AFTER two months of political horse-trading, Germany’s new governing coalition unveiled its programme for government last Friday. Since Germany is the largest economy in Europe and the third-largest in the world, this was an event of considerable importance. Yet the economic ideas behind this programme, which are very unusual, to put it mildly, have inspired surprisingly little debate.
The new German Government is launching one of the boldest experiments ever undertaken in the history of economics — or rather anti-economics. Germany in the past three years has been the world’s most depressed economy, with the weakest growth in economic activity and consumption. The coalition partners — representing, as they do, the opposite ends of the political spectrum — found it hard to find common ground on most issues, but on one point they could emphatically and enthusiastically agree: the way to stimulate an economy suffering from mass unemployment and stagnant consumption is to increase tax.
Germany’s plan to cure its self-confessed economic failure by doing exactly the opposite to what modern economics would suggest is certainly a bold and novel idea. Jim O’Neill, the chief international economist of Goldman Sachs, remarked on television last week that German politicians are acting as if they had never seen an economics textbook, much less understood one.
Accordingly, the new German Government has decided to impose one of the biggest tax increases in postwar history and to target the extra taxes on the weakest and most sensitive parts of the economy: consumption, which will suffer a three percentage point increase in VAT, and housing, which will lose tax incentives for first-time buyers. In addition, to fend off accusations that the new consumption taxes will bear unfairly on poorer consumers, the Government will hit the rich as well, increasing the top rate of income tax from 42 per cent to 45 per cent.
It seems that Angela Merkel’s idea of a compromise between the Christian Democrats, whose most unpopular idea was the VAT increase, and the Social Democrats, who were berated for demanding higher income tax, was to combine the most unpopular measures from both parties’ manifestos, while dropping all the rest.
Speaking to one of Germany’s most prominent economists a few days ago, I noted a decline of consumer spending in response to higher taxes is not just a theoretical possibility but a well-established empirical reality — demonstrated by widespread evidence from a large number of countries.
“Maybe,” he replied, “but the Germans are different. When taxes are raised in Germany, I can guarantee that consumers will become more confident and will spend more. You see, we Germans are today more worried about the deficits of our Government than about the incomes we receive.”
If this turns out to be true — and the Germans really do increase their spending in response to the Merkel Government’s higher taxes — it will certainly be one of the most unexpected events in the history of economics. So what are the chances that the Merkel experiment might actually succeed? Experience suggests success in stimulating the economy through higher taxes is very unlikely, but not entirely impossible. Let me begin with the bad news. The closest analogy for what Germany is now attempting is the rise in consumption-tax imposed by the Hashimoto Government on Japan in 1997. The Japanese economy had already been depressed for five years before this tax increase (just as the German economy has been depressed since 2001), but still Japanese consumption grew by an average of 2.3 per cent annually from 1991 to 1996. In the year following the tax increase, Japanese consumption collapsed by 3 per cent and consumption growth in the following five-year period averaged a meagre 0.2 per cent.
This collapse in Japanese consumption from 1997 onwards triggered the Asian financial crisis and the huge economic dislocations that went with it. In other words, the 1997 tax increase was arguably the most disastrous economic measure imposed by any major government since the Smoot-Hawley tariff of 1931.
If Germany follows the Japanese experience — and this seems the most likely outcome — the Merkel tax hike will probably condemn Germany to depression for the rest of this decade and quite likely trigger an Asian-style financial crisis in much of Eastern Europe some time in the next year or two.
There is, however, a remote possibility of a more benign outcome. The past 20 years have seen several cases of governments managing tax hikes in such a way that they stimulate economic growth — most notably, Bill Clinton’s tax rises in the mid-1990s, Norman Lamont’s austerity budgets after Black Wednesday and the 1981 Thatcher Budget.
Is it possible that the German tax plan will turn out to be another such surprise? It just conceivably might.
The German coalition has made one sensible decision: instead of imposing their tax rises as soon as possible, they have postponed them until January 2007. As a result, it is possible that German consumers will increase their spending next year, in order to avoid the 2007 tax hike. This anticipatory spending could give the economy a temporary boost next year, but would make the downturn in 2007 even worse (as it did in Japan ten years ago).
Also, in every recent experience in which higher taxes have led to economic recoveries instead of depressions, this has been very simply explained: the increase in taxes was combined with a sharp reduction in interest rates and a currency devaluation.
If the German tax increase were combined with a dramatic reduction in European interest rates and a further devaluation of the euro, it would certainly be possible to imagine Germany enjoying a strong economic recovery. But, sadly, the European Central Bank seems to be planning a rise, rather than a cut, in interest rates. The ECB could yet see sense or some other miracle could happen. More likely, however, is that Germany now faces a Japanese-style lost decade.
