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Germany Urged To Drop Tax Cuts In Favour Of Tax Base Expansion

Thursday, February 11, 2010

In its Article IV consultation with the International Monetary Fund (IMF), Germany has been warned that achieving its fiscal consolidation target will be a formidable challenge; one that will only be achieved through determined prudent fiscal management and the widening of the tax base. Germany is tasked with reducing its general government deficit from 5.5% of gross domestic product (GDP), expected by end-2010, to within the Maastricht Criterion of 3% by 2013.

According to the IMF, the recovery in Germany is expected to be moderate; at a rate of about 1.5% in 2010, and 1.9% in 2011, following a sharp decline of about 5% of GDP in 2009. Domestically, the IMF has observed that fiscal stimulus measures will continue to boost the economy during 2010, but consumers are expected to remain cautious given the expected increase in unemployment and moderate income gains, and remaining banking problems will contain credit supply.

“With public debt on a rising path, contingent liabilities associated with financial support measures, and private sector growth expected to become self-sustaining by 2011, fiscal consolidation should become a priority,” the IMF underscored.

“Meeting consolidation targets will allow Germany to regain the fiscal space lost to the crisis and prepare for the rising costs of its aging population. Moreover, Germany’s actions also matter for Europe because, as in the past, German consolidation could set an example for other countries. Conversely, a failure to consolidate the public finances in Germany could greatly damage both the European and the national fiscal frameworks.”

“To fulfill the SGP (Stability and Growth Pact) target, the combined deficit of the local and federal governments, including the social security system, will have to decline annually on average by close to 1% of GDP in 2011-13. While the economic recovery and the withdrawal of the stimulus measures will contribute to meeting the target, the required adjustment is large by historic standards.”

"Further to this, constitutional rule mandates a close-to-balanced structural budget at the federal level by 2016. To comply with this, the required annual structural adjustment of the federal government—which we estimate at 0.5% percent of GDP in 2011-16—will also be demanding."

In addition to cuts in expenditure, the IMF advocated measures to increase tax revenues and cast doubt on the tax cuts agreed by the coalition government.

“The first priority would be to broaden the tax base of the income and VAT taxes by eliminating exemptions, including those recently introduced. If tax rate increases were unavoidable, higher VAT rates would prop up revenues at the federal and local Länder levels, and a reform of the property tax could support local finances. Also, an increase of contribution rates to the unemployment insurance would remove the need for repeated federal government support.”

Concluding, the Fund advised against decisions taken by the coalition government on fiscal policy, urging that “tensions in the fiscal plans for 2011 need to be resolved.”

“The permanent tax cut of about 1% of GDP included in the coalition agreement would kick in just when the recovery is expected to firm up. This would counter the required consolidation effort, while promising only modest efficiency gains,” the report states, recommending that the government introduce tax increases to reign in the deficit rather than cut taxes in the hope of this creating additional economic performance-related revenues.

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