How to finance Germany's modernisation: Financing options under the debt brake

Schuster, Florian; Heilmann, Felix; Krahé, Max; Sigl-Glöckner, Philippa; Steitz, Janek Research Report How to finance Germany's modernisation: Financing options under the debt brake Fachtexte Provided in Cooperation with: Dezernat Zukunft - Institute for Macrofinance, Berlin Suggested Citation: Schuster, Florian; Heilmann, Felix; Krahé, Max; Sigl-Glöckner, Philippa; Steitz, Janek (2024) : How to finance Germany's modernisation: Financing options under the debt brake, Fachtexte, Dezernat Zukunft e.V., Berlin This Version is available at: https://hdl.handle.net/10419/307984 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Dezernat Zukunft is a non-partisan policy institute that aims to explain and re-think monetary, fiscal, and economic policy in an accessible and coherent way. Our articles and proposals are aimed at political decision-makers, at academics and the media, and the next generation of thinkers and citizens. With our work we aim to broaden public debates and support an inclusive process of political will formation. The core values guiding all our work are democracy, dignity, and widespread prosperity. Authors: Dr. Florian Schuster-Johnson Senior Economist [email protected] Felix Heilmann Senior Policy Analyst [email protected] Dr. Max Krahé Research Director [email protected] Philippa Sigl-Glöckner Managing Director [email protected] Janek Steitz Director [email protected] Status as of: September 2024 Dezernat Zukunft – Institute for Macrofinance POLICY PAPER 1 of 29 Germany requires 782 billion euros in additional public spending for modernisation by 2030. German politicians have so far lacked a reliable financing framework for this purpose; there are constant discussions around spending cuts or a constitutional reform of the debt brake. Neither strategy can realistically be implemented in the short term. In this policy paper, we show that many of the needs identified can in fact be financed without amending the Basic Law, and thus addressed in the short term: the debt brake already provides options to take on debt for productive expenditure as part of the cyclical component and financial transactions. Nevertheless, these financing solutions are insufficient, complex, and more expensive than necessary. A reform of the debt brake would therefore be sensible, but this will first require a new understanding of “sustainable public finances”. Executive Summary POLICY PAPER 2 of 29 Table of Contents 1. Introduction ...................................................................................................... 5 2. Public financing needs by 2030 ....................................................................... 6 3. Financing options without altering the debt brake .....................................8 1. Financial transactions .....................................................................................................10 2. Cyclical component ...........................................................................................................16 3. Tax and other revenue .....................................................................................................18 4. Financing options for municipalities ..............................................................................21 4. The debt brake makes many things possible, but also complex and expensive .........................................................................................................23 5. A new definition of sustainable public finances ........................................26 Bibliography ......................................................................................................... 27 POLICY PAPER 3 of 29 Target Additional need (in billions of EUR) Financing options Federal State Municipal Education (127.2 billion euros) School buildings (reducing investment backlog) 57.1 Municipal investment promotion programme of the federal and state governments, funded by financial transactions in the form of loans to municipalities or municipal corporations Teachers (constant student-teacher ratio) 15.5 Cyclical component School digitisation 9.0 Cyclical component All-day childcare (investments) 1.9 Municipal investment promotion programme All-day childcare (personnel) 8.2 Municipal budgets Legal daycare entitlements (investments) 8.4 8.4 States: financial transactions in the form of loans to daycare providers or state construction companies Municipalities: Municipal investment promotion programme Legal daycare entitlements (personnel) 6.8 6.8 States: Cyclical component Municipalities: Municipal budgets University buildings (maintenance) 5.1 Financial transactions in the form of loans to state construction companies Decarbonisation (207.6 billion euros) Additional financing need of the federal government* 159.0 Financial transactions in the form of loans for investment, processed via the KfW or federally owned company; remainder from current tax and other revenue Additional financing need of states and municipalities (excluding public transport) 10.8 37.8 States: Financial transactions in the form of loans to state-owned companies Municipalities: Municipal investment promotion programme R&D (9.9 billion euros) Public R&D funding 5.7 4.2 Cyclical component Health (40.4 billion euros) Structural reform 12.5 12.5 Financial transactions in the form of loans to hospital operators Closure of investment gaps 8.4 Climate change adaptation measures in hospitals 7.1 POLICY PAPER 4 of 29 Transport (165.5 billion euros) Rail infrastructure 62.0 Financial transactions in the form of loans to Deutsche Bahn Road infrastructure (maintenance) 13.5 51.8 Federal government: Financial transactions in the form of loans to Autobahn GmbH Municipalities: Municipal investment promotion programme Public transport 38.2 Financial transactions in the form of loans to public transport companies for investment, remainder from current tax and other revenue Housing (30.6 billion euros) Social housing construction 21.9 8.7 Financial transactions in the form of equity investments in residential real estate companies Internal security (22.8 billion euros) Civil protection and disaster reponse 2.3 3.0 17.5 Federal and state governments: current