Germany's tax debate

Whether and when to cut

An argument about tax cuts causes divisions within as well as between parties

GERMANY'S grand coalition is supposedly a union of the centre-right Christian Democrats (CDU) and their left-leaning foes, the Social Democrats (SPD). Lately, it has been more like an irascible marriage between those who wish to cut taxes fast and those who do not. Most CDU deputies in the Bundestag want tax cuts. The SPD chief, Kurt Beck, even says his party will cook up cuts of its own. But barring the way are the CDU chancellor, Angela Merkel, and the SPD finance minister, Peer Steinbrück. They want to keep a promise to balance the federal budget by 2011. Tax cuts in this parliament? “Not while I'm around,” growls Mr Steinbrück.

The fuss was stirred by the CDU's Bavarian sister party, the Christian Social Union (CSU). Fearful that its five-decade grip on power may be loosened in September's state election, the CSU called for tax breaks that would give low- and middle-income workers “more net from gross pay”, starting next year. The cost: €28 billion ($43 billion) by 2012. Most CDU deputies have since joined their Bavarian colleagues in a plea for rapid tax cuts. And the economy minister, the CSU's Michael Glos, has become the first cabinet member to suggest that the balanced-budget target is not sacrosanct.

The tax-cutting frenzy is stoked both by the political calendar and by the economy's performance. With a federal election due by September 2009 each partner in the grand coalition can do little but think of how to win by a margin wide enough to jettison the other. Their duel will be fought in part over tax. Total tax revenue at all levels of government jumped by 10% in 2007, thanks to a rise in value-added tax and to robust growth. In the first quarter of 2008 the economy grew by 6% at an annualised rate, its fastest in 12 years. That not all have benefited is another reason to argue over taxes. On May 19th the government disclosed that an eighth of Germans were living at or below the poverty line in 2005, early on in the boom. Tax the rich, demanded the left; lighten the burden on ordinary folk, countered the right.

Germans have reason to resent state greed. From 2004 to 2007 the state collected €91 billion in extra taxes, while workers' net incomes rose by just €18 billion, say the main business associations. Germany is not heavily taxed compared with other European countries (see chart), but it takes a bigger bite out of pay than most, a burden borne disproportionately by those on modest salaries. Workers earning only 1.4 times the average pay a top rate of income tax of 42% (there is a special 45% rate for the very rich). Unlike many countries, Germany does not adjust tax brackets automatically for inflation; the result is “cold progression”, which pushes taxpayers into higher brackets even when real incomes have not risen.

The government has been trying both to cut the budget deficit and to make the tax system friendlier to growth and employment. Last year's VAT increase may have disheartened consumers but it allowed a cut in payroll taxes. The previous coalition government of the SPD and the Greens cut income-tax rates. The current one has reduced taxes on companies instead. Most of its deficit reduction has come from higher revenues, but the government has tried to restrain expenditure: federal spending has risen by around 1.5% a year since 2004.

That has not appeased nervous politicians who see tax relief as the quickest route to electoral relief. Their suggestions are a mix of the sensible and the silly. The CSU would reduce the starting rate for income tax from 15% to 12% and lift the threshold for applying the top rate, countering the effects of cold progression. It would also restore a tax break for commuters, a foolish subsidy to pollution and traffic jams. The SPD leans towards cutting social-security contributions, which would stimulate employment. The party largely backs Mr Steinbrück's goal of eliminating the federal deficit first.

What is missing is any serious attempt to weigh the merits of tax cuts against other pressing aims, such as reducing the debt or spending more on research and education. Some economists read the tax-cut movement as a sign that Germans are questioning whether they need a state that consumes 44% of GDP, but there is little evidence for this. Federal spending is expected to jump this year and next, driven by higher pensions, health benefits and wage rises for civil servants, among other things. Mr Steinbrück is battling budget-busting proposals from the foreign-aid, transport, education and economy ministries. Rainer Kambeck of RWI Essen, an economic-research institute, predicts that federal spending will rise by an average of more than 2% a year from 2009 to 2011, well above the finance ministry's projection of 0.8%.

If all goes well the government might afford a voter-pleasing tax cut before the election and still hit its balanced-budget target. But that is a big if. Growth may slow soon. And nobody knows how far the corporate-tax reform, which takes effect this year, will reduce revenue, says Florian Zinsmeister of DIW, an economic-research institute in Berlin. The government could create room for tax cuts by trimming subsidies, which lavish €24 billion a year on such unworthy causes as coal mining. But that seems unlikely so close to an election. On taxes, the government “should drive with a steady hand” over the next two years, says Mr Zinsmeister.

Ms Merkel and Mr Steinbrück may be right to give priority to deficit reduction: interest payments are the second-largest item of federal spending. If Germans really want lower taxes on top, they should demand lower spending, too.

Economics focus

On the poverty line

Has “a dollar a day” had its day?

