Better times ahead? Assessing Germany’s new macro reforms

The German government has been quite an active and bold one since it took office some 15 months ago. Formed as a coalition between the Christian Democratic Union/Christian Social Union (CDU/CSU) and the Social Democratic Party (SPD), they kicked it off before the whistle with a polemic relaxation of the debt brake that allowed them to materially increase defence spending, carried out through a vote in the "old" parliament, only days before the new one took office. There have been continuous disagreements between the partners on a few aspects, including taxes, pensions and others, while there has been unity regarding sidelining the right-wing Alternative for Germany (AfD) party as much as possible. All of this comes in the context of increasing pressure on the government as the German economy is stagnating.

Last week, they delivered one of the most ambitious reform packages in recent times. In stark contrast to the fiscal measures taken in other G7 countries, we think this is a good set of measures that at least aims to tackle some structural issues as opposed to blindly raising taxes to fund unsustainable low-value-added spending. As such, it is not necessarily a package that will yield results tomorrow through higher consumption; instead, its impact is likely to be felt over time as confidence that the economic picture is beginning to look rosier. It is important to note that Germany is in a rare position, having ample fiscal space to increase deficits, as years of austerity have resulted in debt to GDP ratios and budget deficits that are substantially better than those of other G7 peers.

The most important structural measures involve a more flexible labour market, cutting red tape and pension reforms. Germany has high sickness-related absence rates from work, compared to other developed countries. Some changes in this respect include ending the ability to obtain certain sick notes by telephone and requiring workers to see a doctor in person from the first day of illness. Other measures with respect to the labour market include the option to extend fixed term contracts up to six times (from three), better tax treatment for severance payments if a new job is found relatively quickly and an easing of rules to dismiss top earners (those with annual salaries greater than €177,000).

Regarding red tape, there will be less onerous reporting required from companies and an "approval by default" mechanism for projects. This means that qualifying projects will only have a four-month period where authorities can effectively stop them. After that period, if they do not act, the project will be deemed approved.

Pensions are an area where reforms are quite ambitious. The government announced that it will seek to implement the recommendations of the Pension Commission, which include contributions from both employers and employees to a state pension fund, the so-called "funded pillar" inspired by the Swedish model. There will also be a small increase in retirement age linked to life expectancy from 2031, terminating the possibility of early retirement for certain long-term workers, and an obligation imposed on self-employed people to contribute to the pension pot.

On taxes, a moderate tax relief for households on average will be introduced (increasing the tax-free allowance while lowering the threshold for the 45% bracket to kick in and introducing a 47% top tax rate for highest earners). 

We view these reforms as a positive step forward for the German economy. While we would have preferred there to be no increases in income taxes, the rest of the package should bring about higher growth in time. It is not just these specific reforms that have inspired our confidence in the direction of the German fiscal policy, but rather the overall trajectory since the current government came to office. Furthermore, the measures seek to address several structural issues that limit growth potential, such as rigid labour markets and excessive red tape. The expectation is that these proposals will become law in the second half of the year, signalling better times ahead for the German economy.