tax and other revenue Municipalities: Municipal investment promotion programme Climate adaptation (38.0 billion euros) Climate adaptation and nature conservation 9.5 28.5 States: current tax and other revenue Municipalities: Municipal budgets Resilience (15.1–19.8 billion euros) Industrial capacity for energy transition technologies 13.5 Current tax and other revenue Critical raw materials 1.6–6.2 Defence (103.1 billion euros) Bundeswehr (procurement and recurrent costs) 103.1 Financial transactions in the form of loans to defence companies for procurement, remainder from current tax and other revenues Further aspects of external security (21.7 billion euros) Diplomacy and humanitarian aid 9.4 Current tax and other revenue Development cooperation 12.4 Table 1: Overview of public financing needs and financing options * In contrast to the other areas considered, the additional need for decarbonisation at the federal level is calculated as the difference between total financing need and the expected revenue from carbon pricing in two price scenarios. For this reason, the requirement is shown as a collective item; a detailed breakdown can be found in Heilmann et al. (2024). POLICY PAPER 5 of 29 Germany must modernise in order to face geopolitical, demographic, climate and economic challenges. There is a growing consensus that this modernisation requires considerable public spending.1 Nevertheless, it has not been possible to find a reliable funding framework for these needs in recent years. Discussions have largely concerned two options: a constitutional reform of the debt brake or large-scale spending cuts. The former, however, would require a two-thirds majority in the Bundestag and Bundesrat. In the case of the latter, potential savings on the necessary scale are difficult to find and even more difficult to implement without significant economic damage. As a result, the necessary modernisation expenditure has failed to materialise, while the needs have steadily grown as a result of underinvestment. With this paper, we introduce additional financing options into the debate. Even without reforming the debt brake in the Basic Law, many of the additional expenditure needs can still be financed. Concretely, we explain two mechanisms that allow for debt to be taken on within the framework of the debt brake: financial transactions and the cyclical component. Financial transactions represent asset swaps - for example, when the state exchanges cash for equity. Under the debt brake, the economic component allows for debt to be taken out up to full capacity utilisation of the economy. We propose using these mechanisms to finance investments and other expenditures that improve the productive potential of the German economy and thus modernise the country. These will not require an amendment to the Basic Law, but only simple legal adjustments. Our detailed bottom-up analysis of public financing needs in Heilmann et al. (2024) allows us to develop financing solutions tailored to individual areas of expenditure and to qualitatively describe their macroeconomic impact. In Heilmann et al. (2024), we estimate expenditure needs by purpose and level of government. This helps us to identify which expenditures should be sensibly financed by borrowing, but also which additional burdens will be placed on current public revenue. It also serves to delineate the boundaries that are effectively set for German fiscal policy within the current constitutional framework. However, a financial policy that pushes the modernisation of Germany forward will not just come up against constitutional limits, but also the limits of the real economy. One such factor is the availability of a sufficiently large workforce. Policymakers can shift these limits themselves, however, by actively addressing the supply side of the economy, and above all, Germany's labour market potential. Although the latter is not the focus of this paper, it is a key prerequisite both for modernisation and for long-term sustainable finances. This paper also shows that, while many things are possible under the debt brake, they are made unnecessarily complicated. Necessary expenditure to strengthen productivity, public services or defence can already be financed today; however, it requires complex financing models that are not very transparent and will first have to undergo extensive legal review. In some cases, these means also lead to higher costs. It would therefore be sensible to consider a fundamental reform of German financial policy. The overarching aim of this article is thus to further stimulate the debate on financing options. Regardless of whether the recognised financing needs are to be covered by new borrowing, budget restructuring or tax increases, all three approaches become controversial as soon as substantial amounts are involved. Socially, a stable financing framework can only succeed if the chosen instruments enjoy a high level of legitimacy. Such legitimacy requires a broad public debate that makes the pros and cons of the individual options, as well as their 1 In Heilmann et al. (2024), we estimate the relevant additional need to be EUR 782 billion by 2030. The studies by the German Economic Institute (IW) and the Institute for Macroeconomics and Economic Research (IMK) (Dullien et al. 2024) as well as the Federation of German Industries (BDI; 2024) come to similar conclusions in their relevant areas. Introduction1. POLICY PAPER 6 of 29 opportunities and challenges, visible with a view to the next federal election. Table 1 provides an overview of the financing options described in this paper and their areas of application. Chapter 2 describes the public financing needs, and Chapter 3 describes the financing options we assign to each of them. Chapter 4 discusses their limits and limitations. Finally, in Chapter 5, we outline more fundamental ideas and questions whose resolution would be helpful for a reform of German fiscal policy. 