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Country Commercial Guides FY 2000: Germany Report prepared by U.S. Embassy Bonn, released July 1999 Note*

CHAPTER II. ECONOMIC TRENDS AND OUTLOOK

Introduction and Summary

The German economy is the world's third largest, and accounts for about one-third of Euroland's GDP. It is the United States' largest European trading partner and our fifth largest global partner. Germany's strong post-war economic growth has afforded its citizenry one of the highest standards of living in the world, with what some view as the industrialized world's most comprehensive and generous social safety net.

The Germany "social market" economy is based largely on free market principles, but with labor, wage and regulatory issues being largely decided by a broad consensus of government, business, and labor. A record high government outstanding debt, an increasing share of government revenues going for debt service payments, as well as an eroding tax base, a continued high level of net transfer payments to eastern Germany and persistent high unemployment have urged a turnaround in the government economic, fiscal and social policy course towards budget consolidation and structural reforms. In addition, high unit labor costs, growing social security and non-wage labor costs, combined with a record high net direct investment outflow have also contributed to government action to make Germany more attractive for investment and job creation.

On June 23, 1999, the German cabinet approved the government reform program, called "Future Program 2000", a combination of budget consolidation, growth incentives and structural reforms to stimulate economic growth, job creation and to get control of exploding government debt. Key elements of this program are: a DM 30 billion cut in the Federal budget 2000 (compared to estimates of mid-1998), and an outline of the planned business and family tax reforms, a mid-term energy taxation plan and the highly controversial reform of the German mandatory old age pension system. The program goes beyond the reforms pushed by the former conservative Kohl government during the 16-year term of the CDU/CSU/FDP coalition. Changes to the whole package during the lengthy legislative procedure are likely, but nevertheless it represents the first step of a long and difficult process of structural reform and success will require consistent long-term efforts.

Moreover, the Schröder government is also pursuing a new "Alliance for Jobs" initiative to tackle Germany's serious unemployment problem. In early July the top-level roundtable of government, labor and management agreed on a 11-point program, including the crucial issues of: discussing wage policy issues in the "alliance for jobs" talks, making the special early retirement schemes more attractive for small and medium-sized firms, providing more trainee positions for young people and curbing overtime work and more work time flexibility. The next round of "Alliance for Jobs" talks are scheduled for the fall of this year.

With the birth of the euro on January 1, 1999 the European Central Bank (ECB) is responsible for monetary policy in the Euroland. It took its first action on interest rates on April 8 with a 50 basis point cut in the short-term rate to 2.5%. The ECB action followed the late 1998 monetary easing of European National Banks and reflected a virtually non-inflationary climate and a dampened European economic outlook particularly vis-à-vis the robust U.S. economic growth. The euro started at a rate of around 1.17 against the dollar, but has weakened since then to around 1.02. Most German politicians and market analysts seem to be not concerned about this low euro-dollar relation arguing that it is more the result of market speculation to test the 1:1 relation than reflecting the underlying fundamentals such as growth disparities and U.S. interest rate differentials. Moreover, a weak euro should make German products more competitive internationally and thus help to boost German exports.

Slowing Economic Growth in 1999, Improvement in 2000

Real GDP growth in 1997 and 1998 was 1.8 and 2.3% respectively. Eastern Germany was growing at slightly lower rates in both years, renewing fundamental concern about a rapid convergence of the economies in western and eastern Germany. The slowdown in German exports that began in mid-1998 in response to the financial crisis in Russia, Asia and South America, is dampening German economic growth. The consensus forecast projects a slowing of the German economy to 1.5% in 1999, picking-up to around 2.5% in 2000. A recovery of German export markets, improvement in private consumption and a robust investment in equipment will be the main factors behind the projected rebound in the second half of 1999 and through 2000. Private consumption -- the largest component of German GDP with a share of 56% -- will expand at rates above average growth in both years, boosted by slightly lower unemployment, higher wage settlements and lower individual tax and social contribution payments despite planned cuts in social spending and higher energy costs. The Government austerity package "Future Program 2000" will limit the public sector's contribution to growth this year and next year.

