Natnael Mulat

October 31, 2019

International Political Economy
To: Chancellor Angela Markel
From: Natnael Mulat
Date: October 30, 2019
Re: Reform to Boost Germany’s Manufacturing Sector

Executive Summary

Fears of Germany’s economy heading into recession and affecting other European

countries have become apparent as the export and GDP of the country immensely declined. The

chancellor should push for a policy that can increase domestic demand, while restructuring the

manufacturing sector to suit to the needs of the world so that export of the country and investment

increases to counterbalance the recent decline in export and GDP of the country.

The Situation

Germany’s economy relies heavily on manufacturing-- 47% of Germany’s GDP is made

up of manufacturing. This essentially makes Germany’s economy fragile when there is a weak

demand from key partners for Germany goods like automobiles, electronics, and machinery.

According to The Federal Statistical Office of Germany, in 2019 exports of German goods were

down by 8% and car production fell by 17%1 . Most blame the trade war between the U.S. and

China, and Brexit as the major factors that caused this plunge in demand in the largest economy

of the eurozone. Given how dependent German’s economy is on exports of manufactured goods,

recession is predicted in the coming years as trade-war escalates, and Brexit becomes a reality.

In addition to external factors that affected exports, consumers in Germany have become

much more cautious in spending, and that has an effect of lowering investments and productions.

News of a struggling economy, trade wars, and politics of Eurozone do have a big impact on

1
Reports by The Federal Statistical Office of Germany, August 2019, pp1-15
https://www.destatis.de/DE/Themen/Wirtschaft/Aussenhandel/Tabellen/aussenhandel-
detaildaten.pdf?__blob=publicationFile&v=8
expectations of consumers. When consumers expect a rainy day, they tend to save more while

consuming less. According to the IMF, German household consumption has fallen from around

63 percent of GDP in 2005 to 51 percent in 2018. While, in the second quarter of 2019 saving of

the country rose. 2

Implications

If Eurozone’s largest economy goes into recession, past years have shown that other

eurozone countries have a high probability of being hit by this recession since the list of European

countries that count Germany as their No.1 trading partner is long. This list includes UK, France,

Italy, the Netherlands, Belgium, Slovakia, and Sweden. In addition, suppliers throughout Europe

earn much of their revenue by selling to big German car manufacturers. A shock in the economy

of Germany has a high probability of affecting those and other countries.

Actions to change the situation

One-way Germany can avoid a possible recession is by boosting domestic demand

through multiple tax-cuts and government spending. The main reason why Germany’s savings

have risen, and investment has weakened is a large transfer of national income from households

to firms. While this transfer of income boosted the profitability of the enterprise sector and the

price competitiveness of German exports, it has done little to boost investment and hence

productivity. The weakness of domestic consumption has undermined firms’ incentives to invest

at home. Therefore, in order to boost investment in the country, the government should respond

by increasing spending and/or cutting taxes.

In particular, Germany should cut solidarity tax. This tax was introduced in 1991 on the

understanding that it would be imposed only temporarily to finance the reconstruction of the

2
International Monetary Fund. “Germany: Selected Issues.” IMF,
https://www.imf.org/en/Publications/CR/Issues/2019/07/09/Germany-Selected-Issues-47094.
former East Germany following reunification. Given that it has been thirty years, it would make

sense to cut solidarity tax so that consumers could have more income to spend, and that increased

demand can motivate firms to increase investment in Germany.

One may argue that abolishing the solidarity tax will do little to boost investment,

because it will disproportionately benefit the better off and firms with a high propensity to
save. Such concerns are held by Social Democratic Party deputy parliamentary group leader,

Achim Post, who insisted that, "We want to achieve more tax equality step by step, but we certainly

don't want to give away billion-euro tax gifts, " he said. "We need the money for investment in

education and climate protection" referring to cuts in solidarity tax.3

Although the view that the tax cut may benefit the rich may be true, we must also consider

the possibility that it gives consumers more income to spend. But the view that the money raised

from the solidarity tax should go towards public investment is unconvincing because there is no

shortage of funds available for investment. According to IMF, Germany has been running a trade

surplus for 4 years now4, and in addition, Germany’s government basically gets paid for borrowing

money from European Central Bank since it gets negative rate, and so money for investment should

not be a problem as long as the government agrees to expand investment.

Immediate action is also required to cut corporate tax. In Germany, the tax rate for

companies’ retained earnings is around 30%, which is significantly higher than most European

countries. Germany’s export surplus is accompanied by net capital exports, because more

investments are being made abroad than at home. Lowering corporate taxes would change that.

