Every year, in compliance with section 2 of the Economic Stability and Growth Act ( Gesetz zur Förderung der Stabilität und des Wachstums der Wirtschaft ), the German government presents its Annual Economic Report. It contains aggregate economic data for the relevant year and a statement on the German Council of Economic Experts’ annual report.

Entitled “Strengthening the social market economy – leveraging potential for growth, boosting competitiveness”, this year’s Annual Economic Report was adopted by the federal cabinet on 30 January 2019. This article presents extracts from the sections on budget and tax policy as well as European and financial market policy.1

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Pursuing sound fiscal policies, strengthening sources of growth, monitoring and supporting structural change

The German economy is experiencing growth for the tenth year in a row. The labour market continues to thrive. With rising wages, employment, and corporate investment levels, the domestic economy remains a key driver of economic growth, and the upswing is benefiting broad segments of the population. However, risks from the external economic environment have grown.

The German government’s economic and fiscal policies are still guided by the tenets of the social market economy. The aim is to balance, on the one hand, a strong economic order characterised by individual freedom, collective bargaining autonomy and competition and, on the other hand, a high level of social equity, social participation and responsibility for the common good.

The German government continues to pursue forward-looking, fair and sound fiscal policies. Public investment in Germany’s future has been substantially increased, and the disposable incomes of families and low-income earners have been boosted – all without incurring new debt.

According to the Federal Statistical Office’s initial calculations, the general government’s budget surplus in the national accounts amounted to €59.2 billion last year. The federal level contributed to this: primarily as a result of the strong macroeconomic momentum and the very favourable financing conditions, the federal budget (as defined in the national accounts) posted a surplus of €20.3 billion in 2018. Over the projection period, the Länder and local authorities in particular are expected to record surpluses, partly thanks to transfers by the federal government to the Länder and local authorities. General government debt trends also reflect the favourable fiscal situation: for example, the general government debt-to-GDP ratio continued to decline to an estimated 60% last year. According to the government’s most recent projection, the debt-to-GDP ratio will fall below the Maastricht reference value of 60% in 2019 (see Figure 1).

Debt-to-GDP ratio

in %

Sources: 2005–2017: Deutsche Bundesbank; 2018–2022: Federal Finance Ministry projection; figures as of November 2018; projections rounded to ¼% of GDP
Figure 1
JahrDebt-to-GDP ratio

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Greater scope for investment in Länder and local authorities

The Länder and local authorities are increasingly making use of the additional scope for investment created by high receipts in recent years, with average revenue increases of over 5% every year since 2010. This revenue trend is set to continue in the coming years.

According to the current tax revenue estimate, the distribution of tax receipts will continue to shift in favour of the Länder until 2023. The federal government’s supportive policies have played a significant role in improving the financial situation of the Länder and local authorities. In particular, the federal government has eased the burden on local authorities in the area of social spending. For example, it reimburses local authorities in full for the costs of basic income support for elderly people and for people with reduced earning capacity and has increased its contribution towards housing and heating costs provided under Book II of the Social Code.

The Federation will continue its support of the Länder and local authorities. Measures adopted in 2018 provide for continued relief for refugee-related costs (€6.3 billion), increased funding for the Local Transport Financing Act ( Gemeindeverkehrsfinanzierungsgesetz ) (€1.7 billion up to and including 2022), spending in the area of child day care (€5.5 billion), funding for all-day school/all-day childcare for children of primary school age (€2 billion from 2020) and funding for social housing, including compensation payments (an additional €2.5 billion from 2019 to 2021). Funds from the special digital infrastructure fund will be provided to boost the use of digital technology in schools and expand gigabit networks. This special fund already received a €2.4 billion allocation from the federal budget in 2018. Starting in 2019, the Länder will no longer have to contribute to the German Unity Fund. As a result, the Länder share of VAT revenue will increase by more than €2.2 billion per year at the expense of the Federation.

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Compensation payments

Since the 2006 reform of Germany’s federal system, the Länder have been receiving allocations to compensate them for the 2007 discontinuation of financial assistance in areas such as subsidised housing and the improvement of local authorities’ transport infrastructure. These funds are referred to as “unbundling funds” ( Entflechtungsmittel ) and are provided on the basis of the Unbundling Act ( Entflechtungsgesetz ). As part of the reorganisation of the federal financial equalisation system, which will come into effect in 2020, the Länder will receive a higher share of VAT revenue once the compensation payments expire at the end of 2019.

