Enes Sunel
Robert Grundke
OECD Economic Surveys: Germany 2025
Abstract
Regional disparities have decreased but remain high and may rise during the green and digital transition. Weak coordination of place-based policies with conditional federal grants and industrial policies, which are much larger in scale, reduces their effectiveness and spending efficiency. Better coordination of funds should be combined with more forward-looking allocation criteria by including projected climate mitigation and adaptation costs. The weak financial and administrative capacity of many municipalities has contributed to a large infrastructure backlog and weighs on the quality of local public services. Raising more revenue from property taxes should be combined with compensating municipalities for federal legislative changes affecting their budgets. Strengthening cooperation across municipalities, including by bundling of tasks such as procurement or infrastructure planning, can raise spending efficiency and improve administrative capacity, particularly in the context of rising labour shortages. Improving digital, energy, innovation and transport infrastructure is key for regional development. To reduce adjustment costs during the green and digital transition, it is key to expand re- and up-skilling opportunities for workers and use carbon pricing revenues to support vulnerable households.
Germany is a highly decentralised federal country with significant economic and social disparities (Figure 4.1). In particular, the reunification with the socialist German Democratic Republic in 1990 strongly increased regional disparities, as the transition from central planning to a market economy implied major structural changes with high economic and social adjustment costs in the East. Furthermore, structural change related to globalisation and technological change as well as the green transition have strongly affected some Western regions, such as the Ruhr area or other areas with a high concentration of carbon-intensive manufacturing industries and mining (Dauth, Findeisen and Suedekum, 2014[1]) (see the previous OECD Economic Survey of Germany).
GDP per capita in districts, thousand USD 2015 constant prices PPPs, 2021
Note: “Districts” refer to TL3 regions (Kreise for Germany). Country coverage is limited by the availability of regional data at TL3 level. Country averages are weighted by population across districts.
Source: OECD Regional Statistics database.
Over the last two decades, however, economic disparities between districts, and especially between the eastern and western Laender, have narrowed substantially (Figure 4.2). The eastern Laender have benefitted from large public and private investments, improvements in institutional quality and a high quality of education and vocational education and training (VET), which enabled many displaced workers to adapt to changing skill demands (Gagliardi, Moretti and Serafinelli, 2023[2]; von Hagen, Strauch and Wolff, 2002[3]). The high quality of human capital and research allowed for the targeted development of innovation clusters, which have strongly benefitted certain regions, as for example the chip industry cluster in Dresden. An increase in the total fertility rate from a low level and a reversal of net internal migration outflows have decelerated the population decline, while rapidly falling unemployment rates and longer working hours than in western Laender have supported the wage income of middle-income workers in the eastern Laender (BBSR Bonn, 2024[4]). A higher share of value added in the services sector explains why rising energy prices during the last years have affected economic activity less than in many western Laender (BMWK, 2024[5]). Federal and EU place-based policies, which aim to foster economic development in specific geographic areas, have facilitated an increase in public and private investments, which supported the economic integration of the eastern Laender into global markets. As a result, per capita exports in the eastern Laender have strongly increased since the 2000s (Figure 4.2, Panel B).
Note: “Districts” refer to TL3 regions (Kreise for Germany). In Panel B, East Germany does not include Berlin.
Source: OECD Regional Statistics; OECD Economic Outlook database; Federal and States Statistical Offices; and BBSR Bonn (2024[6]).
While economic convergence between the Laender occurred in the last two decades, regional disparities in GDP per capita between districts remain large (Figure 4.3). Agglomeration effects, urban amenities and cultural factors have led to an increasing concentration of economic activity and population in larger metropolitan areas, as observed in many other OECD countries (OECD, 2023[7]). Income and wealth inequality across districts has even increased due to the decline in the share of labour income compared to other income sources, strongly rising property prices in economic centres and the weak progressivity of property taxation and outdated property valuations (see below).
Theil indices of real GDP per capita in 2015 constant USD PPPs across districts
Note: Real GDP per capita at the level of TL3 regions (Kreise for Germany).
Source: BBSR Bonn (2024[6]); OECD Economic Outlook database; and OECD calculations.
Ongoing structural change risks to further widen these regional gaps within the Laender (OECD, 2023[8]). As discussed in the previous OECD Economic Survey of Germany, regions where economic activity is concentrated in carbon-intensive or energy-intensive sectors will be more affected by climate change mitigation policies. Moreover, the structural shift from the internal combustion engine technology to electric vehicles will particularly affect regions with automotive clusters, such as the Stuttgart region or several regions in Bavaria (Figure 4.4, Panel A). However, the green transition will also provide opportunities for some of the currently lagging regions in the North and the East that have a comparative advantage in renewable energy expansion due to weather-related factors and lower population density, facilitating public acceptance of solar and wind parks (Figure 4.4, Panel B). This could help to attract firms from other regions that aim to decarbonise their production, provided that the transmission network and incentives in the grid charge system are improved (see below).
Note: In Panel A, dark colour regions refer to greater than 10% employment share in the automotive industry and lighter colours refer to up to 10% employment share in the automotive industry. The rest of the regions have negligible employment shares in the automotive industry. Regions shown in Panel B are at the level of TL3 districts (Kreise for Germany).
Source: Heider et al. (2023[9]); European Commission (2024[10]).
Moreover, digitalisation will continue to significantly change production processes and the world of work, with heterogenous effects across regions. German urban regions are home to innovation leaders in traditional technologies, but the diffusion of digital technologies remains a challenge due to a lack of digital and entrepreneurial skills and weak access to high-speed broadband among smaller firms (OECD, 2024[11]; BBSR Bonn, 2024[6]). To embrace the digital transformation, investing more in knowledge-based capital, skills and innovation is key. German firms invest less than firms in the United Kingdom, France, and the United States in knowledge-based capital, and the adoption of digital technologies is low compared to top-performing OECD countries. Automation or artificial intelligence (AI)-based solutions will also lead to significant changes in the task content and skill requirements of jobs as well as the need for workers to relocate to other sectors and firms (OECD, 2024[12]). Thus, policies to support the digital transformation should be complemented by well-targeted training and adult learning policies to help workers adjust to changing skill needs (see Chapter 3).
Finally, strong heterogeneity in demographic trends risks further widening regional disparities (Figure 4.5). The old-age dependency ratio is much higher than the EU average in the territorial Laender in the East, in Rhineland and in rural areas, potentially exacerbating skilled labour shortages and weighing on entrepreneurial activity (European Commission, 2024[10]). Over the past two decades, the population of regions far from a midsize or large functional urban area has fallen, while metropolitan regions have seen their population grow. These challenges are exacerbated as young people move to metropolitan regions for educational and employment reasons. As a result, the share of skilled workers among the unemployed and the share of vacancies in professions that require high-skilled workers have increased in the eastern Laender and in the rural regions, indicating a stronger mismatch of skilled workers (BBSR Bonn, 2024[6]). Labour shortages have also been exacerbated by relatively low birth rates in eastern Germany and net migration into western Germany between the reunification and the last decade, particularly for younger people. Foreign migration has mainly entered West Germany and urban regions due to network effects related to existing migrant stocks and the rise of anti-immigration political representation in the East. As knowledge spillovers and network effects with other countries are important for international integration and innovation, this risks to be a major barrier to further economic convergence. Population in some economically weak regions is projected to decline further by more than 10% over the next two decades, significantly increasing the cost of public service provision and changing public service needs due to population ageing (BMWK, 2024[5]).
Old-age dependency ratio, 65+ over population 15-64, %, 2023 or latest available year
Note: The dots indicate the national average. The range indicates the variation at the level of TL2 regions (Laender for Germany).
Source: OECD Regional Statistics database.
To address these challenges, it is key to improve and better coordinate policies in different areas that shape the conditions for regional development. Ongoing structural change requires equipping regional and local governments with the necessary financial and administrative capacity to address large infrastructure and human capital investment needs. This should be complemented by increasingly introducing the rule-based regional focus of national and EU level place-based policies into industrial, energy and transport infrastructure policies. Policies aimed at fostering regional innovation clusters and entrepreneurial activity, including in green technologies, should facilitate knowledge diffusion and commercialisation and scale-up of new ideas, products and services. Active labour market and social policies can go a long way in supporting workers that face real income losses due to structural change and need to adapt to changing labour market needs. Education policies, which are also a key lever for regional development as they form the human capital needed for fostering economic growth (Hanushek, Ruhose and Woessmann, 2017[13]), are referred to in Chapter 3 and will not be discussed in detail in this chapter.
4.2.1. Place-based funds are much smaller than other transfers with regional consequences
To ensure similar living standards across regions despite large differences in economic activity and fiscal capacity, large fiscal transfers exist that are not defined as place-based policy. These include fiscal equalisation and support systems as well as additional inter-governmental transfers to ensure the funding and provision of public services and infrastructure (Box 4.1) (Figure 4.6). Fiscal equalisation across the Laender is based on revenue equalisation through the redistribution of VAT revenues. In addition, unconditional supplementary federal grants to specific Laender further reduce differences in fiscal capacity. Compared with these transfers, the size of fiscal transfers within the Laender is much larger, resulting in Laender being net fiscal contributors to municipalities. The transfers within the Laender comprise grants to municipalities to fund public services, investment and the public administration and are mainly funded through inter-municipal equalisation systems (Thöne and Bullerjahn, 2020[14]). In addition, conditional federal transfers with co-financing by the Laender or municipalities exist to safeguard local public investments in areas such as research, digital and transport infrastructure, public transport, urban development, education, childcare, and housing. All these inter-governmental transfers have significant distributional consequences across the Laender and their municipalities and support framework conditions for local economic development, but are not defined as place-based policies (BMF, 2023[15]). In addition, sizable implicit transfers across regions exists within the health and pension system, the unemployment insurance as well as other federal cash benefit programmes such as student aid, parental benefits, and basic income support (BMF, 2023[15]).
Note: Panel A covers 2022 data for the Federal Funding System for Structural Development Regions. Panel B covers data until 2022. Net transfer revenue is the difference between non-consolidated transfer revenue and transfer expenditure.
Source: Federal Government Equivalence Report (2024[5]); OECD Fiscal Decentralisation database; Federal Ministry of Finance; European Commission; OECD Economic Outlook database; and OECD calculations.
Germany is one of nine OECD countries with a federal structure. Germany’s administrative structure comprises 16 federal states (Laender) and 400 districts (Kreise), corresponding to the OECD (EU) regional classifications of TL2 (NUTS1) and TL3 (NUTS3), as well as 10 775 municipalities. While the city states of Berlin, Bremen and Hamburg have an average population density of more than 12 times the national average, the eastern territorial states of Brandenburg, Mecklenburg-Vorpommern, Saxony-Anhalt, Saxony, and Thuringia have an average density of half the national average.
As Germany is a federal country, many government functions are allocated to sub-central levels of government. Defence and foreign policy are under the responsibility of the federal government, while other legislative areas and the public administration of policies are delegated to the Laender. The Laender oversee most public policies in education, research, transport, environmental protection, housing and community amenities, and social and cultural affairs, and delegate some of these functions to the municipalities, which then administer them locally. The level of decentralisation of functions to municipalities strongly varies across the Laender (Thöne and Bullerjahn, 2020[14]). In health policies, overlapping responsibilities exist between the Laender and the federal government. Taxes are collected by the Laender, except for trade and certain excise taxes collected by the federal customs administration.
To finance these functions, personal income, interest and capital gains, value added and corporate income taxes are shared between the federal government, the Laender and municipalities according to fixed revenue shares. The shares from revenues from these joint taxes for Laender and municipalities are directly linked to economic activity in their territory, except for VAT, which is distributed among the Laender according to population of the Laender. In addition, Laender also receive revenue from the inheritance and real estate transfer tax as well as the beer and gambling duty, while municipalities receive revenues from the local business and property tax, and other local fees. As economic activity differs across the Laender and municipalities and shared taxes are allocated based on the territorial source principle, regional fiscal capacities differ substantially. The Laender are subject to a constitutional debt brake that limits their combined structural annual budget deficits to 0.35% of GDP. The distribution of the permitted borrowing across the Laender is regulated by federal law and requires the consent of the second chamber of the parliament, the Bundesrat. In contrast, municipalities are subject to balanced budget requirements that limit borrowing to finance spending on education infrastructure and other infrastructure investments.
