VZCZCXRO4581
PP RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV RUEHSL RUEHSR
DE RUEHRL #0840/01 1911732
ZNR UUUUU ZZH
P 101732Z JUL 09
FM AMEMBASSY BERLIN
TO RUEHC/SECSTATE WASHDC PRIORITY 4588
INFO RUCNMEM/EU MEMBER STATES COLLECTIVE PRIORITY
RUCNFRG/FRG COLLECTIVE PRIORITY
RUEHDF/AMCONSUL DUSSELDORF PRIORITY 0230
RUEHFT/AMCONSUL FRANKFURT PRIORITY 8093
RUEHAG/AMCONSUL HAMBURG PRIORITY 0313
RUEHLZ/AMCONSUL LEIPZIG PRIORITY 0225
RUEHMZ/AMCONSUL MUNICH PRIORITY 2080
RUEHC/DEPT OF LABOR WASHINGTON DC PRIORITY
RULSDMK/DEPT OF TRANSPORTATION WASHINGTON DC PRIORITY

UNCLAS SECTION 01 OF 03 BERLIN 000840 
 
SENSITIVE 
 
STATE FOR EEB (NELSON), EEB/IFD/OMA (WHITTINGTON), 
DRL/ILCSR AND EUR/CE (SCHROEDER) 
LABOR FOR ILAB (BRUMFIELD) 
TREASURY FOR ERIC MEYER, ICN (KOHLER), IMB (MURDEN, MONROE, 
CARNES) AND OASIA 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PREL GM
SUBJECT: GERMAN FISCAL POLICY: SLAMMING ON THE BRAKES 
 
REF: BERLIN 793 
 
BERLIN 00000840  001.2 OF 003 
 
 
¶1. (SBU) SUMMARY.  While most countries are busy trying to 
pull their economies out of the worst recession in decades, 
Germany is already focusing on next steps.  Chancellor 
Merkel's government has set the country on a course intended 
to reduce its budget deficit to almost zero by 2016, despite 
an economy that is still contracting.  As is the case 
elsewhere, Germany's fiscal position has deteriorated 
markedly since the onset of the financial and economic 
crises.  Due to efforts to combat the crises and declining 
tax receipts, the federal government's budget deficit will 
peak at around 100 billion euros next year; it will not fall 
below levels permitted by the EU's Maastricht Treaty until 
¶2013.  The EU, however, is not the main force driving 
Germany's fiscal retrenchment.  By and large, it is an 
indigenous determination to reduce public debt, now enshrined 
for posterity's sake in the German constitution.  Despite the 
expectation that the crisis will deepen later this year and 
next with a corresponding rise in joblessness, Merkel's party 
has made a campaign promise of moderate tax reductions.  Not 
only is it likely that such a pledge will be forgotten after 
the September elections, but the next Chancellor will 
probably be in the awkward position of having to raise taxes 
and cut spending while the economy is still struggling to get 
back on its feet. END SUMMARY. 
 
DASHED HOPES 
------------ 
 
¶2. (SBU) Balancing the federal budget was a top priority for 
the "Grand Coalition" of Chancellor Merkel's Christian 
Democratic Union (CDU)/Christian Social Union (CSU) and 
Social Democratic Party (SPD) when it took the reins of 
government in October 2005.  Thanks to some notable reforms 
and healthy economic growth driven by strong exports, the 
goal once appeared to be within reach.  Under the careful 
stewardship of Finance Minister Peer Steinbrueck (SPD), an 
outspoken deficit hawk, the federal deficit fell to just 0.4 
percent of GDP in 2008.  But what a difference a few months 
can make.  With exports plummeting and GDP shrinking at its 
fastest pace since the 1930s, a balanced budget is no longer 
even a remote possibility.  In fact, it is estimated that the 
federal budget deficit will swell to 2.1 percent of GDP this 
year. 
 