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Working together on regional structural policy for eastern and western Germany

The strong performance of the German economy has also helped economically weaker regions to catch up. Per capita income levels show a general trend towards convergence. However, progress is slow and not evenly distributed across all regions.

The German government’s regional policy aims to improve the economic prospects of people living in structurally weak regions – in both eastern and western Germany; in both urban and rural areas – and to contribute to ensuring that the standard of living is equally high throughout the country. In addition to established and new programmes such as the joint Federal/ Länder task for the improvement of regional economic structures and the Mining Regions Enterprise project, the German government has set up a commission for equivalent standards of living. The commission’s task is to analyse the financial situation of local authorities in terms of living standards and to propose possible approaches for solving local authorities’ problems in connection with existing debts and cash advances, keeping in mind the constitutional distribution of financial responsibilities. Against the background of the expiry of the Solidarity Pact II at the end of 2019, the commission has also been tasked with developing a funding system for structurally weak regions, building on the key elements adopted in the previous legislative period.

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The Mining Regions Enterprise project

will feature competitions for ideas and projects that could serve as models for the regions affected as well as for other regions. The federal government is providing €4 million annually from the Energy and Climate Protection Fund for at least ten years from 2018 onwards to support structural change in the four lignite-mining regions.

On 6 June 2018, the federal government set up a commission for growth, structural change and employment. Made up of various economic and social stakeholders, the commission has put forward proposals to help achieve the 2030 sectoral target for the energy industry set out in the Climate Action Plan 2050. It has also developed recommendations for the gradual reduction and phasing out of coal power as well as proposals for forward-looking and sustainable structural development in the affected regions.

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Fair and efficient taxation

Overall, Germany’s system of taxes, social security contributions and transfers is fair and efficient. It is an expression of Germany’s social market economy, strengthening social cohesion while also providing performance incentives. In Germany, taxes and social security contributions go hand-in-hand with high-quality public services and a well-developed social security system.

Nevertheless, the federal government aims to make targeted, fair and incentive-enhancing improvements to the transfer systems as well as growth-friendly reductions in taxes and social security contributions that will benefit broad segments of the population. The Act to Reduce Family Tax Burdens and to Modify Additional Tax Regulations ( Gesetz zur steuerlichen Entlastung der Familien sowie zur Anpassung weiterer steuerlicher Regelungen ) entered into force at the beginning of 2019. These measures affect income tax in 2019 and 2020 and will make taxpayers as a whole €9.8 billion better off each year. The tax cuts will especially benefit families and low and middle income earners. In addition, the solidarity surcharge will be abolished for around 90% of all taxpayers through the introduction of an exempt amount (with a sliding transitional range) with effect from 2021.

The Federal Government also intends to create tax incentives in the area of housing policy. On 29 November 2018, the Bundestag passed legislation to implement tax incentives for the construction of new affordable rental properties as provided for in the Housing Initiative. The law still requires the consent of the Bundesrat. In addition, property tax, which represents an indispensable source of income for the local authorities, will undergo a reform, in which the requirements of the Federal Constitutional Court will be observed, a fair and socially equitable distribution of tax payments will be guaranteed, negative effects on rental prices will be avoided, current revenue levels will be secured, and the local authorities will retain the right to apply a multiplier.

The federal government also wants to ensure that businesses enjoy growth-friendly and fair tax conditions on a long-term basis. One important element of this is the introduction of tax incentives for research, as envisaged in the coalition agreement. The Federal Ministry of Finance will present draft legislation on this in the first half of 2019.

Alongside improvements for individuals and companies, another central tax policy priority for the German government is the fight against tax fraud and tax avoidance. The Act on Avoiding Losses in VAT Revenue in the Online Goods Trade and Amending Further Tax Provisions ( Gesetz zur Vermeidung von Umsatzsteuerausfällen beim Handel mit Waren im Internet und zur Änderung weiterer steuerlicher Vorschriften ) of 11 December 2018 made marketplaces liable for remitting VAT.

The government is committed to fair and efficient taxation beyond Germany’s national borders, as well. When it comes to taxing the digital economy, for example, a comprehensive and coordinated international approach is needed. In this context, combating the causes of base erosion and profit shifting (BEPS) remains a central issue, following on from the successful BEPS project of the G20 and the Organisation for Economic Co-operation and Development (OECD). The digital economy throws existing BEPS problems into sharp relief. In order to address existing challenges in taxing the digital economy and other BEPS problems, the OECD is currently discussing the redistribution of taxation rights and – at the joint initiative of Germany and France – measures for effective international minimum taxation.

