Germany’s sizeable stimulus package based on VAT rate cuts and investment support should help steady the euro area’s biggest economy without significantly damaging public finances even though government debt will rise sharply, says Scope Ratings. Country’s €130 bln stimulus program (around 4% of GDP), including a temporary reduction in the main VAT rate to 16%, from 19%, aims to stimulate consumer spending in an effort to kickstart the German economy in the second half of 2020. Among other fiscal measures, the package includes €25 bln in support for the hotel, restaurant and entertainment sectors hit hard by the COVID-19 lockdown and physical-distancing measures and another €50 bln to promote investment in technology-focused research and development.
“In the near term, the VAT cut will help to stabilize economic output over the remainder of this year but comes at the cost of this year’s significant, though still manageable, increase of more than 10% in Germany’s public debt ratio,” says Bernhard Bartels, analyst at Scope. Scope expects Germany’s debt-to-GDP ratio to increase to above 70% of GDP by the end of 2020, from 59.8% in 2019.
“With its focus on stimulating aggregate demand, the latest package could help keep Germany’s 2020 economic contraction close to Scope’s baseline projection of around 5.2% in 2020, followed by growth of 3.3% in 2021,” says Bartels. “This assumes a gradual unwinding of lockdown measures continues, and that we are not exposed to a serious second wave of infections. The alternative – of no further stimulus – would be to risk a deeper recession and eventually a more serious deterioration in Germany’s public finances over the long term. The latest package – in being large, targeted and temporary – may prove more effective than the government’s response to the financial crisis in 2009.”
Reducing the VAT rate is usually a less targeted way to boost the economy compared with other possible budgetary action – such as welfare levies or consumer subsidies – but this time Germany’s approach is expected to be more effective given how widespread the impact of the health crisis has been across the economy. As well as cutting the standard VAT rate, the government is temporarily lowering the reduced rate to 5% from 7%.
“The government’s investment measures should serve to preserve and enhance Germany’s economic productive capacity longer term,” says Bartels, citing the €50 bln “future pact”, or Zukunftspaket, as well as outright support to municipalities and state-owned railway operator Deutsche Bahn. “Investment programs are as important as direct stimulus measures in raising Germany’s growth potential and thereby preserving the government’s ability to repay debt that’s been accrued over this crisis.”
The country has the advantage of a wealthy, large and diversified economy and a relatively strong public health system, which contribute to Germany’s safe-haven status in an increasingly uncertain macro-economic environment, ensuring robust investor demand for German government bonds.
The German government still faces important fundamental challenges of modernizing the economy and improving productivity through investment in physical and digital infrastructure as the population ages and the workforce shrinks. In addition, even as Germany’s explicit debt levels increase, implicit debt is also rising not only due to public debt guarantees but also through higher future EU borrowing during the forthcoming 2021-2027 EU budgetary period.
“This crisis can be seen as a challenge to public finances but also as an opportunity to meet the structural challenges of underinvestment, greening German industry, and better preparing the economy for the digital age,” says Bartels.