Public finance and fiscal policy

Economic Survey - Germany 2004: Linking fiscal consolidation to public sector reform

 

Is fiscal consolidation ambitious enough?

Fiscal consolidation resumed in 2003, with the cyclically adjusted balance improving by ½ per cent of GDP. This improvement did not translate into lower public deficits, however, mainly due to unforeseen cyclical and structural shortfalls in direct and indirect taxes. With economic activity stagnating, the general government deficit deteriorated to almost 4 per cent of GDP, nearly ½ percentage point higher than in 2002. Another fiscal consolidation package is being phased in this year and next, comprising inter alia cuts in subsidies and tax expenditures as well as revenue raising measures, including a tax amnesty with preferential taxation of repatriated assets. At the same time substantial income tax reductions will become effective, partly brought forward into 2004 from 2005. With further reductions scheduled for next year, income tax cuts amount to some one per cent of GDP. The overall deficit is likely to decline to close to 3 per cent of GDP in 2005, helped by strengthening economic activity. On balance the OECD projects that the structural deficit will improve by ¼ per cent of GDP both this year and in 2005, less than officially projected due to expected revenue shortfalls. Repeatedly under achieving fiscal targets undermines confidence. Public finances need to be put back on a sustainable path, which requires a balanced budget within a few years and surpluses further ahead.

General government debt and spending

1. OECD estimates for 2004 and 2005.
2. Both benefits and benefits in kind.
Source: OECD, National Accounts and Economic Outlook Databases.

How can public sector reform make fiscal policy more effective?

While most consolidation measures that are being phased in have a lasting effect, there is a need for more fundamental spending reform in order to address a number of counterproductive features of Germany’s public sector. In their present setting, Germany's federal relations make it difficult to find the necessary political consensus for fiscal reforms, often involving complicated mediation processes between the Bundestag and the Länder chamber of Parliament (Bundesrat), whose outcomes are hard to predict. The working of market forces is hampered by a high tax-wedge on labour while persisting subsidy programmes reduce economic efficiency. Parameters of important ageing-related spending programmes are not sufficiently adjusted to predictable demographic changes and make future contribution changes likely. Special tenure and pension schemes for civil servants reduce labour mobility and make it more costly to reduce public sector employment. Measures which address these issues are explained in more detail below.

Against the background of the various fiscal pressures that are impinging on the general government budget, strict prioritisation of public sector spending projects is required for the sustainability of public sector finances. This can be fostered by a simplified output-oriented budgeting framework that presents to parliament budgetary appropriations for programmes, together with analysis of associated costs and benefits. Such a reform should be introduced and embedded in a medium term budgeting framework. Moreover, untangling the responsibilities of the federal government and the states and communities is one of the most pressing tasks in order to increase the speed and transparency of federal decision making. Reducing the degree of co-financing between the different levels of government and introducing a higher degree of tax autonomy for the Länder and communities, as has been proposed in earlier Economic Surveys for Germany, would go some way towards making decision processes at the federal level simpler and more transparent. In this context the setting up of a high level commission to look for a consensus on modifying those constitutional provisions governing federal relations is a welcome development.

See also Working Paper No. 366: Consolidating Germany's finances: Issues in public sector spending reform

Does the tax system need further reform?

Despite substantial income and corporate tax reductions, phased in since 1999, average and marginal tax rates on incomes in Germany are relatively high in comparison to major competitors and the new EU accession countries. At the same time, many special rules of taxation and tax concessions imply that the deadweight costs of taxation are high and the tax code is complex. In particular, the tax system disadvantages the financing of start-ups relative to investment in established firms. Also, certain tax rules hamper investment in equity capital and the broadening of equity capital markets. Abolishing such distortions is likely to improve not only the efficiency of the economy but also its capacity to innovate. Further tax reform should therefore focus on reducing the deadweight costs of taxation by cutting both tax expenditures and statutory tax rates and should be fully financed.

