## _cr0616

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### Executive Summary — Overview and Key Challenges
- Germany faces serious economic challenges and needs decisive, forward-looking policies to raise employment, investment, and output growth.
- Three interrelated problems:
  - Low and declining trend growth; recently weak domestic demand despite strong exports.
  - High and long-lasting unemployment, with high reservation wages and gross labor costs.
  - Persistent fiscal pressures; public finances and welfare programs not sustainable under current policies.
- Staff recommended mutually reinforcing reform strategy:
  - Fiscal consolidation to reach structural balance by 2010 (cut subsidies and tax expenditures; recalibrate entitlements; cut payroll taxes; raise retirement age; institutional reforms).
  - Labor market reforms (allow wage setting to reflect local imbalances; switch central bargaining to firm level; cut employment protection legislation).
  - Product and services market reforms (increase competition; reduce regulations and administrative hurdles).
  - Financial sector reforms (address banking sector fragmentation; abolish limits on intraregional competition; open public sector banks to private capital).

### Macroeconomic Outlook & Short-term Forecasts
- Staff forecasts:
  - Growth: 0.8 percent in 2005 and 1.2 percent in 2006.
  - Headline real GDP growth (percent): 2003 0.0, 2004 1.6, 2005 0.8, 2006 1.2.
  - Adjusted for working days (percent): 2003 0.0, 2004 1.0, 2005 0.9, 2006 1.4.
- Risks to near-term outlook:
  - Upside: reforms, elections, exports, productivity gains.
  - Downside: reliance on cyclical exports, firms delaying investment, higher oil prices, euro appreciation risk.
  - Oil price shock simulation: "a permanent 10 percent increase in oil prices, at constant exchange rates, reduces real GDP by 0.2 percentage points a year for three years."
- Projections in broader table (selected series, projections):
  - GDP growth (percentage change): 2005 (Proj.) 0.8; 2006 (Proj.) 1.2; 2007 (Proj.) 1.6; 2008 (Proj.) 1.9.
  - Output gap (percent of potential GDP): 2005 (Proj.) -1.6; 2006 (Proj.) -1.7; 2007 (Proj.) -1.5; 2008 (Proj.) -1.1.
  - Unemployment rate (Eurostat definition, percent): 2005 (Proj.) 9.5; 2006 (Proj.) 9.3; 2007 (Proj.) 9.0; 2008 (Proj.) 8.7.
  - CPI (harmonized, percent): 2005 (Proj.) 1.7; 2006 (Proj.) 1.7; 2007 (Proj.) 1.5; 2008 (Proj.) 1.5.

### Labor Market, Employment, and Household Demand
- Hartz IV (UB-II) implementation:
  - Merged long-term unemployment program and social assistance into UB-II in January 2005.
  - UB-II: lower average benefits, expanded means testing and job search requirements; managed jointly by Federal Labor Office and local governments.
  - Implementation challenges: overlapping agency responsibilities, incomplete enforcement, some rollback for elderly workers.
- Labor force and unemployment impact:
  - Labor force increase from Hartz IV triggered unemployment rise to 12 percent (5 million persons, national definition; 9.5 percent on Eurostat definition) in early 2005.
  - UB-II participation snapshot: 4.76 million persons; Working U-II recipients 2.84 million; Unemployed U-II recipients 1.91 million.
- Labor market constraints and recommendations:
  - High reservation wages and centralized wage determination impede job creation at entry and low-skill levels.
  - Recommended: decentralize wage bargaining to firm level; permit lower wage floors for entry/low-skill jobs; reduce EPL; tighten means testing and enforcement in UB-II; reduce high marginal tax rates for UB-II participants.
- Household demand and income:
  - Real disposable household income grew by 0.6 percent a year during 1996–2004, underperforming the euro area by 1 percentage point a year.
  - Household saving rose by 1.4 percentage point to 10.6 percent between 2000 and 2004.
  - Net wealth (mainly housing stock) increased little during 1996–2003.

### Investment, Corporate Sector Behavior, and Financial Conditions
- Profitability and investment:
  - Profit growth concentrated in large export firms; a growing share of investment is taking place abroad.
  - Capacity utilization below average; domestic cost cutting drove profitability; SMEs cautious.
  - SMEs undertake about half of domestic investment; SMEs have weaker finances and depend heavily on banking system.
  - Business sector debt-GDP ratio improved but remains elevated; corporate cash flow mostly used for debt reduction rather than investment.
  - Construction investment "continues to dwindle."
- Credit and banking:
  - Private sector credit declining in real terms; falling loan demand as firms and households reduce debt.
  - Banks with weaker capitalization curtailed credit in 2003–04; constraints beginning to ease.
  - Preparation for Basel II changed bank behavior; lending spreads narrowed; lending surveys document "tightening of credit standards" and "falling loan demand" in 2003–2005.
- Short-term outlook for investment:
  - Investment in machinery and equipment "slowly turning up"; rising employment and balance sheet repair expected to support recovery.

### Fiscal Outlook, Structural Deficits, and Sustainability
- Recent fiscal outcomes and decomposition (percent of GDP):
  - Overall balance: 2004 -3.7; 2005 -3.9; 2006 -3.7; 2007 -3.7.
  - Structural balance (memoranda): 2004 -3.3; 2005 -3.4; 2006 -3.0; 2007 -2.8.
  - Structural shifts and policy measures detailed across 2004–2007 (see source for full table).
- Fiscal pressures and drivers:
  - Main tax base is labor income, yielding about "two-thirds of all revenue"; labor income share in GDP declining.
  - Recent fiscal deficits of "3½–4 percent of GDP" are the largest in six decades.
  - Payroll tax rates increased "from 26 percent in 1970 to 42 percent at present."
  - Hartz IV proved more expensive than expected (additional outlays about ⅓ percent of GDP); means-testing deficiencies raised costs.
  - Sustainability formula for pensions suspended for 2005; pensionable age shift to 67 not implemented then.
- Public sector balance-sheet perspective:
  - Preliminary public sector balance sheet yields net liability position "at over 300 percent of GDP."
  - Long-run impact of Agenda 2010 measures "estimated to have reduced the NPV of future deficits by 70 percent of GDP" — large but insufficient.
- Medium- and long-term outlook:
  - Under current policies, potential output growth would fall from "1.4 percent a year at present to about 1 percent in the long run."
  - Per capita growth projected at "1-1½ percent a year."
  - Working age population "declined by 1 percent between 1999 and 2004"; increased by over 2 percent in the euro area excluding Germany.

### Debt Sustainability Analysis and Scenarios (2004–2050)
- Baseline general government gross debt (percent of GDP): 2004 64.5; 2005 67.7; 2006 70.1; 2007 72.0; 2008 73.2; 2009 73.9; 2010 74.7; 2020 99.6; 2030 159.2; 2040 252.6; 2050 363.6.
- Change in public sector debt (percentage points of GDP, selected): 2004 1.8; 2005 3.1; 2006 2.4; 2007 1.9; 2008 1.2; 2020 24.9; 2030 59.6; 2040 93.4; 2050 111.0.
- Identified debt-creating flows (selected primary deficit and automatic dynamics contributions): primary deficit (2004–2050 baseline): 2004 0.8; 2005 1.0; 2006 0.9; 2010 0.3; 2020 2.2; 2030 5.4; 2040 6.6; 2050 6.7.
- Alternative scenarios (general government gross debt, percent of GDP):
  - Historical averages scenario: 2020 93.1; 2030 116.5; 2040 147.8; 2050 189.7.
  - Constant primary deficit 0.9 percent of GDP: 2020 97.9; 2030 126.8; 2040 157.2; 2050 193.0.
  - Higher growth via enhanced labor utilization: 2020 70.3; 2030 99.3; 2040 157.2; 2050 224.9.
- Staff conclusion: baseline and alternatives show steadily rising debt ratios; further fiscal measures and structural reforms (higher labor utilization, pension/health entitlement adjustments) necessary for intertemporal fiscal consistency.

### Fiscal Strategy, Recommendations, and Coalition Agreement Assessment
- Mission recommended fiscal objective: bring structural fiscal position to balance by 2010.
  - Required pace: annual structural fiscal measures of at least ½ percent of GDP.
  - Emphasize durable expenditure cuts over tax rate increases; avoid one-off measures.
  - Focus on cutting subsidies and tax expenditures; recalibrating entitlements; shifting some revenue to indirect taxes; raising statutory retirement age; improving fiscal institutions and transparency.
- Coalition agreement (post-September 2005) — key elements:
  - VAT increase from 16 to 19 percent in January 2007 as main adjustment measure; package € 138 billion over 2006–2009 (expenditure cuts € 34 billion; abolition of tax expenditures € 33 billion; tax increases € 71 billion).
  - One percentage point of VAT increase earmarked to fund unemployment insurance contribution cut.
  - Extend probationary employment period from 6 to 24 months; increase statutory retirement age from 65 to 67 one month a year starting in 2012; freeze pension benefits; increase pension contribution rate from 19.5 to 19.9 percent effective January 2007.
  - Support package over four years about 1.1 percent of 2005 GDP for R&D, transport, accelerated depreciation, family assistance, building renovation and household services.
- Mission assessment of coalition measures:
  - Positive: commitments on deficit reduction in 2007, reducing nonwage labor costs, retirement-age increase, federalism reform.
  - Concerns: consolidation too backloaded, composition biased toward tax increases rather than durable spending cuts, time inconsistency risk with delayed VAT increase, new spending initiatives could create permanent costs and distortions.
  - Recommendation: bring forward an additional ¼ percent of GDP adjustment to 2006 to achieve annual structural adjustment of at least ½ percent of GDP; options include curtailing new expenditures or advancing VAT increase.

### Product, Services, and Trade Policy Reforms
- Need further deregulation to facilitate structural shift from manufacturing to services and boost employment.
- Germany ranks close to EU-15 average on overall regulations but faces higher barriers in administrative product market regulations, liberal services, and full-time employment.
- Network industries reforms: expanded Federal Network Agency mandate; postal monopoly for letters up to 50 grams to expire in 2006.
- EU Services Directive: mission encourages preserving country-of-origin principle with limited exemptions; authorities cautious about "race to the bottom."
- Regional migration and integration: Germany invoked limits on free migration from new accession countries for a transition period; authorities support multilateral trade liberalization and Doha objectives.

### Financial Sector — Structure, Performance, and Policy Priorities
- Improvements:
  - Banking profitability recovering; cost-income ratios improving; provisioning tapered; insurance earnings higher.
  - Examples: conversion of some Landesbanken to joint-stock companies; cross-border bank acquisition noted.
- Remaining weaknesses and indicators (selected):
  - Nonperforming loans over 5 percent of total loans; unprovisioned impaired loans nearly 47 percent of capital in 2004.
  - Comparative banking indicators (Germany, selected):
    - Regulatory capital to risk-weighted assets — Germany: 11.5, 11.7, 12.0, 12.7, 13.4, 13.2 (1999–2004 series).
    - Nonperforming loans to total gross loans — Germany 1/: 4.2, 4.7, 4.6, 5.0, 5.3, 5.1.
    - Nonperforming loans net of provisions to capital — Germany 1/: 39.2, 44.7, 46.1, 47.5, 52.1, 46.8.
    - After-tax return on average assets — Germany: 0.2, 0.2, 0.2, 0.1, -0.1, 0.1.
    - After-tax return on average equity — Germany: 6.5, 6.1, 4.6, 2.9, -1.5, 1.9.
  - Note: German definition of nonperforming loans differs from IMF Compilation Guide affecting comparability.
- Structural issues and policy recommendations:
  - Three-pillar banking system segmentation impedes revenue growth; regional principle limits competition and risk-pooling.
  - Mission urged market-driven restructuring, opening public sector banks to private capital, transforming public banks into joint-stock corporations, abolishing regional barriers.
  - Recommend publishing timely financial soundness data (including impaired loans) and adopting minimum quantitative criteria for classifying impaired loans.
  - Insurance mandatory 90:10 profit split should be eliminated to provide flexibility (to be considered with Solvency II).
  - Pfandbrief law liberalization (July 2005) expected to foster mortgage bond market; asset-backed securities market growing.

### Statistics, AML/CFT, and Fund Relations
- Statistics adequate for surveillance; recommendations: collect inventory data, compile quarterly general government accounts.
- Participation in IMF Coordinated Compilation Exercise for FSIs; full set of core FSIs to be published by December 2006.
- AML/CFT: legislation strengthened; third EU AML Directive expected to become part of German law by mid-2007; BaFin building AML/CFT audit unit.
- Fund membership and resources (as of July 31, 2005):
  - Germany became a member on August 14, 1952.
  - Quota 13,008.20 (SDR Million) 100.00.
  - Fund holdings of currency 10,164.66 (SDR Million) 78.14.
  - Reserve position in Fund 2,843.60 (SDR Million) 21.86.