2 Heilmann et al. 2024 In a comprehensive assessment of additional public financing needs in order to achieve widely accepted targets by 2030, we have identified a minimum total requirement of 782 billion euros by 2030.2 This corresponds to an average of three percent of the current gross domestic product (GDP) per year. This needs assessment was based on extensive consultations with technical and budget experts. Only those objectives were examined which could be considered to be widely accepted on the basis of these consultations and political decisions. Figure 1 shows the distribution of the additional funding needs across levels of government with needs respectively allocated to the relevant federal level, unless there have been clear decisions made to the contrary to take effect in the future. Over 50 percent of the funds are required for investment measures. At the same time, we have also examined the additional operating costs required in areas where it is not possible to make sensible use of investments without such funds – for example, in the education sector. 19 percent of the identified additional needs relate to operating costs, while a further 28 percent cannot be clearly allocated or are mixed items that include expenditure for both investment and operating costs. Public financing needs by 20302. POLICY PAPER 13 of 29 tions. Loans are a suitable form of financing here because neither daycare centres nor universities are expected to generate a business return, which is why additional equity capital would not help. The loans given would be repaid from grants out of public budgets. Table 2: Financial transactions Target Additional need (in billions of EUR) Financing options Education Legal daycare entitlements (investments) States: 8.4 Financial transactions in the form of loans to daycare providers or state construction companies University buildings (maintenance) States: 5.1 Financial transactions in the form of loans to state construction companies Decarbonisation Additional financing needs of the federal government (investments) Federal: 125.2 Financial transactions in the form of loans for investment, processed via the KfW or a federally owned company Additional financing needs of states and municipalities (excluding public transport)) States: 10.8 Financial transactions in the form of loans to state-owned companies Municipal investment promotion programme Health Structural reform Federal and states: 12.5 each Financial transactions in the form of loans to hospital operators Closing the investment gap States: 8.4 Climate change adaptation measures in hospitals States: 7.1 Transport Rail infrastructure Federal: 62.0 Financial transactions in the form of loans to Deutsche Bahn Road infrastructure (maintenance) Federal: 13.5 Financial transactions in the form of loans to Autobahn GmbH Public transport (investments) States: 19.1 Financial transactions in the form of loans to public transport companies for investment Housing Social housing construction Federal: 21.9 States: 8.7 Financial transactions in the form of equity investments in residential real estate companies Defence Bundeswehr (procurement) Federal: 90.2 Financial transactions in the form of loans to defence companies for procurement POLICY PAPER 14 of 29 Supporting measures by the federal government are also necessary for decarbonisation. In addition to the politically broadly supported goal of offsetting the price of carbon, these include promoting the expansion of renewable energies and energy infrastructures, subsidies for the transformation of industry, the promotion of building refurbishment and heating networks, subsidies for low-emission vehicles and the promotion of a nationwide charging and refuelling infrastructure in the transport sector, and support measures in the area of natural climate protection. Many of the necessary private investments require public subsidies before 2030, even with higher carbon prices, because investments will not automatically follow from higher prices for various reasons. For example, a high carbon price generally reduces the economic efficiency gap between low-emission and fossil-fuel industrial production, but this can lead to competitive disadvantages on international markets without global carbon pricing and therefore to reticence in investment. The European border adjustment mechanism is intended to address this starting in 2027, but will only be introduced gradually until 2035, and only for selected industries. In the building sector, energy-efficient refurbishment may be economical in the medium term if carbon prices are high, but some owners will not be able to afford the high investment costs due to limited creditworthiness. Nevertheless, the overall need for support depends negatively on the price of carbon: the higher the carbon price, the smaller the economic viability gap for climate-friendly investments, and the lower the need for public support – with the above-mentioned restrictions. In our estimate, we use two scenarios that cover a plausible range of possible price developments in order to take account of the uncertainty surrounding the further development of the price of carbon. To determine the financing options, we take the average of the two scenarios and arrive at an additional federal need for investment funding in the energy, industry, buildings, transport and natural climate protection sectors of 125.2 billion euros by 2030. This already takes into account the proportional use of carbon pricing assumptions for investment purposes. These investments are long-term climate protection investments that will benefit both current and future generations. It therefore makes sense to spread their financing – and in particular the annual burden on the federal budget – over time. Financial transactions are suited for this purpose. Specifically, we propose providing these funds in the form of loans. They could be handled by KfW or one or more independent energy transition corporations yet to be established, which would pass on investment grants to industrial companies, energy producers and private households. This enables the latter groups to implement low-CO2 production facilities, expand renewable energy generation or renovate buildings. The repayment of the loans would have to be spread out over time by means of federal subsidies. This does not result in any hidden loans, as all payments are accounted for in the federal budget, but merely spread over the term of the loans. The states, for which we estimate additional needs of 10.8 billion euros for the renovation of public buildings and natural climate