Germany’s new government. Taxing times

Angela Merkel's coalition programme risks doing serious damage to the economy

IT HAS taken weeks of hard bargaining for the partners in Germany's "grand coalition" to agree on a joint programme. Not surprisingly, the outcome was a messy compromise (see page 39). But after the deal was approved by this week's special party congresses, the way is at last clear for Angela Merkel, leader of the Christian Democrats (CDU), to become Germany's first-ever female chancellor on November 22nd.

Sadly, it is not clear that she will be a success in the job. There are some good things in the coalition's programme: a plan to reform Germany's blocked federal system, a shift in foreign policy towards a more pro-American stance, a firmer line on Russia and China. But, in the critical area of economic policy, the clash between Ms Merkel's pro-reform views and the anti-reform instincts of many Social Democrats (SPD) has produced what may prove the worst of both worlds.

The CDU has managed to include minor labour-market reforms, plus confirming an eventual rise in the pension age to 67. But it has had to drop its bolder ideas for liberalising markets and shaking up the welfare state. Instead the coalition deal focuses on cutting Germany's yawning budget deficit by a net euro35 billion ($41 billion) a year. Much of that cut is to be achieved through hefty tax increases: value-added tax is to rise from 16% to 19%, various tax breaks will be scrapped, and the top rate of income tax will go from 42% to 45%. A planned corporate-tax cut has been postponed.

Deficit hawks will be delighted by this outbreak of fiscal austerity. But ordinary Germans may be less pleased. Although the economy is showing welcome signs of life, and German business is in bouncy shape after years of cost-cutting, domestic demand remains extremely weak. In this situation, the last thing that hesitant consumers want is to be clobbered by tax increases. After Japan decided in 1997 to take advantage of an incipient recovery to raise consumption taxes in the hope of cutting its huge budget deficit, the economy tanked again - and the deficit rose.

Yes, but Germany is different, say advocates of fiscal rectitude. For one thing, the coalition negotiators have cleverly put off the biggest tax increases until 2007. Not only does that give the economy a year to cement its recovery; it also gives consumers an incentive to advance big-ticket purchases before higher VAT kicks in. Fiscal retrenchment could also be partly offset by monetary easing. And some economists believe in a German form of "Ricardian equivalence" - the notion that consumers may be readier to spend after tax rises because an improvement in the public finances means they will not face further heavy tax increases in future.

Yet none of these arguments is convincing. After spending years becalmed in the doldrums, only to see an inconclusive election that leads to a postponement of much-needed reforms, German consumers seem unlikely to recover their enthusiasm quickly. A revival in euro-zone output means that interest rates are more likely to be raised, not cut, in the coming months (see page 87); the European Central Bank cannot easily reward a single country for embarking on fiscal tightening. And, although there is some European evidence that fears of future tax increases can lead people to save more today, it seems highly unlikely that a net fiscal adjustment as big as euro35 billion will be offset by lower personal saving. In any event, as the CDU argued in its election manifesto, the last thing a high-tax economy such as Germany's needs is still higher taxes.

Merkel's misfortune

Perhaps the tax increases will not be put into effect. Gerhard Schroder, who became the SPD chancellor in 1998, used to boast that he had never even read his party's coalition deal with the Greens, much less put any of it into effect. Once Ms Merkel takes office, the pressure of events may push her government off the path of fiscal austerity and back towards labour- and product-market reforms instead.

The trouble is that a grand coalition agreement is different from most normal government programmes. The parties disagree so sharply that they will try to hold ministers quite closely to the terms of the deal they have so laboriously hammered out. Indeed, precisely because of this tension, the coalition may well not last much more than two years. As soon as one of the parties senses that fresh elections might be to its advantage, it will be tempted to pull out of the government. The risk is not only that Ms Merkel's coalition will follow wrong-headed economic policies; it may also turn out to be unstable as well. Poor Germany.

Editorial argues that the new 'Grand Coalition' under Angela Merkel has a policy programme that risks doing serious damage to the economy.