Ifo Viewpoint No. 46: Borrowing or Taxes?

Hans-Werner Sinn
Munich 19 June 2003 <p>Europe is experiencing economic stagnation but not a recession. Governments should not use this lull as a pretext for their usual practice of new borrowing to make up for budget shortfalls. The Stability and Growth Pact provides for explicit measures for recessions and sets out clear conditions. As long as GDP does not shrink faster than 0.75%, the countries of the Eurozone must not exceed the 3% deficit limit. Pacta sunt servanda.

A number of countries are still clearly below the 3% deficit limit. These countries can and should step up spending and create scope for Keynesian demand policies, but not the other countries, and particularly not Germany. We should be embarrassed that we originally forced the other countries to accept the Stability and Growth Pact and last year ourselves violated the Pact with new borrowing of 3.6%, which could increase to 4% this year. That is a grave breach of confidence in the credibility and stability of our country and damages Germany’s image as an investment location. All efforts must now be aimed at consolidating public finances.

To be sure, the tax reform should be implemented according to plan, but this should not involve more borrowing. How this will be possible this year is a total mystery. The government has still not defined the cuts it will make to lower borrowing to below 3%. We can be glad if the time schedule of the tax reform remains unchanged with the next stage being implemented in January 2004 and, more important, the following stage in January 2005.

Bringing forward the once postponed tax reform would mean a zigzag course that would only make things worse. The government’s motive would be to win greater approval of an unsound budget policy, but they would be suspected of making accomplices of German taxpayers. This would be too obvious to be taken seriously.

For this reason it is unnecessary to speculate how a debt-financed early implementation of the tax reform would affect the economy. Presumably consumption would increase, but the investments of unincorporated firms would tend to shift abroad via financial markets because of the implicit devaluation of depreciation allowances. These are very complex mechanisms that cannot be explained in three sentences.

We need the tax reform as scheduled without an increase in borrowing. Work must be made worthwhile again and investments must be based on market consideration rather than with a view to possible tax savings. These are all long-term, structural aspects that have nothing to do with the business cycle. It would be a considerable accomplishment if the government managed to implement the projected reform on schedule and to fulfil the criteria of the Stability and Growth Pact. To achieve this, immediate and comprehensive measures are necessary to limit the costs of the welfare state and decrease subsidies. This is what the discussion should focus on. Only if the government manages to say which costs will be cut will it make a credible contribution to reducing the tax burden in Germany. Anything else is political play-acting.

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