protection, could finance decarbonisation measures in a similar manner. Significant infrastructure measures are also necessary to make the healthcare system more efficient. These include new buildings and upgrades to hospitals as part of the ongoing structural reform (12.5 billion euros each for the federal government and the states), closing the existing investment gap in the hospital sector (8.4 billion euros for the states) and climate protection projects, particularly for energyefficient upgrades to buildings (7.1 billion euros for the states). In total, we estimate the additional need at 40.4 billion euros by 2030. Debt financing of these investments makes sense because the healthcare system contributes significantly to German GDP and a functioning healthcare infrastructure increases the well-be- ing of society as a whole.11 Financial transactions are suitable for their financing as hospitals are generally operated by (public or 11 Weil (2005); Fournier (2016) POLICY PAPER 15 of 29 private) legally independent bodies. Since the healthcare system is not subject to targeted financial returns, the federal government and especially the state governments could provide these companies with loans and stretch the repayment over time with subsidies from their budgets. An initial example in this direction is the state of Berlin, which is already supporting the state-owned Vivantes GmbH with the help of financial transactions (in the form of equity injections).12 Transport infrastructure is another area where our model of financial transactions can be applied. We estimate that the federal government will have to invest an additional 62.0 billion euros in railways and a further 3.5 billion euros in federal long-distance roads over the next few years. In addition, there is a financing need of 38.2 billion euros in the area of local public transport, of which a considerable proportion – we assume half, i.e. 19.1 billion euros – is for infrastructure investments and is to be borne at the state level. There is no question in the literature that these investments should be financed with loans, as they have a substantial effect on productivity and potential output.13 In Schuster, Sigl-Glöckner and Heilmann (2024), we outline a financing proposal for transport investments using federal loans and financial transactions. In a similar way, the state governments could grant loans to the public transport providers in the states and municipalities, most of which are independent transport companies. Income is generated from ticket sales which, together with repayment subsidies from the federal and state governments, make the repayment of the loans plausible, therefore qualifying them as financial transactions. We estimate an additional need of 30.6 billion euros for social housing construction by 2030, of which 21.9 billion euros will fall to the federal government and 8.7 billion euros to the states. This estimated need is based on the goal of politicians and the housing industry to build 100,000 new social housing units per year. Investments in residential construction lead to immediate productivity gains in the labour market and capacity expansions in the construction industry.14 These positive effects on potential growth speak in favour of financing them with debt. As social housing construction is largely supported by municipal housing associations, we propose, in line with Dullien and Krebs (2020), to provide them with additional equity from the federal and state governments. This also improves their financing conditions with banks and on the capital market, which play a key role in residential construction. Such equity injections are shares in the traditional sense and therefore financial transactions whose profitability can be secured by future rental income. The Bundeswehr also has a significant need for additional infrastructure. We count armaments as public infrastructure because they are durable goods that fulfil a central purpose for society as a whole – defence capability. In addition, defence companies often produce non-military products for other industrial sectors, such as the automotive industry, at the same time. Government spending on armaments therefore has substantial multiplier effects, such that it is directly reflected in higher economic capacities and added value.15 Our estimate envisages an additional need for procurement investments of 90.2 billion euros by 2030. We propose financing these requirements by means of financial transactions. Specifically, the federal government could grant loans to defence companies. Defence companies face the challenge of obtaining favourable financing on the capital market. Sustainability criteria are becoming increasingly important in the capital market, partly because they are now part of the regulatory framework with the EU taxonomy. Whether defence companies meet these criteria is in many cases questionable. Government loans can help to reduce financing costs and improve access to liquidity because they send positive signals to the private capital market. The granting of loans would provide companies with liquidity to expand production capacities and manufacture the required milit- 12 13 14 15 Berlin Senate Department for Finance (2023) Krebs and Scheffel (2017) Krebs and Scheffel (2017); Hsieh and Moretti (2019) Ramey (2007) POLICY PAPER 16 of 29 ary equipment. The federal government and the company could contractually agree that the government will subsequently pay off its orders from budget funds over several years and thus contribute to the loan repayment. Overall, we propose to finance 405.3 billion euros by 2030 with financial transactions. This represents considerable additional expenditure, the realisation of which requires corresponding economic capacity. This requires a policy that consistently focuses on expanding economic potential, especially employment potential (more on this in Chapter 4). 