Mission Concluding Statement 

Germany -- 2004 Article IV Consultation, Concluding Statement of the IMF Mission

July 5, 2004

1. Germany has begun to address its long-standing structural problems and is better positioned to benefit from the global upswing. Agenda 2010 represents a significant start of needed reforms and the government's commitment to its implementation is welcome. With continued wage moderation and efforts underway by social partners to make labor markets more flexible, competitiveness has improved and exports are responding well to increased world demand. In addition, the banking system is in better shape and should be able to support the economic recovery.

2. Nevertheless, it is widely recognized that Agenda 2010 needs to be augmented to secure durable growth and the viability of the welfare system. Key here is the nexus between the labor market, the entitlement system, and the health of public finances. Entitlements have generated high and rising nonwage costs that are a significant strain on employees and firms, diminishing the incentives to work and invest domestically. The marked decline in labor input in Germany, which has reduced potential output growth, is striking. Policymakers have rightly started to focus on the need to increase potential growth through sharpened incentives to work. Raising labor supply and adapting the welfare system is also critical to meet the challenge of population aging. Progress on these fronts is urgent because population aging will accelerate dramatically after 2010—just one business cycle away.

3. With the improved short-term economic outlook, it is important to seize this opportunity to accelerate fiscal consolidation and structural reform. Real GDP growth is projected to reach 1.8 percent in 2004 and about 2 percent in 2005. Adjusting for working days, this implies a pick-up in growth of nearly a full percentage point between 2004 and 2005. This scenario incorporates a gradual strengthening of domestic demand as in typical German recoveries, where the external impulse leads to higher investment and employment, and finally consumption, with a lag of a few quarters. Although these links may be somewhat weaker than in previous cycles, there is no compelling evidence that such a recovery will not take shape. On the external side, the risks from higher oil prices or euro appreciation appear manageable. On balance, these are favorable circumstances to move more ambitiously to lower the fiscal deficit. And, complementing fiscal consolidation with labor market and entitlement reforms will not only stimulate important synergies, but will also strengthen confidence in the sustainability of public finances and the welfare state. This, in turn, should support domestic demand and output growth.

Fiscal Policy Requirements

4. With growth prospects having firmed, fiscal consolidation should be given additional impetus within the government's three-pronged policy strategy of structural reform, fiscal consolidation, and support for demand through tax cuts. The mission projects the general government deficit in 2004 to be almost 4 percent of GDP, essentially unchanged from 2003, and with no reduction in the cyclically-adjusted deficit. The high deficits are largely a legacy of insufficient expenditure consolidation during previous upswings, and Germany's debt has grown progressively during the past few decades. The medium-term goal should be to achieve small surpluses over the cycle to ease the pressure from debt and put Germany in a sound position to face impending demographic changes. As the upswing unfolds, it will be important to make decisive progress toward this goal in 2005.

5. The 2005 budget objective to reduce the general government deficit to below 3 percent of GDP is appropriate on current growth projections. However, the policy steps to achieve this objective have not yet been fully specified. Specifically, on the basis of current plans, the mission projects a fiscal deficit of about 3 1/3 percent of GDP in 2005, short of the budget objective. In addition to cyclical effects, the reduction in the deficit is based on existing measures in the pipeline that are projected to compensate for next year's tax cut and yield an additional 1/3 percentage point of GDP. Although the measures in the pipeline include a high-quality component, there continues to be reliance on across-the-board expenditure restraint, which will be difficult to sustain over the medium run, especially for public investment. Before the budget is finalized, it will be important to identify additional structural measures to achieve the intended consolidation and bolster its durability. The additional required adjustment of about 1/3 percentage point of GDP should not jeopardize the economic recovery.

6. Larger cuts in tax expenditures and subsidies are the most promising avenue to achieve durable consolidation. Using a broad definition, these have been estimated to be as much as 6 percent of GDP (€ 120 billion) by the Koch-Steinbrück commission, but the agreed reduction—cumulating to about 1/2 percentage point of GDP in 2004-2006—is small. Equity and efficiency considerations call for a more far-reaching approach, which could involve speeding up the agreed across-the-board reductions and abolishing specific programs that are most costly (e.g., the Eigenheimzulage). Additional reductions of about 1/3 percentage point of GDP in 2005 and a further 2/3 percentage point in 2006 would also be in line with the 2003 Article IV Consultation recommendation to reduce the structural deficit by at least 1 1/2 percentage points of GDP over 2004-06 using high-quality measures.

7. Improving budget institutions and intergovernmental fiscal relations can provide incentives for better fiscal management. The central tenets should be to enhance transparency, establish firmer commitments among different levels of government, and introduce a degree of competition in fiscal federalism, thereby improving fiscal discipline and the allocation of resources between the levels of government and among the Länder. Several aspects are worth pursuing:

• The government's plan to begin publishing an annual fiscal sustainability report is welcome, as it will contribute to the debate on the course of fiscal consolidation and welfare policies. Having this report drafted by a nonpartisan body—possibly an independent authority that reports directly to the legislature—would boost its credibility.
  
  
• In framing its fiscal objectives, the government should make the accounting conventions and rules more consistent with the Stability and Growth Pact (as opposed to the current focus on the golden rule for the federal government).
  
