Germany -- 2005 Article IV Consultation Concluding Statement of the IMF Mission

June 28, 2005

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

1. Germany needs a decisive and forward-looking policy strategy to confront the serious challenges it faces. First, high labor costs and rigidities have contributed to intolerable unemployment, especially for the most vulnerable. Second, Germany is at the cusp of a powerful demographic shift and long-run simulations show that public finances and long-standing welfare programs are not sustainable under current policies. Third, globalization and the expanded EU offer valuable opportunities and need to be embraced for Germany's own advantage. These challenges need to be met against the backdrop of broad agreement to preserve the basic tenets of the social welfare model. This requires a coherent plan that includes, at a minimum, fiscal consolidation and a reorientation of policies to reduce distortions, especially in labor markets. The strategy must be decisive, with firm implementation and a clear explanation of the policy steps and their timing. Such an approach offers the best prospect for building confidence and revitalizing growth.

2. To be sure, Germany has made progress in adjustment. Agenda 2010 was a forceful start in reforming pension and health systems and labor markets, and will yield substantial and lasting benefits. Meanwhile, the gradual rebuilding of competitiveness and tax cuts provided support for economic activity.

3. The recovery, however, remains fragile as structural problems hamper domestic demand growth. Wage moderation and high global demand for investment goods have boosted exports. However, weak domestic demand still reflects ongoing internal adjustments to improve efficiency and flexibility. Thus, real GDP is projected to expand by 1 percent in 2005 and 1.3 percent in 2006. Adjusted for working days these rates imply a moderate pick up in growth from 2004, but the short-run outlook remains dependent on external conditions.

Fiscal Policy Reforms

4. The fiscal deficit is largely structural and will tend to increase further unless corrective action is taken. The 2005 deficit is projected to be 3.8 percent of GDP, and only slightly lower for 2006 on the basis of current policies. Notwithstanding expenditure restraint, the structural fiscal deficit remains close to 3 percent of GDP. Key factors are the weakness in labor markets and the need for continued wage moderation, which have led to a secular decline in the labor share of national income. As tax and social security revenues rely heavily on wage income, the revenue base of the public sector is eroding. At the same time, high and long-lasting unemployment benefits and social transfers put pressure on expenditure. This shows that important synergies exist between public finances, the labor market, and social security reform.

5. Long-run projections suggest that current fiscal policies are unsustainable. The public debt ratio is projected to increase sharply as aging raises expenditure on pensions and health care. Policies therefore need to be realigned with what a declining population can reasonably deliver and expectations need to adjust accordingly.

6. In view of the increasing pressure from aging, policies should aim to eliminate the structural deficit by 2010. This goal requires high-quality adjustment of at least half percent of GDP per year, and more when the recovery becomes firmly entrenched. Resorting to one-off measures such as asset sales or bringing forward future revenue streams to meet the golden rule does not address the fundamental fiscal problem and should be avoided.

7. The fiscal strategy needs to combine three elements:

Durable expenditure cuts. There is ample room to cut tax expenditures and subsidies as detailed in the Koch-Steinbrück list. Even moderate cuts can significantly strengthen the public finances if sustained over a long period.

Recalibrating social security benefits. Given the demographic profile, current entitlements, broadly defined, are too costly. Moreover, if left unaltered, they will lower growth through pressure on payroll taxes. An equitable recalibration of benefits that includes increasing the retirement age and shifting health care financing away from payroll taxes can contain nonwage labor costs and other taxes. This will help raise employment, investment, and output growth.

Comprehensive tax reform. The reform should be consistent with fiscal consolidation needs, which leaves no room for uncompensated tax cuts. It should aim at simplifying the tax system and lowering payroll taxes, possibly with some shift of the burden toward indirect taxes. Plans to cut corporate income tax rates should be fully financed with base broadening and cuts in corporate tax expenditures and subsidies. Piecemeal adjustments to the tax code should be avoided as they will make the system even more complicated and reduce yield.

8. Effective communication about the need for reforms is crucial for success. The government has recognized this, and has produced a valuable long-run fiscal sustainability report. This initiative should be taken further by:

• Preparing the baseline projections using current policies, rather than assuming the medium-term financing plan (Mittelfristiger Finanzplan), which is off-track and renders the current sustainability findings too optimistic.

• Preparing and publishing a public sector balance sheet. Initiatives to prepare a balance sheet are already underway in some Länder, including Hesse. The long-run sustainability estimates can be transformed into a net present value of implicit liabilities. This is a powerful instrument to increase transparency in the underlying fiscal position and can help convince the public of the need for reforms.

• Appointing an independent council to prepare an annual assessment of the general government accounts for parliament. Such vetting of fiscal policy could be placed in the context of the long-run sustainability report.

9. Fiscal federalism reforms should be revived. This is a complex task, but early progress should be sought on the following fronts: (i) creating some leeway for competition at the subnational government level to make tax and expenditure policies more efficient and to encourage fiscal consolidation; (ii) strengthening the Internal Stability Pact by including clear commitments of various levels of government, including individual Länder, to help ensure consistency in the overall policy framework; and (iii) cutting redundancies and aligning better the tasks among different parts of government to improve fiscal management.

