Executive summary 1

1. Scene setter: economic situation and outlook 3

2. Imbalances, risks and adjustment 11

2.1. Current account 13

2.2. Private consumption 21

2.3. Investment 29

2.4. Euro area spillovers 49

3. Other structural issues 55

3.1. Taxation, long-term sustainability and fiscal framework 57

3.2. Financial sector 61

3.3. Labour market, education and social policies 63

3.4. Energy, transport, services and public procurement 67

3.5. Policies for long-term growth 71

A. Overview table 73

B. Standard tables 80

LIST OF BOXES

1.1. Economic surveillance process 8

2.1.1. The importance of the income balance to the current account surplus 18

2.2.1. Labour productivity and labour costs developments in Germany 27

2.3.1. A closer look at energy investment 35

2.3.2. Main features of the 2001 and 2008 tax reforms in Germany 42

2.3.3. Price developments and financing conditions in the German housing market 46

LIST OF Tables

1.1. Key economic, financial and social indicators - Germany 9

1.2. Macroeconomic Imbalance Procedure indicators 10

2.1.1. Change in current account and contribution of savings and investment by sector (pps of GDP) 14

2.3.1. Germany's budgetary projections compared to European and national deficit ceilings (% of GDP) 31

2.3.2. Pension fund and insurance sector assets (2012) 32

LIST OF Graphs

1.1. GDP in constant prices (index, 2010 = 100) 3

1.2. Contribution to GDP growth by final demand components (%, pps) 3

1.3. Private consumption in constant prices (index, 2010 = 100) 4

1.4. Gross fixed capital formation and components compared to (autumn and winter) forecasts (annual growth, 2013-15) 4

1.5. Investment gap in relation to the euro area without Germany, Ireland and Spain - contribution by type of goods (% of GDP) 5

1.6. Investment gap in relation to the euro area without Germany, Ireland and Spain - contribution by sector (% of GDP) 5

1.7. Unemployment gap (%) 5

1.8. Contributions to headline inflation (%,y-o-y) 6

1.9. Current account balance by geographical counterpart (% of GDP) 6

1.10. Credit flows by institutional sector (consolidated, % of GDP) 7

1.11. Potential output growth and contributions by production factors (% pps. per year) 7

1.12. Population projections (in million persons) 8

2.1.1. Current account balance, national savings and investment (% of GDP) 13

2.1.2. Sectoral excess savings and current account balance (% of GDP) 13

2.1.3. Households and non-profit institutions serving households (% of GDP) 14

2.1.4. General government (% of GDP) 14

2.1.5. Breakdown of current account balance in relation to all countries (% of GDP) 15

2.1.6. Breakdown of current account balance in relation to the euro area (% of GDP) 15

2.1.7. Current account balance in relation to EU-27, euro area, emerging markets and developing countries (% of GDP) 16

2.1.8. Breakdown of current account balance in relation to China (% of GDP) 16

2.1.9. Exports and imports (annual growth rate, %, y-o-y) 16

2.1.10. Imports by broad economic categories (annual growth rate, %, y-o-y) 16

2.1.11. Changes in trade in goods with vulnerable countries from 2004-2007 to 2011-2014 (EUR billions) 17

2.2.1. Revenue from taxes on income and wealth paid by households and NPISH* and social security contributions (% of GDP) 21

2.2.2. Implicit tax rate on labour (%) 21

2.2.3. Tax wedge at 50% of average earnings in 2001 and 2013 (% of total labour costs) 22

2.2.4. Tax wedge at 67% of average earnings in 2001 and 2013 (% of total labour costs) 23

2.2.5. Implicit rate on consumption (%) 23

2.2.6. Revenue from value added tax and other indirect taxes (% of GDP) 23

2.2.7. HICP* in Germany (annual average index, 2000 = 100) 24

2.2.8. HICP* for electricity (annual average index, 2000 = 100) 24

2.2.9. Kaitz index for gross wages and for labour costs for full-time earners (2013) 25

2.3.1. Gross fixed capital formation by layer of government (% of GDP) 29

2.3.2. Net fixed capital formation by layer of government (% of GDP) 29

2.3.3. Investment by the energy sector 34

2.3.4. Manufacturing as a proportion of total exports (%, 2010-13 average) 38

2.3.5. Manufacturing as a proportion of nominal machinery and equipment investment (%, 2010-13 average) 38

2.3.6. Share of total nominal goods exports and in total nominal machinery and equipment investment (%, 2008-12 average) by manufacturing sub-sector 39

2.3.7. Share of total nominal goods exports and in total nominal machinery and equipment investment (%, 2008-12 average) by manufacturing sub-sector excl. motor vehicles sub-sector 39

2.3.8. Non-financial corporates' acquisition of shares and other equity (% of GDP) 40

2.3.9. Proportion of shares and securities in firms' total assets (in %) 40

2.3.10. Proportion of stakes and securities in firms' total assets (in %) – large firms vs. SMEs 41

2.3.11. Proportion of stakes and securities in firms' total assets (in %) – Incorporated vs. unincorporated 41

2.3.12. Marginal cost of additional domestic investment in different types of assets (in %, corporate level) 43

2.3.13. Marginal tax advantage of debt – individual level (in %) 44

2.4.1. Exports to Germany in value added as a percentage of exporters' GDP (in %, 2011; top 15 EU countries) 49

2.4.2. German exports in value added as a percentage of German GDP (in %, 2011) 50

2.4.3. Gross foreign assets of Germany as a percentage of counterpart GDP (in %, top 15 EU countries, excluding Luxembourg) 51

2.4.4. Gross foreign assets as a percentage of German GDP (in %) 51

2.4.5. Foreign claims of German banks as a percentage of German GDP (in %, by sector) 51

2.4.6. Gross foreign liabilities as a percentage of German GDP (in %) 52

2.4.7. Positive shock to German government investment 54

Economic activity in Germany has been uneven but is expected to gradually strengthen. Domestic demand has eventually taken over as a main driver of growth and household consumption has developed well, but business investment has disappointed and remains subdued. Going forward, economic activity is expected to gradually strengthen. The positive outlook for employment, low interest rates and real wage growth should support private consumption. Business investment should recover, but the housing investment is set to slow to a more moderate pace. Import growth should strengthen, while exports should benefit from increasing demand in Germany’s trading partners. Falling oil prices will exert further downward pressure on consumer prices, but rising labour costs should uphold core inflation.

This Country Report assesses Germany’s economy against the background of the Commission’s Annual Growth Survey, which recommends three main pillars for the EU’s economic and social policy in 2015: investment, structural reforms and fiscal responsibility. In line with the Investment Plan for Europe, it also explores ways to maximise the impact of public resources and unlock private investment. Finally, it assesses Germany in the light of the findings of the 2015 Alert Mechanism Report, in which the Commission found it useful to further examine the persistence of imbalances or their unwinding.

The main findings of the in-depth review contained in this Country Report are:

· The current account consistently shows a very high surplus, which is projected to increase to 8 % of gross domestic product (GDP) in 2015. This is owed to a trade surplus resulting from strong competitiveness, notably in the export-oriented manufacturing sector, and high revenues from private sector investment abroad, which have not been offset by increased domestic demand, in particular due to weak investment. The impact of low energy prices is also contributing to the surplus. Germany’s current account surplus in relation to its euro‑area partners has fallen to less than a quarter of the total surplus, indicating an on-going rebalancing process in the euro area.

· Private consumption has strengthened, but several factors may hamper future growth. Some features of the tax system may hamper future private consumption. These include the high tax burden on labour and the impact of fiscal drag on disposable incomes. Moreover, the surging costs of renewable energies have affected households’ disposable incomes.

· Consistently weak business investment and insufficient public investment remain a drag on growth. Private sector investment has disappointed owing to continued weakness in machinery and equipment investment, and a loss of momentum in growth of residential investment. While investments made by German companies abroad are buoyant, the domestic investment slump is noteworthy given the supportive conditions for capital formation. Public investment has fallen short of the required, and current federal fiscal relations have not ensured adequate public investment at the level of municipalities.

· Germany is closely integrated with the euro area and economic spillovers imply that Germany's economic developments can benefit but also adversely affect other Member States. The German market is an important export destination for other euro area Member States, in particular for countries integrated into German firms’ production chain. While euro area partners benefit from Germany’s success in trading, the weak domestic investment, falling potential growth and dependence on external conditions pose risks to both Germany and the euro area.

The Country Report also analyses other macroeconomic and structural issues and the main findings are:

· Public finances: Balanced headline budgets and structural surpluses in the years to come create scope for investment in the economy’s future growth potential. The tax burden on labour remains high, in particular for low-wage earners, while the scope for shifting taxes to more growth-friendly revenue sources appears underused. Last year’s pension reform put an additional strain on the sustainability of the pension system and the share of public spending on healthcare (in GDP) is one of the highest in the EU. The implementation of the constitutional balanced-budget rule (‘debt brake’) at federal state level is not yet complete.

· Financial sector: The banking sector has become more resilient, but impediments to consolidation in the public banking sector remain and venture capital is underdeveloped. Low profitability and low interest rates may pose a challenge for institutional investors.

· Labour market, education and social policies: Employment continues to rise and unemployment is at a record low. Despite the current overall favourable situation, skills shortages are emerging, unemployment in some regions remains relatively high and the workforce is projected to decline in the medium to long term due to demographic change. In this context, insufficient incentives to work and the employability of workers remain an issue, also with a view to improving their income. Long-term unemployment is an increasing concern and it is still at a high level.

· Energy, transport, services and public procurement: More renewable electricity, combined with insufficient transmission capacity, poses a challenge for network management. Barriers to competition persist in the professional services and railway sectors, while the rate of publication of public contracts under EU procurement legislation remains very low.

