German Tax Cuts Unsettle Brussels

German Chancellor Gerhard Schröder’s announcement on Sunday that his cabinet had approved income tax cuts to kickstart Europe’s largest economy would normally be received with a mild sense of relief in Brussels – anything to pull the German economy out of the doldrums. But the European Commission responded instead with words of caution, saying tax cuts could not be financed through more state debt.

The tax reform put forth by the German government calls for bringing forward to 2004 a cut in income taxes originally scheduled for 2005. The move is expected to result in 10 percent less income tax per person and is believed to save small and medium-sized companies billions of euros.

"Ten percent less tax means 10 percent more consumption," Schröder told reporters on Sunday in a simplified explanation of how the tax cut would spur economic growth. Finance ministry experts claim the package is worth 1.0 percent in terms of annual growth, a significant amount considering the German economy is currently hovering around the zero percent zone.

But the tax cut is also slated to cost the government between 16 and 18 billion euros (17.5 to 20.5 billion dollars). That’s money the government doesn’t have right off the bat.

And that’s what worries EU officials in Brussels.

Proper financing

Although Chancellor Schröder has stressed that the tax cuts would be financed within the budget – he has called for reductions in state subsidies and benefits -- experts are not too sure this is entirely feasible. They worry that Germany would have to resort to borrowing to counter the loss in revenue from the cut in income taxes.

The European Commission for Economic and Monetary Affairs warned Germany of the "risks" involved in financing the multi-billion-euro tax cut. Commission spokesman Gerassimos Thomas said Germany had to be careful not to incur additional debt through the tax reform. "Every tax cut has to be properly financed," he said on Monday.

Last week, Economic and Monetary Affairs Commissioner Pedro Solbes said that Germany could not count on EU support for its stimulus plan if it fails to bring its deficit under the three percent ceiling established by the Stability and Growth Pact. Germany’s finance minister, Hans Eichel, insisted Sunday that next year’s deficit would be just under the EU limit, but most analysts are less optimistic.

Jochen Dieckmann, regional finance minister in Germany’s biggest state North-Rhine Westphalia, and a member of Schröder’s Social Democrats, told reporters on Monday that meeting the EU deficit limit for 2004 is now "simply impossible."

If that is the case, it will be the third year in a row that Germany fails to bring its budget within the EU fiscal framework. Berlin is already facing EU disciplinary measures for surpassing the three percent ceiling. Another missed target could mean a credibility blow to the euro zone pact.

An EU fetish or a valuable tool?

EU Commission President Romano Prodi warned Germany against taking any steps that could cause the euro zone Stability Pact to come unraveled. The pact, which was originally designed to prevent EU countries which adopted the euro from burdening the single currency with hefty budget deficits, has come into question as some of the euro zone’s biggest economies -- Germany, France and Italy -- struggle with economic downturns and risk running foul of the deficit rules.

Germany’s failure to remain within the pact’s budgetary guidelines is seen by many as an indication that the agreement needs to be reformed.

Just ahead of taking over the EU’s rotating presidency on July 1, Italy’s Minister for European Affairs Rocco Buttiglione called for a reconsideration of the Stability Pact. "Many of the things that appeared set in stone at one time are no longer so," he told the daily Berliner Zeitung on Saturday. The Italian minister criticized the pact as "hypocritical" and proposed "a reasonable and transparent reform" which both "reinforces it and makes it more flexible."

Luxembourg’s Prime Minister Jean-Claude Juncker, who was the only foreign official attending the German government’s weekend retreat to discuss tax reforms, said the Stability Pact needed to be reformed. "It simply can’t be that the pact is held onto like a fetish," he was quoted as saying in the Berliner Zeitung.

But Prodi for his part called on the euro zone members to adhere to the budget guidelines, which "have helped the EU to resist inflation and keep interest rates low." He told the German Bild am Sontag that the pact "is and remains an extremely valuable tool which we should use with intelligence."

Although several countries are having difficulty keeping their budget deficit under three percent of GDP, Prodi said in the Sunday paper that he disagreed with those who argued that "governments should move away from a healthy base that supports the euro."