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27 April 2017

EU re­view of Ger­many’s pub­lic fi­nances: Tar­gets met, chal­lenges re­main

  • In its annual Stability Programme, Germany provides the European Commission and the ECOFIN Council with an update on its compliance with the Stability and Growth Pact.
  • The general government budget – which encompasses the budgets of the Federation, Länder, local authorities and social security funds, all of which posted surpluses – is in compliance with all EU rules. All government levels will continue their sound budget policies throughout the 2017–2021 projection period and will thus contribute to the gradual decline of the debt ratio.
  • Despite the balanced budgets, there is an increasing need for action on both the revenue and expenditure sides to ensure that public finances remain resilient to economic trends, interest rate changes and demographic developments.

German government presents 2017 update of the Stability Programme

In April of each year, the member states of the euro area submit Stability Programmes in which they report on compliance with fiscal policy requirements and describe their fiscal policy plans. The 2017 update of the German Stability Programme was approved by the federal cabinet on 12 April 2017.1

The 2017 update of the Stability Programme shows that Germany’s steady and reliable fiscal policy is contributing to positive economic trends and stability in Europe. The general government budget – which encompasses the budgets of the Federation, Länder, local authorities and social security funds – has fulfilled the requirement of being close to balance every year during the current legislative term. In 2016, public budgets generated a surplus of 0.8% of GDP overall. By adopting a federal budget that contained no new borrowing, the federal government played a decisive role in this achievement. Having peaked in 2010, the general government debt-to-GDP ratio has declined considerably in the intervening period. It stood at 68.3% at the end of 2016 and is projected to continue to fall to 66¼% this year.

This development is being boosted by a favourable macroeconomic environment. Germany’s economic growth has continued for eight years in a row and has outstripped potential output since 2014. The number of jobs requiring social security contributions has increased every year since 2010, unemployment is at its lowest level since German reunification, and there has been a significant rise in wages, salaries and pensions. This has resulted in higher revenues for the Federation, Länder, local authorities and social security funds. In 2016, the revenue ratio increased to 45.1% of GDP, the highest level recorded since 2000. At the same time, low interest rates, which are not least a result of the ECB’s extremely expansionary monetary policy, are greatly reducing the interest burden on public budgets. The federal government’s fiscal planning envisages that the general government debt-to-GDP ratio will fall below 60% in 2020. Germany would then be in compliance with the EU’s upper limit on government debt.

Nonetheless, Germany’s public budgets face multiple challenges when it comes to safeguarding the state’s long-term fiscal capacity. The Federation, Länder and local authorities still face the task of providing humanitarian assistance to hundreds of thousands of refugees, fighting the root causes of refugee flows, and supporting the social integration of refugees. The federal government has set aside €18.7bn in reserves for refugee-related costs, which will have been fully drawn down by 2019. The ageing population can be expected to generate greater fiscal burdens for the general government as baby boomers start reaching retirement age towards the beginning of the next decade. Social spending, particularly on long-term care, health care and pensions, is already by far the biggest single item of spending in the federal budget. According to current projections, its share of the budget will continue to rise until 2021. High employment levels and the noticeable increase in salaries and wages caused the ratio of taxes to overall economic output to rise to 40% of GDP in 2016 (well above its long-term average) due to the effects of the progressive tax system. To ensure future growth and employment, disciplined fiscal policies are therefore required on both the expenditure and revenue side. This is even more important given the fact that the interest burden on public budgets is significantly lower – by 0.8 percentage points of GDP – than it was before the financial crisis started in 2008. Overall, forward-looking fiscal policies must prepare for the necessary normalisation of European monetary policy and interest rates.

For this reason, the federal government is committed to continuing its course of sound, growth-friendly fiscal policy. At the same time, it is important to make use of the good economic situation to increase the budget’s resilience to economic trends, interest rate changes and demographic developments and to keep reducing debt levels. Germany’s Stability Programme reflects these goals.