Within the federal framework, place-based objectives are directly addressed by the Federal Funding System for Structural Development regions (GFS) which are much smaller in size and not coordinated with the other fiscal transfers (Figure 4.6). The federal government’s place-based policy framework aims at fostering business activity and employment in disadvantaged regions and supporting them during the green and digital transitions. Funding is administered by seven ministries through 16 programmes and is mainly allocated to disadvantaged regions according to a regional development index. The index measures productivity and employment outcomes, infrastructure quality as well as demographic prospects (BMWK, 2024[16]). The GFS programmes provide investment grants, wage subsidies, below-market loans, support for research and innovation, employee training and digitalisation for firms as well as funding for public infrastructure. This domestic place-based policy framework is further complemented by the EU cohesion policy, which targets transition regions, and is mainly administered by the Laender to provide additional funding to municipalities, research institutions and small and medium-sized enterprises (SMEs).
Inter-governmental transfers impacting regional development are fragmented and need to be better coordinated to be more effective and raise spending efficiency. Compared to the GFS programmes and EU cohesion funds, conditional federal grants to the Laender are much larger and often overlap with the target areas of place-based funds, for example concerning urban development, transport and digital infrastructure, education and research infrastructure or social housing (Figure 4.6). However, they are not provided according to the regional development index used to allocate most of the GFS funding. Instead, they rely on bilateral agreements between the federal government and the Laender, which require approval by the majority of Laender governments in the Bundesrat and in many cases use an index based on tax revenues and population shares (Koenigssteiner Schluessel) for allocation across the Laender. Although co-financing requirements ensure a certain degree of ownership and incentivise the efficient use of resources by the Laender or local governments, a better coordination of these conditional grants with the GFS programmes and EU cohesion funds could improve spending efficiency and the effectiveness of regional development policies. This is particularly important as a recently created infrastructure fund will allocate EUR 100 billion over the next 12 years to support public investment in the Laender and municipalities (see Chapter 1). Allocating the funds to regions where public investment needs are largest and improving coordination with other funding programmes is key to ensure the efficiency of public spending. The wider use of the regional development index to determine funding allocation within the GFS programme, where so far only three out of 16 programmes exclusively use this index to allocate funding, would also support this objective. Strengthening coordination between the national and EU place-based policies is particularly important as both are under review to set funding targets for 2028 onwards.
More transparency and better coordination across funding programmes would also reduce the administrative burden and information asymmetries created by the fragmented funding application procedures, particularly for municipalities with limited administrative capacities (see below). For example, the integration of the funding programme Joint Task: “Improving the Regional Economic Structure” (GRW) into the GFS in 2019 has improved coordination and efficiency by harmonising application procedures and introducing conditional transferability of funds between programmes, raising the flexibility and predictability of funding for recipients (Suedekum, 2023[17]). A planned one-stop shop for funding applications (Foerderzentrale Deutschland), including for programmes aimed at municipalities, should be expanded to include more federal funding programmes, EU cohesion policy funds and Laender programmes and should be used to harmonise and simplify application procedures. Moreover, to further reduce the administrative burden related to the application and monitoring of conditional investment grants, they could be partially replaced with lump-sum grants using cost-based calculations (Blesse, Hoegner; Leon and Necker, 2024[18]; OECD, 2021[19]).
4.2.2. Making place-based policies more effective and forward-looking
Despite large transfers to economically weaker regions, disparities in labour productivity remain high across districts (Figure 4.1;Figure 4.3). This is due to agglomeration effects, the persistent regional heterogeneity in industrial structures and innovation activities, different levels of trade integration as well as intra-national migration. Building on experiences from past place-based policies and fiscal transfers, in particular related to the structural transformation of the Eastern German economy, can help improve the design of future policies (Box 4.2). Despite large fiscal transfers that considerably reduced income inequality and improved infrastructure quality, labour productivity in the eastern Laender is still about 80% of the average of western Laender. One main factor is that large scale subsidies for private investment have led to capital misallocation towards industries with lower-skill intensity and benefitted more mature and bigger firms, hampering business dynamism and innovation, and resulting in spatial displacement of activity. Stringent labour market protection in combination with collective bargaining dominated by Western German worker unions incentivised new firms to stay small, weighing on productivity growth. The privatisation process has led to the fragmentation of the industrial network, reducing agglomeration effects and innovation activity within clusters that had previously linked firms and local research institutions. Moreover, East Germans are significantly underrepresented in economic, political and cultural leadership roles, while trust in institutions is low in the eastern Laender (Vogel, 2022[20]).
Economic disparities between East and West-Germany began to increase from the Second World War until the building of the Berlin Wall in 1961, driven by large-scale selective migration and relocation of firms from the socialist German Democratic Republic (GDR) to the Federal Republic of Germany as well as higher war-related damages and reparation costs (Becker, Mergele and Woessmann, 2020[21]). During the following decades, these disparities have grown, in particular during the 1970s when expropriation of more entrepreneurial smaller and medium-size firms led to an increasing centralisation of the Eastern economy (Blum, 2019[22]). The reunification in 1990, encompassing the transition from a central planning to a market-based economy, including a large-scale and rapid privatisation of firms and real estate property, a strong real appreciation due to the introduction of a single currency and a collapse of export markets in other ex-Soviet countries, first exacerbated these disparities (Figure 4.7). Real GDP in the East had declined by 35% from 1989 until 1991 and industrial production and employment by one third until 1993.
Note: Berlin is included in the East Germany. In Panel A, “GVA” refers to gross value added in EUR billions and average purchase price for land is in EUR per m².
Source: German Regional Statistical Office; BBSR Bonn (2024[6]); Federal Employment Agency; and OECD calculations.
By 1996, however, real GDP had recovered to its pre-reunification level, mainly thanks to a booming construction industry supported by sizable transfers and subsidised loans for infrastructure projects and large fiscal incentives for private investments (von Hagen, Strauch and Wolff, 2002[3]). Other sizable transfers from western to eastern states included transfers within the fiscal equalisation system as well as within the unemployment benefit and the pension system. Despite the sizable transfers and investments, however, real GDP growth slowed down in the second half of the 1990s and unemployment rates remained persistently high, reaching 20% on average in 2005 (Figure 4.7). Including people in active labour market programmes, unemployment was even closer to 30%. In addition to the initial real currency appreciation, the wider application of West German labour market institutions in East Germany led wages to grow faster than labour productivity during the 1990s, raising unit labour costs further and weighing on the competitiveness of firms in East Germany. Today, labour productivity and wages remain at about 80% of the level of western states. The population in eastern states (excluding Berlin) has decreased by 15% since 1989, mainly due to outward migration and strongly declining birth rates, while in western states population increased by about 10%.
The slowdown in convergence can be attributed to several factors, including selective migration of the high-skilled and more entrepreneurial youth to western states, the heavy subsidisation of investments that tried to compensate for high unit labour costs and led to the misallocation of capital, an industry structure skewed towards lower skill intensity, as well as the nature of the privatisation process leading to many dispersed smaller firms and a lack of headquarters and innovation activities in East Germany (Akcigit et al., 2023[23]; Blum, 2019[22]). In particular, significant tax deductions for investments benefited larger and more mature firms incentivising the acquisition of East German firms by West German firms without necessarily generating new production, business start-ups or innovation activities in the East (Sinn, 1995[24]).
During the privatisation process, large state-owned conglomerates were first split up into smaller entities leading to about 11 000 firms, which were then privatised from 1990 until 1994. Fast privatisations favoured West German investors as buyers, particularly of the more productive firms, as foreign or East German investors lacked market knowledge or political connections. International investors acquired less than 7% of all privatised firms, while 45% were acquired by West German investors, limiting competitive pressures on West German firms (Estrin et al., 2009[25]). About 45% of firms, which were generally the less productive firms, where acquired by East German investors, including by associations of employees. This negative selection, limited knowledge about the functioning of markets and firm management as well as weaker access to finance for East German investors due to low wealth levels, but also the decision to not cancel outstanding debt as done for many firms sold to West German investors, contribute to explain why survival rates of firms acquired by East German investors were much lower (Mergele, Hennicke and Lubczyk, 2022[26]). By 1994, one third of all firms were shut down, and by 2010 half of the remaining privatised firms had seized to exist. This considerably weakened the industrial network and reduced agglomeration effects and innovation activity in East Germany (Blum, 2019[22]). Moreover, labour market institutions have incentivised firms in the East to stay small to avoid collective bargaining and high firing costs, weighing on aggregate productivity growth (Bachmann et al., 2024[27]).
Previous evaluations of investment subsidies within the place-based programme GRW, which accounted for around 30% of all GFS funding evaluated in 2022, have shown mixed results (BMWK, 2024[5]). The evaluations have found that GRW programmes increased investment, employment and turnover in the beneficiary regions, particularly for smaller firms and in services, but had weak effects on labour productivity and wages and led to a declining share of high-skilled workers over time compared to untargeted firms (Brachert et al., 2024[28]). This may be because size-dependent eligibility criteria for the subsidies have encouraged firms to remain small, and wage subsidies were not conditional on skill profiles of employees (Garicano, Lelarge and Van Reenen, 2016[29]; Desiere, Toniolo and Bijnens, 2025[30]). In particular, firms below a certain size threshold can claim a larger share of their investment costs compared to larger firms. Conditioning subsidies on trade with more distant regions to boost exports may also have resulted in higher trade costs for supported firms (Siegloch, Wehrhöfer and Etzel, 2021[31]). A 2022 reform is welcome as it links wage subsidies to high-skilled employment and removes the eligibility condition of a minimum distance for trade in goods and services, which is key to foster regional value chains and spillovers (Atalay et al., 2023[32]). Better evaluating investment subsidies and considering abolishing firm size thresholds in eligibility criteria and setting higher wage subsidy rates for the employment of higher-skilled workers with adequate training could help encourage beneficiaries to scale up and support regional innovation and productivity growth. Making all GFS funding conditional on the disclosure of the common electronic identifier for applicant firms – as has been the case for GRW – would facilitate the impact evaluation of GFS programmes. Applying this principle to industrial policies and other funding programmes would further facilitate policy impact evaluation.
Including a forward-looking perspective in all GFS programmes could help regions master the green and digital transitions. The place-based policy framework remains largely a mechanism to equalise existing living conditions across Germany. However, the green and digital transitions will create challenges for currently unassisted regions which should be taken into account to better prepare these regions for structural changes before the costs of addressing them become much larger (Suedekum, 2023[17]). For example, the decarbonisation of energy-intensive industries and the structural transformation of the automotive industry will strongly affect regions which are outside the currently targeted regions, and require large training investments to help workers move to jobs in expanding sectors and firms (OECD, 2023[8]). Moreover, climate change is projected to cause high adaptation costs in almost 90% of all municipalities (Friedrich et al., 2023[33]). So far, demographic projections are the only forward-looking criteria included in the funding allocation mechanism of most of the GFS programmes. Other forward-looking criteria, such as higher risk from climate change or costs from decarbonisation of industries, should also be included in the funding allocation, for example by using the medium-term regional temperature and drought projections of the National Meteorological Service and the long-term regional climate extremes projections of the German Environment Agency. Regional vulnerability to planned climate mitigation measures could be included by using a regional composite indicator approach based on employment and emissions shares (Rodríguez-Pose and Bartalucci, 2023[34]). The relaxation of eligibility conditions for investment subsidies for climate-friendly and research-intensive investments after the 2022 reform of the GRW are welcome (BMWK, 2024[16]). New initiatives to support regions during the green, digital and demographic transitions should be merged with the GFS programmes to improve coordination and strengthen the proactivity of the place-based policies.
A large infrastructure backlog at the municipal level has weighed on economic development and the quality of public services, making it difficult for regions to cope with ongoing structural changes (Figure 4.8). Municipalities account for about 40% of all general government expenditure on investment, including half of all climate-significant investments, and the investment backlog has reached 4.2% of GDP in 2022 (BMF, 2023[15]). Municipalities are responsible for investing in schools and other educational infrastructure, childcare facilities, waterways, energy utilities, local roads, public transport infrastructure, administrative buildings and wastewater management infrastructure. Investments in these areas are needed for the green and digital transitions. Municipalities are also responsible for a range of public and social services, such as health and long-term care, youth assistance services, the administration of basic income support, disability and housing benefits, and the accommodation of refugees, among others, which are key for ensuring high living standards and well-being and building citizens’ trust in institutions.
Gross fixed capital formation less depreciation, % of GDP
Source: OECD National Accounts database.
