The economy will slowly recover due to easing supply-chain bottlenecks, a large order backlog and a pickup in export demand. Despite rising interest rates, investment will recover due to high corporate savings and investment needs related to the relocation of supply chains and renewable energy expansion, as well as rising public investment. High inflation will persist due to a lagged pass-through of producer to consumer prices and rising wage pressures, but will gradually moderate during 2023 on the back of monetary and fiscal tightening and falling energy prices. Real wages will grow in 2024, supporting a recovery of private consumption.

Accelerating the green transition will help to strengthen energy security but requires more investment, innovation and business dynamism, which will also support productivity and potential growth. Since the 2000s, Germany has experienced a large outflow of private capital due to weak domestic demand and business dynamism. Reviving investment and innovation and accelerating the green transition require better public governance to lower the administrative burden, particularly for infrastructure planning, and more effective support for research and development (R&D). It also calls for a stronger competition framework and better access to finance to reduce barriers for young and innovative firms.

Rapid population ageing will exacerbate labour shortages, lowering potential growth and raising fiscal pressures (Figure 1). It will also weigh on many manufacturing sectors, which already suffer from high energy prices. Comprehensive structural reforms are needed to maintain fiscal space, raise productivity and sustain living standards despite a declining workforce. Better incentives to work longer should be combined with improved adult education, training programmes and working conditions for the elderly. Raising labour supply of women and low-skilled adults, facilitating skilled migration and improving educational quality for disadvantaged children are key.

A large infrastructure backlog and investment needs for the green and digital transition require raising spending efficiency, better prioritising spending and reducing tax expenditures. Digitalising the public sector is key to reduce the administrative burden, raise the quality of public spending through better policy targeting and evaluation, and improve tax enforcement (Figure 2).

The fiscal framework needs to be updated. Several special funds are used to address the investment backlog, but expenditures under these funds are not included in the core budget, weakening transparency and the credibility of the fiscal framework. Gradually re-including them into the core budget should be combined with more flexibility in the fiscal rules to allow for adequate investment spending, while better incorporating spending reviews in budgeting procedures at all levels of government.

Labour taxes are among the highest across OECD countries, hampering labour supply, particularly of second earners and low-skilled workers. Around 48% of women work part-time, and many are overqualified for their jobs. Shifting the tax burden from labour towards capital income, property, inheritance and consumption taxes and reforming the current joint income taxation rules for couples would help to raise labour supply.

Effective inheritance and gift tax rates are low, particularly for wealthy households, while wealth inequality is high. Reducing tax-allowance thresholds and business asset exemptions, while further extending instalments for tax payments, would raise revenue and reduce inequality.

Cutting tax exemptions for real estate and VAT and raising property taxes would reduce distortions, increase fairness and raise revenue. Tax expenditures for income from selling or renting real estate are regressive and lead to a misallocation of capital, contributing to rising housing prices. Many municipalities suffer from volatile revenues, but municipal property tax revenues are low in international comparison, despite soaring real estate prices.

Strengthening tax enforcement is key for levelling the playing field and raising revenue. Large firms and wealthier households make greater use of tax avoidance or evasion strategies to lower their effective tax rates, which puts smaller firms and other taxpayers at a disadvantage. Improving tax enforcement requires stronger incentives for the Laender to scale up their enforcement capacities, better IT infrastructure and cooperation across the Laender, which would allow for more specialisation and targeting of enforcement efforts.

Some progress has been made in the fight against money laundering and corruption. Data quality on asset ownership and cooperation across agencies and levels of government is still weak. Establishing a new federal agency to combat financial crime, with sufficient investigative powers, skilled staff and data access would improve capacities to fight complex financial crimes and money laundering. Providing sufficient staff and IT resources to implement and enforce the new lobby register and include a legislative and a regulatory footprint would help to make lobbying activities more transparent.

The digitalisation of the public administration holds large potential to raise spending efficiency, growth and welfare. The high administrative burden particularly hurts young and innovative firms and weakens business dynamism and innovation. The federal government made online access to public services mandatory from 2023 but failed to introduce mandatory common standards on design and interlinkage of data and IT tools for all levels of government. Establishing a centralised and transparent e-procurement platform and encouraging joint procurement initiatives across municipalities would strongly improve spending efficiency. Digitalising the public sector also requires updating the skills of public employees, which calls for better recruitment procedures, incentive structures and training opportunities.

Germany released 39% less GHG emissions in 2021 than in 1990 and set an ambitious target of reaching climate neutrality in 2045, which requires tripling the speed of emission reductions. High energy prices and the need to replace Russian energy imports have amplified the determination to act.

Emission pricing can effectively help to reduce emissions, but effective price levels are too low and unpredictable and differ substantially across sectors due to many tax expenditures and subsidies. Price signals should be strengthened by aligning the emission cap in the national trading system with national targets, phasing out fossil fuel subsidies and tax expenditures, and expanding the use of measures that reduce regulatory risks to green investments.

Stronger emission reductions risk hurting energy-intensive industries that are exposed to international trade. Output-based and renewable energy subsidies can support these industries, but they are costly and lead to higher emissions in other countries. The risk to these industries would be better managed by streamlining the planning and approval procedures for renewable energy projects, subsidising green R&D and pushing for international agreements that enforce faster global emission reduction.

The transition to net zero will require reallocation of labour across sectors and firms and risks increasing inequalities. Workers displaced in high-carbon-intensity sectors tend to suffer more lasting and significant decreases in earnings than other workers, because they tend to be older, work in more specific occupations and are geographically concentrated (Figure 3). Expanding the scope of active labour market programmes – focusing on vocational education and training, and mobility subsidies – could reduce adjustment costs for affected employees. Improving adult education opportunities and the offer of partial qualifications combined with recognition of informal prior learning can facilitate the uptake of vocational education, particularly for low-skilled adults. Using revenue from carbon pricing to support households can minimise adverse distributional effects more generally.

Gradually phasing out non-targeted subsidies as well as subsidies for mature technologies would improve the cost-effectiveness of mitigation efforts. In the housing sector, untargeted subsidies should be replaced by minimum efficiency standards and energy performance certification for existing buildings, while providing loan support for credit-constrained households. In transport, the focus should shift from subsidising electric cars towards expanding the deployment of charging points, while enhancing competition in the charging points market. Further increasing public investment in rail while accelerating the digitalisation of the control and signalling systems and improving competition would help the shift to a sustainable transport system.