Should special programmes for the East be phased out?

Self-sustained growth in the new Länder is still lacking, unemployment remains persistently high, and productivity is still some 30 per cent lower than in the west. There is evidence that the structural weaknesses of the eastern German economy are unlikely to be remedied by special subsidy programmes. Indeed, the OECD has argued in the past that persistently high subsidisation and inefficient labour market policies have biased the structure of the economy and reduced its adaptability to market forces. Hence,

  • The objective of applying the same set of rules for subsidisation to the whole of Germany should be consistently pursued and enforced effectively.
  • Regulatory reform should also apply to all of Germany. However, as a second-best solution, some discretion might be given to economically weak areas in Germany to establish pilot projects of regulatory reform.

See also ECO working paper no.307: The economic integration of Germany's new Länder September 2001.

Can the efficiency of health and long-term care spending be raised?

Health care spending in terms of GDP remains among the highest within the OECD while significant room for efficiency improvement remains. Recent reforms have reduced the share of health care services that are fully financed by the public system and have increased the scope for selective contracting between health care providers and insurance funds. Future reform should:

  • Further widen the scope for selective contracting.
  • Consider reducing the collective role of the doctors’ and insurers’ associations in bargaining supply conditions.
  • Strengthen quality control by securing the independence of the supervising bodies.

Since the end of the 1990s the long-term care insurance has been in deficit, and spending pressures are set to increase substantially, mostly as a result of population ageing. Measures that should be taken to increase the efficiency of the system include:

  • Rebalancing insurance payments so as to create incentives to substitute home and ambulatory care for more expensive stationary care.
  • Re-channelling of funds in favour of better performing service providers.

Should pension reform continue?

From 2005 onwards pension adjustment will be linked to the ratio of dependent employees contributing to the scheme relative to the number of pensioners, and the minimum entry age for early retirement on account of unemployment will be increased from 60 to 63. On the other hand, the government decided to defer to 2010 the decision on whether or not to increase the statutory retirement age above 65. Linking pension adjustments to the ratio of contributors to pensioners, in particular, is an important step to put the public pension system on a sustainable base. Even so, pension contribution rates are set to rise significantly over the next decades due to ageing, driving up non-wage labour costs. Participation in the voluntary funded scheme is hampered by cumbersome regulations, while it is relatively expensive in terms of evolving tax expenditures. Hence, pension reform should be complemented by further measures in order to increase its effectiveness:

  • A phased increase in the statutory retirement age should be announced soon.
  • The system should be made actuarially neutral around the statutory retirement age.
  • The government should evaluate the extent to which tax-subsidies in the funded scheme actually induce households to save more rather than substitute between different savings instruments.

Projected changes of participation, population and the labour force (15 years and over)

1. The "demographic effect" denotes the impact of the change in the age composition of the population on the participation rate, given current participation patterns. The "cohort effect" denotes the effect of new cohorts entering the population of working age, in which women have a higher likelihood of participating and includes a small "fertility effect" resulting from projected changes in fertility on female labour supply decisions.
Source: Burniaux et al. (2003), "Coping with Ageing: A Dynamic Approach to Quantify the Impact of Alternative Policy Options on Future Labour Supply in OECD Countries", Economics Department Working Papers, No. 371, OECD, Paris, table 6, pages 72-73.
Public sector reform will require a more flexible labour force. Pension rules and the terms of health care insurance are not sufficiently harmonised with the private sector scheme and within the public sector, respectively, which hampers the mobility of labour. Obstacles in this respect should be removed by a number of measures:

  • Rules for public sector pensions should be fully harmonised with the general scheme, and a transparent link between contributions and benefits according to individual contribution histories should be established.
  • Special tenure for civil servants (Beamte) with a distinct pension plan should be reduced to the minimum or abolished entirely.
  • Health care insurance for civil servants should be subjected to the rules prevailing for private sector employees.
  • Raising contributions so as to pre-fund retirement outlays should be considered.

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