EZA 921 German politics: no big leap reform to be expected from new government

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1 EZA Report EZA 921 German politics: no big leap reform to be expected from new government The 24th Oct coalition agreement between the conservatives and the Free Democrats marked the beginning for the new German government and the second term for chancellor Angela Merkel. Fighting the financial and economic crisis remains a key priority. Fiscal stimulus in 2010 will be slightly enhanced, with a shift from spending-related stimulus to tax cuts. Other features in economic policy will be cautious pro business reforms and health care reform. FDP ambitions for a major overhaul of the health care funds will face strong opposition from the conservative CSU. Merkel s choice of finance minister, Wolfgang Schäuble, was as much a surprise as the promotion of Philip Rösler to health minister. The appointment of Schäuble, a CDU political heavyweight, confirms Merkel s focus on fiscal policy. Asset conclusions: agreement positive for German assets, notably stocks and the euro. Coalition agreement calculated ambiguity Merkel: We cannot guarantee that we will succeed by banking on growth, but by relying on savings we will stand no chance at all. The key feature of the coalition agreement is the deviation from the strong commitment to fiscal retrenchment a trademark of the grand coalition in propagating more distinctive tax cuts than expected. In sticking to expansionary fiscal policy in 2010 Merkel has decided to place confidence in the coherence of her new coalition rather than heed the advice from the left or the EU which had held Germany up as a paragon to discipline high deficit economies like France and Spain. In effect, agreeing on a continuation of expansionary fiscal policy seemed the quickest way for Merkel to bring about an agreement and bridge conflict between the centrists around the CSU and the FDP s liberals. These potential conflicts within the new coalition are also reflected in the other key areas of economic policy taxes, labour market, health care and business sector reform. Whereas the liberal FDP in principle stands for deregulation as regards labour market, and business and small government in terms of taxes and social security, the CSU and its conservative allies within the CDU prefer a more interventionist or even left wing approach. These policy attitudes are also reflected in party affiliations and personalities. Apart from the two big surprises CDU strongman and former home affairs minister Wolfgang Schäuble heading the finance ministry and FDP shooting star Philip Rösler heading the health care ministry ministerial selection reflects the respective party lines: Those ministries which are regarded most essential to running the administration finance, home affairs and the chancellor s office will be headed by partisans in Merkel s CDU. The FDP will run the economics ministry, which is regarded its core competence, and foreign affairs the latter ranking second after the chancellor in the official protocol. Obtaining the health care ministry can be regarded a strong pro reform signal The CSU, which traditionally pursues a big government policy of subsidies and protecting social transfers, will be in charge of spending ministries like transport, agriculture and defence.

2 In a nutshell: the new government coalition while propagating a slight business-friendly leaning is set to disappoint expectations of far reaching economic reforms. Instead it will be focused on halting the further regulation on minimum wages and early retirement that had been pursued by the grand coalition. The fiscal cycle will be accommodated by political considerations. The coalition is likely to protect its recently won majority in both houses by frontloading tax relief, while imposing painful spending cuts only in Abstaining from far-reaching (hence controversial) reforms seems to be mandated by political tactics, as the CDU has a strong interest in winning next year s state elections in North-Rhine- Westphalia. By holding on to power in that state the CDU would secure its working majority in the upper house for at least two more years, facilitating legislation significantly. Fiscal policy increased expansion in 2010, deficit-neutral tax relief thereafter Generally fiscal policy remains a key focus for investors, as it reflects the government s intentions to steer the economy and strike a balance between private and public sector. The new government inherits two features of fiscal policy from the previous grand coalition: (1) a peak in fiscal expansion in 2010 at a deficit of 5%, to which the federal government contributes 3.5% - and the commitment to subsequent tightening; (2) a so called debt brake, demanding an elimination of the deficit until 2016 and a deficit ceiling of 0.35% in years of normal economic growth. Germany - fiscal retrenchment delayed % of GDP new government previous government source: EU commission, EZA Whereas the new government is sticking to this line officially, it is propagating a shift in priorities away from unconditional tightening towards a stimulatory re-arranging of the tax system. This includes a cut in direct taxes income tax, business taxation and inheritance tax and generating more tax revenue from indirect taxes (VAT) and social tax. For 2010 the government plans an additional tax relief of 7bn (0.3% of GDP) relative to the plans of the former coalition. Before 2013 the government plans to achieve tax relief of 24bn (0.9% of GDP). These plans, however, are meeting staunch resistance from key states, even those controlled by Merkel s CDU, and will demand significant negotiations ahead. 2