The reasons for the infrastructure backlog range from weak infrastructure planning capacities, as discussed in the 2020 OECD Economic Survey of Germany, and lengthy planning and approval procedures, which the government has started to address (see Chapter 2), to a deteriorating financial situation in many municipalities in recent years. Higher social transfers due to the pandemic and energy crisis and benefit increases legislated by the federal government, large inflows of refugees, rising energy prices, public wages and construction costs as well as high interest rates have increased spending pressures, while tax revenues have stalled. However, the disparities across districts remain large due to differences in economic activity (Figure 4.3): For example, in 2022, municipal investment expenditure per capita in Bavaria was 50% more than the average of all territorial Laender, and around 2.5 times that of Saarland (Freier, Geißler and Gnädinger, 2023[35]). The heterogeneity in municipal finances, public investment and the provision of public services is also strongly correlated with trust in institutions (see below). To improve the financial situation of poorer municipalities, it is key to strengthen their local tax bases, devote a larger part of shared taxes to municipalities, improve municipal equalisation systems and increase spending efficiency by incentivising cooperation and bundling of tasks across municipalities and transferring some of their tasks to other levels of government.
4.3.1. Improving public finances of municipalities
Municipalities have a broad range of functions but to finance them they are dependent on transfers from the Laender. Tax revenues of municipalities, including their share from joint taxes, are only about 16% of national tax revenues while they are responsible for close to one fifth of public spending (Table 4.1). The financing gap is filled by grants from the Laender to the municipalities, of which about 90% are recurrent grants, which are mostly unconditional transfers through state-level municipal equalisation systems, and 10% are earmarked investment grants, which cover only around a third of municipal investment expenditure (Figure 4.6) (Deutscher Städtetag, 2023[36]). To address the municipal investment backlog in specific areas such as school and childcare infrastructure, the federal government has also established extra-budgetary funds in agreement with the Laender to circumvent the constitutional ban on providing direct funding to municipalities.
Most state-level municipal equalisation systems are not cost-based and transfers to municipalities strongly fluctuate with state revenues, which exacerbates financial difficulties of municipalities in economic downturns. As municipalities are responsible for part of social protection and housing benefits, their spending pressures increase in economic downturns, while the main revenue source is the local business tax, which is highly pro-cyclical. Laender grants through the municipal equalisation system exacerbate this issue. Many Laender use a pure quota system that allocates a constant share of all state revenues to the municipal revenue equalisation fund. As personal and corporate income taxes are the main resources for state revenues beside VAT, transfers to municipalities also decline during economic downturns. To address this issue, Hesse and Rhineland-Palatinate use a stabilisation model, that combines the pure quota system with a stabilisation fund that is built up in years of high state revenues and drawn down in years of low state revenues. On the other hand, Brandenburg and Schleswig-Holstein additionally consider differences in the costs of fulfilling municipal tasks in their municipal equalisation system and Saxony-Anhalt uses a fully needs-based model. Fostering the use of cost-based equalisation systems should be considered, as for example in Norway and Sweden, where equalisation responds more effectively to external cost shocks, such as rising refugee inflows, increasing energy prices or demographic changes. To facilitate the shift from revenue redistribution to more cost-based equalisation, horizontal contributions from low-cost regions could be included – as practiced in Sweden. Given the difficulty of estimating costs independently from revenues, this could help promote spending efficiency through inter-municipal peer pressure (Thöne and Bullerjahn, 2020[14]; OECD, 2021[37]).
The financial situation of municipalities is further complicated by the high share of rigid expenditures that are determined at other levels of government. For example, federal decisions that lead to higher social benefit payments, including for refugees, severely constrain the budgets of municipalities and reduce their funds for productive investment (Thöne and Bullerjahn, 2020[14]). The federal government temporarily provides earmarked grants or higher VAT shares to the Laender to support municipalities in carrying out these functions, but in many cases funding is not sufficient. Additional federal transfers for basic income support for the elderly and housing benefits have eased the pressure on municipalities with a faster ageing population and a higher number of unemployed persons. However, estimates suggest such transfers cover only about 40% of municipal expenditure on social benefits and not in all cases have the transfers to the Laender also been passed on fully to their municipalities (Freier, Geißler and Gnädinger, 2023[35]). To ease the burden of refugee inflows for municipalities, a cost-based increase in the VAT share for the Laender has been introduced from 2024 to help compensate for the increased costs (Deutscher Städtetag, 2023[36]).
Distribution of joint taxes between levels of government and taxes accruing exclusively to each level of government
Note: “Personal income” includes wages. “Capital gains” include interest income. “Corporate income” excludes local business taxes. 0.7% of total tax revenue accrues to the EU through customs duties. Other fees collected by municipalities account for 0.2% of total national tax revenue. The local business tax is not part of the joint taxes but since 1970 municipalities share some of their revenues with the federal government and the Land in exchange for receiving 15% of personal income tax revenues within their Land.
Source: Federal Ministry of Finance (2023[15]).
Ensuring sufficient and stable funding for local governments
One key policy priority should be to ensure sufficient and stable funding for municipalities to fulfil their core functions, which according to the constitution is a responsibility of the Laender. If functions of municipalities become more costly due to legislative changes at the federal level, municipalities should receive a higher share of value added tax (VAT) or other joint tax revenues, while ensuring that grants from Laender through the municipal equalisation systems or supplementary federal grants are not reduced in exchange (Table 4.1). This is key to preserve balanced public service provision across regions when spending pressures increase. Over-reliance on grants introduces funding uncertainty, also related to the political cycle, which is particularly harmful for infrastructure investments that require spending commitments over longer planning horizons. Capacity in construction services will only increase, within firms or due to new entries, if infrastructure planning is accompanied by stable long-term financing. The recent establishment of a special fund for infrastructure investments, which will allocate EUR 100 billion for public investment to Laender and municipalities over the next 12 years, could significantly increase the resources available for local investments (see Chapter 1). However, financing a high share of municipal expenditure with grants reduces incentives for spending efficiency, as local populations might have less incentives to scrutinise local governments for their spending decisions (Herrmann, 2022[38]; Blöchliger and Kim, 2016[39]). This is a particular problem for conditional grants, in particular if they do not require co-funding by the municipality receiving the grant (Bergvall et al., 2006[40]). As personal income and capital gains taxes fluctuate strongly with the business cycle, receiving a higher share in VAT revenue would help ensure stable funding of core functions. On the other hand, any tax reform at the federal level should be evaluated with respect to its effects on municipal tax revenues and combined with sufficient compensating measures to ensure the stable funding of municipalities.
Another priority should be to raise more revenue from local tax bases, such as recurrent taxes on immovable property or personal income taxes (PIT) (Table 4.1). This would raise accountability, incentivise more effective budgeting and decrease dependence on transfers. Combining the strengthening of municipal tax autonomy with capacity-building initiatives and oversight measures would help ensure responsible management of local revenue (OECD, 2021[37]). If a larger part of municipal revenues is collected from local tax bases and institutional quality is strong – minimising the risk of local capture – local populations are more likely to hold local governments accountable for their spending decisions. This in turn motivates local governments to improve public service quality and spending efficiency (OECD, 2016[41]). A higher share of local tax revenue in local government revenues is also associated with narrowing regional growth disparities, reducing the need for equalising transfers (Blöchliger, Bartolini and Stossberg, 2016[42]).
The PIT in Germany is shared across levels of government according to the territorial source principle, but the share allocated to municipalities is low (Table 4.1). Increasing this share or allowing Laender or municipalities to introduce top-up tax rates on PIT above the national rate, as for example done in the US, could improve incentives to improve public service quality and spending efficiency (Blöchliger and Kim, 2016[39]). The local business tax (Gewerbesteuer), which is the largest local revenue source for municipalities that can set rates freely above a national statutory minimum tax rate, already provides strong incentives for improving local governance and developing the local tax base, but it is highly pro-cyclical and suffers from detrimental tax avoidance schemes (Dinauer, Kammerer and Ott, 2022[43]). Due to their weak financial situation, many poorer municipalities need to set higher rates, which can lead to shifting of economic activity and profits between regions (Beznoska and Hentze, 2019[44]). Increasing the minimum statutory tax rate for municipalities from 7% to 10% would improve capital allocation across regions and reduce the scope for profit shifting, while leading to a combined minimum tax rate of 25% (the federal corporate income tax (CIT) rate is 15%), which would be slightly above the OECD average of 23.3% in 2021 (OECD, 2022[45]). The federal CIT rate could be reduced in response to the higher minimum statutory rate for municipalities, which could be financed by increasing consumption taxes (see Chapter 1). This should be combined with improving data exchange and cooperation between the tax enforcement agencies of the Laender to reduce the scope for tax evasion (see the previous OECD Economic Survey of Germany).
As recurrent taxes on immovable property provide relatively stable revenue streams, increasing effective tax rates based on regularly updated market values of properties would help to reduce the large fluctuations in municipal tax revenue (OECD, 2021[37]). Revenue from taxes on immovable property such as land or buildings are low compared to other countries and have stagnated as a share of GDP since the 1990s, although land prices have more than doubled and real estate prices have increased by about 80% during the last 10 years (Figure 4.9) (Fuest, Hey and Spengel, 2021[46]; Bach and Eichfelder, 2021[47]). In other OECD countries such as the United States or Switzerland, property tax accounts for a much larger share of municipal tax revenues than in Germany, reaching more than 90% in thirteen US federal states (OECD, 2021[37]).
A recent reform of the land tax (Grundsteuer) is an important step into the right direction, as it introduces a regular update of land and property values with market values, whereas so far valuations from the 1960s (and 1930s) had been used to determine the property tax base in West- (and East-) Germany (Bach and Eichfelder, 2021[47]). However, in many Laender the implementation of the reform aims at keeping tax revenues constant, implying a reduction in rates as property and land values are updated to higher market values. In principle, tax rates can be freely set by municipalities. Introducing a national minimum tax rate, however, could help avoid detrimental tax competition and use the regularly updated property values to increase revenue for municipalities (Bach and Eichfelder, 2021[47]; OECD, 2021[48]). As the distribution of wealth and immovable property is relatively unequal compared to other OECD countries, this would also help lowering personal income inequality (see the previous OECD Economic Survey of Germany). To support cash-poor but asset-rich households, tax deferrals could be introduced as in Canada, Denmark, Ireland and some US federal states, provided that the unpaid tax is settled when the property is sold or inherited. The Laender could then finance such deferral programmes to guarantee property tax revenue for municipalities, as is done in nine US federal states (Dougherty and Kim, 2023[49]).
Recurrent taxes on immovable property, % of GDP, 2023 or latest available year
Note: “OECD” refers to an unweighted average.
Source: OECD Revenue Statistics; and OECD calculations.
As economic activity, the age structure of the population and land prices differ strongly across districts, relying more on revenue from local tax bases to encourage spending efficiency would risk exacerbating disparities in fiscal capacity of municipalities. Municipal equalisation schemes, which often consist of formula-based grants that are transferred to financially weak municipalities, should be designed to maintain funding for core local public services, while preserving incentives to develop local tax bases and raise spending efficiency. State-level municipal equalisation schemes remain partly funded by shared taxes, unconditional and conditional federal grants and in about half of all Laender, do not involve horizontal transfer of funds between municipalities. Financing a larger share of the municipal equalisation system with funds from richer municipalities and ensuring strong accountability and direct interaction between municipalities could help raise municipal spending efficiency due to peer pressures. For example, in Sweden, municipalities with higher per capita tax bases contribute to the revenue equalisation system by forgoing central government grants. Those with below-average public service costs also pay into the needs-based cost equalisation pillar. These mechanisms significantly equalise resources and ensure delivery of municipal services at a relatively low overall cost, as their spending share of total government expenditure is only about half the share observed in Germany (OECD, 2021[37]). To maintain incentives to develop the local tax base, contributions to the equalisation scheme should be calculated based on measures of municipal tax capacity rather than actual revenues, which is why standardised tax rates are used to compute local business and property tax capacity. Recently updated cadastral values should be used without adjusting these standardised rates to properly reflect municipal tax capacity.
To create incentives for the Laender to introduce well-designed municipal equalisation systems and better use local tax bases, the fiscal equalisation system between the Laender should be re-adjusted. A strong equalisation of revenue differences across the Laender through the redistribution of VAT revenues, which indirectly affects state-level municipal equalisation schemes, reduces incentives to rely on own efforts to improve the financial situation of municipalities (Figure 4.10). The 2020 fiscal federal reform has made the system more vertical by reducing direct horizontal equalisation across the Laender and strengthening the use of federal supplementary grants to support specific Laender and their municipalities (Bury and Feld, 2023[50]). At the same time, the weight of municipal tax capacity in calculating contributions of Laender to the equalisation system has increased, which has likely raised incentives for municipal tax collection and increased contributions from richer Laender, as they also tend to have richer municipalities. Before the reform, municipalities in richer southern Laender had relatively low tax rates for local business and property taxes, as municipal revenue from shared taxes is high enough to finance municipal tasks. In North Rhine-Westphalia, in contrast, tax rates for local business and property taxes are higher as transfers from the federal equalisation system are low and municipal debt and interest payments are relatively high (Thöne and Bullerjahn, 2020[14]). In eastern Laender, which benefit substantially from the federal equalisation system and supplementary grants that indirectly finance state-level municipal equalisation schemes, tax rates for local business and property taxes are low, which is also a way to attract businesses and households.