16 17 18 19 Federal Ministry of Finance (2022) A technically detailed description of the estimate of potential output can be found at Havik et al. (2014) and Ademmer et al. (2019). Federal Ministry of Finance (2024c) Federal Government (2024a) The instrument: In addition to financial transactions, the cyclical component is the second part of the debt brake that allows debt in excess of the structural deficit of 0.35 percent of GDP. It enables the state to pursue an anticyclical spending policy depending on economic capacity utilisation. The scope for borrowing is increased in economic downturn phases and reduced in economic boom phases. The degree of capacity utilisation is measured using the output gap – the difference between current GDP and an estimated potential output. Specifically, for every euro that GDP is below potential, the cyclical component allows additional borrowing of around 20 cents.16 Potential output cannot be observed and must be estimated. It indicates a hypothetical GDP that the economy would achieve if the production factors of capital and labour were at full utilisation. A number of input variables, which are estimated using statistical econometric methods and extrapolated into the future, play a key role in determining employment potential and a fully utilised capital stock.17 This method is problematic because many of the required input variables cannot be determined on an economic basis alone. Their determination requires a large number of assumptions and methodological definitions which, on closer inspection, appear arbitrary, contradict the current state of research or turn out to be wrong in retrospect. The estimate of potential is therefore susceptible to revisions, which makes it difficult to plan fiscal policy, as well as pro-cyclical, which restricts the fiscal space too harshly during downturns. In addition, the cyclical component lacks democratic legitimacy because many of the methodological determinations are at the discretion of the federal government itself instead of being approved by the Bundestag. A detailed analysis of the problems of estimating potential can be found in Schuster, Krahé and Sigl-Glöckner (2021). The calculation of potential output and the cyclical component is particularly implausible in one respect: It makes the assumption that potential output is independent of actual policy. Political reforms aimed at expanding potential output – especially labour potential – are not taken into account in the statistical model for estimating potential. Particularly as there is already a shortage of labour today, policy measures that expand potential – even beyond infrastructure expansion – are crucial to ensuring the future performance of the economy and the sustainability of public finances. One example from the recent past is the growth initiative adopted by the German government, which includes a large number of statutory measures to increase employment. The declared aim is "[to] substantially increase the long-term growth potential of the German economy with the measures adopted".18 The initiative is even included in the German government's GDP projection, but not in the potential estimate.19 Other countries, such as 2. Cyclical component POLICY PAPER 17 of 29 20 21 22 Office for Budget Responsibility (2022) Korioth and Müller (2021) See Scholz (2021). Although some states use tax trends or tax level procedures instead of the federal procedure, the mechanism of policies that expand potential can be established here in a similar way. A cyclical component designed in this way gives politicians an incentive to pursue sustainable fiscal policy: A good (i.e., potential-expanding) policy brings with it a good amount of money. The process for determining the cyclical component can be used to ensure this extra "wiggle room" for debt is actually employed to this end. It is conceivable, for example, that the federal or state governments could present a list of potential-expanding policy projects as part of the budget preparation process, the effects of which on potential output would be estimated by an independent body made up of economists similar to the British OBR. Both the government proposal and the evaluation should be published so that politicians have to publicly defend their plans. The decision on permissible borrowing for potential policy measures must ultimately be made by the Bundestag or the state parliaments as part of budget legislation. This would also put the power to decide on the determining factors of financial policy back where it belongs according to the constitution: in the hands of the democratically legitimised legislature. the United Kingdom, are already further ahead. In its estimate, the UK's Office for Budget Responsibility (OBR) takes into account the effects of the policy on potential output, provided that these are sustainable, measurable and have a significantly expansive effect.20 The calculation of the cyclical component can be adjusted without amending the Basic Law so that it is based on realistic potential output and creates additional scope for potential-ex- panding policies.21 In 2024, the federal government has already made technical adjustments to the cyclical component, as we analyse in Rennert and Schuster (2024). The main provisions on the calculation procedure are only made at the level of an ordinance to Article 115 of the Basic Law, which regulates the federal debt brake (Art115V). They could be supplemented by a mechanism to take into account the potential effects of current policy measures. Since Art. 115 of the German Basic Law (G115) stipulates that the German procedure must be in line with the European procedure, it may be necessary to amend this provision by means of simple legislation, unless potential-expanding policies are also incorporated into the assessment of economic potential at the European level. Similarly, there are no constitutional changes necessary at the state level either, but only simple legislative changes in order to adapt the economic adjustment procedures accordingly.22 Target Additional need (in billions of EUR) Financing options Education Teachers (constant studentteacher ratio) States: 15.5 Cyclical component School digitisation States: 9.0 Cyclical component Legal daycare entitlements (personnel) States: 6.8 Cyclical component R&D Public R&D funding Federal: 5.7 States: 4.2 Cyclical component Table 3: Cyclical component POLICY PAPER 18 of 29 How these needs can be financed: Other government spending also has positive effects on the productive capacities of the economy without fulfilling the classic definition of an investment. In our estimate, we arrive at