The Federal Constitutional Court had been examining accusations from the main opposition CDU party that Chancellor Olaf Scholz's three-party coalition had acted in contravention of the "debt brake".
This key commitment to balanced budgets caps new borrowing in Europe's top economy to 0.35 percent of gross domestic product.
In particular, it looked at a decision to transfer 60 billion euros ($65 billion) of loan authorisations that had been part of coronavirus pandemic support programmes to a fund aimed mainly at fighting climate change.
The coalition had argued this should be kept outside the main budget, as it was approved as part of emergency funding when the debt brake was suspended during the pandemic.
But the court in Karlsruhe, southwest Germany, found this move was "incompatible" with the constitutionally enshrined debt rules and overturned it, ruling in favour of a legal complaint lodged by the CDU.
"The court's decision means that the volume of the 'climate and transformation fund' is reduced by 60 billion euros," it said in a statement.
If the state "has entered into obligations that it can no longer service as a result of this reduction," it must be compensated for "through other means".
Scholz said the judgement would be "carefully examined", and it could have implications for spending at the national and state levels.
Finance Minister Christian Linder immediately froze the current business plan for the climate fund -- worth about 212 billion euros before the ruling -- affecting projects from 2024 onwards.
- 'Political disaster' -
The fund is aimed in large part at speeding up Germany's shift to an emissions-free economy.
Funds were also earmarked for other measures, however, such as boosting domestic semiconductor production as Europe seeks to reduce reliance on imports from Asia.
The conservative opposition CDU and its sister CSU party seized on the court ruling to call for new national elections, describing it as a "political disaster".
"Lindner is the first finance minister in history to be responsible for an unconstitutional federal budget," the CDU's Thorsten Frei, a leader of the conservatives' group in parliament, told the Bild daily.
ING economist Carsten Brzeski said the government would be left struggling to "fill a hole of 60 billion euros," which could potentially delay agreement on the 2024 budget.
The decision will also likely further strain ties within the coalition, particularly between Scholz's SPD and the Green party on one side, and the pro-market FDP on the other.
The ruling "goes to core disagreements between the coalition partners," analyst Salomon Fiedler of Berenberg Bank told AFP.
"The Greens and large parts of the SPD favour higher deficits and have spoken out against the debt brake in its current form. In contrast, the FDP insists on the debt brake."
The brake was suspended from 2020-2022 to deal with shocks from the coronavirus pandemic and energy crisis, as is permitted during emergencies, but came back into force this year.
In court hearings in June, the government had argued the climate fund also addressed the consequences of the pandemic, which continued to weigh on the economy.
But in their ruling, the judges said "the programmes financed by the (fund) cannot be deemed suitable for crisis management purposes".
It laid out three main requirements for such a budget manoeuvre to meet constitutional rules, and which the coalition had not stuck to.
To allow an exemption to the debt brake and extra spending measures, it needs to be clearly proven the additional funds will be used to deal with an emergency situation.
Budgets have to be annual -- the government cannot roll over debt authorisations granted in one year to later years.
And parliament needs to vote on budget laws before the end of the year to which it applies.
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