Germany’s fiscal situation: Full employment and zero interest rates result in budget surpluses – but demographic development might become a problem!

Germany Monitor

Bundestag elections 2017

In an international comparison, Germany's fiscal situation is very good - thanks to robust GDP growth and zero interest rates. Other important industrial coun- tries, such as the US or Japan, are still struggling with high fiscal deficits and ris- ing public-sector debt. Germany, however, is the only G7 country that has gen- erated fiscal surpluses since 2014, helping to considerably reduce its debt ratio.

In the short to medium term, dynamic revenue growth should help ensure that Germany's fiscal situation remains comfortable, even though expenses look set to rise strongly as well. The budget complies with both national and European debt-limiting rules, and there is a considerable safety margin. The 2017 update of the Stability Programme foresees positive fiscal balances at the general gov- ernment level for the years from 2017 to 2021, which means that - provided growth remains strong and interest rates low - the debt ratio might drop below the Maastricht limit of 60% of GDP by end-2020.

Public finances are currently benefiting from buoyant growth, low interest rates and a "demographic respite". According to our calculations, the German govern- ment saved almost EUR 260 bn in interest payments between 2008 and 2016. However, the current fiscal surplus, which is to a large extent due to these spe- cial factors, should not be used to justify permanent expense increases or cuts in taxes and/or social security contributions.

Rising interest rates and the ageing society look set to put public finances under considerable pressure beginning in the middle of the coming decade. The age- ing society will result in significant burdens for public budgets in the near future, as government revenues (taxes, social security contributions) will probably ad- vance at a slower pace on the back of a shrinking workforce and lower potential growth, while government expenses boom at the same time (in particular for statutory pensions, healthcare and old-age care).

However, the long-term fiscal risks do not appear to play a major role in the cur- rent election campaign. Rather, politicians have included calls for tax cuts and expense increases in their parties' election programmes given the current fa- vourable fiscal situation.

To prepare the economy and public-sector finances for the ageing of the popu- lation and avoid major abrupt fiscal adjustments in the future, the parties should not make increasingly more electoral promises that they will be hard pressed to pay for in the longer term.

In an international comparison, Germany's fiscal situation is very good - thanks to robust GDP growth and zero interest rates

Germany isthe only G7 country that

currently runsa budget surplus 1

General gov ernment budget balance, % of GDP 5

Other important industrial countries, such as the US or Japan, and large Euro- pean economies, such as the UK, France or Spain, are still struggling with high fiscal deficits and rising public-sector debt. Germany, however, is the only G7 country that has generated fiscal surpluses since 2014 (not least thanks to ro- bust economic growth), helping to considerably reduce its debt ratio (charts 1 and 3). In fact, Germany's fiscal situation is better than it has been for a long

0

-5

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time, mainly thanks to strong growth and zero interest rates. According to the Maastricht definition, the general government balance, which includes the budg- ets of the federal government, the federal states, the local authorities and the social security system as well as special budgets, was in the black for the third year in a row in 2016 (c. EUR 23,7 bn or 0.8% of GDP; chart 2).

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01 03 05 07 09 11 13 15 17

DE US CA

JP GB FR

IT ES

Germany registered a general governmentbudget surplusfor the third year in a row in 2016 2

% of GDP

3

2

Germany, UK, France, Italy and Spain: budget balance according to Maastricht definition. US, Canada, Japan: budget balance according to IMF definition.

Sources: IMF WEO, AMECO, Deutsche Bank Research

Germany'sdebt ratio isdeclining

against the trend 3

Gross general gov ernment debt, % of GDP

1

0

-1

-2

-3

-4

-5

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Interest expenditure Fiscal balance Primary balance

250

200

150

100

50

0

01 03 05 07 09 11 13 15 17

DE US CA

JP GB FR

IT ES

Sources: Eurostat, AMECO, Deutsche Bank Research

Decline in German governmentdebt ratio thanksto primary surpluses and declining

interest spending 4

General gov ernment debt ratio: yoy change in pp of GDP

16

12

8

4

0

-4

Germany, UK, France, Italy and Spain: debt stock according to Maastricht definition. US, Canada, Japan: debt stock according to IMF definition.

Sources: IMF WEO, AMECO, Deutsche Bank Research

-8

07 08 09 10 11 12 13 14 15 16

Interest payments Primary balance Real GDP growth

Inflation Stock Flow Adjustment Statistical discrepancy Government debt

Sources: Eurostat, AMECO, Deutsche Bank Research

The spending side of the (general government) budget benefited from the fur- ther decline in interest payments, the revenue side from strong tax and social security revenues. Over the last few years, the tax ratio (as based on German fiscal statistics) has risen considerably thanks to bracket creep (i.e. "veiled" tax hikes) incorporated in the tax system, from 20.6% of GDP in 2010 to c. 22.5% in 2016.

According to the draft budgetfor 2018 and the fiscal plan until 2021, the debt

ratio might drop below 60% by 2020 5

% of GDP

3,0 90

2,5 80

70

2,0 60

1,5 50

40

1,0 30

0,5 20

10

0,0 0

As a result, the government debt ratio has declined markedly in the last few years. At 68.3% of GDP at the end of 2016, it was considerably below its tempo- rary peak of more than 80% of GDP registered at the end of 2010, if slightly above the level seen before the beginning of the global financial crisis (see chart 5). This decline in the German general government debt ratio is largely due to regular primary surpluses (i.e. budget surpluses before interest expenses) at the general government level, which are in turn the result of robust economic growth (which raises tax revenues and also increases the denominator of the debt ratio) and low interest rates (which reduce interest expenses; see chart 4).

