Ifo Viewpoint No. 38: Financing the Flood Damage

Hans-Werner Sinn
Munich 28 August 2002

Ten billion euros are to go to the flood victims, but where will this money come from? The basic choices are tax increases, spending cuts or an increase in the national debt.

Tax increases can be ruled out since lawmakers would lose face if they broke their solemn pledge to reverse tax-and-spend policies. Germany still has a very high public sector share of GDP. Too much money is poured into the welfare state and too much money is frittered away on subsidies. The recent tax reform has hardly helped the working population, and the little tax relief that is planned must not be jeopardised if the devastating, thirty-year trend of rising unemployment is to be reversed.

In terms of the marginal burden of taxation on the average employee, Germany tops the list of all OECD countries. No wonder that it brings up the rear when it comes to economic growth. These factors are linked, permitting no alternative to a policy of reduced taxes and social insurance contributions, even when the costs of a natural disaster must be met.

Tax increases, even those which come in the form of deferred tax reductions, are not in keeping with a healthy economy. The latest results of the Ifo Business Climate Index show a decline – and a considerable one – for the third time in succession. The recovery seems to be on hold, and we can be glad if it doesn’t collapse completely.

It is better in this situation to choose the option of government debt. In Autumn 2001, the German economic research institutes recommended an earlier implementation of the next stage of the tax reform to boost the economy, with the revenue shortfall being compensated by additional debt. Since the economic climate is not much better today than last year, it certainly is ill-advised to take the opposite course of the institutes’ recommendation. A postponement of the next stage of the tax reform would be the wrong reaction.

One problem, that was not so large at the time, was meeting the Maastricht criteria. New government borrowing for this year is expected to be between 2.5% and 2.8% of GDP, leaving little room for manoeuvre. On the other hand, only a small part of the money for flood relief will be spent this year, and the Stability Pact also explicitly excludes natural disasters. For damage compensation in these cases, new borrowing is explicitly allowed. This is a strong argument for debt financing the measures to eliminate the flood damage.

In the long term, a reduction of government expenditure is still the best policy. Social welfare expenditures must be reconsidered along with government subsidies to enterprises, which now amount to between 100 and 150 billion euros. Across-the-board cuts would be an easy way to free funds for assisting the flood victims.

A combination of borrowing and spending cuts would be the best way. As long as the economic recovery is shaky, the necessary funds can be obtained by borrowing, but afterwards loans should be replaced by spending reductions. An accelerated debt repayment should then also be achieved by spending cuts.


Hans-Werner Sinn
Professor of Economics and Public Finance
President of the Ifo Institute