German fiscal policies. Tax and spend

AS BENJAMIN FRANKLIN might have put it, nothing in Germany is certain except death and taxes. On July 1st Chancellor Gerhard Schroder will engineer a lost vote of confidence, opening the way for an election in September that seems sure to lead to his political demise. His government has just finalised its budget for next year, which will boast a record deficit, suggesting that a government led by Angela Merkel, leader of the Christian Democrats (CDU) may have to raise not cut taxes.

The dismal state of Germany's public finances affects both the ruling coalition and the opposition. If he did not have to push through a budget that so obviously does not add up, Mr Schroder might have thought twice about advancing the election. And without money to play with, Ms Merkel will find it hard to pursue the ambitious “government programme” that she plans to present on July 11th.

Hans Eichel, the finance minister, is dramatising the fiscal situation so as to blame the opposition for stopping his spending cuts. The federal government will borrow €22 billion ($27 billion) next year, pushing the overall budget deficit well above 3% of GDP, the ceiling supposedly set by the euro-area's stability pact. Public debt will hit €1.5 trillion by the end of 2005, or 68% of GDP. If nothing is done, some projections have debt rising to an Italian-style 111% by 2050. Adding implicit debt, such as pension liabilities, pushes the ratio to three times as high.

During the miracle years, politicians found it too easy to distribute subsidies, riddle the tax code with exceptions and ignore such structural problems as a rigid labour market. But the fiscal consequences of slow growth have been dire. Last year, interest payments, labour-market programmes, pensions and other social spending soaked up almost two-thirds of federal spending.

Germany's federal system, which gives the states veto power, makes things worse by letting the government cut tax rates, but not subsidies, which consumed almost €60 billion in 2003. Add the costs of unification, mostly financed by debt, and it is easy to see why recent budgets violated the constitutional rule that deficits should be incurred only to finance investment.

All this also explains why German finance ministers have a hard life. They must project the trustworthiness of a chief financial officer, but also have a talent for creative book-keeping. The incumbent, Hans Eichel, once promised a balanced budget by 2006. Now people joke about his securitising future tax revenues (he did this with loans to Russia).

Will Mr Eichel's successor do any better? A CDU-led government will do what it takes to avoid the looming “state bankruptcy”, promises Steffen Kampeter, the party's budget expert. Once in power, it will declare a spending freeze. Then it plans special laws, including wide-ranging cuts in subsidies, to get the budget back on a sustainable track. Because the CDU controls the upper chamber, the Bundesrat, these painful measures have a better chance than usual of passing.

Yet a CDU-led government will want to do a lot more than just get the state's books in order. At first, it might launch reforms that cost nothing, such as more deregulation. But unless the economy unexpectedly bounces back, a clash is inevitable between sound public finances and hoped-for (but costly) reforms to health-care financing or the byzantine tax system. The CDU apparently plans to raise value-added tax to pay for these.

This would also avoid too much stress on belt-tightening, which risks further weakening of domestic demand and consumer confidence. Indeed, it is quite likely that the fiscal situation will get worse before it gets better. It would not be the first time that a new conservative government ended up spending and borrowing more than its centre-left predecessor.

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