Beans: Germany's Destructive Tax Increase

On Friday May the 19th, Germany's lower house of parliament approved a increase in the value added tax from 16% to 19% by 2007. This move is complete madness and risks sending the German economy back into a recession in 2007. At the very least, Germany is likely to perform worse than other European economies -including even Italy-.

That it was this proposed tax increase that prevented the Christian Democrats from gaining a majority with the relatively free market party Free Democrats in last year's election apparently did not deter her from pushing through this tax increase in coalition negotiations with the Social Democrats, nor did it apparently deter the Social Democrats from accepting this despite the fact that they campaigned against it.

Finance Minister Peer Steinbrueck tries to defend the move arguing it is "necessary", presumably with regards to reducing the budget deficit. And he adds that a third of the revenues will be reduced to cut payroll taxes.

To the extent that this is a shift from payroll taxes to the VAT, this is simply a form of mercantilist shift of the tax burden from exporters to importers. A form of non-currency devaluation so to speak. While domestic producers selling goods in Germany will be unaffected by such a shift, imported goods (who are taxed by the VAT but not the payroll tax) will get a tax increase while exporters (who are taxed by payroll taxes but not the VAT) will get a tax cut.

As Germany already have a large trade surplus and a weak domestic economy, it is curious that the German politicians would think that the solution to Germany's weak economy is to aggravate this dichotomy between strong export industries and weak domestic sectors. Still, while it won't do much good, it won't do much damage either as the harm to one part of the economy will largely be cancelled out by the benefits for another.

As for the 2%:points which will not be used for payroll tax cuts, saying this is necessary to reduce the deficit is simply not true, particularly since the government is in fact planning a massive increase in wasteful so-called government investments.It would have been far more effective to cancel this spending increase and instead reduce government spending.

German politicians should have studied the example of Japan who have made the same mistakes that the German politicans now seem hell-bent on repeating. In 1997, the consumption tax in Japan was raised by 2%:points, something which broke the back of the fragile economic recovery that was underway in Japan at the same time. Meanwhile, massive government "investments" have done absolutely nothing to raise growth in Japan. All they have done is to create a hugh national debt.

If the German politicans had wanted to reduce the deficit without weakening the economy, they should instead follow the example of Japanese politicans in recent years. Although the level of government "investments" is still far too high and higher than in most other countries, it have in fact been reduced significantly in recent years. While the spending on purchases classified as government consumption have gone up somewhat, the reduction of government "investments" have been big enough to reduce the overall level of government demand. Yet, in sharp contrast to what happened after the 1997 tax hike, the reduction in government spending have not pushed the Japanese economy into a recession. Instead, Japan have had the longest and strongest period of growth since the bursting of the asset price bubble in 1990. In fact, taking into account the rising investment income surplus and the falling population, income levels in Japan have risen faster than not only the major European economies but in America too.

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