High levels of unemployment and rising social charges have lead to considerable pressure on labour markets to adjust. Major steps in labour market reform have been implemented over the last three years. These need to be followed up in several respects in order to raise the economy’s capacity to generate employment. The present tax and transfer system still implies significant disincentives for labour supply of older people and spouses, which should be eliminated. Unemployment related benefits and active labour market policies can be better geared toward activating the unemployed, while institutional reform of the Public Employment Service should continue. On the labour demand side, there remains scope to raise the efficiency of Germany's employment protection system. Also, provisions should be made to allow for a higher degree of wage flexibility across qualifications and regions to fight unemployment. Regulatory conditions in other parts of the economy interact in important ways with labour market performance, underlining the need for a broad based reform approach. This Working Paper relates to the 2006 OECD Economic Survey of Germany (www.oecd.org/eco/surveys/Germany).