GERMAN FISCAL POLICY: SLAMMING ON THE BRAKES

UNCLAS SECTION 01 OF 03 BERLIN 000840 SENSITIVE STATE FOR EEB (NELSON),EEB/IFD/OMA (WHITTINGTON), DRL/ILCSR AND EUR/CE (SCHROEDER) LABOR FOR ILAB (BRUMFIELD) TREASURY FOR ERIC MEYER, ICN (KOHLER),IMB (MURDEN, MONROE, CARNES) AND OASIA SIPDIS E.O. 12958: N/A TAGS: ECON EFIN PREL GM SUBJECT: GERMAN FISCAL POLICY: SLAMMING ON THE BRAKES REF: BERLIN 793 BERLIN 00000840 001.2 OF 003 ¶1. (SBU) SUMMARY. While most countries are busy trying to pull their economies out of the worst recession in decades, Germany is already focusing on next steps. Chancellor Merkel's government has set the country on a course intended to reduce its budget deficit to almost zero by 2016, despite an economy that is still contracting. As is the case elsewhere, Germany's fiscal position has deteriorated markedly since the onset of the financial and economic crises. Due to efforts to combat the crises and declining tax receipts, the federal government's budget deficit will peak at around 100 billion euros next year; it will not fall below levels permitted by the EU's Maastricht Treaty until ¶2013. The EU, however, is not the main force driving Germany's fiscal retrenchment. By and large, it is an indigenous determination to reduce public debt, now enshrined for posterity's sake in the German constitution. Despite the expectation that the crisis will deepen later this year and next with a corresponding rise in joblessness, Merkel's party has made a campaign promise of moderate tax reductions. Not only is it likely that such a pledge will be forgotten after the September elections, but the next Chancellor will probably be in the awkward position of having to raise taxes and cut spending while the economy is still struggling to get back on its feet. END SUMMARY. DASHED HOPES -------------- ¶2. (SBU) Balancing the federal budget was a top priority for the "Grand Coalition" of Chancellor Merkel's Christian Democratic Union (CDU)/Christian Social Union (CSU) and Social Democratic Party (SPD) when it took the reins of government in October 2005. Thanks to some notable reforms and healthy economic growth driven by strong exports, the goal once appeared to be within reach. Under the careful stewardship of Finance Minister Peer Steinbrueck (SPD),an outspoken deficit hawk, the federal deficit fell to just 0.4 percent of GDP in 2008. But what a difference a few months can make. With exports plummeting and GDP shrinking at its fastest pace since the 1930s, a balanced budget is no longer ;even a remote possibility. In fact, it is estimated that the federal budget deficit will swell to 2.1 percent of GDP this year. ¶3. (SBU) Next year will be worse. The coalition's budget proposal for FY 2010, which Merkel's cabinet passed on June 24, foresees a deficit reaching a new postwar high of 86 billion euros -- twice the previous record -- out of a total budget of 328 billion euros. Corinna Westermann, Ministerial Advisor for Budgetary and Financial Planning, Ministry of Finance, told Econoff that around half of this figure is attributable to the steep drop off in tax revenues. Another 30 billion euros will go towards job market-related expenditures, such as unemployment benefits and the "short-shift" ("Kurzarbeit") scheme, wherein the government subsidizes the salaries of workers agreeing to work fewer hours. The small structural deficit (6 billion euros) and stimulus spending (9 billion euros) make up the difference. ¶4. (SBU) But even this does not tell the whole story, as additional stimulus measures and bailout funds are not included in the 86 billion euro figure. Once they are thrown in, Germany's 2010 federal budget deficit will top 100 billion euros. This easily surpasses 4 percent of GDP, even without including the Maastricht-relevant state and local deficits. Forecasts indicate the red ink will continue to flow over the mid-term. The government predicts a deficit of 71.7 billion euros in 2011, with the shortfall ebbing to 45.9 billion euros in 2013. Germany's public debt, currently 74 percent of GDP, will have increased by 510 billion euros as a result of the crisis, stabilizing at around 82 percent of GDP in 2013, according to government estimates. REMEMBERING MAASTRICHT -------------- BERLIN 00000840 002.2 OF 003 ¶5. (SBU) Germany was one of the strongest proponents of the convergence criteria contained in the 1992 Maastricht Treaty creating the single currency. Ever since, Germans have constantly fretted that if the German deficit breached the 3 percent of GDP limit, there would be little incentive for less fiscally prudent Eurozone peers to keep their spending in check, leaving the German taxpayer to foot the bill for other countries' spendthrift ways. Recent flexibility on the Maastricht criteria on the part of Brussels has met with only tempered enthusiasm in Berlin. Rather, there is considerable pressure within Germany to get the budget under control, as projections indicate Europe's largest economy will be in breach of the Maastricht criteria until 2013. SLAMMING ON THE BRAKES -- FOREVER -------------- -------------- ¶6. (SBU) One of Chancellor Merkel's top priorities at the G-8 Summit in L'Aquila, Italy, was to convince other leaders to examine "exit strategies" from fiscal and monetary measures launched to combat the global slump. Planning for a return to fiscal sustainability now would boost market confidence and lead to stronger growth down the road, she argued, offering up a recently passed amendment to the German constitution ("Basic Law") as a model. This balanced budget amendment is commonly called the "debt brake." ¶7. (SBU) Michael Tonne of the