Overall, Germany has made limited progress in addressing the 2014 country-specific recommendations. As regards policies relevant to the Macroeconomic Imbalance Procedure, some steps were taken to increase public investment, but they appear insufficient to address the investment backlog in infrastructure, education and research. No measures were taken to improve the efficiency of the tax system or reduce high taxes and social contributions. The potential of the general minimum wage to foster private consumption may be limited. As regards recommendations to address other policy challenges, Germany has taken some action to enhance the cost-effectiveness of public spending, but has not acted to ensure the sustainability of the pension system. Germany is making progress in addressing shortages in childcare and all-day schooling, but fiscal disincentives to work have not been tackled. No significant efforts have been made to stimulate competition in the railway and service sectors.

This Country Report reveals the policy challenges stemming from the analysis of macroeconomic imbalances. In particular, while Germany’s international competitiveness is an asset, the country would benefit from greater tapping of domestic sources of growth. In particular:

· A boost to investment could unlock the country’s future growth potential. Taking advantage of its fiscal space would enable Germany to address the backlog in public investment. Improvements in the business environment and corporate taxation would support private sector investment. Substantial investment is needed in both energy infrastructure and energy efficiency if Germany is to reach its targets. Initiatives to reap efficiency gains from sectoral reform, e.g. in the services sector, would also support investment.

· Further tap into the labour and skills potential to strengthen growth and incomes. Reducing disincentives to take up a job or to increase working time and facilitating better education outcomes would also help Germany to increase its growth potential. Addressing the impact of fiscal drag and dealing with the (potential) employment effects of the minimum wage are key medium-term policy challenges in order to ensure appropriate conditions for domestic demand

Other challenges are:

· Structural policies favouring sustainable long-term growth. In the energy sector, it seems important to continue monitoring the impact of renewable energy reform on consumer costs and to coordinate energy policies with neighbouring countries. Moreover, there appears to be scope for sectoral reform to improve competition, particularly in the professional services and railway sectors.

Economic Situation

Economic output in Germany was uneven in the course of 2014 though started to rise at the end of the year. The acceleration of growth in 2013 carried over into the beginning of 2014. The cyclical slowdown that occured over the summer subsided as economic activity started to regain momentum at the end of 2014 (Graph 1.1). This weak development reflected a poor recovery in other euro area Member States, depressed business confidence due to geopolitical tensions as well as sluggish demand from some large German export markets. Quarterly growth rates have been volatile, partly owing to considerable weather effects as well as the fall in oil prices. Real GDP rose by 1.6 % in 2014, mostly driven by domestic demand, after increasing by 0.1 % in 2013.

Graph 1.1: GDP in constant prices (index, 2010 = 100)

Source: European Commission

Economic activity, including corporate investment, is expected to strengthen further in 2015. The Commission winter 2015 forecast expects economic activity to strengthen further over the course of 2015 on the back of a robust labour market, favourable financing conditions and an improving external environment, including a significant boost from falling oil prices. The recovery in corporate investment that was interrupted in mid-2014 is expected to resume cautiously. Private consumption is forecast to grow noticeably thanks to low interest rates, high net migration and continued real wage growth. Very low inflation due to declining oil prices widens the scope for increased consumption expenditure. Overall, the Commission winter 2015 forecast expects GDP to increase by 1.5 % in 2015, helped along by more working days, and to accelerate to a rate of 2 % in 2016.

Graph 1.2: Contribution to GDP growth by final demand components (%, pps.)

Source: European Commission Calculations

Domestic demand has taken over as the main contributor to GDP growth. While external demand played an important role from 2010 to 2012, GDP growth has since been driven mostly by domestic demand (Graph 1.2 and 1.3). In 2014, the largest driver of growth in domestic demand was consumption. Net exports contributed with 0.4 pp. to growth, with moderate export growth exceeding import growth. In the coming years, domestic demand is expected to remain the primary growth driver.

Graph 1.3: Private consumption in constant prices (index, 2010 = 100)

Source: European Commission Calculations

While investment has recovered somewhat, it developed less dynamically than expected. Gross fixed capital formation increased in 2014 across all sectors and asset types, but amid the interruption of the recovery process it increased less dynamically than previously projected by both the federal government and independent forecasters (Graph 1.4). However, as uncertainty decreases in 2015 and underutilisation of domestic production capacity declines, corporate investment is expected to recover in 2015, reflecting in particular pent-up replacement investment and investment in new product lines.

Graph 1.4: Gross fixed capital formation and components compared to (autumn and winter) forecasts (annual growth, 2013–15)

Source: European Commission Calculations

While the investment differential in relation to the euro area has closed for the economy as a whole, public investment remains low. In the past, Germany's generally low investment rate resulted mainly from weakness in residential and non-residential construction investment (Graph 1.5 and Graph 1.6). While the overall investment gap in relation to the euro area seems to have closed, public investment remains comparably low. Even though public investment expanded in 2014 and is expected to pick up further in 2015–16, the public sector investment differential in respect of the euro area is expected to remain largely unchanged (see Section 2.3).

Graph 1.5: Investment gap (1) in relation to the euro area without Germany, Ireland and Spain — contribution by type of goods (% of GDP)

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Source: European Commission Calculations

Graph 1.6: Investment gap(1) in relation to the euro area without Germany, Ireland and Spain — contribution by sector (% of GDP)

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Source: European Commission Calculations

Though the German economy was showing some weakness in 2014, this has not affected the country's robust labour market. In 2014, employment rose by 0.9 pp. and the unemployment rate fell to a record-low of around 5 % (Eurostat definition). Employment growth is expected to slow to 0.5 % in 2015, while the unemployment rate is projected to fall slightly. Going forward, the new general minimum wage may have some negative employment effects. Youth unemployment continues to reach record lows. Contrary to the euro area, the unemployment gap – the difference between actual and structural unemployment – is close to zero in Germany, which suggests that the remaining unemployment in Germany is of a broadly structural nature (Graph 1.7).

Graph 1.7: Unemployment gap (%)

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Source: European Commission Note: NAWRU stands for Non-Accelerating Wage Rate of Unemployment

Both core and headline inflation in Germany remained low in 2014. Harmonised inflation averaged just 0.8 % in 2014, driven mainly by the marked decline in the price of oil and falling prices of unprocessed food (Graph 1.8). Harmonised inflation, excluding food and energy (‘core inflation’), was somewhat higher but still moderate at 1.4 %, suggesting subdued domestic inflation pressures. Amid marked employment growth, remuneration per employee grew by 2.6 % in 2014, yet without feeding much into inflation. In recent years, real wage growth has exceeded that of productivity, which has helped to support domestic demand and maintain core inflation.

Graph 1.8: Contributions to headline inflation (%, y-o-y)

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Source: European Commission

External and sectoral developments

Going forward, the current account surplus is expected to remain at high levels. From 7.7 % in 2014 ([1]), the current account is projected to increase to 8 % of GDP in 2015, while a slight decrease is forecast for 2016 (7.7 %) (Graph 1.9). The main reason for the rise in the persistently high surplus is the projected subdued increase in imports which is owed, on the one hand, to low energy prices and, on the other hand, to weak investment and the associated high import content.

Graph 1.9: Current account balance by geographical counterpart (% of GDP)

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Source: European Commission, Bundesbank

Favourable financing conditions have not led to higher credit growth. Despite favourable financing conditions and although Germany’s banking sector has proven to have healthy balance sheets in the European Central Bank's asset quality review, borrowing by households and the corporate sector has been very low since 2009, in most cases due to a lack of credit demand (see also Section 3.2). For example, in the case of small and medium-sized enterprises bank loans have been amply available with only a 10 % rejection rate. However, firms have not applied as they have adequate internal funds. Likewise, housing investment seems to have been financed largely by own resources. This has coincided with a significant deleveraging of the financial sector via negative credit flows, which has not yet abated.

Graph 1.10: Credit flows by institutional sector (consolidated, % of GDP)

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Source: European Commission

Germany’s public finances are in a sound position, which creates scope for greater investment in the economy’s future growth potential. Germany recorded a general government budget surplus of 0.4 % in 2014. Continued small budget surpluses are projected and the debt-to-GDP ratio is set to fall gradually in the years ahead. Germany is also expected to continue recording structural surpluses and hence over-achieving significantly its medium-term budgetary objective of a structural deficit of no more than 0.5 % of GDP.

Germany’s potential output is highly dependent on strengthening domestic sources of future growth. Total factor productivity growth in Germany has been low and declining in recent years, pointing to the scope and need for efficiency gains in the economy (Graph 1.11). Potential growth has been significantly benefitting from strong immigration since 2010 owing to the related rise in labour supply. In the medium term, however, adverse demographic developments are likely to have an increasing dampening impact, possibly leading to a decline of potential growth to about 1 % per year. It is thus forecast to be one of the lowest average potential growth rates over the next decades.

Graph 1.11: Potential output growth and contributions by production factors (pps. per year)

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Source: European Commission Calculations

Demographic change will remain a key challenge for Germany’s economy due to the imminent impact of an ageing society. Germany’s population is ageing rapidly and in the coming years the impact on the German labour market and public finances will accelerate. This decline in the workforce due to demographic change is expected to increasingly affect potential growth, unless policy measures are taken. The population is projected to fall from around 81 million in 2013 to around 71 million in 2060 and the working-age population to decrease by around 28 % (Graph 1.12) ([2]). Assuming no policy change, this could both lower government revenue and steadily increase age-related expenditure.

Graph 1.12: Population projections (in million persons)

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Source: The 2015 Ageing Report, European Commission

Table 1.1: Key economic, financial and social indicators - Germany

1 Domestic banking groups and stand-alone banks.

2 Domestic banking groups and stand-alone banks, foreign-controlled (EU and non-EU) subsidiaries and branches.

3 Real effective exchange rate

(*) Indicates BPM5 and/or ESA95

Source: European Commission, 2015 winter forecast; ECB

Table 1.2: Macroeconomic Imbalance Procedure indicators

Flags: p: provisional.