Franco-German cooperation on a common corporate tax base will speed up the harmonisation of direct taxes and provide new momentum for the stalled negotiations in the Council of the European Union. This work is based on a draft directive by the European Commission. Germany and France reached a political consensus on their joint position at a meeting of government ministers held in Meseberg in June 2018. They also launched an initiative to breathe new life into the halting negotiations on a European financial transaction tax.

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Shaping Europe and making financial markets fit for the future

Europe is facing major challenges. Alongside global issues such as climate change and the spread of digital technology, these challenges also include Brexit and the future form of the economic and monetary union. It is important to ensure that EU member states retain a high level of competitiveness and that their economies converge at a high level. Other priorities include financial stability, social balance and aspects of ecological sustainability. The German government wants to make Europe and financial markets fit for the future. This involves linking individual responsibility and liability, ensuring subsidiarity in the allocation of responsibilities between the EU and its member states, promoting solidarity in times of crisis, maintaining stable institutions, and supporting an effective, rules-based legal framework.

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Deepening the European single market, developing the economic and monetary union

The European single market is one of the EU’s major achievements. Current challenges include the upheavals precipitated by digital technologies, the structural changes required to achieve climate protection targets, and the need to strengthen the EU’s global competitiveness, adaptability and capacity for innovation. For this reason, framework conditions must be set in such a way that they offer European companies good start-up and growth opportunities in the global environment. In addition, state aid rules need to be reviewed to see whether there is any room for improvement in key areas that will enhance the innovative capacity and viability of European companies.

A competitive and crisis-resistant euro area is central to ensuring that the European Union is fit for the future. At the Euro Summit in December 2018, the member states therefore agreed on a comprehensive package of reforms aimed at strengthening the economic and monetary union. In addition to expanding the European Stability Mechanism (ESM), finance ministers will draw up key points for an instrument to enhance competitiveness and convergence in the euro area, which will be included in the EU budget. The German government believes that this budget should provide genuine added value for the euro area. When it comes to working out the details of this instrument, the German government therefore wants to promote measures that contribute to greater convergence and enhanced competitiveness.

In future, the ESM will contribute to crisis prevention, play a greater role as a creditor institution in ESM programmes, serve as a backstop for the Single Resolution Mechanism (SRM) in a way that is budget-neutral in the medium term, and have more efficient precautionary tools at its disposal. Moreover, the debt sustainability framework will be improved. This includes the inclusion of collective action clauses with single-limb aggregation in newly issued government bonds from 2022 onwards, which will make it easier to prevent holdouts from potentially blocking necessary debt restructuring.

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Improving financial market regulation

A strong financial system is a prerequisite for sustainable financing of economic activity and thus for future growth and employment. However, the most recent financial crisis has shown that disruptions in the financial system can have substantial negative effects on the economy as a whole. Regulatory supervision is therefore justified. Against this background, the impact of climate change on financial stability also needs to be considered. At the same time, financial market regulation needs to be targeted and proportionate to ensure that small and medium-sized enterprises in particular are not unduly burdened by regulatory requirements.

The European banking union contributes to maintaining the stability of the financial sector. Alongside the Single Supervisory Mechanism (SSM), the second element of the banking union is the Single Resolution Mechanism (SRM). These are joint instruments for the supervision and resolution of banks whose difficulties could pose a threat to the stability of financial markets. The European Union has set up the Single Resolution Fund (SRF) to finance future resolutions. Financed through bank levies, its volume is expected to reach approximately €60–70 billion by the end of 2023.

In addition to further steps to reduce risks on bank balance sheets, the member states agreed in December 2018 to further develop the banking union by creating a common backstop to the SRF at the ESM. This will strengthen the resolution fund and enhance the credibility of existing crisis management instruments, thus contributing to the stability of the banking sector. In the German government’s view, negotiations on the European Deposit Insurance Scheme (EDIS) can only be taken up after a substantial further reduction of bank risks.

The capital market union is to be completed by 2019, creating a common EU capital market that will give companies Europe-wide access to a broad range of financing options as an alternative to bank financing. Against the background of Brexit, diversified financing options to cover the capital requirements of the European economy are more important than ever before. Many of the measures proposed by the European Commission since 2015 have already been completed and implemented. Other projects are still being negotiated in Brussels, including changes to European financial market supervision, the introduction of a Europe-wide private pension product, and a proposal for improved supervision of central clearing houses.

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The full report is available (in German only) here.