### Selected Key Numerical Indicators (concise)
- Total area: 357,041 square kilometers.
- Total population (2004): 82.54 million.
- GDP per capita (2004): US$ 33,279.
- Current account (in billions of euros): 2004 84; 2005 97; 2006 101; 2007 102; 2008 111.
- General government debt (end-year, in billions of euros): 2004 1,430; 2005 1,517; 2006 1,602; 2007 1,689; 2008 1,774.
- General government debt (percent of GDP): 2004 64.5; 2005 67.7; 2006 70.1; 2007 72.0; 2008 73.2.
- Overall balance (percent of GDP): 2004 -3.7; 2005 -3.9; 2006 -3.7; 2007 -3.7; 2008 -3.5.
- Household debt to GDP (Dec-04): 71.0.
- Return on average equity (after-tax, Dec-04): 1.9 (percent).
- Nonperforming loans to gross loans (Dec-04): 5.1 (percent).

*IMF staff report excerpt (content unit: _cr0616).*

### Executive Summary ......................................................................................................

### Executive Summary

### Overview and Key Challenges
- Germany faces serious economic challenges and needs decisive, forward-looking policies to raise employment, investment, and output growth.
- The economy is described as wealthy but highly regulated and financing a generous welfare state; rigidities impose long adjustment periods after shocks (unification, rapid regional and global integration, aging).
- Problems manifest in three interrelated features:
  - Low and declining trend growth, and most recently weak domestic demand despite strong exports.
  - High and long-lasting unemployment, with high reservation wages and gross labor costs.
  - Persistent fiscal pressures, and public finances and welfare programs that are not sustainable under current policies.

### Staff Recommended Reform Strategy (mutually reinforcing elements)
- Fiscal consolidation to reach structural balance by 2010 and help secure long run fiscal sustainability. Emphasis on:
  - Cutting subsidies and tax expenditures.
  - Recalibrating entitlement benefits.
  - Cutting payroll taxes.
  - Raising the retirement age.
  - Institutional reforms to improve incentives for better fiscal management.
- Labor market reforms to reduce high unemployment and raise labor utilization:
  - Allow wage setting to reflect local labor market imbalances and productivity differentials.
  - Switch central wage bargaining to the firm level.
  - Cut employment protection legislation to boost employment of the most vulnerable workers.
- Product and services market reforms to boost effectiveness of labor market reforms:
  - Increase competition in product and services markets so wage moderation passes through to lower prices and faster output and employment growth.
  - Reduce regulations and administrative hurdles, particularly to improve the business climate in the service sector.
- Financial sector reforms to make the sector more dynamic and better positioned to support growth:
  - Address banking sector fragmentation that limits economies of scale and risk diversification.
  - Abolish limits on intraregional competition and open up public sector banks to private capital to facilitate market-driven restructuring, foster returns to scale, and bolster profitability.

### Background and Recent Developments
- Policy context: Discussions occurred against low trend growth, persistent fiscal pressures, and Chancellor Schröder’s call for early elections. The main policy initiative since the 2004 Article IV consultation was implementing the Hartz IV labor market reforms in January 2005 (part of Agenda 2010).
- Hartz IV reform details:
  - Merged the long-term unemployment program and social assistance into a single new Unemployment Benefits II (UB-II) program.
  - UB-II features lower average benefits, expanded means testing and job search requirements.
  - UB-II is managed jointly by the Federal Labor Office and local governments.
- Implementation challenges: Hartz IV implementation proved more challenging than expected; overlapping agency responsibilities, incomplete enforcement of eligibility, and some rollback for elderly workers were noted.

### Labor Market and Inflation Indicators
- The increase in the labor force resulting from the Hartz IV reforms triggered a rise in unemployment to 12 percent (5 million persons, national definition; 9.5 percent on Eurostat definition) in early 2005.
- High unemployment has damaged consumer sentiment and muted government enthusiasm for additional reforms.
- Core CPI inflation remained low at 1 percent, while rising commodity prices lifted headline inflation to about 2 percent so far this year.

### External Sector and Competitiveness
- Exports are strong, driven by improved competitiveness and a favorable product mix:
  - Business restructuring, cost cutting, sustained wage moderation, low inflation and unit-labor cost growth helped rebuild competitiveness.
  - Germany’s export mix is dominated by capital goods and has benefited from the global upswing in investment.
  - Exports are oriented to fast growing and oil producing countries and have gained market share both outside and inside the euro area.
- External current account surplus is projected to be over 4 percent of GDP in 2005.
- Specific competitiveness and export indicators:
  - Germany became the world’s largest exporter in dollar value in 2004, surpassing the U.S.
  - Germany’s ULC fell by 8 percent relative to the EU-15 since the start of EMU.
  - Export volume growth was 9 percent in 2004.
  - Econometric estimates suggest Germany’s exports are more elastic to changes in global demand than to price and REER developments.

### Household Demand, Income, and Savings
- Household consumption remains weak:
  - Wage moderation contributed to slow disposable household income growth.
  - Wealth formation was weak in part due to stagnant real asset prices.
- Real disposable household income grew by 0.6 percent a year during 1996–2004, underperforming the euro area by 1 percentage point a year.
- Household saving rose by 1.4 percentage point to 10.6 percent between 2000 and 2004 as households lowered debt and scaled down earnings expectations.
- Net wealth (mainly housing stock) increased little during 1996–2003, reflecting flat housing prices; by contrast, other countries experienced strong housing price-driven wealth gains.

### Past Fund Policy Recommendations and Implementation (summary)
- Directors welcomed Agenda 2010 reforms but noted the need for augmentation to cope with unification costs, globalization, and aging.
- Fiscal consolidation:
  - Directors endorsed the objective to reduce the structural deficit by 1.5 percent of GDP during 2004–06, but the structural deficit is projected to decline only by 0.4 percent of GDP over this period.
  - Efforts to cut tax expenditures and subsidies met with little success; federal reform discussions broke off without agreement.
- Labor market reforms:
  - Directors supported sustained wage moderation and Hartz (I-III) reforms.
  - Wage determination has become more decentralized de-facto, but constraints on firm-level bargaining persist.
  - Employment protection legislation, though streamlined, remains tight.
  - Implementation of Hartz IV encountered operational and political complications.
- Pension reforms:
  - A “sustainability formula” to slow future pension increases was introduced but suspended for 2005 due to a safeguard clause.
  - The recommendation to shift the pensionable age from 65 to 67 has not been followed up.
- Financial sector:
  - Supervision is improving in line with the 2003 FSAP recommendations.
  - Directors called for reducing impediments to market-driven restructuring of the banking system.
  - Some Landesbanken converted into joint-stock companies, but overall restructuring is proceeding slowly and the system remains segmented.
  - Progress is underway in bolstering capital markets, exemplified by fast growth in asset-backed securities.

*Source: Executive Summary, _cr0616 - Executive Summary*

### 6.      Despite improvements in profitability, companies are still cautious about

### _cr0616 - 6.      Despite improvements in profitability, companies are still cautious about investing in Germany

### Profitability, investment behavior, and sectoral differences
- Profit growth is concentrated in large export companies integrating operations into global production chains; imports of intermediate inputs for exports have risen and "a growing share of investment is taking place abroad where cost bases are lower" and demand is expanding faster — "thereby dampening the stimulus from exports to domestic demand."
- Capacity utilization is below average; "domestic cost cutting—rather than demand growth—has been the main factor driving profitability." Manufacturers continue to reduce domestic employment.
- Small and medium-sized enterprises (SMEs):
  - "SMEs have weaker finances and are more oriented toward domestic activity."
  - "SMEs undertake about half of domestic investment."
  - With low equity, SMEs "depend heavily on the banking system for their financing," and SME financial ratios underperform those of large enterprises in Germany and fall short in international comparisons. Adjustment in SMEs "appears incomplete."
- Balance sheet repair is unfinished: the business sector debt-GDP ratio "has improved but remains elevated by historical and international standards." Corporate cash flow is "still mostly used for debt reduction rather than investment."
- Construction investment "continues to dwindle" due to concerns about household income and job losses and excess capacity in the business sector.

### Financial sector, credit conditions, and lending
- Private sector credit is declining in real terms despite accommodating monetary conditions; survey data suggest continued decline in credit demand because of weak activity and efforts by firms and households to reduce debt.
- Banks with weaker capitalization "curtailed the supply of credit in 2003–04, although these constraints are now beginning to ease."
- Preparation for Basle II has changed bank behavior, particularly greater focus on risk differentiation.
- Falling demand for credit, combined with renewed targeting by private sector banks of SMEs, has heightened competition and triggered a narrowing of lending spreads.
- Bank lending survey findings: "tightening of credit standards" and "falling loan demand" for firms documented in 2003–2005 period.

### Short-term economic outlook and forecasts
- Staff forecasts:
  - Growth of 0.8 percent in 2005 and 1.2 percent in 2006.
  - Authorities project slightly higher growth in both years.
- Germany: Real GDP Growth, 2003–2006 (table)
  - Headline real GDP growth, in percent: 2003 0.0, 2004 1.6, 2005 0.8, 2006 1.2
  - Adjusted for working days, in percent: 2003 0.0, 2004 1.0, 2005 0.9, 2006 1.4
- Investment in machinery and equipment is "slowly turning up" and rising employment and progress in balance sheet repair are expected eventually to assist a broader recovery.
- Domestic demand is projected to become stronger moving into 2006 with continued support from the global expansion and low euro area interest rates.

### Risks to the near-term outlook
- Risks are broadly neutral but considerable uncertainty remains given weak domestic demand.
- Upside possibilities:
  - Adjustment efforts may improve conditions for recovery.
  - Elections could provide impetus for reform.
  - Exports could spark a stronger response in domestic demand.
  - Productivity gains from recent reforms may exceed expectations.
- Downside risks:
  - Reliance on cyclical exports and slow domestic demand response increases vulnerability to external developments.
  - Firms may persist in a wait-and-see stance on new investment.
  - Higher oil prices could affect consumer and external demand.
  - Concerns about euro appreciation and volatility; authorities noted "greater flexibility in Asia’s managed exchange rate regimes might alleviate some of the risks for the euro."
- Oil price shock simulation: "a permanent 10 percent increase in oil prices, at constant exchange rates, reduces real GDP by 0.2 percentage points a year for three years."

### Long-term growth and demographics
- Potential output growth:
  - Under current policies, potential output growth would fall from "1.4 percent a year at present to about 1 percent in the long run."
  - Per capita growth projected at "1-1½ percent a year."
- Decline driven largely by aging-related decline in labor supply and hours worked; Germany’s working age population "has already begun to decline."
- Demographic observations:
  - The working age population in Germany "declined by 1 percent between 1999 and 2004," while it "increased by over 2 percent in the euro area excluding Germany."
- Policy implication: "It will be important for the next government to build on the Agenda 2010 reforms by improving incentives and fostering higher labor utilization and potential output growth."

### Fiscal policy, structural deficits, and sustainability
- Fiscal stance and recent policy:
  - Automatic stabilizers have been allowed free play and the fiscal stance has been "broadly neutral in recent years."
  - Discretionary expenditure was contained to offset income tax cuts "amounting to 1 percent of GDP" phased in during 2004–05.
- Structural pressures:
  - Germany’s main tax base is labor income, yielding about "two-thirds of all revenue"; the labor income share in GDP has been declining.
  - Social transfers and unemployment insurance costs have increased sharply, stressing the structural deficit.
  - Recent fiscal deficits of "3½–4 percent of GDP" are the largest in six decades.
  - Payroll tax rates increased "from 26 percent in 1970 to 42 percent at present."
- Medium- and long-term outlook:
  - Under current policies, the structural deficit will widen further because of population aging starting in 2010 and slowing economic growth; widening deficits would lead to long-run debt sustainability problems.
  - Even optimistic scenarios with higher growth and lower unemployment would still leave a sharply widening fiscal gap.
- Fiscal balance-sheet perspective:
  - An illustrative public sector balance sheet combining government assets/liabilities with the net present value (NPV) of future fiscal deficits yields a net liability position "at over 300 percent of GDP," underscoring an unsustainable intertemporal fiscal position.
  - The long run impact of the measures of Agenda 2010 "are estimated to have reduced the NPV of future deficits by 70 percent of GDP" — large but "insufficient to address the threat to fiscal sustainability."
- Policy recommendations (implied in text):
  - Take corrective action urgently to bring public finances in line with long run sustainability.
  - Build on Agenda 2010 with deeper reforms to boost participation rates and sharply reduce unemployment to attenuate the decline in potential output growth.
  - Consider shifting some revenue collection toward indirect taxes combined with further entitlement reforms to alleviate pressure on payroll charges and lower employment costs.
  - Bring public sector balance-sheet information to the public with regular updates to show long run benefits of difficult reforms.

*Italicized source attribution: IMF staff report excerpt (content unit: _cr0616 - 6.      Despite improvements in profitability, companies are still cautious about investing in Germany).*

### 16.      The authorities agreed that future deficit pressures are a serious concern and

### _cr0616 - 16.      The authorities agreed that future deficit pressures are a serious concern and

### Fiscal outlook and short-term projections
- Authorities ruled out expansionary fiscal policies to boost growth but indicated the deficit would remain high in 2005 and 2006.
- Staff projection: general government deficit of 3.9 percent of GDP in 2005 (compared with 3.7 percent projected by the authorities), and little improvement in 2006.
- Authorities’ original 2005 fiscal deficit objective: 3 percent of GDP (wide deviation from this objective in 2005).
- Authorities’ scenarios are more optimistic because of higher growth and lower unemployment and because they assume the government will achieve its financial plan through 2008 (Mittelfristiger Finanzplan), but this plan is off-track.
- Both authorities’ and staff projections assume higher future entitlement expenditures are not automatically financed with higher payroll taxes.