Finance Ministry's Division of Budgetary and Financial Planning told Econoff that the debt brake requires the federal government to run a deficit of no more than 0.35 percent of GDP by 2016. Only "automatic stabilizers" -- entitlements such as unemployment benefits that rise automatically during recessions -- may contribute to a shortfall of up to the Maastricht limit of 3 percent. Exceptions are permissible in "extreme cases," such as natural catastrophes or cases where "accumulated debt exceeds structural and cyclical debt." Extraordinary fiscal stimulus programs are not allowed; in fact, they are now unconstitutional. In the meantime, there are ambitious mid-term targets, which force the federal government to focus on fiscal consolidation starting with the preparation of the 2011 budget next year. The German states (Laender) must eliminate their deficits altogether, though they have until 2020 to pull it off. Under the amendment's provisions, the federal government must assist relatively poor states, such as Berlin, Bremen and Saarland, in reaching the goal. This naturally places yet another burden on the federal government's coffers, just as it attempts to wrest control of its own finances. AND YET, (SMALL) TAX CUTS -------------- ¶8. (SBU) Despite the herculean task of fiscal retrenchment in the midst of the worst recession in 70 years, tax cuts have entered the political discourse. Under pressure from the CSU, Merkel,s CDU agreed to a joint election platform calling for 15 billion euros of tax cuts over several years (REFTEL). The plan is to cut the lowest income tax rate to 12 percent from 14 percent, raise the threshold for the top income tax rate of 42 percent from 52,500 euros to 60,000 euros, and reduce the degree to which a rising income leads to a progressively higher tax rate. The proposed measures would amount to a loss in tax revenue of 9 to 12 billion euros, according to private estimates. ¶9. (SBU) Perhaps so as not to disadvantage SPD Chancellor candidate Frank-Walter Steinmeier, the Social Democrats have also proposed cutting the lowest income tax rate to 12 percent. The plan would be paid for through an increase in the top tax rate from 42 percent to 45 percent for individuals making more than 150,000 euros per year. The SPD also proposes taxing share trades. This mix of tax reductions and hikes would be budget-neutral, according to the SPD. BECOMING CALIFORNIA -------------- BERLIN 00000840 003.2 OF 003 ¶10. (SBU) Economist Christoph Trebesch of Berlin's Hertie School of Governance told Econoff that in comparison with other European countries and the United States, Germany's deficit levels were not particularly dangerous. Germany had room to widen its deficit to counteract the economic downturn. Nevertheless, debt had become, in his estimation, a key economic issue in the election campaign. He lamented that Germany's fiscal consolidation ran counter to the fiscal expansion in France, where the central government will run a deficit of 7 percent of GDP. As for the CDU/CSU pledge of tax cuts, Trebesch dismissed them as "totally unrealistic" -- a sentiment shared by contacts at the Finance Ministry. ¶11. (SBU) Trebesch said Germany was a potential fiscal "train wreck," largely of its own making, due to the debt brake. He said the amendment was "tougher than Maastricht," and he knew of few economists who thought it was a good idea. Enshrining economic policy in the constitution embodied Germany's "moral aversion to debt." Tax revenues are falling at the same time that the government is under pressure to fund bailouts, assist the unemployed, and extend the "short-shift" scheme to keep others in their jobs. Particularly once the mid-term targets kick in, the debt brake will have a "pro-cyclical" effect by forcing the government to cut spending and raise taxes during a downturn. He feared his country would soon "become California," with the difference being that California's budget is constrained on the revenue side, while Germany's is on the expenditure side. COMMENT -------------- ¶12. (SBU) The debate over tax cuts in the election campaign appears completely divorced from reality. Even the SPD's allegedly budget-neutral plan is unrealistic -- a tax on share trading could at best yield additional revenues of 500 million euros, a mere drop in the bucket. Recent polls indicate that most Germans do not believe they will get a tax cut anyway. On September 28, the day after the election, discussion will need to turn abruptly to increasing revenues and decreasing expenditures in order to meet the constitutionally mandated provisions of the debt brake. The most likely adjustment to tax policy will be a rise in the VAT, although Merkel has ruled this out for now. According to Finance Ministry contacts, a one-point VAT increase brings in around 8 billion euros in extra revenue. At 19 percent, German VAT rates are considered moderate by EU standards. ¶13. (SBU) Raising the VAT will, like most other deficit reduction measures, have a negative impact on Germany's already anemic consumption levels. Though consumption makes an abnormally low contribution to Germany's GDP, this can only boost Germany's current account surplus (6.1 percent of GDP in 2008). Moreover, raising taxes and cutting spending as the German economy struggles to emerge from a serious economic downturn could plunge the economy back into recession. With jobless numbers expected to swell by an additional one million between now and 2010 and GDP growth to remain flat, the timing could not be worse. Whoever wins the September election will find his/her room for maneuver severely constrained. Pollard