¶3. (SBU) Next year will be worse.  The coalition's budget 
proposal for FY 2010, which Merkel's cabinet passed on June 
24, foresees a deficit reaching a new postwar high of 86 
billion euros -- twice the previous record -- out of a total 
budget of 328 billion euros.  Corinna Westermann, Ministerial 
Advisor for Budgetary and Financial Planning, Ministry of 
Finance, told Econoff that around half of this figure is 
attributable to the steep drop off in tax revenues.  Another 
30 billion euros will go towards job market-related 
expenditures, such as unemployment benefits and the 
"short-shift" ("Kurzarbeit") scheme, wherein the government 
subsidizes the salaries of workers agreeing to work fewer 
hours.  The small structural deficit (6 billion euros) and 
stimulus spending (9 billion euros) make up the difference. 
 
¶4. (SBU) But even this does not tell the whole story, as 
additional stimulus measures and bailout funds are not 
included in the 86 billion euro figure.  Once they are thrown 
in, Germany's 2010 federal budget deficit will top 100 
billion euros.  This easily surpasses 4 percent of GDP, even 
without including the Maastricht-relevant state and local 
deficits.  Forecasts indicate the red ink will continue to 
flow over the mid-term.  The government predicts a deficit of 
71.7 billion euros in 2011, with the shortfall ebbing to 45.9 
billion euros in 2013.  Germany's public debt, currently 74 
percent of GDP, will have increased by 510 billion euros as a 
result of the crisis, stabilizing at around 82 percent of GDP 
in 2013, according to government estimates. 
 
REMEMBERING MAASTRICHT 
---------------------- 
 
BERLIN 00000840  002.2 OF 003 
 
 
 
¶5. (SBU) Germany was one of the strongest proponents of the 
convergence criteria contained in the 1992 Maastricht Treaty 
creating the single currency.  Ever since, Germans have 
constantly fretted that if the German deficit breached the 3 
percent of GDP limit, there would be little incentive for 
less fiscally prudent Eurozone peers to keep their spending 
in check, leaving  the German taxpayer to foot the bill for 
other countries' spendthrift ways.  Recent flexibility on the 
Maastricht criteria on the part of Brussels has met with only 
tempered enthusiasm in Berlin.  Rather, there is considerable 
pressure within Germany to get the budget under control, as 
projections indicate Europe's largest economy will be in 
breach of the Maastricht criteria until 2013. 
 
SLAMMING ON THE BRAKES -- FOREVER 
-------------- ------------------ 
 
¶6. (SBU) One of Chancellor Merkel's top priorities at the G-8 
Summit in L'Aquila, Italy, was to convince other leaders to 
examine "exit strategies" from fiscal and monetary measures 
launched to combat the global slump.  Planning for a return 
to fiscal sustainability now would boost market confidence 
and lead to stronger growth down the road, she argued, 
offering up a recently passed amendment to the German 
constitution ("Basic Law") as a model.  This balanced budget 
amendment is commonly called the "debt brake." 
 
¶7. (SBU) Michael Tonne of the Finance Ministry's Division of 
Budgetary and Financial Planning told Econoff that the debt 
brake requires the federal government to run a deficit of no 
more than 0.35 percent of GDP by 2016.  Only "automatic 
stabilizers" -- entitlements such as unemployment benefits 
that rise automatically during recessions -- may contribute 
to a shortfall of up to the Maastricht limit of 3 percent. 
Exceptions are permissible in "extreme cases," such as 
natural catastrophes or cases where "accumulated debt exceeds 
structural and cyclical debt."  Extraordinary fiscal stimulus 
programs are not allowed; in fact, they are now 
unconstitutional.  In the meantime, there are ambitious 
mid-term targets, which force the federal government to focus 
on fiscal consolidation starting with the preparation of the 
2011 budget next year.  The German states (Laender) must 
eliminate their deficits altogether, though they have until 
2020 to pull it off.  Under the amendment's provisions, the 
federal government must assist relatively poor states, such 
as Berlin, Bremen and Saarland, in reaching the goal.  This 
naturally places yet another burden on the federal 
government's coffers, just as it attempts to wrest control of 
its own finances. 
 