Germany registered a general governmentbudget surplusfor the third year in row in 2016 6

% of GDP

Interest payments (LHS) Government debt (RHS)

Sources: Eurostat, AMECO, Federal Ministry of Finance, Deutsche Bank Research

3

2

1

0

-1

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2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Fiscal balance Primary balance

Cyclical-adjusted fiscal balance Structural fiscal balance*

German statutory pension system stabilised by high transfer payments

from the federal government 7

* cyclically adjusted, excluding special effects. Forecasts: German Stability Programme (2017 Update).

Sources: Eurostat, AMECO, Federal Ministry of Finance, Deutsche Bank Research

EUR bn

300

250

200

150

100

50

0

90 94 98 02 06 10 14

Revenue of German Statutory Pension Insurance Scheme (of which: transfers from the federal budget)

Strong increase in overall spending foreseen in the fiscal planning until 2021 8

Nominal growth contributions, in pp 6

4

2

0

-2

-4

Revenue of German Statutory Pension Insurance Scheme (of which: contributions)

Revenue of German Statutory Pension Insurance Scheme (total)

Excl. "Deutsche Rentenversicherung Knappschaft- Bahn-See"

Sources: WEFA, Deutsche Bundesbank, Deutsche Bank Research

10 11 12 13 14 15 16 17 18 19 20 21

Other capital expenditure Gross fixed capital formation

Interest Other current expenditure

Subsidies Social transfers in kind via market producers

Social transfers other than in kind Intermediate consumption

Compensation of employees Total expenditure

Forecasts taken from the German Stability Programme (2017 Update).

Sources: Eurostat, AMECO, Federal Ministry of Finance, Deutsche Bank Research

In the short to medium term, dynamic revenue growth should help to ensure that Germany's fiscal situation remains comfortable, even though expenses look set to rise strongly as well

Still a large gap between contribution

revenuesand spending on pensions 9

EUR bn 250

225

200

175

150

125

95 97 99 01 03 05 07 09 11 13 15

Revenue of German Statutory Pension Insurance Scheme (of which: contributions)

Expenditure of German Statutory Pension Insurance Scheme (of which: pensions)

Excl. "Deutsche Rentenversicherung Knappschaft- Bahn-See"

Sources: WEFA, Deutsche Bundesbank, Deutsche Bank Research

The German Statutory Pension Insurance Scheme dependson

federal government transfer payments 10

Federal gov ernment transfers, % of total expenditure of the statutory pension scheme

35

30

25

Despite the significant increase in the general government's primary expenses (i.e. government expenses before interest payments), particularly for social se- curity purposes ("retirement at 63", "pensions paid to mothers" etc), the fiscal sit- uation looks set to remain comfortable, at least in the short to medium term, as public-sector revenues continue to grow at a strong clip. Even if the current, fa- vourable macro outlook deteriorated unexpectedly in the next few years, na- tional and European caps on public-sector borrowing would at least prevent a massive rise in the debt ratio.

The 2017 update of the Stability Programme foresees sustained positive fiscal balances on the general government level for the years from 2017 to 2021 (chart 6), which means that - provided growth remains strong and interest rates low - the debt ratio might be reduced considerably until the end of 2021. Ac- cording to the federal government's projections, the general government debt ratio might drop below the pre-crisis level of 2007 by the end of 2019 and below the Maastricht limit of 60% of GDP by the end of 2020 for the first time since 2002 (chart 5). Even though such a decline in the debt ratio does not appear un- realistic, the strong increase in social spending (pensions, employment, healthcare) may result in immense fiscal pressure in the long run. This might, in turn, limit the scope for necessary future-oriented investments in education and public-sector infrastructure.

Despite the good labour market situation, the German statutory pension system (excluding "Deutsche Rentenversicherung Knappschaft-Bahn-See") is the only social insurance scheme which currently runs a deficit. According to the Deutsche Bundesbank Monthly Report, it registered minor financing deficits over the past two years, which were offset from its reserves. These deficits generated by the statutory pension system despite a strong labour market are even more striking when considering the fact that a significant portion of the aggregate rev- enues of the pension scheme stems from transfer payments by the federal gov- ernment. In fact, the budget for 2016 included a whopping EUR 82.6 bn (c. 2.6% of GDP) for financial support to the statutory pension system. This amount is equivalent to almost one-third of the statutory pension system's annual expendi- ture (chart 10). Assuming that contribution rates and the amount of federal fi- nancial support are unchanged and pension payments are raised further at the recent, generous pace, the statutory pension system will come under increasing financial pressure. In 2016, pensions were hiked by 4.25% in the western and

by 5.95% in the eastern German states, even though the rate of inflation was

20

only 0.5%. Future significant pension increases will increase the need for even

15 more financial support from the government. In fact, the federal government

10 forecasts in its budget draft for 2018 and financial planning until 2021 that over-

5 all federal government subsidies related to statutory pensions1 will rise to EUR

0 94.0 bn in the fiscal year 2018 and climb further to more than EUR 100 bn by

91 93 95 97 99 01 03 05 07 09 11 13 15

Excl. "Deutsche Rentenversicherung Knappschaft- Bahn-See"

Sources: WEFA, Deutsche Bundesbank, Deutsche Bank Research

the end of the coming legislative period (2021F: EUR 103.4 bn). This means that the share of government support for statutory pensions in total federal ex- penditure could rise further, from 27.9% in 2018 to 29.0% in 2021. The financial situation of the statutory pension system, which has been stabilised by consider- able amounts paid from the government coffers, will in the future depend more than ever on the support of the federal government, i.e. ultimately on tax payers.

1 According to the German Federal Insurance Office ("Bundesversicherungsamt"), the federal gov- ernment spent a total of EUR 87.5 bn (2.8% of GDP) on the statutory pension system (incl.

Knappschaft) in 2016.