Current state of play: No budget deficit for the fifth year in a row

The Stability and Growth Pact (SGP) requires member states to bring their budgets close to balance over the medium term and to set their own binding targets to this end. The Pact also sets upper limits on budget deficits and debt ratios. Compliance with these targets and limits serves to safeguard each euro member state’s capacity to act. In this way, the Pact requires that all EU member states pursue stability-oriented fiscal policies as a precondition for ensuring strong, sustainable growth in Europe.

In 2016, Germany once again complied in full with the rules of the SGP. Germany’s budget policies successfully kept the country’s nominal deficit well below the upper limit of 3% of GDP. In 2016, the actual budget balance stood at +0.8% of GDP. This means that Germany’s general government budget (encompassing the Federation, Länder, local authorities and social security funds, including their off-budget entities) fulfilled the requirement of being close to balance for the fifth year in a row. All government levels achieved budget surpluses.

General government structural surplus

From a structural standpoint as well, the general government budget posted a surplus of 0.8% of GDP in 2016. In contrast to the actual balance, the structural balance is not based on the current economic situation but on normal economic conditions, known as potential output.

Potential output

is a measure of the production capacity of the economy as a whole, which determines an economy’s potential for growth over the medium and long term.

The structural balance therefore reflects fiscal conditions based on the fundamental underlying structures, excluding cyclical factors and one-off effects.

Infographic shows the comparison of structural and actual fiscal balance.

While the actual fiscal balance improved slightly on the year in 2016, the opposite is true for the structural balance, as shown in Figure 1: Last year, the structural surplus for the Federation, Länder, local authorities and social security funds declined from 1.0% of GDP to 0.8% of GDP. Overall, economic conditions in Germany improved substantially, with the output gap closing between 2015 and 2016. Taken by itself, the improved economic conditions would have resulted in an even higher general government budget surplus. However, due to the dynamic growth in primary spending (i.e. spending excluding interest payments), which outpaced GDP growth, the structural surplus declined slightly.

The cyclically adjusted primary balance fell in 2016, meaning that Germany’s fiscal policy had an expansionary effect on the economy. This year, too, the impact of fiscal policies is expected to be slightly expansionary, as a result of increased refugee-related expenses; government investment; tax relief for families, single parents and low income earners; and rising levels of expenditure by social security funds.

With the economy near full capacity, an expansionary fiscal policy is, in principle, not appropriate from an economic point of view. It could heighten the risks of regional imbalances, sectoral overheating, and fiscal instability, which would cause medium- and long-term damage to the economy in both Germany and the euro area. All empirical evidence suggests that more government spending in Germany, such as higher levels of public investment, would stimulate only very little growth in partner countries.

Debt levels continuing to decline

Public budget surpluses are contributing to the sustained reduction of the debt ratio to levels below the Maastricht upper limit of 60% of GDP. At 68.3% of GDP, the debt ratio at the end of 2016 was still well above the Maastricht limit. However, it has already been significantly reduced from the levels posted during the crisis, in 2009 and 2010, which makes it clear that the consolidation strategy is working. In 2016, the debt-to-GDP ratio declined appreciably, by 2.9 percentage points. This means that Germany is in compliance with the “1/20 rule”, which has been in effect since the 2011 revisions to the Stability Pact. This rule, which is binding on all member states, requires that the gap between a member state’s debt level and the 60% Maastricht upper limit be reduced by at least 1/20 per year, averaged over the most recent three years. Germany has fulfilled this requirement for the relevant three-year period from 2014 to 2016.

The decline in the 2016 debt ratio is mainly a result of the positive trends in the public budgets of the Federation and the Länder. The reduced debt levels can be attributed in particular to the core budgets of the Federation and the Länder, which generated strong surpluses. The debt levels of the local authorities and social security funds, on the other hand, remained largely unchanged. Unlike in previous years, the resolution authorities set up by the Federation and the Länder did not contribute to a further reduction of debt levels in 2016. Debt reduction at existing resolution authorities was offset by the creation of a new resolution authority at the Länder level.

