.

Boss, Alfred, and Thomas Elendner. 2003. Steuerreform und Lohnsteueraufkommen in Deutschland. Simulationen auf Basis der Einkommenssteuerstatistik. Kiel Working Papers 1185. Kiel: Kiel Institute for World Economics.

Deutsche Bundesbank, 1996. Zur Diskussion über die öffentlichen Transfers im Gefolge der Wiedervereinigung. In: Monatsbericht Oktober 1996, pp. 17

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German Council of Economic Advisers. 1995. Im Standortwettbewerb. Annual Report 1995/96. Stuttgart: Metzler-Poeschel.

German Council of Economic Advisers. 2001. Für Stetigkeit – Gegen Aktionismus. Annual Report 2001/2002. Stuttgart: Metzler-Poeschel.

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German Council of Economic Advisers. 2003. Staatsfinanzen konsolidieren – Steuersystem reformieren. Annual Report 2003/04. Stuttgart: MetzlerPoeschel.

Musgrave, Richard A., and Peggy B. Musgrave. 1989. Public finance in theory

and practice. 5th ed. New York: McGraw-Hill. first published as:

Musgrave, Richard A. 1959. The theory of public finance. A study in public economy. New York: McGraw-Hill.

Olson, Mancur jr., 1969. The Principle of "Fiscal Equivalence": The Division of Responsibilities among Different Levels of Government. American Economic Review 59: 479-487.

Organisation for Economic Co-operation and Development. 1997. Maintaining Prosperity In An Ageing Society: The OECD study on the policy implications of ageing - Fiscal alternatives of moving from unfunded to funded pensions. Working Paper AWP 5.2. OECD. Paris. Available from World Wide Web: (http://www.oecd.org/dataoecd/21/41/2429222.pdf).

Siebert, Horst, 2000. Zum Paradigma des Standortwettbewerbs. Walter Eucken

Institut, Beiträge zur Ordnungstheorie und Ordnungspolitik 165, Tübingen:

Mohr Siebeck.

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