Business investment in equipment will be backed by growing (domestic and foreign) demand, and a continued strong pressure from globalization for modernization and rationalization efforts. Following four years of contraction, construction investment is expected to remain rather flat in 1999 and to recover modestly in 2000. An oversupply in housing and office space, tight (investment) budgets at all levels of government and cuts in construction-related tax preferences continue to weigh on the construction sector. The eastern economy is especially suffering from these problems as the construction sector accounts for roughly one-third of East German GDP compared to just 10% in the West. However, business investment will remain largely dependent upon business confidence in more business-friendly reform policies that tackle Germany's high tax rates, high labor and energy costs as well as labor market rigidities. The planned net business tax relief in 2001 (postponed from an earlier planned implementation in 2000) will be moderate, but planned changes in depreciation regulations may well bring some investment forward and the psychological impact of lower nominal tax rates on business profits should attract more foreign direct investment to Germany. Both export and import growth will slow substantially in 1999 to around 1%-3% from a range of 6% to 8% in 1998. However, German foreign trade should pick-up in the second half of 1999 mainly in response to a weaker than projected euro, improved economic prospects in Germany's export markets and improved competitiveness as a result of job shedding via corporate restructuring.

Plans for further job cuts and the recent government move to make the so-called "DM 630 (part-time) jobs" less attractive by raising social contributions and taxes paid on them are indications that the labor market situation will remain difficult, especially in eastern Germany. Job creation in all of Germany has almost come to a halt and overall unemployment is expected to drop by around 200,000 on average in 1999 primarily for both demographic reasons and the implementation of a special youth employment program in January 1999. In addition, June unemployment figures showed the 6th consecutive decline in (seasonally-adjusted) unemployment in the West but the 4th consecutive rise in the East, putting the (seasonally-adjusted) unemployment rate at 8.8% in the West and 17.5% in the East. For the year as a whole, the unemployment rate is projected to drop to below 11%, down from 11.1% in 1998 and a record high 11.4% in 1997. The 1999 wage round ended up in nominal wage hikes of around 3%, well above estimated inflation of less than 1%. However, despite higher wage settlements and both rising energy prices and taxes German inflation remains subdued so far and is forecast to remain moderate for the near future.

Persistent Structural Problems

Despite some modest reforms implemented by the former Kohl government, Germany had to deal with important structural problems when the SPD/Greens coalition led by the SPD Chancellor Schröder came to power in late 1998. Reforms were needed especially in the areas of business taxation, mandatory pension and health system, labor market flexibility and rising government debt in view of increasing international competition, a graying population, continued high transfers to eastern Germany and persistent high levels of unemployment. Structural unemployment is estimated at 80% of total unemployment. Total government debt (Federal, states and communities) accounts for more than DM 1,500 billion or 61% of GDP and Federal debt service obligations reach 25% of Federal revenues. Once in power, the new government fulfilled election promises and implemented significant tax cuts for low income taxpayers, very modest tax relief for businesses, higher energy taxes in return for lower labor costs. It also reversed major parts of the previous Kohl government's modest social reform steps such as the long-term reductions in pension payments, the reduction in sick payments and the increase in co-payments for drugs in the health insurance system retroactive January 1, 1999.

With the abrupt departure of Lafontaine and the arrival of new Finance Minister Hans Eichel, the German government has moved towards a more pragmatic view of the need for business-friendly policies. Although the government has not taken bold action on structural reforms yet, the proposed Federal budget 2000 and the other parts of the "Future Program 2000" indicate a good start in making German industry more competitive through the reduction of business taxes and labor costs.

Some changes are also coming from labor and management. The nation-wide collective bargaining system produces wage and work time inflexibility and fails to consider disparities by regions and companies. Somewhat more labor flexibility, however, has been reached at the company level, especially in eastern Germany. The rising number of companies that leave industry organizations and negotiate contract and wages at the company level is indicative of the growing discontent with the existing inflexible collective bargaining system. In 1998, only 48% of West German businesses were covered by a collective bargaining contract (1995: 54%) and roughly 25% in the East. However, these western firms account for about 68% of total employees (1995: 72%) and for about 50% in the East.

