Germany tries again

German voters want tax cuts. Can Merkel deliver? Sean O'Grady assesses the chances of her delivering radical reform

Is this a new beginning for Germany? She has already emerged from recession, well ahead of Britain, and in their recent elections Germans voted for a decisive break with the past, backing in record numbers the Free Democrats, the nearest thing that country has seen to a true Thatcherite movement – liberal-minded, business friendly and, above all, tax cutting. The FDP Leader, Guido Westerwelle, has been rewarded with the foreign ministry, and his party is well represented in cabinet: his colleague Rainer Brüderle has gone to the economy ministry. The balance of power in Germany politics has shifted.

Yet Chancellor Angela Merkel, whose no-nonsense style helped her re-election, carefully ensured that the key finance ministry job, the more senior of the two economics positions, was retained for her own party. The man she has placed there, Wolfgang Schäuble, is a formidable fiscal conservative. Indeed, for him, looking after the federal republic's books is almost a family duty; Mr Schäuble is married to an accountant, is the son of a tax adviser and worked in a state tax office before entering politics.

But will he want – or even be able – to keep his coalition's promise to cut €24bn (£22bn) from the nation's tax bill? Will he put tax cuts before prudence?

Mr Schäuble has been around for a long time: he served in Helmut Kohl's administration a quarter of a century ago. Proud conservative though he may be, his devotion to fiscal rectitude has made him sceptical about the tax cuts promised by the Chancellor – and, even more enthusiastically, by the Free Democrats – during the election campaign. Indeed, Mr Schäuble was on record during the election as saying that Mrs Merkel's plans were unaffordable.

Chancellor Merkel's plan for €24bn in tax cuts, to take effect from 1 January 2011, is a straightforward splitting of the difference between her pledge of €15bn in cuts and the FDP's aim of a €35bn reduction in the tax burden. It is thus higher than Merkel's original proposals, which Schäuble had labelled impractical. The total stimulus would equal 2.6 per cent of Germany's GDP, making it by far the boldest in Europe. It is all a little ironic, given that the German government has in the past accused the UK of "crass Keynesianism".

From next year the new coalition will implement a €14bn package of tax reliefs that had already been agreed by the outgoing government. Additional corporate and inheritance tax reforms, and changes to child allowances, will take the total tax relief for 2010 to €24bn in 2011 – 1 per cent of GDP.

Low to medium-income households and families with children are set to benefit most. Corporation taxes will be eased, and inheritance tax rules are to be simplified to help family-owned businesses. Next year child benefit will be uprated and the child tax allowance will rise. More tentatively, social security contributions could go up, and health-care funding could shift away from levies that are proportional to income and partly paid by employers, towards flat-rate health-insurance fees for individuals. Care for the elderly could be funded partly through individual private savings accounts, instead of purely through taxation.

The aim of all this is, in true Laffer-curve style, is to stimulate enterprise and push Germany's growth rate back up. It comes against a background of an ageing population, escalating heath and social costs, but continued domestic hostility to immigration.

Yet despite the scale of the challenge, Mr Schäuble has softened his criticism of the tax-cutting agenda, though his language remains lukewarm. "You can rely on the fact that the coalition has the firm aim to make this happen... if possible, on 1 January 2011." Hardly a zealot, then. "We are pursuing a bit of a wait-and-see policy." Contrast that with Mr Westerwelle's statement that the government is "declaring war against the waste of taxpayer money".

What will happen? The picture is further complicated by a measure passed by the outgoing "grand coalition" – the so called "debt brake law". This extraordinary amendment to Germany's constitution, the Basic Law, requires a zero limit on annual net borrowing for the states, or Länder, and a limit of 0.35 per cent of GDP for the federal government by 2016 – with progress due to begin in 2011 – just when the tax cuts are due. As Mr Schäuble himself has said, "It is ambitious enough simply to stick to the constitutional debt brake.... It makes no sense to talk about savings measures, at a time when you are having to push through stimulus measures."

But, tough as cutting taxes and simultaneously reducing the budget may be, the task is not as ambitious as it would be in the UK. Put simply, Germany has much more scope to cut taxes and borrow, if she wants to.

Germany entered the downturn with a more or less balanced budget, unlike Britain. Even now, after a substantial fiscal boost that has focused on saving jobs through short-term subsidies, Germany's annual budget deficit is running at about 5 per cent of GDP, compared with the UK's 12 per cent. But Germany's national debt remains larger, at least for the time being, at around €1.5 trillion, or 80 per cent of GDP; it is expected to rise to 90 per cent by the middle of the next decade.

Still, a record budget deficit of at least €86bn next year, and possibly as high as €100bn after tax cuts, horrifies many Germans with powerful folk memories of past cataclysms caused by printing money. They yearn for a better economic tomorrow. The post-war certainties of the German mark and the Bundesbank were swept away by the euro a decade ago, but the Maastricht rules, designed to protect the currency, have also been engulfed by the crisis. For 20 years Germany has had to pay for reunification and has found herself at the bottom of the international growth league. It has been an unsettling time. Against that, Germany still enjoys formidable strengths in manufacturing and trade. The IMF predicts growth of 0.3 per cent next year.

The most striking thing about the recent German debate, however, is that, unlike in the UK, comparatively little has been said by the parties about where they might cut public spending. Mr Schäuble may well have some ideas, but the consensus is that radical cuts can come only after the coalition has survived regional elections next year, the outcome of which will determine the government's voting power in the upper house of parliament, the Bundesrat. Without a working majority there the Merkel government will be no more able to deliver reform than any other recent German administration.

As we have seen recently, and many times before in the Bundesrepublik's 60-year history, the constitution and electoral system is geared to coalition building and consensus, and gradual change. Politics and economics may once again conspire to leave Chancellor Merkel and her finance minister disappointing their more impatient friends and allies.