TCS Daily

Flat Tax Frenzy

By Nico Wirtz - September 15, 2005 12:00 AM

Known for having one of the most complicated and onerous tax regimes in the world, Germany recently surprised observers overseas when it started a public discourse on a concept that has been floated in the United States for quite some time and has been implemented in a number of reform economies in Central and Eastern Europe, most recently in Romania and the Republic of Georgia: the flat tax.

But given the well-known rigidity of the German body politic and the curious love Germans seem to have for the status quo, the obvious question is whether this reform debate is any more than a pipe dream. In fact, already it has altered the country's election campaign.

With ever increasing public debt and rising deficit spending, Germany faces a great economic challenge that will continue to grow. Over the past couple of years, publicly held debt has accumulated to a staggering €1.46 trillion. This has largely been caused by a continuous upward spiral of social security outlays of about €90 billion per annum. For all of 2005, the German government will have to borrow an additional €35 billion to at least partially finance its self-inflicted domestic obligations. New borrowing runs €13 billion higher than projected at the beginning of 2005.

Politicians generally, and particularly now, only days before the election, keep telling German taxpayers that the government is fiscally exhausted.

Wary of touching the unpopular issue of benefit cuts, especially during an election, politicians are touting new ways to finance the status quo. While Social Democrats, Greens and the new Left Party have their eyes on a tax-the-rich-scheme, Angela Merkel's CDU and its CSU partner favor and have all but agreed upon an increase of the country's VAT from the current 16 percent to at least 18 percent. The horrendously high state expenditures do not seem to be an election or political issue at all even though the German government is responsible for a staggering 47 percent of all economic activity.

When Merkel invited Germany's former Federal Constitutional Court justice Paul Kirchhof to join her "Competence Team" some fiscal conservatives saw a silver lining for Germany's financial and economic quagmire. Having ruled in favor of a series of tax policy changes during his time on Germany's highest court, Kirchhof was seen by many as the personification of pro-growth tax reform, and, having developed the so-called Kirchhof model, of the flat tax.

When Kirchhof submitted his proposal, it instantly drew fire from the political left. This did not come as a big surprise, but was seen as a somewhat encouraging thing by the Frankfurter Allgemeine Zeitung, Germany's leading conservative newspaper, which stated that "massive resistance by people representing particular interests and associations is the most certain sign that this is the right path to take."

Kirchhof's proposal, which aside from the implementation of a 25 percent flat tax called for the elimination and abolition of 481 tax subsidies and special write-offs, resulted in a political outcry. While this was to be expected from the SPD and the Greens, even the more conservative parties balked: Neither Merkel and the CDU/CSU, nor the normally fiscally conservative Free Democratic Party (FDP), was willing to embrace such an idea.

While not flat-out rejecting the concept -- the party is generally supportive regarding Kirchhof's vision of a streamlined and leaner government -- the FDP does not think the flat tax is politically feasible at this point in time. For now, the FDP favors its own tax simplification plan. Its main pillar is an overall simplification of Germany's highly complex taxes and the replacement of the current system of income tax progressivism with three simplified brackets: 15, 25 and 35 percent.

Realizing that the flat tax concept may cost her votes on Sunday, Angela Merkel, who had thought Kirchhof's expertise would add political clout to her "Competence Team" has back-paddled and has dismissed Kirchhof as a 'visionary' -- and in doing so put him in the academic ivory tower. In sync with the country's tradition of broad based political consensus, ideas such as Kirchhof's are now being brushed aside as too "controversial", too "threatening" and as a frontal assault on the concept of "social harmony and social justice".

Chancellor Gerhard Schröder's SPD/Greens have dismissed and will continue to dismiss core elements of Kirchhof's agenda and with it the need for drastic cuts in public spending. Sensing electoral trouble, the Christian Democrats have followed suit. Even Guido Westerwelle (FDP), normally one of Germany's few free-market champions, has sharply criticized Merkel and her dealings with Kirchhof. With poll numbers falling for the CDU/CSU this past week, Westerwelle suggested Merkel should distance herself more drastically from Kirchhof's flat tax model as to not jeopardize her chances of ousting Schröder. However good policy the Kirchhof plan may be in the eyes of the Free Democrats, it currently looks to be bad politics.

In all this, SPD, Greens and the CDU/CSU have a tendency to forget that Germany's prolific welfare state and exuberant government spending are not limited to helping those in need and distress. German automobile manufactures, the country's fledging movie industry, farmers and artists -- just to name a few -- live off government support programs. Therefore, "reform" in Germany means and will continue to mean only one thing: More money and more rights for everybody who has a vested interest in maintaining the status quo.

Most of the programs Kirchhof would like to do away with did not come into existence because there were sound economic or political arguments for them. Many of them were created during the boom days of the German economy, when the Soziale Markwirtschaft prospered and the government was awash in cash. Handouts were not just en vogue, but they were also financially possible. Once in place, no one would dare to touch them. This became the modus operandi for the entitlement mentality that is now ever so deeply engrained in Germany's political culture.

Seen nationally, as well as internationally, Kirchhof's program of a flat tax coupled with significant cuts in public spending should be embraced by all those seeking to replace Germany's current government. Germany is in dire need of a pro-growth fiscal catalyst. The reform economies in Central and Eastern Europe which have embraced the flat tax have been attracting investment partly on the basis of this system and are growing, while Germany's economy is stagnating.

Germany's ongoing lobbying efforts on the European level against tax competition, a flat tax or broad based liberalization of labor markets and social standards make it even more difficult for Merkel and the CDU/CSU to embrace Kirchhof's agenda it domestically. Therefore, it does not surprise that those who have the most to lose or gain on September 18 have no desire to entertain Kirchhof's notion of reducing the size of government. Every single one of Kirchhof's proposals to slash government spending to finance a flat tax is a stick of political dynamite.

So Merkel carefully words her speeches, avoiding terms like "abolishing", "defunding" or "ending" any given government program, and instead alludes to the generic, and widely accepted notion of "saving money". Despite the fact that in her recent TV debate with Schröder, Merkel used, almost word for word, Ronald Reagan's limited government rhetoric of 1980 in her closing statement, the Christian Democrats in Germany can in no way be compared to Reaganite Republicans in the United States. And while she likes to see herself as the German Margaret Thatcher, she will have a long way to go to live up to her idol should she become chancellor following the election on Sunday.


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