Six leading German think tanks have said in their autumn report that they were pencilling in German gross domestic product (GDP) growth of 2.3 percent in 2006 and 1.4 percent in 2007.

In their previous report published in the spring, the institutes -- -- Ifo in Munich, DIW in Berlin, HWWA in Hamburg, IfW in Kiel, IWH in Halle and RWI in Essen -- had been forecasting GDP growth of 1.8 percent and 1.2 percent respectively for this year and next year.

"The upturn in the German economy has strengthened substantially this year," the report said. "While exports are continuing to expand strongly, the recovery is being increasingly carried by domestic demand."

The government's plan to raise value-added tax (VAT) by three percentage points to 19 percent from Jan. 1 could, however, weigh on activity next year and lead to a marked slowdown in German growth.

"Never was VAT increased so much in one go. Thus it is difficult to gauge to what extent fiscal policy will put the brakes on the economy," the report said. "The annual average rate of GDP growth depends largely on what purchases were brought forward this year as a result of the tax hike."

Anticipatory effects

The institutes calculated that the anticipatory effects of the VAT hike on consumer purchases this year would alone cut a quarter of a percentage point off next year's growth.

"Only in the second half of 2007 will private consumption pick up modestly as employment rises. For the year as a whole consumer spending is likely to stagnate."

Another risk factor for the German economy next year could be a possible downturn in the real estate market in the US and in other major economies which "could lead to a stronger slowdown in the global economy," the report said.

In the meantime, the current stronger performance of the German economy is likely to have a positive effect on public finances in the euro zone's economic powerhouse.

Shrinking deficit

Germany's public deficit was projected to amount to 2.4 percent of GDP this year and shrink further to just 1.4 percent next year.

Under EU budget rules, euro-zone countries are not allowed to run deficits in excess of 3.0 percent of GDP. But Germany, the main architect of the Stability and Growth Pact, has been in breach of the three-percent rule every year since 2002.

The economic upturn was similarly expected to have a positive effect on the labor markets, with the institutes projecting a fall in the unemployment rate from 11.2 percent in 2005 to 10.4 percent in 2006 and 9.9 percent in 2007.

Monetary policy

Turning to monetary policy, the institutes estimated that a further rise in euro-zone interest rates would be appropriate between now and the end of the year, but that the European Central Bank should then hold rates steady next year.

"Since December 2005, the ECB has raised its benchmark interest rate to 3.25 percent," the report said.

"We share the ECB's opinion that there are risks to price stability. We therefore regard a further increase to 3.50 percent by the end of the year as appropriate, especially since the euro-zone economy will remain pointed upwards."

Monetary conditions in the 12 countries that share the euro were likely to remain steady next year.

The German VAT hike would not have a lasting effect on headline inflation in the euro area, the institutes predicted.

"The effects of the VAT hike will be a one-off and will not in themselves be a reason to tighten monetary policy," they said.

In addition, economic growth was expected to slow next year.

"All indications seem to point to steady interest rates," the report said.