additional need of at least 41.2 billion euros by 2030, the financing of which has a potential-ex- panding nature. We therefore propose to finance them with the help of additional leeway for debt under a reformed cyclical component (see Table 3). In addition to infrastructure investments, there is a need for additional personnel and material expenditure in the education sector at the state and municipal levels in order to maintain the current quality of daycare, full-time childcare and schools in general. In the daycare sector, we estimate that 61,200 additional childcare staff (in full-time equivalents) will be needed by 2030 in order to implement parents' legal entitlement to a daycare spot. We estimate the resulting additional costs for the states at 6.8 billion euros (including material costs). In order to maintain the current student-teacher ratio at schools, around 51,700 new teachers (in full-time equivalents) and additional funding of at least 15.5 billion euros will be required. There is also an additional need for the digitisation of schools, which requires construction measures, hardware purchases and the upgrading of employees' digital skills. For this, we have set an additional financing need of 9.0 billion euros at the state level. This expenditure is not covered by the traditional concept of investment, but is essential for the overall economic effects of education. New school buildings are worthless without new teachers, for example. These measures expand the productive potential of the economy through direct employment gains on one hand and productivity gains on the other.23 Education personnel expenses should therefore be financed, at least temporarily, by loans, which are possible under a reformed cyclical component, until the additional tax revenues generated by education are able to cover the financing. Additional public expenditure will also be necessary for research and development in order to achieve the federal and state governments' target of 3.5 percent of GDP spent on research among society as a whole. We estimate a combined additional need of 9.9 billion euros, split roughly equally between the federal and state governments. Higher public spending on research and development has a positive effect on the productivity of the economy because it promotes technological progress and innovation. It should therefore also be financed with debt and could be taken into account under the cyclical component. One thing is important to note: The scope for additional debt available through the cyclical component is not limited to the sums mentioned here. After all, potential output is not just positively impacted by fiscal policy, but also by other legal measures. Further simplifying access to the labour market for foreign workers, or reducing financial disincentives to work, especially for women and families, could make a significant contribution to expanding economic potential. Such reforms are also likely to be necessary in order to overcome the investment backlog in the coming years. 3. Tax and other revenue The instrument: Financing through debt is appropriate for investments and other expenditure that significantly expand the productive capacities of the economy. The decisive factor in this respect is their effect on growth and potential, and not whether they are one-off or ongoing government measures. Many other government expenditures do not fulfil this criterion. Spending on climate adaptation, foreign policy, or national security authorities, for example, are essential for other reasons. They maintain the foundations of safe co-existence, work, and business in Germany, but do not create any additional economic 23 Krebs and Scheffel (2017) POLICY PAPER 19 of 29 capacity. Expenditure of this kind should therefore be financed from the state's current revenues. Nevertheless, they remain important – especially in times of climate change, migration movements and a challenging security situation at home and abroad. How these needs can be financed: Our estimate results in additional financing needs in the amount of 117.5 billion euros for aspects that are socially necessary but which do not count as investments nor expand economic potential (see Table 4). They should therefore be financed from current federal and state revenues. In doing so, we explicitly leave out social expenditure, such as for the Citizen's Income (Bürgergeld), pension subsidies or other social benefits. The largest block is made up of additional needs for personnel expenses, which are incurred in a number of policy areas. The Bundeswehr has the greatest need for personnel. This is due to the fact that all new purchases of military equipment entail additional costs for personnel and operations. In addition to the additional needs for infrastructure (see above), our estimate envisages further personnel and operating costs of 12.9 billion euros by 2030, which are currently not Target Additional need (in billions of EUR) Financing options Decarbonisation Additional financing needs of the federal government (electricity price compensation and municipal climate protection management) Federal: 33.8 Current tax and other revenue (excl. income from carbon pricing) Transport Public transport (personnel and operation) States: 19.1 Current tax and other revenue Internal security Civil protection and disaster response Federal: 2.3 States: 3.0 Current tax and other revenue Adaptation to climate change Climate adaptation and nature conservation States: 9.5 Current tax and other revenue Resilience Industrial capacities for energy transition technologies Federal: 13.5 Current tax and other revenue Critical raw materials Federal: 1.6 Defence Bundeswehr (personnel and operations) Federal: 12.9 Current tax and other revenue Further aspects of external security Diplomacy and humanitarian aid Federal: 9.4 Current tax and other revenue Development cooperation Federal: 12.4 Table 4: Current tax and other income POLICY PAPER 20 of 29 covered. According to our estimates, a portion of the additional requirements of 38.2 billion euros in the transport sector, especially for local public transport, will also go towards personnel, which will have to be paid for out of state budgets (possibly via allocations to the municipalities). For the sake of