An evaluation of observed differences in local tax rates should be conducted to further redesign the federal and municipal equalisation systems to focus on the capacity to deliver core public services across municipalities rather than compensating for the failure to fully use local tax bases (OECD, 2021[37]). In an efficient fiscal equalisation model, local tax differentials should respond only to differences in preferences and tax collection efficiency across regions. Further increasing the weight of municipal tax capacity in computing fiscal capacity of states in the federal equalisation scheme or raising the rate at which the excessive revenue growth is deducted from fiscal capacity would help strengthen incentives to use the local tax base. As discussed in the previous OECD Economic Survey of Germany, the fiscal equalisation system might also reduce incentives for the Laender to collect joint taxes. Increasing transparency about tax gaps and enforcement capacity and setting binding guidelines and performance targets would help strengthen tax enforcement at the Laender level (see Chapter 1).
Fiscal capacity of the Laender, per cent of equalisation index, 2023
Note: The equalisation index is computed by taking the weighted average across the Laender of the revenue accruing to each Land from joint and own taxes, including 75% of the revenue accruing to its municipalities, divided by population. The populations of Berlin, Bremen and Hamburg are weighted at 135% while for municipal revenues in Mecklenburg- Western Pomerania, Brandenburg and Saxony-Anhalt populations are weighted at 105%, 103%, and 102% respectively. The bars show different levels of fiscal capacity as a percentage of the equalisation index depending on the impact of the inter-state equalisation scheme (through the redistribution of VAT revenues), the general supplementary federal grants and the supplementary federal grants for municipalities with low revenue-generating capacity.
Source: Federal Ministry of Finance.
Strengthening the fiscal and financial management capacity of municipalities
Improving the incentives for the Laender to ensure that their municipalities remain funded to fulfil their tasks also requires an incentive-compatible resolution of large debts accumulated by some municipalities. In contrast to the Laender, which under the German debt brake have to limit their annual structural budget deficits, municipalities have the possibility to finance investment spending by issuing debt or taking on loans, and temporarily finance deficits related to current expenditure by cash advances (Bury and Feld, 2023[50]). These cash advances are overdrafts on current accounts with local public saving banks, which are often owned by the municipalities, to meet payment obligations for current expenditure. Due to the strong pro-cyclical fluctuations in municipal revenues, including local business taxes and Laender grants, and the counter-cyclical fluctuations in expenditures, especially social benefits, many municipalities have used this option to finance deficits, which reached 0.4% of GDP in 2024 for all municipalities. Some municipalities were not able to repay the debt during upturns or refinance debt when interest rates were low, leading to rising debt.
The rising municipal debt is weighing on public investment in many regions. Regional disparities in municipal debt at the district level have increased steadily between 2010 and 2019, with municipal debt reaching EUR 10 000 per capita in some districts, more than five times the national average (BBSR Bonn, 2024[6]). In the states of Rhineland-Palatinate, Saarland and North-Rhine Westphalia with high levels of municipal indebtedness, per capita municipal investment expenditure is between 40% and 70% of the national average. While three-quarters of all municipal debt is for investment purposes, equal to about 3% of GDP in 2022, the remaining municipal debt is cash advances (BMF, 2023[15]). Although total cash advances have been declining since 2016 as a share of GDP, in the states of North-Rhine Westphalia, Rhineland-Palatinate and Saarland they were still around 3 times the national average per capita in 2022. Municipalities with high cash advances often lack liquidity reserves and are vulnerable to interest rate increases. Some Laender, such as Lower Saxony, Hesse and Brandenburg, have conducted debt relief programmes to reduce excessive cash advance balances and create fiscal space for investment spending. Laender such as North-Rhine Westphalia, Rhineland-Palatinate and Saarland have asked the federal government to help bail out their municipalities, as the high debt is weighing on investment expenditure and necessary higher local business taxes disincentivise economic activity. Although some of the legacy debt is related to long-term challenges related to structural change, moral hazard and excessive spending have also played a role in generating the local debt overhang. It is key to implement the proposed federal debt relief programme and integrate it into a general reform of the fiscal federal system that strengthens incentives for municipalities to raise spending efficiency, improve accounting practices and develop their own tax bases. Governance issues related to local public banks also need to be addressed (see Chapter 2).
A lack of transparency and standardisation in municipal accounting practices hampers comparability and the early detection of fiscal problems. In Germany, accounting practices for different levels of government are less standardised than in other federal OECD countries, such as Australia, Austria, Canada and Spain that have similar standards for all levels of government (OECD, 2021[51]). While Hesse and Hamburg and most of their municipalities use accrual accounts, Schleswig-Holstein allows its municipalities to choose between the two methods, and Bavaria and Thuringia use cash-based accounting, while allowing their municipalities to voluntarily switch to accrual accounts (BMF, 2023[15]). Making accrual-based accounting mandatory for all municipalities would improve transparency and strengthen early warning mechanisms for fiscal risks. Accrual-based accounting is resource based and thus places greater emphasis on the division of responsibilities and revenue autonomy compared to cash-based accounting. It also creates incentives for municipalities to be more fiscally prudent, as for example, expenditures are recorded when invoiced rather than when paid. 24 OECD countries have moved to accrual-based accounting for their sub-central governments during the 2010s (OECD, 2021[51]). Differences in accounting practices are exacerbated by heterogeneous document formats, and different delineations of tasks between the Laender and their municipalities, which is the reason why German municipal finances data is not included in the OECD Municipal Government Finance database. Introducing mandatory accrual-based accounting should be accompanied by prudent cash flow management. For example, requiring municipalities to maintain a minimum liquidity buffer, as is the case in Baden-Württemberg and Hesse, would prevent the unsustainable accumulation of cash advances. These liquidity buffers could be used in periods of high interest rates to cover current expenditure, including the service of previously accumulated debt, while cash advances could be increased in periods of low interest rates (Freier, Geißler and Gnädinger, 2023[35]).
Integrating spending reviews in the budget process to align spending with policy objectives can help raise spending efficiency at the local level. In most municipalities, spending reviews are seen as an administrative formality that does not discipline the budgeting process. One exception is the state of Brandenburg, where a history of financial difficulties in fiscally weak municipalities required difficult spending prioritisation which helped restore financial stability. In economically stronger Laender, high revenues from shared taxes have weakened the importance of spending reviews, but weak monitoring capabilities also help explain why budget allocations are decided with few linkages to policy impact evaluation (OECD, 2021[52]). The slow digitalisation of the public administration and data protection issues, which prohibit the use and linkage of micro data, hinder policy impact evaluation at all levels of government (see Chapter 2). As recommended by the previous OECD Economic Survey of Germany, developing the necessary data sharing infrastructure, strengthening spending reviews in budgeting procedures and encouraging peer learning across levels of government is key to raise spending efficiency. The Stability Council meetings between the federal and state finance ministries could provide opportunities for peer learning on the use of spending reviews by the Laender to be applied to municipal budgeting procedures.
Introducing medium-term budgeting would help reduce uncertainty for investment financing. Co-financing arrangements between the different levels of the government suffer from a lack of mutual commitment to multi-year budgeting, which complicates the financing of long-term municipal investment projects. Multi-year expenditure ceilings are adopted only on a rolling basis, with the ceilings updated annually by adding an extra outer year, to preserve the constitutional principle of yearly budgeting (Moretti, Keller and Majercak, 2023[53]). The five-year financial plans are instruments adopted by the federal and state governments for longer-term projects, but they are also non-binding. In contrast, in the United Kingdom, binding and fixed expenditure ceilings are set for five years for capital expenditure and three years for other current spending, excluding cyclical spending such as spending for welfare and pensions, and they are updated every two years as a result of the spending review process. In the Netherlands and Finland, such ceilings are set for four years for all expenditures. Setting credible and binding multi-year expenditure ceilings at both aggregate and sectoral levels in line with the OECD Spending Better Framework would help reduce funding uncertainty and address the large investment backlog of municipalities. This should be accompanied by allowing for some degree of flexibility under clearly defined conditions, for example to address the consequences of a rapid rise in social benefits spending due to federal legislation (Deutscher Städtetag, 2023[36]).
4.3.2. Improving the administrative capacity of local governments
Besides financial difficulties, limited capacities for strategic planning and project management have also contributed to large regional disparities in the municipal investment backlog. Limited administrative capacities also complicate the application for and management of conditional grants from other levels of government or the EU, which weakens the effectiveness of these funds to address the local infrastructure backlog. For example, the absorption of GFS funds varied widely, even across municipalities within structurally weak regions (BMWK, 2024[5]). Skilled labour shortages are mounting and it is increasingly difficult to recruit and retain the necessary talent for municipal administrations. Accelerating the digitalisation of the public administration, reducing the administrative burden and improving human resource policies are key policy levers to improve administrative capacities and the quality of public services at the local level (see Chapter 2). This should be combined with better cooperation and the bundling of tasks across municipalities, while delegating certain tasks with large economies of scale to other levels of government.
The potential for lowering unit costs of public services through state-level territorial reforms is high (Figure 4.11). Due to rapid population ageing and decline in specific regions, the unit costs of municipal services and infrastructure investments could rise sharply over the next two decades, exacerbating regional disparities (BMWK, 2024[5]). Although municipal reforms have significantly reduced the number of municipalities since 1990, this consolidation has mainly taken place in the eastern Laender. There are still more than 10 500 municipalities, with an average population of less than 8 000, compared with around 26 000 in the median OECD country. Municipalities employ more than one third of all public employees, and in some municipalities staff numbers per capita have reached four times the national average in 2019 (BBSR Bonn, 2024[6]). Each federal state should consider the likely benefits of a territorial reform in its jurisdiction and implement one if necessary. In Denmark, a 2007 reform of local government largely standardised municipal population sizes and functions in areas such as social welfare administration, environmental protection, and water supply management to improve economies of scale (OECD, 2021[37]). The reform also ensured that local taxation remains the main source of revenue (around three-fifths), while the new costs for municipalities are compensated by higher grants from central government (Bland, Kilpatrick and Dimitrova, 2021[54]).
Size structure of municipalities, based on resident population, %, 2022
Source: OECD Subnational Government Structure and Finance database.
If the scope for territorial reforms is limited, inter-municipal associations provide an appropriate institutional setting to facilitate cooperation between smaller municipalities, already applied in areas such as waste management, public transport or tourism (Zimmermann, 2017[55]). Potential gains from cooperation in the provision of water supply, firefighting and hospital management services but also investment and urban planning across municipalities are possibly large, as the average municipal area is less than one-tenth that of the median OECD country (De Mello, 2019[56]). However, the fear of local administrations of losing autonomy as well as data protection concerns are barriers for institutional cooperation between municipalities. To address these issues, North Rhine-Westphalia has established a central contact point to advise municipalities in the early stages of cooperation, mainly to communicate the potential added value of increased synergies. To raise awareness of successful examples of cooperation, the state provides information on 633 cooperation projects between a total number of 427 cities, municipalities and districts. In the federal state of Brandenburg, municipalities can cooperate extensively to fulfil their public functions, and there are no state regulations against cooperation. In addition to institutionalised models of inter-municipal cooperation, the state also encourages informal networks and working groups to facilitate the exchange of knowledge and experience in urban development, local economic development, and transport, which can also help to build administrative capacity. These efforts should be strengthened and complemented with financial incentives to strengthen municipal cooperation in public service delivery, for example through incentives in municipal equalisation schemes. Mandating cooperation of municipalities for certain services would also be an option.
