As I discussed earlier in a post on the MMP system in Germany and New Zealand, the recent election in Germany has delivered a difficult situation (see also here). Last week, in an article on the new coalition government, The Economist described the challenges ahead for Angela Merkel. In my opinion, the German situation is to be watched for at least two reasons:
- There is a greater likelihood for policy reforms in Germany than in France or in Italy for instance. I suspect a good chunk of the German population understands that the rise of union power, and the implementation of nation-wide collective bargaining and other labor-market regulations over the last twenty years, have taken their tolls on the German economy (for a very good paper on this topic, see “The Rise and Fall of the German Miracle” by Wolfgang Kerber and Sandra Hartig published in Critical Review in 1999).
- The impact of German reforms on Western Europe would be considerable. If Germany were to implement the reforms needed, the French, but also the Italians, the Belgians, and many others in the EU who have resisted most reforms, could not hide their heads in the sand anymore. German reforms would be a catalyst for the rest of Europe – and more so, in my opinion, than reforms in France or Italy would.
As The Economist explains, the recent policy decisions taken by Merkel and her coalition are not very promising. Germany, like France and Italy, badly needs a reform of its labor regulations and tax system, but these ideas have been postponed to a later date. For now, the government wants to reduce the budget deficit by raising the value-added-tax (VAT) from 16% to 19% (in addition to some small spending cuts). Moreover, it plans to implement an “impulse program” of spending in the amount of €25b over the next four years.
The increase in the VAT rests on the idea that taxing consumption is less damaging for investment and growth than taxing income or capital. The VAT, being largely self-enforcing, is one of the preferred tax instruments in the EU. VAT rates throughout the EU have often been very high (even above 30% for some “luxury” goods in the 1970s and 1980s - see here for current rates). This is possibly because the tax-free zones at the bottom of the respective income tax schedules are larger (i.e. a bigger fraction of the population is not tax-liable on its income) in Western Europe than elsewhere (e.g. New Zealand does not have a tax-free zone, but it is an exception).
Considering the size of the VAT base and that the rate is already high, a three-percent increase will have negative consequences on economic activity. How much is hard to say. Moreover, controlling budget deficits via tax increases is almost always a bad idea. Also, it is not true that one can tax consumption without affecting other choices individuals make. At the end of the day, there is only one tax base (i.e. the income derived from market exchanges), but different taxes will offer different avoidance opportunities.
Germany may become a very important laboratory for reforms in the coming months and this would have a huge impact on the EU. I am excited about it, but I don’t hold my breath.
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