simplicity, we assume here that half the sum, i. e. 19.1 billion euros, will go towards personnel costs. There is a mixture of additional needs to cover costs related to personnel, operating and construction in other policy areas. For internal security, especially civil protection, we estimate additional requirements of 2.3 billion euros and 3.0 billion euros for the federal and state governments respectively. In line with an integrated concept of security that also encompasses foreign and development policy, we have also identified additional requirements of 9.4 billion euros for the Federal Foreign Office and 12.4 billion euros for the Ministry of Development. For climate adaptation and nature conservation, there are also additional needs at the state level for coastal protection, flood protection and nature conservation as well as the development of personnel expertise in state administrations, the total cost of which we estimate at just under 9.5 billion euros. Our criteria for financing through financial transactions or loans under the cyclical component cannot be applied to these needs, which is why they would have to be covered by current revenue. For some of the federal government's needs related to decarbonisation, we propose above that they be financed via financial transactions in the form of loans. However, there are also financing needs related to electricity price compensation for industry, which we estimate will cost 27.8 billion euros by 2030, and for the establishment of climate protection management at the municipal level (6.0 billion euros). As these are not investments, we propose covering these parts of the decarbonisation costs from the federal government's current revenues beyond the income from carbon pricing. We have already offset the latter for compensation in the form of a direct payment to private households amounting to 50 percent of the revenue from the German Fuel Emissions Trading Act (BEHG) and the European Emissions Trading Scheme (ETS-2) as well as the pro rata financing of investments in the amount of the remaining revenue. Finally, we identify additional financing needs in order to increase the resilience of the German economy. For one, this includes needs related to stockpiling critical raw materials. This item results from the European Critical Raw Materials Act and is particularly relevant for a country with few raw materials such as Germany considering the more conflict-ridden geopolitical situation of the present. We estimate these costs to be in the range of 1.6 to 6.2 billion euros. There is also an additional need for federal subsidies in order to build up minimum capacities in industrial sectors that are crucial for the energy transition, e.g. in the areas of wind power, solar, batteries, electrolysis and heat pumps. We estimate the costs at 13.5 billion euros. These additional requirements serve economic security rather than the expansion of economic performance, which is why they should be financed from the federal government's current tax and other revenues. Since subsidised economic sectors represent longterm costs, while commercially viable ones generate sustainable tax revenues, a central goal of the federal government should be the economic viability of as many critical sectors as possible. If this is sufficiently achieved, credit financing via financial transactions would be conceivable for similar resilience expenditure in the future. POLICY PAPER 21 of 29 Municipalities are a special case within the constitutional framework of budgetary policy as they are not directly subject to the debt brake. With the exception of the "city-states" of Berlin, Hamburg and Bremen, which are treated like all other federal states with respect to the debt brake, the funding options of financial transactions and the cyclical component cannot be transferred one-to-one to the municipalities. Nevertheless, municipal budgetary policy is also subject to strict rules. In all 13 non-city states, the municipal regulations stipulate that the budget must be balanced.24 This principle relates either to the balancing of income and expenditure (in the double-entry budget system) or income and expenditure (in the cameralistic system), but sets tight limits on the municipalities' debt options either way. Additional restrictions arise from the generally strained situation of municipal budgets. According to data from the Federal Statistical Office, German local authorities are burdened with almost 30 billion euros in old debt. The municipal financing deficit amounted to 6.4 billion euros in 2023, and according to the German Association of Towns and Municipalities, it will move towards 10 billion euros in the coming years, driven by cyclical revenue shortfalls and high costs, e. g. for refugee accommodation.25 Since the start of the millennium, net municipal investment has been negative, meaning that municipal infrastructure is falling into disrepair.26 In this context, it is not surprising that the additional financing need among the municipalities is immense. If we sum up the estimated needs at the municipal level, we arrive at an additional need of 218.0 billion euros by 2030 (see Table 5). The majority of this – 174.5 billion euros – goes towards school buildings (57.1 billion euros) and all-day childcare (1.9 billion euros), daycare centres (8.4 billion euros), municipal roads (51.8 billion euros), district heating networks (12.0 billion euros), the renovation of public buildings (13.0 billion euros), natural climate protection (12.8 billion euros) and the reduction of backlogs in fire and disaster prevention (17.5 billion euros). A further 28.5 billion euros is needed for climate adaptation measures and nature conservation. There is also a need for more staff in all-day childcare (8.2 billion euros) and daycare centres (6.8 billion euros). Given their financial situation, it is doubtful that all local authorities will be able to finance such requirements in the coming years without support from the federal and state governments. To meet investment needs, we therefore propose that the federal and state governments jointly set up investment promotion programmes through which they provide funding to the affected municipalities or municipal corporations. A municipality's participation in the