SARKOZY'S TAX CUTS

UNCLAS SECTION 01 OF 02 PARIS 002089 SIPDIS SENSITIVE SIPDIS PASS FEDERAL RESERVE PASS CEA STATE FOR EB and EUR/WE TREASURY FOR DO/IM TREASURY ALSO FOR DO/IMB AND DO/E WDINKELACKER USDOC FOR 4212/MAC/EUR/OEURA E.O. 12958: N/A TAGS: EFIN ECON ELAB PGOV FR SUBJECT: SARKOZY'S TAX CUTS REF: Paris 2003 ¶1. (SBU) Summary: President Nicolas Sarkozy's proposed fiscal and macro-economic policy reforms are every bit as ambitious as his micro-economic agenda (reftel). In short order we expect Sarkozy to propose eliminating payroll taxes on hours worked above 35 hours, cutting inheritance taxes, introducing the tax deductibility of interest on primary residence mortgages, and limiting overall taxes to 50% of income. Sarkozy hopes to accomplish this - and to increase R&D spending - while cutting France's debt/GDP ratio to 60% (from its current 64%). In combination with proposed labor market reforms (reftel),Sarkozy's program is likely to have a positive short-term impact on economic growth, and a longer-term benefit for French competitiveness. Downside risks include likely push-back from civil servants, whose ranks Sarkozy hopes to thin, and the potential for rising deficits should efforts to trim state spending not take hold. End summary. The Challenge for Sarkozy -------------- ¶2. (SBU) President Nicolas Sarkozy's macro and fiscal policy proposals respond to France's numerous well-publicized economic challenges. These include the burden of a state whose spending represents 53.7% of GDP, public debt of nearly 64% of GDP, low levels of R&D spending, significant payroll taxes, pension systems that discourage labor force participation among 55 - 64 year olds, a rigid labor market, and a tax environment non-conducive to small company growth (among others). Cutting Government and Pensions -------------- ¶4. (SBU) Sarkozy hopes to cut France's budget deficit to 1.5% of GDP by overhauling ministerial structures, and in part by replacing just one out of two retiring civil servants. He has taken an initial symbolically-significant step toward government reform by halving the number of ministries to 15. Moreover, by establishing a budget minister with full cabinet rank (previously the budget minister reported to the Minister of Economy),he creates a guardian of the purse strings whose overriding interest is to balance the books. ¶5. (SBU) That Sarkozy has placed oversight of public administration issues (previously the domain of a separate "public function minister") under the authority of the budget minister is significant. The move has already been contested by unions who say that it is indicative of an approach that treats civil servants as little more than an "expense." Sarkozy is also likely to increase patient fees and focus on prevention in an effort to cut France's healthcare deficit. ¶6. (SBU) One of the most sensitive proposals is likely to be reform to France's "special" pension regimes for certain categories of government workers (including in the energy and transportation sectors). Sarkozy has proposed that workers covered by these systems pay into the system for 40 years, versus 37 and a half as is currently the case. Numerous governments have been down this road before - including most recently Francois Fillon as Labor Minister in 2003 - only to founder on the shoal of strong union opposition. Cutting Taxes -------------- ¶7. (U) Sarkozy has tasked his new budget minister, Eric Woerth, with preparing a number of tax reforms in the coming months. These include the elimination or reduction of taxes paid by employers and employees for "overtime" above the 35 hour workweek, and encouraging employers to boost overtime pay by 25 percent (reftel). Sarkozy's government will also move in the coming months to reduce or eliminate the inheritance tax and to make mortgage interest payments tax-deductible. ¶8. (U) Additional tax measures that can be expected in the near to medium-term include the following: --Lowering payroll taxes paid by employers by testing a social VAT in "some sectors". --Cutting income taxes and social charges as a percent of GDP (44.4 percent in 2006) by 4 percent in ten years (or over a two-term presidency),including one percent (15 billion euros or 20.4 billion USD) as soon as 2007; --Exempting students' part-time work from income taxes; --Imposing an absolute ceiling for total taxes of no more than 50 percent of personal income (versus 60 percent currently) as soon as 2007; PARIS 00002089 002 OF 002 --Exempting from wealth tax any investments in small and-medium sized companies up to 50,000 euros (68,000 USD); --Cutting the value-added tax (VAT) paid by restaurants to 5.5 percent. The Risks -------------- ¶9. (SBU) While the business and economic policy communities have generally applauded the direction of Sarkozy's proposals, some economists have pointed up potential problems. According to some estimates, proposed cuts in payroll taxes could cost the government up to 5% of GDP in revenue. Moreover, there is concern in some quarters about the potential for fraud associated with the elimination of payroll taxes on overtime. The policy could incentivize employers to use the measure to award payroll-tax-free salary increases, rather than to encourage legitimate overtime work. Many economists have also taken issue with the distortional effects of making mortgage interest tax-deductible, and the efficiency of cutting inheritance taxes. Comment -------------- ¶10. (SBU) Sarkozy's biggest challenge will come not from the policy wonks, but rather from the entrenched interests who have successfully seen off many attempts at reform in France. This time may be different, and Sarkozy is off to a good start by having reached across party lines to put together his government. We expect that some measures -- payroll and inheritance tax cuts and deductibility of mortgage interest -- are likely to be enacted quickly and with minimal controversy. However, pension reform and proposed measures to shrink the state are both likely to raise the ire of French civil servants who have successfully blocked reform in the past. Each of these issues, along with unification of the labor market and guaranteed minimum service (reftel),has the potential to put protesters on the street. President Sarkozy will have to tread carefully to keep his ambitious program from getting derailed. STAPLETON