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2018 Report - Trends in federal public finance – The new financial plan and sustainable federal finances

Oct 09, 2018

Executive summary [1]

In 2017, the price-adjusted gross domestic product (GDP) increased for the eighth year in a row. Compared to previous years, economic growth once again accelerated. The German economy grew much faster than the overall production potential. In its spring projection, the Federal Government expects an increase of 2.3 per cent and 2.1 per cent for 2018 and 2019. From a fiscal point of view, these framework conditions form the basis for a positive favourable development: increasing tax revenue and, in particular, low labour market expenditures. The interest rates are at a historical low which also has an easing effect.

In its 2019 government bill, for the fifth time in a row, the Federal Government is able to present a balanced budget without the need for incurring new debts. Also the financial planning period until 2022 does not provide for any new borrowing. This scenario is to be implemented without consolidation. Instead, the Federal Government plans to spend more money, especially on social and welfare policy of the federal states, in particular, regarding primary and secondary education and low income homes. In addition, new costly relief programmes are to be implemented – such as a family housing benefit which practically reinvents the home ownership grant abolished in 2005. The Federal Government did not carry out a comprehensive stocktaking - as we recommended in our last year’s findings.

The Federal Government’s continued practice of transferring expenditure to off-budget funds is subject to applicable regulations in budget law. For instance, a new off-budget fund was set up in the 2018 budget to support digitisation activities. Furthermore, budget funds have been set aside for supporting the expansion of all-day schooling, although no specified strategy is in place for this purpose. There is an increasing trend to appropriate and manage off-budget funds outside the regular core budget. This type of budgeting results in recognising federal grants set aside for off-budget funds as actual expenditure although the capital expenditure projects for which they are designed are usually implemented and accounted for only in later years. This results in abandoning or encroaching upon the key budgetary principles such as the principle of a single and complete budget, the current year principle, and of transparency of the budget.

Budgetary consolidation is not an end in itself but helps ensure fiscal sustainability. And this is where government needs to step in. Despite the favourable framework conditions, the federal budget faces high challenges. The current financial planning period already indicates that although the demographic change is currently at a temporary halt, spending on old-age pensions is to increase significantly. The pension package of the 18th legislative period and other higher levels of benefits envisaged – especially the mothers’ pension II – add to the burden on the budget. The contribution rate of the statutory pension fund is to increase to a maximum of 20 per cent until 2025. At the same time, the pension is to remain at today’s level of 48 per cent of the average income in this period. At least for the period as from 2025, the two backstops will have a major bearing on pension insurance and thus also on the related federal budget grants. This makes the work of the Federal Government’s “reliable intergenerational contract” commission more demanding. This is particularly the case, since the federal Government has taken no sustainable action as abandoning or lifting the contribution assessment ceiling or increasing the effective pension age, to stabilise the financial position of the pension scheme. Social long-term care insurance also faces major financial challenges in terms of eldercare that may impact on the federal budget at least in the medium term.

The financial plan provides for increased investment, especially in the case of transport, digital and educational infrastructure. Lengthy planning and authorisation procedures also add to a staggering outflow of funds. The investment ratio that is the share of investment in the budget volume remains in total far below the share of social security expenditure.

In the financial planning period, funding the reception and integration of migrants and refugees and tackling root causes of migration remains a major field of action. Due to the lower inflow of refugees, the funds may likely decline slightly in the 2019 draft budget and in the subsequent budgets compared to the actual amount of €20.8 billion in 2017. However, total expenditure will remain high. A major portion of the funds go to the budgets of regional and local governments via additional shares of turnover tax. One setback is that the federal government departments and the German SAI are not permitted by budgetary law to monitor the appropriate use of these funds.

