Monday, July 07, 2003

Germany to Try Tax Cuts

I am not convinced that this will work, but something has to be done. To cite the growth and stability pact at this critical moment seems to me extremely short sighted. Of course, one of the major criticisms of the euro in the comparison with the US Federal system of automatic tax stabilisers is the absence of similar remedies in the eurozone countries. Is it not rather ridiculous to have a range of countries enjoying relatively stronger growth while being in receipt of a net inflow of money from Germany via the structural funds at the same time as Germany itself is unable to operate fiscal stimulus due to communally agreed budget constraints? Should someone not suggest the application structural funds in reverse?

One final irony should be noted with reference to my recent posts about Milton Friedman and contractionary monetary policy. The German government seems to be advocating selling securities to pay for the cuts. This is exactly the opposite of what uncle Milton would recommend, since any large scale sale of securities would only depress assett markets further, and as a result (through the effect on bank balance sheets) indirectly restrict credit. So with one hand they take away what they give with the other. And this when Germany may well be faced with deflation and a liquidity trap. This just shows how far we are in reality from having learnt the "lessons" of the Ahearne et al paper.

Gerhard Schr?der, German chancellor, on Sunday announced additional income tax cuts next year worth more than €15bn in an effort to boost economic growth in Europe's largest economy. The decision, taken at a rare cabinet weekend retreat, would "send a signal of revival" to Germany and Europe, the chancellor said. The tax cuts would on average reduce income tax bills by 10 per cent, he said. However, it remained unclear on Sunday night how the government would cover the tax shortfalls next year, given its severe financial problems. Germany's budget deficit last year exceeded the 3 per cent limit under the European Union growth and stability pact, and is almost certain to do so again this year.

Under the terms of Sunday's decision, income tax cuts planned for January 2005 will be brought forward to January 1 next year and combined with other cuts scheduled for that date. Top income tax rates will fall from 48.5 per cent to 42 per cent, while the lowest will go from 19.9 per cent to 15 per cent. Yet doubts emerged on Sunday night on whether the tax cuts would be realised, as leaders of the conservative opposition said they would oppose the way the government intended to make up for the lost tax revenues next year. Mr Schr?der proposed making up for the tax shortfall by privatising state assets, or via new borrowing.

Angela Merkel, leader of the opposition Christian Democrats, called the result of the weekend meeting "hugely disappointing". She said that new borrowing was the wrong way to meet the tax shortfall. The government would need the support of Christian Democrat-led regional states in the upper house of parliament to alter the timetable for tax cuts.

Mr Schr?der also announced unspecified cuts in state subsidies, worth €45bn by 2010, as a way to consolidate government finances. Sunday's announcement came as Germany's powerful engineering union IG Metall was plunged into crisis following its defeat in a controversial month-long strike in eastern Germany for shorter working time. The strike collapsed on Saturday after 16 hours of talks with employers failed to yield a breakthrough. The defeat - the union's first in almost 50 years - followed mounting opposition to the strike from politicians and the public.

Hans Eichel, Germany's finance minister, insisted that, even if borrowing were increased to pay for the loss of tax revenues, next year's budget deficit would return below the 3 per cent limit set in the European Union's stability pact. The privatisation measures may include the sale of further batches of government-held shares in Deutsche Telekom, the telecommunications company, and postal company Deutsche Post. Mr Eichel stressed the sale of state assets would only occur if financial market conditions were right. Government officials admitted predicting the possible effect of the tax cuts was difficult, given the stagnant economy, and the possible counter effect on consumers of other savings measures in next year's budget.
Source: Financial Times

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