### Long-run fiscal projections and public sector balance sheet
- IMF staff calculations show unsustainable long-run debt accumulation under baseline and optimistic scenarios (see Figure 8 in source).
- A preliminary public sector balance sheet suggests a negative net worth of the public sector of 324 percent of GDP.
- Public sector net worth and intertemporal position (selected figures from preliminary balance sheet):
  - Intertemporal financial position (2003): -9,216 (Billions of euros)
  - Intertemporal financial position (2004 Est.): -8,240 (Billions of euros)
  - Net debt already issued (2003): -1,135 (Billions of euros)
  - Net debt already issued (2004 Est.): -1,224 (Billions of euros)
  - NPV of future net debt (2003): -8,081 (Billions of euros)
  - NPV of future net debt (2004 Est.): -7,016 (Billions of euros)
  - Other, net (2003): 104 (Billions of euros); (2004 Est.): 106 (Billions of euros)
  - Public sector net capital stock (2003): 1,096 (Billions of euros); (2004 Est.): 1,098 (Billions of euros)
  - Net worth (2003): -8,016 (Billions of euros); (2004 Est.): -7,036 (Billions of euros)
  - General Government Balance Sheet (percent of GDP, 2003/2004 Est.):
    - Intertemporal financial position: -433; -379
    - Other, net: 55
    - Public sector net capital stock: 5150
    - Net worth: -377; -324
- Note: Staff projections of fiscal balances for a rolling 50-year period (baseline scenario) discounted at the average interest rate on government debt. Figures for 2004 include the impact of reforms of Agenda 2010.

### Drivers of fiscal deterioration (selected findings)
- Hartz IV labor market reforms turned out more expensive than expected: additional outlays of about ⅓ percent of GDP.
- Means-testing deficiencies made income support more costly than expected.
- Weakness in employment subject to social security contributions put pressure on the pension system.
- The sustainability formula for pensions was suspended for 2005 (its first year of operation); applying it would have reduced nominal pensions and triggered a safeguard clause.
- The 2004 health care reform improved finances only temporarily; current trends suggest a shift back into deficit in health care programs in coming years.

### Fiscal outcomes and decomposition (percent of GDP)
- Overall balance: 2004 -3.7; 2005 -3.9; 2006 -3.7; 2007 -3.7
- Change in overall balance: 2004 0.3; 2005 -0.2; 2006 0.1; 2007 0.0
- Structural effects: 2004 0.2; 2005 -0.1; 2006 0.4; 2007 0.2
  - (1) Structural shifts 1/: 2004 -0.3; 2005 0.2; 2006 0.2; 2007 0.1
  - (2) Policy measures: 2004 0.5; 2005 0.1; 2006 0.2; 2007 0.1
    - Tax reform: 2004 -0.4; 2005 -0.1; 2006 0.0; 2007 0.0
    - Health care reform: 2004 0.4; 2005 0.0; 2006 0.0; 2007 0.0
    - Pension reform: 2004 0.2; 2005 0.3; 2006 0.0; 2007 0.1
    - Hartz reforms: 2004 0.0; 2005 -0.3; 2006 0.1; 2007 0.0
    - Subsidy cuts: 2004 0.1; 2005 0.1; 2006 0.1; 2007 0.0
    - Discretionary cuts: 2004 0.2; 2005 0.0; 2006 0.1; 2007 -0.1
- Temporary effects: 2004 0.1; 2005 -0.1; 2006 -0.3; 2007 -0.2
  - (3) Cyclical: 2004 -0.3; 2005 -0.2; 2006 0.0; 2007 0.1
  - (4) One-off: 2004 0.4; 2005 0.1; 2006 -0.3; 2007 -0.3
    - Bundesbank profits: 2004 -0.2; 2005 0.0; 2006 0.0; 2007 0.0
    - Landesbanken guarantees: 2004 0.0; 2005 0.1; 2006 0.1; 2007 -0.2
    - Postal pensions, floods, other: 2004 0.6; 2005 0.1; 2006 -0.4; 2007 -0.1
- Memoranda:
  - Structural balance 2/: 2004 -3.3; 2005 -3.4; 2006 -3.0; 2007 -2.8
  - GDP growth: 2004 1.6; 2005 0.8; 2006 1.2; 2007 1.6
  - 1/ Takes into account trend changes in tax bases relative to GDP.
  - 2/ The change in the structural balance equals the change in the overall balance minus the cyclical and one-off effects.

### One-off financing measures used and scale
- Advance collection of pension contributions by half a month in 2006, resulting in 13 installments next year.
- Securitization of future debt service payments on Russian Paris Club debt provided cash-flow relief in 2004 and 2005.
- Securitization of pension receipts in the postal system will reduce financing needs in 2005 and 2006.
- Landes benefits from reimbursement by Landesbanken of interest subsidies; most Länder will return similar funds to public banks but outlays are registered as equity injection below-the-line, resulting in one-off receipts of ¼ percent of GDP over two years.

### Mission’s recommendations on fiscal strategy
- Avoid one-off policies; adopt a comprehensive forward-looking fiscal strategy to deal with structural changes.
- Recommended goal: bring the structural fiscal position to balance by 2010 when aging accelerates.
- Required pace: annual structural fiscal measures of at least ½ percent of GDP (a reasonable pace with the rate of growth at or above potential).
- Further fiscal measures would be needed beyond 2010 as expenditure pressures grow with aging.
- Adjustment should focus on high-quality durable expenditure cuts rather than increases in tax rates.
- Take advantage of synergies between fiscal reform, recalibrating entitlements, and reforming the labor market.

### Durable adjustment priorities and tax/expenditure reform options
- Priority on spending cuts and expanding the tax base.
- Room for cuts in three main welfare/entitlement blocs:
  - Household and worker benefits: housing and commuter subsidies, tax exemptions for work on Sundays and holidays.
  - Corporate welfare: special depreciation rules, loss carryovers, energy and sectoral subsidies (e.g., in agriculture).
  - General entitlement benefits: cuts in long term care insurance, steps to limit growth in health care spending, lowering cost of unemployment benefits, shift pensionable age from 65 to 67 (as proposed by the Rürup Commission).
- Estimated subsidies and tax expenditures for households, workers, and corporations: as much as 6 percent of GDP (Koch-Steinbrück Commission estimate).
- Consider increasing discounts for early retirement and premia for delayed retirement to improve actuarial balances and labor utilization.
- Authorities noted effective retirement age is going up gradually through policy changes; raising statutory retirement age would need to be considered by the next government.

### Tax policy specifics and corporate tax debate
- Earlier government proposal: six percentage points cut in the federal corporate income tax (CIT) rate, bringing the overall rate to 32 percent, financed by reducing corporate deductions and exemptions — proposal not implemented due to political disagreement on offsetting measures.
- IMF mission: reform worthwhile but any cut in tax rates should be fully compensated as fiscal consolidation remains the top priority; emphasize broadening the tax base and comprehensive tax reform.
- Council of Economic Experts asked to prepare a CIT reform proposal by the end of 2005.

### Fiscal institutions and federalism reform recommendations
- Views differed on an independent fiscal council; mission suggested an annual review by such a council reporting to parliament to enhance transparency and vet long-term policy.
- Authorities noted existing outside reviews (Council of Economic Experts, twice-yearly consultations with economic research institutes) and preferred updating the Long-Run Fiscal Sustainability Report periodically.
- Mission’s view on an effective fiscal council: should have a formal mandate, democratic legitimacy, accountability, and clear channels for policy dialogue and communication.
- Modernizing fiscal federalism is essential to strengthen fiscal management and overcome reform gridlock; suggested priorities:
  - Reduce the number of laws needing approval by both chambers of parliament.
  - Create leeway for competition between subnational governments to improve efficiency and encourage consolidation.
  - Strengthen the Internal Stability Pact with clear commitments by various levels of government, including individual Länder.
  - Cut redundancies and better align tasks among government levels to improve fiscal management.

### Labor market issues and link to fiscal outcomes
- Higher employment growth is key to stronger potential output growth.
- Persistent labor market disequilibria with significant underutilization of labor in persons and hours because of high costs and rigidities; barriers and high reservation wages especially affect elderly workers, women, and low-productivity workers.
- Agenda 2010 reforms have tightened unemployment and welfare benefits and improved work incentives; large enterprises have begun expanding average hours worked per week.
- Hartz IV reforms boosted labor supply: labor supply rose by nearly half million persons (1 percent of the labor force); the unemployment rate jumped by a full percentage point in the national definition in the first few months of 2005.
- Employment growth so far concentrated in temporary work and self-employment; full-time employment remains weak.
- Germany’s tax wedge on labor income remains among the highest in advanced countries; payroll taxes remain very high (figures and charts in source).

*Source: IMF staff report (excerpt provided in content unit).*

### 27.      Further reforms are needed to revitalize labor demand. The mission called for

### _cr0616 - 27.      Further reforms are needed to revitalize labor demand. The mission called for

### Labor market reforms and welfare-to-work
- Formal wage determination is centralized and responds insufficiently to local labor market imbalances and productivity differentials.
- High reservation wages supported by the generous welfare system for entry level and low skill jobs prevent adequate job creation, given that most of the long term unemployed have low productivity.
- Recommended policy adjustments:
  - Reduce central controls on wage bargaining in favor of more firm level bargaining.
  - Loosen employment protection legislation (EPL) to boost employment by lowering job turnover costs and reducing labor court involvement.
- Authorities' view and reactions:
  - Authorities asserted wage bargaining has become more flexible because of widespread “opening clauses,” resulting in large intersectoral pay differentiation.
  - Authorities noted EPL had been relaxed in 2004, but considered it too early to draw firm conclusions about its impact.
- UB-II (Hartz IV) welfare-to-work potential and design issues:
  - UB-II system has the potential to become an effective welfare-to-work program.
  - Authorities explained that of the 4.8 million participants in UB-II, 40 percent were employed and received “top up benefits” to raise their income to a social minimum.
  - Program features resemble a negative income tax and need fine-tuning to improve incentives to work.
  - High marginal income taxes for those that qualify for UB-II are a disincentive to look for work and need to be reduced.
  - Means testing and job search requirements should be applied more firmly.
  - Mission recommended against prolonging unemployment benefit duration for older workers; nevertheless, benefit duration for elderly workers was subsequently extended to limit social hardship.
- UB-II participation snapshot (as presented):
  - 4.76 million persons
  - Working U-II recipients: 2.84 million
  - Unemployed U-II recipients: 1.91 million

### Product and service markets, and trade policy
- Need for deregulation:
  - Further deregulation in product and services markets will be essential to facilitate the structural shift from manufacturing to a more service based economy.
  - Numerous studies indicate supportive interactions between product and services market reforms and employment growth.
- Regulatory stance and barriers:
  - Germany’s overall regulations rank close to the EU-15 average, but administrative product market regulations, liberal services, and full time employment face relatively high barriers.
- Network industries and liberalization progress:
  - Reported progress in reforming markets for network industries; past energy sector issues with network access and high electricity prices are being addressed.
  - An agency with an expanded mandate to supervise electricity grids, gas and railway networks scheduled to become operational in August 2005, charged to devise incentive-compatible pricing mechanisms.
  - Postal monopoly on letters of up to 50 grams to expire in 2006.
- Services sector entry and EU Services Directive:
  - Further efforts to lower barriers to entry in services would improve small business climate and boost job creation, especially in professional services where the restrictiveness index is substantially higher than the EU-15 average.
  - Authorities reported progress: lowering entry barriers and removing master certificate requirements for 53 out of 94 specific activities.
  - Negotiations on the EU Services Directive were continuing; preliminary estimates suggest Germany’s highly skilled engineering, construction, and R&D sectors could benefit substantially by increased access to other EU markets.
  - Authorities concerned country-of-origin principle could lead to a “race to the bottom”; reluctant to endorse without safeguards and exemptions for key sectors such as health care.
  - Mission encouraged preserving the country-of-origin principle while limiting exemptions only to the most sensitive areas and for a transition period.
- Regional integration and labor migration:
  - Public perceives increased competition from trade liberalization and migration as a threat to domestic investment and employment.
  - Mission emphasized integration provides opportunities to exploit comparative advantage with gains for consumers and exporters.
  - Germany has invoked limits on free migration of labor from the new accession countries for a transition period.
- Multilateral trade stance:
  - Authorities support multilateral trade liberalization; in the Doha round Germany backed reduction in tariffs, liberalization of trade in services, and a cut in agricultural subsidies.