  
• The Internal Stability Pacts should be bolstered by firming up the commitments of various levels of government, with emphasis on spelling out these commitments more clearly.
  
  
• The mechanism for allocating revenue across Länder could be reformed to provide stronger incentives for fiscal consolidation by Länder.
  
  
• Länder should be given leeway to attune their regional public sector wage and welfare expenditures as well as revenues (through surcharges or discounts) to local circumstances, thereby improving the business environment for new investment.

8. The government is taking an appropriately cautious stance on proposals for far-reaching tax reform. Additional tax reforms at this stage run the risk of introducing new piece-meal adjustments, further complicating the tax system and the process of fiscal consolidation. Moreover, in view of the high labor costs in Germany, changes in the entitlement system combined with payroll tax cuts are the more pressing priority.

Entitlement Reforms

9. The government's focus on controlling nonwage labor costs as a means to improve labor market conditions and potential output growth is appropriate. In view of demographic trends, and with the German entitlement system largely based on payroll charges, entitlement reforms are key to containing the tax wedge on labor. The mission's projections for age-related expenditure over the long term, after the impact of recent measures, suggest that the payroll burden will still increase substantially. This would inevitably stifle growth, making it essential to introduce further reforms.

• In the pension system, the recent adoption of a sustainability factor and steps to raise the effective retirement age were necessary and important, but are insufficient to balance the system in the long run. Therefore, as is increasingly accepted, the statutory retirement age will have to be raised in line with longer life expectancy. Further, employees should be allowed to work longer than the statutory age, if they wish to do so, without being financially penalized.
  
  
• In the health care system, reforms have so far focused on transferring selected costs to users and containing demand. The next stage of reform targets rigidities in the supply of health care, and the measures being considered by the government (e.g., allowing hospitals to decide for themselves what services they wish to provide and liberalizing the pharmacy sector) should be implemented. There is also room for consolidation among health care insurers to improve scale economies. In addition, it will be important to complement these reforms with efforts to break the link between health care financing and wages.

Labor Market Reforms

10. The labor market—the Achilles heel of the German economy—is becoming more flexible. Wage moderation and the willingness of social partners to adopt innovative wage bargaining agreements that tailor pay and working time to local labor market conditions and global competitive pressures are laudable. Although this has undoubtedly played a major role in improving Germany's external performance, high long-term unemployment, particularly among older workers and the less skilled, remains a major concern, as does the low labor force participation of older workers and women. Further labor market measures are therefore necessary to cut unemployment and increase participation, and the continued development of flexible wage and employment contracts, including for small and medium-sized enterprises, should be encouraged.

11. The labor market reforms under Agenda 2010 are a major step in addressing high unemployment. The shortening of the duration of unemployment benefits and the merger of unemployment and social assistance into the Unemployment Benefit II program are well-targeted steps to address long-term unemployment. The focus should now be on ensuring that administrative arrangements for the program are robust and that it becomes fully functional in early 2005; familiarity with local conditions and close cooperation among the implementing agencies will be necessary to maximize the prospects for reintegrating the long-term unemployed. In parallel, the job acceptance requirement should be strictly enforced. It will also be important to avoid creating new wage floors or expanding active labor market programs that blunt incentives to seek work and dilute this important reform.

Financial System Reforms

12. The financial system has benefited from the cyclical recovery, but fundamental reform has progressed only slowly. Profitability has rebounded (although it remains low), write-offs have become less pressing, and the recovery in the value of financial assets has improved balance sheets of banks and insurance companies. Further, institutions are putting greater focus on risk management. There have also been useful advances in capital market development, including the introduction of hedge funds as well as new asset-backed securities and inflation-indexed government bonds. And, supervision continues to be strengthened, most notably by bringing reinsurance companies under the umbrella of the supervisory authorities. Nevertheless, the structural concerns noted in the 2003 FSAP exercise are essentially unaltered, and further steps are needed to improve the underlying strength of the system. The key issue remains the need to improve revenue through the development of new business strategies that are guided by market forces.

• In the banking system, there are some welcome signs of increased cooperation, both within and across pillars, but the segregation of the three pillars is still largely intact. Efforts to strengthen public sector banks—notably the Landesbanken—are being guided by rating concerns and narrow interests of lower levels of government. It remains vital for Länder to create the legal framework to mobilize private capital, notably by transforming public sector banks into joint-stock corporations. This would allow a better harnessing of market signals for restructuring and strengthen the resilience of the banking system to shocks.

• In the insurance sector, little consolidation has taken place and it is unclear whether underlying structural performance has improved significantly. The capital base of the insurance sector needs to be increased, and it will be important to broaden the supervisory focus beyond solvency margins. In this regard, the 90:10 profit split with policy holders is not consistent with the upcoming provisions of risk-based insurance supervision (Solvency II), which makes this an opportune time to abolish this regulation.

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We thank our interlocutors for productive and friendly discussions. Pressing ahead with a consistent and coherent fiscal and structural reform strategy is within grasp, and will help convince the public that the long-term sustainability of Germany's welfare system and public finances is being secured. Indeed, resolute policy implementation will not only make for a brighter future for Germany, but the country's strong leadership will also have positive regional and global ramifications.