Note: Figures highlighted are the ones falling outside the threshold established by EC Alert Mechanism Report. For REER and ULC, the first threshold concerns Euro Area Member States. (1) Figures in italic are according to the old standards (ESA95/BPM5). (2) Export market shares data: the total world export is based on the 5th edition of the Balance of Payments Manual (BPM5). (3) Unemployment rate i=Eurostat backcalculation to include Population Census 2011 results.

Source: European Commission

Developments in saving and investment balances by sector

The German current account remains at high levels in the coming years. Contrary to the euro area as a whole, the high and persistent German current account surpluses reflect a combination of steadily increasing savings accompanied by low levels of investment for more than a decade. In recent years, the current account surplus has consistently remained at historically high levels (Graph 2.1.1). Going forward it is expected to remain at around 7–8 % of GDP from 2014 to 2016.

Graph 2.1.1: Current account balance, national savings and investment (% of GDP)

Source: European Commission Calculations

In contrast to previous years, a breakdown of excess savings shows that all sectors are now contributing to the current account surplus. While the largest contribution to the current account surplus remains the structurally large excess savings position of the household sector, in recent years the change in the current account balance has been driven mainly by the non‑financial corporate and government sectors. This reflects a continuation of the long-term shift in the non-financial corporate sector towards a structural net saving position. This is coupled with ongoing fiscal consolidation efforts that have produced an excess savings position in the government sector (Graph 2.1.2). The contribution of the non-financial corporate sector to the current account surplus in the years following the crisis has been driven by a marked decrease in investment relative to the pre-crisis period (Table 2.1.1).

Graph 2.1.2: Sectoral excess savings and current account balance (% of GDP)

Source: European Commission Calculations

A further breakdown shows that changes in both savings and investment behaviour at the sectoral level are driving aggregate developments. The position of households and non-profit institutions serving households shows a slight reduction in excess savings as robust household consumption reduced the saving rate moderately (Graph 2.1.3). The excess savings of the general government were mainly driven by significantly higher savings after the crisis, in a context of reduced government expenditure (Graph 2.1.4), while public investment remained at low levels. While in the immediate aftermath of the crisis the excess savings position of non-financial corporate sector rose sharply as savings increased and investment fell, it appeared to be closing somewhat thereafter as both positions moved downwards. However, in 2013 a further divergence was visible as savings and investment moved in opposite directions (see Section 2.3). After a period of relative stability, the excess savings position of the financial corporate sector declined markedly in 2013, driven by a swing in savings.

Table 2.1.1: Change in current account and contribution of savings and investment by sector (pps. of GDP)

Source: European Commission Calculations

.Graph 2.1.3: Households and non-profit institutions serving households (% of GDP)

Source: European Commission

Graph 2.1.4: General government (% of GDP)

Source: European Commission

Current account developments

The German current account surplus increased in 2014, but remained broadly stable in relation to the euro area. The current account surplus increased from 6.7 % of GDP in 2013 to 7.4 % in 2014, well above the Macroeconomic Imbalance Procedure indicative three-year threshold of 6 % of GDP (Graph 2.1.5). The increase in the current account balance in 2014 was mainly explained by a further increase in the trade surplus in goods and a decrease in the deficit in services. According to provisional data, the current account balance in relation to the euro area flattened in 2014 (from 1.7 % to 1.8 % of GDP) and represented less than a quarter of the total current account surplus, compared with more than 60 % at the end of the 2000s (Graph 2.1.6) ([3]). The current account surplus against the EU-28 also increased in 2014 according to provisional data, after some years of registering decreases (Graph 2.1.7). The external position in relation to Germany’s main European partners improved slightly or remained stable.

Graph 2.1.5: Breakdown of current account balance in relation to all countries (% of GDP)

Source: Bundesbank, European Commission Calculation

Graph 2.1.6: Breakdown of current account balance in relation to the euro area (% of GDP)

Source: Bundesbank, European Commission Calculation

The current account surplus with the rest of the world continued to grow, particularly in relation to emerging markets and developing countries. Germany’s surplus against this group of countries has grown steadily in recent years (Graph 2.1.7) and represents almost one third of the total current account surplus. Furthermore, the external position against China has continuously improved since 2008, turning into a surplus in 2012 (Graph 2.1.8). This rise has been driven by a growing balance in goods. The increase in the German current account surplus is also supported by improving positions in relation to the United States and Japan. The increase in the trade surplus in goods in 2014 can be partly attributed to the decline in oil prices and a corresponding reduction of import values. The rising nominal effective exchange rate is not likely to have supported German exports to non-euro area trading partners in 2014 on average. However, the exchange rate declined considerably in the second half of the year, which implies an improvement in price competitiveness. This, together with the projected strong reduction of oil prices in 2015 compared to the previous year, supports the expectation of a further increase in the German current account surplus in 2015.

Germany’s exports reached a record high in 2014 while imports grew less dynamically, contributing to the increase in the current account. Export and import growth accelerated after the crisis, but exports have increased more than imports since 2012, contributing to the increase in the merchandise trade surplus (Graph 2.1.9). The pace of import growth was lower in nominal terms than in volume in 2014,

Graph 2.1.7: Current account balance in relation to EU‑28, euro area, emerging markets and developing countries (% of GDP)

Source: Bundesbank, European Commission Calculation

Graph 2.1.8: Breakdown of current account balance in relation to China (% of GDP)

Source: Bundesbank, European Commission Calculation

reflecting the decline in oil prices, while imports from the other main goods categories rose (Graph 2.1.10).

Graph 2.1.9: Exports and imports (annual growth rate, %, y-o-y)

Source: Bundesbank, European Commission Calculation

Graph 2.1.10: Imports by broad economic categories (annual growth rate, %, y-o-y)

Source: Bundesbank, European Commission Calculation

Rebalancing in relation to the vulnerable EU countries is occurring as a result of import and export developments. A comparison of Germany’s exports, imports and trade balances in relation to vulnerable countries before the crisis and in recent years (2004–2007 and 2011–2014, respectively) suggests that rebalancing within the euro area is taking place, and is a result of lower German exports to these countries and higher German imports (Graph 2.1.11). There are, however, differences between countries. Decreasing trade balances in relation to Spain, Greece and Ireland seem to be mainly related to decreasing exports to those countries, while higher imports explain most of the decreasing German trade surpluses in respect of Italy and Portugal.

Graph 2.1.11: Changes in trade in goods with vulnerable countries from 2004–2007 to 2011–2014 (EUR billions)

Source: Bundesbank, European Commission Calculation

(Continued on the next page)

Box (continued)

Impact of taxation on income and private consumption

Revenue from income taxes paid by households and from social contributions was on a downward trend before the crisis, but has risen in recent years. Total revenue from taxes on income and wealth paid by households and from social contributions, including paid by employers, fell steadily in relation to GDP before the crisis (Graph 2.2.1). This was caused by a sharp reduction in personal income tax rates across the progressive tax scale. Tax rates at the entry and top levels of the progressive tax scale were gradually reduced from 26 % and 53 % respectively in 1999 to 14 % and 42 % in 2009. The bulk of these cuts took place before 2005. Weak employment growth combined with wage moderation also reduced the revenue collected from payroll-related taxes. After the crisis and a temporary spike following the crisis-related GDP slump in 2009, the tax burden resumed its upward trend. Social contributions as a proportion of GDP were on a downward trend for most the 2000s, but have been rising steadily since the end of the decade in the wake of an increasingly favourable labour market, which has weathered the economic crisis remarkably well. Taxes on income and wealth paid by households as a proportion of GDP were on a downward trend for the first half of the 2000s, but have since been rising. The implicit tax rate on labour was also on a downward trend, though it increased briefly before the crisis and again in recent years, suggesting that the sum of all direct and indirect taxes and social contributions levied on labour has grown more quickly than total employee remuneration. The implicit tax rate on labour in Germany has fallen below the euro-area average in recent years, but remains significantly above the EU average (Graph 2.2.2).

Graph 2.2.1: Revenue from taxes on income and wealth paid by households and NPISH* and social contributions (% of GDP)

Source: Destatis, European Commission

Graph 2.2.2: Implicit tax rate on labour (%)

Source: European Commission (Taxation trends in the EU)

While the impact of fiscal drag has in the past been mitigated by discretionary tax cuts and is now strongly limited by low inflation, it remains a potential source of future non-discretionary tax increases. The downward trend in income taxes paid by households until the mid-2000s also reflects the impact of discretionary tax reforms that more than offset the effect of fiscal drag ([4]), i.e. the process where, in a progressive tax system, rising incomes (whether due to inflation or increasing real incomes) result in a higher average tax burden. However, since 2005 there have been no further major discretionary income tax reductions. In 2013, Germany adopted a law aimed at reducing fiscal drag, which slightly increased the basic income-tax allowance. However, the law falls short of the initial proposal to also adjust the tax scale and to introduce a regular review every two years to limit unintended across-the-board tax increases owing to inflation, as already happens in many other Member States. Therefore, while the impact of fiscal drag is currently mitigated by low inflation, with dynamic wage growth and somewhat higher inflation rates in the coming years, fiscal drag could lead to significant non-discretionary tax increases, which could in turn affect disposable incomes. A model-based counterfactual analysis ([5]) which assumes that all tax brackets except the top rate are adjusted in line with inflation indicates that the non-adjustment of tax brackets will lead — at an inflation rate of 0.1 % as projected by the European Commission winter 2015 forecast — to a fall in the disposable income of households of just EUR 143 million in 2015. But in a scenario where there is 2 % inflation, this figure would increase to about EUR 3 billion (0.1 % of GDP). In its recent and first report on the impact of fiscal drag, based on an income tax micro-simulation model, the federal government estimates that in 2015 there will be additional revenue of EUR 0.7 billion (at 1 % inflation), EUR 1.8 billion (at 1.5 % inflation) and EUR 2.9 billion (at 2 % inflation).

