French Budget: Walking the Fine Line edit

Oct. 6, 2006

The 2007 budget should be a decently good vintage for the French economy, given the extraordinary electoral circumstances that will prevail in 2007: Presidential election in May, followed by general elections in June. Against this backdrop, one would have expected the incumbent government to flatter the electorate by injecting some growth boosters by means of budgetary stimulus, leaving to its successor the task to clean up the fiscal mess. My reading of the draft budget as it is now in the hands of the National Assembly is that it is a fair compromise between electoral contingencies and the imperious necessity to rationalize public spending, streamline the tax system, and cut the ballooning public debt. Actually, the public debt should decline already this year, as a percentage of GDP, for the first time since 2001. In my view, the next government will have to go much deeper in reducing still bloated headcounts in the civil service and reforming social security funds (healthcare and pension mainly), but, as far as direct taxation policy is concerned, both for individuals and companies, it is fair to say that this government has done a good job.

-->Overall central government spending, including interest on the debt and civil servant pensions, should decline by 1% in volume terms, that is, should not increase by more than 0.8%, 1.8% being the normative inflation rate the government has in its macro projections. Although less impressive than the 32bn euros cuts announced by the Italian government (15bn on a net basis), this is nevertheless relatively tough by French standards. In particular, the number of civil servants should decline by roughly 15,000, i.e. half of the number of those due to retire. Plotted against the total headcount of the civil service (around 2.3 million), this is still quite small, but nevertheless twice as high as last year and the largest headcount count recorded in the last 15 years. One would only wish that spending by local governments, which increased by more than 3% this year, would be as muted as central government spending.

As already programmed by previous bills passed by the Assembly, the top marginal income tax rate will be cut from 50% to 40% and the capital gain tax for companies will be almost fully scrapped next year. Almost indeed: in order to find some extra resources, the budget is re-integrating capital gains into the income tax base for cessions above 22.8 million euros but less than 5% of the capital of the target company. This should not change the big picture: corporate capital gain taxes (for shares held more than 2 years) will disappear from the French tax landscape. Elsewhere, a cap to local taxes to no more than 3.5% of value added was already decided, but the details were still in the limbo. This might be important in some regions, given the highly uneven distribution of local tax rates.

Overall, the Treasury expects the general government deficit to decline to 2.5% of GDP next year, from an estimated 2.7% this year. The budget is based on a 2.25% GDP growth assumption (between 2.0% and 2.5%), just one-tenth above trend growth, and similar to the assumption made for 2006. With hindsight, last year's growth hypothesis looks pretty accurate -the consensus estimate for GDP growth this year is 2.3%-- although at that time, it had been criticized for being too optimistic, including by yours truly. However, I continue to think that next year is not going to be as good as the government is expecting, because of the fiscal tightening implemented in Germany and Italy, and also the rise in short term interest rates. Our own forecast, 1.9% GDP growth in 2007, would be consistent with a slightly higher deficit, at 2.7% of GDP.

Even so, France would comply with EU budget rules for the third year in a row and, this time, without the help of one-off items such as the transfer of pension liabilities from to/be/privatised companies. More importantly, the debt to GDP ratio would continue to decline, to 64.9% of GDP on our estimates (63.6% on the government projections). Since this year, the debt reduction was largely the result of changes in the management of the very short-term debt, rather than to structural changes, a further decline was not warranted. This is thus good news for French sovereign bonds, in a context of intensifying competition between sovereign issuers in the euro area. However, it will take several years of deleveraging of public finances before the debt dynamics becomes sustainable before the unavoidable rise implied by the demographic transition. Fiscal rigour is here to stay.