European Economy. Economic Papers. Germany's growth performance in the 1990's

Box 3 (continued)
necessarily negligible. Two studies recently carried out for the Federal Ministry of Finance
criticise the consistently negative effects of ABM in reducing the incentives to look for aregular
job for two reasons.
32
First, the wage is paid at 20% less than those in collective agreements and
is therefore often higher than for many regular jobs paid outside collective agreements. Second,
participation in ABM renews the right to unemployment benefits that are higher than
unemployment assistance to which long-term unemployed are entitled; this has already been
abolished for training measures in 1998. The overall conclusion is that ALMP need to be better
targeted to specific problem groups and the requirements of the labour market, but should not
serve merely as a means of reducing unemployment temporarily by creating a second labour
market.
32
Zentrum für Europäische Wirtschaftsforschung 2000 and Schneider et al. 2000

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2.2.A Annex: The effects of German fiscal policy in the 1990s:
It is likely that the German growth potential has been strongly influenced by the effects re-
unification had on public finances. Changes in income taxes and strongly rising social security
contributions have driven the tax wedge up (Table 2A.1). In combination with moderate wage
increases and only minor changes to social security benefits, these developments have at least
not increased incentives to take up a job
33
.
Table 2A.1: Total Tax Wedge on Labour
80
90
91
92
93
94
95
96
97
98
99
00
D
48.9
49.1
49.2
50.1
51.0
52.0
52.0
52.7
53.0
53.3
53.8
53.7
F
49.9
53.2
53.5
53.1
53.4
54.3
54.5
55.7
55.7
55.4
56.1
56.0
EUR-11
45.0
48.5
48.9
49.3
50.4
50.7
50.7
51.2
51.5
51.5
51.9
51.8
Source: Commission services; for the method of calculation cf. Martinez-Mongay (2000)
What are the short and medium-run growth and employment effects of the increase in
government expenditure and the strategy adopted to finance these additional expenditures by the
German government? More precisely to what extent can the lower growth in Germany in the
second half of the 90 be explained by the long run consequences of these fiscal developments
documented above?
Standard macroeconomic models predict that a permanent fiscal expansion - if financed by
distortionary taxation - could potentially generate substantial “hangover effects”, after the
positive demand stimulus has petered out. An important transmission channel from a fiscal
expansion to lower growth operates via crowding out of private investment. The crowding-out
effect arises from a loss of competitiveness, higher expected wage costs and lower expected net
profits from higher taxes. In the case of distortionary tax financing a second transmission
channel emerges. The negative investment response is reinforced by adverse labour market
developments. These arise from attempts of workers/trade unions of shifting part of the
increased labour tax burden onto firms, which react by reducing labour demand.
Both transmission channels are operative in DG ECFINs macroeconomic model QUEST II,
which is used for the quantitative assessment of German fiscal policy in the 1990s. The results
reported below show the evolution of important German macroeconomic variables relative to a
baseline path where the share of government spending as well as the effective tax rates for
labour, capital and consumption are kept at their 1991 levels. Both the permanent nature of the
fiscal shock and its magnitude is likely to have a non trivial macroeconomic impact.
The results reported in Table 2A.2 clearly show an unfavourable trade-off between the short-
term expansionary effects and the long-term output losses inflicted by a tax financed
expenditure of government consumption. While GDP increases initially, though with a
multiplier smaller than one, GDP falls below the baseline already in the fourth year. Already
after the second year, the growth rate is about 0.3% points below baseline growth. The economy
continues to grow by about 0.3% less in the following years and eventually reaches a lower
level of GDP. Similarly, the unemployment rate rises by about 3% points after 10 years. In
QUEST this effect arises from the fact that an increase in labour and indirect taxation lowers the
wedge between the take home market wage and the reservation wage. According to these
results, fiscal policy may have contributed significantly to the growth slowdown in Germany
over the 1990s.
33
On the negative impact of high taxes and a generous social transfer system on labour supply in Germany see
also IMF Art. 4 (Selected issues) ,1999, p. 96 and Ifo, 2001, p. 31

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