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Cablegate: French Budget Developments

DE RUEHFR #3401/01 2251629
R 131629Z AUG 07





E.O. 12958: N/A

REF: Paris 2741

1. (SBU) SUMMARY: The French parliament approved on August 1 one of
France's largest-ever tax packages, a tax reform bill "in favor of
labor, employment and purchasing power." The tax cuts are intended
to improve France's competitiveness, but may have a modest impact on
economic growth in the near term and will compound the central
government budget deficit. The government revised its plans on
cutting the civil service in 2008, and will replace two out of three
(vice one out of two) retiring civil servants. The general
government budget deficit (which includes the central government,
the social security system and local authorities) is expected to top
2.4 percent of GDP in 2007 and drop to 2.3 percent in 2008. END

Lawmakers Pass the Tax Package
2. (U) On August 1 Parliament approved a tax reform bill "in favor
of labor, employment and purchasing power." The bill notably
includes tax breaks on overtime pay, introduces deductions for
mortgage interest payments, reduces inheritance taxes, and lowers
the maximum tax levied on all income from 60 to 50 percent (reftel).
Finance Minister Christine Lagarde stressed that the tax package
was, in the first instance, a tool to boost economic growth. She
underscored that it was "not a gift to please the rich or a package
to harm economic growth" -- an allusion to Socialist objections that
the tax cuts will widen inequalities and fail to spur demand.

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3. (U) The Parliament made only slight modifications to the original
bill. Of note, deputies increased the exemption from the "wealth
tax" (a tax on individuals with net assets greater than 760,000
euros) applicable to a principal residence from 20 percent to 30
percent to take into account the rise in real estate prices. Among
other amendments was a measure to allow for a 50% wealth tax
deduction for investments of up to 10,000 euros in small and
medium-sized companies (SMEs) via mutual funds ("Fonds
d'Investissement de Proximite"). The 75% wealth tax exemption on
investments of up to 50,000 euros in general-interest non-profit
organizations was extended to France's National Agency for Research
(which supports basic and applied research, innovation, partnerships
between public and private sectors and technological transfer
between public and private sectors) and to registered private
research organizations.

Cost of the Tax Package
4. (U) On July 25, Minister of Finance Lagarde confirmed that the
cost of the tax package would be no more than 10-11 billion euros in
2008 (or 0.6 percent of GDP), and 13 billion euros per year once the
tax cuts are fully implemented. (Note: This estimate includes costs
associated with amendments passed by the National Assembly, but not
the cost of amendments approved by a Senate/National Assembly
reconciliation committee subsequent to Lagarde's comments.) The
Finance Minister underscored that 93 percent of the cost is
concentrated on four measures that "benefit all French citizens,
notably the middle class":
--Cost of tax exemptions for overtime work: 6 billion euros net,
including subsequent additional social security receipts);
--Cost of tax credits on mortgage interest: 3.7 billion euros;
--Cost of reducing inheritance taxes: 2.2 billion euros.
--Cost of exempting students from paying income tax: 40 million

5. (U) The fifth measure, which accounts for 7 percent of the total
cost, is "to reconcile the French with success" by lowering the tax
ceiling from 60 to 50 percent of income (cost: 600 million euros)
and by exempting investments in SMEs from the wealth tax (cost: 410
million euros). Lagarde also stressed that it was necessary "to
reestablish the link between success and merit" by imposing strict
conditions on the award of "golden parachutes," including through
fiscal disincentives and by insisting that payouts be tied to

Impact of the Tax Package on Economic Growth
6. (U) The government argued that its tax cuts were part of a wider
structural reform that will lift confidence and deliver stronger
growth and purchasing power. President Nicolas Sarkozy stated that
the tax package would bring "the one percent growth which is
missing." Recently, Lagarde told reporters that the tax package
should contribute 0.3 percent "or maybe a bit more" to the 2008
economic growth forecast of 2.5 percent.

PARIS 00003401 002 OF 003

7. (U) There is general consensus among French economists that the
package will do more to stimulate demand than to improve the
supply-side competitiveness of the French economy. The
"Observatoire des Conjonctures Economiques (OFCE)" a think tank that
favors demand-side measures to spur economic growth, said the tax
package "will secure an economic recovery that is slow to
concretize, and will bring the French economy closer to
full-employment." France's "Bureau d'Information et de Previsions
Economiques (BIPE)" estimates the measures will result in an
additional 8 billion euros in consumption, "a substantial portion of
which will fuel imports." The corporate and investment bank Natixis
deemed the likely final impact on consumption "marginal" (between
0.1 and 0.2 percent of GDP per year). The bank warned that "given
the situation of public finances, the implementation of a clearly
pro-cyclical policy appears to be risky since France has
budget-reduction objectives to satisfy."

