Mission Concluding Statement 

Germany--2006 Article IV Consultation, Concluding Statement of the Mission

September 11, 2006

1. After several years of low growth, a cyclical recovery is finally underway in Germany. Corporate restructuring and wage moderation have lowered costs and improved external competitiveness. These private sector initiatives were accompanied by important reforms of labor market and social welfare programs. The grand coalition that came into office a year ago committed to continue on this path, phasing in fiscal consolidation and reforms to allow space for the economy to pick up. The recovery has benefited from an extended period of favorable external conditions, and strong export growth is beginning to spill over to investment.

2. The task now is to broaden the recovery and make it more sustainable. Improving labor market flexibility to generate faster employment growth is essential to raise domestic demand. Parallel productivity-enhancing reforms in product, service and financial markets would magnify the impact of labor market reforms. Fiscal policies and entitlement reforms need to cement confidence in the sustainability of the welfare state. The upswing provides a conducive setting for progress in these areas.

3. Because the VAT increase in 2007 is part of a broader package, its impact on growth is likely to be limited. Real GDP is projected to expand by 2 percent in 2006, aided by one-time effects related to the pending VAT increase and policies that have stimulated housing construction and remodeling. Against this background, the more moderate projected expansion of 1.3 percent in 2007 does not represent a slowing of underlying growth. The risks to this outlook are on the upside for 2006, as the favorable momentum may continue in the second half of the year. The risks for 2007 are more evenly balanced, despite a possible slowing of external demand. However, economic prospects beyond 2007 are less clear and depend on the success of broadening the recovery to employment and household consumption. Moreover, improved cyclical prospects do not change Germany's low growth potential over the medium and long term.

Fostering Employment Growth

4. Employment growth needs to be further strengthened to generate higher household income and consumption. The recent uptick in employment, including some expansion in full-time jobs, is encouraging, but unemployment at over 10 percent remains intolerably high. Reducing it will require lower reservation wages to bolster labor supply and employment, especially for the lower skilled. Policies that raise labor utilization through support for activity rather than inactivity will have the added benefit of reducing structural welfare costs.

5. Recent labor market reforms were path breaking in several respects, but they need to be modified and implemented better to improve effectiveness. Short-term unemployment is easing with the cycle and responding to reform measures such as shorter duration of unemployment benefits. However, long-term unemployment in the Unemployment Benefit II system (UB-II) has changed little and the system has proven expensive. Remedying this should be the government's top priority in labor market reform. Along the lines recommended by the Council of Economic Experts and several research institutes, the mission sees the following policy implications:

• Working within the existing UB-II framework, we support proposals to withhold 30 percent of the current allowance until there is demonstrated work effort. This would put greater responsibility on the individual to shift from welfare to work.

• Introducing new minimum wages, even at the sectoral level, would be a serious policy mistake because they would set additional floors in wage determination, undermine job creation, and in the end hurt the most vulnerable job seekers. Equally, new wage subsidies should not be introduced. UB-II already has elements of employment support and acts as a wage floor.

• Fully implementing means testing and provisions to regulate access to benefits and stimulate job search will be important to improve the functioning of UB-II. Additionally, the administration of tasks between the Federal Labor Office and local authorities needs to be further improved to increase the effectiveness of job placement.

6. More generally, many of Germany's labor market regulations and programs are complex, expensive, and ineffective. Evaluation reports indicate that active labor market policies have created few new jobs at substantial fiscal cost. Ineffective programs should be eliminated and simplification of the overall system would enhance transparency, including for job seekers.

Raising Productivity to Support Growth and Wages

7. Additional deregulation would strengthen domestic competition and raise productivity. Productivity determines sustainable wages and the standard of living. Indeed, greater reliance on efficiency gains would put less burden on lowering relative wages and be beneficial for Germany and its trading partners. Studies confirm that simultaneous deregulation of labor, product, and services markets provides the biggest gains in efficiency and employment and therefore growth. The mission supports the thrust of the Monopolkommission's recommendations in this area. Priority should be given to:

• Improving the effective contestability of markets in the large network industries to capture efficiency gains and benefit consumers. This should be done by stepping up privatization (including at the local level) and reducing network access costs.

• Lowering entry barriers to improve the climate for small businesses and boost job creation. This will require liberalizing licensing requirements for crafts and price schedules for professional services, where conditions favor incumbents.

• Lowering administrative burdens on enterprises to reduce costs. The initiative in the Chancellery to conduct a systematic cost-benefit analysis of business regulation could provide impetus to this long-standing goal.

Improving the Allocation of Capital

8. A more efficient financial sector would improve the allocation of capital to areas of highest return, strengthening economic performance. Banks and insurance companies are healthier than in recent years, but they still underperform most EU peers and the improvement in earnings is largely cyclical. Structural efficiency gains in the banking system appear slim. However, capital markets are deepening and playing a greater role in guiding corporate decisions.