Bundling tasks or transferring some tasks, which can be fully digitalised and do not require close local counselling, to other levels of government can help reduce pressure on administrative capacities at the local level. For example, the request and delivery of passports, identity cards and driver licenses are centralised and digitalised in many OECD countries, with the handing out of documents made by secured postal mail. In Germany, the printing of these documents is also centralised, but each municipality has its own administration to deal with applications and hand out these documents. Although many municipalities have digitalised the application procedures, they have used different IT providers and inter-linkage of systems is not possible in many cases. Bundling these administrative procedures across municipalities or centralising them would raise spending efficiency and free staff resources for other functions. Other examples of responsibilities that could be bundled or transferred to other levels of government include the definition and monitoring of certain construction standards, including fire protection standards, motor-vehicle registration or procedures for recognition of foreign professional qualifications (Normenkontrollrat, 2025[57]). For example, in Ireland, the building control management, oversight and enforcement processes are streamlined by the introduction of a digital portal to be used by both central and local governments (OECD, 2021[37]). A joint commitment of all levels of government to task bundling, including by reducing legal uncertainties related to the prohibition of mixed administration and including a requirement for cooperation and the anchoring of experimentation clauses in the constitution, as well as a strong steering and implementation unit at the federal government and raising the mobility of public employees across levels of government would support the reform process (Normenkontrollrat, 2025[57]).
The potential for raising spending efficiency through bundling of tasks is particularly large in public procurement and the digitalisation of public services. About 30 000 decentralised procurement bodies are responsible for procurement volumes of around 15% of GDP. A centralised online procurement platform has been established but the publication of tenders is only mandatory for Laender and municipalities for contracts awarded above the EU thresholds, and centralised purchasing bodies are rather the exception than the norm including at the federal level (see Chapter 2). Encouraging the use of the central procurement platform as well as the established e-procurement system would facilitate cooperation across municipalities to reap gains from specialisation and economies of scale and raise spending efficiency (OECD, 2019[58]). Joint procurement has been found to significantly reduce costs compared to local procurement but many standardised goods and services are still procured at the municipal level (Fazekas and Blum, 2021[59]).
Potential for raising spending efficiency is particularly large in IT and software procurement. Many municipalities have developed different IT systems for different types of public services, which does not allow to exchange information between databases within nor across municipalities and levels of government, and unique individual identifiers do not exist. Each municipality signed separate procurement contracts with private providers, who developed different IT systems for the same public service without using economies of scale across municipalities (BMWK, 2021[60]). As discussed in Chapter 2, the introduction of mandatory common IT standards and data formats for all levels of government, including the obligation for all IT services providers to develop products for the public administration in conformity with these standards, should be a key policy priority. Moreover, the Laender should encourage their municipalities to establish joint IT development and procurement initiatives, which would require harmonising administrative procedures and reducing municipal autonomy to a certain extent (Normenkontrollrat, 2021[61]). However, such initiatives would strongly increase spending efficiency and could also lead to significant improvements in the quality of public services due to peer learning effects. At the Laender level, the one-for-all initiative has been successful in developing common IT solutions, for example the digital portal to apply for COVID-19 support. Likewise, in Schleswig-Holstein, a group of municipalities has successfully created an IT procurement group and used a dedicated central purchasing body (OECD, 2019[58]).
4.4.1. Aligning industrial policies with place-based development objectives
In many OECD countries, industrial policies are on the rise due to several reasons. Globalisation and technological change have significantly reduced manufacturing employment in many countries (Gagliardi, Moretti and Serafinelli, 2023[2]). This has led to rising demands for protectionism and place-based industrial policies to support the most affected regions. Fostering the green transition, reducing risk exposure to foreign supply of critical inputs and trade dependency from geopolitical adversaries, and unfair competition from other countries have added to these motives for industrial policies (Millot and Rawdanowicz, 2024[62]). Estimates show that Germany is among the OECD countries with the highest number of industrial policy interventions over the last decade (Juhász et al., 2023[63]). Export incentives, below-market rate loans and loan guarantees, R&D subsidies as well as tax exemptions are reported as the main instruments used by Germany, unlike other big OECD countries, where R&D tax incentives are common.
Across OECD countries, targeted and more discretionary measures have become more frequent recently compared to horizontal industrial policies, reducing the rule-based nature of industrial policies. Targeted measures support specific sectors, regions, industries or technologies, including through subsidies, tax reductions, grants or loan guarantees. They may be more effective in correcting industry- or region-specific market failures than horizontal industrial policies, which do not discriminate between sectors and include for example infrastructure provision or funding for applied research institutions. However, they can distort competition and hamper innovation and structural change, as they can be subject to political capture and rent seeking (see Chapter 2) (Millot and Rawdanowicz, 2024[62]). For example, in many countries firm bailouts have occurred in sectors such as construction, banking, automotive, shipbuilding and retail trade, largely motivated by the goal of protecting jobs. Preventing the failure of firms can lead to moral hazard and distort competition and the efficient allocation of resources. Bailouts might be exceptionally justified, if the failure of the targeted firm may lead to the economy-wide disruption in the provision of the relevant products or services. Although targeted industrial policy might also be used to maintain strategic autonomy in certain production activities amidst geopolitical fragmentation, for example concerning subsidies for chips or battery production, the economic costs of these interventions should be better evaluated.
Large industrial policy interventions are not systematically coordinated with the place-based GFS programmes but have a strong regional impact due to the spatial clustering of the targeted industries (OECD, 2023[64]; Suedekum, 2023[17]). For example, the average annual funding of the coal phase-out programme amounts to about 60% of the entire annual funding of the GFS programmes. Subsidies to the automotive industry to increase the uptake of electric vehicles, boost infrastructure investments for charging stations and support regional innovation clusters that had specialised in internal combustion engine technologies were more than twice the funding under the GFS programmes. Other examples include about EUR 15 billion to subsidise planned chip factories in Magdeburg and Dresden or carbon contracts for difference (CCfDs), which aim at supporting the green transition in carbon-intensive industries with up to EUR 50 billion during the next 15 years. To better use synergies across funding programmes and strengthen spending efficiency, industrial policy should be more closely linked to place-based policy support, which is more rule-based in defining vulnerable regions. Merging some programmes or allowing for conditional transferability of funds between programmes could help improve coordination and reduce administrative burden for recipient regions.
4.4.2. Designing market friendly and fiscally sustainable green industrial policies
Although they have heterogenous effects across regions due to differences in industrial structures, green industrial policies are mainly designed as horizontal policies. Germany’s industrial emission reductions strategy relies on pricing mechanisms, sectoral subsidies and R&D support. The EU Emissions Trading Scheme (ETS) covers about half of emissions and includes energy-intensive industries as well as energy production. This is accompanied by large subsidies to renewable energy producers amounting to more than EUR 18 billion in 2024, which have strongly incentivised the expansion of wind and solar power supply, accounting for almost 60% of electricity supply in 2024. Nuclear power was phased out in 2023 and coal power plants are planned to be phased out by 2038. Finally, R&D support is provided to foster the development of new green technologies, for example green hydrogen, and facilitate emission reductions in sectors with high abatement costs, such as steel and cement production.
Up to EUR 50 billion are planned to be used for CCfD schemes during the next 15 years to reduce uncertainty about future carbon prices, particularly in sectors with high abatement costs and with large long-term investments needs to decarbonise production processes. Based on a competitively auctioned reference carbon price for reducing emissions by switching to green hydrogen, carbon-capture-and-storage, or other low-emissions methods of production, a CCfD guarantees investors a fixed revenue per tonne of non-emitted CO2. The government reimburses the difference if carbon prices are below the auctioned reference carbon price. Conversely, investors return the difference if carbon prices exceed the reference price. A similar logic also applies to the prices of other energy carriers used for production. The first round of CCfD auctions in October 2024 provided EUR 2.8 billion of support to 15 projects from both SMEs and large firms from energy-intensive sectors. The scheme provides a 15-year disbursement arrangement, paid in arrears, conditional on reaching annual emission reduction targets. The scheme will also indirectly stimulate investment in the construction of hydrogen production facilities and pipelines, with direct implications for regions where hydrogen refuelling stations are located and existing natural gas pipelines will be repurposed (see below).
Auctions and contracts for CCfDs should be designed in a technology-neutral way to not hamper competition, business dynamism and innovation (see Chapter 2). Broadening the range of technologies to participate in the auctions risks crowding out technologies at a current cost disadvantage but with high potential to become competitive in the future. In contrast, excluding certain technologies may lower competitive pressures and innovation, and waste resources. For example, allocating large subsidies to support integrated green steel production might lower the comparative advantage of innovations replacing the use of steel in construction. The same is true for innovations to change from integrated to partial steel production, involving the import of particularly energy-intensive inputs from countries with a comparative advantage for renewable energy supply. The government should carefully evaluate the introduced scheme before further expanding CCfDs.
The price signals from carbon taxation to incentivise emission reductions are weakened and distorted by many fossil fuel and other harmful environmental tax expenditures and subsidies amounting to up to EUR 65 billion per year (Burger and Bretschneider, 2021[65]). These subsidies and tax expenditures also hamper the market breakthrough of environmentally-friendly products, and make it more difficult to achieve climate goals. For example, electricity and energy tax as well as grid charge reductions for energy-intensive industries, energy tax concession for diesel fuel, favourable tax treatment for privately used company cars and lower VAT on meat and other animal products lead to annual subsidies of about EUR 21 billion. As discussed in the previous OECD Economic Survey of Germany, existing subsidies and tax expenditures should be carefully evaluated, better targeted and incentivise emission reductions, for example through abatement subsidies or CCfDs. It is key that all subsidies and tax expenditures include sunset clauses announced upfront, to strengthen abatement incentives and reduce future fiscal costs. Tax expenditures indirectly supporting specific sectors, such as those on the consumption of diesel and kerosene fuel, the commuter allowance or the favourable tax treatment for privately used company cars, should be phased out and partly replaced by direct transfers to vulnerable households (see below).
Subsidies to renewable energy producers have helped accelerate the expansion of renewable electricity supply in the North and East, contributing to regional economic convergence by attracting firms that want to produce with green electricity, but have a high fiscal cost. Although the feed-in tariff scheme was reformed to use auction-based electricity price ceilings as a reference for determining the level of the subsidy, the scheme cost about EUR 18.5 billion in 2024. As higher carbon prices make renewable electricity production attractive even without subsidies and the technologies have already matured, renewable energy subsidies should be phased out to free resources for more targeted support for green R&D. Public spending for energy R&D and demonstration in terms of GDP in 2023 was below the OECD average. Estimates show that 35% of global reductions in carbon emissions will have to originate from technologies that are still in prototype or demonstration stage (IEA, 2023[66]). Raising public support to green R&D can improve the overall cost-effectiveness of the policy mix by reducing future costs of low-carbon technologies and stimulating research in green innovations with positive knowledge externalities.
Production of green hydrogen through electrolysis using water and electricity from renewables can significantly reduce greenhouse gas emissions. It has potential to replace fossil fuels in high-temperature industrial processes of hard-to-abate sectors such as steel production, in road freight traffic, and to store energy produced from intermittent sources. However, the production of green hydrogen is still about three times more expensive than hydrogen made from natural gas (Cordonnier and Saygin, 2022[67]). Major cost reductions will crucially depend on R&D and large-scale demonstration projects. To incentivise private investments into hydrogen production and its use in industrial processes, it is key to reduce uncertainties for investors through standardisation and a quick construction of the hydrogen core network (Cammeraat, Dechezleprêtre and Lalanne, 2022[68]). Harmonising quality standards and definitions for the different types of hydrogen (green, blue, turquoise etc.) is key to reduce uncertainty and facilitate coordination, including at the EU level. Reducing the cost disadvantage of producing green hydrogen also requires improving the electricity grid and its management to lower electricity prices for users (see below). Nevertheless, large quantities of green hydrogen will likely need to be imported.
The construction of the hydrogen core network requires close coordination with place-based and industrial policies. The German North Sea and the northern regions have salt caverns suitable for hydrogen storage (OECD, 2023[8]). Increased industrial use of hydrogen technologies and green energy demand will require large investments in production and storage capacity as well as pipeline infrastructure to connect these regions to the hydrogen core network. A large part of the required pipeline and storage infrastructure will be diverted from the gas distribution network, with the remaining new investments to be completed by 2032. Network charges, which will largely finance the new investments, will be capped due to the small number of initial users, in line with EU state aid rules. An amortisation account will cover the initial shortfall in revenue from increased network tariffs at a later stage. If the increased network tariffs will not cover the shortfall in the amortisation account, federal funding will provide a partial backstop. As pipeline transport of hydrogen is subject to economies of scale, new clean production sites in remote areas will have to reach a critical mass to reduce future network tariffs. In this respect, the planning and implementation of the hydrogen core network infrastructure should be closely coordinated with place-based and other industrial policies to ensure the effectiveness of regional development policies and that network charges are self-sustaining, avoiding fiscal risks.
