By Michael Nienaber
BERLIN (Reuters) - Germany's economy is in full swing, the government said on Thursday, a state of affairs that also led to a record 2016 budget surplus likely to irritate much of the rest of the European Union and play directly into election politics.
Germany's overflowing coffers are the subject of intense debate ahead of the Sept. 24 federal election, with the Social Democrats promising more investment and Chancellor Angela Merkel's conservatives a mix of investment, tax cuts and debt reduction.
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Merkel played down the size of the federal government's portion of the surplus, which will go into a fund for refugee-related expenditure following the influx of people, many fleeing war, over the past few years.
"If you look at the federal level alone, the surplus is rather small," Merkel said during a joint news conference with Lithuanian Prime Minister Saulius Skvernelis.
Merkel said the government would further increase spending on defense, as promised to NATO allies, as well as on domestic security and social improvements.
"At the same time, we don't want to take on new debt. So the room for maneuver is rather limited," Merkel added.
The finance ministry, meanwhile, said the economy - dominated by exports - has kicked off the year in fine form.
"The German economy is on a solid growth path," its monthly report said, adding that indicators signaled a continuation of the economic upswing in 2017.
"Consumption will probably remain an important driver of economic growth," the ministry said, pointing to job creation, pay hikes, low interest rates and moderate, albeit rising energy prices.
But it is the budget surplus - reported on Thursday by the Federal Statistics Office - that may raise most eyebrows.
Germany has been running a surplus for three years. Soaring tax revenues, rising employment and low debt costs helped drive the gap higher to 23.7 billion euros ($25 billion) in 2016.
That is the highest since Germany reunified in 1990, and creates a fiscal buffer at a time when authorities are working to house and integrate hundreds of thousands of refugees.
However, the European Commission on Wednesday once again criticized the German current account surplus - which measures the flow of goods, services and investments into and out of a country - as unhealthily large for the euro zone.
Deputy Finance Minister Jens Spahn, a senior member of Merkel's conservatives, defended government policy on Thursday.
"These figures show that Germany is doing well. We invest more than ever - and still have surpluses," he told Reuters.
The government will use the fiscal space to further increase investment and also lower income taxes for workers by at least 15 billion euros as already promised, he said.
Martin Schulz, nominated by the Social Democrats last month to challenge Merkel in the election, has said he does not want the surplus used for tax relief for the rich and wants more investment in education and infrastructure.
Under Schulz, the left-leading Social Democrats have narrowed the gap in opinion polls with Merkel's conservatives.
For 2016, the federal government posted a surplus of 7.7 billion euros while states and municipalities together had 7.8 billion more in their coffers, the office said. Social security funds recorded the biggest surplus with 8.2 billion euros.
Higher state spending on refugees was a factor in boosting overall economic growth to 1.9 percent last year, separate data from the Statistics Office showed.
This was the strongest rate in half a decade, and the finance ministry said it expected spending by households and public authorities to drive growth again this year - consolidating a shift away from the export activity that traditionally powered the economy.
This could help to reduce the surplus which Berlin expects to shrink this year. The government expects growth to slow to a still robust 1.4 percent in 2017, driven by domestic demand.
Business morale was surprisingly buoyant this month, a survey showed on Wednesday although a consumer sentiment survey showed the mood worsened more than expected heading into March.
(For a graphic on G7 economy click, http://tmsnrt.rs/1Vfdhm5)
($1 = 0.9477 euros)
(Additional reporting by Joseph Nasr and Gernot Heller; Writing by Michael Nienaber; Editing by Jeremy Gaunt)