The restructuring of the financial relationships between the Federal Government and the federal states will result in a major burden for the federal budget as from 2020. By that time, the federal states will receive additional assistance from the Federal Government in the annual amount of €10 billion. Furthermore, the Federal Government continues to support the federal states in building low income homes even though they are to be solely responsible for this task as agreed in the negotiations between the Federal Government and the federal states. Task overlaps and fragmentations have not been addressed at all. On the contrary, the Federal Government increases its financial support in almost all regional and municipal key areas (e.g. day-care services for children, nursery school, school, local social welfare, domestic security). This results in a complex and ambiguous structure of responsibilities and funding streams that is not in compliance with the Constitution. Financial autonomy of state and local governments is increasingly at risk of being undermined. In 2017, federal Government decided to disentangle responsibilities by setting up a federal enterprise to build and maintain federal motorways. Until this enterprise is operational, however, major implementation challenges need to be addressed.

As part of the constitutional reform of financial relationships, Parliament took up our proposal to provide the federal government level with the necessary governance and monitoring powers. The German SAI has been authorised to collect evidence at bodies outside the federal administration – that is in particular state and local governments – provided that they manage federal funds. We have launched initial work to audit if federal funds have been put to proper use.

At the European level, the Federal Government faces financial risks over the medium and long term. In addition to implementing assistance to combat the European public debt crisis, such risks especially concern the withdrawal of the United Kingdom from the European Union (Brexit) and the new multi-annual financial framework (2021 to 2027) for the EU budget. Also the European Banking Union poses financial risks to the federal budget. One of these risks concern the proposal made by the European Commission (EU Commission) to transform the European Stability Mechanism into a European Monetary Fund and to authorise it to decide on supporting measures in the banking sector and related fields. We have reported to Parliament on this topic in a special purpose report.

The Federal Government should organise the gradual reduction in the solidarity surcharge envisaged for 2021 in such a way that it withstands a possible constitutional review. If this is not done properly, this may give rise to additional burdens amounting to billions of euros. Also, nuclear waste disposal could pose a risk to the federal budget at least in the long term if the financial resources paid into the public law fund for hazardous waste disposal are insufficient. Ultimately, Germany’s political commitment within the NATO to increasing the annual defence expenditure places a lasting burden on federal finances.

These challenges require a sustainable financial strategy with a pro-active focus on tasks to provide leeway for shaping the financial economy over the next years. A balance must be struck among the competing goals of increased grants for almost any policy areas, increased budget resources set aside for future challenges and noticeable relief for all taxpayers. For this purpose, an overall review is needed of both the expenditure but also the numerous tax benefits for various interest groups. In its subsidy policy guidance on periodic reviews of tax expenditures, Federal Government has also committed itself to check to what extent sustainability considerations have been complied with. However, the Government limits this voluntary commitment to the steps set out in the subsidy report. The coalition agreement remains silent on cutting back subsidies. We believe that action needs to be taken and make reference to our last year’s findings on public finance where we developed a number of suggestions and recommendations – especially on energy tax and VAT.

In the financial planning period until 2022, the level of structural borrowing as provided for in the debt rule remains below the permissible limit of 0.35 per cent of GDP. The proposed safety margin to the limit of structural net borrowing is appropriate under fiscal aspects in order to be able to cope with adverse fiscal developments and new challenges while complying with the debt rule. The Federal Government’s core budget does not have any new debts but the margin left to reach the threshold will decrease in the 2019 draft budget: On the one hand, the cyclical development limits the margin of new borrowing since the aggregate demand exceeds the potential output due to the favourable economic situation. On the other hand, the cash outflow from some special funds (Energy and Climate Fund, Reconstruction Aid Fund, Local Authority Investment Promotion Fund, Digital Fund) leads to a financial deficit which also needs to be taken into account. One merit of the debt rule is that it discloses the limited leeway in public finance.

The 2019 draft budget provides for more expenditure amounting to €5.3 billion than is available. The deficit is to be covered in an amount of €5.0 billion taken from the asylum reserve. The reserve was set up from a financial surplus of the 2015 and 2017 budgets. At year-end 2017, this reserve had a volume of almost €24 billion. The 2018 budget provides for money in an amount of €1.6 billion to be taken from the reserve. The remainder is to cover the loans required to reach budgetary balance in the 2020 and 2022 budgets. They are not set off against the applicable threshold under the debt rule. This results in a balanced budget in the financial planning period. Thus, it may seem that no consolidation requirements are needed. As a consequence, there is no room for efficiently servicing debt that has accrued in prior years: For example, the Federal Government does not seek to accomplish its objective stated to repay - in times of cyclical upswing - debt of €19 billion relating to the special Investment and Redemption Fund established during the economic and financial crisis (2009).

