The following OECD assessment and recommendations summarise Chapter 2 of the Economic Survey of Germany 2006 published on 30 May 2006.
Fiscal consolidation will proceed by cutting expenditure and increasing VAT
Germany’s general government deficit amounted to 3.3% of GDP in 2005, above 3% for the fourth year in a row. While the structural balance improved, considerable spending restraint over the last years was largely offset by weak revenues reflecting both discretionary tax reductions and weak domestic demand. The new government has underlined its commitment to fiscal consolidation and public spending reform. Substantial cuts in spending and tax expenditures are to be phased in over the next four years, generating one half of the overall deficit reduction package. The remaining half of the envisaged consolidation is intended to be brought about by an increase in the standard VAT rate by 3 percentage points in 2007 with one third of additional revenues to be used for reductions in social security contribution rates. At the same time, there are plans to phase in fiscal measures of about ¼ per cent of GDP p.a. to raise medium-term growth and stimulate the economy in the short term. This package foresees inter alia higher spending on innovation and infrastructure, a temporary increase in depreciation rates and tax concessions for refurbishing private homes. Overall, the general government deficit is estimated to be around 3% of GDP in 2006 and around 2¼ per cent of GDP 2007.
Fiscal stance of the general government
1. Excluding interest payments.
Source: OECD Economic Outlook Database.
Further consolidation needs to be expenditure driven
As regards fiscal consolidation, relying to a relatively large extent on revenue increases raises important issues. Consolidation driven by expenditure cuts (including the abolishment of distorting tax expenditures) tends to be more durable and favourable to growth. The increase in VAT, however, should be placed in the specific context of German consolidation which started some years ago with strong emphasis on expenditure control, in association with cuts in direct taxation that increased the structural deficit. Hence, it will be crucial to pursue a credible consolidation strategy via public sector reform, designed to generate positive confidence effects.
Federal fiscal relations urgently need reform
Overlapping responsibilities between the federal government and the states are often associated with inefficient resource allocation and can slow federal legislation. At the same time commitment mechanisms at the level of the federation and the states for ensuring strict implementation of consolidation plans can be made more effective. The new coalition government should use its broad support in both houses of Parliament for fundamental reform of federal fiscal relations.
The decision powers of the inter-governmental Finance Planning Committee should be strengthened. Fiscal targets and monitoring indicators need to be formulated in terms of national accounting conventions. Spending paths should be derived and monitored for each government individually.
Bailing out of states with high deficits by the federal government should be terminated. Solidarity Pact II transfers to the new states should be conditioned on spending adjustment by the new States in favour of investment projects removing bottlenecks for higher growth.
Inter-governmental co-funding is widespread, resulting in insufficient spending control. Co funding of regional projects by the federal government should terminate in all areas where substantial spill-over effects between governments cannot be established. This implies, inter alia, that federal investment aid for the states should be abolished and spending responsibilities together with appropriate financing fully transferred to states and municipalities.
Several administrative tasks, such as tax collection or planning of long-distance motorways, are commissioned by the federal government to the states. In important areas this poses severe principal-agent problems leading to cost shifting and a loss in administrative efficiency. The range of federally commissioned tasks should be reduced by reallocating tasks to either the federation or the states, respectively.
Additional tax revenues generated in a state are almost entirely redistributed between states via fiscal equalisation mechanisms. Inter-governmental transfers in the fiscal equalisation system should be re-designed so as to reduce the disincentive effects for developing the states' own tax base and tax collection efforts. To this end, transfer claims should be computed on the basis of notional rather than actual revenue. Also, more use could be made of lump sum transfers.
The states have only very limited legislative power with respect to taxation, even for taxes whose revenues fully accrue to them. The states and the municipalities should be given more scope in generating own tax revenues, raising accountability of fiscal policies vis-à-vis electorates.
Public-Private Partnerships can be beneficial but need to be handled with care
The government aims at engaging in more public-private partnerships (PPPs) to finance infrastructure investment, based on an evaluation of costs and benefits over the life cycle of the investment project. While PPPs can be associated with efficiency gains there is a considerable risk that this approach is mainly used for accounting purposes and public sector spending obligations are shifted into the future without backing by a proper multi-year budgeting framework. The federal government, the states and the municipalities should only engage in PPPs if there is convincing evidence that efficiency gains outweigh higher financing costs of the private sector.
Distortions in the tax system need to be eliminated on a broad front
Notwithstanding significant reductions in corporate and income taxes over recent years, effective tax rates on company profits and on households’ wage earnings remain relatively high by international comparison. Progress has been made in reducing tax concessions, but more needs to be done to make the tax system less distortionary in a wide variety of areas.
Tax expenditures should be further reduced, widening the scope for reductions in statutory income and profit tax rates.
Reducing carbon-dioxide emissions through subsidies to renewable energies costs much more, at the margin, than achieving this via the carbon tax. In addition, coal-based generation plants are exempt from the carbon tax. Subsidies should be brought in line with what is justified on account of measurable external effects. The planned harmonisation of energy taxation – terminating the exemption for coal – is welcome.
How to obtain this publication
The Policy Brief (pdf format) can also be downloaded. It contains the OECD assessment and recommendations, but not all of the charts included on the above pages.
Der Policy Brief (pdf-Format) steht zum Herunterladen zur Verfügung. Er enthält die Gesamtbeurteilung und die Empfehlungen der OECD aber nicht alle Abbildungen auf den Seiten oben.
The complete edition of the Economic Survey of Germany 2006 is available from:
For further information please contact the Germany Desk at the OECD Economics Department at firstname.lastname@example.org. The OECD Secretariat's report was prepared by Eckhard Wurzel and Andrés Fuentes under the supervision of Andreas Wörgötter.