German tax cut Christmas gift will backfire in 2011

Hooray, Germany can look forward to a series of tax cuts next year (in addition to winning the football world cup in South Africa)!

 

But once economic growth is back on solid ground, in order to bring the soaring budget deficit under control, the country is in for severe hikes that are unlikely to go down well with business or consumers. If at least the tax cuts were worth the creepy outlook…

 

 

Government spending and debt to rise in 2010, but taxes down

 

Yesterday, Germany’s new finance minister, Wolfgang Schäuble, presented his draft budget for 2010, announcing a 10.5% increase in government spending combined with tax revenue decreasing 6.7% (following an already hefty 5.1% decrease in 2009), EUR85.8 billion of new public borrowing (more than twice the previous record from 1996), plus additional expenditure not even included in the official budget, such as further economic stabilisation and rescue measures, potential subsidies from the national administration to troubled federal states, grants to be agreed on at the current climate summit on Copenhagen, etc.

 

And, of course, the above-mentioned series of tax cuts worth around EUR10 billion, in order to help the economy while unemployment will continue to rise well into 2010. These tax cuts had been promised during the campaign in the run-up to this autumn’s general elections, and are now broadcast to the public a week before Christmas, at a time when everyone just loves good news.

 

 

But the public sector deficit is expected to rise from around 3% this year (narrowly in line with EU rules) to between 5% or 6% next year.

                                        

To be fair, that is still pretty low when compared with the expected budget deficits of other EU members, such as the UK (12.6% this year, 12.6% next) or Greece. Still, there is a wide sense of discomfort about tax cuts now among the German public, given that the public administration clearly needs every Euro to keep the country running, in times when tax revenue has been falling fast even without tax cuts.

 

It is also interesting to note that at the national audit office and, in fact, even within the ruling coalition of Christian Democrats and Free Democrats, there have been remarkable articulations of opposition to the tax cuts. Yet the government seems determined to plough ahead.

 

While most tax cuts still need the formal go-ahead from the upper house and are unlikely to be given parliament’s final blessing until March 2010, here’s a list of planned key tax initiatives, in a nutshell, for the sake of early orientation:

 

• Families: Child benefits and tax allowances for families with children to increase. Problems: expensive; to be pushed through even though the government’s board of economic experts has warned that the move might contribute close to nothing to economic growth.

 

• Companies: Tax relief measures to support companies during the downturn, which should help to save jobs. Risk: Measure is part of an expensive tax cut package that will increase the need for tax increases later on. Which dampens long-term economic growth prospects, which in turn could discourage new corporate investment.

 

• Heirs: Overdue reform supporting close relatives of deceased persons, as well as business-owning families. Risks: Could result in even higher burdens on those not benefiting from exceptions; might be rejected by the Federal Constitutional Court.

 

• Hotels: VAT on accommodation switching from 19% standard rate to 7% reduced rate with effect from 1 January 2010. Problems: arbitrary selection of hotel sector for state help; tax cuts unlikely to be passed on to customers; smaller VAT refunds to companies, which makes business travel more expensive if tax cuts aren’t passed on.

 

 

Painful tax hikes and spending cuts to follow next year’s generosity

 

Looking forward, Finance Minister Schäuble has admitted that controlling the budget deficit in the long run will not be achieved “with the conventional instruments”, but only through “a huge effort”. In fact, new constitutional requirements force the government to cut its structural deficit by as much as EUR10 billion per year beginning in 2011, so there will be spending cuts in addition to tax hikes.

 

 

Retailers will feel the difference

 

Even though the government has declined to give details on where exactly expenditure cuts will fall, the public welfare system (unemployed people, pensioners) is the most likely loser. We can also expect reduced investment in infrastructure and education, and perhaps health. Which in turn will impact the job market through pressure on both wage and employment levels, which in turn will impact retail sales.

 

From a retailer’s perspective, at least the reiteration of the government pledge that there will be no VAT rise is somewhat soothing (Schäuble says he has “not thought about this possibility for a second”)… if we can trust the statement. Plans can always change. By the way, experience of the psychological impact of VAT hikes is available from Germany (2006/07) and the UK (right now). 

 

To sum it all up, when asked by journalists who would bear the cost of Germany’s fiscal recovery, Schäuble’s answer yesterday was: “Everyone”. We should take his answer at face value.