With the effects of adverse external shocks diminishing, a strong and competitive export industry is helping the German economy out of a three-year period of near stagnation. Domestic demand has been declining over the last couple of years, as poor labour market performance has weighed on consumer sentiment and business confidence. The labour market still suffers from weak economic growth and distorted incentives, with both contributing to problems in taking up work and providing employment. Productivity growth is not high enough to compensate for the adverse effect of low labour utilization on economic growth. Fiscal targets have been missed on account of both cyclical and structural factors. The government has launched a major reform initiative to reinvigorate economic growth. These reforms are welcome, have to be continued and need to be broadened further to reduce government debt, remove fiscal distortions, and improve incentives to supply and demand labour. Furthermore, there remains considerable scope to foster the creation of new enterprises and widen product market competition, thereby also maintaining the strong innovative capacity of the economy. The major challenges are to link fiscal consolidation to public sector reform and to increase the capacity of the economy to create employment and increase productivity growth. To create confidence and to restore Germany’s traditional economic strength it is necessary that reforms reflect a coherent vision about the reorientation of economic policy - combining a growth and stability oriented macroeconomic policy with structural reforms - and are implemented according to a transparent and predictable roadmap
Linking fiscal consolidation to public sector reform
After phased income tax reductions that contributed to the rise in the structural deficit, priority should now be given to balancing the budget within a limited number of years. For the consolidation process to have maximum beneficial effects on economic activity, much will depend on casting it within a consistent framework that links budgetary improvement to public sector spending reform. The efficiency of the public sector should be increased by providing more scope for output performance budgeting. There remains room for a fully financed tax reform reducing the welfare costs of taxation by cutting high statutory tax rates while broadening the tax base by reducing tax expenditures. On current plans the structural balance is projected to improve by ¼ percentage point per year, which is clearly not enough to prepare for ageing related spending increases.
Important steps have been undertaken to reform health care and pensions, marking progress in re-establishing fiscal sustainability. Increasing co-payments, reducing the catalogue of fully funded health services and involving health funds in managed care should allow insurance funds to contain contributions. More could be done to reduce the power of special interest groups and increase the scope for insurance funds to play an active purchaser role. Progress in pension reform should continue by announcing soon a phased increase of the statutory retirement age. Fiscal subsidisation of the funded system should be reconsidered.
Increasing the capacity of the economy to create employment
Major reform steps to make the German labour market more conducive to employment creation have been legislated and are being phased in. Employment protection legislation (EPL) has been eased, including an increase in the employment threshold above which dismissal protection is binding for small firms. Benefit duration for older workers without job search requirements will be substantially reduced. Unemployment and social assistance will be merged. Active labour market programmes are to be evaluated more systematically. These reforms have to continue and should be broadened. In addition, fiscal obstacles to higher labour supply and demand should be removed. The efficiency of placement services must be further increased and job search requirements should be enforced regardless of age. Active labour market programmes which turn out to be unsuccessful should be terminated. The scope for individual agreements on wage and non-wage aspects of a labour contract should be increased. Opening tertiary education to more competition and widening the autonomy of educational institutions with respect to achieving targets should contribute to more effective human capital accumulation.
Improving the capacity to innovate and increase productivity growth
Competition in product markets should be further strengthened by removing entry barriers and making more progress in reducing administrative overheads. The part of the large German procurement market which falls below EU thresholds should be opened to greater competition, requiring inter alia making transparent the multitude of regulations on lower levels of government.
Key indicators show Germany belonging to the countries in the OECD with strong innovation activity even though some weakening in Germany’s position relative to other OECD countries has occurred recently. Measures to improve the framework conditions for innovation should include removing disincentives to take risks and to provide capital to new firms and raising the efficiency of the higher education sector. Furthermore, making labour markets more flexible and increasing the scope for competition overall, as well as reducing administrative opacity, would improve the capacity of the German economy to innovate and contribute to higher potential growth.
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