To reduce hard-to-abate emissions in industrial processes, such as cement production, it is also key to develop a network for carbon capture and storage. Due to low public acceptance for onshore storage, storage sites are planned to be located in the North Sea, requiring the construction of a pipeline network (OECD, 2023[8]). As existing gas pipelines cannot be rerouted for carbon capture and storage purposes, the network should primarily focus on connecting high-emitting industrial production sites. Thus, designing the network should be closely coordinated with the Laender and place-based federal policies to be aligned with regional development objectives. A draft revision of the carbon management strategy was presented in May 2024 and its implementation would be a significant step forward. It focuses on hard-to-abate emissions in industrial processes and aims to remove existing regulatory barriers, such as long approval times. The draft revision limits offshore storage to Germany’s Exclusive Economic Zone in the North Sea, except for an 8 km buffer zone around the marine protected areas, while export for offshore storage will be possible through the ratification of the amendment to the London Protocol. The Laender retain the power to decide whether to allow onshore storage in their territory. Given the geographically dispersed nature of cement production clusters and high costs of establishing the pipeline infrastructure, allowing also for onshore storage in aquifer and gas clusters could facilitate the use of carbon capture and storage technologies.
4.4.3. Mastering the energy transition
According to the latest data of the German Environment Agency, emissions have been reduced by 10% in 2023 compared to 2022, and by 46% compared to 1990. This is mainly due to a strong acceleration in the deployment of renewables in electricity generation (Figure 4.12). The simplification and acceleration of planning and approval procedures for wind and solar installations as well as rising electricity prices due to the energy crisis have strongly contributed to the expansion of renewables (see Chapter 1 and 2). To ensure stable electricity supply and that consumers can benefit from low producer prices of renewables, while fostering regional development in lagging regions, the grid infrastructure and the design of grid charges needs to be further improved. On the other hand, the transport sector has not reduced emissions much, as large subsidies and tax reductions have weakened carbon price signals and the charging infrastructure has not kept up with the rising number of battery electric vehicles (see the previous OECD Economic Survey of Germany). Decarbonising freight traffic poses significant challenges to regions, which must be addressed.
Note: GHG emissions exclude land use, land-use change and forestry (LULUCF).
Source: IEA, https://www.iea.org/countries/germany/energy-mix#where-does-germany-get-its-energy; OECD Environment Statistics.
Expanding the electricity grid and improving incentives to balance demand and supply
The rapid expansion of wind and solar energy poses challenges for the transmission network: Electricity generation from renewables is less stable over time and the electricity generated by wind turbines in the northern Laender, which have a comparative advantage in wind power, must be transported to the west and south, where most of the population and energy-intensive industries are located. Negative wholesale electricity prices have occurred more frequently in recent years, reflecting coincidences between the increased capacity from wind with periods of low demand (Timera Energy, 2024[69]). A considerable expansion of the electricity network, better interconnections with other European countries, such as France and the Netherlands, and a better balance of supply to variations in demand are needed. The Federal Network Agency’s grid expansion plans indicate that the transmission network could require investments of EUR 160 billion by 2037, while the distribution network will require additional investments of EUR 110 billion by 2033. The connection of the offshore renewable electricity production to the onshore grid will require another EUR 160 billion by 2045.
Electricity security in Germany is high, with power outages among the rarest in Europe – averaging just 13 minutes in 2021 – and declining further despite increased renewable rollout. This reliability is partly due to extensive underground cabling (IEA, 2020[70]). However, a regional mismatch between electricity generation – mainly in the North – and demand – mainly in the South – exposes weaknesses in the single-zone pricing system of the national electricity market. Without zone-based pricing, these imbalances require costly redispatch measures: curtailing renewable supply in the North when it exceeds local demand and scaling up local generation in the South when demand outpaces supply. Such interventions cause deadweight losses for consumers and can result in unscheduled electricity flows into neighbouring countries, raising price variability and forcing them to invest in expensive grid stabilisation. In response, from 2021, thresholds for mandatory redispatch participation were lowered to help relieve regional congestion, and further plans aim to optimise redispatch at the distribution level. Until grid expansion reduces the need for such measures, adopting zone-based pricing, as in Norway and Sweden, could be considered (OECD, 2024[71]). Zone-based pricing could also help foster industrial development in the North, which has a comparative advantage for wind power generation, especially in electricity-intensive industries such as batteries for electric vehicles and data centres. These benefits should be weighed against the higher electricity prices that would result in the South, where many energy-intensive firms are located.
To meet the grid expansion targets, permit approvals need to further accelerate. The government has simplified planning and approval procedures by classifying the electricity grid expansion as a project with overriding national interest, which strongly accelerated permit approvals (Figure 4.13, see Chapter 2). Moreover, the role of federal planning in grid expansion projects has been strengthened, which further simplifies permit procedures. The independence of the federal regulator in setting regulations was strengthened, including abolishing the requirement for the Laender to approve the regulator’s decisions on network access and tariffs, while maintaining their oversight through an advisory body. The regulator is planning to reform the licencing system for grid expansion projects and shorten the regulatory assessment period for network operators from five to three years, including through the digitalisation of procedures. It also plans to simplify the criteria for proving the financial viability of the applicant network operators. Transposing the EU Renewable Energy Directive legislation into national law and implementing it could further speed up grid expansion procedures and facilitate the integration with the EU electricity grid. The regulator should closely monitor connection times and further reduce administrative burden for the connection of storage facilities. This also applies to the connection of large energy-intensive plants that electrify their production, as long waiting times risk to hinder industrial transformation and regional development.
The design of grid charges has hindered economic development as well as the expansion of renewables in poorer regions in the North and East, which have large potential for renewable energy supply due to abundant wind resources and relatively low population density (Figure 4.4, Panel B). Due to insufficient connections to the main grid access points, the connection of renewable power producers to the grid led to higher grid charges in these regions, as grid charges are regionalised and depend on marginal costs of network expansion. Grid charges have been as large as three times the fees paid by consumers in other regions, which disincentivised the relocation of firms that demand green electricity to these areas and hindered the establishment of storage facilities and green hydrogen production. It has also reduced public acceptance for renewable energy expansion. From 2025, a reform of grid charges evenly distributes additional costs from expanding distribution networks among all electricity users in Germany, which is an important step forward. This will reduce yearly electricity consumption costs by about EUR 200 per year for consumers in Brandenburg, Mecklenburg-Western Pomerania and Schleswig-Holstein. To ensure that these price reductions are passed on to consumers, the competition agency and the regulator should closely monitor electricity markets and act in case they find evidence for abuse of dominance (see Chapter 2). Moreover, further improving grid charge incentives for firms to relocate to areas with renewable electricity supply, for example by equalising network charges across regions, could foster regional development and the green transition.
Some progress has been made in making electricity prices more flexible to better balance electricity demand and supply and reduce generation and transmission costs. All electricity suppliers are required to offer dynamic tariffs from 2025, which will help incentivising the use of available technologies, such as smart thermostats and water heating, to shift electricity use across time and reduce peak demand times on the grid (raise load flexibility). Since September 2024, the regulator publishes current and near-term future electricity prices to raise awareness among consumers and incentivise switching to dynamic tariffs. However, so far, only few electricity consumers use such dynamic tariffs and other parts of the electricity price remain static, such as levies, taxes, and grid charges. The grid charges – which account for about 28% of industrial consumer electricity prices – incentivise stable consumption of electricity, especially because large energy-intensive producers receive grid charge reductions conditional on keeping their electricity consumption constant over time (Hanny et al., 2022[72]). Abolishing the concessions for energy-intensive industries before the expiry of the Electricity Network Charges Ordinance in 2028 and introducing time-variable electricity charges as well as peak pricing would help ensure that the costs of grid utilisations are based on the actual state of the grid. The recently introduced variable grid charges for EV charging station and heat pump users are a step into the right direction. Moreover, phasing out subsidies to renewable energy producers would help make renewable supply more sensitive to price changes.
Note: Panel A covers permits under the remit of Federal Network Agency, which account for 60% of all line kilometres.
Source: Federal Network Agency.
To foster the use of contracts with dynamic electricity tariffs and better manage electricity demand and supply, a better communication network is needed to link generation, consumption, and the grid. Smart meters together with better storage units can help households optimise their electricity consumption and even feed the grid in times of high demand. Likewise, they can provide decision makers with a more precise picture of energy consumption patterns and save resources by eliminating the need to visit the traditional meter readers. However, the rollout rate of smart meters remains lower than in most other OECD countries, at around 14% in 2024 (De Paola, Andreadou and Kotsakis, 2023[73]). This is mainly due to data protection issues and to avoid cyber-attacks (European Commission, 2020[74]). A 2023 law aims to accelerate the rollout of smart meters by setting a roadmap for their deployment, reducing unnecessary regulations and facilitating the installation of smart meters’ secure communication units at the grid connection points. The law makes the smart meter installation mandatory for industrial users and consumers above a yearly consumption of kWh 6000 by 2032. As this is double the average household consumption, the threshold should be reduced. The law also caps the annual costs of the meters for private consumers at EUR 20 so the grid operators will have to bear a more significant share of the cost. This measure may reduce the incentives of the grid operators to accelerate the deployment of smart meters and should be evaluated carefully. Increasing investments in data protection and cyber security could help increase public acceptance of the smart meter roll-out.
Rising electricity demand and the coal and nuclear phase-out limit the amount of flexible capacity in the electricity market, creating a risk that producers will raise electricity prices by withholding capacity. In 2021, RWE – the largest electricity supplier in Germany, accounting for 25% of the market – was indispensable for meeting the electricity demand in a significantly higher number of hours, which means it has substantial market power (The Monopolies Commission, 2022[75]). Promoting competition in the market is crucial for keeping electricity affordable. The regulatory set-up in Germany's electricity sector is competition-friendly, but the share of consumers who switch suppliers is lower than in other EU countries (OECD, 2018[76]). Upgrading grid connections with neighbouring countries and improving transparency and data access for investigating anti-competitive behaviour could help to strengthen competition as well as energy security (see Chapter 2). Fostering competition in the cross-zonal intraday market by expanding trading times is also key. It could boost competition between electricity exchanges, which in turn will promote innovation and investment in the intraday market. Moreover, increasing competition in the management of emergency energy reserves would help maintain energy security at a lower cost. Replacing the system of strategic power plant reserves with a competitive capacity market, in which electricity suppliers and large customers competitively procure their expected future demand for power plant capacity, would strengthen competition and energy security, while reducing electricity price volatility. Centralised versions of such capacity markets have been introduced in Poland and Italy, and France has piloted a decentralised capacity market with stronger competitive elements.
Decarbonising freight infrastructure while improving connectivity of regions
Decarbonising the transport system poses multiple challenges for the regions. The transport sector plays a key role for Germany, as the country is a manufacturing centre with a strong reliance on intermediate inputs, and its geographical location makes it an important transit country between EU member states. Expanding the role of rail in freight traffic is a key policy lever, but investments in infrastructure are not sufficient to significantly improve the network capacity during the next years. Moreover, inefficient planning of train routes and imbalances in demand for utilisation lead to large regional differences. The lack of passing tracks for longer trains results in low train speeds. The digitalisation of the rail network is also lagging, with less than 2% of the national rail network compatible with the European Train Control System (SVR, 2024[77]). Due to the slow digitalisation of control and signalling systems, rising skilled labour shortages risk to significantly reduce the supply of passenger and freight rail services. Migration to the EU-wide Digital Automatic Coupling would require additional investment of around EUR 11 billion. Increasing public investment to modernise and expand the existing rail network and accelerate the digitalisation of the control and signalling systems, subject to cost-benefit analysis, is key to improve regional connectivity, enable positive economic spill-overs to lagging regions and reduce emissions in transport. It would also help reduce the high hours of travel lost in urban centres due to peak road traffic (European Commission, 2024[78]). The federal government aims to increase the competitiveness of rail transport by reducing track access charges for rail freight, creating a network for 740-metre freight trains to increase traffic speed, and strengthening the single wagonload services, where wagons from different consignors and destined for different consignees are combined to form a complete train. Strengthening the role of the rail infrastructure operator to allow for systematic advance planning of routes could help use the limited network capacity most efficiently.
Expanding the role of rail in freight traffic should be combined with accelerating the electrification of road transport to close the last mile from rail to customers. It would also help to accelerate decarbonisation in many rural regions that face low rail network density as the expansion of the network will require time. As the introduction of heavy-duty battery electric trucks has high upfront costs, especially for less innovative transport companies, raising investments for expanding the charging network infrastructure in coordination with the grid expansion is key to improve incentives (SVR, 2024[77]).
