of Reform Policy and Privatization
European Economic Senate Survey
by the IW Köln
Summary, conclusion, recommendations
In 2006 and 2007 Germany enjoyed impressive real GDP growth rates which compare well with those of other European countries. In 2008, with a positive development of 1.7 per cent, an acceptable growth rate will have been achieved. However, this is solely due to a good first quarter. The rest of the year has been characterised by stagnation. Nevertheless, looking back, it is worth remembering that Germany has succeeded, at least temporarily, in developing from the "Sick Man of Europe" at the beginning of the decade to an "engine of growth". The Federal Government's economic policy can take a great deal of the credit for this - around a third, in fact, according to the estimate of the IW Köln (Cologne Institute for Economic Studies) (Grömling/Plünnecke/Scharnagel, 43). As the Institute's ‘Reform Barometer' shows, it was above all the "Agenda 2010", introduced by the coalition of the (socialist) SPD and the Greens, which set the economy on course for more employment and growth. The subsequent grand coalition formed by the (conservative) Christian Union and the SPD initially continued along the same successful path and even launched new initiatives to strengthen the potential for growth. However, this positive trend lasted only until the summer of 2007. After that, economic policy was put into reverse and since then the Reform Barometer has tended to point downwards. The Federal Government is now squandering the hard earned dividends of earlier reforms.
Yet there is no reason to abandon the successful course of reform. Firstly, the successes are visible, particularly in the labour market. Secondly, in recent years many other countries have made strenuous efforts to improve their business environment and make themselves attractive locations for investment and production. And indeed, many international location rankings show that Germany has not always succeeded in defending its position. In the widely respected IMD World Competitiveness Ranking, between 1995 and 2008 Germany slipped from sixth to sixteenth position. According to the Fraser Index of Economic Freedom, between 1995 and 2005 Germany dropped from 13th to 17th place. In 1995 Germany was third in the EU 15 in terms of per capita income (in euros and at constant prices and exchange rates), yet in 2007 it was only sixth. Again and again it turns out that Germany's relatively rigid labour market rules and strict regulation are to blame for its below-average showing in comparison with other countries.
Despite a partial relaxation in employment protection, legislation is still much more restrictive in Germany than in many other countries. In this respect the Anglo-Saxon nations, the USA, the United Kingdom and Canada score highest. But even countries like Switzerland, Denmark, Austria and Finland have regulated job protection less. According to an investigation by the World Bank, it costs German companies an average of 69 weeks' wages to dismiss a worker. The equivalent figure for Denmark is only 10 weeks' wages, and even in France, which in this comparison also scores relatively poorly, the cost is only 32 weeks' pay.
This strict labour market regulation is aggravated by high labour costs. According to calculations by the IW Köln, in 2007 companies in German manufacturing industry had to pay just under 33 euros for an hour of labour. Only in Belgium, Sweden and Denmark are labour costs higher than in Germany. German companies are competing in world markets with labour costs of 23 euros in the USA and 18 euros in Japan, for example, to say nothing of the very cheap labour costs in the low cost countries of Eastern Europe. Nor does it change the basic picture if we take into account the fact that the labour costs in important sectors which supply manufacturing industry (for example trade, logistics and business services) are relatively cheaper in Germany. Even factoring in its dense network of intermediate suppliers Germany remains, with its fifth place, in the top group of the labour cost ranking.
Germany's poor showing in terms of labour costs is connected with the high burden of payroll taxes. The ‘tax wedge' (income and social insurance contributions as a percentage of labour costs) for an unmarried employee on an average wage in Germany comes to 52.2 per cent. Put another way: after all deductions employees receive only 47.8 per cent of their total cost to the employer. Only in Belgium and Hungary is the tax wedge higher than in Germany. Ireland's position, by contrast, is particularly favourable: there taxes and social security contributions amount to a meagre 22.3 per cent of total labour costs.
It is not only the burden of payroll taxes which dampens the incentive to work. Equally to blame are the so-called net replacement rates for the unemployed (unemployment benefit as a percentage of net earnings before unemployment), which in comparison with other countries are also relatively high in Germany. According to OECD calculations, the rate in Germany is 73 per cent. In only four countries, Portugal, Switzerland, France and Denmark, is it higher. Even after 60 months of unemployment the net replacement rate is still 52 per cent. As scientific studies have successfully shown, high replacement rates and long periods of entitlement to unemployment benefit reduce the incentives to seek new employment quickly and accept wage cuts and thus prolong the average period of unemployment.