### Financial sector developments and policies
- General improvements and structural progress:
  - Financial sector performance improving; recovery of banking profitability continued into 2005 after trough in 2003.
  - Cost-income ratios improving, cost cutting progressing, buoyant financial markets boosting income.
  - Bank capitalization improving partly by disposing of impaired assets; provisioning has tapered off.
  - Purchase of Germany’s third largest private bank by an Italian bank seen as breakthrough in restructuring and openness to cross-border mergers.
  - Insurance sector recording higher earnings and stronger capitalization.
  - Authorities’ stress tests using the FSAP methodology were encouraging; probability of systemic risks judged to be small despite moderate growth.
- Landesbanken and public bank adjustments:
  - Landesbanken prepared for phase out of state guarantees by stepping up issuance of long term bonds qualifying for grandfathering provisions that lock in guarantees until 2015.
  - Back office and product development cooperation between Landesbanken and Sparkassen intensifying.
  - Number of Sparkassen and Volksbanken gradually declining; most Landesbanken secured ratings in the single-A range; Sparkassen tended to be rated somewhat higher.
- Remaining banking sector weaknesses and indicators:
  - Sector performance continues to fall short of international peers; one of the least profitable in the EU.
  - Impaired loans are over 5 percent of total loans.
  - Unprovisioned (but typically collateralized) impaired loans remain high at nearly 47 percent of capital in 2004.
- Germany: Comparative Banking Sector Indicators, 1999–2004 (as presented)
  - Regulatory capital to risk-weighted assets — Germany: 11.5, 11.7, 12.0, 12.7, 13.4, 13.2
  - EU-15 average: 12.0, 11.6, 11.8, 12.1, 12.8, 12.8
  - United States...: 12.4, 12.9, 13.0, 13.0, 13.2
  - Capital to assets — Germany: 3.1, 3.2, 3.2, 3.5, 3.9, 3.7
  - EU-15 average: 6.0, 6.1, 6.2, 6.1, 6.0, 6.0
  - United States...: 8.5, 9.0, 9.2, 9.2, 10.3
  - Nonperforming loans to total gross loans — Germany 1/: 4.2, 4.7, 4.6, 5.0, 5.3, 5.1
  - EU-15 average: 3.5, 3.0, 2.8, 2.8, 2.9, 2.3
  - United States...: 1.1, 1.3, 1.4, 1.1, 0.8
  - Nonperforming loans net of provisions to capital — Germany 1/: 39.2, 44.7, 46.1, 47.5, 52.1, 46.8
  - EU-15 average: 19.2, 18.2, 15.5, 15.0, ...... 
  - After-tax return on average assets — Germany: 0.2, 0.2, 0.2, 0.1, -0.1, 0.1
  - EU-15 average: 0.9, 0.8, 0.7, 0.6, 0.7, 0.9
  - United States...: 1.1, 1.1, 1.1, 1.3, 1.4, 1.3
  - After-tax return on average equity — Germany: 6.5, 6.1, 4.6, 2.9, -1.5, 1.9
  - EU-15 average: 17.2, 16.6, 14.0, 12.1, 14.5, 17.5
  - United States...: 13.5, 13.0, 14.0, 15.0, 13.3
  - Note: 1/ Based on the German definition of nonperforming loans ("loans with a loss provision requirement"), which differs from the definition proposed in the IMF's Compilation Guide on Financial Soundness Indicators, affecting international comparability.
- Structural segmentation and competition constraints:
  - Three pillar banking system segmentation impedes revenue growth; regional principle confines Sparkassen and Volksbanken to their communities of origin, limiting competition and concentrating risks.
  - Landesbanken need viable business models without state guarantees; public fund injections have shored up capital in some instances and further consolidation seems necessary.
  - Mission urged harnessing market signals to guide restructuring and adoption of legal frameworks by several Länder to mobilize private capital, including transforming public sector banks into joint stock corporations.
  - Dismantling regional barriers for public sector banks would help achieve greater scale economies and diversify risk.
  - Authorities noted regional barriers had begun to soften via collateralized debt obligations market allowing regional bank credit diversification; foreign bank entry in retail market increased dynamism.
  - Silent partnerships (akin to placing subordinated debt) have facilitated some private capital entry into public banks, but private funding remains small.
- Insurance sector issues:
  - Improvements in profitability and solvency mainly in the nonlife sectors; life sector issue: requirement that at least 90 percent of profits be distributed to policyholders constrains flexibility.
  - Mission recommended eliminating the mandatory 90:10 profit split to provide flexibility to replenish reserves; consumer protection could be achieved via better disclosure requirements.
  - Authorities indicated capitalization would be sufficient to meet higher requirements under Solvency II; mandatory profit split could be rescinded at that time.
- Regulatory and transparency follow-up:
  - Financial sector regulatory framework enhanced in response to FSAP recommendations: increased supervisory staff; reinsurance sector regulation strengthened.
  - Mission noted need for further financial sector transparency: publish more timely financial soundness data, in particular on impaired loans.
  - Adopt minimum quantitative criteria for classifying impaired loans and strengthen rules for granting and monitoring loans to related parties.
  - Authorities plan to address these issues via new EU regulations and committed to publishing full set of core financial soundness indicators by December 2006, building on 2005 progress.
- Capital market developments:
  - New Pfandbrief law of July 2005 expected to foster a competitive mortgage bond market by leveling playing field.
  - Market for other asset-backed securities and impaired loans growing quickly.
  - Creation of real estate investment trusts delayed by tax complications under analysis.
  - Developments in funded pension schemes (second pillar corporate and third pillar Riester) likely to stimulate the German financial system.

### Other issues and statistical/AML matters
- AML/CFT:
  - AML/CFT legislation strengthened, including ratification of the UN Convention for the Suppression of Financing of Terrorism (1999).
  - Third EU AML Directive expected to become part of German law by mid-2007.
  - German Financial Supervisory Authority (BaFin) building up its AML/CFT audit unit.
- Statistics and data:
  - Germany’s statistics are adequate for surveillance.
  - Enhancements recommended: collect national accounts data on inventories and compile quarterly accounts for the general government.
  - Authorities participating in IMF's Coordinated Compilation Exercise for Financial Soundness Indicators (FSIs); exercise should produce first data and metadata as of end-2005.
  - In July 2005, authorities received an STA mission preparing a ROSC on statistical and data issues.
- Official development assistance target:
  - Germany aims to increase official development assistance from 0.3 percent of GDP in 2003 to 0.5 percent by 2010, depending on economic and fiscal conditions.

### Staff appraisal and macroeconomic outlook
- Overall appraisal:
  - Germany needs a decisive, forward-looking policy strategy to confront serious challenges: high unemployment, demographic shift, and globalization.
  - Agenda 2010 was a forceful start in reforming entitlement systems and labor markets, with sizeable and lasting benefits expected, but additional steps required.
  - Strategy must include fiscal consolidation and reorientation of policies to reduce distortions, especially in labor markets, with firm implementation and clear explanation of steps and timing to build confidence and revitalize growth.
- Growth prospects and risks:
  - Growth is projected to strengthen in the second half of 2005 and in 2006, but remains unbalanced and highly dependent on the external environment.
  - Corporate sector adapting via cost cutting and wage moderation; competitiveness has improved and exports have been strong.
  - Exports have been slow to ignite domestic demand as firms and households remain cautious.
  - Risks: an abrupt unwinding of global imbalances and rising oil prices may frustrate recovery.
  - Revitalizing sustained demand requires further progress in addressing domestic impediments.

*IMF staff appraisal and findings as presented in the document.*

### 47.      The fiscal deficit is largely structural and long run projections suggest that

### _cr0616 - 47.      The fiscal deficit is largely structural and long run projections suggest that

### Fiscal position and long-run outlook
- The fiscal deficit is characterized as "largely structural" and "current policies are unsustainable."
- Secular decline in the largest tax base: wage income.
- Expenditure pressures from "high and long lasting unemployment benefits and social transfers."
- Public debt ratio is projected to increase sharply as aging raises expenditure on pensions and health care.
- "Corrective action is therefore urgent."
- Policies need realignment "with what a declining population can reasonably deliver," and expectations on output growth and income need to adjust accordingly.
- "Important synergies exist between public finances and labor market and social security reform."

### Fiscal consolidation target and required measures
- Policy goal: eliminate the structural deficit by 2010.
- Required fiscal effort: "high quality measures of at least half percent of GDP a year," with additional efforts after 2010 as aging unfolds.
- One-off measures (e.g., asset sales or bringing forward future revenue streams to meet the golden rule) are discouraged: "does not address the fundamental fiscal problem and should be avoided."
- Fiscal strategy should combine three elements:
  - Durable expenditure cuts.
  - Adjusting entitlement outlays.
  - Tax reform.

- Specific recommendations under the strategy:
  - "There is ample room to cut subsidies and tax expenditures. Even moderate but durable cuts can add up to significant savings over a long period."
  - "Current entitlements are too costly and will exert growing pressure on payroll taxes if left unaltered."
  - Entitlement recalibration options: "increasing the retirement age and shifting health care financing away from payrolls" to contain nonwage labor costs and other taxes, and to "help raise employment and investment."
  - Tax reform objectives: "simplifying the tax code and lowering payroll taxes, possibly with some shift to indirect taxes."
  - Constraint on tax cuts: "there is no room for uncompensated tax cuts. Hence, any plans to lower tax rates should be fully financed with base broadening and cuts in tax expenditures and subsidies."
  - Warning: "Piecemeal adjustments should be avoided as they further complicate the tax system and reduce yield."

### Transparency, institutional reforms, and long-run credibility
- Improve transparency and communication to garner public support and strengthen confidence.
- Government’s Long-Run Fiscal Sustainability Report is noted as "an important innovation" but "uses assumptions that render its findings too optimistic."
- Recommended institutional measures:
  - Appoint an independent fiscal council to prepare an annual assessment of the public finances for parliament to provide more realistic forward-looking perspectives and better identify policy successes and failures.
  - Prepare and publish a public sector balance sheet showing the net present value of the path of future deficits to increase transparency of the intertemporal fiscal position and help convince the public of the need for reforms.

### Intergovernmental fiscal relations
- Revive efforts to reform intergovernmental fiscal relations to provide incentives for better fiscal management.
- Problems identified: current system is "outdated and is hampering consolidation."
- Suggested approaches:
  - Create leeway for competition at the subnational government level to make tax and expenditure policies more efficient and encourage consolidation.
  - Strengthen the internal stability pact by including clear commitments of various levels of government.
  - Cut redundancies and better align tasks among different parts of government to improve fiscal management.

### Labor market and social security reforms to raise labor utilization
- Raising labor utilization is critical to mitigate demographic pressure on growth and public finances.
- Commendation: "The government’s perseverance in introducing the difficult Hartz IV reforms is commendable because the new system has improved incentives to work."
- Limitations: "By themselves these reforms are not sufficient for durable employment growth as high labor costs still hold back demand for full time employment."
- Implementation improvements recommended:
  - Reduce overlap of functions between the Labor Office and local governments.
  - Tighten means testing and enforcement of job search requirements.
  - Improve the UB-II program to become a more effective welfare-to-work program by "improving incentives for participants to increase labor income while receiving partial benefits."

### Measures to increase labor demand and labor market flexibility
- Need wage determination to respond better to labor market imbalances and reflect productivity differentials, including "permitting lower wage floors for entry level and low skill jobs."
- Reduce the wage wedge and remaining central controls on wage bargaining in favor of more decentralized and firm level bargaining.
- Cut employment protection legislation to boost participation and employment, particularly for those with little work experience or skills.

### Product, services, and business environment reforms
- Product and services sector reforms would reinforce labor market reforms by increasing competition and enhancing productivity.
- Priority: establish a business climate more favorable to creating and running small businesses, particularly in the service sector.
- Required actions: further reduce service regulations and administrative hurdles in regulated professions and crafts.
- Support for an EU Services Directive that preserves the country-of-origin principle and limits exemptions to the most sensitive areas for a limited transition period is recommended to improve access to EU markets for high skilled engineering, construction, and R&D sectors.

### Financial sector: profitability, structure, and regulation
- Financial sector profitability is recovering due to cost cutting, lower provisioning, and favorable market conditions.
- Changes in the public banking pillar: intensifying cooperation between Landesbanken and Sparkassen is "welcome."
- Landesbanken actions: have shored up liquidity by raising long term funding prior to the withdrawal of state guarantees in July 2005, but "they still need to develop viable business models."
- Systemic risk assessment: "Although there may be isolated instances of strain, the likelihood of systemic difficulties is small."
- Ongoing structural issue: performance of the German financial system tends to lag EU partners because of continued fragmentation, limiting economies of scale and growth.
- Policy priority: amend legal framework to support market-based restructuring of the banking system.
  - Consolidation hampered by restrictive Länder legislation and outdated regional barriers that limit risk-pooling.
  - Opening up public sector banks to private capital by transforming them into joint-stock companies more decisively would facilitate market-driven restructuring, foster synergies and returns to scale, and help direct funds to areas of highest investment needs.

### Supervision, regulation, and transparency improvements
- Supervisory capacity has been reinforced and regulation of the reinsurance sector has been strengthened.
- Important near-term regulatory action: abolish the mandatory 90:10 profit split between insurers and policyholders as envisaged when the EU Solvency II comes into effect.
- Transparency enhancements: publish more timely financial soundness data, in particular on impaired loans.
- Liberalization of the Pfandbrief law is expected to help advance capital market development.

### Statistics and data
- Germany’s statistics are adequate for surveillance.
- Participation in the IMF’s Coordinated Compilation Exercise for FSIs is welcome.
- Recommendation: collect and publish inventory data to facilitate monitoring of real sector developments.