The tax burden on labour remains relatively high, especially for low-wage earners, with potentially negative effects on labour market participation and disposable income. The tax wedge for workers earning 50 % and 67 % of the average wage has remained largely unchanged since 2001 and remains among the highest in the EU (based on 2013 data for a single person with no children, Graphs 2.2.3 and 2.2.4). In particular, social contributions paid by employees are among the highest in the EU, despite a reduction in contribution rates since the mid-2000s. The recent reforms to social insurance systems are likely to involve a further rise in contribution rates and again increase the tax wedge (see Section 3.1). Inactivity traps — which measure the part of the additional gross wage that is taxed away where an inactive person (not entitled to unemployment benefits but eligible for income-tested social assistance) takes up a job — are relatively high for low-wage earners, with a high contribution from personal income taxes and employee social contributions. For workers earning 50 % of the average wage, the inactivity trap in 2013 was in Germany 73.1 % (euro area average: 58.3 %), of which 30.9 % resulted from labour taxes.

Graph 2.2.3: Tax wedge at 50% of average earnings in 2001 and 2013 (% of total labour costs)

Source: European Commission, OECD (Tax and benefits indicators database)

Graph 2.2.4: Tax wedge at 67% of average earnings in 2001 and 2013 (% of total labour costs)

Source: European Commission, OECD (Tax and benefits indicators database)

While the tax burden on consumption has increased over the last decade, it still does not appear to be particularly high. The implicit tax rate on consumption — the ratio between the revenue from all consumption taxes and the final consumption expenditure of households — increased by 0.6 pp. between 2000 and 2012, mainly due to a major hike in the standard rate of value added tax from 16 % to 19 % in 2007 (Graph 2.2.5). While revenues from value added tax as a proportion of GDP increased slightly over the last decade, those from other indirect taxes including excise duties decreased (Graph 2.2.6). Part of the additional revenue resulting from the increase in value added tax was used to reduce the unemployment insurance contribution rate. Despite the jump in the implicit tax rate on consumption caused by the increase in value added tax, Germany has one of lowest value added tax standard rates in the EU and its consumption taxes represent a below-average proportion of total tax revenue. Consumption-related taxation has been kept stable and does not appear to have constrained private consumption dynamics.

Graph 2.2.5: Implicit rate on consumption (%)

Source: European Commission (Taxation trends in the EU)

Graph 2.2.6: Revenue from value added tax and other indirect taxes (% of GDP)

Source: European Commission

Surging costs for the use of renewable energy has affected households’ disposable income. The surcharge paid by electricity consumers to fund the difference between guaranteed feed-in tariffs for renewable energy producers and market prices has increased steadily in recent years. The surcharge increased by 47 % in 2013 and by a further 18 % in 2014. For 2015, it has been reduced slightly, by 1 %. The total volume of the surcharge has increased significantly in recent years and is projected to reach EUR 21.8 billion or 0.7 % of GDP in 2015. The roll-out of renewable energy with close-to-zero marginal generation costs has helped reduce wholesale prices. However, the hike in the surcharge has caused a significantly stronger increase in consumer electricity prices in Germany in comparison with consumer prices in general (Graph 2.2.7) and consumer electricity prices in other Member States (Graph 2.2.8). The cost of the surcharge has a direct impact on household net disposable income, with a larger impact for lower income households that tend to spend a higher proportion of their incomes on accommodation and energy. For example, based on an average annual electricity consumption of 3 456 kWh per household with on average 2.02 household members in Germany in 2013, the current renewable energy surcharge of 6.17 ct/kWh would amount to EUR 213 per household, per year.

Graph 2.2.7: HICP* in Germany (annual average index, 2000 = 100)

Source: European Commission

Graph 2.2.8: HICP* for electricity (annual average index, 2000 = 100)

Source: European Commission

Overall, tax policies do not stand out as a major reason for subdued private consumption in the pre-crisis period, but — if they are not adjusted — may hamper private consumption in the future. The tax burden has resumed an upward trend in recent years and fiscal drag could lead to non-discretionary tax increases in the coming years and could dampen the effect of continued dynamic wage growth by increasing the average rate of taxation. The tax wedge on labour, in particular for low-wage earners, remains comparatively high, and there are risks of a further rise in social contribution rates. The policy-induced surge in electricity prices has affected disposable incomes and consumption, especially those of low-income households.

The potential impact of the general minimum wage on consumption

Germany has introduced a general minimum wage of EUR 8.50 an hour in 2015 with some exceptions and transitional arrangements. The new legislation is a response to the expansion of low-wage jobs, the increase in wage and income inequality, and the decline in the proportion of workers covered by collective bargaining agreements. Some groups are excluded. Negotiated sector-specific minimum wages remain valid, but cannot be lower than EUR 8.50 an hour from 2017. A new minimum wage commission (Mindestlohnkommission) will make recommendations on future adjustments to the level of the minimum wage every two years, which can be adopted by the government. The law introducing the general minimum wage also provides for an easing of the conditions for applying collective bargaining agreements to all companies in a sector (Allgemeinverbindlicherklärung), and for an extension of the Posting of Workers Act to all sectors (Arbeitnehmer-Entsendegesetz). The minimum wage law is to be reviewed in 2020.

Overall, the potential of the minimum wage to strengthen domestic demand is likely to be limited due to employment and price effects and the interaction with the tax and benefits systems. The general minimum wage is intended to increase the income of low-wage earners, thus contributing to reducing inequality, preventing an increase in-work poverty and increasing consumption and domestic demand. However, the impact of the minimum wage on net disposable incomes and therefore on domestic demand could be mitigated by potential employment and price effects as well as by higher taxes and social contributions and lower benefits, including in some cases the withdrawal or reduction of income top-ups (Aufstockung). Household net equalised income is estimated to increase on average by less than EUR 5 per month due to the minimum wage, even assuming no employment effect ([6]). These results suggest that the impact of the minimum wage on consumption may be rather limited.

The employment impact of the minimum wage is expected to be significant in the eastern federal states and among those sectors with a high share of ‘mini-jobbers’. The share of employees earning less than EUR 8.50 an hour is particularly high in the eastern federal states (23 %) and among ‘mini-jobbers’ (58 %), in specific services (up to 23 %), in companies with fewer than 10 employees (more than 30 %), in jobs requiring no or limited qualifications (35 %), and among women (20 %) and young workers (37 %) ([7]). Measured by estimates of the Kaitz index for full-time workers (quotient of the minimum and the median wages), the effective level of the minimum wage for Germany as a whole and in the western federal states is expected to be in the mid‑range in EU terms, while for the eastern federal states, it would be at the upper end, for both gross wages and labour costs (Graph 2.2.9) ([8]).

Graph 2.2.9: Kaitz index for gross wages and for labour costs, for full-time earners (2013)

Source: OECD, European Commission Calculation based on OECD and European Commission – OECD Tax–Benefit model for labour cost. Note: Definitions of gross wages and labour cost reflect the categorisation of the OECD-EC Tax-Benefit database. Gross wages are equal to employees’ pre-tax compensation. The German minimum wage of EUR 8.50 an hour is set at a gross wage level. The labour cost paid by employers is the sum of the gross wage and employer’s social security contributions.

The overall employment effect is difficult to estimate. Estimates of employment effects range from positive to very significant job losses, in many cases part-time jobs. The strong variation is partly due to different assumptions as regards the wage elasticity of labour demand, the number of workers affected and the impact of the minimum wage on wages in general. Moreover, the employment effect could be stronger if companies substitute labour for capital, or weaker if companies reduce non-wage benefits or if the statutory minimum wage is circumvented. On the other hand, the impact of higher wages on employment will be mitigated if companies pass on wage increases to consumers in the form of higher prices, or absorb part of the cost increases by reducing their profits. The minimum wage may also incentivise labour force participation and higher productivity. The magnitude of these effects is difficult to estimate, however. Price increases could be strong in some service sectors where many workers are affected by the new minimum wage.

(Continued on the next page)

Box (continued)

Public investment in infrastructure and education

While the level of public investment has picked up recently, it still differs significantly from the euro-area average and there has been no lasting trend of positive net investment. After an increase in the second half of the 2000s resulting partly from crisis-related stimulus packages, the share of public sector gross fixed capital formation as a proportion of GDP has been stable in recent years, reflecting moderate nominal growth rates and even a slight fall in real terms in 2012 and 2013 (Graph 2.3.1). As a consequence, the differential in public investment as regards the euro-area average (excluding Germany, Spain and Ireland) remains significant, even though it decreased from 1.5 % of GDP in 2009 to 1.0 % in 2013 (see Graph 1.6). In 2014, gross public investment increased by 3.8 % in nominal terms and 3.1 % in real terms and is projected by the European Commission winter 2015 forecast to continue doing so in 2015/16, given the overall sound position of public finances and the policy measures adopted by the federal government. Moreover, after a short period of positive net public investment, gross investment fell again below depreciation in 2013 and just offset depreciation in 2014 (Graph 2.3.2).

Graph 2.3.1: Gross fixed capital formation by layer of government (% of GDP)

Source: Destatis, European Commission

Graph 2.3.2: Net fixed capital formation by layer of government (% of GDP)

Source: Destatis, European Commission

A public investment backlog has emerged in particular at the level of municipalities and with respect to Germany’s transport infrastructure. Public investment by municipalities decreased from 1.1 % of GDP in 2000 to 0.8 % in 2014, whereas it increased slightly at federal and federal state level (Graph 2.3.1). Hence, the share of municipalities in total public sector gross fixed capital formation fell from 46 % in 2000 to 36 % in 2014. The downward trend in public investment can partly be explained by strong infrastructure investment in East Germany over the 1990s, which has been levelling off since, and by the privatisation of public enterprises and services, such as network industries or waste management. However, especially negative net investment by municipalities since the beginning of the 2000s suggests significant underinvestment (Graph 2.3.2). Investment has also been insufficient to maintain the quality of Germany’s transport infrastructure, with real investment decreasing notably for federal state, county and municipal roads and local public transport. Therefore, bottom-up studies and surveys suggest that additional annual investment of ½ to 1 % of GDP (EUR 15–30 billion) in the coming years is needed to modernise Germany’s transport infrastructure and remove specific bottlenecks as well as overcome the municipal investment backlog ([9]).

