Saturday, November 12, 2005

Both Good and Bad in Germany's New Budget

As I've discussed before, the latest German elections ended with neither of the two main parties, the Christian Democrats and the Social Democrats failed to achieve majority even with their prefered coalition partners, the Liberals and the Greens respectively. The Social Democrats could have held on to power with the help of the post-communist Left Party, but as they have ruled this option, a "grand coalition" with the Christian Democrats is now the only remaining option.

Today, the details of the economic policies of the new "grand coalition" was revealed. And it contained both good and bad policies.

Starting with the good parts, they seem to realize how important it is to reduce Germany's budget deficit especially with its aging population. With regards to the last, they also wisely choose to cut back on pensions both by freezing benefits (which means reducing them in real terms) and raising the retirement age.

Another positive is a slightly less rigid labor regulations and a small cut in the payroll tax.

The bad news is that the small payroll tax cut will be more than offset by much larger tax increase, both in the form of a value added tax (consumption tax) increase from 16% to 19% and a increase in the top income tax from 42% to 45%. Another negative is that government "investment" spending is set to increase.

Given the already too high level of German taxes, further tax increases are particularly damaging and will further reduce the incentives for wealth creation. And contrary to the belief of the Christian Democrats, the value added tax is as damaging as the payroll tax as both act as "tariffs" on economic exchanges and thus reduce economic activity. Instead the budget deficit reduction should have been focused on spending cuts, particularly in the welfare and entitlement systems.

As the package contained both good and bad news, it will probably have almost no net effect either way on the performance of the German economy. But given how weak the German economy is, not doing any further damage is not good enough.


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