*Source: _cr0616 - 47.      The fiscal deficit is largely structural and long run projections suggest that*

### 58.      It is proposed that the next Article IV consultation be held on the standard 12-month

### It is proposed that the next Article IV consultation be held on the standard 12-month cycle.

### Basic country and macroeconomic indicators
- Total area: 357,041 square kilometers
- Total population (2004): 82.54 million
- GDP per capita (2004): US$ 33,279

- GDP growth (selected years, percentage change):
  - 2000: 3.1
  - 2001: 1.2
  - 2002: 0.1
  - 2003: -0.2
  - 2004: 1.6
  - 2005 (Proj.): 0.8
  - 2006 (Proj.): 1.2
  - 2007 (Proj.): 1.6
  - 2008 (Proj.): 1.9

- Output gap (percent of potential GDP):
  - 2000: 1.7
  - 2001: 1.5
  - 2002: 0.2
  - 2003: -1.3
  - 2004: -1.0
  - 2005 (Proj.): -1.6
  - 2006 (Proj.): -1.7
  - 2007 (Proj.): -1.5
  - 2008 (Proj.): -1.1

- Unemployment rate (Eurostat definition, percent):
  - 2000: 7.8
  - 2001: 7.9
  - 2002: 8.7
  - 2003: 9.6
  - 2004: 9.2
  - 2005 (Proj.): 9.5
  - 2006 (Proj.): 9.3
  - 2007 (Proj.): 9.0
  - 2008 (Proj.): 8.7

- Consumer price index (harmonized, percent):
  - 2000: 1.4
  - 2001: 1.9
  - 2002: 1.3
  - 2003: 1.0
  - 2004: 1.8
  - 2005 (Proj.): 1.7
  - 2006 (Proj.): 1.7
  - 2007 (Proj.): 1.5
  - 2008 (Proj.): 1.5

Sources for these indicators: Deutsche Bundesbank; Federal Statistical Office; IMF, World Economic Outlook; IMF, International Financial Statistics; and staff estimates and projections.

### Demand, supply, and external sector (selected series)
- Private consumption (percentage change):
  - 2000: 2.4
  - 2001: 1.9
  - 2002: -0.5
  - 2003: 0.1
  - 2004: 0.6
  - 2005 (Proj.): -0.3
  - 2006 (Proj.): 0.4
  - 2007 (Proj.): 1.6
  - 2008 (Proj.): 2.0

- Gross fixed investment (percentage change):
  - 2000: 3.0
  - 2001: -3.7
  - 2002: -6.1
  - 2003: -0.8
  - 2004: -0.2
  - 2005 (Proj.): -0.8
  - 2006 (Proj.): 2.8
  - 2007 (Proj.): 3.5
  - 2008 (Proj.): 2.8

- Exports of goods and nonfactor services (percentage change):
  - 2000: 13.5
  - 2001: 6.4
  - 2002: 4.2
  - 2003: 2.4
  - 2004: 9.3
  - 2005 (Proj.): 5.5
  - 2006 (Proj.): 5.3
  - 2007 (Proj.): 4.5
  - 2008 (Proj.): 4.5

- Imports of goods and nonfactor services (percentage change):
  - 2000: 10.2
  - 2001: 1.2
  - 2002: -1.4
  - 2003: 5.1
  - 2004: 7.0
  - 2005 (Proj.): 4.2
  - 2006 (Proj.): 5.1
  - 2007 (Proj.): 5.5
  - 2008 (Proj.): 5.1

- Current account (in billions of euros and percent of GDP):
  - Current account (2002–2008, selected): 48 (2002), 45 (2003), 84 (2004), 97 (2005), 101 (2006), 102 (2007), 111 (2008)
  - In percent of GDP (2002–2008): 2.2 (2002), 2.1 (2003), 3.8 (2004), 4.3 (2005), 4.4 (2006), 4.4 (2007), 4.6 (2008)

### Public finances and debt (general government, selected years)
- General government expenditure (in billions of euros and percent of GDP):
  - Expenditure (2000–2008, in billions): 930 (2000), 1,005 (2001), 1,031 (2002), 1,047 (2003), 1,038 (2004), 1,049 (2005), 1,068 (2006), 1,094 (2007), 1,124 (2008)
  - Expenditure (percent of GDP): 45.1 (2000), 47.6 (2001), 48.1 (2002), 48.4 (2003), 46.9 (2004), 46.8 (2005), 46.7 (2006), 46.7 (2007), 46.4 (2008)

- General government revenue (in billions of euros and percent of GDP):
  - Revenue (2000–2008, in billions): 957 (2000), 945 (2001), 951 (2002), 960 (2003), 957 (2004), 962 (2005), 983 (2006), 1,006 (2007), 1,039 (2008)
  - Revenue (percent of GDP): 46.4 (2000), 44.7 (2001), 44.3 (2002), 44.3 (2003), 43.2 (2004), 42.9 (2005), 43.0 (2006), 42.9 (2007), 42.9 (2008)

- Overall balance (in billions of euros and percent of GDP):
  - Overall balance (2000–2008, in billions): 27 (2000), -60 (2001), -80 (2002), -87 (2003), -81 (2004), -87 (2005), -85 (2006), -88 (2007), -85 (2008)
  - Overall balance (percent of GDP): 1.3 (2000), -2.8 (2001), -3.7 (2002), -4.0 (2003), -3.7 (2004), -3.9 (2005), -3.7 (2006), -3.7 (2007), -3.5 (2008)

- Structural balance (in percent of potential GDP):
  - Structural balance (2000–2008): -1.7 (2000), -3.1 (2001), -3.5 (2002), -3.5 (2003), -3.3 (2004), -3.4 (2005), -3.0 (2006), -2.8 (2007), -2.9 (2008)

- General government debt (end-year, in billions of euros and percent of GDP):
  - Debt (in billions): 1,211 (2000), 1,224 (2001), 1,278 (2002), 1,358 (2003), 1,430 (2004), 1,517 (2005), 1,602 (2006), 1,689 (2007), 1,774 (2008)
  - Debt (percent of GDP): 58.7 (2000), 57.9 (2001), 59.6 (2002), 62.8 (2003), 64.5 (2004), 67.7 (2005), 70.1 (2006), 72.0 (2007), 73.2 (2008)

- Table 2 fiscal shares (selected ratios, percent of GDP):
  - Revenue (percent of GDP): 44.3 (2002), 44.4 (2003), 43.2 (2004), 42.9 (2005), 43.0 (2006), 42.9 (2007), 42.9 (2008)
  - Primary expenditure (percent of GDP): 45.1 (2002), 45.4 (2003), 44.0 (2004), 43.9 (2005), 43.9 (2006), 43.9 (2007), 43.6 (2008)
  - Overall balance (percent of GDP): -3.7 (2002), -4.0 (2003), -3.7 (2004), -3.9 (2005), -3.7 (2006), -3.7 (2007), -3.5 (2008)

### Financial sector indicators and balance-sheet metrics (1998–2004 highlights)
- Regulatory capital to risk-weighted assets (total, percent):
  - Dec-98: 11.4
  - Dec-99: 11.5
  - Dec-00: 11.7
  - Dec-01: 12.0
  - Dec-02: 12.7
  - Dec-03: 13.4
  - Dec-04: 13.2

- NPLs to gross loans (total, percent):
  - Dec-98: 4.5
  - Dec-99: 4.2
  - Dec-00: 4.7
  - Dec-01: 4.6
  - Dec-02: 5.0
  - Dec-03: 5.3
  - Dec-04: 5.1

- Return on average assets (after-tax, percent, total):
  - Dec-98: 0.3
  - Dec-99: 0.2
  - Dec-00: 0.2
  - Dec-01: 0.2
  - Dec-02: 0.1
  - Dec-03: -0.1
  - Dec-04: 0.1

- Return on average equity (after-tax, percent, total):
  - Dec-98: 10.2
  - Dec-99: 6.5
  - Dec-00: 6.1
  - Dec-01: 4.6
  - Dec-02: 2.9
  - Dec-03: -1.5
  - Dec-04: 1.9

- Household indicators:
  - Household debt to GDP: 69.5 (Dec-98), 72.7 (Dec-99), 73.1 (Dec-00), 72.4 (Dec-01), 72.0 (Dec-02), 72.1 (Dec-03), 71.0 (Dec-04)
  - Household debt service and principal payments to income: 5.2 (Dec-98), 4.9 (Dec-99), 5.4 (Dec-00), 5.3 (Dec-01), 4.9 (Dec-02), 4.4 (Dec-03), 4.1 (Dec-04)

- Financial system structure (selected totals):
  - Total financial system assets (various dates, in billions of euros): 4,769 / 6,467 (Dec-98), 4,597 / 7,319 (Dec-99), 4,425 / 7,833 (Dec-00), 4,283 / 8,131 (Dec-01), 4,211 / 8,229 (Dec-02), 4,101 / 8,193 (Dec-03)
  - Private depository institutions and component shares are provided across 1998–2004 in Table 6.

Sources for financial sector data: Deutsche Bundesbank; IFS; BaFin; Fund staff estimates.

### Public debt sustainability (Appendix I) — key findings and scenarios
- Overall assessment:
  - Under current policies, Germany’s general government debt/GDP ratio is projected to increase sharply in the long run.
  - Population aging within the context of the current entitlement system poses a serious challenge to fiscal sustainability.
  - Aging and its fiscal costs will accelerate starting in 2010.
  - Until 2010, gross debt is projected to increase to 74 percent of GDP.
  - Germany’s projected increase in the old-age dependency ratio through 2050 is in the upper range of G-7 countries.
  - Recent pension, health care, and labor market reforms lowered future implicit liabilities but were insufficient to assure fiscal sustainability.
  - Structural fiscal adjustment appears necessary under any scenario to achieve intertemporal fiscal consistency.
  - Authorities acknowledge the concern but differ on severity and urgency; their Long Run Fiscal Sustainability Report assumes strong up-front fiscal adjustment combined with higher growth—this would lower the debt profile and postpone acceleration but would not assure long-run sustainability.

- Baseline long-run debt projections (general government gross debt, percent of GDP):
  - 2004: 64.5
  - 2005: 67.7
  - 2006: 70.1
  - 2007: 72.0
  - 2008: 73.2
  - 2009: 73.9
  - 2010: 74.7
  - 2020: 99.6
  - 2030: 159.2
  - 2040: 252.6
  - 2050: 363.6

- Change in public sector debt (percentage points of GDP, selected):
  - 2004: 1.8
  - 2005: 3.1
  - 2006: 2.4
  - 2007: 1.9
  - 2008: 1.2
  - 2009: 0.7
  - 2010: 0.8
  - 2020: 24.9
  - 2030: 59.6
  - 2040: 93.4
  - 2050: 111.0

- Identified debt-creating flows (percentage points of GDP, selected):
  - Primary deficit (2004–2050 baseline): 0.8 (2004), 1.0 (2005), 0.9 (2006), 0.9 (2007), 0.7 (2008), 0.5 (2009), 0.3 (2010), 2.2 (2020), 5.4 (2030), 6.6 (2040), 6.7 (2050)
  - Automatic debt dynamics (contribution): 0.7 (2004), 1.2 (2005), 0.9 (2006), 0.8 (2007), 0.6 (2008), 0.5 (2009), 0.9 (2010), 1.5 (2020), 2.5 (2030), 3.5 (2040), 5.4 (2050)
    - Contribution from real interest rate (selected): 1.7 (2004), 1.7 (2005), 1.8 (2006), 1.9 (2007), 1.9 (2008), 2.0 (2009), 2.2 (2010), 2.5 (2020), 3.9 (2030), 6.2 (2040), 8.9 (2050)
    - Contribution from real GDP growth (selected): -1.0 (2004), -0.5 (2005), -0.8 (2006), -1.1 (2007), -1.3 (2008), -1.5 (2009), -1.3 (2010), -1.0 (2020), -1.5 (2030), -2.7 (2040), -3.4 (2050)

- Alternative scenarios (general government gross debt, percent of GDP):
  - Scenario with key variables at their historical averages:
    - 2005: 67.7; 2006: 69.6; 2007: 71.4; 2008: 72.9; 2009: 74.4; 2010: 75.8; 2020: 93.1; 2030: 116.5; 2040: 147.8; 2050: 189.7
  - Scenario with constant primary deficit of 0.9 percent of GDP (2005–2050):
    - 2005: 67.7; 2006: 70.1; 2007: 72.2; 2008: 73.7; 2009: 74.9; 2010: 76.4; 2020: 97.9; 2030: 126.8; 2040: 157.2; 2050: 193.0
  - Scenario with higher economic growth from enhanced labor utilization:
    - 2005: 66.8; 2006: 67.6; 2007: 68.0; 2008: 67.7; 2009: 67.3; 2010: 66.8; 2020: 70.3; 2030: 99.3; 2040: 157.2; 2050: 224.9

- Key macroeconomic and fiscal assumptions underlying baseline:
  - Real GDP growth (percent): 2004: 1.6; 2005: 0.8; 2006: 1.3; 2007: 1.6; 2008: 1.9; 2009: 2.1; 2010: 1.8; 2020: 1.0; 2030: 1.0; 2040: 1.1; 2050: 1.0
  - Average nominal interest rate on public debt (percent): 2004: 4.6; 2005: 4.4; 2006: 4.4; 2007: 4.3; 2008: 4.3; 2009: 4.3; 2010: 4.5; 2020: 4.4; 2030: 4.4; 2040: 4.4; 2050: 4.4
  - Average real interest rate (percent): 2004: 2.9; 2005: 2.6; 2006: 2.7; 2007: 2.8; 2008: 2.8; 2009: 2.8; 2010: 3.0; 2020: 2.7; 2030: 2.7; 2040: 2.6; 2050: 2.6
  - Inflation rate (GDP deflator, percent): 2004: 1.8; 2005: 1.7; 2006: 1.6; 2007: 1.5; 2008: 1.5; 2009: 1.5; 2010: 1.5; 2020: 1.8; 2030: 1.8; 2040: 1.8; 2050: 1.8
  - Growth of real primary spending (deflated by GDP deflator, percent): 2004: -2.5; 2005: -0.6; 2006: 0.2; 2007: 1.0; 2008: 1.1; 2009: 1.5; 2010: 1.6; 2020: 1.6; 2030: 1.7; 2040: 1.0; 2050: 1.1
  - Primary deficit (percent of GDP): baseline values repeat the identified primary deficit series above.