3 These figures are based on an all other things equal assumption. In effect the government assumes that tax relief will be self-financing or deficit-neutral in a Keynesian way ie. growth stimulation through lower income tax rates should generate higher revenues from consumption related taxes. Tax changes in detail lower income tax rates, higher social tax Tax policy will mainly affect (1) income tax rates, (2) corporate tax base, (3) inheritance tax rates and (4) VAT tax base. The first three are expected to result in net cuts of tax incomes, the last, VAT, should be revenue neutral or result in slightly higher tax income. (1) Income tax: the main change in 2010 will be the increase in the child tax allowance by 1000 to 7000 honouring an election promise to families. This implies a decline in tax revenues by 2.8bn pa. From 2011 income taxation shall be changed from the current sliding scale taxation starting at incomes of pa. with a rate of 14% and progressing to 42% for incomes over to taxation along various income bands. This accommodates a demand from the FDP, which advocated a 3-band tax system. The resulting shortfall of tax revenue has not been specified it is expected to be around 10bn pa. This change is meant to bring major simplification of taxation, but it remains to be seen, to what extent the government manages to combine a cut in tax rates with a broadening of the tax base. (2) Business taxation: although a top priority for the new government, it will focus on piecemeal adjustments rather than big leap reforms in the style of 2001 or Whereas these reforms had been meant to reduce overall taxation, abandon disincentives for foreigners and retain profits, the new government aims to protect capital rather than expose it to more international competition. The steps now envisaged are directed towards small businesses, which are given extra tax relief through a set of measures. These are supposed to take effect as early as 1Jan10. Figure 1: adjustments in corporate taxation Raising threshold for tax deduction of debt servicing costs from 1 million to 3 million Extending loss carry forward option to 5 years (from 3) Providing alternative depreciation options instant depreciation for small business items (up to 410 purchase value) or pool depreciation for all items between 150 and 1000 purchase value Reducing (profit) tax value of rental income from 65% to 50% Allowing netting out of restructuring-related losses in new business units with profits in others Scrapping penalty tax for business relocation abroad Inheritance tax relief will be given in 2011, with inheritance tax rates reduced for second line and third line relatives to 15% and 43% respectively. Inheritance tax had been changed by the last government, but in a fiscally neutral way. The net tax relief from the current government will restore the tax position of more distant relatives. As regards VAT, there are no changes in VAT rates planned, but there will be some changes in application: lodgings services will be subject to the reduced VAT rate of 7% instead of 19%, 3

4 whereas postal services (apart from basic postal services) will become subject to VAT, as will local public services like waste disposal. On balance VAT will be substantially extended, increasing VAT revenue. Social taxes will be substantially re-jigged, while those social taxes borne by employers and employees at equal shares should be kept below 40% of gross incomes. The phrasing implies that there might be a freeze in employers tax share, whereas employees will face an increase in their contribution, notably in health tax and in unemployment insurance. Nursing care contributions will be supplanted by a funded component. All in all the government has chosen to decouple the funding of social security from wage costs, shifting the tax burden onto the employee. Business sector reform cutting red tape on network industries The new government s pro business position will benefit small (unincorporated) businesses in particular, while curbing the market power of large firms. Along with a catalogue of measures which include cutting red tape for building permits reducing (tax) reporting obligations for small firms fostering access to bank loans for small firms promoting private public partnerships and simplify public tendering the government is committed to deregulating network industries. Postal services, where deregulation had come to a halt in early 2008, as minimum wage regulations prevented private competitors from entering the market, received explicit mention in the coalition agreement. So too did helping market forces in network industries energy suppliers and public transport, for example. Although deregulation has been practiced by former centre-left administrations, securing small businesses access to networks for new suppliers is a specific priority of the CDU/FDP government. The government explicitly exempts medical care and pharmacies from deregulation, given the FDP s protective interests in this area. For the same reason little progress can be expected on mandatory membership for small firms of chambers of trade and commerce and in requirements of qualification a key demand from economists and taxpayer groups. Health care gradually liberalising the public health care funds Health care reform has proved to be a minefield of the entrenched interests of insurers and providers, political paradigms and the assumed interests of the insured. In effect past reforms in the health care system had been motivated mainly by cost pressures (see EZAs 739, 750, 762) without allowing for a change in the rules. The new government is committed to overhauling the health care funds which channel contributions by reducing basic contributions and forcing insurers to increase their supplementary fee in order to cover costs. This would re-invigorate competition among insurers. Later, the government intents to introduce a flat rate health tax ( income-independent health tax ) and fix employers contribution. But this is likely to meet with stern resistance from the CSU and its head Horst Seehofer, who made health policy one of his political priorities. 4

5 Figure 2 Political paradigms Income dependent redistribution vs cost-related flat contribution Insurers Health insured equal per capita funding cost sharing in extra medicine vs cost control by competition vs basic provision, needs Providers striking balance between funding needs (R&D, hospitals) and cost control through competition Labour market job mediation, unemployment benefits, retirement and cooperation As in other areas of economic policy the government will not be implementing large scale labout market reforms in the style of the Hartz reforms of Instead it aims to protect these reforms by containing minimum wage regulations current minimum laws are to be evaluated by 2011 and having government sponsored early retirement schemes expire at the end of The new administration will be relying on measures with limited visibility: The central labour office to be evaluated in terms of its performance on job mediation Restrictions to temporary employment to be reduced Creation of low paid jobs ( 400 euro jobs ) to be facilitated Employment of foreign professionals to be be deregulated Corporate governance to be liberalised. This concerns the size of supervisory boards, the relationship between supervisory boards and boards, and the accountability of workers councils to employees. Demands for far-reaching reforms on dismissal laws propagated by the FDP or for changing the system of industry-wide wage bargaining propagated by economists will not be considered. It has to be said that labour market reform is a particularly sensitive subject in German public opinion, as witnessed by the mass demonstrations against the introduction of the Hartz reforms in Summary: The new government will abstains from spectacular but unpopular economic reforms, but aim to enhance competition in key areas of the economy and reduce the size of government. On fiscal policy it errs on the expansionary side, in line with the perception of the duration of financial crisis. 5

6 For further information please contact: Dr Michael Clauss: Politics / Economy / Equities Sectoral Analysis Tel: Michael.clauss@eurozoneadvisors.com Eurozone Advisors Ltd, November 2009 This research is confidential and intended solely for the named person or entity to whom it is addressed. If you have received this in error you are not permitted to disseminate, copy or take any action in reliance on it, and are requested to please notify the sender by return or telephone. No part may be reproduced or passed on without permission. Neither the information nor the opinions herein constitute or are to be construed as an offer or solicitation of an offer to buy or sell investments. EZA information is based on sources believed reliable. Their accuracy cannot however be fully guaranteed. Copyright EuroZone Advisors Ltd