Kohl's Ax Is Really Aimed At Europe

Will his reform ideas spread?

Can German Chancellor Helmut Kohl spark a supply-side revolution in Europe? No one would have believed it just a few months ago. But Kohl's Apr. 26 announcement of plans to ax more than $46 billion from government spending and to roll back Germany's costly tax and social security regimes is the strongest signal yet that such a shakeup is on the way. Kohl's proposed budget cuts--the equivalent of 2% of gross domestic product--would slice far deeper in a single year than then-Prime Minister Margaret Thatcher ever did when she launched her bid to reform Britain.

Kohl's plans could mark the start of an economic and psychological turnaround whose effects would soon ripple throughout Europe. While his program aims to revive Germany's economy, his broader goal is to change Europe's economic mind-set. He wants to scrap the long-held expectation that Europe must have big government, high taxes, unbending labor practices, and huge social spending. "Psychology is 50% of economics," says Meinhard Miegel, head of Bonn's IWG Institute for Economy & Society.

Germany's alarming competitive slide is behind Kohl's break with his trademark consensus politics. A key proposal to cut top corporate and personal tax rates to 28% would rejuvenate business confidence and create a surge of investment in Germany. That would balance out the short-term slump in demand from government spending cuts. The financial discipline would put new pressure on France, Italy, and Spain to get their houses in order. In the best scenario, Germany's economic rebound would fire up the rest of Europe, easing the introduction of the common European currency in 1999. Says Pascal Salin, president of the Mont Pelerin Society, a group of supply-side thinkers: "Germany is making the right decisions."

SHOCK EFFECT. No doubt Kohl will face opposition as he spreads his supply-side gospel in Europe. In Germany, his coalition government is outgunned by the opposition in the Bundesrat, which has to approve finance bills. Labor unions are already threatening a hot summer of strikes against Kohl's planned public sector wage freeze, and industrial lobbies will also fight to keep their subsidies. If other governments follow Kohl's lead, special interests will battle to keep their privileges as well. In France, for example, the government's efforts to cut social spending last December sparked a three-week strike.

Yet the mood is growing among European government and business leaders that the time for drastic measures has come. On May 10, for example, the new center-right government of Spanish Prime Minister Jose Maria Aznar pledged to cut public spending by $1.6 billion and reduce Spain's budget deficit to 4.4% of GDP this year from 5.8% last year. Says Heinrich von Pierer, CEO Siemens: Around Europe, "the call is for political leadership. It will mean the introduction of unpopular measures."

Kohl has several factors working for him. Germany's discount rate is at a post-World War II low of 2.5%, inflation is just 1.3%, money is slack, and Bonn already has two years of budget consolidation behind it. Unemployment, which hit a record 11.1% in February, steps up political pressure on Kohl but also reinforces the argument for radical reform. Above all, Kohl is benefiting from the shock effect of his new decisiveness. At a May 6 meeting of his Christian Democratic Union (CDU) party's inner sanctum, for instance, he boldly ordered two commissions drafting tax and welfare reforms to report by yearend. Kohl wants to push through legislation in 1997.

Here's how a supply-side revolution in Europe could unfold: If Kohl pushes through the bulk of his budget plan by the fall, that could spur Germany Inc. to recapture some of its lost competitive edge. Companies from Daimler Benz to Hoechst have been shaking themselves up to boost productivity. But they have been channeling investment outside of Germany. That flow could be reversed if Kohl overhauls tax rules that hit companies with a top rate of 45% and individuals with a 53% levy once they earn more than $80,000. Gunnar Uldall, CDU economic spokesman in the Bundestag, wants a three-band system of 8%, 18%, and 28% rates. The top rate would apply to incomes of $20,000 and up.

A more favorable tax regime would also kill the incentive for tax dodgers who bank their money in Liechtenstein, Switzerland, and Luxembourg. "It would absolutely stop tax flight from Germany," says Martin Hufner, chief economist of Munich's Bayerische Vereinsbank. That, in turn, would help Germany regain an estimated $70 billion in revenues lost annually through tax evasion. Revamping the tax system is also aimed at luring foreign investors away from other high-tax countries such as France and Italy. Says Herbert Demel, CEO of Audi: "It is the first step to correct Germany's disadvantages as a place to do business."

BIG POTENTIAL. An investment boom could turn current projections for German economic growth on their head. This year, GDP is forecast to rise just 0.75%. Next year, most economists predict growth of not much more than 2%. But if Kohl's plan is implemented, the economy could be ripping along at 3.5% by 2000, says Norbert Walter, chief economist at Deutsche Bank in Frankfurt. Rising consumer spending and investment could recreate the unification boom of the early 1990s, boosting imports from the rest of Europe. Germany's rebound would be "the locomotive for an export-led revival" on the Continent, notes John Praveen, senior international economist at Merrill Lynch & Co. New jobs would be created and bring Europe's double-digit unemployment rates below 10% for the first time since the early '90s.

Even small measures would have big potential. Today, employees in German companies with five or fewer workers have little job protection. Kohl will raise the limit to 10 or fewer workers, allowing another 1.5 million companies to hire and fire workers as needed. If each makes just one new hiring, Kohl will be three-fourths of the way to redeeming his pledge to halve Germany's unemployment of 4 million by 2000.

If Germany achieves even a modicum of success, the onus will be on its neighbors to keep up--or lose investment, jobs, and tax revenues. Nobody expects a quick transformation. "Supply-side reforms don't boost economies overnight," warns Nigel Gault, chief economist at DRI/McGraw-Hill in London. "Kohl's proposals are only a start." But just as in Thatcher's Britain, recognizing the malady is the beginning of the cure. Kohl may be about to do what Thatcher never could: transfer radical new economic thinking to the Continent.

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