- Debt sustainability conclusion:
  - The baseline and alternative scenarios show steadily rising debt ratios under current policies and under plausible alternative assumptions. The analysis concludes that further fiscal measures and structural reforms (including higher labor utilization and pension/health entitlement adjustments) are necessary to strengthen long-run public finances.

*Sources: Deutsche Bundesbank; Federal Statistical Office; IMF, World Economic Outlook; IMF, International Financial Statistics; Ministry of Finance; BaFin; and staff estimates and projections.*

### 5.2 percent; and the primary balance at 0.8 percent of GDP (a s

### _cr0616 - 5.2 percent; and the primary balance at 0.8 percent of GDP (a s

### Long-term projections and debt sustainability
- Content references "Long-term projections 7/" and "Germany: General Government Debt Sustainability Framework, 2004-2050".
- Notes on identified debt-creating flows:
  - "Identified debt creating flows refer to indicated year, not to the decade. Cumulative increases for the decade are indicated in the line 'Change in public sector debt'."
- Definition note:
  - "Derived as nominal interest expenditure divided by previous period debt stock."
- Primary balance and related figures (as presented in source fragments):
  - "5.2 percent; and the primary balance at 0.8 percent of GDP (a surplus)."

### Staff analytical work on Germany (2001–05)
- The appendix lists forthcoming and existing Staff/IMF analytical pieces under thematic headings:
  - Growth and Competitiveness:
    - "Long-run Growth in Germany. Forthcoming Selected Issues Paper."
    - "Does Regulation Impede Growth in Germany? Forthcoming Selected Issues Paper."
    - "The Performance of Germany’s Non-Financial Corporate Sector – An International Perspective. Forthcoming Selected Issues Paper."
    - "External Sector Role in Recent Growth Performance of Large Euro Area Countries. Forthcoming Selected Issues Paper."
    - "Investment Trends in OECD Countries: Long-Term Developments and Future Prospects. IMF Country Report No. 04/340."
    - "Does PPP hold in the Long Run? Germany and Switzerland. IMF Country Report No. 04/340."
    - "Business Investment in the Current Cycle. IMF Country Report No. 03/342."
    - "Growth and Adjustment in Germany. IMF Country Report No. 02/240."
    - "Is Germany Competitive? IMF Country Report No. 02/240."
    - "Job-Rich Growth in Europe. IMF Country Report No. 01/307."
  - Fiscal Policy and Entitlement Programs:
    - "Why is Germany’s Deficit so Large? Forthcoming Selected Issues Paper."
    - "A Preliminary Public Sector Balance Sheet for Germany. Forthcoming Selected Issues Paper."
    - "A Long-Run Fiscal Scenario Based on Current Policies. Forthcoming Selected Issues Paper."
    - "Pensions and Growth. IMF Country Report No. 04/340."
    - "Federalism and the Political Economy of Adjustment. IMF Country Report No. 04/340."
    - "The Fiscal Challenge of Aging: What Needs to Be Done. IMF Country Report No. 02/240."
    - "Health Care Reform in Germany. IMF Country Report No. 02/240."
    - "Rules-Based Fiscal Policy and the Fiscal Framework in France, Germany, Italy and Spain. IMF Country Report No. 01/307."
  - Labor Markets:
    - "Employment, Unemployment, and Labor Supply in Germany. IMF Country Report No. 04/340."
    - "The Unbearable Stability of the German Wage Structure: Evidence and Interpretation. IMF Staff Papers, August 2004."
    - "On Sand and Grease in Labor Markets: How Does Germany Compare. WP/02/164."
  - The Financial System:
    - "Credit Decline and the Efficiency of German Banks. Forthcoming Selected Issues Paper."
    - "Germany’s Three-Pillar Banking System. IMF Occasional Paper 233 (2004)."
    - "Germany’s Financial System: International Linkages and the Transmission of Financial Shocks. IMF Country Report No. 03/342."
    - "The Slowdown in Credit Growth. IMF Country Report No. 02/240."

### Fund relations and membership (as of July 31, 2005)
- Membership:
  - "Germany became a member of the Fund on August 14, 1952."
  - "Germany has accepted the obligations of Article VIII, Sections 2, 3, and 4."
- General Resources Account (SDR Million % Quota):
  - "Quota 13,008.20 100.00"
  - "Fund holdings of currency 10,164.66 78.14"
  - "Reserve position in Fund 2,843.60 21.86"
- SDR Department (SDR Million % Allocation):
  - "Net cumulative allocation 1,210.76 100.0"
  - "Holdings 1,327.05 109.60"
- Outstanding Purchases and Loans: "None"
- Financial Arrangements: "None"
- Projected Payments to Fund (SDR Million; based on existing use of resources and present holdings of SDRs):
  - Charges/Interest: "0.09 0.09 0.09 0.09 0.09" for 2005–2009 (presented as a row of repeated "0.09")
  - Total: "0.09 0.09 0.09 0.09 0.09"
- Exchange Rate Arrangement:
  - "Since January 1, 1999, Germany has been a member of the European Economic and Monetary Union; the deutsche mark entered EMU at a value of DM 1.95583 per euro."
  - Germany is "an Article VIII member and maintains an exchange system free of restrictions on payments and transfers for current international transactions, except for reasons related to security."
  - Measures freezing accounts and banning payments in favor of listed terrorists and related persons were put into effect in December 2001 per Executive Board Decision No. 144-(52/51).
  - Restrictions also applied pursuant to UN Security Council resolutions and/or EU regulations to Iraq, Libya, Zimbabwe, certain individuals in Myanmar, and assets of 13 persons associated with Serbia and Montenegro.
- Article IV Consultations:
  - "Germany is on a 12-month consultation cycle."
  - "The staff report for the last Article IV consultation (IMF Country Report No. 04-341) was discussed at EBM 04/100 (October 25, 2004)."

### Statistical issues and data dissemination
- Assessment:
  - "Germany’s economic and financial statistics are adequate for surveillance purposes."
  - Germany subscribes to the Fund’s Special Data Dissemination Standard (SDDS).
  - Germany adopted the European System of Integrated Economic Accounts 1995 (ESA95) in 1999.
  - In April 2005, revised national accounts statistics were released to comply with EUROSTAT requirements, adopting chain-linked pricing, allocating financial intermediation services to the users, and introducing new data (e.g. hedonic pricing).
- Identified gaps (four significant gaps listed):
  - "Statistics on inventories are unavailable. In the national accounts, inventory accumulation is derived as a residual and lumped together with the statistical discrepancy."
  - "Although explanatory documentation exists, the lack of a table bridging the general government data in the ESA95 classification and the general government cash data on an administrative basis is viewed as impairing fiscal analysis."
  - "Flow-of-funds data for the 1970s and 1980s remain patchy. Also, flow-of-funds data are published on an annual basis only and with a nine-month lag."
  - "The absence of any pre-1970 ESA95 data complicates time series analysis."
- Other data notes:
  - "Germany does not publish quarterly general government revenue, expenditure, and balance on an accrual basis (ESA95). These data, however, are disseminated quarterly on a cash-basis, although Germany no longer reports cash data for publication in the Government Finance Statistics Yearbook (GFSY)."
  - The IMF Statistics Department is collaborating with member states, Eurostat, and the European Central Bank to develop a fiscal data reporting system in line with ESA95 and the Government Finance Statistics Manual 2001.
  - "The 2003 FSAP mission found that the availability and timeliness of financial soundness indicators were relatively weak."
  - Germany is participating in the Coordinated Compilation Exercise for financial soundness indicators (FSIs).
  - "A ROSC Data Module mission in July 2005 assessed Germany’s data dissemination practices and the quality of the main macroeconomic datasets."

### The coalition agreement (post-September 2005 election) — key policy elements
- Political context:
  - "After a close election in September, a 'grand coalition' government took office on November 22, 2005."
  - Government composition: Christian Democratic Union, Christian Social Union, and Social Democratic Party; headed by Mrs. Merkel (CDU). "Mr. Müntefering (SPD) is Vice-Chancellor and Minister of Labor and Social Security."
- Major economic elements of the coalition agreement:
  - Fiscal consolidation:
    - "reducing the deficit below the Maastricht criterion in 2007, with an increase in the VAT rate from 16 to 19 percent in January 2007 as the main adjustment measure."
    - "A package of new expenditure initiatives equivalent to about 1 percent of GDP distributed over four years (with some backloading) is to provide support for selected activities."
  - Labor markets:
    - "reducing nonwage labor costs by cutting unemployment insurance contributions (financed in part by one-third of the receipts from the VAT increase)"
    - "extending the probationary employment period ... in new labor contracts from 6 to 24 months."
  - Product and service markets:
    - "implementing further reform in network industries; tightening licensing requirements for some crafts; and renegotiating the EU Services Directive."
  - Entitlement reforms:
    - "increasing the statutory retirement age from 65 to 67 years at a pace of one month a year starting in 2012;"
    - "freezing pension benefits for the foreseeable future;"
    - "increasing the pension contribution rate from 19.5 to 19.9 percent effective January 2007."
  - Federalism reforms: "reducing complexity and improving political and financial governance."
  - Financial sector:
    - "implementing the Basel II capital adequacy accord 'in a Mittelstand friendly way;'"
    - "reviewing governance aspects of the Federal Office of Financial Supervision (BaFin), including 'reducing supervisory regulation to an appropriate level' to facilitate the extension of credit;"
    - "enhancing the role of the National Development Bank (KfW) to support investment and the market for venture capital."

### Report on discussions between IMF staff and authorities — fiscal policy focus
- Timing and scope:
  - Discussions held December 12–14, 2005 in Berlin and Frankfurt with authorities and Bundesbank staff; supplement reports updated staff appraisal focused on the coalition agreement.
- Authorities’ fiscal stance:
  - General government deficit projected to remain "around 3¾ percent of GDP in 2005."
  - New 2006 budget to be presented in February 2006 and "will aim to lower the deficit by about ¼ percent of GDP (in both nominal and structural terms)."
  - Authorities will prepare "additional durable adjustment measures totaling at least ¾ percent of GDP in 2007, centered around the VAT hike on January 1, 2007."
  - Intention to continue further deficit reduction in later years with objectives to be spelled out in an updated Stability Program to be submitted to the European Commission in February 2006.
- IMF staff reservations and recommendations:
  - The mission judged "the consolidation effort in 2006 is insufficient" and argued that "a small additional effort to achieve structural adjustment of ½ percent of GDP would not pinch off growth."
    - Achieving this would require "adjustment of ¼ percentage points more than planned," which could be done by curtailing new expenditures or advancing the VAT increase by three to six months.
  - Time inconsistency risk:
    - "The preannounced VAT increase introduces a time inconsistency risk." If the recovery remains fragile, pressure could arise to postpone or scale back the VAT increase.
    - Authorities intend to "contain it by seeking early legislative commitment to the VAT increase in 2007 (possibly in a by-law to the 2006 budget)."
  - Composition concerns:
    - "The deficit reduction effort puts more emphasis on increases in tax rates as opposed to durable expenditure cuts."
    - Authorities noted political constraints on cutting pensions and other entitlements; they highlighted cuts in tax expenditures and subsidies that "will cumulate to 0.6 percent of GDP a year by 2009" and a decline in spending on active labor market policies.
  - Risks from new expenditures:
    - "The package of new expenditures offsets the other efforts to cut spending and some elements could become permanent and introduce new distortions," e.g., accelerated depreciation and new subsidies for household services.
    - Authorities stated the accelerated depreciation rules would be valid only in 2006 and 2007.
  - Counterpart and leakage risks:
    - Some measures assume counterpart efforts by subnational governments and the labor office that "have not yet been fully specified."
    - For example, it is assumed subnational governments will save all proceeds from higher tax revenue transfers following the VAT hike; no mechanism was specified to ensure this.
    - Authorities considered the risk of leakage small, citing fiscal needs of many subnational governments and broad coalition representation in the Länder.
- Staff numerical summaries from coalition agreement (as presented in the source):
  - General government balance projected in the staff report (in billions of euros): "1/-86.5-85.1-87.6"
  - Cumulative measures in the coalition agreement (in billions of euros):
    - "VAT increase......21.1"
    - "Reducing tax expenditures and subsidies...1.27.6"
    - "Cost cutting in Hartz IV program...5.06.0"
    - "Increase in pension contribution rate......3.8"
    - "Reduction in the unemployment contribution rate......-13.0"
    - "Support package over four years...-2.9-5.5"
    - "Discretionary spending cuts and other... 1.30.2 to 9.9"
  - General government balance after measures (in billions of euros): "3/-86.2-80.5-67.3 to -57.6"
  - General government balance projected in the staff report (in percent of GDP): "-3.9-3.7-3.7"
  - Cumulative measures in the coalition agreement (in percent of GDP): "...0.2¾ to 1¼"
  - General government balance after measures (in percent of GDP): "-3.8-3.6-3 to -2½"
  - Footnotes as presented:
    - "Source: Staff estimates based on information provided in the coalition agreement."
    - "1/ The projections in the staff report were premised on policy plans prior to the elections."
    - "2/ Projected cumulative impact in billions of euros, a negative number widens the deficit."
    - "3/ Also reflects small data revisions since issuing the staff report."