Unfortunately, high labour costs are not compensated for by an equally high level of productivity compared with other countries, as some never tire of asserting. If labour costs are set in relation to productivity, to give unit labour costs, we find that, of our competitors, only British industry has higher unit labour costs to contend with. In the other countries unit labour costs are below the German level. The USA has the most favourable unit labour costs - 15 per cent lower than those in Germany. It must also be remembered that where investment abroad is under consideration labour costs carry more weight than unit labour costs. This is because the technical standards and know-how which determine the level of domestic productivity are mobile. The difference in labour costs is particularly significant when production is transferred to locations in central and eastern European.
Germany pays a great deal for its social security system. Relative to GDP Germany's spending on social security for its citizens is the fifth highest in the European Union, after Sweden, France, Denmark and Belgium. The way social protection is financed varies from country to country. While Denmark finances its welfare system entirely from taxes and levies no social security contributions, in the Czech Republic the employers' social insurance contributions alone amount to 35 per cent of gross wages and salaries. Some countries levy a single contribution, others, including Germany, collect separate amounts for the different branches of the welfare system. With an employers' share of just under 20 per cent Germany comes in the lower third of the ranking.
Despite tax reductions in recent years the tax burden on individuals and companies in Germany is still comparatively high. Few countries (that is to say, only Belgium, Denmark, Finland, France, Netherlands, Austria, Sweden and Japan) have a higher top band of income tax. While progress has been made on corporate taxation, within the EU 27 Germany is still among the third of countries with the highest tax rates for companies' profits. In a recently-published study by the Stiftung Familienunternehmen (Family-Owned Company Foundation) Germany's tax environment for family-owned companies ranks 12th out of 18 European countries.
In contrast to labour markets, the liberalisation of product markets previously dominated by state monopolies is relatively well advanced. Germany is no exception in this. Indeed, in some cases, such as postal services, Germany has even been one of the pioneers. Only Germany, the United Kingdom, Sweden and Finland have now completely deregulated the delivery of letters. In this respect, other countries have some catching up to do. Many countries continue to drag their feet on liberalisation, particularly with regard to market access for the domestic letter post. In the deregulation of the telecommunications market the European Commission has been the driving force. Looking back, the liberalisation of this market can be considered a European success story. The opening of the market to competition has lowered prices for telecommunications services drastically. However, this process is far from complete. The market shares of the former monopolists may have fallen, but in some cases they remain relatively high. In 2005 the average market share of the former monopoly enterprises in the EU 25 was still 72 per cent; in Germany it was 57 per cent.
A pleasing amount of progress has been made on the deregulation of the railways in Germany. In the IBM Global Business Services' liberalisation index for rail freight and passenger services Germany comes second only to Great Britain. This index covers both statutory hurdles to market access and practical limitations, such as administrative and operative barriers.
Further deregulation is required in the energy sector. It was not until the Second Single Market Directive - the so-called Acceleration Directive - on Electricity and Gas was issued in June 2003 that liberalisation, which up to that point had been very hesitant, could be moved steadily forward. And still the goal has not been reached. To judge by the cumulative market shares of the large generating companies (providers with more than five per cent of the market) competition still does not seem to be sufficiently intense. Germany, where the major players have a market share of 77 per cent, is some way below the EU 27 average. Poland and Austria are among the countries with better scores. Malta and Cyprus are still farthest from having competitive market structures, but they are joined by larger EU countries such as Greece and France.
Our conclusion, then, is that until the summer of last year the government was on the right track. Overall, they had improved the economic fundamentals necessary for a long-term rise in the growth rate and thus supported companies' efforts to increase their international competitiveness and create profitable jobs in Germany. Despite the clearly recognisable and even quantifiable returns generated by reform, this course has been abandoned. A further course correction is therefore necessary.
The European Union has a great influence on German legislation. For example, in the 2002-2005 parliamentary session over 40 per cent of all internal affairs legislation could be traced back to a European initiative and therefore to the European Union. In general, however, German legislators are left with sufficient leeway to set their own accents.