The Government Prepares the 2008 Central Government Budget
--------------------------------------------- --------
8. (U) The 2008 central government (CG) budget is based on an
inflation-adjusted GDP growth rate forecast of 2.5 percent and an
inflation rate of 1.6 percent. Following a government
inter-departmental seminar on the 2008 CG budget, Prime Minister
Francois Fillon said in late July that overall public spending would
not increase in 2008, thanks in part to the non-replacement of one
out of three retiring civil servants (a cut of approximately 22,700
positions). Budget Minister Eric Woerth said this was expected to
generate 350-450 million euros in annual savings. A portion of the
money would be used to increase remaining civil servants' salaries.
Research, justice and national education are among budget priorities
that would be relatively sheltered from planned cuts (though only
two out of three retiring teachers will be replaced).

9. (U) In a recent interview, Gilles Carrez, the National Assembly
Finance Committee spokesman, warned that "missions of the government
must be redefined" before cutting the civil service. Polling data
released on August 12 indicate that the civil service reduction is
the least popular of Sarkozy's reforms, with 61% of respondents
disapproving of the measure.

Government Forecasts a Decrease in the General Government Budget
--------------------------------------------- ---------
10. (U) The GOF forecasts that the general government budget deficit
(including central government, social security system and local
authorities) will decrease to 2.3 percent of GDP in 2008 from a
projected 2.4 percent in 2007. President Sarkozy promised the
European Commission "to do everything possible" to accelerate
reduction of the public debt from 65 percent of GDP in the first
quarter of 2007 to 60 percent by 2012 at the latest. The government
has started to explore additional means of adjustment, including
through measures to control health insurance expenditures and the
creation of a social VAT. The government is also planning to pursue
pension reform, but has yet to provide details.

Social Security Deficit Remains a Concern
11. (U) The social security system is likely to incur a 12 billion
euro deficit in 2007 according to the Social Security Accounts
Commission. This is almost 4 billion euros more than the deficit
set in the December 21, 2006 social security financing law. The
deterioration is largely due to deficits in health insurance (6.4
billion euros) and pensions (2.8 billion euros). The GOF forecasts
that in ten years there will be 2 million French men and women over
the age of 85, resulting in a 20% increase in the number of
dependent people in France. In a July 31 visit to a health unit in
Dax, France, Sarkozy announced the creation of a fifth branch of the
French social security system for the aged and the handicapped (the
four existing branches include health insurance, work-related
accidents, family allowances, and pensions).

12. (U) He also announced a new levy on health care to fight cancer
and Alzheimer's disease. Under the plan, patients would pay a
non-refundable 0.50 euro fee on top of the price of each medication
and paramedical aid, and 2 euros for medical transport such as
ambulance journeys. The amount levied would be capped at 50 euros
maximum per year, per person. Health Minister Roselyne Bachelot
indicated that the levies are expected to result in an additional
850 million euros in revenues. Government spokesman Laurent
Wauquiez made clear that the fees would finance "tomorrow's
challenges," such as Alzheimer's disease, and would not be used to
cover the social security deficit.

PARIS 00003401 003 OF 003

Social VAT to Finance Social Security Expenditures?
--------------------------------------------- ------
13. (U) Prime Minister Fillon has invited Eric Besson, former
Socialist chief economist and current State Secretary in charge of
Forward Planning and Evaluation of Public Policies, to make
proposals on a social Value Added Tax (VAT) to help finance health
expenditures. The social VAT, vetted controversially by
then-Finance Minister Jean-Louis Borloo between rounds of
legislative elections in June, would consist of an increase in the
VAT paid by households and a reduction in payroll taxes. Besson
made an initial report to the Prime Minister in late July following
fact-finding trips to Denmark and Germany (where the social VAT has
been implemented). Besson should provide his final official
conclusions by the end of August. The ruling majority party UMP is
studying the issue separately and will present its own conclusions
in September before the party's National Council. The Socialists
have denounced a social VAT, saying it would hurt those with modest
incomes the most.

14. (SBU) The Sarkozy government's tax reform package represents an
important symbolic step in making the French economy more
competitive, in part by loosening the 35 hour work week and through
initial (albeit limited) steps to reduce the weight of the state
sector in the economy. However, its short-term direct impact on
economic growth is likely to be modest, and its pro-cyclical timing
has come in for considerable criticism. Efforts to reduce
rigidities in France's labor market, currently the subject of
negotiation between unions and employers, and eventually
product-market reform, will be the real tests for the Sarkozy
government. In the meantime the unpopularity of the civil service
reductions and the considerable squawking over the modest health
service co-payment proposals indicate the considerable challenges
that lie ahead in bringing government spending under control.


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