The federal government has committed itself to taking on no new debt in 2017, too. The federal cabinet reaffirmed this commitment on 15 March 2017 when it adopted its benchmark figures for the 2018 federal budget. The current federal government plans to continue its course of sound budgetary and fiscal policies that take the demographic situation into account. In the financial plan for 2018–2021, the federal government reaffirmed its goal of achieving balanced federal budgets. However, the draft budgetary plan envisages that the next federal government will reduce budget-wide spending by €4.9bn in total.

Declining interest payments, rising government spending ratio

To ensure sound fiscal and budget policies, it is essential not only to address current challenges but also to identify in advance basic spending trends and their medium- and long-term consequences so that appropriate measures can be adopted if necessary. For example, the share of interest expenditure in total federal budget spending (interest expenditure ratio, as defined in fiscal statistics) declined from its highest level of 16.6% in 1999 to 5.6% in 2016. Interest expenditure again declined in 2016, by 8.3% in year-on-year terms. The lower interest burdens are mainly a result of extraordinary monetary policy measures and associated conditions on European capital markets. However, the low interest spending is temporary and should not allow policy-makers to lose sight of the fact that government expenditure rose by 4.0% in 2016, a higher increase than in previous years. The government expenditure ratio stood at 44.3%.

This was once again driven by expenditures on social benefits (i.e. social benefits other than social transfers in kind as well as social benefits in kind), which grew by 4.5% on the year, and by a sharp year-on-year rise of +8.7% in intermediate consumption.

Intermediate consumption

According to the definition of the Federal Statistical Office, intermediate consumption refers to the value of goods and services procured by the government and used in the course of its own production. Under the 2010 European system of integrated economic accounts, government intermediate consumption does not include spending on purchased research and development or military weapons systems.

The main factors behind this were trends in spending by social security funds and the costs of refugee assistance and accommodation. According to current estimates, costs associated with refugee-related immigration required additional budgetary resources totalling ½% of GDP in 2016 compared with 2014, the year preceding the strong influx of refugees. All government levels will cover additional costs associated with the refugee situation. However, the federal government is giving additional support to the Länder and local authorities to help them provide assistance and housing for refugees and is therefore bearing the lion’s share of the burden.

Outlook: Fiscal policy in the coming years

The general government budget is expected to remain close to balance throughout the 2017–2021 projection period (Table 1). Factors that will have an adverse impact on the general government budget balance in 2017 and in subsequent years are the outflows of funds from the Local Authority Investment Promotion Fund, the Energy and Climate Fund, and the reserves to cover the costs of tasks associated with receiving and accommodating refugees and asylum-seekers. As a result, the general government balance will deteriorate slightly, but will continue to be able to post surpluses thanks to positive economic trends and the relief provided by lower interest expenditure.

Government budget surplus to be maintained in the medium term

The Federation, Länder and local authority budgets are expected to remain close to balance throughout the projection period to 2021. Overall, the budgets of social security funds are expected to be balanced in the years from 2017 to 2021, although there will be financing deficits in the statutory pension insurance system due to a decline in sustainability reserves. Surpluses in recent years, especially in the statutory pension and health insurance funds, allowed these systems to build up large financial reserves. As long as deficits in the pension insurance system can be financed by drawing on reserves, increases in contribution rates will not be necessary.

Table 1: Budget balances according to government level
 201620172018201920202021

- in % of GDP -

Central government0.2000¼¼
State government0.2¼00¼¼
Local government0.1¼0000
Social security funds0.300000
General government0.8½¼¼½½
Discrepancies in the totals are due to rounding. Figures for the projection period are rounded to a quarter of a percentage point of GDP.
Source: Federal Ministry of Finance

Compliance with structural deficit limit, but above-average increase in primary spending

According to the federal government’s projection, Germany’s structural balance will remain balanced throughout the entire projection period, with an output gap close to zero. Germany will therefore continue to fulfil its medium-term objective of a structural deficit no higher than 0.5% of GDP in the years from 2017 to 2021.