The particular issues which government policy can tackle to ensure more economic growth have been set out by the German Council of Economic Experts in their analysis of growth factors (SVR, 2002, 594 ff.) In their empirical analysis, which is based on sound economic theory, the Council identified the following key policy-related growth factors (the direction of their affect on growth is given in brackets):
Corporate investment (+)
Public sector investment (+)
Human capital (+)
Taxes and social insurance contributions (-)
Public spending deficit (-)
(Structural) unemployment (-)
In its "Vision for Germany" (IW Köln, 2007, 89 ff.) the IW Köln has already developed a comprehensive reform strategy based on this list and from it developed a reform agenda for the current parliament, which as yet the government has only begun to implement, however. In the IW Köln's view, in terms of these six growth factors the government's to-do list currently contains the following measures, which I will here only outline in note form:
Growth factor "Corporate Investment":
- Abolition of inheritance tax:
- - There are no good economic or fiscal reasons for retaining inheritance tax
- - We should therefore follow the example of other countries: Sweden and Luxembourg have already abolished it, France and Austria are planning to do so
- - If this is not politically feasible in the short to medium term, an alternative would be to grant the Länder, the sixteen states which constitute the federal republic, the option of abolishing it. This would have the positive side effect of increasing economic competition among the Länder.
- Abolition of the ‘solidarity levy', originally introduced to finance reunification, as part of a comprehensive reform of income tax
- Abandonment of the planned tax on cross-border production transfers within the field of corporate taxation
- Dismantling of bureaucracy, particularly for small and medium-sized enterprises: increase the pace and define ambitious and verifiable reduction targets and the corresponding packages of measures as soon as possible.
Growth factor "Public sector investment":
- The consolidation of the last few years has taken a high toll on public investment (consolidation having been quantitative rather than qualitative)
- Public investment must again be accorded a greater long-term priority within public spending
- At the local government level we are experiencing a remunicipalisation of previously privatised functions; instead of adopting an entrepreneurial role and ousting private firms from the marketplace local government should be concentrating more on expanding the infrastructure for transport and childcare (thus making it easier to combine family and profession).
Growth factor "Human capital"
- Pre-school and school education: intensify the educational element in pre-school education, expand all-day schooling
- Vocational training: reduce the net costs for companies that provide apprenticeships and occupational training, improve language skills and familiarity with new technologies
- Academic education: give universities more independence and increase the proportion of private funding while supporting poorer students; allow universities to select their students
- Continuing education and training: make vocational and academic education more permeable, create incentives for investment in further education and training
Growth factor "Taxes and social insurance contributions"
- Use funding freed up by the Federal Employment Agency (Bundesagentur für Arbeit) for further reductions in unemployment insurance contribution rates
- Reform income tax (reduce the tax wedge particularly for mid-range incomes), remove fiscal drag and abolish the solidarity levy on income and corporation tax
- Long-term and sustainable reform of statutory long-term care insurance by introducing a funded system of financing and detaching it from employment.
- Abandon plans for a centralised health fund and unified statutory health insurance contribution rates; instead really open up the system to competition
Growth factor: "Public sector deficit"
- Despite welcome surpluses in public sector budgets the task of budget consolidation has not yet been completed: there is still a structural (cyclically adjusted) deficit
- There is therefore no occasion to reduce efforts to find and make savings
- Consolidation must be effected not by finding structural means to improve revenues but by tackling public spending
- Currently it is the federal deficit which is in particular need of further reduction.
Growth factor "(Structural) Unemployment"
- Avoid setting labour policy on the wrong course:
- - No expensive programmes for kick-starting the labour market: these prevent further reductions in unemployment insurance contributions and have been shown to be ineffective
- - No national or sectoral minimum wages
- Facilitate immigration:
- - Skills shortages could prove a bottleneck for economic growth
- - Currently economically motivated immigration requires the negotiation of high bureaucratic hurdles; immigration should be subject to clear, easily understood rules
- - A points system, including in its assessment procedures employability criteria such as qualifications, language skills, marital status and labour market situation, should be introduced
- - Parallel to this, immigrants and their descendants already living in this country should be better integrated
- Wages and salaries will have to adapt better and faster to changing conditions if global trends are not to have a detrimental effect on employment:
- - Collective agreements will have to become even more flexible, with increased use of opening clauses and an employment-friendly, statutory definition of the favourability principle
- - No government intervention in free collective bargaining by means of minimum wages or orders extending the coverage of collective agreements
- - Increased use of target- and performance-related remuneration systems
The Grand Coalition cannot realistically be expected to find the strength to adopt and implement such a programme in what is left of its current term. But even small steps, if they are in the right direction, contribute to growth and employment. This reform package, which concentrates exclusively on strengthening the basis for growth, offers a suitable frame of reference for judging whether that is the case.