Since the financial year 2012, the Federal Government has drawn up its draft budget and financial plan by means of the top-down procedure. In addition to that, spending reviews have been taken into account since the 2016 preparation of the budget. In the course of the 2019/2020 budget preparation, “receivables management” will be subject to review. The German SAI will monitor these spending reviews.

On the spending side of the federal budget, the Federal Government expects social security expenditure to continue to increase despite the favourable overall economic trend. In accordance with the 2019 draft budget, social security expenditure amounts to €178.2 billion. This is exactly half of the budget total. Until the end of the financial planning period in 2022, social security expenditure is expected to increase to €193.7 billion. Then, the social expenditure ratio would increase to 51.6 per cent. Federal grants to pension insurance, relief grants to local governments for social welfare and expenditure related to refugees especially add to social security expenditure. The implemented rise in child benefits and tax relief for parents is not even included since they are recorded as tax revenue shortfalls in the wage and income tax. The same applies to turnover tax allocations related to migration to the federal states for social security purposes. In contrast, the investment ratio remains at a rather low level of under 11 per cent.

The Federal Government’s grants to the statutory pension insurance scheme are the largest item in this expenditure category. These grants are expected to rise from €98.1 billion (2019) to €110.0 billion (2022); they would then amount to 29.3 per cent of the budget total (2019: 27.5 per cent). This expenditure alone exceeds the budgeted investments by more than two and a half times.

Due to the increasingly positive situation at the labour market, the burden on the federal budget as well as the Federal Employment Agency’s budget decreased significantly. This allows the Federal Government to reduce unemployment contributions by 0.5 percentage points to 2.5 per cent as from 1 January 2019. The downward trend of labour market expenditure has also impacted on the 2019 draft budget and the financial planning – despite additional expenditures incurred for promoting employment and the integration of refugees into the labour market. As a result, labour market expenditure is to increase only slightly until 2022.

With €14.5 billion per year, the grants awarded by the Federal Government via the health care fund to the statutory health insurance schemes remain high. The financial situation of the health care fund and the statutory health insurance schemes is still robust. In some sectors of health care, however, expenditures are on the rise, which is partly due to the demographic development. This increase has as yet been set off by the positive trend in contributions received and federal grants. However, the funding needs linked to major expenditure items – such as ambulant and hospital treatment as well as medication – will probably further increase. This will increase the burden on the federal budget. It is doubtful as to whether the level of federal grants, that have been awarded as a lump sum to statutory health insurance schemes to cover non-insurance benefits, will then be high enough. As yet, the federal grant has not been determined on the basis of a meaningful calculation of non-insurance benefits by the statutory health insurance schemes.

For a number of years, the Federal Government has benefited from a low level of interest expenditure due to positive refinancing conditions. In addition to that, the high premium income running into tens of billions of euros over the past few years alleviated the strain on the federal budget. The immediate recognition of premiums or discounts, i.e. a direct cash inflow or outflow, may be a matter of financial concern because such premiums or discounts relate to various financial years: The high premium income eventually contributes to reducing current interest expenditure, which may distort the effect of falling interest rates at the expense of future budgets. The Federal Government should therefore allocate and accrue premiums and discounts to the various periods – an approach which has successfully been applied to inflation-linked bonds.

Overall, the federal budget benefits from interest expenditures which are significantly lower than earlier planning indicated: For the period 2014 to 2021, the reduction totals almost €117 billion. The interest expenditure ratio and the interest tax rate, i.e. the portion of tax revenue needed to cover interest expenditures, reach historically low levels. For example, the interest tax rate will fall to 5.5 per cent at the end of the financial planning period. This is below the 1977 level of 6.0 per cent – however, with a current public debt ratio which is three times higher than in 1977. At the end of the 1990s, the ratio was 21.4 per cent. Due to an annual average follow-up financing of some €190 billion, the interest rate exposure remains high in the financial planning period.