Economic Objectives and Policies The government's declared primary objective is to stimulate economic growth and employment and to get a grip on rising government debt. To this end, the government has proposed its "Future Program 2000" package, a combination of budget consolidation, growth incentives and structural reforms. Key elements of this program are: basic expenditure and revenue figures for the Federal budget for Fiscal Year 2000 through 2003 (Fiscal year equals to calendar year) and an outline of the planned business and family tax reforms, a mid-term energy taxation plan and the highly controversial reform of the German mandatory old age pension system. In the Federal budget 2000, the government managed to cut Federal expenditures by DM 30 billion (compared to estimates of mid-May 1998). The DM 30 billion cuts in 2000 represent the largest austerity package in German history, although some DM 5 billion out of the total have not yet been specified. Federal spending in 2000 (DM 478.2 billion) will be 1.5% lower than the 1999 target (DM 485.7 billion) and the deficit will be reduced to DM 49.5 billion or 1.2% of GDP (1998: 1.4%). With investment expenditures budgeted at DM 57.6 billion, the deficit in 2000 also meets the constitutional deficit limit. In the years 2001-2003, the deficit is planned to decline further to around DM 50 billion by 2003, helped by an annual average expenditure rise of below 2%.

In 2000, the highest cuts are coming from the labor ministry's budget (DM 12.5 billion), followed by transportation and defense outlays (DM 3.6 billion and DM 3.5 billion). The labor ministry budget cuts largely center on lower pension payments, lower contributions to the social security system for unemployed and lower annual increases in unemployment benefits. Direct subsidy cuts are also programmed mainly in the area of agriculture, shipbuilding, coal mining and social housing, as well as cuts in tax preferences. Moreover, government pensions will increase only in line with inflation and another 6% drop in Federal employment during the next 4 years will also help to trim expenditure growth and meet the constitutional deficit limit as well as the Maastricht criteria over the period 2000-2003.

On top of minor business tax changes effective January 1, 1999, a more comprehensive business tax reform is planned for implementation in January 2001 and will reduce the net tax burden of businesses by some DM 6-8 billion per year. The tax rate for business profits will be reduced to 25 percent. At present, corporation profits are taxed at a flat 40% rate, while profits from individual entrepreneurs and partnerships are taxed at a maximum rate of 45%. The local tax on business profits will be maintained and add an estimated 10-13 percentage points on top of the 25% rate, thus bringing the total tax rate on business profits up to 35-38%.

On top of income tax changes effective January 1, 1999 and in order to fulfill the January 1999 Supreme Court ruling, the taxation of families will be reformed. In a first step the special per child tax deduction in personal income taxation as well as the direct monthly child payments will be raised effective January 1, 2000. Both measures will reduce the tax burden of families by an estimated DM 6.5 billion annually. A 2nd step is planned to come by 2002. The government will decide upon the shaping of step 2 in 2001.

On top of a rise in energy taxes effective April 1, 1999, the petroleum product tax will be increased in each of the 4 years 2000-2003 by 6 Pfennig and the electricity tax will also be raised by 0.5 Pfennig per kilowatt hour each year. The extra revenues will be largely used to finance a further reduction in the contribution rate to the mandatory pension fund from currently 19.5% of gross salaries (equally paid by employer and employee) to 18.5% in 2003. This re-allocation of funds reduces employer's labor costs and is expected to stimulate job creation. A smaller part of the extra tax revenues will go for paying special pension payments (like the new "means-tested" basic old age assistance).

A major and highly controversial element of the pension reform is to limit the annual adjustment of pension payments to inflation in the years 2000 and 2001 (i.e. to around 0.7% and 1.5%) until a new adjustment rule based on wage developments will be established in 2002. The current rule is based on net wage developments of the previous year, i.e. pension payments would otherwise have been increased by some 3-4% in 2000. This measure reduces the standard pension level (defined as 45 years of work with an average salary) to about 66% of former net salary (from currently 70%. Other elements of the reform would be some kind of a "means-tested" basic old age assistance, a change in pension payments for widows and widowers as well as a change in disability payments.

In addition, investment outlays for R&D, education and science will be raised by DM 1 billion in each of the coming years. The volume of transfers to eastern Germany will be continued on a high level although the special Federal programs and the quasi-government programs (KFW, ERP etc.) for eastern Germany will be reviewed for better coordination. The volume of active labor market support programs will be maintained at the 1999 level and the special program to reduce youth unemployment will be extended through 2000. But the annual increase in unemployment benefits will be restricted to inflation (rather than to average wage developments under the current system) and government contributions to the social security system for unemployed will also be reduced. Changes to the package during the lengthy legislative procedure are likely, but nevertheless it represents the first step of a long and difficult process of structural reform and success will require consistent long-term efforts.