Is the German Boom a Mirage?

Here's an interesting fact from supposedly sclerotic Europe. The German economy outperformed the United States in 2006, with real GDP up 3.7 percent for the year—the strongest growth in six years, more than twice the 1.7 percent rate of 2005 and a huge improvement from the average 0.2 percent between 2002 and 2004.

German economic activity, it's said, is acting as a "locomotive" for growth across Europe. Real GDP in the euro zone grew 3.3 percent last year. Three million new jobs were created. Unemployment fell a full point to 7.4 percent. After decades of sub-par performance, many economists and politicians have begun talking of a "renaissance" in Europe, with worldwide benefits ranging from higher global investment returns to rising tax revenue and lower costs for social welfare and unemployment insurance.

The reality is very different. These optimistic forecasts have little chance of coming to pass. Reason? The surge in 2006 German economic growth did not come from an improvement in the underlying economy. Because German tax rates were scheduled to move higher on Jan. 1, 2007, many companies and individuals simply shifted income and spending forward into lower-tax 2006. Those who did so were able to avoid a 3 percent hike in the VAT tax, to 19 percent, as well as a 3 percent hike in the top marginal income- tax rate to 45 percent. After all, if you knew that a store was raising prices next week, you would probably do your shopping this week, right?

For Germany, this means that growth was stolen from 2007, artificially boosting 2006. The forward shift in economic activity caused many forecasters to lift their projections for euro-zone growth in 2007. Others have been tempted to believe that Germany can raise taxes without hurting overall economic activity. If Germany has entered a "self-sustaining" recovery—not just surviving higher taxes, but actually seeing a boost in growth—then perhaps other countries can, too. Instead of being considered a drag on growth, tax hikes are suddenly being seen as not such a bad idea.

Again, this is illusory. The German economy accelerated toward the end of 2006 because of the anticipated 2007 taxhikes, not despite them. If tax cuts had been scheduled, instead, the opposite would have occurred. The economy would have been weaker in the months leading up to the change, as income and spending were shifted toward the lower-tax year. If you knew that a store was cutting its prices next week, you would probably not shop this week.

The danger in all this is already showing in Germany's performance numbers. Early data on consumer and business sentiment show a reversal from the positive outlook of 2006. Industrial production and factory orders fell in December. Car sales dropped 10.5 percent in January. A recent Bloomberg survey of 340 German retailers for January and February shows the weakest consumer activity since early 2004—a 0.2 percent real GDP growth year.

The economic consensus—German real GDP growth rate of 1.5 percent to 2 percent this year, and even higher European growth—is therefore overly optimistic. And another tax issue looms, this time from the opposite direction. In 2008, the German government plans to reduce corporate-tax rates from roughly 40 percent to 30 percent. This will create a strong incentive for corporations of all sizes to push income and profits from 2007 into 2008. Result: 2007 will be far worse for the German economy than many predict.

The bottom line? Germany remains a very high-tax economy. Factor in top income-tax rates of 45 percent, social-security taxes of 19.9 percent, health-care payroll taxes of 14.3 percent, un-employment insurance of 4.2 percent and the 19 percent VAT tax, and many working Germans face a marginal tax rate of 50 percent or more on their wages—like most Continental Europeans. That remains a huge drag on entrepreneurship, profitability and wealth creation—not to mention growth. That's why 2006 looks more and more like a one-year wonder.