9. Adjustment needs to be accelerated, especially in the large public banking pillar. The withdrawal of government guarantees in 2005 has spurred Landesbanken to develop new strategies. Ownership of several banks is changing, which should have positive consequences for performance. However, it remains vital to allow more private capital to enter Landesbanken and Sparkassen to harness market signals and facilitate restructuring. This will require legal changes by Laender that have not already moved in this direction. Such changes are overdue as strains could reemerge during the next downturn and developments in neighboring countries may leave the German banking system further behind.

10. Increasing flexibility in the real estate market would contribute to overall economic efficiency. The real estate market has stagnated with low liquidity and controls on rental markets. The immediate priority should be to push ahead with the introduction of REITs covering both residential and commercial properties. These trusts would facilitate large-scale divestiture and allow owners to focus on their core activities.

11. Although the role of private equity in Germany has increased, there is still considerable untapped potential. Private equity facilitates the entry of new firms, spurs innovation, and enhances corporate governance. The mission therefore supports the authorities' intention to formulate a more effective legal framework for private equity. A deeper capital market can also offer new instruments for long-term saving in the second and third-pillar pension schemes and help manage aging costs.

12. Financial sector soundness has improved, but continued supervisory and regulatory vigilance is required. In this context:

• The mission supports BaFin's move towards risk-oriented supervision, which should lead to more efficient use of supervisory resources. With this move, it is important that supervision is guided solely by prudential criteria determined by BaFin. The ongoing review of BaFin should be used to buttress its operational independence.

• Transparency should be improved by publishing the methodology underlying BaFin's risk-oriented supervision and more timely dissemination of financial soundness indicators, particularly for non-performing loans.

• The July 2005 Supreme Court ruling on profit participation of holders of life insurance policies should be implemented in a way that does not undermine the health of the sector. Consumer protection should be achieved primarily through better disclosure.

• Efforts to increase the portability of reserves to enhance competition among private health insurers are appropriate. Additionally, care will be needed to ensure that the role of private insurers as an alternative to public insurers is not disrupted by reforms in this sector.

Advancing Fiscal Consolidation

13. Good progress has been made in reducing the fiscal deficit in 2006 and policies are in place to deliver further adjustment in 2007. The mission projects the 2006 deficit to be 2.6 percent of GDP, meeting the Maastricht deficit criterion one year ahead of schedule (and better than the forecast in the IMF's September 2006 World Economic Outlook). The goal should be to reduce the deficit to no more than 2 percent of GDP in 2007, which is achievable with resolute implementation of current policies. The structural balance is on track to be reduced by a cumulative 1 percentage point of GDP in the period 2006-2007, with a significant expenditure component. Although expenditure-based measures should continue to be the cornerstone for lasting fiscal adjustment, the VAT increase combined with a reduction in payroll taxes is a positive structural measure. The government should not repeat the past mistake of failing to consolidate during an economic upswing. Thus, if revenues turn out stronger than expected, they should be used to reduce the borrowing requirement and not to increase spending.

14. To achieve further deficit reduction after 2007, measures already in the pipeline will need to be augmented. The goal should be to achieve structural balance by 2010 to anticipate pressure from population aging. This will require structural adjustment of at least half a percent of GDP a year. As across-the-board restraint on discretionary expenditure becomes inefficient and unsustainable over time, the emphasis should be on reducing subsidies and tax expenditures, cutting spending on active labor market programs, and lowering unemployment costs. Measures should also continue to focus on reducing aging-related structural expenditure by reforming entitlement programs.

15. Corporate income tax and health care reforms need to be implemented in a way that meets stated objectives and does not increase fiscal risks. The reforms are important to get right, even if it takes time to frame sound and transparent solutions; the authorities should not rush into compromises that fail to deliver greater efficiency and competition.

• Corporate income tax reform. The mission supports the goal of reducing statutory tax rates, accompanied by base broadening to limit the net budgetary cost to no more than €5 billion. Reducing the deductibility of interest as a business cost, however, would be a departure from common practice and further complicate the corporate tax system. Other base broadening measures, such as reducing Germany's unusually rapid depreciation rates or raising revenue from the tax on business assets would be preferable. The proposals to reform the inheritance tax system for transfer of enterprise assets to next of kin should be reconsidered as they are difficult to defend on economic grounds and risk introducing new distortions.

• Health care reform. Lowering the trajectory of health-care cost will require, among other things, a substantial increase in competition among health care providers and insurers. The proposed central health fund needs to be designed in a way that helps reduce pressure on payroll taxes without adding to bureaucracy. Measures also need to be identified to offset the additional budgetary cost of shifting child health care expenses to the budget.

16. Long-run fiscal sustainability is not yet assured. Germany has begun to reduce long-run aging costs and narrow the fiscal sustainability gap. However, even if the structural deficit can be eliminated by the turn of the decade, the debt ratio would still rise in the long run. A comprehensive strategy that combines fiscal steps with reforms to increase productivity and labor utilization offers the best prospect for securing long-run sustainability. To help guide policies, the authorities should convene a group of independent experts to estimate aging costs as is done for the preparation of joint tax estimates.

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17. We thank our interlocutors for stimulating discussions and generous hospitality.