Table 2: Structural balance compared with actual balance and GDP trend
 201620172018201920202021
Structural balance (% of GDP)0.8½¼¼½½
Actual balance (% of GDP)0.8½¼¼½½
Real GDP (% change yoy)1.91.41.61.51.51.5
Source: Federal Ministry of Finance

In addition to the medium-term objective, the preventive arm of the SGP also includes an expenditure benchmark. Under this rule, member states that do not yet comply with their medium-term budgetary objective, or comply without a safety margin, must make sure their primary expenditure does not increase at a faster pace than their average nominal potential output (i.e. GDP trends under normal capacity utilisation). Primary spending is adjusted for cyclical labour market effects, fluctuations in investment spending from the average investment level, co-financed EU programmes, discretionary measures on the revenue side, and one-off effects on the revenue and expenditure sides.

In some years, Germany’s primary spending is projected to rise at a significantly higher rate than its nominal potential output. Because Germany will continue to meet its medium-term objective by a comfortable margin, the expenditure benchmark under Article 5 of Council Regulation (EC) No 1466/97 is not binding, in accordance with the Specifications on the implementation of the Stability and Growth Pact. Nevertheless, this indicator points to heightened budgetary risks in the event of a normalisation of interest expenditure or less favourable economic trends.

Table 3: Expenditure benchmark: Projected primary expenditure and potential output
 201620172018201920202021
Primary expenditure
(yoy increase; according to the expenditure benchmark definition)
4.7

Nominal GDP potential

(moving ten-year annual average)

2.72.72.82.93.03.1
Figures for the projection period are rounded to the nearest quarter of a percentage point of GDP.
Source: Federal Ministry of Finance

Debt ratio to fall below 60% of GDP in 2020

The good condition of public budgets and the planned further winding down of the resolution authorities’ portfolios will continue to have a favourable impact on the debt ratio over the course of the projection period to 2021. This ratio is expected to decline in 2017, falling by roughly 2 percentage points to 66¼% of GDP. The debt ratio is projected to drop to 57% of GDP by the end of the projection period in 2021. It is set to fall below the 60% limit in 2020, which would achieve a key target of the coalition agreement between the current governing parties.

The fact that debt trends in the projection period to 2021 are slightly less favourable than forecast last year can be attributed to a revision of nominal GDP trends. The GDP deflator declined following a fall in energy prices, resulting in slightly weaker GDP projections at the beginning of 2017 than had been anticipated in 2016.

Table 4: Trends in the debt-to-GDP ratio
 201620172018201920202021
 - Debt ratio in % of GDP -
April 2017 update68.366¼6461¾59¾57
April 2016 update68½65¾63½61¼59½-
Debt-to-GDP ratios for the projection period are rounded to a quarter of a percentage point of GDP.
Source: Federal Ministry of Finance

Conclusion

By staying on the path towards consolidation, the federal government has reinforced domestic growth drivers and bolstered consumer and business confidence. Moreover, this path has led to a steady reduction in structural debt and enabled the government to comply with constitutional debt brake requirements by solid margins. In this way, the course has been set for the long-term sustainability of public finances. The 2017 update of Germany’s Stability Programme also makes it clear that Germany will continue to comply in full with all its European and domestic fiscal policy obligations in the coming years.

In order to maintain the state’s full capacity to act in the face of demographic change, increasing social spending and a creeping rise in the burden of tax and social security contributions, Germany will have to continue along its path of growth-friendly fiscal and budget policy. Sustainable public finances will ensure that future generations have flexible options when it comes to making decisions and taking policy action. This remains the guiding principle behind Germany’s fiscal policy strategy.

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