Labor Market Reforms

10. Persistent disequilibria in the labor market and the need to raise participation call for further reforms. Labor supply is improving but labor demand is still restrained by high costs and rigidities. Raising labor utilization is important to mitigate demographic pressure on growth and public finances.

11. The Hartz IV reforms are boosting labor supply, but by themselves are not sufficient for durable employment growth. The new system has improved incentives to work and the government's perseverance in introducing these difficult reforms is commendable. However, employment growth has so far been limited to temporary work and self-employment, and high labor costs still hold back demand for full-time employment.

12. The fiscal costs of Hartz IV are higher than expected and implementation needs to be improved. The increase in registered unemployment was underestimated, implementation has been hampered by the program's complex design, and the reduction in reservation wages has been limited. Streamlining responsibilities between labor offices and local governments needs to aim at a more efficient distribution of tasks and at reducing administrative overlap. As experience is gained, the means testing of benefits needs to be tightened to lower costs and reduce inequities. Lower volumes will then free up time to intensify job placement. The transfer of former welfare recipients from local authorities (welfare) to federal programs (unemployment) has resulted in additional federal fiscal costs that should be offset by lower intergovernmental transfers from the federal government.

13. Unemployment Benefits II needs to become an effective welfare-to-work program. The UB-II has the basic feature of a negative income tax as it is being used to top up income for workers earning below the social minimum. However, the incentives for participants to increase labor income while receiving (partial) benefits need to be improved. If able-bodied participants are unwilling to work, benefits should be reduced further. The extension of assistance duration for elderly unemployed workers undermines the benefits of the new system. It creates confusion about the government's resolve and diminishes confidence in the durability of other aspects of the reform, thereby reducing overall effectiveness.

14. As more workers are now looking for jobs, greater emphasis needs to be put on reforms that increase labor demand:

• Wage setting needs to respond better to labor market imbalances and more closely reflect productivity differentials. With the majority of unemployed having low productivity, it will be important to reduce wage floors for entry-level and low-skill jobs. Reducing central controls on wage bargaining in favor of more decentralized and firm-level bargaining is a priority.

• Cutting employment protection legislation would boost participation and employment, in particular for the young, old, and unskilled. A loosening of the existing legislation could improve conditions for hiring those with little work experience or skills.

Product and Services Market Reforms

15. Product and service market reforms can reinforce labor market reforms by increasing competition and enhancing productivity. Numerous studies point toward supportive interactions between product and service market reforms and employment growth. These issues are also coming to the fore in the debate on globalization. Germany's support for an EU Services Directive that preserves the country of origin principle and limits exemptions only to the most sensitive areas for a limited transition period would serve the country well. Preliminary estimates show that Germany would gain a substantial number of jobs as its high value-added engineering, construction, and R&D sectors could gain by obtaining easier access to EU countries. A more dynamic services sector is crucial to help offset the decline in manufacturing employment where jobs are shifting to lower cost locations. Explicit or de-facto sectoral minimum wages should be avoided; these would further undercut chances for the most vulnerable unemployed workers.

Financial Sector Reforms

16. A more dynamic banking system would be better able to support growth. The strains of 2002-03 have lessened, but the banking system continues to under-perform its EU peers and reforms have been slow. In the private banking pillar, cross-border consolidation has gained attention with the merger of the third largest bank and a major foreign bank. The changes underway in the public pillar, which include adjustments in funding strategies in response to the upcoming expiry of state guarantees and intensified cooperation between Landesbanken and Sparkassen, are also welcome. However, the opening up of public banks to private capital is still small, while further infusions of public capital are proceeding in some Landesbanken. To reduce segmentation between the banking pillars and better harness market signals for restructuring, it remains vital for all Länder to create the legal framework to mobilize private capital, notably by transforming public sector banks into joint-stock corporations. Further, the regional barriers to operating public sector banks are becoming increasingly obsolete and should be removed to achieve greater scale economies and diversification of risk.

17. Vulnerabilities in the insurance sector have declined, but some policy tasks remain. Insurance companies' solvency ratios have increased and hidden losses have declined. Exposure to risky assets has been reduced but companies need to adjust further to low long-term interest rates. A key issue in the life sector remains the combination of strong competitive pressures in a dispersed market with the requirement that at least 90 percent of profits must be distributed to policy holders. Eliminating the profit split regulation when EU Solvency II comes into effect would increase flexibility to build capital. Consumer protection is important but can be achieved through other means such as better disclosure requirements.

18. Capital market innovations can open up new avenues for business financing. The new Pfandbriefe Law, which will come into force on July 19, is likely to foster a dynamic and competitive market for mortgage bonds. Abolishing penalties for early mortgage payoffs could further stimulate mortgage financing and the real-estate market. Funded pension schemes such as Riester pensions could also stimulate the German financial system, as they have done in other countries, but this requires simplification of these schemes to increase their attractiveness. The possibility for Real Estate Investment Trusts should also remain on the agenda. Although tax difficulties have prevented their introduction for now, such investment funds can play an important role in capital market development.

19. Given the ongoing changes in the financial system, supervisors need to remain proactive in monitoring and addressing new risks. The regulatory framework has been enhanced by strengthening the supervision of the reinsurance sector and increased staffing. Transparency in the financial sector would be aided by publishing more timely financial soundness data, in particular on impaired loans.

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We thank our many interlocutors for the interesting discussions and generous hospitality.


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