According to Deutsche bank research, if the corporate tax rate were to drop from 30% to 25%,

3
Deutsche Welle. “German Government Moves to End 'Solidarity Tax' for Eastern Germany: DW:
11.08.2019.” DW.COM, https://www.dw.com/en/german-government-moves-to-end-solidarity-tax-for-
eastern-germany/a-49983217.
4
International Monetary Fund. “Germany: Selected Issues.” IMF,
https://www.imf.org/en/Publications/CR/Issues/2019/07/09/Germany-Selected-Issues-47094.
companies in Germany could increase investment by up to 14%. In addition, owing to reduced tax

avoidance, profits recorded in Germany would rise by some 4%.5 If this tax cut is implemented, it

can significantly change the current prospects of the economy by raising investment.

In addition to tax cuts, the manufacturing sector of the economy should try to cope with

changing demands of the world. The Chinese market is the most important market for the majority

of German car manufacturers. In 2018, almost one-quarter of all cars sold in China were German.

However, a new environmental act has affected the sale of these cars-- by July 2020, all light

vehicles in China need to comply with the 6a emission standard, based on European and US

regulations.6 And German car manufacturers have struggled to adapt to changing consumer

demands for more electric mainly due to the cost involved in changing to a new type of products

that requires new skills and technologies.7 Therefore, the government should incentivize the

manufacturing sectors by tax cuts and subsidies to produce cars that are more suited to the needs

of importing countries, that way Germany can increase its export and hence its GDP to avoid a

recession.

Conclusion

The policy for reforming Investment and spending while restructuring the manufacturing

sector at this time is crucial to avoid recession. Since the obstacles to full, system-wide reform are

formidable, primary focus should be on identifying those key changes that will initiate a

sustainable process of reform.

5
Deutsche Bank Research. “German Corporate taxes, growing need for action,” September 14, 2018.
https://www.dbresearch.com/PROD/RPS_EN-
PROD/PROD0000000000476988/German_corporate_taxes%3A_Growing_need_for_action.pdf
6
Corne, Peter, and Johnny Browaeys. “China Cleans up Its Act on Environmental Enforcement.” 中外对
话 China Dialogue, 6 Dec. 2017, https://www.chinadialogue.net/article/show/single/en/10272-China-
cleans-up-its-act-on-environmental-enforcement.
7
“Is The German Car Industry Losing The Electric Race?” CleanTechnica, 21 June 2018,
https://cleantechnica.com/2018/06/21/is-the-german-car-industry-losing-the-electric-race/
 Bibliography

Deutsche Bank Research. “German Corporate taxes, growing need for action,” September 14, 2018.

https://www.dbresearch.com/PROD/RPS_EN-

PROD/PROD0000000000476988/German_corporate_taxes%3A_Growing_need_for_action.pdf

Deutsche Welle. “German Government Moves to End 'Solidarity Tax' for Eastern Germany: DW:
11.08.2019.” DW.COM, https://www.dw.com/en/german-government-moves-to-end-solidarity-tax-for-
eastern-germany/a-49983217.
International Monetary Fund. “Germany: Selected Issues.” IMF,
https://www.imf.org/en/Publications/CR/Issues/2019/07/09/Germany-Selected-Issues-47094.
Reports by The Federal Statistical Office of Germany, August 2019, pp1-15
https://www.destatis.de/DE/Themen/Wirtschaft/Aussenhandel/Tabellen/aussenhandel-
detaildaten.pdf?__blob=publicationFile&v=8
https://tradingeconomics.com/germany/government-bond-yield
Frankel, Jeffrey. “It's Time for German Fiscal Expansion by Jeffrey Frankel.” Project Syndicate, 30 Sept.
2019, https://www.project-syndicate.org/commentary/germany-austerity-time-for-fiscal-expansion-by-
jeffrey-frankel-2019-09.
Ewing, Jack. “Germany Nears Recession and Chinese Factories Slow in Trade War Fallout.” The New
York Times, The New York Times, 14 Aug. 2019,
https://www.nytimes.com/2019/08/14/business/german-economy.html.

Corne, Peter, and Johnny Browaeys. “China Cleans up Its Act on Environmental Enforcement.” 中外对
话 China Dialogue, 6 Dec. 2017, https://www.chinadialogue.net/article/show/single/en/10272-China-
cleans-up-its-act-on-environmental-enforcement.

“Is The German Car Industry Losing The Electric Race?” CleanTechnica, 21 June 2018,
https://cleantechnica.com/2018/06/21/is-the-german-car-industry-losing-the-electric-race/

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