4.4.4. Fostering innovation in the regions
Germany’s economic model is based on one of the most advanced innovation systems in the world. Despite regional disparities, expenditure on R&D is higher than in most other OECD countries (Figure 4.14). A robust science, technology, and innovation ecosystem, and close collaboration between research and industry have helped to sustain an export-driven economy (OECD, 2022[79]). Key sectors such as automotive, machinery, chemicals and pharmaceuticals have both innovation-driven large manufacturers and numerous innovative SMEs in their supply chain. However, low levels of innovation-driven business creation, partly related to weak access to private finance by innovative start-ups as well as barriers to competition (see Chapter 1 and 2), difficulties in transferring knowledge from public research to the creation of new products and services, and slow digital adoption by firms pose challenges for fostering innovation in many regions.
Germany's innovation ecosystem is managed with a decentralised approach. More than 1 000 publicly funded research institutions (excluding higher education institutions) are engaged in both basic and applied research. This includes the many institutes of four major public research organisations – the Fraunhofer Society, the Helmholtz Association, the Leibniz Association, and the Max Planck Society – which are dispersed across the Laender. The Federal Ministry of Education and Research and the corresponding Laender ministries together set federal and regional education and research priorities, while the Federal Ministry for Economic Affairs and Climate Action and corresponding Laender ministries support industry applications of innovations. Extensive decentralisation and regional autonomy allow policies to be more closely aligned with local priorities, including specific industry needs. In addition, the Laender have a high degree of autonomy in education policy, including university governance, which allows for further tailoring to regional needs. Public research institutes and universities also enjoy considerable autonomy, allowing them to set their own research agendas independent of federal influence (OECD, 2022[79]).
Note: The range indicates the variation at the level of NUTS2 regions (Regierungsbezirk for Germany).
Source: OECD Main Science and Technology Indicators database; European Commission (2024[10]).
Regional heterogeneity in innovation outcomes is large due to the uneven distribution of large firms across regions and weak links between university, research institutes and smaller firms. Innovation activity is particularly concentrated in densely populated, urban regions (Figure 4.15). Bavaria and Baden-Württemberg in the south have the highest number of patent applications per inhabitant in Europe, while in Mecklenburg-Western Pomerania this number is twenty times lower (European Commission, 2024[10]). The strong innovation outcomes in the south are related to major innovation hubs including large leading companies in automotive and other manufacturing as well as services sectors. The share of large firms in business expenditure on R&D in Germany is the highest in the OECD after Japan (OECD, 2022[79]). After passing a critical threshold of accumulated knowledge, talent and resources, large firms rely more on their own R&D capabilities and are less dependent on cooperations with public research institutions. To raise innovation activity in smaller firms, it is key to improve the cooperation between smaller firms and universities. Defining collaboration with private sector innovation actors as a formal pillar of research institutions and launching training and information campaigns to local business associations can help enhance university engagement with industry.
Average patent applications per 50 000 inhabitants relative to functional urban area (FUA) population size, 2022
Note: Number of German and OECD FUAs in parentheses. Patent data refer to patent applications at internationalisation phase filled under the Patent Co-operation Treaty (PCT) at the World Intellectual Property Organisation (WIPO). Patent counts are based on the inventor’s region of residence. “OECD” refers to the unweighted average of the indicated FUA value.
Source: OECD (2024[80]).
The federal government should also review the regulatory framework to allow universities to engage more closely with venture capital funds or banks, to facilitate the commercialisation of knowledge transfer from research institutions to firms. Such practices take place in Belgium, Denmark and the United Kingdom. This would encourage and facilitate the development of university proof-of-concept funds to support academic spin-offs and start-ups. Expanding the use of regulatory sandboxes and creating a public-private laboratory would support experimentation, implementation and monitoring of innovation policy tools. In addition, the government should promote open platforms and networks for data-based innovation, for example as planned by the Research Data Act. To facilitate research cooperations with smaller firms it is key to reduce administrative burden of innovation support applications. According to a recent evaluation, the Central Innovation Programme for SMEs (ZIM) crowded in additional expenditure of 90 cents on R&D and research-related employment in recipient SMEs for every euro of public funding invested in new R&D expenditure (Stehnken et al., 2024[81]). The programme also encouraged collaboration between firms and research institutions, helping to close the innovation capacity gap in SMEs (BMWK, 2024[5]). However, applying for funding was found to be time-consuming, especially for first-time applicants, half of which sought to hire external consultants to assist application procedures. Recent reforms to simplify procedures of the programme are welcome. Better coordination of the ZIM programme with EU cohesion policy in support of innovation is key to foster complementarity between national and EU place-based innovation policies and to lower fiscal costs.
Improving evaluation of federal education and research funding could further strengthen the governance of innovation policy. Although the Laender have a high degree of autonomy in higher education and research, the German constitution allows the federal government to co-finance research support with the Laender for projects of national importance. Such co-financing is close to three times higher than for GFS programmes and is allocated primarily to pursue scientific excellence, while regional development policy objectives are only subsidiary (BMF, 2023[15]). The priorities for these co-financing funds are decided jointly between the Laender and the Federal Ministry of Education and Research, but an evaluation whether the funding has reached its objectives is often not conducted. The federal government can require the recipient state to submit reports and documents, but this is not mandatory. Moreover, the federal government also provides supplementary grants to the Laender to close part of the gap in research expenditure per inhabitant relative to the average Laender. However, these grants are not earmarked to research funding, making them an artificial extension of the fiscal equalisation system without any possibility of evaluating their impact. To improve spending efficiency and better coordinate funding for education and research with regional development policies, an impact evaluation of the supported programmes through these funding arrangements should become mandatory, while taking into account their different objectives.
A key policy lever to support innovation activity in firms are subsidies or tax credits for research and development (R&D) spending. According to the OECD R&D Tax Incentives Database, in 2023, direct government funding and government tax support for business expenditure on R&D amounted to about 0.2% of GDP in the average OECD country, with more than half of the support in tax relief. This was more than twice the amount provided by the refundable R&D tax credit (Forschungszulage) in Germany, which was first introduced in 2020. After the latest amendments in 2024, the refundable R&D tax credit subsidises 25% and 35%, respectively, of up to EUR 10 million of business expenditure on R&D per year for large firms and SMEs, respectively. The tax credit is deducted from income tax payments and is paid out in case the firms’ tax payments are smaller than the subsidy amount. Paying out the tax credit supports younger and more innovative firms, as these firms often do not generate profits yet and thus don’t pay income taxes. The new refundable R&D tax credit should be expanded if, after close monitoring, it proves effective in stimulating business innovation. It would be beneficial for the monitoring to also examine the impact of the size-dependent thresholds for eligible support on firms’ decisions to scale up.
Innovative procurement can also play an important role in supporting new ideas and start-ups and the green and digital transitions. A stakeholder consultation revealed that procurement procedures are too burdensome and costly for innovative young firms. A recent draft bill planned to facilitate reporting requirements for the participation of start-ups and innovative firms in public tenders and raise thresholds for direct contracting. Implementing these plans would be an important step forward but should be complemented by making the publication of tenders below EU thresholds on the recently launched federal e-procurement website mandatory for all levels of government. This would reduce information asymmetries and further lower barriers to bidder participation (see Chapter 2).
Continuing to facilitate skilled migration can also help foster innovation. Labour shortages are high in knowledge- and research-intensive as well as in IT and natural science-related industries, with large regional differences (BBSR Bonn, 2024[6]). According to the OECD Twin Transition Tracker database, the share of migrants with a tertiary education degree is low in many German regions. In Australia, a one percentage point increase in the regional employment share of highly educated migrants relative to total employment has increased regional patent applications by 4.8% over five years. The effects are also more pronounced for migrants in scientific occupations and in regions with lower initial patenting activity (OECD, 2024[82]). In the United States, an increased number of H1-B visa programme admissions for science and engineering occupations led to an increased patenting activity by inventors in recipient cities, with no displacement effect of residents (Kerr and Lincoln, 2010[83]). Reducing administrative burden related to visa and work permits, creating a one-stop shop for migration-related procedures in the Laender and fostering a welcome culture can help attract more skilled migrants to the regions (see Chapter 3).
4.4.5. Strengthening the adoption of digital technologies
Expanding access to high-performance network connectivity to all regions is a key policy lever to foster the adoption of digital technologies by firms. While business expenditure for R&D is above the OECD average, investment in knowledge-based capital (KBC) remains relatively low, hampering the adoption of digital technologies such as cloud computing and big data analysis (Figure 4.16, Figure 4.17). A key factor is the low average download speed, which varies significantly across regions, particularly between urban and rural areas (Figure 4.18). Although the high capacity network coverage has increased to 76% of households in June 2024, the fibre coverage to premises is still low at 36% (European Commission, 2024[84]). According to the OECD Broadband Statistics, only around 11% of all fixed broadband subscriptions were fibre-based compared to around 42% in the average OECD country at the end of 2023. The heavy reliance on the Digital Subscriber Line (DSL) technology network, which is mainly based on copper cables, is hampering fibre roll-out. Two-thirds of all household internet connections are either directly through the copper network of Deutsche Telekom or indirectly through other access providers (VATM, 2024[85]). Without careful planning, the transition from copper to fibre networks could create significant barriers to entry for new entrants, hampering competition and slowing the uptake of fibre. As discussed in the 2020 OECD Economic Survey of Germany, infrastructure sharing should be facilitated to foster competition and remove connectivity bottlenecks for fibre access. This should be accompanied by simplifying and accelerating planning and approval procedures and establishing national standards for low-cost roll out technologies. A national standard for reducing the required digging depth for earth cables has been established in 2023 and has the potential to significantly reduce uncertainty among local planning and approval agencies and the population regarding security, safety and health concerns.
Note: Other intangible assets cover assets not yet classified as investment in national accounts – Attributed designs (industrial), Financial product development design, Market research and branding, Operating models, platforms, supply chains, and distribution networks and Employer-provided training. “OECD” refers to an unweighted average.
Source: OECD calculations based on OECD National Accounts database and Global INTAN-Invest database, https://global-intaninvest.luiss.it.
Adequate funding is also needed to improve connectivity in remote areas, as market failures can lead to underinvestment in high-speed broadband capacity. In this respect, the allocation of about EUR 760 million in broadband support through the GFS programme to lagging regions, as defined by the regional development index of the joint task programme GRW, is a welcome step (BMWK, 2024[5]). In August 2024, the European Investment Bank approved a EUR 350 million co-financing for a EUR 970 million project to improve fibre optic broadband coverage in rural and suburban areas across Germany. Funding from the Recovery and Resilience Facility for investment in high-speed networks to support communication technologies and advanced cloud infrastructure should be accompanied by more domestic funding to close the infrastructure gap, while ensuring that private sector funding is not crowded out. Better connectivity would not only improve the adoption of digital technologies by firms but could also help to foster regional development by improving the conditions for telework and attracting high-skilled workers to more remote areas. In addition, to raise investment in software and data, ICT equipment as well as in management capacity, which is needed to benefit from the productivity gains offered by digital or AI-based solutions, the newly introduced refundable R&D tax credit could be expanded to include R&D-related capital expenditure. Currently, it does not apply to the purchase of software, licences and IP rights used for R&D.
Enterprises using specific digital technologies, % of enterprises, 2023 or latest available year
Note: Data correspond to the share of businesses with ten or more employees with broadband connection (fixed or mobile); with a website or home page; using social media; using Enterprise Resource Planning (ERP) software; using Customer Relationships Management (CRM) software; purchasing cloud computing services; receiving orders over computer networks; sharing electronically information with suppliers and customers (SCM); using Radio Frequency Identification (RFID) technology, and having performed big data analysis.
Source: OECD ICT Access and Usage by Businesses Database.
Average download speed for fixed network in the regions, Mbps, 2023Q1
Note: The range indicates the variation at the level of NUTS2 regions (Regierungsbezirk for Germany).
Source: European Commission (2024[10]).
The shortage of workers with advanced digital skills is another factor hampering the adoption of digital technologies in firms. Regional differences in demand for workers with advanced digital skills are high and faster ageing in the eastern Laender is exacerbating regional gaps (Figure 4.5). Expanding adult learning opportunities for workers and improving training quality, including by introducing standardised quality certification for training courses, and facilitating skilled migration is key to address skilled labour shortages (see Chapter 3). At the request of the state authorities in Bavaria and North-Rhine Westphalia, an EU Technical Support Instrument has been used to develop approaches to outreach, marketing, and stakeholder engagement to improve digital skills. In Bavaria, the programme has led to a large-scale digital upskilling campaign, launched in April 2023 in cooperation with large technology firms. In North Rhine-Westphalia, the programme focused on fostering digital skills among civil servants to improve the delivery of digital public services. However, knowledge transfer from higher education institutions to the private sector remains limited to traditional industry needs and is slow to adapt to the pressing need for digital skills (OECD, 2022[79]). State authorities in North Rhine-Westphalia have identified the need to further improve the targeting and curriculum development of digital training programmes. These efforts should be complemented by using the newly introduced digital education platform to establish a skills inventory to assess the competencies of the workforce and identify gaps to inform the design of targeted training and adult learning policies.