Some progress has been made towards increasing public investment in infrastructure and enhancing the fiscal space of municipalities. The federal government has made available an additional EUR 5 billion for investment in public transport infrastructure and EUR 600 million for urban development over the period 2014–17. There are also plans to partly compensate municipalities for social expenditure by an additional EUR 5 billion annually, which should increase their fiscal space for investment. To this end, in December 2014 a law was adopted to relieve the federal states and municipalities by EUR 1 billion annually and to top up the special fund for the expansion of childcare facilities by EUR 550 million. Further financial relief for municipalities is to be provided in the form of funding for the integration of people with disabilities. There are also plans to make more flexible use of funds for infrastructure investment and to further develop infrastructure funding through public-private partnerships. An expert group has been set up to develop proposals on how to raise private and public investment, e.g. by tapping more into private funds for public infrastructure projects. More recently, a further EUR 10 billion for infrastructure investment over the period 2016–18 has been announced, though not yet specified, and proceeds from auctioning broadcast spectrum are planned to be invested in broadband expansion.

However, the planned measures fall short of the requirements to tackle the investment backlog in public infrastructure. If fully implemented, these measures would amount to about EUR 10 billion or 0.3 % of GDP per year and are thus significantly below the identified additional annual investment requirement of ½ to 1 % of GDP. Given the evidence of underinvestment, especially at local level, the fiscal position of municipalities and their resulting capacity to invest is particularly relevant in this context. This is also affected by the allocation of revenue and expenditure competences between the federal government, the federal states and the municipalities (see Section 3.1).

Germany has made limited progress in raising education spending, which remains rather low by international standards, especially as regards primary and lower secondary education. In 2011, Germany’s total public and private expenditure on educational institutions of 5.1 % of GDP was well below the OECD average of 6.1 %, although educational institutions’ expenditure per student of 27 % of per capita GDP was in line with the OECD average. This may also reflect the lower proportion of the under-30s in the German population. Expenditure per student relative to GDP per capita is below the OECD average in primary and lower secondary education, above average in upper secondary education and in line with the average in tertiary education. Public spending on education amounted to 4.4 % of GDP in 2011, compared to an average of 5.1 % in the euro area and 5.3 % in both the EU and the OECD. In 2012, public expenditure on education in Germany fell to 4.3 % of GDP.

Table 2.3.1: Germany’s budgetary projections compared to European and national deficit ceilings (% of GDP)

Source: 1) German draft budgetary plan 2015; 2) Federal Ministry of Finance, Eckwertebeschluss der Bundesregierung zum Regierungsentwurf des Bundeshaushalts 2015 und zum Finanzplan 2014 bis 2018 sowie zum Sondervermögen ‘Energie- und Klimafonds’, March 2014.

In contrast, Germany has made some progress in increasing research spending and has almost reached its Europe 2020 target. Expenditure on research and development is mainly provided by the private sector and increased from 2.4 % of GDP in 2000 to an estimated 2.94 % in 2013, well above the estimated EU-28 average of 2.02 %. While Germany is close to achieving its Europe 2020 expenditure target of 3 % of GDP, other advanced economies such as Finland, Sweden and South Korea are investing even more. Moreover, significant disparities exist in innovation performance and expenditure at regional level, especially as regards private investment in research and development.

The federal government has taken measures to increase spending on education and research, but additional efforts appear needed to reach the national target. The 2014 stability programme already included plans to provide an additional EUR 6 billion to support the federal states in financing childcare facilities, schools and higher education institutions and additional EUR 3 billion for research. Moreover, it is planned to enhance cooperation between the federal government and the federal states in the area of science and research. However, the latest available data suggest that total public and private expenditure on education and research may fall short of the national target of 10 % of GDP by 2015 as agreed by the federal government and the federal state governments. While total expenditure increased from 8.6 % of GDP in 1995 to 9.1 % in 2011, it decreased to 9.0 % in 2012. Therefore, further efforts appear necessary at all levels of government to meet the 10 % expenditure target, and even would be needed to catch up with the most innovative economies. Besides an increased expenditure level, also the outcomes in the education system (see Section 3.3) and start-up companies’ access to venture capital (see Sections 3.2 and 3.5) remain important challenges.

Germany’s currently favourable fiscal position provides significant scope for additional infrastructure investment and education expenditure in full respect of European and national budget rules. Current projections indicate scope of up to 1 % of GDP under Germany’s medium-term budgetary objective and of up to ½ % of GDP under its national ‘debt brakeֹ’. According to the European Commission winter 2015 forecast, Germany is projected to comply with its medium-term budgetary objective with a margin of around 1.2 % of GDP in 2015 and 1.0 % of GDP in 2016. According to the draft budgetary plan for 2015, Germany plans to continue overachieving its medium-term objective during 2017–18 with a margin of about 1 % of GDP (Table 2.3.1). The federal government also plans to comply with a margin of about ½ % of GDP with the deficit ceiling for the federal budget set by the national ‘debt brake’ in the period 2015–

Table 2.3.2: Pension fund and insurance sector assets (2012)

Source: Eurostat, ESA2010 and OECD SNA2008 financial balance sheets national accounts (not consolidated). Note: * Refers to total assets excluding insurance technical reserves, which mostly relate to within-sector positions to reinsurers. Note that figures do not add up to 100% as assets under 'other accounts receivable' are not displayed. Repartition of mutual funds derives from 'look-through' data on the sector published by the Dutch Central Bank for the Netherlands, and from Banque de France (monthly bulletin Q3-2013) estimates for France (with proportionally allocated residual). For Germany, they are estimates deriving from book-value data on life insurance assets from Gesamtverband der Deutschen Versicherungswirtschaft (2014), ‘Statistical Yearbook of German Insurance 2014’.

18 ([10]). Therefore, the national deficit ceiling is more constraining and sets the maximum fiscal buffer.

The role of life insurance savings

The German life insurance sector is an important financial intermediary of household savings. In particular, life insurance and pension funds account for a large part of household financial assets. The sector's assets (life and non-life insurance and pension funds) represent EUR 2.1 trillion in total, or 75 % of GDP, which is in relative terms comparable to the euro area. The sector can play an important role in intermediating savings into long-term real investment in Germany and potentially also the rest of the euro area.

However, only a relatively small share of these savings is currently funnelled to private sector investment. The assets of German insurers and pension funds are concentrated on debt, mostly direct loans (Table 2.3.2). While a high share of the sector's assets are allocated in some forms of debt of highly rated issuers in the financial and government sectors, private sector debt accounts for only about 15 % of total assets ([11]). Moreover, the sector holds 10 % in equity investment. In some non-euro area countries, equity accounts for a considerably larger portfolio share (UK: 21 %, US: 34 %). In the rest of the euro area, the sector targets an equity allocation (12 %) comparable to Germany’s, but holds considerably more equity through mutual funds. A low proportion of equity investment limits the risk and expected return on assets. At the same time, however, it affects the supply of equity available to corporates for investment, and thus the amount the corporate sector may leverage up through bank lending.

The relatively low appetite for equity and private sector debt stems from high demand for life insurance plans with a guaranteed return. The majority of German third-pillar pension savings are in life insurance products that provide guaranteed returns. Such guarantees are structured in ways that do not only cover the paid-in principal, but also provide a guaranteed minimum return over the life-time of the plan. By contrast, Dutch, UK and US savings mainly go into pension funds that offer asset management products with only a principal guarantee. In Germany, this guaranteed minimum return is centrally set each year and despite having been recently lowered to 1.25 % for new contracts, it still averages 3.2 % over all plans in the sector. In response to the large share of guaranteed return products, German life insurers are required to match their liabilities with an asset allocation that can guarantee that minimum return at all times, not only over a plan’s life-time. While this is in line with prudential requirements, from a balance sheet viewpoint, it also induces the sector to forego assets with higher returns such as equity or corporate debt. Recent reforms and sector initiatives have strengthened the sector’s sustainability in ensuring guaranteed returns under the current low-interest environment.

Subsidy schemes for household pension savings foster demand for products with guaranteed returns. As regards the third pillar of pension savings, households benefit from pay-in tax allowances and subsidies only when investing in life insurance products with a strong principal guarantee element (Sonderausgabenabzug). In particular, this applies to the Riester plans introduced in 2000, which account for roughly half of the market and grant pay-in subsidies ([12]). Pay-ins to, and capital pay-outs from, plans that had started before 2005 (which constitute a significant portion of the market to date) are tax-free under certain conditions. Subsidies and tax allowances ([13]) are available on a variety of Riester plans, including the choice of a pure deposit saving plan. To be eligible for tax benefits, a Riester plan must provide a principal guarantee that is binding at all times during the saving phase. Moreover, many plans in addition provide a life-time minimum return guarantee, which magnifies the focus on safe assets. The strict guarantee requirement also implies that pension funds with end-date guarantees, common in other European countries, are not eligible for subsidies and tax allowances in Germany. Overall, tax and benefits thus seem to incentivise household demand towards pension savings plans that require the life insurance sector to provide comparatively little capital to real private sector investment.

Investment in the energy sector

From an investment perspective, energy generation, efficiency and networks play a significant role. Corporate investment in the energy sector alone represented 9 % of total gross capital formation in 2013, not including most energy efficiency and photovoltaic investment, which are accounted for in the buildings sector (Graph 2.3.3). Total investment amounted to EUR 16.1 billion in renewable energy generation in 2013, up to EUR 10 billion in energy efficiency in residential buildings in 2011 ([14]) and EUR 5.5 billion in energy networks in 2013 (Table 1 in Box 2.3.1).

