Sept. 5 (Bloomberg) -- The taxman is about to pay a visit to consumers and businesses in Europe that will inflict pain around the world.

German Chancellor Angela Merkel and Italian Prime Minister Romano Prodi plan to raise taxes to reduce their budget deficits, increasing pressure on the European economy only months after it recorded its best growth since 2000. Confidence in Europe's expansion is already waning amid rising interest rates, declining foreign demand and record fuel bills.

A slowdown in the dozen euro nations would deal a blow to global growth at a time when the U.S., the world's largest economy, is decelerating with the end of a housing boom.

The higher taxes are ``coming at a bad time, when we can see other problems for the global economy coming down the line,'' says Michael Heise, Frankfurt-based chief economist at Allianz AG, Europe's largest insurer.

Adding to the concern, Japanese leaders, whose economy is just emerging from a decade of deflation, may consider tax increases of their own after Prime Minister Junichiro Koizumi retires this month.

The tax increases in Germany, the world's third-largest economy, would be the largest since World War II. Merkel, 52, says she intends to raise the value-added tax, a form of national sales tax, to 19 percent in January from 16 percent.

`A Virtuous Trend'

Prodi, 66, who is seeking to cut his government's deficit by about 14 billion euros ($18.1 billion) next year, says he wants to raise some capital-gains taxes and hasn't ruled out introducing an inheritance tax. His government is trying to ``create a virtuous trend and maintain it'' by controlling the deficit, he said in a Sept. 3 interview.

``It's a delicate time,'' says Harvard University professor Ken Rogoff, a former chief economist at the International Monetary Fund. `It would help a lot if Europe grew more strongly, and raising taxes doesn't make sense.''

Both Germany and Italy, which together account for half the euro region's $10 trillion economy, have breached European Union spending rules every year since 2003, with both running deficits above the EU's ceiling of 3 percent of gross domestic product.

Governments take a risk in boosting taxes as their economies gain momentum. In 1997, Japan, the world's second-biggest economy, raised its VAT rate to 5 percent from 3 percent and triggered a recession a year later.

A Toll on Growth

Eric Chaney, chief European economist with Morgan Stanley in London, says such a downturn is possible next year in Europe for the first time since 1993. David Mackie, chief European economist at JPMorgan Chase & Co. in London, estimates the planned increases in taxes will knock 0.5 percentage point off Europe's rate of growth, with Germany's losing 0.8 percentage point.

German Finance Minister Peer Steinbrueck said in an Aug. 31 interview that while his country's tax increase will ``of course have an impact on growth, possibly also on inflation,'' the effect won't be as ``dramatic as some people think'' because the economy has ``a lot of tailwind.''

Even so, recent economic reports suggest Europeans are already bracing themselves. Confidence among households and businesses fell in August for the first month since November, the European Commission reported last week; investors expect the European Central Bank to raise its key rate twice more this year, taking it to 3.5 percent from 3 percent.

The Koizumi Succession

Japan's experience in the 1990s hasn't kept some potential Koizumi successors from talking about higher taxes only nine months after consumer prices began to rise again.

Finance Minister Sadakazu Tanigaki said July 27, after announcing his candidacy to replace Koizumi, that he wants to double the sales tax from 5 percent. Chief Cabinet Secretary Shinzo Abe, another potential prime minister, also wants to generate more tax income, the Yomiuri newspaper said Aug. 22.

``If Europe's day in the sun is over and Japan is unable to grow much faster, we could see all of the industrial economies growing more slowly next year,'' says Michael Mussa, senior fellow at the Institute for International Economics in Washington and another former IMF chief economist.

Slower growth abroad may make it harder for the U.S. to count on export growth to prop up a domestic economy slowing under the weight of the Federal Reserve's two-year campaign to raise interest rates. Expansion in the second quarter was little more than half that of the prior quarter. Since then, consumer confidence has fallen and sales of previously owned homes tumbled to the lowest in more than two years.

Bad News for China?

If a weaker Europe is bad news for American exporters, it may be worse for China, whose sales to Europe exceeded those of U.S. during the first five months of this year.

Those who worry that Asia may be hurt by a U.S. slowdown are ``perhaps debating the wrong thing,'' Brad Setser, head of economic research at Roubini Global Economics in New York, said on his Web log last week. ``They should be asking whether China can decouple from Europe.''

Europe's finance ministers -- many of whom this week are preparing their budgets for release later this month and meet Sept. 8 in Helsinki to discuss the economic outlook -- contend they must cut deficits to protect long-term growth after years of fiscal excess.

That's what happened in the U.S. in the 1990s, when tax increases pushed by President Bill Clinton helped narrow a deficit that had reached 4.7 percent of GDP in 1992. The subsequent return to budget surpluses boosted confidence and contained interest rates, helping pave the way for the longest U.S. economic expansion in history.

``The European tax increases are going to have a detrimental impact on growth,'' says Jean-Michel Six, chief European economist at Standard & Poor's in London. ``Nevertheless it's necessary to put a lid on the deficits, and given the robust growth of 2006, next year may be the best time to do it.''

Last Updated: September 5, 2006 00:20 EDT