*INTERNATIONAL MONETARY FUND — GERMANY — Staff Report for the 2005 Article IV Consultation: Supplementary Information; Prepared by the European Department; Approved by Michael Deppler and Adnan Mazarei; December 28, 2005*

### 7.      The authorities recognize that the small deficit reduction planned for 2006 will

### _cr0616 - 7.      The authorities recognize that the small deficit reduction planned for 2006 will

### Fiscal implications under the revised Stability and Growth Pact (SGP)
- The authorities recognize that the small deficit reduction planned for 2006 will have implications under the revised Stability and Growth Pact rules.
- Authorities point to a concrete plan to bring the deficit into compliance with the Maastricht criterion in 2007 and argue this sets Germany apart from other countries with excessive deficits.
- Authorities are engaged in dialogue with the European Commission to reach satisfactory understandings.
- Mission stressed importance of accepting the consequences under the SGP (primarily intensified fiscal surveillance by the Commission).
- Mission warned that resistance would have grave implications for the credibility of both Germany and the Pact.
- Policy recommendation: Germany could exert leadership by accepting the consequences of its policy plans and then overcoming these difficulties in 2007 with the already-agreed deficit reduction package.

### Structural issues — summary of coalition agreement measures and mission views
- General: Coalition agreement makes important headway on structural issues; some measures go farther than commonly appreciated, others set principles needing translation into policy plans.
- Retirement age:
  - Increasing the retirement age seen as a major achievement.
  - Implementation criticized as excessively gradual: a 24-year time span to achieve a two year increase.
  - Mission recommendation: accelerate implementation, noting further increases likely needed in line with life expectancy.
- Labor market reforms:
  - Main accomplishments: reduction in the wage wedge by cutting contribution rates for unemployment insurance from 6.5 to 4.5 percent, and loosening employment protection by lengthening probation periods for new labor contracts.
  - Improvements underway in Unemployment Benefit II (UB-II) program drawing on Hartz IV experience.
  - Mission welcomed initiatives but noted more time may be needed to agree on other reforms to revitalize labor demand (see ¶27 and ¶52 of the staff report).
  - Footnote: A technical error in UB-II design caused a sharp increase in the marginal tax rate for participants transitioning from welfare to work, weakening program effectiveness and raising costs.
- Product and services market reforms:
  - Proposals fall short and in some aspects go in the wrong direction; mission reiterated views in staff report (¶29-32 and ¶53) and emphasized complementarities with labor market reforms.
  - Authorities’ immediate priority: reforms of network industries, including partial privatization of the national railroad and reform of postal services when monopoly for letter delivery expires in 2007.
  - Authorities express concern about the EU Services Directive raising risks of a "race to the bottom" in labor conditions and service quality.
- Federalism reforms:
  - Planned focus: reduce number of laws requiring upper house approval and clarify responsibilities (environmental policy for federal government; education policy for the Länder).
  - Mission welcomed effort but urged deeper second stage reforms (see ¶23 and ¶50): seek possibilities for small revenue surcharges and independent expenditure decisions at the Länder level; strengthen the Internal Stability Pact (ISP) with quantitative targets and penalties.
  - Authorities: no support for more competitive federalism due to concerns of poorer Länder; options to strengthen ISP are being discussed at an early stage.
- Health insurance and corporate income tax (CIT) reforms:
  - Authorities committed to reform health insurance system and CIT regime, but coalition partners need more time to develop common approach.
  - Health care reform to be formulated in the course of 2006; CIT reform envisaged to go into effect in 2008.
  - Mission recommendations: health care reform should seek financing models that do not increase the burden on payrolls (see ¶20 in the staff report); CIT reform should endeavor to be revenue neutral with base broadening and a lowering of tax rates (see ¶21).
- Mission view: Many details still need to be worked out; careful implementation required to avoid introducing new distortions.

### Financial sector policies
- Mission concern: coalition agreement initiatives could be interpreted as implying relaxation of supervision, possibly reducing independence of BaFin — this would be ill-advised.
- Reasons for concern:
  - High level of impaired loans in the banking system.
  - Low overall profitability.
  - Isolated signs of stress (recent difficulties in a large mortgage bank and a real estate investment fund).
- Authorities’ position:
  - Not their intention to weaken financial sector supervision or regulation.
  - Intend to implement coalition objectives to strengthen and make the financial sector more efficient.
  - Reiterated commitment to independence and autonomy of BaFin, while wanting to review its governance structure and learn from three and a half years of experience since establishment.
- Basel II:
  - Authorities noted potential burden for smaller banks and companies, and that bank federations have made good progress developing centralized risk models.
  - Mittelstand companies will need to accept being rated.
- KfW and small enterprise investment:
  - Authorities view KfW as a useful institution with a niche in the German capital market.
  - Will explore options to stimulate investment in smaller enterprises, including development of a more active venture capital market.

### Updated macroeconomic outlook (2005–2007)
- Uncertainty: Lack of clarity about timing and size of some coalition policy measures; coalition agreement lacks a macroeconomic framework and many policies are unquantified.
- Common view: fiscal strategy and structural policy mix will likely be about neutral on growth and inflation in 2006, but result in slowing growth and a temporary uptick in inflation in 2007.
- Key projections and staff table (Supplement and Staff Report; Percentage change):
  - Real GDP (2005, 2006, 2007): Supplement 0.8, 1.2, 1.6; Staff Report 1.0, 1.5, 1.0
  - Final domestic demand (contribution) (2005, 2006, 2007): Supplement -0.4, 0.8, 1.8; Staff Report -0.1, 1.2, 0.7
    - Private consumption (2005, 2006, 2007): Supplement -0.3, 0.3, 0.7; Staff Report -0.3, 0.6, 0.1
    - Gross fixed investment (2005, 2006, 2007): Supplement -0.8, 2.8, 3.5; Staff Report 0.2, 3.7, 3.2
  - Foreign balance (contribution) (2005, 2006, 2007): Supplement 0.7, 0.3, -0.2; Staff Report 1.1, 0.3, 0.4
  - CPI inflation (2005, 2006, 2007): Supplement 1.7, 1.7, 1.5; Staff Report 1.9, 1.9, 2.5
  - Unemployment rate (ILO) (2005, 2006, 2007): Supplement 9.5, 9.3, 9.0; Staff Report 9.1, 8.8, 8.9
- Staff projections and narrative:
  - Economic growth strengthened in second half of 2005 and expected to continue firming in 2006; output projected to expand by 1 percent in 2005 and by about 1½ percent in 2006.
  - Projection for 2007 more uncertain: possible advance of consumer purchases at end-2006 in anticipation of VAT hike, then drop in consumption in first half of 2007, with normalization in second half of 2007.
  - Fiscal impulse projected to be negative by at least ¾ percent of GDP in 2007.
  - Output growth in 2007 likely to slow to between ¾-1¼ percent.
  - Consumer price inflation expected to remain steady at 1¾ percent in 2006, followed by a one-off increase to about 2½ percent in 2007 because of the VAT hike.
  - Employment not expected to strengthen significantly; unemployment expected to remain comparatively high.
- Notes:
  - Staff mid-point projection caveat: depending on consumer response to VAT increase and final fiscal package, staff projects growth in 2007 to be in a range of ¾ to 1¼ percent.
  - VAT increase expected to be reflected only partially in headline inflation because categories subject to the reduced 7 percent rate are exempted, and with the wage wedge declining slightly, suppliers do not need to adjust output prices fully with the tax hike.
  - Headline growth figures adjusted for working days are approximately 0.1-0.2 percentage points higher.

### Staff appraisal — findings and recommendations
- Positive elements:
  - Coalition agreement contains several measures aligned with comprehensive strategy in the staff report: commitment to reduce significantly the fiscal deficit in 2007; reduce cost of employment; shift some fiscal revenue from direct to indirect taxes; planned increase in statutory pension age; move toward reforming federal fiscal structure.
- Concerns and recommendations:
  - Many details still need to be worked out; success depends on careful and steadfast implementation that avoids new distortions.
  - Short delay in implementing health care financing and CIT reforms is appropriate to design bold, revenue-neutral policies.
  - Fiscal consolidation objective for 2007 is welcome but path is too backloaded and composition has drawbacks:
    - Consolidation planned for 2006 is insufficient.
    - Strategy heavily weighted toward increases in tax rates rather than expenditure cuts.
    - Recommendation: deeper, broader-based approach to reducing tax expenditures and subsidies preferable.
    - Time inconsistency concern from delayed VAT increase.
    - New spending initiatives could lead to permanent costs and distortions and are unlikely to be effective.
  - To meet previously recommended target of annual structural adjustment of at least ½ percent of GDP, adjustment amounting to ¼ percent of GDP should be brought forward from 2007 to 2006.
    - Options: curtail new expenditures and drop those that may create new distortions, or bring forward somewhat the VAT increase.
    - Cyclical conditions do not preclude the small additional adjustment in 2006.
  - Coalition agreement should be used as a stepping stone for bolder structural reform and continued fiscal consolidation.
    - Labor, product, and services reforms are not strong enough to significantly bolster competition, employment, and long-run growth.
    - Effort should be made to augment agreement to improve efficiency and exploit synergies between labor, product, and services market reforms and structural fiscal adjustment.
    - Fiscal consolidation package should be first step toward eliminating structural deficit by the turn of the decade and reducing public debt-to-GDP ratio.
    - Welfare programs need sound intertemporal footing.
    - Financial sector implementation should not infringe on BaFin independence or weaken prudential oversight.
- Overall conclusion: Valuable initiatives developed, but Germany needs a more cohesive, decisive, quantified policy strategy with firm implementation that accounts for looming demographic changes; the grand coalition offers a unique opportunity to address challenges.

### Box 1 — Key Fiscal Policy Steps of the Coalition Agreement (as presented)
- General note: Many measures not fully quantified; some small components may already be in fiscal baseline.
- Measures to increase revenue:
  - Increase VAT rate in January 2007 from 16 to 19 percent, yielding about 1 percent of GDP.
    - Note: One percentage point of the VAT increase is earmarked to fund the reduction in unemployment contribution rates. A similar amount for this purpose is to be obtained through cost cutting in the Federal Labor Office (cutting active labor market programs and Hartz IV costs).
  - Cut tax expenditure and subsidies with savings accumulating to 0.6 percent of GDP by 2009.
    - Note: Cuts in tax expenditure will raise revenue; subsidy cuts (the minor part) will lower expenditure.
  - Increase pension contribution rate in January 2007 from 19.5 to 19.9 percent, yielding about 0.2 percent of GDP.
  - Increase top marginal income tax from 42 to 45 percent for individuals earning over €250,000 or couples earning over €500,000 a year (small yield from 2007).
- Measures that reduce revenue:
  - Cut the unemployment contribution rate in January 2007 from 6.5 to 4.5 percent of gross taxable wages, costing about 0.5 percent of GDP.
  - Eliminate inheritance tax for qualifying small firms (no yield or timing available).
- Measures that increase expenditure:
  - Support package to be implemented over four years from 2006 to fund higher R&D spending, transportation infrastructure, accelerated depreciation for investments in machinery and equipment, family assistance, and building renovation and household services, totaling about 1.1 percent of 2005 GDP.
- Measures that reduce expenditure:
  - Rationalize active labor market programs from 2006.
  - Cut Hartz IV costs through improved design and administration from 2006.
  - Cut pension contributions on behalf of unemployment benefit recipients from 2006.
  - Cuts in public administration and other from 2006.
  - Cut federal subsidies to health insurance funds from 2007.
  - Extend pensionable age from 65 to 67 at a pace of 1 month a year from 2012.