IN DECEMBER 2007 the World Bank unveiled the results of the biggest exercise in window shopping in history. Scouts in 146 countries scoured stalls, supermarkets and mail-order catalogues, recording the price of more than 1,000 items, from 500-gram packets of durum spaghetti to low-heeled ladies' shoes.

This vast enterprise enabled the bank to compare the purchasing power of many countries in 2005. It uncovered some statistical surprises. Prices in China, for example, were much higher than earlier estimates had indicated, which meant the Chinese income in 2005 of 18.4 trillion yuan ($2.2 trillion at then-market exchange rates) could buy less than previously thought. At a stroke, the Chinese economy shrank, in real terms, by 40%.

Since then, many scholars have wondered what this economic demotion means for the bank's global poverty counts. It famously draws the poverty line at “a dollar a day”, or more precisely $1.08 at 1993 purchasing-power parity (PPP). In other words, a person is poor if they consume less than an American spending $1.08 per day in 1993. By this yardstick 969m people suffered from absolute poverty in 2004, a drop of over 270m since 1990. The world owed this progress largely to China, where poverty fell by almost 250m from 1990 to 2004.

But if the Chinese economy was 40% smaller than previously thought, surely its poverty count must be correspondingly higher. Surjit Bhalla, of Oxus Investments, speculated that China's toll would increase by more than 300m. He mischievously accused the bank's number-crunchers of conspiring to lift the poverty count so as to keep their employer in business beyond its natural life.

Give a quarter, take a quarter

The dollar-a-day definition of global destitution made its debut in the bank's 1990 World Development Report. It was largely the discovery of Martin Ravallion, a researcher at the bank, and two co-authors, who noticed that the national poverty lines of half-a-dozen developing countries clustered around that amount. In two working papers* published this week, Mr Ravallion and two colleagues, Shaohua Chen and Prem Sangraula, revisit the dollar-a-day line in light of the bank's new estimates of purchasing power. They also provide a new count of China's poor.

Thanks to American inflation, $1.08 in 1993 was worth about $1.45 in 2005 money. In principle, the researchers could count the number of people living on less than this amount, converted into local money using the bank's new PPP rates. But $1.45 a day strikes the authors as a bit high. Rather than update their poverty line, they propose to abandon it. It is time, they say, to return to first principles, repeating the exercise Mr Ravallion performed almost two decades ago, using the better, more abundant data available now.

They gather 75 national poverty lines, ranging from Senegal's severe $0.63 a day to Uruguay's more generous measure of just over $9. From this collection, they pick the 15 lowest (Nepal, Tajikistan and 13 sub-Saharan countries) and split the difference between them. The result is a new international poverty line of $1.25 a day.

Why those 15? The answer is philosophical, as well as practical. In setting their poverty lines, most developing countries aim to count people who are poor in an absolute sense. The line is supposed to mark the minimum a person needs to feed, clothe and shelter himself. In Zambia, say, a poor person is defined as someone who cannot afford to buy at least two to three plates of nshima (a kind of porridge), a sweet potato, a few spoonfuls of oil, a handful of groundnuts and a couple of teaspoons of sugar each day, plus a banana and a chicken twice a week.

But even in quite poor countries, a different concept of poverty also seems to creep in, the authors argue. It begins to matter whether a person is poor relative to his countrymen; whether he can appear in public without shame, as Adam Smith put it.

This notion of relative deprivation seems to carry weight in countries once they grow past a consumption of $1.95 per person a day. Beyond this threshold, a country that is $1 richer will tend to have a poverty line that is $0.33 higher (see chart). The authors thus base their absolute poverty line on the 15 countries in their sample below this threshold.

How many people in the world are poor by this new definition? The authors are not yet ready to say. But they have taken another look at China. By their new standard, they find that 204m Chinese people were poor in 2005, about 130m more than previously thought.

That is the bad news. The brighter news is that China's progress against poverty is no less impressive than previously advertised. By Mr Ravallion's and Ms Chen's new standard, the number of poor in China fell by almost 407m from 1990 to 2004, compared with the previous estimate of almost 250m.

China's economic co-ordinates may be different than thought, but its trajectory is much the same. And therein lies a lesson. Give or take a dime or two, it matters little where a poverty line is drawn. Like a line in the sand, an absolute poverty standard shows whether the economic tide is moving in or out. It does not matter too much where on the beach it is drawn.

For practical purposes, policymakers will always care more about their own national poverty lines than the bank's global standard. The dollar-a-day line is more of a campaigning tool than a guide to policy. And as a slogan, $1.25 just doesn't have the same ring to it. A better option might be to reset the poverty line at $1 in 2005 PPP, which would line up reasonably well with at least ten countries in the authors' sample. In adding a quarter to the dollar-a-day poverty line, the researchers may cut its popular appeal by half.