Necessity forces Schroder to take the gamble of his career

Despite the looming election, Chancellor Schröder has postponed tax cuts for a year to help fund flood repairs and so far the risky move appears to be paying off

Necessity is the mother of invention and it was sheer necessity that made the German Chancellor, Mr Gerhard Schröder, take the biggest gamble of his career this week.

For days, Germans watched in disbelief as flood waters surged through eastern Germany, washing away homes, businesses, roads and railways - a decade of careful investment financed by the government's Aufbau Ost ("Rebuilding of East Germany") programme. The programme is financed by a 0.75 per cent "solidarity tax" that Germans have been paying, and west Germans complaining about, since 1990.

In a huge outpouring of solidarity, Germans have donated more than €40 million to charities helping flood victims. But solidarity has its limits and Mr Schröder knew that, with an election looming in a month, it would be dangerous to increase taxes.

Instead he decided to postpone for a year tax cuts due to take effect from January. The top and entry-level tax rates will stay at 48.5 and 19.9 per cent for another year respectively, before dropping to 47 per cent and 17 per cent.

Combined with the money freed up by a spending freeze, the government conjured up more than €9.2 billion overnight without hitting anyone directly in the pocket."With this plan we arrive at an amount with which one can eliminate lasting damage fast and precisely," said Mr Schröder.

Nevertheless, it was a painful decision for Mr Schröder and his finance minister, Mr Hans Eichel. The 1999 tax reform was one of the government's great achievements. But the decision got the government out of a precarious situation in Berlin, not to mention Brussels. The German public deficit is already running at 2.7 per cent, according to a Bundesbank forecast this week, skirting the 3 per cent ceiling laid down in the EU's Stability and Growth Pact.

Had Mr Schröder decided to finance the reconstruction programme by borrowing, he would have incurred the wrath of Mr Pedro Solbes, the European Commissioner for Economic and Monetary Affairs.

But Mr Solbes has praised what he called a sensible solution. "I welcome the fact that the measures announced by the German authorities can be financed without endangering the fiscal consolidation process," he said.

The European Union has promised €5 billion by bringing forward structural investment agreed in the last EU budget. Yesterday, Mr Schröder appealed to other EU leaders to support the creation of an EU disaster fund. In a letter to other member-states, he called for a €500 million fund that would provide bridging funding to victims of the current flooding disaster.

At the moment, the European Commission has no budget to cope with natural disasters after a rarely used fund was abolished a number of years ago.

The floods have put an end to election campaigning, though the government and the opposition parties are still trying to score points by outdoing the concern of the other when it comes to financing the flood damage.

The opposition conservatives had been certain of coasting back into power next month on a tide of disillusionment with the government's management of the economy. But Mr Schröder has cut the ground out from under them - making it impossible for them to promise voters additional tax cuts next year as they had promised in their election manifesto.

Mr Edmund Stoiber, the conservative challenger hoping to unseat Mr Schröder, said he wouldn't block the postponement of tax cuts, but has called for an accompanying increase in corporate tax. "The move is fair because it puts a greater demand on those with higher incomes, such as managers and large firms," he said.

German industry says it can live with increased taxes to support the government. "If greater means are required to finance the damage repair, than it goes without question that business leaders will participate in a solidarity action," said Mr Michael Rogowski, president of the Federal Assocation of German Industry.

Mr Schröder said he would go along with the opposition's proposal if it guaranteed swift agreement when the parliament meets to vote on the reconstruction measures next Thursday. "We have no reason to reject this additional source of financing if it would help to gain opposition agreement," said Mr Schröder yesterday, announcing a one-off 1.5 per cent rise in corporate tax to 46.5 per cent.

It will be weeks, if not months, before the full cost of the floods to the German economy is known, but already finance ministry officials in Berlin are talking of a bill of at least €25 billion. An initial estimate by the eastern state of Saxony, worst affected by the flooding, put the damage in its state alone at over €15 billion.

Berlin has agreed to divide its €9 billion flood fund with individiual state governments and local councils, concentrating its own investment on infrastructure and support for small and medium-sized businesses.

The government is adamant that postponing tax cuts will not damage Germany's already underperforming economy, but that view is not shared by everyone.

"We are already in a situation of extreme economic weakness with high unemployment. The government's chosen path will only compound that," said Mr Rolf Peffekoven, a leading economist.

So far, Mr Schröder's gamble appears to have paid off: his party rose one point in polls conducted after the plan was announced. Another survey shows two-thirds of Germans agreed the tax-cut postponement was necessary. But as flood waters recede, revealing the full extent of the damage, he will need all the finances and public solidarity at his disposal to get Germany back on its feet.