Cablegate: French Tax Reform Package

DE RUEHFR #2741/01 1771527
R 261527Z JUN 07





E.O. 12958: N/A

REF: (A) Paris 2089; (B) Paris 2003

1. SUMMARY: New French Finance Minister Christine Lagarde
introduced a tax reform bill on June 20 "in favor of labor,
employment and purchasing power". The cost of the tax package could
mean the government budget deficit in 2007 and 2008 will again
exceed the EU-imposed limit of 3 percent of GDP. The impact of the
package on economic growth is likely to be modest in 2007 and
slightly more significant in 2008. END SUMMARY

Exempting from Taxes Overtime Work
2. Finance Minister Christine Lagarde introduced a tax reform bill
on June 20. The eight-chapter tax bill includes details of measures
the GoF had announced in May. . The tax package includes tax
exemptions on overtime work to encourage companies to increase
employment, which would allow employees to increase working hours
and thus their purchasing power (ref A). The bill proposes overtime
work rates to be paid on the basis of collective agreements, and if
there are none, at legal rates (25 percent or 50 percent more than
normal hours) to employees working full time, and at 25 percent to
employees working part time. The key measure of the scheme is the
proposal to exempt overtime work from income taxes and payroll
taxes. Exemptions will apply to both private-and government sector
employees, who will benefit from exemption of both income tax and
payroll taxes including the contribution on all incomes (CSG) and
the contribution for the repayment of the social security debt
(CRDS). In the civil service sector the scheme will be negotiated
with unions before the publication of decrees. For special regimes
(e.g. railroad company SNCF, railway company RATP, etc.), the
implementation of the scheme raises a number of questions that will
need to be resolved because changes to the transportation sector are
politically difficult. The government took into account
recommendations of the supervisory State Council ("Conseil d'Etat",
which assists the Executive with legal advice) on executives and
part-time employees. Executives working above the 1607-hour quota
or giving up rest days above the annual 218-day quota would benefit
from exemptions. Tax exemption for part-time employees working
above the contractual work duration would be increased from 10
percent to 30 percent.

3. For their part, employers would be exempted from payroll taxes
on overtime work depending on employees' positions and the size of
the companies: 0.50 euro per overtime worked hour in companies with
more than 20 employees and 1.50 euros in companies with less than 20
employees. Payroll taxes on overtime by employees in low wage
positions in those companies would be fully offset. The scheme,
which should become effective on October 1, 2007, would be subject
to an evaluation by July 1, 2009.

Exempting Students from Income Taxes
4. To improve the financial situation of young students who work to
finance their studies, the proposal would extend income tax
exemptions to all income earned by students younger than 25. The
annual ceiling for exemption would be three times the monthly
minimum wage or 3,750 euros. Students would still have the choice
to opt for the Earned Income Tax Credit if that solution is more

Implementing Tax Credit on Mortgage Interests
5. Presently, only 56 percent of French households are landlords of
their main residences, while the average in Europe is 75 percent.
The tax package proposes tax credits for the acquisition or the
construction of a main residence. This new advantage, which adds to
the current zero-interest rate loan scheme aimed at modest-income
earners, would also benefit non-taxable households via a repayment.
New home buyers would be allowed to deduct from their income taxes
20 percent of their mortgage interest in the first five years. This
measure would apply to both existing and new loans, for any interest
due after the first day following the implementation of the tax
bill. This measure, which is one of the top topics of conversation
among the French, caps the tax break at 3,750 euros for singles and
7,500 euros for households plus 500 euros per dependent child.

Reducing Inheritance taxes
6. New measures would exonerate 9 out of 10 people from inheritance
taxes, and would bring France more in line with most other European
countries. The tax package eliminates inheritance taxes for the
surviving spouse or the surviving partner linked by a civil
solidarity pact (PACS). Partners linked by a "PACS" would benefit
from the same tax exemption as spouses on gifts below 7,600 euros,

PARIS 00002741 002 OF 003

and would be subject to the same rates of taxation (5 percent to 40
percent versus 40 percent and 50 percent currently) for gifts
exceeding 7,600 euros. Measures also include reducing inheritance
and gift taxes in favor of ascendants and descendants or between
brothers and sisters on inheritances up to 150,000 euros (versus up
to 50,000 euros). Gifts in favor of a child, a grand-child, a
grand-grand child (or a nephew or a niece if there are no such
inheritors) would be exempt up to 20,000 euros. The inheritance tax
reform would be applicable as soon as the law is published in the
French Official Journal. An exception is made for stock options.

7. Stock options: the tax package proposes to submit the exercise
of options in case of gift or sale to the tax regime applicable to
the attribution of free equities. The idea is to ensure that the
increase in personal exemption applicable to inheritances (new
version) does not benefit stock options. The Confederation of
Businessmen (MEDEF) succeeded in obtaining agreement that taxation
would be applicable as of June 20, 2007, and not retroactively.

Reducing Absolute Tax Ceiling of No more 50 Percent
--------------------------------------------- ------
8. Since January 1, 2007, direct taxes paid by an individual cannot
exceed 60% of his or her income. Taxpayers may ask for a refund of
payments exceeding that threshold. The tax ceiling includes income
tax, wealth tax, and local taxes paid for the main residence, but
not the contribution on all incomes "CSG" and the contribution to
the repayment of the social debt "CRDS." The reform bill proposes to
include CSG and CRDS, and to reduce the amount of direct taxes paid
by a taxpayer from 60 percent to 50 percent of income. The goal is
"to improve the attractiveness of the tax system, and to give new
confidence to investors in favoring the return in France of all
talents that France needs." The measure would apply on January 1,

Exempting from Wealth Tax Investments in SMEs
9. To attract further investment in small- and medium sized
companies, the government now proposes to exempt from the wealth tax
75 percent of any investment in SMEs (or enterprises inserting the
jobless, education and research establishments, and public utility
foundations) up to 50,000 euros. The measure would apply on June
20, 2007 on investment, and be included in the calculation of the
wealth tax on January 1, 2008.