investment promotion programme could be linked to its individual budget situation. Three conditions seem particularly plausible in this respect. Firstly, for local authorities whose budgets are prepared using the double-entry system, their equity base is decisive in determining whether there is scope for financing additional needs. Secondly, high levels of liquidity loans are a burden on many municipal budgets, piled up as a result of insufficient funding allocations and revenue shortfalls coupled with rising costs. Thirdly, the municipalities differ according to the extent to which they are affected by structural change. For example, cities and municipalities in coal-mining regions have to shoulder significantly higher financial burdens than those in areas where companies in the chip or renewable energy industries are located today. These three criteria are not exhaustive and are mutually correlated. Nevertheless, investment promotion should be geared towards at least these conditions in order to ensure an effective and fair distribution of financial resources. This is necessary so that urgent needs can be met where they are greatest. The necessary and sensible level of co-financing by the municipalities should there- 24 25 26 Mühlenkamp and Glöckner (2010) Federal Association of Municipal Umbrella Organizations (2023) Gemeinschaftsdiagnose (2024) 4. Financing options for municipalities POLICY PAPER 22 of 29 fore be carefully weighed up depending on the funding programme and objective. The funding programmes can take the form of loans as described above and can therefore be booked as financial transactions. Loans to the public sector are expressly exempt from the debt brake; their repayment can be agreed with the municipalities or their corporations and supported by federal subsidies. With the municipal investment promotion fund, which expires in 2025, the federal government has already created a role model for this approach, although it provided direct grants instead of loans.27 Since 2015, a total of seven billion euros has been made available for infrastructure and school renovation projects via this fund. Since the identified needs of the municipalities lie particularly in the areas of municipal roads and the construction of schools and daycare centres, a permanent, reliable continuation of the previous funding framework seems feasible here. In order to ensure a smooth outflow of funds, the granting of loans should be limited to only the most necessary bureaucracy. The additional financing needs we have identified, particularly with regard to additional staff in daycare centres and full-time childcare, as well as for climate measures, would have to be covered by the current revenues of the municipal budgets unless other support systems are developed for this purpose. 27 Federal Ministry of Finance (2024b) Target Additional need (in billions of EUR) Financing options Education School buildings (reducing the investment backlog) 57.1 Municipal investment promotion programme of the federal and state governments, funded by financial transactions in the form of loans to municipalities or municipal corporations All-day childcare (Investments) 1.9 Municipal investment promotion programme All-day childcare (personnel) 8.2 Municipal budgets Legal daycare entitlements (investments) 8.4 Municipal investment promotion programme Legal daycare entitlements (personnel) 6.8 Municipal budgets Decarbonisation Additional needs of municipalities (excluding local public transport, investments) 37.8 Municipal investment promotion programme Transport Road infrastructure (maintenance) 51.8 Municipal investment promotion programme Internal security Fire and disaster prevention (investments) 17.5 Municipal investment promotion programme Adaptation to climate change Climate adaptation and nature conservation 28.5 Municipal budgets Table 5: Financing options for municipalities POLICY PAPER 29 of 29 available online at: https://www. bertelsmann-stiftung.de/fileadmin/files/ BSt/Publikationen/GrauePublikationen/ NW_OEff entliche_Investitionen_und_ inklusives_Wachstum.pdf [last accessed: 02.09.2024]. 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(2024): "Die Konjunkturkomponente wurde angepasst: ein guter Anfang und noch Luft nach oben", Dezernat Zukunft, available online (in German) at: https://dezernatzukunft.org/ evaluation-konjunkturkomponente/ [last accessed: 05.09.2024]. German Council of Economic Experts (2023): "Overcoming Sluggish Growth - Investing in the Future", Annual Report 2023/2024, available online (in German) at: https:// www.sachverstaendigenrat-wirtschaft.de/ fileadmin/dateiablage/gutachten/jg202324/ JG202324_Gesamtausgabe.pdf, English summary at: https://www. sachverstaendigenrat-wirtschaft.de/ fileadmin/dateiablage/gutachten/jg202324/ JG202324_ExecutiveSummary.pdf [last accessed: 02.09.2024]. Scholz, B. 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POLICY PAPER 30 of 29 Funding the modernisation of Germany – Options for financing under the debt brake Version 1.0 This work was supported by the Allianz Foundation, the European Climate Foundation, the William and Flora Hewlett Foundation, the Laudes Foundation and Open Philanthropy. Imprint Project leads: Felix Heilmann, Dr. Max Krahé, Dr. Florian Schuster-Johnson Steering committee: Felix Heilmann, Dr. Max Krahé, Dr. Sabrina Schulz, Dr. Florian Schuster-Johnson, Philippa Sigl-Glöckner, Janek Steitz Proofreading: Dr. Maria Seidl Published by: Dezernat Zukunft e.V. Chausseestraße 111, 10115 Berlin www.dezernatzukunft.org Authorised representative of the Board of Directors: Dr. Max Krahé Board of Directors: Dr. Max Krahé, Dr. Maximilian Paleschke, Nicolas Gassen Registered association at the Amtsgericht Charlottenburg Association register number 36980 B Responsible for content according to §18 MstV: Dr. Max Krahé Publisher: Dr. Max Krahé, Berlin E-Mail: [email protected] Design: Burak Korkmaz This work by Dezernat Zukunft is licensed under CC BY-NC 4.0. . The contents may be used with clear identification of the source and, if indicated, with reference to the author. POLICY PAPER 31 of 29 Textelemente? Logo o.ä.? Download the study: Register for our newsletter: Dezernat Zukunft e.V. Chausseestaße 111 - 10115 Berlin www.dezernatzukunft.org [email protected]