Graph 2.3.3: Investment by the energy sector

Source: Destatis

Private investors dominate energy investment. With public investment as a proportion of total investment in renewable energy generation at 2.5 % and in energy efficiency at 8.6 % in 2010, the role of the public sector as a direct investor is limited. Banks and private intermediaries provide the bulk of energy financing in Germany with households accounting for 37 % of total renewable energy investment in 2012. In 2010, concessionary loans by KfW, Rentenbank, and state banks were equivalent to EUR 16.5 billion or 45 % of energy efficiency and renewable energy investment in Germany. Private intermediaries provided EUR 12.4 billion in the same year ([15]).

The current policy framework and Germany’s geographical location underline the relevance of investment in the energy sector. In the broader context of EU climate and energy policy, the Energiewende (transformation of Germany’s energy system) and various policy instruments, such as the feed-in tariff for renewable energy, play a central role in this regard. The Energiewende sets renewable energy and energy efficiency objectives for 2020 and 2050, and requires the phasing out of nuclear energy by 2022, along with ambitious greenhouse gas reduction targets. These objectives require significant investment in renewable energy for power and heating, in energy efficiency of the existing building stock and in the expansion and upgrading of power and gas networks. As a central ‘switch table’ in the EU’s internal energy market, Germany’s energy investment choices also have important spillover effects on the EU. Germany’s geographical location requires significant domestic and cross-border network expansion in line with the requirements for electricity generation, transmission and distribution (see Section 3.4). Investment in gas declined between 1994 and 2004. Despite the slow recovery after 2005, investment should increase by a total of EUR 1.9 billion between 2014 and 2019 in order to meet the targets of 260 megawatts additional compressor capacity and 423 km grid expansion until 2019, according to the Network Development Plan Gas 2014.

(Continued on the next page)

Box (continued)

(Continued on the next page)

Box (continued)

Investment in machinery and equipment

The German manufacturing sector accounts for a significant proportion of German investment in machinery and equipment, exports and gross value added. Its importance for the overall economy is reflected in its proportion of total economy gross value added, which has averaged 22 % since the mid-1990s without seeing a significant decline. The sector has also continued to dominate Germany’s goods exports , accounting for around 80 % on average of the annual value of total German exports since the early 2000s. Finally, the manufacturing sector is an important driver of investment in Germany, accounting for an average of around 30 % nominal investment in machinery and equipment on average since the mid-1990s. Notably, while a trend decrease in its proportion of machinery and equipment investment took place between the mid-1990s and the mid-2000s, stabilisation or possibly even a trend reversal has since be observed.

A cross-country comparison shows that the German manufacturing sector drives the country’s total exports to a larger extent than is the case for the entire euro area. The German manufacturing sector makes up nearly 80 % of the country’s total exports compared to around 70 % in the euro area (2010–13 average). This reflects the relatively large importance of the manufacturing sector for the German economy (Graph 2.3.4 and 2.3.5). Having seen a less pronounced decline compared to other Member States since the mid-1990s, the German manufacturing sector as a proportion of total gross value added exceeds the euro area average by more than 6 pps. The sector’s role for investment in machinery and equipment is above average also from a European perspective, although this difference is less pronounced owing to a larger role of leasing financing in Germany than elsewhere, since in such cases investments are recorded in the (financial) services sector.

Graph 2.3.4: Manufacturing as a proportion of total exports (%, 2010–13 average)

Source: European Commission Calculations

Graph 2.3.5: Manufacturing as a proportion of nominal machinery and equipment investment (%, 2010–13 average)

Source: European Commission Calculations

Data for German manufacturing sub-sectors show that the most export-oriented branches are the same ones that drive manufacturing investment in machinery and equipment. In 2011 the sub-sector chemicals, pharmaceuticals, petroleum, minerals and rubber accounted for almost 20 % of gross value added of the total manufacturing sector, followed by cars and transport at 18 %. A pronounced positive correlation emerges when contrasting each manufacturing sub-sector’s share of total German nominal investment in machinery and equipment with its share of total nominal goods exports. Unsurprisingly, the manufacturers of motor vehicles, chemicals electrical equipment, basic metals and other machinery and equipment are among those driving both aggregates.

In a cross-country perspective, the difference between Germany and other Member States is driven mainly by the German automotive sector. While the positive association between machinery and equipment investment and exports is more pronounced in Germany than in Italy, Spain, the United Kingdom or than in comparison with the euro-area average, the difference narrows when excluding the manufacturing of motor vehicles from the data (Graph 2.3.6 and 2.3.7). This reflects the strong position of the German automotive sector and in particular the non-price competitiveness advantage that it enjoys relative to other Member States, including a specialisation in end products that is sustained by high levels of research & development investment. Moreover, the sub-sector ‘motor vehicles and land vehicles’ has benefited from growth in emerging market economies (Brazil, Russia, India and China) and the US.

Graph 2.3.6: Share of total nominal goods exports and total nominal machinery and equipment investment (%, 2008–12 average) by manufacturing sub-sector

Source: European Commission Calculations

Graph 2.3.7: Share of total nominal goods exports and total nominal machinery and equipment investment (%, 2008–12 average) by manufacturing sub-sector, excl. motor vehicles sub-sector

Source: European Commission Calculations

The central role of export-oriented manufacturing companies in driving machinery and equipment investment could reduce the scope for an investment-induced current account rebalancing. First, manufacturing plays a central role in quantitative terms in total machinery and equipment investment in Germany and the sector’s investment behaviour is a main driver behind the overall cyclical machinery and equipment investment pattern. Second, machinery and equipment investment seems to be closely correlated with goods exports. Hence, given the current growth pattern of the German economy with a significant focus on exports, and with limited scope in the medium term for replacing exports with domestic demand in view of the shrinking German market, the current analysis supports the view that it is unlikely that a significant expansion in machinery and equipment investment would be observed without an associated increase in exports. This would offset part of the current account rebalancing that the high import content of machinery and equipment investment causes.

Understanding the nature of German corporates' financial acquisitions

The German non-financial corporates have maintained their excess savings position in the post-crisis period. Since the early 2000s the excess savings of Germany’s non-financial corporate sector have been mainly used to acquire equity and investment fund shares ([16]). These financial investments have been very substantial, also in comparison with other EU Member States of similar size. A breakdown of equity and investment fund shares ([17]) shows that German non-financial corporates have primarily invested into listed and unlisted shares. During the crisis, however, other equity grew in importance, potentially reflecting the injection of capital into smaller supplier companies and/or the acquisition of privately-owned firms (Graph 2.3.8).

Graph 2.3.8: Non-financial corporates' acquisition of shares and other equity (% of GDP)

Source: European Commission Calculations

Firm-level balance sheet data for the period 1997-2012 provides evidence that strategy-related equity holdings in other firms are of increasing importance. This finding is based on extrapolated results based on firm-level annual balance sheet data from a large number of sectors ([18]). From a cross-sector perspective the importance of shares in other firms held with a view to supporting the holding firm's business activity by establishing a lasting relation with the other firms (shares or stakes, Beteiligungen) has increased from below 10 % in the mid-1990s to close to 16 % in 2012 (Graph 2.3.9). By contrast, the proportion of securities acquired without the motivation of a direct return on the investment made (securities, Wertpapiere) in total assets has been fluctuating around 2-3 % of total assets over the same period. Coinciding with the increase in German non-financial corporates' savings and acquisition of equity and investment fund shares, these developments give an indication that firms' increasing equity investments have been related to their corporate strategy, i.e. to support their business activity.

Graph 2.3.9: Proportion of shares and securities in firms’ total assets (in %)

Source: Bundesbank

The size of strategic equity acquisition has increased over time, and is especially pronounced for manufacturing sub-sectors with a strong export orientation. Notably, the largest proportion of strategy-related shares is found in some of the export-oriented manufacturing sectors, such as chemicals and transport equipment, suggesting a likely link to their internationalisation strategy. Disaggregated stock data show heterogeneity across firms. The largest average proportion of stakes in total assets is found for the sectors ‘manufacture of chemical and pharmaceutical products’ and ‘transport equipment’ (around 29 %, 2006–11 average), and ‘data processing, electrical and optical equipment’ (25 %, 2006–11 average). For 2011 additional non-extrapolated data broken down by sector and size as well as legal form show that also in the sectors where shares are quantitatively most important (e.g. manufacturing of chemicals) developments are driven by large firms and, even among the latter group, developments are driven by incorporated firms ([19]). Holdings of securities only play a minor role in these sectors. These manufacturing sub-sectors are characterised by a strong export orientation; together, they accounted for close to one third of German exports. At the same time, their internationalisation strategy goes beyond pure reliance on exports. In particular, transport equipment includes the car manufacturing sector, which has been widely documented to be well-integrated in global value chains, making inter alia intensive use of foreign direct investment. The sector's high proportion of stakes is therefore presumably related to its internationalisation strategy. By contrast, very low average shares of stakes were found in typically domestically oriented service sectors such as construction and retail.

Equity holdings in other firms are especially high in large incorporated firms, which own quantitatively important holdings of shares for strategic reasons. Large firms drive the result of a large and increasing proportion of stakes in total assets (Graph 2.3.10). In a similar vein, strategy-related shares are more important for incorporated than unincorporated firms (Graph 2.3.11). On average incorporated firms’ holdings of shares outstripped those of their unincorporated peers, but the data does not allow for a clear conclusion on whether this predominantly reflects a size effect. The importance of strategic investments for incorporated firms reflects the behaviour of stockholding companies (Aktiengesellschaften, AG). For AGs, typically the form of the largest, often internationally active enterprises, shares account for around 33 % of assets, whereas for smaller limited liability companies (Gesellschaft mit beschränkter Haftung, GmbH) it is only approximately 9 %.