Subordinating Golden Parachutes to Performance
--------------------------------------------- -
10. Golden parachutes, which are not affected by tax measures, were
nonetheless included in the tax package. Sarkozy described "golden
parachutes for top executive as intolerable" (ref B), saying the
government wants to modify the system as soon as possible. Sarkoky
said "the measure is very simple, and will consist in linking the
existence of departure bonuses, which have to be approved by the
board of directors, to the performance of the executive", commenting
"no performance, no premium." The scheme also aims at improving the
transparency of executive rewards and maintaining France as an
attractive place to do business.

Creating Active Solidarity Income
11. Local governments ("departements") may volunteer to experiment
with an "Active Solidarity Income," which should guarantee for three
years an increase in incomes for all beneficiaries of the minimum
income ("Revenu Minimum Income - RMI") who find jobs. The scheme
would offset the loss of allowances paid or advantages to RMI
beneficiaries. A similar scheme could be put in place for "isolated
parents," who get specific allowances.

Cost of the Tax Package
12. Prime Minister Francois Fillon outlined the total cost of the
tax package (11 billion euros or 0.6 percent of GDP): "between 5 and
6 billion euros in overtime work exemption, 3 billion euros in tax
deduction of mortgage loans and 1.7 billion euros in reduced
inheritance taxes." Critics, including former socialist Minister of
Finance Dominique Strauss-Kahn, charged that the tax package would
be extremely costly (at least 15 to 20 billion euros) at a time when
the GOF is trying to bring spending under control. Sarkozy and
Fillon reiterated that the cost would be offset by higher tax
receipts resulting from higher economic growth, and cuts in budget
expenditures with the elimination of one out of two retiring civil
servant positions (30,000 to 40,000 total positions to be cut in
2008) and cuts in social security expenditures. A 50 percent cap on
income taxes would not prove a drain on government coffers because
"if it works, it will reduce capital outflows." The government

PARIS 00002741 003 OF 003

forecasts its budget deficit to decrease to 2.4 percent of GDP in
2007 and to 1.7% in 2008 partially due to the tax package. That
strategy should worry the European Union, which wants France to rein
in its government budget deficit. France has attempted to reassure
its euro zone partners about its plan to foster economic growth with
tax cuts. Former finance minister Jean-Lous Borloo (now Minister of
Environment, Sustainable Development and Planning) left Luxemburg
Prime and Finance Minister Jean-Claude Juncker with no doubt on June
4 that France would respect the EU Stability and Growth Pact.
Sarkozy subsequently reaffirmed that France will balance its budget
by 2012. That said, Philippe Seguin, the head of the Public
Accounts watchdog ("Cour des Comptes") recently acknowledged that
public finances have improved, but warned they remained "fragile."

Reactions to the Tax Package
13. The daily left-wing newspaper Liberation argues that Sarkozy's
tax package will increase the gap between the classes, "favoring the
richest and best-placed French." The daily Le Monde remarks that
the real efficiency of the measure in favor of overtime work
requires companies to have order books full enough, and favors
employees, not the unemployed. Unions have focused on perverse
effects of the tax exemption of overtime work since the cost of
overtime work will be lower than that of regular work hours. On
their part, some economists find the overtime scheme too complex.
The new government spokesman Laurent Wauquiez admitted that the
overtime work scheme could "evolve" during the examination of the
tax package by the new National Assembly in early July. Morgan
Stanley senior economist Eric Chaney asserted that tax breaks for
existing housing loans are only tax gifts, "which will increase the
budget deficit without helping the economy to grow faster." In
contrast, tax breaks for new housing loans and "more substantial
reforms" including tax breaks for overtime "go in the right
direction, albeit, regrettably, with some fiscal laxity." Chaney
raised its GDP forecast for France in 2008 to 2.3 percent from 2.2
percent, and government deficit forecast from 2.6 percent of GDP to
2.7 percent in 2007, and from 2.7 percent of GDP to 2.9 percent in

President: Tax Package is a Step
14. Sarkozy says that the tax package is only a first step. In
explaining his economic program for the next five years to UMP
deputies and also to the French on the TF1 TV channel on June 21, he
said he wanted to give a new impulse to reforms, reiterating plans
for a minimum service in public transportation and giving autonomy
to universities (ref B), reform taxes and social contributions "to
encourage labor, production and investment", reform of the minimum
wage income ("SMIC"), end of early retirements, new limits
("franchises") to health repayments, and quicker moves in the
government reform. Sarkozy also said he did not rule out the
implementation of a social VAT to fund health expenditures, although
opponents argued it would raise prices, cut domestic consumption,
dampen economic growth and increase joblessness. Sarkozy said "we
haven't yet decided anything. If we find that social VAT did show
that it facilitates job creation, we'll do it, but not before 2009;
if it didn't show, we'll not do it." The union of farmers (FNSEA)
opined they were ready to experiment with a social VAT, arguing it
would be painless to the French consumers if the government reduces
social taxes paid by farmers.

15. The tax package should be easily passed during the summer
session ending August 10 by Sarkozy's UMP party, which controls a
large majority of seats at the National Assembly. The impact of the
package on economic growth will be modest in 2007 (septel) since
measures will take place in the second half, but should be more
significant in its full year of implementation, in 2008. The main
risk of the tax package is an increase in the government budget
deficit. Nevertheless, the wave of structural reforms announced by
Sarkozy will help boost potential economic growth in the medium
term. Investors and companies welcome reform plans as they are
widely seen as positive for the French economy.


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