Germany's economic non-miracle: how Finance Minister Hans Eichel's policies have hurt the Schroeder government.

• Author: Welfens, Paul

When the Kohl government fell after 16 years in 1998 there was hope that the red-green coalition government under Chancellor Schroeder would overcome the gridlock in economic reforms concerning taxes, the social security system, labor market institutions, and prudential supervision. Germany's economic growth had fallen to 1.5 percent in the period 1993-98. Once the reunification boom of 1990-92 was over, fuelled largely by generous tax benefits for investors in eastern Germany, a reunited Germany faced serious problems, the least of which was a shocking 4.5 million unemployed.

The politico-economic heritage of the conservative government was very difficult because high deficit-to-GDP ratios--close to 7 percent in the early 1990s--had become a serious problem during the early years of German unification. Of course, the Maastricht Treaty stipulated that the deficit-to-GDP ratio should not exceed 3 percent and the debt-to-GDP ratio 60 percent. While the latter ratio had barely been met in 1999 with the beginning of the Euro and the ECB, the deficit-to-GDP ratio was a more crucial issue particularly because the Stability and Growth Pact adopted by the Euro starter countries required member countries of the euro zone to achieve a nearly balanced budget in the medium term. Hans Eichel, Germany's Minister of Finance, thus emphasized the need for a reduction of the deficit-to-GDP ratio in his first days in office. Indeed, in the first year at the top of the ministry he achieved a solid public profile as a savvy political hero; the deficit ratios under Eichel were between two and three percent. High extra revenues from auctioning off licences for the mobile telephone industry translated into a modest budget surplus. Unfortunately, in less than two years it became clear that Eichel did not really have a consistent concept to combine fiscal consolidation with the need to raise output growth and stimulate employment.

Mr. Eichel had initially boosted his public profile with a broad tax reform which combined a reduction of income tax rates with a reduction of the corporate tax. Regarding the latter, Eichel abolished the previous split tax rate arrangement which had been 40 percent for profits withheld in the company and 30 percent for profits disbursed. The regime applied to both stock companies and limited liability companies. The split of rates implied a curious balance sheet item for Germany's firms since firms had an option to retroactively change...