Graph 2.3.10: Proportion of stakes and securities in firms’ total assets (in %) — large firms vs SMEs

Source: Bundesbank

Graph 2.3.11: Proportion of stakes and securities in firms’ total assets (in %) — incorporated vs unincorporated

Source: Bundesbank

Complementary data showing important transactions and financial crossholdings among firms in German corporate groups of affiliated companies further supports the hypothesis of financial assets being held especially for business strategy reasons. The aggregate results show that financial assets as a proportion of total assets are indeed substantially lower based on large corporations’ consolidated balance sheets (almost 13 %, end-2013) ([20]) than on average for the individual balance sheets of the same firms’ (around 27 %). In addition to the data on shares in individual firms’ balance sheets discussed above, this further supports the interpretation that financial assets are held by German non-financial corporates especially for strategic reasons. The aim could be to establish strategic ties with other firms that are linked to the international value chain of the company.

Graph 2.3.12: Marginal cost of additional domestic investment in different types of assets (in %, corporate level)

Source: ZEW (2014), ‘Effective tax levels using the Devereux/Griffith methodology’.

The impact of tax reforms on the incentives for corporate investment and the financing structure

Corporate taxation in Germany was substantially reshaped by two major tax reforms of 2001 and 2008. At the corporate level, the corporate income tax rate was gradually reduced and in 2001 the split-rate on retained and distributed profits was eliminated. At the same time, the tax base was enlarged by tightened depreciation rules and an interest barrier limiting the tax deductibility of interest expenses. At the level of the shareholder, the full imputation system of corporate and personal income tax was ultimately converted into a final flat withholding tax on capital income (dividends, interest and capital gains) (Box 2.3.2).

As regards domestic investment, the two tax reforms have increased the relative attractiveness of retained earnings as a source of funding, but not eliminated the positive debt bias, which is high in international comparison. Graph 2.3.12 shows that prior to the 2001 reform the marginal cost of debt-financed investment ([21]) at the corporate level was much lower than of equity-financed investment, across all asset types considered (industrial buildings, machinery and patents as a proxy of intangible assets). The ‘tax value’ of interest expenditure was large due to the high corporate income tax rate against which the deduction can be claimed and the ‘tax penalty’ for equity particularly high for retained earnings. By lowering the statutory corporate income tax rate and limiting the deductibility of interest expenses, the two reforms in the 2000s have narrowed the gap between equity and debt financing, although it remains positive. This has created a more neutral tax incentive structure, which has made retained earnings as a source of funds for investments relatively more attractive, but still less attractive than debt finance. Econometric work with firm level data (ORBIS database) for German corporations over the period 1998-2013 has been carried out by the European Commission’s Joint Research Center, focusing on the impact of the two tax reforms. First indications show that the effect of the tax reforms on excess savings of domestic operations is statistically significant, but of moderate magnitude, suggesting that tax changes are only one factor behind the observed trend in corporate savings ([22]).

Graph 2.3.13: Marginal tax advantage of debt — individual level (in %)

Source: ZEW (2014), ‘Effective tax levels using the Devereux/Griffith methodology’.

The tax reforms have also changed the incentives for financing real investment abroad. One of the hypotheses for the dynamics observed in German corporate investment and net savings is that corporations might have had incentives, including from the tax system, to redirect investment from the domestic economy to foreign locations. A forward-looking indicator of the marginal cost of investment, adjusted to account for relevant tax provisions, allows assessing the tax-adjusted cost of an outbound investment compared to an investment undertaken domestically for various financing modes. The analysis shows that using retained earnings in a foreign subsidiary to fund domestic investment is more expensive than undertaking the same (marginal) investment abroad. This is in particular the case when the parent company raises debt domestically to co-finance the investment abroad. The same is the case for an investment financed by new equity issued by the subsidiary. At the same time, the gap between the marginal costs of alternative investment scenarios has generally been shrinking over time, thanks also to changes introduced by the 2001 and 2008 tax reforms.

Average tax rates point to a general trend after 2001 towards a lower tax burden on newly setup foreign operations, e.g. investment via a new subsidiary. The effective average tax rate captures the incentives for locating abroad a discrete rather than marginal investment. The investment project is supposed to have a 20 % pre-tax return. Among the main destinations for German foreign direct investment, falling effective average tax rates are found in Belgium, the Netherlands, the Czech Republic and the US, while tax incentives for investing in Luxembourg have remained constant for many years ([23]). This can be attributed to the tax reforms in Germany as well as concomitant changes to the tax systems in potential source countries, notably their lowering of headline corporate income tax rates.

At the level of the individual investor, debt has been tax-favoured relative to equity since 2009. Measured by the marginal tax advantage of debt, which factors in both corporate taxes and taxes on interest, dividends and capital gains at the individual level ([24]), debt was relative disadvantaged with respect to equity between 2001 and 2009 (Graph 2.3.13). This was driven by the fact that due to the half-income system personal taxes on interest income were much higher than those on dividends and capital gains. By ending the half-income system, debt has again been tax-favoured since 2009, since all types of capital income became subject to a final flat withholding tax. This implied a strong reduction of the personal tax rate on interest income, which tax-favoured debt compared to equity. At the same time, retained earnings compared to dividends were tax-disadvantaged before 2001 since capital gains were fully subject to personal taxes while not benefiting from the full imputation credit granted to dividends. In addition, under the split system, undistributed profits at the corporate level were taxed at a higher corporate income tax rate than distributed profits. After the 2001 reform, taxes on dividends and capital gains were de facto aligned, resulting in a broadly neutral tax treatment between them (Box 2.3.2).

Changes in tax incentives have impacted on firms’ capital structure and pay-out policies, giving some weight to the hypothesis that the tax arrangements have supported corporate deleveraging and made retained earnings more attractive as a source of funding. A statistically significant relationship between the tax advantage of debt and the debt ratio has been found for a panel of German companies, indicating that an increase in the tax advantage of debt is associated with a higher debt ratio ([25]). The overall reduction in the positive debt bias at corporate level could therefore in principle be one reason behind German corporate deleveraging. There is also empirical evidence that the interest barrier, which has not been captured by the indicators used in the analysis above, has led firms to lower their debt-to-assets ratios and their net interest expenditure. Supposedly opposing its originally intended effects, national firms also adjusted their capital structure, and external rather than internal debt (i.e. intra-group lending) was reduced ([26]). At the same time, the tax favouring of debt at an individual level following the 2009 tax reform does not appear to have had a major impact on the corporate debt-to-asset ratio. Changes to the tax system have also created an incentive for accumulating reserves out of earnings as a source of funds. Asymmetric tax treatment of dividends and capital gains is one factor determining the way shareholders are remunerated. In the German case, the abolishment of the tax advantage of dividends and the lowering of the corporate income tax rate — which has correspondingly reduced the tax value of deductible interest — has increased the relative attractiveness of retained earnings as a source of funding for possible real investment by corporations. Before the 2001 reform, dividend payments were regularly preferred to repurchases of shares, whereas the reform appears to have reduced both the propensity to pay dividends as well as their size ([27]). Furthermore, the switch from the full imputation to the half-income system by the 2001 tax reform may have contributed to a reduction in share ownership diffusion ([28]).

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Box (continued)

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Box (continued)

Trade and financial linkages between Germany and other EU countries

The German domestic market represents an important export destination for several other EU Member States, and in particular for smaller neighbouring countries. German-bound exports are of major significance to Hungary and the neighbouring countries of Czech Republic, the Netherlands, Austria and Luxembourg, accounting for between 15–25 % of their respective GDPs. For Belgium and Poland, Germany also represents an important market with exports amounting to over 10 % of national GDP, while in Bulgaria, Croatia and Denmark the figure is somewhat lower but still significant at 6–8 %. The larger EU Member States — France, Italy, the United Kingdom and Spain — all show export linkages in the range of 3–4 % of GDP.

In terms of inward trade spillovers, German exports still depend on the EU market though the rest of the world has become progressively more important. In 2013, total exports of goods and services represented approximately 46 % of German GDP. German exporters depend on a set of large markets across the world, most importantly France (4.4 % of German GDP) and the United States (4.3 %), followed by the United Kingdom, the Netherlands, China, Switzerland, Austria and Italy, with figures ranging between 2–3.5 % of GDP. Other important markets include neighbouring Belgium, Poland and the Czech Republic, as well as Spain (all above 1 % of German GDP).

When measured in exported value added ([29]), exports to Germany remain significant for many geographically-close EU countries, reflecting integration into global value chains. In value-added terms, exports to Germany are most important for the Czech Republic and Hungary, while for seven other EU Member States ([30]) exports — in terms of value added — account for over 4 % of domestic GDP. In many cases, this reflects the upstream position of these countries in global value chains involving German firms (Graph 2.4.1).

In exported value added, German exports are most significant to distant large economies. The main destinations of German exports in value added terms are the United States, China and France, confirming the picture of increasing diversification in Germany’s external trade dependence (Graph 2.4.2).

Graph 2.4.1: Exports to Germany in value added as a percentage of exporters' GDP (in %, 2011; top 15 EU countries)

Source: World Input-Output database (2011). International Monetary Fund, World Economic Outlook database. European Commission. based on the methodology of Koopman, Wang and Wei (2014), 'Tracing Value-Added and Double Counting in Gross Exports', American Economic Review 104:2, pp. 459-494.

Graph 2.4.2: German exports in value added as a percentage of German GDP (in %, 2011)

Source: World Input-Output database (2011). International Monetary Fund, World Economic Outlook database. European Commission based on the methodology of Koopman, Wang and Wei (2014), 'Tracing Value-Added and Double Counting in Gross Exports', American Economic Review 104:2, pp. 459-494. ROW denotes the residual trading partner from a dataset comprising 39 trading partners.

Financial integration between Germany and other EU countries

Other EU Member States have large financial and banking exposures to Germany creating the possibility for significant outward spillovers. In 2012, financial interlinkages were strongest with Ireland and the Netherlands, where gross financial exposures to Germany via equity and debt instruments accounted for 95 % and 76 % of domestic GDP, respectively. Nine additional Member States, including the United Kingdom and France ([31]), registered exposures ranging from 15–35 % of national GDP. As regards the exposures of the banking sectors of EU Member States to Germany, the Netherlands, followed by Sweden, Italy and Austria recorded the largest exposures to Germany.

