Jürgen Matern via Wikimedia Commons
German Reforms: Progress Ahead
Holger Schmieding
Berenberg Bank
Dr Holger Schmieding is Chief Economist at Berenberg in London. Before joining Berenberg in October 2010, Holger worked as Chief Economist Europe at Merrill Lynch, Bank of America and Bank of America-Merrill Lynch in London. Having studied economics in Munich, London and Kiel, he holds a doctorate from the University of Kiel. Prior to this, he also worked as a journalist at Westfälische Nachrichten in Germany, as head of a research group on east-central Europe at the Kiel Institute of World Economics and as a desk economist at the International Monetary Fund in Washington, DC.
From stagnation to mini-boom
No other major economy has fared as badly as Germany in the last few years. In 2025, real GDP surpassed its pre-pandemic level of 2019 by just 0.9 percent versus a gain of 8.9 percent for the remainder of the eurozone and a debt-fueled 15.1 percent surge for the United States. As the traditional global powerhouse of high-end manufacturing, Germany has been hit hard by major external shocks ranging from China’s subsidized gains in market share across key industries to Donald Trump’s trade wars and the fallout from Russia’s war against Ukraine. However, the major impediments to German growth are homemade. They include excessive red tape, an expensive energy policy, a tax-and-benefit system that stifles incentives to work and invest, and the rising burden of payroll taxes. The private sector has responded with “Standortflucht,” a penchant to invest abroad rather than at home. Private investment (excluding residential construction) has fallen by 11 percent since 2019. The rise in public investment (+27 percent over the 2019 average) has not sufficed to offset that.
Fortunately, the government of Chancellor Friedrich Merz is finally addressing these structural problems in earnest. If parliament passes the planned reforms without diluting them too much in the second half of 2026, the long-term outlook for the German economy could improve materially. If private spending responds to the reforms over the course of 2027, as we expect, Germany could even enjoy a mini-boom in 2028, just ahead of the next federal election in early 2029.
The lesson of the past
As one of his top priorities, Merz wants to rein in the dangerous rise in payroll taxes. These levies fund most of Germany’s social system, ranging from pensions, health care, and elderly care to unemployment benefits. The surcharge on labor costs is paid roughly half and half by workers and employers. Higher payroll taxes thus curtail the gains in the purchasing power of consumers and add to labour costs for employers. When these levies surged from 36.4 percent of gross wages in 1991 to 42 percent in 1995 to foot part of the bill for German unification, companies shifted jobs abroad in droves. By the late 1990s, Germany had turned into the sick man of Europe with more unemployment and higher fiscal deficits than most other member countries of the EU.
It took a series of major reforms including the “Agenda 2010” of 2003/2004 spearheaded by then-Chancellor Gerhard Schröder and extra revenues from a 3-point VAT hike in 2007 to reverse the trend. Following a decline in payroll taxes back to 39.5 percent by 2009, German investment rebounded strongly. This paved the way for Germany’s “golden decade” with ten years of solid growth after the Lehman crisis and a spectacular 28 percent rise in employment until late 2019. Additional tax receipts translated into modest fiscal surpluses at the time.
However, the good times did not last beyond 2019 when a series of external shocks started to batter a country whose voters and policymakers had become far too complacent in the meantime. In an echo of the misery of the late 1990s and early 2000s, the renewed rise in payroll taxes from 39.6 percent in 2020 to 42.3 percent in 2026 is now one major reason for the dearth of domestic investment and the ongoing loss of jobs in manufacturing.
Progress ahead
After Merz narrowly won the federal election in February 2025, a loosening of Germany’s fiscal straitjacket, the so-called “debt brake,” helped the economy to turn the corner. Thanks partly to extra public spending on infrastructure and defense, growth edged up to 1.0 percent year-over-year in Q2 2026. While that remains well below the 1.3 percent gain in the remainder of the eurozone and the 2.1 percent rise in the United States, it exceeds the cumulative 0.9 percent increase in German GDP in the six years before Merz took power.
However, the Merz record on pro-growth structural reforms has been quite patchy so far. To his credit, he has started to cut red tape more energetically than his predecessors. In mid-2025, his coalition also legislated a stepwise reduction of corporate taxes from c30 percent to c25 percent starting in 2028 to replace a temporarily enhanced depreciation allowance. In addition, Berlin took first steps to make German energy policy (better grid, more storage facilities to cope with the intermittent nature of wind and solar power) and immigration policy (fewer fake asylum seekers, more qualified immigrants) more rational. But until mid-2026, Merz did not tackle the key issue of rising payroll taxes. Instead, his coalition made matters worse last autumn by increasing some pension entitlements that are largely financed by payroll taxes.
Reform proposals
This is now changing. In late June, the government outlined a sweeping reform to rein in the mounting deficits in Germany’s pay-as-you-go pension system. Key elements include an end to early-retirement schemes, a slower pace of pension increases from 2032 onward, a gradual increase of the retirement age beyond 67 years after 2031, and a new Swedish-style statutory funded pension to complement the current pay-as-you-go system. Such a reform would not offer a quick fix. But it would go a long way to make Germany’s pension system much more sustainable. Over time, the additional pool of capital could also fund more investment via capital markets. In early July, the heads of Merz’s coalition also agreed on other changes, including measures to save costs in the health care system. All in all, the reform package can help to revive private sector investment and raise Germany’s rate of potential growth from currently c0.4 percent to 0.8 percent and thus closer to the Eurozone average of 1.2 percent.
Of course, the political debate over the next few months will be contentious, not least within the Merz coalition of his center-right Christian Democratic Union/Christian Social Union (CDU/CSU) with the center-left Social Democrats (SPD). But the coalition leaders seem to understand that they do not have an alternative. Letting the problems fester would only make the right-wing Alternative for Germany (AfD) stronger, which is already riding high in opinion polls with an average of 28 percent support versus 21 percent for the CDU/CSU and 12 percent for the SPD in August. Bringing the government down over a failure to agree on such reforms would benefit the AfD even more. Most likely, the Merz coalition will implement some serious, if partly unpopular reforms, over the next few months and soldier on until the next regular federal election in early 2029. If so, an economic mini-boom in 2028 could help to contain the appeal of the AfD to voters who are currently disaffected.
