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German coalition's tax cut plans may have to wait

BERLIN (Reuters) - Germany is unlikely to see sweeping tax cuts any time soon despite a victory for the center-right in Sunday’s federal election, as a swollen budget deficit restricts the new government’s room for maneuver.

The win for Chancellor Angela Merkel’s conservatives and the business-friendly Free Democrats (FDP) gives the new partners a mandate to pursue their campaign pledges to reduce taxes, but any such cuts will likely have to wait at least a year.

Investors and economists welcomed the projected result, which would free Merkel’s conservatives from the awkward “grand coalition” in which they ruled for the last four years with the center-left Social Democrats (SPD).

“It’s a good outcome for Germany,” said Andrew Bosomworth, a senior portfolio manager at Pimco.

He hoped the change would result in a simplification of Germany’s tax system and cuts to public spending, which the FDP has campaigned for.

Europe’s biggest economy has just emerged from its deepest recession since World War Two but the recovery is fragile. Lower tax revenues, combined with higher welfare payments, are putting the public finances under strain.

Germany’s budget deficit is expected to reach 6 percent of gross domestic product (GDP) in 2010 -- twice the European Union limit -- and federal new borrowing has been earmarked at a record 86 billion euros ($126.3 billion) for next year.


“It will be enormously difficult for the government to strike a balance between reducing state debt and consolidating the budget at the same time as stimulating growth,” said Andreas Rees, economist at UniCredit.

Additional pressure on public coffers is likely to kick in next year, when unemployment is expected to rise above 4 million, and the German government risks incurring EU disciplinary action unless it tackles the deficit.

“I don’t think they’re going to just walk in there and start slashing taxes, but that could happen in conjunction with expenditure cuts in other areas and that will take a bit of time,” said Bosomworth at Pimco.

So far, rises in joblessness have been limited by a government program that subsidizes workers’ pay and benefits when they are shifted from regular to shorter working hours.

The budget deficit could rise further if firms lay off workers who had been on short-time contracts, said Bosomworth.

Gianluigi Mandruzzato, fixed income strategist at BSI, expected the new government would not cut taxes until 2011.

“I think given the constraints that are coming from the current situation in the budget, the reduction (in taxes) will only be implemented in progressive steps,” he added.


The new government will face domestic and foreign pressure to reform the economy. Germany was the world’s biggest exporter of goods last year but the domestic economy is marked by stagnant consumer spending and firms want cuts to taxes.

Industry immediately pressed for reform.

“State spending on areas such as social welfare, subsidies and development could now be called into question,” said Hans Heinrich Driftmann, president of the German Chambers of Industry and Commerce (DIHK).

“Of key importance is how quickly the new government deals with corporate and inheritance tax,” he added.

Tax cuts could boost consumer spending and help rebalance the economy. Germany is under pressure to cut back its reliance on exports from peers among the Group of 20 economic powers.

U.S. President Barack Obama last Sunday singled out Germany when saying he wanted the G20 to rethink the global economy.

Washington’s plan involves shrinking surpluses in big exporting countries such as China and Germany, and boosting savings in debt-laden nations that include the United States.

Germany has shown it is unwilling to shrink its export sector, so rebalancing would mean boosting domestic demand -- a difficult task without putting more money in people’s pockets.

The clear-cut projected win for the center-right relieves markets of the uncertainties about economic policy that would have come with another “grand coalition.”

The FDP’s strong showing -- winning just under 15 percent of the vote to nearly 34 percent for the conservatives -- should give the business-friendly party a strong voice in the next government and they could take the economy or finance ministry.

Editing by Mark Trevelyan