Germany is also a major funding partner and investor in several EU Member States. According to 2012 data, Germany is a major funding partner and investor, which holds domestic large gross financial stakes in Malta, Ireland, the Netherlands and Austria. For seven other Member States, including the United Kingdom, France and Spain ([32]), German financial assets corresponded to approximately 20–35 % of domestic GDP (Graph 2.4.3) ([33]). Funding from the German banking sector remains important for Malta and Cyprus as well as for the economies of Ireland, Austria and the United Kingdom ([34]). A large set of other Member States also benefit significantly from German bank funding ([35]).

Graph 2.4.3: Gross foreign assets of Germany as a percentage of counterpart GDP (in %, top 15 EU countries, excluding Luxembourg)

Source: European Commission based on Hobza and Zeugner (2014), 'Current account and financial flows in the euro area', Journal of International Money and Finance 48, pp. 291-313.

In terms of inward spillovers, Germany has the highest financial exposure towards the main financial centres of the EU and the United States. Luxembourg, the United Kingdom, France and the Netherlands are the countries where Germany’s financial exposure is largest. Exposures to Italy, Spain, Austria and Ireland are also sizeable (Graph 2.4.4). Foreign claims of the German banking sector are mostly exposed to the United States and the United Kingdom, a large proportion of which is invested in the non-bank private sector. France, Italy, Spain, the Netherlands and Luxembourg follow (Graph 2.4.5). The funding dependence of the German economy is largely concentrated in the same set of countries (Graph 2.4.6).

Graph 2.4.4: Gross foreign assets as a percentage of German GDP (in %)

Source: European Commission based on Hobza and Zeugner (2014), 'Current account and financial flows in the euro area', Journal of International Money and Finance 48, pp. 291-313.

Graph 2.4.5: Foreign claims of German banks as a percentage of German GDP (in %, by sector)

Source: European Commission based on Bank of International Settlements (2014), consolidated banking statistics (ultimate risk basis, Q2-2014). International Monetary Fund, World Economic Outlook database.

Graph 2.4.6: Gross foreign liabilities as a percentage of German GDP (in %)

Source: European Commission based on Bank of International Settlements (2014), consolidated banking statistics (ultimate risk basis, Q2-2014). International Monetary Fund, World Economic Outlook database.

Economic spillovers and euro area macroeconomic policy

Reinvigorating Germany’s aggregate demand would raise growth domestically and have the additional benefit of supporting the euro area recovery. Coordinating the policy stance at euro area level is of major importance to avert the risk of halting the economic upswing and the rebalancing process. It is in this context that economic conditions in Germany and their impact on other economies of the euro area are of particular importance. The persistently high current account surplus in Germany partly reflects remaining weaknesses in domestic demand. This implies that there is scope to strengthen Germany’s performance and at the same time contribute to foster growth dynamics and tackle downwards price pressures in the euro area as a whole. This appears particularly pertinent in light of the interplay between unprecedented monetary policy action, an appropriate fiscal policy stance and an ambitious structural reform agenda. Moreover, with Germany representing a large part of the euro area’s growing current account surplus between 2008-14, it holds a central position in ensuring that the euro area contributes to the G20 objective of strong and sustainable global growth over the medium term, including the pledge to take policy action to achieve a lasting reduction in global imbalances.

Germany and the euro area would mutually benefit from a more symmetric adjustment. With a goods export share of around 40 % to the euro area and about 60 % to the EU, economic conditions in other Member States play a key role for Germany. Since external demand markedly determines German firm’s investment and employment decisions, bringing an end to the demand contraction in other EU Member States would help strengthening their import demand and thereby boost German companies' confidence and longer-term sales expectations. It is therefore in the interest of the good functioning of both the German and the euro area economies to ensure that the adjustment becomes more symmetric than what has been observed in the past, further supporting the ongoing rebalancing of trade flows within the euro area (see Section 2.1). Given Germany’s strong production chain linkages with its euro area partners, German import demand considerably impacts other Member States' economic situation. Hence, providing the conditions for continued robust private consumption growth and addressing the remaining weaknesses in private and public investment would be beneficial to Germany in its own right and would in addition strengthen import dynamics, also due to the relatively high import content of investment goods.

Euro area partners directly benefit from Germany’s success in trade and share the risks of its reliance on external demand to drive growth. Euro area partners that are integrated in German firms' production chain benefit from their strong international price and non-price competitiveness. Almost half of German exports consist of imported intermediate goods of which around half of them are provided by other euro area Member States. Preserving Germany’s international competitiveness is therefore to the benefit of the EU's economy as a whole. At the same time, the strong dependence of the German economy on external conditions combined with the rather weak trend growth adversely affect economic prospects in the euro area. Just as euro area partners benefit from the trade prowess of Germany, they likewise suffer from the risks associated with the heavy reliance on external demand to drive growth. As shown by Germany’s low trend growth, securing Germany’s future economic potential depends on broadening its growth model, tapping more into domestic sources of growth. The current export-led growth model exposes Germany and its euro area partners to volatility in economic activity, which makes it more difficult for euro area partners to adjust production capacities and employment plans to meet fluctuating German import demand. Increasing the resilience of the German economy to external shocks by attaining over time a more balanced growth pattern is therefore in the common interest.

Policy settings as regards structural reform and fiscal policy are of direct importance for both Germany and its partners. Investment decisions in the private and public sector in Germany have a pronounced euro area dimension. While it is in the interest of the German economy itself to raise potential growth, this would also benefit the euro are as a whole since Germany’s weak potential growth implies that also euro area partners are likely to move along a flatter long-term growth path. Private and public investment that raises productivity and seizes the economic efficiency gains embedded in new capital would shift the German economy to a more dynamic growth path. This would have both a lasting positive effect on potential growth in the euro area and in the shorter term benefit euro area partners via the provision of investment goods to Germany. These positive spillovers would support the recovery of the euro area economy, which in turn would be to the benefit of the German economy itself given the sizeable share of the EU and euro area in German exports. Furthermore, improving the euro area economic prospects would help to re-channel a larger part of Germany’s excess savings towards investment in the internal market. Combined with investing more in Germany itself, these mutually reinforcing investments would increase the resilience of the German economy to external shocks. It would also reduce the risk of again experiencing large valuation losses of assets invested abroad, which could cause adverse wealth effects for German households and firms.

Higher public investment would strengthen growth in Germany and provide a considerable positive spillover on the euro area. Public sector investment can play an important role in addressing Germany’s overarching challenge of strengthening domestic demand and the economy's growth potential. It is a tool available to policy makers, which has the potential to impact productivity growth in the economy directly but also indirectly by improving conditions for private investment. As analysed in Section 2.3, Germany’s currently favourable fiscal position provides scope for additional public sector investment, in full respect of European and national budget rules. Current projections indicate scope annually of up to 1 % of GDP under Germany’s medium-term budgetary objective and of up to ½ % of GDP under its national ‘debt brakeֹ’. Therefore, even under the more constraining national 'debt brake', fiscal space exists for a timebound boost of public investment. As previously analysed by the European Commission ([36]), a positive boost to German public investment has a sizable effect on German GDP that grows over time. Private consumption increases, and German net exports fall during the first 4 years after the policy action. Initially, private investment falls, but in the medium terms private investment rises, as the rise in government capital raises the productivity of private production capital. GDP in the rest of the euro area falls in the very short term, but rises subsequently (see Graph 2.4.7). In the model simulation, the response of economic activity to a public investment boost is muted by a rise in the monetary policy rate. When monetary policy – as under the current circumstances - is constrained by the zero lower bound, the impact on economic activity is larger for Germany and growth in the rest of the euro area benefits already on impact. This assessment is supported by an economic analysis by the International Monetary Fund ([37]), which suggests that a four-year increase in public investment by ½ % of GDP would yield a persistent increase in Germany’s real GDP of ¾ %. In the case of accommodative monetary policy, it would also raise growth in the euro area by 1/3 %, with substantial positive effects on peripheral countries. In addition to the positive economic impact on Germany and the euro area as a whole, decisive policy action to increase public investment in Germany would strengthen confidence in the policy stance at the euro area level, thereby also facilitating the implementation of much-needed structural reforms.

Graph 2.4.7: Positive shock to German government investment

Dynamic responses to a positive 1% of GDP innovation to German government investment. Trade balance responses are shown as differences from unshocked path normalized by steady state domestic GDP; responses of other variables shown as relative % deviations from unshocked paths. Source: European Commission Calculations

Tax system

There has been no progress in shifting the tax burden towards more growth-friendly revenue sources. Revenues continue to rely strongly on labour taxation (22.1 % of GDP in 2012 vs 20 % in the EU-28) ([38]), which also implies a shrinking revenue base in view of demographic trends. The share of consumption taxes as a proportion of total tax revenues is below the EU average (27.5 % of total revenue vs 28.5 % in the EU-28). Moreover, the share of potential value added tax revenue lost due to the application of the reduced rate and exemptions is increasing ([39]). The federal government commissioned a study on the fiscal impact of the reduced value added tax rate (currently 7 %) ([40]), but this has not resulted in specific measures. The revenues from recurrent property taxes remain comparatively low (0.5 % of GDP in 2012 vs 1.5 % in the EU-28) and the valuation of property is outdated, dating back to market values of 1963/64 in the western federal states and 1935 in the eastern federal states. Although a reform of the municipal real‑estate tax (Grundsteuer) is part of the coalition agreement and announced in the 2014 National Reform Programme, no concrete action has been taken so far. Instead of relying more on less distortive recurrent property taxes, the trend of increasing real estate transfer taxes has continued. After Berlin, Lower Saxony, Schleswig-Holstein and Bremen in January 2014, also Hessen, from August 2014, and S