According to the estimation of taxes presented in May 2018, the tax revenue of all public budgets will further increase. Between 2019 and 2022, annual tax revenue will rise by more than 4 per cent. If the taxes will not be cut substantially, the taxation rate could reach 23.2 per cent of GDP until the end of the financial planning period. Compared to 2017 (22.5 per cent), this would mean another increase of 0.7 per cent or some €27 billion (2022). The Federal Government, however, would benefit less from this development since it has to transfer an increasingly high portion of turnover tax revenue to the federal states and local governments: Between 2019 and 2022, the Federal Government may expect an annual increase of 3.4 per cent, while the annual tax revenue of federal states will increase by 4.1 per cent in this period. As from 2021, the Federal Government’s annual tax revenue could further decrease by €10 billion if the solidarity surcharge is reduced as planned.

After 2021, the portion of tax revenue transferred to the European Union could surge compared to the 2018 estimation of taxes due to the Brexit and the new EU financial framework. The introduction of a tax on financial transactions in the European Union, which was planned for 2012, has been postponed for an indefinite period.

As required by the vertical financial equalization system, the Federal Government will continue to transfer high amounts of tax revenue to the federal states. In the wake of the restructuring of the fiscal relations between the Federal Government and the federal states, federal supplementary grants will increase by €11 billion per year as from 2020 – compared to €8.0 billion shown in the 2019 draft budget.

Compared to the previous year, the federal debt, including off-budget funds, is expected to slightly decrease again by year-end 2018. The federal debt has thus constantly been decreasing since 2014. As a result, the debt-to-GDP ratio will also decrease. The credit economy’s debts which were assumed by the Federal Government in order to overcome the economic and financial crisis slightly decreased. The question as to what extent such obligations will keep debt levels high in the long term can only be answered once all support measures of the current financial planning period have been phased out.

Apart from the guarantees set out in the Federal Budget Act, the Federal Government made guarantee commitments towards the European rescue funds. Such commitments are to support action taken to provide financial assistance to euro area countries. This might place non-projected burdens on future federal budgets. Whether the scenario actually materialises particularly depends on whether Greece, which is the major beneficiary of such action, succeeds in further reforming the public sector and considerably reducing its debt ratio in the next few years.

The European rules of the Stability and Growth Pact and the Fiscal Compact aim at supporting sustainable public finances and structural reforms in the member states. It is imperative to comply with these rules in order to sustainably reduce the risk of a new sovereign debt crisis in the European Union. In the past, the problem rather lay in lacking implementation of these rules. Therefore, the commitment to adhering to the stability objectives set by European fiscal policy should be underpinned by consistently applying the fiscal rules, and room for discretionary decisions should be limited. The European Public Sector Accounting Standards (EPSAS), on the other hand, which the European Commission plans to introduce to strengthen budgetary control, are inappropriate to strengthen budgetary discipline in Europe. In our report to Parliament, we warned against a compulsory transition to EPSAS in all EU member states and especially in Germany. We consider it unlikely that the EU Commission will achieve its objectives – i.e. sound public finances – or at least support achieving such objectives in an effective manner by making EPSAS compulsory for all member states.

The preventive arm of the Stability and Growth Pact stipulates that the structural deficit in Germany shall not exceed 0.5 per cent of GDP over the medium term. This upper limit has not been exceeded by German public bodies since 2012. Current projections show that this limit will also not be exceeded in the period of the medium-term financial planning. In terms of public finances, Germany is one of the most robust EU member states.

With a decreasing public debt ratio, in 2019, Germany will comply with the debt ceiling of 60 per cent of GDP for the first time ever in almost 20 years. To ensure a larger scope for financial decision-making, this positive trend should be supported by a sustainable fiscal policy.



[1] The reporting item adopted by the Senate of the German SAI on 1 October 2018 reflects the status of budget and planning as at the end of September 2018.


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