*IMF staff report content (chapter/section provided).*

### Box 2. Large Increases in Consumption Taxes – The Experience of Japan and the United Kingdom

### Box 2. Large Increases in Consumption Taxes – The Experience of Japan and the United Kingdom

### Japan: April 1997 consumption tax hike (3 to 5 percent) — observed effects and context
- Consumption tax rate increased from 3 to 5 percent in April 1997.
- Consumption fell sharply in 1997Q2; some purchases were brought forward into 1997Q1, and spending resumed in 1997Q3.
- Primary drivers of the 1997–1998 domestic demand weakness:
  - A large contraction in business investment attributed to domestic financial stress associated with the failure of several large financial institutions.
  - The Asian crisis contributing to a stall in export growth.
- The consumption tax hike was part of a broader fiscal consolidation that included:
  - Withdrawal of temporary tax cuts;
  - An increase in medical insurance copayments;
  - Continued cuts in public investment.
- Combined effect of the above fiscal measures: a structural fiscal contraction of slightly more than 1 percent of GDP in fiscal year 1997.
- Inflation dynamics:
  - Inflation increased temporarily to 1.7 percent in 1997,
  - Falling back to 0.6 percent in 1998,
  - Second-round inflation effects were small because of slack in the economy.

### United Kingdom: VAT increase (15 to 17½ percent in 1991) — observed effects and context
- VAT increased from 15 to 17½ percent in 1991.
- The VAT increase was part of a broader reorientation of fiscal policy:
  - Helped finance a decrease in the corporate income tax rate and the elimination of the “poll” tax;
  - Other fiscal measures and a privatization program aimed to balance the budget over the cycle.
- Monetary policy and cyclical context:
  - Significant monetary tightening in 1990 to slow an overheating economy.
- Outcomes:
  - Consumption fell, but several concurrent factors alongside the VAT increase contributed to this result.
  - As in Japan, second-round inflation effects were small.

### Lessons and implications for a VAT increase in Germany
- General conclusion: VAT increases have cyclical impacts on consumption, but effects on growth depend critically on accompanying policies and circumstances.
- Reasons effects of a VAT increase in Germany may be less severe than Japan (1997) or the UK (1991):
  - (i) the fiscal shock is smaller than that in Japan in 1997 and it is not accompanied by the same degree of financial sector difficulties as in Japan;
  - (ii) fiscal multipliers in Germany have been estimated to be smaller than in Japan;
  - (iii) even though the European Central Bank recently raised its policy rate, the extent of ECB cumulative tightening is envisaged to be much lower than the doubling of interest rates in the UK in 1990.
- Second-round inflation effects in Germany are expected to be small, especially with continued high unemployment.
- Cautionary note: consumer confidence in Germany remains subdued, growth still driven primarily by external demand, and a VAT increase in this environment could slow the momentum of economic recovery.

### Policy-relevant observations and recommendations drawn from the episodes
- Assess VAT increases in the context of broader fiscal and monetary measures; isolated attribution to VAT changes can be misleading where other policy or financial shocks are present.
- When contemplating consumption tax increases:
  - Consider accompanying measures that mitigate adverse cyclical impacts (for example, avoid simultaneous large fiscal consolidation or financial-sector stress).
  - Recognize that second-round inflation effects may be limited where slack and high unemployment persist.
- For countries with smaller fiscal multipliers and limited financial-sector vulnerability, the adverse growth impact of VAT increases may be attenuated.

*Source: IMF staff box "Large Increases in Consumption Taxes – The Experience of Japan and the United Kingdom" from the provided content unit.*

### 1. The new government has put forward an ambitious agenda designed to meet the dual

### 1. The new government has put forward an ambitious agenda designed to meet the dual

### Overview
- Objectives: fiscal consolidation and stronger economic growth, with focus on globalization and demographic change.
- Builds on: consolidates, deepens and extends reforms under Agenda 2010; generally in line with longstanding Fund recommendations.
- Political context: implementation facilitated by solid majorities in both chambers of parliament.
- Major political breakthroughs: agreement on federalism reforms and an increase of the retirement age.
- Reform approach: well-sequenced with a clear timetable; complex structural reforms (health care funding and corporate income taxation) to be prepared in 2006 and 2007 with no “quick fixes”.
- Emphasis: comprehensive agenda, quality of fiscal adjustment, complementarities of growth-enhancing and deficit-reducing reforms; intended to safeguard and strengthen the economic basis of the German social model.
- Legacy factor: annual fiscal transfers to the New Länder are projected at about 4 percent of GDP.

### Economic Outlook
- Recovery signals:
  - Exports: continue to expand strongly due to high international competitiveness and brisk foreign demand.
  - Pattern of growth: becoming more balanced with domestic demand beginning to catch up.
  - Private investment: has gained significant momentum.
  - Construction sector: recovering after years of contraction.
  - Consumer confidence: clear indications of strengthening.
- Employment and consumption: recovery not yet firmly translated into higher employment and stronger household consumption.
- Authorities’ view:
  - Broad concurrence with staff’s updated macroeconomic outlook.
  - Recovery taking hold; overall fiscal stance turning only slightly tighter in 2006.
  - Household spending expected to strengthen over the course of the year, supported by some additional expenditures being brought forward in anticipation of the VAT increase planned for 2007.
  - Confidence that the VAT increase will not derail the economic upswing in 2007.
  - Concern that a more front-loaded consolidation path, as recommended by the staff, could jeopardize the recovery and undermine the environment for fiscal consolidation.

### Fiscal Policy
- Overall package: € 138 billion over the period 2006 to 2009.
  - Expenditure cuts: € 34 billion.
  - Abolition of tax exemptions and tax expenditures: € 33 billion.
  - Tax increases: € 71 billion.
- VAT: to be raised by three percentage points to 19 percent at the beginning of 2007 (noted: “still below EU average”).
  - One percentage point of the VAT increase earmarked to fund the reduction in unemployment insurance contribution rates.
- Expenditure-side measures include:
  - Reductions in entitlements and stronger means-testing under the new Unemployment Benefit II (UB-II) program.
  - Savings from streamlining active labor market policies and the administration of the Federal Labor Office.
  - Cuts in the federal subsidy of health insurance funds, in the public sector payroll, and in funds for regional development and agriculture.
- Measures to broaden the tax base include:
  - Abolition of the home owner subsidy (Eigenheimzulage).
  - Significant cut of the commuter tax exemption.
- Income-side measures:
  - Marginal income tax increased for high income earners.
- Legislation timing: VAT increase legislation to be passed well before implementation to remove uncertainties and bolster confidence.
- Alignment with staff recommendations: shift revenue collection towards indirect taxes combined with entitlement reforms to alleviate pressure on payroll taxes.

### Growth-Enhancing Measures (linked to fiscal consolidation)
- Corporate income tax reform:
  - Planned to go into effect in 2008.
  - Objectives: make tax system more competitive, less prone to allocative distortions and tax avoidance, and reduce volatility of tax revenues.
- Other package measures:
  - Package amounting to € 25 billion over the next four years.
  - Includes promotion of research and development and improved depreciation rules to stimulate investment in machinery and equipment (until corporate income tax reform is introduced in 2008).

### Fiscal Framework
- Commitment: authorities remain firmly committed to the Stability and Growth Pact (SGP).
- Target: consolidation strategy designed to bring the general government deficit below the Maastricht limit of 3 percent of GDP in 2007.
- Publication: details to be published in the update of Germany’s Stability Program to be presented next month.
- Federalism reforms:
  - Aim to enhance efficiency by disentangling competencies of the federal government and the Länder.
  - Strengthen the Internal Stability Pact by clarifying responsibilities of federal and Länder governments in context of the SGP.
  - Ease legislative process by limiting the number of bills requiring upper house approval.
  - Streamline complex financial relations within the government sector to be addressed later during the legislative period.
- Fiscal council: staff propose a new fiscal council; authorities skeptical about added value given existing non-partisan institutions (Council of Economic Advisors (Sachverständigenrat), the Bundesbank, private research institutes).

### Labor Market
- Strategy: threefold — improve existing labor market reforms, introduce additional reforms affecting supply and demand, and undertake measures to promote growth potential and job creation.
- UB-II program:
  - Streamline and optimize, including more stringent means testing to strengthen work incentives and combat misuse.
  - “Top up benefits” to be streamlined and combined to resemble a negative income tax.
- Active labor market policies: to be cut back significantly and limited to those of proven effectiveness.
- Tax wedge and contributions:
  - Unemployment insurance contribution rate to be lowered by 2 percentage points from the beginning of 2007.
  - Pension contribution rate to increase by 0.4 percentage points.
  - Net effect: overall reduction in non-wage labor costs to below 40 percent.
- Tax deductions: for household services and home improvements up to a specific limit to promote job creation in the service sector and encourage formalization of informal activities.
- Family support: enhanced financial support for families and increased investment in child-care and all-day schools to raise labor participation, especially among women.
- Employment protection legislation (EPL):
  - Gradual reforms to balance flexibility and preservation of the social model.
  - Building on 2004 deregulation, the probationary period for new employees to be extended from six months to two years to simplify EPL and reduce costly labor court involvement.
- Wage bargaining: current system delivered wage moderation; authorities welcome increased use of opening clauses and firm-level bargaining to allow more pay differentiation.

### Pensions and Health Care
- Pensions:
  - Introduction of a sustainability formula capping pension growth in line with the rising dependency ratio to promote inter-generational equity and long-term sustainability.
  - Since 2004, pensions have effectively been declining in real terms.
  - Sustainability formula to be strengthened by an arrangement offsetting expenditure overruns in future years.
  - Retirement age: statutory retirement age to be gradually raised from 65 to 67 years from 2012 onwards.
- Health care:
  - Recent reform led to a public health care finances surplus of € 4 billion in 2004; another surplus expected for 2005.
  - Surpluses helped stabilize health insurance contribution rates and non-wage labor costs.
  - Risk: renewed financial strains likely due to sunset clauses attached to recent measures.
  - Government commitments: promote competition, individual responsibility, and cost-effectiveness while preserving quality.
  - Plan: fundamental reform of the health care system to be worked out in 2006, with elements of a funded scheme to be added to the current pay-as-you-go long-term care insurance.

### Product and Service Markets
- General goal: further product and service market reforms to contribute to higher employment growth.
- Measures include:
  - “Small company act” to comprehensively cut back administrative regulation of SMEs and start-up businesses.
  - General application of simplified and expedited planning processes for construction and infrastructure projects (tools proven useful in the New Länder).
  - Energy sector: Federal Network Agency’s mandate expanded in July 2005 to electricity and gas sectors to improve market mechanisms and strengthen price incentives.
  - EU services market: authorities support a well-functioning internal services market while avoiding erosion of important social and quality standards; will work towards an EU Services Directive that meets both objectives.

### Financial Sector
- Recent performance:
  - DAX stock market index gained almost 30 percent.
  - Profitability in banking and insurance sectors improved further.
- Institutional reforms: continued swift and full implementation of agreed EU regulations and gradual modernization of national financial sector laws and regulations.
- BaFin: governance and working methods of the German Federal Financial Supervisory Authority (BaFin) to be reviewed three and a half years after inception to ensure appropriate structure, independence, autonomy, and means to fulfill its mission.
- Banking system:
  - Generally well-placed to support recovery.
  - Profitability and cost-income ratios have further improved.
  - Profitability gaps of big internationally active banks vis-à-vis international competitors have narrowed due to cost-cutting and tapering-off of provisioning.
  - Impaired loans are on the decline.
  - Authorities note caveats in international comparisons of impaired loans due to diverging definitions; Germany’s definition of non-performing loans (NPLs) is relatively broad, resulting in comparatively higher NPL figures.
- Transparency and indicators:
  - Additional financial indicators compiled in September 2005.
  - Germany committed to providing the IMF with the full set of Core Financial Soundness Indicators for publication in December 2006.
  - Authorities exploring appropriate dissemination of indicators and metadata in accordance with the IMF Compilation Guide on Financial Soundness Indicators.
- Capital markets development:
  - Market for asset-backed securities growing quickly.
  - Scope for public-private partnerships to be expanded.
  - Introduction of real estate investment trusts under serious consideration.
  - Provision of venture capital to be promoted further; conditions for private equity financing to be improved.

### Other Issues
- Trade policy:
  - Firm support for international trade liberalization.
  - Welcome the recent agreement reached in Hong Kong as an important intermediate step towards a successful conclusion of the Doha Round.
  - Strong support for EU offer to eliminate all forms of agricultural export subsidies and their phasing out by 2013 as part of an overall Doha Agreement.
  - Look forward to more progress in liberalization of industrial goods and services, in particular financial services.
- Official Development Assistance (ODA):
  - Germany agreed to increase ODA to 0.33 percent of GNI until 2006 and to achieve 0.51 percent of GNI by 2010 as an intermediate step towards reaching 0.7 percent of GNI by 2015.
  - New government remains committed to these targets, especially to support low-income countries in reaching the Millennium Development Goals.
  - Given fiscal consolidation needs, Germany stresses the importance of innovative financial instruments for ODA funding.
- Fund-related assessments:
  - Authorities appreciate and support the role of FSAPs and ROSCs in Fund surveillance.
  - With recent conclusion of a data ROSC (to be published with the 2005 Article IV papers), Germany will be one of the few Fund members for which both an FSAP and all Fund-led ROSC modules have been completed and published.

*IMF staff report excerpt: Germany — government reform agenda and macro-fiscal assessment.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr0616.pdf_