What Reforms Does Germany Need to Return to Growth?

The German economy is stagnating. What needs to be done for it to overcome this phase and return to growth? Currently, two developments are particularly concerning: First, private sector investments are declining. Today, they are lower than they were in 2019. Second, fewer and fewer housing units are being built. Especially in urban areas, it is becoming increasingly difficult for newcomers to find apartments. This investment reluctance not only dampens the economy in the short term but also leads to declining prosperity in the medium to long term. Low investments today mean lower productivity, lower wages, and less economic dynamism tomorrow.

The reasons for this investment hesitation are diverse. An aging population means that the number of workers in Germany will decline. This demographic shift is also affecting many small and medium-sized family businesses. The next generation of these family-run companies is often more internationally oriented than the previous one and is therefore less tied to the local market. German corporate tax rates are the highest among the G-7 countries, while public infrastructure is deteriorating. Additionally, excessive bureaucracy is being built up, leading to high costs and sometimes expensive misallocations. The decarbonization of the energy system and the exit from nuclear energy are shrinking the energy supply, raising energy costs, and creating uncertainty about future energy availability. Digitalization and the transition to electric mobility are forcing a profound structural shift in German industry. At the same time, growing global protectionism encourages companies to produce directly in the markets where they sell, rather than exporting from Germany. As companies reorient, many are choosing to establish new production capacities abroad.

In the housing sector, a mix of high interest rates, regulatory-driven construction costs, a shortage of available land, lengthy approval processes, and policies like rent caps and expropriation debates are scaring off investors.

German policymakers have certainly begun responding to the country's economic slowdown. The first steps toward stimulating the economy are included in the policy package approved by the federal government in July 2024. This includes, among other things, improved tax depreciation rules for private investments, tax incentives for attracting skilled workers, and measures to speed up building permit processes. However, if Germany’s government truly wants to turn around its economic stagnation, it will need to do more.
 

Avoiding Further Damage

The first priority should be to avoid causing further harm and not make the economic situation worse. This might sound obvious, but it’s not. Despite the current economic challenges, some political factions regularly push for the introduction of a net wealth tax in Germany. Doing so would further reduce private investment and speed up the economic decline. Similarly, proposals to reintroduce rent controls, expropriate rental properties, or link rents to tenants' incomes in response to rising urban rents would have a negative impact.
 

Boosting Employment Incentives through Taxes and Transfers

Employment is the most important driver of economic growth. To increase the labor supply, policymakers can focus on several areas. For many parents, the lack of adequate childcare remains a barrier to full-time employment. Replacing the current system of marital tax splitting with individual taxation could help address this. Greater willingness to reform the education system could reduce dropout rates and strengthen the supply of skilled labor. Given increasing life expectancy, raising the retirement age is also necessary. Social benefits, such as the basic income (“Bürgergeld”) or housing benefits, could be more targeted to encourage employment. However, there are clear trade-offs with redistribution goals – higher benefits for non-working individuals can reduce the available labor supply. Policymakers will have to decide what they prioritize.
 

Easing the Tax Burden on Investments

Germany's tax environment for private investments is uncompetitive on an international scale. The country should further improve its tax depreciation rules and gradually reduce the tax burden on retained earnings for corporations to 25% over the coming years.
 

Eliminating Regulations and Laws Without Replacement

More needs to be done to cut unnecessary bureaucracy and regulations. Examples include the centrally planned taxonomy for sustainable finance, sustainability reporting requirements, supply chain due diligence laws, and the so-called Energy Efficiency Act. Some of these regulations can be eliminated without replacement, such as the taxonomy and the Energy Efficiency Act. In the case of supply chains, general codes of conduct with spot-check audits should replace comprehensive reporting requirements.
 

Consistent Investment in Infrastructure

When it comes to public infrastructure, it’s crucial not only to increase maintenance and modernization investments, but to ensure they are steady and predictable. This consistency allows private companies, such as road construction firms, to invest in the necessary capacity. During renovations, it’s important to minimize disruptions to traffic flows, as such interruptions can significantly hinder economic development.
 

Simplifying Energy and Climate Policy

Germany’s energy and climate policy should be less fragmented. The focus should be on a well-conceptualized carbon pricing system, supplemented with tools like subsidies for decarbonization investments where necessary. Adaptation to climate change is just as important as reducing greenhouse gas emissions.
 

A Strategy for More Innovation

Germany needs more innovation and new business ventures. What’s required is a comprehensive agenda that fosters entrepreneurship. Capital market reforms should aim to mobilize more venture capital. Tax policies, particularly around loss carryforwards, should be more start-up friendly, and labor market regulations must provide start-ups with greater flexibility when it comes to hiring and layoffs.
 

Finalizing Free Trade Agreements

The German government should push harder for the further integration of the European single market, especially in services – and finalize free trade agreements with third-party countries like Mercosur.
 

The Country Can Recover

A growth agenda like this comes with trade-offs. For example, tax relief for private investments or increased public spending on infrastructure means that spending in other areas, like social welfare, may need to be reduced or grow at a slower pace. This reflects the fact that, at least in the short term, efficiency and redistribution goals can conflict. However, in the long run, this conflict becomes less significant, as without economic growth, it will become increasingly difficult to maintain welfare systems and other public services. The good news is that Germany has the ability to overcome its economic stagnation on its own. Whether this happens depends on whether policymakers have the will to make the necessary decisions.

Clemens Fuest
Professor of Economics and Public Finance
President of the ifo Institute

Published under the title “In acht Schritten zum Aufschwung“, Welt am Sonntag, August 25, 2024.