German reforms trigger a seismic shift in Europe

ECONOMIC VIEW

The weekend saw Chancellor Helmut Kohl of Germany and President Jacques Chirac of France asserting that EMU would go forward on schedule, and in some ways more important, that their countries would be able to qualify for EMU.

As far as France is concerned the statement has to be read simply as an act of faith: a political statement from a politician which may or may not be born out by subsequent events. It is very hard to see France cutting its budget deficit by enough to qualify for the 3 per cent of GDP Maastricht criterion, but it is always conceivable that the figures can be massaged enough to squeak by for one year. It looks impossible, just as it looks inevitable that another winter of discontent looms, but in politics nothing is certain.

For Germany the question is qualitatively different, for sleight of hand will be less warmly welcomed and, in some ways, the German fiscal position is even more serious than the French. State spending is lower as a percentage of GDP (50.6 per cent last year as opposed to 53.7 per cent for France) and the fiscal deficit seemingly under better control (3.6 per cent of GDP against 5 per cent), but the starting point is worse, for France still has some clearance under the 60 per cent of GDP debt total, whereas Germany has none. This year German debt looks like being 60.5 per cent of GDP, while forecasts for next year are worse.

But cutting across these efforts to meet Maastricht is the need for tax cuts. Britons may think of the quest for tax cuts as being principally an Anglo-American preoccupation - the invention of Thatcherism or Reaganomics. They might be surprised to know that the cry for tax cuts is now stronger on the Continent than it is here or in the US.

So currently much more interesting, for ordinary German citizens, than the efforts to meet Maastricht, are the tax reforms now being promised by the authorities. Details of these will be produced in the next few days. France too, has a budget looming, but there is not yet much of a feel for what the French will do. We know from a speech last week by President Chirac that the French will try to cut taxation to put spending power back into the hands of ordinary citizens. But we have no idea of what that statement means or how it might be reconciled with Maastrich objectives.

Germany, on the other hand, has proposed reforms which in many ways parallel the tax reforms which took place in the UK in the 1980s: a rebalancing of the tax system from direct taxation to indirect and from high nominal rates of tax, softened by numerous loopholes, to lower overall rates but with fewer loopholes.

A number of ideas are being discussed. These include cuts in inheritance taxation and in local corporation tax, and the abolition of the wealth tax on 1 January next. The most striking proposal, though, is a plan for cutting the top rate of income tax, currently 53 per cent, to either 40 per cent or maybe 35 per cent. A government commission on this is due to report in November, the idea being to have the cuts in place by 1998 or 1999 at the earliest. How to pay for all this? Well, aside from spending cuts already proposed (and likely to be passed later this month), it has been noted that at 15 per cent the German VAT rate is low by European standards. The latest paper on EMU preparations by France and Germany from PaineWebber, a US investment bank, notes that a rise in VAT is being kept in reserve to pay for cuts in income tax, but that it could be deployed earlier if necessary.

To anyone in the UK, all this sounds familiar. Why, one might ask, is this Anglo-American tax-cutting agenda now finding favour in Germany? The answer is jobs.

As the graph on the left shows, employment growth in Germany has been bad even by European standards, let alone North American. While the German economy now does seem to be recovering after two quarters of shrinkage, it is a jobless recovery. German exporters have managed to improve their efficiency to compensate (to some extent at least) for the higher German mark, but they have done so at the expense of jobs. Even in 1994, when the economy grew by about 3 per cent, employment in the former West Germany shrank. JP Morgan, the US bank which has just done a study of employment in Germany, points out that both France and Italy have outperformed Germany's employment record in recent years. One could envisage, on present trends, the German economy growing at 2.5 per cent, yet employment still falling and, naturally, unemployment rising. JP Morgan reckons that employment growth will continue to be negative right through next year.

To see one of the reasons why, look at the chart on the right. Social security contributions have risen inexorably as a percentage of gross pay. German social security payments may be not uniquely high by European standards, but add in German pay packets and they make the cost of labour the highest in the world. Cutting the social security wedge to below 40 per cent is one of the targets the government announced earlier this year as part of a plan to halve unemployment by the end of the century, but that would still leave social security costs far higher than they were at the time of unification. Looking further ahead, the combination of Germany's pay-as-you-go pension system and a deteriorating demographic pattern will make it impossible to do anything about the largest segment of those social security costs, that of pensions. That pension block at the bottom of the graph is far too low to service future needs.

So what will give? I don't think we will get a sudden, easy answer. Instead, think of us at the very early stage of a seismic shift in continental European thinking about its tax and welfare systems. Germany here is enormously important, not just because of its economic dominance but because of its intellectual dominance. The German social model has been the standard one for much of the rest of continental Europe. As it is gradually reformed, the changes will be reflected in changes elsewhere in Europe. But this will not happen quickly. The political consensus does not yet really exist, and while it was possible to push through a tax-rebalancing exercise in the UK, it will take longer in Germany. This will be a 20-year process, encompassing all the large political parties, not something which can be achieved in a couple of budgets by a radical finance minister.

Nevertheless, expect German tax plans to have some influence here, even if superficially it seems that Germany is simply following the UK model. For example, if Germany has, by the end of the year, announced plans to cuts its top tax rate to 35 per cent, it would be politically easier for a new Labour government, committed to keeping the UK top rate in line with major European countries, to hold the UK rate at 40 per cent. There is an international market for ideas about the appropriate system and levels of taxation into which all politicians tap. UK ideas on tax used to look odd by European standards (though not by Japanese or East Asian). Now they are beginning to appear commonplace. But UK is not much of a direct influence on continental Europe. When Germany switches the balance of taxation from direct to indirect, expect the rest of Europe to follow fast.