Data protection and security concerns contribute to the weak adoption of digital technologies by firms (see the 2020 OECD Economic Survey of Germany). The use of cloud computing, including for software and database hosting, is particularly affected by security concerns (Figure 4.17). Such concerns are high in Germany both compared with other countries, and compared with other obstacles to cloud computing such as interoperability or skills. Many German firms are implementing practical and technical digital security measures but lack a strategic approach to digital security, based on risk management. Implementing digital security risk management in firms requires elevating digital security from being merely a technical issue to the top of business decision making. A revision of the Cybersecurity Strategy for Germany should lead to a stronger focus on firms in general and on digital security risk management in particular while strengthening cooperation of the involved ministries. Moreover, the heterogeneous interpretation of data protection regulation across the Laender leads to a fragmentation of markets and hampers digital adoption, innovation and market entry (see Chapter 2). The draft bill for the Research Data Act aims to facilitate the access, linkage and processing of sensitive data by both private and public institutions for research purposes, in line with the EU Data Protection Regulation, and should be implemented. When data projects involve collaborators from different Laender, the approval granted by the data protection officer in one Land should be accepted by the other Laender to reduce administrative burden for firms.
Accelerating the digitalisation of the public sector and upskilling civil servants could significantly raise spending efficiency and reduce the administrative burden, while also helping to develop innovative AI solutions. A solid computational capacity and a pool of highly qualified researchers has enabled robust contributions from German researchers in all AI sub-disciplines and supported the German AI ecosystem (OECD, 2024[86]). A national AI strategy was issued in 2018, one of the first examples in the OECD. The strategy’s human-centred regulatory approach has kept social acceptance among workers at a relatively high level. It also includes clear plans and legal provisions for regulatory sandboxes. However, limited administrative expertise, including at the Laender and municipality level hinders its implementation. Improving coordination, clarifying responsibilities, training civil servants, and updating the roadmap for public sector initiatives could speed up the transition to greater use of AI-based solutions. Thereby, accelerating the digitalisation of the public sector is key to improve data quality and availability to train AI applications for public service delivery (see Chapter 2). Better coordination between federal and state education ministries is also needed to include more AI programmes, especially in English, in universities to expand the AI talent pool and workforce.
Although incomes have converged across the Laender, income disparities between districts remain high, in particular between urban centres and their commuting zones (Figure 4.19, Panel A). The concentration of economic activity in larger metropolitan areas and heterogeneity in labour productivity but also features of the tax and transfer system lead to high income inequality across districts (Figure 4.20, Panel A, Figure 4.3). For example, while labour income taxation is high and strongly progressive, capital income and property are taxed less than in the average OECD country (see Chapter 1). The strong rise in house prices in larger urban areas have also added to rising inequality across districts, especially considering the relatively low home ownership rates according to the OECD Affordable Housing Database (Figure 4.19, Panel B). Structural adjustments related to the decline in carbon-intensive industries, increasing trade exposure and automation as well as the German reunification have also affected employment biographies and incomes of workers in specific regions more than others. Moreover, wealth inequality is high due to low savings of East Germans during the socialist period, the nature of the privatisation process after the reunification and an effectively regressive inheritance tax (Box 4.2, see the previous OECD Economic Survey of Germany). Only about 2% of inheritance tax revenues is collected in eastern Laender (Jirmann, 2022[87]).
Note: Number of functional urban areas (FUAs) in parentheses. A functional urban area (FUA) includes the urban centre as well as the commuting zone around that centre. Panel A uses only FUAs with more than 5 small areas units and with a size larger than 250 000 inhabitants. Grey dots in Panel A show, for each FUA in each country, the difference in mean household disposable income between its urban centre and the respective commuting zone. Housing prices in Panel B refer to the average price per square metre of residential dwellings by FUA, except for the United Kingdom and the United States, where prices consider other observable characteristics of the dwellings.
Source: OECD (2024[80]).
Income inequality is strongly correlated with other socio-economic inequalities as well as trust in institutions (Rodríguez-Pose, Dijkstra and Poelman, 2024[88]). A regional indicator constructed for this Survey, which measures discontent with economic and labour market prospects, the access to and quality of public services such as education, health, public transport and social services, quality of digital and transport infrastructure and environmental outcomes, is strongly correlated with the prevalence of low labour income and wealth (Figure 4.20). As the green and digital transitions will have heterogenous effects across regions, income disparities risk to further increase (Figure 4.21). Regions with a high share of carbon-intensive industries will be more affected by emission abatement policies, while rising automation will have larger effects on regions with a higher share of occupations with tasks that are automatable. Workers will have to relocate to new jobs in expanding sectors and firms and adapt their skills to changing task content of jobs. Adjustment costs will be high due to large re-training and up-skilling needs, social costs of moving to other regions or longer periods of unemployment for displaced workers. As discussed in the previous OECD Economic Survey of Germany, workers displaced in carbon-intensive sectors face higher displacement costs than other displaced workers due to fewer outside options in their local labour markets, human capital specificity and higher wage premiums in their former jobs. Thus, policies should support incomes of affected workers and help them acquire new skills by improving and expanding training and adult learning opportunities (see Chapter 3). The transition also could reduce income inequalities as lower-income regions with greater potential for the expansion of renewables could benefit from the green transition, especially if additional incentives are created for energy-intensive industries to relocate in those regions (Figure 4.4).
Note: Regional units shown in the graph are at the level of TL3 districts (Kreise for Germany). Panel B shows the unweighted average of quantified responses collected in a range from 1 to 3 (low to high discontent) to questions on prospects that reflect perceptions of the current regional economic situation and regional growth and employment prospects, firm creation and social cohesion, access to public transport, high-speed internet, schools, childcare facilities, and local retail outlets, the state of environment in the region, air quality and the quality of regional recreational areas, access to health care services and safety, regional life satisfaction from a comparative perspective, overall life satisfaction, and confidence in the region’s prospects.
One option to compensate workers for the negative consequences of the green transition is to rebate part of the carbon price revenues to households. As discussed in the previous OECD Economic Survey of Germany, rising carbon prices would disproportionally affect poorer households as they consume a larger share of their income for carbon-intensive heating fuels and electricity, and because their wage income declines. However, if carbon pricing revenues are recycled as an equal lump-sum transfer to each household, rising carbon prices would become progressive and the poorest households could even face an improved purchasing power. Currently, carbon pricing revenues are transferred to the Climate and Transformation Fund (KTF), which is a special fund to support the green transformation. About a third of the KTF’s spending was used to subsidise energy efficiency improvements in buildings in 2024 and a large part of the remaining funds is used to provide subsidies to supporting the decarbonisation of energy-intensive industries. However, transfers to compensate vulnerable households for higher carbon prices still do not exist. The previous federal government has introduced the legal basis and technical infrastructure for lump-sum transfers to households’ bank accounts in 2025. Using this technical infrastructure to establish transfers to households through the KTF and allocating a larger share of KTF spending to financing of incentives for energy efficiency improvements in low-income housing would help compensate vulnerable households for the negative consequences of the green transition.
Note: The ranges shown in Panel B indicate the regional variation at the level of the Laender. A job is considered at high risk of automation if more than 25% of a job's tasks are highly automatable through recent advances in robotics and AI. The extent to which a job's tasks can be automated is estimated based on an expert survey, indicating the degree to which each skill can be automated, and using job-level task information. The share of jobs at high risk of automation is then computed for regions using regional employment data.
Source: 2023 OECD Economic Survey of Germany; OECD Twin Transition Tracker database.
As budget resources are scarce, the transfer to households could even be targeted at poorer and more affected households or regions more negatively affected by the green transition. For example, a previous eco-social tax reform in Austria combined carbon pricing in non-ETS sectors with the introduction of a tax-exempt lump-sum climate bonus, which is differentiated according to place of residence and access to public transport. Results from an OECD survey show that the public acceptance of carbon pricing is higher if revenues are used for transfers to more vulnerable households instead of an equal transfer to all households (Dechezleprêtre et al., 2022[89]). Ensuring that transfers to households are income-dependent to make the redistribution of carbon pricing revenues in Germany more progressive requires linking administrative datasets across the Laender and harmonising the definition of income (see Chapter 2). Solving this issue should be a key policy priority, as the lack of compensation for rising carbon prices is likely hampering public acceptance of the green transition (see the previous OECD Economic Survey of Germany).
Improving active labour market policies is a key policy lever to reduce adjustment costs for workers in the regions. Only a small proportion of working-age adults participate in training (Figure 4.22). Older workers in particular are less likely to participate in training (see Chapter 3). This risks exacerbating regional disparities, as regions with faster demographic decline due to ageing, such as the eastern Laender, are left further behind (Figure 4.5). Training rates for workers at high risk of job loss due to decarbonisation of industries are also lower than for other workers, raising adjustment costs during the transition (OECD, 2023[90]). Although some room to increase spending on training measures exists, it is particularly the quality of training that needs to improve. The lack of harmonised quality standards and certification for non-formal training courses leads to large information asymmetries, low quality of many courses and weak targeting of training to skill needs in local labour markets (Gontek and Sutera, 2024[91]). Introducing harmonised quality standards and certification for training and adult learning courses should be a priority to improve the quality of training (see Chapter 3). The recent reform of the basic income support has abolished the prioritisation of job-uptake over training and facilitated the completion of three-year vocational education and training (VET) programmes while receiving basic income support. This is a significant step forward as formal VET courses are subject to stringent quality standards and certification, and many workers will need to change jobs during to the green and digital transition. Moreover, the VET system is based on a close cooperation between firms, unions and VET institutes at the regional level which facilitates the adjustment of training content and capacity to skill needs in local labour markets. Facilitating such a coordination also in non-formal training, including through the establishment of harmonised quality standards and certifications, and further fostering the cooperation between local employers and the public employment services agency is key to increase the effectiveness of training measures for the unemployed.
Note: The adult learning ratio is the share of population aged 25-64 that participated in job-related training in the past month (EU), 3 months (the UK), or 12 months (Australia, Canada, and the United States). Different time horizons are due to geographical differences in survey questions.
Source: OECD Twin Transition Tracker database.
Targeted hiring subsidies should complement improved training and education opportunities to strengthen the employability of individuals, who are at risk of long-term unemployment due to the green and digital transitions. The Participation Opportunities Act, which has been in force since 2019, provides targeted wage subsidies as well as coaching and training and helps long-term unemployed persons to find a stable job, but these services are exclusively available for individuals who have been unemployed for at least two years. This programme could be expanded to vulnerable groups already in early stages of their unemployment spell to improve their re-employment chances. Profiling tools based on statistical models to predict jobseekers’ likelihood of becoming long-term unemployed should be used to better identify such vulnerable individuals. This would also prevent the exclusive targeting of individuals with very high chances of re-employment to maximise the performance outcomes of public employment agencies. Well-known examples are the Work Profiler in the Netherlands, the Job Seeker Classification Instrument in Australia and the Worker Profiling and Reemployment Services (WPRS) initiative in the United States (Desiere, Langenbucher and Struyven, 2019[92]).
Repurposing existing assets through infrastructure investments while retraining the labour force is a key policy lever to preserve agglomeration economies in transforming regions. This helps mitigating strong outmigration of workers from struggling regions and avoid negative feedback effects. A recent programme supports regions affected by the phase-out of coal power plants and lignite production with EUR 41 billion until 2038, including for infrastructure investments, innovation and training support, and investment subsidies. Subsidies are available for investments in the production of renewable energy equipment such as solar panels, battery cells, wind turbines, heat pumps, and electrolysers as well as for expenditure on innovation-related knowledge transfer and networking activities, start-up financing, and the recruitment of skilled workers. For the estimated 20 000 lignite and coal workers directly affected, this means an annual average cost of EUR 100 000 per job over the programme period (Suedekum, 2023[17]). The EUR 5 billion allocated to early-retirement schemes for older workers, in addition to the EUR 41 billion of subsidies for coal phase-out regions, could be better targeted, as welfare losses are particularly high for mid-age workers and early-retirement generates additional costs due to higher pension spending (Haywood, Janser and Koch, 2024[93]). Using the funds to finance wage subsidies instead would increase total welfare and reduce fiscal costs by facilitating re-employment of affected workers in other industries.
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