German upper house votes for VAT hike

The Bundesrat, the German upper house of parliament, today voted in favour of the government's controversial plans to raise value-added tax (VAT) by three full percentage points in a move critics say will put the brakes on recovery in the euro zone's biggest economy.

Barely a month after the plans were rubber-stamped by the German lower house, the Bundestag, the Bundesrat also approved the proposals by the government of Chancellor Angela Merkel to raise VAT  from 16% to 19% from January 1, 2007.

The Bundesrat, which is made up of representatives of Germany's 16 regional states, was the last parliamentary hurdle the law had to clear before it comes into effect from the start of next year. Out of the 16 states, only five voted against the proposals or abstained.

Part of the additional tax revenues will be used to finance a planned reduction in non-labour wage costs for employers. And some of the revenues will be used to help plug the gaping holes in the German public purse.

Berlin hopes to cut its public deficit to €22 billion next year from an anticipated $38 billion this year, meaning the government will make a great deal of headway in bringing its deficit back within EU limits by 2007.

However, the VAT hike has come under fire from industry, as well as experts such as the Bundesbank and Germany's leading economic think-tanks. They argue it could put the brakes on the fledgling economic recovery in Germany by dampening consumer demand, which is also now beginning to show signs of a pick-up.

The Organisation for Economic Cooperation and Development  (OECD) recently estimated the tax hike could knock around 0.25 percentage points off overall growth.

In addition, the higher tax is likely to push up headline inflation in Germany, which will have consequences for the whole of  the euro area.

Finance Minister Peer Steinbrueck has acknowledged the risks, but insisted the government had no alternative for getting its public finances back in order. The German government is expecting economic growth to slow to 1% next year from an anticipated 1.6% this year.