AND YET, (SMALL) TAX CUTS 
------------------------- 
¶8. (SBU) Despite the herculean task of fiscal retrenchment in 
the midst of the worst recession in 70 years, tax cuts have 
entered the political discourse.  Under pressure from the 
CSU, Merkel,s CDU agreed to a joint election platform 
calling for 15 billion euros of tax cuts over several years 
(REFTEL). The plan is to cut the lowest income tax rate to 12 
percent from 14 percent, raise the threshold for the top 
income tax rate of 42 percent from 52,500 euros to 60,000 
euros, and reduce the degree to which a rising income leads 
to a progressively higher tax rate.  The proposed measures 
would amount to a loss in tax revenue of 9 to 12 billion 
euros, according to private estimates. 
¶9. (SBU) Perhaps so as not to disadvantage SPD Chancellor 
candidate Frank-Walter Steinmeier, the Social Democrats have 
also proposed cutting the lowest income tax rate to 12 
percent.  The plan would be paid for through an increase in 
the top tax rate from 42 percent to 45 percent for 
individuals making more than 150,000 euros per year.  The SPD 
also proposes taxing share trades.  This mix of tax 
reductions and hikes would be budget-neutral, according to 
the SPD. 
 
BECOMING CALIFORNIA 
------------------- 
 
BERLIN 00000840  003.2 OF 003 
 
 
 
¶10. (SBU) Economist Christoph Trebesch of Berlin's Hertie 
School of Governance told Econoff that in comparison with 
other European countries and the United States, Germany's 
deficit levels were not particularly dangerous.  Germany had 
room to widen its deficit to counteract the economic 
downturn.  Nevertheless, debt had become, in his estimation, 
a key economic issue in the election campaign.  He lamented 
that Germany's fiscal consolidation ran counter to the fiscal 
expansion in France, where the central government will run a 
deficit of 7 percent of GDP.  As for the CDU/CSU pledge of 
tax cuts, Trebesch dismissed them as "totally unrealistic" -- 
a sentiment shared by contacts at the Finance Ministry. 
 
¶11. (SBU) Trebesch said Germany was a potential fiscal "train 
wreck," largely of its own making, due to the debt brake.  He 
said the amendment was "tougher than Maastricht," and he knew 
of few economists who thought it was a good idea.  Enshrining 
economic policy in the constitution embodied Germany's "moral 
aversion to debt."  Tax revenues are falling at the same time 
that the government is under pressure to fund bailouts, 
assist the unemployed, and extend the "short-shift" scheme to 
keep others in their jobs.  Particularly once the mid-term 
targets kick in, the debt brake will have a "pro-cyclical" 
effect by forcing the government to cut spending and raise 
taxes during a downturn.  He feared his country would soon 
"become California," with the difference being that 
California's budget is constrained on the revenue side, while 
Germany's is on the expenditure side. 
 
COMMENT 
------- 
 
¶12. (SBU) The debate over tax cuts in the election campaign 
appears completely divorced from reality.  Even the SPD's 
allegedly budget-neutral plan is unrealistic -- a tax on 
share trading could at best yield additional revenues of 500 
million euros, a mere drop in the bucket.  Recent polls 
indicate that most Germans do not believe they will get a tax 
cut anyway.  On September 28, the day after the election, 
discussion will need to turn abruptly to increasing revenues 
and decreasing expenditures in order to meet the 
constitutionally mandated provisions of the debt brake. The 
most likely adjustment to tax policy will be a rise in the 
VAT, although Merkel has ruled this out for now.  According 
to Finance Ministry contacts, a one-point VAT increase brings 
in around 8 billion euros in extra revenue.  At 19 percent, 
German VAT rates are considered moderate by EU standards. 
 
¶13. (SBU) Raising the VAT will, like most other deficit 
reduction measures, have a negative impact on Germany's 
already anemic consumption levels.  Though consumption makes 
an abnormally low contribution to Germany's GDP, this can 
only boost Germany's current account surplus (6.1 percent of 
GDP in 2008).  Moreover, raising taxes and cutting spending 
as the German economy struggles to emerge from a serious 
economic downturn could plunge the economy back into 
recession.  With jobless numbers expected to swell by an 
additional one million between now and 2010 and GDP growth to 
remain flat, the timing could not be worse.  Whoever wins the 
September election will find his/her room for maneuver 
severely constrained. 
Pollard